Subcommittee on Securities

Hearing on Competition and Transparency in
the Financial Marketplace of the Future

Prepared Testimony Mr. Kenneth D. Pasternak
Chairman and CEO
Knight Securities, LLP

10:00 a.m., Wednesday, April 26, 2000

I am Kenneth Pasternak, President and Chief Executive Officer of Knight/Trimark Group, Inc. I want to thank Senator Grams, Senator Dodd and the entire Subcommittee for giving me this opportunity to testify today.

When my partner, Walter Raquet, and I founded Knight/Trimark five years ago, the securities markets had long been dominated by large, powerful institutional investors. We saw an opportunity to help restore balance--by empowering, encouraging and serving the self-directed individual investor. Our goal is to provide the processing power for the on-line securities trading revolution--to give individual investors the same speed, low cost, and dependability in their securities transactions long enjoyed by institutional investors. And unlike traditional Wall Street market-makers, we are committed to offering the same efficient, dependable service, whether people wish to trade a single share of securities or a thousand shares.

As you know, the popularity of on-line trading has surpassed all expectations--including ours. More than a third of individual investor transactions now occur over the Internet. Our company quickly became the leading destination for on-line trade executions.(1) As a result, within three years of our founding we were the largest market-maker in Nasdaq and non-Nasdaq securities. In fact, in the first quarter of this year we handled almost 20 percent of dealer volume in Nasdaq and other over-the-counter securities. Numerous competitors have also thrived, and, like us, they have done so by recognizing the importance of self-directed individual investors and focusing on their needs.

The largest, most established Wall Street firms are primarily focused on serving institutions. They have long regarded "retail customers"--their name for individual investors--as second-class citizens. Nevertheless, the self-empowered individual investor today is the driving force in the securities markets. Because our company and others are vigorously competing to serve these investors, they now command services and market access that were unimaginable at the time we founded our company.

The Securities Markets Revolution

Let's suppose that today's date is April 26, 1995--instead of April 26, 2000--and that we are gathered here to debate the same market structure issues. And let's also suppose that I testify to the following:

First, I assert that, over the next few years, millions of Americans will demand the ability to enter orders to buy and sell securities from their personal computers, twenty-four hours a day. And they will further demand the ability to trade from the beach or on the road, using small, wireless hand-held computers that fit into their pockets.

Second, I tell you that these same investors will insist on paying as little as five dollars per trade.

Third, I assert that Americans will demand that their entire order, irrespective of quoted size, be executed and confirmed to them in a matter of seconds.

Fourth, I tell you that so many Americans will soon demand so much liquidity in the securities markets that trading volumes will be measured in billions of shares traded each day.

And finally, I testify that, to inform and facilitate their trading, individual investors will demand to receive real-time market information, delivered instantly to their homes and hand-held computers.

Had you heard this testimony five years ago, no doubt you would have dismissed it as highly unlikely--even though all of these things have indeed come true. The securities markets have been transformed by the overwhelming popularity of on-line trading. Daily volumes in listed and over-the-counter trading are measured in billions of shares. And these things have come about because millions of Americans are seizing new opportunities to participate directly in the securities markets.

At the same time, they are demanding and receiving better and cheaper service to help them do it. For example:

Transaction costs for individual investors are at historic lows, with continuing downward pressure.

Market centers like Knight have invested millions of dollars in sophisticated technology to accelerate and increase the reliability of the execution process. In fact, we plan to spend another $100 million within the next twelve to eighteen months on technology.

On-line brokers now provide individual investors with free or low-cost on-line research and market information that was simply unavailable to them a few years ago.

And perhaps most importantly, the market now provides even the smallest investor with instant liquidity at the best price available. At Knight/Trimark, we commit millions of dollars of our own capital every day, so that whether the investor wants to trade shares of Microsoft or an obscure over-the-counter issue, buy and sell orders are executed in a matter of seconds, at low cost and at the best price available.

These dramatic enhancements in the marketplace have occurred not due to our company alone, but because of vigorous competition among many companies pursuing the individual investor's business. In our eagerness to serve the self-directed investor, we and our competitors are continually lowering prices, committing capital, improving service and investing in new technology--all for the benefit of this newly empowered investor.

"Do No Harm"

The secondary trading markets are instrumental to the capital formation process in this country as they allow large numbers of individual investors to share in the risks and benefit from the rewards of a vibrant economy. Indeed, I would argue that the ability of this country's securities markets to allocate capital efficiently among competing uses has greatly contributed to this country's unparalleled recent economic expansion. Therefore, the outcome of debates relating to market structure will have profound implications not just to the securities markets themselves, but to this nation's economic future.

In responding to proposals for a so-called Central Limit Order Book--which would effectively become a monopoly securities market--my first plea, echoing Senator Phil Gramm and Federal Reserve Chairman Alan Greenspan, is to heed the medical profession's Hippocratic Oath: "First, do no harm."

The existing market structure encourages vigorous competition among different market centers--each offering their customers a different value proposition. At Knight/Trimark, as a large-scale market-maker and processor of trades, our value proposition is to offer a combination of enhanced liquidity, speedy executions, price improvement, and dependability in trading 18,500 equity securities, as well as in trading options, equity indices, fixed income instruments and many commodities. We enable our immediate customer--the on-line broker--to guarantee investors superior service, as well as low cost.

Is our company's trade execution service the very best available? For the typical self-directed investor, we certainly think so, but the marketplace will be the final judge. Only the marketplace can determine which company offers the superior value proposition for each type of investor.

There is no question, however, that robust competition in the marketplace is the best way to deliver optimal benefits for the investor. As Securities and Exchange Commission Chairman Arthur Levitt told the Economic Club of Washington this month, a market structure with multiple market centers competing with one another for business results in faster, cheaper and higher quality executions of customer orders.

By the same token, the dramatically different market structure that has been proposed--a monolithic single market imposed by government decree--would surely result in slower, more expensive, lower quality executions for individuals. Its sole benefit would be higher profits for the handful of Wall Street institutional brokers with the largest trading desks. Call it a Central Limit Order Book, a black box or whatever name you wish, a single monopolistic system would be antithetical to free and fair competition among companies and market centers seeking to serve the investor.

Why Fragmentation is a False Issue

I can understand the concerns voiced by some market participants that the existence of multiple market centers creates isolated pools of investor orders, thereby reducing market efficiency. Let me explain, however, why these concerns about so-called market fragmentation are misplaced.

First, let's bear in mind an important principle that we have learned in recent years: Advancing technology batters down barriers and democratizes access to information. Technology has already produced dramatic improvements in market efficiency--and it will continue to do so.

Secondly, the securities industry's rapid consolidation in recent years has resulted in certain markets that are less fragmented than at any time in recent history. In the Nasdaq market, for instance, the top five market participants now account for approximately 60 percent of customer transactions, compared with 40 percent ten years ago.

The mere fact that scores of electronic systems are seeking to become ECNs or ATSs does not signify a fragmented marketplace. As Chairman Greenspan testified to this Subcommittee recently: In the long run, unfettered competitive pressures will foster consolidation, as liquidity tends to centralize in the system providing the narrowest bid-offer spread at volume. To a significant extent, this consolidation already has occurred in Nasdaq.

I strongly suspect that those voicing the most concern about market fragmentation are really opposed to greater market competition. I also suspect that the call for "market reform" by some of these market participants is really a euphemism for "Let's turn back the clock": Let's turn it back to the days of $300 commissions, slow executions, inefficient technologies, and less competition to serve the interests of the individual investor.

To those who would return to that bygone era of charging investors fat commissions for the privilege of receiving indifferent service and minimal information, my response is this: The days of short-changing retail investors are over! It's time that we all compete just as hard as we can to empower and to serve the individual investor. It's time that we help individuals participate in the amazing benefits of our capital markets, so that they in turn can help deepen those markets and make them even stronger.

And to those who assume that best execution would be almost guaranteed in a centralized market, my response is this: Investors should not have to sacrifice the benefits of an innovative, dynamic marketplace merely to make the fiduciary's job a little easier. Investors are not only focused on the price at which an order is executed. In many cases, speed, enhanced liquidity and certainty of execution are also important priorities. To eliminate competition, to narrow the markets to a one-size-fits-all approach, would be to pander to the narrow interests of certain market participants, while denying investors many important options. Besides, in the end one must ask: How good would even the best execution be in a marketplace devoid of real competition?

One final thought on the issue of market fragmentation: As one whose company has been built upon supporting market participation by individuals, I can tell you that individual investors who send in orders for 300, 400 or 500 shares now provide the market with so much liquidity that even the largest institutional investors are being forced to access that liquidity directly.

This is why the securities market paradigm is shifting. The market centers processing the order flow from self-directed individual investors are increasingly those providing the highest quality price discovery and the greatest liquidity. The individual investor increasingly controls market prices, not the institutional investor or the institutional brokerage firms.

The issue, then, is not that the marketplace has become more fragmented; it has not. The issue is that liquidity patterns are changing and creating a more level playing field for individual investors. The reason we are having this debate about market structure is that these changing liquidity patterns have eroded the advantage long enjoyed by institutional investors and by the large Wall Street brokerage firms that cater to them.

This change is healthy, and it is no reason to stifle competition. In fact, the changes in the marketplace demonstrate that our existing regulatory framework is working and will continue to deliver impressive, tangible results for all investors--individuals and institutions alike.

Market Transparency

Now, let me address two other issues--market transparency and payment for order flow. Again, let me remind you of another time-tested principle: The regulation of U.S. securities markets--arguably the most enlightened in the world--has always rested on the precept of full and fair disclosure. That is, by providing all investors--not just market professionals--with clear, adequate information, we empower them to make intelligent choices among all the available options without unnecessarily stifling competition or innovation.

SEC Chairman Levitt has called for a voluntary private sector initiative to make limit order books available to the public, while Commissioner Laura Unger recommends that all market centers be required to provide uniform information on various best execution factors. Both of these recommendations would improve market transparency, and both should be adopted. Better informed investors are more likely to participate in the capital formation process, making our securities markets even deeper and more liquid in the process.

There is no justification for the age-old practice of market professionals walling off access to important market information. It is neither fair to individual investors, nor healthy for the marketplace. All investors should be provided not only with quotation and trade information, but also with the limit order files of the various market centers and with information that objectively measures the quality of execution at those market centers.

Chairman Levitt's recent call for a voluntary private sector initiative to improve the transparency of limit order books across all markets is vital to ensuring that investors receive the benefits of intermarket competition. Knight/Trimark wants to ensure that limit order information becomes available to the individual investor, and we look forward to working with the SEC and other securities market participants to that end.

Commissioner Unger's suggestion is equally important. If investors themselves had the information to identify which market centers have superior execution standards and trading protocols, their orders inevitably would receive better execution. At Knight/Trimark, we have begun publishing our execution standards and protocol on our website. We will soon begin publishing execution results as well--including price improvement rates, enhanced liquidity rates, immediacy rates, and price disimprovement rates--and we encourage all of our competitors to do the same.

Knight/Trimark will soon put its rebate schedules on its website for all to see, and we would welcome a chance to work with regulators, competitors and others to improve industry standards and perhaps develop a third-party rating system.

Payment for Order Flow

Next, let's turn to the practice of payment for order flow. It has been the subject of incessant debate because it obviously poses a potential conflict: If a market center like ours gives brokers cash rebates or other inducements, how can the investor be sure that an order will receive the best possible execution?

Incidentally, I find myself in the strange position of defending a practice that costs my company an enormous amount of money. Last year, we rebated nearly $139 million to our broker-dealer clients who sent us their order flow. What our client firms did with that money is a question best answered by them, but no doubt they would tell you that, because of those rebates, their customers paid lower commissions, received more free real-time market data, and more free technical and fundamental analysis of more and more securities.

Let's begin by acknowledging that the securities industry is rife with conflicts. Besides payment for order flow, why not debate the wisdom of combining the broker and dealer functions in one company; or of allowing securities firms to both underwrite securities and issue research reports on them? After all, the most conspicuous conflict on Wall Street is that broker-dealers habitually recommend the purchase of securities for which they also make markets. Once again, the solution to such conflicts is not to disallow them--which would do severe damage to the efficiency of our capital markets. Rather, it is to insist upon full and fair disclosure.

Payment for order flow should be approached in a similar light. Indeed, the SEC debated the issue in the early nineties and concluded that full and fair disclosure was the right approach. By giving investors high-quality, real-time market information and execution results, by providing them with a clear explanation of each market center's policies, procedures, execution standards and trading protocols, and by fully disclosing any practice that might be considered a conflict of interest, we empower them to make intelligent choices among all of the available options.

The cash rebates paid by our firm have important benefits for the investor. They give us the volume of order flow we need to guarantee fast, dependable order execution at the best available price in over 18,500 securities. Outlawing the practice would eliminate investor access to immediate liquidity for any securities they wish to trade. Rather than denying investors this access simply because of a potential conflict, it would be far better to ensure that they have the information and the tools they need to detect evidence of inferior service.

There is strong evidence that cash rebates are not adversely affecting firms' order routing decisions. For instance, some firms that do not accept cash rebates route their customer orders to my firm and receive the same quality executions as firms that do accept cash rebates. The real power that brokers possess is not the ability to demand cash rebates, but rather, to demand higher quality executions for their customers. On-line brokers are able to assert the power of many with the voice of one. My clients constantly look to my firm to find innovative ways to improve the quality of our executions for their customers. This competitive pressure has resulted in guarantees that would have been unheard of a few years ago, such as, guaranteed automated price improvement, guaranteed executions greater than the quoted size in a matter of seconds, and mid-point pricing at the opening of the market and IPOs.

Let me also point out that cash rebates are not the only form of inducement for order flow. To truly understand this issue, one also needs to examine reciprocal order-routing and clearing arrangements; soft dollars; directed brokerage; and commission recapture programs--where institutions and their advisers receive rebates in the form of cash, research or brokerage services in direct relation to the amount of order flow sent to a broker-dealer.

The accepted broker-dealer practice of executing orders internally poses the same potential conflict. How can investors be assured that each order will be executed quickly and fairly when the broker is, in effect, trading against them?

In each case, the solution to perceived conflicts lies in full and fair disclosure. Again, we would welcome an opportunity to help improve industry standards and practices.


My purpose today is to urge Congress not to turn back the clock. We are only at the beginning stages of a stock market revolution that empowers individual investors, encourages them to participate in our capital markets system, and challenges my company and our competitors to serve them better.

A Utopian might envision a securities market completely free of intermediaries and transaction costs, one that also provides unlimited liquidity and exhaustive market information. However, a centrally planned and controlled marketplace would certainly bring us no closer to this vision, nor to meeting the rising demands of the American investor.

By promoting vigorous competition among competing market centers, our existing market structure has not only adapted to changing market patterns; it has delivered spectacular results for the public. It has promoted unprecedented innovation and service for investors. It has helped to revitalize our markets and preserve their status as the envy of the world. On behalf of our customers and the individual investors of America, I ask you not to kill competition in the securities markets, but to preserve and promote it.

Thank you.


1 Knight/Trimark Group, Inc. consists of three large market-making subsidiaries. These include Knight Securities for Nasdaq and non-Nasdaq OTC securities, Knight Capital Market (formerly Trimark Securities) for Third Market securities, and Knight Financial Products (formerly Arbitrade) for options market making.

Home | Menu | Links | Info | Chairman's Page