Chairman Grams, and Members of the Subcommittee:
Thank you for asking me to testify this morning. My name is David Colker. I am President and Chief Operating Officer of The Cincinnati Stock Exchange ("Cincinnati" or "CSE"), which is the first all-electronic stock exchange in the country. We find it satisfying to see many of our competitors now working to employ the technology necessary to facilitate electronic trading that we have provided for years.
Because of our low cost, all-electronic operation, the CSE is poised to compete for order flow, even in today's changing marketplace. However, we are concerned that regulatory forces may impede not only our ability to compete but also may stifle competition generally across our securities market.
My purpose today is: (1) to describe how the CSE enables its specialists to compete for order flow by providing them with the technological ability to execute orders efficiently through internalization or some other means, (2) to address whether fragmentation in the securities market warrants market restructuring as contemplated by the SEC, and (3) to recommend two simple regulatory changes that, if adopted, would significantly streamline the operation of the national market system and enhance securities market competition.
Benefits of Internalization
Because of the New York Stock Exchange's ("NYSE") dominance, the simple fact is that Cincinnati specialists have to do a great job pricing executions. We have to offer a better service than the NYSE in order to compete. And our specialists do, in part because internalization has given them more control over execution quality and incented them to develop automated price improvement algorithms. We use a multiple specialist system; we have a preferencing rule for specialists who wish to internalize their order flow; we are the only exchange that provides automatic Intermarket Trading System ("ITS") executions; and we are the only exchange that requires the exposure of market orders for price improvement.
Cincinnati specialists have developed technology which, when coupled with Cincinnati's fully automated trading system, enables them to offer their customers instantaneous executions at prices at or better than the national best bid or offer. The cost structure of Cincinnati internalizers is the lowest in the industry because Cincinnati has eliminated its physical trading floor and because of the efficiencies of internalization. As a result, our specialists can effectively compete for customers by offering some of the lowest commissions in the industry.
At a time when one specialist can no longer provide enough liquidity to stabilize market volatility, internalization encourages broker-dealers to risk their capital in order to provide liquidity to their customers. It incents broker-dealers to invest in technology and to apply their market-making expertise in order to provide investors with what they want: the fastest execution at the best price for the lowest cost. As Charles Schwab noted in his February 20th testimony, "internalization is one of the most effective ways to ensure that customers get reliable, high quality executions."
The quality of Cincinnati's executions was established by a 1997 SEC study ("Preferencing Report"), which is the only recent study that has objectively examined execution quality across all exchanges. The SEC concluded that Cincinnati's frequency of price improvement was as good as, and in some cases better than, price improvement on the NYSE. And our current numbers are still impressive; for example, last month Cincinnati specialists improved the prices of customer orders 40% of the time when the national spread was an 1/8th and 80% of the time when the spread was 1/4th.
In addition, the Preferencing Report found that limit order fill rates on the Cincinnati exceeded those on other exchanges. Limit order fill rates are a measure of the frequency that limit orders are executed on any particular market. On the Cincinnati, over 90% of quote improving limit orders were filled, while on the NYSE, this number was 80%. The high fill rate of limit orders on the CSE extended to at-the-quote limit orders as well. The SEC found that 60% of at-the-quote limit orders were filled on the CSE versus a fill rate of 45% on the NYSE. Recently, these statistics have taken on increasing significance because at-the-quote limit orders are precisely the type of limit order that the SEC believes are most susceptible to isolation in a fragmented market. If, as these numbers demonstrate, internalization increases the fill rate of at-the-quote limit orders, thereby lessening the likelihood that such orders may become isolated, then the Commission's concerns with fragmentation and the isolation of orders may be unfounded.
I would like to emphasize that beyond price improvement and limit order fill rates there are other methods employed by our specialists to improve customer executions. By processing executions faster, charging lower commissions, and providing liquidity greater than the quoted size, Cincinnati specialists have been able to attract an increasing volume of customer orders. Recognizing the value of CSE's innovative market structure, Chairman Levitt, in a letter dated July 3, 1996, to the Honorable Edward Markey, stated that the Commission had found that the Cincinnati's preferencing (internalization) program had, "increased the CSE's ability to compete with other markets without sacrificing investor protection, and thus furthered the objectives of Section 11A of the Exchange Act. The Commission found no evidence that investors' orders were disadvantaged." That is why I am concerned about the proposal that the NYSE is currently promoting. Their proposal would require an internalizing specialist to hand over his customer order to a NYSE specialist, who is the internalizer's competitor, even though the internalizer is willing to provide a faster execution and confirmation for a lower cost at the same displayed price.
There has been no empirical evidence since the Preferencing Report that alters my view that internalization is a positive competitive force. Current arguments against internalization are based on worn-out, unproven hypotheses advocated by market participants that have the most to gain from restrictions on internalization. Since the adoption of the 1975 amendments to the Exchange Act and the establishment of the national market system, the NYSE has been claiming that the elimination of its anti-competitive off-board trading restrictions will harm the market through the rise of fragmentation and internalization in other markets. As I stated earlier, no evidence exists to substantiate these claims. The NYSE's recent anti-internalization proposal may be best characterized as an attempt to control through regulatory action that which they might lose through competition.
Vigorous competition for order flow among multiple linked market centers has been producing significantly better service for public investors. There are some, however, that express concern that competition "fragments" the market and thereby compromises the ability of the investor to obtain the best price. However, I believe that today's securities market is becoming less fragmented rather than more as a result of technological innovation and improved access to market information, all of which have developed through competition. I believe that the remarkable success of Nasdaq -- a market that many consider fragmented in nature -- speaks for itself. With transactions now exceeding two billion shares a day, Nasdaq investors apparently believe that they are being well served, even though Nasdaq dealers predominantly internalize their customer orders.
When competition is permitted to flourish -- which is the ostensible purpose behind the elimination the NYSE's Rule 390 -- exchanges and brokers find ways to improve service and increase benefits to their customers. Referring to the same issues before us today, Federal Reserve Board Chairman Greenspan has testified that: "[F]ragmentation is a necessary consequence of competition. Fragmentation signals the value that investors place on the services and functions offered by competing trading systems. In the long run, activity will migrate to the system that best meets the needs of investors, absent impediments to competition." Imposing limitations on the practice of internalization will hinder CSE specialists in their efforts to best serve their customers in the current fast paced and volatile markets. This is particularly true in light of the fact that we will soon be experiencing a major structural change with decimal pricing, which will only increase the pace of quotation changes and transaction volume. Decimal pricing may obviate many of the perceived concerns related to fragmentation and internalization through an expected narrowing of bid/ask spreads. With this major structural change in the offing, I urge this Subcommittee to counsel the SEC to move slowly in adopting any rules or regulations that impede any competitive practice that benefits investors until such time as we are aware of the consequences of decimal pricing.
The same entities claiming fragmentation also would have you believe that best execution can only be achieved if all orders interact in one place. In cautioning regulators against attempting to rescue long-standing, traditional market players, Chairman Greenspan observed that: "[E]ven the NYSE can be displaced by another as other trading systems take advantage of newer technology to offer greater efficiency or to provide new functions investors value more highly." In the light of day, fragmentation is not a problem; it is merely a pejorative word for competition.
In the SEC's recent release, two of the options proposed to address fragmentation entail the adoption of market structures that, if adopted, will ultimately eliminate competing market centers through the operation of a monolithic market design and thereby stifle competition generally. Whether through a market-wide time/price priority requirement or through a central limit order book ("CLOB"), I believe that the results will be the same. Public investors will suffer because exchanges and broker-dealers will no longer have an incentive to innovate and offer better services at lower costs. In deciding where and when to execute an order, the mix of services which exchanges and brokers use to distinguish themselves -- criteria such as speed of execution and available liquidity -- will be irrelevant and price will become the sole determining factor. Is this monolithic market structure, with its increasing risk of a single point of failure, the type of structure that best serves the American public?
In creating the national market system, Congress stated that: ". . . it is not the intention of the bill to force all markets for all securities into a single mold." Since 1975, nothing has occurred to warrant a change in philosophy. I believe that market structures, such as the CLOB, are antithetical to the American business model. If this hearing were concerned with other competitive industries -- for example, the telecommunications industry -- we might be discussing the length of time we have waited for cell phones or the internet if we still had just one phone company.
I also believe that we make a mistake if we underestimate the public investor and assume that people like you and me cannot make an informed judgment about execution quality simply because all order flow is not interacting in one market or because our broker is also our executing specialist. The customer today has more real-time financial information, more trading tools, and is more sophisticated than at any time in our history. With the advent of the consolidated tape, the SEC order handling rules, and the availability of real-time financial data to every investor, there has never been more transparency and exposure of trading interest, which directly impacts order pricing even if all orders are not interacting in one market. We do not need to impose unproven restrictions on order routing choices -- such as the current NYSE proposal to limit internalization to price-improved orders -- in order to protect investors. Investors are able to make their own order routing decisions based on factors they determine to be important, whether it is a market's enhanced liquidity, lower costs, faster or more reliable systems, or lower rates of failed trades. Competition among multiple market participants, supported by full disclosure and an effective national market system, best serves the public investor.
National Market System Enhancements
There are, however, some things that should be done. I believe that this Subcommittee can best enhance the liquidity, transparency, and integrity of the securities market by insisting on two simple changes to the national market system. First, modify the ITS unanimity requirement in order to free up decision making. And second, significantly reduce the time frames that the exchanges and the NASD have to report trades, update quotations, and process ITS commitments. Today, we permit time frames that were established 20 years ago, and the resultant slowness has affected the quality of the market data on which public investors rely and has limited the ability of brokers to reach across markets to get the best price for their customers.
If these two simple changes were implemented, then I believe that our securities market would become even more competitive. At the CSE, we want to compete and, with our low cost structure and quality executions, we are in a good position to do so. Securities market competition or the protection of public investors will not be enhanced either by restricting internalization or otherwise mandating some centralized market structure.
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