In all, the BiosGroup model delivered six key findings—most of them troubling to Nasdaq. Besides the impact of decimalization, the most worrisome was the realization that market makers began to change their trading strategies as the bid-ask gap came under attack from individual day traders as well as institutional traders seeking the lowest transaction fees. The simulation wasn't completely clear on exactly which new tactics market makers would embrace, but it seemed likely that trading on ECNs would increase substantially—and Nasdaq's transaction-fee revenue would consequently drop.

Two years after BiosGroup finished its work with Nasdaq, the simulation has turned out to be a remarkably accurate predictor of the future. Five of its six conclusions proved to be accurate. Only the forecast that overall trade volume would increase did not come true—but that was primarily the result of the bursting of the bubble. That highlights a limitation of these models, says Alexander Outkin, a member of the BiosGroup team that created the Nasdaq simulation and now a chief scientist at Strategic Analytics Inc. in Santa Fe: "The model made its predictions based on the market conditions at the time the model was run. Then, the market bubble burst, fewer people wanted to buy stocks and volume dropped, proving us wrong. We were working with information that was correct for its time, but incorrect for the future."

As a management tool, says Berkeley, the agent-based model was especially potent. It allowed him to brace the organization for the ringing changes that decimalization brought when it was finally introduced in April 2001. For instance, as suggested by the model, Nasdaq's market share has dipped. In the first quarter of 2003, the percentage of share volume in Nasdaq-listed stock executed on Nasdaq's systems fell to 19 percent from 31.6 percent in the first quarter of 2002. What's more, Instinet now tops Nasdaq in trading volume on Nasdaq stocks, and other ECNs are making inroads. But this revenue hemorrhage to other electronic exchanges could have been worse had Nasdaq not focused during the past few years on building its own version of an ECN, called SuperMontage.

"Nasdaq has spent a lot to improve their technology and make their system more desirable to trade on," says Ken DeGiglio, chief technology officer at Renaissance Trading Technologies, which makes a portal system that links market makers to all of the over-the-counter electronic exchanges. "But the fact is Nasdaq will have to keep the pressure on, because now it's just another trading destination."

Meanwhile, Nasdaq management, expecting a consolidation of its market makers as spreads declined and their profits were hammered, has developed a cost-containment program that even now continues to reduce technology and overhead expenditures, by as much as 6 percent in the first quarter of 2003 over the year-earlier quarter. With all of this and a bear market, Nasdaq has at least held its own. Net income is up 13 percent in the first quarter compared with the prior quarter despite a 10 percent drop in revenue during the same period.

"The model clarified the important management issues that we had to face," says Berkeley. "Our traditional economists pooh-poohed all of it, but I'm confident that the agent-based model was a better way to look at our marketplace than statistically standard deviations. The hardest thing for a manager is to think clearly. The model forces that discipline on you."

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