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July 31, 2001

The Decimal Disaster

By John A. Byrne Editor

The deterioration in spread-based trading has taken hold like a cancer across trading desks, eating up revenues, and throwing some traders onto the sidelines. The pain is not spread evenly. A firm deriving a large portion of its revenue from investment banking activities, for instance, is less worried than a major wholesaler. The former often operates a dealer desk as an ancillary revenue source, not as a money-making machine.The latter depends heavily on the revenues generated from order flow.

Many market makers have taken it on the chin with penny pricing. The lackluster stock market does not help. But penny pricing has plunged the sword in deeper. The result, as the cockney trader might say, is bloody awful, mate. Adjustments are being made in trading practices to compensate for the loss of revenue (see Cover Story by Peter Chapman). Decimal pricing will reduce payment for order flow. Order-routing firms that send trades to wholesalers could see their costs for trade executions compounded if wholesalers are forced to charge some form of special commission. One analyst estimated that pre-tax earnings of Nasdaq market makers have slid some 40 percent since decimals were introduced. Meanwhile, some firms are waiting until after Labor Day to decide if another round of belt-tightening is necessary. "They are waiting to see how the markets perform," he said. "No one wants to cutback unless it is vitally necessary."

The big picture is more visible. The Nasdaq dealer market is in the throes of radical change. It resembles an auction market in which several forces are competing for customer assets. They are also affected by heightened technological advances and Washington regulation. Nasdaq's SuperMontage is an example of technology and regulation interacting. And it could hurl Nasdaq into the future with direct-access-style brokerage. Nasdaq has an extraordinary, some would say an unfair, headstart. The SuperMontage will derive order flow from retail and, presumably, small institutional customers. The latter may have no choice. Market makers in the penny environment may be squeamish about committing capital on certain block trades. When they later try to dispose of these blocks for a potential profit, it may be as risky as careening down Niagara Falls on a banana skin. Nasdaq is also counting on support from its current market makers for liquidity to prop up the SuperMontage. But some dealers - perhaps angry at how they were metaphorically thrown to the dogs - may have a better idea: Set up their own direct access units.

Many larger firms, which have market making units, own direct access brokers. Though direct access does not account for a large proportion of Nasdaq executions, it could grow immensely, according to some analysts. And that raises an intriguing question as to why the high premiums were paid last year for market making firms? Maybe the market making business is readjusting and will come back stronger. Certainly it is still a good franchise to own. However, it has become a game for the toughest players, say some traders. Only those players with the resources who know how to position stocks and manage risk will survive a cancer.