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April 30, 2002

Light at the End of the Tunnel...

By John A. Byrne Editor

A drive - bordering on fanaticism - to reduce costs when businesses are loosing money is an old trick borrowed from the texbooks of Harvard. It's simple: A business is losing 100 grand. Two employees equal 95 grand. Fire the employees and toss out the water coolers. Problem solved. It is not a creative approach but a sort of destructive alternative used by financial engineers to make both sides of the ledger neatly balance. That same approach may be evident in the current drive to reduce costs in the institutional trading markets.

If you listen hard enough you'll hear it over and over: Cost control - knock it down - is the mantra. A study by the Plexus Group discovered that institutions pay up to 46 cents per share in hidden trading costs, a sum that equals $100 million each year. Of course, the only reason cost control is a mantra is because the stock market has been upended by federal laws, declining indices and a reduction in volume. Mutual fund complexes, as well as dealers on the sellside, face the same challenge: How can they become more profitable? Some on the buyside think part of the answer comes from bypassing intermediaries, such as market makers.

Indeed, there is a "buzz" - it's the only appropriate word - about some upstart trading systems that allow buyside institutions to meet each other directly without a market maker touching the trade. There are efforts to reduce broker lists on buyside desks. One major fund, for example, is planning to reduce the volume of business it routes to the sellside by 50 percent. Sure, the drive is actually producing gains on paper for institutions. But the argument that dealers or intermediaries are somehow directly responsible for higher transaction costs is specious. Market makers as a group do add economic value (as Wayne Wagner, the noted market expert with the Plexus Group, argues in this issue).

A frequent refrain is that the market is bifurcated. And it is the interaction of these two parts that is the root cause of our market problems, including some of the hidden costs of business: On the one side are the retail investors; on the other are the institutions. The interaction causes volatility and price discovery nightmares. It turns the search for liquidity into a kind of blind man's bluff. Whatever nonsense is taking place, it is time it was fixed. Perhaps, the industry is headed, as some have suggested, in two directions: One marketplace for retail investors, another for institutions. It might not be a bad solution. It is outrageous that the best prices on some individual stocks publicly quoted in the U.S. markets (quotes accessed by deep-pocketed institutions) might sometimes only reflect 100 shares. Where's the liquidity? Perhaps these nickel and dime orders should be executed only in a special market center, a center run by part-time librarians in Idaho.

For more, turn to this issue's Traders Magazine Annual Survey of Market Makers. Is there light at the end of the tunnel for market makers? The survey picks up that question. The answer is a little more creative than some may think. Ah, it's called commissions.