Subcommittee on Securities

Hearing on "Trading Places: Markets for Investors"

Prepared Testimony Mr. Gerald Putnam
Archipelago LLC

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

Good morning Chairman Grams, Senator Dodd, and other distinguished members of the Subcommittee. My name is Jerry Putnam, and I am Chief Executive Officer of Archipelago, LLC. I founded Archipelago over three years ago. Today, it is a leading electronic communications network, or "ECN," that serves a varied client base and executes trades involving over 60 million shares a day, predominantly in Nasdaq companies.

Just last week, on March 14 of this year, Archipelago joined with the Pacific Stock Exchange ("PCX") to announce our plan to create the first fully electronic national stock exchange for both listed and Nasdaq securities. This new market will be fully integrated into the National Market System ("NMS") and will compete toe-to-toe with the New York Stock Exchange ("NYSE"), the American Stock Exchange ("Amex"), and the Nasdaq Stock Market ("Nasdaq"). It will enable all buyers and sellers - - including broker-dealers, market makers, institutions and retail traders - - to meet electronically.

Our new alliance with the PCX will offer investors in listed securities the same benefits that have been available to investors in Nasdaq securities through the Archipelago ECN: namely, greater transparency, faster speed and lower cost. Although our new market will create a change in paradigm for investors and will differ in dramatic ways from the status quo, our mantra will remain as it has always been at the Archipelago ECN since we first opened its doors: serve investors first.

Because of the foregoing, Archipelago is keenly interested in participating in the development of policy that will reshape the landscape of U.S. capital markets to ensure that competition and innovation provide maximum benefit to investors. I am pleased to have the opportunity to appear before the Subcommittee once more and share my views on the global transformation that is occurring in the securities markets.

I. The "Next Generation" Exchange

Since we flicked the switch on January 20, 1997 and began operating, Archipelago has grown rapidly in several ways. First, our volume is now nearly 60 million shares a day - - more than double the amount that we executed only six months ago. Second, our client base has expanded and diversified considerably since our inception, and now includes Nasdaq market makers, institutional investors, online retail brokerage firms, proprietary trading houses, and options market makers. Third, our vision has become a global one. Last May, Archipelago became a member of a consortium that acquired a majority interest in Tradepoint Financial Networks PLC, a for-profit, U.K.- based electronic stock exchange. Fourth, and perhaps most importantly, a number of premier institutions made substantial investments in our company last year. They include Goldman Sachs, E*TRADE, J.P. Morgan, Instinet, Merrill Lynch, CNBC, and BNP/Cooper Neff. These investments provide a validation of our passionate belief that the time has come for a for-profit, technology-driven, "next generation" exchange to bring innovation to U.S. capital markets.

Central to Archipelago's business model is our "best execution" order routing system, which externalizes our own orders to find executions at superior quotations outside of Archipelago itself. For example, if our best buy order (bid) is priced at $20 and another trading venue has a buy order at $20 1/8, we will route any marketable sell order entered into Archipelago to the $20 1/8 bid. By routing orders in this manner, Archipelago facilitates "best execution" for investors and rewards price competition both on and off our system. And, from a business perspective, Archipelago has always lived by the axiom that we would rather take one side of the trade than no side of the trade.

As I testified before you last fall, from the implementation of the Order Handling Rules in 1997, ECNs, in three short years, have evolved from mere ideas and concepts to dominate the trading volume in many of Nasdaq's most active stocks. Price spreads between "bids" and "offers" have, on average, been reduced by about 30%, and minimum price increments have gone from 1/8th to 1/256th in some cases. The cost of execution has declined from pennies per share to fractions of a cent. The ultimate beneficiary of this sea of change has been the investor. Make no mistake, the alliance of Archipelago and the PCX, along with the implementation this summer of penny-based pricing increments and the retooling of the Intermarket Trading System ("ITS"), will again benefit the investor and strengthen America's capital markets.

Further, Archipelago has chosen to display multiple book information on our system and website. While exchange specialists are trying to hide their books, we are trying to give ours away. Our vision is that all ECN books will be integrated and provided to investors to create an informationally-rich environment, particularly after decimalization, when spreads will narrow and best quotes become more shallow. We intend to incorporate this vision into the PCX, and the regulatory environment should be constructed in such a manner that we are not disadvantaged from doing so.

We do not minimize or underestimate the enormous task of converting the PCX to a new, fully-electronic, for-profit exchange. Let me suggest that we eagerly accept the enormity of the task and, with due respect to all, will succeed in its outcome. While the marketplace will ultimately decide our fate, we like our chances.

II. Competition: Let Investors Decide!

As excited as I am today about the possibilities of our new relationship with the PCX, I am equally enthusiastic about the debate that is occurring before this Subcommittee and elsewhere, both inside and outside of government. The fact that I am speaking here today is attributable to three factors: developments in technology, liberalization of regulatory restrictions, and competition. Please let me underscore the importance of the latter: competition. And, while I speak of them as three distinct factors, the driver of these changes has been competition.

As SEC Chairman Levitt noted last fall in testimony before this Subcommittee: "[i]t is competition, above all else, that produces efficiency in our markets over time - - and efficiency is a core element of the protection of investors." Further, just last week in Chicago at Northwestern Law School, Chairman Levitt reiterated the quintessential importance of competition when he said: "[W]e at the Commission do not view ourselves as the grand architects of the future market. Our job, rather, is to maintain and monitor a framework in which the forces of true competition shape fair, efficient, and orderly markets." Thus, the challenge of the Subcommittee and the SEC is to continue to sow the seeds of open and fair competition and to be eternally vigilant over the fertile soil where innovators like Archipelago have laid root.

Archipelago is of the view that investors through the time-tested laws of supply and demand, and not governments or market center institutions, should direct the transformation of the marketplace. With these themes in mind, I want to share my views on several ways in which regulation can enhance competition. As I will discuss more fully, I respectfully suggest that we need to: (1) rebuild our current systems of linkage; (2) adopt decimalization on July 3rd of this year, as directed by the SEC; and (3) not adopt a government-mandated and organized Central Limit Order Book ("CLOB"), as some have suggested.

A. Allow Robust Competition Among Market Centers - - Improve Information Linkages

Robust competition among market centers should be promoted by improving information and order delivery linkages. Participation in the intermarket groups responsible for information aggregation - - Consolidated Tape Association - Consolidated Quotation System ("CTA-CQS"), the ITS, and Nasdaq's Unlisted Trading Privileges Plan - - must be extended in a fair and reasonable manner to new exchanges and ECNs. Currently, the governance rules and technology supporting ITS are prohibitive and need radical change so that for-profit exchanges can be integrated into the world of NYSE-listed trading. As Chairman Levitt pointed out recently, the creaky, outdated ITS system needs to be improved to meet the challenges of the markets - - or scrapped entirely. ITS is slow; it has a 1-minute minimum life for orders and is not well integrated into exchange operations. Further, the ITS Operating Committee has a flawed governance structure that allows each member's self-interest to veto and stymie constructive and beneficial changes. In a more competitive exchange environment, the critically important linkage function is far too important to be left to such an anachronistic structure. We should not accept as fact the perception that the ITS structure needs to be maintained as a monopoly supported indirectly by government regulation.

B. Promote Quote Competition - - Implement Decimalization By July 3rd

Quote competition, which results in savings to investors, will be heightened by implementing decimalization immediately. The archaic system of presenting quotes in 1/8ths and 1/16ths has prohibited robust competition in liquid securities. In January, the SEC issued an order requiring the U.S. securities markets to shift to decimal pricing no later than July 3rd of this year. Under the original plan, the securities markets were to convert quotation price increments from 1/16th to five cents or less beginning on July 3rd. The minimum price increments were to drop to one penny later in the year. Archipelago believes that it is so important to ATSs and other entities to trade and quote below the nickel that we are already doing so. Every day, ECNs execute trades in 64ths and even 256ths. Decimal pricing will increase quotation price competition significantly, and this price competition could save investors potentially tens of millions of dollars almost overnight.

In our view, decimalization would create such a tremendous benefit for investors that its implementation should be the first priority, not the last. Accordingly, Archipelago is very disappointed by the NASD's recent request to delay decimalization, despite the fact that they have been on notice of the issue for more than three years and had, in essence, entered into a bargain with investors, Congress, and the SEC to implement decimals immediately after the passage of the Y2K event (January 1, 2000, and immediately thereafter). The NASD is now attempting to breach that good faith bargain by petitioning Congress and the SEC to "bail them out." In the interests of investors and to avoid encouraging "moral hazards," among other things, Congress and the SEC should reject any NASD bail-out.

Additionally, we believe that the many and complicated NASD proposed market structure changes now pending, in addition to the enormous resources expended in the course of multiple forays into overseas markets, are not as important to investors as is the successful and timely implementation of decimalization. At a minimum, the NASD should delay the implementation of these other proposed changes and their overseas adventures to focus its resources on decimalization.

We support the SEC's efforts to encourage lower trading costs and greater market efficiencies. Like the SEC, we are of the view that decimalization is paramount to producing these results. Moreover, we are of the view that many of the concerns that the SEC is attempting to address through its recent Concept Release may be mitigated, if not eliminated, by the shift to penny-based pricing. We believe, therefore, that the SEC should demand an expeditious, though safe, shift to decimalization prior to entertaining further structural changes affecting the Nasdaq market. Once decimalization is implemented, competition in the marketplace may naturally resolve the issues underlying the Concept Release.

III. Opportunity Not To Regulate: "Let the Marketplace Decide"

Finally, I want to speak about one area where government action is not necessary and, if I may say, would actually cause harm. A single order aggregation system - - sometimes referred to as a CLOB - - would stifle innovation and smother competition, would provide a government-guaranteed outcome by granting the CLOB franchise to a single winner, and would protect vested interests. The need for the physical centralization of orders has been overtaken by changes in technology that allow robust competition for orders among linked market centers.

Lately, would-be competitors to new exchanges, ECNs and ATSs have floated the misconception, often in an alarmist fashion, that these new entities cause "market fragmentation" and that a CLOB is the only answer. The argument goes something like the following: without a physical central location where all orders can be aggregated, fragmentation results, which in turn distorts price discovery and harms investors. With all due respect: that is nonsense. First, as Chairman Gramm has alluded to on many an occasion, fragmentation should not be confused with competition. Second, regulation is not the answer to fragmentation; the marketplace will provide the appropriate answer, especially after the implementation of decimals. Indeed, in a technological environment where pools of liquidity can be and are linked at sub-one second speeds, the fragmentation bogeyman is designed to support the status quo with all of its vested interests that continue to profit without adding commensurate value.

Another example, which refutes the fragmentation argument, is the multilateral decision by ECNs to build efficient electronic linkages for both market hours and off-hours trading. Using the Congress' NMS as a blue print, a group of eight ECNs - - including Archipelago - - have already begun completing the construction of an electronic network which enables the sharing of market information and makes orders accessible to one another. It is noteworthy that we undertook this effort voluntarily because it supports our belief that a transparent, efficiently linked environment is the only way to ensure price transparency and protect investors.

We are concerned that the implementation of any CLOB would discourage further competition and is based on the incorrect premise that order execution itself is a commodity business. We believe that brands do matter. We believe that individual markets can differentiate themselves. Opportunities for liquidity enhancement; more consistent, efficient executions; and additional features that may not even be apparent to us now, will provide meaningful opportunities for competition for orders. We share the concern voiced by others that commitment to a single infrastructure, potentially fraught with conflicts of interest, will produce an inflexible vehicle that will stymie innovation.

IV. Conclusion: Competition, Innovation and Competition

Together with the incredible march of technology, competition has made possible what was unimaginable a decade - - or even a few years ago. These twin beacons of competition and technology should guide the future of our securities markets. Competition will serve as more than an adequate substitute for regulation; and when combined with technology, market-based solutions usually fashion an appropriate response to most regulatory concerns. As Chairman Levitt stated in his testimony at an earlier hearing held by this Subcommittee:

The Commission's role, I believe, is not to dictate the ultimate structure of our markets; rather it is to establish and monitor a framework that gives market forces the room and the sustenance to flourish.

Today, our capital markets are without doubt a national treasure and the envy of the world. Globally, the United States securities markets have a trusted brand that offers a tremendous advantage in competing for orders. We must, however, guard against complacency as technology marches on.

Unreasonable barriers and unfair advantages only serve to inhibit competition and decrease the quality of U.S. markets. Competition in our markets could be enhanced by the improvement of our information linkages and by the timely implementation of decimalization. Competition would not be enhanced by a government-mandated and organized CLOB. Using these as our guiding principles, market innovations will continue - - if not accelerate - - as the marketplace is decimalized, globalized, and democratized.

Archipelago looks forward to working with the Subcommittee throughout its review of the many changes occurring in today's capital markets. Thank you for your time and interest concerning these important matters.

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