Nasdaq's proposal for an integrated order-delivery and execution system may hinge on market makers quoting all stocks in proprietary trade sizes of 100 shares, that is, in so-called actual sizes. The National Association of Securities Dealers contends that order-size rules for the handling of small orders currently executed on SOES are unnecessary and should be eliminated.

Nasdaq states that if artificial quote-size requirements on all Nasdaq securities are not eliminated ahead of a new integrated order-delivery and execution system, some order-entry features of the facility would not be appropriate. In that case, Nasdaq thinks that order-entry firms should not be permitted to enter trades larger than 1,000 shares. The NASD proposes that if the absence of full implementation of the actual-size rule, non-market makers should not be permitted to enter trades in the new system larger than 1,000 shares on non-preferenced orders.

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The pink sheets, the last vestige of over-the-counter trading before Nasdaq came about, is planning to shed its manual, old-fashioned image. The pink sheets, pending regulatory approval, want to automate. An automated pink-sheet system, of course, would spell the end of a quaint but increasingly popular style of trading. That system still uses pink -colored paper to exclusively carry the price-quote information on 2,700 equity issues and a roster of stocks quoted on the OTC Bulletin Board.

The National Quotation Bureau, which owns and operates the pink sheets, said the new system would provide a real-time bulletin board of market-maker quotations and an electronic negotiation and order-routing facility for subscribers. In a letter to subscribers, the company said it is in discussions with the Securities and Exchange Commission and the National Association of Securities Dealers, "to increase the visibility and transparency of market-maker quotations through automation of our service."

To be sure, the pink sheets account for a small proportion of trading in the full universe of Nasdaq and over-the-counter stocks. But that could change dramatically over the coming months under rules approved for the OTC Bulletin Board. These rules will require companies listed on the electronic stock-quotation service to file financial statements. As a result, some pros think hundreds if not thousands of companies will delist to the pink sheets.

First came the study in May 1994 by two academics, William Christie and Paul Shultz, that purported to demonstrate the absence of odd-eighth quotes on Nasdaq was evidence of price fixing by market makers. Now comes a sequel, of sorts – a study by two other academics, Yusif Simaan of Fordham University and David Whitcomb of Rutgers University, that purports to demonstrate the absence of odd-sixteenth quotes on Nasdaq over two separate two-week periods, in September and October, as fresh evidence of more price fixing.

"The most striking finding in this paper is clearly that leading market makers still have an extreme tendency to avoid odd intervals in their advertised [Nasdaq] quotations," the paper noted. "The same firms, when they come to lay off positions on electronic communications networks (and to a lesser extent, in their advertised quotations toward the end of the day) appear more willing to quote odd sixteenths."

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The dust is finally settling on the class-action lawsuit brought by thousands of investors alleging price-fixing among Nasdaq market makers. A $900 million settlement has been reached. The lawsuit was filed in U.S. District Court in Manhattan in 1994 against 37 firms, including two industry giants, Merrill Lynch & Co. and Goldman Sachs & Co., that are among 30 firms that settled. Six other firms settled their case earlier, agreeing to pay $98 million of the final settlement. The defendants neither denied nor confirmed any wrongdoing.

How the $900 million will be divided among the investors is unclear. Each named defendant that settled, however, will make payments based on their percentage of Nasdaq trading volume. Merrill and Lehman Brothers agreed to pay $100 million and $80 million, respectively, while J.C. Bradford & Co. and Furman Selz will each pay less than $10 million. A judge must still determine how plaintiffs' lawyers will be compensated.

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Sen. Lauch Faircloth (R-N.C.) has come out swinging against a new derivative accounting rule proposed by the Financial Accounting Standards Board (FASB), a privately-funded independent agency.

Faircloth, head of the Senate Banking Committee's financial institutions and regulatory relief panel, has one enemy in mind the Securities and Exchange Commission. Faircloth said "the FASB has worked so closely with the SEC, this appears to be a regulatory dispute, not an accounting dispute."

That's good news for the head of the Senate Banking Committee, Sen. Phil Gramm (R-Texas), and others who oppose the rule, but possibly bad news for a staunch supporter of the proposal, SEC Chairman Arthur Levitt.

Disclosure

The proposal would require greater public disclosure by Wall Street firms dealing in derivatives, in particular the reporting of gains and losses in quarterly earnings statements.

A derivative is a financial contract whose value is derived from an underlying security. Banks are especially worried about the FASB proposal because they are heavy users of derivatives. (The FASB establishes accounting standards for publicly-traded companies.)

Some Capitol Hill insiders think Levitt's blessing may be a curse in disguise for him, ultimately hurting his chances of renomination to a second five-year term as chairman of the SEC. That's because his support of the FASB rule has annoyed critics here in Washington. And that could have implications next summer when Congress must confirm the choice of SEC chairman when Levitt's current term expires.

If Levitt is renominated the White House recently indicated it would do so the process could be derailed by pesky senators, such as Faircloth and Gramm, should the FASB proposal not be harmoniously resolved. Indeed, these Senators may be warming-up for battle. "You can't rule anything out," a source on Capitol Hill said.

The Senate must approve every presidential nomination to the SEC, and the chamber's rules allow a single senator, who customarily remains anonymous, to place a hold on a nomination.

Second-Guessing

As previously reported, Gramm last October accused Levitt of interfering in congressional business after the SEC chairman attacked Congress for "second-guessing" both the SEC and FASB.

Gramm was particularly upset when Levitt demonstrated his support of the accounting rule proposal in three separate speeches and private meetings, and attacked those who opposed the rule as attempting to scuttle the independent rule-making process instead of raising real concerns.

Faircloth stresses that he has no objections to the rule being written by the FASB. But he is upset with the involvement of the SEC, and is waging war. As a result, he introduced legislation that would delay the FASB's proposed rules in the final hours of the Senate's legislative year.

Even Federal Reserve Board Chairman Alan Greenspan is reportedly concerned about the proposed rules.

Whether Levitt has walked himself into a high-stakes political poker game with the Republican-controlled Senate remains to be seen.

It is taken for granted, inside the Beltway, that Levitt wants another five years at the helm of the SEC. Serving a full second term would make Levitt the longest-sitting chairman in the SEC's 63-year history.

Faircloth's office did not respond to several requests for comment. A White House official said it is still far too early to comment on whether President Clinton will renominate Levitt, whose term as SEC chairman expires in June.

The Security Traders Association is planning later this month to publish the findings of its inaugural year-end membership survey on a range of trading and regulatory issues, according to John Tognino, president of the roughly 8,000-strong industry group.

"The survey represents an excellent opportunity to gauge members' priorities," Tognino said in a telephone interview. The survey, overseen by STA strategic consultant Laura Cooley, involved a 26-question form mailed to the entire STA membership in mid-December. Most questions required a simple yes or no answer. The emphasis was on short, concise questions to encourage strong membership participation.

The questions will no doubt help to forge common ground among groups of STA traders with distinct agendas, ranging from institutional market makers and wholesalers on the sellside, to institutional traders on the buyside. The STA made clear it is looking for areas of common agreement in the survey results.

Major Changes

Tognino noted that the past 12 months have witnessed some major changes in equity-trading practices, in particular the implementation of the order handling rules.

Tognino said the questions touched upon the use of circuit breakers that halted stock trading twice on Oct. 27; decimalization, which was the subject of two recent high-level meetings the Securities and Exchange Commission conducted with industry officials; the National Association of Security Dealers' central limit order book; and electronic communications networks.

The STA president said the results will provide a road map to help the STA board of governors develop industry positions and, as such, will be something more than fodder for Capitol Hill lobbying.

Some leaders in the trading community have stepped-up the fight against a central limit order book, the controversial system at the center of an integrated trading platform the National Association of Securities Dealers is hoping to implement.

On Dec. 22, the NASD sent a rule filing on the new system to the Securities and Exchange Commission for public comment.

The integrated platform, originally dubbed Next Nasdaq, has some traders hot under the collar. They view a central limit order book as direct competition.

"Most of us in the industry do not understand the NASD's rationale," said Bernard L. Madoff, chairman of the Securities Industry Association's Trading Committee. The committee is leading a push to have the limit-order-book proposal, as currently planned, scrapped.

Imprimatur

The proposed system initially received the imprimatur of Nasdaq's Quality of Market Committee, as well as approval late last year from the NASD board of governors. The system would create a single integrated order delivery and execution system, melding SOES and SelectNet functions. The central limit order book would not be mandatory.

At press time, Madoff was continuing his battle to have the central-limit-order-book proposal dropped. "One has a demonstrated need and is not controversial, while the other [the central limit order book] has a need yet to be demonstrated and is controversial," Madoff said.

Madoff added that the SIA recently met with NASD officials, presenting them with a proposal he said would satisfy the NASD's plan without compromising the market-making community. While some of the singular details are not groundbreaking, combined they are significantly different from the NASD's plan.

The SIA proposal would provide the ability to place orders into the market on an anonymous basis; allow limit-order execution capability for smaller broker dealers that have no special arrangements with wholesale market makers; provide market makers that don't want to display limit orders in their own quotes the ability to send the orders to other market makers or electronic communications networks; and finally, provide a system of last resort.

SIA Plan

Under the SIA plan, limit orders would first be transmitted into Nasdaq and then rerouted to market makers on a rotating basis. Market makers would receive a fee for putting the limit orders in their quotes. However, if no market makers display a transmitted limit order, Nasdaq's central limit order book would operate as a fail-safe system and display the limit order.

Madoff said this plan "would, in our mind, provide all of the services that the central limit order book would provide the industry, both for the buyside and the sellside."

"It would also have another advantage, allowing limit orders to be handled by market makers as distinct from an NASD system competing with them," he added.

While Madoff was hopeful that the NASD would consider the SIA plan, he acknowledged that he had no reason to believe it was acceptable to them. At press time, he had not received an official response from the NASD.

Voluntary

Meanwhile, many Nasdaq traders have echoed Madoff's criticism of the NASD's plan, targeting for their attack the so-called voluntary nature of the central limit order book.

Some predict market makers will lose order flow and have to protect limit orders they are holding for execution in the central limit order book. They contend that this could ultimately result in all limit orders being displayed in the proposed Nasdaq book.

One well-informed member of Nasdaq's Quality of Markets Committee, who spoke on the condition of anonymity, said there was disagreement on the committee about the proposal. "What drives me nuts is that it is hard to see the need for a new system," the trader fumed.

Madoff said wholesale market makers and regional firms view the proposed system as a real threat. Even the New York Stock Exchange, Madoff said, "has never done something like this, building a book bypassing their specialists."

The question remains: Why is the NASD strongly advocating a central limit order book? Individual-investor sentiment may be high on the list. For his part, Madoff feels the NASD wants to secure a "revenue stream." The Quality of Markets Committee member, on the other hand, views it as yet another example of the NASD "tripping all over themselves trying to make the SEC happy."

Indeed, a concern is pressure from the SEC to build strong electronic systems compatible with the highest standards of individual-investor protection. The NASD is under watch by the SEC in the wake of two governmental investigations, some sources stress. Certainly, no one wants to see Congress enter the fray. "It would be a mistake to involve Congress," Madoff said.

As for the renaming of Next Nasdaq, an NASD spokesman told a reporter, "It has a new name, but I have no idea what that name is. Look at the SEC filing."

Big changes are afoot with the National Association of Securities Dealers' OTC Bulletin Board, the electronic stock quotation service for the trading of shares in nearly 7,000 companies. Many of these are small-cap and thinly-traded issues.

The bulletin board is loosely regulated. About half of the listed companies file financial statements. There are no listing standards.

The bulletin board is controversial. In fact, regulators charge that investors have been duped out of billions of dollars in stock scams perpetrated on the bulletin board. Some people closely connected to bulletin-board trading, however, dispute this estimate, saying it is grossly inflated.

Investor Protection

The main changes announced by the NASD would enhance investor protection by significantly increasing the amount of timely and accurate information about the companies that are quoted on the bulletin board.

The changes are subject to approval by the Securities and Exchange Commission.

In a release, the NASD said brokers in the future would be required to take additional steps prior to recommending or conducting a transaction in an over-the-counter (OTC) security not traded on Nasdaq.

The NASD is seeking comment from investors, regulators and other groups on each of three proposals prior to their submission to the SEC. The first would allow only those companies that report their current financial information to the SEC, or banking and insurance regulators, to be quoted on the bulletin board. This proposal would provide a phase-in period for those securities already quoted on the bulletin board.

The second would require brokers, before they recommend a transaction in an OTC security, to review current financial statements on the company they are recommending.

Finally, prior to the initial purchase of an OTC security, the proposals would require that every investor receive a standard disclosure statement, prepared by the NASD, emphasizing the differences between OTC stocks and other market-listed securities.

Securities quoted on the bulletin board include national, regional and foreign equity issues, warrants, units and American Depositary Receipts not listed on any other U.S. national securities market or exchange. Beginning in April, foreign securities will have to be fully registered with the SEC to remain quoted on the bulletin board.

Under the proposals, the NASD said, all companies that do not report to the SEC, or bank and insurance regulators, would be eliminated from the bulletin board. The delisted companies would be eligible, however, for quotation on the pink sheets. A phase-in period would apply before this measure is implemented.

Further Changes

The NASD is considering further changes. These include a halt on trading in a bulletin board stock when a foreign regulator halts trading in the same stock in the primary market.

While there have been scams associated with the bulletin board as well as the pink sheets, the old-fashioned manual OTC trading service run by the National Quotation Bureau in New York, defenders of the non-Nasdaq side of the OTC market stress that a huge majority of trading is fair and legitimate.

The intense scrutiny of this OTC market by regulators in recent times is particularly troubling, the defenders stress. "They are painting the industry with one broad brush and that's unfair," one trader said.

"I've been in this business all my life," the trader added, "and I've always played by the rules. But reading newspaper reports, you would think I was engaged in the organized crime business."

Indeed, small-cap trading on the OTC market has been hurt by allegations that organized crime entered some of the business. Last year, Business Week ran a sensational cover story on how organized crime had supposedly infiltrated the small-cap market on Nasdaq stocks. Some traders think the piece went over-the-top, once again grossly inflating the truth.

Private vendors will be allowed to confirm and affirm trades between institutional customers and broker dealers under a plan announced by the National Association of Securities Dealers.

Rules approved in 1982 restrict confirmation and affirmation, or acknowledgment services, to Securities and Exchange Commission-registered clearing organizations, such as the New York's Depository Trust Company (DTC). The DTC currently has a monopoly in the confirmation and affirmation business.

The NASD said its plan recognizes the technical advances that have occurred in trade processing. The changes must be approved by the SEC.

Under the NASD plan, vendors would be allowed to confirm and affirm transactions once an independent auditor has certified that they have met specified financial and operational standards. The SEC also has authority to review all vendor applications.

Institutional Trades

The NASD said that every trade between an institution and a broker today must be affirmed and confirmed before the trade can be settled and the securities can change hands. At the moment, the NASD estimated that more than half of Nasdaq's average daily volume, 600 million shares, are institutional trades.

As previously reported, Boston-based Thomson Electronic Settlements Groups (ESG) has lobbied to bust open the DTC monopoly in the electronic confirmation and affirmation of institutional trades. Thomson ESG, whose position was supported by the Securities Industry Association, an industry trade group, petitioned the SEC to amend the 1982 rules.

Now, the rule change would seem to pave the way for Thomson's entry into this potentially lucrative business.

"This plan is designed to ensure the safety and soundness of the nation's clearance and settlement systems, while encouraging innovation and competition from the private sector," said NASD Chairman Frank Zarb in a prepared statement. "Working together with the government, industry and other self-regulators to develop this plan is self-regulation at its best."

(Thomson ESG is a subsidiary of Thomson Financial Services, the parent company of Securities Data Publishing, publisher of Traders Magazine.)

The National Association of Securities Dealers' effort to keep its proposed integrated trading system under wraps, until details were filed for public comment on Dec. 22, riled a well-known electronic communications network (ECN).

"The general NASD membership had not been allowed to hear the proposal ideas beforehand," said Kevin Foley, manager of equity-trading applications at Bloomberg Tradebook, the ECN launched 12 months ago by Bloomberg L.P. Bloomberg is an NASD member firm.

"I am finding out about NASD plans as a member of the general public," Foley added.

The proposed trading platform, originally billed Next Nasdaq, could radically transform Nasdaq's current system. But full details are sketchy, as the trading community has yet to interpret the full scope of the NASD's 119-page filing.

As envisioned by the NASD board of governors, the new system aims to integrate SOES and SelectNet and to provide a voluntary central limit order file.

Some ECNs, meanwhile, worry that the proposed facility could turn into a mandatory, centralizing network that somehow sets the inside market.

Foley worries that the new system could replicate an earlier but unsuccessful Nasdaq plan NAqcess to launch an integrated system.

Foley said that if the market is forced to protect the file and not allow trading around it, the system could unfairly hurt competition.

"It would be unfair if all ECN orders had to go to the book for execution," Foley added. "You can't prevent competition."

However, if the Nasdaq system functions as an ECN, Foley said, it would be a welcome competitor in the marketplace.

Island, an SEC-approved ECN used by day-trading firms, but unpopular with market makers, is also concerned.

"It is hard to say how the new system will look like until it is filed," said Josh Levine, president of New York-based Big J. Securities, prior to the December filing. "If it is fair, that will be great. But if it unfair, it could be awful."

Levine added that an equitable system, in his view, would immediately match customers' orders under certain parameters, and would not shut out rival systems. "Any system just needs to keep a level playing field," he said.

Outlines

Several people close to Nasdaq's Quality of Markets Committee, who were consulted on the NASD's proposed platform, provided some outlines of the system, but were unclear about substantive elements.

Based on accounts from these sources, broker dealers will have access to the system for the execution of customer orders. The current plan allows broker dealers to sponsor an institutional client's direct access to the new system. Under this arrangement, the system would operate on a price-time priority, interacting with any quote in the book.

Nasdaq considered a ten-second delay rule for orders entered into the system, apparently as an effort to curb gaming or market manipulation on ECNs. With the delay rule, an order placed in the new system could not be canceled until ten seconds had elapsed.

SOES Bandits

Another suggested measure could crimp abuses by so-called SOES bandits who enter small orders for automatic execution. Under this proposal, a market maker would have up to 30 seconds to execute or decline an order of up to 1,000 shares if that market maker has already traded that stock at the current posted quote-size.

If the market maker declines to execute the small order, the market maker's quote would have to be adjusted. If the quote was not adjusted within 30 seconds, the order would be automatically executed. Conversely, a market maker who had not traded at a current quote could not decline an order of up to 1,000 shares.

The new Nasdaq system would track whether market makers have traded at their current quote-size, and automatically execute orders as appropriate. However, if the market makers' current quote-size is 5,000 shares or more, this rule would not apply.

Some experts question a 30-second delay rule, suggesting it seems to technically violate the firm-quote rule.

Disapproval

Meanwhile, many Nasdaq market makers have voiced their disapproval of a Nasdaq execution system. Foley offered his sympathy.

"I think NASD members question why a regulator is getting into a competitive marketplace," he said. "We at Bloomberg can't be afraid of competition, but will the competition be fair?"

A member of the Quality of Markets Committee, who requested anonymity, agrees.

"Should a self-regulating agency be competing with ECNs?" the committee member asked. "Does the NASD have the technology to pull this off?"