Volatility Is the Byproduct When Market Makers Are on the Sidelines

Market-Maker Myopia

SAN FRANCISCO -- In the wake of Tuesday's Steve Martin-esque market (wild and crazy), market players predicted the Nasdaq Composite had established the kind of bottom most desk jockeys can only long for. (Firm, that is).

But nobody forecast the volatility would end. Fittingly, the Nasdaq rose from its initial low of 4009.09 Wednesday to as high as 4286.88 before swan-diving in the final hour of trading. The index closed up a modest 20.45 to 4169.34.

Which brings me to Scott Bleier, chief investment strategist at Prime Charter (and a longtime column favorite), who was talking Tuesday afternoon about the role (or lack thereof) of market makers in the increasingly volatile stock market.

While others searched for catalysts to bloody selling early Tuesday , Bleier laid the blame on the very rules designed to protect individual investors.

"It's not the economy, stupid," or the Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) ruling, the Fed or Abby Cohen, he said. "It's not even about correcting excessive speculation. It's about pure supply/demand and momentum. That's what this market has become, due to best bid/offer" regulations.

Specifically, he referred to the order-handling rules established by the Securities and Exchange Commission in 1997. The rules forced broker/dealers to post limit orders with electronic communications networks (ECNs) or other "third market" participants. (Limit orders specify that stock must be bought or sold at a set price, vs. market orders, which call for the best available price. If you didn't already know the difference, please learn it before you trade again.)

The rules resulted in a narrowing of spreads for over-the-counter stocks. In January 1997, when the order-handling rules went into effect, the average spread for a Nasdaq stock was 1.72%, according to the exchange. By February 2000, the average had narrowed to 0.31%.

That, of course, has benefited individual investors. But the shrinking profits had the (presumably) unintended effect of forcing some traditional market-making firms such as Lehman Brothers and Merrill Lynch to cut back their activities or to seek mergers to ensure survival. (Last month, TSC reported on Merrill's plans to redouble its efforts in the area.)

At the end of February, 44% of all Nasdaq trades were handled by so-called wholesale firms such as Knight/Trimark Group (NITE Quote - Cramer on NITE - Stock Picks), Herzog Heine Geduld and Charles Schwab's (SCH Quote - Cramer on SCH - Stock Picks) Capital Markets L.P. (formerly Mayer & Schweitzer) vs. 28% at the beginning of 1999, according to Greg Smith, a senior research analyst at Chase H&Q in San Francisco.

The purpose of this column is not to lament the demise of the "noble" market maker. The industry has what can generously be called a "spotty" track record of serving the investing public. In fact, the order-handling rules were enacted largely in reaction to the collusion of so-called SOES (small-order-execution-system) bandits in the mid-1990s. And there are plenty of conspiracy theorists who (mon Dieu!) still believe transgressions occur.

Market makers (they're called "specialists" on the New York Stock Exchange) maintain a balance between buyers and sellers and, if necessary, will use their own capital to buy or sell stocks to ensure that balance. Or, at least, that's been their traditional role.

Bleier and others note the narrowing spreads for over-the-counter stocks resulted in an unwillingness of market makers to commit capital.

"They don't get paid to commit capital so nobody is willing to," he said. Therefore, "you get these blowoffs to the upside and crashes to the downside." In other words, why the Nasdaq could trade in a 700-point range in a day while individual stocks swung 50 (or more) points in either direction in a heartbeat.

Admittedly, certain market watchers have warned for some time that the market-making community would not be willing or able to step in and stem a big decline.

So ingrained is that belief that on days like Tuesday, when a stock such as Exodus Communications (EXDS Quote - Cramer on EXDS - Stock Picks) trades as low as 92 and as high as 140, institutional clients "have figured out no one is going to commit a lot of capital," said Timothy Heekin, director of equity trading at Thomas Weisel Partners in San Francisco. In fact, "customers in general aren't asking for it."

The trader acknowledged the order-handling rules "exacerbated" the situation, but he deemed volatility the biggest cause of market makers' unwillingness to commit capital, rather than an effect thereof.

You can argue endlessly which came first -- volatility or a lessening of capital commitment (or why the market makers crossed the road, for that matter) -- but the bigger question is how market participants are dealing with the reality of the altered landscape.

The head trader at one San Francisco firm told me certain institutional clients have asked to be charged for his firm's market-making services on a commission basis rather than on spreads, which is how NYSE specialists are compensated. This creates a "more effective market," he said, because the market maker is then working solely on the clients' behalf, rather than worrying about squeezing out a few "teenies" for themselves.

"I think the NASD is trying subtly to move the market in that direction," the trader said, admitting it is a bone of contention for wholesalers who cater more to the retail and online trading crowd and prefer getting paid on a spread basis.

NASD officials were unavailable to talk about this practice, but I'm certain the issue of how market makers get paid is central to the debate over creating a centralized market.

Meanwhile, Tim McCormick, an academic liaison to the NASD, denied the idea there is less capital being committed for OTC stocks, arguing that ECNs and others have replaced whatever market-making capacity was lost in the wake of the order-handling rules. The fact spreads have narrowed while volatility is on the rise is proof there's ample liquidity, he said.

Furthermore, "market makers aren't there to make sure the price doesn't go down to X," McCormick continued. "They try to provide liquidity when they can. When there is a barrage like [Tuesday], they are not going to be in there holding up prices. They don't have the capital to buy the whole market."

I wonder if that explanation is going to satisfy the irate reader who emailed Tuesday night, wondering "where the hell are these Nasdaq market makers that are supposedly there to assure an orderly market, the 'buyers of last resort'?"

Given the investing public has clamored for cheaper, faster execution, those seeking salvation from the very market forces hampered by those requests should realize sometimes you do indeed reap what you sow. That's something to keep in mind as the markets lurch toward decimalization, which is expected to narrow spreads further still.