In the 1975 Amendments to the Exchange Act of 1934, Congress chose to place basic reliance upon competition to evolve the appropriate structure of securities markets, with regulators in the role of facilitators.
History since that time has documented the wisdom of that policy. When problems occur, they often relate to attempts to regulate the economics of trading. Fixed commission rates are a prime example of that kind of failure before 1975.
Attempts to fix minimum marketmaker quotation sizes between mid-1988 and 1997 are another more recent example of efforts to force the market into a pre-conceived regulatory mold. The minimum sizes merely reduced the exposure of bids and offers and widened the bid-ask spreads paid by small investors in automated systems. These fixed minimum exposure limits (5000 shares in most active stocks) were eliminated when the order handling rules were adopted.
Current problems with market data systems are another example of regulatory intervention that has not worked well because competition is stifled by exclusive processor unrestrained monopsonistic (power over suppliers) and monopolistic control over the collection and distribution of quotation and trade report information.
Unlike the National Securities Clearing Corporation (NSCC), exclusive processors of market data are not end-user controlled. Self Regulatory Organizations (SROs) and the processing vendors have contracts that require information producers to give up all proprietary rights in the information submitted to the SRO exclusive processors and their fees have discriminated against online investors, who must pay a fee, while traditional firms do not generally incur such charges. The former restriction prevents the recapture of information production costs by those who input information into SRO systems and the latter unfairly burdens a selected group of individual investors with unnecessary costs and restricts their access to information.
Exacerbating these anti-competitive features of market information system plans is an absence of restraints on the SROs use of surplus revenues generated by market data sales.
Yet, as was the case before the 1975 Amendments to the Exchange Act of 1934, competition has resulted in a highly efficient structure in spite of regulatory constraints. Individual investors are especially dependent upon competitive forces to help them capture the efficiencies of the new technologies. Unlike institutions, they individually, do not have the economic power to require lower commissions and a sharing of the orderflow value that their orders help to create.
Competition is the best friend of the individual investor. Intense competition at the retail level assures that individual investors can effectively demand the prices and services that they wish. The growth of the online brokerage business is a perfect example of this thesis. If there is flaw in regulatory processes, it is a chronic lack of faith in the ability of markets to effectively regulate the supply, demand, and prices of securities market services.
Congress should reinforce its pro-competition policy, restated in the history of the 1975 Amendments to the Exchange Act, with a requirement that the SEC establish and maintain a capability to root out anti-competitive biases in existing and proposed regulatory and self-regulatory activity and in economic policy. Combined Limit Order Book ("CLOB") proposals, selective focus on cash payment for orderflow and internalization, and an overemphasis on the collection of public orders without the intervention of a dealer are example of economic policy biases that negatively affect individual investors.
Congress and the SEC should permit market participants and SROs to restructure as they think appropriate in response to market forces so long as the resulting structure enhances competition and does not result in monopoly power.
NYSE and Nasdaq are under competitive pressure, which is in the public interest. If they think they need to restructure to be competitive by going to a stock form of ownership to align their interests with their listed companies and with their broker constituents in order to compete, they should be permitted to do so. Two caveats: Congress should be skeptical of the monopoly power that would be granted by an amalgamation of NYSE with Nasdaq and any restructuring should result in a separation of the governmental regulatory power in the existing SROs from the profit-making enterprise. The possibility for abuse of investor interest is just too high. Recall that when the NYSE had such power, it imposed fixed-commission rates which stifled competition.
Only a market structure which results in a competitive environment will continue to foster innovations such as on-line trading, which has lowered commission costs and increased liquidity and volume which, in turn, has resulted in better pricing and terms of trading to investors. Stock of ownership for NASDAQ and NYSE can contribute to this trend so long as new entrants and new technologies in the market are not discouraged.
These two topics are directly related. Vertically integrated firms that provide both retail and wholesale trade execution services are in competition with firms such as Ameritrade that provide only a retail brokerage service and route orderflow to independent market centers in an arms length relationship. Cash payment for orderflow is the competitive process for non-integrated retail brokers to capture the value that exists in the aggregation of trades into an orderflow stream. Integrated firms capture this value internally, payment for orderflow, in that context is real, it is just not visible and not in cash.
Unfortunately, regulators are perennially trying to eliminate the cash payments for orderflow, payments that are established in arm's length bargaining. In contrast, non-cash payments for orderflow are essentially ignored. Of course, neither form should be eliminated by regulation. They represent the competitive processes for capturing orderflow values that inevitably work their way back in some form to investors through reduced commissions, lower spreads, and better services.
Internalization is commonly thought of as the capture of orderflow by retail brokers in their own trading departments (Merrill Lynch) or through subsidiaries (Schwab). It is a form of vertical integration or market structure organization that permits organizations (firms or groups of firms) to capture the profits from orderflow available at both the wholesale and retail levels.
For example, marketmakers, specialists, ECNs, Exchange floor brokers and others that perform the actual execution of trades are providing wholesale services. Singularly or in groups, they incentivize orderflow to be directed to their market centers either with cash payments, member services and discounts, reciprocal business, or similar inducements.
Subject to the agency obligation of best execution, vertically integrated retail firms that own trading departments, floor brokers and specialist units do not need to incentivize to capture their own organizations' orderflow. There are obvious incentives to route retail orders to their own trading departments or floor brokerage units on exchanges.
In fact, internalization has exerted a strong competitive pressure from large retail firms on specialists, marketmakers and floor brokers.
Currently the "concern" over internalization seems to arise from the elimination of NYSE Rule 390, which prohibited members from executing principal trades off-board in stocks listed before 1979. The fear of the exchanges and their floor members is that such a rule change may result in further volume moving away from the floors.
Internalization in Nasdaq stocks has always occurred, and the competition has helped rather than hurt the investor.
Incentives for orderflow can be cash or non-cash. Soft dollar payments seek to capture values inherent in packaging, bundling and/or batching orders. While the SEC's focus has generally been on cash payment, soft dollar payments should receive greater scrutiny. For example, Exchanges incentivize members to route orderflow to their markets over and above the natural incentive of integrated members that own floor brokers and specialists. Fee discounts related to volume and sharing of market data fees with specialists who can use the revenues as payment for orderflow are examples of this practice.
An NASD blue ribbon report of a committee chaired by former SEC Chairman David Ruder listed several other non-cash payments for orderflow such as reciprocal business practices, free services and institutional section 28(e) soft dollar payments.
Cash payments are in the open, negotiated in a competitive market with arm's length bargaining in an intensely competitive market where benefits quickly flow to investors at the retail level. Those who would eliminate cash payments probably want the liquidity, market information and other values inherent in small investor orderflow to be directed to CLOBs, where their own operational costs can be reduced.
On their own, individual customer orders have little value. When combined into a flow they have great value. Competition at the wholesale level guarantees that that value flows back to the public investor in the form of lower commissions and better services like immediate executions.
For example, forcing small orderflow into a single center or channel to be auctioned to the other side probably shifts liquidity value from small to large investors. If this happens through competition, it would be fine since the investors would get some benefits. Conversely though, for regulators to force small orderflow to incur increased costs, perhaps worse executions and decreased speed of execution simply because the artificial centralization of orderflow fits unvetted regulatory theories as to what market structure is most efficient would be poor regulatory policy.
The SEC should turn its regulatory attention to soft dollar practices instead of focusing on payment for order flow ("PFOF"). While the markets will take care of PFOF, soft dollar practices are not easily susceptible to calculation and are hidden. Perhaps the SEC should require the mutual fund investor to be told more specifically (not in general, boilerplate disclosure) how much in dollars his or her account is worth to the advisor who receives soft money and that amount included in the gross fees amount disclosed by the advisor. While soft dollars could be an item listed by the committee, it should be pointed out that these new stock institutions will be looking for volume and might be in a better position once they have internalized PFOF to pay for more order flow from the institutions.
It would appear to me that a central limit order book has all of the disadvantages economically of a monopoly and would necessitate a public utility type regulation, a fruitless exercise. Volume is so large in the market that price discovery is not adversely affected by competing books. Market destination and execution points should be allowed to compete with required transparency.
Mandatory Central Limit Order Books and Call markets are proposed by market participants that seek to reduce their own operational costs by eliminating the marketmaker or proprietary intermediary from their trades. They wish to have all orderflow forced to their market venues to maximize their opportunities for executions of large positions or limit priced orders that compete with proprietary intermediaries. There are reasons why central limit order books and call markets did not evolve in OTC trading.
The fallacy of such proposals that would purportedly maximize the meeting of public orders and price improvement is that they focus on only the gross execution price that investors receive, ignoring the higher commission costs and the reduction in the speed of execution received by individual investors by forced rerouting of orders outside of competitively determined channels.
When regulation imposes a "gross price" standard on market structure, it determines that individual market order investors will incur higher costs, lessened services and bear a greater share of market costs. Large investors will incur lower operational costs and limit order users will be competitively advantaged reducing their respective shares of market costs. Even the NYSE presently depends on a 40 percent ratio of proprietary volume to public volume in order to provide the continuous liquidity demanded by investors.
Individual investors are likely to be paying a spread to someone. It may be to their advantage to pay it to the dealer that will provide guaranteed executions of all their orders at all times at published prices, particularly if the dealer returns order value through payments for orderflow that reduce commissions. Routing of such orders to dealers maximizes order handling efficiencies and exerts pressure on large orders and limit order users to improve the published quotation to attract the other side.
Just as regulation should make sure that there are no anti-competitive restraints to the formation of central limit order books and call markets, there should be no artificial restraints on where individual investor brokers route their orders.
Self-regulation is dead. The function of self-regulation was to avoid unnecessary governmental regulation and to minimize the cost of regulation that was unavoidable. It appears to do neither of these. Since 1975, the SEC reviews virtually every significant action of SROs. They are like divisions of the SEC that operate securities market centers. Yet even in this heavily regulated environment, the NASD did not detect that some of its members were involved in collusive and anticompetititve marketmaking practices.
Because they avoid the Congressional budgetary process, SROs can or may be forced to implement every program the SEC wishes (or indirectly coerces) them to adopt. Because of their historical and statutory basis, SROs should not be providing securities market services in competition with members or vendors of information. SROs should spin off all market activities to users.
Because those systems (consolidated tape and quotation) are institutions for the public benefit, they should not be publicly owned or for profit. These facilities are highly significant and should be user controlled.
The most efficient mechanism would be for the SEC to handle all regulation. Since the SEC's budget is reviewed by the Congress, the public can be assured that any and all regulatory or other fees imposed on the industry are appropriate and nondiscriminatory.
If the SROs are restructured, the timing would seem right to take away from the SROs the power they now have over quotation and transaction reporting data. All such data could be put into a user controlled entity whose costs are spread in a nondiscriminatory way. There is no persuasive case that they need control of this mechanism.
The public policy makers need to focus on the investor. Whenever competition is enhanced, costs are lowered and service is expanded. The result is increased volume, better prices and liquid markets for the United States as well as world investors.
6) Lastly, while I have not been asked to speak to this issue, I would like to comment that the concept of suitability does not pertain to the online brokerage industry and the self-directed investor. Were the regulators to impose such a standard in this context, it would only raise costs for the small investor and impose intervention in investment decisions that the customer does not want. Furthermore, the legal standards that lead to the suitability requirement do not apply to online execution brokerage services.
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