Nasdaq's Spin Off: Not Far Enough?

Despite its move to go public, the exchange still favors insiders

Score one for Nasdaq. After almost 30 years in the shadow of the New York Stock Exchange, the junior stock market will beat the Big Board in remaking itself as a for-profit, shareholder-owned exchange. A sweeping plan announced on Jan. 4 will separate Nasdaq from its parent, the National Association of Securities Dealers, by mid-year, raising about $1 billion in capital. More important, the spin-off will enable Nasdaq to invest, upgrade, and innovate for today's bruising competition--months before the NYSE can overhaul itself.

But NASD Chief Executive Frank G. Zarb shouldn't take much comfort from the points he's scoring over NYSE Chairman Richard A. Grasso. Nasdaq's real competition isn't the Big Board: It's the smaller, nimbler electronic trading systems that are stealing business and cutting investors' costs. To compete with these electronic communications networks (ECNs), Nasdaq will need faster, more automated trading that focuses on investors' needs.

That's a big change for a market that, under insiders' control, has more often tilted toward giving brokers and dealers an edge. "The restructuring means nothing unless Nasdaq changes its business strategy," warns Harold S. Bradley, senior vice-president of American Century Investments, a Kansas City mutual-fund manager. Such a wholesale shift is unlikely before Nasdaq moves to true public ownership through an initial public offering, possibly this year.

ECNs have taken 30% of Nasdaq's soaring trading volume away from traditional market-makers. The ECNs are now part of Nasdaq's market--but two of the leading ones, The Island ECN and Archipelago, have applied to the Securities & Exchange Commission to become stock exchanges in their own right. "[Nasdaq] will have to meet us on speed, price, service, and liquidity--and we're ahead on all four," boasts Matthew Andresen, Island's president.

Zarb says the new Nasdaq will be "more agile, financially stronger, and technologically more advanced." The restructuring will net about $200 million in capital for new systems and initiatives--more if Nasdaq makes an IPO.

But control--not capital--may be the real problem. The private stock offering will leave Nasdaq's current players in charge: Big market-makers will own 31% of the shares, small brokers 25%, and NASD itself 23%. Over the long haul, ownership will give them an incentive to make Nasdaq more investor-friendly. Short run, though, they'll have a strong interest in preserving their insider advantages.

Indeed, rivals and big investors charge that Nasdaq's newest electronic order system does just that. Nasdaq's proposed "super montage," now awaiting SEC approval, gives Nasdaq dealers first crack at orders. Instead of enabling instant trades--as ECNs do--the system would build in delays to allow brokers to trade ahead of pension and mutual funds, Bradley says. NASD officials say the delays are a firewall against market manipulation.

Many of Nasdaq's new owners face divided loyalties because they have bigger stakes in potential competitors. Goldman, Sachs & Co., for example, is already an owner of Archipelago. Meantime, Nasdaq is trying to win back business lost to ECNs. Nasdaq-Japan, a new venture to trade U.S. and Japanese stocks in Tokyo, will soon roll out a system to link market-makers via the Internet. Nasdaq hopes to export the system to Europe and eventually bring it to the U.S. The system could offer Nasdaq-listed companies "access to a global pool of liquidity that doesn't exist now," says Zarb.

Nasdaq also plans to invade the NYSE's turf. It has enlisted Primex Trading, an electronic facility owned by Goldman, Bernard L. Madoff Investment Securities, and other big brokers, to offer an electronic auction in NYSE-listed stocks to Nasdaq brokers. The NYSE's plans to partner with an ECN to trade Nasdaq shares have stalled. And the Big Board won't decide on changing its broker-dominated ownership for almost another year.

But for both traditional markets, overhauling their ownership is but a first step. With technology whittling away the profits of brokers and middlemen in every industry, stock exchanges have to figure out whether to cater to market insiders or stock issuers and investors. The outcome will determine whether the new Nasdaq can best its surging electronic rivals.

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