Mr. Chairman and Members of the Subcommittee. My name is Kevin Foley, and I am pleased to testify on behalf of Bloomberg Tradebook concerning the role of Electronic Communications Networks (ECNs) in the financial markets.
Bloomberg Tradebook is owned by Bloomberg L.P. We are an electronic agency broker serving institutions and other brokers-dealers. We count among our clients many of the nation's largest institutional investors. Bloomberg Tradebook specializes in providing innovative tools that allow our clients to step unobtrusively into the electronic "crowd" of the new national market system to find liquidity for themselves and, in the process, provide it for others. Our clients have rewarded our creativity and our service by trusting us with their business. Our 55 million shares matched per day this month represents a six-fold increase in the past year.
ECNs - A Market Solution to a Market Problem.
Some have lamented the existence of ECNs, suggesting that we are an unwanted development. It's worth asking the question, exactly what are ECNs, and why do we have them?
ECNs are distinguished by three characteristics -- neutrality, transparency and fairness. Neutrality? By definition we are agency brokers and take no positions for our own accounts. Thus, we are neutral in the marketplace and exist only to serve our customers' need to buy or sell shares. Transparency? Like market-makers, we maintain an electronic book of our customers' bids and offers. But unlike market-makers, we publish our entire book of quoted prices electronically for all our customers to see. That's transparency. Fairness? ECNs are required by SEC rules to respond immediately - and I mean immediately - to orders in the order they are received, whether they come from our best customers or from our competitors. That's probably the highest standard of fairness in the industry.
Add to that lots of enthusiasm and creativity from people passionately devoted to serving their customers and you have a picture of who we are and why we exist.
In his statement before the Senate Banking Committee last month, Frank Zarb, the Chairman of the National Association of Securities Dealers, stated that "... I guess I sum up the answer as to why we have ECNs as the fact that the national stock exchanges, and I'm not only talking about ours, but the exchanges around the world haven't been keeping pace with the needs of the market."
Mr. Zarb is an accomplished leader in business and public service. Investors are fortunate for his leadership at this time, but I respectfully submit that the reason ECNs exist is not only because of what national stock exchanges failed to do, but also because of what we innovating broker-dealers have done, in the heat of competition. Mr. Chairman, it's worth pondering why the stock exchanges didn't keep pace, as Mr. Zarb says. I would submit that a government-sponsored monopoly ultimately cannot provide the innovative ideas and customer service of the best ECNs precisely because they are a government-sponsored monopoly. To spur future innovation, I'd rather place my faith in their members -- the marketplace of competing broker-dealers.
What are ECNs? At Bloomberg Tradebook we see ourselves as a market solution to a market need. A brokerage need. Nothing more. This should be kept in mind as Congress and the SEC weigh whether and how to react to the growth of ECNs.
ECNs - Consumers and Investors Benefit.
So who has benefited from the existence of ECNs? For one, small retail customers who, for the first time, have gained direct unfettered access to the liquidity of institutional order flow represented directly in the market. Institutional investors who, for the first time, are able to find liquidity for their orders by interacting directly with small order flow. All investors who have seen the speed and fairness of their executions improve, as ECNs have raised the standard for all broker-dealers. Even traders not participating directly in ECNs benefit from our depth, liquidity and immediacy each time they hit an ECN bid or take an ECN offer.
Some skeptics concede that ECNs bring enormous efficiency to the market, but express concerns regarding the impact on market transparency and the threat of market fragmentation, and the effect on competition.
Let's start with transparency. As we have seen, ECNs are by definition transparent. Unlike market-makers, we display our entire customer order book to our customers or, in some cases, to anyone that wants to see it. We believe we are the last folks in the market to give cause for concern about transparency.
But it is up to government-sponsored market centers like the New York Stock Exchange and the Nasdaq Stock Market to make ECN transparency available to the entire national market system. They can enhance transparency by incorporating ECNs into their market display, as Nasdaq did early in 1997. Or they can reduce transparency by seeking to block ECN display linkages, or roll them back, as seems to be the effort now in 1999.
What about fragmentation? Market fragmentation occurs when buyers and sellers fail to meet because they are looking for each other in different places. Unable to learn the existence of each other, they transact at inefficient prices, raising costs for themselves and market volatility for everyone else.
So doesn't that mean that ECNs are causing fragmentation? Yes, there are a lot of new competitors in the field. But the SEC knows that the antidote for fragmentation is transparency and market linkages, which have been the law of the land in the Nasdaq market for nearly three years. Sure, without these linkages ECNs would be causing fragmentation. But without linkages, all broker-dealers would be causing fragmentation. It makes as much sense to fret over ECN fragmentation as to worry that there are too many brokerage firms. Imagine that - some investors are choosing Merrill Lynch, some are choosing Morgan Stanley Dean Witter. Should there only be one?
It's important to note that the Nasdaq market of today is consolidated, not fragmented. Customers' orders are displayed to all and interact freely among market-makers, ECNs, order entry firms and even regional exchanges. Through this system of display of customers' orders and electronic linkages that provide instant access to those orders, ECNs in Nasdaq participate in the least fragmented market of all time.
Not so in the listed markets, where such linkages with ECNs have not been forthcoming for three years, despite the SEC's mandate, repeated again last year with Regulation ATS. The explanation for this real market fragmentation may lie with the governance rules of the Intermarket Trading System (ITS) committee; it certainly doesn't lie with ECNs like Bloomberg Tradebook, who are eager to see ITS reform and improved market linkages. An ineffective ITS has long allowed the New York Stock Exchange to dominate the regional exchanges and is also a pretty effective tool if your aim is to block the success of newcomers like ECNs.
As Mr. Grasso has observed in testimony before this Committee, ECNs don't do as much listed business. I'd say the strategy is working. Our customers would like us to act as their agent for listed stocks, as we do in Nasdaq stocks. But, in the present circumstances, their orders cannot interact with the orders of others who happen not to be our customers. That's a shame. The losers are all the investors who would benefit from the transparency and liquidity ECNs provide.
The truth is that, for all their hand-wringing, a fragmented market is precisely what the established folks would prefer, because that means keeping the new guys out. Congress has addressed this problem successfully in the past, and the same model will address it in the future. The model calls for more transparency and more linkages.
Finally, a word about competition. Bloomberg Tradebook does not compete against the NASD or the New York Stock Exchange. We compete against our competitors. We compete against exchange members and, in the case of the NASD, we are one. But all members compete against other members. That's what we're supposed to do.
Perhaps the national stock exchanges see us as a competitor because of our independence: we could take our customers and their order flow to another stock exchange. That would mean that exchanges would have to compete against each other to keep that customer order flow. Maybe they think that order flow is theirs rather than their customers'. But investors have clearly indicated that ECNs are an important part of their market structure.
It seems the first response of the dominant national stock exchanges has not been to compete against each other for the business of this new type of broker-dealer. One gets the feeling that they'd rather avoid the whole headache by passing a few new rules and holding their order flow captive. Little wonder some ECNs would rather become exchanges themselves.
We don't think that's right. We think the national stock exchanges should have to compete against each other for our business or the business of any other broker-dealer.
Conclusion - What Congress should worry about.
Congress doesn't have to worry too much about the right market structure. The model Congress put forth in 1975 is still the right model today. The past few years have seen an unleashing of innovation and competition that is again the envy of the rest of the world. Regulators throughout the world are watching our capital markets and again examining how they can be more like us.
I'm certainly not here to argue that Congress needs to worry about the health of ECNs like Bloomberg Tradebook. We are a pretty nimble group of competitors, as Mr.Grasso has characterized us, and I assure you we'll be here serving our customers no matter what the rules of the game.
Congress should be concerned, however, about misguided efforts to roll back the progress of the SEC's recent market structure initiatives. The Congress should be concerned about the potential anti-competitive effect of new initiatives proposed by the dominant exchanges. It would be a terrific opportunity missed if the final result is a market that's less innovative, has less system capacity, and has less ability internally to generate new solutions to new problems. A market too reliant on government-sponsored monopolies for innovative solutions may not fare well against future offshore competition. And Congress should be concerned about that.
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