NASDAQ: The Fight of Its Life

The once-dazzling market is on the ropes as the bear market, fierce competition -- and hubris -- take their toll

Robert Greifeld likes to run. "It blows off the tension and gets my mind focused," he says. So he ran a marathon in Ottawa on May 11, and when he reported to work in Lower Manhattan's One Liberty Plaza as the new CEO of the NASDAQ Stock Market (NDAQ ) the next day, he knew exactly what he had to do: By 8 a.m., the top layer of management was gone. Then he started axing a long list of overseas and domestic ventures. Within six weeks, he killed off NASDAQ Europe, an effort to build a European version of the U.S. market that had attracted only 36 companies in five years. He canceled a joint venture with a London exchange to trade stock futures. He shelved plans for NASDAQ's own splashy initial public offering. And he nixed a new system for trading small-company stocks in the U.S. "When Bob came in, there were a lot of fires that needed to be put out," says F. Warren Hellman, whose Hellman & Friedman LLC venture-capital firm is NASDAQ's largest private owner.

The fires aren't all doused. Unbeknownst to all but a handful of insiders and industry players, NASDAQ is fighting for its life. Three years in the crushing grip of an ugly bear have squeezed all stock markets, and NASDAQ's franchise technology stocks have been especially hurt. But NASDAQ's problems run far deeper than others' -- and are largely self-inflicted. Its recent history resembles a Greek tragedy of epic proportions, complete with management miscues, fierce infighting among constituents, costly regulatory misunderstandings, greed, and a big dose of hubris.

The question now is: Will NASDAQ survive as a thriving market for tech stocks? It is under assault on all sides. While it pursued a business model that faced tortuous regulatory delays, superfast electronic communications networks (ECNs) such as Reuters Group (RTRSY ) PLC's Instinet, stole its lunch. As a result, ECNs have snatched almost half the trading volume in NASDAQ-listed stocks, or 2 1/2 times as much as NASDAQ's own trading system. What's more, the market famed for its boom-era IPOs is getting a run for its money from its old-line rival, the New York Stock Exchange, which nabbed 45 IPOs last year, three more than NASDAQ, according to Thomson Financial. Combined with the tech bust, the harsh competition drove NASDAQ back into operating losses late last year -- sparking a boardroom revolt that put the 46-year-old Greifeld, who had launched one of NASDAQ's electronic competitors, in the hot seat. The board's marching orders: Cut overstuffed operations to the bone.

Unless they're resolved soon, NASDAQ's problems could seriously hobble tech companies' ability to raise capital just as the tech sector starts to revive. "NASDAQ is on the cusp of meltdown," warns Jefferies & Co. analyst Charlotte A. Chamberlain. "If it self-destructed, it would leave a huge dent in the economy." Since 1971, NASDAQ has been the gateway to capital for thousands of small companies, linking entrepreneurs with investors willing to fund their dreams of expansion. In a world without NASDAQ, innovative but risky high-tech companies might be forced to delay a public listing for years. They could go to a small regional exchange such as Philadelphia's. But the only comparable alternative would be to list on the NYSE, which requires a solid track record of revenues and profits. Without a thriving central market for tech stocks, venture capitalists would have to nurse fewer infant companies for far longer. "If NASDAQ suddenly imploded," says Mark G. Heesen, president of the National Venture Capital Assn., "I don't know where these companies would go."

For the moment, Greifeld's toughest challenge is coping with NASDAQ's regulator. For nearly three years, NASDAQ has pressed the Securities & Exchange Commission to let it break free of its parent, the National Association of Securities Dealers, and operate as a stand-alone stock exchange. That would allow it to raise more capital to fight the ECNs and the Big Board. The SEC hopes to take up NASDAQ's application this fall.

BusinessWeek has learned, however, that the SEC is unlikely to approve the application anytime soon. Agency officials see fundamental flaws in the way NASDAQ trades that, they argue, could harm investors. But NASDAQ can't revamp its plan without losing the support of its main players, the big Wall Street brokerage houses. If the stalemate persists -- and so far neither side is offering a compromise -- a schizophrenic NASDAQ will remain stuck between its old persona as a regulated utility and its new identity as a for-profit company, with few good options for securing its financial future. Privately, some SEC commissioners say they worry about NASDAQ's ability to recover its footing.

NASDAQ's current woes spring from its structure. Unlike the NYSE, it isn't an exchange -- a market with a single order book showing the trading interest in stocks among retail investors, mutual funds, pension funds, and hedge funds. At the NYSE, the vast majority of orders come together on the trading floor, where bidders fight to get the best prices. NASDAQ has no trading floor; instead it runs over a sophisticated telecom network linking about 600 customers in 1,000 locations. Quotes and orders come from three major sources: market-makers, or dealers, such as the trading desks at Goldman Sachs and Charles Schwab (SCH ) Capital Markets; the ECNs, some of which are backed by the big Wall Street firms; and online brokers such as E*Trade (ET ) and AmeriTrade (AMTD ). NASDAQ collects and displays everyone's data, then consolidates them into a single tape.

SuperMontage -- the snazzy $107 million order-matching system rolled out last year -- was supposed to give NASDAQ its first shot at running its own trading book. But it put NASDAQ in competition with its own customers, the ECNs and dealers. And its background as a trading utility under the thumb of NASD, which still owns 55% of its equity, left it ill-equipped to do battle with the eager innovators. "NASDAQ was a government-like bureaucracy trying to be a startup," says Joseph Lombard, president of Wave Securities LLC, a brokerage owned by Archipelago Holdings PLC, an ECN. "First it had to figure out the politics...and whose ox was being gored. It was innovation by committee, and it showed."

NASDAQ's former bosses say their ambitions were well-suited for the late '90s boom era. Frank G. Zarb, the Wall Street veteran who pushed NASDAQ's expansion as chairman and CEO from 1997 to 2001, thinks the global trading he promoted, and even his proposed NASDAQ IPO, will be realized one day. "I can't think of a single decision that I would have made differently," says Zarb, who is now a managing director at Hellman & Friedman. "The story simply is not finished."

The next chapter will be written by a down-to-earth manager. Greifeld has all the right credentials to halt NASDAQ's slide. The board plucked him from SunGard Data Systems (SDS ) Inc., where he was an executive vice-president. A native of Queens, N.Y., he sold computers to the Street for Burroughs Corp. (now Unisys (UIS ) Corp.) while studying nights for his MBA at New York University's Stern School of Business. The topic of his 1986 thesis: how automation would make institutions the dominant force in NASDAQ trading. In 1991, he joined Automated Securities Clearance Ltd. (ASC), where he spearheaded the development and marketing of BRASS, the system that most Wall Street trading desks still use to manage their orders of NASDAQ stocks. He understands NASDAQ's ECN challenge firsthand; in 1998, he led a team that developed an ECN called BRUT, which now handles about 5% of trading in NASDAQ stocks. After SunGard bought ASC in 1999, netting him stock now worth $47 million, he melded a bevy of business units into a one-stop info-tech shop for Wall Street's back offices. "What Bob is very good at is coming up with a clear road map and relentlessly executing that plan," says SunGard CEO Cristóbal Conde.

Greifeld's first goal is to mimic the ECNs' nimble order-matching systems. Soon, he plans to go on the offensive against the NYSE with the aim of persuading companies to switch from the Big Board. "We're fast and electronic," boasts Greifeld. "The competition is slow and manual." It's a message he hopes will bring NASDAQ closer to his third goal: persuading the SEC to let NASDAQ break free from NASD and become a full-fledged exchange.

The new CEO contends that NASDAQ naysayers miss the big picture. The market has a $490 million war chest. And despite the puny 17% of trading volume that SuperMontage captures, NASDAQ maintains that 68% of all trading volume passes through its computers, if only to be reported on its consolidated tape. Resale of that data to vendors such as Bloomberg LP generates about $75 million in annual revenue. "NASDAQ is a big tent, and SuperMontage is one player under the tent," says Greifeld. Acquiring an ECN rival such as Archipelago, which Greifeld does not rule out, could lift NASDAQ back to the top of the pile.

The NASDAQ name, burnished with expensive marketing campaigns and a glitzy MarketSite on Times Square, is still magic in many circles. Last year, JetBlue Airways (JBLU ) Corp. chose NASDAQ over the NYSE for its IPO because "NASDAQ's image as young and efficient is consistent with that of JetBlue," says CEO David Neeleman.

If all the stars align, NASDAQ could once again become a valuable property. Freed from NASD, the market could issue more stock to acquire competitors and bolster its own trading system. It could drive a harder bargain to cut the $70 million a year it pays NASD for regulatory oversight. And eventually a more measured approach to global expansion through joint ventures and branding could plant the NASDAQ flag firmly in key European and Asian trading centers.

But Greifeld's game plan is fraught with risk -- and depends on decisions largely beyond his control. His efforts to make NASDAQ more ECN-like are alienating the traditional dealers who form the market's backbone. Persuading the SEC's five commissioners to set aside objections by the agency's senior staff to NASDAQ's exchange application will be a tough sell. And persuading NYSE-listed companies to switch to NASDAQ is an uphill job, too. In the past 3 1/2 years, 109 companies have moved to the NYSE from NASDAQ. In NASDAQ's 32-year history, only one company -- Aeroflex Inc., a Plainview (N.Y.) microelectronics company -- has made the trek in reverse. Why would Greifeld think he can overcome such odds? "What choice does he have?" asks Hellman.

Such fatalism would astonish anyone familiar with the unbeatable market that NASDAQ seemed to be at its peak in 2000. Since then, its roster of listed companies has shrunk by 27%, while NYSE listings are off just 4%. NASDAQ is likely to break even at best this year, says analyst Chamberlain. That's going to force it to eat into its cash hoard, which it needs to pay down a hefty $430 million in debt, more than half of which is due in 2006. And although its shares trade on the Over the Counter Bulletin Board, NASDAQ would find it hard to tap the public equity markets for capital because it's still technically owned by NASD, a nonprofit trade group.

For the past three years, NASDAQ has suffered through the same sluggish economy and bear-market doldrums that felled many of its once-illustrious companies. A sour economy hits NASDAQ in all four of its major revenue sources. Wall Street firms retrench, leasing fewer NASDAQ trading terminals. As companies falter, their stocks are delisted, cutting NASDAQ's fee revenue. When listings decline, the market receives fewer quotes from market-makers and ECNs and can't collect as much from reselling the data. As fewer shares trade, transaction fees shrink. Compounding those cyclical problems: When NASDAQ applied for exchange status, it gave up its monopoly over selling trading data -- cutting tape revenue by $25 million over two years.

Revenue and earnings are sliding. In the quarter ending Mar. 31, revenue came in at $166 million, 22% below the same quarter last year; net income was a paltry $2.6 million, down a hefty 88%. Despite the recent surge in share trading, analysts don't expect second-quarter results, due out on Aug. 5, to be much better because of the cost of shuttering numerous sideline ventures.

NASDAQ's problems can be traced to a mid-1990s price-fixing scandal that severely tarnished its image and made the SEC ultracautious about granting it any regulatory favors. An investigation showed that market-makers were ignoring customer limit orders that offered better prices than dealers wanted to post. In the cleanup, the SEC ordered dealers to post such prices but gave them the option of routing the unwanted orders to ECNs, thus encouraging a host of new ECNs.

The scandal also led then-SEC Chairman Arthur Levitt Jr. to recruit Zarb, who first dreamed of turning NASDAQ into the world's primary equities market. In the frothy atmosphere of 1999, he spun a grand vision of a 24-hour global marketplace. The NASD board agreed to convert NASDAQ to a for-profit company, spin it off as a stand-alone exchange, and eventually do an IPO to raise capital for NASDAQ to spread its brand worldwide. Even the collapse of tech stocks starting in March, 2000, couldn't cool NASDAQ's ardor. A special meeting of NASD members approved the restructuring on Apr. 14, 2000 -- the day the NASDAQ composite index plummeted 355 points, its largest-ever point drop.

In hindsight, Zarb's plans were overly ambitious. Worse, the architects of the new market badly misread the SEC. At first, the agency was supportive. It approved NASDAQ's for-profit status and allowed it to issue securities representing about half the market's value to NASD members, listed companies, and investors. But the SEC balked when it came to the hard questions of how a NASDAQ exchange would operate -- and it hasn't budged for nearly three years.

The main issue: "price-time priority," or making sure that customers who first offer the best price for a stock have their orders filled first. NASDAQ has never done that. For about a third of trades, dealers match buyers and sellers in their own order books -- without giving any other market participant a chance to fulfill the order. The resulting "internalized" trades are then reported to NASDAQ as done deals.

The SEC values price-time priority because it rewards the most aggressive buyers and sellers and produces fairer prices. It also ensures that market insiders don't ignore retail investors. The SEC has never approved an exchange that did not force orders to interact -- and officials say it's not likely to do so soon. But NASDAQ's market-makers count on these highly profitable in-house trades, on which they collect commissions from both the buyer and seller plus the spread between the buy and sell prices. "If NASDAQ implements price-time priority," says Larry Leibowitz, head of equities for Schwab's trading unit, "the whole market-maker model comes into question -- and all bets are off." Dealers are vital to NASDAQ because they keep trades flowing -- by posting quotes, maintaining an inventory in the stocks they handle, and putting up their own capital as buyer of last resort in disorderly markets. A market that depended solely on ECNs, which don't have such obligations, could break down under stress.

So NASDAQ is caught in a dilemma: The SEC may not let it become an exchange unless it alters how it works. But if it changes the way it works, megadealers such as Schwab and Knight Securities might flee, further reducing NASDAQ's relevance.

To NASDAQ officials, the SEC's attitude smacks of favoritism toward the NYSE, which says all the orders that its specialists handle get price-time priority. They're careful not to blame SEC Chairman William H. Donaldson, who once headed the Big Board. But they complain the SEC is holding up NASDAQ over a theoretical possibility that the best-priced orders won't get filled. "It's like looking at a corner of the Sistine Chapel and complaining about a smudge," says Edward S. Knight, NASDAQ's general counsel. "You've got to look at the whole picture."

SEC officials say they're not wedded to the Big Board model. After all, the agency let Archipelago, an all-electronic trading system, merge with the Pacific Stock Exchange -- proof, they say, that the SEC is open to new models. Archipelago was able to win over the SEC in part because it has price-time priority.

NASDAQ executives are furiously churning out statistics to placate the SEC. Greifeld's team insists that investors get high-quality order executions. One study of trades done in January shows that a NASDAQ customer has a 93% chance of landing the market's best posted price, or better, on an order for fewer than 500 shares of a stock in the Standard & Poor's 500-stock index -- the typical individual investor's order. On the NYSE floor, the study says, only 76% of such orders get the best market price or better.

NASDAQ further claims that spreads between buy and sell prices are narrower on its stocks than the NYSE's. In May, NASDAQ says, the average spread on Cisco Systems (CSCO ) Inc. shares on NASDAQ was 0.7 cents, vs. 1.4 cents for AT&T, a comparably priced stock that trades on the NYSE. NASDAQ hopes that its performance, combined perhaps with new disclosures, will sway the SEC. The NYSE says NASDAQ's data are selective and misleading.

To make his case, Greifeld met with key lawmakers and SEC commissioners in mid-July in Washington. The SEC seems ready to bring the issue to a head this fall, after spending almost two years dealing with corporate and accounting scandals. Annette L. Nazareth, director of the SEC's Market Regulation Div., and other senior staff have been briefing Donaldson and other commissioners on the issue.

No one is saying how the SEC will rule. A minority of commissioners is thought to be sympathetic to NASDAQ's argument that its market doesn't need price-time priority if it executes orders swiftly and at fair prices. But the staff, wary of NASDAQ's past transgressions, would like rules to ensure that the best orders always get filled first. The key player is the chairman -- and Donaldson's NYSE background and instincts seem aligned with his staff's insistence on price-time priority. "Competition between buyers and sellers is the essential competition, not the competition between market centers," Donaldson told BusinessWeek in June.

And if the SEC rejects the exchange petition? "They can continue to do business just as they are," says Nazareth. But that would leave NASDAQ in purgatory. At the SEC's insistence, NASD remains NASDAQ's regulator -- and keeps voting control of the company. As long as NASD can call the shots, investors aren't likely to scarf up NASDAQ shares in an IPO. And relations between the two are increasingly bitter, as they feud over details of their separation and the relatively high price NASDAQ pays for regulation compared to ECNs.

Even as it struggles with a messy divorce and an uncertain future, NASDAQ must clean up the shambles of its broken ambitions. Many of NASDAQ's global ventures -- one board member calls them "ego trips" -- became black holes for money. Even after the bubble burst, NASDAQ kept investing overseas. In March, 2001, it bought majority control of NASDAQ Europe for $12 million, on top of its earlier $25 million stake. NASDAQ Japan, which never took off, was even costlier, reporting cumulative losses of $88 million from 2000 to 2002.

When Zarb retired in 2001, Hardwick Simmons, a former Prudential Securities (PRU ) CEO, was hired to carry out the strategy. When it became clear that the ECNs were eating NASDAQ alive, the market hatched SuperMontage as the killer app to restore its supremacy. The ECNs were furious and hit back. They claimed NASDAQ could use SuperMontage -- along with its links with NASD, their regulator -- to gain unfair advantages. Their complaints to the SEC, echoed by friendly lawmakers on Capitol Hill, delayed the new system for two years and forced NASDAQ to make compromises. NASD, for example, agreed not to require dealers and ECNs to post their quotes on SuperMontage.

While NASDAQ haggled with the SEC, competition among the ECNs turned brutal, slashing more than a dozen players down to six major firms. So by the time SuperMontage finally launched last October, "[NASDAQ] hopped into a shark tank with some pretty hungry sharks," says Gerald D. Putnam, CEO of Archipelago, one of the largest ECNs.

Instead of being the hunter, NASDAQ turned out to be the prey. Its system lacked many of the gee-whiz features that attract big institutions to ECNs. Large traders don't dare advertise that they want to buy, say, 100,000 shares of Cisco for fear other players will bid the stock up. ECNs allow traders to trickle out orders without revealing their full hand. To avoid angering the market-makers, SuperMontage left out such features. Says Putnam: "SuperMontage was antiquated from the day it came out."

SuperMontage failed to halt the slide in NASDAQ's share of trading its own stocks, and Simmons didn't respond to shrinking revenues quickly. Hellman -- who became a director in 2001 when his San Francisco firm lent NASDAQ $240 million to buy back its shares -- and his fellow board members stepped in. Simmons left, and Greifeld came on board. The incumbent management's choice for CEO, President Richard G. Ketchum, departed to become general counsel of Citigroup's investment-banking unit. Also out in short order: Steven Dean Furbush, an executive vice-president who oversaw the main trading business, and William S. Harts, director of strategy. Simmons says his plan would have worked if stocks had stabilized in 2002. "We made what I thought were the right decisions," Simmons says. Harts declined to comment on the record. Ketchum and Furbush did not return several calls.

Greifeld brings a nose-to-the-grindstone ethic to NASDAQ, which long behaved as a complacent bureaucracy. And he has the outsider's ability -- and the board's mandate -- to slash expenses. He has cut about 80 staff and chopped five noncore products.

Former NASDAQ officials say most of the downsizing so far was already in the works, and Greifeld will need to go much further -- cutting payroll by an additional 300 staffers -- to bring NASDAQ's costs in line with those of the lean ECNs. For now, the board seems elated with Greifeld: "Bob is exactly what we hoped he would be -- a no-nonsense manager," says Hellman.

Greifeld realizes that NASDAQ can't cut its way back to prosperity. His first challenge is to recapture institutional business from the ECNs. Soon, dealers and brokers will be able to post anonymous quotes on SuperMontage. But there's a catch: Traditional NASDAQ market-makers complain bitterly that by improving SuperMontage, NASDAQ is cutting them out of the picture. "Market-makers can't trust NASDAQ," gripes Arthur J. Pacheco, senior managing director at Bear, Stearns & Co. "Do they intend to be in direct competition with us?"

Even with a larger share of trading, NASDAQ will spiral downward if it doesn't reverse its decline in listings. So Greifeld plans to go toe-to-toe with the NYSE. In marketing campaigns and personal visits to CEOs, he will argue that NASDAQ is the better place to list. It set up a Market Intelligence Desk to alert companies of unusual trading activity in their shares. But few industry mavens think Greifeld can win a prolonged shootout with NYSE Chairman Richard A. Grasso. Says Bernard L. Madoff, a former NASDAQ chairman whose firm, Bernard L. Madoff Investment Securities LLC, does about 10% of NYSE trades: "Take it from me, as someone who's been competing against New York for 40 years, NASDAQ will have a tough time."

NASDAQ does have some ammunition. Since the price-fixing scandal, trade execution on NASDAQ has improved immensely. Indeed, some institutional traders say they now prefer trading NASDAQ stocks over the Big Board's. "I'd much rather trade Microsoft [on NASDAQ] than IBM [on the NYSE] because trading a NASDAQ stock is that much easier," says Holly A. Stark, director of trading at New York money-management firm Kern Capital Management.

Greifeld could try to buy market share by acquiring an ECN. "Acquisitions are certainly something we should be thinking about, no denying that," he says. In one move, he could nearly double SuperMontage's share of trading and radically upgrade NASDAQ's technological underpinnings. Privately held Archipelago might be the most alluring: Since it merged with the Pacific exchange in 2001, it has had the exchange license that NASDAQ so ardently desires. In fact, NASDAQ has flirted with Archipelago before. A source close to both markets says the two discussed a merger earlier this year but couldn't agree on a price. Former NASDAQ execs also say Putnam and Greifeld didn't hit it off.

Instinet, 63% owned by Reuters, is an alternative. It executes about 28% of NASDAQ trades, vs. Archipelago's 15%. Instinet CEO Edward J. Nicoll is now moving Instinet's trading business to its Island subsidiary -- potentially setting up a sale of the trading system, industry sources say. But Instinet, with a market cap of $1.6 billion, wouldn't come cheap. The enlarged Island could fetch $750 million -- a hefty chunk of change for NASDAQ -- says Benn Steil, an expert on global stock exchanges and senior fellow at the Council on Foreign Relations.

In any case, an acquisition won't guarantee NASDAQ the exchange status and freedom it craves. The SEC would have to approve any transfer of Archipelago's license. Since the Pacific exchange has price-time priority, adopting that would likely be a condition for NASDAQ to buy Archipelago.

How did NASDAQ get into this corner, where every strategy seems to force a choice between its independence and its dominant market-makers? Counselor Knight gripes that the SEC led NASDAQ on by approving its private issuance of shares in 2001. "Those shares were premised on us becoming an exchange," he says. Not so, say SEC officials. "They jumped the gun," says Nazareth. "We could not have anticipated all of the details of their application. They should've waited for the exchange application to be approved."

Why didn't they? "They were pursuing the riches of the Internet bubble," says Instinet's Nicoll. Some former NASDAQ officials think stock options were the lure. "It was an attempt to become a real company," says one, "but you could say a major motivation was to get stock options." Zarb, who received 2 million options over two years, says that idea is "ridiculous." The market issued shares to gain "an equity base so NASDAQ could separate from its regulator [NASD] and support itself."

That separation now looks like a distant dream. A financial crunch looms as NASDAQ figures out how to repay its venture backers. Some industry players and SEC officials think that has made NASDAQ more attuned to Hellman's interests than to its own constituencies. "Clearly, it's dominated by the venture capitalists now," says Madoff. A former top NASDAQ exec agrees: "At this point, Bob Greifeld's job is to dress up NASDAQ long enough for Warren Hellman to get his $240 million back." Greifeld says only: "I am here to protect and grow our shareholders' interests."

In the long term, NASDAQ could struggle to remain just a player, let alone become the world-beater it once was. It has long odds of winning exchange status from the SEC. And despite its for-profit status, it will have a tough time raising the capital it needs as long as it's tethered to NASD. Owned by a stodgy regulator, NASDAQ remains flat-footed and ill-equipped for the cutthroat competition that's taking over markets worldwide. It will have to make far more painful cuts to payroll and operations to joust with the lean-and-mean ECNs. And its quest to lure companies away from the NYSE is a long shot.

Even if it cannot break free, NASDAQ won't disappear overnight. The screens will still flash on Times Square, and for many, NASDAQ will still evoke the glamour of high tech and go-go growth. But those technicolor panels already seem a facade for a shrunken market. The trading venue that once called itself the stock market for the next 100 years could become a mere shadow of what it was in the last decade.

By Paula Dwyer and Amy Borrus

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