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July 31, 1998

Nasdaq as a Competitor

By Sam Scott Miller

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  • Nasdaq as a Competitor

Once the National Association of Securities Dealers announced its deal with Jersey City-based OptiMark Technologies, Bernard L. Madoff founder of third-market firm Bernard L. Madoff Investment Securities is reported to have said that the NASD has "come out of the closet as a major competitor."

Closeted or not, self-regulatory organizations (SROs) are undoubtedly competing with members. Given the competitive stress of preserving and expanding their market share, there is little reason to expect SROs to perform more admirably in the future.

The ability of SROs to impinge on their members' livelihood and to foster anti-competitive practices suggests that self-regulation should be more carefully circumscribed and monitored.

Nasdaq CLOB

The latest example of an SRO meddling in its members' livelihood is the proposed Nasdaq central limit-order book. The Nasdaq proposal would not only dispense the favor of sponsoring institutional access to certain firms, it would have members competing with a new Nasdaq brokerage business regulated by its affiliate. (Indeed, Nasdaq now advertises itself as a National Association of Securities Dealers company.)

The Nasdaq best bid and offer quotes on Nasdaq terminals would have the identifier NSDQ alongside quotes posted by NASD members. Nasdaq would display the depth of orders at all prices on its book. Market makers and electronic communications networks (ECNs), however, would only be permitted to display best-priced orders and quotations.

Nasdaq's product puts the NASD squarely in competition with its broker-dealer members, and with built-in trade protection, giving it advantageous terms.

Moreover, the proposed OptiMark linkage would permit interaction with orders and quotes displayed on Nasdaq including the full depth of the Nasdaq limit-order book but not all orders of competing market markers and ECNs.

When a market has moved, all orders in the Nasdaq book would have time priority over the earlier orders of ECNs, and of market makers that must update their prices after each execution.

Notwithstanding placement by the NASD of its regulatory and market peas under separate shells, the NASD has implicitly approved Nasdaq's system as a method of order routing and execution that it believes would fulfill an order-routing firm's best-execution obligations.

Since the duty of best execution is vaguely defined, broker dealers would likely seek the safety of routing customer orders to a limit-order file operated by Nasdaq, in essence the regulator, rather than having to justify alternative order-routing or execution decisions.

Ultimately, a monopoly would evolve where all orders in over-the-counter securities flow through NASD-affiliated systems. Competition is, of course, the key to innovation. But the compulsory nature of Nasdaq's limit-order book would eventually destroy competition for order flow in Nasdaq securities. Competition results in investor choice. That is often critical for investors using various execution strategies. But if a competitor is allowed to conquer its members due to a regulatory advantage, investors suffer. Their flexibility to determine the best execution in Nasdaq stocks would be diminished, forcing them to accept the Nasdaq option.

In section 11(a) of the Securities Exchange Act of 1934, Congress directed the Securities and Exchange Commission to "assure fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets."