Nasdaq: Power To The People?
When the new NASDAQ Stock Market opened for business in 1971, it was heralded as the market of the future. Instead of face-to-face haggling at the existing exchanges, it featured a new electronic stock-quote system. Since then, NASDAQ has grown astronomically to become the world's second-largest market, after the New York Stock Exchange. For all its expansion and technological advances, though, NASDAQ is increasingly in the spotlight for its failings instead of its strong points. As the market has evolved, it has tilted further away from the small investor in favor of brokerage firms, who make huge trading profits, often at the little guy's expense.
Not any longer, if Arthur Levitt Jr. has his way. The Securities & Exchange Commission chairman is personally overseeing a revolutionary overhaul that could drastically change and improve the way NASDAQ does business.
Part of what might be called Levitt's Crusade is aimed at breaking down the clubby way NASDAQ is governed. But Levitt's prime goal is shifting the advantage away from the professionals back toward small investors. The SEC is mulling new rules mandating that small investors in all stock markets have the same access as the pros to the best stock prices. In any given trade, the small investor might only come out a few dollars ahead. But cumulatively over a year, the difference could amount to many billions. "You are talking about major, major changes overnight," says Michael Murphy, senior director at Morgan Grenfell Capital Management Inc.
FAVORITISM. Because offering better prices to small investors on NASDAQ will take a big chunk of trading profits out of broker-dealers' pockets, many NASDAQ dealers are skeptical, even angry, about the changes. But in the long run, the rules should force NASDAQ to become a far more efficient trading system. With its superior electronic capabilities, NASDAQ will be in a much better position than less automated exchanges to turn the rules to its advantage. Says Harold S. Bradley, head trader at the Twentieth Century mutual fund group: "If NASDAQ does that, it may surpass the New York Stock Exchange and truly become the stock market of the 21st century"--something NASDAQ has relentlessly promised in its ads but has yet to deliver.
Levitt's method for achieving these changes, though, flies in the face of the prevailing deregulatory ethos in Washington. Although the SEC has the power to implement these rules, which are scheduled to be recommended in some form by the staff for commissioners' approval by May, they are certain to encounter intense criticism. Still, Levitt is likely to prevail. "It's almost like a regulator designing a car for General Motors," says Robert A. Schwartz, a finance professor at New York University.
NASDAQ's favoritism toward pros and big investors is rooted in its system of about 500 broker-dealer firms, who buy and sell stock among themselves to complete investors' orders. For each NASDAQ stock, small groups of dealers advertise "bid" and "ask" prices, which are displayed on a national network of electronic quote machines. Generally, investors must sell at the quoted bid price and buy at the ask price.
Since last October, though, the Justice Dept. has been investigating whether dealer firms who trade the same stock sometimes conspire to set an artificially wide "spread"--the difference between the bid-ask prices. The incentive: Dealers make profits by trading shares inside the spread, often buying for less than the advertised ask price and selling for more than the bid price. The dealers keep the difference--usually at least an eighth of a point, or 12.5 cents, and often more. For instance, if Apple Computer Inc. stock is quoted at $27.75 ask and $27.50 bid, a dealer may buy it from another dealer for $27.62 and sell it to a customer at the higher price of $27.75, pocketing the difference.
The ability of brokers to strike favorable deals at prices better than the spread has become more prevalent with the advent of new electronic markets such as Instinet, owned by Reuters Holdings PLC. These offshoot electronic systems are a quick and anonymous way for big traders to buy and sell stock at prices better than the quoted NASDAQ spread. But only the biggest players--broker-dealers and mutual-fund traders--have access to these systems. NASDAQ dealers are the biggest users, buying and selling stock at prices superior to their own advertised quotes.
The individual investor comes up short in another way, when he or she submits a "limit order"--a request to buy or sell at a specific price inside the dealers' quoted range. These orders are regularly ignored because more competitive offers would narrow dealers' spreads and cut profits.
The SEC has been debating for years how to direct the National Association of Securities Dealers, which oversees NASDAQ, to fix these flaws. Levitt's new rules should go a long way toward reducing the dealers' edge.
A major proposed change requires dealers to update their bid-ask quote if they have made a better offer on another market, such as Instinet. That would cause dealers to adjust their advertised quotes and effectively narrow the spread, allowing investors to trade at those better prices. A second rule would require dealers to broadcast customer limit orders to the market when they are offering a better price than the one being quoted in the market. Publicizing limit orders will improve small investors' chances of locking in the price they want. A third rule would force dealers to try to nail down a better price for customers than the price quoted in the market.
Many dealers and academics worry that the SEC's meddling could stifle innovation and competition--and undermine NASDAQ's strength. Narrowing spreads in the thinly traded and often volatile stocks in which NASDAQ specializes, traders argue, could reduce their incentives to make markets in these stocks. Ultimately, they caution, that could reduce liquidity in a market that last year traded 100 billion shares worth $2.4 trillion. The rules will mean "existing liquidity and price continuity will be irreparably harmed," Merrill Lynch & Co., a big NASDAQ player, warned the SEC.
Levitt counters that the rules will only improve NASDAQ and other markets. He insists that the changes simply "level the playing field." And removing the advantage dealers have over small players, he says, will attract more market participants and increase liquidity. "This will strengthen NASDAQ," he asserts.
He does not dispute, however, that the changes will hit many NASDAQ dealers in their pocketbooks. A comment on the proposed changes from the American Stock Exchange, a NASDAQ competitor, estimates that artificially wide spreads cost investors $9 billion a year--which ends up in broker-dealers' pockets. "The guys that just scalp eighths and quarters won't be there anymore," says Morgan Grenfell's Murphy.
Admitting that NASDAQ dealers will get hurt, Joseph R. Hardiman, chief executive of NASDAQ and its operator, the NASD, says the SEC rule proposals go too far too fast. The NASD supports advertising limit orders and has a proposed new system, NAqcess, designed to do just that. "The SEC rules have sparked strong debate as to the future structure of the equity markets. That's healthy," Hardiman says. "But I believe we should take steps one at a time."
SNOWBALLING REFORM. Still, NASDAQ knows the reform sweeping the markets can't be stopped. It's preparing for more changes. Earlier this year the NASD quietly formed a task force, headed by NYU's Schwartz, to study additional improvements to NASDAQ. One of the initiatives, which was recommended by the Justice Dept., would make NASDAQ more competitive. A panel of institutional traders and NASDAQ dealers is examining a proposed system that would electronically set prices at the opening bell of each trading day. Known as a "call market," the electronic system would batch together orders that accumulate overnight and matchthem, in the process setting a new morning price. Currently, broker-dealers tend to reset prices each day by being the first to execute a trade in individual stocks, a somewhat artificial and often inaccurate system for opening trading.
CONFLICTS OF INTEREST. The rule changes are just one part of Levitt's campaign to fix NASDAQ. Many of the changes have been spurred by the SEC's investigation into possible dealer trading violations and the NASD's lax oversight. Levitt declined comment on the investigation. But he says of the market's overhaul: "To have NASDAQ emerge from this unhappy process as a stronger enterprise, viewed by their various constituents as a fair and innovative marketplace, a lot of changes have to take place."
The biggest issue: better policing of the NASDAQ market. The existing system is rife with potential conflicts of interest, because the NASD serves as both the operator of the stock market and the first-line regulator of more than 500,000 brokers.
At Levitt's urging, the NASD board accepted in principle reforms that were recommended by a panel headed by former Senator Warren Rudman (R-N.H.). Under the reorganization, the NASD will become a holding company with two relatively autonomous subsidiaries: the NASDAQ market itself and an entity called NASD Regulation Inc., which will police not only NASDAQ dealers but also 5,000 other U.S. securities firms. Levitt has personally recruited big-name candidates for the expanded board, including Merrill Lynch Chairman Daniel P. Tully and Goldman Sachs Chairman Jon S. Corzine. Merrill and Goldman declined comment.
At the speed with which Arthur Levitt is moving, NASDAQ just may have something to celebrate when the 21st century rolls along.