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July 31, 2001

Nasdaq Market Makers Rescue Plan: When is a commission not a commission? When firms facing downward

By Peter Chapman

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  • Nasdaq Market Makers Rescue Plan: When is a commission not a commission? When firms facing downward
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Faced with thinner spreads because of decimalization, anxious Nasdaq market makers are charging a commission-like fee to prop up their ailing trading businesses.

The new charge, which is called a "commission-equivalent," is being added to or subtracted from execution prices by some market makers when filling the orders of institutional customers.

At around five cents per share, its purpose is to replace lost profits stemming from this year's five-and-a-quarter cent cut in the minimum trading increment.

The practice is not yet widespread. However, it is gaining traction among the larger East Coast brokers. Among them are Merrill Lynch and UBS Warburg, according to those firms' head traders. The charge is used in relatively few trades today, but is expected to become more popular in three to six months.

The fee is one more step on Nasdaq's long, tortuous road to agency trading, but it is a big one. Since the mid-90s, the Nasdaq market has been forcibly reshaped along the lines of an agency market. Manning, the order handling rules, ECNs, decimalization, riskless principal trading, SuperSOES and SuperMontage are the primary driving forces. Fee-charging by dealers is seen as the final nail.

Minimum Increment

Nasdaq's adoption of decimal trading this April cut the minimum trading increment from one sixteenth of a dollar, or six-and-a-quarter cents, to one cent. Quoted spreads, or the difference between market maker bid and ask prices, have gone in the same direction. Competition has driven them down to a penny on some of the most actively traded stocks -the favorites of the institutions. Since those spreads are the source of dealer profits, margins have been squeezed.

Stocks with smaller capitalizations have seen their spreads tightened as well.

"We provide capital which creates liquidity," said Pat Davis, co-head of Nasdaq trading at UBS Warburg. "For that to continue, there must be compensation. Penny spreads are not fair compensation."

Rather than fight a war of attrition in the hope that spreads widen, market makers are declaring themselves in the service business. Like a commission, the commission-equivalent is a payment for services rendered. But where the commission pays for agency representation of a customer's order, the commission-equivalent pays for capital commitment.

"The commission-equivalent is a step along the way to a market that will have a much larger agency component," said Leo Ressa, Merrill Lynch's head of Nasdaq trading. "One where institutions pay true commissions," he added. Merrill has, in fact, been handling orders on a pure agency basis for a few customers for over a year, according to Ressa.

On its surface, the move is not as radical as it sounds. A commission-equivalent is essentially an out-of-the-closet sales credit. The sales credit is the fee negotiated by the market maker and his customer that determines how much over or under the market maker's execution price the customer will pay or receive. While it is, in effect, a charge to the customer, it is deemed part of the price of the stock he pays or receives. It is usually not disclosed on his confirmation.