[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]



 
                COMPETITION IN THE NEW ELECTRONIC MARKET

=======================================================================

                                HEARINGS

                               before the

            SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS

                                 of the

                         COMMITTEE ON COMMERCE
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             SECOND SESSION

                               __________

                         PART I--MARCH 29, 2000
                         PART II--MAY 11, 2000

                               __________

                           Serial No. 106-111

                               __________

            Printed for the use of the Committee on Commerce


                   U.S. GOVERNMENT PRINTING OFFICE
69-533                     WASHINGTON : 2000


                         COMMITTEE ON COMMERCE

                     TOM BLILEY, Virginia, Chairman

W.J. ``BILLY'' TAUZIN, Louisiana     JOHN D. DINGELL, Michigan
MICHAEL G. OXLEY, Ohio               HENRY A. WAXMAN, California
MICHAEL BILIRAKIS, Florida           EDWARD J. MARKEY, Massachusetts
JOE BARTON, Texas                    RALPH M. HALL, Texas
FRED UPTON, Michigan                 RICK BOUCHER, Virginia
CLIFF STEARNS, Florida               EDOLPHUS TOWNS, New York
PAUL E. GILLMOR, Ohio                FRANK PALLONE, Jr., New Jersey
  Vice Chairman                      SHERROD BROWN, Ohio
JAMES C. GREENWOOD, Pennsylvania     BART GORDON, Tennessee
CHRISTOPHER COX, California          PETER DEUTSCH, Florida
NATHAN DEAL, Georgia                 BOBBY L. RUSH, Illinois
STEVE LARGENT, Oklahoma              ANNA G. ESHOO, California
RICHARD BURR, North Carolina         RON KLINK, Pennsylvania
BRIAN P. BILBRAY, California         BART STUPAK, Michigan
ED WHITFIELD, Kentucky               ELIOT L. ENGEL, New York
GREG GANSKE, Iowa                    TOM SAWYER, Ohio
CHARLIE NORWOOD, Georgia             ALBERT R. WYNN, Maryland
TOM A. COBURN, Oklahoma              GENE GREEN, Texas
RICK LAZIO, New York                 KAREN McCARTHY, Missouri
BARBARA CUBIN, Wyoming               TED STRICKLAND, Ohio
JAMES E. ROGAN, California           DIANA DeGETTE, Colorado
JOHN SHIMKUS, Illinois               THOMAS M. BARRETT, Wisconsin
HEATHER WILSON, New Mexico           BILL LUTHER, Minnesota
JOHN B. SHADEGG, Arizona             LOIS CAPPS, California
CHARLES W. ``CHIP'' PICKERING, 
Mississippi
VITO FOSSELLA, New York
ROY BLUNT, Missouri
ED BRYANT, Tennessee
ROBERT L. EHRLICH, Jr., Maryland

                   James E. Derderian, Chief of Staff

                   James D. Barnette, General Counsel

      Reid P.F. Stuntz, Minority Staff Director and Chief Counsel

                                 ______

            Subcommittee on Finance and Hazardous Materials

                    MICHAEL G. OXLEY, Ohio, Chairman

W.J. ``BILLY'' TAUZIN, Louisiana     EDOLPHUS TOWNS, New York
  Vice Chairman                      PETER DEUTSCH, Florida
PAUL E. GILLMOR, Ohio                BART STUPAK, Michigan
JAMES C. GREENWOOD, Pennsylvania     ELIOT L. ENGEL, New York
CHRISTOPHER COX, California          DIANA DeGETTE, Colorado
STEVE LARGENT, Oklahoma              THOMAS M. BARRETT, Wisconsin
BRIAN P. BILBRAY, California         BILL LUTHER, Minnesota
GREG GANSKE, Iowa                    LOIS CAPPS, California
RICK LAZIO, New York                 EDWARD J. MARKEY, Massachusetts
JOHN SHIMKUS, Illinois               RALPH M. HALL, Texas
HEATHER WILSON, New Mexico           FRANK PALLONE, Jr., New Jersey
JOHN B. SHADEGG, Arizona             BOBBY L. RUSH, Illinois
VITO FOSSELLA, New York              JOHN D. DINGELL, Michigan,
ROY BLUNT, Missouri                    (Ex Officio)
ROBERT L. EHRLICH, Jr., Maryland
TOM BLILEY, Virginia,
  (Ex Officio)

                                  (ii)


                            C O N T E N T S

                               __________
                                                                   Page

Hearings held:
    March 29, 2000, Part I.......................................     1
    May 1, 2000, Part II.........................................    71
Testimony of:
    Andresen, Matthew, President, The Island ECN.................     6
    Atkin, Douglas M., CEO and President of Instinet.............    75
    Dorsch, Shawn A., President and COO, DNI Holdings, Inc.......    20
    Foley, Kevin, CEO, Bloomberg Tradebook.......................    13
    Jenkins, Peter W., Director of Equity Trading, Scudder Kemper 
      Investments................................................   106
    Kamen, Kenneth A., President, Princeton Securities 
      Corporation................................................   110
    Ketchum, Richard G., President, National Association of 
      Security Dealers, Inc......................................   100
    McSweeney, Robert J., Senior Vice President, Special 
      Committee on Market Structure, Governance, and Ownership, 
      New York Stock Exchange, Inc...............................    97
    Schaible, John M., Founder and President, NexTrade...........    24
    Stark, Holly A., Director of Trading, Kern Capital Management    92
    Wheeler, John J., Manager Equity Trading, American Century 
      Investments................................................    80
Material submitted for the record by:
    Andresen, Matthew, President, The Island ECN, letter dated 
      May 2, 2000, to Hon. Tom Bliley, enclosing response for the 
      record.....................................................    64
    Foley, Kevin, CEO, Bloomberg Tradebook, responses for the 
      record.....................................................    50
    Galbraith, Steven, Senior Investment banking and Brokerage 
      Analyst, Sanford G. Bernstein & Co., prepared statement of.   163
    Ketchum, Richard G., President, National Association of 
      Security Dealers, Inc., responses for the record...........   264
    McSweeney, Robert J., Senior Vice President, Special 
      Committee on Market Structure, Governance, and Ownership, 
      New York Stock Exchange, Inc., letter dated June 8, 2000, 
      to Hon. Thomas Bliley, enclosing response for the record...   270
    Putnam, Gerald D., CEO, Archipelago, letter dated March 28, 
      2000, to Hon. Michael G. Oxley.............................    49
    Schaible, John M., Founder and President, NexTrade, letter 
      dated April 21, 2000, to Hon. Tom Bliley, enclosing 
      response for the record....................................    55

                                 (iii)




            COMPETITION IN THE NEW ELECTRONIC MARKET: PART I

                              ----------                              


                       WEDNESDAY, MARCH 29, 2000

                  House of Representatives,
                             Committee on Commerce,
           Subcommittee on Finance and Hazardous Materials,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 10 a.m., in 
room 2123, Rayburn House Office Building, Hon. Michael G. Oxley 
(chairman) presiding.
    Members present: Representatives Oxley, Tauzin, Gillmor, 
Bilbray, Ganske, Shimkus, Wilson, Fossella, Ehrlich, Towns, 
Engel, Barrett, Luther, Capps, Markey, and Rush.
    Also present: Representatives Burr and Rogan.
    Staff present: David Cavicke, majority counsel, Linda 
Dallas Rich, majority counsel; Brian McCullough, professional 
staff; Robert Simison, legislative clerk; and Consuela 
Washington, minority counsel.
    Mr. Oxley. The subcommittee will come to order. The Chair 
will recognize himself for an opening statement.
    Technology is changing our lives dramatically as our 
economy continues to evolve into an information-based society. 
In one decade, we realize the tangible benefits of the 
convergence of telecommunications, the computer industry and 
the emergence of the Internet. Wireless technology allows us to 
communicate, conduct commerce through cell phones or hand-held 
PCs and perform other tasks with breathtaking efficiency. 
Information is easier to access than we could have ever 
imagined just a few years back. The Internet is providing 
global competition that has lowered cost to consumers and 
businesses.
    Our capital markets are experiencing a similar 
technological evolution. Better and more readily available 
information is changing the composition of the markets. Self-
directed investors now have access to securities professionals 
research analysis graphs and quotes from which they can make 
informed decisions. Not to commend any particular market 
participants' TV commercials, but you know the world has 
changed when you see Ringo Starr talking about asset allocation 
and portfolio diversification.
    Today we begin a series of hearings on competition in the 
new electronic marketplace. This is a subject that is as 
challenging and as interesting as anything we have examined in 
this subcommittee heretofore. Just a couple of years ago, 
electronic communication by the Internet and through the 
proprietary systems of electronic communications networks, or 
ECNs, began a revolutionary and astonishingly rapid 
transformation of our financial markets. Even before the advent 
of the Internet, technology fostered competition within the 
markets. Technology led to the development of the dealer 
market, which was conceived as an alternative to the 
traditional auction market of the exchanges. That competition 
has served the markets well.
    More recently, the emergence of ECNs has provided 
additional competition in the markets and a possible glimpse 
into the future. ECNs vary in their business models, but all 
offer an alternative trading mechanism for investors to execute 
their trades. ECNs provide investors with many benefits, 
including reduced trading costs, faster execution and more 
choices of where to trade stock. Some commentators have raised 
concerns that multiple venues competing for order flow will 
fragment the market, but couldn't fragmentation be just another 
word for competition? This is an issue that we will learn more 
about through the hearing.
    The markets will determine the best price available for a 
stock. One of our jobs here in Congress is to make sure that 
the rules that govern our markets allow price discovery to 
happen in the fairest and most efficient way. I believe 
competition should determine the best structure for the 
financial markets. The government is notoriously bad at 
predicting the future and designing marketplace or picking 
winners and losers. What we can do is make sure that the rules 
we have put into place foster competition, not monopolistic 
behavior.
    I look forward to learning about how ECNs are reshaping our 
markets. One of the questions that has been raised is whether 
multiple markets can function efficiently in a market in which 
they are competing for liquidity. While ECNs initially catered 
to institutional clients, we are seeing a move into the retail 
marketplace. I look forward to learning more about these 
developments as well as how these trading models compare with 
the traditional auction and dealer markets. We will hear from 
these traditional markets at an upcoming hearing on this 
subject. I am pleased to welcome today's witnesses who hail 
from four very different ECNs, and I will introduce them before 
they begin their testimony.
    The Chair yields the balance of his time and now recognizes 
the ranking member, the gentleman from New York, Mr. Towns.
    Mr. Towns. Thank you very much, Mr. Chairman.
    Let me also thank you for holding this very important 
hearing. The U.S. securities markets, which is the heart of the 
subcommittee's jurisdiction, is undergoing rapid change. While 
I do not believe that any legislative action is necessary to 
address these revolutionary changes at this time, I do think 
that it is vital for the subcommittee to closely monitor these 
changes. We must educate ourselves on changes in the market and 
responsible oversight over the SEC's responses to these 
changes. We must ensure that neither our actions nor the 
actions of the SEC accidentally threatens the phenomenal 
success of the U.S. securities markets, which just happens to 
be centered in New York City, which I happen to be from. That 
is an important issue.
    I have not reached any conclusion on many of these issues 
raised by the fundamental changes of our securities markets. 
However, I have followed the debate on these issues with 
interest. For example, some have stated that the changes in the 
securities markets require the introduction of a central limit 
order book. This contention raises a number of questions in my 
mind. Who would set the rules of a CLOB? Who would enforce 
these rules? Would a CLOB deter innovation? The kind of 
innovation that is changing our markets for the better today?
    We need to be concerned about that. Would all customers' 
orders or just retail orders be required to be submitted to a 
CLOB? If only retail orders must be submitted to a CLOB, would 
this disadvantage these customers? I think these questions need 
to be answered, Mr. Chairman, and I think we need to get 
answers on these questions before we move forward. Would it 
threaten the extremely high level of retail participation that 
make our securities markets the envy of the world?
    There has also been much discussion of the role of ITS, the 
intermarket trading system. In the future, again, I haven't 
come to any conclusion, Mr. Chairman, but I do have many 
questions. As I understand it, ITS was created at a time when 
there was no linkage between securities markets at all. ITS 
made it possible for broker-dealers to ensure that they were 
getting the best price for their customers. In a way, the 
markets relieved broker-dealers from their best execution 
obligation. While ITS technology has advanced, questions still 
remain, many questions. Is the technology available today for 
broker-dealers to take complete responsibility for fulfilling 
their best execution obligation without the help of ITS? If it 
isn't available, will it be available soon? How will this 
change the debate about the structure of ITS? And even the need 
for ITS.
    Again, Mr. Chairman, thank you for calling this hearing. I 
look forward to the testimony of the witnesses today, and at 
the other hearing that I understand that you intend to call in 
the very near future, and I think that it is important that we 
do have that hearing because we are dealing with a situation 
where there is a lot of changes, and I think we need to be on 
top of them, and I don't think that we need to do something 
without really having all of the information before we move 
forward.
    Thank you, Mr. Chairman, for having these hearings.
    Mr. Oxley. Are there any other opening statements?
    Hearing none----
    Mr. Shimkus. Mr. Chairman.
    Mr. Oxley. The gentleman from Illinois.
    Mr. Shimkus. I think this hearing is timely and I have to 
remark about the young pups we have now testifying who are CEOs 
and presidents of these companies. I think that really speaks 
to the industry. So the basic question we have to ask is does 
the existing regulatory structure encourage or discourage and 
questions of safety and soundness. I appreciate you all coming, 
and I yield back the balance of my time.
    [Additional statements submitted for the record follow:]

 PREPARED STATEMENT OF HON. W.J. ``BILLY'' TAUZIN, A REPRESENTATIVE IN 
                  CONGRESS FROM THE STATE OF LOUISIANA

    Thank you Mr. Chairman.
    With the advent of the Internet, we have seen an unprecedented 
growth of new goods and services that Americans have simply never had 
before.
    There are, of course, many benefits to the array of new choices now 
provided in competitive marketplaces, but what excites me most about 
the way new technologies are changing our lives is that now, more than 
ever, the American consumer is empowered to make fully informed 
purchasing and investing decisions.
    There is no denying that the Internet is transforming traditional 
relationships between merchant and buyer . . . between fiduciary and 
beneficiary . . . and between institutional investors, issuers, retail 
investors, and securities exchanges.
    In telecommunications marketplaces, the deployment of ``backbone 
infrastructure,'' ``advanced data services over DSL lines and cable 
modems,'' ``interactive software,'' and ``fixed and mobile wireless 
technologies,'' has, ALMOST OVERNIGHT, given life to an e-commerce 
kingdom over which the consumer reigns. Today, consumers can access 
tremendous amounts of quality content . . . run businesses . . . shop 
at almost any store . . . communicate with friends, family, and 
colleagues ALL WITHOUT LEAVING HOME.
    In the securities marketplace, we are finding that a similar 
phenomenon is taking place. Because of the Internet, retail investors 
can now trade securities at home without paying traditional 
commissions, they can access analyst research reports that were once 
available only to institutional investors, and they can also now invest 
in new IPOs at initial offering prices as opposed to higher prices 
resulting from trading in secondary markets.
    The point I'm trying to make here is that now, more than ever, new 
technological advances, as well as Internet-centric business models, 
are forcing us to re-examine the roles played by market intermediaries 
who for so long have dictated the pace of business . . . of investing.
    Today, we are here to learn more about the way that the so-called 
``ECNs'' (Electronic Communication networks) are implementing changes 
in securities markets. Like nothing we have seen before, ECNs provide a 
forum for online trading of stocks, derivatives, and options by 
capitalizing upon recent advances in computing power and bandwidth 
capacity.
    The ECNs (Electronic Commerce Network) are slowly but surely 
allowing investors to buy securities from and sell securities to one 
another in true auction fashion without having to go through broker-
dealers to execute trades and without having to buy or sell at a price 
listed on an exchange.
    Because of what they propose to do, ECNs, are no doubt, exciting 
new creations of technological advance, and I am looking forward to 
hearing more about them from our witnesses today.
    However, I want to point out that we have to proceed with caution 
when we begin discussing altering life as we know it. While I am very 
interested in bringing full investing choice to investors via new 
trading forums, it is not time to simply disregard the undeniable value 
and importance of current market intermediaries, such as broker-dealers 
registered with the NASD and the exchanges.
    For purposes of this debate, it is important for me, and for all 
the members of this Committee, to understand the full impact of 
sweeping market structure changes sought at this point before we can 
completely pass judgment on the pending ECN applications for exchange 
status.
    Ultimately, we have to rely on our process to come up with a 
recommendation to the SEC that enables new trading opportunities for 
retail investors while affording a fair degree of deference to 
longstanding NASD and NYSE policies at the same time.
    With that, Mr. Chairman, I yield back. Thank you.
                                 ______
                                 
 PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE

    Good morning, thank you Chairman Oxley. The youth on the panel 
before us at today's hearing is a testament to the changes new 
technology has brought to our markets. New ideas are transforming the 
marketplace in ways that would have been unimaginable a few years ago.
    Indeed innovation is an engine that will outdo even the most 
visionary of prophets. Theodore Vail, the chairman of AT&T at the turn 
of the century, had the dream of a phone in every town in America. That 
was thinking big. He could not have imagined that folks in our hearing 
room today would be carrying a phone in their pocket--never mind that 
that phone would not only make calls but also access the Internet, e-
mail, and heaven knows what else by now.
    What is happening in our financial markets today reminds me of the 
change in our telecommunications markets after the enactment of the 
Telecommunications Act. New entrants to the marketplace had been 
stymied by regulatory barriers that impeded fair competition. Our 
Committee developed the Act to eliminate those barriers. As a result, 
new entrants are flourishing, and old stalwarts are being forced to 
innovate.
    Today, new entrants to our financial marketplace are shaking up the 
status quo. The standard-bearers are innovating. Technological advances 
and new trading mechanisms are improving price discovery and the 
quality of trade executions. Our markets--and investors--are thriving.
    But, there is work to be done to ensure that market forces and 
innovation in the financial marketplace are not hampered by old 
regulations. As one of our witnesses today notes, back in 1975 Congress 
instructed the Securities and Exchange Commission, in developing a 
National Market System, that ``competition, rather than regulation, 
should be the guiding force.'' Those are words to live by.
    I believe we should examine the need for regulatory changes in 
order to free up the forces of competition. For example, I am curious 
to learn more about the impact of changing the rules that limit 
membership in the Intermarket Trading System. Today, the ITS does not 
include representation by non-exchange marketplaces. And any single 
member can veto proposed rule changes. Is this really the best 
structure for our modern financial markets?
    No blueprint exists for the marketplace of the future. Our task is 
to ensure that rules allow the best marketplace to evolve. We may not 
be able to imagine what the world will be like when ``a phone in every 
pocket'' sounds as quaint as ``a phone in every town.'' But we can take 
action to make sure the rules are flexible enough to work in years to 
come.
     I thank our witnesses today for participating in this most 
important initiative of the Subcommittee, and look forward to hearing 
from the exchanges and other market participants who will be testifying 
at our subsequent hearings.

    Mr. Oxley. The Chair would now recognize a distinguished 
visitor from another subcommittee, the gentleman from North 
Carolina, for the purposes of introducing one of our witnesses.
    Mr. Burr. I thank the Chair for the opportunity to be here. 
I am amazed that the gentleman from Illinois would compare the 
age of the chairman to our witnesses in calling them young 
pups, only in comparison to the chairman's age. That would 
never happen in another subcommittee.
    Mr. Oxley. That is why you're not on this subcommittee.
    Mr. Burr. I think clearly the world is changing, as 
everybody has said in their opening statements. There is a 
North Carolina influence to that, Shawn Dorsch. Shawn is the 
founder, president, COO of Blackbird in Charlotte, North 
Carolina. He was a former derivative and technology expert at 
J.P. Morgan and First Union Bank. He has an degree in economics 
from North Carolina State University and I am surprised after 
last night's game in the NIT semifinals, since I am a Wake 
graduate, he is allowing me to introduce him. Blackbird was co-
founded in 1996 by Shawn Dorsch and Raymond May. Clearly it is 
a new and emerging business. It is the first system of its kind 
and has significant momentum in the marketplace having signed 
up 32 financial institutions as customers.
    Blackbird offers its customers a number of advantages, 
including significantly lower fees, superior execution, 
increased market liquidity and greater operational efficiency. 
Gosh, I hope we stay out of the way of what they are 
accomplishing. Blackbird was designed with input from leading 
derivative dealers. Blackbird is now setting its sites on 
revolutionizing the global market by opening offices in London 
and Tokyo later this year.
    Mr. Chairman, thank you for having this hearing and more 
importantly, thank you for inviting who I believe is one of the 
best, and I welcome Shawn.
    Mr. Oxley. I thank the gentleman. Let me now introduce with 
a lot less fanfare the rest of the panel. Mr. Matthew Andresen, 
president of The Island ECN. Mr. Kevin Foley of Bloomberg 
Tradebook, the aforementioned Mr. Dorsch from Blackbird, and 
Mr. John Schaible, founder and president of NexTrade. 
Gentlemen, thank you for your appearance today. I see we are 
going to have some interactive participation here which is 
always good for the committee. We always enjoy that. We will 
begin with Mr. Andresen.

  STATEMENTS OF MATTHEW ANDRESEN, PRESIDENT, THE ISLAND ECN; 
    KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK; SHAWN A. DORSCH, 
 PRESIDENT AND COO, DNI HOLDINGS, INC.; AND JOHN M. SCHAIBLE, 
                FOUNDER AND PRESIDENT, NEXTRADE

    Mr. Towns. Mr. Chairman, may I interrupt for 1 second. We 
have two New Yorkers on here, and when I am chairman next year, 
I am going to allow you to introduce panel members from your 
State.
    Mr. Oxley. If you had just asked.
    Mr. Andresen.
    Mr. Andresen. I would like to thank Chairman Oxley and 
members of the subcommittee for holding these important and 
timely hearings on the structure and the future of our equity 
markets. As this subcommittee begins its deliberations on these 
critical public policy issues, we have already heard two 
distinct proposals.
    On the one hand, the traditional human intermediaries, 
uneasy with the effects of enhanced competition, have called 
for direct Federal intervention to create a new central public 
utility in our dynamic markets.
    On the other hand, the new electronic markets like Island 
have led the charge to instead knock down the remaining 
historic barriers to competition, thereby bringing the benefits 
of speed, reliability and transparency that have defined the 
ECN model to the market for New York Stock Exchange listed 
stocks.
    My name is Matt Andresen and I am the president of The 
Island. We are a network of over 290 brokerage firms trading 
over 200 million shares a day. Island does 12 percent of 
NASDAQ's trades. That is one in every eight transactions. Last 
year Island matched over 26 billion shares of stock directly 
without the spread or time loss associated with traditional 
market participants. These shares accounted for a dollar amount 
last year of $1.6 trillion. At this time we have unprecedented 
numbers of investors in the marketplace, as noted by the 
distinguished members already, in 1980 only one in 10 Americans 
participated in our markets.
    Today that number is over 52 percent. While these investors 
have new-found access to market research and market data, some 
proposed taking a giant step backwards from these innovations 
by calling for a central limit order book or so-called CLOB. 
Its advocates claim that the CLOB would cure the fragmentation 
allegedly attributable to those in front of you today. I argue 
that ECNs have, in fact, consolidated the markets. If you look 
at the stock market in 1996 before ECNs, the top four 
participants on NASDAQ accounted for 40 percent of the volume. 
Yet now in this era of enhanced competition and alleged 
fragmentation, the top four participants on NASDAQ now account 
for over 60 percent of the volume illustrating the degree to 
which open competition facilitates investors consolidating in 
the most efficient place. What would the effect be of a 
government-installed CLOB? One of the most immediate effects 
would be to eliminate a market participant's ability to compete 
on the basis of speed, reliability and cost, in essence, 
dumbing down the innovative technology, which has so benefited 
investors.
    It is precisely because of these advantages that investors 
have voted with their feet now sending one out of every 3 
NASDAQ trades to ECNs. What can we do to extend this 
competitive environment on NASDAQ to the market for New York 
Stock Exchange listed stocks where competition does not now 
exist? There is perhaps no better place to start than with the 
1975 congressional mandate for the creation of a National 
Market System which gives us the road map. Congress called for 
the meeting of two goals: No. 1, competition between 
marketplaces; No. 2, accessibility of information to investors.
    Today consistent with this mandate, ECNs have their best 
prices included in the NASDAQ quote. Island actually goes so 
far as to not only include this best price to NASDAQ, but 
actually to give all of their prices at all of the price levels 
out over the Internet for anyone with a browser. As Chairman 
Levitt noted last week, it is terribly important not just to 
show investors the tip of the iceberg, but also the entire 
iceberg under the water, show them the depth of all of the 
supply and demand. We have a demonstration that we will go 
through in the Q and A, which shows how someone who has access 
to the Internet can have access to the information heretofore, 
the province only of traditional market participants.
    Isn't it ironic that 25 years later the industries' very 
initiatives put in place to meet these two congressional goals 
are the very historical franchises now preventing competition. 
Island is not able to compete in the market for New York Stock 
Exchange listed stocks and is unable to provide their 
information to investors.
    Mr. Chairman, it is an honor to have had this chance to 
present Island's perspective on these critical public policy 
issues. These hearings present all of us with a compelling 
opportunity to shape the future of our Nation's equity markets 
and ensure their continued strength and prosperity. We must be 
wary of those proposals, which too quickly embrace Federal 
intervention in our free markets and commit us to risky 
regulatory schemes. We must not squander the position of 
financial strength that we have achieved at great cost and 
commitment over the past two centuries. Instead, let us work 
toward greater openness and greater transparency and greater 
accountability in the market. There is too much at stake to do 
otherwise. Thank you.
    [The prepared statement of Matthew Andresen follows:]

   PREPARED STATEMENT OF MATTHEW ANDRESEN, PRESIDENT, THE ISLAND ECN

    I commend the Chairman and the Members of the House Commerce 
Finance and Hazardous Materials Subcommittee for holding these hearings 
on the future of our Nation's equity markets and the benefits of 
electronic markets. Electronic markets--fueled by the revolution in 
communications and computing power--are today driving some of the most 
profound developments in the history of markets and investing. Most 
significantly, we are witnessing a rapid and sweeping democratization 
of the markets. As a result of these changes, we have an historic 
opportunity to create fairer, more competitive markets and ensure that 
America's role as the financial center of the world continues into the 
next millennium.
    As the pioneer in bringing the advantages of electronic markets to 
individual investors, Island greatly appreciates the opportunity to 
share its views on these important public-policy issues. Recent events, 
including the publication of the SEC Concept Release on fragmentation, 
present all of us with the chance to discuss several proposed dramatic 
changes to the structure and operation of our markets. As SEC Chairman 
Arthur Levitt stated in his Northwestern University speech last week, 
today's debate is really about ``how best to let unburdened competition 
and unbridled innovation drive the future of the market. It is a debate 
about how best to equip our markets to compete and win in an 
increasingly globalized electronic marketplace.''
    The success of our markets is based on innovation spurred by 
competition. By remaining committed to such entrepreneurial capitalism, 
we can secure and extend our global, financial leadership role. Yet 
some in today's debate have chosen an alternative model: their 
uneasiness with the effects of enhanced competition prompts them to 
seek Federal intervention in the marketplace. For example, the proposed 
consolidated limit order book would eliminate the incentive for 
different marketplaces to innovate and deliver superior technology and 
service. Such a monopolistic utility would certainly fail to meet the 
investor's needs.
    Consequently, we urge the Committee to resist embracing any of the 
proposed risky regulatory schemes, and instead seize the chance to 
strengthen our markets by unleashing greater competition. I look 
forward today to beginning a dialogue with the Committee about knocking 
down the remaining barriers to competition between markets; bringing 
the benefits of cutting-edge technology into the marketplace; and 
empowering the individual investor with greater access to the market.

                            THE ISLAND STORY

    I am Matthew Andresen, President of The Island ECN (``Island''). 
Island is an automated trading system for equity securities. It gives 
brokers the power to electronically display customer orders. We 
function as a pure auction market--directly matching buy and sell 
orders. We currently have more than 280 broker-dealer subscribers. 
Island was founded approximately three years ago with the intent of 
providing all market participants--from individual investors to large 
financial institutions--with the ability to execute transactions on a 
level playing field, at an extremely low cost without the presence of 
intermediaries or dealers.
    On an average day, Island trades over 200 million shares--
approximately 12 percent of the transaction volume on Nasdaq. We keep 
our market open every trading day, from 8am-8pm. All this is done on a 
single, off-the-shelf Dell computer about the size of a large 
briefcase. For the year 1999, Island trading volume was over 26.5 
billion shares, with a total dollar volume of $1.56 trillion. Overall, 
Electronic Communications Networks (so-called ECNs) account for 
approximately 30 percent of the Nasdaq average daily transaction 
volume.
    The Island story--from our founding to the present day--is about 
fighting for a chance to compete in new markets and allowing investors 
to vote with their feet. If we cannot offer a better product, then we 
should be out of business. Fortunately, investors have welcomed our 
products and services, and Island has enjoyed explosive growth. For 
example, we heard investors ask for greater flexibility in managing 
their finances, and we delivered our superior services earlier and 
later each trading day. Specifically, Island's extended-hours trading 
session (8am-9:30am. And 4pm-8pm) began mid-1999 with only about 1 
million shares traded; today, we are regularly doing over 20 million 
shares during this session--when the traditional markets are closed, 
Island is open for business. For these reasons, Mr. Chairman, I doubt 
you'll find a witness today who is a greater champion--or beneficiary--
of our Nation's free markets and the individual's unfettered right to 
profit from hard work and innovation.
    I learned early in my financial career that there are two things 
you can never overestimate: the amount of market information denied the 
individual investor, and the eagerness with which the investor uses 
this information once provided. Virtually right out of college and 
needing a job, I initially landed at the commodities desk of a major 
New York investment bank. Yet I found myself frustrated and disturbed 
by many of the market's hidebound operations and the market 
professionals' advantages over the individual investor. Needless to 
say, I was not long in that job.
    Soon thereafter, I was fortunate enough to meet some brilliant 
software programmers at Island--individuals who grasped a magnificently 
simple and elegant truth: the markets could be made far more rationale 
and fair if investors were allowed access to the same sorts of 
information uniquely available to market professionals. Not only would 
our markets be strengthened and investors derive more value, but there 
would be an unprecedented degree of accountability, openness, and 
transparency.
    On my first day as President of Island, I walked into the office--
and we were, literally, just four employees in one office--with little 
more than a passion for market structure and a steadfast commitment to 
cracking wide open the monopoly on information enjoyed by market 
professionals at the expense of the individual investor.
    We watched carefully as investors consumed real-time market data 
for the first time. And we recalled how many market professionals had 
insisted that such ``arcane'' information would be at best a 
distraction, and probably a nuisance for the investor. How wrong they 
were. As we know, investors today demand access to real-time data and 
the latest research reports as well as the ability to enter orders more 
efficiently and at a fraction of the cost once paid for such 
transactions. Yet while the investor had been empowered to know what to 
buy and when to buy it, a key component of this equation has, until 
recently, been missing: how to buy. That's where Island jumped in.
    Traditionally, investors have only been provided with the highest 
bid and lowest offer in a security. The depth of the market, which 
gives an indication of the true supply and demand for a security, has 
been the exclusive province of market professionals. More specifically, 
what happens to an order after it is placed with your broker? What sort 
of accountability exists? At Island, we urge investors to ask 
themselves what just happened to their order after they click on the 
``Submit'' button. After all that thorough and careful research, why is 
the investor--at this final stage of the process--essentially staring 
into a black box--or at best a screen with the words ``Your Order Has 
Been Placed.''
    That lack of accountability--in other words, denial of information 
to the investor--was unacceptable to us. To provide the best resource 
possible to the investor, we became the first marketplace to provide a 
free, real-time display of all its orders, through the Island 
BookViewer TM. Such transparency is precisely what SEC 
Chairman Levitt recently called for in his Northwestern University 
speech: ``Now is the time to embrace a broader and deeper transparency. 
Now is the time for all market participants to move toward open books 
across all markets . . . These are forward looking initiatives that 
answer the investor's call for greater transparency and more efficient 
pricing.'' Island couldn't agree more. That's why orders received by 
Island for display on the limit order book are immediately visible to 
anyone with a web browser regardless of whether the order was received 
from an individual investor or a large institution. Why is this 
important? Investors can use the additional information provided by 
Island to more accurately price their orders. The Island BookViewer 
TM also reduces the informational and temporal advantages 
traditionally enjoyed by floor brokers, market makers, and specialists. 
In other words, the average investor is not disadvantaged because of a 
lack of access to, for example, the floor of an exchange. By 
eliminating these time and place disparities--in essence, putting the 
investor ``virtually'' right next to the market maker or specialist--
Island helps lower the hidden costs associated with higher spreads and 
inferior executions. In fact, according to the Securities and Exchange 
Commission, spreads--the difference between the highest price to buy 
and the lowest price to sell--have narrowed substantially since the 
time ECNs were given access to the Nasdaq market, saving investors 
hundreds of millions of dollars per year.
    Island's mission is to provide investors with an open, transparent 
market so that they can know precisely what happens to an order after 
sending it to their broker. Traditionally, the markets have conferred 
what are called ``time-place'' advantages on certain of its 
professionals. For example, the specialist on the floor of the New York 
Stock Exchange responsible for a specific stock has unique access to 
all the buy and sell orders for that stock; only that person knows what 
the true supply and demand is for that stock. Consequently, that 
individual has both an informational advantage and the opportunity to 
take advantage of that information in order to make a profit for 
himself and his firm. A perfectly legal business, but one that clearly 
leaves the average investor at a disadvantage.

               WHEN COMPETITION FAILS, AND WHEN IT WORKS

    It is certainly true that much of the Island story is about using 
technology to provide investors with a more efficient, faster, and 
lower cost forum for trading. Yet Island's success is much more than a 
technology story--it is about the tremendous benefits that redound to 
the investor when our markets compete; when one marketplace can 
challenge another with a dizzying array of innovations and offer the 
investor unprecedented opportunities to leverage technological 
breakthroughs.
    As described above, recent advances in computing power and 
bandwidth deployment made it possible for Island to provide investors 
with new and powerful resources to access to the marketplace. We simply 
needed the right legal and regulatory opening to offer our services and 
roll out our product.
    How such an opportunity came about tells us much about how markets 
succeed and fail. About three years ago, as many on this Committee will 
recall, Nasdaq was the subject of a scathing Securities and Exchange 
Commission's 21(a) report about improper market practices; the Justice 
Department had launched an investigation that revealed widespread 
collusion and price fixing; and a billion dollar investor, class-action 
lawsuit against Nasdaq was in the works. More than anything else, the 
problems plaguing Nasdaq were the unfortunate result of what happens 
when a marketplace lacks competition. As we now know, Nasdaq was fenced 
off from any true competition, and the investor had no recourse in 
terms of finding a better marketplace to seek the best execution. Yet 
rather than micromanage the overhaul of Nasdaq, the SEC adopted rules 
(known as the Order Handling Rules) designed to introduce competition 
and greater transparency into Nasdaq--all of which led directly to the 
creation of Electronic Communication Networks.
    Island seized this opening and offered investors a faster, cheaper, 
and more reliable forum for trading. From Island's inception, we 
counted on the fact that investors--when given the choice--would always 
want a more accessible and transparent marketplace. To reach that goal, 
we focused on what we considered the glaring gap in the Nasdaq model: 
the inability of investors to meet directly in the marketplace without 
having to rely on professional intermediaries.
    Moreover, by eliminating the informational disparities discussed 
above, we built a marketplace that is inherently safer, fairer, and 
easier to surveil. For example, participants on the floor of an 
exchange generally possess more trade and order information than the 
average investor sitting at home. Through surveillance and the 
implementation of restrictions on the activities of those in the 
trading crowds, regulators attempt to prevent the misuse of 
information. As recent events have shown, however, no amount of 
surveillance or regulation can completely prevent the misuse of 
information.
    ECNs, such as Island, reduce the opportunities for improprieties by 
eliminating informational disparities. ECNs empower all investors by 
allowing them to step into a virtual trading crowd and compete 
directly. Since all orders are delivered to the virtual trading crowd 
and instantaneously displayed to everyone, no single person has an 
informational advantage that needs to be regulated or surveilled. That 
means we have been able to deliver to investors the benefits of lower 
cost, more transparent, fairer markets, while still complying with 
strict Commission standards designed to ensure the integrity of our 
trading systems. Island, for example, must comply with regulatory 
standards concerning the security, capacity and reliability of our 
system. In fact, due to its use of the latest, most advanced technology 
as well as its proprietary architecture, Island has a superb record for 
reliability and performance. For example, during the past year when the 
Nasdaq market has periodically experienced system delays due to the 
tremendous surges in trading volume, Island has never experienced a 
capacity-related problem. Even during peak trading periods. Island's 
average turnaround time is approximately three one-hundredths (.03) of 
a second--exponentially faster than our nearest competitor. By 
combining the latest technology with our advanced system architecture, 
Island has created a scalable, robust trading system with virtually no 
capacity limitations.
    Finally, we have never taken our eye off the bottom-line for the 
investor; we have always believed that any money funneled out of the 
marketplace--whether to pay for high commissions or to outfit an 
exchange with brass and mahagony--comes directly out of the investors' 
pockets. Consequently, Island has sliced its margins razor thin. 
Island, for example, only receives $.00075 per share per side on every 
transaction executed on its system; in other words, a trade for 1,000 
shares of stock means only seventy-five cents for Island. I like to 
point this out to my staff when others question our spartan offices--
like a recent New Yorker magazine profile noting that we have 
``upgraded our offices from grungy to nondescript. `` I like to believe 
that there are millions of investors across the country benefiting from 
the fact that Island has the least stylish offices on Wall Street.

                       THE FUTURE OF THE MARKETS

    Once we have empowered the investor by providing an open and 
transparent marketplace, there remains one final challenge. How do we 
unleash these benefits on as wide a scale as possible, without 
sacrificing investor protection or the integrity of our capital 
markets? How can we further promote competition between markets and 
ensure that our Nation maintains its leadership role in finance and 
technology?
    Addressing some of these issues, the Securities and Exchange 
Commission published its Concept Release on Fragmentation. In its 
Release, the Commission raised the concern that the U.S. equity markets 
are becoming more fragmented and, thus, less efficient. One key concern 
for the Commission is that the practices of internalization and payment 
for order flow may increase with the repeal of Rule 390. In addition, 
the Commission is concerned that since many market participants are 
assured of receiving order flow either from an affiliate or by paying 
for the order flow, market centers may have little incentive to compete 
based on their quoted price. The Commission also questioned whether the 
practices of payment for order flow and internalization result in some 
brokers routing orders to marketplaces providing inferior executions. 
In response to these concerns, some market participants support the 
adoption of a consolidated limit order book (the so-called ``CLOB'') to 
eliminate the negative impacts of fragmentation, internalization and 
payment for order flow.

Island's Position on Current Proposals
    As stated at the outset, Island believes that the issues raised in 
the SEC Concept Release give us an opportunity to shape the future 
financial marketplace in a manner consistent with the best aspects of 
America's entrepreneurial capitalism. If we choose wisely today, we can 
avoid the mistakes of the past when we embraced risky regulatory models 
proposed by Federal agencies.
    The Island story and the rise of ECNs embody the benefits of 
competition. The dramatic changes in technology have allowed new 
competitors to offer new services at a lower cost and capture market 
share from traditional market participants in a relatively short time 
period. As a result, there has never been a better time to be an 
investor. Interestingly, many of the same traditional firms that have 
long benefited from an environment favoring market professionals are 
now calling for drastic changes to the market--at the very time when 
investors are finally starting to take more control over their own 
financial decision-making. For example, to solve the ``problem'' of 
fragmentation, some market professionals have suggested proposals that 
would inhibit the ability of new entrants to challenge the traditional 
markets. Embarking upon some of these risky regulatory schemes would 
undermine many of the technological breakthroughs pioneered by the ECNs 
and discourage any future innovation.
    To understand why rules mandating price-and-time priority between 
markets and--in their most extreme form--the Consolidated Limit Order 
Book would eliminate competition, consider the following example:
    Assume that ECN A is a market that provides its members with the 
fastest and most reliable trading system in the industry. In addition, 
assume that Traditional Market B utilizes obsolete technology that 
lacks adequate capacity. If, under a regime of price/time priority, 
Market B is the first to display the best offer of $100 in stock XYZ, 
any order to buy XYZ at $100 received by ECN A must be routed to 
Traditional Market B--despite its inferior technology. Thus, even if 
you as an investor intentionally sent your order to ECN A to take 
advantage of its superior speed of execution, ECN A would be required 
to route your order to Traditional Market B. Thus, ECN A would be 
completely dependent on a response back from Traditional Market B in 
order to fill your order.
    This simple scenario demonstrates why price/time priority fails to 
serve the investor:

1.) It is impossible for ECN A to offer a faster execution or better 
        service in its competition with Traditional Market B, since 
        Market A will always be dependent on Traditional Market B for 
        execution and service; and vice versa;
2.) ECN A and Traditional Market B are dependent on the linkage between 
        them and cannot offer service any faster or more reliable than 
        permitted by the linkage; or each other's interaction with the 
        linkage;
3.) In light of the first two points, investors will become insensitive 
        to which market the order is entered, leaving no basis for 
        competition between markets.
    In sum, not only do we prevent markets from competing with one 
another on any basis beside price, but we actually undermine the very 
technological breakthroughs that have strengthened our Nation's equity 
markets.
    To appreciate the real-life consequences of mandating price 
priority between markets, consider the current state of the listed 
market. The listed market has operated a so-called ``trade-through 
rule'' since the implementation of the National Market System more than 
20 years ago. During this entire period, the NYSE has dominated the 
listed market and to this day still controls approximately 75% of the 
share volume. The Commission has long recognized that, despite the 
existence of the regional exchanges, there has never been vigorous 
quote competition between the exchanges. One key barrier to competition 
in listed stocks is the mandating of price priority via the trade 
through rule. The trade through rule states that one market cannot 
trade at a price inferior to a price displayed by another market. 
Although each market is prohibited from trading at an inferior price 
displayed by another market, a market sending an order as required to 
the best priced market must wait up to two minutes for a response. Even 
after two minutes, however, it is still possible not to receive an 
execution from the other market. In such instances, the investor is 
worse off than if he purchased the security at the ``inferior'' price 
to begin with. As in the example with price/time priority above, the 
trade through rule prevents one market from offering services that are 
substantially different or better than the other markets. Price again 
becomes the only competitive factor.

Fragmentation and Internalization
    The proponents of a consolidated limit order book or rules 
mandating price/time priority insist that their initiatives are a 
response to the threat of fragmentation. They tell us that 
fragmentation is increasing and that Federal intervention is needed to 
reverse the trend. In fact, when competition is permitted to flourish, 
orders will gravitate to only a few market centers. This is best 
exemplified by the Nasdaq market. Prior to 1997, volume was spread 
among numerous market makers, and spreads, the difference between the 
bid and the ask, were very wide. Due to the increased competition from 
ECNs, spreads have narrowed dramatically and the Nasdaq market has 
actually become less fragmented. The intense competition has eliminated 
numerous market makers and forced dramatic consolidation. Moreover, 
according to a recent Sanford Bernstein study, the top 4 Nasdaq market 
participants (Instinet, Island, Knight Securities, and Mayer & 
Schweitzer) combined account for approximately 60% of the Nasdaq market 
today compared to 40% a decade ago. With the introduction of 
decimalization, the Nasdaq market should consolidate further.
    It is also important to note that Nasdaq does not have a trade-
through rule or rules requiring price-time priority. If Nasdaq did have 
such rules, it is doubtful that ECNs would have been able to 
effectively compete. By adopting free-market solutions that promoted 
competition, we not only delivered greater value to the investor, but 
fundamentally strengthened the overall marketplace and set the stage 
for the technological breakthroughs exemplified by the ECNs.
    The Commission is also concerned about the possibility that the 
repeal of NYSE Rule 390 will lead to more internalization, and thus may 
harm investors. Island believes that the best way to address these 
concerns, as with those of fragmentation, is to increase competition. 
Internalization is more likely in a non-competitive environment where 
spreads are wide and thus, dealers can more easily profit from the 
difference between the bid and ask prices. As competition increases and 
spreads narrow, it will become increasingly difficult for dealers to 
intrernalize order flow. This is especially true with decimalization, 
where spreads will narrow to just fractions of a penny in many of the 
most active securities. That is why Island is proud to have led the way 
in building a decimal-based marketplace. In fact, Island's market has 
always gone down to ten decimal points.
    Competition between brokers will also reduce any negative impacts 
of internalization. With the availability of real-time quotes and 
innovations such as the Island BookViewer TM, investors are 
better able to monitor their execution quality. As investor 
sophistication increases, brokerages will increasingly begin to 
advertise how they execute orders. Competition will force brokers to 
make the right decisions with respect to where they send their order 
flow.

A Free-Market Model
    Island believes that the U.S. Congress has already designed the 
roadmap for ensuring the continued success of our capital markets. In 
1975, Congress created the National Market System, with the goal of 
constructing a more efficient and transparent market. We could not ask 
for a better building block.
    The mandate of the NMS, as envisioned by Congress, is defined by 
two objectives: first, to promote competition between markets (fair 
competition between exchange markets and markets other than exchange 
markets); and second, to make quotation and transaction information 
available to investors (assure the availability to brokers, dealers, 
and investors of information with respect to quotations for the 
transactions in securities.).
    Consistent with this mandate, the SEC adopted rules that permitted 
ECNs to have their quotations included in the Nasdaq best bid and offer 
that is disseminated to the entire marketplace. As described earlier, 
competition between markets flourished (with ECNs having captured 30 
percent of the Nasdaq transaction volume), and Nasdaq itself was 
significantly reformed. When provided a level playing field, ECNs can 
compete for market share and bring the benefits of competition to the 
investor.
    This situation contrasts sharply with the rules and regulations 
governing Island's ability to compete in NYSE-listed stocks. 
Ironically, almost 25 years later, the rules and market structure 
implemented to achieve the goals of a National Market System are now 
inhibiting competition between markets and restricting the information 
available to investors. Regulatory obstacles block Island from having 
its quotation information included in the two main components of the 
National Market System--the Consolidate Quotation System (CQS) and the 
Intermarket Trading System (ITS).
    I would pose two questions for this committee:
    First, what public-policy benefits are served by stifling 
competition and barring Island from sharing its pricing information?
    I cannot imagine there are any. Consider that when Island trades 
the stock of America Online, at various times during the trading day, 
Island would have the best quote in the National Market System. 
Unfortunately, due to the current regulatory structure, market 
participants (other than Island subscribers) are denied the opportunity 
to see and access the better price on Island. This pure fragmentation 
is completely inconsistent with the spirit of the National Market 
System.
    Second, what public-policy benefits would be served by promoting 
competition and integrating Island into the NYSE's pricing mechanism?
    Most importantly, Island's price information would no longer be 
fragmented from the rest of the marketplace. The market for NYSE-listed 
stocks would immediately become more integrated and efficient. The 
resulting competition between marketplaces (again, a central goal of 
the National Market System) would result in benefits for the investor.
    In light of the proven benefits to investors and the efficiency of 
the market, it is time to take immediate action to give ECNs access to 
the Consolidated Quotation System. ECNs, such as Island, must be 
permitted to disseminate their quotation in listed stocks to all market 
participants. Yet in moving forward on this issue, we must still 
confront and deal with a version of price-time priority currently 
operating for the listed market. As discussed earlier, under the plan 
governing the operation of the Intermarket Trading System, each 
participant exchange is prohibited from trading at a price inferior to 
another participant.
    Just as the Federal government does not negate customer choice by 
requiring consumers to buy goods from the lowest price merchant, market 
participants should not be required to buy from the best-priced market. 
As long as market participants know the price in each market and have 
the ability to access each market, there is no need for the Federal 
government to require the market participant to favor any one market. 
Accordingly, in addition to allowing ECNs to disseminate their 
quotations directly through the consolidated quote, the elimination of 
the trade-through rule is another important step toward more fully 
realizing Congress's objectives in the National Market System.

                               CONCLUSION

    Mr. Chairman, it is an honor to have had this chance to present 
Island's perspective on these critical public-policy issues. These 
hearings today present all of us with a compelling opportunity to shape 
the future of our Nation's equity markets and ensure their continued 
strength and prosperity. As we consider the various proposals under 
discussion, we must be careful of those proposals that too quickly 
embrace Federal intervention in our free-markets and commit us to risky 
regulatory schemes. We must not squander the position of financial 
strength we achieved at great cost and commitment over the past 200 
years. Instead, let us always work towards greater openness, 
transparency, and accountability in the marketplace. There is too much 
at stake to do otherwise.

    Mr. Oxley. Thank you. I now recognize Mr. Foley.

                    STATEMENT OF KEVIN FOLEY

    Mr. Foley. Thank you, Mr. Chairman and members of the 
committee. My name is Kevin Foley. I am chief executive of 
Bloomberg Tradebook, and I am pleased to have the opportunity 
to testify regarding competition in the new electronic market. 
Bloomberg Tradebook is located in New York City. We are an 
electronic agency broker. And one of the things that 
distinguishes us among ECNs is that our focus is serving 
institutions and other broker-dealers who typically serve 
institutions themselves. We count among our clients many of the 
Nation's largest institutional investors and the millions of 
individuals whose pension funds and retirement savings and so 
forth are pooled in institutional investors assets.
    We specialize in providing innovative tools that allow our 
clients to step directly into the electronic crowd, both the 
National Market System such as it is today to find liquidity 
for themselves and to provide their institutional liquidity for 
others, the retailer that is now enfranchised in finding itself 
moving directly into the marketplace. Our clients rewarded our 
creativity and service by trusting us with their business. We 
are the third largest ECN by volume. We had our first day of 
over 100 million shares and we are grateful to our clients for 
that. Competition in the new electronic marketplace is doing 
today what competition does. It is benefiting consumers, it is 
benefiting investors, it is revolutionizing our markets, and it 
is also generating opposition from some who may feel that their 
position could be threatened by revolutionary changes.
    Those who have sought to halt these changes have argued for 
a massive and intrusive regulatory intervention that would roll 
back the clock. They have sought to justify these steps by 
claiming that fragmentation is a threat to our markets. This is 
a traditional refrain of virtually every industry when change 
threatens established players. The telecommunications industry 
is one that comes to mind. When the status quo laments harmful 
fragmentation, it is time for all of us to be careful. Often it 
is really the sound of beneficial competition being bemoaned by 
those who prefer and enjoy the status quo. Some have urged 
support for a time priority central limited order book, CLOB, 
centralizing orders in a single black box. The technology of 
today makes a centralized order book unnecessary.
    It is possible to have transparency and linkages in the 
markets. The central black box runs contrary to the operation 
of state-of-the-art modern telecommunications, the Internet 
being the best model. The innovations that ECNs have brought to 
the market like, for example, one called Reserve from Bloomberg 
Tradebook which we can talk about later, could not occur under 
an industry sponsored CLOB, an industry-sponsored black box or 
one sponsored by NASDAQ, for example, which they have currently 
proposed in their SuperMontage proposal before the SEC. The 
pending SuperMontage proposal carries many of the downsides of 
a traditional CLOB. If you are against a CLOB, you've got to be 
against the NASDAQ SuperMontage proposal, and it is happening 
now. It creates a centralized single point of failure, and it 
creates a single decisionmaking apparatus that is resistant to 
change. The public would be much better served if the NASD 
focuses resources on the capacity issues critical for the 
implementation of decimalization, as championed for years by 
this committee.
    Prior to focusing on securing what we believe to be an 
anticompetitive beachhead in anticipation of the transparency 
to a for-profit entity, Congress and the SEC should not 
entertain significant structural changes to NASDAQ or to the 
equity markets in general until after decimalization has been 
completed and the full range of its benefits have been 
assessed. Congress should oppose the imposition of a CLOB, and 
it should oppose the imposition of a structure that gives you 
95 percent of what a CLOB will give you as NASDAQ has claimed 
the SuperMontage proposal will do. It is something that 
Congress needs to look at immediately. I am looking forward to 
the rest of the hearings and the questions and answers 
afterwards. Thank you, Mr. Chairman.
    [The prepared statement of Kevin Foley follows:]

   PREPARED STATEMENT OF KEVIN FOLEY ON BEHALF OF BLOOMBERG TRADEBOOK

                              INTRODUCTION

    Mr. Chairman and Members of the Subcommittee. My name is Kevin 
Foley, and I am pleased to testify on behalf of Bloomberg Tradebook LLC 
regarding competition in the new electronic market.
    We commend this Committee for its efforts to bring the benefits of 
competition to our markets and the investing public. To ensure the 
continuation of an environment in which competition flourishes, we urge 
the Committee to oppose efforts to create a Consolidated Limit Order 
Book (CLOB) whether run by the industry itself or by NASD. We 
specifically urge the Committee to oppose SEC approval of the NASD's 
proposed CLOB known as the SuperMontage. We also urge the Committee to 
consider carefully the implications of privatization of the dominant 
national exchanges. Allowing a government-mandated monopoly to enter 
the markets as a for-profit entity raises enormous concerns, including 
concerns regarding the availability of real-time market data--the 
``oxygen'' of our markets. We commend this Committee's efforts to 
protect the availability of market data and prod the industry on 
decimalization. We urge that significant structural changes to the 
market not be considered until after decimalization has been completed 
and the full range of its beneficial impact assessed.
    Bloomberg Tradebook LLC is owned by Bloomberg L.P. and is located 
in New York City. Bloomberg Tradebook is an electronic agency broker 
serving institutions and other broker-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 
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.
    We are the third largest electronic communications network (ECN) by 
volume. Indeed, two weeks ago we saw the day on which the orders 
matched on Bloomberg Tradebook exceeded 100 million shares, a landmark 
representing a more than ten-fold increase over the past year-and-one-
half.

              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 how do consumers and investors benefit from the competition 
ECNs bring to the new electronic marketplace?
    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? We publish not only our entire 
book of quoted prices electronically for all our customers to see, but 
also all other available pricing information. Unlike some of our ECN 
competitors, we take advantage of this transparency to route our 
customers to the best available price, even if that is outside of 
Bloomberg Tradebook. 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 in the industry.
    Among the innovations Bloomberg Tradebook has brought to the market 
is the beneficial mixing of small retail order flow and institutional 
order flow. For the first time, small retail customers have gained 
direct unfettered access to the liquidity of institutional order flow 
represented directly in the market. Likewise, institutional investors 
are, for the first time, able to find liquidity for their orders by 
interacting directly with small order flow.
    Along with neutrality, transparency, fairness and innovation, add 
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 a statement before the Senate Banking Committee, 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 around the world haven't been keeping 
pace with the needs of the market.''
    Mr. Zarb is a 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. NASD's CLOB proposal for the Nasdaq market--known 
as the SuperMontage--is an effort by the NASD to ``keep pace'' not by 
moving themselves forward, but by drastically slowing down all market 
participants. To spur future innovation, I'd rather place my faith, not 
in the exchange, but in its members--the marketplace of competing 
innovative broker-dealers.
    What are ECNs? At Bloomberg Tradebook we see ourselves as a market 
solution to our customers' market problems. This should be kept in mind 
as Congress and the SEC consider whether and how to react to the growth 
of ECNs.
    Bloomberg Tradebook intends to remain a broker-dealer and an ECN. 
We believe it's the most effective way for our customers to obtain 
liquidity and best execution. While we are proud to be and remain a 
broker-dealer/ECN, we are also supportive of the efforts of some of our 
ECN brethren to either affiliate with or become exchanges. Just as 
competition among ECNs has been good for investors and the market, 
competition among stock exchanges also benefits all. We think the 
national stock exchanges should have to compete against each other for 
our business and the business of any other broker-dealer. Bloomberg 
Tradebook looks forward to the day when some of our ECN colleagues will 
be--as new exchanges--competing with the established exchanges for our 
business.

             COMPETITION IN THE NEW ELECTRONIC MARKETPLACE

    Competition in the new electronic equity marketplace is doing what 
competition generally does. It is benefitting consumers and investors 
while revolutionizing markets. It is also generating opposition from 
those who may believe their position is threatened by these 
revolutionary changes.
    Those who have sought to halt these changes have argued for massive 
and intrusive regulatory intervention to roll back the clock. They have 
sought to justify these steps by arguing that ``fragmentation'' is a 
threat to our markets.
    This is a traditional refrain, sung in virtually every industry 
when change threatens established players. It is a refrain that this 
Committee--given its preeminent role in deregulating markets--has 
repeatedly heard in extended-play versions and wisely greeted with a 
skeptical ear.
    In 1975, when Congress and the SEC deregulated brokerage 
commissions, there was much anxiety on Wall Street. Critics charged 
that the unfixing of rates would damage and fragment America's capital 
markets. Instead, commission rate competition reduced prices for 
investors and helped spur explosive growth in the market.
    In deregulating the telecommunications industry, Congress--this 
Committee in particular--and the courts were regularly warned that 
then-upstarts like MCI were ``fragmenting'' the telephone market, 
destroying the world's greatest communications system. When the status 
quo laments the impact of ``harmful fragmentation'' be careful--often 
it is really bemoaning beneficial competition.
    In fact, the Nasdaq market 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. 
ECNs in Nasdaq participate in the least fragmented market of all time, 
thanks to this system of customer order display and electronic linkages 
that provide instant access to those orders.
    In a very significant speech delivered recently at Northwestern 
University, SEC Chairman Levitt called on market participants to make 
publicly available all customer bids and offers, not just their best 
bids and offers. Chairman Levitt called for a competitive, free market 
solution to seize this opportunity for greater transparency. Bloomberg 
Tradebook wholeheartedly supports this increased market transparency.
    Useful linkages have yet to be developed for the New York Stock 
Exchange listed market. Our customers would like us to act as their 
agent for New York Stock Exchange listed stocks, as we do in Nasdaq 
stocks. Recently the SEC has approved an NASD proposal to allow ECNs 
access to the Intermarket Trading System (ITS) through Nasdaq. This is 
helpful, but not nearly sufficient since ITS remains crippled by both 
its technological ineffectiveness and an unworkable governance 
structure that makes any movement nearly impossible.

            THE THREAT OF A CENTRAL LIMIT ORDER BOOK (CLOB)

    Those who would stifle change in the markets have urged support for 
a time priority central limit order book (CLOB) as the panacea 
necessary to deal with the alleged ``problem'' of fragmentation. The 
notion behind the CLOB is that if you centralize orders in one place, a 
single ``black box'', maximum order interaction and perhaps better 
prices might be achieved.

                  TECHNOLOGY MAKES A CLOB UNNECESSARY

    There are a number of very serious problems with this concept. When 
this concept was first broached some thirty years ago, our markets 
lacked the technology to achieve order interaction without 
centralization. Now, technology allows the advantages of maximum order 
interaction without the downside of centralization.
    In short, the technology of today makes a centralized order book 
unnecessary. These technological advances have revolutionized other 
industries, and despite protests, they are revolutionizing our equity 
markets. At a time when even public utilities like telephones and 
electric power are abandoning their ``black boxes'' for decentralized 
structures, does it make sense to threaten innovation by centralizing 
the stock markets? State-of-the-art telecommunications systems like the 
Internet don't rely on a single monopoly channel--rather they rely on 
networked webs of multiple private competing linkages. Why should the 
securities markets work differently?
    Centralized systems are resistant to change. The innovations that 
ECNs have brought to the market could not occur under a CLOB system, 
including under the SuperMontage Proposal of the NASD.
    A centralized system also provides the significant downside of a 
central point of failure. Those of us who deal regularly with Nasdaq's 
SelectNet system know only too well how cumbersome and inefficient a 
centralized system can be. Like SelectNet, the ITS system is conceded 
even by the sympathetic to be technologically outmoded, with a 
bureaucracy that thwarts change. Why make those failed systems the 
model?

                    THE CLOB IS COMING--SUPERMONTAGE

    Indeed, the pending SuperMontage Proposal carries many of the 
downsides of a traditional CLOB. The proposal would convert Nasdaq from 
a largely decentralized market, which has been its major strength for 
thirty years, to one in which virtually all executions take place 
centrally. Of the concerns which the Nasdaq market faces today, 
capacity limitation is certainly the greatest. In recent years Nasdaq's 
systems have become an increasingly serious messaging bottleneck. Yet 
the proposal would convert Nasdaq to a central execution utility only 
months before the U.S. markets are scheduled to grapple with the 
intensifying volume expected with decimalization. This CLOB-like 
centralization would create a government-sponsored monopoly that would 
deter today's decentralized market innovators from adding market 
capacity and from introducing further innovations. Recent press reports 
that the SEC wants to move quickly to approve the SuperMontage concern 
us and, we respectfully submit, should concern Congress.

                               CLOB CZAR

    While there are serious technological problems with the CLOB, there 
are equally troubling political problems. Someone or some entity will 
have to decide how the CLOB will work, who gets access and how, and 
what innovations are to be allowed. That gatekeeper and CLOB czar is 
certain to be enormously influenced by those who are already in the 
club. Will those who are already in the club allow the emergence of 
innovators who potentially threaten their business? We don't think so. 
Is innovation likely to occur when the potential innovator must raise 
his or her hand to seek permission from the powers-that-be in order to 
innovate? We don't think so.
    NASD Chairman Zarb told the Senate Banking Committee during its 
CLOB hearing that 95% of everything CLOB proponents sought could be had 
under the SuperMontage. That's accurate, and underscores that we are 
looking in part at a political battle for control of this centralized 
entity. I don't know who will win, but I know who will lose in this 
kind of battle--markets and consumers.

                           RISK TO INNOVATION

    There are always those who worry about regulation driving 
industries offshore. What will drive industry offshore faster than 
anything else would be depriving that industry of the ability to 
innovate in the United States. Under a CLOB or SuperMontage, the 
greater risk is that industry will leave the States for shores where it 
can innovate.

                      HUMILITY BEFORE THE MARKETS

    The most significant problem with a CLOB is that, even if we get it 
``right'' for now, it's not clear we will have gotten it ``right'' for 
all time. Over the past three years, Bloomberg Tradebook has devised a 
number of innovations that have come to be industry standards. I'd like 
to mention one briefly.
    At its inception in 1996, Bloomberg Tradebook introduced the 
concept of ``Reserve'' to the U.S. equity markets. ``Reserve'' is a 
process that controls the release of orders into the market, enabling 
clients to trade large orders more efficiently.
    Like all innovations, the ``Reserve'' gave us a leg up on our 
competitors for a brief period of time. Soon it was adapted by others. 
Today no one would introduce a system without it, including Nasdaq in 
its SuperMontage Proposal. Any edge we gain is a momentary one--and we 
are forced to continue to innovate. We have done so continually in the 
three years since.
    If a CLOB had been imposed three years ago, clearly this innovation 
wouldn't exist. Are we confident that further innovation won't be 
needed? That we can't do what we do more efficiently? I'd argue that 
the innovation is just beginning, and we need to maintain the 
incentives that make that innovation possible. Innovations occur in a 
dynamic competitive market. They won't occur in a centralized black 
box.

                    THE MARKETS NEED DECIMAL PRICING

    It is a pleasure to address this Committee on the subject of 
pricing in decimals. It is a natural segue from our expressions of 
concern regarding the industry CLOB and the Nasdaq SuperMontage 
Proposal.
    Over a period of years, this Committee has rendered an enormous 
public service by spearheading the effort to convert to decimalization. 
As this Committee well knows, the United States is the only major 
country whose stock markets still trade in fractions. Presenting quotes 
in \1/8\ths and \1/16\ths has reduced competition and liquidity in our 
markets. It is a system both archaic and anti-competitive.
    Bloomberg Tradebook has allocated significant time and resources to 
decimalization. As a result, we will be ready for decimal pricing as 
scheduled in July. Thus, Bloomberg Tradebook and our customers were 
extremely disappointed by the NASD's recent request to delay 
decimalization. Decimalization would create such an enormous benefit to 
investors and the markets that implementation should be the top 
priority.
    The NASD appears to be focusing significant resources on 
initiatives--like the SuperMontage Proposal--that have as its primary 
objective securing an anti-competitive beachhead prior to NASD's 
desired transformation into a for-profit entity. While we believe 
SuperMontage is terrible public policy, even those who might be more 
sympathetic would have to concede that the public would be infinitely 
better served if the NASD focused its finite resources as other market 
participants have had to--namely on timely preparation for prompt 
conversion to decimals.
    Putting aside resource allocation concerns, we'd also argue that 
SuperMontage and any other CLOB proposal should be tabled until market 
participants have an opportunity to assess the impact of a successful 
conversion to decimals. The decimalization championed by the Commerce 
Committee will significantly change our markets for the better. It will 
result in lower trading costs. It will result in greater market 
efficiencies. In short, it may well address many of the issues raised 
in the SEC's recent Concept Release. The Congress and the SEC should 
not entertain significant structural changes to the Nasdaq market until 
after decimalization has been completed and the full range of its 
beneficial impact assessed.
    I'd like to conclude the discussion of decimalization with a 
relevant, personal aside. When my boss, Mike Bloomberg, wants something 
done, he often says to me ``get it done or I'll find someone who can''. 
Our customers often send us the same message. The phrase ``get it done, 
or else . . .'' is the humble seed from which many giant redwoods of 
innovation have sprung. The Commerce Committee's journey with NASD on 
decimalization is a cautionary tale of how hard it is to prod movement 
from a government-sponsored monopoly. It will be infinitely harder to 
prod change from an industry CLOB or a CLOB like the SuperMontage.

           OPPOSITION TO PRIVATIZATION OF THE STOCK EXCHANGES

    Allowing a government-mandated monopoly to enter the markets as a 
for-profit entity raises enormous concerns for a host of regulatory and 
enforcement reasons. I'll focus on one that is very familiar to this 
Committee as both an historic and current controversy, namely the issue 
of access to market data.
    A quarter century ago, this Committee spearheaded the effort to 
enact the Securities Acts Amendments of 1975. That legislation 
established the goal of producing a national market system. To this 
day, that remains the correct goal. In furtherance of that objective, 
Congress mandated a consolidated system for distributing market data in 
an effort to ensure that stock-market information was accurate and 
accessible. The securities markets were allowed to charge a reasonable 
rate for gathering and distributing that information.
    When the Commission, in 1972, first proposed rules to provide for 
the consolidated reporting of transactions and quotations, the New York 
Stock Exchange asserted that the SEC not only lacked authority under 
the securities laws to adopt the quotations rule, but also such action 
would deprive the Exchange of property in violation of the due process 
provisions of the Constitution of the United States. Despite these 
objections, Congress and the SEC were determined to achieve the goal of 
public access to consolidated market information.
    Even in this day of on-line investing, the exchanges continue to 
argue that they ``own'' or ought to own quote information. Indeed, 
during the last Congress the dominant national exchanges were major 
proponents of legislation reported from the House Judiciary Committee--
the ``Collections of Information Antipiracy Act''--which would have 
created an unprecedented ownership interest in facts, including stock 
quotes. Though well-intentioned, this legislation--which has also been 
reported from the House Judiciary Committee this Congress-- would 
create a property right in facts that extends not only to presently 
existing markets, but also, incredibly, to hypothetical, presently non-
existing markets.
    We applaud the bi-partisan leadership of the Commerce Committee for 
crafting critical competing legislation, the ``Consumer and Investor 
Access to Information Act''. That legislation, which was reported from 
the Commerce Committee last year, would also provide additional 
protections for databases but would do so while assuring that consumers 
and investors have continued access to factual information.
    Chairman Oxley has observed that real-time stock data is like 
``oxygen'' to investors. We worry about the prospects of a government-
mandated monopoly over the most important information in the market--
truly the markets' oxygen--being controlled by a for-profit entity that 
not only believes it ``owns'' data our clients create, but also wants 
to control the downstream uses of that data in currently non-existing 
markets outside of the real-time market window.
    At the core of this market data debate is the outmoded concept that 
market participants should continue to provide market data to a 
government-sponsored monopoly and then pay to see it. We endorse an 
alternative model recently proposed by SEC Chairman Levitt in the 
context of market depth. During his March 16th speech at Northwestern, 
Chairman Levitt urged our markets--exchanges, dealers, and ECNs--to 
make their limit order books available to the public where vendors 
could consolidate this data and repackage it in a form that would be 
most useful to their customers. A similar model allowing the 
establishment of private quote aggregators to which one could report 
market data-- breaking the SRO monopoly on data--would certainly 
improve the quality, comprehensiveness, reliability and capacity of 
this information while reducing its cost.

  REGULATORY CHANGES NEEDED FOR FULL COMPETITION IN THE EQUITY MARKETS

    A few years ago, the Nasdaq market was rocked by a scandal when 
Nasdaq market-makers were found to be colluding to keep spreads 
artificially high. The SEC's response in issuing its Order Handling 
Rules helped launch ECNs while narrowing Nasdaq spreads by nearly 30% 
in a year.
    Chairman Levitt has stated that the three components of a 
successful U.S. equities market are quote transparency, market 
linkages, and the obligation of brokers to seek best execution on 
behalf of their customers. All these goals can be promoted without 
risking the enormous negative ramifications of an industry CLOB or 
SuperMontage. Congress should support the SEC's actions in promoting 
transparency and in insuring linkages in the Nasdaq market, as well as 
in exporting the germ of reform to the listed markets, which have been 
so resistant to change. Congress has already vastly improved the 
opportunities for best execution with its decimalization initiative. 
Congress should oppose privatization of the exchanges while working to 
fashion a means of providing more ready access to the market data which 
is the ``oxygen'' of the marketplace.
    Congress should oppose the imposition of a unitary CLOB. Congress 
should oppose such a CLOB whether sponsored by industry or by Nasdaq as 
the SuperMontage Proposal.

                               CONCLUSION

    Every advance in our markets in recent years--from the elimination 
of brokerage fee schedules, to the emergence of off-hour trading and 
ECNs--has been greeted by the cry of ``fragmentation'' by the powers-
that-be. Our equity markets are the finest in the world because we've 
established a regulatory structure that rewards innovation. As soon as 
the U.S. regulatory structure stops rewarding innovation our markets 
will go abroad. We shouldn't allow those who are threatened by change 
to encourage us to freeze in place a system which then won't be subject 
to innovation and improvement--and thinking outside the black box.
    Changes in market structure will have implications for the American 
people that are just as significant--if not more--than those of the 
landmark banking reform legislation enacted last year. We very much 
appreciate the diligence of the Members and staff of this Committee in 
tackling these issues of complexity and importance.

    Mr. Oxley. Mr. Dorsch.

                  STATEMENT OF SHAWN A. DORSCH

    Mr. Dorsch. Thank you, Mr. Chairman and members of the 
committee. My name is Shawn Dorsch. I am the President and 
Chief Operating Officer of DNI, the builders of the Blackbird. 
I am pleased to have the opportunity to appear before the 
subcommittee and discuss our experience as the company which 
has brought electronic trading to what is perhaps the world's 
most complex and most dynamic financial sector, namely, the 
inter-dealer, privately negotiated interest rate and currency 
derivatives transactions business, more commonly referred to as 
the ``SWAPS'' business.
    I would like to make clear that we are not in the 
securities business, but it is a very important financial 
market for this country.
    It is vital to the U.S. public interest that our markets, 
including our financial markets, remain the most competitive 
fair and efficient in the world. This will only be the case if 
we succeed in harnessing the power and efficiency of new 
electronic technologies in the service of these markets. DNI is 
a corporation based in Charlotte, North Carolina. It was formed 
in 1996 to build and operate a computerized communications 
information system known as Blackbird. The Blackbird was built 
to help major financial institutions, primarily banks, find, 
negotiate and agree to custom-tailored SWAPS transactions 
directly with each other.
    The founders of DNI are experienced SWAPS professionals, 
the Blackbird system is operational and successfully serving 
the major SWAP dealers in the United States. The Blackbird is 
not open to the public.
    Blackbird is designed to compete with so-called voice 
brokers who charge dealers commissions for arranging SWAPS 
transactions over the telephone. The fundamental goal of the 
Blackbird is to provide its financial institutions clients with 
a computerized system that will bring greater speed, precision, 
safety and security and lower cost to the very same interest 
rate and currency risk management activities that are now 
taking place every day in numerous U.S. financial institutions 
on the telephone.
    In spite of this goal, we initially found ourselves subject 
to a searching regulatory review by the Commodity and Futures 
Trading Commission, and harsh criticism from some of the 
traditional exchanges that were subject to the CFTC's 
jurisdiction. It was and remains our understanding that the 
types of transactions that may be negotiated on Blackbird are 
exempt from CFTC jurisdiction under the Commodity Exchange Act.
    In April 1999, when we were on the verge of making 
Blackbird operational, we received a letter from the CFTC 
asking us to provide certain information so that the CFTC could 
make an assessment of its own jurisdiction over Blackbird. 
Certainly, the CFTC is not to be faulted for making due inquiry 
to assure itself that it is fulfilling its regulatory 
responsibilities. This CFTC, however, was the same CFTC which 
issued a concept release read by many as proposing that it take 
jurisdiction over the SWAPS community. This was the same CFTC 
which was at loggerheads with the Treasury, the SEC and the 
Federal Reserve Board, and which was admonished by Congress not 
to take action following from its concept release.
    Fortunately, we do not have the same CFTC today. If we did, 
we might be speaking of the Blackbird as a U.S. entity in the 
past tense as we would have been forced to relocate to London. 
The details of the public controversy we faced are less 
interesting than the deeper effects of the controversy. Senior 
company personnel had to shift their attention from building a 
business to explaining and defending that business. Obviously, 
substantial financial resources had to be focused on the 
regulatory situation. Potential clients needed to be reassured 
that transactions negotiated through the Blackbird would not be 
void as a legal off exchange futures contracts.
    Potential investors also needed to be held to a level of 
comfort with the regulatory situation. What was really wrong 
about all of this? It all came about simply because Blackbird 
offered SWAPS dealers the opportunity to do the same business 
as before but via new media. It was the medium of computerized 
communication when viewed through the lens of a poorly drafted 
statute, the Commodity Exchange Act, which provided the basis 
for a CFTC assertion of jurisdiction, not some risk to the 
public. Fortunately, the new CFTC reinvented itself under 
Chairman Rainer and has participated in the President's Working 
Group Report and has put forth a new regulatory proposal that 
attempts to build afresh on the positions of policy and 
principles and that attempts to encourage the use of electronic 
systems.
    Congress also seems to be well focused on the fact that the 
existing statutory and regulatory regimes may not adopt readily 
to the promise and challenges of new technologies. The efforts 
of this committee and others will be invaluable in determining 
the direction for a redesign of our Nation's statutes and 
regulations. We encourage Congress to watch closely to be sure 
that new regulatory constructs are sufficiently resilient to 
weather changes in administration as well as changes in 
technology.
    Our message is not that all electronic systems should be 
unregulated. Our message is that regulatory concerns should be 
focused not on the medium of communication, or for that matter, 
on the medium of the transaction execution. Concern should be 
focused on the activities accomplished with that medium and 
should be coupled with consideration of the inherent market 
discipline likely to shape those activities. If, as the case 
with Blackbird, those activities do not raise serious concerns, 
great care should be taken to protect them from the very, very 
serious countervailing threats of overly broad or 
anticompetitive regulation.
    Thank you, Mr. Chairman, and members of the committee for 
giving me an opportunity to present this testimony.
    [The prepared statement of Shawn A. Dorsch follows:]

 PREPARED STATEMENT OF SHAWN A. DORSCH, PRESIDENT AND CHIEF OPERATING 
                      OFFICER, DNI HOLDINGS, INC.

    DNI Holdings, Inc. (``DNI'') is pleased to have the opportunity to 
deliver this written statement to the Subcommittee on Finance and 
Hazardous Materials of the Committee on Commerce.
    The matter before the Subcommittee, competition in the new 
electronic markets, is a very important one. It is vital to the US 
public interest that our markets, including our financial markets, 
remain the most innovative, fair and efficient in the world. This will 
be the case only if we succeed in harnessing the power and efficiency 
of new electronic technologies in the service of our markets.
    We have been asked to focus our testimony on regulatory impediments 
to electronic systems used in trading financial instruments. DNI has 
indeed seen some regulatory impediments to the development of its own 
business. Although DNI's business is not the securities business of 
primary concern in today's hearing, DNI's experience may be easily 
generalized. Even before introducing itself, DNI would like to offer 
three propositions that are as applicable to the securities markets as 
to DNI's own business in interest rate and currency derivatives. First, 
if the mere introduction of electronic systems use threatens to bring 
regulation where there was none before, the need for regulation should 
be closely examined. (DNI's own electronic system, for example, merely 
allows sophisticated dealers to do among themselves via the internet 
virtually the same business they previously did on the telephone; yet 
DNI was nearly the subject of an entirely novel Commodity Futures 
Trading Commission regulatory effort.) Second, if existing statutory 
and regulatory language fails to correspond to evolving commercial 
reality, that language must be re-examined and, if necessary, re-cast 
in light of fundamental public policy goals--before it stifles 
commerce. Third, those advantaged by the status quo may raise 
regulatory concerns about the use of new technology as a means of 
defending their competitive position--which may require careful 
winnowing of legitimate public policy concerns from less worthy efforts 
to limit competition. The following will explain how we have arrived at 
these propositions.
    DNI hails from different venues than many of our fellow witnesses, 
both in terms of geography and commerce. DNI is a corporation based in 
Charlotte, North Carolina. It was formed in 1996 to build and operate a 
computerized communications and information system (known as 
``Blackbird'' or the ``Blackbird system'') to help major financial 
institutions find, negotiate and agree to custom-tailored interest rate 
and currency derivatives transactions (for ease of reference, 
``swaps'') directly with each other. The founders of DNI are 
experienced swaps professionals. The Blackbird system is operational 
and successfully serving major swaps dealers in the U.S.
    The fundamental goal of DNI is to provide its financial institution 
customers with a computerized system that will bring greater speed, 
precision, safety and security, and lower costs, to the very same 
interest rate and currency risk management business activities that are 
now taking place every day in numerous U.S. financial institutions.
    In spite of this goal, DNI initially found itself subject to 
searching regulatory review by the CFTC and harsh criticism from some 
of the traditional exchanges subject to the CFTC's jurisdiction. It was 
(and remains) DNI's understanding that the types of transactions that 
may be negotiated on Blackbird are exempt from CFTC jurisdiction under 
the Commodity Exchange Act. Nonetheless, DNI was to learn two lessons. 
First, DNI learned that the computerized enhancement through Blackbird 
of services now commonly provided over the telephone by swaps brokers 
unregulated by the CFTC might lead to an assertion of CEA jurisdiction, 
even though there existed no plausible regulatory structure applicable 
to Blackbird and no demonstrated need for any regulation of Blackbird. 
Second, DNI found that certain entities actually subject to CEA 
jurisdiction would do all they could to focus CFTC attention on DNI. 
These entities did so even though they never have offered the kinds of 
transactions that might be negotiated through Blackbird.
    In April 1999, DNI was on the verge of making Blackbird 
operational. DNI received a letter from the CFTC asking DNI to provide 
certain information so that the CFTC could make an assessment of its 
own jurisdiction over Blackbird. Certainly, the CFTC is not to be 
faulted for making due inquiry to assure itself that it is fulfilling 
its regulatory responsibilities. This CFTC, however, was the same CFTC 
that had issued a ``concept release'' read by many as proposing that it 
take jurisdiction over the swaps community. This was the same CFTC 
which was at loggerheads with the Treasury, the SEC and the Federal 
Reserve Board and which was admonished by Congress not to take action 
following from its concept release. Fortunately, it is not the same 
CFTC today. If it were, we might now be speaking of DNI as a U.S. 
entity in the past tense. U.S. banks and investment banks, which 
presently occupy a leadership role in providing interest rate and 
currency risk management products, might have been deprived of access 
to leading edge technology that will help them compete.
    DNI recognized the potential difficulties in its situation with the 
CFTC. What followed, however, was truly bewildering. DNI, a small North 
Carolina company, and its computer system were mentioned in multiple 
Congressional hearings, only one of which DNI attended. The fact of the 
CFTC inquiry became general industry knowledge. Even our product name, 
``Blackbird'', which had resulted from one of our principal's 
admiration, as an amateur pilot, for a fast, high-flying U.S. airplane, 
was publicly ridiculed as an indication of evil, evasive intent.
    The details of the public controversy we faced are less interesting 
than are some of the deeper effects of the controversy. Perhaps most 
importantly, senior DNI personnel had to shift their attention from 
building a business to explaining and defending that business. 
Obviously, substantial financial resources had to be focused on the 
regulatory situation. Potential customers needed to be reassured that 
transactions negotiated through Blackbird would not be void as illegal 
off-exchange futures. Potential investors also needed to be helped to a 
level of comfort with the regulatory situation. The net effect was that 
the CFTC inquiry and attendant public attention significantly slowed 
our growth for a time.
    Perhaps there is little surprising in all this until one stops to 
consider what was mentioned above: most, if not all, of what the 
Blackbird system does is now done by ``voice brokers'', human beings 
using telephones and squawk boxes, and operating without threat of 
sanction or illegality.
    In fact, Blackbird fulfills the same functions as the voice 
brokers, but with far greater efficiency and benefit to the financial 
system. Blackbird is not an exchange or a clearing house. Blackbird 
does not enter into transactions, provide credit support or take or add 
credit risk. Blackbird does not change the individual customized nature 
of swaps. Blackbird does not introduce preference or bias into 
negotiations. Blackbird simply provides sophisticated dealers (and not 
the public) with a computer-based electronic communications alternative 
for the direct negotiation and agreement of bilateral transactions.
    Blackbird offers an improved electronic method for a dealer to 
identify other dealers who may, subject to the resolution of credit and 
other terms, be willing to enter into a transaction having particular 
economic terms desired by the first dealer. Use of Blackbird promotes 
competition, improves transparency, record-keeping and risk control, 
and reduces costs. Blackbird brings substantial private and public 
benefit, without changing any meaningful feature of custom-tailored 
swaps activities as they currently operate, and without creating any 
need for novel regulation.
    If Blackbird brings all these benefits, why did it encounter the 
problems described above? It may be helpful to the Subcommittee to 
consider for a moment the underlying legislative and regulatory causes 
of DNI's predicament. First, there is the archaic language of the 
Commodity Exchange Act itself. This language was stretched far beyond 
its originally intended use (even before the advent of new electronic 
technology) as ``commodity'' exchange-traded contracts have moved from 
the agricultural into the financial. This inadequate statutory language 
has led to the situation, bewildering to the uninitiated, where 
Congress has directed the CFTC to exempt certain swaps from its 
jurisdiction without Congress's ever deciding that these swaps were 
``futures'' subject to the CEA to begin with. Build on top of this 
rickety legislative base a regulatory exemptive structure struggling 
for words to describe what might and might not be exempt and you have 
all the makings of a roadblock to progress in an era of technological 
innovation.
    When words and reality no longer mesh, it is time to restore 
direction by returning to basic principles. Fortunately, in the 
Commodity Exchange Act context, we have seen this recognized on several 
fronts. First, the Report of The President's Working Group on Financial 
Markets entitled ``Over-the-Counter Derivatives Markets and the 
Commodity Exchange Act'' explicitly recognized that the ``method by 
which a transaction is executed has no obvious bearing on the need for 
regulation in markets, such as the markets for financial derivatives, 
that are not used for price discovery.'' The Report went on to note 
that there is no ``demonstrable need for regulation'' of certain 
electronic systems. Second, the new CFTC, reinventing itself under 
Chairman Rainer, has participated in the President's Working Group 
Report and has put forth a new regulatory proposal that attempts to 
build afresh on positions of policy and principle, and that attempts to 
encourage use of electronic systems. We are encouraged by Chairman 
Rainer's very constructive attitude. Finally, the Congress now seems to 
be well-focused on the fact that existing statutory and regulatory 
regimes may not adapt readily to the promise and challenge of the new 
technologies. The efforts of this Committee and others will be 
invaluable in determining the direction for a redesign of our nation's 
statutes and regulations. We encourage Congress to watch closely to be 
sure that new regulatory constructs are sufficiently resilient to 
weather changes in administration, as well as changes in technology.
    DNI's message is not that all electronic systems should be 
unregulated. DNI's message is that regulatory concern should be focused 
not on the medium of communication or, for that matter, the medium of 
transaction execution. Concern should be focused on the activities 
accomplished with the medium, and should be coupled with consideration 
of the inherent market discipline likely to shape those activities. If, 
as is the case with Blackbird, those activities do not raise serious 
concerns, great care should be taken to protect them from the very, 
very serious countervailing threats of overbroad or anticompetitive 
regulation.

    Mr. Oxley. Thank you.
    Next is John Schaible of NexTrade.

                  STATEMENT OF JOHN M. SCHAIBLE

    Mr. Schaible. I would like to thank you, Mr. Chairman, and 
members of the subcommittee. I am John Schaible, president and 
co-founder of NexTrade Holdings. I have been asked by the 
committee to address the following questions: What regulatory 
changes are needed to promote full competition in our equity 
markets? Would a central limit order book be desirable? What 
are the implications of privatization of stock exchanges? And 
finally, is NexTrade ready for decimalization.
    In 1995 NexTrade was founded with the goal of providing 
technological innovation to the financial services industry. 
The little company started in 1995 has applied to become a 
stock exchange, now employs nearly 60 people developing 
technology for other brokerage firms across the globe. Before 
we can answer the first question, we must define full 
competition. Full competition is not a market where two 
participants handle 95 percent of the shares traded in this 
country. In order for the financial markets to become fully 
competitive, we must promote competition between exchanges. 
This competition can only be encouraged by the approval of new 
for-profit exchanges. The Commission is currently considering 
two applicants to become new fully electronic exchanges. 
NexTrade notified the Commission of its intention to become an 
exchange in 1998, and worked in draft mode with the Commission 
in 1999 in preparing its formal exchange application. Despite 
having filed this application, NexTrade has no clear timeframe 
for approval. NexTrade fully appreciates the important role the 
Commission serves in protecting the public. Nevertheless we 
fear that inadequate staffing due to inadequate funding has, in 
this tidal wave of change, overwhelmed the Commission. We fear 
that the Commission's inability to review the applications is 
one of the greatest risks to the continued supremacy of 
America's capital markets. Recently, a third applicant decided 
to halt its application in favor of becoming a facility of an 
existing exchange. This decision may have been based in part on 
a perceived lack of progress by the Commission.
    The need for new electronic exchanges has been exacerbated 
by NASDAQ's failure to be ready for decimals. This demonstrates 
that we cannot rely on the existing nonprofit exchange model to 
be the standard bearer in a new electronic environment. The 
for-profit model has always been the hallmark of efficiency and 
progress in our economy. Consequently, new for-profit exchanges 
must be approved to promote full competition in our equity 
markets.
    Turning to the second question, a central limit order book, 
or CLOB, would not be desirable. Like any centralized 
marketplace, it would represent a single point of failure. It 
would not enhance the marketplace, but harm innovation and 
reduce the competitiveness of our markets. In comparison, the 
competitive for-profit model exemplified by ECNs has had a 
proven, beneficial impact on our markets. In 1998 alone, the 
cost of a trade on NASDAQ fell 23 percent and spreads fell 41 
percent. While ECNs have helped investors, this progress is 
minimal in comparison to the benefits that will be derived from 
the privatization of stock exchanges.
    Privatization will result in exchanges that are more 
competitive and will respond better to the needs of the 
investors. New for-profit exchanges will enable the United 
States to maintain its position as the preeminent global 
market. Critics may claim that the drive to be the most 
profitable exchange will result in a race to the bottom in 
terms of quality of surveillance and investor protection. This 
claim is without merit, because the exchanges with the best 
investor protection will attract the best issuers, thereby 
securing the most formidable competitive advantage.
    Finally, NexTrade is disappointed that the move to 
decimalization which may save the public up to $2 billion a 
year may be delayed because some traditional marketplace 
participants have failed to take appropriate steps to modernize 
their technology. NexTrade applauds NASDAQ officials for their 
concern for the integrity of the financial markets and also 
appreciates NASDAQ's candor in admitting that its systems lack 
the capacity to handle the projected increase in message 
traffic that will result from decimalization.
    Nevertheless, NASDAQ's failure to be decimal ready is of 
great concern. It may be due to NASDAQ's antiquated technology, 
which is systematically flawed, or that rather than 
concentrating on being ready for decimals, the NASDAQ has 
invested substantial resources in developing the proposed 
SuperMontage. The prudence of allocating resources to such a 
project in lieu of decimal compliance is questionable, 
particularly in light of the vigorous industry opposition to 
the proposed SuperMontage.
    In contrast, NexTrade has been ready for decimal trading 
since 1997. Chairman Oxley, Ranking Member Towns and members of 
the committee, we are in danger of falling behind foreign 
competitors in modernizing our capital markets. If America is 
to retain its primacy in this critical area, we must implement 
decimalization and we must foster competition by approving new 
electronic exchanges. Moving forward, we must remove our 
commitment to the principles that has served us in the past. 
The best way to protect the investor is through vigorous 
competition. We thank you very much.
    [The prepared statement of John M. Schaible follows:]

 PREPARED STATEMENT OF JOHN M. SCHAIBLE, PRESIDENT, NEXTRADE HOLDINGS, 
                        INC. AND NEXTRADE, INC.

    Chairman Oxley, Ranking Member Towns, and Members of the 
Subcommittee: My name is John M. Schaible. I am the President and Co-
founder of NexTrade Holdings, Inc. I commend the Chairman and the 
Members of the Finance Committee for holding these hearings on 
Competition in the New Electronic Market. As an innovative force in 
bringing about positive changes to the financial services industry, 
NexTrade appreciates the opportunity to share our views on these 
important public-policy issues. I have been asked by the Committee to 
address the future of the securities markets and regulation of those 
markets. Specifically, I will address the following questions:

A. What regulatory changes are needed to promote full competition in 
        the equity markets?
B. Would a Central Limit Order Book be desirable?
C. What are the implications of privatization of the stock exchanges?
D. NexTrade's readiness for decimalization?
    NexTrade's vision of the future of the financial markets is deeply 
rooted in the entrepreneurial spirit of its founders. In 1995, Mark 
Yegge, NexTrade's C.E.O., and I founded a new technology driven 
brokerage firm with the goal of promoting technological innovation of 
the financial services industry.
    The little company we founded in the living room of Mark Yegge's 
apartment in 1995, now develops technology for the financial services 
industry that is used by firms in this country and sought by firms 
around the world. NexTrade Holdings also develops the systems for its 
own subsidiaries, including the NexTrade Electronic Communications 
Network (the ``NexTrade ECN'') and the proposed NexTrade Exchange. 
NexTrade has invested millions of dollars in creating one of the most 
sophisticated and robust transaction systems in the world. This new 
technology will be the engine behind the NexTrade ECN and the proposed 
NexTrade Exchange.
    The NexTrade ECN is an automated trading system for equity 
securities. It gives brokers the power to electronically display 
customer orders. As an electronic auction market, the NexTrade ECN 
directly matches buy and sell orders. The NexTrade ECN currently has 
more than 60 broker-dealer subscribers and is used by many more non-
subscriber members of the National Association of Securities Dealers. 
On an average day, NexTrade executes orders representing millions of 
shares. All of the NexTrade ECN's orders are processed by computers in 
a room the size of a large walk-in closet.
    The proposed NexTrade Exchange is an example of the future of the 
financial markets in that it makes use of innovative technology and new 
regulatory structures as part of a for-profit exchange. The proposed 
NexTrade Exchange plans to make available for the benefit of its 
members and their customers an electronic trading system (the 
``NexTrade Exchange System'') to effect the purchase or sale of 
securities listed or admitted to trading on the proposed Exchange and 
on other exchanges. The proposed exchange, however, will not maintain a 
physical-trading floor. Members will access the NexTrade Exchange 
System from their own computer terminals and communicate with the 
NexTrade Exchange System over commercial information services and 
networks.
    As a member of the group of ECNs which account for approximately 35 
percent of the Nasdaq's volume, as the developer of innovative new 
technologies for the financial services industry, and as one of only 
two ECNs currently seeking approval to operate new electronic stock 
exchanges, NexTrade hopes the Committee will find my comments useful in 
its consideration of the future of the financial services industry.
   let technology lead the changes in the financial services markets
    As the Chairman of the Securities and Exchange Commission, Arthur 
Levitt, recently stated, ECNs ``have been one of the most important 
developments in our markets in years--perhaps decades.'' Innovation and 
new technology developed by ECNs and non-traditional market 
participants are promoting the rapid and sweeping democratization of 
the markets. Some experts predict that ECNs will represent 50 percent 
of the volume on the Nasdaq by 2001. As a member of this group, 
NexTrade is very proud of the role we have played in creating positive 
change that has saved the public billions of dollars. Despite the great 
progress that has been made, we still must strive to create fairer, 
more competitive markets and to ensure that America maintains its 
position as the financial center of the world.
    In considering the future of the financial markets, lawmakers and 
the Commission should heed the advice of Senator Gramm who recently 
noted ``Let technology lead.'' As a technology leader, NexTrade 
believes this approach will best serve the public. Lawmakers and the 
Commission should resist the temptation to divine where the market is 
going in a misguided attempt to conceive a new regulatory structure.

          THE NEED FOR A NEW COMPETITVE NATIONAL MARKET SYSTEM

    NexTrade believes with respect to regulation of the securities 
markets, it is incumbent upon the Commission and Congress to question 
each component of our current regulatory structure and ask this 
question: ``Does the additional cost of the regulation outweigh its 
benefit to the market and the individual investor?'' Rules that add 
benefit should remain in effect and rules that detract from the market 
or impede competition should be eliminated. While most components of 
our current regulatory structure pass this test, certain components, 
such the National Market System (``NMS'') do not.
    NexTrade believes the Commission and Congress should strive to 
remove artificial barriers to competition. An important step in 
promoting greater competition would be the reform of the NMS. In 
framing the 1975 amendments to the Act, Congress instructed the 
Commission that in developing a National Market System, ``competition, 
rather than regulation, should be the guiding force.'' The Commission 
is mandated by Congress to facilitate the development of a national 
market system not to be its chief architect. In establishing this 
mandate, Congress identified five criteria that should drive the 
Commission's role in the establishment of a NMS:

1. promotion of the development of mechanisms that allows for 
        economically efficient execution of securities transactions;
2. promotion of fair competition;
3. promotion of transparency;
4. improvement of investor access to the best markets; and
5. the development of mechanisms that allow for investors' orders to be 
        executed without the participation of a dealer.
    There are numerous barriers to competition between markets, 
including the NMS. The governance structures of the NMS plans are in 
need of significant reform. Currently, the boards of these plans are 
composed of representatives from each exchange. Any change to the rules 
governing the operation of the NMS systems, such as the very rule 
changes necessary to accommodate new electronic exchanges, require the 
unanimous consent of the participants. The governance structures of the 
NMS plans should be amended to include a broad constituency of market 
participants including the existing exchanges, new electronic 
exchanges, ECNs, broker-dealers and the investing public.
    NexTrade believes the technology driving the NMS should also be 
replaced. Two of the current plan participants, through the Securities 
Industry Automation Corporation (``SIAC''), develop and operate the 
computer systems that perform the responsibilities outlined in the NMS 
plans. SIAC operates all of the NMS technologies, other than the Nasdaq 
Unlisted Trading Privileges Plan, which is administered by the Nasdaq. 
The American Stock Exchange and the New York Stock Exchange own SIAC. 
Coupled with the anti-competitive governance structure of the NMS 
plans, SIAC's administration of the NMS technologies allows two members 
of the NMS plans to effectively impede the integration of new 
electronic markets and the implementation of new technologies into the 
NMS.
    To address these issues, NexTrade recommends the modification and 
opening of the NMS plans. NexTrade does not support the Commission or 
Congress designating a third party that will operate the new NMS 
systems. Rather, NexTrade believes that by opening the NMS plans to new 
participants and by consolidating the functions of the NMS plans into a 
single plan, market forces would ensure that the new plan could not be 
used to protect antiquated markets from competition. Moreover, such a 
structure would force SIAC, for the first time in nearly twenty-five 
years, to compete with new firms that are interested in developing the 
technologies that drive the new NMS.

A CENTRAL LIMIT ORDER BOOK WOULD NOT ENHANCE THE MARKETPLACE AND WOULD 
 ONLY HARM INNOVATION, ADD BUREAUCRACY, AND REDUCE THE COMPETITIVENESS 
                             OF OUR MARKETS

    There are those with less confidence in the economic efficiencies 
produced by competition who continue to express concerns about 
fragmentation when trading is spread across competing markets. The same 
people that have contributed to fragmentation have also supported the 
centralization of all trading in a time-priority central limit order 
book, or CLOB. Academics and the Commission have debated this vision of 
transforming America's financial markets into a CLOB in the past, only 
to be rejected each time as a bad idea.
    The notion behind the CLOB is that technology can be employed to 
centralize orders in one place, thus resulting in maximum order 
interaction and perhaps even better prices. A CLOB, however, will 
sacrifice the innovation that has made our markets the best in the 
world. Research has shown that competitive markets are better equipped 
to implement technological innovations to address market 
inefficiencies. Centralized markets, no matter how well intentioned 
their architects, will typically be obsolete by the time they commence 
operation. Competition creates incentives for markets to upgrade and 
innovate. Centralized markets do not. Unlike open markets, centralized 
markets serve to impede the ability of innovative firms to develop new 
technologies and mechanisms that promote better execution. Proponents 
of a CLOB typically rely on claims that the markets are fragmented and 
that this fragmentation can only be addressed by means of a CLOB.

      FRAGMENTATION IS BEST ADDRESSED BY COMPETITIVE MARKETS AND 
                        TECHNOLOGICAL INNOVATION

    Fragmentation has always been a problem for our markets. It is not 
a question of if fragmentation exists, but rather a question of degree. 
In the past, fragmentation was severe and was compounded by inadequate 
information technology. As technology evolved, the degree of 
fragmentation has diminished while the number of market participants 
has skyrocketed. However, the level of fragmentation in our markets 
could be greatly reduced by reforming the NMS.
    Statistical evidence supports the conclusion that ECNs produced 
more efficient and less fragmented markets. Since the arrival of 
qualified ECNs, evidence reveals dramatic improvements in the costs of 
trading stocks in the United States. The average cost of executing a 
trade on the Nasdaq Stock Market fell by 23 percent in 1998, spreads 
fell 41 percent, and volume increased substantially. If left to 
competitive devices, the degree of fragmentation within the markets 
will continue to be reduced despite the introduction of a multitude of 
market participants.
    There has always been a tension between the efficiencies of 
centralizing order flow and the benefits of competition between 
markets. Currently, the markets are linked by the NMS plans. One plan 
that is very important in reducing market fragmentation is the Inter-
market Trading System (``ITS''), which allows orders to be routed to 
the best market regardless of which market originally received the 
order. Unfortunately, the technology and the rules governing the 
operation of the system are, in Chairman Levitt's words, ``archaic.'' 
Market participants using ITS to route orders to other markets may wait 
as long as two minutes to receive a response and, even then, may not 
receive an execution.
    Historically, the traditional market participants were opposed to 
technological innovations that could undermine their hegemony over the 
markets. This resistance to technology has resulted in fragmentation. 
However, competitive market participants have responded to perceived 
fragmentation and inefficiencies with market-based innovative 
solutions. A variety of ECNs and other trading systems have responded 
with systems that consolidate and provide efficient access to the best 
prices among competing markets. One firm has connected all nine 
original ECNs, the NYSE and the Nasdaq to their system. Similarly, when 
the current Nasdaq linkage (SelectNet) proved too expensive and 
inefficient to handle record volumes, market participants forged links 
with one another to create trading networks that bypass SelectNet for 
faster and more reliable access to the best market prices.

  A CENTRAL LIMIT ORDER BOOK IS ANTI-COMPETITIVE AND HARMS THE PUBLIC

    The proposed CLOB is anti-competitive and would impede the 
development of new for-profit electronic stock exchanges. If the 
Commission mandates a monopolistic central execution system, such as 
the proposed CLOB, with which all market-participants must comply, 
innovation could be eliminated. Such a dearth of innovation would not 
serve the goals of the Act, the NMS, or the public. Rather than 
developing a system that would reduce innovation by new for-profit 
electronic exchanges, ECNs and other market participants, and halt the 
development of technologies that provide additional liquidity and 
transparency, the Commission should encourage a new and equitable NMS.
    Government imposed centralization will cost all investors in terms 
of less competition, less choice, and ultimately less efficiency. The 
expensive new infrastructure and bureaucracy required to support a CLOB 
would impose significant costs on new electronic for-profit exchanges, 
the market and ultimately issuers. Most importantly, a CLOB will result 
in worse prices for ordinary retail investors.
    The amount of price improvement available in new and traditional 
markets is obviously an important factor in this equation. NexTrade 
supports new ways to get better prices for customers, but this should 
be achieved through competition, not legislation. More importantly, we 
caution against adoption of a single structure or price improvement 
formula at the expense of competition and innovative alternatives. The 
proposed CLOB offers no additional benefits, and only serves to impede 
competition and the development of new electronic markets.

    A CLOB PRESENTS A CENTRAL POINT OF FAILURE THAT WOULD THREATEN 
                      AMERICA'S FINANCIAL MARKETS

    Like any centralized marketplace, a CLOB would have substantial 
dangers. Most importantly, a CLOB would represent a single point of 
failure that could jeopardize the global economy. The danger of such 
centralization is apparent in light of recent well-publicized attacks 
on some of the largest Internet web sites and service providers. It is 
economically impracticable to design a centralized marketplace that 
would be completely free of vulnerability to attacks by cyber-
terrorists. The implausibility of designing a totally safe CLOB will 
become increasingly apparent in the future as warfare and terrorism 
move from city streets to the Internet. In contrast, the currently 
developing network of trading facilities, much like the Internet, 
mitigates these potential dangers through numerous alternative trade 
destinations.
    The greatest negative effect that would result from the 
implementation of the proposed CLOB would be that the entire NMS would 
become dependent on the capacity, integrity and security of a single, 
largely antiquated system, which has proven to be unreliable. NexTrade 
believes investors and the market benefit from a variety of alternative 
systems that route, display and execute orders. The rapidly declining 
costs of telecommunications technology has made it possible to build 
and maintain redundant, competitive systems to handle orders without 
the need for a single monolithic service provider.
    The currently developing network of electronic exchanges and market 
participants offers the best solution in a competitive environment. A 
reformed and more open NMS that is not dominated by a single exchange 
and its technology will promote the continuing development of 
innovative trading tools that electronically process orders in an 
efficient and reliable manner across multiple sources of liquidity.

  NEXTRADE IS READY FOR DECIMALS AND IS DISAPPOINTED THAT THE MOVE TO 
 DECIMILZATION WHICH WILL SAVE THE PUBLIC UP TO TWO BILLION DOLLARS A 
 YEAR MAY BE DELAYED BECAUSE SOME TRADITIONAL MARKET PARTICIPANTS HAVE 
     FAILED TO TAKE APPROPRIATE STEPS TO MODERNIZE THEIR TECHNOLOGY

    Like most ECNs and Alternative Trading Systems designed in the past 
five (5) years, the technology behind the NexTrade ECN and the proposed 
NexTrade Exchange is ready for trading in decimals. As a member of the 
National Association of Securities Dealers (``NASD'') trading on the 
Nasdaq, the NexTrade ECN System currently has to convert orders that 
are in decimal increments into fractions for execution. Like many 
members of the Nasdaq, NexTrade has eagerly awaited the arrival of 
decimalization.
    In order to ensure that NexTrade's linkages to the NMS and the 
Nasdaq are ready for decimalization, NexTrade is planning on 
participating in the industry wide decimalization testing. 
Unfortunately, as a member of the NASD and a Nasdaq participant, any 
delays by the Nasdaq in implementing decimalization will impact 
NexTrade's ability to conduct this testing and will delay the 
introduction of decimal pricing for our subscribers.
    On January 28, 2000, the Commission ordered the securities markets 
to begin trading in decimals on July 3, 2000.1 The 
transition to decimals will save investors anywhere from $300 million 
to almost $2 billion annually. The transition to decimals, however, 
must be delayed because some traditional market participants have 
failed to invest in technology that will enable them to handle the 
increased quote traffic resulting from the switch to decimals from 
fractions.
---------------------------------------------------------------------------
    \1\ Exchange Act Release No. 34-42360, 65 Fed. Reg. 5003 (Jan. 28, 
2000).
---------------------------------------------------------------------------
    A recent study conducted by SRI Consulting projected that message 
traffic for stock and options quotes would likely rise dramatically 
when decimal trading begins. The SRI study projected that options 
trading in decimals could lead to a 3,000 percent increase in peak 
message traffic by December 2001. The study also noted that even if 
decimals were not introduced, message traffic would rise 779 percent. 
According to SRI, the transition to decimals will mean that Nasdaq 
message traffic could rise as much as 700 percent by December 2001. 
Even without decimals, the peak message traffic for Nasdaq stocks could 
be 174 percent higher. Message traffic for securities traded on the 
exchanges would be 50 percent higher by the end of 2001 from its 
December 1998 levels without any impact from decimal trading.
    NexTrade applauds Nasdaq officials for their concern for the 
integrity of the NMS and for having informed the Commission that their 
market would not be ready until the first quarter of 2001 to 
accommodate the increased message traffic expected from decimal 
trading. NexTrade, however, is troubled by the Nasdaq's failure to take 
the necessary steps to ensure that it would be ready for the 
implementation of decimalization. Nasdaq, however, is not alone in its 
failure to address systems capacity problems associated with the 
conversion to decimals.
    According to the General Accounting Office, the Options Price 
Reporting Authority (``OPRA'') will also face considerable difficulties 
as it attempts to handle the increased message traffic. OPRA, the NMS 
system used to disseminate trade and price quote messages for equity 
and index options industry wide, is currently incapable of handling the 
increased volume levels that will result from the transition to 
decimals. OPRA officials have admitted that upgrading their systems to 
handle the increased options traffic expected from decimalization is a 
major challenge. In order to address the current and projected message 
traffic volumes, OPRA and SIAC intend to begin increasing system 
capacity. OPRA plans to increase system capacity by December 2000 from 
its current maximum of 3,000 messages per second to 12,000 messages per 
second. It is unclear if this additional capacity is sufficient to 
accommodate the volume levels projected in the SRI study.
    NexTrade is concerned that the delays requested by traditional 
market participants that are not ready for decimalization will cost the 
public the $300 million to almost $2 billion dollars in annual savings 
that will be the result of the transition to decimals. The market 
structure that has resulted in the delay in the implementation of 
decimal pricing is in need of fundamental restructuring. The opening of 
the NMS to greater public and non-traditional market participant 
involvement will help to promote innovation and greater competition. 
Such competition and innovation will result in more efficient markets 
that benefit the public.

                               CONCLUSION

    Mr. Chairman, and members of the House Subcommittee on Finance and 
Hazardous Materials, we have the unique opportunity to create fairer 
and more competitive markets. While it is unclear what the future holds 
for the development of the financial markets, we must remember that the 
Internet empowers entrepreneurs and the public like no other vehicle 
has in the past. If we are to retain our primacy in the capital markets 
we must embrace two concepts: (1) the Internet will transcend our 
ability to regulate the markets, and (2) the future of finance does not 
have a Wall Street address, it has an IP address.
    As this Committee works its way through these various public-policy 
issues, NexTrade would welcome the chance to elaborate on the proposals 
put forth today, and to contribute in the most constructive way 
possible to this important dialogue.
    Thank you very much.

    Mr. Shimkus [presiding]. I think what we will do for the 
benefit of members who have gone to the floor for the vote, I 
will ask a few questions, which will allow the chairman and the 
ranking member time to get back so they can see both 
demonstrations.
    So if I may, a question for all of you is what percentage 
of limit orders placed on each of your systems is completed in 
the very impressive 1\300\ of a second that I have heard 
discussed?
    Mr. Andresen. On The Island, it is benchmarked around 1 
millisecond, as you've noted, but it is difficult to quantify 
the percentage of limit orders that are executed because Island 
encourages the submitting of limit orders such as buying Dell 
at a dollar or selling Amazon at $200. I used to laugh at both 
of those. Now I just laugh when people are selling Amazon too 
early. With limit orders because you are placing a specific 
price limit on what you are willing to buy or sell, you can 
only quantify the percentage that get to the market and then 
are executed. And because ECNs are included within the national 
market system for NASDAQ stocks, all orders represented on ECNs 
like Island are executed that become marketable.
    Mr. Shimkus. Let's just go down the panel.
    Mr. Foley.
    Mr. Foley. \3/100\ of a second, that is a technical 
question that requires a technical answer. ECNs are, by 
regulation----
    Mr. Shimkus. And let me just clarify. The direction of this 
question is obviously there is great, quick equally matching 
when you have a buyer and a seller. What percentage of that is 
in that rapid response? What percentage is not within that 
quick reaction time, and probably the vast majority if you take 
the majority of transactions?
    Mr. Foley. When you have a buyer and a seller that matches, 
it is 100 percent. That is the business that we are in. We 
match immediately. We are agents only. We have no other 
business with that information except getting our customers' 
trades done. That includes orders that come from noncustomers, 
from the outside. We have an obligation to our customers to 
execute the trades immediately and we do so. It is another 
matter--I would say the amount of time it may take a 
noncustomer's order to get to us if it goes through NASDAQ 
technology, for example, but many of the ECNs have connected to 
each other privately in order to maintain rapid communications 
between ECNs, which is an obvious addition to your ability to 
respond instantaneously. So the direction of technology is to 
do things rapid fire. Where technology is allowed to compete in 
an unfettered fashion, you have greater speed, greater 
reliability and greater customer satisfaction. That is what we 
are committed to.
    Mr. Shimkus. And I will let this question evolve as I go 
through the panel. The various published reports state that 
this happens approximately 25 percent of the time. So the 
question that is emerging is what happens to the 75 percent, 
and if they are executed because they are sent elsewhere?
    Mr. Dorsch. I think this question is probably more geared 
to the other members of the panel today. In our arena, SWAPS 
trading and negotiation is done differently. We don't match 
orders, per se. It is an electronically negotiated process. 
Having said that, to quantify how much we have speeded up the 
process is a little bit like somebody who was once walking and 
now they are flying in a jet fighter. We have added that much 
speed to the process.
    Mr. Oxley. Mr. Schaible?
    Mr. Schaible. I will take the question to mean what happens 
to the order if the ECN does not have a match inside the book.
    In that circumstance, and I am speaking for NexTrade, we 
have invested millions of dollars in order routing technology 
that will allow us to handle market orders and orders that do 
not have a match inside our system to go to the best 
destination as quickly as possible. We have found that is to 
other ECNs quite frequently.
    Mr. Foley. I didn't interpret the question referring to 
that issue, and it is an important issue. What we do at 
Bloomberg Tradebook is show the best prices to our customers 
from any place we can get them, from the market makers in 
NASDAQ, from other ECNs, and we present our clients with the 
opportunity to route directly to the best price, wherever it 
may be, and that is not something that every ECN does, and it 
is an important part of the service that we provide for our 
customers because they need to know more than just what the 
best price is among our customers.
    As we have grown, that becomes more and more important 
information. The success in our markets, both the market in 
general and also for our customers, the individual 
participants, means the ability to see where everybody else who 
may be the other side of your trade is and that is 
transparency, and the ability to get there. And that is the 
market linkage, and that is what we promote. It is an important 
value to our clients at Bloomberg Tradebook.
    Mr. Shimkus. Let me throw out this question to the 
panelists. You all talk about immediate access to the 
Intermarket Trading System. Why should you be able to access 
the ITS in a manner that is different from all of the other 
broker-dealers?
    Mr. Andresen. I don't think that we should have any 
different access as long as we meet the regulatory obligations 
of the structure within which we exist. Island is regulated as 
a broker-dealer itself by the NASD, and also as an alternative 
trading system or ATS by the SEC. I believe that if a broker-
dealer, whether electronic or otherwise, can make itself 
accessible to investors, they should have the opportunity to 
compete. One thing that ECNs do differently than traditional 
marketplaces is allow for instant information and instant 
access.
    If you see something on an ECN, you can get to it 
immediately because it is, in fact, a live order, in The 
Island's case, a retail order. If there is a traditional 
intermediary, the one problem with that is if they don't make 
themselves immediately accessible, everyone's systems have to 
slow down to the lowest common denominator.
    Mr. Foley. I would like to be explicit about this. We don't 
believe that ECNs need to have direct access to the ITS. We 
understand the argument, and some have used the analogy of the 
NFL. There is the NFL or you can start your own league. You 
can't demand entry into this league.
    The issue is this: We want there to be competition among 
the exchanges because if there is competition among the 
exchanges, then we know that exchanges who want the order flow 
from our customers are going to be responsive to our needs for 
innovation and so forth. The ITS committee in our view, the way 
ITS is governed, restrains and discourages competition among 
exchanges.
    It has been more than a year and a half since the Director 
of the Division of Market Regulation, then the Director, 
Richard Lindsay, wrote a letter to the ITS committee expressing 
concern over how ITS is governed. They make decisions by a 
blackball method. If anybody is opposed, then change can't 
happen. That has made it difficult for the NASD to bring ECNs 
in, and it makes any kind of technological change all but 
impossible.
    Our issue is that the Congress should be concerned. The 
Commission should follow up on this question of how ITS is 
governed because if ITS is allowed to make decisions on the 
basis of what the exchanges themselves feel is in their best 
interest and exchange competition can flourish, we think that 
there will be exchanges that want a home for us and innovative 
broker-dealers and will provide services for us and our clients 
that we currently can't get in the listed markets.
    Mr. Oxley. Thank you, and thank you to the gentleman from 
Illinois for sitting in the chair. This will be an appropriate 
time to have our show and tell.
    Mr. Andresen, if you would proceed with that, we would 
appreciate that.
    Mr. Andresen. What you are looking at here is the wide 
market in the stock Cisco Systems which is the largest stock by 
market cap in the world. All of those colors that you see, and 
I understand that it is hard to make out from up on the dais, 
all of those changes that you see are retail investors putting 
in indications to buy or sell, live accessible orders. And this 
is important in our minds for two reasons: one, because people 
can now make better investing decisions. Chairman Levitt has 
said over and over again that the best investor protection tool 
is the use of a priced order. The reason why people place 
market orders in the stock market is because they lack 
knowledge of what the order is. You would never place a market 
order for an automobile or a box of Cheerios, but in my mind it 
is even more distressing that you place one for your life 
savings or pension into a stock market with no knowledge of 
what you are going to pay.
    And as an example, the price line IPO, one of the hot IPOs 
of last year, the investment bankers priced that deal at $9 a 
share. The opening price was at $90 a share, which is where all 
of those market orders got filled. The investors found out 
about those executions when the stock was back down at $60 a 
trade. The use of limit orders hinges on your ability to know 
the prices. And it is not good enough to be able to look the 
next day in the Wall Street Journal or The Washington Post in 
the stock tables. You must be able to know right now what 
everyone is doing. Just looking at the last sale in the stock 
is like driving a car down the road by looking over your 
shoulder and saying wow, this road sure is straight. Not seeing 
the orders, what everyone else wants to do in the stock is very 
dangerous.
    The other thing that seeing the entire limit order book 
enables you to do is have accountability for your order. Right 
now, in traditional marketplaces, they will only tell you the 
best price. That means they will tell you the highest price 
anyone is willing to buy Cisco at is $77. The lowest price 
someone is willing to sell is $77\1/2\. That is interesting 
information, but not being able to see what is behind those 
orders, who wants to buy at $76\3/4\ or $75 is damaging. In 
addition, not seeing your order within that list of orders is 
very dangerous.
    What we have given with the Island Book viewer is pure 
instant accountability for your broker. Instead of talking to 
your broker 3 years ago and saying gee, Broker Bob, I would 
like to buy Dell and have him say you can buy it at $38, having 
him tell you that a day later. Now the conversation is gee, 
Bob, I put my limit order in to buy Dell at $38\1/16\ when it 
was $38\1/8\ by $38\5/16\, and it traded down to $37\31/32\, 
and I didn't get an execution. What are you doing over there? 
And that is an empowered investor, an investor who has the 
tools to be able to judge the service that they are given. 
Everyone knows about commissions, margin lending rates and 
access to research. Until now, they have not been able to know 
about execution quality. Execution quality, the price your 
trade is actually given to you at is far more expensive, a dead 
weight loss to the investor. Seeing your order in there with 
everyone else's is the kind of transparency that is essential 
for investor protection. Thank you.
    Mr. Oxley. Thank you. Mr. Schaible.
    Mr. Schaible. Actually, I am going to need the phone cord 
from Matt's machine to do the connection. In the interim, I 
want to return to a question that the gentleman had asked 
before you came back into the room about whether or not we 
believe that all broker-dealers should have access to ITS equal 
to what ECNs are asking for, and I want to agree with what Matt 
had said with one important caveat.
    I think that anybody who has access to the National Market 
System should have to pass a validation of some kind with 
respect to the level of technology that they can bring and that 
certainly, that level of technology should be held to the 
current ITS. If Matt participated in ITS on the way orders are 
executed today, they would absolutely expose themselves to 
double, triple, quadruple execution for a single order. The 
current ITS system holds single orders alive for up to 2 
minutes because their technology is so antiquated. I think it 
is an important topic.
    Mr. Oxley. Who would determine that capability, that 
technological capability?
    Mr. Schaible. We have suggested that we broaden the 
governing structuring of the National Market System plans, 
particularly ITS, to get in a wider representation base. 
Currently only exchange members can be part of the ITS 
governance board. We think there should be broker-dealers, 
members of the public, issuers, representing a board similar to 
the structures of an exchange and that board can make the 
decision what the standard should be and submit it to the 
Commission for approval.
    This will take me just 1 minute. What you see on the screen 
on the left-hand side is information on the current NASDAQ 
operating environment. It is structured to display what are 
called level 2 quotes, which shows essentially the best prices 
of every market maker or ECN today on Dell computers. This 
system is a system that a lot of our broker-dealer clients 
utilize to connect to the NexTrade ECN.
    On the right-hand side of the screen is the NexTrade order 
book, and we anonymously show the interest of every order 
inside on the NexTrade ECN so that any investor or market 
participant can see the complete depth of NexTrade's book. This 
is an important difference from left to right. On the left-hand 
side the NASDAQ, you see only the top of the book of the market 
participants, and to get access to this information you must 
pay a professional fee of $50 a month to the NASDAQ.
    For the information on the right you see the entire depth 
of book in real time for free. And that is something that I 
think NexTrade is doing. I believe Island offers their quote 
depth for free as well, and it is something that we do as a 
competitive tool because we can show that depth and we do that 
to attract market share away from the NASDAQ. This system can 
do everything that NASDAQ can do with respect to executing 
orders and more, and we can do it over the Internet. We can 
trade like the NASDAQ in 20 seconds, and that is what 
competition will do for the market.
    Mr. Foley. Mr. Chairman, I wonder if I can give you a 
verbal demonstration of some of the differences in the ECN 
space. One of the things that we think is really important for 
our clients is to show the full depth of the market, including 
all of the quotes from NASDAQ and combine them with the orders 
of our clients and route our client's orders to the best 
market, the best market maker, or the best ECN to satisfy our 
best execution obligations. And let me put it this way. If you 
look at the display that shows the depth of book from a single 
participant, even a large one, 12 percent of the market, for 
example, you are still missing out on the other 88 percent of 
where the best price may be and the best place to execute a 
brokers--customer's trade.
    And so the display that we provide for our customers is one 
that shows the complete information and we are enthusiastic 
advocates of public displays that combine rather than having to 
go from one place to other, that combine the aggregate market 
depth. We enthusiastically endorse the proposal that SEC 
Chairman Levitt put forth at Northwestern a couple of weeks ago 
that the industry should work toward a free market solution for 
this.
    We enthusiastically oppose NASDAQ's proposal, which you 
will find presents depth of market information, but it takes 
our names off the source of the quotes and replaces it with 
NASDAQ's name. Hence, centralizing not just the display but the 
execution into a black box because you have to go through them 
to get to that so-called anonymous quote.
    I just wanted to lay out a couple of distinctions that we 
think it is in the best interest of the investing public to see 
all of the information in one place, and all of the places 
where you can execute with the ability to get there. We do that 
for our clients. We support Chairman Levitt's initiative that 
will do that for the investing public in general, and we oppose 
the SuperMontage which purports to do that, but we think is an 
anticompetitive positioning of NASDAQ as a government-sponsored 
monopoly technology provider in advance of their privatization.
    Mr. Oxley. The Chair recognizes himself for 5 minutes for 
some questions.
    Mr. Foley, and maybe some others, could you help me with 
this issue, that is the SuperMontage idea versus central limit 
order book. Explain to the uninitiated, are they competing 
concepts or are they similar from your perspective and how 
should this committee perceive both of these initiatives?
    Mr. Foley. The distinguishing characteristic of the CLOB is 
that someone or some entity is in charge, and some of the 
debates you might hear at the top about this proposal versus 
that, this is not a CLOB and this is, really the debate comes 
down to who is in charge. NASDAQ's SuperMontage proposal, has 
all of the centralizing aspects of a generic CLOB proposal, but 
it has a specific characteristic that NASDAQ is in charge of 
it.
    One of the issues that came up earlier had to do with the 
compelling of orders into a CLOB? Would retail orders be 
compelled but institutional orders not be compelled? We think 
that orders that are displayed to anyone should be displayed to 
everybody and that should be a requirement. But what particular 
technology you go into should be a matter for the free market 
to decide, and that is the danger of a CLOB. No matter what you 
call it, if it centralizes the black box, you are going to have 
a single point of failure. You are going to have a single point 
that is resistant to change. You are going to have to have 
people like us on this panel raising our hands for permission 
to innovate in the future, and that is not the way that we have 
managed to serve our customers and grow our businesses over the 
last few years.
    Mr. Oxley. May I interrupt. If all of these impediments are 
out there, how have you been so successful so far?
    Mr. Foley. That is a great question. A lot of these issues 
can be confusing because there are different things going on. I 
boil it down to this.
    The NASDAQ market is a market where new nimble competitors 
can come in and introduce innovations and thrive. It is 
consolidated and not fragmented. Where NASDAQ's linkages don't 
suffice, ECNs can connect privately to each other and replace 
those outworn solutions with state-of-the-art solutions.
    The SuperMontage proposal says there is a lot of chaos 
here. There is a lot of change. Things are going on. Let's take 
an example. Bloomberg Tradebook's innovation of reserve, which 
allows for the handling of large orders in an electronic 
marketplace, is incorporated into the NASDAQ SuperMontage 
proposal. You wouldn't introduce an electronic trading system 
today without the innovation that we introduced 3 years ago. 
You know, the issue in the NASDAQ market is when you say this 
is the institutionalized, centralized level of innovation, do 
we really know that we don't need any more innovation, that 
there are not customers that we can serve better with new 
competitors. I would argue if you hold this panel 3 or 4 years 
from now, if a central limit order book or the CLOB takes hold, 
it will be the same innovators here. We will be talking about 
innovations that we had 5 years ago in the year 2000.
    Because of the NASDAQ market maker collusion scandal in 
1996, it was much more open to the reforms of the SEC than the 
listed markets have been. But we think what makes the U.S. 
securities markets the best in the world and what is going to 
keep U.S. securities markets in the U.S., is transparency. Now 
we are defining transparency and we are thrilled to see this 
debate move forward as the full market depth for everyone to 
see. Linkages. You see the best prices. Do you have the ability 
to get there, and the best execution obligations that brokers 
such as ourselves should take advantage of the linkages to do 
the right thing for our clients.
    We have been able to innovate on NASDAQ, not so much on the 
listed side. We don't want to see NASDAQ innovation stopped and 
we would like to see it started up on the listed side.
    Mr. Oxley. Thank you.
    Mr. Andresen. I think it is sometimes instructive to look 
at what NASDAQ is. We are all interested in making sure that 
investors get all of the information that they can. That, in 
fact, is NASDAQ's core competency. NASDAQ is not a central 
meeting place at all. Instead, it is a collection of different 
participants, three of whom you see represented today. Others 
like Goldman Sachs or Morgan Stanley also participate in 
NASDAQ.
    What the SEC did in 1997 was say this NASDAQ world, if you 
think of it perhaps as a shopping mall, the shopping mall 
doesn't buy or sell things. They provide the roof for the 
different stores to transact their business. NASDAQ ensures, 
just as a shopping mall does, that you have a map of where to 
go, and if you lack the ability to get there, give you the 
communication path to be able to buy whatever you want from the 
prices they give you. ECNs were not in that shopping mall in 
1996. The SEC insisted in their order handling rules that they 
should be so you now have different types of stores within this 
mall applying slightly different wares.
    The issue before you today is not so much what is going on 
in the shopping mall, in NASDAQ. Maybe NASDAQ through the 
SuperMontage wants to open its own store. I am not afraid of 
competing with NASDAQ on the basis of service, cost and 
reliability. If they can do a better job than Island, they are 
welcome to the business. On the listed side, however, their 
shopping mall is a collection of the 10 established stock 
exchanges: The New York Stock Exchange, Am Ex, Philadelphia 
Boston, Cincinnati Chicago, et cetera.
    The ECNs are just like Burlington Coat Factory. We are 
stuck on the other side of the expressway, hoping that people 
stop by our stores on the way to the centralized meeting place. 
We ask for a chance to share our prices with the other 
marketplaces. Let's let investors vote with their feet and 
select the marketplaces which adds the most valuable.
    Mr. Oxley. Thank you. The gentleman from New York.
    Mr. Towns. Thank you, Mr. Chairman. Who is proposing a 
CLOB? And why?
    Mr. Foley. The CLOB is not a formal proposal before the 
public at this point. We understand that there is a white paper 
that is in draft form drafted by some of the leading brokerage 
firms on Wall Street that formulates the notion of a CLOB and 
why markets need a CLOB today.
    The second place where you see evidence of the debate over 
a CLOB is with a paper that the SEC recently released. It was a 
concept release asking for public comment on various issues of 
market structure and the first and most important issue that 
they ask for is do we need a central limit order book to 
address issues of market structure.
    Finally, it has been raised by panelists who have testified 
on the Senate side before the Senate Banking Committee on 
market structure. I say this about the debate. If you really 
want to boil it down to one thing that we think is the most 
important, there is a lot of concern about how our equity 
markets are going to be structured to be the most competitive 
for the world in the future. There is a lot of debate around 
decimalization and the Commerce Committee championed 
decimalization, and I congratulate the chairman on the issue of 
decimalization.
    On one level it was a question of I buy my groceries in 
dollars and cents and I would like my stock purchases to make 
sense as well. You have academicians weighing in saying 
decimalization carries with it so many beneficial effects that 
address a lot of the complicated issues in market structure.
    Our issue is simply this: We don't know what decimalization 
is going to solve until we have decimalization, and we don't 
think that we should be looking at intrusive, sweeping 
regulatory changes in a marketplace that is going to change for 
the better once we see decimalization. As I think someone else 
on the panel mentioned, we think everyone's first priority 
should be getting to decimalization, and we will see what the 
benefits are and we then can see what else we need in the 
marketplace.
    Mr. Towns. You anticipated my second question.
    Mr. Andresen. I think any time you look at Wall Street or 
any other industry, you have to look at underlying motivations. 
What is in it for me. Those who propose a CLOB are people that 
stand to benefit.
    I used to be a big fan of the Price Is Right when I was 
sick and staying home from school--a couple of years ago. I 
remember always feeling really sorry for the first poor guy 
that had to make the first bid. He would say $300 for that 
laptop, and everyone else would be $301, $299. He would just 
sit up there all morning and people would sandwich him on 
either side.
    If you look at Morgan Stanley, Merrill Lynch and Goldman 
Sachs, who are the ones who proposed this most directly on the 
Senate side in their hearings in New York, these companies 
don't really control much retail order flow. That has gone to 
places like Island or market makers like Knight Trimark. They 
control institutional order flow. So they propose having a 
public utility, being the initial transparent venue for all 
retail investors for them to make that first bid. Their 
customers can come in through their gateway and pick off the 
retail investors as they see fit.
    I believe transparency is not about holding up retail 
investors for them to be cherry-picked. It is about creating a 
truly level playing field where everyone has access to everyone 
else's information at the same time.
    If you look at the CLOB, inevitably there are those little 
carve-outs. They want a CLOB but not for our customers, because 
in the end, a market is about asymmetric information. If I know 
the final score between Wake Forest and Notre Dame, I will make 
a lot of money betting on it. If everybody knows the final 
score, it is uninteresting information to have. Everyone wants 
to see what everyone else is doing without showing their own 
cards. When you look at someone else's proposal, you should see 
that through the lens of their own business model.
    Mr. Towns. Thank you very much. One more question, Mr. 
Chairman.
    What can this subcommittee do to foster reform of the ITS? 
What can we do?
    Mr. Andresen. Well, I think the most important thing is 
just to make this a debate. I think market structure is 
something which has been very opaque to retail investors. I 
remember reading an article in the Wall Street Journal about an 
investor that lost a tremendous amount of money in the Palm 
Pilot IPO because the market center had held his order for a 
substantial amount of time. And I was struck and the reporter 
was struck by what did you think happened to your order when 
you submitted it? Didn't you think that it was sold to someone 
else who was going to trade against it? He said I just thought 
they sent it to the stock market, and this illustrates the 
degree to which the investors have become knowledgeable about 
individual stocks and the market direction, but have not 
thought about market structure.
    As long as we look to create in ITS an environment where 
new competitors can come in and actually compete, we will have 
an efficient system. If this committee considers the structure 
right now which is, as alluded to before, the old U.N. Security 
Council situation where one person can veto a change. It is 
really a situation where if we are soda manufacturers and I 
have to go with my new soda pop to Coke and Pepsi for 
permission to compete, and they can say yes, just serve it at 
120 degrees Fahrenheit, it makes the benefits of that new soda 
obsolete.
    ECNs are new markets that are as revolutionary and as 
innovative as the light bulb was to the candlestick, but we are 
being asked by the existing candlemakers to screw our light 
bulb into their candlestick.
    Mr. Oxley. The gentleman's time has expired. The gentleman 
from Iowa, Mr. Ganske.
    Mr. Ganske. Thank you, Mr. Chairman. While I have learned a 
lot in your presentation, I appreciate your testimony. Mr. 
Chairman, I have here some remarks by Chairman Levitt on a 
speech that he gave at Northwestern University on March 16, and 
I am going to skip around a little bit but read part of this, 
and then my question will be to get each of your remarks on 
what Chairman Levitt had to say.
    Chairman Levitt said, ``We can all agree that a market 
structure tilted toward the needs of hedge fund managers should 
not be our goal. At the same time, we should not foster a 
system bent toward day traders. Our future markets must serve 
the diversity of American investors. Of course, if we have a 
single monolithic market fulfilling this responsibility to 
customers would be much simpler, but I believe Congress was 
visionary in choosing not to mandate such a market. Over the 
last 25 years, our system of competing market centers has been 
the driving force behind faster and cheaper executions spawning 
new trading systems that provide anonymity and greater 
liquidity.''
    He goes on to say, ``Market centers in a dynamic National 
Market System must be able to hone a niche, develop a brand or 
offer value-added features.'' I think that is some of what you 
are talking about in your testimony. ``Any linkage must 
accommodate innovation and the imperative to compete on the 
basis of value. Moreover, inner market linkages are not 
intended to promote unlimited free access to a competitor's 
market. Why, for example, would anyone want to purchase a seat 
on the New York Stock Exchange if a connection to ITS offered 
equivalent benefits. At the Commission we well know that ITS 
has not kept pace with the technological change sweeping our 
markets. Its archaic structure and cumbersome governmental 
provisions are not fit for today's market, let alone the market 
of the future. The over-the-counter linkage, SelectNet, 
continues to be plagued with shortcomings and delays during 
heavy trading volume and even outages. Given the decentralized 
nature of the NASDAQ market, this is a critical and core flaw 
and one that must receive intense scrutiny and committed 
resources until resolved. We expect to exercise increasingly 
active oversight of these linkages in the near future.''
    Mr. Levitt continues, ``In a more positive note, the 
Commission today,'' that was March 16, ``approved a NASDAQ 
proposal to link ECNs to the listed market through ITS. I 
firmly believe that investors will be winners as fuller, more 
robust competition between equity exchanges unfolds.'' Then Mr. 
Levitt finished by saying ``This is not a debate about big 
firms versus small firms. This is not a debate about 
institutional interests versus retail interest. It is not a 
debate about a monolithic market versus a splintered market. It 
is not a debate about human intelligence versus the quiet hum 
of a computer. Rather, it is a debate about how best to let 
unburdened competition and unbridled innovation drive the 
future of the market. It is a debate about how best to meet the 
needs of our investors, it is a debate about how best to equip 
our markets to compete and win in an increasingly globalized 
electronic market. It is, I believe, the most important debate 
our capital markets face.''
    I wonder if each of you can comment on those selected 
remarks of Chairman Levitt or focus on any particular part of 
those parts that I read. Maybe we can start with Mr. Andresen.
    Mr. Andresen. Thank you. I think Chairman Levitt has, 
throughout his entire tenure, worked to foster competition 
within the markets. Island's very existence is owed fully to 
the SEC's intervention in 1997. Without that, Island would 
never have had the chance to differentiate ourselves as a 
marketplace from everyone else.
    I am sure it would not be surprising for you to know that 
the people in front of you today are not really friends. When 
we go back to New York or Florida, we will scratch and claw and 
fight to try to find some tiny advantage over the other person. 
That is the healthy aspect of competition. Without competition 
you have stagnation. Our phone company in 1981 was certainly 
the envy of the world, but there were busy signals and rotary 
dial phones. Today in the era of robust competition, we have 
tremendous breadth of service at incredibly lower cost. The 
equity markets are the same way. Island was designed to be 
fully decimalized. Island doesn't go to nickels or pennies but 
actually to tenth of a tenth of a tenth. We go to 10 decimal 
places.
    Mr. Ganske. Let me ask each of you to try to limit your 
remarks to 30 seconds or a minute so that all of the other 
members have a chance also.
    Mr. Andresen. Because we exist in a noncompetitive 
structure we have to take our fine increments and pound them 
away to NASDAQ's chubby price increments.
    Mr. Foley. Congressman, those are great remarks by Chairman 
Levitt. I agree that the SEC has been an important influence 
for guiding competition. You pull out a couple of things from 
those statements. One, when you are relying on a central single 
point of failure in technology, you have problems finding 
alternatives. When Mike Bloomberg, my boss, wants something 
done, he will say to me, all too often, get it done or I will 
find someone else who can. If this committee could say that 
regarding decimalization in the NASDAQ market, get it done or I 
will find someone who can.
    We think that the market structure of the future should not 
be one in which everyone gets a free call on all of the 
services of the New York Stock Exchange without having to pay 
for them. There should be a market structure where we look for 
free market competing solutions because we will have the best 
chance of having reliable ones and alternatives to turn to when 
we need them. It is the same thing with the model of a CLOB. 
There is a central black box that you have to go to and that is 
a basic problem.
    I would sum up on the ITS question this way. We don't 
believe that it is a monolithic club, the members of the ITS 
committee. We would like to see competition unleashed among the 
exchanges, and regarding the linkages between the exchanges, we 
call for one basic reform and that is the governance of the ITS 
committee. A lot of good things will flow from that. One member 
of the committee can veto any action on the part of the 
committee. Want to improve the technology? One guy can vote 
against it. I am concerned about this.
    So that is a fundamental issue. As I mentioned earlier, the 
Commission took a look at that issue a year and a half ago, and 
we think that this committee would be well served to ask the 
Commission how that issue is progressing.
    Mr. Dorsch. In order for this country to maintain its 
preeminent position in the financial arena, I think competition 
is absolutely necessary and I don't think any one group or 
entity should be allowed to stand in the way of innovation.
    Mr. Schaible. Access to ITS is not enough. NexTrade would 
like the opportunity to compete for the National Market System 
technology business. We are forced by regulation to deal with 
the technology that is rather antiquated and that the previous 
exchange members already paid for. That is not a technology 
that we can easily interact with because it can result in 
double executions.
    Something else that Chairman Levitt talked about is the 
crisis that the Commission is facing with respect to flight of 
talent. Ranking Member Towns asked earlier what this committee 
could do to help foster competition. I think one of the best 
things you could do is to look to fund the Commission more 
fully. Their hands are tied. They have exchange applications in 
front of them. They have National Market System issues pending. 
They are in a complete personnel crunch over there. I 
understand that SEC fees generate 5 times what the SEC actually 
sees. It is likely that we could take some of the funding and 
direct that to the Commission to allow them to deal with this 
crisis.
    Mr. Ganske. I thank you all.
    Mr. Ehrlich [presiding]. Mr. Barrett.
    Mr. Barrett. In January 1997, were you all sitting around 
and you saw this order came through and said hey, let's try 
something?
    Mr. Foley. Island and Bloomberg Tradebook and InstaNet 
existed prior to the order handling rules, and it changed the 
nature of our business models dramatically. It became possible 
to display your customers orders so that the rest of the world 
could see them. Why did that come about? It came about because 
previously there had been a private market inside the best bid 
and the best offer that the public saw, and while large volume 
is trading inside the prices that you can see on the screen, 
and market orders as Matt referred to before, were getting 
executed at this published bid off the spread that had nothing 
to do with where the market was really trading. People were 
writing to Congress complaining about that, I might add.
    The upshot was that, with the new order handling rules, you 
couldn't keep your market private to yourself and say I am just 
going to match my customers' orders with each other.
    Mr. Barrett. How long did it take you to realize that?
    Mr. Foley. Three seconds.
    Mr. Barrett. For us Neanderthals--you can see there are 
more Republicans here than Democrats. We don't have as much to 
invest.
    Mr. Foley. This happens so frequently. When you go back to 
deregulation of commissions or various issues, and 
decimalization is going to be another issue like that, there is 
a lot of hand wringing about what the change is going to be, 
and the way things have operated before which has been very 
profitable for the operators going to have to change. The 
reality is in many of these issues, it brings about new 
opportunities to do business and service your clients, and we 
market participants, reformulate our strategies for how we are 
going to serve our customers.
    Now these customers have new rights and it turns out there 
are a hundred new ways to serve your customers and 
differentiate yourself from your competitors, and that is sort 
of what has brought us to this point. Our business models 
existed before, but it really changed the rules of the game 
that favored innovators.
    Mr. Barrett. How did you sort of glom onto this?
    Mr. Andresen. The good thing about competition is that you 
never know where the next competitor is going to pop up. I 
always say there is an annoying amount of ease of entry and 
exits in the marketplace, and that is healthy. Back in 1996 
when this happened, as you point out there was only one 
competitor, InstaNet, where most of the trading was done. What 
we saw was an opportunity to serve people that InstaNet did not 
want to help, the retail brokerages.
    We said if we can do this at a cost level, we can change 
the world. It doesn't take long to figure out an on-line broker 
that make $10 a trade, and has to pay $15 to execute it, even 
on the Internet, is a bad business model. If we can make it 75 
cents and make it cost effective and give good service to the 
customers, we would be able to grow with the on-line brokage 
industry.
    Mr. Schaible. NexTrade is predominantly a technology house, 
and in late 1996, we had brokerage firms that were asking us to 
develop matching systems because the clearing costs were lower. 
Instead of having to send two trades to their clearing company 
and pay two costs, if they could match a system in-house, match 
a trade in-house, they would pay one clearing cost. So we 
started developing the technology in late 1996 to be an ECN. 
And in 1997 with the order handling rules, we began the 
approval process which took NexTrade about 18 months until they 
could become a qualified ECN.
    Mr. Dorsch. Our business is different. Having said that, we 
were able to introduce decimalization in our business at the 
very get-go and the results for our clients have been 
phenomenal.
    Mr. Barrett. The other thing listening to all of you, this 
world is changing so quickly. What is it going to look like in 
5 years? What is the New York Stock Exchange going to look like 
in 5 years?
    Mr. Andresen. I think it is difficult to predict how 
anything will turn out. Everything will be cheaper and faster 
and more transparent. I am sure that the day that the New York 
Stock Exchange is forced to compete, they will change their 
business model to meet that competition. I do not believe in 5 
years you will have floors where people transact. You will 
instead have everything done electronically.
    Mr. Foley. I don't think anyone can say for sure who are 
going to be the dominant competitors. It was remarked earlier 
about the two largest players, New York and NASDAQ being 95 
percent of the market. And I have to say that I don't think 
that it is necessarily a bad thing that large entities dominate 
our marketplace. They just simply need to have to compete to 
take on that role. A naturally forming monopoly has to compete 
to maintain its position in the marketplace, and a government-
sponsored monopoly does not have to compete and serve 
consumers' needs.
    Mr. Dorsch. I think the scope and speed of change is going 
to be faster, and I think it will reach further and I think the 
complexity of transactions that will be able to be done 
electronically will stagger people's mind. It is going to be 
beyond stocks and bonds.
    Mr. Schaible. We talk about the future of capital markets 
resembling the Web, a number of portals interacting through a 
national market system with true transparency and quality of 
assess. The New York Stock Exchange has a lot of smart people, 
and when they are forced to compete, they will be one of the 
larger portals.
    Mr. Barrett. If I can take a minute for Mr. Ganske. He 
wanted a minute.
    Mr. Ehrlich. Without objection.
    Mr. Ganske. I think a lot of people would see the services 
your companies offer as great for individuals. We just passed a 
financial services bill, which I think will bring many more 
players into this. Are some of the large financial institutions 
utilizing your company's services?
    Mr. Foley. That is a space where Bloomberg Tradebook 
excels. What we have done is introduce innovations that make it 
possible for the larger orders that are handled directly by 
institutions or by broker-dealers who handle large 
institutional orders, to bring these orders directly into the 
National Market System instead of having them hang back and be 
worked upstairs and so forth.
    And one of the revolutions in the marketplace right now is 
that we are coming directly into contact with institutional 
order flow for the first time. We make that possible by 
building tools that maintain the anonymity of the participant 
because if your fund managers spend a lot of time researching 
this stock, you want to make sure that he gets to buy it before 
everyone else knows about the idea and to allow those orders to 
participate in the market leaving a footprint of a lot of small 
orders rather than the footprint of one big order. That is 
where our 100 million shares come from.
    Mr. Dorsch. Our business only serves large financial 
institutions. I don't think we have ever had a transaction 
under $50 million. It is hundreds of millions of dollars in a 
chunk.
    Mr. Oxley. I recognize the gentleman from Illinois, Mr. 
Shimkus.
    Mr. Shimkus. Mr. Andresen, the central limit order book, 
how does it affect your analogy of the shopping mall? What 
would happen in simplistic terms if you turned that shopping 
mall into a CLOB.
    Mr. Andresen. I remember when I was 18 I was on the 
national fencing team and we went to Hungary. This was 1988, 
and I remember going shopping in Hungary and they had a big 
place called Store, and you went into Store and it had stuff 
and you could buy food and clothes and other generic things. 
While it seemed for me coming from America like some sort of 
Orwellian nightmare, I believe this is exactly what you would 
have with a central limit order book. Make everything generic. 
All of the technology would converge at one point. You could 
never be any faster than the slowest participant. Everything 
gets dumbed down to the lowest common denominator.
    My concern with the central limit order book is even if you 
went today and said let's find the best technology, let's say 
that Island is lucky enough to be selected as the central limit 
order book, it is pretty good right now, a millisecond is 
pretty fast, but what happens in the future when that is not 
enough. What happens when instead of 2 billion shares a day, 
the market wants to trade 20 billion shares a day. You will 
call me and I am going to be working 4 hour days instead of 16 
hour days, and I will tell you I will get around to it when I 
can. I believe to ensure we don't have that kind of stagnation, 
you must provide incentive.
    Mr. Shimkus. Thank you. I yield back the balance of my 
time.
    Mr. Oxley. The gentleman from Illinois, Mr. Rush.
    Mr. Rush. I yield my time to the gentleman from Wisconsin.
    Mr. Oxley. The gentleman from Wisconsin.
    Mr. Barrett. Thank you, Mr. Rush. I know so little about 
this, I figured I can learn something here this morning. If 
this is a form of a CLOB, if you can explain what it is and 
what the problem is.
    Mr. Andresen. One of the rules of an efficient marketplace 
is sort of the law of the playground, the best price wins. If 
two people have the same price, whoever was first in line wins. 
People call that price-kind priority, and it is something at 
Island that we believe very strongly in. We have built our 
entire system around that idea. Even if you are only a one-
share retail order, you are in first or better price, you win, 
you get the trade.
    But it is very difficult, I believe, in fact, impossible to 
ensure time price parity, not just in a system but across 
systems. My concern is when you go back to the shopping mall 
analogy, when you try to ensure that kind of protection between 
markets, you actually undermine it and if you would indulge me 
with a quick hypothetical. What would happen if Kevin was 
trying to use Island to buy Cisco at $79 a share? He places his 
intention to buy on Island. Now, let's say that the two 
distinguished gentlemen up there both make the decision roughly 
at same time that you want to trade with Kevin on Island. So 
you both send an intention to sell to that order. If Island was 
the best price this is easy. Whichever one of you happened to 
type a little faster would win. But let's take the hypothetical 
where we have a trade-through rule. Let's say that you are just 
a little faster than him, and you send the order and I say I 
can't let you trade with Kevin because the Pacific Coast Stock 
Exchange out in Los Angeles has a penny better price.
    I am going to reroute your order through the intermarket 
trading system for the next 2 minutes. Now, you are second in 
line and should be punished by being behind you, but you end up 
getting an immediate execution from Mr. Foley. You wait for the 
next 2 minutes to find out what happened. During that time, if 
it happens to be the Palm Pilot IPO that I mentioned before, 
during that 2 minutes, that stock will move 12 points.
    Now 2 minutes later, you find out from ITS, I'm sorry, you 
didn't get an execution. Start over again. So despite the fact 
that you had time and price priority, because of the trade-
through rule, you lack the ability to actually win.
    Mr. Barrett. Why does it exist?
    Mr. Andresen. I believe it is to protect the existing 
markets. If you have the biggest market you don't want to have 
true competition or accessibility to your marketplace. Island 
is a very big ECN. We make ourselves available to every other 
ECN because we believe that is the only way to run a 
marketplace.
    Mr. Barrett. How long has it been in existence?
    Mr. Andresen. Since ITS was implemented back in 1979. When 
Congress laid down their goals in 1975, they insisted that the 
industry come up with a National Market System. They insisted 
on the meeting of two goals: competition between markets and 
the sharing of price information for the benefit of investors.
    When they did this, the industry took these goals and said 
we will meet them and they set up the Intermarket Trading 
System. So it was up to them to work out the details. 
Unfortunately, those details while at least on the surface in 
some ways, meeting those goals actually interfere with the 
meeting of those goals.
    Mr. Barrett. Back in 1977, when the SEC came down with the 
order handling rule, what did that apply to and what did it not 
apply to?
    Mr. Andresen. That applied most aggressively to NASDAQ. 
They said New York and ITS had some unspecified time to figure 
out how to meet these goals. On NASDAQ they were forced to 
implement it directly.
    Mr. Barrett. Why the difference?
    Mr. Andresen. I don't know.
    Mr. Barrett. Anybody? Any speculation?
    Mr. Andresen. I believe that the New York Stock Exchange 
controlling 80 percent of the market in that stock would want 
to, as any good business, would want to protect that market 
share. Having the method of linkage and the method of sharing 
of price information be less than perfect, you must go to the 
place where you have the best chance of meeting, thereby 
forcing all market people to stay in the place that happens to 
be at that moment the largest.
    Mr. Barrett. I yield back to Mr. Rush.
    Mr. Oxley. The gentleman's time has expired. The gentleman 
from Staten Island, Mr. Fossella.
    Mr. Fossella. I have one quick question and that is just 
out of curiosity, do you guys see any benefits to the central 
limit order book?
    Mr. Andresen. I think that the theoretical benefit is very 
profound. If everyone is meeting in one place, you are assured 
of having the positive effects of consolidation. I think that 
you can see that benefit on the New York Stock Exchange where 
you have a huge number of buyers and sellers meeting. You can 
see it certainly in the market on Island, and I think the idea 
is very compelling. The idea of getting all of those people 
together in one place.
    I worry that by accomplishing that the other effect will be 
that the technology that keeps these people together will 
eventually, and I believe by pretty much 12 hours after you put 
it in, be obsolete.
    Mr. Schaible. I have to agree with Matt in the short term, 
there could be some benefits with respect to protection of 
investors and the quality of markets, but without the impetus 
that is competition that drives innovation, then you will see 
what we believe in this country is monopolies lead to 
stagnation, and the free market generally will lead to better 
pricing.
    Mr. Dorsch. I would concur with those remarks.
    Mr. Fossella. The theory then seems sound to you, but the 
practical effect of it is not. Is there any way that you could 
take it to your theoretical conclusion?
    Mr. Andresen. Like I said, I agree with the end result.
    Mr. Fossella. How would you do it?
    Mr. Andresen. I believe you can do it by letting 
competition reign. We have many long-distant companies but only 
a few big ones. We have many ECNs but just a few big ones. We 
have many stock exchanges but only one big one. The natural 
economic forces which give those benefits from a consolidation, 
they will be wrought in a much more efficient way than 
government action could possibly bring them about.
    The market centers that have the best markets will win. 
Look at E.bay. E.bay has a tremendous market for collectibles 
and other things. I once saw a human kidney bid on. I saw a 
half eaten bag of Fritos with over 700 bids in 1 hour. You 
might say that is just a joke product, but it is an incredibly 
powerful network where you have many people wasting their time 
putting in a fake bid.
    We can start an auctionsite ourselves, but we would have 
trouble getting people to use it because they are never going 
to find that seller or buyer. We will always be driven to the 
largest place because of the efficiencies commensurate with 
those economies of scale and those kinds of network economies.
    Mr. Schaible. Chairman Levitt refers to a virtual CLOB, and 
I think the reference is similar to what we discuss, a web of 
portal executions coming together that allow functionally the 
transparency of a central limit order book, but also foster 
competition, and I think that is what Matt was also saying.
    Mr. Foley. Mr. Chairman, on the question of the trade-
through rule, in our view the most important issue is the 
linkage and the ability to get to the best price. One of the 
things that we talked about during the demonstration portion is 
what differentiates ECNs from one other, do you show the best 
price outside of your market and do you allow your customers to 
go hit the best bid or take the best offer.
    The trade-through rule in our view is consistent with 
investor protection, but it makes no sense without a technology 
linkage that is state-of-the-art, and allows you, in fact, to 
get to that price at a reasonable timeframe and not in the 
terminology of the financial markets right to a particular 
exchange a free option on your order for the 2 minutes that 
they have.
    In our mind, with transparency, linkages, and best 
execution of brokers, you will have the strongest market 
structure in the world.
    Mr. Ganske [presiding]. Mr. Engel is recognized for 5 
minutes.
    Mr. Engel. I understand that all of my questions were asked 
by my colleague from New York and other people. I want to thank 
the chairman for holding this hearing. I think that ECNs are 
very exciting, and it is one of the things that makes this 
committee so exciting because of all of the new technology that 
we discuss and we are able to question. I am delighted that two 
of the four panelists are from my hometown, New York, and it 
just shows the vibrancy of how New York continues to be a 
leader in the financial world. I just think that this is only 
part one on this hearing. We are going to have more hearings. I 
have some questions about decimalization and restructuring, but 
I understand that those have already been asked. So let me just 
say that I look forward to continuing the dialog. The dialog 
emergence of ECNs is certainly exciting. Anything that can 
enhance competition is a plus for everyone concerned.
    I yield back the balance of my time. I am delighted to see 
the gentlemen here today and it makes me realize how old I am 
when I see how young they are. They are making money and we are 
not, Mr. Chairman. Something is wrong somewhere.
    Mr. Ganske. I point out that my farmers and small town 
businessmen can get on the Internet and trade like crazy.
    The gentleman from California is recognized for 5 minutes.
    Mr. Bilbray. I am sure that my colleague wasn't implying 
that we want to get back to the good old days when politicians 
were able to make a lot of money in the field. My wife is from 
New Orleans and she always says if you want to do that, go back 
to Louisiana where half of the State is underwater and the 
other half is under indictment.
    Mr. Engel. I don't think politicians should make money, but 
I don't think that people need to make money before they come 
to Congress. We ought to have a mix of people.
    Mr. Bilbray. I agree with you coming from that same 
background. I really came here as a parent, not as a Member of 
Congress. I watch my 13-year-old daughter buy her Qualcomm and 
Home Depot over the Internet, and I think there is a whole 
issue that we are missing, and that is, this whole access of a 
whole different population and that population not just being 
the farmer in Iowa, but also teenagers and young people getting 
interested in the market and a field that may have a whole 
cultural change, and hopefully will have a security, financial 
security change in the next generation. Rather than my daughter 
thinking about what new shoes or dress to buy, she is looking 
at which stocks to invest in, rather than going to the mall.
    That is a real culture shock for someone who spent his time 
at the beach rather than worrying about computers or TVs. I 
would like for you to comment on this access issue and 
especially how we are starting to see a new generation get into 
this, because I am not going to call a stockbroker, I am going 
to talk to my daughter. She is now culturally getting into that 
though she does worry about the new rock stars, if you can call 
them that nowadays. But can you articulate about this whole 
issue of the access component and average citizens and young 
people getting into a field that they feel comfortable with and 
that is the Internet?
    Mr. Andresen. Two things that enfranchise people is 
information and cost. Those two things have certainly come 
under tremendous pressure within the last several years. In 
1975, the SEC unbundled advice from commission so that people 
no longer had to pay $500 a trade as if they were paying for 
help in making that decision. It doesn't take a rocket 
scientist to know if you have $600 invested at the end of the 
month and you spent $500 on commissions, you probably end up 
going to the mall or the track. If you are given the chance to 
pay only $15 in commission, suddenly this has opened up the 
stock market not just to the wealthy and the elite, but to 
anyone. I know when I graduated no one explained the stock 
market or how to balance my checkbook with predictable results. 
And what I believe----
    Mr. Bilbray. That is why you get married so someone does it 
for you. Go ahead.
    Mr. Andresen. I won't comment on that.
    But I believe that information is a great empowering 
factor. People become aware of the fact that it is cost-
effective. When your daughter is able to make those decisions, 
not because she pours over dense tables in the paper but 
because it is presented in a real time manner over the 
Internet, and I think that trend, as noted earlier by some of 
my other colleagues, that is only going to increase. The level 
of information, the speed of that information increases is just 
going to enfranchise more people.
    Mr. Foley. I would add to that a couple of points. One, we 
have long in this country believed that homeownership promotes 
good citizenship, and we have policies to try to encourage 
individuals to own their homes, and I think a similar 
phenomenon, that individuals owning the assets of the U.S. 
economy really has to ultimately promote good citizenship and 
have positive effects in many directions.
    Mr. Bilbray. Are you talking about the tearing down of the 
barrier between the proletariat and the bourgeois?
    Mr. Foley. Yes. More and more employees own shares directly 
of the companies that they work in, and more and more 
individuals are concerned about their 401(k)s and IRAs and 
pension plan and mutual fund investment. We ought not to forget 
the revolution going on in institutional trading and the 
empowerment of institutions who, after all, represents millions 
of individuals who are by pooling their resources investing 
just as much in our economy and safely and soberly and so 
forth, and the opportunity to innovate, to compete, to serve 
the interest of institutional clients is actually flat out 
delivering better returns for individual investors, and it is 
lowering the cost of capital for issuers, which is why issuers 
from around the world want to come to the United States to have 
their stocks traded, and it is providing employment for the 
U.S. securities industry in the U.S. which we think is the most 
important issue.
    Mr. Dorsch. I think both of them gave great answers.
    Mr. Bilbray. What is the defense about having young people 
get into the market, not that I think it is a bad thing, but 
obviously my wife had to participate in the setting up of the 
account. Now I say that and then I say obviously, why couldn't 
my daughter have done the same thing? Is that because of credit 
cards or credit numbers or some kind of account?
    Mr. Andresen. Whenever an introducing broker, like e-trade, 
any time they open up an account, they must meet suitability 
obligations, they must have money in the account and experience 
and they have to have those things set out. I anticipate one of 
the things that the SEC will continue to look at very closely 
is the obligations of those brokerage firms to ensure that the 
people that they are talking to are really there.
    Mr. Dorsch. In our environment we service the institutional 
environment, and suitability is a big concern for us and our 
users.
    Mr. Bilbray. I want to clarify my comment about my marriage 
and keeping the books clean is I married an accountant so it 
came in very handy. I yield back the balance of my time, Mr. 
Chairman.
    Mr. Ganske. I would entertain any additional questions from 
any of the panel members?
    Seeing none, I want to thank you gentlemen for coming 
today. Anyone who wishes to submit comments for the record are 
welcome to do so, and that's the end of the hearing.
    [Whereupon, at 12:05 p.m., the subcommittee was adjourned.]
    [Additional material submitted for the record follows:]

                                        Archipelago
                        100 S. Wacker Dr., Chicago IL 60606
                                                     March 28, 2000
Honorable Michael G. Oxley
Chairman, Subcommittee on Finance & Hazardous Materials
Committee on Commerce
United States House of Representatives
2125 Rayburn House Office Building
Washington, DC 20515

Re: Decimal Pricing for the U.S. Securities Markets

    Dear Chairman Oxley: I am writing to thank you for inviting me to 
testify before the House Subcommittee on Finance and Hazardous 
Materials at your hearing on ``Competition in the Evolving Electronic 
Market.'' Unfortunately, as I have previously communicated to your 
staff, I will be unable to testify because of a prior commitment to my 
wife and children. In connection with your hearing, however, I do want 
to respectfully express the concern of Archipelago, LLC\1\ 
(Archipelago) over the recent request by the National Association of 
Securities Dealers, Inc. (``NASD'') to delay implementation of decimal 
pricing in our securities markets.\2\
---------------------------------------------------------------------------
    \1\ Gerald D. Putnam is the co-founder and Chief Executive Officer 
of Archipelago. Archipelago is a leading electronic communication 
network, or ``ECN,'' that serves a varied client base and executes over 
60 million shares per day.
    \2\ Frank G. Zarb, NASDD Chairman and CEO, submitted this request 
to Securities and Exchange Commission (``SEC'') Chairman Arthur Levitt 
in a letter dated March 6, 2000.
---------------------------------------------------------------------------
    While we agree with the NASD that market changes should not put 
markets and investors at risk, we also believe that the implementation 
of decimalization should be priority number one at the NASD. In our 
view, decimalization would create such a tremendous benefit for 
investors that its implementation should be the first priority, not the 
last. The NASD, while requesting a delay in the implementation of 
decimalization, is proposing at the same time other complex structural 
changes that would affect the Nasdaq market. Also, the NASD has been 
pouring enormous amounts of resources into international joint venture 
projects. Finally, the NASD has been on notice of this issue for more 
than three years and had, in essence, entered into a good faith bargain 
with investors, Congress, and the SEC to implement decimals immediately 
after Y2K. The NASD is now attempting to breach that good faith 
bargain. At a minimum, the NASD should delay the implementation of 
their other proposed changes and ventures and should focus all of its 
resources on decimalization.
    On January 28, 2000, the SEC issued an order requiring the U.S. 
securities markets to shift to decimal pricing no later than July 3, 
2000. The SEC described the many potential benefits of decimal pricing 
in its order requiring the markets to adopt decimal pricing, and the 
NASD reiterated these points in its March 6 letter to Chairman Levitt. 
Probably the most important of these benefits is that decimal pricing 
would significantly increase quote competition, and this competition 
would save investors potentially tens of millions of dollars almost 
overnight. Further, decimal pricing will improve price efficiency in 
our securities markets through the mechanisms of the free market.
    As a leader in this effort for many years, you are fully aware of 
the potential benefits that decimalization will bring to our markets as 
reflected by your recent statements:
          I wanted to [convert from fractions to decimals] for three 
        reasons: (1) I believed the free market, not the government, 
        should determine stock prices; (2) decimals would make the 
        markets more accessible, because they are easier to understand 
        than fractions; and (3) decimals would promote the 
        competitiveness of the U.S. stock markets, because the rest of 
        the world was already trading in decimals.
    In addition, the SEC presented a number of potential changes in 
market structure in a recent concept release on market fragmentation 
(``SEC Concept Release''). We are of the view that many of the concerns 
that the SEC is attempting to address through the SEC Concept Release 
may be mitigated, if not eliminated, by the shift to decimal pricing. 
Once decimalization is implemented, competition in the free market may 
naturally resolve the issues underlying the Concept Release. We support 
the SEC's efforts to encourage lower trading costs and greater market 
efficiencies. Like the SEC, we are of the view that decimalization is 
paramount to producing these results.
    For all of the foregoing reasons, we encourage you to monitor the 
NASD's request to change the implementation schedule for 
decimalization. In response to any change in the implementation date, 
please consider communicating to the NASD that it should also delay 
mandating additional market structure changes until the benefits of 
decimal pricing are realized by investors. However, the best result 
would be no delay in implementing decimal-based pricing so that the 
investing public would reap its benefits more quickly.
    Thank you for your consideration.
            Very truly yours,
                                                   Gerald d. Putnam
                                 ______
                                 
   RESPONSES FOR THE RECORD OF KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK

1. How do ECNs increase transparency?
    ECNs are distinguished by three characteristics--neutrality, 
transparency and fairness. Like market-makers, ECNs maintains an 
electronic book of customers' bids and offers. Unlike market-makers, 
however, Bloomberg Tradebook publishes our entire book of quoted prices 
electronically for all our customers to see, as well as publishing all 
other available pricing information. That's the ultimate in 
transparency.
    I'd add that, unlike some of our ECN competitors, we empower our 
customers to take the fullest advantage of this transparency by 
actually routing them to the best available price, even if that is 
outside Bloomberg Tradebook. That's the ultimate in best execution.
    As a practical matter, those who provide transparency within a 
system while not routing to the best available price are often 
providing benefits that are more illusory than real. As the largest ECN 
offering customers this ability to have their orders executed at the 
best price--even outside of our ECN--Bloomberg Tradebook is known as a 
``Best-Execution ECN''.
    In the final analysis, however, it is up to the 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. These government-sponsored market centers 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 
current effort.

2. Are your systems decimal ready?
    Over a period of years, the Commerce Committee has rendered an 
enormous public service by spearheading the effort to convert to 
decimals. Decimalization would create such an enormous benefit to 
investors and the markets that implementation should be the top 
priority for all market participants.
    Accordingly, Bloomberg Tradebook has allocated significant time and 
resources to the capacity issues surrounding decimalization. As a 
result, we will be ready for decimal pricing as scheduled in July. Thus 
Bloomberg Tradebook and our customers were extremely disappointed by 
the NASD's recent request to delay decimalization. Again, the benefits 
of decimalization are such that the public would be best served if the 
NASD focused its resources on the capacity issues critical for 
implementation of decimalization prior to focusing on ill-advised 
efforts like the SuperMontage.
    I'd conclude by noting that conversion to decimals will change our 
markets radically for the better. Congress and the SEC should not 
entertain significant structural changes to the Nasdaq market--like the 
SuperMontage--until after decimalization has been completed and the 
full range of its beneficial impact assessed.

3. What can you do to facilitate trading in decimals even though Nasdaq 
        is not decimal ready?
    As discussed above, Bloomberg Tradebook has allocated significant 
time and resources to decimalization and, as a result, we will be ready 
for decimal pricing as had been previously scheduled in July. We and 
our clients understand that presenting quotes in 1/8ths and 1/16ths has 
reduced competition and liquidity in our markets to the serious 
detriment of investors.
    Ultimately, however, there is precious little additionally that can 
be done by us to facilitate trading in decimals in light of Nasdaq's 
failure to adhere to the conversion schedule negotiated among the 
Congress, SEC and the NASD. As the decimalization experience makes 
clear it is hard to prod movement from a government-sponsored monopoly 
even when it is clearly acting as a counterproductive bottleneck. This 
should be kept in mind as the Congress contemplates Nasdaq's 
SuperMontage proposal which would require that virtually all executions 
take place centrally, creating an enormous bottleneck that would 
further stifle innovation.

4. What structural changes should accompany the demutualization of NYSE 
        and Nasdaq to ensure a competitive market?
    Allowing a government-mandated monopoly to enter the markets as a 
for-profit entity raises enormous concerns for a host of regulatory and 
enforcement reasons. I'll focus on one that is very familiar to the 
Commerce Committee as both an historic and current controversy, namely 
the issue of access to market data.
    A quarter century ago, the Commerce Committee spearheaded the 
effort to enact the Securities Acts Amendments of 1975. That 
legislation established the goal of producing a national market system. 
To this day, that remains the correct goal. In furtherance of that 
objective, Congress mandated a consolidated system for distributing 
market data in an effort to ensure that stock market information was 
accurate and accessible. The securities markets were allowed to charge 
a reasonable rate for gathering and distributing that information.
    When the Commission, in 1972, first proposed rules to provide for 
the consolidated reporting of transactions and quotations, the New York 
Stock Exchange asserted that the SEC not only lacked authority under 
the securities laws to adopt the quotations rule, but also such action 
would deprive the Exchange of property in violation of the due process 
provisions of the Constitution of the United States. Despite these 
objections, Congress and the SEC were determined to achieve the goal of 
public access to consolidated market information.
    Even in this day of on-line investing, the exchanges continue to 
argue that they ``own'' or ought to own quote information. Indeed, 
during the last Congress the dominant national exchanges were major 
proponents of legislation reported from the House Judiciary Committee--
the ``Collections of Information Antipiracy Act''--which would have 
created an unprecedented ownership interest in facts, including stock 
quotes. Though well-intentioned, this legislation--which has also been 
reported from the House Judiciary Committee this Congress--would create 
a property right in facts that extends not only to presently existing 
markets, but also, incredibly, to hypothetical, presently non-existing 
markets.
    We applaud the bi-partisan leadership of the Commerce Committee for 
crafting critical legislation, the ``Consumer and Investor Access to 
Information Act''. That legislation, which was reported from the 
Commerce Committee last year, would also provide additional protections 
for databases but would do so while assuring that consumers and 
investors have continued access to factual information.
    It has been observed that real-time stock data is like ``oxygen'' 
to investors. We worry about the prospects of a government-mandated 
monopoly over the most important information in the market--truly the 
market's oxygen--being controlled by a for-profit entity that not only 
believes it ``owns'' data our clients create, but also wants to control 
the downstream uses of that data in currently non-existing markets 
outside of the real-time market window.
    At the core of this market data debate is the outmoded concept that 
market participants should continue to provide market data to a 
government-sponsored monopoly and then pay to see it. We endorse an 
alternative model recently proposed by SEC Chairman Levitt in the 
context of market depth. Chairman Levitt has urged our markets--
exchange, dealers, and ECNs--to make their limit order books available 
to the public where vendors could consolidate this data and repackage 
it in a form that would be most useful to their customers. A similar 
model allowing the establishment of private quote aggregators to which 
one could report market data--breaking the SRO monopoly on data--would 
certainly improve the quality, comprehensiveness, reliability and 
capacity of this information while reducing the cost.

5. What benefits will electronic exchanges provide that traditional 
        exchanges do not?
    In a statement before the Senate Banking Committee, 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 around the world haven't been keeping 
pace with the needs of the market.''
    It's worth pondering why the stock exchanges didn't keep pace, as 
Mr. Zarb says. We 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.
    Simply put, as is the case with ECNs, the primary benefit that 
electronic exchanges will provide is that of an entity that keeps pace 
with the needs of the market and, by doing so, prods traditional 
exchanges to improve their performance, thus benefitting all market 
participants.

6. Is the Nasdaq super-montage an ECN? What types of problems do you 
        anticipate in a market in which your regulator competes with 
        you?
    The Nasdaq SuperMontage is not an ECN. Nasdaq would remain a 
marketplace, but would be transformed from a largely decentralized 
market--its major strength for 30 years--to a market in which virtually 
all executions take place centrally. Of the concerns which the Nasdaq 
market faces today, capacity limitation is certainly the greatest. In 
recent years Nasdaq's systems have become an increasingly serious 
messaging bottleneck. Yet the proposal would convert Nasdaq to a 
central execution utility only months before the U.S. markets are 
scheduled to grapple with the intensifying volume expected with 
decimalization.
    This CLOB-like centralization would create a government-sponsored 
monopoly that would deter today's decentralized market innovators--
ECNs--from adding market capacity and from introducing further 
innovations. In short, the major threat to competition from the 
SuperMontage is the fact that it would preclude ECNs from competing 
among themselves.
    Let me offer one brief example. In 1996, Bloomberg Tradebook 
introduced the concept of the ``Reserve'' to the U.S. equity markets. 
``Reserve'' is a process that controls the release of orders into the 
market enabling clients to trade large orders more efficiently. Like 
all innovations, the ``Reserve'' gave Bloomberg Tradebook a leg up on 
our competitors for a brief period of time. Soon it was adapted by 
others. Today no one would introduce a system without it, including 
Nasdaq in its SuperMontage proposal.
    Any edge we gain is momentary, and we are forced to continue to 
innovate. If a CLOB like the SuperMontage had been imposed three years 
ago, clearly this innovation wouldn't exist. Innovations occur in a 
dynamic competitive market. They won't occur when innovators need to 
seek permission to innovate.

7. Which regulations most inhibit ECNs from competing with exchanges?
    The pending SuperMontage proposal is far and away the pending 
regulation that will be most destructive of ECNs. It will harm 
investors and the markets by severely undermining the ability of ECNs 
to compete with each other.
    A word is in order about ECNs competing with exchanges. Bloomberg 
Tradebook does not compete against the NASD or the New York Stock 
Exchange. We compete against exchange members and, in the case of the 
NASD, we are one.
    It's possible that the national stock exchanges see us as a 
competitor because of our independence--i.e. we could take our 
customers and order flow to another stock exchange. That would mean the 
exchanges would have to do something they haven't historically done--
namely compete against each other to keep that customer order flow. 
While they may think that order flow is theirs rather than their 
customers, investors have clearly indicated that ECNs are an important 
part of their market structure.
    Unfortunately, when confronted with ECNs the first response of the 
dominant national stock exchanges has not been to compete against each 
other for the business of this new kind of broker/dealer. It seems the 
dominant exchanges would rather avoid the whole headache by passing a 
few rules in an attempt to hold order flow captive. Little wonder some 
ECNs would rather become exchanges themselves.
    In short, we think the national stock exchanges should have to 
compete against each other for our business or the business of any 
other broker-dealer.

8. What is the Intermarket Trading System (ITS)? How should it be 
        changed?
    The Intermarket Trading System (ITS) theoretically allows orders to 
be routed to the best market regardless of which market originally 
received the order. Unfortunately, as Chairman Levitt has observed, the 
technology and rules governing the operation of the system are 
``archaic''. Market participants using ITS to route orders to other 
markets may wait as long as two minutes to receive a response and, even 
then, may not receive an execution. An ineffective ITS has long allowed 
the NYSE to dominate the regional exchanges and is also a potentially 
effective tool for blocking newcomers like ECNs.
    Bloomberg Tradebook is eager to see ITS reform and improved market 
linkages. We'd warn that, just as centralization and self-interest have 
created an ITS system that doesn't serve the market or public--the same 
destructive dynamic would be present in an exaggerated form in a CLOB, 
whether industry run or run by Nasdaq as SuperMontage.

9. What is the Consolidated Quotation System (CQS)? How should it be 
        changed?
    The Consolidated Quotation System is a key component of our current 
arrangement for disseminating ``market information''--information 
concerning quotations for and transactions in equity securities and 
options that are actively traded in the U.S. markets. The information 
is ``consolidated'' in that it is continually collected from the 
various market centers that trade the security and then disseminated in 
a single stream of information.
    This system is premised on the outmoded concept that market 
participants should continue to provide market data to a government-
sponsored monopoly and then pay to see it. We would endorse an 
alternative model recently proposed by SEC Chairman Levitt in the 
context of market depth. Chairman Levitt has urged our markets--
exchanges, dealers, and ECNs--to make their limit order books available 
to the public where vendors could consolidate this data and repackage 
it in a form that would be most useful to their customers. A similar 
model allowing the establishment of private quote aggregators to which 
one could report market data--breaking the SRO monopoly on data--would 
certainly improve the quality, comprehensiveness, reliability and 
capacity of this information while reducing its cost.

10. Has the current regulatory structure of the National Market System 
        (NMS) actually created market fragmentation by disallowing ECNs 
        to share pricing information?
    Yes. The current regulatory structure of the National Market System 
has actually created fragmentation by disallowing ECNs to share pricing 
information, especially as it relates to listed stocks. The NMS impedes 
access to pricing information by mandating a monopoly in data 
gathering. Access is further impeded by the monopoly's settled habit of 
charging the public fees for market data that far exceed the actual 
costs associated with the collection and dissemination of that data. 
The cumulative impact of unnecessarily centralizing, and then 
overcharging for, market data is to retard significantly the sharing of 
pricing information while increasing market fragmentation. This result 
cries out for remedy as this kind of centralized monopoly routing and 
collection of data is no longer technologically necessary to facilitate 
a National Market System. Indeed, as your questions suggests, this 
regulatory structure is an obstacle to the realization of the most 
beneficial and effective National Market System.
    The current regulatory structure of the NMS, premised as it is on 
the technology and markets of a quarter century ago, is clearly a poor 
way of disseminating critical market information. Again, we would urge 
an alternative model recently proposed by SEC Chairman Levitt in the 
context of market depth when he urged our markets--exchanges, dealers, 
and ECNs--to make their limit order books available to the public where 
vendors could consolidate this data and repackage it in a form that 
would be most useful to customers. A similar model allowing the 
establishment of private quote aggregators to which one could report 
market data--breaking the SRO monopoly on data--would certainly improve 
the quality, comprehensiveness, reliability and capacity of this 
information while reducing its cost.

11. Have you applied to become an Exchange? What is the status of your 
        application?
    Bloomberg Tradebook has not and does not intend to become an 
Exchange. We intend to remain a broker-dealer and a ``Best Execution 
ECN''. We believe that is the most effective way for our customers to 
obtain not only liquidity but also the best execution that comes from 
Bloomberg Tradebook's policy of routing our customers to the best 
available price--even if that is outside Bloomberg Tradebook.
    While we are proud to be and remain a broker-dealer/ECN, we are 
also supportive of the efforts of some of our ECN brethren to either 
affiliate with or become exchanges. Just as competition among ECNs has 
been good for investors and the market, competition among stock 
exchanges also benefits all. We think the national stock exchanges 
should have to compete against each other for our business and the 
business of any other broker-dealer. Bloomberg Tradebook looks forward 
to the day when some of our ECN colleagues will be--as new exchanges--
competing with the established exchanges for our business.

12. How is Nasdaq's super-montage like a Central Limit Order Book 
        (CLOB)?
    The Nasdaq SuperMontage proposal carries most of the major 
downsides of a traditional CLOB. It would convert Nasdaq from a largely 
decentralized market, which has been its major strength for thirty 
years, to one in which virtually all executions take place centrally. 
As with the CLOB, this centralization runs counter to the spirit of the 
age in which even public utilities like telephones and electric power 
are abandoning their ``black boxes'' for decentralized structures. It 
would not only impose a technology that is already outmoded, but also 
preclude the prospects of exploiting advancing technology in the 
future. As with a traditional CLOB, SuperMontage would create an 
enormous messaging bottleneck--and do so at the time that the U.S. 
markets are scheduled to be grappling with the intensified volume 
expected with decimalization.
    Indeed, NASD Chairman Zarb illuminated precisely how the Nasdaq 
SuperMontage is like a CLOB when, in testimony before the Senate 
Banking Committee, he observed that 95% of everything CLOB proponents 
sought could be had under the SuperMontage. That's accurate, and 
underscores that we are looking in part at a political battle for 
control of this centralized entity. I don't know who will win, but I 
know who will lose this kind of battle--markets and consumers.
    I'd add that the effort to create this Nasdaq CLOB--the 
SuperMontage--is a critical component of the for-profit picture Nasdaq 
envisions for itself. In its recent private placement memorandum/proxy 
statement distributed to NASD members asking members to vote to make 
Nasdaq a private, for-profit entity, the NASD cites the SuperMontage as 
its most prominent business plan for Nasdaq and warns quite candidly 
that the threat to Nasdaq's monopoly position is one of the most 
significant risk factors:
        ``SelectNet is Nasdaq's automated market service that enables 
        securities firms to route orders, negotiate terms, and execute 
        trades in Nasdaq securities. If pairs of market makers or ECNs 
        determine that they do enough order routing traffic in a day so 
        as to justify setting up an alternative proprietary network for 
        their traffic, Nasdaq may be forced to reduce its fees or risk 
        losing its share of the order routing business. A reduction in 
        the order routing business could have an adverse effect on 
        Nasdaq's business, financial condition and operating results.''
    From Nasdaq's perspective--looking towards a future as a for-profit 
entity charged with maximizing value for shareholders--the SuperMontage 
CLOB makes great sense. The forced centralization of electronic 
messaging will indeed eliminate the risk that ECNs seeking more 
efficiency or better service for our customers might set up an 
``alternative proprietary network for their traffic.''
    From the perspective of the public, however, the SuperMontage is 
enormously harmful. Like all CLOBs, this centralization will harm the 
marketplace by creating a single point of failure and by eliminating 
innovation. This CLOB capacity to extract monopoly profits from market 
participants is exactly what benefits prospective Nasdaq shareholders 
while disadvantaging the public and the markets.

13. What are the key problems with a Central Limit Order Book (CLOB)?
    The notion behind the CLOB is that if you centralize orders in one 
place, a single ``black box'', maximum order interaction and perhaps 
better prices might be achieved.
    There are a number of very serious problems with this concept. When 
this concept was first broached thirty years ago, our markets lacked 
the technology to achieve order interactions without centralization. 
Now, technology allows the advantages of maximum order interaction 
without the downside of centralization.
    The technology of today makes a centralized order book unnecessary. 
These technological advances have revolutionized other industries, and 
despite protests, they are revolutionizing our equity markets. At a 
time when even public utilities like telephones and electric power are 
abandoning their ``black boxes'' for decentralized structures, does it 
make sense to threaten innovation by centralizing the stock markets? 
State-of-the-art telecommunications systems like the Internet don't 
rely on a single monopoly channel--rather they rely on networked webs 
of multiple private competing linkages. Why should the securities 
markets work differently?
    Centralized systems are resistant to change. The innovations that 
ECNs have brought to the market could not occur under a CLOB system, 
including the SuperMontage Proposal of the NASD.
    A centralized system also provides the significant downside of a 
central point of failure. Those of us who deal regularly with Nasdaq's 
SelectNet system know only too well how cumbersome and inefficient a 
centralized system can be. Like SelectNet, the ITS system is conceded 
even by those who are sympathetic to be technologically outmoded with a 
bureaucracy that thwarts change. Why make those failed systems the 
model?

14. In what ways is a Central Limit Order Book anti-competitive?
    As described previously, from a technological perspective the CLOB 
is inherently anti-competitive. Beyond the serious technological 
problems with the CLOB, there are equally troubling political problems 
that underscore the enormous threat to competition posed by a CLOB. 
Someone or some entity will have to decide how the CLOB will work, who 
gets access and how, and what innovations are to be allowed. That 
gatekeeper and CLOB czar is certain to be enormously influenced by 
those who are already in the club. Will those who are already in the 
club allow the emergence of innovators who potentially threaten their 
business? We don't think so. Is innovation likely to occur when the 
potential innovator must raise his or her hand to seek permission from 
the powers-that-be in order to innovate? We don't think so.

15. Recently we have seen an increase in message bottlenecking due to 
        capacity problems with individual systems. Would the existence 
        of a Central Limit Order Book (CLOB) exacerbate the capacity 
        problems we have been witnessing?
    Absolutely. The centralization that--as both a technological and 
political matter--precludes innovation would exacerbate capacity 
problems. It should also be stressed that the CLOB's central point of 
failure would dramatically exacerbate capacity problems, whether we are 
talking of an industry CLOB or a CLOB like the Nasdaq SuperMontage.

16. The idea of a Central Limit Order Book (CLOB) was first tossed 
        around in the 1970s when fragmentation was high because 
        technology could not facilitate efficient order interaction 
        without centralization. Has current technology rendered the 
        notion of a CLOB obsolete?
    Absolutely. Current technology has rendered the notion of a CLOB 
obsolete, whether we are talking of an industry CLOB or a CLOB like the 
Nasdaq SuperMontage. State-of-the-art telecommunications systems like 
the Internet don't rely on a single monopoly channel--rather they rely 
on networked webs of multiple private competing linkages. The equities 
markets should benefit from the same telecommunications advances that 
have revolutionized other industries--to the enormous benefit of the 
public.
                                 ______
                                 
                            NexTrade Holdings, Inc.
                                  Clearwater, Florida 33756
                                                     April 21, 2000
Honorable Tom Bliley
U.S. House of Representatives
Committee on Commerce
Room 2125, Rayburn House Office Building
Washington, D. C. 20515-6115

Re: Responses to questions for the record for the Competition in the 
New Markets Hearing: Part I

    Dear Chairman Bliley: NexTrade Holdings, Inc., the parent company 
of the NexTrade Electronic Communications Network (``ECN'') and the 
proposed NexTrade Exchange, is pleased to submit the following 
responses to the questions set forth in your letter of March 29, 2000, 
as part of the Competition in the New Markets Hearing: Part I.

1. How do ECNs increase transparency?
    ECNs increase transparency in a number of ways. One way that ECNs 
increase transparency is by allowing individual investors direct access 
to the Nasdaq. This access empowers investors with the ability to post 
their limit orders instantaneously for review by other Nasdaq market 
participants. ECNs also increase transparency through their proprietary 
networks that link alternative trading systems, market-makers, and 
other ECNs outside of Nasdaq for the purposes of redundancy, speed, and 
greater reliability. Some ECNs even display all of their orders, 
instead of merely the highest bid and lowest offer in a security, on 
their systems or the Internet. This enables investors to see the depth 
of the market and helps them to more accurately price their orders.
    Statistical evidence supports the conclusion that ECNs have helped 
to produce more transparent, less fragmented and more efficient 
markets. Since the arrival of qualified ECNs, there have been dramatic 
reductions in the costs associated with trading stocks. The average 
cost of executing a trade on the Nasdaq fell by 23% in 1998, spreads 
fell 41%, and volume increased substantially. If left to competitive 
devices, the degree of fragmentation within the markets will continue 
to be reduced despite the introduction of a multitude of market 
participants.

2. Are your systems decimal ready?
    Like most ECNs and Alternative Trading Systems designed in the past 
five (5) years, the technology behind the NexTrade ECN and the proposed 
NexTrade Exchange is ready for trading in decimals. As a member of the 
National Association of Securities Dealers (``NASD'') trading on the 
Nasdaq, the NexTrade ECN System currently has to convert orders that 
are in decimal increments into fractions for execution. In order to 
ensure that NexTrade's linkages to the National Market System (``NMS'') 
and the Nasdaq are ready for decimalization, NexTrade is planning on 
participating in the industry wide decimalization testing. 
Unfortunately, as a member of the NASD and a Nasdaq participant, the 
delays by the Nasdaq in implementing decimalization will impact 
NexTrade's ability to conduct this testing and will delay the 
introduction of decimal pricing for our subscribers.

3. What can you do to facilitate trading in decimals even though Nasdaq 
        is not decimal ready?
    NexTrade plans to work in conjunction with other industry 
participants including the Nasdaq, other ECNs and broker-dealers in 
order to expeditiously move forward with decimal trading. NexTrade, 
however, is concerned that certain industry participants apparently 
seeking nothing more than to gain favorable press coverage have elected 
to move forward with the implementation of decimal trading in an 
uncoordinated manner. While NexTrade has been ready to trade in 
decimals for some time, we appreciate the importance of working with 
other industry participants, including those which are not prepared to 
trade in decimals, in order to ensure a smooth and efficient transition 
to decimal trading.

4. What structural changes should accompany the demutualizations of 
        NYSE and Nasdaq to ensure a competitive market?
    While NexTrade has the utmost confidence in the integrity of the 
directors, officers and staff of the New York Stock Exchange (``NYSE'') 
and the Nasdaq, it is inappropriate to place individuals in a situation 
rife with potential conflicts of interest. The directors, officers and 
personnel of new for-profit exchanges that have regulatory 
responsibilities could be placed in situations that interfere with 
their ability to satisfy their regulatory responsibilities. In order to 
avoid such potential conflicts of interest, NexTrade believes there 
must be a suitable level of separation between the business and 
regulatory groups of all for-profit exchanges. While NexTrade does not 
believe that this separation necessarily requires the creation of a 
distinct corporate subsidiary to house the regulatory functions of the 
exchange, any exchange electing not to do so should be subject to 
heightened scrutiny to ensure that the necessary separation does in 
fact exist.

5. What benefits will electronic exchanges provide that traditional 
        exchanges do not?
    Electronic exchanges will provide numerous benefits that 
traditional exchanges cannot provide. Like ECNs, electronic exchanges 
will utilize technology to provide faster and more accurate executions 
than traditional exchanges. Unlike traditional exchanges, electronic 
exchanges will allow orders to interact without a market maker or 
specialist. This ability to execute orders without an intermediary will 
result in lower transaction fees for investors. Additionally, by 
decreasing the number of personnel involved in processing transactions, 
electronic exchanges will reduce the likelihood of abuses by trading 
personnel. Moreover, by reducing the number of personnel involved in 
processing transactions and by reducing the number of potential trading 
abuses, electronic exchanges will reduce the amount of resources that 
the Commission and the exchanges must spend on surveillance and 
enforcement. Finally, electronic exchanges will function with a lower 
degree of errors in processing trades and will enable customers' orders 
to be executed at the best price by means of linkages between new 
electronic exchanges.

6. Is the Nasdaq super-montage an ECN?
    Yes, the Nasdaq super-montage is an ECN.
What types of problems do you anticipate in a market in which your 
        regulator competes with you?
    Although NexTrade has confidence in the integrity of the directors, 
officers and staff of the NASD and its subsidiaries, there would be an 
inherent conflict of interest if the Nasdaq was allowed to operate the 
super-montage while regulating competing ECNs. Accordingly, NexTrade 
believes that the regulatory group of the NASD, NASD Regulation must 
operate as a distinct and fully autonomous entity from the Nasdaq 
before the Nasdaq should be allowed to compete with the ECNs it 
currently regulates. NexTrade also questions the propriety of the 
NASD's use of fees paid by members, including those paid by ECNs and 
ECN owners, to subsidize, develop and operate the proposed Nasdaq 
Super-Montage which will compete with these members.

7. Which regulations most inhibit ECNs from competing with exchanges?
    Although there are numerous regulations that inhibit ECNs from 
competing with exchanges, the most significant barrier to competition 
is the current structure of the National Market System (``NMS''). The 
current structure of the NMS impedes the entry of new market 
participants that would introduce new technology. Under the current 
regulatory structure, the boards of the NMS Plans are composed of 
representatives from each exchange. Any change to the rules governing 
the operation of the NMS systems, including the very rule changes 
necessary to accommodate new market participants, require the unanimous 
consent of the participants. Accordingly, if one board member feels 
threatened by an ECN's technology, that board member can prevent the 
ECN from participating.
    In 1936, Congress noted that a major responsibility of the 
Commission in the administration of the securities laws is to ``create 
a fair field of competition.'' 1 The current national market 
system does not create a fair field of competition. Rather, the current 
national market system protects antiquated participants from 
competition, while subsidizing its members' operations.
---------------------------------------------------------------------------
    \1\ Pub. L. No. 94-29, 89 Stat. 97 (1985).
---------------------------------------------------------------------------
    The consolidated, real-time stream of market information has been 
an essential element in the success of the America's equities markets. 
It is the principal tool for enhancing the transparency of the buying 
and selling interest in a security, for addressing the fragmentation of 
buying and selling interest among different market centers, and for 
facilitating the best execution of customers' orders by their broker-
dealers.2 The consolidation of quotations and last sale 
information was an important goal of the Securities Acts Amendments of 
1975.3 Congress believed that the need for market 
effectiveness and efficiency required that a neutral central processor 
be organized and responsible for collecting and distributing market 
data to market participants. Section 11A called for the Commission to 
use its authority to facilitate the establishment of a national market 
system which has, as one of its objectives, the availability of quote 
and transaction information for brokers dealers and 
investors.4
---------------------------------------------------------------------------
    \2\ See 64 Fed. Reg. 70613 (Dec. 17, 1999).
    \3\ Pub. L. No. 94-29, 89 Stat. 97 (1985).
    \4\ Section 11A(a)(1).
---------------------------------------------------------------------------
    The national market system that Congress meant to promote equal 
access, market transparency, and fair competition, is now attainable 
because of twenty-first century technology. However, the governance 
structures and technology that modernized our markets in 1975 are ill 
suited to achieve the goals of the national market system for the next 
century. Market data that was once the property of a few and was only 
available to market participants, is now in the hands of the public. 
This liberation of information has been the result of the development 
of the Internet. Over the last decade, the Internet has revolutionized 
the way people access and use information.
    The current National Market System no longer serves to promote the 
development of mechanisms that allow for economically efficient 
executions of securities transactions. The current National Market 
System impedes fair competition and reduces market transparency. The 
current National Market System prevents large pools of liquidity 
contained in ECN order books from interacting with other market 
participants. These deficiencies result in decreased investor access to 
the best markets.
    In order to ensure that the National Market System meets its 
congressional mandate, the governance structure of the national market 
system should be amended. The NMS governing boards should be eliminated 
and replaced with a new national market system board. This new National 
Market System board should include representatives from the existing 
exchanges, new electronic exchanges, ECNs, broker-dealers, issuers and 
the public. The new NMS board should be structured in such a way as to 
ensure that at least 50 percent of the representatives are not industry 
participants. This structure is similar to the structure endorsed by 
the Commission in recent years with respect to public representation on 
the boards of self-regulatory organizations.5 Industry 
associations such as the Securities Industry Association and the 
Security Traders Association could select broker-dealer representatives 
from firms of various sizes.6
---------------------------------------------------------------------------
    \5\ See, e.g., Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and The Nasdaq Market (August 
8, 1996); Order Granting Approval to Philadelphia Stock Exchange 
Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997) 
(requiring 50 percent board representation by public governors).
    \6\ This approach was also discussed in the SIA Report on Market 
Data Pricing, which noted that SIA would also like to explore/encourage 
an alternative governance structure for market data that would include 
a broader exchange, industry, and public representation. See Report on 
Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999).
---------------------------------------------------------------------------

8. What it the Intermarket trading system (ITS). How should it be 
        changed?
    Currently, the markets are linked by the National Market System 
Plans. One plan that is very important in reducing market fragmentation 
is the Intermarket Trading System (``ITS''), which allows orders to be 
routed to the best market regardless of which market originally 
received the order. Unfortunately, the technology and the rules 
governing the operation of the system are, in Chairman Levitt's words, 
``archaic.'' Market participants using ITS to route orders to other 
markets may wait as long as two minutes to receive a response and, even 
then, may not receive an execution. NexTrade believes that the 
traditional markets participants' opposition to technological 
innovations has resulted in unnecessary market fragmentation. 
Accordingly, NexTrade believes the technology behind the ITS should be 
updated.
    On January 26, 1978, the Commission issued a statement on the 
national market system calling for the prompt development of 
comprehensive market linkage and order routing systems to permit the 
efficient transmission of orders among the various markets for 
qualified securities, whether on an exchange or over-the-
counter.7 In particular, the Commission stated that an 
intermarket order routing system was necessary to ``permit orders for 
the purchase and sale of multiply-traded securities to be sent directly 
from any qualified market to another such market promptly and 
efficiently.'' 8 The Commission further stated that ``[t]he 
need to develop and implement a new intermarket order routing system to 
link all qualified markets could be obviated if participation in the 
ITS market linkage currently under development were made available on a 
reasonable basis to all qualified markets and if all qualified markets 
joined that linkage.'' 9
---------------------------------------------------------------------------
    \7\ Exchange Act Release No. 14416 (January 26, 1978) (``1978 
Statement''), at 26, 43 FR 4354, 4358. Previously, on June 23, 1977, 
the Commission had indicated that a national market system would 
include those ``regulatory and technological steps [necessary] to 
achieve a nationwide interactive market system.'' See Exchange Act 
Release No. 13662 (June 23, 1977), at 20, 42 FR 33510, 33512.
    \8\ 1978 Statement, supra note 5, at 4358.
    \9\ In this connection, the Commission specifically indicated that 
``qualified markets'' would include not only exchanges but OTC market 
makers as well. Id.
---------------------------------------------------------------------------
    Unfortunately, the goals of the ITS, have not come to fruition. 
Originally, designed to link the existing exchanges, ITS currently 
handles a relatively small proportion of trading in listed equities. In 
September 1999, for example, ITS volume represented 2.2% of total NYSE-
listed trades.10 One of the primary reasons for the anemic 
performance of ITS, is its failure to include ECNs and its slow and 
inefficient technology.
---------------------------------------------------------------------------
    \10\ 
---------------------------------------------------------------------------
    On December 9, 1999, in an apparent attempt to open the ITS, the 
Commission adopted amendments to the ITS Plan. The amendments expand 
the ITS/Computer Assisted Execution System linkage to all listed 
securities.11 The Commission also noted that:
---------------------------------------------------------------------------
    \11\ Exchange Act Release No. 42212 (Dec. 9, 1999).
---------------------------------------------------------------------------
        in order to further the goals of the national market system, 
        ECNs trading in listed securities should be linked to ITS. ITS 
        should not prevent efficient electronic routing between 
        markets.12
---------------------------------------------------------------------------
    \12\ Id. (emphasis added).
---------------------------------------------------------------------------
While the opening of ITS to ECNs is a step in the right direction, the 
value of such a step will be minimized as long as the current 
governance structures of the ITS and other NMS Plans remain in place.
    The ITS Plan should be opened to new constituencies, including 
ECNs, broker-dealers, issuers and the public. In order to ensure that 
the new National Market System meets its congressional mandate, the 
governance structure of the NMS should be amended. The NMS governing 
boards should be eliminated and replaced with a new National Market 
System board. This new NMS board should include representatives from 
the existing exchanges, new electronic exchanges, ECNs, broker-dealers, 
issuers and the public. The new National Market System board should be 
structured in such a way as to ensure that at least 50 percent of the 
representatives are not industry participants. This structure is 
similar to the structure endorsed by the Commission in recent years 
with respect to public representation on the boards of self-regulatory 
organizations.13 Industry associations such as the 
Securities Industry Association and the Security Traders Association 
could select broker-dealer representatives from firms of various 
sizes.14
---------------------------------------------------------------------------
    \13\ See, e.g., Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and The Nasdaq Market (August 
8, 1996); Order Granting Approval to Philadelphia Stock Exchange 
Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997) 
(requiring 50 percent board representation by public governors).
    \14\ This approach was also discussed in the SIA Report on Market 
Data Pricing, which noted that SIA would also like to explore/encourage 
an alternative governance structure for market data that would include 
a broader exchange, industry, and public representation. See Report on 
Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999).
---------------------------------------------------------------------------

9. What is the Consolidated Quotation System (CQS)?
    The Consolidated Quotation System (``CQS'') enables the regional 
exchanges and the Nasdaq to jointly disseminate quotation information 
available to market participants and investors. The Consolidated Tape 
Association Plan (``CTA Plan'') and the Consolidated Quotation Plan 
(``CQ Plan'') operate a data network commonly known as Network A that 
disseminates market information for any common stock, long-term 
warrant, or preferred stock admitted to dealings on the 
NYSE.15 All of the SROs are participants in the CTA Plan and 
CQ Plan.
---------------------------------------------------------------------------
    \15\ CTA Plan, Sections I(p) and VII(a)(i).
---------------------------------------------------------------------------
    The Consolidated Tape Association (``CTA'') is a committee made up 
of one representative of each of the participants. The CTA Committee 
administers the CTA Plan and is registered as a securities information 
processor (``SIP'') under Section 11A(b) of the Exchange 
Act.16 The administrator of Network A's day-to-day 
operations is the NYSE, and its information processor is the Securities 
Industry Automation Corporation (``SIAC'').17
---------------------------------------------------------------------------
    \16\ An Operating Committee that is substantially the same as the 
CTA administers the CQ Plan.
    \17\ SIAC is jointly owned by the NYSE and Amex and is a registered 
SIP under Section 11A(b).
---------------------------------------------------------------------------
    The CTA Plan and the CQ Plan also operate a second network commonly 
known as Network B. This network disseminates market information for 
any common stock, long-term warrant, or preferred stock admitted to 
dealings on the Amex or the regional exchanges, but not also admitted 
to dealings on the NYSE or included in the Nasdaq market.18 
Its day-to-day administrator is Amex, and its information processor is 
SIAC.
---------------------------------------------------------------------------
    \18\ CTA Plan, Sections I(q) and VII(a).
---------------------------------------------------------------------------
How should it be changed?
    Like the other NMS Plans, the CQS Plan should be opened to new 
constituencies, including ECNs, broker-dealers, issuers and the public. 
In order to ensure that the new National Market System meets its 
congressional mandate, the governance structure of the NMS should be 
amended. The NMS governing boards should be eliminated and replaced 
with a new National Market System board. This new NMS board should 
include representatives from the existing exchanges, new electronic 
exchanges, ECNs, broker-dealers, issuers and the public. The new 
National Market System board should be structured in such a way as to 
ensure that at least 50 percent of the representatives are not industry 
participants. This structure is similar to the structure endorsed by 
the Commission in recent years with respect to public representation on 
the boards of self-regulatory organizations.19 Industry 
associations such as the Securities Industry Association and the 
Security Traders Association could select broker-dealer representatives 
from firms of various sizes.20
---------------------------------------------------------------------------
    \19\ See, e.g., Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and The Nasdaq Market (August 
8, 1996); Order Granting Approval to Philadelphia Stock Exchange 
Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997) 
(requiring 50 percent board representation by public governors).
    \20\ This approach was also discussed in the SIA Report on Market 
Data Pricing, which noted that SIA would also like to explore/encourage 
an alternative governance structure for market data that would include 
a broader exchange, industry, and public representation. See Report on 
Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999).
---------------------------------------------------------------------------

10. Has the current regulatory structure of the National Market System 
        (NMS) actually created market fragmentation by disallowing ECNs 
        to share pricing information?
    The governance structures of the NMS Plans and the antiquated 
technologies that drive those plans have unnecessarily increased the 
level of fragmentation of America's financial markets by preventing 
competition and the participation of ECNs. The current regulatory 
structure of the NMS is an impenetrable barrier to entry to new market 
participants that would enhance competition. If one NMS participant 
does not want an ECN to participate or is threatened by an ECN's 
technology, the ECN is precluded from participating. Accordingly, 
NexTrade believes that broader industry and public participation is 
needed in the governance of the NMS to ensure the access of new market 
participants.
    While fragmentation has always been a problem for our markets, it 
is not a question of if fragmentation exists, but rather a question of 
degree. In the past, fragmentation was severe and was compounded by 
inadequate information technology. As technology evolved, the degree of 
fragmentation has diminished while the number of market participants 
has skyrocketed. However, the level of fragmentation in our markets 
could be greatly reduced by reforming the NMS.
    Statistical evidence supports the conclusion that the introduction 
of ECNs produced more efficient and less fragmented markets. Since the 
arrival of qualified ECNs, evidence reveals dramatic improvements in 
the costs of trading stocks in the United States. The average cost of 
executing a trade on the Nasdaq Stock Market fell by 23 percent in 
1998, spreads fell 41 percent, and volume increased substantially. If 
left to competitive devices, the degree of fragmentation within the 
markets will continue to be reduced despite the introduction of a 
multitude of market participants.
    Traditional market participants, including the members of the NMS 
Plans, are opposed to technological innovations that could undermine 
their hegemony over the markets. This resistance to technology has 
resulted in unnecessary fragmentation. Competitive market participants, 
however, have responded to fragmentation and inefficiencies with 
market-based innovative solutions. A variety of ECNs and other trading 
systems have responded with systems that consolidate and provide 
efficient access to the best prices among competing markets. One firm 
has connected all nine original ECNs, the NYSE and the Nasdaq to their 
system. Similarly, when the current Nasdaq linkage (SelectNet) proved 
too expensive and inefficient to handle record volumes, market 
participants forged links with one another to create trading networks 
that bypass SelectNet for faster and more reliable access to the best 
market prices. These are just a few examples of the types of solutions 
produced by innovation and competition that could reduce fragmentation.

11. Have you applied to become an Exchange?
    NexTrade Holdings, Inc., the parent company of the NexTrade ECN, 
has applied to operate a new electronic for-profit exchange, known as 
the NexTrade Exchange. In November 1998, NexTrade began discussions 
with the Commission regarding applying to operate an electronic 
exchange. Rather than filing its exchange application without speaking 
with Commission staff, NexTrade spent nearly one year working with 
Commission staff in draft mode in order to facilitate meaningful 
discussion of NexTrade's exchange application. Only after determining 
the draft exchange application discussions had exhausted their 
usefulness, did NexTrade formally file its exchange application with 
the Commission in December 1999.21
---------------------------------------------------------------------------
    \21\ NexTrade re-filed its exchange application in March 2000, in 
order to address issues raised by Commission staff.
---------------------------------------------------------------------------
    The proposed NexTrade Exchange is an example of the future of the 
financial markets in that it makes use of innovative technology and new 
regulatory structures as part of a for-profit exchange. The proposed 
NexTrade Exchange plans to make available for the benefit of its 
members and their customers an electronic trading system (the 
``NexTrade Exchange System'') to effect the purchase or sale of 
securities listed or admitted to trading on the proposed Exchange and 
on other exchanges. The proposed exchange, however, will not maintain a 
physical-trading floor. Members will access the NexTrade Exchange 
System from their own computer terminals and communicate with the 
NexTrade Exchange System over commercial information services and 
networks.
What is the status of your application?
    When NexTrade notified the Commission of its desire to operate an 
exchange, the Commission advised NexTrade that it could not provide a 
specific time frame with respect to an approval date. NexTrade was only 
told that the process could take two (2) to three (3) years to complete 
and that there was no guarantee that the application would be approved. 
NexTrade has been advised on several occasions by Commission staff that 
the Commission is struggling with issues regarding the governing 
structures of new for-profit exchanges that had to be addressed before 
the Commission could move forward with NexTrade's exchange application. 
NexTrade has also been advised on several occasions by Commission staff 
that the Commission was attempting to address issues relating to the 
performance of regulatory functions by for-profit exchanges. As of the 
date of this response, NexTrade has received no information regarding 
either issue from the Commission despite having provided an application 
that includes viable solutions to both issues.
    Commission staff recently advised NexTrade that it could be another 
12 to 18 months before the Commission issues a decision on NexTrade's 
exchange application. Although NexTrade fully understands the 
importance of the exchange approval process, we do not believe that a 
two (2) to three (3) year review process is warranted or necessary in 
order to make a decision regarding new electronic exchanges. NexTrade 
appreciates that Commission staff are over worked and underpaid in 
comparison to their colleagues in other federal regulatory agencies, 
however, the failure to reach a decision on pending exchange 
applications serves only to penalize the public by unnecessarily 
shielding antiquated exchanges from competition that would benefit the 
public.

12. How is Nasdaq's super-montage like a Central Limit Order Book 
        (CLOB)?
    The Nasdaq's proposed super-montage is like a Central Limit Order 
Book or CLOB in that the super-montage anonymously centralizes all 
limit orders into an order consolidation facility. These centralized 
orders do not reflect the market participants acting as agent or 
principal of the transactions. The super-montage will not reflect the 
identity of the market participant that posted the order. This function 
coupled with the reserve function of the proposed super-montage, bear a 
striking resemblance to the functions of most ECNs.
    The proposed Nasdaq super-montage would create a central market 
execution system composed of two tiers of ``Quoting Market 
Participants.'' Participation would be mandatory for market makers and 
``voluntary'' for ECNs. Nasdaq states that two types of participation 
would be offered to ECNs: ``full'' and ``order entry''. ``Full'' 
participation would require ECNs for the first time to be subject to 
automatic executions, which would put ECNs at a severe competitive 
disadvantage. Order-entry participation would be a continuation of 
current SelectNet linkage and functions, but would marginalize the 
contribution ECNs could make to the marketplace. Consequently, the 
proposed Nasdaq super-montage is fundamentally flawed in that it would 
become increasingly ineffective as ECNs continued to grow.
    Full Participation in the proposed Nasdaq super-montage leaves ECNs 
with a Hobson's choice. While Full Participation in the proposed Nasdaq 
super-montage would allow ECNs to connect with the proposed Nasdaq 
CLOB, it would also allow the proposed Nasdaq CLOB to ``sweep'' the 
ECNs' top-of-book orders into the proposed Nasdaq CLOB. This function 
would hit or take all market-maker, ECN or proposed Nasdaq CLOB 
quotations at the best bid or ask price. Access to the ``sweep'' 
function in the proposed Nasdaq CLOB, however, would involve a trade-
off for ECNs because of the disadvantages associated with full 
participation by ECNs in the proposed Nasdaq Order Display Facility.
    Market makers and institutional customers of ECNs often prefer to 
trade on an ECN because of the additional services and features offered 
on ECNs. Through competition, ECNs have developed a variety of 
innovative capabilities to allow traders to customize their trading 
methods to meet their needs. One such feature is a reserve quotation. 
Nasdaq has stated that in the proposed Nasdaq CLOB any ECN reserves 
would be bypassed, but the reserve feature of the proposed Nasdaq CLOB 
would function. As a result, Nasdaq would in effect preference its own 
additional functions, at the expense of those ECNs that do not want to 
``agree'' to become Nasdaq CLOB participants.
    The proposed super-montage is also like a CLOB in that market 
participants would be forced to link through a central location, the 
Nasdaq. This kind of forced linkage diminishes the competitive 
advantages of ECNs by making them dependant on the capacity, integrity 
and security of a single, largely antiquated system, which has proven 
to be unreliable. NexTrade believes investors and the market benefit 
from a variety of alternative systems that route, display and execute 
orders.

13. What are the key problems with a Central Limit Order Book (CLOB)?
    The notion behind the CLOB is that technology can be employed to 
centralize orders in one place, thus resulting in maximum order 
interaction and perhaps even better prices. A CLOB, however, will 
sacrifice the innovation that has made our markets the best in the 
world. Research has shown that competitive markets are better equipped 
to implement technological innovations to address market 
inefficiencies. Centralized markets, no matter how well intentioned 
their architects, will typically be obsolete by the time they commence 
operation. Competition creates incentives for markets to upgrade and 
innovate. Centralized markets do not. Unlike open markets, centralized 
markets serve to impede the ability of innovative firms to develop new 
technologies and mechanisms that promote better execution.
    Like any centralized marketplace, a CLOB would have substantial 
dangers. Most importantly, a CLOB would represent a single point of 
failure that could jeopardize the global economy. The danger of such 
centralization is apparent in light of recent well-publicized attacks 
on some of the largest Internet web sites and service providers. It is 
economically impracticable to design a centralized marketplace that 
would be completely free of vulnerability to attacks by cyber-
terrorists. The implausibility of designing a totally safe CLOB will 
become increasingly apparent in the future as warfare and terrorism 
move from city streets to the Internet. In contrast, the currently 
developing network of trading facilities, much like the Internet, 
mitigates these potential dangers through numerous alternative trade 
destinations.
    Moreover, a CLOB is anti-competitive. If the Commission mandates a 
monopolistic central execution system, such as the proposed CLOB, with 
which all market-participants must comply, innovation could be 
eliminated. Such a dearth of innovation would not serve the goals of 
the Act, the NMS, or the public. Rather than developing a system that 
would reduce innovation by ECNs and other market participants, and halt 
the development of technologies that provide additional liquidity and 
transparency, the Commission should encourage a new and equitable NMS.
    A CLOB would also impede the development of new for-profit 
electronic stock exchanges. If the Commission mandates a monopolistic 
central execution system, such as the proposed CLOB, with which all 
market-participants must comply, innovation could be eliminated. Such a 
dearth of innovation would not serve the goals of the Act, the NMS, or 
the public. Rather than developing a system that would reduce 
innovation by new for-profit electronic exchanges, ECNs and other 
market participants, and halt the development of technologies that 
provide additional liquidity and transparency, the Commission should 
encourage a new and equitable NMS.
    Finally, a CLOB would inevitably operate at the speed of its 
slowest participant. While many ECN's execute their transactions in 
milliseconds, the New York Stock Exchange proudly stated in its address 
to Congress in September 1999 that its average transaction time was 22 
seconds. Accordingly, a CLOB would likely execute transactions at 
speeds much slower than many ECNs.

14. In what ways is a Central Limit Order Book (CLOB) anti-competitive?
    A CLOB would be anti-competitive and would impede the development 
of new for-profit electronic stock exchanges for several reasons. By 
mandating that market participants link to a CLOB, the Commission would 
create a monopolistic central execution system. A CLOB with its 
specified technology would reduce innovation. A CLOB would be anti-
competitive in that it would require all market participants to utilize 
uniform government mandated technology. A CLOB would also impose 
significant costs on new electronic for-profit exchanges, the market 
and ultimately issuers, in order to off-set the costs of the new 
infrastructure and bureaucracy.
    A CLOB would also be anti-competitive because there would be no 
competition for order flow. Without competition for order flow, there 
would be little incentive for firms to develop technologies that 
provide additional liquidity and transparency. The CLOB would also be 
anti-competitive because the system would dictate where a broker-dealer 
sends an order. A CLOB would not allow market participants to develop 
technological linkages with other market participants and take suitable 
steps to ensure that they satisfy their best execution responsibilities 
when handling orders. Rather, than allowing for innovation by market 
participants that can reduce costs for their clients, a CLOB would 
dictate an order routing regimen. Such a dearth of innovation would not 
serve the goals of the Act, the NMS, or the public. Rather than 
developing a system that would reduce innovation by new for-profit 
electronic exchanges, ECNs and other market participants, and halt the 
development of technologies that provide additional liquidity and 
transparency, the Commission should encourage a new and equitable NMS.

15. Recently we have seen an increase in message bottlenecking due to 
        capacity problems with individual systems. Would the existence 
        of a Central Limit Order Book (CLOB) exacerbate the capacity 
        problems we have been witnessing?
    The existence of a CLOB would only exacerbate the capacity problems 
we have been witnessing. Under such a facility, the entire NMS and all 
market participants would be dependent on the capacity, integrity and 
security of a single system. The dangers associated with such a 
strategy are discussed in greater detail above. However, a CLOB that 
relies on a single technology could jeopardize our financial markets if 
it fails for any of a variety of reasons. A CLOB that relies on a 
single technology would also eliminate the positive effects of 
innovation by requiring all firms to adopt a uniform technology and 
order routing regimen for linking to the CLOB. This lack of innovation 
would reduce the positive gains that are being made by innovative 
market participants to minimize the message bottlenecks currently 
occurring on well established markets.
    The dangers of a CLOB and its reliance on a single technology are 
apparent upon examining the record of the current order routing 
technology used by the Nasdaq. The level of trading activity on the 
Nasdaq over the past year has overwhelmed the Nasdaq's SelectNet 
system. Over the past year, the Nasdaq SelectNet system has suffered 
several well-publicized failures that have seriously endangered the 
National Market System. Some of the most notable and publicly 
acknowledged recent Nasdaq system failures include the following:
 (March 6, 1999, 9:41 a.m. to shortly after 11:00 a.m. ET, 
        Nasdaq SOES (Small Order Execution System) and SelectNet 
        Equipment failed.
 (April 1-13, 1999, Nasdaq SelectNet has higher volume of 
        SelectNet orders (a 25% increase over 1998) and suffers from 
        the capacity impact on systems, leading to slowed trading in 
        the first half hour of trading as systems labored to clear 
        orders that accumulated overnight.
 (October 6, 1999, Nasdaq SelectNet's system, triggered by a 
        software change made overnight to allow the market to extend 
        hours for its trade-reporting and quotation systems, runs 
        slowly for hours and the Instinet, Island and Brut ECNs are 
        removed from Nasdaq's quote display.
 (November 16, 1999, Nasdaq SelectNet and SOES fail during a 
        mid-day software upgrade that was attempted during a record 
        1.46 billion share trading day causing a black out of SelectNet 
        and SOES from 3:40 EST to 3:57 EST. Nasdaq has claimed that it 
        has adequate capacity for a four billion shares trade day, 
        however, this claim is seriously suspect based on the 
        aforementioned system failures.
The failings of the Nasdaq's SelectNet system are but one example of 
the dangers of America's financial markets relying on a single 
technology such as a CLOB.

16. The idea of a Central Limit Order Book (CLOB) was first tossed 
        around in the 1970's when fragmentation was high because 
        technology could not facilitate efficient order interaction 
        without centralization. Has the current technology rendered the 
        notion of a CLOB obsolete?
    Current technology has rendered the notion of a CLOB obsolete. The 
rapidly declining costs of telecommunications technology has made it 
possible to build and maintain redundant, competitive systems to handle 
orders without the need for a single monolithic service provider. 
Consequently, there is no reason to compel market participants to 
participate in a government designed CLOB. Advocates of the CLOB claim 
that it is the only means of addressing fragmentation. Such claims are 
without merit.
    Fragmentation has always been a problem for our markets. It is not 
a question of if fragmentation exists, but rather a question of degree. 
In the past, fragmentation was severe and was compounded by inadequate 
information technology. As technology evolved, the degree of 
fragmentation has diminished while the number of market participants 
has skyrocketed. However, the level of fragmentation in our markets 
could be greatly reduced by reforming the NMS.
    Rather than developing a CLOB that would reduce innovation by ECNs 
and other market participants, the Commission should encourage the 
development of a new and equitable NMS. The combination of private and 
public linkages that has formed the market network since the advent of 
the Order Handling Rules is the best model for growth and development 
of the United States capital markets in the future. The Commission 
should not allow market participants that rely on antiquated 
technologies to undermine the positive gains that have been made since 
the advent of the Order Handling Rules towards the creation of a open, 
efficient and equitable market.
    Should you have any questions regarding this or any other matter, 
please do not hesitate to contact me at the telephone number above.
            Sincerely,
                                           John M. Schaible
              President, NexTrade Holdings, Inc. and NexTrade, Inc.
                                 ______
                                 
                                      The Island ECN., Inc.
                                                        May 8, 2000
Mr. Tom Bliley, Chairman
U.S. House of Representatives
Committee on Commerce
Room 2125
Rayburn House Office Building
Washington, DC 20515-6115
    Dear Mr. Chairman: Please find the enclosed answers to the 
questions you had posed regarding the role ECNs and Island in 
particular are playing in the evolving financial marketplace. I look 
forward to working with you and the rest of the Commerce Committee on 
these important issues. If I can be of any further assistance, please 
let me know.
            Sincerely,
                                Matthew Andresen, President
                                              The Island ECN., Inc.
Enclosure (1)

   FOLLOW-UP QUESTIONS FOR THE RECORD FOR THE COMPETITION IN THE NEW 

                        MARKETS HEARING: PART I

    Question 1. How do ECNs increase transparency?
    Response: ECNs increase transparency by making more information 
available to the investor. Traditionally, investors have only been 
provided with the highest bid and lowest offer in a security. The depth 
of the market, which gives an indication of the true supply and demand 
for a security, has been the exclusive province of market 
professionals. More specifically, what happens to an order after it is 
placed with your broker? What sort of accountability exists? At Island, 
we urge investors to ask themselves what just happened to their order 
after they click on the ``Submit'' button. After all that thorough and 
careful research, why is the investor--at this final stage of the 
process--essentially staring into a black box--or at best a screen with 
the words ``Your Order Has Been Placed.''
    That lack of accountability--in other words, denial of information 
to the investor--was unacceptable to us. To provide the best resource 
possible to the investor, we became the first marketplace to provide a 
free, real-time display of all its orders, through the Island 
BookViewer TM. Such transparency is precisely what SEC 
Chairman Levitt recently called for in his Northwestern University 
speech: ``Now is the time to embrace a broader and deeper transparency. 
Now is the time for all market participants to move toward open books 
across all markets . . . These are forward looking initiatives that 
answer the investor's call for greater transparency and more efficient 
pricing.'' Island couldn't agree more. That's why orders received by 
Island for display on the limit order book are immediately visible to 
anyone with a web browser regardless of whether the order was received 
from an individual investor or a large institution. Why is this 
important? Investors can use the additional information provided by 
Island to more accurately price their orders. The Island BookViewer 
TM also reduces the informational and temporal advantages 
traditionally enjoyed by floor brokers, market makers, and specialists. 
In other words, the average investor is not disadvantaged because of a 
lack of access to, for example, the floor of an exchange. By 
eliminating these time and place disparities--in essence, putting the 
investor ``virtually'' right next to the market maker or specialist--
Island helps lower the hidden costs associated with higher spreads and 
inferior executions. In fact, according to the Securities and Exchange 
Commission, spreads--the difference between the highest price to buy 
and the lowest price to sell--have narrowed substantially since the 
time ECNs were given access to the Nasdaq market, saving investors 
hundreds of millions of dollars per year.
    Question 2. Are you decimals ready?
    Response: Yes. See answer below.
    Question 3. What can you do to facilitate trading in decimals even 
though Nasdaq is not decimal ready?
    Response: The Island ECN, Inc., has announced that, consistent with 
the U.S. Congress's deadline for conversion to decimals for trading of 
stocks, on July 3, 2000, Island shall be the first U.S. equity 
marketplace to offer investors the ability to trade in decimals. As the 
U.S. Congress has made clear, decimalization is one of the most 
important initiatives for creating a fairer, simpler, and more 
accessible marketplace for the individual investor. Investors should 
not be burdened with the cost of industry-established increments that 
limit investors' ability to obtain the best possible price.
    The Island decimalization plan is completely voluntary and allows 
all participants to transition into the program in a fair, orderly, and 
clear fashion. Brokers and investors can select their preferred trading 
environment--decimals or fractions. Another key aspect of the Island 
plan is that it provides market participants with a competitive and 
economic incentive to progress to decimals as quickly as practicable. 
By providing market incentives, the Island plan ensures a timely 
transition to decimals that will benefit investors. We expect that 
investors will save hundreds of millions of dollars a year as the 
industry moves toward decimal trading, and we are proud to be one of 
the catalysts for this change.
    Island's decimalization plan is consistent with the current 
relationship between Nasdaq and Island. Island already trades in 
increments finer than the Nasdaq market as a whole and is required to 
round its quotation information prior to transmission to Nasdaq. 
Different quote increments already exist within Nasdaq and have not 
been the source of any system problems or investor confusion. By 
progressing to decimals, we are further simplifying the market for 
millions of investors.
    Question 4. What structural changes should accompany the 
demutualization of NYSE and Nasdaq to ensure a competitive market?
    Response: Island believes that the U.S. Congress has already 
designed the roadmap for ensuring the continued success of our capital 
markets. In 1975, Congress created the National Market System, with the 
goal of constructing a more efficient and transparent market. We could 
not ask for a better building block.
    The mandate of the NMS, as envisioned by Congress, is defined by 
two objectives: first, to promote competition between markets (``fair 
competition between exchange markets and markets other than exchange 
markets''); and second, to make quotation and transaction information 
available to investors (``assure the availability to brokers, dealers, 
and investors of information with respect to quotations for the 
transactions in securities.'').
    Consistent with this mandate, the SEC adopted rules that permitted 
ECNs to have their quotations included in the Nasdaq best bid and offer 
that is disseminated to the entire marketplace. As described earlier, 
competition between markets flourished (with ECNs having captured 30 
percent of the Nasdaq transaction volume), and Nasdaq itself was 
significantly reformed. When provided a level playing field, ECNs can 
compete for market share and bring the benefits of competition to the 
investor.
    This situation contrasts sharply with the rules and regulations 
governing Island's ability to compete in NYSE-listed stocks. 
Ironically, almost 25 years later, the rules and market structure 
implemented to achieve the goals of a National Market System are now 
inhibiting competition between markets and restricting the information 
available to investors. Regulatory obstacles block Island from having 
its quotation information included in the two main components of the 
National Market System--the Consolidate Quotation System (CQS) and the 
Intermarket Trading System (ITS).
    We do not believe that any public-policy benefits are served by 
stifling competition and barring Island from sharing its pricing 
information. Consider that when Island trades the stock of America 
Online, at various times during the trading day, Island has the best 
quote in the National Market System. Unfortunately, due to the current 
regulatory structure, market participants (other than Island 
subscribers) are denied the opportunity to see and to access the better 
price on Island. This is completely inconsistent with the spirit of the 
National Market System.
    In addition, we would witness significant public-policy benefits by 
promoting competition and integrating Island into the NYSE's pricing 
mechanism. Most importantly, Island's price information would no longer 
be fragmented from the rest of the marketplace. The market for NYSE-
listed stocks would immediately become more integrated and efficient. 
The resulting competition between marketplaces (again, a central goal 
of the National Market System) would result in benefits for the 
investor.
    In light of the proven benefits to investors and the efficiency of 
the market, it is time to take immediate action to give ECNs access to 
the Consolidated Quotation System. ECNs, such as Island, must be 
permitted to disseminate their quotation in listed stocks to all market 
participants. Yet in moving forward on this issue, we must still 
confront and deal with a version of price-time priority currently 
operating for the listed market. As discussed earlier, under the plan 
governing the operation of the Intermarket Trading System, each 
participant exchange is prohibited from trading at a price inferior to 
another participant.
    Just as the Federal government does not negate customer choice by 
requiring consumers to buy goods from the lowest price merchant, market 
participants should not be required to buy from the best-priced market. 
As long as market participants know the price in each market and have 
the ability to access each market, there is no need for the Federal 
government to require the market participant to favor any one market. 
Accordingly, in addition to allowing ECNs to disseminate their 
quotations directly through the consolidated quote, the elimination of 
the trade-through rule is another important step toward more fully 
realizing Congress's objectives in the National Market System.
    Question 5. What Benefits will electronic exchanges provide that 
traditional exchanges do not?
    Response: Electronic exchanges provide investors with a faster, 
cheaper, more reliable, and transparent method of trading equity 
securities. Prior to the introduction of ECNs, investors did not have 
any choice but to send their orders to market makers for execution. 
Following the SEC's 21(a) Report detailing collusion and fraud by 
market makers as well as the Justice Department's investigation into 
similar conduct, the SEC adopted the Order Handling Rules which 
permitted ECNs to display customer orders directly in the market 
without the participation of a traditional intermediary. By placing a 
limit order on an ECN, investors are empowered to determine their own 
price at which they want to buy or sell or security. In addition, by 
eliminating the traditional intermediaries, ECNs provide faster and 
lower cost executions than traditional market centers. Due to their 
rather simple business model and state of the art technology, ECNs are 
also able to provide services that traditional markets cannot or, in 
order to protect their franchises, will not provide. For example, 
Island was the first equity market in the United States to make its 
limit order book available for free over the Internet. Island was also 
the first equity market in the United States to announce its intention 
to trade in decimals on the Congressionally mandated deadline of July 
3, 2000.
    Moreover, by eliminating the informational disparities, ECNs are 
inherently safer, fairer, and easier to surveil. For example, 
participants on the floor of an exchange generally possess more trade 
and order information than the average investor sitting at home. 
Through surveillance and the implementation of restrictions on the 
activities of those in the trading crowds, regulators attempt to 
prevent the misuse of information. As recent events have shown, 
however, no amount of surveillance or regulation can completely prevent 
the misuse of information.
    ECNs, such as Island, reduce the opportunities for improprieties by 
eliminating informational disparities. ECNs empower all investors by 
allowing them to step into a virtual trading crowd and compete 
directly. Since all orders are delivered to the virtual trading crowd 
and instantaneously displayed to everyone, no single person has an 
informational advantage that needs to be regulated or surveilled. That 
means we have been able to deliver to investors the benefits of lower 
cost, more transparent, fairer markets, while still complying with 
strict Commission standards designed to ensure the integrity of our 
trading systems. Island, for example, must comply with regulatory 
standards concerning the security, capacity and reliability of our 
system. In fact, due to its use of the latest, most advanced technology 
as well as its proprietary architecture, Island has a superb record for 
reliability and performance. For example, during the past year when the 
Nasdaq market has periodically experienced system delays due to the 
tremendous surges in trading volume, Island has never experienced a 
capacity-related problem. Even during peak trading periods. Island's 
average turnaround time is approximately three one-hundredths (.03) of 
a second--exponentially faster than our nearest competitor. By 
combining the latest technology with our advanced system architecture, 
Island has created a scalable, robust trading system with virtually no 
capacity limitations.
    Furthermore, because electronic markets automatically capture and 
store all information, a complete audit trail is available for every 
order entered into the system. Accordingly, electronic markets can 
monitor a much larger and complete dataset for trading abuses such as 
price manipulation. At Island, we are able to monitor not just 
completed transactions, but all open orders in the system. This gives 
us the ability to not only detect violations that have already 
occurred, but also to prevent future violations.
    Finally, we have never taken our eye off the bottom-line for the 
investor; we have always believed that any money funneled out of the 
marketplace comes directly out of the investors' pockets. Consequently, 
Island has sliced its margins razor thin. Island, for example, only 
receives $.00075 per share per side on every transaction executed on 
its system; in other words, a trade for 1,000 shares of stock means 
only seventy-five cents for Island. I like to point this out to my 
staff when others question our spartan offices--like a recent New 
Yorker magazine profile noting that we have ``upgraded our offices from 
grungy to nondescript.'' I like to believe that there are millions of 
investors across the country benefiting from the fact that Island has 
the least stylish offices on Wall Street.
    Question 6. Is the Nasdaq supermontage an ECN? What types of 
problems do you anticipate in a market in which your regulator competes 
with you?
    Response: When evaluating the Super-Montage Proposal, it is 
important to understand that there are two aspects to the proposal. 
First, there is the initiative that would allow market participants to 
display greater depth to the market on a voluntary basis. Strangely 
hidden in the proposed rule, however, is a proposal for the creation of 
something named the ``Order Collector Facility.'' Although Nasdaq has 
gone to great lengths to trumpet the benefits of the greater 
transparency, it has ignored the competitive implications of the 
combination of the Order Display Facility (the system that will 
actually display the orders of market participants) with the Order 
Collector Facility (the system for the execution of orders displayed on 
the Order Display Facility). Yet, the Super-Montage Proposal states 
that the Order Collector Facility would be established as the ``single 
point of order entry and single point of delivery of liability orders 
and executions.'' By creating a platform for both the display and 
execution of orders, Nasdaq is essentially proposing the functional 
equivalent of a consolidated limit order book. One of the key 
attributes of the system is that, as Nasdaq states in a footnote, it 
would meet ``the requirements of the Display Alternative, Exchange Act 
Rule 11Ac1-4(c)(5).'' In other words, the Super Montage proposal would 
create a Nasdaq sponsored ECN.
    To understand the competitive implications of the new system it is 
important to understand how Nasdaq operates today. Currently, Nasdaq 
operates as a communications system that links the various market 
participants by: 1) consolidating the quotation information of the 
various market participants; and 2) operating the SelectNet system that 
allows market participants to electronically access the orders 
displayed in Nasdaq's consolidated quote. SelectNet allows Nasdaq 
market participants to route orders to the best price with the 
subsequent execution occurring on the system of the market participant 
receiving the order. The Super-Montage Proposal, however, would require 
executions to occur, not on the system of the ECN or market maker that 
receives the order, but on the Nasdaq operated Order Collector 
Facility. As a result, every market participant would become dependent 
on Nasdaq technology. Island strongly believes, however, that both 
competition and investors would be better served if, instead of trying 
to become the execution point for all Nasdaq market participants, 
Nasdaq substantially upgraded the SelectNet system. This upgrade, in 
conjunction with new rules requiring all market participants respond to 
orders in an automated fashion, would heighten competition on Nasdaq 
and, thus, bring greater benefits to investors.
    It is also important to note that regardless of whether the Super-
Montage proposal is approved, the current regulatory structure is 
tilted in favor of Nasdaq. Not only does Nasdaq have the authority to 
pass and interpret rules governing the activities of ECNs but, Nasdaq 
uses the revenue it makes from ECNs to finance initiatives intended to 
compete with ECNs. For instance, all Nasdaq market participants, 
including ECNs such as Island, are required by Commission rules to 
report every transaction to Nasdaq. Not only does Nasdaq charge Island 
a fee for every transaction that Island is required by regulation to 
report to Nasdaq, but Nasdaq then sells that same trade information for 
hundreds of millions of dollars. In fact, Island believes that it is 
one of Nasdaq's largest sources of revenue. The fact that the Nasdaq 
may separate itself from the NASD-R is irrelevant to these issues. Even 
after the separation, Nasdaq still would retain the ability to adopt 
rules that could disproportionately impact ECNs and use its monopoly 
position to disadvantage ECNs. For example, ECNs are required by SEC 
rules to maintain connectivity to Nasdaq. Yet, Nasdaq dictates the 
price and quality of that connectivity. If ECNs encounter problems with 
their Nasdaq operated connections they must call Nasdaq for assistance. 
This conflict of interest has already created problems and will only 
intensify if the relationship between Nasdaq and ECNs is not re-
structured to ensure fair competition. By heightening competition and 
spawning innovation, ECNs have played a major role in strengthening the 
Nasdaq market. The Super-Montage proposal risks undermining these 
accomplishments.
    Question 7. Which regulations most inhibit ECNs from competing with 
exchanges?
    Response: See answer to question 4 above.
    Question 8. What is the Intermarket Trading system. How should it 
be changed?
    Response: The Intermarket Trading System (``ITS'') is the system 
that links all exchange markets. For instance, if an investor sends an 
order to buy shares of IBM to the Chicago Stock Exchange when there is 
a better price available on the NYSE, ITS allows the Chicago Stock 
Exchange specialist to route that order to the NYSE to obtain the 
better price. As has been recognized by the Securities and Exchange 
Commission itself, however, ITS is based on obsolete technology, 
outmoded miles, and a dysfunctional governance structure. The best 
solution is to completely replace ITS and rethink many of the 
assumptions that underlie its creation. Island will be submitting a 
comment letter to the Commission in the near future that will provide a 
detailed proposal with respect to the future of ITS. It is important to 
note, however, that ITS is not the key competitive barrier that 
prevents ECNs from effectively competing in NYSE listed stocks. 
Instead, the key issue is representation. Island must be able to 
disseminate its quotation as part of the consolidated quotation in 
order to compete on a level playing field in NYSE listed securities.
    Question 9. What is the Consolidated Quotation System? How should 
it be changed?
    Response: The Consolidated Quote System is the system that displays 
the best quotation from all 8 Self-Regulatory Organizations that trade 
listed securities. ECNs, however, due to regulatory barriers do not 
have their quotes represented in CQS. While Island, for example, has 
developed a robust business in trading Nasdaq securities (accounting 
for approximately 1 in every 8 transactions), the inability of Island 
to disseminate its quotations through CQS have prevented Island from 
capturing a significant share of the volume in securities listed on the 
NYSE. By preventing fair competition between ECNs and traditional 
markets for listed securities, the current regulatory scheme harms 
investors.
    The Commission must take immediate action to allow ECNs to include 
their quotation information in the Consolidated Quotation for listed 
securities. Traditionally, ECNs have resisted posting their quotation 
in CQS because, by posting a quote in CQS, ECNs would be required to 
participate in ITS. Given the consensus that ITS is obsolete, Island 
recently the order of an ECN, such quote would contain an identifier 
indicating that it is the quote of an ECN not accessible through ITS. 
In turn proposed that the SEC take steps that would allow ECNs to 
immediately begin representing their quotations for NYSE-listed stocks 
in CQS without participating in ITS until a more permanent long-term 
solution is found. Specifically, Island proposed that ECNs be permitted 
to immediately begin displaying their quotations in listed stocks 
through Nasdaq. If the Nasdaq quote in CQS reflected, other markets 
could access the ECN quote by linking directly to the ECN or by simply 
contacting the phone desk of the ECN. The phone desk would provide at 
least the same quality of access that is currently provided by ITS. 
More importantly, the inclusion of ECN quotes in CQS would bring true 
competition to the listed market and allow investors to obtain better 
prices.
    Question 10. Has the current regulatory structure of the National 
Market System actually created market fragmentation by disallowing ECNs 
to share pricing information?
    Response: The two main goals of the National Market System were to 
heighten competition between markets and increase the amount of 
quotation information available to investors. Ironically, almost 25 
years later, the rules and market structure implemented to achieve the 
goals of a National Market System are now inhibiting competition 
between markets and restricting the information available to investors. 
Regulatory obstacles block Island from participating in the two main 
components of the National Market System--the Consolidate Quotation 
System (CQS) and the Intermarket Trading System (ITS).
    Consider that when Island trades the stock of America Online, at 
various times during the trading day, Island has the best quote in the 
National Market System. Unfortunately, due to the current regulatory 
structure, market participants (other than Island subscribers) are 
denied the opportunity to see and to access the better price on Island. 
This is completely inconsistent with the spirit of the National Market 
System.
    Instead, we should promote competition and integrate Island into 
the NYSE's pricing mechanism. Most importantly, Island's price 
information would no longer be fragmented from the rest of the 
marketplace. The market for NYSE-listed stocks would immediately become 
more competitive and efficient. The resulting competition between 
marketplaces (again, a central goal of the National Market System) 
would result in benefits for the investor.
    Question 11. Have you applied to become an Exchange? What is the 
status of your application?
    Response: Island applied to the SEC become a registered securities 
exchange on June 28, 1999. Island is in regular dialogue with the SEC 
on the status of the application, and awaits specific recommendations 
from the SEC.
    Question 12. How is Nasdaq's super-montage like a Central Limit 
Order book?
    Response: See answer to question 6 above.
    Question 13. What are the key problems with a Central Limit Order 
Book?
    Response: The debate over the creation of a Consolidated Limit 
Order Book (CLOB)--a government-mandated, central order book, based on 
strict time-price priority between markets--has highlighted many of the 
problems with a CLOB. Its advocates insist that a CLOB is now necessary 
because ECNs have ``fragmented'' the marketplace. In fact, the rise of 
ECNs has, by increasing competition, have led to consolidation of the 
marketplace. A decade ago, the top four market participants (before 
ECNs were around) accounted for 40 percent of the total Nasdaq volume; 
today, the top four (now including ECNs) account for 60 percent. 
Building upon this suspect fragmentation claim, the traditional market 
professionals then seek to impose a CLOB across markets.Interestingly 
enough, the immediate and most important effect of a CLOB is to deny an 
ECN's ability to compete with traditional players on the basis of 
speed, technology, and reliability. The CLOB inhibits competition by 
forcing markets to route orders to other marketplaces for execution. 
The resulting inter-dependence between the markets would prevent any 
one market from distinguishing itself on the basis of speed, 
reliability and quality of service. For example, if an order is sent to 
Market A for execution but Market B was displaying a better price, 
Market A would be required to send the order to Market B for execution. 
As a result, the quality of service that Market A could offer its 
customer is only as good as the quality of service of Market B. The 
basis for competition between markets would be eliminated since the 
only factor that would determine which market received the order would 
be price.
    Question 14. In what ways is a CLOB anti-competitive?
    Response: To understand why rules mandating price-and-time priority 
between markets and--in their most extreme form--the Consolidated Limit 
Order Book are anti-competitive, consider the following example:
    Assume that ECN A is a market that provides its members with the 
fastest and most reliable trading system in the industry. In addition, 
assume that Traditional Market B utilizes obsolete technology that 
lacks adequate capacity. If, under a regime of price/time priority, 
Market B is the first to display the best offer of $100 in stock XYZ, 
any order to buy XYZ at $100 received by ECN A must be routed to 
Traditional Market B--despite its inferior technology. Thus, even if 
you as an investor intentionally sent your order to ECN A to take 
advantage of its superior speed of execution, ECN A would be required 
to route your order to Traditional Market B. Thus, ECN A would be 
completely dependent on a response back from Traditional Market B in 
order to fill your order.
    This simple scenario demonstrates why price/time priority fails to 
serve the investor:

1.) It is impossible for ECN A to offer a faster execution or better 
        service in its competition with Traditional Market B, since 
        Market A will always be dependent on Traditional Market B for 
        execution and vice versa;
2.) ECN A and Traditional Market B are dependent on the linkage between 
        them and cannot offer service any faster or more reliable than 
        permitted by the linkage.
3.) In light of the first two points, investors will become insensitive 
        to which market the order is entered, leaving no basis for 
        competition between markets.
    In sum, not only do we prevent markets from competing with one 
another on any basis beside price, but we actually undermine the very 
technological breakthroughs that have strengthened our Nation's equity 
markets.
    Question 15. Recently we have seen an increase in message 
bottlenecks due to capacity problems with individual systems. Would the 
existence of a CLOB exacerbate the capacity problems we have been 
witnessing?
    Response: Yes. The very definition of a CLOB is a centralized 
system where all market participants are dependent on such system for 
the execution of orders. Since the system's development must be a 
cooperative effort led by the government, there is every reason to 
believe that the end result would be a system that was technologically 
obsolete before it was even completed. Given the advances in 
technology, our markets can only maintain their technological lead by 
constantly innovating. To the extent that one monolithic system was 
created, innovation would be extinguished.
    Question 16. The idea of a Central Limit Order Book (CLOB) was 
first tossed around in the 1970s when fragmentation was high because 
technology could not facilitate efficient order interaction without 
centralization. Has current technology rendered the notion of a CLOB 
obsolete?
    Response: Yes. Given the tremendous advances in technology, market 
participants are now able to route orders to the best market without a 
CLOB performing such a function. There are many proprietary systems 
available today that allow traders to determine and subsequently route 
an order to the best market. In fact, many systems do this in an 
automated fashion. As the level of investor sophistication has 
increased, these systems will continue to proliferate and become more 
efficient.


           COMPETITION IN THE NEW ELECTRONIC MARKET: PART II

                              ----------                              


                         THURSDAY, MAY 11, 2000

                  House of Representatives,
                             Committee on Commerce,
           Subcommittee on Finance and Hazardous Materials,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 10:05 a.m., in 
room 223, Rayburn House Office Building, Hon. Michael G. Oxley 
(chairman) presiding.
    Members present: Representatives Oxley, Greenwood, Shimkus, 
Towns, Stupak, Engel, Luther, and Rush.
    Staff present: Linda Dallas Rich, majority counsel; David 
Cavicke, majority counsel; Brian McCullough, professional 
staff, Shannon Vildostegui, professional staff; Robert Simison, 
legislative clerk; and Consuela Washington, minority counsel.
    Mr. Oxley. The subcommittee will come to order. The Chair 
would indicate that I am instructed the House will have a 
series of six votes on the floor beginning almost immediately, 
and so it would be the idea to give my opening statement and if 
the ranking member is here, his opening statement; and we will 
recess until we can get those votes out of the way and then 
return. The Chair apologizes for that inconvenience, but some 
of you have been around long enough to know how things work 
around here. So the Chair would recognize himself for an 
opening statement.
    I am pleased to convene this, our second hearing, to 
examine the implications of how technology is transforming our 
capital markets. Indeed, technology has completely rewritten 
the rules of competition and survival in the new electronic 
marketplace. As we learned at the subcommittee's last hearing 
on this subject, barriers to entry are falling as knowledge, 
creativity, and the Dell computer can make a couple of young 
guys in a basement office a significant force in the equities 
market. But not all barriers to entry have fallen, and they 
remain regulatory anachronisms that stand in the way of optimum 
efficiency and fairness for all participants in these new 
markets.
    At our last hearing, we heard from representatives of the 
new ECNs who are pioneering changes and gaining a hold on the 
market through the innovative use of technology. At that 
hearing, we learned about some of the regulatory anachronisms 
and barriers that remain such as the intermarket trading 
system. I look forward to hearing today's witnesses point of 
view on how ITs should be changed or replaced to address the 
problems of outdated technology and inefficient and unfair 
market access.
    This morning we will hear from market participants who have 
been around since the prehistoric times when faxes were 
considered high-tech. Technology has had no less impact on 
these players. Their business models are changing as we speak, 
the direct result of the forces of innovation and computation.
    Increased competition is translated into reduced 
transaction costs, faster executions, and more choices in 
trading venue for retail and institutional investors. Retail 
investors can now trade on-line with e-brokers at a fraction of 
the cost of the commissions they would pay a traditional full 
service broker. Even the most stalwart of the traditional 
brokers have followed suit offering investors the option of 
trading on-line.
    One thing that concerns me, however, is that investors can 
be better served by not only lower commissions but better 
executions of their trade. On a 1,000 share trade, one-
sixteenths of a point, which is currently the thinnest spread 
available on an exchange, amounts to $166.67. That is more than 
23 times the cheap $7 commission that some firms charge.
    As I have said for some time now, when the markets move to 
decimal pricing, investors will save bills in the form of 
narrower spread. I can't emphasize enough how important it is 
that the markets move expeditiously to pricing in dollars and 
cents and join the rest of the world. The decimal pricing alone 
will not ensure that investors get the best execution of their 
trades.
    We will hear from our witnesses today, and in particular 
the fund companies here today that invest on behalf of 
investors, about how the rules of today's markets work or don't 
work to ensure that investors get the best possible price on 
their trades.
    Technology has also forced the reevaluation of the role and 
structure of traditional exchanges. Indeed one commentator 
suggested in Monday's Wall Street Journal that there is no 
reason to have stock exchanges at all. James Glassman, the 
author who has testified before this committee, observed that 
the Internet can instantly link buyers and sellers around the 
world, so why is there a need for a place for buyers and 
sellers to physically get together to come to terms on shares 
of stock or carloads of wheat? That anybody is even asking this 
question illustrates how fundamentally the sweeping changes of 
technology have affected our markets.
    ECNs, best described as hybrids of exchanges in brokers, 
have led the challenge to the exchange structure. Because the 
linkage provided by the current SROs was, in their view, 
inefficient, they connected their own order books and pools of 
liquidity. In fact, last fall the ECNs links with one another 
allowed continuous trading even when NASDAQ systems were 
stressed by trading volume.
    This linkage did not, however, address the question of how 
to ensure the public is informed of the better prices for 
listed stocks that might exist on ECNs. In response, 
traditional exchanges are contemplating introducing their own 
ECNs dissolving current linkage systems and planning 
privatization. I doubt we will recognize their business models 
even a year from now. These new proposals raise important 
questions about the proper role of regulation by self-
regulatory organizations that compete with the entities they 
regulate. I look forward to addressing some of these questions 
today.
    Though these changes are stunning, I believe they are just 
the beginning of a complete revolution in the securities 
industry. I did not call this series of hearings to contemplate 
a future design for the market. That is surely not the role of 
government. I am confident competition will shape the market 
more liquid, transparent, and efficient than one we can 
structure. However, this can only happen if we ensure that 
regulations that govern our market foster competition in 
response to the changing landscape of the industry.
    I am pleased to welcome today's witnesses. We have an 
extensive and distinguished panel of experts representing many 
sectors of the marketplace including traditional brokers, 
institutional investors, the first ECN, and traditional 
exchanges. With all points of view represented today, I look 
forward to a lively debate on how best to promote competition, 
efficiency, and fairness to investors in our electronic 
marketplace.
    The Chair now is pleased to yield to the ranking member, 
the gentleman from New York, Mr. Towns.
    Mr. Towns. Thank you very much, Mr. Chairman. I also want 
to thank you for holding this hearing this morning. As I have 
observed at previous hearings, the securities market are 
important to the State of New York and vital to the New York 
City economy. Therefore, they are very, very important to me. I 
really want to make that clear.
    This subcommittee is front and center on the debate about 
how markets are changing, how competition and efficiency can be 
enhanced and how investors can benefit. We must look carefully 
at all the changes which are occurring. And let me pause here 
and say, Mr. Chairman, I salute you. And let the record reflect 
that I remain committed to market-oriented solutions to the 
changes that are taking place in the securities markets.
    The hearings we are holding on these issues provide an 
important platform for the industry, the regulators, and the 
investing public to be heard. I particularly want to welcome 
Bob McSweeney, the senior vice president of the New York Stock 
Exchange this morning. Since the subcommittee's last hearing on 
these issues, the Exchange has released its market structure 
report. The report makes recommendations on expanded choices of 
investors of the New York Stock Exchange. Building on the 
existing strength of the SEC floor system, these expanded 
choices will include automatic electronic execution and opening 
the specialist book to on-line investors through the Internet.
    The report also supports elimination of the intermarket 
trading system in favor of a private sector technological 
initiative. One of the most important recommendations is 
improving the education of investors about order execution and 
market-structure issues.
    Mr. Sweeney, I look forward to your testimony this morning. 
I would also like to express my concerns about the SEC concept 
release on securities market data. I strongly disagree with the 
idea raised by some broker dealers that investors do not have 
cheap access to real-time market data. In fact, free quotes are 
available on cable television and the Internet. I support the 
New York Stock Exchange's decision to leave the Consolidated 
Tape Association.
    I believe that with careful supervision by the SEC, each 
exchange can sell its own data and allow market forces to 
determine who offers the best product. The SEC should not 
regulate market data fees through cost base rating making 
procedures like a public utility does. That method of 
regulation would add new levels of bureaucracy to the SEC and 
would distract the agency from more urgent investor protection 
issues. So, Mr. Chairman, I look forward to hearing from all 
the witnesses, and on that note I yield back.
    [Additional statement submitted for the record follows:]

 PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE

    I commend the Chairman for holding this hearing today on 
competition in our new electronic capital markets.
    More than half of all Americans now have an ownership stake in our 
economy through investments in the stock markets. I am optimistic that 
the number of investors in our markets will continue to rise and will 
allow every citizen to participate. It is no coincidence that this 
trend corresponds directly to improvements in technology.
    Personal computers are as powerful as the old mainframes, and 
combined with the Internet investors now have real time access to 
information and to the markets. The speed and efficiency offered by 
these developments have increased competition and reduced trading costs 
for both institutional and individual investors.
    Technology has brought our markets new forms of trading, perhaps 
most dramatically illustrated by the evolution of electronic 
communication networks (ECNs). This and other technological 
developments have led to questions about the utility and efficiency of 
the existing regulatory model of our securities markets, including the 
concept of a traditional exchange.
    At the last hearing we heard some of the newest ECNs describe their 
ability to match customer orders electronically without human 
intervention. Today we will hear from the pioneer in that field, 
Instinet, the broker-dealer that brought us the first ECN. We will also 
hear from the traditional auction and dealer markets, as well as the 
users of both newfangled and oldfangled markets--the buy side.
    The National Association of Securities Dealers and the New York 
Stock Exchange are contemplating changes to their business models and 
regulatory structure to better compete with ECNs and foreign 
competitors. I suspect some of these changes would not have been 
contemplated a few years ago absent the development of the electronic 
trading facilities. I am very interested to learn more about the 
proposed changes and their impact on competition.
    In particular, the New York Stock Exchange has suggested that the 
Intermarket Trading System (ITS) may have passed its time in this age 
of instantaneous execution. I congratulate them on recognizing the need 
to improve outdated systems and technology, and am curious to learn how 
that system might be changed or replaced to provide fairer and more 
efficient markets.
    Additionally, the NASD has proposed a centralized trading system. I 
am concerned about possible conflicts that could arise when a Self 
Regulating Organization enters into competition with the very entities 
it regulates.
    We are not here to decide which business model is correct. 
Competition is the force that best serves investors and our markets. 
But biased or outdated regulatory restrictions get in the way of that 
positive force. Today we will learn what steps are necessary to ensure 
that the rules of the game actually permit competition to flourish.
    I welcome our witnesses today.

    Mr. Oxley. I thank the gentleman and the Chair does 
indicate there is a series of six votes on the floor of the 
House, and so, reluctantly, we will have to stand in recess 
until we return. I would hope it would be within a half-hour or 
so. So enjoy yourselves. The committee stands in recess.
    [Brief recess.]
    Mr. Oxley. The subcommittee will reconvene. Once again the 
Chair apologizes for the delay. I hope you enjoyed our 
hospitality here at the Commerce Committee during our absence. 
Let me introduce our distinguished panel, Mr. Douglas M. Atkin, 
CEO and president of Instinet; Mr. John J. Wheeler, manager, 
equity trading of American Century Investments from Kansas 
City; Ms. Holly A. Stark, director of trading, Kern Capital 
Management in New York; Mr. Robert J. McSweeney, senior vice 
president of special committee on market structure, governance, 
and ownership, New York Stock Exchange; Mr. Richard G. Ketchum, 
president, National Association of Securities; Mr. Peter 
Jenkins, director of equity trading, Scudder Kemper Investments 
in New York; and Mr. Kenneth Kamen, president, Princeton 
Securities Corporation in Princeton, New Jersey. Mr. Steven 
Galbraith, senior analyst for Sanford C. Bernstein & Co. was 
expected to be here, was taken ill; but I ask unanimous consent 
that his statement be made part of the record. All of your 
formal statements will be made part of the record.
    So let us begin with Mr. Atkin, and again we appreciate 
your patience with the committee. Mr. Atkin?

STATEMENTS OF DOUGLAS M. ATKIN, CEO AND PRESIDENT OF INSTINET; 
   JOHN J. WHEELER, MANAGER EQUITY TRADING, AMERICAN CENTURY 
INVESTMENTS; HOLLY A. STARK, DIRECTOR OF TRADING, KERN CAPITAL 
MANAGEMENT; ROBERT J. McSWEENEY, SENIOR VICE PRESIDENT, SPECIAL 
 COMMITTEE ON MARKET STRUCTURE, GOVERNANCE, AND OWNERSHIP, NEW 
   YORK STOCK EXCHANGE, INC.; RICHARD G. KETCHUM, PRESIDENT, 
   NATIONAL ASSOCIATION OF SECURITY DEALERS, INC.; PETER W. 
      JENKINS, DIRECTOR OF EQUITY TRADING, SCUDDER KEMPER 
    INVESTMENTS; AND KENNETH A. KAMEN, PRESIDENT, PRINCETON 
                     SECURITIES CORPORATION

    Mr. Atkin. Thank you, Mr. Chairman, and members of the 
subcommittee. First of all, the last time that I enjoyed recess 
I think was about 32 years. I was a bit disappointed we weren't 
able to use the gym to shoot baskets. I hear it is for Members 
only. It is a pleasure to be here. My name is Doug Atkin, and I 
am president and CEO of Instinet Corporation. We are the 
world's largest agency broker. We trade over 300 million shares 
a day in U.S. markets. We operate in 40 markets overseas and 
earned over $1 billion a year in revenues in 1999.
    Only in the NASDAQ market, I think it's important to 
understand, do we operate as an ECN due to the unique nature of 
that market. To date, this subcommittee has heard a lot of 
arguments made by market intermediaries or the middlemen who 
trade against their customers' principle. We have also heard 
from the NASD and New York Stock Exchange's self-regulatory 
organizations currently operated as quasi-government utilities 
but with firm plans to become for-profit competitors in the 
near future.
    I think, today, the subcommittee will hear not just from 
the intermediaries but from the real parties at interest, the 
investors, the people really providing capital to the markets. 
After all, markets exist to serve issuers and investors, not 
the middlemen. When I talk about investors, I just don't mean 
Wall Street professionals. Everyone who buys and holds a mutual 
fund or is involved in a State pension plan is an investor. For 
over 30 years, we have allowed buyers and sellers of securities 
to meet electronically and unlike dealers, we are a pure agent 
meaning we don't trade for our own account. We never buy or 
sell securities for our own account, and we have provided this 
service to investors such as mutual funds and pension plans and 
have recently expanded our service directly to retail investors 
as well.
    In the last year alone, according to outside studies, 
Instinet has saved investors over $2 billion in transaction-
cost savings. However, just as competition is beginning to make 
real inroads, the old order, as in any time of transition, is 
trying to rewrite the rules of the game to preserve its 
advantage. NASDAQ SuperMontage is just one example of this type 
of anticompetitive behavior.
    In the Internet age, rather than carry forward outdated 
structures, rules, and practices, we would be far better off by 
introducing competition. Some would say more competition. I 
would say some competition into our markets. Currently the 
NASDAQ, under NASDAQ, controls 100 percent of the trading in 
its market. Those that trade NASDAQ stocks have to use its 
infrastructure and publish its quotes to its market.
    We believe U.S. investors are not getting what they want 
and need out of the present market structure. We think what 
they want is inefficient market which lowers their total 
trading costs. Let me identify just two examples of what I 
mean. Certainly trading in decimals would make markets easier 
for investors to understand. It would also allow spreads 
between buy and sell orders to narrow allowing investors to get 
better prices.
    We operate, as I said, in 40 markets. We operate in 
decimals in 39 markets. The only market we don't is the United 
States, and we don't think that that is the best market for 
investors. Also, today when an investor improves the price for 
its security, that is, an investor is the first one willing to 
pay more than another buyer or accept less than any other 
seller, their order can sit unfilled all day while others' 
orders get filled at the very price that they set. I don't 
believe that is the best for the market, best market for 
investors either.
    I think today's network technology is bringing buyers and 
sellers together directly in industry after industry. The 
Internet is changing the way travelers buy airline tickets, the 
way car manufacturers buy auto parts, the way utilities buy 
electricity. Compared to these examples, the way people buy and 
sell stocks has hardly changed particularly at the market 
level. In our industry, mainframe-era rules and structures 
continue to protect middlemen to the detriment of investors.
    Mr. Chairman, you mentioned the Wall Street Journal 
article. I too found that very interesting calling into 
question this very fundamental issue. For example, the self-
regulatory organizations, at present, are able to use their 
regulatory authority to write rules that keep themselves and 
the dealers in the middle and capture the benefits of other 
people's innovations.
    I would also say, though, again this isn't just an SRO 
issue. It is also an SEC SRO issue. There is a lot of issues 
that are intertwined between the SEC and NASDAQ for example. I 
think the members of this committee have worked extremely hard 
to end monopolies and introduce greater competition as in the 
telecommunications industry fostering innovation and reducing 
consumer costs. To achieve this result in the industry, I 
believe we must dismantle the outdated rules written in the 
1970's based on 1960's technology that protects the entrenched 
interest.
    Let me offer three examples of the kind of change I am 
talking about. First we cannot allow one competitor to write 
the rules for another competitor. That is like allowing the 
pitcher to determine the size of the strike zone. It just is 
not a level playing field. If the pitcher were able to 
determine the size of the strike zone, I don't think Sammy Sosa 
or Mark McGwire would have hit 50 or 60 home runs.
    Mr. Oxley. Could you sum up. We are trying to stick to the 
5-minute rule since we have so many on the panel.
    Mr. Atkin. Certainly. The new world of competitive 
opportunity created by technology is not limited to our shores. 
Trading U.S. stocks overseas was not possible 25 years ago, but 
it is possible today. I think European exchanges are already 
offering more efficient operations than their U.S. 
counterparts; and I think, to sum up, what we really need in 
this country is to make sure that before NASDAQ or any other 
SRO is able to build, in essence, a competing order matching 
functionality or system, what we need is to allow ECNs who are 
really frustrated stock exchanges to operate on a level playing 
field and to be able to compete fairly or have that choice.
    [The prepared statement of Douglas M. Atkin follows:]

 PREPARED STATEMENT OF DOUGLAS M. ATKIN, PRESIDENT AND CHIEF EXECUTIVE 
                     OFFICER, INSTINET CORPORATION

                 I. MARKETS SERVE ISSUERS AND INVESTORS

    Mr. Chairman and members of the Subcommittee, thank you for the 
opportunity to appear before you today. My name is Doug Atkin and I am 
the President and Chief Executive Officer of Instinet Corporation.
    There is an exciting transformation now underway in the securities 
markets, as new competitors to the old, established brokerage firms and 
technological innovations are offering investors benefits and 
advantages once reserved only for market ``insiders,'' leveling what 
has long been an uneven playing field. Over the past several years, the 
National Association of Securities Dealers (NASD) and the New York 
Stock Exchange have faced increasingly vigorous competition from 
electronic brokers like Instinet. By empowering investors to trade 
directly with one another, we have brought competition to stock 
trading, which ensures that investors get the best price at the lowest 
transaction cost by driving down spreads.
    Two months ago, this Subcommittee started hearings on the future of 
the markets. To date, you have heard a lot of arguments made by market 
intermediaries--the ``middlemen'' who trade against their customers as 
principal, and the NASD and NYSE--self-regulatory organizations 
currently operated as quasi-governmental non-profit utilities, but with 
plans to become for-profit competitors in the very near future.
    Today, the Subcommittee will hear not just from the intermediaries 
but from the real parties at interest: the investors, the people 
providing capital. After all, markets exist to serve issuers and 
investors, not to serve the middlemen. And when I talk about investors, 
I don't just mean Wall Street professionals. Everyone who buys and 
holds a mutual fund is an investor.
    For over 30 years, Instinet has allowed buyers and sellers of 
securities to meet electronically. Unlike middlemen, we are a pure 
agency broker--we never buy or sell securities for our own account. We 
have provided this service to investors such as mutual funds and 
pension funds and will very shortly expand our service directly to 
retail investors as well.
    Given the bull market of recent years, it may seem strange to 
suggest that the U.S. stock markets are not as efficient as they should 
be. But the fact is, our markets remain dominated by monopoly 
competitors still using mainframe technologies. And, just as 
competition is beginning to make real inroads, the old order--as in any 
time of transition--is trying to rewrite the rules of the game to 
preserve its advantage. Nasdaq's ``SuperMontage'' is just one example 
of this type of anticompetitive behavior. In the Internet Age, rather 
than carry forward outdated structures, rules and practices, we will be 
far better off by introducing more competition into our markets. This 
will serve investors better, as well as maintain our global 
competitiveness.

           II. INVESTORS ARE NOT GETTING AN EFFICIENT MARKET

    Today U.S. investors are not getting what they want and need: an 
efficient market. Let me identify a few examples of what I mean:

 Trading in decimals would make markets easier for investors to 
        understand. It also would allow the spreads between buy and 
        sell orders to narrow, allowing investors to get better prices. 
        However, because of a market structure that has a single point 
        of failure, we don't even know when trading in decimals will 
        begin. That's not the best market for investors.
 Today, trading takes place around the world 24 hours a day. 
        Investors demand information about prices and trades before the 
        traditional markets open and after they close. This information 
        is generally not available to investors today. That's not the 
        best market for investors.
 Today, when an investor improves the price for a security, 
        that is, is the first one willing to pay more than any other 
        buyer or accept less than any other seller, his order can sit 
        unfilled all day while others' orders get filled at the very 
        price he set. That's not the best market for investors.

   III. REMOVE OBSTACLES TO MAKE MARKETS MORE EFFICIENT FOR INVESTORS

    As Members of this Committee know well, today's network technology 
is bringing buyers and sellers together directly in industry after 
industry. The Internet is changing the way travelers buy airline 
tickets, the way car manufacturers buy auto parts, the way utilities 
buy electricity. In financial markets, futures, derivatives and bonds 
are increasingly traded over electronic systems. We recently launched 
Instinet Fixed Income, which will bring better performance and cost 
effectiveness to trading in fixed-income securities.
    Compared to these examples, the way people buy and sell stocks has 
hardly changed. In our industry, mainframe-era rules and structures 
continue to protect middlemen to the detriment of investors. For 
example, the self-regulatory organizations are able to use their 
regulatory authority to write rules that keep themselves in the middle 
and capture the benefits of other people's innovations.
    The members of this Committee have worked hard to end monopolies 
and introduce greater competition in the telecommunications industry. 
The Committee currently is reviewing monopolies and barriers to 
competition in the energy market. As in telecommunications, as in 
energy, we need to introduce more competition in the securities 
markets, to unleash the benefits of technology, speed, efficiency and 
lower costs. Our markets need to work for issuers and investors rather 
than the middlemen. To achieve this, we must dismantle the outdated 
rules written in the 1970's, based on 1960's technology, that protect 
the entrenched interests.
    Let me offer three examples of the kind of change in thinking I am 
talking about.
    First, we cannot allow one competitor to write the rules for 
another competitor. That's like allowing the pitcher to determine the 
strike zone--even Sammy Sosa or Mark McGwire would have a tough time in 
that situation! And yet it is happening in our securities markets. The 
New York Stock Exchange and the NASD write the rules that all 
competitors must play by. And they are planning to become for-profit 
competitors themselves.
    When you write the rules and play in the game, you face an inherent 
conflict of interest. As an example, consider the NASD's proposed 
``SuperMontage.'' Today, the NASD runs a system that lets market 
participants control who they send orders to. In SuperMontage, the NASD 
is proposing to control who market participants send their orders to. 
It would give the NASD an unfair advantage over its competitors, 
ultimately harming investors.
    Instinet's April 20, 2000 comment letter to the SEC on the NASD's 
SuperMontage proposal is attached to this testimony in exhibit. Let me 
briefly explain why SuperMontage really should be called 
``SuperMonopoly'':

 It is not really voluntary. The proposal requires all markets 
        trading Nasdaq stocks to submit their quotes to SuperMontage. 
        In addition, brokers will feel tremendous pressure to use the 
        order execution system run by their regulator--ultimately 
        reducing investor choice.
 It could give investors worse prices than they get today. As 
        currently designed, the algorithm at the heart of SuperMontage 
        coupled with Nasdaq's pricing conventions would put certain 
        ECNs last in line to execute orders entered through Nasdaq, 
        even when those ECNs offer the best prices for investors. This 
        would inappropriately disadvantage certain market participants, 
        particularly those who have brought down spreads and helped 
        provide investors with the best price.
 It could provide investors with less information than they get 
        today. As James Glassman described in the Wall Street Journal 
        this week, ECNs already expose their entire limit order books 
        to their subscribers and some even to the public over the 
        Internet. SuperMontage displays only the three best price 
        levels. If SuperMontage draws order flow away from ECNs because 
        of its privileged regulatory status, that will be a step 
        backward in transparency.
    To eliminate this inherent conflict, we must end the ability of one 
competitor to regulate another. Regulation must be carried out by 
independent, unbiased regulators. 100% separation of the Nasdaq from 
the NASD and NASD Regulation should be an absolute precondition for the 
privatization of the Nasdaq.
    Second, we must remove outdated and biased trading rules that serve 
the middlemen rather than investors. Current rules allow unfair trading 
practices such as ``internalization.'' Internalization allows middlemen 
to profit from the difference between their customers' buy orders and 
sell orders, without ever exposing those orders to the market. This 
reduces competition, which in turn produces worse prices for investors. 
Not only that, the order placed by an investor who first sets the best 
price can go unfilled. One possible solution to internalization is to 
prevent any intermediary from trading against its customers as 
principal unless it improves the best available price in the market.
    Finally, we must promote fair competition. Competition breeds 
innovation, and innovation benefits investors. This Committee wrote the 
law requiring the Baby Bell phone companies to allow competition for 
local service before they can offer long distance service. If not for 
this requirement, the Baby Bells would be using their monopoly revenues 
from local service to subsidize their long distance business. As 
Congress realized, monopoly subsidies are unfair, inefficient and 
stifle innovation. The current monopoly on revenues from market data 
illustrates these risks.
    Today, the rules allow the self-regulatory organizations to engage 
in exactly this type of unfair and inefficient behavior. For example, 
all brokers must report their market data to their SROs. The SROs then 
enjoy exclusive rights to revenues from the sale of that data. They 
earn monopoly revenues in this area and can use it to subsidize other 
areas of business--including efforts to compete with their own members.
    The solution to this problem is to allow innovators to keep the 
benefits of their innovations. To continue the example I gave, Instinet 
and other market participants already use their data as important parts 
of their business strategy. The monopolies should not be able to 
dictate the terms on which their competitors may use their data.

                             IV. CONCLUSION

    The new world of competitive opportunity created by technology is 
not limited to our shores. Trading U.S. stocks overseas was not 
possible 25 years ago, but it is possible today. European exchanges are 
already more efficient than their U.S. counterparts. They have been 
free to trade one another's shares without having first to get approval 
from their competitors. For example, the London Stock Exchange set up 
the electronic SEAQ International to trade French, German and Swiss 
stocks. SEAQ International captured a significant share of trading from 
the traditional exchanges. This competition forced European exchanges 
to respond by adopting more efficient electronic systems, benefiting 
issuers and investors across Europe. If SEAQ International had been 
required to go to the European exchanges for permission to trade their 
stocks, or forced to operate through their systems--as the ECNs must 
today with the NYSE and Nasdaq--the European exchanges likely never 
would have innovated. The recently-announced merger of the London Stock 
Exchange and the Deutsche Boerse will create an efficient all-
electronic stock market that rivals U.S. markets in size.
    By contrast, in the United States competition to the Nasdaq for 
trading Nasdaq stocks is limited. ECNs essentially are frustrated 
exchanges that are not able to compete with the Nasdaq on an equal 
footing. Even those ECNs that have applied to become exchanges have not 
been able to. This is even more important, now that the Nasdaq is 
becoming a for-profit competitor and is proposing to use its regulatory 
authority to hobble its competitors before competition even begins.
    If the U.S. markets do not become more efficient, securities 
trading could easily move overseas. I have argued for a change in 
thinking, to allow more competition in securities trading. This will be 
good for issuers, good for investors, and will maintain the 
international competitiveness of the U.S. markets. If we build a market 
that best serves investors, we can continue to control our destiny. If 
we try to erect barriers around an inefficient market, we will harm 
investors and lose control to others.

    Mr. Oxley. Thank you.
    Mr. Wheeler?

                  STATEMENT OF JOHN J. WHEELER

    Mr. Wheeler. Thank you. Chairman Oxley, distinguished 
representatives of the subcommittee, my name is John Wheeler; 
and it is an honor to be here today representing 2 million 
shareholders at American Century Investors with over $110 
billion in assets. I am the manager of the domestic trading 
operation at American Century. I have been with the firm for 
over 9 years; and previous to that time, I spent 5 years in the 
over-the-counter marketplace as a market maker.
    [Slide.]
    I would like to start this morning with a little bit of 
historical perspective. This slide represents a survey taken at 
Trader Forum, a buyside organization, done over 5 years ago. If 
you focus in on the three qualities of a marketplace that the 
institutional investors said that they wanted exchanges to 
adopt, three responses garnered more than 90 percent positive 
votes. That would be order anonymity, full but anonymous 
disclosure of supply and demand schedules, basically a depth of 
book argument, and integration of price discovery, execution 
and transaction reporting.
    Second, a little bit of historical perspective on what we 
have done at American Century. We started doing business with 
Mr. Atkin's firm, Instinet, over 10 years ago; and as you can 
see by the blue line represented here, our average commission 
rate paid by our mutual fund shareholders has dropped 
precipitously over the last 10 years from a rate above 6 cents 
a share to most recently below 3 cents a share on average. If 
you look at the bottom line, electronic brokers that we do 
business with at American Century, rates have dropped on a very 
dramatic percentage basis from over 3 cents a share to right 
now at a penny a share on average for our electronic brokers.
    There has been a lot of talk recently about fragmentation. 
It is our view at American Century that ECNs like Instinet, 
Archipelago, Bloomberg's B-Trade product do not fragment 
markets. They have invested a lot of money in technology into 
integrating linkages between markets. We believe that ECNs link 
markets to the benefit of our investors.
    Last year, one out of three NASDAQ trades were made by 
wholesalers who were free riding on ECN quotes in our view. 
There is currently not an incentive in NASDAQ nor at the New 
York Stock Exchange for an investor, small or large, to 
disclose a trading interest to the rest of the remaining 
investing public. There is, in fact, an incentive to withhold 
quotes and withhold orders, withhold limit orders from the 
public because they are preyed upon by the intermediaries of 
those market plays in today's world.
    Internalization runs rampant at the New York stock exchange 
and regional exchanges, as well as NASDAQ currently. Large 
block trading houses internalize order flow. Retail firms pay 
for order flow and internalize that order flow at great, great 
profit to their particular firms at the expense of investors 
large and small. We view this as a very serious problem.
    Preferencing arrangements between competing intermediaries, 
we should be competing with each other again is a very big 
concern at American Century. As documentation of a previous 
point, this is a snapshot of four stocks, Friday January 8, 
1999. Just to take a brief look at how those stocks are quoted 
within NASDAQ, who is driving the inside market? Who is telling 
the world their best bid? Who is displaying to the world the 
best offer and price? You can see it is predominantly the ECNs 
alone at the inside marketplace and those four stocks. If you 
look at the next column, market makers alone at the inside, on 
average about a quarter of the time with ECNs half the time or 
more.
    Mr. Oxley. Before you switch that, I am not quite sure I 
follow that.
    Mr. Wheeler. Percentage of time throughout the trading day 
that the inside quote was only in an ECN as the best bid or 
only in an ECN as the best offering, in other words, 
Archipelago, Instinet, e-trade driving the inside market not 
NASDAQ market makers not NASDAQ member firms. Predominantly it 
is the ECNs that are driving the inside market because NASDAQ 
dealers have the ability to free ride off of the quotes of 
limit orders that are inputted by the investing public.
    Mr. Oxley. Thank you.
    Mr. Wheeler. At the expense of going over and not being 
able to complete the rest of my testimony, I want to spend a 
little bit of time on this particular slide. This I just 
prepared last week. This is a snapshot of our over-the-counter 
trading at American Century for the last 12 months of data. I 
compared our trading on two ECNs, our two largest ECNs, 
Archipelago and B-Trade, and I compared that to our over-the-
counter trading at the infamous MGM, Morgan Stanley, Goldman 
Sachs, and Merrill Lynch.
    Mr. Chairman, actually you touched earlier on the 
difference between explicit commission rates and the true cost 
of execution. I think this slide graphically illustrates that 
point. Our average trading costs with those three Wall Street 
firms average 286 basis points of round trip overall cost to 
our shareholders and would be commission costs, the explicit 
commission costs plus the market impact costs through linkages 
of information et cetera, et cetera. Compared to the cost 
incurred by Archipelago and B-Trade of just 98 basis points. We 
saved our shareholders over $220 million in marketing impact 
costs by executing over $11 billion in transactions on these 
two ECNs last year alone.
    I would like to touch on decimals, if time allows. Where 
are decimals right now? The marketplace has been calling for 
them for years. Regulators have been calling for decimals for 
years. Trades are occurring on ECNs and in our marketplaces at 
\1/256\ths of a point currently, and we currently restrict our 
investing public to display their limit orders in fractions of 
a \1/16\th of a point. It is very discouraging for us to see 
that the day traders and professional traders all day long can 
quote stocks in \1/256\ and gain standing a step ahead of 
customers' limit orders or \1/256\th of a point when we tell 
the investing public that they must abide by \1/16\ths.
    Last, ACIM thinking about our markets, investors have long 
been ignored by traditional intermediaries. The biggest point 
we would like to drive home is that ECNs force brokers and 
exchanges to compete by meeting those needs that investors ask 
for. New technology platforms give investors anonymity, full 
disclosure of supply and demand schedules and integration of 
price discovery, execution, and transaction reporting, features 
long requested by mutual fund investors.
    Competition from cost-efficient ECNs has lowered our 
commission rates and will save our shareholders $35 million in 
explicit commission costs this year alone. When you look at 
overall market impact costs, we are looking at a number 
approaching $500 million this year alone saved at American 
Century through cost-efficient ECNs.
    [The prepared statement of John J. Wheeler follows:]

   PREPARED STATEMENT OF JOHN J. WHEELER, MANAGER OF EQUITY TRADING, 
                 AMERICAN CENTURY INVESTMENT MANAGEMENT

    Chairman Oxley, Rep. Markey and other distinguished members of the 
Subcommittee, thank you for the opportunity to share my vision for the 
securities markets and the regulatory environment needed to accommodate 
that vision. I am John J. Wheeler, and as an active voice for two 
million investors entrusting more than $100 billion to American Century 
mutual funds and retirement programs, I'm excited to participate in 
this dialogue. For too long, the voices at hearings like this have 
represented the deep pockets and economic interests of entrenched 
financial intermediaries--and not the direct voice of investors who 
daily face the arcane, archaic and anti-competitive rules of member-
owned exchanges.
    As Manager of the domestic trading desk at American Century 
Investment Management (ACIM), now recognized as one of the earliest and 
most aggressive users of electronic trading technologies, I oversee a 
staff of ten traders responsible for executing equity trades for our 
forty equity mutual funds. I was a Market Maker of NASDAQ traded OTC 
stocks for five years before joining ACIM as a Senior Trader in 1991. 
During my tenure at ACIM, I have served as a member of the New York 
Stock Exchange's Institutional Traders Advisory Committee (ITAC) and 
various NASDAQ committees as well. My immersion into the complexity of 
the ``rules of engagement'' at both the NYSE and NASDAQ has been both 
educational and troubling.
    I serve on these committees because the method and costs for 
securities trading directly affect investment performance for our 
investors, whose portfolios reflect prices after trading costs are 
paid. Both large and small investors suffer equally and proportionately 
when there are marketplace inefficiencies and inequalities.
Investor Benefits from Emerging Trading Technologies
    Our 1992 response to the Securities and Exchange Commission's 
Market 2000 Concept Release was one of only four filed by investor 
constituents. The issues in that release are eerily similar to those 
contained in the Commissions' recent request for comment on market 
fragmentation. In the early 90's study, opponents to newly emerging and 
efficient technology platforms spawned language that asked whether such 
systems threatened ``fragmentation,'' ``segmentation,'' and 
``balkanization'' of the nation's securities markets. I remain 
convinced now, as I was then, that such language reflects the howls 
from entrenched exchanges and brokers who have been insulated from 
competition by rules that masquerade as investor-friendly safeguards.
    Our data indicates that ACIM's overall trading costs, including 
commissions and market impact have fallen steadily and progressively 
throughout the 1990s. (see exhibit 4) The enactment of the Order 
Handling Rules in mid-1997 generated significant additional savings. We 
can attribute virtually all of the cost savings--which go right into 
our investor's pockets--to the use of ECN's and other electronic 
trading technologies. The data suggests that new ways to trade have 
saved our investors as much as $110 million each year for the past 10 
years as compared to our costs for traditional brokerage services. (see 
exhibits 3) In the last year alone, our traders' use of more efficient 
platforms have saved our investors more than $500 million 
1--the size of a pretty good-sized mutual fund. 
Consequently, our traders rely on alternative trading systems for about 
40% of the dollars traded by ACIM on behalf of investors.
---------------------------------------------------------------------------
    \1\ Extrapolation of most recent 6-month OTC trading costs at 
Goldman Sachs as compared to Archipelago
---------------------------------------------------------------------------
    The efficiency of such systems appears to extend only to NASDAQ-
registered securities. The NYSE somehow escapes obligations under the 
Order Handling Rules and continues to refuse direct electronic access 
by investors to the specialist order book. That would appear to 
contravene the spirit of the 1975 amendment to the Exchange Act that 
calls for markets to provide buyers and sellers an opportunity to 
discover prices ``without the intermediation of a dealer.''
Internalization and Payment for Order Flow
    While we do not perceive a ``fragmentation'' threat from the 
emergence of new automated transaction systems since they match, cross 
and route orders automatically, we are nonetheless troubled by the 
``fragmentation'' foisted upon the market by dealer intermediaries who 
either internalize or pay for order flow. Many wholesale broker dealers 
and exchange markets engaged in internalization practices rely on the 
national market's disclosure of visible, limit orders to price and 
trade market orders generated by captive constituencies. Investors who 
display the desire to trade by using limit orders instead subsidize 
internalization practices. Ultimately, I expect to see internalization 
practices constrict the number and size of limit orders in the 
marketplace with a likely increase in volatility. Internalization and 
payment for order flow threaten transparency of trading processes. For 
instance, brokers now regularly receive so-called ``VWAP'' orders for 
specific securities--sometimes hundreds of thousands of shares--on both 
sides of the market.2 Potentially millions of shares are now 
internalized at the VWAP price, without ever participating in the 
market's price discovery processes and without any semblance of order 
interaction with other investor orders. Many of these orders are now 
``book entered'' overseas by U.S. brokers.
---------------------------------------------------------------------------
    \2\ Many trading consultants now evaluate the efficacy of trading 
by measuring how closely trades approximate the day's volume weighted 
average price for all trades in a given stock.
---------------------------------------------------------------------------
    Major wholesale market-making firms, whose business models rely on 
payment for order flow, were engaged in about one-third of all trades 
in NASDAQ securities last year (see exhibit 5) and have seen increasing 
market share gains as more and more retail investors trade individual 
stocks. At the same time, market makers often are represented in the 
market as the ``best'' buying or selling price only 25% of the time in 
many high profile, actively traded stocks while ECNs typically 
represent the market's best price more than 50% of the 
time.3 (see exhibit 6)
---------------------------------------------------------------------------
    \3\  Source: NASDAQ Stock Market data
---------------------------------------------------------------------------
    Internalization practices prove anti-competitive in a host of 
trading venues--and the traditional exchange markets retain ``members-
only'' benefits, marketing agreements and other ``practices'' that 
erode our confidence in trading on even the most well branded 
exchanges.

Internalization at the NYSE
    The NYSE suggests that fragmentation caused by internalization 
might be mitigated by a market-wide price improvement rule. In other 
words, orders could only be internalized by dealers who pay a price 
``better'' than the national market's best prices for both buys and 
sells. In principal, we believe that this simple change in intermarket 
rules would be favorable for investors. At the same time, we can't 
understand how the NYSE might impose that rule on other exchanges or 
dealers when much of the physical, floor-based model of that exchange 
depends on layers of such internalizing rules:

 Price and time priority exists in only one place at the NYSE--
        on the specialist's book. If one customer sends a buy order to 
        the exchange and a second customer sends an additional buy 
        order to the floor at the same price, the first customer's 
        order must be filled before the second customer's receives 
        attention. This would appear to be a fundamentally fair 
        outcome. However, third and fourth in-line buyers could place 
        an order with member firms represented in the floor ``crowd'' 
        and they are granted the right to share pro-rata in every trade 
        at the first customer's price. The second customer must wait 
        patiently. Where is the notion of price improvement in this 
        circumstance?
 The ``clean cross'' rule allows member brokers to 
        ``internalize'' blocks of 25,000 shares or more at the same 
        price as smaller, pre-existing orders on the specialist book 
        without satisfying those orders that established the price of 
        the trade. How is this functionally different than the 
        practices employed by wholesale dealer firms who only match 
        prices set in other markets when they pay for order flow? How 
        does the small investor benefit by posting limit orders if they 
        are afforded no protection when a ``clean cross'' occurs at 
        their price?
 ``Participate'' orders are instructions given to floor brokers 
        (and even specialists) on the NYSE floor that ask them to 
        passively ``go along'' with other trades until an order is 
        complete. The rules of the NYSE give these orders standing in 
        the markets even though they do not contribute to price 
        formation. No information is transmitted about these trades 
        because they can only occur when someone else commits to make a 
        trade at mutually agreeable prices. How does one ever ``price 
        improve'' a participate order at the NYSE?
 ``Freezing the book'' is a little understood specialist 
        practice used to manage the trading process. If an electronic 
        order arrives to buy a stock at the offered price on the book, 
        the specialist may ``freeze'' the book to enable the floor 
        crowd to make the trade at that price. After the trade is 
        completed, he then ``unfreezes'' the book to allow the new 
        electronic order to take its place in queue. Discussions with 
        exchange officials suggest that this is a ``practice'' rather 
        than a rule-enabled function of the specialist.
 The NYSE has resisted institutional calls for years to show 
        more than the market's best bid and offer--to create a supply 
        and demand schedule for the market. The NYSE has created rules 
        that actively discourage the use of technology to trade there. 
        Simply put, if you want equal (or advantageous) standing on the 
        NYSE, you are required to hire a NYSE floor broker. There is no 
        alternative choice.

Competition and the NYSE
    At the New York Stock Exchange, our orders cannot be traded without 
the intervention of a dealer--the specialist. Not much data exists 
about the profitability of specialist operations but the recent 
prospectus offering by LaBranche, the second or third largest NYSE 
specialist firm, provided a glimpse at the following:

 LaBranche consistently earns more than 75% of profits from 
        dealer trading activity;
 That specialist unit has been profitable every quarter for 22 
        years; that would include the market's record single day drop 
        in 1987, the major bear markets in 1980 and 1982, and other 
        periods of market ``distress.''
 The company averages consistent returns on capital and equity 
        of more than 70%;
 The company posts consistent profit margins of about 70%;
    How do they earn such economic rents? I would suggest that the 
designation of the NYSE as the ``primary'' market on which all other 
pricing should be based has established the NYSE as the principal 
``operating system'' for the market. That status has been conferred 
upon member-owned exchanges by the Congress and by SEC regulatory 
interpretations over time.
    It strikes me that an analogous situation might be the 
establishment by Congress of Microsoft as the official operating 
standard for the computer. Obviously Microsoft was the first to 
discover the true power of a standard operating system for the desktop 
computer. Recent events here and in the courts would suggest that 
Microsoft also discovered that bundling increasing numbers and kinds of 
software applications into the operating system pleased consumers--but 
displeased those who believe that competition spurs innovation.
    The NYSE sits as the sole arbiter on a number of shared exchange 
operating committees like the Intermarket Trading System--the effective 
operating system for the nation's exchanges. The use of veto power in a 
number of these venues successfully stymies efforts to stimulate 
interconnectivity of markets. And the NYSE has, over the years, 
incorporated innovations begun at regional markets only after a concept 
is proven and is considered a potential threat to the established 
hierarchy of exchanges.

Innovation by Regional Exchanges
    The recent launch of the OptiMark trading utility of the Pacific 
Stock Exchange (PSE) provides needed insight into the anti-competitive 
practices at both the primary and regional exchange 
markets.4 OptiMark's system relied on effective linkages 
between markets--as promised by the Intermarket Trading System (ITS). 
The historical record reflects that the SEC was forced to broker a 
compromise between competing parties on the ITS operating committee 
after principals exhausted more than a year in fruitless, back room 
debate on how OptiMark could or should be linked to the NYSE market. 
That process helped draw down a new competitor's intellectual and 
economic resources required to compete effectively. The final solution 
reflected the economic staying power of NYSE monopoly position rather 
than a rational attempt to further the goals of a National Market 
System.
---------------------------------------------------------------------------
    \4\ American Century Companies (ACC), along with a number of major 
Wall Street firms, owns a small equity position in the OptiMark auction 
utility.
---------------------------------------------------------------------------
    Shortly after effective launch of the new system, the NYSE 
effectively shut down ITS access to the OptiMark utility--based on 
arbitrary volume limitations. As an early user of the utility, our 
company documented numerous failures by NYSE specialists to abide by 
conventions of the ITS agreement and filed that report with both the 
Commission and exchange officials. In several documented cases, we were 
unable to execute orders sent from the Pacific Exchange to New York 
that were subsequently and immediately executed when sent through the 
NYSE proprietary Super DOT, order delivery system.
    Our experience with the OptiMark utility also produced an eye-
opening understanding of the marketing arrangements of regional 
exchanges that subvert competitive quote-making among exchanges. ACIM 
recognized early that the Pacific Stock Exchange (PSE), in combination 
with the OptiMark utility, might provide an effective mechanism to 
generate competing quotes with the NYSE. We asked ECNs with whom we do 
business to build an order display link to the PSE such as that already 
in existence at the NYSE.5 American Century traders 
subsequently sent orders to the PSE that ``improved'' the NYSE best 
bids and offers. Those orders were intended to serve as an 
advertisement on the Consolidated Quote System of potentially larger 
block trading opportunities available through the OptiMark utility. 
Instead, we found that PSE specialists almost immediately sent these 
``price improving'' limit orders across ITS from the West Coast to the 
NYSE specialists' books.
---------------------------------------------------------------------------
    \5\ Archipelago Holdings, LLC built such a linkage to the PSE which 
allowed us to send large orders to that market for posting by the 
specialist there. ACC subsequently purchased a small and indirect 
economic interest in Archipelago through JP Morgan Capital.
---------------------------------------------------------------------------
    In trying to provide price competition, we discovered that PSE 
specialists have marketing obligations to a number of broker-dealers 
who internalize order flow. To protect those firms' ability to 
internalize customer orders, the specialist offers ``primary market 
protection'' on the regional floors. That protection essentially 
promises ``internalizing'' firms that if stocks trade at the retail 
order's price on the ``primary'' exchange, the PSE specialist would use 
his capital to execute the order at that price on the regional 
exchange. There were three problems with the new competing orders that 
we were sending for display to the PSE. One, the large size of the 
orders on the PSE book meant that small retail orders, previously 
internalized, had to wait in queue until the larger block traded. When 
ACIM offered to forego ``primary market protection,'' the specialists 
requested that we also allow small retail orders to be traded in front 
of the large order, even if they arrived at a later time. The PSE could 
not excuse one firm from that ``marketing arrangement'' without 
compromising the entire business model of the exchange. Two, the large 
size of the orders provided an unacceptable risk to undercapitalized 
specialists who did not wish to ``protect'' our orders against trades 
in other markets. And three, it narrowed the spread that could be 
internalized by PSE firms that sent listed orders to that venue for 
trading--thereby cutting the profitability of that practice.
    This, to us, is prima facie evidence that regional exchanges--under 
current rules--provide neither competitive quoting nor innovation. We 
are inspired by the recent announcement that the PSE and Archipelago 
will attempt to create a truly competitive and automated stock 
exchange. We can only hope that promises of price/time priority and 
electronic and non-dealer intermediated access to the PSE will not be 
perpetually stalled by entrenched and dominant exchanges, operating 
committees and member firms--all wrapped in concerns about investor 
protection.

Regulatory Requirements
    The SEC has long sought to respond to the language of the 1975 
Amendment to the Exchange Act and its call for markets that:

 maximize the opportunity for investors' orders to interact in 
        an agency auction and;
 for buyers and sellers to execute without the intervention of 
        a dealer.
    A recent survey of more than 40 traders of major institutions 
showed strong consensus that ``ideal market'' attributes would include:

 Anonymity of orders entered within a system;
 Time priority of orders entered at a price;
 Full, but anonymous, disclosure of the supply and demand 
        schedule;
 Integration of price discovery, execution and transaction 
        reporting.6
---------------------------------------------------------------------------
    \6\ Economides and Schwartz, ``Assessing Asset Managers' Demand for 
Immediacy: Equity Trading Practices and Market Structure'' 
substantiates the institutional traders' desire for such rules of 
engagement.
---------------------------------------------------------------------------
    We support the call for markets with transparency and ``quote'' 
competition. The current state of affairs in the NASDAQ market, with 
wholesale market makers and even at the NYSE fails to meet the minimum 
standards that the buyside requires to best protect investor interests. 
(see exhibit 2) The explosive growth of ECNs in the U.S. marketplace 
and across Europe validates such surveys of investor preference. If 
ECNs were allowed to compete directly with the NYSE, we think sizeable 
economic benefits would accrue to investors.
    For years, ACIM has advocated a strict price and time priority 
intermarket linkage. We continue to believe that the best market for 
investors would foster maximum order interaction and transparency. At 
the same time, recent experience with the ITS trading system, the rules 
of trading at the NYSE and the structural problems related to ECNs and 
mandated SelectNet linkages suggests that the SEC focus first on order 
disclosure, priority and interaction rules within individual markets.

How Can We Get There?
    The explosive growth of the Internet in part provides the solutions 
to these vexing issues. Electronic, non-intermediated auctions on-line 
are drawing huge resources and attention from buyers and sellers of 
Beanie Babies, airline tickets and auto parts. Ford, Chrysler and GM 
seek such a venue to reduce supplier costs. Why do member firms of the 
major exchanges resist the major virtues that their own securities 
analysts extol as ``beneficial'' to the economy in enterprises outside 
of securities trading?
    We believe that the Commission should regulate the form of 
individual markets and refrain from regulating the technology that 
might be used to integrate markets. Already, eight ECNs are building a 
virtual private network to link order books and dispersed pools of 
liquidity. These robust networks tie together systems that already 
incorporate the four major tenets of the buyside investor's ``ideal 
market'' without creating a single point of technology failure--a 
virtual limit order book. The systems recognize that the ``market'' no 
longer is limited by access to the physical trading floor on Wall 
Street.7
---------------------------------------------------------------------------
    \7\ See Domowitz and Steil, ``Automation, Trading Costs and the 
Structure of the Securities Industry
---------------------------------------------------------------------------
    The government's time is misspent trying to regulate the technology 
capacity of markets. If competitively-limiting linkages like ITS were 
simply eliminated, one must consider whether the market would not 
quickly establish network linkages as a direct response to customer 
demand. These linkages would recognize and penalize inefficient 
systems--like those currently operated by the NASDAQ stock market--
where legacy systems impede the delivery and reliability of trading 
information.
    Insight into the regulator's role over tariff setting within the 
securities markets can also be gained from the implementation of the 
Order Handling Rules. The sudden mixing of dealer systems (where all 
customer charges are implicit) and of agency auction systems (ECNs who 
explicitly charge for access) squarely placed the Commission in the 
role as a rate-setter. Dealers argued they should not have to pay for 
access to ECNs because dealer-to-dealer trade in NASDAQ is ``free.'' 
However, dealer trading is free only if dealers have zero profitability 
in the business model. Rather, dealer trading imputes hidden tariffs. 
As an investor, I would rather see charges assessed explicitly. Why 
should the SEC sit as judge as to what constitutes reasonable charges?
    One could argue that competing venues should be able to charge 
whatever fee for access to a proprietary pool of liquidity would be 
economically competitive. That would imply that linkages could not be 
forced upon centers but that such centers must be compelled to accept 
orders from other markets or exchanges. I would expect that technology 
integrators would quickly create algorithms allowing me to choose a 
trading venue based on price, time and cost of access metrics. If one 
market's cost of access were too high or the system's response too 
slow, I would expect liquidity to migrate to the most dependable, 
lowest cost, and most secure venue.

The Role of Decimals
    The markets currently are digging their heels in on the issue of 
decimal trading increments. We remain the only market in the world that 
continues to rely on centuries old pricing conventions--pieces of 
eight. At the NYSE, an immediate move to decimals combined with price 
time priority, would create significant competitive pressure on payment 
for order flow and internalization business models that rely on ``fixed 
price spreads'' to support the economics of the business. Within 
NASDAQ, we are deeply concerned about the ongoing practice of 
disseminating public quotes and customer limit orders in 16's while 
professional investors can post limit orders in increments as fine as 
256's. If Mr. Daytrader can have limit order protection for one 256, 
shouldn't we allow Mr. Smith to buy the same protection for one penny? 
We would argue that a move to decimals would simplify NASDAQ and once 
again unify quotes, trades and trade reports at the same increment 
while lowering trading costs for all investors. (see exhibit 8)

Summary and Conclusions
    We believe that true competition among markets and among quotes may 
be harmed by mandated linkages--without the complete reform of anti-
competitive structures like ITS and the elimination of order 
internalization practices by dealers, brokers and exchanges.
    We believe that a ``hard CLOB'' or central limit order book which 
consolidates all orders in disparate venues is undesirable and would be 
subject to a single point of technology failure. That said, we 
encourage the virtual development of a market that guarantees 
investors:

 Anonymity of orders entered within a system;
 Time priority of orders entered at a price;
 Full, but anonymous, disclosure of the supply and demand 
        schedule;
 Integration of price discovery, execution and transaction 
        reporting.
    We believe that price and time priority structures within markets 
and an intermarket ``price improvement'' feature would be beneficial to 
investors. That rule would allow internalization of market orders only 
at prices better than those quoted among competing market centers--even 
a penny of price improvement changes the economics of the payment for 
order flow business.
    We believe that truly competing markets and exchanges should be 
required to accept non-intermediated, electronic orders from other 
exchanges or markets; furthermore each market center should be free to 
establish the cost for access to that market.
    True competition often creates fear and uncertainty. We must not 
fear such competition in the structure of the capital markets. Thank 
you for the opportunity to share my thinking with this subcommittee.

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[GRAPHIC] [TIFF OMITTED] T3803.005

    Mr. Oxley. Thank you.
    Ms. Stark.

                  STATEMENT OF HOLLY A. STARK

    Ms. Stark. Chairman Oxley, I would like to thank you and 
the other distinguished members of the subcommittee for 
allowing me the opportunity to share my views on the evolving 
structure of the U.S. equities markets.
    My name is Holly Stark, and I serve as the director of 
trading for Kern Capital Management, LLC, a privately held 
investment advisor in New York, managing in excess of $2 
billion. Our specialty is small and microcap growth investing. 
We act as subadvisor for a number of mutual funds as well as 
manage assets for a roster of clients ranging from ERISA plans 
to college endowments.
    I would like to talk a little bit about fragmentation, 
internalization, and transparency. Fragmentation has emerged 
recently as a major issue in the equities markets with the SEC 
publishing a concept release soliciting the views of market 
participants on the subject. Fragmentation occurs when orders 
trade in multiple market venues without interaction with each 
other. Some have argued that fragmentation has increased with 
the emergence of multiple ECNs, as an investor must search out 
many market places including those of ECNs where a stock might 
trade to determine the best price and access sufficient 
liquidity to complete the trade.
    In a fast-moving volatile market, this exercise becomes 
extremely difficult, and the difficulty increases with the size 
of the trade. However, functionality has been introduced by a 
number of ECNs to permit a trader to access orders across 
multiple venues so that those fragmented bids or offers are 
readily available to execute against. What these tools do not 
offer is the ability to access orders that are internalized by 
broker dealers.
    Internalization occurs when broker dealers do not expose 
their orders to the marketplace. They are able to buy on the 
prevailing bid or sell on the offer capturing the posted spread 
while never accessing or interacting with limit orders 
displayed in the marketplace. The investor who has posted the 
limit order has in effect set a price for other investors to 
trade at, though he himself will not participate in any volume 
that trades at his displayed price. The limit order investor 
may even have set a new bid or offer when entering his order, 
but internalization practices preclude him from receiving an 
execution. The stock will, in effect, trade around him; and he 
may never fill his order at his publicly displayed price.
    Have the investors whose orders are internalized received 
best execution? Has the limit order investor been treated 
equitably? Such practices more so than the existence of 
multiple ECNs reduce market efficiency and serve to fragment 
the market. If an investor is hesitant to display a limit order 
for fear that his order may never be executed, market 
transparency, depth and liquidity may well be compromised.
    Certainly broker dealers are not required to display market 
orders. They must execute the order at the best available price 
in the market. With the adoption of the display rule by the SEC 
in 1996, broker dealers and market makers are required 
immediately upon receipt of a customer's qualified limit order 
to display the order in their quote if it improves the price or 
adds to the size of their quote. If the order is not displayed, 
it must be executed or routed to other market centers for 
display or execution.
    But on May 4, 2000, the SEC released a report describing 
violations by both market makers and specialists in their 
handling of customer limit orders. The violations included 
failure to display proper order size and failure to display 
orders within 30 seconds after receipt. Surprisingly, the 
report concluded that the SROs' surveillance and enforcement of 
limit order handling was not up to par. Without required limit 
or display, limit order buyers and sellers might be dissuaded 
from placing such orders, compromising market transparently and 
ultimately liquidity.
    An investor who publicly displays limit order is not 
guaranteed an execution even if a stock trades at his price 
because provisions for price and time priority across markets 
do not exist. In NASDAQ, the first dealer displaying the best 
bid offer has no priority over other dealers displaying the 
best bid or offer--the same bid or offer. On the New York Stock 
Exchange, orders on the specialist book do receive price and 
time priority status, but floor brokers may participate in 
executions that would satisfy orders on the book, in effect 
jumping the cue that is on the specialist book.
    The floor brokers standing in the crowd do not have to 
publicly display to the greater market place their trading 
intention. They can merely go along with other participants and 
benefit from the price discovered by limit order investors. 
Because of such actions, some have called for the creation of a 
central limit order book, or CLOB, that would consolidate all 
orders in one trading venue with strict time and price 
priority. Launching a national CLOB would be problematic. Who 
would create it and maintain it? Who would pay for it? Who 
would regulate it? If all market participants were required to 
participate, would reliance on a single point of entry risk 
market failure should that point of entry be disabled? Would 
the fostering of innovation in market structure be compromised? 
Instead, a more workable solution would be to encourage 
intermarket linkages that provide for strict price and time 
priority and preclude any one market center or participant from 
controlling the linkages.
    Technology would allow for the creation of a virtual limit 
order book that could satisfy the need for price/time priority 
across markets without relying upon a single entity to 
establish and maintain the linkage.
    I would like to make one comment about decimals. U.S. 
markets have the dubious distinction of being the only markets 
in the world that still trade in fractions. Decimals are far 
easier to comprehend. Decimals are already the preferred means 
of operating on many institutional trading desks. Prices 
reported in fractions are immediately converted into decimals 
when executions are entered into order management systems. 
Realtime prices flow from quote vendors into order blotters in 
decimals. Stocks are cleared in decimals and the trades are 
cleared in decimals. While it is critical that all market 
systems are able to handle anticipated increase message and 
quote traffic, every reasonable effort should be made to move 
ahead on decimal pricing sooner rather than later.
    Thank you.
    [The prepared statement of Holly A. Stark follows:]

PREPARED STATEMENT OF HOLLY A. STARK, DIRECTOR OF TRADING, KERN CAPITAL 
                            MANAGEMENT, LLC

    I would like to thank Chairman Oxley and the other distinguished 
members of the Subcommittee for allowing me the opportunity to share my 
views on the evolving structure of the US equities markets. My name is 
Holly Stark, and I serve as the Director of Trading for Kern Capital 
Management LLC, a position I have held since the end of February. Kern 
Capital is a privately held investment advisor in New York managing in 
excess of $2 billion. Our specialty is small and micro cap growth 
investing. We act as sub-advisor for a number of mutual funds as well 
as manage assets for a roster of clients ranging from ERISA plans to 
college endowments. My trading experience spans 18 years, and I have 
served on advisory committees at the New York Stock Exchange, the 
American Stock Exchange, and Nasdaq. I currently serve on Nasdaq's 
Quality of Markets Committee and the Investment Company Institute's 
Equity Advisory Task Force.
    The US equities markets have changed dramatically during my tenure 
as a trader, with many positive changes taking place in the last few 
years. However, as I have become more familiar with the intricacies of 
market structure and the sometimes-arcane rules that govern our 
markets, I strongly believe that more change is necessary, especially 
if we are to maintain our global preeminence versus other world 
equities markets. While some may consider the changes to be seismic, 
others view it as evolutionary. Whatever the characterization, the 
impact of technology, competition, and new rules that govern our 
markets will result in profound changes that will result in meaningful 
reform.

Market Fragmentation, Internalization and Transparency
    Fragmentation has emerged recently as a major issue in the equities 
markets, with the SEC publishing a concept release 1 
soliciting the views of market participants on the subject. 
Fragmentation occurs when orders trade in multiple market venues 
without interacting with each other. Some have argued that 
fragmentation has increased with the emergence of multiple ECN's, as an 
investor must search out many marketplaces, including those of ECN's, 
where a stock might trade to determine the best price and access 
sufficient liquidity to complete the trade. In a fast-moving, volatile 
market, this exercise becomes extremely difficult, and the difficulty 
increases with the size of the trade. However, functionality has been 
introduced by a number of ECN's to permit a trader to access orders 
across multiple venues, so that those ``fragmented'' bids or offers are 
readily available to execute against. What these tools do not offer is 
the ability to access orders that are internalized by broker-dealers.
---------------------------------------------------------------------------
    \1\  Securities Exchange Act Release No. 42450 (February 23, 2000) 
65 FR 10577 (February 28, 2000) (``Concept Release'')
---------------------------------------------------------------------------
    Internalization occurs when broker-dealers do not expose their 
orders to the marketplace. They are able to buy on the prevailing bid 
and sell on the offer, capturing the posted spread, while never 
accessing or interacting with limit orders displayed in the 
marketplace. The investor who has posted the limit order has in effect 
set a price for other investors to trade at, though he himself will not 
participate in any volume that trades at his displayed price. The limit 
order investor may even have set a new bid or offer when entering his 
order, but internalization practices preclude him from receiving an 
execution--the stock will ``trade around'' him, and he may never fill 
his order at his publicly displayed price. Have the investors whose 
orders are internalized received best execution? Has the limit order 
investor been treated equitably? Such practices, more so than the 
existence of multiple ECN's, reduce market efficiency and serve to 
fragment the market. If an investor is hesitant to display a limit 
order for fear that his order may never be executed, market 
transparency, depth and liquidity may well be compromised.
    Certainly, broker-dealers are not required to display market 
orders; they must execute the order at the best available price in the 
market. With the adoption of the Display Rule by the SEC in1996, 
broker-dealers and market makers are required to immediately, upon 
receipt of a customer's qualified limit order, display the order in 
their quote if it improves the price or adds to the size of their 
quote.
    If the order is not displayed, it must be executed or routed to 
other market centers for display or execution. On May 4, 2000, the SEC 
released a report (Press Release 2000-59) describing violations by both 
market makers and specialists in their handling of customer limit 
orders. The violations included failure to display proper order size 
and failure to display orders within 30 seconds after receipt. 
Surprisingly, the report concluded that the SRO's surveillance and 
enforcement of limit order handling was not up to par.
    SEC Chairman Levitt has been a consistent supporter of limit orders 
and their proper display. He is quoted in the release, ``Limit orders 
have been a powerful force for competition in our markets--narrowing 
spreads, increasing transparency, and supplying liquidity. The report's 
findings of neglect and inattention on the part of some market 
participants to display requirements should be a wake-up call. Market 
participants must redouble their commitment to ensure that the full 
power of limit orders is felt in our markets. Their effect on the price 
setting process simply cannot be compromised.'' Without required limit 
order display, limit order buyers and sellers might be dissuaded from 
placing such orders, compromising market transparency and ultimately 
liquidity.

Central Limit Order Book and Price/Time Priority
    As discussed above, an investor who publicly displays a limit 
orders is not guaranteed an execution, even if stock trades at his 
price, because provisions for price and time priority across markets do 
not exist. The order has no priority over other orders entered later, 
and market centers are not obligated to route orders that would fill 
the investor limit order to another market center. In Nasdaq, the first 
dealer displaying the best bid or offer has no priority over other 
dealers displaying the same bid or offer. On the New York Stock 
Exchange, orders on the specialist book do receive price and time 
priority status, but floor brokers may participate in executions that 
would satisfy orders on the book, in effect jumping the queue that is 
on the specialist book. The floor brokers, standing in the crowd, do 
not have to publicly display to the greater market their trading 
intention. They can merely ``go along'' with other participants and 
benefit from the price ``discovered'' by limit order investors.
    Because of such actions, some have called for the creation of a 
central limit order book, or CLOB, that would consolidate all orders in 
one trading venue, with strict price/time priority in force. Nasdaq's 
proposed Super Montage is a laudable initial step in the right 
direction to provide price and time priority for limit orders, and to 
permit display of a more complete picture of trading interest, not only 
at the inside quote, but at prices several increments away from the 
best bid or offer. Most ECN's already permit a complete ``look at the 
book'' for their users, and all market centers and trading venues 
should be required to permit such information to be readily 
disseminated to investors. While the institution of the Super Montage 
will help to further transparency and fairness in the Nasdaq market, it 
is not a panacea, as it permits internalization of customer orders by 
broker-dealers
    Launching a national CLOB would be problematic. Who would create 
and maintain it? Who would pay for it? Who would regulate it? If all 
market participants were required to participate, would reliance upon a 
single point of entry risk market failure should that single point of 
entry be disabled? Would the fostering of innovation in market 
structure be compromised? Instead a more workable solution would be to 
encourage intermarket linkages that provide for strict price and time 
priority--and preclude any one market center or participant from 
controlling the linkages. Technology would allow for the creation of a 
``virtual'' limit order book that could satisfy the need for price/time 
priority across markets without relying upon a single entity to 
establish and maintain the linkage.
    Web sites currently exist that will search other sites for the best 
price on a particular book or model of computer, with the purchase of 
the book or computer completed with several mouse clicks. A buyer might 
choose one web site over another because one is easier to navigate, or 
has a better delivery timetable. It is not hard to envision similar 
tools, with appropriate regulatory safeguards in place, available to 
all investors. Investors would be able to access all market centers and 
pools of liquidity, without necessitating the intervention of a dealer. 
Would physical trading floors still be needed? If they can provide 
innovative trading solutions for market participants while not 
hampering fair and equal access, there is no reason that physical 
trading floors cannot coexist with electronic markets. The key, however 
is to ensure that price/time priority is afforded to all participants.

Decimal Pricing
    The phase-in of decimal pricing beginning July 3, 2000 that was 
ordered by the SEC at the end of January has been suspended due to 
Nasdaq's lack of preparedness to accommodate decimal prices in their 
systems by the target date. In requesting the delay, NASD Chairman 
Frank Zarb pointed out that Nasdaq volume levels have more than doubled 
and Nasdaq quote message traffic that has more than tripled since 1998.
    US markets have the dubious distinction of being the only markets 
in the world that still trade in fractions. Decimals are far easier to 
comprehend--not many know the decimal equivalent of 17/32's or 59/64's 
without resorting to a calculator. Decimals are already the preferred 
means of operating on many institutional trading desks. Prices reported 
in fractions are immediately converted into decimals when executions 
are entered into order management systems employed by the buy side. 
Real-time prices that flow from quote vendors into electronic blotters 
appear as decimals, not fractions, and end-of-day average prices are 
reported in decimals. Trades are cleared in decimal prices. While it is 
critical that all market systems are able to handle anticipated 
increased message and quote traffic, every reasonable effort should be 
made to move to decimal pricing sooner rather than later.

Conclusion
    Technology can and should play an important role in determining the 
future structure of our markets. Market integration using technological 
innovation should be a priority, and regulatory bodies must weigh 
carefully their role to oversee and regulate markets while not 
hampering market reform. Entrenched practices that are detrimental to 
fair access of markets by all participants must be reformed. Systems 
and linkages that allow for true price and time priority across 
markets, full but anonymous display of supply and demand, and a means 
of allowing unfettered price discovery must be encouraged. 
Internalization, without price improvement, must be discouraged, while 
the display of limit orders that add depth and transparency to the 
market must be afforded the opportunity to interact with all 
participants.
    Perhaps the changes we face are in fact seismic and not 
evolutionary. It is conceivable that a better, faster, fairer and 
cheaper exchange platform that is owned by a foreign entity could 
become a significant force in the trading of US equities. We must not 
let that earthquake happen, but if significant changes are not made in 
the structure of markets as they exist today, we run the risk of losing 
our place as the world's leader in equities trading.
    Thank you for the opportunity to share my views with this 
subcommittee, and I would be pleased to answer any questions that you 
may have.

    Mr. Oxley. Thank you.
    Mr. McSweeney.

                STATEMENT OF ROBERT J. McSWEENEY

    Mr. McSweeney. Chairman Oxley and members of the 
subcommittee, thank you for the opportunity to testify this 
morning. The New York Stock Exchange appreciates the leadership 
on these complex issues and remains committed to assisting in 
your deliberations. This ongoing debate is extremely important 
and will strengthen the competitive position of our Nation's 
equity markets.
    Chairman Oxley, much of my testimony will focus on issues 
that are discussed in detail in the exchanges market structure 
report. A copy of that report is appended to my testimony, and 
I ask that it be included in the record as part of my complete 
statement.
    Mr. Oxley. Without objection.
    Mr. McSweeney. A special committee of the NYSE's board of 
directors composed entirely of public directors produced the 
report which lays out a blueprint that will allow the NYSE to 
evolve into a platform for customer choice. We have labeled 
this continuous process of reinvention ``network NYSE.'' The 
NYSE must provide a market structure that offers investors the 
best execution of their orders. One which is flexible enough to 
accommodate multiple investor objectives including best price, 
the opportunity for price improvement, and low costs as well as 
speed and certainty of execution.
    By next year, the NYSE will unveil two order execution 
systems that will empower investors with greater choices as to 
how to access the NYSE's unrivaled depth of liquidity, 
Institutional Xpress and NYSE Direct+. Institutional Xpress 
will allow institutional investors new ways of accessing the 
NYSE floor. NYSE Direct+ will make available automatic 
execution of smaller trade.
    A related initiative will soon be on-line which is virtual 
NYSE, a realtime virtual representation of the exchange floor. 
A fourth initiative will provide investors access to each 
specialist book of limit orders. The NYSE supports the phasing 
out of three components of the National Market System, NMS. The 
Intermarket Trading System, commonly referred to as ITS, should 
be replaced by industry initiatives to ensure investor access 
to the best available price.
    Second, the Consolidated Tape Association, or as it is 
known, CTA; and the Consolidated Quotation System, commonly 
referred to as CQ, should be replaced by market-based 
initiatives. ITS, CTA, and CQ have all played an important role 
in fostering intermarket competition, and we are not suggesting 
the elimination of the consolidated data or connectivity.
    While the NYSE remains dedicated to the goals of the 
National Market System, we no longer believe that ITS, CTA, and 
CQ are needed to secure those goals. The philosophy of 
competing markets embodied in the National Market System have 
served investors well. We believe, however, that developments 
in communications technology have eliminated the need for a 
government-mandated intermarket order routing system such as 
ITS. The combination of 21st century technology with the 
fiduciary obligation of brokers to achieve best execution, 
warrants a different approach today from the solutions from a 
quarter of a century ago. Today, the electronic systems 
developed by broker dealers themselves make equities trading a 
global operation. When there are insufficient linkages, market 
participants will create their own superior linkages.
    To the extent policymakers believe that ITS continues to be 
needed, membership should require self-regulatory status as 
approved by the SEC. Broker dealers should link to ITS only 
through SROs participating in the ITS plan. This is essential 
in maintaining the integrity of our markets, and governance 
should be consistent with allowing each market to retain 
control over its own business model. In addition, if a market 
executes a majority or even a substantial minority of its 
orders through the ITS, it is probable that those entering 
orders on the alternative system are doing so primarily to free 
ride the liquidity of the competing markets. The NYSE and other 
ITS participants should not be subject to free riding. NYSE 
membership is valuable because of the benefits it confers, 
namely, access to the world's most liquid marketplace.
    CTA and CQ are two other NMS systems that we believe should 
be phased out. Market data must be consolidated and should be 
done at the vendor level by competing consolidation services. 
At the same time, each market should have the right to market 
its data based upon the inherent value of that data. While we 
believe that the SEC has a continuing role in ascertaining that 
these prices are fair and reasonable, we believe that the 
market participants are best suited to judge the value of that 
information for themselves.
    The NYSE continues to be concerned about practices like 
payment for order flow and internalization. We believe that 
these practices promote unproductive fragmentation, diminished 
price discovery, and can benefit intermediaries at the expense 
of investors. Much of the debate over the future of the markets 
has focused on CLOBs. The NYSE would not support such a 
monolithic trading system. We believe it would result in two 
separate pools of liquidity for retail and investor order flow 
and would increase market volatility.
    We should maintain our primary goal, the achievement of 
marketplace connectivity, with competing arenas for order flow 
and guaranteeing best system-wide pricing as our standard. It 
is essential that best execution fostered by connectivity and 
transparency dictate where a customer's order is executed. The 
NYSE is committed to the plan of action they have outlined for 
you. Our competitive position demands nothing less. 
Implementation of cutting edge technology is part of the plan. 
Equally important is permitting technology to provide market-
based answers to problems that once demanded government 
solutions.
    Mr. Chairman, I ask that my complete statement be entered 
in the record and of course would gladly answer whatever 
questions you or the members may have.
    [The prepared statement of Robert J. McSweeney follows:]

 PREPARED STATEMENT OF ROBERT J. MCSWEENEY, SENIOR VICE PRESIDENT, NEW 
                       YORK STOCK EXCHANGE, INC.

    Chairman Oxley, Congressman Towns, and Members of the Subcommittee, 
thank you for the opportunity to testify this morning. The New York 
Stock Exchange appreciates your leadership on these complex issues, and 
remains committed to assisting your deliberations. This ongoing debate 
is extremely important and will strengthen the competitive position of 
our nation's equities markets.

Network NYSE--a platform for customer choice
    Chairman Oxley, much of my testimony will focus on issues that are 
discussed in detail in the Exchange's Market Structure Report. A copy 
of that Report is appended to my testimony and I ask that it be 
included in the record as part of my complete statement.
    A Special Committee of the NYSE's Board of Directors, composed 
entirely of public directors produced the Report, which lays-out a 
blueprint that will allow the NYSE to evolve into a platform for 
customer choice. We've labeled this continuous process of reinvention 
``Network NYSE.'' The NYSE must provide a market structure that offers 
investors the best execution of their orders; one which is flexible 
enough to accommodate multiple investor objectives--including best 
price, the opportunity for price improvement and low costs, as well as 
speed and certainty of execution.
    By next year, the NYSE will unveil two order execution systems that 
will empower investors with greater choices as to how to access the 
NYSE's unrivalled depth of liquidity--Institutional Xpress and NYSE 
Direct+. Institutional Express will allow institutional investors new 
ways of accessing the NYSE floor. NYSE Direct+ will make available 
automatic execution of smaller trades. A related initiative that will 
soon be online is Virtual NYSE, a real-time virtual representation of 
the Exchange floor. A fourth initiative will provide investors access 
to each specialist's book of limit orders.

The National Market System
    The NYSE supports the phasing-out of three components of the 
National Market System (``NMS''). The Intermarket Trading System 
(commonly referred to as ``ITS'') should be replaced by industry 
initiatives to ensure investor access to the best available price. 
Second, the Consolidated Tape Association (or as it known ``CTA'') and 
the Consolidated Quotation System (commonly referred to as ``CQ'') 
should be replaced by market-based initiatives. ITS, CTA and CQ have 
all played important roles in fostering inter-market competition, and 
we are not suggesting the elimination of consolidated data or 
connectivity. While the NYSE remains dedicated to the goals of the 
National Market System, we no longer believe that ITS, CTA and CQ are 
needed to secure those goals.
    The philosophy of competing markets embodied in the National Market 
System has served investors well. We believe, however, that 
developments in communications technology have eliminated the need for 
a government-mandated intermarket order-routing system such as ITS. The 
combination of 21st Century technology with the fiduciary obligation of 
brokers to achieve best execution warrants a different approach today 
from the solutions of a quarter century ago.
    Today, the electronic systems developed by broker-dealers 
themselves make equities trading a global operation. When there are 
insufficient linkages, market participants will create their own 
superior linkages.
    To the extent that policy makers believe that ITS continues to be 
needed, membership should require self-regulatory status as approved by 
the SEC. Broker-dealers should link to ITS only through SROs 
participating in the ITS plan. This is essential to maintaining the 
integrity of our markets, and governance should be consistent with 
allowing each market to retain control over its own business model.
    In addition, if a ``market'' executes a majority, or even a 
substantial minority, of its orders through the ITS, it is probable 
that those entering orders on that alternate system are doing so 
primarily to ``free-ride'' the liquidity of competing markets. The NYSE 
and other ITS participants should not be subject to free-riding. NYSE 
membership is valuable because of the benefit it confers--namely, 
access to the world's most liquid marketplace.
    CTA and CQ are two other NMS systems that we believe should be 
phased-out. Market data must be consolidated--but that can and should 
be done at the vendor level by competing consolidation services. At the 
same time, each market should have the right to market its data, based 
on the inherent value of that data. While we believe that the SEC has a 
continuing role in ascertaining that these prices are fair and 
reasonable, we believe that market participants are best-suited to 
judge the value of that information for themselves.

Other issues
    The NYSE continues to be concerned about practices like payment for 
order flow and internalization. We believe that these practices promote 
unproductive fragmentation, diminished price discovery, and can benefit 
intermediaries at the expense of investors.
    Much of the debate over the future of the markets has focused on 
``CLOBs.'' The NYSE would not support such a monolithic trading system. 
We believe that it would result in two separate pools of liquidity for 
retail and institutional order flow, and would increase market 
volatility. We should maintain as our primary goal the achievement of 
marketplace connectivity--with competing arenas for order flow and 
guaranteeing best system-wide pricing as our standard. It is essential 
that best execution, fostered by connectivity and transparency, dictate 
where a customer's order is executed.

Conclusion
    The NYSE is committed to the plan of action that I have outlined 
for you. Our competitive position demands nothing less. Implementation 
of cutting-edge technology is part of the plan. Equally important is 
permitting technology to provide market-based answers to problems that 
once demanded government solutions.
    Mr. Chairman, I ask that my complete statement be entered in the 
record, and of course, would gladly answer whatever questions you or 
the members may have.

    Mr. Oxley. Thank you, Mr. McSweeney.
    Mr. Ketchum?

                STATEMENT OF RICHARD G. KETCHUM

    Mr. Ketchum. Thank you, Chairman Oxley. I want to thank 
very much the committee for giving me the opportunity to 
testify on the competition of the new electronic market, and I 
want to compliment you, Mr. Chairman, on focusing attention on 
these critically important issues.
    In today's trading environment, investors want to know in 
realtime the prices at which securities can be bought and sold. 
They want that information simple and in one place, and they 
want rapid executions at the lowest cost possible. The NYSE 
believes that transparency, execution quality, and competition 
among intermediaries and markets will propel the market overall 
to fulfill these fundamental principles.
    The SEC's order-handling rules took a major step in 
enhancing market transparency by requiring the customer limit 
orders be displayed immediately. In the NASDAQ market, these 
rules have helped to enhance transparency, increase 
competition, narrow quotation spreads and meet market makers 
and ECNs and their customers. NASDAQ's market structure also 
provides open, efficient, and quick access to deep pools of 
liquidity. NASDAQ promotes price discovery through a system 
where multiple market makers risk their capital and compete for 
order flow.
    We believe that this competition combined with immediate 
electronic executions has been critical to NASDAQ's ability to 
respond to the speed and market liquidity demands posed by the 
explosion of on-line trading. NASDAQ is also the only market in 
the United States which fully integrates ECNs, those entities 
which open their electronic books to investors and allow them 
to advertise prices at which they are willing to trade. 
Investors benefit directly from this innovation and competition 
through dramatically reduced commissions and other trading 
costs.
    In fact, I also want to compliment you and indicate how 
pleased I am to participate on this panel with representatives 
from both the investor community and the broker community, all 
of which either directly or through their firms provide an 
important contribution to the NASD and NASDAQ in evaluating 
many of these issues.
    While NASDAQ has been successful in integrating both ECNs 
and market makers into a single highly transparent high speed 
environment, additional progress should be made. That is why 
NASDAQ has proposed the addition of an order display window, 
often referred to as the Super Montage. In today's market 
environment of multiple ECNs, lower trading increments, and on-
line trading, it is not enough to provide a consolidated 
picture of just the best bids and offers. The Super Montage, 
which is pending approval by the SEC, will allow market 
participants to view the best bid and offer and two price 
levels away.
    Market makers and ECNs will be permitted, but not required, 
to display their customer and proprietary orders at each of 
these price levels. Super Montage also will be open to any 
exchange wishing to compete in NASDAQ securities. The Super 
Montage should help to reduce fragmentation and enhance 
transparency by encouraging investors to show greater size in 
the NASDAQ market and allowing market participants to see a 
more complete view of the depth of that market. I should note 
in that connection that, indeed, as was stated earlier, with 
respect to the real parties at interest, the investors, it is 
interesting to note that a recent independent study developed 
and conducted by the institutional committee of the Stock 
Traders Association, 89 percent of those responding to the 
study, those institutional investors, favored the 
implementation of the Super Montage without suggesting that 
they may also favor additional market structure changes in the 
market.
    The Super Montage is built on the general premise that 
orders placed in the system should be executed based on price 
and time priority. I would believe that strict adherence to 
price time priority across all markets, market makers, and ECNs 
would unnecessarily limit broker dealers flexibility to provide 
a complete mix of execution services to meet their customers' 
needs. This flexibility is particularly critical in the new on-
line trading world where investors demand immediacy, low cost, 
and liquidity. The NASD believes the Super Montage will 
provide, at least as a first step, a preferable market 
structure solution to fragmentation than more radical 
structural changes such as proposals to implement a 
consolidated limit order book, or CLOB, which would remove some 
of the flexibility to innovate the market professionals now 
have.
    In sum, we believe that to satisfy investors needs in the 
e-commerce world, market structure must be both open and 
inclusive, not closed and exclusive. NASDAQ Super Montage is 
open and inclusive and, therefore, responds to investors' 
needs.
    Again, I want to thank the subcommittee for allowing me to 
come here today, and I would be happy to answer any questions.
    [The prepared statement of Richard G. Ketchum follows:]

     PREPARED STATEMENT OF RICHARD G. KETCHUM, PRESIDENT, NATIONAL 
                ASSOCIATION OF SECURITIES DEALERS, INC.

                              INTRODUCTION

    I want to thank the Committee for giving me the opportunity to 
testify on competition in the new electronic market. As a pioneer of 
electronic commerce, Nasdaq has been at the forefront of the electronic 
commerce revolution. It is no coincidence that many of the companies 
that are leading this revolution--Intel, Microsoft, Cisco Systems, 
Yahoo!, Dell, and Amazon.Com--to name just a few, choose to list on 
Nasdaq. These pioneers of the electronic age understand that for 
electronic commerce to flourish, it must be conducted in an atmosphere 
that promotes robust competition and innovation. What is true for the 
marketplace at large is equally true for U.S. capital markets. To 
promote vibrant capital markets, we must ensure that they remain 
transparent, provide a fair and efficient means for investors to access 
deep pools of liquidity and remain open to innovation.
    I believe that Nasdaq's success is a testament to its ability to 
provide such a market structure. Indeed, Nasdaq currently accounts for 
more than one-half of all equity shares traded in the nation and is the 
largest stock market in the world in terms of dollar value of shares 
traded. Nasdaq lists the securities of over 4,700 domestic and foreign 
companies, more than all other U.S. stock markets combined. There are 
over 70 million investors in Nasdaq companies. In the first quarter of 
2000 Nasdaq's average daily volume reached a record of 1.8 billion 
shares, an increase of 81.8 percent from the first quarter of 1999 and 
a gain of 33.6 percent from the fourth quarter of 1999. On February 17, 
2000, Nasdaq's volume exceeded two billion shares for the first time. 
Subsequently, Nasdaq experienced nine additional days in the first 
quarter of 2000 when daily volume surpassed 2 billion shares.
    I believe that Nasdaq has achieved this success by providing a high 
speed, electronic market that is open to all market participants, is 
transparent, encourages competition, and promotes innovation. I posit 
that these attributes should serve as yardsticks by which we measure 
how successful our securities markets are in promoting the capital 
formation that is fueling the electronic age. Today I will discuss some 
of the ways in which I believe that Nasdaq's current market structure 
helps to promote competition in the electronic market. In addition, I 
will discuss some of the innovations Nasdaq is developing to better 
serve the needs of all market participants.

                    OVERVIEW--WHAT DO INVESTORS WANT

    In today's trading environment, as always, investor interests are 
paramount. Investors want to know in real time the prices at which 
securities can be bought and sold. They want that information assembled 
in one place, so that they have complete information on which to make a 
trading decision. When an investor decides to trade, he or she expects 
to be able to obtain a rapid execution at the best displayed price and 
at the lowest cost possible. Thus, the markets and their intermediaries 
need to create structures and systems that facilitate these investor 
demands. The NASD believes that transparency, execution quality, and 
competition among intermediaries and markets will propel the market 
overall to fulfill these fundamental principles. The NASD firmly 
believes that, as explained below, Nasdaq provides to investors today 
what others are trying to build for tomorrow.

                              TRANSPARENCY

    Transparency is one of the keys to Nasdaq's success. Transparency 
is the ability of market participants to determine from all markets the 
best available price and the size or depth of that interest. 
Transparency is critical to the maintenance of fair and orderly markets 
and is a key to the success of any market structure. The SEC's Order 
Handling Rules require that customer limit orders be displayed 
immediately. The enhanced transparency brought about by these rules has 
increased competition in the Nasdaq Stock Market by allowing customers 
that choose to do so to set the inside quotation spread. This increased 
competition naturally reduces quotation spreads and allows investors to 
obtain better prices for their securities.
    The Order Handling Rules also help to ensure that no matter where a 
limit order is displayed, whether it be in Nasdaq or in an Electronic 
Communications Network or ECN, that order will be accessible to all 
investors. Gone are the days when ECNs stood as ``private markets'' for 
the fortunate few where large institutions and market professionals 
could access better prices than were available to the public at large. 
The Order Handling Rules have helped Nasdaq to link market makers and 
ECNs and all of their customers to ensure that the best prices for 
Nasdaq securities are publicly disseminated.

             OPEN, EFFICIENT AND QUICK ACCESS TO LIQUIDITY

    Another key component of Nasdaq's market structure that promotes 
competition and capital formation is its ability to provide open, 
efficient and quick access to deep pools of liquidity. It is not enough 
that investors see the best prices that are available in the market. 
They must also be able to obtain those prices and do so quickly at a 
low cost. Nasdaq's market structure provides all of these benefits. 
Nasdaq was founded on the premise that the best way to promote price 
discovery in the securities markets is through a system where multiple 
market makers risk their capital and compete for order flow. This 
competition combined with every broker-dealer's responsibility to 
obtain best execution for its customers' orders was viewed as the 
optimal way to create a fair and efficient marketplace. Nasdaq's system 
is also open to ECNs, which open their electronic order books to 
investors and allow those investors to advertise prices at which 
investors and market professionals are willing to trade. No other 
market in the world has set up a structure like this.
    By linking competing dealers and ECNs electronically rather than 
through a physical trading floor, Nasdaq helps to ensure that spatial 
considerations alone are not a factor in determining the number of 
firms that may provide liquidity to the Nasdaq market. As a result, 
Nasdaq has dozens of competing market makers and ECNs in many of its 
most actively traded stocks, which provide dozens of sources of 
liquidity and dozens of opportunities for innovation. Investors have 
benefited directly from this innovation and competition through 
dramatically reduced commissions and other trading costs.
    Moreover, through its various facilities, Nasdaq provides a broad 
array of choices for investors to access the pools of liquidity 
provided by Nasdaq's multiple market makers and ECNs. For over a 
decade, investors have been able to obtain what is often an 
instantaneous electronic execution of an order at the best publicly 
displayed price through Nasdaq's Small Order Execution System or SOES. 
Since 1997, Nasdaq's SelectNet system has allowed market participants 
to rapidly and electronically reach the quotations displayed in 
Nasdaq's deep and abundantly populated Quote Montage. This year, Nasdaq 
is enhancing SOES to provide for automatic execution of orders up to 
9900 shares and to allow market professionals to enjoy automatic 
executions. We are confident that SuperSOES will be a great boon to 
investors by helping them to receive automatic executions for large 
orders at a single price.
    But investors that wish to obtain a rapid automatic execution are 
not limited to the SOES system. Under Nasdaq's approach to its market 
structure, individual market makers have the flexibility to offer their 
own automatic execution guarantees and often are willing to do so for 
size that exceeds that which is displayed in the market. In this way, 
market liquidity and efficiency of execution are enhanced dramatically 
for investors using the services of these market makers.
    For investors who are more interested in seeking price improvement 
than an automatic execution at the best publicly displayed price at a 
given time, Nasdaq will continue to provide SelectNet, its facility for 
negotiating prices. SelectNet will also continue to play the important 
role of linking ECNs to the Nasdaq market. Like market makers, ECNs 
provide an important source of liquidity for Nasdaq stocks. ECNs also 
provide innovative means for moving securities positions, not the least 
of which is anonymity. By trading anonymously institutions and other 
large investors, such as pension funds, can trade in and out of large 
positions without signaling other market participants and thereby risk 
impacting a security's price to the investor's detriment.

                             SUPER MONTAGE

    While I believe that Nasdaq's market structure is the best suited 
for promoting competition in an electronic age, I also understand that 
its continued success depends on its ability to remain innovative and 
adapt to the ever-changing marketplace. To help Nasdaq stay at the 
forefront of e-commerce, it is developing a number of innovations that 
are designed to improve Nasdaq's market structure. One of the more 
important of these is known as the ``Super Montage.''
    The Super Montage, which is pending approval by the SEC, will allow 
market participants to view the best bid and offer and two price levels 
away from the best bid and offer in Nasdaq securities. Market makers 
and ECNs will be permitted but not required to display their customer 
and proprietary orders at each of those price levels. The Super Montage 
also will permit exchanges granted Unlisted Trading Privileges to 
Nasdaq securities (``UTP Exchanges'') to display their customer orders 
at each of those price levels.
    The Super Montage also will permit market participants to indicate 
a reserve size for an order, which is additional depth that is ``in the 
wings'' so to speak, waiting for the right market conditions before it 
will be available for interaction with other trading interest. Reserve 
size should help to bring larger orders, which are now often executed 
``upstairs,'' down to interact with the rest of the marketplace.
    While participation in the Super Montage is voluntary, Nasdaq is 
confident that its many advantages will encourage a broad range of 
market participants to use the system. For instance, the system should 
help to reduce fragmentation by allowing market participants to 
transmit to Nasdaq multiple levels of orders and aggregate and 
dynamically display all orders at the inside price and two price levels 
away. The system's ``non-attributable'' order feature encourages market 
participants to show greater size in Nasdaq, rather than disbursing 
that size over several trading venues to avoid adverse market impact. 
Moreover, market participants will see for the first time in the Super 
Montage a more complete view of the depth of the inside market and two 
price levels away, thereby enhancing transparency.
    The SuperMontage is built on the general premise that orders placed 
in the system should be executed based on price/time priority. At the 
same time, however, we believe that strict adherence to the principle 
of price/time priority across all markets, market makers and ECNs would 
unnecessarily limit broker-dealers' flexibility to provide a creative 
mix of execution services to meet their customers' needs in a manner 
that is consistent with the duty of best execution. It is Nasdaq's 
belief that, as long as no order is executed at a price worse than that 
which is publicly displayed, market makers and ECNs should continue to 
have the flexibility to interact with their own order flow. We believe 
that this flexibility is particularly critical in the new on-line 
trading world where investors demand immediacy, low cost, and 
liquidity. Some market makers have responded to these demands by 
providing guaranteed executions up to two thousand shares at the best 
bid or offer or better regardless of the displayed quotation size. Some 
ECNs have responded to these needs by providing low cost crossing 
executions in their systems and sophisticated order routing algorithms 
into Nasdaq for orders that the ECN cannot execute. These innovations 
benefit investors daily and care should be taken with respect to any 
actions that might deprive investors of these valuable execution 
services.
    With the addition of the Super Montage, Nasdaq will be able to link 
all markets, including UTP exchanges, that trade Nasdaq securities. In 
this way, the Super Montage should encourage competition by providing 
an open and inclusive model in which competing market centers may 
operate. While the Super Montage proposal provides a central means for 
accessing liquidity in Nasdaq securities, it in no way establishes the 
Nasdaq system as the sole means for providing or accessing liquidity. 
NASD members (including market makers, ECNs and order entry firms), 
individual investors, and members of other exchanges will be free to 
route their orders to, and access pools of liquidity in, any linked 
market center trading Nasdaq securities. We believe that all of these 
attributes make the Super Montage a strong means for combating what 
many perceive as a fragmenting of our securities markets.
    In this connection, the NASD believes that the Super Montage will 
provide a preferable market structure solution to fragmentation than 
more radical structural changes, such as a composite CLOB. Many 
variations of a CLOB have been discussed over the past several months. 
One such approach would effectively link all markets' limit order books 
and dealer quotations by requiring that all displayed trading interest 
be executed according to strict price and time priority. Although in 
theory executions could occur at the local market level, we believe 
that in practice such a proposal would require the creation of a 
national utility, which would sacrifice marketwide competition at a 
cost that would outweigh the benefit to be derived from such a 
proposal.
    It is our belief that a system based on strict price/time priority 
may disadvantage investors by funneling all market orders toward a 
single liquidity source, whether it be a customer limit order or a 
dealer quotation. Investors would be required to wait to determine 
whether they had received an execution. If they did not, they would be 
forced to route their orders to the next trading venue that displayed 
the best price with time priority. This process of chasing liquidity 
would slow down the trading process and greatly reduce the likelihood 
of obtaining an automatic execution.
    A proposed solution to this problem, which we believe would be even 
more chilling, would be the creation of a composite CLOB. Unlike 
Nasdaq's current market structure and the structure it will enjoy with 
the Super Montage, however, a strict price time priority CLOB could not 
by its nature offer the flexibility for multiple competing liquidity 
sources, all of which could offer an automatic execution at a 
guaranteed minimum size at the best publicly displayed price. Moreover, 
strict time priority would preclude market makers from interacting with 
their own order flow and therefore remove an important incentive for 
risking capital and providing an innovative service mix that includes 
automatic execution at a minimum guaranteed size.
    We believe that Nasdaq's current market structure and the proposed 
Super Montage will address many of the concerns raised about 
fragmentation while continuing to provide incentives to liquidity 
providers and choices for liquidity seekers. Because the Nasdaq system 
provides incentives for market makers to continuously display 
quotations and provide immediate guaranteed executions in size to 
investors, it has been able to respond to the revolutionary demands of 
the online trading world. Mandatory CLOBs and system-wide time priority 
requirements do not effectively incorporate or provide incentives for 
multiple market makers and ECNs who now provide liquidity and immediate 
executions on Nasdaq, and who thus help to ensure that investors have 
quick and easy access to the markets in good times and in bad. In sum, 
our view is that to satisfy investor needs in an e-commerce world, 
market structure must be open and inclusive, not closed and exclusive. 
Nasdaq's Super Montage is open and inclusive and, therefore, responds 
to investor needs.

                           OTHER INITIATIVES

    In our view, the Super Montage will provide the most benefits to 
investors and to market participants if it is carried out under a 
corporate structure that can respond nimbly to competitive and 
technological changes in the marketplace. That is why the NASD Board 
and its members approved a restructuring plan that is designed to 
enhance the competitiveness of Nasdaq, while reducing members' 
regulatory costs and strengthening NASD Regulation.
    Nasdaq is also committed to building on our successful domestic 
stock market model internationally. As a result, we continue to explore 
overseas ventures and alliances with market participants abroad with 
the ultimate goal of providing investors with rapid, open, low cost 
access to deep pools of liquidity around the world.

               ITS, CQA AND CTA PARTICIPATION BY NON-SROS

    Now I would like to turn to two related issues addressed in the 
Subcommittee's invitation letter: the desirability of opening the 
Intermarket Trading System to membership by non-self-regulatory 
organization market participants and whether the Consolidated Quotation 
Association and Consolidated Tape Association should permit competition 
in market data by non-SROs. First, we share the general frustration of 
all market participants with ITS, which is clearly technologically 
outmoded, a trading hindrance that Nasdaq and the Cincinnati Stock 
Exchange have been able to reduce somewhat by offering automatic 
executions for ITS commitment. As the Subcommittee may know, Nasdaq and 
its members were hampered for over twenty years with limited access to 
all of the securities traded through ITS. Recently, however, the rules 
restricting Nasdaq's access to ITS as well as NYSE Rule 390 (which 
restricted off-board trading of certain listed companies) were 
rescinded, thereby creating a more level playing field between Nasdaq 
and the listed markets. Therefore, the NASD believes that it is time to 
make a concerted effort to improve the way markets access each other. 
For its part, the NASD has already adopted rules and developed 
technology to open its NYSE-listed trading facilities to a broader 
array of market participants. The NASD has opened its facilities to 
ECNs as well as registered market makers and thus opened access to ITS 
and the Consolidated Quotation System to ECNs, which may now 
participate in these systems.
    The question raised by the Subcommittee, however, is whether 
individual broker-dealers, including ECNs, should directly display 
their quotes and trade in these national market systems. ITS membership 
is currently limited to the NASD and registered national securities 
exchanges, all of which are registered with the SEC as SROs. As such, 
the SROs are required to establish and maintain regulatory programs to 
ensure that their members act in accordance with the requirements of 
the ITS Plan and the federal securities laws, including the rules of 
the SROs, which are adopted under those laws. To open membership to the 
ITS to entities that are not subject to those same regulatory 
safeguards could create a regulatory gap for orders that are routed 
through ITS to a non-SRO.
    With respect to CTA and CQA membership, the fees that are generated 
from such membership are used to offset the costs of regulation. 
Marketplaces that are not subject to the same regulatory burden but 
that enjoy the fees derived from CTA and CQA membership would enjoy a 
windfall. The NASD is not, as a matter of principle, opposed to 
expanded membership in these National Market System plans, but it must 
be done on a level playing field. Thus, if an entity providing a 
trading venue wants to operate as a registered SRO, like the other 
National Market System Plan participants, it should be able to 
participate fully in CTA, CQA and ITS. On the other hand, if that 
entity determines that its business model is better served by being a 
broker-dealer, it should only participate in these plans as a member of 
one of the SROs that is a direct participant.

                                DECIMALS

    Finally, I wanted to address the possible benefits that the move to 
decimals is likely to have for investors. First, let me say that the 
NASD's decision to request an extension of the SEC's July 3, 2000, 
target date for starting the implementation of decimals was not one 
that we took lightly. As you know, the NASD supports the move to 
decimals. I believe that it should benefit investors by making 
securities prices easier to understand and by keeping the U.S. 
securities markets competitive with major markets abroad, which quote 
in decimals already. Therefore, I wanted to give you my assurance that 
the NASD is committed to building the necessary capacity enhancements 
to ensure that the move to decimals occurs as quickly and safely as 
possible.

                               CONCLUSION

    Again I wanted to thank the Subcommittee for allowing me to come 
here today to share the NASD's views on competition in the electronic 
market. It is a subject that is at the very core of the existence of 
the NASD and the Nasdaq Stock Market. I believe that Nasdaq's market 
structure is the best model for continuing to promote the type of 
capital formation that has been so important for the development of our 
electronic age. I would ask that you join me in encouraging the 
transparency, openness, and accessibility that have been the hallmark 
of Nasdaq.
    Thank you, and I will be happy to answer any questions that you may 
have.

    Mr. Oxley. Thank you.
    Mr. Jenkins?

                 STATEMENT OF PETER W. JENKINS

    Mr. Jenkins. Chairman Oxley and members of the 
subcommittee, thank you. I would like to thank you for this 
opportunity to express my views on competition in the new 
electronic marketplace and the structural changes taking place 
in the equity markets today. I am director of Global Equity 
Trading at Scudder Kemper Investments, managing approximately 
$280 billion. With the limited time, though, I have today 
before this committee, I would like to focus my attention on 
three areas that I believe are most important in shaping the 
future of the electronic marketplace.
    First is protection of limit orders, second is transparency 
of markets, and the third, of course, is the linkage of the 
trading venues and exchanges.
    On the protection of limit orders, limit orders are the 
basis for pricing securities in the markets today. On the New 
York Stock Exchange and the regional exchange, limit orders 
reside on the specialist book. These orders allow for floor 
brokers to determine strong levels of supply and demand. They 
allow specialists and position traders off the floor to make 
bigger markets for their customers, who allow for greater 
liquidity for institutional and retail customers.
    The institutional buyside traders rely on the limit orders 
to help price blocks of stocks for their clients. These limit 
orders allow the institutional trader a reference so we can be 
realistic when approaching upstairs position traders or 
specialists when we request the use of their capital. Limit 
orders also offer quantitative traders the ability to size up a 
market and offer traders over entire portfolios because these 
orders are firm and real.
    In the over-the-counter market, the success of the ECNs was 
built on limit orders. Traders from both the buyside and 
sellside migrated to these systems because of the existence of 
those orders and rules protecting them. Because of the limit 
order facility, ECNs have captured greater than 20 percent of 
the over-the-counter market. Why don't we try to protect these 
orders in all venues? These orders are the backbone of the 
future virtual marketplace. If protected these orders could be 
successful in increasing the depth and structure of the market.
    Today, in the listed marketplace when an offer is too large 
on one exchange, we allow trades to take place at the same 
price on an exchange where there is less depth. On the New York 
Stock Exchange, we have created rules such as the Clean Cross 
Rule that allows the trader to shut out a bid or an offer as 
long as the size you want to trade is greater, and this rule 
was actually put in place to try to keep block flow on that 
exchange. On the floor of the New York Stock Exchange after a 
hundred shares trade at a specific price, the crowd splits 
evenly afterwards. Nothing to support price improvement.
    In the over-the-counter market, the best bids and offers 
displayed by dealers as well as the best bids and offers posted 
on ECNs is not protected. This practice is known as 
internalization of order flow, as stocks are crossed outside of 
those markets. Close to a third of all NASDAQ orders are 
internalized. Wholesalers are paying for the order flow to 
trade against the limit orders and markets exposed. This 
practice has become very profitable for the wholesalers.
    The SROs seem to be protecting this practice instead of 
encouraging order interaction. If institutional limit orders 
were given greater protection, traders would populate these 
limit order books. Limit order transparency has been argued for 
many years. I served on the New York Stock Exchange 
Institutional Traders Advisory Committee as chairman in the 
early 90's. A look at the specialist book was the No. 1 focused 
topic on that committee for my tenure. We are just getting 
around to this issue today. As the markets move to 
decimalization, it will be imperative for the institution to 
see below the top of the book.
    The ECN success is also due to its transparency. The 
trading information gained through seeing orders interact on 
the limit order book allow for the institutional trader to make 
a more informed trading decision. Decimalization will move the 
most liquid stocks to one penny spreads over time. The volumes 
will increase as the spreads tighten. The need to see where the 
large orders reside will be most important to the institutional 
trader. With this depth of book, inefficiencies of access will 
erode the competitive positions of the primary exchange.
    Last, linkages, Scudder Kemper Investments supports the 
concept of a virtual global limit order facility. To achieve 
this, the most important aspect of efficient market structure 
will be the linkage between the ECNs, the exchanges, and the 
crossing networks. Competition will force systems with weak 
linkage out of business. Firms with less than adequate 
technology should not be subsidized by the industry. To move to 
a virtual limit order book and to protect limit orders in the 
different trading venues, linkages need to be efficient and 
meet minimum technological standards.
    I applaud the New York Stock Exchange for its proposed 
automatic execution system through Institutional Xpress. 
Although it is just the start, institutions as well as retail 
investors need direct electronic access to these limit order 
facilities. If the inefficient Super Dot system has been a 
problem and often when transmitting an order, you do not 
receive what you expect. ITS links the various exchange quotes, 
but does not allow for time priority across its markets. With 
the Archipelago and Pacific Coast Stock Exchange combination, 
we hope to see the first steps in efficient linked market with 
price/time priority without the involvement of specialists or 
the dealer.
    Mr. Oxley. Would you summarize.
    Mr. Jenkins. In the long term, Scudder Kemper Investments 
would like to see protection across all markets of all limit 
orders and price time priority. If the linkages do not allow 
interaction, we at the very least would like to see price time 
priority in each trading venue with trade through rules.
    We support a regulatory focus on order interaction. We are 
concerned with the wholesalers' increased practice of 
internalization without price improvement. This trend could 
undermine transparency and support for limit order exposure. 
The fragmentation of the equity markets is the product of 
technological innovation and competition. The industry is 
dealing with this through electronic connectivity.
    We support speedy conversion to decimals, but decimals 
without a fully transparent book will be problematic. The quick 
move to decimals will allow for less confusion, tighter 
spreads, and may help generate a stronger limit order book. 
Depth of book use is needed and should be made available to all 
market participants. Thank you very much.
    [The prepared statement of Peter W. Jenkins follows:]

  PREPARED STATEMENT OF PETER W. JENKINS, MANAGING DIRECTOR, HEAD OF 
           GLOBAL EQUITY TRADING, SCUDDER KEMPER INVESTMENTS,

    Chairman Oxley and members of the subcommittee on Finance and 
Hazardous materials, my name is Peter Jenkins, I am the Director of 
Global Equity Trading at Scudder Kemper Investments. I would like to 
thank you for this opportunity to express my views on competition in 
the new electronic market place and the structural changes taking pace 
in the equities markets.
    Scudder Kemper Investments leads the Global Investments management 
business of the Zurich Financial Group. With more than $280 billion 
currently under management and almost 80 years of experience Scudder 
Kemper Investments is among the world's largest and most experienced 
asset managers. Scudder Kemper's client base includes institutions, 
individual investors and financial intermediaries worldwide. We trade 
equities in sixty-nine different markets around the globe and staff a 
22-hour trading desk out of our offices in New York City.
    I have been involved in equity market structure issues since 1988 
when I was asked to be on the NYSE market performance committee, and 
the NASDAQ institutional Committee. I served as Chairman for both the 
NYSE Institutional Traders Advisory Committee and the STA Institutional 
Committee. I have been trading equities since 1980 and have experienced 
a great deal change.
    With the limited time I have before this committee I would like to 
focus my attention on three areas that I believe are most important in 
shaping the future electronic market: 1. Protection of Limit Orders; 2. 
Transparency of markets; and 3. Linkage of trading venues and 
exchanges.

                       PROTECTION OF LIMIT ORDERS

    Limit orders are the basis for pricing securities in the markets 
today. On the New York Stock Exchange and the regional exchanges limit 
orders reside on the specialist book. These orders allow for floor 
brokers to determine strong levels of supply and demand. They allow 
specialists and position traders off the floor to make bigger markets 
for their customers who allow for greater liquidity for institutional 
and retail customers.
    Institutional Buyside traders rely on limit orders to help price 
blocks of stocks for their clients. These limit orders allow the 
institutional trader a reference so we can be realistic when 
approaching ``upstairs position traders,'' or specialists when we 
request the use of their capital.
    Limit orders offer quantitative traders the ability to size up a 
market and offer trades over entire portfolios, because these order are 
firm and real.
    In the over the counter market the success of the ECN's was built 
on limit orders. Traders from both the buyside and the sellside 
migrated to these systems because of the existence of those orders and 
rules protecting them. Because of the limit order facility, ECN's have 
captured greater than 20 percent of the Over the Counter Market.
    Why don't we try to protect these orders in all venues? These 
orders are the backbone of the future virtual market place. If 
protected these orders could be successful in increasing the depth and 
structure of the market.
    Today in the Listed market place, when a bid or offer is too large 
on one exchange we allow trades to take place at the same price on an 
exchange where there is less depth.
    On the New York Stock Exchange we have created the ``clean cross 
rule'' that allows a trader to ``shut out'' a bid or offer as long as 
the size you want to trade is greater. This rule was actually put in 
place to try to keep block order flow on that exchange. On the floor of 
the New York Stock Exchange after 100 shares trade at a specific price 
where there are limit orders the crowd splits each new trade at that 
price equally.
    In the Over the Counter market the best bids and offers displayed 
by dealers, as well as the best bids and offers posted on ECN's, are 
not protected. This practice is known as internalization of order flow. 
Close to a third of all NASDAQ orders are internalized. Wholesalers are 
paying for order flow to trade against the limit orders and markets 
exposed. This practice has become very profitable for these 
wholesalers. The SRO's seem to be protecting this practice instead of 
encouraging order interaction.
    If institutional limit orders were given greater protection traders 
would populate the limit order books.

                        TRANSPARENCY OF MARKETS

    Limit order transparency has been argued for many years. I served 
on the New York Stock Exchange Institutional Traders Advisory Committee 
as Chairman in the early 90's. A look at the specialist book was the 
number one focus topic on that committee for my tenure. As the markets 
move to decimalization it will be imperative for the institution to see 
below the top of the book.
    The ECN's success is also due to its transparency. The trading 
information gained through seeing orders interact with the Limit book 
allow for the institutional trader to make a more informed trading 
decision.
    Decimalization will move the most liquid stocks to ``one penny'' 
spreads over time. The volumes will increase as the spreads tighten. 
The need to see where the larger orders reside will be most important 
to the institutional trader. Without this depth of book, inefficiencies 
of access will erode the competitive positions of the primary exchange.

                LINKAGE OF TRADING VENUES AND EXCHANGES

    Scudder Kemper Investments supports the concept of a virtual global 
limit order facility. To achieve this, the most important aspect of 
efficient market structure will be the linkage between the ECN's, 
exchanges and crossing networks. Competition will force systems with 
weak linkage out of business. Firms with less than adequate technology 
should not be subsidized by the industry. To move to a virtual limit 
order book, and to protect limit orders in the different trading 
venues, linkages need to be efficient and meet minimum technological 
standards.
    I applaud the New York Stock Exchange for its proposed automatic 
execution system through Institutional Express. Institutions as well as 
retail investors need direct electronic access to limit order 
facilities. The inefficient Super Dot system has been a problem, and 
often when transmitting an order you do not receive what you think you 
will get. ITS links the various exchange quotes but does not allow for 
Price Time Priority, across the markets. With the Archipelago and 
Pacific Coast Stock Exchange combination, we hope to see the first 
steps to an efficient linked market with Price Time Priority without 
the involvement of the specialist as dealer.
    The move by ECN's to set up direct efficient linkages to pools of 
liquidity is a promising step for buyside trading desks. Maybe these 
direct linkages will offer competition to the NASDAQ SelectNet system, 
which to date has proven less than adequate.

                        SOLUTIONS AND CONCLUSION

    In the long term Scudder Kemper Investments would like to see 
protection across markets of limit orders in Price Time Priority. If 
the linkages do not allow interaction we would at the very least like 
to see Price Time Priority in each trading venue with trade through 
rules.
    We support a regulatory focus on order interaction. We are 
concerned with the Wholesalers increased practice of internalization 
without price improvement. This trend could undermine transparency and 
support for limit order exposure. The fragmentation of the Equity 
Markets is the product of technological innovation and competition. The 
industry is dealing with this through electronic connectivity.
    We support a ``speedy conversion'' to decimals. But decimals 
without a fully transparent book will be problematic. The quick move to 
decimals will allow for less confusion, tighter spreads and may help 
generate a stronger limit order book.
    Depth of book in all venues is needed, and should be made available 
to all market participants.
    Thank you very much for this opportunity to offer my views on 
market structure to this sub-committee.

    Mr. Oxley. Thank you, Mr. Jenkins.
    Mr. Kamen.

                 STATEMENT OF KENNETH A. KAMEN

    Mr. Kamen. I would like to thank Chairman Oxley, Mr. Towns, 
and Mr. Greenwood for the opportunity to testify on these 
critical issues. I am testifying today as the chairman of the 
board of the Regional Investment Bankers association and on 
behalf of the small issuer marketplace we service. While Wall 
Street's largest brokerage firms and investment banks have 
lobbied the Securities and Exchange Commission to adopt a 
sweeping new market system, the voice of small regional firms 
and the small issuer market they serve have gone largely 
ignored.
    Amidst the euphoria surrounding the bull market and the 
proliferation of electronic communication networks and 
alternative trading systems, certain investors, market 
practitioners, and regulators have abandoned the small business 
issuer. In the process, they are potentially threatening the 
longest economic expansion in the history of this country.
    U.S. capital markets are preeminent because they enable 
entrepreneurs to raise capital efficiently and provide a 
reliable secondary market to investors. The U.S. securities 
industry is unique in the degree of participation in capital 
provided by retail investors. Indeed, these investors are the 
life blood of the small issuer marketplace. The vibrant small 
issuer equity market includes an estimated 22 million investors 
and small publicly traded companies, approximately 9,000 small 
issuers, and tens of thousands of officers, directors and 
employees.
    While some of these companies are speculative investments, 
informed investors accept these risks because of the 
opportunities they offer. It is important to remember that the 
large cap companies driving our markets to record highs were in 
many cases at one stage in their development small businesses. 
An efficient and liquid small issuer market helps channel risk 
capital from investors to innovative emerging companies, 
affording them the opportunity to expand, make acquisitions, 
and retire debt.
    The companies listed on the NASDAQ Small Cap and the Over-
The-Counter Bulletin Board are clear examples of the 
contribution that small equity markets make to our company. 
While these companies represent all sectors of the economy, the 
information technology and biotechnology companies that are at 
the forefront of current U.S. economic growth are listed 
overwhelmingly on these markets. It is the small underwriters 
and broker dealers who commit their own capital and provide 
necessary liquidity to the small issuer capital market.
    Few if any ECNs or ATSs are operating in the lower tiers. 
Unlike the ECNs, market makers must maintain fair and orderly 
markets at all times. In addition, they provide valuable 
liquidity to the small issuer markets. The active support and 
services provided by the Regional Investment Bankers 
Association member firms is necessary. Their absence would 
threaten small issuer markets.
    In the past few years, technology and regulatory change has 
caused rapid, dramatic, and unprecedented changes in the equity 
trading markets. While all these developments are worthy of 
appropriate regulatory reforms, the highly successful dealer 
markets servicing small issuers must not be sacrificed. Too 
often, however, regulatory reforms have been shaped almost 
exclusively by the analysis of the top tier of the market, 
consisting mostly of the most actively traded securities in 
U.S. equity markets.
    Although the consequences are unintended to the lower-tier 
markets, we continue to suffer from this apparent benign 
neglect. The potential erosion of the small issuer equity 
market is a growing concern for small business entrepreneurs in 
every region of the country. Failing to consider the 
contribution of the lower-tier markets may stifle the growth 
and innovation that is sustaining and expanding our current 
booming economy.
    Small issuers have recently enjoyed an enormous increase in 
the funds received from venture capital firms and so-called 
angel investors who have made capital investments in 
anticipation of an initial public offering. These angel 
investors often evaluate companies less on the long-term growth 
capabilities than on their short term IPO prospects. If changes 
in market structure adversely affect the small cap markets and 
the market makers ability to service them, the venture capital 
stream will likely dry up.
    I'd like to comment on some of the specific issues under 
consideration by the committee. First, I would caution 
regulators to consider the potential for large firms to 
dominate the self-regulatory process in a new market structure. 
Under the influence of large firms, for-profit self-regulatory 
organization can raise the cost of regulation to levels that 
would force small firms out of the industry.
    Second, the concept of single centralized markets such as a 
centralized limit order book also raises concern for individual 
investors that may be handicapped by institutional investors 
who are able to dominate markets by mobilizing vast amounts of 
capital instantaneously. Third, I would emphasize that pricing 
for market data must be streamlined. Buying discounts favoring 
larger financial service firms should not disadvantage regional 
brokerage firms servicing the small issuer marketplace.
    Fourth, the spate of recent proposals for new market 
linkages in execution firms should prompt an examination of the 
practical impact on the lower-tier markets. Regulatory 
policymakers must ask whether the future of ITS', SelectNet, 
and Super SOES will provide appropriate applications for lower-
tier markets. Finally, I urge the SEC to clarify its best 
execution standards and specify their application to the lower-
tier markets.
    In conclusion, I would like to take this opportunity to 
highlight what I see as the most important issue, the benign 
neglect of the lower-tier markets by regulators and 
policymakers. To avoid the kind of adverse consequences I have 
discussed with you today, I have two specific recommendations: 
first, I ask all policymakers and regulators to move ahead more 
cautiously and deliberately in considering the effects of 
future changes on all marketers. Second, I urge to make good 
use of the expertise of the Regional Investment Bankers 
Association and the small issuers that rely on the lower-tier 
markets for their lifeblood.
    I would like to commend the full committee and its staff 
for reaching out and soliciting the views of the small broker 
dealer community. We hope that your leadership in creating a 
more inclusive debate becomes the standard rather than the 
exception. Thank you.
    [The prepared statement of Kenneth A. Kamen follows:]

   PREPARED STATEMENT OF KENNETH A. KAMEN, EXECUTIVE VICE PRESIDENT, 
                    PRINCETON SECURITIES CORPORATION

                                  RIBA

    I am testifying today as the Chairman of the Board of Directors of 
the Regional Investment Bankers Association (RIBA) and on behalf of the 
small issuer marketplace we service.\1\ RIBA was organized in June, 
1994 as a national association of regional and independent broker-
dealer and investment banking firms seeking to improve conditions in 
our industry, strengthen the free-enterprise system and provide a vital 
source of information and education to RIBA members and the investing 
public.
---------------------------------------------------------------------------
    \1\ Mr. Kamen has 20 years industry experience and is currently 
Executive Vice President of Princeton Securities Corporation.
---------------------------------------------------------------------------
    RIBA is committed to assisting regional broker-dealers in the 
syndication of their capital formation projects. While our initial goal 
was to provide a forum for small-cap companies seeking public 
financings, we have since expanded our focus to address the overall 
concerns of the lower tier market. Toward this end, RIBA has 
represented the interests of smaller broker-dealers to the securities 
regulators who govern our industry and the policymakers in Washington, 
DC. RIBA now holds regularly scheduled conferences where member firms 
exchange ideas, voice opinions on pending legislation and become 
educated on matters affecting the industry. As the bonds among RIBA 
members continue to strengthen, we hope to enhance our contribution to 
regulatory and legislative matters.

                              INTRODUCTION

    While Wall Street's largest brokerage firms and investment banks 
have lobbied the Securities and Exchange Commission (SEC) to adopt a 
sweeping new market system, the voices of small regional firms and the 
small issuer market they serve have gone largely ignored. Amidst the 
euphoria surrounding the bull market and the proliferation of 
electronic trading systems such as electronic communications networks 
(ECNs) and alternative trading systems (ATSs), certain investors, 
market practitioners and regulators have abandoned the small business 
issuer. In the process, they are potentially threatening the longest 
economic expansion in the history of this country. RIBA urges that any 
sweeping new market restructure consider its impact on the small issuer 
marketplace. RIBA believes the failure to do so is irresponsible and 
risky economic policy. Unfortunately, the current dramatic proposals to 
reform market structure may ultimately reduce liquidity and capital 
flow in the small issuer market.
    The U.S. capital markets are preeminent because they enable 
entrepreneurs to raise capital efficiently and provide a reliable 
secondary market to investors. The U.S. securities markets are unique 
in the degree of participation and capital provided by retail 
investors. Unlike our European and Asian competitors, the U.S. markets 
rely on a confident and vigorous retail investing public. These 
investors are the lifeblood of the small issuer marketplace. The lower 
tier market functions are facilitated by the small underwriters who 
bring emerging companies to the public market and by market makers who 
commit capital to maintain a market for these companies' securities. 
The vibrant small issuer equity market includes an estimated 22 million 
investors \2\ in small publicly traded companies, approximately 9,000 
\3\ small issuers and tens of thousands of officers, directors and 
employees. While some of these small companies are speculative 
investments, informed investors accept the risks they pose because of 
the opportunities they offer. It is important to remember that the 
large cap companies driving our markets to record highs were in many 
cases, at one stage in their development, small businesses.
---------------------------------------------------------------------------
    \2\ Small Business Administration. Office of Advocacy.
    \3\ Id.
---------------------------------------------------------------------------
    An efficient and liquid small issuer market helps channel risk 
capital from investors to innovative emerging companies, affording them 
the opportunity to expand, make acquisitions and retire debt. 
Capitalizing these companies creates an enormous number of new jobs. 
The companies listed on Nasdaq SmallCap and the Over The Counter 
Bulletin Board (OTCBB) are clear examples of the contribution that 
small issuer equity markets make to our economy. Although the Nasdaq 
SmallCap and the OTCBB companies represent all sectors of the economy, 
the information technology and biotechnology companies that are at the 
forefront of current U.S. economic growth are listed overwhelmingly on 
these markets.
    It is the small underwriters and broker-dealers, not the ECNs and 
ATSs, who commit their own capital and provide necessary liquidity to 
the small issuer capital market. Few, if any, ECNs or ATSs are 
operating in the lower tiers. Unlike the ECNs, market makers are 
obliged to maintain fair and orderly markets in both rising and falling 
markets. In addition, they provide valuable liquidity to the small 
issuer markets through their buying and selling activities. Market 
makers temper the price volatility of securities and preserve market 
integrity by identifying over-valued and under-valued companies, 
leading to pricing efficiencies in the market. This dealer market 
should be preserved and enhanced as new securities regulatory policy is 
developed. Small issuers continue to need the active support and 
services provided by RIBA member firms. In the absence of their 
support, no market exists for these small issuers.
    RIBA recommends establishing a special small issuer capital market 
task force to evaluate and shape market reform proposals unique to the 
small issuer. The SEC and Nasdaq should also consider the negative 
impact of current rules and regulations on the small issuer market. 
RIBA is willing to take an active role in establishing this task force 
and will work with regulators, market practitioners, issuers and 
investors to make recommendations that address the interests of the 
small issuer capital market.

                   A SHORT HISTORY OF MARKET CHANGE.

The 1975 Amendments to Securities Laws: Creation of a National Market 
        System.
    Nearly 25 years ago, in response to new data processing and 
communication techniques, Congress amended the securities laws to 
create a fair and efficient national market system. The amendments were 
designed to improve the execution quality of securities transactions 
and foster fair competition among various participants in the markets, 
including brokers, dealers, exchanges and markets other than the listed 
exchange markets,
    Congress believed that expanding the availability of quotation and 
transaction information would result in the execution of investor 
orders in the best market available, possibly without the participation 
of a dealer. To accomplish its goals, Congress ended fixed commissions 
on what is now known as ``May Day''. May Day referred to May 1, 1975, 
when the SEC eliminated the fixed commissions brokers were charging for 
all securities transactions. This change allowed regional firms to 
compete on price and quality of service. Further, the inception and 
rise of discount brokerages grew out of the ``May Day'' Proclamation. 
In this landmark legislation, Congress also called for the development 
of a consolidated quotation system and consolidated tape, as well as 
the creation of the inter-market trading system (ITS). Finally and 
perhaps most significantly, a statutory directive ordered the SEC to 
take steps to foster the development of a national market system 
consistent with these goals.

1994: The SEC Market 2000 Study.
    Almost twenty years after the 1975 Amendments, the SEC embarked on 
an ambitious project. After conducting several years of research, the 
SEC's Division of Market Regulation issued its voluminous Market 2000 
Report in 1994 (the Report). The Report was several hundred pages long 
and summarized the state of the securities markets and made several 
recommendations for substantive change. Despite its extraordinary 
length, the Report focused almost exclusively on the conclusion that 
further changes in technology and product development had caused 
dramatic changes in large-cap markets since the 1975 amendments. 
Unfortunately, the question of applicability of these findings to the 
small-cap markets went unnoticed.
    Although the Report concluded that the equity markets were 
operating efficiently and effectively, and that no major revision of 
equity market regulation was needed, it did recommend several 
improvements. The Report found that securities professionals, for 
example, needed to devote greater effort to securing the best prices 
for their customers and to the full disclosure of relationships that 
could interfere with the customers' interests. The Report also urged 
more timely and comprehensive information with respect to quotation, 
price and volume data. The Report also anticipated that the development 
of alternative trading vehicles required regulatory adjustments, and 
that increased market access for competitors was essential.

1996: Adoption of SEC Order Handling Rules.
    Soon after the release of the Market 2000 Report, in the spring of 
1994, a widely publicized economic study suggested that the largest 
Nasdaq market makers implicitly colluded to maintain artificially wide 
inside spreads by avoiding odd-eighth quotations in many stocks.\4\ In 
addition, media accounts reported widespread allegations that market 
makers routinely refused to trade at their published quotes, 
intentionally reported transactions late in order to hide trades from 
other market participants, and engaged in other market practices 
detrimental to individual investors. Certain National Association of 
Securities Dealers (NASD) member firms, sometimes referred to as SOES 
Bandits, also alleged that the NASD had targeted them for regulatory 
and disciplinary action because the largest market makers that 
dominated and controlled the NASD disapproved of the trading practices 
engaged in by these firms. The Department of Justice and the SEC 
investigated the NASD and the Nasdaq Stock Market for almost two years 
and then issued a series of enforcement actions alleging that 
activities by market makers had contributed to a two-tier market in 
Nasdaq securities and had artificially maintained the size of spreads 
paid by retail investors for Nasdaq securities.\5\
---------------------------------------------------------------------------
    \4\ William G. Christie & Paul H. Schultz, Why Do NASDAQ Market 
Makers Avoid Odd-Eighth Quotes?, 49 J. Fin. 1813, 1813-40 (1994) 
[hereinafter the ``Christie-Schultz Study''].
    \5\ See SEC, Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996) 
[hereinafter the ``NASD 21(a) Report''].
---------------------------------------------------------------------------
    In September 1996, the SEC adopted Order Handling Rules designed to 
reduce spreads and protect investor interests.\6\ Concurrently with the 
investigation of the NASD and before drafting the rules, the SEC 
performed a comprehensive study of top tier Nasdaq securities. However, 
the SEC did not study how the proposed Order Handling Rules would 
affect the liquidity and volatility of small cap stocks. In hindsight 
this omission was a critical error. Despite the limited range of its 
evaluation, the SEC adopted the Order Handling Rules and applied them 
to all stocks trading on the Nasdaq market.
---------------------------------------------------------------------------
    \6\ See Proposed Rules on Order Execution Obligations, 60 Fed. Reg. 
52792 (Sept. 29, 1995); Adopted Rules on Order Execution Obligations, 
Securities Exchange Act Rel. No. 34-37619A (Sept. 6, 1996).
---------------------------------------------------------------------------
    Subject to certain limited exceptions, the Order Handling Rules 
require market makers to include customer limit orders in their own 
quotes and mandate that dealer orders in ECNs be included in the inside 
market. The enactment of these Order Handling Rules reduced the spread 
between the best bid and best offer quoted on Nasdaq.\7\
---------------------------------------------------------------------------
    \7\ The SEC emphasized that the duty of best execution could 
require brokers to do more than simply execute orders at the NBBO. It 
stated that brokers had a duty to ``regularly and rigorously'' assess 
the quality of the executions provided to customers.
---------------------------------------------------------------------------
    Since the adoption of the Order Handling Rules, RIBA members have 
noted a dramatic increase in market volatility in the small cap market. 
While RIBA recognizes the effects of many factors, in addition to the 
Order Handling Rules, RIBA recommends that the SEC evaluate the 
unintended negative consequences of the application to the lower tier 
markets.

1998: Adoption of Regulation ATS.
    The Adoption of Regulation ATS in December, 1998 by the SEC was a 
radical development whose impact is driving the current debate on 
market structure. The new regulation put into place many of the changes 
first raised in the Market 2000 Report. The new regulation defined the 
registration and regulatory requirements for alternative trading 
systems, including ECNs and exchanges, and floated the concept of a 
``for-profit'' exchange. Ultimately, Regulation ATS sparked the push by 
various exchanges and the NASD for demutualization and contributed to 
the proliferation and expansion of ECNs and ATSs. As was the case with 
the Order Handling Rules, Regulation ATS was adopted without the 
benefit of a comprehensive evaluation of its impact on the lower tier 
markets.
    The catalyst for the changes wrought by Regulation ATS has been the 
growth of ECNs as market centers. Unfortunately, technological change 
has produced a degree of uncertainty for some market participants. RIBA 
recognizes the tremendous potential that new technology brings to the 
capital markets. In order to be prepared for uncertainties, however, 
new regulation must allow flexibility in deciding how to regulate the 
markets of the future. RIBA believes that what in theory looks sound 
may in practice be less advantageous to all market tiers.
    Very little, if any, of the underlying philosophy and the practical 
application driving the development of Regulation ATS concerned small 
tier markets. Because ECNs were created to facilitate matching investor 
orders, ECNs are not reliable liquidity providers. Rather, ECNs are 
most efficient for the highly capitalized markets where there are large 
numbers of both buyers and sellers. As a result, Regulation ATS 
effectively discourages small broker-dealers from providing market 
liquidity. It remains to be seen who will provide liquidity to the 
lower tier capital markets during a sustained downturn. RIBA believes 
this is a critical issue worthy of Congressional inquiry, as liquidity 
often dictates whether a fair and orderly market may be maintained. For 
many ECNs, volume comes largely from retail orders and it is 
instructive to note that the current stock market boom is fueled by 
retail investors. However, even in today's robust market, ECNs cannot 
efficiently trade in the less capitalized markets, such as the Nasdaq 
SmallCap market and the OTCBB, as small broker-dealers can. Given this 
reality, it seems poor public policy to embrace a one-size-fits-all 
approach to regulating all market tiers.
    RIBA members report the one-size-fits-all approach has added to the 
volatility discussed above. In addition, the current regulatory 
environment has greatly reduced the number of RIBA underwritings. 
According to RIBA statistics, the number of small underwritings has 
declined precipitously from 190 offerings totaling $2.3 billion in 1994 
to just 38 totaling $221 million in 1999.\8\
---------------------------------------------------------------------------
    \8\ RIBA, 1993-1999 Underwriting Survey Totals.
---------------------------------------------------------------------------
    It is critical for beltway policymakers to remember that small 
underwriters and broker-dealers, not ECNs, provide the necessary 
liquidity to the small issuer capital market through the comm' ment of 
their own capital and through buying and selling activity. One of the 
fundamental market principles is the obligation of market makers to 
maintain fair and orderly markets in both rising and falling markets. 
Market makers temper the price volatility of securities and preserve 
market integrity by identifying over-valued and under-valued companies, 
leading to pricing efficiencies in the market. This lower tier market 
should be preserved and enhanced as new securities regulatory policy is 
developed. Without support there is no market for these small issuers.

                            CURRENT ISSUES.

Fragmentation.
    Assuring fair competition among market centers is a principal 
objective for the national market system. Market centers (including 
exchange markets, over-the-counter market makers, and ATSs) compete to 
provide a forum for the execution of securities transactions, 
particularly by attracting order flow from brokers seeking execution of 
their customers' orders. One of the results of this fierce competition 
among market centers, however, can be fragmentation of the buying and 
selling interest for individual securities. Due in large part to the 
regulatory reforms discussed earlier, market fragmentation has 
stimulated healthy competition. In the past four years, several ECNs 
and ATSs have successfully challenged traditional market centers and 
offered improved efficiency to investors. This positive development has 
yet to be realized by the lower tier markets. However, substantial 
time, energy, analysis and regulatory resources have already been 
expended to manage constructively the fragmentation of the top tiers. 
RIBA believes a similar analysis and resources dedicated to the small 
issuer markets is overdue.

For-Profit Exchanges.
    Under its current structure, the Nasdaq Stock Market is owned by 
the NASD, a nonprofit membership corporation with over 5,500 members. 
In an effort to strengthen its financial position without significantly 
burdening existing members, the NASD has announced plans to restructure 
Nasdaq. Under the new regime, the NASD would retain a minority stake in 
Nasdaq, while the majority would be owned by current NASD members, 
security firms, issuers, buy-side firms, technology partners and the 
public. Control over the new entity would shift from the NASD to its 
new owners when Nasdaq is registered as an exchange with the SEC. The 
new plan was approved by a membership vote on April 14, 2000.\9\
---------------------------------------------------------------------------
    \9\ In reportedly the highest NASD member vote recorded, 4075 
ballots were cast, 3423 in favor and 652 against the restructuring. See 
Securities Week, April 17, 2000.
---------------------------------------------------------------------------
    Any final plans will involve separating NASD-Regulation from the 
for-profit market. In prepared testimony before the Senate Committee on 
Banking, Housing and Urban Affairs on September 28, 1999, Frank G. 
Zarb, the NASD Chairman explained that ``early in the process we 
decided that an NASD-Regulation, independent from a for-profit 
marketplace, was the best means of maintaining our high regulatory 
standards.'' This view is consistent with that expressed by SEC 
Chairman Levitt in a major policy address at Columbia Law School that 
``strict corporate separation of the self-regulatory role from the 
marketplace it regulates is a minimum for the protection of investors 
in a for-profit structure.'' \10\ RIBA supports an independent Self-
Regulatory Organization (SRO) as long as the SRO is charged with 
recognizing the inherent differences in the various market tiers. As 
stated earlier, one-size-fits-all regulation can be very harmful to 
small issuers andtheir shareholders.
---------------------------------------------------------------------------
    \10\ Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, 
Timeless Principles, Columbia Law School (September 23, 1999).
---------------------------------------------------------------------------
    Under a for-profit Nasdaq, RIBA is concerned about whether the 
Nasdaq SmallCap market will receive the attention and resources it 
deserves. Resources dedicated to small cap marketing and regulation in 
a for-profit environment must take immediate priority. If the lower 
tier markets suffer from benign neglect today, RIBA is very concerned 
that in the future, small issuers and small broker-dealers will suffer 
and eventually individual investors and the economy will be negatively 
affected as well.
    RIBA also notes that it is unclear whether the OTCBB market is 
going to be part of the new Nasdaq or remain under the NASD. There has 
been no announcement about the OTCBB's fate. In fact, the lack of 
information about the role of the OTCBB in the Nasdaq demutualization 
plan underscores RIBA's concern about the future treatment of this 
market and its participants. The private placement memorandum 
circulated to the NASD members prior to the vote contained just 69 
words regarding the OTCBB. RIBA understands that the OTCBB is not the 
catalyst for page one news stories of multinational business mergers. 
Nonetheless, thousands of domestic small issuers rely on the OTCBB for 
their public capital. Recently, these companies have been benefiting 
greatly from the investments made by venture capital and angel 
investors. If the NASD does not support the small tier market 
sufficiently, small broker-dealers will continue to abandon the market, 
potentially hurting small issuers, individual investors and the 
economy. If that were to happen it remains to be seen what effect a 
shrinking IPO market will have on all private equity financing in the 
future. RIBA believes it is critical that the SEC and Congress require 
the application of proper due diligence to such a fundamental 
restructuring.

Market Data/Fees.
    Market information fees are addressed most directly by various 
provisions of the Exchange Act, all of which were added to the Act by 
the 1975 Amendments discussed above.\11\ With the enactment of the 1975 
Amendments, Congress granted the SEC flexible reign in overseeing the 
establishment of a national market system for securities. Consistent 
with the central market approach initiated by the SEC, the two 
``paramount objectives'' of the national market system were ``the 
maintenance of stable and orderly markets'' and ``the centralization of 
all buying and selling interest so that each investor will have the 
opportunity for the best possible execution of his order, regardless of 
where in the system it originates.'' \12\ To achieve these objectives, 
Congress recognized that ``communication systems, particularly those 
designed to provide automated dissemination of last sale and quotation 
information with respect to securities, will form the heart of the 
national market system.'' \13\ The Amendment provisions are designed to 
ensure the fair and reasonable dissemination of market information on 
terms that are ``not unreasonably discriminatory.'' \14\
---------------------------------------------------------------------------
    \11\ Pub. L. No. 94-29, 89 Stat. 97 (June 4, 1975). See Sections 
6(b)(4), 11A(c)(1)(C), 11A(c)(1)(D) and 15A(b)(5) of the Exchange Act.
    \12\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 7 (1975) (``Senate 
Report'').
    \13\ H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975) 
(``Conference Report'').
    \14\ Exchange Act, Section 11A(c)(1)(D).
---------------------------------------------------------------------------
    Under the amended rules, national securities exchanges and national 
securities associations must also allocate their fees equitably among 
members. The legislative history of these provisions indicates 
Congress' intent that the fees collected from everyone using an SRO's 
facilities could appropriately be directed to funding the ``costs 
associated with the development and operation of a national market 
system.'' \15\
---------------------------------------------------------------------------
    \15\ Conference Report, at 92.
---------------------------------------------------------------------------
    In 1975, Congress found that new data processing and communications 
techniques created the opportunity for more efficient and effective 
market operations, and that the linking of all markets through such 
data processing and communications facilities would increase the 
information available to brokerdealers and investors. Congress was 
particularly concerned about entities that would be exclusive 
processors of market information to SROs. Unfortunately, Congressional 
intent did not lead to the application of these improvements to the 
lower tier markets. Thousands of small companies continue to trade 
solely over the phone among market makers willing to commit risk 
capital. While readily available, efficient technological innovations 
have yet to be universally applied. RIBA believes that the SEC should 
require a more equitable distribution of resources and technology.
    As noted above, Congress did not include a strict, cost-of-service 
standard in the Exchange Act, opting instead to allow the SEC some 
flexibility in assessing the fairness and reasonableness of fees. 
Nevertheless, the fees charged by service monopolies (such as the 
exclusive processors of market information) need to be tied to some 
type of cost-based standard to preclude excessive profits if fees are 
too high and to prevent underfunding or subsidization if fees are too 
low. RIBA believes that the total amount of market information revenues 
should remain reasonably related to the cost of generating such market 
information. Today that is not the case; small broker-dealers shoulder 
proportionately higher costs which are in turn passed along to small 
issuers and their shareholders. RIBA feels strongly that this is wrong 
and should be corrected.
    The cost of member regulation should not be considered part of the 
cost of market information. The financial soundness of broker-dealers 
is undoubtedly an essential factor in the overall integrity of the 
markets; however, the connection between regulatory oversight of market 
integrity and the quality of market information is much more attenuated 
than in the case of market operation and market regulation.\16\ An 
SRO's member regulation costs are more directly associated with the 
regulatory fees charged to members than with any other source of 
funding. Also, the cost of market information should omit costs that 
are directly associated with other SRO services, such as advertising 
and marketing expenditures to obtain corporate listings.\17\ This 
segregation is essential in today's highly competitive environment. 
Failure to segregate will continue to disadvantage the small regional 
firms unfairly.
---------------------------------------------------------------------------
    \16\ See Regulation of Market Information Fees and Revenues, 
Securities Exchange Act Rel. No. 34-42208; File No. S7-28-99 (December 
9, 1999).
    \17\ Id.
---------------------------------------------------------------------------
    The arrangements for disseminating market information should be 
modified in several respects. RIBA's review of its membership has 
indicated the importance of adapting market information fees to the 
increasing retail investor demand for real-time information and to the 
changing structure of the securities industry. RIBA endorses the 
concept of a flexible, cost-based approach to evaluating the fairness 
and reasonableness of such fees and revenues. SROs should provide 
greater public disclosure of their fees, revenues and costs. The same 
standards of disclosure enforced by the SROs should be applied to the 
SROs. Furthermore, vendors, broker-dealers and users of market 
information should participate in the process of setting and 
administering fees. Failure to seek a more open process will continue 
the effective isolation of RIBA member interests.
    Since the enactment of the 1975 Amendments, the SEC has relied 
primarily on consensus among the SROs and the securities industry to 
resolve issues concerning market information fees and revenues. RIBA 
believes that recent changes in the securities markets may require a 
revised approach that provides greater guidance to the SROs and the 
rest of the securities industry. The advent of for-profit SROs, whose 
financial objective will be generating profits for their owners, could 
result in increased pressure to raise fees and revenues and to cut back 
on costs not directly associated with a source of revenue. RIBA 
believes that SRO fees and financial structures may warrant increased 
oversight by the SEC. RIBA members are very concerned that failure to 
do so may result in regional firms being priced out of the market due 
to open-ended fee increases.
    Since market information fees cannot be unreasonably 
discriminatory, any disparities in fees should be justified by such 
legitimate factors as differences in relevant costs or degree of 
use.\18\ RIBA believes it is important to recognize that the basic 
information stream will be the same, and will have the same production 
costs, no matter how many vendors and subscribers receive the 
information. As the SEC states in its market data release, ``although 
there may be differences in costs of disseminating information to 
different categories of vendors and subscribers (such as the costs of 
administering a fee structure), it is vendors and broker-dealers who, 
for the most part, bear the costs of receiving the data stream and 
passing it on to individual subscribers. These redistribution costs are 
not appropriately incorporated into a fee structure.'' \19\
---------------------------------------------------------------------------
    \18\ Id.
    \19\ Id.
---------------------------------------------------------------------------
    In order to assure the wide availability of market information, 
individual SRO fees should be evaluated in terms of the objectives of 
the national market system. RIBA feels that market data fees should not 
be set at levels that effectively restrict the availability of real-
time information. The current effect is anticompetitive and 
disadvantages the smaller firms.
    Fee structures often include various discounts that are based on 
the size of the subscribing firm or on whether the firm is a member of 
an SRO that participates in the particular network.\20\ RIBA believes 
these discounts are inconsistent with the Exchange Act objective that 
exclusive processors of information should remain neutral in their 
treatment of firms and customers. Once again, disparities in fees 
should be Justified by such legitimate factors as differences in 
relevant costs, degree of use, or quality of service. Market data 
providers should demonstrate that the size of the discounts corresponds 
with the size of the relative difference in administrative costs. 
Today's discounts clearly benefit the largest broker-dealers at the 
expense of RIBA members. Additionally, the proportionally inflated fees 
paid by RIBA members subsidize the top tier markets. RIBA feels the SEC 
should address this inequity. Ultimately these unique costs are 
partially subsidized by the issuers and their shareholders.
---------------------------------------------------------------------------
    \20\ Id.
---------------------------------------------------------------------------
    RIBA is also concerned about the anti-competitive fees that ECNs 
charge non-subscriber users to access their quotes through Nasdaq. 
Nasdaq market makers do not charge access fees. In order for a broker 
to comply with his best execution duties it may be necessary to access 
the NBBO that is quoted on an ECN and pay the access fees. We feel, and 
SEC Chairman Arthur Levitt has agreed, that the ECNs should apply 
uniform charges to subscribers and non-subscribers alike eliminating 
the access fees.\21\ Today's regulatory regime is anti-competitive and 
anti-small business.
---------------------------------------------------------------------------
    \21\ See Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, 
Timeless Principles, Columbia Law School, (September 23, 1999).
---------------------------------------------------------------------------

After-Hours Trading.
    On October 25, 1999, Nasdaq began a voluntary pilot program 
extending the availability of the Nasdaq quotation, trade reporting and 
communications until 6:30 p.m. Eastern time. As of February 7, 2000, 
Nasdaq calculates and disseminates the inside market. Firms were 
initially called upon to input trade reports voluntarily on a real-time 
basis for trades occurring between 5:15 and 6:30 p.m. Real time 
reporting became mandatory as of November 15, 1999. Although the 
application of SEC and Nasdaq rules on the handling and protection of 
limit orders was temporarily deferred until December 6, 1999, the rules 
are now in effect during the extended trading hours. RIBA members 
report that the practical effect is that lower tier market liquidity 
does not support after-hours trading. RIBA members who keep their 
trading desks open in after-hours sessions are forced to assume 
operating costs without the likelihood of offsetting revenue.
    On October 8, 1999, three working groups delivered reports on 
issues relating to extended trading hours: the Committee on Investor 
Protection and Education (CIPE), the Committee on Clearance, Settlement 
and Operations (CCSO) and the Working Group on Trading Conventions 
(WGTC). Unfortunately small, regional broker-dealers were not 
represented on these committees. The reports of these groups 
highlighted some of the issues that extended hours trading may present. 
CIPE, for example, emphasized ``complete and full disclosure of the 
nature and risks of extended hours trading for investors,'' and urged 
``that best practices be adopted industrywide.''
    CIPE also noted that the risks of extended hours trading include 
lack of liquidity, volatility, fragmentation of the market, impact of 
news announcements and the lack of depth and breadth in the extended 
hours markets expected initially. CIPE suggested that investors should 
actively be required to ``opt-in'' to extended hours trading.
    Nasdaq's foray into extended hours is directed, in large part, 
toward West Coast customers and traders. Although its after-hours entry 
had little effect on the first night (Nasdaq reported only 27,000 
shares traded compared to the 933 million shares traded overall that 
day) it is anticipated that the volume will grow despite limited and 
costly access. Many ECNs currently operate even longer hours, including 
at least two ECNs that operate 24 hours a day. Small broker-dealers are 
often unable to compete because of staffing costs associated with 
keeping extended hours. Unfortunately, the SEC failed to consider 
adequately the negative effects on small issuers and small broker-
dealers that arise when investors lose money because of price swing in 
less liquid stocks traded after hours. Stung by their losses, investors 
are more likely to avoid the after-hours market, thus injuring the 
liquidity of some small businesses.

Solutions.
    The SEC's attention to market fragmentation derives from its 
commitment to the interests of investors pursuant to Section 11A(a)(1) 
of the Securities Exchange Act of 1934.\22\ The market ideally should 
offer the greatest opportunity for interaction among buyers and sellers 
while encouraging fair competition among market centers. Fairness and 
efficiency translate into reduced transaction costs and more accurate 
pricing of securities. This time-honored goal must be applied to all 
market tiers. The SEC must expand its analysis and consider the 
opportunities for markets servicing small issuers.
---------------------------------------------------------------------------
    \22\ Section 11A(a)(1) reads: ``The interests of investors (both 
large and small) are preeminent, especially the efficient execution of 
their securities transactions at prices established by vigorous 
competition.''
---------------------------------------------------------------------------
    Fragmentation can occur when market forces combine to isolate 
investors' orders and hamper price competition. The potential decrease 
in liquidity and increase in price volatility deprive investors of the 
benefits of fairness and efficiency. The market currently addresses 
fragmentation in three major ways: (i) price transparency, (ii) 
intermarket links to displayed prices, and (iii) the brokers' duty of 
best execution.

Price Transparency.
    Price transparency is an essential component of a unified national 
market system. All significant market centers are required to make 
available to the public their best prices and the size of the order 
associated with those prices.\23\ The market centers provide quote and 
trade information through central processors that are responsible for 
collecting and disseminating the market information for different types 
of securities. The processors consolidate the information of individual 
market centers, determine the NBBO and distribute the information to 
broker-dealers and information vendors who make the information 
available to the public. Due to the lack of dynamic quotes and the 
absence of electronic order execution, these technological advances 
improving transfers have yet to reach the OTCBB.
---------------------------------------------------------------------------
    \23\ See, e.g., Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1; 
Exchange Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4; NASD Rule 4613; NYSE 
Rule 60.
---------------------------------------------------------------------------

Linkages.
    ITS and SelectNet.--As noted above, one component of the national 
market system designed to address fragmentation is the establishment of 
systems that link the various market centers and provide access to the 
market center with the best displayed prices. The Intermarket Trading 
System (ITS) was created under the NMS Plan as an attempt to link the 
country's then existing markets. The ITS linkage handles a relatively 
small proportion of trading in listed equities. In September 1999, for 
example, ITS volume represented 2.2% of total NYSE-listed trades.\24\ 
The ITS linkage has weaknesses that must be addressed, including 
restricted ECN access and slow and inefficient execution procedures.
---------------------------------------------------------------------------
    \24\ Securities Exchange Act Release No. 34-42450; File No. SR-
NYSE-99-48; Proposed Rescission of NYSE Rule 390 Commission Request for 
Comment on Issues Relating to Market Fragmentation; (February 23, 
2000).
---------------------------------------------------------------------------
    In recent speeches, SEC Chairman Levitt stated that the SEC is 
considering ways to address the problem of market fragmentation: ``At 
the Commission, we know well that ITS has not kept pace with the 
technological changes sweeping our markets. Its archaic structure and 
cumbersome governance provisions are not fit for today's market, let 
alone the market of the future.'' \25\ Such inefficient governance has 
led to stagnated technology, requiring private market-based trading 
systems to address inefficiencies. The growth of alternative trading 
systems such as ECNs has occurred outside of ITS.
---------------------------------------------------------------------------
    \25\ Arthur Levitt, Chairman SEC, ``Visible Prices, Accessible 
Markets, Order Interaction'', Northwestern School of Law, (March 16, 
2000).
---------------------------------------------------------------------------
    On December 8, 1999, the SEC took the first step toward reforming 
market linkage with the adoption of an amendment ITS plan, expanding 
the ITS/Computer Assisted Execution System (CAES) linkage to all listed 
securities. The amendment allows all members of ITS to trade non-Rule 
19c(3) listed securities \26\ thus enabling non-exchange members of ITS 
\27\ to trade in listed securities. This amendment also paved the way 
for the admission of ECNs into the ITS, enabling ECNs to trade all 
listed securities while linked to each other and to the exchanges. On 
March 16, 2000, the SEC approved the NASD proposal allowing ECNs to 
become part of CAES and therefore linked with ITS. In reaction to these 
attempts at reforming ITS, the NYSE has recently proposed to withdraw 
from ITS. Though ITS may not be the ideal form of market linkage, RIBA 
believes that the NYSE must play a central role in any future National 
Market System linkage plan and so recommends that the SEC reject any 
unilateral withdrawal by the NYSE.
---------------------------------------------------------------------------
    \26\ Non-Rule 19c(3) listed Securities are those listed pre-April, 
1979 and subject to NYSE Rule 390.
    \27\ Third Market Makers such as Trimark Securities and Madoff 
Securities.
---------------------------------------------------------------------------
    The market centers that trade Nasdaq equities currently are linked 
by the NASD's SelectNet system, by telephone and through private links. 
In September 1999, approximately thirty percent of trades in Nasdaq 
equities were routed through SelectNet, a sharp reduction from just 
five years ago. Chairman Levitt stated that SelectNet continues to be 
plagued with shortcomings, delays during heavy trading volume, and even 
outages. Given the decentralized nature of the Nasdaq market, this is a 
critical and core flaw--and one that must receive intense scrutiny and 
committed resources until resolved.\28\ The SEC recently approved a 
proposed rule change by the NASD to establish a revised order delivery 
and execution system-the Nasdaq National Market Execution System 
(NNMS).\29\ The new system, also known as Super-SOES, will consolidate 
the Small Order Execution System or ``SOES'' and SelectNet and allow 
delivery against the best prices displayed in the Nasdaq Display 
Window. Customers will enjoy virtually instant automatic executions 
against market maker quotes. The system will provide, among other 
things, automatic execution for customer and market maker orders up to 
9900 shares. Once again, it appears to RIBA that the new rules and new 
system have been developed for the top thirty percent of the Nasdaq 
participants only.
---------------------------------------------------------------------------
    \28\ Id.
    \29\ Securities Exchange Act Rel. No. 42344 (Jan. 18, 2000), 65 FR 
3987.
---------------------------------------------------------------------------
    RIBA believes that any proposals regarding linkages should be 
concerned with the entire range of securities in the markets, not just 
the very top tier of actively-traded issues. The relevant question is 
whether the efficiency of the markets for all or any particular 
category of securities could be substantially improved through market 
structure changes. Ultimately, only fair and vigorous competition can 
be relied upon to set efficient prices.
    The advent of decimal pricing introduces another example of the 
inherent differences among market tiers. The current momentum 
surrounding the conversion to decimal pricing in the most liquid 
stocks, is certainly warranted. While most experts agree that decimal 
pricing will substantially reduce spreads, perhaps down to a penny in 
the most liquid stocks, RIBA suggests that in the lower tier markets 
its effects may be unforeseen. A pilot program in the lower tier 
markets may be a constructive first step in evaluating the impact of 
decimal pricing in the lower tiers.
    At present, there is no linkage of quotations or trading on the 
options markets. This deficiency impairs the price discovery mechanism 
and makes it difficult for brokers to get the best price for their 
clients, particularly in light of the increased dual listing of 
options. This is particularly difficult for regional firms with fewer 
resources and strategic business partners. SEC Chairman Levitt has on 
several occasions called for a linkage between the options markets, and 
has imposed a deadline on the options exchanges to come up with a 
plan.\30\ An integrated options trading market should present an 
opportunity for increased competition for regional broker-dealers.
---------------------------------------------------------------------------
    \30\ See e.g. Speech by Arthur Levitt, SEC Chairman, Dynamic 
Markets, Timeless Principles, Columbia Law School, (September 23, 
1999). See also, Securities Exchange Act Rel. No. 34-42456: File No. 4-
429 (February 24, 2000).
---------------------------------------------------------------------------
    Central Limit Order Book.--As a result of the tension between 
encouraging competition and having a centralized marketplace, the SEC 
has called for a study of centralization of order flow through a 
centralized limit order book.\31\ Some proposed market structure 
reforms would hurt small broker-dealers who engage in underwriting and 
market making. One such proposal is the centralizing of all trading in 
one system, what is sometimes referred to as a time-priority central 
limit order book, or CLOB. The CLOB would be fully transparent to all 
market participants. In other words, the public would have access to 
all CLOB orders and quotations, including the size of transactions and 
the identity of the investor. Market makers would only be able to trade 
as a principal if they provided price improvement to the CLOB listings.
---------------------------------------------------------------------------
    \31\ Securities Exchange Act Rel. No. 34-42450, File No. SR-NYSE-
99-48, Proposed Rescission of NYSE Rule 390 Commission Request for 
Comment on Issues Relating to Market Fragmentation, (February 23, 
2000).
---------------------------------------------------------------------------
    The prospect of transforming our markets into a single ``black 
box'' does not recognize the important role market makers play in the 
securities markets, especially the smaller, less liquid securities. In 
testimony before the Senate, the NASD voiced its disapproval of the 
CLOB system:
        Because the Nasdaq system provides incentives for market makers 
        to continuously display quotations and provide immediate 
        guaranteed executions in size to investors, it has been able to 
        respond to the revolutionary demands of the online trading 
        world. On the other hand, mandatory CLOBs and system wide time 
        priority requirements do not effectively incorporate or incent 
        the multiple market makers who now provide liquidity and 
        immediate executions on Nasdaq, and who thus cushion the market 
        when it is under stress.
    As stated earlier, market makers provide liquidity to the market by 
guaranteeing executions to their customers at the inside market price 
or better, often at low cost. The willingness of market makers to 
provide investors with access to guaranteed executions is critical to 
the ability of the entire dealer market to respond to the extraordinary 
demands of today's trading. While proponents argue the CLOB would 
certainly encourage maximum interaction among orders, it will likely do 
so at the expense of competition. Faced with one centrally planned 
structure, market participants may lose any incentive to upgrade or 
create new technologies. Furthermore, the CLOB's inclusion of 
information such as transaction size and investor identity may favor 
professionals and institutional investors with ``time and place 
advantage'' over retail investors.\32\ RIBA is concerned that the CLOB 
will allow professionals and institutional investors, who regularly 
monitor trading activity literally second by second, to place retail 
investors at a disadvantage by mobilizing vast amounts of capital 
instantaneously. Individual investors comprise the overwhelming 
majority of RIBA members'customers. RIBA opposes market initiatives 
that disadvantage individual RIBA clients.
---------------------------------------------------------------------------
    \32\ See Regulatory Costs in the Financial Marketplace of the 
Future Before the Senate Comm. of Banking, Housing, and Urban Affairs 
(Feb. 29, 2000) (testimony of Charles R. Schwab, Chairman and CEO of 
Charles Schwab & Co., Inc.).
---------------------------------------------------------------------------
    NASD Electronic Order Display Window.--On November 22, 1999, the 
NASD filed a rule change about Nasdaq's proposal for a new and 
``revolutionary'' order display window to be launched this summer, 
assuming SEC approval.\33\ The new window based on the NNMS operating 
system was designed to respond to the increased fragmentation and loss 
of transparency resulting from having multiple, competing market 
centers. Nasdaq expects that this change will make trading Nasdaq 
shares more fair and efficient by giving investors a more complete 
picture of prices gathered from exchanges, market makers and ECNs.
---------------------------------------------------------------------------
    \33\ Securities Exchange Act Release No. 34-42166 (Nov. 22, 1999), 
64 FR 69125.
---------------------------------------------------------------------------
    The new system, sometimes referred to as Super-Montage, will 
utilize the recently approved Super-SOES system and allow delivery 
against the best prices displayed in the Nasdaq Display Window. As with 
other new linkage proposals discussed above, the new system has 
developed according to considerations of the top tier markets only.
    Broker's Duty of Best Execution.--In accepting orders and routing 
them to a market center for execution, brokers act as agents for their 
customers and owe them a duty of best execution. The duty, which 
derives from common law agency principles and fiduciary obligations, is 
incorporated both in self-regulatory organization rules and, through 
judicial and SEC decisions, in the antifraud provisions of the federal 
securities laws. The duty requires a broker to seek the most favorable 
terms reasonably available under the circumstances for a customer's 
transaction.\34\
---------------------------------------------------------------------------
    \34\ Securities Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 FR 
48290 (``Order Handling Rules Release''), Section III.C.2.
---------------------------------------------------------------------------
    A broker's duty of best execution applies to both customer market 
orders and limit orders. Although obtaining the best price is the 
single most significant factor with respect to market orders, limit 
orders are a different story since they are sensitive to both time and 
price. The duty of best execution is therefore not fulfilled 
automatically by guaranteeing execution at the NBBO.\35\ For example, 
brokers should consider opportunities for ``price improvement.'' or 
execution at a better price than the NBBO, when routing customer 
orders.\36\ Other factors, such as cost, the availability of accurate 
information and the historical characteristics of the particular 
security involved all affect the ability to provide best execution.\37\
---------------------------------------------------------------------------
    \35\ See id. at n.360 and accompanying text.
    \36\ See id. at nn.356-57 and accompanying text.
    \37\ SEC, Report oil the Practice of Preferencing (April 11, 1997) 
(``Preferencing Report''), at 89 n.207.
---------------------------------------------------------------------------
    RIBA is most concerned that the best execution standards 
articulated by the SEC are ambiguous. This problem is especially acute 
for small broker-dealers specializing in thinly traded stocks and 
dealing primarily with retail orders. RIBA believes the SEC should 
clarify the Rules and specify the definitions as applied to best 
execution for the lower tier markets. Clarity will ensure greater 
compliance, avoid creating traps for the unwary and, ultimately, serve 
the investor well.
    The Super-SRO.--Securities markets are now facing the question of 
how to perform SRO functions after demutualization of the exchanges. 
While SEC Chairman Levitt did not take a definitive stance on this 
topic, he has suggested the intriguing idea of having a single 
regulator for general issues such as net capital, financial 
responsibility, sales practices, etc., while allowing the exchanges to 
continue to regulate their own trading markets.\38\
---------------------------------------------------------------------------
    \38\ See Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, 
Timeless Principles, Columbia Law School, (September 23, 1999).
---------------------------------------------------------------------------
    The SEC has made it clear that strict corporate separation of the 
selfregulatory role from the marketplace it regulates is a minimum 
threshold for SEC approval of for-profit exchanges. The form this will 
take is open to several possibilities. One would have each market be 
similar to the current NASD structure in which NASD-Regulation is a 
separate entity within the NASD holding company. There is also the 
possibility of one ``Super'' SRO for all the markets. Another hybrid 
model would allow each market to maintain its own regulatory (i.e., 
trading rules) and surveillance function, while a single SRO would 
oversee member regulation, sales practice and intermarket trading.
    Whatever the model, the SRO must be adequately funded. RIBA also 
cautions regulators to consider the potential for large firms to 
dominate the self-regulatory process in a new market structure. Under 
the influence of large firms, for-profit SROs could raise the costs of 
regulation to levels which would force small firms out of the industry. 
In addition, RIBA is concerned that large firms could also dominate the 
rule-making process resulting in impractical and unfair rules as 
applied to the lower-tier markets and the firms that service those 
markets.

                              CONCLUSION.

    In the past few years, technology and regulatory changes have 
caused rapid, dramatic and unprecedented changes in the equity trading 
markets. Online trading, real time access to stock quotation, volume 
and trade execution data, a proliferation of ECNs and extended trading 
hours are transforming the equity markets faster than ever before. 
Changes in demographics are resulting in a larger pool of retail 
investors with more money to invest. This democratization of the U.S. 
stock markets has led to an explosive cash flow into the market. 
Increasing globalization is encouraging more foreign companies and 
investors to trade in the U.S. markets and forging greater numbers of 
international alliances and ventures.\39\
---------------------------------------------------------------------------
    \39\ Speech by Frank Zarb, Chairman and CEO of the NASD, The Coming 
Global Digital Market (June 23, 1999).
---------------------------------------------------------------------------
    While all of these developments are worthy of appropriate 
regulatory reforms, the highly successful dealer market servicing small 
issuers must not be sacrificed. Too often, however, regulatory reforms 
have been shaped almost exclusively by analyses of the top tier of the 
market consisting of the most actively traded securities in the U.S. 
equities markets. Although the consequences are unintended, the lower 
tier continues to suffer from this regulatory benign neglect.
    The potential erosion of the small issuer equity market is a 
growing concern for small business entrepreneurs in every region of the 
country. Failing to consider the contribution of lower tier markets 
will stifle precisely the kind of new growth and innovation that is 
sustaining and expanding our current booming economy. Small issuers 
have recently enjoyed an enormous increase in the funds received from 
venture capital firms and so-called angel investors who have made seed 
capital investments in anticipation of an IPO as their investment exit 
strategy. These angel investors often evaluate companies less on their 
long-term growth capabilities than on their short-term IPO prospects. 
If changes in market structure adversely affect the small cap markets 
and the market makers' ability to serve them, the venture capital 
stream will likely dry up. Further, if market structure reforms harm 
the broker-dealer community the result may have a chilling effect on 
small business capital formation.
    Respectfully, RIBA would like to make several suggestions for 
Congressional and regulatory policymakers to consider.
    First and foremost, RIBA implores Congress, the SEC and the SROs to 
consider carefully and completely the impact of all rules, regulations 
and policy proposals on the lower tier markets. It has been RIBA's 
experience that when considering regulatory changes effects on all 
market tiers are not fully considered. As noted above, these less 
liquid, more volatile markets have distinct needs and service a 
critical aspect of our entrepreneurial industries.
    Second, the spate of recent proposals for new market linkages and 
execution forums should prompt an examination of the practical impact 
on the lower tier markets. Regulatory policymakers must ask whether the 
future of ITS, SelectNet and Super-SOES will provide appropriate 
applications for small market makers to compete effectively with their 
large counterparts.
    Third, the concept of a single centralized market such as a CLOB 
also raises concerns for individual investors that may be handicapped 
by institutional investors who are able to dominate markets by 
mobilizing vast amounts of capital instantaneously.
    Fourth, as discussed earlier RIBA recommends establishing a small 
issuer capital market task force to evaluate and shape market reform 
proposals unique to the small issuers. RIBA is willing to take an 
active role in establishing the task force and is committed to working 
with the regulators, market practitioners, the issuer community and 
investors to make specific recommendations for constructive reforms.
    Fifth, RIBA urges the SEC to clarify its best execution standards 
and specify their applications to the lower tier markets. As new 
technologies continue to transform the markets, it is imperative that 
regulations provide concise guidelines.
    Last, RIBA would like to thank Chairman Oxley and Ranking Member 
Towns for the opportunity to testify on these critical issues. RIBA 
commends the full Committee and its Staff for reaching out and 
soliciting the views of the small broker-dealer community. We hope that 
your leadership in creating a more inclusive debate becomes the 
standard rather than the exception.

    Mr. Oxley. Thank you. Thanks to all of the panel.
    The Chair will recognize himself for the first round of 
questions.
    The fragmentation issue comes up time and time again. I 
think it is worthy of some discussion. Many people say that 
``fragmentation'' is just another word for ``competition.''
    Why should we fight fragmentation? Don't we really have 
fragmentation breaking out all over the place, and if it 
appears to be competitive in nature, what is really wrong with 
that?
    Let me begin with Mr. Atkin.
    Mr. Atkin. Thank you, Mr. Chairman.
    I would say, looking on the fragmentation issue, it is in 
some ways very complex and in some ways very simple. Looking at 
it one way within Nasdaq, you could say there is a lot of 
fragmentation, that there are multiple ECNs, multiple market 
makers, et cetera. I would argue that Nasdaq has 100 percent 
market share within its stocks, that all ECNs have to operate 
presently within Nasdaq, and there is no alternative but for 
anyone who wishes to trade Nasdaq stocks to go through the 
Nasdaq infrastructure.
    Mr. Oxley. Let me interrupt then, because at least at first 
blush it would appear that the Super Montage could be 
considered a central limit order book. Is that your cut on 
that?
    We will give Mr. Ketchum a chance.
    Mr. Atkin. It is certainly our view that the Nasdaq Super 
Montage is really an ECN. It is Nasdaq, in essence building a 
competing ECN, and the ECNs themselves are forced to operate 
under Nasdaq's infrastructure.
    I think it would be like FedEx and UPS being forced to go 
through the postal delivery system. We are forced to go through 
the Nasdaq infrastructure, and what we believe is, they are 
building their own competitive system, which will have the 
likely effect of draining liquidity out of the ECNs into a less 
transparent marketplace.
    Mr. Oxley. Mr. Ketchum, do you have a different view on 
that?
    Mr. Ketchum. Well, probably a little bit, I guess.
    Chairman Oxley, to get to your question first, no, I don't 
think Super Montage is anything like a composite limit order 
book. It is an effort to recognize, particularly as we move, 
and positively so, to a decimalized small increment world that 
is showing simply the consolidated best bid and offer is of 
limited value, that in order to understand what is happening in 
the market, you need to understand something, the depth going 
around both above the market and below the market.
    It is not intended to either compete directly or replace 
ECNs. ECNs will continue to be the place that provides a 
separate, anonymous opportunity to allow buyers and sellers to 
connect, to match orders beforehand and the like. What we think 
this will do is provide more substantial depth and transparency 
to the market.
    We do recognize that these orders are the orders of ECNs 
and market makers. They should receive compensation with 
respect to it, and we expect to share both fees and tape data, 
because we think that is the appropriate and fair way to do it.
    With respect to Doug's thoughts with regard to a single 
infrastructure, it is true that based on the SEC's order 
handling the rules, not on any NASD rules, if ECNs want to 
provide an environment where market makers show better prices 
anonymously than they do in their quote, that they must be 
linked into Nasdaq in two ways. Both from the standpoint of 
having their best quotes disseminated in the system and in 
providing a linkage so that people who are not participants in 
that ECN have an ability to access the best price.
    I think those two reforms by the SEC allowed us just in the 
nick of time to avoid a two-tier market environment and avoid a 
situation where institutions had access to better prices and 
liquidity than individual investors.
    So while I think, in fact, ECNs have plenty of choices in 
the markets, I think there does need to be sufficient linkage 
to assure that individual investors are treated the same way as 
institutional investors.
    Mr. Oxley. Does anybody else want to comment on the 
fragmentation issue, as well as the Super Montage?
    Mr. Wheeler. I would like to say a couple of things.
    Our current view of Super Montage is flawed in a couple of 
ways. The current proposal, as I understand it, is to display 
three levels of price through the book. There is no trade-
through protection to address some of the issues that Holly 
spoke of. A retail investor, willing to display a limit order 
at a particular price, has no protection that that limit order 
will be executed against, as a lot of stock may trade at that 
particular price without an execution due to that customer. It 
creates a single point of failure.
    We have had that experience in the past with Nasdaq, the 
infamous squirrel that took the system down 10 years ago, and 
the arbitrary delays that Super Montage imposes on the rest of 
the marketplace.
    As it is written right now, the way I understand it, the 
market maker would have up to 5 seconds to decide whether they 
want to execute against an incoming order or simply get out of 
the way and let that order go on through the system. We are not 
in favor of anything like the 5-second rule as it stands right 
now.
    Mr. Oxley. My time has expired. We will get back to some 
other issues.
    Let me now recognize the gentleman from Michigan, Mr. 
Stupak.
    Mr. Stupak. Thank you, Mr. Chairman. Thank you for holding 
this hearing.
    Mr. McSweeney, could you elaborate on the New York Stock 
Exchange concern about CLOB? How would this affect the retail 
investor?
    Mr. McSweeney. The problem we have regarding the CLOB is 
multifaceted. The major concern that we have is the fact that 
none of the proponents of a CLOB could describe how the large 
order flow would be handled in that type of an environment.
    The CLOB is basically an environment in which you would 
nationalize the marketplace. All limit orders would be 
displayed and executed automatically in terms of strict price-
time priority. But there was a recognition by each of the 
proponents that large-size orders would have to be executed 
outside of the consolidated limit order book because there 
would not be sufficient liquidity, and those orders would not 
be fully disclosed because the market impact would result in 
the market moving away from those disclosed orders. Therefore, 
you would have an environment in which there would be less 
transparency.
    Approximately 50 percent of the NYSE's volume and about 45 
percent of the consolidated volume is represented by 
transactions of 10,000 shares or more. You would extract that 
order flow from the price discovery process; it would result in 
a widening of the bid and offer spreads. Therefore, it would 
increase volatility by the widening of the spreads and the fact 
that there would be no specialties function in it; and it also 
would dampen intermarket competition based upon the strict 
price-time requirements of the CLOB.
    Actually, there was no agreement among proponents of the 
CLOB exactly how that should be structured.
    Mr. Stupak. Could the CLOBs then do a two-tier system, like 
one system for institutional and one system for retail 
investors?
    Mr. McSweeney. If they did that, Mr. Congressman, what 
would take place is, you would have a significant diminution of 
the liquidity and price discovery process that takes place now. 
You would extract a significant portion of the price discovery 
represented by larger orders from that process, and it would 
result in more volatility and less efficient markets.
    Mr. Stupak. Does the payment for order flow hurt the retail 
investor, the order flow?
    Mr. McSweeney. I believe it does, because payment for order 
flow is a practice that does not include rebating that payment 
to the ultimate customer, and it is closely aligned with 
internalization; and internalization is a serious concern, 
despite the fact that we have 83 percent market share. The fact 
that a percentage of that involves internalized order flow 
where public orders are not afforded the benefit of the price 
discovery process and the potential for price improvement is a 
concern, particularly the fact that we have recently eliminated 
Rule 390. And we were gratified to see in the SEC's release 
that approved removal of 390 that the SEC would be monitoring 
closely any significant change in order direction by member 
firms that would involve internalization.
    Mr. Stupak. Is your concern about the CLOBs related to your 
concerns about payment of order flow, or are they separate 
issues?
    Mr. McSweeney. No, Mr. Congressman, that is a separate 
issue. The issue is really one in which we believe that a 
market structure that would nationalize the securities industry 
would not promote competition, that would seriously impact 
liquidity of the market; and as I mentioned, the most serious 
impact would be bifurcating the institutional and the retail 
order flow and the price discovery process.
    Mr. Stupak. Thank you.
    I have nothing further, Mr. Chairman.
    Mr. Oxley. The gentleman's time has expired.
    The Chair now recognizes the gentleman from Pennsylvania, 
Mr. Greenwood.
    Mr. Greenwood. Thank you, Mr. Chairman. I am going to 
address the question to my constituent, Mr. Kamen.
    Can you be specific about--what regulations that are in 
place now do you think are limiting the ability of investors in 
the small cap issue market from fully benefiting from 
technology, if there are such regulations?
    Mr. Kamen. Well, a lot of it has to do with the systems. In 
the lower-tier markets, mainly the OTC bulletin board, there is 
no automatic execution electronically the way it happens in the 
upper tiers. The Instanets and the ECNs don't practice in those 
markets. As a matter of fact, I had discussion with Mr. Ketchum 
earlier that that is on the horizon.
    I think the problem we face in the lower-tier markets is 
that many of of the suggestions and policies that have been 
kicked around and adopted have all been done with the 
consideration of the largest tier of the marketplace. What is 
good for Microsoft might not necessarily be good for a stock 
trading at $4 or $5 or $10. Nor would one would argue that 
liquidity is the driving factor of all securities. And in the 
lower-tier markets, where liquidity tends to be less by the 
average daily volume of the securities, making rules that only 
look at the ramifications of the most liquid securities leaves 
the potential for a lot of unforeseen consequences in the lower 
tier.
    I think that is the overall picture that makes the most 
damage to the smaller cap market, and that is why we need to 
take a look every time we want to change something and do an 
analysis of how that will affect the smaller cap stocks.
    Mr. Green. Aside from coming and testifying here, what is 
necessary to get you and the folks you represent at the right 
table, besides this one, in order not to be left behind and be 
not considered?
    Mr. Kamen. I would certainly love for the NASD and the 
regulators to formally adopt, whether it is a small issue task 
force or in some other type of venue, to allow the voice of the 
smaller markets to be heard. I mean, realistically, our issues 
don't tend to be front page news. I mean, we are not 
multinational and we are not trading 20, 30, or 50 million 
shares a day. Our companies tend to trade 200-, 300-, 400,000 
shares a day, and in some cases, 800,000 shares a day. I think 
everyone needs to recognize that our voice must be invited to 
the table, and we need to have specific debate on these issues, 
starting with these types of things, and at the NASD; that 
would be most helpful.
    Mr. Green. Would any of the other panelists like to comment 
on that?
    Ms. Stark. Thank you. My firm manages microcap and small 
cap assets, and in fact, I do trade bulletin board stocks and 
ECNs right now. They are different animals than are the 
Microsoft and Dells of the world, and they are predominantly 
Nasdaq-listed stocks.
    I would have great difficulty indeed executing without 
ECNs. The benefit of using ECNs is, especially in fast-moving 
markets, the interlinkages they have created among themselves, 
so that I can access other ECNs or bids and offers by broker-
dealers who might be active in those names. In fact, there are 
lots of names that we have that don't even open on any 
particular day.
    But the dilemma is a real one, and we certainly would not 
want to do anything that would discourage or hamper trading in 
them further. But it is a reality right now, and I don't think 
that anything being proposed today, and especially in Super 
Montage, is going to hurt trading of the small and microcap 
stocks. In fact, I think it will enhance it.
    Mr. Ketchum. Congressman Greenwood, I would just say that I 
think Mr. Kamen makes some very sound points. We always try to 
look, but it is always helpful to get greater input from 
interested parts of the constituency of the impact on different 
parts of the market. We do have a Small Firm Advisory Board. I 
think the concept of a Small Issuer Advisory Committee is a 
sound one we will look very closely at.
    I think Holly Stark makes a excellent point. I think that 
support of the marketplace will be enhanced if there is greater 
ability to display orders, and as indicated by Mr. Kamen, if 
there is an ability to provide more efficient execution and 
order routing systems than exist in the bottom tier of the 
market. We are committed to do that, and committed to ensure 
that this market is as liquid as possible.
    Mr. Atkin. I would like to add a comment, Mr. Congressman, 
and that would be, currently we are trading about 70 million 
shares a day of bulletin board stocks, and I believe on Nasdaq 
they are trading in the--700 or 800 million shares a day. We 
certainly view the OTC bulletin board sector as an opportunity, 
as a big opportunity, to help lower costs for investors by 
providing an electronic means for investors to match stocks.
    I also think that does need to be complemented by those who 
do wish to commit capital. I think a lot of what we are talking 
about today is, should people get privileges for committing 
capital to retail investors? And really, what is going on in 
many of the markets, markets where the big American firms seem 
to be doing very well, is that their capital commitment 
providers do not get any privileges.
    I think, as most of the buy-side participants have been 
saying, that orders have price-time priority, and if you wish 
to commit capital, you must satisfy--whether it is a retail 
investor's order or an institutional investor's order--first 
before committing your capital; and people are finding it very 
profitable to do it in that environment.
    So we think it is important for both to occur, but not to 
advantage and give privileges to those who commit capital over 
individual investor's orders or institutional orders.
    Mr. Oxley. The gentleman's time has expired.
    Mr. Stupak. Could we have unanimous consent to enter 
opening statements in the record?
    Mr. Oxley. Yes, it has already been done.
    The gentleman from Chicago, Mr. Rush.
    Mr. Rush. Thank you, Mr. Chairman. On May 4, 2000, the SEC 
released a report of a special study by both the Office of 
Economic Analysis and the Office of Compliance, Inspection and 
Examination, regarding the display of customer limit orders. 
Mr. Chairman, I ask unanimous consent that this report be 
included in the record.
    Mr. Oxley. Without objection.
    [The report follows:]

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    Mr. Rush. Mr. Chairman, the report reveals the problems and 
violations in the display of limit orders in equities and 
options markets and the inadequacies in the market's 
surveillance and disciplinary programs for limit order display. 
The violations include failures to display proper order size, 
failure to display orders within 30 seconds after receipt, and 
failure to properly transfer the order display obligation to 
another exchange system or members.
    As a matter of fact, Chairman Levitt said, ``Limit orders 
have been a powerful force for competition in our markets, 
narrowing spreads, increasing transparency, and supplying 
liquidity.'' He went on to say, ``Their effect on the price-
setting process simply cannot be compromised.''
    These are strong words and they are troubling findings.
    We have heard testimony today about the importance of limit 
orders. I would ask Mr. McSweeney and Mr. Ketchum to respond to 
the report's findings and to indicate what they intend to do by 
way of reform. Then I will ask the rest of the panel for their 
thoughts about what should be done.
    Mr. McSweeney and Mr. Ketchum.
    Mr. McSweeney. Congressman, I would like to agree with you 
that the results of the SEC's report were troubling, and give 
you and this committee an assurance that the issues that were 
raised in that report were not issues that related to the 
surveillance and enforcement at the New York Stock Exchange.
    As you would note, there were no exchanges or market 
centers identified specifically in the report. The Exchange has 
a very robust and extensive surveillance program dealing with 
the issue of limit order exposure, and our compliance rate is 
99.997 percent. In instances in which we believe that 
compliance is not being effectuated by the specialist or 
brokers, we will take enforcement action, as we have done in 
the past.
    The New York Stock Exchange, in fact, had an order display 
rule in place before the SEC's adoption of the order handling 
rules, which were adopted specifically to address specific 
abuses in the over-the-counter market. Albeit our guideline was 
a 2-minute guideline as opposed to the immediate and up to 30 
second parameters that are in section 11(a) currently. But it 
is something we take seriously and we enforce aggressively.
    Mr. Ketchum. Congressman, again, I would also like to 
assure you that the NASD and the Nasdaq stock market take the 
order display requirement extremely seriously. We believe they 
are indeed a critical part of our marketplace.
    That is the reason why over the last 2 years NASD 
regulation has brought 49 disciplinary actions with respect to 
violations of the order display rules, and why we will be in 
the process in the next month of moving from our examination 
program to being able to use our now-available order 
information on timing to implement more electronic surveillance 
systems that will allow us on a real-time basis to be able to 
respond to any failures for the expected delay of information.
    This is a critical issue for us. We have brought, I 
believe, more disciplinary actions than all other markets 
combined, and we are absolutely committed to provide every 
surveillance technique we can to ensure that orders are 
properly exposed.
    Mr. Rush. So both the market witnesses here agree that the 
report is an accurate report. Do you agree with the findings of 
the report?
    Mr. Ketchum. I think the SEC does a great credit in 
bringing forward and focusing attention on this issue, and I 
think the issues are extremely important.
    It is probably useful to note with respect to some the 
percentages noted with respect to large market makers, those 
characterized as large market makers, that those percentages 
involve three market makers that account for less than one-
third of 1 percent of the transactions in the Nasdaq market, so 
it is an unusual definition of ``large.''
    But the basic point that there is no acceptable level of 
noncompliance with respect to the order handling rules is 
absolutely correct, and the Commission did a service to focus 
on that issue; and we are absolutely committed to throw every 
regulatory and surveillance focus on it that we possibly can.
    Mr. Oxley. The gentleman's time has expired.
    The gentleman from Illinois, Mr. Shimkus.
    Mr. Shimkus. Thank you, Mr. Chairman. I have been sitting 
here wondering how I was going to gracefully admit to the fact 
that this is pretty much over my head, even though I consider 
myself a learned individual. So I am going to try to boil it 
down simply, and then I have a few questions.
    Is it safe to say that the exchanges are like traditional 
auctioneers in that the ECNs currently have to go through a 
gatekeeper, it is kind of a closed system, and the real debate 
is, should the ECNs eventually be able to be their own 
auctioneer? If we are going to boil this down simplistically, 
infantryman style, a ``keep it simple, stupid'' proposal?
    Mr. Atkin. I think you have hit on the fundamental issue, 
and that is, as I believe I said earlier, I think many ECNs, in 
essence, are frustrated exchanges. ECNs do not exist in any 
other market structure or in any other market around the world, 
except the U.S. market. I believe the main reason for that is, 
other marketplaces allow true competition to exist between 
auctioneers or between exchange entities.
    I think what is going on in this marketplace right now, to 
go with the analogy, is maybe Nasdaq and the New York Stock 
Exchange have been Christie's and the Sotheby's, but it is as 
if eBay could go into business, but only if it abided by the 
rules set by Christie's or Sotheby's.
    What we are saying is, to promote competition and to 
promote innovation in these markets, you need to set these 
companies free and allow them to operate on a level playing 
field. The fact that the Nasdaq has its SRO and the New York 
Stock Exchange has its SRO, which gives it significant 
rulemaking advantages, we think that that prohibits competition 
from truly blossoming in this marketplace.
    Mr. Shimkus. Let me follow up, and I appreciate that, and I 
did write eBay in some of my scribbled notes as I was thinking 
it through, is it the Exchange's argument that the investor is 
best protected by the current, maybe partially monopolistic 
approach?
    Mr. McSweeney. Congressman, I would respond to that by 
saying regulation ATS presently provides an alternative for 
ECNs to either register as broker-dealers, which the current 
nine ECNs are presently broker-dealers registered with the 
NASD, or they can register as exchanges with the SEC and meet 
the regulatory requirements that are appropriate for a self-
regulatory organization. In fact, three of the ECNs, Nextrade, 
Island and Archipelago, have filed with the SEC for that 
status. It is moot with respect to Archipelago because of their 
proposed alliance with the Pacific Stock Exchange, but that 
option is open and available to ECNs if they wish to choose 
that route.
    Mr. Shimkus. Mr. Ketchum?
    Mr. Ketchum. I think Bob has hit an important point. Let me 
say a couple of things in addition.
    First, it is probably necessary to understand that ECNs 
don't operate entirely within an exchange or Nasdaq 
infrastructure. They have a separate technology infrastructure 
in which anyone who wishes to be a participant with respect to 
what that ECN electronically connects to. They are enormously 
efficient from that standpoint, compete extremely well, and 
provide a great benefit to the marketplace. They, as Bob 
indicates, have a choice now as to whether to be a broker or an 
exchange environment, and gain some of the benefits and yet 
costs and delays that are involved in having to operate as a 
fully regulated exchange; and we support that choice.
    Given that environment, I don't think that they are 
hampered in any way with respect to their choices, particularly 
from a Nasdaq situation in which we are committed to linking 
with an ECN that wants to operate either as an exchange or an 
ECN in an open, inclusive environment.
    Mr. Shimkus. Let me then move, Mr. Ketchum, and follow up. 
Some of these may have been asked earlier.
    Should the Nasdaq allow others to trade in decimals, even 
though you have not moved to decimal trading yet?
    Mr. Ketchum. Well, that is a good question, Congressman. In 
fact today, Nasdaq, unlike other markets in the United States, 
because of the manner in which it is structured, does allow 
anyone to trade in decimals who operates on the Nasdaq market. 
Indeed, we think that is an important right, and we think they 
should continue to be able to do that.
    We are able to facilitate anyone who wishes to report in 
decimals through the clearing system, and we are absolutely 
committed to continuing to do that. We think people who are 
participating in the market should respond to whatever their 
customer needs are.
    Mr. Shimkus. When will you be prepared? When do you 
envision being able to fully move? I think the committee, as a 
whole--I can't speak for all the members, but I think we are 
obviously--we really want to see this happen, as you know.
    Mr. Ketchum. Congressman, I think that there is probably 
nobody in this this room that is more aware that this committee 
wants to see this happen than me. Let me emphasize and say this 
very, very clearly, that Nasdaq and the NASD strongly believe 
in the implementation of decimalization as well, and we very 
much want to see it happen.
    We submitted a comment letter to the SEC this week in which 
we have indicated our ability to be able to move and support, 
based on whatever the SEC determines to do, either a pilot or 
full implementation of trading in listed securities in 
September of this year. We will be able to support, in light of 
the explosion of volume on Nasdaq, the implementation of 
decimalization in the Nasdaq marketplace, full implementation, 
beyond the ability to support anyone who chooses to trade in 
decimals now, by the end of the first quarter of 2001.
    I want to commit to you, sir, decimalization is our first 
priority. We will let nothing stand in front of or let no 
resources not be dedicated that are necessary to meet those 
commitments.
    Mr. Shimkus. Mr. Chairman, I would like Mr. Atkin to 
answer, and then we can cut my time off.
    Mr. Atkin. I think going back to the choice issue of reg 
ATS, it is a choice, but I would say it is a false choice. 
There is absoultely no clear path for those ECNs who wish to 
compete on a level playing field with either Nasdaq or the New 
York Stock Exchange; or if Goldman Sachs chooses to compete 
with Nasdaq and the New York Stock Exchange, to do so. It is an 
extremely unclear process. The last exchange to do it was the 
International Securities Exchange, which was a small options 
exchange. It took 3 years for that to occur.
    In the meantime, Nasdaq is building with its Super Montage 
proposal something that has very competitive aspects, I would 
say a direct competitor to the ECNs that wish to get out from 
under its infrastructure.
    In my view, this is all about timing. I believe Nasdaq 
should be allowed to do whatever it wants to its market, but 
only after those who want to compete with it are able to do so 
on a level playing field. Nasdaq cannot have the monopoly on 
regulation in its market, it can't have the monopoly on market 
data and use of its infrastructure.
    This is really a sequencing problem more than anything 
else.
    Mr. Shimkus. Well, I appreciate that. I would just end up 
by saying we have a lot of education from all parties to work 
with with members, and I look forward to learning more. I don't 
watch much TV, but the commercial I like is when the boss calls 
Stewart into his office. This Gen-Xer comes in, rock and roll 
and trading stock. He is the hero. And the guy gives him the 
Xerox copy of the party, and the guy says ``I think I might be 
there, Stewart.''
    So the world is changing, and I think we all need to get on 
board.
    With that, I yield back my time.
    Mr. Oxley. Thank you. I was thinking about Ringo Starr, but 
that is a whole different story.
    The gentleman from New York, Mr. Engel.
    Mr. Engel. Thank you, Mr. Chairman.
    Ms. Stark, your testimony states, ``Nasdaq's proposed Super 
Montage is a laudable initial step in the right direction to 
provide price and time priority for limit orders and to permit 
display of a more complete picture of trading interests, not 
only of the inside quote, but of prices several increments away 
from the best bid and offer.''
    You go on to concede that, ``It is not a panacea as it 
permits internalization of customer orders by broker-dealers.'' 
That is a practice you obviously condemn elsewhere in your 
testimony.
    Mr. Atkin, on the other hand, calls Super Montage ``super 
monopoly.'' You say it will allow Nasdaq ``to control who 
market participants send their orders to and give the NASD an 
unfair advantage over its competitors, ultimately harming 
investors.'' That is what you say.
    You go on to say, ``Because it is not really voluntary, it 
could give investors worse prices than they get today and 
provide investors with less information than they get today.'' 
If I misquote you, please correct me.
    If I take the testimony of both of you, it is hard to 
believe that you are talking about the same system. So my 
question to the two of you, and then the rest of the panel, is, 
whose conclusion is correct and why?
    Ms. Stark, if you would begin.
    Ms. Stark. Thank you, Congressman. I sit on Nasdaq's 
Quality of Markets Committee and have spent many long committee 
hours going through the creation of the proposal first of 
NAQsi.net, I believe. And usually these things have Q's in 
them; for some reason, Super Montage does not.
    The Nasdaq marketplace is evolving, and the Nasdaq, or the 
NASD, is made up of many different constituents with many 
different interests. Super Montage is the first proposal that I 
have seen that Nasdaq has been able to successfully put out to 
its membership that actually has a chance of passing, and I 
think it is a good step in the right direction in terms of 
opening up the marketplace for everyone to see what is going on 
there. I don't think it is the best step that could be made 
because, similar to what Doug has said, there is an issue about 
whether or not you are forcing everyone into one switch.
    I think on a short-term basis this might be our best shot 
to move the market forward, perhaps to a better place and a 
better structure. But because of the varying interests of the 
people who make up the NASD, who are NASD members, I don't 
think it is realistic to expect a sweeping change to make the 
major, major steps that perhaps could be made.
    Mr. Atkin. First of all, Holly and I have known each other 
a long time, and I think we share the same goal in getting the 
markets as efficient as possible for investors. I think Holly 
hit on maybe the area of perceived disagreement or 
disagreement, and that is, over what time period are you 
looking at this proposal? In the short term, given all the 
political issues within Nasdaq and, you know, the market 
makers' strong interest and their desires to internalize order 
flow, I believe that this is the best that they can get out of 
the current governing structure at Nasdaq.
    What I would suggest, though, is that if you look at this, 
what is likely to occur if this is implemented, if Nasdaq is 
building its own ECN, Nasdaq, under its current proposal, is 
only willing to go out to the three best bids and offers. The 
ECNs that exist, Instanet included, show investors full depth 
of book.
    If Super Montage is successful at draining liquidity out of 
the ECNs, I think you are going to see market structure go 
backwards and transparency go backwards.
    Mr. Kamen. I would just like to add, this is an example of 
the type of benign neglect that I was talking about in the 
small-tier markets. In very liquid markets where it is likely 
there will be many participants posting bids and offers, the 
Super Montage could certainly have its purpose. But in the 
lower-tier markets, where it is mostly dominated by market 
makers that display 100 share bid-and-offer size and wait for 
the phone call, if you will, to react to the real bid or offer 
that is being shown them, the Super Montage just might display 
300 shares bid at one level and 100 at another and 400 at 
another, giving the false illusion that at the low end there is 
no interest in these stocks, because the market markers would 
only put up these de minimis bids.
    If I can, I would just like to clarify something I said 
earlier. In the lower-tier markets, I can't access as a small 
broker-dealer, if I am not an Instanet access firm, the OTC 
bulletin board and the order systems that they were talking 
about. Predominately, the regional investment banker 
association firms don't enjoy some of the access that the 
larger firms do to the systems of the private companies.
    Mr. Engel. Mr. Ketchum.
    Mr. Ketchum. Thank you, Congressman. I would just like to 
briefly hit on this issue, because I think the issues are 
important, and I think the points made by both Ms. Stark and 
Mr. Atkin deserve a little response.
    Undoubtedly, the market structure in the United States will 
continue to evolve for a long period of time. We, perhaps more 
than any country, have to solve two different problems that 
relate. We have to handle the largest institutional investing 
market in the world, and we have to handle an explosive on-line 
trading environment of individual investors that result in 
literally hundreds of orders in a single stock focusing in a 
very short period. So I have no doubt that, whatever occurs, 
the Super Montage display window will not be the last step in 
the line.
    I do believe that we need to do a good deal more talking 
with our ECN friends and certainly with Instanet, which has 
been a critical innovator and substantial liquidity support of 
the Nasdaq market for some time.
    I don't believe Doug's points are correct, and we will 
spend some time trying to work through them, because in fact 
the intent is to continue to allow the full display of ECN 
depth through the marketplace, to encourage additional display 
of market maker limit orders that are not seen today, and not 
to require ECNs to necessarily leave orders one way or another, 
whether they choose to go with us for automatic execution or 
through communication with our existing transaction link with 
the system now. We intend to provide the alternative, and we 
would like them to be participants in our market, if they 
choose as brokers, either way.
    So we need to do our work in better communicating with the 
ECNs, but I do believe this is a step, as Holly indicates, very 
much in the right direction.
    Mr. Oxley. The gentleman's time has expired.
    Let me recognize myself for another round for 5 minutes.
    Mr. McSweeney, at our last hearing, we had some folks from 
Island testify about their entire order book that is publicly 
available in real time. Doesn't this level of transparency help 
investors, and why does the New York Stock Exchange refuse 
direct electronic access by investors to the specialist order 
book?
    Mr. McSweeney. Mr. Chairman, we agree that that level of 
transparency does help investors, and we intend to make the 
entire limit order book of each of our specialists fully 
available before the end of the year.
    Mr. Oxley. Are we making news here today, Mr. McSweeney?
    Mr. McSweeney. No, I don't believe so. We have indicated in 
the past that that has been in our technology plans.
    Mr. Oxley. And that will be by the end of the year?
    Mr. McSweeney. Yes, sir.
    Mr. Oxley. Any reactions?
    Mr. Atkin. We welcome it. We think it would be great for 
investors, and showing more information to investors is 
critical for them to lower their trading costs.
    Mr. Oxley. Does everybody else agree with that?
    Good.
    Mr. McSweeney how do you respond to the concerns raised by 
Mr. Wheeler that the physical floor base model of the Exchange 
depends on layers of internalizing rules?
    Mr. McSweeney. Mr. Chairman, I don't agree with that 
characterization. There is an ability for customers of our 
member firm broker-dealers to access the floor of the NYSE 
through our SuperDOT network. In fact, 93 percent of the orders 
and 50 percent of the volume that comes to the Exchange floor 
is coming to the floor through an e-commerce electronic 
platform.
    There clearly is a different market structure than an ECN 
market structure, which provides solely an automatic execution 
for the order flow. It is an agency auction market. That really 
does not amount to internalization, because internalization 
involves a situation in which orders are not provided an 
opportunity for price improvement. In fact, all of the order 
flow that comes to the NYSE's floor, including that coming 
through our systems, is afforded an opportunity at price 
improvement, which results in 35 percent of the volume 
receiving price improvement; and if you move beyond 1 point 
spreads, it amounts to 52 percent of the volume receiving price 
improvement.
    So it is really not an internalized environment. It is an 
auction environment that provides an opportunity for late 
interest, represented by brokers, to provide that price 
improvement.
    Mr. Jenkins. Mr. Chairman, I just want to clarify 
something, though, as an institutional trader.
    If I go to the floor and I send through this SuperDOT 
system a limit order, if a stock is offered at $20 and I send a 
limit order to the floor, I am in agreement that I will buy 
that stock at $20.
    In many cases, you do not buy the stock because, in the 
current system, they put it out for auction and the floor-based 
traders who have standing are able to go in and then take that 
offer, while I am trying to bid for a price, at a price that I 
didn't even agree to.
    Does that not occur on the floor? Because I am willing to 
pay that price, yet I can't take the stock at that price. I 
have to give others that are not even willing to pay that price 
on the floor the ability to come up and compete with me.
    Why do they get to compete? If I step in and I say, here is 
the auction, we are offering it at this price; and I step in 
and say, I will buy that stock, why then do I have to bid a 
lower price first and allow everybody to step ahead of me 
before my order is executed?
    Mr. McSweeney. The point Mr. Jenkins is raising is an 
important one. The agency auction provides the opportunity for 
price improvement, but quite often we have seen situations in 
which large orders that are brought to the marketplace result 
in latent interest stepping up and participating on the same 
side of the market.
    That is the reason why, later this year, we are going to be 
introducing a new institutional express product that includes 
express order. What that will allow for is the entry of orders, 
initially for 25,000 shares or more, and then after 3 months, 
for 15,000 or more, an opportunity to lock in to the contra-
interest if that quote has aged initially 30 seconds and, 
subsequently, 15 seconds in a manner in which the opportunity 
for crowd interest to interact with that contra-side of the 
market will not be available, but the order be exposed for the 
possibility only of price improvement.
    So I think the point he is raising is a good one, and I 
think the product that we will be rolling out in the next 
several months will address that specific issue.
    Mr. Oxley. Now, is that a viable solution, Mr. Wheeler and 
Mr. Jenkins?
    Mr. Jenkins. It is not, because 30 seconds in an electronic 
world is an eternity. I guarantee you that you will not have 
orders available on the institutional express for institutions 
to take, because they will disappear as you approach that 30-
second limit.
    Mr. Wheeler. A couple of points I would like to make in 
response to this:
    No. 1, I think institutional express, the Exchange should 
be commended in that it is a positive step in the right 
direction, albeit in our view a very small baby step, if you 
will.
    Throughout the testimony, and I think Mr. Jenkins probably 
verbalized it best, limit orders are the backbone of trading 
throughout the world. If you look at Mr. Atkin's system and all 
the ECNs, they thrive and are gaining market share because they 
protect limit orders. The New York Stock Exchange currently 
does not protect limit orders, i.e., the investing public, who 
is willing to display to the world that they are willing to buy 
a particular stock at a particular price. I would go so far as 
to say that members of these exchanges prey off of these limit 
orders.
    Limit orders have an economic value. They are worth 
something. There is a value to a limit order. No matter how far 
away from the current market it is or how small a quantity that 
order is for, it has an economic value. If you look at options 
to buy and sell a particular stock in the newspaper, options 
that are away from the market all have a value; there is an 
economic value attached to them.
    Our exchanges do not recognize the economic value of those 
limit orders. They need to be protected and the investors 
behind the orders that are willing to display their trading 
interest need to be protected if our exchanges are going to 
compete in the global marketplace going forward.
    In Mr. Jenkins' example, if he is down on the floor willing 
to pay $20 for a stock and he is displaying that limit to the 
public and he is the high bid in the ``auction system'' of the 
New York Stock Exchange, and I come in to sell that stock to 
Mr. Jenkins, it is very feasible for a member standing in the 
crowd, instead of allowing me to sell stock to Mr. Jenkins at 
$20, that they just step in and say, I will pay a ``teenie'' 
for American Century Stock. This gets written off as ``price 
improvement.'' The New York Stock Exchange, in a sense, wraps 
themselves in the American flag over price improvement.
    We think the whole price improvement idea is flawed. Price 
improvement is nothing more than a short-term breakup of a 
clean trade in order to get one side of that transaction to 
ultimately pay a higher economic price than the minimum tic 
that they just stepped ahead of that order for.
    In this particular example, when I try to sell stock to Mr. 
Jenkins at $20, but I am broken up--but I am broken up by a 
member in the crowd who pays \1/16\ for that, Mr. Jenkins still 
has a buy ticket on his desk.
    Our portfolio managers put in orders to buy and sell 
particular stocks. They don't give us orders that say buy IBM, 
Dell or Compaq. They give us an order that says, buy IBM. The 
members of the crowd know full well that if Mr. Jenkins can't 
buy his stock at $20, he is going to have to pay \1/8\ or \3/
16\ or \1/4\ for that.
    So what happens when someone takes that stock at \1/16\? 
Yes, I am price improved by \1/16\ of a point. But what happens 
to Mr. Jenkins?
    I will tell you what happens to him. The member turns 
around and says, oh, Mr. Jenkins, I will sell you your stock at 
\1/4\; and it is like the infamous oil commercial, either pay 
me now or pay me later.
    Mr. Oxley. So in that case, it would appear to always 
benefit the seller versus the buyer. Is that too simple, or is 
that basically it?
    Mr. Wheeler. That is basically it. The structure of the 
express product benefits the responder to a trade, and that is 
where we view that as fundamentally flawed. It does nothing to 
protect the investor who is willing to display a trading 
interest by telling the world they will pay the highest 
published price for a given stock. No one else is willing to 
pay a higher price. Even though there may be members in the 
crowd that are willing to pay \1/16\ or \1/8\, they don't have 
an economic interest in displaying that \1/16\ or \1/8\ to the 
world to say the stock is not worth $20, this stock is worth 
20\1/16\ or 20\1/8\.
    Why? Because when I come in to sell it to them, they can 
just sit back and say, I will take that stock at \1/16\. Mr. 
Jenkins' order becomes a free option for everyone else in the 
crowd. This is why seats at the New York Stock Exchange sell 
for $1.5 million or $2 million, because of this economic rent 
they are able to garner from shareholders.
    In our viewpoint, all the dollars made by the specialists 
in the crowds are dollars that were at one time in the pockets 
of the public investors, retail or institutional, and those 
dollars are being siphoned off under the guise of price 
improvement every day, day in and day out, on the floor of the 
Stock Exchange.
    Mr. Oxley. Mr. McSweeney, you were looking askance there at 
that last comment. Could you defend yourself there?
    Mr. McSweeney. Mr. Chairman, I didn't agree with the 
characterization, because even in Mr. Wheeler's example, the 
customer for whom he was entering that order was receiving the 
economic benefit of the price improvement, and in the example 
the customer that was being represented by Mr. Jenkins was not 
willing to price improve above the price that was being bid. It 
was somebody else in the crowd that stepped up and provided 
that additional----
    Mr. Oxley. That is why it was a limited order, was it not?
    Mr. McSweeney. That is exactly right.
    Mr. Oxley. But in fact he has his whole soul out there for 
everybody to see. He has pretty much bared it all, and your guy 
comes in there and moves ahead of him, but he hasn't risked 
anything.
    Mr. McSweeney. Well, part of the price discovery process is 
bringing out the latent interest to provide price improvement.
    Mr. Oxley. That is great for the guy that is selling, but 
what about this poor guy that is sitting there thinking he is 
going to pick this thing off at $40?
    Mr. McSweeney. Well, the NYSE direct cost product that we 
will be rolling out before the end of the year will provide an 
opportunity for investors who want automatic execution to seek 
that route initially for limit orders of 1,099 shares or less, 
and there will be absolutely no crowd interaction except what 
was represented the display bid and offer. So the opportunity 
for investors to send orders through the system sponsored by 
their broker-dealers to interact directly with the entire bid 
and offer without any crowd interaction will be available 
through the NYSE direct.
    Mr. Oxley. That will be transparent?
    Mr. McSweeney. That will be fully transparent.
    Mr. Oxley. My time has long expired.
    The gentleman from New York.
    Mr. Engel. Thank you, Mr. Chairman. I won't be long. I know 
everyone has been sitting here for a while. I just think it is 
a bit unfair, some of the comments that have been made.
    I am glad that Mr. McSweeney put the market structure 
report into the record, because I think it is important that we 
have balanced testimony here. The report makes recommendations 
on expanded choices for investors at the New York Stock 
Exchange, and it builds, as was said before, on the existing 
strengths of the New York Stock Exchange floor system; and some 
of the expanded choices include automatic electronic execution 
and opening the specialist's book to on-line investors 
throughout the Internet. And the report, of course, supports 
elimination of the intermarket trading system in favor of a lot 
of different private sector initiatives.
    Quite frankly, I have found the New York Stock Exchange 
willing to make the necessary changes in all the different 
subjects that we have covered in this subcommittee and the 
committee through the years. So I think some of the accusations 
are a bit unfair. I want to give Mr. McSweeney a chance to 
perhaps respond further to anything he might want to say.
    Mr. McSweeney. Well, I appreciate the compliment, 
Congressman, and I can assure you that our Special Committee 
worked very long and hard over 6 months to receive a broad 
range of input and put the recommendations in the light of what 
would be in the best interests of the ultimate investors, as 
opposed to the interests of the intermediaries. I think that is 
reflected in the recommendations.
    Mr. Engel. Thank you.
    Mr. Chairman, I have no further questions.
    Mr. Oxley. Thank you.
    Thanks to all of our panel for your patience in waiting for 
those floor votes and for a most interesting and lively debate 
on some very, very important issues that face this 
subcommittee, as well as the SEC.
    With that, the subcommittee stands adjourned.
    [Whereupon, at 12:52 p.m., the subcommittee was adjourned.]
    [Additional material submitted for the record follows:]

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  RESPONSES FOR THE RECORD OF RICHARD G. KETCHUM, PRESIDENT, NATIONAL 
                   ASSOCIATION OF SECURITIES DEALERS

    Question 1. Should NASDAQ's delay cause the entire market to delay 
trading in decimals? Does the NASDAQ plan to develop a rounding 
indicator for those trading in decimals? If not, will it be difficult 
for brokers to comply with best execution obligations?
    Response: On May 10, 2000 the NASD responded to the SEC's release 
on revising the decimal implementation schedule. We stated in our 
comment that the NASD will be ready to implement either of the 
alternatives suggested in the SEC's release for the exchange-listed 
market, full dual pricing or a pilot of dual pricing by September 4, 
2000, as the SEC finds to be in the public interest in maintaining fair 
and orderly markets and to protect investors. The NASD will also be 
ready to initiate decimal pricing in Nasdaq securities on March 31, 
2001. There has been no change to these dates.
    Today, no rounding indicator is supported in the Nasdaq production 
software. If an indicator were to be required, it would be a new 
requirement, with technical implications for our downstream systems as 
well as vendors. Adding this requirement could jeopardize the planned 
implementation dates for decimals. This question has arisen previously, 
specifically during the implementation of the SEC Order Handling Rules. 
At that time, the SEC did not require special rounding indicators.
    Once the new software is implemented, firms will be allowed to 
enter prices up to 4 decimal places. The system will round, according 
to pre-defined logic, to the minimum price variation for the security 
(pennies or nickels). Screens will display the rounded price. It should 
also be noted that our systems currently accept quote entries in 64ths 
and round to 16th or 32nds, as required.
    The issue of rounding is an important one that the SEC, the NASD, 
the other markets, and the securities industry must carefully consider, 
because of, among other things, the implications for best execution 
obligations. One of the benefits of a decimalization pilot, if the SEC 
were to request one, would be to understand the need for rounding 
conventions and how best to provide them.
    Question 2. NASDAQ has recently announced alliances in Germany, 
England and Japan. These are all decimalized markets. Why can't NASDAQ 
use those countries' decimalized systems here?
    Response: The other international markets that Nasdaq has announced 
alliances with now run on separate hardware platforms and networks, all 
of which handle far lower message traffic and are not connected to U.S. 
clearance and settlement systems. Moreover, none of these systems 
support either market makers or Electronic Communications Networks 
(ECNs). Conversion of any of these systems to support Nasdaq Stock 
Market in the short term is simply impractical.
    Question 3. When will NASDAQ be ready to trade all stocks in 
decimals?
    Response: As stated in the answer to question 1 above, the NASD 
recently responded to the SEC's release on revising the decimal 
implementation schedule. We stated in that comment letter that the NASD 
will be ready to implement either of the alternatives suggested in the 
SEC's release for the exchange-listed market, full dual pricing or a 
pilot of dual pricing by September 4, 2000, as the SEC finds to be in 
the public interest in maintaining fair and orderly markets and to 
protect investors. The NASD will also be ready to initiate decimal 
pricing in Nasdaq securities on March 31, 2001. There has been no 
change to these dates.
    Question 4. What is the single biggest market inefficiency 
investors are facing in the market? What rule changes are/is necessary 
to eliminate this inefficiency?
    Response: We believe that the single greatest inefficiency 
investors are facing in the market today is fragmentation. In our 
opinion, fragmentation continues to pose a tremendous and credible 
threat to the integrity of the U.S. securities markets. We believe that 
this threat is not insurmountable and that the best way to address it 
is through quick, decisive, cooperative efforts by the NASD/Nasdaq and 
the SEC with Congress' support.
    As you are aware, electronic communications networks (ECNs) have 
become a significant force in the Nasdaq market. They collect hundreds 
of thousands of orders from customers across the country, and perhaps, 
world. Thus, ECNs contain and provide access to huge pools of 
liquidity. While recent rule and market-structure changes have 
increased transparency and access to these pools of investor interests, 
today it is still impossible to determine the entire depth of the 
market within the ECNs and consequently, within Nasdaq. This, in turn, 
limits the quality and efficiency of the Nasdaq market and potentially 
harms the individual investor.
    As I am sure you are aware, under the firm quote rule of the 
Exchange Act, a market maker may place a better-priced order into an 
ECN and not update its quote to reflect the better-priced order if the 
ECN disseminates the top of its file to Nasdaq and the ECN provides 
broker/dealers equivalent access to these orders. Thus, the public only 
sees the best-priced buy and the best-priced sell order (i.e., top-of-
file) that resides in each of the nine ECNs in Nasdaq. The public does 
not see the often significant liquidity in the ECN that is just below 
the ECNs' top of file. If a market maker places into an ECN an order 
that is priced better than the market maker's quote but is below the 
ECN's top of the file, that order will remain hidden from the market 
unless that order becomes the ECN's top of file. Currently, the only 
way for a market participant to monitor the full depth of the market is 
to subscribe to each of the ECNs, which is costly, inefficient, and 
unmanageable. This type of fragmentation makes it particularly 
difficult for institutions to conduct business in Nasdaq because the 
institution cannot adequately determine the available liquidity at and 
near the inside market. In addition, because only the top of the file 
of each ECN's and market maker's book is displayed in Nasdaq, it is 
possible for the market to trade through orders that reside on the 
market participant's back book at a price away from the inside. Because 
there currently is no way in Nasdaq to aggregate and display trading 
interest at multiple price levels, the current market structure fosters 
fragmentation.
    In response to the second part of the above question, we believe 
that the best way to address the problem of fragmentation is to allow 
the markets and market participants--fueled by the forces of 
competition and innovation--to provide a solution. Specifically, we 
believe that the Nasdaq Order Display Facility, or SuperMontage, which 
we submitted to the SEC last year, addresses the problem of 
fragmentation. In essence the SuperMontage will build on Nasdaq's 
strengths, as a collector and aggregator of trading interests--the 
traditional role of a market. In addition, the SuperMontage will be an 
inclusive model, in that it does not favor or a particular business 
type (e.g., ECN, fully integrated market making firm, wholesale market 
making firm). It will encourage innovation and competition while 
improving on transparency and liquidity. Technology advances have for 
the first time allowed Nasdaq to create a market where investors around 
the world can view and have electronic access to virtually the full 
depth of the market and can have their orders interact with one another 
virtually instantaneously.
    The SuperMontage will show the best bid/best offer in Nasdaq and 
two price levels away, accompanied at each price level by the aggregate 
size of the ``displayed'' trading interest of market makers, ECNs, and 
exchanges granted Unlisted Trading Privileges to Nasdaq securities (UTP 
Exchanges). Nasdaq market participants will be able to designate an 
order as ``attributable'' or ``non-attributable,'' and also will be 
able to indicate a reserve size for an order. Attributable orders will 
be displayed next to the Nasdaq market participant's acronym (Market 
Maker ID or MMID) in the current Nasdaq quotation montage, and will 
also be displayed in the SuperMontage as part of the aggregate trading 
interest at the inside and two prices away). Non-attributable orders 
will be displayed only in the Nasdaq Order Display Facility as part of 
the aggregate trading interest at the inside and two prices away. In 
addition, Nasdaq market makers and ECNs will be permitted for the first 
time to give multiple orders and orders at multiple price levels, which 
the system will manage and display in Nasdaq when the order is eligible 
for display next to the market participant's MMID and/or in the 
SuperMontage. Further, Nasdaq market participants will be able to 
access orders in the SuperMontage virtually instantaneously using a 
substantially-enhanced Nasdaq order delivery and execution system, 
which will be built on an architecture that accommodates the technology 
needs of all Nasdaq market participants, market makers and ECNs alike. 
The system will route orders to the market participant in queue and 
next eligible (based on a general time priority) to receive an order/
execution against its quote. Thus, the system will provide one of 
potentially many links of all market participants trading Nasdaq-listed 
securities.
    We believe that the SuperMontage provides substantial benefits to 
the individual investor and improves market quality, while also 
encouraging innovation and competition. The system reduces 
fragmentation by allowing market participants to transmit to Nasdaq 
multiple levels of orders and by aggregating and dynamically displaying 
all orders at the inside and two price levels away. Market participants 
will see for the first time in the SuperMontage the full depth of the 
inside market and two price levels away, which will enhance 
transparency and liquidity, and will also be able to view the full 
depth of the market in Nasdaq for all prices levels.
    The ability to transmit and display multiple orders will reduce the 
possibility that an order will be traded through in a fast moving 
market and also enhances best execution, which directly benefits the 
individual investor. The order routing capability of SuperMontage will 
enable the system to effectively link all markets--including UTP 
Exchanges--that trade Nasdaq securities. We believe this will create, 
for the first time, a national market system consistent with Congress' 
mandate in the 1975 amendments to the Exchange Act.
    Question 5. What are the expected benefits decimalization will 
bring to investors?
    Response: Potential benefits that decimalization may provide 
include more easily understood numbers and investor savings. The least 
disputed benefit of decimal pricing is that decimal pricing is easier 
for investors to understand.
    Regarding savings for investors, there is an increased savings 
potential for investors if decimal pricing leads to smaller price 
increments and narrower bid-ask spreads. Each price change (called an 
uptick or downtick respectively) would increase or decrease the price 
per share by 6.25 cents at a minimum. With decimals, there is the 
potential to trade at a nickel or a penny increment. At a nickel 
increment, the uptick or downtick will be at 5 cents per share; a 
potential savings of 1.25 cents per share for investors. At a penny 
increment, investors could save up to 5.25 cents per share as the 
uptick or downtick goes one cent at a time. Narrower spreads mean 
investors could save money as they are able to achieve a more precise 
price for their trades. Of course, any calculation of benefits should 
recognize that in many cases there will be relatively little depth at a 
penny increment and that most of the buying and selling interest will 
likely be five to ten cents away from the displayed price.
    Question 6. What effect would the NASD's SuperMontage proposal have 
on competition in the marketplace? How would use of the SuperMontage be 
voluntary if the NASD retains any affiliation with the regulator of 
competitors of SuperMontage?
    Response: We believe that the SuperMontage is a pro-competitive 
development that will broaden competition and lead to further 
innovation. SuperMontage will also permit Nasdaq to remain competitive 
in an environment of increased globalization of the world's securities 
markets. We firmly believe the proposal meets the statutory 
requirements under the Exchange Act, and that the proposal responds 
directly to Congress' goal of establishing a true national market 
system. We believe that the proposal protects investors and promotes 
the establishment of a free and open national market system, in that it 
reduces fragmentation in the Nasdaq market and improves the efficiency 
of transactions in Nasdaq.
    Specifically, the SuperMontage attempts to increase price 
transparency and alleviate fragmentation by providing a means for 
centralizing trading interest, displaying this trading interest to 
investors, and providing an efficient means for accessing such 
interest. We note that these are essential functions of an exchange. 
Every registered securities exchange in the United States has a limit 
order facility, which serves as the point of order aggregation. Nasdaq 
is currently in the process of registering as an exchange. Nasdaq 
should be permitted to have a method of aggregating, displaying, and 
accessing investors' interest to better serve investors in Nasdaq-
listed securities and in the spirit of equal regulation of similarly 
situated market participants.
    The SuperMontage encourages competition by providing an open and 
inclusive architecture in which competing market centers may operate. 
We are not, as some have suggested, directly competing with our 
members. Rather, we recognize that market centers that trade Nasdaq 
securities add value to the market and offer alternative services. For 
example, we are not offering through the SuperMontage certain value-
added services, such as anonymity through settlement, that ECNs offer 
today. Moreover, while the proposal provides a central means for 
accessing liquidity in Nasdaq and other market centers, it in no way 
establishes the SuperMontage as the sole means for providing or 
accessing liquidity. NASD members, individual investors, and members of 
other exchanges are free to leave their orders with any market center 
they chose. Moreover, subscribers of ECNs are free to use the execution 
services offered by the ECNs to access liquidity within those markets. 
UTP Exchanges will continue to offer innovative execution services to 
their members. Orders will continue to be handled by and executed in 
multiple trading venues. SuperMontage thus provides a central, but not 
exclusive, means of accessing liquidity and of exposing trading 
interest to the market.
    Competition will continue to flourish in the new regulatory 
environment that the SEC has created through its recent regulatory 
initiatives, as shown by recent announcements by certain ECNs to link 
with one another (independent of the Nasdaq network and systems) and 
plans of some broker/dealers to register as exchanges.
    As the second part of your question, we reiterate the position that 
we have publicly articulated to our members and the SEC--the 
SuperMontage is completely voluntary. Nothing requires or compels 
market participants to give their order book to Nasdaq. We understand 
that market participants may not wish to relinquish their order book to 
Nasdaq and that they may provide valuable services away from the 
central Nasdaq market. ECNs and market makers are free to give Nasdaq 
only their best buy and sell orders, or they can chose to give Nasdaq 
all or some of their orders. Nor does anything require that executions 
in Nasdaq securities occur through the SuperMontage, or other Nasdaq 
facility. Any of these options for handling and executing orders would 
be consistent with NASD rules. This is similar to the experience of 
exchanges. In the past every exchange has had a limit order facility, 
and that members of such exchanges have not been compelled by rule or 
regulation to leave their limit orders with the member's resident 
exchange or the primary market. To the contrary, the SEC has encouraged 
exchanges to actively compete for order flow and avoided requiring 
members to leave orders with the primary exchange.
    Finally, we reiterate that we in no way believe or intend for the 
SuperMontage to be mandatory, regardless of the NASD and Nasdaq's 
affiliation. NASD Regulation--a separate, wholly-owned subsidiary of 
the NASD--is vested with regulatory authority over Nasdaq. Other than 
its role in establishing market policy and rules, Nasdaq's regulatory 
role is extremely limited. The separation between the regulatory 
function of NASD Regulation and the market function of Nasdaq is clear 
and strong. The separation between these two corporations will become 
even greater when Nasdaq recapitalizes, Nasdaq registers as an 
exchange, and the NASD becomes a minority owner of Nasdaq.
    Question 7. I introduced a bill that passed the House and requires 
trade reporting information to be disseminated to improve price 
transparency for corporate debt. How will NASDAQ's TRACE proposal 
impact the market? Is it more than just price reporting? Is it in the 
interest of competition to have an SRO set the rules for trading that 
will be centralized with the NASD and benefit NASDAQ? Does this 
proposal use regulatory power to create a monopoly?
    Response: The NASD is responsible for regulating virtually all 
securities trading on Nasdaq and in the over-the-counter (OTC) market, 
including corporate bonds. Section15A of the Securities Exchange Act of 
1934 was adopted to expand the concept of self-regulation to the OTC 
market, and the NASD was formed to provide a mechanism to supervise the 
conduct of broker-dealers participating in that market.
    This authority includes the regulation of trading in corporate debt 
securities. The NASD is the only self-regulatory organization (SRO) 
that has regulatory authority over NASD broker-dealers that trade 
corporate debt securities over-the-counter, that is, not on a 
registered securities exchange, and is thus the only SRO that can 
enhance the oversight of the operation of the OTC corporate bond 
market.
    SEC Chairman Levitt called for increased transparency in the 
corporate bond markets by requesting: rules requiring dealers in US 
corporate bonds to report all transactions, systems to receive and 
distribute transaction prices immediately, a regulatory database of 
bond transactions, and a bond market surveillance system using that 
database.
    The NASD filed a proposal with the SEC that both responded to 
Chairman Levitt's request and addressed the goals in your bill. The 
NASD's proposal will provide: (1) a flexible trade reporting facility 
based upon standards all NASD members must adhere to when trading over-
the-counter; (2) a mechanism to give price disclosure to all market 
participants equally; and (3) an audit trail for NASDR to surveill the 
market.
    The NASD is responding to Congressional and SEC objectives by using 
facilities that are in place and have worked well for the last decade. 
TRACE uses existing linkages between the industry, Nasdaq, and NASDR, 
to solve the regulation and transparency problems of the corporate bond 
market quickly and efficiently. The NASD will use its wholly owned 
subsidiary, NASD Regulation, to regulate under new trade reporting 
rules we have filed with the SEC. The NASD will enhance transparency 
through trade reporting facilities also already in place and operated 
by its other subsidiary, Nasdaq.
    It is important to note that the system is not a bond trading 
system, and that Nasdaq's role will be simply that of providing a 
facility, not making rules or regulating the system. The NASD will in 
no way use its regulatory powers to enhance the position of Nasdaq, and 
will not use regulatory power to create a monopolistic situation. The 
NASD, not Nasdaq, has been charged by the SEC with collecting, 
disseminating, and policing the information on corporate bond trade 
reports. The NASD, not Nasdaq, will be responsible for owning and 
operating the mechanism for trade reporting and regulation of this 
market.
    There has been confusion about the role of the NASD regarding the 
ownership and revenue from the sale of the data collected. While others 
have suggested that they should instead provide the data on a selective 
basis, the NASD, as it now does with equity trade data, will distribute 
bond transaction data to all vendors on an open, fair and independent 
basis, subject to SEC regulation. We expect a robust market for resale 
of that data by vendors, just as now exists in equity trade data. The 
NASD will use any revenues that it receives from the sale of TRACE data 
to cover the NASD's costs in operating the system, including NASDR's 
regulatory activities and the systems that collect and disseminate the 
trade information to the public. Any revenue beyond these regulatory 
and technology costs will be shared with the market participants that 
provided the data in the first place.
    Finally, the TRACE proposal addresses the balance of market impact 
and market transparency by setting dissemination caps for the 
investment grade and the below investment grade markets. The NASD will 
also conduct liquidity studies to monitor market impact. We have 
already begun discussions with firms and industry organizations to 
address their concerns on both the market impact and market data 
issues.
    Question 8. Given the technical difficulty that NASDAQ has had in 
converting to decimals, why should we rely on NASDAQ to build a central 
point of failure for the bond market through TRACE?
    Response: The NASD is confident that Nasdaq will be able to 
implement TRACE as a trade reporting facility. TRACE is based in large 
part on Nasdaq's current trade reporting system for equity securities--
the Automated Confirmation Transaction Service (ACT). Every trading day 
ACT technology reliably processes hundreds of thousands of last-sale 
trade reports in equity securities and accurately disseminates that 
information to market participants worldwide. This existing facility 
will be tailored to handle the different data elements necessary for 
corporate bonds. It should also be noted that corporate bonds trade 
less frequently than equities and that the system hardware for TRACE is 
independent of equity trading hardware.
    There must be a single mechanism that consolidates and validates 
the trade reporting information for regulatory and transparency 
purposes. Historically, the single mechanism for performing this task 
has been operated by an SRO that has the statutory obligations to 
ensure that all information is properly collected, fairly disseminated, 
and closely scrutinized. The TRACE proposal follows that historical 
model.
    Question 9. A CLOB, based on price-time priority reduces best 
execution to the NBBO. There are, however, many factors that could 
influence a decision to trade. In your opinion, what factors should be 
considered for best execution?
    Response: Although we believe that a CLOB based on strict 
(universal) price-time priority would stifle market-wide competition 
and disadvantage investors, we also note that Commission has stated 
that best execution cannot simply be reduced to guaranteeing the NBBO 
(National Best Bid or Offer). Rather, a market participant must also 
evaluate the opportunity for its customers to receive price improvement 
or other value-added benefits.
    As a general matter, however, best execution is a facts and 
circumstances determination. As the SEC has stated, there are a number 
of factors for market participants to consider in evaluating the 
quality of the executions they receive and whether they are providing 
best execution to their customers. Execution quality may involve the 
following: the opportunity for and likelihood of receiving price 
improvement; the speed and certainty of execution; the adequacy and 
certainty of accessible liquidity, including liquidity beyond what is 
displayed; the nature of the security to be traded; the type of order 
to be placed; the level of transactions costs; and the scope of trading 
anonymity available. Individual investors may focus entirely on one 
factor, or on several. For example, one investor may wish to receive a 
guaranteed execution at the prevailing NBBO, while another may forego 
speed of execution in favor of the opportunity for price improvement. 
Institutional investors may desire to have their orders executed 
anonymously, regardless of speed or price improvement. The same 
investors may focus on different factors in different contexts. 
Finally, a member is obligated to make a routine and rigorous analysis 
of order routing arrangements to determine the quality of executions he 
or she is receiving for customers.
    Nasdaq aims to provide a broad array of choices for investors to 
access the liquidity provided by Nasdaq in the manner that best serves 
their needs.
    Question 10. Should we call for the elimination of the Intermarket 
Trading System? Do we need to designate a replacement for that system, 
or would market forces adequately fill the gap?
    Response: While we share the general frustration of all market 
participants with the Intermarket Trading System (ITS), which is 
clearly technologically outmoded and which has raised concerns on the 
unanimous vote requirement, we do not believe it should be eliminated. 
While ITS technology and corporate governance are in need of 
improvement, we do not believe this is the time to abandon a system 
that links the markets. Instead, we believe it is time to make a 
concerted effort to improve the way markets access each other. The NASD 
has taken steps in this direction. In particular, the NASD has adopted 
rules and developed technology to open its exchange-listed trading 
facility to a broader array of market participants. The NASD has opened 
its facilities to ECNs as well to registered market makers and thus 
opened access to ITS and the Consolidated Quotations System to ECNs, 
which may now participate in these systems.
    Even if improvements undertaken by the NASD and other participants 
are not sufficient and a new system were introduced for accessing 
market liquidity, we do not believe that ITS should be eliminated 
without a thorough assessment of the new system's efficacy in linking 
the markets.
    Furthermore, under the ITS National Market System Plan approved by 
the SEC, ITS membership is limited to the NASD and registered national 
securities exchanges, all of which are registered with the SEC as self-
regulatory organizations (``SRO''). As such, the SROs are required to 
establish and maintain regulatory programs to ensure that their members 
act in accordance with the requirements of the Plan and the federal 
securities laws, including the rules of the SROs, which are adopted 
under those laws. Any entity providing a trading venue that wants to 
operate as a registered SRO, like the other National Market System 
participants, should be able to participate fully in ITS. Similarly, we 
believe that any entity that wants to set up a competing system should 
also be required to register with the SEC as an SRO, submit a National 
Market System Plan for the system to the SEC for approval, and be 
subject to SEC oversight.
    Question 11. The NASD recently granted ECNs access to their market 
linkage system through the Computer Assisted Execution System (CAES). 
Please explain what CAES does and why this does or does not adequately 
address the problems of efficient linkage among markets. Have any ECNs 
chosen to use CAES? Please identify them.
    Response: Nasdaq operates the Computer Assisted Execution System 
(CAES), a trading system that allows NASD member firms to direct orders 
in exchange-listed securities to NASD Market Makers for execution. 
Through CAES, NASD market makers and ECNs are able to enter marketable 
limit orders in exchange-listed securities to be executed against other 
market makers and ECNs who are quoting in those securities. CAES also 
serves as the NASD's interface with the ITS, a trading link between the 
Nasdaq system and U.S. stock exchanges, including The American Stock 
Exchange, the New York Stock Exchange, and the regional stock 
exchanges. Through CAES, all qualifying NASD members are able to 
effectively link to all other ITS participant markets.
    On March 16, 2000, the SEC approved an NASD rule filing that allows 
ECNs to participate in CAES on an equal basis as market makers, and 
therefore, to link to ITS. CAES will be open to all NASD member ECNs 
that are able to demonstrate compliance with the CAES rules and system 
requirements. To date, several ECNs have expressed interest in CAES 
participation and were recently provided with the modified CAES system 
specifications that will allow them to assess any internal system 
modifications necessary for participation in CAES.
    The NASD believes that CAES will provide an efficient and well-
regulated linkage for market makers and ECNs to access other market 
centers. As with the ECNs that participate in Nasdaq for Nasdaq-listed 
securities, customer orders of CAES-participant ECNs will be afforded 
broad exposure to all other NASD members in exchange-listed securities. 
Furthermore, any order displayed by a CAES-participant ECN is broadly 
displayed through the Consolidated Quotation System to all vendors and 
market participants. These displayed orders are then available to be 
accessed by any ITS participant.
    Although CAES is linked to ITS, CAES is itself a self-standing 
linkage that can accommodate various market participants and competing 
market centers. CAES also offers its participants distinct options in 
determining best execution, rather than placing sole emphasis on global 
time priority. With the inclusion of ECNs, CAES participants will be 
able to offer their customers an expanded range of desired execution 
characteristics, such as stock price, speed of execution, fill rate, 
commission cost, or some combination of the above.
    By encouraging direct competition among participants, the Third 
Market via CAES will assure service innovations that are not possible 
in the current ITS environment. Unlike ITS, the Third Market itself 
will continue to innovate and evolve its market structure and 
technology to benefit all participants. The Third Market has the 
potential to ultimately serve as the next-generation direct linkage for 
all markets, rather than as a conduit to those markets through ITS.
    Question 12. I understand both the NASDAQ and the NYSE are planning 
to become for-profit exchanges. Do you plan to spin off your regulatory 
arm entirely? If not, why should you have any interest in the regulator 
of your competitors?
    Response: The NASD currently operates in a structure where it is 
the parent to the Nasdaq Stock Market, the American Stock Exchange, and 
NASD Regulation, and is thus a full owner of these three subsidiaries. 
Under the current separately operating subsidiary structure Nasdaq and 
NASDR, our regulatory arm, are more widely separated than any other 
U.S. market and its regulator. When Nasdaq completes its 
recapitalization, the NASD will spin off about 80% of the ownership of 
Nasdaq to NASD members, Nasdaq issuers, and other market participants 
who purchase shares in it. This will increase the separation between 
market and regulator--and the potential for conflicts of organizational 
interest--to a degree not found in any other market in the world, and 
allow the market and the regulator to function independently. It is the 
NASD's present intention to sell its remaining shares in Nasdaq in the 
near term after the Nasdaq Board reaches a determination as to whether 
to move forward on a public offering.
    Question 13. What disclosure do you provide regarding your costs 
and revenues associated with market data? Would you object to providing 
more information about those costs and revenues to the public?
    Response: As noted by the Commission in its recent market data 
concept release, the NASD, through its consolidated financial 
statements, already provides detailed information regarding its 
internal cost and revenue structures. In addition, Nasdaq, as a 
registered Securities Information Processor (SIP), also files with the 
SEC a detailed financial statement that outlines the revenues received 
from the operation of numerous Nasdaq systems and services, including 
those that distribute market data. While the NASD fully supports the 
provision of complete and accurate market data cost and revenue 
information to the public, the scope and manner of such disclosure 
should take into consideration SRO administrative costs and burdens in 
producing such information. As the acknowledged leader in SRO cost 
disclosure, the NASD looks forward to working with Congress and the 
Commission in establishing fair and reasonable uniform cost and revenue 
disclosure standards for all market participants that consolidate and 
distribute market data.
                                 ______
                                 
                              New York Stock Exchange, Inc.
                                                       June 8, 2000
The Honorable Thomas Bliley
Chairman
U.S. House of Representatives
Committee on Commerce
Room 2125, Rayburn House Office Building
Washington, D.C. 20515-6115
    Dear Chairman Bliley, It was a pleasure to appear before the 
Finance Subcommittee of the House Commerce Committee. I appreciate the 
opportunity to respond to your follow-up questions. I would be pleased 
to meet with you or your staff if I can be of any further assistance.
            Sincerely,
                                                Robert J. McSweeney
Enclosures

            RESPONSES FOR THE RECORD OF ROBERT J. MCSWEENEY

    Question 1. Will the elimination of Rule 390 allow ECNs to compete 
directly with the NYSE? If not, what other regulatory changes are 
needed? Will they be able to compete if they become an exchange, as 
several have filed an application to become an exchange?
    Response. As NASD broker-dealers, ECNs were never subject to Rule 
390. NYSE members could always use ECNs for one-sided agency 
transactions (not ``crosses''). Since ECNs are basically limit order 
matching files, the removal of Rule 390 permits our members to execute 
proprietary trades in the 23% of stocks previously covered by the rule.
    The SEC's Regulation ATS provides sufficient flexibility for ECNs 
to compete with the NYSE as NASD broker-dealers, or by registering as 
an exchange with the SEC, provided they meet the Commission's 
regulatory infrastructure requirements to do so.
    Question 2. What is the single biggest market inefficiency 
investors are facing in the market? What rule change(s) is (are) 
necessary to eliminate this inefficiency?
    Response. The biggest single market inefficiency that investors 
face is internalization (and related payment for order flow economic 
inducement). A broker-dealer internalizes when it either trades as a 
dealer against a customer agency order or directs the order to an 
affiliated dealer for execution. Broker-dealers internalize agency 
market orders by buying from their customers at or near the bid price, 
and selling to their customers at or near the offer price. These agency 
orders do not interact with other public orders, and they are often 
denied the opportunity to receive the full degree of price improvement 
available at the NYSE. Internalization allows the order-originating 
broker-dealer to profit at the expense of denying the customer the 
ability to obtain a better price. In addition to the conflicts that 
internalization practices raise, these practices seriously threaten the 
price discovery process because the internalized order flow is not 
exposed to, and therefore does not directly interact with, the overall 
liquidity of the marketplace.
    If a significant amount of internalization takes place, the agency 
auction, in which 75% of the price discovery represents customers 
meeting customers (rather than dealer intermediation) would disappear 
and become a ``dealerized'' market, depriving customers of the savings 
between the quotation spread associated with customer-to-customer price 
discovery.
    Therefore, we believe internalization should be banned. Absent 
that, broker-dealers should be required to provide customers with price 
improvement over the national best bid or offer. We have proposed that 
the SEC enact such a rule in our filing to repeal Rule 390, as well as 
in our response to the SEC's Concept Release on Fragmentation.
    Question 3. What are the expected benefits decimalization will 
bring to investors?
    Response. Decimalization will result in narrower quotation spreads 
in many stocks, providing significant savings to investors, presuming 
that the minimum price variation is reduced to a penny rather than a 
nickel. It will certainly make it easier for retail investors to track 
price movement and trading variations.
    Question 4. What are the competitive implications of 
internalization?
    Response. Because internalization deprives markets of optimal price 
discovery, U.S. markets will be less competitive than they would be 
otherwise. To compete with foreign markets, U.S. markets should be as 
robust as possible through the full participation of both retail and 
institutional order flow in the price discovery process.
    Question 5. A CLOB, based on price-time priority reduces best 
execution to the NBBO. There are however, many factors which could 
influence a decision to trade. In your opinion, what factors should be 
considered for best execution?
    Response. Best execution should be determined based upon each 
customer's needs, and we believe technology would enable that to be on 
an order-by-order basis. Factors that should be weighed in making 
order-routing decisions include: the bid and offer prices; their size, 
in terms of depth of liquidity, and the probability of receiving a 
complete ``fill'' (rather than partial execution); the probability of 
price improvement; the probability of receiving an execution in size 
greater than the displayed bid or offer and the market impact of large 
orders; the speed of execution-, as well as the cost of execution.
    We believe that our platform of customer choice, called ``Network 
NYSE'' recognizes that ``one size doesn't fit all'', and that a range 
of execution services will provide the optimal facility for best 
execution.
    Question 6. Should we call for the elimination of the Intermarket 
Trading System? Do we need to designate a replacement for the system, 
or would market forces adequately fill the gap?
    Response. Yes, you should call for the replacement of the 
Intermarket Trading System. It provides inappropriate free access to 
our market by competitors and its quarter-century-old market-to-market 
linkage should be replaced with the more efficient and robust 
communications technology available today for linking broker-dealers 
and brokers to markets. A conversion period would be appropriate, 
during which time we would work with the industry, similar to Y2K and 
decimalization, to ensure that a sufficient time would be provided for 
broker-dealers and individual market members to avail themselves of 
that technology. (Enclosed is a copy of our response to the SEC's 
Concept Release on Market Fragmentation.)
    In that way, broker-dealers and brokers can exercise their best-
execution responsibilities in a more efficient manner. If an order is 
routed to a market and a better price becomes available on another 
market, the market where the order was routed would match or the 
participant would electronically transmit the order to the market 
providing the opportunity for the best execution.
    If ITS is not eliminated, an important prerequisite for direct 
access should be SEC-approved self-regulatory organization status, as 
presently required, for reasons outlined in the response to your next 
question.
    Question 7. The NASD recently granted ECNs access to their market 
linkage system through the Computer Assisted Execution System (CAES). 
Please explain what CAES does and why this does or does not adequately 
address the problems of efficient linkage among markets. Has CAES 
sufficiently linked ECNs with ITS?
    Response. I would defer to the NASD for an explanation of the 
specific infrastructure of that interface. The NASD access is 
appropriate since ECNs are NASD broker-dealers; however, some ECNs want 
direct linkage to the NMS without exchange status. That would create an 
unfair advantage vis-a-vis other broker-dealers; it would result in 
insufficient regulatory safeguards; and it would fragment liquidity 
rather than consolidate order flow. It would suggest that countless 
entities technologically capable of creating an order file and 
interface network should proliferate quotes, while retaining order flow 
in the hope of attracting a ``match'', resulting in capacity and 
fragmentation inefficiencies.
    Question 8. I understand both the NASDAQ and the NYSE are planning 
to become for-profit exchanges. Do you plan to spin off your regulatory 
arm entirely? If not, why should you have any interest in the regulator 
of your competitors?
    Response. No decision has been made regarding the advisability of 
demutualization. Our Board formed a Special Committee on Market 
Structure, Governance and Ownership in October of 1999, comprised 
entirely of the public directors. Because market structure decisions 
can influence deliberations regarding governance and ownership, the 
Committee spent six months considering a broad spectrum of market 
structure recommendations. The result is the Market Structure Report 
embraced by our full Board in April. A copy is enclosed for your 
review.
    The NYSE is recognized as the world's pre-eminent self-regulator. 
We have invested more than any other market center in differentiating 
our regulatory brand to our competitive advantage. Therefore, we do not 
intend to spin-off our regulatory function.
    Later this year, and hopefully with the benefit of an appreciation 
of the industry impact of decimalization, the Committee will consider 
the issues of governance and ownership. Within the context of the 
demutualization deliberations, we will assess the issue of forming a 
separate NYSE regulatory entity within a holding company structure and 
with separate governance.
    As to the issue of regulating our competitors, the self-regulatory 
process presently has that potential conflict in that we regulate 
members who compete for market share through their equity in ECNs and 
``internalize'' order flow on regional and OTC markets. We do not 
regulate ECNS, since they are NASD broker-dealers, and our members have 
been able to effect trades on regional exchanges for decades. There has 
never been an allegation of inappropriate regulatory action based upon 
that potential conflict. I am sure the SEC would expeditiously 
investigate and not tolerate regulatory discrimination. The alternative 
of a single-self-regulatory body suggested by some would result in 
greater broker-dealer expenses, since present regulatory funding is 
subsidized by the broader exchange revenues. In addition, it would lack 
sufficient marketplace accountability, which could lead to an 
inappropriate expenses and bureaucracy.
    Question 9. Mr. Atkin states that the SROs earn monopoly revenues 
in the area of market data and use it to subsidize business activities 
they enter into in competition with their own members. Should the 
regulation of market data be changed to provide for competition among 
market data providers, and, if so, how?
    Response. SROs develop and maintain the order-routing 
infrastructure and capacity infrastructure necessary to create market 
data. Our market data revenues are not ``monopoly'' revenues. They are 
subject to constituent consensus through Board approval and SEC 
oversight in terms of their fairness. In fact, those fees have 
decreased significantly in conjunction with increased volume. The 
percentage of NYSE market data revenues to our overall revenues has 
remained relatively constant over the years, at 14-17 percent.
    We have recently responded to a SEC release on market data (also 
enclosed) in which we state our belief that, rather than the suggested 
``utility rate-making,'' self-regulatory organizations should be 
permitted sell market data based upon freemarket vendor pricing and 
consolidation, which would continue to be subject to SEC review for 
fairness. We believe that supply and demand is the best regulator of 
prices.
    Question 10. Do current market information fees restrict the 
availability of real-time information?
    Response. No. I have enclosed a copy of our market data fee 
structure. For public investors, real-time data is free and ubiquitous.
    Question 11. What disclosure do you provide regarding your costs 
and revenues associated with market data? Would you object to providing 
more information about those costs and revenues to the public?
    Response. Our market data revenues, as well as our expenses for 
systems and related support are disclosed to the public in our Annual 
Report (enclosed). More detailed disclosure of the costs associated 
with the performance of each SRO function would push each market into 
product-line accounting, would produce arbitrary results that are 
susceptible to second guessing, would require the Commission to 
establish uniform accounting standards and procedures, would require 
each market to overhaul its accounting and auditing functions, and 
would require difficult allocations of overhead and other costs. If the 
Commission were to mandate cost-based ratemaking, than all of these 
burdens would represent unavoidable consequences of that decision. If 
the Commission does not adopt a cost-based rate-making requirement, 
then such significant and expensive new burdens require careful thought 
and the assessment of a cost/benefit analysis.
    Question 12. At our last hearing, one of our witnesses, Island, 
demonstrated how their entire order book is publicly available on their 
web site in real time. Doesn't this level of transparency help 
investors? You stated that the NYSE intends to provide such access to 
investors. Please describe exactly what information will be provided to 
investors and how they will access it.
    Response. We agree that making the electronic limit order books 
available increases transparency to the advantage of investors. We are 
exploring three non-exclusive alternatives: a direct transmittal to 
member broker-dealers; a similar transmittal to vendors; and 
publication on our web site. The entering firm identity would be 
blocked and broker-dealers and vendors would format the data as they 
choose. A publication on our web site would provide total shares and 
number of orders at several increments above and below the best bid and 
offer, with a summary-range format beyond the designated level. We are 
in the process of identifying the needs of broker-dealers and investors 
as to the most effective means of making that information available.

                                
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