A Small Voice In Cyberspace

[Georgia Bard]

Are we returning to 1997's effective market?

When I first came on line back in 1996-1997, I opened account with PC Finical Network. I was pretty happy with them as I could finally take my investment destiny into my own hands. No longer would I have to watch my newly bought investment decline that was recommended by my financial advisor and vice versa. Seems the market was fraught with professionals that could not pick the right side of the investment if their lives depended on it. Totally incompetent but hey they got that commission buying or selling regardless.

However, the commission schedule for an on line trade with PCF was $24.95 and $0.005 per share. The execution was excellent and almost instantaneous every time. So if I bought 10,000 shares of say a $0.50 security, my cost would be $5,000.00 initial money plus $24.95 for the trade and $50.00 for the volume (10,000 x .005 = $50.00) for a total of $74.95 in commissions or 1.49%. But if you traded 10,000 at say .10 then your commission did not change so your total cost would be $1,074.95 which was 7.49% in commissions. The lower the price the higher the commission %, which was why no one wanted to trade stocks under $0.25. Trading lower priced securities was not advantageous at all considering the commission schedule.

Then along came Farsight that did not charge the per share commission. So I moved my account and the commissions were excellent but the execution was terrible most of the time. I would have to wait for a fill (buy or sell) as I was forced to chase a price to get a fill. Thus I became acquainted with ¡§its an over the counter security¡¨ excuse. But the savings in commissions alone made it somewhat bearable so I remained until Farsight decided they were not making enough money and were going to the per share cost.

By then National Discount Brokers and E-Trade were not charging a per share cost. Moving my account to NDB at first there was good execution for the most part but eventually it got to where some trades took as long as 45 minutes to fill and when they did it was a partial a lot of times and the bid/ask would move. But what became a reality was the minute I pressed the order (buy or sell) the bid or ask, depending on what trade I was trying to execute, would move and sometimes pass me by. I was not alone because it got so bad that the public began screaming.

Then came the MMM (Market Maker Manipulation) screams of unfairness. The more the public screamed the more certain rules and functions were put in place. Of course the public believes the MMs are the truest evil though it is most likely a big money scenario or market influence affecting the market. None the less, NASD and the SEC put into place rules to assist the poor investor from horrible spreads, none fills and so forth.

For example some basic rules to ensure better execution opportunities for investors and some trading functions to increase the efficiency of market participants are:

BEST EXECUTION RULE - Market Makers are required to execute customer retail orders at the best price available in the market, even if the executing dealer is quoting an inferior price.
MANNING RULE - Rules to provide better opportunity for customers¡¦ order execution - when a Market Maker trades for its own account at a price superior to a customer order, the firm must promptly execute the order (- up to the size of its own trade).
ORDER HANDLING RULE - when a firm receives a customer order (in a Hybrid stock) that is priced equal to or better than its own quotes, the MM must display the order in its quote
INTERNAL MATCHING FUNCTION (CROSS TRANSACTION) - Internal Matching allows a Market Maker to proceed the so-called "cross trade" with customers based on the Best Execution rule. ***kkkkbob is going to hate this Cross trading term, so I suggest he go read the NASDAQ press release on May 15, 2001***
NEGOTIATION FUNCTION - Electronic negotiation increases the speed and efficiency of firm-to-firm negotiation for large sized trades.
ROUTING FUNCTION - This function assists Market Makers in gathering order flow from non-Market Makers (broker order entry firms).
AUTO-EXECUTION FUNCTION - This is essentially the same functionality as the current auction book. Market participants can get immediate auto-executions against quotes and orders displayed on the central book (for Hybrid stocks), or against quotes only (Pure- Market Making stocks).

The result of rules and functions such as these was an increase in better execution for the most part and this does not include the market order and limit order scenarios. But has it gone to far helping the investor with decimal pricing, which was adopted in the belief that it would narrow spreads and lead to less costly order execution. As a result, the decision was made for major market centers to reduce their MINIMUM PRICE VARIATION or MPV to a penny ($0.01). In 1997, when the major market centers dropped the MPV from one-eighth of a dollar (12.5 cents) to one-sixteenth of a dollar (6.25 cents), the narrowing of spreads reduced trading costs for many investors, but increased costs for others. This is very important because if the cost was reduced for investors then apparently Market Makers (not the brokers) were the ones with increased cost. So this leads to the NASD Guideline of the maximum 5% commission per trade. This is not a law or rule mind you, only a guideline.

OK fine! What is the point to this composition ...

Market Maker NITE's new release on July 18, 20001, as a follow-up to a horrible SEC filing, states they are losing their royal backsides. In that release are certain statements in response to the information I have provided. Seems Market Makers are (in fact) losing their royal backsides and not covering their costs.

http://www.knight-sec.com/pressroom/index.asp?title=news34

"Knight was fully prepared from a systems and client product position for the impact of decimalization. This regulatory change was fully implemented on April 9th for all NASDAQ securities," stated Kenneth D. Pasternak, Chairman and Chief Executive Officer of Knight Trading Group. "We knew the operating environment would be challenging under decimalization. However, we could not foresee the full magnitude of a concurrent, but separate, rule -- the implementation of a one-penny minimum price variant (MPV), which allowed for trading in increments as small as one cent."
"To face this challenge, Knight is using the experience gained over the last 14 weeks to fine-tune our trading algorithms. This will ensure that our trading methodologies better reflect the dynamics of a one-penny MPV marketplace,' continued Mr. Pasternak. 'In addition, consolidation in our industry and reduction in the depth of book have resulted in greater demand for Knight as a liquidity provider. THEREFORE, ON JULY 1ST WE REVISED OUR REBATE SCHEDULES (KNOWN AS "PAYMENT FOR ORDER FLOW") TO CLIENTS AND ARE CONSIDERING THE INTRODUCTION OF FEES FOR CERTAIN TRANSACTIONS. These changes reflect better the value that Knight's liquidity provides to the marketplace, and should result in a more acceptable level of profitability to the benefit of the Company and our shareholders."

In other words, it appears NITE has stopped paying for Order Flow. This was received well by the market as NITE¡¦s stock price has improved since this news release. But the key sentence is the "considering the introduction of fees for certain transactions" or do they mean all transactions. Like maybe the $0.005 per share we had back in 1997. But this time it would be different. Much different!

If NITE was to adopt this FEE in order to "recoup costs" this does not affect the 5% maximum commission guideline. Also if NITE changes its commission schedule they do not have to notify the NASD, according to the NASD. All NITE has to do is show they are recouping costs, which most likely they can support just on recouping ticket charges. Now once they do this, if at all, the cost would then come to the brokers that use NITE. This would be a cost that the brokers can either eat or pass on. But remember it would have to be consistent. If NITE goes across the board then so would the cost to the brokers. Of course, they are entitled to recoup their cost too, so the cost would most likely pass on to the investor.

If this were to be done by NITE to recoup costs, the cost of say buying a $0.05 security for say $1,000.00 initial investment would be 20,000 shares at the regular commission of say $19.95 plus $0.005 per share. That would be an addition $100.00 in commissions for the share volume, which would make the cost $1,119.95 or $0.056 and remember when you sell it will cost you another $119.95. Thus for the 20,000 shares the in and out commission would be $239.90 IF you could get the whiole blocked traded at one time whether you make a gain or not. Thus a 23.95% commission would be hard to make a gain and hamper day trading as not being very cost effective on pennies. So you would not make a profit on a $0.05 buy until the stock was over $0.062.

This can be easily supported by looking at the required size lots the market makers have to quote depending on the stock price. Under $0.50 the bid/ask size is 5,000 and since a ticket charge is between $20.00 and $25.00 a .005 fee would be $25.00. Between $0.50 - $1.00 the size is 2,500 and the cost would be $12.50 for a ticket charge and above a dollar it does not matter because the cost has hardly an affect on the commission %. But think of the money the market makers can make from large orders.

Not to mention if NITE was to introduce this type of fee that brokers would have to pay I believe SCHB (Schwab), Herzog Heine Geduld (Merril Lynch) and others would soon follow suit. Market makers could justify this also as merely wanting to be paid for his firm's market-making services on a per share commission basis rather than on spreads, which is how NYSE specialists are compensated. This would go back to 1997 when you made an order and it got filled efficiently and would create a more effective market, because the market maker is then working solely on the clients' behalf, rather than worrying about squeezing out a few "cents" for themselves.

Would the OTC traders scream? Probably especially ones that held say 200,000 shares of a security under $0.05 because not counting the regular commission to sell that 200,000, .005 would be a cool $1,000.00 per share cost.

Just remember you can't ask Market Makers to lose their backsides when they have the right to recoup their costs!

I am not a professional in the market or a financial advisor just someone who was doing due diligence on why NITE¡¦s stock went up after that horrible filing. Hey, I could be wrong.


:=) Gary Swancey