Equities trading is about to change, and change dramatically. Ever since Congress passed the Securities Reform Act in 1975, the Securities and Exchange Commission has been attempting to facilitate the establishment of a national market system for trading securities, using modern technology, to accomplish the congressional mandate.
Initially, the commission got it right. The SEC recognized that the best way to obtain the most favorable prices for investors was by leading the industry towards the development of a new system in which all bids and offers for each security could be entered and queued in price-time priority. First-come, first-served, the traditional American measure of fairness would be invoked.
The name of the feature that would make this possible was variously known as a central limit-order book, or CLOB, composite limit-order file, central limit-order file and electronic book.
The ultimate goal was to get investors' orders into this book or file. There was little consideration of integrating market makers' and other intermediaries' bids and offers as well.
However, in an effort spurred by the economic self-interest of the dealers and coordinated by the New York Stock Exchange deathly afraid of a dreaded "black box" approach to trading the market centers talked the commission out of proposing a CLOB. The CLOB was replaced with the disconnected triumvirate of the Intermarket Trading System, the Composite Quotation System and the Consolidated Tape System. When the SEC approved these three systems, it unwittingly ensured that a national market system, as envisaged by Congress, would be almost indefinitely delayed.
But now, nearly a quarter of a century later, following pressure from large institutional investors and others, recognition has finally dawned on at least one market-center operator that the day of the CLOB has finally arrived. Fragmentation of order flow has reached an intolerable level, and it is time to put Humpty Dumpty back together again!
Nasdaq's proposed trading system, containing a limit-order file permitting both investor orders and dealer quotes to be integrated, has caused consternation among many members of the National Association of Securities Dealers.
"Why," they ask, "should the NASD, our regulator, build a system, partly with our money, which will compete directly against the systems we have built or are building with the blessing and encouragement of the SEC?"
That's a tough question with no easy, satisfactory answer for the dealers. So who's to blame? My candidate is the SEC itself. From the day it wimped out and decided to scrap the CLOB, until now, it has focused on encouraging competition about where to trade, rather than at what price the trades should take place. That makes about as much sense as encouraging competing air-traffic controllers at a single airport.
In addition, having a self-regulator it makes little difference if it is the NASD or the NYSE also operate a for-profit trading system creates irreconcilable conflicts of interest. That became evident in the Department of Justice's and the SEC's investigations of the NASD and Nasdaq, and the civil litigation that cost the industry hundreds of millions of dollars.
What should be done? First, Nasdaq should be privatized, and its ownership transferred to the NASD membership that use the system. The NASD should stick to what Congress meant when the Maloney Act created it: self-regulation.
If a privatized Nasdaq can capture the market, let it do so. If other market centers prove superior, let the market not the government decide on winners.
Nasdaq has two important existing advantages, however. First, it is the largest over-the-counter trading system extant today. Second, and perhaps even more importantly, it embraced the concept of a limit-order book, and linked with the most powerful and innovative facility in the last 25 years, OptiMark, a system though unproven, appears to meet the needs of most institutional investors for low-cost and efficient order handling, minimal market impact and anonymity.
In the meantime, there will be a major battle among the dealers who wish a CLOB would disappear and the executives who make policy for Nasdaq. The SEC will be an interested observer, and will have to balance the needs of investors against the interests of intermediaries. It will be a fascinating fight to watch. The winners, hopefully, will be American and international investors.
Junius W. Peake, a former NASD governor, is Monfort distinguished professor of finance at the University of Northern Colorado.
