Savvy institutional clearing firms have a new sales pitch: anonymity brokerage services.

The latest clearing broker to join the marketing bandwagon is New York-based Citicorp subsidiary Citicorp Securities Services (CSS), which has provided institutional agency-only brokerage and clearing services since 1984.

Citicorp's foray into clearing has been somewhat overshadowed by larger clearing outfits that capitalize on an image of size and service.

Now the planned implementation of the OptiMark Trading System initially for listed business may burnish CSS's image and help it snare more business, clearing experts suggest.

Driving this view is concern among some investment managers about OptiMark's basic design as a supercomputer that aggregates, executes and does not disclose the customer behind an institutional order.

At issue is fear that an investment manager runs the risk of leakage, or revealing valuable information behind a block trade if the manager clears through a firm that has proprietary equity positions. By the same token, agency-only clearing brokers do not take positions, providing investment managers more protection, experts say.

"Agency-only clearing brokers believe they can attract business from OptiMark users nervous about information being revealed," said one person familiar with the institutional clearing business.

Citicorp has signed an agreement with OptiMark and The AutEx Group, a division of Thomson Financial Services. The agreement will allow institutions to route orders to OptiMark via AutEx's TradeRoute, and to designate CSS as its clearing broker. (Thomson Financial Services is the parent of Securities Data Publishing, publisher of Traders Magazine.)

Earlier this year, New York-based Bank of New York's BNY ESI & Co., an agency-only broker and clearing unit for institutional clients, signed a similar agreement with OptiMark.

Nasdaq traders preparing for the National Association of Securities Dealers' Series 55 trader examination can turn to several training programs for help.

One was developed by the Atlanta-based Investment Training Institute (ITI), and is endorsed by the Security Traders Association, the umbrella group for more than 7,000 mostly U.S.-based equity professionals.

Similar courses are provided by the Securities Training Corporation in New York and Chicago's Dearborn Financial Training.

As of April 1, Series 55 accreditation has been required for Series 7 and Series 62 licensed representatives who trade in Nasdaq and non-Nasdaq over-the-counter securities.

Mandate

The regulatory mandate covers market makers, agency traders, proprietary traders in equity or convertible-debt securities, and professionals who directly supervise these activities.

The 90-question examination tests traders expertise in four areas: Nasdaq and market-maker activities, automated execution and trading systems, trade-reporting requirements and securities-industry regulations.

Deadline

Veterans had until May 15 to submit exemption forms to regulators, giving them until May 1, 2000 to pass the examination. Rookies, on the other hand, must sit for the test within 90 days of filing appropriate papers, the same period allowed veterans who missed the May 15 deadline.

Classroom instruction, costing $300 per student, is given for ITI's Series 55 program, while an alternative ITI self-study program is available for $150.

ITI is a subsidiary of Atlanta-based Dover International, a financial-services consulting firm. (The ranks of senior management at Dover include Washington-based executive vice president John Pinto, a former 29-year veteran of market regulation at the NASD.)

With the largest concentration of U.S. securities firms based in New York, Baruch College's Zicklin School of Business in the Big Apple is appropriately the principal site for ITI's classroom training.

Six Series 55 training courses will be held at Baruch this summer. Another four will be held until September at ITI's Atlanta headquarters.

Self Study

Meanwhile, Securities Training Corporation said it is selling self-study materials and classroom instruction for $150.

Supplementary classroom instruction is available for $150. Customized training is also available.

Dearborn Financial Training said it plans to offer study materials starting in the fall.

Charles Schwab & Co., the San Francisco-based discount broker, is launching an online service this year for retail investors in the U.K. who want to trade U.S.-listed stocks.

Guy Knight, a Schwab spokesman in London, said the discount broker is enhancing its web trading service, so that U.K. investors will have the same tools residents in Asia and Latin America now have to buy and sell stocks listed in the U.S.

"We're planning to have it operational before year-end," Knight told Traders Magazine.

About three years ago, Schwab became the first broker in the U.K. to introduce trading on the web. Earlier this year, Schwab launched a domestic service for U.K. investors, which allows them to trade stocks listed on the London Stock Exchange.

Subscribers

More than 1,300 individual investors have subscribed so far to the U.K. online service, though that is merely a blip compared with the 1.7 million Schwab online accounts in the U.S., accounting for roughly $1.2 billion in assets on an annualized basis.

To be sure, the term online retail trading can be misleading. It certainly does not mean direct access to the New York Stock Exchange's SuperDOT trading mechanism, nor to Nasdaq. "The orders must first go to the broker-dealer intermediary that assumes the counterparty risk," Knight stressed.

In the U.K., online orders are first delivered to Schwab's dealer desk in Birmingham. In the U.S., Nasdaq stocks are handled by Schwab's burgeoning Mayer & Schweitzer desk in Jersey City.

For now, Schwab in the U.K. has hitched its online marketing wagon to Nasdaq, betting that its image as the home of U.S. high-technology stocks will resonate with individual investors.

"Nasdaq is heavily promoted here, and there is certainly a demand among our investor bases for its technology-heavy issues," Knight said.

Earlier this year, Nasdaq was one of the sponsors of a private investor conference hosted by Schwab in London.

The National Association of Securities Dealers is studying a plan to use a private auditor for monitoring the quality of market makers' executions.

The hiring of an outside outfit is now a top NASD priority since a federal appeals court ruled that best execution is no longer compatible with the best market available on U.S. exchanges the so-called national best bid and offer, or NBBO.

The emphasis on best-execution obligations was originally fostered by the Securities and Exchange Commission's scathing 1996 report on Nasdaq price-fixing allegations. The report urged brokers to "regularly and vigorously" examine execution quality and to obtain the best terms possible for investors.

However, the landmark Newton vs. Merrill Lynch federal appeals-court ruling helped to dramatically change the outlook for market makers seeking compliance with that responsibility.

One option now being considered is a uniform audit system for market makers. A senior NASD official said the association is looking at a business arrangement with The Transaction Auditing Group (TAG), a Northport, N.Y. firm specializing in audits that measure execution quality for exchanges and broker dealers.

Speaking in New York at a compliance conference hosted by the Securities Industry Association, Jim Cangianlo, senior vice president at the NASD's regulatory subsidiary NASD Regulation, did not elaborate on possible arrangements for a TAG connection.

A spokesman for the NASD said it had no current business relationship with TAG, but was interested in its technology.

TAG was hired earlier this year by the Chicago Stock Exchange to conduct audits on a quarterly basis, based on a set of price-improvement, order-fill, liquidity and timeliness statistics.

TAG President Alan Shapiro acknowledged that his firm has had discussions with Nasdaq, but agreement had not been reached as of press time. "We would be happy to do business with Nasdaq," he said.

Ten years ago, an initial public offering was a rare bird. Capital was raised for corporations with high-yield bonds, revolving credit, secondary offerings and bank loans. Oftentimes, an IPO was just an afterthought.

But a remarkable change eventually occurred IPOs got hot.

According to Securities Data Co., investors pumped up to $109.3 billion into 1,700 new issues within the past two-and-half years.

Access to these potentially lucrative investments was another matter, of course. During much of the 1990s, access was limited to institutional investors and high net-worth individuals.

New Opportunity

Beginning in February 1998, however, individual investors moms and pops had a new opportunity to participate. Greenwich-based Renaissance Capital opened the door through the first-ever mutual fund devoted exclusively to the new-issues market The IPO Plus Aftermarket Fund.

"A lot of investors would love to get in on IPOs at the offering," said Linda Killian, a portfolio manager and one of Renaissance Capital's three founders. "That's the main reason we started the fund."

The fund's three managers, all former investment bankers, founded Renaissance Capital in 1991 to provide investors with an independent source for IPO research.

Now four months old, Killian said The IPO Plus Aftermarket Fund relies simply on word of mouth and does not advertise.

Even so, response has been "very enthusiastic." About 1,500 people have invested roughly $12 million, directly participating in some of the year's most successful offerings.

Moreover, access to these offerings is through some of Wall Street's largest syndicate operations, a gateway critics suggested would be difficult to traverse.

According to Killian, the fund's five largest holdings are:

*Keebler Foods (NYSE:KBL), the world's second-largest manufacturer of cookies and crackers, which debuted at $24 a share in February through a syndicate led by investment-banking giant CS First Boston.

*Steelcase (NYSE:SCS), the world's largest manufacturer of office furniture and related products, which placed 12.13 million shares at $28, through a syndicate headed by investment- banking giant Goldman, Sachs & Co.

*CB Commercial Holdings (Nasdaq: CBCG), one of the largest vertically-integrated providers of real-estate services, such as brokerage, investment management, property management, real-estate market research and mortgage banking through 107 locations. This November 1996 IPO priced 4.35 million shares at $20, through a syndicate headed by brokerage powerhouse Merrill Lynch & Co.

*E*Trade (Nasdaq:EGRP), a pioneer of the online brokerage industry. This August 1996 IPO priced 5.67 million shares at $10 1/2, through a syndicate headed by San Francisco's Robertson, Stephens & Co.

*Delia*s (Nasdaq:DLIA), a leading direct-mail retailer of apparel and accessories for teenage girls. The company's 2.35 million offering in December 1996 opened at $11, through a syndicate headed by San Francisco-based Hambrecht & Quist.

Other Holdings

According to Renaissance Capital's web site (www.ipo-fund.com), some of the fund's other top holdings include mutual-fund giant Waddel & Reed (NYSE:WDR), telecommunications provider Hyperion Telecommunications (Nasdaq:HYPT) and telecommunications-equipment company Reltec (NYSE:RLT).

The fund purchased at offering and still holds both Keebler and Steelcase. CB Holdings and E*Trade were both purchased in the aftermarket, a period defined by the fund as up to ten years after a company goes public.

Aftermarket investments, however, are confined to securities with unseasoned trading and are limited by research, float, public ownership, operating history, or relative anonymity in the U.S. capital markets.

Normal Conditions

Under normal market conditions, the fund will invest at least 65 percent of its assets in common stocks, and up to 25 percent in foreign stocks.

To prevent investors from flipping, or liquidating their holdings during difficult market conditions, the fund imposes a two-percent redemption fee on shares that have been held for less than 90 days.

"That's especially important when you're dealing with a small-cap fund, where stocks are generally less liquid," noted Jim Raker, who tracks the mutual-fund industry for Morningstar, the Chicago-based research outfit.

While impressed with its redemption feature, Raker said the fund's annual management fee of 1.5 percent of net asset value, or NAV, is slightly above the average 1.4 percent of the overall NAV charged for U.S. diversified equity funds.

Renaissance Capital capped total expenses at 2.5 percent of net assets, which is at the high end of average total expenses for mutual funds.

"It's not unusual for smaller funds to have higher management fees because they generally require more maintenance," Raker said.

But, he added: "The bottom line is that we're in an unprecedented bull market and investors don't pay as much attention to 100 basis points when they're making 25 percent or 30 percent each year."

The fund's NAV at the close of trading June 16 stood at $14.08, a 12.28 percent increase over the fund's initial NAV of $12.54 on Dec. 31, 1997, and about 4.6 percent above its NAV when the fund was opened to investors.

IPO Returns

While returns across the IPO market have soured in recent weeks, plummeting from 34.3 percent at the end of April to 12.94 percent as of mid-June, The IPO Plus Aftermarket Fund had pared just 2.8 percent of its gains as of June 16.

As the IPO calendar began to show signs of expanding in June, Killian was encouraged by the high quality and diversity of the new-issues market.

"This year's IPO market got off to a slow start," Killian said. "But throughout, the quality of offerings has remained relatively high."

One of the principal reasons for the robust market is a more diverse set of industries going public.

The emergence of rollups, or companies that consolidate fragmented industries (such as road services and equipment-rental concerns), Year-2000 business, online retailing and the expansion of healthcare, are expected to stoke the IPO machine, Killian said.

Experience

"There are a lot of factors coming together suggesting we'll have a sustainable market for IPOs," she said.

Banking on the long and varied investment experience of its management team, The IPO Aftermarket Plus Fund will consider most IPOs.

According to Killian, the only IPOs the fund disdains are real-estate investment trusts, or REIT's.

"We're diligent investors, and we do our homework on companies where we think there are opportunities," Killian said.

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

A full-blown dispute has emerged between traders and electronic communications networks (ECNs). At issue is the transaction or access fee, charged each time a market maker hits the bid or takes the offer on a stock an ECN is publicly quoting on Nasdaq.

Many market makers complain that these fees should not be charged, in part because ECN orders are similar in one respect to the quotes posted on Nasdaq by market makers. They are all part of the Nasdaq price-quote montage.

Consequently, many market makers, from the largest to the smallest, are refusing to pay access fees on orders executed as a result of ECN price quotes on Nasdaq. ECNs, in turn, are now refusing to accept orders preferenced by some of the brokers withholding access payments.

Compete Publicly

Market maker quotes and ECN customer orders compete publicly each day on Nasdaq. Some of the best known ECNs are Reuters Holding's Instinet and Bloomberg Tradebook. ECNs frequently stand alone at the inside price. In some securities, in fact, ECN orders outnumber market-maker quotes. That is likely to become more common as firms reduce their market-making commitments and new ECNs enter the market.

In addition to the access fees charged at up to one and a half cents per share as well as the ECN's posted stock prices, traders incur Nasdaq's one-cent fee whenever their trades with ECNs are transmitted over SelectNet. ECN customers on the other side of the trade are often charged a similar ECN fee, but are not charged a Nasdaq fee.

Market makers, on the other hand, do not charge an access fee. Nor do they pass along the ECN fees, which can add up quickly, to their customers. As market makers see it, the ECNs should be collecting fees only from their customers, who are getting the benefit of executions on their anonymous orders. Without regulatory guidelines, many market makers, as mentioned earlier, are withholding payments to ECNs. These tactics have resulted in several legal and regulatory issues noted herewith:

*Breach of agreement lawsuits.

ECNs are allowed by the Securities and Exchange Commission to charge a reasonable fee to non-subscribers for accessing an ECN. An ECN, which is responsible for communicating its fee structure, may require that non-customers enter contractual agreements on the payment of access fees. Furthermore, the SEC has informally told ECNs that they may refuse to trade with any entity that does not pay its fees.

The first of probably many lawsuits was recently filed by Montvale, N.J.-based All-Tech Investment Group, operator of the ECN ATTN, against a large Jersey City-based Nasdaq wholesaler.

*Heightened NASD scrutiny for unnecessarily locking or crossing markets.

A locked or crossed market occurs when the publicly-displayed inside bid and offer prices are identical or inverted (e.g., an inside bid priced at 10 1/2, and an inside offer priced at 10 1/2 or 10 3/8). A market maker is more likely to enter a locking or crossing quote when it is denied access to an ECN's inside market in order to attract trading interest. While failure to pay an ECN its fees may not be a regulatory issue, the increased incidence of locked or crossed markets is a market-integrity issue.

*Best-execution violations.

This could occur if traders are unable to obtain the best Nasdaq price available.

Interestingly, the National Association of Securities Dealers does not seem concerned that ECNs, which are registered broker dealers, may be failing to provide best execution when they do not fill their customer orders.

*Disruption of trading operations.

Instead of several seconds to execute an order, a trader who is denied access to an ECN may take the time to either call around to get execution at the inside price or enter a locking or crossing order.

ECNs were approved by the SEC under the terms of the order handling rules to operate trade-matching systems through a SelectNet linkage to Nasdaq. When the two-tiered market ended in January 1997 with implementation of the SEC's order handling rules, there were four SEC-approved ECNs. Now there are eight. A ninth ECN is awaiting final regulatory approval.

ECNs transmit their best customer and subscriber orders to Nasdaq and accept preferenced SelectNet orders from third parties. ECN orders can also be accessed by telephone, while subscribers have direct access to ECNs via dedicated terminals and PC-based modems.

The SEC and the NASD are aware of the current controversy between market makers and ECNs, and are considering rule proposals that may resolve the situation.

One rule proposal, a copy of which was obtained by Traders Magazine, would prohibit ECNs from refusing "to deal with any person who attempts to access the quote of the [ECN] when one or more [ECN] is responsible for the inside quote, on the basis that such person has not paid or will not pay any charge or fee that is in addition to the publicly-quoted price of the [ECN]."

Meanwhile, regulators are keeping a noticeably low profile. It is too early to draw conclusions about their ultimate decision. Nevertheless, Richard Lindsey of the SEC's Division of Market Regulation, informed attendees at a recent Securities Industry Association conference that the SEC looks favorably on the NASD proposal.

An NASD spokesman, however, declined to comment, noting the sensitive nature of the issue.

Times Change

Less than two years ago, many of these same Nasdaq market makers wholeheartedly subscribed to Instinet and paid its transaction fees. Instinet provided anonymity and participation in a two-tiered Nasdaq market: the public quote montage and the better-priced Instinet subscribers' market. Market makers were allowed to attract trading interest at prices inside the Nasdaq public market spread without adjusting their quotes. For Instinet and Nasdaq market makers, it was a "win-win" situation.

Currently, however, the combination of dramatically reduced spreads, significant NASD fines and ECN fees may be just too much for Nasdaq market makers and traders to countenance. And the burden of ECN fees can only worsen as more ECNs enter the market.

Firms may continue to pay the ECNs' fees for accessing their price quotes on Nasdaq. If so, these market makers will have uninterrupted access to all inside markets.

Firms that withhold payments, however, can expect to be denied access to ECN orders. When this occurs, the best advice I can offer is this: market makers must be able to demonstrate that they attempted to access the ECNs prior to entering a quote that effectively locks or crosses the market.

Howard L. Haykin, CPA, is president of Compliance Solutions, a New York-based specialist in regulatory compliance for NASD broker dealers and SEC investment advisers.

An uninterrupted and staggering 20-year decline in the average equity commissions paid to broker dealers by U.S. institutions is slowing unceremoniously, a new report by Greenwich Associates reveals.

"The point of resistance has been reached," said Wayne Wagner, president of the Plexus Group, a Santa Monica, Calif.-based firm that studies institutional-trading costs. "Brokers are simply saying, Let's have no more declines in commissions.'"

Across a range of 400 institutions that responded to the study, Greenwich notes that weighted average commissions in aggregate remained unchanged at 5.6 cents per share for the 12 months ended January 1998, the same average rate of a year earlier.

That's the first yearly measurement taken since 1977 by the Greenwich-based research firm, that average commissions did not decline by roughly one-tenth of one cent each year. (Average commissions are the total commissions reported, divided by the shares executed, irrespective of institutions' weight or size.)

Back in 1977, the average "unweighted" commission was 13.6 cents, compared with 6.4 cents in 1997. Adjusted for inflation, the effective 20-year decline is even more stunning than the more than 50-percent decline.

An official at Greenwich said in an interview that the results in the report, compiled for U.S. institutional equity investors, confirmed what the firm had been anticipating as far back as 1994 that commissions would eventually hold relatively steady. Of course, the closer to zero commission, the smaller the room becomes for rate shrinkage.

Nevertheless, taking the four years starting in 1993, commission rates per share on agency trades, as measured by the reporting institutions' weight, fell until 1995 from 6.3 cents to 6.1 cents to 5.9 cents, and held steady in 1996 and 1997 at 5.6 cents per share.

While some U.S. institutions from mutual funds and pension plans to money managers and other buy-side firms expect downward movement in commissions in the coming year, only the very largest envision slight declines in rates, according to Greenwich.

Increasing Profitability?

But does the study, as the Plexus' Wagner and other experts suggest, really convey that broker dealers are headed for a new period of increasing profitability on the tail of a rip-roaring stock market?

The answer is not that simple. At best, the picture is clouded. For one thing, a breakdown of the unweighted average commissions per share on agency trades shows a divergence in rates paid by the very largest institutions on the one hand, and some of the smallest institutions on the other.

While institutions with total commissions of over $20 million annually saw average commissions dip from 5.7 cents to 5.6 cents, institutions generating commissions of $5 million to $9.9 million reported that their average jumped from 6 cents to 6.2 cents.

On the Nasdaq side, that pattern was only evident between the very small institutions and all the other reporting institutions. Imputed commissions for these smaller buy-side firms rose significantly, while the commissions actually declined for all the rest. (Imputed commission, classified by traders as net-trading costs paid as Nasdaq credits to market makers, are implied by factoring the stock value plus the spread divided by the number of shares executed.)

To be sure, the rate increases noted among the smaller institutions clearly contributed to the reversal in overall commission rates in 1997. Even so, on an unweighted basis, commissions on agency trades fell from 6.7 cents in 1995 to 6.5 cents in 1996, and to 6.4 cents in 1997. On the Nasdaq side, imputed commissions dropped from 7.3 cents in 1995 to 7.2 cents in 1996, and to 6.6 cents in 1997.

Explicit Commissions

The continuing decline in imputed commissions raises the prospect that Nasdaq institutional desk's will eventually charge explicit, or actual, commissions for handling block orders.

That's even more likely if the Securities and Exchange Commission approves a proposal by the National Association of Securities Dealers to eliminate double counting on riskless principal and other trades.

Altering the way trades are counted would result in single prints instead of two-sided prints. "That would make it easier to charge institutions a straight commission," said George Jennison, head of Nasdaq trading at Richmond, Va.-based Wheat First Union.

"At the moment, there is significant margin pressure on Nasdaq institutional business," Jennison added. "We're probably going to see some repricing on orders."

Some institutional traders suggest that institutions themselves are really holding up commission rates. In their view, institutions are loathe to push rates down much further because that would hurt the level of soft-dollar research services they receive.

Greenwich noted that the soft-dollar conversion ratio now hovers at 1.55. In a soft-dollar arrangement, a specified proportion of an institution's total agency-commission business is rebated or softed to institutions in the form of research and other services.

Thus, with a conversion ratio of 1.55, an institution receiving a total of $100,000 in soft-dollar services would be required to transact $155,000 in commission business.

"If commission rates drop much further, institutions would be hurt," said Raymond Murray, director of trading at Minneapolis-based Investment Advisers.

On the other hand, Wall Street firms, such as New York-based Lynch, Jones & Ryan, that specialize in soft-dollar services to institutional accounts, may be holding a lid on commission rates, according to other experts.

"Soft-dollar brokers may be providing a level of competition to executing brokers in general," said Lee Pickard, a Washington-based attorney specializing in soft dollars. "If these soft-dollar firms were not around, rates might now be even higher."

Electronic Brokerages

Finding a clear sign of where commissions are headed, therefore, is not easy.

The popular use of electronic brokerages, such as Reuters Holdings' Instinet, somewhat clouds the landscape. Greenwich's study notes that institutions paid 3.8 cents per share on electronic brokerages, dubbed as "non-traditional" trading systems by Greenwich.

At least 96 percent of institutions generating more than $20 million a year in commissions using non-traditional systems for Nasdaq business. Greenwich further noted that among institutions generating more than $5 million a year in commission volume, 82 percent use non-traditional systems, up from roughly 75 percent in 1995 and 1996.

"Even if use is not so widespread among institutions that are not quite so giant," said Greenwich consultant Bjorn Forfang in a foreword to the study, "it is extremely widespread and rising."

The message now is that there is less homogenization of commission rates than ever before, according to another expert. "Some institutions will pay six cents to a broker for block positioning or capital commitment, and use an electronic broker for plain-vanilla agency execution," the expert said.

By Greenwich's calculations, average commissions on agency trades as distinct from all other business are expected to decline to 5.5 cents in 1998 from 5.6 cents in 1997. But even that may not change the current steady trend in rates. "If the commission rates stay flat and then begin to rise, that could be significant for sure," said an official at Greenwich.

But the official pointed out that the consolidation trend among institutions is likely to put a further squeeze on commissions. "Commissions could go down further in the coming year," the official added.

All told, total commissions generated in the U.S. institutional equity business increased modestly for the 12 months ended January 1998, gaining just two percent over the prior year, according to Greenwich.

Broken down, listed commissions, accounting for more than half of all institutional equity order flow up three percent since 1996 increased by seven percent. Imputed commissions rose by ten percent and now comprise 25 percent of all commissions.

Significantly, commissions generated from new issues or initial public offerings fell dramatically, nearly 25 percent in 1997 from the previous year's record high. At the 75 largest reporting institutions that each generate more than $20 million in aggregate business, commissions dropped from 33 percent to 24 percent of total commissions.

Retail

While Greenwich's study might hint that institutional broker dealers may be headed to higher levels of profitability, that conclusion must be juxtaposed beside the impact of narrowing spreads on Nasdaq (most obviously on the retail side).

Indeed, Greenwich notes that imputed commissions on Nasdaq from handling block orders executed with a spread continued to decline from 6.8 cents per share in 1995 to 7.3 cents in 1996, and to 5.9 cents in 1997.

And the 1998 Traders Magazine Nasdaq Market-Maker Survey revealed profitability, across a range of small to large firms, declined among roughly 60 percent of the desks.

Although that data could not be independently verified, the reported decline was attributed by head traders to the ongoing impact of the order handling rules and the widespread quoting of Nasdaq stocks in sixteenths.

For its part, Nasdaq said spreads declined by up to 33 percent soon after the implementation of the order handling rules in January 1996.

"Over-the-counter profitability is way down," lamented Wheat First Union's Jennison.

Skeptics

Some experts, however, are now questioning if the narrower spreads can be equated with declining profitability.

"During the trading day, I suspect some market makers are simultaneously moving their bid and asked prices up and down on a Nasdaq stock, before committing to handling a large block of shares behind a smaller order," said one expert, who declined to be named.

"On a buy order, institutions are paying more, and on a sell order they are getting less," added the expert. "Spreads have narrowed, but not the effective profitability."

Are market makers engaging in this practice?

"Oh, that's plain silly," snapped a New York-based market maker.

Commission Rates in Cents Per Share (Agency Trades) Commission Volume 93 94 95 96 97 98*

Over $20 million 6.2 5.9 5.8 5.5 5.4 5.4

$10 million to $20 million 6.4 6.2 6 5.8 5.8 5.7

$5 million to $9.9 million 6.1 6.2 6.1 6.1 6.3 5.9

$2.6 million to $4.9 million 6.2 6.5 6.2 5.8 6.3 6

$2 million to $2.5 million 6.8 6.5 6.6 6.5 6.2 5.9

$1 million to $1.9 million 7.3 7.2 6.5 7 6.7 6.5

Under $1 million 8.3 9.1 9.2 7.7 7.7 7.3

Total Institutions 6.3 6.1 5.9 5.6 5.6 5.5

*estimated

Note: Average weighted by Commission and based on matched volume

Source: Greenwich Associates

On Wall Street, firms guard intelligence secrets with a passion rivaled perhaps only in international espionage.

But the programmers and scientists guarding the secrets of so-called intelligent trading systems more closely resemble James Bond's pal Q the brainy inventor of 007's electronic gadgets than they do the British secret agent.

Since their introduction into Wall Street in the late 1980s, intelligence systems have made significant inroads into proprietary trading. Employing mathematicians and physicists, certain firms have used the systems based on mathematical models, or algorithms, that help process information and recognize patterns to locate mispriced securities and project future stock movements.

But recently, a number of trading firms have used intelligence software to trade stocks on an agency basis.

"Agency trading will have to go this way," said Dr. Mark Gimple, managing director of quantitative methodologies at New York-based Reynders, Gray & Co., an institutional agency-trading firm. "Investors are looking worldwide for liquidity, and they will need that technology to find it."

Gimple a Stanford University Ph.D. and former aerospace and biomedical scientist developed his firm's distinct intelligence system. With initial start-up costs of more than $400,000 for equipment and software, it took Gimple six months to get the trading system running.

Aimed at lessening market impact, the quantitative trading system is programmed to follow the daily volume in New York Stock Exchange-listed stocks. The system equipped to trade up to 6,000 client orders each day will trade for orders when a particular stock's volume is peaking during the day.

The system does not handle Nasdaq orders. "Because of the nature of the dealer market," Gimple said, "Nasdaq orders require a little more human attention."

Affectionately nicknamed "the walking algorithm" by his co-workers, Gimple said the system keeps track of multiple liquidity sources and accurately projects when volume in certain stocks will rise.

When the desk receives an order from a client at a pension fund, trust fund, institution or from a broker, Gimple or a Reynders Gray trader will give the client a first assessment of the market, hoping to get a sense of how the client wants the order to trade. Some orders may need to trade quickly, others can be stretched out over days. Based on the client's instructions, the desk will enter the order for execution within a certain time frame.

The desk then enters the order into the system, providing the system with a designated price range and time frame for execution. The system will execute an order within the designated parameters when it predicts volume will peak.

"We call it trading in the shadows,'" Gimple added. "We try to be present in the market, but we don't want our orders impacting the marketplace."

When the system determines an order should be filled, it will be sent to the NYSE's DOT system if it is a market order, or to SuperDOT if it is a limit order. The Big Board's electronic systems, in turn, route the orders directly to the specialist for execution.

Reynders Gray has eight equity traders in New York and Boston. Of the 1.5 million shares the desks average each day, almost half are executed by the trading system.

Across town from Reynders Gray's midtown Manhattan offices, New York-based Investment Technology Group (ITG) also utilizes a distinct quantitative algorithm to trade securities on an agency basis.

QuantEx ITG's quantitative trading system monitors market conditions and is programmed to make trading decisions based on weighted factors. Like the system at Reynders Gray, QuantEx will route orders directly to liquidity sources when market conditions are most favorable.

"It is almost like the system has a series of questions it asks thousands of times a day," said Suzanne Christensen, ITG's director of product marketing for QuantEx. "If all of the market conditions click, the system will trade the order."

In 1990, ITG acquired a small technology company, Integrated Analytics Company, that had developed a successful quantitative system. Hoping to transform it into a transaction system, ITG spent almost three years reprogramming the quantitative software.

Orders are entered into QuantEx during the day, and are routed to DOT, over-the-counter market makers, electronic communications networks (ECNs), crossing networks and brokers when market conditions fulfill the system parameters.

Aside from handling orders on its own agency desk, ITG has licensed 115 QuantEx links to 60 clients. The ITG clients with QuantEx links route orders directly to liquidity sources through ITG's routing server.

David Cushing, ITG's director of research, provides all coverage and strategy writing for QuantEx clients. Aside from its research responsibilites, Cushing's staff works with clients to help integrate QuantEx into the client's trading operations.

"Working so closely with clients, we can help identify what clients want on their end," Cushing said. "That lets us know what enhancements will keep our system up to date."

QuantEx clients route more than ten million shares a day, and ITG routes up to seven million shares daily on the intelligence system.

"What QuantEx does would be impossible to do on a human level," said Scott Mason, ITG's president. "It would take a large team of traders to trade the way it does. I can't see how agency desks will be able to continue to trade without some kind of intelligence system."

Algorithms, Quants and Expert Systems

An algorithm is a mathematical program that surveys inputted data and charts predictions based on that data.

Applied to trading, algorithm programmers believe that market behavior, although appearing very chaotic and random, follows a pattern. By analyzing various data sources and weighting those sources based on importance programmers hope a system can find a pattern and make predictions based on that pattern.

A genetic algorithm programmed to mimic the human thought process runs whole sets of algorithms together, constantly updating and modifying predictions based on changing inputs. A genetic algorithm attempts to solve problems through constant trial-and-error processes.

"Genetic algorithms are built with more parameters than simple algorithms," said Richard Bauer Jr., a finance professor at San Antonio's St. Mary's University, and author of "Genetic Algorithms and Investment Strategies," a book on the application of algorithm models on Wall Street.

Bauer said that genetic algorithms distinct from the most basic algorithms are more dependent on human programmers to produce forecasts.

"An algorithm can be generic and just react to information," Bauer added. "But because it has a memory, a genetic algorithm reacts the way humans would react if they could analyze data that quickly and efficiently."

A neural network as described by Dr. J. Doyne Farmer, a senior scientist at Santa Fe algorithm investment firm Prediction Company is a series of algorithms working together for more detailed predictions.

"You set up a neural network with algorithms connected in layers," Farmer said. "They work like nerves do, with the firing of one triggering processes in subsequent nerves."

Neural networks, according to Farmer, mimic the human brain's repetitive processes of measuring data, making adjustments and remeasuring data until predictions run smoothly. Once a certain algorithm makes a projection, it spurs the firing of a subsequent algorithm.

At Prediction Company, Farmer helped develop the detailed neural network that manages a portfolio of investments for international banking giant Swiss Bank Corp. Farmer started the company in 1991 with Dr. Norman H. Packard, his former University of California at Santa Cruz physics classmate.

But according to Lawrence Tabb, a group director at Newton, Mass.-based research company The Tower Group, many Wall Street firms have turned away from neural-network technology because of the complexity of the forecasting processes.

"Because the processes are so layered, I think people on Wall Street have backed away because they can't understand how the systems reach conclusions," Tabb said. "Data goes in, but a lot of people don't trust the answers that come out."

Tabb added that more Wall Street firms have turned to expert systems and quantitative models in recent years.

An expert system is a series of algorithms based on expert analytics. With rules derived from professionals in the designated industry, an expert system will process data based on those rules.

In trading, an expert system could be programmed with algorithms based on rules followed by certain traders. The system would rapidly process data and make predictions based on the preprogrammed trading rules.

A quantitative system or quant in trading uses complex algorithms programmed into the system as rules. Based on market conditions, like current prices and order flow, for example, the rules would ensure a desk's orders are handled within certain bounds.

"Often, a firm setting up for quantitative analysis knows what kind of results it wants, but it doesn't know how to program the system to achieve those results," Gimple said. "Quantitative systems may not actually trade, some just make sure a desk stays within its limits."

Intelligence Systems in Trading

Intelligence systems are used all over Wall Street, from exchange order books to money-management software and trading systems.

D.E. Shaw & Co. is the most well-publicized Wall Street firm using intelligence systems in proprietary trading.

Launched in 1988, D.E. Shaw utilizes algorithm models to exploit securities-pricing inefficiencies. The investment bank, founded by former Columbia University computer-science professor David Shaw, is reported to have spent over $100 million to research, construct and maintain its systems.

D.E. Shaw's mathematical models and risk-management systems try to identify pricing anomalies in over 100 worldwide markets. In recent years, the investment bank has expanded, creating a broker-dealer subsidiary for third-market trading and an international derivatives business.

Like most Wall Street firms using intelligence software, D.E. Shaw works to maintain a level of secrecy surrounding its trading systems. Few firms are open about their specific technology, and most keep volume figures hidden.

But according to Reynders Gray's Gimple, the growth in volume on the DOT and SuperDOT systems may in some ways mirror the development of intelligence trading over the last ten years.

In 1988, according to NYSE-published figures, the Big Board averaged more than 82 million shares each day over the DOT systems. That same year, more than 238 million shares were traded each day on the NYSE floor off of the DOT systems.

In 1993, DOT volumes jumped to 192 million shares a day, while almost 330 million shares traded off of the systems. Last year, volume on the DOT systems boomed, handling more than 475 million shares each day, close to the daily NYSE floor volume of almost 550 million shares for 1997.

Santa Fe's Prediction Company was one of the firm's that contributed to the growth in DOT and SuperDOT trading in recent years.

The firm's neural network makes all of the firm's investment decisions, and routes limit orders directly to SuperDOT. Prediction Company is bound by their contract with Swiss Bank Corp. from discussing its trading volume, but Farmer said since 1991, the firm has grown from just seven employees to more than 20 today.

Farmer added that Prediction Company has invested more than $10 million since 1991 in updating its neural network.

David Whitcomb, a Rutgers University finance professor, started an algorithm trading firm in 1988 that used to route limit orders to SuperDOT.

"I think we were the first firm to use an expert system to trade limit orders on the NYSE," Whitcomb said.

His Charleston-based Automated Trading Desk began trading limit orders on an agency basis for an investment bank. Although business remained profitable, the investment bank broke its relationship with Automated Trading Desk in 1995.

Today, Whitcomb's firm trades three million shares a day through its system for the 18 high net-worth customers of its brokerage subsidiary. Having spent millions to update its technology, the firm's expert system analyzes market information based on its clients' portfolios, makes trading decisions and routes orders to liquidity sources. The system now trades only Nasdaq securities, sending orders to SelecNet, SOES and licensed ECNs.

"Firms will have to do some of their trading this way," Whitcomb said. "Small trades should be done by expert systems because they can handle hundreds of orders at once. And human traders generally don't handle small retail orders with the same kind of attention they give to big blocks."

While still trading for its brokerage subsidiary, Whitcomb would like Automated Trading Desk to get back into trading on an agency basis as well. "It's our roots, and it kept us in business our first seven years," he added.

Agency Intelligence Systems

Although a number of agency desks are trading for clients with intelligence systems, it is by no means a standard practice among firms.

"That type of technology is used for proprietary trading, not agency trading," said Jim Hanrahan, head trader at New York-based Lynch, Jones & Ryan, a leading agency-trading firm. "Quants. Algorithms. That's business for a D.E. Shaw. What we do is follow customer orders."

Junius Peake, a University of Northern Colorado finance professor and Nasdaq market-structure expert, was unaware of any agency firm using intelligence software, but felt it was a logical and necessary development.

"I can't say I'm shocked agency desks are using that technology. It can do calculations that traders just can't," Peake added.

At ITG, Mason believes that although software and programming may differ greatly, intelligence systems will become the standard on Wall Street trading desks.

"There will always be agency trades that have to be handled the old-fashioned way, but intelligence trading will just continue to grow" Mason added.

Gimple agrees. "Investors are looking worldwide for liquidity, and they increasingly need technology to find it," he said. "A trader can't keep track of all the market information out there. You need the smartest technology to stay ahead."

Huge mainframes. Fiber-optic networks. State-of-the-art telecommunication systems. Worldwide market news delivered real-time.

Sound familiar? It should. These and more are at the very heart of a Nasdaq trading room.

Back in the pioneer days, much of what is today's Nasdaq trading-room technology did not exist. By contrast, some of today's technology has a pedestrian aura.

The consequences of that might be viewed as a mixed blessing desks have no choice but to collectively spend billions of dollars to remain competitive, but in return they transact business at an exponential rate.

Now Nasdaq, an electronic marketplace, is grappling with technology changes as never before.

Electronic communications networks (ECNs), such as Reuters Holding's Instinet, New York-based Investment Technology Group's POSIT equity matching system and an upstart crossing network, MatchPoint, developed by The AutEx Group and State Street in Boston, are helping to raise the stakes.

Never known for avoiding a challenge, the Street is embracing all this technology and more.

Three Areas

According to the latest institutional-equity study by Connecticut research firm Greenwich Associates, spending on technology is going to explode in the coming year.

Much will primarily be spent in three areas of Nasdaq trading: simplifying trading desks, deploying the Internet and client services.

"More and more firms are looking to deploy technology because the market has become extremely competitive, and recent regulations have cut into the spreads," said Lawrence Tabb, group director at The Tower Group, a Newton, Mass.-based consulting firm, referring to the order handling rules.

Tabb says that firms will use technology to make their operations more efficient and profitable.

To begin with, Tabb feels that desktop enhancements will be a priority for market makers, "because traders have to keep a grip on the various places they are trading in."

"When we started, there was the Nasdaq trading terminal and the Quotron," said Tom Norby, head Nasdaq trader at Portland, Ore.-based Black & Company. "Now there are so many platforms that you need to be a wizard to stay on top of every single one."

For one thing, the number of ECNs is on the rise. Besides Instinet, other ECNs include Bloomberg TradeBook. (Greenwich noted that 57 percent of all traders now report using Bloomberg terminals.)

Coming down the pike is BRUT, or the Brass Utility, developed by Automated Securities Clearance Corp., a Weehawken, N.J.-based company, and STRIKE, a Bear, Stearns & Co.-backed ECN.

Usage

According to Greenwich, among institutions generating more than $5 million a year in commissions, 82 percent now make use of non-traditional systems for Nasdaq business, up from 75 percent in 1995 and 1996.

The study notes that these same firms are expected to do 22 percent of their business in 1998 on non-traditional systems, up from 20 percent in 1997.

"Ten years ago, if you were an institution, you had to go to a Nasdaq trader to buy a stock," Tabb said. "Times have changed. Traders have to keep clients happy."

It is no surprise that technology budgets are being earmarked for running Nasdaq and ECN software as well as data feeds on one screen, instead of several standalone terminals.

"Traders won't have to deal with so many boxes anymore," Tabb said. Norby's Black & Co. is planning to run ECNs on one computer, allowing traders to view data in several windows on a single screen. Clearly, the plan would help cut operating costs.

As always, costs are uppermost on traders' minds. According to Greenwich, institutions paid an average 6.4 cents per share on listed agency trades, 6.6 cents per share on Nasdaq trades, and only 3.8 cents a share on ECN-based transactions for the year ended January 1998.

While the numbers appear to give ECNs a competitive edge, there are factors worth noting that make listed and Nasdaq commissions higher than ECN commissions.

For one thing, institutions use some brokers on listed agency business chiefly for soft-dollar services.

Nevertheless, the lower commission costs on ECNs have clearly helped them to gain market share.

Internet

The Internet is another hotbed of technology spending. And it is helping desks achieve another goal improving client services.

Buysiders see the Internet as an important source of after-hours research, according to the Greenwich study.

The same study finds an increasing number of institutions want their broker dealers to supply them research via the Internet.

What's more, broker dealers are bowing to the demands of their clients even as spreads shrink.

WorldStreet Inc. of Cambridge, Mass. provides sell-side trading desks a product that helps them share information more easily with buy-side clients, giving them around-the-clock service, seven-days-a-week sell-side access via the Internet.

The Internet is expected to be deployed for the National Association of Securities Dealers' Order Audit Trail System, or OATS.

OATS is a real-time electronic system, which gathers and reports up to 25 trade details from order-entry to order execution. OATS will replace current trade reporting that requires certain data to be sent to the NASD within 90 seconds of execution.

OATS will be implemented in phases. As part of the first phase, by March 1, 1999 electronic orders received by ECNs or at the trading departments of market makers will be subject to OATS reporting.(Electronic orders are defined as orders that are captured in an electronic order-routing or execution systems.)

FIX

Meanwhile, speed is becoming a buzz word.

"Brokerages are using FIX more extensively to become more responsive to their clients' need for faster delivery of research and other data," Tabb said.

FIX, or the Financial Information Exchange, is a communications protocol that enables securities firms and institutional investors to interact electronically.

This set of data structures and rules is radically changing the way financial counterparts communicate, enabling efficient distribution of information and transactions among a larger selection of trading partners.

FIX protocol was rolled out in 1992 after mutual-fund giant Fidelity Investments requested its broker-dealer trading partners to more fully automate the interaction among broker dealers and buy-side trading desks.

In 1993, several firms banded together to create FIX's comprehensive open standard, allowing firms to communicate indications, orders, confirmations and trade-allocation information, virtually without charge.

FIX is currently being adopted by the majority of U.S.-based equity buy-side and sell-side trading-platform vendors, and is gaining global acceptance as well.

The protocol is also being embraced by U.S. equity exchanges, trade-matching facilities and order-routing systems, and is quickly becoming the default standard for communicating all equity-trading information in the U.S.

According to Greenwich, the FIX protocol is now used by 21 percent of investors generating more than $20 million in commissions, up from 12 percent. On the growth side, Greenwich noted that 40 percent of the largest funds plan to use FIX protocol, and 35 percent all of investors generating more than $5 million are likely to be users.

The FIX protocol, combined with the Internet backbone, has enabled firms to create a global financial infrastructure, linking firms and branches seamlessly, Tabb says.

As more firms gain confidence in electronic trading technologies, and more platforms provide FIX-enabled order routing, Tabb believes that the number of trades and allocations routed will increase to approximately ten percent of total FIX traffic by the new millennium.

Priorities

When Greenwich asked institutions what changes they would most like Wall Street to make, many of their answers referred to technology-based services, said Greenwich consultant Phil Kemp in a foreword to his firm's report.

A striking number of institutions say they would like brokers to convert to electronic trading, said another Greenwich consultant, Bjorn Forfang, noting that many institutions are looking for new types of research services.

A sampling of other comments noted that some institutions wanted better electronic delivery of research and the ability to download spreadsheets.

"Targeted delivery of research [with] more active use of the Internet [is needed]," said one institution. "More efficient formats for electronic transfer of data," added another.

But all these technological enhancements do not mean anything to sell-side traders such as Norby.

"Ultimately, I need a reliable system which brings some value-added to my business and does not break down on me," he quipped.

It's a popular misconception that island life is always lazy and carefree. David Lunn head of equity and fixed-income trading at Bermuda International Securities in Bermuda argues that because of its exotic location, his desk is forced to work harder than its onshore competitors.

"We have to naturally price our services higher because we're an offshore firm," Lunn said. "But to do that, we have to make sure we provide better services."

About 600 miles off the coast of Virginia in Hamilton Bermuda's capital Bermuda International Securities is the trading subsidiary of the Bank of Bermuda. With 17 international offices, the Bank of Bermuda manages more than $6 billion in assets through its family of mutual funds.

Lunn and his team of four traders provide execution services for the Bank of Bermuda's portfolio managers. The desk also trades for the bank's clients pension funds, insurance companies, corporations and high net-worth individuals.

Because the desk executes orders for all types of international investments from equities and bonds to currencies and commodities Lunn's team of native Bermudans must be disciplined in markets all over the world.

"We spend a lot of time cross training on the desk," he said. "It's not a simple process. It takes a veteran trader about two years to learn this business."

Even after completing the initial cross training, Lunn expects his traders to spend up to two hours every day reading about international market developments. Aside from executing orders, the desk has to understand how different settlement processes work.

"The task here is a lot more involved than your average Wall Street firm," Lunn said. "Our traders are so sharp because they have to learn so many markets inside and out. That adds such a higher level of service to the firm."

Settlement procedures are typically straightforward in countries with developed markets, like the U.S., Japan or the U.K., Lunn said. But when dealing with smaller markets, in countries like Malaysia or Indonesia, settlement issues can get decidedly more complex.

"Because we have to know so much about the markets around the world," Lunn added, "we become a storefront of knowledge at the bank. People direct a lot of questions to us that we have to be able to answer."

Averaging about 100 trades each day, Lunn estimates that 40 percent of his desk's transactions are in equities. The desk structures its workday around the U.S. markets, because a majority of its equity transactions are in U.S. securities. (Bermuda is one hour and thus one time zone ahead of Eastern Standard Time.)

"Our customers are more familiar with the U.S.," Lunn said. "The U.S. has the world's largest and most sophisticated markets, and it's closest to us geographically."

When a client wants to execute an order in a market open at an odd hour, Lunn said his traders have a responsibility to be on the desk to provide that service.

But usually, the desk will send a limit order to a market open during the night. The limit order ensures a customer an execution at a specified price, and it keeps a trader from having to sit on the desk during the night.

Aside from his trading responsibilities, Lunn's extensive background in the international fixed-income markets helps him manage his own bond portfolio.

Lunn was born in Bermuda, the son of an Irish-born policeman and an English nurse. He left the island in the early 1980s and settled in London, getting his start in the financial-services industry as a fixed-income salesman, first at a small firm and then at Bankers Trust.

He moved from London to Hong Kong in the late 1980s to join Kidder Peabody, where he was responsible for the fixed-income business in the firm's Asia Pacific division.

He worked in Hong Kong for more than six years, where he met and married his wife Dolores, an Irish citizen working for cosmetic company Estee Lauder. When she was pregnant with their first child four years ago, they quit their jobs and moved back to Bermuda.

"I wanted to go back to bring up my children" Lunn said. "I loved growing up in Bermuda, and I couldn't think of a better place to raise our family."

The couple now has two children son David and daughter Olivia and Lunn is again a devoted Bermudan rugby player, a sport he was forced to abandon in Hong Kong.

"Bermuda is a beautiful place to live, and I never feel I'm out of the loop at work," he said. "I still work for a firm that is globally sophisticated."