Mr. Chairman and Members of the Committee:
I am John Bachmann, Managing Director of Edward Jones. I would like to thank you for the opportunity to share our views on the future of the United States securities markets.
Edward Jones is one of the only major financial services firms focused solely on serving the needs of individual investors. The firm, which traces its roots back to 1871, currently serves more than 4 million clients through 5000 offices in the United States and abroad. We at Edward Jones pride ourselves on our philosophy of personal service aimed at helping customers achieve their long-term financial goals. I hope that our experience in the securities markets proves helpful to the Committee in its consideration of the issues at hand.
As we strive every day to serve the best interests of our customers, we have seen and experienced the exciting changes taking place in today’s securities markets. Cutting edge technology has led the way in dramatically altering the manner in which investors buy and sell securities. Indeed, we have had the privilege of witnessing greater changes in the markets in the last few years than have occurred over the last century. For example, direct access to markets, lower transaction costs and instantaneous access to information have empowered investors in ways unimaginable just a few years ago. In the grand tradition of American enterprise, new alternative trading venues have emerged to develop business opportunities created by technological advances, thereby testing centuries-old trading patterns. This is, indeed, an exciting time.
Change, however, naturally brings new challenges. For years, the United States capital markets have enjoyed the preeminent position as the largest and most trusted securities markets in the world. In large part, that preeminence is the result of the ability of the U.S. markets to change in a constructive and innovative manner. For example, whether it was the shift to continuous net settlement in the 1960’s, the development of block trading in the ’60’s and ’70’s, the elimination of fixed commission rates or movement to T+3 settlement, the securities markets constantly have been able to change in a manner which both preserves and enhances individual investor protection while at the same time allowing competitive market dynamics to create new trading opportunities for investors. Indeed, the current concern regarding so-called market fragmentation is, in many respects, an outgrowth of those competitive dynamics. Accordingly, while we should be vigilant in ensuring the protection of investors, we should be equally anxious to maintain an environment which encourages competitive experimentation.
At Edward Jones, we believe that the United States will continue to excel in the securities arena, provided that, in this time of change, we take a step back and critically evaluate the overall market structure and regulatory regime in light of the new trading environment. In doing so, our guiding principle and paramount concern should be the protection of investors, just as it has always been since the adoption of the federal securities laws. By continuing to offer investors the fairest, most competitive securities markets, the United States will continue to attract investors, thereby maintaining its status as the financial capital of the world.
Using the protection of investors as the baseline objective, we believe that a core set of principles should be used to evaluate the changes in the securities markets. Briefly stated, these principles are:
(1) Individual investors should be assured of obtaining best execution of their orders.
In striving to reach these goals, we also should be cognizant of the bedrock regulatory principle embraced by Chairman Greenspan in his recent testimony – "first, do no harm." Let me emphasize this point by way of an historical example. If I may suggest, many of us in this room, living through the greatest bull market in the history of the markets, find it hard to remember how different things were just two or three decades ago and how far we have come. Today we have consolidated quotation information. Today we expect instantaneous access to markets and information. Today we expect cheap execution. Today we have instant liquidity. Today we demand immediate executions at the best price. There was a time, however, when investors could not find the best price, could not obtain access, could not trade cheaply, did not have direct access. We should not allow ourselves to be deluded by the success of the last 25 years in creating a more or less, integrated, cheap and accessible national marketplace into thinking that if we simply let a thousand flowers bloom that the robust, transparent, liquid market will re-create itself. Rather, I believe we have much to lose unless we continue to insist that our core principles – best execution, transparency and fair oversight – are maintained.
As alternative trading systems proliferate and flourish, they have attracted increasingly larger volumes from Nasdaq and the traditional exchanges. This competition among trading systems, although beneficial in many ways, has fragmented the market. Edward Jones is concerned about the recent increase in fragmentation because it has hurt – and will continue to hurt – investors’ best interest in several ways. First, orders to buy and sell securities may be isolated, preventing all orders from meeting each other. Because of the decreased opportunity for buyers and sellers to meet, investors are deprived of an effective price discovery process. Second, dealers who quote aggressively and investors who offer to buy or sell better than any price in the market may go unrewarded. Third, multiple, insular markets may make it difficult for a broker to obtain best execution for an investor’s orders. Finally, by dividing the orders among many markets, fragmentation may decrease liquidity in general For all these reasons, market fragmentation may cause investors’ orders to be executed at a less than optimal price.
We believe that technology can and should be used to resolve the very fragmentation issues that technology has helped to create. In other words, Balkanization of trading venues may provide for the transitory appearance of competition among broker-dealers and markets building their own order flow fortresses, but, such competition will be purchased through a loss of best execution and investor protection. All exchanges and alternative trading systems should be electronically linked to encourage the maximum interaction of all investors’ orders. The aggregation of liquidity through a market-wide linkage will enhance the efficiency of the market, thus enabling investors to receive the best executions available. Furthermore, an enhanced linkage between the market centers will not impair the competitive position and uniqueness of the individual market competitors.
b. Price Improvement
An important corollary to efficient linkages is the need to insist on price improvement as an antidote to, and justification for, internalization and fragmentation. As this Committee is well aware, the simple economics of a securities transaction at bottom entails trying to profit either by charging a commission (or commission equivalent) to execute the transaction or trying to profit by buying low and selling high (or, in the jargon of the trade, "buy on the bid" and "sell on the ask"). Historically, brokers were compensated based on their commissions and dealers were compensated based on the bid/ask spread. Over the last 30 years, and increasingly over the last 10 years, these distinctions have evaporated. Today many firms seek out revenues on an integrated basis. In other words, they seek to capture both the commission and the spread. Nevertheless, in seeking to capture the entire revenue stream, firms often seek to execute their customer orders without exposing those orders to other market interest. They internalize the order flow. Such internalization runs the risk of both depriving the customer of opportunities for superior executions and the risk of creating a net adverse effect on market liquidity if each firm becomes its own isolated redoubt, cut off from the market as a whole.
To counteract these potentially adverse consequences, internally executed orders, at a minimum, should be executed at prices which improve the best displayed consolidated bid and offer. This would prevent the so-called practice of price matching whereby an individual market center can essentially keep the spread by free-riding on the prices of other markets without contributing additional price incentives. More could be done. For example, a first come, first served principle could be adopted (so-called price/time priority). Under this approach, aggressive quoting would be encouraged because investors who are willing to pay the highest price or sell at the lowest price would be first in line for execution. In order to bypass existing orders at a particular price, an investor must submit an order at a better price.
We believe price/time priority offers substantial opportunities for achieving competitive, vibrant markets while ensuring that the individual investor receives the best price, wherever located. At the same time, we recognize the uncertainties surrounding the implementation of such an approach as well as the strongly held views of others regarding whether the consequences of price/time priority are too rigid (although I am not certain that being rigid about protecting investors is a vice). Accordingly, while we would prefer a price/time system, we believe that, as a matter of public policy, we must ensure efficient national linkages, coupled with a requirement of price improvement to internalize a customer order.
Another way in which the integrity of our changing markets may be improved is through increased transparency. No segment of the market should enjoy an unfair trading advantage as a result of unnecessary restrictions on the dissemination of relevant market information. Chairman Levitt noted in his speech at Northwestern University last month that currently most market participants can see only the "top of the book" -- the single best quote available. But, "seeing the top of the book is like seeing the tip of an iceberg -- and having no idea how much rests below." Information about orders, prices and executions should be open and accessible to as broad a cross section of market participants as possible. Investors should be informed, not only about the price of a security, but also about the costs and methods by which trading occurs. For example, such costs may involve delayed executions, failures to execute, or forgone profit if there is no opportunity for price improvement. The disclosure of all aspects associated with trading allows investors to make informed choices about how best to ensure quality executions.
3. Hybrid Model
The changes taking place in the securities markets, including the demutualization efforts of certain exchanges, have fostered a debate on whether today’s regulatory structure will continue to be as effective as it has been in the past. We believe there is room for improvement in the current regulatory structure. If an exchange were to operate as a for-profit entity, we must ensure that the exchange’s current responsibility for overseeing its competitors is transferred to an independent and neutral self-regulator. Therefore, in light of the public announcement of the exchanges’ reorganization plans, we advocate the consideration of the hybrid regulatory model recently endorsed by the Securities Industry Association.
The hybrid model would consolidate many, but not all, of the functions of the various self-regulatory organizations into one centralized SRO that is separate from all the marketplaces. This new, central regulatory entity would be charged with the oversight of a core body of financial responsibility and sales practice rules. Each existing self-regulatory organization would continue to police its own market and to ensure adherence to its trading rules. We emphasize that we do not support a single regulator responsible for all oversight activities. We firmly believe that exchanges should have the right and the responsibility to assure those who use their system also abide by their rules.
Such a regulatory model would improve upon the existing self-regulatory structure in two primary ways. First, the hybrid model would eliminate one market competitor’s oversight of another competitor. With the introduction of an impartial overseer, this conflict of interest would disappear. Second, the consolidation of many aspects of broker-dealer oversight into a single regulator, rather than eight or more, would eliminate a variety of redundancies and inefficiencies. For example, large broker-dealers that are members of multiple SROs would no longer need to comply with multiple and inconsistent rules and examinations. We hope and expect that the elimination of these inefficiencies would create cost savings to the benefit of all market participants.
Let me close where I began. The touchstone for improving our securities markets must be the protection of investors. What is truly special, perhaps even unique, about the American capital markets is the willingness of individuals to put their savings at risk in our securities markets. This means our markets are deeper, more robust and more diverse than other more highly concentrated and controlled capital markets. In turn, those markets have helped us maintain our competitive edge globally as a result of our ability to raise risk capital. Thus, I would urge this Committee that the acid test of reform should be whether the individual investor is treated fairly. Competition among markets and broker-dealers will come and go, but the trust and confidence of the individual investor is the real prize.
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