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."
Congress did not address the principle of fair competition between broker dealers and markets because true competition is impossible when that market operates under the umbrella of the competitor's SRO.
The NASD's concept of a "voluntary," or non-mandatory Nasdaq-run limit-order file is an illusion. Nasdaq's status as a subsidiary of the NASD gives it a self-regulatory character that would confer an unfair and unacceptable competitive advantage.
Other Competition
While the proposed Nasdaq limit-order book is a particularly egregious example, self-regulators competing with members is not a new phenomenon. The espousal of anti-internalization rules by stock exchanges is an example.
Although their advocacy was couched in terms of concerns about best execution of customer orders and fragmentation of markets, the exchanges are obviously aware of the volume that might be lost to their larger members.
Thus, such concerns may disguise an effort to create new artificial restraints against retail firms competing as market makers. Similarly, the off-board trading rules of exchanges prevent member firms' execution of principal transactions in listed securities (or those admitted to unlisted trading privileges) other than on an exchange.
Once again, such restrictions limit competition between exchanges and their members, as well as the NASD, thereby augmenting an exchange's transaction volume.
Likewise, the aggressive proliferation by exchanges of new trading products increases the competitive tension. Like their members, exchanges are attempting to diversify their product base as well as to protect their product market share. To do so, they must grow and generate new sources of revenue.
The advent of electronic systems that channel orders directly to automated order-routing and execution systems also gives exchanges opportunities for competitive challenges against their members. These SROs enjoy structural advantages over their membership because of their trading and clearing and settlement structure, as well as their collaborative relationship with the SEC.
The conflicts engendered by a quasi-governmental body competing with its regulated stable should be of great concern to congressional overseers.
Quote Monopoly
In a separate development, the New York Stock Exchange and the Consolidated Tape Association are asserting their rights to exploit their quote monopoly by doubling the real-time quotation fee charged to broker dealers' online business.
A challenge to this information tax by Charles Schwab & Co. brought the response that the monopoly does not have to justify the cost of the fee hike. Moreover, the stock exchanges are pressing Congress and the states to lock-in market-data charges on investors. Recently, the exchanges sought special status protections in H.R. 2652 The Collection of Information Antipiracy Act to extend antipiracy protection to quotes (in contrast to other government data bases that remain uncopyrightable and open to fair use by consumers).
Finally, the NASD's role as a competitor for market share is illustrated by its proposed amendments to NASD Rules 6530 and 6540, that would prohibit quotations on the OTC Bulletin Board of issuers that are not reporting companies (that is, companies that do not file current financial reports with the SEC pursuant to the Securities Exchange Act).
These proposals would be a dangerous step backwards to a time when markets for micro-cap securities were less transparent, more illiquid and less efficient.
Rather than combat the perpetrators of micro-cap fraud or improve the quality of the OTC Bulletin Board, the NASD appears intent on relegating smaller issuers to less transparent markets. Though its perceived responsibility in these markets may be less, the dangers to issuers and investors are far greater.
The NASD would be streamlining its operations to focus on its more profitable lines of business, commendable for a profit-seeking enterprise (which may be what it intends to become).
However, given its regulatory mission at least the mission embodied in the Securities Exchange Act this is a cynical sidestepping of a pesky problem that would relegate thousands of companies that trade on the OTC Bulletin Board to the less-automated pink sheets if they don't file financial reports with the SEC, or banking or insurance regulators.
Sam Scott Miller is a partner specializing in market regulation at the New York-based law firm of Orrick, Herrington & Sutcliffe.
