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December 1, 1998

The Big Question: Moving to Commissions on Nasdaq?

By Michael O'Reilly

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With the cost of trading rising on the sellside, Nasdaq market makers and their institutional clients are speaking publicly in favor of a shift in how block trades are handled from net trading to a system based more on commissions.

The shift would effectively change the very structure of the dealer market, with market makers acting more as agents than principals on most institutional trades.

On the buyside, institutions generally support the move toward commission-based trading because they believe it would create more liquidity in Nasdaq, and improve overall trading performance.

For sell-side traders, commissions would likely alleviate some of the financial pressures of declining profitability.

The evidence, gathered by Traders Magazine, suggests that competitive forces are among the primary reasons the transformation to a more agency style of institutional trading has not yet occured.

Despite the general welcome for commissions on Nasdaq, most market makers and buy-side traders seem reticent to be the first to step forward and unleash commission-based trading.

"The only thing that is going to force Nasdaq to move to agency trading is a 800-pound institutional gorilla like Fidelity [Investments], Putnam [Investments] or Alliance Capital [Markets] coming forward," said George Jennison, head of Nasdaq trading at Richmond-based Wheat First Union. "What's holding back the shift is somebody wanting to trade for commissions exclusively. Nobody on the buyside has said that yet."

Other traders believe one of the major Nasdaq market makers will have to first make the jump to commissions.

"That's the question, who's going to go to commission's first. It's not going to be EVEREN," said Dan Kravits, director of Nasdaq trading at Chicago-based market maker EVEREN Securities. "I think one of the big New York market makers will have to come forward and make a statement they are going to switch. Once a large firm moves, other firms will follow."

At the moment, Nasdaq institutional trades are primarily handled on a net basis, with market makers profiting on the difference between the buying and selling price of a stock or the spread.

Nasdaq market makers act as principals on trades between institutional clients, buying stock from one client and taking it into their own accounts before trying to sell that stock to another client at a profitable spread.

But with spreads narrowing in recent years due to new regulations and smaller trading increments, market makers are profiting less on each transaction.

"Spreads have gotten so narrow that market makers are trading stocks at losses," said Jamie Atwell, head trader at Nicholas Applegate Capital Management, a large San Diego-based asset manager. "It's a hard thing on the sellside knowing you're going to lose money on a position because the spread is too narrow. With commissions, at least a market maker will know he's going to collect something on a trade."

If negotiated commissions replace spreads on Nasdaq, market makers will simply charge set fees on institutional trades, acting as an agent rather than a principal. Many small retail orders on Nasdaq are already handled on a commission basis.

"You're going to have a transition from a negotiated market to a quasi-auction market," said