Investors, while they should encourage the federal investigations into the pricing inefficiencies of stocks traded on NASDAQ, would be better served by a comprehensive study of the costs and effectiveness of all securities market regulation.
The nation's primary over-the-counter market, NASDAQ - the National Association of Securities Dealers Automated Quotations - operates under severe discipline from the marketplace of investors, aside from regulatory requirements.
It competes every day with the New York Stock Exchange for listings. Increasingly, it faces tough competition in trading for large transactions with Instinet Corp.'s trading system. Pressures, largely political, force conformance with NYSE models, even where it may be inappropriate.
Yet last month the Department of Justice, and, this month, the Securities and Exchange Commission, began investigations into NASDAQ pricing, rather than extending their inquiries to pricing inefficiencies in all stock markets.
Although groups of Wall Street professionals including traders often are together at industry functions, trade association meetings, or at Harry's in Hanover Square and other brokerage hangouts, no one is expecting to find that these have been occasions for collusive activity. In a highly competitive industry whose traders delight in picking each other off for sport and profit, it is unlikely there is such active collusion.
The dealers, in defense of what have been quarter-point quotation spreads in OTC securities, point out that actual transactions, involving trades of more than 1,000 shares (not the quotes studied by academics), are often executed within the bid-asked spreads. These large trades are negotiated between dealers rather than being processed through NASDAQ's automated small-order execution system.
The goad for the larger trades may well be Instinet, whose volume reaches one-fifth of NASDAQ's on any given day. In a sense, Instinet is a parasite of NASDAQ because it is based on NASDAQ prices.
The existence of Instinet as an alternate OTC market both shows NASDAQ's inefficiencies and raises an important issue to small investors. Because the efficiency of a market is in direct ratio to the amount of business it does, volume on alternate markets undermines the pricing mechanism of the primary market.
More important, economic dislocations imposed on the markets are anti-competitive measures promulgated by securities regulators in the name of investor protection. These have been of concern in the past to the Justice Department.
Regulations that we accept on faith as protecting the market, such as net capital requirements imposed on dealers, also limit the number of competitors and the depth of markets competitors can make.
All brokerage firms' costs of doing business are raised, too, when brokerage firms are in effect required to buy government-sponsored insurance - namely, through the Securities Investor Protection Corp. - to cover their customers against the possibility of broker insolvency.
Their costs are raised also by the nation's layered and duplicative system of regulators at the federal, state and self-regulatory levels.
Needless to say, all of these costs are passed along to customers either directly or through a reduction of the firm's willingness to accept risk or offer services.
Not to be ignored are ethical concepts translated into economic regulation. The NASD, for instance, limits the amount of mark-up or profit a brokerage firm can charge its customers on a transaction to a maximum of 5% over "prevailing market." It is as if your local piano dealer were required as a matter of business ethics, enforced at risk of loss of license, not only to inform its customers what it paid for a baby grand taken in trade, say $5,000, but also to limit its gross profit - out of which it had to pay a sales commission, overhead and cost of carry of inventory, all before seeking to earn a return on capital - to $250.
NASDAQ and the New York Stock Exchange are different concepts in structuring securities markets. The NYSE uses specialists, who ameliorate volatility in prices and are obligated to make a fair and orderly market. The OTC market, on the other hand, has competing dealers, or market makers. However, the image in people's minds of what a securities market should be has been formed by the NYSE. So a market can be forced to conform to the NYSE even if it makes little sense.
Thus, NASD also has been forced by congressional and regulatory pressure to accept dislocations of the NASDAQ trading market to conform to perceived advantages in the New York Stock Exchange model.
This year NASD, parroting NYSE regulation, introduced short sale regulation, despite acknowledgement that it inhibits pricing efficiency. Until recently, NASDAQ had no rule requiring short sales be made only on an uptick. NASDAQ adopted the rule just to get the issue out of the way in the face of other pressures. Even so, many believe the short-sale rule, whether on NASDAQ or the New York Stock Exchange, is economically harmful and infringes on the flow of transactions. Raising costs makes markets less efficient and ultimately customers pay for them.
NASD also this year introduced so-called limit order protection for customers. In simple terms, this means that a customer can enter a dealer's flow of orders and buy a security (before mark-up) at exactly the price a market maker pays (plus a fee the market maker charges). Customers now have the pricing advantage of owning a brokerage firm with none of the annoying details like investing capital, paying rent, hiring personnel or disposing of inventory.
On Nov. 14, the SEC announced its own inquiry into NASDAQ market practices. This investigation comes after a September call by SEC Chairman Arthur Levitt for a review of regulation of financial markets.
Investors would be best served by a comprehensive study of the dollars and cents cost and effectiveness of the regulation of the securities markets.
Saul S. Cohen is a partner at Rosenman & Colin, New York.