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April 30, 2000

Fragmented Dealing Under Fire

By Peter Chapman

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The Securities and Exchange Commission is taking a critical look at a fundamental practice in the dealer market.

Filling customer orders out of inventory rather than exposing themto the broader marketplace is the focus of a 30-page concept release on market structure published by the agency in February. The regulator is trying to determine whether the fragmented nature of over-the-counter trading leads to poor fills for investors.

The SEC's move comes in the midst of a sea change in stock dealing at several large wirehouses. Merrill Lynch and Salomon Smith Barney, for instance, plan to trade on a principal basis in significantly more stocks than they do today. The hope is to offset declining commissions with higher trading revenues. Other dealers are expected to do the same, traders say.

The pace could quicken even further, they add, if the SEC approves the New York Stock Exchange's rescission of Rule 390.

Nearly 200 firms compete for order flow in the OTC market. Most either internalize or pay for their order flow. Wirehouses internalize when orders are transmitted from registered representatives in the front office to the firm's dealing desk. Wholesalers and wirehouses both pay for order flow when they rebate or otherwise compensate other order-sending brokers.

The SEC's big question: Should a trading room be the last stop for these orders? The academic experts and the buyside generally say it should not. The sellside is split, but says the pluses of a competing dealer structure outweigh the minuses. Commenters had 80 days to consider two major issues.

The first is whether dealers should attempt to fill market orders at prices better than the prevailing best bid or offer. That's called price improvement.' Most buy orders are executed at the national best offer while sell orders are filled at the bid. The spread accrues to the dealer and not to the investor.

The second is the question of time priority. The SEC is trying to decide whether or not to ban dealers from trading ahead of pre-existing limit orders or dealer quotes in other market centers. Currently, a market maker is not required to take out a quote or order posted by another market maker, exchange specialist or alternative trading system (ATS), even if it came first.

This is perhaps the most contentious of the two issues. Market makers say if they are forced to route their hard-won order flow to other execution centers, they won't compete as aggressively for those orders in the first place.

"People want to be able to retain their order flow," said Bernard Madoff, president of Bernard L. Madoff Investment Securities. "And they should, providing that their customers get the best price available. Matching [the NBBO] should solve that."

The authors of the SEC concept release aren't so sure. They wonder whether the SEC shouldn't mandate a market-wide linkage system complete with rules requiring market makers to send out orders they do not price improve' to other venues. The proposal has been dubbed a hard CLOB,' or central limit order book. It is hard' because its usage would be mandatory. (In contrast, Nasdaq's proposed supermontage is considered a soft' CLOB because it is voluntary.)