Good Morning. Chairman Enzi, Senator Dodd and members of the Subcommittee on Securities and Investment, I thank you for the opportunity to comment on the implementation and future of the decimilized market. My name is Peter Jenkins and I serve as Managing Director and Head of Global Equity Trading at Zurich Scudder Investments. Zurich Scudder Investments manages nearly $400 billion in individual accounts, institutional portfolios and mutual funds, as well as private equity, private debt and hedge fund assets. Our clients include individuals, institutions, corporations, retirement funds, pension plans and insurance companies. It is important to note that while Zurich Scudder Investments, as well as other mutual funds, are correctly viewed as institutional investors because we frequently execute large sized-orders, we are acting on behalf of the millions of individual investors who put their trust in us to invest their money.
As a trader for the last 21 years, I speak today on behalf of Zurich Scudder Investments, though the views that I express are shared by the Investment Company Institute, as well as many of my colleagues on the buyside. My comments today will illustrate some of the practical frustrations we as institutional traders face daily. I submit that the suggestions I offer will enhance overall market efficiency, which, in turn, will benefits all market participants and U.S. consumers.
As a preliminary comment, I would like to point out that I strongly support the move to decimal pricing in the U.S. securities markets and the trading of securities in minimum increments of one penny. The move to smaller trading increments reduces the spread in securities, which in turn will result in benefits to our shareholders. In addition, the implementation of decimalization has enabled the pricing of securities in the United States to conform with securities markets around the world. Most institutional traders, such as myself, are continually adjusting to the new trading environment and we are already seeing the development of competitive products to help us cope with the change.
Some critics have contended that the problems that market participants are facing since the move to decimalization have arisen solely as a result of that move. I do not believe this to be the case. Instead, I would suggest that many of those problems are the result of the underlying structure of the securities markets on which we trade. Decimalization has simply brought these longstanding issues to the forefront, thereby highlighting the urgency of addressing several unresolved market structure issues. These include the need for the display of a meaningful depth of limit orders by both specialists and market makers; the need for priority rules for orders entered into the securities markets; and the need to address problems arising from the internalization of orders. I have long advocated that with the move to decimals, we need greater transparency and increased electronic access to the floor. Since decimalization, there are many more transactions, yet overall trading volume has not been affected. Furthermore, the depth or amount of shares on the inside market has been reduced.
Candidly, I should note that most of the difficulties that I have faced since decimalization have occurred while trading on the New York Stock Exchange (NYSE). In contrast, we have had few such problems when trading securities on the NASDAQ Stock Market, due largely to the fact that electronic communications networks (ECN’s) have offered efficient access and have allowed traders to deal in smaller increments while at the same time retain control over order flow.
To their credit, though, the NYSE has taken some bold steps to address these emerging market issues, including the implementation of the "Network NYSE," a program that offers a limited degree of transparency and connectivity for both institutional and retail customers. Furthermore, I commend the Exchange for attempting to address some of the unintended consequences of decimalization by introducing two initiatives – Depth Condition and Depth Indicator – to increase transparency and improve the communication of market depth in a decimal trading environment, and by allowing users to view the entire NYSE electronic limit order book.
However, since the implementation of decimalization on the NYSE, the execution of large orders has actually been hampered by the reduced transparency of orders on the Exchange’s limit order book and by increased instances of market participants stepping ahead of orders by increments of as little as one penny. The net effect has been for the institutional trader to lose control of his/her order flow, since no effective tools exist in the NYSE listed market to reach the market efficiently. The "upstairs" trader does not have the time to negotiate trades as quotes change rapidly. This lack of control has led the "upstairs" trader to expose less to the Market for fear of being "front run" for a penny (See Attachment A).
Examples such as this have created a disincentive for market participants to enter orders of any significant size into the Exchange. As a result, an increasing amount of order flow has left the Exchange and been directed to alternative markets where institutions face less of a risk of having their orders stepped ahead, further fragmenting the listed market.
These problems are not due to decimalization. They result from the fact that the NYSE does not provide sufficient protection to the orders that I -- and other institutional traders -- utilize in trading large amounts of stock. Today, when an electronic order is sent to the exchange via Super-Dot (an electronic order-routing system that links member firms to specialists' posts on the trading floor,) the order is first exposed to the brokers on the floor who surround the specialists post prior to actually interacting with the Limit Order book. This technique is called "an attempt at price improvement." If an electronic order is small, it may in fact receive price improvement. If, on the other hand, the electronic order is large, the specialist may first allow the crowd to interact with the limit order prior to execution of the trade.
These hidden orders in the "pockets" of the floor brokers gain standing. When an institution attempts to interact with limit orders on the book, most institutional traders feel this exposure to the crowd is unnecessary. If the "upstairs" trader were able to interact with the limit order book without delay, floor brokers might be compelled to make instantaneous decisions and not use limit orders as options. In order to resolve these problems, institutions must have facilities for the automatic execution of large orders on the Exchange and the ability to trade large orders without subjecting those orders to the price improvement mechanisms.
These remedies to the problems that institutions are facing were recently included in a letter from the Investment Company Institute (ICI) to the NYSE, which I have attached as part of my official statement (See Attachment B). In this letter, the ICI recommends changes to the NYSE’s new system to facilitate the ability of institutional investors to trade large orders on the Exchange ("Institutional Xpress"). Specifically, the ICI recommends that large orders eligible for execution in that system should not be permitted to be represented by specialists to the crowd on the floor of the Exchange. In addition, the orders do not become expressible until it is on the best bid or offer for a time period of thirty seconds. This should be changed, to enhance efficiency, there should be no time limit. Institutional Xpress also requires that an order be at least 25,000 shares in size- this number is too high. Furthermore, Institutional Xpress should be able to reach through the offer to get to the available liquidity pool. These are all significant concerns that must be addressed.
While the NYSE and the specialists will tell you that they are benefiting investors by providing price improvement, I, along with my colleagues on the buyside (would gladly forego this price improvement, which can be as little as a penny in a decimal environment, to receive protection for our displayed orders. By making this change to the Institutional Xpress system, the NYSE has the opportunity to promote the placement of limit orders on the book by providing protection for, and rewarding the placement of, those orders and attracting order flow. These improvements that I suggest will serve to increase the depth and liquidity of the market.
More importantly, though, the changes I suggest- both a stronger limit order book and greater transparency- will result in enhanced liquidity for all users of the NYSE. Greater liquidity enables more cost-effective execution. It follows that the more transparent the market is, the more informed decisions an investor can make whether he/she is an institutional trader or a retail customer.
In closing, I want to stress that I have worked with the NYSE and other exchanges directly for many years to voice my opinions - along with those of my competitors - on how best to provide institutions the liquidity we need to perform effectively on behalf of our clients’ portfolios. These changes I suggest do not pose a threat to the NYSE. In fact, these enhancements will offer the ability for both institutions and retail participants to transact more efficiently and at the best price.
I thank you again for this opportunity to testify, and I am pleased to answer any questions you may have.
Example of "Penny Jumping" and Problem of Executing Institutional Orders
A stock is quoted at $20.00 - $20.20 on the NYSE. ABC mutual fund places a limit order to buy 50,000 shares of a stock at $20.00 on the specialist’s book. A trader at XYZ mutual fund now gets a sell ticket from a portfolio manager for 50,000 shares of the same stock and the trader at that fund enters a sell order for 50,000 shares at $20.00. The specialist and the brokers in the crowd see that 50,000 shares are about to trade at $20.00 and a floor broker chooses to "price improve" the XYZ Fund to $20.01 and the XYZ Fund sells their stock. This process goes on for some time and eventually the best offer becomes $20.18. ABC Fund, now tired of continually being unable to buy stock at $20.00, enters a new order to buy his 50,000 shares at $20.18, at which point the same floor broker "price improves" them to $20.16 and sells them 50,000 shares.
The bottom line is that a trade that was about to happen between two institutions at $20.00 is broken up under the auspices of "price improvement." While XYZ Fund was price improved by a penny and made $500 for their shareholders, it cost ABC Fund’s shareholders $8,000 more to execute their trade (with the floor broker making $7,500 in the process). In addition, while ABC Fund provided a benefit to the marketplace by placing a limit order on the Exchange and setting the best bid, they derived none of the benefit.
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