Nasdaq: An Embarrassment Of Embarrassments

The joke is circulating among institutional investors, but no one is laughing at the Washington headquarters of NASDAQ, the huge electronic trading system for over-the-counter stocks. It goes like this: "Did you hear the one about the new NASDAQ ad slogan? `NASDAQ. The stock market for the next 100 years--with 25 years off for good behavior."'

On Oct. 19, the Justice Dept. confirmed that it's looking at whether NASDAQ dealers illegally collude to set stock prices. While NASDAQ adamantly denies any improprieties by its 500 or so brokerage members, for a business that depends on the trust of investors, "this has been devastating," says Richard Y. Roberts, a member of the Securities & Exchange Commission.

GROWING PAINS? The probe, though, is just the latest controversy to hit the embattled NASDAQ. Instead of moving closer to realizing its promise of overtaking the New York Stock Exchange as the premier U.S. stock market, NASDAQ has become mired in a broad array of difficulties.

NASDAQ's troubles range from technical glitches to fundamental questions about the effectiveness of its operations. Last summer, the market was beset by two embarrassing computer outages that shut down the network for a total of 3 hours. Many of NASDAQ's constituencies are dissatisfied: Institutional investors are clamoring for more price information, member firms are upset about rules that limit their trading flexibility, and companies listed on NASDAQ are angry about the Justice probe. Further, sources inside and outside the system question whether management can cope with NASDAQ's explosive growth and stay ahead of technological advances in competing markets. NASDAQ "hasn't kept up very well--but I wonder if anyone could have," says Mary L. Schapiro, a former SEC commissioner and now chairwoman of the Commodity Futures Trading Commission.

NASDAQ's growing pains have been particularly virulent. In just two decades NASDAQ has been transformed from a sleepy backwater to a dynamic force in the equity markets. It's owned and operated by the National Association of Securities Dealers, a 56-year-old, self-regulatory organization. Trading has swollen from $153 billion in 4,097 companies a decade ago to more than $1.3 trillion in 4,861 listed companies last year, making NASDAQ the second-largest market in the world, competing head to head with the NYSE. Indeed, in the first six months of 1994, the volume of shares traded outpaced the Big Board. But the glowing aura of NASDAQ's Cinderella rise has given way to tough scrutiny.

The task of answering hard questions has fallen to Joseph R. Hardiman, a former top executive at Alex. Brown & Sons Inc., the Baltimore securities firm. In the seven years since Hardiman jumped from the ceremonial job of NASD chairman to full-time president, he is credited with upgrading the system after the 1987 market crash and stiffening enforcement. But critics within NASD and on the Street say Hardiman has failed to assemble a management team with sufficient depth for the NASDAQ market. "He's saddled with too many sleepy career bureaucrats who rose through the ranks at NASD," says a source with close connections with

NASDAQ. Hardiman was unavailable for comment. Regarding NASDAQ's management, spokesman Robert J. Firri Jr. says: "Our senior management includes thoughtful and insightful people. That's widely recognized."

Industry and NASD sources blame upper management for the latest stain on NASDAQ's reputation. The investigation into the wide spreads has cast a cloud on the public relations department's ad campaign, which promotes NASDAQ's star listings and has helped fuel the market's expansion. Yet efforts by NASD officials to deal with the spread probe at an early stage were thwarted by higher-ups, say NASD sources.

Investors had grumbled for years about the wide spreads. The gaps between the bid and ask price, often a quarter of a point or more, end up in dealers' pockets. The American Stock Exchange sought to capitalize on the unhappiness back in 1990, when it tried to quantify the price investors were paying for NASDAQ's excessive trading costs. The Amex came up with the tidy little sum of $2 billion. In what may have been a major miscalculation, NASDAQ not only dismissed the study out of hand as bunk but provided little corroboration of its position.

Then, last spring, William Christie and Paul H. Schultz, professors at Vanderbilt University and Ohio State University, respectively, released research showing a suspicious lack of odd eighths--such as 103/8--for the most active NASDAQ stocks. The evidence, they said, "raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads."

The studies--due to be published in December in the well-regarded Journal of Finance--spurred about two dozen investor suits against dealers, alleging unfair stock pricing. Both the suits and studies got the attention of Justice officials, who are always on the prowl for high-profile antitrust cases. NASD Chief Operating Officer Richard G. Ketchum, a former top SEC official, says the spreads simply reflect supply and demand in a market dominated by thousands of risky stocks that are difficult even for dealers to trade. NASDAQ critics--and competing stock exchanges--contend that wide spreads have persisted even among the biggest and most active stocks, where pricing should be more competitive.

Some independent securities experts agree with Ketchum that Justice will have a tough time proving overt collusion, even though dealers could well maintain similar spreads through tacit understandings. But what irks NASDAQ partisans is that the uhole flap could have been averted if it had been confronted early on. Ferri, director of media relations and a former Senate staffer, had lobbied for the market to sponsor an academic study to evaluate the spread issue in mid-1993. Ferri declines comment. But three people close to NASDAQ assert that internal politics and inertia stymied the strategy, even after the most recent damning research was released. Gene L. Finn, NASD's chief economist, submitted a paper to the Journal of Finance to rebut the research by Christie and Schultz, but it was turned down for publication.

HOSTILITY. Ketchum claims there are plenty of academic studies that support NASDAQ's benefits to the market. The studies make the case that NASDAQ provides superior liquidity for small-company stocks because of the dealer network. "They probably could have done a better job and didn't, and now they are playing catch-up. They need a lot more work on the PR side," says Leonard R. Hefter, head of OTC trading at Jeffries & Co. and a strong NASDAQ supporter.

A lot more clout, too. NASD sources argue that NASDAQ could have appealed directly to big member firms to slice spreads as a way to avert SEC action or legislation. Indeed, following the public release of the latest research, spreads in many large-cap NASDAQ stocks dropped from a quarter to an eighth of a point. But NASDAQ management may not have the stature to appeal directly to the senior management of most big Wall Street houses. At least three big firms have a hostile relationship with NASDAQ management. "If [NASDAQ officials] showed up in the lobby [of any of those firms], security would probably throw them out," one NASDAQ source says. When asked about the virtues of the New York Stock Exchange vs.

NASDAQ, the head of one major firm responds: "Morgan Stanley lists on the NYSE. Dean Witter is on the NYSE. Lehman is on the NYSE. PaineWebber is on the NYSE. Why are all those firms listed on the NYSE if the NASD is so great? They must think it's a better market."

"SOES BANDITS." One reason for the disdain may be that market makers don't think they'll get anything in return from NASDAQ. In the past few years, for example, many market makers have complained bitterly about some small firms that make big money at the expense of big firms by jumping on price discrepancies through a mechanism called the Small Order Execution System. SOES was designed to allow small investors to trade directly on an electronic NASDAQ system, and the large firms thought it was abusive. Market makers wanted the "SOES bandits" banned, but the NASD had trouble adopting even modest


Market makers also gripe that the NASD imposes rules without enough consultation. It barred dealers from ignoring limit orders, in which customers tell brokers they want a trade executed when a stock reaches a specified price. Most observers felt the rule made sense. But dealers were upset not just because the rule could produce narrower spreads but because the NASD unilaterally pushed the rule down dealers' throats.

Big institutional traders are also upset. They say the NASD fails to investigate complaints about failures by market makers to report trades quickly. And institutions in vain have demanded access to internal dealer quotes on a private system called Selectnet, which is used only by dealers. Ketchum concedes that NASDAQ has to communicate better with members and institutional traders.

Not only has NASDAQ failed to grapple successfully with its internal problems, it has been slow to react to competitive threats from the outside. Instinet, an electronic trading system operated by Reuters that enables dealers to trade automatically with each other, now accounts for between 15% and 40% of all NASDAQ trades, depending on whom you talk to. NASDAQ market makers, in contrast, usually rely on the telephone to make trades. NASDAQ needs to develop a system like Instinet, says Harold Bradley, head trader for Twentieth Century Funds, a $27 billion Kansas City mutual fund group.

Even when NASDAQ has the right idea, it sometimes bungles the execution. Three years ago, it launched NASDAQ International System, a trading system that allows investors to tap into the NASDAQ market from London at 3:30 a.m. EST. But it has been a miserable failure. For one thing, NASDAQ delayed, until recently, enacting an "uptick" rule allowing short sales only at a higher price than the proceeding trade. An uptick rule would have allowed foreigners to trade NYSE stocks because the NYSE allows short sales by foreigners outside the exchange only on an uptick. That little glitch has stymied development of NASDAQ International, which only has one market maker and no trading volume. NASDAQ also has fallen behind in signing up foreign listings. The NYSE has 84% of the dollar volume of foreign trading while NASDAQ only has 14%.

NASDAQ's most immediate problem, though, is dealing with the impact of the Justice probe. Even normally docile companies listed on NASDAQ are seething. Company executives are angry that they'll have to answer to shareholders and directors about the investigation. Ketchum says that NASDAQ has received calls from only a half-dozen small companies, none of which have threatened to leave NASDAQ. But a Wall Street executive says that "very extensive discussions" have been under way for some time between the NYSE and several top NASDAQ companies about switching. The top-tier issuers are worried that "any investigation casts doubt on the quality of their markets," he says.

DECIMAL ERA. NASDAQ also may feel the wrath of the SEC, which oversees the NASD's regulatory function. In January, the SEC issued a market study aimed at tightening trading practices, including a move to trading in decimals rather than increments of 12.5 cents, which would narrow spreads. And now the SEC, which sources say is "embarrassed" by the Justice probe, may go further. SEC Chairman Arthur Levitt Jr. is scheduled to hold a staff meeting on NASDAQ on Oct. 28. Commission sources add that the agency is conducting its own inquiry of possible trading violations at NASDAQ. Ketchum says he's not aware of any SEC review.

Whatever the outcome of the Justice Dept's investigation, it already is spurring some changes. The deluge of publicity is forcing market makers to rethink how they do business. Spreads already are narrowing. And more changes are likely. But NASDAQ will have to overcome a very troubled present to maintain its once convincing claim on the role of the "stock market for the next 100 years."

      Back On Track
      NASDAQ was a pioneer in automated securities trading, bringing the antiquated over-the-counter market into the 20th century. But numerous critics now say NASDAQ is faltering and requires a major overhaul.
                      management and attract
      Shake up        high-profile talent. NASDAQ executives are doing a poor job
                      handling the system's rapid growth.
                      new technologies. Other mar-
      Develop         kets, especially Instinet, an electronic trade-execution sys-
                      tem, are winning away business.
                      the market's reputation for
      Improve         fairness. Excessively wide trading spreads and other market
                      failings impose costs on investors.
                      better relations with institu-
      Foster          tional traders, market makers, and listed companies. They com-
                      plain NASDAQ doesn't consult with them enough.
                      more respect from Wall
      Cultivate       Street firms. Many firms consider NASDAQ inferior to the Big
                      a more proactive approach
      Initiate        in answering critics and promoting its markets' strengths.
                      NASDAQ failed to forestall the Justice Dept. probe.
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