Commentary: At Last, Nasd Shoos The Fox From The Henhouse

For two years, the National Association of Securities Dealers has been in a state of denial. Despite withering government and academic probes questioning the fairness of its electronic NASDAQ stock market to investors, NASD President Joseph R. Hardiman has steadfastly refused to acknowledge any problems.

Suddenly that's all changed. And only good can come from it. On Sept. 19, Hardiman announced that the NASD board had agreed to a sweeping reorganization of the market and its regulatory structure. The beleaguered organization, Hardiman says, will implement the long-awaited recommendations of a blue-ribbon committee chaired by former Republican New Hampshire Senator Warren B. Rudman.

Hardiman may have had little choice but to accept Rudman's findings. The Securities & Exchange Commission has been investigating NASD's oversight of NASDAQ, and accepting reforms may be the only way to stave off stiff penalties. Undoubtedly, Rudman's key finding confirms the SEC's suspicions: NASD oversight hasn't kept pace with the market's astronomical growth. In just the past five years, NASDAQ's annual volume has doubled, to 80 billion shares. "We see cracks developing in the [current] system," Rudman says.

BETTER POLICING. That's something Hardiman has never acknowledged. But accepting Rudman's recommendations for dealing with these cracks should substantially boost protections for investors. The biggest issue: better policing of the market. The existing system is rife with potential conflicts of interest because the NASD serves as operator of the market and as regulator of the security industry's 500,000 brokers and 5,400 brokerage firms.

Under the NASD's new structure, the functions of regulating and operating the market will be separated into autonomous units answering to a new parent organization, NASD Inc.--all three with their own boards, staffs, and chief executives. The enforcement arm will be separated by a Chinese wall from the NASDAQ stock market, the other autonomous subsidiary, according to Hardiman. "We believe this is a model that will bring the market into the next century," he says.

A more independent oversight board should significantly temper the NASD's clubbiness. The Rudman commission calls for at least half the members of each board to be independent of the brokerage industry, coming from the ranks of academics, portfolio managers, and state securities regulators. That's up from a maximum of 20% under the old system. No longer will boards be dominated by broker-dealers who may have a tough time passing disciplinary judgment on their colleagues.

But making the new structures work still will take some effort. Critics have accused the NASD of stacking existing NASD and NASDAQ boards with members friendly and loyal to the organization. Indeed, Hardiman must make sure the new boards are truly independent by nominating some of the market's most outspoken critics. Good candidates include Vanderbilt University professor William Christie and Ohio State University professor Paul H. Schultz, who together published research raising questions about possible price-fixing by NASDAQ dealers.

Ultimately, though, the key to success lies in better policing of the market. The new enforcement organization won't be an improvement unless NASDAQ roots out rule breakers. There are signs that's already happening. On Sept. 15, Morgan Stanley & Co. was sanctioned for several incidents of failing to honor its publicly quoted stock prices. But Morgan's $19,000 fine was hardly tough enough. The new NASD must put sharper teeth into its penalties.

Some NASDAQ watchers have their doubts about the long-term benefits of the makeover. Says Daniel G. Weaver, finance professor at Marquette University: "I don't think it will work. After the hype dies down, it will be business as usual."

But the coming changes are bound to mark a positive turn for NASDAQ investors. Hardiman, for instance, plans to open a new office to serve individual investors. That's an acknowledgment that any loss of investor confidence could stall the growth that in 25 years has turned NASDAQ into the world's second-largest market. Indeed, an updated management structure could be a big step toward making NASDAQ what it always claims to be: the stock market of the future.

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