The battle over Nasdaq's future – whether the regulators should finally give approval to its exchange application – is not over.
At least that's what one of its major competitors is telling lawmakers. NYSE officials recently sent a blistering letter to a member of Congress about Nasdaq's seemingly interminable exchange application, which is now some two years old.
There is no indication the application process will end anytime soon. "The commission is considering the matter," an SEC spokesman said. There is also no indication that the heated debate is close to finished.
"Nasdaq's proposed exchange rules violate the existing law," Big Board's counsel recently wrote. These rules would "overturn fundamental, long-standing safeguards that protect investors," he added.
Big Board officials also charge that Nasdaq's history of regulatory problems will mean that – giving it the legal privileges of an exchange – the individual investor will be hurt. They also suggest that there will be scandals as there were in the 1990s. Nasdaq sent its own letter to Congress charging that NYSE's contentions are without any basis. The NYSE is fearful of competition, Nasdaq officials assert.
The charge and counter charge has re-opened a bevy of issues. These divisive issues include Nasdaq's business model, whether for profit-exchanges violate the substance of the 1930s securities laws and if approving the application will allow other markets to make the same metamorphosis by simply citing the Nasdaq approval.
"Nasdaq," said veteran Bear Stearns trading executive Aldo Parcesepe, a critic of the application, "should be a utility and nothing else. I don't understand how it can be a central collection point and then step forward now and be a competitor. It doesn't make sense," he added.
Parcesepe's complaints echo those of some other traders who believe that Nasdaq, as a former regulator and onetime child of the National Association of Securities Dealers, will have unique advantages as a for-profit exchange. The issue continues to divide the trading profession.
"I have no problems with Nasdaq reorganizing itself as an exchange if they feel that it will allow them to provide a more competitive platform," said Mark Madoff, a trading director for market maker Bernard L. Madoff Investment Securities.
Madoff argues that Nasdaq, as a for-profit exchange, will bring more competition to the marketplace. "And even the suggestion of more competition between markets is a good thing," he added.
Fragmentation
The Big Board letter to Congressman Doug Ose (R-Calif), a rehash of previous letters to the SEC, nevertheless raises some other contentious matters on the minds of traders. NYSE Big Board Counsel Richard Bernard wrote that Nasdaq's exchange application, as presently constituted, will further fragment the market and will hurt the individual investor. He argues that Nasdaq's market structure was conducive to conflicts of interest and the dot.com bubble of the 1990s.
"As the stock prices rose and then collapsed in the after-market, Nasdaq dealers went along for the ride, stepping between public orders to pocket the spreads. Derelict directors, ethically-challenged executives and accountants without accountability then destroyed real companies with financial gimmickry, shedding what was left of investor trust and confidence," according to Bernard.
Nasdaq's structure remains a problem, he added. Nasdaq's dealers, Bernard contended, are under no obligation to yield to public orders on Nasdaq's limit order book.
"As one astute observer reportedly quipped, Nasdaq is not an exchange – it's a shopping mall. As a result, by interposing itself between a willing buyer and a willing seller and trading with each in turn, a Nasdaq dealer pockets the bid-asked spread," according to Bernard. He estimates that this process costs investors "$2.0 billion each year." Bernard and his Big Board colleagues state the exchange application, as presently constituted, violates "the provisions of the Securities Exchange Act of 1934."
But Nasdaq officials privately say they see the NYSE's intervention – at this late date – as a sign that they simply fear competition. That's because their structure and execution quality is better than the NYSE, which is losing ground to competitors, they added. Nasdaq's chief counsel, Edward Knight, in his own letter to Representative Ose, wrote that public orders on the Nasdaq are resolved in favor of the investor.
"In fact, Nasdaq market makers are prohibited from trading ahead of their customer limit orders, regardless of whether the limit order is placed in Nasdaq's book or routed to another market maker or electronic communications network," according to Nasdaq's Knight.
"This longstanding Nasdaq rule is called the Manning Rule and is a customer protection requirement developed by Nasdaq and the SEC to address specifically a geographically disparate electronic market."
Ose, a member of the House Financial Services Committee, sent a letter to the Securities and Exchange Commission asking that it move faster. "I remain concerned that the Nasdaq application has been pending at the SEC for well over two years and I urge you to move forward to resolve any remaining issues so that the application can finally be approved."
But SEC Commissioner Roel Campos, speaking at a recent Security Traders Association conference, said he doesn't expect the commission to act on the application in the short term. Obviously, this is because the SEC already has a full agenda of other pressing issues, which includes the divisive topic of ECN access fees.
"I expect that the access fees subject will be handled separately," Madoff predicted. The SEC is also not expected to finish with the Nasdaq exchange application in the short term because there are still several outstanding issues about the exchange application. These are questions about whether more conditions will be added to the application.
Explanation
One of Ose's colleagues, Congressman Richard Baker (R-Louisiana), the chairman of the House Subcommittee on Capital Markets, told Traders Magazine that he is going "to ask the SEC why the application is taking so long. I'd like to have a good explanation for this."
Nevertheless, Ose, in urging that the regulators speed up the process, mentioned several questions that he wants answered about the application. "Won't the SEC's authority over Nasdaq," Ose asked, "be more direct once it becomes an exchange? Doesn't this broad authority empower the SEC to modify the Nasdaq's market structure if necessary?" Ose also wants to know if Nasdaq shouldn't be allowed "to develop a business model that is different from and, in fact, in competition with the NYSE model?" And, he asked, "Is strict price-time priority essential in a decentralized, electronic environment?"
The latter is a sensitive point that was raised in the war of letters to Ose. "The NYSE's position," Nasdaq's Knight wrote, "is that the only type of market that can be an exchange is one that replicates its own auction market structure." That position, Knight added, "is self-serving."
Maybe. But the SEC, which will not comment on the pending application, may have the most difficult task of all the parties to the application controversy: It not only has to decide whether the application is finally approved or not. If it decides to approve the exchange application, it might face a more daunting task: How many conditions might be added contingent to approval?
Some Nasdaq critics, in a paraphrase of backwoods wisdom, might say that "there is more than one way to skin a cat." They are hoping that the SEC would add so many conditions that Nasdaq would give up and just continue operating as it is now. These same critics are also hoping, to quote one, "that additional conditions would be the end of Nasdaq."
Nasdaq officials, in prodding the SEC to act, noted in the Ose letter that they virtually have exchange status already. "As a threshold matter, there is no doubt that Nasdaq is, for all practical purposes, an exchange today. Registration is simply legal recognition of current reality," Knight wrote.
Possibly, but some trading industry executives are sick of the issue, especially the bitter debates between the Big Board and Nasdaq. "Maybe it would be better if both of them [NYSE and Nasdaq] just shut up and concentrated on doing the best job possible," said Bear Stearns' Parcesepe.