Hearing on Public Ownership of the U.S. Stock Markets


Prepared Testimony of the Mr. Richard A. Grasso
Chairman and CEO
New York Stock Exchange


10:00 a.m., Tuesday, September 28, 1999

Mr. Chairman. Senator Sarbanes. Members of the Committee. My name is Richard A. Grasso, Chairman and Chief Executive Officer of the New York Stock Exchange, Inc. I welcome this opportunity to appear before you this morning to discuss the potential demutualization of the New York Stock Exchange. Clearly, this is an historic step for our 207-year-old institution -- one that involves important public policy issues. At the same time, given the current business environment, I believe it may be critically needed to assure the continued competitiveness and position of the NYSE as the world's pre-eminent equity market.

A properly structured demutualization should strengthen our institution's ability to serve the needs of the investing public in a competitive environment marked by increased globalization and rapid technological change. As is the case with all sectors of the economy, technology is having a profound and dramatic impact on the world's capital markets. Technological advancements have benefited our market, making possible the explosive growth we have experienced over the past 10 years. Our business continues to reach new heights in trading volume, market capitalization of listed companies, and growth in non-US listings. Technology presents us with virtually limitless potential for future growth.

Technology has also given rise to the development of new forms of competition, including electronic communications networks, or "ECNs." These new electronic systems are for the most part owned by well-capitalized, for-profit entities. They are nimble competitors, unencumbered by the membership structures that characterize the primary markets and regional exchanges. Moreover, due to recent regulatory action, they will now have the opportunity to compete with these markets as fully registered national securities exchanges.

To date, ECNs have not significantly impacted NYSE market share. However, to preserve the efficiencies that result from our position as the central market for NYSE-listed securities and avoid the fragmentation that plagues the over-the-counter market, we must have the tools to stay ahead of this changing competitive and regulatory landscape. Demutualization will better align the interests of NYSE owners with those of the Exchange itself and enable us to provide quicker and more innovative responses to competitive challenges. It will also give us access to capital for business enhancements and strategic affiliations which may be needed to compete with private trading systems who enjoy access to large pools of public capital.

Over the years, the NYSE has served investors well by providing a highly liquid, efficient, and transparent market, with a system of self-regulation that is second to none. We do not ask for government intervention or special protective measures to ensure our future. We do ask for your recognition that we are a business in a highly competitive environment and that demutualization could be key to our continuing ability to serve the American investing public.

The NYSE Has Benefited from Technology

For most of the 32 years I have worked for the NYSE, naysayers have predicted that technology would eventually sound the death knell of the NYSE's floor-based system. Actual experience has proved quite the opposite to be true. Technology has been our partner, not our adversary. Over the past decade, we have spent over $2 billion in technology and that investment has, in turn, fueled an unprecedented expansion in our business.

Over the past decade, volume has increased five-fold. In 1990, average daily volume was 157 million shares; today, it is 781 million shares. On September 1 of last year, we traded a record 1.2 billion shares, the seventh time our systems handled over 1 billion shares in one day. By the end of this year, we will have the systems capacity to process over 4 billion shares a day.

Listings have exploded. Over the past 15 years, more than 2,000 of our 3,100 currently listed companies have joined us, including almost 300 non-U.S. companies. The total market capitalization of NYSE listed domestic stocks has grown from 2.7 trillion in 1990, to 11.2 trillion today.

Technology has enabled us to continue to be the world's low cost provider of trading services. Of the total amount paid each year by individual and institutional investors in brokerage commissions for our listed securities, NYSE-related transaction fees and commissions represent only 2.6%. Over 90% of orders sent to the NYSE, and over 50% of the volume, are processed through our electronic order routing system, known as SuperDOT. When a market order arrives electronically over SuperDOT, that order will be executed and returned to the originating broker-dealer, on average, in 22 seconds or less, often with a price that is superior than the nationally displayed quotation.

The cost of institutional equity trading at the NYSE is the lowest among the world's major markets. The overwhelming majority of small, individual investors whose orders are sent to the NYSE receive executions that are virtually free of NYSE-related costs. No trading floor brokerage fees apply to orders sent through SuperDOT of 2,099 shares or less which are executed in less than two minutes. Under a policy recently adopted by the NYSE Board, specialist's commissions on all SuperDOT orders executed in two minutes or less -- already minimal -- will also be eliminated.

Buyers and sellers of securities want liquidity, they want low cost executions, and they want confidence that they have received the best price on their trade. They also want to be guaranteed that the counterparties to their transactions will be financially able to complete the trade. By combining technology with our floor-based auction market, supported by an extensive self-regulatory structure, we have been able to provide investors with all these services. No automated system provides an equivalent product.

As foreign markets begin to demutualize and seek electronic access to the US markets, and as for-profit, investor owned ECNs seek status as national securities exchanges, we have confidence that the NYSE will maintain its pre-eminence as the world's premier equity market. Indeed, we are optimistic that in the next millennium, technology will present us with new opportunities for unlimited growth. To seize those opportunities, however, we must have a competitive structure that allows us to respond as quickly as our competitors to technological change.

New Forms of Competition

Electronic communications networks provide one example of how technology can quickly impact market structure and transform ways of doing business.

The term "electronic communication networks" generally refers to commercially-owned electronic trading systems that seek to link geographically dispersed buyers and sellers of securities. ECNs, also known as "alternative trading systems," can utilize a variety of trading approaches. Some allow market participants to convey firm orders at specific prices to other participants and then execute those orders against matching interest in the system. Others operate "crossing" networks, which allow investors to enter orders against corresponding orders at prevailing market prices. There are currently nine major ECNs, which according to the most recent figures available, account for approximately 20% of volume in NASDAQ stocks and approximately 4% of volume in NYSE-listed securities. These figures are up significantly from 1994, when ECN volume accounted for approximately 13% of NASDAQ stocks, and 1% of listed securities. Significantly, most ECN volume in listed stocks has been drawn from the third market and has not significantly impacted NYSE market share. This brings up a major distinction that I wish to emphasize: while the NYSE cannot be complacent in the face of the changes sweeping the over-the-counter market, the listed market has never been stronger.

ECNs are operated as for-profit, commercial enterprises and are generally owned by large, publicly-traded companies or their subsidiaries. The ownership structure of ECNs gives them potential access to large pools of capital which dwarf the resources of the NYSE and other regulated markets. Attached to my testimony is a chart listing owners of each of the nine major ECNs.

ECNs, because of their relative newness, do not fit neatly into the securities regulatory structure. Although ECNs have been regulated as broker-dealers, as trading systems, they do not fit the mold of traditional broker-dealers. As trading systems, they differ significantly from traditional securities exchanges as well. Unlike exchanges, they bear no self-regulatory obligations, and are not subject to the same requirements regarding fairness, efficiency, transparency and capacity. Unlike exchanges, which, by statute, can be accessed only by registered broker-dealers, ECNs can be accessed directly by investors, whether or not those investors know that none of the traditional protections offered by the public markets are afforded them.

Over the past three years, the SEC has struggled mightily with public policy issues associated with the growth of ECNs. Although ECNs have brought about helpful competition and agency/auction trading into the over-the-counter markets, their operating history raises important regulatory issues. These include questions regarding fair investor access to these private systems; adequacy of their capacity to handle heavy trading volume in times of market stress; adequacy of market surveillance; and perhaps most importantly, issues of market fragmentation. Centralization of order flow is an important component in providing efficient price discovery and assuring best execution for investors. It is difficult for ordinary investors to know if they are getting the best available price for their trades when multiple private markets are providing executions in the same publicly traded stocks.

In an attempt to address these issues, the SEC sought this year to better integrate ECNs into the regulated market structure by amending several key SEC rules (including the definition of "exchange") and adopting "Reg-ATS." Under the SEC's new rules, ECNs can choose to continue to be regulated as broker-dealers, subject to certain additional regulatory requirements, or they can choose to become registered as national securities exchanges. If they chose to continue to be regulated as broker-dealers, they are obligated to disseminate priced orders to the general public in those stocks where they do significant volume; set objective standards for investor access to their systems; and establish procedures to ensure adequate systems capacity, integrity and contingency planning. If they choose to become registered exchanges, they are required to assume the self-regulatory obligations associated with being an exchange, and are subject to the statutory requirement that only registered broker-dealers can be members. However, significant benefits can also accrue if they choose to become exchanges. These include eligibility to receive a share of revenues generated from the sale of market data, and membership in the Intermarket Trading System.

Two ECNs have filed to become national securities exchanges, and at least two others have publicly said that they are considering doing so. Both applications are currently pending before the SEC and it is unclear when the SEC will act upon them. It is also unclear to what extent the SEC will be able to attach regulatory obligations on these ECNs that are truly on a par with that imposed on traditional exchanges.

The Benefits of Demutualization

In adopting Reg-ATS, the SEC specifically recognized that,

With the question of whether national securities exchanges may demutualize seemingly resolved by the SEC, the NYSE is in the process of developing a plan for a demutualization to occur in the Year 2000. To understand why we have undertaken this historic step and the benefits we hope to derive, it is necessary to first review the current structure of the NYSE.

The Exchange is, and always has been, a membership organization. It is currently organized under Section 201 of the New York Not-for-Profit Corporation Law. Notwithstanding the name of that statute, the Exchange is permitted to, and does, make a profit and it is fully subject to corporate income tax at the federal, state and local level. The Exchange's membership consists of 1366 "regular" members, often frequently referred to as "seatholders." (1) Members must be natural persons, but corporations and other entities may beneficially own memberships. To become a member, an eligible person must acquire a seat from a person wishing to sell his or her membership and be approved for membership by the Exchange.

Regular memberships may be analyzed as embodying both proprietary interests and trading rights. The trading rights permit the holder to effect transactions on the trading floor and through Exchange facilities without the services of another person acting as broker. The proprietary rights are those normally associated with the status of a stockholder, viz., the right to vote for the election of Directors and for all other matters that arise at meetings.

Subject to eligibility rights and approval, a regular member has a right to lease his or her seat to a person approved by the Exchange. The lessee is entitled to exercise the member's trading privileges. Voting rights may be granted to the lessee or retained by the lessor, although they are almost universally retained by the lessor. Any distribution of assets of the Exchange must be made to the regular member/lessor. Currently 863 of our 1,366 regular seats are leased.

Under the current ownership structure, NYSE members are only able to realize economic value from their right to trade on the NYSE floor. This fact skews the interests of member-owners toward the value of the floor trading privilege, since they currently have no ability to profit from initiatives that may serve the interests of the institution, but may not beneficially impact the floor trading privilege. The problem is exacerbated by the fact that even among NYSE members, there are diverging interests depending on the nature and structure of each member's business. Some firms market to the retail investor; others, have an institutional investor base; some concentrate on "upstairs" trading; others concentrate on the floor; some offer full service to their customers; other focus exclusively on discount brokerage. Our firms compete with each other; they also compete with us as market makers in listed securities trading over-the-counter. This diversity of interest among NYSE members is a continual source of tension and conflict. At times it leads to careful deliberations and consensus judgment. All too often it can lead to cumbersome decision-making and strategic gridlock.

Under the demutualization plan we currently have under review, NYSE members will maintain a trading right that is coextensive with the trading right that they hold today. They will also receive shares of stock which will be able to separately reflect the value of the NYSE as a business enterprise, giving our members, for the first time, a separate tangible economic stake in the future of the franchise. Though we do not anticipate mandating that members sell a certain portion of their shares, we will structure the IPO to create incentives so that a percentage of their shares are sold to non-member institutions and public investors. By giving current members a realizable equity interest in our market, as well as broadening our investor base, we hope to create a diverse class of shareholders with one, singular interest: the continuation of the NYSE as the world's leading equity market.

The desire to create common interest among owners and thus a governing structure that is more conducive to quick response and innovation has led at least two non-US exchanges -- Australia, and Stockholm - to become for-profit, publicly traded companies. Other non-US exchanges that have announced demutualization plans include London, Toronto, Hong Kong, and Singapore. Domestically, the two markets that appear before you today have decided to move ahead with developing plans for demutualization. The Pacific Stock Exchange is also moving ahead, and the Chicago Board Options Exchange is in the preliminary stages of considering a demutualization. In addition, it has been reported that the three largest futures exchanges: The Chicago Board of Trade; the Chicago Mercantile Exchange, and the NY Mercantile Exchange are actively considering demutualizations and are in various stages of the process.

Exchanges throughout the world are facing increasing competitive pressures from the development of alternative trading systems and the globalization of the equity product. Demutualization offers greater commonality among equity owners and avoids concentration of ownership power in a particular group of exchange participants. It can also be a means to raise capital to engage in strategic affiliations with other markets, or to develop technological improvements or new systems to reposition the market against well-financed competitors.

Notwithstanding the benefits of demutualization, legitimate concerns have been raised about the compatibility of demutualization with the role of the NYSE and other markets as self-regulators. First, it has been argued that the conversion of the NYSE into a for-profit commercial enterprise could threaten the continued adequacy of funding of regulation. Second, it has been suggested that our conversion will create new risks that self-regulation could be used against trading right holders for competitive advantage. Conversely, it has been argued that we may be reluctant to bring enforcement actions against holders of trading rights if they are also major stockholders. Finally, it has been argued that to address these concerns, the NYSE should be required to "spin off" its self-regulatory functions as a precondition to demutualization.

I believe these concerns are well-intentioned but ill-founded. Because of the long-standing importance of market integrity to the NYSE's competitive position, converting to for-profit status will, if possible, strengthen our resolve to maintain the highest standards of self-regulation.

Demutualization Will Strengthen the NYSE's Commitment to Regulation

The NYSE is without parallel in its leadership among the world's equity markets. The market capitalization of domestic NYSE listed stocks stands at 11.2 trillion dollars. The capitalization of the second largest market, Tokyo, is a distant 3.3 trillion dollars.

Central to the NYSE's global pre-eminence is its reputation for market integrity and a strong self-regulatory program. This reputation has contributed enormously to the growth of our market in an increasingly competitive and global securities marketplace. We spent $97.2 million on regulation in 1998, which represented approximately 20% of total NYSE expenditures. Our regulatory staff represents a full third of total NYSE personnel. We forecast spending $110 million for 1999, and perhaps as much as $125 million in 2000 on our Regulatory Group. There has always been competition for resources among the various divisions of the NYSE, and we have an excellent record of assuring that in good times or bad, our regulatory division receives adequate funding.

Our commitment to a strong self-regulatory function is a fundamental part of our long-term ambition for the Exchange: to remain the trusted marketplace of choice. Far from diluting our commitment to maintaining stringent regulatory standards, our conversion to for-profit status will underscore the absolute necessity of preserving our strong regulatory reputation. As new trading venues develop and competition intensifies, strong regulation will be one way of differentiating ourselves from our competitors. The money we spend on regulatory oversight, far from being an impediment to our viability as a publicly traded company, builds equity in our brand, which will have beneficial spillover effects into other market competitors. It will force them to also invest in self-regulation, thus ensuring that public confidence in the fairness of our markets will be enhanced.

The NYSE Has Successfully Regulated Its "Competitors" For Over Half a Century

With the advent of off-board trading in the 1930's, and especially, since the creation of NASDAQ in the 1970's, the NYSE has been in the business of regulating members who are also its competitors. The reality is that the NYSE's major members are also NASDAQ's major market makers. Many of them internalize NYSE-listed orders or direct them to alternate markets for execution. In addition, many of them have made major investments in electronic communications networks.

Conflicts and tension have arisen from time to time, but these have always been resolved in a fair and even-handed way. We have built extensive due process requirements into our disciplinary processes. All our self-regulatory functions are subject to the oversight of our Board and the SEC. We intend to make no changes in procedural safeguards currently available to our members as a result of demutualization, nor do we intend to alter our Board's composition, which consists of 50% industry representation, and 50% public directors unaffiliated with our members. We will also maintain our existing strict and successful fire walls between our examination staff and our policy staff.

Our proposed conversion does not increase the risks of conflicts of interest. Fair and even-handed regulation of our members will always be paramount. Our long-term success depends on the continuing integrity of the Exchange which, in turn, requires our complete objectivity in the conduct of our self-regulatory function. If holders of NYSE trading rights perceive our market as biased they will no doubt take their business elsewhere.

Perhaps the best evidence of the integrity and high quality of our regulatory staff lies in the fact that we have agreements with regional exchanges to conduct their self-regulatory functions with regard to the off-floor trading practices of their members. These regional exchanges compete with us directly for market share in listed securities. Yet they have sufficient confidence in the objectivity of our regulatory unit to entrust us with reviewing our common members for compliance with regulatory standards.

The converse concern that we might be reluctant to bring enforcement actions against securities firms which are large shareholders similarly ignores our long history of vigorous enforcement against NYSE member/owners which have violated NYSE rules or SEC regulations. Without hesitation, we have brought actions against the largest of our broker/dealer and specialists firms when their conduct has so warranted, and would continue to do so post-demutualization.

"Spinning Off" Regulation Would Weaken Investor Protection

The debate over demutualization has stimulated discussion over the continued role of self-regulation. Some, such as my friend Frank Zarb, have suggested that the markets should spin-off their self-regulatory functions into a new, separate regulatory authority. In his speech last week at Columbia University, SEC Chairman Arthur Levitt said he was intrigued by the idea of a single-regulator. While I would not presume to judge the structural changes NASD may wish to undertake in confronting its own competitive challenges, I believe firmly that spinning NYSE Regulation into an unaffiliated regulatory entity would weaken investor protections and do irreparable harm to the NYSE brand.

Since its inception 207 years ago, the NYSE, as a securities market, has had to be in the position of setting rules and standards of conduct for its members. With enactment of the Securities Exchange Act of 1934, Congress formalized the role of self-regulation and made it a central part of the federal scheme for the regulation of the securities markets and their participants. The Securities Acts Amendments of 1975 redefined and strengthened the role of self-regulation in our nation's capital markets. Both the 1934 Act and the '75 Acts Amendments recognized that the markets themselves were better equipped to develop and enforce regulatory systems to deter and prevent wrongful conduct, without intruding unnecessarily into normal and legitimate business practices. Congress recognized that the individuals who designed and actually ran the markets and their systems were in the best position to recognize and address regulatory abuses.

Congress' longstanding commitment to self-regulation has been validated by the success of the NYSE's strong regulatory program. At the NYSE, our self-regulatory duties literally permeate every part of the Exchange. Severance of them would be both culturally and practically, impossible. The costs of regulation at the Exchange are part of our overall budget, and are supported by regulatory fees and other revenue sources. Funding a separate regulatory body independent of the Exchange would eliminate the economic efficiencies and synergies that result from the integration of regulation into the NYSE market as a whole. For example, the introduction of new systems of automated data recording and reporting serves the market itself, aids in the production and sale of quotation and last sale data and also helps to create a regulatory audit trail. Separating the cost of regulatory hardware and software would diminish the economies of scale we now enjoy and introduce inefficiencies.

An independent regulatory body, separately funded by the industry, would not be able to piggyback on market-related systems improvements. The effect of such a separation might well make the orphaned regulatory body more susceptible to financial pressures, and poorly situated to ensure that regulatory considerations are taken into account in the design and implementation of systems enhancements. At the NYSE, key regulatory personnel are involved extensively in Exchange operations, contributing to board deliberations and executive management decisions at all levels. The involvement of regulatory personnel who understand the workings of the Exchange from the inside has been invaluable to the development of trading and information systems and in ensuring the enhanced integrity of our market. Separating them from the Exchange would remove the "cop on the beat" and result in a regulatory staff less knowledgeable about market operations.

Congress embraced self-regulation as an adjunct to government regulation, not as an alternative to "for-profit" regulation. Congress recognized that self-regulation is the least market intrusive means of providing regulatory oversight and certainly more cost effective than government oversight. Self-regulation allows the SEC to fulfill its statutory duties and leverage its resources by sharing the responsibility to enforce the securities laws with the SROs. The late Justice William O. Douglass, former Chairman of the SEC, described the SEC's regulatory powers as being akin to a shotgun, well oiled and primed, ready for use, but kept behind the door when its immediate use was not called for.

For 65 years, self-regulation has worked effectively. Our securities regulatory system is the envy of the world, and self-regulation lies at its centerpiece. The NYSE should not be required to turn its back on this principle as a precondition to demutualization.

The Next Steps

On September 2, the NYSE Board of Directors voted to move ahead with developing a plan for our demutualization, and further authorized the creation of a Board committee comprised of NYSE public directors to work with the NYSE management to resolve outstanding policy and market structure issues. A team of investment bankers at the Financial Institutions Group of Merrill Lynch are providing analysis and recommendations. Our conversion to for-profit status is contingent upon successful resolution of public policy issues; receiving a favorable tax ruling from the IRS on the transaction; and, of course, final approval of the specific transaction by the NYSE Board and by our membership. All aspects of the conversion are subject to review by the SEC, both with regard to our role as an SRO, as well as our role as a prospective applicant for SEC registration of our securities.

Clearly, this is a major step for the NYSE, one that we do not undertake lightly. Assuring the continued viability of the world's pre-eminent capital market requires that we begin down this road. The NYSE has served American investors well. Time and again, our central agency auction market has proven itself to be a highly efficient means of price discovery. By providing narrow spreads, low transaction costs, and stringent self-regulation, we have been able to maintain a dominant market share in NYSE listed securities. This has prevented market fragmentation, giving NYSE customers confidence that when their order reaches our floor, they will receive the best price to be found in that security. We view increasing competition from electronic communication networks as a healthy phenomenon. The challenges they present will only make us work harder to further improve our market and its systems. Anachronistic views of the Exchange as a quasi-public utility have no place in today's world. We are a business in a highly competitive environment. We are determined to take whatever steps may be necessary to ensure that for the next 207 years, we will provide the same high quality of services to American investors that has been our hallmark.

Chairman Gramm, Senator Sarbanes, members of the Committee, we appreciate your interest in our move toward becoming a for-profit, publicly traded company. I hope this hearing this morning has proven helpful in educating members of Congress about the challenges that lie ahead of us and why we believe that demutualization may be crucial to our survival. I would now be pleased to answer any questions you may have.


1 In addition to the regular members, there are a handful of physical access (24) and electronic access (32) members. They have limited, or no, voting rights and they are not entitled to any distribution of Exchange assets on liquidation.

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