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February 1, 2012

SEC Quashes Nasdaq Proposal

By Peter Chapman

Nasdaq OMX, on the verge of creating a stock exchange for small companies, was dealt a setback by the Securities and Exchange Commission over a plan to ask issuers to pay market makers for quoting.

The SEC rejected a proposal by Nasdaq to establish a "Market Quality Program" that would permit issuers of exchange-traded funds to pay market makers to quote these funds on Nasdaq's flagship exchange.

The proposal was intended to be followed by a similar proposal from Nasdaq's new BX Venture Market for small capitalization stocks. The exchange operator plans to launch BX Venture this year.

Behind both proposals is an attempt by Nasdaq to solve a longstanding problem of illiquidity in small cap stocks. Because dealer profits are lower on these low volume names, firms have little incentive to support them.

Under Nasdaq's MQP proposal, market makers would be required to quote in 500-share lots at prices no further than one percent from the market's best bid or offer. For this dealers would split proceeds of between $50,000 to $100,000 per quarter.

This so-called paid-for-market-making scheme is used in some parts of Europe, including on Nasdaq's First North exchange. In the U.S. however, it is illegal.

In 1997, the Financial Industry Regulatory Authority (then the NASD) created a rule banning payments by issuers for quotes. Nasdaq has a similar rule on its books, which would be voided for market makers participating in the MQP inititiative.

Before 1997, the practice was generally recognized as taboo. Still, a firm called General Bond & Share Co. began charging issuers for quotes which led to a trial which pushed NASD to write the rule. The concern has been that the monetary incentives from issuers could cause dealers to manipulate prices in an attempt to drum up trading interest.

Still, such a proposal is not out of line in the current environment in Washington where industry executives, politicians, academics, and others are bemoaning the drop in publicly listed companies. Between 1997 and 2009, the number of publicly-listed U.S. companies fell from about 8,200 firms to 4,400.

"The SEC should allow companies to pay for market quality by allowing exchanges to establish programs to reward broker dealers for committing capital," Nasdaq OMX executive Ed Knight testified in front of the Senate Banking Committee in December. "This has worked in our Nordic markets."

The rejected proposal only covered ETFs on Nasdaq's flagship exchange. Nasdaq would not comment as to whether or not it still planned to file a MQP proposal for its BX Venture Market.


Editors note: Nasdaq's BX Venture Market is intended to support capital formation for early stage and smaller companies, according to the exchange operator. It is also intended as an exit opportunity for the long-term investments made by venture capitalists.


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