Hearing on the "Financial Marketplace of the Future"

Prepared Testimony of Mr. Frank Zarb
Chairman and CEO
National Association of Securities Dealers

9:30 a.m., Tuesday, February 29, 2000
13th Floor Conference Room - Securities and Exchange Commission Offices
7 World Trade Center, New York, NY

I. Introduction

I am Frank Zarb, Chief Executive Officer of the National Association of Securities Dealers, Incorporated. I thank the Committee for this opportunity to testify on the future of the securities markets.

We commend the Chairman for his work that produced the historic-Gramm- Leach-Bliley Financial Services Modernization Act of 1999 to revise the regulation of the financial services industry. Given your achievements there and your stated goal to accomplish a similar modernization for the regulatory structure governing the securities industry, we can be sure that the Committee will be involved deeply in the changes that are now facing this industry.

Your invitation letter for the hearing today asked me to share my vision of the future of the securities markets and the regulatory environment in which they will operate. More specifically, you asked me to address whether technological and marketplace changes will continue the preeminence of U.S. markets into the future; and what regulatory and market structures would enhance the value of our markets and which would harm efficiency, add bureaucracy or other costs, and thus reduce the value and competitiveness of our markets.

By way of summary, the NASD's vision for the future of the stock markets is tightly coupled with needed changes in market structure, market ownership, and globalization without changing the fundamental flexibility of the securities laws that has been so critical to the growth of the U.S. financial markets. The NASD has initiatives under way in each of these areas to ensure that the markets of the future continue to compete and innovate for the benefit of the investors who channel their capital to the companies who need it to grow and create jobs. All that we ask of the Committee is to be permitted to compete fairly - under the watchful eye of the Securities and Exchange Commission (SEC) - to complete those initiatives and build the markets of the future.

I would like to note that the SEC last week issued a concept release on issues relating to market fragmentation. We welcome the release and are reviewing it closely. We believe that the issues that we discuss in today's testimony are those that are most important to our Nasdaq Stock Market. In addition to the general themes that I address in my testimony today, I have attached a more specific summary of our upcoming NASD regulatory and market structure legislative issues.


Let me briefly outline the role of the NASD in the regulation and operation of our securities markets. The NASD covers the entire range of the securities markets in the U.S., from the largest broker dealers to the smallest, and from companies with the largest market capitalization in the U.S. to the newest startups.

Established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization (SRO) for the securities industry in the world. Virtually every broker-dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD's membership comprises 5,600 securities firms that operate in excess of 80,000 branch offices and employ more than 620,000 registered securities professionals. Our member brokerage firms range from the nation's largest firms, represented by the companies at this table with me today, to single person firms in small towns.

The NASD is the parent company of The Nasdaq Stock Market, Inc., the American Stock Exchange, and NASD Regulation, Inc. (NASDR). These wholly owned subsidiaries operate under the authority of the parent, which retains overall responsibility for ensuring that the organization's statutory and self-regulatory functions and obligations are fulfilled.

NASD Regulation is responsible for the registration, education, testing, and examination of member firms and their employees. In addition, it oversees and regulates our members' market-making activities and trading practices in securities, including those that are listed on The Nasdaq Stock Market and those that are not listed on any exchange.

The American Stock Exchange is the nation's second largest floor-based securities exchange, and is the only U.S. securities exchange that is both a primary market for listed equity securities as well as a market for equity options, index options, and equity derivatives.

The Nasdaq Stock Market is the largest electronic, screen-based securities market in the world. Founded in 1971 as the world's first all electronic stock exchange, it is the original on-line market, and the pioneer in e-commerce. Nasdaq today accounts for more than one-half of all equity shares traded in the nation and, since January of last year, is also the largest stock market in the world in terms of dollar value of shares traded. On February 17 it passed the two billion shares per day mark. Nasdaq lists the securities of 4,748 domestic and foreign companies, more than all other U.S. stock markets combined.

Just as NASD member firms range from the largest to the smallest broker dealers, the issuers that list on Nasdaq also span the breadth of industry in the U.S. Those companies range from companies like Microsoft, Intel, Cisco, and Starbucks to the smallest, newest startups. There are over 70 million investors in Nasdaq companies.

III. Markets and Economic Growth

Vibrant equity markets are important contributors to today's robust economy. Efficient and liquid equity markets help channel risk capital from investors to new and innovative companies who desperately need it. Equity shares allow investors to take part in the profit of firms while at the same time allowing firms to undertake the projects that lead to their growth. In addition to channeling capital to companies, equity markets produce a price for the equity of a company as a by-product of their trading operation, and that price is central to a market economy's allocation of capital.

Nasdaq is a clear example of the contribution that equity markets make to the economy. For example, 83% of all Initial Public Offerings (IPOs) -- and 98% of all venture capital deals -- come to market on Nasdaq. The capital thus created in turn creates a massively disproportionate number of jobs. A 1995 study by Cognetics of Cambridge, Massachusetts found that while Nasdaq companies made up less than 1% of all public and private companies in the United States over the previous four years, they had created more than 16% -- one in six -- of all new U.S. jobs created during that period. Over that same time, Fortune 500 companies were losing 200,000 jobs per year.

Although Nasdaq companies represent all sectors of the economy, the technology and biotech companies that are at the forefront of U.S. economic growth are overwhelmingly listed on Nasdaq, as shown in the following table.

Nasdaq's Hi-Tech Market Share

Total Companies in U.S. Equity Market Nasdaq Companies Nasdaq Market Share
Software 608 560 92.1%
Computer Manufacturers 250 211 84.4%
Communications Equipment 191 156 81.7%
Electronic Components 204 157 77.0%
Electrical Equipment 202 155 76.7%
Biotechnology 410 341 83.2%
As of 5/98
Source: The Nasdaq Stock Market and FactSet Research Systems, Inc.

Nasdaq has become the largest stock market in the world as measured by dollar or share volume by competing to give investors and other market participants what they want: a high speed electronic market, based on open access, that encourages competition, that does not force participants to operate in only one way, and that has integrated market makers and Electronic Communications Networks (ECNs) so that participants can see -- and get to the best price -- wherever it is.

IV. Nasdaq's Vision

Your invitation letter asked for our vision of the future, and I will respond by making the following predictions:

If collectively we all make the correct decisions, all of this will be available in an orderly, fair, well-regulated, and lower-cost environment, with improved high-tech electronic surveillance of trading to protect the integrity of the markets.

As for stock markets, they will see global alliances, mergers, and new electronic ventures. That will give companies listed on these markets access to pools of capital internationally, not just domestically, and consumers will be able to invest in a worldwide list of companies as easily as trading locally.

This 21st century stock market will be multi-dealer, computer-screen based, technology-driven and open to all - all because people will have access to information that they want to act on. We intend to be at the forefront of this open access movement.

This new market will bring benefits to investors, listed companies, and the economies of countries. Trading will cost less for consumers. Markets will have more liquidity. Raising capital for companies will be easier and more efficient. Entrepreneurial businesses in both established and developing economies will be encouraged. New investors and markets will grow in places like China. Investors from Europe to Japan to the Americas will invest across borders with ease.

I have described what I think that the markets of the not too distant future will look like, but how do we get there, and what should be the central concerns of those of us in this room today?

V. Getting to the Future

I believe that the central issues for our attention should be perfecting market structure to respond to the needs of investors and market participants, rationalizing market ownership and regulation, and consciously and expeditiously moving toward global markets. Nasdaq is moving ahead in all three areas with concrete proposals to implement our vision.

A. Market Structure

The critical issue in securities market structure is how we balance the important need for centralization in the market with the equally important principles of competition and choice that continue to make our markets the envy of the world.

We at Nasdaq have addressed this issue of balance and formulated a proposal to implement it this year. That proposal is officially known as the Nasdaq Order Display Window, but is popularly named "Super Montage" because of the significant improvement that it makes over the current Nasdaq system quote montage or screen.

Because this proposal is ground breaking, not all understand it. Before I describe it in detail, I also need to describe what it is not. Super Montage is not a Consolidated Limit Order Book (CLOB) that forces all quotes into one central system. Similarly, it does not by regulatory fiat impose strict time priority across the Nasdaq market. We have investigated such systems and rules and believe that they will undermine the strengths that investors and other market participants seek in Nasdaq. Those strengths are based on an open system built on choice and competition and the provision by market makers of continuous liquidity. Because the Nasdaq system provides incentives for market makers to continuously display quotations and provide immediate guaranteed executions in size to investors, it has been able to respond to the revolutionary demands of the online trading world. On the other hand, mandatory CLOBs and system wide time priority requirements do not effectively incorporate or incent the multiple market makers who now provide liquidity and immediate executions on Nasdaq, and who thus cushion the market when it is under stress. Such monolithic solutions will also effectively end the competition and innovation in market structure that have given us the markets we have today, and prevent realization of the vastly better markets we would otherwise see for the future.

We believe the Super Montage is an important step to achieving greater centrality and less fragmentation in the marketplace while allowing competition to flourish. In essence, the proposal will build on Nasdaq's strengths as a collector and aggregator of trading interests -- the traditional role of a market. In addition, the Super Montage will be an inclusive model in that it will not favor or disfavor a particular business type - ECN, fully integrated market making firm, or wholesale market making firm. It will encourage innovation and competition while improving transparency and liquidity. Investors around the world will be able to view and electronically access virtually the full depth of the market and have their orders interact with one another almost instantaneously. Importantly, the Super Montage in no way forecloses any other initiative that Congress, the SEC, Nasdaq, or others may pursue to reduce fragmentation.

Specifically, the Super Montage will show the best bid and best offer in Nasdaq and two price levels away from the best bid and offer. Each price level will be accompanied by the aggregate size of the "displayed" trading interest of market makers, ECNs, and exchanges granted Unlisted Trading Privileges to Nasdaq securities ("UTP Exchanges"). Nasdaq market participants will be able to obtain the anonymity they frequently seek from ECNs by designating an order as "attributable" or "non-attributable," and also will be able to indicate a reserve size for an order. Attributable orders will be displayed next to the Nasdaq market participant's acronym in the current Nasdaq quotation montage, and will also be displayed in the Super Montage as part of the aggregate trading interest at the inside bid and offer and two levels away. Non-attributable orders will be displayed only in the Super Montage as part of the aggregate trading interest at the inside bid and offer and two levels away. Execution through the system is voluntary; participants are under no obligation to execute their trade through Super Montage.

In addition, Nasdaq market makers and ECNs will be permitted for the first time to give multiple orders and orders at multiple price levels. The system will manage and display those orders in Nasdaq when they are eligible for display next to the market participant's acronym and in the Super Montage. Nasdaq market participants will be able to access orders in the Super Montage almost instantaneously using a substantially enhanced Nasdaq order delivery and execution system, which will be built on an architecture that accommodates technology needs of all Nasdaq market participants -- market makers and ECNs alike.

The Super Montage will provide numerous benefits to the individual investor and will improve market quality, while also encouraging innovation and competition:

Minimizes Fragmentation. The system reduces fragmentation because it allows market participants to transmit to Nasdaq multiple levels of orders and aggregate and dynamically display all orders at the inside and two price levels away. The non-attributable order function encourages market participants to show greater size in Nasdaq. Moreover, market participants will see for the first time in the Super Montage the full depth of the inside market and two price levels away, improving transparency and liquidity.

Enhances Best Execution. The ability to transmit and display multiple orders will reduce the possibility that an order will be traded through in a fast moving market and enhances best execution, which directly benefits and protects the individual investor. Similarly, this capability will make it easier for Nasdaq market participants to manage their trading book, and will assist firms in complying with the SEC's Limit Order Display and Firm Quote Rules.

The Super Montage takes into account the specific character of the Nasdaq market structure as well as the value that Nasdaq market makers provide. The system generally provides for the execution of orders against quotes in price/time priority. Nevertheless, exceptions to strict time-priority should be allowed where market makers provide value away from the "market center." This recognizes that market makers provide liquidity to the market by guaranteeing executions to their customers at the inside market price or better, often with size up to 2,500 shares no matter what the size displayed in the quotation. The willingness of market makers to provide investors with instant access to guaranteed executions is critical to the ability of Nasdaq to respond to the extraordinary demands of on-line trading. Moreover, by giving market makers priority to interact with their own orders, the system will encourage market makers to give Nasdaq their full book, thereby reducing fragmentation and increasing transparency. The proposal also recognizes that ECNs have had concerns with participating in Nasdaq's automatic execution system, and provides flexibility for ECNs to choose the manner in which they wish to link into Nasdaq, either by order delivery or automatic execution.

Inclusive Model with Effective Linkage. The Super Montage's order routing capability of the system will enable the system to link all markets, including UTP exchanges, that trade Nasdaq securities. The Super Montage also encourages competition by providing an open and inclusive model in which competing market centers may operate. That is, while the Super Montage proposal provides a central means for accessing liquidity in Nasdaq securities, it in no way establishes the Nasdaq system as the sole means for providing or accessing liquidity. NASD members, individual investors, and members of other exchanges will be free to leave their orders with, and access pools of liquidity through, any linked market center trading Nasdaq securities.

Enhances Capacity. The Super Montage will be built using technology and architectures that will substantially improve Nasdaq's capacity.

In short, the Super Montage responds to the competitive forces the SEC has encouraged through its efforts to "democratize" the market, while protecting the integrity of the market. The proposal strikes the difficult balance of competing effectively while offering room for other market participants to innovate and improve upon the Nasdaq model. If the past is any indication, the exponential growth in technology will only continue, and dramatic technological advances will provide low cost methods for others to improve upon and actively compete against Nasdaq and its services.

B. Market ownership and regulation

In our view, the Super Montage will only be successful if it is part of a corporate structure that can respond nimbly to competitive and technological changes in the marketplace. For more than a year, the NASD Board discussed the need for, and ways to, restructure and capitalize Nasdaq in light of today's fast-changing and competitive environment. At a special meeting in January of this year, the Board gave final approval to a restructuring plan -- a two-phase private placement to NASD members, Nasdaq issuers, and other key partners -- that will better align their interests and the interests of the market.

Our goals in pursuing this restructuring include enhancing the competitiveness of the Nasdaq market, fairly recognizing members' contributions to building Nasdaq, reducing members' regulatory costs, and strengthening NASD Regulation and enhancing its independence, all of which will benefit investors. Under this plan, the NASD's ownership of Nasdaq will shift from 100 percent to a minority stake of approximately 22 percent. Nasdaq will file an application for exchange registration and become a separate SRO. Finally, the NASD will remain the parent company of NASD Regulation and the American Stock Exchange ("Amex"), which will retain its separate SRO status.

As part of its deliberative process, the Board formed a Fairness Committee, an eight-member Board subcommittee that conducted an in-depth analysis of the entire restructuring plan. The Fairness Committee was chaired by Governor Robert R. Glauber of Harvard University and included a majority of public and non-industry Governors. The Fairness Committee engaged its own legal and financial advisors. NASD, Nasdaq, NASD Regulation, and Amex staff provided extensive briefings to the Committee about the details of the transaction and its impact on the NASD companies and the NASD membership. At the conclusion of its deliberations, the Fairness Committee presented a report finding that the restructuring plan was fair and unanimously recommended that the full Board approve the plan.

As SEC Chairman Levitt said in his Columbia speech on September 23, 1999, any market restructuring must ensure that the self-regulatory obligation be vigorously fulfilled, adequately funded, and dedicated to serving the public interest. These principles guided all of our deliberations. The Fairness Committee and the full Board found that, following the restructuring, NASD Regulation will continue to be a strong and independent regulator.

First, NASD Regulation will continue to serve as regulator of Nasdaq under a ten-year service contract.

Second, a substantial portion of the proceeds from the restructuring will be earmarked for NASD Regulation.

Finally, a complete separation of Nasdaq and NASD Regulation is the first step toward our view of the right regulatory model. This model is a hybrid. A single independent self-regulatory organization is responsible for member regulation and inter-market issues of exchange regulation. Each exchange is responsible for regulating its own intra-market issues.

The Fairness Committee and the full Board also found that the restructuring plan is fair to NASD members because, among other things, all NASD members will have an opportunity to purchase securities in the private placements, and the NASD is committed to reducing NASD member fees and assessments over a seven-year period without sacrificing regulatory quality. Members also will benefit from further separation of regulatory and market functions, allowing Nasdaq and NASD Regulation to focus on their primary missions free of potential conflicts.

Investors will benefit from a stronger market and a stronger, more independent self-regulator. Nasdaq's new structure will enable it to compete and innovate to produce a better marketplace for investors. NASD Regulation will be well funded and even more independent, which will enhance investors' confidence in the integrity of the market. We have also taken steps to preserve this investor confidence well into the future. To ensure there is no concentration of ownership in Nasdaq after the private placements, which might allow narrow interests to prevail over the interests of all investors and market participants, we have included transfer and voting restrictions on the securities. In sum, we believe the restructuring plan will serve the interests of investors and all market participants.

C. Globalization

With regard to the international market, we need to build on our successful domestic stock market model internationally. We continually explore overseas ventures and alliances.

Our goal overall is to expose listed companies to global pools of capital and our American investors to non-U.S. listed companies, and to connect pools of liquidity around the world through around the clock trading.

In June of last year, we announced an effort to introduce an all-new electronic, Internet-based stock market in Japan. Called Nasdaq-Japan, it will give Japanese growth companies the ability to raise capital and trade in both markets. Japanese investors will have access to those stocks and to Nasdaq stocks.

The plan is that while the U.S. Nasdaq is open, Japanese investors will be able to trade in actively traded Nasdaq stocks on Nasdaq-Japan. After we close in the U.S., Nasdaq-Japan will permit trading in top Nasdaq companies in Japan. In addition, some of the Japanese stocks will list with us in the U.S. so Americans can trade those Japanese entrepreneurial companies. Thus, Nasdaq-Japan could have an almost around the clock trading day.

The Nasdaq-Japan Planning Company Inc. that has been formed to implement the plan recently signed a memorandum of understanding with the Osaka Securities Exchange (OSE), the largest derivative market in Japan. This agreement establishes the Nasdaq-Japan Market as a new section of the OSE. It will also give Japanese investors the opportunity to invest in high-growth Japanese IPOs as early as mid-2000.

This agreement will also provide the Nasdaq Japan Market with clearance and settlement services, market surveillance, and review of listing applications. The OSE will establish a communication network to link the 100 Japanese market participants to Nasdaq. OSE's new, fully automated computerized trading system, regarded as one of the most advanced systems in the world, will be available for the Nasdaq Japan Market by mid year.

Also in Asia, the NASD and the Stock Exchange of Hong Kong (SEHK) recently signed regulatory agreements for a pilot program to transfer data to permit Nasdaq-listed companies to list on the SEHK. This program will enable some Nasdaq-listed companies to acquire listings in Hong Kong and will establish Hong Kong as a major trading center for global stocks in Asia.

We have also announced an agreement with the Australian Stock Exchange to co-list and co-trade stocks.

In Europe, we recently announced the formation of yet another joint international venture -- Nasdaq-Europe. Slated to open in early 2001, this new market will create a superior pan European platform for IPOs, listing high-growth technology companies from all across Europe. It will offer European investors a trading platform linked on a global basis with Nasdaq markets in the U.S. and Asia. In addition to creating a liquid trading platform for the first pan-European stock market, Nasdaq-Europe will provide European investors with access to the world's preeminent stocks while offering an unmatched opportunity to participate in the new global economy.

VI. Conclusion

Clearly stock markets of the future will have a redefined purpose and reinvented architecture, all because more and more people have access to more and more information that they want to act on instantly. The Internet gives us the tools to bring new services to the marketplace, with investor-friendly systems bringing buyers and sellers closer together and eliminating intermediaries who do not add value.

In the near future, price information will be available globally, electronically and paperlessly, and accessible equally to all, individuals as well as institutions, in real time. There will be fair, transparent, and immediate execution of trades. Market makers will be connected globally, 24 hours a day. Stock markets will be linked with new platforms, ventures, and alliances on a 24-hour basis. Competing for stock listings will give way to global listing. Cross-border stock trading barriers will be reduced. Trade rules and accounting standards will help accommodate this as investor needs influence the political process. Costs of processing the buying and selling of stocks will drop dramatically due to technology and competition. Regulation enforcement will improve from increased electronic surveillance. Better regulation will bring an increase in investor confidence, the underpinning of a successful market. In turn, investor confidence will help raise capital and maintain liquidity, building economies and creating jobs.

Mr. Chairman, we believe, and we think you believe, that the genius behind U.S. stock markets' innovation is not a centrally prescribed single market, but free competition. To attain the improvements that I have just described, all we ask of you is to continue your policy of letting the markets develop, under the protective eye of the SEC, to improve services to investors and other market participants.

Thank you for the opportunity to testify, and I will be happy to answer any questions that you may have.

Upcoming NASD Regulatory/Market Structure Legislative Issues

E-Commerce/E-Signatures: We support efforts that will allow the industry and investors to better employ technology in all aspects of the trading of stocks. While have some concerns, from a regulatory perspective, with the House version of the e-signature bill, we are supportive of an e-signature bill as soon as possible.

Market Data Fees: We believe it is appropriate to review current market data structure under Section 11A and welcome the opportunity to present our views on the issues raised in the SEC's concept release.

Section 31 Fees/Adequate SEC Funding: We are committed to full funding of the Commission and taking the necessary steps to enable it to retain top quality, professional staff. However, revenue collections under Section 31 of the 1934 Securities Exchange Act are based on market volumes. Because of the huge growth in market volume, this has resulted in a large amount of fees being collected. Those fees were intended to cover the cost of running the SEC, but now are collecting five times the cost of running the agency. Clearly, they should be adjusted to reduce the fees that investors are paying.

Bond Market Transparency: Responding to a request from Chairman Levitt and the active encouragement of key members of the House Committee on Commerce we have proceeded with our bond market transparency proposal. The Commission has published that proposal for comment and the comment period has expired. We are looking toward expeditious approval by the Commission so that the bond market participants can be accorded that same level of transparency that is available in the equities markets.

Shad/Johnson Repeal: We remain committed to the proposition that the SEC should regulate equities and equity surrogates as securities. Any other course could affect the confidence of investors in the underlying integrity of our equities markets.

FASB Proposal to Repeal Pooling Accounting: We are concerned that the proposed repeal of pooling accounting by FASB will adversely affect the high tech/bio tech community. Those sectors have been engines of growth for the economy and changes that could retard their growth and expansion should be very carefully considered. The "new economy" is upon us and we should be careful to accommodate its unique features.

Bankruptcy: We support the provision in both versions of the pending bankruptcy bills that provide for an exemption from the automatic stay in bankruptcy for SRO enforcement actions and delistings. This provision will allow us to proceed against bad actors and companies who can now hide behind the cloak of a bankruptcy filing.

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