Little things mean a lot in series of suits against Nasdaq's market-makers

THE BALTIMORE SUN

The price-fixing charges that have been leveled against the brokerages that trade Nasdaq stocks amount to a matter of nickels and dimes.

But in a market that trades an average of 240 million shares of stock a day, that change adds up.

That's why some of Wall Street's largest brokerage firms -- and some closer to home, namely Alex. Brown & Sons Inc. and Legg Mason Wood Walker Inc. -- are defendants in a series of lawsuits that accuse them of conspiring to profit by withholding those nickels and dimes from their customers, particularly individual retail investors.

The suits claim that the "market-makers," the firms that control the trading flow of various Nasdaq stocks, have conspired to fix the prices for those stocks by artificially increasing the spreads.

The spread is the difference between the bid price -- what a buyer is willing to pay -- and the asked price, or what a seller is willing to accept for stock. In addition to brokerage commissions earned on each trade, often the higher the spread the more money a market maker earns when the stock is traded.

The securities firms that have responded to the lawsuits deny any wrongdoing. The National Association of Securities Dealers Inc., the Washington-based organization that runs the computerized Nasdaq system and is not a defendant in the lawsuits, essentially acknowledges that spreads are higher on average for Nasdaq stocks than for those on the New York or American stock exchanges.

But the NASD says the higher average spread is the result of a variety of economic and technical factors, some of which are aimed at providing better overall service for investors, especially large investors such as institutions. Collusion has nothing to do with it, says the NASD.

Whether or not that's true, some investors may be excused for wondering why the little guys so often end up paying more, and what if anything they can do about it.

The short answer, according to the NASD, is that there are some alternatives, albeit imperfect ones, and that more help is on the way.

In the meantime, the legal system is taking the matter under consideration. The lawsuits, including the one filed in the U.S. District Court for the southern district of Maryland, are seeking to establish a plaintiff class of all people who traded stocks with the Nasdaq market makers since May 1989, and therefore may have suffered from the alleged conspiracy.

"As a result of that price-fixing," the Maryland suit claims, "plaintiff and class members have paid more to conduct securities transactions than they would in a competitive market."

The lawsuits claim the brokers have carried out the alleged conspiracy by:

* "Following the spread set by the dominant dealer (known as 'the name')" in a particular security.

* "Cajoling and pressuring" traders who seek to compete by " 'breaking the spread.' "

* Agreeing not to compete by offering a lower spread.

* "And, on rare occasions, when someone has attempted to break the spread, stopping all trades in a security to restore the spread."

All these charges were laid out first in a Forbes magazine article last August.

Another, more technical charge echoes a study by two business professors released in May. It says that Nasdaq market-makers have raised the spreads for many stocks by 12.5 cents each. They've done this, according to the lawsuits and the study, by avoiding the "odd-eighth" quotes, or refusing to quote stock prices that end in 1/8 , 3/8 , 5/8 , or 7/8 of a dollar. If true, that practice would raise the spread on some purchases to 25 cents, rather than 12.5 cents.

NASD officials point to a summary statement in the study which seems to admit that the professors could find no evidence of a conspiracy: "Our data do not provide direct evidence of tacit collusion among Nasdaq market makers," reads part of the conclusion, written by William G. Christie of Vanderbilt University and Paul H. Schultz of Ohio State University.

But Mr. Christie said that wasn't the intent of the study. "We're not proving that there's some sort of illegal notion of collusion where people are getting together in a smoke-filled room, agreeing to" avoid the odd-eighth quotes, he said.

"I don't know what their motives are," Mr. Christie added. "Certainly they make additional profit if they can keep the spread higher."

One major difference between Nasdaq and the other exchanges, the NASD responds, is that large institutions which trade on Nasdaq deal directly with the market-makers -- there is more than one market maker for many Nasdaq stocks; some have 50 or 60 -- and the prices quoted for each stock reflect the total cost; there are no commissions.

Since the total cost of a trade for those institutions is reflected in the spread, the spreads seem to be wider, said Gene L. Finn, vice president and chief economist for the NASD.

One alternative for individual traders, Mr. Finn said, is to ask their brokers to place their order through something called SelectNet. SelectNet is an electronic system run by the NASD that often allows investors to make trades "inside the spread."

But not all brokers use SelectNet. And it's especially tough to find a discount broker who will execute a SelectNet trade. That's because it can add just enough to the cost of doing a trade that it no longer makes economic sense for a broker that already discounts commissions.

Help may be on the way for small investors in the form of something called N-Prove. Yet another electronic trading system, Prove will allow brokers to serve customers who want to buy or sell between the bid and ask prices. The system would automatically try to match those requests with subsequent "market" orders, ones where the investor is content to buy or sell at whatever happens to be the going price, Mr. Finn said.

N-Prove could affect 12 percent to 13 percent of all Nasdaq orders, although probably a much smaller percentage as measured in dollars.

The Securities and Exchange Commission has yet to approve the new system, but that's expected by early fall, Mr. Finn said.

Bear in mind, he noted, this whole question of splitting the spread probably won't even enter the radar screens of small investors who are "doing what they ought to be doing . . . buying and holding."

Only investors who trade quickly and often will notice if the stock they buy costs an extra eighth of a dollar, Mr. Finn said. On a 200-share purchase of a $40 stock, for instance, that eighth would mean the difference between paying $8,000 and $8,025, not including the commission.

For many investors, who buy and sell stock only occasionally, that $25 probably doesn't mean a whole lot, especially if an investor holds a stock for a year or longer.

But the issue raised by the lawsuits, and by the articles and academic studies, is that for the brokerage firms that trade millions of shares a day, every little penny counts.

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