[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]





                       THE SEC PROPOSAL ON MARKET
                  STRUCTURE: HOW WILL INVESTORS FARE?

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

                                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
____________________________________________________________________________
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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

                              ----------                              
                                                                   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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