Subcommittee on Securities

Hearing on "Trading Places: Markets for Investors"

Prepared Testimony Mr. Kevin Foley
President and CEO
Tradebook, LLC

10:00 a.m., Wednesday, March 22, 2000

Introduction. Mr. Chairman and Members of the Subcommittee. My name is Kevin Foley, and I am pleased to testify on behalf of Bloomberg Tradebook LLC regarding meeting investors' needs in the financial marketplace of the future.

Bloomberg Tradebook LLC is owned by Bloomberg L.P. and is located in New York City. Bloomberg Tradebook is an electronic agency broker serving institutions and other broker-dealers. We count among our clients many of the nation's largest institutional investors. Bloomberg Tradebook specializes in providing innovative tools that allow our clients to step unobtrusively into the electronic "crowd" of the national market system to find liquidity for themselves and, in the process, provide it for others. Our clients have rewarded our creativity and our service by trusting us with their business.

We are the third largest electronic communications network (ECN) by volume. Indeed, last week saw the day on which the orders matched on Bloomberg Tradebook exceeded 100 million shares, a landmark representing a more than ten-fold increase over the past year-and-one-half.

Some have lamented the existence of ECNs, suggesting that we are an unwanted development. Others have wondered whether ECNs will continue to exist in this fast-changing market. ECNs have developed because exchanges haven't kept pace with the needs of the market. Thus, Bloomberg Tradebook and other ECNs have thrived for the simplest of reasons - we are a market solution to our customers' market problems.

Bloomberg Tradebook intends to remain a broker-dealer and an ECN. We believe it's the most effective way for our customers to obtain liquidity and best execution. While we are proud to be and remain a broker-dealer/ECN, we are also supportive of the efforts of some of our ECN brethren to either affiliate with or become exchanges. Just as competition among ECNs has been good for investors and the market, competition among stock exchanges also benefits all. We think the national stock exchanges should have to compete against each other for our business and the business of any other broker-dealer. Bloomberg Tradebook looks forward to the day when some of our ECN colleagues will be - as new exchanges - competing with the established exchanges for our business.

Fragmentation. Those who have argued for massive and intrusive regulatory change have sought to justify it by arguing that "fragmentation" is a threat to our markets. This is a traditional refrain, sung in virtually every industry when change threatens established players.

In 1975, when Congress and the SEC deregulated brokerage commissions, there was much anxiety on Wall Street. Critics charged that the unfixing of rates would damage and fragment America's capital markets. Instead, commission rate competition did what competition normally does -- reduced prices for investors and helped spur explosive growth in the market.

In deregulating the telecommunications industry, Congress and the courts were regularly warned that then-upstarts like Sprint and MCI were "fragmenting" the telephone market, destroying the world's greatest communications system. One person's harmful fragmentation is often another person's beneficial competition.

In fact, the Nasdaq market today is consolidated, not fragmented. Customers' orders are displayed to all and interact freely among market-makers, ECNs, order-entry firms and even regional exchanges. ECNs in Nasdaq participate in the least fragmented market of all time, thanks to this system of customer order display and electronic linkages that provide instant access to those orders.

In a very significant speech delivered last week at Northwestern University, SEC Chairman Levitt called on market participants to make publicly available all customer bids and offers, not just their best bids and offers. Chairman Levitt called for a competitive, free market solution to seize this opportunity for greater transparency. Bloomberg Tradebook wholeheartedly supports this increased market transparency.

Useful linkages have yet to be developed for the listed market. Our customers would like us to act as their agent for New York Stock Exchange listed stocks, as we do in Nasdaq stocks. Recently the SEC has approved an NASD proposal to allow ECNs access to the Intermarket Trading System (ITS) through Nasdaq. This is helpful, but not nearly sufficient since ITS remains crippled by both its technological ineffectiveness and an unworkable governance structure that makes any movement nearly impossible.

Central Limit Order Book. One panacea that has been offered to deal with the "problem" of fragmentation is a time priority central limit order book (CLOB). The notion behind the CLOB is that if you centralize orders in one place, a single "black box", maximum order interaction and perhaps better prices might be achieved.

There are a number of very serious problems with this concept. When this concept was first broached some thirty years ago, our markets lacked the technology to achieve order interaction without centralization. Now, technology allows the advantages of maximum order interaction without the downside of centralization.

In short, the technology of today makes a centralized order book unnecessary. These technological advances have revolutionized other industries, and despite protests, they are revolutionizing our equity markets. At a time when even public utilities like telephones and electric power are abandoning their "black boxes" for decentralized structures, does it make sense to threaten innovation by centralizing the stock markets? State-of-the-art telecommunications systems like the Internet rely on networked webs of multiple private competing linkages, rather than a single monopoly channel. Why should the securities markets work differently?

A centralized system also provides the significant downside of a central point of failure. Those of us who deal regularly with Nasdaq's SelectNet system know only too well how cumbersome and inefficient a centralized system can be. Like SelectNet, the ITS system is conceded even by the sympathetic to be technologically outmoded, with a bureaucracy that thwarts change. Why make those failed systems the model?

Centralized systems are resistant to change. The innovations that ECNs have brought to the market could not occur under a CLOB system, nor could it occur under the modified-CLOB proposed by the NASD in its SuperMontage Proposal.

While there are serious technological problems with the CLOB, there are equally troubling political problems. Someone or some entity will have to decide how the CLOB will work, who gets access and how, and what innovations are to be allowed. That gatekeeper and CLOB czar is certain to be enormously influenced by those who are already in the club. Will those who are already in the club allow the emergence of innovators who potentially threaten their business? I don't think so.

We believe advocates of a CLOB may well be mistaking a risk to their business for a risk to the marketplace. A CLOB would freeze markets in place, reducing risks to individual firms that fare well currently, but may fare less well as technology disrupts markets while improving those markets. Policy makers should not mistake a risk to individual firms as being a systemic risk to the overall market.

Fragmentation is a problem only if it means orders entered into different liquidity pools cannot interact with one another via linkages or other means. If "fragmentation" instead is used to refer to the very existence of separate liquidity pools - be they ECNs, exchanges or other market centers - that nevertheless are transparent and are linked and permit outsiders to access their liquidity, it is not a problem at all. The linking of markets, with greater transparency of each, is what is needed to resolve any problems of access to liquidity, not the imposition of an all-encompassing monolithic CLOB.

Humility before the markets. The most significant problem with a CLOB is that, even if we get it "right" for now, it's not clear we will have gotten it "right" for all time. Over the past three years, Bloomberg Tradebook has devised a number of innovations that have come to be industry standards. I'd like to mention one briefly.

At its inception in 1996, Bloomberg Tradebook introduced the concept of "Reserve" to the U.S. equity markets. "Reserve" is a process that controls the release of orders into the market, enabling clients to trade large orders more efficiently.

Like all innovations, the "Reserve" gave us a leg up on our competitors for a brief period of time. Soon it was adapted by others. Today no one would introduce a system without it, including Nasdaq in its SuperMontage Proposal. Any edge we gain is a momentary one -- and we are forced to continue to innovate. We have done so continually in the three years since.

If a CLOB had been imposed three years ago, clearly this innovation wouldn't exist. Are we confident that further innovation won't be needed? That we can't do what we do more efficiently? I'd argue that the innovation is just beginning, and we need to maintain the incentives that make that innovation possible. Innovations occur in a dynamic competitive market. They won't occur in a centralized black box.

Are regulatory changes needed to preserve and enhance the liquidity, transparency and integrity of the securities markets? A few years ago, the Nasdaq market was rocked by a scandal when Nasdaq market-makers were found to be colluding to keep spreads artificially high. The SEC's response in issuing its Order Handling Rules helped launch ECNs while narrowing Nasdaq spreads by nearly 30% in a year.

Congress should support the SEC's actions in promoting transparency and in insuring linkages in the Nasdaq market, as well as in exporting the germ of reform to the listed market, which has been so resistant to change. Congress should oppose the imposition of a unitary CLOB. Congress should oppose such a CLOB whether it is the one proposed by Nasdaq or a variation proposed by the industry.

Conclusion. Every advance in our markets in recent years - from the elimination of brokerage fee schedules, to the emergence of off-hour trading and ECNs - has been greeted by the cry of "fragmentation" by the powers that be. Our equity markets are the finest in the world because we've established a regulatory structure that rewards innovation. We shouldn't allow those who are threatened by change to encourage us to freeze in place a system which then won't be subject to innovation and improvement - and thinking outside the black box.

Changes in market structure will have implications for the American people that are just as significant - if not more - than those of the landmark banking reform legislation enacted last year. We very much appreciate the diligence of the Members and staff of this Committee in tackling these issues of complexity and importance.

Home | Menu | Links | Info | Chairman's Page