Tough Love At Nasdaq

Frank Zarb's reforms are stirring up controversy

Things looked pretty bleak for the NASDAQ stock market a year or so ago. A price-fixing investigation ended in a humiliating settlement with the Securities & Exchange Commission that in effect had put NASDAQ on probation for three years. The scandal made it possible for its archrival, the New York Stock Exchange, to pick off some of NASDAQ's star listings. As morale sank among the 570 employees at NASDAQ's parent, the National Association of Securities Dealers, talented staff began jumping ship. A slew of alternative trading systems, meanwhile, was eating into market share.

Then Frank G. Zarb showed up, a veteran Wall Street hand, former Smith Barney Inc. chairman, Lazard Freres & Co. partner, and White House energy czar during the turbulent 1970s oil embargo. Zarb concluded that NASDAQ was like Icarus--a high-flying exchange that flew too close to the sun and got burned. His solution: rebuild the organization with stronger wings so it can soar even higher.

"CHANGE AGENT." After just eight months as NASD chairman, president, and CEO, Zarb is wasting little time trying to fulfill his grand vision. He's pushing an ambitious plan to turn NASDAQ into a futuristic trading system that would collect pricing information now held in dozens of competing dealers' systems, and allow traders to arrange deals at the push of a button, instead of by telephone. He hopes to have the new system, called Next NASDAQ internally, running by mid-1998. He's aggressively courting foreign companies to list on the exchange. He has convinced SEC Chairman Arthur Levitt Jr. that a NYSE rule making it impossible for companies to decamp to another exchange is anticompetitive, meaning he may soon court Big Board companies. And he struck a deal with the SEC to revamp NASD's corporate governance, effective Jan. 1.

For someone who wasn't even sure he wanted the top NASD job when first approached late last year, Zarb, 62, certainly has moved with lightning speed. "Maybe at this stage I have a better opportunity to be a change agent," he says. At the same time, Zarb seems resigned to the idea that this will be his swan song in private and public life. "I'm here to make a difference, and not to feather my nest. This isn't a stepping stone to higher office."

Zarb certainly gets high marks for restoring the luster to a tarnished marketplace. Yet some of his ideas are running into serious flack, especially among NASDAQ's market makers, the 500 or so dealers who quote firm bid and ask prices and are on at least one end of nearly every NASDAQ trade. For example, at an Oct. 15 meeting in his Washington office, some of the most powerful market makers strongly objected to portions of Zarb's restructuring proposal. Their main criticism: The new NASDAQ market would compete with them.

One reason Zarb is free to plan NASDAQ's next-generation trading system is that the regulatory side is running smoothly under NASD Regulation President Mary L. Schapiro, who arrived in February, 1996, a year before Zarb. NASD's almost complete failure to enforce its own rules and police the NASDAQ market was cited by the SEC in a scathing August, 1996, report. Regulatory functions now are separately housed at NASD Regulation Inc., which oversees 500,000 individual brokers, 5,400 firms, and the NASDAQ market itself.

Under Schapiro, a former SEC commissioner and Commodity Futures Trading Commission chairwoman, the regulatory budget has jumped 45%, to $222 million, while disciplinary actions surged 31% in 1996, to 1,200. And as part of the SEC settlement, NASD is spending $20 million to develop audit-trail software that will track buy and sell orders. The new Chinese wall separating regulation from the NASDAQ market frees Schapiro from worrying whether her actions will affect such competitive issues as NASDAQ's ability to attract new listings. "I don't think NASD will ever again let regulation take a backseat," Schapiro says.

TOO LITTLE? At the same time, new SEC rules have helped make trading on NASDAQ more transparent, or understandable to investors, and lowered trading costs. In January, the SEC began phasing in a requirement to display customer limit orders--investors' requests to buy or sell at a specified price--on NASDAQ screens.

Since January, according to one study, there has been a 30% decline in spreads, or the difference between buy and sell quotes. That's saved investors about $1.3 billion. "There is far more competition and transparency in the market today than a year ago," says Richard R. Lindsey, director of the SEC's Division of Market Regulation.

But critics say NASD isn't going far enough. Some academicians and NASDAQ users believe the market should spin off the regulatory body altogether. Market makers, on the other hand, hope to stop portions of the new NASDAQ system before they leave the drawing board. And Zarb is in the middle.

The most contentious part of Next NASDAQ would have the exchange act as a central facility for investors' limit orders. Currently, each market maker has its own limit order book, in which customers specify the price at which they would buy or sell stocks, but those prices aren't always posted. "We want to force all this valuable information into the system before the fact instead of after the fact," says NASDAQ President Alfred R. Berkeley III. "We want to be the market of choice for investors."

Another feature would allow institutional investors to trade with each other, as long as they act through a NASDAQ dealer account. Unlike now, all trading would be anonymous. NASDAQ essentially would become a hybrid of its present quote-driven system and the NYSE's order-driven exchange, but without the expense of a trading floor. The London Stock Exchange and many others around the world are moving to this hybrid.

One reason behind the Next NASDAQ proposal is that the exchange is feeling competitive pressure. "It's the marketplace saying NASDAQ hasn't provided what the market needs," says Zarb. "I don't think we did our jobs very well for the past five years." In addition to Instinet, an independent, automated trading system, and a limit-order facility developed by Bloomberg Financial Markets, several major Wall Street firms have decided to develop their own electronic systems. "We're operating in a world where if you're not moving, you're falling behind," says Lindsey, whose office oversees exchanges.

To investors, it all sounds good: Trading is easier, spreads are narrower, and transaction costs are down. But Next NASDAQ is threatening if you're a market maker, which includes giant, full-service brokerages such as Merrill Lynch & Co. "The concern," says Bernard L. Madoff, whose Bernard L. Madoff Investment Securities is one of NASDAQ's largest market makers, "is that NASDAQ would be competing with us. We think it makes more sense to let industry build these mousetraps."

The road ahead could be rocky for Zarb. Not only does he have to convince reluctant market makers that Next NASDAQ is good for them in the long run, but he also has to convince companies overseas, where most of the growth in listings is, that NASDAQ has corrected its problems. At the same time, he is about to go head-to-head with the NYSE for company listings. In the last 10 months, NASDAQ has lost more listings than it has gained.

Under SEC pressure, according to a commission source, the NYSE's board soon will vote on whether to lift Rule 500, which prevents companies from listing elsewhere. The smart bet is that directors will scuttle the rule, giving Zarb a green light to woo Big Board companies for the first time. But even he concedes it will be a hard slog persuading companies to defect to NASDAQ unless he can prove that Icarus has an improved set of wings.

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