Nasdaq's Trading Problems
Make It Vulnerable to Rivals
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
The price rise of theglobe.com's stock on its first day of
trading last Nov. 13 was the most spectacular ever for an
initial public offering. But the trading session also was one of
the messiest ever on the Nasdaq Stock Market.
Theglobe.com was priced the night before at $9 a share. The
next morning, there was a crush of demand. At the opening,
some investors bought it for $96 to $97 a share from Mayer
& Schweitzer Inc., a unit of Charles Schwab Corp. At the
same time, underwriter Bear Stearns Cos. was selling shares
for $90, and someone sold it on Instinet Corp.'s screen-based
trading system for $87. The apparent result: Some buyers
overpaid or some sellers sold too low.
The controversial opening
illustrates the structural
problems plaguing Nasdaq.
Though it once boasted of
being "the stock market for the
next hundred years," Nasdaq's
inability so far to resolve these
issues could make it vulnerable
to competition from upstart
electronic exchanges and,
perhaps soon, from the New York Stock Exchange, too.
By all accounts, the 1997 reforms that followed an
investigation into dealers' alleged fixing of stock prices made
Nasdaq a fairer market. But those reforms, coupled with
advances in electronic trading, are fragmenting Nasdaq into
many submarkets, making it harder to ensure that buyers and
sellers are getting the best price. "It's an absolute
Frankenstein," Douglas Atkin, chief executive officer of
Instinet, said at a conference in March.
The National Association of Securities Dealers, Nasdaq's
parent, thought it had a solution last year to this problem: a
"central limit order book" into which investors and dealers
from around the country could funnel orders. Big brokerage
firms and institutional investors backed it as an essential step.
But some firms saw it as proof that NASD management was
bent on competing with its own members. Seeing a threat to
their livelihoods, those members fought and killed the
proposal.
NASD's chairman and chief executive officer, Frank Zarb,
and its president, Richard Ketchum, have responded to that
defeat with a series of reforms they hope will blunt investors'
biggest complaints about Nasdaq while keeping members
happy. "The next set of steps gets us a long way to addressing
the problems that are frustrating people," Mr. Ketchum says
confidently.
If they don't, the competition awaits, mainly in the form of
about 10 quasi-stock exchanges called "electronic
communications networks," the largest of which is operated
by Instinet. The Big Board is talking to several of these ECNs
about forming a new stock market to trade Nasdaq's busiest
stocks under the New York Stock Exchange's name.
Separately, some ECNs -- which are now NASD members
and trade 30% of Nasdaq's volume -- may quit the NASD and
become stock exchanges themselves. These potential rivals
threaten the more than $300 million that the NASD earns
annually on transactions and data fees, 42% of its total
budget.
The irony is, Nasdaq's challenges today are a result of its
phenomenal success. Born in 1971, it grew to challenge the
Big Board and not only surpassed but eventually bought the
American Stock Exchange. At first, Nasdaq was simply a
network on which dealers posted bid and ask prices for small,
thinly traded stocks. They risked their own capital to trade
with investors and, in return, pocketed the bid-ask spread.
That contrasted with the Big Board, whose members usually
act as agents to match buyers and sellers and charge a
commission for the service.
Nasdaq was also decentralized. Dealers executed orders either
internally or by telephoning or e-mailing each other. That, too,
contrasts with the centralized trading floor of the Big Board,
where more than 80% of the volume in its stocks is sent,
either by hand or electronically, to a designated spot on the
floor. (The remainder trades on regional exchanges and
among NASD members.)
Over time, many companies, such as Microsoft, elected to
stay rather than jump to the Big Board. This changed the
nature of Nasdaq. While investors needed to trade small,
untried stocks through dealers because there weren't a lot of
natural buyers and sellers around, there was no shortage of
buyers and sellers for Microsoft. And institutional investors
increasingly bypassed dealers and their spreads to trade such
stocks directly with each other through Instinet, now a unit of
Reuters Group PLC.
This two-tiered market -- one for institutions and dealers, and
one for everyone else -- collapsed when the government
began its investigation in 1994 into alleged collusion by
Nasdaq dealers to keep spreads wide. Widespread reforms
following that investigation have shrunken dealers' spreads
and profits. Some firm members have put full-time
compliance officers on their Nasdaq desks to deal with the
blizzard of rule changes. The volume of orders through
Nasdaq's e-mail system, called SelectNet, has repeatedly
slowed and even crashed the system.
All of which bothers people like Arthur Pacheco, who has
traded over-the-counter stocks since 1965, most recently for
Bear Stearns. He says Nasdaq is abandoning its roots trading
small stocks among dealers and disagrees with management's
priorities. "The NASD thinks nothing of going out and paying
millions of dollars for a billboard in Times Square, but they
can't seem to get the technology right. Philosophically, what
drives them increasingly is competing with [the Big Board]
and, recently, their own constituencies."
So last year, he helped form a new ECN called Strike
Technologies, in which numerous dealers have invested.
Strike is one of several ECNs that is interested in joining a
super-ECN run by the Big Board to trade Nasdaq stocks.
While ECNs are technically brokerage firms, the NASD has
come to see them as competitors because they act more like
stock exchanges, displaying a "book" of investors' buy and sell
orders but not committing capital to trade them. ECNs show
their best-priced orders on Nasdaq, but the rest are accessible
only to subscribers. The NASD cited the plans of some
ECNs, such as Eclipse Trading Inc., to trade at night as a
competitive reason to do the same.
While the growth of ECNs and other trading systems has
spurred innovation, institutional investors would generally
prefer to look in just one place for the buyer or seller of a
block of stock. Says Andrew Brooks, head of trading for
mutual-fund giant T. Rowe Price Associates, "What we have
today is incredible fragmentation, all in the name of
competition."
Since April, ECNs have been allowed to go the final step to
compete with both Nasdaq and the Big Board by applying to
become stock exchanges. In May, Instinet, with 20% of
Nasdaq's volume, bought a stake in Britain's Tradepoint
Financial Networks PLC, a tiny for-profit stock exchange.
Tradepoint is cleared to trade British stocks in the U.S., but
Mr. Atkin says it could become a venue to trade U.S. stocks.
Island ECN, with 6% of Nasdaq's volume, has also applied to
become an exchange. Had the NASD built a central limit
order book, it "would have put both Instinet and Island out of
business," says Joshua Levine, an Island founder.
The NASD has long wanted a central order book. In the one
Mr. Zarb proposed last year, no buyer would pay more than
the lowest seller was asking. The first order to arrive would be
the first executed. All opening orders could be executed at one
price, avoiding the chaos of theglobe.com's opening.
Most important for big investors like Mr. Brooks, it would, if
successful, give him just one place to look for other investors
with whom to trade, instead of a dozen. And it was exactly
that threat to their own existence that prompted the ECNs and
some dealers to oppose a central order book so vociferously
that the NASD, after consulting with the Securities and
Exchange Commission, shelved the plan.
In a letter to the SEC, David Pottruck, co-chief executive
officer of Schwab, whose Mayer & Schweitzer unit is
Nasdaq's second-biggest dealer, accused the NASD of "total
disregard for the competitive burdens of the proposal."
Dealers and ECNs "would find themselves competing directly
with their regulator on their regulator's terms." He said
brokers would feel they ought to send orders to Nasdaq's
book instead of dealers or ECNs simply because it had their
regulator's seal of approval.
Now the NASD is proceeding with several less-ambitious
steps: allowing dealers to separately display their own and
their customers' orders in Nasdaq, speeding up SelectNet by
enabling it to automatically execute orders, and compelling
ECNs to display previously hidden orders. Mr. Ketchum and
Mr. Zarb hope these steps will make Nasdaq feel more
centralized.
But in April, with the SEC's support, they also quietly
resurrected the central order book proposal. While the same
opponents are lining up against it, the result may be different
since the news in February that the New York Stock
Exchange was considering, in essence, building Nasdaq's
central order book. The Big Board is to decide whether to
proceed this summer. The news prompted Mr. Zarb to
announce that the Big Board should first remove some of its
own anticompetitive rules. But it has also added urgency to
his efforts to garner support for the order book, especially
among smaller dealers.
Says Mr. Ketchum, "It would not be an even playing field,
and quite ironic, if the first market to have a limit order book
in Nasdaq stocks would be the New York Stock Exchange." |
