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August 31, 2001

Agents in the Nasdaq Field: Firms not ready for the new era of commissions risk marginalization

By Wayne Wagner

Also in this article

  • Agents in the Nasdaq Field: Firms not ready for the new era of commissions risk marginalization
  • Page 2
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Nasdaq dealers have lost their long-held ability to control the spread and maintain their accustomed profitability. That's because new market regulations allow the buyside, or non-dealer trading naturals', to place limit orders into the Nasdaq quote display.

Dealers wonder if they can survive the cost squeeze and still provide smooth functioning, liquid markets. Will it be economically feasible to imbed the cost of transacting services into the trading price of Nasdaq stocks?

The root of their problem is narrower spreads, a problem caused by decimal pricing (and the limit order protection rules that proceeded this). The dealers are worried. The traditional market-making functions under these conditions can't be performed.

With the time-honored practice of embedding the so-called dealer vigorish' or net price in the trade disappearing, dealers see hope in explicit commission charges on Nasdaq trades.

That raises the question, why exactly do Nasdaq stocks trade without commissions? On an agency trade, an investor pays a broker a fee to represent his trade to the market. In a dealer market, an institution buys and sells from a dealer who marks up the price to cover costs. That means the dealer is the market.

The markup' pricing is similar to what we find in retail stores. In contrast, the agent receives an explicit commission in a real estate sale between private parties. This distinction sounds clear, but gets fuzzy in the middle. Conversely, some brokers executing Nasdaq trades currently charge a commission. A trader using Instinet, Bloomberg, Liquidnet or POSIT already pays a commission on a Nasdaq trade. ECNs make no distinction, and charge a commission on a Nasdaq or listed trade.

Most importantly, electronic trading can bring the buyer and seller together at the mid-spread price. By eliminating the middleman, price improvement can lead to a net execution price, including a commission, that is better for both parties than a trade with a dealer.

Electronic trading provides total anonymity, where no entity (except the system provider) knows the identity of the trader. This appeals to institutional traders who fear that revealing their trading interest to a broker or a dealer can work to their disadvantage. As ECNs proliferate, businesses are forming that rapidly scan the many pools of liquidity for the best available price.

Agents, on the other hand, charge a commission on Nasdaq trades because they provide linkage between naturals or between a natural and a dealer. Collecting a commission is how they finance the provision of their services.

Block Trading

Plexus Group's universe of institutional trading data indicates that the average institutional trade dollar is part of an order that exceeds a day's trading volume. Many large orders trade continuously for days or even weeks.

Thus it is important to differentiate the facilities that work best for small trades versus larger trades. A large trade (say 250,000+ shares, or greater than a quarter of a normal day's volume) will not find handy liquidity already revealed in the quote. Large trades need to seek out liquidity, whether or not it is currently visible in the market. Plexus Group has identified five levels of liquidity:

* Revealed liquidity, aggregated into the quote montage.