Hearing on Public Ownership of the U.S. Stock Markets

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

10:00 a.m., Tuesday, September 28, 1999

I am Frank G. Zarb, Chairman and CEO of the National Association of Securities Dealers, Incorporated. The NASD would like to thank the Committee for this opportunity to testify on the proposed recapitalization of the Nasdaq Stock Market. As I will describe more fully below, the NASD is proposing to restructure the Nasdaq Stock Market into a broader stock-based ownership structure in order to fulfill its mission in the years ahead.

Why does a stock market like Nasdaq exist? The answer is not complicated - our mission is to provide investors and other market participants with five "bests":

  1. The best information;
  2. The best trade execution;
  3. At the best rate of speed;
  4. At the best cost;
  5. With the best market integrity.

To date, the Nasdaq Stock Market has been an engine of growth in our economy and has listed the securities of many of the country's fastest growing companies. Millions of jobs have been created in the United States by companies listed on Nasdaq. Since 1990, Nasdaq companies have grown nearly three times as fast as the Dow Jones Industrial Average and have substantially contributed to America's long- term prosperity. However, this leadership position is not preordained. Rapid changes in technology, globalization of the securities markets and increasing competition demand a responsiveness and flexibility that appears to be inconsistent with our current structure. As the global markets around us change, we must change our organizational and capital structure, as well as our technology platform. If we do not, our performance will suffer and the investor will be harmed. The question is not whether we want to make these changes - we must do it to fulfill our mandate.

The fundamental purpose of this proposal is to allow Nasdaq to take full advantage of emerging opportunities as we move toward globalization of the securities industry. Our vision of the future is one in which state-of-the-art computer systems and networks provide a market that best serves investors and issuers of securities - one that is efficient, transparent, and liquid. We envision a global market in which services are delivered at lower cost and with better safeguards for investors. One significant consequence of the restructuring will be to provide an infusion of capital that will allow us to fully fund a stronger, more independent regulator to ensure the integrity of our market. We will also be in a position to provide additional capital for emerging technologies and to enter into new partnerships and joint ventures as we create the next-generation stock market. In short, as a for-profit company governed by the market's leading participants, Nasdaq will be in a better position to help chart the future of tomorrow's financial markets.


Let me briefly outline the role of the NASD in the regulation and operation of our securities markets. 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 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 75,000 branch offices and employ more than 600,000 registered securities professionals.

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. The NASD is governed by a 33-member Board of Governors, a majority of whom are non-securities industry affiliated. Board members are drawn from leaders of industry, academia, and the public. Among many other responsibilities, the Board, through a series of standing and select committees, monitors trends in the industry and promulgates rules, guidelines, and policies to protect investors and ensure market integrity.

The Nasdaq Stock Market

The Nasdaq Stock Market is the largest electronic, screen-based market in the world, currently capable of handling trading of up to four billion shares a day and can be scaled up, if necessary, to accommodate an eight billion share day. Founded in 1971, Nasdaq today accounts for more than one-half of all equity shares traded in the nation and, since January of this year, is also the largest stock market in the world in terms of share volume and dollar value traded. Average Nasdaq volume in 1999 is 985 million shares per day, with a peak of 1.4 billion shares reached on April 14, 1999. It lists the securities of 5,288 domestic and foreign companies, more than all other U.S. stock markets combined. There are over 70 million investors in Nasdaq companies.

NASD Regulation

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.

NASDR carries out its mandate from its Washington headquarters and 14 district offices located in major cities throughout the country. Through close cooperation with federal and state authorities and other self-regulators, overlap and duplication is minimized, freeing governmental resources to focus on other areas of securities regulation.

NASDR has examination responsibilities for all of its 5,600 members. In addition to special cause investigations that address customer complaints and terminations of brokers for regulatory reasons, NASDR conducts a comprehensive routine cycle examination program.

NASDR was established as an independent subsidiary of the NASD in 1996 following recommendations by the NASD's own Select Committee on Structure and Governance, headed by former Senator Warren Rudman, and the SEC 21(a) report issued by the SEC, that found the NASD's former structure would not allow it to succeed as both the primary regulator of the U.S. broker-dealer profession and the regulator, operator, and owner of The Nasdaq Stock Market. The NASD formally separated its regulatory duties from its stock market to "put more daylight" between them.

Today, the NASDR board of directors, as well as its network of committees, are composed of knowledgeable, experienced individuals, balanced evenly between industry and non-industry members to reflect more accurately the breadth of participation in securities markets. This "investor protection by equal representation" set a new standard for securities industry SROs.

The American Stock Exchange

The American Stock Exchange is the nation's second largest floor-based securities exchange, listing 770 companies, 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. Amex has been the nation's foremost innovator in structured derivative securities and index share securities. The latter are registered investment companies that permit an indexed equity investment, as do index mutual funds, but afford investors the opportunity to purchase or sell on the Exchange at any time during the trading day.

The Changing Financial Environment and Markets

The Internet revolution in the securities industry is creating a better informed investor, inviting more participation and lowering the cost of capital for America's new and established companies, and creating new and exciting opportunities in the industry. There are 41 million individuals with a brokerage account, millions more who are shareholders, and 80% of households participate directly or indirectly in the capital formation process - the vast majority of whom hold Nasdaq stocks. Nasdaq transaction volume has grown to over a million trades per day while the average number of shares exchanged per trade has dropped from 2,125 in 1990 to 835 YTD as of August, 1999. Technology has brought new investors into the stock market and stimulated more trading activity among all investors.

The Internet has given global visibility to publicly held companies and is causing a behavior shift - information technology and the Internet are facilitating a dramatic and profound shift in consumer behavior. The securities industry is one of the sectors in the economy being affected most by the e-commerce revolution. Both individual and institutional investors are demanding the access, information, and transactional capabilities that creative applications of on-line technology can provide to the process of trading stocks.

The traditional business model of brokers and market makers is undergoing rapid design changes. There are currently nine Electronic Communications Networks (ECNs), and in the last year alone over three million new on-line brokerage accounts were opened, twenty-two new investor websites made their debut, and the average commission cost of a retail stock trade dropped to approximately $77.

Functions and tasks previously performed for premium prices are being replaced by software solutions at substantially lower price or even for free. Individual and institutional investors have more trading choices than ever before -- traditional advice, self-directed on-line, electronic order matching, hybrid electronic auctions, and automated price improvement mechanisms.

These new transaction mechanisms, and the firms that produce them, have been successful because they work. They do a better, faster, cheaper job of satisfying the needs of many investors than traditional models. For many investors, electronic brokers have replaced human brokers. For many brokers, electronic systems have replaced market makers and specialists. Some investors have direct on-line access to the "market" by "passing through" the computers of a brokerage firm. They are living proof of the power of Internet-based technology in facilitating creative advancements to the process of bringing buyers and sellers together.

The Internet is propelling a level of customization and segmentation that was difficult, if not impossible, to imagine only a few years ago. From day traders to large institutions, from small odd lot limit orders to million share blocks, for practically every type of investor, for every type of trade, firms are developing new services using on-line technology.

While these trends are accelerating, they are putting strains on the current structures of stock markets. The growth in segmentation is spawning a new kind of cyber-parochialism, where the investors using one mechanism may not have access to all the investors in the "market." As cyber-parochialism accelerates and pools of investors become more isolated, the present process for price discovery -- the process that measures all supply and demand forces in the "market" at a given point in time -- will become increasingly less effective.

Parochialism can also reduce the markets' liquidity by making it more costly for traders of large blocks to locate a combination of "other sides" to complete a transaction. It can reduce transactional liquidity, the fuel of orderly markets, by increasing market makers risk because fewer customer orders will mean fewer opportunities for the market maker to unwind a position.

While there are changes resulting from the financial environment, other changes result from the effects of regulation and globalization on that environment. Among such major changes that we see are:

The challenge facing the securities industry is therefore the development of a stock market structure that accomplishes several goals: (1) embraces the power and benefits of the Internet; (2) provides an open platform that encourages continued innovation by firms seeking better ways to satisfy the needs of investors; (3) utilizes a technological architecture that can aggregate parochial interests without diminishing their unique benefits; (4) provides incentives for market makers to provide transactional liquidity in an on-line environment; (5) maximizes efficiency through centralized price discovery, transparency, and a level playing field; (6) recognizes the new structures permitted by ground-breaking regulations and globalization, and; (7) reduces costs to bare minimums.

In short, to fully realize the benefits that the Internet can provide to the capital formation process, Nasdaq must be reinvented for the digital age.

The velocity of change in our financial markets has been phenomenal. The speed of this change has been facilitated by advances in technology that have spawned new market participants and new markets. These changes have prompted an in-depth review of strategic alternatives that would position us to continue to be a major force in the marketplace of the future. We support competition and believe change is inevitable. However, we also believe that protection of market integrity and the interest of the investing public must be paramount in any such undertaking.

The Proposed Recapitalization

On July 29, 1999, the NASD Board of Governors outlined its vision of how it intends to restructure The Nasdaq Stock Market into a broader stock-based ownership structure. At that time, the Board approved the concept of a stand-alone Nasdaq Stock Market. These actions were the culmination of a ten-month evaluation by a special committee of the Board headed by NASD Board Member Frank E. Baxter, Chairman and Chief Executive Officer of the Jeffries Group. Other members of the committee include: Herbert M. Allison, former President and Chief Operating Officer, Merrill Lynch & Co., Inc.,; James Dimon; LaRae Bakerink, First Vice President and Chief Compliance Officer, Pacific American Securities, LLC; Phillip Frost, M.D., Chairman and CEO, IVAX Corporation; Michael W. Brown, Retired Chief Financial Officer, Microsoft Corporation; Arvind Sodhani, Vice President and Treasurer, Intel Corporation; and E. David Coolidge, Chief Executive Officer, William Blair & Company, LLC. Mr. Baxter best described the motivation behind his committee's recommendations when he said:

The stock-based structure will allow Nasdaq to compete successfully in today's highly competitive market environment for three fundamental reasons: First, it better aligns the interests of the Market with the interests of its key participants. Second, it provides both an initial infusion of capital and easier ongoing access to capital. Third, as a for-profit stock-based company governed by the Market's leading participants, Nasdaq should be more agile, flexible, and effective in responding to industry and market conditions.

Nasdaq today is owned by the NASD, a nonprofit membership corporation, with over 5,600 members. The recapitalization is intended to strengthen The Nasdaq Stock Market financially without burdening the existing members with the required cost. The recapitalization responds to the major market challenges and opportunities facing us in a new, electronic, highly competitive environment. It will also strengthen our self-regulation model, through NASD Regulation, and protect the existing regulatory funding support for small broker-dealers. The creation of a strong financial base for Nasdaq, the NASD, and NASD Regulation will ensure that NASD members are treated equitably in return for helping to build Nasdaq.

We expect this new structure will allow us to build a consensus for offering, in one place, the transparent price discovery needed by the market to address a continually increasing trend toward market fragmentation that creates a market structure that combines the best elements of a dealer based and aggregate display market. In the near future, I expect to submit to the SEC a plan which will garner the benefits of centrality without stifling competition. By having the opportunity to partner with key technology companies and other market participants, we will be able to move more quickly to a low-cost technology platform that permits Nasdaq to effectively expand both in the United States and globally.

The Process

The process we envision will be to conduct a private placement under which the NASD's ownership of Nasdaq will shift over time from 100% to a minority stake. The majority portion of the market would be owned by current NASD members, securities firms, issuers, buy-side firms, and technology partners. Nasdaq starts as a wholly owned subsidiary of the NASD. New Nasdaq shares and warrants from NASD will be sold at fair market value to key strategic partners in a private placement, with a subscription sale of warrants to all NASD members who wish to purchase them. Control over the new entity will pass from NASD to its new owners when Nasdaq is registered as an exchange with the SEC. Although it is very uncertain at this point, these steps could be followed by an initial public offering, possibly in 2000, that would substantially reduce the NASD's ownership position in, and effectively eliminate its control of, the Nasdaq Stock Market.

The current recapitalization plans do not include the American Stock Exchange. Since the acquisition of the Amex last fall, we have begun a series of initiatives to strengthen that market. We are making good progress and hope to be in a position to recapitalize the Amex in the next few years.

Benefits to NASD Regulation Mean Benefits to Investors

The system of securities self-regulation in the United States has served investors and the markets well. Through the efforts of the NASD and the other self regulatory organizations (SROs), it has provided a level of funding and allowed the functional expertise of market operators to be brought effectively to bear on regulatory problems under the strong oversight of the SEC.

We are proud of the operation of self-regulation and know that it is a major contributor to the leading position the United States markets enjoy in the world today. However, we believe that the market changes outlined above will profoundly affect the system of self-regulation in the US. For example, to the extent that for-profit ECNs become exchanges, they will compete with the NASD and the NYSE, which operate markets, but also aggressively regulate them. In this wider market competition we believe that there exists the potential for a conflict of interest, where markets could compete based on the ease - rather than the rigor - of their regulation.

In addition, as multiple markets seek to register as exchanges, we believe there exists the potential for the fragmentation of regulation that would seriously undercut the overall quality of regulation and make a consolidated regulatory view of trading activity extremely inefficient and costly to achieve, to the ultimate detriment of the investor.

Therefore, early in the process we decided that an NASD Regulation, independent from a for-profit marketplace, was the best means of maintaining our high regulatory standards. We have remained steadfast in this belief and our commitment to it.

As you know, currently, each of the major U.S. stock markets is self-regulated. While this system, when combined with vigorous SEC oversight, serves the investor very well, it is untested in meeting the future demands of a newly restructured marketplace. As the speed and complexities of the digital age present our industry with even more challenges, it is essential that we have in place a regulatory system that will continue to ensure market integrity and maintain the public trust. This is especially true if we move to the for-profit landscape.

The time may therefore be right to consider whether it makes sense for the regulatory units of all institutions choosing to register as exchanges to be combined into a single SRO governed by market participants and public representatives. Such an entity could be given the primary financial, sales practice and market rules examination, surveillance and enforcement responsibility for all broker-dealers. Clearly, many issues need to be identified, examined, and resolved before this could be a reality. We are committed to working through these issues and believe that a thorough analysis to determine the benefits to the marketplace and investors should be conducted before deciding whether to support or oppose such a proposal.

A major goal of the recapitalization is for NASD Regulation to become the best-funded financial industry self-regulatory organization in the world. A better-capitalized, more independent NASD Regulation will provide even stronger self-regulation over all NASD members for the protection of all investors, without financially burdening our membership, particularly the small broker-dealers who will continue to benefit from subsidization. We expect that a substantial portion of the receipts from the initial private placement raised by NASD will be used to support NASD Regulation and hold down the costs of regulation for all members.


We believe that we can best serve investors and the marketplace by adhering to the following fundamental guiding principles:

Some would argue that a failure to act in the current environment would diminish the value of the Nasdaq market, NASD Regulation's ability to regulate, and the opportunities available to our members and investors. We believe that we have developed a model that will best serve the interests of all affected parties for today and tomorrow. Be assured that this action will not lull us into complacency. We have every reason to assume that the pace of change will continue and we are committed to positioning ourselves to best address those changes.

We look forward to working with this Committee as we continue through this process and welcome your interest in this important matter.

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