The National Association of Securities Dealers is expected to submit a separate plan for a revamped limit-order book, the centerpiece of the original proposal for Nasdaq's order-delivery and execution system, or NODES.

The new version of the limit-order book will likely be accompanied by a trade-through rule, according to a member of Nasdaq's Quality of Markets Committee, who declined to be named.

The rule would ensure that superior bids and offers sent to the book receive an execution whenever inferior-priced orders in the same stocks are executed outside of the book.

Trade-through rules are a standard feature of limit-order books run by the New York Stock Exchange and the regional stock exchanges.

An NASD spokesman said the agency is still considering splitting the proposal, but declined to elaborate.

"A limit-order book hinges on price and time priority," the Nasdaq committee member said. "That's why you need a trade-through rule. It would create a central place and protect the customer."

Centralize

Nevertheless, the Nasdaq committee member warned that a trade-through rule would centralize the market.

"That may be why the NASD initially resisted it," the Nasdaq committee member said. "But you really can't have a limit-order book without a trade-through rule."

The member added that, "overall, the plan would auctionize the dealer market by centralizing quotes."

STA Letter

In a comment letter, the Security Traders Association urged the NASD to adopt the trade-through rule under NASD consideration.

Separately, the STA said the NODES proposal raised the issue of credit reliability.

"Where is the line of responsibility for assuring proper credit, particularly if a customer is trading anonymously through a broker dealer?" the STA asked in the comment letter filed with the Securities and Exchange Commission on June 11.

"Should any broker dealer have the ability to enter proprietary orders for 999,000 shares? Is a firm responsible for customer transactions effected outside the knowledge of the respective broker dealer?" the letter asked.

Time

The STA also raised questions about the time parameters of NODES, and argued that the proposed three-minute close rule would be disadvantageous for the market.

"The current rule allowing a five-minute window, with a 20-day suspension for market making for failure to update, has proved sufficient," the STA said.

Both the 17-second and the 32-second delivery parameters are too confusing, and the 32-second parameter is too long, the STA said, which proposed a new time parameter of 22 seconds.

Have the order handling rules gone too far? Nasdaq President Alfred Berkeley thinks that's a question worth asking.

Berkeley raised the question in reaction to a study by two academics that shows spreads have narrowed substantially on Nasdaq since the order handling rules were implemented last year.

William Christie and Paul Shultz, whose 1994 study helped trigger the Nasdaq price-fixing investigations, report in a new study to be published early next year that spreads have narrowed by 30 percent since the rules went into effect.

The new study found that spreads narrowed the most among stocks that previously had the widest spreads. Among them, Nature's Sunshine Products has seen its average spread narrow 65 percent since the rules were triggered. The most dramatic narrowing was noted among smaller trades: 34 percent on trades of 1,000 shares or less, compared with 19 percent on trades of 10,000 shares or more.

Berkeley responded cautiously to the study, which independently confirms similar findings made last year by Nasdaq. He said the narrower spreads have reduced trading profits, causing traders to drop market making in less profitable issues.

"Have we swung the pendulum so far to the investor that the business may not be as attractive to traders in a downturn?," Berkeley was quoted in a story by Bloomberg. "That's the gut issue."

The New York Stock Exchange is upping the ante in its effort to foil Jersey City-based OptiMark Technologies' plan to go live this fall with its OptiMark Trading System.

The Big Board claims parts of the OptiMark plan contravene core principals of the National Market System (NMS).

At issue are amendments to the Intermarket Trading System (ITS), proposed in July by the Securities and Exchange Commission, that would allow OptiMark to operate as a facility of the Pacific Exchange (PCX).

In a comment letter, the Big Board said several concerns must still be resolved.

The NYSE questions how the PCX and OptiMark platform will "reasonably probe" the PCX for unmatched orders before submitting the orders to the ITS.

In addition, the Big Board asks if a ceiling should be placed over PCX and OptiMark-generated orders, given that the planned platform, if unchecked, could become a system for routing orders to the Big Board and other exchanges.

The initial-public-offering market appears to be a victim of its own success. An excess supply of stocks, combined with the market's recent sluggish performance, has hurt potentially lucrative IPOs, making them tougher sells.

The pain caused by dramatic market dips and a slowdown in the IPO market is not confined to individual investors. Traders on both the sellside and the buyside know of the agony.

"It makes our life more demanding," admitted Raymond Murray, director of trading at Minneapolis-based Investment Advisors.

For one thing, uncertain expectations can cause portfolio managers to suddenly drop out of a pending IPO, and leave traders feeling a little flabbergasted. (Conversely, less competition over IPOs can enhance some institutional firm's allocation prospects.)

For another thing, some traders said that money flowing into mutual funds is not keeping pace with the flood of new issues, thus hurting the trading performance of seasoned stocks competiting for a proportionately smaller pool of capital.

Moreover, the tremendous supply of new offerings hitting the market over the past three years has partly contributed to the relative underperformance of small-cap stocks, market sources noted.

"There's enough pain for investors, and they're not really interested in adding new stocks to their portfolios," said Tom Dudenhoefer, head of Nasdaq trading at Raymond James & Associates in St. Petersburg. "The general response we're hearing is, I don't need to add a new name in that industry when I already have four other companies in the same sector that are underperforming.'"

"There's been a real liquidity crunch in the stock market in general," added Bruce Lupatkin, director of research at Hambrecht & Quist in San Francisco. "The supply of large-cap names doesn't grow nearly as fast as the supply of small-cap names."

Institutions

Institutional clients, comprising the bulk of an offering's book and the majority of first-day trading activity, have largely vacated the IPO market to concentrate on their existing holdings, according to trading officials.

"IPOs are an interesting anomally to the overall market," Murray said. "With an IPO, you have the chance to safely land on the beach when you want. Lately, underwriters have been saying to themselves, I'd like to land on the beach when their is a little less gunfire.'"

In the midst of a plummeting Dow Jones Industrial Average, just 16 issuers were able to bring deals to market in August. In contrast, underwriters were able to place a total of 47 IPOs in July.

With the pace of IPO issuance slowing and many underwriters forced to severely discount deals due to market conditions, first-day trading volumes have soared on many recent deals.

"IPOs generally price at about a 20-percent discount to publicly-traded comparables," noted the head of one over-the-counter trading desk, who requested anonymity. "Ideally, an underwriter would like to see very little volume in the initial day of trading."

With the market's recent volatility, however, such discounting has become accelerated, leading to higher-than-normal first-day trading activity, traders said.

Oversupply

Since the beginning of 1997 through the end of the second quarter 1998, there were 2,082 IPOs and secondary offerings, tapping investors for $298.3 billion, according to Securities Data Co. Over the same period, investors poured $372.9 billion in fresh capital into mutual funds, according to Washington-based Investment Company Institute.

During the second quarter, however, new-equities issuance totaled $71.1 billion, outstripping net sales into mutual funds by $2.28 billion.

"Liquidity is certainly a problem," said the head of a major New York trading desk, who declined to elaborate for fear of antagonizing his firm's syndicate department.

Although IPO issuance could once again reach historic heights in 1998 trailing perhaps only 1996, when 872 issuers raised $49.89 billion a growing list of companies are seeking shelter from increasingly hostile public markets. They are either withdrawing proposed IPOs or opting toward the inviting arms of private equity groups or willing acquirers.

"There is no question that the IPO market has cooled dramatically since the red-hot peak of 1996," said Paul Deninger, chairman and chief executive of Broadview, a New York-based mergers-and-acquisition investment bank.

Because fund managers have consistently underperformed the broader market indices over the past few years, most have shied away from more volatile IPOs, said Claudia Mott, who tracks the small-cap and mid-cap markets for New York-based Prudential Securities.

During difficult market conditions, the ability of investment banks to underwrite potential new offerings becomes further exasperated as individual investors pull money out of smaller mutual funds.

"It's like putting lighter fluid on a gas grill," noted Mott, alluding to the need of fund managers to liquidate holdings to meet the investor redemptions.

Over the four-week period ending Aug. 5, 1998, investors pulled a total of $662.4 million out of small-cap growth funds, according to AMG Data Services in Arcadia, Calif.

Small-Cap Earnings

Some of the market's hostility toward small-cap stocks is attributed to recent earnings performances, which have only begun to feel the pinch of the Asian financial crisis, market observers noted.

"Since the beginning of the year, there has been selected underperformance within the small-cap area," Lupatkin said. "In June, earnings performances for companies in our universe weren't improving, they were decelerating."

Year-over-year, second-quarter earnings for small-cap companies climbed about 2.2 percent, compared to a 2.8-percent increase for Standard & Poor's 500 companies, according to Chuck Hill, director of research at First Call in Boston.

While second-quarter earnings growth between small-cap and large-cap companies appears to be comparable, the disparity is highlighted by their respective sequential growth. According to Hill, first quarter, small-cap earnings climbed 8.1 percent, versus 3.8 percent for S&P 500 companies.

Tough Sell

The net result of all the new supply and the slumping earnings performances: Investors are balking at many new offerings. During the month of August alone, about 20 potential deals were postponed due to "market conditions."

Some portfolios managers, however, are quick to point out that when IPO issuance has stumbled in the past, such discounting has created a healthier environment for long-term capital appreciation.

"Our philosophy is about trying to remain in stock selection," said Kathleen Smith, a manager of the IPO Plus Aftermarket Fund, a mutual fund that invests in recently-issued stocks. "We believe that there are still some attractive opportunities our there."

Unlike other funds, the IPO Plus Aftermarket Fund has remained an active purchaser of new offerings, keeping just ten percent of its assets in cash.

Investment Advisors' Murray added that his firm is still active in the IPO market, and that his portfolio managers are assessing each issue on an individual basis.

Stephen Lacey is associate editor of The IPO Reporter, a sister publication of Traders Magazine.

New Issues Squeeze Capital Supply

(Yearly Quarters)

1997

Q1 Q2 Q3 Q4

IPOs and Secondary Offerings $29,147.3 $40,907.7 $40,401.5 $82,846.4 $33,848.9 $71,111.6

Net Mututal-Fund Sales $59,559.8 $53,081.7 $63,547.7 $64,101.9 $63,746.1 $68,832.5

Source: Securities Data Publishing. Note: Dollar figures are in millions.

cont'd

1998

Q1 Q2

$33,848.9 $71,111.6

$63,746.1 $68,832.5

Source: Securities Data Publishing. Note: Dollar figures are in millions.

<TBL>

The only thing certain about the duty of best execution is what the regulatory arm of the National Association of Securities Dealers will ask broker dealers: How do they plan to supervise the compliance effort?

Despite the continued regulatory chorus of vague principles and promises of future guidance, NASD Regulation expects firms to have a supervisory system in place to assure that customer orders are receiving quality executions.

Given that reality, head traders, compliance officers and information-technology personnel need to work together to ensure that the examiner, when he strikes, will be presented with evidence that your firm is addressing best-execution issues.

While there is no one "right" way to surveill for best execution, the cornerstone of any firm's supervisory system should be a set of written procedures documenting the chosen approach. Such procedures should have four basic elements: who is responsible for each part of your firm's best-execution review; what they do to fulfill their responsibilities; how often their review is conducted; and a record that the review was performed.

In this vein, daily exception reports can be particularly useful. They can be generated on a regular basis, reviewed by a supervisor quickly and efficiently, and initialed and filed away as evidence for regulatory authorities.

Reports that should be considered include lists detailing market orders executed outside the national best bid and offer, or NBBO; limit orders not executed despite an obligation under Manning Rules; and instances of potential front-running.

Drafting procedures, however, is only the start of the process. Thoughtful implementation is essential to avoid a compliance disaster. Worse than having no procedures is having procedures that are not followed. Successful implementation requires a coordinated effort of front-line and backoffice personnel.

Given that so many best-execution issues arise in the trenches, on an ongoing basis, desk heads and supervisors play a vital role. Compliance and other support personnel must provide professionals with the information and education to carry out their best-execution duties in an efficient and effective manner. Manageable exception reports, technology-enhanced follow-ups and assistance with trader education allows managers to properly supervise best execution without jeopardizing other responsibilities.

The labor-intensive nature of monitoring best execution makes technology-based solutions not only an attractive alternative, but the only alternative for high-volume firms. However, if an order-management system operates in a way that raises a best-execution issue for one customer order, it is likely to do so for thousands of others. Accordingly, all aspects of the manner in which a firm's systems process orders should be evaluated to ensure that orders are not auto-disadvantaged.

Once a firm's system has been programmed to fulfill certain best-execution responsibilities, an answer that "the system takes care of it" will not appease an examiner. Murphy's Law dictates that systems don't always work. Procedures must be devised to ensure that systems will be periodically tested to verify continued operation. When a malfunction does occur, back-up plans should be in place to ensure that customers do not suffer as a result. Once again, these procedures should be documented in writing.

The agency desk can easily become the forgotten stepchild of a market-making firm's best-execution supervisory program, with potentially damaging results. Agency order flow can be seen as a means to generate reciprocal business from fellow market makers, an idea that regulators could view as being in direct conflict with best-execution principles. The hackneyed mantra of "we know who gives us good executions" is insufficient in this era of documentation. Firms must be in a position to prove how best execution, rather than business considerations, is the primary factor in the order-routing decision.

This is not to say that firms have no discretion in deciding where to route agency order flow. A literal interpretation of best execution, which would require broker dealers to route all their order flow to the one firm that wins the battle of best-execution statistics, is recognized as impractical and counterproductive.

What is required, however, by an order-routing firm, is an ongoing effort to ensure that agency-desk customers are not materially disadvantaged by order-routing decisions. This requires a periodic (read quarterly) evaluation of the best-execution performance of your executing firm(s) versus competing markets.

As the amount of publicly-available data increases, this task becomes easier as the awkward process of requesting specific order-execution information directly from competitors becomes unnecessary. So long as this data suggests the executing firm is competitive on a best-execution basis, your order-routing determinations are likely to go unchallenged by regulators.

At best, the lack of clarity surrounding the duty of best execution gives firms some much-needed flexibility in developing supervisory solutions. Regardless of particular methods, evidence of an honest, consistent monitoring effort can go a long way towards satisfying an examiner. Absent a supervisory void or a complete lack of regard for best execution, regulatory authorities will be hard-pressed to assert a firm violated a regulatory obligation that has not yet been completely defined.

William O'Brien is an associate in the New York office of Orrick, Herrington & Sutcliffe LLP. He specializes in broker-dealer and securities-market regulation.

Staring at his computer screen, a trader watches his position heading south. Stock XYZ is tanking. About ten seconds later, a second dealer offers 1,000 shares in XYZ, up 1/16. The trend is reversing.

The stock's underlying value slowly moves north, driven by informed traders who react to market fundamentals, such as positive-earnings surprises.

The first trader then unloads his position, making a modest profit. Cool as a breeze, he allows himself a sharp guffaw before plunging back into the market.

What the heck, he tells himself, buy another 1,000 shares of XYZ. Now, the market makes him modestly rich on paper. Boy, was that easy.

A trader in another environment would have given high fives to his buddies. But not this guy. The problem or perhaps the beauty is that he's playing a game on I-SMARTS, the interactive securities-market trading simulation.

The trading system is the brainchild of Robert Schwartz, finance professor at New York's Baruch College, and Bruce Weber, assistant finance professor at New York University in downtown Manhattan.

I-SMARTS, which is DOS-based, features five fictitious traders each with funny names, such as Tuna and Dog. And the buzz is that it is the only system available that adequately replicates several separate markets: quote-driven markets for dealer orders; order-driven markets for customer limit orders; and a call auction with periodic matches.

I-SMARTS is not perfect, of course. It is not networked and is only programmed to trade a single stock, which has no fundamental information (though it does post the prices on its last 15 trades).

The system itself really only allows trading in 99 units, or 9,900 shares, though the live trader could enter a block order of more than 10,000 shares. But that would trigger market impact and render ongoing trading meaningless under current parameters.

The absence of a SelectNet and SOES functionality for dealer trading, as well as orders residing on simulated electronic communications networks, might also be viewed as a limiting feature.

But the game tries hard to be realistic. Each trader starts with no cash, and can accumulate long or short positions over several hours. A market index gives traders a performance measurement. (A history of a trader's decisions is available).

To stimulate traders' attention under research conditions, Schwartz and Weber give out cash authentic legal tender based on their performance.

"After half an hour of trading on I-SMARTS, I said to one guy from the industry, You've made enough. We'll buy a Big Mac with your $5,'" Schwartz recalled with a laugh. "My experience is that it is not easy to make money trading."

The two academics developed simulations that are not purely random, meaning that buying and selling pressures, for example, do not strictly follow textbook economics models, but patterns analogous to real-world conditions.

Experimental Conditions

While the academic field of experimental economics has cranked out volumes based on studies of networked or electronically-connected participants playing the roles of traders entering bids and offers, I-SMARTS is distinctly different.

Three marketplaces can be commingled simply by clicking on a menu. Equally important, it is programmed with order-flow scenarios and other market parameters that would test the nerves of the most seasoned buy-side and sell-side traders.

Machine-generated orders, for example, can be programmed to arrive every 30 seconds, while intra-day volatility can be sent to move within a 20-percent range. Increments can be adjusted from fractions to decimals at the touch of a keystroke.

Want to have your order flow preferenced? Simple.

"So you say, Hmm, preferencing is nice. I can get order flow without being competitive,'" Schwartz explained. "Then you play the game to see just how much more difficult it is to control your inventory."

Schwartz's and Weber's collaboration stems from painstaking research each has done separately on market simulations. Schwartz previously researched order-driven markets with academic peers Kal Cohen, Stephen Maier and David Whitcomb, while Weber's dissertation was on quote-driven markets.

"What makes our system so close to the real thing is that the machine generates a lot of activity," Schwartz said. "The computer is sort of like exogenous order flow that will react to what the participant does, triggering momentum or contrarian activity."

The system is used by attendees at an annual global equity conference in Geneva, hosted by Schwartz and Weber, as well as in classroom settings at Baruch. Nasdaq, which has financed part of the development, is carrying a dealer version on its web page. The recently formed Security Traders Institute, the training affiliate of the Security Traders Association, will use I-SMARTS in classes.

Despite the best talk of Schwartz and Weber, however, I-SMARTS is unlikely to produce, any time soon, the pure unadulterated andrenalin rush of an authentic dealer's desk. Ask some traders.

"I have never been a fan of these systems," said Jim Volk co-head of institutional equity trading at D.A. Davidson & Co. in Portland. "If I am training a guy, would I use it? No, I would put him on the desk for six months and have him yelled at. You have to learn on the job."

Another trader takes a different view. "[I-SMARTS] is not the real thing, but I think aspiring traders could learn a lot from it," said David O'Shea, head of equity trading at New York-based Needham & Co.

Hollerin' Joe

Schwartz and Weber are painfully aware that the most mild-mannered trader can be transformed from a Gentleman Jim to a Hollerin' Joe within seconds.

To that end, they are toying with a CD-Rom version, possibly carrying a background cacophony of human voices.

"Anyway, when we network [I-SMARTS], some of the participants will be drawn naturally into the environment of [a noisy trading room]," Schwartz said.

Still, I-SMARTS does allow the novice and veteran traders and individuals with an interest in how trading works, a good hands-on feel without serious loss of money.

But is I-SMARTS more than a toy and educational tool? Schwartz thinks it could be used "as a screening device to separate the chaff from the wheat when a desk is hiring."

Moreover, a lot of traders are intuitive, he pointed out.

"An aspiring trader may sit down and use [I-SMARTS] and see if he has that intuition," he said.

Art Kearney has never had problems making a commitment. He's been married to his wife Connie for 29 years, and they have seven children, ages seven to 27.

He's been an employee at John G. Kinnard & Co. all of his working life, starting as a mailroom employee at the Minneapolis brokerage firm in 1968. Today, he is director of capital markets at Kinnard, overseeing almost half of the firm's 350 employees. He also sits on the firm's board of directors.

Next month, Kearney will be named the 1998 chairman of the Security Traders Association, capping a 25-year affiliation with the organization.

"This business has been very good to me. I started as a mailboy and worked my way up. I feel I have something to give back to this industry," Kearney said. "That's one of the reasons I've committed myself to the STA. You have to be involved and put something back into the business."

Kearney would like to build the public profile of the STA, and get the organization more involved in new developments that affect trading.

"I want to continue to build the visibility of the STA, so that we have an impact in the growth of the marketplace," Kearney said. "A lot of major issues affecting the future of Nasdaq and trading are being decided now. Exchange consolidation. Electronic trading. New regulations. The STA needs to fill an important role in how these developments come to fruition."

Kearney has a close association with Nasdaq, having begun his trading career during the infancy of the market.

Promoted from the mailroom to the operations department in 1968, he was given a spot on Kinnard's agency-trading desk in 1972. In 1973, he began trading Nasdaq stocks at the firm.

"In 1973, Nasdaq was only two years old, and I was trading on the agency desk," Kearney recalled. "One of our senior traders was trading on Nasdaq when it started, and it literally drove him crazy. He just walked off the desk one day and never came back."

Kearney moved over to the Nasdaq desk to replace the senior trader. He credits the growth of Nasdaq over the next 25 years as a key to his firm's success.

In 1973, the firm had three Nasdaq market makers and covered only a handful of stocks. By the early 1980s, when Kearney began to co-manage the desk, the firm had 14 market makers in two offices, and handled more than 400 stocks.

In 1996, Kearney left the desk to manage equity capital-market operations for Kinnard. Responsible for trading, institutional sales, research and corporate finance at the firm, he dramatically rebuilt the trading department.

He closed the firm's Denver office and trimmed the trading department from 14 traders to eight. He also reduced its roster of stocks, from 425 in 1996 to 175 today.

Kearney said changes in the structure of Nasdaq in the last two years has cut profitability at Kinnard, and forced the firm to consolidate its trading operations.

"Nasdaq allowed us to grow so much in the last 25 years. But now it's creating a lot of frustrations, and we've had to restructure our operations," Kearney said. "That's why I'm committed to building the presence of the STA. I want traders to be involved in the changes in our marketplace."

What is the responsibility of the Security Traders Association chairman?

Art Kearney: Mostly to help focus the organization.

The chairman has to work with the regulators and stay on top of the issues. He must influence the design and the structure of the business at hand.

The chairman has to continue to create the visibility that the STA needs in the trading community. We want to be looked upon as a source of information and an authority on the issues. We need to address the issues affecting market making. We don't want to get into a position again where a regulator has to come in and investigate our industry.

What would you like to see the STA do in the years ahead?

AK: We have to sit down with the regulators and solve some of the key problems with our markets. I would like to get some of the key issues in front of the people who can make a decision and get them fixed, without all of the rhetoric.

Is it difficult to meet with the regulators to address the issues?

AK: I think they have so much on their plates. We tend to have myopic vision, thinking that we're the only people pounding on the door to the Securities and Exchange Commission with issues. But the SEC has the exchanges and investors pounding on their door also.

This is a crucial time for the future of market making. You're going to have a lot of firms, in the next two years, taking a hard look at their Nasdaq market making and deciding if they want to stay in the business. If we don't push to get some of these issues fixed, a lot of these firms may choose to abandon the marketplace.

So what are the issues in Washington that the STA is most vocal about?

AK: Right now, we're pushing the SEC 31(a) transaction fees. If we can get 31(a) fees reduced, it could really catch the attention of our membership. We've already seen some relief proposed. Relief would mean savings of literally hundreds of millions of dollars each year for the brokerage community.

It seems the National Association of Securities Dealers has been more supportive recently of getting 31(a) fees reduced.

AK: The NASD has always been supportive of a reduction in fees, but I think they've had to be very careful. The SEC oversees the NASD, and the NASD has to be cautious of what it says. They've always been in favor of having the fees reduced, but they haven't always been able to come right out and say it.

The NASD is considering changing the way Nasdaq counts riskless principal trades. The change would eliminate double-counting, as each trade for a customer order would be counted as one transaction. Would that lessen the burden of 31(a) fees?

AK: That may well be the NASD's way of giving us some relief from the fees. But to be truthful, that's not the relief we're looking for. That would only generate a savings of maybe $14 million a year. We're looking for something in the area of $60 million to $90 million. Stopping double-counting is a step in the right direction, but it's not the solution to the problem.

It's been less than a year since the STA's political action committee, STAPAC, was formed. Any progress?

AK: I think it's made tremendous progress. We've built our visibility in Washington. And [STA President] John Tognino is very good in that town. He knows what buttons to push in Washington.

The only failure of STAPAC is that we haven't marketed it enough to our membership. The STA needs to get the word out to its membership that STAPAC needs contributions. People in this business can be complacent to a certain degree.

How much money has STAPAC raised thus far?

AK: I would say about $150,000, all from member contributions.

Speaking about objectives, the STA seems to have focused more on their buy-side members in recent years.

AK: Definitely. It has to. A lot of our industry has gravitated to the buyside. It used to be that we would say the STA represents the market makers. But I think we represent the whole trading community. The buyside is as entwined in trading as the sellside. What affects us affects them.

That's why you have people like Holly Stark [head of trading at New York's Dalton, Greiner, Hartman, Maher & Co.] and Peter Jenkins [head of trading at New York-based Scudder Kemper Investments] working on STA committees alongside market makers. They may not agree with us at all times. But I think they understand that what affects the sellside also affects them.

Buy-side traders need to have strong relationships with sell-side firms, so they feel comfortable sending their orders to certain market makers for execution. The relationships in the industry may change with electronic trading and exchange consolidations, but you're always going to need relationships in this business.

You mentioned exchange consolidations. The Pacific Exchange and the Chicago Board Options Exchange have agreed to merge. The Cincinnati Stock Exchange and the Boston Stock Exchange are rumored to be in merger talks. The NASD merger with the American Stock Exchange [AMEX] and the Philadelphia Stock Exchange is close to approval. Is consolidation a wave of the future?

AK: Without question. Economies of scale is the name of the game with the exchanges. You're not going to be able to have eight different places trading the same stocks. You're starting to see some of the regional exchanges admit they can't survive on their own.

I don't think a lot of these exchanges have the money or the technology to grow. That's why they sign on with larger exchanges with deep pockets, to develop the technology to keep their business growing.

Are mergers among the regionals a threat to the New York Stock Exchange?

AK: What it does is maybe make the NYSE more competitive, and drive the costs of doing business down. Does a better marketplace surface as a result of the consolidation? Maybe. Maybe not. The NYSE is a tremendous organization with great leadership. Maybe they have to cut costs to the broker dealers or the customers as a result of the competition. They'll continue to maintain their market share, but maybe their margins will decrease a little bit.

Is this consolidation necessary?

AK: Yes. It is going to make for stronger markets going forward.

Is there a fear that too much of the order flow will go to only one or two exchanges instead of being spread around?

AK: I think that is one of the big issues today. But if you look at Nasdaq, I think that you have the opposite problem. There's fragmentation, and order flow is going to market makers, the ECNs [electronic communications networks], different crossing systems, and you've got to hope an investor has his order in the right place. The investor has to continually search all these places for the liquidity at each particular moment. Fragmentation is an issue being addressed on the listed side, but it's a real problem on the dealer side.

A person with an order can only watch so many screens and monitor so many liquidity sources. There has to be some technology changes and structural developments to match the changing market structure.

Some of the regional stock exchanges have developed innovative technology, but they lack the resources to develop it on a broad scale. Some of them have designed better mousetraps. But they don't have the order flow to build these mousetraps. Maybe with consolidation, they'll be able to do that.

How will the NASD's merger with the AMEX, an auction market, impact the Nasdaq dealer environment, if the two exchanges are ever integrated?

AK: Everything the NASD has said is that they will not integrate the two. They will run Nasdaq and the AMEX as separate entities. The NASD plans to install new technology on the AMEX to better compete with the NYSE.

If that is what happens, I think a lot of firms currently trading on Nasdaq will eventually have the opportunity to switch over to the auction environment of the AMEX. That's why it's crucial to fix the dealer market and level the playing field. Orders have to be traded fairly, and the market maker needs the same opportunity to make a return on his capital as his counterpart in the auction market.

The Actual-Size Rule was a huge benefit to the market-making community, and it's a start. But there is a lot still to be done.

The Actual-Size Rule, which was expanded in July, now allows market makers to quote all Nasdaq stock in minimum sizes of 100 shares. What's the benefit?

AK: It allows the market makers to commit their capital, when they want to commit it, with whom they want to commit it.

If market makers are trading high-flying, active stocks that can move dramatically in a matter of minutes, before the rule they could be long 4,000 shares and down a few points before they knew it. It was costing market makers a fortune.

Now, if market makers want to quote 500 shares or 100 shares, they can watch the stock and trade the stock before deciding to buy shares. Now it's their decision to commit capital, and that's the big difference. They can also decide who they commit capital to.

In the past, the market makers would be long before the natural sellers showed up. They'd already be caught in that stock, and it would be difficult to commit capital to the real sellers. Now, the market makers have a better chance of keeping out of trouble and reliquifying their positions. When the order comes in that they want to put their capital to, the market makers can make that decision themselves.

How will the NASD's proposed order-execution system affect trading?

AK: It will help level the playing field by letting market makers access the bids and offers on the ECNs without having to go through the convoluted, three-minute, SelectNet process. It's very difficult to access the market from a market-maker's standpoint, especially when stocks are in motion.

Do you support the proposal to create a limit-order book that is attached to the NASD proposal for a new order-execution system?

AK: I think the concept of a limit-order book in itself is probably a good idea. I don't think the NASD should design it and run it. The NASD has taken the limit-order book and tied it to the order-execution system. It has to be uncoupled. There is no way the two issues are the same.

You also have to do some forward thinking when looking at the limit-order book. Before you decide you should have a limit-order book, I think you first have to decide whether you need a trade-through rule, and you have to consider what affect the OptiMark Trading System will have, and you have to see how the different players in the marketplace will interact with the limit-order book.

And then it comes down to the issue of whether the NASD should compete with its member broker dealers and ECNs, or are the broker dealers and ECNs capable of handling limit orders.

Will the NASD separate the two proposals?

AK: I think they're going to have to.

What is the right way to build a limit-order book?

AK: I'm not sure I have that answer. You need a trade-through rule. You need to provide access to the book. I think you need to reward the people building the book. I don't think people should be able to take advantage of the book for nothing.

I look at the ECNs and certain market structures, and see that you pay for certain things. Why does a trader use [Reuters Holdings'] Instinet? If he's using it for anonymity, he should pay for that service. If he doesn't care to be anonymous, then he'll just publish his market on Nasdaq. Why should a trader have to pay an ECN when he doesn't care about its anonymity? But if he's paying for liquidity, then he should have to pay.

That's the way I look at the business. They should unbundle the services and let the market makers pay for the ones they want, and let them get paid for the ones they provide.

Are there too many ECNs out there?

AK: I think so.

Are the ECNs not adding value for the investor? Is there an ideal number of ECNs?

AK: I think they're adding value for the investor. But they are not being held to the same standards as the market makers. They are locking and crossing markets. It's like the Wild West. I know the NASD is looking at the issue. But there doesn't seem to be any rules or regulations the ECNs are being held accountable to. They can do whatever they want, which can create problems in the marketplace.

How can you say there are too many when the SEC says there can be as many as possible? My opinion is that the regulators would like to see the market makers on equal footing with the ECNs, with the ECNs contributing to a continuous market as much as market makers.

Unfortunately, the market maker has to be there every day, and the ECN doesn't.

So you think the ECNs should be regulated as broker dealers?

AK: Definitely. There should be new procedures for monitoring their order flow and regulating how they do business. Right now, I think the ECNs are unregulated from that standpoint.

What do you think of OptiMark or Instinet trying to get access to the Intermarket Trading System? How do you see the future of electronic trading?

AK: The future of electronic trading goes deeper than OptiMark and Instinet. They are just two parts of what is taking place in our market. One of the things I want to do as STA chairman is to continue to build the visibility of the STA so it can have an impact when it comes to the integration of these new developments.

One of the problems is that with the ECNs and the order handling rules, the playing field has been skewed tremendously away from the market maker. He's got to pay ECN fees. Accessibility to the ECNs is a joke. They can throw bids and offers out there, and the market maker can't get to them. And when he does get to them, they don't respond. They're not held to the same rules as the market maker.

One of my goals is to level the playing field next year.

How?

AK: The STA is in a strong position. If we can't get the NASD or the SEC to look at an issue, then we need to have the ability, visibility and credibility to file our own petitions and get the NASD and the SEC to address these issues.

We have to make sure the order flow going into Nasdaq is treated equally. Institutions and market makers need access to the ECNs, and the ECNs need access to market makers' bids and offers. But right now, if a market maker is not tied into a particular ECN, it's very difficult to get access to the orders it's reflecting.

The NASD has been trying to build their new order-execution system for Nasdaq, but for whatever reason, it keeps getting stuck in the mud. By the time the system does get up and running, it could be too late.

Ten years ago, Automated Securities Clearance was a small but pushy software company that competed for order-management business with TCAM Systems.

How times have changed. Weehawken, N.J.-based Automated is no longer an upstart, peddling its core BRASS system and order-routing services.

BRASS now overshadows the rival product of TCAM, the New York affiliate of Waltham, Mass.-based Stratus Computers, and upstages the products of other vendors.

These include London's Royalblue Group, Trinitech Systems in Stanford and New York's QV Trading Systems. Moreover, BRASS handles a majority of the order flow on Nasdaq desks.

But the question remains: Can BRASS, the industry standard, stay on top in a business with hostile competitors?

Bygone Days

BRASS and its competitors have their origin in a bygone era. Years ago, Nasdaq traders used paper pads to track their changing positions, profitability and average costs.

On a busy day, the trader's assistant scribbled down trade information. Sometimes keeping track of information was not easy. Mistakes were made.

Clearing and settling trades was another matter. After a trade was executed, a ticket was typically dropped into a box which was taken to the backoffice. Keypunch operators then entered trade data for processing.

Eventually, entrepreneurial vendors developed order-management and trade-processing systems to make post-execution support speedier and cheaper.

BRASS, for instance, allows traders on Nasdaq desks to adjust their quotes; to hold limit orders if necessary; to monitor profit and losses, or P&L; and to interface with clearing brokers.

Faced with a cost-efficient alternative, traders abandoned the paper-based record-keeping and order management for TCAM, BRASS and others.

Two Categories

Wall Street's order-management and trade-processing systems fall roughly into two categories: proprietary software developed by firms, accounting for 40 percent of the business; and the rest, handled by vendors such as BRASS.

BRASS is estimated to control 50 percent of the market, and has about 130 accounts.

Order-management and trade-processing firms make money by selling their software and hardware to the sell-side community, and through subscriptions, with sell-side firms paying for each terminal or for licensing the vendor's software.

In the latter, the trading firms do not have to buy and maintain the products.

TCAM sells and licenses its product and competes with Royalblue in the outright sale of its business.

BRASS sells a total package to some firms, particularly the largest, and it runs the software and provides backup for other firms.

First Vendor

In 1982, TCAM became the first vendor to develop an electronic trading system. In the roaring 1980s, TCAM was the only game in town. Mentioning Automated to a trader would have invited a blank stare.

In the early 1990s, computer-hardware maker Stratus acquired TCAM, hoping that the software-maker's dominant position would help it sell more computers on Wall Street.

The shaky marriage, however, distracted TCAM from its core business product for equity-trading operations, say people familiar with the firm.

The timing of the marriage could not have been better for BRASS and Automated, which had launched a new software written for the newly-popular UNIX platform.

Under sustained attack from BRASS, TCAM fired back in 1994, acquiring Marlboro, Mass.-based Femcon Associates, then the number-two player in the order-management business.

Upheaval

While BRASS's dominant position is still not in dispute, upheaval in the securities industry can sometimes take even the smartest players by surprise.

"The advent of electronic trading, alternative trading systems, FIX [the Financial Information Exchange, a computer protocol for buy-side and sell-side firms] and other developments is also contributing to the upheaval," said Joseph Rosen, managing director at New York-based technology consultants Enterprise Technology Corporation.

Stratus was recently acquired by Alameida, Calif.-based Ascend Communications, a networking hardware maker. Ascend indicated it will spin-off or sell non-core networking and telecommunications businesses.

If it does, TCAM will embark on an amicable divorce from Stratus and revert to being an independent company with $25 million in sales and 150 employees worldwide, say people familiar with the firm.

Dave Bennett, TCAM's sales director for North America, is optimistic, but he cautions that the vendor needs to refocus on software. "We were distracted by the acquisition," he said.

TCAM has mapped ambitious plans that could unsettle the field of competitors.

"Our real thrust is to provide an Interment-based front-end to capture order flow," Bennett said. TCAM said it had signed accounts recently with Detroit-based Olde Discount Corp., New York's National Discount Brokers and St. Louis-based Edward Jones.

The plan clearly does not surprise one industry expert.

"Technology has advanced so much that there is a lot of opportunity for new and existing players," Rosen said. "Trading firms, meanwhile, are looking for alternatives.

Some experts think TCAM's strength lies in winning business from stock exchanges around the globe. TCAM, for instance, has already signed deals with the Istanbul Stock Exchange and the National Stock Exchange in India.

Big Plans

TCAM is not the only vendor with big plans. Royalblue is also upping the ante.

Royalblue makes the Fidessa trading systems, which are used on the London Stock Exchange's order-driven market.

The U.S. subsidiary, Royalblue Technologies Corporation, has signed its first major order, worth $2 million, and has passed the breakeven mark on a monthly basis.

However, Royalblue's threat to BRASS is questionable.

"As the company tries to take the product international, Fidessa is a threat, but not a major one, to BRASS," said Lawrence Tabb, director of technology research at The Tower Group in Newton, Mass.

In the U.K., Royalblue's accounts include brokerage giants Merrill Lynch & Co., Dresdner Kleinwort Benson and Morgan Stanley.

Most recently, Royalblue signed an agreement with Tradepoint Financial Networks, the U.K. electronic stock exchange, and with the London Stock Exchange. The agreement will enable investment banks using Fidessa to execute orders on either exchange.

Even more seasoned players, such as Trinitech, are muscling in on the order-management and trade-routing marketplace.

Trinitech is marketing NYFIX, the Exchange Access Network and FIX-compliant system that links buy-side and sell-side firms and exchange floors.

"We are seeing a rapid increase in quarterly recurring revenue supporting our strategic vision of electronic order routing, which we began executing in late 1997," Peter Kilbinger Hansen, Trinitech's president and chief executive, noted in a recent earnings announcement.

Bothered?

The competition does not overly bother Robert Greifeld, who heads up Automated. He is confident that his company will not only retain its leadership position, but will take market share from competitors.

Moreover, Greifeld is prepared to take on all comers even though the competition is formidable. Some rivals are said to have more "open" systems than Automated. Royalblue, for instance, has been complimented for being accessible to other industry systems.

"We have, and we are going to take market share away [from our rivals]," Greifeld said.

Partly to retain traders' loyalty, Automated launched several other products, including BRUT, an electronic communications network. Before that, it launched BNET, which allows broker dealers to route orders to other broker dealers.

Greifeld's next big project is a so-called "OATS-in-a-box system" which basically combines the trader's needs on one desktop. As the name suggests, that includes compliance with the Securities and Exchange Commission's Order Audit Trail System, or OATS.

Minneapolis-based Piper Jaffray and brokerage giant CIBC Oppenheimer recently signed up for the new products.

"The only way we [can grow] is by being more responsive to our customers' needs, making sure that we meet the demands of the trading community," Greifeld said.