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Justice Department Suggests Nasdaq Improvements

January 12, 1995

WASHINGTON (AP) _ The Justice Department, probing charges of collusion on the Nasdaq stock market, is proposing changes to a small order trading system it contends will improve competition.

The Justice Department’s detailed proposals, obtained Wednesday by The Associated Press, offer the first public glimpse into an extensive antitrust investigation of the nation’s second largest stock exchange.

In October, the Justice Department said it was reviewing possible anticompetitive behavior on Nasdaq, an electronic stock market run by the National Association of Securities Dealers Inc., an industry group.

The probe came after numerous class action lawsuits filed last summer charged major Wall Street firms conspired to charge excessively wide ``spreads″ in Nasdaq stocks to fatten their profits at the expense of individual investors.

The spread is the difference between the buying and selling price of a stock, and is essentially the profit that Nasdaq brokers receive for executing a trade. Nasdaq and the firms strongly deny the allegation.

The price fixing charges can partly be traced to an intense dispute over operation of a Nasdaq trading system known as SOES, or Small Order Execution System.

The SOES system is a key reform to emerge from the 1987 stock market crash. The presidential commission that examined causes of the crash found that many Nasdaq market markers failed to answer their telephones to fill orders of panicked investors. SOES was created as a computerized trading system so small orders of 1,000 shares or less would be executed without dealer involvement.

Nasdaq has since moved to scrap SOES, charging it was abused by professional traders who took advantage of momentary price discrepancies among the stocks to make quick profits. The traders countered that Nasdaq was protecting powerful Wall Street firms which opposed competition on SOES because it eroded their profits.

Nasdaq has asked the Securities and Exchange Commission for permission to replace SOES with a new system, called N-Prove. The Justice Department took the unusual step of providing a detailed 19-page comment letter on the N-Prove proposal, in which it alluded to the broader investigation.

``...Increasing the competitiveness of N-Prove may ultimately enhance the competitiveness of other Nasdaq trading systems,″ the department’s letter said. It was signed by Robert E. Litan and Richard J. Gilbert, deputy assistant attorneys general in the antitrust division, as well as 10 other attorneys, economists and computer experts.

Justice Department officials didn’t return several telephone calls seeking comment.

Nasdaq says a key selling point for N-Prove is that it will allow certain customer orders to get better prices than what they normally would on Nasdaq.

The Justice Department said price improvement claims may be ``illusory″ since N-Prove doesn’t contain sufficient incentives for market makers to improve the prices of their quotes for extended periods of time.

Competition would improve by allowing automatic execution of quotes posted by Nasdaq market makers with public limit orders, which are a customer’s order specifying a price to buy or sell shares. Market makers form the backbone of Nasdaq by buying and selling stocks at prices they post, risking their firm’s own money in the process.

The department’s comments are in line with criticisms from several leading Nasdaq experts. Junius W. Peake, a professor at University of Northern Colorado in Greeley, Colo., charged that N-Prove is seriously flawed and anticompetitive. Peake said he would be ``very surprised and distressed″ if the SEC approved the proposals in their current form.

The department’s ``principal concern″ is a proposal to give market makers a 15 second delay before deciding whether or not to execute a customer’s limit order. During that 15 second period, firms could make the trade at a slightly better price or let it pass for execution by computer or elsewhere.

The department said such a delay would reduce the incentive for any investor to enter limit orders. That’s because the Wall Street firms would only pounce on the incoming limit orders when the market moved in the firms’ favor, it said.

Elimination of the delay ``is likely to increase competition″ and ``would decrease spreads,″ the department said.

The SEC hasn’t scheduled a hearing on the proposals.

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