Is Nasdaq Tilting At Windmills? Embattled Organization Tries to Make History

Nasdaq, once a giant of the trading industry and the dominant player in OTC trading, has stumbled over the last few years.

"They certainly have had their troubles," said Steve Swanson, president of Automated Trading Desk, an electronic brokerage based in Charlotte, North Carolina. Nevertheless, Swanson says he is confident that Nasdaq's new leadership will "figure it out."

Nasdaq is now taking a big gamble that it can convince the regulators to take unprecedented steps. This is a gamble that could result in the biggest stumble of all for this embattled organization.

The litany of stumbles over the past three years is considerable: Unexpected red ink. The biggest part of that was the alarming drop in the revenues of Nasdaq's Transaction Services, which generates critical trade reporting, access services and execution fees business. This group's revenues over a year and a half dropped by about 40 percent to just $60 million in the second quarter. In the third quarter, the problems continued when Transaction Services revenues decreased to $54 million. Nasdaq's foreign ventures have been an embarrassment, with its German, Japanese and European operations all recently shuttered.

Some ECNs have declined to use the so far disappointing SuperMontage trading platform, which Nasdaq officials had once predicted would lead the organization to capture a whopping 70 percent of the OTC market. That has not happened.

But Nasdaq's much heralded trading platform also has stumbled. That's because the platform was launched without a dedicated sales force that could show market participants its usefulness.

The SEC's snail like review of Nasdaq's exchange status application has hurt. The application, filed in November 2000, was designed in part to generate new sources of income and free it from the oversight of the National Association of Securities Dealers.

This delay has been very costly for Nasdaq. It has also led to the forced departure of several Nasdaq leaders. Some execs likely fled voluntarily, dreading Nasdaq's future. Some were involved in efforts to win approval of the application and the failure led the board to install new management.

More Capital

The inability to win exchange status also hampers the efforts of Nasdaq to compete because it is cut off from needed capital. "It hinders Nasdaq's ability to quickly respond to ECN competitors," according to a report by financial consultanting firm Celent Associates, "Nasdaq: Here for the Long Haul?" Nasdaq responses are sluggish because, in the organization's current holding pattern, every critical decision requires the approval of two boards of directors -Nasdaq's and the NASD's. The latter continues to be its nominal parent and retains a 55 percent stake in Nasdaq.

These woes have all added up to an even bigger problem for the struggling Nasdaq: The loss of a considerable amount of market share. For example, back just before the launch of SuperMontage, Nasdaq had some 25 percent of the market, according to Celent Associates. But, by the beginning of this year, the share number had declined to 19 percent. By late summer, the number was down to 16.6 percent.

Predictions of Nasdaq's collapse have been frequent. New leadership was brought in, with Robert Greifeld taking over as Nasdaq's President and CEO.

Nevertheless, despite the almost relentless bad news, Nasdaq's new leadership has said it has committed to a three-step strategy it hopes will turn the tide.

1. It expects to increase its IPO share.

2. It will obtain more listed and non-listed trading volume and it also expects to take order flow from other exchanges.

3. It also puts new emphasis on the tape revenue business.

"I believe that it is doing the right things. And if I happen to be wrong, then that would be a major setback for the market as well as our economy," said Nick Ponzio, President and CEO of Hill Thompson Magid, a market making firm. Ponzio voices the concerns of many market makers. He also looks to Nasdaq to lead the charge for market structure reforms, reforms he says that are needed "so market makers are on equal footing with electronic firms."

Growth Forecast

Celent, despite detailing these woes, says the new leadership is pursing the right strategies and that its share will jump to about 35 percent by the middle of 2005. It calls its tape revenue sharing plans and its emphasis on linkages "positive steps."

Indeed, Nasdaq recently convinced INET – the combined new operation of Instinet and Island – to begin posting its quotes on SuperMontage. The move hurts the National Stock Exchange (NSX) – formerly known as the Cincinnati Stock Exchange – and the NASD's ADF, the two entities previously handling this lucrative business between them.

However, it is not clear that INET's move was a net plus for Nasdaq. That's because the Island/Instinet combo will still continue to use the NSX for the printing of trades, even though it is committed to posting quotes on SuperMontage. NSX officials have also cautioned that the INET move may not be final. David Colker, CEO of the NSX, says the exchange will attempt to have INET reverse its decision.

Still, the INET move could signal an eventual merger between INET and Nasdaq, according to some analysts, who note that Nasdaq will also market Instinet's SmartRouter technology to its customers

The most controversial part of Nasdaq's comeback may be its strategy on the exchange application, an application that is critically important to the organization. That's regardless of whether it becomes a full-fledged exchange or possibly turns to another exchange, or a merger to solve its persistent problems.

Big Gamble

Nasdaq officials are asking regulators for exchange approval. This is likely a big, complicated gamble. It hinges on the difference between a national securities exchange (NSE) and a national securities association (NSA). NSEs were created by Congress in the Great Depression and filled the role of self-regulation. An example of an NSE is the NYSE and the National Stock Exchange.

In the late 1930s, federal legislation created the national securities association, which was an attempt to extend self-regulation to the over-the counter market. Nasdaq's parent, the NASD, is to date the only exisiting NSA. In theory at least, there's nothing that would stop the regulators from sanctioning more NSAs. And this, according to the Celent report, is a critical point for Nasdaq as it struggles to come up with a new model. Nasdaq has insisted all along that it wants to become an NSE.

"NSAs are permitted to operate trade reporting facilities, while NSEs are not," according to Celent. Trade reporting facilities are the critical factor in controversial issues such as internalization and price time priority. Nasdaq rules don't prohibit internalization. Therefore, no price time priority exists in its market, although price priority exists in the form of best execution. But internalization goes against the principles of what the SEC has insisted an NSE is supposed to be. "It is a dilemma. It is certainly a Catch 22 situation," said ATD's Swanson.

Nasdsaq market makers are allowed to execute orders on their own desks as long as they report all executions within 90 seconds. Because Nasdaq orders are not interacting within a closed limit order book, marketable orders, sent to a market maker, may be executed before and after marketable orders sent at the same time to another market maker. Therefore internalization and price time priority are mutually exclusive.

Fees Generated

Nasdaq permits internalization because it operates ACT, which allows members to internalize trades and publicly disseminate trades via the Securities Industry Processor (SIP). ACT is important for Nasdaq because of the reporting fees generated. ACT can be used to create proprietary data fees, such as liquidity trackers, which can create a "compelling business advantage."

Nasdaq asked to be an NSE instead of an NSA. "This is problematic for the SEC because Nasdaq would like to continue operating ACT, even though this is not permitted under NSE license. Because Nasdaq is attempting to change the role of national securities exchange, the SEC has delayed a decision. The revenue generated by the SIP sale of market data to market participants and vendors is also controversial.

ADT's Swanson says he's confident that Nasdaq will "figure it all out" in the end. Although he concedes it is a tremendous problem. He also concedes that it is possible that the NSE problem may mean the application is never approved. In that case, he says it is possible that Nasdaq might merge or buy an exchange such as the NSX. "It wouldn't solve all the problems, but they would be able to survive," he said.