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August 31, 2000

Net Trading Under Fire: Riskless Principal Rule Could Crimp Margins

By Peter Chapman

Also in this article

  • Net Trading Under Fire: Riskless Principal Rule Could Crimp Margins

If Nasdaq block traders want to continue

their age-old practice of net trading, they'll have to ask their customers for permission. That's the fine print of the NASD's new riskless principal trade reporting rules.

From November 1, dealers must report the customer leg of a two-sided transaction as "riskless principal" if it is filled at the same price as the first leg. In addition, the NASD expects both legs to be filled at one price. That means no mark-ups or mark-downs as is customary in net trading. If market makers want to trade net they are now required to send a letter to the customer requesting approval.

The contentious ruling is a small, but telling victory for Nasdaq over dealers in its ongoing war to reshape the market along the lines of a New York Stock Exchange-style auction. In dictating how a market maker should report so-called "riskless principal" trades, the ruling reclassifies certain block trades as agency transactions.

Traders consider them risk' trades and were outraged when they first got wind of Nasdaq's plan two years ago. They appear stoic and resigned today.

Nasdaq considers riskless all block trades done with the Street by institutional dealers to satisfy customer orders. The dealer is not filling the order from inventory so he is not risking capital, Nasdaq contends. He should therefore execute the customer leg at the same price he received from the Street. The dealer is, in effect, acting in an agency, rather than principal, capacity. That gives him the right to tack on a commission, but not a spread.

In effect, Nasdaq is saying the block market for Nasdaq shares is no different than the one for listed shares.

The NASD is implementing the riskless principal trade reporting rule to appease retail traders who complain they are required to double count certain transactions. That causes them to double-pay their Section 31(a) fees to the Securities and Exchange Commission. The fee is levied at 1/300 of one percent of the value of each transaction. Retail traders are less concerned than institutional dealers about the loss of spread revenue as they may already be charging customers a commission. Also, customer limit orders earn them no spread.

Nasdaq's insistence that both trades take place at a single price flies in the face of the traditional dealer practice of net trading. Dealers typically transact the Street leg at one price, then mark it up or down to fill the customer leg. Thus, two prices. Dealers are understandably bitter. "It's all part of a larger plan to get to where consumers can trade stock without the intervention of a dealer," said one dealer who wished to remain anonymous. "They don't like my profit margins."

Those margins aren't that much higher than a listed trader's commission, however. Spreads on the most heavily traded Nasdaq stocks are only 6.25 cents while commissions on listed block trades are around five cents.