Chairman Grams and other distinguished members of the Subcommittee, thank you for the opportunity to share my vision for the securities markets and the regulatory environment needed to accommodate that vision. I am Harold Bradley, and as an active voice for two million investors entrusting more than $100 billion to American Century mutual funds and retirement programs, I’m excited to participate in this dialogue. For too long, the voices at hearings like this have represented the deep pockets and economic interests of entrenched financial intermediaries – and not the direct voice of investors who daily face the arcane, archaic and anti-competitive rules of member-owned exchanges.
For ten years, I managed the trading operations for American Century Investors (ACI), now recognized as one of the earliest and most aggressive users of electronic trading technologies. For two years, I led the portfolio management teams for two small and mid-size "growth" mutual funds with assets of more than $2 billion. Only recently, I was asked to lead the ACI effort to identify new companies and technologies that might improve our ability to better serve investors. My immersion into the complexity of the "rules of engagement" at both the NYSE and NASDAQ has been both educational and troubling.
During my years at American Century, I have represented our investors on committees at the Investment Company Institute, the New York Stock Exchange and at NASDAQ. We are involved because the method and costs for securities trading directly affect investment performance for our investors, whose portfolios reflect prices after trading costs are paid. Both large and small investors suffer equally and proportionately when there are marketplace inefficiencies and inequalities.
Investor Benefits from Emerging Trading Technologies
Our 1992 response to the Securities and Exchange Commission’s Market 2000 Concept Release was one of only four filed by investor constituents. The issues in that release are eerily similar to those contained in the Commissions’ recent request for comment on market fragmentation. In the early 90’s study, opponents to newly emerging and efficient technology platforms spawned language that asked whether such systems threatened "fragmentation," "segmentation," and "balkanization" of the nation’s securities markets. I remain convinced now, as I was then, that such language reflects the howls from entrenched exchanges and brokers who have been insulated from competition by rules that masquerade as investor-friendly safeguards.
Our data indicates that ACI’s overall trading costs, including commissions (see exhibit 1, 2, 3) and market impact have fallen steadily and progressively throughout the 1990s. The enactment of the Order Handling Rules in mid-1997 generated significant additional savings. We can attribute virtually all of the cost savings – which go right into our investor’s pockets – to the use of ECN’s and other electronic trading technologies. The data suggests that new ways to trade have saved our investors as much as $110 million each year for the past 10 years (see exhibit 4) as compared to our costs for traditional brokerage services. In the last year or two, our traders’ use of more efficient platforms saved our investors more than $500 million a year – the size of a pretty good-sized mutual fund. Consequently, our traders rely on alternative trading systems for about 40% of the dollars traded by ACI on behalf of investors.
The efficiency of such systems appears to extend only to NASDAQ-registered securities. The NYSE somehow escapes obligations under the Order Handling Rules and continues to refuse direct electronic access by investors to the specialist order book. That would appear to contravene the spirit of the ’75 amendment to the Exchange Act that calls for markets to provide buyers and sellers an opportunity to discover prices "without the intermediation of a dealer." (see exhibit 5)
Internalization and Payment for Order Flow
While we do not perceive a "fragmentation" threat from the emergence of new automated transaction systems, we are nonetheless troubled by the "fragmentation" foisted upon the market by dealer intermediaries who either internalize or pay for order flow. Many wholesale broker dealers and exchange markets engaged in internalization practices rely on the national market’s disclosure of visible, limit orders to price and trade market orders generated by captive constituencies. Investors who display the desire to trade by using limit orders instead subsidize internalization practices. Ultimately, I expect to see internalization practices constrict the number and size of limit orders in the marketplace with a likely increase in volatility. Internalization and payment for order flow threaten transparency of trading processes. For instance, brokers now regularly receive so-called "VWAP" orders for specific securities – sometimes hundreds of thousands of shares – on both sides of the market. Potentially millions of shares are now internalized at the VWAP price, without ever participating in the market’s price discovery processes and without any semblance of order interaction with other investor orders. Many of these orders are now "book entered" overseas by U.S. brokers.
Major wholesale market-making firms, whose business models rely on payment for order flow, were engaged in about one-third of all trades in NASDAQ securities last year and have seen increasing market share gains as more and more retail investors trade individual stocks. At the same time, market makers often are represented in the market as the "best" buying or selling price only 25% of the time in many high profile, actively traded stocks while ECNs typically represent the market’s best price more than 50% of the time. (see exhibit 6)
Internalization practices prove anti-competitive in a host of trading venues – and the traditional exchange markets retain "members-only" benefits, marketing agreements and other "practices" that erode our confidence in trading on even the most well branded exchanges.
Internalization at the NYSE
The NYSE suggests that fragmentation caused by internalization might be mitigated by a market-wide price improvement rule. In other words, orders could only be internalized by dealers who pay a price "better" than the national market’s best prices for both buys and sells. In principal, we believe that this simple change in intermarket rules would be favorable for investors. At the same time, we can’t understand how the NYSE might impose that rule on other exchanges or dealers when much of the physical, floor-based model of that exchange depends on layers of such internalizing rules:
Competition and the NYSE
At the New York Stock Exchange, our orders cannot be traded without the intervention of a dealer – the specialist. Not much data exists about the profitability of specialist operations but the recent prospectus offering by LaBranche, the second or third largest NYSE specialist firm, provided a glimpse at the following:
How do they earn such economic rents? I would suggest that the designation of the NYSE as the "primary" market on which all other pricing should be based has established the NYSE as the principal "operating system" for the market. That status has been conferred upon member-owned exchanges by the Congress and by SEC regulatory interpretations over time.
It strikes me that an analogous situation might be the establishment by Congress of Microsoft as the official operating standard for the computer. Obviously Microsoft was the first to discover the true power of a standard operating system for the desktop computer. Recent events here and in the courts would suggest that Microsoft also discovered that bundling increasing numbers and kinds of software applications into the operating system pleased consumers – but displeased those who believe that competition spurs innovation.
The NYSE sits as the sole arbiter on a number of shared exchange operating committees like the Intermarket Trading System – the effective operating system for the nation’s exchanges. The use of veto power in a number of these venues successfully stymies efforts to stimulate interconnectivity of markets. And the NYSE has, over the years, incorporated innovations begun at regional markets only after a concept is proven and is considered a potential threat to the established hierarchy of exchanges.
Innovation by Regional Exchanges
The recent launch of the OptiMark trading utility of the Pacific Stock Exchange (PSE) provides needed insight into the anti-competitive practices at both the primary and regional exchange markets. OptiMark’s system relied on effective linkages between markets – as promised by the Intermarket Trading System (ITS). The historical record reflects that the SEC was forced to broker a compromise between competing parties on the ITS operating committee after principals exhausted more than a year in fruitless, back room debate on how OptiMark could or should be linked to the NYSE market. That process helped draw down a new competitor’s intellectual and economic resources required to compete effectively. The final solution reflected the economic staying power of NYSE monopoly position rather than a rational attempt to further the goals of a National Market System.
Shortly after effective launch of the new system, the NYSE effectively shut down ITS access to the OptiMark utility – based on arbitrary volume limitations. As an early user of the utility, our company documented numerous failures by NYSE specialists to abide by conventions of the ITS agreement and filed that report with both the Commission and exchange officials. In several documented cases, we were unable to execute orders sent from the Pacific Exchange to New York that were subsequently and immediately executed when sent through the NYSE proprietary Super DOT, order delivery system.
Our experience with the OptiMark utility also produced an eye-opening understanding of the marketing arrangements of regional exchanges that subvert competitive quote-making among exchanges. ACI recognized early that the Pacific Stock Exchange (PSE), in combination with the OptiMark utility, might provide an effective mechanism to generate competing quotes with the NYSE. We asked ECNs with whom we do business to build an order display link to the PSE such as that already in existence at the NYSE. American Century traders subsequently sent orders to the PSE that "improved" the NYSE best bids and offers. Those orders were intended to serve as an advertisement on the Consolidated Quote System of potentially larger block trading opportunities available through the OptiMark utility. Instead, we found that PSE specialists almost immediately sent these "price improving" limit orders across ITS from the West Coast to the NYSE specialists’ books.
In trying to provide price competition, we discovered that PSE specialists have marketing obligations to a number of broker-dealers who internalize order flow. To protect those firms’ ability to internalize customer orders, the specialist offers "primary market protection" on the regional floors. That protection essentially promises "internalizing" firms that if stocks trade at the retail order’s price on the "primary" exchange, the PSE specialist would use his capital to execute the order at that price on the regional exchange. There were three problems with the new competing orders that we were sending for display to the PSE. One, it narrowed the spread that could be internalized by PSE firms that sent listed orders to that venue for trading – thereby cutting the profitability of that practice. Two, the large size of the orders provided an unacceptable risk to undercapitalized specialists who did not wish to "protect" our orders against trades in other markets. Three, the large size of the orders on the PSE book meant that small retail orders, previously internalized, had to wait in queue until the larger block traded. When ACI offered to forego "primary market protection," the specialists requested that we also allow small retail orders to be traded in front of the large order, even if they arrived at a later time. The PSE could not excuse one firm from that "marketing arrangement" without compromising the entire business model of the exchange.
This, to us, is prima facie evidence that regional exchanges – under current rules – provide neither competitive quoting nor innovation. We are inspired by the recent announcement that the PSE and Archipelago will attempt to create a truly competitive and automated stock exchange. We can only hope that promises of price/time priority and electronic and non-dealer intermediated access to the PSE will not be perpetually stalled by entrenched and dominant exchanges, operating committees and member firms – all wrapped in concerns about investor protection.
The SEC has long sought to respond to the language of the 1975 Amendment to the Exchange Act and its call for markets that:
A recent survey of more than 40 traders of major institutions showed strong consensus that "ideal market" attributes would include:
We support the call for markets with transparency and "quote" competition. The current state of affairs in the NASDAQ market, with wholesale market makers and even at the NYSE fails to meet the minimum standards that the buyside requires to best protect investor interests. (see exhibit 7) The explosive growth of ECNs in the U.S. marketplace and across Europe validates such surveys of investor preference. If ECNs were allowed to compete directly with the NYSE, we think sizeable economic benefits would accrue to investors.
For years, ACI has advocated a strict price and time priority intermarket linkage. We continue to believe that the best market for investors would foster maximum order interaction and transparency. At the same time, recent experience with the ITS trading system, the rules of trading at the NYSE and the structural problems related to ECNs and mandated SelectNet linkages suggests that the SEC focus first on order disclosure, priority and interaction rules within individual markets.
How Can We Get There?
The explosive growth of the Internet in part provides the solutions to these vexing issues. Electronic, non-intermediated auctions on-line are drawing huge resources and attention from buyers and sellers of Beanie Babies, airline tickets and auto parts. Ford, Chrysler and GM seek such a venue to reduce supplier costs. Why do member firms of the major exchanges resist the major virtues that their own securities analysts extol as "beneficial" to the economy in enterprises outside of securities trading?
We believe that the Commission should regulate the form of individual markets and refrain from regulating the technology that might be used to integrate markets. Already, eight ECNs are building a virtual private network to link order books and dispersed pools of liquidity. These robust networks tie together systems that already incorporate the four major tenets of the buyside investor’s "ideal market" without creating a single point of technology failure – a virtual limit order book. The systems recognize that the "market" no longer is limited by access to the physical trading floor on Wall Street.
The government’s time is misspent trying to regulate the technology capacity of markets. If competitively-limiting linkages like ITS were simply eliminated, one must consider whether the market would not quickly establish network linkages as a direct response to customer demand. These linkages would recognize and penalize inefficient systems – like those currently operated by the NASDAQ stock market – where legacy systems impede the delivery and reliability of trading information.
Insight into the regulator’s role over tariff setting within the securities markets can also be gained from the implementation of the Order Handling Rules. The sudden mixing of dealer systems (where all customer charges are implicit) and of agency auction systems (ECNs who explicitly charge for access) squarely placed the Commission in the role as a rate-setter. Dealers argued they should not have to pay for access to ECNs because dealer-to-dealer trade in NASDAQ is "free." However, dealer trading is free only if dealers have zero profitability in the business model. Rather, dealer trading imputes hidden tariffs. As an investor, I would rather see charges assessed explicitly. Why should the SEC sit as judge as to what constitutes reasonable charges?
One could argue that competing venues should be able to charge whatever fee for access to a proprietary pool of liquidity would be economically competitive. That would imply that linkages could not be forced upon centers but that such centers must be compelled to accept orders from other markets or exchanges. I would expect that technology integrators would quickly create algorithms allowing me to choose a trading venue based on price, time and cost of access metrics. If one market’s cost of access were too high or the system’s response too slow, I would expect liquidity to migrate to the most dependable, lowest cost, and most secure venue.
The Role of Decimals
The markets currently are digging their heels in on the issue of decimal trading increments. We remain the only market in the world that continues to rely on centuries old pricing conventions – pieces of eight. An immediate move to decimals would create significant competitive pressure on payment for order flow and internalization business models that rely on "fixed price spreads" to support the economics of the business.
Summary and Conclusions
We believe that true competition among markets and among quotes may be harmed by mandated linkages – without the complete reform of anti-competitive structures like ITS and the elimination of order internalization practices by dealers, brokers and exchanges.
We believe that a "hard CLOB" or central limit order book which consolidates all orders in disparate venues is undesirable and would be subject to a single point of technology failure. That said, we encourage the virtual development of a market that guarantees investors:
We believe that price and time priority structures within markets and an intermarket "price improvement" feature would be beneficial to investors. That rule would allow internalization of market orders only at prices better than those quoted among competing market centers – even a penny of price improvement changes the economics of the payment for order flow business.
We believe that truly competing markets and exchanges should be required to accept non-intermediated, electronic orders from other exchanges or markets; furthermore each market center should be free to establish the cost for access to that market.
True competition often creates fear and uncertainty. We must not fear such competition in the structure of the capital markets. Thank you for the opportunity to share my thinking with this subcommittee.
(Note: Right-click on the exhibit and select "View Image" to see it full-size)
Home | Menu | Links | Info | Chairman's Page