[Senate Hearing 108-828]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-828


                  THE FUTURE OF THE SECURITIES MARKETS

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

                                HEARING

                               before the

               SUBCOMMITTEE ON SECURITIES AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

 THE STRUCTURE OF THE U.S. EQUITIES MARKETS, WITH PARTICULAR REGARD TO 
                     THEIR FAIRNESS AND EFFICIENCY

                               __________

                            OCTOBER 15, 2003

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


   Available at: http: //www.access.gpo.gov /senate /senate05sh.html


                                 ______

                    U.S. GOVERNMENT PRINTING OFFICE
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                 ______

               Subcommittee on Securities and Investment

                   MICHAEL B. ENZI, Wyoming, Chairman

            CHRISTOPHER J. DODD, Connecticut, Ranking Member

MIKE CRAPO, Idaho                    TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire        JACK REED, Rhode Island
CHUCK HAGEL, Nebraska                CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
ROBERT F. BENNETT, Utah              DEBBIE STABENOW, Michigan
WAYNE ALLARD, Colorado               JON S. CORZINE, New Jersey
RICK SANTORUM, Pennsylvania

                       Greg Dean, Staff Director

           Alexander M. Sternhell, Democratic Staff Director

                                  (ii)



                            C O N T E N T S

                              ----------                              

                      WEDNESDAY, OCTOBER 15, 2003

                                                                   Page

Opening statement of Senator Enzi................................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     3
    Senator Bunning..............................................     4

                                WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission, accompanied by Annette L. Nazareth, Director, 
  Division of Market Regulation, U.S. Securities and Exchange 
  Commission.....................................................     5
    Prepared statement...........................................    27
    Response to written questions of:
        Senator Hagel............................................    32
        Senator Johnson..........................................    35

                                 (iii)

 
                  THE FUTURE OF THE SECURITIES MARKETS

                              ----------                              


                      WEDNESDAY, OCTOBER 15, 2003

                               U.S. Senate,
        Subcommittee on Securities and Investments,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:10 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Michael B. Enzi (Chairman of 
the Subcommittee) presiding.

          OPENING STATEMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. I call to order the hearing on the future of 
the securities market. This is the first hearing of the 
Subcommittee on Securities and Investment. One of the reasons 
it is the first hearing that we have held is that so many of 
the hearings have been elevated to a Full Committee status, and 
we have been pursuing a number of these things throughout the 
year. In fact, Chairman Donaldson has been here several times 
and testified. And in order for them to be able to do their 
work, we hope that we can change that to maybe a once every 6 
months thing instead of a weekly or monthly appearance here.
    We do thank you for being here, and also for Annette 
Nazareth, the Director of the Division of Market Regulation of 
the SEC, for being here as well.
    There is no doubt that the securities markets of the United 
States are the best in the world. Over the years, our 
competitive market system has brought the best of the floor-
based and electronic markets to the forefront. The laws that 
are the underpinning of the structure of our securities market, 
the Securities Exchange Act of 1934, and the provisions of the 
Securities Acts Amendments of 1975 that created the national 
market system, have held up fairly well in the face of constant 
change. One of the things that has set our markets apart from 
international markets has been our ability to foster innovation 
and technology. Maintaining that competitive edge is an 
absolute priority.
    Several years ago, the securities market saw unprecedented 
change. The bull market of the 1990's retreated, the arrival of 
trading in decimals forever changed the markets, and then the 
events of September 11 put tremendous stress on the system. 
Then the accounting issues of a year-and-a-half ago added 
stress and as a result, the system we have today appears to be 
at a crossroads.
    The Securities and Exchange Commission has recognized that 
the changes in the market have caused issues of market 
structure to become more complex and intertwined. In 2000, the 
Commission created an Advisory Committee on Market Information. 
In addition, it was exactly a year ago that Commissioner 
Glassman chaired a series of Commission hearings on market 
structure.
    Just a few of the issues facing our markets include: One, 
whether to update the Intermarket Trading System established by 
the 1975 Act; two, whether to change the collection and 
distribution of market data fees; and three, whether there 
currently exists fair and equitable access to trading venues.
    With respect to modernizing the Intermarket Trading System, 
both traders on the floor-based and electronic markets have 
concerns with the system and, in particular, with its trade-
through rule. When the Intermarket Trading System was 
implemented in 1978, no one could have predicted the level and 
speed of trading done today. Unfortunately, the national market 
linkage that it was supposed to achieve has come to represent 
the great divide between our competing market structures and 
the diverse trading venues available to investors. Clearly, 
fixing the system needs to be a priority.
    With regard to market data fees, again, the system, as 
originally intended, was to fairly and equitably collect and 
distribute monies to facilitate the market data to investors 
and to finance the regulation of the markets. Over the years, 
the fees have been subject to a number of factors, including 
being tied to incentives for trading platforms and to elements 
to boost market shares.
    While the underlying goal of the fees is to create market 
data that is accurate, uniform, and available in real-time to 
investors, the fees also must ensure a strong regulatory 
environment. Today, I believe the system is not operating as it 
was intended.
    On a related matter, the access to and trading on the 
various trading venues and markets also must be done in a fair 
and equitable manner. Our current system has brought about 
innovation and change to the market. However, as our markets 
continue to evolve and mature, level playing fields are harder 
to achieve. It has become even harder for market participants 
to act in the best interests of their investors. Should all 
fees and charges involved in a 
securities purchase be fully taken into account toward the 
price of securities, or should investors be given more 
comprehensive information on how the markets perform prior to 
placing an order are but two of the many questions that need to 
be addressed to determine whether we have fair and equitable 
markets.
    In addition to these issues, we must also address whether 
the self-regulatory structure that we rely upon for oversight 
of the markets is in need of change. Recent events have shown 
significant strains and weaknesses on that structure. I will be 
interested to hear how the reforms that you implemented over 
the summer are proceeding and what additional reforms will be 
necessary.
    With any review of the future of the securities markets, we 
should take a look back to how our markets have evolved over 
the past 20 or 30 years. The tremendous changes to the markets 
are due, in large part, to how technology and innovation have 
transformed not only the markets, but also our economy. For 
example, the Nasdaq Stock Market was transformed by the 
technology boom of Silicon Valley. As venture capitalists 
invested money into the high-technology companies, they needed 
a way to ``cash out'' their investments through initial public 
offerings on Nasdaq. Today, the testaments to the high 
technology market are household names. Today, not only are our 
securities markets at a crossroads, but also our economy is at 
a crossroads. Recently, numerous articles have appeared in the 
news stating that many of the high technology jobs are being 
transferred overseas. In addition, one article discussed how 
many countries, including China, are spending lots of money to 
create their own Silicon Valleys. While the U.S. initial public 
offerings, IPO's, were at a standstill for the first 6 months 
of this year. The Asian stock markets dominated the number of 
IPO's.
    Will overseas venture capitalists and investment bankers 
transfer foreign securities markets to facilitate high 
technology industries in a similar manner that happened with 
Nasdaq? Time can only tell.
    However, we must ensure that our securities market remain 
the best in the world. In doing so, we must ensure that 
technology and innovation are key to our evolving stock 
markets. Currently, market participants are unwilling to invest 
in infrastructure and technology without clear guidance from 
the Securities and Exchange Commission of where the markets are 
headed. If the securities markets are at a crossroads, then 
they are looking to the SEC for guidance.
    Chairman Donaldson, thank you again for being with us 
today. I have to commend you for doing an excellent job in your 
very short time on the Commission. There have been a lot of 
issues vying for your attention during these past few months. I 
also appreciate, Ms. Nazareth, the Director of the Division of 
Market Regulation. We welcome both of you, and I look forward 
to your testimony.
    I will call on Senator Sarbanes for any comments.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Enzi. I 
want to commend you and Senator Dodd on holding this morning's 
hearing on the important subject of the structure of the 
securities markets.
    This subject inevitably raises important and complex 
questions about market structure, among them what form should 
self-regulation take; how can we assure fair access to the 
securities markets; does an exchange need to provide time, 
price, priority; what constitutes best execution of an 
investor's stock order; and of course many others.
    Because markets change over time in response to the needs 
of investors and issuers, these questions recur. The answers 
are not fixed in stone. Chairman Donaldson was quoted as saying 
in The Wall Street Journal, markets experience ``operating 
stresses and strains,'' similar to the experience of the 
Chairman and those of us on the Committee, I might add.
    [Laughter.]
    It is, therefore, important for the Commission to resolve 
these issues in a timely manner through rulemaking, ruling on 
applications and working with self-regulatory organizations. It 
falls to the Commission to adjust the regulation of the markets 
to accommodate the legitimate needs of market participants, 
while at the same time upholding its fundamental mandate to 
assure the investor protection and market integrity mandated by 
our securities laws.
    I welcome SEC Chairman Donaldson and Ms. Nazareth before 
the Committee. Chairman Donaldson returns to testify before the 
Committee or one of its Subcommittees for the sixth time this 
year and for the third time since the end of the summer recess. 
This Committee and its Subcommittee hearings and Chairman 
Donaldson's frequent appearance in them, underscore both the 
central importance of the securities markets to the Nation's 
economy and this Committee's concern that these markets operate 
at the highest levels of transparency and efficiency.
    Chairman Donaldson, I want to commend you for your 
willingness to come before the Committee or its Subcommittees 
repeatedly. I think it is a very important part of laying these 
issues out for public discussion, and I think it contributes 
markedly to enhancing the understanding of the Members of the 
Congress, but also the members of the public on a range of 
complex issues that are on the agenda of the SEC. We are 
pleased to have you back before us today.
    Thank you.
    Senator Enzi. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman, for holding this 
very important hearing. You picked a very important and timely 
topic to which you hold your first Subcommittee meeting.
    I would also like to thank Chairman Donaldson and Ms. 
Nazareth for testifying today.
    Our equity markets are the envy of the world. They have 
obviously taken a beating and battering over the last few 
years, but they are once again showing their resilience. Last 
May, I had, in my Subcommittee, a hearing on economic policy, 
increasing investment in the equity markets. Since that 
hearing, the Dow has gone up 1,200 points----
    [Laughter.]
    --the Nasdaq 435 points. Now, there may have been a tax 
bill that was passed that day, also. That may deserve some of 
the credit for the rebound in the markets, but that is okay. I 
can share the credit with the President.
    Senator Sarbanes. We urge you to hold another hearing as 
soon as you can.
    [Laughter.]
    Senator Bunning. Though the markets are looking stronger, 
there can be improvement. I worked in the security industry for 
25 years, so market issues have a special place in my heart. 
There are many issues confronting the markets today--overall 
structure, fragmentation, hedge funds, the impact of 
decimalization, and we have to worry about market manipulations 
and fraud.
    I am very interested in hearing what you have to say about 
the issue confronting our markets. It is no secret that there 
has been a lot of turmoil at the SEC over the last couple of 
years. It is my hope you will bring needed stability there. Our 
markets need that stability.
    Once again, Chairman Enzi, thank you for holding this 
important and timely hearing and thanks to our witnesses for 
their testimony today.
    Senator Enzi. Any other statements?
    [No response.]
    If not, again, we thank you for coming, and I would mention 
that of course when we do the full Committee hearings, those 
are the ones where we get into concepts. When we get to 
Subcommittee, we get into technicalities. So this may be as 
easily understood as some of the accounting hearings that we 
had last year.
    [Laughter.]
    But it is the technicalities that make the difference, and 
so we do appreciate your being here to provide the testimony 
that we can delve into and figure out what we, as Members of 
Congress, need to do to aid you in your work.
    Again, we thank you for coming.
    You may begin Chairman Donaldson.

          STATEMENT OF WILLIAM H. DONALDSON, CHAIRMAN

               ACCOMPANIED BY ANNETTE L. NAZARETH

            DIRECTOR, DIVISION OF MARKET REGULATION

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Thank you, and good morning, Chairman 
Enzi, and Ranking Member Dodd, and Members of the Subcommittee. 
I am delighted to be here to discuss some of the significant 
market structure issues that we are facing in the U.S. equities 
market today.
    In the coming months, the Commission will be focusing with 
increased intensity on the structure of the U.S. equities 
markets, with particular regard to their fairness and 
efficiency. As you know, Congress formally directed the 
Commission to address market structure when it enacted the 
Securities Acts Amendments of 1975. That legislation instructed 
the SEC to facilitate the creation of a national market system 
for securities that would maintain fair and orderly markets and 
tie together all buying and selling interest so that investors 
would have the opportunity for the best possible execution of 
their orders, regardless of where in the system they originate.
    Rather than attempt to dictate the specific elements of 
U.S. market structure, however, Congress chose to rely on an 
approach designed to provide maximum flexibility to the 
Commission and the securities industry in its development.
    The 1975 Amendments to the Exchange Act created a framework 
for fostering transparency, interconnectivity, and competition 
in our securities markets. As a result, today, equity market 
centers compete with one another in an environment where quotes 
and transaction prices are widely available to all market 
participants.
    Direct and indirect linkages among competing market centers 
help ensure that brokers can access the best quotes available 
in the market for their customers. Market centers, including 
exchange markets, over-the-counter market makers, and 
alternative trading systems, have an incentive to offer 
improvements in execution quality and to reduce trading costs 
in order to attract order flow away from other market centers.
    The national market system has worked remarkably well for 
the past quarter century, and in recent years, it has become 
increasingly efficient. At the same time, this very efficiency, 
arising from technological and other market developments, has 
put strains on existing national market structures. One 
significant change has been the proliferation of new electronic 
markets, such as the ECN's, that offer fast executions and have 
spurred competition among market centers, but at the same time 
have exacerbated concerns about market fragmentation, the 
feasibility of integrating 
different market models into the national market system and 
maintaining a level regulatory playing field among functionally 
equivalent market participants. The implementation of decimal 
pricing in 2001, and the concurrent move to a minimum tick of 
one penny in the equity markets, has narrowed spreads and 
enhanced the efficiency of the price discovery process, but at 
the same time reduced the liquidity available at each price 
point and made it easier to step ahead of limit orders and 
placed economic strains on the dealer business.
    Decimal pricing has also put a premium on swift access to 
displayed prices so investors can quickly reach these smaller 
quotes before they change. The trend toward demutualization of 
exchanges, and their conversion to for-profit enterprises, has 
heightened concerns about the inherent tensions in the self-
regulatory model, in particular the concern that the funding 
and vigor of the regulatory function might be sacrificed in 
favor of delivering returns to shareholders.
    Over the last several years, the Commission has taken a 
number of steps to address concerns facing our national market 
system. In the Order Handling Rules and Regulation ATS, for 
example, the Commission broadened the class of market centers 
required to make their quotations and orders publicly 
accessible. In doing so, it sought to redefine the idea of an 
exchange to include not just traditional exchanges, but also 
trading systems where orders interact according to specified 
trading rules. The Commission has also adopted rules to improve 
the disclosure by market centers of execution quality data, and 
the disclosure by broker-dealers of their order routing 
practices, in order to enable investors to ``comparison shop'' 
among the myriad market centers and to stimulate competition on 
the basis of execution quality.
    There is no doubt that there are issues regarding our 
national market system that call for our attention. Commission 
staff is in the midst of developing proposals that address, in 
a comprehensive fashion, the various market structure issues. I 
would like to focus the remainder of my testimony on four key 
areas of the Commission's market structure initiative: First, 
access to markets; second, market data; third, the whole self-
regulatory model; and, four, the nature of a securities 
exchange.
    Access to markets and fair access. A significant market 
structure issue on the Commission's agenda is making sure that 
access between markets is as fair and as efficient as it can 
be. If best execution is to be achieved in an environment 
characterized by multiple competing markets, broker-dealers 
must be able to identify the location of the best available 
prices and obtain access to those prices routinely and 
efficiently.
    The Commission's approval last year of the NASD's 
Alternative Display Facility as a pilot program has highlighted 
the issue of intermarket access. Rather than obtaining access 
through ``hard'' linkages directly between markets, in a way 
that competing markets can access the New York Stock Exchange, 
in the Alternative Display Facility, competing market centers 
obtain access to each other directly through privately 
negotiated access agreements and indirectly through 
subscribers. The Commission will be evaluating this 
decentralized access approach to determine whether, as a 
practical matter, it would be an appropriate model for the 
national market system and thus could be applied to other 
market centers.
    Access fees. Access fees charged to reach a quote create 
another difficult market structure problem. Some markets charge 
varied per-share transaction fees for access to their quotes. 
Therefore, a displayed price may represent the true price that 
a customer will pay or it may represent only a base price to 
which an undisclosed access fee will later be added. To ensure 
real access to public quotes between competing markets, it is 
important that quotes be accessible to other market 
participants on clear and fair terms.
    Price protection. As part of our examination of intermarket 
linkages, we also intend to reassess the question of 
intermarket trade-throughs, which occur when orders are 
executed in one market at prices inferior to the prices 
disseminated on another market. The challenge before the 
Commission is to devise standards that allow faster markets and 
slower markets to thrive within a single system of 
interconnected markets, while at the same time providing order 
executions to customers that display prices and for those 
customers who desire the best price on their orders.
    Market data. An additional market structure challenge 
facing the Commission involves the collection and reporting of 
trading information and influence of the market data revenues 
on market structure. Under the current system, distributions of 
market data revenues to self-regulatory organizations are based 
primarily on each self-regulatory organization's reported trade 
volume. This compensation scheme has created a financial 
incentive for self-regulatory organizations to report as many 
trades as possible. As a result, markets are vying for ECN's 
and market makers to report their trades through them, as this 
allows markets to tap more deeply into the pool of available 
market data revenue and to rebate substantial portions of the 
additional revenue to the entity reporting the trade.
    All of this calls into question whether the method of 
distributing market data revenue as we know it creates 
appropriate economic incentives and whether it furthers the 
goal of rewarding markets that make valuable contributions to 
the market data being disseminated.
    Third, the self-regulatory model. Another matter of great 
importance is the effectiveness of the self-regulatory system 
of securities markets. The principle of self-regulation is 
based on the idea that regulation can best be done as close as 
possible to the regulated activity. However, an SRO that 
operates a market has an inherent conflict of interest between 
its roles as a market and as a regulator. The advent of for-
profit, shareholder-owned exchanges 
creates additional issues, including ensuring that self-
regulatory obligations do not take a back seat to the interests 
of shareholders. The challenge for the Commission and the SRO's 
is to ensure that as the securities markets grow more 
competitive, the SRO's continue to dedicate their energies and 
resources to surveillance and enforcement. We also must prevent 
fragmentation of trading from creating gaps in SRO oversight of 
these markets.
    As part of our review of the self-regulatory structure, I 
believe the Commission must thoroughly review the SRO's 
governance practices. Recent events at the New York Stock 
Exchange point to the need for this review. SRO's play a 
critical role as standard setters for sound governance 
practices. Just as SRO's have demanded that their listed 
companies strengthen their governance practices, we must demand 
that, at a minimum, SRO's match the standards that they set for 
listed companies. There are several topics that merit our 
consideration, including board composition, independence of 
directors, and independence and function of key board 
committees, the transparency of the SRO's decisionmaking 
process, and the diligence and competence required of board and 
committee members and ensuring their focus on the adequacy of 
regulation.
    Exchange criteria. The last topic that I would like to 
touch upon is what it means to be registered as a national 
securities exchange. All currently registered exchanges have a 
limit order book, in which the better-price orders take 
precedence. But a mandatory order book system is not easily 
reconciled with a dealer model, such as the Nasdaq stock 
market, in which there is no central limit order book.
    I spoke earlier about the merits of price protection across 
the markets. Nasdaq's application to register as an exchange 
places squarely before the Commission the issue of whether 
price protection within a market is a requirement of exchange 
registration. One issue is customer expectations. I suspect the 
customers generally expect their better-priced orders to be 
protected within an exchange.
    We do not expect all exchanges to be identical, much less 
to replicate any market's faults. Yet, until now, all exchanges 
have given their limit orders priority throughout their 
marketplace. If the Commission were to approve Nasdaq's 
application, other exchanges would likely seek to eliminate 
intramarket price priority from their rules. As a result, the 
protection of limit orders within markets would decrease. For 
this reason, Nasdaq's exchange application raises market 
structure issues that transcend the particular question of 
whether Nasdaq, or any other particular market, should be 
registered as an exchange.
    In conclusion, I would like to reiterate that the market 
structure challenges that I have discussed may shape the 
national market system for years to come. I look forward to 
continued input from this Subcommittee on these important 
matters.
    Thanks again for inviting me to speak on behalf of the 
Commission. I would be happy to answer any questions or hear 
any observations.
    Thanks very much.
    Senator Enzi. Thank you, and I appreciate your taking a 
very complex subject and making it relatively simple.
    We are going to be interrupted by a vote. I believe it is a 
stacked vote of two. I think that we should be able to get 
through one round of questions before the lights show up for 
the half-time of the vote, and at that time we can go vote on 
two issues and then come back and continue with rounds of 
questioning.
    To begin the questioning, in 1975, Congress passed 
legislation that established the national market system that 
led to the creation of the Intermarket Trading System in 1978, 
and the governance of that system requires there has to be a 
unanimous vote of the system's participants before any changes 
can be made to the system.
    Currently, it appears that there is not an agreement by all 
of the participants on how to amend the trade-through rule. 
There is precedent of the SEC stepping in to fix the system 
when not all of the parties agree. Will the SEC step in to 
solve the trade-through problem?
    Chairman Donaldson. Well, as I intimated in my formal 
testimony, the issue of trade-through is a considerable one, 
and it has to do, essentially with the different desires of 
investors, and let me try and elaborate on that.
    You have, as a result of the nanosecond capability of some 
of the electronic markets, the ability to transact a 
transaction in a nanosecond--so fast you can hardly see it with 
your naked eye. And at the same time, we have had 
decimalization of the spread, so that now we have a penny 
difference, if you will, in markets, and price improvement 
represents a penny improvement. So that we have created a new 
desire, on the part of many investors, to give up the 
opportunity for price improvement of only a penny in order to 
achieve immediacy of execution and surety of execution.
    And that is in contrast to some of our more particular 
markets, and in particular the New York Stock Exchange, where 
the guarantee of the best price requires a period of time to 
search for that best price. And although that period of time 
seems pretty fast, in terms of the current situation; for 
example, 30 seconds or so, 30 seconds is an eternity for 
somebody who trades in nanoseconds, and that is the problem. 
And what you have seen is a strain on our trade-through 
regulations, where people are willing to ``accept a less good 
price'' to trade through a better bid in order to get immediacy 
of action.
    Senator Enzi. You think the Intermarket Trading System 
needs to be completely overhauled?
    Chairman Donaldson. Well, I think there needs to be a 
reexamination of the trade-through rules. I think we need to 
try and see if we cannot get a compromise between what I have 
just been talking about. There are many different ways of 
achieving that. Customers or clients could formally opt out of 
seeking best execution and, in so doing, allow brokers to deal 
in the faster market. There are a number of things that can be 
done.
    You might want to add to that, Annette.
    Ms. Nazareth. Yes. I agree with everything you said. I 
think, in response to the issue, the Commission, as you alluded 
to, would probably have to take some action because, as you 
said, the governance rules require unanimity, and it certainly 
would be in keeping with what the Commission has done in the 
past to step in when the markets cannot agree on a solution.
    Senator Enzi. It has been argued that there is not enough 
enforcement of that trade-through rule. For example, some 
market participants believe offers to purchase securities 
through the Intermarket Trading System are posted without the 
intent of execution. A good indicator of this is when a posted 
quote fades away, when the 30-second time limit to accept an 
offer expires, how do the SEC and the self-regulatory 
organizations police for market participants an attempt to 
manipulate the market in this manner?
    Chairman Donaldson. This is again one aspect of changes 
that we are in the process of examining. I think the unanimity 
rule, I did not answer your question directly, but that is 
something we are going to have to take a good hard look at.
    I think we are also going to have to take a good hard look 
at the ability to monitor trade-through after we come up with 
an approach to allowing perhaps some modification of the trade-
through rules.
    Senator Enzi. My time has expired. I will do another 
follow-up in writing on that one.
    Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    The market structure issues you have discussed, and 
contained in your statement, are complex. They obviously 
require significant staff expertise to resolve. My first 
question is whether the division of market regulation has been 
given the additional staff to handle these new issues.
    Chairman Donaldson. We have been through a rather intensive 
process of evaluating where our additional hiring capability 
should, how that should be divided between the various 
competing divisions within the SEC. I believe that we have 
allocated adequate resources to the market regulation, but let 
me ask the Director of Market Regulation whether she agrees 
with that.
    Ms. Nazareth. Absolutely. Yes. We have been allocated a 
substantial number of additional positions that we are in the 
process of filling in order to meet the additional needs in the 
Division.
    Senator Sarbanes. Do you think the resources you are being 
given are adequate to your tasks?
    Ms. Nazareth. Yes, I do.
    Senator Sarbanes. We will hold you to that.
    The Wall Street Journal, Chairman Donaldson, on September 
26--I am going to quote them a little at length--they talked 
about Mr. Reed coming back to the United States to take on his 
job.

    He is dumping a draft report of corporate governance 
changes prepared by the New York Stock Exchange board for the 
SEC in favor of a new review that promises to recommend tougher 
changes.
    One of the main issues being reviewed, according to people 
with knowledge of the matter, is whether issues such as pay, 
corporate governance, and audits should be reviewed by board 
committees, as they now are, or by the full New York Stock 
Exchange board.
    A number of broader issues facing the big board remain on 
the table, among them, whether to split the chairman and CEO 
posts, whether to split off the New York Stock Exchange's 
regulatory function, and whether to issue shares to the public.
    The scandal also has intensified the debate over whether 
the New York Stock Exchange can continue as a human-dominated 
system after most exchanges around the world have replaced 
people with matchmaking software.

    Is the Commission examining all of these issues that I just 
referenced in the course of its oversight over the New York 
Stock Exchange and what is your view of these issues and how 
they should be resolved?
    Chairman Donaldson. Let me begin by saying that, yes, we 
are very much concerned with the governance structure of the 
New York Stock Exchange. I wrote the then Chairman of the Stock 
Exchange a number of months ago--I think in March I believe of 
this year--asking him and, I might add, the heads of all of the 
other exchanges to report to us on the governance structure of 
their exchanges, to report to the SEC on the many issues 
involved that you just brought up that fall in the general 
category of governance issues: Salary setting, how new 
directors are elected, basically how the place is run, from a 
corporate governance point of view.
    If you fast forward now to the time that we are in, John 
Reed, and then if I can put my comments specifically to the New 
York Stock Exchange, John Reed has, in a public-spirited way, 
agreed to come out of retirement and come back to the New York 
Stock Exchange in an acting role as a chief executive to 
spearhead a thorough examination of the corporate governance 
structure.
    We are in touch with Chairman Reed. We want to be of 
whatever help we can. However, at the first instance here, the 
responsibility for the governance structure of the New York 
Stock Exchange remains with the New York Stock Exchange. We 
have an oversight responsibility. We will exercise that 
oversight, but the first step here is for the Stock Exchange 
itself to come up with whatever revisions they believe is 
necessary in light of current circumstances.
    Senator Sarbanes. I take it that means that the last step, 
if necessary, though, is with the Securities and Exchange 
Commission.
    Chairman Donaldson. The last step will be the approval of 
the governance structure by the SEC.
    Now, you bring up a most important issue here which has to 
do with not only the structure of the governance, but also the 
definitions of independence that apply to that structure, what 
is a truly independent director, can it be a member of the 
securities industry, can it be a sitting executive of a listed 
company, are these independent directors or are they not? Are 
they true public directors?
    The second issue is of course the structure of how that 
board is elected, the structure of the nominating committee, 
the compensation committee, the audit committee, all of these 
things which pertain particularly to the New York Stock 
Exchange, but also pertain to companies listed on the New York 
Stock Exchange.
    That raises some additional issues that you have touched 
on, which has to do with the self-regulatory function of the 
exchange. And, again, if I can oversimplify this, it seems as 
though there are two main functions that a stock exchange 
market like the New York Stock Exchange has.
    One is the market itself, a competitive entity which is 
competing with other market centers, and with ECN's, and with 
broker dealers, and so forth; and the second is the regulatory 
function that is there to make sure that the dictates or 
competitive nature of the marketplace does not act to the 
detriment of public investors, both institutional and 
individual.
    And I think the issue confronting the New York Stock 
Exchange now and confronting Mr. Reed's efforts here are what a 
structure can you come up with that, in effect, separates that 
regulatory responsibility so that it does not get mixed up with 
the competitive aspects of running the marketplace.
    I would suggest that there are a number of different ways 
of doing that, ranging all of the way from reporting structures 
within the exchange framework that separate out a reporting 
line for regulation that reports to a newly defined, 
independent board, all of the way to taking regulation totally 
away from the self-regulatory organization and putting it out 
in space somewhere as a separate organization.
    And this is an interesting issue. I think that traditional 
thought has been that the regulation should be as close to the 
marketplace as it can be and be effected by people who are 
familiar with the marketplace, as opposed to some disengaged 
bureaucracy. But I think that is the issue now that faces John 
Reed and faces the board of directors of the Stock Exchange.
    Senator Enzi. Senator Bunning.
    Senator Bunning. Thank you. I have three questions. I am 
going to ask one and submit two because we are on a--we have 
got 10 minutes on a vote, and we have a 7-minute vote to 
follow.
    The first question I would like to ask, because of all of 
the turmoil over at the SEC for the last few years, I am 
concerned with the length of time it takes for an application 
to be approved or disapproved. Do you agree that 2-plus years 
is too long for an application decision, and are you doing 
anything to speed up the process?
    Chairman Donaldson. Well, I think, if you are referring to 
an application such as the Nasdaq application to become a 
market, if that is the----
    Senator Bunning. That type of application or any other 
applications that are submitted to the Securities and Exchange 
Commission.
    Chairman Donaldson. Yes. This is an extremely complex 
subject. It is not just----
    Senator Bunning. I understand that, sir. I am just asking 
you over a period of 2 years seems to be plenty of time to make 
a decision, even though it is complex.
    Chairman Donaldson. I believe that the fact of the matter 
is that the application by Nasdaq to become a market, to become 
a stock exchange brings with it implications for the entire 
market structure system. It is not a simple decision for them 
alone; it is a decision that has ramifications for the entire 
rest of the marketplace.
    Senator Bunning. I understand that.
    Chairman Donaldson. And that is an issue that the SEC has 
been faced with long before I got there, and it is not a matter 
of somebody dragging their heels or the application in an out-
basket or an in-basket; it is a matter that has been before the 
Commission. There have been all types of panels, and discussion 
groups and so forth. It is a tough question, Senator.
    Senator Bunning. I understand that, but 2 years is too 
long.
    So, therefore, the decision should be made and all of the 
consequences of the decision should have been considered, and 
whether you like the application or whether you do not like the 
application or whether you think of the unintended consequences 
that come from the decision. Obviously, we know that it is 
complex. It would not take 2 years to make a decision if it 
were not complex. But I think somebody deserves an answer.
    Chairman Donaldson. Well, I agree with you in the sense 
that a certain amount of time has passed. On the other hand, 
the stakes are tremendous. If you step back from our market 
system, with all its warts and pimples, the U.S. market system 
is the best in the world, and it is functioning the best.
    If we make a quick decision that has implication for the 
whole rest of the marketplace, we run the risk of doing great 
damage to our central market system. I want to assure you that 
there is nothing that we are looking at now that has a higher 
priority than the restructuring of the central market system. 
We have the best minds that we have in the SEC working on it. 
We are reaching out to everyone we can, and I see it as a top 
priority item for my tenure as Chairman of the SEC.
    I do not know whether you want to add to that. You have 
been in the midst of this, Annette.
    Ms. Nazareth. I have. I guess I would just add the point 
that if we are to be faulted for anything, it is that we do not 
say, no, we keep saying maybe. Let us see if we can get to a 
yes answer, and that unfortunately takes some time. It is very 
easy to say, no, but I can fully appreciate the----
    Senator Bunning. Ms. Nazareth, what is ``some time''?
    Ms. Nazareth. What is?
    Senator Bunning. What is ``some time''? What are you 
considering that ``some time'' is? Is it 2 years, 4 years, 6 
years, 10 years?
    Ms. Nazareth. I think it would be normally something quite 
short of 2 years.
    Senator Bunning. Something short of 4 years?
    Ms. Nazareth. Of 2 years.
    Senator Bunning. Of 2 years.
    Ms. Nazareth. Normally, it would be.
    Senator Bunning. Some applications are sitting there over 2 
years.
    Chairman Donaldson. The issue has not just been sitting 
there, Senator. It has been worked on.
    Senator Bunning. But it is still not resolved. That is the 
whole question.
    Chairman Donaldson. That is absolutely right, and we have 
it as a priority item, and we are going to resolve it.
    Senator Bunning. I can be assured of that, the next time I 
come back, if I ask the same question?
    Chairman Donaldson. No.
    Senator Bunning. Will you say it is less than 2 years?
    Chairman Donaldson. I will have to ask the Chairman when he 
is going to ask me back again.
    [Laughter.]
    Senator Bunning. You will be back before the full Committee 
before you get back to the Subcommittee.
    Thank you very much, and I will submit the other two in 
writing.
    Chairman Donaldson. Thank you.
    Senator Enzi. We are in a very fortunate situation. Senator 
Dodd has already voted, so we will have Senator Sununu ask his 
questions, and then we will allow Senator Dodd to continue the 
hearing while we go vote.
    Senator Sununu. Thank you, Mr. Chairman.
    I only have easy questions.
    Mr. Donaldson, is the role of the regulator, I heard you 
use the phrase ``price improvement'' and ``price protection,'' 
and it put a question in my mind, which is, is the role of the 
regulator to guarantee the best price or to ensure a fair and 
transparent system that is free from conflicts of interest?
    Chairman Donaldson. As I tried to say, rather 
inarticulately, the definition of what the participant in a 
marketplace wants is changing, and it used to be that best 
price was a sine qua non of the market, that small investors 
were guaranteed, alongside large institutional investors, that 
they would get the best price. But as I said, I think that in 
the age of electronic markets, the very rapid transaction 
times, and the decimalization, the best price is not always, in 
some people's minds, worth waiting for.
    Senator Sununu. I understand that point that you made, 
which is that different investors have different needs and 
different wants----
    Chairman Donaldson. Right.
    Senator Sununu. --from the exchange or the broker or the 
system that they are using to execute a trade. I understand 
that. But my question is what is the job of the regulator? Is 
your job to ensure the best price or is your job to ensure a 
fair and open system, free of conflicts of interest? And I 
think that is a very important distinction because I can go to 
an auction for furniture or go to buy a rug at auction and that 
auctioneer may be working very hard to give the seller of that 
coffee table the ``best possible price'' in a way that involves 
people planted in the audience or someone working against 
bidders or ensuring that the price is bid up in a way that 
participants in the auction do not necessarily know, and I 
think this is an important distinction.
    My sense would be that, as an investor, I simply want to 
make sure that we have the fairest possible process, the best 
possible transparency, and of course a system that is free from 
conflicts of interest. And I respect the fact that you brought 
up the issue of conflict of interest in discussing the role of 
SRO's. So that is just a distinction that I want to make, and I 
imagine, and I hope, does carry through in the work that the 
SEC does.
    Let me talk about a specific example, and then you can 
elaborate, because I want to ask you a question not just ask 
you to make conceptual comments, and that is with the auction 
specialist process used by the NYSE.
    I read some articles recently that threw out two numbers 
that I found to be interesting. One is the trend toward or the 
increase in trades that are made on the specialist account. 
Now, a specialist is there to act as a buyer or seller of last 
resort when a market does not exist for a particular trade, but 
over recent years the number of trades made on specialist 
accounts has gone from 8 to 15 percent, and maybe even a more 
impressive number is that I think that it was over 70 percent 
of the profits made by specialist firms are on trades made for 
their own accounts.
    I think those numbers are right. If they are not right, 
please correct me, and what thoughts or comments do those evoke 
from you?
    Chairman Donaldson. Let me go to your first line of 
questioning in terms of the role of the regulator. I think that 
our role is to make sure that the price discovery process, if 
you will, is free from conflict and is as efficient as it 
possibly can be.
    I think that our role also is to effect rules such that 
even the smallest knows that he or she has made the decision to 
forego, let us say, price improvement in order to get speed, 
that cannot be a decision made for them. There have to be rules 
and regulations that allow the individual investor to 
understand exactly what the executing broker is doing with that 
order within the context of fairness of the marketplace itself.
    In terms of your statistics on the option exchanges and the 
specialists, I am going to ask Annette to comment on that.
    Ms. Nazareth. I think the numbers were in the range, but 
your question really went to do we have issues with this or are 
we looking at the----
    Senator Sununu. Well, if a specialist is intended to be a 
buyer or seller of last resort, what market rationale is there 
for a dramatic, 100-percent increase--I suppose that is pretty 
dramatic--dramatic increase in the number of trades being 
executed on their accounts? Are there market phenomena to 
explain this, and why would it be that the lion's share of 
trading profits come from trades executed on their own 
accounts, again, if you are acting as a market of last resort?
    I thought that the question or the point was a pretty clear 
one.
    In this line, could you also talk a little bit about 
internalization and maybe provide me--I have only heard of the 
term recently--and provide a little bit of a description about 
the phenomena and whether that is problematic for investors. 
The question with specialists is no big surprise. It is one of 
front-running and whether or not this is a problem, whether or 
not it exists, and nobody is for that, but can you talk about 
internalization and whether or not that raises any similar 
concerns about conflict of interests.
    Chairman Donaldson. Go ahead.
    Ms. Nazareth. I will go back for a minute to the 
specialists. I mean, as you know, it is widely publicized that 
we are looking, as is the New York Stock Exchange, at certain 
issues in the specialist system, including how they satisfied 
their affirmative and negative obligations. Obviously, to the 
extent that there are any issues there, they will be addressed. 
And the statistics that you point out do raise questions about 
whether or not they needed to be stepping into the in-between 
orders or interpositioning in situations where two customer 
orders could meet. So, I can assure you that, to the extent 
there are issues there, they will be acted upon.
    In internalization, as you know, the concern that we have 
with internalization really goes again to whether or not it has 
some negative affect on the price formation process. To the 
extent that many believe that the best way to achieve the most 
efficient price is to have the most order interaction in a 
single venue with the most, the greatest number of orders 
competing on the basis of price.
    When you have internalization, you have taken a whole 
subset of those orders out of the equation and, as you know, 
what they do is they mimic the price that was set in the more 
price formation venue.
    Senator Sununu. Does that suggest that your rulemaking or 
approval or disapproval of rule changes would tend to favor the 
elimination of internalization or a movement away from allowing 
that to happen?
    Chairman Donaldson. Are you referring now to options 
exchanges?
    Senator Sununu. Yes, that is where it has, again, been in 
the news most recently, having to do with the options exchanges 
and whether or not this is a good practice, a positive 
practice.
    Chairman Donaldson. I think that the competition that we 
are looking for between natural buyers and sellers, in terms of 
price discovery, can be severely impeded, if you will, by 
internalization, where, in fact, orders are put together inside 
a particular entity, firm, whatever, and are not exposed to the 
general interests in those orders outside. And taken to its 
extreme, you would have a less-efficient price discovery 
mechanism. You would have orders that have had a fence put 
around them and can only deal inside a firm, as opposed to 
orders that rightly need to be exposed to outside the firm to 
the broad market.
    Senator Sununu. Now, how is that any different, 
conceptually, than a specialist providing price improvement in 
front of a book of limit orders?
    Chairman Donaldson. Again, this gets to the price 
improvement is part and parcel of a marketplace that exposes 
the orders to the general market, as opposed to exposing those 
orders just to a limited part of the market. You are depending, 
in a fractionalized situation, on the price discovery coming 
from only a fraction of the marketplace, a limited part of the 
marketplace. This is not true in terms of the way that a pure 
auction market works.
    Ms. Nazareth. I think you are, if I gather what your point 
is, your point is that if the specialist does not act in a 
manner consistent with the way the affirmative and negative 
obligations of the rules work, then what the specialist is 
doing is akin to an internalizer who--I understand that point.
    Senator Sununu. That is correct.
    Ms. Nazareth. Yes, I understand the point. That is why the 
rules prohibit that activity.
    Senator Sununu. Thank you very much.
    Thank you, Mr. Chairman.
    Senator Dodd. [Presiding.] Thank you very much, Senator 
Sununu. Excellent questions.
    And I apologize to both of you for not being here at the 
outset of your testimony. I was unavoidably absent. I will take 
just a few minutes before the next vote occurs to raise a 
couple of questions, if I may. I thank Senator Enzi for 
allowing me to chair the Subcommittee for a few minutes. If I 
look around, I might get away with some things here.
    [Laughter.]
    Anyway, just a couple of questions. First of all, let me 
thank both of you. Ms. Nazareth, it is good to have you here. 
The last time I was looking at you I think I saw you sitting in 
the seat behind the witness we had.
    Ms. Nazareth. That is right.
    Senator Dodd. So it is a pleasure to have you sitting at 
the witness table with us.
    Mr. Chairman, I have said, on numerous occasions, that I 
think we are very fortunate to have you in charge of the SEC. 
You and I have known each other a long time, and I am very 
confident you are going to do a very fine job.
    A couple of questions come to mind. If these have been 
raised, by the way, some of my colleagues have already brought 
this up, stop me immediately, and I will go onto another 
question. I am not aware of all of the questions that have been 
raised, and not having been here to hear them, I do not want to 
be duplicative.
    I do not know if the issue of decimalization has been 
raised with you this morning. Has that been raised?
    Chairman Donaldson. Only tangentially.
    Senator Dodd. Well, I am interested, if you might, just 
give us a few questions I have associated with the issue. 
Obviously, this was a big change and a lot of anticipation 
about what the change and decimal pricing how it would change 
the environment and the structure of our markets, and I wonder 
if you might just give us some sense of what the anticipated 
benefits have been. Have they been realized, such as price 
improvement and the declining affect on spreads? Does it also 
change the necessity to change rules, any rules changes or 
regulations? And is there an appropriate minimum decimal 
pricing increment that you think might be necessary?
    And the last question I maybe should have raised first, and 
that is has liquidity been reduced as a result of the increase 
in the number of price points here?
    Senator Dodd. Decimalization has resulted, at least insofar 
as the markets are operating today, basically, with a 
proliferation of price points, it has obscured in a way the 
true size of the market. In other words, the amount of shares 
offered at a particular point are not necessarily reflective of 
the amount of shares offered or bid for at points only pennies 
away from that.
    Senator Dodd. Right.
    Chairman Donaldson. So you have a proliferation of price 
points.
    In addition to that, because of some of the arrangements in 
some of the markets, you have the threat of an explosion of 
price points if we get into subpenny decimalization, and that 
is why we have real trouble with subpenny decimalization.
    In terms of the impact on the market, there are lots of 
different judgments on this emanating from academic 
institutions and so forth. I think it is clear that the 
individual investor has been advantaged, if you will, in terms 
of the efficiency of the marketplace and the functional cost of 
doing business. I think it is equally clear that perhaps some 
of the institutions are paying more. And then if you consider 
an institution to be an amalgamation of individuals, if you 
follow that through, individual holders of institutional funds 
have been disadvantaged.
    I think that there is some feeling that the depth of the 
markets has eroded, particularly in thinly traded stocks, where 
the profit motive, if you will, for the dealer, the profit 
potential for the dealer is less, and therefore the liquidity 
in that market is not what it used to be.
    Senator Dodd. Yes.
    Chairman Donaldson. But those are all things that we are 
trying to get more information on and trying to make judgments 
on. We read everything that is written and then try and make 
judgments on it, but those are at least a partial answer to the 
question you asked.
    Senator Dodd. Let me, because you have raised, ask two 
quick questions: One, are you anticipating any rule or 
regulation changes to address some of these questions? For 
instance, you have identified what I think is a very legitimate 
point, and that is the minimum increment in the fractions. So 
is there some idea here to set a minimum? That seems to be what 
you are saying.
    Chairman Donaldson. If you are talking about going back to 
eighths, and quarters, and halves, and so forth, I do not think 
so, Senator. I think that we are past that point. I think in 
terms of subdeci-
malization, if you will, I, personally--and I do not speak for 
the Commission, but speaking personally--I hope we can avoid 
that because I think it will just cause an impossible not only 
computer capability, but also an impossible marketplace if we 
are dealing in subpennies.
    Senator Dodd. And the issue of rules and regulations of 
this at all, other than just conversation at this point or is 
there any anticipation of changes necessary in the market 
structure?
    Chairman Donaldson. No, we had a brief discussion here 
about exactly what the Commission is doing, and what we are 
seeking to do is--you push this thing in one place, and it pops 
out in another place, and we are trying to look at the whole.
    Senator Dodd. Sure.
    Chairman Donaldson. And we are trying to come up with some 
rules and regulations that look at the whole structure, and 
this is a top priority for the Commission. It is a complex 
subject, but we are going to do something about it.
    Senator Dodd. Let me jump--I gather Senator Sarbanes may 
have raised some points here regarding the review of the SRO 
structures, the functions of the New York Stock Exchange, but 
also the functions of both Nasdaq and NASD.
    In your testimony, I gather here, you reference the 
numerous concerns about obviously the conflicts of interest, 
governance, excessive compensation and the like, and I know 
that you have responded in part, anyway, to Senator Sarbanes 
about the SEC's role in the SRO review.
    I wonder if you might give us some sense of timing with 
regard to Nasdaq and NASD, where they are in some stage of 
separating ownership and governance questions there, and I 
wonder if you can tell us what the time line for the completion 
of the complete separation would be.
    Chairman Donaldson. Are you referring to the governance and 
regulatory aspects of just Nasdaq or the New York Stock 
Exchange or the other exchanges?
    Senator Dodd. Just Nasdaq.
    Chairman Donaldson. Just Nasdaq, yes. Well, the resolution 
of the Nasdaq application to be treated as an exchange depends 
upon the impact that recognition would have on other parts of 
the marketplace.
    As you know, each of the registered exchanges have priority 
rules, and they are designed to promote order interaction. If 
the Commission were to approve the Nasdaq application, as it 
has been proposed, it would have to likewise permit other 
exchanges to abandon priority rules, and thus the Nasdaq 
application raises profound market structure issues that could 
have implications for all of our registered exchanges and 
ultimately the investors in the markets.
    I could go through a whole list of other aspects of the 
Nasdaq application which have profound implications for the 
rest of the marketplace, and I would simply say that we are 
trying to treat the Nasdaq application--it has not been 
shelved, and gathering dust and so forth--within the context of 
our overall market structure review.
    And when you were not in the room, I said, and I will say 
again, that we have market structure as the resolution of this 
very high on our agenda, on our front burner, and I do not want 
to put a specific time frame on it, but we recognize that some 
final decisions must be made here. But we recognize that if we 
make the wrong decisions and are precipitous and haven't tried 
to anticipate the unanticipated consequences, we could do 
severe damage to the whole system.
    Senator Dodd. I think we all understand that because not 
making a decision either has consequences, too.
    Chairman Donaldson. Well, we are working on it.
    Senator Dodd. You will be back before the Committee, and I 
presume that this is a good answer you have right now of 
dealing with the whole, but there is going to come a point when 
people are going to want some answers on how these things, the 
time lines and so forth are going to be there. So, I am not 
telling you something you do not know.
    Let me jump, last, to one other point I would like to raise 
with you. In your prepared statement, you stated that the rise 
of ECN's had exacerbated concerns, ``a number of concerns and 
issues including the feasibility of integrating different 
market models into the national market system.''
    Now, it is not entirely clear to me from the statement 
whether you believe that the existence of more than one market 
model is a source of concern, something which would be 
surprising to some of us, in a way, given our market's long 
history of innovation and advance or whether you see the 
concern as the current framework for integrating those 
different models, in a sense, following the response, again, 
trying to be more cautious and careful about how this all 
works.
    I wonder if you might offer us a little clarification on 
which of those two points should I take as the reason for your 
statement.
    Chairman Donaldson. Well, we believe very strongly in the 
innovation inherent in the many different market models that 
have come into being, the electronic markets, et cetera.
    I think what we are seeking here is an ability for all of 
these different models to operate together in a national system 
that allows for efficient price discovery and allows for the 
individual investor and the large investor to operate side-by-
side, allows for transparency, and allows for the efficiency 
inherent in true price discovery. I believe we encourage the 
innovation of these new models and the new electronic markets, 
but we want to be very careful, that they are not operating to 
the detriment of those principles I just talked about.
    Senator Dodd. Yes.
    Chairman Donaldson. If they act to increase internalization 
and fragmentation, that is not so good. If they act to somehow 
deprive a customer or client of price improvement that that 
customer wants, that is not so good either.
    So we are trying to find a way to get a compatibility 
between the, to put it in superficial terms, the ``fast'' and 
``slow'' markets.
    Senator Dodd. I do not disagree with that. I do not think 
anyone on this side of the dais would at all either.
    Obviously, there are some wonderful opportunities as well 
emerging with the technologies to be provided, and we do not 
want to miss the opportunity to provide the consumer with a 
heightened degree of confidence, which is critical in this 
area, but also recognizing what the consumer needs today in 
light of the tremendous pressures they are under as well and 
looking for efficiencies in these systems.
    So, I would be very interested to see how this progresses. 
There has been a lot of hostility in the past, at least 
perceived hostility, merely because it was almost a threat, a 
business threat, and that is not a good reason, in my view. And 
if that is all it is, then it has no place in this debate or 
discussion.
    If it is as you have described it, very legitimate reasons, 
then obviously proceeding with caution is necessary. But there 
is a growing concern that maybe there is more of the former and 
less of the latter, in some people's minds, and we want to move 
through this if we can.
    It is getting harder and harder to explain to the consuming 
public, the investing public, why we cannot move in this 
direction, given our ability to innovate in so many other 
areas, and given the fact that our markets have been so 
innovative over the years.
    That is one of the reasons the world still comes here and a 
reason we have been able to generate as much wealth and 
strength in our economy is because of innovation. So we are 
still interested in pursuing those goals, keeping in mind the 
points you have raised, which I think are very legitimate.
    Chairman Donaldson. I think it is not to protect individual 
business models, but rather to protect the investor. And I 
think there are a number of characterizations out there that 
are put forth by those who want to push their model, and there 
is the glorification of immediacy in electronics and so forth--
--
    Senator Dodd. I agree.
    Chairman Donaldson. --which is very appealing. There is, 
also, for us old-timers, if you will, when we see markets----
    Senator Dodd. What are you talking about now? Speak for 
yourself there.
    [Laughter.]
    Chairman Donaldson. Not ``us'' old-timers, sorry. But there 
are periods of stress where we sometimes are glad to have human 
beings putting together trades in periods when there is stress, 
and I think it is too easy to just discount that completely in 
terms of the speed of electronics.
    Senator Dodd. I do not disagree, and I feel the same, 
whether that is because we both have gray hair or not, I do not 
know. I certainly am conscious of those points. But I also 
understand there are a lot of other things that can urge to do 
as well, that there is wonderful ability to innovate so 
effectively here that we can really make some wonderful changes 
in the system, in the models.
    Anyway, I see we have been joined once again by my good 
friend and colleague from New Hampshire. I did not intend--
obviously, I can see you have your coat off. You thought you 
were going to get out of here. I do not think you are yet, Mr. 
Chairman.
    Senator Sununu. I do have a couple more questions.
    Senator Dodd. There you go.
    Senator Sununu. Unless you wanted to pursue your tough line 
that you had there.
    Senator Dodd. No, no. We have covered--there are some other 
questions here, but let me ask the Senator from New Hampshire 
to proceed.
    Senator Sununu. I just wanted to take a couple of minutes 
to finish the line of questioning or the discussion we were 
having. You indicated that you did not feel that 
internalization was a positive thing for investors with regard 
to options markets. My question is are there existing options 
markets that allow this process and procedure? How commonplace 
is it among the existing options exchanges?
    Chairman Donaldson. Let me turn to our options expert here.
    Ms. Nazareth. It is probably much more prevalent than you 
would imagine.
    Senator Sununu. Is it allowed? Are there options 
exchanges----
    Ms. Nazareth. It is a question of how it functions. If a 
firm is bringing its own orders to the floor and is trading 
against those orders as the market maker on the floor and 
others are not participating in the trade, that is akin to 
internalization, and that goes on a fair amount even in our 
floor-based options markets today.
    So it is not a notion that is foreign to our existing 
options markets.
    Senator Sununu. I believe former SEC Chairman Pitt had 
raised this issue with a number of options. It said that he 
wrote to the other exchanges and requested they eliminate rules 
that guarantee members a portion of internalized orders. Has 
any progress been made on this request? Is this something that 
you are still pursuing?
    Ms. Nazareth. We are working on a concept release on 
internalization in the options markets that the staff is hoping 
to bring to the Commission within the next several weeks. So we 
are following up on the issues that were raised by Chairman 
Pitt at the end of his tenure.
    I should also point out that even embedded today in the 
options markets' rules, order entry firms can basically cross 
40 percent. They can keep 40 percent of the orders that are 
above 50 contracts. So there are notions of internalization 
currently embedded in, some notion, some amount of it. It does 
not encourage full-blown internalization, but 40 percent, being 
able to get a guarantee of 40 percent of the order flow that 
you bring to the floor is a form of internalization.
    Senator Sununu. When the staff brings forward this concept 
paper, does it become public at that time?
    Ms. Nazareth. Yes.
    Senator Sununu. Excellent.
    With regard to self-regulation, and in particular the 
governance structure between the trading entity and the 
regulatory entity, there has been some discussion and I suppose 
there may be some markets that are actually engaging in 
outsourcing of their regulation. I think this nice article with 
the Chairman's picture in it that I showed him earlier, I think 
that the Nasdaq is heading in this direction; that their long-
term goal is to have a formal break and then to contract, the 
exchange to contract with the NASD--that is not an exchange, I 
know--but for them to contract with the NASD. So it would be 
effectively outsourcing their regulation.
    My question is, is this a good trend? The concept or the 
idea of outsourcing regulation where you engage with or 
contract with a separate entity or separate party to enforce 
regulation?
    Chairman Donaldson. Well, I think it is an interesting 
concept. I do not think it is the only concept, in terms of 
this clash, if you will, between regulatory responsibility and 
the responsibility for running a profitable market business.
    There are, taken to its extreme, you could have a total 
outsourcing of all regulation in an outsourced regulatory body 
that would be a junior varsity SEC or you could take it all of 
the way to the SEC if you want to. I mean, that is one extreme, 
and I think that the bureaucratic aspects of that, and the 
expense of doing that, would not be in the best interests of 
keeping up with fast-paced markets. I think that bureaucracy 
could not move fast enough, and I think that the original 
concept of the self-regulatory organization or the delegation 
of that responsibility to the market centers was a good 
decision.
    Now, I think we have to, in light of all that has gone on, 
I think we have to examine whether there is not, are not other 
ways of getting that regulation more independent, without 
destroying the efficiency of having it close to the marketplace 
itself. And this is, I think, one of the things that the New 
York Stock Exchange is facing right now, and I think there are 
a number of different models.
    I would not say that the Nasdaq model is, it is fine for 
Nasdaq, but it is not the only model.
    Senator Sununu. Thank you.
    Thank you very much, Senator Dodd.
    Senator Dodd. Thank you, Senator.
    I just wanted to ask a few more questions. I do not know if 
enough time has elapsed to allow you to answer this question. I 
would like to raise it with you anyway, and it has to go to the 
issue that has been discussed, in broad terms. Over the last 
number of months since the accounting scandals of Enron and 
WorldCom and the worry that was raised, investor confidence. I 
am wondering if there has been any assessment that the SEC has 
been able to make about market volume and liquidity that you 
have been able to detect, decline as a result of the accounting 
scandals.
    Also, the concern was raised that we might find, in fact, 
investors moving off-shore or off-shore investors not coming 
here. Have we seen any benefit accrue to foreign exchanges 
because of any perceived loss of confidence in the U.S. 
markets?
    And, last, just the related, which would obviously be part 
of your answer, I suspect, and that is whether or not the 
market structures are operating efficiently enough to allow us 
to maintain the global leadership we have historically prior to 
these set of incidents.
    Chairman Donaldson. To answer your last question first, we 
do not see any movement off-shore in order to deal in better 
regulated markets or to deal in markets that investors would 
want to be operating in. As a matter of fact, the volumes that 
are being done here in the United States continue to increase.
    I think the ability of our markets to be competitive with 
the rest of the world is again, in the biggest picture, a 
trade-off between regulation that those who are regulated want 
to deal in a market that is regulated, and that regulation 
tends to inhibit, if you will, in certain instances, but people 
are willing to accept that because of the positive aspects of 
it.
    And I think that, to date, if you ask most investors, 
institutional and individual, they still have considerable 
faith in our marketplace.
    The confidence aspect that you are talking about, I think 
we are making some considerable strides through the Sarbanes-
Oxley formation of PCAOB and the new standards in investigation 
and so forth.
    I think we are also making some progress, although it is 
slow, in terms of reconciliation of foreign accounting schemes, 
with our own accounting schemes, working toward an 
international scheme, although that is going to be a while in 
coming.
    I think that my judgment is that the combination of all of 
the things that are going on now, in terms of the independence 
of audit committees and the restructuring of the responsibility 
of a corporate entity, I think that is having is effect. I 
think directors are paying more attention than ever.
    Senator Dodd. Certainly.
    Chairman Donaldson. I think confidence will slowly come 
back, but unfortunately there continue to be evidences of 
malfeasance, and rulebreaking, and so forth that undermine that 
concurrently with it.
    Senator Dodd. But in the meantime, we have not discerned 
any shift.
    Chairman Donaldson. I do not think so. No, I do not think 
so.
    Senator Dodd. Thank you.
    John, anything else?
    Senator Sununu. No. Thank you.
    Senator Dodd. Well, listen, I thank both of you very, very 
much. Obviously, we will stay very much in touch with you. 
Chairman Enzi, I know, feels as I do. We need to stay in close 
contact with you to see how things are progressing.
    Chairman Donaldson. Thank you.
    Senator Dodd. We are just recessing the hearing. Thank you.
    [Recess.]
    Senator Enzi. [Presiding.] I thank everybody for their 
patience. The 15-minute vote took almost an hour, but we have 
gotten the second one underway now, and I thank Senator Dodd 
for voting early and keeping the hearing going.
    To return to the questions, and I am not sure whether we 
will have anyone else come back, but when we finish the round 
of questions, we will leave the testimony open for a period of 
10 days for submission of questions and to give you some time 
to answer them.
    Earlier this year, you sent letters to each of the self-
regulatory organizations requesting information concerning 
their corporate governance practices. In response, several 
SRO's initiated changes to their corporate governance 
practices.
    In light of the recent events at the New York Stock 
Exchange, you stated that you will let Mr. Reed, as interim 
Chairman, evaluate the New York Stock Exchange prior to the New 
York Stock Exchange submitting changes to the SEC.
    What I am interested in is will you move forward with the 
other SRO's corporate governance reviews while you wait for the 
New York Stock Exchange to complete its evaluation or will you 
address all of the SRO corporate governance reviews at the same 
time?
    Chairman Donaldson. I believe it is a continuing process. 
We have put out the original letter from me to the other 
exchanges. We received responses from that. We asked them for 
some more information subsequent to that. We have all of those 
pieces of information under review right now. Clearly, front 
and center is the New York Stock Exchange. This is not to say 
we are looking for one universal corporate governance structure 
or regulatory structure, and I think we are going to work on 
all of them, with the New York Stock Exchange being number one 
priority now for us.
    Senator Enzi. Thank you. To change topics a little bit, a 
review of the major foreign securities markets reveal these 
markets primarily are electronic based and have demutualized 
the regulatory functions from the business operations. In 
addition, several of the markets operate on a for-profit basis. 
It is apparent that these markets view their securities markets 
as business operations, rather than as utilities for the 
trading and securities.
    As the SEC reviews the corporate governance structure of 
the U.S. securities markets, should the SEC look at separating 
out the business functions from the regulatory oversight?
    Chairman Donaldson. Clearly, that is an issue, and it is 
keyed or tied to the words ``separating out.'' Again, I think 
that there are different ways of separating regulation from the 
markets in themselves without putting the word ``out'' there. 
It has to do I think with the independence of the regulatory 
mechanism, as opposed to exactly where it is, either inside a 
corporate structure, an exchange structure, or outside of it.
    Senator Enzi. With respect to the market structure issues, 
the Commission has already held a series of hearings and 
received recommendations from an independent advisory 
committee. What additional information does the Commission need 
in order to start making decisions on the future of the 
securities market and have you initiated a timetable or a 
blueprint on how to resolve the significant issues?
    Chairman Donaldson. Well, we have a number of issues not 
pertaining to market structure on our agenda. As I said way 
back in my confirmation hearing, I viewed market structure as 
one of the more important and also more complex issues facing 
the Commission, and it is very much on the front burner for us 
right now.
    In terms of the exact timing, I would rather not tie us to 
a specific time, except to say that we are pretty much at the 
end of the fact gathering. We are pretty much at the end of the 
conversations that we have had through the various panels and 
so forth, individual conversations, and we are going to be 
working on an overall approach just as soon as we can, and it 
is not years from now and it is not weeks from now.
    Do you want to put a more definitive definition on that?
    Ms. Nazareth. No, I think it is somewhere in between there, 
which sounds like several months to me.
    Senator Enzi. I know that in our work a lot of times if it 
weren't for deadlines, we wouldn't get anything done. I can 
understand a reluctance to want to put out a timeline for us, 
but internally do you have more of a timeline than you are 
giving us here at the hearings?
    Chairman Donaldson. Absolutely. We are working on it just 
as fast as we can. Again, I would refer back to the statement I 
made earlier, which is that it is not a matter of it is not 
being worked on, it is a matter of making some tough decisions 
and trying to anticipate the unintended consequences of what we 
are doing within the context of stepping back and saying that, 
even with the stresses and strains, our system is working 
pretty well.
    And the thing we want to avoid is making some ad hoc 
decisions that change the whole system rapidly for the worse. 
And we are keeping our staff's feet to the fire, and we will be 
keeping the Commission's feet to the fire here in the weeks and 
months ahead.
    Senator Enzi. I appreciate that. I know that if I tell my 
staff that I want it as fast as I can, it is different than if 
I say I want it by this afternoon.
    [Laughter.]
    I do fully appreciate your wanting to review the market 
structures in a complete and comprehensive manner. However, 
considering the reluctance of market participants to invest in 
capital 
infrastructure and technology until guidance is received from 
the SEC, some forward movement on these issues is necessary.
    With respect to the market structure issues, hearings have 
already been held by the Commission and by the advisory 
committee on market information, and that committee has issued 
its recommendations to the Commission, as I understand it.
    At a minimum, should you direct the SEC staff to come up 
with a staff report on market structure in a similar manner 
that was done very recently for the hedge funds? Will you be 
doing that?
    Chairman Donaldson. I think that would be a delaying thing, 
Senator. I think that we feel more impetus than that to make 
some decisions. I think that to enter into another study, you 
know, and have months and months go by would not add much to 
our knowledge base. I think we know the arguments pretty well 
now, and it is just a matter of resolving this thing, which is 
what we want to do.
    Believe me, we are as eager as you are to see it done.
    Senator Enzi. Well, the securities markets are the best in 
the world, and in order for us to retain that distinction, the 
evolution of the underlying structure of the market has to be 
done to keep innovation, technology, and efficiency of the 
markets at the forefront.
    I thank you for your testimony today and your patience in 
putting up with the votes. As Senator Sarbanes and I were 
noting, as we waited for the subway to go over and do our vote, 
your more relaxed appearance before us, after the practice that 
you have had----
    [Laughter.]
    Senator Enzi. We knew you always had the capability, but 
now you take this a little more in stride, remembering back to 
the first hearing that you had here. You have given us a 
greater understanding of what the most pressing market 
structure issues are that we need to focus on. I am a little 
disappointed that you did not set out more of a timetable on 
how to address those concerns. I believe that it is essential 
for the regulator of our securities markets to give guidance to 
the markets when necessary and, accordingly, I would like to 
address these issues again probably in about 6 months from now 
by this Subcommittee and if possible earlier by the full 
Committee.
    I appreciate the fine job that you are doing at the 
Commission since your tenure began earlier this year. You have 
had to address a wide variety of issues. I think you have done 
it well. I look forward to working with you and the rest of the 
Commissioners and the SEC staff. And, Ms. Nazareth, I thank you 
for being here as well.
    The Committee record will be open for 10 days. If Members 
wish to file additional questions, I would encourage them to 
file them immediately so that the Chairman has time to answer 
them. We would appreciate your cooperation in responding with 
those answers.
    The hearing is adjourned.
    [Whereupon, at 11:54 a.m., the hearing was adjourned.]
    [Prepared statement and response to written questions 
supplied for the record follow:]

               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                            October 15, 2003

    Good morning Chairman Enzi, Ranking Member Dodd, and Members of the 
Subcommittee. I am delighted to be here to discuss some of the 
significant market structure issues that we are facing in the U.S. 
equities market today.
    In the coming months, the Commission will be focusing with 
increased intensity on the structure of the U.S. equities markets, with 
particular regard to their fairness and efficiency. As you know, 
Congress formally directed the Commission to address market structure 
when it enacted the Securities Acts Amendments of 1975. That 
legislation instructed the SEC to facilitate the creation of a national 
market system for securities that would maintain fair and orderly 
markets, and tie together all buying and selling interest so investors 
would have the opportunity for the best possible execution of their 
orders, regardless of where in the system they originate.
    Congress specified five key objectives of the national market 
system: (1) economically efficient executions of securities 
transactions; (2) fair competition among markets and securities firms; 
(3) the availability of market information to investors; (4) execution 
of orders in the best market; and (5) direct interaction among investor 
orders. To achieve these objectives, Congress recognized that 
communication systems, particularly those designed to disseminate 
market data, would form the heart of the national market system. Rather 
than attempt to dictate the specific elements of U.S. market structure, 
however, Congress chose to rely on an approach designed to provide 
maximum flexibility to the Commission and the securities industry in 
its development.
    The 1975 Amendments to the Exchange Act created a framework for 
fostering transparency, interconnectivity, and competition in our 
securities markets. As a result, today, equity market centers compete 
with one another in an environment where quotes and transaction prices 
are widely available to all market participants. Direct and indirect 
linkages among competing market centers help ensure that brokers can 
access the best quotes available in the market for their customers. 
Market centers (including exchange markets, over-the-counter market 
makers, and alternative trading systems) have an incentive to offer 
improvements in execution quality and to reduce trading costs in order 
to attract order flow away from other 
market centers. This competition among market centers encourages 
ongoing innovation and the use of new technology. Within all existing 
registered exchanges and a number of other markets, investor orders 
have the possibility of interacting directly without the intervention 
of intermediaries. This furthers Congress's fifth objective--direct 
interaction of customer orders--allowing investors to obtain executions 
at better prices than otherwise would be available.
    The national market system has worked remarkably well for the past 
quarter century. And in recent years it has become increasingly 
efficient. At the same time, this very efficiency, arising from 
technological and other market developments, has put strains on 
existing national market structures. One significant change has been 
the proliferation of new electronic markets, such as ECN's, that offer 
fast executions and have spurred competition among market centers, but 
at the same time exacerbated concerns about market fragmentation, the 
feasibility of integrating different market models into the national 
market system, and maintaining a level regulatory playing field among 
functionally equivalent market participants. The implementation of 
decimal pricing in 2001, and the concurrent move to a minimum tick of 
one penny in the equity markets, has narrowed spreads and enhanced the 
efficiency of the price discovery process, but at the same time reduced 
the liquidity available at each price point, made it easier to step 
ahead of limit orders, and placed economic strains on the dealer 
business. Decimal pricing has also put a premium on swift access to 
displayed prices so investors can quickly reach these smaller quotes 
before they change. The trend toward demutualization of exchanges, and 
their conversion to for-profit enterprises, has heightened concerns 
about the inherent tensions in the self-regulatory model, in particular 
the concern that the funding and vigor of the regulatory function might 
be sacrificed in favor of delivering returns to shareholders.
    The issues surrounding intermarket access provide a good example of 
some of the strains impacting U.S. market structure in recent years. In 
a system with many competing market centers and pools of liquidity, 
participants clearly need to know what the best prices are and where 
they are available. But this information is of little use in the 
absence of effective access to the market centers with the best prices. 
Implementing market access, however, has raised a number of difficult 
issues. Offering access to one's market to competitors can conflict 
with the core business strategy and commercial self-interest of a 
market. Over the years, markets have sought to maintain strict control 
over access and often have erected barriers to achieve this objective. 
These barriers historically have taken the form of direct bans, 
restrictive membership requirements, discriminatory execution 
priorities, fees, and information restrictions. Finally, even setting 
aside intentional barriers to access, significant practical 
difficulties must be overcome to ensure the availability of access in 
an environment where scores of separate market centers--floor-based and 
electronic, both fast and slow--may be actively quoting and trading a 
security. The existing compulsory market-to-market linkage in stocks--
the Intermarket Trading System (ITS)--applies only to NYSE and Amex 
stocks and, in the view of many, has been less than successful in 
overcoming these obstacles to providing effective intermarket access.
    Over the last several years, the Commission has taken a number of 
steps to address concerns facing our national market system. In the 
Order Handling Rules and Regulation ATS, for example, the Commission 
broadened the class of market centers required to make their quotations 
and orders publicly accessible. In doing so, it sought to redefine the 
idea of an exchange to include not just traditional exchanges, but also 
trading systems where orders interact according to specified trading 
rules. The Commission also adopted rules to improve the disclosure by 
market centers of execution quality data, and the disclosure by broker-
dealers of their order routing practices, in order to enable investors 
to ``comparison shop'' among the myriad market centers, and to 
stimulate competition on the basis of execution quality.
    In addition, the Commission has developed ideas and solicited 
public comment on some of the more difficult market structure issues, 
such as the regulation of market data fees and revenues, the 
fragmentation of the U.S. securities markets, and the regulation of 
exchanges. A Federal advisory committee also was convened to address 
market data concerns, and last year the Commission held public hearings 
on the full range of market structure issues.
    There is no doubt that there are issues regarding our national 
market system that call for our attention. In my view, several aspects 
of equity market structure raise pressing questions. These include: (1) 
the implications of differences among markets in the means by which 
their quotes may be accessed by nonmembers and of access of transaction 
fees that are not included in displayed quotations; (2) the role of 
trade-through rules in intermarket trading for very different types of 
markets and systems; (3) the manner in which market data is 
consolidated and distributed, and the resulting revenues allocated 
among the markets; (4) whether a mixed dealer and auction market such 
as Nasdaq should be allowed to register as a for-profit exchange; (5) 
whether the fragmentation of markets that results from competition is 
reducing the effectiveness of regulatory processes; and (6) the 
effectiveness of the current self-regulatory system for the securities 
markets.
    That said, I firmly believe our system of multiple, competing 
markets--on balance--has worked remarkably well. We have the world's 
most competitive and efficient markets. Competition among markets has 
fostered innovation and led to the creation of a variety of trading 
platforms designed to meet the needs of different types of investors. 
New entrants, particularly those with fully electronic platforms, keep 
the pressure on established markets to innovate. However, new entrants 
also challenge our existing infrastructure, much of which was created 
in the 1970's before the dramatic advancements in technology.
    As has always been the case in our competing markets model, our 
challenge as regulators is to ensure fair and efficient markets through 
a balance of competition and regulation. Fair and efficient markets, of 
course, are the key goals of securities market regulation. But fairness 
and efficiency are at least superficially different concepts, creating 
tensions in our regulatory mandate. Fairness suggests the use of 
regulation to ensure against unfair results. Efficiency, on the other 
hand, suggests reliance on free markets and competitive forces to 
achieve an efficient result, which may not necessarily be a ``fair'' 
one. Regulation and competition do not necessarily conflict, as 
regulation often seeks to remove barriers to competition or promote 
efficiency. In other cases, there will be a tension between regulation 
and competition. Striking the appropriate balance is the responsibility 
of the Commission.
    The optimal equity market structure, in my view, is based on 
several fundamental principles. First, I believe we should seek to 
achieve the benefits of competition while countering the negative 
effects of fragmentation from trading in multiple markets, through 
widely available market data, ready access among markets, price 
protection principles, and best execution standards.
    Second, to the greatest extent possible, I believe we should let 
market forces determine outcomes by seeking to have the marketplace, 
rather than the Government or its regulators, choose the ``winners'' 
and ``losers.'' We must seek to provide a level playing field in which 
all markets can compete fairly and aggressively. That said, regulation 
is necessary in certain situations, such as when an exchange exercises 
market power, or when externalities such as principal/agent conflicts 
obstruct otherwise competitive outcomes. Regulation is also appropriate 
when its benefits to the marketplace exceed its costs and reduce market 
frictions, such as when settlement date standards or quoting 
conventions are established.
    Finally, I believe that market transparency, fairness, and 
integrity are key to the strength of our marketplace. These fundamental 
concepts underpin the Commission's approach to regulation, and 
contribute substantially to investor confidence in our markets.
    With these general principles in mind, I would like to focus the 
remainder of my testimony on four key areas of the Commission's market 
structure initiative: (1) access to markets; (2) market data; (3) the 
self-regulatory model; and (4) the nature of a securities exchange.

Access to Markets
Fair Access
    In our modern-day marketplace for securities, the New York Stock 
Exchange, Nasdaq, the American Stock Exchange, the regional exchanges, 
and numerous electronic communications networks, all compete with each 
other to offer the deepest pools of liquidity to investors at the very 
best prices. I believe that the Commission must resist the temptation 
to force these diverse securities markets to mimic each other, but 
rather to encourage them to compete over their differences within a 
single, robust, national system. In the end, there is little doubt in 
my mind that investors benefit from markets that compete, so long as 
the competition is truly fair.
    With that in mind, a significant market structure issue on the 
Commission's agenda is making sure access between markets is as fair 
and as efficient as it can be.
    If best execution is to be achieved in an environment characterized 
by multiple competing markets, broker-dealers must be able to identify 
the location of the best available prices and obtain access to those 
prices routinely and efficiently. In contrast, a market center that is 
inaccessible does little to promote efficiency and fairness in the 
marketplace.
    Most brokers send orders directly to the market that they expect 
will provide their orders best execution most of the time, and most of 
these orders are executed in the market that receives them. At times, 
however, the best price at that moment may be in another market. And 
traders in one market may need to access prices in another market to 
keep prices in line. For these reasons, markets need easy access to 
each other, either directly or indirectly through brokers.
    The Commission's approval last year of the NASD's Alternative 
Display Facility pilot program has highlighted this issue. Rather than 
obtaining access through ``hard'' linkages directly between markets, in 
the way that competing markets can access the New York Stock Exchange, 
in the Alternative Display Facility competing market centers obtain 
access to each other directly through privately negotiated 
access agreements and indirectly through subscribers. The Commission 
will be evaluating this decentralized access approach to determine 
whether, as a practical matter, it would be an appropriate model for 
the national market system, and thus could be applied to other market 
centers.

Access Fees
    Access fees charged to reach a quote create another difficult 
market structure problem. Some markets charge varied per-share 
transaction fees for access to their quotes. Therefore, a displayed 
price may represent the true price that a customer will pay or it may 
represent only a base price to which an undisclosed access fee will 
later be added.
    These pricing disparities can impede access between competing 
markets, raise trading costs, and create confusion about the true 
quoted prices. The absence of a uniform quoting convention across all 
markets also raises the incidence of locked and crossed quotations. To 
ensure real access to public quotes between competing markets, it is 
important that these quotes be accessible to other market participants 
on clear and fair terms.
    I should also mention that, because access fees have gradually 
shrunk to less than one-cent-per-share in most markets, the imposition 
of the fees results in de facto subpenny pricing. Indeed, many market 
participants have suggested that these access fees have precipitated 
trading in subpennies, thus magnifying the strains caused by the move 
to decimal pricing. The Commission intends to work closely with the 
industry and investors to find appropriate solutions to the challenges 
raised by access fees and subpenny pricing. Whatever solution the 
Commission decides to adopt, we must assure that access fees will not 
function as a tollbooth that snarls traffic along the national market 
system.

Price Protection
    As part of our examination of intermarket linkages, we also intend 
to reassess the question of intermarket trade-throughs, which occur 
when orders are executed in one market at prices inferior to the prices 
disseminated on another market. Today's highly competitive securities 
markets include fully electronic markets that provide swift automatic 
execution of customer orders, as well as traditional floor-based 
markets that execute orders through human interaction. Although a 
market participant that desires an opportunity for price improvement 
may prefer that its order be routed to a floor exchange for execution, 
an investor who values speed and certainty of order execution over a 
marginally higher price may find such a delay intolerable. Accordingly, 
the challenge before the Commission is to devise standards that allow 
faster markets and slower markets to thrive within a single system of 
interconnected markets, at the same time providing order executions to 
customers that display prices and for those customers who desire the 
best price on their orders.

Market Data
    Another significant market structure challenge facing the 
Commission involves the collection and reporting of trading information 
and influence of the resulting revenues on market structure. Our 
existing market data system has strengthened the U.S. equity markets 
and has assured that investors have real-time access to accurate, 
reliable, and affordable information from all significant U.S. market 
centers. And yet the increasing number and diversity of U.S. market 
centers, has fueled demands for modernizing the current market data 
structure. Despite the sweeping changes that have taken place in the 
markets over the past 30 years, the structure for market data, 
including the collection and dissemination of a market's best bid and 
offer, the national best bid and offer, trading volume statistics, and 
last-trade prices, has changed very little.
    The Commission recognizes that market data revenue is very 
important to our markets. Indeed, in recent years, self-regulatory 
organizations have drawn as much as 45 percent of their total revenues 
from market data revenue. In 2001, the Commission convened a panel of 
experts, chaired by Dean Joel Seligman, that looked into the structure 
of our market data system, as well as the compensation that markets 
have been receiving for their market data. The Seligman Committee noted 
that under the current system, securities information processors 
distribute market data revenues to self-regulatory organizations based 
primarily on each self-regulatory organization's reported trade volume. 
This compensation scheme has created a financial incentive for self-
regulatory organizations to report as many trades as possible. As a 
result, markets are vying for ECN's and market makers to report their 
trades through them, as this allows markets to tap more deeply into the 
pool of available market data revenue and to rebate substantial 
portions of the additional revenue to the entity reporting the trade.
    Significantly, in 2002 the Commission determined that programs for 
rebating market-data fee proceeds to market participants were creating 
incentives for traders to engage in transactions with no economic 
purpose other than to increase the amount of the market data revenues 
that they received. In this regard, the Commission abrogated several 
more extreme proposals to extend rebates of market data revenues to 
market participants, to allow more time for consideration of these 
issues.
    It is my belief that market centers should be rewarded for 
providing better services. The recent developments call into question 
whether the current method of distributing market data revenue creates 
appropriate economic incentives, and whether it furthers the goal of 
rewarding markets that make valuable contributions to the market data 
being disseminated.

The Self-Regulatory Model
    Another matter of great importance is the effectiveness of the 
self-regulatory system of securities markets. Recently, a number of 
concerns have been raised about the current state of self-regulation, 
including SRO conflicts of interest, SRO governance, and inefficiencies 
in self-regulation.
    Congress and the Commission have long recognized that self-
regulation has both benefits and weaknesses. The principle of self-
regulation is based on the idea that regulation can best be done as 
close as possible to the regulated activity. However, an SRO that 
operates a market has an inherent conflict of interest between its 
roles as a market and as a regulator. I believe that the Commission 
must continue its work in ensuring that SRO's vigorously fulfill their 
obligation to enforce their rules and the Federal securities laws and 
rules. The advent of for-profit, shareholder-owned exchanges creates 
additional issues, including ensuring that self-regulatory obligations 
do not take a backseat to the interests of shareholders. The challenge 
for the Commission and the SRO's is to ensure that as the securities 
markets grow more competitive, the SRO's continue to dedicate their 
energies and resources to surveillance and enforcement. We also must 
prevent fragmentation of trading from creating gaps in SRO oversight of 
the markets.
    As part of our review of the self-regulatory structure, I believe 
the Commission must thoroughly review the SRO's' governance practices. 
Recent events at the New York Stock Exchange point to the need for this 
review. SRO's play a critical role as standard setters for sound 
governance practices. Just as SRO's have demanded that their listed 
companies strengthen their governance practices, we must demand that, 
at a minimum, SRO's match the standards they set for listed companies. 
There are several topics that merit our consideration, including board 
composition and independence of directors; the independence and 
function of key board committees; the transparency of the SRO's 
decisionmaking process; and the diligence and competence required of 
board and committee members and ensuring their focus on the adequacy of 
regulation.
    These are critical issues facing the SRO's and the Commission. I am 
committed to ensuring that our system of self-regulation continues to 
serve as an effective and efficient means of overseeing our securities 
markets.

Exchange Criteria
    The last topic that I would like to touch upon is what it means to 
be registered as a national securities exchange. All currently 
registered exchanges have a limit order book in which better-priced 
orders take precedence. But a mandatory order book system is not easily 
reconciled with a dealer model, such as the Nasdaq stock market, in 
which there is no central limit order book.
    I spoke earlier about the merits of price protection across 
markets. Nasdaq's application to register as an exchange places 
squarely before the Commission the issue of whether price protection 
within a market is a requirement of exchange registration. One issue is 
customer expectations. I suspect that customers generally expect their 
better priced orders to be protected within an exchange.
    We do not expect all exchanges to be identical, much less to 
replicate any market's faults. Yet until now all exchanges have given 
their limit orders priority throughout their marketplace. If the 
Commission were to approve Nasdaq's application, other exchanges would 
likely seek to eliminate intramarket price priority from their rules. 
As a result, the protection of limit orders within markets would 
decrease. For this reason, Nasdaq's exchange application raises market 
structure issues that transcend the particular question of whether 
Nasdaq, or any other particular market, should be registered as an 
exchange.
    In conclusion, I would like to reiterate that the market structure 
challenges I have discussed today may shape the national market system 
for years to come. I look forward to continued input from this 
Subcommittee on these important matters.
    Thank you again for inviting me to speak on behalf of the 
Commission. I would be happy to answer any questions that you may have.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL 
                   FROM WILLIAM H. DONALDSON

Q.1. What are the advantages and disadvantages of a floor-based 
exchange versus an electronic exchange?

A.1. An evaluation of the relative strengths and weaknesses of 
floor-based versus electronic exchanges clearly is an important 
and difficult issue on which a great deal could be, and over 
the years has been, written. Moreover, how one views these 
relative strengths and disadvantages may vary significantly 
based on the type of orders involved (for example, small retail 
versus large institutional) or the type of stock involved (for 
example, a well-seasoned stock in the top tier of trading 
volume versus a relatively young stock with limited trading 
volume). This response necessarily will attempt merely to set 
forth an overview of the issue.
    The primary difference between a floor-based and an 
electronic exchange is the extent of involvement of human 
beings in the floor-based model. Both models rely to a great 
extent on technology to bring buying and selling interest 
together, such as through electronic order delivery systems. 
Even the NYSE offers the possibility of automated executions in 
some circumstances (for example, for small orders pursuant to 
the NYSE's Direct+ program). The NYSE clearly differs from 
electronic systems, however, in the opportunity it provides for 
human beings to interact face-to-face in a single, physical 
location.
    Perhaps the most significant potential strength of human 
interaction in a trading model is that it enables the flexible 
representation of very large orders submitted by institutional 
investors. 
Because of their size, these orders seldom can be disclosed 
entirely to the market without significantly moving prices 
against them. Brokers on the floor of an exchange may be able 
to use their discretion in ``working'' these orders so as to 
obtain favorable executions without significantly moving 
prices. Notably, electronic trading systems also have developed 
features that facilitate the working of undisplayed orders. One 
of the significant issues that ultimately must be determined by 
competitive forces is whether the electronic models offer a 
superior level of flexibility and efficiency than the floor-
based model.
    An exchange floor also facilitates face-to-face contact 
between the specialist and brokers. This interaction 
potentially is valuable in a variety of situations, including 
when there is a short-term imbalance between buying and selling 
interest in a stock. The specialist, because of his or her 
intimate knowledge of trading in the specialty stock, could be 
aware of brokers that might represent offsetting buying or 
selling interest. If so, the specialist has the discretion to 
call these brokers to the specialist's post. As a result, the 
physical presence of the specialist and brokers on the trading 
floor may help avoid sharp price swings that otherwise could be 
caused by these short-term imbalances.
    Finally, a potentially significant benefit of a floor-based 
exchange is the accountability and responsibility it focuses on 
those who act as market makers in a stock. During the toughest 
market conditions, such as a severe price drop, the floor 
specialist remains accountable in a most visible way--a human 
being standing at the specialist post.
    A potential weakness of a floor-based model, and 
correspondingly a potential strength of an electronic model, is 
cost of operation. A physical trading floor can be expensive to 
maintain relative to an electronic trading system. In addition, 
employing human floor brokers to represent orders on a trading 
floor may be more costly than representing those orders 
directly within an electronic trading system. Nevertheless, the 
operational costs of a trading floor must be considered within 
the larger picture of the total costs of trading in a 
particular model. For example, the market for Nasdaq stocks in 
the early 1990's collected quotes electronically, but was also 
very inefficient and costly to investors because of, among 
other things, the collusive practices of market makers. 
Ultimately, competition and market forces must decide the 
bottom-line efficiency of floor-based versus electronic 
exchanges.
    A potential strength of electronic trading systems, such as 
those that operate electronic limit order books, is that they 
facilitate direct interaction of investor buying and selling 
interest without the participation of a dealer. Although floor-
based exchanges frequently match buying and selling interest 
directly, the specialist also often has the option of taking 
one side of an order. As discussed below, the NYSE rules are 
intended to assure that the specialist only participates in 
trading when it will contribute to the maintenance of a fair 
and orderly market. Nevertheless, an electronic order book 
affords no special advantage in trading to any particular 
intermediary and thereby promotes the most direct interaction 
of buying and selling interest.
    Other issues are separate from, yet frequently linked with, 
the issue of floor-based versus electronic exchanges. Examples 
include auction versus dealer markets, and concentrated versus 
fragmented markets. These linked issues reflect the historical 
differences between the actual markets for NYSE and Nasdaq 
stocks as they have developed in the United States. The NYSE 
floor, for example, is known for its auction market, yet 
electronic trading systems also have been developed that 
implement an auction market. Conversely, Nasdaq historically 
has been primarily a dealer market, yet the entry of ECN's 
operating electronic limit order books has resulted in a 
substantial percentage of agency trading in Nasdaq stocks. 
Analogously, the market for NYSE stocks always has been highly 
concentrated--approximately 80 to 90 percent of trading in NYSE 
stocks is funneled through the NYSE floor. In contrast, the 
market for Nasdaq stocks has been much more fragmented.

Q.2. How does the SEC define ``best execution?'' Are factors 
other than price considered?

A.2. In accepting orders and routing them to a market center 
for execution, brokers act as agents for their customers and 
owe them a duty of best execution. The duty requires a broker 
to seek the most favorable terms reasonably available under the 
circumstances for a customer's transaction. Brokers must 
regularly and rigorously review their order-routing practices 
to assure that they are meeting their duty of best execution.
    Although price is a very important term, the Commission 
often has noted that price is not the sole relevant factor in 
obtaining best execution of investor orders. Other factors also 
are relevant, including: (1) the trading characteristics of the 
security involved, (2) the availability of accurate information 
affecting choices as to the most favorable market center for 
execution and the availability of technological aids to process 
such information, and (3) the cost and 
difficulty associated with obtaining an execution in a 
particular market center.

Q.3. Specialists are required to buy into a falling market and 
sell into a rising market, even if they take a loss in doing 
so. Do you keep track of how often specialists benefit and how 
often they are hurt by their trading decisions?

A.3. The NYSE rules establish procedures for monitoring 
specialists' performance of their duty to maintain, in so far 
as reasonably practicable, a fair and orderly market in their 
specialty stocks. The maintenance of a fair and orderly market 
includes maintenance of price continuity with reasonable depth, 
and the minimizing of the effects of temporary disparity 
between buying and selling interest. Specialists report 
quarterly on the quality of their performance.
    The NYSE uses a number of different objective criteria to 
monitor specialist performance. One is a specialist's 
``stabilization rate''--the percentage of shares sold at a 
price below the last different price, and the percentage of 
shares purchased at a price above the last different price. The 
stabilization rate thereby measures the extent to which 
specialists buy and sell against the prevailing trend of the 
market. For 2002 (the most recent year for which data are 
publicly available), the overall NYSE stabilization rate was 
80.2 percent. Another objective indicator of specialist 
performance is ``price continuity''--the size of the price 
variation, if any, from one trade to the next in the same 
stock. Specialist trading is intended to limit the size of 
price variations. In 2003, 95.1 percent of NYSE trades were 
priced within 5 cents of the preceding trade, and 99.9 percent 
were priced within 25 cents.
    Whether any particular specialist trade is profitable or 
unprofitable depends on a variety of factors, including the 
status of the specialist's inventory at the time of the trade 
and the volatility of price movements in a stock. Although the 
NYSE monitors the dealer profit and loss of specialists in 
their specialty stocks, its rules focus primarily on whether 
the specialist has met its affirmative duty to maintain a fair 
and orderly market. Assuming specialists fulfill this duty, 
they are not prohibited from profiting from their trading.

Q.4. Why do we require specialists to have such a prominent 
role in determining a stock's price? What would be the result 
if the price of a security was determined by the market as a 
whole rather than relying so heavily on the judgment of a 
specialist?

A.4. The overall balance of buying and selling interest in a 
security ultimately determines the price of NYSE stocks. 
Specialist trading is intended only to smooth out the sharp 
price fluctuations that otherwise might result from temporary 
disparities between buying and selling interest. For example, 
if selling interest in a stock heavily outweighs buying 
interest at any particular time, the price of the stock is 
going to drop. Specialist trading is intended to slow the rate 
of the drop, perhaps allowing time for compensating buying 
interest to mobilize and reach the NYSE floor.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR JOHNSON 
                   FROM WILLIAM H. DONALDSON

Q.1. Chairman Donaldson, at the hearing before the Banking 
Committee on September 30, Senator Carper asked if you intended 
to seek the views of the President's Working Group on Financial 
Markets before voting on any changes to the regulation of hedge 
funds. You replied that you intended to do so. Have you 
requested the input of the President's Working Group?

A.1. Over the past decade, there have been periodic calls for 
increased regulation of hedge funds. In 1999, after the near 
collapse of Long-Term Capital Management, the Commission 
participated in the study of hedge funds conducted by the 
President's Working Group on Financial Markets. The Working 
Group's principal focus in that study was on the effect of the 
exposure of large financial institutions, including broker-
dealers and banks, on the stability of the financial markets.
    In June 2002, the Commission initiated an investigation 
under Section 21(a) of the Exchange Act concerning the growth 
of hedge funds. Unlike previous studies, which focused 
primarily on market stability issues, this investigation 
focused on the effect of hedge fund growth on investor 
protection. On May 14 and 15, 2003, the Commission held a 
roundtable on hedge funds, which included the participation of 
senior staff members of the Commodity Futures Trading 
Commission, a fellow Working Group member.
    At the conclusion of the hedge fund roundtable, I asked the 
Commission's Division of Investment Management to prepare a 
report on the implications of the growth of hedge funds. I kept 
the Working Group informed on the progress of the report and, 
as you know, the report was issued on September 29, 2003. At 
the last meeting of the Working Group, which took place on 
December 3, 2003, hedge fund issues were included on the agenda 
and I intend to keep the Working Group informed of the 
Commission's efforts regarding hedge funds going forward.
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