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January 3, 2006

Manning Rules Again

By Peter Chapman

A new NASD rule set to go into effect next month will cut into the profitability of Nasdaq market makers.

The NASD recently received approval from the Securities and Exchange Commission to extend Manning limit order protection to market orders. The new Rule 2111 prohibits a dealer from trading for its own account ahead of a customer's market order.

"If a firm accepts and holds a market order," Richard Wallace, the NASD's chief counsel, told a recent gathering of trading officials, "it cannot trade on the same side of the market. It must immediately offer the customer a fill at the same price."

The ruling, effective January 6, extends the protections given to customer limit orders 10 years ago. Then, the so-called Manning Rule was made effective, prohibiting dealers from trading ahead of customer limit orders.

The new rule applies to both market and marketable limit orders in both Nasdaq and listed names. It applies to orders received directly from customers as well as indirectly from other broker-dealers. Specifically, it prohibits a dealer from trading on the same side of the market for his own account unless he immediately thereafter executes the customer market order.

Dealers must "make every effort" to cross that market or marketable limit order with an order on the opposite side of the market priced at the NBBO or better, according to the new regulation.

The rule has been in the making for about one-and-a-half years and is already in effect at "most" broker dealers, according to the Securities Industry Association (SIA).

Knight Capital Markets began honoring the rule earlier this year, albeit reluctantly.

"This is a good one for investors," Tom Joyce, Knight's chief executive, told analysts, but "a somewhat negative one for revenue capture."

The industry did not put up much of a fight against the new rule. That's even though it removes the dealer and his profits from certain trades.

That's despite initial complaints by the Security Traders Association (STA).

The STA said that the rule "eliminates the ability of a market maker to earn a spread except in very limited circumstances."

The SIA's Manning committee stated in a letter to the SEC earlier this year that it "supported the concept of a Market Manning Rule."

The SIA added that "most member firms currently offer Manning protection to their customer market orders."

The SIA did have a few quibbles with the new ruling. But they were mostly of a technical nature.