Nasdaq's Pursuit of Exchange Status and an Initial Public Offering

CRS Report for Congress
Nasdaq’s Pursuit of Exchange Status and an
Initial Public Offering
Gary Shorter
Specialist in Business and Government Relations
Government and Finance Division
Traditionally, the Nasdaq stock market was a for-profit, but wholly-owned
subsidiary of the nonprofit National Association of Securities Dealers, Inc. (NASD), the
largest self-regulatory organization (SRO) for the securities industry. In 2000, in a
strategic response to an increasingly competitive securities trading market, the NASD
membership approved spinning off the for-profit NASD-owned Nasdaq and converting
it into a for-profit shareholder-owned market that later planned to issue publicly traded
stock. For Nasdaq, this process has involved three basic stages: (1) issuing privately
placed stock; (2) converting to technical exchange status; and (3) issuing publicly-held
stock. Stage one, the private placement stage has been completed. In March 2001,
Nasdaq submitted an application for exchange status to the Securities and Exchange
Commission (SEC), an application that has been amended several times to address
certain criticisms. Obtaining exchange status is necessary for Nasdaq to proceed to
stage three, the issuance of publicly held stock. Realization of that stage became much
closer on January 13, 2006, when after more than a half decade, the SEC approved
Nasdaq’s application to become a registered national securities exchange.
Established in 1971 at the request of the SEC, the Nasdaq stock market is an
all-electronic trading facility, which, unlike traditional exchanges like the New York
Stock Exchange (NYSE) and the American Stock Exchange (AMEX), has no trading
floors and facilitates the trading of over-the-counter (OTC) stocks through a network of
market makers connected by telephone and computer. Nasdaq stock market was
originally a wholly-owned for-profit subsidiary of the nonprofit NASD, which also served
as its direct regulator or self-regulatory organization (SRO).
In the mid-1990s, NASD’s integrity as a self regulator was called into question when
Nasdaq market makers were accused of manipulating stock prices. After a federal
investigation, the NASD Regulation (NASDR) was established in 1996 as an
independent subsidiary of the NASD. The main purpose was to separate the regulation

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of the broker/dealer profession from the operation of the Nasdaq. The NASDR became
the primary regulator of broker-dealers and of the Nasdaq. All broker-dealers who are
registered with the SEC, except those doing business exclusively on a securities exchange,
are required to join the NASD. The NASDR’s regulatory budget is derived solely from
fees and fines imposed on NASD member firms.
When it began, Nasdaq was regarded as a technological innovator because it did not
rely on a physical trading floor. But over the last decade, both Nasdaq and traditional
exchanges have faced growing competition from two principal sources: First, global
stock markets that compete with U.S. markets for multinational corporate listings have
grown dramatically. Second, continuous technological change has led to automated,
computer-matching, trading platforms called electronic communication networks (ECNs).
Indeed, Nasdaq has developed its own ECN, the SuperMontage and has acquired another
one, Brut.
To help themselves remain competitive, the world’s major stock markets are
reexamining their governance and capital structures with an eye toward changes that
would enable them to react more deftly to the rapidly changing securities marketplace.
Conversion from privately-held (mutual) status to shareholder-owned status known as
demutualization, has become an increasingly attractive strategic response to the changing
market dynamics.
Many international and domestic stock exchanges have demutualized over the last
decade or so, including the London, Tokyo, Philadelphia, and the New York Stock
Exchange (in early 2006 after merging with Archipelago, the electronic communication
trading network). Key reasons for demutulization have included that (1) it enables
exchanges to more immediately raise capital and provide better regular access to capital
markets;1 (2) it makes exchanges better able to align their interests with those of their key
participants; and (3) it provides exchanges with greater flexibility and speed in adapting
to changing market conditions.
SRO Concerns Raised by Demutualization
In the summer of 1999, the Nasdaq announced its intent to demutualize. This change
raised a number of policy concerns that largely involved demutualized stock markets’
ability to effectively discharge their SRO duties. Among the key questions raised by the
prospect of demutulization were (1) Is there a cause for concern when a for-profit,
shareholder-owned SRO regulates entities like broker-dealers who in turn have ownership
stakes in competitive rivals such as electronic communication networks? and (2) Would
the altered economics of being a for-profit, shareholder-owned exchange affect an
exchange’s ability to effectively regulate itself?

1 In the spring 2005, in an acquisition that may foreshadow future acquisitions, Nasdaq
announced an agreement to purchase Instinet’s electronic communication network and to
consolidate their trading platforms.

Nasdaq’s Demutualization and
Approval as an Exchange
After announcing its interest in pursuing demutualization, the NYSE cited other
pressing concerns and put the process on hold. In April 2000, however, the NASD
membership approved spinning off the for-profit Nasdaq from the non-profit NASD and
converting it into a shareholder-owned market. The process was initially envisioned to
have three broad stages: (1) issuing privately placed stock; (2) converting to technical
exchange status; and (3) issuing public stock.
The private placement took place in two sub-stages. In the initial sub-stage, the
private placement, which was completed in June 2000, the NASD sold shares and issued
warrants on shares of Nasdaq that it owned, and Nasdaq also issued and sold additional
shares. The NASD’s ownership interest in Nasdaq was reduced from 100% to 60%. The
second sub-phase of the private placement was completed on January 18, 2001, with
NASD’s ownership interest then falling to 40% or about 77 million Nasdaq shares. The
NASD, however retained 51% of the actual voting interest in Nasdaq. On February 21,

2002, Nasdaq acquired 13.5 million shares held by the NASD. On March 8, 2001,

Nasdaq acquired 20.3 million shares from the NASD, leaving 43.2 million shares still
owned by the NASD in the form of underlying warrants that had been issued during
Nasdaq’s private placements. Concurrently, a new series of preferred voting stock was
issued to the NASD, allowing it to continue to have majority voting interest in Nasdaq.
The second stage, conversion to exchange status, was a requirement for the third
stage — sale of Nasdaq shares to the public. Although from a practical standpoint it has
little significance, Nasdaq currently is exempt from the definition of an “exchange” under
Rule 3a1-1 of the Securities and Exchange Act of 1934 because it is operated by the
NASD. Before the NASD could relinquish control of it, Nasdaq was required to register
as a national securities exchange. With approval of Nasdaq’s exchange application, the
preferred shares that provide the NASD with its majority vote interest over Nasdaq will
expire and it will no longer have effective control over Nasdaq. The exchange’s ultimate
goal has been to conduct an initial public offering (IPO).
On March 15, 2001, Nasdaq submitted an initial application for exchange status to
the SEC, an application that the agency published for comment on June 14, 2001. It later
made several amendments to the application in late 2001 and early 2002. After the initial
application, the foremost regulatory concern for the SEC and a number of securities
market participants was that, as written, the application would have continued to allow
Nasdaq to operate without a trade execution protocol known as intra-market price and
time priority, which is required of exchanges. This protocol is described below.
Nasdaq processes limit orders, orders to buy or sell a stock when it hits a specified
price. The NYSE centrally posts limit orders, which permits better-priced orders to
receive priority execution there or on the various other interlinked market centers that
trade NYSE-listed stocks. This is known as price and time priority and all exchanges
abide by it. (Both the Nasdaq and the NYSE are markets in which brokers are required
to exercise their duty of best execution when they route their customer’s orders. The
concept is inexplicit but is often interpreted to means that an order should be sent to the
market center providing the best prevailing price.)

But a significant fraction of Nasdaq market makers match buyer and seller orders
from their own order books. Known as internalization, this can result in well priced limit
orders outside of a market maker’s book being ignored. Nasdaq officials have argued that
their market permits competing dealers to add liquidity to the markets by interacting with
their own order flow but SEC officials have concerns about the formal absence of price
priority. This was a major sticking point in the agency’s delay in approving the exchange
application, concerns that Nasdaq attempted to address through subsequent amendments
to its exchange application.
On January 13, 2006, the SEC approved Nasdaq’s application to become a
registered national securities exchange. As a registered exchange, Nasdaq will become
a self-regulatory organization (SRO) with ultimate responsibilty for its own and its
members compliance with the federal securities laws. Several years ago, Nasdaq entered
into a Regulatory Services Agreement with the NASD to perform certain key regulatory
functions for it, an arrangement that should continue.
Nasdaq is now officially a registered an exchange, but the SEC will not permit
Nasdaq to begin operations as an exchange and to fully relinquish its independence from
ongoing control by the NASD until various conditions, including the following key ones,
are satisfied:
!Nasdaq must join the various national market system plans and the
Intermarket Surveillance Group;2
!The NASD must determine that its control of Nasdaq through its
Preferred Class D share is no longer necessary because NASD can fulfill
through other means its obligations with respect to non-Nasdaq
exchange-listed securities under the Exchange Act;
!The SEC must declare certain regulatory plans to be filed by Nasdaq to
be effective; and
!Nasdaq must file, and the Commission must approve, an agreement
pursuant to Section 17d-2 of the Securities Exchange Act of 1934 that
allocates to NASD regulatory responsibility with respect to certain
activities of common members.
Nasdaq’s exchange application limits the exchange to transactions in the Nasdaq
Market Center, previously known as SuperMontage and Brut, which will adhere to rules
on intramarket priorities. However, orders that are internalized by NASD broker dealers
that may not adhere to intra-market priority rules would be reported through the new
Trade Reporting Facility (TRF), which must go through a separate regulatory review

2 The National Market System (NMS) is composed of the various systems that govern the
communication links among domestic stock exchanges. The NMS plans are the various rules that
govern the linkages. The Intermarket Surveillance Group was created in 1983 by the major U.S.
securities exchanges to provide a consistent protocol for the exchange of information across the
different securities trading jurisdictions.

process and which will be administered by the NASD. Nasdaq will receive revenues from
TRF trades (a contentious point for a number of its rivals).