The Rising Fourth Market

The one-room office of Donald J. Tomaso Associates, in an aging building on the fringe of Chicago's La Salle Street financial district, has three battered desks, one typewriter and a jumble of card files. From that dingy setting, Donald Tomaso, 36, handles some of the biggest stock deals in the U.S. Often talking simultaneously over two telephones--one connected to a buyer, the other to a seller--Tomaso arranges direct trades between large institutional investors. He is one of the handful of entrepreneurs who run the "fourth market," so named because it bypasses the three more conventional methods of trading securities: the stock exchanges, the over-the-counter market, and the market for listed stocks created by brokers who are not members of the exchanges.

On the Cheap. The fourth market is still in its infancy. Its volume last year equaled an estimated 2% of the $60 billion of trades by institutions on the New York Stock Exchange. But it is growing fast enough to worry brokers and exchange officials, who are losing business to this new form of competition. The fourth market offers two allures. First, all trades are secret; that enables would-be sellers to avoid a quick price drop that sometimes develops when word of a large offering percolates through the financial community. Second, institutions avoid the large brokerage commissions that the exchanges require. Most of Tomaso's 78 customers--mutual funds, insurance companies, banks, university endowment funds--pay him only 25-c- per share traded, up to a maximum of $10,000 a year. Thus, after a client has traded 40,000 shares, he gets a free ride. By comparison, one sale of 40,000 shares of a $50 stock on the Big Board costs $11,360.

Tomaso, a former brokerage-house executive, started his business four years ago with only $15,000 capital, half of which he spent on traveling around the U.S. to sell his idea. "People laughed at me," he recalls. But after seven weeks of visiting and calling around to institutions, he arranged his first trade: 48,000 shares of Zenith Radio for $3,264,000. Now Tomaso or his 24-year-old assistant phone all of the firm's clients each morning, asking what stocks they want to buy or sell. When he hits a set of matching intentions, Tomaso calls back and --without revealing the identity of the seller to the buyer--tries to close a deal. The price is usually based on the most recent transaction on the exchanges. Last year, says Tomaso, he handied some $350 million worth of stock deals, enough to put his pretax earnings well into six figures.

Naturally, such easy profit has attracted competitors. Among them are two former executives of the floundering brokerage house of Kleiner, Bell. The pair, Robert Brandt, 43, and Barry Zwick, 35, formed a fourth-market firm in Los Angeles in August. Operating in much the same way as Tomaso, they made four deals in their first month, enough to bring a small profit. "Everyone thinks he is the only one trading in the fourth market," says Brandt. "Soon people will find out everybody is doing it."

The most elaborate fourth-market enterprise, Manhattan's Institutional Networks Corp., or "Instinct," enables clients to trade stocks over a private network of teletype machines linked to a computer. A client can consult Instinct's "offer file" for any of 1,550 stocks by punching keys on his teletype, which prints out a list. If a buyer spots an offer he wants, he can instruct the computer to connect him with a potential seller to dicker over the terms. To preserve the coveted anonymity, both parties are identified only by coded numbers. A deal is closed when a trader pushes the teletype's "accept" button. Instinct began operating last December, and this year its 25 subscribers (mostly banks) hive made 500 trades involving 1,600,000 shares of stock. The fees often amount to only one-third of the commissions on the Big Board.

Questions of Secrecy. Despite its midget size, the fourth market challenges the established structure of the securities business and puts pressure on the exchanges to reduce their minimum commissions. The Securities and Exchange Commission has nourished the fourth market by urging institutions to trade stocks at the lowest possible cost. But stock exchange officials complain that off-the-board trading in listed securities tends to weaken the exchanges' auction market, on which all traders rely for prices.

Unlike transactions elsewhere, stock deals made in the fourth market are not subject to scrutiny by either the exchanges or the SEC. Says Donald Regan, president of Merrill Lynch: "I don't think it's fair to the small investor that institutions can do some things in the stock market that he can't do." It certainly does not seem fair that a listed stock can be actively traded without anybody knowing about it, except a few insiders.

These real or potential dangers might seem to call for new SEC regulations. Yet the fourth market is only a small part of a complex question: What changes should be made in the markets to cope with the great rise in institutional trading? By year's end the SEC is due to publish a long awaited report on this touchy subject. If direct trading in stocks is to be put under controls, it makes sense to adopt them only as part of a large overhaul of SEC rules.

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