Ailing Nasdaq forced to undo work of its Mr. Fixit


During a long career in government and private industry, Frank G. Zarb has been Mr. Fixit.

Now, however, one of his major repair jobs appears to have sprung leaks. The Nasdaq stock market, following a strategy that Zarb developed in the late 1990s to try to keep it from coming apart, has rapidly lost money and market share.

Amid a continued defection of customers to upstart electronic communications networks, or ECNs, Nasdaq's share of trades in its own listed stocks has fallen to 17 percent as of June from 18.7 percent in December, costing it fees.

Nearly half of all trades in Nasdaq-listed stocks done by broker-dealers who participate in the Nasdaq network are reported elsewhere, causing a further loss of revenue.

Faced with shrinking revenue, a new Nasdaq chief executive has cut some Zarb-inspired ventures and embarked on a major cost-cutting effort that includes layoffs and taking a hard look at the expenses involved in operating MarketSite, the glitzy TV backdrop and office building Zarb built in Times Square.

Nasdaq's plight has "tremendous" implications for investors and the marketplace, said Robert A. Schwartz, a professor of finance at Baruch College. "To have good stocks and good companies, you need well-functioning liquid markets."

It is an axiom of trading that the more orders that interact with each other in a market, the better prices will be for investors. Moreover, companies too small to list on the nation's largest market, the New York Stock Exchange, have long relied on Nasdaq, the second-largest, to help them raise capital.

Mark G. Heesen, president of the National Venture Capital Association, said Nasdaq's "imprimatur" is crucial for new companies, especially those seeking overseas investors.

"Nasdaq took a very long time to put together," Heeson said. "It's not something you can replicate overnight."

Some critics blame Nasdaq's problems on Zarb, 68, who retired from it and its parent, the National Association of Securities Dealers, in February 2002. They say he was too sure that the bull market global cachet of Nasdaq stocks would last and that he was too confident of getting key parts of his plans approved by market members and regulators.

Zarb, whose resume includes top-ranking positions at Smith Barney and at Alexander & Alexander in Baltimore, said his Nasdaq strategy was a good one when hatched, but that his successors weren't quick enough to "ratchet back" on growth when global markets turned down.

"I don't think I made mistakes," Zarb said in a recent interview. "You make a decision for the moment, then you re-evaluate it when things change. You always manage to the new reality."

Largely because of the cost of shrinking Nasdaq's operations and staff, the Nasdaq Stock Market Inc. lost $46.4 million in the first half of this year. Its earnings have declined steadily for the past three quarters and its stock, which trades thinly on the over-the-counter bulletin board, sells for less than half what it did a year ago.

Nasdaq's latest chief executive, Robert Greifeld, told investors this month that the company intends to become "the dominant U.S. equity market."

So far, he has closed all of the market's overseas operations; started to tinker with Nasdaq's trading mechanism, which was altered under pressure from members after Zarb first proposed it; and replaced a lot of top management.

Eighty jobs have been cut, and the company is scrutinizing other expenses.

Christopher R. Concannon, Nasdaq's strategist, said the review includes MarketSite, which people familiar with Nasdaq's operations said costs more than $20 million a year to maintain.

Greifeld declined requests for an interview, as did Hardwick Simmons, who took over Nasdaq's leadership from Zarb and stepped down in May under pressure from Nasdaq's board.

Market professionals say Nasdaq is at a crucial juncture.

"If they continue down the path they're going at the moment, Nasdaq will become less and less relevant," said Octavio Marenzi, chief executive of Celent Communications, a Boston financial services research and advisory firm. "I don't say they would disappear, but ... Nasdaq will [be transformed] from what was once an enormous, a tremendous brand name, into something of marginal significance."

The NASD created Nasdaq in 1971 to link broker-dealers trading in stocks not listed on national exchanges. An electronic network, it operates through computers in Connecticut and Maryland, rather than having a physical trading floor as does the New York Stock Exchange.

When Zarb became the NASD's head in 1997, Nasdaq was trying to recover from a dealer bid-rigging scandal that had tarnished its image with investors and it was threatened by new competitors that were eating into its trading business.

Rival electronic communications networks automatically matched orders without intervention by a dealer, saving time and money for investors. They also offered anonymity, a feature that appealed to mutual funds and other large investors afraid of tipping off other traders about their intentions.

To benefit from what he saw as growing demand for 24-hour global trading, Zarb began an ambitious program to build overseas exchanges. He laid plans to overhaul Nasdaq's trading system so it would display and automatically execute more orders, making it more attractive to institutional investors.

Zarb, who served as "energy czar" in the Ford administration, also began the process of spinning off Nasdaq as a public company, partly to reduce conflicts of interest between the market and the NASD, its regulator, and partly to allow it to move more quickly.

Each leg of the strategy has stumbled. The overseas exchanges never attracted much business. Simmons closed Nasdaq Japan late in 2002. In June, Greifeld closed Nasdaq Europe in Brussels, Belgium, and last week he closed Nasdaq Deutschland, which was begun by Simmons after Zarb left.

SuperMontage, the new centralized, electronic trading system Zarb hoped would attract more business to Nasdaq, was hotly opposed by many market members, including the electronic communications networks, which feared it would take business away from them. As a result, it went through at least eight makeovers before finally becoming fully operational in December 2002.

During the long delay, electronic communications networks gained customers and consolidated through mergers. The second-largest ECN, Archipelago, now called ArcaEx, has won independent exchange status from regulators.

Archipelago and the biggest ECN, Instinet/Island, not only don't execute trades on Nasdaq, they have stopped reporting their trading activity to the network. That deprives Nasdaq of revenue from reselling market data to vendors, who then resell it to outlets such as newspapers.

Finally, although Nasdaq raised $326 million in two private stock placements orchestrated by Zarb, it hasn't split off from the NASD because the Securities and Exchange Commission hasn't approved its application to become an exchange. Nasdaq's ability to operate a market depends on its NASD affiliation.

The fact that the NASD still has voting control of Nasdaq has forced postponement of an initial public offering that might have showered investors with huge profits, had it occurred during the bull market when the Nasdaq composite index stood above 5,000. Instead, stock sold in the private placements trickled out last summer when restrictions on sales by insiders were lifted.

Some academic and industry observers say Zarb's strategy was so flawed that it was doomed to fail.

Benn Steil, a senior fellow at the Council on Foreign Relations and an authority on exchanges, said Zarb's overseas expansion plan was "really foolish" because it targeted areas that were already crowded with competitors. He also said Nasdaq officials should have known that the exchange application process would be lengthy, if only because it was sure to be hotly opposed, as it has been by the New York Stock Exchange and other competitors.

Matt Andresen, who directs global trading at Sanford C. Bernstein & Co., said the SuperMontage idea was flawed because it treated electronic communications networks as competitors, rather than adding value to Nasdaq, much as individual stores provide value to a shopping mall.

Zarb owns slightly more than 1 million options for Nasdaq shares that are worthless because the stock price is hovering around $7 and the options' exercise price is $13 a share.

Simmons has 1.3 million options, also exercisable at $13, and Greifeld has 1 million at $5.28 a share and another million at $6.30, subject to approval by the compensation committee.

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