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The National Association of Securities Dealers, Inc. (NASD), is a self-regulating association that runs NASDAQ, an automated over-the-counter stock market which lists the shares of more than 4,600 companies. NASDAQ is the second largest stock market, in terms of dollar values of trade, in the world, and the fastest growing securities market in the United States. NASD got its start during the Depression as the federal government tried to re-establish order in the American financial industry. In the early 1970s, it instituted a technological breakthrough in stock trading with the introduction of NASDAQ. The association has refined this system as its market has grown.
NASD was founded in 1939 in the wake of the 1938 Maloney Act amendments to the Securities Exchange Act of 1934. In cooperation with the United States Congress and the Securities and Exchange Commission (S.E.C.), the nation's dealers and brokers in over-the-counter securities joined together to regulate themselves, under the government's supervision. The market in over-the-counter (OTC) stocks was made up of transactions conducted between investors and "market makers" who were authorized to trade a company's stock. Between the association's founding in 1939 and 1970, it functioned primarily as a regulatory body for the activities of buyers and sellers of OTC stocks.
During this time, trades were carried out through a cumbersome process. In order to buy stock, it was necessary to shop around by phone among the various market makers, in order to see who was offering the best price. With this system, it was impossible to give a fixed price for any stock at any given time, so it was also impossible to keep track of whether a stock's price was rising or falling.
In 1971 NASD introduced an automated system that recorded all price quotes for a given stock by the different market makers authorized to sell it. "Bid" and "ask" quotes, the prices for which a dealer was willing to buy or sell a stock, along with volume figures, were updated once a day, in the same way that mimeographed stock listings had previously been left at each broker's door every morning. The new computerized system was called the National Association of Securities Dealers Automated Quotations (NASDAQ) stock market. With this move, NASD brought market transparency to the OTC stock market.
With NASDAQ, the association brought an end to the need to shop around for the lowest price on a stock. The OTC stock market became an electronic dealer's market, a fully automated exchange which operated without a trading floor. NASD began to compete with the older New York Stock Exchange and the American Stock Exchange to list companies that were offering stock to the public for the first time, and to win investors.
Although it competed with the older exchanges, NASDAQ operated in a somewhat different way because of the presence of the market makers. Instead of one dealer authorized to sell a stock, NASDAQ had multiple dealers. Each OTC stock was typically carried by seven to 11 market makers, which included some of the world's largest securities firms, who competed for an investor's order by posting prices on NASDAQ.
This competitive system provided efficient pricing, and also increased the capacity of the stock market to handle high volumes of orders, eliminating the trading halts that were periodically instituted in traditional exchanges. Market makers also produced research reports on the stocks they handled, raising visibility in the investment community, and provided distribution services through a retail arm.
Despite these technological advances, the OTC stock market in the early 1970s was considered "a moribund backwater of the security industry," as NASD's president Gordon S. Macklin told Forbes magazine at the time. Requirements for joining the NASD stock market were extremely loose. Companies were required only to have stock that was publicly traded, and to pay their NASD fees faithfully.
Every day, NASD published a listing of its stocks in newspapers around the country, which was based on volume of shares traded. Because this was the sole criterion for appearing in the printed list, small companies with very cheap stocks could make a big splash simply by having a lot of their shares moved around. Under this system, companies also enjoyed the benefit of appearing in the newspaper very shortly after going on the exchange.
Four years after NASD established NASDAQ, stocks listed on the system were purchased by five million different investors. With a high capital gains tax in place, activities in all stock markets were slowed during the 1970s.
During the 1980s NASD began a push to increase the size and prestige of NASDAQ. At the end of 1981, the association changed the way its stocks were listed in daily newspapers. Rather than judge by volatility, NASD established a two-tiered system for ranking its 3,600 companies. Those in the top tier, who met certain financial criteria, such as market value, net worth, length of time in operation, and profitability, were put on the NASDAQ National Market list. The selection criteria for these companies was nearly as rigorous as that for the older American Stock Exchange. "It's a pretty swanky list," Macklin told Forbes at the time. "You have Berkshire Hathaway, 500 or 600 New York Stock Exchange-eligible companies and hundreds of banks."
Companies that did not meet these new stringent criteria were put on a supplemental list, which came to be called the NASDAQ SmallCap Market, and was carried by far fewer newspapers than the main tally. With this step, NASD moved to make its biggest and best-established companies happy, at the expense of smaller, less mainstream members of the association.
By 1982, NASDAQ had grown to encompass 25 percent of all trading done in the markets. In addition, the system had attracted a significant number of institutional investors, which made up 50 percent of the exchange's volume. As the capital gains tax had dropped, investment in all stock markets had increased dramatically, and NASDAQ's tally of investors had doubled in five years to reach 10 million by 1980.
NASDAQ had also become more popular with companies looking to raise capital. Although half of the 3,400 companies listed with NASD qualified for bigger stock exchanges in 1982, they had chosen to stay with NASDAQ because of the advantages it offered over competing markets. Popular companies such as Apple Computer Inc., MCI Communications Corporation, and Intel Corporation started out on NASDAQ and then stayed. Decisions like these helped to make NASD the fastest-growing stock exchange in the early 1980s. With the presence of larger companies and institutional investors, however, NASDAQ began to resemble its big siblings more closely, becoming more volatile and more closely tied to the performance of other markets.
To foster further growth, NASD upgraded its computer systems in the early 1980s. In April 1982, the association introduced the National Market System (NMS). This advance, which started with 40 companies, meant that the price and volume of popular securities was updated on NASDAQ computer screens 90 seconds after a transaction occurred. This "last-sale" reporting, which made the system's information more timely, helped NASDAQ come closer to duplicating the up-to-the-minute trading conditions of the other two major exchanges.
This advance, plus the large number of new companies coming to market to sell stocks, helped to fuel NASDAQs growth in the mid-1980s. In 1983 NASDAQ's listings grew by 60 percent to reach 3,901. Since many of the new companies started during this time were computer makers or other high-tech firms, NASDAQ gained a reputation as the stock market with cutting edge companies on its list.
NASDAQ was also popular with start-up companies because of its looser regulations. Many firms founded by an entrepreneur set up unequal stock structures when they sold shares to the public, in which the original owners retained almost all of the control of the company, even though other people had contributed money. This unequal arrangement was forbidden on the New York Stock Exchange, which held to a one share, one vote standard.
NASD made another significant technological breakthrough in December 1984, when the association introduced its Small Order Execution System. With this program, brokers could place an order for a stock without having to pick up the phone and call a dealer. Instead, the dealer offering the lowest price for a stock was automatically given the sale. For large orders, however, the old, telephone-based system remained, since brokers liked the flexibility it gave them, which allowed them to maximize their profits in the market.
In December 1984, NASD won a ruling from the S.E.C. that gave it the right to expand the number of companies linked by its NMS from 1,102 to 2,600. The New York Stock Exchange and the American Stock Exchange vociferously objected to this ruling, since it narrowed the distinction between their operations and NASDAQ.
Despite these advances, in 1985 NASD encountered an extremely irate investor, who raised a controversy about the way the market worked. This investor discovered that his NASDAQ broker was dealing primarily in his own interest, and only secondarily in his client's, and that this practice was permitted by the exchange. Although NASD asked its brokers to alert their customers to the rules of the exchange, and to follow their fiduciary responsibility to their customers, the structure of the market, which benefitted the large broker over the individual investor, was not substantially changed. This dispute was a harbinger of a much larger number of complaints which would erupt later in the decade.
In April 1985, NASD won a further ruling from the S.E.C. expanding the limits of its activities. This move, however, proved to be a double-edged sword. After NASD petitioned for the right to trade options on six of its most popular shares, as well as the shares themselves, the other stock markets were granted the same privileges. In this way, NASD lost the exclusive right to deal in shares of Apple Computer, Convergent Technologies, Digital Switch, Intel, MCI Communications, and Tandem Computers, which were among its hottest stocks.
By 1987, when Macklin resigned and a new head took over NASD, two issues had come to the forefront. The association needed to strengthen its self-regulatory posture, to better protect investors, and also to move more forcefully into the market for foreign capital. As a start in this direction, NASD set up a quotation link with London early in 1987, and added a second tie to Singapore by the end of that year. At the same time, the association extended its regulatory oversight to include 60 government securities dealers, and considered including investment advisors as well.
Before these steps could be fully implemented, however, the NASD suffered a severe blow on October 19, 1987, when all of the American stock markets crashed on one day, Black Monday. In the chaos of the crash, a number of the weaknesses of the NASD system which had led to abuse were revealed, and the association later received more than 4,000 complaints from investors. After the shock, amid the soul-searching that ensued, NASD made a number of changes in its operations.
Because investors had accused OTC stock brokers of not answering the phone while the crash was in progress, so that shareholders were unable to bail out of the market, the association eliminated phone ordering altogether. Instead, in effect, it forced all market makers into its previously instituted Small Order Execution System. To do this, NASD instituted a computer-to-computer purchasing system called Order Confirmation Transaction, which was designed to handle large orders. By the end of January 1988, this program had replaced the telephone with software which electronically transferred orders, offering greater efficiency and capacity than the phone-based system.
In July 1988, NASD moved to put the last price quotes of penny stocks, previously listed on the "pink sheet," on line, in an effort to better police the market. In addition, NASD stepped up its market surveillance overall, searching out embezzlement, misrepresentation, and unauthorized trading on its own, rather than waiting for an investor complaint to act. The association began to refer criminal violations to the Justice Department, and made brokers' NASD disciplinary proceedings part of the public record. With all of these moves, NASD hoped to rebuild the public's confidence in the financial markets.
By the end of the 1980s, these efforts had proven largely successful, and NASDAQ resumed its strong growth. In March 1991, the association moved to branch out into another aspect of the financial industry when it developed a system to provide price quotations and trading data on high-yield debt and other fixed income securities, known colloquially as junk bonds. Called Fixed Income Prototype System (FIPS), this system was developed at the behest of the S.E.C.
Two years later, NASD began a push to expand into other markets, when it petitioned the S.E.C. for the right to trade index warrants on the NASDAQ indices. A few months later, the association also moved to enter the market in derivatives and hybrid products. If the proposals were approved, NASD would be taking on the other exchanges in these fields.
In May 1993, FIPS began operating, bringing enhanced transparency to the junk bond market. With the NASD system, trading in these securities was made more straightforward and easy to police, since the computer retained an audit trail of all transactions. At its start, FIPS covered 50 bonds. With this service, smaller profits on bond sales were anticipated. Brokers hoped that higher volume, with the increased credibility of the market, would offset this decrease.
Three months later, NASD also tried to refine its Small Order Execution System. Over the years, NASD had discovered that the system was being abused in a number of ways. To prevent outsiders from using it to break the monopoly of the market makers, the association proposed that the maximum order be cut from 1,000 shares to 500. In addition, NASD requested permission to partially dismantle the system, removing the mandatory lowest bid feature, and replacing it with an order routing and execution system that would give market makers wider latitude in trading.
In addition to fine-tuning its computerized stock market at home, NASDAQ worked to export its proprietary technology and programs to other countries seeking to set up capital markets. In 1993 the London Stock Market announced that it was considering a purchase of NASDAQ's system. Markets in Paris, Frankfurt, Sydney, and Toronto had also moved toward a screen-based, rather than trading floor-based, system. National markets in Argentina, Korea, and Taiwan were also set up on the NASDAQ model. Whether or not these would indeed become the "Stock Market for the Next 100 Years," as the company's advertising campaign proclaimed, it seemed clear that automated trading in general and the markets regulated by NASD in particular would continue to grow and thrive in the coming years.