<DOC>
[107th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:82451.wais]
ECNs AND MARKET STRUCTURE: ENSURING BEST PRICES FOR CONSUMERS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
OCTOBER 17, 2002
__________
Serial No. 107-134
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
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____________________________________________________________________________
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan
JOE BARTON, Texas HENRY A. WAXMAN, California
FRED UPTON, Michigan EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia SHERROD BROWN, Ohio
RICHARD BURR, North Carolina BART GORDON, Tennessee
ED WHITFIELD, Kentucky PETER DEUTSCH, Florida
GREG GANSKE, Iowa BOBBY L. RUSH, Illinois
CHARLIE NORWOOD, Georgia ANNA G. ESHOO, California
BARBARA CUBIN, Wyoming BART STUPAK, Michigan
JOHN SHIMKUS, Illinois ELIOT L. ENGEL, New York
HEATHER WILSON, New Mexico TOM SAWYER, Ohio
JOHN B. SHADEGG, Arizona ALBERT R. WYNN, Maryland
CHARLES ``CHIP'' PICKERING, GENE GREEN, Texas
Mississippi KAREN McCARTHY, Missouri
VITO FOSSELLA, New York TED STRICKLAND, Ohio
ROY BLUNT, Missouri DIANA DeGETTE, Colorado
TOM DAVIS, Virginia THOMAS M. BARRETT, Wisconsin
ED BRYANT, Tennessee BILL LUTHER, Minnesota
ROBERT L. EHRLICH, Jr., Maryland LOIS CAPPS, California
STEVE BUYER, Indiana MICHAEL F. DOYLE, Pennsylvania
GEORGE RADANOVICH, California CHRISTOPHER JOHN, Louisiana
CHARLES F. BASS, New Hampshire JANE HARMAN, California
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska
ERNIE FLETCHER, Kentucky
David V. Marventano, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Commerce, Trade, and Consumer Protection
CLIFF STEARNS, Florida, Chairman
FRED UPTON, Michigan EDOLPHUS TOWNS, New York
NATHAN DEAL, Georgia DIANA DeGETTE, Colorado
Vice Chairman LOIS CAPPS, California
ED WHITFIELD, Kentucky MICHAEL F. DOYLE, Pennsylvania
BARBARA CUBIN, Wyoming CHRISTOPHER JOHN, Louisiana
JOHN SHIMKUS, Illinois JANE HARMAN, California
JOHN B. SHADEGG, Arizona HENRY A. WAXMAN, California
ED BRYANT, Tennessee EDWARD J. MARKEY, Massachusetts
GEORGE RADANOVICH, California BART GORDON, Tennessee
CHARLES F. BASS, New Hampshire PETER DEUTSCH, Florida
JOSEPH R. PITTS, Pennsylvania BOBBY L. RUSH, Illinois
MARY BONO, California ANNA G. ESHOO, California
GREG WALDEN, Oregon JOHN D. DINGELL, Michigan,
LEE TERRY, Nebraska (Ex Officio)
ERNIE FLETCHER, Kentucky
W.J. ``BILLY'' TAUZIN, Louisiana
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Foley, Kevin M., Chief Executive Officer, Bloomberg
Tradebook, LLC............................................. 6
Gasser, Robert C., Chief Executive Officer, Nyfix Millennium,
LLC........................................................ 25
O'Brien, William, Senior Vice President and General Counsel,
Brut, LLC.................................................. 19
O'Hara, Kevin J.P., General Counsel, Archipelago............. 14
Ryan, Michael J., Jr., General Counsel, American Stock
Exchange LLC............................................... 29
Additional material submitted for the record:
Foley, Kevin M., Chief Executive Officer, Bloomberg
Tradebook, LLC, response for the record.................... 56
O'Brien, William, Senior Vice President and General Counsel,
Brut, LLC, response for the record......................... 63
Ryan, Michael J., Jr., General Counsel, American Stock
Exchange LLC, letter dated November 22, 2002, enclosing
response for the record.................................... 66
(iii)
ECNs AND MARKET STRUCTURE: ENSURING BEST PRICES FOR CONSUMERS
----------
THURSDAY, OCTOBER 17, 2002
House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Commerce, Trade and
Consumer Protection,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:35 a.m., in
room 2123, Rayburn House Office Building, Hon. Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns and Towns.
Staff present: David Cavicke, majority counsel; Shannon
Vildostegui, majority counsel; Brian McCullough, majority
counsel; Will Carty, legislative clerk; and Consuela
Washington, minority counsel.
Mr. Stearns. Good morning, everybody. The subcommittee will
come to order.
Let me welcome our witnesses. In the securities area, there
has been an intense focus today on corporate governance, and of
course, with that, accounting governance over the past year.
And, of course, rightly so. There has been a tremendous need
for oversight and correction in these areas. And these areas,
these issues, will continue to be of heightened concern as
corporate America works to regain investors' confidence.
But today we will take a look at another set of very
important issues. These issues are less sensational than the
scandals of the last year, so we are not likely to see
extensive media coverage of this hearing today. Yet these
issues are no less important to the functioning of the capital
markets and, of course, to the protection of investors.
Today we will focus on market structure issues. There have
been significant market structure changes in the past year that
have important implications for all investors. These are ECNs.
And ECNs are basically electronic communication networks. They
are basically technologically advanced communication systems
for simply trading securities. As a result of advances in
computing power and telecommunication technology as well as
certain changes in security rules, ECNs have emerged as
competitive alternatives to traditional stock markets.
ECNs are basically order matching services, matching buy
and sell orders entered into their systems by their
subscribers, and through this simple procedure, buyers and
sellers are able to come together. But they are relatively new
market participants that provide trading platforms that are
distinct from traditional floor and specialist models of the
New York Stock Exchange and the quotation montage and market-
maker model of the Nasdaq. So basically ECNs models vary. Some
are order matching systems, others are order routing systems.
They have different fee structures as well as different
customer bases.
What the ECNs do have in common, though, is that they
provide much of the impetus for market improvements, those we
have seen over the past few years and certainly we will see
into the future. ECNs were the first to trade in decimals, the
first to show depth of book, the first to offer reserves, and
the first to allow anonymity to trades. These are common
features now, and the Nasdaq has incorporated these functions
into its SuperMontage. But the competitive pressures that ECNs
have brought to the marketplace have made trading cheaper,
faster, and tailored to fit real market needs, and their
presence in the marketplace will continue to push forward
cheaper, faster, and, of course, more innovative services.
But it is not only institutional investors that have reaped
the benefits of ECN innovation. Small investors have also
reaped the benefits. Competition from ECNs have reduced
transaction costs marketwide; namely, commissions and spreads
have dropped. For example, ECNs lead the push to
decimalization, reducing the trade increments in which
investors trade from one-sixteenth of $1 to a fraction of a
cent.
ECNs also introduced anonymity of trades, allowing my
mutual funds to buy or sell securities without moving the
market. This, of course, has a direct impact on the value of my
mutual fund investment, for example.
Over the past year, there have been some important market
structure developments. One ECN was approved to operate as an
exchange. Some ECNs merged and the SEC approved the Nasdaq
SuperMontage. All have significant implications for the future
of the marketplace, and I look forward to hearing the testimony
of our panel today to discuss some of these issues raised by
these market developments.
In particular, I hope that our panel will discuss market
data issues: Are customers still paying too much for market
data? Are market data rebates a benefit to investors? Will
market data rebates solve the market issues, or is a regulatory
fix required?
I also hope to hear some testimony on the status of
SuperMontage: Has the Nasdaq addressed the competitive concerns
raised by ECNs? What potential benefits or risk does the
SuperMontage bring to the marketplace? What is the status of
ITS. Are the access rules for listing securities responsible
for ECNs' lower trading volumes in listed securities than in
the Nasdaq securities?
And finally, my colleagues, inter-ECN access fees: What are
the different fee structures in place for access to ECN
systems? Are these fees consistent with ECN obligations under
the order handling rules to provide access to the best prices
in the marketplace?
These are some of the questions we would like to have
discussed today and I look forward to discussing these with our
panel. So I welcome your comments and I appreciate your
appearing before your committee. Even though Congress is out,
we wanted to continue the schedule of this hearing. So I thank
you for coming.
With that, I offer an opening statement to the
distinguished ranking member from New York, Mr. Towns.
[The prepared statement of Hon. Clifford Stearns follows:]
Prepared Statement of Hon. Cliff Stearns, Chairman, Subcommittee on
Commerce, Trade and Consumer Protection
In the securities area, there has been an intense focus on
corporate governance and accounting governance over the past year. And
rightly so, there was a tremendous need for oversight and correction in
these areas. And these issues will continue to be of heightened concern
as corporate America works to regain investor confidence.
But today we will take a look at another set of important issues.
These issues are less sexy than the scandals of the last year so we are
not likely to see extensive media coverage of the hearing here today.
Yet these issues are no less important to the functioning of the
capital markets and the protection of investors. Today we will focus on
market structure issues. There have been significant market structure
changes in the past year that have important implications for
investors.
ECNs are relatively new market participants that provide trading
platforms distinct from the traditional floor and specialist model of
the New York Stock Exchange and the Quotation Montage and Market Maker
model of the NASDAQ. ECN models vary--some are order-matching systems.
Others are order routing systems. They have different fee structures as
well as different customer bases.
What the ECNS do have in common is that they provide much of the
impetus for market improvements, those we have seen over the past few
years and certainly those we will see in the future. ECNs were the
first to trade in decimals, the first to show depth of book, the first
to offer reserves and the first to allow anonymity to trades. These are
common features now--and the NASDAQ has incorporated these functions
into its SuperMontage--but the competitive pressure ECNs have brought
to the marketplace has made trading cheaper, faster and tailored to fit
real market needs. And their presence in the marketplace will continue
to push forward cheaper, faster and more innovative service.
It is not only institutional investors that have reaped the
benefits of ECN innovation. Small investors have too. Competition from
ECNs has reduced transaction costs market-wide--namely commissions and
spreads have dropped. For example, ECNs lead the push to
decimalization, reducing the trade increments in which investors trade
from \1/16\ths of one dollar to fractions of a cent. ECNs also
introduced anonymity of trades--allowing my mutual fund to buy or sell
securities without moving the market. This has a direct impact on the
value of my mutual fund investment.
Over the past year there have been some important market structure
developments. One ECN was approved to operate as an exchange, some ECNs
merged and the SEC approved the NASDAQ's SuperMontage. All have
significant implications for the future of the marketplace and I look
forward to hearing our panel discuss some of the issues raised by these
market developments.
In particular, I hope that our panel will discuss market data
issues. Are customers still paying too much for market data? Are market
data rebates a benefit to investors? Will market data rebates solve the
market data issues or is a regulatory fix required?
I also hope to hear some testimony on the status of SuperMontage.
Has the NASDAQ addressed the competitive concerns raised by the ECNs?
What potential benefits or risks does the SuperMontage bring to the
marketplace?
What is the status of ITS? Are the access rules for listed
securities responsible for ECN lower trading volume in listed
securities than in NASDAQ securities?
And finally, inter-ECN access fees. What are the different fee
structures in place for access to ECNs systems? Are these fees
consistent with ECN obligations under the order handling rules to
provide access to the best prices in the marketplace?
I look forward to discussing these and other issues with our panel
today. I welcome you all and thank you for appearing before the
Subcommittee.
Mr. Towns. Thank you very much, Mr. Chairman. I agree with
you that I think that this is a very important hearing, and
even though the Congress is out, I really feel we should move
forward with this particular hearing, and I want to thank you
for holding it. I welcome all of my New York constituents this
morning, of course, but I look forward to everybody's
testimony.
While the title of this hearing suggests that the focus is
solely ECNs, it would be a mistake to overlook or to minimize
the contributions and value of the exchanges and all that they
contribute to market liquidity, capital formulation, and
economic improvement in this country. One of the hallmarks of
our system is that we offer users a broad array of competitive
alternative trading venues, and I hope that we will always
continue to do that.
Let me note that as a result of changes in the House rules
adopted by this Congress, most of the committee's historical
jurisdiction over securities and exchanges are transferred to
the newly created Committee on Financial Services. However, it
was agreed that this committee would retain jurisdiction over
legislation dealing broadly with electronic commerce, including
ECNs, and that none of our jurisdiction over consumer affairs
and consumer protection would be limited in any way.
Accordingly, I commend the chairman of the subcommittee for
exercising this jurisdiction and looking into these important
matters this morning. I salute you for that, Mr. Chairman. A
great deal has changed since the subcommittee's December 19,
2001 hearing on ECNs. For starters, two of the witnesses at
that hearing, Island and Instinet, have merged. Mr. Chairman,
maybe we should not have allowed them to sit next to each other
during that day. Also, Nasdaq commenced trading on the
SuperMontage system this week with five stocks.
I hope we will revisit the issue raised by these and other
events early next year after we have had a chance to measure
the effects on electronic commerce and the consumers. With
Nasdaq trading below 1300 and the Dow trading only near about
8000 and with the steady beat of corporate and accounting
scandals and bad economic news, Wall Street is facing difficult
times and so is the economy. Investor confidence has taken a
serious beating.
I hope the Congress and this administration will take the
necessary steps to adopt responsible economic policies and to
finish the job that the Sarbanes and Oxley Act begins. Mr.
Chairman, on that note, I yield back and I am anxious to hear
from my witnesses.
[The prepared statement of Hon. Edolphus Towns follows:]
Prepared Statement of Hon. Edolphus Towns, a Representative in Congress
from the State of New York
I welcome all of our witnesses this morning, especially my New York
constituents, but I look forward to hearing the testimony of all of our
witnesses.
While the title of this hearing suggests that the focus is solely
ECNs, it would be a mistake to overlook or minimize the contributions
and value of the exchanges and all that they contribute to market
liquidity, capital formation, and economic improvement in this country.
One of the hallmarks of our system is that we offer users a broad array
of competitive alternative trading venues, and I hope that we will
always continue to do that.
Let me note that, as a result of changes in the House Rules adopted
at the beginning of this Congress, most of this Committee's historical
jurisdiction over securities and exchanges was transferred to the newly
created Committee on Financial Services. However, it was agreed that
this committee would retain jurisdiction over legislation dealing
broadly with electronic commerce, including ECNs, and that none of our
jurisdiction over consumer affairs and consumer protection would be
limited in any way. Accordingly, I commend the chairman of the
subcommittee for exercising this jurisdiction and looking into these
important matters this morning.
A great deal has changed since the subcommittee's December 19, 2001
hearing on ECNs. For starters, two of the witnesses at that hearing,
Island and Instinet, have merged. Maybe we shouldn't have let them sit
next to each other that day. Also, NASDAQ commenced trading on its
SuperMontage system this week with five stocks. I hope that we will
revisit the issues raised by these and other events early next year
after we have had a chance to measure their effects on electronic
commerce and on consumers.
With NASDAQ trading below 1300 and the Dow trading only narrowly
above 8000, and with the steady beat of corporate and accounting
scandals and bad economic news, Wall Street is facing difficult times
and so is the economy. Investor confidence has taken a serious beating.
I hope that Congress and the Administration will take the necessary
steps to adopt responsible economic policies, and to finish the job
that the Sarbanes-Oxley Act begins.
Mr. Stearns. I thank my colleague.
[Additional statement submitted for the record follows:]
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee
on Energy and Commerce
This hearing on ECNs and the benefits they provide to consumers is
timely and I want to commend Chairman Cliff Stearns and Ranking Member
Towns for convening it. ECNs are a relatively new way of trading stock;
most are less than five years old. In that time, ECN's speed, agility
and the favorable prices and market access they provide to consumers
have been an important addition to our financial markets. ECNs are the
venue for over 40% of the trading in NASDAQ Stock. Last December
Chairman Stearns held a hearing on the role ECNs played in restoring
trading activity after the terrorist attacks on September 11th. These
hearings demonstrate our continuing interest in and enthusiasm for the
development of ECNs in the market place.
There are a number of important issues facing ECNs that have
significant effects on consumers. These issues include the creation of
an ECN within NASDAQ called the Supermontage. I understand that today
is the forth day of operation of the Supermontage, and NASDAQ couldn't
be with us today. I think we will have a hearing next spring to see the
effects Supermontage is having on competition within the NASDAQ market.
We learned after 9-11 that we do not want to have a single point of
failure that would render the markets unable to function and we will
want to be sure that Supermontage does not inadvertently become such a
single point of failure.
Additionally, there are important issues affecting ECNs that have
been repeatedly studied and have been awaiting resolution at the SEC
for too long. These issues include:
<bullet> Market access fees charged by both NASDAQ and some ECNs;
<bullet> The continued viability of the intermarket trading system,
which all participants say is broken but no one wants to fix;
And
<bullet> The costs that investors are forced to pay for market data,
that everyone agrees greatly exceeds the cost of collection and
dissemination of that market data.
Prior to the discovery of serious accounting fraud at Enron,
WorldCom, Tyco and Global Crossings, ECNs and market structure issues
were front and center both in the Committee and at the SEC. I would not
want to see resolution of market structure issues and the important
benefits they present for consumers to be neglected or put on the back
burner at the SEC because of the egregious conduct corporate officers
elsewhere. Just because these issues are not on the front pages of the
business section does not mean that there are not important consumer
and competitive concerns that need to be addressed.
Times have changes dramatically in the past year, and the ECNs are
no exception. There has been consolidation among the ECNs, an ECN has
been granted ``exchange'' status, and the SEC recently approved the
NASDAQ's Supermontage.
This Committee has tackled and uncovered some egregious practices
by market participants that have rattled the markets and investors in
the last year. As investors become increasingly disenchanted with the
integrity of the securities markets and its participants, it is vitally
important that we continue to examine all aspects of our economy and
make necessary changes as appropriate. Restoring ``transparency'' has
been the buzzword this year, but regulators have more to do than that.
Investors need to know that the system is not stacked against them, and
market participants must be free to compete. Regulatory barriers should
not determine winners and losers; innovation and competition should
determine the winners.
I look forward to hearing from our witnesses on these issues and
yield back the balance of my time.
Mr. Stearns. And of course as you pointed out, these are
constituents of yours, so we welcome all of you: Kevin Foley,
the Chief Executive Officer, Bloomberg Tradebook; Kevin O'Hara,
General Counsel of Archipelago; William O'Brien, Senior Vice
President and General Counsel of Brut; Robert Gasser, Chief
Executive Officer of NYFIX Millennium; and Michael Ryan,
General Counsel for the American Stock Exchange. We welcome you
and look forward to your opening statement.
And, Mr. Foley, we will start with you.
STATEMENTS OF KEVIN M. FOLEY, CHIEF EXECUTIVE OFFICER,
BLOOMBERG TRADEBOOK, LLC; KEVIN J.P. O'HARA, GENERAL COUNSEL,
ARCHIPELAGO; WILLIAM O'BRIEN, SENIOR VICE PRESIDENT AND GENERAL
COUNSEL, BRUT, LLC; ROBERT C. GASSER, CHIEF EXECUTIVE OFFICER,
NYFIX MILLENNIUM, LLC; AND MICHAEL J. RYAN, JR., GENERAL
COUNSEL, AMERICAN STOCK EXCHANGE LLC
Mr. Foley. Thank you, Mr. Chairman and members of the
committee. Thank you for your insightful comments. My name is
Kevin Foley and I am pleased to testify on behalf of Bloomberg
Tradebook regarding ``ECNs and Market Structure: Ensuring the
Best Prices for Consumers.'' The topic is both important and
timely.
Bloomberg Tradebook is owned by Bloomberg L.P. And is
located in New York City. Bloomberg L.P. Provides multimedia,
analytical, and news services to more than 170,000 terminals
used by 350,000 financial professionals in 100 countries
worldwide. Bloomberg News is syndicated in over 350 newspapers
and on 550 radio and television stations worldwide. Bloomberg
publishes 7 magazines as well as books on financial subjects
for the investment professional and nonprofessional reader.
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
representing through pension funds, mutual funds and other
vehicles, the savings of millions of ordinary Americans.
Bloomberg Tradebook specializes in providing innovative tools
that make large orders small and eliminate the traditional
barrier between the upstairs market for large orders and the
trading floor. We bring upstairs liquidity directly into
contact with small retail trading and other small order flows
and, in the process we consolidate what has been a fragmented
market. Our clients have rewarded our creativity and service by
trusting us with their business, allowing us to regularly trade
more than 150 million shares a day in the U.S. And a quarter
again as much in international securities.
Electronic communications networks, ECNs, are electronic
systems that facilitate trading and securities. Market
structure decisions, specifically the SEC's 1996 issuance of
the order handling rules in the wake of collusion on the Nasdaq
market, have permitted ECNs to flourish over the past 6 years
benefiting consumers and the markets generally. These rules
were designed to promote market transparency in the Nasdaq
market. In the words of then SEC Chairman Arthur Levitt:
Electronic communication networks have been one of the most
important developments in our markets in years, perhaps
decades.
But exactly what are ECNs and what are we to make of their
impact on our markets? In simplest terms, ECNs bring buyers and
sellers together for electronic execution of trades. They have
provided investors with greater choices and have driven
execution costs down to a fraction of a penny. As a result,
these networks present serious competitive challenges to the
established market centers. More fundamentally, they illustrate
the breathtaking pace of change that results when technology
and competition coalesce.
As has often been observed, sunlight is the best
disinfectant. Indeed, the increase promoted by the SEC's order
handling rules and the subsequent integration of ECNs into the
national quotation montage narrowed Nasdaq's spreads by nearly
30 percent in the first year following adoption of the order
handling rules. These and subsequent reductions in
transactional costs constitute significant savings that are now
available for investment that fuels business expansion and job
creation. The resolution of questions regarding the Nasdaq
exchange application and the manner in which SuperMontage is
phased in will go a long way toward determining whether the
securities markets of the future will be shaped by competition
or dominated by government-sponsored monopolies. That will have
much to do with whether our markets remain competitive, robust
and open to innovation. For-profit exchanges will have powerful
incentives to leverage their existing government-sponsored
monopolies to gain an unfair advantage in currently competitive
markets. They will have incentives to keep pace with market
innovators not by moving forward themselves, but by slowing
down all market participants and centralizing order flow. If
that occurs, consumers, investors in the markets themselves,
will be denied the benefits of competition. Everyone loses if
exchanges comfortable as government-sponsored monopolies fail
to innovate, leaving American markets vulnerable to offshore
competitors.
As the growth of ECNs illustrates, modern technology allows
the advantages of maximum order interaction without the
downside of centralization. State-of-the-art telecommunication
systems like the Internet don't rely on a single monopoly
channel; rather they rely on the networked web of multiple
competing and redundant linkages.
Why shouldn't the securities markets work the same way and
reap those same benefits? Centralized systems are resistant to
change. The innovations that ECNs have brought to the market
would not have occurred under more centralized systems. A
centralized system also provides a significant downside of a
central point of failure.
So who has benefited from the existence of ECNs? For one,
small retail customers who for the first time have gained
direct unfettered access to liquidity of institutional order
flow represented directly in the market.
Who else has benefited? Clearly, American business. The
President of the United States Chamber of Commerce, Tom
Donahue, summed it up succinctly in a letter to SEC Chairman
Pitt, stating: American business has benefited mightily in
recent years from SEC initiatives like the order handling rules
that have enhanced market transparency, fostered competition in
our securities markets and reduced transaction costs,
significantly reduced spreads and increased efficiencies, and
freed up more capital for launching new businesses and creating
new jobs. This sunshine is important to ensure the most
efficient capital formation process in the U.S. And to ensure
that America's market continues to be the preeminent market in
the world.
Who else benefits from ECNs? All investors who have seen
the speed and fairness of their executions improve. ECNs have
raised the standards for all broker dealers. Even traders now
participating in ECNs benefit from our depth liquidity and
immediacy each time they hit an ECN bid or take an ECN offer.
Who hasn't benefited from ECNs? Useful linkages have yet to
be developed for the exchange listed market. As a result,
investors in those markets have yet to reap the full benefits
of the competition provided by ECNs. This is why it is
imperative that the steps necessary to facilitate the promised
display of listed stocks in the NASD's alternative display
facility be undertaken as soon as possible.
Clearly, the New York Stock Exchange has historically had
no interest in encouraging linkages that would make ECNs
players in the listed markets. It is long past time for the
benefits ECNs have brought to the market in over-the-counter
securities to be extended to markets in listed securities as
well.
The neutrality, transparency, fairness, and innovation ECNs
collectively bring to the Nasdaq market have dramatically
increased competition and efficiency on Wall Street, redounding
to the benefit of consumers on Main Street and to the benefit
of our economy. Investors in the New York Stock Exchange listed
market should be permitted an opportunity to enjoy those same
benefits.
Historically, not-for-profit exchanges are contemplating a
for-profit future. As market players that have traditionally
functioned as public utilities become for-profit entities,
their goals, incentives and agendas radically change as well.
Consumers and investors will suffer if exchanges succeed in
leveraging their existing government-sponsored monopolies into
currently competitive arenas. These efforts will suppress
competition, discourage innovation, and harm consumers. Thank
you, Mr. Chairman.
[The prepared statement of Kevin M. Foley follows:]
Prepared Statement of Kevin M. Foley, Chief Executive Officer,
Bloomberg Tradebook LLC
introduction.
Mr. Chairman and Members of the Subcommittee. My name is Kevin
foley, and I am pleased to testify on behalf of Bloomberg Tradebook
regarding ``ECNs and market structure: ensuring the best prices for
consumers.'' the topic is both important and timely.
Bloomberg Tradebook is owned by Bloomberg L.P. and is located in
New York City. Bloomberg L.P. provides multimedia, analytical and news
services to more than 170,000 terminals used by 350,000 financial
professionals in 100 countries worldwide. Bloomberg tracks more than
135,000 equity securities in 85 countries, more than 50,000 companies
trading on 82 exchanges and more than 406,000 corporate bonds.
Bloomberg News is syndicated in over 350 newspapers, and on 550 radio
and television stations worldwide. Bloomberg publishes seven magazines,
as well as books on financial subjects for the investment professional
and non-professional reader.
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 representing--through
pension funds, mutual fund and other vehicles--the savings of millions
of ordinary Americans. Bloomberg Tradebook specializes in providing
innovative tools that make large orders small and eliminate the
traditional barrier between the upstairs market and the trading floor.
We bring upstairs liquidity directly into contact with small retail
trading, the options market-makers and program trading flow and in the
process we consolidate what has been a fragmented market. Our clients
have rewarded our creativity and our service by trusting us with their
business, allowing us to regularly trade more than 150 million shares a
day.
what are ecns?
electronic communications networks--ECNs--are electronic systems
that facilitate trading in securities. Market structure decisions--
specifically the SEC's 1996 issuance of the order handling rules--have
permitted ECNs to flourish over the past six years, benefiting
consumers and the markets generally. These rules--aimed primarily at
exchange specialists and Over-the-Counter market makers--were designed
to promote market transparency in the Nasdaq market. In the words of
then SEC Chairman Arthur Levitt:
Electronic communication networks have been one of the most
important developments in our markets in years--perhaps
decades. But exactly what are ECNs, and what are we to make of
their impact on our markets? In simplest terms, ECNs bring
buyers and sellers together for electronic execution of trades.
They have provided investors with greater choices, and have
driven execution costs down to a fraction of a penny. As a
result, these networks present serious competitive challenges
to the established market centers. More fundamentally, they
illustrate the breath-taking pace of change that results when
technology and competition coalesce.<SUP>1</SUP>
---------------------------------------------------------------------------
\1\ Speech by SEC Chairman Arthur Levitt, Dynamic Markets, Timeless
Principles, Columbia Law School, September 23, 1999, available on the
Internet at http://www.sec.gov/news/speeches/spch295.htm.
---------------------------------------------------------------------------
As has often been observed, sunlight is the best disinfectant.
Indeed, the increased transparency promoted by the SEC's Order Handling
Rules and the subsequent integration of ECNs into the national
quotation montage narrowed Nasdaq spreads by nearly 30% in the first
year following adoption of the order handling rules. These, and
subsequent reductions in transactional costs, constitute significant
savings that are now available for investment that fuels business
expansion and job creation.
While the complete list of reforms ordered by the SEC to promote
transparency is long and varied, all of these changes, including the
promulgation of the Order Handling Rules, were animated by the same
underlying principle--namely that sunlight--increased transparency--
produces the most honest and efficient markets.
ecns--a market solution to a market problem.
A regulatory regime that encourages transparency was a necessary,
but not sufficient, precondition to the growth of ECNs. The reason ECNs
have long accounted for nearly half of the reported share volume of
Nasdaq is simple--ECNs are a market solution to a market problem.
not all ECNs are alike. Agency ecns such as Bloomberg Tradebook,
however, share four characteristics--neutrality, transparency, fairness
and innovation.
Neutrality? Bloomberg Tradebook is an agency broker. We take no
position for our own account. Thus we are neutral in the marketplace
and exist only to serve our customers' need to buy or sell shares. In
addition, we are an open-architecture ECN, by which we mean that we do
not simply internalize our participants' orders. Instead, we route most
of the orders we receive to market makers and other ECNs for
execution--giving our participants the option to select whatever prices
are available in the markets. In that way, we differ from ECNs such as
island, a closed-architecture system, which does not route orders to
other market centers.
Transparency? Like market makers, we maintain an electronic book of
our customers' bids and offers. But unlike market makers we publish our
entire book of quoted prices electronically for all our customers to
see. Indeed, as noted above, we take advantage of this transparency to
allow our customers to route their orders to the best available prices,
even if they are outside of Bloomberg Tradebook.
Fairness? ECNs are required by SEC rules to respond immediately--
and I mean immediately--to orders at any given price, in the time
sequence they are received, whether they come from our best customers
or from our competitors. That's probably the highest standard of
fairness in the industry.
Innovation? Unlike Nasdaq and the NYSE, ECNs do not enjoy the
privileged and protected status of a government-sponsored monopoly.
Instead, ECNs must earn their keep by innovating. At its inception in
1996, for example, Bloomberg Tradebook introduced the concept of
electronic order sizing to the U.S. equity markets. Electronic order
sizing is a Bloomberg functionality that permits investors to divide
large orders automatically into small, random-sized pieces before being
presented to the market. With electronic order sizing, ECNs have given
investors the tools to control the market impact of their transactions,
reducing the extent to which the market ``moves away'' from them while
they are buying or selling in significant quantities.
Just as the competition from ECNs has reduced explicit
transactional costs--commissions and spreads--innovations like reserve,
discretion, electronic order sizing and other order handling tools have
broken down the barrier between the upstairs market and the trading
floor, increasing liquidity and leading to dramatic decreases in the
implicit costs of transacting in the public markets for Nasdaq
securities.
Any edge we gain from introducing an innovation is a momentary one.
To remain competitive, we must continue to innovate. We have done so
continuously over the past six years.
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.
When the Senate Banking Committee held a hearing in the last
Congress exploring the role of ECNs, Frank Zarb, then Chairman of the
National Association of Securities Dealers, stated, ``I guess I sum up
the answer as to why we have ECNs as the fact that the national stock
exchanges, and I'm not only talking about ours, but the exchanges
around the world haven't been keeping pace with the needs of the
market.''
Mr. Zarb is a recognized leader in business and public service.
Investors are fortunate to have had the benefit of his leadership, 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 stated.
We would submit that Nasdaq and the other exchanges, because they
are government-sponsored monopolies, ultimately cannot provide the
innovative ideas and customer service of the best ECNs and other
private market participants. To spur future innovation, I'd rather
place my faith in NASD's members--the marketplace of competing broker-
dealers.
the current challenge.
At present, most SROs are nonprofit organizations. NASD, however,
has largely completed its privatization of Nasdaq and it may well be
that other privatizations will follow. Historically, Under the cover of
a nontransparent bureaucracy, non-profit SROs have exploited the
opportunity to subsidize their other costs (for example, costs of
market operation, market regulation, market surveillance, member
regulation) through market information fees. For all SROs, the
incentive will be strong to continue to exploit this government-
sponsored monopoly over market data by charging excessive rates for
market data and by using the resulting monopoly rents to subsidize
their competitive businesses. Indeed, shareholders of the now-for-
profit exchanges will effectively demand that market data charges
remain excessive.
Along with its market data monopoly, Nasdaq also will have a
powerful incentive to leverage its trade execution monopoly to the
detriment of consumers, investors and the markets. Currently, there is
no real alternative to Nasdaq's monopoly with respect to the execution
of market-maker quotations/orders in securities traded via Nasdaq.
Through a series of developments, starting with the inauguration of the
Small Order Execution System (``SOES'') in the 1980's and progressing
through the development of SuperSOES and SuperMontage, Nasdaq has
evolved from a decentralized, quotation- and telephone-based system
into a screen-based, electronic communications network embodying a
central, electronic limit order book.
In theory, NASD members can bypass SuperSOES through private wire
connections between a market maker and a customer or dealer. In
reality, however, that means of avoiding SuperSOES is not on an equal
competitive footing with the use of SuperSOES. Orders transmitted
through SuperSOES impose obligations on the market maker to execute
against its published quotation.
Only Nasdaq has the monopolistic power to deliver mandatory
executions to market makers against their quotations. Individual market
participants do not have the market power to replicate that obligation
through private contractual arrangements or other private ordering.
supermontage and the nasdaq exchange application.
The resolution of questions regarding the Nasdaq exchange
application and the manner in which Supermontage is phased in will go a
long way toward determining whether the securities markets of the
future will be shaped by competition or dominated by government-
sponsored monopolies. That will have much to do with whether our
markets remain competitive, robust and open to innovation.
Nasdaq has applied to the SEC to become a for-profit exchange.
Unfortunately, Nasdaq would like not only to maintain, but also to
expand, its government-sponsored monopoly powers while becoming a for-
profit exchange. To that end, Nasdaq petitioned the SEC in 1999, to
expand its monopoly by centralizing quotation display and order
execution in a ``SuperMontage'' nasdaq would control.
Recognizing the potential anticompetitive impact of SuperMontage,
the SEC made its January 2001 approval of SuperMontage contingent on
Nasd's meeting certain critical preconditions which were intended to
ensure that particpation in SuperMontage was truly voluntary.
alternative display facility.
Preeminent among these preconditions was the establishment of an
``alternative display facility'' (ADF)--a display facility that would
be run by NASD and stand as an alternative to Nasdaq.
The ADF was deemed so critical to the SEC that it was cited as a
precondition to both the rollout of SuperMontage and the possible
approval of the Nasdaq exchange application.
NASD is not independent of Nasdaq. Unfortunately, a number of
obstacles have been placed in the way of creating a commericially
viable ADF, some flowing from the fact that NASd--which is charged with
organizing and running the ADF--is not independent of Nasdaq.
NASD and Nasdaq have interlocking boards. NASD retains a
significant ownership interest in Nasdaq and a commercial interest in
Nasdaq's eventual success as a for-profit exchange. The significance of
NASD's not being independent of Nasdaq is driven home in Nasdaq's
Amendment 2 to its form 10 registration statement. Discussing the ADF
and its competitive potential, Nasdaq states:
If this market becomes a viable alternative to Nasdaq, then
Nasdaq faces the risk of reduced market share in transactions
and market information services revenues, which would adversely
affect Nasdaq's business, financial condition, and operating
results.
With Nasdaq viewing the ADF as a potential threat, we believe the
SEC and Congress need to remain vigilant to ensure that NASD is
wholeheartedly committed to the ADF.
commending the sec.
Signficantly, as NASD and Nasdaq initially designed it, the ADF was
to be a hidden market--in essence a ``display'' facility that few
market participants could see. Market participants could have chosen to
display their quotations on the ADF, but no provision had been made for
the market at large to see those quotations. As proposed by NASD and
Nasdaq, the transparency that has been the hallmark of regulation since
the promulgation of the order handling rules would have been vitiated
for the ADF, to the detriment of consumers and markets. This summer,
the SEC rejected Nasdaq's call for a hidden market and issued
interpretive guidance that will go a long way toward ensuring that adf
quotations will be seen in a meaningful way.
Likewise, while Nasdaq had argued that a viable ADF is not
essential, the SEC made clear that a viable ADF is essential to curtail
the potential anticompettive impact of SuperMontage. NASD hobbled the
launch of the ADF by not releasing the final technical specifications
necessary for participation in the ADF until August 2002, placing ECNs
and other potential ADF participants in a difficult and disadvantaged
position. The SEC this summer, seeking to mitigate the more damaging
effects of an ADF that would launch too late to be an effective
alternative to SuperMontage, took the important step of ensuring that
the ADF and SuperMontage ``rollout'' simultaneously, a process that is
commencing this week.
We would also commend the SEC for recognizing that major
superMontage/ADF issues--expressly including discriminatory and
anticompetitive fees--will require ongoing SEC engagement.
discriminatory and anticompetitive practices.
Practices that are discriminatory and anticompetitive stand as good
examples of the kinds of issues that merit both SEC and congressional
attention. In particular, i want to call your attention to quote
decrementation and discriminatory fees.
Quote decrementation has to do with how orders are displayed and
adjusted on SuperMontage to the disadvantage of ECNs and their
customers. Under SuperMontage rules, if an ECN posts a quotation for a
certain price and quantity in a given security, it will be penalized
for declining an order from a counterparty with whom the ECN chooses
not to do business. Such a counterparty may be an entity that is an
unacceptable credit risk, but it is most likely to be one that refuses
to pay an ECN's access fees.
Under the SuperMontage rules, when an ECN declines an order, even
if only for part of the quantity displayed in its quotation, the ECN's
entire quotation will be removed from the SuperMontage quotation
display. As a result, the ECN's customers will lose their place in the
SuperMontage time-price queue. In addition, ECNs will be at increased
risk for incurring costs instead of revenue. What is telling about the
quote decrementation feature of SuperMontage is that its adverse
effects fall exclusively upon ECNs. It is grossly discriminatory.
SuperMontage fees differentiate between order types in a way that
is both unfair and discriminatory. In Nasdaq's nomenclature, a
``preferenced order'' is an order sent to a specific market participant
that has a quotation displayed in SuperMontage at the best bid or
offer. A preferenced order is executed through the use of the
SuperMontage execution algorithm. A ``directed order'' is an order sent
to a specific ECN that has elected to receive orders rather than
executions.
Nasdaq proposes to impose a penalty of 150% on orders directed to
ECNs or other participants that are permitted to accept order delivery
rather than automatic executions. By charging 150% more for directed
orders than for orders executed using the SuperMontage algorithm, the
fee structure penalizes ECNs and other market participants that wish to
use their own trading algorithms to access liquidity on the
SuperMontage screen via directed orders. These deliberately
discriminatory fees would force orders into SuperMontage's execution
algorithm, thereby restricting market participants from having equal
access to all avenues of execution.
Effectively, the proposed fees impose a penalty on NASD members
that use alternatives to SuperMontage. By increasing the cost of using
facilities other than SuperMontage, the SuperMontage fees compel NASD
members to keep their trading volume on SuperMontage and discourage
them from using the ADF or other alternatives to SuperMontage.
Other elements of Nasdaq's proposed SuperMontage fee schedule also
are intended to suppress competition. Nasdaq has proposed extending the
pricing scheme it currently uses for SuperSOES--its current order
execution system--to SuperMontage. Under the SuperSOES pricing scheme,
NASD members that report to Nasdaq at least 95% of their trades in
Nasdaq securities for the preceding month are deemed ``Full
contribution members''. Those reporting fewer than 95% of their trades
in Nasdaq securities for the preceding month to Nasdaq are deemed
``Partial contribution members''. Full contribution members would pay
substantially lower Nasdaq access fees than partial contribution
members. In short, the access fee differential would punish NASD
members for doing more than de minimis business on the ADF, or any
trading facility other than Nasdaq's SuperMontage. It's hard to imagine
an action more contrary to consumers' interests than extending such an
anticompetitive pricing structure to SuperMontage.
As it is, Nasdaq has taken unto itself the enterprise value of its
market system, which NASD's members developed over 30 years. Nasdaq
embodies both a quotation facility and an execution/clearance facility,
which the ADF is not intended to provide. It may be that the ADF will
nevertheless be a preferred venue, but that will eventuate only if it
is allowed to compete on an equal footing with Nasdaq. Exclusionary and
anticompetitive elements in the SuperMontage/SuperSOES combination
should be revised to provide that equal footing.
centralization versus de-centralization.
For-profit exchanges will have powerful incentives to leverage
their existing government-sponsored monopolies to gain an unfair
advantage in currently competitive markets. They'll have incentives to
``keep pace'' with market innovators not by moving forward themselves,
but by slowing down all market participants and centralizing order
flow.
If that occurs, consumers, investors and the markets themselves
will be denied the benefits of competition. Everyone loses if
exchanges--comfortable as government-sponsored monopolies--fail to
innovate, leaving American markets vulnerable to offshore competitors.
Technology makes possible a market structure that wouldn't
previously have been possible. That has spawned a debate over the past
few years over whether public policy should favor a more decentralized
market structure, or whether public policy should encourage
centralization, as often advocated by the exchanges.
This argument has manifested itself in a number of different ways.
A few years ago, proponents of centralization urged support for a time
priority Central Limit Order Book (CLOB) to deal with the alleged
``problem'' of market fragmentation. The notion behind the CLOB was
that, by centralizing orders in one place, a single ``black box'',
maximum order interaction and perhaps better prices might be achieved.
While the CLOB was ultimately rejected as unworkable and unwise,
the previously described interaction of SuperSOES and SuperMontage
within Nasdaq represent the same effort to centralize. The recent
Nasdaq pricing proposal, which would clearly discourage execution of
trades outside of Nasdaq--even if the best price for a stock were being
offered outside of Nasdaq--is simply the latest manifestation of this
urge towards centralization. As exchanges contemplate becoming for-
profit companies, this urge to centralize order flow and execution will
grow more pronounced. This emphasizes the need for a functional, fully
competitive ADF as a means to mitigate the anticompetitive effects of
Nasdaq's market scheme. It may well be that additional remedial
measures will be needed. The continued vigilance of the Congress and
the SEC will be essential as these developments unfold.
As the growth of ECNs illustrates, modern technology allows the
advantages of maximum order interaction without the downside of
centralization. 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 competing and redundant linkages. Why
shouldn't the securities markets work the same way and reap the same
benefits?
centralized systems are resistant to change.
The innovations that ECNs have brought to the market would not have
occurred under more centralized systems. A centralized system also
provides the significant downside of a central point of failure.
Nasdaq and the nyse argue that the absence of centralization is
``fragmentation''. Properly understood, market fragmentation is the
failure of supply to interact with demand and vice versa. The cure for
fragmentation is a combination of transparency and interlinkage of
multiple market venues and liquidity pools, a combination that takes
place on investors' desk tops. The cure for fragmentation need not
involve a single, monopolistic market--indeed Nasdaq proposes to trade
NYSE stocks on its exchange and that competition is beneficial. To
ignore these basic realities and to argue that fragmentation somehow
justifies centralizing and monopolistic market models is fundamentally
misleading.
ecns--consumers and investors benefit.
So who has benefited from the existence of ECNs? For one, small
retail customers who, for the first time, have gained direct unfettered
access to the liquidity of institutional order flow represented
directly in the market. Through electronic order sizing, Bloomberg
Tradebook's system permits direct interaction between institutional
orders and retail orders since the institution can cut its order into
pieces that will interact effectively with the much smaller retail
orders. Institutional investors--which pool the savings of many, many
small investors--are able for the first time to find liquidity for
their orders by interacting directly with small order flow, thereby
consolidating what had been a fragmented market.
who else benefits from ecns?
All investors who have seen the speed and fairness of their
executions improve, as ECNs have raised the standard for all broker-
dealers. Even traders not participating in ECNs benefit from our depth,
liquidity and immediacy each time they hit an ECN bid or take an ECN
offer.
who hasn't benefited from ecns?
Useful linkages have yet to be developed for the New York Stock
Exchange listed market. As a result, investors in that market have yet
to reap the full benefits of the competition provided by ECNs. While
the SEC has allowed ECNs access to the Intermarket Trading System
through Nasdaq, this is not sufficient. The Intermarket Trading System
remains crippled both by its technological ineffectiveness and an
unworkable governance structure that makes any movement nearly
impossible. This is why it is imperative that the steps necessary to
facilitate the promised display of NYSE listed stocks in the ADF be
undertaken as soon as possible.
Government-sponsored market centers like the Nasdaq Stock Market
and the New York Stock Exchange can either make ECN transparency
available to the entire national market system or reduce transparency
by seeking to block ECN display linkages. Clearly the NYSE has
historically had no interest in encouraging linkages that would make
ECNs players in the listed market. It is long past time for the
benefits ECNs have brought to the market in over-the-counter securities
to be extended to markets in listed securities.
conclusion.
The neutrality, transparency, fairness and innovation ECNs
collectively bring to the Nasdaq market have dramatically increased
competition and efficiency on Wall Street, redounding to the benefit of
consumers on Main Street and the economy. Investors in the New York
Stock Exchange listed market should be permitted an opportunity to
enjoy the same benefits.
Historically not-for-profit exchanges are contemplating a for-
profit future. As market players that have traditionally functioned as
public utilities become for-profit entities, their goals, incentives
and agendas radically change as well. Consumers and investors will
suffer if exchanges succeed in leveraging their existing government-
sponsored monopolies into currently competitive arenas. These efforts
will suppress competition, discourage innovation and harm consumers.
Mr. Stearns. Thank the gentleman.
Mr. O'Hara, welcome.
STATEMENT OF KEVIN J.P. O'HARA
Mr. O'Hara. Good morning, Chairman Stearns, Congressman
Towns, and other distinguished members of the subcommittee. On
behalf of Archipelago, I am pleased and honored to be with you
this morning and commend the subcommittee for holding this
hearing.
And to your earlier point, Congressman Towns, to your
earlier point regarding Instinet and Island, let the record
reflect that I am sitting next to representatives of Brut and
Bloomberg Tradebook. We will come back and test your hypothesis
several months from now.
Let me begin by saying that were this a State of the Union
on market structure and best execution, I would declare that
the State of the Union is good. Though unfinished business
still remains, significant progress has been made in recent
years. And this subcommittee should be commended for supporting
this progress,such as your hard work on decimalization.
Without question, the prime benefactor of this progress is
the consumer, or the investor in capital markets' parlance. At
no other time has the investor enjoyed greater transparency,
better technology, and more innovation than now in the
execution business. Importantly, tired bogeymen, thrown up to
retard progress by reactionaries-like market fragmentation,
ECNs unwilling to ``catch the falling knife'' in times of
stress--have been run out of town on a rail by a Joe Friday-
like analysis: Just the facts, ma'am, and only the facts.
At Archipelago, we are proud of our contribution to this
progress. And in connection with that, I am happy to report
that the Archipelago Exchange is open for business. Not long
ago, the Archipelago Exchange was but a dream of its cofounders
Jerry Putnam and MarrGwen and Stuart Townsend. In March 2002,
after much inspiration and even more perspiration, the dream
culminated in a launch of the first fully open electronic
national exchange.
Armed with a ``best execution'' business model in which we
reach out electronically to other markets to obtain the best
price for customers, the Archipelago Exchange delivers
transparency, speed, innovation and efficiency.
Beginning in January 1997, the day the Archipelago ECN--our
exchange's younger brother, if you will--executed its first
order, our current Nasdaq business has grown to an almost daily
average of 400 million shares or roughly 20 percent of overall
volume. In terms of New York Stock Exchange and Amex-listed
securities, the Archipelago Exchange executes almost 50 million
shares per day.
The model for an exchange is its--the business model for an
exchange is its market structure as set out in its trading
rules. Archipelago's market structure can be best characterized
as fully open and transparent. Everyone, institutional
investors, broker-dealers, and retail customers has access to
the same information such as limited order book at the core of
our exchange. Everyone can see the same information at the same
time. Everyone's orders are matched consistently using strict
price and time priority. No order can jump ahead of another
unless it is at a superior price. The end result: Our customers
operate on a level playing field.
Two tenets of best execution--two central tenets of best
execution are transparency and access. The two work cheek by
jowl to produce a quality market. Transparency is the ability
to see information such as a limit order book, while access is
the ability to interact with such information. Historically,
the market for New York Stock Exchange and Amex-listed trading
was not driven by technological solutions to provide
transparency and access. Instead, floor-based systems of
frenetic brokers and ever-present and very profitable
specialists were charged with providing transparency and
access. Consequently, technology-based marketplaces had
problems gaining traction in listed trading. While Archipelago
has found a way to bridge this cultural gap by integrating our
prices into the international market system, friction still
exists.
Until recently, two of the largest ECNs' merger partners,
Island and Instinet, were permitted to hide their prices for
exchange-listed securities from the public. Citing
insurmountable technology, these ECNs refused to display their
quotes in the national market system. As a result, better
prices in their marketplaces were not available to customers
who were not part of the club. Membership had its privileges.
The SEC has quietly begun to tackle the sticky issue of
public display of security prices for listed securities,
however. Two months ago, the SEC enforced the provisions of
Federal regulation ATS and took appropriate remedial steps
against these hermit markets. Curiously, instead of choosing
transparency and showing its quote to the public, Island
defiantly went dark and ceased displaying a private market in
five popularly traded ETFs: QQQ, DIA and SPY, SMH and MKH.
Instinet similarly shut down its private market altogether in
certain listed securities during regular trading hours.
Nevertheless, the resiliency of the marketplace is such that
these listed shares continue to trade efficiently on platforms
despite the Island and Instinet rolling blackouts.
As many can attest the Inner Market Trading System, or ITS,
is the crotchety old man of electronic linkages. But while in
need of an overhaul, to refuse ITS linkage is to make mischief
with public investors, depriving them of both transparency and
access.
Happily, ITS reform is not far off. To address the issue,
the SEC summoned the country's exchanges to Washington last
week to discuss the trade-through provisions of the ITS plan.
With the introduction of decimal pricing and technology changes
that have enabled vastly reduced execution times, the trade-
through provisions of the ITS plan have limited the ability of
automated marketplaces to provide executions when a better
price is displayed by a market that provides manual executions.
For example, the Archipelago Exchange can offer internal
executions at a fraction of a second, whereas New York Stock
Exchange or Amex often takes 15 or even 30 seconds to respond
to a commitment to trade.
At the SEC's urging, the ITS Operating Committee is working
on reform. A consortium of committee members have proposed an
approach that would accommodate the differences between floor-
based traditionalists and technology-based new entrants. This
approach allows for the differences among marketplaces without
a time penalty for those markets that have speed and efficiency
as their goals. Moreover, it preserves a ``best price''
principle to protect investors whose orders were represented at
a venue willing to make them accessible for instant execution.
Finally, this committee has a record of championing the
cause of small investors. Case in point: decimalization of our
markets. You were a critical catalyst for this positive change
that has narrowed effective spreads in the most liquid stocks
on Nasdaq and the New York Stock Exchange. This fundamental
change has led to enormous reductions in trading costs and put
hundreds of millions of dollars back in the pockets of
investors; i.e., your constituents. Thank you for your
steadfast perseverance.
Likewise, I know you care about this subject matter we are
discussing today. ``Best execution'' is the heart of our
markets. By your continued oversight of our markets on matters
of transparency and access, you provide effective stewardship
and support of best execution. Archipelago looks forward to
continue to work with the subcommittee to enhance our
securities markets for the benefits of investors. And I will
gladly take your questions at the appropriate time.
[The prepared statement of Kevin J.P. O'Hara follows:]
Prepared Statement of Kevin J.P. O'Hara, General Counsel & Corporate
Secretary, Archipelago Holdings, L.L.C.
Good morning Chairman Stearns, Vice-Chairman Deal, Congressman
Towns and other distinguished members of the Subcommittee. On behalf of
Archipelago, I am pleased and honored to be with you this morning and
commend the Subcommittee for holding this hearing on ECN market
structure and the quest to ensure best price for consumers.
i. introduction
Let me begin by saying that were this a ``State of the Union
address'' on market structure and best execution, I would declare that
``the state of the union is good.'' Though unfinished business still
remains, significant progress has been made in recent years. Without
question, the prime benefactor of this significant progress is the
``consumer,'' known as the ``investor'' in the context of capital
markets. At no other time has the investor enjoyed greater
transparency, better technology, and more innovation than now in the
execution business. Importantly, tired bogeymen thrown up to retard
progress by reactionaries--like market fragmentation, ECNs unwilling to
``catch the falling knife'' in times of market stress, and the
Pavlovian definition of best execution as the untimely price
improvement by a floor-based traditionalist--have been run out of town
on a rail by a Joe Friday-like analysis. ``Just the facts, Ma'am, and
only the facts.''
At Archipelago, we are proud of our contribution to this progress.
And in connection with that, I am happy to report that the Archipelago
Exchange is open for business!
Not long ago, the Archipelago Exchange was but a dream of its co-
founders Jerry Putnam and MarrGwen and Stuart Townsend. In March 2002,
after much inspiration and even more perspiration, that dream
culminated in the launch of the first fully open electronic national
stock exchange. This ``next-generation'' exchange competes toe-to-toe
with the New York Stock Exchange (``NYSE'') and American Stock Exchange
(``Amex''). Armed with a ``best execution'' business model--in which we
reach out electronically to other markets to obtain the best price for
customers--the Archipelago Exchange delivers transparency, speed,
innovation, and efficiency.
Beginning in January 1997, the day the Archipelago ECN--our
exchange's younger brother, if you will--executed its first order, our
current Nasdaq business has grown to an average of almost 400 million
shares per day, or roughly 20% of overall volume. In terms of NYSE- and
Amex-listed securities, the Archipelago Exchange executes almost 50
million shares per day. Very soon, we will roll our Nasdaq business
into the Archipelago Exchange as well, which will afford us the ability
to deliver an even ``better execution'' for consumers by performing
executions in a more efficient and cost-effective manner.
From the day we filed our application seeking exchange status with
the Securities and Exchange Commission (``SEC'') in August 1999, to the
forging of our business partnership with the Pacific Exchange in July
2000, to the day in October 2001 when the SEC formally granted
Archipelago exchange status, it has been our singular focus to do to
the exchange business what innovators such as Dell, Wal*Mart , and
Southwest Airlines have done for their respective businesses: that is,
deliver a higher quality and cost-effective product to the consumer.
And like those agents of change, our mission has been to rework the
traditional exchange business model using a one-two combination of
cutting-edge technology and a laser-like focus on customer needs.
ii. archipelago market structure: best execution business model
The business model for an exchange is its market structure, as set
out in its trading rules. Archipelago's market structure can be best
characterized as ``fully open and transparent.'' Everyone--
institutional investors, broker-dealers, and retail customers--has
access to the same information, such as the limit order book at the
core of our exchange. Everyone can see the same information at the same
time. Everyone's orders are matched consistently using strict price-
time priority. No order can jump ahead of another unless it is at a
superior price. The end result: our customers operate on a level
playing field.
With our linkages to other markets, we offer an efficient path to
the best price, even if it resides at a competing marketplace. Standing
orders are anonymously displayed on our book, and marketable orders are
either matched internally or electronically routed to a superior price
at other marketplaces. Simply put, our exchange is the manifestation of
best execution principles put into practice.
iii. importance of the public quote to consumers
Two central tenets of best execution are ``transparency'' and
``access.'' The two-work cheek by jowl to produce a quality market:
transparency is the ability to see information, such as a limit order
book, while access is the ability to interact with such information.
Historically, the market for NYSE- and Amex-listed trading was not
driven by technological solutions to provide transparency and access.
Instead, floor-based systems of frenetic brokers and ever-present (and
very profitable!) specialists were charged with providing transparency
and access. Consequently, technology-based marketplaces had trouble
gaining traction in listed trading.
While the Archipelago Exchange has found ways to bridge this
cultural gap by integrating our prices into the National Market System,
frictions still exist. Indeed, many still maintain that any such
integration is a ``a bridge too far.'' Until recently, two of the
largest ECNs--merger partners Island and Instinet--were permitted to
hide their prices for exchange-listed securities from the public.
Citing insurmountable technology hurdles, these ECNs refused to display
their quotes in the National Market System. As a result, better prices
in their private markets were not available to consumers who were not
part of the club. Membership had its privileges.
The SEC has quietly begun to tackle the sticky issue of public
display of securities prices for listed securities, however. Two months
ago, the SEC enforced the provisions of a federal regulation and took
appropriate remedial steps against these ``hermit markets.'' Regulation
ATS clearly states that ECNs with more than 5 per cent of the volume in
any one security are required to display their quotes to the public.
Curiously, instead of choosing transparency and showing its quote to
the public, Island defiantly went ``dark'' and ceased displaying a
private market in five popular exchange-traded funds, or ETFs: QQQ,
DIA, SPY, SMH and MKH. Instinet, on the other hand, shut down its
private market altogether in certain popular listed securities, such as
SPY, during regular trading hours. Nevertheless, the resiliency of the
marketplace is such that these listed-shares continue to trade
efficiently on other platforms despite the Island and Instinet
``rolling blackouts.''
iv. importance of linkage: reform of its
As many can attest, the Intermarket Trading System, or ITS, is the
crotchety old man of electronic linkages. But while in need of an
overhaul, to refuse ITS linkage is to make mischief with public
investors, depriving them of both transparency and access. And SEC
action clearly indicates that refusing ITS linkage has regulatory
consequences: by letting the technological perfect be the enemy of the
investor good, Island and Instinet brinksmanship beat a path to a
Conrad-esque heart of ETF darkness.
Happily, ITS reform is not far off. To address this very issue, the
SEC summoned the country's exchanges to Washington last week to discuss
the trade-through provisions of the ITS Plan. With the introduction of
decimal pricing and technology changes that have enabled vastly reduced
execution times, the trade-through provisions of the ITS Plan have
limited the ability of automated marketplaces to provide executions
when a better price is displayed by a market that provides manual
executions. For example, the Archipelago Exchange can offer internal
executions in a fraction of a second, whereas the NYSE or Amex often
takes fifteen or even thirty seconds to respond to a commitment to
trade.
At the SEC's urging, the ITS Operating Committee is working on
reform. A consortium of Committee members has proposed an approach that
would accommodate the differences between floor-based traditionalists
and technology-based new entrants. Under this proposal, automated
exchanges like Archipelago could trade through the prices displayed by
a manual exchange in an amount up to three cents. Prices displayed by
an automated exchange could not be traded through, however, since these
markets provide an automatic execution. This approach allows for the
differences among market centers without a time penalty for those
markets that have made speed and efficiency their goal. Moreover, it
preserves a ``best price'' principle to protect investors whose orders
were represented at a venue willing to make them accessible for instant
execution.
v. conclusion: congressional oversight champions the individual
investor
This Committee has a record of championing the cause of the small
investor. A case in point: the decimalization of our equity markets.
You were a critical catalyst for this positive change that, to date,
has narrowed effective spreads in the most liquid stocks on Nasdaq and
the NYSE by an average of 50% and 15%, respectively. This fundamental
change has directly led to enormous reductions in trading costs and put
hundreds of millions of dollars back in the pockets of investors. Thank
you for your steadfast perseverance.
Likewise, you should care about the subject matter that I have
discussed today. Best execution is a core principle of our markets. By
your continued oversight of our markets on matters of transparency and
access, you provide effective stewardship in support of best execution.
The ITS Plan reform underway by the Committee and the SEC is important
work that will lead to better price competition and efficient order
execution for consumers.
Archipelago looks forward to continuing to work with the Committee
to enhance our securities market for the benefit of investors. I will
be glad to respond to any questions that the members of the
Subcommittee may have at the appropriate time.
Mr. Stearns. Thank you.
Mr. O'Brien, welcome.
STATEMENT OF WILLIAM O'BRIEN
Mr. O'Brien. Thank you. Good morning, Chairman Stearns and
Congressman Towns, members of the subcommittee and their
staffs. I am Bill O'Brien, Senior Vice President and General
Counsel of Brut. On behalf of Brut, I commend the subcommittee
for focusing on the issue of best execution of customer orders
at this important time in the history of our Nation's markets.
I would like to thank you for the opportunity to testify.
Brut operates one of the largest ECNs, routinely executing over
100 million shares of Nasdaq volume per day with a growing
business in exchange-listed stocks as well. In August 2002,
Brut was acquired by SunGard Data Systems, a leading financial
services technology provider which purchased the interests of a
consortium of broker-dealers which included Bear Stearns,
Goldman Sachs, Morgan Stanley, Merrill Lynch and Salomon Smith
Barney.
The last 5 years have seen an unprecedented transformation
regarding the manner in which security transactions are
executed. In order to ensure that these dynamic conditions do
not produce cataclysmic results, the legislators and regulators
will need to work tirelessly to evolve legacy approaches to the
oversight of market structure. Nevertheless, the core
principles that the Congress gave the SEC in 1975 when it
mandated the creation of a national market System can, if
applied consistently and balanced carefully, ensure that the
most important component of market structure, the individual
investor, continues to receive the best possible prices when
trading stocks.
The launch this week of Nasdaq's SuperMontage trading
system is but a part of the crescendo of competition in the
securities industry that is blurring traditional distinctions.
This environment has the potential to be a boon for the
ultimate consumer, reducing costs, improving service, and
furthering innovation if it takes place within a constructive
framework.
In drafting the Securities Act Amendments of 1975, the
Congress emphasized that fair competition among brokers and
dealers, among exchange markets, and among the markets other
than exchange markets, and between exchange markets and markets
other than exchange markets was in the best interest of the
Nation's investors. Given the interdependence among market
participants and the impact on market quality on certain
competitive tactics, this competition must be carefully
nurtured in order to produce the desired impact.
Several of the issues currently facing ECN operators and
the market at large are reflective of the debate regarding what
is needed to ensure a truly fair and level playing field.
SuperMontage has been a focal point for many of these issues.
It is a watershed in Nasdaq's efforts to transform itself into
the principal provider of execution services in the over-the-
counter market. Historically, Nasdaq's primary role has been to
serve market makers and ECNs by collecting and redistributing
their quote and trade information, leaving the business of
actually executing trades to those parties. In a series of
steps culminating in SuperMontage, Nasdaq now aims to draw more
and more actual executions away from the market makers and ECNs
and into their own internal systems, with the self-stated aim
of becoming a central form of the execution of transactions in
Nasdaq stocks.
Brut thinks that Nasdaq should be free to move forward with
this approach, enjoying the right that all enterprises should
have to pursue their own strategic vision. At the same time,
however, Brut has been a strong advocate for the creation of
viable alternatives to SuperMontage so that Nasdaq's legacy of
regulatory monopoly does not produce unintended and
uncompetitive consequences. Market structure regulation has
long relied upon Nasdaq infrastructure for ensuring the display
of best price quotation information to the public. Market
makers and ECNs effectively had no choice but to post their
quotations in Nasdaq to comply with SEC regulations. As Nasdaq
sought to transform those quotations into orders within
SuperMontage, the competitive ramifications became clear: Any
business whose use is mandated by law is virtually unstoppable.
This is why Brut has been a strong proponent of the
development of the alternative display facility, or ADF. Owned
and operated by the NASD, the ADF allows market makers and ECNs
to do business outside of SuperMontage altogether, publicly
displaying their best prices to consumers through a truly
market-neutral facility. After over 18 months of development,
the ADF took on its first customer earlier this week, providing
meaningful choice for the first time since Nasdaq's creation.
Whether the ADF fulfills its long-term mission will be
dependent upon a collective will to ensure that the NASD
continues to provide an effective option to its former progeny,
Nasdaq.
Brut has delayed its own consideration of usage of the ADF
while the technological and economic barriers to its usage are
moderated by the NASD with improved connectivity solutions and
more realistic economics. These steps are important for the
NASD to prove to market makers and ECNs that it is serious
about operating a truly viable SuperMontage alternative. In its
May 2002 report, the General Accounting Office noted the need
to manage market structure in light of such concerns, stating
that an ongoing challenge will be to respond effectively to
both real and perceived conflicts of interest. A continued
insistence from the SEC and the Congress that the ADF offer
modern technological solutions and competitive economics will
provide meaningful discipline on Nasdaq as it competes with
market makers and ECNs that help to build it.
The adaptation of current regulation to promote even
further competition in this arena should be strongly
considered. Regional exchanges such as the Cincinnati Stock
Exchange are implementing a variety of business models that
would provide quotation and trade reporting services to market
makers and ECNs in competition with SuperMontage and also
remedy some of the inefficiencies in the pricing of market data
that have arisen out of Nasdaq dominance. The current
regulation of registered security exchanges can at times serve
as a barrier to deployment of these business models. The
reduced relevance of the distinction between heavily traded
exchange-listed and Nasdaq stocks and the increased
electronification of both markets dictate a reconsideration of
how exchanges are to be regulated going forward, in order to
realize the full competitive potential of current market
structure.
As ECNs seek to compete within this landscape, the need for
ECN pricing flexibility should also be emphasized. In this
challenging economic environment, fees are a matter of both
extreme importance and sensitivity to Brut's customers. Our
rate structure, which is fairly common in the industry, rewards
users that are willing to initiate and display orders into its
ECN with a cash rebate, while charging firms that seek to
access that liquidity a fee. Since the implementation of the
SEC's order handling rules in 1997, the debate over these ECN
and access fees has ebbed and flowed with changing economic and
regulatory conditions. Brut believes that competitive forces
rather than regulation are appropriate to discipline the nature
and structure of prices. These forces currently serve to
pressure ECN rate structures in both directions. The entry of
Nasdaq as a competitor and the rate structure for SuperMontage
which also offers rebates to initiators of liquidity
necessitates similar pricing in the quest to be competitive.
What the market will bear in terms of costs also has revealed
itself as some ECNs that have attempted to take these rate
structures to extremes have experienced financial difficulty
and unsustainable collection rates. ECNs themselves have worked
to eliminate pricing inefficiencies between one another.
Continued vibrant rate competition, rather than intervention
and its potential for unintended adverse consequences will best
serve the economic needs of both ECN operators and their users.
As ECNs and others have asserted their competitive
independence from Nasdaq, some are concerned that increased
fragmentation will inevitably impact on another national market
system principle, ensuring economically efficient execution of
security transactions. Brut counts itself among the firms with
the vision and technology to remedy such concerns, providing an
example of how the market can respond to a changing environment
to provide customers with the best of all possible worlds. Brut
is representing our customer orders within SuperMontage,
delivering customers the full functionality and liquidity of
that market in addition to its own. We are doing so because we
believe that to do otherwise will deny our customers best
execution opportunities inconsistent with the congressional
goal of executing investor orders in the best possible market.
In addition, we offer quote information from and direct
connectivity to nonSuperMontage ECNs and other significant
market centers in order to provide customers with a seamless
one stop shopping trading environment.
Our ability to navigate this more complex market structure
while still preserving execution quality provides evidence that
fragmentation can work to the ultimate benefit of the consumer.
Private connectivity between and among ECNs, broker-dealers,
and other major markets now exist such that public utilities
are no longer a linchpin to ensure execution quality and that
customers receive the best prices for their transactions. This
gives each market participant the freedom to offer its own
unique solution to customers on its terms without any single
point of collective reliance. This can free each firm to
innovate, letting the market decide whether a firm's offering
provides required service to meet trader needs.
Legacy regulations that subvert the ability of a market
center to offer customers its version of a quality execution to
a need for centralization should be reevaluated in light of
this new reality. With respect to transactions in exchange-
listed stocks, ECNs have attracted significant order flow in
recent years as innovative products like exchange-traded funds,
the Qs, SPDRs, the transition to decimalization, and the
homogenization of trading operations have all eroded resistance
to electronic trading of these securities. This success has
triggered SEC requirements that dictate at times participation
in the Intermarket Trading System, or ITS, an exchange-
dominated consortium with requirements that do not fit all ECN
business models. This has put some ECNs in the uneviable
position of choosing between options that all dilute their
value proposition and customer execution quality. Some, like
Island, have chosen to cease displaying their order prices to
all customers, forcing people to trade blind. Others, like
Instinet, have ceased trading some of these securities
altogether. While Brut is an ITS participant through its
involvement in the Nasdaq Intermarket, we see this development
as counterproductive. In this era of customer mobility and
information availability, regulations that thwart an ECN's
ability to deliver what it perceives that it customers want
should be reconsidered in light of the continued relevance of
their original purpose.
The rapid rate at which our markets are transforming
creates the potential for a regulation gap which ECNs often
find themselves in the middle of, due to their innovative
nature, that puts consumer interests at risk. Chairman Pitt has
recognized this risk, asking the staff of the SEC to hold
public hearings on market structure issues which will be held
over the next several weeks. ECNs have had an important role in
helping consumers achieve the best prices by increasing
transparency, reducing spreads, and perhaps as the greatest
fulfillment of the congressional directive, to provide an
opportunity for investor orders to interact without the
participation of a dealer. In light of the changing market
structure before us, Brut believes the principles enunciated by
the Congress in 1975--fair competition, efficient execution,
and flexible regulation--can continue to serve as a road map to
promote market structure quality and investor interests.
Mr. Chairman, Brut welcomes the subcommittee's interest in
these important issues and I look forward to answering any
questions that you or members have at the appropriate time.
[The prepared statement of William O'Brien follows:]
Prepared Statement of William O'Brien, Senior Vice President & General
Counsel, Brut, LLC
Good morning Chairman Stearns, Congressman Towns, and members of
the Subcommittee. My name is William O'Brien, and I am Senior Vice
President and General Counsel of Brut, LLC (``Brut''). On behalf of
Brut, I commend the Subcommittee for focusing on the issue of best
execution of customer orders during this pivotal point in the history
of the nation's securities markets, and would like to thank you for the
opportunity to testify.
Brut operates one of the largest electronic communications networks
(or ``ECN'') for the trading of Nasdaq and exchange-Iisted securities.
Brut routinely executes 100 million shares per day of volume in Nasdaq
securities, and has a growing business in exchange-listed stocks and
exchange-traded funds through. In August 2002, Brut was acquired by
SunGard Data Systems, which purchased the interests of the other
members of a consortium that had previously owned Brut, which included
Bear Stearns, Goldman Sachs, Knight Trading Group, Merrill Lynch,
Morgan Stanley, and Salomon Smith Barney.
introduction
The last five years have seen an unprecedented transformation
regarding the manner in which equity security transactions are
executed. The pace of change, however, is poised to increase
exponentially, as developments in the economic, technological and
competitive environments converge to alter the landscape with rapid-
fire regularity and seismic frequency. In order to ensure that these
dynamic conditions do not produce cataclysmic results, legislators and
regulators will need to work tirelessly to evolve legacy approaches for
the oversight of market structure. The core principles that the
Congress gave the SEC as its mandate in 1975, when the SEC was
instructed to foster the creation of a ``national market system,''
continue to be a relevant and insightful road map as to how to respond
to the pressing issues of today's markets. Applied consistently and
balanced carefully, these values can offer insight across a variety of
scenarios and ensure that the most important component of market
structure--the individual investor--continues to receive the best
possible prices when trading stocks.
constructive competition
The launch this week of Nasdaq's SuperMontage trading system is but
a part of the crescendo of competition in the securities industry that
is blurring traditional distinctions. Nasdaq, a former not-for-profit
utility intended to serve the collective interests of the brokerage
firms that paid to build it, is now aggressively pursuing an IPO-driven
strategy that dictates rivalry with its creators. Regional exchanges,
trying to remain relevant, are attempting to gain a piece of certain
information businesses that had previously been Nasdaq's monopoly. And
new technologies that allow for instantaneous changes in usage patterns
have helped unleash a ferocious price war among ECNs, who can no longer
count on customer loyalty lasting longer than a single trading day. All
the while, firms with proprietary trading operations face their own
competitive pressures in light of an atmosphere of declining share
prices and sagging investor confidence.
This competitive environment has the potential to be a boon for the
ultimate consumer--reducing cost, improving service, and furthering
innovation--if it takes place within a constructive framework. In
drafting the Securities Act Amendments of 1975, the Congress emphasized
that ``Fair competition among brokers and dealers, among exchange
markets, and between exchange markets and markets other than exchange
markets'' was in the best interest of the nation's investors. Given the
inter-dependence among market participants and the impact on market
quality of certain tactics, however, this competition must be carefully
nurtured in order to produce the desired impact. Several of the issues
currently facing ECN operators--and the market at large--are reflective
of the debate regarding what is needed to ensure a truly fair and level
playing field.
The implementation of Nasdaq's SuperMontage trading system has been
a focal point for many of these issues. SuperMontage is a watershed in
Nasdaq's efforts to transform itself into the principal provider of
execution services in the over-the-counter market. Historically,
Nasdaq's primary role has been to serve market makers and ECNs by
collecting and re-distributing their quote and trade information,
leaving the business of actual execution of transactions to those
parties. In a series of steps culminating in SuperMontage, Nasdaq now
aims to draw more and more actual executions away from market makers
and ECNs and into their own internal systems, with the self-stated aim
of becoming ``a central forum'' <SUP>1</SUP> for the execution of
transactions in Nasdaq stocks.
---------------------------------------------------------------------------
\1\ See Exchange Act Release No. 43514 (November 3, 2000), 65 Fed.
Reg. 69084 (November 15, 2000) at 69108.
---------------------------------------------------------------------------
Brut thinks that Nasdaq should be free to move forward with this
approach, enjoying the right that all enterprises should have to pursue
their own strategic vision. At the same time, Brut has been a strong
advocate for the creation of viable alternatives to SuperMontage so
that Nasdaq's legacy of regulatory monopoly does not produce unintended
anti-competitive consequences. Market structure regulation has long
relied upon Nasdaq infrastructure for ensuring the display of best-
priced quotation information to the public. Market makers and ECNs
effectively had no choice but to post their quotations in Nasdaq to
comply with SEC regulations. As Nasdaq sought to transform these
quotations into executable orders within SuperMontage, the competitive
ramifications became clear--any business whose use is mandated by law
is virtually unstoppable.
This is why Brut has been a strong proponent of the development of
the Alternative Display Facility (``ADF''). Owned and operated by the
NASD, the ADF allows market makers and ECNs to do business outside of
SuperMontage altogether--publicly displaying their best prices to
consumers through a truly market-neutral facility. After over eighteen
months of development, the ADF took on its first customer earlier this
week, providing meaningful choice to market participants for the first
time since Nasdaq's creation. Whether the ADF fulfills its long-term
mission will be dependent upon a collective will to ensure that the
NASD continues to provide an effective option to its former progeny,
Nasdaq. Brut has delayed its own consideration of usage of the ADF
while the technological and economic barriers to its usage are
moderated by the NASD offering improved connectivity solutions and more
realistic economics. These steps are important for the NASD to prove to
market makers and ECNs that it is serious about operating a truly
viable SuperMontage alternative. In its May 2002 report, the General
Accounting Office noted the need to manage market structure in light of
concerns regarding viability, stating ``an ongoing challenge . . . will
be to respond effectively to both real and perceived conflicts of
interest.'' <SUP>2</SUP> A continued insistence from the SEC and the
Congress that the ADF offer modern technological solutions and
competitive economics will provide meaningful competitive discipline on
Nasdaq as it competes with market makers and ECNs.
---------------------------------------------------------------------------
\2\ United States General Accounting Office, Securities Markets:
Competition and Multiple Regulators Heighten Concern About Self-
Regulation, at 29 (May 2002).
---------------------------------------------------------------------------
The adaptation of current regulation to promote even further
competition in this area should be strongly considered. Regional
exchanges such as the Cincinnati Stock Exchange are considering a
variety of business models that would provide quotation and trade
reporting services to market makers and ECNs in competition with
SuperMontage. The current regulation of registered securities exchanges
can at times serve as the barrier to deployment of these business
models. The reduced relevance of the distinction between heavily traded
exchange-listed and Nasdaq stocks, and the increased electronification
of both markets, dictate a reconsideration of how exchanges are to be
regulated going forward in order to realize the full competitive
potential of current market structure.
As ECNs seek to compete within this landscape, the need for ECN
pricing flexibility should also be emphasized. In this challenging
economic environment, pricing is a matter of both extreme importance
and sensitivity to Brut's customers. Our rate structure, which is
fairly common in the industry, rewards users that are willing to
initiate and display orders into its ECN with a cash rebate, while
charging firms that seek to access Brut's liquidity a fee. Since the
implementation of the SEC's Order Handling Rules in 1997, the debate
over these ``ECN access fees'' has ebbed and flowed with changing
economic and regulatory conditions. Brut believes that competitive
forces, rather than regulation, are appropriate to discipline the
nature and structure of prices. These forces currently serve to
pressure ECN rate structures in both directions. The entry of Nasdaq as
a competitor and the rate structure of SuperMontage (which also offers
rebates) necessitates similar pricing in the quest for liquidity. What
the market will bear in terms of cost has also revealed itself, as ECNs
that have attempted to take rate structures to the extreme have
experiences unsustainable collection rates. ECNs themselves have worked
to eliminate pricing inefficiencies between one another. Continued
vibrant rate competition, rather than intervention and its potential
for unintended adverse consequences, will best serve the economics
needs of both ECN operators and their users.
efficient fragmentation
As ECNs and others assert their competitive independence from
Nasdaq, some concerned that increased fragmentation will negatively
impact on another national market system principle, ensuring
``economically efficient execution of securities transactions.''
<SUP>3</SUP> Brut counts itself among the firms with the vision and
technology to remedy such concerns, providing an example of how the
market can respond to a changing environment to provide consumers with
the best of all possible worlds.
---------------------------------------------------------------------------
\3\ Exchange Act Section 11A(a)(1)(c)(i).
---------------------------------------------------------------------------
Brut is representing customer orders within SuperMontage,
delivering customers the full functionality and liquidity of that
market in addition to its own. We are doing so because we believe that
to do otherwise will deny our customers best execution opportunities
inconsistent with the Congressional goal of ``executing investors
orders in the best market.'' <SUP>4</SUP> In addition, we offer quote
information from and direct connectivity to non-SuperMontage ECNs and
other significant market centers, in order to provide customers with a
seamless, ``one stop shopping'' trading environment that fulfills the
need for ``availability to brokers, dealers and investors of
information with respect to quotations for and transactions in
securities.'' <SUP>5</SUP> All the while we are exploring ways to
reduce our Nasdaq reliance from a cost perspective, so as to eliminate
dependencies without jeopardizing customer interests.
---------------------------------------------------------------------------
\4\ Exchange Act Section 11A(a)(1)(c)(iv).
\5\ Exchange Act Section 11A(a)(1)(c)(iii).
---------------------------------------------------------------------------
Our ability to navigate this more complex market structure while
still preserving execution quality provides evidences that
fragmentation can and will work to the ultimate benefit of the
consumer. The private connectivity between and among ECNs, broker-
dealers and other major markets now exists such that public utilities
are no longer a lynch-pin to ensure that consumers receive the best
prices for their securities transactions. This gives each market
participant the freedom to offer its own unique solution to its
customers, on its terms, without any single point of collective
reliance. This can free each firm to innovate, letting the market
decide whether a firm's offering provide required service to meet
trader needs. The SEC's proactive efforts to ensure market centers
provide the investing public with objective, consistent information
regarding execution quality, as embodied by recent Rules 11Ac1-5 and
11Ac1-6 under the Exchange Act, allow investors to compare ``apples to
oranges'' and make smart order-routing decisions.
Legacy regulations that subvert the ability of a market center to
offer customers its version of a quality execution to a need for
centralization should be re-evaluated in light of this new reality.
With respect to transactions in exchange-listed stocks, ECNs have
attracted significant order flow in recent years, as innovative
products like exchange-traded funds (such as the ``QQQ'' and ``SPDR''),
the transition to decimalization, and the homogenization of trading
operations have all eroded resistance to electronic trading of these
instruments. This success has triggered SEC requirements under
Regulation ATS, which mandate the display of ECN order prices into the
public quotation system once certain volume thresholds have been
surpassed. Unlike mechanisms for Nasdaq securities, however, the means
to comply with this requirement for listed stocks also require
participation in the Intermarket Trading System (or ``ITS''), an
exchange-dominated consortium with requirements that do not fit all ECN
business models. This has put some ECNs in the unenviable position of
choosing between options that all dilute their value proposition and
consumer execution quality. Some have chosen to cease display of their
order prices to all customers--forcing people to ``trade blind''.
Others have ceased trading these securities altogether. While Brut is
an ITS participant, through its involvement in the Nasdaq Intermarket,
we see this development as counterproductive. In this era of customer
mobility and information availability, regulations that thwart an ECN's
ability to deliver what its customers want should be reconsidered in
light of the continued relevance of their original purpose.
conclusion
The rapid rate at which our markets are transforming creates the
potential for a regulation gap--which ECNs often find themselves in the
middle of due to their innovative nature--that puts consumer interests
at risk. Chairman Pitt has recognized this risk, asking the staff of
the SEC to hold public hearings on market structure issues. ECNs have
had an important role helping consumers achieve the best prices, by
increasing transparency, reducing spreads, and perhaps as the greatest
fulfillment of the Congressional mandate, to provide ``an opportunity .
. . for investors' orders to be executed without the participation of a
dealer.'' <SUP>6</SUP> In light of the changing market structure before
us, Brut believes that the principles enunciated by the Congress in
1975--fair competition, efficient executions and flexible regulation--
can continue to serve as a road map to promote market structure quality
and investor interests.
---------------------------------------------------------------------------
\6\ Exchange Act Section 11A(a)(1)(c)(v).
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Mr. Chairman, Brut welcomes the Subcommittee's interest in these
important issues, and I look forward to any questions you and the other
Members may have.
Mr. Stearns. I thank the gentleman.
Mr. Gasser, welcome.
STATEMENT OF ROBERT C. GASSER
Mr. Gasser. Good morning, Chairman Stearns, Mr. Towns, and
members of the subcommittee. I am Robert Gasser, Chief
Executive Officer of NYFIX Millennium. On behalf of our parent
company NYFIX, Inc., our partners and clients, I thank the
committee for the opportunity to appear before you today to
discuss the role ECNs play in current U.S. Market structure. I
thank you for holding this hearing on the subject that is at
the heart of the matter when talking about market structure,
and that is the effects that changes, and sometimes lack of
change, have had on the end investor.
In 1999, Millennium was founded by a partnership comprised
of NYFIX, Inc. and 10 prominent U.S. Investment banks,
including ABN Amro, Bank of America, Deutsche Bank, JP Morgan,
Lehman Brothers, Morgan Stanley, SC Bernstein, SG Cowen, UBS
Warburg, and Wachovia Securities. We are a firm focused on the
electronic interaction of listed equity order flow. As a
result, my comments will almost exclusively focus on listed
equity securities.
Millennium went live in September of 2001 and has steadily
grown its daily executed volume to our current average of
approximately 9 million shares a day in the most recent 90 day
period. Our customers are comprised of investment banks, on-
line trading firms, and program trading entities. In total, we
have 65 contracted users of the system. Importantly, they
contribute a pool of liquidity to our system by passing their
DOT and institutional block volume through Millennium by
default on its way to the floor of the New York Stock Exchange.
This pass-through, as we refer to it, is allowed to
interact with resting orders that can improve the price
reflected on the New York Stock Exchange by at least one penny.
If our system cannot improve price, that order is immediately,
100 to 150 milliseconds as we clock it, sent on to its original
destination. Trades are immediately printed in the Nasdaq
Intermarket. We do not publish a quote in competition with the
New York Stock Exchange and we presently have no aspirations to
become a U.S. Stock Exchange.
NYFIX, Inc., the parent of Millennium, is the dominant
provider of network services and order management technology to
the listed trading marketplace. We estimate that we touch
approximately 40 percent of institutional block trading
liquidity every trading day. On the reopening of the exchange
September 17, 2001, NYFIX, Inc. touched 1.2 billion shares of
executed listed volume. On any given day, 15 to 20 percent of
that volume is passed through Millennium.
U.S. Listed market structure is differentiated in one very
critical way from the Nasdaq marketplace. In 1996, the change
in Nasdaq order handling rules mandated by the regulatory
overhaul of that market catalyzed growth of the ECN model. In
effect, Nasdaq market access was democratized. The U.S. Listed
marketplace has not experienced a transformational event of
this magnitude. While investors who have electronic access,
such as DOT, with the New York Stock Exchange, they must always
interact with a gatekeeper, that being the New York Stock
Exchange specialist, when transacting with trading
counterparties. Firms wishing to compete with the New York
Stock Exchange specialist have historically been relegated to
the ITS. Many of our constituent clients aspire to compete with
the New York Stock Exchange specialist. We provide a mechanism
by which they can interact electronically with a subset of New
York Stock Exchange liquidity as long as they are willing to
improve price. We give these firms the ability to submit order
flow instantaneously and cancel order flow instantaneously.
Their only obligation when they submit a live order into our
system is to transact.
There is a quiet revolution starting in the U.S. Listed
marketplace. Investors and traders who have become disenchanted
with current market structure are moving beyond the
experimentation phase. They are starting to employ ATSs like
the ones represented here today. The value proposition is
clear. Execution that is electronically matched without human
intermediation takes one middleman and the resulting economic
impact of that middleman out of the equation. What makes that
possible today? I would submit to you that advanced technology,
industry protocols, and high-speed networks support this type
of healthy competition without the resultant risk of
fragmentation.
This quiet revolution combined with the decimalization of
stocks, the consolidation of the New York Stock Exchange
specialist units, the requirement to submit quality of
execution data for the public record, and the extended bear
market in the U.S. Equity markets is in the process of causing
profound change to the security industry.
Given the lack of investment returns generated in the past
3 years, there has been increasing scrutiny placed on
transaction costs by end investors. In an era where outsized
investment returns have been eliminated by poor market
performance, best execution is not a luxury item; it can make
or break best performance.
Market centers are compelled to publish their quality of
execution data in accordance with SEC Reg 11ac1-5. We welcome
this objective measurement of performance. In our most recent
filing as of August 2002, we compared very favorably against
the listed equity market center average in the four main
categories used to measure performance. They are the following:
percentage of order flow executed in 0-9 seconds; percentage of
orders that were price improved; average order size; and
percentage of orders exercised outside the quote. Millennium
executed 97.9 percent of its order flow within 0-9 seconds
versus a market center average of 52 percent. Millennium price
improved 75.6 percent of its order flow versus a market center
average of 32.9. Millennium's average order size was equal to
926 shares versus a market center average of 882 shares.
Millennium traded outside of the quote 5.9 percent of the time
as opposed to a market center average of 21.3.
While we can argue about the changing role of an
intermediary, round or flat, there is one inescapable and
unavoidable truth to the present supply chain in the trading of
U.S. Listed equity securities. There are a lot of middlemen.
The question becomes how does each link in that chain justify
its own unique cost/benefit. We would argue that technology is
changing the answer to that question and the possible outcomes.
Special interests that argue against fragmentation are really
arguing against competition. Our publicly available quality of
execution data clearly makes the case for the automation of
client interaction and the resultant benefits.
We thank you, Chairman Stearns, Mr. Towns, and members of
the committee for your focus on these issues.
[The prepared statement of Robert C. Gasser follows:]
Prepared Statement of Robert C. Gasser, Chief Executive Officer, NYFIX
Millennium, LLC
Good morning Chairman Stearns, Mr. Towns and members of the
Subcommittee. I am Robert Gasser, Chief Executive Officer of NYFIX
Millennium, L.L.C. (Millennium). On behalf of our parent company NYFIX,
Inc., our partners, and clients, I thank the committee for the
opportunity to appear before you today to discuss the role ECN's play
in current US Market Structure.
i. comparing and contrasting millennium and other nasdaq-centric ecn's
In 1999, Millennium was founded by a partnership comprised of
NYFIX, Inc. and 10 prominent US Investment Banks including ABN Amro,
Bank of America, Deutsche Bank, JP Morgan, Lehman Brothers, Morgan
Stanley, SC Bernstein, SG Cowen, UBS Warburg, and Wachovia Securities.
We are a firm focused on the electronic interaction of listed equity
order flow. As a result my comments will focus exclusively on Listed
equity securities.
Millennium went live in September of 2001 and has steadily grown
daily executed volume to our current average of approximately 9 million
shares/day. Our customers are comprised of Investment Banks, Online
Trading Firms, and Program Trading entities. In total we have 65
contracted users of the system. Importantly, they contribute a pool of
liquidity to our system by passing their DOT and institutional block
volume though Millennium by default on its way to the floor of the
NYSE.
This pass through volume is allowed to interact with resting orders
that can improve the price reflected on the NYSE by at least $0.01. If
our system cannot improve price that order is immediately (100-150
milliseconds) sent onto its original destination. Trades are
immediately printed in the NASDAQ Intermarket. We do not publish a
quote in competition with the NYSE and we presently have no aspirations
to become a US Stock Exchange.
NYFIX, Inc. the parent of Millennium is the dominant provider of
Network Services and Order Management Technology to the Listed Trading
Marketplace. We estimate that we touch approximately 40% of
institutional block trading liquidity every trading day. On the re-
opening of the exchange September 17, 2001 NYFIX, Inc. touched 1.2
billion shares of executed Listed volume. On any given day, 15%-20% of
this volume is passed through Millennium.
ii. a quiet revolution
US Listed market structure is differentiated in one very critical
way from the Nasdaq marketplace. In 1996, the change in Nasdaq order
handling rules mandated by the regulatory overhaul of that market
catalyzed growth of the ECN model. In effect, Nasdaq market access was
``democratized''. The US Listed marketplace has not experienced a
transformational event of this magnitude. While investors have
electronic access (such as DOT) to the NYSE, they must interact with a
``gatekeeper'' (NYSE Specialist) when transacting with trading
counterparties. Firms wishing to compete with the NYSE Specialist as
market makers have historically been relegated to the ITS (Intermarket
Trading System). This has created a market opportunity for Millennium.
Many of our constituent clients aspire to compete with the NYSE
Specialist. We provide a mechanism by which they can interact
electronically with a subset of NYSE liquidity as long as they are
willing to improve price. We give these firms the ability to submit
order flow instantaneously and cancel order flow instantaneously. Their
only obligation when they submit a live order into our system is to
transact.
There is a quiet revolution starting in the US Listed marketplace.
Investors and traders who have become disenchanted with current market
structure are moving beyond the experimentation phase. They are
starting to employ ATS' like the ones represented here today. The value
proposition is clear--execution that is electronically matched without
human intermediation takes one middleman and the resulting economic
impact out of the equation. What makes that possible today? I would
submit to you that advanced technology, industry protocols, and high
speed networks support this type healthy competition without the
resultant risk of fragmentation.
iii. profound change
This quiet revolution combined with the decimalization of stocks,
the consolidation of NYSE Specialist units, the requirement to submit
quality of execution data for the public record, and the extended bear
market in the US Equity Markets is in the process of causing profound
change to the Securities Industry.
Given the lack of investment returns generated in the past three
years, there has been increasing scrutiny placed on transaction costs
by end investors. In an era where outsized investment returns have been
eliminated by poor market performance, best execution is not a luxury
item. It can make or break best performance.
Market centers are compelled to publish their quality of execution
data in accordance with SEC Regulation 11ac1-5. We welcome this
objective measurement of performance. In our most recent filing as of
August, 2002 we compared very favorably against a listed equity market
center average In the four main categories used measure performance.
They are the following: 1) Percentage of order flow executed in 0-
9seconds, 2) Percentage of orders that were price improved, 3) Average
order size, and 4) Percentage of orders executed outside the quote.
Millennium executed 97.9% of its order flow within 0-9 seconds versus a
market center average of 52%. Millennium price improved 75.6% of its
order flow versus a market center average of 32.9%. Millennium's
average order size was equal to 926 shares versus a market center
average of 882 shares. Millennium traded outside of the quote 5.9% of
the time versus a market center average of 21.3%.
iv. summary
While we can argue about the changing role of an intermediary all
day long, there is one inescapable and unavoidable truth to the present
supply chain in the trading US listed equity securities--there are a
lot of middlemen. The question becomes--how does each link in that
chain justify its own unique cost/benefit. We would argue that
technology is changing the answer to that question and the possible
outcomes. Special interests that argue against ``fragementation'' are
really arguing against competition. Our publicly available quality of
execution data clearly makes the case for the automation of client
interaction and the resultant benefit.
Mr. Stearns. I thank you.
Mr. Ryan.
STATEMENT OF MICHAEL J. RYAN, JR.
Mr. Ryan. Good morning. My name is Michael Ryan and I am
Executive Vice President and General Counsel for the American
Stock Exchange. Chairman Stearns, Mr. Towns, and your staffs, I
appreciate the opportunity to testify before this subcommittee
today.
Over the past year, as you noted, a great deal of the
financial community's attention has been focused on the threat
of terrorism and the need to bring law and order back to
corporate America. As operator of a securities market that
happens to be located less than 300 feet from Ground Zero, we
cannot overstate the importance of both of these efforts. We
believe the current efforts by the government will strengthen
the existing market systems and provide new protections to
customers, and we intend to remain an active participant in
this process. Indeed, we look forward to participating in the
SEC's upcoming hearings on market structure.
Today, however, I would like to focus on a series of
activities that relate to serious violations of the Federal
securities laws. Before I discuss my specific points, though, I
would like to give you a brief overview of the American Stock
Exchange and the National Market System. The American Stock
Exchange has a long history of innovation and is unique among
U.S. Securities markets in that we are the only market that
actively lists and trades securities across three diverse
business lines: We trade equities, options, and exchange-traded
funds, commonly referred to as ETFs.
In equities we focus principally on providing a well-
regulated auction market for small- and mid-cap companies. Our
options market is the second largest in the United States, and
for the first time since getting into the business more than 25
years ago, recently have had days where we are the most active
equity options market. What really sets the Amex apart from all
of the markets in the U.S. Are ETFs, which is the fastest
growing, most innovative financial product offered by an
exchange over the last decade. After more than 4 years of
working with the SEC and millions of dollars in R&D expense,
the Amex pioneered ETFs in 1993 with the introduction of an ETF
base on the S&P 500 index, known as the SPIDER. Since then, we
have spent millions more in developing new products, in
educating the marketplace about the benefits of ETFs. Nine
years later the Amex remains the clear leader in ETF listings,
listing 121 of the 123 in the U.S. Market today, including in
addition to SPIDERs, the QQQ which is based on the Nasdaq 100
and DIAMONDS, which is based on the Dow 30.
Now we are also planning the next generation of ETF
products, variations that will provide investors even greater
flexibility and new investment opportunities. We launched fixed
income ETFs this summer and are getting ready to introduce
leverage ETFs, inverse ETFs, and, most significantly, actively
managed ETFs.
We have been able to leverage our reputation in ETFs to
create a global presence for the Amex. In the last year we have
reached agreements to trade Amex-listed ETFs in Europe and
Asia. In short, the American Stock Exchange has emerged as a
strong, innovative, international competitor, especially in the
development and trading of sophisticated derivative securities.
I would like to turn to a brief description of the National
Market System. In 1975, Congress adopted substantial amendments
to the Federal securities laws that mandated the creation of a
National Market System for trading securities. To achieve this
congressional mandate, at the direction of the SEC, we now have
in place three critical National Market System plans for Amex-
listed securities.
Two of these plans consolidate trade and quote information
which is sold to market participants on a real-time basis. The
revenue generated is shared among the exchanges and Nasdaq
ratably based on the number of trades executed in Amex-listed
securities by each market.
The third plan provides the mechanism for market
participants to access trading interest across all markets,
which is critical in achieving best execution for investors
orders.
Of course, with the evolution of the markets, the
Commission has found it necessary from time to time to take
additional steps to ensure that the National Market System is
kept current. Most significantly, on December 8, 1998, the
Commission adopted a new rule known as regulation ATS for
alternative trading systems. This new rule is designed to
integrate significant alternative trading systems into the
National Market System. The SEC took this action to deal with
the growing regulatory disparity between ATSs and other
markets, disparities the SEC found negatively affected other
securities markets and, most importantly, investors. Without
justification however, one ATS, Island, has openly violated and
disregarded ATS by steadfastly refusing to display its best
price orders and the consolidation quotations and providing
access to those orders by investors across all markets.
Because of these violations of this new rule, we have now a
two-tiered market rife with fraudulent and misleading trade
reporting. To fully appreciate this problem, it is important to
connect a few dots. First, NASDAQ has in place a payment for
order flow program under which they pay their members,
including Island, for trades and Amex listed securities.
Because of an historical anomaly, NASDAQ is given credit for
Island's trades, even though Island refuses to participate in
the two most significant components of the National Market
System, consolidating quotations and providing fair access to
those quotes.
To restore balance to the National Market System, in
February of this year the overwhelming majority of the markets
proposed an interpretation of the National Market System plans
to end the practice of giving NASDAQ credit under the revenue
sharing formula for Island's trades until Island became a full
partner in the National Market System. Ironically, if this
interpretation were permitted to stand, many of the problems
today that I am raising would long have been resolved. It would
also absolutely have prevented the next problem on the horizon,
which is fraudulent and misleading trade reporting, which is
the second situation I will describe to you today.
At the beginning of this year, Island also began paying for
order flow using the money it receives from NASDAQ. The clever
structure of their scheme has directly led to a practice known
as trade shredding and at least in some instances to
manipulative wash sales. Yesterday's enforcement settlement by
the NASD was swift securities is directly attributed to wash
sales on Island solely for the purpose of collecting market
data revenue.
Third, to exacerbate matters, Island has recently announced
that it will begin reporting--that is, selling--its trades and
ETFs to the Cincinnati Stock Exchange in a manner that will
neither display their best price quotes nor make them
accessible to public investors. Regrettably, we note that the
Cincinnati arrangement with Island, which has not been filed
with the SEC, undermines the core purposes of Regulation ATS
and the National Market System. Island will not be displaying
its best orders through Cincinnati and none of Island's quotes
will be accessible to other markets through ITS.
Fourth, this past August the Commission provided an
exemption for one of the most significant ITS rules for the
three most active ETFs. This action was obviously designed
directly to accommodate Island. Despite this and many other
accommodations, Island has cavalierly ignored the Commission's
efforts to have it join the National Market System, most
recently by going dark in an effort to use a loophole in the
provisions of Regulation ATS. As a result, Island has all the
benefits of being exchanged without any of the burdens. It does
not regulate the practice of its subscribers. Trading in wash
sales are classic examples of this. Nor does it provide
surveillance of the trading activity of its own market, does
not need SEC approval of changes to its system or changes to
its rules or fees, and it can pick and choose who is and who is
not a member.
To make matters worse, it markets itself as faster and less
costly than exchanges, a claim so absurd that it is insulting
to the intelligence of anyone truly familiar with their
practices. The principal reason Island is faster is because it
ignores investor protection rules followed by the other markets
that ensure investors receive the best available price in the
market. That is, it refuses to participate in the
congressionally mandated National Market System.
Worse still, although it defies new SEC rules explicitly
requiring them to join the National Market System, they
actually receive revenue generated from the National Market
System. In other words, we, the markets that comply with the
Federal securities laws by fully participating in the National
Market System, are actually providing a direct financial
support to a competitor that is ignoring these laws.
In closing, we are simply asking that all investors be
given the greatest assurances that they have access to the most
fair and efficient markets, and that the Amex and the rest of
the markets be given a fair playing field by ensuring even-
handed enforcement of the rules.
Thank you for your time, and I look forward to your
questions.
[The prepared statement of Michael J. Ryan, Jr. follows:]
Prepared Statement of Michael J. Ryan, Jr., Executive Vice President
and General Counsel, American Stock Exchange
Good morning, my name is Michael Ryan and I am Executive Vice
President and General Counsel for the American Stock Exchange. Chairman
Stearns, Mr. Towns and distinguished members, I appreciate the
opportunity to testify before the Subcommittee on Commerce, Trade and
Consumer Protection concerning ``ECNs & Market Structure: Ensuring Best
Prices for Consumers'' and wish to thank you for holding this important
hearing. Over the past year, a great deal of the financial community's
attention has been focused on the threat of terrorism and the need to
bring law and order back to corporate America. As the operator of a
securities market less than three hundred feet from Ground Zero, we
cannot overstate the importance of both these efforts. We believe
current efforts by the Government will strengthen the existing market
system and provide new protections and assurances to consumers and we
intend to remain an active participant in this process. Indeed, we look
forward to participating in the SEC's upcoming hearings on market
structure. In examining the current market structure today, I would
also like to bring to your attention several issues that relate to
serious violations of the federal securities laws that until recently
went unchecked for more than a year and a half and are, without a
doubt, counter to those principles that ensure a fair market for
investors.
Before I discuss specific points, however, it is important to
provide you a brief overview of the American Stock Exchange and of the
National Market System (NMS).
The American Stock Exchange has a long history of innovation and
diversification, and it proudly carries on this distinguishing
trademark among exchanges today. As one of the most diversified
financial marketplaces in the U.S., the Amex is the only primary
exchange in the United States that actively lists and trades securities
across three diverse business lines--equities, options and exchange
traded funds or ETFs. We continue to provide investors--whether it be
retail or institutional investors--with investment opportunities that
best meet their needs.
Since being purchased by the NASD in 1998, the Amex has undergone
dramatic changes. For the next couple of minutes, I'd like to highlight
some of those exciting changes and the distinguishing characteristics
of the Amex as a self-regulatory organization (SRO), and how it differs
and offers critical advantages to the market as compared to the other
exchanges and ECNs.
Essentially, the Amex marries the rules of the auction market and
the expertise of an Exchange professional to create a high-quality,
well regulated trading environment. The result of this advantageous
combination is the Amex's ability to provide investors with greater
liquidity, narrower spreads, decreased volatility and meaningful price
discovery.
The Amex market is a technologically advanced centralized auction
and specialist system whose strength comes from the fact that the
specialists have an affirmative obligation to maintain a fair and
orderly market. This means they risk their own capital, maintaining a
continuous two-sided quotation. With a specialist intrinsically linked
to creating the best market for a stock, the best interest of listed
companies and their shareholders are achieved. Other markets--whether
they be regional exchanges, dealer markets or ECNs--provide far less of
a commitment to the investing public.
By buying and selling from their own account, specialists increase
liquidity and maintain orderly markets by helping companies avoid the
wild fluctuations and price volatility securities often seen on other
markets. Investors also benefit from ``truer price discovery'' and
decreased fragmentation, as customer orders in our market are matched
up together over 70 percent of the time.
The combination of our auction market, diversified product line,
state-of-the-art technology and large pools of liquidity on our market
provided by Wall Street's most experienced and well-capitalized firms,
delivers a superior marketplace for investors in all our products.
equities
The Amex equity marketplace continues to outperform the market.
Following a strategic restructuring of the equity program which
refocused the business on small and middle market companies, the Amex
composite index outperformed every other domestic exchange and
virtually every other index in both 2000 and 2001, and is on track to
do so again this year.
The Amex, unlike the other primary markets which focus exclusively
on servicing large cap stocks, acts as a conduit in helping small and
mid-sized companies develop and grow.
We feel that now, more than ever, in this economic and political
climate, it's critical to provide support to the capital markets--
especially the small and mid-cap companies who are more often than not
our nation's principal source of innovation, job creation and future
economic growth.
Our advanced centralized auction and specialist system is
especially beneficial to small and mid-cap companies as it maximizes
liquidity at the point of sale. Specialists also serve as a single
point of contact that a company can turn to for critical insight on
their company's trading activity.
By offering a catalogue of value-added services through our
Investor Relations Alliance to our listed companies, we've created a
niche marketplace for companies who can use guidance and assistance in
seeking visibility and coverage in a difficult economy and an
increasingly sophisticated market environment.
Offering additional diversification and opportunities to
investors--we also began trading NASDAQ stocks this summer. By trading
NASDAQ stocks, the Amex is providing for the first time in these
securities, a meaningful auction market environment with real
opportunities for price improvement. The Amex is providing deep
liquidity for large, institutional size orders, which creates new
investment opportunities for investors.
options
The Amex is also the second largest options exchange in the U.S.,
trading options on broad-based and sector indexes as well as domestic
and foreign stocks.
We trade call and put options on more than 1,800 stocks and 25
broad, sector-specific and international indexes. And we continue to
close in on becoming the number one domestic options marketplace for
equity options.
Even amid tough market conditions, we continue to see growth in our
options business. In looking at third quarter Amex's total options
equity volume for this year, it is up 18% as compared to this same time
last year.
etfs
In addition to its role as a national equities market and leading
options exchange, the Amex is the pioneer of the Exchange Traded Fund
(``ETF''). ETFs are the fastest growing, most innovative financial
products offered by an exchange over the last decade. After more than
four years of working with the SEC and millions of dollars of R&D
expense, we launched the first ETF in 1993 with the creation of the
Standard & Poor's Depository Receipts (or commonly referred to as the
``spider''), which is based on the Standard and Poor's 500 Composite
Stock Price Index.
Over the next several years, we spent millions more developing new
products and educating the marketplace about the benefits of ETFs. Nine
years later, the Amex remains the clear leader in ETF listings, listing
121 of the 123 in the U.S. market today.
For a six-year stretch through 2001, the Amex had seen ETF assets
and average daily volume nearly double year after year. In 1999, ETFs
at the Amex had $35.9 billion in assets. That grew to $70.3 billion in
2000 and to $87 billion by year-end 2001. Last year, we witnessed ETF
assets increase more than 26% at a time when most underlying indexes
were declining.
Remarkably, ETFs have grown globally in the face of the market
downturn. That is due in large part to the basic features of the ETF
and the attractive advantages they offer investors, especially in
turbulent markets. ETFs offer investors diversification, flexibility
against intra-day price swings and lower cost structures. Certainly,
today these qualities are even more appealing to any investors--whether
retail or institutional.
Now, we're also planning the next generation of ETF products--
variations that will allow investors even greater flexibility and new
opportunities. We launched fixed income ETFs this summer and are
getting ready to introduce leveraged ETFs, inverse ETFs and actively
managed ETFs.
global
We have been able to leverage our reputation in ETFs to create a
global presence for the Amex. In the last year, we have reached
agreements to trade Amex-listed ETFs in Europe and Asia.
Our global expansion includes a joint venture with the Singapore
Exchange. In May, we began trading Amex-listed ETFs in Asia, becoming
the very first fungible trading of a product across time zones.
We've also listed the first U.S. equivalent of an ETF trading on
the Tokyo Stock Exchange. And we continue to work on agreements with
the Tokyo Stock Exchange and Euronext with respect to the listing and
trading of each other's ETFs.
As regulations allow, we anticipate that these centers will also
provide international trading venues for our listed companies seeking
exposure to the global markets.
critical issues
In short, the new American Stock Exchange has emerged as a strong,
innovative international competitor, especially in the development and
trading of sophisticated derivative securities.
Amidst all of this, we are also preparing to separate from the
NASD. As the NASD has publicly stated, it is ready to refocus solely on
its role as a regulator, divesting itself of ownership of both NASDAQ
and the Amex. That process is well underway for NASDAQ, and the Amex is
actively discussing with interested parties the best opportunities for
our separation from the NASD.
Importantly, at the Amex, we pride ourselves on being a guardian of
the capital markets as well as a proponent of innovation. The Amex has
always been a regulator that is focused not only on strong regulation
but also enhancing prospects for current and future economic
prosperity. This has been at the core of the Amex for many, many years
and will continue to be well into the future, regardless of ownership.
national market system
Let me now turn to a brief description of the national market
system--its formation and purposes.
In 1975 Congress adopted substantial amendments to the federal
securities laws designed to enhance the integrity and efficiency of our
national securities markets and to ensure that all investors, wherever
located and irrespective of their connections or affiliations, were
provided contemporaneous, equal and fair access to market information
and pricing.
Thus, Congress directed the SEC to develop a national market
system. The Commission, in turn, adopted rules under this mandate to
enhance transparency of market information and to foster interaction of
investor trading interest. These rules require that the markets
disseminate to the marketplace, in real time, consolidated order and
quotation information as well as trade executions. These rules also
require that the markets maintain linkages among one another in order
to minimize fragmentation.
The SEC directed all the exchanges and NASDAQ to adopt plans to
implement a national market system and to integrate the various
exchanges into them. Ultimately, three critical national market system
plans were adopted for equity securities: the Consolidated Quote
(``CQ'') Plan, the Intermarket Trading System (``ITS'') and the
Consolidated Tape Association (``CTA'') Plan.
To put it in simple terms, CQ lets market participants see trading
interest as soon at it arises, ITS provides the mechanism for market
participants to access this trading interest across markets and CTA
provides the mechanism to learn about trades that occur almost
immediately after they are executed. Collectively, these three plans
achieve the Congressional mandate of developing a national market
system by enhancing real time consolidated transparency of market data
(i.e., the CQ Plan for quotes and CTA Plan for trades) and fostering
interaction of investor trading interest (i.e., ITS). Each of the Plans
was submitted to and approved by the Commission.
The CQ and CTA Plans provide that the market data generated from
these Plans is to be sold to market participants on a real-time basis.
The revenue generated is then shared among the exchanges and NASDAQ
ratably based on the number of trades executed by that market.
Since the adoption of these Plans, the Commission has on many
occasions refined its national market system related rules, reinforced
the importance of the national market system and underscored the
central role these Plans play in meeting the mandate set forth in the
1975 Amendments.
Most significantly, on December 8, 1998, the Commission adopted a
new rule--Regulation ATS (Alternative Trading System)--designed to
integrate significant alternative trading system activity into the
national market system. This new rule was adopted after extensive and
careful consideration and for the express purpose of integrating ATSs
into the national market system.
Much like the Commission's 1996 order handling rules that were
designed to eliminate the two-tiered market being created by Instinet
in NASDAQ securities, Regulation ATS was adopted to address the
Commission's well-founded concerns that these systems were leading to
market fragmentation and harming market transparency by operating as
private `` `hidden markets,' in which a market participant privately
publishes quotations at prices superior to the quotation information it
disseminates publicly.'' Further, the SEC did this to deal with the
growing regulatory disparity between ATS's and other markets,
disparities the SEC found negatively affected other securities markets
and, most importantly, investors.
The SEC noted at the time that ATS trading activity was not fully
disclosed to or accessible by public investors, that this activity
would likely not receive adequate surveillance for market manipulation
and fraud, and that ATS's had ``no obligation to provide investors a
fair opportunity to participate in their systems or to treat
participants fairly.''
Without justification, however, Island has openly violated and
disregarded the clear provision of Regulation ATS that expressly
requires orders entered in Island to be publicly displayed in the
consolidated quotation. The violation of these important aspects of our
federal securities laws has created a two-tiered market, complete with
unfair advantages for certain market professionals, to the direct
disadvantage of the other market participants and, most significantly,
retail investors. Because of these violations of this new rule, we now
have a two-tiered market rife with fraudulent and misleading trade
reporting.
The American Stock Exchange believes very strongly that this
subcommittee should view with deep concern Island's open and continuous
violation of Regulation ATS since May 2001. For more than a year the
Amex has repeatedly raised objection to these violations and other
related abuses.
To add to this problem, NASDAQ has in place a payment for order
flow program whereby they pay their members--including, most notably,
Island--for trades in Amex listed securities. To be precise, NASDAQ
``kicks back'' to Island a percentage of the market data revenue NASDAQ
receives as a result of Island's trades, even though Island refuses to
participate in the two most significant components of the national
market system--consolidating quotations and providing fair access to
those quotes.
We believe NASDAQ's payment for order flow program raises serious
and significant issues regarding investor protection, market
transparency and best execution. This program directly violates the
fundamental principles of the national market system as it was
conceived and mandated by this Congress. Indeed, the entire system has
now seriously deteriorated and broken down.
Back in February, the overwhelming majority of the CTA participants
proposed an interpretation of the CQ and CTA Plans to end the practice
of giving NASDAQ credit under the revenue sharing formula for Island's
trades. After all, it defies both logic and principles of fundamental
fairness to permit NASDAQ or Island to receive direct financial benefit
for Island's trades from the national market system when Island
stubbornly refuses to participate in the most fundamental national
market system functions.
Ironically, if the American Stock Exchange and a majority of the
other CQ/CTA participants were not forced to reverse this
interpretation, much if not all of this problem would have long been
resolved. It would also have absolutely prevented the next problem on
the horizon--fraudulent and misleading trade reporting.
Beginning sometime in February or March, Island also began paying
for order flow. They cleverly structured their scheme along the lines
of the NASDAQ payment for order flow program, which mirrors the CQ/CTA
market data revenue sharing plan. That is, you get paid for every trade
in excess of 100 shares. Needless to say, it wasn't long before
Island's customers were breaking up trades into 100 share increments--a
practice know as ``trade shredding'' in its most benign form and, in
many instances, wash sales, an explicit violation of the
antimanipulation provisions of the federal securities laws. So, for
example, if Island is paying you $1.00 per trade regardless of the size
and you want to trade 1000 shares, you are going to send into Island 10
orders at 100 shares rather than 1 order at 1000 shares. Trade
shredding and wash sales flowing from Island's scheme have proliferated
since then.
Unfortunately, this is not even the latest chapter. There are two
more.
First, to exacerbate matters, Island has recently announced that it
will begin reporting (that is, selling) trades in ETFs to the
Cincinnati Stock Exchange (``CSE'') in a manner that will neither
display their quotes nor make them accessible to public investors.
According to Island, CSE will pay Island 90% of CSE's market data
revenue that it receives under the CTA Plan. Island therefore will be
able to pay its users even more than under NASDAQ's Pilot Payment for
Order Flow (``PFOF'') Program, with the aim of further increasing
Island market share and siphoning even greater volume away from
national market facilities. In this regard, we note that CSE's
arrangement with Island, which has not been separately filed with the
SEC, undermines the core purposes of Regulation ATS. Island will not be
displaying its best orders through CSE and none of Island's quotes will
be accessible to other markets through ITS. Indeed, Island has
explicitly stated that orders matched at a price outside the best
market--that is, that trade through a better price in the national
market system, will continue to be reported to NASDAQ and be
compensated for under NASDAQ's Pilot PFOF Program.
Finally, against this backdrop, we were amazed and frustrated when
we learned this past August that the Commission without discussion or
debate amended the ITS plan for SPY (the S&P 500 ETF), QQQ (the Nasdaq
100 ETF) and DIA (the Dow 30 ETF). The action was obviously designed
directly to accommodate Island.
During this entire period the Amex has honored every request by the
Commission to refrain from taking any action based on the Commission's
promises that the issues would be addressed expeditiously. While we
have complied with the Commission's requests, Island has cavalierly
ignored the Commission's efforts to have it join the national market
system, most recently by ``going dark''--and thereby making an absolute
mockery of the entire purpose of Regulation ATS--after the Commission
granted a three cent exemption to the ITS trade-through rule. Our
frustration with the situation has reached the breaking point.
What has happened here sends a clear message to market
participants: If you are part of the private club (in this case,
Island), you don't need to worry about the rules and you can trade
away. This means that outsiders cannot see or get access to a better
price within the private club. What's more, because the private club
refuses to connect to the national market system, investor's orders in
the private club are disadvantaged because they cannot access a better
price in a competing market.
Although characterized as ATSs, these private clubs on one level
operate for all practical and competitive purposes as an ``exchange,''
competing each day with the registered national securities exchanges.
On another level, however, these private clubs have none of the
regulatory burdens of an exchange. They do not regulate the practices
of their subscribers (to wit, trade shredding and wash sales). They do
not provide surveillance of the trading activity of their own market.
They do not need SEC approval of changes to their systems. They do not
need SEC approval to change their rules or fees. They can pick and
choose who is and who is not a club member. And, in complete defiance
of Regulation ATS, has operated in blatant and open violation of the
federal securities laws for 18 months. In violating Regulation ATS,
they do not disseminate their best available orders for consolidation
with all other markets and they do not provide access to anyone who is
not a part of their club.
As a result, an ATS has all the benefits of being an exchange
without any of the burdens. To make matters worse, they market
themselves as faster and less costly than exchanges--a claim so absurd
that it is insulting to the intelligence of anyone truly familiar with
their practices.
The only reason an ATS is faster is because they ignore the
investor protection rules followed by the other markets that ensure
investors receive the best available price in the market--that is, they
refuse to participate in the Congressionally mandated national market
system.
Worse still, although they defy new SEC rules explicitly requiring
them to join the national market system, they actually receive revenue
generated from the national market system. In other words, we--the
markets that comply with federal securities laws by fully participating
in the national market system--are actually providing direct financial
support to a competitor that is ignoring the federal securities laws.
conclusion
During this session, Congress has had to shore up the integrity of
our markets and the governance of our corporations in the context of
such examples as Enron and WorldCom, which involved private ``deals''
to accommodate ``star performers,'' all undertaken in an opaque
regulatory environment. We view the current regulatory scheme applied
to ECNs as perilous because a regulatory pattern has emerged that has
allowed certain market participants to operate outside the rules and
outside the Congressionally mandated national market system. We are
simply asking that all investors be given the greatest assurances that
they have access to the most fair and efficient markets and that the
Amex be given a fair playing field by ensuring evenhanded enforcement
of the rules. If the house of cards falls, then Congress, together with
regulators, securities markets and investors, will be asking why the
warning signals had not been adequately dealt with. Thank you for your
time.
Mr. Stearns. I thank the gentleman. Let me just say, as
many of you mentioned, we have had--this is a second hearing.
And we invited NASDAQ and we invited the New York Stock
Exchange. They came to the first hearing; they decided not to
come to this one. Mr. Ryan, we invited Island; they didn't want
to come. So--for whatever reason. We want to thank you folks
for coming.
As a person that is really not a sophisticated--has a
sophisticated understanding of all this, it seems to me, just
as a person standing on the outside, every time I go toCNN and
I see the New York Stock Exchange and people running around
down on the floor, human beings running around, making orders,
it occurs to me, gee whiz, this could be done by computers. It
seems something simple, but as we move forward in technology it
seems like you could handle many more sales of stock and bonds
by computer rather than having people run around on the floor.
The second thing that occurs to me after 9/11 is that, why
does it have to be in Wall Street in New York?
And, third, why does it have to be a certain hour? Because
if you go to an electronic communication network, you could
actually get it at midnight. If you go on and log in and you
find somebody selling IBM, you could buy the stock yourself.
And so that you would have this type of fluid market where you
wouldn't need to have a location and 9/11, which is very
susceptible to terrorists. Second, it could have any hours. And
then, third, it seems like it would be more efficient.
So that is sort of the impetus that all of us think to have
these hearings, is to understand how can ECN start to play a
more prominent role, not just for the institutional investors,
but also for the everyday investor who wants to buy.
Probably a fourth reason for the ECN being advantageous is
if you want to sell a large block of shares today. If you sell
them in which you have a lot of interface with a lot of people,
a lot of other people are going to tell a lot of other people
and pretty soon that is going to affect the market. So it is
like the old Heisenberg uncertainty principle: You never know
exactly where something is because as soon as you go to touch
and look at that particular subatomic particle, you changed its
location. So if T. Rowe Price and Merrill Lynch goes in, wants
to sell a million shares of IBM and pretty soon all the people
who are on the floor of the Stock Exchange know it, that is
going to impact it in some way.
So the Heisenberg uncertainty principle, which was
enormously famous, it almost applies to this in that you cannot
sell large blocks unless you go out and get 10 brokers to sell
the stock for you and let them do it under a code name or under
a false name so that you don't disrupt the market.
So there seems to be a lot of advantage to ECNs, and I
think our purpose today is to understand what is preventing
ECNs from becoming more competitive and at the same time not
disrupt the market or not try to put any particular self-
interest at risk, but just try to let, as you pointed out,
democracy work; that is, democratize this Stock Exchange so
that we have innovation, speed, higher productivity and
efficiency, and at the same time protect investors so that we
don't have some exclusive processor having all the information,
making all the money, and having perhaps a self-interest at the
same time they are pushing stocks.
So toward that end, let me just start out and move to this
Intermarket Trading System, which all of you seem to think is
the problem. I mean, that is what I suspect.
So, Mr. Foley, if you can, just try to give us in a very
short amount of time or quickly tell me what the Intermarket
Trading System is. It looks to us it is a little bit like the
Senate where you need a unanimous consent from everybody to get
anything done, whereas in the House it is not quite like that.
So everybody says, well, why do you want to be a Senator? Well,
everybody wants to be a Senator because one person can hold up
the train, and whereas a U.S. Congressman for the House, it is
much more difficult.
But this Intermarket Trading System, give us a little bit
of a layman's term what this is and how it prevents this
democratization of the market.
Mr. Foley. Well, let us first describe--excuse me. Let us
first describe the era in which the ITS came to be. I mean, I
am still listening to the Rolling Stones, and I think we all
are as we were in 1975. But at that time I listened on an eight
track, and in the middle of a song there would be a 10-second
pause with a loud click before the song would continue. And
that is the era in which the ITS was originally conceived. We
don't think it is designed to work. And, as you referred to the
governance structure, that is not designed to help anybody who
wants to make it work. It is a method whereby an exchange that
has an order that wants to be executed and doesn't have the
best price on the other side of that order can send a
commitment to trade to another exchange that does have the best
price.
All right. The structure of ITS is at the heart of the
debate between Island and the American Stock Exchange. Island
under ITS rules would have to slow itself down to the pace of
the ITS system and wait 30 seconds and so forth to find out if
they have a trade with another exchange before they are allowed
to effect an exchange--rather, a trade in their system. That is
rather like telling a consumer using eBay that before you can
buy these baseball cards we have got to go send all the
information about the pending transaction to Sotheby's and wait
until Sotheby's convenes an auction and make sure that
Sotheby's doesn't have a better price, whereas the guy on eBay
just wants to buy his baseball cards.
So at the heart of this debate is that the current system
really would eviscerate the benefits to consumers, which is,
after all, why they are going to ECNs like Island to trade
things in the first place.
We have chosen to wait for the SEC to resolve some of the
market structure issues that make us reluctant ourselves to
participate in ITS. Island made a different choice. But to say
that they are not abiding by investor protection rules, I would
say they are probably not abiding by exchange protection rules,
and that is a serious matter of concern. We think that the
solution is for the SEC to move forward quickly on rules for
how folks can be able to display their orders and listed shares
in the alternative display facility, which will put it on
every, you know, Reuters and Bloomberg machine and TV screen
across the globe. That is the disinfectant, transparency.
In the meantime, we think it is important that this
committee take a serious look at the consumer protection issues
that are, we think, at the heart of the issue.
Mr. Stearns. Mr. Ryan, would you like to comment on that?
Mr. Ryan. Sure. I agree with Kevin's assessment that the
ITS system needs a lot of work. I think----
Mr. Stearns. It was started in 1975.
Mr. Ryan. Yes.
Mr. Stearns. Okay.
Mr. Ryan. It is an outgrowth--I mentioned that in my
testimony--an outgrowth of the National Market System. It is
the critical part of the National Market System for trading
listed securities.
Mr. Stearns. So would you agree that something that was
established in 1975 probably needs updating or at least some
change or not?
Mr. Ryan. Unequivocally. I think that is true. I think that
the--and you addressed this earlier--that the issue of market
data and the notion of how that is distributed among the market
participants needs a lot of work and within the next 2 or 3
weeks the American Stock Exchange is going to be meeting with
the other markets to talk about and put a proposal on the table
to give credit for market data along the lines of markets who
provide liquidity and better price discovery.
So we look forward to the SEC's hearings and look forward
to working on all of these issues, and I think no doubt the
time has come to take a real hard look at this.
I do want to make one note, though, that in terms of kind
of the distinction--a distinction between exchanges and ECNs
and a point that you were making about the role of an exchange,
exchanges have specialists who have a deferment of obligation
to the market to maintain a fair and orderly market to risk
their capital. ECN marketplaces don't do that. They don't
provide any liquidity if their subscribers don't show up. So,
for--and ECNs never trade in any significant volume when--
unless the primary market is open with the specialists
providing that liquidity. And the ECNs do come in and their
members do come in and access that liquidity.
That is not to say that I don't think that there may be
room for ECNs in the marketplace, but I think that this
committee and the SEC and the marketplace should be very
concerned about what incentives there are to go risk capital
and provide a continuous two-sided market and do that in a fair
and--have the affirmative obligation of maintaining a fair and
orderly market which exchange markets do require. I think that
is critical and it is--unless you pull that away and let the
markets kind of go without having the specialists there you
will never really know the answer to that question.
But I think when you see events like 1987, you see
September 11th, and you see how our markets respond, and
obviously in the days after both of those events there was a
lot of chaos and you had specialists there who have committed
millions and millions of capital maintaining fair and orderly
markets, that is critical in that process.
I also want to address the issue you raised about the
electronic environment. The exchange markets--speaking for the
American Stock Exchange, we are incredibly innovative in terms
of our electronics, and we are always rolling out new trading
systems, new mechanisms for routing orders to our floor, and we
are in the process as well of developing a whole new trading
environment. It will be a floor-based system, but it will also
be capable of going off floor, if that is where the markets
take us. We believe that the markets should drive where and how
trading occurs, but we do think that the price discovery
mechanism of in-person trading in today's environment provides
a lot of value. Floor brokers going in--and they can go in and
represent a customer order and they can have 100,000 shares and
only show 1,000 shares or 10,000 shares and work that order for
their customer. So that they are not by showing up and moving
that price. And there is a variety of mechanisms for doing
that.
So I think there are significant value added having
exchange markets and the specialist and the deferment of
obligations that they provide to the marketplace.
Mr. O'Hara. Chairman Stearns.
Mr. Stearns. Yeah.
Mr. O'Hara. If I may be heard on this, becauseArchipelago,
like the Amex, is actually part of--through the PCX we actually
operate or are a participant on these National Markets Plans.
And I think it is worth noting that what ITS stood for as a
principle is a good principle, and that was the concept of
linkage. Now, we can argue about the technology and some of the
rules surrounding that linkage, but the concept of linkage to
getting best price or best execution for customers is a good
idea and worth fighting for. And today, through this plan, the
ITS committee and the SEC, we are working very quickly toward--
or apparently we are working very quickly toward amending the
plan so that automated markets can interact in a way that don't
hurt their business models with these traditional marketplaces.
I hear this argument about Island not wanting to
participate because it slows them down. Well, there is two ways
of operating in this world: There is one that if there is a
stop sign outside your house, you want the stop sign shouldn't
be there? You don't just keep running through the stop sign.
You go down to the mayor's office and you complain and you show
statistics why it shouldn't exist. Well, Island just keeps
running through the stop sign.
What we did, Archipelago--we operate much like Island, we
are an automated market. What we did within the System, we went
down to ITS, we went down to ITS, we went down to the SEC, we
have come up to the Hill, we have our data supporting us, and
we have made what I believe are very solid arguments which have
resulted in an ITS proposal for a major overhaul, the plan
which I spoke about today. And a consortium of people on the
committee----
Mr. Stearns. Mr. O'Hara, would you want to make that part
of the record?
Mr. O'Hara. Yes, I would. It is ITS Proposal, ITS Operating
Committee of October 10, 2002.
Mr. Stearns. By unanimous consent, so ordered. If you don't
mind giving a copy to our staff, then we will make it part of
the record.
[The information referred to follows:]
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
Mr. O'Hara. Great. And this was presented to the SEC. That
was vetted last week. The ITS committee is talking about it
today, and we believe in very short order this plan or a
derivative of it will come in and will be approved and will
make major changes with the ITS plan. It is worth noting that
the two main obstacles to the plan are the New York Stock
Exchange and my friend down at the end of the table, Mr. Mike
Ryan. And if Mr. Ryan says he wants to support the ITS proposal
today, I would be willing to hand it down and he can sign up on
the dotted line.
But in truth, again, we are working very quickly in the
system to get it changed so that automated markets can interact
with traditional markets. And I just want to underscore, the
idea of linkage isn't a bad idea. It is good for consumers.
Best price is good for consumers and investors and your
constituents.
Mr. Stearns. My time has expired. I just remember from the
last hearing when we were talking about ECNs, we asked them
that, during 9/11 they had trading--trading on Enron had
stopped. The New York Stock Exchange specialist stopped trading
blocks of it, and there were imbalances, and the ECNs picked
that up and that was a success story. So I remember that from
the last hearing.
Mr. O'Hara. Right. That was the--this was last November
when the specialists on the New York Stock Exchange shut down
his post because that one person, the anointed person who
controlled all the orders decided that he or she was
overwhelmed and they couldn't get a guaranteed profit. So while
he or she shut down their post, and in order to sort of balance
things out so they would get their guaranteed profit,
alternative trading systems, ECNs were in there executing
trades for institutions, broker-dealers, and small investors.
Mr. Stearns. Okay.
Mr. Towns.
Mr. Towns. Thank you very much, Mr. Chairman. Let me begin
by first answering the question that you raised, Mr. Chairman.
Mr. Chairman, let me begin by answering the question that you
raised. You said why this has to be done in New York, Mr.
Chairman. New York is the appropriate place for it to be done.
I know that is not the nature of this hearing, but I will
explain that to you later.
Mr. Stearns. I think we touched a hot button.
Mr. Towns. Let me begin by asking you, Mr. O'Brien. You
testified that Brut has delayed its usage of the alternative
display facility because of technological and economic barriers
to its usage, and you urge the SEC and the Congress to insist
on improved connectivity solutions and more realistic
economics.
Could you explain what these technological and economic
barriers are and even the solutions you might propose?
Mr. O'Brien. Sure. I would be happy to. And it was
interesting to note that the NASD announced that the
alternative display facility was quote, unquote, live on July
29, when it didn't take on its first actual user until just
this week, which highlights some of the difficulties of
connectivity to these systems.
When the NEC undertook the commitment to build the ADF,
they went out and hired a Swedish technology vendor, OM Group,
to help them build it. The technology platform that OM used was
something basically unknown to U.S. financial market
participants, which basically meant that to build connectivity
to the ADF you need to build an interface, which would require
significant investment of technology resources at a time when
there are just not that many to spare. And when you are talking
about wanting to have a viable competitive alternative,
barriers to users of that alternative need to be really low.
We have been a strong advocate for ADF interfaces to
accommodate the financial information exchange protocol, also
known as FIX, which is basically a standard messaging language
by which security market participant systems talk with one
another.
When we were required by the SEC to certify as to whether
or not we could use the ADF as our primary means for quoting
NASDAQ securities on or before October 11th--which they
required us to do at the end of the month--we talked with the
folks at the NASD and asked when they might have fixed
connectivity, which they had alluded to for quite some time.
They gave us the good news that they had undertaken to hire a
vendor to provide that connectivity, but that testing for
quotation capability wouldn't be available until sometime in
December. So that made how we answered that certification
request very easy.
But it is the example--I mean, I guess ITS provides a good
example, that you can't create a static system at a single
point in time and assume that that is going to be viable, and
given that the pace of change in this industry really is week
to week.
On the economic front, they had originally come forth with
a fee schedule that mimicked that of NASDAQ despite the fact
that the systems they are offering are far less complex and
their justification for that was, well, we needed to recoup our
costs to build the system. I had a little hard time accepting
that answer when you realize that they oversaw the creation of
NASDAQ, they spun off NASDAQ, and received over $400 million in
return, and that spin-off really necessitated the need to build
the ADF. So the justification of cost recovery for a
noncompetitive fee structure was a little hard to swallow.
They have since modified that fee structure, offering
volume discounts and the like, but only on a pilot basis, and
it will be interesting to see when they set a permanent fee
structure going forward that it will be a realistic alternative
to SuperMontage usage, and I would implore the subcommittee to
focus on that and be a strong advocate on that.
Mr. Foley. Congressman Towns, could I address a portion of
that question?
Mr. Towns. Sure.
Mr. Foley. The exchanges in NASDAQ have a monopoly on the
gathering and dissemination of market data. All right? And
through that monopoly we believe they seek to perfect a
monopoly in the execution of trades as well. And we believe and
the SEC agreed that the alternative display facility would give
market participants a competitive alternative and would allow
the free market competition really to be the regulator on a
number of market structure issues. The SEC said the ADF had to
be ready before SuperMontage was allowed to go forward. Now,
the ADF from the NASD--the NASD and NASDAQ have interlocking
directorates. They have members on each other's boards and so
forth. And NASDAQ----
Mr. O'Brien. Common spelling.
Mr. Foley. Right. And NASDAQ is a for-profit entity. The
people that run NASDAQ have stock options to profit from the
performance of NASDAQ, and NASDAQ's own prospectus indicates
that the success of the ADF would be a bad thing for NASDAQ's
shareholders. And we think that may have something to do with
why the ADF was approved as viable when the very market
participants who argued for its creation indicated from--by our
nonparticipation at this point it just isn't viable. The
alternative display facility just doesn't display in the ways
that we would need it to do for us to bet our business on it.
So we are currently in the position of--for our NASDAQ
stocks of being stuck with the SuperMontage. We believe that is
implicitly in the market structure plan for the ADF, but it
just isn't there right now.
Mr. Towns. Any other comments on that before I move on?
Okay.
Mr. Chairman, I am going to take mine right now, because I
want to ask them all the same question.
Mr. Stearns. Sure. Go ahead.
Mr. Towns. Okay.
Several of you mentioned the phenomenon of Island going
dark and ceasing to display private market in five popular
exchange trading funds while Instanet shut down its private
market altogether in certain popular listed securities during
regular trading hours. Mr. Ryan characterized this activity as
a serious violation of the Federal Securities laws. My question
is, what has the SEC done about this? And let me just go right
down the line. I would like for all of you to respond to that,
starting with you, Mr. Foley.
Mr. Foley. Okay. Well, first let me say that I don't view
this as a long-term market structure problem, because Island,
for example, their market shares collapsed since they have
denied their own participants the ability to see their
liquidity. So transparency is good for business. Right? So I
think maybe there is a fait accompli over how things have
played out and how the SEC has moved kind of slowly.
Securities law violations, I leave that to the Securities
law cops for them to indicate.
Mr. Towns. Has anything been done?
Mr. Foley. Well, using the word ``done,'' we wouldn't be
informed about enforcement action against somebody else. But I
don't believe--I am not expert on it, but I don't believe that
the decision to go dark is a securities law violation. I do
recall at the beginning of this year Chairman Pitt asked the
NASD and Barry Shapiro not to take action against Island for
the activity they had going on in the queues, and we thought
presumably because they thought that was good for investors and
they were going to work out the market structure issues. All
right?
I am not comfortable that the ITS Committee, in spite of
having a great plan, needs unanimous vote to get anything done.
After 27 years, I am not confident that they are going to
resolve these issues. All right? I am confident that they
wouldn't be meeting to talk about this if the envelope hadn't
been pushed a little bit. And I think, you know, we have to
understand the underlying conflicts and maybe be a little bit
sympathetic to the behavior of all participants while we are
still awaiting these issues to be fully resolved.
Mr. Towns. Mr. O'Hara.
Mr. O'Hara. Yes. Thank you, Congressman Towns.
First off, on the ITS issue, note that not only is the
committee involved, but the SEC is involved. And in fact, one
of the Commissioners at our meeting last week said: You guys
get it done; that is, reform it, or we will do for you.
So literally, I mean, the tone we are getting from the SEC
is it had better be done--and reading between the lines--and it
better be done before the end of the year.
Putting that aside, the reason--and again, I will venture
some guesses. I am lawyer. I know a little bit about this, but
again I will defer as well to the SEC and the regulators. The
reason that Island and Instanet--well, with Island, has gone
dark, or suffering a brownout, if you will, and Island--or
Instanet has completely shut down its market is because they
were forced to comply with the law.
Let us just take a step back. When the NASDAQ collusion
investigation settlement broke, one of the consequences or one
of the observations was there was a world of two markets in OTC
or NASDAQ stocks. There was the public market that you and I
would see, retail investors would see, and then there was the
private, clubby market that no one saw except the people in the
room. And that was on the one hand NASDAQ and on the other hand
was Instanet. Instanet then was a private market that most of
the world didn't have access to. What the SEC did in
implementing the order handling rules and other types of rules
associated with that was to force Instanet to show its market
to retail customers and the rest of the world, if you will, to
get a quote out in the public. And what has gone on with these
ETF, these exchange-traded fund products primarily, is that
Island and Instanet decided--and apparently against, if you
look at the text of Reg ATS--that they refused to reflect their
quotes to the world again.
Again, we went back--sort of went back to the future, if
you will. That is, they went back to sort of 1990's, pre-1997,
refused to show the world their quotes, and only let their club
members see the quotes. And my understanding is that the SEC
stepped forward and said, either get yourselves into the
quote--okay?--show yourself, let ordinary retail investors have
access and see your quote, or shut it down. It is illegal.
And I believe--if I may be heard. I believe, instead of
integrating technology and showing their quote, they decided to
take these actions, and that is to go dark, if you will.
Mr. Foley. Wasn't it true that Island--I mean, they are not
here and we don't have a horse in this race, you know,
Bloomberg, really. But wasn't the case that Island published
all this information on the Internet?
Mr. Ryan. Yes. But it was not consolidated. So you, as a
public investor, you needed to go to two different places. And
the National Market System requires at this stage consolidation
of information.
Mr. O'Hara. Plus, I mean, Kevin, how many traders do you
know that actually trade from a sophisticated standpoint
staring at the Internet?
Mr. Ryan. Quite frankly----
Mr. Foley. A lot of people.
Mr. Ryan. Kevin, your own business model is undermining the
market, the data that Bloomberg sells, because it is not
selling--it doesn't have all the information that should be
available to it.
Mr. Towns. I didn't mean to start a fight.
Mr. Foley. We are in favor of transparency, and you are
right----
Mr. Ryan. But Bloomberg as a disseminator of market data to
customers is not getting all of the data because you are not
taking the fee from----
Mr. Towns. Mr. O'Brien.
Mr. O'Brien. But I think it underscores a need in listed
market structure reform to separate information display issues
from execution issues. If you compare NASDAQ and the NASDAQ
market, NASDAQ and now slowly but surely the ADF offer means
for market makers and ECNs to show their best prices to the
public without participating in execution system rules that
undermine their business models. Actually, NASDAQ begrudgingly
at times has been good about modifying the rules of its
execution system to address ECN needs. For example, ECNs don't
need to take automatic executions from NASDAQ because that
subjects ECNs to financial risks as opposed to market makers,
which are--unfortunately in the listed market, to display your
best price quotations to the public you need to participate in
ITS and the execution rules that come with it.
And with all due respect to my colleague from Archipelago,
nothing happens quickly with respect to ITS nor ever will with
its current governance structure. And Brut says this as an ITS
participant through our participation in the NASDAQ
intermarket.
But basically, each ECN is subjected to a Hobsian choice of
getting its quotes out into the public marketplace in ways that
may force it to undermine the execution quality of its own
system, and that separation needs to take place.
Mr. Towns. Thank you very much.
Mr. Gasser.
Mr. Gasser. Yeah. I think as a Reg ATS, that the philosophy
behind Reg ATS is very simple, and that is publish a quote to
one and you must publish it to many or to all. And I think
Island in the ETF controversy, of which we are not a part,
thankfully, but Island in the ETF controversy is interesting in
that I think it represents some of the unintended consequences
of the things we talked about today on the ECN front, and that
is democratization of the, quote, democratization of access
participation within that quote. And at the end of the day I
suspect that the SEC delayed enforcement of the Reg ATS because
of Island's arguments regarding investor protection for some of
the folks that were used to operating within their system.
But that does not, or and should not--and I think it is
inconsistent with, I think, the views you have heard today from
major vendors in the ECN space--it should not give them the
ability to trade through, it should not give them the ability
to trade through anyone. Anyone that has a legitimate quote and
posts a better offer should have that ability to trade against
counterparties entering the National Market System.
But I think what it has also proven is that at the end of
the day free market forces will prevail when the rules are
enforced. And they certainly have in this case in that Island
has lost significant share in the ETF as a result.
Mr. Towns. Thank you very much, Mr. Gasser.
Mr. Ryan.
Mr. Ryan. Sure. A couple points just to be clear. Although
I personally believe that Island is operating in violation of
the Federal securities law right now in the way it is
operating, I think it is clearly a much closer call than prior
to when they went blank, where there was no doubt, I don't
think anybody reasonably could say, they were operating in
compliance with the law. They are certainly in violation of the
spirit of Regulation ATS and in violation of the spirit of the
National Market System by going blank.
I also am not fully convinced that they have been damaged
as much as others might be because of their arrangement with
the Cincinnati Stock Exchange, and in some of the products
involved where Instanet has not shut down, they may be shifting
some of that overflow there. There is a lot of moving pieces,
it is hard to tell.
I agree with both Kevin Foley and Kevin O'Hara. It is
difficult for me to kind of speculate as to why the SEC hasn't
taken more action in this area. I know we have raised these
issues with them many, many times. They have been struggling
internally with a lot of conflicting principles that are
involved. I think they were completely caught off guard that
Island would take this much market share as quickly as they
have. There was a lot of transition obviously at the SEC and a
lot of very significant issues facing the Commission over the
last year. And in many respects, this is probably a very
unfortunate accident of timing, but it is, I think, a very,
very serious accident, and something needs to be done about it
and something should be done to look at what can avoid these
types of situations in the past where a law can go 18 months
like this with no enforcement.
One thing I think is very important to note, and this goes
back to Kevin's analogy of a stop sign, you know, maybe that
stop sign shouldn't be there or maybe it should be a yield
sign, you know. And there is a lot of complexities to these
issues and a lot of varying views, but there is a process for
fixing things. And the SEC is the arbiter of this. And if you
don't like it, you go and try and change it. And the
frustrating part for us is we had in fact a little over a year
ago started having conversations with Island about coming to
some arrangement with them and having them become part of our
market to help bring them in compliance with the Reg ATS, and
it was rejected because that approach would have violated other
principles that have been kind of near and dear to the
securities markets long before the 1975 act amendment.
So what is frustrating from our perspective, and I think to
a degree I am probably speaking for the rest of the panel here
at some level, that there are rules and we should be following
those rules. If they are broken, they need to be fixed, and
there is a process for doing that. Until they are changed,
everybody should be abiding by the rules that apply to them.
There has got to be some sense that we know what is right and
what is wrong. And it is not a perfect world and things take
time. And God knows, you know, these are complicated times and
complicated issues. But there has got to be some degree of
reliability that the system is going to work and that you know
that the rules are going to be enforced and abided by. And I
know that at least some of the panel here have modified their
trading models so that they are in compliance with these rules,
and it has been to their disadvantage. We have been handcuffed,
and things that we wanted to do we have not been able to do. A
lot of innovative issues that we have tried to bring to the
forefront, until we get the approval from the Commission, we
are not doing them, you know. And we think everybody else
should be held to that standard as best as possible.
Mr. O'Hara. Congressman Towns, if I could just follow up on
that. What that gets is the concept of regulatory arbitrage,
some people who play by the rules and have to pay the expense
of playing by the rules and others that don't. And that is what
Michael is alluding to. And, for instance, Island, you know,
running through the stop sign and getting to where they want to
get quicker while the rest of us are having to stop.
And again, our system looks a lot like Island from the
extent that we are an electronic system and we reach out for
best price, but we have worked in the system. And, quite
frankly, we have had to go through what we call the sort of
fraternity house hazing of getting into these ITS committees.
We did. We did it successfully. Was it easy? No. Did it cost
some money and time? Yes. But is it changing--are our
circumstances changing? They are. And again, we have a
marketplace here.
Bill, my good friend Bill O'Brien, says he doesn't think
there is going to be change at the ITS, a quick change. I think
there is. And we will come back several months from now and we
will compare notes, and I think it would be important for this
committee to follow up on that issue.
Some of our friends from the SEC are here. They have told
this ITS Committee last Friday--they said, get it done or we
will get it done for you. Right from the lips of one of the
Commissioners.
So again, I think that we are at a point in time where it
will change, but that the underlying philosophy of ITS and what
it was created for, linkage to give customers best prices, your
constituents to get them best prices, is still a concept, a
principle worth fighting for.
Mr. Towns. Thank you very much. Thank all of you for your
answers. On that note, I yield.
Mr. Stearns. Thank you.
I think after just listening to you, I think a lot of us on
this subcommittee think it probably would be appropriate for
the subcommittee to start looking at legislation to modernize
ITS. So that is probably one of the things that we are getting
out of this hearing, to try and move toward that. I am just
going to ask two more questions, and then if Mr. Towns wants to
ask two more then we will complete. So we appreciate your
patience. Maybe it is a good question for Mr. Foley.
Are customers still paying too much for market data?
Mr. Foley. Yes.
Mr. Stearns. And let me just go down. Mr. O'Hara?
Mr. O'Hara. Correct.
Mr. Stearns. Mr. O'Brien.
Mr. O'Brien. Yes.
Mr. Stearns. Mr. Gasser.
Mr. Gasser. Yes.
Mr. Stearns. Mr. Ryan.
Mr. Ryan. I think it is a great bargain for customers.
Mr. Stearns. Okay. You think it is a great bargain. Okay.
And I ask who collects the money for the market data.
Mr. Foley. It is, after all, the customers' own information
that they contribute in the form of their orders that they then
are required to buy back through information vendors. You know,
if you look at the debates over payment for order flow from the
1990's, which we don't really hear so much about, the reason we
had payment for order flow was because spreads were
artificially wide, and this committee addressed that issue and
went right to the heart of the matter. Spreads are not
artificially wide any more, and so the profit from extracting
those spreads isn't being funneled back to investors in the
form of cheaper commissions they get through payment for order
flow. Now they get better execution of their orders.
Similarly, plans to share market data fees with the brokers
who contribute the orders that make up the market data, those
plans can result in lower commissions and increased benefits
for the investors that contribute that data or those data in
the first place. But if the market data fees weren't
artificially high, you wouldn't have that situation either.
Mr. Stearns. Just to get on the record, has NASDAQ
addressed the competitive concerns raised by the ECNs regarding
the SuperMontage? Anybody can answer that.
Mr. Foley. Kicking and screaming, right, and not in any,
you know, willing fashion they have addressed some of the
issues. But you have to be on your toes. New ones pop up in the
technology. We are dealing with a pernicious problem right now
where the SuperMontage technology can take an ECN's order out
of the quotation system. Now, they use their monopoly as a
place to go quote securities to try to effect a monopoly as the
place for executing and trading securities. That monopoly would
work to the benefit of NASDAQ shareholders, but it is not in
the benefit of investors who, you know, would otherwise enjoy
the fruits of competition. Real competition for NASDAQ,
SuperMontage, just as real competition for the New York Stock
Exchange through the ADF we think will be a solution. And then
that is something we think the committee ought to, you know,
continue to look at.
Mr. Stearns. Okay. What are the different fee structures in
place for access to ECN systems? Mr. O'Brien?
Mr. O'Brien. I am happy to talk to that. As I said in my
remarks, most if not all ECNs offer a rebate for initiated
order flow. And what do I mean by that? If the market in Cisco
Systems is $10.00 to buy and $10.02 to sell, someone wishes to
put in an order to buy at $10.01 into the system, which means
it is not marketable against anything else either within the
system or with Brut, in the public market, that will be
displayed within Brut system and in the public quote. That is
an initiated order. When that order gets executed against, the
person who put that order into the system would receive a cash
rebate.
On the flip side, where someone executes against the order
that has been put on Brut's book, basically withdrawing
liquidity from the system, they are charged an access fee. This
is very similar to the pricing model that NASDAQ uses for
SuperMontage. It is a horse by different color in the sense
that they call the rebates they hand out to market makers
liquidity provider rebates and their charge is execution fees.
But it is that basic same model.
Mr. Gasser. And that is actually where the NASDAQ and the
lucid markets are actually radically apart from one another, in
that that is no cross subsidy, if you will, in the lucid
marketplace. There is no encouragement to post limit order flow
while folks like Arch and Island will do that, there--the
inefficiency of that market--and that inefficiency gets back
down to this ITS issue. By inefficiency, I mean the inability
for that quote to always interact with the marketplace and the
listed. The marketplace has prevented that type of
encouragement for folks to add liquidity to the market in
competition with the New York Stock Exchange specialists. So in
the listed centric marketplace, such as the one that we operate
in, it is a usage fee only. It is only a charge today.
Mr. O'Hara. Chairman Stearns, if I may add to that, the
concept of access fees is a very American concept. That is, if
you provide a service or a product, one should have to pay for
it. And I think we all believe in that concept. Whether
Archipelago reached in and took liquidity from the New York
Stock Exchange or from Brut or from any other venue for one of
our customers, we should have to pay for that. And that should
apply across the board, quite frankly, that whether it is a
market reaching into a market maker on an ECN or any other
venue that has a service or product to provide, they should pay
a market rate for it.
One problem, however, that has cropped up with these access
fees is that some venues are using their market power to charge
competitors with sometimes three, four, five times what they
would charge a normal ordinary customer for a hit and take. So,
for instance, we have a best execution obligation, and we
believe in it because Congress told us to believe in it, and we
believe in it just as a business philosophy. So when we reach
out to our customer--previously when we reached out to our
customer, to Islander or Instanet, Island would charge us five
times what they would charge a normal customer to access
liquidity. Again, we are reaching out because Congress told us
to get best execution, we want to get best execution for our
customer, and they would charge us five times that rate.
Instanet, not as bad, but a multiple of two or three times what
they would charge their customer.
Now, as of recently, they have changed their ways, and we
will see if they stand on that position going forward, although
I do note that Island has arbitrated against us. We received a
filing saying that they want to recoup all these gouge fees
that we have refused to pay recently, and some of my ECN
friends as well have had to endure that. Again, we are reaching
out for best price for our customers, and some of these other
venues out there are saying, well, if you want to do that,
guess what, I know it is a Federal regulation, I know it is a
Federal concept, but we are going to charge you five times what
we charge our customers for that.
That is unfair and it is something that this committee--
this subcommittee should mark, because in the future we may be
coming back and discussing this issue depending how Island and
Instanet act going forward.
Mr. Foley. Mr. Chairman, there is an easy way to clear up
this issue, we think. We believe access fees should be
abolished. As former SEC Chairman Levitt said a couple years
ago, there is no room for these access fees in what is in the
listed markets, for example, and otherwise fee-less world. They
don't exist in contravention to the order handling rules
because they were created by the order handling rules, and, you
know, as a market compromise at the time. We charge ECN access
fees. We are not going to unilaterally disarm when our
competitors have that source of funding for their business
models. But we deplore the fact that NASDAQ has now--NASDAQ,
who has been given the power by the SEC all along to abolish
these fees, NASDAQ has instead determined to adopt the model of
access fees in their government-sponsored monopoly position as
a for-profit entity, managed by people whose, you know,
personal fortunes ride on the success of the NASDAQ securities.
They have decided that access fees are going to be a permanent
part of the landscape for NASDAQ securities, and we are very
sorry to see that happen.
Mr. O'Brien. Now, I am going to disagree quite a bit,
because access fees, you know, it is what it is. It is just a
business model. It is not per se wrong. ECNs is a pure agency
broker. They do not make money on proprietary trading activity
unless they have to charge a per transaction fee for users of
their system. There is nothing wrong with that. I think
sometimes the outcry over ECN access fees is a thinly veiled
attempt to eliminate paying ECNs altogether for the valuable
services of transparency and connectivity and order management
that they provide to the marketplace.
So I think the subcommittee should be focused more upon
ways to keep the access fee market competitive. There is one
example that I believe that NASDAQ is considering right now.
How SuperMontage works is that within any certain price point--
meaning, by that, I mean $20 or $19.99--they allow people
entering orders into SuperMontage to trade against firms that
do not charge an access fee, market makers, before trading with
firms that do, ECNs, offering price protection within any one--
within one-cent increment, but reducing, if not eliminating,
ECN access fees.
I think they are looking at improving the technology even
further, because right now when looking at someone as to
whether or not they charge an access fee, it is kind of a Y or
N logic. But they are exploring making that logic scaler, and
by that meaning treating ECNs that charge lower access fees
better than those that have taken that rate structure to an
unreasonable extreme.
Things like that which promote competition within a
business model as opposed to, you know, draconian measures to
force industries to change business models altogether are what
the subcommittee should be looking at to reduce cost and
improve efficiency in this area.
Mr. Stearns. Gentlemen, I thank you. What we are going to
do is wrap up here. We appreciate all of you staying and
participating. What we would like all of you to do, we have
some follow-up questions we will submit in writing to you, and
we would like you to respond. And also, we will leave the
record open so that members can offer their opening statements
who are not here.
The jurisdiction of this committee today includes consumer
protection, obviously, but also dealing with commerce, and this
electronic ECNs are applicable. So we feel a certain amount of
fiduciary responsibility for our constituents to bring up
consumer protection as well as commerce. So I think we have
done that this morning. And so I want to thank you for your
participation, and I look forward to continuing this in the
future. And I thank the distinguished members for being here
today.
With that, the subcommittee is adjourned.
[Whereupon, at 12:26 p.m., the subcommittee was adjourned.]
[Additional material submitted for the record follows:]
Responses for the Record of Kevin Foley, Chief Executive Officer,
Bloomberg Tradebook LLC
Question 1. What are the potential costs and benefits to investors
of a market in which market information is available through
competitive forces rather than an exclusive processor?
Response. The potential benefits to investors of a market in which
market information is available through competitive forces are truly
substantial. A quick look at how we have arrived at the current
situation is instructive.
Historically, under the cover of a non-transparent bureaucracy,
non-profit self-regulatory organizations (SROs) have exploited their
government-sponsored monopoly over market data fees to subsidize their
other costs--for example, costs of market operation, market regulation,
market surveillance, and member regulation. While at present most SROs
are non-profit organizations, NASD has largely completed its
privatization of Nasdaq and it may well be that other privatizations
will follow. For all SROs, the incentive will be strong to continue to
exploit this government-sponsored monopoly over market data by charging
excessive rates from a captive rate base (i.e., investors) and by using
the resulting monopoly rents to subsidize their competitive businesses.
Indeed, shareholders of for-profit exchanges will demand that market
data charges remain at whatever level will maximize shareholder profit,
which likely will result in excessive charges.
The public creates the data. While the public should bear the cost
of consolidating the data--plus a reasonable rate of return for the
consolidator--the public should not subsidize other exchange activities
and thereby give them unfair advantages over their non-subsidized
competitors.
In enacting the Securities Acts Amendments of 1975 (the ``1975
Amendments''), the Congress presciently warned against possible abuses
of market power by market centers such as the New York Stock Exchange
(NYSE) and Nasdaq that control or operate an exclusive securities
information processor:
The Committee believes that if economics and sound regulation
dictate the establishment of an exclusive processor for the
composite tape or any other element of the national market
system, provision must be made to insure that this central
processor is not under the control or domination of any
particular market center. Any exclusive processor is, in
effect, a public utility, and thus it must function in a manner
which is absolutely neutral with respect to all market centers,
all market makers, and all private firms . . .
Securities Acts Amendments of 1975, Report of the Senate Committee on
Banking, Housing and Urban Affairs to Accompany S.249, S. Rep. No. 94-
75, 94th Cong., 1st Sess.11-12 (1975).
We think the 1975 Amendments got it right. If consolidation of
market data is truly a public utility function, it is imperative that
it be regulated as such--with some measure of cost controls--and that
the exclusive processor be independent of any exchange that intends to
compete in the downstream market for financial information.
In short, the public can have the benefits of competition even with
an exclusive processor--as long as that monopoly public utility
function is separated from competitive functions.
Otherwise, the public is disadvantaged twice. First, the public is
disadvantaged when they pay excessive rates to see the data the public
itself creates. Second, the public is disadvantaged when those monopoly
rents are used by SROs to unfairly subsidize entrance into currently
competitive businesses because that anticompetitive behavior will
undoubtedly have an adverse effect on competition in those businesses
and will restrict output, reduce innovation and keep the prices in
those businesses artificially high.
Question 2. What are market data rebates and how do they work?
Question 3. Are market data rebates good for investors? Why or why
not?
Response 2 and 3. Nasdaq and the NYSE have exploited their
government-sponsored monopoly over market data to charge the public
sums far more than the actual value of their consolidation function.
Some of this excess market data revenue can be paid by exchanges to
brokers that give them order flow.
Imagine if a city government provided a hypothetical company ``call
it Acme Transportation--with a monopoly to manage the city subway and
permitted Acme to charge fares that far exceeded the all-in costs of
operation plus a reasonable rate of return on Acme's invested capital.
If Acme periodically defused public criticism by rebating some fraction
of their overcharges, would subway riders be well served?
In the short run, the rebates are positive--rebates are the only
way our hypothetical subway riders receive some share of what they are
overcharged. In the long run, however, the public would be better
served if government ensured the public that they were not being
overcharged for services provided by a government-sponsored monopoly.
In a case where government in fact grants monopoly mandates' to either
private or quasi-private entities--it should maintain close scrutiny on
the rents the monopolist can charge, precisely to prevent overcharges.
In the case of the SROs, our markets would be far more efficient and
fair if charges for the fruits of the government-sponsored monopoly
over market data bore a closer relationship to actual cost, plus a
reasonable return on capital necessary to sustain the service.
Rebates were recently halted in the Nasdaq market because of
concerns over the potential for market manipulation--activity that is
already illegal and is easy to spot and to punish. We believe rebates
should be reinstated until such time as the revenues generated by
government-sponsored monopolies bear a closer relationship to costs. At
present, these rebates are the only method for redistributing excess
market data fees to the people who both create the data and then have
to pay too much for it--the investors.
Question 4. Will market data rebates solve market data issues or is
a regulatory solution required?
Response 4. I believe market data rebates should be reinstated.
Until real reform occurs, these rebates are important as a means of
allowing the public to receive some percentage of the overcharges they
are paying.
The rebates, however, are not the real reform. Far from being a
solution, market data rebates are, in part, symptomatic of an
underlying problem. In effect, the exchanges can afford to provide
market data rebates because they use governmental power to require
their members to give them for free the raw material for generating
market data, and the exchanges then extract monopoly rents by charging
fees for market data that bear no reasonable relation to the actual
costs of producing, consolidating and making it available. Regulatory
action--coupled with the ongoing engagement of elected officials--will
be essential to address these issues.
Question 5. Are market data rebates creating problems with wash
trades--are buy and sell quotes being entered simultaneously by the
same party to generate trade revenue from market data rebates? If so,
how do we solve this problem?
Response 5. Not being in the enforcement business, I cannot offer
much insight into whether wash trades are currently a problem. I'd note
that market manipulation is already illegal and easy to spot and
punish.
Question 6. Is current ECN access to ITS adequate? Why or why not?
Response 6. The ITS is an exchange-dominated consortium whose
outmoded technology and antiquated governance structure serve as a
significant barrier to ECNs who would seek to compete in the NYSE-
listed market. Current ECN access to ITS is thoroughly inadequate.
Along with ITS reform, urging the SEC to take the steps necessary
to facilitate the promised display of NYSE-listed stocks in the
Alternative Display Facility (ADF) may be the best way to bring the
benefits of competition to the listed market. The SEC should approve
the ADF rules proposed by the NASD regarding NYSE-listed stocks.
Question 7. Are the access rules for ITS responsible for ECNs'
lower trading volume in listed securities than in NASDAQ securities?
Why or why not?
Response 7. Certainly the access rules for the ITS contribute to
the lower trading volume in listed securities. ECNs' share of the
listed market is lower because ECNs are not allowed to quote in the
listed market independently of the exchanges, which brings ECNs under
the umbrella of the ITS. ECNs should be able to quote in the listed
market without having to participate in the ITS.
There are, of course, additional impediments to ECN participation
in the listed market. In the mid-1990s, the SEC issued the Order
Handling Rules. The resultant transparency and the subsequent
integration of ECNs into the national quotation montage narrowed Nasdaq
spreads by nearly 30% in the first year. Reform of comparable scope has
not occurred at the NYSE.
For years, the NYSE has erected barriers to competition. Its
infamous Rule 390, which prohibited NYSE members from dealing in listed
securities off an exchange, is a case in point. Even if the ITS were
reformed tomorrow, we would anticipate renewed efforts to establish
other roadblocks to competition. That's why it is critical that there
be significant ongoing scrutiny provided by regulators and legislators
on market structure issues and also why it's critical that the SEC
approve the NASD's proposed rules as soon as possible regarding the
promised display of NYSE-listed stocks in the Alternative Display
Facility.
Question 8. Do access rules for ITS presume best execution at the
NBBO? Are there any other factors that should be considered for best
execution?
Response 8. ITS justifies their rules by talking about best
execution, but investors taking matters into their own hands have
chosen ECNs for best execution when given the choice. There are indeed
numerous other factors that should be considered for best execution,
particularly in a decimalized environment, including speed, size, and
quality of execution and the role of the trade-through rule.
Question 9. Please describe the governance structure of ITS. Does
the governance structure of ITS inhibit innovation? If so, please
explain.
Response 9. We are not members of the ITS, but it is our
understanding that unanimity is required to effectuate major changes.
That is clearly a major impediment to change, and a major impediment to
bringing competition to the NYSE-listed market.
Question 10. What is the difference between the old NASDAQ as an
infrastructure for quotations and the new Nasdaq with the SuperMontage
as an order execution facility?
Response 10. Through a series of developments starting with the
inauguration of the Small Order Execution System (``SOES'') in the
1980s and progressing through the development of SuperSOES and, more
recently, SuperMontage, Nasdaq has evolved from a decentralized,
quotation-and-telephone system into a screen-based, electronic
communications network embodying a central limit order book.
In theory, NASD members can bypass SuperSOES through private wire
connections between a market maker and a customer or dealer. In
reality, however, that means of avoiding SuperSOES is not on an equal
competitive footing with the use of SuperSOES. Orders transmitted
through SuperSOES impose obligations on the market maker to execute
against its published quotation.
Only Nasdaq has the monopolistic power to deliver mandatory
executions to market makers against their quotations. Individual market
participants do not have the market power to replicate that obligation
through private contractual arrangements or other private ordering.
SuperMontage represents the next step in this process of
potentially harmful centralization. It is particularly disconcerting as
it effectively expands Nasdaq's government-sponsored monopoly powers at
exactly the moment when the changed incentives of privatization would
argue for curtailing Nasdaq's government-sponsored monopoly powers.
Question 11. What potential benefits or risks does the SuperMontage
bring to the marketplace?
Response 11. SuperMontage centralizes display and order execution
in one soon-to-be for-profit entity, unfairly disadvantaging all other
competitors. Nasdaq has argued that the benefits of SuperMontage
include upgrading Nasdaq's technology and promoting the display of
greater depth of book. While all Nasdaq members applaud Nasdaq's
upgrading its technology, this upgrade could have been done without
centralizing display and order execution in a Nasdaq controlled entity.
All of Nasdaq's competitors upgrade technology constantly without the
carrot of an enormous government gift, the grant of Nasdaq's power to
use regulatory compulsion to enforce its restrictions on competition
and to advance its commercial objectives.
Likewise Nasdaq could have opted to display greater depth of book
without requiring the centralization of display and order execution.
Indeed, as Nasdaq fought hard to make sure that the Alternative Display
Facility didn't actually display quotes, it became clear that Nasdaq is
interested in displaying its own quotations, but not in allowing the
market-wide transparency that would foster competition. The SEC wisely
rejected Nasdaq's position and instead issued vendor display rule
guidance that goes a long way toward ensuring that Alternative Display
Facility quotations can be seen.
The potential risks of SuperMontage are clear. A for-profit Nasdaq
will have a powerful incentive to leverage its existing government-
sponsored market data monopoly and its newly granted trade execution
monopoly to deter competitors and discourage innovation. Nasdaq will
have incentives to ``keep pace'' with market innovators not by moving
forward themselves, but by slowing down all market participants and
centralizing order flow. Everyone loses if exchanges--comfortably
situated as government-sponsored monopolies--fail to innovate, leaving
American markets vulnerable to offshore competition.
The potential remedies are also clear. For good reason, the SEC
deemed the ADF so critical to the maintenance of competition that the
SEC set the existence of a viable ADF as a precondition to both the
rollout of SuperMontage and the possible approval of the Nasdaq
exchange application. A commercially viable Alternative Display
Facility, coupled with strong and engaged government oversight, will
create an environment in which SuperMontage can yet be a net plus for
the market.
Question 12. Is SuperMontage a Central Limit Order Book (CLOB)?
Response 12. SuperMontage is certainly an order book. The
implication of a ``central'' order book is that everyone is compelled
to participate in it. We think compelling everyone to participate
stifles competition and robs consumers of the benefits of innovation
and reduced costs.
While no single rule compels everyone to participate in
SuperMontage, an arcane combination of rules gives many market
participants little choice but to participate in SuperMontage. That's
great for Nasdaq shareholders, but it would be better for investors if
Nasdaq had to entice, rather than compel, participation in
SuperMontage.
A few years ago, proponents of centralization urged support for a
time priority central limit order book (CLOB) to deal with the alleged
``problem'' of market fragmentation. The notion behind the CLOB was
that, by centralizing orders in one place, a single ``black box'',
maximum order interaction and perhaps better prices might be achieved.
While the CLOB was ultimately rejected as unworkable and unwise, the
interaction of SuperSOES and SuperMontage represent the same effort to
centralize. The recent Nasdaq pricing proposal, which would clearly
discourage execution of trades outside of Nasdaq--even if the best
price were being offered outside of Nasdaq--is simply the latest
manifestation of this urge toward centralization. As exchanges
contemplate becoming for-profit companies, this urge to centralize
order flow and execution and cut off the development of competitive
alternatives--to ``CLOB'' the market--will grow more pronounced. This
threat emphasizes the need for a functional, fully competitive
Alternative Display Facility as a means to mitigate the potential
anticompetitive impacts of SuperMontage. It may well be that additional
remedial measures are needed. The continued vigilance of the Congress
and the SEC will be essential as these developments unfold.
Question 13. Have structural changes that have accompanied the
privatization of the NASDAQ been sufficient to ensure a competitive
marketplace?
Response 13. Structural changes necessary to ensure a competitive
marketplace have simply not been effectuated. The most significant
structural change to ensure a competitive marketplace would be the
creation of a commercially viable ADF. Unfortunately, a number of
obstacles have been placed in the way of creating a commercially viable
ADF, some flowing from the structural problems associated with the fact
that NASD--which is charged with organizing and running the ADF--is not
independent of Nasdaq.
NASD and Nasdaq have interlocking boards. NASD retains a
significant ownership interest in Nasdaq and a commercial interest in
Nasdaq's eventual success as a for-profit exchange. For example, NASD
claims they no longer have any common stock in Nasdaq, except the stock
that underlies the warrants issued in the Nasdaq private placement--but
underlying those warrants held by NASD are more than 43 million shares
of Nasdaq common stock, a significant ownership interest in Nasdaq
representing a considerable stake on the part of NASD in the success of
Nasdaq as a stock exchange. In addition, when NASD sold 33.7 million
shares of Nasdaq common stock to Nasdaq earlier this year, it received
approximately $440 million, payable in a combination of cash and the
issuance to NASD of two newly issued series of Nasdaq preferred stock.
While we could go on, the bottom line is that NASD's holdings
represent a substantial and continuing economic interest in the success
of Nasdaq.
The significance of NASD's not being independent of Nasdaq is
driven home in Nasdaq's Amendment 2 to its Form 10 Registration
Statement. Discussing the ADF and its competitive potential, Nasdaq
states:
If this market becomes a viable alternative to Nasdaq, then
Nasdaq faces the risk of reduced market share in transactions
and market information services revenues, which would adversely
affect Nasdaq's business, financial condition, and operating
results.
Nasdaq views the ADF as a potential threat. The entity charged with
organizing and running the ADF--NASD--has a powerful interest in
Nasdaq's success. The structural change of separating NASD's interests
from Nasdaq's interest may be a necessary predicate to the structural
change of ensuring a viable ADF.
Question 14. How does the NASD's Alternative Display Facility (ADF)
differ from the SuperMontage? Has Bloomberg signed up for the ADF? Why
or why not?
Response 14. Bloomberg intends to participate in the ADF at the
earliest opportunity permitted by safe and prudent procedures for
implementing new technology.
There are a number of differences between the SuperMontage and the
ADF. SuperMontage is both a display facility and an execution/clearance
facility. ADF is just a display facility. SuperMontage is building on
Nasdaq's enterprise value, which NASD's members developed over 30
years. The ADF is forced to start from scratch. Those responsible for
organizing and running SuperMontage--Nasdaq--have a clear and
unequivocal financial interest in the success of SuperMontage. Those
responsible for organizing and running the ADF--NASD--not only lack an
unequivocal financial interest in the success of ADF, but also have a
significant financial interest in seeing SuperMontage succeed.
Bloomberg Tradebook believes a commercially viable ADF is critical
to address the anticompetitive aspects of SuperMontage. We believe a
viable ADF will present our clients with new opportunities to lower
their overall transaction costs. That's why we were the first market
participant to commit publicly to the ADF, and it is why we remain
committed to undertake the technical steps necessary to enable
Bloomberg Tradebook to display quotations in the ADF.
Bloomberg has signed up for the ADF, although we have not certified
participation to the SEC. The distinction between signing up and
certifying requires brief discussion.
The SEC made its January 2001 approval of SuperMontage contingent
on the NASD's establishing an Alternative Display Facility as an
alternative to Nasdaq. To say the least, the NASD has not moved
expeditiously to take the basic steps necessary to allow potential ADF
participants to move into the ADF. To take but one example, the NASD
took from January 2001 until August 6, 2002--18 months--to provide
market participants with final technical specifications necessary as an
initial step to connect to the ADF. We believe many of the impediments
to development of the ADF have been a function of the NASD's financial
interest in Nasdaq and the interlocking Nasdaq/NASD boards.
On August 28, 2002, the SEC asked ECNs to certify, under oath, an
intention to use the ADF as our primary order collection and display
facility for a significant portion of our business in Nasdaq securities
on or before October 11, 2002. As a business matter, we certainly did
not feel we could commit to move significant business to a facility
that did not yet exist. As a technical matter--having only received
technical specifications necessary for coding on August 6--we believed
it impossible for us to ensure we could display quotes by October 11,
especially in light of other programming demands generated by the
simultaneous rollout of SuperMontage. Thus, we did not certify
participation on the timetable laid out by the SEC, but we have
communicated to the NASD a commitment to participate in the ADF.
I would add that SEC approval of the proposed rules regarding ADF
display of listed stocks would certainly attract additional market
participants to the ADF.
Question 15. Is the ADF a true alternative to the NASDAQ's
SuperMontage?
Response 15. The ADF is not presently a true alternative to
Nasdaq's SuperMontage, but it is imperative for investors and the
markets that it becomes a true alternative.
Recognizing the potential anticompetitive impact of SuperMontage,
the SEC made its January 2001 approval of SuperMontage contingent on
the establishment of an ADF--a display facility that would stand as an
alternative to Nasdaq. The ADF was deemed so critical to the SEC that
it was cited as a precondition not only to the rollout of SuperMontage,
but also to the possible approval of the Nasdaq exchange application. A
commercially viable ADF is intended to make participation in
SuperMontage ``voluntary''. Without a viable ADF--a facility where
market participants could find potentially superior stock prices and
liquidity in venues other than Nasdaq--the enormous reductions in
investment spreads and transaction costs enjoyed by Americans in recent
years will be imperiled.
ADF is, of course, a display facility while SuperMontage combines
in one place display and execution of orders. Despite that difference,
the ADF can be an alternative. As long as market participants can see
and identify liquidity, market participants can build the connectivity
necessary to execute orders. Indeed, that is exactly what has
transpired in the Nasdaq market over the past six years, as ECNs have
built faster, more reliable connections to each other in the process of
working around slower and less reliable Nasdaq systems.
Question 16. How does the ``full contribution member'' and
``partial contribution member'' dichotomy punish NASD members for doing
business on a facility other than SuperMontage?
Response 16. There are a number of elements of Nasdaq's proposed
SuperMontage fee schedule that are intended to suppress competition.
Nasdaq has proposed extending the pricing scheme it currently uses for
SuperSOES--its current order execution system--to SuperMontage. Under
the SupersSOES pricing scheme, NASD members that report to Nasdaq at
least 95% of their trades in Nasdaq securities for the preceding month
are deemed ``full contribution members''. Those reporting fewer than
95% of their trades in Nasdaq securities for the preceding month to
Nasdaq are deemed ``partial contribution members.''
``Full contribution members'' would pay substantially lower Nasdaq
access fees than ``partial contribution members.'' In short, the access
fee differential would punish NASD members for doing more than de
minimis business on the ADF, or any trading facility other than
Nasdaq's SuperMontage. It is hard to imagine an action more contrary to
consumers' interests than extending such an anticompetitive pricing
structure to SuperMontage.
Question 17. What are the main ADF issues that need to be addressed
on an ongoing basis?
Response 17. There are a number of ADF issues that need to be
addressed on an ongoing basis. The most important of these issues would
include the following: (1) The ramifications of NASD--which is charged
with organizing and running the ADF--not being independent of Nasdaq,
an entity that ardently desires that the ADF fail; (2) the potential
for Nasdaq to misuse the proceeds of its government-sponsored market
data monopoly and/or its government-sponsored trade execution monopoly
to preclude the realization of a competitive ADF; (3) the imposition by
Nasdaq of discriminatory fees intended to discourage use of the ADF;
(4) the necessity that the NASD hire the staff and invest in the
hardware necessary to run the facility, especially as volume increases;
and (5) the importance of the SEC approving the pending rules that
would permit trading in NYSE-listed stocks on the ADF. This will help
bring the benefits of competition and innovation to the NYSE listed
market, while helping to ensure the ADF's commercial viability.
Question 18. Why would an ECN elect to receive orders rather than
executions? How do SuperMontage fees discriminate against ECNs that
elect to receive orders rather than executions?
Response 18. ECNs are required by SEC rules to respond
immediately--and I mean immediately--to orders at any given price in
the time sequence they are received, whether they come from our best
customers or from our competitors. Bloomberg Tradebook, like many ECNs,
has a system that is much faster than Nasdaq's. If Bloomberg Tradebook
elected to receive executions, our combination of speed and immediate
response would result in double executions.
SuperMontage fees discriminate against ECNs that elect to receive
orders rather than executions. In Nasdaq's nomenclature, a
``preferenced order'' is an order sent to a specific market participant
that has a quotation displayed in SuperMontage at the best bid or
offer. A preferenced order is executed through the use of the
SuperMontage execution algorithm. A ``directed order'' is an order sent
to a specific ECN or other market participant that has elected to
receive orders rather than executions.
Nasdaq proposes to impose a penalty of 150% on orders directed to
ECNs or other participants that are permitted to accept order delivery
rather than automatic executions. By charging 150% more for directed
orders than for orders executed using the SuperMontage algorithm, the
fee structure penalizes ECNs and other market participants that wish to
use their own trading algorithms to access liquidity on the
SuperMontage screen via directed orders. These deliberately
discriminatory fees would force orders into SuperMontage's execution
algorithm, thereby restricting market participants from having equal
access to all avenues of execution.
Effectively, the proposed fees impose a penalty on NASD members
that use alternatives to SuperMontage. By increasing the cost of using
facilities other than SuperMontage, the SuperMontage fees compel NASD
members to keep their trading volume on SuperMontage and discourage
them from using the ADF or other alternatives to SuperMontage.
Question 19. Are access fees consistent with ECN obligations under
the order handling rules to provide access to the best prices in the
marketplace?
Response 19. While Bloomberg Tradebook is not prepared to
``unilaterally disarm'' by forswearing collection of access fees while
others charge us such fees, it is clear as a matter of public policy
that access fees should be abolished. They distort order flow and add
to everyone's execution costs, costs that deliver no benefit to the
marketplace. Access fees also create an artificial distinction between
ECN and market-maker liquidity.
Unfortunately, the pricing structure Nasdaq is promoting threatens
to make access fees and payment for order flow an even more dominant
part of the National Market System. This year, in a series of pricing
changes, Nasdaq has not only mandated an access fee for all market-
maker liquidity in SuperSOES, but also positioned itself as the
collector of those access fees.
Nasdaq's embrace of access fees and rebates won't decrease market-
place distortions or increase innovation. Rather, the goal is to
establish the dominance of Nasdaq's execution facilities and enhance
its own revenues. As bad as access fees are when charged by ECNs, the
ability to go to an ECN with lower fees provides a market check on
excessive charges. Unless there is a commercially viable ADF, there is
no comparable check on the access fees charged by Nasdaq.
Nasdaq is a stock market. The role of Nasdaq should be to act as an
impartial clearinghouse that doesn't favor one set of market players,
including itself, over another. Access fees should be abolished for
both ECNs and Nasdaq.
Question 20. Should ECNs be required to apply uniform charges to
subscribers and non-subscribers?
Response 20. As described above, we believe access fees should be
abolished. Access fees distort the market and disadvantage investors by
raising costs and undermining efficiency. That said, the worst kind of
access fee is one in which a non-subscriber (i.e., competitor) is
charged fees that are often many times the amount charged to
subscribers. These charges, of course, bear no relationship to cost or
value--they are simply intended to punish a competitor without the
bother of actually bringing greater value to investors. There shouldn't
be access fees, but if they exist, public policy dictates such fees be
uniform for subscribers and non-subscribers.
I should add that, while ECNs should be required to apply uniform
charges for subscribers and non-subscribers, the same principle should
apply even more strongly for Nasdaq. Nasdaq has proposed a series of
fees that similarly bear no relationship to covering costs or providing
value--rather these fees are intended to thwart competition by
establishing obstacles to trading outside of SuperMontage. Again, by
virtue of the fact that there are multiple competing ECNs, there is
some market check on potentially abusive ECN access fees. Unless there
is a viable ADF, there is no comparable market check on abusive Nasdaq
fee practices.
Question 21. Should an ECN be required to fill an order it has
displayed when the counterparty refuses to pay the access fee?
Response 21. Again, it would be a better world for investors and
the markets if access fees didn't exist. However, as long as access
fees are a legitimate and widely accepted element of the business
models of ECNs, ECNs should certainly have the authority to refuse to
fill an order when counterparty refuses to pay an access fee.
The ramifications within SuperMontage of an ECN's refusing to fill
an order when a counterparty won't pay an access fee illustrates the
kind of discriminatory and anticompetitive practice that merits both
SEC and Congressional attention. In this regard, I wish to call your
attention to the controversy surrounding the issue of quotation
decrementation.
Quotation decrementation has to do with how orders are displayed
and adjusted on SuperMontage to the disadvantage of ECNs and their
customers. Under SuperMontage rules, if an ECN posts a quotation for a
certain price and quantity in a given security, it will be penalized
for declining an order from a counterparty with whom the ECN chooses
not to do business. Such counterparty may be an entity that is an
unacceptable credit risk or one that refuses to pay an ECN's access
fees.
Under the SuperMontage rules, when an ECN declines an order, even
if only for part of the quantity displayed in its quotation, the ECN's
entire quotation will be removed from the SuperMontage quotation
display. As a result, the ECN's customers will lose their place in the
SuperMontage time-price queue. In addition, ECNs will be at increased
risk for incurring costs instead of revenue.
What is telling about the quote decrementation feature of
SuperMontage is that its adverse effects fall exclusively upon ECNs.
That is deliberate on Nasdaq's part, and grossly discriminatory.
Question 22. Mr. Ryan, General Counsel of the American Stock
Exchange, testified that some of the ECNs operate as de facto clubs
and, in effect, an exchange without the regulation or burdens
associated with being an exchange. What should be the regulatory burden
for ECN business as an agency order matching facility?
Response 22. In his testimony, Mr. Ryan takes issue specifically
with one ECN--Island--characterizing it as a ``private club'' because
of Island's refusal to display its quotes in a handful of stocks. I
understand the Amex's frustration at Island's decision. I also
understand Island's frustration at being locked into a market structure
where including Island's quotation data in the consolidated quote would
require that Island participate in the Intermarket Trading System--a
participation that would negate Island's advantages of speed and
certainty of execution. This controversy underscores how critical it is
for policy makers to comprehensively address these market structure
issues.
As to the general question of the proper regulatory burden for
ECN's, I would say the SEC got it right with Regulation ATS. The level
of regulation necessary to ensure the integrity of an agency order
matching facility characterized by maximal transparency is going to be
different than the regulation necessary for an exchange.
I would add that Island's (unsuccessful) and Archipelago's
(successful) bids to become exchanges suggest that rational market
players do not view exchange regulation as excessively burdensome vis-
a-vis ATS regulation, especially when that regulation is viewed in the
context of the substantial benefits of being an exchange--i.e., sharing
directly in market data revenue that bears no relationship to cost,
listing revenue, etc.
______
Response for the Record of William O'Brien, Senior Vice President and
General Counsel, Brut, LLC
Question 1. What are the potential costs and benefits to investors
of a market in which market information is available through
competitive forces rather than an exclusive processor?
Response. Multiple distributors of market data would likely restore
prices to true competitive levels, rather than the artificially high
prices that exist today. An exclusive processor has no incentive to
lower prices to the actual consumers of market data. Competition among
multiple distributors of such data would require pricing reflective of
the cost of collection of such information. This competition could take
place without any deleterious consequences for market data users, given
a regulatory framework that already requires the provision of complete
market information by vendors.
Question 2. What are market data rebates and how do they work?
Response. Market data rebates reflect the inefficiencies of the
current pricing structure for market information. Because prices are
artificially high, it produces substantial revenue for exchanges and
Nasdaq far in excess of the costs of collection and dissemination of
such data. These profits compel Nasdaq and some exchanges to lure the
true generators of market data to use their facilities to report market
information, which is done by ``rebating'' a portion of the revenue
received from the exclusive processor to the participant generating the
data.
Question 3. Are market data rebates good for investors? Why or why
not?
Response. Given the current structure for dissemination of market
information, market data rebates provide some value because they
transfer excessive market information revenues back to the trading and
investing public, albeit indirectly, which heretofore have previously
been kept by Nasdaq and the exchanges, who provide relatively little
value in the process other than commodity-like collection and
transmission facilities. These rebates, however are highly imperfect,
in that they:
a. Favor the generators of market data while still imposing excessive
costs on the users of market data. A broker-dealer with an
extensive retail brokerage operation, but little proprietary
trading activity, will continue to pay non-market costs for
market information without receiving any rebates. High-volume
proprietary or agency trading operations are the prime
beneficiaries of such rebates.
b. It maintains the current system whereby Nasdaq and the exchanges
control the cost of market information. These parties set the
rebate structures and continue to cloud the discussion of
market data pricing inefficiency by linking such revenues to
regulatory and other costs, with Nasdaq pursuing a for-profit
business models that makes such arguments suspect.
c. They create incentives for perverse market behavior, such as
``wash'' transactions and ``shredding'' of large trades into
smaller ones, that furthers no national market system objective
and degrades the quality of market information.
Question 4. Will market data rebates solve market data issues or is
a regulatory solution required?
Response. A regulatory solution is required to impose a system
whereby the rates paid for market information by end users reflect the
true cost of collection and distribution of such information. Given the
essential nature of widely-distributed market data to comply with best
execution obligations and advance various national market system
objectives, the creation of a system of competing market data
processors would produce optimal pricing for the marketplace.
Question 5. Are market data rebates creating problems with wash
trades--are buy and sell quotes being entered simultaneously by the
same party to generate trade revenue from market data rebates? If so,
how do we solve this problem?
Response. Market data rebates do create perverse incentives to: (a)
create ``wash transactions''; and (b) ``shred'' large transactions into
a series of smaller ones, given revenue is received on a per trade
basis. Both practices degrade the quality of the market information
without any benefit. Recent SEC enforcement actions regarding these
practices highlight that regulatory oversight is important given the
current framework. A more long-term solution, however, would flow from
more market-driven structures for the pricing of such data.
Question 6. Is current ECN access to ITS inadequate? Why or why
not?
Response. Current ECN access to ITS is adequate. What is inadequate
is an unequal application and enforcement of ITS rules between manual
and electronic market center participants. Whereby an ECN must
configure their system's operation to ensure 100% compliance with
applicable rules, the NYSE and other manual-intensive market centers
routinely flout ITS requirements by ``trading through'' better prices
posted on ECNs.
Question 7. Are the access rules for ITS responsible for ECNs lower
trading volume in listed securities than in Nasdaq securities? Why or
why not?
Response. ITS rules inhibit the growth of ECN trading of listed
securities for two reasons: (a) greater visibility of order prices that
flow with ITS participation come at the cost of compliance with a rule
set that can dilute the attractiveness of certain ECN business models;
and (b) ECNs that choose to comply with ITS requirements do not get the
advantages of increased exposure of their orders and access to other
liquidity pools because the NYSE and other established markets do not
comply with ITS requirements.
Question 8. Do access rules for ITS presume best execution at the
NBBO? Are there any other factors that should be considered for best
execution?
Response. The ITS access rules imply a policy of strict ``price/
time'' priority--that is, the market posting the best bid or offer
should participate in the next transaction, subject to limited
exceptions. This presumes: (a) that price is the paramount factor in
all best execution analyses; and (b) the best-execution interests of
the provider of liquidity (i.e., the party placing a limit order for
display to the market at large) are paramount to those of the taker of
liquidity (i.e., the party placing a market order for immediate
execution against previously displayed interest). Both assumptions
should be re-considered in light of diverse views on what truly is best
execution.
Question 9. Please describe the governance structure for ITS. Does
the governance structure inhibit improvement? If so, please explain.
Response. The ITS Plan is the document which governs the operation
of ITS. The Plan calls for oversight by an Operating Committee composed
of one representative from each SRO participant (i.e., the exchanges
and Nasdaq, on behalf of the NASD). Votes to make material amendments
to the ITS Plan generally require the unanimous vote of all Plan
participants. This requirement inhibits meaningful reform. Imagine the
amount of legislation that would be passed if Congress had a similar
requirement.
Question 10. What is the difference between the old Nasdaq as an
infrastructure for quotations and the new Nasdaq with the SuperMontage
as an order execution facility?
Response. The primary difference between the ``old'' Nasdaq that
merely collected and distributed broker-dealer quotations and trade
reports, and the ``new'' Nasdaq that, culminating in SuperMontage,
offers execution services bundled with those facilities, is that Nasdaq
now competes directly with the market makers and ECNs it was originally
created to serve. This is exacerbated by Nasdaq's desire to shift from
a non-profit, market-neutral subsidiary of an self-regulatory
organization (the NASD) to a publicly-held, for-profit entity.
Question 11. What potential benefits and risks does SuperMontage
bring to the marketplace?
Response. SuperMontage has the potential to provide benefits to the
marketplace as a new competitor in the field of trade execution
services, offering its own unique value proposition in terms of price,
technology and service. Given Nasdaq's regulatory legacy and historical
monopoly privileges, however, the risk is Nasdaq will thwart
competition through unfair use of its status within current market
structure.
Question 12. Is SuperMontage a Central Limit Order Book (CLOB)?
Response. SuperMontage is a limit order book that Nasdaq hopes will
become a CLOB. Provided that the Alternative Display Facility and other
market centers are allowed and committed to providing non-Nasdaq
alternatives for compliance with SEC quotation-display and trade-
reporting requirements, SuperMontage will likely remain in vibrant
competition with other limit order book operators and never gain CLOB
status.
Question 13. Have structural changes that have accompanied the
privatization of Nasdaq been sufficient to ensure a competitive
marketplace?
Response. There has been positive steps towards preserving market
competition but more must be done. The Alternative Display Facility
must continue to reduce technological and economic barriers to usage,
both now and on a continuing basis in the future, to provide a non-
exchange, market-neutral facility to comply with SEC quotation and
trade reporting obligations. The SEC should also take action regarding
proposals by existing exchanges that wish to modify their rules to
provide further competition to Nasdaq for these services.
Question 14. How does the NASD's Alternative Display Facility (ADF)
differ from the SuperMontage? Has Brut signed up for the ADF? Why or
why not?
Response. The ADF much resembles the ``old'' Nasdaq in that it
merely provides broker-dealers a facility through which to comply with
SEC quotation and trade-reporting obligations, without providing any
supplemental execution services. Brut has not yet signed up to use the
ADF for the reasons described below, along with a desire to offer
subscribers the flexibility to expose their limit orders in
SuperMontage.
Question 15. Is the ADF a true alternative to the Nasdaq's
SuperMontage?
Response. The Alternative Display Facility can become a truly
viable alternative to SuperMontage if the NASD: (a) completes the
creation of compatibility with the Financial Information Exchange
(``FIX'') protocol, which will ease the technological burdens of
connectivity; and (b) makes permanent a fee structure that reflects the
limited purposes of the system and operates the ADF like the low-cost
utility it should be.
Question 16. How does the ``full contribution member'' and
``partial contribution member'' dichotomy punish NASD members for doing
business on a facility other than the SuperMontage?
Response. This pricing dichotomy, which we understand has been
withdrawn as a rule filing, is anti-competitive in that it effectively
ties the use product in a market where there is competition (trade
reporting) to use of a market where there is not (removal of liquidity
from SuperMontage). Firms seeking to pursue savings by reporting trades
to non-Nasdaq venues would be faced with higher costs for trading
against market makers via SuperMontage, which is effectively required
to provide best execution of customer orders.
Question 17. What are the main ADF issues that need to be addressed
on an ongoing basis?
Response. See the answer to question 15 above. The NASD must be
committed on an ongoing basis to ensure that the ADF is technologically
and economically viable. It should operate the ADF on a true ``non-
profit'' model, and not allow ADF-related fees to subsidize other NASD
activities, including but not limited to the provision of regulatory
services to Nasdaq. Potential conflicts of interest between the NASD
and Nasdaq should be completely eliminated to ensure this commitment.
Question 18. Why would an ECN elect to receive orders rather than
executions? How do SuperMontage fees discriminate against ECNs that
elect to receive orders rather than executions?
Response. ECNs elect to receive orders rather than executions
because to do otherwise exposes them to ``double liability'' (i.e., the
execution of one order twice--within its own system and within Nasdaq
simultaneously) that would crate proprietary trading risk inconsistent
with ECN business models. SuperMontage fees currently do not
discriminate against ECNs that elect to receive orders rather than
executions (though early versions of the SuperMontage proposal sought
to do so).
Question 19. Are access fees consistent with ECN obligations under
the order handling rules to provide access to the best prices in the
marketplace?
Response. SEC no-action letters provided to ECN operators under the
``ECN Display Alternative'' component of the Order-Handling Rules
validate the practice of ECN access fees. Such fees are consistent with
execution service fees charged by other market centers, and facilitate
an agency business model where an ECN operator engages in no
proprietary trading activity.
Question 20. Should ECNs be required to apply uniform charges to
subscribers and non-subscribers?
Response. ECNs are currently required, under the terms of their no-
action letters with the SEC as referenced above, to charge non-
subscriber broker-dealers a rate no higher than that paid by a
substantial portion of its active broker-dealer subscribers. When this
requirement is complied with, it is more than sufficient to meet fair
access requirements. In October 2002, over 80% of Brut's broker-dealer
subscribers paid fees at the rate that non-subscribers were charged.
Question 21. Should an ECN be required to fill an order it has
displayed when the counterparty refuses to pay the access fee?
Response. ECNs should not be required to fill orders for
counterparties that refuse to pay access fees. Much of the debate
surrounding ECN access fees can be eliminated if: (a) viable
alternatives to Nasdaq are created and maintained so that ECNs may
comply with SEC quotation-display requirements through a facility that
does not have execution capabilities (such as the ADF); and (b) greater
clarity is given that Nasdaq and other execution system operators can
restrict ECN participation in their systems based on access fee
considerations. If ECNs have viable alternatives for public display of
their quotations (which did not exist until very recently), the concern
that firms are ``forced'' to trade with ECNs becomes an issue for
Nasdaq and other execution venue operators to decide. They will balance
the liquidity provided by ECNs versus the user concerns regarding
access fees and make decisions within a competitive market framework.
Question 22. Mr. Ryan, General Counsel of the American Stock
Exchange, testified that some of the ECNs operate as de facto clubs
and, in effect, an exchange without the regulation or burdens
associated with being an exchange. What should be the regulatory burden
for ECN business as an agency order matching facility?
Response. The argument that ECNs have unfair advantages due to
their classification is without merit, given that each market
participant is free to choose its regulatory classification and the
benefits and compliance burdens associated therewith. Exchange
registration brings with it: (a) the ability to generate revenue from
listing securities on your exchange; (b) direct participation in
national market system plans such as ITS and the CTA/CQS plans (which
govern market data); (c) can reduce clearing costs; and (d) offer
certain brand advantages. Firms that choose to operate as exchanges and
enjoy these advantages must comply with applicable regulatory
requirements, while those that choose to operate as broker-dealers
forego exchange-related privileges for a less restrictive compliance
regimen. Current exchanges, however, should not be hamstrung by their
current classification if they wish to seek alternative business
models; any exchange wishing to de-register and pursue operation as a
broker-dealer operator of an ATS should be allowed to do so by the SEC.
______
American Stock Exchange
November 22, 2002
Mr. Cliff Stearns
Chairman
Subcommittee on Commerce, Trade and Consumer Protection
U.S. House of Representatives
Committee on Energy and Commerce
Washington, D.C. 20515-6115
Re: ECNs and Market Structure
Dear Mr. Stearns: In response to your October 25, 2002 letter, The
American Stock Exchange appreciates this opportunity to provide
additional information to the Subcommittee on the important issues
raised during the October 17, 2002 hearing regarding ECNs and market
structure.
The American Stock Exchange
The American Stock Exchange has a long history of innovation and
diversification, and it proudly carries on this distinguishing
trademark among exchanges today. As one of the most diversified
financial marketplaces in the U.S., the Amex is the only primary
exchange in the United States that actively lists and trades securities
across three diverse business lines--equities, options and exchange
traded funds (``ETFs''). We continue to provide investors--whether they
be retail or institutional investors--with investment opportunities
that best meet their needs.
The Amex market is a technologically advanced centralized auction
and specialist system whose strength comes from the fact that the
specialists have an affirmative obligation to maintain a fair and
orderly market. This means they risk their own capital, maintaining a
continuous two-sided quotation. With a specialist intrinsically linked
to creating the best market for a stock, the best interests of listed
companies and their shareholders are achieved. Other markets--whether
they be regional exchanges, dealer markets or ECNs--provide far less of
a commitment to the investing public.
The combination of our auction market, diversified product line,
state-of-the-art technology and the large pools of liquidity provided
by Wall Street's most experienced and well-capitalized firms, delivers
a superior marketplace for investors in all our products.
Equities
The Amex equity marketplace continues to outperform the market.
Following a strategic restructuring of the equity program which
refocused the business on small and middle market companies, the Amex
composite index outperformed every other domestic exchange and
virtually every other index in both 2000 and 2001, and is on track to
do so again this year.
The Amex, unlike the other primary markets which focus exclusively
on servicing large cap stocks, acts as a conduit in helping small and
mid-sized companies develop and grow.
We feel that now, more than ever, in this economic and political
climate, it is critical to provide support to the capital markets--
especially the small and mid-cap companies who are more often than not
our nation's principal source of innovation, job creation and future
economic growth.
Our advanced centralized auction and specialist system is
especially beneficial to small and mid-cap companies as it maximizes
liquidity at the point of sale. Specialists also serve as a single
point of contact that a company can turn to for critical insight on
their stock's trading activity.
Offering additional diversification and opportunities to
investors--we also began trading NASDAQ stocks this summer. By trading
NASDAQ stocks, the Amex is providing for the first time in these
securities, a meaningful auction market environment with real
opportunities for price improvement. The Amex is providing deep
liquidity for large, institutional size orders, which creates new
investment opportunities for investors.
Options
The Amex is the second largest options exchange in the U.S.,
trading options on broad-based and sector indexes as well as domestic
and foreign stocks.
We trade call and put options on more than 1,800 stocks and 25
broad, sector-specific and international indexes. And we continue to
close in on becoming the number one domestic options marketplace for
equity options.
Even amid tough market conditions, we continue to see growth in our
options business. In looking at third quarter Amex's total options
equity volume for this year, it is up 18% as compared to this same time
last year.
ETFs
In addition to its role as a national equities market and leading
options exchange, the Amex is the pioneer of the Exchange Traded Fund
(``ETF''). ETFs are the fastest growing, most innovative financial
products offered by an exchange over the last decade. After more than
four years of working with the SEC and millions of dollars of R&D
expense, we launched the first ETF in 1993 with the creation of the
Standard & Poor's Depository Receipts (commonly referred to as the
``spider''), which is based on the Standard and Poor's 500 Composite
Stock Price Index.
Over the next several years, we spent millions more developing new
products and educating the marketplace about the benefits of ETFs. Nine
years later, the Amex remains the clear leader in ETF listings, listing
121 of the 123 in the U.S. market today.
Global
We have been able to leverage our reputation in ETFs to create a
global presence for the Amex. In the last year, we have reached
agreements to trade Amex-listed ETFs in Europe and Asia. Our global
expansion includes a joint venture with the Singapore Exchange. In May,
we began trading Amex-listed ETFs in Asia, becoming the very first
fungible product traded across time zones. We've also listed the first
U.S. equivalent of an ETF trading on the Tokyo Stock Exchange. And we
continue to work on agreements with the Tokyo Stock Exchange and
Euronext with respect to the listing and trading of each other's ETFs.
As regulations allow, we anticipate that these centers will also
provide international trading venues for our listed companies seeking
exposure to the global markets. In short, the new American Stock
Exchange has emerged as a strong, innovative international competitor,
especially in the development and trading of sophisticated derivative
securities.
Background of the National Market System
We believe an overview of relevant national market system
developments will serve as a useful context for the issues raised in
your October 25 letter. In 1975 Congress adopted substantial amendments
to the Securities Exchange Act of 1934 (``Act'') designed to enhance
the integrity and efficiency of our national securities markets (the
``1975 Amendments''). Specifically, Congress mandated the
implementation of a national market system. The Securities and Exchange
Commission (``Commission''), in turn, adopted rules under this mandate
to require the industry to develop mechanisms and procedures designed,
among other things, to enhance transparency of market data (e.g.,
timely display of trading interest and trade executions) and foster
interaction of investor trading interest (that is, minimize
fragmentation and intermediation).
Central to meeting these requirements, all the exchanges and the
NASD/Nasdaq adopted three critical national market systems plans for
listed equity securities: the Consolidated Quote (``CQ'') Plan, the
Intermarket Trading System (``ITS'') and the Consolidated Tape
Association (``CTA'') Plan (collectively referred to as ``Plans'').
Collectively, these three plans enhance real time consolidated
transparency of market data (i.e., the CQ Plan for quotes and CTA Plan
for trades) and foster interaction of investor trading interest (i.e.,
ITS). Each of the Plans was submitted to and approved by the
Commission. Their common objective is to provide the investing public
with a consolidated national market system which provides, inter alia,
best bid and offer information that can be viewed and accessed by any
investor, regardless of the market to which the order is routed.
The CQ and CTA Plans provide that the market data generated from
these Plans be sold to market participants on a real-time basis. Under
the current Plans, the revenue generated is then shared among the
exchanges and NASD/Nasdaq ratably based on the number of trades
executed by each market, but without reference to the number or quality
of quotes displayed or whether any quotes are displayed at all.
Since the adoption of these Plans and other similar Plans, the
Commission has on many occasions refined the rules relating to the
national market system (including adopting the Quote Rule and
Regulation ATS), reinforced the importance of the national market
system and underscored the central role these Plans play in meeting the
mandate set forth in the 1975 Act Amendments. The Commission has done
this by approving amendments to these Plans, approving rule changes
submitted by all the exchanges and the NASD/Nasdaq in connection with
the implementation of these Plans, and by adopting Commission rules
governing the operation of the exchanges, the NASD/Nasdaq and broker-
dealers.
In 1998, reacting in part to its well-founded concerns documented
in the Commission's 21(A) Report against the NASD that alternative
trading systems were leading to market fragmentation and harming market
transparency by operating as private ``hidden markets,'' the Commission
adopted Regulation ATS. Specifically, the operation of these
alternative trading systems was--and, unfortunately, still is--leading
to a two-tiered market, an unofficial one only viewable and accessible
by the alternative trading system's members and the official market
being created by the national market system and used by public
investors. The Commission also took this step to address the growing
regulatory disparity between ATS's and other markets, disparities the
Commission found negatively affected other securities markets and, most
importantly, public investors.
In adopting Regulation ATS, the Commission sought to establish a
better balance between the regulatory needs of the Congressionally
mandated national market system and the need to encourage the
development of innovative new markets. The Commission sought to
accomplish its goal by allowing, on the one hand, an ATS that operated
below a threshold of 5% of the average daily trading volume in a
security largely to escape the regulatory constraints placed upon
registered exchanges. On the other hand, in an effort to bring ATSs
into the national market system, Regulation ATS attempted to subject an
ATS that exceeded the 5% threshold to an order display and equivalent
access requirement and an ATS that exceeded a 20% threshold to a fair
access and certain requirements relating to its operational system.
Since its adoption, it has become increasing clear that Regulation
ATS has not resulted in the better balance between regulation and
innovation sought by the Commission. While a single de minimis ATS (an
ATS with less than 5% market share) may not have a significant impact
on the U.S. securities markets, the Commission failed to anticipate
that the trading of multiple ATSs operating under the de minimis
exemption can, in the aggregate, have a very negative overall impact on
the national market system's guiding principals of transparency, best
execution, equal regulation and fair competition. Amex advocates the
repeal of Regulation ATS in its current form, and we have communicated
this view to the Commission.
The ability of an ATS to frustrate the Regulation ATS requirements
designed to integrate ATSs into the national market system has recently
been vividly demonstrated by The Island ECN's choice to ``go dark''
(with no information at all disseminated about priced orders entered in
Island), a tactic it adopted notwithstanding the Commission's grant of
an unprecedented exemption to a core national market system principle--
the ITS trade-through rule--designed specifically to accommodate
Island. Thus, a market, like Island, that matches customer orders with
other customer orders, does not display its customers' orders and
reports its trades through the CT Plan avoids the most substantive
provisions of Regulation ATS, including: (1) the order display and
equivalent access requirement, (2) the limitation on fees that are
inconsistent with the equivalent access requirement, (3) the fair
access requirement, and (4) the requirements with respect to the
capacity, integrity, and security of the ATS's automated systems.
By going dark, Island achieved precisely the result that the
Commission sought to avoid with the adoption of Regulation ATS, namely
the presence of a two-tired market--an unofficial one only viewable and
accessible by the alternative trading system's members and the official
market existing within the national market system that is available to
all investors. Island's actions have lead to the truly perverse result
seen today of an alternative trading system (Island) and a facility of
a national securities association (Nasdaq) sharing in revenue generated
by two national market system plans (the CQ and CTA Plans) while the
ATS is invisible and inaccessible to the intended beneficiaries of the
national market system--the investing public. Nasdaq receives the
revenue and then pays a portion of it over to Island as payment for
order flow. It should go without saying that allowing significant ATSs
to opt out of the national market system because the Commission is
reluctant to allow Regulation ATS to be enforced or because of the
exception that allows markets, like Island, to go dark, undermines the
core national market principles of transparency, best execution, equal
regulation and fair competition.
The Commission's permissive attitude toward Island provides
incentives to these enterprises to proliferate outside the national
market system constructs that the Amex and other market participants
are required to abide by. Amex acknowledges the benefits of
competition, and is eager to see the Commission facilitate market
innovation. But by continuing to allow Island to reap artificial
financial benefits (by the receipt of payment for order flow), to be
unreachable and, in the actively-traded ETFs, invisible, the Commission
is not allowing Amex to compete to attract those orders and to provide
investors with superior executions.
Question 1. What are the potential costs and benefits to investors
of a market in which market information is available through
competitive forces rather than an exclusive processor?
Response. As Amex stated during its participation in the SEC
Advisory Committee on Market Information (known as the Seligman
Committee) in 2000 and 2001, there are certain types of facilities that
should be exclusive because they call for centralized operations that
can best be performed by a single entity. Securities clearing
operations are a good example of this type of exclusive utility.
Although there were five different equity clearing systems at the time
the 1975 Securities Acts Amendments were adopted, today there is only
one. The additional costs associated with operating multiple clearing
organizations outweighed any benefits of competition. We believe a
central processor operates in a similar manner.
Under the existing market structure, there are two kinds of
exclusive securities information processors: entities like SIAC and
Nasdaq that actually process trade data, and entities like the CTA and
Options Price Reporting Authority (``OPRA'') that administer, collect
and distribute market data fees. Leaving Nasdaq aside for the moment
because it serves several simultaneous roles as securities information
vendor, marketplace and central processor, the other central processor,
SIAC, performs its service at cost. We find it hard to believe that a
for-profit entity could perform the services SIAC currently performs,
with the same level of service, for less money.
Amex sees no advantage in having multiple, competing consolidators
of market data. The consolidation function should be performed by an
exclusive consolidator under each of the plans. We are concerned that
increasing the number of consolidators would simply introduce
complexity and inefficiencies, such as the need for multiple disaster
recovery sites and plans, without producing any real, offsetting
benefits. Moreover, we believe that the competing consolidator model
would create the possibility of differing data streams and thus is
fundamentally at odds with the national market system. Data streams may
vary for many reasons, including differing standards for rejecting
apparently inaccurate data, differing transmission times among markets
or differing timestamps for incoming market data among consolidators.
If data streams are different, both last sale and quotation information
could differ among vendors.
Amex believes that SIAC has done an exemplary job as the exclusive
information processor under the CTA and CQ Plans. The efficiency of its
operations is demonstrated by its long record of providing reliable,
real-time market data to the industry without significant disruptions.
This record is all the more impressive if one takes into account the
exponential growth in recent years in the amount of data that SIAC has
had to collect, consolidate and make available for re-dissemination.
That said, Amex is willing to explore opening the exclusive processing
function to competitive bidding, if other markets believe that is
appropriate.
Questions 2 through 5. Market Data Rebates
As background for the issues raised in Questions 2 through 5
relating to market data rebates and associated regulatory problems, we
believe it is helpful to describe how market data is calculated and
distributed for listed securities.
The national market system in listed securities is funded by
revenues generated from the sale of quotations and last sale
transaction data to vendors and subscribers at prices that are fixed by
the Participants under the direct supervision of the Commission. As
detailed in the Commission's recent study of the economics of market
data by the Seligman Committee, market data revenues are an essential
mechanism for financing the operation of various markets and their
surveillance and compliance programs.
Pursuant to the CTA Plan, the calculation of revenue for each
Participant is based upon the number of last sale transactions reported
by that Participant. More specifically, the ``Gross Income'' of each CT
Network <SUP>1</SUP>, from which each Participant receives its ``Annual
Share,'' is based on fees received from subscribers, vendors and others
for the ``privilege of receiving and using the network's last sale
price information.'' The ``Annual Share'' is calculated by a fraction
using a numerator based upon the total number of last sale price
transactions reported by the Participant and a denominator based upon
the total number of last sale price transactions reported by all
Participants in the network. Under the CQ Plan, the ``Annual Share'' is
calculated the same way as in the CTA Plan, i.e., according to the
number of last sale transaction reported in the network's securities ,
and not according to the number of quotes disseminated in those
securities. This formula was established when the CTA was formed, at a
time when there was no real time dissemination of quotation
information. In 1978 when the CQ Plan was formed there seemed to be no
point in changing this allocation formula since market data charges for
trades and quotes were bundled and every market that reported trades in
a security was also required to disseminate quotations. Thus, not using
quotes to calculate quotation revenues--and using transactions
instead--was at the time believed to be relatively inconsequential.
However, with significant changes in the markets, including some market
participants operating outside of the national market system, the
allocation formula rewards market participants for violating the law
and undermining the national market system.
---------------------------------------------------------------------------
\1\ There are two networks in the CTA and CQ Plans: Network A
provides quotes and last sale price information in securities traded on
the New York Stock Exchange and Network B provides quotes and last sale
price information in securities traded on the American Stock Exchange.
---------------------------------------------------------------------------
This dysfunctionality is exacerbated by the practice of NASD/Nasdaq
of rebating a portion of market data revenue to their members to use as
``payment for order flow.'' Island is a beneficiary of this rebate
program. Even though Island never reports its quotations to NASD/Nasdaq
and never links with ITS, NASD/Nasdaq receives a share of both
quotation and transaction market data revenues based on the number of
trades Island generates. NASD/ Nasdaq, in turn, passes a substantial
portion of its CTA and CQ Plan revenues attributable to Island's trades
on to Island as part of its ``Payment for order flow'' program.
Thus, despite the fact that Island does not disseminate its
quotations to any of the Participants or allow other markets to access
its quotations, it nevertheless gets ``paid'' a share of both CTA Plan
and CQ Plan revenues. Island then pays over a percentage of the money
to brokers or other of its customers as ``payment'' for executing their
trades on Island as opposed to some other marketplace (like AMEX). The
Island payment scheme rebates to users of its system a fixed fee for
every trade in listed stocks regardless of size. Indeed, Island
actively markets on its web site the fact that its customers receive
rebates of CTA/CQ tape revenues on a ``trade-by-trade'' basis, thus
encouraging users to break larger trades into small ones, thereby
maximizing their rebate (and in the process moving more trades--and
thus more CTA Plan and CQ Plan revenues--to Island).
Revenues under the CQ and CTA Plans are allocated among market
centers on the basis of the respective number of trades they each
report, without regard to share volume or the quality of those markets.
This approach disadvantages the market centers that provide greater
liquidity by treating a single trade for 100 shares of stock the same
as a single trade for 100,000 shares of the same stock in a different
market. By the same token, the quality of quotation information is
completely ignored in the allocation formula.
Though the current methodology has the virtue of being procedurally
simple, its simplicity comes at the great expense of substance. Indeed,
its reliance solely on counting the number of trades (a practice dating
back to the mid-1970s) causes it to be overly simplistic and,
unfortunately, subject to gaming and manipulation solely for the
purposes of collecting market data revenue, not improving the quality
of the market. The time has come to recognize that the current
methodology has utterly failed to achieve what should be the major
goals of the Commission and the CQ/CTA participants--to encourage the
provision of maximum liquidity to, and the tightest possible spreads
in, national market system securities. To that end, Amex has proposed a
more logical method of allocating market data revenue, rewarding
superior pricing and displayed size.
Question 2. What are market data rebates and how do they work?
Response. Several markets, including the Nasdaq Stock Market, the
Cincinnati Stock Exchange and the Chicago Stock Exchange, rebate a
portion of their market data revenue under the CQ/CTA Plans to their
members as a reward for executing trades on those markets. These
payment for order flow schemes are generally filed with SEC without the
benefit of publication in the Federal Register for notice and comment
before they become effective. They may involve payment or credit for
each print in an Amex or NYSE security, for example, or a more
elaborate system of credits based on trade volume executed over a
specified time period. Amex has had a longstanding opposition to such
schemes, which we have communicated to the Commission on numerous
occasions--and, indeed, the Commission recognized the abuses that can
result from those payments when it abrogated certain payment for order
flow programs on July 2, 2002, stating that these programs ``raise
serious questions as to whether they are consistent with the Act and
with the protection of investors. These questions include, among other
things, the effect of market data rebates on the accuracy of market
data [i.e., the potential distortion of trade reporting through wash
sales and trade shredding] and on the regulatory functions of self-
regulatory organizations.'' <SUP>2</SUP>. The Commission stated further
that ``[i]f the self-regulatory organizations choose to re-file the
proposed rule changes, they must do so pursuant to sections 19(b)(1)
and 19(b)(2) of the Act.'' [Emphasis supplied].
---------------------------------------------------------------------------
\2\ Securities Exchange Act Release No.46159 (July 2, 2002) 67 FR
45775 (July 10, 2002).
---------------------------------------------------------------------------
Ironically, despite the Commission's clear directive in its
abrogation Order, on July 8, Nasdaq filed a proposal to reinstate its
payment for order flow program. The Nasdaq's reinstated proposal did
not address any of the serious questions raised by the Commission in
the abrogation Order nor did it try to justify why the proposal is
consistent with the Act and with the protection of investors. On July
19, 2002, the Commission allowed Nasdaq to reinstate the program
retroactively to July 1. To date, none of the important questions
raised by the Commission have been answered.
Question 3. Are market data rebates good for investors? Why or why
not?
Response. Market data rebates--that is, payment for order flow--are
undermining national market system facilities by providing financial
support and incentives to market participants that may decide to trade
in a particular market based solely, or principally, on rebates, rather
than whether investor orders receive best execution; by encouraging
violations by ECNs of Regulation ATS under the 1934 Act; and by
providing direct and significant financial support for market
participants to engage in fraudulent and misleading trade reporting. We
can identify no benefit--and a clear potential for harm--to public
investors from such practices. The reason that some market centers can
provide such inflated market data rebates is that they are not burdened
with the regulatory or listing requirements of the primary markets.
These market centers are able to offer low cost alternatives to the
primary market (including negative costs such as market data rebates)
while free-riding on the price discovery process occurring in the
primary market. This is even more egregious if members of these markets
do not participate in CQ/CTA or ITS, ironically reducing the integrity
of the price discovery value of the market data for which they are
being paid.
Question 4. Will market data rebates solve market data issues or is
a regulatory solution required?
Response. Rebates have promoted investor harm as a result of market
data revenue distributed under the CQ/CTA Plans, which was not
contemplated when the markets agreed to the current revenue
distribution methodology under those Plans. Amex views the current
methodology for distributing revenue to CQ/CTA Participants as
irremediably flawed--and a major contributing factor to incenting to
markets to pay their members for order flow, with attendant regulatory
problems, noted in Question 5, below. We believe a regulatory response
is needed. (See response to Questions 5.)
Question 5. Are market data rebates creating problems with wash
trades--are buy and sell quotes being entered simultaneously by the
same party to generate trade revenue from market data rebates? If so,
how do we solve this problem?
Response. Trading to create artificial reports based on per trade
market data rebates has become a serious problem. Nasdaq, for example,
pays Island on a per trade basis and Island rebates to users of its
system a fixed fee for every trade in listed stocks regardless of size.
Indeed, Island actively markets on its web site the fact that its
customers receive rebates of CTA/CQ tape revenues on a ``trade-by-
trade'' basis, thus encouraging users to break larger trades into small
ones, thereby maximizing their rebate. As a result, for example, an
Island customer wishing to execute an order for 1,000 shares of QQQ is,
in fact, directly paid to break that order up into 10 trades of 100
shares. Island's users were obviously breaking their orders into 100
share lots, encouraged by the trade-by-trade rebate. This creates the
false and misleading impression that 10 separate orders were executed
each at 100 shares. Regulators have taken notice. The NASD recently
reached a settlement with Swift Trade Securities USA, Inc. and its
president, Peter Beck, for engaging in a deceptive trading scheme
involving fictitious wash trades in the QQQ ETF in an effort to obtain
market data revenue generated from such transactions. (See Exhibit B)
In addition, the SEC has taken action to abrogate several markets'
payment for order flow programs, based at least in part on potential
wash sales problems resulting from those programs. The Exchange views
such activity as seriously undermining the integrity of consolidated
tape reporting and is contrary to the intent and purpose of the CQ/CTA
Plans to distribute revenue based on full participation in all national
market facilities by CQ/CTA Participant members.
In order to encourage marketplaces to improve their displayed
pricing and order size--and to contribute to market depth and
liquidity--Amex has proposed to CTA Participants that CQ/CTA market
data revenues be distributed as follows: (1) 25% based on the number of
trades; (2) 25% based on share volume traded; (3) 25% based on bids
that are at the national best bid (NBB); and (4) 25% based on offers
that are the national best offer (NBO). The distributions based on the
NBB and NBO would be weighted by volume (the number of shares in the
bid or offer), time (the number of seconds the NBB or NBO exists) and
the percentage that each stock's traded share volume amounts to of all
Network A or Network B securities' traded share volume.
Question 6. Is current ECN access to ITS adequate? Why or why not?
Response. ITS is accessible to all market participants pursuant to
the provisions of the ITS Plan. The ITS Plan currently provides for
delivery of ITS commitments which expire in 30 seconds, 1 minute, or 2
minutes, at the discretion of the sending market. While a time frame of
30 seconds <SUP>3</SUP> may not fit into the model of an ECN, the ITS
trade through protections are designed to protect the customers of both
the participant accessing liquidity and the participant providing
liquidity by quoting at the NBBO. Nasdaq and the Cincinnati Stock
Exchange, currently provide access by their members to all other
markets through ITS. All ECNs can take advantage of the ITS link
provided by Nasdaq, as Archipelago has before becoming an Exchange. No
ECN that is required to provide equal access should be treated any
differently with respect to ITS provisions than the members of Nasdaq
and the Cincinnati Stock Exchange.
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\3\ The time frame of 30 seconds is the maximum time that a market
center can take to execute an ITS commitment before the commitment
automatically expires. Nasdaq and the Cincinnati stock exchange provide
immediate automated response to ITS commitments, and manual market
centers often provide responses in a time frame well under 30 seconds.
In October 2002, over 75% of all ITS commitments received a response in
less than 15 seconds.
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The ITS Operating Committee recognizes that in a decimal
environment, the protection afforded by the ITS Plan to a limit order
on an away market priced only 1 cent better than orders on the home
market may not always be justifiable if the limit order is not easily
accessible, and if the risk of the prices moving in the home market are
high. The ITS Operating Committee is currently in discussions regarding
changes to the ITS plan that may be required. The Operating Committee
is considering issues raised by all parties, including both manual
markets and markets that provide automated executions such as Nasdaq
and the Cincinnati Stock Exchange.
Question 7. Are the access rules for ITS responsible for ECN's
lower trading volume in listed securities than in NASDAQ securities?
Why or why not?
Response. ECNs have access to other markets through their automated
order delivery systems outside of ITS. Indeed, the number of orders and
share volume sent to Amex's Amex Order File or NYSE's DOT system, for
example, from other market participants, including dealers, far exceeds
the number of ITS commitments, with associated volume sent through ITS.
Even if ITS were inaccessible, this would not be a reason for ECNs'
lower trading volume in listed securities. Indeed, in Amex-listed ETFs
such as QQQS, SPY and DIA, Island's volume was astronomically high at
the same time that it had determined to operate entirely outside ITS in
these securities. However, ITS is accessible to all market participants
as stated earlier. Island, in its single tepid initiative to inquire to
ITS Participants about ITS access several years ago, proposed to have
only one-way access--Island to other markets. Island has never
seriously explored meaningful ITS access with other participant
markets. Their purported lack of access has certainly not had any
negative impact on their trading volume in listed ETFs. The fact that
Island operates entirely outside ITS in all listed securities, but has
only gained significant volume in ETFs clearly shows that their lack of
success in non-ETF listed securities has nothing whatsoever to do with
ITS rules. The phenomenal success ECNs have seen in Nasdaq securities
and in ETFs is due largely to the intra-day volatility of these
securities that attracts day traders, the largest constituency of most
ECNs. Additionally, ETFs are derivatively priced, so primary market
protection is not as important as an execution near the NAV, which is
not set by supply and demand on the primary listing market.
Question 8. Do access rules for ITS presume best execution at the
NBBO? Are there any other factors that should be considered for best
execution?
Response. The NBBO is the starting point for executions through
ITS. All ITS participants should attempt to access a superior priced
away market (i.e., a market at the NBBO), and should avoid executing an
order at a price inferior to the NBBO (a ``trade-through''). Proponents
of alternative trading systems and Nasdaq recently have been advocating
``speed of execution'' as the primary consideration in best execution.
The Commission however, has clearly stated, ``price is the predominant
element of the duty of best execution.'' The Commission's view of a
national market system consisting of ``equally regulated, individual
markets, which are linked together to make their best prices publicly
known and accessible,'' presupposes that price is the most important
factor in best execution and that speed of execution, like many other
considerations, is a secondary factor.
The SEC also has identified the other factors to be considered by a
broker-dealer in satisfying its best execution obligations, including
the size of the order, the trading characteristics of the security
involved, the availability of accurate information, technological aids
to process such data, access to the various market centers, and the
cost and difficulty associated with achieving an execution in a
particular market center.
Questionn 9. Please describe the governance structure of ITS. Does
the governance structure of ITS inhibit improvement? If so, please
explain?
Response. The ITS Plan is a national market system. All provisions
of or amendments to the Plan are approved by the SEC. The ITS Operating
Committee, which includes representatives of all U.S. exchanges and
Nasdaq, administers Plan provisions but is not a policy making or rule
making body. Amendments to the Plan must be effected by a written
amendment to the Plan, executed on behalf of each Participant
(unanimous vote required). Plan amendments are filed with the SEC for
approval, generally with notice and the opportunity for public comment
prior to approval. Any Participant can enforce its views regarding any
action or inaction of the ITS Operating Committee to the SEC or any
other forum it deems appropriate.
The SEC attends meetings of the ITS Operating Committee and Users
Subcommittee. The ITS Operating Committee considers all proposals of
all participants; participants affected by an action of the Operating
Committee, for example, as a result of failure to approve a Plan
amendment proposed by a Participant, are able to petition the SEC to
take appropriate action, or the Commission itself can take action it
deems necessary to implement or amend provisions of the Plan. The
Operating Committee is currently addressing important issues regarding
ITS trade throughs and other issues as requested by the Commission.
Amex believes that ITS governance promotes consensus by all markets and
promotes progress consistent with integrity of the market structures of
all participants.
Question 10. What is your per trade revenue for market data? How
does that compare to the NYSE's per trade revenue?
Response. The per trade revenue from market data for securities
listed on the Amex is $2.39 and for securities traded on the NYSE the
per trade revenue is $0.27. The difference in revenue per trade is a
reflection of the fact that there are fewer trades executed in Amex
securities than in NYSE securities. Market data can not be sold on a
per trade basis, the appropriate measure is the revenue per terminal
since that is the way revenue is collected under the Plans and is
reflective of the infrastructure costs of providing market data. As
discussed below, the revenue collected per terminal is comparable to
both the NYSE and Nasdaq, however the number of trades occurring on the
NYSE and through Nasdaq is greater resulting in lower per trade
revenue.
Market data revenue for Amex (CTA Network B), NYSE (CTA Network B)
and Nasdaq data are reasonably comparable, on a per terminal basis.
Despite a tenfold increase in consolidated share and trade volume in
Amex-listed securities since 1992 (the last time rates were raised for
Networks A and B), market data rates have not increased. In 1992, the
consolidated daily average Network B volume was 19.3 million shares and
15,248 trades. In 2002 (year to date), that figure has climbed to 186.6
million shares and 155,989 trades. Network B rates are $27.25 monthly
per terminal (members) and $30.20 (non-members).
Network A utilizes a sliding scale, ranging from $127.25 monthly
for the first terminal to $18.75 per month per terminal for 10,000 or
more terminals (members and non-members). The price for Nasdaq data,
which was most recently changed in 1997, is $20 per terminal.
Question 11. You testified about alleged abuses by Island regarding
their trades of ETFs being sold to the Cincinnati Stock Exchange and
Island's refusal to report trades. Could you elaborate why this is a
violation of the securities laws, how it affects market competition and
why the SEC has not taken action?
Response. For more than 18 months the Island ECN has operated in
open and notorious violation of the federal securities laws. Without
any justification, Island has flagrantly violated Regulation ATS as
well as engaging in and fostering other abusive and fraudulent trading
practices. Throughout this period, the American Stock Exchange as well
as many other market participants and regulators have brought these
activities to the attention of the Commission and pleaded with the
Commission to take the appropriate action to bring it to an end.
Regulation ATS--On December 8, 1999, the Commission adopted
Regulation ATS, which is designed to integrate significant alternative
trading system activity into the national market system. Regulation ATS
was adopted after two extensive public comment periods and much
consideration by the Commission and the industry. The expressed purpose
of integrating ATSs into the national market system was to address the
Commission's well-founded concerns that these systems were leading to
market fragmentation and harming market transparency by operating as
private, `` `hidden markets,' in which a market participant privately
publishes quotations at prices superior to the quotation information it
disseminates publicly.'' Because of the lack of enforcement of
Regulation ATS, these concerns continue to be a reality.
Specifically, Regulation ATS requires an ATS to consolidate their
quotes with all other markets and to provide access to these quotes
when the ATS achieves five percent market share for four out of six
months. Island triggered these requirements in QQQ in May 2001, in DIA
in August 2001 and SPY in February 2002.
Island has recently announced that it will begin reporting (that
is, selling) trades in ETFs to the Cincinnati Stock Exchange (``CSE'')
in a manner that will neither display their quotes nor make them
accessible to public investors. Under the current CSE payment for order
flow arrangement, CSE will pay a 50% market data rebate of revenue that
it receives under the CTA Plan. Island therefore will be able to pay
its users even more than under NASDAQ's payment for order flow program
(under which Island is paid a 40% rebate), with the aim of further
increasing Island market share and siphoning even greater volume away
from national market facilities. CSE's arrangement with Island has not
been separately filed with the SEC, and undermines the core purposes of
Regulation ATS. Island will not be displaying its best orders through
CSE and none of Island's quotes will be accessible to other markets
through ITS. As we understand the situation, Island has set up a scheme
to report trades through CSE as follows: When an order entered in
Island ECN is priced at or between the NBBO, Island ECN transfers the
order to Island Execution Services for matching and printing on CSE.
Because CSE's displayed quote typically is well outside the NBBO and
because few, if any, limit orders are resident on CSE's ``book'', there
is virtually no chance that the Island orders to be matched will be
broken up by other trading interest. Island orders not priced at the
NBBO would continue to be executed in Island, outside the NBBO, but
still rewarded by Nasdaq payment as a third market print.
Question 12. Please explain how, in your view, Island is exploiting
the National Market System (NMS) by collecting fees from it while not
participating in it?
Response. Market data revenue should only be distributed to SROs
and their members that fully participate in the national market system.
This involves all of the burdens necessary to comply with last sale
reporting, quotation reporting, making oneself accessible to other
markets through ITS and complying with the trade through rules. Markets
and their members that choose not to undertake these obligations should
not share in the revenues derived from them.
Island does not disseminate quotations for inclusion in the
consolidated quote and is not accessible by other markets through
national market facilities. Island also receives direct payments from
certain CQ/CTA participant markets for trades in listed securities, a
portion of which Island has in the past paid to its customers for
executing orders in Island. This is an abuse of the revenue sharing
provisions of the CQ/CTA Plans, undermines market transparency and best
execution of investors' orders, and encourages abusive and potentially
fraudulent practices such as wash sales and tape shredding.
Question 13. Your testimony states that some of the ECNs operate as
de facto clubs and, in effect, an exchange without the regulation or
burdens associated with being an exchange. What should be the
regulatory burden for their business as an agency an order matching
facility?
Response. ECN order matching facilities, while, in our view, fully
within the definition of ``exchange'' in the 1934 Act and Rule 3b-16
thereunder, shoulder none of the regulatory burdens of other exchanges.
Exchanges are subject to a raft of regulatory requirements. Exchanges
are obligated to enforce compliance by their members with their rules
and the federal securities laws. Amex and other exchanges have spent
heavily on technology and incur significant data storage costs in
connection with the fulfillment of their obligation to surveil trading
in their markets. Not only are these systems very expensive to create,
maintain and revise as is frequently needed, but given their necessary
limitations, they also require the exchanges to employ large staffs to
review the various reports created by them.
In addition to the exchanges' wide-ranging regulatory
responsibilities, they also are subject to a number of additional
burdensome and costly requirements that are inapplicable to ATSs. Among
these additional requirements are obligations to file and obtain
Commission approval of rule and system changes, file to adopt, change
and even eliminate fees (which must be fair), provide for fair
representation of members in the management of exchange affairs, have
outside directors on the governing board, dual siting and system
redundancy requirements and fair membership access rules. The numerous
requirements applicable to exchanges stifle innovation and impede their
ability to compete with the less regulated ECN's.
We believe ECN's should be subject to comparable regulatory
burdens. If this does not occur, the logical alternative is for other
exchanges to be relieved of many of the current regulatory burdens that
impact their competitiveness.
Sincerely,
Michael J. Ryan, Jr.
General Counsel
cc: Mr. David Cavicke
Mr. William Carty