Revolutionary pricing changes coming to Nasdaq will have a profound affect on institutional investors. The impact of this pricing shift on institutional investors and the way they manage Nasdaq trading is likely to be as profound as the May 1, 1975, changes in the auction market, that is, the New York Stock Exchange and other exchanges. Those May Day changes more than two decades ago had profound ramifications for auction market participants and changed investing in ways that continue to affect us.Now, in dealer equity markets, namely, Nasdaq, another kind of May Day is imminent, although probably not arriving industrywide on a single day. The pricing changes are the result of rules recently imposed on the industry and a new climate at the Securities and Exchange Commission. The Nasdaq pricing changes are being spawned by new limit order handling rules. Phased in during 1997, the rules require a market maker to either satisfy a customer's limit order or incorporate the customer's bid or offer into the dealer's own quote. While seemingly limited on their face, the rules have altered fundamentally the economics of Nasdaq market making, and might change the way institutions interact with dealers and conduct their transactions. Let me share five major changes affecting institutional investors that may result from Nasdaq's upcoming "May Day."
New pricing and unbundling
1. Dealers will explore new pricing alternatives. The existing Nasdaq pricing structure, in which the price of a security is bundled with the price of the transaction service, is becoming illogical.Nasdaq's version of May Day probably will involve the unbundling of transactional services. Unbundling would result in the introduction of more complex, more customized and, ultimately, more rational pricing formulas.
New pricing could be developed jointly by institutions and market makers to suit specific requirements, particularly the need for liquidity. The SEC probably would support the new pricing schemes, as it prefers fee-based compensation arrangements. (In the past, the NASD under SEC supervision made it virtually impossible for market makers to charge commissions on trades.)Under the coming pricing umbrella, some trades may carry a commission, others may be done on a net basis. Institutions using their own capital to effect a trade under a flexible deadline probably will pay a simple commission for trade execution.Those that require immediate liquidity would be able to "rent" a market-maker's capital by paying more to offset the dealer's risk. The cost would be a function of how quickly the institution required execution. The cost of larger, more immediate trades obviously would be greater than the cost of smaller, less time-sensitive transactions.Because institutions could determine how they would want to use a market maker whether as agent or as dealer they would have greater latitude in how they use their own capital. These capital and cash management decisions, which now often are made as an integral but ancillary aspect of trading, would become more prominent.
Commissions and soft dollars?
2. One result of new pricing possibilities would be that Nasdaq market makers could offer new services. As pricing changed, market makers would have an opportunity to offer different services to institutions. One service likely to be offered is soft-dollar research. Under the current pricing formula, no facility exists to charge commissions, which are the necessary framework for soft-dollar services. If commissions are charged, these services become possible. Other innovations are likely to emerge as market makers buy or merge with firms in other lines of business such as retail asset management and advisory services.Fewer market makers3. Market makers probably will be fewer and more substantial. Several of the largest securities firms, for which market making is essentially a corporate-finance support function, e.g., supporting initial public offerings, have started to pare down their market-making activities. This shift obviously reflects their view that capital that had been committed to Nasdaq market making can be used to earn higher returns in other lines of business. Market makers without a major corporate finance effort are cutting back for other reasons. The technology investment required to handle the new rules is significant. Because of the additional costs, several firms already have pared the number of issues in which they make markets. As market-making costs increase and traditional profit-making opportunities fade, fewer firms are likely to engage in dealer activity. The ones that remain should be stronger, have greater capital, and be more technologically advanced. A market with fewer, stronger dealers would be more efficient for institutions.
Transparency over liquidity
4. Transparency has trumped liquidity. Transparency is the market characteristic that describes buyer and seller awareness of each other's intentions. By requiring market-makers to reveal limit orders that fall within their quoted price, the SEC has increase transparency, a desirable characteristic of any market.But coincident with the gains in transparency, there is a loss of liquidity and increased volatility. Some of this may be explained by the fact that the SEC rule reduced market-maker opportunities to earn a profit on a large class of transactions. Market-maker willingness to commit capital to market has waned. If this is a trend continues, institutions will become more concerned about entering and exiting positions without unduly affecting the market price. They will become more concerned about liquidity and their ability to avoid wide price swings. Market liquidity, therefore, will assume greater importance.Dealers as partners5. Successful institution/market-maker relationships will become more collaborative. Concentration among market makers and added value placed on liquidity probably will lead to relationships where dealers are seen more as partners in on-going relationships rather than as transactional counterparties. Much like the downsizing that has affected industrial companies and resulted in fewer suppliers having closer relationships with manufacturers, these closer dealer/institutional relationships will result in greater efficiencies.With their market-making partners, institutions will engage in some trades where a dealer's liquidity is vital and others where it is of less importance.
A final vision
A quarter century ago, many on Wall Street were convinced the end of fixed commissions would mean the end of Wall Street. Only the most irrationally exuberant could have predicted today's reality - a billion-share trading day, online trading, widespread direct stock ownership and mass equity participation through an array of mutual funds.Nasdaq's own pricing metamorphosis is about to take place. Like Wall Streeters of 1975, many who sense an era is ending are worried about the future. Certainly, there are reasons for concern. The jury is still out on the long-term impact of the rule change. Transparency has increased, but at a cost: volatility is greater and there is less liquidity. Is the tradeoff worth it? We'll see.Like the auction market price revolution, Nasdaq's new pricing structure is likely to produce a larger, more dynamic market than anyone can imagine. For institutional participants and their market maker partners, the changes represent a tremendous opportunity.
