The rising volume of online retail order flow is bringing revolutionary change to market making in Nasdaq stocks.
Profit margins declined at many market makers in the past 12 months, continuing a trend fueled by federal regulations and trading in smaller fractions. But many firms are offsetting the margin squeeze with increasing amounts of online trades.
These firms are led by large wholesalers that benefit the most from online orders routed by smaller broker dealers. Topping the group in transaction volume are, in descending order, Knight Securities, the Nasdaq arm of Knight/Trimark Group, discount-brokerage giant Charles Schwab & Co.'s Mayer & Schweitzer subsidiary, and Herzog, Heine, Geduld, according to Boston-based AutEx.
The continuing profit-margin squeeze and the ascension of powerful wholesalers are some of the highlights of Traders Magazine's latest survey of market makers for the 12-month period ending March 31, 1999. These wholesalers make markets in a vast universe of over-the-counter stocks, including OTC Bulletin Board and Pink Sheet securities.
Knight Securities said it plans to increase the number of stocks it trades by ten percent in the coming 12 months, to slightly more than 8,100. Mayer & Schweitzer did not respond to the survey, while Herzog, Heine, Geduld projected increasing the number of individual stocks it trades, though it did not quantify the number.
The Charles Schwab subsidiary currently makes markets in about 6,500 stocks, while its cross-town rival Herzog, Heine, Geduld trades roughly 5,200 stocks, according to AutEx.
"We plan to make markets in every single stock on Nasdaq," said Kenneth Pasternak, president and chief executive of Jersey City-based Knight/Trimark. "The Internet is bringing revolution, and we are very bullish"
Knight Securities, the youngest and most successful market maker, had the benefit of $25 million of technology spending, with a further $20 million earmarked for 1999.
"We see the firm increasing its market share in Nasdaq trading," said Bryan Keane, an electronic financial-services analyst at BankBoston Robertson Stephens. "The firm has been very successful in getting online order flow and increasing their institutional business at the same time." (The investment-banking giant was lead underwriter in Knight/Trimark's 1998 initial public offering.)
Like many other market makers today, Knight Securities uses technical analysis to make fast decisions on how to position stocks profitably. "A good firm wants to be long on a stock when there are a lot of buyers, and to be short before everybody dumps the stock," Keane said.
Wholesalers, with lots of liquidity, don't face rigorous competition from electronic communications networks (ECNs) for order flow. That's despite a perception that ECNs' stock-trading muscle can intimidate trading desks in general.
"If I send my trade to an ECN, I am not guaranteed liquidity," Keane said. "If I go through a large wholesaler, I know it has the biggest book of business. I am guaranteed best execution."
Overall Picture
Meanwhile, the overall picture for market makers bodes well for large desks, while some doubt and uncertainty remains for smaller, less-capitalized firms, according to the survey. All told, 37 market- making firms responded, covering a representative sample of top market makers as well as medium and small-sized desks.
Many of the desks reporting declining profit margins in the Traders Magazine survey were small, while some of their larger competitors reported either stable or increasing profits. In some cases that was attributed to industry consolidation. One major wirehouse said the firm's net returns on Nasdaq trading had stabilized, having dipped in the past as a result of narrowing spreads triggered by the order handling rules and trading in smaller fractions.
Generally, the outlook for market making is good. With strong equity issuance, the majority of respondents, roughly 57 percent, or 21 market makers, said they plan to increase the number of stocks they make markets in over the coming year. Moreover, roughly 73 percent, or 27 market makers, plan to increase their capital commitment, reflecting the continuing surge in institutional and retail stock-trading volume.
Still, the onslaught of rapid-fire online day trading (as distinct from more orderly online trades accepted by discount brokers such as Palo Alto-based E*Trade) has undermined the ability of some market makers to provide trade-size guarantees.
"The ability to make automated executions and provide guaranteed size is changing dramatically," said Bernard L. Madoff of New York's Bernard L. Madoff Investment Securities, which makes markets in 200 stocks. "With these day-trading cowboys around, the risks are too great." Madoff stressed that his firm honors trade sizes of 5,000 shares.
George Jennison, head of Nasdaq trading at First Union Capital Markets in Richmond, said the reality is that the volatility created by online trading is a permanent phenomenon.
"Most people assert that volatility scares the mom-and-pop investors," Jennison said. "When they see the market at 100 at noon, dropping to 90 an hour later, and rising later still to 110, it makes them scared. But you know, I don't think anybody really cares."
Reflecting the changes brought about in part by the order handling rules, a sizable number of respondents in the survey, roughly 46 percent, or 17 market makers, reported an increase in the percentage of the limit orders they have executed in the past 12 months.
The dichotomy between large and small firms was most pronounced on the question of extended trading hours on Nasdaq, according to the survey.
The majority of respondents, 70 percent, or 26 market makers, opposed extending Nasdaq's trading day for investors – most of the opponents being small and medium-sized desks. Large desks, including Knight Securities, support full-fledged extended trading hours.
One Nasdaq trader, Tom Dudenhoefer of Raymond James & Associates in St. Petersburg, quipped that Nasdaq market making should be compacted into ten-hour days, four days a week. "We love three-day weekends," Dudonhoefer said.
Many small desks are reluctant to commit staff and money for extending the trading day, realizing that the main beneficiaries for extended trading would be large market makers with substantial trade volume and online brokerage accounts, one desk said.
Regardless, Pasternak of Knight/Trimark said that eventually all stock markets in the world will be interconnected and operating "24 by seven," meaning 24 hours a day, seven days a week.
