Subcommittee on Securities


Hearing on "The Changing Face of Capital Markets
and the Impact of ECN's"


Prepared Testimony of Mr. Jerry Putnam
Chief Executive Officer
Archipelago ECN


10:00 a.m., Wednesday, October 27, 1999

Good morning Chairman Grams, Senator Dodd, and other distinguished members of the Subcommittee. My name is Jerry Putnam, and I am Chief Executive Officer of Archipelago, LLC. (A detailed biography is provided as Attachment A.) I founded Archipelago nearly three years ago. Today it is a leading electronic communications network, or "ECN," that serves a varied client base and executes nearly 30 million shares a day. On August 9, 1999, Archipelago filed an application with the Securities and Exchange Commission ("SEC" or "Commission") to become a national securities exchange. As such, Archipelago is keenly interested in participating in the formation of policy that will reshape the landscape of U.S. capital markets to ensure that competition and innovation provide maximum benefit to investors. I thank you for this opportunity to discuss these critical issues in this forum today.

I. Foundation of Today's Dynamic Marketplaces and Archipelago's Role

During the past 25 years, we have witnessed extraordinary changes in our capital markets. Beginning in 1975, Congress called for the creation of a National Market System ("NMS") to consolidate marketplace information and link trading venues to ensure access to the best prices. The NMS benefited investors by spurring competition between marketplaces and providing transparency. After "Black Monday," in October 1987, investors rightly questioned their ability to access marketplaces during tumultuous and stressful conditions. In response, the SEC prodded (directed) exchanges to improve electronic order-routing tools for investors, and the seeds of an electronic revolution were sown.

In August 1996, the Commission and the Department of Justice censured The Nasdaq Stock Market ("Nasdaq") and its market maker participants for price-fixing. In order to remedy these structural deficiencies, in part, the Commission approved its Order Handing Rules ("OHR") in September 1996. The OHR include two components: (1) the requirement that investor limit orders be reflected in market maker quotes; and (2) the integration of ECNs into the Nasdaq marketplace. The OHR have led to substantial and well-documented benefits for investors, including a significant reduction in bid-ask spreads for Nasdaq securities. By including superior prices in the Nasdaq quotation montage, ECNs have played a major part in this unquestionably successful policy initiative that has saved investors billions of dollars; and, in turn, has allowed companies to raise capital more efficiently and cheaply, which has lead to the rapid and dynamic growth in our economy and the lowest unemployment rate in decades.

In part to keep pace with ECNs--most of which trade at a minimum increment of $ 1/64 or lower--Nasdaq, the New York Stock Exchange ("NYSE"), and the American Stock Exchange ("Amex") lowered their minimum quotation increment for most securities from $1/8 to $1/16 in July 1997. Later that year, and after substantial investor and congressional pressure, these marketplaces agreed to quote prices in decimals in 2000.

In December 1998, the SEC instituted Regulation ATS ("Reg ATS"), a forward-thinking regulatory approach that recognized the important and unique role of ECNs in the marketplace. The fundamental concept underlying Reg ATS was the fact that ECNs and other alternative trading systems, or "ATSs," now provide many of the identical services that exchanges and Nasdaq have traditionally provided, yet prior to the adoption of Reg ATS were regulated as traditional brokers instead of marketplaces. Reg ATS remedied this situation by giving ECNs and ATSs the option of registering as full blown "national securities exchanges," or, alternatively, being regulated under a new set of standards for ATSs.

In late 1996, I read the Commission's OHR proposal several times from beginning to end, and coupled with business acumen accumulated over two decades of working in the broker-dealer industry, I founded the Archipelago ECN to provide investors of all stripes--from the largest broker-dealer in New York to the smallest retail customer in Sioux City, Iowa--with low-cost, technology-driven access to and representation in the marketplace. Central to our business model is our "best execution" order routing system, which externalizes our own orders to find execution at superior quotations outside of Archipelago itself. For example, if our best buy order (bid) is priced at $20 and another trading venue has a buy order at $20 1/8, we will route any marketable sell order entered into Archipelago to the $20 1/8 bid. By routing orders in this manner, Archipelago facilitates "best execution" for investors and rewards price competition both on and off our system. And, from a business perspective, Archipelago has always lived by the axiom that we would rather take one side of the trade than no side of the trade. As such, we resolutely believe that our business model is consistent with and a manifestation of congressional will for the construction of a National Market System.

Since we flicked the switch on January 20, 1997 and began operating, Archipelago has grown rapidly in several ways. First, our volume is now nearly 30 million shares a day--indeed, we execute almost 2.5% of Nasdaq volume with a staff of only 35, including a 5-person trading desk. Second, our client base has expanded and diversified considerably since inception, and now includes Nasdaq market makers, institutional investors, online retail brokerage firms, proprietary trading houses, and options market makers. Third, and perhaps most importantly, a number of premier institutions have made substantial investments in our company. They include Goldman Sachs and E*Trade (January 1999), J.P. Morgan (June 1999), Instinet (July 1999), and Merrill Lynch and CNBC (September 1999). We believe that these investments provide a validation --- or more parochially, "putting their money where their mouth is" --- of our passionate belief that the time has come for a for-profit, technology-driven, "next generation" exchange to bring innovation to U.S. capital markets.

II. "Next Generation" Exchanges: What? Why? How?

Tomorrow's exchanges will be characterized by two distinguishing factors: for-profit corporate organization and technological expertise. Indeed, in the near future, exchanges may look very much like today's technology companies, continuously upgrading and improving on its technology, with the added focus on implementing rules and policies to ensure liquidity, transparency, and investor protection. That said, we are not so naïve to believe that the floor-based, human-intensive exchange model will disappear overnight. Human interaction and all its permutations and combinations will continue to employ the use of a floor for executing certain order types, such as extremely large orders that require "working" by an intermediary. Next generation exchanges will almost certainly cut into their traditional counterparts' market share, but we do not foresee the total extinction of the floor-based model, at least until the time artificial intelligence can duplicate these complex interactions.

Recently, the NYSE and Nasdaq, among other exchanges and marketplaces, have announced their intention to convert their business organization from mutualized ownership to for-profit. These exchanges and marketplaces have pointed out that, although reasonably well capitalized, they require greater access to capital, which would be accomplished through conversion to the for-profit model. Although important, Archipelago would argue that the real key is the discipline imposed by for-profit corporate governance and decision-making, especially in a rapidly changing industry. Additionally, a for-profit organization ensures that the exchange is truly accountable to its investors, thereby achieving better, more accountable management. Further, were a for-profit exchange to go public, it would have public representation on its board. Historically, the SEC has directed exchanges to include considerable public representation on their governing boards in order to protect investors. Archipelago agrees with this proposition, and would take it to the next, logical level. By allowing public shareholders, an exchange will enjoy a public representation that is buttressed by economic self-interest.

In contrast to existing exchanges which are endeavoring to transform themselves to a for-profit organization, Archipelago is today a for-profit company that is attempting to graduate from ECN to exchange status. On August 9, 1999, we filed our Form 1 application with the Commission to become a national securities exchange. While ECNs have provided substantial innovation and benefits to U.S. capital markets, Archipelago believes that there are compelling reasons to pursue exchange status. First, as discussed below, ECNs face substantial barriers to entry in trading NYSE-listed securities. Second, for-profit governance will allow exchanges to manage costs more effectively, and thereby provide market participants--and therefore investors--with better value than traditional venues. Third, ECNs are in the very uncomfortable position of being regulated by their competitors. For instance, Archipelago is a registered member of the National Association of Securities Dealers ("NASD"), which is the parent company of our competitor, Nasdaq. Exchange status is a remedy to this awkward and conflicted situation. Fourth, exchanges are able to collect listing and tape fees. Although Archipelago's business model would not rely heavily on these fees because we see them growing less significant over time, they still nonetheless would be a source of revenue. Last, only a registered exchange may use the term "exchange" as part of its name and marketing efforts. Accordingly, we believe that there is significant brand value associated with having the ability to use the term "exchange."

We do not minimize or underestimate the enormous task in building a new, fully-electronic, for-profit exchange. Let me suggest that we eagerly accept the enormity of the task and, with due respect to all, will succeed in the outcome. Indeed, because of our technological expertise, considerable marketplace experience, and unparalleled base of premier investors, we are uniquely positioned to successfully matriculate to exchange status. One of Archipelago's investors, General Electric Corporation, through its CNBC subsidiary, is especially important to those concerned that exchanges have a public governance component. After all, GE is a company that makes and sells everything from light bulbs to jet engines and from medical equipment to mortgages. It would be difficult to imagine a better partner in terms of public governance.

Lately, would-be competitors to new exchanges, ECNs, and ATSs have floated the misconception, often in an alarmist fashion, that these new entities cause market "fragmentation." Ironically, these critics have used language that closely parallels the language employed by AT&T executives in the mid-1970s when fighting off its critics who accused them of monopolist conduct. The argument goes something like the following: without a physical central location where all orders can be aggregated, fragmentation results, which in turn distorts price discovery and harms investors. Let me allay anyone's fears: there is nothing further from the truth than these arguments. First, fragmentation should not be confused with competition. Indeed, in a technological environment in which pools of liquidity can be and are linked at sub-one second speeds, the fragmentation bogeyman is designed to support the status quo with all its vested interests that continue to profit without adding commensurate value. Second, such claims beg the question of fragmentation in a floor-based environment. Could one similarly argue that an exchange floor is fragmented because exchange specialists and floor traders do not share the sentient being at the same exact moment? (Attachment B to this testimony graphically illustrates this point.)

Another example which refutes the fragmentation argument and again illustrates the ability of ECNs and soon-to-be exchanges to leverage technology is our multilateral decision to build efficient electronic linkages for off-hours trading. Recently, market participants, including many retail investors, have expressed interest in trading outside traditional market hours (9:30 AM ET to 4:00 PM ET). Using the NMS as a blue print, a group of 8 ECNs--including Archipelago and the firms of my fellow panelists--have begun to construct an electronic network which enables the sharing of market information and makes orders accessible to one another. It is noteworthy that we undertook this effort voluntarily because it supports our belief that a transparent, efficiently-linked environment is the only way to ensure price transparency and protect investors in off-hours trading.

To reiterate, Archipelago employs cutting-edge technology to link our marketplace through a best execution order routing, which we use to externalize order flow to the best available price in the marketplace. In order to better implement best execution, Archipelago has developed a proprietary order routing algorithm to help subscribers optimize fill rate and execution speed. Institutional investors, critical of Nasdaq fragmentation long before the term ECN was coined, have been extremely supportive of our efforts in this regard.

III. The Many Challenges for New Exchanges

Fundamentally, exchanges serve three purposes: execute orders, aggregate information, and regulate exchange participants. Both the NYSE and Nasdaq have traditionally served two of the three, although not the same two. The NYSE executes orders on its floor and regulates its members, but leaves information aggregation to the Consolidated Tape Association ("CTA") and Consolidated Quotation System ("CQS"). Like the NYSE, Nasdaq too regulates its market participants but, conversely, it aggregates information. Market makers and ECNs, and not Nasdaq, however, provide order execution.

As SEC Chairman Levitt recently underscored at Columbia University, it is absolutely critical that information be centralized and accessible to the public in order to protect investors. Chairman Levitt, however, did not communicate, directly or indirectly, as some have implied, that order execution and information aggregation be bundled. To the contrary, Chairman Levitt said that he expects competition in all three areas of exchange services to rid our markets of "pockets of monopoly," in order to substantially benefit investors.

Using history as our guide, competition will induce exchange specialization in these three services, barring an economic efficiency in horizontal integration. Instead of efficiencies, however, considerable conflicts of interest are associated with the bundling of the three services. To wit: Do not conflicts of interest arise when an exchange, which regulates its market participants, competes with these same participants in providing execution services? Alternatively, do not conflicts of interest arise when an exchange acts as aggregator of market information--which involves building inter-market routing infrastructure--and at the same time competes with the exchanges to which it links?

Today, Chairman Levitt's "pockets of monopoly" are most evident in the inability of ECNs to effectively trade NYSE-listed securities. Because ECNs have not been integrated for NYSE-listed securities, the many innovations and cost savings associated with ECN participation in Nasdaq securities have been denied to investors trading in NYSE-listed securities. Take note: today, ECNs execute roughly 30% of Nasdaq orders, but less than 5% of NYSE orders. Why? Let me suggest that this phenomenon has nothing to do with the liquidity characteristics or other trading differences between Microsoft (Nasdaq) and IBM (NYSE), or Yahoo! (Nasdaq) and AOL (NYSE). Instead, I would argue that it has everything to do with very powerful vested interests protecting their franchises.

For instance, the NYSE has a rule--Rule 390--that prohibits members from off-exchange trading on their own behalf. Doubtless, member firms would continue to use the NYSE trading floor were Rule 390 abolished. But by irrationally chaining our nation's largest investment houses to a human-intensive, floor-based model--regardless whether the order is for 10, 1000, or 100,000 shares--the cost of trading operations are artificially high. Unavoidably, these costs are passed on to investors in the form of higher commissions. And, further, in an overt attempt to restrict the ability of ECNs to compete in trading listed stocks, the NYSE recently filed SR-NYSE-97-18, a rule which proposes to severely limit the ability of NYSE specialists to use ECNs in specialty stocks. Like Rule 390, from my standpoint, its ultimate purpose is anti-competitive.

In addition, participation in the inter-market groups responsible for information aggregation--CTA, CQS, the Intermarket Trading System ("ITS"), and Nasdaq's Unlisted Trading Privileges Plan--must be extended to new exchanges and ECNs. Currently, the governance rules and technology supporting ITS are prohibitive, and need radical change so that for-profit exchanges can be integrated in the world of NYSE-listed trading. ITS is slow: it has a 1-minute minimum life for orders and is not well integrated into exchange operations. Further, the ITS Operating Committee has a flawed and oligopolistic governance structure where a single participant can veto any initiative. In a more competitive exchange environment, the critically important linkage function is far too important to be left to an anachronistic structure.

Finally, existing exchanges must provide fair access to information aggregation services that they currently provide. As noted earlier, potential conflicts of interest exist when a marketplace both aggregates information and executes orders. We believe that this conflict manifests itself in Nasdaq's latest central limit order book proposal, the "Order Display Window." If approved, the proposal would harm competition by granting competing exchanges "second class" access by giving UTP exchanges priority only after market makers, and then ECNs. On its face, this proposal disrupts competition and flies in the face of Chairman Levitt's call for increased competition. Accordingly, it must not be approved.

IV. A Competitive Framework for Regulatory Services

One could argue that the great success of U.S. capital markets over the last 50 years is directly correlated to the establishment of a fair and credible, though flexible, regulatory structure based on the philosophy of self-regulation. This bottom-up approach adopted by our capital markets--in which market participants are regulated by self-regulatory organization rules, as well as by their own compliance departments, all under SEC and Congressional oversight--has given the industry the type of flexibility to allow it to innovate and adapt to market forces. At the same time, this structure has upheld and maintained the integrity of the marketplace. Importantly, where market failure or fraud or other malfeasance occurs, investors have the opportunity to have their grievances heard--whether through administrative action at the SEC, legal action in federal court, or arbitration action--and proper remedies fashioned. All and all, our capital markets can make the bona fide claim to investors worldwide that "you'll get a fair shake" when trading on venues.

Today, we hear a number of voices, from Washington to Wall Street, stating that the ongoing exchange revolution may put the hard-earned reputation of our capital markets in jeopardy. Questions have been asked and comments made about ECNs and new exchanges indulging in "regulation on the cheap," whether or not for-profit business models can effectively self-regulate themselves, and the ubiquitous "if it ain't broke, why fix it." First, let me be unequivocal: if there is one point you take away from my testimony today, please let it be that Archipelago is as concerned about maintaining the regulatory reputation of our markets as any Senator, regulator, exchange official, or compliance officer. For if nothing else, as a matter of business self-interest, I realize that were Archipelago (or any other exchange) to fail to maintain a reputation of credibility, integrity, and fairness, we would unconditionally fail as a business. There are far too many competitors that would jump at the opportunity to take order flow from us because of the taint associated with regulatory failure. The economic value associated with even-handed and appropriate regulation is substantial, because it directly creates investor trust. It is axiomatic: good regulation equals good business.

All of the above being said, I believe that we can improve on and make more efficient our regulatory framework. For instance, what technology has done for order execution can just as easily be applied to our regulatory oversight responsibilities; and, in fact, the marketplaces have leveraged technology to conduct market surveillance for insider trading, market manipulation, violations of the short sale rule, and many other proscribed trading behaviors. Archipelago believes that leveraging technology, in fact, will bring about better quality and more efficient market surveillance because, similar to our model for executing orders, we believe that less human intervention (or "touches") corresponds to less risk of misfeasance and malfeasance.

In contrast to front-line market surveillance, the other half of regulation involves member regulation. Here, another hot-button issue--whether for-profit entities can provide fair and quality regulatory services--has drawn much attention recently. Perhaps our industry can learn from industries that outsource to the major accounting firms, which provide good, cost-effective value in a highly-regulated environment. Indeed, the Commission already relies heavily on the reputation and work product of accounting firms, who certify annual audits for public companies and stand behind companies when they register to go public. In this spirit, new for-profit exchanges will work with the SEC to explore competitive, innovative methods to provide quality regulation in a cost-effective fashion. (A comparison between today's and tomorrow's regulatory environment is presented in Attachment C.)

A more pressing member regulation issue, however, is the potential for bad-faith regulation in today's conflict-filled environment. Specifically, market participants--especially ECNs--frequently compete with exchanges, and now possibly Nasdaq, to provide order execution. It is, therefore, critically important for exchanges that chose to retain the member regulation function within their corporate umbrella to make strident efforts to erect a wall between such regulatory efforts and the business of market operation. If existing marketplaces are allowed to hold regulatory court over member firm competitors without adequate, well-documented controls, the potential for abuse will be large, and robust competition will be endangered.

V. Conclusion: Competition and Innovation Must Carry the Day

One month ago Chairman Levitt called on stock exchanges and market participants to embrace a vision of a true national market system for the next millennium. Importantly, Levitt underscored the critical role of a "timeless principle," competition, in achieving this vision. Together with the incredible march of technology, competition has made possible what was unimaginable a decade--or even a few years--ago.

In 1975, the U.S. Congress was prescient when it directed the Commission to construct the NMS. Chairman Levitt's speech is a clarion call to return to the principles of transparency, efficiency, and competition in realizing the goal of a true national market system. Allowing newly-minted for-profit exchanges, ECNs, and other innovative market entrants to freely and fairly compete is critical to this end. If existing exchanges and intermarket clubs will not open themselves to competitive forces, it falls on the government to take appropriate action.

Through efficient governance and improved managerial accountability, for-profit exchanges will fare far better than their traditional membership counterparts in the face of future challenges. Unlike traditional marketplaces, which propped up a fixed commission structure, pooh-poohed the Order Handling Rules, and decried decimalization, for-profit exchanges that ignore overwhelming public sentiment imperil their very existence. Furthermore, for-profit exchanges that allow ownership to reinforce public representation will be uniquely positioned to respond to investor needs and concerns.

Today, our capital markets are without doubt a national treasure and the envy of the world. We must, however, guard against complacency as technology marches on. Already, unfortunately, the U.S. lags behind places such as Australia and Sweden in terms of equity exchange innovation. Both of these countries have fully-automated, for-profit marketplaces.

In the best interests of U.S. investors, therefore, we must role up our sleeves and get to work laying the technological, legal and regulatory foundation for the next millennium. Unreasonable barriers and unfair advantages only serve to inhibit competition and decrease the quality of U.S. markets. Why risk the unthinkable: the diminution of our capital markets?

So let's get to work improving our intermarket facilities to ensure that they are fair, efficient, and cost-effective, so that we fulfill Congress's 1975 mandate. If we succeed, innovations will continue--if not accelerate--as the marketplace is decimalized, globalized, and democratized.

Archipelago looks forward to working with the Subcommittee throughout your review of the many changes occurring in today's capital markets. Thank you for your time and interest concerning these important matters.



Attachment A

GERALD D. PUTNAM, JR.
Chief Executive Officer
Archipelago Holdings, L.L.C.

Jerry Putnam is the founder and Chief Executive Officer of Archipelago Holdings, L.L.C. and its wholly owned subsidiary Archipelago L.L.C., an electronic communications network (collectively "Archipelago"). Archipelago is one of the original four ECNs approved in January 1997 by the U.S. Securities and Exchange Commission (SEC).

Mr. Putnam has attracted premier investors from the financial industry, including Goldman Sachs, E*Trade, J.P. Morgan, American Century, Instinet, Merrill Lynch and CNBC. Under his leadership, Archipelago has dramatically increased its daily trading volume from a few thousand to approximately 30 million shares per day. Further, on August 9, 1999, Archipelago filed to become a national securities exchange.

Since 1983, Mr. Putnam has developed a profound understanding of the securities industry, and the technologies that have revolutionized it, through his involvement in institutional and derivative sales at several major financial institutions in New York and Chicago. They include Walsh, Greenwood in New York City and Jefferies & Company, PaineWebber, Prudential and Geldermann Securities, Inc. in Chicago.

In 1994, Mr. Putnam became an entrepreneur when he founded Terra Nova Trading, L.L.C., an on-line broker-dealer, and served as its president until the end of 1998. He continues to serve on its board of managers.

In 1981, Mr. Putnam received a bachelor of science degree in economics and accounting from the University of Pennsylvania's Wharton School. While at Penn, he rowed for its renowned varsity crew team.

Mr. Putnam is 41 years old, and is married with two daughters. His interests include fishing, reading novels, water sports, and "making breakfast for his children." He has been involved in fundraising for a charities such as the North Shore Settlement House, which provides support for low-income families and runs a charter school. In addition, Mr. Putnam and his wife help operate a Wisconsin summer camp for children.



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