- The Washington Times - Tuesday, August 27, 2002

With all of the recent attention focused on corporate and accounting fraud, few investors are aware that the Securities and Exchange Commission (SEC) now has before it a decision that could radically change the structure of today's securities markets. Nasdaq was originally established as a neutral and nonprofit facility through which market makers in securities could make their bid and ask prices available to brokers, dealers and, ultimately, the investing public. It has applied to the SEC to become a privatized securities exchange and a profit-making entity on which trades in Nasdaq-listed securities would be executed. If the Nasdaq application is approved, Nasdaq would go into competition with a number of electronic communications networks, known as ECNs, which specialize in the same order-matching that Nasdaq now proposes to do through a software structure it calls "SuperMontage."
Over the last decade, the innovative order-matching services of ECNs which use computer-based algorithms to match the orders of buyers and sellers of securities automatically have attracted increasing amounts of trading in Nasdaq securities. This has significantly reduced investor costs and bid ask spreads. Now, Nasdaq, recognizing the inherent technological advantage and lower transaction costs pioneered by the ECNs, would like to adopt this business model itself. There is nothing objectionable in this; clearly, more competition is good for investors. But there is one problem: Under SuperMontage, the ECNs which are technically broker-dealers would have to supply their best bid and ask quotes in Nasdaq-listed securities to Nasdaq. Ironically, this would add to the liquidity and competitive advantages that Nasdaq will already enjoy because of its historical role as the central place in which market makers have displayed their quotes. In addition, if Nasdaq's application to become an exchange is approved, Nasdaq will be the regulator of the market for Nasdaq-listed securities at the same time that it is competing with the ECNs in that same market.
To its credit, the SEC has not been entirely blind to the anti-competitive consequences that could ensue from its approval of Nasdaq's applications. In its initial approval of the SuperMontage concept, the SEC required that the NASD Nasdaq's parent until complete privatization occurs establish an Alternative Display Facility (ADF) on which ECNs would be able to meet their regulatory obligation to display their quotes without having to supply those quotes to Nasdaq. This is not an entirely satisfactory solution; it will still leave Nasdaq as the place where all market makers must display their quotes in Nasdaq-listed securities with an advantage by dint of regulation over its ECN competitors. But at the moment, it appears that the SEC has settled on the ADF as the most practical way to maintain some competition for Nasdaq once SuperMontage is implemented.
And that is indeed the issue whether the ECNs will be able to compete with a profit-seeking Nasdaq or will be gradually squeezed out of the market by the advantages Nasdaq will have obtained from the SEC itself. If Nasdaq succeeds in this, technological and other innovation in securities trading will cease and spreads will widen. Investors will be the losers.
In late July, as required by the SEC, the NASD set up an ADF, and declared it open for business as a nine-month "pilot program." It is much too early to tell whether the ADF will attract enough liquidity to be viable, whether the essential communications links necessary to its functioning will be established by broker-dealers interested in trading with ECNs other than Nasdaq, and whether its net costs will be competitive with the costs of using Nasdaq's SuperMontage.
Clearly, the development of a viable ADF infrastructure will take some time probably the full nine months that the NASD has projected for its pilot program. Meanwhile, the decision now facing the SEC is whether to permit the implementation of SuperMontage before the ADF has proven itself as a way for the ECNs to continue to compete with Nasdaq. If the SEC acts precipitously if it approves the implementation of SuperMontage before seeing any results from the ADF experiment it risks creating a permanent monopolistic market for Nasdaq-listed securities. The ECNs will inevitably be confined to narrow niches, or driven from the market altogether. Investors will have fewer choices for reducing transaction costs. This is an outcome that few SEC commissioners will be proud to cite as a legacy.

Peter J. Wallison is a resident fellow at the American Enterprise Institute.

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