Chairman Grams, Ranking Member Dodd, and Members of the Subcommittee:
I am pleased to testify on behalf of the Securities and Exchange Commission ("Commission") concerning structural issues presented by the dynamic changes occurring in our markets. Today, the forces of competition, technology, and globalization have converged to spur innovation and to transform the way business is done in the securities industry. Although these forces have been enormously beneficial in many ways, they raise pressing challenges for the Commission and our markets -- the proposed demutualization of exchanges; the impact that greater competition is having on order flow, liquidity, and execution costs; the imperative to enhance the linkage of market centers; and more broadly, the question of whether the markets can provide investors with the efficiency of greater centrality without sacrificing competition and innovation. This testimony is intended to provide the Subcommittee with a survey of the landscape that the Commission and the securities industry will be navigating in the coming months.
Our purpose, as we face these challenges, remains clear -- fair and orderly markets that allow for efficient capital formation, while protecting the interests of investors. We cannot forget it is the interests of investors that ultimately must guide the Commission's actions, not the interests of individual market centers or their participants. When all is said and done, markets exist to act as intermediaries for the investors they serve. Any rules or practices that place the interests of intermediaries ahead of those of investors should not be part of the future of the securities markets.
I. THE COMMISSION'S ROLE AND MISSION
What should be the role of the Commission in the development of the marketplace of the future? Our role is to maintain and monitor a framework in which fair competition can flourish, and to assure market integrity. It is not now and has never been to dictate the ultimate structure of the markets. As we have for the past 65 years, we expect the markets themselves to develop workable solutions. Our markets have not achieved their great successes as a result of government fiat, but rather through efforts of competing interests working to meet the demands of investors and to fulfill the promises posed by advancing technology. We approach regulation of the markets in this way for a very simple reason -- it best serves the interests of investors.
Twenty-five years ago, the marketplace consisted of a number of different exchanges and dealers -- some large, some small. Each operated separately, attracting what order flow it could. The difficult task of determining where the best price was across these many different markets fell on brokers. Although this system had served our nation well in many respects, it became clear that a national market system would never come to fruition. Transparency of quotes would never prevail. Healthy price competition would never become part of a normal business day.
So, in 1975, Congress called on the Commission to facilitate the creation of a national market system to foster greater competition. This framework included three central components. The first was transparency -- exchanges and broker-dealers would publish both the prices at which they were willing to trade, and the prices at which stocks have traded. Second, linkages between exchanges would assist customers in obtaining the best prices available for their orders in any market, wherever first routed. And third, brokers would remain obligated to seek best execution of their customer orders.
Twice in recent years the Commission has promulgated rules to reinforce the framework for competition. An investigation of the over-the-counter ("OTC") market had revealed that quoted spreads were artificially wide and that a two-tiered market had developed. Market makers were trading within the spread in electronic communications networks ("ECNs") not accessible to the general public. In addition, customer limit orders that would have narrowed spreads were not publicly displayed by broker-dealers. To remedy these structural flaws, the Commission adopted the Order Handling Rules, which required that customer limit orders in all markets be publicly exposed and two-tiered pricing eliminated.(1) In the OTC market, a single public quote stream developed which, among other things, gave ECN quotes greater public exposure. Competition from ECNs energized the OTC marketplace.
At the same time, the proliferation of ECNs highlighted the need for an approach to regulating the new market centers that embodied both flexibility and accountability. To address this need, the Commission adopted Regulation ATS,(2) which created a new regulatory regime for these alternative trading systems ("ATSs"). It extended basic market responsibilities -- such as quotation display, systems capacity, and fair access -- to all significant market centers. It also allowed exchanges to innovate more freely and, in doing so, responded to the competitive changes in the markets brought on by advancing technology.
In sum, the quality of our markets today has never been higher. Investors have unprecedented access to information about securities and trading. As a result of the joint efforts of the Commission, the SROs, and market participants, investors enjoy narrower spreads, lower execution costs, and faster execution speeds. Yet the markets are in the midst of dynamic change. New market participants are emerging like never before. Liquidity, while not decreasing, must at times be sought in new places and in new ways. It is incumbent on us to facilitate the development of a market structure that best assures that these changes benefit the U.S. securities markets as a whole. If we do not, today's global marketplace always stands ready to offer alternatives that are more responsive to investor needs.
II. COMPETITION, FRAGMENTATION, AND MARKET LINKAGES
The success of the U.S. securities markets has been achieved through a structure that has encouraged vigorous competition between market participants in meeting the needs of investors. Many of the innovations and advances we've seen in our markets are the product of this competition. Nevertheless, the principle of centrality also is an essential element of providing an efficient marketplace. The Commission historically relied on the framework of the national market system -- transparency, in particular -- to reduce some of the most harmful effects of fragmented markets.
Specifically, exchanges and market makers are required to publish the prices at which they are willing to trade. These quotations, as well as reports of securities transactions, are disseminated to the public in a real-time stream of consolidated information.(3) In addition, brokers are required to seek best execution of their customers' orders and, to facilitate this, linkages have been established that provide one market center with the ability to access the quotes of another market center. The Commission's Order Handling Rules and Regulation ATS both were designed to ensure that the development of private electronic trading markets contributed to and did not undermine these national market system goals. Consolidated quotes and transaction reports, in short, link the separate pools of liquidity that make up the national market system.
Nevertheless, some have voiced the concern that heightened competition has resulted in a fragmented marketplace. The tension between centrality, on the one hand, and competition, on the other, is probably the oldest of all market structure issues. Centralized markets ensure maximum interaction among orders. They also facilitate the representation of complex orders, including undisclosed orders, which provides the possibility of "price improvement" to all orders. And, as a practical matter, centralized markets help brokers to achieve "best execution" for smaller orders. The substantial benefits of centrality are evidenced, for example, by the liquidity and narrow spreads of the NYSE's market.
In contrast, a market structure that permits competing markets to develop allows much greater participation by dealers, which arguably leads to more sources of liquidity. It also may lead to faster and more efficient executions of smaller orders, often in sizes larger than the published quote, as a result of vigorous competition to gather and retain order flow. Further, competition encourages innovation.
Linkages between markets represent one of the principal tools for achieving both centrality and competition. The less close the linkage between markets, the greater the potential that different markets may be trading the same securities at different prices. If we hope to be fair to smaller investors in our markets, we can't afford inferior executions for these investors. In addition, unnecessarily fragmented markets create transaction costs even for sophisticated investors who must expend resources searching out the best prices. All investors benefit from an efficient market that reduces their total trading costs (which include both explicit trading costs, such as commissions and other fees, and implicit trading costs, such as the effective, as opposed to the published, spread between buying and selling interests).
Linkages, of course, are not merely sound policy; they are an essential element of the Exchange Act. To guide the Commission in establishing a national market system, Congress stated that one of its principal goals is "the practicability of . . . executing . . . orders in the best market" and that the means, generally, of achieving that goal is "the linking of all markets . . . through communication and data processing facilities."(4) Congress determined that such linkages, among other things, foster efficiency and enhance competition. The tremendous success of the U.S. securities markets since Congress directed the Commission to establish a national market system in 1975 amply demonstrate the wisdom of this congressional determination.
The specific features that should be incorporated into market linkages, however, raise many questions. There is no single, cookie-cutter solution to the problem of creating linkages that strikes the proper balance between centrality and competition. The complexity of the securities markets themselves defies such a simplistic approach. Different securities have different trading patterns. Some are heavily traded and have very narrow spreads between the published best bid and offer. Other securities have less of a following and a correspondingly less liquid market. In these less active securities, dealers provide a particularly needed source of liquidity.
But there are not only differences between securities. Investors as well have different needs and objectives. There are important differences in trading strategies, and the same investor may have different needs for different types of trades. Sometimes an investor's highest priority may be fast and inexpensive executions at whatever is the best price available at the time. At other times, the investor may be less concerned with timing and, instead, attempt to "work" an order to get a better price than is currently available.
The securities markets must be sufficiently flexible and robust to serve, to the greatest extent possible, the varied needs of all investors in all securities. The Commission's goal is not to settle on and impose a single solution, but to assure that the structure of the markets offers investors a wide range of services. In sum, linkages between competing market centers should provide investors with a broad range of options to meet their trading needs.
Not surprisingly, competitive forces are driving market participants to explore creative new alternatives for investors. Some have suggested that advancing technology now has made it possible to develop mechanisms that would greatly expand the opportunity for investors to take advantage of centralized order flow. We cannot afford to ignore the possibility that aggregating limit orders across markets and rewarding those that post the best price first would produce better prices for customers. In addition, several SROs are working on new market structure models that would provide closer links between market centers. One example is Nasdaq's recent "SuperMontage" proposal. Among other things, the proposal would simplify order delivery and execution. It would also allow -- but not require -- Nasdaq participants to display more of their customers' limit orders on the Nasdaq screen. Specifically, the Nasdaq screen still would show all the information it does now, but also would show the top three levels of what would become the Nasdaq "book." These levels would aggregate all quotes by price. The Nasdaq proposal soon will be published for public comment.
Finally, there may be ways to achieve some of the benefits of centrality through enhanced broker-dealer order-routing systems. Commercial systems for broker-dealers recently have emerged that include sophisticated algorithms for automatically routing investor orders in a security to the best market. These systems are linked to the various market centers trading a security and are programmed to incorporate many of the different factors that are relevant to a broker-dealer in handling an order. Like formal intermarket linkages, these systems help a broker-dealer to fulfill its best execution obligations and may provide a supplement to such linkages.
Even aside from the potential for new systems and linkages, the Commission expects market participants to develop a way to integrate alternative trading systems into the existing quote and linkage mechanisms for listed securities. While there is room for separate market centers, access must not be frustrated by unreasonable fees or other barriers that have an anticompetitive effect. The existing impediments to fulfilling the Commission's mandate that alternative trading systems publicly display, and allow access to, their best priced orders in securities - including listed securities - must be addressed.(5)
The options markets present another important linkage issue. Today, it is clear that the technology exists to allow the options exchanges to develop better linkage systems than those that have existed for years in the equity markets. Such systems would enhance the opportunity for brokers to achieve best execution of their customers' orders. To further the development of linkages among the options markets, the Commission last week issued an order requiring the existing markets and requesting the International Securities Exchange (whose application for registration as an exchange is pending before the Commission) to develop an intermarket linkage plan for multiply-traded options and to submit this plan to the Commission within 90 days.(6) The Commission expects the options markets to act promptly and make rapid progress in developing and implementing this plan.
III. ECN FEES
An issue closely related to linkages is the fees charged by ECNs in the Nasdaq market. Under the current structure of that market, ECN access fees are not subject to the same competitive pressures as other forms of compensation. Unlike market makers, ECNs do not trade as principal. Instead, when an ECN matches two subscribers' orders, it charges both those subscribers a fee for acting as agent. At the time ECNs were integrated into the Nasdaq market by the Order Handling Rules, the Commission decided to permit ECNs to extend their fees to non-subscribers when they accessed an ECN's best-priced orders through SelectNet. ECNs are permitted to charge these access fees even though other market participants are not.
Many have argued that ECN fees are inconsistent with the requirement set forth in Regulation ATS that alternative trading systems not set fees that effectively create barriers to accessing their quotes.(7) In fact, officials of at least two ECNs have stated publicly that they believe ECN fees should be eliminated.(8) This is one possible solution, although we need to remain mindful of the positive competitive force that ECNs have been in their current form. Moreover, this would preclude an ECN from charging nonsubscribers for access to the ECN's liquidity. Alternatively, rather than eliminating fees altogether, ECNs could be required to reduce fees to levels that may be more consistent with open access to their trading platforms. This would at least minimize whatever distorting effect such fees have on the market. Finally, a third possibility is to require ECNs to incorporate their fees into their public quote. Because, however, the minimum trading increment is so much larger than the fees charged by ECNs, this solution would have to wait until the Nasdaq market converts to decimals. In sum, ECN fees represent yet another knotty market structure issue that will require close attention and creative thinking by the Commission and the securities industry to resolve.
IV. AFTER-HOURS TRADING
The after-hours market is another area with a great need for improved linkages and transparency. The good news is that technological advances and flexible regulatory structures have provided a wide range of investors with more opportunities to trade after the primary stock markets close at 4:00 p.m. The bad news is that investors in the after-hours market have not had access to price information to easily ascertain if they are obtaining good prices for their trades.
Several industry Working Groups have been formed to consider the investor protection and market integrity issues that need to be addressed as the after-hours market develops. These Working Groups canvassed a wide range of views on these issues, including the views of the markets, alternative trading systems, other broker-dealers, mutual funds, clearing organizations, and consumer groups. The Working Groups for Investor Protection & Education, Trading Conventions, and Clearance/Settlement & Operations issued their reports to the NASD and NYSE on October 8. The NASD and NYSE have invited comments on the Working Groups' recommendations by placing the reports on their web sites.
Although many of the Working Groups' recommendations to the NYSE and NASD are directed toward developing a framework for next year's planned expansion of the NYSE and NASD into after-hours trading, some recommendations have immediate application, particularly with regard to investor protection. The Working Groups have issued best practices guidelines for broker-dealers to provide their customers with adequate disclosure about the current after-hours trading environment and the risks associated with after-hours trading. The Commission's staff will be working with the SROs over the next few months to assure that investors are receiving adequate disclosures in this area.
Another recommendation from the Working Groups was that the consolidated transaction reporting and quotation dissemination systems need to operate during after-hours trading. Investors have come to rely on access to these systems during the day, and broker-dealers need this information to fulfill their best execution duties. The Commission is pleased that the first steps in extending the hours of operation of the consolidated systems are already on track. On October 13, the Commission approved pilot programs for the Chicago Stock Exchange and Nasdaq that will extend their reporting systems until 6:30 p.m.(9)
We recognize that these are only the first steps in improving the after-hours trading environment. More needs to be done to further improve transparency and expand systems linkages in this market to help assure that investors receive the best execution protections that they have every right to expect.
V. SRO DEMUTUALIZATION
Demutualization is another very significant issue facing the Commission. Not only have a number of different alternative trading systems expressed interest in registering as for-profit exchanges, but most of the existing exchanges have, over the past several months, expressed some interest in converting to for-profit status. While exchanges in other countries, including Sweden and Australia, have converted to for-profit organizations, no U.S. registered exchange has ever been a for-profit organization.
Because exchanges are not merely trading facilities, but also our front-line regulators, the possibility of for-profit exchanges raises a number of questions and some concerns. First, how should the perceived conflicts of interest between operating a for-profit corporation and fulfilling self-regulatory obligations be addressed? There always has been an inherent conflict of interest in a regulatory scheme where SROs controlled by broker-dealers are supervising those same members. In addition, an SRO affiliated with a market potentially could use its regulatory power to promote that market's interests over other markets or their members. Our current model of self-regulation works - and works relatively well - with these existing conflicts of interest. The question is how the conflicts of interest might change or grow in a for-profit environment.
These issues are particularly acute for the primary SROs responsible for supervising the vast majority of U.S. broker-dealers. And the conflicts, or perceived conflicts, have become more acute as their member firms have become major investors in competing trading venues. Any regulatory structure involving the primary SROs must be able to control and minimize these conflicts, although they probably cannot ever be completely eliminated. At a minimum, there must be strict corporate separation of the self-regulatory role from the marketplace it regulates. Some have suggested that the creation of a single SRO to regulate all markets would alleviate conflicts and reduce redundancy, paperwork, and operational costs. Others support a model in which each SRO would perform the regulatory and surveillance functions for its own market, but member regulation, sales practices, and intermarket trading would be overseen by a single SRO.
In addition to the conflicts of interest posed by demutualization, the Commission will need to assure that the regulatory functions associated with any for-profit exchange are adequately funded, that its staff has the expertise to understand the market it regulates, that the self-regulatory functions are vigorously fulfilled, that duplication of regulatory oversight is minimized, and that the SRO is dedicated to serving the public interest.
VI. NYSE RULE 390
One important aspect of preparing for the future is to eliminate any existing rules or practices that distort competition and introduce unnecessary costs. NYSE Rule 390 is an example of such a rule. It stands out from other SRO rules as an explicit prohibition against competition. The applications of alternative trading systems for registration as exchanges, as well as the NASD's consideration of whether to register the third market as an exchange, clearly display an interest on the part of these entities in allowing their members to compete directly with the NYSE. Indeed, they may eventually vitiate the practical effects of Rule 390 by registering as exchanges. The question remains, however, whether this type of rule should have any place in our markets, particularly in the context of a for-profit exchange. Commission rulemaking is certainly an option, but, one way or another, Rule 390 should not be part of our markets' future. Legitimate concerns about an increase in fragmentation if the Rule is eliminated can be addressed more properly in the broader context of establishing more effective linkages.
VII. COMMISSION'S INITIAL STEPS
The foregoing survey of market structure issues should serve to demonstrate the steep challenges facing the Commission and the securities industry in the months ahead. One of our first efforts in meeting this challenge will be to consider whether to expand the linkage between the over-the-counter and exchange markets to encompass all listed stocks, including those that remain subject to NYSE Rule 390, and thereby eliminate another barrier to access. We also are moving ahead quickly with the application by the International Securities Exchange ("ISE") to register as a fully electronic options exchange. In response to public comments, the ISE has filed an amendment to their application that the Commission has just published for public comment.(10) The ISE promises to be the first new competitor in the options markets in 20 years and increases the urgency to develop and implement a linkage plan. In addition, the Commission soon will consider issuing a concept release on market information fees and revenues and on their role in funding the operation and regulation of the securities markets. This release would invite public comment on ways to assure that the arrangements for disseminating market information properly reflect advancing technology and changes in the structure of the securities industry. Finally, the Commission's staff is preparing a release that will request comments, proposals, and ideas on how we can effectively garner the benefits of centrality without stifling competition. Among other things, this release will request views on the extent to which fragmentation is a problem in today's markets, and, if so, what steps might be taken to address it.
Change is coming at a furious pace. Advancing technology and innovation do not allow us the luxury of simply standing still. Although the landscape of tomorrow's markets may not resemble today's, the fundamental Exchange Act objective that will guide the Commission -- a national market system characterized by transparency, competition, and linkages -- remains the same. It has served us well in the past and will continue to do so in the future.
1. Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290.
2. Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 63 FR 70844.
3. See, e.g., Exchange Act Rules 11Aa3-1, 11Ac1-1, and 11Ac1-2 (providing for the consolidated dissemination of transaction reports and quotations).
4. Sections 11A(a)(1)(C)(iv) and 11A(a)(1)(D) of the Exchange Act.
5. See Securities Exchange Act Release No. 40760, note 4 above, at notes 185-222 and accompanying text. Currently, there is no mechanism available for alternative trading systems to publicly display their best-priced orders in exchange-listed securities.
6. Securities Exchange Act Release No. 42029 (Oct. 19, 1999).
7. The Securities Traders Association ("STA") has filed with the Commission a petition for rulemaking to "obviate the requirement of paying a fee to execute an order through an ECN when the ECN's market is alone at the inside quotation." Letter from Andrew N. Glass, Jr., Senior Vice President/General Counsel, STA, to Jonathan G. Katz, Secretary, SEC, dated August 28, 1998.
8. Letter from Cameron Smith, General Counsel, Island ECN, to Jonathan G. Katz, Secretary, SEC, dated May 19, 1999; letter from Gerald D. Putnam, Chief Executive Officer, Archipelago L.L.C., to Jonathan G. Katz, Secretary, SEC, dated June 9, 1999.
9. Securities Exchange Act Release Nos. 42003 and 42004 (Oct. 13, 1999).
10. Securities Exchange Act Release No. 42042 (Oct. 20, 1999).
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