[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE SEC PROPOSAL ON MARKET
STRUCTURE: HOW WILL INVESTORS FARE?
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HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
MAY 18, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-88
U.S. GOVERNMENT PRINTING OFFICE
95-595 WASHINGTON : DC
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida DAVID SCOTT, Georgia
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona JOSEPH CROWLEY, New York
JIM RYUN, Kansas STEVE ISRAEL, New York
VITO FOSSELLA, New York, MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
May 18, 2004................................................. 1
Appendix:
May 18, 2004................................................. 27
WITNESSES
Tuesday, May 18, 2004
Andresen, Matthew, Former President and Chief Executive Officer,
Island ECN, Inc................................................ 4
Bang, Kim, President and Chief Executive Officer, Bloomberg
Tradebook LLC.................................................. 16
Giesea, John, President and Chief Executive Officer, Security
Traders Association, Inc....................................... 10
Leibowitz, Larry, Executive Vice President and Co-CEO of Schwab
Soundview Capital Markets...................................... 6
McCabe, Daniel, Chief Executive Officer, Bear Hunter Specialty
Products....................................................... 8
Steil, Benn, Andre Meyer Senior Fellow in International
Economics, Council on Foreign Relations........................ 12
Wallison, Peter J., Resident Fellow, American Enterprise
Institute...................................................... 18
Weaver, Daniel G., Visiting Associate Professor of Finance,
Department of Finance, Rutgers School of Business.............. 14
APPENDIX
Prepared statements:
Crowley, Hon. Joseph......................................... 28
Fossella, Hon. Vito.......................................... 30
Gillmor, Hon. Paul E......................................... 32
Hinojosa, Hon. Ruben......................................... 33
Kanjorski, Hon. Paul E....................................... 35
Andresen, Matthew............................................ 37
Bang, Kim.................................................... 46
Giesea, John................................................. 70
Leibowitz, Larry............................................. 75
McCabe, Daniel............................................... 78
Steil, Benn.................................................. 83
Wallison, Peter J............................................ 88
Weaver, Daniel G............................................. 96
Additional Material Submitted for the Record
Crowley, Hon. Joseph:
The Public Advocate for the City of New York letter to the
Securities and Exchange Commission, May 3, 2004............ 102
Trading-rule change cheats investor, USA Today, February 26,
2004....................................................... 103
Steil, Benn:
Written response to questions from Hon. Vito Fossella........ 104
Wallison, Peter J.:
Written response to questions from Hon. Vito Fossella........ 105
Weaver, Daniel G.:
Written response to questions from Hon. Vito Fossella........ 107
THE SEC PROPOSAL ON MARKET
STRUCTURE: HOW WILL INVESTORS FARE?
----------
Tuesday, May 18, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and,
Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 2:03 p.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Ryun, Fossella, Hart,
Brown-Waite, Kanjorski, Ackerman, Inslee, Moore, Hinojosa,
Lucas of Kentucky, Crowley, Baca, Miller of North Carolina and
Velazquez.
Chairman Baker. [Presiding.] I would like to call this
meeting of the Capital Markets Subcommittee to order. This is
the subcommittee's fourth hearing in this Congress on the
subject of U.S. capital market structure. Our first hearing on
corporate governance issues was conducted in New York and
examined the regulatory role of the exchanges and the potential
conflicts of interest that are created by self-regulation.
The second examined reforms that potentially would enhance
competition in the securities markets. The third focused on
reform efforts at the New York Exchange and the role of the
specialist system in a technologically revolutionized
marketplace. The 211-year-old NYSE is the leading auction
market in the United States. In my judgment, it has worked very
effectively throughout the years in providing for capital
expansion needed for our economic growth.
The NASDAQ market is an inter-dealer quotation system
established in 1971. Over-the-counter securities and NYSE-
listed stocks may also trade through NASDAQ. Dealers quote, bid
and ask prices and the NASDAQ computer system integrates the
quotations, calculates the best bidder offer, and displays the
prices on screens. The development of electronic communications
networks, ECNs, that link institutional investors so they can
trade directly with each other revolutionized equity markets.
They diminished the role of the specialist by allowing users to
enter orders at specific prices and execute them automatically
against other orders.
The trade-through rule is the subject of discussion and a
somewhat controversial provision that has been recently
addressed by the SEC. The rule states one market cannot trade
at prices inferior to a price displayed by another market.
Critics of the rule analogize it to requiring a consumer to
purchase ice cream at a store across town which sells ice cream
at a slightly lower price than a store located closer to the
consumer. Opponents of the trade-through argue the NYSE holds a
dominant position in the global marketplace not because of
superiority of service, but because of the coercive power of
this rule.
Instead of instantaneous computer-to-computer transactions,
the trade-through rule causes a delay for up to 30 seconds in
the execution of investor orders, in some cases a very
significant delay to the consumer's best interest. In fast-
moving trading, brokers find that the NYSE price fluctuates
during the time it takes for execution. The reality is that the
inferior price that calls the order to be routed to the
exchange may be a better price once the order is received by
the NYSE specialist.
The SEC proposed a reform of the rule that expands the
reach to include NASDAQ, but would relax the rule in ways that
would favor, could possibly, electronic markets. The theory
behind the proposal is that speed and anonymity of execution
should take precedence in trading and competing markets should
be able to ignore potentially superior price if it slows down
execution. So far, even the New York Exchange appears amenable
to the modification that would allow for fast markets to trade
through slower markets within certain limits, because they hope
to bring greater automation to its own trading floor so it can
fall within the definition of a fast market.
However, the NYSE is opposed to allowing consumers to opt
out of the trade group. They argue that the opt-out may
compromise the quality of executions that investors receive.
ECNs argue that the opt-out is necessary because the so-called
``best available price'' is not always accessible.
The conclusion I have reached is that executing an order at
the best price is certainly a laudatory goal and should be the
principal mission which the exchanges engage in regardless of
the site of execution. However, it is clear to me that in
today's marketplace, trades executed through the NYSE do not
always automatically reflect best price. In fact, on as many as
thousands of occasions in a given week's trading, best price
may be offered on a competing exchange and the order not
appropriately routed, given current technological constraints.
And in my judgment, the buyer should be the determining
factor in how the trade is executed. Whether best price is the
most important to their trading perspective or whether other
considerations take precedence should be left to the consumer's
best judgment on an informed basis.
For these reasons, I am anxious to hear the testimony of
those who have agreed to participate in today's hearing. I
believe this to be a most important issue facing the committee
and the Congress. It is certainly significant in the overall
capital formation of our American capitalistic system and we
hope to come to the most appropriate conclusions based on the
best advice we can receive.
With that, I call on Mr. Kanjorski.
Mr. Kanjorski. Thank you, Mr. Chairman.
We meet for the fourth time in the 108th Congress to review
the organization of our capital markets and evaluate the need
for further reforms in light of technological advances and
competitive developments. This hearing seeks to examine how the
market structure changes recently proposed by the Securities
and Exchange Commission will affect investors.
As I have regularly observed at our previous hearings, a
variety of agents in our equities markets have questioned one
or more aspects of the regulatory system during the last
several years. We have also, in my view, come to a crossroads
in the securities industry, confronting a number of decisions
that could fundamentally alter its organization for many years
to come.
We have elaborately interconnected systems and
relationships in our equities markets. I therefore believe that
we should heed the philosophy of Edmund Burke and refrain from
pursuing change for change's sake. We should only modify the
structure of our securities markets if it will result in
improvements for investors. The Chairman of the Securities and
Exchange Commission has recently observed that in pursuing any
change to fix those portions of our markets experiencing
genuine strain, we must ensure that we do not disrupt those
elements of our markets that are working well.
In February, the Commission put forward for discussion four
interrelated proposals that would reshape the structure and
operations of our equities markets. Because these proposals
have generated considerable debate, the Commission announced
last week that it would extend the public comment period until
the end of June.
In adopting the Securities Acts Amendments of 1975, the
Congress wisely decided to provide the Commission with a broad
set of goals and significant flexibility to respond to market-
structure issues. From my perspective, this legal framework has
worked generally well over the last three decades. It is also
appropriate for the commission at this time to review its rules
governing market structure and for our panel to conduct
oversight on these matters.
Mr. Chairman, as you already know, I have made investor
protection one of my highest priorities for my work on this
committee. Although many of the agents in our securities
markets have called for adopting market-structure reforms and
some of them may benefit from these changes, the commission
must thoroughly examine the effects of its reform proposals on
average retail investors before approving any change.
Today, I suspect that many of our witnesses will discuss
the Commission's proposal to alter the trade-through rule.
Retail investors are guaranteed the best price that our
securities markets have to offer regardless of the location of
a trading transaction under our present regulatory system. By
ensuring fair treatment, this best-price guarantee has
significantly increased confidence in our securities markets. I
also believe that this directive has served most investors
generally well.
The Commission, however, has issued a proposal to permit
participants in our capital markets to opt out under certain
circumstances of this best-price guarantee. Some have suggested
that this proposal could potentially produce unintended
consequences like fragmenting our securities markets,
decreasing liquidity, and limiting price discovery. Because
such results could prove harmful for small investors, I will be
monitoring this issue very closely in the weeks and months
ahead.
A recent survey of older American investors also found that
86 percent of the respondents agreed that they should be
alerted before the completion of a transaction in which the
best available price is not the top priority. I would
consequently like to learn from our witnesses how
unsophisticated investors should be notified if their mutual
fund manager, stockbroker, or pension fund adviser decides to
opt out of the present best-price mandate. For example, it
would be helpful to debate whether such opt-outs should be
completed via a blanket disclosure or on a per-trade basis.
In sum, Mr. Chairman, we should continue to conduct
vigorous oversight of our equities markets to determine whether
or not the present regulatory structure is working as intended
or to study how we could make it stronger. The observations of
today's witnesses about these complex matters will further help
me to discern how we can maintain the efficiency, effectiveness
and competitiveness of our nation's capital markets into the
foreseeable future.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 35 in the appendix.]
Chairman Baker. I thank the gentleman.
Mr. Fossella, did you have an opening statement?
Mr. Fossella. I will just submit mine for the record and
look forward to hearing the testimony of these witnesses.
[The prepared statement of Hon. Vito Fossella can be found
on page 30 in the appendix.]
Chairman Baker. Without objection.
Ms. Velazquez, did you have an opening statement?
Ms. Velazquez. No, Mr. Chairman, but I will ask unanimous
consent for my opening statement to be inserted into the
record.
Chairman Baker. Without objection, all Members's opening
statements will be included in the record.
At this time, I would proceed to our distinguished panel of
witnesses. First to give testimony today is Mr. Matthew
Andresen, former president and chief executive officer of The
Island ECN. Welcome, sir.
By way of customary practice, we would request if possible
each statement be constrained to 5 minutes. Your entire
official statement will be made part of the record. And make
sure your button is on and pull the mike close. With that, take
off.
STATEMENT OF MATTHEW ANDRESEN, FORMER PRESIDENT AND CEO, THE
ISLAND ECN, INC.
Mr. Andresen. Thank you, Chairman Baker, Ranking Member
Kanjorski, members of the subcommittee. Thank you for holding
this hearing and for inviting me to speak before you today.
We are at a crucial juncture in the evolving equity market
structure of the United States. For decades, the electronic and
traditional market structures continued their respective
evolutions in relative isolation from each other. However, the
furious pace of technological innovation, which I was
privileged to be part of in my days at Island, has driven the
electronic trading realm further and further away from the
traditional human-driven markets of the NYSE-listed world.
The proponents of electronic markets believe that the
results of this process have been purely positive. The
champions of traditional markets believe that these rapid
enhancements have sacrificed crucial elements of price
discovery. I am certain, given the amount of legroom I have
here today, that we will be hearing our fill today from both
sides.
What is not in dispute, however, is that the rapid
evolution of technology is forcing these two disparate worlds
back together. The two competing market structures can no
longer live in isolation from one another. This has manifested
itself in several ways. First, the introduction of
sophisticated technology tools to the brokerage and trading
community has made it simple to deliver orders to either an
electronic OTC market or to the NYSE through one common
interface. This has facilitated the broad trend of
sectorization whereby Wall Street firms reorganize their
trading desks based not on where stocks might be listed, but
rather based on what industry the companies themselves are in.
Secondly, the rise of automated and so-called ``program''
trading has blurred the distinction between listed and over-
the-counter trading by often grouping orders together into
lists of trades to be executed as a group. Third, the
electronic markets have evolved into significant enterprises
who view the big market cap stocks of the NYSE with jealous
eyes. They know well the opportunity available. Despite their
dominance of OTC trading, alternative trading systems and
electronic exchanges account for only a tiny percentage of
trading in NYSE-listed stocks.
It has long been my contention that this is due not only to
the NYSE's significant liquidity advantage, but also the
existence of the trade-through rule. This rule is an
unfortunate relic of an age before fully electronic markets
were in fact even contemplated. Obviously, they are commonplace
today. But while the markets have evolved, the trade-through
rule lives on in its original form. The essential issue with
this rule is that it attempts to distill all of the value in a
potential transaction down to one factor: advertised price. But
advertised price is but one factor in determining the best
execution for a customer. Factors such as time, implicit costs,
fees, adverse selection and reliability can often make a much
greater difference to a customer's quality of execution.
In my opinion, the debate over trade-through has been
consistently misstated as one of speed versus price. To me,
that is not wholly correct. The correct date is about true
price versus advertised price, because in the stock market as
in other transactions there are a myriad of factors that can
lead to significant variance between the true and advertised
price.
The aforementioned factors of time, certainty of execution,
fees, adverse selection or reliability makes advertised prices
only one small part of the execution story. We must have a
regulatory structure that recognizes this face. I commend the
committee for moving to address this issue.
Thank you, Mr. Chairman.
[The prepared statement of Matthew Andresen can be found on
page 37 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next witness is Mr. Larry Leibowitz, executive vice
president, co-head of Equities Division, Schwab Soundview
Capital Markets. Welcome, sir.
STATEMENT OF LARRY LEIBOWITZ, EXECUTIVE VICE PRESIDENT, CO-HEAD
OF EQUITIES DIVISION, SCHWAB SOUNDVIEW CAPITAL MARKETS
Mr. Leibowitz. Chairman Baker, Ranking Member Kanjorski,
distinguished members of the committee, my name is Larry
Leibowitz. I am executive vice president and co-CEO of Schwab
Soundview Capital Markets, the institutional trading, research
and retail execution arm of The Charles Schwab Corporation.
Thank you for the opportunity to speak today on the vital
market structure reforms proposed by the Securities and
Exchange Commission.
Before I jump into my main statement, I would like to make
a brief point. One thing that we on the panel here can all
agree on is that these are relatively arcane topics. Talking
about market linkages makes even my eyes glaze over so I can
imagine yours. But in the end, they all impact the transparency
and openness of the markets, and therefore contribute to
investor confidence and the integrity and fairness in the
largest and most successful system for capital formation in the
world. Helping that system reflect the reality of today's
information age is what this is all about.
Schwab Soundview Capital Markets, as the largest NASDAQ
market-maker by volume, and Charles Schwab & Company, with its
millions of retail customers, believe that the time is ripe for
modernization of our national market system. We process
millions of orders a day and those orders are directly impacted
by the conflict between modern technology and human interaction
when trading securities. These rules primarily serve to
insulate outdated and inefficient manual markets from
competition and actually harm, rather than protect, investors.
For too long, competition has been stifled in the market
for NYSE-and Amex-listed securities. Given the very limited
time available, I will focus my comments on the two main
impediments: the trade-through rule and the market data
charging system.
The trade-through rule purportedly protects investors from
inferior prices, but has actually insulated the NYSE and its
specialist system from competition and protected its privileged
position. Given the NYSE's role in the creation of the original
trade-through rule, the rule has worked as intended to protect
its monopoly profits.
Being forced to route orders to manual markets for
execution lowers efficiency and in some cases actually
undermines a broker's duty of best execution. Moreover,
investors attempting to cancel orders often find themselves in
limbo waiting for an exchange response and discovering that
their orders have been executed against their wishes. A better
alternative is available. When securities are traded in an
automated environment without a trade-through rule, as they are
in NASDAQ today, investors obtain greater order protection,
faster executions and better prices. Investors are protected by
the broker-dealer's overriding legal obligation to provide best
execution to customers.
In addition, when a market is efficient, you do not need a
rule prohibiting trade-throughs. They simply do not happen. And
you do not have to take my word for it. The Commission's own
order-handling statistics, the so-called 11ACL-5 numbers, prove
that automatic markets that are free of trade-through
restrictions provide investors with better results, better
prices, and faster executions.
The appropriate reform is obvious. Eliminate the ITS trade-
through rule and allow competition to flourish as it does in
the NASDAQ market. Short of full and outright repeal, Schwab
proposes alternatively that the Commission first act to improve
the interaction among markets trading listed securities. Then,
after appropriate analysis of listed trading data, determine
whether to eliminate the trade-through rule in its entirety.
Specifically we believe the Commission should take the
following steps. Investors should be given the choice to ignore
slow and inefficient market centers. Therefore, we urge the
Commission to support a fast market/slow market exception to
the trade-through rule. Such an exception will induce markets
to implement automatic execution and automatic quote trading,
thereby benefiting investors through the ensuing efficiency.
Second, the Commission should require specific disclosure
of trade-throughs as part of 11AC 1-5 reporting, thereby
allowing investors to determine the execution quality of their
orders and allowing regulators to determine if the brokers are
fulfilling best execution obligations.
Finally, Schwab believes that customers should be allowed
to decide for themselves what constitutes best execution.
Therefore, Schwab urges the Commission to amend the ITS plan to
include an opt-out provision so that investors, rather than
one-size-fits-all rules, can determine how to execute orders.
With regard to market data, Schwab believes that the
current SEC proposal simply misses the real problem. Rather
than treat the symptoms, the Commission should focus on
reforming a monopoly-based system that wildly increases the
cost to investors for trading information.
Investors have heard lots of stories about why market data
is so expensive. We heard 2 weeks ago that it costs the NYSE
$488 million per year to generate market data. That is hard to
believe given that as the commission described in its reform
proposal, last year the Plan Networks made $424 million in
revenue and incurred only $38 million in expenses. That is a
monopoly markup of 1,000 percent.
Further, NASDAQ, operator of one of the data networks,
recently stated that it believes it can cut its monopoly data
prices by 75 percent and still provide a sufficient return to
shareholders. Clearly, there is excess market data money
sloshing around the exchanges, which manifests itself in
everything from tape shredding to market data rebates, to
exorbitant pay packages for executives. This excess revenue is
extracted from average investors who pay inflated charges to
the exchanges to see their own limit orders displayed.
The government-created market data cartels should be asked
to justify their cost. Until there is transparency in cost and
governance, the market data cartels will never change and
investors will continue to subsidize markets. Schwab believes
that markets should fund their own regulatory and operational
functions directly and transparently themselves, rather than
indirectly through opaque market data charges to investors.
Schwab has three recommendations. First, price information
relating to the NBBO be based on its cost, thereby facilitating
widespread availability. Second, simplify and standardize
network accounting so that the expenses relating to market data
consolidation are transparent, available to individual
investors and independently audited. Finally, require public
representation on network operating committees. A toothless
advisory committee is a status quo proposal. Today, everyone
acknowledges the need for independent members on the boards of
public companies, mutual funds, and even SROs. Governance of
market data should be no different.
In closing, Schwab commends this committee for exercising
its oversight role and examining these important issues. To sum
up, Schwab hopes the SEC repeals the trade-through rule, or at
a minimum institutes meaningful reforms, thereby unleashing a
wave of modernization in the listed market. Furthermore, we
urge the Commission to reexamine its market data proposal to
end monopoly profits and ensure that all investors have access,
at a reasonable price, to the most basic trading information.
Thank you again for the opportunity to testify today. I
look forward to any questions you may have.
[The prepared statement of Larry Leibowitz can be found on
page 75 in the appendix.]
Chairman Baker. Thank you, sir.
Our next witness is Mr. Daniel McCabe, chief executive
officer, Bear Hunter Specialty Products. Welcome.
STATEMENT OF DANIEL MCCABE, CEO, BEAR HUNTER SPECIALTY PRODUCTS
Mr. McCabe. Thank you. Good afternoon and thank you, Mr.
Chairman, for the opportunity to testify in front of the
committee.
A little bit of background first for the committee. I am
the CEO of Bear Hunter Structured Products LLC. We are
liquidity providers in derivative products such as options,
futures and exchange-traded funds. Bear Hunter is a wholly
owned subsidiary of Bear Wagner, which is one of the five major
specialist firms on Wall Street. We represent more than 350
listed companies, including such household names as Pepsi,
Aetna, Alcoa, Xerox and Kimberly-Clark to name a few. Bear
Wagner is a member of the NYSE, Amex, CME, ISE, CBOT, and CBOE
and actively trades in all venues.
Mr. Chairman, I am sincerely worried about the impact of
the proposed changes, not only on the individual investor, but
also on our listed companies and on the New York Stock Exchange
itself. I am deeply concerned because the thrust of these new
regulations is focused on speed only, and speed will ferment
both price and temporal volatility in the market, scaring off
individual investors, destroying confidence and over time
driving down the market capitalization of our listed entities.
Since the introduction of decimal pricing, the markets have
already experienced a 126 percent growth in program trading,
much to the detriment of the individual investor.
Allow me to elaborate. Excessive volatility serves no one
but professional investors. Over the last 2 years, some 39
NASDAQ-listed companies have chosen to move to the New York
Stock Exchange in order to reduce their volatility. They have,
on average, experienced a 50 percent reduction in inter-day
volatility. They made this choice to facilitate the raising of
capital. After five years of market softness and financial
scandals, is volatility really going to help lure investors
back into the market, or are we creating a market dominated by
professional program traders?
What is driving the focus on speed? Certainly not the
majority of investors in this country. When AARP recently
surveyed nearly 2,000 of its members, two-thirds of them said
price is the top priority when engaging in a market
transaction. The second consideration was brokerage fees. Speed
barely registered in the survey.
Chris Hansen of AARP, representing that organization's 35
million voters, said, ``The SEC needs to proceed carefully in
proposing changes that could undermine the ability of
individual investors to get the best price for the lowest
transaction cost.'' I could not agree more.
Some of our competitors say everything should be done in
nanoseconds, same-second executions should be the driving force
in markets. I do not think we want the NYSE looking like an
ECN, where stocks flicker excessively while attempting to
discover price, nor do I understand why the markets with
excessive volatility will be rewarded through the proposed
changes in reg NMS.
In addition, I think the logical outcome of these proposed
rules will be dramatic fragmentation and internalization of
orders, where sophisticated investors opt out and the common
person is left behind. The solution is not to develop a
bifurcated market for insiders and small investors, but to
instead link the markets together. Define a reasonable time
frame, say five or six seconds, where orders must be executed
or else face a penalty. Mandate that all parties compete on
price.
Today, many people have the vision of the NYSE from a
bygone era, with brokers wandering the floor, hand-writing
orders on tiny scraps of paper. Over 85 percent of the orders
are executed in less than 10 seconds. Specialists only provide
liquidity roughly 15 percent of the time to smooth out short-
term volatility, which helps stabilize the market for both
investors and our listed companies. I think the real motive
behind much of this debate has nothing to do with the
individual consumer, but rather an attempt by failing business
models to gain an advantage through regulations.
Here is a recent quote from Steve Pearlstein of The
Washington Post: ``The fact that these parties are trying to
divert more trading away from the exchange raises suspicions
that their lobbying campaign may have less to do with
protecting the interests of the investing public than with
gaining competitive advantage or taking over the market-making
function themselves.''
Again, let's look at NASDAQ. Five years ago, the exchange
handled more than 90 percent of the market in their own stocks.
Today, it is less than 20 percent. Currently, the NASDAQ and
all of its electronic competitors move at the same speed. So
why have they lost market share? Simply because of practices
like payment for order-flow or the sharing of tape revenue.
Those practices must be disbanded for the mere health of the
market.
Individual investors buy and sell based on price. When
millions of investors get home tonight and check on their
401(k) programs, they will carefully watch the prices of their
stocks and mutual funds. I cannot believe a single one of them
will wonder whether their shares traded in 5 seconds or 8
seconds. Moreover, most will have no knowledge of which
exchange traded their security or under what rules they were
traded.
In conclusion, sir, the NYSE can move faster and yes, it
should. But price and transparency are equally important
principles this committee and the SEC must not abandon.
Thank you for your time and consideration.
[The prepared statement of Daniel McCabe can be found on
page 78 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next witness is Mr. John Giesea, president and chief
executive officer, Security Traders Association. Welcome, sir.
STATEMENT OF JOHN GIESA, PRESIDENT AND CEO, SECURITY TRADERS
ASSOCIATION, INC.
Mr. Giesea. Good afternoon, Chairman Baker, Ranking Member
Kanjorski and members of the committee. Thank you for the
opportunity to testify this afternoon.
The Security Traders Association, or STA, is comprised of
some 6,000 professionals engaged in the purchase, sale and
trading of securities, representing individuals and
institutions. In the context of today's topic, how will the
investor fare, I would comment that I believe that investors
have benefited greatly over recent years given improved market
efficiencies and regulation. Proposed Regulation NMS, if
properly implemented, will further these gains through improved
linkages, liquidity and competition.
The STA is currently in the process of completing its
formal comment on proposed Regulation NMS. This has involved
input from more than 60 professional traders representing both
the buy side and the sell side. I will highlight the major
points of Regulation NMS where STA has preliminarily reached
consensus with regard to the trade-through. The STA believes
that a fully linked market with automatic execution capability
will substantially diminish the need for a trade-through rule.
One way to address the trade-through proposal would be to
execute it in a phased approach and implement it only after a
comment period for review. Phase one, define automated and a
non-automated markets; phase two, oversee the creation of
linkages to ensure a high degree of connectivity and access;
phase three, reexamine the need for a trade-through rule as
such a rule may be impossible to enforce as well as unnecessary
given the competitive forces driving best execution standards.
The result of this phase-in approach would be a major step
towards the envisioned national market system and beneficial
for market participants and investors.
The current proposal would extend the trade-through rule to
the NASDAQ market. We question why when there have not been
problems regarding price protection the rule should be imposed
upon the NASDAQ stock market. It would be incorrect to impose
this rule at the onset. Although there may be some practical
and other drawbacks to an opt-out, we would support an opt-out
exception on an interim basis for the purpose of driving
greater automation in or access to markets. This would provide
incentive for change. However, if automatic execution and
economic access to quotes were achieved, an opt-out provision
would become unnecessary.
A key determination is the definition of an automated
market. STA believes that a market must provide for an
automatic execution, coupled with an immediate refresh
capability. With regard to access fees in lock and cross
markets, the Commission has correctly identified access fees as
a critical component of any discussion regarding best
execution. The SEC's proposal to cap fees at $0.001 per share
is a very positive step towards reducing the current problems
in the marketplace. However, we believe the preferred action is
complete elimination of access fees, which would also eliminate
the economic, or at least one of the economic incentives which
cause lock and cross markets. The SEC's proposal appropriately
calls upon markets to create and enforce rules eliminating lock
and cross markets which STA strongly supports.
With regard to sub-penny quotes, sub-penny quotations
create a number of problems, and we are against the
introduction of decimals as originally proposed, and we
strongly support the Commission's recommendation that sub-penny
quotations be eliminated. We do distinguish between quotation
and transaction as there are some common needs to have a
transaction that creates a sub-penny, but quotations should be
limited to two decimals.
With regard to market data, the STA is not in a position to
comment on the precise formula to be used for the distribution
of market data revenues. We are, however, supportive of the
market data allocation proposals that lead to rewarding quality
quotes at the same time eliminating the practices only designed
to gain the revenue stream.
With regard to liquidity providers, I would also note the
importance of liquidity providers, namely specialists and
market-makers, to the capital formation and the efficient
functioning of the markets. The trend in rulemaking has been to
encourage the matching of buyers and sellers without an
intermediary. Highly liquid stocks do not under normal
circumstances require a liquidity provider to facilitate the
execution of trades. However, the need for liquidity providers
becomes important in stress situation, be they stock-specific
or general market conditions.
In conclusion, I thank the members of the subcommittee for
your continued interest in ensuring that U.S. markets are
efficient and liquid. Such characteristics are important to a
robust capital formation process, benefit the U.S. economy, and
ultimately benefit all investors.
The STA views the national market system principles
established in the Securities Acts Amendments of 1975, namely
the maintenance of efficient, competitive and fair markets, as
both a measure and a goal. The SEC proposed Regulation NMS is a
step toward the goal of a true national market system.
Thank you.
[The prepared statement of John Giesea can be found on page
70 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next witness is Dr. Benn Steil, the Andre Meyer Senior
Fellow in International Economics, Council on Foreign
Relations. Welcome.
STATEMENT OF BENN STEIL, ANDRE MAYER SENIOR FELLOW IN
INTERNATIONAL ECONOMICS, COUNCIL ON FOREIGN RELATIONS
Mr. Steil. Thank you, Mr. Chairman, members of the
committee.
Although the SEC's proposed Regulation NMS covers a wide
range of important issues related to market linkages, access
fees and market data, I will confine my brief prepared remarks
to the specific matter of the trade-through rule, changes in
which have the greatest potential to improve the ability of our
securities markets to service investors.
Although the idea of having a simple market-wide rule to
ensure that investors always have access to the best price is
an attractive one, in practice the trade-through rule has
operated to force investor orders down to the floor of the New
York Stock Exchange irrespective of investors's wishes. The
rule therefore operates to discourage free and open competition
among marketplaces and market structures, the type of free and
open competition which has in Europe produced a new global
standard for best practice both in trading technology and
exchange governance.
The trade-through rule should therefore be eliminated, as
it serves neither to protect investors nor to encourage vital
innovation in our marketplace. Those who support the
maintenance of some form of trade-through rule, most notably
the New York Stock Exchange, have raised five main arguments in
its defense. The most effective way to illustrate why the rule
is undesirable is to address each of these directly.
First argument: Why should speed be more important than
price? According to this view, eloquently presented by Mr.
McCabe, the whole debate is about whether traders should be
allowed to sacrifice best price in pursuit of speed. But the
notion that investors would ever sacrifice price for speed is
nonsensical. In the marketplace, it is always about price. It
is about the price for the number of shares the trader wants to
trade, not just the 100 shares advertised on the floor of the
New York Stock Exchange, and it is about the price that is
really there when the trader wants to trade. Statistics from
competing marketplaces about fill rates, response times and the
like make very nice input into a trader's decision, but they
are not substitutes for a decision.
Argument two: But the rule is necessary to protect market
orders. The normal fiduciary principle says that the agent must
act in the customer's interest, but the trade-through rule says
that the agent must ignore the customer's interest. In other
words, to eliminate any possibility that a broker may abuse his
discretion, regulators should forbid not only his discretion,
but his customer's discretion. This cannot be sensible, Mr.
Chairman.
To illustrate, an investor may wish to buy 10,000 shares at
$20 a share done at a keystroke on market X. The trade-through
rule, however, would oblige that investor instead to buy only
100 shares at $19.99 at the New York Stock Exchange and then
submit to a floor auction there, so that exchange members on
the floor may profit from knowledge of his desire to buy many
more shares. Tellingly, the same people who insist that brokers
will abuse discretion or that their customers should not be
entitled to it, will defend to the death the right of
specialists to use discretion. This view, curiously, is
entirely unburdened by knowledge of the $241.8 million in fines
paid by five of the seven NYSE specialist firms for improper
discretionary trading.
Argument three: But the rule is necessary to protect limit
orders. According to this argument, it is not the market orders
that have to be protected, but rather 100-share limit orders.
But this is a strange principle for the NYSE to defend, given
that the floor could not even exist were it not for the ability
of specialists and floor brokers to trade in front of limit
orders. Indeed, the most frequent complaint of institutional
investors about trading on the floor is precisely the fact that
limit orders are revealed to the crowd, who are then allowed to
use that information to trade in front of them. In a
marketplace, Mr. Chairman, it takes two to trade. The fellow
who puts down a limit order in market X has no moral standing
over the gal who sees a better package deal in market Y.
Appeals to fairness favor neither one over the other.
Fourth argument: But if limit orders are traded through, no
one will place them. If limit orders are traded through on
market X, they just will not be placed on market X. They will
move to market Y, where they will not get traded through.
Fifth and final argument: But a fair compromise is to have
a trade-through rule among fast markets. The NYSE has stated
repeatedly that in the fast exchange of the future, there must
be a role for the floor action. To be clear, this means that
the NYSE will only be fast for as few shares as the SEC will
let them get away with. So to go back to the example of an
investor wanting to buy 10,000 shares available on market X at
$20 a share, if the NYSE is designated a fast market it means
only that the NYSE might sell him a fast few hundred shares at
$19.99, but then just like old times, Mr. Chairman, the
exchange will force him into a floor auction.
More fundamentally, do we really want the government to be
in the business of determining which markets are fast enough
for all investors, now and in the future, and doling out
protection from competition on that basis? My judgment is that
we do not.
To conclude, I do not believe that any of these arguments
for a trade-through rule are compelling. Moreover, the rule is
not even enforced at present against its leading supporter and
only systematic violator, the New York Stock Exchange, which
trades through other markets hundreds, even thousands of times
every day. Since the SEC is silent on the question of how the
rule will actually be enforced in the future, it must be
assumed that if perpetuated it will continue to operate solely
to force investors to trade on the New York Stock Exchange,
even if they desire to do otherwise.
The SEC should, of course, be concerned to see that
intermediaries do not abuse their discretion in handling
investor orders, but given that the focus of recent SEC
disciplinary action has been improper discretionary trading by
specialists, it cannot be in the interest of investors to
oblige them to trade with specialists if they do not wish to do
so. After all, the SEC emphasizes in its proposal that a trade-
through rule, and I am quoting, ``in no way alters or lessens a
broker-dealer's duty to achieve best execution for its
customers's orders.'' If this is truly the case, Mr. Chairman,
then a trade-through rule is neither necessary nor desirable.
I thank you for the opportunity to testify this afternoon
and I look forward to assisting your deliberations in any way
possible.
[The prepared statement of Benn Steil can be found on page
83 in the appendix.]
Chairman Baker. Thank you, sir.
Our next witness is Dr. Daniel G. Weaver, visiting
associate professor of finance, Department of Finance, Rutgers
School of Business. Welcome, sir.
STATEMENT OF DANIEL G. WEAVER, VISITING ASSOCIATE PROFESSOR OF
FINANCE, DEPARTMENT OF FINANCE, RUTGERS SCHOOL OF BUSINESS
Mr. Weaver. Thank you.
Mr. Chairman, let me state unequivocally that I am against
repeal of the trade-through rule. If the rule is repealed, it
will further fragment our markets and hurt investors. It will
be a large step backward in the modernization of U.S. markets,
effectively taking us back to pre-Manning rule days. The
history of the Manning rule has reverse parallels to the
proposed repeal of the trade-through rule. Prior to Manning I,
which was enacted in 1994, if an individual investor sued their
broker, NASDAQ dealers could simply ignore customer limit
orders. Customers learned that limit orders were not executed
and did not submit them.
Manning I prevented NASDAQ dealers from trading through
customer limit orders at better prices, much like current
trade-through rules do today. However, after the passage of
Manning I, NASDAQ dealers could still trade ahead of their
customer's limit orders at the same price. There was no public
order priority rule.
Manning II enacted about a year later gave public limit
orders priority, but only within a dealer firm. In other words,
a customer submitting a limit order to dealer X could still see
trades occurring at other dealers at the same price or worse
than the customers's limit order. Thus, Manning II still
discouraged public limit order submission. It took the order
handling rules enacted by the SEC in early 1997 to unleash the
potential of public limit orders in the NASDAQ market. After
the OHR, spreads dropped dramatically. ECNs, which despite
customer limit orders, grew in market share from about 10
percent to 80 percent today. ECNs allow public limit orders to
compete with NASDAQ market-maker quotes.
The lesson is clear. If limit orders stand a chance of
execution, they will be submitted and can then become an
important source of liquidity for markets. We need liquidity in
our markets. Limit orders are shock absorbers for liquidity
events. Without limit orders to absorb trades from liquidity
demanders, large orders will increasingly push prices away from
current prices. While it may be argued that price impact is a
fact of life for large institutional traders, I am more
concerned about the small trader that submits an order at the
same direction, but just behind the large order. The small
order will execute at an inferior price before sufficient
liquidity can be sent back to the market by traders.
Repeal of the trade-through rule, then, would take us back
to pre-Manning rule days. It will discourage limit order
submission and in turn increase volatility in affected stocks.
This will result in a higher effective execution cost for the
average investors. A few large players will benefit, but it
will be at the expense of the majority of long-term investors.
It has been shown time and time again that investors factor
execution costs into the required cost of supplying funds to
firms. Therefore, higher execution costs will translate into
higher costs of capital for firms and stock prices will fall.
This will make it more difficult to raise capital and hence
provide a drag on the economy.
As an example, on April 11 of 1990, the Toronto Stock
Exchange, TSX, enacted rules that resulted in the effective
execution costs increasing by about .025 percentage points.
Within a week, prices declined by over 6 percent and stayed
there. This impact on prices will happen if the trade-through
rule is repealed. It will set us back 10 years and put us dead
last in the modernization of markets among industrial nations.
Other nations have seen the value of routing orders
according to price. The TSX affected rules that require brokers
receiving market orders of 5,000 shares or less to either
improve on price or send the order to the TSX for execution
against public limit orders. Following that action, affected
stocks experienced an immediate increase in depth and reduction
in spread. Evidence from U.S. markets finds the same result.
When Merrill Lynch decided to stop routing their orders to
regional stock exchanges and instead routed them directly to
the New York Stock Exchange, spreads narrowed and customers
obtained better executions. Recently, the EU has passed the
investment services directive II, which is similar to TSX
concentrates on rules and requires orders that occur off
exchanges to be improved-on price; not worse price, not same
price, better price.
The above are examples of the adage that liquidity begets
liquidity. In other words, limit order traders will submit
limit orders where market orders are. It is similar to the fact
that the more traffic exists on a highway, the more gas
stations will exist. If the traffic goes away, so will the gas
stations. Similarly, if market orders get routed away from the
venue with the best price, limit orders will leave that venue
as well. Going back to the gas station example, it does not
matter how cheap your gas is. You will not sell much at the
back of a dead-end street.
If markets want to truly compete, they should do so on
price, which is the current structure. However, the entire
notion of markets competing is problematic. True competition is
between natural buyers and sellers. I doubt if any member of
the public ever received a call from the Chicago Stock Exchange
asking them to send their orders in NYSE-listed stocks to them,
but their brokers did.
Allowing orders to be routed for reasons other than best
price will increase the incidence of preferencing, again taking
us a big step backward in efforts to modernize our market. I am
generally against allowing traders to give blanket opt-outs of
the best price rule. Most investors do not know their bid from
their ask, and I am afraid will quickly agree to allow their
brokers to opt out of their accounts. This opens the floodgates
for abuse by brokers, undoing years of regulatory mandated
improvements in our markets. There may be something to be said
for allowing some large traders to make an informed decision to
opt out on a trade-by-trade basis. However, I would suggest
that this can be accomplished through the changes to the rule
for block trades.
Therefore, I really do not see a need for an opt-out
ability. If enough investors opt out, then market orders can be
routed away from current venues and executed at inferior
prices. This will discourage traders from providing liquidity,
leaving more volatility in the markets, higher execution costs,
and higher costs of capital for U.S. firms. Repealing the
trade-through rule in listed markets will result in
fragmentation for listed stocks similar to that on NASDAQ. The
fragmentation of NASDAQ has led to an increased usage of order
routers to find liquidity. The creation and sale of order
routers is perhaps the biggest growth segment of the securities
industry today.
Companies like ITG do a big business selling trading firms
their order routing services. Now, these order routing firms
are not charitable organizations, but for-profit. Therefore, it
costs money to find liquidity in the OTC market today. This
further adds to execution costs, therefore increasing the
fragmentation of markets by allowing opt-outs to the trade-
through rule and will result in higher execution costs because
of the increased cost of finding liquidity.
Thank you for inviting me today, Mr. Chairman.
[The prepared statement of Daniel G. Weaver can be found on
page 96 in the appendix.]
Chairman Baker. Thank you, sir.
Our next witness is Mr. Kim Bang, president and chief
executive officer, Bloomberg Tradebook. Welcome.
STATEMENT OF KIM BANG, PRESIDENT AND CEO, BLOOMBERG TRADEBOOK
LLC
Mr. Bang. Thank you, Mr. Chairman and members of the
subcommittee. My name is Kim Bang and I am pleased to testify
on behalf of Bloomberg Tradebook.
In early market structure hearings, Chairman Oxley asked,
why does the New York Stock Exchange control 80 percent of the
trading volume of its listed companies, when NASDAQ controls
only about 20 percent of the volume of its listed companies?
The answer is simple. There has been and continues to be
numerous impediments to electronic competitors. The NASDAQ
price-fixing scandal of the mid-1990s resulted in sanctions by
the SEC and the Department of Justice and decisions on market
structure intended to enhance transparency and competition in
the NASDAQ market.
Specifically, the SEC's 1996 issuance of the order-handling
rules permitted electronic communication networks, ECNs, to
flourish, benefiting investors and enhancing the quality of the
market. NASDAQ spreads narrowed by nearly 30 percent in the
first year following the adoption of the order-handling rules.
These and subsequent reductions in transactional costs
constitute significant savings that are now available for
investments that fuel business expansion and job creation.
The question confronting the SEC and Congress is whether
equity markets can be reformed to bring the same benefits to
the New York Stock Exchange investor as they have to the NASDAQ
investor. The trade-through rule is the foremost impediment to
that opportunity.
Currently, the inter-market trading system trade-through
rule protects inefficient markets, while depriving investors of
the choice of anonymity, speed or liquidity by mandating
instead that investors pursue the advertised theoretical best
price, instead of the best available firm price. Ending the
trade-through rule would allow investors to choose the markets
in which they wish to trade, which would in turn promote
competition and benefit investors. The results would be greater
transparency, greater efficiency, greater liquidity and less
intermediation in the national market system, which are
precisely the goals of the Securities Acts Amendment of 1975.
Rather than introducing a complex new trade-through rule
that would be expensive to implement and unlikely to be
enforced, we suggest launching a pilot program similar to the
ETF de minimus exemption for a cross-section of listed stocks.
With no trade-through rule restriction, the Commission could
then monitor and measure the results of these three competitive
forces.
I cite in my testimony a study appraising a real-world
experience in which market quality did not diminish, but
actually improved in the ETFs with the relaxation of the trade-
through rule. This is no surprise, as the second largest market
in the world, namely NASDAQ, functions very effectively without
a trade-through rule.
As to market data, the Financial Services Committee has
long held that market data is the oxygen of the markets.
Ensuring that market data is available in a fashion where it is
both affordable to retail investors and where market
participants have the widest possible latitude to add value to
that data are high priorities. In its 1999 concept release on
market data, the Commission noted that market data should be
for the benefit of the investing public. Indeed, market data
originates with specialist market-makers, broker-dealers and
investors. The exchanges and the NASDAQ marketplace are not the
sources of market data, but rather the facilities through which
market data are collected and disseminated.
In that 1999 release, the SEC proposed a cost-based limit
to market data revenues. We believe the SEC was closer to the
mark in 1999 when it proposed making market data revenues cost-
based, rather than in its Regulation NMS proposal which
proposes a new formula for dispensing market data revenue
without addressing the underlying question of how effectively
to regulate this public utility function.
In addition to questions regarding who owns market data and
who shares in the revenue and the size of the data fees, we
believe the Commission ought also to revisit how much market
data should be made available to investors. Here,
decimalization has been the watershed event. Going to decimal
trading has been a boon for sure to retail investors. It has
been accompanied, however, by a drastically diminished depth of
displayed and accessible liquidity. With 100 price points to
the dollar, instead of eight or sixteen, the informational
value and available liquidity at the best bid and offer have
declined substantially. In response to decimalization, the
Commission should restore lost transparency and liquidity by
mandating greater real-time disclosure by market centers of
liquidity, at least five cents above and below the best prices.
I would like to touch briefly on one other aspect of
Regulation NMS, namely access fees. Bloomberg has long believed
that access fees should be abolished for all securities in all
markets. While we applaud the SEC's efforts to reduce access
fees, we are concerned that the complexities inherent in
curtailing these fees without eliminating them are likely to
create an uneven playing field.
In conclusion, this committee has been at the forefront of
the market structure debate and I appreciate the opportunity to
discuss how these seemingly abstract issues have a real
concrete affect on investors. Regulation NMS is a bold step to
bring our markets into the 21st century. However, we believe
there is a risk that Regulation NMS may reshuffle, rather than
eliminate current impediments to market efficiency. Elimination
of the trade-through rule, elimination of access fees, to
restore lost transparency lost to decimalization, and to
control the cost of market data would help promote a 21st
century equity market that best serves investors.
Thank you very much.
[The prepared statement of Kim Bang can be found on page 46
in the appendix.]
Chairman Baker. Thank you, sir.
Our next witness is Mr. Peter J. Wallison, resident fellow,
American Enterprise Institute. Welcome.
STATEMENT OF PETER J. WALLISON, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Wallison. Thank you very much, Mr. Chairman. I am
pleased to have this opportunity to offer my views on the SEC's
proposed Regulation NMS.
Regulation NMS is a complex proposal with elements that
address different aspects of the national market system. I will
only discuss the basic question of market structure, which is
implicated by the regulation's proposed changes in the
applicability of the trade-through rule.
The U.S. securities market today consists of two entirely
different structures, a centralized market for the trading of
New York Stock Exchange-listed securities; and a set of
competing market centers for the trading of NASDAQ securities.
One of these models and only one is likely to be best for
investors, and hence the best market structure. But Regulation
NMS does not help us decide which it is. In fact, by allowing
some investors and markets to trade-through prices on the New
York Stock Exchange and by attempting to impose the trade-
through rule on the trading of NASDAQ securities, Regulation
NMS further confuses the issues.
The fundamental question of market structure is whether
investors are better off when securities trading is centralized
in a single dominant market, or when it is spread among a
number of competing market centers. If the SEC is interested in
reforming securities market structure, it must address this
question. Regulation NMS does not do so.
Accordingly, I believe the regulation should be withdrawn
until the SEC has done sufficient study and analysis of market
structure to make an appropriate recommendation.
There are two basic models for organizing a securities
trading system. In the first, trading in specific securities is
centralized so that, to the maximum extent possible, all orders
to buy and sell meet each other in a central market. In
economic theory, this produces the greatest degree of liquidity
and thus the best prices and narrowest spreads.
This model has two potential large-scale deficiencies,
however. It forces all trading into a single mode--one size
fits all--and thus will not meet the trading needs of some
investors; and it does not create incentives for innovation or
encourage accommodation to the changing needs of investors. The
second model is a decentralized structure that contemplates
competing market centers. Any security can be traded in any
market. The advantages of this structure are that it can
potentially meet the trading requirements of the greatest
number of investors, and because the markets are in competition
with one another, it provides adequate incentives for
innovation and change.
The disadvantage of this structure is that is breaks up
liquidity and thus could potentially interfere with price
discovery. It also could result in investors getting different
prices for the same security, executed at the same time, which
some regard as unfair. The reason for the difference between
competitive conditions in the two markets is probably the
trade-through rule, which is applicable to New York Stock
Exchange-listed securities, but not, for historical reasons, to
those listed on NASDAQ.
The trade-through rule requires that customer orders to buy
or sell NYSE securities be forwarded to the market center where
the best price for those securities has been posted, usually
the NYSE. The purpose of the rule in conformity with the SEC's
longstanding policy, is to increase the chances that buyers and
sellers of a security will get the best price available in the
market at the time they want to trade, even if the security is
traded in different markets.
It appears that if the trade-through rule were eliminated
entirely, much of the trading in New York Stock Exchange
securities would move to the automated markets such as the
ECNs. This seems likely because in the NASDAQ market, where the
trade-through rule was not applicable, ECNs have been able to
capture much of the trading from NASDAQ market-makers
themselves. There are good reasons for this, especially for
institutional investors, detailed in my prepared testimony.
From the perspective of institutional investors, electronic
markets may offer the best available prices because they allow
trading in large amounts with relatively low market impact.
Thus, one way to state the question before the SEC is
whether the trade-through rule should remain applicable to
trading in New York Stock Exchange securities. If the SEC
believes that overall, taking into account its advantages and
disadvantages, the centralized trading on the New York Stock
Exchange is superior to the decentralized structure of the
NASDAQ market, then it should retain the trade-through rule. On
the other hand if it believes that the decentralized structure
of the NASDAQ market overall is superior, then it should
eliminate the trade-through rule entirely so that all market
centers could trade all securities.
In Regulation NMS, the SEC has done neither and both. It is
proposing to eliminate the trade-through rule in some
circumstances, and to impose it in others where it does not
currently apply. This indicates to me that the SEC is unwilling
or unable to grapple with the central question of market
structure--whether to favor a centralized trading model like
the New York Stock Exchange, or a market that consists of
competing trading venues.
Without deciding this question, there is no point in
adopting another regulation. Instead, I would suggest that the
SEC withdraw the regulation and do the necessary work to decide
how the securities market should be structured in the future.
That is my testimony, Mr. Chairman.
[The prepared statement of Peter J. Wallison can be found
on page 88 in the appendix.]
Chairman Baker. Thank you, Mr. Wallison.
Mr. McCabe, much of your testimony is based on the
principle that execution at the best price should be the
stalwart principle from which we should not retreat. To that
extent, I think most would agree that coming down on the side
of the consumer is always a good choice. But can you represent
to me that today all trades are executed at the best price
available on the New York Exchange at the time of execution?
Mr. McCabe. Sir, first off I have to say that I do not
represent the New York Stock Exchange. I work for a subsidiary
broker-dealer. On the New York Stock Exchange, we have rules
that say that we must attempt always to get the best price for
a customer. If for any reason we fail at that, there are
methods for people to redress that. But I would say that the
vast majority of the time, yes, they do get the best price.
Chairman Baker. I do not know if there is someone who
chooses to offer the counter view. I have received information
from other exchange representatives who allege as to the
frequency of thousands of times a week that there are
executions that occur on the New York exchange, not by
necessarily adverse intent, but due to technological limitation
that the executions do not occur at the best price. That is, in
fact, what is driving my review of the matter is that I believe
the current system is faulty in that regard, and that you do
not necessarily attain best price.
But let's move past that. Assume for the moment you are
correct and some investor has reason to want to have some other
principle guiding his investment decision. Dr. Weaver, you
indicated that most investors do not know bid from ask, but
let's assume for a moment we have one who has gotten pointed
out in the right direction. If he has some other strategic
reason to want to execute, why should not that consumer be
given his choice as opposed to the mandatory rule?
Mr. Weaver. Are we only going to worry about that consumer?
Or are we going to worry about the market as a whole? If orders
get routed away from a market center, then people realize that
their limit orders are not going to get executed and they are
not going to submit them. Too long in this country, the SEC has
focused on coming up with the smallest spread, but we need to
worry about providing liquidity to the marketplace. Liquidity
is a shock absorber. You need to have them there. You do not
want to have your shock absorbers at home in the garage right
before you get into a pothole.
Chairman Baker. That assumes that once the order would not
be placed, that the demise of the western civilization follows
because the liquidity disappears, as opposed to going to
perhaps another exchange. You are saying it parks on the
sideline and forever disappears from the economic system? How
do we get to that conclusion?
Mr. Weaver. No, sir, I am not saying that at all. First of
all, you are assuming there is another exchange for them to go
to. What if it is a market-maker who is operating proprietarily
and does not accept customer limit orders to compete for the
other customer's order? There is no way for that limit order to
get there.
Chairman Baker. I am not arguing that the role of the
specialist is not needed.
Mr. Weaver. No, I am not talking about the role of the
specialist either, sir.
Chairman Baker. I am saying that where there is a liquid
market for a publicly traded stock, where someone has an
alternative reason for exercising other than best price, which
by the way we do not get in the New York Exchange anyway, why
don't we let the customer choose? We can put a big bumper
sticker, the surgeon general says this could be hazardous to
your health, whatever we want, but let people make choices. I
think that is more the inherent in the free market system than
something that says you must do this in order to participate.
Mr. McCabe. Mr. Chairman, if I may address that just
quickly.
Chairman Baker. Sure.
Mr. McCabe. The point you have just made is that you do not
get the best price on the New York Stock Exchange. I have not
seen anyone publish data that says that, other than some of
these competitors sitting around here, and quite frankly I
question some of that data. The most recent 11(a)(c)1-5 report
shows that actually the fill rate on the New York Stock
Exchange for marketable limit orders is 72.3 percent. The
highest competitor below that for market orders is the NASDAQ.
They are at 60 percent, sir. All the other RCNs go down from
there.
Chairman Baker. So it would be, not easy, it takes some
work for folks to determine it, but based on that we will get
the SEC working to find out.
Let me ask another question though. The Philadelphia model
has competitive specialists, as opposed to the New York
Exchange which has the dedicated specialist. Is there something
wrong with the Philadelphia model that would not make sense? If
we are going to have limited competition, can't we at least
have it among the specialists on the trading floor?
Mr. McCabe. I think it is always good to know if you have a
problem you have to address, so I do think it is important that
you have one person in control. I do agree that there are
different market structures and some of them work rather well.
I think that the market structure on the Chicago Mercantile
Exchange with comparative market-makers and also the new
futures that they are rolling out have what they call DPMs,
that market structure even in the futures is a very interesting
market structure. It may actually sometime in the future be
what the New York Stock Exchange evolves into.
Chairman Baker. But you do not necessarily see the
Philadelphia model as a flawed model?
Mr. McCabe. I do not quite frankly know the percentages of
trades that are going on there, nor do I know enough about that
model to speak appropriately on it.
Chairman Baker. We will just say possibly could be, but we
need to have further examination.
My time has expired, and I know we are going to have to
break for votes here shortly. I want to make sure other members
get their chance to make their statements.
Mr. Hinojosa is next, then you, Mr. Crowley.
Mr. Hinojosa. Thank you, Chairman Baker. I want to thank
you for holding an additional hearing to review the structure
of our capital markets, in particular the SEC's proposed
national market system regulation and how investors would fare
under that proposal.
My first question is for Dan Weaver. Dr. Weaver, what
impact would the SEC's proposed national market system rule
have on limit orders?
Mr. Weaver. Which part of the NMS are you referring to? I
am sorry. The trade-through rule?
Mr. Hinojosa. Yes, the trade-through.
Mr. Weaver. It encourages limit order submission. Right
now, there is a trade-through rule on NASDAQ. It is on a firm-
by-firm basis. It does not apply across the market. The SEC is
suggesting that we should apply it across the market. I
strongly support that. It will encourage limit order
submission. The reason ECNs were started on NASDAQ was because
limit orders were being ignored by the market-makers, and
anything that we can have that will give limit orders some
priority in the marketplace will help our markets.
Mr. Hinojosa. Dr. Weaver, how will all investors, not just
the sophisticated ones, be notified that their mutual fund
manager, their broker or pension fund manager, is opting out of
the trade-through rule?
Mr. Weaver. I do not know how they would be notified
because I am against them opting out, really.
Mr. Hinojosa. Who can tell me how that notification would
occur? Anybody on the panel? Yes, sir.
Mr. Leibowitz. It is my understanding that the intention
would not be for mutual fund managers to notify specific
investors. Remember that mutual fund managers first of all have
a great degree of discretion in execution anyway. They also
have a fiduciary responsibility to the client, and it is their
job as a sophisticated investor themselves to get the best
prices for their client. That is part of what they do as a
money manager.
Mr. McCabe. If I may also, today currently I believe
Charles Schwab, working the best execution for their customers,
internalizes 95 percent of the order flow in NASDAQ securities.
I would question whether or not all those customers are
guaranteed best price.
Mr. Hinojosa. Okay.
Mr. Leibowitz. I would like to respond to that, if you do
not mind.
Mr. Hinojosa. Certainly, go ahead.
Mr. Leibowitz. I can tell you that it is our best execution
obligation and that we would be examined and fined if we did
not provide it. If you look at our best execution stats, they
are actually superior to the New York Stock Exchange in almost
every instance, and you not only get better prices, but it is
at a faster speed.
Mr. McCabe. I agree with Larry you can do things quickly,
but he did not say that they guarantee best price.
Mr. Leibowitz. No. In fact, I am saying we do guarantee
them the best price.
Mr. Hinojosa. The next question would be for Dan McCabe.
Mr. McCabe, what is the fundamental difference between the
electronic commercial networks and the exchanges?
Mr. McCabe. Quite frankly, sir, the ECNs are just what they
state. They are electronic communication networks. They match
orders that happen to be in the system. If there are no buyers
or no sellers on one side, a trade cannot occur. There is
nobody in any of these platforms that is mandated or required
to provide liquidity. On the exchanges, whether it be on
Philadelphia or the New York or out in Chicago, there are
people who are given the responsibility of making fair and
orderly markets. That is the difference between the exchanges.
Mr. Hinojosa. This last question is for Dan Weaver and
Daniel McCabe. What would happen if in the end, the SEC were to
withdraw the proposed NMS rule?
Mr. McCabe. If I may, I think the New York Stock Exchange
quite frankly has changed. I think the proposed rules have
caused people to address things that needed to be addressed for
some time. I am very happy to see that. I think those changes
will continue because of people like Mr. Thain coming into the
exchange and bringing the appropriate people with him.
If it is withdrawn, I think that there are certain portions
that we are still going to have problems with, most notably not
the trade-through rule, but the payment-for-order flow and the
sharing of tape revenue that really needs to be addressed in
these markets.
Mr. Weaver. Let me follow up on that, if I may. I think if
they withdrew the proposal, it would keep us near the back of
the pack in the modernization of markets. In particular, the
portion of the NMS that refers to decimalization and attempting
to ban sub-penny quoting would continue to further fragment our
markets and discourage limit order submission. I am afraid that
a down market of the ilk of 1987 could be more disastrous
because there is a lot less liquidity in the marketplace than
their used to be.
Mr. Hinojosa. Chairman Baker, I look forward to hearing
investors's opinions of the SEC's proposal in the near future.
I found you always to be inclusive, so we have no doubt that
you will allow us to hear from investors before this is over,
before the end of this session. Finally, I ask unanimous
consent that my opening remarks be made a part of the record
because I was on the floor and I could not be here for the
beginning.
[The prepared statement of Hon. Ruben Hinojosa can be found
on page 33 in the appendix.]
Chairman Baker. Mr. Hinojosa, your statement will be
incorporated as part of the record, and I assure you will hear
a great deal more about this subject.
Mr. Crowley?
Mr. Crowley. Thank you, Mr. Chairman. I, too, want to thank
you for holding these series of hearings on market
restructuring reform.
I, too, have an opening statement that I would also submit
for the record.
[The prepared statement of Hon. Joseph Crowley can be found
on page 28 in the appendix.]
Chairman Baker. All members's statements will be made part
of the official record.
Mr. Crowley. Thank you, Mr. Chairman.
I would first of all want to, in the sense of truth in
advertising, follow up on what Mr. Hinojosa just spoke about,
the hearing is entitled ``The SEC Proposal on Market
Structure.'' How will investors fare? I am struggling as best I
can, and I can certainly make arguments, and this is not
disparaging of the panelists before us, but I am trying to
determine who here really represents the interests of the
investor. The investor today has taken on many, many new forms,
and especially mom-and-pops who in the past were not
necessarily in the market, but who are in there today.
So I would also like to include for the record someone who
does represent, at least in some capacity, the investors. That
is the public advocate for the city of New York, Betsy Gotbaum,
who in a letter representing more than eight million New
Yorkers, many of whom are mom-and-pops, as well as others who
are invested in the markets today, who is offering her opinion
in opposition to any change in the trade-through rule. I would
offer that for the record.
Chairman Baker. Without objection.
[The following information can be found on page 102 in the
appendix.]
Mr. Crowley. Just one more point, again truth in
advertising, and again, Mr. Steil, this is toward you, I note
that on the witness list it says that you are a Andre Meyer
Senior Fellow in International Economics at the Council for
Foreign Relations. Are you representing the Foreign Relations
Council here today?
Mr. Steil. No one can represent the Council on Foreign
Relations in terms of representing its views. The Council on
Foreign Relations has no institutional position on any subject
matter whatsoever. Even the president of the Council on Foreign
Relations cannot state a view on policy of the Council on
Foreign Relations.
Mr. Crowley. I appreciate that. You are probably right. But
are you not also the director of the London-based stock
exchange Virt-x, an ECN that would clearly benefit if the
trade-through were eliminated or at least provided with an opt-
out provision?
Mr. Steil. In fact, I was discussing this matter with Dan
Weaver before we started the testimony here today. Virt-x is a
stock exchange, not an ECN. It trades primarily Swiss SMI
stocks. The biggest beneficiary in the world that I know of, of
a trade-through rule would be Virt-x, the reason being that
Virt-x, being a new competitor in the pan-European trading
market was trying to generate liquidity in non-Swiss stocks
when it did not have it in the first place.
In its first year of operation, it was quite successful in
achieving very narrow spreads on a limited number of high-
volume European stocks. For example on Deutsche TeleKom, on
many months Virt-x had a narrower inside spread on most days
than the home market Deutsche Borse, yet Virt-x got very little
order flow in Deutsche Telekom. So Virt-x would be an enormous
beneficiary of a European trade-through rule.
Mr. Crowley. I am not so sure where your conflict comes in.
It is either with Virt-x, or for the panel today in terms of
your discussion.
Mr. Steil. You are making my argument for me. I am not here
to represent Virt-x in any capacity whatsoever. I am a non-
executive director of Virt-x. I do not come here speaking for
Virt-x in any capacity whatsoever. I am speaking here today
solely for myself.
Mr. Crowley. Fair enough. Let me just move on.
A number of years ago, a number of firms represented here
today were making the argument that the New York Stock Exchange
was a dinosaur, that it was outmoded, that it was not
performing in essence in a fair way towards its investors in
providing fast enough or expedited movement. They were making
the argument that the lack of speed was the downfall of the
stock exchange. I, for one, and many in the committee have made
the point that we believe that price needs to be the issue over
speed.
Now that it appears as though the exchange is moving ever
so quickly towards a more competitive, if not almost identical
rate of speed, what does that do to the argument?
Chairman Baker. That will need to be the gentleman's last
question, so I can get to Mr. Inslee before we leave for votes.
Someone please pick up wherever you might.
Mr. Giesea. I will quickly respond to that to suggest that
should that occur, that is what the objective of the national
market system is, in my opinion. It envisions a market that can
be seen and accessed on an immediate basis. That is I think the
overall envisionment of the national market system.
Mr. Crowley. So if you have speed and you have price, there
is really no need to change the trade-through rule. Is that
correct?
Mr. Giesea. And accessibility.
Mr. Crowley. Thank you.
I yield back.
Chairman Baker. Mr. Inslee? The gentleman passes.
I will just do some quick follow-ups, and by way of
explanation, I would really like to stay for considerably
longer and have an exchange. We have either four or five votes,
I am not sure which, in a series, so we are going to be over
there for a bit. I think it unreasonable to expect you to
remain here while we go do that stuff.
I will follow up in written form to a number of you with
regard to specific questions. I do believe it the case that the
trade-through rule does no in effect result in execution at
best price. I do believe that consumers ultimately are the ones
we should be concerned about and should be able to act at their
instruction since the markets are actually facilitators of a
transaction which is initiated by the initial investor.
To that end, I do not believe that the opt-out rule
properly constructed is a bad thing. I will follow these
observations up with questions about the triple-Q trade and the
ETF transactions in which the SEC eased the rules for a bit, de
minimus opportunity to conduct business, and ask for your
perspectives on that versus the transitions that occurred in
Europe. I am not at all interested in contributing to the
demise of our economic system, which has been portrayed as a
consequence of looking at facilitated trading. We really do
need to have careful consideration, time to do the analysis,
and even with Mr. Hinojosa's requests for additional hearings,
we certainly will. In the interim, I hope to ask the SEC
specifically to help us navigate through this maze with
specific data that would be helpful in our insights.
I regret that I do not have time to engage you in more
thoughtful discussion today, but given the flow of votes, I
think it more appropriate to release you at this point and ask
for your response in writing to questions we will formulate
over the coming days.
I express my deep appreciation to each of you for your
participation here. It has been helpful to the committee's
deliberations.
We stand adjourned.
[Whereupon, at 3:21 p.m., the subcommittee was adjourned.]
A P P E N D I X
May 18, 2004
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