Nasdaq will introduce next month a rule change it hopes will cut down on the number of markets that open locked or crossed. The problem is that most market makers don't think it's enforceable.
The much-flouted Rule 4613(e), which loosely regulates locking and crossing of quotes by market makers and electronic communications networks, has been overhauled. Market makers' will be hit in the pocket book, forced to buy or sell at least 5,000 shares, if they flout the new requirements.
The amendment by the National Association of Securities Dealers goes into effect on May 15, which is the same day Nasdaq implements its SuperSOES system.
Under the rule change, if a market maker locks or crosses another trader's quote between 9:20 a.m. and 9:30 a.m., the market maker is required to send a special SelectNet message stating trade-or-move' to the locked party, offering to trade at least 5,000 shares. The recipient of the message must then trade or move his quote.
As it now stands, Rule 4613(e) simply instructs traders to avoid locking or crossing markets by making a reasonable attempt to trade. Most reportedly do not.
Stocks opening locked or crossed have bedeviled traders with greater frequency in recent times. Traders say it is difficult, if not impossible, to trade a stock when the bid is equal to the offer in a locked market, or is greater than the offer in a crossed market. Many don't bother to trade.
In a normal market, the bid, or the price at which a market maker is willing to buy stock, is lower than the offer, the price at which he is willing to sell stock.
The anomaly occurs when one market maker purposely locks or crosses the quote of another to force him to either update his quote or move out of the way. His goal is to push up the offer or force down the bid to suit his trading strategy. If the second trader does nothing then the market will open locked or crossed.
A trader, for example, might start his day flat or short a particular issue, but will have a large number of buy orders to fill. He presumably believes the market will rise once it opens. If he has guaranteed his customers the opening [offer] price he may try to game' the pre-opening offer higher so he doesn't lose money covering his position in a rising market. Better to push the market higher before, rather than after the open, he would reason.
To game the market, he will enter into the Nasdaq system a bid equal to and an offer higher than the best offer. That locks the market and sends a signal to the locked party to get out of the way. He is supposed to send a SelectNet message indicating a desire to trade, but usually doesn't. Trading is not his intention.
Nasdaq Wholesalers
In most cases, the locker' is a Nasdaq wholesaler with a backlog of retail orders that came in overnight, or a large program trade to execute. One of the largest wholesellers is considered a major locker. The new rule aims to improve the landscape.
"We expect the rule change to reduce the number of locked and crossed markets at the open and to increase the communication in the [price] discovery process that must occur to have a rational opening," said Dan Franks, senior vice president of market operations at Nasdaq.
"A trader must have some idea of what kind of size he's dealing in. In other words, does the other guy have 1,500 to buy or 15,000?" he added.
The Security Traders Association supports the rule, but is not convinced it has any teeth. "It's a step in the right direction," said Lee Korins, the STA's president. "The locking parties have to be prepared to trade in decent size. If they're not and they do not move they will be in violation. But unless somebody strong oversees the rules then they aren't worth a nickel."
Traders are skeptical of the ability of NASD Regulation, the NASD's regulatory arm, to enforce a trade-or-move policy because of its perceived inability to enforce the rules governing backing aways.' A market maker backs away when he does not honor his quote. Under trade-or-move, the concern is that a trader will send a message to trade 5,000 shares, but still not honor it.
"Theoretically, people are supposed to be honoring your [SelectNet message]," said Dan Schaub, head Nasdaq trader at A.G. Edwards. "But often nothing happens. [NASD Regulation] is so tied up that it can't handle all the backing aways so a violation doesn't matter anyway. There's no question that locked and crossed markets effect everyone, but I don't know if this will solve the problem."
Franks admits the legal process is slow, but maintains it is fair. "Unfortunately, due process and expediency seem to be mutually exclusive," he said.
Fraud at Giant
Morgan Stanley Dean Witter is a case in point. It took five years, but in January NASD Regulation finally levied a $495,000 fine on the brokerage giant and its former head of Nasdaq trading, David Robert Slaine, for fraudulently raising the prices of nine stocks that underlie the Nasdaq 100 index.
Some $450,000 of the fine was for price manipulation while $45,000 was for causing locked and crossed markets. In 1995, according to Nasdaq, the broker dealer raised its bids without buying any stock prior to the opening, causing the opening print price to rise artificially. The tactic was used to facilitate a program trade.
The lynchpin of the trade-or-move amendment is the 5,000 shares, a sizable amount for many stocks. "Now, somebody who locks the market has to be ready to accept 5,000 shares on their lock," Korins said. "If you're just gaming and you only accept 100 shares, you have to get out of the way. The only way you can stay there is if you accept the 5,000 shares."
Many traders, including Ken Pasternak, chief executive of Knight Securities, reportedly consider the 5,000 shares excessive.
Michael Barone, a trader at Chicago's William Blair & Co., favors the rule but is concerned that the 5,000-share minimum could put him in a bind with a customer. "It could create some problems if you're protecting a client [with a limit order to sell] and you're forced to move [your offer] up because you have only 1,000 shares for sale," Barone said.
"You may be unable to sell those shares above his limit once the market opens," he added. "Then, if the stock drops back down below his limit, your client is disadvantaged."
