Charles M. Smith, a retired north suburban investor, tried to buy 1,000 shares of a Nasdaq-listed stock earlier this year and ended up soured by the experience.
While he was able to buy 200 shares at his specified price, the rest of his order went unfilled-even as other investors were purchasing shares at prices lower than his offer.
“This was the only Nasdaq stock I’ve ever owned, and I won’t own another one-not until they change the system,” he said.
Smith’s complaint is typical of those often voiced about the Nasdaq stock market by small investors, many of whom have been advised by their brokers to avoid buying the stocks sold through this market unless they’re especially adept at swimming with sharks.
According to critics, Nasdaq makes it tough for an individual investor to get a fair shake. Transaction costs for buying and selling shares are much higher-artificially high, some say-than on other exchanges.
And current trading rules don’t require Nasdaq market makers, the central figures who make Nasdaq work, to always treat orders from individuals with the alacrity they offer big institutional traders, or other dealers.
So, Smith was left fuming on the sidelines last spring, wanting to buy 1,000 shares of Deerbank Corp., a Deerfield-based banking firm, for $43.75 apiece. Smith said he tracked the stock’s trading activity in the newspaper for 10 days and found that others were buying the stock at prices below his offer, yet his order remained largely unfilled.
Why? Because his broker was unable to crack the Nasdaq system. Dealers were buying shares at “wholesale” bid prices below his-which were dutifully reported in the Nasdaq newspaper listings-but refusing to sell to him unless he met their higher “retail” ask price. Thinly traded bank stocks frequently have a dealer spread of $1 or more.
Even a formal complaint to the National Association of Securities Dealers failed to bring him a satisfactory explanation for why he was unable to buy the shares he wanted, he said, “other than it’s an insiders’ market and I didn’t fit on the inside.”
The Nasdaq market, which bills itself as “the stock market for the next 100 years,” is trying hard to change its image but not necessarily its way of doing business.
More than 11 million individuals owned Nasdaq-listed shares at the end of 1994 and millions more have flooded in this year as the market has soared. Millions more own Nasdaq stocks through mutual-fund and pension-plan holdings.
After a year of intense, and ongoing, scrutiny by the Securities and Exchange Commission, the Justice Department and a committee appointed by the NASD and headed by former U.S. Sen. Warren B. Rudman, Nasdaq expects to launch a series of changes soon that will offer important protections for small investors. Other reforms already are in place, including one intended to prevent just what happened to investor Smith.
The Rudman committee, which issued its report last week, avoided the dollars-and-cents issues important to many individual investors and focused instead on how the Nasdaq market is governed. It strongly recommended separating Nasdaq more cleanly from its parent, NASD, and making its oversight structure more responsive to the interests of public investors.
NASD has “failed to keep pace with the significant growth and continuing evolution of the Nasdaq market,” the report said.
Nasdaq was founded in 1971 as what the Rudman report labeled “little more than an automated quotation service of limited scope and importance.”
But in less than 25 years, the market has grown into the largest stock market in the world in dollar volume after the New York Stock Exchange.
Investors can buy and sell shares of 4,902 Nasdaq-listed companies; some as large and well-known as Microsoft Corp. or Apple Computer Inc. and others as small as Jake’s Pizza International, of west-suburban Addison.
It’s best known for its stocks of high-technology companies, which comprise 27 percent of the companies listed, and as the home for companies making their initial public offerings of stock. The recent popularity among investors of technology and startup companies has driven the unprecedented growth in Nasdaq trading volume.
From 1990 to 1994, annual Nasdaq volume more than doubled to more than 74 billion shares from 33 billion. In 1972, its first full year of operation, Nasdaq traded 2.2 billion shares.
Unlike the New York Stock Exchange, where stocks are bought and sold in a clamorous auction atmosphere, the Nasdaq trading “floor” in Trumbull, Conn., and its mirror-image backup floor in Rockville, Md., is virtually silent. There’s not even a sign telling visitors they are on a trading floor of the world’s second-biggest stock market.
In an electronic age, Nasdaq contends, it is no longer necessary for people to meet face to face in one location to trade securities.
In a typical Nasdaq transaction, someone who wants to buy shares in a company calls his or her broker and places an order for, say, 100 shares of XYZ company at the market price.
Using the Nasdaq computer network, the broker sends a message that he is willing to buy 100 shares at the current market price. The message is received by the stock’s market maker, a dealer who agrees to handle the buy and sell orders for certain stocks.
At the same time, the market maker may receive an order to sell 100 shares of XYZ “at the market.” The market maker agrees to buy the shares being sold at his “bid” price, knowing he can sell them-for his higher “ask” price-to the broker who just placed the buy order. Posting continuous “bid” and “ask” prices is the primary obligation of the Nasdaq market maker.
The difference between the “bid and “ask” prices is called the spread. It has traditionally been 25 cents a share for most Nasdaq issues-higher than on other exchanges-and is a chief cause of complaints about Nasdaq trading.
About 500 market makers, or dealers, compete for investor orders on the Nasdaq market, and also buy and sell stocks for their own account.
A typical Nasdaq stock has 12 market makers, while some of the most heavily traded Nasdaq stocks have 40 market makers. The minimum requirement for a company to be listed on Nasdaq is two market makers.
In contrast, a New York Stock Exchange-listed stock has one specialist at the NYSE. He is paid a fee to match trades at single prices agreed to by buyers and sellers, much like a real estate agent. When trades don’t match, he maintains a bid/ask spread and risks his own capital to facilitate trading, just as the Nasdaq market maker or a car dealer does.
Under new rules just approved by NASD-which still need approval by the SEC-Nasdaq would introduce a matching system for many orders placed by individual investors, similar to the system on stock exchanges such as the New York, American and Chicago exchanges.
Under the proposed rules, Nasdaq will set up an order-handling system that automatically matches “limit orders” to buy or sell a stock at a specified price.
That would mean if there’s an individual investor willing to buy 100 shares of XYZ company at $20 a share at the same time someone else wants to sell 100 shares of XYZ company at $20 a share, buyer and seller would be brought together. The trade would be executed at $20 a share, no market maker would pocket a spread and transaction costs for both buyer and seller would be lower than they are now.
Under this proposed system, called N.AQCESS, brokers will be paid commissions for handling these trades, but won’t collect a spread.
But the reforms leave untouched the practice for handling “market orders” on Nasdaq. When a customer places a market order, he asks his broker to buy a certain number of shares of a stock at the best price available. These orders would still be handled by market makers, who would collect the spreads, which are usually higher than those offered on other exchanges.
To benefit from N.AQCESS, investors must specifically request that their limit order be placed on the N.AQCESS system. If they do not, broker-dealers are free to enter the order into their own proprietary systems, but those systems must offer the same protections offered by N.AQCESS, said Marc Beauchamp, a spokesman for Nasdaq.
The NASD believes that allowing investors to avoid the spread-when there are interested buyers or sellers on the other side of a trade-will silence critics who have said Nasdaq market makers have colluded to keep these “spreads” artificially wide.
Bartley Madden, a partner at Chicago-based HOLT Value Associates and a critic of the Nasdaq market, said N.AQCESS will have no impact on the size of the bid-ask spread for most Nasdaq stocks. The changes, he said, are an example of how “the foxes will take care of the chickens.”
What stock investors really need, he said, is an alternative to the Nasdaq market.
“Why can’t an investor have an opportunity to make a better trade? That really strikes at the heart of this entire issue,” he said.
For some of the most widely traded stocks listed on Nasdaq, individual investors could go elsewhere: the Chicago Stock Exchange, for example.
Since 1990, investors can ask brokers to route their orders for 100 of the most actively traded Nasdaq-listed companies through the Chicago exchange, said Terence Hurley, vice chairman of the exchange, where these orders are submitted to the exchange’s auction process.
The SEC recently has approved an expansion of this program to an additional 400 Nasdaq-listed shares, Hurley said. The exchange has yet to identify which 400 Nasdaq stocks it will offer to trade.
“As the market gets larger and becomes more prominent, there have been efforts at reform,” said Smith, the investor whose hoped-for trade apparently was shoved aside at Nasdaq earlier this year. “Hopefully reforms will continue in the future.”
But he’s not yet ready to go back to Nasdaq. “I’m committed to trading on a regular exchange for my personal funds.”
