Keynote Address

Matthew Goldstein
President, Baruch College:

It is a special privilege for me to introduce the President of The Nasdaq Stock Market, Alfred R. Berkeley, III. Al is quite a person, I am told. I have never met Al except for a few minutes ago, but I have it on great authority. I have spoken to Bob Schwartz about Mr. Berkeley and he has given me some inside information to share with you.

Going back to the 1970s, Al has been involved with technology. I can put it in perspective in the following way: He was a visionary with regard to technology when Bill Gates was still in high school. While at Alex. Brown, he figured out how technology is where you want to be and today it is understandable why Alfred Berkeley is running the Nasdaq market.

Nasdaq, as a market center, makes heavy use of technology. With regard to its listed companies, we read all the time in the press about Nasdaq being the market that is laden with technology companies. But it is not only technology. Al knows how to treat the people around him. From what we have heard, his people really appreciate it and deeply respect him for the dignity that he bestows upon them.

Under Al's leadership, much emphasis has been placed on providing information to shareholders about the Nasdaq-listed companies. For this purpose, the Web is now being used extensively. Much emphasis is now also being placed on openness, particularly with regard to discussions about the Nasdaq market. Nasdaq has reached out in its discussions with broker/dealers, buy-side traders, and, I might say, to academics as well.

Without this openness, a day like today would not have been possible. Nasdaq leadership not only endorsed this conference, they not only provided funding for it, but they also let us organize the conference with absolutely no intervention on their part. They responded to our request for help, but they insisted that this is our conference—without any kind of interference at all.

This is remarkable. To have this openness and "hands off" is something that we in the University community deeply admire and respect. We have spent an entire day analyzing, debating and, at times, criticizing their market in a public forum, and we have done so with their full support of the process.

It has been excellent having Nasdaq with us at Baruch today. We look forward to our ties with this market center strengthening further in the future. Ladies and gentlemen, it is truly an honor and a privilege for me to introduce Alfred R. Berkeley.

"Technology Curves, Innovation, and Financial Markets"
Speaker:
Alfred R. Berkeley, III
President, The Nasdaq Stock Market:

Having spent many years as a securities analyst and, more recently, as a market operator, I am delighted to have this opportunity to speak before people who have spent just as long studying the markets we are running. I also want to thank Bob Schwartz and the Zicklin School of Business, Baruch College, for putting together this open forum on the pros and cons, not just of Nasdaq, but of the entire engine for capital formation in the U.S. and around the globe.

Let me start by telling you a little about myself. Before coming to Nasdaq two years ago, I had spent 20 years at Alex. Brown, including a couple of years running their back office operations. I walked by the trading desk every single day and thought that I knew everything there was to know about trading. After the last couple of years at the helm of Nasdaq, I can tell you that I didn't know much about it at all.

When I consider the steady stream of international business and government leaders who visit Nasdaq these days, I am gratified and often humbled by the trust that is placed in us. Very often these visitors are looking to us for help in setting up an entrepreneurial economy. They look to Nasdaq because we have become a beacon of light pointing to free and open markets that invite competition and reward risk-taking.

Recently, we were visited by officials from a South American country that is trying to make the difficult transition from military rule to democratic capitalism. They needed advice on everything from bankruptcy and contract law to setting up a securities market. We spent a lot of time coaching them on the essential building blocks that have to be in place before someone can pick up a phone and say "Yes, I'll buy 'x' million dollars worth of 'y' for you" and do that sight unseen. Completing that kind of transaction presupposes the existence of a paperless, verbal marketplace, which is a very complex value proposition.

So, there is a lot more to the wondrous engine of capital formation than just the Nasdaq market itself. I'm sure that you have heard a great deal about the parade of new issues that is coming before securities markets. A few weeks ago Bob (Schwartz) and I were talking about the possibility of Nasdaq positioning itself as a sort of "Ellis Island of capitalism," and doing so very proudly.

On that score, Baruch College and Nasdaq have a lot in common. Baruch opens doors of opportunity for tens of thousands of people who have a burning desire to succeed by living by their wits. Similarly, at Nasdaq you don't have to buy a seat, but you do have to take exams, which has incredibly important implications for the type of markets we are creating. Let me describe just a couple of these implications and their connection to the trading initiatives we are working on now at Nasdaq.

What does it mean when a securities market has a limited number of seats? What does it mean when your capital has to go into your trading inventory? This is a simple but highly significant hurdle for any new business. If Bob and I were to try to start up "Berkeley Schwartz, Inc.," and try to find our way into the order flow, we would have to contend with one very basic reality. We would have to compete with dozens of other firms that are already happily resident in the order flow. To make ourselves heard above all the competition, we would have to do something else. We'd have to innovate. It is the total amount of innovation, compounded from all sides in an intensely competitive market, that makes the difference. In any single month, quarter, or year, it may not look like much innovation is taking place in the market. But the overall effect of innovation resembles the compound return you get on a savings account. While it doesn't look like much in the short run, compound innovation over time is an awesome force to be reckoned with.

When you look at America's financial markets, one place you will find real innovation is in the trading technology arena. Much of it is taking place under the Nasdaq umbrella. Innovation is coming to us from electronic communications networks that enter the Nasdaq quote montage as broker/dealers; innovation is coming from software companies that are writing innovative trading desk software to fit our computer system; and it's coming to us indirectly from competitors that interface with other competitors.

It is this compounding of innovation that allows us constantly to drive down costs and raise performance. Could Nasdaq afford to do all of this by ourselves? Not at all! Like the structure of the World Wide Web, where no single participant is dominant, Nasdaq enjoys "network economics," which is like the economies of scale of a phone book. The more telephone numbers there are, the more useful it is to the customer. What has happened since 1990 is that Nasdaq has reached "critical mass," in terms of the number of companies participating in our market and the benefits we are able to offer them.

A number of large and very innovative companies, like Intel and Microsoft, recognized Nasdaq's power of critical mass early on, which led them to us. Not long ago, I asked leaders of these companies why they stayed with our market. What they told me was surprising, at first. They said they stayed with us because they planned to get much bigger. I was stumped and asked them to keep talking. They told me that the biggest markets in the world-currency markets, government bond markets and oil markets—all have the same structure as Nasdaq.

I hadn’t thought about it that way, but they were absolutely right. The biggest global markets are organized around networks, with a multi-participant structure, because that is the best way to generate sufficient capital to provide liquidity.

The more I thought about it, the more sense it made-especially when you applied it to Nasdaq's screen-based, competitive-dealer structure. The fact is that technology develops along a curve; it gets better over time and then peaks out. No matter how much more is invested in it, performance does not improve.

For example, consider the growth curve of the eight-bit computer chip. Companies kept trying to improve it, but beyond a certain point it was essential to come up with a 16-bit chip. Once the 16-bit chip was introduced, it still had to overcome certain disadvantages. The new chip had less functionality and lacked an installed customer base and training infrastructure. Nevertheless, the potential of the new chip to outperform the old one was undeniable.

The same is true of securities markets. There are technology curves at work in the way these markets operate that are very important to understand. In 1972, communications technology was such that there was no alternative but to trade in a physical, paper-bound market centered in one place. But the technology curve in trading has vastly accelerated-from the telegraph and ticker tape machine, to telephones and high-speed computers and communications networks. Today, even this technology curve is starting to wear out.

The technology curve that Nasdaq is part of derives from the 1960s, when Dartmouth College came up with computer time-sharing, which allows multiple users onto the same computer. This represented a major challenge to the existing technology curve, and helped propel Nasdaq into the age of screen-based, competitive-dealer trading.

Guess what! We have pushed the existing technology curve about as far as it will go and a new technology curve is on the horizon. It is as threatening to Nasdaq’s trading technology as ours was to its predecessor.

The easiest way to conceptualize the new trading paradigm is to think of the World Wide Web. Its full significance is difficult to appreciate because it is part of an adjacent technology curve—similar in some respects to proprietary information services, but very different in terms of its unlimited access to the market. When markets move from an old technology curve to a new one, there is normally a gap, and that can be startling at first.

At Nasdaq we know that we have to move to the World Wide Web. We have developed a three-part plan with that in mind. The first component rests with putting quotes on the Web, which we are doing on a 15-minute-delay basis. Our Web site, Nasdaq.com, is attracting a very large audience, averaging seven million hits daily. Ninety to 95 percent of these hits are for stock quotes. There is a huge pent-up demand for basic information on companies.

The second part of our strategy is to team up with Nasdaq Market Maker firms to put order entry functions out on the Web. There are roughly 20 companies that are now gathering orders over the Web in one way or another. We expect to see that explode over the next two years. There isn’t a significant broker/dealer in America that doesn’t recognize the promise and the threat that the Web represents to the existing order. The third piece of this structure, which is further out on the horizon, is figuring out if we need to move trading onto the Web. That possibility already exists, because huge intranets are currently available. You may have seen MCI’s advertisement proclaiming that they run the largest U.S. intranet, spanning more than a quarter of a million miles of leased network capability. That intranet is Nasdaq. It has 6,000 trading terminals, and connects our data vendors to 420,000 information terminals around the world. This is an enormously significant network, because it reaches virtually everyone who wants intranet access.

Having said that, what is Nasdaq doing to stay competitive amidst the cataclysmic shifts taking place in the marketplace? We strongly believe that the future belongs to the market that is the low-cost provider. In other words, markets will follow cost. They have in every other market, and they will in ours as well. For that reason, we’re working on driving our cost per transaction as far down as possible.

What's standing in our way? A major consideration is regulatory assurance. We operate in a regulatory environment that is subject to the Securities and Exchange Commission as well as Nasdaq's sister self-regulatory organization, NASD Regulation. We are working with regulators to come up with the right mix of change and stability so that markets can continue progressing technologically. The SEC’s request for comments on its Concept Release (pertaining to the role of alternative trading systems as securities markets rather than as brokers) is part of this evolutionary process.

The larger issue for our society is how to deal effectively and fairly with the communications revolution spawned by the microchip and the World Wide Web. This is difficult enough for a market to deal with, much less a government that has to be open and accountable to everyone. That is why the SEC is seeking comments on the proper balance between current securities markets and newer alternative trading systems.

What is the answer? Where should markets be heading? I have asked that question of my staff as well as securities industry participants. Simply put, the consensus at Nasdaq is "put investors first."

Now, a lot of people are cynical about that. But I have become a fervent believer that we cannot make our market right for anybody unless we can make it right for investors first. If it’s right for investors, it will be right for the companies that trade on our market; and if it is right for these Nasdaq-listed companies, it will be right for Nasdaq Market Makers, namely, the firms that buy and sell Nasdaq securities.

We have spent considerable time at Nasdaq discussing what "putting investors first" really means. We have a strategic planning group that has studied this thoroughly. We also brought in one of the pre-eminent management consulting firms to help us understand what happens when you put investors first. If you apply this concept to all parts of your strategic plan, what alignments change?

In addition to what our studies told us, Nasdaq’s performance this year has helped us answer this question. So far this year, the pendulum has been swinging in favor of investors, in part due to implementation of the SEC Order Handling Rules, which has lowered their trading costs.

The SEC Order Handling Rules brought a tremendous flow of orders into our quote stream, which gave us enormous liquidity, particularly for our largest stocks. I can tell you, it is quite ironic that "the little market that could," whose primary function has been capital formation for entrepreneurs, has suddenly become a market unlike any other for many of the America’s largest companies.

For example, last week we traded 125 million shares for MCI and WorldCom. That volume was for those two companies alone, without a single market closing. There were no "order imbalances."

We now have a situation where the pendulum is swinging very much in favor of the investor. So, where does that leave the Market Makers? Can they still make a living balancing risk with the reward? My answer is that Nasdaq has an important role to play in answering that question. All markets have a very important role to play in keeping transaction costs low so that investors get the best price and the industry is still able to make a profit.

The way to do that is by harnessing the incredible proliferation of desktop computing power that characterizes this market. That amounts to leveraging the "webbiness" of this market to drive our volume higher and higher over this fixed base. And we have plans to move to PCs so that we can cut the cost of that fixed base very substantially.

In theory, there is no reason we cannot trade our 6,300 securities on 6,300 PCs. With the right software, PCs have enough power to get the job done. The machine I’m using right now to keep track of my notes is more powerful than the one I used to run all of Alex. Brown’s operations in the mid-1980s! That is hard to believe, but it’s true.

The power of the PC gives us the leverage to drive down our cost structure so that investors get very low trading cost, and we will still have sufficient profit to build the facilities and markets we need. What are these facilities, and how do we know that they are the right ones?

I believe in listening to customers, because they will tell you what they want. We did that at Nasdaq, and then looked to see where people were voting with their wallets. In other words, talk is cheap and trades are real! Where you find the growth in trading, you will find what people really want.

We also looked at survey results. The surveys said that investors want anonymity. They want a single integrated price discovery execution and reporting system. In other words, "make my desk less complicated." Customers are telling us that they have all these functions to perform—finding the liquidity and the price, negotiating, price reporting, and keeping track of all these things.

In a nutshell, customers are telling us they want a central limit order file. There has been a lot of talk today about limit order files. It is in the Security Traders Association (STA) survey. Customers want the ability to negotiate price. They want maximum order influence. In other words, let’s get all the interest in the stock available for people to deal in. They want time priority and they want decimal pricing. But they are also worried about Year 2000 issues. First, they want to take care of those bugs, then they want to move on to decimal pricing. There is too much risk in trying to manage both of these issues at the same time.

After listening to customers, what did we decide to do? We arrived at a value proposition that rests fundamentally on driving cost down and functions up—which is what customers really want. We have learned that if you provide customers with a certain level of service today, they will want more tomorrow. You might call that an inexorable law of today’s marketplace.

You cannot stay where you are in any business. The problem at Nasdaq is that we have pretty much stayed put for the last couple of years, and we need to innovate once again. We need to take the check list that the STA developed for the entire country and get it done. And that is what we want to do.

We have a rule filing that will be submitted shortly to the SEC that essentially hits all the points on this list, except for decimals. We hope we can implement our filing, because if we don't make these innovations, someone else in an unregulated environment will.

You cannot stop progress, and we know that the world is not going to stop for Nasdaq. If investors do not find these trading functions at Nasdaq, they will find them somewhere else.

The changes we have made recently in our market have not been without controversy. For all the strengths the order handling rules have brought to the market, they have left a sense of inequality in the Market Maker community. Many Market Makers feel that they would rather be an ECN, or at least would like to have one as an alternative.

The handwriting on the wall is clear. Either Nasdaq provides these advanced functionalities, or others will. And if that happens, it will fragment liquidity in the industry, which will create a very different set of economics, one that adversely affects investors.

As presently constituted, Nasdaq performs a valuable "utility" function for the industry by bringing together the bids and asks and putting out the trade report. We see that function continuing, in addition to the other enhancements I have mentioned.

All in all, we are still seeing extraordinary growth in this market. We are running about a hundred million shares a day more than we ran last year. People ask "why?" I believe it is because we have a better market than we have ever had before. It comes down to Economics 101. Our market structure makes it cheaper to trade. The liquidity is there and, therefore, there is more trading. And we will continue to ride that technology curve as we go forward. There is no standing still—not for Nasdaq, or for anyone else in this industry.

Thank you.