Order Code RS21193
Updated March 29, 2005
CRS Report for Congress
Received through the CRS Web
Nasdaq’s Pursuit of Exchange Status and an
Initial Public Offering

Gary Shorter
Specialist in Business and Government Relations
Government and Finance Division
Summary
Until recently, 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. The process has three broad 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).
Obtaining exchange status is necessary for Nasdaq to proceed to stage three of
Introduction, its conversion to an independent shareholder owned market — a public
stock offering. A major reason that the SEC continues to hold up Nasdaq’s exchange
application is that exchanges must comply with a trading protocol in which they provide
execution priority to the best priced offers to trade known as price priority. As an
association and not an exchange, Nasdaq is not beholden to such a rule. And SEC
officials have been reluctant to grant it exchange status without a price priority trading
protocol, which Nasdaq officials say is an intrinsic and beneficial part of its business
model.
Introduction
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).
Congressional Research Service ˜ The Library of Congress

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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
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 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.
Occurring in growing numbers of stock exchanges worldwide, demutualization
appears to be attractive for three central reasons: (1) it would enable exchanges to more
immediately raise capital and provide better regular access to capital markets; (2)
exchanges would be better able to align their interests with those of their key participants
and; (3) probably most importantly, it would provide exchanges with greater flexibility
and speed in adapting to changing market conditions.
In the last several years, the Chicago Mercantile Exchange and the the Philadelphia
Stock Exchange have demutualized. In addition, the Pacific Exchange demutualized its
equity business, allowing it to align with the ECN Archipelago, which became ArcaEx.
SRO Concerns Raised by Demutualization
In the summer of 1999, the Nasdaq and the NYSE announced their intent to
demutualize. A debate largely on demutualized stock markets’ ability to effectively
discharge their SRO duties ensued in Congress, the SEC, among some academics, and
various members of the financial community. Among the key questions raised were the
following: (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 ECNs? and (2) Would the altered economics of being a for-profit,
shareholder-owned exchange affect an exchange’s ability to effectively regulate itself?

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Nasdaq’s Demutualization
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, is a requirement for the third stage
— sale 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 can relinquish control of it, Nasdaq must register as a national securities exchange.
The NASD’s majority voting interest is currently voted by a trustee at its behest. 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). And according to some Nasdaq officials, an IPO in which the voting
rights are still controlled by another entity (currently the NASD) would probably have
diminished appeal.
Approval of Nasdaq’s exchange application would also mean that the stock market
would become its own SRO, legally independent of the NASD and on the same legal
footing as the other domestic exchanges. On March 15, 2001, Nasdaq submitted its 8,000
page application for exchange status to the SEC, an application that the agency published
for comment on June 14, 2001. As a group, ECNs have been rather critical of the
application. Criticism has also come from other interests, including the NYSE and the
Securities Industry Association (SIA), a major association of securities firms. And citing
some concerns, the SEC has delayed acting on the exchange application. Its core concern
is described below.

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Some Responses to the Exchange Application
The NASDR is currently contracted to perform regulatory functions for Nasdaq
under the auspices of the NASD, which has SRO responsibility over Nasdaq. Nasdaq
officials say that NASDR will continue its contracted SRO relationship with the stock
market. With receipt of exchange status, however, Nasdaq would move from under the
NASD/NASDR self-regulatory-organization umbrella and be ultimately responsible for
its own SRO obligations, its members, and its operations.
A number of the concerns expressed in the comments on Nasdaq’s exchange
application have related to the potential ramifications of such a change. Other comments
involved concerns over the absence of key data on Nasdaq’s post-exchange structure, and
issues surrounding Nasdaq’s proposed membership rules. Among those issues were the
following: (1) Given some observers’ perception that SROs have had a history of favoring
certain segments of their membership over others, or of ignoring potential misconduct that
benefitted the SRO or its members, there were concerns that giving Nasdaq for-profit,
shareholder-owned exchange status might impair its ability to effectively and impartially
carry out its SRO functions. (2) Nasdaq was also criticized for its perceived failure to
disclose important information about its post-exchange trading rules and its corporate
governance methods. (3) Nasdaq’s new proposed membership rules were criticized for
requiring a Nasdaq member to be a member of at least one other self-regulatory
organization before it could apply for membership in Nasdaq.
SEC Concerns Over the Exchange Application and
Some Congressional Responses
The SEC has now had the Nasdaq exchange application for several years. The
central hold up is over the agency’s concern with how 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 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 argue 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 is a major sticking point in its reluctance to approve the exchange
application. Exchange officials are also concerned that if they provide Nasdaq with an
exemption from price priority, other exchanges will ask for the same, potentially resulting
in a “race to the bottom” among exchanges.
During the 108th Congress, a number of Members spoke of their concerns that the
SEC was dragging its feet on Nasdaq’s application. They included the Honorable Richard

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Baker, chairman of the Capital Markets Subcommittee of the House Financial Services
Committee, and the Honorable Michael Enzi who is now chairman of the Senate Health,
Education, Labor and Pensions Committee.
In December 2004, SEC staffers announced that they were optimistic about having
reached a breakthrough on Nasdaq’s long-pending exchange application and that they
would be presenting the plan to the full commission.

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