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March 1, 1998

The Secaq Marketplace!

By Jeffry Davis

The National Association of Securities Dealers has proposed an ambitious remodeling of Nasdaq.

The blueprint, however, fails to give credit to the architectural firm that had the most to do with the new design namely, the Securities and Exchange Commission.

Instead of calling the new market Next Nasdaq as originally envisaged, they should have named it Secaq.

The clear message to the dealers is simple: Thanks very much for building such a fine marketplace, but please close the door on your way out.

Admittedly, this exaggerates the effects of the proposed changes, at least the immediate effects. There will still be a need for market makers in Secaq, but that need is clearly diminished. The consolidated or central limit-order book (participation is supposedly optional) is a direct challenge to the heart of the dealer market.

As previously noted in Traders Magazine, the dealers are stinging from a slap across the face.

Some observers, of course, would say that the dealers are getting what they deserve, referring to allegations of price fixing and embarrassing settlements with the SEC and others.

I think, however, that the scandal simply hastened the inevitable takeover by the SEC.

The SEC has taken advantage of the opportunity to force its order handling rules upon the industry, and it is these rules that provide the impetus for Secaq.

It may be that Secaq will be a wonderful marketplace, thanks to the brilliant architects at the SEC. But I have to wonder why they have ceded so much power, and whether investors ultimately would be better served by curtailing that power.

I cannot think of any other market where consumers have benefited from such a concentration of authority in the hands of a government agency.

Nasdaq, with all its faults, is a tremendous success story.

In just a quarter of a century, Nasdaq turned the backwater over-the-counter market into a rival of the New York Stock Exchange. And all that was accomplished while it remained an unabashed dealer market.

As serious as the trading scandal was, it did not frighten away investors.

Even so, Nasdaq has been treated by the SEC as if it were fatally flawed, unable to continue business without a wholesale redesign of its trading system. And, it appears, the NASD has done little more than throw itself upon the mercy of its master.

What can the dealers do? Probably not much. Can they abandon the NASD and form their own self-regulatory organization? Maybe, but they would still have to report to the SEC.

Can they challenge the SEC's authority? They can, but success is unlikely, given their weakened political position. The dealers are now portrayed as the bad guys.

Their every effort to resist the changes being forced upon their marketplace is viewed as a greedy attempt to maintain their unnecessary position as middlemen, skimming off a fat profit that would otherwise stay in the pockets of investors.

A key point lost in the fray is that the SEC, and now even the NASD, is taking away the dealer marketplace. This is made possible by the membership and governance structure of the NASD, as stipulated by the Securities and Exchange Act.

Unlike the exchanges, which are still allowed to limit their memberships, the NASD is required to extend membership to any registered broker dealer.

Because of this open membership, the dealers who made Nasdaq such a success are now faced with the prospect of being squeezed out having lost two things.

First, they have lost the power to control the way Nasdaq is operated, because of the dilution of their power as members.

Second, they have lost the increase in the value of membership.

This means that, not only have they lost control of Nasdaq, but they have also been deprived of any benefit due to the increased value of Nasdaq, for which they are largely responsible.

It is truly ironic, at least to me, that the process of converting Nasdaq to a more order-driven market is the process by which the Nasdaq dealers will lose what exchange members have preserved.

It remains to be seen whether the dealers will leave with a whimper or a bang.

Jeffry Davis is a senior economist with Economists Incorporated in Washington, and formerly was director of economic and policy research at the Securities and Exchange Commission.