<DOC>
[106th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:63803.wais]
COMPETITION IN THE NEW ELECTRONIC MARKET
=======================================================================
HEARINGS
before the
SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS
of the
COMMITTEE ON COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
__________
PART I--MARCH 29, 2000
PART II--MAY 11, 2000
__________
Serial No. 106-111
__________
Printed for the use of the Committee on Commerce
U.S. GOVERNMENT PRINTING OFFICE
69-533 WASHINGTON : 2000
COMMITTEE ON COMMERCE
TOM BLILEY, Virginia, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana JOHN D. DINGELL, Michigan
MICHAEL G. OXLEY, Ohio HENRY A. WAXMAN, California
MICHAEL BILIRAKIS, Florida EDWARD J. MARKEY, Massachusetts
JOE BARTON, Texas RALPH M. HALL, Texas
FRED UPTON, Michigan RICK BOUCHER, Virginia
CLIFF STEARNS, Florida EDOLPHUS TOWNS, New York
PAUL E. GILLMOR, Ohio FRANK PALLONE, Jr., New Jersey
Vice Chairman SHERROD BROWN, Ohio
JAMES C. GREENWOOD, Pennsylvania BART GORDON, Tennessee
CHRISTOPHER COX, California PETER DEUTSCH, Florida
NATHAN DEAL, Georgia BOBBY L. RUSH, Illinois
STEVE LARGENT, Oklahoma ANNA G. ESHOO, California
RICHARD BURR, North Carolina RON KLINK, Pennsylvania
BRIAN P. BILBRAY, California BART STUPAK, Michigan
ED WHITFIELD, Kentucky ELIOT L. ENGEL, New York
GREG GANSKE, Iowa TOM SAWYER, Ohio
CHARLIE NORWOOD, Georgia ALBERT R. WYNN, Maryland
TOM A. COBURN, Oklahoma GENE GREEN, Texas
RICK LAZIO, New York KAREN McCARTHY, Missouri
BARBARA CUBIN, Wyoming TED STRICKLAND, Ohio
JAMES E. ROGAN, California DIANA DeGETTE, Colorado
JOHN SHIMKUS, Illinois THOMAS M. BARRETT, Wisconsin
HEATHER WILSON, New Mexico BILL LUTHER, Minnesota
JOHN B. SHADEGG, Arizona LOIS CAPPS, California
CHARLES W. ``CHIP'' PICKERING,
Mississippi
VITO FOSSELLA, New York
ROY BLUNT, Missouri
ED BRYANT, Tennessee
ROBERT L. EHRLICH, Jr., Maryland
James E. Derderian, Chief of Staff
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Finance and Hazardous Materials
MICHAEL G. OXLEY, Ohio, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana EDOLPHUS TOWNS, New York
Vice Chairman PETER DEUTSCH, Florida
PAUL E. GILLMOR, Ohio BART STUPAK, Michigan
JAMES C. GREENWOOD, Pennsylvania ELIOT L. ENGEL, New York
CHRISTOPHER COX, California DIANA DeGETTE, Colorado
STEVE LARGENT, Oklahoma THOMAS M. BARRETT, Wisconsin
BRIAN P. BILBRAY, California BILL LUTHER, Minnesota
GREG GANSKE, Iowa LOIS CAPPS, California
RICK LAZIO, New York EDWARD J. MARKEY, Massachusetts
JOHN SHIMKUS, Illinois RALPH M. HALL, Texas
HEATHER WILSON, New Mexico FRANK PALLONE, Jr., New Jersey
JOHN B. SHADEGG, Arizona BOBBY L. RUSH, Illinois
VITO FOSSELLA, New York JOHN D. DINGELL, Michigan,
ROY BLUNT, Missouri (Ex Officio)
ROBERT L. EHRLICH, Jr., Maryland
TOM BLILEY, Virginia,
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Hearings held:
March 29, 2000, Part I....................................... 1
May 1, 2000, Part II......................................... 71
Testimony of:
Andresen, Matthew, President, The Island ECN................. 6
Atkin, Douglas M., CEO and President of Instinet............. 75
Dorsch, Shawn A., President and COO, DNI Holdings, Inc....... 20
Foley, Kevin, CEO, Bloomberg Tradebook....................... 13
Jenkins, Peter W., Director of Equity Trading, Scudder Kemper
Investments................................................ 106
Kamen, Kenneth A., President, Princeton Securities
Corporation................................................ 110
Ketchum, Richard G., President, National Association of
Security Dealers, Inc...................................... 100
McSweeney, Robert J., Senior Vice President, Special
Committee on Market Structure, Governance, and Ownership,
New York Stock Exchange, Inc............................... 97
Schaible, John M., Founder and President, NexTrade........... 24
Stark, Holly A., Director of Trading, Kern Capital Management 92
Wheeler, John J., Manager Equity Trading, American Century
Investments................................................ 80
Material submitted for the record by:
Andresen, Matthew, President, The Island ECN, letter dated
May 2, 2000, to Hon. Tom Bliley, enclosing response for the
record..................................................... 64
Foley, Kevin, CEO, Bloomberg Tradebook, responses for the
record..................................................... 50
Galbraith, Steven, Senior Investment banking and Brokerage
Analyst, Sanford G. Bernstein & Co., prepared statement of. 163
Ketchum, Richard G., President, National Association of
Security Dealers, Inc., responses for the record........... 264
McSweeney, Robert J., Senior Vice President, Special
Committee on Market Structure, Governance, and Ownership,
New York Stock Exchange, Inc., letter dated June 8, 2000,
to Hon. Thomas Bliley, enclosing response for the record... 270
Putnam, Gerald D., CEO, Archipelago, letter dated March 28,
2000, to Hon. Michael G. Oxley............................. 49
Schaible, John M., Founder and President, NexTrade, letter
dated April 21, 2000, to Hon. Tom Bliley, enclosing
response for the record.................................... 55
(iii)
COMPETITION IN THE NEW ELECTRONIC MARKET: PART I
----------
WEDNESDAY, MARCH 29, 2000
House of Representatives,
Committee on Commerce,
Subcommittee on Finance and Hazardous Materials,
Washington, DC.
The subcommittee met, pursuant to notice, at 10 a.m., in
room 2123, Rayburn House Office Building, Hon. Michael G. Oxley
(chairman) presiding.
Members present: Representatives Oxley, Tauzin, Gillmor,
Bilbray, Ganske, Shimkus, Wilson, Fossella, Ehrlich, Towns,
Engel, Barrett, Luther, Capps, Markey, and Rush.
Also present: Representatives Burr and Rogan.
Staff present: David Cavicke, majority counsel, Linda
Dallas Rich, majority counsel; Brian McCullough, professional
staff; Robert Simison, legislative clerk; and Consuela
Washington, minority counsel.
Mr. Oxley. The subcommittee will come to order. The Chair
will recognize himself for an opening statement.
Technology is changing our lives dramatically as our
economy continues to evolve into an information-based society.
In one decade, we realize the tangible benefits of the
convergence of telecommunications, the computer industry and
the emergence of the Internet. Wireless technology allows us to
communicate, conduct commerce through cell phones or hand-held
PCs and perform other tasks with breathtaking efficiency.
Information is easier to access than we could have ever
imagined just a few years back. The Internet is providing
global competition that has lowered cost to consumers and
businesses.
Our capital markets are experiencing a similar
technological evolution. Better and more readily available
information is changing the composition of the markets. Self-
directed investors now have access to securities professionals
research analysis graphs and quotes from which they can make
informed decisions. Not to commend any particular market
participants' TV commercials, but you know the world has
changed when you see Ringo Starr talking about asset allocation
and portfolio diversification.
Today we begin a series of hearings on competition in the
new electronic marketplace. This is a subject that is as
challenging and as interesting as anything we have examined in
this subcommittee heretofore. Just a couple of years ago,
electronic communication by the Internet and through the
proprietary systems of electronic communications networks, or
ECNs, began a revolutionary and astonishingly rapid
transformation of our financial markets. Even before the advent
of the Internet, technology fostered competition within the
markets. Technology led to the development of the dealer
market, which was conceived as an alternative to the
traditional auction market of the exchanges. That competition
has served the markets well.
More recently, the emergence of ECNs has provided
additional competition in the markets and a possible glimpse
into the future. ECNs vary in their business models, but all
offer an alternative trading mechanism for investors to execute
their trades. ECNs provide investors with many benefits,
including reduced trading costs, faster execution and more
choices of where to trade stock. Some commentators have raised
concerns that multiple venues competing for order flow will
fragment the market, but couldn't fragmentation be just another
word for competition? This is an issue that we will learn more
about through the hearing.
The markets will determine the best price available for a
stock. One of our jobs here in Congress is to make sure that
the rules that govern our markets allow price discovery to
happen in the fairest and most efficient way. I believe
competition should determine the best structure for the
financial markets. The government is notoriously bad at
predicting the future and designing marketplace or picking
winners and losers. What we can do is make sure that the rules
we have put into place foster competition, not monopolistic
behavior.
I look forward to learning about how ECNs are reshaping our
markets. One of the questions that has been raised is whether
multiple markets can function efficiently in a market in which
they are competing for liquidity. While ECNs initially catered
to institutional clients, we are seeing a move into the retail
marketplace. I look forward to learning more about these
developments as well as how these trading models compare with
the traditional auction and dealer markets. We will hear from
these traditional markets at an upcoming hearing on this
subject. I am pleased to welcome today's witnesses who hail
from four very different ECNs, and I will introduce them before
they begin their testimony.
The Chair yields the balance of his time and now recognizes
the ranking member, the gentleman from New York, Mr. Towns.
Mr. Towns. Thank you very much, Mr. Chairman.
Let me also thank you for holding this very important
hearing. The U.S. securities markets, which is the heart of the
subcommittee's jurisdiction, is undergoing rapid change. While
I do not believe that any legislative action is necessary to
address these revolutionary changes at this time, I do think
that it is vital for the subcommittee to closely monitor these
changes. We must educate ourselves on changes in the market and
responsible oversight over the SEC's responses to these
changes. We must ensure that neither our actions nor the
actions of the SEC accidentally threatens the phenomenal
success of the U.S. securities markets, which just happens to
be centered in New York City, which I happen to be from. That
is an important issue.
I have not reached any conclusion on many of these issues
raised by the fundamental changes of our securities markets.
However, I have followed the debate on these issues with
interest. For example, some have stated that the changes in the
securities markets require the introduction of a central limit
order book. This contention raises a number of questions in my
mind. Who would set the rules of a CLOB? Who would enforce
these rules? Would a CLOB deter innovation? The kind of
innovation that is changing our markets for the better today?
We need to be concerned about that. Would all customers'
orders or just retail orders be required to be submitted to a
CLOB? If only retail orders must be submitted to a CLOB, would
this disadvantage these customers? I think these questions need
to be answered, Mr. Chairman, and I think we need to get
answers on these questions before we move forward. Would it
threaten the extremely high level of retail participation that
make our securities markets the envy of the world?
There has also been much discussion of the role of ITS, the
intermarket trading system. In the future, again, I haven't
come to any conclusion, Mr. Chairman, but I do have many
questions. As I understand it, ITS was created at a time when
there was no linkage between securities markets at all. ITS
made it possible for broker-dealers to ensure that they were
getting the best price for their customers. In a way, the
markets relieved broker-dealers from their best execution
obligation. While ITS technology has advanced, questions still
remain, many questions. Is the technology available today for
broker-dealers to take complete responsibility for fulfilling
their best execution obligation without the help of ITS? If it
isn't available, will it be available soon? How will this
change the debate about the structure of ITS? And even the need
for ITS.
Again, Mr. Chairman, thank you for calling this hearing. I
look forward to the testimony of the witnesses today, and at
the other hearing that I understand that you intend to call in
the very near future, and I think that it is important that we
do have that hearing because we are dealing with a situation
where there is a lot of changes, and I think we need to be on
top of them, and I don't think that we need to do something
without really having all of the information before we move
forward.
Thank you, Mr. Chairman, for having these hearings.
Mr. Oxley. Are there any other opening statements?
Hearing none----
Mr. Shimkus. Mr. Chairman.
Mr. Oxley. The gentleman from Illinois.
Mr. Shimkus. I think this hearing is timely and I have to
remark about the young pups we have now testifying who are CEOs
and presidents of these companies. I think that really speaks
to the industry. So the basic question we have to ask is does
the existing regulatory structure encourage or discourage and
questions of safety and soundness. I appreciate you all coming,
and I yield back the balance of my time.
[Additional statements submitted for the record follow:]
PREPARED STATEMENT OF HON. W.J. ``BILLY'' TAUZIN, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF LOUISIANA
Thank you Mr. Chairman.
With the advent of the Internet, we have seen an unprecedented
growth of new goods and services that Americans have simply never had
before.
There are, of course, many benefits to the array of new choices now
provided in competitive marketplaces, but what excites me most about
the way new technologies are changing our lives is that now, more than
ever, the American consumer is empowered to make fully informed
purchasing and investing decisions.
There is no denying that the Internet is transforming traditional
relationships between merchant and buyer . . . between fiduciary and
beneficiary . . . and between institutional investors, issuers, retail
investors, and securities exchanges.
In telecommunications marketplaces, the deployment of ``backbone
infrastructure,'' ``advanced data services over DSL lines and cable
modems,'' ``interactive software,'' and ``fixed and mobile wireless
technologies,'' has, ALMOST OVERNIGHT, given life to an e-commerce
kingdom over which the consumer reigns. Today, consumers can access
tremendous amounts of quality content . . . run businesses . . . shop
at almost any store . . . communicate with friends, family, and
colleagues ALL WITHOUT LEAVING HOME.
In the securities marketplace, we are finding that a similar
phenomenon is taking place. Because of the Internet, retail investors
can now trade securities at home without paying traditional
commissions, they can access analyst research reports that were once
available only to institutional investors, and they can also now invest
in new IPOs at initial offering prices as opposed to higher prices
resulting from trading in secondary markets.
The point I'm trying to make here is that now, more than ever, new
technological advances, as well as Internet-centric business models,
are forcing us to re-examine the roles played by market intermediaries
who for so long have dictated the pace of business . . . of investing.
Today, we are here to learn more about the way that the so-called
``ECNs'' (Electronic Communication networks) are implementing changes
in securities markets. Like nothing we have seen before, ECNs provide a
forum for online trading of stocks, derivatives, and options by
capitalizing upon recent advances in computing power and bandwidth
capacity.
The ECNs (Electronic Commerce Network) are slowly but surely
allowing investors to buy securities from and sell securities to one
another in true auction fashion without having to go through broker-
dealers to execute trades and without having to buy or sell at a price
listed on an exchange.
Because of what they propose to do, ECNs, are no doubt, exciting
new creations of technological advance, and I am looking forward to
hearing more about them from our witnesses today.
However, I want to point out that we have to proceed with caution
when we begin discussing altering life as we know it. While I am very
interested in bringing full investing choice to investors via new
trading forums, it is not time to simply disregard the undeniable value
and importance of current market intermediaries, such as broker-dealers
registered with the NASD and the exchanges.
For purposes of this debate, it is important for me, and for all
the members of this Committee, to understand the full impact of
sweeping market structure changes sought at this point before we can
completely pass judgment on the pending ECN applications for exchange
status.
Ultimately, we have to rely on our process to come up with a
recommendation to the SEC that enables new trading opportunities for
retail investors while affording a fair degree of deference to
longstanding NASD and NYSE policies at the same time.
With that, Mr. Chairman, I yield back. Thank you.
______
PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE
Good morning, thank you Chairman Oxley. The youth on the panel
before us at today's hearing is a testament to the changes new
technology has brought to our markets. New ideas are transforming the
marketplace in ways that would have been unimaginable a few years ago.
Indeed innovation is an engine that will outdo even the most
visionary of prophets. Theodore Vail, the chairman of AT&T at the turn
of the century, had the dream of a phone in every town in America. That
was thinking big. He could not have imagined that folks in our hearing
room today would be carrying a phone in their pocket--never mind that
that phone would not only make calls but also access the Internet, e-
mail, and heaven knows what else by now.
What is happening in our financial markets today reminds me of the
change in our telecommunications markets after the enactment of the
Telecommunications Act. New entrants to the marketplace had been
stymied by regulatory barriers that impeded fair competition. Our
Committee developed the Act to eliminate those barriers. As a result,
new entrants are flourishing, and old stalwarts are being forced to
innovate.
Today, new entrants to our financial marketplace are shaking up the
status quo. The standard-bearers are innovating. Technological advances
and new trading mechanisms are improving price discovery and the
quality of trade executions. Our markets--and investors--are thriving.
But, there is work to be done to ensure that market forces and
innovation in the financial marketplace are not hampered by old
regulations. As one of our witnesses today notes, back in 1975 Congress
instructed the Securities and Exchange Commission, in developing a
National Market System, that ``competition, rather than regulation,
should be the guiding force.'' Those are words to live by.
I believe we should examine the need for regulatory changes in
order to free up the forces of competition. For example, I am curious
to learn more about the impact of changing the rules that limit
membership in the Intermarket Trading System. Today, the ITS does not
include representation by non-exchange marketplaces. And any single
member can veto proposed rule changes. Is this really the best
structure for our modern financial markets?
No blueprint exists for the marketplace of the future. Our task is
to ensure that rules allow the best marketplace to evolve. We may not
be able to imagine what the world will be like when ``a phone in every
pocket'' sounds as quaint as ``a phone in every town.'' But we can take
action to make sure the rules are flexible enough to work in years to
come.
I thank our witnesses today for participating in this most
important initiative of the Subcommittee, and look forward to hearing
from the exchanges and other market participants who will be testifying
at our subsequent hearings.
Mr. Oxley. The Chair would now recognize a distinguished
visitor from another subcommittee, the gentleman from North
Carolina, for the purposes of introducing one of our witnesses.
Mr. Burr. I thank the Chair for the opportunity to be here.
I am amazed that the gentleman from Illinois would compare the
age of the chairman to our witnesses in calling them young
pups, only in comparison to the chairman's age. That would
never happen in another subcommittee.
Mr. Oxley. That is why you're not on this subcommittee.
Mr. Burr. I think clearly the world is changing, as
everybody has said in their opening statements. There is a
North Carolina influence to that, Shawn Dorsch. Shawn is the
founder, president, COO of Blackbird in Charlotte, North
Carolina. He was a former derivative and technology expert at
J.P. Morgan and First Union Bank. He has an degree in economics
from North Carolina State University and I am surprised after
last night's game in the NIT semifinals, since I am a Wake
graduate, he is allowing me to introduce him. Blackbird was co-
founded in 1996 by Shawn Dorsch and Raymond May. Clearly it is
a new and emerging business. It is the first system of its kind
and has significant momentum in the marketplace having signed
up 32 financial institutions as customers.
Blackbird offers its customers a number of advantages,
including significantly lower fees, superior execution,
increased market liquidity and greater operational efficiency.
Gosh, I hope we stay out of the way of what they are
accomplishing. Blackbird was designed with input from leading
derivative dealers. Blackbird is now setting its sites on
revolutionizing the global market by opening offices in London
and Tokyo later this year.
Mr. Chairman, thank you for having this hearing and more
importantly, thank you for inviting who I believe is one of the
best, and I welcome Shawn.
Mr. Oxley. I thank the gentleman. Let me now introduce with
a lot less fanfare the rest of the panel. Mr. Matthew Andresen,
president of The Island ECN. Mr. Kevin Foley of Bloomberg
Tradebook, the aforementioned Mr. Dorsch from Blackbird, and
Mr. John Schaible, founder and president of NexTrade.
Gentlemen, thank you for your appearance today. I see we are
going to have some interactive participation here which is
always good for the committee. We always enjoy that. We will
begin with Mr. Andresen.
STATEMENTS OF MATTHEW ANDRESEN, PRESIDENT, THE ISLAND ECN;
KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK; SHAWN A. DORSCH,
PRESIDENT AND COO, DNI HOLDINGS, INC.; AND JOHN M. SCHAIBLE,
FOUNDER AND PRESIDENT, NEXTRADE
Mr. Towns. Mr. Chairman, may I interrupt for 1 second. We
have two New Yorkers on here, and when I am chairman next year,
I am going to allow you to introduce panel members from your
State.
Mr. Oxley. If you had just asked.
Mr. Andresen.
Mr. Andresen. I would like to thank Chairman Oxley and
members of the subcommittee for holding these important and
timely hearings on the structure and the future of our equity
markets. As this subcommittee begins its deliberations on these
critical public policy issues, we have already heard two
distinct proposals.
On the one hand, the traditional human intermediaries,
uneasy with the effects of enhanced competition, have called
for direct Federal intervention to create a new central public
utility in our dynamic markets.
On the other hand, the new electronic markets like Island
have led the charge to instead knock down the remaining
historic barriers to competition, thereby bringing the benefits
of speed, reliability and transparency that have defined the
ECN model to the market for New York Stock Exchange listed
stocks.
My name is Matt Andresen and I am the president of The
Island. We are a network of over 290 brokerage firms trading
over 200 million shares a day. Island does 12 percent of
NASDAQ's trades. That is one in every eight transactions. Last
year Island matched over 26 billion shares of stock directly
without the spread or time loss associated with traditional
market participants. These shares accounted for a dollar amount
last year of $1.6 trillion. At this time we have unprecedented
numbers of investors in the marketplace, as noted by the
distinguished members already, in 1980 only one in 10 Americans
participated in our markets.
Today that number is over 52 percent. While these investors
have new-found access to market research and market data, some
proposed taking a giant step backwards from these innovations
by calling for a central limit order book or so-called CLOB.
Its advocates claim that the CLOB would cure the fragmentation
allegedly attributable to those in front of you today. I argue
that ECNs have, in fact, consolidated the markets. If you look
at the stock market in 1996 before ECNs, the top four
participants on NASDAQ accounted for 40 percent of the volume.
Yet now in this era of enhanced competition and alleged
fragmentation, the top four participants on NASDAQ now account
for over 60 percent of the volume illustrating the degree to
which open competition facilitates investors consolidating in
the most efficient place. What would the effect be of a
government-installed CLOB? One of the most immediate effects
would be to eliminate a market participant's ability to compete
on the basis of speed, reliability and cost, in essence,
dumbing down the innovative technology, which has so benefited
investors.
It is precisely because of these advantages that investors
have voted with their feet now sending one out of every 3
NASDAQ trades to ECNs. What can we do to extend this
competitive environment on NASDAQ to the market for New York
Stock Exchange listed stocks where competition does not now
exist? There is perhaps no better place to start than with the
1975 congressional mandate for the creation of a National
Market System which gives us the road map. Congress called for
the meeting of two goals: No. 1, competition between
marketplaces; No. 2, accessibility of information to investors.
Today consistent with this mandate, ECNs have their best
prices included in the NASDAQ quote. Island actually goes so
far as to not only include this best price to NASDAQ, but
actually to give all of their prices at all of the price levels
out over the Internet for anyone with a browser. As Chairman
Levitt noted last week, it is terribly important not just to
show investors the tip of the iceberg, but also the entire
iceberg under the water, show them the depth of all of the
supply and demand. We have a demonstration that we will go
through in the Q and A, which shows how someone who has access
to the Internet can have access to the information heretofore,
the province only of traditional market participants.
Isn't it ironic that 25 years later the industries' very
initiatives put in place to meet these two congressional goals
are the very historical franchises now preventing competition.
Island is not able to compete in the market for New York Stock
Exchange listed stocks and is unable to provide their
information to investors.
Mr. Chairman, it is an honor to have had this chance to
present Island's perspective on these critical public policy
issues. These hearings present all of us with a compelling
opportunity to shape the future of our Nation's equity markets
and ensure their continued strength and prosperity. We must be
wary of those proposals, which too quickly embrace Federal
intervention in our free markets and commit us to risky
regulatory schemes. We must not squander the position of
financial strength that we have achieved at great cost and
commitment over the past two centuries. Instead, let us work
toward greater openness and greater transparency and greater
accountability in the market. There is too much at stake to do
otherwise. Thank you.
[The prepared statement of Matthew Andresen follows:]
PREPARED STATEMENT OF MATTHEW ANDRESEN, PRESIDENT, THE ISLAND ECN
I commend the Chairman and the Members of the House Commerce
Finance and Hazardous Materials Subcommittee for holding these hearings
on the future of our Nation's equity markets and the benefits of
electronic markets. Electronic markets--fueled by the revolution in
communications and computing power--are today driving some of the most
profound developments in the history of markets and investing. Most
significantly, we are witnessing a rapid and sweeping democratization
of the markets. As a result of these changes, we have an historic
opportunity to create fairer, more competitive markets and ensure that
America's role as the financial center of the world continues into the
next millennium.
As the pioneer in bringing the advantages of electronic markets to
individual investors, Island greatly appreciates the opportunity to
share its views on these important public-policy issues. Recent events,
including the publication of the SEC Concept Release on fragmentation,
present all of us with the chance to discuss several proposed dramatic
changes to the structure and operation of our markets. As SEC Chairman
Arthur Levitt stated in his Northwestern University speech last week,
today's debate is really about ``how best to let unburdened competition
and unbridled innovation drive the future of the market. It is a debate
about how best to equip our markets to compete and win in an
increasingly globalized electronic marketplace.''
The success of our markets is based on innovation spurred by
competition. By remaining committed to such entrepreneurial capitalism,
we can secure and extend our global, financial leadership role. Yet
some in today's debate have chosen an alternative model: their
uneasiness with the effects of enhanced competition prompts them to
seek Federal intervention in the marketplace. For example, the proposed
consolidated limit order book would eliminate the incentive for
different marketplaces to innovate and deliver superior technology and
service. Such a monopolistic utility would certainly fail to meet the
investor's needs.
Consequently, we urge the Committee to resist embracing any of the
proposed risky regulatory schemes, and instead seize the chance to
strengthen our markets by unleashing greater competition. I look
forward today to beginning a dialogue with the Committee about knocking
down the remaining barriers to competition between markets; bringing
the benefits of cutting-edge technology into the marketplace; and
empowering the individual investor with greater access to the market.
THE ISLAND STORY
I am Matthew Andresen, President of The Island ECN (``Island'').
Island is an automated trading system for equity securities. It gives
brokers the power to electronically display customer orders. We
function as a pure auction market--directly matching buy and sell
orders. We currently have more than 280 broker-dealer subscribers.
Island was founded approximately three years ago with the intent of
providing all market participants--from individual investors to large
financial institutions--with the ability to execute transactions on a
level playing field, at an extremely low cost without the presence of
intermediaries or dealers.
On an average day, Island trades over 200 million shares--
approximately 12 percent of the transaction volume on Nasdaq. We keep
our market open every trading day, from 8am-8pm. All this is done on a
single, off-the-shelf Dell computer about the size of a large
briefcase. For the year 1999, Island trading volume was over 26.5
billion shares, with a total dollar volume of $1.56 trillion. Overall,
Electronic Communications Networks (so-called ECNs) account for
approximately 30 percent of the Nasdaq average daily transaction
volume.
The Island story--from our founding to the present day--is about
fighting for a chance to compete in new markets and allowing investors
to vote with their feet. If we cannot offer a better product, then we
should be out of business. Fortunately, investors have welcomed our
products and services, and Island has enjoyed explosive growth. For
example, we heard investors ask for greater flexibility in managing
their finances, and we delivered our superior services earlier and
later each trading day. Specifically, Island's extended-hours trading
session (8am-9:30am. And 4pm-8pm) began mid-1999 with only about 1
million shares traded; today, we are regularly doing over 20 million
shares during this session--when the traditional markets are closed,
Island is open for business. For these reasons, Mr. Chairman, I doubt
you'll find a witness today who is a greater champion--or beneficiary--
of our Nation's free markets and the individual's unfettered right to
profit from hard work and innovation.
I learned early in my financial career that there are two things
you can never overestimate: the amount of market information denied the
individual investor, and the eagerness with which the investor uses
this information once provided. Virtually right out of college and
needing a job, I initially landed at the commodities desk of a major
New York investment bank. Yet I found myself frustrated and disturbed
by many of the market's hidebound operations and the market
professionals' advantages over the individual investor. Needless to
say, I was not long in that job.
Soon thereafter, I was fortunate enough to meet some brilliant
software programmers at Island--individuals who grasped a magnificently
simple and elegant truth: the markets could be made far more rationale
and fair if investors were allowed access to the same sorts of
information uniquely available to market professionals. Not only would
our markets be strengthened and investors derive more value, but there
would be an unprecedented degree of accountability, openness, and
transparency.
On my first day as President of Island, I walked into the office--
and we were, literally, just four employees in one office--with little
more than a passion for market structure and a steadfast commitment to
cracking wide open the monopoly on information enjoyed by market
professionals at the expense of the individual investor.
We watched carefully as investors consumed real-time market data
for the first time. And we recalled how many market professionals had
insisted that such ``arcane'' information would be at best a
distraction, and probably a nuisance for the investor. How wrong they
were. As we know, investors today demand access to real-time data and
the latest research reports as well as the ability to enter orders more
efficiently and at a fraction of the cost once paid for such
transactions. Yet while the investor had been empowered to know what to
buy and when to buy it, a key component of this equation has, until
recently, been missing: how to buy. That's where Island jumped in.
Traditionally, investors have only been provided with the highest
bid and lowest offer in a security. The depth of the market, which
gives an indication of the true supply and demand for a security, has
been the exclusive province of market professionals. More specifically,
what happens to an order after it is placed with your broker? What sort
of accountability exists? At Island, we urge investors to ask
themselves what just happened to their order after they click on the
``Submit'' button. After all that thorough and careful research, why is
the investor--at this final stage of the process--essentially staring
into a black box--or at best a screen with the words ``Your Order Has
Been Placed.''
That lack of accountability--in other words, denial of information
to the investor--was unacceptable to us. To provide the best resource
possible to the investor, we became the first marketplace to provide a
free, real-time display of all its orders, through the Island
BookViewer <SUP>TM</SUP>. Such transparency is precisely what SEC
Chairman Levitt recently called for in his Northwestern University
speech: ``Now is the time to embrace a broader and deeper transparency.
Now is the time for all market participants to move toward open books
across all markets . . . These are forward looking initiatives that
answer the investor's call for greater transparency and more efficient
pricing.'' Island couldn't agree more. That's why orders received by
Island for display on the limit order book are immediately visible to
anyone with a web browser regardless of whether the order was received
from an individual investor or a large institution. Why is this
important? Investors can use the additional information provided by
Island to more accurately price their orders. The Island BookViewer
<SUP>TM</SUP> also reduces the informational and temporal advantages
traditionally enjoyed by floor brokers, market makers, and specialists.
In other words, the average investor is not disadvantaged because of a
lack of access to, for example, the floor of an exchange. By
eliminating these time and place disparities--in essence, putting the
investor ``virtually'' right next to the market maker or specialist--
Island helps lower the hidden costs associated with higher spreads and
inferior executions. In fact, according to the Securities and Exchange
Commission, spreads--the difference between the highest price to buy
and the lowest price to sell--have narrowed substantially since the
time ECNs were given access to the Nasdaq market, saving investors
hundreds of millions of dollars per year.
Island's mission is to provide investors with an open, transparent
market so that they can know precisely what happens to an order after
sending it to their broker. Traditionally, the markets have conferred
what are called ``time-place'' advantages on certain of its
professionals. For example, the specialist on the floor of the New York
Stock Exchange responsible for a specific stock has unique access to
all the buy and sell orders for that stock; only that person knows what
the true supply and demand is for that stock. Consequently, that
individual has both an informational advantage and the opportunity to
take advantage of that information in order to make a profit for
himself and his firm. A perfectly legal business, but one that clearly
leaves the average investor at a disadvantage.
WHEN COMPETITION FAILS, AND WHEN IT WORKS
It is certainly true that much of the Island story is about using
technology to provide investors with a more efficient, faster, and
lower cost forum for trading. Yet Island's success is much more than a
technology story--it is about the tremendous benefits that redound to
the investor when our markets compete; when one marketplace can
challenge another with a dizzying array of innovations and offer the
investor unprecedented opportunities to leverage technological
breakthroughs.
As described above, recent advances in computing power and
bandwidth deployment made it possible for Island to provide investors
with new and powerful resources to access to the marketplace. We simply
needed the right legal and regulatory opening to offer our services and
roll out our product.
How such an opportunity came about tells us much about how markets
succeed and fail. About three years ago, as many on this Committee will
recall, Nasdaq was the subject of a scathing Securities and Exchange
Commission's 21(a) report about improper market practices; the Justice
Department had launched an investigation that revealed widespread
collusion and price fixing; and a billion dollar investor, class-action
lawsuit against Nasdaq was in the works. More than anything else, the
problems plaguing Nasdaq were the unfortunate result of what happens
when a marketplace lacks competition. As we now know, Nasdaq was fenced
off from any true competition, and the investor had no recourse in
terms of finding a better marketplace to seek the best execution. Yet
rather than micromanage the overhaul of Nasdaq, the SEC adopted rules
(known as the Order Handling Rules) designed to introduce competition
and greater transparency into Nasdaq--all of which led directly to the
creation of Electronic Communication Networks.
Island seized this opening and offered investors a faster, cheaper,
and more reliable forum for trading. From Island's inception, we
counted on the fact that investors--when given the choice--would always
want a more accessible and transparent marketplace. To reach that goal,
we focused on what we considered the glaring gap in the Nasdaq model:
the inability of investors to meet directly in the marketplace without
having to rely on professional intermediaries.
Moreover, by eliminating the informational disparities discussed
above, we built a marketplace that is inherently safer, fairer, and
easier to surveil. For example, participants on the floor of an
exchange generally possess more trade and order information than the
average investor sitting at home. Through surveillance and the
implementation of restrictions on the activities of those in the
trading crowds, regulators attempt to prevent the misuse of
information. As recent events have shown, however, no amount of
surveillance or regulation can completely prevent the misuse of
information.
ECNs, such as Island, reduce the opportunities for improprieties by
eliminating informational disparities. ECNs empower all investors by
allowing them to step into a virtual trading crowd and compete
directly. Since all orders are delivered to the virtual trading crowd
and instantaneously displayed to everyone, no single person has an
informational advantage that needs to be regulated or surveilled. That
means we have been able to deliver to investors the benefits of lower
cost, more transparent, fairer markets, while still complying with
strict Commission standards designed to ensure the integrity of our
trading systems. Island, for example, must comply with regulatory
standards concerning the security, capacity and reliability of our
system. In fact, due to its use of the latest, most advanced technology
as well as its proprietary architecture, Island has a superb record for
reliability and performance. For example, during the past year when the
Nasdaq market has periodically experienced system delays due to the
tremendous surges in trading volume, Island has never experienced a
capacity-related problem. Even during peak trading periods. Island's
average turnaround time is approximately three one-hundredths (.03) of
a second--exponentially faster than our nearest competitor. By
combining the latest technology with our advanced system architecture,
Island has created a scalable, robust trading system with virtually no
capacity limitations.
Finally, we have never taken our eye off the bottom-line for the
investor; we have always believed that any money funneled out of the
marketplace--whether to pay for high commissions or to outfit an
exchange with brass and mahagony--comes directly out of the investors'
pockets. Consequently, Island has sliced its margins razor thin.
Island, for example, only receives $.00075 per share per side on every
transaction executed on its system; in other words, a trade for 1,000
shares of stock means only seventy-five cents for Island. I like to
point this out to my staff when others question our spartan offices--
like a recent New Yorker magazine profile noting that we have
``upgraded our offices from grungy to nondescript. `` I like to believe
that there are millions of investors across the country benefiting from
the fact that Island has the least stylish offices on Wall Street.
THE FUTURE OF THE MARKETS
Once we have empowered the investor by providing an open and
transparent marketplace, there remains one final challenge. How do we
unleash these benefits on as wide a scale as possible, without
sacrificing investor protection or the integrity of our capital
markets? How can we further promote competition between markets and
ensure that our Nation maintains its leadership role in finance and
technology?
Addressing some of these issues, the Securities and Exchange
Commission published its Concept Release on Fragmentation. In its
Release, the Commission raised the concern that the U.S. equity markets
are becoming more fragmented and, thus, less efficient. One key concern
for the Commission is that the practices of internalization and payment
for order flow may increase with the repeal of Rule 390. In addition,
the Commission is concerned that since many market participants are
assured of receiving order flow either from an affiliate or by paying
for the order flow, market centers may have little incentive to compete
based on their quoted price. The Commission also questioned whether the
practices of payment for order flow and internalization result in some
brokers routing orders to marketplaces providing inferior executions.
In response to these concerns, some market participants support the
adoption of a consolidated limit order book (the so-called ``CLOB'') to
eliminate the negative impacts of fragmentation, internalization and
payment for order flow.
Island's Position on Current Proposals
As stated at the outset, Island believes that the issues raised in
the SEC Concept Release give us an opportunity to shape the future
financial marketplace in a manner consistent with the best aspects of
America's entrepreneurial capitalism. If we choose wisely today, we can
avoid the mistakes of the past when we embraced risky regulatory models
proposed by Federal agencies.
The Island story and the rise of ECNs embody the benefits of
competition. The dramatic changes in technology have allowed new
competitors to offer new services at a lower cost and capture market
share from traditional market participants in a relatively short time
period. As a result, there has never been a better time to be an
investor. Interestingly, many of the same traditional firms that have
long benefited from an environment favoring market professionals are
now calling for drastic changes to the market--at the very time when
investors are finally starting to take more control over their own
financial decision-making. For example, to solve the ``problem'' of
fragmentation, some market professionals have suggested proposals that
would inhibit the ability of new entrants to challenge the traditional
markets. Embarking upon some of these risky regulatory schemes would
undermine many of the technological breakthroughs pioneered by the ECNs
and discourage any future innovation.
To understand why rules mandating price-and-time priority between
markets and--in their most extreme form--the Consolidated Limit Order
Book would eliminate competition, consider the following example:
Assume that ECN A is a market that provides its members with the
fastest and most reliable trading system in the industry. In addition,
assume that Traditional Market B utilizes obsolete technology that
lacks adequate capacity. If, under a regime of price/time priority,
Market B is the first to display the best offer of $100 in stock XYZ,
any order to buy XYZ at $100 received by ECN A must be routed to
Traditional Market B--despite its inferior technology. Thus, even if
you as an investor intentionally sent your order to ECN A to take
advantage of its superior speed of execution, ECN A would be required
to route your order to Traditional Market B. Thus, ECN A would be
completely dependent on a response back from Traditional Market B in
order to fill your order.
This simple scenario demonstrates why price/time priority fails to
serve the investor:
1.) It is impossible for ECN A to offer a faster execution or better
service in its competition with Traditional Market B, since
Market A will always be dependent on Traditional Market B for
execution and service; and vice versa;
2.) ECN A and Traditional Market B are dependent on the linkage between
them and cannot offer service any faster or more reliable than
permitted by the linkage; or each other's interaction with the
linkage;
3.) In light of the first two points, investors will become insensitive
to which market the order is entered, leaving no basis for
competition between markets.
In sum, not only do we prevent markets from competing with one
another on any basis beside price, but we actually undermine the very
technological breakthroughs that have strengthened our Nation's equity
markets.
To appreciate the real-life consequences of mandating price
priority between markets, consider the current state of the listed
market. The listed market has operated a so-called ``trade-through
rule'' since the implementation of the National Market System more than
20 years ago. During this entire period, the NYSE has dominated the
listed market and to this day still controls approximately 75% of the
share volume. The Commission has long recognized that, despite the
existence of the regional exchanges, there has never been vigorous
quote competition between the exchanges. One key barrier to competition
in listed stocks is the mandating of price priority via the trade
through rule. The trade through rule states that one market cannot
trade at a price inferior to a price displayed by another market.
Although each market is prohibited from trading at an inferior price
displayed by another market, a market sending an order as required to
the best priced market must wait up to two minutes for a response. Even
after two minutes, however, it is still possible not to receive an
execution from the other market. In such instances, the investor is
worse off than if he purchased the security at the ``inferior'' price
to begin with. As in the example with price/time priority above, the
trade through rule prevents one market from offering services that are
substantially different or better than the other markets. Price again
becomes the only competitive factor.
Fragmentation and Internalization
The proponents of a consolidated limit order book or rules
mandating price/time priority insist that their initiatives are a
response to the threat of fragmentation. They tell us that
fragmentation is increasing and that Federal intervention is needed to
reverse the trend. In fact, when competition is permitted to flourish,
orders will gravitate to only a few market centers. This is best
exemplified by the Nasdaq market. Prior to 1997, volume was spread
among numerous market makers, and spreads, the difference between the
bid and the ask, were very wide. Due to the increased competition from
ECNs, spreads have narrowed dramatically and the Nasdaq market has
actually become less fragmented. The intense competition has eliminated
numerous market makers and forced dramatic consolidation. Moreover,
according to a recent Sanford Bernstein study, the top 4 Nasdaq market
participants (Instinet, Island, Knight Securities, and Mayer &
Schweitzer) combined account for approximately 60% of the Nasdaq market
today compared to 40% a decade ago. With the introduction of
decimalization, the Nasdaq market should consolidate further.
It is also important to note that Nasdaq does not have a trade-
through rule or rules requiring price-time priority. If Nasdaq did have
such rules, it is doubtful that ECNs would have been able to
effectively compete. By adopting free-market solutions that promoted
competition, we not only delivered greater value to the investor, but
fundamentally strengthened the overall marketplace and set the stage
for the technological breakthroughs exemplified by the ECNs.
The Commission is also concerned about the possibility that the
repeal of NYSE Rule 390 will lead to more internalization, and thus may
harm investors. Island believes that the best way to address these
concerns, as with those of fragmentation, is to increase competition.
Internalization is more likely in a non-competitive environment where
spreads are wide and thus, dealers can more easily profit from the
difference between the bid and ask prices. As competition increases and
spreads narrow, it will become increasingly difficult for dealers to
intrernalize order flow. This is especially true with decimalization,
where spreads will narrow to just fractions of a penny in many of the
most active securities. That is why Island is proud to have led the way
in building a decimal-based marketplace. In fact, Island's market has
always gone down to ten decimal points.
Competition between brokers will also reduce any negative impacts
of internalization. With the availability of real-time quotes and
innovations such as the Island BookViewer <SUP>TM</SUP>, investors are
better able to monitor their execution quality. As investor
sophistication increases, brokerages will increasingly begin to
advertise how they execute orders. Competition will force brokers to
make the right decisions with respect to where they send their order
flow.
A Free-Market Model
Island believes that the U.S. Congress has already designed the
roadmap for ensuring the continued success of our capital markets. In
1975, Congress created the National Market System, with the goal of
constructing a more efficient and transparent market. We could not ask
for a better building block.
The mandate of the NMS, as envisioned by Congress, is defined by
two objectives: first, to promote competition between markets (fair
competition between exchange markets and markets other than exchange
markets); and second, to make quotation and transaction information
available to investors (assure the availability to brokers, dealers,
and investors of information with respect to quotations for the
transactions in securities.).
Consistent with this mandate, the SEC adopted rules that permitted
ECNs to have their quotations included in the Nasdaq best bid and offer
that is disseminated to the entire marketplace. As described earlier,
competition between markets flourished (with ECNs having captured 30
percent of the Nasdaq transaction volume), and Nasdaq itself was
significantly reformed. When provided a level playing field, ECNs can
compete for market share and bring the benefits of competition to the
investor.
This situation contrasts sharply with the rules and regulations
governing Island's ability to compete in NYSE-listed stocks.
Ironically, almost 25 years later, the rules and market structure
implemented to achieve the goals of a National Market System are now
inhibiting competition between markets and restricting the information
available to investors. Regulatory obstacles block Island from having
its quotation information included in the two main components of the
National Market System--the Consolidate Quotation System (CQS) and the
Intermarket Trading System (ITS).
I would pose two questions for this committee:
First, what public-policy benefits are served by stifling
competition and barring Island from sharing its pricing information?
I cannot imagine there are any. Consider that when Island trades
the stock of America Online, at various times during the trading day,
Island would have the best quote in the National Market System.
Unfortunately, due to the current regulatory structure, market
participants (other than Island subscribers) are denied the opportunity
to see and access the better price on Island. This pure fragmentation
is completely inconsistent with the spirit of the National Market
System.
Second, what public-policy benefits would be served by promoting
competition and integrating Island into the NYSE's pricing mechanism?
Most importantly, Island's price information would no longer be
fragmented from the rest of the marketplace. The market for NYSE-listed
stocks would immediately become more integrated and efficient. The
resulting competition between marketplaces (again, a central goal of
the National Market System) would result in benefits for the investor.
In light of the proven benefits to investors and the efficiency of
the market, it is time to take immediate action to give ECNs access to
the Consolidated Quotation System. ECNs, such as Island, must be
permitted to disseminate their quotation in listed stocks to all market
participants. Yet in moving forward on this issue, we must still
confront and deal with a version of price-time priority currently
operating for the listed market. As discussed earlier, under the plan
governing the operation of the Intermarket Trading System, each
participant exchange is prohibited from trading at a price inferior to
another participant.
Just as the Federal government does not negate customer choice by
requiring consumers to buy goods from the lowest price merchant, market
participants should not be required to buy from the best-priced market.
As long as market participants know the price in each market and have
the ability to access each market, there is no need for the Federal
government to require the market participant to favor any one market.
Accordingly, in addition to allowing ECNs to disseminate their
quotations directly through the consolidated quote, the elimination of
the trade-through rule is another important step toward more fully
realizing Congress's objectives in the National Market System.
CONCLUSION
Mr. Chairman, it is an honor to have had this chance to present
Island's perspective on these critical public-policy issues. These
hearings today present all of us with a compelling opportunity to shape
the future of our Nation's equity markets and ensure their continued
strength and prosperity. As we consider the various proposals under
discussion, we must be careful of those proposals that too quickly
embrace Federal intervention in our free-markets and commit us to risky
regulatory schemes. We must not squander the position of financial
strength we achieved at great cost and commitment over the past 200
years. Instead, let us always work towards greater openness,
transparency, and accountability in the marketplace. There is too much
at stake to do otherwise.
Mr. Oxley. Thank you. I now recognize Mr. Foley.
STATEMENT OF KEVIN FOLEY
Mr. Foley. Thank you, Mr. Chairman and members of the
committee. My name is Kevin Foley. I am chief executive of
Bloomberg Tradebook, and I am pleased to have the opportunity
to testify regarding competition in the new electronic market.
Bloomberg Tradebook is located in New York City. We are an
electronic agency broker. And one of the things that
distinguishes us among ECNs is that our focus is serving
institutions and other broker-dealers who typically serve
institutions themselves. We count among our clients many of the
Nation's largest institutional investors and the millions of
individuals whose pension funds and retirement savings and so
forth are pooled in institutional investors assets.
We specialize in providing innovative tools that allow our
clients to step directly into the electronic crowd, both the
National Market System such as it is today to find liquidity
for themselves and to provide their institutional liquidity for
others, the retailer that is now enfranchised in finding itself
moving directly into the marketplace. Our clients rewarded our
creativity and service by trusting us with their business. We
are the third largest ECN by volume. We had our first day of
over 100 million shares and we are grateful to our clients for
that. Competition in the new electronic marketplace is doing
today what competition does. It is benefiting consumers, it is
benefiting investors, it is revolutionizing our markets, and it
is also generating opposition from some who may feel that their
position could be threatened by revolutionary changes.
Those who have sought to halt these changes have argued for
a massive and intrusive regulatory intervention that would roll
back the clock. They have sought to justify these steps by
claiming that fragmentation is a threat to our markets. This is
a traditional refrain of virtually every industry when change
threatens established players. The telecommunications industry
is one that comes to mind. When the status quo laments harmful
fragmentation, it is time for all of us to be careful. Often it
is really the sound of beneficial competition being bemoaned by
those who prefer and enjoy the status quo. Some have urged
support for a time priority central limited order book, CLOB,
centralizing orders in a single black box. The technology of
today makes a centralized order book unnecessary.
It is possible to have transparency and linkages in the
markets. The central black box runs contrary to the operation
of state-of-the-art modern telecommunications, the Internet
being the best model. The innovations that ECNs have brought to
the market like, for example, one called Reserve from Bloomberg
Tradebook which we can talk about later, could not occur under
an industry sponsored CLOB, an industry-sponsored black box or
one sponsored by NASDAQ, for example, which they have currently
proposed in their SuperMontage proposal before the SEC. The
pending SuperMontage proposal carries many of the downsides of
a traditional CLOB. If you are against a CLOB, you've got to be
against the NASDAQ SuperMontage proposal, and it is happening
now. It creates a centralized single point of failure, and it
creates a single decisionmaking apparatus that is resistant to
change. The public would be much better served if the NASD
focuses resources on the capacity issues critical for the
implementation of decimalization, as championed for years by
this committee.
Prior to focusing on securing what we believe to be an
anticompetitive beachhead in anticipation of the transparency
to a for-profit entity, Congress and the SEC should not
entertain significant structural changes to NASDAQ or to the
equity markets in general until after decimalization has been
completed and the full range of its benefits have been
assessed. Congress should oppose the imposition of a CLOB, and
it should oppose the imposition of a structure that gives you
95 percent of what a CLOB will give you as NASDAQ has claimed
the SuperMontage proposal will do. It is something that
Congress needs to look at immediately. I am looking forward to
the rest of the hearings and the questions and answers
afterwards. Thank you, Mr. Chairman.
[The prepared statement of Kevin Foley follows:]
PREPARED STATEMENT OF KEVIN FOLEY ON BEHALF OF BLOOMBERG TRADEBOOK
INTRODUCTION
Mr. Chairman and Members of the Subcommittee. My name is Kevin
Foley, and I am pleased to testify on behalf of Bloomberg Tradebook LLC
regarding competition in the new electronic market.
We commend this Committee for its efforts to bring the benefits of
competition to our markets and the investing public. To ensure the
continuation of an environment in which competition flourishes, we urge
the Committee to oppose efforts to create a Consolidated Limit Order
Book (CLOB) whether run by the industry itself or by NASD. We
specifically urge the Committee to oppose SEC approval of the NASD's
proposed CLOB known as the SuperMontage. We also urge the Committee to
consider carefully the implications of privatization of the dominant
national exchanges. Allowing a government-mandated monopoly to enter
the markets as a for-profit entity raises enormous concerns, including
concerns regarding the availability of real-time market data--the
``oxygen'' of our markets. We commend this Committee's efforts to
protect the availability of market data and prod the industry on
decimalization. We urge that significant structural changes to the
market not be considered until after decimalization has been completed
and the full range of its beneficial impact assessed.
Bloomberg Tradebook LLC is owned by Bloomberg L.P. and is located
in New York City. Bloomberg Tradebook is an electronic agency broker
serving institutions and other broker-dealers. We count among our
clients many of the nation's largest institutional investors. Bloomberg
Tradebook specializes in providing innovative tools that allow our
clients to step unobtrusively into the electronic ``crowd'' of the
national market system to find liquidity for themselves and, in the
process, provide it for others. Our clients have rewarded our
creativity and our service by trusting us with their business.
We are the third largest electronic communications network (ECN) by
volume. Indeed, two weeks ago we saw the day on which the orders
matched on Bloomberg Tradebook exceeded 100 million shares, a landmark
representing a more than ten-fold increase over the past year-and-one-
half.
ECNS--A MARKET SOLUTION TO A MARKET PROBLEM
Some have lamented the existence of ECNs, suggesting that we are an
unwanted development. It's worth asking the question, exactly what are
ECNs, and how do consumers and investors benefit from the competition
ECNs bring to the new electronic marketplace?
ECNs are distinguished by three characteristics--neutrality,
transparency and fairness. Neutrality? By definition we are agency
brokers and take no positions for our own accounts. Thus, we are
neutral in the marketplace and exist only to serve our customers' need
to buy or sell shares. Transparency? We publish not only our entire
book of quoted prices electronically for all our customers to see, but
also all other available pricing information. Unlike some of our ECN
competitors, we take advantage of this transparency to route our
customers to the best available price, even if that is outside of
Bloomberg Tradebook. Fairness? ECNs are required by SEC rules to
respond immediately--and I mean immediately--to orders in the order
they are received, whether they come from our best customers or from
our competitors. That's probably the highest standard in the industry.
Among the innovations Bloomberg Tradebook has brought to the market
is the beneficial mixing of small retail order flow and institutional
order flow. For the first time, small retail customers have gained
direct unfettered access to the liquidity of institutional order flow
represented directly in the market. Likewise, institutional investors
are, for the first time, able to find liquidity for their orders by
interacting directly with small order flow.
Along with neutrality, transparency, fairness and innovation, add
lots of enthusiasm and creativity from people passionately devoted to
serving their customers and you have a picture of who we are and why we
exist.
In a statement before the Senate Banking Committee, Frank Zarb, the
Chairman of the National Association of Securities Dealers, stated that
``. . . I guess I sum up the answer as to why we have ECNs as the fact
that the national stock exchanges around the world haven't been keeping
pace with the needs of the market.''
Mr. Zarb is a an accomplished leader in business and public
service. Investors are fortunate for his leadership at this time, but I
respectfully submit that the reason ECNs exist is not only because of
what national stock exchanges failed to do, but also because of what we
innovating broker-dealers have done, in the heat of competition.
Mr. Chairman, it's worth pondering why the stock exchanges didn't
keep pace, as Mr. Zarb says. I would submit that a government-sponsored
monopoly ultimately cannot provide the innovative ideas and customer
service of the best ECNs precisely because they are a government-
sponsored monopoly. NASD's CLOB proposal for the Nasdaq market--known
as the SuperMontage--is an effort by the NASD to ``keep pace'' not by
moving themselves forward, but by drastically slowing down all market
participants. To spur future innovation, I'd rather place my faith, not
in the exchange, but in its members--the marketplace of competing
innovative broker-dealers.
What are ECNs? At Bloomberg Tradebook we see ourselves as a market
solution to our customers' market problems. This should be kept in mind
as Congress and the SEC consider whether and how to react to the growth
of ECNs.
Bloomberg Tradebook intends to remain a broker-dealer and an ECN.
We believe it's the most effective way for our customers to obtain
liquidity and best execution. While we are proud to be and remain a
broker-dealer/ECN, we are also supportive of the efforts of some of our
ECN brethren to either affiliate with or become exchanges. Just as
competition among ECNs has been good for investors and the market,
competition among stock exchanges also benefits all. We think the
national stock exchanges should have to compete against each other for
our business and the business of any other broker-dealer. Bloomberg
Tradebook looks forward to the day when some of our ECN colleagues will
be--as new exchanges--competing with the established exchanges for our
business.
COMPETITION IN THE NEW ELECTRONIC MARKETPLACE
Competition in the new electronic equity marketplace is doing what
competition generally does. It is benefitting consumers and investors
while revolutionizing markets. It is also generating opposition from
those who may believe their position is threatened by these
revolutionary changes.
Those who have sought to halt these changes have argued for massive
and intrusive regulatory intervention to roll back the clock. They have
sought to justify these steps by arguing that ``fragmentation'' is a
threat to our markets.
This is a traditional refrain, sung in virtually every industry
when change threatens established players. It is a refrain that this
Committee--given its preeminent role in deregulating markets--has
repeatedly heard in extended-play versions and wisely greeted with a
skeptical ear.
In 1975, when Congress and the SEC deregulated brokerage
commissions, there was much anxiety on Wall Street. Critics charged
that the unfixing of rates would damage and fragment America's capital
markets. Instead, commission rate competition reduced prices for
investors and helped spur explosive growth in the market.
In deregulating the telecommunications industry, Congress--this
Committee in particular--and the courts were regularly warned that
then-upstarts like MCI were ``fragmenting'' the telephone market,
destroying the world's greatest communications system. When the status
quo laments the impact of ``harmful fragmentation'' be careful--often
it is really bemoaning beneficial competition.
In fact, the Nasdaq market today is consolidated, not fragmented.
Customers' orders are displayed to all and interact freely among
market-makers, ECNs, order-entry firms and even regional exchanges.
ECNs in Nasdaq participate in the least fragmented market of all time,
thanks to this system of customer order display and electronic linkages
that provide instant access to those orders.
In a very significant speech delivered recently at Northwestern
University, SEC Chairman Levitt called on market participants to make
publicly available all customer bids and offers, not just their best
bids and offers. Chairman Levitt called for a competitive, free market
solution to seize this opportunity for greater transparency. Bloomberg
Tradebook wholeheartedly supports this increased market transparency.
Useful linkages have yet to be developed for the New York Stock
Exchange listed market. Our customers would like us to act as their
agent for New York Stock Exchange listed stocks, as we do in Nasdaq
stocks. Recently the SEC has approved an NASD proposal to allow ECNs
access to the Intermarket Trading System (ITS) through Nasdaq. This is
helpful, but not nearly sufficient since ITS remains crippled by both
its technological ineffectiveness and an unworkable governance
structure that makes any movement nearly impossible.
THE THREAT OF A CENTRAL LIMIT ORDER BOOK (CLOB)
Those who would stifle change in the markets have urged support for
a time priority central limit order book (CLOB) as the panacea
necessary to deal with the alleged ``problem'' of fragmentation. The
notion behind the CLOB is that if you centralize orders in one place, a
single ``black box'', maximum order interaction and perhaps better
prices might be achieved.
TECHNOLOGY MAKES A CLOB UNNECESSARY
There are a number of very serious problems with this concept. When
this concept was first broached some thirty years ago, our markets
lacked the technology to achieve order interaction without
centralization. Now, technology allows the advantages of maximum order
interaction without the downside of centralization.
In short, the technology of today makes a centralized order book
unnecessary. These technological advances have revolutionized other
industries, and despite protests, they are revolutionizing our equity
markets. At a time when even public utilities like telephones and
electric power are abandoning their ``black boxes'' for decentralized
structures, does it make sense to threaten innovation by centralizing
the stock markets? State-of-the-art telecommunications systems like the
Internet don't rely on a single monopoly channel--rather they rely on
networked webs of multiple private competing linkages. Why should the
securities markets work differently?
Centralized systems are resistant to change. The innovations that
ECNs have brought to the market could not occur under a CLOB system,
including under the SuperMontage Proposal of the NASD.
A centralized system also provides the significant downside of a
central point of failure. Those of us who deal regularly with Nasdaq's
SelectNet system know only too well how cumbersome and inefficient a
centralized system can be. Like SelectNet, the ITS system is conceded
even by the sympathetic to be technologically outmoded, with a
bureaucracy that thwarts change. Why make those failed systems the
model?
THE CLOB IS COMING--SUPERMONTAGE
Indeed, the pending SuperMontage Proposal carries many of the
downsides of a traditional CLOB. The proposal would convert Nasdaq from
a largely decentralized market, which has been its major strength for
thirty years, to one in which virtually all executions take place
centrally. Of the concerns which the Nasdaq market faces today,
capacity limitation is certainly the greatest. In recent years Nasdaq's
systems have become an increasingly serious messaging bottleneck. Yet
the proposal would convert Nasdaq to a central execution utility only
months before the U.S. markets are scheduled to grapple with the
intensifying volume expected with decimalization. This CLOB-like
centralization would create a government-sponsored monopoly that would
deter today's decentralized market innovators from adding market
capacity and from introducing further innovations. Recent press reports
that the SEC wants to move quickly to approve the SuperMontage concern
us and, we respectfully submit, should concern Congress.
CLOB CZAR
While there are serious technological problems with the CLOB, there
are equally troubling political problems. Someone or some entity will
have to decide how the CLOB will work, who gets access and how, and
what innovations are to be allowed. That gatekeeper and CLOB czar is
certain to be enormously influenced by those who are already in the
club. Will those who are already in the club allow the emergence of
innovators who potentially threaten their business? We don't think so.
Is innovation likely to occur when the potential innovator must raise
his or her hand to seek permission from the powers-that-be in order to
innovate? We don't think so.
NASD Chairman Zarb told the Senate Banking Committee during its
CLOB hearing that 95% of everything CLOB proponents sought could be had
under the SuperMontage. That's accurate, and underscores that we are
looking in part at a political battle for control of this centralized
entity. I don't know who will win, but I know who will lose in this
kind of battle--markets and consumers.
RISK TO INNOVATION
There are always those who worry about regulation driving
industries offshore. What will drive industry offshore faster than
anything else would be depriving that industry of the ability to
innovate in the United States. Under a CLOB or SuperMontage, the
greater risk is that industry will leave the States for shores where it
can innovate.
HUMILITY BEFORE THE MARKETS
The most significant problem with a CLOB is that, even if we get it
``right'' for now, it's not clear we will have gotten it ``right'' for
all time. Over the past three years, Bloomberg Tradebook has devised a
number of innovations that have come to be industry standards. I'd like
to mention one briefly.
At its inception in 1996, Bloomberg Tradebook introduced the
concept of ``Reserve'' to the U.S. equity markets. ``Reserve'' is a
process that controls the release of orders into the market, enabling
clients to trade large orders more efficiently.
Like all innovations, the ``Reserve'' gave us a leg up on our
competitors for a brief period of time. Soon it was adapted by others.
Today no one would introduce a system without it, including Nasdaq in
its SuperMontage Proposal. Any edge we gain is a momentary one--and we
are forced to continue to innovate. We have done so continually in the
three years since.
If a CLOB had been imposed three years ago, clearly this innovation
wouldn't exist. Are we confident that further innovation won't be
needed? That we can't do what we do more efficiently? I'd argue that
the innovation is just beginning, and we need to maintain the
incentives that make that innovation possible. Innovations occur in a
dynamic competitive market. They won't occur in a centralized black
box.
THE MARKETS NEED DECIMAL PRICING
It is a pleasure to address this Committee on the subject of
pricing in decimals. It is a natural segue from our expressions of
concern regarding the industry CLOB and the Nasdaq SuperMontage
Proposal.
Over a period of years, this Committee has rendered an enormous
public service by spearheading the effort to convert to decimalization.
As this Committee well knows, the United States is the only major
country whose stock markets still trade in fractions. Presenting quotes
in \1/8\ths and \1/16\ths has reduced competition and liquidity in our
markets. It is a system both archaic and anti-competitive.
Bloomberg Tradebook has allocated significant time and resources to
decimalization. As a result, we will be ready for decimal pricing as
scheduled in July. Thus, Bloomberg Tradebook and our customers were
extremely disappointed by the NASD's recent request to delay
decimalization. Decimalization would create such an enormous benefit to
investors and the markets that implementation should be the top
priority.
The NASD appears to be focusing significant resources on
initiatives--like the SuperMontage Proposal--that have as its primary
objective securing an anti-competitive beachhead prior to NASD's
desired transformation into a for-profit entity. While we believe
SuperMontage is terrible public policy, even those who might be more
sympathetic would have to concede that the public would be infinitely
better served if the NASD focused its finite resources as other market
participants have had to--namely on timely preparation for prompt
conversion to decimals.
Putting aside resource allocation concerns, we'd also argue that
SuperMontage and any other CLOB proposal should be tabled until market
participants have an opportunity to assess the impact of a successful
conversion to decimals. The decimalization championed by the Commerce
Committee will significantly change our markets for the better. It will
result in lower trading costs. It will result in greater market
efficiencies. In short, it may well address many of the issues raised
in the SEC's recent Concept Release. The Congress and the SEC should
not entertain significant structural changes to the Nasdaq market until
after decimalization has been completed and the full range of its
beneficial impact assessed.
I'd like to conclude the discussion of decimalization with a
relevant, personal aside. When my boss, Mike Bloomberg, wants something
done, he often says to me ``get it done or I'll find someone who can''.
Our customers often send us the same message. The phrase ``get it done,
or else . . .'' is the humble seed from which many giant redwoods of
innovation have sprung. The Commerce Committee's journey with NASD on
decimalization is a cautionary tale of how hard it is to prod movement
from a government-sponsored monopoly. It will be infinitely harder to
prod change from an industry CLOB or a CLOB like the SuperMontage.
OPPOSITION TO PRIVATIZATION OF THE STOCK EXCHANGES
Allowing a government-mandated monopoly to enter the markets as a
for-profit entity raises enormous concerns for a host of regulatory and
enforcement reasons. I'll focus on one that is very familiar to this
Committee as both an historic and current controversy, namely the issue
of access to market data.
A quarter century ago, this Committee spearheaded the effort to
enact the Securities Acts Amendments of 1975. That legislation
established the goal of producing a national market system. To this
day, that remains the correct goal. In furtherance of that objective,
Congress mandated a consolidated system for distributing market data in
an effort to ensure that stock-market information was accurate and
accessible. The securities markets were allowed to charge a reasonable
rate for gathering and distributing that information.
When the Commission, in 1972, first proposed rules to provide for
the consolidated reporting of transactions and quotations, the New York
Stock Exchange asserted that the SEC not only lacked authority under
the securities laws to adopt the quotations rule, but also such action
would deprive the Exchange of property in violation of the due process
provisions of the Constitution of the United States. Despite these
objections, Congress and the SEC were determined to achieve the goal of
public access to consolidated market information.
Even in this day of on-line investing, the exchanges continue to
argue that they ``own'' or ought to own quote information. Indeed,
during the last Congress the dominant national exchanges were major
proponents of legislation reported from the House Judiciary Committee--
the ``Collections of Information Antipiracy Act''--which would have
created an unprecedented ownership interest in facts, including stock
quotes. Though well-intentioned, this legislation--which has also been
reported from the House Judiciary Committee this Congress-- would
create a property right in facts that extends not only to presently
existing markets, but also, incredibly, to hypothetical, presently non-
existing markets.
We applaud the bi-partisan leadership of the Commerce Committee for
crafting critical competing legislation, the ``Consumer and Investor
Access to Information Act''. That legislation, which was reported from
the Commerce Committee last year, would also provide additional
protections for databases but would do so while assuring that consumers
and investors have continued access to factual information.
Chairman Oxley has observed that real-time stock data is like
``oxygen'' to investors. We worry about the prospects of a government-
mandated monopoly over the most important information in the market--
truly the markets' oxygen--being controlled by a for-profit entity that
not only believes it ``owns'' data our clients create, but also wants
to control the downstream uses of that data in currently non-existing
markets outside of the real-time market window.
At the core of this market data debate is the outmoded concept that
market participants should continue to provide market data to a
government-sponsored monopoly and then pay to see it. We endorse an
alternative model recently proposed by SEC Chairman Levitt in the
context of market depth. During his March 16th speech at Northwestern,
Chairman Levitt urged our markets--exchanges, dealers, and ECNs--to
make their limit order books available to the public where vendors
could consolidate this data and repackage it in a form that would be
most useful to their customers. A similar model allowing the
establishment of private quote aggregators to which one could report
market data-- breaking the SRO monopoly on data--would certainly
improve the quality, comprehensiveness, reliability and capacity of
this information while reducing its cost.
REGULATORY CHANGES NEEDED FOR FULL COMPETITION IN THE EQUITY MARKETS
A few years ago, the Nasdaq market was rocked by a scandal when
Nasdaq market-makers were found to be colluding to keep spreads
artificially high. The SEC's response in issuing its Order Handling
Rules helped launch ECNs while narrowing Nasdaq spreads by nearly 30%
in a year.
Chairman Levitt has stated that the three components of a
successful U.S. equities market are quote transparency, market
linkages, and the obligation of brokers to seek best execution on
behalf of their customers. All these goals can be promoted without
risking the enormous negative ramifications of an industry CLOB or
SuperMontage. Congress should support the SEC's actions in promoting
transparency and in insuring linkages in the Nasdaq market, as well as
in exporting the germ of reform to the listed markets, which have been
so resistant to change. Congress has already vastly improved the
opportunities for best execution with its decimalization initiative.
Congress should oppose privatization of the exchanges while working to
fashion a means of providing more ready access to the market data which
is the ``oxygen'' of the marketplace.
Congress should oppose the imposition of a unitary CLOB. Congress
should oppose such a CLOB whether sponsored by industry or by Nasdaq as
the SuperMontage Proposal.
CONCLUSION
Every advance in our markets in recent years--from the elimination
of brokerage fee schedules, to the emergence of off-hour trading and
ECNs--has been greeted by the cry of ``fragmentation'' by the powers-
that-be. Our equity markets are the finest in the world because we've
established a regulatory structure that rewards innovation. As soon as
the U.S. regulatory structure stops rewarding innovation our markets
will go abroad. We shouldn't allow those who are threatened by change
to encourage us to freeze in place a system which then won't be subject
to innovation and improvement--and thinking outside the black box.
Changes in market structure will have implications for the American
people that are just as significant--if not more--than those of the
landmark banking reform legislation enacted last year. We very much
appreciate the diligence of the Members and staff of this Committee in
tackling these issues of complexity and importance.
Mr. Oxley. Mr. Dorsch.
STATEMENT OF SHAWN A. DORSCH
Mr. Dorsch. Thank you, Mr. Chairman and members of the
committee. My name is Shawn Dorsch. I am the President and
Chief Operating Officer of DNI, the builders of the Blackbird.
I am pleased to have the opportunity to appear before the
subcommittee and discuss our experience as the company which
has brought electronic trading to what is perhaps the world's
most complex and most dynamic financial sector, namely, the
inter-dealer, privately negotiated interest rate and currency
derivatives transactions business, more commonly referred to as
the ``SWAPS'' business.
I would like to make clear that we are not in the
securities business, but it is a very important financial
market for this country.
It is vital to the U.S. public interest that our markets,
including our financial markets, remain the most competitive
fair and efficient in the world. This will only be the case if
we succeed in harnessing the power and efficiency of new
electronic technologies in the service of these markets. DNI is
a corporation based in Charlotte, North Carolina. It was formed
in 1996 to build and operate a computerized communications
information system known as Blackbird. The Blackbird was built
to help major financial institutions, primarily banks, find,
negotiate and agree to custom-tailored SWAPS transactions
directly with each other.
The founders of DNI are experienced SWAPS professionals,
the Blackbird system is operational and successfully serving
the major SWAP dealers in the United States. The Blackbird is
not open to the public.
Blackbird is designed to compete with so-called voice
brokers who charge dealers commissions for arranging SWAPS
transactions over the telephone. The fundamental goal of the
Blackbird is to provide its financial institutions clients with
a computerized system that will bring greater speed, precision,
safety and security and lower cost to the very same interest
rate and currency risk management activities that are now
taking place every day in numerous U.S. financial institutions
on the telephone.
In spite of this goal, we initially found ourselves subject
to a searching regulatory review by the Commodity and Futures
Trading Commission, and harsh criticism from some of the
traditional exchanges that were subject to the CFTC's
jurisdiction. It was and remains our understanding that the
types of transactions that may be negotiated on Blackbird are
exempt from CFTC jurisdiction under the Commodity Exchange Act.
In April 1999, when we were on the verge of making
Blackbird operational, we received a letter from the CFTC
asking us to provide certain information so that the CFTC could
make an assessment of its own jurisdiction over Blackbird.
Certainly, the CFTC is not to be faulted for making due inquiry
to assure itself that it is fulfilling its regulatory
responsibilities. This CFTC, however, was the same CFTC which
issued a concept release read by many as proposing that it take
jurisdiction over the SWAPS community. This was the same CFTC
which was at loggerheads with the Treasury, the SEC and the
Federal Reserve Board, and which was admonished by Congress not
to take action following from its concept release.
Fortunately, we do not have the same CFTC today. If we did,
we might be speaking of the Blackbird as a U.S. entity in the
past tense as we would have been forced to relocate to London.
The details of the public controversy we faced are less
interesting than the deeper effects of the controversy. Senior
company personnel had to shift their attention from building a
business to explaining and defending that business. Obviously,
substantial financial resources had to be focused on the
regulatory situation. Potential clients needed to be reassured
that transactions negotiated through the Blackbird would not be
void as a legal off exchange futures contracts.
Potential investors also needed to be held to a level of
comfort with the regulatory situation. What was really wrong
about all of this? It all came about simply because Blackbird
offered SWAPS dealers the opportunity to do the same business
as before but via new media. It was the medium of computerized
communication when viewed through the lens of a poorly drafted
statute, the Commodity Exchange Act, which provided the basis
for a CFTC assertion of jurisdiction, not some risk to the
public. Fortunately, the new CFTC reinvented itself under
Chairman Rainer and has participated in the President's Working
Group Report and has put forth a new regulatory proposal that
attempts to build afresh on the positions of policy and
principles and that attempts to encourage the use of electronic
systems.
Congress also seems to be well focused on the fact that the
existing statutory and regulatory regimes may not adopt readily
to the promise and challenges of new technologies. The efforts
of this committee and others will be invaluable in determining
the direction for a redesign of our Nation's statutes and
regulations. We encourage Congress to watch closely to be sure
that new regulatory constructs are sufficiently resilient to
weather changes in administration as well as changes in
technology.
Our message is not that all electronic systems should be
unregulated. Our message is that regulatory concerns should be
focused not on the medium of communication, or for that matter,
on the medium of the transaction execution. Concern should be
focused on the activities accomplished with that medium and
should be coupled with consideration of the inherent market
discipline likely to shape those activities. If, as the case
with Blackbird, those activities do not raise serious concerns,
great care should be taken to protect them from the very, very
serious countervailing threats of overly broad or
anticompetitive regulation.
Thank you, Mr. Chairman, and members of the committee for
giving me an opportunity to present this testimony.
[The prepared statement of Shawn A. Dorsch follows:]
PREPARED STATEMENT OF SHAWN A. DORSCH, PRESIDENT AND CHIEF OPERATING
OFFICER, DNI HOLDINGS, INC.
DNI Holdings, Inc. (``DNI'') is pleased to have the opportunity to
deliver this written statement to the Subcommittee on Finance and
Hazardous Materials of the Committee on Commerce.
The matter before the Subcommittee, competition in the new
electronic markets, is a very important one. It is vital to the US
public interest that our markets, including our financial markets,
remain the most innovative, fair and efficient in the world. This will
be the case only if we succeed in harnessing the power and efficiency
of new electronic technologies in the service of our markets.
We have been asked to focus our testimony on regulatory impediments
to electronic systems used in trading financial instruments. DNI has
indeed seen some regulatory impediments to the development of its own
business. Although DNI's business is not the securities business of
primary concern in today's hearing, DNI's experience may be easily
generalized. Even before introducing itself, DNI would like to offer
three propositions that are as applicable to the securities markets as
to DNI's own business in interest rate and currency derivatives. First,
if the mere introduction of electronic systems use threatens to bring
regulation where there was none before, the need for regulation should
be closely examined. (DNI's own electronic system, for example, merely
allows sophisticated dealers to do among themselves via the internet
virtually the same business they previously did on the telephone; yet
DNI was nearly the subject of an entirely novel Commodity Futures
Trading Commission regulatory effort.) Second, if existing statutory
and regulatory language fails to correspond to evolving commercial
reality, that language must be re-examined and, if necessary, re-cast
in light of fundamental public policy goals--before it stifles
commerce. Third, those advantaged by the status quo may raise
regulatory concerns about the use of new technology as a means of
defending their competitive position--which may require careful
winnowing of legitimate public policy concerns from less worthy efforts
to limit competition. The following will explain how we have arrived at
these propositions.
DNI hails from different venues than many of our fellow witnesses,
both in terms of geography and commerce. DNI is a corporation based in
Charlotte, North Carolina. It was formed in 1996 to build and operate a
computerized communications and information system (known as
``Blackbird'' or the ``Blackbird system'') to help major financial
institutions find, negotiate and agree to custom-tailored interest rate
and currency derivatives transactions (for ease of reference,
``swaps'') directly with each other. The founders of DNI are
experienced swaps professionals. The Blackbird system is operational
and successfully serving major swaps dealers in the U.S.
The fundamental goal of DNI is to provide its financial institution
customers with a computerized system that will bring greater speed,
precision, safety and security, and lower costs, to the very same
interest rate and currency risk management business activities that are
now taking place every day in numerous U.S. financial institutions.
In spite of this goal, DNI initially found itself subject to
searching regulatory review by the CFTC and harsh criticism from some
of the traditional exchanges subject to the CFTC's jurisdiction. It was
(and remains) DNI's understanding that the types of transactions that
may be negotiated on Blackbird are exempt from CFTC jurisdiction under
the Commodity Exchange Act. Nonetheless, DNI was to learn two lessons.
First, DNI learned that the computerized enhancement through Blackbird
of services now commonly provided over the telephone by swaps brokers
unregulated by the CFTC might lead to an assertion of CEA jurisdiction,
even though there existed no plausible regulatory structure applicable
to Blackbird and no demonstrated need for any regulation of Blackbird.
Second, DNI found that certain entities actually subject to CEA
jurisdiction would do all they could to focus CFTC attention on DNI.
These entities did so even though they never have offered the kinds of
transactions that might be negotiated through Blackbird.
In April 1999, DNI was on the verge of making Blackbird
operational. DNI received a letter from the CFTC asking DNI to provide
certain information so that the CFTC could make an assessment of its
own jurisdiction over Blackbird. Certainly, the CFTC is not to be
faulted for making due inquiry to assure itself that it is fulfilling
its regulatory responsibilities. This CFTC, however, was the same CFTC
that had issued a ``concept release'' read by many as proposing that it
take jurisdiction over the swaps community. This was the same CFTC
which was at loggerheads with the Treasury, the SEC and the Federal
Reserve Board and which was admonished by Congress not to take action
following from its concept release. Fortunately, it is not the same
CFTC today. If it were, we might now be speaking of DNI as a U.S.
entity in the past tense. U.S. banks and investment banks, which
presently occupy a leadership role in providing interest rate and
currency risk management products, might have been deprived of access
to leading edge technology that will help them compete.
DNI recognized the potential difficulties in its situation with the
CFTC. What followed, however, was truly bewildering. DNI, a small North
Carolina company, and its computer system were mentioned in multiple
Congressional hearings, only one of which DNI attended. The fact of the
CFTC inquiry became general industry knowledge. Even our product name,
``Blackbird'', which had resulted from one of our principal's
admiration, as an amateur pilot, for a fast, high-flying U.S. airplane,
was publicly ridiculed as an indication of evil, evasive intent.
The details of the public controversy we faced are less interesting
than are some of the deeper effects of the controversy. Perhaps most
importantly, senior DNI personnel had to shift their attention from
building a business to explaining and defending that business.
Obviously, substantial financial resources had to be focused on the
regulatory situation. Potential customers needed to be reassured that
transactions negotiated through Blackbird would not be void as illegal
off-exchange futures. Potential investors also needed to be helped to a
level of comfort with the regulatory situation. The net effect was that
the CFTC inquiry and attendant public attention significantly slowed
our growth for a time.
Perhaps there is little surprising in all this until one stops to
consider what was mentioned above: most, if not all, of what the
Blackbird system does is now done by ``voice brokers'', human beings
using telephones and squawk boxes, and operating without threat of
sanction or illegality.
In fact, Blackbird fulfills the same functions as the voice
brokers, but with far greater efficiency and benefit to the financial
system. Blackbird is not an exchange or a clearing house. Blackbird
does not enter into transactions, provide credit support or take or add
credit risk. Blackbird does not change the individual customized nature
of swaps. Blackbird does not introduce preference or bias into
negotiations. Blackbird simply provides sophisticated dealers (and not
the public) with a computer-based electronic communications alternative
for the direct negotiation and agreement of bilateral transactions.
Blackbird offers an improved electronic method for a dealer to
identify other dealers who may, subject to the resolution of credit and
other terms, be willing to enter into a transaction having particular
economic terms desired by the first dealer. Use of Blackbird promotes
competition, improves transparency, record-keeping and risk control,
and reduces costs. Blackbird brings substantial private and public
benefit, without changing any meaningful feature of custom-tailored
swaps activities as they currently operate, and without creating any
need for novel regulation.
If Blackbird brings all these benefits, why did it encounter the
problems described above? It may be helpful to the Subcommittee to
consider for a moment the underlying legislative and regulatory causes
of DNI's predicament. First, there is the archaic language of the
Commodity Exchange Act itself. This language was stretched far beyond
its originally intended use (even before the advent of new electronic
technology) as ``commodity'' exchange-traded contracts have moved from
the agricultural into the financial. This inadequate statutory language
has led to the situation, bewildering to the uninitiated, where
Congress has directed the CFTC to exempt certain swaps from its
jurisdiction without Congress's ever deciding that these swaps were
``futures'' subject to the CEA to begin with. Build on top of this
rickety legislative base a regulatory exemptive structure struggling
for words to describe what might and might not be exempt and you have
all the makings of a roadblock to progress in an era of technological
innovation.
When words and reality no longer mesh, it is time to restore
direction by returning to basic principles. Fortunately, in the
Commodity Exchange Act context, we have seen this recognized on several
fronts. First, the Report of The President's Working Group on Financial
Markets entitled ``Over-the-Counter Derivatives Markets and the
Commodity Exchange Act'' explicitly recognized that the ``method by
which a transaction is executed has no obvious bearing on the need for
regulation in markets, such as the markets for financial derivatives,
that are not used for price discovery.'' The Report went on to note
that there is no ``demonstrable need for regulation'' of certain
electronic systems. Second, the new CFTC, reinventing itself under
Chairman Rainer, has participated in the President's Working Group
Report and has put forth a new regulatory proposal that attempts to
build afresh on positions of policy and principle, and that attempts to
encourage use of electronic systems. We are encouraged by Chairman
Rainer's very constructive attitude. Finally, the Congress now seems to
be well-focused on the fact that existing statutory and regulatory
regimes may not adapt readily to the promise and challenge of the new
technologies. The efforts of this Committee and others will be
invaluable in determining the direction for a redesign of our nation's
statutes and regulations. We encourage Congress to watch closely to be
sure that new regulatory constructs are sufficiently resilient to
weather changes in administration, as well as changes in technology.
DNI's message is not that all electronic systems should be
unregulated. DNI's message is that regulatory concern should be focused
not on the medium of communication or, for that matter, the medium of
transaction execution. Concern should be focused on the activities
accomplished with the medium, and should be coupled with consideration
of the inherent market discipline likely to shape those activities. If,
as is the case with Blackbird, those activities do not raise serious
concerns, great care should be taken to protect them from the very,
very serious countervailing threats of overbroad or anticompetitive
regulation.
Mr. Oxley. Thank you.
Next is John Schaible of NexTrade.
STATEMENT OF JOHN M. SCHAIBLE
Mr. Schaible. I would like to thank you, Mr. Chairman, and
members of the subcommittee. I am John Schaible, president and
co-founder of NexTrade Holdings. I have been asked by the
committee to address the following questions: What regulatory
changes are needed to promote full competition in our equity
markets? Would a central limit order book be desirable? What
are the implications of privatization of stock exchanges? And
finally, is NexTrade ready for decimalization.
In 1995 NexTrade was founded with the goal of providing
technological innovation to the financial services industry.
The little company started in 1995 has applied to become a
stock exchange, now employs nearly 60 people developing
technology for other brokerage firms across the globe. Before
we can answer the first question, we must define full
competition. Full competition is not a market where two
participants handle 95 percent of the shares traded in this
country. In order for the financial markets to become fully
competitive, we must promote competition between exchanges.
This competition can only be encouraged by the approval of new
for-profit exchanges. The Commission is currently considering
two applicants to become new fully electronic exchanges.
NexTrade notified the Commission of its intention to become an
exchange in 1998, and worked in draft mode with the Commission
in 1999 in preparing its formal exchange application. Despite
having filed this application, NexTrade has no clear timeframe
for approval. NexTrade fully appreciates the important role the
Commission serves in protecting the public. Nevertheless we
fear that inadequate staffing due to inadequate funding has, in
this tidal wave of change, overwhelmed the Commission. We fear
that the Commission's inability to review the applications is
one of the greatest risks to the continued supremacy of
America's capital markets. Recently, a third applicant decided
to halt its application in favor of becoming a facility of an
existing exchange. This decision may have been based in part on
a perceived lack of progress by the Commission.
The need for new electronic exchanges has been exacerbated
by NASDAQ's failure to be ready for decimals. This demonstrates
that we cannot rely on the existing nonprofit exchange model to
be the standard bearer in a new electronic environment. The
for-profit model has always been the hallmark of efficiency and
progress in our economy. Consequently, new for-profit exchanges
must be approved to promote full competition in our equity
markets.
Turning to the second question, a central limit order book,
or CLOB, would not be desirable. Like any centralized
marketplace, it would represent a single point of failure. It
would not enhance the marketplace, but harm innovation and
reduce the competitiveness of our markets. In comparison, the
competitive for-profit model exemplified by ECNs has had a
proven, beneficial impact on our markets. In 1998 alone, the
cost of a trade on NASDAQ fell 23 percent and spreads fell 41
percent. While ECNs have helped investors, this progress is
minimal in comparison to the benefits that will be derived from
the privatization of stock exchanges.
Privatization will result in exchanges that are more
competitive and will respond better to the needs of the
investors. New for-profit exchanges will enable the United
States to maintain its position as the preeminent global
market. Critics may claim that the drive to be the most
profitable exchange will result in a race to the bottom in
terms of quality of surveillance and investor protection. This
claim is without merit, because the exchanges with the best
investor protection will attract the best issuers, thereby
securing the most formidable competitive advantage.
Finally, NexTrade is disappointed that the move to
decimalization which may save the public up to $2 billion a
year may be delayed because some traditional marketplace
participants have failed to take appropriate steps to modernize
their technology. NexTrade applauds NASDAQ officials for their
concern for the integrity of the financial markets and also
appreciates NASDAQ's candor in admitting that its systems lack
the capacity to handle the projected increase in message
traffic that will result from decimalization.
Nevertheless, NASDAQ's failure to be decimal ready is of
great concern. It may be due to NASDAQ's antiquated technology,
which is systematically flawed, or that rather than
concentrating on being ready for decimals, the NASDAQ has
invested substantial resources in developing the proposed
SuperMontage. The prudence of allocating resources to such a
project in lieu of decimal compliance is questionable,
particularly in light of the vigorous industry opposition to
the proposed SuperMontage.
In contrast, NexTrade has been ready for decimal trading
since 1997. Chairman Oxley, Ranking Member Towns and members of
the committee, we are in danger of falling behind foreign
competitors in modernizing our capital markets. If America is
to retain its primacy in this critical area, we must implement
decimalization and we must foster competition by approving new
electronic exchanges. Moving forward, we must remove our
commitment to the principles that has served us in the past.
The best way to protect the investor is through vigorous
competition. We thank you very much.
[The prepared statement of John M. Schaible follows:]
PREPARED STATEMENT OF JOHN M. SCHAIBLE, PRESIDENT, NEXTRADE HOLDINGS,
INC. AND NEXTRADE, INC.
Chairman Oxley, Ranking Member Towns, and Members of the
Subcommittee: My name is John M. Schaible. I am the President and Co-
founder of NexTrade Holdings, Inc. I commend the Chairman and the
Members of the Finance Committee for holding these hearings on
Competition in the New Electronic Market. As an innovative force in
bringing about positive changes to the financial services industry,
NexTrade appreciates the opportunity to share our views on these
important public-policy issues. I have been asked by the Committee to
address the future of the securities markets and regulation of those
markets. Specifically, I will address the following questions:
A. What regulatory changes are needed to promote full competition in
the equity markets?
B. Would a Central Limit Order Book be desirable?
C. What are the implications of privatization of the stock exchanges?
D. NexTrade's readiness for decimalization?
NexTrade's vision of the future of the financial markets is deeply
rooted in the entrepreneurial spirit of its founders. In 1995, Mark
Yegge, NexTrade's C.E.O., and I founded a new technology driven
brokerage firm with the goal of promoting technological innovation of
the financial services industry.
The little company we founded in the living room of Mark Yegge's
apartment in 1995, now develops technology for the financial services
industry that is used by firms in this country and sought by firms
around the world. NexTrade Holdings also develops the systems for its
own subsidiaries, including the NexTrade Electronic Communications
Network (the ``NexTrade ECN'') and the proposed NexTrade Exchange.
NexTrade has invested millions of dollars in creating one of the most
sophisticated and robust transaction systems in the world. This new
technology will be the engine behind the NexTrade ECN and the proposed
NexTrade Exchange.
The NexTrade ECN is an automated trading system for equity
securities. It gives brokers the power to electronically display
customer orders. As an electronic auction market, the NexTrade ECN
directly matches buy and sell orders. The NexTrade ECN currently has
more than 60 broker-dealer subscribers and is used by many more non-
subscriber members of the National Association of Securities Dealers.
On an average day, NexTrade executes orders representing millions of
shares. All of the NexTrade ECN's orders are processed by computers in
a room the size of a large walk-in closet.
The proposed NexTrade Exchange is an example of the future of the
financial markets in that it makes use of innovative technology and new
regulatory structures as part of a for-profit exchange. The proposed
NexTrade Exchange plans to make available for the benefit of its
members and their customers an electronic trading system (the
``NexTrade Exchange System'') to effect the purchase or sale of
securities listed or admitted to trading on the proposed Exchange and
on other exchanges. The proposed exchange, however, will not maintain a
physical-trading floor. Members will access the NexTrade Exchange
System from their own computer terminals and communicate with the
NexTrade Exchange System over commercial information services and
networks.
As a member of the group of ECNs which account for approximately 35
percent of the Nasdaq's volume, as the developer of innovative new
technologies for the financial services industry, and as one of only
two ECNs currently seeking approval to operate new electronic stock
exchanges, NexTrade hopes the Committee will find my comments useful in
its consideration of the future of the financial services industry.
let technology lead the changes in the financial services markets
As the Chairman of the Securities and Exchange Commission, Arthur
Levitt, recently stated, ECNs ``have been one of the most important
developments in our markets in years--perhaps decades.'' Innovation and
new technology developed by ECNs and non-traditional market
participants are promoting the rapid and sweeping democratization of
the markets. Some experts predict that ECNs will represent 50 percent
of the volume on the Nasdaq by 2001. As a member of this group,
NexTrade is very proud of the role we have played in creating positive
change that has saved the public billions of dollars. Despite the great
progress that has been made, we still must strive to create fairer,
more competitive markets and to ensure that America maintains its
position as the financial center of the world.
In considering the future of the financial markets, lawmakers and
the Commission should heed the advice of Senator Gramm who recently
noted ``Let technology lead.'' As a technology leader, NexTrade
believes this approach will best serve the public. Lawmakers and the
Commission should resist the temptation to divine where the market is
going in a misguided attempt to conceive a new regulatory structure.
THE NEED FOR A NEW COMPETITVE NATIONAL MARKET SYSTEM
NexTrade believes with respect to regulation of the securities
markets, it is incumbent upon the Commission and Congress to question
each component of our current regulatory structure and ask this
question: ``Does the additional cost of the regulation outweigh its
benefit to the market and the individual investor?'' Rules that add
benefit should remain in effect and rules that detract from the market
or impede competition should be eliminated. While most components of
our current regulatory structure pass this test, certain components,
such the National Market System (``NMS'') do not.
NexTrade believes the Commission and Congress should strive to
remove artificial barriers to competition. An important step in
promoting greater competition would be the reform of the NMS. In
framing the 1975 amendments to the Act, Congress instructed the
Commission that in developing a National Market System, ``competition,
rather than regulation, should be the guiding force.'' The Commission
is mandated by Congress to facilitate the development of a national
market system not to be its chief architect. In establishing this
mandate, Congress identified five criteria that should drive the
Commission's role in the establishment of a NMS:
1. promotion of the development of mechanisms that allows for
economically efficient execution of securities transactions;
2. promotion of fair competition;
3. promotion of transparency;
4. improvement of investor access to the best markets; and
5. the development of mechanisms that allow for investors' orders to be
executed without the participation of a dealer.
There are numerous barriers to competition between markets,
including the NMS. The governance structures of the NMS plans are in
need of significant reform. Currently, the boards of these plans are
composed of representatives from each exchange. Any change to the rules
governing the operation of the NMS systems, such as the very rule
changes necessary to accommodate new electronic exchanges, require the
unanimous consent of the participants. The governance structures of the
NMS plans should be amended to include a broad constituency of market
participants including the existing exchanges, new electronic
exchanges, ECNs, broker-dealers and the investing public.
NexTrade believes the technology driving the NMS should also be
replaced. Two of the current plan participants, through the Securities
Industry Automation Corporation (``SIAC''), develop and operate the
computer systems that perform the responsibilities outlined in the NMS
plans. SIAC operates all of the NMS technologies, other than the Nasdaq
Unlisted Trading Privileges Plan, which is administered by the Nasdaq.
The American Stock Exchange and the New York Stock Exchange own SIAC.
Coupled with the anti-competitive governance structure of the NMS
plans, SIAC's administration of the NMS technologies allows two members
of the NMS plans to effectively impede the integration of new
electronic markets and the implementation of new technologies into the
NMS.
To address these issues, NexTrade recommends the modification and
opening of the NMS plans. NexTrade does not support the Commission or
Congress designating a third party that will operate the new NMS
systems. Rather, NexTrade believes that by opening the NMS plans to new
participants and by consolidating the functions of the NMS plans into a
single plan, market forces would ensure that the new plan could not be
used to protect antiquated markets from competition. Moreover, such a
structure would force SIAC, for the first time in nearly twenty-five
years, to compete with new firms that are interested in developing the
technologies that drive the new NMS.
A CENTRAL LIMIT ORDER BOOK WOULD NOT ENHANCE THE MARKETPLACE AND WOULD
ONLY HARM INNOVATION, ADD BUREAUCRACY, AND REDUCE THE COMPETITIVENESS
OF OUR MARKETS
There are those with less confidence in the economic efficiencies
produced by competition who continue to express concerns about
fragmentation when trading is spread across competing markets. The same
people that have contributed to fragmentation have also supported the
centralization of all trading in a time-priority central limit order
book, or CLOB. Academics and the Commission have debated this vision of
transforming America's financial markets into a CLOB in the past, only
to be rejected each time as a bad idea.
The notion behind the CLOB is that technology can be employed to
centralize orders in one place, thus resulting in maximum order
interaction and perhaps even better prices. A CLOB, however, will
sacrifice the innovation that has made our markets the best in the
world. Research has shown that competitive markets are better equipped
to implement technological innovations to address market
inefficiencies. Centralized markets, no matter how well intentioned
their architects, will typically be obsolete by the time they commence
operation. Competition creates incentives for markets to upgrade and
innovate. Centralized markets do not. Unlike open markets, centralized
markets serve to impede the ability of innovative firms to develop new
technologies and mechanisms that promote better execution. Proponents
of a CLOB typically rely on claims that the markets are fragmented and
that this fragmentation can only be addressed by means of a CLOB.
FRAGMENTATION IS BEST ADDRESSED BY COMPETITIVE MARKETS AND
TECHNOLOGICAL INNOVATION
Fragmentation has always been a problem for our markets. It is not
a question of if fragmentation exists, but rather a question of degree.
In the past, fragmentation was severe and was compounded by inadequate
information technology. As technology evolved, the degree of
fragmentation has diminished while the number of market participants
has skyrocketed. However, the level of fragmentation in our markets
could be greatly reduced by reforming the NMS.
Statistical evidence supports the conclusion that ECNs produced
more efficient and less fragmented markets. Since the arrival of
qualified ECNs, evidence reveals dramatic improvements in the costs of
trading stocks in the United States. The average cost of executing a
trade on the Nasdaq Stock Market fell by 23 percent in 1998, spreads
fell 41 percent, and volume increased substantially. If left to
competitive devices, the degree of fragmentation within the markets
will continue to be reduced despite the introduction of a multitude of
market participants.
There has always been a tension between the efficiencies of
centralizing order flow and the benefits of competition between
markets. Currently, the markets are linked by the NMS plans. One plan
that is very important in reducing market fragmentation is the Inter-
market Trading System (``ITS''), which allows orders to be routed to
the best market regardless of which market originally received the
order. Unfortunately, the technology and the rules governing the
operation of the system are, in Chairman Levitt's words, ``archaic.''
Market participants using ITS to route orders to other markets may wait
as long as two minutes to receive a response and, even then, may not
receive an execution.
Historically, the traditional market participants were opposed to
technological innovations that could undermine their hegemony over the
markets. This resistance to technology has resulted in fragmentation.
However, competitive market participants have responded to perceived
fragmentation and inefficiencies with market-based innovative
solutions. A variety of ECNs and other trading systems have responded
with systems that consolidate and provide efficient access to the best
prices among competing markets. One firm has connected all nine
original ECNs, the NYSE and the Nasdaq to their system. Similarly, when
the current Nasdaq linkage (SelectNet) proved too expensive and
inefficient to handle record volumes, market participants forged links
with one another to create trading networks that bypass SelectNet for
faster and more reliable access to the best market prices.
A CENTRAL LIMIT ORDER BOOK IS ANTI-COMPETITIVE AND HARMS THE PUBLIC
The proposed CLOB is anti-competitive and would impede the
development of new for-profit electronic stock exchanges. If the
Commission mandates a monopolistic central execution system, such as
the proposed CLOB, with which all market-participants must comply,
innovation could be eliminated. Such a dearth of innovation would not
serve the goals of the Act, the NMS, or the public. Rather than
developing a system that would reduce innovation by new for-profit
electronic exchanges, ECNs and other market participants, and halt the
development of technologies that provide additional liquidity and
transparency, the Commission should encourage a new and equitable NMS.
Government imposed centralization will cost all investors in terms
of less competition, less choice, and ultimately less efficiency. The
expensive new infrastructure and bureaucracy required to support a CLOB
would impose significant costs on new electronic for-profit exchanges,
the market and ultimately issuers. Most importantly, a CLOB will result
in worse prices for ordinary retail investors.
The amount of price improvement available in new and traditional
markets is obviously an important factor in this equation. NexTrade
supports new ways to get better prices for customers, but this should
be achieved through competition, not legislation. More importantly, we
caution against adoption of a single structure or price improvement
formula at the expense of competition and innovative alternatives. The
proposed CLOB offers no additional benefits, and only serves to impede
competition and the development of new electronic markets.
A CLOB PRESENTS A CENTRAL POINT OF FAILURE THAT WOULD THREATEN
AMERICA'S FINANCIAL MARKETS
Like any centralized marketplace, a CLOB would have substantial
dangers. Most importantly, a CLOB would represent a single point of
failure that could jeopardize the global economy. The danger of such
centralization is apparent in light of recent well-publicized attacks
on some of the largest Internet web sites and service providers. It is
economically impracticable to design a centralized marketplace that
would be completely free of vulnerability to attacks by cyber-
terrorists. The implausibility of designing a totally safe CLOB will
become increasingly apparent in the future as warfare and terrorism
move from city streets to the Internet. In contrast, the currently
developing network of trading facilities, much like the Internet,
mitigates these potential dangers through numerous alternative trade
destinations.
The greatest negative effect that would result from the
implementation of the proposed CLOB would be that the entire NMS would
become dependent on the capacity, integrity and security of a single,
largely antiquated system, which has proven to be unreliable. NexTrade
believes investors and the market benefit from a variety of alternative
systems that route, display and execute orders. The rapidly declining
costs of telecommunications technology has made it possible to build
and maintain redundant, competitive systems to handle orders without
the need for a single monolithic service provider.
The currently developing network of electronic exchanges and market
participants offers the best solution in a competitive environment. A
reformed and more open NMS that is not dominated by a single exchange
and its technology will promote the continuing development of
innovative trading tools that electronically process orders in an
efficient and reliable manner across multiple sources of liquidity.
NEXTRADE IS READY FOR DECIMALS AND IS DISAPPOINTED THAT THE MOVE TO
DECIMILZATION WHICH WILL SAVE THE PUBLIC UP TO TWO BILLION DOLLARS A
YEAR MAY BE DELAYED BECAUSE SOME TRADITIONAL MARKET PARTICIPANTS HAVE
FAILED TO TAKE APPROPRIATE STEPS TO MODERNIZE THEIR TECHNOLOGY
Like most ECNs and Alternative Trading Systems designed in the past
five (5) years, the technology behind the NexTrade ECN and the proposed
NexTrade Exchange is ready for trading in decimals. As a member of the
National Association of Securities Dealers (``NASD'') trading on the
Nasdaq, the NexTrade ECN System currently has to convert orders that
are in decimal increments into fractions for execution. Like many
members of the Nasdaq, NexTrade has eagerly awaited the arrival of
decimalization.
In order to ensure that NexTrade's linkages to the NMS and the
Nasdaq are ready for decimalization, NexTrade is planning on
participating in the industry wide decimalization testing.
Unfortunately, as a member of the NASD and a Nasdaq participant, any
delays by the Nasdaq in implementing decimalization will impact
NexTrade's ability to conduct this testing and will delay the
introduction of decimal pricing for our subscribers.
On January 28, 2000, the Commission ordered the securities markets
to begin trading in decimals on July 3, 2000.<SUP>1</SUP> The
transition to decimals will save investors anywhere from $300 million
to almost $2 billion annually. The transition to decimals, however,
must be delayed because some traditional market participants have
failed to invest in technology that will enable them to handle the
increased quote traffic resulting from the switch to decimals from
fractions.
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\1\ Exchange Act Release No. 34-42360, 65 Fed. Reg. 5003 (Jan. 28,
2000).
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A recent study conducted by SRI Consulting projected that message
traffic for stock and options quotes would likely rise dramatically
when decimal trading begins. The SRI study projected that options
trading in decimals could lead to a 3,000 percent increase in peak
message traffic by December 2001. The study also noted that even if
decimals were not introduced, message traffic would rise 779 percent.
According to SRI, the transition to decimals will mean that Nasdaq
message traffic could rise as much as 700 percent by December 2001.
Even without decimals, the peak message traffic for Nasdaq stocks could
be 174 percent higher. Message traffic for securities traded on the
exchanges would be 50 percent higher by the end of 2001 from its
December 1998 levels without any impact from decimal trading.
NexTrade applauds Nasdaq officials for their concern for the
integrity of the NMS and for having informed the Commission that their
market would not be ready until the first quarter of 2001 to
accommodate the increased message traffic expected from decimal
trading. NexTrade, however, is troubled by the Nasdaq's failure to take
the necessary steps to ensure that it would be ready for the
implementation of decimalization. Nasdaq, however, is not alone in its
failure to address systems capacity problems associated with the
conversion to decimals.
According to the General Accounting Office, the Options Price
Reporting Authority (``OPRA'') will also face considerable difficulties
as it attempts to handle the increased message traffic. OPRA, the NMS
system used to disseminate trade and price quote messages for equity
and index options industry wide, is currently incapable of handling the
increased volume levels that will result from the transition to
decimals. OPRA officials have admitted that upgrading their systems to
handle the increased options traffic expected from decimalization is a
major challenge. In order to address the current and projected message
traffic volumes, OPRA and SIAC intend to begin increasing system
capacity. OPRA plans to increase system capacity by December 2000 from
its current maximum of 3,000 messages per second to 12,000 messages per
second. It is unclear if this additional capacity is sufficient to
accommodate the volume levels projected in the SRI study.
NexTrade is concerned that the delays requested by traditional
market participants that are not ready for decimalization will cost the
public the $300 million to almost $2 billion dollars in annual savings
that will be the result of the transition to decimals. The market
structure that has resulted in the delay in the implementation of
decimal pricing is in need of fundamental restructuring. The opening of
the NMS to greater public and non-traditional market participant
involvement will help to promote innovation and greater competition.
Such competition and innovation will result in more efficient markets
that benefit the public.
CONCLUSION
Mr. Chairman, and members of the House Subcommittee on Finance and
Hazardous Materials, we have the unique opportunity to create fairer
and more competitive markets. While it is unclear what the future holds
for the development of the financial markets, we must remember that the
Internet empowers entrepreneurs and the public like no other vehicle
has in the past. If we are to retain our primacy in the capital markets
we must embrace two concepts: (1) the Internet will transcend our
ability to regulate the markets, and (2) the future of finance does not
have a Wall Street address, it has an IP address.
As this Committee works its way through these various public-policy
issues, NexTrade would welcome the chance to elaborate on the proposals
put forth today, and to contribute in the most constructive way
possible to this important dialogue.
Thank you very much.
Mr. Shimkus [presiding]. I think what we will do for the
benefit of members who have gone to the floor for the vote, I
will ask a few questions, which will allow the chairman and the
ranking member time to get back so they can see both
demonstrations.
So if I may, a question for all of you is what percentage
of limit orders placed on each of your systems is completed in
the very impressive 1\300\ of a second that I have heard
discussed?
Mr. Andresen. On The Island, it is benchmarked around 1
millisecond, as you've noted, but it is difficult to quantify
the percentage of limit orders that are executed because Island
encourages the submitting of limit orders such as buying Dell
at a dollar or selling Amazon at $200. I used to laugh at both
of those. Now I just laugh when people are selling Amazon too
early. With limit orders because you are placing a specific
price limit on what you are willing to buy or sell, you can
only quantify the percentage that get to the market and then
are executed. And because ECNs are included within the national
market system for NASDAQ stocks, all orders represented on ECNs
like Island are executed that become marketable.
Mr. Shimkus. Let's just go down the panel.
Mr. Foley.
Mr. Foley. \3/100\ of a second, that is a technical
question that requires a technical answer. ECNs are, by
regulation----
Mr. Shimkus. And let me just clarify. The direction of this
question is obviously there is great, quick equally matching
when you have a buyer and a seller. What percentage of that is
in that rapid response? What percentage is not within that
quick reaction time, and probably the vast majority if you take
the majority of transactions?
Mr. Foley. When you have a buyer and a seller that matches,
it is 100 percent. That is the business that we are in. We
match immediately. We are agents only. We have no other
business with that information except getting our customers'
trades done. That includes orders that come from noncustomers,
from the outside. We have an obligation to our customers to
execute the trades immediately and we do so. It is another
matter--I would say the amount of time it may take a
noncustomer's order to get to us if it goes through NASDAQ
technology, for example, but many of the ECNs have connected to
each other privately in order to maintain rapid communications
between ECNs, which is an obvious addition to your ability to
respond instantaneously. So the direction of technology is to
do things rapid fire. Where technology is allowed to compete in
an unfettered fashion, you have greater speed, greater
reliability and greater customer satisfaction. That is what we
are committed to.
Mr. Shimkus. And I will let this question evolve as I go
through the panel. The various published reports state that
this happens approximately 25 percent of the time. So the
question that is emerging is what happens to the 75 percent,
and if they are executed because they are sent elsewhere?
Mr. Dorsch. I think this question is probably more geared
to the other members of the panel today. In our arena, SWAPS
trading and negotiation is done differently. We don't match
orders, per se. It is an electronically negotiated process.
Having said that, to quantify how much we have speeded up the
process is a little bit like somebody who was once walking and
now they are flying in a jet fighter. We have added that much
speed to the process.
Mr. Oxley. Mr. Schaible?
Mr. Schaible. I will take the question to mean what happens
to the order if the ECN does not have a match inside the book.
In that circumstance, and I am speaking for NexTrade, we
have invested millions of dollars in order routing technology
that will allow us to handle market orders and orders that do
not have a match inside our system to go to the best
destination as quickly as possible. We have found that is to
other ECNs quite frequently.
Mr. Foley. I didn't interpret the question referring to
that issue, and it is an important issue. What we do at
Bloomberg Tradebook is show the best prices to our customers
from any place we can get them, from the market makers in
NASDAQ, from other ECNs, and we present our clients with the
opportunity to route directly to the best price, wherever it
may be, and that is not something that every ECN does, and it
is an important part of the service that we provide for our
customers because they need to know more than just what the
best price is among our customers.
As we have grown, that becomes more and more important
information. The success in our markets, both the market in
general and also for our customers, the individual
participants, means the ability to see where everybody else who
may be the other side of your trade is and that is
transparency, and the ability to get there. And that is the
market linkage, and that is what we promote. It is an important
value to our clients at Bloomberg Tradebook.
Mr. Shimkus. Let me throw out this question to the
panelists. You all talk about immediate access to the
Intermarket Trading System. Why should you be able to access
the ITS in a manner that is different from all of the other
broker-dealers?
Mr. Andresen. I don't think that we should have any
different access as long as we meet the regulatory obligations
of the structure within which we exist. Island is regulated as
a broker-dealer itself by the NASD, and also as an alternative
trading system or ATS by the SEC. I believe that if a broker-
dealer, whether electronic or otherwise, can make itself
accessible to investors, they should have the opportunity to
compete. One thing that ECNs do differently than traditional
marketplaces is allow for instant information and instant
access.
If you see something on an ECN, you can get to it
immediately because it is, in fact, a live order, in The
Island's case, a retail order. If there is a traditional
intermediary, the one problem with that is if they don't make
themselves immediately accessible, everyone's systems have to
slow down to the lowest common denominator.
Mr. Foley. I would like to be explicit about this. We don't
believe that ECNs need to have direct access to the ITS. We
understand the argument, and some have used the analogy of the
NFL. There is the NFL or you can start your own league. You
can't demand entry into this league.
The issue is this: We want there to be competition among
the exchanges because if there is competition among the
exchanges, then we know that exchanges who want the order flow
from our customers are going to be responsive to our needs for
innovation and so forth. The ITS committee in our view, the way
ITS is governed, restrains and discourages competition among
exchanges.
It has been more than a year and a half since the Director
of the Division of Market Regulation, then the Director,
Richard Lindsay, wrote a letter to the ITS committee expressing
concern over how ITS is governed. They make decisions by a
blackball method. If anybody is opposed, then change can't
happen. That has made it difficult for the NASD to bring ECNs
in, and it makes any kind of technological change all but
impossible.
Our issue is that the Congress should be concerned. The
Commission should follow up on this question of how ITS is
governed because if ITS is allowed to make decisions on the
basis of what the exchanges themselves feel is in their best
interest and exchange competition can flourish, we think that
there will be exchanges that want a home for us and innovative
broker-dealers and will provide services for us and our clients
that we currently can't get in the listed markets.
Mr. Oxley. Thank you, and thank you to the gentleman from
Illinois for sitting in the chair. This will be an appropriate
time to have our show and tell.
Mr. Andresen, if you would proceed with that, we would
appreciate that.
Mr. Andresen. What you are looking at here is the wide
market in the stock Cisco Systems which is the largest stock by
market cap in the world. All of those colors that you see, and
I understand that it is hard to make out from up on the dais,
all of those changes that you see are retail investors putting
in indications to buy or sell, live accessible orders. And this
is important in our minds for two reasons: one, because people
can now make better investing decisions. Chairman Levitt has
said over and over again that the best investor protection tool
is the use of a priced order. The reason why people place
market orders in the stock market is because they lack
knowledge of what the order is. You would never place a market
order for an automobile or a box of Cheerios, but in my mind it
is even more distressing that you place one for your life
savings or pension into a stock market with no knowledge of
what you are going to pay.
And as an example, the price line IPO, one of the hot IPOs
of last year, the investment bankers priced that deal at $9 a
share. The opening price was at $90 a share, which is where all
of those market orders got filled. The investors found out
about those executions when the stock was back down at $60 a
trade. The use of limit orders hinges on your ability to know
the prices. And it is not good enough to be able to look the
next day in the Wall Street Journal or The Washington Post in
the stock tables. You must be able to know right now what
everyone is doing. Just looking at the last sale in the stock
is like driving a car down the road by looking over your
shoulder and saying wow, this road sure is straight. Not seeing
the orders, what everyone else wants to do in the stock is very
dangerous.
The other thing that seeing the entire limit order book
enables you to do is have accountability for your order. Right
now, in traditional marketplaces, they will only tell you the
best price. That means they will tell you the highest price
anyone is willing to buy Cisco at is $77. The lowest price
someone is willing to sell is $77\1/2\. That is interesting
information, but not being able to see what is behind those
orders, who wants to buy at $76\3/4\ or $75 is damaging. In
addition, not seeing your order within that list of orders is
very dangerous.
What we have given with the Island Book viewer is pure
instant accountability for your broker. Instead of talking to
your broker 3 years ago and saying gee, Broker Bob, I would
like to buy Dell and have him say you can buy it at $38, having
him tell you that a day later. Now the conversation is gee,
Bob, I put my limit order in to buy Dell at $38\1/16\ when it
was $38\1/8\ by $38\5/16\, and it traded down to $37\31/32\,
and I didn't get an execution. What are you doing over there?
And that is an empowered investor, an investor who has the
tools to be able to judge the service that they are given.
Everyone knows about commissions, margin lending rates and
access to research. Until now, they have not been able to know
about execution quality. Execution quality, the price your
trade is actually given to you at is far more expensive, a dead
weight loss to the investor. Seeing your order in there with
everyone else's is the kind of transparency that is essential
for investor protection. Thank you.
Mr. Oxley. Thank you. Mr. Schaible.
Mr. Schaible. Actually, I am going to need the phone cord
from Matt's machine to do the connection. In the interim, I
want to return to a question that the gentleman had asked
before you came back into the room about whether or not we
believe that all broker-dealers should have access to ITS equal
to what ECNs are asking for, and I want to agree with what Matt
had said with one important caveat.
I think that anybody who has access to the National Market
System should have to pass a validation of some kind with
respect to the level of technology that they can bring and that
certainly, that level of technology should be held to the
current ITS. If Matt participated in ITS on the way orders are
executed today, they would absolutely expose themselves to
double, triple, quadruple execution for a single order. The
current ITS system holds single orders alive for up to 2
minutes because their technology is so antiquated. I think it
is an important topic.
Mr. Oxley. Who would determine that capability, that
technological capability?
Mr. Schaible. We have suggested that we broaden the
governing structuring of the National Market System plans,
particularly ITS, to get in a wider representation base.
Currently only exchange members can be part of the ITS
governance board. We think there should be broker-dealers,
members of the public, issuers, representing a board similar to
the structures of an exchange and that board can make the
decision what the standard should be and submit it to the
Commission for approval.
This will take me just 1 minute. What you see on the screen
on the left-hand side is information on the current NASDAQ
operating environment. It is structured to display what are
called level 2 quotes, which shows essentially the best prices
of every market maker or ECN today on Dell computers. This
system is a system that a lot of our broker-dealer clients
utilize to connect to the NexTrade ECN.
On the right-hand side of the screen is the NexTrade order
book, and we anonymously show the interest of every order
inside on the NexTrade ECN so that any investor or market
participant can see the complete depth of NexTrade's book. This
is an important difference from left to right. On the left-hand
side the NASDAQ, you see only the top of the book of the market
participants, and to get access to this information you must
pay a professional fee of $50 a month to the NASDAQ.
For the information on the right you see the entire depth
of book in real time for free. And that is something that I
think NexTrade is doing. I believe Island offers their quote
depth for free as well, and it is something that we do as a
competitive tool because we can show that depth and we do that
to attract market share away from the NASDAQ. This system can
do everything that NASDAQ can do with respect to executing
orders and more, and we can do it over the Internet. We can
trade like the NASDAQ in 20 seconds, and that is what
competition will do for the market.
Mr. Foley. Mr. Chairman, I wonder if I can give you a
verbal demonstration of some of the differences in the ECN
space. One of the things that we think is really important for
our clients is to show the full depth of the market, including
all of the quotes from NASDAQ and combine them with the orders
of our clients and route our client's orders to the best
market, the best market maker, or the best ECN to satisfy our
best execution obligations. And let me put it this way. If you
look at the display that shows the depth of book from a single
participant, even a large one, 12 percent of the market, for
example, you are still missing out on the other 88 percent of
where the best price may be and the best place to execute a
brokers--customer's trade.
And so the display that we provide for our customers is one
that shows the complete information and we are enthusiastic
advocates of public displays that combine rather than having to
go from one place to other, that combine the aggregate market
depth. We enthusiastically endorse the proposal that SEC
Chairman Levitt put forth at Northwestern a couple of weeks ago
that the industry should work toward a free market solution for
this.
We enthusiastically oppose NASDAQ's proposal, which you
will find presents depth of market information, but it takes
our names off the source of the quotes and replaces it with
NASDAQ's name. Hence, centralizing not just the display but the
execution into a black box because you have to go through them
to get to that so-called anonymous quote.
I just wanted to lay out a couple of distinctions that we
think it is in the best interest of the investing public to see
all of the information in one place, and all of the places
where you can execute with the ability to get there. We do that
for our clients. We support Chairman Levitt's initiative that
will do that for the investing public in general, and we oppose
the SuperMontage which purports to do that, but we think is an
anticompetitive positioning of NASDAQ as a government-sponsored
monopoly technology provider in advance of their privatization.
Mr. Oxley. The Chair recognizes himself for 5 minutes for
some questions.
Mr. Foley, and maybe some others, could you help me with
this issue, that is the SuperMontage idea versus central limit
order book. Explain to the uninitiated, are they competing
concepts or are they similar from your perspective and how
should this committee perceive both of these initiatives?
Mr. Foley. The distinguishing characteristic of the CLOB is
that someone or some entity is in charge, and some of the
debates you might hear at the top about this proposal versus
that, this is not a CLOB and this is, really the debate comes
down to who is in charge. NASDAQ's SuperMontage proposal, has
all of the centralizing aspects of a generic CLOB proposal, but
it has a specific characteristic that NASDAQ is in charge of
it.
One of the issues that came up earlier had to do with the
compelling of orders into a CLOB? Would retail orders be
compelled but institutional orders not be compelled? We think
that orders that are displayed to anyone should be displayed to
everybody and that should be a requirement. But what particular
technology you go into should be a matter for the free market
to decide, and that is the danger of a CLOB. No matter what you
call it, if it centralizes the black box, you are going to have
a single point of failure. You are going to have a single point
that is resistant to change. You are going to have to have
people like us on this panel raising our hands for permission
to innovate in the future, and that is not the way that we have
managed to serve our customers and grow our businesses over the
last few years.
Mr. Oxley. May I interrupt. If all of these impediments are
out there, how have you been so successful so far?
Mr. Foley. That is a great question. A lot of these issues
can be confusing because there are different things going on. I
boil it down to this.
The NASDAQ market is a market where new nimble competitors
can come in and introduce innovations and thrive. It is
consolidated and not fragmented. Where NASDAQ's linkages don't
suffice, ECNs can connect privately to each other and replace
those outworn solutions with state-of-the-art solutions.
The SuperMontage proposal says there is a lot of chaos
here. There is a lot of change. Things are going on. Let's take
an example. Bloomberg Tradebook's innovation of reserve, which
allows for the handling of large orders in an electronic
marketplace, is incorporated into the NASDAQ SuperMontage
proposal. You wouldn't introduce an electronic trading system
today without the innovation that we introduced 3 years ago.
You know, the issue in the NASDAQ market is when you say this
is the institutionalized, centralized level of innovation, do
we really know that we don't need any more innovation, that
there are not customers that we can serve better with new
competitors. I would argue if you hold this panel 3 or 4 years
from now, if a central limit order book or the CLOB takes hold,
it will be the same innovators here. We will be talking about
innovations that we had 5 years ago in the year 2000.
Because of the NASDAQ market maker collusion scandal in
1996, it was much more open to the reforms of the SEC than the
listed markets have been. But we think what makes the U.S.
securities markets the best in the world and what is going to
keep U.S. securities markets in the U.S., is transparency. Now
we are defining transparency and we are thrilled to see this
debate move forward as the full market depth for everyone to
see. Linkages. You see the best prices. Do you have the ability
to get there, and the best execution obligations that brokers
such as ourselves should take advantage of the linkages to do
the right thing for our clients.
We have been able to innovate on NASDAQ, not so much on the
listed side. We don't want to see NASDAQ innovation stopped and
we would like to see it started up on the listed side.
Mr. Oxley. Thank you.
Mr. Andresen. I think it is sometimes instructive to look
at what NASDAQ is. We are all interested in making sure that
investors get all of the information that they can. That, in
fact, is NASDAQ's core competency. NASDAQ is not a central
meeting place at all. Instead, it is a collection of different
participants, three of whom you see represented today. Others
like Goldman Sachs or Morgan Stanley also participate in
NASDAQ.
What the SEC did in 1997 was say this NASDAQ world, if you
think of it perhaps as a shopping mall, the shopping mall
doesn't buy or sell things. They provide the roof for the
different stores to transact their business. NASDAQ ensures,
just as a shopping mall does, that you have a map of where to
go, and if you lack the ability to get there, give you the
communication path to be able to buy whatever you want from the
prices they give you. ECNs were not in that shopping mall in
1996. The SEC insisted in their order handling rules that they
should be so you now have different types of stores within this
mall applying slightly different wares.
The issue before you today is not so much what is going on
in the shopping mall, in NASDAQ. Maybe NASDAQ through the
SuperMontage wants to open its own store. I am not afraid of
competing with NASDAQ on the basis of service, cost and
reliability. If they can do a better job than Island, they are
welcome to the business. On the listed side, however, their
shopping mall is a collection of the 10 established stock
exchanges: The New York Stock Exchange, Am Ex, Philadelphia
Boston, Cincinnati Chicago, et cetera.
The ECNs are just like Burlington Coat Factory. We are
stuck on the other side of the expressway, hoping that people
stop by our stores on the way to the centralized meeting place.
We ask for a chance to share our prices with the other
marketplaces. Let's let investors vote with their feet and
select the marketplaces which adds the most valuable.
Mr. Oxley. Thank you. The gentleman from New York.
Mr. Towns. Thank you, Mr. Chairman. Who is proposing a
CLOB? And why?
Mr. Foley. The CLOB is not a formal proposal before the
public at this point. We understand that there is a white paper
that is in draft form drafted by some of the leading brokerage
firms on Wall Street that formulates the notion of a CLOB and
why markets need a CLOB today.
The second place where you see evidence of the debate over
a CLOB is with a paper that the SEC recently released. It was a
concept release asking for public comment on various issues of
market structure and the first and most important issue that
they ask for is do we need a central limit order book to
address issues of market structure.
Finally, it has been raised by panelists who have testified
on the Senate side before the Senate Banking Committee on
market structure. I say this about the debate. If you really
want to boil it down to one thing that we think is the most
important, there is a lot of concern about how our equity
markets are going to be structured to be the most competitive
for the world in the future. There is a lot of debate around
decimalization and the Commerce Committee championed
decimalization, and I congratulate the chairman on the issue of
decimalization.
On one level it was a question of I buy my groceries in
dollars and cents and I would like my stock purchases to make
sense as well. You have academicians weighing in saying
decimalization carries with it so many beneficial effects that
address a lot of the complicated issues in market structure.
Our issue is simply this: We don't know what decimalization
is going to solve until we have decimalization, and we don't
think that we should be looking at intrusive, sweeping
regulatory changes in a marketplace that is going to change for
the better once we see decimalization. As I think someone else
on the panel mentioned, we think everyone's first priority
should be getting to decimalization, and we will see what the
benefits are and we then can see what else we need in the
marketplace.
Mr. Towns. You anticipated my second question.
Mr. Andresen. I think any time you look at Wall Street or
any other industry, you have to look at underlying motivations.
What is in it for me. Those who propose a CLOB are people that
stand to benefit.
I used to be a big fan of the Price Is Right when I was
sick and staying home from school--a couple of years ago. I
remember always feeling really sorry for the first poor guy
that had to make the first bid. He would say $300 for that
laptop, and everyone else would be $301, $299. He would just
sit up there all morning and people would sandwich him on
either side.
If you look at Morgan Stanley, Merrill Lynch and Goldman
Sachs, who are the ones who proposed this most directly on the
Senate side in their hearings in New York, these companies
don't really control much retail order flow. That has gone to
places like Island or market makers like Knight Trimark. They
control institutional order flow. So they propose having a
public utility, being the initial transparent venue for all
retail investors for them to make that first bid. Their
customers can come in through their gateway and pick off the
retail investors as they see fit.
I believe transparency is not about holding up retail
investors for them to be cherry-picked. It is about creating a
truly level playing field where everyone has access to everyone
else's information at the same time.
If you look at the CLOB, inevitably there are those little
carve-outs. They want a CLOB but not for our customers, because
in the end, a market is about asymmetric information. If I know
the final score between Wake Forest and Notre Dame, I will make
a lot of money betting on it. If everybody knows the final
score, it is uninteresting information to have. Everyone wants
to see what everyone else is doing without showing their own
cards. When you look at someone else's proposal, you should see
that through the lens of their own business model.
Mr. Towns. Thank you very much. One more question, Mr.
Chairman.
What can this subcommittee do to foster reform of the ITS?
What can we do?
Mr. Andresen. Well, I think the most important thing is
just to make this a debate. I think market structure is
something which has been very opaque to retail investors. I
remember reading an article in the Wall Street Journal about an
investor that lost a tremendous amount of money in the Palm
Pilot IPO because the market center had held his order for a
substantial amount of time. And I was struck and the reporter
was struck by what did you think happened to your order when
you submitted it? Didn't you think that it was sold to someone
else who was going to trade against it? He said I just thought
they sent it to the stock market, and this illustrates the
degree to which the investors have become knowledgeable about
individual stocks and the market direction, but have not
thought about market structure.
As long as we look to create in ITS an environment where
new competitors can come in and actually compete, we will have
an efficient system. If this committee considers the structure
right now which is, as alluded to before, the old U.N. Security
Council situation where one person can veto a change. It is
really a situation where if we are soda manufacturers and I
have to go with my new soda pop to Coke and Pepsi for
permission to compete, and they can say yes, just serve it at
120 degrees Fahrenheit, it makes the benefits of that new soda
obsolete.
ECNs are new markets that are as revolutionary and as
innovative as the light bulb was to the candlestick, but we are
being asked by the existing candlemakers to screw our light
bulb into their candlestick.
Mr. Oxley. The gentleman's time has expired. The gentleman
from Iowa, Mr. Ganske.
Mr. Ganske. Thank you, Mr. Chairman. While I have learned a
lot in your presentation, I appreciate your testimony. Mr.
Chairman, I have here some remarks by Chairman Levitt on a
speech that he gave at Northwestern University on March 16, and
I am going to skip around a little bit but read part of this,
and then my question will be to get each of your remarks on
what Chairman Levitt had to say.
Chairman Levitt said, ``We can all agree that a market
structure tilted toward the needs of hedge fund managers should
not be our goal. At the same time, we should not foster a
system bent toward day traders. Our future markets must serve
the diversity of American investors. Of course, if we have a
single monolithic market fulfilling this responsibility to
customers would be much simpler, but I believe Congress was
visionary in choosing not to mandate such a market. Over the
last 25 years, our system of competing market centers has been
the driving force behind faster and cheaper executions spawning
new trading systems that provide anonymity and greater
liquidity.''
He goes on to say, ``Market centers in a dynamic National
Market System must be able to hone a niche, develop a brand or
offer value-added features.'' I think that is some of what you
are talking about in your testimony. ``Any linkage must
accommodate innovation and the imperative to compete on the
basis of value. Moreover, inner market linkages are not
intended to promote unlimited free access to a competitor's
market. Why, for example, would anyone want to purchase a seat
on the New York Stock Exchange if a connection to ITS offered
equivalent benefits. At the Commission we well know that ITS
has not kept pace with the technological change sweeping our
markets. Its archaic structure and cumbersome governmental
provisions are not fit for today's market, let alone the market
of the future. The over-the-counter linkage, SelectNet,
continues to be plagued with shortcomings and delays during
heavy trading volume and even outages. Given the decentralized
nature of the NASDAQ market, this is a critical and core flaw
and one that must receive intense scrutiny and committed
resources until resolved. We expect to exercise increasingly
active oversight of these linkages in the near future.''
Mr. Levitt continues, ``In a more positive note, the
Commission today,'' that was March 16, ``approved a NASDAQ
proposal to link ECNs to the listed market through ITS. I
firmly believe that investors will be winners as fuller, more
robust competition between equity exchanges unfolds.'' Then Mr.
Levitt finished by saying ``This is not a debate about big
firms versus small firms. This is not a debate about
institutional interests versus retail interest. It is not a
debate about a monolithic market versus a splintered market. It
is not a debate about human intelligence versus the quiet hum
of a computer. Rather, it is a debate about how best to let
unburdened competition and unbridled innovation drive the
future of the market. It is a debate about how best to meet the
needs of our investors, it is a debate about how best to equip
our markets to compete and win in an increasingly globalized
electronic market. It is, I believe, the most important debate
our capital markets face.''
I wonder if each of you can comment on those selected
remarks of Chairman Levitt or focus on any particular part of
those parts that I read. Maybe we can start with Mr. Andresen.
Mr. Andresen. Thank you. I think Chairman Levitt has,
throughout his entire tenure, worked to foster competition
within the markets. Island's very existence is owed fully to
the SEC's intervention in 1997. Without that, Island would
never have had the chance to differentiate ourselves as a
marketplace from everyone else.
I am sure it would not be surprising for you to know that
the people in front of you today are not really friends. When
we go back to New York or Florida, we will scratch and claw and
fight to try to find some tiny advantage over the other person.
That is the healthy aspect of competition. Without competition
you have stagnation. Our phone company in 1981 was certainly
the envy of the world, but there were busy signals and rotary
dial phones. Today in the era of robust competition, we have
tremendous breadth of service at incredibly lower cost. The
equity markets are the same way. Island was designed to be
fully decimalized. Island doesn't go to nickels or pennies but
actually to tenth of a tenth of a tenth. We go to 10 decimal
places.
Mr. Ganske. Let me ask each of you to try to limit your
remarks to 30 seconds or a minute so that all of the other
members have a chance also.
Mr. Andresen. Because we exist in a noncompetitive
structure we have to take our fine increments and pound them
away to NASDAQ's chubby price increments.
Mr. Foley. Congressman, those are great remarks by Chairman
Levitt. I agree that the SEC has been an important influence
for guiding competition. You pull out a couple of things from
those statements. One, when you are relying on a central single
point of failure in technology, you have problems finding
alternatives. When Mike Bloomberg, my boss, wants something
done, he will say to me, all too often, get it done or I will
find someone else who can. If this committee could say that
regarding decimalization in the NASDAQ market, get it done or I
will find someone who can.
We think that the market structure of the future should not
be one in which everyone gets a free call on all of the
services of the New York Stock Exchange without having to pay
for them. There should be a market structure where we look for
free market competing solutions because we will have the best
chance of having reliable ones and alternatives to turn to when
we need them. It is the same thing with the model of a CLOB.
There is a central black box that you have to go to and that is
a basic problem.
I would sum up on the ITS question this way. We don't
believe that it is a monolithic club, the members of the ITS
committee. We would like to see competition unleashed among the
exchanges, and regarding the linkages between the exchanges, we
call for one basic reform and that is the governance of the ITS
committee. A lot of good things will flow from that. One member
of the committee can veto any action on the part of the
committee. Want to improve the technology? One guy can vote
against it. I am concerned about this.
So that is a fundamental issue. As I mentioned earlier, the
Commission took a look at that issue a year and a half ago, and
we think that this committee would be well served to ask the
Commission how that issue is progressing.
Mr. Dorsch. In order for this country to maintain its
preeminent position in the financial arena, I think competition
is absolutely necessary and I don't think any one group or
entity should be allowed to stand in the way of innovation.
Mr. Schaible. Access to ITS is not enough. NexTrade would
like the opportunity to compete for the National Market System
technology business. We are forced by regulation to deal with
the technology that is rather antiquated and that the previous
exchange members already paid for. That is not a technology
that we can easily interact with because it can result in
double executions.
Something else that Chairman Levitt talked about is the
crisis that the Commission is facing with respect to flight of
talent. Ranking Member Towns asked earlier what this committee
could do to help foster competition. I think one of the best
things you could do is to look to fund the Commission more
fully. Their hands are tied. They have exchange applications in
front of them. They have National Market System issues pending.
They are in a complete personnel crunch over there. I
understand that SEC fees generate 5 times what the SEC actually
sees. It is likely that we could take some of the funding and
direct that to the Commission to allow them to deal with this
crisis.
Mr. Ganske. I thank you all.
Mr. Ehrlich [presiding]. Mr. Barrett.
Mr. Barrett. In January 1997, were you all sitting around
and you saw this order came through and said hey, let's try
something?
Mr. Foley. Island and Bloomberg Tradebook and InstaNet
existed prior to the order handling rules, and it changed the
nature of our business models dramatically. It became possible
to display your customers orders so that the rest of the world
could see them. Why did that come about? It came about because
previously there had been a private market inside the best bid
and the best offer that the public saw, and while large volume
is trading inside the prices that you can see on the screen,
and market orders as Matt referred to before, were getting
executed at this published bid off the spread that had nothing
to do with where the market was really trading. People were
writing to Congress complaining about that, I might add.
The upshot was that, with the new order handling rules, you
couldn't keep your market private to yourself and say I am just
going to match my customers' orders with each other.
Mr. Barrett. How long did it take you to realize that?
Mr. Foley. Three seconds.
Mr. Barrett. For us Neanderthals--you can see there are
more Republicans here than Democrats. We don't have as much to
invest.
Mr. Foley. This happens so frequently. When you go back to
deregulation of commissions or various issues, and
decimalization is going to be another issue like that, there is
a lot of hand wringing about what the change is going to be,
and the way things have operated before which has been very
profitable for the operators going to have to change. The
reality is in many of these issues, it brings about new
opportunities to do business and service your clients, and we
market participants, reformulate our strategies for how we are
going to serve our customers.
Now these customers have new rights and it turns out there
are a hundred new ways to serve your customers and
differentiate yourself from your competitors, and that is sort
of what has brought us to this point. Our business models
existed before, but it really changed the rules of the game
that favored innovators.
Mr. Barrett. How did you sort of glom onto this?
Mr. Andresen. The good thing about competition is that you
never know where the next competitor is going to pop up. I
always say there is an annoying amount of ease of entry and
exits in the marketplace, and that is healthy. Back in 1996
when this happened, as you point out there was only one
competitor, InstaNet, where most of the trading was done. What
we saw was an opportunity to serve people that InstaNet did not
want to help, the retail brokerages.
We said if we can do this at a cost level, we can change
the world. It doesn't take long to figure out an on-line broker
that make $10 a trade, and has to pay $15 to execute it, even
on the Internet, is a bad business model. If we can make it 75
cents and make it cost effective and give good service to the
customers, we would be able to grow with the on-line brokage
industry.
Mr. Schaible. NexTrade is predominantly a technology house,
and in late 1996, we had brokerage firms that were asking us to
develop matching systems because the clearing costs were lower.
Instead of having to send two trades to their clearing company
and pay two costs, if they could match a system in-house, match
a trade in-house, they would pay one clearing cost. So we
started developing the technology in late 1996 to be an ECN.
And in 1997 with the order handling rules, we began the
approval process which took NexTrade about 18 months until they
could become a qualified ECN.
Mr. Dorsch. Our business is different. Having said that, we
were able to introduce decimalization in our business at the
very get-go and the results for our clients have been
phenomenal.
Mr. Barrett. The other thing listening to all of you, this
world is changing so quickly. What is it going to look like in
5 years? What is the New York Stock Exchange going to look like
in 5 years?
Mr. Andresen. I think it is difficult to predict how
anything will turn out. Everything will be cheaper and faster
and more transparent. I am sure that the day that the New York
Stock Exchange is forced to compete, they will change their
business model to meet that competition. I do not believe in 5
years you will have floors where people transact. You will
instead have everything done electronically.
Mr. Foley. I don't think anyone can say for sure who are
going to be the dominant competitors. It was remarked earlier
about the two largest players, New York and NASDAQ being 95
percent of the market. And I have to say that I don't think
that it is necessarily a bad thing that large entities dominate
our marketplace. They just simply need to have to compete to
take on that role. A naturally forming monopoly has to compete
to maintain its position in the marketplace, and a government-
sponsored monopoly does not have to compete and serve
consumers' needs.
Mr. Dorsch. I think the scope and speed of change is going
to be faster, and I think it will reach further and I think the
complexity of transactions that will be able to be done
electronically will stagger people's mind. It is going to be
beyond stocks and bonds.
Mr. Schaible. We talk about the future of capital markets
resembling the Web, a number of portals interacting through a
national market system with true transparency and quality of
assess. The New York Stock Exchange has a lot of smart people,
and when they are forced to compete, they will be one of the
larger portals.
Mr. Barrett. If I can take a minute for Mr. Ganske. He
wanted a minute.
Mr. Ehrlich. Without objection.
Mr. Ganske. I think a lot of people would see the services
your companies offer as great for individuals. We just passed a
financial services bill, which I think will bring many more
players into this. Are some of the large financial institutions
utilizing your company's services?
Mr. Foley. That is a space where Bloomberg Tradebook
excels. What we have done is introduce innovations that make it
possible for the larger orders that are handled directly by
institutions or by broker-dealers who handle large
institutional orders, to bring these orders directly into the
National Market System instead of having them hang back and be
worked upstairs and so forth.
And one of the revolutions in the marketplace right now is
that we are coming directly into contact with institutional
order flow for the first time. We make that possible by
building tools that maintain the anonymity of the participant
because if your fund managers spend a lot of time researching
this stock, you want to make sure that he gets to buy it before
everyone else knows about the idea and to allow those orders to
participate in the market leaving a footprint of a lot of small
orders rather than the footprint of one big order. That is
where our 100 million shares come from.
Mr. Dorsch. Our business only serves large financial
institutions. I don't think we have ever had a transaction
under $50 million. It is hundreds of millions of dollars in a
chunk.
Mr. Oxley. I recognize the gentleman from Illinois, Mr.
Shimkus.
Mr. Shimkus. Mr. Andresen, the central limit order book,
how does it affect your analogy of the shopping mall? What
would happen in simplistic terms if you turned that shopping
mall into a CLOB.
Mr. Andresen. I remember when I was 18 I was on the
national fencing team and we went to Hungary. This was 1988,
and I remember going shopping in Hungary and they had a big
place called Store, and you went into Store and it had stuff
and you could buy food and clothes and other generic things.
While it seemed for me coming from America like some sort of
Orwellian nightmare, I believe this is exactly what you would
have with a central limit order book. Make everything generic.
All of the technology would converge at one point. You could
never be any faster than the slowest participant. Everything
gets dumbed down to the lowest common denominator.
My concern with the central limit order book is even if you
went today and said let's find the best technology, let's say
that Island is lucky enough to be selected as the central limit
order book, it is pretty good right now, a millisecond is
pretty fast, but what happens in the future when that is not
enough. What happens when instead of 2 billion shares a day,
the market wants to trade 20 billion shares a day. You will
call me and I am going to be working 4 hour days instead of 16
hour days, and I will tell you I will get around to it when I
can. I believe to ensure we don't have that kind of stagnation,
you must provide incentive.
Mr. Shimkus. Thank you. I yield back the balance of my
time.
Mr. Oxley. The gentleman from Illinois, Mr. Rush.
Mr. Rush. I yield my time to the gentleman from Wisconsin.
Mr. Oxley. The gentleman from Wisconsin.
Mr. Barrett. Thank you, Mr. Rush. I know so little about
this, I figured I can learn something here this morning. If
this is a form of a CLOB, if you can explain what it is and
what the problem is.
Mr. Andresen. One of the rules of an efficient marketplace
is sort of the law of the playground, the best price wins. If
two people have the same price, whoever was first in line wins.
People call that price-kind priority, and it is something at
Island that we believe very strongly in. We have built our
entire system around that idea. Even if you are only a one-
share retail order, you are in first or better price, you win,
you get the trade.
But it is very difficult, I believe, in fact, impossible to
ensure time price parity, not just in a system but across
systems. My concern is when you go back to the shopping mall
analogy, when you try to ensure that kind of protection between
markets, you actually undermine it and if you would indulge me
with a quick hypothetical. What would happen if Kevin was
trying to use Island to buy Cisco at $79 a share? He places his
intention to buy on Island. Now, let's say that the two
distinguished gentlemen up there both make the decision roughly
at same time that you want to trade with Kevin on Island. So
you both send an intention to sell to that order. If Island was
the best price this is easy. Whichever one of you happened to
type a little faster would win. But let's take the hypothetical
where we have a trade-through rule. Let's say that you are just
a little faster than him, and you send the order and I say I
can't let you trade with Kevin because the Pacific Coast Stock
Exchange out in Los Angeles has a penny better price.
I am going to reroute your order through the intermarket
trading system for the next 2 minutes. Now, you are second in
line and should be punished by being behind you, but you end up
getting an immediate execution from Mr. Foley. You wait for the
next 2 minutes to find out what happened. During that time, if
it happens to be the Palm Pilot IPO that I mentioned before,
during that 2 minutes, that stock will move 12 points.
Now 2 minutes later, you find out from ITS, I'm sorry, you
didn't get an execution. Start over again. So despite the fact
that you had time and price priority, because of the trade-
through rule, you lack the ability to actually win.
Mr. Barrett. Why does it exist?
Mr. Andresen. I believe it is to protect the existing
markets. If you have the biggest market you don't want to have
true competition or accessibility to your marketplace. Island
is a very big ECN. We make ourselves available to every other
ECN because we believe that is the only way to run a
marketplace.
Mr. Barrett. How long has it been in existence?
Mr. Andresen. Since ITS was implemented back in 1979. When
Congress laid down their goals in 1975, they insisted that the
industry come up with a National Market System. They insisted
on the meeting of two goals: competition between markets and
the sharing of price information for the benefit of investors.
When they did this, the industry took these goals and said
we will meet them and they set up the Intermarket Trading
System. So it was up to them to work out the details.
Unfortunately, those details while at least on the surface in
some ways, meeting those goals actually interfere with the
meeting of those goals.
Mr. Barrett. Back in 1977, when the SEC came down with the
order handling rule, what did that apply to and what did it not
apply to?
Mr. Andresen. That applied most aggressively to NASDAQ.
They said New York and ITS had some unspecified time to figure
out how to meet these goals. On NASDAQ they were forced to
implement it directly.
Mr. Barrett. Why the difference?
Mr. Andresen. I don't know.
Mr. Barrett. Anybody? Any speculation?
Mr. Andresen. I believe that the New York Stock Exchange
controlling 80 percent of the market in that stock would want
to, as any good business, would want to protect that market
share. Having the method of linkage and the method of sharing
of price information be less than perfect, you must go to the
place where you have the best chance of meeting, thereby
forcing all market people to stay in the place that happens to
be at that moment the largest.
Mr. Barrett. I yield back to Mr. Rush.
Mr. Oxley. The gentleman's time has expired. The gentleman
from Staten Island, Mr. Fossella.
Mr. Fossella. I have one quick question and that is just
out of curiosity, do you guys see any benefits to the central
limit order book?
Mr. Andresen. I think that the theoretical benefit is very
profound. If everyone is meeting in one place, you are assured
of having the positive effects of consolidation. I think that
you can see that benefit on the New York Stock Exchange where
you have a huge number of buyers and sellers meeting. You can
see it certainly in the market on Island, and I think the idea
is very compelling. The idea of getting all of those people
together in one place.
I worry that by accomplishing that the other effect will be
that the technology that keeps these people together will
eventually, and I believe by pretty much 12 hours after you put
it in, be obsolete.
Mr. Schaible. I have to agree with Matt in the short term,
there could be some benefits with respect to protection of
investors and the quality of markets, but without the impetus
that is competition that drives innovation, then you will see
what we believe in this country is monopolies lead to
stagnation, and the free market generally will lead to better
pricing.
Mr. Dorsch. I would concur with those remarks.
Mr. Fossella. The theory then seems sound to you, but the
practical effect of it is not. Is there any way that you could
take it to your theoretical conclusion?
Mr. Andresen. Like I said, I agree with the end result.
Mr. Fossella. How would you do it?
Mr. Andresen. I believe you can do it by letting
competition reign. We have many long-distant companies but only
a few big ones. We have many ECNs but just a few big ones. We
have many stock exchanges but only one big one. The natural
economic forces which give those benefits from a consolidation,
they will be wrought in a much more efficient way than
government action could possibly bring them about.
The market centers that have the best markets will win.
Look at E.bay. E.bay has a tremendous market for collectibles
and other things. I once saw a human kidney bid on. I saw a
half eaten bag of Fritos with over 700 bids in 1 hour. You
might say that is just a joke product, but it is an incredibly
powerful network where you have many people wasting their time
putting in a fake bid.
We can start an auctionsite ourselves, but we would have
trouble getting people to use it because they are never going
to find that seller or buyer. We will always be driven to the
largest place because of the efficiencies commensurate with
those economies of scale and those kinds of network economies.
Mr. Schaible. Chairman Levitt refers to a virtual CLOB, and
I think the reference is similar to what we discuss, a web of
portal executions coming together that allow functionally the
transparency of a central limit order book, but also foster
competition, and I think that is what Matt was also saying.
Mr. Foley. Mr. Chairman, on the question of the trade-
through rule, in our view the most important issue is the
linkage and the ability to get to the best price. One of the
things that we talked about during the demonstration portion is
what differentiates ECNs from one other, do you show the best
price outside of your market and do you allow your customers to
go hit the best bid or take the best offer.
The trade-through rule in our view is consistent with
investor protection, but it makes no sense without a technology
linkage that is state-of-the-art, and allows you, in fact, to
get to that price at a reasonable timeframe and not in the
terminology of the financial markets right to a particular
exchange a free option on your order for the 2 minutes that
they have.
In our mind, with transparency, linkages, and best
execution of brokers, you will have the strongest market
structure in the world.
Mr. Ganske [presiding]. Mr. Engel is recognized for 5
minutes.
Mr. Engel. I understand that all of my questions were asked
by my colleague from New York and other people. I want to thank
the chairman for holding this hearing. I think that ECNs are
very exciting, and it is one of the things that makes this
committee so exciting because of all of the new technology that
we discuss and we are able to question. I am delighted that two
of the four panelists are from my hometown, New York, and it
just shows the vibrancy of how New York continues to be a
leader in the financial world. I just think that this is only
part one on this hearing. We are going to have more hearings. I
have some questions about decimalization and restructuring, but
I understand that those have already been asked. So let me just
say that I look forward to continuing the dialog. The dialog
emergence of ECNs is certainly exciting. Anything that can
enhance competition is a plus for everyone concerned.
I yield back the balance of my time. I am delighted to see
the gentlemen here today and it makes me realize how old I am
when I see how young they are. They are making money and we are
not, Mr. Chairman. Something is wrong somewhere.
Mr. Ganske. I point out that my farmers and small town
businessmen can get on the Internet and trade like crazy.
The gentleman from California is recognized for 5 minutes.
Mr. Bilbray. I am sure that my colleague wasn't implying
that we want to get back to the good old days when politicians
were able to make a lot of money in the field. My wife is from
New Orleans and she always says if you want to do that, go back
to Louisiana where half of the State is underwater and the
other half is under indictment.
Mr. Engel. I don't think politicians should make money, but
I don't think that people need to make money before they come
to Congress. We ought to have a mix of people.
Mr. Bilbray. I agree with you coming from that same
background. I really came here as a parent, not as a Member of
Congress. I watch my 13-year-old daughter buy her Qualcomm and
Home Depot over the Internet, and I think there is a whole
issue that we are missing, and that is, this whole access of a
whole different population and that population not just being
the farmer in Iowa, but also teenagers and young people getting
interested in the market and a field that may have a whole
cultural change, and hopefully will have a security, financial
security change in the next generation. Rather than my daughter
thinking about what new shoes or dress to buy, she is looking
at which stocks to invest in, rather than going to the mall.
That is a real culture shock for someone who spent his time
at the beach rather than worrying about computers or TVs. I
would like for you to comment on this access issue and
especially how we are starting to see a new generation get into
this, because I am not going to call a stockbroker, I am going
to talk to my daughter. She is now culturally getting into that
though she does worry about the new rock stars, if you can call
them that nowadays. But can you articulate about this whole
issue of the access component and average citizens and young
people getting into a field that they feel comfortable with and
that is the Internet?
Mr. Andresen. Two things that enfranchise people is
information and cost. Those two things have certainly come
under tremendous pressure within the last several years. In
1975, the SEC unbundled advice from commission so that people
no longer had to pay $500 a trade as if they were paying for
help in making that decision. It doesn't take a rocket
scientist to know if you have $600 invested at the end of the
month and you spent $500 on commissions, you probably end up
going to the mall or the track. If you are given the chance to
pay only $15 in commission, suddenly this has opened up the
stock market not just to the wealthy and the elite, but to
anyone. I know when I graduated no one explained the stock
market or how to balance my checkbook with predictable results.
And what I believe----
Mr. Bilbray. That is why you get married so someone does it
for you. Go ahead.
Mr. Andresen. I won't comment on that.
But I believe that information is a great empowering
factor. People become aware of the fact that it is cost-
effective. When your daughter is able to make those decisions,
not because she pours over dense tables in the paper but
because it is presented in a real time manner over the
Internet, and I think that trend, as noted earlier by some of
my other colleagues, that is only going to increase. The level
of information, the speed of that information increases is just
going to enfranchise more people.
Mr. Foley. I would add to that a couple of points. One, we
have long in this country believed that homeownership promotes
good citizenship, and we have policies to try to encourage
individuals to own their homes, and I think a similar
phenomenon, that individuals owning the assets of the U.S.
economy really has to ultimately promote good citizenship and
have positive effects in many directions.
Mr. Bilbray. Are you talking about the tearing down of the
barrier between the proletariat and the bourgeois?
Mr. Foley. Yes. More and more employees own shares directly
of the companies that they work in, and more and more
individuals are concerned about their 401(k)s and IRAs and
pension plan and mutual fund investment. We ought not to forget
the revolution going on in institutional trading and the
empowerment of institutions who, after all, represents millions
of individuals who are by pooling their resources investing
just as much in our economy and safely and soberly and so
forth, and the opportunity to innovate, to compete, to serve
the interest of institutional clients is actually flat out
delivering better returns for individual investors, and it is
lowering the cost of capital for issuers, which is why issuers
from around the world want to come to the United States to have
their stocks traded, and it is providing employment for the
U.S. securities industry in the U.S. which we think is the most
important issue.
Mr. Dorsch. I think both of them gave great answers.
Mr. Bilbray. What is the defense about having young people
get into the market, not that I think it is a bad thing, but
obviously my wife had to participate in the setting up of the
account. Now I say that and then I say obviously, why couldn't
my daughter have done the same thing? Is that because of credit
cards or credit numbers or some kind of account?
Mr. Andresen. Whenever an introducing broker, like e-trade,
any time they open up an account, they must meet suitability
obligations, they must have money in the account and experience
and they have to have those things set out. I anticipate one of
the things that the SEC will continue to look at very closely
is the obligations of those brokerage firms to ensure that the
people that they are talking to are really there.
Mr. Dorsch. In our environment we service the institutional
environment, and suitability is a big concern for us and our
users.
Mr. Bilbray. I want to clarify my comment about my marriage
and keeping the books clean is I married an accountant so it
came in very handy. I yield back the balance of my time, Mr.
Chairman.
Mr. Ganske. I would entertain any additional questions from
any of the panel members?
Seeing none, I want to thank you gentlemen for coming
today. Anyone who wishes to submit comments for the record are
welcome to do so, and that's the end of the hearing.
[Whereupon, at 12:05 p.m., the subcommittee was adjourned.]
[Additional material submitted for the record follows:]
Archipelago
100 S. Wacker Dr., Chicago IL 60606
March 28, 2000
Honorable Michael G. Oxley
Chairman, Subcommittee on Finance & Hazardous Materials
Committee on Commerce
United States House of Representatives
2125 Rayburn House Office Building
Washington, DC 20515
Re: Decimal Pricing for the U.S. Securities Markets
Dear Chairman Oxley: I am writing to thank you for inviting me to
testify before the House Subcommittee on Finance and Hazardous
Materials at your hearing on ``Competition in the Evolving Electronic
Market.'' Unfortunately, as I have previously communicated to your
staff, I will be unable to testify because of a prior commitment to my
wife and children. In connection with your hearing, however, I do want
to respectfully express the concern of Archipelago, LLC\1\
(Archipelago) over the recent request by the National Association of
Securities Dealers, Inc. (``NASD'') to delay implementation of decimal
pricing in our securities markets.\2\
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\1\ Gerald D. Putnam is the co-founder and Chief Executive Officer
of Archipelago. Archipelago is a leading electronic communication
network, or ``ECN,'' that serves a varied client base and executes over
60 million shares per day.
\2\ Frank G. Zarb, NASDD Chairman and CEO, submitted this request
to Securities and Exchange Commission (``SEC'') Chairman Arthur Levitt
in a letter dated March 6, 2000.
---------------------------------------------------------------------------
While we agree with the NASD that market changes should not put
markets and investors at risk, we also believe that the implementation
of decimalization should be priority number one at the NASD. In our
view, decimalization would create such a tremendous benefit for
investors that its implementation should be the first priority, not the
last. The NASD, while requesting a delay in the implementation of
decimalization, is proposing at the same time other complex structural
changes that would affect the Nasdaq market. Also, the NASD has been
pouring enormous amounts of resources into international joint venture
projects. Finally, the NASD has been on notice of this issue for more
than three years and had, in essence, entered into a good faith bargain
with investors, Congress, and the SEC to implement decimals immediately
after Y2K. The NASD is now attempting to breach that good faith
bargain. At a minimum, the NASD should delay the implementation of
their other proposed changes and ventures and should focus all of its
resources on decimalization.
On January 28, 2000, the SEC issued an order requiring the U.S.
securities markets to shift to decimal pricing no later than July 3,
2000. The SEC described the many potential benefits of decimal pricing
in its order requiring the markets to adopt decimal pricing, and the
NASD reiterated these points in its March 6 letter to Chairman Levitt.
Probably the most important of these benefits is that decimal pricing
would significantly increase quote competition, and this competition
would save investors potentially tens of millions of dollars almost
overnight. Further, decimal pricing will improve price efficiency in
our securities markets through the mechanisms of the free market.
As a leader in this effort for many years, you are fully aware of
the potential benefits that decimalization will bring to our markets as
reflected by your recent statements:
I wanted to [convert from fractions to decimals] for three
reasons: (1) I believed the free market, not the government,
should determine stock prices; (2) decimals would make the
markets more accessible, because they are easier to understand
than fractions; and (3) decimals would promote the
competitiveness of the U.S. stock markets, because the rest of
the world was already trading in decimals.
In addition, the SEC presented a number of potential changes in
market structure in a recent concept release on market fragmentation
(``SEC Concept Release''). We are of the view that many of the concerns
that the SEC is attempting to address through the SEC Concept Release
may be mitigated, if not eliminated, by the shift to decimal pricing.
Once decimalization is implemented, competition in the free market may
naturally resolve the issues underlying the Concept Release. We support
the SEC's efforts to encourage lower trading costs and greater market
efficiencies. Like the SEC, we are of the view that decimalization is
paramount to producing these results.
For all of the foregoing reasons, we encourage you to monitor the
NASD's request to change the implementation schedule for
decimalization. In response to any change in the implementation date,
please consider communicating to the NASD that it should also delay
mandating additional market structure changes until the benefits of
decimal pricing are realized by investors. However, the best result
would be no delay in implementing decimal-based pricing so that the
investing public would reap its benefits more quickly.
Thank you for your consideration.
Very truly yours,
Gerald d. Putnam
______
RESPONSES FOR THE RECORD OF KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK
1. How do ECNs increase transparency?
ECNs are distinguished by three characteristics--neutrality,
transparency and fairness. Like market-makers, ECNs maintains an
electronic book of customers' bids and offers. Unlike market-makers,
however, Bloomberg Tradebook publishes our entire book of quoted prices
electronically for all our customers to see, as well as publishing all
other available pricing information. That's the ultimate in
transparency.
I'd add that, unlike some of our ECN competitors, we empower our
customers to take the fullest advantage of this transparency by
actually routing them to the best available price, even if that is
outside Bloomberg Tradebook. That's the ultimate in best execution.
As a practical matter, those who provide transparency within a
system while not routing to the best available price are often
providing benefits that are more illusory than real. As the largest ECN
offering customers this ability to have their orders executed at the
best price--even outside of our ECN--Bloomberg Tradebook is known as a
``Best-Execution ECN''.
In the final analysis, however, it is up to the government-
sponsored market centers like the New York Stock Exchange and the
Nasdaq Stock Market to make ECN transparency available to the entire
national market system. These government-sponsored market centers can
enhance transparency by incorporating ECNs into their market display,
as Nasdaq did early in 1997. Or they can reduce transparency by seeking
to block ECN display linkages, or roll them back, as seems to be the
current effort.
2. Are your systems decimal ready?
Over a period of years, the Commerce Committee has rendered an
enormous public service by spearheading the effort to convert to
decimals. Decimalization would create such an enormous benefit to
investors and the markets that implementation should be the top
priority for all market participants.
Accordingly, Bloomberg Tradebook has allocated significant time and
resources to the capacity issues surrounding decimalization. As a
result, we will be ready for decimal pricing as scheduled in July. Thus
Bloomberg Tradebook and our customers were extremely disappointed by
the NASD's recent request to delay decimalization. Again, the benefits
of decimalization are such that the public would be best served if the
NASD focused its resources on the capacity issues critical for
implementation of decimalization prior to focusing on ill-advised
efforts like the SuperMontage.
I'd conclude by noting that conversion to decimals will change our
markets radically for the better. Congress and the SEC should not
entertain significant structural changes to the Nasdaq market--like the
SuperMontage--until after decimalization has been completed and the
full range of its beneficial impact assessed.
3. What can you do to facilitate trading in decimals even though Nasdaq
is not decimal ready?
As discussed above, Bloomberg Tradebook has allocated significant
time and resources to decimalization and, as a result, we will be ready
for decimal pricing as had been previously scheduled in July. We and
our clients understand that presenting quotes in 1/8ths and 1/16ths has
reduced competition and liquidity in our markets to the serious
detriment of investors.
Ultimately, however, there is precious little additionally that can
be done by us to facilitate trading in decimals in light of Nasdaq's
failure to adhere to the conversion schedule negotiated among the
Congress, SEC and the NASD. As the decimalization experience makes
clear it is hard to prod movement from a government-sponsored monopoly
even when it is clearly acting as a counterproductive bottleneck. This
should be kept in mind as the Congress contemplates Nasdaq's
SuperMontage proposal which would require that virtually all executions
take place centrally, creating an enormous bottleneck that would
further stifle innovation.
4. What structural changes should accompany the demutualization of NYSE
and Nasdaq to ensure a competitive market?
Allowing a government-mandated monopoly to enter the markets as a
for-profit entity raises enormous concerns for a host of regulatory and
enforcement reasons. I'll focus on one that is very familiar to the
Commerce Committee as both an historic and current controversy, namely
the issue of access to market data.
A quarter century ago, the Commerce Committee spearheaded the
effort to enact the Securities Acts Amendments of 1975. That
legislation established the goal of producing a national market system.
To this day, that remains the correct goal. In furtherance of that
objective, Congress mandated a consolidated system for distributing
market data in an effort to ensure that stock market information was
accurate and accessible. The securities markets were allowed to charge
a reasonable rate for gathering and distributing that information.
When the Commission, in 1972, first proposed rules to provide for
the consolidated reporting of transactions and quotations, the New York
Stock Exchange asserted that the SEC not only lacked authority under
the securities laws to adopt the quotations rule, but also such action
would deprive the Exchange of property in violation of the due process
provisions of the Constitution of the United States. Despite these
objections, Congress and the SEC were determined to achieve the goal of
public access to consolidated market information.
Even in this day of on-line investing, the exchanges continue to
argue that they ``own'' or ought to own quote information. Indeed,
during the last Congress the dominant national exchanges were major
proponents of legislation reported from the House Judiciary Committee--
the ``Collections of Information Antipiracy Act''--which would have
created an unprecedented ownership interest in facts, including stock
quotes. Though well-intentioned, this legislation--which has also been
reported from the House Judiciary Committee this Congress--would create
a property right in facts that extends not only to presently existing
markets, but also, incredibly, to hypothetical, presently non-existing
markets.
We applaud the bi-partisan leadership of the Commerce Committee for
crafting critical legislation, the ``Consumer and Investor Access to
Information Act''. That legislation, which was reported from the
Commerce Committee last year, would also provide additional protections
for databases but would do so while assuring that consumers and
investors have continued access to factual information.
It has been observed that real-time stock data is like ``oxygen''
to investors. We worry about the prospects of a government-mandated
monopoly over the most important information in the market--truly the
market's oxygen--being controlled by a for-profit entity that not only
believes it ``owns'' data our clients create, but also wants to control
the downstream uses of that data in currently non-existing markets
outside of the real-time market window.
At the core of this market data debate is the outmoded concept that
market participants should continue to provide market data to a
government-sponsored monopoly and then pay to see it. We endorse an
alternative model recently proposed by SEC Chairman Levitt in the
context of market depth. Chairman Levitt has urged our markets--
exchange, dealers, and ECNs--to make their limit order books available
to the public where vendors could consolidate this data and repackage
it in a form that would be most useful to their customers. A similar
model allowing the establishment of private quote aggregators to which
one could report market data--breaking the SRO monopoly on data--would
certainly improve the quality, comprehensiveness, reliability and
capacity of this information while reducing the cost.
5. What benefits will electronic exchanges provide that traditional
exchanges do not?
In a statement before the Senate Banking Committee, Frank Zarb, the
Chairman of the National Association of Securities Dealers, stated that
``. . . I guess I sum up the answer as to why we have ECNs as the fact
that the national stock exchanges around the world haven't been keeping
pace with the needs of the market.''
It's worth pondering why the stock exchanges didn't keep pace, as
Mr. Zarb says. We would submit that a government-sponsored monopoly
ultimately cannot provide the innovative ideas and customer service of
the best ECNs precisely because they are a government-sponsored
monopoly.
Simply put, as is the case with ECNs, the primary benefit that
electronic exchanges will provide is that of an entity that keeps pace
with the needs of the market and, by doing so, prods traditional
exchanges to improve their performance, thus benefitting all market
participants.
6. Is the Nasdaq super-montage an ECN? What types of problems do you
anticipate in a market in which your regulator competes with
you?
The Nasdaq SuperMontage is not an ECN. Nasdaq would remain a
marketplace, but would be transformed from a largely decentralized
market--its major strength for 30 years--to a market in which virtually
all executions take place centrally. Of the concerns which the Nasdaq
market faces today, capacity limitation is certainly the greatest. In
recent years Nasdaq's systems have become an increasingly serious
messaging bottleneck. Yet the proposal would convert Nasdaq to a
central execution utility only months before the U.S. markets are
scheduled to grapple with the intensifying volume expected with
decimalization.
This CLOB-like centralization would create a government-sponsored
monopoly that would deter today's decentralized market innovators--
ECNs--from adding market capacity and from introducing further
innovations. In short, the major threat to competition from the
SuperMontage is the fact that it would preclude ECNs from competing
among themselves.
Let me offer one brief example. In 1996, Bloomberg Tradebook
introduced the concept of the ``Reserve'' to the U.S. equity markets.
``Reserve'' is a process that controls the release of orders into the
market enabling clients to trade large orders more efficiently. Like
all innovations, the ``Reserve'' gave Bloomberg Tradebook a leg up on
our competitors for a brief period of time. Soon it was adapted by
others. Today no one would introduce a system without it, including
Nasdaq in its SuperMontage proposal.
Any edge we gain is momentary, and we are forced to continue to
innovate. If a CLOB like the SuperMontage had been imposed three years
ago, clearly this innovation wouldn't exist. Innovations occur in a
dynamic competitive market. They won't occur when innovators need to
seek permission to innovate.
7. Which regulations most inhibit ECNs from competing with exchanges?
The pending SuperMontage proposal is far and away the pending
regulation that will be most destructive of ECNs. It will harm
investors and the markets by severely undermining the ability of ECNs
to compete with each other.
A word is in order about ECNs competing with exchanges. Bloomberg
Tradebook does not compete against the NASD or the New York Stock
Exchange. We compete against exchange members and, in the case of the
NASD, we are one.
It's possible that the national stock exchanges see us as a
competitor because of our independence--i.e. we could take our
customers and order flow to another stock exchange. That would mean the
exchanges would have to do something they haven't historically done--
namely compete against each other to keep that customer order flow.
While they may think that order flow is theirs rather than their
customers, investors have clearly indicated that ECNs are an important
part of their market structure.
Unfortunately, when confronted with ECNs the first response of the
dominant national stock exchanges has not been to compete against each
other for the business of this new kind of broker/dealer. It seems the
dominant exchanges would rather avoid the whole headache by passing a
few rules in an attempt to hold order flow captive. Little wonder some
ECNs would rather become exchanges themselves.
In short, we think the national stock exchanges should have to
compete against each other for our business or the business of any
other broker-dealer.
8. What is the Intermarket Trading System (ITS)? How should it be
changed?
The Intermarket Trading System (ITS) theoretically allows orders to
be routed to the best market regardless of which market originally
received the order. Unfortunately, as Chairman Levitt has observed, the
technology and rules governing the operation of the system are
``archaic''. Market participants using ITS to route orders to other
markets may wait as long as two minutes to receive a response and, even
then, may not receive an execution. An ineffective ITS has long allowed
the NYSE to dominate the regional exchanges and is also a potentially
effective tool for blocking newcomers like ECNs.
Bloomberg Tradebook is eager to see ITS reform and improved market
linkages. We'd warn that, just as centralization and self-interest have
created an ITS system that doesn't serve the market or public--the same
destructive dynamic would be present in an exaggerated form in a CLOB,
whether industry run or run by Nasdaq as SuperMontage.
9. What is the Consolidated Quotation System (CQS)? How should it be
changed?
The Consolidated Quotation System is a key component of our current
arrangement for disseminating ``market information''--information
concerning quotations for and transactions in equity securities and
options that are actively traded in the U.S. markets. The information
is ``consolidated'' in that it is continually collected from the
various market centers that trade the security and then disseminated in
a single stream of information.
This system is premised on the outmoded concept that market
participants should continue to provide market data to a government-
sponsored monopoly and then pay to see it. We would endorse an
alternative model recently proposed by SEC Chairman Levitt in the
context of market depth. Chairman Levitt has urged our markets--
exchanges, dealers, and ECNs--to make their limit order books available
to the public where vendors could consolidate this data and repackage
it in a form that would be most useful to their customers. A similar
model allowing the establishment of private quote aggregators to which
one could report market data--breaking the SRO monopoly on data--would
certainly improve the quality, comprehensiveness, reliability and
capacity of this information while reducing its cost.
10. Has the current regulatory structure of the National Market System
(NMS) actually created market fragmentation by disallowing ECNs
to share pricing information?
Yes. The current regulatory structure of the National Market System
has actually created fragmentation by disallowing ECNs to share pricing
information, especially as it relates to listed stocks. The NMS impedes
access to pricing information by mandating a monopoly in data
gathering. Access is further impeded by the monopoly's settled habit of
charging the public fees for market data that far exceed the actual
costs associated with the collection and dissemination of that data.
The cumulative impact of unnecessarily centralizing, and then
overcharging for, market data is to retard significantly the sharing of
pricing information while increasing market fragmentation. This result
cries out for remedy as this kind of centralized monopoly routing and
collection of data is no longer technologically necessary to facilitate
a National Market System. Indeed, as your questions suggests, this
regulatory structure is an obstacle to the realization of the most
beneficial and effective National Market System.
The current regulatory structure of the NMS, premised as it is on
the technology and markets of a quarter century ago, is clearly a poor
way of disseminating critical market information. Again, we would urge
an alternative model recently proposed by SEC Chairman Levitt in the
context of market depth when he urged our markets--exchanges, dealers,
and ECNs--to make their limit order books available to the public where
vendors could consolidate this data and repackage it in a form that
would be most useful to customers. A similar model allowing the
establishment of private quote aggregators to which one could report
market data--breaking the SRO monopoly on data--would certainly improve
the quality, comprehensiveness, reliability and capacity of this
information while reducing its cost.
11. Have you applied to become an Exchange? What is the status of your
application?
Bloomberg Tradebook has not and does not intend to become an
Exchange. We intend to remain a broker-dealer and a ``Best Execution
ECN''. We believe that is the most effective way for our customers to
obtain not only liquidity but also the best execution that comes from
Bloomberg Tradebook's policy of routing our customers to the best
available price--even if that is outside Bloomberg Tradebook.
While we are proud to be and remain a broker-dealer/ECN, we are
also supportive of the efforts of some of our ECN brethren to either
affiliate with or become exchanges. Just as competition among ECNs has
been good for investors and the market, competition among stock
exchanges also benefits all. We think the national stock exchanges
should have to compete against each other for our business and the
business of any other broker-dealer. Bloomberg Tradebook looks forward
to the day when some of our ECN colleagues will be--as new exchanges--
competing with the established exchanges for our business.
12. How is Nasdaq's super-montage like a Central Limit Order Book
(CLOB)?
The Nasdaq SuperMontage proposal carries most of the major
downsides of a traditional CLOB. It would convert Nasdaq from a largely
decentralized market, which has been its major strength for thirty
years, to one in which virtually all executions take place centrally.
As with the CLOB, this centralization runs counter to the spirit of the
age in which even public utilities like telephones and electric power
are abandoning their ``black boxes'' for decentralized structures. It
would not only impose a technology that is already outmoded, but also
preclude the prospects of exploiting advancing technology in the
future. As with a traditional CLOB, SuperMontage would create an
enormous messaging bottleneck--and do so at the time that the U.S.
markets are scheduled to be grappling with the intensified volume
expected with decimalization.
Indeed, NASD Chairman Zarb illuminated precisely how the Nasdaq
SuperMontage is like a CLOB when, in testimony before the Senate
Banking Committee, he observed that 95% of everything CLOB proponents
sought could be had under the SuperMontage. That's accurate, and
underscores that we are looking in part at a political battle for
control of this centralized entity. I don't know who will win, but I
know who will lose this kind of battle--markets and consumers.
I'd add that the effort to create this Nasdaq CLOB--the
SuperMontage--is a critical component of the for-profit picture Nasdaq
envisions for itself. In its recent private placement memorandum/proxy
statement distributed to NASD members asking members to vote to make
Nasdaq a private, for-profit entity, the NASD cites the SuperMontage as
its most prominent business plan for Nasdaq and warns quite candidly
that the threat to Nasdaq's monopoly position is one of the most
significant risk factors:
``SelectNet is Nasdaq's automated market service that enables
securities firms to route orders, negotiate terms, and execute
trades in Nasdaq securities. If pairs of market makers or ECNs
determine that they do enough order routing traffic in a day so
as to justify setting up an alternative proprietary network for
their traffic, Nasdaq may be forced to reduce its fees or risk
losing its share of the order routing business. A reduction in
the order routing business could have an adverse effect on
Nasdaq's business, financial condition and operating results.''
From Nasdaq's perspective--looking towards a future as a for-profit
entity charged with maximizing value for shareholders--the SuperMontage
CLOB makes great sense. The forced centralization of electronic
messaging will indeed eliminate the risk that ECNs seeking more
efficiency or better service for our customers might set up an
``alternative proprietary network for their traffic.''
From the perspective of the public, however, the SuperMontage is
enormously harmful. Like all CLOBs, this centralization will harm the
marketplace by creating a single point of failure and by eliminating
innovation. This CLOB capacity to extract monopoly profits from market
participants is exactly what benefits prospective Nasdaq shareholders
while disadvantaging the public and the markets.
13. What are the key problems with a Central Limit Order Book (CLOB)?
The notion behind the CLOB is that if you centralize orders in one
place, a single ``black box'', maximum order interaction and perhaps
better prices might be achieved.
There are a number of very serious problems with this concept. When
this concept was first broached thirty years ago, our markets lacked
the technology to achieve order interactions without centralization.
Now, technology allows the advantages of maximum order interaction
without the downside of centralization.
The technology of today makes a centralized order book unnecessary.
These technological advances have revolutionized other industries, and
despite protests, they are revolutionizing our equity markets. At a
time when even public utilities like telephones and electric power are
abandoning their ``black boxes'' for decentralized structures, does it
make sense to threaten innovation by centralizing the stock markets?
State-of-the-art telecommunications systems like the Internet don't
rely on a single monopoly channel--rather they rely on networked webs
of multiple private competing linkages. Why should the securities
markets work differently?
Centralized systems are resistant to change. The innovations that
ECNs have brought to the market could not occur under a CLOB system,
including the SuperMontage Proposal of the NASD.
A centralized system also provides the significant downside of a
central point of failure. Those of us who deal regularly with Nasdaq's
SelectNet system know only too well how cumbersome and inefficient a
centralized system can be. Like SelectNet, the ITS system is conceded
even by those who are sympathetic to be technologically outmoded with a
bureaucracy that thwarts change. Why make those failed systems the
model?
14. In what ways is a Central Limit Order Book anti-competitive?
As described previously, from a technological perspective the CLOB
is inherently anti-competitive. Beyond the serious technological
problems with the CLOB, there are equally troubling political problems
that underscore the enormous threat to competition posed by a CLOB.
Someone or some entity will have to decide how the CLOB will work, who
gets access and how, and what innovations are to be allowed. That
gatekeeper and CLOB czar is certain to be enormously influenced by
those who are already in the club. Will those who are already in the
club allow the emergence of innovators who potentially threaten their
business? We don't think so. Is innovation likely to occur when the
potential innovator must raise his or her hand to seek permission from
the powers-that-be in order to innovate? We don't think so.
15. Recently we have seen an increase in message bottlenecking due to
capacity problems with individual systems. Would the existence
of a Central Limit Order Book (CLOB) exacerbate the capacity
problems we have been witnessing?
Absolutely. The centralization that--as both a technological and
political matter--precludes innovation would exacerbate capacity
problems. It should also be stressed that the CLOB's central point of
failure would dramatically exacerbate capacity problems, whether we are
talking of an industry CLOB or a CLOB like the Nasdaq SuperMontage.
16. The idea of a Central Limit Order Book (CLOB) was first tossed
around in the 1970s when fragmentation was high because
technology could not facilitate efficient order interaction
without centralization. Has current technology rendered the
notion of a CLOB obsolete?
Absolutely. Current technology has rendered the notion of a CLOB
obsolete, whether we are talking of an industry CLOB or a CLOB like the
Nasdaq SuperMontage. State-of-the-art telecommunications systems like
the Internet don't rely on a single monopoly channel--rather they rely
on networked webs of multiple private competing linkages. The equities
markets should benefit from the same telecommunications advances that
have revolutionized other industries--to the enormous benefit of the
public.
______
NexTrade Holdings, Inc.
Clearwater, Florida 33756
April 21, 2000
Honorable Tom Bliley
U.S. House of Representatives
Committee on Commerce
Room 2125, Rayburn House Office Building
Washington, D. C. 20515-6115
Re: Responses to questions for the record for the Competition in the
New Markets Hearing: Part I
Dear Chairman Bliley: NexTrade Holdings, Inc., the parent company
of the NexTrade Electronic Communications Network (``ECN'') and the
proposed NexTrade Exchange, is pleased to submit the following
responses to the questions set forth in your letter of March 29, 2000,
as part of the Competition in the New Markets Hearing: Part I.
1. How do ECNs increase transparency?
ECNs increase transparency in a number of ways. One way that ECNs
increase transparency is by allowing individual investors direct access
to the Nasdaq. This access empowers investors with the ability to post
their limit orders instantaneously for review by other Nasdaq market
participants. ECNs also increase transparency through their proprietary
networks that link alternative trading systems, market-makers, and
other ECNs outside of Nasdaq for the purposes of redundancy, speed, and
greater reliability. Some ECNs even display all of their orders,
instead of merely the highest bid and lowest offer in a security, on
their systems or the Internet. This enables investors to see the depth
of the market and helps them to more accurately price their orders.
Statistical evidence supports the conclusion that ECNs have helped
to produce more transparent, less fragmented and more efficient
markets. Since the arrival of qualified ECNs, there have been dramatic
reductions in the costs associated with trading stocks. The average
cost of executing a trade on the Nasdaq fell by 23% in 1998, spreads
fell 41%, and volume increased substantially. If left to competitive
devices, the degree of fragmentation within the markets will continue
to be reduced despite the introduction of a multitude of market
participants.
2. Are your systems decimal ready?
Like most ECNs and Alternative Trading Systems designed in the past
five (5) years, the technology behind the NexTrade ECN and the proposed
NexTrade Exchange is ready for trading in decimals. As a member of the
National Association of Securities Dealers (``NASD'') trading on the
Nasdaq, the NexTrade ECN System currently has to convert orders that
are in decimal increments into fractions for execution. In order to
ensure that NexTrade's linkages to the National Market System (``NMS'')
and the Nasdaq are ready for decimalization, NexTrade is planning on
participating in the industry wide decimalization testing.
Unfortunately, as a member of the NASD and a Nasdaq participant, the
delays by the Nasdaq in implementing decimalization will impact
NexTrade's ability to conduct this testing and will delay the
introduction of decimal pricing for our subscribers.
3. What can you do to facilitate trading in decimals even though Nasdaq
is not decimal ready?
NexTrade plans to work in conjunction with other industry
participants including the Nasdaq, other ECNs and broker-dealers in
order to expeditiously move forward with decimal trading. NexTrade,
however, is concerned that certain industry participants apparently
seeking nothing more than to gain favorable press coverage have elected
to move forward with the implementation of decimal trading in an
uncoordinated manner. While NexTrade has been ready to trade in
decimals for some time, we appreciate the importance of working with
other industry participants, including those which are not prepared to
trade in decimals, in order to ensure a smooth and efficient transition
to decimal trading.
4. What structural changes should accompany the demutualizations of
NYSE and Nasdaq to ensure a competitive market?
While NexTrade has the utmost confidence in the integrity of the
directors, officers and staff of the New York Stock Exchange (``NYSE'')
and the Nasdaq, it is inappropriate to place individuals in a situation
rife with potential conflicts of interest. The directors, officers and
personnel of new for-profit exchanges that have regulatory
responsibilities could be placed in situations that interfere with
their ability to satisfy their regulatory responsibilities. In order to
avoid such potential conflicts of interest, NexTrade believes there
must be a suitable level of separation between the business and
regulatory groups of all for-profit exchanges. While NexTrade does not
believe that this separation necessarily requires the creation of a
distinct corporate subsidiary to house the regulatory functions of the
exchange, any exchange electing not to do so should be subject to
heightened scrutiny to ensure that the necessary separation does in
fact exist.
5. What benefits will electronic exchanges provide that traditional
exchanges do not?
Electronic exchanges will provide numerous benefits that
traditional exchanges cannot provide. Like ECNs, electronic exchanges
will utilize technology to provide faster and more accurate executions
than traditional exchanges. Unlike traditional exchanges, electronic
exchanges will allow orders to interact without a market maker or
specialist. This ability to execute orders without an intermediary will
result in lower transaction fees for investors. Additionally, by
decreasing the number of personnel involved in processing transactions,
electronic exchanges will reduce the likelihood of abuses by trading
personnel. Moreover, by reducing the number of personnel involved in
processing transactions and by reducing the number of potential trading
abuses, electronic exchanges will reduce the amount of resources that
the Commission and the exchanges must spend on surveillance and
enforcement. Finally, electronic exchanges will function with a lower
degree of errors in processing trades and will enable customers' orders
to be executed at the best price by means of linkages between new
electronic exchanges.
6. Is the Nasdaq super-montage an ECN?
Yes, the Nasdaq super-montage is an ECN.
What types of problems do you anticipate in a market in which your
regulator competes with you?
Although NexTrade has confidence in the integrity of the directors,
officers and staff of the NASD and its subsidiaries, there would be an
inherent conflict of interest if the Nasdaq was allowed to operate the
super-montage while regulating competing ECNs. Accordingly, NexTrade
believes that the regulatory group of the NASD, NASD Regulation must
operate as a distinct and fully autonomous entity from the Nasdaq
before the Nasdaq should be allowed to compete with the ECNs it
currently regulates. NexTrade also questions the propriety of the
NASD's use of fees paid by members, including those paid by ECNs and
ECN owners, to subsidize, develop and operate the proposed Nasdaq
Super-Montage which will compete with these members.
7. Which regulations most inhibit ECNs from competing with exchanges?
Although there are numerous regulations that inhibit ECNs from
competing with exchanges, the most significant barrier to competition
is the current structure of the National Market System (``NMS''). The
current structure of the NMS impedes the entry of new market
participants that would introduce new technology. Under the current
regulatory structure, the boards of the NMS Plans are composed of
representatives from each exchange. Any change to the rules governing
the operation of the NMS systems, including the very rule changes
necessary to accommodate new market participants, require the unanimous
consent of the participants. Accordingly, if one board member feels
threatened by an ECN's technology, that board member can prevent the
ECN from participating.
In 1936, Congress noted that a major responsibility of the
Commission in the administration of the securities laws is to ``create
a fair field of competition.'' <SUP>1</SUP> The current national market
system does not create a fair field of competition. Rather, the current
national market system protects antiquated participants from
competition, while subsidizing its members' operations.
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\1\ Pub. L. No. 94-29, 89 Stat. 97 (1985).
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The consolidated, real-time stream of market information has been
an essential element in the success of the America's equities markets.
It is the principal tool for enhancing the transparency of the buying
and selling interest in a security, for addressing the fragmentation of
buying and selling interest among different market centers, and for
facilitating the best execution of customers' orders by their broker-
dealers.<SUP>2</SUP> The consolidation of quotations and last sale
information was an important goal of the Securities Acts Amendments of
1975.<SUP>3</SUP> Congress believed that the need for market
effectiveness and efficiency required that a neutral central processor
be organized and responsible for collecting and distributing market
data to market participants. Section 11A called for the Commission to
use its authority to facilitate the establishment of a national market
system which has, as one of its objectives, the availability of quote
and transaction information for brokers dealers and
investors.<SUP>4</SUP>
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\2\ See 64 Fed. Reg. 70613 (Dec. 17, 1999).
\3\ Pub. L. No. 94-29, 89 Stat. 97 (1985).
\4\ Section 11A(a)(1).
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The national market system that Congress meant to promote equal
access, market transparency, and fair competition, is now attainable
because of twenty-first century technology. However, the governance
structures and technology that modernized our markets in 1975 are ill
suited to achieve the goals of the national market system for the next
century. Market data that was once the property of a few and was only
available to market participants, is now in the hands of the public.
This liberation of information has been the result of the development
of the Internet. Over the last decade, the Internet has revolutionized
the way people access and use information.
The current National Market System no longer serves to promote the
development of mechanisms that allow for economically efficient
executions of securities transactions. The current National Market
System impedes fair competition and reduces market transparency. The
current National Market System prevents large pools of liquidity
contained in ECN order books from interacting with other market
participants. These deficiencies result in decreased investor access to
the best markets.
In order to ensure that the National Market System meets its
congressional mandate, the governance structure of the national market
system should be amended. The NMS governing boards should be eliminated
and replaced with a new national market system board. This new National
Market System board should include representatives from the existing
exchanges, new electronic exchanges, ECNs, broker-dealers, issuers and
the public. The new NMS board should be structured in such a way as to
ensure that at least 50 percent of the representatives are not industry
participants. This structure is similar to the structure endorsed by
the Commission in recent years with respect to public representation on
the boards of self-regulatory organizations.<SUP>5</SUP> Industry
associations such as the Securities Industry Association and the
Security Traders Association could select broker-dealer representatives
from firms of various sizes.<SUP>6</SUP>
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\5\ See, e.g., Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and The Nasdaq Market (August
8, 1996); Order Granting Approval to Philadelphia Stock Exchange
Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997)
(requiring 50 percent board representation by public governors).
\6\ This approach was also discussed in the SIA Report on Market
Data Pricing, which noted that SIA would also like to explore/encourage
an alternative governance structure for market data that would include
a broader exchange, industry, and public representation. See Report on
Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999).
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8. What it the Intermarket trading system (ITS). How should it be
changed?
Currently, the markets are linked by the National Market System
Plans. One plan that is very important in reducing market fragmentation
is the Intermarket Trading System (``ITS''), which allows orders to be
routed to the best market regardless of which market originally
received the order. Unfortunately, the technology and the rules
governing the operation of the system are, in Chairman Levitt's words,
``archaic.'' Market participants using ITS to route orders to other
markets may wait as long as two minutes to receive a response and, even
then, may not receive an execution. NexTrade believes that the
traditional markets participants' opposition to technological
innovations has resulted in unnecessary market fragmentation.
Accordingly, NexTrade believes the technology behind the ITS should be
updated.
On January 26, 1978, the Commission issued a statement on the
national market system calling for the prompt development of
comprehensive market linkage and order routing systems to permit the
efficient transmission of orders among the various markets for
qualified securities, whether on an exchange or over-the-
counter.<SUP>7</SUP> In particular, the Commission stated that an
intermarket order routing system was necessary to ``permit orders for
the purchase and sale of multiply-traded securities to be sent directly
from any qualified market to another such market promptly and
efficiently.'' <SUP>8</SUP> The Commission further stated that ``[t]he
need to develop and implement a new intermarket order routing system to
link all qualified markets could be obviated if participation in the
ITS market linkage currently under development were made available on a
reasonable basis to all qualified markets and if all qualified markets
joined that linkage.'' <SUP>9</SUP>
---------------------------------------------------------------------------
\7\ Exchange Act Release No. 14416 (January 26, 1978) (``1978
Statement''), at 26, 43 FR 4354, 4358. Previously, on June 23, 1977,
the Commission had indicated that a national market system would
include those ``regulatory and technological steps [necessary] to
achieve a nationwide interactive market system.'' See Exchange Act
Release No. 13662 (June 23, 1977), at 20, 42 FR 33510, 33512.
\8\ 1978 Statement, supra note 5, at 4358.
\9\ In this connection, the Commission specifically indicated that
``qualified markets'' would include not only exchanges but OTC market
makers as well. Id.
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Unfortunately, the goals of the ITS, have not come to fruition.
Originally, designed to link the existing exchanges, ITS currently
handles a relatively small proportion of trading in listed equities. In
September 1999, for example, ITS volume represented 2.2% of total NYSE-
listed trades.<SUP>10</SUP> One of the primary reasons for the anemic
performance of ITS, is its failure to include ECNs and its slow and
inefficient technology.
---------------------------------------------------------------------------
\10\
---------------------------------------------------------------------------
On December 9, 1999, in an apparent attempt to open the ITS, the
Commission adopted amendments to the ITS Plan. The amendments expand
the ITS/Computer Assisted Execution System linkage to all listed
securities.<SUP>11</SUP> The Commission also noted that:
---------------------------------------------------------------------------
\11\ Exchange Act Release No. 42212 (Dec. 9, 1999).
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in order to further the goals of the national market system,
ECNs trading in listed securities should be linked to ITS. ITS
should not prevent efficient electronic routing between
markets.<SUP>12</SUP>
---------------------------------------------------------------------------
\12\ Id. (emphasis added).
---------------------------------------------------------------------------
While the opening of ITS to ECNs is a step in the right direction, the
value of such a step will be minimized as long as the current
governance structures of the ITS and other NMS Plans remain in place.
The ITS Plan should be opened to new constituencies, including
ECNs, broker-dealers, issuers and the public. In order to ensure that
the new National Market System meets its congressional mandate, the
governance structure of the NMS should be amended. The NMS governing
boards should be eliminated and replaced with a new National Market
System board. This new NMS board should include representatives from
the existing exchanges, new electronic exchanges, ECNs, broker-dealers,
issuers and the public. The new National Market System board should be
structured in such a way as to ensure that at least 50 percent of the
representatives are not industry participants. This structure is
similar to the structure endorsed by the Commission in recent years
with respect to public representation on the boards of self-regulatory
organizations.<SUP>13</SUP> Industry associations such as the
Securities Industry Association and the Security Traders Association
could select broker-dealer representatives from firms of various
sizes.<SUP>14</SUP>
---------------------------------------------------------------------------
\13\ See, e.g., Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and The Nasdaq Market (August
8, 1996); Order Granting Approval to Philadelphia Stock Exchange
Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997)
(requiring 50 percent board representation by public governors).
\14\ This approach was also discussed in the SIA Report on Market
Data Pricing, which noted that SIA would also like to explore/encourage
an alternative governance structure for market data that would include
a broader exchange, industry, and public representation. See Report on
Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999).
---------------------------------------------------------------------------
9. What is the Consolidated Quotation System (CQS)?
The Consolidated Quotation System (``CQS'') enables the regional
exchanges and the Nasdaq to jointly disseminate quotation information
available to market participants and investors. The Consolidated Tape
Association Plan (``CTA Plan'') and the Consolidated Quotation Plan
(``CQ Plan'') operate a data network commonly known as Network A that
disseminates market information for any common stock, long-term
warrant, or preferred stock admitted to dealings on the
NYSE.<SUP>15</SUP> All of the SROs are participants in the CTA Plan and
CQ Plan.
---------------------------------------------------------------------------
\15\ CTA Plan, Sections I(p) and VII(a)(i).
---------------------------------------------------------------------------
The Consolidated Tape Association (``CTA'') is a committee made up
of one representative of each of the participants. The CTA Committee
administers the CTA Plan and is registered as a securities information
processor (``SIP'') under Section 11A(b) of the Exchange
Act.<SUP>16</SUP> The administrator of Network A's day-to-day
operations is the NYSE, and its information processor is the Securities
Industry Automation Corporation (``SIAC'').<SUP>17</SUP>
---------------------------------------------------------------------------
\16\ An Operating Committee that is substantially the same as the
CTA administers the CQ Plan.
\17\ SIAC is jointly owned by the NYSE and Amex and is a registered
SIP under Section 11A(b).
---------------------------------------------------------------------------
The CTA Plan and the CQ Plan also operate a second network commonly
known as Network B. This network disseminates market information for
any common stock, long-term warrant, or preferred stock admitted to
dealings on the Amex or the regional exchanges, but not also admitted
to dealings on the NYSE or included in the Nasdaq market.<SUP>18</SUP>
Its day-to-day administrator is Amex, and its information processor is
SIAC.
---------------------------------------------------------------------------
\18\ CTA Plan, Sections I(q) and VII(a).
---------------------------------------------------------------------------
How should it be changed?
Like the other NMS Plans, the CQS Plan should be opened to new
constituencies, including ECNs, broker-dealers, issuers and the public.
In order to ensure that the new National Market System meets its
congressional mandate, the governance structure of the NMS should be
amended. The NMS governing boards should be eliminated and replaced
with a new National Market System board. This new NMS board should
include representatives from the existing exchanges, new electronic
exchanges, ECNs, broker-dealers, issuers and the public. The new
National Market System board should be structured in such a way as to
ensure that at least 50 percent of the representatives are not industry
participants. This structure is similar to the structure endorsed by
the Commission in recent years with respect to public representation on
the boards of self-regulatory organizations.<SUP>19</SUP> Industry
associations such as the Securities Industry Association and the
Security Traders Association could select broker-dealer representatives
from firms of various sizes.<SUP>20</SUP>
---------------------------------------------------------------------------
\19\ See, e.g., Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and The Nasdaq Market (August
8, 1996); Order Granting Approval to Philadelphia Stock Exchange
Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997)
(requiring 50 percent board representation by public governors).
\20\ This approach was also discussed in the SIA Report on Market
Data Pricing, which noted that SIA would also like to explore/encourage
an alternative governance structure for market data that would include
a broader exchange, industry, and public representation. See Report on
Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999).
---------------------------------------------------------------------------
10. Has the current regulatory structure of the National Market System
(NMS) actually created market fragmentation by disallowing ECNs
to share pricing information?
The governance structures of the NMS Plans and the antiquated
technologies that drive those plans have unnecessarily increased the
level of fragmentation of America's financial markets by preventing
competition and the participation of ECNs. The current regulatory
structure of the NMS is an impenetrable barrier to entry to new market
participants that would enhance competition. If one NMS participant
does not want an ECN to participate or is threatened by an ECN's
technology, the ECN is precluded from participating. Accordingly,
NexTrade believes that broader industry and public participation is
needed in the governance of the NMS to ensure the access of new market
participants.
While fragmentation has always been a problem for our markets, it
is not a question of if fragmentation exists, but rather a question of
degree. In the past, fragmentation was severe and was compounded by
inadequate information technology. As technology evolved, the degree of
fragmentation has diminished while the number of market participants
has skyrocketed. However, the level of fragmentation in our markets
could be greatly reduced by reforming the NMS.
Statistical evidence supports the conclusion that the introduction
of ECNs produced more efficient and less fragmented markets. Since the
arrival of qualified ECNs, evidence reveals dramatic improvements in
the costs of trading stocks in the United States. The average cost of
executing a trade on the Nasdaq Stock Market fell by 23 percent in
1998, spreads fell 41 percent, and volume increased substantially. If
left to competitive devices, the degree of fragmentation within the
markets will continue to be reduced despite the introduction of a
multitude of market participants.
Traditional market participants, including the members of the NMS
Plans, are opposed to technological innovations that could undermine
their hegemony over the markets. This resistance to technology has
resulted in unnecessary fragmentation. Competitive market participants,
however, have responded to fragmentation and inefficiencies with
market-based innovative solutions. A variety of ECNs and other trading
systems have responded with systems that consolidate and provide
efficient access to the best prices among competing markets. One firm
has connected all nine original ECNs, the NYSE and the Nasdaq to their
system. Similarly, when the current Nasdaq linkage (SelectNet) proved
too expensive and inefficient to handle record volumes, market
participants forged links with one another to create trading networks
that bypass SelectNet for faster and more reliable access to the best
market prices. These are just a few examples of the types of solutions
produced by innovation and competition that could reduce fragmentation.
11. Have you applied to become an Exchange?
NexTrade Holdings, Inc., the parent company of the NexTrade ECN,
has applied to operate a new electronic for-profit exchange, known as
the NexTrade Exchange. In November 1998, NexTrade began discussions
with the Commission regarding applying to operate an electronic
exchange. Rather than filing its exchange application without speaking
with Commission staff, NexTrade spent nearly one year working with
Commission staff in draft mode in order to facilitate meaningful
discussion of NexTrade's exchange application. Only after determining
the draft exchange application discussions had exhausted their
usefulness, did NexTrade formally file its exchange application with
the Commission in December 1999.<SUP>21</SUP>
---------------------------------------------------------------------------
\21\ NexTrade re-filed its exchange application in March 2000, in
order to address issues raised by Commission staff.
---------------------------------------------------------------------------
The proposed NexTrade Exchange is an example of the future of the
financial markets in that it makes use of innovative technology and new
regulatory structures as part of a for-profit exchange. The proposed
NexTrade Exchange plans to make available for the benefit of its
members and their customers an electronic trading system (the
``NexTrade Exchange System'') to effect the purchase or sale of
securities listed or admitted to trading on the proposed Exchange and
on other exchanges. The proposed exchange, however, will not maintain a
physical-trading floor. Members will access the NexTrade Exchange
System from their own computer terminals and communicate with the
NexTrade Exchange System over commercial information services and
networks.
What is the status of your application?
When NexTrade notified the Commission of its desire to operate an
exchange, the Commission advised NexTrade that it could not provide a
specific time frame with respect to an approval date. NexTrade was only
told that the process could take two (2) to three (3) years to complete
and that there was no guarantee that the application would be approved.
NexTrade has been advised on several occasions by Commission staff that
the Commission is struggling with issues regarding the governing
structures of new for-profit exchanges that had to be addressed before
the Commission could move forward with NexTrade's exchange application.
NexTrade has also been advised on several occasions by Commission staff
that the Commission was attempting to address issues relating to the
performance of regulatory functions by for-profit exchanges. As of the
date of this response, NexTrade has received no information regarding
either issue from the Commission despite having provided an application
that includes viable solutions to both issues.
Commission staff recently advised NexTrade that it could be another
12 to 18 months before the Commission issues a decision on NexTrade's
exchange application. Although NexTrade fully understands the
importance of the exchange approval process, we do not believe that a
two (2) to three (3) year review process is warranted or necessary in
order to make a decision regarding new electronic exchanges. NexTrade
appreciates that Commission staff are over worked and underpaid in
comparison to their colleagues in other federal regulatory agencies,
however, the failure to reach a decision on pending exchange
applications serves only to penalize the public by unnecessarily
shielding antiquated exchanges from competition that would benefit the
public.
12. How is Nasdaq's super-montage like a Central Limit Order Book
(CLOB)?
The Nasdaq's proposed super-montage is like a Central Limit Order
Book or CLOB in that the super-montage anonymously centralizes all
limit orders into an order consolidation facility. These centralized
orders do not reflect the market participants acting as agent or
principal of the transactions. The super-montage will not reflect the
identity of the market participant that posted the order. This function
coupled with the reserve function of the proposed super-montage, bear a
striking resemblance to the functions of most ECNs.
The proposed Nasdaq super-montage would create a central market
execution system composed of two tiers of ``Quoting Market
Participants.'' Participation would be mandatory for market makers and
``voluntary'' for ECNs. Nasdaq states that two types of participation
would be offered to ECNs: ``full'' and ``order entry''. ``Full''
participation would require ECNs for the first time to be subject to
automatic executions, which would put ECNs at a severe competitive
disadvantage. Order-entry participation would be a continuation of
current SelectNet linkage and functions, but would marginalize the
contribution ECNs could make to the marketplace. Consequently, the
proposed Nasdaq super-montage is fundamentally flawed in that it would
become increasingly ineffective as ECNs continued to grow.
Full Participation in the proposed Nasdaq super-montage leaves ECNs
with a Hobson's choice. While Full Participation in the proposed Nasdaq
super-montage would allow ECNs to connect with the proposed Nasdaq
CLOB, it would also allow the proposed Nasdaq CLOB to ``sweep'' the
ECNs' top-of-book orders into the proposed Nasdaq CLOB. This function
would hit or take all market-maker, ECN or proposed Nasdaq CLOB
quotations at the best bid or ask price. Access to the ``sweep''
function in the proposed Nasdaq CLOB, however, would involve a trade-
off for ECNs because of the disadvantages associated with full
participation by ECNs in the proposed Nasdaq Order Display Facility.
Market makers and institutional customers of ECNs often prefer to
trade on an ECN because of the additional services and features offered
on ECNs. Through competition, ECNs have developed a variety of
innovative capabilities to allow traders to customize their trading
methods to meet their needs. One such feature is a reserve quotation.
Nasdaq has stated that in the proposed Nasdaq CLOB any ECN reserves
would be bypassed, but the reserve feature of the proposed Nasdaq CLOB
would function. As a result, Nasdaq would in effect preference its own
additional functions, at the expense of those ECNs that do not want to
``agree'' to become Nasdaq CLOB participants.
The proposed super-montage is also like a CLOB in that market
participants would be forced to link through a central location, the
Nasdaq. This kind of forced linkage diminishes the competitive
advantages of ECNs by making them dependant on the capacity, integrity
and security of a single, largely antiquated system, which has proven
to be unreliable. NexTrade believes investors and the market benefit
from a variety of alternative systems that route, display and execute
orders.
13. What are the key problems with a Central Limit Order Book (CLOB)?
The notion behind the CLOB is that technology can be employed to
centralize orders in one place, thus resulting in maximum order
interaction and perhaps even better prices. A CLOB, however, will
sacrifice the innovation that has made our markets the best in the
world. Research has shown that competitive markets are better equipped
to implement technological innovations to address market
inefficiencies. Centralized markets, no matter how well intentioned
their architects, will typically be obsolete by the time they commence
operation. Competition creates incentives for markets to upgrade and
innovate. Centralized markets do not. Unlike open markets, centralized
markets serve to impede the ability of innovative firms to develop new
technologies and mechanisms that promote better execution.
Like any centralized marketplace, a CLOB would have substantial
dangers. Most importantly, a CLOB would represent a single point of
failure that could jeopardize the global economy. The danger of such
centralization is apparent in light of recent well-publicized attacks
on some of the largest Internet web sites and service providers. It is
economically impracticable to design a centralized marketplace that
would be completely free of vulnerability to attacks by cyber-
terrorists. The implausibility of designing a totally safe CLOB will
become increasingly apparent in the future as warfare and terrorism
move from city streets to the Internet. In contrast, the currently
developing network of trading facilities, much like the Internet,
mitigates these potential dangers through numerous alternative trade
destinations.
Moreover, a CLOB is anti-competitive. If the Commission mandates a
monopolistic central execution system, such as the proposed CLOB, with
which all market-participants must comply, innovation could be
eliminated. Such a dearth of innovation would not serve the goals of
the Act, the NMS, or the public. Rather than developing a system that
would reduce innovation by ECNs and other market participants, and halt
the development of technologies that provide additional liquidity and
transparency, the Commission should encourage a new and equitable NMS.
A CLOB would also impede the development of new for-profit
electronic stock exchanges. If the Commission mandates a monopolistic
central execution system, such as the proposed CLOB, with which all
market-participants must comply, innovation could be eliminated. Such a
dearth of innovation would not serve the goals of the Act, the NMS, or
the public. Rather than developing a system that would reduce
innovation by new for-profit electronic exchanges, ECNs and other
market participants, and halt the development of technologies that
provide additional liquidity and transparency, the Commission should
encourage a new and equitable NMS.
Finally, a CLOB would inevitably operate at the speed of its
slowest participant. While many ECN's execute their transactions in
milliseconds, the New York Stock Exchange proudly stated in its address
to Congress in September 1999 that its average transaction time was 22
seconds. Accordingly, a CLOB would likely execute transactions at
speeds much slower than many ECNs.
14. In what ways is a Central Limit Order Book (CLOB) anti-competitive?
A CLOB would be anti-competitive and would impede the development
of new for-profit electronic stock exchanges for several reasons. By
mandating that market participants link to a CLOB, the Commission would
create a monopolistic central execution system. A CLOB with its
specified technology would reduce innovation. A CLOB would be anti-
competitive in that it would require all market participants to utilize
uniform government mandated technology. A CLOB would also impose
significant costs on new electronic for-profit exchanges, the market
and ultimately issuers, in order to off-set the costs of the new
infrastructure and bureaucracy.
A CLOB would also be anti-competitive because there would be no
competition for order flow. Without competition for order flow, there
would be little incentive for firms to develop technologies that
provide additional liquidity and transparency. The CLOB would also be
anti-competitive because the system would dictate where a broker-dealer
sends an order. A CLOB would not allow market participants to develop
technological linkages with other market participants and take suitable
steps to ensure that they satisfy their best execution responsibilities
when handling orders. Rather, than allowing for innovation by market
participants that can reduce costs for their clients, a CLOB would
dictate an order routing regimen. Such a dearth of innovation would not
serve the goals of the Act, the NMS, or the public. Rather than
developing a system that would reduce innovation by new for-profit
electronic exchanges, ECNs and other market participants, and halt the
development of technologies that provide additional liquidity and
transparency, the Commission should encourage a new and equitable NMS.
15. Recently we have seen an increase in message bottlenecking due to
capacity problems with individual systems. Would the existence
of a Central Limit Order Book (CLOB) exacerbate the capacity
problems we have been witnessing?
The existence of a CLOB would only exacerbate the capacity problems
we have been witnessing. Under such a facility, the entire NMS and all
market participants would be dependent on the capacity, integrity and
security of a single system. The dangers associated with such a
strategy are discussed in greater detail above. However, a CLOB that
relies on a single technology could jeopardize our financial markets if
it fails for any of a variety of reasons. A CLOB that relies on a
single technology would also eliminate the positive effects of
innovation by requiring all firms to adopt a uniform technology and
order routing regimen for linking to the CLOB. This lack of innovation
would reduce the positive gains that are being made by innovative
market participants to minimize the message bottlenecks currently
occurring on well established markets.
The dangers of a CLOB and its reliance on a single technology are
apparent upon examining the record of the current order routing
technology used by the Nasdaq. The level of trading activity on the
Nasdaq over the past year has overwhelmed the Nasdaq's SelectNet
system. Over the past year, the Nasdaq SelectNet system has suffered
several well-publicized failures that have seriously endangered the
National Market System. Some of the most notable and publicly
acknowledged recent Nasdaq system failures include the following:
<bullet> (March 6, 1999, 9:41 a.m. to shortly after 11:00 a.m. ET,
Nasdaq SOES (Small Order Execution System) and SelectNet
Equipment failed.
<bullet> (April 1-13, 1999, Nasdaq SelectNet has higher volume of
SelectNet orders (a 25% increase over 1998) and suffers from
the capacity impact on systems, leading to slowed trading in
the first half hour of trading as systems labored to clear
orders that accumulated overnight.
<bullet> (October 6, 1999, Nasdaq SelectNet's system, triggered by a
software change made overnight to allow the market to extend
hours for its trade-reporting and quotation systems, runs
slowly for hours and the Instinet, Island and Brut ECNs are
removed from Nasdaq's quote display.
<bullet> (November 16, 1999, Nasdaq SelectNet and SOES fail during a
mid-day software upgrade that was attempted during a record
1.46 billion share trading day causing a black out of SelectNet
and SOES from 3:40 EST to 3:57 EST. Nasdaq has claimed that it
has adequate capacity for a four billion shares trade day,
however, this claim is seriously suspect based on the
aforementioned system failures.
The failings of the Nasdaq's SelectNet system are but one example of
the dangers of America's financial markets relying on a single
technology such as a CLOB.
16. The idea of a Central Limit Order Book (CLOB) was first tossed
around in the 1970's when fragmentation was high because
technology could not facilitate efficient order interaction
without centralization. Has the current technology rendered the
notion of a CLOB obsolete?
Current technology has rendered the notion of a CLOB obsolete. The
rapidly declining costs of telecommunications technology has made it
possible to build and maintain redundant, competitive systems to handle
orders without the need for a single monolithic service provider.
Consequently, there is no reason to compel market participants to
participate in a government designed CLOB. Advocates of the CLOB claim
that it is the only means of addressing fragmentation. Such claims are
without merit.
Fragmentation has always been a problem for our markets. It is not
a question of if fragmentation exists, but rather a question of degree.
In the past, fragmentation was severe and was compounded by inadequate
information technology. As technology evolved, the degree of
fragmentation has diminished while the number of market participants
has skyrocketed. However, the level of fragmentation in our markets
could be greatly reduced by reforming the NMS.
Rather than developing a CLOB that would reduce innovation by ECNs
and other market participants, the Commission should encourage the
development of a new and equitable NMS. The combination of private and
public linkages that has formed the market network since the advent of
the Order Handling Rules is the best model for growth and development
of the United States capital markets in the future. The Commission
should not allow market participants that rely on antiquated
technologies to undermine the positive gains that have been made since
the advent of the Order Handling Rules towards the creation of a open,
efficient and equitable market.
Should you have any questions regarding this or any other matter,
please do not hesitate to contact me at the telephone number above.
Sincerely,
John M. Schaible
President, NexTrade Holdings, Inc. and NexTrade, Inc.
______
The Island ECN., Inc.
May 8, 2000
Mr. Tom Bliley, Chairman
U.S. House of Representatives
Committee on Commerce
Room 2125
Rayburn House Office Building
Washington, DC 20515-6115
Dear Mr. Chairman: Please find the enclosed answers to the
questions you had posed regarding the role ECNs and Island in
particular are playing in the evolving financial marketplace. I look
forward to working with you and the rest of the Commerce Committee on
these important issues. If I can be of any further assistance, please
let me know.
Sincerely,
Matthew Andresen, President
The Island ECN., Inc.
Enclosure (1)
FOLLOW-UP QUESTIONS FOR THE RECORD FOR THE COMPETITION IN THE NEW
MARKETS HEARING: PART I
Question 1. How do ECNs increase transparency?
Response: ECNs increase transparency by making more information
available to the investor. Traditionally, investors have only been
provided with the highest bid and lowest offer in a security. The depth
of the market, which gives an indication of the true supply and demand
for a security, has been the exclusive province of market
professionals. More specifically, what happens to an order after it is
placed with your broker? What sort of accountability exists? At Island,
we urge investors to ask themselves what just happened to their order
after they click on the ``Submit'' button. After all that thorough and
careful research, why is the investor--at this final stage of the
process--essentially staring into a black box--or at best a screen with
the words ``Your Order Has Been Placed.''
That lack of accountability--in other words, denial of information
to the investor--was unacceptable to us. To provide the best resource
possible to the investor, we became the first marketplace to provide a
free, real-time display of all its orders, through the Island
BookViewer <SUP>TM</SUP>. Such transparency is precisely what SEC
Chairman Levitt recently called for in his Northwestern University
speech: ``Now is the time to embrace a broader and deeper transparency.
Now is the time for all market participants to move toward open books
across all markets . . . These are forward looking initiatives that
answer the investor's call for greater transparency and more efficient
pricing.'' Island couldn't agree more. That's why orders received by
Island for display on the limit order book are immediately visible to
anyone with a web browser regardless of whether the order was received
from an individual investor or a large institution. Why is this
important? Investors can use the additional information provided by
Island to more accurately price their orders. The Island BookViewer
<SUP>TM</SUP> also reduces the informational and temporal advantages
traditionally enjoyed by floor brokers, market makers, and specialists.
In other words, the average investor is not disadvantaged because of a
lack of access to, for example, the floor of an exchange. By
eliminating these time and place disparities--in essence, putting the
investor ``virtually'' right next to the market maker or specialist--
Island helps lower the hidden costs associated with higher spreads and
inferior executions. In fact, according to the Securities and Exchange
Commission, spreads--the difference between the highest price to buy
and the lowest price to sell--have narrowed substantially since the
time ECNs were given access to the Nasdaq market, saving investors
hundreds of millions of dollars per year.
Question 2. Are you decimals ready?
Response: Yes. See answer below.
Question 3. What can you do to facilitate trading in decimals even
though Nasdaq is not decimal ready?
Response: The Island ECN, Inc., has announced that, consistent with
the U.S. Congress's deadline for conversion to decimals for trading of
stocks, on July 3, 2000, Island shall be the first U.S. equity
marketplace to offer investors the ability to trade in decimals. As the
U.S. Congress has made clear, decimalization is one of the most
important initiatives for creating a fairer, simpler, and more
accessible marketplace for the individual investor. Investors should
not be burdened with the cost of industry-established increments that
limit investors' ability to obtain the best possible price.
The Island decimalization plan is completely voluntary and allows
all participants to transition into the program in a fair, orderly, and
clear fashion. Brokers and investors can select their preferred trading
environment--decimals or fractions. Another key aspect of the Island
plan is that it provides market participants with a competitive and
economic incentive to progress to decimals as quickly as practicable.
By providing market incentives, the Island plan ensures a timely
transition to decimals that will benefit investors. We expect that
investors will save hundreds of millions of dollars a year as the
industry moves toward decimal trading, and we are proud to be one of
the catalysts for this change.
Island's decimalization plan is consistent with the current
relationship between Nasdaq and Island. Island already trades in
increments finer than the Nasdaq market as a whole and is required to
round its quotation information prior to transmission to Nasdaq.
Different quote increments already exist within Nasdaq and have not
been the source of any system problems or investor confusion. By
progressing to decimals, we are further simplifying the market for
millions of investors.
Question 4. What structural changes should accompany the
demutualization of NYSE and Nasdaq to ensure a competitive market?
Response: Island believes that the U.S. Congress has already
designed the roadmap for ensuring the continued success of our capital
markets. In 1975, Congress created the National Market System, with the
goal of constructing a more efficient and transparent market. We could
not ask for a better building block.
The mandate of the NMS, as envisioned by Congress, is defined by
two objectives: first, to promote competition between markets (``fair
competition between exchange markets and markets other than exchange
markets''); and second, to make quotation and transaction information
available to investors (``assure the availability to brokers, dealers,
and investors of information with respect to quotations for the
transactions in securities.'').
Consistent with this mandate, the SEC adopted rules that permitted
ECNs to have their quotations included in the Nasdaq best bid and offer
that is disseminated to the entire marketplace. As described earlier,
competition between markets flourished (with ECNs having captured 30
percent of the Nasdaq transaction volume), and Nasdaq itself was
significantly reformed. When provided a level playing field, ECNs can
compete for market share and bring the benefits of competition to the
investor.
This situation contrasts sharply with the rules and regulations
governing Island's ability to compete in NYSE-listed stocks.
Ironically, almost 25 years later, the rules and market structure
implemented to achieve the goals of a National Market System are now
inhibiting competition between markets and restricting the information
available to investors. Regulatory obstacles block Island from having
its quotation information included in the two main components of the
National Market System--the Consolidate Quotation System (CQS) and the
Intermarket Trading System (ITS).
We do not believe that any public-policy benefits are served by
stifling competition and barring Island from sharing its pricing
information. Consider that when Island trades the stock of America
Online, at various times during the trading day, Island has the best
quote in the National Market System. Unfortunately, due to the current
regulatory structure, market participants (other than Island
subscribers) are denied the opportunity to see and to access the better
price on Island. This is completely inconsistent with the spirit of the
National Market System.
In addition, we would witness significant public-policy benefits by
promoting competition and integrating Island into the NYSE's pricing
mechanism. Most importantly, Island's price information would no longer
be fragmented from the rest of the marketplace. The market for NYSE-
listed stocks would immediately become more integrated and efficient.
The resulting competition between marketplaces (again, a central goal
of the National Market System) would result in benefits for the
investor.
In light of the proven benefits to investors and the efficiency of
the market, it is time to take immediate action to give ECNs access to
the Consolidated Quotation System. ECNs, such as Island, must be
permitted to disseminate their quotation in listed stocks to all market
participants. Yet in moving forward on this issue, we must still
confront and deal with a version of price-time priority currently
operating for the listed market. As discussed earlier, under the plan
governing the operation of the Intermarket Trading System, each
participant exchange is prohibited from trading at a price inferior to
another participant.
Just as the Federal government does not negate customer choice by
requiring consumers to buy goods from the lowest price merchant, market
participants should not be required to buy from the best-priced market.
As long as market participants know the price in each market and have
the ability to access each market, there is no need for the Federal
government to require the market participant to favor any one market.
Accordingly, in addition to allowing ECNs to disseminate their
quotations directly through the consolidated quote, the elimination of
the trade-through rule is another important step toward more fully
realizing Congress's objectives in the National Market System.
Question 5. What Benefits will electronic exchanges provide that
traditional exchanges do not?
Response: Electronic exchanges provide investors with a faster,
cheaper, more reliable, and transparent method of trading equity
securities. Prior to the introduction of ECNs, investors did not have
any choice but to send their orders to market makers for execution.
Following the SEC's 21(a) Report detailing collusion and fraud by
market makers as well as the Justice Department's investigation into
similar conduct, the SEC adopted the Order Handling Rules which
permitted ECNs to display customer orders directly in the market
without the participation of a traditional intermediary. By placing a
limit order on an ECN, investors are empowered to determine their own
price at which they want to buy or sell or security. In addition, by
eliminating the traditional intermediaries, ECNs provide faster and
lower cost executions than traditional market centers. Due to their
rather simple business model and state of the art technology, ECNs are
also able to provide services that traditional markets cannot or, in
order to protect their franchises, will not provide. For example,
Island was the first equity market in the United States to make its
limit order book available for free over the Internet. Island was also
the first equity market in the United States to announce its intention
to trade in decimals on the Congressionally mandated deadline of July
3, 2000.
Moreover, by eliminating the informational disparities, ECNs are
inherently safer, fairer, and easier to surveil. For example,
participants on the floor of an exchange generally possess more trade
and order information than the average investor sitting at home.
Through surveillance and the implementation of restrictions on the
activities of those in the trading crowds, regulators attempt to
prevent the misuse of information. As recent events have shown,
however, no amount of surveillance or regulation can completely prevent
the misuse of information.
ECNs, such as Island, reduce the opportunities for improprieties by
eliminating informational disparities. ECNs empower all investors by
allowing them to step into a virtual trading crowd and compete
directly. Since all orders are delivered to the virtual trading crowd
and instantaneously displayed to everyone, no single person has an
informational advantage that needs to be regulated or surveilled. That
means we have been able to deliver to investors the benefits of lower
cost, more transparent, fairer markets, while still complying with
strict Commission standards designed to ensure the integrity of our
trading systems. Island, for example, must comply with regulatory
standards concerning the security, capacity and reliability of our
system. In fact, due to its use of the latest, most advanced technology
as well as its proprietary architecture, Island has a superb record for
reliability and performance. For example, during the past year when the
Nasdaq market has periodically experienced system delays due to the
tremendous surges in trading volume, Island has never experienced a
capacity-related problem. Even during peak trading periods. Island's
average turnaround time is approximately three one-hundredths (.03) of
a second--exponentially faster than our nearest competitor. By
combining the latest technology with our advanced system architecture,
Island has created a scalable, robust trading system with virtually no
capacity limitations.
Furthermore, because electronic markets automatically capture and
store all information, a complete audit trail is available for every
order entered into the system. Accordingly, electronic markets can
monitor a much larger and complete dataset for trading abuses such as
price manipulation. At Island, we are able to monitor not just
completed transactions, but all open orders in the system. This gives
us the ability to not only detect violations that have already
occurred, but also to prevent future violations.
Finally, we have never taken our eye off the bottom-line for the
investor; we have always believed that any money funneled out of the
marketplace comes directly out of the investors' pockets. Consequently,
Island has sliced its margins razor thin. Island, for example, only
receives $.00075 per share per side on every transaction executed on
its system; in other words, a trade for 1,000 shares of stock means
only seventy-five cents for Island. I like to point this out to my
staff when others question our spartan offices--like a recent New
Yorker magazine profile noting that we have ``upgraded our offices from
grungy to nondescript.'' I like to believe that there are millions of
investors across the country benefiting from the fact that Island has
the least stylish offices on Wall Street.
Question 6. Is the Nasdaq supermontage an ECN? What types of
problems do you anticipate in a market in which your regulator competes
with you?
Response: When evaluating the Super-Montage Proposal, it is
important to understand that there are two aspects to the proposal.
First, there is the initiative that would allow market participants to
display greater depth to the market on a voluntary basis. Strangely
hidden in the proposed rule, however, is a proposal for the creation of
something named the ``Order Collector Facility.'' Although Nasdaq has
gone to great lengths to trumpet the benefits of the greater
transparency, it has ignored the competitive implications of the
combination of the Order Display Facility (the system that will
actually display the orders of market participants) with the Order
Collector Facility (the system for the execution of orders displayed on
the Order Display Facility). Yet, the Super-Montage Proposal states
that the Order Collector Facility would be established as the ``single
point of order entry and single point of delivery of liability orders
and executions.'' By creating a platform for both the display and
execution of orders, Nasdaq is essentially proposing the functional
equivalent of a consolidated limit order book. One of the key
attributes of the system is that, as Nasdaq states in a footnote, it
would meet ``the requirements of the Display Alternative, Exchange Act
Rule 11Ac1-4(c)(5).'' In other words, the Super Montage proposal would
create a Nasdaq sponsored ECN.
To understand the competitive implications of the new system it is
important to understand how Nasdaq operates today. Currently, Nasdaq
operates as a communications system that links the various market
participants by: 1) consolidating the quotation information of the
various market participants; and 2) operating the SelectNet system that
allows market participants to electronically access the orders
displayed in Nasdaq's consolidated quote. SelectNet allows Nasdaq
market participants to route orders to the best price with the
subsequent execution occurring on the system of the market participant
receiving the order. The Super-Montage Proposal, however, would require
executions to occur, not on the system of the ECN or market maker that
receives the order, but on the Nasdaq operated Order Collector
Facility. As a result, every market participant would become dependent
on Nasdaq technology. Island strongly believes, however, that both
competition and investors would be better served if, instead of trying
to become the execution point for all Nasdaq market participants,
Nasdaq substantially upgraded the SelectNet system. This upgrade, in
conjunction with new rules requiring all market participants respond to
orders in an automated fashion, would heighten competition on Nasdaq
and, thus, bring greater benefits to investors.
It is also important to note that regardless of whether the Super-
Montage proposal is approved, the current regulatory structure is
tilted in favor of Nasdaq. Not only does Nasdaq have the authority to
pass and interpret rules governing the activities of ECNs but, Nasdaq
uses the revenue it makes from ECNs to finance initiatives intended to
compete with ECNs. For instance, all Nasdaq market participants,
including ECNs such as Island, are required by Commission rules to
report every transaction to Nasdaq. Not only does Nasdaq charge Island
a fee for every transaction that Island is required by regulation to
report to Nasdaq, but Nasdaq then sells that same trade information for
hundreds of millions of dollars. In fact, Island believes that it is
one of Nasdaq's largest sources of revenue. The fact that the Nasdaq
may separate itself from the NASD-R is irrelevant to these issues. Even
after the separation, Nasdaq still would retain the ability to adopt
rules that could disproportionately impact ECNs and use its monopoly
position to disadvantage ECNs. For example, ECNs are required by SEC
rules to maintain connectivity to Nasdaq. Yet, Nasdaq dictates the
price and quality of that connectivity. If ECNs encounter problems with
their Nasdaq operated connections they must call Nasdaq for assistance.
This conflict of interest has already created problems and will only
intensify if the relationship between Nasdaq and ECNs is not re-
structured to ensure fair competition. By heightening competition and
spawning innovation, ECNs have played a major role in strengthening the
Nasdaq market. The Super-Montage proposal risks undermining these
accomplishments.
Question 7. Which regulations most inhibit ECNs from competing with
exchanges?
Response: See answer to question 4 above.
Question 8. What is the Intermarket Trading system. How should it
be changed?
Response: The Intermarket Trading System (``ITS'') is the system
that links all exchange markets. For instance, if an investor sends an
order to buy shares of IBM to the Chicago Stock Exchange when there is
a better price available on the NYSE, ITS allows the Chicago Stock
Exchange specialist to route that order to the NYSE to obtain the
better price. As has been recognized by the Securities and Exchange
Commission itself, however, ITS is based on obsolete technology,
outmoded miles, and a dysfunctional governance structure. The best
solution is to completely replace ITS and rethink many of the
assumptions that underlie its creation. Island will be submitting a
comment letter to the Commission in the near future that will provide a
detailed proposal with respect to the future of ITS. It is important to
note, however, that ITS is not the key competitive barrier that
prevents ECNs from effectively competing in NYSE listed stocks.
Instead, the key issue is representation. Island must be able to
disseminate its quotation as part of the consolidated quotation in
order to compete on a level playing field in NYSE listed securities.
Question 9. What is the Consolidated Quotation System? How should
it be changed?
Response: The Consolidated Quote System is the system that displays
the best quotation from all 8 Self-Regulatory Organizations that trade
listed securities. ECNs, however, due to regulatory barriers do not
have their quotes represented in CQS. While Island, for example, has
developed a robust business in trading Nasdaq securities (accounting
for approximately 1 in every 8 transactions), the inability of Island
to disseminate its quotations through CQS have prevented Island from
capturing a significant share of the volume in securities listed on the
NYSE. By preventing fair competition between ECNs and traditional
markets for listed securities, the current regulatory scheme harms
investors.
The Commission must take immediate action to allow ECNs to include
their quotation information in the Consolidated Quotation for listed
securities. Traditionally, ECNs have resisted posting their quotation
in CQS because, by posting a quote in CQS, ECNs would be required to
participate in ITS. Given the consensus that ITS is obsolete, Island
recently the order of an ECN, such quote would contain an identifier
indicating that it is the quote of an ECN not accessible through ITS.
In turn proposed that the SEC take steps that would allow ECNs to
immediately begin representing their quotations for NYSE-listed stocks
in CQS without participating in ITS until a more permanent long-term
solution is found. Specifically, Island proposed that ECNs be permitted
to immediately begin displaying their quotations in listed stocks
through Nasdaq. If the Nasdaq quote in CQS reflected, other markets
could access the ECN quote by linking directly to the ECN or by simply
contacting the phone desk of the ECN. The phone desk would provide at
least the same quality of access that is currently provided by ITS.
More importantly, the inclusion of ECN quotes in CQS would bring true
competition to the listed market and allow investors to obtain better
prices.
Question 10. Has the current regulatory structure of the National
Market System actually created market fragmentation by disallowing ECNs
to share pricing information?
Response: The two main goals of the National Market System were to
heighten competition between markets and increase the amount of
quotation information available to investors. Ironically, almost 25
years later, the rules and market structure implemented to achieve the
goals of a National Market System are now inhibiting competition
between markets and restricting the information available to investors.
Regulatory obstacles block Island from participating in the two main
components of the National Market System--the Consolidate Quotation
System (CQS) and the Intermarket Trading System (ITS).
Consider that when Island trades the stock of America Online, at
various times during the trading day, Island has the best quote in the
National Market System. Unfortunately, due to the current regulatory
structure, market participants (other than Island subscribers) are
denied the opportunity to see and to access the better price on Island.
This is completely inconsistent with the spirit of the National Market
System.
Instead, we should promote competition and integrate Island into
the NYSE's pricing mechanism. Most importantly, Island's price
information would no longer be fragmented from the rest of the
marketplace. The market for NYSE-listed stocks would immediately become
more competitive and efficient. The resulting competition between
marketplaces (again, a central goal of the National Market System)
would result in benefits for the investor.
Question 11. Have you applied to become an Exchange? What is the
status of your application?
Response: Island applied to the SEC become a registered securities
exchange on June 28, 1999. Island is in regular dialogue with the SEC
on the status of the application, and awaits specific recommendations
from the SEC.
Question 12. How is Nasdaq's super-montage like a Central Limit
Order book?
Response: See answer to question 6 above.
Question 13. What are the key problems with a Central Limit Order
Book?
Response: The debate over the creation of a Consolidated Limit
Order Book (CLOB)--a government-mandated, central order book, based on
strict time-price priority between markets--has highlighted many of the
problems with a CLOB. Its advocates insist that a CLOB is now necessary
because ECNs have ``fragmented'' the marketplace. In fact, the rise of
ECNs has, by increasing competition, have led to consolidation of the
marketplace. A decade ago, the top four market participants (before
ECNs were around) accounted for 40 percent of the total Nasdaq volume;
today, the top four (now including ECNs) account for 60 percent.
Building upon this suspect fragmentation claim, the traditional market
professionals then seek to impose a CLOB across markets.Interestingly
enough, the immediate and most important effect of a CLOB is to deny an
ECN's ability to compete with traditional players on the basis of
speed, technology, and reliability. The CLOB inhibits competition by
forcing markets to route orders to other marketplaces for execution.
The resulting inter-dependence between the markets would prevent any
one market from distinguishing itself on the basis of speed,
reliability and quality of service. For example, if an order is sent to
Market A for execution but Market B was displaying a better price,
Market A would be required to send the order to Market B for execution.
As a result, the quality of service that Market A could offer its
customer is only as good as the quality of service of Market B. The
basis for competition between markets would be eliminated since the
only factor that would determine which market received the order would
be price.
Question 14. In what ways is a CLOB anti-competitive?
Response: To understand why rules mandating price-and-time priority
between markets and--in their most extreme form--the Consolidated Limit
Order Book are anti-competitive, consider the following example:
Assume that ECN A is a market that provides its members with the
fastest and most reliable trading system in the industry. In addition,
assume that Traditional Market B utilizes obsolete technology that
lacks adequate capacity. If, under a regime of price/time priority,
Market B is the first to display the best offer of $100 in stock XYZ,
any order to buy XYZ at $100 received by ECN A must be routed to
Traditional Market B--despite its inferior technology. Thus, even if
you as an investor intentionally sent your order to ECN A to take
advantage of its superior speed of execution, ECN A would be required
to route your order to Traditional Market B. Thus, ECN A would be
completely dependent on a response back from Traditional Market B in
order to fill your order.
This simple scenario demonstrates why price/time priority fails to
serve the investor:
1.) It is impossible for ECN A to offer a faster execution or better
service in its competition with Traditional Market B, since
Market A will always be dependent on Traditional Market B for
execution and vice versa;
2.) ECN A and Traditional Market B are dependent on the linkage between
them and cannot offer service any faster or more reliable than
permitted by the linkage.
3.) In light of the first two points, investors will become insensitive
to which market the order is entered, leaving no basis for
competition between markets.
In sum, not only do we prevent markets from competing with one
another on any basis beside price, but we actually undermine the very
technological breakthroughs that have strengthened our Nation's equity
markets.
Question 15. Recently we have seen an increase in message
bottlenecks due to capacity problems with individual systems. Would the
existence of a CLOB exacerbate the capacity problems we have been
witnessing?
Response: Yes. The very definition of a CLOB is a centralized
system where all market participants are dependent on such system for
the execution of orders. Since the system's development must be a
cooperative effort led by the government, there is every reason to
believe that the end result would be a system that was technologically
obsolete before it was even completed. Given the advances in
technology, our markets can only maintain their technological lead by
constantly innovating. To the extent that one monolithic system was
created, innovation would be extinguished.
Question 16. The idea of a Central Limit Order Book (CLOB) was
first tossed around in the 1970s when fragmentation was high because
technology could not facilitate efficient order interaction without
centralization. Has current technology rendered the notion of a CLOB
obsolete?
Response: Yes. Given the tremendous advances in technology, market
participants are now able to route orders to the best market without a
CLOB performing such a function. There are many proprietary systems
available today that allow traders to determine and subsequently route
an order to the best market. In fact, many systems do this in an
automated fashion. As the level of investor sophistication has
increased, these systems will continue to proliferate and become more
efficient.
COMPETITION IN THE NEW ELECTRONIC MARKET: PART II
----------
THURSDAY, MAY 11, 2000
House of Representatives,
Committee on Commerce,
Subcommittee on Finance and Hazardous Materials,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:05 a.m., in
room 223, Rayburn House Office Building, Hon. Michael G. Oxley
(chairman) presiding.
Members present: Representatives Oxley, Greenwood, Shimkus,
Towns, Stupak, Engel, Luther, and Rush.
Staff present: Linda Dallas Rich, majority counsel; David
Cavicke, majority counsel; Brian McCullough, professional
staff, Shannon Vildostegui, professional staff; Robert Simison,
legislative clerk; and Consuela Washington, minority counsel.
Mr. Oxley. The subcommittee will come to order. The Chair
would indicate that I am instructed the House will have a
series of six votes on the floor beginning almost immediately,
and so it would be the idea to give my opening statement and if
the ranking member is here, his opening statement; and we will
recess until we can get those votes out of the way and then
return. The Chair apologizes for that inconvenience, but some
of you have been around long enough to know how things work
around here. So the Chair would recognize himself for an
opening statement.
I am pleased to convene this, our second hearing, to
examine the implications of how technology is transforming our
capital markets. Indeed, technology has completely rewritten
the rules of competition and survival in the new electronic
marketplace. As we learned at the subcommittee's last hearing
on this subject, barriers to entry are falling as knowledge,
creativity, and the Dell computer can make a couple of young
guys in a basement office a significant force in the equities
market. But not all barriers to entry have fallen, and they
remain regulatory anachronisms that stand in the way of optimum
efficiency and fairness for all participants in these new
markets.
At our last hearing, we heard from representatives of the
new ECNs who are pioneering changes and gaining a hold on the
market through the innovative use of technology. At that
hearing, we learned about some of the regulatory anachronisms
and barriers that remain such as the intermarket trading
system. I look forward to hearing today's witnesses point of
view on how ITs should be changed or replaced to address the
problems of outdated technology and inefficient and unfair
market access.
This morning we will hear from market participants who have
been around since the prehistoric times when faxes were
considered high-tech. Technology has had no less impact on
these players. Their business models are changing as we speak,
the direct result of the forces of innovation and computation.
Increased competition is translated into reduced
transaction costs, faster executions, and more choices in
trading venue for retail and institutional investors. Retail
investors can now trade on-line with e-brokers at a fraction of
the cost of the commissions they would pay a traditional full
service broker. Even the most stalwart of the traditional
brokers have followed suit offering investors the option of
trading on-line.
One thing that concerns me, however, is that investors can
be better served by not only lower commissions but better
executions of their trade. On a 1,000 share trade, one-
sixteenths of a point, which is currently the thinnest spread
available on an exchange, amounts to $166.67. That is more than
23 times the cheap $7 commission that some firms charge.
As I have said for some time now, when the markets move to
decimal pricing, investors will save bills in the form of
narrower spread. I can't emphasize enough how important it is
that the markets move expeditiously to pricing in dollars and
cents and join the rest of the world. The decimal pricing alone
will not ensure that investors get the best execution of their
trades.
We will hear from our witnesses today, and in particular
the fund companies here today that invest on behalf of
investors, about how the rules of today's markets work or don't
work to ensure that investors get the best possible price on
their trades.
Technology has also forced the reevaluation of the role and
structure of traditional exchanges. Indeed one commentator
suggested in Monday's Wall Street Journal that there is no
reason to have stock exchanges at all. James Glassman, the
author who has testified before this committee, observed that
the Internet can instantly link buyers and sellers around the
world, so why is there a need for a place for buyers and
sellers to physically get together to come to terms on shares
of stock or carloads of wheat? That anybody is even asking this
question illustrates how fundamentally the sweeping changes of
technology have affected our markets.
ECNs, best described as hybrids of exchanges in brokers,
have led the challenge to the exchange structure. Because the
linkage provided by the current SROs was, in their view,
inefficient, they connected their own order books and pools of
liquidity. In fact, last fall the ECNs links with one another
allowed continuous trading even when NASDAQ systems were
stressed by trading volume.
This linkage did not, however, address the question of how
to ensure the public is informed of the better prices for
listed stocks that might exist on ECNs. In response,
traditional exchanges are contemplating introducing their own
ECNs dissolving current linkage systems and planning
privatization. I doubt we will recognize their business models
even a year from now. These new proposals raise important
questions about the proper role of regulation by self-
regulatory organizations that compete with the entities they
regulate. I look forward to addressing some of these questions
today.
Though these changes are stunning, I believe they are just
the beginning of a complete revolution in the securities
industry. I did not call this series of hearings to contemplate
a future design for the market. That is surely not the role of
government. I am confident competition will shape the market
more liquid, transparent, and efficient than one we can
structure. However, this can only happen if we ensure that
regulations that govern our market foster competition in
response to the changing landscape of the industry.
I am pleased to welcome today's witnesses. We have an
extensive and distinguished panel of experts representing many
sectors of the marketplace including traditional brokers,
institutional investors, the first ECN, and traditional
exchanges. With all points of view represented today, I look
forward to a lively debate on how best to promote competition,
efficiency, and fairness to investors in our electronic
marketplace.
The Chair now is pleased to yield to the ranking member,
the gentleman from New York, Mr. Towns.
Mr. Towns. Thank you very much, Mr. Chairman. I also want
to thank you for holding this hearing this morning. As I have
observed at previous hearings, the securities market are
important to the State of New York and vital to the New York
City economy. Therefore, they are very, very important to me. I
really want to make that clear.
This subcommittee is front and center on the debate about
how markets are changing, how competition and efficiency can be
enhanced and how investors can benefit. We must look carefully
at all the changes which are occurring. And let me pause here
and say, Mr. Chairman, I salute you. And let the record reflect
that I remain committed to market-oriented solutions to the
changes that are taking place in the securities markets.
The hearings we are holding on these issues provide an
important platform for the industry, the regulators, and the
investing public to be heard. I particularly want to welcome
Bob McSweeney, the senior vice president of the New York Stock
Exchange this morning. Since the subcommittee's last hearing on
these issues, the Exchange has released its market structure
report. The report makes recommendations on expanded choices of
investors of the New York Stock Exchange. Building on the
existing strength of the SEC floor system, these expanded
choices will include automatic electronic execution and opening
the specialist book to on-line investors through the Internet.
The report also supports elimination of the intermarket
trading system in favor of a private sector technological
initiative. One of the most important recommendations is
improving the education of investors about order execution and
market-structure issues.
Mr. Sweeney, I look forward to your testimony this morning.
I would also like to express my concerns about the SEC concept
release on securities market data. I strongly disagree with the
idea raised by some broker dealers that investors do not have
cheap access to real-time market data. In fact, free quotes are
available on cable television and the Internet. I support the
New York Stock Exchange's decision to leave the Consolidated
Tape Association.
I believe that with careful supervision by the SEC, each
exchange can sell its own data and allow market forces to
determine who offers the best product. The SEC should not
regulate market data fees through cost base rating making
procedures like a public utility does. That method of
regulation would add new levels of bureaucracy to the SEC and
would distract the agency from more urgent investor protection
issues. So, Mr. Chairman, I look forward to hearing from all
the witnesses, and on that note I yield back.
[Additional statement submitted for the record follows:]
PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE
I commend the Chairman for holding this hearing today on
competition in our new electronic capital markets.
More than half of all Americans now have an ownership stake in our
economy through investments in the stock markets. I am optimistic that
the number of investors in our markets will continue to rise and will
allow every citizen to participate. It is no coincidence that this
trend corresponds directly to improvements in technology.
Personal computers are as powerful as the old mainframes, and
combined with the Internet investors now have real time access to
information and to the markets. The speed and efficiency offered by
these developments have increased competition and reduced trading costs
for both institutional and individual investors.
Technology has brought our markets new forms of trading, perhaps
most dramatically illustrated by the evolution of electronic
communication networks (ECNs). This and other technological
developments have led to questions about the utility and efficiency of
the existing regulatory model of our securities markets, including the
concept of a traditional exchange.
At the last hearing we heard some of the newest ECNs describe their
ability to match customer orders electronically without human
intervention. Today we will hear from the pioneer in that field,
Instinet, the broker-dealer that brought us the first ECN. We will also
hear from the traditional auction and dealer markets, as well as the
users of both newfangled and oldfangled markets--the buy side.
The National Association of Securities Dealers and the New York
Stock Exchange are contemplating changes to their business models and
regulatory structure to better compete with ECNs and foreign
competitors. I suspect some of these changes would not have been
contemplated a few years ago absent the development of the electronic
trading facilities. I am very interested to learn more about the
proposed changes and their impact on competition.
In particular, the New York Stock Exchange has suggested that the
Intermarket Trading System (ITS) may have passed its time in this age
of instantaneous execution. I congratulate them on recognizing the need
to improve outdated systems and technology, and am curious to learn how
that system might be changed or replaced to provide fairer and more
efficient markets.
Additionally, the NASD has proposed a centralized trading system. I
am concerned about possible conflicts that could arise when a Self
Regulating Organization enters into competition with the very entities
it regulates.
We are not here to decide which business model is correct.
Competition is the force that best serves investors and our markets.
But biased or outdated regulatory restrictions get in the way of that
positive force. Today we will learn what steps are necessary to ensure
that the rules of the game actually permit competition to flourish.
I welcome our witnesses today.
Mr. Oxley. I thank the gentleman and the Chair does
indicate there is a series of six votes on the floor of the
House, and so, reluctantly, we will have to stand in recess
until we return. I would hope it would be within a half-hour or
so. So enjoy yourselves. The committee stands in recess.
[Brief recess.]
Mr. Oxley. The subcommittee will reconvene. Once again the
Chair apologizes for the delay. I hope you enjoyed our
hospitality here at the Commerce Committee during our absence.
Let me introduce our distinguished panel, Mr. Douglas M. Atkin,
CEO and president of Instinet; Mr. John J. Wheeler, manager,
equity trading of American Century Investments from Kansas
City; Ms. Holly A. Stark, director of trading, Kern Capital
Management in New York; Mr. Robert J. McSweeney, senior vice
president of special committee on market structure, governance,
and ownership, New York Stock Exchange; Mr. Richard G. Ketchum,
president, National Association of Securities; Mr. Peter
Jenkins, director of equity trading, Scudder Kemper Investments
in New York; and Mr. Kenneth Kamen, president, Princeton
Securities Corporation in Princeton, New Jersey. Mr. Steven
Galbraith, senior analyst for Sanford C. Bernstein & Co. was
expected to be here, was taken ill; but I ask unanimous consent
that his statement be made part of the record. All of your
formal statements will be made part of the record.
So let us begin with Mr. Atkin, and again we appreciate
your patience with the committee. Mr. Atkin?
STATEMENTS OF DOUGLAS M. ATKIN, CEO AND PRESIDENT OF INSTINET;
JOHN J. WHEELER, MANAGER EQUITY TRADING, AMERICAN CENTURY
INVESTMENTS; HOLLY A. STARK, DIRECTOR OF TRADING, KERN CAPITAL
MANAGEMENT; ROBERT J. McSWEENEY, SENIOR VICE PRESIDENT, SPECIAL
COMMITTEE ON MARKET STRUCTURE, GOVERNANCE, AND OWNERSHIP, NEW
YORK STOCK EXCHANGE, INC.; RICHARD G. KETCHUM, PRESIDENT,
NATIONAL ASSOCIATION OF SECURITY DEALERS, INC.; PETER W.
JENKINS, DIRECTOR OF EQUITY TRADING, SCUDDER KEMPER
INVESTMENTS; AND KENNETH A. KAMEN, PRESIDENT, PRINCETON
SECURITIES CORPORATION
Mr. Atkin. Thank you, Mr. Chairman, and members of the
subcommittee. First of all, the last time that I enjoyed recess
I think was about 32 years. I was a bit disappointed we weren't
able to use the gym to shoot baskets. I hear it is for Members
only. It is a pleasure to be here. My name is Doug Atkin, and I
am president and CEO of Instinet Corporation. We are the
world's largest agency broker. We trade over 300 million shares
a day in U.S. markets. We operate in 40 markets overseas and
earned over $1 billion a year in revenues in 1999.
Only in the NASDAQ market, I think it's important to
understand, do we operate as an ECN due to the unique nature of
that market. To date, this subcommittee has heard a lot of
arguments made by market intermediaries or the middlemen who
trade against their customers' principle. We have also heard
from the NASD and New York Stock Exchange's self-regulatory
organizations currently operated as quasi-government utilities
but with firm plans to become for-profit competitors in the
near future.
I think, today, the subcommittee will hear not just from
the intermediaries but from the real parties at interest, the
investors, the people really providing capital to the markets.
After all, markets exist to serve issuers and investors, not
the middlemen. When I talk about investors, I just don't mean
Wall Street professionals. Everyone who buys and holds a mutual
fund or is involved in a State pension plan is an investor. For
over 30 years, we have allowed buyers and sellers of securities
to meet electronically and unlike dealers, we are a pure agent
meaning we don't trade for our own account. We never buy or
sell securities for our own account, and we have provided this
service to investors such as mutual funds and pension plans and
have recently expanded our service directly to retail investors
as well.
In the last year alone, according to outside studies,
Instinet has saved investors over $2 billion in transaction-
cost savings. However, just as competition is beginning to make
real inroads, the old order, as in any time of transition, is
trying to rewrite the rules of the game to preserve its
advantage. NASDAQ SuperMontage is just one example of this type
of anticompetitive behavior.
In the Internet age, rather than carry forward outdated
structures, rules, and practices, we would be far better off by
introducing competition. Some would say more competition. I
would say some competition into our markets. Currently the
NASDAQ, under NASDAQ, controls 100 percent of the trading in
its market. Those that trade NASDAQ stocks have to use its
infrastructure and publish its quotes to its market.
We believe U.S. investors are not getting what they want
and need out of the present market structure. We think what
they want is inefficient market which lowers their total
trading costs. Let me identify just two examples of what I
mean. Certainly trading in decimals would make markets easier
for investors to understand. It would also allow spreads
between buy and sell orders to narrow allowing investors to get
better prices.
We operate, as I said, in 40 markets. We operate in
decimals in 39 markets. The only market we don't is the United
States, and we don't think that that is the best market for
investors. Also, today when an investor improves the price for
its security, that is, an investor is the first one willing to
pay more than another buyer or accept less than any other
seller, their order can sit unfilled all day while others'
orders get filled at the very price that they set. I don't
believe that is the best for the market, best market for
investors either.
I think today's network technology is bringing buyers and
sellers together directly in industry after industry. The
Internet is changing the way travelers buy airline tickets, the
way car manufacturers buy auto parts, the way utilities buy
electricity. Compared to these examples, the way people buy and
sell stocks has hardly changed particularly at the market
level. In our industry, mainframe-era rules and structures
continue to protect middlemen to the detriment of investors.
Mr. Chairman, you mentioned the Wall Street Journal
article. I too found that very interesting calling into
question this very fundamental issue. For example, the self-
regulatory organizations, at present, are able to use their
regulatory authority to write rules that keep themselves and
the dealers in the middle and capture the benefits of other
people's innovations.
I would also say, though, again this isn't just an SRO
issue. It is also an SEC SRO issue. There is a lot of issues
that are intertwined between the SEC and NASDAQ for example. I
think the members of this committee have worked extremely hard
to end monopolies and introduce greater competition as in the
telecommunications industry fostering innovation and reducing
consumer costs. To achieve this result in the industry, I
believe we must dismantle the outdated rules written in the
1970's based on 1960's technology that protects the entrenched
interest.
Let me offer three examples of the kind of change I am
talking about. First we cannot allow one competitor to write
the rules for another competitor. That is like allowing the
pitcher to determine the size of the strike zone. It just is
not a level playing field. If the pitcher were able to
determine the size of the strike zone, I don't think Sammy Sosa
or Mark McGwire would have hit 50 or 60 home runs.
Mr. Oxley. Could you sum up. We are trying to stick to the
5-minute rule since we have so many on the panel.
Mr. Atkin. Certainly. The new world of competitive
opportunity created by technology is not limited to our shores.
Trading U.S. stocks overseas was not possible 25 years ago, but
it is possible today. I think European exchanges are already
offering more efficient operations than their U.S.
counterparts; and I think, to sum up, what we really need in
this country is to make sure that before NASDAQ or any other
SRO is able to build, in essence, a competing order matching
functionality or system, what we need is to allow ECNs who are
really frustrated stock exchanges to operate on a level playing
field and to be able to compete fairly or have that choice.
[The prepared statement of Douglas M. Atkin follows:]
PREPARED STATEMENT OF DOUGLAS M. ATKIN, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, INSTINET CORPORATION
I. MARKETS SERVE ISSUERS AND INVESTORS
Mr. Chairman and members of the Subcommittee, thank you for the
opportunity to appear before you today. My name is Doug Atkin and I am
the President and Chief Executive Officer of Instinet Corporation.
There is an exciting transformation now underway in the securities
markets, as new competitors to the old, established brokerage firms and
technological innovations are offering investors benefits and
advantages once reserved only for market ``insiders,'' leveling what
has long been an uneven playing field. Over the past several years, the
National Association of Securities Dealers (NASD) and the New York
Stock Exchange have faced increasingly vigorous competition from
electronic brokers like Instinet. By empowering investors to trade
directly with one another, we have brought competition to stock
trading, which ensures that investors get the best price at the lowest
transaction cost by driving down spreads.
Two months ago, this Subcommittee started hearings on the future of
the markets. To date, you have heard a lot of arguments made by market
intermediaries--the ``middlemen'' who trade against their customers as
principal, and the NASD and NYSE--self-regulatory organizations
currently operated as quasi-governmental non-profit utilities, but with
plans to become for-profit competitors in the very near future.
Today, the Subcommittee will hear not just from the intermediaries
but from the real parties at interest: the investors, the people
providing capital. After all, markets exist to serve issuers and
investors, not to serve the middlemen. And when I talk about investors,
I don't just mean Wall Street professionals. Everyone who buys and
holds a mutual fund is an investor.
For over 30 years, Instinet has allowed buyers and sellers of
securities to meet electronically. Unlike middlemen, we are a pure
agency broker--we never buy or sell securities for our own account. We
have provided this service to investors such as mutual funds and
pension funds and will very shortly expand our service directly to
retail investors as well.
Given the bull market of recent years, it may seem strange to
suggest that the U.S. stock markets are not as efficient as they should
be. But the fact is, our markets remain dominated by monopoly
competitors still using mainframe technologies. And, just as
competition is beginning to make real inroads, the old order--as in any
time of transition--is trying to rewrite the rules of the game to
preserve its advantage. Nasdaq's ``SuperMontage'' is just one example
of this type of anticompetitive behavior. In the Internet Age, rather
than carry forward outdated structures, rules and practices, we will be
far better off by introducing more competition into our markets. This
will serve investors better, as well as maintain our global
competitiveness.
II. INVESTORS ARE NOT GETTING AN EFFICIENT MARKET
Today U.S. investors are not getting what they want and need: an
efficient market. Let me identify a few examples of what I mean:
<bullet> Trading in decimals would make markets easier for investors to
understand. It also would allow the spreads between buy and
sell orders to narrow, allowing investors to get better prices.
However, because of a market structure that has a single point
of failure, we don't even know when trading in decimals will
begin. That's not the best market for investors.
<bullet> Today, trading takes place around the world 24 hours a day.
Investors demand information about prices and trades before the
traditional markets open and after they close. This information
is generally not available to investors today. That's not the
best market for investors.
<bullet> Today, when an investor improves the price for a security,
that is, is the first one willing to pay more than any other
buyer or accept less than any other seller, his order can sit
unfilled all day while others' orders get filled at the very
price he set. That's not the best market for investors.
III. REMOVE OBSTACLES TO MAKE MARKETS MORE EFFICIENT FOR INVESTORS
As Members of this Committee know well, today's network technology
is bringing buyers and sellers together directly in industry after
industry. The Internet is changing the way travelers buy airline
tickets, the way car manufacturers buy auto parts, the way utilities
buy electricity. In financial markets, futures, derivatives and bonds
are increasingly traded over electronic systems. We recently launched
Instinet Fixed Income, which will bring better performance and cost
effectiveness to trading in fixed-income securities.
Compared to these examples, the way people buy and sell stocks has
hardly changed. In our industry, mainframe-era rules and structures
continue to protect middlemen to the detriment of investors. For
example, the self-regulatory organizations are able to use their
regulatory authority to write rules that keep themselves in the middle
and capture the benefits of other people's innovations.
The members of this Committee have worked hard to end monopolies
and introduce greater competition in the telecommunications industry.
The Committee currently is reviewing monopolies and barriers to
competition in the energy market. As in telecommunications, as in
energy, we need to introduce more competition in the securities
markets, to unleash the benefits of technology, speed, efficiency and
lower costs. Our markets need to work for issuers and investors rather
than the middlemen. To achieve this, we must dismantle the outdated
rules written in the 1970's, based on 1960's technology, that protect
the entrenched interests.
Let me offer three examples of the kind of change in thinking I am
talking about.
First, we cannot allow one competitor to write the rules for
another competitor. That's like allowing the pitcher to determine the
strike zone--even Sammy Sosa or Mark McGwire would have a tough time in
that situation! And yet it is happening in our securities markets. The
New York Stock Exchange and the NASD write the rules that all
competitors must play by. And they are planning to become for-profit
competitors themselves.
When you write the rules and play in the game, you face an inherent
conflict of interest. As an example, consider the NASD's proposed
``SuperMontage.'' Today, the NASD runs a system that lets market
participants control who they send orders to. In SuperMontage, the NASD
is proposing to control who market participants send their orders to.
It would give the NASD an unfair advantage over its competitors,
ultimately harming investors.
Instinet's April 20, 2000 comment letter to the SEC on the NASD's
SuperMontage proposal is attached to this testimony in exhibit. Let me
briefly explain why SuperMontage really should be called
``SuperMonopoly'':
<bullet> It is not really voluntary. The proposal requires all markets
trading Nasdaq stocks to submit their quotes to SuperMontage.
In addition, brokers will feel tremendous pressure to use the
order execution system run by their regulator--ultimately
reducing investor choice.
<bullet> It could give investors worse prices than they get today. As
currently designed, the algorithm at the heart of SuperMontage
coupled with Nasdaq's pricing conventions would put certain
ECNs last in line to execute orders entered through Nasdaq,
even when those ECNs offer the best prices for investors. This
would inappropriately disadvantage certain market participants,
particularly those who have brought down spreads and helped
provide investors with the best price.
<bullet> It could provide investors with less information than they get
today. As James Glassman described in the Wall Street Journal
this week, ECNs already expose their entire limit order books
to their subscribers and some even to the public over the
Internet. SuperMontage displays only the three best price
levels. If SuperMontage draws order flow away from ECNs because
of its privileged regulatory status, that will be a step
backward in transparency.
To eliminate this inherent conflict, we must end the ability of one
competitor to regulate another. Regulation must be carried out by
independent, unbiased regulators. 100% separation of the Nasdaq from
the NASD and NASD Regulation should be an absolute precondition for the
privatization of the Nasdaq.
Second, we must remove outdated and biased trading rules that serve
the middlemen rather than investors. Current rules allow unfair trading
practices such as ``internalization.'' Internalization allows middlemen
to profit from the difference between their customers' buy orders and
sell orders, without ever exposing those orders to the market. This
reduces competition, which in turn produces worse prices for investors.
Not only that, the order placed by an investor who first sets the best
price can go unfilled. One possible solution to internalization is to
prevent any intermediary from trading against its customers as
principal unless it improves the best available price in the market.
Finally, we must promote fair competition. Competition breeds
innovation, and innovation benefits investors. This Committee wrote the
law requiring the Baby Bell phone companies to allow competition for
local service before they can offer long distance service. If not for
this requirement, the Baby Bells would be using their monopoly revenues
from local service to subsidize their long distance business. As
Congress realized, monopoly subsidies are unfair, inefficient and
stifle innovation. The current monopoly on revenues from market data
illustrates these risks.
Today, the rules allow the self-regulatory organizations to engage
in exactly this type of unfair and inefficient behavior. For example,
all brokers must report their market data to their SROs. The SROs then
enjoy exclusive rights to revenues from the sale of that data. They
earn monopoly revenues in this area and can use it to subsidize other
areas of business--including efforts to compete with their own members.
The solution to this problem is to allow innovators to keep the
benefits of their innovations. To continue the example I gave, Instinet
and other market participants already use their data as important parts
of their business strategy. The monopolies should not be able to
dictate the terms on which their competitors may use their data.
IV. CONCLUSION
The new world of competitive opportunity created by technology is
not limited to our shores. Trading U.S. stocks overseas was not
possible 25 years ago, but it is possible today. European exchanges are
already more efficient than their U.S. counterparts. They have been
free to trade one another's shares without having first to get approval
from their competitors. For example, the London Stock Exchange set up
the electronic SEAQ International to trade French, German and Swiss
stocks. SEAQ International captured a significant share of trading from
the traditional exchanges. This competition forced European exchanges
to respond by adopting more efficient electronic systems, benefiting
issuers and investors across Europe. If SEAQ International had been
required to go to the European exchanges for permission to trade their
stocks, or forced to operate through their systems--as the ECNs must
today with the NYSE and Nasdaq--the European exchanges likely never
would have innovated. The recently-announced merger of the London Stock
Exchange and the Deutsche Boerse will create an efficient all-
electronic stock market that rivals U.S. markets in size.
By contrast, in the United States competition to the Nasdaq for
trading Nasdaq stocks is limited. ECNs essentially are frustrated
exchanges that are not able to compete with the Nasdaq on an equal
footing. Even those ECNs that have applied to become exchanges have not
been able to. This is even more important, now that the Nasdaq is
becoming a for-profit competitor and is proposing to use its regulatory
authority to hobble its competitors before competition even begins.
If the U.S. markets do not become more efficient, securities
trading could easily move overseas. I have argued for a change in
thinking, to allow more competition in securities trading. This will be
good for issuers, good for investors, and will maintain the
international competitiveness of the U.S. markets. If we build a market
that best serves investors, we can continue to control our destiny. If
we try to erect barriers around an inefficient market, we will harm
investors and lose control to others.
Mr. Oxley. Thank you.
Mr. Wheeler?
STATEMENT OF JOHN J. WHEELER
Mr. Wheeler. Thank you. Chairman Oxley, distinguished
representatives of the subcommittee, my name is John Wheeler;
and it is an honor to be here today representing 2 million
shareholders at American Century Investors with over $110
billion in assets. I am the manager of the domestic trading
operation at American Century. I have been with the firm for
over 9 years; and previous to that time, I spent 5 years in the
over-the-counter marketplace as a market maker.
[Slide.]
I would like to start this morning with a little bit of
historical perspective. This slide represents a survey taken at
Trader Forum, a buyside organization, done over 5 years ago. If
you focus in on the three qualities of a marketplace that the
institutional investors said that they wanted exchanges to
adopt, three responses garnered more than 90 percent positive
votes. That would be order anonymity, full but anonymous
disclosure of supply and demand schedules, basically a depth of
book argument, and integration of price discovery, execution
and transaction reporting.
Second, a little bit of historical perspective on what we
have done at American Century. We started doing business with
Mr. Atkin's firm, Instinet, over 10 years ago; and as you can
see by the blue line represented here, our average commission
rate paid by our mutual fund shareholders has dropped
precipitously over the last 10 years from a rate above 6 cents
a share to most recently below 3 cents a share on average. If
you look at the bottom line, electronic brokers that we do
business with at American Century, rates have dropped on a very
dramatic percentage basis from over 3 cents a share to right
now at a penny a share on average for our electronic brokers.
There has been a lot of talk recently about fragmentation.
It is our view at American Century that ECNs like Instinet,
Archipelago, Bloomberg's B-Trade product do not fragment
markets. They have invested a lot of money in technology into
integrating linkages between markets. We believe that ECNs link
markets to the benefit of our investors.
Last year, one out of three NASDAQ trades were made by
wholesalers who were free riding on ECN quotes in our view.
There is currently not an incentive in NASDAQ nor at the New
York Stock Exchange for an investor, small or large, to
disclose a trading interest to the rest of the remaining
investing public. There is, in fact, an incentive to withhold
quotes and withhold orders, withhold limit orders from the
public because they are preyed upon by the intermediaries of
those market plays in today's world.
Internalization runs rampant at the New York stock exchange
and regional exchanges, as well as NASDAQ currently. Large
block trading houses internalize order flow. Retail firms pay
for order flow and internalize that order flow at great, great
profit to their particular firms at the expense of investors
large and small. We view this as a very serious problem.
Preferencing arrangements between competing intermediaries,
we should be competing with each other again is a very big
concern at American Century. As documentation of a previous
point, this is a snapshot of four stocks, Friday January 8,
1999. Just to take a brief look at how those stocks are quoted
within NASDAQ, who is driving the inside market? Who is telling
the world their best bid? Who is displaying to the world the
best offer and price? You can see it is predominantly the ECNs
alone at the inside marketplace and those four stocks. If you
look at the next column, market makers alone at the inside, on
average about a quarter of the time with ECNs half the time or
more.
Mr. Oxley. Before you switch that, I am not quite sure I
follow that.
Mr. Wheeler. Percentage of time throughout the trading day
that the inside quote was only in an ECN as the best bid or
only in an ECN as the best offering, in other words,
Archipelago, Instinet, e-trade driving the inside market not
NASDAQ market makers not NASDAQ member firms. Predominantly it
is the ECNs that are driving the inside market because NASDAQ
dealers have the ability to free ride off of the quotes of
limit orders that are inputted by the investing public.
Mr. Oxley. Thank you.
Mr. Wheeler. At the expense of going over and not being
able to complete the rest of my testimony, I want to spend a
little bit of time on this particular slide. This I just
prepared last week. This is a snapshot of our over-the-counter
trading at American Century for the last 12 months of data. I
compared our trading on two ECNs, our two largest ECNs,
Archipelago and B-Trade, and I compared that to our over-the-
counter trading at the infamous MGM, Morgan Stanley, Goldman
Sachs, and Merrill Lynch.
Mr. Chairman, actually you touched earlier on the
difference between explicit commission rates and the true cost
of execution. I think this slide graphically illustrates that
point. Our average trading costs with those three Wall Street
firms average 286 basis points of round trip overall cost to
our shareholders and would be commission costs, the explicit
commission costs plus the market impact costs through linkages
of information et cetera, et cetera. Compared to the cost
incurred by Archipelago and B-Trade of just 98 basis points. We
saved our shareholders over $220 million in marketing impact
costs by executing over $11 billion in transactions on these
two ECNs last year alone.
I would like to touch on decimals, if time allows. Where
are decimals right now? The marketplace has been calling for
them for years. Regulators have been calling for decimals for
years. Trades are occurring on ECNs and in our marketplaces at
\1/256\ths of a point currently, and we currently restrict our
investing public to display their limit orders in fractions of
a \1/16\th of a point. It is very discouraging for us to see
that the day traders and professional traders all day long can
quote stocks in \1/256\ and gain standing a step ahead of
customers' limit orders or \1/256\th of a point when we tell
the investing public that they must abide by \1/16\ths.
Last, ACIM thinking about our markets, investors have long
been ignored by traditional intermediaries. The biggest point
we would like to drive home is that ECNs force brokers and
exchanges to compete by meeting those needs that investors ask
for. New technology platforms give investors anonymity, full
disclosure of supply and demand schedules and integration of
price discovery, execution, and transaction reporting, features
long requested by mutual fund investors.
Competition from cost-efficient ECNs has lowered our
commission rates and will save our shareholders $35 million in
explicit commission costs this year alone. When you look at
overall market impact costs, we are looking at a number
approaching $500 million this year alone saved at American
Century through cost-efficient ECNs.
[The prepared statement of John J. Wheeler follows:]
PREPARED STATEMENT OF JOHN J. WHEELER, MANAGER OF EQUITY TRADING,
AMERICAN CENTURY INVESTMENT MANAGEMENT
Chairman Oxley, Rep. Markey and other distinguished members of the
Subcommittee, thank you for the opportunity to share my vision for the
securities markets and the regulatory environment needed to accommodate
that vision. I am John J. Wheeler, and as an active voice for two
million investors entrusting more than $100 billion to American Century
mutual funds and retirement programs, I'm excited to participate in
this dialogue. For too long, the voices at hearings like this have
represented the deep pockets and economic interests of entrenched
financial intermediaries--and not the direct voice of investors who
daily face the arcane, archaic and anti-competitive rules of member-
owned exchanges.
As Manager of the domestic trading desk at American Century
Investment Management (ACIM), now recognized as one of the earliest and
most aggressive users of electronic trading technologies, I oversee a
staff of ten traders responsible for executing equity trades for our
forty equity mutual funds. I was a Market Maker of NASDAQ traded OTC
stocks for five years before joining ACIM as a Senior Trader in 1991.
During my tenure at ACIM, I have served as a member of the New York
Stock Exchange's Institutional Traders Advisory Committee (ITAC) and
various NASDAQ committees as well. My immersion into the complexity of
the ``rules of engagement'' at both the NYSE and NASDAQ has been both
educational and troubling.
I serve on these committees because the method and costs for
securities trading directly affect investment performance for our
investors, whose portfolios reflect prices after trading costs are
paid. Both large and small investors suffer equally and proportionately
when there are marketplace inefficiencies and inequalities.
Investor Benefits from Emerging Trading Technologies
Our 1992 response to the Securities and Exchange Commission's
Market 2000 Concept Release was one of only four filed by investor
constituents. The issues in that release are eerily similar to those
contained in the Commissions' recent request for comment on market
fragmentation. In the early 90's study, opponents to newly emerging and
efficient technology platforms spawned language that asked whether such
systems threatened ``fragmentation,'' ``segmentation,'' and
``balkanization'' of the nation's securities markets. I remain
convinced now, as I was then, that such language reflects the howls
from entrenched exchanges and brokers who have been insulated from
competition by rules that masquerade as investor-friendly safeguards.
Our data indicates that ACIM's overall trading costs, including
commissions and market impact have fallen steadily and progressively
throughout the 1990s. (see exhibit 4) The enactment of the Order
Handling Rules in mid-1997 generated significant additional savings. We
can attribute virtually all of the cost savings--which go right into
our investor's pockets--to the use of ECN's and other electronic
trading technologies. The data suggests that new ways to trade have
saved our investors as much as $110 million each year for the past 10
years as compared to our costs for traditional brokerage services. (see
exhibits 3) In the last year alone, our traders' use of more efficient
platforms have saved our investors more than $500 million
<SUP>1</SUP>--the size of a pretty good-sized mutual fund.
Consequently, our traders rely on alternative trading systems for about
40% of the dollars traded by ACIM on behalf of investors.
---------------------------------------------------------------------------
\1\ Extrapolation of most recent 6-month OTC trading costs at
Goldman Sachs as compared to Archipelago
---------------------------------------------------------------------------
The efficiency of such systems appears to extend only to NASDAQ-
registered securities. The NYSE somehow escapes obligations under the
Order Handling Rules and continues to refuse direct electronic access
by investors to the specialist order book. That would appear to
contravene the spirit of the 1975 amendment to the Exchange Act that
calls for markets to provide buyers and sellers an opportunity to
discover prices ``without the intermediation of a dealer.''
Internalization and Payment for Order Flow
While we do not perceive a ``fragmentation'' threat from the
emergence of new automated transaction systems since they match, cross
and route orders automatically, we are nonetheless troubled by the
``fragmentation'' foisted upon the market by dealer intermediaries who
either internalize or pay for order flow. Many wholesale broker dealers
and exchange markets engaged in internalization practices rely on the
national market's disclosure of visible, limit orders to price and
trade market orders generated by captive constituencies. Investors who
display the desire to trade by using limit orders instead subsidize
internalization practices. Ultimately, I expect to see internalization
practices constrict the number and size of limit orders in the
marketplace with a likely increase in volatility. Internalization and
payment for order flow threaten transparency of trading processes. For
instance, brokers now regularly receive so-called ``VWAP'' orders for
specific securities--sometimes hundreds of thousands of shares--on both
sides of the market.<SUP>2</SUP> Potentially millions of shares are now
internalized at the VWAP price, without ever participating in the
market's price discovery processes and without any semblance of order
interaction with other investor orders. Many of these orders are now
``book entered'' overseas by U.S. brokers.
---------------------------------------------------------------------------
\2\ Many trading consultants now evaluate the efficacy of trading
by measuring how closely trades approximate the day's volume weighted
average price for all trades in a given stock.
---------------------------------------------------------------------------
Major wholesale market-making firms, whose business models rely on
payment for order flow, were engaged in about one-third of all trades
in NASDAQ securities last year (see exhibit 5) and have seen increasing
market share gains as more and more retail investors trade individual
stocks. At the same time, market makers often are represented in the
market as the ``best'' buying or selling price only 25% of the time in
many high profile, actively traded stocks while ECNs typically
represent the market's best price more than 50% of the
time.<SUP>3</SUP> (see exhibit 6)
---------------------------------------------------------------------------
\3\ Source: NASDAQ Stock Market data
---------------------------------------------------------------------------
Internalization practices prove anti-competitive in a host of
trading venues--and the traditional exchange markets retain ``members-
only'' benefits, marketing agreements and other ``practices'' that
erode our confidence in trading on even the most well branded
exchanges.
Internalization at the NYSE
The NYSE suggests that fragmentation caused by internalization
might be mitigated by a market-wide price improvement rule. In other
words, orders could only be internalized by dealers who pay a price
``better'' than the national market's best prices for both buys and
sells. In principal, we believe that this simple change in intermarket
rules would be favorable for investors. At the same time, we can't
understand how the NYSE might impose that rule on other exchanges or
dealers when much of the physical, floor-based model of that exchange
depends on layers of such internalizing rules:
<bullet> Price and time priority exists in only one place at the NYSE--
on the specialist's book. If one customer sends a buy order to
the exchange and a second customer sends an additional buy
order to the floor at the same price, the first customer's
order must be filled before the second customer's receives
attention. This would appear to be a fundamentally fair
outcome. However, third and fourth in-line buyers could place
an order with member firms represented in the floor ``crowd''
and they are granted the right to share pro-rata in every trade
at the first customer's price. The second customer must wait
patiently. Where is the notion of price improvement in this
circumstance?
<bullet> The ``clean cross'' rule allows member brokers to
``internalize'' blocks of 25,000 shares or more at the same
price as smaller, pre-existing orders on the specialist book
without satisfying those orders that established the price of
the trade. How is this functionally different than the
practices employed by wholesale dealer firms who only match
prices set in other markets when they pay for order flow? How
does the small investor benefit by posting limit orders if they
are afforded no protection when a ``clean cross'' occurs at
their price?
<bullet> ``Participate'' orders are instructions given to floor brokers
(and even specialists) on the NYSE floor that ask them to
passively ``go along'' with other trades until an order is
complete. The rules of the NYSE give these orders standing in
the markets even though they do not contribute to price
formation. No information is transmitted about these trades
because they can only occur when someone else commits to make a
trade at mutually agreeable prices. How does one ever ``price
improve'' a participate order at the NYSE?
<bullet> ``Freezing the book'' is a little understood specialist
practice used to manage the trading process. If an electronic
order arrives to buy a stock at the offered price on the book,
the specialist may ``freeze'' the book to enable the floor
crowd to make the trade at that price. After the trade is
completed, he then ``unfreezes'' the book to allow the new
electronic order to take its place in queue. Discussions with
exchange officials suggest that this is a ``practice'' rather
than a rule-enabled function of the specialist.
<bullet> The NYSE has resisted institutional calls for years to show
more than the market's best bid and offer--to create a supply
and demand schedule for the market. The NYSE has created rules
that actively discourage the use of technology to trade there.
Simply put, if you want equal (or advantageous) standing on the
NYSE, you are required to hire a NYSE floor broker. There is no
alternative choice.
Competition and the NYSE
At the New York Stock Exchange, our orders cannot be traded without
the intervention of a dealer--the specialist. Not much data exists
about the profitability of specialist operations but the recent
prospectus offering by LaBranche, the second or third largest NYSE
specialist firm, provided a glimpse at the following:
<bullet> LaBranche consistently earns more than 75% of profits from
dealer trading activity;
<bullet> That specialist unit has been profitable every quarter for 22
years; that would include the market's record single day drop
in 1987, the major bear markets in 1980 and 1982, and other
periods of market ``distress.''
<bullet> The company averages consistent returns on capital and equity
of more than 70%;
<bullet> The company posts consistent profit margins of about 70%;
How do they earn such economic rents? I would suggest that the
designation of the NYSE as the ``primary'' market on which all other
pricing should be based has established the NYSE as the principal
``operating system'' for the market. That status has been conferred
upon member-owned exchanges by the Congress and by SEC regulatory
interpretations over time.
It strikes me that an analogous situation might be the
establishment by Congress of Microsoft as the official operating
standard for the computer. Obviously Microsoft was the first to
discover the true power of a standard operating system for the desktop
computer. Recent events here and in the courts would suggest that
Microsoft also discovered that bundling increasing numbers and kinds of
software applications into the operating system pleased consumers--but
displeased those who believe that competition spurs innovation.
The NYSE sits as the sole arbiter on a number of shared exchange
operating committees like the Intermarket Trading System--the effective
operating system for the nation's exchanges. The use of veto power in a
number of these venues successfully stymies efforts to stimulate
interconnectivity of markets. And the NYSE has, over the years,
incorporated innovations begun at regional markets only after a concept
is proven and is considered a potential threat to the established
hierarchy of exchanges.
Innovation by Regional Exchanges
The recent launch of the OptiMark trading utility of the Pacific
Stock Exchange (PSE) provides needed insight into the anti-competitive
practices at both the primary and regional exchange
markets.<SUP>4</SUP> OptiMark's system relied on effective linkages
between markets--as promised by the Intermarket Trading System (ITS).
The historical record reflects that the SEC was forced to broker a
compromise between competing parties on the ITS operating committee
after principals exhausted more than a year in fruitless, back room
debate on how OptiMark could or should be linked to the NYSE market.
That process helped draw down a new competitor's intellectual and
economic resources required to compete effectively. The final solution
reflected the economic staying power of NYSE monopoly position rather
than a rational attempt to further the goals of a National Market
System.
---------------------------------------------------------------------------
\4\ American Century Companies (ACC), along with a number of major
Wall Street firms, owns a small equity position in the OptiMark auction
utility.
---------------------------------------------------------------------------
Shortly after effective launch of the new system, the NYSE
effectively shut down ITS access to the OptiMark utility--based on
arbitrary volume limitations. As an early user of the utility, our
company documented numerous failures by NYSE specialists to abide by
conventions of the ITS agreement and filed that report with both the
Commission and exchange officials. In several documented cases, we were
unable to execute orders sent from the Pacific Exchange to New York
that were subsequently and immediately executed when sent through the
NYSE proprietary Super DOT, order delivery system.
Our experience with the OptiMark utility also produced an eye-
opening understanding of the marketing arrangements of regional
exchanges that subvert competitive quote-making among exchanges. ACIM
recognized early that the Pacific Stock Exchange (PSE), in combination
with the OptiMark utility, might provide an effective mechanism to
generate competing quotes with the NYSE. We asked ECNs with whom we do
business to build an order display link to the PSE such as that already
in existence at the NYSE.<SUP>5</SUP> American Century traders
subsequently sent orders to the PSE that ``improved'' the NYSE best
bids and offers. Those orders were intended to serve as an
advertisement on the Consolidated Quote System of potentially larger
block trading opportunities available through the OptiMark utility.
Instead, we found that PSE specialists almost immediately sent these
``price improving'' limit orders across ITS from the West Coast to the
NYSE specialists' books.
---------------------------------------------------------------------------
\5\ Archipelago Holdings, LLC built such a linkage to the PSE which
allowed us to send large orders to that market for posting by the
specialist there. ACC subsequently purchased a small and indirect
economic interest in Archipelago through JP Morgan Capital.
---------------------------------------------------------------------------
In trying to provide price competition, we discovered that PSE
specialists have marketing obligations to a number of broker-dealers
who internalize order flow. To protect those firms' ability to
internalize customer orders, the specialist offers ``primary market
protection'' on the regional floors. That protection essentially
promises ``internalizing'' firms that if stocks trade at the retail
order's price on the ``primary'' exchange, the PSE specialist would use
his capital to execute the order at that price on the regional
exchange. There were three problems with the new competing orders that
we were sending for display to the PSE. One, the large size of the
orders on the PSE book meant that small retail orders, previously
internalized, had to wait in queue until the larger block traded. When
ACIM offered to forego ``primary market protection,'' the specialists
requested that we also allow small retail orders to be traded in front
of the large order, even if they arrived at a later time. The PSE could
not excuse one firm from that ``marketing arrangement'' without
compromising the entire business model of the exchange. Two, the large
size of the orders provided an unacceptable risk to undercapitalized
specialists who did not wish to ``protect'' our orders against trades
in other markets. And three, it narrowed the spread that could be
internalized by PSE firms that sent listed orders to that venue for
trading--thereby cutting the profitability of that practice.
This, to us, is prima facie evidence that regional exchanges--under
current rules--provide neither competitive quoting nor innovation. We
are inspired by the recent announcement that the PSE and Archipelago
will attempt to create a truly competitive and automated stock
exchange. We can only hope that promises of price/time priority and
electronic and non-dealer intermediated access to the PSE will not be
perpetually stalled by entrenched and dominant exchanges, operating
committees and member firms--all wrapped in concerns about investor
protection.
Regulatory Requirements
The SEC has long sought to respond to the language of the 1975
Amendment to the Exchange Act and its call for markets that:
<bullet> maximize the opportunity for investors' orders to interact in
an agency auction and;
<bullet> for buyers and sellers to execute without the intervention of
a dealer.
A recent survey of more than 40 traders of major institutions
showed strong consensus that ``ideal market'' attributes would include:
<bullet> Anonymity of orders entered within a system;
<bullet> Time priority of orders entered at a price;
<bullet> Full, but anonymous, disclosure of the supply and demand
schedule;
<bullet> Integration of price discovery, execution and transaction
reporting.<SUP>6</SUP>
---------------------------------------------------------------------------
\6\ Economides and Schwartz, ``Assessing Asset Managers' Demand for
Immediacy: Equity Trading Practices and Market Structure''
substantiates the institutional traders' desire for such rules of
engagement.
---------------------------------------------------------------------------
We support the call for markets with transparency and ``quote''
competition. The current state of affairs in the NASDAQ market, with
wholesale market makers and even at the NYSE fails to meet the minimum
standards that the buyside requires to best protect investor interests.
(see exhibit 2) The explosive growth of ECNs in the U.S. marketplace
and across Europe validates such surveys of investor preference. If
ECNs were allowed to compete directly with the NYSE, we think sizeable
economic benefits would accrue to investors.
For years, ACIM has advocated a strict price and time priority
intermarket linkage. We continue to believe that the best market for
investors would foster maximum order interaction and transparency. At
the same time, recent experience with the ITS trading system, the rules
of trading at the NYSE and the structural problems related to ECNs and
mandated SelectNet linkages suggests that the SEC focus first on order
disclosure, priority and interaction rules within individual markets.
How Can We Get There?
The explosive growth of the Internet in part provides the solutions
to these vexing issues. Electronic, non-intermediated auctions on-line
are drawing huge resources and attention from buyers and sellers of
Beanie Babies, airline tickets and auto parts. Ford, Chrysler and GM
seek such a venue to reduce supplier costs. Why do member firms of the
major exchanges resist the major virtues that their own securities
analysts extol as ``beneficial'' to the economy in enterprises outside
of securities trading?
We believe that the Commission should regulate the form of
individual markets and refrain from regulating the technology that
might be used to integrate markets. Already, eight ECNs are building a
virtual private network to link order books and dispersed pools of
liquidity. These robust networks tie together systems that already
incorporate the four major tenets of the buyside investor's ``ideal
market'' without creating a single point of technology failure--a
virtual limit order book. The systems recognize that the ``market'' no
longer is limited by access to the physical trading floor on Wall
Street.<SUP>7</SUP>
---------------------------------------------------------------------------
\7\ See Domowitz and Steil, ``Automation, Trading Costs and the
Structure of the Securities Industry
---------------------------------------------------------------------------
The government's time is misspent trying to regulate the technology
capacity of markets. If competitively-limiting linkages like ITS were
simply eliminated, one must consider whether the market would not
quickly establish network linkages as a direct response to customer
demand. These linkages would recognize and penalize inefficient
systems--like those currently operated by the NASDAQ stock market--
where legacy systems impede the delivery and reliability of trading
information.
Insight into the regulator's role over tariff setting within the
securities markets can also be gained from the implementation of the
Order Handling Rules. The sudden mixing of dealer systems (where all
customer charges are implicit) and of agency auction systems (ECNs who
explicitly charge for access) squarely placed the Commission in the
role as a rate-setter. Dealers argued they should not have to pay for
access to ECNs because dealer-to-dealer trade in NASDAQ is ``free.''
However, dealer trading is free only if dealers have zero profitability
in the business model. Rather, dealer trading imputes hidden tariffs.
As an investor, I would rather see charges assessed explicitly. Why
should the SEC sit as judge as to what constitutes reasonable charges?
One could argue that competing venues should be able to charge
whatever fee for access to a proprietary pool of liquidity would be
economically competitive. That would imply that linkages could not be
forced upon centers but that such centers must be compelled to accept
orders from other markets or exchanges. I would expect that technology
integrators would quickly create algorithms allowing me to choose a
trading venue based on price, time and cost of access metrics. If one
market's cost of access were too high or the system's response too
slow, I would expect liquidity to migrate to the most dependable,
lowest cost, and most secure venue.
The Role of Decimals
The markets currently are digging their heels in on the issue of
decimal trading increments. We remain the only market in the world that
continues to rely on centuries old pricing conventions--pieces of
eight. At the NYSE, an immediate move to decimals combined with price
time priority, would create significant competitive pressure on payment
for order flow and internalization business models that rely on ``fixed
price spreads'' to support the economics of the business. Within
NASDAQ, we are deeply concerned about the ongoing practice of
disseminating public quotes and customer limit orders in 16's while
professional investors can post limit orders in increments as fine as
256's. If Mr. Daytrader can have limit order protection for one 256,
shouldn't we allow Mr. Smith to buy the same protection for one penny?
We would argue that a move to decimals would simplify NASDAQ and once
again unify quotes, trades and trade reports at the same increment
while lowering trading costs for all investors. (see exhibit 8)
Summary and Conclusions
We believe that true competition among markets and among quotes may
be harmed by mandated linkages--without the complete reform of anti-
competitive structures like ITS and the elimination of order
internalization practices by dealers, brokers and exchanges.
We believe that a ``hard CLOB'' or central limit order book which
consolidates all orders in disparate venues is undesirable and would be
subject to a single point of technology failure. That said, we
encourage the virtual development of a market that guarantees
investors:
<bullet> Anonymity of orders entered within a system;
<bullet> Time priority of orders entered at a price;
<bullet> Full, but anonymous, disclosure of the supply and demand
schedule;
<bullet> Integration of price discovery, execution and transaction
reporting.
We believe that price and time priority structures within markets
and an intermarket ``price improvement'' feature would be beneficial to
investors. That rule would allow internalization of market orders only
at prices better than those quoted among competing market centers--even
a penny of price improvement changes the economics of the payment for
order flow business.
We believe that truly competing markets and exchanges should be
required to accept non-intermediated, electronic orders from other
exchanges or markets; furthermore each market center should be free to
establish the cost for access to that market.
True competition often creates fear and uncertainty. We must not
fear such competition in the structure of the capital markets. Thank
you for the opportunity to share my thinking with this subcommittee.
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Mr. Oxley. Thank you.
Ms. Stark.
STATEMENT OF HOLLY A. STARK
Ms. Stark. Chairman Oxley, I would like to thank you and
the other distinguished members of the subcommittee for
allowing me the opportunity to share my views on the evolving
structure of the U.S. equities markets.
My name is Holly Stark, and I serve as the director of
trading for Kern Capital Management, LLC, a privately held
investment advisor in New York, managing in excess of $2
billion. Our specialty is small and microcap growth investing.
We act as subadvisor for a number of mutual funds as well as
manage assets for a roster of clients ranging from ERISA plans
to college endowments.
I would like to talk a little bit about fragmentation,
internalization, and transparency. Fragmentation has emerged
recently as a major issue in the equities markets with the SEC
publishing a concept release soliciting the views of market
participants on the subject. Fragmentation occurs when orders
trade in multiple market venues without interaction with each
other. Some have argued that fragmentation has increased with
the emergence of multiple ECNs, as an investor must search out
many market places including those of ECNs where a stock might
trade to determine the best price and access sufficient
liquidity to complete the trade.
In a fast-moving volatile market, this exercise becomes
extremely difficult, and the difficulty increases with the size
of the trade. However, functionality has been introduced by a
number of ECNs to permit a trader to access orders across
multiple venues so that those fragmented bids or offers are
readily available to execute against. What these tools do not
offer is the ability to access orders that are internalized by
broker dealers.
Internalization occurs when broker dealers do not expose
their orders to the marketplace. They are able to buy on the
prevailing bid or sell on the offer capturing the posted spread
while never accessing or interacting with limit orders
displayed in the marketplace. The investor who has posted the
limit order has in effect set a price for other investors to
trade at, though he himself will not participate in any volume
that trades at his displayed price. The limit order investor
may even have set a new bid or offer when entering his order,
but internalization practices preclude him from receiving an
execution. The stock will, in effect, trade around him; and he
may never fill his order at his publicly displayed price.
Have the investors whose orders are internalized received
best execution? Has the limit order investor been treated
equitably? Such practices more so than the existence of
multiple ECNs reduce market efficiency and serve to fragment
the market. If an investor is hesitant to display a limit order
for fear that his order may never be executed, market
transparency, depth and liquidity may well be compromised.
Certainly broker dealers are not required to display market
orders. They must execute the order at the best available price
in the market. With the adoption of the display rule by the SEC
in 1996, broker dealers and market makers are required
immediately upon receipt of a customer's qualified limit order
to display the order in their quote if it improves the price or
adds to the size of their quote. If the order is not displayed,
it must be executed or routed to other market centers for
display or execution.
But on May 4, 2000, the SEC released a report describing
violations by both market makers and specialists in their
handling of customer limit orders. The violations included
failure to display proper order size and failure to display
orders within 30 seconds after receipt. Surprisingly, the
report concluded that the SROs' surveillance and enforcement of
limit order handling was not up to par. Without required limit
or display, limit order buyers and sellers might be dissuaded
from placing such orders, compromising market transparently and
ultimately liquidity.
An investor who publicly displays limit order is not
guaranteed an execution even if a stock trades at his price
because provisions for price and time priority across markets
do not exist. In NASDAQ, the first dealer displaying the best
bid offer has no priority over other dealers displaying the
best bid or offer--the same bid or offer. On the New York Stock
Exchange, orders on the specialist book do receive price and
time priority status, but floor brokers may participate in
executions that would satisfy orders on the book, in effect
jumping the cue that is on the specialist book.
The floor brokers standing in the crowd do not have to
publicly display to the greater market place their trading
intention. They can merely go along with other participants and
benefit from the price discovered by limit order investors.
Because of such actions, some have called for the creation of a
central limit order book, or CLOB, that would consolidate all
orders in one trading venue with strict time and price
priority. Launching a national CLOB would be problematic. Who
would create it and maintain it? Who would pay for it? Who
would regulate it? If all market participants were required to
participate, would reliance on a single point of entry risk
market failure should that point of entry be disabled? Would
the fostering of innovation in market structure be compromised?
Instead, a more workable solution would be to encourage
intermarket linkages that provide for strict price and time
priority and preclude any one market center or participant from
controlling the linkages.
Technology would allow for the creation of a virtual limit
order book that could satisfy the need for price/time priority
across markets without relying upon a single entity to
establish and maintain the linkage.
I would like to make one comment about decimals. U.S.
markets have the dubious distinction of being the only markets
in the world that still trade in fractions. Decimals are far
easier to comprehend. Decimals are already the preferred means
of operating on many institutional trading desks. Prices
reported in fractions are immediately converted into decimals
when executions are entered into order management systems.
Realtime prices flow from quote vendors into order blotters in
decimals. Stocks are cleared in decimals and the trades are
cleared in decimals. While it is critical that all market
systems are able to handle anticipated increase message and
quote traffic, every reasonable effort should be made to move
ahead on decimal pricing sooner rather than later.
Thank you.
[The prepared statement of Holly A. Stark follows:]
PREPARED STATEMENT OF HOLLY A. STARK, DIRECTOR OF TRADING, KERN CAPITAL
MANAGEMENT, LLC
I would like to thank Chairman Oxley and the other distinguished
members of the Subcommittee for allowing me the opportunity to share my
views on the evolving structure of the US equities markets. My name is
Holly Stark, and I serve as the Director of Trading for Kern Capital
Management LLC, a position I have held since the end of February. Kern
Capital is a privately held investment advisor in New York managing in
excess of $2 billion. Our specialty is small and micro cap growth
investing. We act as sub-advisor for a number of mutual funds as well
as manage assets for a roster of clients ranging from ERISA plans to
college endowments. My trading experience spans 18 years, and I have
served on advisory committees at the New York Stock Exchange, the
American Stock Exchange, and Nasdaq. I currently serve on Nasdaq's
Quality of Markets Committee and the Investment Company Institute's
Equity Advisory Task Force.
The US equities markets have changed dramatically during my tenure
as a trader, with many positive changes taking place in the last few
years. However, as I have become more familiar with the intricacies of
market structure and the sometimes-arcane rules that govern our
markets, I strongly believe that more change is necessary, especially
if we are to maintain our global preeminence versus other world
equities markets. While some may consider the changes to be seismic,
others view it as evolutionary. Whatever the characterization, the
impact of technology, competition, and new rules that govern our
markets will result in profound changes that will result in meaningful
reform.
Market Fragmentation, Internalization and Transparency
Fragmentation has emerged recently as a major issue in the equities
markets, with the SEC publishing a concept release <SUP>1</SUP>
soliciting the views of market participants on the subject.
Fragmentation occurs when orders trade in multiple market venues
without interacting with each other. Some have argued that
fragmentation has increased with the emergence of multiple ECN's, as an
investor must search out many marketplaces, including those of ECN's,
where a stock might trade to determine the best price and access
sufficient liquidity to complete the trade. In a fast-moving, volatile
market, this exercise becomes extremely difficult, and the difficulty
increases with the size of the trade. However, functionality has been
introduced by a number of ECN's to permit a trader to access orders
across multiple venues, so that those ``fragmented'' bids or offers are
readily available to execute against. What these tools do not offer is
the ability to access orders that are internalized by broker-dealers.
---------------------------------------------------------------------------
\1\ Securities Exchange Act Release No. 42450 (February 23, 2000)
65 FR 10577 (February 28, 2000) (``Concept Release'')
---------------------------------------------------------------------------
Internalization occurs when broker-dealers do not expose their
orders to the marketplace. They are able to buy on the prevailing bid
and sell on the offer, capturing the posted spread, while never
accessing or interacting with limit orders displayed in the
marketplace. The investor who has posted the limit order has in effect
set a price for other investors to trade at, though he himself will not
participate in any volume that trades at his displayed price. The limit
order investor may even have set a new bid or offer when entering his
order, but internalization practices preclude him from receiving an
execution--the stock will ``trade around'' him, and he may never fill
his order at his publicly displayed price. Have the investors whose
orders are internalized received best execution? Has the limit order
investor been treated equitably? Such practices, more so than the
existence of multiple ECN's, reduce market efficiency and serve to
fragment the market. If an investor is hesitant to display a limit
order for fear that his order may never be executed, market
transparency, depth and liquidity may well be compromised.
Certainly, broker-dealers are not required to display market
orders; they must execute the order at the best available price in the
market. With the adoption of the Display Rule by the SEC in1996,
broker-dealers and market makers are required to immediately, upon
receipt of a customer's qualified limit order, display the order in
their quote if it improves the price or adds to the size of their
quote.
If the order is not displayed, it must be executed or routed to
other market centers for display or execution. On May 4, 2000, the SEC
released a report (Press Release 2000-59) describing violations by both
market makers and specialists in their handling of customer limit
orders. The violations included failure to display proper order size
and failure to display orders within 30 seconds after receipt.
Surprisingly, the report concluded that the SRO's surveillance and
enforcement of limit order handling was not up to par.
SEC Chairman Levitt has been a consistent supporter of limit orders
and their proper display. He is quoted in the release, ``Limit orders
have been a powerful force for competition in our markets--narrowing
spreads, increasing transparency, and supplying liquidity. The report's
findings of neglect and inattention on the part of some market
participants to display requirements should be a wake-up call. Market
participants must redouble their commitment to ensure that the full
power of limit orders is felt in our markets. Their effect on the price
setting process simply cannot be compromised.'' Without required limit
order display, limit order buyers and sellers might be dissuaded from
placing such orders, compromising market transparency and ultimately
liquidity.
Central Limit Order Book and Price/Time Priority
As discussed above, an investor who publicly displays a limit
orders is not guaranteed an execution, even if stock trades at his
price, because provisions for price and time priority across markets do
not exist. The order has no priority over other orders entered later,
and market centers are not obligated to route orders that would fill
the investor limit order to another market center. In Nasdaq, the first
dealer displaying the best bid or offer has no priority over other
dealers displaying the same bid or offer. On the New York Stock
Exchange, orders on the specialist book do receive price and time
priority status, but floor brokers may participate in executions that
would satisfy orders on the book, in effect jumping the queue that is
on the specialist book. The floor brokers, standing in the crowd, do
not have to publicly display to the greater market their trading
intention. They can merely ``go along'' with other participants and
benefit from the price ``discovered'' by limit order investors.
Because of such actions, some have called for the creation of a
central limit order book, or CLOB, that would consolidate all orders in
one trading venue, with strict price/time priority in force. Nasdaq's
proposed Super Montage is a laudable initial step in the right
direction to provide price and time priority for limit orders, and to
permit display of a more complete picture of trading interest, not only
at the inside quote, but at prices several increments away from the
best bid or offer. Most ECN's already permit a complete ``look at the
book'' for their users, and all market centers and trading venues
should be required to permit such information to be readily
disseminated to investors. While the institution of the Super Montage
will help to further transparency and fairness in the Nasdaq market, it
is not a panacea, as it permits internalization of customer orders by
broker-dealers
Launching a national CLOB would be problematic. Who would create
and maintain it? Who would pay for it? Who would regulate it? If all
market participants were required to participate, would reliance upon a
single point of entry risk market failure should that single point of
entry be disabled? Would the fostering of innovation in market
structure be compromised? Instead a more workable solution would be to
encourage intermarket linkages that provide for strict price and time
priority--and preclude any one market center or participant from
controlling the linkages. Technology would allow for the creation of a
``virtual'' limit order book that could satisfy the need for price/time
priority across markets without relying upon a single entity to
establish and maintain the linkage.
Web sites currently exist that will search other sites for the best
price on a particular book or model of computer, with the purchase of
the book or computer completed with several mouse clicks. A buyer might
choose one web site over another because one is easier to navigate, or
has a better delivery timetable. It is not hard to envision similar
tools, with appropriate regulatory safeguards in place, available to
all investors. Investors would be able to access all market centers and
pools of liquidity, without necessitating the intervention of a dealer.
Would physical trading floors still be needed? If they can provide
innovative trading solutions for market participants while not
hampering fair and equal access, there is no reason that physical
trading floors cannot coexist with electronic markets. The key, however
is to ensure that price/time priority is afforded to all participants.
Decimal Pricing
The phase-in of decimal pricing beginning July 3, 2000 that was
ordered by the SEC at the end of January has been suspended due to
Nasdaq's lack of preparedness to accommodate decimal prices in their
systems by the target date. In requesting the delay, NASD Chairman
Frank Zarb pointed out that Nasdaq volume levels have more than doubled
and Nasdaq quote message traffic that has more than tripled since 1998.
US markets have the dubious distinction of being the only markets
in the world that still trade in fractions. Decimals are far easier to
comprehend--not many know the decimal equivalent of 17/32's or 59/64's
without resorting to a calculator. Decimals are already the preferred
means of operating on many institutional trading desks. Prices reported
in fractions are immediately converted into decimals when executions
are entered into order management systems employed by the buy side.
Real-time prices that flow from quote vendors into electronic blotters
appear as decimals, not fractions, and end-of-day average prices are
reported in decimals. Trades are cleared in decimal prices. While it is
critical that all market systems are able to handle anticipated
increased message and quote traffic, every reasonable effort should be
made to move to decimal pricing sooner rather than later.
Conclusion
Technology can and should play an important role in determining the
future structure of our markets. Market integration using technological
innovation should be a priority, and regulatory bodies must weigh
carefully their role to oversee and regulate markets while not
hampering market reform. Entrenched practices that are detrimental to
fair access of markets by all participants must be reformed. Systems
and linkages that allow for true price and time priority across
markets, full but anonymous display of supply and demand, and a means
of allowing unfettered price discovery must be encouraged.
Internalization, without price improvement, must be discouraged, while
the display of limit orders that add depth and transparency to the
market must be afforded the opportunity to interact with all
participants.
Perhaps the changes we face are in fact seismic and not
evolutionary. It is conceivable that a better, faster, fairer and
cheaper exchange platform that is owned by a foreign entity could
become a significant force in the trading of US equities. We must not
let that earthquake happen, but if significant changes are not made in
the structure of markets as they exist today, we run the risk of losing
our place as the world's leader in equities trading.
Thank you for the opportunity to share my views with this
subcommittee, and I would be pleased to answer any questions that you
may have.
Mr. Oxley. Thank you.
Mr. McSweeney.
STATEMENT OF ROBERT J. McSWEENEY
Mr. McSweeney. Chairman Oxley and members of the
subcommittee, thank you for the opportunity to testify this
morning. The New York Stock Exchange appreciates the leadership
on these complex issues and remains committed to assisting in
your deliberations. This ongoing debate is extremely important
and will strengthen the competitive position of our Nation's
equity markets.
Chairman Oxley, much of my testimony will focus on issues
that are discussed in detail in the exchanges market structure
report. A copy of that report is appended to my testimony, and
I ask that it be included in the record as part of my complete
statement.
Mr. Oxley. Without objection.
Mr. McSweeney. A special committee of the NYSE's board of
directors composed entirely of public directors produced the
report which lays out a blueprint that will allow the NYSE to
evolve into a platform for customer choice. We have labeled
this continuous process of reinvention ``network NYSE.'' The
NYSE must provide a market structure that offers investors the
best execution of their orders. One which is flexible enough to
accommodate multiple investor objectives including best price,
the opportunity for price improvement, and low costs as well as
speed and certainty of execution.
By next year, the NYSE will unveil two order execution
systems that will empower investors with greater choices as to
how to access the NYSE's unrivaled depth of liquidity,
Institutional Xpress and NYSE Direct+. Institutional Xpress
will allow institutional investors new ways of accessing the
NYSE floor. NYSE Direct+ will make available automatic
execution of smaller trade.
A related initiative will soon be on-line which is virtual
NYSE, a realtime virtual representation of the exchange floor.
A fourth initiative will provide investors access to each
specialist book of limit orders. The NYSE supports the phasing
out of three components of the National Market System, NMS. The
Intermarket Trading System, commonly referred to as ITS, should
be replaced by industry initiatives to ensure investor access
to the best available price.
Second, the Consolidated Tape Association, or as it is
known, CTA; and the Consolidated Quotation System, commonly
referred to as CQ, should be replaced by market-based
initiatives. ITS, CTA, and CQ have all played an important role
in fostering intermarket competition, and we are not suggesting
the elimination of the consolidated data or connectivity.
While the NYSE remains dedicated to the goals of the
National Market System, we no longer believe that ITS, CTA, and
CQ are needed to secure those goals. The philosophy of
competing markets embodied in the National Market System have
served investors well. We believe, however, that developments
in communications technology have eliminated the need for a
government-mandated intermarket order routing system such as
ITS. The combination of 21st century technology with the
fiduciary obligation of brokers to achieve best execution,
warrants a different approach today from the solutions from a
quarter of a century ago. Today, the electronic systems
developed by broker dealers themselves make equities trading a
global operation. When there are insufficient linkages, market
participants will create their own superior linkages.
To the extent policymakers believe that ITS continues to be
needed, membership should require self-regulatory status as
approved by the SEC. Broker dealers should link to ITS only
through SROs participating in the ITS plan. This is essential
in maintaining the integrity of our markets, and governance
should be consistent with allowing each market to retain
control over its own business model. In addition, if a market
executes a majority or even a substantial minority of its
orders through the ITS, it is probable that those entering
orders on the alternative system are doing so primarily to free
ride the liquidity of the competing markets. The NYSE and other
ITS participants should not be subject to free riding. NYSE
membership is valuable because of the benefits it confers,
namely, access to the world's most liquid marketplace.
CTA and CQ are two other NMS systems that we believe should
be phased out. Market data must be consolidated and should be
done at the vendor level by competing consolidation services.
At the same time, each market should have the right to market
its data based upon the inherent value of that data. While we
believe that the SEC has a continuing role in ascertaining that
these prices are fair and reasonable, we believe that the
market participants are best suited to judge the value of that
information for themselves.
The NYSE continues to be concerned about practices like
payment for order flow and internalization. We believe that
these practices promote unproductive fragmentation, diminished
price discovery, and can benefit intermediaries at the expense
of investors. Much of the debate over the future of the markets
has focused on CLOBs. The NYSE would not support such a
monolithic trading system. We believe it would result in two
separate pools of liquidity for retail and investor order flow
and would increase market volatility.
We should maintain our primary goal, the achievement of
marketplace connectivity, with competing arenas for order flow
and guaranteeing best system-wide pricing as our standard. It
is essential that best execution fostered by connectivity and
transparency dictate where a customer's order is executed. The
NYSE is committed to the plan of action they have outlined for
you. Our competitive position demands nothing less.
Implementation of cutting edge technology is part of the plan.
Equally important is permitting technology to provide market-
based answers to problems that once demanded government
solutions.
Mr. Chairman, I ask that my complete statement be entered
in the record and of course would gladly answer whatever
questions you or the members may have.
[The prepared statement of Robert J. McSweeney follows:]
PREPARED STATEMENT OF ROBERT J. MCSWEENEY, SENIOR VICE PRESIDENT, NEW
YORK STOCK EXCHANGE, INC.
Chairman Oxley, Congressman Towns, and Members of the Subcommittee,
thank you for the opportunity to testify this morning. The New York
Stock Exchange appreciates your leadership on these complex issues, and
remains committed to assisting your deliberations. This ongoing debate
is extremely important and will strengthen the competitive position of
our nation's equities markets.
Network NYSE--a platform for customer choice
Chairman Oxley, much of my testimony will focus on issues that are
discussed in detail in the Exchange's Market Structure Report. A copy
of that Report is appended to my testimony and I ask that it be
included in the record as part of my complete statement.
A Special Committee of the NYSE's Board of Directors, composed
entirely of public directors produced the Report, which lays-out a
blueprint that will allow the NYSE to evolve into a platform for
customer choice. We've labeled this continuous process of reinvention
``Network NYSE.'' The NYSE must provide a market structure that offers
investors the best execution of their orders; one which is flexible
enough to accommodate multiple investor objectives--including best
price, the opportunity for price improvement and low costs, as well as
speed and certainty of execution.
By next year, the NYSE will unveil two order execution systems that
will empower investors with greater choices as to how to access the
NYSE's unrivalled depth of liquidity--Institutional Xpress and NYSE
Direct+. Institutional Express will allow institutional investors new
ways of accessing the NYSE floor. NYSE Direct+ will make available
automatic execution of smaller trades. A related initiative that will
soon be online is Virtual NYSE, a real-time virtual representation of
the Exchange floor. A fourth initiative will provide investors access
to each specialist's book of limit orders.
The National Market System
The NYSE supports the phasing-out of three components of the
National Market System (``NMS''). The Intermarket Trading System
(commonly referred to as ``ITS'') should be replaced by industry
initiatives to ensure investor access to the best available price.
Second, the Consolidated Tape Association (or as it known ``CTA'') and
the Consolidated Quotation System (commonly referred to as ``CQ'')
should be replaced by market-based initiatives. ITS, CTA and CQ have
all played important roles in fostering inter-market competition, and
we are not suggesting the elimination of consolidated data or
connectivity. While the NYSE remains dedicated to the goals of the
National Market System, we no longer believe that ITS, CTA and CQ are
needed to secure those goals.
The philosophy of competing markets embodied in the National Market
System has served investors well. We believe, however, that
developments in communications technology have eliminated the need for
a government-mandated intermarket order-routing system such as ITS. The
combination of 21st Century technology with the fiduciary obligation of
brokers to achieve best execution warrants a different approach today
from the solutions of a quarter century ago.
Today, the electronic systems developed by broker-dealers
themselves make equities trading a global operation. When there are
insufficient linkages, market participants will create their own
superior linkages.
To the extent that policy makers believe that ITS continues to be
needed, membership should require self-regulatory status as approved by
the SEC. Broker-dealers should link to ITS only through SROs
participating in the ITS plan. This is essential to maintaining the
integrity of our markets, and governance should be consistent with
allowing each market to retain control over its own business model.
In addition, if a ``market'' executes a majority, or even a
substantial minority, of its orders through the ITS, it is probable
that those entering orders on that alternate system are doing so
primarily to ``free-ride'' the liquidity of competing markets. The NYSE
and other ITS participants should not be subject to free-riding. NYSE
membership is valuable because of the benefit it confers--namely,
access to the world's most liquid marketplace.
CTA and CQ are two other NMS systems that we believe should be
phased-out. Market data must be consolidated--but that can and should
be done at the vendor level by competing consolidation services. At the
same time, each market should have the right to market its data, based
on the inherent value of that data. While we believe that the SEC has a
continuing role in ascertaining that these prices are fair and
reasonable, we believe that market participants are best-suited to
judge the value of that information for themselves.
Other issues
The NYSE continues to be concerned about practices like payment for
order flow and internalization. We believe that these practices promote
unproductive fragmentation, diminished price discovery, and can benefit
intermediaries at the expense of investors.
Much of the debate over the future of the markets has focused on
``CLOBs.'' The NYSE would not support such a monolithic trading system.
We believe that it would result in two separate pools of liquidity for
retail and institutional order flow, and would increase market
volatility. We should maintain as our primary goal the achievement of
marketplace connectivity--with competing arenas for order flow and
guaranteeing best system-wide pricing as our standard. It is essential
that best execution, fostered by connectivity and transparency, dictate
where a customer's order is executed.
Conclusion
The NYSE is committed to the plan of action that I have outlined
for you. Our competitive position demands nothing less. Implementation
of cutting-edge technology is part of the plan. Equally important is
permitting technology to provide market-based answers to problems that
once demanded government solutions.
Mr. Chairman, I ask that my complete statement be entered in the
record, and of course, would gladly answer whatever questions you or
the members may have.
Mr. Oxley. Thank you, Mr. McSweeney.
Mr. Ketchum?
STATEMENT OF RICHARD G. KETCHUM
Mr. Ketchum. Thank you, Chairman Oxley. I want to thank
very much the committee for giving me the opportunity to
testify on the competition of the new electronic market, and I
want to compliment you, Mr. Chairman, on focusing attention on
these critically important issues.
In today's trading environment, investors want to know in
realtime the prices at which securities can be bought and sold.
They want that information simple and in one place, and they
want rapid executions at the lowest cost possible. The NYSE
believes that transparency, execution quality, and competition
among intermediaries and markets will propel the market overall
to fulfill these fundamental principles.
The SEC's order-handling rules took a major step in
enhancing market transparency by requiring the customer limit
orders be displayed immediately. In the NASDAQ market, these
rules have helped to enhance transparency, increase
competition, narrow quotation spreads and meet market makers
and ECNs and their customers. NASDAQ's market structure also
provides open, efficient, and quick access to deep pools of
liquidity. NASDAQ promotes price discovery through a system
where multiple market makers risk their capital and compete for
order flow.
We believe that this competition combined with immediate
electronic executions has been critical to NASDAQ's ability to
respond to the speed and market liquidity demands posed by the
explosion of on-line trading. NASDAQ is also the only market in
the United States which fully integrates ECNs, those entities
which open their electronic books to investors and allow them
to advertise prices at which they are willing to trade.
Investors benefit directly from this innovation and competition
through dramatically reduced commissions and other trading
costs.
In fact, I also want to compliment you and indicate how
pleased I am to participate on this panel with representatives
from both the investor community and the broker community, all
of which either directly or through their firms provide an
important contribution to the NASD and NASDAQ in evaluating
many of these issues.
While NASDAQ has been successful in integrating both ECNs
and market makers into a single highly transparent high speed
environment, additional progress should be made. That is why
NASDAQ has proposed the addition of an order display window,
often referred to as the Super Montage. In today's market
environment of multiple ECNs, lower trading increments, and on-
line trading, it is not enough to provide a consolidated
picture of just the best bids and offers. The Super Montage,
which is pending approval by the SEC, will allow market
participants to view the best bid and offer and two price
levels away.
Market makers and ECNs will be permitted, but not required,
to display their customer and proprietary orders at each of
these price levels. Super Montage also will be open to any
exchange wishing to compete in NASDAQ securities. The Super
Montage should help to reduce fragmentation and enhance
transparency by encouraging investors to show greater size in
the NASDAQ market and allowing market participants to see a
more complete view of the depth of that market. I should note
in that connection that, indeed, as was stated earlier, with
respect to the real parties at interest, the investors, it is
interesting to note that a recent independent study developed
and conducted by the institutional committee of the Stock
Traders Association, 89 percent of those responding to the
study, those institutional investors, favored the
implementation of the Super Montage without suggesting that
they may also favor additional market structure changes in the
market.
The Super Montage is built on the general premise that
orders placed in the system should be executed based on price
and time priority. I would believe that strict adherence to
price time priority across all markets, market makers, and ECNs
would unnecessarily limit broker dealers flexibility to provide
a complete mix of execution services to meet their customers'
needs. This flexibility is particularly critical in the new on-
line trading world where investors demand immediacy, low cost,
and liquidity. The NASD believes the Super Montage will
provide, at least as a first step, a preferable market
structure solution to fragmentation than more radical
structural changes such as proposals to implement a
consolidated limit order book, or CLOB, which would remove some
of the flexibility to innovate the market professionals now
have.
In sum, we believe that to satisfy investors needs in the
e-commerce world, market structure must be both open and
inclusive, not closed and exclusive. NASDAQ Super Montage is
open and inclusive and, therefore, responds to investors'
needs.
Again, I want to thank the subcommittee for allowing me to
come here today, and I would be happy to answer any questions.
[The prepared statement of Richard G. Ketchum follows:]
PREPARED STATEMENT OF RICHARD G. KETCHUM, PRESIDENT, NATIONAL
ASSOCIATION OF SECURITIES DEALERS, INC.
INTRODUCTION
I want to thank the Committee for giving me the opportunity to
testify on competition in the new electronic market. As a pioneer of
electronic commerce, Nasdaq has been at the forefront of the electronic
commerce revolution. It is no coincidence that many of the companies
that are leading this revolution--Intel, Microsoft, Cisco Systems,
Yahoo!, Dell, and Amazon.Com--to name just a few, choose to list on
Nasdaq. These pioneers of the electronic age understand that for
electronic commerce to flourish, it must be conducted in an atmosphere
that promotes robust competition and innovation. What is true for the
marketplace at large is equally true for U.S. capital markets. To
promote vibrant capital markets, we must ensure that they remain
transparent, provide a fair and efficient means for investors to access
deep pools of liquidity and remain open to innovation.
I believe that Nasdaq's success is a testament to its ability to
provide such a market structure. Indeed, Nasdaq currently accounts for
more than one-half of all equity shares traded in the nation and is the
largest stock market in the world in terms of dollar value of shares
traded. Nasdaq lists the securities of over 4,700 domestic and foreign
companies, more than all other U.S. stock markets combined. There are
over 70 million investors in Nasdaq companies. In the first quarter of
2000 Nasdaq's average daily volume reached a record of 1.8 billion
shares, an increase of 81.8 percent from the first quarter of 1999 and
a gain of 33.6 percent from the fourth quarter of 1999. On February 17,
2000, Nasdaq's volume exceeded two billion shares for the first time.
Subsequently, Nasdaq experienced nine additional days in the first
quarter of 2000 when daily volume surpassed 2 billion shares.
I believe that Nasdaq has achieved this success by providing a high
speed, electronic market that is open to all market participants, is
transparent, encourages competition, and promotes innovation. I posit
that these attributes should serve as yardsticks by which we measure
how successful our securities markets are in promoting the capital
formation that is fueling the electronic age. Today I will discuss some
of the ways in which I believe that Nasdaq's current market structure
helps to promote competition in the electronic market. In addition, I
will discuss some of the innovations Nasdaq is developing to better
serve the needs of all market participants.
OVERVIEW--WHAT DO INVESTORS WANT
In today's trading environment, as always, investor interests are
paramount. Investors want to know in real time the prices at which
securities can be bought and sold. They want that information assembled
in one place, so that they have complete information on which to make a
trading decision. When an investor decides to trade, he or she expects
to be able to obtain a rapid execution at the best displayed price and
at the lowest cost possible. Thus, the markets and their intermediaries
need to create structures and systems that facilitate these investor
demands. The NASD believes that transparency, execution quality, and
competition among intermediaries and markets will propel the market
overall to fulfill these fundamental principles. The NASD firmly
believes that, as explained below, Nasdaq provides to investors today
what others are trying to build for tomorrow.
TRANSPARENCY
Transparency is one of the keys to Nasdaq's success. Transparency
is the ability of market participants to determine from all markets the
best available price and the size or depth of that interest.
Transparency is critical to the maintenance of fair and orderly markets
and is a key to the success of any market structure. The SEC's Order
Handling Rules require that customer limit orders be displayed
immediately. The enhanced transparency brought about by these rules has
increased competition in the Nasdaq Stock Market by allowing customers
that choose to do so to set the inside quotation spread. This increased
competition naturally reduces quotation spreads and allows investors to
obtain better prices for their securities.
The Order Handling Rules also help to ensure that no matter where a
limit order is displayed, whether it be in Nasdaq or in an Electronic
Communications Network or ECN, that order will be accessible to all
investors. Gone are the days when ECNs stood as ``private markets'' for
the fortunate few where large institutions and market professionals
could access better prices than were available to the public at large.
The Order Handling Rules have helped Nasdaq to link market makers and
ECNs and all of their customers to ensure that the best prices for
Nasdaq securities are publicly disseminated.
OPEN, EFFICIENT AND QUICK ACCESS TO LIQUIDITY
Another key component of Nasdaq's market structure that promotes
competition and capital formation is its ability to provide open,
efficient and quick access to deep pools of liquidity. It is not enough
that investors see the best prices that are available in the market.
They must also be able to obtain those prices and do so quickly at a
low cost. Nasdaq's market structure provides all of these benefits.
Nasdaq was founded on the premise that the best way to promote price
discovery in the securities markets is through a system where multiple
market makers risk their capital and compete for order flow. This
competition combined with every broker-dealer's responsibility to
obtain best execution for its customers' orders was viewed as the
optimal way to create a fair and efficient marketplace. Nasdaq's system
is also open to ECNs, which open their electronic order books to
investors and allow those investors to advertise prices at which
investors and market professionals are willing to trade. No other
market in the world has set up a structure like this.
By linking competing dealers and ECNs electronically rather than
through a physical trading floor, Nasdaq helps to ensure that spatial
considerations alone are not a factor in determining the number of
firms that may provide liquidity to the Nasdaq market. As a result,
Nasdaq has dozens of competing market makers and ECNs in many of its
most actively traded stocks, which provide dozens of sources of
liquidity and dozens of opportunities for innovation. Investors have
benefited directly from this innovation and competition through
dramatically reduced commissions and other trading costs.
Moreover, through its various facilities, Nasdaq provides a broad
array of choices for investors to access the pools of liquidity
provided by Nasdaq's multiple market makers and ECNs. For over a
decade, investors have been able to obtain what is often an
instantaneous electronic execution of an order at the best publicly
displayed price through Nasdaq's Small Order Execution System or SOES.
Since 1997, Nasdaq's SelectNet system has allowed market participants
to rapidly and electronically reach the quotations displayed in
Nasdaq's deep and abundantly populated Quote Montage. This year, Nasdaq
is enhancing SOES to provide for automatic execution of orders up to
9900 shares and to allow market professionals to enjoy automatic
executions. We are confident that SuperSOES will be a great boon to
investors by helping them to receive automatic executions for large
orders at a single price.
But investors that wish to obtain a rapid automatic execution are
not limited to the SOES system. Under Nasdaq's approach to its market
structure, individual market makers have the flexibility to offer their
own automatic execution guarantees and often are willing to do so for
size that exceeds that which is displayed in the market. In this way,
market liquidity and efficiency of execution are enhanced dramatically
for investors using the services of these market makers.
For investors who are more interested in seeking price improvement
than an automatic execution at the best publicly displayed price at a
given time, Nasdaq will continue to provide SelectNet, its facility for
negotiating prices. SelectNet will also continue to play the important
role of linking ECNs to the Nasdaq market. Like market makers, ECNs
provide an important source of liquidity for Nasdaq stocks. ECNs also
provide innovative means for moving securities positions, not the least
of which is anonymity. By trading anonymously institutions and other
large investors, such as pension funds, can trade in and out of large
positions without signaling other market participants and thereby risk
impacting a security's price to the investor's detriment.
SUPER MONTAGE
While I believe that Nasdaq's market structure is the best suited
for promoting competition in an electronic age, I also understand that
its continued success depends on its ability to remain innovative and
adapt to the ever-changing marketplace. To help Nasdaq stay at the
forefront of e-commerce, it is developing a number of innovations that
are designed to improve Nasdaq's market structure. One of the more
important of these is known as the ``Super Montage.''
The Super Montage, which is pending approval by the SEC, will allow
market participants to view the best bid and offer and two price levels
away from the best bid and offer in Nasdaq securities. Market makers
and ECNs will be permitted but not required to display their customer
and proprietary orders at each of those price levels. The Super Montage
also will permit exchanges granted Unlisted Trading Privileges to
Nasdaq securities (``UTP Exchanges'') to display their customer orders
at each of those price levels.
The Super Montage also will permit market participants to indicate
a reserve size for an order, which is additional depth that is ``in the
wings'' so to speak, waiting for the right market conditions before it
will be available for interaction with other trading interest. Reserve
size should help to bring larger orders, which are now often executed
``upstairs,'' down to interact with the rest of the marketplace.
While participation in the Super Montage is voluntary, Nasdaq is
confident that its many advantages will encourage a broad range of
market participants to use the system. For instance, the system should
help to reduce fragmentation by allowing market participants to
transmit to Nasdaq multiple levels of orders and aggregate and
dynamically display all orders at the inside price and two price levels
away. The system's ``non-attributable'' order feature encourages market
participants to show greater size in Nasdaq, rather than disbursing
that size over several trading venues to avoid adverse market impact.
Moreover, market participants will see for the first time in the Super
Montage a more complete view of the depth of the inside market and two
price levels away, thereby enhancing transparency.
The SuperMontage is built on the general premise that orders placed
in the system should be executed based on price/time priority. At the
same time, however, we believe that strict adherence to the principle
of price/time priority across all markets, market makers and ECNs would
unnecessarily limit broker-dealers' flexibility to provide a creative
mix of execution services to meet their customers' needs in a manner
that is consistent with the duty of best execution. It is Nasdaq's
belief that, as long as no order is executed at a price worse than that
which is publicly displayed, market makers and ECNs should continue to
have the flexibility to interact with their own order flow. We believe
that this flexibility is particularly critical in the new on-line
trading world where investors demand immediacy, low cost, and
liquidity. Some market makers have responded to these demands by
providing guaranteed executions up to two thousand shares at the best
bid or offer or better regardless of the displayed quotation size. Some
ECNs have responded to these needs by providing low cost crossing
executions in their systems and sophisticated order routing algorithms
into Nasdaq for orders that the ECN cannot execute. These innovations
benefit investors daily and care should be taken with respect to any
actions that might deprive investors of these valuable execution
services.
With the addition of the Super Montage, Nasdaq will be able to link
all markets, including UTP exchanges, that trade Nasdaq securities. In
this way, the Super Montage should encourage competition by providing
an open and inclusive model in which competing market centers may
operate. While the Super Montage proposal provides a central means for
accessing liquidity in Nasdaq securities, it in no way establishes the
Nasdaq system as the sole means for providing or accessing liquidity.
NASD members (including market makers, ECNs and order entry firms),
individual investors, and members of other exchanges will be free to
route their orders to, and access pools of liquidity in, any linked
market center trading Nasdaq securities. We believe that all of these
attributes make the Super Montage a strong means for combating what
many perceive as a fragmenting of our securities markets.
In this connection, the NASD believes that the Super Montage will
provide a preferable market structure solution to fragmentation than
more radical structural changes, such as a composite CLOB. Many
variations of a CLOB have been discussed over the past several months.
One such approach would effectively link all markets' limit order books
and dealer quotations by requiring that all displayed trading interest
be executed according to strict price and time priority. Although in
theory executions could occur at the local market level, we believe
that in practice such a proposal would require the creation of a
national utility, which would sacrifice marketwide competition at a
cost that would outweigh the benefit to be derived from such a
proposal.
It is our belief that a system based on strict price/time priority
may disadvantage investors by funneling all market orders toward a
single liquidity source, whether it be a customer limit order or a
dealer quotation. Investors would be required to wait to determine
whether they had received an execution. If they did not, they would be
forced to route their orders to the next trading venue that displayed
the best price with time priority. This process of chasing liquidity
would slow down the trading process and greatly reduce the likelihood
of obtaining an automatic execution.
A proposed solution to this problem, which we believe would be even
more chilling, would be the creation of a composite CLOB. Unlike
Nasdaq's current market structure and the structure it will enjoy with
the Super Montage, however, a strict price time priority CLOB could not
by its nature offer the flexibility for multiple competing liquidity
sources, all of which could offer an automatic execution at a
guaranteed minimum size at the best publicly displayed price. Moreover,
strict time priority would preclude market makers from interacting with
their own order flow and therefore remove an important incentive for
risking capital and providing an innovative service mix that includes
automatic execution at a minimum guaranteed size.
We believe that Nasdaq's current market structure and the proposed
Super Montage will address many of the concerns raised about
fragmentation while continuing to provide incentives to liquidity
providers and choices for liquidity seekers. Because the Nasdaq system
provides incentives for market makers to continuously display
quotations and provide immediate guaranteed executions in size to
investors, it has been able to respond to the revolutionary demands of
the online trading world. Mandatory CLOBs and system-wide time priority
requirements do not effectively incorporate or provide incentives for
multiple market makers and ECNs who now provide liquidity and immediate
executions on Nasdaq, and who thus help to ensure that investors have
quick and easy access to the markets in good times and in bad. In sum,
our view is that to satisfy investor needs in an e-commerce world,
market structure must be open and inclusive, not closed and exclusive.
Nasdaq's Super Montage is open and inclusive and, therefore, responds
to investor needs.
OTHER INITIATIVES
In our view, the Super Montage will provide the most benefits to
investors and to market participants if it is carried out under a
corporate structure that can respond nimbly to competitive and
technological changes in the marketplace. That is why the NASD Board
and its members approved a restructuring plan that is designed to
enhance the competitiveness of Nasdaq, while reducing members'
regulatory costs and strengthening NASD Regulation.
Nasdaq is also committed to building on our successful domestic
stock market model internationally. As a result, we continue to explore
overseas ventures and alliances with market participants abroad with
the ultimate goal of providing investors with rapid, open, low cost
access to deep pools of liquidity around the world.
ITS, CQA AND CTA PARTICIPATION BY NON-SROS
Now I would like to turn to two related issues addressed in the
Subcommittee's invitation letter: the desirability of opening the
Intermarket Trading System to membership by non-self-regulatory
organization market participants and whether the Consolidated Quotation
Association and Consolidated Tape Association should permit competition
in market data by non-SROs. First, we share the general frustration of
all market participants with ITS, which is clearly technologically
outmoded, a trading hindrance that Nasdaq and the Cincinnati Stock
Exchange have been able to reduce somewhat by offering automatic
executions for ITS commitment. As the Subcommittee may know, Nasdaq and
its members were hampered for over twenty years with limited access to
all of the securities traded through ITS. Recently, however, the rules
restricting Nasdaq's access to ITS as well as NYSE Rule 390 (which
restricted off-board trading of certain listed companies) were
rescinded, thereby creating a more level playing field between Nasdaq
and the listed markets. Therefore, the NASD believes that it is time to
make a concerted effort to improve the way markets access each other.
For its part, the NASD has already adopted rules and developed
technology to open its NYSE-listed trading facilities to a broader
array of market participants. The NASD has opened its facilities to
ECNs as well as registered market makers and thus opened access to ITS
and the Consolidated Quotation System to ECNs, which may now
participate in these systems.
The question raised by the Subcommittee, however, is whether
individual broker-dealers, including ECNs, should directly display
their quotes and trade in these national market systems. ITS membership
is currently limited to the NASD and registered national securities
exchanges, all of which are registered with the SEC as SROs. As such,
the SROs are required to establish and maintain regulatory programs to
ensure that their members act in accordance with the requirements of
the ITS Plan and the federal securities laws, including the rules of
the SROs, which are adopted under those laws. To open membership to the
ITS to entities that are not subject to those same regulatory
safeguards could create a regulatory gap for orders that are routed
through ITS to a non-SRO.
With respect to CTA and CQA membership, the fees that are generated
from such membership are used to offset the costs of regulation.
Marketplaces that are not subject to the same regulatory burden but
that enjoy the fees derived from CTA and CQA membership would enjoy a
windfall. The NASD is not, as a matter of principle, opposed to
expanded membership in these National Market System plans, but it must
be done on a level playing field. Thus, if an entity providing a
trading venue wants to operate as a registered SRO, like the other
National Market System Plan participants, it should be able to
participate fully in CTA, CQA and ITS. On the other hand, if that
entity determines that its business model is better served by being a
broker-dealer, it should only participate in these plans as a member of
one of the SROs that is a direct participant.
DECIMALS
Finally, I wanted to address the possible benefits that the move to
decimals is likely to have for investors. First, let me say that the
NASD's decision to request an extension of the SEC's July 3, 2000,
target date for starting the implementation of decimals was not one
that we took lightly. As you know, the NASD supports the move to
decimals. I believe that it should benefit investors by making
securities prices easier to understand and by keeping the U.S.
securities markets competitive with major markets abroad, which quote
in decimals already. Therefore, I wanted to give you my assurance that
the NASD is committed to building the necessary capacity enhancements
to ensure that the move to decimals occurs as quickly and safely as
possible.
CONCLUSION
Again I wanted to thank the Subcommittee for allowing me to come
here today to share the NASD's views on competition in the electronic
market. It is a subject that is at the very core of the existence of
the NASD and the Nasdaq Stock Market. I believe that Nasdaq's market
structure is the best model for continuing to promote the type of
capital formation that has been so important for the development of our
electronic age. I would ask that you join me in encouraging the
transparency, openness, and accessibility that have been the hallmark
of Nasdaq.
Thank you, and I will be happy to answer any questions that you may
have.
Mr. Oxley. Thank you.
Mr. Jenkins?
STATEMENT OF PETER W. JENKINS
Mr. Jenkins. Chairman Oxley and members of the
subcommittee, thank you. I would like to thank you for this
opportunity to express my views on competition in the new
electronic marketplace and the structural changes taking place
in the equity markets today. I am director of Global Equity
Trading at Scudder Kemper Investments, managing approximately
$280 billion. With the limited time, though, I have today
before this committee, I would like to focus my attention on
three areas that I believe are most important in shaping the
future of the electronic marketplace.
First is protection of limit orders, second is transparency
of markets, and the third, of course, is the linkage of the
trading venues and exchanges.
On the protection of limit orders, limit orders are the
basis for pricing securities in the markets today. On the New
York Stock Exchange and the regional exchange, limit orders
reside on the specialist book. These orders allow for floor
brokers to determine strong levels of supply and demand. They
allow specialists and position traders off the floor to make
bigger markets for their customers, who allow for greater
liquidity for institutional and retail customers.
The institutional buyside traders rely on the limit orders
to help price blocks of stocks for their clients. These limit
orders allow the institutional trader a reference so we can be
realistic when approaching upstairs position traders or
specialists when we request the use of their capital. Limit
orders also offer quantitative traders the ability to size up a
market and offer traders over entire portfolios because these
orders are firm and real.
In the over-the-counter market, the success of the ECNs was
built on limit orders. Traders from both the buyside and
sellside migrated to these systems because of the existence of
those orders and rules protecting them. Because of the limit
order facility, ECNs have captured greater than 20 percent of
the over-the-counter market. Why don't we try to protect these
orders in all venues? These orders are the backbone of the
future virtual marketplace. If protected these orders could be
successful in increasing the depth and structure of the market.
Today, in the listed marketplace when an offer is too large
on one exchange, we allow trades to take place at the same
price on an exchange where there is less depth. On the New York
Stock Exchange, we have created rules such as the Clean Cross
Rule that allows the trader to shut out a bid or an offer as
long as the size you want to trade is greater, and this rule
was actually put in place to try to keep block flow on that
exchange. On the floor of the New York Stock Exchange after a
hundred shares trade at a specific price, the crowd splits
evenly afterwards. Nothing to support price improvement.
In the over-the-counter market, the best bids and offers
displayed by dealers as well as the best bids and offers posted
on ECNs is not protected. This practice is known as
internalization of order flow, as stocks are crossed outside of
those markets. Close to a third of all NASDAQ orders are
internalized. Wholesalers are paying for the order flow to
trade against the limit orders and markets exposed. This
practice has become very profitable for the wholesalers.
The SROs seem to be protecting this practice instead of
encouraging order interaction. If institutional limit orders
were given greater protection, traders would populate these
limit order books. Limit order transparency has been argued for
many years. I served on the New York Stock Exchange
Institutional Traders Advisory Committee as chairman in the
early 90's. A look at the specialist book was the No. 1 focused
topic on that committee for my tenure. We are just getting
around to this issue today. As the markets move to
decimalization, it will be imperative for the institution to
see below the top of the book.
The ECN success is also due to its transparency. The
trading information gained through seeing orders interact on
the limit order book allow for the institutional trader to make
a more informed trading decision. Decimalization will move the
most liquid stocks to one penny spreads over time. The volumes
will increase as the spreads tighten. The need to see where the
large orders reside will be most important to the institutional
trader. With this depth of book, inefficiencies of access will
erode the competitive positions of the primary exchange.
Last, linkages, Scudder Kemper Investments supports the
concept of a virtual global limit order facility. To achieve
this, the most important aspect of efficient market structure
will be the linkage between the ECNs, the exchanges, and the
crossing networks. Competition will force systems with weak
linkage out of business. Firms with less than adequate
technology should not be subsidized by the industry. To move to
a virtual limit order book and to protect limit orders in the
different trading venues, linkages need to be efficient and
meet minimum technological standards.
I applaud the New York Stock Exchange for its proposed
automatic execution system through Institutional Xpress.
Although it is just the start, institutions as well as retail
investors need direct electronic access to these limit order
facilities. If the inefficient Super Dot system has been a
problem and often when transmitting an order, you do not
receive what you expect. ITS links the various exchange quotes,
but does not allow for time priority across its markets. With
the Archipelago and Pacific Coast Stock Exchange combination,
we hope to see the first steps in efficient linked market with
price/time priority without the involvement of specialists or
the dealer.
Mr. Oxley. Would you summarize.
Mr. Jenkins. In the long term, Scudder Kemper Investments
would like to see protection across all markets of all limit
orders and price time priority. If the linkages do not allow
interaction, we at the very least would like to see price time
priority in each trading venue with trade through rules.
We support a regulatory focus on order interaction. We are
concerned with the wholesalers' increased practice of
internalization without price improvement. This trend could
undermine transparency and support for limit order exposure.
The fragmentation of the equity markets is the product of
technological innovation and competition. The industry is
dealing with this through electronic connectivity.
We support speedy conversion to decimals, but decimals
without a fully transparent book will be problematic. The quick
move to decimals will allow for less confusion, tighter
spreads, and may help generate a stronger limit order book.
Depth of book use is needed and should be made available to all
market participants. Thank you very much.
[The prepared statement of Peter W. Jenkins follows:]
PREPARED STATEMENT OF PETER W. JENKINS, MANAGING DIRECTOR, HEAD OF
GLOBAL EQUITY TRADING, SCUDDER KEMPER INVESTMENTS,
Chairman Oxley and members of the subcommittee on Finance and
Hazardous materials, my name is Peter Jenkins, I am the Director of
Global Equity Trading at Scudder Kemper Investments. I would like to
thank you for this opportunity to express my views on competition in
the new electronic market place and the structural changes taking pace
in the equities markets.
Scudder Kemper Investments leads the Global Investments management
business of the Zurich Financial Group. With more than $280 billion
currently under management and almost 80 years of experience Scudder
Kemper Investments is among the world's largest and most experienced
asset managers. Scudder Kemper's client base includes institutions,
individual investors and financial intermediaries worldwide. We trade
equities in sixty-nine different markets around the globe and staff a
22-hour trading desk out of our offices in New York City.
I have been involved in equity market structure issues since 1988
when I was asked to be on the NYSE market performance committee, and
the NASDAQ institutional Committee. I served as Chairman for both the
NYSE Institutional Traders Advisory Committee and the STA Institutional
Committee. I have been trading equities since 1980 and have experienced
a great deal change.
With the limited time I have before this committee I would like to
focus my attention on three areas that I believe are most important in
shaping the future electronic market: 1. Protection of Limit Orders; 2.
Transparency of markets; and 3. Linkage of trading venues and
exchanges.
PROTECTION OF LIMIT ORDERS
Limit orders are the basis for pricing securities in the markets
today. On the New York Stock Exchange and the regional exchanges limit
orders reside on the specialist book. These orders allow for floor
brokers to determine strong levels of supply and demand. They allow
specialists and position traders off the floor to make bigger markets
for their customers who allow for greater liquidity for institutional
and retail customers.
Institutional Buyside traders rely on limit orders to help price
blocks of stocks for their clients. These limit orders allow the
institutional trader a reference so we can be realistic when
approaching ``upstairs position traders,'' or specialists when we
request the use of their capital.
Limit orders offer quantitative traders the ability to size up a
market and offer trades over entire portfolios, because these order are
firm and real.
In the over the counter market the success of the ECN's was built
on limit orders. Traders from both the buyside and the sellside
migrated to these systems because of the existence of those orders and
rules protecting them. Because of the limit order facility, ECN's have
captured greater than 20 percent of the Over the Counter Market.
Why don't we try to protect these orders in all venues? These
orders are the backbone of the future virtual market place. If
protected these orders could be successful in increasing the depth and
structure of the market.
Today in the Listed market place, when a bid or offer is too large
on one exchange we allow trades to take place at the same price on an
exchange where there is less depth.
On the New York Stock Exchange we have created the ``clean cross
rule'' that allows a trader to ``shut out'' a bid or offer as long as
the size you want to trade is greater. This rule was actually put in
place to try to keep block order flow on that exchange. On the floor of
the New York Stock Exchange after 100 shares trade at a specific price
where there are limit orders the crowd splits each new trade at that
price equally.
In the Over the Counter market the best bids and offers displayed
by dealers, as well as the best bids and offers posted on ECN's, are
not protected. This practice is known as internalization of order flow.
Close to a third of all NASDAQ orders are internalized. Wholesalers are
paying for order flow to trade against the limit orders and markets
exposed. This practice has become very profitable for these
wholesalers. The SRO's seem to be protecting this practice instead of
encouraging order interaction.
If institutional limit orders were given greater protection traders
would populate the limit order books.
TRANSPARENCY OF MARKETS
Limit order transparency has been argued for many years. I served
on the New York Stock Exchange Institutional Traders Advisory Committee
as Chairman in the early 90's. A look at the specialist book was the
number one focus topic on that committee for my tenure. As the markets
move to decimalization it will be imperative for the institution to see
below the top of the book.
The ECN's success is also due to its transparency. The trading
information gained through seeing orders interact with the Limit book
allow for the institutional trader to make a more informed trading
decision.
Decimalization will move the most liquid stocks to ``one penny''
spreads over time. The volumes will increase as the spreads tighten.
The need to see where the larger orders reside will be most important
to the institutional trader. Without this depth of book, inefficiencies
of access will erode the competitive positions of the primary exchange.
LINKAGE OF TRADING VENUES AND EXCHANGES
Scudder Kemper Investments supports the concept of a virtual global
limit order facility. To achieve this, the most important aspect of
efficient market structure will be the linkage between the ECN's,
exchanges and crossing networks. Competition will force systems with
weak linkage out of business. Firms with less than adequate technology
should not be subsidized by the industry. To move to a virtual limit
order book, and to protect limit orders in the different trading
venues, linkages need to be efficient and meet minimum technological
standards.
I applaud the New York Stock Exchange for its proposed automatic
execution system through Institutional Express. Institutions as well as
retail investors need direct electronic access to limit order
facilities. The inefficient Super Dot system has been a problem, and
often when transmitting an order you do not receive what you think you
will get. ITS links the various exchange quotes but does not allow for
Price Time Priority, across the markets. With the Archipelago and
Pacific Coast Stock Exchange combination, we hope to see the first
steps to an efficient linked market with Price Time Priority without
the involvement of the specialist as dealer.
The move by ECN's to set up direct efficient linkages to pools of
liquidity is a promising step for buyside trading desks. Maybe these
direct linkages will offer competition to the NASDAQ SelectNet system,
which to date has proven less than adequate.
SOLUTIONS AND CONCLUSION
In the long term Scudder Kemper Investments would like to see
protection across markets of limit orders in Price Time Priority. If
the linkages do not allow interaction we would at the very least like
to see Price Time Priority in each trading venue with trade through
rules.
We support a regulatory focus on order interaction. We are
concerned with the Wholesalers increased practice of internalization
without price improvement. This trend could undermine transparency and
support for limit order exposure. The fragmentation of the Equity
Markets is the product of technological innovation and competition. The
industry is dealing with this through electronic connectivity.
We support a ``speedy conversion'' to decimals. But decimals
without a fully transparent book will be problematic. The quick move to
decimals will allow for less confusion, tighter spreads and may help
generate a stronger limit order book.
Depth of book in all venues is needed, and should be made available
to all market participants.
Thank you very much for this opportunity to offer my views on
market structure to this sub-committee.
Mr. Oxley. Thank you, Mr. Jenkins.
Mr. Kamen.
STATEMENT OF KENNETH A. KAMEN
Mr. Kamen. I would like to thank Chairman Oxley, Mr. Towns,
and Mr. Greenwood for the opportunity to testify on these
critical issues. I am testifying today as the chairman of the
board of the Regional Investment Bankers association and on
behalf of the small issuer marketplace we service. While Wall
Street's largest brokerage firms and investment banks have
lobbied the Securities and Exchange Commission to adopt a
sweeping new market system, the voice of small regional firms
and the small issuer market they serve have gone largely
ignored.
Amidst the euphoria surrounding the bull market and the
proliferation of electronic communication networks and
alternative trading systems, certain investors, market
practitioners, and regulators have abandoned the small business
issuer. In the process, they are potentially threatening the
longest economic expansion in the history of this country.
U.S. capital markets are preeminent because they enable
entrepreneurs to raise capital efficiently and provide a
reliable secondary market to investors. The U.S. securities
industry is unique in the degree of participation in capital
provided by retail investors. Indeed, these investors are the
life blood of the small issuer marketplace. The vibrant small
issuer equity market includes an estimated 22 million investors
and small publicly traded companies, approximately 9,000 small
issuers, and tens of thousands of officers, directors and
employees.
While some of these companies are speculative investments,
informed investors accept these risks because of the
opportunities they offer. It is important to remember that the
large cap companies driving our markets to record highs were in
many cases at one stage in their development small businesses.
An efficient and liquid small issuer market helps channel risk
capital from investors to innovative emerging companies,
affording them the opportunity to expand, make acquisitions,
and retire debt.
The companies listed on the NASDAQ Small Cap and the Over-
The-Counter Bulletin Board are clear examples of the
contribution that small equity markets make to our company.
While these companies represent all sectors of the economy, the
information technology and biotechnology companies that are at
the forefront of current U.S. economic growth are listed
overwhelmingly on these markets. It is the small underwriters
and broker dealers who commit their own capital and provide
necessary liquidity to the small issuer capital market.
Few if any ECNs or ATSs are operating in the lower tiers.
Unlike the ECNs, market makers must maintain fair and orderly
markets at all times. In addition, they provide valuable
liquidity to the small issuer markets. The active support and
services provided by the Regional Investment Bankers
Association member firms is necessary. Their absence would
threaten small issuer markets.
In the past few years, technology and regulatory change has
caused rapid, dramatic, and unprecedented changes in the equity
trading markets. While all these developments are worthy of
appropriate regulatory reforms, the highly successful dealer
markets servicing small issuers must not be sacrificed. Too
often, however, regulatory reforms have been shaped almost
exclusively by the analysis of the top tier of the market,
consisting mostly of the most actively traded securities in
U.S. equity markets.
Although the consequences are unintended to the lower-tier
markets, we continue to suffer from this apparent benign
neglect. The potential erosion of the small issuer equity
market is a growing concern for small business entrepreneurs in
every region of the country. Failing to consider the
contribution of the lower-tier markets may stifle the growth
and innovation that is sustaining and expanding our current
booming economy.
Small issuers have recently enjoyed an enormous increase in
the funds received from venture capital firms and so-called
angel investors who have made capital investments in
anticipation of an initial public offering. These angel
investors often evaluate companies less on the long-term growth
capabilities than on their short term IPO prospects. If changes
in market structure adversely affect the small cap markets and
the market makers ability to service them, the venture capital
stream will likely dry up.
I'd like to comment on some of the specific issues under
consideration by the committee. First, I would caution
regulators to consider the potential for large firms to
dominate the self-regulatory process in a new market structure.
Under the influence of large firms, for-profit self-regulatory
organization can raise the cost of regulation to levels that
would force small firms out of the industry.
Second, the concept of single centralized markets such as a
centralized limit order book also raises concern for individual
investors that may be handicapped by institutional investors
who are able to dominate markets by mobilizing vast amounts of
capital instantaneously. Third, I would emphasize that pricing
for market data must be streamlined. Buying discounts favoring
larger financial service firms should not disadvantage regional
brokerage firms servicing the small issuer marketplace.
Fourth, the spate of recent proposals for new market
linkages in execution firms should prompt an examination of the
practical impact on the lower-tier markets. Regulatory
policymakers must ask whether the future of ITS', SelectNet,
and Super SOES will provide appropriate applications for lower-
tier markets. Finally, I urge the SEC to clarify its best
execution standards and specify their application to the lower-
tier markets.
In conclusion, I would like to take this opportunity to
highlight what I see as the most important issue, the benign
neglect of the lower-tier markets by regulators and
policymakers. To avoid the kind of adverse consequences I have
discussed with you today, I have two specific recommendations:
first, I ask all policymakers and regulators to move ahead more
cautiously and deliberately in considering the effects of
future changes on all marketers. Second, I urge to make good
use of the expertise of the Regional Investment Bankers
Association and the small issuers that rely on the lower-tier
markets for their lifeblood.
I would like to commend the full committee and its staff
for reaching out and soliciting the views of the small broker
dealer community. We hope that your leadership in creating a
more inclusive debate becomes the standard rather than the
exception. Thank you.
[The prepared statement of Kenneth A. Kamen follows:]
PREPARED STATEMENT OF KENNETH A. KAMEN, EXECUTIVE VICE PRESIDENT,
PRINCETON SECURITIES CORPORATION
RIBA
I am testifying today as the Chairman of the Board of Directors of
the Regional Investment Bankers Association (RIBA) and on behalf of the
small issuer marketplace we service.\1\ RIBA was organized in June,
1994 as a national association of regional and independent broker-
dealer and investment banking firms seeking to improve conditions in
our industry, strengthen the free-enterprise system and provide a vital
source of information and education to RIBA members and the investing
public.
---------------------------------------------------------------------------
\1\ Mr. Kamen has 20 years industry experience and is currently
Executive Vice President of Princeton Securities Corporation.
---------------------------------------------------------------------------
RIBA is committed to assisting regional broker-dealers in the
syndication of their capital formation projects. While our initial goal
was to provide a forum for small-cap companies seeking public
financings, we have since expanded our focus to address the overall
concerns of the lower tier market. Toward this end, RIBA has
represented the interests of smaller broker-dealers to the securities
regulators who govern our industry and the policymakers in Washington,
DC. RIBA now holds regularly scheduled conferences where member firms
exchange ideas, voice opinions on pending legislation and become
educated on matters affecting the industry. As the bonds among RIBA
members continue to strengthen, we hope to enhance our contribution to
regulatory and legislative matters.
INTRODUCTION
While Wall Street's largest brokerage firms and investment banks
have lobbied the Securities and Exchange Commission (SEC) to adopt a
sweeping new market system, the voices of small regional firms and the
small issuer market they serve have gone largely ignored. Amidst the
euphoria surrounding the bull market and the proliferation of
electronic trading systems such as electronic communications networks
(ECNs) and alternative trading systems (ATSs), certain investors,
market practitioners and regulators have abandoned the small business
issuer. In the process, they are potentially threatening the longest
economic expansion in the history of this country. RIBA urges that any
sweeping new market restructure consider its impact on the small issuer
marketplace. RIBA believes the failure to do so is irresponsible and
risky economic policy. Unfortunately, the current dramatic proposals to
reform market structure may ultimately reduce liquidity and capital
flow in the small issuer market.
The U.S. capital markets are preeminent because they enable
entrepreneurs to raise capital efficiently and provide a reliable
secondary market to investors. The U.S. securities markets are unique
in the degree of participation and capital provided by retail
investors. Unlike our European and Asian competitors, the U.S. markets
rely on a confident and vigorous retail investing public. These
investors are the lifeblood of the small issuer marketplace. The lower
tier market functions are facilitated by the small underwriters who
bring emerging companies to the public market and by market makers who
commit capital to maintain a market for these companies' securities.
The vibrant small issuer equity market includes an estimated 22 million
investors \2\ in small publicly traded companies, approximately 9,000
\3\ small issuers and tens of thousands of officers, directors and
employees. While some of these small companies are speculative
investments, informed investors accept the risks they pose because of
the opportunities they offer. It is important to remember that the
large cap companies driving our markets to record highs were in many
cases, at one stage in their development, small businesses.
---------------------------------------------------------------------------
\2\ Small Business Administration. Office of Advocacy.
\3\ Id.
---------------------------------------------------------------------------
An efficient and liquid small issuer market helps channel risk
capital from investors to innovative emerging companies, affording them
the opportunity to expand, make acquisitions and retire debt.
Capitalizing these companies creates an enormous number of new jobs.
The companies listed on Nasdaq SmallCap and the Over The Counter
Bulletin Board (OTCBB) are clear examples of the contribution that
small issuer equity markets make to our economy. Although the Nasdaq
SmallCap and the OTCBB companies represent all sectors of the economy,
the information technology and biotechnology companies that are at the
forefront of current U.S. economic growth are listed overwhelmingly on
these markets.
It is the small underwriters and broker-dealers, not the ECNs and
ATSs, who commit their own capital and provide necessary liquidity to
the small issuer capital market. Few, if any, ECNs or ATSs are
operating in the lower tiers. Unlike the ECNs, market makers are
obliged to maintain fair and orderly markets in both rising and falling
markets. In addition, they provide valuable liquidity to the small
issuer markets through their buying and selling activities. Market
makers temper the price volatility of securities and preserve market
integrity by identifying over-valued and under-valued companies,
leading to pricing efficiencies in the market. This dealer market
should be preserved and enhanced as new securities regulatory policy is
developed. Small issuers continue to need the active support and
services provided by RIBA member firms. In the absence of their
support, no market exists for these small issuers.
RIBA recommends establishing a special small issuer capital market
task force to evaluate and shape market reform proposals unique to the
small issuer. The SEC and Nasdaq should also consider the negative
impact of current rules and regulations on the small issuer market.
RIBA is willing to take an active role in establishing this task force
and will work with regulators, market practitioners, issuers and
investors to make recommendations that address the interests of the
small issuer capital market.
A SHORT HISTORY OF MARKET CHANGE.
The 1975 Amendments to Securities Laws: Creation of a National Market
System.
Nearly 25 years ago, in response to new data processing and
communication techniques, Congress amended the securities laws to
create a fair and efficient national market system. The amendments were
designed to improve the execution quality of securities transactions
and foster fair competition among various participants in the markets,
including brokers, dealers, exchanges and markets other than the listed
exchange markets,
Congress believed that expanding the availability of quotation and
transaction information would result in the execution of investor
orders in the best market available, possibly without the participation
of a dealer. To accomplish its goals, Congress ended fixed commissions
on what is now known as ``May Day''. May Day referred to May 1, 1975,
when the SEC eliminated the fixed commissions brokers were charging for
all securities transactions. This change allowed regional firms to
compete on price and quality of service. Further, the inception and
rise of discount brokerages grew out of the ``May Day'' Proclamation.
In this landmark legislation, Congress also called for the development
of a consolidated quotation system and consolidated tape, as well as
the creation of the inter-market trading system (ITS). Finally and
perhaps most significantly, a statutory directive ordered the SEC to
take steps to foster the development of a national market system
consistent with these goals.
1994: The SEC Market 2000 Study.
Almost twenty years after the 1975 Amendments, the SEC embarked on
an ambitious project. After conducting several years of research, the
SEC's Division of Market Regulation issued its voluminous Market 2000
Report in 1994 (the Report). The Report was several hundred pages long
and summarized the state of the securities markets and made several
recommendations for substantive change. Despite its extraordinary
length, the Report focused almost exclusively on the conclusion that
further changes in technology and product development had caused
dramatic changes in large-cap markets since the 1975 amendments.
Unfortunately, the question of applicability of these findings to the
small-cap markets went unnoticed.
Although the Report concluded that the equity markets were
operating efficiently and effectively, and that no major revision of
equity market regulation was needed, it did recommend several
improvements. The Report found that securities professionals, for
example, needed to devote greater effort to securing the best prices
for their customers and to the full disclosure of relationships that
could interfere with the customers' interests. The Report also urged
more timely and comprehensive information with respect to quotation,
price and volume data. The Report also anticipated that the development
of alternative trading vehicles required regulatory adjustments, and
that increased market access for competitors was essential.
1996: Adoption of SEC Order Handling Rules.
Soon after the release of the Market 2000 Report, in the spring of
1994, a widely publicized economic study suggested that the largest
Nasdaq market makers implicitly colluded to maintain artificially wide
inside spreads by avoiding odd-eighth quotations in many stocks.\4\ In
addition, media accounts reported widespread allegations that market
makers routinely refused to trade at their published quotes,
intentionally reported transactions late in order to hide trades from
other market participants, and engaged in other market practices
detrimental to individual investors. Certain National Association of
Securities Dealers (NASD) member firms, sometimes referred to as SOES
Bandits, also alleged that the NASD had targeted them for regulatory
and disciplinary action because the largest market makers that
dominated and controlled the NASD disapproved of the trading practices
engaged in by these firms. The Department of Justice and the SEC
investigated the NASD and the Nasdaq Stock Market for almost two years
and then issued a series of enforcement actions alleging that
activities by market makers had contributed to a two-tier market in
Nasdaq securities and had artificially maintained the size of spreads
paid by retail investors for Nasdaq securities.\5\
---------------------------------------------------------------------------
\4\ William G. Christie & Paul H. Schultz, Why Do NASDAQ Market
Makers Avoid Odd-Eighth Quotes?, 49 J. Fin. 1813, 1813-40 (1994)
[hereinafter the ``Christie-Schultz Study''].
\5\ See SEC, Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996)
[hereinafter the ``NASD 21(a) Report''].
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In September 1996, the SEC adopted Order Handling Rules designed to
reduce spreads and protect investor interests.\6\ Concurrently with the
investigation of the NASD and before drafting the rules, the SEC
performed a comprehensive study of top tier Nasdaq securities. However,
the SEC did not study how the proposed Order Handling Rules would
affect the liquidity and volatility of small cap stocks. In hindsight
this omission was a critical error. Despite the limited range of its
evaluation, the SEC adopted the Order Handling Rules and applied them
to all stocks trading on the Nasdaq market.
---------------------------------------------------------------------------
\6\ See Proposed Rules on Order Execution Obligations, 60 Fed. Reg.
52792 (Sept. 29, 1995); Adopted Rules on Order Execution Obligations,
Securities Exchange Act Rel. No. 34-37619A (Sept. 6, 1996).
---------------------------------------------------------------------------
Subject to certain limited exceptions, the Order Handling Rules
require market makers to include customer limit orders in their own
quotes and mandate that dealer orders in ECNs be included in the inside
market. The enactment of these Order Handling Rules reduced the spread
between the best bid and best offer quoted on Nasdaq.\7\
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\7\ The SEC emphasized that the duty of best execution could
require brokers to do more than simply execute orders at the NBBO. It
stated that brokers had a duty to ``regularly and rigorously'' assess
the quality of the executions provided to customers.
---------------------------------------------------------------------------
Since the adoption of the Order Handling Rules, RIBA members have
noted a dramatic increase in market volatility in the small cap market.
While RIBA recognizes the effects of many factors, in addition to the
Order Handling Rules, RIBA recommends that the SEC evaluate the
unintended negative consequences of the application to the lower tier
markets.
1998: Adoption of Regulation ATS.
The Adoption of Regulation ATS in December, 1998 by the SEC was a
radical development whose impact is driving the current debate on
market structure. The new regulation put into place many of the changes
first raised in the Market 2000 Report. The new regulation defined the
registration and regulatory requirements for alternative trading
systems, including ECNs and exchanges, and floated the concept of a
``for-profit'' exchange. Ultimately, Regulation ATS sparked the push by
various exchanges and the NASD for demutualization and contributed to
the proliferation and expansion of ECNs and ATSs. As was the case with
the Order Handling Rules, Regulation ATS was adopted without the
benefit of a comprehensive evaluation of its impact on the lower tier
markets.
The catalyst for the changes wrought by Regulation ATS has been the
growth of ECNs as market centers. Unfortunately, technological change
has produced a degree of uncertainty for some market participants. RIBA
recognizes the tremendous potential that new technology brings to the
capital markets. In order to be prepared for uncertainties, however,
new regulation must allow flexibility in deciding how to regulate the
markets of the future. RIBA believes that what in theory looks sound
may in practice be less advantageous to all market tiers.
Very little, if any, of the underlying philosophy and the practical
application driving the development of Regulation ATS concerned small
tier markets. Because ECNs were created to facilitate matching investor
orders, ECNs are not reliable liquidity providers. Rather, ECNs are
most efficient for the highly capitalized markets where there are large
numbers of both buyers and sellers. As a result, Regulation ATS
effectively discourages small broker-dealers from providing market
liquidity. It remains to be seen who will provide liquidity to the
lower tier capital markets during a sustained downturn. RIBA believes
this is a critical issue worthy of Congressional inquiry, as liquidity
often dictates whether a fair and orderly market may be maintained. For
many ECNs, volume comes largely from retail orders and it is
instructive to note that the current stock market boom is fueled by
retail investors. However, even in today's robust market, ECNs cannot
efficiently trade in the less capitalized markets, such as the Nasdaq
SmallCap market and the OTCBB, as small broker-dealers can. Given this
reality, it seems poor public policy to embrace a one-size-fits-all
approach to regulating all market tiers.
RIBA members report the one-size-fits-all approach has added to the
volatility discussed above. In addition, the current regulatory
environment has greatly reduced the number of RIBA underwritings.
According to RIBA statistics, the number of small underwritings has
declined precipitously from 190 offerings totaling $2.3 billion in 1994
to just 38 totaling $221 million in 1999.\8\
---------------------------------------------------------------------------
\8\ RIBA, 1993-1999 Underwriting Survey Totals.
---------------------------------------------------------------------------
It is critical for beltway policymakers to remember that small
underwriters and broker-dealers, not ECNs, provide the necessary
liquidity to the small issuer capital market through the comm' ment of
their own capital and through buying and selling activity. One of the
fundamental market principles is the obligation of market makers to
maintain fair and orderly markets in both rising and falling markets.
Market makers temper the price volatility of securities and preserve
market integrity by identifying over-valued and under-valued companies,
leading to pricing efficiencies in the market. This lower tier market
should be preserved and enhanced as new securities regulatory policy is
developed. Without support there is no market for these small issuers.
CURRENT ISSUES.
Fragmentation.
Assuring fair competition among market centers is a principal
objective for the national market system. Market centers (including
exchange markets, over-the-counter market makers, and ATSs) compete to
provide a forum for the execution of securities transactions,
particularly by attracting order flow from brokers seeking execution of
their customers' orders. One of the results of this fierce competition
among market centers, however, can be fragmentation of the buying and
selling interest for individual securities. Due in large part to the
regulatory reforms discussed earlier, market fragmentation has
stimulated healthy competition. In the past four years, several ECNs
and ATSs have successfully challenged traditional market centers and
offered improved efficiency to investors. This positive development has
yet to be realized by the lower tier markets. However, substantial
time, energy, analysis and regulatory resources have already been
expended to manage constructively the fragmentation of the top tiers.
RIBA believes a similar analysis and resources dedicated to the small
issuer markets is overdue.
For-Profit Exchanges.
Under its current structure, the Nasdaq Stock Market is owned by
the NASD, a nonprofit membership corporation with over 5,500 members.
In an effort to strengthen its financial position without significantly
burdening existing members, the NASD has announced plans to restructure
Nasdaq. Under the new regime, the NASD would retain a minority stake in
Nasdaq, while the majority would be owned by current NASD members,
security firms, issuers, buy-side firms, technology partners and the
public. Control over the new entity would shift from the NASD to its
new owners when Nasdaq is registered as an exchange with the SEC. The
new plan was approved by a membership vote on April 14, 2000.\9\
---------------------------------------------------------------------------
\9\ In reportedly the highest NASD member vote recorded, 4075
ballots were cast, 3423 in favor and 652 against the restructuring. See
Securities Week, April 17, 2000.
---------------------------------------------------------------------------
Any final plans will involve separating NASD-Regulation from the
for-profit market. In prepared testimony before the Senate Committee on
Banking, Housing and Urban Affairs on September 28, 1999, Frank G.
Zarb, the NASD Chairman explained that ``early in the process we
decided that an NASD-Regulation, independent from a for-profit
marketplace, was the best means of maintaining our high regulatory
standards.'' This view is consistent with that expressed by SEC
Chairman Levitt in a major policy address at Columbia Law School that
``strict corporate separation of the self-regulatory role from the
marketplace it regulates is a minimum for the protection of investors
in a for-profit structure.'' \10\ RIBA supports an independent Self-
Regulatory Organization (SRO) as long as the SRO is charged with
recognizing the inherent differences in the various market tiers. As
stated earlier, one-size-fits-all regulation can be very harmful to
small issuers andtheir shareholders.
---------------------------------------------------------------------------
\10\ Speech by Arthur Levitt, SEC Chairman, Dynamic Markets,
Timeless Principles, Columbia Law School (September 23, 1999).
---------------------------------------------------------------------------
Under a for-profit Nasdaq, RIBA is concerned about whether the
Nasdaq SmallCap market will receive the attention and resources it
deserves. Resources dedicated to small cap marketing and regulation in
a for-profit environment must take immediate priority. If the lower
tier markets suffer from benign neglect today, RIBA is very concerned
that in the future, small issuers and small broker-dealers will suffer
and eventually individual investors and the economy will be negatively
affected as well.
RIBA also notes that it is unclear whether the OTCBB market is
going to be part of the new Nasdaq or remain under the NASD. There has
been no announcement about the OTCBB's fate. In fact, the lack of
information about the role of the OTCBB in the Nasdaq demutualization
plan underscores RIBA's concern about the future treatment of this
market and its participants. The private placement memorandum
circulated to the NASD members prior to the vote contained just 69
words regarding the OTCBB. RIBA understands that the OTCBB is not the
catalyst for page one news stories of multinational business mergers.
Nonetheless, thousands of domestic small issuers rely on the OTCBB for
their public capital. Recently, these companies have been benefiting
greatly from the investments made by venture capital and angel
investors. If the NASD does not support the small tier market
sufficiently, small broker-dealers will continue to abandon the market,
potentially hurting small issuers, individual investors and the
economy. If that were to happen it remains to be seen what effect a
shrinking IPO market will have on all private equity financing in the
future. RIBA believes it is critical that the SEC and Congress require
the application of proper due diligence to such a fundamental
restructuring.
Market Data/Fees.
Market information fees are addressed most directly by various
provisions of the Exchange Act, all of which were added to the Act by
the 1975 Amendments discussed above.\11\ With the enactment of the 1975
Amendments, Congress granted the SEC flexible reign in overseeing the
establishment of a national market system for securities. Consistent
with the central market approach initiated by the SEC, the two
``paramount objectives'' of the national market system were ``the
maintenance of stable and orderly markets'' and ``the centralization of
all buying and selling interest so that each investor will have the
opportunity for the best possible execution of his order, regardless of
where in the system it originates.'' \12\ To achieve these objectives,
Congress recognized that ``communication systems, particularly those
designed to provide automated dissemination of last sale and quotation
information with respect to securities, will form the heart of the
national market system.'' \13\ The Amendment provisions are designed to
ensure the fair and reasonable dissemination of market information on
terms that are ``not unreasonably discriminatory.'' \14\
---------------------------------------------------------------------------
\11\ Pub. L. No. 94-29, 89 Stat. 97 (June 4, 1975). See Sections
6(b)(4), 11A(c)(1)(C), 11A(c)(1)(D) and 15A(b)(5) of the Exchange Act.
\12\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 7 (1975) (``Senate
Report'').
\13\ H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975)
(``Conference Report'').
\14\ Exchange Act, Section 11A(c)(1)(D).
---------------------------------------------------------------------------
Under the amended rules, national securities exchanges and national
securities associations must also allocate their fees equitably among
members. The legislative history of these provisions indicates
Congress' intent that the fees collected from everyone using an SRO's
facilities could appropriately be directed to funding the ``costs
associated with the development and operation of a national market
system.'' \15\
---------------------------------------------------------------------------
\15\ Conference Report, at 92.
---------------------------------------------------------------------------
In 1975, Congress found that new data processing and communications
techniques created the opportunity for more efficient and effective
market operations, and that the linking of all markets through such
data processing and communications facilities would increase the
information available to brokerdealers and investors. Congress was
particularly concerned about entities that would be exclusive
processors of market information to SROs. Unfortunately, Congressional
intent did not lead to the application of these improvements to the
lower tier markets. Thousands of small companies continue to trade
solely over the phone among market makers willing to commit risk
capital. While readily available, efficient technological innovations
have yet to be universally applied. RIBA believes that the SEC should
require a more equitable distribution of resources and technology.
As noted above, Congress did not include a strict, cost-of-service
standard in the Exchange Act, opting instead to allow the SEC some
flexibility in assessing the fairness and reasonableness of fees.
Nevertheless, the fees charged by service monopolies (such as the
exclusive processors of market information) need to be tied to some
type of cost-based standard to preclude excessive profits if fees are
too high and to prevent underfunding or subsidization if fees are too
low. RIBA believes that the total amount of market information revenues
should remain reasonably related to the cost of generating such market
information. Today that is not the case; small broker-dealers shoulder
proportionately higher costs which are in turn passed along to small
issuers and their shareholders. RIBA feels strongly that this is wrong
and should be corrected.
The cost of member regulation should not be considered part of the
cost of market information. The financial soundness of broker-dealers
is undoubtedly an essential factor in the overall integrity of the
markets; however, the connection between regulatory oversight of market
integrity and the quality of market information is much more attenuated
than in the case of market operation and market regulation.\16\ An
SRO's member regulation costs are more directly associated with the
regulatory fees charged to members than with any other source of
funding. Also, the cost of market information should omit costs that
are directly associated with other SRO services, such as advertising
and marketing expenditures to obtain corporate listings.\17\ This
segregation is essential in today's highly competitive environment.
Failure to segregate will continue to disadvantage the small regional
firms unfairly.
---------------------------------------------------------------------------
\16\ See Regulation of Market Information Fees and Revenues,
Securities Exchange Act Rel. No. 34-42208; File No. S7-28-99 (December
9, 1999).
\17\ Id.
---------------------------------------------------------------------------
The arrangements for disseminating market information should be
modified in several respects. RIBA's review of its membership has
indicated the importance of adapting market information fees to the
increasing retail investor demand for real-time information and to the
changing structure of the securities industry. RIBA endorses the
concept of a flexible, cost-based approach to evaluating the fairness
and reasonableness of such fees and revenues. SROs should provide
greater public disclosure of their fees, revenues and costs. The same
standards of disclosure enforced by the SROs should be applied to the
SROs. Furthermore, vendors, broker-dealers and users of market
information should participate in the process of setting and
administering fees. Failure to seek a more open process will continue
the effective isolation of RIBA member interests.
Since the enactment of the 1975 Amendments, the SEC has relied
primarily on consensus among the SROs and the securities industry to
resolve issues concerning market information fees and revenues. RIBA
believes that recent changes in the securities markets may require a
revised approach that provides greater guidance to the SROs and the
rest of the securities industry. The advent of for-profit SROs, whose
financial objective will be generating profits for their owners, could
result in increased pressure to raise fees and revenues and to cut back
on costs not directly associated with a source of revenue. RIBA
believes that SRO fees and financial structures may warrant increased
oversight by the SEC. RIBA members are very concerned that failure to
do so may result in regional firms being priced out of the market due
to open-ended fee increases.
Since market information fees cannot be unreasonably
discriminatory, any disparities in fees should be justified by such
legitimate factors as differences in relevant costs or degree of
use.\18\ RIBA believes it is important to recognize that the basic
information stream will be the same, and will have the same production
costs, no matter how many vendors and subscribers receive the
information. As the SEC states in its market data release, ``although
there may be differences in costs of disseminating information to
different categories of vendors and subscribers (such as the costs of
administering a fee structure), it is vendors and broker-dealers who,
for the most part, bear the costs of receiving the data stream and
passing it on to individual subscribers. These redistribution costs are
not appropriately incorporated into a fee structure.'' \19\
---------------------------------------------------------------------------
\18\ Id.
\19\ Id.
---------------------------------------------------------------------------
In order to assure the wide availability of market information,
individual SRO fees should be evaluated in terms of the objectives of
the national market system. RIBA feels that market data fees should not
be set at levels that effectively restrict the availability of real-
time information. The current effect is anticompetitive and
disadvantages the smaller firms.
Fee structures often include various discounts that are based on
the size of the subscribing firm or on whether the firm is a member of
an SRO that participates in the particular network.\20\ RIBA believes
these discounts are inconsistent with the Exchange Act objective that
exclusive processors of information should remain neutral in their
treatment of firms and customers. Once again, disparities in fees
should be Justified by such legitimate factors as differences in
relevant costs, degree of use, or quality of service. Market data
providers should demonstrate that the size of the discounts corresponds
with the size of the relative difference in administrative costs.
Today's discounts clearly benefit the largest broker-dealers at the
expense of RIBA members. Additionally, the proportionally inflated fees
paid by RIBA members subsidize the top tier markets. RIBA feels the SEC
should address this inequity. Ultimately these unique costs are
partially subsidized by the issuers and their shareholders.
---------------------------------------------------------------------------
\20\ Id.
---------------------------------------------------------------------------
RIBA is also concerned about the anti-competitive fees that ECNs
charge non-subscriber users to access their quotes through Nasdaq.
Nasdaq market makers do not charge access fees. In order for a broker
to comply with his best execution duties it may be necessary to access
the NBBO that is quoted on an ECN and pay the access fees. We feel, and
SEC Chairman Arthur Levitt has agreed, that the ECNs should apply
uniform charges to subscribers and non-subscribers alike eliminating
the access fees.\21\ Today's regulatory regime is anti-competitive and
anti-small business.
---------------------------------------------------------------------------
\21\ See Speech by Arthur Levitt, SEC Chairman, Dynamic Markets,
Timeless Principles, Columbia Law School, (September 23, 1999).
---------------------------------------------------------------------------
After-Hours Trading.
On October 25, 1999, Nasdaq began a voluntary pilot program
extending the availability of the Nasdaq quotation, trade reporting and
communications until 6:30 p.m. Eastern time. As of February 7, 2000,
Nasdaq calculates and disseminates the inside market. Firms were
initially called upon to input trade reports voluntarily on a real-time
basis for trades occurring between 5:15 and 6:30 p.m. Real time
reporting became mandatory as of November 15, 1999. Although the
application of SEC and Nasdaq rules on the handling and protection of
limit orders was temporarily deferred until December 6, 1999, the rules
are now in effect during the extended trading hours. RIBA members
report that the practical effect is that lower tier market liquidity
does not support after-hours trading. RIBA members who keep their
trading desks open in after-hours sessions are forced to assume
operating costs without the likelihood of offsetting revenue.
On October 8, 1999, three working groups delivered reports on
issues relating to extended trading hours: the Committee on Investor
Protection and Education (CIPE), the Committee on Clearance, Settlement
and Operations (CCSO) and the Working Group on Trading Conventions
(WGTC). Unfortunately small, regional broker-dealers were not
represented on these committees. The reports of these groups
highlighted some of the issues that extended hours trading may present.
CIPE, for example, emphasized ``complete and full disclosure of the
nature and risks of extended hours trading for investors,'' and urged
``that best practices be adopted industrywide.''
CIPE also noted that the risks of extended hours trading include
lack of liquidity, volatility, fragmentation of the market, impact of
news announcements and the lack of depth and breadth in the extended
hours markets expected initially. CIPE suggested that investors should
actively be required to ``opt-in'' to extended hours trading.
Nasdaq's foray into extended hours is directed, in large part,
toward West Coast customers and traders. Although its after-hours entry
had little effect on the first night (Nasdaq reported only 27,000
shares traded compared to the 933 million shares traded overall that
day) it is anticipated that the volume will grow despite limited and
costly access. Many ECNs currently operate even longer hours, including
at least two ECNs that operate 24 hours a day. Small broker-dealers are
often unable to compete because of staffing costs associated with
keeping extended hours. Unfortunately, the SEC failed to consider
adequately the negative effects on small issuers and small broker-
dealers that arise when investors lose money because of price swing in
less liquid stocks traded after hours. Stung by their losses, investors
are more likely to avoid the after-hours market, thus injuring the
liquidity of some small businesses.
Solutions.
The SEC's attention to market fragmentation derives from its
commitment to the interests of investors pursuant to Section 11A(a)(1)
of the Securities Exchange Act of 1934.\22\ The market ideally should
offer the greatest opportunity for interaction among buyers and sellers
while encouraging fair competition among market centers. Fairness and
efficiency translate into reduced transaction costs and more accurate
pricing of securities. This time-honored goal must be applied to all
market tiers. The SEC must expand its analysis and consider the
opportunities for markets servicing small issuers.
---------------------------------------------------------------------------
\22\ Section 11A(a)(1) reads: ``The interests of investors (both
large and small) are preeminent, especially the efficient execution of
their securities transactions at prices established by vigorous
competition.''
---------------------------------------------------------------------------
Fragmentation can occur when market forces combine to isolate
investors' orders and hamper price competition. The potential decrease
in liquidity and increase in price volatility deprive investors of the
benefits of fairness and efficiency. The market currently addresses
fragmentation in three major ways: (i) price transparency, (ii)
intermarket links to displayed prices, and (iii) the brokers' duty of
best execution.
Price Transparency.
Price transparency is an essential component of a unified national
market system. All significant market centers are required to make
available to the public their best prices and the size of the order
associated with those prices.\23\ The market centers provide quote and
trade information through central processors that are responsible for
collecting and disseminating the market information for different types
of securities. The processors consolidate the information of individual
market centers, determine the NBBO and distribute the information to
broker-dealers and information vendors who make the information
available to the public. Due to the lack of dynamic quotes and the
absence of electronic order execution, these technological advances
improving transfers have yet to reach the OTCBB.
---------------------------------------------------------------------------
\23\ See, e.g., Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1;
Exchange Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4; NASD Rule 4613; NYSE
Rule 60.
---------------------------------------------------------------------------
Linkages.
ITS and SelectNet.--As noted above, one component of the national
market system designed to address fragmentation is the establishment of
systems that link the various market centers and provide access to the
market center with the best displayed prices. The Intermarket Trading
System (ITS) was created under the NMS Plan as an attempt to link the
country's then existing markets. The ITS linkage handles a relatively
small proportion of trading in listed equities. In September 1999, for
example, ITS volume represented 2.2% of total NYSE-listed trades.\24\
The ITS linkage has weaknesses that must be addressed, including
restricted ECN access and slow and inefficient execution procedures.
---------------------------------------------------------------------------
\24\ Securities Exchange Act Release No. 34-42450; File No. SR-
NYSE-99-48; Proposed Rescission of NYSE Rule 390 Commission Request for
Comment on Issues Relating to Market Fragmentation; (February 23,
2000).
---------------------------------------------------------------------------
In recent speeches, SEC Chairman Levitt stated that the SEC is
considering ways to address the problem of market fragmentation: ``At
the Commission, we know well that ITS has not kept pace with the
technological changes sweeping our markets. Its archaic structure and
cumbersome governance provisions are not fit for today's market, let
alone the market of the future.'' \25\ Such inefficient governance has
led to stagnated technology, requiring private market-based trading
systems to address inefficiencies. The growth of alternative trading
systems such as ECNs has occurred outside of ITS.
---------------------------------------------------------------------------
\25\ Arthur Levitt, Chairman SEC, ``Visible Prices, Accessible
Markets, Order Interaction'', Northwestern School of Law, (March 16,
2000).
---------------------------------------------------------------------------
On December 8, 1999, the SEC took the first step toward reforming
market linkage with the adoption of an amendment ITS plan, expanding
the ITS/Computer Assisted Execution System (CAES) linkage to all listed
securities. The amendment allows all members of ITS to trade non-Rule
19c(3) listed securities \26\ thus enabling non-exchange members of ITS
\27\ to trade in listed securities. This amendment also paved the way
for the admission of ECNs into the ITS, enabling ECNs to trade all
listed securities while linked to each other and to the exchanges. On
March 16, 2000, the SEC approved the NASD proposal allowing ECNs to
become part of CAES and therefore linked with ITS. In reaction to these
attempts at reforming ITS, the NYSE has recently proposed to withdraw
from ITS. Though ITS may not be the ideal form of market linkage, RIBA
believes that the NYSE must play a central role in any future National
Market System linkage plan and so recommends that the SEC reject any
unilateral withdrawal by the NYSE.
---------------------------------------------------------------------------
\26\ Non-Rule 19c(3) listed Securities are those listed pre-April,
1979 and subject to NYSE Rule 390.
\27\ Third Market Makers such as Trimark Securities and Madoff
Securities.
---------------------------------------------------------------------------
The market centers that trade Nasdaq equities currently are linked
by the NASD's SelectNet system, by telephone and through private links.
In September 1999, approximately thirty percent of trades in Nasdaq
equities were routed through SelectNet, a sharp reduction from just
five years ago. Chairman Levitt stated that SelectNet continues to be
plagued with shortcomings, delays during heavy trading volume, and even
outages. Given the decentralized nature of the Nasdaq market, this is a
critical and core flaw--and one that must receive intense scrutiny and
committed resources until resolved.\28\ The SEC recently approved a
proposed rule change by the NASD to establish a revised order delivery
and execution system-the Nasdaq National Market Execution System
(NNMS).\29\ The new system, also known as Super-SOES, will consolidate
the Small Order Execution System or ``SOES'' and SelectNet and allow
delivery against the best prices displayed in the Nasdaq Display
Window. Customers will enjoy virtually instant automatic executions
against market maker quotes. The system will provide, among other
things, automatic execution for customer and market maker orders up to
9900 shares. Once again, it appears to RIBA that the new rules and new
system have been developed for the top thirty percent of the Nasdaq
participants only.
---------------------------------------------------------------------------
\28\ Id.
\29\ Securities Exchange Act Rel. No. 42344 (Jan. 18, 2000), 65 FR
3987.
---------------------------------------------------------------------------
RIBA believes that any proposals regarding linkages should be
concerned with the entire range of securities in the markets, not just
the very top tier of actively-traded issues. The relevant question is
whether the efficiency of the markets for all or any particular
category of securities could be substantially improved through market
structure changes. Ultimately, only fair and vigorous competition can
be relied upon to set efficient prices.
The advent of decimal pricing introduces another example of the
inherent differences among market tiers. The current momentum
surrounding the conversion to decimal pricing in the most liquid
stocks, is certainly warranted. While most experts agree that decimal
pricing will substantially reduce spreads, perhaps down to a penny in
the most liquid stocks, RIBA suggests that in the lower tier markets
its effects may be unforeseen. A pilot program in the lower tier
markets may be a constructive first step in evaluating the impact of
decimal pricing in the lower tiers.
At present, there is no linkage of quotations or trading on the
options markets. This deficiency impairs the price discovery mechanism
and makes it difficult for brokers to get the best price for their
clients, particularly in light of the increased dual listing of
options. This is particularly difficult for regional firms with fewer
resources and strategic business partners. SEC Chairman Levitt has on
several occasions called for a linkage between the options markets, and
has imposed a deadline on the options exchanges to come up with a
plan.\30\ An integrated options trading market should present an
opportunity for increased competition for regional broker-dealers.
---------------------------------------------------------------------------
\30\ See e.g. Speech by Arthur Levitt, SEC Chairman, Dynamic
Markets, Timeless Principles, Columbia Law School, (September 23,
1999). See also, Securities Exchange Act Rel. No. 34-42456: File No. 4-
429 (February 24, 2000).
---------------------------------------------------------------------------
Central Limit Order Book.--As a result of the tension between
encouraging competition and having a centralized marketplace, the SEC
has called for a study of centralization of order flow through a
centralized limit order book.\31\ Some proposed market structure
reforms would hurt small broker-dealers who engage in underwriting and
market making. One such proposal is the centralizing of all trading in
one system, what is sometimes referred to as a time-priority central
limit order book, or CLOB. The CLOB would be fully transparent to all
market participants. In other words, the public would have access to
all CLOB orders and quotations, including the size of transactions and
the identity of the investor. Market makers would only be able to trade
as a principal if they provided price improvement to the CLOB listings.
---------------------------------------------------------------------------
\31\ Securities Exchange Act Rel. No. 34-42450, File No. SR-NYSE-
99-48, Proposed Rescission of NYSE Rule 390 Commission Request for
Comment on Issues Relating to Market Fragmentation, (February 23,
2000).
---------------------------------------------------------------------------
The prospect of transforming our markets into a single ``black
box'' does not recognize the important role market makers play in the
securities markets, especially the smaller, less liquid securities. In
testimony before the Senate, the NASD voiced its disapproval of the
CLOB system:
Because the Nasdaq system provides incentives for market makers
to continuously display quotations and provide immediate
guaranteed executions in size to investors, it has been able to
respond to the revolutionary demands of the online trading
world. On the other hand, mandatory CLOBs and system wide time
priority requirements do not effectively incorporate or incent
the multiple market makers who now provide liquidity and
immediate executions on Nasdaq, and who thus cushion the market
when it is under stress.
As stated earlier, market makers provide liquidity to the market by
guaranteeing executions to their customers at the inside market price
or better, often at low cost. The willingness of market makers to
provide investors with access to guaranteed executions is critical to
the ability of the entire dealer market to respond to the extraordinary
demands of today's trading. While proponents argue the CLOB would
certainly encourage maximum interaction among orders, it will likely do
so at the expense of competition. Faced with one centrally planned
structure, market participants may lose any incentive to upgrade or
create new technologies. Furthermore, the CLOB's inclusion of
information such as transaction size and investor identity may favor
professionals and institutional investors with ``time and place
advantage'' over retail investors.\32\ RIBA is concerned that the CLOB
will allow professionals and institutional investors, who regularly
monitor trading activity literally second by second, to place retail
investors at a disadvantage by mobilizing vast amounts of capital
instantaneously. Individual investors comprise the overwhelming
majority of RIBA members'customers. RIBA opposes market initiatives
that disadvantage individual RIBA clients.
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\32\ See Regulatory Costs in the Financial Marketplace of the
Future Before the Senate Comm. of Banking, Housing, and Urban Affairs
(Feb. 29, 2000) (testimony of Charles R. Schwab, Chairman and CEO of
Charles Schwab & Co., Inc.).
---------------------------------------------------------------------------
NASD Electronic Order Display Window.--On November 22, 1999, the
NASD filed a rule change about Nasdaq's proposal for a new and
``revolutionary'' order display window to be launched this summer,
assuming SEC approval.\33\ The new window based on the NNMS operating
system was designed to respond to the increased fragmentation and loss
of transparency resulting from having multiple, competing market
centers. Nasdaq expects that this change will make trading Nasdaq
shares more fair and efficient by giving investors a more complete
picture of prices gathered from exchanges, market makers and ECNs.
---------------------------------------------------------------------------
\33\ Securities Exchange Act Release No. 34-42166 (Nov. 22, 1999),
64 FR 69125.
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The new system, sometimes referred to as Super-Montage, will
utilize the recently approved Super-SOES system and allow delivery
against the best prices displayed in the Nasdaq Display Window. As with
other new linkage proposals discussed above, the new system has
developed according to considerations of the top tier markets only.
Broker's Duty of Best Execution.--In accepting orders and routing
them to a market center for execution, brokers act as agents for their
customers and owe them a duty of best execution. The duty, which
derives from common law agency principles and fiduciary obligations, is
incorporated both in self-regulatory organization rules and, through
judicial and SEC decisions, in the antifraud provisions of the federal
securities laws. The duty requires a broker to seek the most favorable
terms reasonably available under the circumstances for a customer's
transaction.\34\
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\34\ Securities Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 FR
48290 (``Order Handling Rules Release''), Section III.C.2.
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A broker's duty of best execution applies to both customer market
orders and limit orders. Although obtaining the best price is the
single most significant factor with respect to market orders, limit
orders are a different story since they are sensitive to both time and
price. The duty of best execution is therefore not fulfilled
automatically by guaranteeing execution at the NBBO.\35\ For example,
brokers should consider opportunities for ``price improvement.'' or
execution at a better price than the NBBO, when routing customer
orders.\36\ Other factors, such as cost, the availability of accurate
information and the historical characteristics of the particular
security involved all affect the ability to provide best execution.\37\
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\35\ See id. at n.360 and accompanying text.
\36\ See id. at nn.356-57 and accompanying text.
\37\ SEC, Report oil the Practice of Preferencing (April 11, 1997)
(``Preferencing Report''), at 89 n.207.
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RIBA is most concerned that the best execution standards
articulated by the SEC are ambiguous. This problem is especially acute
for small broker-dealers specializing in thinly traded stocks and
dealing primarily with retail orders. RIBA believes the SEC should
clarify the Rules and specify the definitions as applied to best
execution for the lower tier markets. Clarity will ensure greater
compliance, avoid creating traps for the unwary and, ultimately, serve
the investor well.
The Super-SRO.--Securities markets are now facing the question of
how to perform SRO functions after demutualization of the exchanges.
While SEC Chairman Levitt did not take a definitive stance on this
topic, he has suggested the intriguing idea of having a single
regulator for general issues such as net capital, financial
responsibility, sales practices, etc., while allowing the exchanges to
continue to regulate their own trading markets.\38\
---------------------------------------------------------------------------
\38\ See Speech by Arthur Levitt, SEC Chairman, Dynamic Markets,
Timeless Principles, Columbia Law School, (September 23, 1999).
---------------------------------------------------------------------------
The SEC has made it clear that strict corporate separation of the
selfregulatory role from the marketplace it regulates is a minimum
threshold for SEC approval of for-profit exchanges. The form this will
take is open to several possibilities. One would have each market be
similar to the current NASD structure in which NASD-Regulation is a
separate entity within the NASD holding company. There is also the
possibility of one ``Super'' SRO for all the markets. Another hybrid
model would allow each market to maintain its own regulatory (i.e.,
trading rules) and surveillance function, while a single SRO would
oversee member regulation, sales practice and intermarket trading.
Whatever the model, the SRO must be adequately funded. RIBA also
cautions regulators to consider the potential for large firms to
dominate the self-regulatory process in a new market structure. Under
the influence of large firms, for-profit SROs could raise the costs of
regulation to levels which would force small firms out of the industry.
In addition, RIBA is concerned that large firms could also dominate the
rule-making process resulting in impractical and unfair rules as
applied to the lower-tier markets and the firms that service those
markets.
CONCLUSION.
In the past few years, technology and regulatory changes have
caused rapid, dramatic and unprecedented changes in the equity trading
markets. Online trading, real time access to stock quotation, volume
and trade execution data, a proliferation of ECNs and extended trading
hours are transforming the equity markets faster than ever before.
Changes in demographics are resulting in a larger pool of retail
investors with more money to invest. This democratization of the U.S.
stock markets has led to an explosive cash flow into the market.
Increasing globalization is encouraging more foreign companies and
investors to trade in the U.S. markets and forging greater numbers of
international alliances and ventures.\39\
---------------------------------------------------------------------------
\39\ Speech by Frank Zarb, Chairman and CEO of the NASD, The Coming
Global Digital Market (June 23, 1999).
---------------------------------------------------------------------------
While all of these developments are worthy of appropriate
regulatory reforms, the highly successful dealer market servicing small
issuers must not be sacrificed. Too often, however, regulatory reforms
have been shaped almost exclusively by analyses of the top tier of the
market consisting of the most actively traded securities in the U.S.
equities markets. Although the consequences are unintended, the lower
tier continues to suffer from this regulatory benign neglect.
The potential erosion of the small issuer equity market is a
growing concern for small business entrepreneurs in every region of the
country. Failing to consider the contribution of lower tier markets
will stifle precisely the kind of new growth and innovation that is
sustaining and expanding our current booming economy. Small issuers
have recently enjoyed an enormous increase in the funds received from
venture capital firms and so-called angel investors who have made seed
capital investments in anticipation of an IPO as their investment exit
strategy. These angel investors often evaluate companies less on their
long-term growth capabilities than on their short-term IPO prospects.
If changes in market structure adversely affect the small cap markets
and the market makers' ability to serve them, the venture capital
stream will likely dry up. Further, if market structure reforms harm
the broker-dealer community the result may have a chilling effect on
small business capital formation.
Respectfully, RIBA would like to make several suggestions for
Congressional and regulatory policymakers to consider.
First and foremost, RIBA implores Congress, the SEC and the SROs to
consider carefully and completely the impact of all rules, regulations
and policy proposals on the lower tier markets. It has been RIBA's
experience that when considering regulatory changes effects on all
market tiers are not fully considered. As noted above, these less
liquid, more volatile markets have distinct needs and service a
critical aspect of our entrepreneurial industries.
Second, the spate of recent proposals for new market linkages and
execution forums should prompt an examination of the practical impact
on the lower tier markets. Regulatory policymakers must ask whether the
future of ITS, SelectNet and Super-SOES will provide appropriate
applications for small market makers to compete effectively with their
large counterparts.
Third, the concept of a single centralized market such as a CLOB
also raises concerns for individual investors that may be handicapped
by institutional investors who are able to dominate markets by
mobilizing vast amounts of capital instantaneously.
Fourth, as discussed earlier RIBA recommends establishing a small
issuer capital market task force to evaluate and shape market reform
proposals unique to the small issuers. RIBA is willing to take an
active role in establishing the task force and is committed to working
with the regulators, market practitioners, the issuer community and
investors to make specific recommendations for constructive reforms.
Fifth, RIBA urges the SEC to clarify its best execution standards
and specify their applications to the lower tier markets. As new
technologies continue to transform the markets, it is imperative that
regulations provide concise guidelines.
Last, RIBA would like to thank Chairman Oxley and Ranking Member
Towns for the opportunity to testify on these critical issues. RIBA
commends the full Committee and its Staff for reaching out and
soliciting the views of the small broker-dealer community. We hope that
your leadership in creating a more inclusive debate becomes the
standard rather than the exception.
Mr. Oxley. Thank you. Thanks to all of the panel.
The Chair will recognize himself for the first round of
questions.
The fragmentation issue comes up time and time again. I
think it is worthy of some discussion. Many people say that
``fragmentation'' is just another word for ``competition.''
Why should we fight fragmentation? Don't we really have
fragmentation breaking out all over the place, and if it
appears to be competitive in nature, what is really wrong with
that?
Let me begin with Mr. Atkin.
Mr. Atkin. Thank you, Mr. Chairman.
I would say, looking on the fragmentation issue, it is in
some ways very complex and in some ways very simple. Looking at
it one way within Nasdaq, you could say there is a lot of
fragmentation, that there are multiple ECNs, multiple market
makers, et cetera. I would argue that Nasdaq has 100 percent
market share within its stocks, that all ECNs have to operate
presently within Nasdaq, and there is no alternative but for
anyone who wishes to trade Nasdaq stocks to go through the
Nasdaq infrastructure.
Mr. Oxley. Let me interrupt then, because at least at first
blush it would appear that the Super Montage could be
considered a central limit order book. Is that your cut on
that?
We will give Mr. Ketchum a chance.
Mr. Atkin. It is certainly our view that the Nasdaq Super
Montage is really an ECN. It is Nasdaq, in essence building a
competing ECN, and the ECNs themselves are forced to operate
under Nasdaq's infrastructure.
I think it would be like FedEx and UPS being forced to go
through the postal delivery system. We are forced to go through
the Nasdaq infrastructure, and what we believe is, they are
building their own competitive system, which will have the
likely effect of draining liquidity out of the ECNs into a less
transparent marketplace.
Mr. Oxley. Mr. Ketchum, do you have a different view on
that?
Mr. Ketchum. Well, probably a little bit, I guess.
Chairman Oxley, to get to your question first, no, I don't
think Super Montage is anything like a composite limit order
book. It is an effort to recognize, particularly as we move,
and positively so, to a decimalized small increment world that
is showing simply the consolidated best bid and offer is of
limited value, that in order to understand what is happening in
the market, you need to understand something, the depth going
around both above the market and below the market.
It is not intended to either compete directly or replace
ECNs. ECNs will continue to be the place that provides a
separate, anonymous opportunity to allow buyers and sellers to
connect, to match orders beforehand and the like. What we think
this will do is provide more substantial depth and transparency
to the market.
We do recognize that these orders are the orders of ECNs
and market makers. They should receive compensation with
respect to it, and we expect to share both fees and tape data,
because we think that is the appropriate and fair way to do it.
With respect to Doug's thoughts with regard to a single
infrastructure, it is true that based on the SEC's order
handling the rules, not on any NASD rules, if ECNs want to
provide an environment where market makers show better prices
anonymously than they do in their quote, that they must be
linked into Nasdaq in two ways. Both from the standpoint of
having their best quotes disseminated in the system and in
providing a linkage so that people who are not participants in
that ECN have an ability to access the best price.
I think those two reforms by the SEC allowed us just in the
nick of time to avoid a two-tier market environment and avoid a
situation where institutions had access to better prices and
liquidity than individual investors.
So while I think, in fact, ECNs have plenty of choices in
the markets, I think there does need to be sufficient linkage
to assure that individual investors are treated the same way as
institutional investors.
Mr. Oxley. Does anybody else want to comment on the
fragmentation issue, as well as the Super Montage?
Mr. Wheeler. I would like to say a couple of things.
Our current view of Super Montage is flawed in a couple of
ways. The current proposal, as I understand it, is to display
three levels of price through the book. There is no trade-
through protection to address some of the issues that Holly
spoke of. A retail investor, willing to display a limit order
at a particular price, has no protection that that limit order
will be executed against, as a lot of stock may trade at that
particular price without an execution due to that customer. It
creates a single point of failure.
We have had that experience in the past with Nasdaq, the
infamous squirrel that took the system down 10 years ago, and
the arbitrary delays that Super Montage imposes on the rest of
the marketplace.
As it is written right now, the way I understand it, the
market maker would have up to 5 seconds to decide whether they
want to execute against an incoming order or simply get out of
the way and let that order go on through the system. We are not
in favor of anything like the 5-second rule as it stands right
now.
Mr. Oxley. My time has expired. We will get back to some
other issues.
Let me now recognize the gentleman from Michigan, Mr.
Stupak.
Mr. Stupak. Thank you, Mr. Chairman. Thank you for holding
this hearing.
Mr. McSweeney, could you elaborate on the New York Stock
Exchange concern about CLOB? How would this affect the retail
investor?
Mr. McSweeney. The problem we have regarding the CLOB is
multifaceted. The major concern that we have is the fact that
none of the proponents of a CLOB could describe how the large
order flow would be handled in that type of an environment.
The CLOB is basically an environment in which you would
nationalize the marketplace. All limit orders would be
displayed and executed automatically in terms of strict price-
time priority. But there was a recognition by each of the
proponents that large-size orders would have to be executed
outside of the consolidated limit order book because there
would not be sufficient liquidity, and those orders would not
be fully disclosed because the market impact would result in
the market moving away from those disclosed orders. Therefore,
you would have an environment in which there would be less
transparency.
Approximately 50 percent of the NYSE's volume and about 45
percent of the consolidated volume is represented by
transactions of 10,000 shares or more. You would extract that
order flow from the price discovery process; it would result in
a widening of the bid and offer spreads. Therefore, it would
increase volatility by the widening of the spreads and the fact
that there would be no specialties function in it; and it also
would dampen intermarket competition based upon the strict
price-time requirements of the CLOB.
Actually, there was no agreement among proponents of the
CLOB exactly how that should be structured.
Mr. Stupak. Could the CLOBs then do a two-tier system, like
one system for institutional and one system for retail
investors?
Mr. McSweeney. If they did that, Mr. Congressman, what
would take place is, you would have a significant diminution of
the liquidity and price discovery process that takes place now.
You would extract a significant portion of the price discovery
represented by larger orders from that process, and it would
result in more volatility and less efficient markets.
Mr. Stupak. Does the payment for order flow hurt the retail
investor, the order flow?
Mr. McSweeney. I believe it does, because payment for order
flow is a practice that does not include rebating that payment
to the ultimate customer, and it is closely aligned with
internalization; and internalization is a serious concern,
despite the fact that we have 83 percent market share. The fact
that a percentage of that involves internalized order flow
where public orders are not afforded the benefit of the price
discovery process and the potential for price improvement is a
concern, particularly the fact that we have recently eliminated
Rule 390. And we were gratified to see in the SEC's release
that approved removal of 390 that the SEC would be monitoring
closely any significant change in order direction by member
firms that would involve internalization.
Mr. Stupak. Is your concern about the CLOBs related to your
concerns about payment of order flow, or are they separate
issues?
Mr. McSweeney. No, Mr. Congressman, that is a separate
issue. The issue is really one in which we believe that a
market structure that would nationalize the securities industry
would not promote competition, that would seriously impact
liquidity of the market; and as I mentioned, the most serious
impact would be bifurcating the institutional and the retail
order flow and the price discovery process.
Mr. Stupak. Thank you.
I have nothing further, Mr. Chairman.
Mr. Oxley. The gentleman's time has expired.
The Chair now recognizes the gentleman from Pennsylvania,
Mr. Greenwood.
Mr. Greenwood. Thank you, Mr. Chairman. I am going to
address the question to my constituent, Mr. Kamen.
Can you be specific about--what regulations that are in
place now do you think are limiting the ability of investors in
the small cap issue market from fully benefiting from
technology, if there are such regulations?
Mr. Kamen. Well, a lot of it has to do with the systems. In
the lower-tier markets, mainly the OTC bulletin board, there is
no automatic execution electronically the way it happens in the
upper tiers. The Instanets and the ECNs don't practice in those
markets. As a matter of fact, I had discussion with Mr. Ketchum
earlier that that is on the horizon.
I think the problem we face in the lower-tier markets is
that many of of the suggestions and policies that have been
kicked around and adopted have all been done with the
consideration of the largest tier of the marketplace. What is
good for Microsoft might not necessarily be good for a stock
trading at $4 or $5 or $10. Nor would one would argue that
liquidity is the driving factor of all securities. And in the
lower-tier markets, where liquidity tends to be less by the
average daily volume of the securities, making rules that only
look at the ramifications of the most liquid securities leaves
the potential for a lot of unforeseen consequences in the lower
tier.
I think that is the overall picture that makes the most
damage to the smaller cap market, and that is why we need to
take a look every time we want to change something and do an
analysis of how that will affect the smaller cap stocks.
Mr. Green. Aside from coming and testifying here, what is
necessary to get you and the folks you represent at the right
table, besides this one, in order not to be left behind and be
not considered?
Mr. Kamen. I would certainly love for the NASD and the
regulators to formally adopt, whether it is a small issue task
force or in some other type of venue, to allow the voice of the
smaller markets to be heard. I mean, realistically, our issues
don't tend to be front page news. I mean, we are not
multinational and we are not trading 20, 30, or 50 million
shares a day. Our companies tend to trade 200-, 300-, 400,000
shares a day, and in some cases, 800,000 shares a day. I think
everyone needs to recognize that our voice must be invited to
the table, and we need to have specific debate on these issues,
starting with these types of things, and at the NASD; that
would be most helpful.
Mr. Green. Would any of the other panelists like to comment
on that?
Ms. Stark. Thank you. My firm manages microcap and small
cap assets, and in fact, I do trade bulletin board stocks and
ECNs right now. They are different animals than are the
Microsoft and Dells of the world, and they are predominantly
Nasdaq-listed stocks.
I would have great difficulty indeed executing without
ECNs. The benefit of using ECNs is, especially in fast-moving
markets, the interlinkages they have created among themselves,
so that I can access other ECNs or bids and offers by broker-
dealers who might be active in those names. In fact, there are
lots of names that we have that don't even open on any
particular day.
But the dilemma is a real one, and we certainly would not
want to do anything that would discourage or hamper trading in
them further. But it is a reality right now, and I don't think
that anything being proposed today, and especially in Super
Montage, is going to hurt trading of the small and microcap
stocks. In fact, I think it will enhance it.
Mr. Ketchum. Congressman Greenwood, I would just say that I
think Mr. Kamen makes some very sound points. We always try to
look, but it is always helpful to get greater input from
interested parts of the constituency of the impact on different
parts of the market. We do have a Small Firm Advisory Board. I
think the concept of a Small Issuer Advisory Committee is a
sound one we will look very closely at.
I think Holly Stark makes a excellent point. I think that
support of the marketplace will be enhanced if there is greater
ability to display orders, and as indicated by Mr. Kamen, if
there is an ability to provide more efficient execution and
order routing systems than exist in the bottom tier of the
market. We are committed to do that, and committed to ensure
that this market is as liquid as possible.
Mr. Atkin. I would like to add a comment, Mr. Congressman,
and that would be, currently we are trading about 70 million
shares a day of bulletin board stocks, and I believe on Nasdaq
they are trading in the--700 or 800 million shares a day. We
certainly view the OTC bulletin board sector as an opportunity,
as a big opportunity, to help lower costs for investors by
providing an electronic means for investors to match stocks.
I also think that does need to be complemented by those who
do wish to commit capital. I think a lot of what we are talking
about today is, should people get privileges for committing
capital to retail investors? And really, what is going on in
many of the markets, markets where the big American firms seem
to be doing very well, is that their capital commitment
providers do not get any privileges.
I think, as most of the buy-side participants have been
saying, that orders have price-time priority, and if you wish
to commit capital, you must satisfy--whether it is a retail
investor's order or an institutional investor's order--first
before committing your capital; and people are finding it very
profitable to do it in that environment.
So we think it is important for both to occur, but not to
advantage and give privileges to those who commit capital over
individual investor's orders or institutional orders.
Mr. Oxley. The gentleman's time has expired.
Mr. Stupak. Could we have unanimous consent to enter
opening statements in the record?
Mr. Oxley. Yes, it has already been done.
The gentleman from Chicago, Mr. Rush.
Mr. Rush. Thank you, Mr. Chairman. On May 4, 2000, the SEC
released a report of a special study by both the Office of
Economic Analysis and the Office of Compliance, Inspection and
Examination, regarding the display of customer limit orders.
Mr. Chairman, I ask unanimous consent that this report be
included in the record.
Mr. Oxley. Without objection.
[The report follows:]
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Mr. Rush. Mr. Chairman, the report reveals the problems and
violations in the display of limit orders in equities and
options markets and the inadequacies in the market's
surveillance and disciplinary programs for limit order display.
The violations include failures to display proper order size,
failure to display orders within 30 seconds after receipt, and
failure to properly transfer the order display obligation to
another exchange system or members.
As a matter of fact, Chairman Levitt said, ``Limit orders
have been a powerful force for competition in our markets,
narrowing spreads, increasing transparency, and supplying
liquidity.'' He went on to say, ``Their effect on the price-
setting process simply cannot be compromised.''
These are strong words and they are troubling findings.
We have heard testimony today about the importance of limit
orders. I would ask Mr. McSweeney and Mr. Ketchum to respond to
the report's findings and to indicate what they intend to do by
way of reform. Then I will ask the rest of the panel for their
thoughts about what should be done.
Mr. McSweeney and Mr. Ketchum.
Mr. McSweeney. Congressman, I would like to agree with you
that the results of the SEC's report were troubling, and give
you and this committee an assurance that the issues that were
raised in that report were not issues that related to the
surveillance and enforcement at the New York Stock Exchange.
As you would note, there were no exchanges or market
centers identified specifically in the report. The Exchange has
a very robust and extensive surveillance program dealing with
the issue of limit order exposure, and our compliance rate is
99.997 percent. In instances in which we believe that
compliance is not being effectuated by the specialist or
brokers, we will take enforcement action, as we have done in
the past.
The New York Stock Exchange, in fact, had an order display
rule in place before the SEC's adoption of the order handling
rules, which were adopted specifically to address specific
abuses in the over-the-counter market. Albeit our guideline was
a 2-minute guideline as opposed to the immediate and up to 30
second parameters that are in section 11(a) currently. But it
is something we take seriously and we enforce aggressively.
Mr. Ketchum. Congressman, again, I would also like to
assure you that the NASD and the Nasdaq stock market take the
order display requirement extremely seriously. We believe they
are indeed a critical part of our marketplace.
That is the reason why over the last 2 years NASD
regulation has brought 49 disciplinary actions with respect to
violations of the order display rules, and why we will be in
the process in the next month of moving from our examination
program to being able to use our now-available order
information on timing to implement more electronic surveillance
systems that will allow us on a real-time basis to be able to
respond to any failures for the expected delay of information.
This is a critical issue for us. We have brought, I
believe, more disciplinary actions than all other markets
combined, and we are absolutely committed to provide every
surveillance technique we can to ensure that orders are
properly exposed.
Mr. Rush. So both the market witnesses here agree that the
report is an accurate report. Do you agree with the findings of
the report?
Mr. Ketchum. I think the SEC does a great credit in
bringing forward and focusing attention on this issue, and I
think the issues are extremely important.
It is probably useful to note with respect to some the
percentages noted with respect to large market makers, those
characterized as large market makers, that those percentages
involve three market makers that account for less than one-
third of 1 percent of the transactions in the Nasdaq market, so
it is an unusual definition of ``large.''
But the basic point that there is no acceptable level of
noncompliance with respect to the order handling rules is
absolutely correct, and the Commission did a service to focus
on that issue; and we are absolutely committed to throw every
regulatory and surveillance focus on it that we possibly can.
Mr. Oxley. The gentleman's time has expired.
The gentleman from Illinois, Mr. Shimkus.
Mr. Shimkus. Thank you, Mr. Chairman. I have been sitting
here wondering how I was going to gracefully admit to the fact
that this is pretty much over my head, even though I consider
myself a learned individual. So I am going to try to boil it
down simply, and then I have a few questions.
Is it safe to say that the exchanges are like traditional
auctioneers in that the ECNs currently have to go through a
gatekeeper, it is kind of a closed system, and the real debate
is, should the ECNs eventually be able to be their own
auctioneer? If we are going to boil this down simplistically,
infantryman style, a ``keep it simple, stupid'' proposal?
Mr. Atkin. I think you have hit on the fundamental issue,
and that is, as I believe I said earlier, I think many ECNs, in
essence, are frustrated exchanges. ECNs do not exist in any
other market structure or in any other market around the world,
except the U.S. market. I believe the main reason for that is,
other marketplaces allow true competition to exist between
auctioneers or between exchange entities.
I think what is going on in this marketplace right now, to
go with the analogy, is maybe Nasdaq and the New York Stock
Exchange have been Christie's and the Sotheby's, but it is as
if eBay could go into business, but only if it abided by the
rules set by Christie's or Sotheby's.
What we are saying is, to promote competition and to
promote innovation in these markets, you need to set these
companies free and allow them to operate on a level playing
field. The fact that the Nasdaq has its SRO and the New York
Stock Exchange has its SRO, which gives it significant
rulemaking advantages, we think that that prohibits competition
from truly blossoming in this marketplace.
Mr. Shimkus. Let me follow up, and I appreciate that, and I
did write eBay in some of my scribbled notes as I was thinking
it through, is it the Exchange's argument that the investor is
best protected by the current, maybe partially monopolistic
approach?
Mr. McSweeney. Congressman, I would respond to that by
saying regulation ATS presently provides an alternative for
ECNs to either register as broker-dealers, which the current
nine ECNs are presently broker-dealers registered with the
NASD, or they can register as exchanges with the SEC and meet
the regulatory requirements that are appropriate for a self-
regulatory organization. In fact, three of the ECNs, Nextrade,
Island and Archipelago, have filed with the SEC for that
status. It is moot with respect to Archipelago because of their
proposed alliance with the Pacific Stock Exchange, but that
option is open and available to ECNs if they wish to choose
that route.
Mr. Shimkus. Mr. Ketchum?
Mr. Ketchum. I think Bob has hit an important point. Let me
say a couple of things in addition.
First, it is probably necessary to understand that ECNs
don't operate entirely within an exchange or Nasdaq
infrastructure. They have a separate technology infrastructure
in which anyone who wishes to be a participant with respect to
what that ECN electronically connects to. They are enormously
efficient from that standpoint, compete extremely well, and
provide a great benefit to the marketplace. They, as Bob
indicates, have a choice now as to whether to be a broker or an
exchange environment, and gain some of the benefits and yet
costs and delays that are involved in having to operate as a
fully regulated exchange; and we support that choice.
Given that environment, I don't think that they are
hampered in any way with respect to their choices, particularly
from a Nasdaq situation in which we are committed to linking
with an ECN that wants to operate either as an exchange or an
ECN in an open, inclusive environment.
Mr. Shimkus. Let me then move, Mr. Ketchum, and follow up.
Some of these may have been asked earlier.
Should the Nasdaq allow others to trade in decimals, even
though you have not moved to decimal trading yet?
Mr. Ketchum. Well, that is a good question, Congressman. In
fact today, Nasdaq, unlike other markets in the United States,
because of the manner in which it is structured, does allow
anyone to trade in decimals who operates on the Nasdaq market.
Indeed, we think that is an important right, and we think they
should continue to be able to do that.
We are able to facilitate anyone who wishes to report in
decimals through the clearing system, and we are absolutely
committed to continuing to do that. We think people who are
participating in the market should respond to whatever their
customer needs are.
Mr. Shimkus. When will you be prepared? When do you
envision being able to fully move? I think the committee, as a
whole--I can't speak for all the members, but I think we are
obviously--we really want to see this happen, as you know.
Mr. Ketchum. Congressman, I think that there is probably
nobody in this this room that is more aware that this committee
wants to see this happen than me. Let me emphasize and say this
very, very clearly, that Nasdaq and the NASD strongly believe
in the implementation of decimalization as well, and we very
much want to see it happen.
We submitted a comment letter to the SEC this week in which
we have indicated our ability to be able to move and support,
based on whatever the SEC determines to do, either a pilot or
full implementation of trading in listed securities in
September of this year. We will be able to support, in light of
the explosion of volume on Nasdaq, the implementation of
decimalization in the Nasdaq marketplace, full implementation,
beyond the ability to support anyone who chooses to trade in
decimals now, by the end of the first quarter of 2001.
I want to commit to you, sir, decimalization is our first
priority. We will let nothing stand in front of or let no
resources not be dedicated that are necessary to meet those
commitments.
Mr. Shimkus. Mr. Chairman, I would like Mr. Atkin to
answer, and then we can cut my time off.
Mr. Atkin. I think going back to the choice issue of reg
ATS, it is a choice, but I would say it is a false choice.
There is absoultely no clear path for those ECNs who wish to
compete on a level playing field with either Nasdaq or the New
York Stock Exchange; or if Goldman Sachs chooses to compete
with Nasdaq and the New York Stock Exchange, to do so. It is an
extremely unclear process. The last exchange to do it was the
International Securities Exchange, which was a small options
exchange. It took 3 years for that to occur.
In the meantime, Nasdaq is building with its Super Montage
proposal something that has very competitive aspects, I would
say a direct competitor to the ECNs that wish to get out from
under its infrastructure.
In my view, this is all about timing. I believe Nasdaq
should be allowed to do whatever it wants to its market, but
only after those who want to compete with it are able to do so
on a level playing field. Nasdaq cannot have the monopoly on
regulation in its market, it can't have the monopoly on market
data and use of its infrastructure.
This is really a sequencing problem more than anything
else.
Mr. Shimkus. Well, I appreciate that. I would just end up
by saying we have a lot of education from all parties to work
with with members, and I look forward to learning more. I don't
watch much TV, but the commercial I like is when the boss calls
Stewart into his office. This Gen-Xer comes in, rock and roll
and trading stock. He is the hero. And the guy gives him the
Xerox copy of the party, and the guy says ``I think I might be
there, Stewart.''
So the world is changing, and I think we all need to get on
board.
With that, I yield back my time.
Mr. Oxley. Thank you. I was thinking about Ringo Starr, but
that is a whole different story.
The gentleman from New York, Mr. Engel.
Mr. Engel. Thank you, Mr. Chairman.
Ms. Stark, your testimony states, ``Nasdaq's proposed Super
Montage is a laudable initial step in the right direction to
provide price and time priority for limit orders and to permit
display of a more complete picture of trading interests, not
only of the inside quote, but of prices several increments away
from the best bid and offer.''
You go on to concede that, ``It is not a panacea as it
permits internalization of customer orders by broker-dealers.''
That is a practice you obviously condemn elsewhere in your
testimony.
Mr. Atkin, on the other hand, calls Super Montage ``super
monopoly.'' You say it will allow Nasdaq ``to control who
market participants send their orders to and give the NASD an
unfair advantage over its competitors, ultimately harming
investors.'' That is what you say.
You go on to say, ``Because it is not really voluntary, it
could give investors worse prices than they get today and
provide investors with less information than they get today.''
If I misquote you, please correct me.
If I take the testimony of both of you, it is hard to
believe that you are talking about the same system. So my
question to the two of you, and then the rest of the panel, is,
whose conclusion is correct and why?
Ms. Stark, if you would begin.
Ms. Stark. Thank you, Congressman. I sit on Nasdaq's
Quality of Markets Committee and have spent many long committee
hours going through the creation of the proposal first of
NAQsi.net, I believe. And usually these things have Q's in
them; for some reason, Super Montage does not.
The Nasdaq marketplace is evolving, and the Nasdaq, or the
NASD, is made up of many different constituents with many
different interests. Super Montage is the first proposal that I
have seen that Nasdaq has been able to successfully put out to
its membership that actually has a chance of passing, and I
think it is a good step in the right direction in terms of
opening up the marketplace for everyone to see what is going on
there. I don't think it is the best step that could be made
because, similar to what Doug has said, there is an issue about
whether or not you are forcing everyone into one switch.
I think on a short-term basis this might be our best shot
to move the market forward, perhaps to a better place and a
better structure. But because of the varying interests of the
people who make up the NASD, who are NASD members, I don't
think it is realistic to expect a sweeping change to make the
major, major steps that perhaps could be made.
Mr. Atkin. First of all, Holly and I have known each other
a long time, and I think we share the same goal in getting the
markets as efficient as possible for investors. I think Holly
hit on maybe the area of perceived disagreement or
disagreement, and that is, over what time period are you
looking at this proposal? In the short term, given all the
political issues within Nasdaq and, you know, the market
makers' strong interest and their desires to internalize order
flow, I believe that this is the best that they can get out of
the current governing structure at Nasdaq.
What I would suggest, though, is that if you look at this,
what is likely to occur if this is implemented, if Nasdaq is
building its own ECN, Nasdaq, under its current proposal, is
only willing to go out to the three best bids and offers. The
ECNs that exist, Instanet included, show investors full depth
of book.
If Super Montage is successful at draining liquidity out of
the ECNs, I think you are going to see market structure go
backwards and transparency go backwards.
Mr. Kamen. I would just like to add, this is an example of
the type of benign neglect that I was talking about in the
small-tier markets. In very liquid markets where it is likely
there will be many participants posting bids and offers, the
Super Montage could certainly have its purpose. But in the
lower-tier markets, where it is mostly dominated by market
makers that display 100 share bid-and-offer size and wait for
the phone call, if you will, to react to the real bid or offer
that is being shown them, the Super Montage just might display
300 shares bid at one level and 100 at another and 400 at
another, giving the false illusion that at the low end there is
no interest in these stocks, because the market markers would
only put up these de minimis bids.
If I can, I would just like to clarify something I said
earlier. In the lower-tier markets, I can't access as a small
broker-dealer, if I am not an Instanet access firm, the OTC
bulletin board and the order systems that they were talking
about. Predominately, the regional investment banker
association firms don't enjoy some of the access that the
larger firms do to the systems of the private companies.
Mr. Engel. Mr. Ketchum.
Mr. Ketchum. Thank you, Congressman. I would just like to
briefly hit on this issue, because I think the issues are
important, and I think the points made by both Ms. Stark and
Mr. Atkin deserve a little response.
Undoubtedly, the market structure in the United States will
continue to evolve for a long period of time. We, perhaps more
than any country, have to solve two different problems that
relate. We have to handle the largest institutional investing
market in the world, and we have to handle an explosive on-line
trading environment of individual investors that result in
literally hundreds of orders in a single stock focusing in a
very short period. So I have no doubt that, whatever occurs,
the Super Montage display window will not be the last step in
the line.
I do believe that we need to do a good deal more talking
with our ECN friends and certainly with Instanet, which has
been a critical innovator and substantial liquidity support of
the Nasdaq market for some time.
I don't believe Doug's points are correct, and we will
spend some time trying to work through them, because in fact
the intent is to continue to allow the full display of ECN
depth through the marketplace, to encourage additional display
of market maker limit orders that are not seen today, and not
to require ECNs to necessarily leave orders one way or another,
whether they choose to go with us for automatic execution or
through communication with our existing transaction link with
the system now. We intend to provide the alternative, and we
would like them to be participants in our market, if they
choose as brokers, either way.
So we need to do our work in better communicating with the
ECNs, but I do believe this is a step, as Holly indicates, very
much in the right direction.
Mr. Oxley. The gentleman's time has expired.
Let me recognize myself for another round for 5 minutes.
Mr. McSweeney, at our last hearing, we had some folks from
Island testify about their entire order book that is publicly
available in real time. Doesn't this level of transparency help
investors, and why does the New York Stock Exchange refuse
direct electronic access by investors to the specialist order
book?
Mr. McSweeney. Mr. Chairman, we agree that that level of
transparency does help investors, and we intend to make the
entire limit order book of each of our specialists fully
available before the end of the year.
Mr. Oxley. Are we making news here today, Mr. McSweeney?
Mr. McSweeney. No, I don't believe so. We have indicated in
the past that that has been in our technology plans.
Mr. Oxley. And that will be by the end of the year?
Mr. McSweeney. Yes, sir.
Mr. Oxley. Any reactions?
Mr. Atkin. We welcome it. We think it would be great for
investors, and showing more information to investors is
critical for them to lower their trading costs.
Mr. Oxley. Does everybody else agree with that?
Good.
Mr. McSweeney how do you respond to the concerns raised by
Mr. Wheeler that the physical floor base model of the Exchange
depends on layers of internalizing rules?
Mr. McSweeney. Mr. Chairman, I don't agree with that
characterization. There is an ability for customers of our
member firm broker-dealers to access the floor of the NYSE
through our SuperDOT network. In fact, 93 percent of the orders
and 50 percent of the volume that comes to the Exchange floor
is coming to the floor through an e-commerce electronic
platform.
There clearly is a different market structure than an ECN
market structure, which provides solely an automatic execution
for the order flow. It is an agency auction market. That really
does not amount to internalization, because internalization
involves a situation in which orders are not provided an
opportunity for price improvement. In fact, all of the order
flow that comes to the NYSE's floor, including that coming
through our systems, is afforded an opportunity at price
improvement, which results in 35 percent of the volume
receiving price improvement; and if you move beyond 1 point
spreads, it amounts to 52 percent of the volume receiving price
improvement.
So it is really not an internalized environment. It is an
auction environment that provides an opportunity for late
interest, represented by brokers, to provide that price
improvement.
Mr. Jenkins. Mr. Chairman, I just want to clarify
something, though, as an institutional trader.
If I go to the floor and I send through this SuperDOT
system a limit order, if a stock is offered at $20 and I send a
limit order to the floor, I am in agreement that I will buy
that stock at $20.
In many cases, you do not buy the stock because, in the
current system, they put it out for auction and the floor-based
traders who have standing are able to go in and then take that
offer, while I am trying to bid for a price, at a price that I
didn't even agree to.
Does that not occur on the floor? Because I am willing to
pay that price, yet I can't take the stock at that price. I
have to give others that are not even willing to pay that price
on the floor the ability to come up and compete with me.
Why do they get to compete? If I step in and I say, here is
the auction, we are offering it at this price; and I step in
and say, I will buy that stock, why then do I have to bid a
lower price first and allow everybody to step ahead of me
before my order is executed?
Mr. McSweeney. The point Mr. Jenkins is raising is an
important one. The agency auction provides the opportunity for
price improvement, but quite often we have seen situations in
which large orders that are brought to the marketplace result
in latent interest stepping up and participating on the same
side of the market.
That is the reason why, later this year, we are going to be
introducing a new institutional express product that includes
express order. What that will allow for is the entry of orders,
initially for 25,000 shares or more, and then after 3 months,
for 15,000 or more, an opportunity to lock in to the contra-
interest if that quote has aged initially 30 seconds and,
subsequently, 15 seconds in a manner in which the opportunity
for crowd interest to interact with that contra-side of the
market will not be available, but the order be exposed for the
possibility only of price improvement.
So I think the point he is raising is a good one, and I
think the product that we will be rolling out in the next
several months will address that specific issue.
Mr. Oxley. Now, is that a viable solution, Mr. Wheeler and
Mr. Jenkins?
Mr. Jenkins. It is not, because 30 seconds in an electronic
world is an eternity. I guarantee you that you will not have
orders available on the institutional express for institutions
to take, because they will disappear as you approach that 30-
second limit.
Mr. Wheeler. A couple of points I would like to make in
response to this:
No. 1, I think institutional express, the Exchange should
be commended in that it is a positive step in the right
direction, albeit in our view a very small baby step, if you
will.
Throughout the testimony, and I think Mr. Jenkins probably
verbalized it best, limit orders are the backbone of trading
throughout the world. If you look at Mr. Atkin's system and all
the ECNs, they thrive and are gaining market share because they
protect limit orders. The New York Stock Exchange currently
does not protect limit orders, i.e., the investing public, who
is willing to display to the world that they are willing to buy
a particular stock at a particular price. I would go so far as
to say that members of these exchanges prey off of these limit
orders.
Limit orders have an economic value. They are worth
something. There is a value to a limit order. No matter how far
away from the current market it is or how small a quantity that
order is for, it has an economic value. If you look at options
to buy and sell a particular stock in the newspaper, options
that are away from the market all have a value; there is an
economic value attached to them.
Our exchanges do not recognize the economic value of those
limit orders. They need to be protected and the investors
behind the orders that are willing to display their trading
interest need to be protected if our exchanges are going to
compete in the global marketplace going forward.
In Mr. Jenkins' example, if he is down on the floor willing
to pay $20 for a stock and he is displaying that limit to the
public and he is the high bid in the ``auction system'' of the
New York Stock Exchange, and I come in to sell that stock to
Mr. Jenkins, it is very feasible for a member standing in the
crowd, instead of allowing me to sell stock to Mr. Jenkins at
$20, that they just step in and say, I will pay a ``teenie''
for American Century Stock. This gets written off as ``price
improvement.'' The New York Stock Exchange, in a sense, wraps
themselves in the American flag over price improvement.
We think the whole price improvement idea is flawed. Price
improvement is nothing more than a short-term breakup of a
clean trade in order to get one side of that transaction to
ultimately pay a higher economic price than the minimum tic
that they just stepped ahead of that order for.
In this particular example, when I try to sell stock to Mr.
Jenkins at $20, but I am broken up--but I am broken up by a
member in the crowd who pays \1/16\ for that, Mr. Jenkins still
has a buy ticket on his desk.
Our portfolio managers put in orders to buy and sell
particular stocks. They don't give us orders that say buy IBM,
Dell or Compaq. They give us an order that says, buy IBM. The
members of the crowd know full well that if Mr. Jenkins can't
buy his stock at $20, he is going to have to pay \1/8\ or \3/
16\ or \1/4\ for that.
So what happens when someone takes that stock at \1/16\?
Yes, I am price improved by \1/16\ of a point. But what happens
to Mr. Jenkins?
I will tell you what happens to him. The member turns
around and says, oh, Mr. Jenkins, I will sell you your stock at
\1/4\; and it is like the infamous oil commercial, either pay
me now or pay me later.
Mr. Oxley. So in that case, it would appear to always
benefit the seller versus the buyer. Is that too simple, or is
that basically it?
Mr. Wheeler. That is basically it. The structure of the
express product benefits the responder to a trade, and that is
where we view that as fundamentally flawed. It does nothing to
protect the investor who is willing to display a trading
interest by telling the world they will pay the highest
published price for a given stock. No one else is willing to
pay a higher price. Even though there may be members in the
crowd that are willing to pay \1/16\ or \1/8\, they don't have
an economic interest in displaying that \1/16\ or \1/8\ to the
world to say the stock is not worth $20, this stock is worth
20\1/16\ or 20\1/8\.
Why? Because when I come in to sell it to them, they can
just sit back and say, I will take that stock at \1/16\. Mr.
Jenkins' order becomes a free option for everyone else in the
crowd. This is why seats at the New York Stock Exchange sell
for $1.5 million or $2 million, because of this economic rent
they are able to garner from shareholders.
In our viewpoint, all the dollars made by the specialists
in the crowds are dollars that were at one time in the pockets
of the public investors, retail or institutional, and those
dollars are being siphoned off under the guise of price
improvement every day, day in and day out, on the floor of the
Stock Exchange.
Mr. Oxley. Mr. McSweeney, you were looking askance there at
that last comment. Could you defend yourself there?
Mr. McSweeney. Mr. Chairman, I didn't agree with the
characterization, because even in Mr. Wheeler's example, the
customer for whom he was entering that order was receiving the
economic benefit of the price improvement, and in the example
the customer that was being represented by Mr. Jenkins was not
willing to price improve above the price that was being bid. It
was somebody else in the crowd that stepped up and provided
that additional----
Mr. Oxley. That is why it was a limited order, was it not?
Mr. McSweeney. That is exactly right.
Mr. Oxley. But in fact he has his whole soul out there for
everybody to see. He has pretty much bared it all, and your guy
comes in there and moves ahead of him, but he hasn't risked
anything.
Mr. McSweeney. Well, part of the price discovery process is
bringing out the latent interest to provide price improvement.
Mr. Oxley. That is great for the guy that is selling, but
what about this poor guy that is sitting there thinking he is
going to pick this thing off at $40?
Mr. McSweeney. Well, the NYSE direct cost product that we
will be rolling out before the end of the year will provide an
opportunity for investors who want automatic execution to seek
that route initially for limit orders of 1,099 shares or less,
and there will be absolutely no crowd interaction except what
was represented the display bid and offer. So the opportunity
for investors to send orders through the system sponsored by
their broker-dealers to interact directly with the entire bid
and offer without any crowd interaction will be available
through the NYSE direct.
Mr. Oxley. That will be transparent?
Mr. McSweeney. That will be fully transparent.
Mr. Oxley. My time has long expired.
The gentleman from New York.
Mr. Engel. Thank you, Mr. Chairman. I won't be long. I know
everyone has been sitting here for a while. I just think it is
a bit unfair, some of the comments that have been made.
I am glad that Mr. McSweeney put the market structure
report into the record, because I think it is important that we
have balanced testimony here. The report makes recommendations
on expanded choices for investors at the New York Stock
Exchange, and it builds, as was said before, on the existing
strengths of the New York Stock Exchange floor system; and some
of the expanded choices include automatic electronic execution
and opening the specialist's book to on-line investors
throughout the Internet. And the report, of course, supports
elimination of the intermarket trading system in favor of a lot
of different private sector initiatives.
Quite frankly, I have found the New York Stock Exchange
willing to make the necessary changes in all the different
subjects that we have covered in this subcommittee and the
committee through the years. So I think some of the accusations
are a bit unfair. I want to give Mr. McSweeney a chance to
perhaps respond further to anything he might want to say.
Mr. McSweeney. Well, I appreciate the compliment,
Congressman, and I can assure you that our Special Committee
worked very long and hard over 6 months to receive a broad
range of input and put the recommendations in the light of what
would be in the best interests of the ultimate investors, as
opposed to the interests of the intermediaries. I think that is
reflected in the recommendations.
Mr. Engel. Thank you.
Mr. Chairman, I have no further questions.
Mr. Oxley. Thank you.
Thanks to all of our panel for your patience in waiting for
those floor votes and for a most interesting and lively debate
on some very, very important issues that face this
subcommittee, as well as the SEC.
With that, the subcommittee stands adjourned.
[Whereupon, at 12:52 p.m., the subcommittee was adjourned.]
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RESPONSES FOR THE RECORD OF RICHARD G. KETCHUM, PRESIDENT, NATIONAL
ASSOCIATION OF SECURITIES DEALERS
Question 1. Should NASDAQ's delay cause the entire market to delay
trading in decimals? Does the NASDAQ plan to develop a rounding
indicator for those trading in decimals? If not, will it be difficult
for brokers to comply with best execution obligations?
Response: On May 10, 2000 the NASD responded to the SEC's release
on revising the decimal implementation schedule. We stated in our
comment that the NASD will be ready to implement either of the
alternatives suggested in the SEC's release for the exchange-listed
market, full dual pricing or a pilot of dual pricing by September 4,
2000, as the SEC finds to be in the public interest in maintaining fair
and orderly markets and to protect investors. The NASD will also be
ready to initiate decimal pricing in Nasdaq securities on March 31,
2001. There has been no change to these dates.
Today, no rounding indicator is supported in the Nasdaq production
software. If an indicator were to be required, it would be a new
requirement, with technical implications for our downstream systems as
well as vendors. Adding this requirement could jeopardize the planned
implementation dates for decimals. This question has arisen previously,
specifically during the implementation of the SEC Order Handling Rules.
At that time, the SEC did not require special rounding indicators.
Once the new software is implemented, firms will be allowed to
enter prices up to 4 decimal places. The system will round, according
to pre-defined logic, to the minimum price variation for the security
(pennies or nickels). Screens will display the rounded price. It should
also be noted that our systems currently accept quote entries in 64ths
and round to 16th or 32nds, as required.
The issue of rounding is an important one that the SEC, the NASD,
the other markets, and the securities industry must carefully consider,
because of, among other things, the implications for best execution
obligations. One of the benefits of a decimalization pilot, if the SEC
were to request one, would be to understand the need for rounding
conventions and how best to provide them.
Question 2. NASDAQ has recently announced alliances in Germany,
England and Japan. These are all decimalized markets. Why can't NASDAQ
use those countries' decimalized systems here?
Response: The other international markets that Nasdaq has announced
alliances with now run on separate hardware platforms and networks, all
of which handle far lower message traffic and are not connected to U.S.
clearance and settlement systems. Moreover, none of these systems
support either market makers or Electronic Communications Networks
(ECNs). Conversion of any of these systems to support Nasdaq Stock
Market in the short term is simply impractical.
Question 3. When will NASDAQ be ready to trade all stocks in
decimals?
Response: As stated in the answer to question 1 above, the NASD
recently responded to the SEC's release on revising the decimal
implementation schedule. We stated in that comment letter that the NASD
will be ready to implement either of the alternatives suggested in the
SEC's release for the exchange-listed market, full dual pricing or a
pilot of dual pricing by September 4, 2000, as the SEC finds to be in
the public interest in maintaining fair and orderly markets and to
protect investors. The NASD will also be ready to initiate decimal
pricing in Nasdaq securities on March 31, 2001. There has been no
change to these dates.
Question 4. What is the single biggest market inefficiency
investors are facing in the market? What rule changes are/is necessary
to eliminate this inefficiency?
Response: We believe that the single greatest inefficiency
investors are facing in the market today is fragmentation. In our
opinion, fragmentation continues to pose a tremendous and credible
threat to the integrity of the U.S. securities markets. We believe that
this threat is not insurmountable and that the best way to address it
is through quick, decisive, cooperative efforts by the NASD/Nasdaq and
the SEC with Congress' support.
As you are aware, electronic communications networks (ECNs) have
become a significant force in the Nasdaq market. They collect hundreds
of thousands of orders from customers across the country, and perhaps,
world. Thus, ECNs contain and provide access to huge pools of
liquidity. While recent rule and market-structure changes have
increased transparency and access to these pools of investor interests,
today it is still impossible to determine the entire depth of the
market within the ECNs and consequently, within Nasdaq. This, in turn,
limits the quality and efficiency of the Nasdaq market and potentially
harms the individual investor.
As I am sure you are aware, under the firm quote rule of the
Exchange Act, a market maker may place a better-priced order into an
ECN and not update its quote to reflect the better-priced order if the
ECN disseminates the top of its file to Nasdaq and the ECN provides
broker/dealers equivalent access to these orders. Thus, the public only
sees the best-priced buy and the best-priced sell order (i.e., top-of-
file) that resides in each of the nine ECNs in Nasdaq. The public does
not see the often significant liquidity in the ECN that is just below
the ECNs' top of file. If a market maker places into an ECN an order
that is priced better than the market maker's quote but is below the
ECN's top of the file, that order will remain hidden from the market
unless that order becomes the ECN's top of file. Currently, the only
way for a market participant to monitor the full depth of the market is
to subscribe to each of the ECNs, which is costly, inefficient, and
unmanageable. This type of fragmentation makes it particularly
difficult for institutions to conduct business in Nasdaq because the
institution cannot adequately determine the available liquidity at and
near the inside market. In addition, because only the top of the file
of each ECN's and market maker's book is displayed in Nasdaq, it is
possible for the market to trade through orders that reside on the
market participant's back book at a price away from the inside. Because
there currently is no way in Nasdaq to aggregate and display trading
interest at multiple price levels, the current market structure fosters
fragmentation.
In response to the second part of the above question, we believe
that the best way to address the problem of fragmentation is to allow
the markets and market participants--fueled by the forces of
competition and innovation--to provide a solution. Specifically, we
believe that the Nasdaq Order Display Facility, or SuperMontage, which
we submitted to the SEC last year, addresses the problem of
fragmentation. In essence the SuperMontage will build on Nasdaq's
strengths, as a collector and aggregator of trading interests--the
traditional role of a market. In addition, the SuperMontage will be an
inclusive model, in that it does not favor or a particular business
type (e.g., ECN, fully integrated market making firm, wholesale market
making firm). It will encourage innovation and competition while
improving on transparency and liquidity. Technology advances have for
the first time allowed Nasdaq to create a market where investors around
the world can view and have electronic access to virtually the full
depth of the market and can have their orders interact with one another
virtually instantaneously.
The SuperMontage will show the best bid/best offer in Nasdaq and
two price levels away, accompanied at each price level by the aggregate
size of the ``displayed'' trading interest of market makers, ECNs, and
exchanges granted Unlisted Trading Privileges to Nasdaq securities (UTP
Exchanges). Nasdaq market participants will be able to designate an
order as ``attributable'' or ``non-attributable,'' and also will be
able to indicate a reserve size for an order. Attributable orders will
be displayed next to the Nasdaq market participant's acronym (Market
Maker ID or MMID) in the current Nasdaq quotation montage, and will
also be displayed in the SuperMontage as part of the aggregate trading
interest at the inside and two prices away). Non-attributable orders
will be displayed only in the Nasdaq Order Display Facility as part of
the aggregate trading interest at the inside and two prices away. In
addition, Nasdaq market makers and ECNs will be permitted for the first
time to give multiple orders and orders at multiple price levels, which
the system will manage and display in Nasdaq when the order is eligible
for display next to the market participant's MMID and/or in the
SuperMontage. Further, Nasdaq market participants will be able to
access orders in the SuperMontage virtually instantaneously using a
substantially-enhanced Nasdaq order delivery and execution system,
which will be built on an architecture that accommodates the technology
needs of all Nasdaq market participants, market makers and ECNs alike.
The system will route orders to the market participant in queue and
next eligible (based on a general time priority) to receive an order/
execution against its quote. Thus, the system will provide one of
potentially many links of all market participants trading Nasdaq-listed
securities.
We believe that the SuperMontage provides substantial benefits to
the individual investor and improves market quality, while also
encouraging innovation and competition. The system reduces
fragmentation by allowing market participants to transmit to Nasdaq
multiple levels of orders and by aggregating and dynamically displaying
all orders at the inside and two price levels away. Market participants
will see for the first time in the SuperMontage the full depth of the
inside market and two price levels away, which will enhance
transparency and liquidity, and will also be able to view the full
depth of the market in Nasdaq for all prices levels.
The ability to transmit and display multiple orders will reduce the
possibility that an order will be traded through in a fast moving
market and also enhances best execution, which directly benefits the
individual investor. The order routing capability of SuperMontage will
enable the system to effectively link all markets--including UTP
Exchanges--that trade Nasdaq securities. We believe this will create,
for the first time, a national market system consistent with Congress'
mandate in the 1975 amendments to the Exchange Act.
Question 5. What are the expected benefits decimalization will
bring to investors?
Response: Potential benefits that decimalization may provide
include more easily understood numbers and investor savings. The least
disputed benefit of decimal pricing is that decimal pricing is easier
for investors to understand.
Regarding savings for investors, there is an increased savings
potential for investors if decimal pricing leads to smaller price
increments and narrower bid-ask spreads. Each price change (called an
uptick or downtick respectively) would increase or decrease the price
per share by 6.25 cents at a minimum. With decimals, there is the
potential to trade at a nickel or a penny increment. At a nickel
increment, the uptick or downtick will be at 5 cents per share; a
potential savings of 1.25 cents per share for investors. At a penny
increment, investors could save up to 5.25 cents per share as the
uptick or downtick goes one cent at a time. Narrower spreads mean
investors could save money as they are able to achieve a more precise
price for their trades. Of course, any calculation of benefits should
recognize that in many cases there will be relatively little depth at a
penny increment and that most of the buying and selling interest will
likely be five to ten cents away from the displayed price.
Question 6. What effect would the NASD's SuperMontage proposal have
on competition in the marketplace? How would use of the SuperMontage be
voluntary if the NASD retains any affiliation with the regulator of
competitors of SuperMontage?
Response: We believe that the SuperMontage is a pro-competitive
development that will broaden competition and lead to further
innovation. SuperMontage will also permit Nasdaq to remain competitive
in an environment of increased globalization of the world's securities
markets. We firmly believe the proposal meets the statutory
requirements under the Exchange Act, and that the proposal responds
directly to Congress' goal of establishing a true national market
system. We believe that the proposal protects investors and promotes
the establishment of a free and open national market system, in that it
reduces fragmentation in the Nasdaq market and improves the efficiency
of transactions in Nasdaq.
Specifically, the SuperMontage attempts to increase price
transparency and alleviate fragmentation by providing a means for
centralizing trading interest, displaying this trading interest to
investors, and providing an efficient means for accessing such
interest. We note that these are essential functions of an exchange.
Every registered securities exchange in the United States has a limit
order facility, which serves as the point of order aggregation. Nasdaq
is currently in the process of registering as an exchange. Nasdaq
should be permitted to have a method of aggregating, displaying, and
accessing investors' interest to better serve investors in Nasdaq-
listed securities and in the spirit of equal regulation of similarly
situated market participants.
The SuperMontage encourages competition by providing an open and
inclusive architecture in which competing market centers may operate.
We are not, as some have suggested, directly competing with our
members. Rather, we recognize that market centers that trade Nasdaq
securities add value to the market and offer alternative services. For
example, we are not offering through the SuperMontage certain value-
added services, such as anonymity through settlement, that ECNs offer
today. Moreover, while the proposal provides a central means for
accessing liquidity in Nasdaq and other market centers, it in no way
establishes the SuperMontage as the sole means for providing or
accessing liquidity. NASD members, individual investors, and members of
other exchanges are free to leave their orders with any market center
they chose. Moreover, subscribers of ECNs are free to use the execution
services offered by the ECNs to access liquidity within those markets.
UTP Exchanges will continue to offer innovative execution services to
their members. Orders will continue to be handled by and executed in
multiple trading venues. SuperMontage thus provides a central, but not
exclusive, means of accessing liquidity and of exposing trading
interest to the market.
Competition will continue to flourish in the new regulatory
environment that the SEC has created through its recent regulatory
initiatives, as shown by recent announcements by certain ECNs to link
with one another (independent of the Nasdaq network and systems) and
plans of some broker/dealers to register as exchanges.
As the second part of your question, we reiterate the position that
we have publicly articulated to our members and the SEC--the
SuperMontage is completely voluntary. Nothing requires or compels
market participants to give their order book to Nasdaq. We understand
that market participants may not wish to relinquish their order book to
Nasdaq and that they may provide valuable services away from the
central Nasdaq market. ECNs and market makers are free to give Nasdaq
only their best buy and sell orders, or they can chose to give Nasdaq
all or some of their orders. Nor does anything require that executions
in Nasdaq securities occur through the SuperMontage, or other Nasdaq
facility. Any of these options for handling and executing orders would
be consistent with NASD rules. This is similar to the experience of
exchanges. In the past every exchange has had a limit order facility,
and that members of such exchanges have not been compelled by rule or
regulation to leave their limit orders with the member's resident
exchange or the primary market. To the contrary, the SEC has encouraged
exchanges to actively compete for order flow and avoided requiring
members to leave orders with the primary exchange.
Finally, we reiterate that we in no way believe or intend for the
SuperMontage to be mandatory, regardless of the NASD and Nasdaq's
affiliation. NASD Regulation--a separate, wholly-owned subsidiary of
the NASD--is vested with regulatory authority over Nasdaq. Other than
its role in establishing market policy and rules, Nasdaq's regulatory
role is extremely limited. The separation between the regulatory
function of NASD Regulation and the market function of Nasdaq is clear
and strong. The separation between these two corporations will become
even greater when Nasdaq recapitalizes, Nasdaq registers as an
exchange, and the NASD becomes a minority owner of Nasdaq.
Question 7. I introduced a bill that passed the House and requires
trade reporting information to be disseminated to improve price
transparency for corporate debt. How will NASDAQ's TRACE proposal
impact the market? Is it more than just price reporting? Is it in the
interest of competition to have an SRO set the rules for trading that
will be centralized with the NASD and benefit NASDAQ? Does this
proposal use regulatory power to create a monopoly?
Response: The NASD is responsible for regulating virtually all
securities trading on Nasdaq and in the over-the-counter (OTC) market,
including corporate bonds. Section15A of the Securities Exchange Act of
1934 was adopted to expand the concept of self-regulation to the OTC
market, and the NASD was formed to provide a mechanism to supervise the
conduct of broker-dealers participating in that market.
This authority includes the regulation of trading in corporate debt
securities. The NASD is the only self-regulatory organization (SRO)
that has regulatory authority over NASD broker-dealers that trade
corporate debt securities over-the-counter, that is, not on a
registered securities exchange, and is thus the only SRO that can
enhance the oversight of the operation of the OTC corporate bond
market.
SEC Chairman Levitt called for increased transparency in the
corporate bond markets by requesting: rules requiring dealers in US
corporate bonds to report all transactions, systems to receive and
distribute transaction prices immediately, a regulatory database of
bond transactions, and a bond market surveillance system using that
database.
The NASD filed a proposal with the SEC that both responded to
Chairman Levitt's request and addressed the goals in your bill. The
NASD's proposal will provide: (1) a flexible trade reporting facility
based upon standards all NASD members must adhere to when trading over-
the-counter; (2) a mechanism to give price disclosure to all market
participants equally; and (3) an audit trail for NASDR to surveill the
market.
The NASD is responding to Congressional and SEC objectives by using
facilities that are in place and have worked well for the last decade.
TRACE uses existing linkages between the industry, Nasdaq, and NASDR,
to solve the regulation and transparency problems of the corporate bond
market quickly and efficiently. The NASD will use its wholly owned
subsidiary, NASD Regulation, to regulate under new trade reporting
rules we have filed with the SEC. The NASD will enhance transparency
through trade reporting facilities also already in place and operated
by its other subsidiary, Nasdaq.
It is important to note that the system is not a bond trading
system, and that Nasdaq's role will be simply that of providing a
facility, not making rules or regulating the system. The NASD will in
no way use its regulatory powers to enhance the position of Nasdaq, and
will not use regulatory power to create a monopolistic situation. The
NASD, not Nasdaq, has been charged by the SEC with collecting,
disseminating, and policing the information on corporate bond trade
reports. The NASD, not Nasdaq, will be responsible for owning and
operating the mechanism for trade reporting and regulation of this
market.
There has been confusion about the role of the NASD regarding the
ownership and revenue from the sale of the data collected. While others
have suggested that they should instead provide the data on a selective
basis, the NASD, as it now does with equity trade data, will distribute
bond transaction data to all vendors on an open, fair and independent
basis, subject to SEC regulation. We expect a robust market for resale
of that data by vendors, just as now exists in equity trade data. The
NASD will use any revenues that it receives from the sale of TRACE data
to cover the NASD's costs in operating the system, including NASDR's
regulatory activities and the systems that collect and disseminate the
trade information to the public. Any revenue beyond these regulatory
and technology costs will be shared with the market participants that
provided the data in the first place.
Finally, the TRACE proposal addresses the balance of market impact
and market transparency by setting dissemination caps for the
investment grade and the below investment grade markets. The NASD will
also conduct liquidity studies to monitor market impact. We have
already begun discussions with firms and industry organizations to
address their concerns on both the market impact and market data
issues.
Question 8. Given the technical difficulty that NASDAQ has had in
converting to decimals, why should we rely on NASDAQ to build a central
point of failure for the bond market through TRACE?
Response: The NASD is confident that Nasdaq will be able to
implement TRACE as a trade reporting facility. TRACE is based in large
part on Nasdaq's current trade reporting system for equity securities--
the Automated Confirmation Transaction Service (ACT). Every trading day
ACT technology reliably processes hundreds of thousands of last-sale
trade reports in equity securities and accurately disseminates that
information to market participants worldwide. This existing facility
will be tailored to handle the different data elements necessary for
corporate bonds. It should also be noted that corporate bonds trade
less frequently than equities and that the system hardware for TRACE is
independent of equity trading hardware.
There must be a single mechanism that consolidates and validates
the trade reporting information for regulatory and transparency
purposes. Historically, the single mechanism for performing this task
has been operated by an SRO that has the statutory obligations to
ensure that all information is properly collected, fairly disseminated,
and closely scrutinized. The TRACE proposal follows that historical
model.
Question 9. A CLOB, based on price-time priority reduces best
execution to the NBBO. There are, however, many factors that could
influence a decision to trade. In your opinion, what factors should be
considered for best execution?
Response: Although we believe that a CLOB based on strict
(universal) price-time priority would stifle market-wide competition
and disadvantage investors, we also note that Commission has stated
that best execution cannot simply be reduced to guaranteeing the NBBO
(National Best Bid or Offer). Rather, a market participant must also
evaluate the opportunity for its customers to receive price improvement
or other value-added benefits.
As a general matter, however, best execution is a facts and
circumstances determination. As the SEC has stated, there are a number
of factors for market participants to consider in evaluating the
quality of the executions they receive and whether they are providing
best execution to their customers. Execution quality may involve the
following: the opportunity for and likelihood of receiving price
improvement; the speed and certainty of execution; the adequacy and
certainty of accessible liquidity, including liquidity beyond what is
displayed; the nature of the security to be traded; the type of order
to be placed; the level of transactions costs; and the scope of trading
anonymity available. Individual investors may focus entirely on one
factor, or on several. For example, one investor may wish to receive a
guaranteed execution at the prevailing NBBO, while another may forego
speed of execution in favor of the opportunity for price improvement.
Institutional investors may desire to have their orders executed
anonymously, regardless of speed or price improvement. The same
investors may focus on different factors in different contexts.
Finally, a member is obligated to make a routine and rigorous analysis
of order routing arrangements to determine the quality of executions he
or she is receiving for customers.
Nasdaq aims to provide a broad array of choices for investors to
access the liquidity provided by Nasdaq in the manner that best serves
their needs.
Question 10. Should we call for the elimination of the Intermarket
Trading System? Do we need to designate a replacement for that system,
or would market forces adequately fill the gap?
Response: While we share the general frustration of all market
participants with the Intermarket Trading System (ITS), which is
clearly technologically outmoded and which has raised concerns on the
unanimous vote requirement, we do not believe it should be eliminated.
While ITS technology and corporate governance are in need of
improvement, we do not believe this is the time to abandon a system
that links the markets. Instead, we believe it is time to make a
concerted effort to improve the way markets access each other. The NASD
has taken steps in this direction. In particular, the NASD has adopted
rules and developed technology to open its exchange-listed trading
facility to a broader array of market participants. The NASD has opened
its facilities to ECNs as well to registered market makers and thus
opened access to ITS and the Consolidated Quotations System to ECNs,
which may now participate in these systems.
Even if improvements undertaken by the NASD and other participants
are not sufficient and a new system were introduced for accessing
market liquidity, we do not believe that ITS should be eliminated
without a thorough assessment of the new system's efficacy in linking
the markets.
Furthermore, under the ITS National Market System Plan approved by
the SEC, ITS membership is limited to the NASD and registered national
securities exchanges, all of which are registered with the SEC as self-
regulatory organizations (``SRO''). As such, the SROs are required to
establish and maintain regulatory programs to ensure that their members
act in accordance with the requirements of the Plan and the federal
securities laws, including the rules of the SROs, which are adopted
under those laws. Any entity providing a trading venue that wants to
operate as a registered SRO, like the other National Market System
participants, should be able to participate fully in ITS. Similarly, we
believe that any entity that wants to set up a competing system should
also be required to register with the SEC as an SRO, submit a National
Market System Plan for the system to the SEC for approval, and be
subject to SEC oversight.
Question 11. The NASD recently granted ECNs access to their market
linkage system through the Computer Assisted Execution System (CAES).
Please explain what CAES does and why this does or does not adequately
address the problems of efficient linkage among markets. Have any ECNs
chosen to use CAES? Please identify them.
Response: Nasdaq operates the Computer Assisted Execution System
(CAES), a trading system that allows NASD member firms to direct orders
in exchange-listed securities to NASD Market Makers for execution.
Through CAES, NASD market makers and ECNs are able to enter marketable
limit orders in exchange-listed securities to be executed against other
market makers and ECNs who are quoting in those securities. CAES also
serves as the NASD's interface with the ITS, a trading link between the
Nasdaq system and U.S. stock exchanges, including The American Stock
Exchange, the New York Stock Exchange, and the regional stock
exchanges. Through CAES, all qualifying NASD members are able to
effectively link to all other ITS participant markets.
On March 16, 2000, the SEC approved an NASD rule filing that allows
ECNs to participate in CAES on an equal basis as market makers, and
therefore, to link to ITS. CAES will be open to all NASD member ECNs
that are able to demonstrate compliance with the CAES rules and system
requirements. To date, several ECNs have expressed interest in CAES
participation and were recently provided with the modified CAES system
specifications that will allow them to assess any internal system
modifications necessary for participation in CAES.
The NASD believes that CAES will provide an efficient and well-
regulated linkage for market makers and ECNs to access other market
centers. As with the ECNs that participate in Nasdaq for Nasdaq-listed
securities, customer orders of CAES-participant ECNs will be afforded
broad exposure to all other NASD members in exchange-listed securities.
Furthermore, any order displayed by a CAES-participant ECN is broadly
displayed through the Consolidated Quotation System to all vendors and
market participants. These displayed orders are then available to be
accessed by any ITS participant.
Although CAES is linked to ITS, CAES is itself a self-standing
linkage that can accommodate various market participants and competing
market centers. CAES also offers its participants distinct options in
determining best execution, rather than placing sole emphasis on global
time priority. With the inclusion of ECNs, CAES participants will be
able to offer their customers an expanded range of desired execution
characteristics, such as stock price, speed of execution, fill rate,
commission cost, or some combination of the above.
By encouraging direct competition among participants, the Third
Market via CAES will assure service innovations that are not possible
in the current ITS environment. Unlike ITS, the Third Market itself
will continue to innovate and evolve its market structure and
technology to benefit all participants. The Third Market has the
potential to ultimately serve as the next-generation direct linkage for
all markets, rather than as a conduit to those markets through ITS.
Question 12. I understand both the NASDAQ and the NYSE are planning
to become for-profit exchanges. Do you plan to spin off your regulatory
arm entirely? If not, why should you have any interest in the regulator
of your competitors?
Response: The NASD currently operates in a structure where it is
the parent to the Nasdaq Stock Market, the American Stock Exchange, and
NASD Regulation, and is thus a full owner of these three subsidiaries.
Under the current separately operating subsidiary structure Nasdaq and
NASDR, our regulatory arm, are more widely separated than any other
U.S. market and its regulator. When Nasdaq completes its
recapitalization, the NASD will spin off about 80% of the ownership of
Nasdaq to NASD members, Nasdaq issuers, and other market participants
who purchase shares in it. This will increase the separation between
market and regulator--and the potential for conflicts of organizational
interest--to a degree not found in any other market in the world, and
allow the market and the regulator to function independently. It is the
NASD's present intention to sell its remaining shares in Nasdaq in the
near term after the Nasdaq Board reaches a determination as to whether
to move forward on a public offering.
Question 13. What disclosure do you provide regarding your costs
and revenues associated with market data? Would you object to providing
more information about those costs and revenues to the public?
Response: As noted by the Commission in its recent market data
concept release, the NASD, through its consolidated financial
statements, already provides detailed information regarding its
internal cost and revenue structures. In addition, Nasdaq, as a
registered Securities Information Processor (SIP), also files with the
SEC a detailed financial statement that outlines the revenues received
from the operation of numerous Nasdaq systems and services, including
those that distribute market data. While the NASD fully supports the
provision of complete and accurate market data cost and revenue
information to the public, the scope and manner of such disclosure
should take into consideration SRO administrative costs and burdens in
producing such information. As the acknowledged leader in SRO cost
disclosure, the NASD looks forward to working with Congress and the
Commission in establishing fair and reasonable uniform cost and revenue
disclosure standards for all market participants that consolidate and
distribute market data.
______
New York Stock Exchange, Inc.
June 8, 2000
The Honorable Thomas Bliley
Chairman
U.S. House of Representatives
Committee on Commerce
Room 2125, Rayburn House Office Building
Washington, D.C. 20515-6115
Dear Chairman Bliley, It was a pleasure to appear before the
Finance Subcommittee of the House Commerce Committee. I appreciate the
opportunity to respond to your follow-up questions. I would be pleased
to meet with you or your staff if I can be of any further assistance.
Sincerely,
Robert J. McSweeney
Enclosures
RESPONSES FOR THE RECORD OF ROBERT J. MCSWEENEY
Question 1. Will the elimination of Rule 390 allow ECNs to compete
directly with the NYSE? If not, what other regulatory changes are
needed? Will they be able to compete if they become an exchange, as
several have filed an application to become an exchange?
Response. As NASD broker-dealers, ECNs were never subject to Rule
390. NYSE members could always use ECNs for one-sided agency
transactions (not ``crosses''). Since ECNs are basically limit order
matching files, the removal of Rule 390 permits our members to execute
proprietary trades in the 23% of stocks previously covered by the rule.
The SEC's Regulation ATS provides sufficient flexibility for ECNs
to compete with the NYSE as NASD broker-dealers, or by registering as
an exchange with the SEC, provided they meet the Commission's
regulatory infrastructure requirements to do so.
Question 2. What is the single biggest market inefficiency
investors are facing in the market? What rule change(s) is (are)
necessary to eliminate this inefficiency?
Response. The biggest single market inefficiency that investors
face is internalization (and related payment for order flow economic
inducement). A broker-dealer internalizes when it either trades as a
dealer against a customer agency order or directs the order to an
affiliated dealer for execution. Broker-dealers internalize agency
market orders by buying from their customers at or near the bid price,
and selling to their customers at or near the offer price. These agency
orders do not interact with other public orders, and they are often
denied the opportunity to receive the full degree of price improvement
available at the NYSE. Internalization allows the order-originating
broker-dealer to profit at the expense of denying the customer the
ability to obtain a better price. In addition to the conflicts that
internalization practices raise, these practices seriously threaten the
price discovery process because the internalized order flow is not
exposed to, and therefore does not directly interact with, the overall
liquidity of the marketplace.
If a significant amount of internalization takes place, the agency
auction, in which 75% of the price discovery represents customers
meeting customers (rather than dealer intermediation) would disappear
and become a ``dealerized'' market, depriving customers of the savings
between the quotation spread associated with customer-to-customer price
discovery.
Therefore, we believe internalization should be banned. Absent
that, broker-dealers should be required to provide customers with price
improvement over the national best bid or offer. We have proposed that
the SEC enact such a rule in our filing to repeal Rule 390, as well as
in our response to the SEC's Concept Release on Fragmentation.
Question 3. What are the expected benefits decimalization will
bring to investors?
Response. Decimalization will result in narrower quotation spreads
in many stocks, providing significant savings to investors, presuming
that the minimum price variation is reduced to a penny rather than a
nickel. It will certainly make it easier for retail investors to track
price movement and trading variations.
Question 4. What are the competitive implications of
internalization?
Response. Because internalization deprives markets of optimal price
discovery, U.S. markets will be less competitive than they would be
otherwise. To compete with foreign markets, U.S. markets should be as
robust as possible through the full participation of both retail and
institutional order flow in the price discovery process.
Question 5. A CLOB, based on price-time priority reduces best
execution to the NBBO. There are however, many factors which could
influence a decision to trade. In your opinion, what factors should be
considered for best execution?
Response. Best execution should be determined based upon each
customer's needs, and we believe technology would enable that to be on
an order-by-order basis. Factors that should be weighed in making
order-routing decisions include: the bid and offer prices; their size,
in terms of depth of liquidity, and the probability of receiving a
complete ``fill'' (rather than partial execution); the probability of
price improvement; the probability of receiving an execution in size
greater than the displayed bid or offer and the market impact of large
orders; the speed of execution-, as well as the cost of execution.
We believe that our platform of customer choice, called ``Network
NYSE'' recognizes that ``one size doesn't fit all'', and that a range
of execution services will provide the optimal facility for best
execution.
Question 6. Should we call for the elimination of the Intermarket
Trading System? Do we need to designate a replacement for the system,
or would market forces adequately fill the gap?
Response. Yes, you should call for the replacement of the
Intermarket Trading System. It provides inappropriate free access to
our market by competitors and its quarter-century-old market-to-market
linkage should be replaced with the more efficient and robust
communications technology available today for linking broker-dealers
and brokers to markets. A conversion period would be appropriate,
during which time we would work with the industry, similar to Y2K and
decimalization, to ensure that a sufficient time would be provided for
broker-dealers and individual market members to avail themselves of
that technology. (Enclosed is a copy of our response to the SEC's
Concept Release on Market Fragmentation.)
In that way, broker-dealers and brokers can exercise their best-
execution responsibilities in a more efficient manner. If an order is
routed to a market and a better price becomes available on another
market, the market where the order was routed would match or the
participant would electronically transmit the order to the market
providing the opportunity for the best execution.
If ITS is not eliminated, an important prerequisite for direct
access should be SEC-approved self-regulatory organization status, as
presently required, for reasons outlined in the response to your next
question.
Question 7. The NASD recently granted ECNs access to their market
linkage system through the Computer Assisted Execution System (CAES).
Please explain what CAES does and why this does or does not adequately
address the problems of efficient linkage among markets. Has CAES
sufficiently linked ECNs with ITS?
Response. I would defer to the NASD for an explanation of the
specific infrastructure of that interface. The NASD access is
appropriate since ECNs are NASD broker-dealers; however, some ECNs want
direct linkage to the NMS without exchange status. That would create an
unfair advantage vis-a-vis other broker-dealers; it would result in
insufficient regulatory safeguards; and it would fragment liquidity
rather than consolidate order flow. It would suggest that countless
entities technologically capable of creating an order file and
interface network should proliferate quotes, while retaining order flow
in the hope of attracting a ``match'', resulting in capacity and
fragmentation inefficiencies.
Question 8. I understand both the NASDAQ and the NYSE are planning
to become for-profit exchanges. Do you plan to spin off your regulatory
arm entirely? If not, why should you have any interest in the regulator
of your competitors?
Response. No decision has been made regarding the advisability of
demutualization. Our Board formed a Special Committee on Market
Structure, Governance and Ownership in October of 1999, comprised
entirely of the public directors. Because market structure decisions
can influence deliberations regarding governance and ownership, the
Committee spent six months considering a broad spectrum of market
structure recommendations. The result is the Market Structure Report
embraced by our full Board in April. A copy is enclosed for your
review.
The NYSE is recognized as the world's pre-eminent self-regulator.
We have invested more than any other market center in differentiating
our regulatory brand to our competitive advantage. Therefore, we do not
intend to spin-off our regulatory function.
Later this year, and hopefully with the benefit of an appreciation
of the industry impact of decimalization, the Committee will consider
the issues of governance and ownership. Within the context of the
demutualization deliberations, we will assess the issue of forming a
separate NYSE regulatory entity within a holding company structure and
with separate governance.
As to the issue of regulating our competitors, the self-regulatory
process presently has that potential conflict in that we regulate
members who compete for market share through their equity in ECNs and
``internalize'' order flow on regional and OTC markets. We do not
regulate ECNS, since they are NASD broker-dealers, and our members have
been able to effect trades on regional exchanges for decades. There has
never been an allegation of inappropriate regulatory action based upon
that potential conflict. I am sure the SEC would expeditiously
investigate and not tolerate regulatory discrimination. The alternative
of a single-self-regulatory body suggested by some would result in
greater broker-dealer expenses, since present regulatory funding is
subsidized by the broader exchange revenues. In addition, it would lack
sufficient marketplace accountability, which could lead to an
inappropriate expenses and bureaucracy.
Question 9. Mr. Atkin states that the SROs earn monopoly revenues
in the area of market data and use it to subsidize business activities
they enter into in competition with their own members. Should the
regulation of market data be changed to provide for competition among
market data providers, and, if so, how?
Response. SROs develop and maintain the order-routing
infrastructure and capacity infrastructure necessary to create market
data. Our market data revenues are not ``monopoly'' revenues. They are
subject to constituent consensus through Board approval and SEC
oversight in terms of their fairness. In fact, those fees have
decreased significantly in conjunction with increased volume. The
percentage of NYSE market data revenues to our overall revenues has
remained relatively constant over the years, at 14-17 percent.
We have recently responded to a SEC release on market data (also
enclosed) in which we state our belief that, rather than the suggested
``utility rate-making,'' self-regulatory organizations should be
permitted sell market data based upon freemarket vendor pricing and
consolidation, which would continue to be subject to SEC review for
fairness. We believe that supply and demand is the best regulator of
prices.
Question 10. Do current market information fees restrict the
availability of real-time information?
Response. No. I have enclosed a copy of our market data fee
structure. For public investors, real-time data is free and ubiquitous.
Question 11. What disclosure do you provide regarding your costs
and revenues associated with market data? Would you object to providing
more information about those costs and revenues to the public?
Response. Our market data revenues, as well as our expenses for
systems and related support are disclosed to the public in our Annual
Report (enclosed). More detailed disclosure of the costs associated
with the performance of each SRO function would push each market into
product-line accounting, would produce arbitrary results that are
susceptible to second guessing, would require the Commission to
establish uniform accounting standards and procedures, would require
each market to overhaul its accounting and auditing functions, and
would require difficult allocations of overhead and other costs. If the
Commission were to mandate cost-based ratemaking, than all of these
burdens would represent unavoidable consequences of that decision. If
the Commission does not adopt a cost-based rate-making requirement,
then such significant and expensive new burdens require careful thought
and the assessment of a cost/benefit analysis.
Question 12. At our last hearing, one of our witnesses, Island,
demonstrated how their entire order book is publicly available on their
web site in real time. Doesn't this level of transparency help
investors? You stated that the NYSE intends to provide such access to
investors. Please describe exactly what information will be provided to
investors and how they will access it.
Response. We agree that making the electronic limit order books
available increases transparency to the advantage of investors. We are
exploring three non-exclusive alternatives: a direct transmittal to
member broker-dealers; a similar transmittal to vendors; and
publication on our web site. The entering firm identity would be
blocked and broker-dealers and vendors would format the data as they
choose. A publication on our web site would provide total shares and
number of orders at several increments above and below the best bid and
offer, with a summary-range format beyond the designated level. We are
in the process of identifying the needs of broker-dealers and investors
as to the most effective means of making that information available.
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