A Revolt At Nasd?

Small firms are rejecting Chairman Zarb's expansion plans

Alan L. Davidson is spoiling for a fight. The Jericho (N.Y.) bond dealer thinks nit-picking regulators are hounding small brokerage firms like his out of business. Worse, he sees the National Association of Securities Dealers--the securities industry's biggest regulator, and operator of the NASDAQ and American Stock Exchange--racing ahead with after-hours trading and links with overseas exchanges. Moves like that, he charges, will "bankrupt" most NASD member firms. "In today's NASD," complains Davidson, president of Zeus Securities Inc., "the big are getting bigger--and the small are getting annihilated."

Rantings of a regressive dissident? That's what NASD's leaders thought--until last December, when Davidson, president of the Independent Broker-Dealer Assn., and his allies ousted big-name incumbents to capture two board seats in the first contested election in NASD's 60-year history. Admission into the boardroom's sanctum hasn't dulled Davidson's tongue or softened his outsider tactics. Now, he's warming up for Round Two--a better-organized campaign to contest all seven of the seats up for election this fall on NASD's 32-member board. And with the angry mood among its smaller members, he could prevail. That hobbles NASD's efforts to make its markets more competitive.

This bullfight in a bourse could hardly come at a worse time for NASD. While small firms stew, the group faces an even greater threat to its business from its big members. Securities powerhouses like Merrill Lynch and Goldman Sachs are investing heavily in new trading platforms, called electronic communications networks (ECNs), that divert trades away from NASDAQ's traditional market makers. The oldest E-bourse, Instinet Corp., is even negotiating a link with NASD's longtime rival, the New York Stock Exchange, that would make it easier for Big Board traders to deal in NASDAQ-listed stocks.

NASD Chairman Frank G. Zarb won't talk publicly about Davidson or the challenge from small firms. But he is moving rapidly not only to update NASDAQ and the Amex but to stake a claim to overseas and after-hours trading before his three-year term expires in January.

To accomplish this, he has little choice but to line up with the big brokerage houses, says Columbia University law professor John C. Coffee: "If the top 10 firms on Wall Street end up owning ECNs, they'll have no incentive to help NASDAQ. If NASD can't align itself with the major players, those players will just keep hollowing out NASDAQ."

FOR SALE. To head off that challenge, Zarb is pursuing a breakup that would convert NASDAQ to a for-profit, shareholder-owned exchange. Shares would be sold to securities houses first, then to the public through an IPO. The NASD board may vote on the outlines of a spin-off plan at its next board meeting on July 29. Besides raising new capital to upgrade market technology, the move would give brokerages, especially big firms, a stake in NASDAQ--and incentives to concentrate trading there, thus undercutting the ECNs.

The breakup would also cure the conflicts built into NASD's structure. The group regulates every securities firm in the country--firms that are both the backbone of NASD's markets and the members who select the association's leaders. In the past, NASD resolved those conflicts by skimping on enforcement. That culminated in the collusion scandal of the early 1990s, when NASDAQ dealers were charged with browbeating competitors to maintain wide and profitable spreads between shares' bid and ask prices. NASD has vastly improved its market supervision. But Davidson & Co. charge that small firms, while largely blameless in the scandal, are bearing the brunt of the extra scrutiny and enforcement it produced.

Worse, small brokers charge that they're not consulted on NASD's new directions. The association didn't submit its 1998 purchase of the Amex to a membership vote. Nor has it sought approval for a plan to trade the 100 most prominent NASDAQ stocks in Japan. "Our members don't have a presence in Japan," says Davidson. "If a 10-person firm has to monitor markets 21 hours a day, it will go broke."

The fight over extended trading is fueling the latest small-broker revolt. With ECNs gearing up to offer individual investors evening and early-morning trading, NASD declared in May that it could offer its own extended trading by September. Exchanges, ECNs, and online brokers maintain that investors are demanding the freedom to buy and sell stocks outside the current 9:30-to-4:00 trading day: 40% of online brokers' orders are placed overnight, a buildup that contributes to huge volume spikes in the minutes after markets open.

PACIFIER. But small brokers say they see no sign that longer hours are needed or wanted. "My customers say, `Thank God it shuts down at 4:00--I don't have to worry about my positions flying around overnight,"' says Jay Shartsis, director of options trading at R.F. Lafferty & Co., a 30-broker New York firm. "But NASD is shoving this down our throats."

Zarb is now moving to mollify the small firms. While declaring NASDAQ ready to meet ECNs in the after-hours, he quietly lobbied SEC Chairman Arthur Levitt Jr. to put the brakes on the move. The result: A June 30 agreement among the SEC, NASDAQ, and the NYSE to study the effects of extended hours, effectively stalling new trading hours on the major markets until mid-2000.

Further, Zarb created a small-firm slot on NASD's board--in addition to the seats won by Davidson and an ally--and appointed a Small Firm Advisory Board. Stephen J. Perrone, chairman of Northeast Securities Inc. in Uniondale, N.Y., and a member of the nominating committee for this fall's board contest, says he's urging the panel to include small-firm brokers and entrepreneurs among the seven official board candidates. But that's unlikely to blunt the Independent Broker-Dealers' challenge.

But small firms face tough hurdles in trying to wrest control of NASD. If Davidson's seven-person slate wins in December, small broker-dealers will have the largest voting bloc on the NASD board. But that constitutes only 9 out of 32 seats. And all securities firms, large and small, face a limit on their clout over NASD, thanks to a new board structure imposed in 1996 by the SEC: Only one-third of governors are from member firms. The rest must represent the public, listed companies, or institutional investors. Says Levitt: "If the NASD goes backward and starts protecting parochial interests at the expense of the public interest, it will ruin the institution."

So the small brokers' major power may have to come through agitation, not elections. Zarb is trying to ease their way into the new trading world: by contracting with clearing firms--dealers that handle back-office operations for other brokers--to manage small firms' after-hours operations. NASDAQ may also offer a link on its Web site where small firms' customers can buy and sell stocks, with the trade credited to the broker.

But catering to the small firms, while good internal politics, may be bad business for NASD. "Extended hours, overseas trading--it's not a question of whether, it's just when," says Washington lawyer and former SEC Commissioner A.A. Sommer Jr. The need to coax small brokers along can only hamper NASD in its struggle to compete. Little of that matters to the small brokers: They're more ready to fight than switch. Zarb may be preparing to move his markets into the 21st century. But the way his smaller constituents see it, that will happen over their dead bodies.

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