Market fragmentation? It could soon become worse. It is amazing but true that the system of trading stocks in the U.S. markets has served its purpose, rather brilliantly in fact, in all but one respect: The infrastructure for allocating equity capital is a fiasco. The problem may soon be compounded by the introduction of a rather strange creature known as the "residual market." That's what investors must endure so that the unlisted dealer market, known as Nasdaq, receives the imprimatur of the big guns at the Securities and Exchange Commission. Nasdaq is petitioning the SEC to formally become a stock exchange. The residual market, according to the SEC, is a "quotation and transaction reporting facility" that Nasdaq must establish for current issuers that do not join the new Nasdaq stock market. "Under Nasdaq's mandate [for exchange status] they can't abandon those issuers and this is what the SEC is somewhat concerned about," said STA President Lee Korins. In effect, the residual market could become the newest breed of OTC "unlisted" market, joining a plethora of venues that execute customer orders in U.S. territory.
If you need more examples of U.S. market structure gone haywire this issue of Traders Magazine will provide you with fascinating fodder. Some of the stories are inextricably linked by one common issue: The National Market System (NMS) enacted by Congress in 1975. Many of the interventionist market structure changes of the past quarter of a century are guided by the Congressional vision of a unified, electronically linked U.S. stock market. But here's the dreadful legacy of the NMS: A fight by one of the largest Nasdaq dealers to fend off competition from the regional exchanges (Cover Story by Gregory Bresiger); an ex-SEC lawyer speaking of the "strange alliances" ECNs face if they join current competitors in the oversight of the Intermarket Trading System and other NMS offspring (Q&A by Peter Chapman); a hard time for the little guys coping with huge compliance costs (Special Feature by Sanford Wexler.). A former director of economic policy at the SEC, Jeffry Davis, weighs in with a spirited attack on the NMS.
There is no perfect market model. However, since Wall Street is driven by can-do free enterprise impulses, the very antithesis of the planned socialist economy, a period of "creative destruction" (a process explored by the eminent economist, Joseph Schumpeter) could eliminate the most inefficient players. The SEC, ultimately, seems to envisage a mandatory central limit order book sucking in investors orders from all over the U.S. as the solution. That approach takes a calculated risk, a risk that could be passed along to the already overburdened taxpayer. Since a so-called hard CLOB would be mandatory and not a product of mutual cooperation by the capital raising pros, it amounts to skating on thin ice just as the sun is coming up. It leads to the inevitable problem of a "single point of failure." It would be outrageous to accuse the SEC of some nefarious plot to topple the trading markets. What is not in dispute is the sometimes bizarre liberal impulses that have guided the agency in deadly earnest for more than a quarter of a century. Harvey Pitt, recently nominated by President Bush to be the next SEC chairman, will have his hands full if he is confirmed by Congress.
John A. Byrne
Editor
