A few months after taking on the online brokers, retail giant

Merrill Lynch

(MER)

is now plotting to take back some of the increasingly lucrative

Nasdaq

trade-execution turf.

In the past couple of years, firms such as

Knight/Trimark Group

(NITE)

and

Charles Schwab's

(SCH)

Capital Markets L.P.

(formerly

Mayer & Schweitzer

) have benefited from the surge in Nasdaq trading.

Merrill and other major securities firms, meanwhile, have trimmed their efforts in over-the-counter-stock market making as new order-handling rules narrowed spreads and began cutting into trading profits in 1997. (Market makers are firms that maintain firm prices on stocks, sometimes committing their own capital to execute trades.)

But now, Merrill will challenge those Nasdaq firms for their share of that pot of gold. The firm plans to trade about 1,500 new Nasdaq stocks by early next year on a new technology platform, and it will continue to trade the 550 stocks it now makes markets in on a separate floor.

Traditionally, these firms have profited from playing the spread between what they buy the stock for and what they can sell it for, but as those spreads have narrowed, the firms have turned to volume to boost the bottom line. Knight, in particular, has played this game successfully, to the tune of a $5.3 billion market capitalization. Because Merrill is one of Knight's top five customers, that could mean fewer trades on certain stocks.

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"It's not good news

for Knight. I'm actually surprised that Merrill is doing that," says Rich Sokol, an analyst for Denver-based

Westcore Funds

. (His fund owns Knight.) "If Merrill is doing this, that would be bucking the trend. If you look at most of the other market makers, they have all scaled back their activity."

Knight and Merrill, however, are less concerned, saying that the plan will have no effect on their current ties, including Merrill's agreement to clear trades for Knight. The unit, which hasn't yet been named, is expected to be located in New Jersey, not in Merrill's New York headquarters.

Ken Pasternak, president and chief executive officer of Knight, says, "We actually see ourselves having the potential to increase our volume with

Merrill." He cites growing overall securities volume and the fact that Merrill will be trading only 1,500 stocks, while online trading customers may want to trade thousands of other stocks, as reasons Knight won't be affected. Knight makes markets in 8,800 stocks.

So while some of Merrill's business no longer will be going to Knight or other market makers, the firm still will need to send order flow to outside market makers for stocks it doesn't make markets in.

Sokol suggests that with the order flow Merrill has from its customers alone, it has a better shot at being able to get enough liquidity for success than some of its competitors.

In fact, the Merrill Lynch unit will have enough volume just from executing orders from Merrill's retail and institutional customers to get started, in part due to explosive trading volume and the growth of self-directed online trading, Merrill executives say. New technology also means trading will be more efficient than it was a few years ago when Merrill began slimming down, and that's likely to result in lower trading costs for its clients.

"Here it is two-and-one-half to three years later and the conditions of the market are such, and the order flow our customers are sending us is such, that we think it's time to expand our market-making capabilities," says Tom Joyce, Merrill's head of equity market structures.

The market is ripe. In 1999, the value of shares traded on the Nasdaq rose to $11 trillion, up from $5.8 trillion in 1998. At the same time, average daily share volume on the Nasdaq reached more than 1.08 billion shares in 1999, up from 802 million shares in 1998.

New technology and liquidity are what's needed to compete with firms such as Knight, and the fast and cheap electronic order-matching systems that have sprung up in recent years. Because of the broker-dealer's obligation to get the best execution for the customer, orders naturally flow to the most liquid markets with the best prices, creating a circular effect that in turn makes that market more attractive to outside orders.

As financial markets change -- highlighted by the

Pacific Exchange's

recent

news that it will team up with electronic communications network

Archipelago

to make its exchange entirely electronic -- customers are increasingly going to demand the cheapest, fastest trades.

It's up to Merrill to deliver.