If Nasdaq block traders want to continue
their age-old practice of net trading, they'll have to ask their customers for permission. That's the fine print of the NASD's new riskless principal trade reporting rules.
From November 1, dealers must report the customer leg of a two-sided transaction as "riskless principal" if it is filled at the same price as the first leg. In addition, the NASD expects both legs to be filled at one price. That means no mark-ups or mark-downs as is customary in net trading. If market makers want to trade net they are now required to send a letter to the customer requesting approval.
The contentious ruling is a small, but telling victory for Nasdaq over dealers in its ongoing war to reshape the market along the lines of a New York Stock Exchange-style auction. In dictating how a market maker should report so-called "riskless principal" trades, the ruling reclassifies certain block trades as agency transactions.
Traders consider them risk' trades and were outraged when they first got wind of Nasdaq's plan two years ago. They appear stoic and resigned today.
Nasdaq considers riskless all block trades done with the Street by institutional dealers to satisfy customer orders. The dealer is not filling the order from inventory so he is not risking capital, Nasdaq contends. He should therefore execute the customer leg at the same price he received from the Street. The dealer is, in effect, acting in an agency, rather than principal, capacity. That gives him the right to tack on a commission, but not a spread.
In effect, Nasdaq is saying the block market for Nasdaq shares is no different than the one for listed shares.
The NASD is implementing the riskless principal trade reporting rule to appease retail traders who complain they are required to double count certain transactions. That causes them to double-pay their Section 31(a) fees to the Securities and Exchange Commission. The fee is levied at 1/300 of one percent of the value of each transaction. Retail traders are less concerned than institutional dealers about the loss of spread revenue as they may already be charging customers a commission. Also, customer limit orders earn them no spread.
Nasdaq's insistence that both trades take place at a single price flies in the face of the traditional dealer practice of net trading. Dealers typically transact the Street leg at one price, then mark it up or down to fill the customer leg. Thus, two prices. Dealers are understandably bitter. "It's all part of a larger plan to get to where consumers can trade stock without the intervention of a dealer," said one dealer who wished to remain anonymous. "They don't like my profit margins."
Those margins aren't that much higher than a listed trader's commission, however. Spreads on the most heavily traded Nasdaq stocks are only 6.25 cents while commissions on listed block trades are around five cents.
The victory, however, appears more symbolic than economic. The ruling does not prohibit dealers from trading on a net basis as long as they get their customers' approval. Dealers must send "negative" consent letters notifying customers that they intend to trade the account on a net basis unless the customer objects in writing. Dealers do not – as Nasdaq initially wished – have to send "affirmative" consent letters asking the customer to respond with a letter granting permission.
The customer-letter is the result
of a year of negotiations between several large institutional trading houses, the Securities Industry Association, Nasdaq and NASD Regulation.
The talks were kicked off by the NASD's August 1999 release of its Notices to Members 99-65 and 99-66, explaining the ruling and outlining its block trade presumptions. (The SEC approved the ruling in March 1999.) Both Nasdaq and the firms successfully petitioned the SEC three times to postpone the implementation date.
In February, Goldman Sachs, Morgan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney and Donaldson, Lufkin & Jenrette co-authored a letter to the SEC (also signed by an additional eight firms) requesting postponement. The reasons: systems issues and Nasdaq's "presumption that our institutional trades are effected on a riskless principal basis." None of the five firms would comment.
A NASD Regulation official, who requested anonymity, said the negotiations focused solely on how to obtain the required customer consent and not Nasdaq's presumptions. "It really is just one trade economically," the official said.
A trader disagrees. "If you bid for stock and you buy it, that's your firm's capital at work, period," he said. "I sat on the bid. I assumed risk."
Another half agrees. "If someone gets a call from a customer saying hey, I want to pay you for your research. Take 100,000 to buy and call me with a report' then I might agree with Nasdaq's thinking," he said. "But I don't get those calls. If we get 100,000 to buy it's because we already shorted them 25,000. Only one percent of what we do is riskless."
Customers call him if they see his offer on Nasdaq's Level II screen. He will fill 25,000 off his own book to win a mandate to work the remaining 75,000. He does not consider that 75,000 to be riskless, however.
"In my mind, the whole order is a risk order," he added. "If I lose money on that first 25,000, when does the 75,000 become riskless?"
Nasdaq believes the answer should be clear after the second, or customer leg, is filled. Nasdaq initially hoped firms would report the first, or Street leg, of the transaction as riskless principal and suppress the second leg when reporting to the ACT system. In the letter to the SEC, the firms called that set-up unworkable because they would not know if the first leg was riskless until after they had completed the second leg. They wanted to report the first leg as principal, per usual, and report the second leg as riskless principal. Nasdaq could then suppress the report of the first leg itself.
Nasdaq will now allow this as an alternative approach. In essence, it has decided that firms cannot judge the risk nature of the transaction until it is all over. Nasdaq is making changes to ACT to accommodate the new report.
"We will soon issue a new Notice to Members that will talk about this alternative approach as well as the net trading issue," said the NASD Regulation official. "We're coming to the conclusion of a long process where we've reached a result that works for everybody. Everybody seems to be happy with this."
Resigned may be closer to the truth. "Once we go to decimals next year the whole dynamic of how you charge on Nasdaq will change anyway," said Tony Cecin, director of equity trading at U.S. Bancorp Piper Jaffray. "We're not going to do our institutional business $10.00 to $10.02. You're not going to see two transactions. It will be a one-price transaction and an agency commission look-alike on both sides of the transaction. That's the same as we do for our listed institutional business today."
