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January 1, 2001

Market Makers Prosper: Benefiting from a boom in order flow and retail business, those market make

By Gregory Bresiger

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It is indeed the best of times for many market makers these days.

The Securities and Exchange Commission's much maligned order handling rules haven't hurt the market making business at all. In fact, they've helped it.

Those statements, which are privately made by some officials of several market makers, would have been inconceivable four years ago as the reviled regulators tried to clean up the bid-rigging mess at Nasdaq. Yet today, although many market makers privately say the controversial rules have not been bad for business, they still wonder if new regulatory and market problems are on the horizon.

Today some market makers worry about the possibility that the volume explosion will end as the market plummets into a bear market. Nevertheless, few of them could have expected the turnaround in the market making business over the last two years.

"Many who were hesitant before the order handling rules, now feel it's safe to trade on Nasdaq," according to one trading executive who didn't want to be quoted by name.

Trading firms, once oriented to the institutional investor, have been forced to pay attention to the previously neglected retail business.

"The retail investor has recently had such a profound effect on the primary and secondary pricing of securities, I think institutional firms came to the conclusion that they needed to see that kind of order flow in order to better price IPOs and in order to give their institutional traders an opportunity to sit in the middle of price discovery," said Lon Gorman, president of Schwab Capital Markets in Jersey City.

This retail business allowed trading firms to see "a variety of different kinds of order flows," he added. And Gorman says it is the main reason why institutional firms have been buying up retail trading firms.

Prosperous market makers with strong margins are back. In fact, the third quarter was a good one for most of the biggest ten firms in market making (see chart). That means that well-run independents are likely to be courted by giant financial institutions that want to expand their market making operations, which were viewed a few years ago as a drag on profits.

"Reports of the death of market making a few years ago were premature," according to David Whitcomb, the president of Automated Trading Desk in New York City and a business professor emeritus at Rutgers University in New Jersey. "And I should know because a few years ago I was making those predictions and I have to admit that today I am surprised," he added.

"Traders quite simply have been able to adjust to the order handling rules," said Sam Scott Miller, a securities attorney in New York. Just as traders and other financial professionals wrongly predicted that the end of fixed commissions would wreck the securities business back in 1975, Miller says, most well-run market making firms have been able to adjust and prosper in a new regulatory climate. Market makers, say analysts, are adding more securities. They are specializing in securities that have limited liquidity.

They are becoming parts of bigger operations that use internalization to generate bigger profits.