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May 31, 1998

The Market Makers' Research Challenge:Sell-Side Traders More Closely Following Stocks They Trade

By Michael L. O'Reilly

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Long gone are the days when a market maker could just sit at a desk and trade.

Some fundamental market changes and a hard-nosed business sense have forced over-the-counter traders to reduce the odds of taking unprofitable positions. More than ever before, sell-side traders are researching the stocks they trade.

"Nowadays, I would say I spend 30 percent of my work day doing research," said Nicholas Ponzio, managing director of equity trading at Jersey City-based Hill, Thompson, Magid & Co. "I make more effective decisions the more I know about a company."

While 30 percent may be high for others, most traders are studying research to perform effectively.

"A well-informed trader is a better trader," said Bill Rothe, head of equity trading at BT Alex. Brown in Baltimore. "A trader not knowing a stock's name is a thing of the past."

Generally, sell-side traders are short-term buyers and sellers. Traders typically do not make investment decisions based on long-term goals. Market makers need liquidity, order flow and a spread to profit in position trading.

But with tighter spreads and profitability declining on equity-trading desks, traders need to make more informed decisions to maintain a competitive edge. Studying research is now of paramount importance.

"Trading has gotten so much more competitive and difficult," said Peter DaPuzzo, president of equity sales and trading at Cantor Fitzgerald in New York. "Traders need to know their stocks so much better."

A 40-year Wall Street veteran, DaPuzzo recalled that in the past, OTC traders just came onto the desk and traded. But over the last ten years, several factors have increased an equity trader's responsibilities.

The Past

In January 1997, the Securities and Exchange Commission imposed the order handling rules, requiring market makers to publicly expose customer limit orders and display the best prices quoted on private trading systems.

Last summer, the U.S. stock markets reduced their minimum quote increments for all stocks from eighths to sixteenths.

With the new rules and smaller increments, Nasdaq spreads narrowed by about 30 percent. Consequently, many Wall Street desks saw profitability decline.

"Trading isn't quite as profitable as it used to be," said Bill Allyn, head of block trading at Los Angeles-based Jefferies & Company. "I think a lot of desks have had to reexamine the way they do business to remain profitable."

To combat declining profitability, major Nasdaq broker dealers stopped making markets in certain stocks. Last September, for example, global giant Merrill Lynch & Co. dropped more than 300 Nasdaq stocks, or 40 percent of the Nasdaq stocks the firm traded. Another Wall Street giant, Bear, Stearns & Co., trimmed its Nasdaq roster from 550 to 450. And New York-based PaineWebber reduced its Nasdaq count from 735 to 525 in 1998.

With trading less profitable, desks are more closely following the stocks they trade, hoping to minimize the impact of trading on a net basis, largely a result of less profitable retail-sized order flow.

"The industry has changed so much in the last two years, I think trading desks had to really study their operations to keep the business profitable," Ponzio said.