Last week, the Nasdaq stock exchange, controlled by the Nasdaq OMX Group Inc. (NDAQ), sustained what might be the worst computer-related shutdown of an American market. Though the damage to investors from this shutdown was minimal, the company's reaction to this problem and its recent history indicate that a management change at the highest levels must be considered.
Before I get into the nitty-gritty of the problem, I must preface it by stating that it really is true that the average retail investor was not bothered by this shutdown. This is true for many reasons, including that the average American has limited equity exposure and that the majority of it is limited to mutual funds that are held in employee sponsored retirement accounts such as 401(k)s and 403(b)s, among others, and such funds do not even allow for mid-day buying, selling or trading.
As a result, mutual fund and employee sponsored retirement plan holders missed no opportunities to buy or sell. Moreover, for those investors who could and did want to buy or sell intra-day, the market did still provide them with the opportunity to do so in the late afternoon, and valuations were largely unaffected by the shutdown. Therefore, the shutdown only postponed any possible retail activity by a few hours. Such transactions were not even a day later, and not a dollar shorter.
The primary entities to truly get affected by the shutdown were day-traders, including high frequency computerized trading, Such entities are in many ways only looking for opportunities to exploit short-term market inefficiencies and front-run presumed or already recognized investor activity. As a result, most of the blood-pumping populace will not shed a tear for their mid-day recess. Still, those entities tend to be large member firms that likely have a growing level of dissatisfaction with the Nasdaq marketplace.
What is likely most shocking about this shutdown and other recent problematic events is that they have hardly minimized market confidence in the concept of a for profit exchange or in Robert Greifeld, the Chief Executive Officer of the Nasdaq OMX Group. This may soon change. As a public company, the Nasdaq OMX group's primary responsibility is to maximize shareholder value, and this would appear to be an inherent conflict of interest with the broader public's interest in minimizing costs and inefficiencies related to the acquisition and divestment of securities.
There is a threshold question as to whether it is in the best interest of the public for securities markets to be private, and especially now when it would appear a digitized open marketplace that would be more orderly, efficient and transparent could be developed. Moreover, it raises a question as to whether recent issues are a consequence of endeavors for the benefit of the exchange owners and at the expense of market participants. This is an issue that is complicated and it is certainly possible that competing private exchanges can produce a better marketplace than would a public counterpart. Investors should expect a coming debate over this issue as well as government scrutiny of the matter.
In the nearer term, the value of Bob Greifeld's continued stewardship is a more pressing matter. Greifeld became Nasdaq's CEO on May 12, 2003. Under his tenure, the company's equity has performed well, with shares appreciating nearly 400 percent and substantially outperforming the indices. Much of this outperformance was due to the growth in global equity trading that occurred prior to the sub-prime fueled market collapse. Greifeld had sought to further the company's growth through some high profile acquisitions, including the failed attempts to purchase the London Stock Exchange in 2007 and the NYSE Euronext (NYX) in 2011.
This most recent shutdown was apparently not directly caused by anything in particular that the company or Greifeld did, but instead by connectivity issues that degraded quote processing. It would appear wholly possible that such an issue could have been prevented through the existence of a double redundant backup system, though it is still premature to diagnose the problem's cause or cure. Nonetheless, and even presuming that the problem was wholly external to the company's practices, those practices can be an issue.
On Friday, Mr. Greifeld argued that Nasdaq "communicated with our constituents as well as we possibly could have." Sadly, this does not necessarily mean that the company communicated well, but instead that the company couldn't possibly do so. Moreover, claims that the shutdown was set off by another participant indicate a lack of responsibility for the entity's own failings, including communication of and responses to external issues.
This is the second recent public issue for the company, following Nasdaq's mismanagement of the initial public offering of Facebook Inc. (FB) on May 18, 2012. The IPO's problems should have indicated to the market that though the company was growing and benefiting from inevitable volume increases and digitized efficiencies, it lacked focus on risk mitigation and public communication.
When the Facebook IPO issues developed, where was Nasdaq's leader? He was at FB's headquarters, clear on the other side of the country from Nasdaq's own headquarters, standing in the spotlight, applauding an accomplished mission that was actually falling to pieces. This, too, was an example of the poor systems and decision-making processes and while Nasdaq's technology failed, Mr. Greifeld was busy commuting by plane back to New York, where a leader was needed. The company subsequently settled SEC charges of poor systems and decision-making relating to the debacle for $10 million, and submitted a plan to pay $62 million to member firms that sustained losses.
Market participants bore hundreds of millions of dollars in losses related to the Facebook IPO, and it is likely that the bulk of these losses were directly due to Nasdaq's conduct prior to and during the offering. Several member firms have argued that Nasdaq's proposed plan does not adequately address the scope and magnitude of the market's failure(s) and the member firm losses. The company is shielded from total liability and requirements for total restitution due to rules and regulations that were developed when exchanges were owned by the securities industry rather than by a publicly traded entity. Much like the need for revised Nasdaq systems, these rules also require updating and it is probable that exchanges will not benefit from such liability protection in the future.
While this latest disruption did not result in substantial losses, that does not mean it was not a sign of a substantial problem, just like how a drunk driver is a problem even if managing to drive past a school without hitting children. And much like that drunk driver, the markets have been moving forward, confidently presuming that there is no chance for them to fail. In reality, there will always be a chance of failure, and regulations require modification so that the proper parties are held responsible for failing.
There can be no doubt that the exchanges will now receive enhanced scrutiny by regulators and fortified complaints by member-firms. This probable coming assault on negative publicity may hurt share prices and force Nasdaq to make changes in its management. Greifeld should do himself a favor and announce his retirement before this onslaught further tarnishes his broader market reputation, which is still favorable. The longer he stays onboard, the more likely he is to be blamed for past and possible future issues. Moreover, a present departure can be on his own terms, while any further issues will likely prompt his removal.
In the near-term, the level of uncertainly surrounding NDAQ is increasing and such uncertainty is generally a bad thing for equity performance. Given its recent substantial outperformance of the market, it is of growing likelihood that the company will enter a period of underperformance while this shadow of overhanging uncertainty persists. Investors may benefit by waiting for the next shoe to drop.