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April 30, 2003

Hanging On For Dear Life

By John A. Byrne

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  • Hanging On For Dear Life

Signal changes shake up market makers. Have dealers a fighting chance of survival?

Brutal competition from cutthroat electronic services, penny trading and a bear market - in a world of advanced automation - are eclipsing the once essential role of market makers.

Dramatic change is taking place in the Nasdaq and OTC trade execution business. So have market makers a fighting chance of survival?

Can market makers pick up the pieces in a business in which margins continue to be squeezed? Can they pick up the pieces while several desks acknowledge that their operations are now cost centers?

Some dealers are willing to try. Others are worried that this is a game with dire economic consequences ahead. Blaming it all on decimalization seems like the inescapable logic for many.

"The agency model only works in an auction market," said a market marker at a dealer in New York that handles retail orders. "The spread and the opportunity to earn a spread attracts competition," he added. "That's the only true force to determine the correct price."

The trading manager made his bleak comments in the questionnaire for the 2003 Traders Magazine Annual Survey of Market Makers. His comments echo the frustration of market makers across the industry, a group fighting a regulatory climate that some say is biased toward alternative trading venues - ECNs, in particular. ECNs can charge access fees, siphon away order flow from Nasdaq and may be better equipped to survive in a penny environment.

Dealers have lost much of their bread and butter business.

"The elimination of the spread has converted a competitive dealer market into a Third World market economy - pay me first and then I will supply the goods later," said the same trading manager.

The regulatory climate is the favorite whipping boy for recent steep job losses on trading desks. Some of the largest players, including Goldman Sachs and Knight Securities, have cut dozens of trading posts.

Another market maker said in an interview that more dealers are ready to throw in the towel if the environment does not improve. "If the bear continues, you will see more layoffs," said Marty Cunningham, head of Nasdaq trading at Wien Securities. "It'll be cease and desist."

But despite these difficulties, there are many dealers willing to bet there are ways to prosper. Indeed, Cunningham's former employer, Charles Schwab, which months ago eliminated about 250 trading jobs (including Cunningham's), in its Nasdaq market maker unit, has embarked on a massive overhaul of that operation. That's despite reporting softer volume in the first quarter of about 114,600 customer trades daily. That number was down some 13 percent from the fourth quarter and off 22 percent from a year ago.

Order Handling

Schwab, in a sign of the changed economics in trading, has installed an advanced order handling system called SmartEx for trades under 10,000 shares. And the firm uses an electronic system that replaces the human intermediary as part of the new cost-efficient strategy. This system can pick and choose where to offload positions. Schwab makes no bones that it believes the old market maker model of recent years is dead.