Thank you Mr. Chairman. I want to welcome Chairman Greenspan. And I want to thank the Chairman for holding this hearing today. Few issues are as important to the prosperity of the United States as the structure of our capital markets.
Today, talk about the markets happens just as often on Main Street as Wall Street. That's largely because over the last five years technology has almost fully democratized our markets. And now its revolutionizing them. As Chairman Grasso has said, "I don't think there's ever been a period like this in the history of world capital markets." And where we end up is anyone's guess.
Some soothsayers see "straight through processing" where a trade would be ordered, executed, recorded, reported and paid for in an instant, instead of the 3 days it takes today. Others consider an intermediary model necessary to maintain market integrity. But whichever model prevails, I think we all agree the future will be built on technology.
Some – including Chairman Gramm, I fear -- are of the opinion that government has no role in shaping this future. That we should simply step back and let competitive forces dictate the evolution of the markets. They argue that rational actors acting in their self-interest will produce the best markets. That if liquidity is important to the markets and fragmentation splinters liquidity, firms will demand convergence and the market will oblige. And, as a result, there's a smaller role for the SEC in shaping that future.
I agree in part, -- but, I disagree in a few fundamental ways.
Since the Great Depression when we decided a certain degree of regulation was necessary in our securities markets and the SEC was created, there are certain values the government has promoted– values that enhance competition, not inhibit it. These values, based on the free market principles of Adam Smith, include market fairness, transparency and disclosure, ensuring a level playing field and correcting market failures that arise when rational actors produce irrational results. These values – along with protecting against fraud and misrepresentation – have been at the center of free markets since 1929, and the SEC has been an excellent way to achieve that goal.
There are some who would prefer the government not promote these values. They would prefer to see the SEC eliminated altogether. But not one of them would be found on Wall Street. Ask them and they'll tell you, the SEC has been their best friend. Due in part to their rigorous oversight, US markets have become the deepest, most liquid and most fair. In short, the envy of the world.
But today, the transparency of our markets -- the hallmark of the SEC--is at a critical juncture.
Transparency is in jeopardy from some self-interested industry practices --like payment for order flow and internalization-- that, left unchecked, could undermine the otherwise beneficent results of competition.
Left to their own devices, every Member of the NYSE or Nasdaq would choose to internalize their order flow. It is in their self-interest to reduce trading costs by executing it themselves. Everyone wants to internalize. But internalization has risks for the overall market, like fragmentation of liquidity.
At the same time, an individual firm's ability to internalize depends upon prices in the public markets. And this fact makes it easier to understand the NYSE's desire to pull out of the Consolidated Tape Association. The price discovery process is most efficient when it includes all trades. The most efficient price is a collective price.
But this pricing mechanism --upon which all firms depend-- is undermined by market fragmentation, some of which is the result of internalization and payment for order flow.
Just as liquidity begets liquidity, fragmentation begets fragmentation. And with decimalization and the elimination of Rule 390, internalization will become even more attractive.
Given the pervasiveness of payment for order flow–which one senior member of the industry estimates at 60% of all retail trades– I think we can conclude that the self-interested choice of the rational actor has the potential to undermine the integrity of our markets.
Congress reached the same conclusion in 1975 with the passage of the Securities Act amendments that set up the principles of a National Market System built on linkage and transparency. Congress was practically prescient in seeing that a linkage of the markets was possible. Today that linkage, that vision for a national market system is within our grasp. And it would be an abdication of our responsibility to investors and a violation of Congressional mandate to let the opportunity slip by.
Does the goal of a National Market System lead inexorably to a Central Limit Order Book (CLOB)? No.
But it doesn't lead inexorably to an entirely laissez-faire approach either. To say that it does is like saying that just because government isn't good at making better, cheaper cars, that it shouldn't be involved in building interstate highways or setting the rules of the road.
And I'm worried that in the zeal to kill the CLOB we're confusing those two, very different things. The government should set speed limits -- even if it's a state government -- and it should build and maintain highways. And I think industry appreciates the role that government should play. As Chairman O'Neill of Alcoa, recently said, the SEC should give industry "a blueprint to create the future instead of letting it happen to us."
What is that blueprint? The government should have three obligations: ensuring linkage, transparency and price priority.
Linkage and transparency are interdependent; for a linkage to be meaningful, prices must also be transparent. For example, if I'm looking for the best price on Cisco, transparent prices allow me to look at every market center to decide where to route my order. If the best price is on the Archipelago, linkages would allow me to send it there. Price priority means that I will get the price offered.
Simply put, transparency means everyone can see prices in all markets, all the time. Linkage and price priority means I get it.
But transparency also means that firms that internalize or engage in payment for order flow should disclose the true costs of execution. Spreads alone are no longer the obvious indicator of the true market price. As chairman Greenspan has noted, costs from delayed or failed executions or forgone profit from if there is no opportunity to price improve must be known to the investor for him to compare prices across markets and for the best market to win.
The SEC should first bring industry together to develop a strategy for implementing linkages and trade through rules that protect price priority and mandate implementation. Whether this linkage is constructed through private sector initiatives or regulatory initiatives and how market centers are accessed and compensated are open questions.
Everyone was shocked last week by the NYSE's endorsement to eliminate the Intermarket Trading System. Not because anyone thinks ITS works well. As has been often noted, it's slow, clunky, antiquated.
In fact, it's probably faster to drive your order from the P-Coast to the New York than to route it through ITS.
The shock was less about what ITS does and more because of what ITS represents -- a linkage of market centers that everyone – from Schwab to Goldman -- supports.
What does linkage not mean? Linkage does not mean a socialist, monolithic, centralized, bureaucratic, boys club. Nor is it an automatic execution based on "price/time priority," because the investor decides where to send their order.
And it doesn't stifle competition. In fact, the beauty of linkages is that --if done properly–they will be a crucible for competition because they will allow every independent market to compete on a level playing field for customer orders.
So the irony is that to create real competition, the worst thing government could do is sit on its hands. Competition is engendered, not inhibited, by rules that guarantee the fundamental principles of free market forces.
Of course linkages have limitations. Transparency, linkage and price priority will not necessarily eliminate payment for order flow or internalization, but it will showing investors the opportunity cost of these practices. And it will solve the basic problem of fragmentation by eliminating the inefficiencies of disparate pricing that, in turn, enhance the incentives for firms to internalize.
Linkage, transparency, price priority. These are the most fundamental rules of the road that simultaneously promote competition, insure against fragmentation and make certain that investors are receiving best execution of their orders.
For those who want to drive a little faster, I sympathize.
Thank you Mr. Chairman and I look forward to hearing the testimony of Chairman Greenspan.