Locked and crossed markets are a reality of Nasdaq trading. They always have been.
But in recent months – with online investors flooding the market with orders, and some electronic communications networks (ECNs) refusing to trade with certain market makers – markets in Nasdaq stocks are locking more frequently than ever before.
"Firms are locking the markets without trying to reach the other side, and ECNs aren't trading with some market makers because they refuse to pay [access] fees," said Nicholas Ponzio, managing director of Jersey City-based market maker Hill, Thompson, Magid & Co.
"These problems didn't exist in the past. It's dissecting the market."
In normal situations on Nasdaq, the best bid, or buying price, is slightly lower than the best offer. The difference is the market maker's spread. But when a market becomes locked or crossed, the best bid will be at the same price as the best offer, or higher.
So in a normal situation, the best bid on ABC Corp., for instance, could be $10 a share, with the best offer higher, at $10 1/4. In a locked market, the best bid and the best offer would both be at $10. In a crossed market, the best bid would be at $10 1/4, with the best offer lower, at $10.
According to the National Association of Securities Dealers, Nasdaq averaged 104 daily locked or crossed markets of one minute or more in January. Nasdaq averaged 51 locked or crossed markets a day last August, and only 22 daily locked or crossed markets the previous January.
Averaged out, three-tenths of one percent of all daily quotes on Nasdaq were locked and crossed for a minute or more in January.
Last August, only two-tenths of one percent of all daily Nasdaq quotes locked. In January of 1998, just one-tenth of one percent of all daily quotes locked or crossed the market.
With 327,303 Nasdaq inside-quote updates a day this January, 104 locked or crossed markets may seem insignificant. But tripling in frequency over last year, locked markets have become a greater frustration for market makers and broker dealers seeking executions.
"It's a real problem," said Ben Marsh, managing director of over-the-counter trading at Adams, Harkness & Hill, a Boston-based market maker. "The system is out of whack. It's got to be cleaned up somehow."
Market makers and broker dealers cite two factors for causing the tripling of locked and crossed markets over the last year: the boom in online orders, and ECNs refusing to trade with certain market makers which have not paid access fees.
Online Exuberance
According to London-based Reuters Corp., first quarter online trading volumes in the U.S. rose more than 30 percent from the fourth quarter of 1998, to 450,000 trades a day. That surge in online trading volume came despite overall market volume rising less than five percent.
With online volume booming, broker dealers handling online order flow have struggled with the glut of new business.
"There are so many more participants, so much order flow, so much business," said Dan Kravits, director of Nasdaq trading at Chicago-based market maker EVEREN Securities. "Things are happening so much faster than they ever did. Nasdaq itself can't handle the influx of orders and make sure the markets are set up appropriately."
Some traders also blame wholesale market makers, the main recipients of online order flow, with causing the increase in locked markets, particularly with trading in new issues.
For example, a market maker with a large volume of retail buy orders – particularly before the market opens – may note that the best offer in the market is for fewer shares than it needs to buy to fill those orders. So to move the market and fill its orders, the market maker may enter a bid at or higher than the current best offer to lock the market, hoping to get other market makers to adjust their quotes.
"Wholesalers jack-up their prices at the opening, then short the stock before the prices retreat to regular levels," said Michael Barone, head of Nasdaq trading at William Blair & Co., a full-service broker and investment bank in Chicago. "It happens every day in dozens of stocks. It's a problem that needs to be looked at."
Nasdaq's leading wholesaler, Knight Securities, a unit of Jersey City-based Knight/Trimark Group, has been cited by some traders for frequently locking the market.
But Kenneth Pasternak, Knight/ Trimark's president and chief executive, blames increased volume and technology disconnects – and not wholesalers – with locking the markets.
"There is a real pricing imbalance," Pasternak said. "There should be balanced supply and demand in the market. But online investors move on news, and they come into the market in a narrow time frame all wanting to trade in the same direction."
He added that some broker dealers are trying to respond to the large flow of online orders in a non-automated fashion, which can cause locks in the market. "I'm an advocate of electronic order delivery," Pasternak said. "Integrated delivery and execution could make a lot of locks irrelevant."
Traders also blame the reluctance of certain market makers to talk to each other over the telephone – a result of U.S. Department of Justice investigations two years ago – as contributing to locked and crossed markets.
"It's hard if not impossible to get another market maker on the telephone," Ponzio of Hill, Thompson, Magid said. "With a crossed market, you're dealing with a firm inundated with orders. You need to talk to them to help find a good price."
Fee Battles
Knight/Trimark is also in the middle of the controversy surrounding ECN access fees, with certain market makers refusing to pay those fees.
This month, the Jersey City-based wholesaler, which has refused to pay fees for accessing quotes on Attain, the ECN operated by All-Tech Investment Group, is scheduled to contest charges at an NASD arbitration hearing.
All Securities and Exchange Commission-approved ECNs are allowed to charge fees to firms accessing quotes in that ECN. But some market makers – who are not allowed to charge fees when their quotes are accessed – have refused to pay those fees. ECNs, in turn, are not trading with firms that have failed to pay access fees.
"The ECNs are telling us we have to be their customers to trade with them," said Marsh of Adams, Harkness & Hill. "The SEC should make ECNs trade with anybody. I don't charge a fee to hit my bid. Why do I have to pay a fee when I hit someone else's bid?"
When an ECN at the inside market refuses to fill a market maker's order, the market maker is forced to short the stock and change its quote to fill its customer's order. Shorting the stock without being able to find the shares at the appropriate price in the marketplace locks the market.
"When I can't buy it at the ECN price, I can't penalize my clients for that," Barone said. "So I have to lock the market to fill that order."
Pasternak said ECNs that refuse to trade with certain market makers may be shirking best-execution responsibilities by not acknowledging the other side of a trade.
"All liquidity providers that display quotes should not be allowed to charge other liquidity providers access fees," he added. "Absent that, there is a real disparity between ECNs charging fees and market makers not being allowed to charge fees."
But Harvey Houtkin, chairman and chief executive of All-Tech, said regardless of whether a market maker approves of ECN access fees or not, they are required by law to pay them.
"It's a disgrace that certain market makers are not paying fees," Houtkin added. "I want these people cited for not paying their bills. It rings of scandal. We are approved by the SEC. They knew we charged access fees when the traded with us. When they refuse to pay, it's the same as shoplifting. It's theft of services."
Houtkin said that about 30 broker dealers, including Knight/Trimark, are withholding payments for accessing Attain quotes.
Unlocking Markets
The NASD's recent agency-quote proposal, currently awaiting SEC approval, could alleviate many of the problems associated with ECN access fees. The proposal would allow market makers a second quote, separate from their proprietary quote, for agency orders. Market makers would be allowed to charge fees for firms accessing their agency quotes.
"The agency-quote proposal recognizes the problem, and attempts to deal with it," Pasternak said. "It recognizes the need for a frictionless market."
Also awaiting SEC review is an NASD proposal for a one-year pilot program that would require a firm locking or crossing the market between 9:20 a.m. and 9:30 a.m. to send a message via SelectNet to the firm whose quotes are being locked or crossed.
The message recipient would then have to trade with the message sender for up to 5,000 shares, or move its quote within 30 seconds of receiving the message.
Tied to the one-year pilot program is a third NASD proposal that would require market makers to lower their quotes whenever they fail to execute a large order. They would also be prohibited from using an electronic system to repeatedly execute small orders at the same price, while the large order goes unfilled.
Aside from the three pending proposals, the NASD can also fine firms up to $15,000 for locking or crossing the markets. By checking SelectNet messages, the NASD will fine a market maker for locking or crossing a market only if that market maker did not first try to find the other side of the trade.
But many traders feel the NASD and the SEC should do more to decrease the occurrence of locked markets.
"I'm surprised the NASD and the SEC have not resolved the issue by now," Barone said. "This is a sophisticated marketplace. It's interesting that it's still a problem."
A spokesman for the NASD said it hoped the new proposals would alleviate many of the problems causing locked Nasdaq markets. Beyond those three measures, the spokesman stressed that market participants can offer any additional ideas through Nasdaq's industry committees.
An SEC spokesman said the agency recognizes the problems of locked markets on Nasdaq, but maintained that it is primarily the NASD's issue. "We are currently working with the NASD on the underlying issues as they relate to locked and crossed markets," the SEC spokesman added.
