Chairman Gramm and Members of the Committee, I am Philip J. Purcell, Chairman and Chief Executive Officer of Morgan Stanley Dean Witter. I want to thank you for giving me the opportunity to discuss with you some very important issues relating to the future structure of our equity markets.
For over two centuries the United States has boasted the largest, most liquid and well regulated securities markets in the world. The record trading volumes the U.S. markets have been experiencing reflect the quality and variety of financial services in this country and the ever-evolving technology used to deliver these services. Perhaps more importantly, the structure of our markets and the regulatory framework surrounding them have traditionally been guided by the objectives of market integrity and investor protection. Indeed, the increasing rate of individual investor participation in the equity markets, whether directly or through mutual and pension funds, indicates the confidence investors have in the integrity of our markets, a confidence nurtured over many decades.
The recent growth in our markets has been enhanced by the so-called "new economy." At the heart of the new economy have been the U.S. capital markets, particularly with respect to their pivotal role in providing capital for newly public companies, both domestic and foreign. The new economy has similarly had an impact on our market structure - intense competition among traditional and Internet brokers, triggered by advances in technology and facilitated by regulatory freedom, has transformed a market structure conceived over 200 years ago. In many respects, what is happening to companies in the new economy is also happening to the markets. For example, the development of new, cutting edge technologies and efficient use of communications networks have reduced the turnaround time for securities transactions to seconds (or less) and enabled market participants to reduce operating and transaction costs dramatically. Moreover, technology has empowered individual investors as never before through the accessibility of information and direct access to the markets. The inability of our major markets to respond to the diverse needs of all end-users has encouraged the formation of technologically innovative alternative trading venues.
These developments, however, have not been all positive. These alternative trading venues, while clearly responsive to the needs of end-users, are diverting significant liquidity away from the primary exchanges and Nasdaq, and consequently the "stock market" is becoming increasingly fragmented. Instead of buyers and sellers coming together and interacting in a single pool of liquidity, their orders are dispersed among multiple, effectively unlinked, market centers with little or no opportunity to interact. This increased market fragmentation impedes the price discovery process and diminishes transparency, liquidity, and, ultimately, best execution of customers' orders.
This is particularly troublesome given the increased globalization of financial markets. International exchanges, which have evolved into automated and efficient markets, are providing increasingly attractive investment and trading alternatives to the U.S. markets. Accordingly, U.S. markets are already losing business to foreign markets and will lose even more business in the future unless the U.S. markets become more competitive in terms of cost and efficiency. Although at present the stocks of the top 100 global companies are predominantly traded in the United States, we cannot ignore the fact that they could be traded nearly anywhere. This competition from overseas markets is real and growing and must be given serious consideration in assessing policies with respect to the future of U.S. markets.
In light of all these developments, the time has come for us to reevaluate critically our major markets, the overall market structure and the regulatory structure to ensure that the U.S. maintains its global preeminence by offering investors the fairest and most technologically advanced, competitive and efficient markets - markets that are adaptable to changes spurred by the new economy. The question is - is it practical to expect that our major markets and the market structure will naturally evolve to achieve this goal? Or, on the other hand, will the markets need a "helping hand" to reach that point?
Traditionally we have been accustomed to stocks effectively trading within a single, deep pool of liquidity, in other words, the New York Stock Exchange and Nasdaq, subject to investor-protection rules and protocols. There are changes that our major markets can make to enable them to retain this deep liquidity pool. Their constituencies and boards have to decide how to proceed. More likely, though, we are evolving to a network, if you will, of multiple market centers. The new economy people would argue that the "network is the market." In this case, the market structure issue is, by what rules should this network operate?
The network requires standards and protocols by which it should operate, relating, for example, to the treatment and accessibility of orders, the conduct of network participants and the integrity of the network technology. In essence, the idea is to build a framework of general rules and principles around this network, though not to the exclusion of reasonable and practical exceptions, to ensure that the fundamental goals of investor protection and market integrity are optimally served.
Given the move away from the central liquidity pool model, I believe the network should operate according to three guiding principles: One, the dispersed market centers comprising this network must be electronically linked. Two, investors' limit orders must be executed on a "first come, first served" basis. And three, the network should foster competition among orders, as distinguished from competition among order-handlers. Let me explain each of these in a little more detail.
Establishment of network linkages should entail leveraging the most advanced technology available to ensure that customer limit orders represented on the various market centers comprising the network are collected, prioritized and displayed, and that such orders are readily accessible by market participants. Such linkages will enhance the price discovery process and the best execution of investors' orders by maximizing the opportunities for limit orders to come together and interact.
In addition, a price/time priority rule is needed so that customer limit orders displayed in this network will be executed on a first come, first served basis. In other words, the first to declare at a particular price should be rewarded by being the first to trade at that price. A price/time priority rule will also mitigate the effects of certain externalities, such as internalization and payment for order flow, by insisting on actual price improvement in order to bypass resting limit orders.
A combination of electronic linkages and a price/time priority rule would effectively ensure that orders are exposed to each other, thereby creating the competition that will ensure investors receive the best price. In aggregate, these changes will serve to protect the interests of investors, thereby improving the overall integrity of the market, breeding investor confidence and consequently, perpetuating the willingness of investors here and abroad to continue to supply liquidity to the U.S. market system.
Our current major markets also have to adapt to this new environment and new network. We know they are actively working on this. For example, the New York Stock Exchange is considering ways in which automation can be used to enhance the efficiency with which orders for the most liquid stocks are executed. With regulatory barriers to competition falling away, the NYSE and other floor-based exchanges can learn from the experiences of exchanges in Europe and elsewhere that have already converted from the costly and manually-intensive trading floor infrastructure to an automated environment, and in many cases, quickly surpassed their floor-based rivals.
I want to emphasize that I am not advocating a philosophy of central planning to create a centralized market. There are very real benefits to competition among the various markets and intermediaries in terms of the diverse services they provide. At the end of the day, the markets need to be flexible and multi-faceted in order to accommodate all the various end-user needs. I am advocating, however, these network linkages as a way to alleviate fragmentation borne of competition and automate where needed to modernize our trading and execution systems.
We recognize the dilemma faced by policymakers. Can we expect these structural changes to arrive through natural market forces? Or, stated differently, can we expect to retain our global primacy by allowing our market structure to evolve naturally without a helpful nudge from the government?
Ideally, the major markets would assume the leadership role by making dramatic changes to their business models with a view toward creating effective linkages and more efficient marketplaces by leveraging technology. However, these changes I am advocating, while in the best interests of investors and the country as a whole, may not necessarily align with the interests of individual markets or order-handlers. This lack of consensus on what constitutes the optimal market structure will impede the natural evolution of the markets in the direction I have described - it is clear, therefore, that some level of government encouragement will be needed. It will be incumbent on policymakers to maintain a steady focus on what is in the best interests of public investors. We cannot afford to allow existing and nascent overseas competitors to frontrun this extremely important policy issue and set standards to which we may be forced to react.
As policymakers consider what role they may play in addressing this issue, they should recognize that attempts to facilitate creation of a network linkage with a first come/first served standard may be met with charges of central planning and excessive government interference. I believe something akin to this market structure is precisely what Congress had in mind 25 years ago when it directed the SEC to facilitate the establishment of a national market system. Among the explicit objectives of a national market system were the efficient and best execution of securities transactions and an opportunity for investors' orders to be executed without the participation of a dealer. It is clear the congressional mandate has not yet been completely satisfied. While the system that was implemented at the time was likely the most that could be done with existing technology, the fragmentation of our markets over time underscores the need for improvement, which, given modern technology, is a very reachable goal.
It also seems clear that linkage and price/time priority will promote, not hinder, competition. There are innumerable ways in which markets can and do distinguish themselves from one another in competing for order flow, including through offering unique services, business models, technologies, cost structures, and efficiencies. Today there are markets that operate electronic limit order books, continuous auctions, blind call auctions, and numerous others. There is no reason to think that markets will suddenly become homogeneous if linked together and forced to comply with certain minimum standards of best practice and fairness. Incentives will always exist to innovate, because the end-users - investors - will demand it. Perhaps more importantly, as I noted earlier, the essence of competition in the securities markets, and the ultimate end-game of a national market system, is competition among orders, rather than among order-handlers. Markets cannot be said to compete if the orders they represent are not afforded the opportunity to meet.
We are now at a critical juncture in the evolution of our markets. Bold and effective leadership is needed to implement certain changes, disciplined by a set of core principles that maintains its focus squarely on protecting the interests of investors, thus ensuring that our markets remain not only vibrant, efficient and competitive, but also fair and orderly. With all the changes occurring globally, especially in Europe, where existing and nascent exchanges are all fighting for the same order flow, we have a unique and advantageous opportunity to be the first to get it right. These changes will surely allow us to retain our global primacy.
As a final point, both the network and the individual markets will require an effective yet efficient regulatory framework. However, this regulatory framework cannot be fully determined until the issues surrounding the structure of our markets are ultimately resolved. Conceptually, the core objectives of investor protection and market integrity upon which our regulatory and self-regulatory system were established should not be compromised in any way, regardless of the market structure. Nevertheless, while some modifications to our regulatory system can and should be made to reduce unnecessary burdens and expenses, they should not unduly impede the uniqueness of certain regulatory functions performed by the various exchanges and Nasdaq.
Mr. Chairman, the time for a clear and definite response to the forces rapidly changing the face of our markets is now upon us. The greatest challenge will be navigating reform against the tide of special interests to arrive at a market structure that gives paramount consideration to the public investor, and does not serve to preordain winners and losers among the various market centers or order-handlers. The decisions that are made over the course of the next year will likely define our markets, and our place in the global order, for many years to come.
It seems we have come full circle from the birth of our system of markets in 1792. Then, the creation of what later became the NYSE was intended to centralize the trading of stocks, which had become fragmented in scattered coffeehouses around the city. We are again faced with the same dilemma, although this time the risk of inaction - loss of global primacy - could be far more profound.
Home | Menu | Links | Info | Chairman's Page