Hearing on the "Financial Marketplace of the Future"

Prepared Testimony of Mr. Henry M. Paulson
Chairman and CEO
Goldman Sachs & Company

9:30 a.m., Tuesday, February 29, 2000
13th Floor Conference Room - Securities and Exchange Commission Offices
7 World Trade Center, New York, NY

Mr. Chairman & Members of the Committee:

I am pleased to appear today to respond to your request that we share our vision of the future of the U. S. securities markets, and the regulatory environment in which they operate.

Goldman Sachs is privileged to be among the top tier of global investment banks. We commit substantial capital every day to bringing new companies to market. We make markets in hundreds of stocks and provide high quality investment research to our customers. We are proud of the innovations, such as block trading, we have brought to the market place. We believe this privilege, combined with the experience gained in the 130 years of our existence, and our international perspective, imposes an obligation on us to look objectively and dispassionately at the structure of our markets.

Let me begin by saying that the whirlwind of change driven by technology and globalization is dramatically changing the landscape of our markets, and how both individuals and institutions buy and sell securities.

Clearly, technology is leading the way, to the benefit of most investors. Given this reality, and given the compelling empirical evidence reinforcing it in other jurisdictions, we support a model that will permit technology to shape the continuing evolution of our markets - from what they were to what they will become. At the same time, however, the problem of fragmentation is real. And growing. That is why we are also convinced that, to ensure true competition, and fairness for each investor, big or small, all orders should meet in a central place - one that will promote greater liquidity, and that cannot be dominated by people with special knowledge, or able to gain unfair advantage. We believe such competition is in the best interests of both companies seeking capital and investors placing their money at risk.

I. Meeting the Challenge of Technology in U.S. Equity Markets.

A. The Competitive Environment.

Now permit me to expand on those points.

First, technology and innovation have brought us to where we are. Immediate access to information and online trading has lowered transaction costs and empowered investors as never before.

Today, ECNs with advanced automated trading systems execute market orders in fractions of a second.

The SEC has just approved the registration of a totally electronic options exchange. And the CFTC, following the unanimous recommendation of the President's Working Group on Financial Markets, has proposed dramatic initiatives that will permit development of electronic trading facilities for some types of swaps.

Three ECNs have filed applications to become electronic stock exchanges.

It is no longer possible to easily distinguish whether any given recipient of a customer order is a conduit to the marketplace or an execution destination.

Nor can we ignore what is happening in the rest of the world. Europe has taken the lead relative to the United States in abandoning their physical floors for new technologies on their exchanges. These advances in technology have created fundamental changes in their market structure. However, unlike the U.S., Europe's primary challenge is not technology, but consolidation. Currently, the overhead and inefficiencies created by having to transact on multiple exchanges are costly. Clearance and settlement expenses in Europe currently are significantly higher than in the U.S. The exchanges are constructed on disparate technology platforms, operate under different trading rules and national regulation, and offer varying degrees of transparency. To date, the existing bourses have guarded their liquidity pools and vested interests at the expense of unification.

A number of consolidating initiatives have been undertaken, any one of which could result in the creation of a pan-European exchange. Similar efforts have begun to rationalize the clearance and settlement system to create seamless, "straight through processing" of transactions. The "Alliance" between eight major bourses announced last fall, the Deutsche Börse's Euroboard, the London Stock Exchange's proposed demutualization to provide greater flexibility for future mergers, Nasdaq Europe and EASDAQ all have an opportunity to unify European trading. These initiatives propose to harmonize the different systems to create a continuous pan-European market, first for blue chips, and potentially for mid- and small-caps. While we do not endorse any one particular scenario, we hope to see an electronic pan-European trading system that is fair, open, and competitive with consolidated liquidity and some degree of transparency. Such a move by the European exchanges to consolidate their already technologically robust markets, combined with rationalizing their clearance and settlement system, would undoubtedly threaten U.S. capital market supremacy.

These developments have spurred competition in the equity markets, among intermediaries, among exchanges, and indeed, among the world's capital markets themselves. Such competition should not surprise us, for, Mr. Chairman, we delude ourselves if we believe that the United States has the exclusive franchise on trading the securities of U.S. companies. Those who have capital and those who need it will eventually move to where they can meet most efficiently.

The stakes are high, very high. Certainly, individually and collectively, we can all point with great pride to the success of our markets. America's capital markets are the envy of the world. Nonetheless, this is no time for self-satisfaction, or complacency. The two words that mean death to any business or industry today are - status quo. In this new fiercely competitive environment, all of us in the business - whether we are brokers, market-makers, ECNs or even an exchange - must avoid becoming so locked into a business model that our services become irrelevant. At the same time we must remember that just because technology makes a market innovation possible does not mean that the innovation advances the goal of improving our marketplace.

B. Responding to the Challenge of Technology and Change.

And so, in response to the question you put before us, while technology and marketplace changes can assure the pre-eminence of the U.S. capital markets, there is no guarantee that they will. My concern is that in our human tendency to fear change, we tend to bask in legacies of past successes, forgetting that we can also become victimized by them.

Admittedly, change can be difficult. Change can be frightening. But, we must be on guard against defending what once began as a "best practice," but is now simply a shield for profitable vested interest.

A second conclusion concerns the process of change required for our markets to flourish. We believe that there must be a regulatory environment that empowers and creates incentives for change, while encouraging competition, and challenging, rather than rewarding, the status quo. At the same time, regulation should require that market developments adhere to fundamental principles consistent with the legitimate differences among the products traded.

Chairman Levitt challenged us to reexamine our mission. Your committee has expressed its own concerns. In response, we and other members of the securities industry are recommending comprehensive, structural reform. We will state our views in detail in response to the Commission's Concept Release on Market Fragmentation published on February 23rd, but I can give you a preview of what Goldman Sachs's response to that Release will be.

We believe there are 5 core principles underpinning our proposals. These are:

First, the protection of all investors should be paramount, from the largest institutional investor to the smallest of our 80 million investors.
Second, competition among exchanges and other trading venues should be preserved and promoted, but it is the competition of the buy and sell orders of all market participants that will assure the integrity of the price discovery function.
We believe in a level playing field that does not allow any particular exchange or market participant to have an undue advantage or to become entrenched.
Third, markets should be open, accessible and transparent. Consistent with the concept that no exchange or venue should enjoy unfair advantage or entitlement, we believe that price discovery information and execution quality should be easily accessible to a much broader cross section of market participants.
Fourth, liquidity venues should be linked to encourage aggregation rather than fragmentation. The market structure that aggregates pools of liquidity will enhance efficiencies, enabling investors to achieve the best possible execution.
Fifth, the regulatory regime should stand for fairness, integrity and protect against conflicts of interest. It should also be efficient and consistent in the application and enforcement of rules.
Where does this lead us?

1. Eliminate Exchange Rules that Impede Price Discovery in an Open Market. Consistent with our principles, we have advocated that any exchange rules that impede the ability of members to trade freely in the emerging technology-driven marketplace must be critically reexamined. We urged the repeal of the New York Stock Exchange's Rule 390, and we were pleased that the Exchange's Board voted to do so. Whatever justification there may have been for that rule is no longer relevant in today's environment.

2. Create a Central Electronic Linkage for Order Display and Execution.

In our opinion, the Commission in its Concept Release correctly summarized the key problem of fragmentation in today's marketplace as follows:

As the intermarket linkage systems are currently constituted, they provide access to the best displayed prices, but a market center is not required to route its incoming market orders to a market center that is displaying the best prices. Instead, the market center to which an order is initially routed is permitted to match the best price and execute the order internally. Indeed, the executing market center need not ever have displayed the best price. Thus, the current market structure allows price-matching rather than requiring that orders be routed to the market center that is displaying the best price, thereby isolating the orders of different market centers.

We believe fragmentation of trading interest among competing market centers does have the potential to inappropriately isolate orders, interfere with vigorous price competition, public price discovery, best execution of investor orders, and market liquidity.

For this reason, we have advocated, as our ideal model, an electronically-driven central market - a single network, linked to every market and trading venue. The driving principle must be equal competition of orders; competition that assures efficiency and fairness; and that assures every investor "best execution".

When we speak about linkages, we need to ask ourselves, why aren't our current markets effectively linked already? After all, Congress mandated a national market system in 1975. Unfortunately, the exchanges themselves created these linkages and did so through the Inter-market Trading System Plan. ITS is technologically outmoded and its governance structure is dysfunctional. It should be totally scrapped and replaced with an independent legal body governed by a broad constituency of market participants including the exchanges, ECNs, broker/dealers and the investing public. We are pleased to see that the Commission's Concept Release recognizes this alternative and asks for comment on it.

For our part, we say, let the SEC first set the standards for effective order competition. The SEC should then mandate that this new, independent body develop technical standards for communications protocols, find the best technology to carry it out, and administer its operation. The SEC should also oversee and review its performance. This entity should have an adequate source of funds to carry out its charge. The funds can be raised through access fees, or from a share in data revenues. The plan should, at a minimum, remove barriers to direct access to the linkage by the greatest number of intermediaries.

At the same time, our markets should have the capability to offer different trading systems and opportunities for price improvement, particularly in those cases where liquidity is insufficient to assure that speed of execution equals best execution. And there should be appropriate, volume based block trade exceptions to assist in reducing the volatility (and the resulting implicit costs to investors that the Commission correctly identifies) that large transactions can have on the market.

We think having as key features both time and price priority in an electronic marketplace creates the best incentives to maintain tight markets by rewarding those who are willing to step up and pay the highest price, or to sell at the lowest price, by assuring them that they will be first in line for execution.

Those of us who believe that electronic markets are the future, and who also believe that time and price priority should prevail in these systems, must do all that we can to encourage our principal markets in this direction. That is why we have been vocal in urging the New York Stock Exchange to act boldly to improve electronic execution in their market. We have urged the NYSE to allow a significant number of the most liquid stocks to trade in a totally electronic system, where orders at some reasonable minimum size will be assured of automatic execution on a time and price priority basis. We note that recent rule changes in the Nasdaq stock market will increase the display and execution of orders of up to 9,999 shares. We hope that the NYSE's proposals to initiate an electronic auto-execution facility for customer orders of a thousand shares is not their last word on the subject.

We have also invested in and encouraged the development of alternative trading systems in all of our markets: equities, debt, options and futures. We think that these competitive systems create the most effective pressure on entrenched interests to consider change or to legitimately prove to investors that their system is truly the best.

While we believe it is axiomatic that a truly open, accessible and transparent linked marketplace aggregating customer order flow must also have time and price priority and automatic execution. We acknowledge that others may disagree. But we argue that the onus is on those who disagree to do more than offer reasons why strong linkages providing for truly open and democratic competition of orders in the marketplace is not the best price discovery environment in our technology-driven marketplace. The Commission's Concept Release offers the appropriate setting for the open discussion necessary to move forward without further delay. We will urge the Commission to complete its review promptly and then act decisively.

II. Meeting the Challenge of Technology in U. S. Options Markets

I would now like to discuss the challenges facing our options markets. These markets have become an integral part of our capital markets, and the need for efficiency and integrity in the price-discovery function is as important in options as it is in equities.

Regrettably, these markets have failed to embrace technology to the detriment of customers. The price discovery function is flawed because these markets fail to offer an environment which brings the benefits of universal and instant access of trading interest to those who are willing to provide liquidity as well as those who need it. We are not sure that any linkage plan will address the problem unless the change is environmental and not just technical.

To understand how we have reached this conclusion, it may be helpful to review how our options markets developed and contrast them to foreign options markets.

A. United States Options Markets

Trading of standardized stock and index options began in 1973, replacing what had been an inefficient over-the-counter brokered market characterized by numerous regulatory problems. The coincidence of a standardized product issued and cleared by the Options Clearing Corporation ("OCC") and the refinement by our late partner Fischer Black and his colleague Myron Scholes of the option pricing model that bears their names spurred the phenomenal growth of these markets in the United States. Markets for standardized options developed later in Europe and Asia. These products now trade in growing volumes on exchanges in Honk Kong, Tokyo, Sydney and the major market centers in Europe.

A comparison of the U. S. and foreign options markets clearly demonstrates the need for reform of our markets.

There are four principal options exchanges in the U. S. market. All four exchanges (the Chicago Board Options Exchange, the Philadelphia Stock Exchange, the Pacific Coast Stock Exchange and the American Stock Exchange) have floor-based trading with variously designated "primary market makers (PMMs)" or specialists similar to the New York Stock Exchange model. The PMMs have principal responsibility for making a continuous market in the options they are assigned to trade. Existing rules of these exchanges create incentives for their PMMs to provide continuous quotes by assuring that they will have an opportunity to participate in a transaction between a member and the member's customer even if the transaction price is better than the price quoted by the PMM, thereby permitting the PMM to profit from the bid/ask spread. Liquidity is also provided by exchange members who trade for their own account and by brokers who represent customer orders in the trading crowd.

Each of the four exchanges offers an electronic system that posts firm quotes for small customer orders only. Current rules liberally allow PMMs to "turn off" the automatic execution feature of these systems, in which case customer orders entered electronically find their way instead into the order book which the PMM controls and to which only the PMM has access. This feature has been justified on the grounds that the PMM must be able to assure that his prices are competitive with prices quoted on other exchanges. Whether valid or not, the current system has been criticized because customers increasingly find that they cannot obtain an execution at the posted price. The criticism serves to highlight the current inefficiencies in our options markets.

A fifth exchange, an all-electronic exchange called the International Stock Exchange, LLC, ("ISE") has just been approved by the SEC. It will have PMMs responsible for providing continuous "firm" markets in their assigned options as well as market makers and licensed traders who can provide liquidity and interact with the PMMs' order book and to a limited extent with customer orders. Our subsidiary, the Hull Group, will be one of the ISE's PMMs.

B. Foreign Options Markets

In contrast, virtually every foreign options market is completely electronic, employing the latest trading technology to allow the display and execution of orders. Each market center currently has one central, order-driven electronic trading platform. Many markets recognize market makers and professional traders as members, but some markets permit customers to enter orders directly on the exchange's trading platform, as long as the customer has made appropriate arrangements for clearing trades.

Thus, while it is true that there currently is minimal competition among exchanges in the local markets of Europe and Asia, there is certainly a robust price discovery function as a result of the equal competition of orders. Instead of concentrating order flow into different competing quasi-intermediary market centers, the most successful of these models provide users with an open, democratic meeting of supply and demand.

These markets seem to prosper without the need for designated market makers. Professional traders employing the most advanced technology are able to populate the many series and maturities of options with quotations. Because many of these markets also provide efficient electronic executions of stocks underlying the options, hedging of positions is efficient and can be virtually instantaneous. Typical of all options markets, trading interest in particular names, strikes and maturities varies dramatically. Quoted markets, while representing firm bids and offers, are often wide until trading interest develops, at which time the bid/offer spread tightens as volume increases.

C. S.E.C. Response

Until recently, an option on a particular stock was only traded on one exchange. Most options are now dually listed.

Options investors have benefited from the competition among market centers. At the same time, customers and professional traders have criticized the markets because bids and offers constituting the best prices for a particular size, series and maturity on one market have been "traded through" in transactions reported on another market. In a trade through, a customer offering to pay, say, $5.00 for 10 June $100 strike call options on XYZ stock on exchange A sees the same 10 calls trade at $4.75 on exchange B.

In response to these criticisms, the SEC ordered the exchanges to come up with a linkage plan by January 19th. The exchanges filed proposals, but were not in agreement about a number of significant elements crucial to a successful linkage. The plans are highly detailed. They reflect an attempt to reconcile the differences among the various markets and the degree to which they have, or have not, embraced technology or adapted their rules and trading models to take full effect of the opportunities offered by such technologies. The common theme, however, is that none of the plans addresses the inefficiencies which exist in the respective markets themselves.

Although all of the exchanges offer some form of electronic access, none of the options exchanges offers an electronic environment open to all participants on an equal basis in a manner which assures automatic execution of displayed size. We believe this is ultimately detrimental to customers.

D. Goldman Sachs's Position

We are not generally in favor of mandates. The options markets are truly markets where diverse models should be allowed to develop and compete. The issue of price discovery must, however, be addressed. We believe the answer lies not in linkages of inefficient markets, but in the development of standards by which execution quality of the organized exchanges themselves should be judged. It is the appropriate role of the SEC to set these standards. As with the equity markets, we think the focus should be on those standards that are most likely to assure "best execution" by maximizing the competition among orders, regardless of their source..

We think an authorized market should be entitled to be considered a "best execution" destination for customer orders only if the exchange's posted quotes are firm and executable by any other market participant. This level playing field will create incentives for a broader spectrum of participants to supply liquidity as well as to obtain it. Formal, mandated linkages will be unnecessary, because they will evolve simply by requiring execution of customer orders at no less than the best displayed price by an NBBO-qualifying exchange. Exchanges should be free to compete for large orders by adopting rules which allow members to facilitate customer orders by contributing capital to take the other side of the order.

If the SEC determines that some linkage of the existing markets is necessary in the near term to improve the price discovery process, we believe very strongly that the model of the linkage plan which has prevailed in the equity markets should not be the model for options. As we have stated elsewhere, the ITS plan has been ineffective and must be scrapped. The last thing we should do is replicate it in the options markets. That is why we will urge the SEC to order the exchanges to develop a separate entity to develop and oversee the linkage, and to assure that all market participants are represented in the governance of this entity.

III. The Challenge of Technology and Change to Self-Regulation in the United States

The third area for re-examination and reform is the structure of broker/dealer regulation, a function now shared by the SEC and the self regulatory organizations ("SROs"), principally the New York Stock Exchange and NASD Regulation Inc. A key role of the SROs is to conduct examinations of their members for compliance not only with their trading rules but also of capital, customer protection and margin rules. In the examination process, the SROs must necessarily have access to sensitive proprietary information about the business of their members. This access, in our view, creates a potential conflict of interest in an era when the organized markets and the intermediaries they regulate are competitors.

But this is not the only reason to review the structure of broker/dealer regulation. Many of the regulations applicable to a broker/dealer's business such as customer margin maintenance requirements are SRO rules. While the SROs essentially adopt identical rules, there is no assurance that these are consistently applied by the SROs. Inconsistent interpretation can lead to unfair competitive advantages.

In addition, we and other global firms have, for many years, urged the SEC to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore, so that our firms can remain competitive with our foreign competitors risk-based capital standards must become the norm. The SEC has made it clear that risk-based capital rules can be implemented only when the Commission is confident that firms employing value-at-risk models have robust credit and risk management policies in place. This means that needed net capital reform is likely to come only when the SEC is prepared to conduct these risk management examinations with its own staff or is confident that SROs have the capability to perform them. This degree of oversight will require development of staff experienced in this area. We believe there is little incentive for the SROs to meet this responsibility.

For these reasons we think it is time to seriously consider the creation of a single, independent SRO to adopt, examine and enforce a core body of financial responsibility, customer protection and margin rules. We hope and expect that there would be savings generated by economies of scale. These savings could be used to increase the compensation of a professional staff, thereby improving the qualifications of examiners. We do not necessarily advocate a "single regulator" model for all purposes. Exchanges and electronic trading systems have a right to be assured that those who use their systems also abide by their rules. They should have both the responsibility and the authority to surveil their own markets.


In conclusion, let me again thank this Committee for its interest in this subject. Few areas are more important to the continued financial growth and the stability of our economy than well functioning capital markets. Our firm is proud of our role in developing these markets through the years. We look forward to working with you and with those who directly regulate us to keep American markets the preeminent capital markets in the world.

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