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March 23, 2005

Keeping Control at The NYSE and Nasdaq

By Gregory Bresiger

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The Worst Nightmare Reg NMS Scenarios

The Reg NMS debate is as much about what the two biggest players in the trading industry don't want as what they do want.

Nasdaq and the New York Stock Exchange possibly have the most to lose in this high stakes regulatory game, a game that may end sometime in the first half of the year. That's when the SEC Chairman William Donaldson and his colleagues could possibly decide the biggest part of the NMS issue, reform of the trade-through rule.

For the Big Board, its dominance in listed stocks and its attempt to re-invent itself through a proposed hybrid plan are at stake in the Reg NMS debate. That could result in a depth of book plan that some say would be the end of the Big Board.

For Nasdaq, the great potential nightmare is that the SEC commissioners - under pressure from Big Board supporters - might strengthen or extend the much-maligned trade-through rule into electronic markets.

Officials of these faster electronic markets believe their strength is in not having the rule. And they also argue that problems of market structure are the result of the Big Board not keeping up technologically; that the supposed problems of limit orders and a paucity of liquidity are not real. They also believe that, without the controversial rule, the NYSE would lose market share. And they would likely be the beneficiaries of that loss in market share.

"All we want is competition among markets that are electronically linked," according to David Colker, chief executive and president of the National Stock Exchange. The NSE filed its own comment letter supporting Nasdaq and asking that, if the trade-through rule is continued, that new rule exemptions of ITS securities be added besides the two ETF securities.

However, if the trade-through rule is extended, Nasdaq officials have contended in filings that it would amount to needless government intervention in markets. The regulators would become "the decision maker," not market forces, they complain

"We believe that applying the trade-through rule to Nasdaq-listed securities is not supported by facts and will be harmful to investors," wrote Nasdaq general counsel Edward Knight in Nasdaq's latest filing.

Nasdaq officials warn that extending the trade-through rule will not encourage the use of limit orders. The extension of the rule is based on faulty research studies done by the SEC, Nasdaq officials have charged. The evidence is an exhibit that accompanied their latest comment letter.

"The Trade Through Study," Knight wrote, referring to research by the SEC's Office of Economic Analysis (OEA), "fails to acknowledge advances in the Nasdaq listed trading environment during 2004 that have lowered the trade-through rate in Nasdaq stocks to 1.5 percent, significantly less than the 2.5 percent reported for 2003 in the commission's study."

Nasdaq officials also insist that differential fill rates for large marketable limit orders are not a problem. Instead, they indicate "the prevalence of reserve size in Nasdaq quotes." And Nasdaq officials contend that large marketable limit orders perform better in their exchange than in their main competitor, the Big Board.