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November 1, 2000

Madoff: Profits Safe in Net Trade Rule: Nasdaq's New Backdoor Way of Reducing Section 31 Fees

By William Hoffman

Nasdaq's new riskless principal trade reporting requirement shouldn't hurt dealers' bottom lines, according to a Nasdaq trading chief who helped craft the rule.

It could bring some welcome relief, however, from Section 31 transaction fees, he added.

"There is a perception that a very large percentage of all Nasdaq trades are these riskless principal trades," said Andrew Madoff, a member of the Nasdaq trading rules subcommittee that promulgated the rule.

Future Shock

Such trades, now counted as two or more trades, might be consolidated under the new rule, relieving traders of duplicate Section 31 assessments. "But I think people will be shocked to find how little [duplication] there really is," Madoff cautioned.

Madoff, who is also director of Nasdaq trading at Bernard L. Madoff Investments in New York City, said the subcommittee negotiated more than two years with dealers and regulators to bring Nasdaq trade reporting more in line with the auction style in New York Stock Exchange-listed trading.

The new rule requires that Nasdaq traders handling institutional orders obtain their customers' permission to trade on a net basis. Dealers have to report the customer part of two-sided transactions as "riskless principal," if filled at the same price as the dealer part.

Institutional Dealers

Nasdaq considers certain block trades "riskless" when done by institutional dealers to fulfill customer orders. The rule is expected to reduce, if not eliminate, mark-ups and mark-downs customary in net trading, leaving dealers the right to add a commission, but not a spread.'

Lee Korins, chief executive of the Security Traders Association, exclaimed, "I didn't expect this [rule] to come about [so soon]," and added, "Nobody was prepared for it."

Korins agreed with Madoff's judgment that the rule is meant to cut down on the number of transactions reported twice to Nasdaq when, in fact, two transactions may constitute a single trade. "There's nothing wrong with that," Korins said, though the definition of "riskless principal" is not clear to all participants, he argued.

Korins also said congressional sources and industry participants he has spoken with expect a 5- to 10-percent reduction in overall Section 31 fee collections as a result of the new rule.

On the other hand, Kenneth Pasternak, chief executive of Knight Trading Group, said he's heard compelling arguments on why riskless principal transactions may be exempt from Section 31 fees. Given Knight's role in fulfilling limit orders as riskless principal, he said the new rule could lower Knight's Section 31 assessments by as much as 40 percent.

"I think there is a good case to be made that these transactions are exempt from Section 31 fees," Pasternak said.

New Services

Knight is in discussions with clients about offering services to take advantage of the new rule. Other firms could soon start exploring the opportunity, Pasternak said. "You'd have to create some fairly complex software" for firms not already involved in riskless principal transactions, he said. "It's not impossible, but it's not trivial either."

"It's all about giving the marketplace innovative flexibility to offer new products and services," he added.

Nasdaq did not respond to questions about the new rule.

Several broker dealers contacted for comment said they considered themselves prepared for implementation of the new reporting requirement.

Complex Rule

Madoff acknowledged the rule's complexity, but said he expects Nasdaq regulators "will take a more cooperative approach" toward dealer compliance in the early weeks of the new rule.

Some firms are reviewing the new rule, even though they expect it will have no impact on them.