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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

* Hidden liquidity, held back for fear of swamping the market or disclosing information to brokers, dealers, or specialists. Instantly accessible when a trading opportunity arises.

* Flow liquidity, arriving over time as market orders.

* For-hire liquidity, made available short-term by a market speculator who hopes to turn a quick profit by buying at a better price than the selling price. These entities, usually a market maker, broker, hedge fund or similar party, are able to make quick capital commitments - for a price.

* Last-resort liquidity, provided when a natural buyer or seller - typically a value oriented investor - can be enticed to trade by available liquidity at an irresistible price.

Little and Large

Discovering (and dislodging) these pockets of liquidity requires a large expenditure of facilities (access) and personnel (relationships). From an institutional perspective, the extensive facilities maintained by top-tier brokers are indispensable for managing large pools of assets. At even five or six cents a share, they are often a bargain when measured against the potential negative impact and delay when trading large blocks.

However, an institutional broker that matches off natural buyers and sellers at a fair price with anonymity offers an agency-based business relationship. The buyer and seller pay a commission for the match making, as would occur in an auction market. In the absence of easy match making, however, the dealer role remains paramount.

Small institutional Nasdaq traders face an entirely different hierarchy of needs. Searching for liquidity is not as important as price, immediacy and clean handling. Historically, the organization at the top of the list is the Instinet platform. Instinet acts as agent, and collects an agency fee for providing the connection.

Liquidnet provides a similar service, tapping directly into the electronic order management systems used by institutional trade desks.

A variety of brokerage firms are aggressively pursuing the area of smart routing.' They are learning how to sweep, ping and tickle the ECNs to find liquidity and good prices. ITG, Bloomberg, UNX, ATD and others provide this service, competing on the basis of the cleverness of their routing and the cleanliness of their backoffices.

Some routing services are not electronic. Some brokers provide intelligent active routing to human market makers, positioning themselves in a traditional agency stance with respect to the dealers. Similarly, firms like Jefferies, Cantor Fitzgerald, Bob Brandt and Jones & Co. - the decades-old third market - serve as agents, searching for liquidity among dealers and natural trading partners.

The world of brokers can be divided into two groups:

* Navigators, with knowledge of and access to the multiple pathways to liquidity.

* Risk-takers, willing to accept occasional principal losses in return for high-level market participation.

The new for-commission brokers in Nasdaq securities will be in the navigator category. Since the navigators will control the commission, a reversal is likely in payment for order flow arrangements, a pattern of business arrangements so worrisome to some in the 90's.

In the past, dealers would pay the introducers to bring trades to them. In future, dealers will likely demand payment for maintaining a liquid market. This is consistent with the traditional risk-taker role of selling liquidity.