[Senate Hearing 108-887]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-887

 
                    REGULATION NMS AND DEVELOPMENTS
                          IN MARKET STRUCTURES

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

                                HEARINGS

                               before the

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

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                                   ON

      EXAMINATION OF REGULATION OF THE NATIONAL MARKET SYSTEM AND 
 DEVELOPMENTS IN MARKET STRUCTURE, FOCUSING ON PROPOSALS TO MODERNIZE 
THE NATIONAL MARKET SYSTEM TO IMPROVE THE REGULATORY STRUCTURE OF U.S. 
                             EQUITY MARKETS

                               __________

                          JULY 21 AND 22, 2004

                               __________

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


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



                                 ______

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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

                       Bryan N. Corbett, Counsel

                 Dean V. Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, JULY 21, 2004

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2
    Senator Schumer..............................................    11
    Senator Corzine..............................................    14
    Senator Bunning..............................................    36

                               WITNESSES

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission.....................................................     3
    Prepared statement...........................................    36
    Response to written questions of:
        Senator Allard...........................................    67
        Senator Bunning..........................................    67
Robert Greifeld, CEO and President, the Nasdaq Stock Market, Inc.    17
    Prepared statement...........................................    41
David F. Harris, Senior Vice President, Strategic Planning, 
  American Stock Exchange, LLC...................................    19
    Prepared statement...........................................    49
Edward J. Nicoll, CEO, Instinet Group Incorporated...............    23
    Prepared statement...........................................    56
Gerald D. Putnam, Chairman and Chief Executive Officer, 
  Archipelago
  Holdings, LLC..................................................    25
    Prepared statement...........................................    58
John A. Thain, Chief Executive Officer, New York Stock Exchange, 
  Inc............................................................    27
    Prepared statement...........................................    63
    Response to written questions of Senator Bunning.............    69
                              ----------                              

                        THURSDAY, JULY 22, 2004

Opening statement of Chairman Shelby.............................    73

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................    88
    Senator Bunning..............................................    91

                               WITNESSES

David Colker, CEO and President, the National Stock Exchange.....    74
    Prepared statement...........................................   100
Kevin Cronin, Senior Vice President and Director of Equity 
  Trading, AIM Investments.......................................    75
    Prepared statement...........................................   102
Scott DeSano, Head of Equity Trading Desk, Fidelity Investments..    78
    Prepared statement...........................................   104
Phylis M. Esposito, Executive Vice President and Chief Strategy 
  Officer, Ameritrade Holding Corporation........................    80
    Prepared statement...........................................   108
Bernard Madoff, Chairman and CEO, Bernard L. Madoff Investment
  Securities.....................................................    82
    Prepared statement...........................................   115
Robert H. McCooey, Jr., President and Chief Executive Officer, 
  the Griswold
   Company, Incorporated.........................................    83
    Prepared statement...........................................   116
Kim Bang, President and Chief Executive Officer, Bloomberg 
  Tradebook, LLC.................................................    95
    Prepared statement...........................................   120
Davi M. D'Agostino, Director, Financial Markets and Community 
  Investment,
  U.S. General Accountibility Office.............................    97
    Prepared statement...........................................   128
Robert B. Fagenson, Vice Chairman, Van der Moolen Specialists....    98
    Prepared statement...........................................   142
John C. Giesea, President and CEO, Security Traders Association..    98
    Prepared statement...........................................   145
Charles Leven, Vice President, Board Governance and Chair, Board 
  of Directors, AARP.............................................    98
    Prepared statement...........................................   148


                    REGULATION NMS AND DEVELOPMENTS
                          IN MARKET STRUCTURE

                              ----------                              


                        WEDNESDAY, JULY 21, 2004

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

    The Committee met at 10:46 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will finally come to order.
    [Laughter.]
    This morning the Committee will hold the first of two 
hearings examining Regulation NMS and its potential impact on 
market structure. I would like to acknowledge here the work of 
my colleague, Senator Enzi, in this area. Senator Enzi has 
already held a hearing on market structure in the Subcommittee 
on Securities and Investment. These hearings are intended to 
compliment the Subcommittee's work.
    In 1975, Congress mandated the creation of a ``national 
market system'' and gave the SEC substantial discretion to 
facilitate the development of this system. Congress enumerated 
certain principles to guide the SEC, including efficiency, 
competition, price transparency, best execution, and direct 
interaction of investor orders. These principles constitute the 
core of our securities markets and serve as a guidepost for 
reform. At the center of the current market structure reform 
debate is the question of how to implement these principles in 
today's market and with today's technology.
    Since 1975, competition and technological developments have 
transformed our securities markets. Technological innovations 
allow investors to obtain near-instantaneous execution of their 
orders. As our market structure evolves, the SEC must monitor 
these changes and ensure that the our regulatory structure 
continues to facilitate competition, innovation, and efficient 
price discovery without producing unnecessary fragmentation of 
liquidity. As we consider fundamental changes to our markets, I 
believe we must remain mindful that our markets are the deepest 
and most liquid in the world.
    The stakes are extremely high in this debate. We have to 
first truly retain capital market in the world. Ordinary 
Americans enter the securities markets in large part because 
they believe that our capital markets are fast, fair, and 
reliable, and that their order will receive the same treatment 
as an order submitted by a professional trader.
    The current debate is an opportunity to modernize and 
improve a national system that has generated tremendous wealth 
for millions of ordinary Americans. The goal should be to 
define the world's premier price discovery and order execution 
system, without unwanted, unintended consequences.
    On February 24, the SEC proposed Regulation NMS as a 
response to calls for reform. This regulation is an important 
step in addressing the need to modernize our markets and 
charting a course for future development. As always, we should 
be mindful of picking winning or losing business models in this 
debate. In the end, market forces should be the final arbiter.
    I look forward to discussing these issues and others with 
Chairman Donaldson this morning.
    On the second panel, following Chairman Donaldson, the 
Committee will hear from Mr. Robert Greifield, President and 
CEO, Nasdaq Stock Market; Mr. David Harris, Senior Vice 
President, Strategic Planning, American Stock Exchange; Mr. 
Edward Nicoll, CEO and Director, Instinet Group; Mr. Gerald 
Putnam, CEO, Archipelago Exchange; and Mr. John Thain, CEO, New 
York Stock Exchange. We look forward to your testimony here.
    I would note that this is the Chairman's second appearance 
before this Committee in the last week. The Chairman may be 
looking forward to an August recess as much as the Members.
    [Laughter.]
    We certainly appreciate your time and willingness to join 
us.
    Chairman Donaldson. Thank you.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby.
    The United States has the most sophisticated infrastructure 
in the world through which investors can trade securities. Our 
market structure includes stock exchanges, electronic stock 
markets, broker-dealers that internalize trades, and 
alternative display facilities. In many cases, a company's 
stock can be traded in any of several competing marketplaces.
    Modern computer technology has changed trading dynamics and 
enhanced market efficiency. New investment strategies are 
developing which take advantage of such technology. New fully 
electronic marketplaces, which process transactions in a 
fraction of a second, have developed and compete with auction 
markets, which historically have served investors well.
    The SEC has the responsibility to monitor these 
developments and to ensure that the Federal regulatory 
structure promotes the efficient and fair operation of the 
secondary securities markets, while not stifling competition.
    I commend Chairman Donaldson, the Division of Market 
Regulation, and the Commission for proceeding very carefully 
and cautiously in their consideration of this complex subject, 
with very full input from the interested parties. As the 
proposal notes, the Commission's review of these issues ``has 
included multiple public hearings and roundtables, an advisory 
committee, four concept releases, the issuance of temporary 
exemptions intended in part to generate useful data on policy 
alternatives, and a constant dialogue with industry 
participants and investors.''
    On February 24 of this year, the SEC proposed Regulation 
NMS, which addresses four subjects: The trade-through rule, 
access fees, prohibiting stock quotes in increments finer than 
one penny, and changing the formula for distributing data fees 
to markets.
    The Commission gave the public an appropriately long 
comment period, which extended until June 30 of this year. It 
has received over hundreds of comment letters, including many 
thoughtful comments from market participants that would be 
affected by the rule. The Commission is now in the process of 
reviewing these statements.
    Mr. Chairman, I join with you in looking forward to hearing 
the testimony of Chairman Donaldson--we are very pleased to 
have the Chairman with us--and the testimony of the 
representatives of the equity marketplaces which will follow, 
on the impact of the SEC proposals on the systems and on 
investors.
    Thank you very much.
    Chairman Shelby. Mr. Donaldson.

               STATEMENT OF WILLIAM H. DONALDSON

       CHAIRMAN, U.S. SECRETARIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Thank you very much, Chairman Shelby, 
Ranking Member Sarbanes, and Members of the Committee, wherever 
you are.
    [Laughter.]
    Chairman Shelby. They might be trying to get in the 
building.
    [Laughter.]
    Chairman Donaldson. Thank you for inviting me to testify 
today on proposals to modernize the national market system for 
equity securities. I welcome your continuing interest in an 
issue of such vital importance to investors and the economy. 
The national market system encompasses the equities of more 
than 5,000 companies, which collectively represent more than 
$15 trillion in market capitalization. The Commission is 
committed to ensuring that investors have the fairest and most 
efficient markets possible for investing in these securities.
    Since I appeared before you last October to discuss the 
state of the national market system, the Commission has made a 
great deal of progress. In February, we published for public 
comment Regulation NMS, a broad set of proposals designed to 
improve the regulatory structure of the U.S. equity markets. In 
April, we held public hearings on the proposals, and then 
followed up in May by publishing a supplemental request for 
comment to reflect a number of important matters discussed at 
the public hearing. In addition, the comment period was 
extended until June 30 to give the public ample opportunity to 
prepare their views. I might add that the updated figure is 
close to 600 letters of comment with the extended period, still 
coming in.
    Consequently, this Committee's hearings on the national 
market system are particularly timely. Your consultation and 
oversight will provide a major contribution to the Commission's 
efforts as it moves forward in the rulemaking process. With 
your help, I am confident that we will succeed in our efforts 
to assure that the equity markets continue to meet the needs of 
investors and public companies.
    The Regulation NMS proposals encompass four substantive 
areas: Trade-throughs, market access, sub-penny quoting, and 
market data. My written testimony provides an overview of the 
proposals, and I look forward to answering your questions about 
those specifics.
    First, however, I would like to take a broader view of the 
market structure issues facing the Commission, as well as the 
policy objectives that the proposals are intended to achieve.
    When assessing the current state of the national market 
system, the starting point is to recognize just how well it 
works overall. The system needs to be modernized for sure, but 
it is far from broken. The U.S. equity markets have never been 
more fair and efficient for such a broad spectrum of investors 
than they are today. Since the national market system was 
created, investor trading costs have significantly declined. 
Not surprisingly, as trading costs have declined, the volume of 
trading has climbed inexorably upward. Indeed, our markets now 
routinely handle trading volumes that would have been nearly 
unimaginable just a decade ago. These are telling indicators of 
markets that are vibrant and healthy.
    With all of this success, inevitably, come problems. In the 
past few years, in particular, a remarkable confluence of 
forces has strained the existing components of the national 
market system. These forces have included technological 
advances, of course, but also the arrival of entirely new 
security products and trading strategies. These include among 
others, derivative products, such as exchange-traded funds, 
which generate enormous trading volumes, as well as program 
trading in large baskets of stocks and statistical arbitrage 
trading. Moreover, the commencement of decimal trading in 2001 
further transformed the equity markets. The number of quote 
updates exploded, and the quoted size at any particular price 
level dropped. Investors adopted new tactics to deal with the 
changed trading environment and found that they needed new 
trading tools to implement these tactics. In particular, 
investors have adopted automated order routing strategies that 
require exceptionally fast execution and response times from 
the markets. Finally, a variety of new, electronic markets have 
arisen that offer innovative trading mechanisms designed to 
meet the needs of those using the new security products and 
trading strategies.
    The proliferation of fast, electronic markets 
simultaneously trading the same stocks as slower, manual floor-
based exchanges have complicated the task of making sure that 
an investor order receives best execution. The Commission's 
challenge is to craft rules that reconcile different trading 
models without sacrificing the fundamental principle of 
assuring the best execution for investor orders. I believe this 
creates the conditions under which an investor can achieve the 
best available price.
    In sum, the national market system needs to be modernized, 
not because it has failed investors, but because it has been so 
successful in promoting growth, efficiency, and innovation that 
many of its old rules now are outdated. Identifying and 
improving these outdated rules is the ultimate goal of the 
Regulation NMS proposals. To this end, the Commission is 
engaged in an exceptionally open and interactive process. It 
has actively sought out the views of a wide range of market 
participants. There are few areas of securities regulation in 
which the considered views of practitioners are more needed 
than market structure.
    When the Commission published Regulation NMS proposals for 
public comment, it fully expected the proposals would be 
revised and improved after hearing the views of commentaters. 
Indeed, the public hearing on Regulation NMS in April produced 
just such valuable suggestions for improvements that the 
Commission published a supplemental request for comment to 
incorporate some of these suggestions. This process is 
continuing. I fully expect that our review of the comment 
letters will promote additional improvements in the proposals 
as the Commission moves foward in the rulemaking process.
    This process will be guided by those fundamental principles 
for the national market system that were established by 
Congress in 1975 and have guided the Commission over the years. 
While the particular rules and facilities that implement these 
principles may be in need of updating, I believe that the 
principles themselves remain as valid as ever. In particular, 
the Commission has always sought to achieve the benefits of 
competition, while countering the negative effects of 
fragmentation from trading in multiple markets. The national 
market system has promoted the wide availability of market data 
so that investors can determine the best prices, ready access 
among markets to obtain those prices, protection of investor 
limit orders, and the duty of brokers to obtain best execution 
for their customer orders.
    I particularly want to emphasize the importance of price 
protection and encouraging the display of investor limit 
orders. These orders typically define the best displayed prices 
in a stock. They are a critical source of public price 
discovery that is essential to the efficient operation of 
markets. Competition among markets is a vital aspect of 
efficient markets, but we must also assure vigorous competition 
among the orders of buyers and sellers in a stock. If investor 
limit orders are neglected and trades occur at inferior prices 
without good reason, I believe that it harms both the 
particular investors involved and perhaps more importantly, the 
integrity of the markets as a whole. Small investors, 
justifiably, may not understand why their order is bypassed by 
trading in other markets. But many of the largest institutional 
investors have also stressed to the Commission that they 
believe enhanced protection of investor limited orders is one 
of the weaknesses in the current national market system that 
needs to be addressed.
    I will conclude by addressing the future of the Regulation 
NMS rulemaking process. When I spoke to you last fall, I 
emphasized that the Commission intended to take action to 
address market structure problems. Many of the issues raised by 
the Regulation NMS proposals have lingered for many years, and 
caused serious discord among market participants. These issues 
have been studied, debated, and evaluated from nearly every 
conceivable angle. Few would seriously oppose the notion that 
the current structure of the NMS is outdated in some respects 
and needs to be modernized. I believe that the Commission must 
move forward and make decisions concerning final rules if the 
United States equity markets are to continue to meet the 
evolving needs of investors in public companies.
    Thanks again for inviting me to speak on behalf of the 
Commission. I submitted, as I said earlier, extended written 
testimony that discusses the Regulation NMS proposals. I look 
forward to answering your questions on the particulars of the 
proposal, as well as on any other market structure issues 
facing the Commission. Thank you.
    Chairman Shelby. Thank you, Mr. Donaldson. Your written 
testimony will be made part of the record in its entirety for 
all Members to read.
    Mr. Chairman, the trade-through rule is one of the more 
controversial issues in the market structure debate. Why do you 
believe that the trade-through rule is essential to our 
securities markets, and would you just give us an example of 
what you mean by the trade-through rule?
    Chairman Donaldson. Again, the trade-through rule is a rule 
designed to counter the effects of a proliferation of markets 
so that when the best price is available, the orders are 
executed against that best price.
    Chairman Shelby. Give us an example of how this might work 
or it could work.
    Chairman Donaldson. Basically, if you have an investor who 
has put a limit order on the books, and that limit order is a 
national best bid or offer, however, is not the national best 
bid or offer, the trade-through rule allows or forces that the 
execution of that order to be done at the best bid, and does 
not allow the so-called trading-through of that bid, and 
basically does not allow an order to be executed without its 
exposure to the rest of the marketplace.
    What the trade-through rule does and why it is so important 
is that it encourages investor limit orders by protecting these 
best displayed prices, the source of price discovery and 
efficiency. And of course, the inducement for somebody to place 
a limit order is the essence of a marketplace, and to try and 
get as much display, both of price and size as you can get, and 
there needs to be an inducement to do that, to stick your neck 
out, if you will, and the trade-through tule rewards people for 
doing that, rewards traders for doing that by preventing people 
from trading around that. It promotes the best execution of 
customer orders. Customers should receive the best price when 
it is accessible. I think that is the clear issue here this 
morning, the accessibility of that best price.
    The problem here, as you know better than I, is to update 
our existing rules to reflect to so-called ``fast markets 
versus slow quotes,'' and eliminate any existing advantage that 
the slow markets have. The fast quote approach, which has 
evolved from our original publishing NMS rules and then the 
conversations and discussions we have had, we are now giving 
serious consideration to the quote, if you will, the fast quote 
approach.
    Do you want me to go on? You asked a fairly defined 
question.
    Chairman Shelby. That is fine.
    Chairman Donaldson. Let me just try to elaborate on that.
    Chairman Shelby. This goes to the heart of what we are 
talking about here.
    Chairman Donaldson. Yes. The issue is that, because of 
electronic trading mechanisms, we now have the ability to trade 
at electronic speeds, if you will. The traditional floor-based 
auction markets, in main, have a delay in terms of executing an 
order, so that they may display a bid that is the best bid, but 
the electronic market cannot get to that bid, and oftentimes 
when it gets to that bid, the bid has either disappeared, or 
the electronic market is unable to get their size done because 
somebody else has nibbled away at it, and that is the 
frustration of the electronic markets.
    What again has come from the discussions that we have had 
and the modifications that we are now considering is the 
concept of defining electronic execution as the electronic 
execution of a posted bid offer, and what we are saying, and it 
seems to be open for examination, is that if, let us say, the 
New York Stock Exchange or the Chicago Stock Exchange, can 
create an electronic capability, an instantaneous trading 
capability that matches what the electronic markets can do, and 
if that electronic capability is untouched by human hands if 
you will, and if the order that is being shown, it can be 
reached at the speed of light or at some electronic speed, then 
that market will be competitive with the electronic markets, 
and there will no longer be the problem that the electronic 
markets have of getting through to the bid.
    Chairman Shelby. Are we not really interested in first 
integrity in the markets? You have to have integrity, 
efficiency in the markets for the markets to work.
    Chairman Donaldson. I am sorry. I did not get the first.
    Chairman Shelby. What we are really interested in, in the 
execution of orders, is integrity and efficiency, is it not?
    Chairman Donaldson. With a big underline on integrity. In 
other words, if the markets are efficient, but lack integrity--
--
    Chairman Shelby. I agree. I said integrity first.
    Chairman Donaldson. I am defining integrity as being the 
not pushing aside the best bid or offer. Integrity, and here 
again, I get back to what----
    Chairman Shelby. Or not trading for yourself ahead of your 
customers too, right?
    Chairman Donaldson. I believe we have to have a marketplace 
that has integrity for both institutional and individual 
investors.
    Chairman Shelby. Absolutely.
    Chairman Donaldson. I am going to leap now ahead a little 
bit. Maybe I should not, but I will, if you will let me.
    Chairman Shelby. Go ahead.
    Chairman Donaldson. To the theory here that if a quote is 
electronic, is accessible, and is untouched by human hands, 
then one would question why you would need to have an opt out 
rule. In other words, why should you have to opt out of that a 
system? The second part of this is that if in fact you have a 
quote that is not electronic and is so designated, then it 
becomes a slow market quote, and there one can say that you 
would want to have to eliminate the trade-through rules and 
allow trading through a slow market. In other words, a slow 
market should not be protected by the trade-through rule.
    Chairman Shelby. You are talking about the two proposed 
exceptions to the trade-through rule? For example, the opt out 
exception, how it would work, and also the Fast Market or Fast 
Quote exception?
    Chairman Donaldson. What I am suggesting, and again, we are 
in the very midst of trying to determine exactly how to do 
this, but what we are really talking about is a bifurcated kind 
of approach, where you have the access to the electronic speeds 
and so forth, but at the same time, at the customer's 
discretion, they can move their order into a slow quote market, 
and get some of the advantages that some of the slow markets 
basically give, and that would be price improvement and a 
gathering together of liquidity that comes in a slow market.
    Chairman Shelby. Mr. Chairman, I know my time is up, but I 
will be generous with the others. The over-the-counter market, 
it is my understanding, has never operated under a trade-
through rule. If that is so, how will application of the trade-
through rule impact the over-the-counter market?
    Chairman Donaldson. We have suggested that the trade-
through rule be extended to the over-the-counter Nasdaq market.
    Chairman Shelby. So it would have an impact on what they do 
today.
    Chairman Donaldson. We are suggesting that the benefits 
that come from electronic and trade-through, as I described it, 
be extended to the over-the-counter market.
    Chairman Shelby. Senator Sarbanes, thank you for your 
indulgence.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    First of all, Chairman Donaldson, I have been struck by how 
open and comprehensive your examination of this issue has been. 
As I indicated at the outset, it is quite a complex issue, but 
you have held these hearings and roundtables, as I understand 
it, as a consequence of some of the hearings. You did a 
supplemental request for comment, which went out. Have you 
gotten any complaint from any source that the SEC has not been 
fully open and accessible with respect to drawing comments? 
Because we want to be certain that no one comes along later and 
says, ``We were not included in the hearing process.'' My 
perception is that there is not a problem in that regard, but 
have you gotten any complaints?
    Chairman Donaldson. I think this has been the most 
incredibly complete process. It is a process that has really 
been going on for a number of years, if you will. I mean it 
really preceded the actual focus we are bringing to it in the 
last year or so. There has been incredible outreach on the part 
of the SEC. There has been, I think, great participation by the 
industry in panels and open discussions and so forth, and now 
it has been augmented by studies that have been done, and now 
augmented by comment letters. I think it would be pretty 
impossible for anybody to say that they have not been heard.
    Senator Sarbanes. That leads, of course, to the next 
question, so to speak. I notice in your statement toward the 
end you say, ``Although I cannot predict the outcome of the 
Commission's proposed rulemaking, I do believe it is extremely 
important that there be an outcome, and that the outcome be 
reached in a timely manner.''
    What is your view of what a timely manner encompasses?
    Chairman Donaldson. I just knew you were going to ask that 
question.
    [Laughter.]
    As I said, we have 600 comment letters. We have all the 
testimony and data that has come from the meetings and so 
forth. We are digesting that. I believe that we should be in a 
position to boil this down and come up with some refined rules 
before the end of the year.
    Having said that, when we get down to refining these rules 
and get down to plugging in on some of the contentious areas 
that they are at, that does not mean that there will not be an 
even more focused attempt on the part of commentators to judge 
those rules.
    But in terms of the desires of the Commission, it is to try 
and bring this thing to fruition just as soon as we can.
    Senator Sarbanes. In recent years the securities markets 
have seen the consolidation of some electronic communication 
networks and market centers. What effect do you believe the 
proposal will have on the structure or consolidation of the 
securities marketplaces?
    Chairman Donaldson. There has already been some 
consolidation, as you know, in the markets, particularly the 
electronic markets, as there is this tradeoff between the 
diversity and spread of marketplaces. Fragmentation is the buzz 
word, fragmentation of the markets. Basically, the pure theory 
of the best market in economic terms is when buyers and sellers 
get together and compete with each other. That is the 
definition. In theory, the best market in the world would be 
where everybody is competing, all the buyers and sellers are 
together, and that is true price discovery. Insofar as you 
fragment that, you lose something. Now, you gain something too. 
You gain some service aspects to these markets, some innovation 
and so forth that has come from competing markets, but you 
lose. So it is a trade-off, and to answer your question 
specifically, I believe that the natural forces, first of all, 
have caused some electronic markets to go out of business 
because they did not have a good model, and I think it has 
taken some other electronic markets into a merge mode with 
other electronic markets, and I think that is healthy because 
that moves it toward all buying and selling in one place, but 
it does not move it completely. We still have the benefit of 
the competing market factor.
    Senator Sarbanes. Let me ask you this question. I am trying 
to understand these issues, and I do not pretend to be an 
expert in them, but in the electronic marketplace you would not 
be able to have the specialist abuses that occurred which 
prompted the New York Stock Exchange and the SEC to take these 
enforcement actions.
    Would that be correct?
    Chairman Donaldson. You are asking a question that is not 
that easy to answer, the second part of it, which is the abuses 
that occurred on the floor of the stock exchange, and I guess 
my attitude toward that is the model wrong or was the policing 
of the abuses wrong, and that to me is the issue.
    Senator Sarbanes. Would such abuses be possible in an 
electronic marketplace?
    Chairman Donaldson. Different kinds of abuses, yes.
    Senator Sarbanes. The types that we encounter here?
    Chairman Donaldson. Yes. I mean there are a whole series of 
practices, let us say, that prevail. I do not mean to damn them 
all, but there is a series of practices that prevail that give 
monetary incentives, if you will, to bringing orders to an 
electronic market. An ugly word is the rebate, but in essence, 
to attempt to get and induce buyers and sellers to get together 
in the electronic market, and one would question whether some 
of those payments are valid payments.
    Senator Sarbanes. The fact that it is executed 
automatically without human hands, which presumably on its face 
would address these questions that were raised on the stock 
exchange with the specialists--where they said executing orders 
for the dealer accounts ahead of executable public customer 
agency orders, and therefore, violating the basic obligation to 
match executable public customer buy and sell orders, and not 
to fill customer orders through trades from the firm's own 
account when those customer orders could be matched with other 
customer orders, thereby profiting from it, disadvantaging 
customer orders. On an electronic 
exchange with an instantaneous execution, this abuse could not 
happen. But you are telling me other abuses could take place. 
Is that correct?
    Chairman Donaldson. Yes. And again, without excusing in any 
way violations on the floor of the stock exchange of the 
trading rules, I would simply say that decimalization and all 
of the things that I referred to before in terms of changes 
brought about by new trading strategies and so forth, and the 
reduction of spreads to pennies and so forth, severely tested 
the price improvement backbone of the New York Stock Exchange, 
severely tested the speed of all of this, has tested the 
ability of the specialists to do their thing.
    Senator Sarbanes. That raises a question now about whether 
they can perform their function in terms of affecting 
volatility. As I understand it, the arguments for the 
traditional exchange is you get better price, or at least the 
argument is made that we get better price, and also that you 
are able to ease the volatility issues. Now, is that argument 
being undercut or weakened by the development of this very fast 
transaction ability now?
    Chairman Donaldson. Yes. I think in the following way, that 
if we had only electronic markets and did not have the 
liquidity improving and price improving capabilities of the so-
called ``slow market,'' auction market, specialist market, or 
whatever name you want to put on it, I think our central market 
would lose a great deal. Particularly in times of stress, 
particularly in times of violently up markets, or more 
particularly or more importantly, violently down markets, where 
liquidity can be created not only by the specialist himself or 
herself, but also the liquidity that the specialist brings to 
bear on the marketplace. You have a human being, and human 
beings involved in a real time situation. I am going to say 
something now that I hope is not misinterpreted, but it is too 
easy to turn off an electronic market. It is too easy to have 
gaps, particularly under times of stress, and this gets to also 
the difference in the way stocks are traded. I mean there are 
stocks on the Nasdaq market, on the New York Stock Exchange 
that, as the expression goes, trade like water. I mean there 
really is no intervening function here. That is very different 
than the great bulk of stocks that have wider spreads, have 
less liquidity on both sides of the market, and have less 
trading volume, and require the gathering together of liquidity 
to make an orderly market. Having an orderly market is so 
important to our system, I mean the multiples that stocks sell 
at, that the quality of the stock and so forth is dependent on 
the orderliness of the market, and it is in particularly times 
of stress that this is so important.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. I want to thank 
you for holding this very timely hearing. I want to add my 
voice to that of Senator Sarbanes here, and I imagine yours 
too, Mr. Chairman, although I did not get to hear your opening 
remarks. The process which the SEC is using deserves a lot of 
commendation. It is open, and I think it is very aware, if you 
will, if a process can be aware, that these are very difficult 
issues, and that if you make the wrong turn, you could do 
something terribly damaging that you might not recoup. I thank 
you for the care with which you are going through.
    I know there has been a lot of pushing: Change quick, 
change quick. I worry about that. I worry because, again, our 
market system, you put it very well. It is far from broken, but 
it needs changing. Technology always introduces change. But 
technology is not the end-all and be-all, because if we were to 
have the most technologically efficient market, the quickest 
market, and yet it was not as transparent, it was not as deep, 
it became fragmented in six different places, and it was 
opaque, my guess is the number one thing that has made American 
markets the envy of the world and why trillions of dollars come 
here, that people know it is open and on the level, would be 
gone.
    So, I think we have to be careful, and I do not think we 
should be involved in this technology mania. We have to adapt 
to technology, no question. If we do not, we will lose. But at 
the same time, we have to be mindful that there are a lot of 
other benefits here that are part of the market.
    I would just like to mention a few. Because of whatever it 
was, broken water main, I did not get a chance to make a few 
points, and then I will ask a question or two with the 
Chairman's indulgence.
    Chairman Shelby. Go ahead.
    Senator Schumer. First, best price is still, if you had to 
pick one thing, speed or best price, you would want best price, 
and let us take a look at the small investor. My father is a 
small investor in stocks. He has been doing this for years. 
When I was a little kid, I remember all those little booklets, 
you know, things I never heard of, Buckby Meers coming to the 
house, and he would pour over them.
    Senator Sarbanes. I thought you read them all.
    [Laughter.]
    Senator Schumer. No. The amount of time he put in.
    Senator Corzine. Are you trying to think of the term 
``prospectus?''
    Senator Schumer. Prospectus, that is it. It was not 
prospectus, no. They were the annual reports. That is what they 
were.
    But in any case, the amount of time he put in compared to 
the amount of money he made, made it not a very good 
investment, I think. But he wants best price. I asked him the 
other day. He is 81. Knock wood, he is still doing this, still 
spends time, to my mother's chagrin, at the desk looking at all 
these reports and stuff and figuring out things. He does not 
care if it takes 3 seconds, 10 seconds, or 2 minutes. He wants 
best price, and I do not think we should abandon the small 
investor.
    I understand that the big boys may want it another way, but 
as you so well put in the answer to Senator Sarbanes' question, 
for both many stocks and even for larger stocks, you have to be 
mindful of both. So that is one point I would make.
    Then there is a more fundamental point. By the way, the 
AARP surveyed in their investors, and they found that two-
thirds said that price, not balancing price with speed, was 
their number one priority when trading, and that is whether 
they are trading IBM or some tiny little stock.
    Second, I greatly worry about fragmentation of the market, 
and the concomitant opacity. We could make a change here. No 
one can fully predict what will happen. Instead of one deep 
liquid market, you get six little markets. That could really 
lead first to a failure to get best price, but second, if each 
market is not so deep and so liquid--I understand capitalism. I 
know there are people in the audience who say: Give me my 
chance. But we have a greater good here, and the greater good 
is one deep, liquid market, and we could end up losing that to 
some other country. As somebody from New York, the financial 
center of the world, I hope we do not roll the dice in that 
regard, even though I know people are pushing. I have read all 
the stuff and heard all that from all these people who were 
pushing.
    Fragmentation is my greatest worry, and again, that means 
moving with care. Competition is good and there is a tension 
between competition and depth in liquidity. Be careful.
    Finally, again, I want to get to opacity. Senator Sarbanes 
mentioned that a specialist can take advantage. Sure, but you 
put it well. Is it the system or the individual specialist? A 
broker-dealer can also take advantage, and we are not hearing, 
because we have had charges against broker-dealers here and 
there, that we should get rid of that system. In fact, I would 
say in an open auction system rather than a closed system where 
things can be reported under the screen and much later, you 
have a greater chance for those scoundrels, if you want to call 
them that, to take advantage of the system.
    I think again your approach has been great. I worry about 
opt out. I think opt out could undo all the things you are 
talking about here, all the things I am talking about. I know 
that some of the big boys want to opt out. I wonder if it is 
really speed they are after, Mr. Chairman. I think they want 
opacity. I think they want to hide their trades. Some of that 
is legitimate. I understand if you are trading a huge amount 
you want to maximize what you can trade it at and not tip your 
hand. But with opacity comes the problem that more illicit 
things can happen, and comes the fact that people may be taken 
advantage of and not either get best price or quickest trade.
    So, again, these are balances here, and the simple notion 
that I know that a few of the Commissioners have, just let a 
thousand flowers bloom, let everybody just do what they want. 
Well, in the 1890's that argument made sense, and we have had 
100 years of history, maybe 200 and something since the 
buttonwood tree. I do not know when the buttonwood tree was. We 
have learned that the balance is important, the balance between 
technology and regulation, the balance between opacity and 
openness, the balance between all of these things. So, I just 
hope that you will be careful because I think the Opt Out Rule, 
is a little bit of a disguise here to undo a lot of the other 
things that you are trying to do. Fast market-slow market, that 
makes eminent sense to me, and I think you should have that, 
but you opt out and you have large players opt out, and you can 
end up with the fragmented market system that we have, and even 
worse, an opaque system where there is no ability to police, or 
there is policing after the action, et cetera. I believe you 
are right on trade-through in this Regulation NMS, and it is 
fine to have it for Nasdaq too, but not opt out. I would be 
really careful before going to opt out.
    Maybe I will let you comment on what I had to say since it 
was a little longer, but I feel this issue quite passionately.
    Chairman Donaldson. There are several words that you use 
that are in my view right on; the word balance, the word 
protecting individual investors. We have a unique situation in 
this country as you all know, which is that we have more 
participation by individual investors than any other market in 
the world, and it is interesting to me how many institutional 
clients have told us in their filings how important it is to 
maintain the diversity of individual investors in a 
marketplace, and there is no other market in the world that has 
that the way we have it, no other industrialized society.
    I think it is hard for small investors to feel like they 
are not up against it if a big institutional investor sweeps 
through the marketplace and bypasses the individual. I think we 
have to protect against that.
    Having said that, the Commission's role here, as I see it, 
is to try and modify this marketplace so we get a combination 
that addresses some of the issues that you are saying, but also 
addresses some of the issues that come from large institutional 
investors of all sorts who claim that their ability to get to 
the best bid or offer is inhibited. By the time they get there, 
they cannot get their trade done because the bid is no longer 
there, all legitimate, in my view, complaints, and I think the 
bifurcated structure that maybe we are heading toward, where 
you have eliminated a lot of that by the electronic capability 
of some of our auction markets, but at the same time by 
signaling that some of those electronic bids do not qualify to 
be classified as electronic.
    Senator Schumer. Right.
    Chairman Donaldson. You can designate this on the tape, and 
therefore, they go into the slow market mode for whatever 
reason, and then in the slow market you are able to get some of 
the benefits of the auction process. And I just want to assure 
you in terms of your comments that we are not wedded to any 
particular market structure. We are wedded to benefits the 
different market structures have, and ways of doing business 
and the different demands of institutional investors versus 
individual investors.
    Senator Schumer. Do you worry about fragmentation?
    Chairman Donaldson. We are worried about fragmentation, and 
we worry about opt out too. The concept of opt out, again, I go 
back to asking the question that we are asking ourselves, which 
is if this electronic, instantaneous capability can be 
developed by the so-called ``slow markets,'' then what do you 
have to opt out for?
    Senator Schumer. Exactly.
    Chairman Donaldson. It is totally competitive with the 
electronic market.
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman. I appreciate you 
holding this hearing, and I must say, for someone that worked 
for more than a quarter of a century in this market, this is a 
tough issue. This is not the kind of thing that I think there 
is a how-to manual or obvious perfect solution. So, I 
compliment the Commission and the Chairman for the 
thoughtfulness and the dedication to fully exploring all of 
those elements of balance appropriately. I wish it were obvious 
exactly how this works.
    I do have some questions that go at what is reality. Can we 
put together all of these various markets electronically now?
    Is it technologically real, aside from the fact that we are 
going to start in a particular order that is designated for a 
slow market process. Is it something that actually can be done 
technologically now? Do we have the engineering capacity to put 
all of these markets together?
    Chairman Donaldson. To connect them electronically, yes, I 
believe this can be done. I think the technology is cascading. 
I think that one of the problems, on a trade-through thing, is 
the antiquated ITS system that does not connect the way it 
should.
    On the other hand, I think there are new programs being 
written where bids and offers can be blasted to the best market 
electronically, and therefore the Government or the industry 
itself can solve some--the Government does not have to get 
involved, and the industry can get after the failings of the 
ITS system by privately linking in an instantaneous linking of 
these markets, so that orders go directly to the best-bid 
market and solving----
    Senator Corzine. So, if you put down a rule that said we 
are going to implement in 2 years, you could transition, on an 
engineering basis, to an appropriate technological response 
which, in many ways, deals with the fragmentation question, if 
I am not mistaken. In theory, if you can get all of these 
markets hooked into the same box, you all have to come in, you 
have to homogenize how they come into that box, but I presume 
that if you get all of those things hooked together, you 
actually could have a common market and sort to the best bid, 
best price or best offer, best execution.
    Chairman Donaldson. You know, I do not want to overestimate 
the technology. I will say that it has been indicated by some 
of the so-called ``slow markets'' that they are able to create 
a fast market and can do it I think the quote was: ``faster 
than we can pass a rule,'' and I think we are seeing movement 
now in the place of----
    Senator Corzine. I compliment those initiatives because, in 
fact, best price is an important piece, but it only goes to the 
amount of transaction that is executed at the best price. You 
also have to look at, if you want to sell a thousand shares, 
but you can only do 100 shares at the best price, and by the 
time you get the second 900 shares executed, you get a lousy 
price for the balance of those, you may not have gotten, in 
total, the best price on how this happens. Has the Commission 
examined whether you could show the full book of bids in price 
order so that people would understand the depth, as well as the 
speed, of how you get to best prices?
    Chairman Donaldson. I would not say that the Commission has 
devised it. I would say that the Commission has done its very 
best to talk to everyone that thinks they have devised that 
thing.
    I think that there is a legitimate argument here for the 
institutional trader who says that, for me, the best price is 
not 100 shares that shows for me. It is the average price I get 
on executing a huge order, and therefore I have to go down 
until I get my whole order and that best execution is the 
average price I have on that whole order.
    There is a lot of legitimacy to that point of view, and I 
think----
    Senator Corzine. By the way, a lot of those institutional 
investors actually represent retail investors through mutual 
funds and pension funds.
    Chairman Donaldson. Well, you did not let me get to that. 
But I have difficulty, even in that instance, thinking that 
that one 100-share order that had the courage to post it, post 
a limit order, does not get executed. And let us say it is 
Senator Schumer's father there who posted that order, and all 
of a sudden transactions take place, and he had the best bid 
and did not get it.
    Senator Corzine. But is that not a technological issue 
about how you queue up to execute to a certain price to a limit 
order to accomplish----
    Chairman Donaldson. Yes. It gets very technical as to how 
you do that, and I think we have the seeds of operating outside 
of the electronic automatic capability. I think we have the 
seeds of allowing people to go into that market, into the slow 
market, and get the benefits of it.
    Senator Corzine. But if I understand this right, the opt 
out rule is designed so that potentially Senator Schumer's 
father's 100-share order does not get executed. That is the end 
result of it. The go to the size execution.
    Chairman Donaldson. Well, let me say that the dangers of 
opt out are that at least two people get hurt. They get hurt, 
the people who had the best bid and offer and the transaction 
is not done, it is opted out, and it is not done at that price. 
You are leaving a best bid on the books of a place like the New 
York Stock Exchange. That person is hurt. You have two sides of 
the trade and, in effect, to take it to back in days when I was 
active in the business, and when you were, you know, we used to 
talk about doing the trades in the closet, doing off-market in 
a closet and so forth.
    Electronics has changed a lot of that, but there are 
serious--serious, in my view--aspects to a random opt out, and 
I think we have to, if we still need it--and I think on the 
electronic side we are not going to need it I think we have to 
think very hard about what, if any, parameters or limitations 
we put on that.
    Senator Corzine. I am trying to be agnostic here, although 
I think the opt out rule sounds unfortunate because I would 
rather see a rule that takes into account the queuing, both on 
time and size, so that you could execute a total order, which 
is essentially what a block trade would be, with somebody 
outside the market, they pick a price that they think they can 
execute the overall transaction back through those exchanges.
    The opt out rule strikes me it has a lot of--I hate this 
term--unintended consequences about leaving out Chuck's father 
and not getting to the best price even for the institutional 
investor because you are leaving out some of those better-
priced bids and offers in computing the average. You are going 
to wherever the size is, which would be a very hard thing to I 
think justify after the fact, at least on person's point of 
view.
    So I think, again, fragmentation you believe we can 
accomplish by--I want to get this on--that the technological 
framework is there for the various marketplaces, people have to 
meet certain standards and questions about opt out, but 
acknowledging you need some balance with regard to the depth 
and size of markets. I am hearing the concern of the Commission 
with regard to making sure that depth is there as well.
    Chairman Donaldson. Again, what I was, I mean, it is 
possible now to send, as you know, to simultaneously deliver a 
whole batch of orders to the best markets all at once, 
electronically. The order delivery systems in many of the 
brokerage firms are such that they can blast multiple orders 
out electronically. And I think that solves a lot of the 
problems associated in a market trading system which is limping 
along.
    Senator Corzine. I know my time is up. Mr. Chairman, this 
is----
    Chairman Shelby. It is a very important issue.
    Senator Corzine. It absolutely is--tricky to a fault, 
though, because of sometimes best price and depth of execution 
are in conflict with each other, and we need both of those. 
When you asked about integrity----
    Chairman Shelby. Tell me, I know we have to vote, and the 
time is running--they are holding it for us--but the best price 
and execution and conflict, give us an example.
    Senator Corzine. Well, I go back to the thousand shares. 
The best price execution for a thousand shares might not 
reflect that. Chuck's father did not get the best execution on 
his 100 shares if you have opt out. So it strikes me that there 
is another algorithm that one wants to look for that takes in 
Chuck's father, but gets at the depth. Anyway. Good luck.
    [Laughter.]
    Chairman Shelby. Mr. Chairman, thank you for your 
appearance here today. We have to vote. Our time is running. We 
thank you. We are going to recess for a few minutes, let us go 
vote, and we will go back on the second panel.
    Thank you a lot.
    Chairman Donaldson. Glad to be here. Thank you.
    Chairman Shelby. We are in recess.
    [Recess.]
    Chairman Shelby. The hearing will come back to order, and 
if the second panel will take your seats. Most of you know this 
is the way the Senate operates. We were slow getting started 
today and will be here all night probably, but I hope we will 
not be here all afternoon.
    All of your written testimony will be made part of the 
record in its entirety. We have a lot of things going on in the 
Senate, as you know today, and everybody cannot be here, but 
their staffs will see and will review your testimony.
    We will start with you is it ``Greifeld?''
    Mr. Greifeld. Greifeld.
    Chairman Shelby. We will start with you, and if all of you 
could sum up your testimony in about 5 minutes or less, we 
would appreciate it very much. It will give us a chance to have 
a dialogue. Thank you.
    Mr. Greifeld.

                  STATEMENT OF ROBERT GREIFELD

             PRESIDENT AND CHIEF EXECUTIVE OFFICER

                   NASDAQ STOCK MARKET, INC.

    Mr. Greifeld. Thank you. I certainly have to go away from 
my prepared remarks because it says ``Chairman Shelby and 
Members of the Committee.'' So, Chairman Shelby, I certainly 
appreciate the opportunity to be here today and thanks for the 
invitation.
    Nasdaq is the pioneer of electronic trading. We started 
electronic trading 30 years ago. Today, the rest of the 
developed world has transitioned to the electronic model. The 
New York Stock Exchange is the only market that relies on the 
foot speed of its participants. I had a great opportunity to 
see the Olympic trials last weekend in Sacramento. The runners 
there were incredibly fast. I have been on the floor of the New 
York Stock Exchange. The brokers there are not so fast. The 
foot speed-based market exists because we have rules that have 
protected their monopoly position.
    Through the good work of Chairman Donaldson and the 
Commission we have Reg NMS. This represents a bold attempt to 
move the U.S. markets forward. Nasdaq is the model that the 
rest of the world has copied. How is Nasdaq performing for 
investors in this country? Companies that come to market are 
choosing Nasdaq as their market of choice two-thirds of the 
time. Most notable is the choice that Google recently made to 
list on Nasdaq.
    These companies have very good reasons to choose Nasdaq. In 
the S&P stocks, Nasdaq stocks have a spread of 1.17 cents 
compared to stocks on the New York Stock Exchange of 1.8. Our 
speed of execution is about 5 seconds versus theirs of 18. Our 
quality of execution, that is, how often we print at or inside 
the spread, is 92 percent compared to 82 percent. This data is 
derived from data mandated by the Securities and Exchange 
Commission. In addition, large companies on the Nasdaq Stock 
Market experience reduced volatility, as compared to the New 
York Stock Exchange when you measure that volatility by the 
midpoint of the quoted spread, which is the proper way to do 
it.
    Nasdaq is the standard that the world has copied, and we 
now see statements from New York that they also want to emulate 
our electronic market model.
    Now, when we think about Nasdaq, we realize that we do not 
have a trade-through rule on the Nasdaq Stock Market. Investors 
have prospered as a result of that. In attempting to fix the 
problems of the New York Stock Exchange, we should not impose a 
trade-through rule on the trading of Nasdaq stocks. Let us not 
fix what is not broken. The intention of Reg NMS is to 
modernize the New York Stock Exchange.
    As you read the comment letters of all of the interested 
parties, we see their arguments, their self-interests being 
elevated to the high moral ground. We also see clever turns of 
logic linking their institutions, their self-interests with the 
American flag.
    We also hear very clever turns of phrase, where competition 
is distorted through negative terms, meaning fragmentation or 
internalization. In the Nasdaq market, we have competition. The 
competition has been good for individual investors and 
institutional 
investors. My competition is here at this table today--Jerry 
and Ed, representing Arca and Instinet. I do not consider that 
fragmentation. I consider that competition that has resulted in 
a good outcome for investors.
    We also see during this debate self-interested parties 
adopting radical theories of how the sky will fall if their 
positions are not adopted. And as this Reg NMS process has gone 
on, we see increased self-importance from the commentators, we 
see increased aggression, and for those of us who were here at 
the last Congressional hearing in New York City, we see some 
general silliness that comes from the interested parties. 
Hopefully, we can all stay above that level today.
    But, in fact, if you do separate the rhetoric, the 
posturing, and the hyperbole, the real message is that the 
parties essentially agree on what our responsibilities are to 
investors. We must encourage and protect limit orders. We must 
provide access to best price. We must provide certainty of 
execution that comes with speed. In fact, this destination is 
not in dispute, and the road that we have to take to get there 
is actually not in dispute. We all agree that on this road, 
limit order protection, best price, and certainty through speed 
is important.
    We also agree that on this road there is a slow lane that 
investors can bypass by their choice. What we are really 
debating is whether investors in the middle lane of this three-
lane highway have the right to decide if they can opt out and 
travel with the fast cars in the left lane.
    When I think of this issue, I do not think of it in terms 
of trade-throughs or the opt out. I think of it in terms of a 
market-based approach or a rules-based approach, and I say that 
in the context of the fact that the SEC has complete and total 
regulatory control of our market. When we think about a rules-
based approach, we certainly see certain advantages, and when 
we think about a market-based approach we see other advantages.
    I have formed my opinion on this question through basically 
the years of experience I had running a technology business. I 
had customers for 14 years that were the institutional and 
professional traders. All these traders were concerned with the 
speed of the service that I provided to them. They expressed 
that concern through contractual requirements: One was I had 
certain customers request immediate right to cancel the 
contract if they were not happy with the service. The other 
type of customer wanted to specify in great detail what service 
level they wanted from the services that I provided.
    As I contemplated Reg NMS and this trade-through rule, I 
said how were my customers, over that 14-year period, best 
served? And it was clear to myself and everyone else involved, 
the customers that were best served were the customers that had 
the right to leave my service when they were dissatisfied with 
the service. The customers who had contractual protections were 
less covered by the contract since one can never contemplate 
every particular permutation or thing that might happen to 
impact that particular service.
    And when I think about what happened with my customers, 
those that had the right to walk away, we operated with a 
philosophy that the customer is always right. Those customers 
that had a long and detailed contract, we operated by the 
letter of the rule of the contract. Clearly, it is our opinion 
we are better off operating when the customer is always right.
    When I ran these technology businesses, I had 
responsibility for several hundred customers. Here, as the head 
of the Nasdaq Stock Market, we operate on a broader stage. It 
is of critical importance to millions of investors that we get 
this right.
    I am probably alone in stating that we could adopt a rules-
based approach or a market-based approach and get to the same 
destination to protect investors, for our fundamental job here, 
and we are chartered to this, is to find the best way to get 
there.
    Clearly, a market-based approach results in a higher 
standard and really the key fact we have to look at is Nasdaq 
has served as that laboratory. We do not have a trade-rule in 
the Nasdaq Market, and because of market forces people do not 
trade through. The New York Stock Exchange has a trade-through 
rule, but it is written in the rules. And as a result of that, 
people find a way around that, and they do trade through.
    A key point I also want to make is the time is long 
overdue. The electronic markets arrived in Europe and the Far 
East a decade ago. It is time for us to step forward and move 
forward with these decisions.
    Thank you.
    Chairman Shelby. Mr. Harris.

                  STATEMENT OF DAVID F. HARRIS

           SENIOR VICE PRESIDENT, STRATEGIC PLANNING

                  AMERICAN STOCK EXCHANGE, LLC

    Mr. Harris. Thank you, Chairman Shelby, and thank you for 
inviting the American Stock Exchange to appear before you to 
present our views on the important issues raised by Regulation 
NMS. Before I discuss our position on the SEC's trade-through 
proposal, let me briefly describe the unique place that the 
Amex holds in our equity markets.
    The Amex is the premier auction-based market for small- and 
mid-cap companies. These companies are headquartered across the 
United States and are diverse not only in their line of 
business, but also on how actively their securities trade. For 
example, while some of our listed stocks trade actively in the 
millions of shares a day, the stock of many other Amex-listed 
companies trade far less frequently, with 50,000 shares being 
considered a busy day.
    Over the last decade, the Amex has also created and 
nurtured many innovative financial products, including 
exchange-traded funds, commonly known as ETF's. An ETF is, in 
effect, a basket holding many securities which, while trading 
like an individual stock, is price-based on all of the 
underlying stocks in the basket. The Amex introduced the first 
ETF, known as the Spiders, 11 years ago, based on the S&P 500 
Index. Since then, ETF's have become a whole new class of 
securities, growing to more than $166 billion in assets. More 
than 90 percent of all ETF's are listed on the Amex, including 
two of the most actively traded securities in the world--the 
Spiders and the QQQ, which is based on the Nasdaq 100 Index.
    Why do small- and mid-cap companies and issuers of 
innovative financial products choose to list on the Amex? We 
believe, because of the level of service and support we provide 
to our issuers, as well as the unique benefits offered by our 
market structure, which, through our dedicated liquidity 
providers, is designed to maximize price discovery and a 
potential for price improvement.
    Of equal importance are dedicated liquidity providers who 
minimize price volatility caused by temporary order imbalances, 
in other words, the lack of natural price liquidity, by buying, 
using their own capital when there are not enough buyers and 
selling from their own inventory when there are not enough 
sellers. Thus, these dedicated liquidity providers are traders 
of last resort that moderate price movements until a natural 
price equilibrium is reached, where once again buyers and 
sellers can meet.
    Because of the diverse securities that list and trade on 
the Amex, some of which are actively traded, some of which are 
price based on underlying securities, but most of which are 
neither, we believe we can offer a unique perspective on market 
structure.
    Now, let me turn to the most controversial of the proposals 
contained in Regulation NMS, the trade-through proposal.
    For over 20 years, to facilitate best execution, provide 
nationwide price protection, and increase competition, 
securities listed on the Amex and the New York Stock Exchange 
have traded with a best-price guarantee. This is commonly known 
as trade-through protection. Trade-through protection simply 
prohibits one market from executing a trade at an inferior 
price when another market displays a better price for the same 
security.
    The Amex supports a proposal to extend trade-through 
protection beyond exchange-listed securities to all national 
market system stocks. For exchange-listed stocks, trade-through 
protection currently guarantees that all investors, large and 
small, novice and sophisticated, all obtain the best price 
regardless of the market or where those orders are sent.
    Equally important, trade-through protection encourages 
competitive price discovery across markets by ensuring that an 
investor who enters the national best-price limit order does 
not have his or her limit order ignored. Thus, we believe in a 
uniform trade-through rule, with the best price assurance it 
affords, provides critical investor protection and enhances 
investors' confidence in the fairness and integrity of the U.S. 
markets.
    As part of Regulation NMS, in addition to establishing 
uniform trade-through rule, the SEC also proposes creating two 
new exceptions to the trade-through rule, the first of which 
turns on whether a particular market or its quotes are 
automatically accessible.
    The SEC contends that this proposed exception is designed 
to reflect the comparative difficulty in accessing quotes from 
nonautomated markets and to adjust the trade-through 
requirements for those difficulties. We oppose the version of 
the exception that would allow all markets that are 
automatically accessible, so-called fast markets, to trade 
through better price quotations on markets that are not 
automatically accessible, referred to as slow markets.
    Regardless of whether the particular quote at issue is, in 
fact, readily accessible, we believe that the fast market/slow 
market dichotomy is overbroad and not sufficiently tailored to 
address the concerns about inaccessible quotes. However, the 
alternative version of the exception, which focuses on 
individual quotes rather than entire markets, appears more 
appropriately gauged to address the concerns about inaccessible 
quotes across different markets.
    Therefore, subject to an appropriate and responsible 
industrywide roll-out through a pilot program, we support a 
quote-by-quote exception that would allow a market participant 
to trade through, up to certain limits, the better priced, but 
inaccessible quote, of another market.
    We support a pilot program not only for public policy 
reasons, but also for practical considerations.
    First, the quote-by-quote approach recognizes that 
securities with different characteristics trade differently. We 
at the Amex know firsthand that actively traded securities 
trade differently than inactively traded securities. Thus, we 
believe focusing on quotes, rather than entire markets, allows 
more flexibility for market centers to compete, notwithstanding 
the different market structures that cater to different types 
of listed companies and securities.
    Second, the quote-by-quote approach lends itself more 
easily to responsible, industrywide roll-out, requiring 
immediate automatic accessibility of quotes as a precondition 
for trade-through protection is a dramatic industrywide change.
    In some regards, developing and implementing the relevant 
technology is the easy part. The more difficult challenge is to 
create an effective hybrid model that responsibly integrates 
automatic execution functionality into different types of 
market models.
    Further, one type of hybrid model may not be optimal for 
all equities. For example, the appropriate hybrid model for the 
most actively traded securities is unlikely to be the optimal 
model for the less-liquid securities which rely on price 
discovery. Therefore, we support phasing in the quote-by-quote 
exception, starting the most actively traded securities and 
progressively expanding the exemption to less-actively traded 
securities. Sequencing the implementation of a quote-by-quote 
exception provides two benefits:
    First, sequencing allows all market participants to make 
required technological and business model changes which are 
very substantial in terms of time and money.
    Second, of equal importance, industrywide phasing in of the 
exception would provide empirical evidence on whether the 
exception creates unintended consequences, such as increased 
spreads for illiquid securities, decreased execution quality or 
increased volatility and perceived disorder.
    Armed with empirical data, while phasing in a pilot 
program, would allow the Securities and Exchange Commission to 
respond to and adjust for any unanticipated consequences that 
might undermine investor confidence, increase the cost of 
capital, or discourage the development of innovative products.
    As to the second proposed exception to the trade-through 
rule, we have very serious concerns about and oppose the 
proposal to allow institutions and other traders to opt out of 
the best price protection offered by the trade-through rule. 
Under the current 
proposed opt out exception, institutions and traders wanting to 
sacrifice the best price for themselves or their customers 
could, but those trades would occur at the expense of other 
investors who, without their consent, would have had their 
better-priced limit orders passed over. Thus, in effect, the 
proposed opt out provision allows the interests of a small 
group of traders who prefer speed to trump the interests of the 
vast majority of investors who are most interested in receiving 
the best price.
    In any event, if the quote-by-quote exception to the trade-
through rule is adopted, we see no reason why anyone should be 
allowed to trade through an automatically accessible better 
price. To allow otherwise, risks creating a two-tiered, 
disorderly market, which we believe will undermine investors' 
confidence in our equity markets.
    In the coming weeks and months as the debate on market 
structure and proposed Regulation NMS continues, we urge 
remembering that the important and unique role option markets 
and their dedicated liquidity providers play in facilitating 
capital formation for the small- and mid-cap companies and in 
nurturing innovative financial products. In our view, when it 
comes to market structure, one size does not fit all. And when 
in doubt, the best price for the ultimate investor must trump 
all else.
    I will be honest. I am relatively new to the Amex, and so 
before I came I had never heard of the trade-through rule, and 
I found it very difficult conceptually to my hands around and 
understand what it is. So, for me, getting an example of what 
it actually means on an individual investor basis was critical. 
And so we picked a company that is listed on the Amex, which 
coincidentally is in Jasper, Alabama.
    Pinnacle Bancshares, and Pinnacle is a small company in 
Jasper, Alabama, that extends mortgage loans to retail 
customers, and yesterday, it was trading at $15.75.
    Chairman Shelby. I own none of it.
    [Laughter.]
    Mr. Harris. Then I will be the owner.
    Chairman Shelby. Okay.
    Mr. Harris. Let us say hypothetically, I have owned 
Pinnacle Bancshares for 5 years, and I think when the price 
reaches $17, it is time for me to sell. So I put in a limit 
order to sell Pinnacle Bancshares at $17. I am an ordinary 
person, so I am not watching my stocks every day. My limit 
order goes in, and lo and behold, Pinnacle Bancshares rises to 
$17, but I am not really paying attention.
    Theoretically, at a given moment, I am the best price to 
buy Pinnacle Bancshares, because I am the lowest-price seller. 
At that very moment, there is a person who is interested in 
buying Pinnacle Bancshares. But if there is no trade-through 
rule, that person can get executed at $17.03, at a price worse 
than I am willing to sell, and my price goes unexecuted.
    At the end of the day, when I log onto my computer, and I 
see the daily range for Pinnacle Bancshares, I think to myself, 
hey, it traded up to $17.03, and I should have been executed. 
So I go, and I check my brokerage account, and lo and behold, 
my limit order was not executed. And unfortunately for me, 
during the day, the price of Pinnacle fell back down to $16.75, 
so I missed out on my opportunity to trade, and I was a victim, 
because the trade-through rule did not protect me, and another 
person was cheated generally, because he paid more than he 
could have paid had there been a trade-through rule.
    And that, for me, kind of crystallized the danger here, and 
I heard the exchange that, you know, institutions are 
representing the mutual funds, and mutual funds are 
representing the people, but the reality is 52 percent of all 
order flow comes from retail customers, so this is not an 
unsizeable group of people. And if this occurs even 20 percent 
of the time, you know, very quickly, lots of people will be 
disadvantaged.
    Thank you.
    Chairman Shelby. Thank you.
    Mr. Nicoll.

                 STATEMENT OF EDWARD J. NICOLL

                   CEO, INSTINET GROUP, INC.

    Mr. Nicoll. Chairman Shelby, Ranking Member Sarbanes, thank 
you for having me.
    My name is Ed Nicoll. I am the CEO of Instinet Group. 
Through our affiliates, we provide sophisticated electronic 
trading solutions that allow buyers and sellers worldwide to 
trade securities directly and anonymously with each other, 
interact with global securities markets, have the opportunity 
to gain price improvement of their trades, and lower their 
overall trading costs.
    What I would like to do, if it is okay with the Committee, 
is to submit my original testimony to you in writing, and I 
would like to make some comments.
    Chairman Shelby. It will be made part of the record without 
objection, all of it.
    Mr. Nicoll. Thank you very much, Mr. Chairman.
    I just have to try and make a few comments about some of 
the points that have been made before me. I think it is 
extremely important to keep in the back of your mind that we do 
not have a trade-through rule in the Nasdaq marketplace. All of 
these parade of horribles do not occur in the Nasdaq 
marketplace. Let us talk about retail investors. The majority 
of retail orders today are in the Nasdaq marketplace, yet there 
is no trade-through protection in the Nasdaq marketplace.
    In the example that was just given by Mr. Harris, he 
supposes that somebody would deliberately pay more for an order 
than his offer. It is not in somebody's interest to pay more 
than his offer. As long as we have a rule which makes sure that 
his market is accessible and is transparent, and people see 
that there is an offer out there for $17, it does not make an 
awful lot of sense that somebody is going to pay $17.03 for an 
order when it is available to everybody at $17.
    There has been an awful lot of talk about protections of 
limit orders, and the SEC here says that this is paramount in 
their thinking; that we need to protect limit orders; and that 
a trade-through rule protects limit orders. But they make no 
necessary connection between those two statements. One would 
think if a trade-through rule protects limit orders, that we 
would have a lot more limit orders on the New York Stock 
Exchange than we have in the Nasdaq.
    Yet my facility, the INET Alternative Trading System, only 
accepts limit orders. That is it. We trade every day 25 percent 
of the Nasdaq. Today, we are the largest single pool of 
liquidity in Nasdaq. After Bob buys one of my competitors, we 
will be about the same size. But we only trade limit orders. I 
would think that the SEC, if they thought that the trade-
through rule protected limit orders and therefore incentivized 
people to place more limit orders in a market with a trade-
through rule than one without one that they would do some kind 
of empirical study to see how many limit orders are placed in 
the Nasdaq market versus how many limit orders are placed on 
the New York Stock Exchange.
    I am not aware of any study that has been done. The SEC has 
the power to fairly quickly aggregate, for instance, the number 
of retail orders that are placed in both markets and the 
percentage of limit orders to market orders. We can do this 
work. We can see if, in fact, there is any correlation between 
a trade-through rule and the protection of limit orders.
    If the logic is correct, ECN's should never have aggregated 
the volume that they did, because ECN's are limit order 
mechanisms. They aggregate limit orders; they display limit 
orders; and when they touch, they create a match and an 
execution in an ECN. ECN's advertise those limit orders within 
the Nasdaq marketplace, but there is no obligation for anybody 
to interact with those limit orders. Nobody has to come and 
take an order off of the INET ECN in Nasdaq. They can trade 
right through and go to a dealer if they want to, but they do 
not.
    Why do they not? Because markets work. People act in their 
self-interest. They buy at the best price that they can and 
they sell at the best price that they can. We rely upon these 
market forces everywhere else; yet, it is ironic that my 
competitors, who are at the heart of capitalism, do not believe 
that these market forces will work in the securities markets.
    And Nasdaq has shown that they do. We have evidence before 
us that we can look at, and we can see. The SEC's own mandated 
statistics show, as Bob just said, that Nasdaq markets actually 
have better statistics from the SEC's point of view than the 
listed marketplace. I am not here to say that one model is 
better than the other. In fact, our position is that the models 
should be free to compete. When you link these models together 
artificially; when you create a complex web of rules that is 
necessary to link these models together, they cannot compete. 
There is no reason to do that; there is every reason to believe 
that competition will shape the markets in accordance to the 
preferences of the consumers in the securities markets just 
like competition shapes markets elsewhere.
    Thank you.
    Chairman Shelby. Mr. Putnam.

                 STATEMENT OF GERALD D. PUTNAM

          CHAIRMAN AND CEO, ARCHIPELAGO HOLDINGS, LLC

    Mr. Putnam. Good afternoon, Chairman Shelby and Ranking 
Member Sarbanes. Thanks for having me here this afternoon.
    I am Chairman and CEO of the Archipelago Exchange. We are 
an all-electronic stock exchange. And I think I would just like 
to start that there have been a couple of things that have been 
said here today, and I will echo some of what Bob and Ed just 
mentioned. But one, the idea that fragmentation is a potential 
problem in the listed world. In the over-the-counter world, 
there are three of us today who compete head-to-head. We have 
great linkage; we do not have a trade-through problem, and 
through that linkage and competition, we have no fragmentation.
    The idea that liquidity is not as good on an electronic 
stock exchange as it is on a floor-based, manual exchange, the 
evidence simply is not there. There is actual proof to the 
contrary. When Enron announced its problems, the New York Stock 
Exchange stopped trading for about an hour and a half. The 
electronic markets continued to trade. There were not big gaps 
and spikes and distortions in the price of Enron stock; it 
continued to trade.
    For the most part, when you compare the two marketplaces, 
the electronic world is mature enough now that we find the 
liquidity in stocks on either platform is about the same. There 
is not a huge difference; there are maybe small differences in 
some places but not enough, I think, to decide to eliminate 
them.
    Finally, the idea that what happened on the New York Stock 
Exchange with its specialists could happen on ArcaEx, our 
exchange, is just simply untrue. That could not happen on our 
exchange. Somebody manipulating a stock order for their own 
benefit, it is not in the algorithm. You cannot stop it from 
trading to allow that to happen.
    Chairman Shelby. Why would it not happen?
    Mr. Putnam. Excuse me?
    Chairman Shelby. Why would that not happen?
    Mr. Putnam. Well, we have, as does Ed's system and also the 
Nasdaq Super Montage System, we have firm limit orders on our 
books. No one can actually get in the middle of the process, 
halt it with the intention or excuse of trying to find better 
prices, somehow inject themselves in front of the trade, put a 
piece of it in their own pocket, because it is a great trade at 
that moment in time, and then profit from it as the stock 
continues to trade.
    You cannot do that in our system. You cannot stop the 
algorithm. It is built into the computer. You cannot stop the 
trouble to front-run it, interposition it, any of those things. 
So the idea that that could happen on our system is simply 
untrue. We would have to program the computer in such a manner 
to allow that to happen.
    So, I think with that, the trade-through rule is certainly 
the big issue here. There are a couple of other things that are 
on the Reg NMS proposal that are worth mentioning. But as far 
as the trade-through proposal goes, I agree with my competitors 
on the OTC or Nasdaq trading world: We do not have one; things 
did not always work the way they did today in the OTC world, 
though. There were prices that were ignored. People backed away 
from quotes; they were not firm.
    Those things changed through competition, and we are in a 
great position there today. In the listed world, we have one 
very large competitor who is looking to change their model to 
become more electronic to respond to some competition they are 
facing, which is basically customers saying if you do not 
change it, we are going to quit using you.
    The New York Stock Exchange is basically, in my view, and I 
will let John speak, but I have read I think what is being 
proposed, and they have basically come around to our way of 
thinking. In 1997, we built a system that was designed to find 
customers the best price regardless of where that price 
existed, and that could have been in 300 different places in 
the Nasdaq world. Today, those things are all linked 
electronically, and we all, within our marketplace, obey one 
another's best prices.
    And we are in agreement. We would be willing to sign up for 
that deal today. If the NYSE would make quotes firm, we will 
respect all of their firm quotes. When they are not firm, which 
is this hybrid model, we will give customers the choice of 
skipping those quotes that are not firm, and I think that will 
work fine for us, and we will sign up for that today.
    There are two missing ingredients, however, from that 
proposal, and I think it addresses a lot of the concern that 
has been brought up in this room and that is the protection of 
customer limit orders beyond the NBBO. So in our world today, 
and actually, I have a chart, and these guys were making fun of 
me for bringing this chart along, but it may help.
    Chairman Shelby. Show it to us.
    Mr. Putnam. This is an example of our book in Nokia 
yesterday.
    Chairman Shelby. Eyes are not that good.
    Mr. Putnam. I am sorry.
    Chairman Shelby. Go ahead.
    Mr. Putnam. Okay; at 62 cents, we had 2,000 shares. At 64 
cents, 500; 10,000 at 65; and on up 6 cents. At up to 68 cents, 
there were a total of 35,000 shares here. The current trade-
through rule protects the 62-cent offer on the 2,000 shares; 
then leaves our competitors free in the listed world to trade 
at higher prices and skip the other 33,000 shares up 6 cents.
    Our proposal would be to take this concept of firm markets 
and that we will all respect one another's firm markets but 
also respect them beyond the NBBO. So when you take out that 
best price, and there is another price that is better just 
above it, well, respect that one, too. All the quotes on our 
system are firm. What is going to happen here under this 
proposal is that best price is going to get taken out. Then, 
the specialist is going to go put a trade on 10 cents higher, 
ignore Senator Schumer's dad's order up a penny and the next 
one after that and the next one after that; stick it in their 
pocket for their own account; and then come back in and scoop 
those prices on our system.
    And they will make that profit, the difference where that 
print went on and where the other prices were made available. 
Our view at Archipelago is to include all the firm prices, not 
just the one of 100 shares but the next one and the next one 
after that, and we would sign up for that deal today.
    The second thing that I think is missing here, and John, 
you have come into this late in the game, but we have suffered 
through this for years. Someone go back to the floor of the New 
York Stock Exchange and ask those guys, since it is so critical 
to the business model, and it is so important that limit orders 
are protected, to quit trading through our electronic limit 
orders every day.
    It happens every day. In the 30 years this rule has been 
around, I do not believe that the New York Stock Exchange has 
ever once punished a specialist for violating another market's 
best price. It happens to us about 1,100 times a day. So if 
someone would go back, go to the floor and say stop it, or we 
are going to fine you. I mean, it is like having the State 
trooper pull you over and saying, you know, because one of the 
excuses is that we are so busy, we cannot get to all those 
prices.
    Well, it is like saying I was too busy driving my car 125 
miles an hour to obey the 65-mile-an-hour speed limit. Enforce 
the rule and show that you really care about it, and then, we 
would accept this proposal as-is and move on with our business.
    Thank you.
    Chairman Shelby. Mr. Thain.

                   STATEMENT OF JOHN A. THAIN

               CEO, NEW YORK STOCK EXCHANGE, INC.

    Mr. Thain.Thank you. Chairman Shelby, Ranking Member 
Sarbanes, I appreciate the opportunity to present our views on 
proposed Reg NMS.
    We believe that the SEC has done an excellent job in 
setting forth a comprehensive proposal. And Chairman Donaldson, 
I think, sets the right challenges for all of us in this panel 
by emphasizing protecting the public good and preserving the 
competitive strengths of our capital markets. Our goal should 
not be a victory for one market over another, but rather, we 
should find a way for competition among markets to create the 
best possible national market system for all investors, for 
issuers, and for our economy. A fractured market that betrays 
the interests of investors, that puts U.S. capital market 
leadership at risk, would not be a victory, and it would be a 
loss for America.
    Building a better national market begins with core 
principles that have served the needs of all investors and have 
enabled the U.S. markets to become the world's best. The most 
important of these principles are that customers' interests 
must come before those of intermediaries and that every order 
should have the opportunity to receive the best price. For that 
reason, we are gratified that the SEC has maintained the trade-
through rule or best price rule as the centerpiece of its 
proposed NMS.
    Now, Chairman Shelby, you asked why is the trade-through 
rule so important? You have heard a little bit of this, but I 
will give you four reasons.
    Chairman Shelby. Sure.
    Mr. Thain. First, it protects investors by ensuring that 
they can continue to buy or sell their shares at the best price 
available in the national market system. Second, it ensures 
that investors who place limit orders in the market and 
continue to provide that liquidity to the marketplace will not 
be ignored. This means that the small investors, Chuck's 
father, can compete on an equal footing with large 
institutions. Third, it improves transparency and price 
discovery by ensuring that stocks are priced at their true 
value. And finally, because it deepens the liquidity, and it 
strengthens capital formation by increasing investor confidence 
in the fairness of the market, and confident investors are more 
likely to maintain and to increase their limit orders and their 
participation in the marketplace.
    The trade-through rule and the continuous auction process 
also serves the interests of listed companies through reduced 
volatility. When the New York Stock Exchange surveyed the chief 
executives and the senior officers of 400 of our listed 
companies, by far the most important factor in choosing a 
trading venue was market quality. And by far the most important 
determinant of market quality was reduced volatility.
    Over the past 2 years, 51 companies have moved their 
listing from Nasdaq to the New York Stock Exchange. The intra-
day volatility of those companies' stocks fell, on average, by 
50 percent. Now, while best price execution must remain the 
overriding principle, we recognize that speed is also important 
to certain customers, and we are listening to those customers. 
We will offer our customers the ability to trade 
electronically, quickly, and with anonymity.
    As someone who has spent 25 years at the crossroads of 
technology and finance, I enthusiastically embrace 
opportunities to enhance the speed and the efficiency of 
trading. But at the same time, we want to retain for our 
customers the advantages of the auction market, where floor 
brokers and specialists add judgment, add liquidity, and 
improve prices moment to moment on the floor of the New York 
Stock Exchange.
    The market capitalization of the companies traded on the 
New York Stock Exchange is over $17 trillion. The next-largest 
competitor is about $3 trillion. We trade on average 1.5 
billion shares a day. We offer the most liquidity, the best 
prices in our listed stocks over 90 percent of the time and the 
lowest execution costs.
    We believe the solution is to marry the best of both 
worlds, which is what we are intending to do. Once execution 
speeds are comparable, there is no justification for opting 
out, no justification for overcharging customers, no 
justification for giving every investor anything less than the 
best price. So the operating rule for investor protection 
should always be let the best price win.
    The position we have articulated is one of sound public 
policy that has been endorsed by a wide range of investors and 
investor groups representing millions of investors and 
trillions of investable dollars. Just to cite a few, the AARP, 
as Senator Schumer said, whose members believed two to one that 
best price should be a top priority; CIEBA, the Committee on 
Investment of Employee Benefit Assets, which represents large 
corporate pension plans; ICI, the Investment Company Institute; 
and the CFA, the Consumer Federation of America.
    Now, some have asserted that the trade-through rule is a 
barrier to competition. In fact, the opposite is true. Markets 
are more efficient, more robust, and more competitive today 
than they have ever been before. Over the last year, the 
average spread of the national best bid and best offer on the 
93 New York Stock Exchange stocks listed on the S&P 100 Index 
has narrowed from about 5 cents to 2 cents.
    Those who lobby to remove the investor protection provided 
by the trade-through rule are doing so because they have not 
been competitive in attracting order flow. They do not offer 
competitive prices. That is why they are asking the SEC to put 
their marketplace ahead of market principles. That is why they 
are asking to put their personal interests ahead of investor 
interests. It is imperative that the SEC not allow the best 
interests of investors to be ignored. The opt out exception 
contained in the SEC's proposal should be eliminated.
    At a time when our Nation is tightening rules on mutual 
funds, late trading, market timing and corporate governance, 
intermediaries should not be permitted to run roughshod over 
longstanding rules that ensure fair and honest markets. To do 
so would be an invitation for future problems, to improper 
trading by intermediaries that harms investors, such as 
internalization; that harms competitiveness of U.S. markets 
through fragmentation; and ultimately would harm the health and 
well-being of our economy.
    We can best serve the public good by strengthening 
competition among our markets to create a superior national 
market system that is based upon the standards of best price 
and putting the interests of investors first. These are the 
principles that have made the U.S. securities markets the 
largest, most liquid, and most vibrant in the world, and we at 
the New York Stock Exchange are committed to working with you 
and the SEC to ensure that U.S. markets continue to maintain 
their position in the 21st century.
    Thank you.
    Chairman Shelby. Thank you.
    We will start with you, Mr. Thain, from right to left. Just 
briefly, would you describe the most important attribute of the 
market structure under which your particular market center 
operates?
    Mr. Thain. We provide the most liquidity, the best prices, 
and the least volatility in the trading of our stocks and the 
most efficient trading in terms of lowest cost of trading 
impact.
    Chairman Shelby. Mr. Putnam, what is your strongest 
attribute of the market that you operate?
    Mr. Putnam. We protect limit orders within our system, so 
all limit orders that sit in our system are available and 
accessible immediately and electronically without any human 
intervention.
    Chairman Shelby. Integrity, another one?
    Mr. Putnam. I think that is integrity, right? I mean, 
integrity of the quote. Knowing that it is real when you see 
it. You know what you are going to get when you show up, 
because there is a computer program that executes an order the 
same way every single time. It is that certainty and speed at 
which we respond to the other customers' orders.
    Chairman Shelby. Mr. Nicoll, is it similar?
    Mr. Nicoll. Yes, I would say it is transparency and 
fairness. In an electronic market, which everybody can see and 
have access to; everybody gets the same information at the same 
time and can interact with that information on an equal 
footing, whereas, in a floor-based market, the people down on 
the floor have an advantage over those who are upstairs.
    Chairman Shelby. Mr. Harris.
    Mr. Harris. It is a market that cares to small- and mid-cap 
companies and innovative products. I would say price discovery 
and reduction of volatility.
    Chairman Shelby. Mr. Greifeld.
    Mr. Greifeld. Definitely choice and competition. If I can 
just read one quote from Bob Pisani, who was talking after the 
Martha Stewart announcement was made, and this was from CNBC, 
he said there was a small crowd of traders gathered around the 
site--this is on the floor of the New York Stock Exchange.
    When you see floor brokers, that is a sign of institutional 
interest. The floor of the New York Stock Exchange, the basic 
fabric of that exchange 211 years ago, was built for the large 
person, for the large institutional investors. The Nasdaq model 
is about choice and competition, and individual investors are 
the beneficiary.
    Chairman Shelby. How does the Frankfurt exchange work, Mr. 
Putnam?
    Mr. Putnam. It is all electronic.
    Chairman Shelby. I thought it was. Nothing else?
    Mr. Putnam. No.
    Chairman Shelby. And how long has it been that way?
    Mr. Putnam. Probably 5 or more years. I am not certain, 
between 5 and 10.
    Chairman Shelby. What about the London exchange?
    Mr. Putnam. Same, but that is more recent than Frankfurt. 
That is probably in the last 6 or 7 years.
    Chairman Shelby. How will the SEC's proposed amendments to 
the trade-through impact your companies in our national 
securities markets? How will the opt out and fast market 
exceptions operate in the marketplace?
    Mr. Greifeld. Well, this is about introducing efficiency in 
the trading of stocks it lists. It is my personal opinion that 
80 percent market share in any market whether it is soda or 
trading of stocks, is not healthy. And we certainly believe 
that the specialist scandal is a result of not having enough 
competition.
    That lack of competition results in inefficiencies in the 
capital-raising process. And we need to make sure that this 
process is as efficient as possible and allow more investors to 
have a fair shake at investing in this country.
    Chairman Shelby. Mr. Harris.
    Mr. Harris. Generally, most of the provisions in Regulation 
NMS are going to improve our market. We recognize the need, 
that our market, which is an auction-based market, needs to 
have quicker executions in an automated way. At the same time, 
we need to be very careful on how we meld the services that our 
liquidity providers provide without fully losing them in an 
electronic environment.
    Chairman Shelby. Mr. Nicoll.
    Mr. Nicoll. I actually fear that many of the provisions of 
NMS are going to hamstring our ability to compete. We think 
what we need is to look at the models that exist today in both 
the listed and the Nasdaq environment and choose the best of 
those. And quite honestly, we think that if we are going to 
have a trade-through rule applying to Nasdaq that at the very 
least, we need an effective opt out in order to be competitive.
    Chairman Shelby. Mr. Putnam.
    Mr. Putnam. I think with regards to the trade-through rule 
and the NYSE's proposal, we can live with that and actually 
do----
    Chairman Shelby. How about the fast quote proposal?
    Mr. Putnam. Fast quote, and that is what I am speaking 
about, if they make fast quotes available and obvious to us, 
then, we have no problem with that. I do think you have to ask 
the question here today, though, when the New York Stock 
Exchange says it is all about protecting customer limit orders, 
do they intend to protect those limit orders that are at the 
next best price and the next best price?
    This plan does not call for that, so a lot of passion 
exists over the concept of best price, but this plan does not 
take care of that. One other aspect of Reg NMS that we have an 
issue with is the market access fees, and our view there is 
that we do not need Government ratemaking. This is a rare 
instance where Instinet, Nasdaq, Arca, and the New York Stock 
Exchange all agree we do not need any Government ratemaking 
here, so we think that aspect of proposed regulation NMS should 
not be part of the final rule.
    Chairman Shelby. Let the market do it?
    Mr. Putnam. You heard Chairman Donaldson talking earlier 
about how competitive the prices were and how pricing has come 
way down. I do not know why we need to throw a little 
ratemaking on top of that. We are already almost at zero.
    Chairman Shelby. Mr. Thain.
    Mr. Thain. We are supportive of the SEC's fast quote-slow 
quote proposal. We believe the opt out is not good public 
policy.
    Chairman Shelby. What about the SEC's proposal for 
reallocating market revenues? Is this a fair allocation 
formula? In other words, the fees that market centers charge 
for the data, how are these fees calculated? Who wants to take 
that?
    Mr. Greifeld. We believe that the Reg NMS proposal with 
respect to market data misses the mark. The issue is not really 
about reallocation; it is a question of how you determine the 
pool that gets shared. This pool was established by Nasdaq 20 
years ago in the trading of our stocks, and the price for that 
pool is not set by any market forces. It is our position that 
we should minimize the data that is subject to this sharing 
pool, and it should be data that is clearly in the common good.
    And that data would basically be the national best bid and 
offer. The rest of the data should be subject to competitive 
forces and let the market determine what the prices are. And 
when we talk about the allocation, that will obviously reduce 
the pool, but the allocation should be on shares traded, and 
that is the least gameable of the different points that you can 
choose to use as a formulation.
    Chairman Shelby. Mr. Thain, how do you respond to the 
contention that was made by Mr. Putnam that specialists trade 
through electronic orders, you know, 1,000 times or more a day?
    Mr. Thain. It requires an explanation of how the trade-
through rule actually works. What the trade-through rule says 
is if you trade through a better bid or a better offer, you 
must satisfy the person who you traded through.
    Chairman Shelby. What does that mean, satisfy?
    Mr. Thain. Satisfy means that you have to make them good at 
the price that they were willing to buy or to sell. And so, 
there are trade-throughs that occur, primarily because the 
linkages between the markets are not sufficient. And the New 
York Stock Exchange has a policy and does, in fact, make good 
on any legitimate trade-throughs.
    Chairman Shelby. Mr. Putnam, you have a comment?
    Mr. Putnam. Yes, the 1,000-plus trade-throughs that we 
complain about a day are ones that have not been satisfied and 
that did take into account the slowness of the NYSE's system. 
So we wait for 8 seconds before we--the order has been on our 
system for 8 seconds before we would look at it as a possible 
trade-through. It still has to be there 8 seconds after it was 
traded through. And then, once those two conditions are set--8 
and 8 is a pretty good amount of time; even though systems can 
be slow, that is a pretty good amount of time.
    Those orders are still traded through. The satisfaction 
only comes if you get on the telephone and spend 20 minutes 
arguing about it, and sometimes, the order shows up; other 
times, it does not. The way our system works is when we see a 
better price on the New York Stock Exchange than what our 
customer could find on our system, we send an order to the New 
York Stock Exchange at that best price and then move on and 
continue trading.
    That is not the way it works at the New York Stock 
Exchange, and it is violated in excess of 1,000 times a day.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Mr. Chairman, I have another engagement, 
but I will just ask a couple of questions.
    First, does anyone at the table disagree with the view that 
was expressed when Chairman Donaldson was here that the SEC has 
had a very open, forthcoming process for examining this issue, 
or does anyone feel that they have not done what they should 
have done in terms of gathering information and giving people 
an opportunity to be heard? Can I hear from each of you on that 
point?
    Mr. Thain. No, I think the SEC has done an excellent job.
    Mr. Putnam. They have done a fabulous job. We have been 
heard, and we think everyone else has had a chance to be heard 
as well.
    Mr. Nicoll. I certainly agree with that.
    Mr. Harris. I do, too.
    Mr. Greifeld. The process has been fair and open.
    Senator Sarbanes. Okay; very good.
    Mr. Thain, I would like to ask you, the New York Stock 
Exchange, I take it, is the first line of defense in dealing 
with the practices of the specialist firms. Am I correct in 
that regard?
    Mr. Thain. Yes.
    Senator Sarbanes. And the SEC is, as it were, a backup to 
that or an overseer to that, or how would you describe that 
relationship?
    Mr. Thain. Yes, the SEC has oversight of the New York Stock 
Exchange.
    Senator Sarbanes. Now, what changes has the New York Stock 
Exchange put into place following this March settlement of SEC 
enforcement actions for about a quarter of a billion dollars to 
prevent future abuses and to enhance the ability of its 
regulatory function to prevent misconduct?
    Mr. Thain. Thank you. There have been quite a number of 
changes at the New York Stock Exchange really over the last 
year. As everyone knows, we have a new chairman. We also have 
almost an entirely new board of directors. We also have a new 
structure, whereby the regulatory functions have been separated 
from the business functions of the exchange. I, as the CEO of 
the New York Stock Exchange, run the business side, and Rick 
Ketcham, who is new, who is our Chief Regulatory Officer, has 
the regulatory side. So we have separated the business of the 
Exchange from the regulatory functions of the Exchange.
    Those regulatory functions run by Rick Ketcham report up to 
a subcommittee of the board of directors that is chaired by 
Marsh Carter which is also totally independent directors and 
then ultimately up to the board itself. This structure, the 
separation of the regulatory functions from the business of the 
exchange was approved unanimously by the SEC in December.
    Senator Sarbanes. Well, that describes the structure. But 
what substantive changes have been instituted to address this 
question with respect to the specialty firms that resulted in 
this major settlement?
    Mr. Thain. Besides a complete revamp of the leadership of 
the regulatory side and the replacement of those individuals 
responsible for the enforcement part of the Exchange's 
regulatory side, we have also invested substantially in the 
system's capability to monitor the behavior of the specialists. 
And so, the most egregious forms of behavior of the 
specialists, the computer systems no longer would allow to 
happen, and we are spending a substantial amount of funds both 
on the system side and on the people side to enhance the 
enforcement capability.
    Just to give you an idea, of the 1,500 employees of the New 
York Stock Exchange, 500 work in the regulatory and enforcement 
side.
    Senator Sarbanes. I would say to the other members of the 
panel, Mr. Thain in his statement says this is no time to put 
personal interests ahead of investor interests. What is your 
response to that in terms of your activities, whether they, in 
fact, put personal interests ahead of investor interests? I 
mean, what do you make of that argument?
    Mr. Greifeld. I think Mr. Thain was taking a position as if 
we had substantial differences. As I said in my testimony, we 
certainly believe that limit order protection is paramount. We 
believe individual investors have to be protected, and we 
believe that best price is of particular importance. Our 
difference is not on those items. Our difference is in how to 
get there. We fundamentally believe an opt out represents 
market forces that allow competitors to compete and make sure 
investors are well taken care of.
    If you go with a rules-based approach, you are subject to 
gaming. We have very smart people at this table and very smart 
people in this industry. And if the rule is not perfectly cast, 
there are gaming opportunities that exist. If you have a 
market-based approach, you have to respect the customer's 
wishes. If you have a rules-based approach you have to figure 
out how to work within the construct of the rule.
    Senator Sarbanes. Does anyone else want to add?
    Mr. Putnam. I would; I mean, certainly, our view is 
protection of investors and not personal interest, and no one 
else has asked the question, so I will: Does the New York Stock 
Exchange plan call for protecting limit orders on competitors' 
systems beyond the NBBO? Will the NYSE protect firm orders 
through depth of book under that plan and in a competitor's 
marketplace?
    Mr. Thain. As Mr. Putnam knows very well, there is no 
protection anywhere in the marketplace on anyone's system other 
than at the best bid or the best offer. So there is neither 
protection for better limit orders on the floor of the 
Exchange, which, of course, also exists, nor is there any 
protection in any of the market linkages.
    Mr. Nicoll. If I can just add, we clearly have been 
consistent in our position. We believe in competition. 
Competition has been very difficult for Instinet. Instinet, 
through competition, has seen its revenue capture in its ECN go 
from $3 for every 1,000 shares that it trades 3 years ago to 
under 40 cents today.
    The biggest beneficiaries of competition are always the 
consumers, not the producers, and we have seen rigorous 
competition in our marketplace to the detriment of our bottom 
line. But we very much believe that competition is in the best 
interests of the consumers. This debate that just played out, 
it is a very interesting one. There are lots of difficulties 
here in connecting these marketplaces in a way that is fair.
    Only the best bid and offer is ever shown. So if we are 
going to require somebody go to the highest, best bid and 
offer, but we are not going to require them to honor the better 
priced limit orders beyond the best bid and offer, then, we are 
going to create enormous gaming opportunities for people to 
show small, little bids and offers at the highest price and the 
fill the balance of the orders at prices which are much worse 
than that which is shown.
    We could have a system which Jerry is talking about where 
when we go to one exchange, and we hit the highest bid, we then 
stop the trading and look around and see, okay, now, who is the 
next-highest bid? Now, let me go out to Archipelago. Let me 
execute that portion of my order at Archipelago. Right now, the 
New York Stock Exchange is now the best bid; let me turn around 
and go back to the New York Stock Exchange.
    These are very difficult questions. When you try and 
connect these markets through a rule-based approach, as Bob 
said, they are very gameable; they are very complex. And as 
Senator Corzine said, it is a very difficult task. But there is 
actually an easy and a clean solution, and it is to rely upon 
competition. Competition works; it has played out in the Nasdaq 
marketplace to the consumer's benefit, to the investor's 
benefit.
    I do not believe your offices or the SEC is getting 
enormous complaints from people in placing limit orders in the 
Nasdaq marketplace from being traded through. They are not. And 
with respect to fragmentation, if I can just one, your 
indulgence on one last point: Fragmentation is not the fact, 
does not occur because trading occurs in different venues. 
Fragmentation occurs when those different venues create 
inefficiencies because people trade at inferior prices in one 
venue, because they get trapped in one venue, and they cannot 
see that there is a better price in another venue.
    When, through technology and communications, we can show 
all of the marketplaces simultaneously, and people can see 
where the liquidity is and where the best prices are, it does 
not matter that a third is traded in one place, and a third is 
traded in another place, as long as it is accessible, and the 
people can see those prices, and they can choose to go where 
the best price is.
    So in a marketplace we have today, through technology, we 
can eliminate much of the down side of so-called 
``fragmentation,'' and we think that the better public policy 
is to let these markets compete. Investors and consumers will 
benefit from that competition.
    Mr. Greifeld. The one thing that I will add is when we 
compete, we are still under the watchful eye of the SEC. This 
is not unfettered market competition. We all are subject to 
their regulation, and we are well-regulated. So we want to 
compete within that construct.
    Mr. Nicoll. I agree.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. I want to thank all of you. I think this 
has been an interesting hearing. I am sorry it was delayed, and 
you had to go into the early afternoon. We learned something 
from the hearing.
    Thank you. The hearing is adjourned.
    [Whereupon, at 1:13 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR JIM BUNNING

    I would like to welcome Chairman Donaldson and all of our witnesses 
here today. I applaud the Chairman Shelby for holding this very 
important hearing on the proposed new market structure or NMS rules 
that will govern our equities markets.
    Our equities markets or the envy of the world. It is important we 
maintain our market superiority. Access to capital is one of the major 
reasons America has always been the land of opportunity. Our markets 
have been a big reason why American businesses can access capital. We 
cannot lose that.
    But we also must ensure our markets move forward to compete in the 
global marketplace. We must incorporate new technology to ensure our 
markets are more efficient. The speed of trades is now becoming almost 
as important as price. And surety of execution might be more important 
than both speed and price. The importance of speed and execution have 
led to the tremendous in growth in our electronic markets. Our 
electronic markets, first with the Nasdaq and then with the ECN's have 
dramatically changed the landscape of investing. More and more 
individual investors are online checking their accounts. The 
competition in our electronic markets is intense and has brought down 
the cost per trade dramatically. Our auction markets, have not 
responded as quickly to change, but are now headed in that direction.
    The rule the Commission has put out for comment is pretty 
controversial. I think it has upset all sides of this debate. That may 
not be a bad thing. I am not sure the NYSE, for instance, would be 
moving so aggressively to implement technology if it were not for your 
proposed rule. And that may have been the Commissions's intent.
    I know you have received many comments on the NMS rule. I hope you 
will look at them fairly and open-mindedly. I do not believe you did so 
on the mutual fund rule. When you testified before us on the highly 
controversial mutual fund rule, a number of my colleagues on both sides 
of the aisle expressed their strong reservations to the independent 
chairman rule. But it was obvious, Mr. Chairman, that your mind was 
made up long before you came into the hearing. I hope will do not have 
a repeat of that on the NMS rule.
    This is a very important rule before the Commission today. I look 
forward to hearing from all of our witnesses and getting their opinions 
and expertise on the question facing us.
    Thank you Mr. Chairman.

                               ----------
               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                             July 21, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today on proposals to 
modernize the national market system for equity securities. I welcome 
your continuing interest in an issue of such vital importance to 
investors and the economy. The national market system encompasses the 
stocks of more than 5,000 companies, which collectively represent more 
than $15 trillion in market capitalization. The Commission is committed 
to promoting the fairest and most efficient markets possible for these 
securities.
    Since I appeared before you last October to discuss the state of 
the national market system, the Commission has made a great deal of 
progress. In February, we published for public comment Regulation NMS--
a broad set of proposals designed to improve the regulatory structure 
of the U.S. equity markets. In April, we held public hearings on the 
proposals, then followed up in May by publishing a supplemental request 
for comment to reflect a number of important matters discussed at the 
public hearing. In addition, the comment period was extended until June 
30 to give the public ample opportunity to prepare their views.
    Consequently, this Committee's hearings on the national market 
system are particularly timely. Your consultation and oversight will 
make an indispensable contribution to the Commission's efforts as it 
moves forward in the rulemaking process. With your help, I am confident 
that we will succeed in our efforts to assure that the equity markets 
continue to meet the needs of investors and public companies.

National Market System Principles
    The Regulation NMS proposals encompass four substantive areas--
trade-throughs, market access, sub-penny quoting, and market data. 
Today, I intend to give an overview of the proposals, as well as offer 
a few thoughts on the Commission's road forward. First, however, I 
would like to take a broader view of the market structure issues facing 
the Commission, as well as the policy objectives that the proposals are 
intended to achieve.
    When assessing the current state of the national market system, the 
starting point is to recognize just how well it works overall. The 
system needs to be modernized, but it is far from broken. The U.S. 
equity markets have never been more fair and efficient for such a broad 
spectrum of investors than they are today. Since the national market 
system was created, investor trading costs have steadily declined. Not 
surprisingly, as trading costs have declined, the volume of trading has 
climbed inexorably upward. Indeed, our markets now routinely handle 
trading volumes that would have been nearly unimaginable just a decade 
ago. These are telling indicators of markets that are vibrant and 
healthy.
    With all this success, inevitably, come problems. In the past few 
years, in particular, a remarkable confluence of forces has strained 
the existing components of the national market system. These forces 
have included technology advances, of course, but also the arrival of 
entirely new securities products and trading strategies. These include 
derivative products such as exchange-traded funds, which generate 
enormous trading volumes, as well as program trading in large baskets 
of stocks and statistical arbitrage trading. Moreover, the commencement 
of decimal trading in 2001 further transformed the equity markets. The 
number of quote updates exploded, and the quoted size at any particular 
price level dropped. Investors adopted new tactics to deal with the 
changed trading environment and found that they needed new trading 
tools to implement these tactics. In particular, investors have adopted 
automated order routing strategies that require exceptionally fast 
execution and response times from the markets. Finally, a variety of 
new, electronic markets have arisen that offer innovative trading 
mechanisms designed to meet the needs of those using the new securities 
products and trading strategies.
    The proliferation of fast, electronic markets simultaneously 
trading the same stocks as slower, manual floor-based exchanges has 
complicated the task of making sure that an investor order receives 
best execution. The Commission's challenge is to craft rules that 
reconcile different trading models without sacrificing the fundamental 
principle of assuring the best execution for investor orders. I believe 
this creates the conditions under which an investor can achieve the 
best available price.
    In sum, the national market system needs to be modernized, not 
because it has failed investors, but because it has been so successful 
in promoting growth, efficiency, and innovation that many of its old 
rules now are outdated. Identifying and improving these outdated rules 
is the ultimate goal of the Regulation NMS proposals. To this end, the 
Commission has engaged in an exceptionally open and interactive 
process. It has actively sought out the views of a wide range of market 
participants. There are few areas of securities regulation in which the 
considered views of practitioners are more needed than market 
structure. When the Commission published the Regulation NMS proposals 
for public comment, it fully expected that the proposals would be 
revised and improved after hearing the views of commenters. Indeed, the 
public hearing on Regulation NMS in April produced such valuable 
suggestions for improvements that the Commission published a 
supplemental request for comment to incorporate these suggestions. This 
process is continuing. I fully expect that our review of the comment 
letters will promote additional improvements in the proposals as the 
Commission moves forward in the rulemaking process.
    This process will be guided by those fundamental principles for the 
national market system that were established by Congress in 1975 and 
have guided the Commission over the years. Although the particular 
rules and facilities that implement these principles may be in need of 
updating, I believe that the principles themselves remain as valid as 
ever. In particular, the Commission has always sought to achieve the 
benefits of competition, while countering the negative effects of 
fragmentation from trading in multiple markets. The national market 
system has promoted the wide availability of market data so that 
investors can determine the best prices, ready access among markets to 
obtain those prices, protection of investor limit orders, and the duty 
of brokers to obtain best execution for their customer orders.
    I particularly want to emphasize the importance of price protection 
and encouraging the display of investor limit orders. These orders 
typically represent the best displayed prices in a stock. They 
therefore are a critical source of public price discovery that is 
essential to the efficient operation of the markets. Competition among 
markets is a vital aspect of efficient markets, but we must also assure 
vigorous competition among the orders of buyers and sellers in a stock. 
If investor limit orders are neglected and trades occur at inferior 
prices without good reason, I believe that it harms both the particular 
investors involved and the integrity of the markets as a whole. Small 
investors justifiably may not understand why their order is by-passed 
by trading in other markets. But many of the largest institutional 
investors also have stressed to the Commission that they believe 
enhanced protection of investor limit orders is one of the weaknesses 
in the current national market system that needs to be addressed. Each 
of the Regulation NMS proposals is intended in large part to achieve 
this vital objective.

The Regulation NMS Proposals
    The Commission is in the midst of extensive rulemaking process for 
its Regulation NMS proposals. This process has included a public 
hearing, a supplemental request for comment to reflect the topics 
raised at the hearing, and the extension of an already long comment 
period. Even prior to publishing the specific rule proposals in 
February, the Commission repeatedly sought the views of market 
participants and the public. It held multiple public hearings and 
roundtables, established an Advisory Committee on market data, and 
issued four concept releases on a variety of NMS issues. The Commission 
used the information and data gathered by these steps to form the basis 
of its NMS proposals. These proposals encompass four substantive 
areas--trade-throughs, market access, sub-penny quoting, and market 
data.

Trade-Through Proposal
    The trade-through proposal has thus far garnered the most 
attention. It would, for the first time, establish a uniform trade-
through rule for all NMS stocks. The rule would protect the best 
displayed quotes in a stock from trades at inferior prices. It is 
intended to encourage the placement of investor limit orders, which 
often provide the best displayed prices, as well as to promote the best 
execution of investor orders. As a uniform rule, it would cover both 
exchange-listed stocks, which are governed by an existing SRO trade-
through rule, and Nasdaq stocks, which have never been subject to a 
trade-through rule.
    I will briefly review the proposal's application to each type of 
stock, but first want to emphasize a more general point. Some have 
debated the trade-through proposal as if it were a kind of referendum 
on the merits of exchange auction markets versus fully electronic 
markets. I do not approach the issue in these narrow terms. The 
Commission's goal is neither to reward nor punish any particular type 
of market mechanism. Instead, the trade-through proposal is intended to 
address potential weaknesses in--and thereby improve--the markets for 
both exchange-listed and Nasdaq stocks.
    For exchange-listed stocks, the proposal would address a serious 
weakness in the existing ITS trade-through rule, which was established 
by the exchanges and approved by the Commission. This weakness is 
caused by the disparate degree of 
access to quotes displayed by manual markets and those displayed by 
automated markets. Manual markets--those with traditional trading 
floors on which human beings effect trades--generally take from 10 to 
30 seconds to respond to incoming orders. Automated markets respond 
much more quickly. Notice that I use the word ``respond.'' Some have 
confused speed of response with certainty of execution. Neither manual 
nor automated markets guarantee the execution of orders at their best 
displayed quotes. Such quotes, for example, may already have been 
executed against by previous incoming orders or have been withdrawn 
prior to order arrival. Indeed, according to Rule 11Ac1-5 execution 
quality reports from one active market center, even the fastest 
electronic markets generally have fill rates for marketable orders of 
approximately 60 percent to 75 percent in the most actively traded 
stocks.
    Consequently, the problem that the trade-through proposal is 
intended to address for exchange-listed stocks is not differing 
certainty of execution, but differing speed of response and differing 
execution prices. With automated quotes, investors can know in less 
than a second whether their order has been executed and can adjust 
their trading strategy accordingly. With manual quotes, many traders--
including large institutional investors seeking to trade in significant 
size--have emphasized that they may ultimately receive an inferior 
price if the manual quote turns out not to be available after waiting 
10 to 30 seconds for a response. In such cases, some would prefer to 
send an order immediately to an automated market displaying an inferior 
price, rather than accept the risk of a slower response from a manual 
market and perhaps an execution at an even worse price.
    As proposed, the trade-through rule would address the disparity of 
access between automated and manual quotes by providing an exception 
that would allow automated markets to trade-through manual markets up 
to a specified amount. Among the most interesting developments at our 
public hearing in April, however, were statements by representatives of 
exchanges with traditional trading floors that they were committed in 
the coming months to establishing auto-execution facilities for access 
to their quotes. In addition, other hearing participants noted that 
existing order routing technologies were capable of reacting, on a 
quote-by-quote basis, to indications from a market that its quote was, 
or was not, accessible through automatic execution.
    The capacity to identify individual quotes as automatic or manual 
potentially would give exchanges with trading floors the needed 
flexibility to integrate effectively a trading floor with an auto-
execution facility. Rather than being lumped into a single regulatory 
classification as ``fast'' or ``slow,'' markets would be allowed to 
offer choices to investors. In those particular contexts when a manual 
execution on a trading floor potentially could offer the most value--
such as to generate additional liquidity for a large order or to offer 
price improvement on an order--the exchange could identify its quote as 
manual, thereby affording a brief period for human beings to 
participate in an auction. Such a manual quote would not, however, be 
entitled to trade-through protection. Investors therefore would have 
the freedom to send orders to markets with worse quotes if they 
believed they could obtain better executions in those markets. As I 
will note later, some believe that this freedom to 
bypass all manual quotes could eliminate the need for the proposed 
``opt out'' exception to the trade-through rule.
    The concept of an exception for manual quotes appears promising. 
One of the primary purposes of the Commission's supplemental request 
for comment in May was to give the public a full opportunity to express 
their views on this concept. Their views will play a vital role in 
determining the course of any final rulemaking.
    Switching to the market for Nasdaq stocks, the practical effect of 
the trade-through proposal would be quite different. Nearly all quotes 
in Nasdaq stocks currently are accessible through automatic execution. 
Nasdaq stocks have never been covered by the ITS trade-through rule, 
and therefore have not been given trade-through protection. Commenters 
note, however, that brokers must fulfill their best execution 
obligations when routing customer orders. One of the most significant 
issues currently before the Commission is whether application of a 
trade-through rule to Nasdaq stocks would enhance protection of 
investor limit orders and promote improved public price discovery. We 
currently are evaluating the information and data submitted on this 
issue in the comment letters. An important part of our policy analysis 
will be to consider the potential benefits--as well as any negative 
impact--of trade-through protection for the more than 3,000 stocks of 
companies listed on Nasdaq, not just the relatively small number of 
stocks in the very top tier of trading volume.
    The final issue regarding the trade-through proposal that I would 
like to discuss is the proposed opt out exception. This exception would 
allow one market to trade-through a superior price displayed on another 
market if the customer submitting an order consents to disregarding the 
superior price. One objective of the proposed exception was to give 
investors the freedom of choice to access quotes with inferior prices 
if they were not satisfied with the level of automation or service of a 
market displaying the best-priced quote. The proposing release noted, 
however, that the exception may be inconsistent with the principle of 
price protection for limit orders and could undermine investor 
confidence that their orders will receive the best available price.
    In sum, the opt out exception as proposed presents a conflict 
between policy objectives. On the one hand, we want to promote 
competition among markets and freedom of choice for investors in 
choosing where to route orders. On the other hand, investors who post 
limit orders establishing the best prices contribute greatly to public 
price discovery. But these investors may not be rewarded for this 
contribution if their orders are by-passed by trades at inferior prices 
in other markets.
    The comment letters have expressed strongly held views both for and 
against the opt out exception. A critically important issue will be to 
determine how best to reconcile the legitimate desire of investors to 
send their orders to the most accessible quotes with the policy 
objective of protecting limit orders. Panelists at the public hearing, 
for example, suggested that, if the only quotes that received trade-
through protection were those that were truly accessible through 
automatic execution facilities, there would be no need to by-pass such 
quotes with an opt out. Other panelists believed that an opt out 
exception would remain necessary to discipline markets that fail to 
maintain truly automatic execution facilities.
    Clearly, the Commission must work hard to evaluate the views of 
commenters and reach the best possible solution to this difficult 
issue. We are committed to the policy objective of strengthening public 
price discovery, without interfering with efficient operation of the 
markets.

Market Access Proposal
    Discussion of the proposed opt out exception highlights the 
importance of the market access proposal. A trade-through requirement 
that orders be routed to the best available bid or offer would be 
entirely unworkable if all markets did not provide fair and efficient 
access to their quotes. The market access proposal is designed to 
achieve this goal in two ways. First, to establish linkages between 
markets, the proposal would require quoting markets to allow 
nondiscriminatory access to their quotes through members or 
subscribers. The proposal therefore does not mandate that the markets 
establish inflexible, ``hard'' linkage facilities, such as the current 
ITS linkage facility. Second, the proposal would limit the fees that a 
market could charge for access to its quotes. Currently, some markets 
are permitted to charge these access fees and some are not. There also 
are significant variations in the amount of fees charged by different 
markets. The proposal would create a more level playing field. It also 
would establish an outer limit on the amount that could be charged to 
market participants when they route orders to other markets. This limit 
could be particularly important when orders are routed to meet 
regulatory responsibilities, such as to comply with a trade-through 
rule or to obtain best execution for customer orders.
    Clearly, the proposed fee limitation is the most controversial 
aspect of the access proposal. One commenter noted that fee issues have 
``vexed'' the industry for years. On the one hand, all markets 
obviously must be permitted to charge for their services, particularly 
agency markets such as ECN's that do not trade as principal and 
therefore cannot earn trading profits. On the other hand, these ECN's 
typically do not retain the bulk of the access fees that they collect. 
Instead, these fees mostly are paid out as rebates to customers who 
post limit orders with the ECN's. Consequently, two limit orders 
offering to sell the same stock at $10 per share posted in two 
different markets may in fact not represent equally priced quotes. One 
order may receive a rebate out of access fees charged by the posting 
market and therefore effectively is offering to sell, not at $10, but 
at $10 plus the rebated amount. The fee proposal would control the 
extent to which rebates detract from the comparability of orders with 
identical displayed prices. In this respect, it may be more accurate to 
view the proposal as a limitation, not on compensation to markets, but 
on the additional compensation paid to some traders beyond the price 
they place on their orders.
    Some commenters have argued, however, that regulatory action is not 
needed to assure the comparability of public quotes because market 
forces alone will be sufficient to address the issue. The Commission 
will need to evaluate this view carefully, as well as the views of all 
commenters, to reach an appropriate resolution of what has been an 
intractable issue.

Sub-Penny Quoting and Market Data Proposals
    The sub-penny quoting and market data proposals have not received 
as much attention as the other proposals, but are important parts of 
the proposed regulatory reform. Both are intended primarily to promote 
public price discovery. The sub-penny quoting proposal would prohibit 
markets from accepting or displaying quotes in price increments of less 
than a penny, except in stocks with prices of less than $1 per share. 
The proposal would help protect limit orders by addressing the practice 
of ``stepping ahead'' of displayed orders by economically insignificant 
amounts.
    The market data proposal, among other things, would modify the 
current formulas for allocating revenues that are generated from fees 
for dissemination of the consolidated data stream. The revised formula 
would reward markets for the value of their quotes--those that reflect 
the best prices for the largest sizes and thereby contribute the most 
to public price discovery. In addition, the market data proposal would 
promote the public dissemination of market information beyond that 
which currently is provided through the consolidated data stream.
    Many commenters on the market data proposal have suggested that the 
Commission should revisit the issue of the level of fees charged by the 
markets for the consolidated data stream. In particular, some believe 
that such fees are too high and that the Commission should adopt a 
cost-based approach for evaluating the reasonableness of fees. The 
Commission extensively addressed this issue in 1999 when it published a 
concept release on market data fees and information. The release 
specifically requested comment on the concept of a cost-based approach 
for evaluating fees. The responses to this concept reflected deep 
divisions in the securities industry. In an attempt to resolve these 
divisions and to obtain additional views, the Commission established an 
Advisory Committee on Market Regulation in 2000. The Committee included 
a diverse range of participants drawn from the securities and market 
data industries. It specifically considered whether the Commission 
should adopt a cost-based approach for evaluating fees, but rejected 
the idea as unworkable.
    As evidenced by the comments on the Regulation NMS proposal, 
however, many continue to believe that some cost-based limitation on 
market data fees has merit. Separately from the Regulation NMS 
proposal, the Commission currently is reviewing the governance and 
transparency standards that apply to SRO's. The level of market data 
fees is closely related to these issues because such fees represent a 
very significant source of SRO funding. The Commission will need to 
select the most appropriate forum in which to address continuing 
concerns about market data fees.

The Road Forward
    I will conclude by offering a few thoughts on the future of the 
Regulation NMS rulemaking process. The comment period ended only a few 
weeks ago, and we continue to review the large number of comment 
letters. It therefore would be premature to predict how the Commission 
ultimately will resolve the many difficult issues raised by the 
proposals. I do want, however, to express my appreciation to the 
public, to the Members of Congress, and to market participants for the 
enormous effort and insight reflected in their comments. At the public 
hearing in April, I asked the participants temporarily to set aside 
their individual interests and to put on their public policy hats. I am 
very pleased that not just the hearing participants, but the public in 
general, have responded quite positively. The views expressed in their 
comment letters, though naturally reflecting differing perspectives and 
priorities, have almost uniformly focused their attention on the public 
welfare and on promoting the efficiency and fairness of the U.S. equity 
markets as a whole. The letters fully warrant close review, and their 
insights will be reflected in any final rulemaking.
    Although I cannot predict the outcome of the Commission's proposed 
rulemaking, I do believe it is extremely important that there be an 
outcome, and that the outcome be reached in a timely manner. Many of 
the issues raised by the Regulation NMS proposals have lingered for 
many years and caused serious discord among market participants. These 
issues have been studied, debated, and evaluated from nearly every 
conceivable angle. Few would seriously oppose the notion that the 
current structure of the national market system is outdated in some 
respects and needs to be modernized. The Commission must move forward 
and make decisions with regard to final rules if the U.S. equity 
markets are to continue to meet the needs of investors and public 
companies.
    I will conclude by emphasizing that the Commission recognizes the 
far-reaching nature of many of the proposals. If adopted, some would 
require significant industry efforts to modify systems and otherwise 
prepare for the new regulatory structure. We are sensitive to these 
concerns and will work closely with the industry on the process needed 
to implement any new rules efficiently. This process clearly would 
include appropriate time periods for the industry to prepare before the 
new rules become effective.
    Thank you again for inviting me to speak on behalf of the 
Commission. I would be happy to answer any questions that you might 
have.

                               ----------
                 PREPARED STATEMENT OF ROBERT GREIFELD
               CEO and President, The Nasdaq Stock Market
                             July 21, 2004

    Chairman Shelby, Ranking Member Sarbanes and Members of the 
Committee, thank you for inviting me to testify before you today on a 
subject of great importance to investors. I am here today as a strong 
and committed advocate for the elimination of the trade-through rule. 
The trade-through rule today is the primary obstacle to competition 
amongst our nation's equity markets, and competition is the driving 
force in making U.S. markets the strongest in the world, the best for 
investors large and small, and accountable to the public.
    On February 26, 2004, the Securities and Exchange Commission (the 
SEC or Commission) published for public comment Regulation NMS, which 
proposes to reform the trade-through rule, and includes other critical 
reforms regarding market access, market data revenue allocation, and 
sub-penny trading. These proposals are designed to modernize U.S. 
market structure and increase competition in our markets. Yet, the 
question remains whether the Commission's actions will result in 
marginal change or the substantial reform that is necessary if we are 
to meet the needs of investors and maintain U.S. leadership in the 
global equity markets.
    The complexity of the current rules and the nature of trading 
securities where practices have grown up over many decades mask a 
fundamental truth: Today, electronic trading is best for investors. 
Importantly, this truth is implicit in the SEC's proposal, which 
essentially forces floor-based auction markets to automate and migrate 
to a Nasdaq model.
    One might ask why does the Government have to change the rules? The 
reason is that the business of running a floor-based auction market is 
currently protected from competition by a set of SEC-mandated rules. 
These rules, which are relics of our past, have provided an 
extraordinary dividend to the intermediaries participating in these 
floor-based markets. The investing public and the industry are eager 
for change.
    In fact, in a recent survey completed by the Tabb Group in April 
2004, 71 percent of all institutional traders interviewed named the 
``Specialist & NYSE Market Structure'' as one of the greatest trading 
challenges facing them today.\1\
---------------------------------------------------------------------------
    \1\ The Tabb Group, April 2004, Institutional Equity Trading in 
America: A Buy Side Perspective, Larry Tabb at page 43.
---------------------------------------------------------------------------
    Despite the strong views of the investment community that 
meaningful change is long overdue, a powerful constituency with 
substantial resources to resist change has grown around these rules. 
Just as the candle making industry surely opposed Edison by citing job 
loss and safety risks to consumers, so too the floor exchange 
participants who benefit from the status quo have lobbied in the name 
of the individual investor to prevent change. We must see through these 
tired arguments.
    The emergence of electronic trading in the United States has been 
limited, with only Nasdaq-listed securities enjoying the fairness and 
efficiencies of electronic trading. Internationally, electronic trading 
systems are the norm. Moreover, a number of established international 
exchanges clearly are in the process of launching efforts to compete 
with U.S. markets for listings and eventually for business supremacy in 
our capital markets. Surely if we do not take this opportunity, 
European markets are fully prepared to take the lead from the United 
States in providing investors with modern electronic markets. Trade-
through reform is an important aspect of American competitiveness, 
because if we will not compete with one another, we will not be ready 
to compete with them.
    We are at a critical point. Watered-down half measures often do 
more harm than good by facilitating the ``gaming'' of the rules. It is 
just this gaming that has generated so much of the frustration with the 
current state of affairs and that was the underlying message of many of 
the witnesses at the SEC's April hearing on Regulation NMS in New York 
City. The public is ready for and, in fact, invites real change.
    The trade-through rule does not protect investors. Competition and 
rigorous, conflict-free regulation protects investors. Investors who 
are not shackled by, or can opt out of, the trade-through rule have a 
choice. The existence of that choice creates competition, whether or 
not the choice is exercised. Without choice, all investors are trapped 
in a closed system. With choice, all investors, both institutional and 
retail alike, are empowered to make the best investment choices.
    The fact that most of the world's major equity exchanges are 
following Nasdaq's competitive electronic model confirms the wisdom of 
having the right structure and quality. It also underscores the need 
for stock markets to evolve and innovate.
How the Nasdaq Stock Market Operates and why Repeal of the Trade-

Through Rule is so Important
How the Nasdaq Stock Market Operates
    Nasdaq is the largest U.S. electronic stock market. With 
approximately 3,300 companies, it lists more companies and, on average, 
trades more shares per day than any other U.S. market. Nasdaq has built 
a market that brings buyers and sellers together efficiently and 
effectively, one that connects investors and capital with industry-
leading companies, and champions and seeks to protect the interest of 
all investors. Investors come to Nasdaq because they get better 
execution of their trades in a more transparent environment.
    Nasdaq has a decentralized structure of many competing market 
centers linked together--multiple dealers committing capital and 
competing for orders under the Nasdaq ``big tent'' which gives 
investors a healthy and liquid environment. Nasdaq's open and 
electronic trading environment allows an unlimited number of 
participants to trade a company's shares. Instead of representation by 
individual specialists (such as is the case with the NYSE model), over 
300 market makers sponsor Nasdaq companies and trade Nasdaq stocks. An 
average of 20 cover each Nasdaq security, and as many as 100 or more 
make markets in some securities. Nasdaq also offers a high level of 
transparency that helps investors gauge trends and make more informed 
decisions.
    Computerized trading systems lend themselves to open, efficient, 
and nearly frictionless markets. Nasdaq has been using advanced 
technology to operate its market for more than 30 years. By creating 
the right balance of man and machine, the human factor comes into play, 
but only where it adds value. The advantages of a technologically 
advanced market include the ability to continuously lower cost per 
transaction without sacrificing reliability. This raises the value 
delivered to investors.
    Nasdaq is the home to category-defining companies that are leaders 
across all areas of business, including technology, retail, 
communications, financial services, transportation, media, and 
biotechnology. Companies list on the Nasdaq market because they support 
our model and believe it is the best means for them to access capital--
and investors--to nurture and grow their innovative businesses and 
technologies, and to create new jobs. Nasdaq-listed companies have a 
committed interest in ensuring their investors get best execution. This 
means lower execution cost and higher speed, efficiency, and 
reliability are critical. That is another reason why we are so 
intensely focused on maintaining the quality of the Nasdaq market with 
the right and best technology and structure for all investors.

Why Nasdaq Believes Repeal of the Trade-Through Rule is so Important
    First, Nasdaq has never had a trade-through rule. Instead, Nasdaq 
has relied on a combination of vigorous regulation and competitive 
forces to protect investors. In proposed Regulation NMS, the SEC is 
proposing to extend the trade-through rule to the Nasdaq market. We 
have grave concerns about the impact this rule could have on our 
market, and the SEC has expressed no need for the rule on our market 
other than that it would promote uniformity of regulation. Critically, 
the SEC has not analyzed or assessed the impact of the rule to the 
Nasdaq market, yet it seems prepared to dramatically alter the way our 
market works.
    With regard to the application of the trade-through rule to NYSE-
listed stocks, Nasdaq also has a strong interest. You see, Nasdaq is 
not just a market where companies list and investors trade those listed 
companies' stocks. Nasdaq is a trading execution platform for investors 
to trade all equities, not just those listed on Nasdaq. It comes as a 
surprise to many to learn that approximately 15 percent of the volume 
in NYSE-listed stocks trade today on Nasdaq.
    But that number could be much higher. Investor demand for our 
trading platform is strong, yet the trade-through rule is an enormous 
impediment to investors wishing to exercise their choice of market as 
to where they can get the best execution of their trades. I am here 
today urging the repeal of the trade-through rule because I have 
customers--investors--who want to use the Nasdaq trading platform, but 
are prevented from doing so due to the trade-through rule. This rule 
hurts our business and it hurts investors.
    In the next section of the testimony, I will address in more detail 
Nasdaq's position on the trade-through rule and why its repeal is 
important to markets and investors.
Nasdaq Opposes a Trade-Through Rule for the Trading of Nasdaq-Listed
Securities
    The trade-through rule is unnecessary for Nasdaq securities because 
the proposed rule's objectives have already been achieved in this 
market. The SEC itself provides a solid case against a trade-through 
rule for Nasdaq. At the time proposed Regulation NMS was released for 
comment, the Commission stated: ``Even without a trade-through rule, 
the Nasdaq market does not appear to lack competitive quoting in the 
most actively traded securities.''
    Statistics derived from Rule 11Ac1-5 data clearly evidence the 
results of the competitiveness in the Nasdaq market. As the table below 
demonstrates, when compared to the NYSE, Nasdaq offers investors 
tighter quoted and effective spreads with greater speed and certainty 
of execution.\2\ Our belief is that, in fact, there is substantial 
likelihood that applying the trade-through rule to the Nasdaq market 
will harm investors.
---------------------------------------------------------------------------
    \2\ SEC Rule 11AC1-5 data, January 2004 marketable orders of all 
sizes under 10,000 shares, provided by Market Systems, Inc. See SEC 
Release No. 34-43590; File Sy-16-00 (November 17, 2000).

------------------------------------------------------------------------
                                  Effective Spreads  (Cents)
                     ---------------------------------------------------
                               Nasdaq                     NYSE
------------------------------------------------------------------------
S&P 500 Stocks                           1.17                      1.82
Dow Jones U.S. Large                     1.18                      1.79
 Cap Index Stocks
Russell 1000 Stocks                      1.37                      1.97
------------------------------------------------------------------------

    A trade-through rule imposed on the Nasdaq market could harm the 
quality executions and competition that exist in the Nasdaq market. The 
harm to investors may take many forms, including increasing the cost of 
trading due to the additional costs of complying with the rule. Whether 
the SEC adopts an automated market or automated quote approach for the 
trade-through rule, market participants will be required to make 
complex and expensive system changes to recognize when a market or 
quote is ``nonautomated.'' The markets and market participants trading 
Nasdaq securities will bear a disproportionate amount of these costs 
because there is no trade-through rule today for Nasdaq securities. 
Finally, evidence indicates that these costs are unnecessary because 
the trade-through rate for Nasdaq-listed securities, without a trade-
through rule, is lower than for listed securities, which trade under 
such a rule.

                               Obeserved Trade-Through Rates using Last Sale Data
                                                April 1-12, 2004
----------------------------------------------------------------------------------------------------------------
                          NYSE-Listed  (Avg. 1.95 MM Trades/day)       Nasdaq-Listed  (Avg. 3.49 MM Trades/day)
Detection Rule Before/------------------------------------------------------------------------------------------
   After  (seconds)      Trades  (Percent)      Shares  (Percent)      Trades  (Percent)      Shares  (Percent)
----------------------------------------------------------------------------------------------------------------
              0/0                    4.2                   10.2                    7.7                   11.5
----------------------------------------------------------------------------------------------------------------
              5/2                    2.0                    6.9                    1.6                    5.1
----------------------------------------------------------------------------------------------------------------
             10/5                    1.5                    5.3                    0.9                    3.5
----------------------------------------------------------------------------------------------------------------
            25/10                    1.0                    3.6                    0.5                    2.0
----------------------------------------------------------------------------------------------------------------

    In a larger sense, however, the current proposal has a fundamental 
flaw because it will nullify the improvements the SEC has implemented 
in the Nasdaq market over the past 10 years. During this period, the 
SEC has adopted a series of rules that use market forces to produce a 
structure that provides quality executions, freedom of choice, and cost 
savings to investors. These initiatives include the limit order display 
rule and Rules 11Ac1-5 and 11Ac1-6.
    In adopting the limit order display rule, the SEC went beyond 
ensuring that limit orders are treated fairly and contribute to quote 
competition; the SEC created an environment where market forces and 
competition would flourish to the benefit of investors. Specifically, 
the SEC allowed market makers to continue to send limit orders to 
broker-dealer matching systems, known as electronic communications 
networks (ECN's), at a time when Nasdaq did not have its own limit 
order book. The result was that many ECN's entered the market and 
became the de facto limit order books for Nasdaq.
    Nasdaq responded to this competition by creating its own electronic 
limit order book. Currently, over 65 percent of Nasdaq trading occurs 
on these limit order books. While the number of limit order book 
providers has decreased, the competition among those remaining 
continues and has led to a dramatic reduction in execution fees. Faster 
execution times are another result of this competition, as these market 
participants innovate and improve services to distinguish themselves 
from their competitors.
    With competition firmly established, the SEC then adopted Rules 
11Ac1-5 and 11Ac1-6 to assist investors in making informed decisions. 
Giving consumers accurate information upon which to evaluate 
competitors also enhances competition. Today, market participants can 
``shop'' when deciding where to send their orders. Nasdaq understands 
that customers are using the execution quality statistics as benchmarks 
that their brokers must not only just meet, but also exceed.
    Importantly, none of the SEC's initiatives constrained customer 
choice as to how their orders could be executed or how they should 
measure execution quality. For example, the SEC did not choose to 
mandate a central limit order book that would have limited choices and 
decreased competition. A trade-through rule has many of the same 
drawbacks as a central limit order book because of its exclusive focus 
on displayed price as the benchmark for defining execution quality. The 
SEC risks undoing a decade's worth of progress by adopting a trade-
through rule for Nasdaq securities.
Nasdaq Supports Repeal of the Trade-Through Rule; Nonetheless, Reform
which Includes a Workable Opt Out Exception would Improve Execution

Quality and Competition in the NYSE-Listed Environment
The Trade-Through Rule no Longer Serves a Purpose and should be 
        Eliminated
    So that investors can realize the full benefits of a truly 
competitive market, the SEC should eliminate any trade-through 
restrictions for NYSE-listed securities. While the market for trading 
Nasdaq securities is better because of the SEC initiatives previously 
discussed, the market for trading NYSE-listed securities has been stuck 
in a time warp and has not seen the same benefits of competition. 
Nasdaq believes the different results can be traced to one major 
difference between the markets: The trade-through rule.
    The trade-through rule is a vestige of an antiquated, manual, 
floor-based, single specialist market that has stifled competition in 
the trading of NYSE-listed securities and does not reward or recognize 
the speed and certainty of execution or other factors investors may 
consider when measuring best price. The trade-through rule creates a 
monopoly at the best posted price, a monopoly that favors slow, manual 
markets whose posted price may not reflect the price available on the 
floor. In this regard, electronic markets' participation in the listed 
market has been hobbled.
    If the Commission adopts a trade-through rule without an opt out 
provision, basic trading choices that exist today will be eliminated, 
which could increase costs to investors. For example, investors seek to 
execute orders with minimal price impact. In fact, analyses of trading 
costs include measurement of market impact--how much did the market 
move in reaction to the existence of a large order.
    Today, investors use many different means to lessen market impact, 
including utilizing the block-order exemption from the trade-through 
rule for NYSE securities. Of course, in the Nasdaq market these 
investors have the greatest degree of flexibility because there is no 
trade-through restriction. As a result, investors can execute sizable 
trades immediately with dealers or other investors through crossing 
mechanisms, without ``tipping'' the market about the pending large 
order by being forced to trade with the displayed price. Investors are 
willing to accept prices that are ``away'' from the prevailing ``best'' 
price because of the certainty and speed they obtain.
If the SEC Chooses to Reform Rather than Repeal the Trade-Through Rule,
a Workable Opt Out Provision is Critical
    A viable opt out provision will impose competitive discipline by 
allowing market participants to avoid a market center that routinely 
fails to provide timely executions at the price reflected in its quote. 
However, market participants will still have every incentive to seek 
the best certain price, and brokers that routinely fail to do so will 
be subject to disciplinary action and will lose business to 
competitors.
    As proposed by Regulation NMS, however, the opt out exception may 
be unworkable. It will frustrate rather than enable freedom of choice 
for investors and limit rather than promote automated executions. In an 
unprecedented manner, the opt out exception imposes burdens on both the 
investor seeking to opt out and the broker-dealer handling opt out 
orders. Some aspects of the proposal impose the burden on both parties, 
while other aspects only affect the broker-dealer handling the opt out 
order. For example, the need for informed consent on an order-by-order 
basis imposes a burden on both parties. The broker-dealer handling the 
order must provide disclosure each time an order is received, and the 
entity opting out (for example, a customer or another broker-dealer) 
must affirmatively opt out each time it places an order. For some 
market participants, this exchange of information would be necessary 
hundreds or thousands of times per day. These exchanges will most 
certainly delay the execution of orders, while contributing little, if 
any, investor protection.
    The opt out exception requirement to provide customers the best bid 
or offer that existed at the time their order was executed is a burden 
that will be imposed on broker-dealers directly, and possibly on 
customers indirectly if the costs of complying with this aspect of the 
rule are passed along to customers. Trading does not occur in a manner 
that allows each order to be matched easily with a particular execution 
or quote. In particular, large orders often are placed for multiple 
accounts, and the executing broker-dealer may not know to which account 
the trade should be allocated until after the order is fully executed. 
Broker-dealers will have to recreate the execution history of orders so 
that they can provide the best quote that existed at the time each 
portion of an order was executed. To provide this information for each 
of the thousands of orders executed each day, whether or not the 
customer wants the information, will impose a significant burden 
because firms will have no choice but to find some manner of automating 
the process.
    Nasdaq has proposed two modifications that will make the opt out 
exception less burdensome, while not diminishing its investor 
protection elements. First, Nasdaq proposes that broker-dealers be 
required to disclose the best bid or offer at the time of execution to 
customers only upon request. This is the same approach the SEC adopted 
with respect to payment for order flow and other types of disclosure. 
Specifically, Rule 10b-10 permits broker-dealers to include a general 
statement concerning whether payment for order flow was accepted, and 
to disclose the source and nature of the compensation separately, upon 
receiving a written request from the customer. Similarly, a broker-
dealer must provide its customer the identity of the contra party only 
after receiving a written request. Adopting this approach for the opt 
out exception will require broker-dealers to provide the information to 
those investors most interested, but not force them to undertake costly 
system modifications that would be necessary to provide the information 
to all customers--regardless of whether they want the information.
    Second, to satisfy the informed consent obligation, Nasdaq proposes 
that broker-dealers be permitted to provide an annual statement 
disclosing the implications of opting out of the trade-through rule. 
The proposed order-by-order requirement will require the disclosure to 
be repeated hundreds or perhaps thousands of time per day. Therefore, 
broker-dealers are likely to provide summary statements about the rule. 
In contrast, an annual statement could result in a more fulsome 
disclosure, because it is not being delivered in the midst of a trading 
day. Requiring an annual statement is consistent with the disclosure 
obligations concerning margin trading, and is more conservative than 
the disclosure obligations concerning day trading and trading in penny 
stocks, which only require one disclosure.

Nasdaq does not Believe the SEC Should Define what Constitutes a Fast
Market; However, if the SEC does so, it must Establish Standards that 
        are
Sufficient and Enforceable
    Nasdaq maintains that an effective opt out exception eliminates the 
difficult task of defining ``fast'' because investors will be able to 
decide for themselves which markets are meeting their needs. No one 
wants to see an SEC enforcement officer sitting on the floor of an 
exchange with a stopwatch. The public will be best served by the SEC 
focusing its resources on matters other than mediating disputes over 
whether markets are responding to orders within the requisite number of 
milliseconds.
    However, if the SEC believes it is necessary to define ``fast'' in 
order to ensure some minimum level of automation, Nasdaq supports a 
quote-by-quote distinction that requires markets to identify quotes 
that are slow. A market must identify ``slow'' quotes on all of its 
published feeds, and when its best bid-and-offer quotation is sent to 
the Securities Information Processor (SIP) for calculation and 
dissemination of the National Best Bid/Best Offer (NBBO). In addition, 
the SIP should be required to enhance its distribution of NBBO data by 
adding a flag to identify a national best bid or offer as ``fast'' or ``slow,'' in addition to the market center associated with the bid and/or offer, so that investors will know whether the quote is subject to a trade-through restriction. Without this critical transparency, investors will 
become confused as to the trade-through treatment of each published quote/order. If investors see the NBBO being traded through, the flag will serve as a visible explanation for this occurrence.
    Markets should be required to respond to a party submitting an 
order within 250 milliseconds. This automated response must indicate 
that the order was either executed (in full or partially) or rejected.
    The automated response requirement also must apply to requests to 
cancel orders. This requirement will be particularly necessary if 
markets can alternate between automated and nonautomated. For example, 
a market participant sends its order to a market providing automated 
access; however, while the order is waiting to execute the market 
switches to manual execution in order to conduct an auction. Some 
market participants may not want to participate in a manual auction, 
but prefer instead to cancel the order and send it to a market that can 
provide a fast, automatic execution. If markets are not subject to a 
maximum response time requirement for cancellations, they can hold 
orders hostage. The maximum response time to process cancellation 
requests should not exceed 250 milliseconds.
    Markets also should be required to update their quotes within 250 
milliseconds of an execution. The benefits of automated access to 
quotes are defeated if markets are not required to automatically update 
their quotes. Market participants will be attempting to trade with 
quotes that are no longer available, which is a problem that exists 
today, and will just result in an increased number of rejected orders.
    Nasdaq supports the requirement that markets make public available 
statistics showing how often they comply with the turnaround time 
requirement, and proposes that markets make other similar information 
available. Specifically, if the SEC adopts such requirements, markets 
must be required to disclose how often they comply with the maximum 
response times for quote updates and order cancellation requests. 
Similarly, if the SEC adopts a rule that distinguishes between 
automated and nonautomated on a quote-by-quote basis, markets that do 
not provide automated access to their quotes at all times must disclose 
how often their quotes are not accessible on an automated basis. 
Requiring disclosure of the information discussed above will impose 
competitive pressures on markets to remain in compliance with the 
requirements.

The Myth of ``Best Price''
    Supporters of the trade-through rule disingenuously describe it as 
a ``best price'' rule that protects investors, rather than what it is--
a rule to protect floor-based markets from competition.
    Best price in today's trading world is a relative concept. With the 
change to decimal pricing 3 years ago, the amount of stock available 
for sale at a given price has gone down. This was an expected outcome 
as the minimum spread literally went from Spanish ``pieces of eight'' 
to one penny. Lowering the spreads between bid and offer from 12.5 
cents (1/8ths) to 6.25 cents (1/16ths) to one penny had a profound 
impact on trading behavior. Simply put, investors no longer need nor 
want to slow down their orders to participate in an auction when the 
best they will get is a one-penny price improvement (and they could see 
price worsen, or even lose the order entirely). Finding liquidity has 
become a tougher proposition, so investors reward markets that help 
them find it, sometimes forgoing a penny or two in order to obtain 
their needed blocks of stock.
    When one considers the effect of the trade-through rule on an 
actual trade, you can easily see that investors often receive inferior 
executions at inferior prices, even though their order was delivered to 
a market on the belief that they would get the ``best'' price. Quotes 
carry two bits of important information, the price and the amount of 
stock offered at that price. Many times, in part because of decimals, 
the best-priced quotes will only accommodate small amounts of stock. 
Thus, the trade-through rule can ``lure'' larger orders to the floor, 
resulting in the disclosure of vital and material trading information 
to the specialist. Prices change quickly, and orders end up costing 
more to an investor, than a one or two cent trade-through in another 
market would have cost. Last, remember that a trade sent to the floor 
under the trade-through rule carries no mandate for the specialist to 
actually fill the order at the posted quote. Furthermore, each order 
does not occur in a vacuum, so quotes can disappear after orders have 
been routed to the floor for execution. Traders seeking to fill orders 
are frustrated when they have to wait 30 seconds to learn that they did 
not get an execution.
    With electronic markets, execution surety is a one or two second 
proposition. Search for liquidity is a point and click proposition. 
Thus, many investors believe they are getting the best price when they 
can trade without question, delay, or market impact. They are getting 
best price for their order.
    It has also been suggested that institutional investors or brokers 
may trade-through to the detriment of those for whom they serve as 
fiduciaries. These arguments are specious. Brokers are judged by their 
clients and monitored by enforcement officials. Their clients look at 
the broker's ability and performance in meeting their needs. Brokers 
will lose customers and be subject to disciplinary action if they 
mistreat the customer orders. It is important to remember, brokers do 
not want trade-through reform because they want bad prices for their 
customers, they want reform because they cannot get good prices for 
their customers on an exchange floor. Their clients do not understand 
missed trading opportunities. In the point and click era, clients do 
not accept the manual uncertain methods of the floor exchanges.
    Irrespective of the trade-through rule, both investors and 
intermediaries in the securities markets have fiduciary duties and 
economic incentives to seek the best price when the best price is a 
real price (that is, immediately accessible and tradable). The 
fundamental problem with the trade-through rule is it forces market 
participants to seek a ``best'' price that may have substantial 
uncertainty associated with it.
    Officials responsible for investing State pension funds and other 
public monies clearly understand the importance of trade-through 
reform. Here is just a sample:

 Steve Westly, California's Chief Financial Officer and a board 
    member of the State's pension funds CalPERS and CalSTRS: 
    ``[R]eforming trade through . . . allows [investors] . . . to 
    consider factors that may be as important or even more important 
    than the `best advertised price' proviso of the trade-through rule, 
    including quality and speed of execution.'' \3\
---------------------------------------------------------------------------
    \3\ Letter from State of California Controller Steve Westly to SEC 
Chairman Donaldson, January 30, 2004.
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 Patricia Anderson, the State Auditor of Minnesota: ``The 
    concept of `best price' is an attractive one in principle. 
    Unfortunately, in practice, it has too often become a justification 
    for delayed trades and reduced flexibility. In fact, preliminary 
    information suggests that the rule's mandate to seek the best price 
    has instead often resulted in noticeably higher prices for 
    investors.'' \4\
---------------------------------------------------------------------------
    \4\ Letter from State of Minnesota Auditor Patricia Anderson to SEC 
Chairman Donaldson, February 20, 2004.
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 Charlie Crist, the Attorney General of the State of Florida: 
    ``The trade-through rule effectively grants floor specialists 
    monopoly power over trading in NYSE listed stocks. As a result, 
    Florida investors (truly all investors) suffer from slower trade 
    executions, increased transaction costs, and decreased 
    competition.'' \5\
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    \5\ Letter from State of Florida Attorney General Charlie Crist to 
SEC Chairman Donaldson, February 12, 2004.
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 Resolution of the Alabama State Senate: ``. . . residents of 
    the State of Alabama have large investments in the stock markets . 
    . . the current trade-through provision is obsolete . . . proposed 
    reforms will improve investor freedom and preserve investor 
    protection . . . experience has shown that the most efficient 
    markets are those that permit transparency and individual choice . 
    . .'' \6\
---------------------------------------------------------------------------
    \6\ Resolution of the Alabama State Senate ``Urging support for 
Federal Security and Exchange Commission proposed rule No. S7-10-04, to 
allow for more electronic trading in the national securities market,'' 
adopted May 6, 2004.
---------------------------------------------------------------------------
 Sean Harrigan, President, CalPERS Board of Administration: 
    ``It is our hope that the regulatory authorities will further 
    improve the efficiency of the markets by eliminating the trade-
    through rule.'' \7\
---------------------------------------------------------------------------
    \7\ Press release from Sean Harrigan, CalPERS President, Board of 
Administration, January 14, 2004.

    In closing, the comments of Dr. Benn Steil, Andre Meyer Senior 
Fellow in International Economics, Council on Foreign Relations, before 
the House Financial Services Capital Markets Subcommittee, on May 18, 
---------------------------------------------------------------------------
2004 are most instructive:

        Although the idea of having a simple, market-wide rule to 
        ensure that investors always have access to the ``best price'' 
        is an attractive one, in practice the trade-through rule has 
        operated to force investor orders down to the floor of the New 
        York Stock Exchange, irrespective of investor wishes. The rule 
        therefore operates to discourage free and open competition 
        among marketplaces and market structures; the type of free and 
        open competition which has in Europe produced a new global 
        standard for best practice both in trading technology and 
        exchange governance. The trade-through rule should therefore be 
        eliminated, as it serves neither to protect investors nor to 
        encourage vital innovation in our marketplace.

Repeal of the Trade-Through Rule Benefits all Investors, Including
Retail Investors
    In the Nasdaq market, where no trade-through rule exists, investors 
get better prices with faster executions at lower execution costs then 
they do on the NYSE, where a trade-through rule exists. This is 
according to the SEC's own 11Ac1-5 data. These statistics demonstrate 
that the best execution standard imposed on brokers works for 
investors.
    Retail investors are present in the markets in a number of forms. 
Some are directly buying securities for their own accounts. Many are 
accessing the markets as pension fund contributors--from States, 
businesses, and unions--and a vast majority of individual investors are 
in the markets through mutual fund share ownership. No matter what form 
they take, they are important and their trading needs may vary.
    Like all consumers, retail investors benefit from competition. 
Nasdaq investors get better prices because average quoted spreads for 
Nasdaq-listed securities are tighter than the NYSE equivalents. If we 
look at Nasdaq in its most actively traded stocks, we have a spread of 
one penny. Our minimum price variation is one cent. We cannot do any 
better. These narrow spreads mean we have vigorous limit order 
competition in our market. Investors on Nasdaq are the beneficiaries of 
this competition.
    Tighter quoted spreads benefit both traders and investors accessing 
liquidity. Furthermore, customers get their orders executed at the NBBO 
at a higher rate on Nasdaq than on the NYSE for all order sizes. 
According to the SEC's definition of a trade-through, Nasdaq customers 
actually trade-through less than the rate on the floor of the NYSE.
    In the securities markets, costs are represented by transaction 
costs as well as spreads. On Nasdaq, competition has lowered execution 
costs, as trading platforms have improved efficiencies and vied for 
order flow.
    Finally, investors save money trading on Nasdaq because we are 
faster. Orders in Nasdaq-listed stocks receive faster executions than 
orders in comparable NYSE-listed stocks. Faster executions reduce 
investor uncertainty and decrease the likelihood of the market moving 
away from the investor's price.
    Nasdaq is governed by the principle of best execution. Nasdaq is a 
better market because brokers have control of their customer's orders 
and follow best execution for their clients. In 1993, the SEC's 
payment-for-order-flow release defined best execution by terms in 
addition to price. Best execution says that one-size-does-not-fit-all. 
The Commission specified that liquidity, cost, price impact, 
accessibility, and certainty were other important factors in 
determining best execution.
    Best execution may mean that for small orders, the best price is 
the customer's one and only priority. It may however mean that for 
larger orders other factors 
matter to the customer, like minimizing the impact of his order on the 
price of the security market-wide. Best execution may include remaining 
as an anonymous participant in the market or trading where the most 
stock is available within a certain price range to minimize the price 
of the entire basket of securities bought at a given time. The current 
trade-through rule ignores these trading concerns.
    Regulation NMS should not be about rolling back carefully evolved 
principles. I do not want to see the concept of best execution placed 
in a straitjacket, as the floor markets want.
    Supporters of the trade-through rule claim that it protects 
investors from self-serving brokers and puts the ``little guy'' on 
equal footing with the large investment firms and institutional 
investors. They argue that trade-through reform could be used to give 
investors inferior prices. But investor complaints and the need for 
market structure review did not originate based on broker misbehavior, 
this regimen of change originated on manual floors and complaints 
emerged from specialists' and floor brokers' misbehavior. These 
demagogic claims pray on the ignorance of investors and trouble 
policymakers. They irresponsibly undermine investor confidence. They 
also are patently false.

Nasdaq Exchange Application is Important to Fair Competition
    Finally, I want to discuss one unresolved critical issue. For 
almost 4 years now, Nasdaq has awaited word from the SEC on our 
application to become an exchange. As an exchange, Nasdaq would have a 
legal structure that companies considering their listing decisions 
could not question. Currently, Nasdaq is frozen in a partially 
separated structure that complicates our corporate governance and 
confuses those looking at us. Many decisions approved by the Nasdaq 
board still have to be approved by the NASD board.
    Nasdaq is a mature, well-developed, and highly efficient market. We 
trade more shares every day than any market in the world. We diligently 
protect investors. Our rules are fair and unbiased--and SEC approved.
    Nasdaq is working with the SEC to address their remaining concerns. 
I appreciate the interest of many of the Members of this Committee in 
the status of our application and hope to report back to you soon about 
that progress.
    Thank you again for this opportunity to testify. I would be happy 
to answer any questions you may have.
                               ----------
                 PREPARED STATEMENT OF DAVID F. HARRIS
               Senior Vice President, Strategic Planning
                      American Stock Exchange, LLC
                             July 21, 2004

Introduction
    Good morning, Chairman Shelby, Senator Sarbanes, and Members of the 
Committee. Thank you for inviting the American Stock Exchange LLC 
(Amex) to appear before you to present our observations and comments on 
the important issues raised by the four interrelated proposals 
contained within proposed Regulation NMS.
    After a brief description of the Amex and its unique role in the 
U.S. equity markets, we discuss our views on each of the four 
substantive topics that make up Regulation NMS: (1) trade-through 
protection, (2) inter-market access, (3) market data, and (4) sub-penny 
pricing.

Background
    The Amex has had a long history not only as the premier auction-
based market for small- and mid-cap companies, but also as the creator 
and nurturer of innovative financial products. Companies choose to list 
on the Amex because of the unique benefits offered by our market 
structure, which is designed to maximize price discovery and the 
potential for price improvement, while minimizing volatility caused by 
temporary order imbalances or the lack of natural liquidity. Our market 
offers dedicated liquidity providers that enhance liquidity and 
stability through affirmative obligations to ensure continuous and 
orderly trading. These liquidity providers are required to maintain a 
continuous two-sided market (that is, a fair bid and offer). They are 
also required to moderate price changes between transactions and buy, 
using their own capital, when there are not enough buyers, and sell 
from their inventory when there are not enough sellers. Thus, these 
dedicated liquidity providers are traders of last resort that moderate 
price movements until natural price equilibrium is reached where, once 
again, buyers and sellers can meet directly without an intermediary.
    For many of the same reasons companies list on the Amex, our market 
structure creates an environment that nurtures the growth of new and 
innovative financial products. These innovative financial products 
range from a vast array of structured products to exchange-traded funds 
(commonly known as ETF's). Eleven years ago, Amex pioneered the ETF 
with the introduction of an ETF based on the Standard & Poor's 
500' Index, known as the Spiders (Amex: SPY). Since then, 
ETF's have become a whole new class of securities growing to more than 
$166 billion in assets. More than ninety-percent of all ETF's are 
listed on the Amex, including the two most actively traded securities 
in the world: The Spiders and the ETF based on the Nasdaq 100 Index 
(Amex: QQQ)). Since the beginning of the year, the Spiders and QQQ's on 
average have combined for daily trading volume in excess of 147 million 
shares. ETF's were not an instant, overnight success, but thrived, we 
believe, as a result of being listed and traded on a market with 
dedicated liquidity providers that have affirmative obligations to 
enhance liquidity.

Trade-Through Protection
Uniform Trade-Through Rule
    In 1975, when Congress directed the Commission to facilitate the 
establishment of a national market system, Congress envisioned an 
eclectic, rather than single monolithic, system that would draw on the 
strengths of each type of marketplace.\1\ Without specifying a 
structure, Congress articulated the basic tenets of the national market 
system as fostering efficiency, enhancing fair competition, increasing 
price transparency, achieving best execution, and facilitating direct 
interaction of investor orders, when consistent with the other four 
principles.\2\ Then in 1981, to facilitate best execution, provide 
nationwide price protection, and to increase quote competition, the 
first ``trade-through'' rules were adopted for securities listed on the 
Amex and New York Stock Exchange. These rules generally prohibit one 
market from executing a trade for a security at an inferior price when 
another market displays a better price for the same security.\3\
---------------------------------------------------------------------------
    \1\ Securities Exchange Act of 1934, Sec. 11A(a)(2), 15 U.S.C. 
Sec. 78k-1(a)(2)(2004)(added by the Securities Act Amendments of 1975, 
Pub. L. No. 94-29, Sec. 7, 89 Stat. 111 (1975)).
    \2\ 15 U.S.C. Sec. 11A(a)(1)(2004).
    \3\ E.g., Amex Rule 239, Amex Guide (CCH) para. 9359 (2004).
---------------------------------------------------------------------------
    The Amex supports the proposal in Regulation NMS to extend trade-
through protection beyond exchange-listed securities to all national 
market system (NMS) stocks. For exchange-listed stocks, trade-through 
protection currently guarantees that investors--large and small, 
sophisticated and novice, trading for their own account or trading 
through a representative--all obtain the best price regardless of the 
market where those orders are sent. Equally important, trade-through 
protection encourages competitive price discovery across markets by 
ensuring that an investor that posts the national best-priced limit 
order does not have his or her order ignored. At its core, a trade-
through rule provides essential customer protection by ensuring that 
investors always get the best price available for their trades. Such a 
rule also facilitates a fair and orderly market by decreasing the 
harmful effects of market fragmentation and the disorder caused by 
different groups of traders paying different prices for the same 
securities at the same, or virtually the same, time. Thus, we believe 
that a uniform trade-through rule, with the best-price assurance it 
affords, provides critical investor protection and enhances investors' 
confidence in the fairness and integrity of the U.S. equity markets. 
This is the heart of the national market system.

Proposed Exceptions to the Uniform Trade-Through Rule
    In addition to establishing a uniform trade-through rule, the 
Securities and Exchange Commission (SEC or the Commission) through 
Regulation NMS also proposes codifying a number of existing exceptions 
to the current trade-through rules as well as creating two new 
exceptions. One proposed new exception turns on whether a particular 
market or its quotes are automatically accessible. The other proposed 
new exception would allow ``informed'' investors to ``opt out'' of the 
best-price protection of the trade-through rule.

Exception for Markets or Quotes that are not Automatically Accessible
    As to the exception related to whether a particular market or its 
quotes are automatically accessible, the SEC initially proposed 
allowing ``automated execution facilities'' (or so-called ``fast'' 
markets) to trade through, up to certain price limits, the better 
prices posted on nonautomated execution facilities (or so-called 
``slow'' markets). The SEC maintains that this ``exception is designed 
to reflect the comparative difficulty of accessing market quotes from 
nonautomated markets, and to adjust the trade-through requirements to 
these differences.'' \4\ In its supplemental release, the Commission 
also requested comment on whether the proposed exception should apply 
to individual quotes, rather than entire markets.\5\
---------------------------------------------------------------------------
    \4\ Securities Exchange Act Release No. 49325, Regulation NMS (Feb. 
26, 2004), 69 Fed. Reg. 11125, 11140 (Mar. 9, 2004).
    \5\ Securities Exchange Act Release No. 49749, Regulation NMS: 
Supplemental Request for Comment (May 20, 2004), 69 Fed. Reg. 30142, 
30143 (May 26, 2004).
---------------------------------------------------------------------------
    We oppose the version of the exception that would allow all 
``fast'' markets to trade through better priced quotes of ``slow'' 
markets regardless of whether the particular quote at issue is, in 
fact, readily accessible. The ``fast market-slow market'' dichotomy is 
overbroad and not sufficiently tailored to address the Commission's 
articulated concern: Inaccessible quotes. In contrast, the alternative 
version of the exception, which focuses on individual quotes (the 
``quote-by-quote'' exception) appears more appropriately gauged to 
address concerns regarding the inaccessibility of quotes and the 
related impact of that inaccessibility on effective and efficient 
integration of pools of liquidity across different markets. Therefore, 
subject to an appropriate and responsible industry-wide rollout through 
a pilot program, we support a quote-by-quote exception that would 
require all markets to indicate whether a particular quote is 
immediately accessible through an automated execution facility. If a 
quote is not designated as immediately accessible, then the party 
routing the order could trade through, up to certain limits, the better 
priced but inaccessible quote of another market.\6\ Of course, the 
party routing an order that trades through another market pursuant to 
the quote-by-quote exception would still have to otherwise fulfill his 
or her best execution obligations.\7\
---------------------------------------------------------------------------
    \6\ For purposes of the quote-by-quote exception, we support 
defining an ``automated execution facility'' as one that provides an 
immediate, automated response (that is, a response without any human or 
manual intervention) to the router of an incoming order. For purposes 
of this exception, we believe a ``response'' should include either (1) 
an order execution (in full or in part) or (2) a reply that the order 
was not executed. However, we oppose the SEC dictating performance 
standards as part of this exception. We believe that rule-based 
performance standards (1) would set a floor, not a ceiling, (2) would 
rapidly become antiquated, (3) would lead to endless disputes and 
litigation even if meticulously drafted, and (4) would remove 
competitive incentives to innovate and differentiate based on speed. In 
our view, while aspirational industry standards may initially provide 
useful rules of thumb, only as a last resort should the Government 
mandate performance standards by rule. In any event, if the Commission 
determines to impose rule-based performance standards, we request the 
phasing in of such standards to give all market participants sufficient 
time to develop and implement technology to meet those standards.
    \7\ Any proposed exceptions to the trade-through rule would not 
provide a safe-harbor from broker-dealers otherwise fulfilling their 
fiduciary duty to obtain best execution for their customers. The duty 
of best execution predates the Federal securities laws and stems from 
common law agency obligations whereby an agent owes his or her 
principal undivided loyalty and reasonable care. Newton v. Merrill, 
Lynch, Pierce, Fenner & Smith, 135 F.3d 266, 270 (3d Cir. 1998) (Since 
it is understood by all that the client-principal seeks his own 
economic gain and the purpose of the agency is to help the client-
principal achieve that objective, the broker-dealer, absent 
instructions to the contrary, is expected to use reasonable efforts to 
maximize the economic benefit to the client in each transaction.). 
Therefore, broker-dealers must continue to meet their basic best 
execution obligations to regularly and rigorously review the execution 
quality of markets to which they direct orders and must direct orders 
to the markets with the best execution quality. And, even with a quote-
by-quote exception, we believe that broker-dealers would still have to 
regularly and rigorously assess the executions offered by markets whose 
quotes are not immediately accessible, in whole or in part.
---------------------------------------------------------------------------
    We support a pilot program for the quote-by-quote exception not 
only for public policy reasons, but also for practical considerations. 
First, in addition to being more appropriately gauged to address 
concerns regarding the inaccessibility of quotes, the quote-by-quote 
approach implicitly recognizes that securities with different 
characteristics trade differently (for example, actively traded or 
derivatively priced securities trade differently from inactively traded 
securities). By focusing on quotes rather than entire markets, the SEC 
appropriately allows more flexibility for market centers to compete 
more fairly with one another notwithstanding different market 
structures that may cater to different types of listed companies and 
securities. Such an approach is also more consistent with Congress's 
mandate to the Commission to facilitate fair competition between and 
among markets.
    Second, the quote-by-quote approach lends itself more easily to 
responsible industry-wide rollout. Requiring immediate, automatic 
accessibility of quotes as a precondition for trade-through protection 
is a dramatic industry-wide change. In some regards developing and 
implementing the relevant technology is the easy part. The more 
difficult challenge is to create an effective hybrid model that 
responsibly integrates automatic execution functionality into market 
models, like the Amex, that are designed to maximize price discovery 
and improvement, while minimizing price volatility. Further, one type 
of hybrid model may not be optimal for all securities. For example, the 
appropriate hybrid model for the most actively traded and derivatively 
priced securities is unlikely to be the optimal model for less liquid 
securities, which rely more heavily on price discovery and stability 
offered by dedicated liquidity providers.
    Therefore, we propose phasing in the quote-by-quote exception 
through a pilot program, starting with the most actively traded 
securities and progressively expanding the exception, in traunches, to 
less actively traded securities.\8\ Sequencing the implementation of 
the quote-by-quote exception provides two benefits. First, sequencing 
allows all market participants to make required technological and 
business model changes. Second, of equal importance, industry-wide 
phasing in of the exception through a pilot program would provide 
empirical evidence on whether the 
exception creates unintended consequences, such as increased spreads 
for illiquid securities, decreased execution quality, or increased 
volatility and perceived disorder. Armed with empirical data while 
phasing in a pilot program for the exception, the SEC would have the 
opportunity to respond to, and adjust for, any unanticipated 
consequences that might undermine investor confidence, increase the 
cost of capital for small- and mid-cap companies, or discourage the 
development of new, innovative products.
---------------------------------------------------------------------------
    \8\ We propose starting with the most actively traded securities 
because they are generally less reliant on dedicated liquidity 
providers except at times of market stress; and, at least for actively 
traded ETF's, may rely on price discovery in the futures, rather than 
the securities, markets.
---------------------------------------------------------------------------
Exception for ``Informed'' Investors to ``Opt Out''
    As to the proposed exception for ``informed'' investors, we have 
serious concerns about, and oppose, the SEC's proposal to allow 
institutions and other traders to ``opt out'' trade-by-trade of the 
best-price protection provided by the trade-through rule. We believe 
that there is no justification to adopt this exception, especially if 
traders know (as they would with the adoption of the quote-by-quote 
exception) before an order is sent whether a displayed price is 
immediately accessible; and, once the order is sent would receive an 
immediate, automatic response as to whether the order was filled.
    As the Commission concedes in its proposing release: ``The price at 
which an order can be executed is of paramount importance for most 
investors . . . .'' \9\ In fact, the American Association of Retired 
Persons recently conducted a survey of investors aged 50 and over and 
found that nearly two thirds said that price--not the balancing of 
price with speed--was the number one priority when conducting 
transactions.\10\ However, under the current proposed opt out 
exception, institutions and traders wanting to sacrifice the best price 
(for themselves or their ultimate customers) for idiosyncratic reasons 
could. And those trades would occur at the expense of other investors 
who, without their consent, would have their better-priced limit orders 
passed over.\11\ Thus, in effect, the proposed opt out provision allows 
the interests of a small group of traders who prefer speed to trump the 
interests of the vast majority of investors who expect to receive the 
best price.
---------------------------------------------------------------------------
    \9\ Regulation NMS Release at 11153.
    \10\ AARP, Investor Perceptions and Preferences Toward Selected 
Stock Market Conditions and Practices: An AARP Survey of Stock Owners 
Ages 50 and Older (Mar. 2004).
    \11\ For example, suppose that you owned 200 shares of ABC Inc., 
which was trading at $15.25. And, let us assume that if ABC's stock 
price increases to $16.00 per share, you want to sell your 200 shares, 
so you place a limit order to sell at $16.00. Now, let us further 
suppose that the market for ABC stock increases and your order becomes 
the national best offer, meaning that you are offering to sell ABC 
stock at the cheapest price nationwide. However, without a trade-
through rule, your order to sell could be ignored and a trade could be 
executed at, for example, $16.02. Thus, not only have you not been able 
to sell when your limit order represented the national best offer, but 
also the investor who bought paid more than necessary for the stock.
---------------------------------------------------------------------------
    We also believe that the opt out exception would undermine market 
integrity and investor confidence by increasing disorder and confusion 
caused by disjoined groups of traders paying different prices for the 
same security at the same time. Thus, the opt out exception would 
undermine one of the fundamental purposes of the trade-through rule: To 
ensure that buyers and sellers in one market compete head-to-head, 
based on price with buyers and sellers in other markets. The proposal 
also creates an economic incentive for an unscrupulous broker to 
convince an investor to opt out so that the broker can fill the 
investor's order internally at an inferior price, pocketing the 
difference. Finally, if the Commission adopts the quote-by-quote 
exception to the trade-through rule, we see no reason why anyone should 
be allowed to trade through an automatically accessible better price. 
Simply stated, we think the proposed opt out is unnecessary if the 
quote-by-quote exception is adopted and wrong as a matter of public 
policy.

Inter-Market Access
    Amex agrees with the Commission that fair access to the best prices 
available across competing market centers is essential to achieve an 
efficient, transparent national market system where markets vigorously 
compete and, as a result, investors' orders have the opportunity to 
interact directly and receive best execution. Essential to that 
competition is the ability for one market to see and have fair and 
efficient access to another market's best bids and offers. Hidden 
markets with hidden prices or undisclosed fees undermine fair 
competition and access. Thus, we agree with the Commission that even 
when quoted prices are not hidden, published quotes do not necessarily 
reflect the true price available to investors because of access fees 
charged by electronic communication networks (ECN's) to nonsubscribers. 
These types of access fees not only undermine transparency, but also--
when used to fund liquidity rebate programs--degrade market quality by 
encouraging the locking and crossing of markets. Such behavior 
undermines the basic tenets of the national market system.
    However, we believe that the Commission's proposed solution of 
placing a ``de minimis'' cap on access fees fails to address the 
fundamental problem with access fees imposed on nonsubscribers and is 
over-inclusive, as drafted. First, we question whether the Commission's 
proposed solution of fixing maximum rates for access to quotes moves us 
any closer to true fair access across markets. Instead, we believe that 
the proposal not only places the SEC in the unfamiliar role of rate 
maker, but also fails to directly address the fundamental problem: 
ECN's charging market participants, with whom they have no contractual 
or other relationship, a surcharge to access the ECN's' quotes. Then, 
pursuant to what these market participants perceive as their best 
execution obligations to their customers, they believe that they are, 
in effect, forced to access the ECN's' prices and pay any additional 
charges that the ECN's wish to impose. This is akin to a private entity 
placing a tollbooth on a public highway.
    Second, rather than focusing on the questionable activity--imposing 
a surcharge on parties unilaterally--the proposed rule also appears to 
reach transaction and other fees charged by self-regulatory 
organizations (SRO's) and other market centers to their members and 
subscribers. Transaction and other fees charged by SRO's (or even 
access fees charged by ECN's to their subscribers) are fundamentally 
different from access fees ECN's charge to nonsubscribers. At the most 
basic level, transaction and other fees charged by SRO's and other 
market centers to their members and subscribers are consented to (that 
is, bi-lateral) and tied to services provided. For example, the Amex 
has a market structure and applicable rules designed to establish fair 
prices on open and close, facilitate single-priced auctions, manage 
market imbalances, reduce daily stock-price volatility, and provide 
dedicated liquidity. And unlike ECN's, SRO's like the Amex have 
obligations not only to ensure that their members comply with the 
Federal securities laws, but also to adopt and enforce rules to prevent 
fraudulent and manipulative acts and practices, promote just and 
equitable principles of trade, and protect investors and the public 
interest.
    Thus, we believe it is fundamentally unfair to allow market centers 
to access the quotes of other market centers at prices set by the SEC--
and not the marketplace itself--without commensurate obligations to 
provide dedicated liquidity and regulatory services. Such an approach 
fails to acknowledge that there are different levels of service and 
responsibilities (regulatory and otherwise) provided by market centers 
for which members, subscribers, and investors are willing to pay.
    As to the SEC's proposal related to Regulation ATS, we oppose 
merely lowering the fair access standard of Regulation ATS from 20 to 5 
percent of trading volume. Instead, we believe that the first step in 
true fair access is to mandate fair access by all alternative trading 
systems (ATS's) regardless of the percentage of their trading volume. 
And, to minimize the cost to other market participants for obtaining 
access to ATS's with trading volume below 5 percent we propose 
requiring that those ATS's display and make available their quotes 
through an SRO. Finally, to facilitate fair access and enhance 
transparency, we urge the Commission to eliminate the loophole in 
Regulation ATS that allows an ATS to avoid disseminating its quotes 
into the national market system by ``going dark'' (that is, not even 
displaying subscribers' quotes to other subscribers). We believe that 
the above-described steps would advance the goal of eliminating hidden 
markets with hidden prices, which undermines fair competition between 
market centers and fair and efficient access to all best bids and 
offers.

Market Data
Collecting, Consolidating, and Disseminating Market Data
    One of the fundamental achievements of the national market system 
is wide-spread, public accessibility of reliable consolidated market 
information, including real-time access to the national best quotes 
for, and trades in, NMS stocks. Collecting, consolidating, and 
disseminating real-time market information across all market centers 
nationwide enhances transparency and competition. Of equal importance, 
real-time dissemination of market data arms investors with information 
essential to (1) make more informed decisions when placing limit 
orders, (2) monitor the quality of their trade executions, and (3) 
evaluate the performance of the market professionals executing trades 
on their behalf.
    As such, we support codifying the requirement that all SRO's must 
participate in, and act together through, joint-industry plans that 
ensure the collection and dissemination of real-time ``core'' 
consolidated market information--the national best bid and offer (NBBO) 
and time and sale data--to the public through a single processor for 
each NMS stock. However, we oppose (1) reducing the type of information 
included in the consolidated display, (2) limiting the circumstances 
under which investors must receive consolidated market information, or 
(3) allowing market centers to sell duplicative core market data 
independent of the joint-industry plans. We believe that these three 
proposed changes will not enhance transparency for investors, but will 
increase the risk of disseminating incomplete, nonsequential market 
data that will confuse investors and complicate the management of 
market data for vendors and broker-dealers.
    First, as to the proposed definition of ``consolidated display,'' 
the SEC in Regulation NMS suggests eliminating the current requirement 
that the display must include a complete montage of quotes from all 
reporting market centers trading a 
particular security. We oppose this change because we believe that the 
complete montage provides valuable information to investors, especially 
in the era of decimal-ization. For example, two market centers could be 
quoting minimum depth at the NBBO, while a third market center is 
quoting substantial depth not at, but close to, the NBBO. An investor 
wanting to execute a large trade but only receiving information 
constituting the newly defined consolidated display would arguably lack 
the most significant piece of information to that investor: The 
substantial depth being offered close to the NBBO by the third market 
center. Thus, we believe requiring the consolidated display to include 
a complete montage of quotes from all reporting market centers provides 
essential transparency to investors and should continue.
    Second, the Commission appears to have potentially narrowed the 
circumstances under which investors must receive the consolidated 
display to only situations ``in which a trading or order-routing 
decision can be implemented.'' \12\ In our view, any display of market 
data can lead to a trading decision (including a decision not to 
trade), and we believe that investors should make all trading decisions 
based on market information that is as complete as possible. Therefore, 
we are concerned that broker-dealers or others could unintentionally 
provide incomplete or skewed market data to investors upon which those 
investors may make preliminary investment decisions. And only when 
those investors actually access a system to place or route an order (if 
they are able to do so at a reasonable cost under this new regime) 
would the complete picture of the market come to light through the 
consolidated display.
---------------------------------------------------------------------------
    \12\ Regulation NMS Release at 11209.
---------------------------------------------------------------------------
    Third, we support fostering innovation and competition between 
markets by allowing market centers to develop and independently sell 
ancillary, noncore information (such as their depth of book) with as 
little regulation as possible and without requiring dissemination 
through a specific consolidator. However, we are concerned that 
allowing market centers to independently sell duplicative core market 
data will diminish transparency for investors. For example, 
notwithstanding best intentions to the contrary, a risk exists that 
independently disseminated, unconsolidated quotes would not reach 
vendors simultaneously with the consolidated NBBO. As a result of 
mismatches between the NBBO and independently disseminated quotes, we 
believe that the appearance of a disorderly, incongruent market will 
increase as will investor confusion.
    In addition, combining the proposed independent sale of core data 
with the narrowing of the definition of the consolidated display 
creates the risk of anticompetitive practices with respect to the 
joint-industry plan for Nasdaq securities. Unlike the plans for 
exchange-listed securities, the joint-industry plan for securities 
traded on Nasdaq allows subscribers to either purchase (1) the last 
sale and the NBBO (so-called ``Level 1'' service) or (2) the quotes of 
each market maker and exchange with unlisted trading privileges in 
addition to Level 1 data (Level 2 service). Thus, not requiring the 
quotes of other market centers as part of the consolidated display 
could lead to a scenario where Nasdaq charges little or nothing for the 
quotes of its market makers. This could create a strong economic 
incentive for subscribers to only purchase Level 1 data and obtain 
market maker quotes directly from Nasdaq. As a result, these 
subscribers would not obtain the quotes of exchanges with unlisted 
trading privileges. We believe that such an outcome would deprive 
investors of essential information from exchanges with unlisted trading 
privileges, such as substantial depth being offered close to the NBBO, 
and would lessen competition among markets in Nasdaq securities to the 
detriment of investors.\13\
---------------------------------------------------------------------------
    \13\ No similar problem exists for exchange-listed stocks because 
the joint-industry plans for these securities provide all subscribers 
with the same data (that is, last sale and all quotation information 
together) and the current governance structure of these plans make 
changes unlikely because unanimity of plan participants is required.
---------------------------------------------------------------------------
Governance of Market Data Plans
    The Amex supports the creation of nonvoting advisory committees to 
participate in network operating committee meetings. We believe that 
advisory committees will give a formal voice to the key constituencies 
that have historically provided informal input: Investors and their 
representatives, alternative trading venues, and data vendors. To make 
the advisory committees as effective as possible, we also support 
granting advisory committee members the ability to receive the same 
materials as operating committee members and to attend and participate 
in all operating committee meetings (with the exception of executive 
sessions).

Distribution of Market Data Revenue
    As to the distribution of market data revenue, the Amex strongly 
endorses the Commission's goal of revising existing distribution 
formulas to remove or diminish economic incentives for trading 
practices that degrade the accuracy and usefulness of market data, 
confuse investors, and unnecessarily increase message traffic for all 
market participants. The current distribution formulas, with their 
myopic focus on trades alone, create incentives for ``gaming'' through 
fraudulent, deceptive, or market-distorting trading practices driven by 
the desire to capture data revenue.\14\ Thus, we strongly support the 
Commission's proposed revisions to the distribution formula, with some 
minor adjustments, as a thoughtful, innovative mechanism to discourage 
deceptive and market-distorting trading practices while encouraging 
enhanced liquidity and price discovery.
---------------------------------------------------------------------------
    \14\ Such practices include: ``wash trading,'' ``tape shredding,'' 
and ``print facilities.'' Wash trading occurs when traders purchase and 
sell the same security at the same time or within a short period of 
time in non-bona-fide transactions to create the false or misleading 
appearance of active trading. Trade shredding occurs when a single 
order is divided into multiple, smaller orders to increase the 
allocation of market data revenue. And, a so-called ``print facility'' 
is an SRO that rebates a portion of its market data revenue to market 
makers and ATS's for reporting their trades through the SRO, but those 
entities otherwise have little or no relationship with the SRO and may 
even display quotes through a second SRO. Thus, print facilities not 
only confuse investors about the actual location of liquidity, but also 
complicate regulatory and surveillance efforts by obscuring where a 
trade actually occurred.
---------------------------------------------------------------------------
    We acknowledge that the proposed formula appears relatively 
complex. Nevertheless, the network processors already capture all of 
the essential data needed to implement the formula (except for the 
portion of the formula related to price improving quotes, which we 
recommend that the SEC not adopt). Likewise, the formula easily can be 
programmed into a computer without the component related to price 
improving quotes. And, regardless of its perceived complexity, the only 
parties that need to deal directly with the formula are the network 
processors and the professionals auditing the calculation and 
distribution of market data revenue. What must not be lost in the 
debate on the details of the proposed formula is its most compelling 
attribute: The formula encourages market transparency and liquidity by 
rewarding quoting at the national best price.

Sub-Penny Pricing
    Amex believes that the proposal in Regulation NMS that would 
prohibit market participants from ranking, displaying, or accepting 
orders, quotes, or indications of interest in sub-pennies does not go 
far enough. Sub-penny quoting diminishes market transparency and depth 
and degrades price priority by allowing orders offering economically 
meaningless price improvement to step in front of resting limit orders. 
Therefore, we believe that the prohibition against sub-penny quoting 
should extend to all NMS stocks, including stock trading below $1.00. 
We also believe that the Commission should ban trading in sub-pennies 
except for the reporting or ``printing'' of trades resulting from 
pricing mid-point, volume-weighted average, or other similar trades, so 
long as the trades do not otherwise violate the prohibition against 
quoting in sub-pennies.
    In addition to banning sub-penny quoting and allowing sub-penny 
trading only under limited circumstances, we believe that the 
Commission should take this opportunity to reassess whether ``one-size-
fits-all'' with respect to minimum tick size. Professor William 
Christie who, along with Professor Paul Schultz, in 1994 suggested that 
Nasdaq market makers were maintaining artificially wide spreads, is now 
suggesting reevaluating the penny tick size.\15\ He contends, and we 
believe, that a penny creates such a small pricing increment that it 
destroys the critical roles played by price priority and limit orders. 
A penny tick size, like sub-penny quoting, encourages gaming whereby 
economically meaningless price improvement is used to step in front of 
existing limit orders. Professor Christie has suggested considering a 
minimum tick size of $0.05.\16\ We agree, especially for appropriate, 
high-priced securities.
---------------------------------------------------------------------------
    \15\ William G. Christie, A Minimum Increment Solution, Traders, 
Nov. 2003, at 40.
    \16\ Id.
---------------------------------------------------------------------------
Conclusion
    Thirty years ago when setting out the basic tenets of a national 
market system, Congress knew then--and it is equally applicable today--
that when it comes to market structure ``one-size-does-not-fit-all.'' 
In the coming weeks and months as the debate on market structure and 
Regulation NMS continues, we urge Congress and the Commission to turn 
back to these core principles and remember the important and unique 
role that auction markets and their dedicated liquidity providers play 
in facilitating capital formation for small- and mid-cap companies and 
in nurturing innovative financial products. Ultimately, investors, 
listed companies, and innovative 
financial products all benefit from vigorous but fair competition 
between diverse market centers offering value-added services.
    Thank you again for providing the Amex with the opportunity to 
express our views on some of the key proposals contained within 
Regulation NMS. I would now be pleased to answer any questions you may 
have.

                               ----------
                 PREPARED STATEMENT OF EDWARD J. NICOLL
                    CEO, Instinet Group Incorporated
                             July 21, 2004

    Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, 
thank you for holding this hearing and for inviting me to speak before 
you today.
    My name is Ed Nicoll and I am the CEO of Instinet Group 
Incorporated. Through our affiliates, we provide sophisticated 
electronic trading solutions that enable buyers and sellers worldwide 
to trade securities directly and anonymously with each other, interact 
with global securities markets, have the opportunity to gain price 
improvement for their trades, and lower their overall trading costs.
    The U.S. Government today--in the form of the SEC, Reg. NMS, and 
the oversight provided by Congress--is basically debating whether or 
not to allow true competition between America's stock markets or to 
keep in place the status quo. Simply said, competition and openness 
will benefit investors more than the status quo or mere ``window-
dressing'' reforms.
    In 1975, Congress tasked the SEC to create the national market 
system (or NMS) and provided it with a roadmap for developing a market 
structure designed to preserve and strengthen our markets. But over the 
past three decades, new trading technologies have had an incredible 
impact on our financial markets. With these advancements, there is now 
general consensus that one of the key market rules, the trade-through 
rule, is outdated. Even those calling for minimal reforms are not 
arguing that no change is needed.
    Despite the recognition that the rule is outdated and actually 
undermines market efficiency, many want to retain its core principles 
rather than eliminate it or provide an effective way to opt out of its 
prohibitions. Those arguing in favor of retaining the trade-through 
rule assert that trade throughs lead to investor confusion, fewer limit 
orders, reduced liquidity and, given the hyperbole of some, the 
collapse of our financial markets.
    But we already know what happens in the absence of a trade-through 
rule. In particular, when we compare a market without a trade-through 
rule--the market for Nasdaq securities--to a market with a trade-
through rule--the market for NYSE securities--we see that the Nasdaq 
market provides investors with execution quality that is as good as, 
and in many cases better than, that of the NYSE. This is borne out by 
the SEC's own mandated execution quality statistics, as well as other 
analyses that we submitted with our comments on Reg. NMS and which I 
ask be included in the record.*
---------------------------------------------------------------------------
    * Held in Committee files.
---------------------------------------------------------------------------
    Nevertheless, the SEC is currently considering adopting a new 
trade-through rule that would continue to prohibit market participants 
to trade through advertised prices of so-called ``fast'' markets. In 
short, the Government would designate an arbitrary speed limit for the 
marketplace. The NYSE is attempting to gather support for the ``fast'' 
market proposal by making its system just automated enough so that the 
SEC will designate it as a ``fast'' market. Ironically, these changes 
by the NYSE only serve to underscore the benefits of eliminating the 
trade-through rule or adopting an effective opt out provision.
    But the issue with a trade-through rule is not related to speed. It 
is that the rule substitutes the judgment of the Federal Government for 
that of the marketplace--thereby distorting competition and inhibiting 
innovation. Many of the traditional market participants, with high cost 
structures, find themselves unable to compete with new, nimbler 
competitors who are able to adapt to consumer demands. In the face of 
declining trading profits, it is hardly surprising that they seek 
assistance from the Government to slow down the changes in the 
marketplace.
    But do we really want to hamstring the most technologically 
advanced markets, with a proven track record of delivering increased 
value to investors, in order to protect the old way of doing things? 
The cost of any regulatory approach that inhibits new methods of 
trading efficiency will be borne by investors who will pay more when 
they buy and sell securities. The question becomes, will SEC rules 
foster technological growth or cling to an outdated regulatory 
structure that inhibits it?
    We should also consider the limited proposal to reform the trade-
through rule in the context of the other elements of proposed 
Regulation NMS such as: (1) fixing the prices a market can charge; (2) 
fixing the increments in which they can trade; (3) dictating terms of 
access; (4) establishing the terms and price for each market's data; 
and, (5) limiting transparency and information sharing in order to 
protect consumers from ``confusing'' bids and offers. I ask that the 
executive summary of our comment letter to the SEC, which discusses 
these issues, be included in the record.
    On top of all this, effectively setting a speed limit for markets 
by defining ``fast'' could result in denying markets one of the last 
ways they have to compete against one another. I cannot imagine that we 
want to limit--rather than promote--competition in the most efficient, 
dynamic markets in the world. In fact, some might wonder whether 
Congress' call for a national market system is getting closer to a 
``nationalized'' market system--and not the diverse system of competing 
markets that Congress originally envisioned. Our markets have long been 
the best and strongest in the world. We cannot bury them in regulatory 
mandates and micromanage their operations like we do the local power 
plant or phone company and not expect to eventually pay a price in 
terms of our global competitiveness.
    The NYSE's publicly stated intent to reform its internal processes 
only underscores the benefits of eliminating the trade-through rule. It 
is no coincidence that the NYSE is considering ways to make its market 
more efficient and electronic at the same time that we are all here to 
discuss the fate of the trade-through rule. The NYSE's timing proves 
our point. If the trade-through rule were not in some way protecting 
its business, then the NYSE would not be making such an effort to 
defend it. But innovation cannot be limited to time periods when 
regulations are under review. It must be continuous and spurred by 
competition. That is why we simply need to either eliminate the trade-
through rule or adopt an effective opt out.
    Anything less and we risk squandering both this opportunity for 
reform as well as our position as the preeminent capital market in the 
world.
    Thank you for the opportunity to address you today and I look 
forward to answering any questions you might have.

                               ----------

                 PREPARED STATEMENT OF GERALD D. PUTNAM
                  Chairman and Chief Executive Officer
                       Archipelago Holdings, LLC
                             July 21, 2004

    Good morning Chairman Shelby, Ranking Member Sarbanes, and other 
distinguished Members of the Committee. As Chairman and CEO of the 
Archipelago Exchange (ArcaEx), it is a high privilege and great honor to 
be provided the opportunity to submit a written statement to and testify 
before the Committee on proposed Regulation NMS and developments in 
market structure.

The History of ArcaEx
    ArcaEx's beginnings were sown in the immediate aftermath of the 
Nasdaq price-fixing scandal of the mid-1990's, which culminated in 
sanctions being brought by the Securities and Exchange (SEC) and the 
Department of Justice.\1\ One of the chief reforms exacted on the OTC 
marketplace in response to the scandal was the introduction of the so-
called ``Order Handling Rules'' in 1996.\2\ These rules provided me 
with an opportunity to design a trade-execution business that, although 
seemingly very simple, was revolutionary for its time. It was ``to do 
the right thing'' by the customer by creating a level playing field for 
all investors in an industry traditionally filled with insiders and 
insider deals. With that, our credo has always been: No special(ist) 
handshakes, no ``negative obligations,'' no ``jaywalking,'' and no 
thirty-second free options; rather, all investors are given the 
opportunity to play on a level playing field. This has been and will 
continue to be one of our competitive advantages.
---------------------------------------------------------------------------
    \1\ See Report Pursuant to Section 21(a) of the Securities Exchange 
Act of 1934 Regarding the NASD and the Nasdaq Market, SEC, August 8, 
1996.
    \2\ Securities Exchange Act Release No. 37619A (September 6,1996), 
61 FR 48290 (September 12, 1996) (File No. S7-30-95).
---------------------------------------------------------------------------
    From day one, we branded our business as ``best execution'' by 
delivering to all of our customers: (1) access to full and timely 
market information; (2) fast electronic and anonymous executions; (3) 
sophisticated order types and other value-added functionality; and, (4) 
arguably our biggest contribution to market structure--algorithmic 
outbound routing to guarantee best price where that price did not 
reside in ArcaEx. This latter element was both a sizeable technological 
innovation and a manifestation of two primary goals articulated by 
Congress in the National Market System Amendments in 1975.\3\ By 
establishing proprietary linkages among marketplaces, we were able to 
create a large virtual pool of liquidity where customers were given 
electronic access to best price, not only within ArcaEx's own system, 
but also at other (competitor) electronic marketplaces. Unlike the 
listed market,\4\ the OTC market does not have a ``trade-through'' rule 
today. Thus, in lieu of Government fiat such as the ITS trade-through 
rule, getting ``best price'' for our customers was driven by a business 
idea, newly created customer demand, and our fiduciary obligation to 
achieve ``best execution'' for our customers.
---------------------------------------------------------------------------
    \3\ National Market System Amendments of 1975 to the Securities 
Exchange Act of 1934; Pub. L. No. 94-29, 89 Stat. 97 (1975).
    \4\ The ``listed marketplace'' is defined as those national 
securities exchanges and self-regulatory organizations that trade NYSE- 
and AMEX-listed securities, as well as securities listed on their own 
markets, and include ArcaEx (as a facility of Pacific Stock Exchange), 
Boston Stock Exchange, Philadelphia Stock Exchange, National Stock 
Exchange, Chicago Stock Exchange, NASD (Nasdaq 3rd Market) and, of 
course, the NYSE and AMEX, themselves. These listed markets interface 
and interact with one another in accordance with intermarket 
regulations and rules governed by national market system committees--
ITS and CQ/CTA--and by the SEC. In contrast, the ``over-the-counter 
(OTC) marketplace'' is defined as those national securities exchanges 
and self-regulatory organizations that trade Nasdaq securities and 
include many of the entities listed immediately above such as ArcaEx. 
The ``OTC marketplace'' is structured under a wholly different set of 
intermarket regulations, rules, and committees than the ``listed 
market.''
---------------------------------------------------------------------------
    In late 2001, ArcaEx was unanimously approved by the SEC to operate 
a fully automated electronic stock exchange regulated by the Pacific 
Stock Exchange. ArcaEx became operational to trade listed stocks in 
2002, and OTC shares in 2003. ArcaEx is now available to execute trades 
in over 8,000 exchange-listed and OTC securities.
    From literally zero volume as an ECN in 1997, ArcaEx now handles 
over 25 percent of the trading volume in OTC securities, over 19 
percent of total trading 
volume in Amex-listed securities, and 1.6 percent of total trading 
volume in NYSE-listed securities.

Big Doings in Market Structure Debate
    In the past, I have come before this Committee and other 
Congressional Subcommittees and expressed the significance and 
importance of the issues of that day. However, today's hearing is 
easily the most consequential since I first appeared before a 
Congressional Committee in 1999. The large number of executives from my 
industry and K-Street lobbyists walking these corridors over the last 
several months and the amount of letters generated by Members of 
Congress and the public certainly bears out the politically charged 
nature of Regulation NMS.
    Regulation NMS is a big-impact proposal. As you know, it tackles 
weighty and sensitive issues--the ``trade-through'' rule, access fees, 
and market data fees--and is the SEC's most ambitious architectural 
transformation of our markets since the SEC created the national market 
system (NMS) in response to Congressional direction as part of the 1975 
amendments to the Securities Exchange Act of 1934. The implementation 
of Regulation NMS, in current or modified form, could have colossal 
effects on the economics of this industry and the trading of equities, 
and could redefine long-standing investment relationships.
    Competition has served the investing public in the OTC market and 
could in the listed market as well. Generally speaking, the OTC market 
was (re)built from the ``bottom up'' by entrepreneurs, among others, 
after the implementation of the Order Handling Rules in 1997. 
Competitive forces have compelled every legitimate OTC market center to 
provide firm quotes that are accessible by automatic execution with no 
human intervention or intermediation. This is true for not only the 
best bid and best offer (BBO) of each OTC market center, but also for 
their entire depth of book. If limit order protection is sacrosanct, 
then why stop at the BBO? Competitive forces in the OTC market have 
essentially caused all market centers to respect all limit orders, not 
just the BBO.
    The listed market, on the other hand, was built from the ``top 
down'' where lots of rules exist and bureaucracy, with all of its 
interpretive complexity, reigns. The listed market could stand a good 
dose of competition. Adherence to the findings of Congress in 1975 
would ``kick down the door of monopoly'' and sweep in the fresh air of 
competition. In this manner, services will grow, and the investing 
public will benefit.
    Since a trade-through rule already exists, and has existed for 
decades, in the listed market, we understand why the SEC would continue 
to press for its existence, but in a reformed manner to make sure that 
investors can really receive the best price for their orders, and not 
just the best price for the specialist. ``Best price'' vs. ``speed'' is 
a false dichotomy. If the NYSE were providing ``best price'' to its 
customers than why the SEC fines of NYSE specialists for $250 million, 
public complaints by customers of the NYSE, and editorializing by 
leading newspapers for change at the NYSE?

Regulation NMS
    In this winter and spring, the SEC proposed several market 
structure initiatives, including trade-through reform, new market 
access standards, and market data revenue-sharing reform. Although we 
have strong views on each of the SEC's proposals, and I will mention 
briefly the market data proposal, I will focus today, for the most 
part, on two of these items: The need for reform of the current trade-
through rule and the no-need for Government ratemaking in our extremely 
competitive markets.

Trade-Through Reform
    Without question, the operation of the trade-through rule has been 
one of the most highly debated issues in the securities markets over 
the last several years. In its current form, it thwarts competition and 
impedes efficient execution. We believe that the solution to trade-
through reform is simple: Allow markets with firm quotes to trade-
through markets with nonfirm quotes, but not to trade-through markets 
with firm quotes.
    The recent history of reform in the OTC market vividly displays the 
benefits of efficient market access and firm quotes. It is beyond 
question at this point that the business model of ArcaEx and our direct 
competitors has had a profoundly positive effect on the OTC marketplace 
that has benefited investors. Our early success in the OTC market was 
attributable to the ability of ArcaEx and its competitors to access 
firm quotes on other markets to assure that investors always receive 
best execution.
    Today, in the NYSE-listed marketplace, however, nonfirm quotes are 
rampant and preclude firm quotes from timely execution. The trade-
through rule in NYSE-listed securities was designed to provide price 
protection and encourage display of aggressively priced limit orders. 
The rule sought to assure that better priced orders would not be 
circumvented by inferior executions in other markets. In an electronic 
environment, however, this means that orders must be transmitted to any 
market center with the best price, whether a manual or electronic 
market, even though that best price may no longer exist by the time 
that the order is received. Thus, there are few, if any, commentators 
today that question the desperate need to modernize this rule.
    The current ITS trade-through rule was designed for a 1970's market 
structure when all exchanges were slow and manual and specialist-based 
ones. In today's electronic world, however, the rule limits customer 
choice and dumbs-down best execution to the lowest common denominator 
of the slowest market. It compels fast 
electronic markets, and their customers, to play at glacial speed. A 
broader effect of the trade-through rule is to thwart competition 
between electronic markets and the NYSE.
    A modern trade-through rule must protect published prices that are 
firm quotes and that are immediately accessible and responded to 
instantaneously without human intervention.\5\ If a market still wants 
to operate in a manual manner, however, then electronic markets should 
be able to trade-through those slow quotes.\6\ Moreover, the rule must 
apply to all markets trading NYSE-listed securities--including those 
that internalize without reflecting their interest in the consolidated 
quote. The end result is that only true prices are protected and 
afforded the ability to instantaneously execute when at the best price. 
This concept was the cornerstone of the ``Three Amigos'' Proposal of 
2002, which ArcaEx still stands behind strongly.
---------------------------------------------------------------------------
    \5\ It is important to stress that accessibility includes the 
ability to enter and to exit a market center. Otherwise, some market 
centers will become ``sticky'' in an anticompetitive sense and will 
suck a market participant in with no ability to cancel and exit without 
an execution.
    \6\ ArcaEx supports the proposed rule for listed trade-throughs: 
Markets representing firm quotes may not trade-through markets 
representing firm quotes but may trade-through markets representing 
nonfirm quotes up to $.03; nonfirm quotes may not trade-through any 
other quote whether firm or nonfirm.
---------------------------------------------------------------------------
    The existing trade-through rule protects the NYSE's market share by 
requiring orders to be funneled to the specialists at the NYSE when 
they display the best price. This provides the specialist with a 
virtual put option on the order and ensures that they, the specialist, 
obtains the best price.\7\ The customer, on the other hand, may or may 
not get the best price and may have even lost the opportunity, through 
this process, to receive any execution at all, not only at the NYSE but 
also across all market centers.
---------------------------------------------------------------------------
    \7\ Earlier this year, the NYSE's five largest specialist firms 
agreed to pay a total of about $240 million to settle SEC allegations 
that they short changed customers by trading for their own accounts. 
See ``NYSE Traders Will Pay Fines Of $240 Million,'' Wall Street 
Journal, February 18, 2004. Some 5 months after these five large 
specialist firms paid nearly a quarter of a billion dollars to settle 
SEC trading ahead allegations, the NYSE's other two much smaller 
specialist firms paid roughly $5 million to resolve similar SEC 
charges. See ``NYSE Small Specialists to Pay $5 Million in Cases on 
Trading,'' Wall Street Journal, July 9, 2004.
---------------------------------------------------------------------------
    We also want to caution that the SEC may have a difficult challenge 
in defining the concept of ``fast'' and ``slow'' markets, or even 
``automated'' and ``nonautomated'' markets.\8\ Definitions too often 
result in unnecessary complexity. For this reason, as well as others, 
we believe that investors must have the ability to bypass market 
centers where quotes are not firm, and this ability is critically 
important both in terms of enhancing market competition and in terms of 
maintaining market discipline.
---------------------------------------------------------------------------
    \8\ ArcaEx is of the view that whether a quote is firm should not 
be determined on a quote-by-quote basis at the discretion of an 
intermediary, such as a specialist, because such a structure would 
represent a step backward to a time when intermediaries, such as market 
makers and specialists, could exercise individual discretion on when to 
turn on and to turn off automated systems. The potential for customer 
abuse, as well as customer confusion, in that environment is obvious 
and was well documented as such in the OTC market pre-Order Handling 
Rules.
---------------------------------------------------------------------------
Trade-Through Reform Is Not Necessary in the OTC Market
    While we support reform of the current trade-through rule, we 
believe that a new trade-through rule is unnecessary in the OTC 
marketplace because competition already has driven the market to 
develop its own means of price protection. Importantly, we believe that 
a trade-through rule in OTC would damage a marketplace that has changed 
dramatically for the better since the implementation of the Order 
Handling Rules. It makes little sense to us to pursue additional reform 
of the OTC market because of the recent mishaps of the NYSE. Execution 
speeds in OTC stocks are generally sub-second and currently surpass 
quote update speeds. Accordingly, introducing a trade-through rule in 
OTC would result in holding up executions while awaiting dissemination 
of quote updates, or worse yet, in instigating increased cancellation 
of orders. From a practical perspective, in OTC stocks where speed and 
certainty of execution are critical, the customer sending the order in 
an environment with a trade-through rule is disadvantaged because not 
only will it take longer to execute the order, but he or she may also 
receive a partial fill--or no fill at all. In other words, the OTC 
market is not broken so why fix it.

The SEC Must Monitor and Enforce the Trade-Through Rules
    Our second proposal for trade-through reform is equally simple: The 
SEC must monitor and enforce whatever trade-through rules are in place. 
Industry insiders have known for years that the trade-through rule is 
the least enforced rule this side of the double nickel speed limit on 
America's highways. For example, despite the fact that there is a 
trade-through rule for NYSE-listed securities, ArcaEx quotes are traded 
through on average of over 2,000 times per day.\9\ In fact, trade-
through violations have actually risen most recently despite the glare 
of the regulator spotlight on the NYSE. On any given day, ArcaEx has a 
billion shares on or near the national best bid or offer. Yet, the NYSE 
sends only two million shares to ArcaEx over ITS when we have the best 
price.
---------------------------------------------------------------------------
    \9\ ArcaEx runs software (aptly named whiner) that messages alerts 
when exchanges trade through an ArcaEx quote in violation of the ITS 
Plan. For the week of June 21, 2004, ArcaEx complained to other 
exchanges 11,816 times about being traded-through for an average of 
2,363 complaints per day.
---------------------------------------------------------------------------
    Clearly, today's trade-through rule is not effectively enforced, 
other than to ensure that the NYSE specialists receive the best 
price.\10\ Implementing a clear-cut rule with no exceptions will be 
essential to ensure that the rule is adhered to and enforced. Reform 
would enable investors to choose how they want their limit orders 
handled. They could then send them to electronic markets that provide 
instantaneous display and automatic executions against incoming orders. 
Or, investors could choose to send them to a manual market if they want 
to expose the orders to specialist and floor broker handling.
---------------------------------------------------------------------------
    \10\ It is difficult for a market participant to pursue enforcement 
of the current trade-through rule because it is an ITS rule and not an 
SEC rule. One has to go to the ITS Committee to complain before 
approaching the SEC. In addition, enforcement is after the fact so it 
is time-consuming and otherwise troublesome. Moreover, the existing 
rule is riddled with exceptions which has built up interpretive 
complexity over time.
---------------------------------------------------------------------------
Market Access Proposal
    A second important issue raised by the SEC relates to accessing 
quotations displayed through the national market system (Market Access 
Proposal). The Proposal establishes general principles designed to 
ensure all participants in the market have fair access to quoted 
prices--regardless of whether or not they are a member of the entity 
displaying the price. The Market Access Proposal also sets forth more 
specific regulations establishing fee caps for market centers and 
restrictions on a broker's ability to lock/cross the NBBO.
    Our success is based on a business model in the OTC market that 
requires fair access. We are 100 percent in favor of a framework by 
which competitive proprietary intermarket linkages also can develop in 
the marketplace for NYSE-listed securities.\11\ In our view, all market 
centers and linkages should benefit by ``most favored nation'' status 
requiring not only fair access, but also access on the same terms as 
afforded others.
---------------------------------------------------------------------------
    \11\ It also is worth noting that the establishment of a vibrant 
and dynamic competitive marketplace will positively impact our Nation's 
risk management which was exposed by the events of September 11, 2001. 
Certainly, a competitive network of multiple competitive market centers 
linked by robust linkages would appear to assuage this risk and avoid 
any single point of failure. A system of linked competitors is 
identical to the Internet model, originally designed to provide 
redundancy and avert such a single point of failure. It was precisely 
this decentralized model that proved unconditionally successful as a 
means of communication on September 11.
---------------------------------------------------------------------------
    At the same time, however, ArcaEx fervently opposes rash rulemaking 
proposed in the fee area that is designed to address problems that are 
either nonexistent or resolvable through less intrusive methods. In 
this hypercompetitive marketplace, why the need for command economy 
price-fixing? The SEC provided no data to support the need for this 
part of the proposal.
    As a result of the SEC's Order Handling Rules that were designed to 
stimulate competition, the OTC marketplace has become fiercely 
competitive and highly efficient. Today, the OTC market consists of 
four major liquidity pools connected by hundreds of private linkages. 
Not only are broker/dealers able to freely become members of any of 
these liquidity centers, but also should they not want to become 
members or establish connectivity to any one of the liquidity pools, 
hundreds of brokers stand ready to provide direct access to any or all 
markets for a small fee. All major liquidity pools in the OTC market 
utilize computer execution algorithms, meaning all participants 
attempting to interact with the liquidity pools receive equal execution 
treatment--members, nonmembers, and competitors. In addition, it is our 
understanding and experience that all members pay roughly equivalent 
transaction fees. This structure enables all market participants--
brokers, institutions, and even retail investors--to directly access 
any published quote at the touch of a button regardless of whether they 
are direct members of the venue publishing the quote.
    Standards of fair access are not commonplace, however, in the 
market for Amex- and NYSE-listed securities. As the Committee is well 
aware, markets are extremely efficient. Most ECN's were able to charge 
significant access fees only when participants were not technically 
able to avoid trading with them. Nasdaq--through SuperSOES and 
SuperMontage--did not provide members with the ability to avoid trading 
with auto-ex ECN's, even when they charged exorbitant access fees. 
However, with Nasdaq's self-imposed cap on ECN access fees, such 
excessive fees are no longer a significant issue. Moreover, the problem 
will not recur so long as OTC market participants are provided with the 
ability to choose not to trade with a market center that charges 
unreasonable fees. By virtue of market competition, fees have dropped 
well in excess of 80 percent since 1997. Competitors that did not 
reduce fees as a result of market forces found their market share and 
profits eroded.
    We are very concerned, however, about the role of Government in 
regulating the amount of any fees. History has not been favorable to 
command economies, in which the Government places its judgment above 
that of the free market. In essence, by setting maximum access fees, 
the SEC would engage in ratemaking, substituting its views for that of 
the markets. Assuming that the SEC had the authority to engage in such 
actions, which is not clear to us in light of the 1975 Amendments, what 
would also prevent the SEC from regulating maximum advisory fees for 
mutual funds, setting the spreads for market makers, establishing fee 
caps for retail brokerage firms, or setting the maximum investment 
banking fees?

Market Data Proposal
    Another aspect of Regulation NMS is a proposal to replace the 
existing market data revenue formula with a new allocation method that 
bases revenues on the data's theoretical information content. While we 
are not confident that we fully understand all of the ins and outs of 
this new proposed formula (read: it's really complicated!), we do see 
that it merely reconfigures the revenue for existing participants 
without injecting competition into the mix.
    Any allocation formula maintained by plan cartels or by regulatory 
directives will always create unintended consequences and is suspect in 
our judgment. The better approach would be to let the marketplace make 
its own judgments about market data economics, and the best mechanism 
for doing so is a competitive consolidator model. Absent a competitive 
consolidator model which lets the market decide what the data is worth, 
the data plans should reflect the costs of producing the data; and they 
should also reflect the economic value of the data.

Conclusion
    ArcaEx believes that a light regulatory touch is better than a 
heavy one; that targeted rulemaking is better than broad policymaking; 
and that simple is always 
better than complicated. We already have learned that when Government 
makes decisions that permit competition, the markets transform rapidly 
to increase efficiencies. This has clearly occurred on Nasdaq which 
causes us to question why the SEC desires to impose on the OTC 
marketplace a trade-through rule where there is none. However, we do 
agree with the SEC that the trade-through rule now existing in the 
listed area needs to be reformed and enforced to eliminate its 
anticompetitive effects that weigh heavily in favor of manual markets 
like the NYSE. This rule ensures the best price, but, alas, only for 
the specialist and not for the customer.
    It is critical to any reform to preserve innovation and investor 
choice by maintaining an opportunity for automated exchanges to bypass 
manual ones. It is just as critical that reform not stop with the BBO. 
Competitive forces have compelled every legitimate OTC market center to 
provide firm quotes that are accessible by automatic execution with no 
human intervention or intermediation. This is true for not only the BBO 
of each OTC market center, but also for their entire depth of book, and 
such should be the case for the listed market as well. If one of the 
objectives of Regulation NMS is to protect limit orders, then reform 
should not stop at the BBO. Again, competitive forces in the OTC market 
have essentially caused all market centers to respect all limit orders, 
not just the BBO, and that has to be the case in the listed market too 
for meaningful reform to be achieved.
    While we also wholeheartedly endorse increased access as a means to 
encourage competition, we want to caution that rate setting in the form 
of caps on access fees does not represent sound policy. Markets should 
set rates, not Government.
    Thank you for providing me this opportunity to testify, and I look 
forward to responding to your questions at the appropriate time.

                               ----------
                  PREPARED STATEMENT OF JOHN A. THAIN
         Chief Executive Officer, New York Stock Exchange, Inc.
                             July 21, 2004

Introduction
    Mr. Chairman, Members of the Committee, thank you for inviting me 
to present our views on proposed Regulation NMS. We appreciate your 
initiative as we collaborate on how best to modernize our national 
market system, (NMS). We applaud the SEC for its leadership in 
advancing a comprehensive proposal that serves as the basis for our 
discussions. The issues before us are complex in a time of rapidly 
advancing technologies and evolving market models. That is all the more 
reason to stay focused on our primary mission.
    Our goal is not a victory for one market over another, but, rather, 
competition among markets to create the best possible national market 
system for all investors, with one deep pool of liquidity. This policy 
is both the fairest for all, and the surest way to keep the United 
States in the forefront of global competition. A fractured market that 
betrays the interests of investors and that puts our capital market 
leadership at risk would be a pyrrhic victory at best, and a major loss 
for America.
    Long before I joined the New York Stock Exchange, I considered the 
NYSE a great American institution. Already, my brief tenure at the 
Exchange has reaffirmed that belief. However, after months of debate 
over the issues of market structure, I have also come to realize that 
our national market system is also a great American institution.
    As we move forward, let us be guided by the principles designed to 
protect the public good, and that have enabled our national market 
system to become the world's best. Technology has changed since the 
national market system was created, and the trading choices available 
to investors are different. But these principles are every bit as 
valid, and as vital, today as they were at the origins of the NMS.

 The Customer Comes First. Our national market structure should 
    require intermediaries to place their customers' interests ahead of 
    their own;
 Best Price. Every order, regardless of the market to which it 
    is sent, should have the opportunity to receive the best price 
    available;
 Protection of Limit Orders. Limit orders provide liquidity to 
    the market and accessible limit orders must be assured an execution 
    before a trade occurs at an inferior price;
 Choice. Investors are best served when markets are free to 
    compete and offer an array of execution options, including the 
    opportunity for price improvement;
 Reduced Volatility. Greater intraday volatility raises the 
    cost of capital for listed companies;
 Speed. Speed should be an option for those customers who want 
    it, but not at a price of damaging the integrity of markets or 
    introducing excessive volatility;
 Transparency. Investors should have widespread access to the 
    market data of their choosing on an uninterrupted basis; and
 Competition. Commission ratemaking should always be a last 
    resort. Competition typically does a better job than Government 
    ratemaking in providing fairly priced services to investors.

    These principles have served the Nation well. As Chairman Donaldson 
stated at the SEC's hearings in April, ``Our markets are among the 
world's most competitive and efficient. Competition among markets has 
fostered technological innovation and the creation of trading platforms 
. . . that address the needs of all types of investors, regardless of 
size and sophistication. Investor participation in the markets has 
exploded in the last decade.''
    When individual markets have competed within the NMS to uphold 
these principles and add value for investors, their businesses have 
been rewarded. When markets have not done so, their customers have 
taken their business elsewhere. We are pleased that, for the most part, 
proposed Regulation NMS strives to defend those principles and to end 
practices that are contrary to them. However, certain proposals are 
inconsistent with our goal of protecting investors, and we believe they 
must be improved.

Trade-Through Rule
    The best way to characterize the trade-through rule is to consider 
it the ``best-price'' rule, for that is what it guarantees to each 
investor. Approved by the SEC in 1981, its purpose is to ensure price 
protection for investors who post limit orders in any market 
participating in our national market system. The system envisioned a 
structure that would enable investors in any region to see the prices 
being bid and offered for listed stocks in all markets. The trade-
through rule ensures that their limit orders will be protected at the 
best price.
    The trade-through rule is the essence of good public policy for our 
markets. It is the heart of an honest market. And it is the beginning 
of a virtuous circle for investors. When investors are assured their 
orders will receive the best price, and that small investors can 
compete with large institutions, their confidence in the fairness and 
integrity of that market is bolstered. As investor confidence rises, 
they are more willing to maintain, or increase, their limit orders, and 
thus, liquidity is enhanced. A larger, deeper pool of liquidity serves, 
in turn, to decrease market volatility and to promote fair and orderly 
markets.
    Nevertheless, the many virtues of best price are no guarantee of 
success. Today, the NYSE posts the best price in our listed securities 
over 90 percent of the time, yet nothing prevents investors from 
sending their orders elsewhere.
    We compete tenaciously and tirelessly, and evidence of that 
competition can be seen in the price spread between bids and offers. 
Over the past year, the average spread of the National Best Bids and 
Offers on the 93 NYSE-listed stocks in the S&P 100 Index has narrowed 
from about 5 cents to 2 cents. A 2-cent spread is a fraction of the 
historic spread and illustrates that every market maker in NYSE shares 
competes aggressively for orders. Clearly, there is no monopoly in the 
financial marketplace.
    As the trade-through rule serves the interests of individual 
investors, its role in reducing volatility is equally significant for 
listed companies. When the NYSE surveyed chief executives and senior 
officers of some 400 of our listed companies, their most important 
factor in choosing a trading venue was market quality. And, by far, the 
most important determinant of market quality was reduced volatility. 
That preference is also borne out by reality. Over the past 2 years, 51 
companies moved their listings from the Nasdaq, where no trade-through 
rule is in effect, to the New York Stock Exchange. The intra-day 
volatility of those companies fell, on average, by 50 percent--a 
substantial decline.
    The dynamics of best price that strengthen competition, reduce 
volatility, and 
narrow spreads create real dollars-and-cents-benefits. Companies 
benefit from reductions in their cost of capital. And, billions of 
dollars in savings flow through to investors to their individual 
investments, or investment accounts, such as 401K's, pension funds, and 
college education accounts.
    The Congress, the Commission, and industry all understood the 
central importance of the trade-through rule. They considered its 
protections and advantages to be the foundation of good public policy. 
And, they embraced price-protection and best-price execution as the 
organizing principles of the NMS. Recognizing both benefits and 
beneficiaries, let us also be clear that bypassing, or trading through, 
a market's best price quotations creates four victims:

 The investor who buys or sells shares at a price inferior to 
    the best price;
 The investor whose better-priced limit order is ignored;
 Market transparency and price discovery, since a stock is 
    priced at something other than its true value; and,
 Liquidity and capital formation, since investors will lose 
    confidence in the fairness of the market and will be less willing 
    to submit limit orders knowing that they may be bypassed.

    While price-protection and best-price execution must remain guiding 
principles, we recognize that speed is important to certain customers 
in the 21st century marketplace. Some of our customers have told us 
they can better serve investors by taking a price that is available 
immediately by automated execution, rather than exposing an order to 
the floor auction for potential price improvement. Our data shows that 
orders executed on our floor in the auction often receive better prices 
than orders that simply hit our quote.
    Nevertheless, we understand why our customers have raised this 
issue. We are continuing to listen to our customers. We will continue 
to be responsive to them. And, we are determined to be competitive 
across the national market system.
    Our commitment is to offer customers the ability to trade 
electronically, quickly, with certainty and anonymity. At the same 
time, we want to retain the advantages of the auction market, where 
floor brokers and specialists are adding value and competing to improve 
prices, moment-to-moment, on the floor of the New York Stock Exchange. 
As one who spent 25 years at the crossroads of technology and finance, 
I enthusiastically embrace opportunities to enhance the speed and 
efficiency of trading. However, there are many occasions, such as 
during an earnings surprise or outside event that disrupts the market, 
when the judgment and abilities embodied by the human factor are 
invaluable, if not indispensable. This is why we believe that the 
solution is to marry the best of both worlds by creating a hybrid 
market.
    Last week, the New York Stock Exchange completed a draft of a 
filing to the SEC which represents a major step to leverage technology 
and offer more choices to investors and to all constituents of the 
Exchange. The filing will expand application of our electronic 
platform, known as Direct+. The hybrid platform will provide customers 
sub-second, automatic execution, as well as broader choice than any 
other market center, and the most flexible access to the world's 
deepest pool of equity liquidity. We are reviewing that draft with our 
various constituents who will be affected, and anticipate a formal 
filing with the SEC within the next few weeks.

Opt Out Exception
    Proposed Regulation NMS acknowledges that nationwide price 
protection is a core feature of the national market system. As a 
result, the Commission is recommending extension of the application of 
the trade-through rule to Nasdaq stocks. Given this fact, we are 
concerned that the Commission has included a provision that would allow 
certain institutions to forego giving their customers the best price by 
simply ignoring--or, opting out--of the trade-through rule.
    Permission to opt out would undermine the basic objectives of 
Regulation NMS, compromise the integrity of the marketplace and risk 
grave consequences to our national market system. The opt out provision 
amounts to nothing less than sanctioning the deliberate overcharging of millions of investors. In addition, by encouraging other harmful practices, such as internalization--where orders are never exposed to the 
market--the opt out provision would permit intermediaries to profit in 
other instances at the expense of unsuspecting investors.
    Associations representing millions of investors have completed 
their due diligence on Regulation NMS and come out strongly opposed to 
the opt out provision. To cite three:

 The AARP has noted that its members, by more than two to one, 
    believe that the ``best available price'' should be the ``top 
    priority'' when engaging in a market transaction.
 CFA (Consumer Federation of America), states that the opt out 
    provision would undermine the trade-through rule's objectives and 
    would take away with one hand the benefits that it has given with 
    another.
 CIEBA (Committee on Investment of Employee Benefit Assets) 
    observes that its constituency is concerned with long-term growth 
    and market stability, and that the ability to opt out could place 
    those investors at a disadvantage, creating one set of rules for 
    the small investor and another for large institutions.

    These associations are keenly aware that their members would be the 
first casualties of best-price violations. But they would not be the 
last. As losses from patently bad public policy rippled through the 
NMS, they would trigger other negative repercussions. Seeing their 
orders bypassed, investors' confidence in the fairness and integrity of 
the market would be shaken. They would no longer be willing to maintain 
limit orders, which would result in reduced liquidity, wider spreads, 
and increased volatility. And, as intermediaries used the loophole of 
an opt out to create their own, private trading market, the NMS would 
become fragmented and less competitive--an unquestionable loss for 
investors, U.S. markets and U.S. competitiveness.
    The operating rule should be, ``Let the best price win.''
    To those who refuse to compete on the basis of best price, 
important questions need to be asked: Why do proponents of an opt out 
exception call for elimination of the requirement in the NMS proposal 
that investors be advised how much they lost by not receiving the best 
price?
    Why do proponents of an opt out exception, who premise their 
lobbying on the concern about missing quotes because of a delay in 
execution, still insist on that premise when the SEC proposes to allow 
fast quotes to trade-through slow quotes?
    The answer is economic self-interest. At whose expense? The 
unsophisticated investor. That is what these associations know, that is 
why they are gravely concerned about an opt out exemption. We believe 
you should be concerned, as well.
    We strongly urge the SEC to eliminate the ``opt out'' provision in 
the final rule.

Market Access
    The Commission has proposed a series of related rules to accomplish 
universal access to markets. We support the Commission's proposal to 
require all market centers to permit access to their quotes on terms 
that are not ``unfairly discriminatory,'' as well as broader 
alternatives for intermarket access than the Intermarket Trading System 
currently provides.

Access Fees
    We understand the Commission's desire to address hidden access fees 
charged when an ECN's quote is accessed through SuperMontage. However, 
we believe that the Commission's proposal to regulate by Commission 
rule the transaction charges imposed by every market in the United 
States is not an efficient way of dealing with what we consider an 
isolated problem.
    Unfortunately, the Commission's proposal would deprive markets of 
the flexibility envisioned by the Exchange Act, thus forcing them to 
charge a standard fee to all users. We believe a more sensible solution 
would be to amend Regulation ATS and the Commission's quote rule, so 
that no market could publish a quotation that would include an 
additional fee not expressly agreed to by its members or subscribers. 
Thus, exchange and association member fees, and ECN subscriber fees--
all agreed to in advance--would be permitted, but fees that are charged 
to the contra party to the trade without consent would be prohibited. 
In this way, quotations at stated prices would all have the same 
meaning and members of exchanges and associations, and subscribers to 
ECN's, can factor in those charges when making routing decisions.

Market Data
    We recognize the Commission's need to address a number of 
objectionable practices that have arisen over the past decade, 
including the use of exchanges as print facilities, payment for order 
flow, wash sales, and tape shredding. We agree that these are serious 
issues, but we would prefer an approach that deals with them directly, 
rather than through market data revenue. For example, using markets as 
print facilities for transactions that occur elsewhere, thereby 
distorting perceptions of market liquidity and undermining price 
transparency, is a much bigger issue than is the market data revenue 
allocation. The Commission should simply ban the undesirable practices, 
and disband the CTA consortium at the heart of the economic 
inefficiencies producing such behavior.

Conclusion
    In conclusion, we appreciate this opportunity to appear before your 
Committee. Regulation NMS represents the most far-reaching reform of 
the national market system since its creation 30 years ago. This is a 
pivotal moment. Investors across America are looking to their leaders, 
and trusting their leaders, to do the right thing. We should not let 
them down.
    This is no time to put personal interests ahead of investor 
interests, to put the interests of individual markets ahead of market 
principles. It is important Government do the right thing by not 
allowing the best interests of investors to be ignored.
    At a time when the Nation is tightening rules on mutual funds, late 
trading, market timing, and raising standards for corporate governance, 
it should not allow intermediaries to run roughshod over long-standing 
rules that ensure fair and honest markets. To do so will be an 
invitation to future problems--to improper trading that harms 
investors, harms the competitiveness of our markets, and harms the 
health and well-being of our economy.
    We can best serve the public good by strengthening competition 
among markets to create a superior national market system that is based 
upon standards of best price and putting the interests of investors 
first. These are the principles have made the U.S. securities markets 
the largest, most liquid, and most vibrant in the world, and they can 
and must continue to do so in the 21st Century.

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

Q.1. Could you briefly explain the CLOB concept, and whether or 
not the Commission revisited this concept?

A.1. The concept of a CLOB, or central limit order book, refers 
to the display of orders from all market centers through a 
single limit order book that would be fully transparent to all 
market participants, including the public. To encourage entry 
of limit orders, orders in the CLOB would be accorded strict 
price/time priority across markets. Thus, the order that was 
displayed first at the best price--across markets--would 
receive priority. While conceptually the CLOB itself would not 
be a market center, and execution of orders could still occur 
(through automatic execution) at the level of individual market 
centers, the simplest way of assuring strict time priority 
would be a single system for accessing the CLOB.
    The concept of a CLOB has been discussed for many years. 
Most recently, the Commission requested comment on the 
desirability of a ``virtual'' CLOB in 2000 in the context of 
requesting comment on issues related to market fragmentation. 
In particular, the Commission requested comment on whether it 
would be advisable to mandate a CLOB.

Q.2. Would such an approach be appropriate for today's markets?

A.2. In response to its 2000 request for comment regarding a 
``virtual'' CLOB, the Commission received a large number of 
comments opposed to a CLOB. These commenters opposed to the 
proposal believed that a CLOB would be anticompetitive, hinder 
innovation, and increase market volatility, and further noted 
that a single system linking the markets would create a single 
point of failure with no incentive to improve technology. These 
commenters believed that the CLOB would focus competition on a 
sole factor, namely, the first market to display a price, and 
require brokers to ignore other features of a trade and other 
costs in handling trades. Several commenters also pointed out 
that a CLOB was not likely to provide investors with price 
improvement. Commenters also believed that a CLOB would 
negatively impact the ability of brokers to achieve best 
execution by potentially reducing speed and certainty of 
execution. Other commenters, primarily institutional 
investors, supported the establishment of intermarket price/
time priority in the belief that it would enhance price 
competition and increase transparency.

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

Q.1. Do you believe an opt out on trade-through will lead to 
internalization? Could internalization disadvantage small 
investors? Or do you believe the 1940 Act has the safeguards to 
prevent that?

A.1. The Commission has received extensive public comment on 
the proposed opt out exception, both at the public hearings on 
Regulation NMS as well as in written comment letters. Some 
commenters have expressed a concern that the opt out exception 
would lead to increased opportunity for internalization and 
that internalization potentially could disadvantage investors 
if it resulted in investors receiving inferior executions.
    In the Proposing Release for Regulation NMS, the Commission 
stated that an opt out exception would be inconsistent with the 
principle of price protection for limit orders because it would 
allow investors to choose to have their orders executed without 
regard to better prices that might be available on other 
markets. The Commission stated, however, that an opt out 
provision would not change the broker-dealers' duty of best 
execution with respect to customer orders and would not 
authorize a broker to give retail investors executions at 
prices inferior to the quote absent specific informed consent 
by the customer. The Commission continues to evaluate whether 
the proposed opt out exception is consistent with the goals of 
price priority and investor protection.

Q.2. Is the current trade-through rule ever violated, if so, 
how often?

A.2. Trade-throughs do occur today under the existing trade-
through rules. The current trade-through rule uses an 
``avoidance'' standard, combined with a procedure for 
satisfying quotes that were traded-through, on request. In 
addition, as the Commission noted in the Proposing Release for 
Regulation NMS, a certain amount of trades that appear to be 
trade-throughs likely will be unavoidable, given the speed with 
which quotes are updated and orders are executed in certain 
stocks. The Commission's Office of Economic Analysis is 
undertaking an analysis of trade-through data for purposes of 
analyzing proposed Regulation NMS.

Q.3. Does the Commission have an opinion on allowing 
institutional investors to ``sweep the book'' to ensure that 
they can make the large scale trades they are concerned they 
cannot always make?

A.3. The Commission generally is concerned with assuring that 
the interaction among the different markets in the United 
States develops in keeping with the objectives and requirements 
of the Federal securities laws, and in particular with the 
national market system objectives outlined in Section 11A of 
the Securities Exchange Act of 1934. The proposed trade-through 
rule in Regulation NMS is designed to enhance the principle of 
price protection across markets, an important national market 
system goal. The Commission requested comment on an 
``intermarket'' sweep exception to the proposed trade-through 
rule in Regulation NMS that would allow 
market participants to continue the practice of sending orders 
to multiple markets simultaneously to attempt to execute 
against orders displayed in those markets--to, in effect, 
``sweep'' displayed interest across markets. The Commission 
currently is evaluating the comments received in response to 
this request.
    With respect to the internal operation of, and the services 
provided by, individual markets in the national market system, 
the Commission generally believes that each market should be 
free to determine its structure, within the parameters of the 
Federal securities laws. For instance, a market that provides 
an automatic execution functionality may choose whether or not 
to allow incoming orders to automatically execute through 
several price levels displayed at that market.

Q.4. With all the competition in the electronic markets, are 
investors already getting best price?

A.4. The current structure of our national market system, which 
incorporates price protection as a fundamental principal, has 
greatly contributed to investor confidence. A goal of proposed 
Regulation NMS is to enhance the existing structure to help 
further ensure that investors are able to obtain best execution 
of their orders. As noted above, trade-throughs occur today in 
which posted quotes are not executed when trades go off at 
worse prices. The Commission is conducting an analysis of 
trade-throughs in the current marketplace as it evaluates the 
comments received in response to proposed Regulation NMS.

Q.5. How many enforcement actions have been brought against 
NYSE members for trade-through violations?

A.5. The individual exchanges that trade NYSE- and Amex-listed 
securities have adopted their own trade-through rules; 
currently, there is no Commission trade-trade rule. The 
exchanges, as self-regulatory organizations, are responsible 
for surveillance and enforcement of their rules. The exchanges 
generally do not provide the Commission with detailed 
statistics on such matters. Based on information provided by 
the NYSE to the Commission's Office of Compliance Inspections 
and Examination, for calendar year 2003 the NYSE issued nine 
admonition letters and imposed eight summary fines, and to date 
in 2004 has issued eleven admonition letters and imposed 31 
summary fines, in relation to its members' compliance with its 
trade-through rule.

Q.6. Any update on the Nasdaq Exchange application?

A.6. We continue to review Nasdaq's Exchange application. One 
topic of major discussion and one of the key issues that the 
Commission must resolve before acting on Nasdaq's application 
is whether a registered exchange must have market-wide rules 
that promote order interaction. Today, each of the registered 
exchanges in the United States has priority rules that are 
designed to promote order interaction, which facilitates the 
price discovery process. Nasdaq's application without such 
rules raises profound market structure issues that could have 
implications for all registered exchanges and, ultimately, 
investors in our markets. The Commission is dedicated to 
working with Nasdaq to resolve these and other remaining issues 
on its exchange application. However, the Commission must be 
assured that the rules approved for Nasdaq are consistent with 
the goals of a national market system. Further, the Commission 
must be assured that, if Nasdaq becomes an exchange, it can 
fulfill its statutory obligations as a separate self-regulatory 
organization.

        RESPONE OF WRITTEN QUESTIONS OF SENATOR BUNNING 
                       FROM JOHN A. THAIN

Q.1. Will the NYSE allow more transparency in the specialists' 
books?

A.1. Yes. The NYSE's OpenBook information product currently 
discloses the aggregate limit order interest at each price 
point. At present, it is refreshed on a five-second basis. 
Before year-end, we anticipate that this data will be made 
available on a real time basis.

Q.2. Will the NYSE allow funds to ``sweep the book'' in order 
to get price surety of execution they need?

A.2. Yes. In our hybrid market initiative, investors will be 
able to sweep at and beyond the published bid and offer to the 
nearest full nickel, a range of five to nine cents outside the 
quote.
    We are not allowing a full sweep of the book. We believe 
this would increase the volatility of our market and lead to 
higher trading costs for investors and higher costs of capital 
for listed companies. We are committed to maintaining the 
advantages of the 
continuous auction system over a purely electronic market, and 
dampened volatility is an important feature of our market.

Q.3. Is the current trade-through rule ever violated? How 
often?

A.3. Yes. We are committed to eliminating all trade-throughs. 
We are currently rolling out our new ``fast commitment'' 
software to speed up the sending of ITS commitments to multiple 
markets in fewer keystrokes. Going forward, as part of our 
Hybrid Market initiative, we will automatically send out a 
commitment to trade with another market if a trade would have 
resulted in trading-through that market.
    Below are tables detailing the number of trade-throughs on 
the NYSE for 2003 and the first 6 months of 2004. The number of 
trade-throughs on the NYSE is dropping as a result of our 
initiatives.



    According to our analysis of the market based on samples of 
trading in September 2003 and April 2004, trade-throughs as a 
percentage of total volume are dropping in all markets within 
the national market system. The percentage of trade-throughs is 
lower on the NYSE than in most other markets.



Q.4. How many enforcement actions have been brought against 
NYSE members for trade-through rule violations?

A.4. The NYSE has issued 59 admonition letters and summary 
fines in the past 18 months. The current ITS trade-through rule 
does not prohibit trade-throughs. Rather, it states that trade-
throughs should be avoided and provides a process of complaint 
and remedy when a trade-through occurs. Because of the speed of 
trading, many trades that appear to be trade throughs are not, 
and many trade-throughs do not evoke complaints because the 
party traded through no longer wishes to trade at that quoted 
price since the market has moved in his or her favor. The NYSE 
pursues the satisfaction of all valid trade-through complaints. 
However, when the Exchange identifies an inappropriate pattern 
of trade-throughs in a particular stock, regulatory actions are 
taken.





                    REGULATION NMS AND DEVELOPMENTS
                          IN MARKET STRUCTURE

                              ----------                              


                        THURSDAY, JULY 22, 2004

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

    The Committee met at 10:02 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing shall come to order.
    This morning, the Committee continues its examination of 
Regulation NMS. Yesterday, we heard testimony here from 
Chairman Donaldson and executives from several market centers. 
Today, we will hear from a broad array of industry and outside 
experts, who will share their insights and discuss the 
implications of Regulation NMS.
    The witnesses on the panel today will be: Mr. David Colker, 
President and CEO, National Stock Exchange; Mr. Kevin Cronin, 
Senior Vice President and Head of Domestic Equity Trading, AIM 
Capital Management; Mr. Scott DeSano, Senior Vice President and 
Head of Equity Trading, Fidelity Investments; Ms. Phyllis 
Esposito, Executive Vice President and Chief Strategy Officer, 
Ameritrade; and Mr. Bernard Madoff, Chairman and CEO, Bernard 
L. Madoff Investment Securities; and Mr. Robert McCooey, 
President and CEO, the Griswold Company.
    The witnesses on the second panel will be Mr. Kim Bang, 
Chairman and CEO, Bloomberg Tradebook; Ms. Davi D'Agostino, 
Director of Financial Markets and Community Investment, 
Government Accountability Office; Mr. Robert Fagenson, Vice 
Chairman, Van der Moolen Specialists; and Mr. John Giesea, 
President and CEO, Securities Traders Association; and Mr. 
Charles Leven, Vice President and Governance Board Chair, AARP.
    Given the number of witnesses with us today on both panels, 
I hope you will limit your oral testimony to no more than 5 
minutes. Your written testimony will be made a part of the 
hearing record in its entirety.
    Chairman Shelby. We welcome you here. We will start with 
you, Mr. Colker.

                   STATEMENT OF DAVID COLKER

           PRESIDENT AND CEO, NATIONAL STOCK EXCHANGE

    Mr. Colker. Chairman Shelby, thank you for inviting me to 
testify today.
    Publication of proposed Regulation NMS by the Securities 
and Exchange Commission has given our industry a unique 
opportunity for improvement. If we are committed enough to the 
idea of competition, then, we can reshape the regulatory 
environment in a way that will have significant positive 
benefits for the public investor. One opportunity for 
improvement is the Intermarket Trading Systems trade-through 
rule.
    Originally, this rule was put in place to require the New 
York Stock Exchange to honor better prices that were being 
displayed on nonprimary markets. Unfortunately, the trade-
through rule has now become an instrument for unfair protection 
of the New York's manually intensive monopoly.
    Because of the trade-through rule, exchanges that provide 
automatic executions are required to send an order to a New 
York quote that, though it may appear to be the best price in 
the country, often is not available. Even if it is available, 
an automated market may have to wait up to 30 seconds to get an 
execution, which can cause market losses due to changes in 
valuation during that time.
    And even worse, the New York's execution price is often 
inferior to their quoted price that induced the order to be 
sent to New York in the first place.
    The SEC's own execution quality statistics clearly reveal 
that the trade-through rule is a major barrier to competition. 
The New York Stock Exchange-listed stocks which are subject to 
the trade-through rule have wider spreads; get slower 
executions, and impose higher costs on investors. In contrast, 
the Nasdaq-listed stocks, which have no trade-through rule, 
have faster executions, higher fill rates, and better-priced 
executions. In addition, experience with the SEC's exception to 
the trade-through rule for exchange-traded funds demonstrates 
that quote spreads narrowed and trading volume significantly 
grew after the trade-through rule was modified to allow trade-
throughs in the top three ETF products.
    The trade-through rule has become unnecessary and actually 
counterproductive, I believe, as a result of easy access to 
complete market data, technological advances in trading 
systems, the increase in market competitors, and the 
implementation of decimal trading. The obvious solution, then, 
is to eliminate the trade-through rule and let competition 
between exchanges drive best execution. It is time for the 
Government to stop telling the American public where they have 
to conduct their business.
    A consensus is building about the necessity for a trade-
through opt out for manual or slow markets. There are three 
reasons I think it is important to preserve that same opt out 
flexibility for fast markets as well. First, attempts to define 
what a fast market is will become a slippery slope that will 
force the SEC to regulate more and more aspects of market 
technology. Second, fiduciary duty and economic self-interest 
eliminate the need for such a distinction. If there really is 
no incentive to avoid a fast market, then a rule is not needed 
to require an investor to act in his own economic self-
interest. And third, as stated above, an opt out has worked for 
fast markets; it has worked well in Nasdaq for many years.
    On the issue of market data, I would like to challenge the 
assumption in proposed Regulation NMS that the current system 
for market data revenue distribution needs to be changed. The 
current distribution method has worked well for over 25 years. 
It is fair, and easy to administer. It was first questioned 2 
years ago by Nasdaq for competitive reasons, because the 
National Stock Exchange had captured significant order flow in 
Nasdaq-listed securities as a result of cost initiatives that 
involved the sharing of market data revenue with members.
    The fact is that because of that competition, investors 
have been saving more than $100 million annually, and many 
broker-dealers can now offer investors free streaming quotes 
and automated price-improved executions for under $10. The 
premise that a trade-based formula creates economic 
distortions, regulatory distortions, or inappropriate 
incentives to engage in fraudulent behavior has not been 
sufficiently proven to warrant the proposed change to market 
data revenue distribution.
    The SEC's proposed formula amendment is unnecessarily 
complex. It is misguided in its price discovery value judgment, 
and it is expensive to administer. The complexity of the 
formula has made it a poster child in the industry for the 
inherent limitations of regulation. In addition, all trade 
reports have price discovery value, not just those valued at 
$5,000 or more. Finally, in a world that is generating 18 
million NBBO quote changes daily, imagine what the annual cost 
would be of determining how many thousands of quote credits 
each particular quote is due for each of the 23,400 seconds of 
each trading day.
    So while NSX respects the desire of the Commission to 
encourage quote competition, we believe that the benefits of 
doing so through the proposed formula amendment simply do not 
come close to outweighing the new formula's administrative 
costs. For that reason, we do not believe the adoption of this 
market data reallocation formula would be sound public policy.
    Thank you. I look forward to answering any questions that 
you may have.
    Chairman Shelby. Thank you.
    Mr. Cronin.

                   STATEMENT OF KEVIN CRONIN

                   SENIOR VICE PRESIDENT AND

              DIRECTOR OF DOMESTIC EQUITY TRADING

                        AIM INVESTMENTS

    Mr. Cronin. Good morning. My name is Kevin Cronin, and I am 
Senior Vice President and Director of Equity Trading at AIM 
Investments.
    AIM Investments was founded in 1976 and had $148 billion in 
assets under management and approximately 11 million 
shareholders as of March 31, 2004. I want to thank Chairman 
Shelby for providing me the opportunity this morning to testify 
on the SEC's Regulation NMS proposal and developments in the 
structure of the U.S. securities markets.
    While I am speaking today on behalf of AIM Investments, I 
am also speaking on behalf of the Investment Company Institute. 
I am a member of the Institute's Equity Markets Advisory 
Committee, which consists of approximately 80 senior traders 
from various large and small mutual funds. I currently serve as 
the Chairman of the New York Stock Exchange Institutional 
Traders' Advisory Committee, although I want to be clear that I 
am not here testifying on behalf of the New York Stock 
Exchange.
    In the interests of time, I am going to focus my comments 
this morning on the Regulation NMS trade-through proposal, 
which arguably could have the most impact on the structure of 
the securities markets going forward. Before I discuss some of 
the specific issues relating to the trade-through proposal, 
however, I would like to take a minute to discuss why the 
issues raised by Regulation NMS and the debate over market 
structure is an important one to investors and as well to the 
mutual fund industry.
    Increased efficiencies in the securities markets will 
significantly benefit mutual fund shareholders in the form of 
lower cost. Mutual funds, therefore, have a vested interest in 
ensuring that the securities markets are highly competitive, 
transparent, and efficient and that the regulatory structure 
that governs the securities markets encourages rather than 
impedes liquidity, transparency, and price discovery.
    In order to create this optimal market structure for 
investors, investors, among other things, must be provided with 
incentive to publicly display their limit orders, which we 
believe are the cornerstone of efficient, liquid markets and as 
such should be afforded as much protection as possible. In 
order to provide investors such incentive, several changes must 
be made to the market structure. Most significantly, price and 
time priority should be provided for displayed limit orders 
across all markets. Strong linkages between markets should be 
created that make limit orders easily accessible to all 
investors, and standards relating to the execution of orders 
should be created that provide the opportunity for fast, 
automated executions at best available prices.
    Although Regulation NMS and the trade-through rule proposal 
would not implement all of these components we believe 
necessary for a fully efficient market structure, we believe, 
if appropriately instituted and enforced, a uniform trade-
through rule would increase investor confidence in the 
securities markets by helping to prevent an investor order 
executing at a price that is worse than a displayed quote. We 
therefore support the establishment of such a rule.
    In order, however, for a trade-through rule to fully 
achieve its objectives, it is extremely important that only 
automated quotes be protected. It is for this reason that we 
support an exception to the trade-through rule that would 
permit an automated market to trade through a manual market for 
an unlimited amount, or, as has been recently proposed by the 
SEC, an automated quote to trade through a manual quote of an 
unlimited amount.
    Such an exception would correctly focus the trade-through 
rule on providing protection only to those quotes that are 
truly firm and immediately accessible and not quotes that 
require manual execution and are, in effect, only indications 
of trading interest or difficult or slow to access.
    While most trading venues provide the opportunity for true 
automated executions, certain exchanges still do not offer such 
a choice for institutional investors. The New York Stock 
Exchange has stated that they intend to provide automatic 
execution to at least the best bid and offer on the Exchange 
and has been discussing plans to transform their market into a 
hybrid market.
    While we are encouraged by their stated intentions, it is 
imperative that any proposed automation on the New York Stock 
Exchange not be wrought with conditions and exceptions that 
would, in effect, make claims of automation folly. Too often, 
institutions have heard plans to automate New York Stock 
Exchange trading systems, only to find out after examining 
details of the plans that they did not go nearly far enough 
toward implementing the necessary automation.
    We, therefore, urge the New York Stock Exchange to move 
expeditiously to implement true automation in its market that 
would provide investors much-needed automatic execution for 
their orders. Such changes should be implemented regardless of 
whether the SEC's Regulation NMS proposal is adopted. One 
thing, however, is certain: Until the New York Stock Exchange 
provides true automatic execution on its market, manual quotes 
on the New York Stock Exchange should not be afforded the 
protections of any trade-through rule adopted by the SEC.
    The proposed trade-through rule also contains an opt out 
exception, which would permit a person for whose account an 
order is entered to opt out of the protections of the trade-
through rule. We oppose the opt out exception. While there is 
no doubt that at times, investors may determine that speed and/
or certainty is more important than price in executing an 
order, and while investors may be best served on a particular 
trade by opting out from executing against the best price 
placed in another market, we believe in the long-term, all 
investors will benefit by having a market structure where all 
limit orders are provided protection and incentives to place 
those orders into the markets.
    We are therefore dubious of any regulation that would 
tacitly approve the pursuit of inferior prices to the detriment 
of those willing to display liquidity. I know I am going to run 
out of time here. Nevertheless, there is no consensus among 
market participants and even among some institutional investors 
on whether an opt out exception is necessary.
    There does, however, seem to be agreement that the SEC, if 
it does not fully identify and define what automated markets 
are, automated quotes, then, we believe that some flexibility 
should be conferred upon the institutional investor to permit 
them to trade through markets that cannot provide the highest 
order of certainty and speed.
    In such a case, we believe a block trade exception to the 
trade-through rule may be necessary in order for institutions 
to efficiently trade large amounts of stock. In any case, we 
believe a block trade exception would be preferable to an opt 
out exception to facilitate these types of transactions. Most 
significantly, a block trade exception would be more limited in 
nature than an opt out and would be more feasible to employ.
    Thank you again for providing me the opportunity this 
morning.
    Chairman Shelby. Thank you.
    Mr. DeSano.

                   STATEMENT OF SCOTT DESANO

                  HEAD OF EQUITY TRADING DESK

                      FIDELITY INVESTMENTS

    Mr. DeSano. Good morning. I am Scott DeSano, Head of Equity 
Trading at Fidelity Investments. I thank Chairman Shelby, 
Ranking Member Sarbanes, and other distinguished Members of 
this Committee for the opportunity to offer our views on 
proposed Reg NMS and its important implications for the future 
role of competition in this Nation's equity securities trading 
markets.
    I am speaking for Fidelity as the investment manager and 
the fiduciary for its 190 mutual funds that invest in equity 
securities, which have aggregate assets of over $597 billion, 
18 million investors, 60 percent of which is retirement money. 
Our call for trading reforms is solely motivated by our duty to 
meet fiduciary obligations to our mutual fund investors.
    As a matter of fiduciary principle, reinforced by the 
provisions of the Investment Company Act of 1940, Fidelity does 
not trade as principal with its funds. On any given day, the 
trading by Fidelity Funds in New York Stock Exchange-listed and 
Nasdaq securities can account for 3 to 5 percent of the total 
trading volume of each market and has been, at times, 40 to 50 
percent of an individual security.
    By far, the most important rule proposal that the SEC has 
included in its proposed Reg NMS is the so-called ``trade-
through rule.'' The trade-through rule, absent an exception, 
would deny a willing buyer and willing seller the freedom to 
choose the marketplace at which to trade and the price at which 
they are willing to trade. You should note that the trade-
through rule leaves untouched rules of markets such as the New 
York Stock Exchange that deny intramarket time priority for 
limit orders over later bids and offers at the same price from 
the trading crowd, and the trade-through rule also denies a 
willing buyer and seller the opportunity to sweep the limit 
order book even when the buyer or seller is willing to do so at 
the most favorable price.
    The SEC has identified two cases where its proposed trade-
through rule would not apply. First, the rule would not apply 
to buy and sell quotes on slow or nonautomated markets. The SEC 
recognizes that it is fundamentally unfair to force an investor 
to send his buy or sell order to a slow market, because there 
is a high risk that the supposedly better-quoted price may 
disappear by the time his order finally receives an execution 
on that slow market.
    To protect investors from this unfair result, the SEC would 
allow an investor to disregard a slow market and the frequently 
unattainable prices quoted on that market. Under the SEC's 
proposed rule, the New York Stock Exchange is a slow market. 
Second, the SEC proposes to give investors the right to opt 
out. This would allow willing buyers and sellers in market A to 
trade with one another at an agreed upon price even though 
market B or market C might be quoting a price that would be 
more favorable to the buyer or seller.
    If this sounds like the American way, it is, for two very 
important reasons: It gives freedom of choice to investors to 
decide for themselves what is in their best interests, and it 
provides incentives to market centers to compete and to 
innovate.
    Now, let me clearly state Fidelity's views on the proposed 
trade-through rule and the opt out right as we have set forth 
in our comment letter submitted to the SEC last month. First, 
we urge the SEC not to adopt the proposed trade-through rule 
because it will impede competition among market centers. The 
Government should permit market centers to compete based upon a 
wide range of factors that are important to investors and bear 
upon best execution, including efficiency, reliability, 
transaction and data costs, transparency, fairness, and 
innovative use of technology to lower costs to investors and, 
last but not least, something that this Committee cares a great 
deal about, the quality of the market center's program of self-
regulation, which includes how well it monitors the trading 
activities of its members and its record for enforcing and 
disciplining its members that violate trading rules. These 
factors all bear upon best overall prices for investors, which 
are not necessarily achieved by walking a market up or down 
and, hence, best execution.
    Second, a trade-through rule is not necessary to promote 
best execution in the equity markets. Order flow will naturally 
gravitate to market centers that respond to investors' needs. 
This is not a matter of conjecture or theory. It has been 
clearly shown by the vigorous competition that has been taking 
place for several years among different market centers trading 
in Nasdaq securities. Economic self-interest and fiduciary duty 
will lead investors to markets providing the best combination 
of low transactional and access costs, speed, reliability, 
liquidity, and innovation.
    Third, if the SEC adopts a trade-through rule, we strongly 
urge retention of an opt out right. An opt out provision is 
crucial to allow investment managers, such as Fidelity, to 
perform their fiduciary responsibilities to the fullest extent 
in seeking best execution for the mutual funds or accounts 
under their management.
    Fourth, to address unfairness that hurts investors large 
and small, we have urged the SEC to focus on reforming rules 
within the New York Stock Exchange's own market that confer 
informational and trading privileges on NYSE members solely by 
virtue of their physical presence on the floor. Today, 
investors are deterred from sending limit orders to the New 
York Stock Exchange specialist book, because these orders, 
under the New York's rules, are not given time priority over 
bids and offers made later in the day at the same price by 
brokers in the trading crowd or by the specialist trading for 
his own account.
    Fifth, to avoid unfairness for investors, the SEC should 
also require changes to the New York's rules that prevent a 
willing buyer or seller from automatically sweeping the limit 
order book at prices that investors have already freely 
committed to accept. For example, assume that different 
investors have sent limit orders to the New York committing to 
sell stock of company A at prices ranging from $10 to $10.05 
per share. The New York rules today do not allow a willing 
buyer to sweep the specialist limit order book at one time and 
pay the highest price, $10.05, to all investors, price 
improving them all.
    This is simply unfair to all investors, whether a mutual 
fund investor or a small retail investor who wants to sell and 
has committed to do so. It is also unfair to the buyer who is 
willing to pay the best price to all of them.
    In conclusion, we have urged the SEC, and we urge this 
Committee, to allow competition to shape the future of our 
equity securities markets, buttressed by widely available and 
accessible quotes and other market data and reinforced by the 
fiduciary duties that investment managers, like Fidelity, owe 
to the millions who invest in mutual funds. Investors, 
including fiduciaries acting for their benefit, armed with 
real-time information on prices available in competing markets 
will seek out those markets that are most responsive to their 
needs and are best-suited to provide best all-end pricing for 
their trades. This will result in lower trading costs and 
better returns to mutual fund and public investors alike.
    Thank you.
    Chairman Shelby. Ms. Esposito.

                 STATEMENT OF PHYLLIS ESPOSITO

      EXECUTIVE VICE PRESIDENT AND CHIEF STRATEGY OFFICER

                AMERITRADE, HOLDING CORPORATION

    Ms. Esposito. Chairman Shelby, Ranking Member Sarbanes, 
Members of the Committee, I am Phyllis Esposito. I am an 
Executive Vice President and Chief Strategy Officer at 
Ameritrade. Thank you for the invitation to testify today.
    Ameritrade is a leading retail online broker, and we are 
ranked number one in number of retail online equity trades 
transacted in the marketplace on a daily basis. As of last 
quarter, our customers executed on average 164,000 trades each 
and every day. Those customers include 3.5 million accounts, 
representing all 50 States.
    In less than a decade, online retail client accounts have 
grown to a total of 27 million in the United States. Ameritrade 
is a public company, and our business model and our financial 
interests are directly aligned with retail investor 
participation in the U.S. equity markets.
    At yesterday's hearing, there was unanimous agreement on 
the need to protect the integrity of the capital markets and 
enhance their efficiency. I would like to give you the point of 
view of retail investors as to how, in fact, we can accomplish 
that. There has been much debate in the industry during these 
past few months over who is speaking for the retail investors, 
be they individuals or institutions.
    Many of those firms and organizations do not actually deal 
directly with retail investors who are investing in the 
marketplace on a daily basis. We do. We not only interact daily 
with investing clients, but also those clients who phone our 
client call center; and email our client representatives--so we 
know their views well.
    What exactly are retail online investors telling us today 
about what they want from the marketplace? Overwhelmingly, they 
seek the following: Number one, consistency of trade execution, 
whether those trades are in listed securities or whether they 
are in over-the-counter securities. And what are the metrics? 
Speed, quality of execution, and a common, level playing field 
in how those orders are processed and executed.
    Number two, firm quotes. When investors go to their online 
screens, and they see bids and offers, they want those quotes 
to be available and tradeable. They want them to be, number 
three, immediately executable. There has been quite a bit of 
discussion which is more important about speed versus best 
price, and let me be perfectly clear. Retail investors clearly 
prefer--first and foremost--best price. Speed is but a means to 
obtain the certainty of the price they see on the screen.
    And finally, investors are interested in personal choice. 
Many of our retail clients are investing for their own 
retirement, their children's education, or to buy a home. They 
believe that they have the right to choose for themselves among 
the various market participants which market--in their opinion, 
based on their criteria--a trade will receive the best 
execution.
    The over-the-counter marketplace today provides all these 
incentives and gives investors exactly what they are looking 
for, whereas the listed markets which have a trade-through rule 
do not. This is because the trade-through rule today protects 
best advertised price, not best available price. It protects 
the best displayed price. Our retail clients do not place much 
value on that, since it is not a tradeable quote.
    This is what our clients are saying, but I believe that 
actions speak louder than words, I would like to tell you what 
our clients are actually doing. Ameritrade is an agency broker, 
meaning that we do not have proprietary trading accounts and we 
do not give advice, so we cannot suggest to our clients what to 
trade or how to trade. To the trades they place with us are 
their own trades, which they themselves directed.
    What online retail investors are voicing in the marketplace 
is their preference for one market over another, and they are 
voting with their pocketbooks. Ameritrade clients today do 74 
percent of their transactions on Nasdaq-listed securities. They 
do only 19 percent on New York Stock Exchange-listed 
securities, and only 7 percent on American Stock Exchange-
listed securities.
    Why is that? The Nasdaq marketplace gives them what they 
deem important: Firm quotes, transparency of those quotes; 
transparency and depth of book, and speed of execution, with 
the highest likelihood of executions at the quoted price or 
better.
    That is actual market behavior. Is that market behavior 
rational? According to the SEC's own public numbers for May 
2004, for retail orders of 100 to 2,000 shares, in the Nasdaq 
marketplace, 88 percent of the orders were executed or better 
than the quoted price and in only 3 seconds; whereas, on the 
New York Stock Exchange only 78 percent of the orders were 
executed at the quoted price or better and it took an average 
of 13 seconds.
    The bottom line is the Nasdaq marketplace provides tighter 
spreads and faster executions. Let me clear up something that 
came up yesterday: There absolutely is, today, ``price 
improvement'' among the electronic markets. In fact, using that 
same SEC data for trades occuring in S&P 100 stocks, the New 
York Stock Exchange received price improvement for orders only 
25 percent of the time, whereas Ameritrade placing orders 
through regional exchanges and market makers received price 
improvement 37 percent of the time. Let me also say that the 
majority of our orders are limit orders, so we certainly want 
to encourage limit orders. Not only are the majority of our 
clients placing orders on Nasdaq, but they are placing limit 
orders.
    Finally, I want to comment on a proposal for a hybrid 
system of fast and slow quotes that is gaining attention. This 
is not a panacea for retail investors. Clearly, professional 
participants in the marketplace will understand and recognize 
fast from slow quotes. But retail investors will be confused. 
Seeing both a fast and a slow quote, they will not easily be 
able to ascertain and distinguish between them. This will just 
add to confusion and a perceived lack of integrity in the 
markets.
    In addtion, the ``opt out'' for professional in the hybrid 
plan will create a bifurcated market. We will be taking a step 
backward by not putting retail on a level playing field with 
other investors. A bifurcated market, also creates the 
opportunity for professional arbitrage, as those who can opt 
out begin to trade between the fast and slow markets at the 
expense of retail investors.
    In conclusion, if the trade-through rule is maintained or 
extended, the only way to make it work is through the auto-
execution alternative that the SEC proposed where all markets, 
all the time, are fast; there is consistency, among trades 
there is immediate execution, for all; and, firm quotes and 
personal choice.
    Thank you.
    Chairman Shelby. Mr. Madoff.

                  STATEMENT OF BERNARD MADOFF

                        CHAIRMAN AND CEO

            BERNARD L. MADOFF INVESTMENT SECURITIES

    Mr. Madoff. Madoff Securities is pleased to participate in 
the Senate's hearing on Regulation NMS.
    We applaud the SEC's proposal to address this complex set 
of issues. One of the great difficulties we face in addressing 
these issues is that so many of them are inextricably linked. 
In order to support a trade-through rule that would truly 
benefit investors, it is critical to implement a system that 
includes seamless linkages and a fee structure that does not 
interfere with price discovery.
    Madoff Securities has long held the position that the 
integrity of the quote is instrumental to the efficient 
functioning of a national market system. Investors must be 
assured that regardless of where their orders are routed, they 
will be in a position to reap the benefits of a national market 
system. It is our belief that the foundation of this system 
should be publicly displayed quotes that are firm and 
accessible.
    The best way to ensure this result would be to require all 
quoting market centers to employ an automated auto-execution 
facility for intermarket orders seeking to satisfy those quotes 
deemed to be firm and accessible and therefore eligible for 
inter- and intra-market price protection. A quote is deemed to 
be fair and accessible when it is subject to automatic and 
immediate execution or cancellation on a computer-to-computer 
basis with no human intervention for up to its total displayed 
size.
    Accessibility of the quote is a critical component of the 
integrity of a national market system. The need for efficient 
linkages to assure accessibility is an absolute imperative in 
an NMS predicated on investor protection. Effective linkages, 
both public and private, must be in place, and price displayed 
must truly reflect the actual cost of trading. Market 
participants should only be allowed to be part of the national 
best bid or offer and receive price protection if those quotes 
are deemed firm and accessible through either a public or 
private linkage.
    The Securities Exchange Commission must describe the scope 
and minimum standards for public intermarket linkages. 
Individual markets would also be free to define and enter into 
private linkages in order to the public linkage requirement. In 
the absence of a mandatory automated order execution facility 
for all quoting market centers, it is critical to the success 
of any trade-through rule proposal that those markets unwilling 
to implement such a mechanism be subject to an unfettered opt 
out for those quotes deemed to be nonautomated or inaccessible. 
The proposal requirement for such an opt out of nonautomated or 
inaccessible quotes should only be governed by the fiduciary 
requirements of best execution.
    Thank you for allowing us an opportunity to contribute to 
this discussion.
    Chairman Shelby. Thank you.
    Mr. McCooey.

              STATEMENT OF ROBERT H. MCCOOEY, JR.

         PRESIDENT AND CEO, THE GRISWOLD COMPANY, INC.

    Mr. McCooey. Good morning, Chairman Shelby. Thank you for 
inviting me here to testify in connection with your review of 
the capital markets here in the United States. My name is Bob 
McCooey. I am a proud member of the New York Stock Exchange, 
and I am honored to serve on the New York Stock Exchange Board 
of Executives.
    In my primary job, I am President and Chief Executive 
Officer of a New York Stock Exchange member firm, the Griswold 
Company. Griswold is an agency broker, and we execute orders 
for institutional clients on the floor of the Stock Exchange. 
As an agency broker, we make trades on behalf of customers. We 
do not make markets or engage in proprietary trading. Our 
clients are some of the largest mutual and pension funds in the 
United States.
    Chairman Shelby, I am also very happy that you chose to 
have John Thain testify in front of this Committee yesterday. I 
think it is clear to all that there has been a dramatic change 
at the New York Stock Exchange. The membership is hopeful that 
regulators and legislators will support the new changes to the 
continued benefit of all who trade at the New York Stock 
Exchange.
    Mr. Chairman, I am truly a practitioner. I work orders on 
the floor every day on behalf of my customers. I may not be an 
Olympic-quality sprinter, but my customers are quite happy with 
my market knowledge and experience that I bring to their 
execution every day.
    Increasingly, the goal for clients has been to find ways to 
gain efficiencies at the point of sale and get a best 
execution. Independent agents, working on behalf of their 
customers, now furnish real-time market information coupled 
with tremendous cost savings to their institutional clients. 
These assets that are managed by my institutional clients are 
owned by the small retail customer: The pensioner, the parent 
saving for college, the worker funding their IRA, and all 
others that invest in equities traded here in the United 
States.
    Today, we have an opportunity to do what is right for the 
marketplace and all the participants, and we must realize that 
the retail customer and the institutional customer are often 
one and the same. Floor brokers play an important role in the 
price discovery process. The competition between orders 
represented by brokers at the point of sale helps to ensure 
fair, orderly and liquid markets.
    The floor broker serves as a point of accountability and 
information with flexibility to represent large orders over 
time at the point of sale, not found in dealer markets and 
ECN's, and employs the most advanced technology to support his 
or her professional judgment. The combination of best price and 
intelligent information is the backbone of the New York Stock 
Exchange.
    Electronic execution is not new to us at the New York Stock 
Exchange. Direct+, our automatic execution facility, was 
introduced in the year 2000 and since then has grown from 1 
percent to approximately 10 percent of our average daily 
volume. As I speak to my customers about the multiple 
marketplaces in which they trade, one theme about the NYSE is 
constantly voiced: Customers appreciate the fact that the 
floor-based NYSE provides the participants in that market with 
valuable information that aids them, aids the buyers and 
sellers, in making market entry and exit decisions. This 
results in natural buyers and natural sellers meeting over 80 
percent of the time with minimal market impact. The kind of 
information is impossible in electronic markets.
    Trading technologies have allowed both customers and 
broker-dealers to work more efficiently as the markets have 
grown. Occasionally, technology can have its problems. There 
have been several occasions over the past few months that 
illustrate the need for professionals working in concert with 
technology.
    A number of months ago, a large NYSE-member firm initiated 
a program trade for a customer involving a large basket of big-
cap stocks. Unfortunately, somebody added an extra zero at the 
end and the trade that was supposed to be a $40 million basket 
ballooned to a $400 million basket. On the floor, those trades 
were quickly identified as possible errors; the firm was 
contacted; the problem was realized, and the firm was able to 
cancel the vast majority of those trades before they were 
executed.
    In another scenario, a member firm entered an order to sell 
1 million shares of Xerox at the market. While preparing to 
trade the stock at the appropriate price where supply and 
demand met, the firm was contacted, and an error was again 
prevented. This order was supposed to be for only 1,000 shares.
    This course of action could not happen in an electronic 
market, where there is no one designated to recognize a 
potential problem such as the ones I have described. More 
importantly, these trades could have been executed quickly, 
with the primary focus on speed that some have been asking for. 
But the outcome to the customer would have been quite negative. 
Only through intervention and immediate dialogue between market 
participants were huge losses to investors prevented.
    One of the four major areas for comment contained in Reg 
NMS was the trade-through rule. I believe the customers always 
deserve the best price. Price matters to my customers, and at 
the end of the day, they do not ask how long it took me to 
execute their order, but they do focus on the price that they 
received. The trade-through protects the best prices and 
rewards the market centers that post them.
    Tremendous competition exists today between markets. Order 
competition as the critical factor in price discovery is based 
upon protecting those who display the best prices. This 
promotes the entry of limit orders, narrows spreads, and 
reduces execution costs. Eliminating the trade-through rule 
would produce inferior prices, increase costs, increase market 
volatility, reduce accountability and transparency.
    We do not think that any marketplace should receive 
regulatory relief from a rule that accrues such tremendous 
benefits to investors. By ensuring that price is paramount to 
markets, customers, as well as the competitive nature of the 
U.S. securities markets, will be well-served.
    At the New York Stock Exchange, we embrace change. 
Providing choices to our customers has been the hallmark of the 
NYSE for as long as I have been a member, and we are again 
addressing the needs of our customers who have asked us to 
provide more choice. In fact, one of the goals of Reg NMS was 
to provide competition among marketplaces in order to encourage 
innovation. The NYSE, in keeping with its pattern of 
innovations, committed to being a fast market with immediately 
accessible quotations, even before the release of Reg NMS. With 
that in mind, I support the Commission's suggestion, as 
articulated in the supplemental release, for a fast market to 
be designated on a security-by-security, quote-by-quote basis 
rather than as a whole.
    At the NYSE, we will continue to change, adapt, and 
innovate to best serve our customers and fulfill our commitment 
to producing the highest levels of market quality. We continue 
to provide a fair and level playing field that investors want 
and expect from us. We will compete on the basis of discovering 
and delivering the best price coupled with highest levels of 
transparency.
    The interaction of specialists and agency floor brokers 
creates a value proposition in which the NYSE delivers to its 
customers the best prices, deepest liquidity, narrowest 
spreads, and lowest volatility. This results in multimillion 
dollars of savings to your constituents each year. In all we 
do, we take pride in the fact that we always place the investor 
first.
    Thank you.
    Chairman Shelby. I thank all of you.
    During yesterday's hearing, witnesses discussed among other 
things problems associated with both the floor of the New York 
Stock Exchange, such as specialists trading ahead of customers, 
and problems associated with a dealer market such as payment 
for order flow. Will each of you just briefly address the 
criticisms aimed at the market structures in which you operate? 
How do we ensure that intermediaries act in the best interests 
of their customers?
    Mr. Colker, we will start with you.
    Mr. Colker. Well, I think as a beginning premise, certainly 
there should be an emphasis on allowing free competition and 
not assuming that the public investor is not a sophisticated, 
knowledgeable investor, and is not willing to make that choice, 
as Ms. Esposito so articulately expressed, based on their own 
package of expectations.
    With respect to payment for order flow, that has been a 
common practice, really, on just about every exchange. 
Exchanges compete for order flow. This is what we do. But there 
is no compromise to the issue of best execution, and the public 
has available to it SEC information which shows the quality of 
those executions, and they can choose based on that where to 
send their order flow.
    Chairman Shelby. Mr. Cronin.
    Mr. Cronin. I would certainly concur that no system 
presently is perfect. There are problems with a floor; there 
are problems with a specialist system, and as Mr. DeSano 
touched on, certainly, some of the rules going forward at the 
New York Stock Exchange, at a minimum, should change.
    The dealer market and internalization obviously is a 
problem as well that needs to be addressed. We think the best 
way to address a situation like this is to recognize that 
better protections for orders be provided to investors.
    NMS is not perfect. We think time priority should be part 
of it, but it is not part of it. We will accept price priority 
as part of this. But to be sure, automation is also a critical 
part of the link between bridging the gaps between the current 
system and what is necessary going forward. There has to be 
automation.
    It is interesting to hear the gentleman from the New York 
Stock Exchange talk about automation. We have been clamoring 
collectively as institutions and others for years for more 
automation, and while we are encouraged by their particular 
persuasion now to give us more automation, we want to make sure 
that the automation that we are given is true automation.
    Turning on and off an automatic quote, for example, at the 
whim of a specialist or with some minimum amount of price 
variance, we do not believe constitutes a fast market. We do 
not believe a quote like that should be afforded the 
protection. If we really want to address these issues, I think 
that the central themes have to be let us provide protection 
for investors; let us provide automation and choice, and we 
think the attendant competition that will result from this will 
result in much greater and more efficient capital markets.
    Chairman Shelby. Mr. DeSano.
    Mr. DeSano. My view on this is pretty simple, and we stated 
it in our testimony. We believe in competition, free, 
unfettered competition. That will allow for the marketplaces to 
compete on all levels at all times, and in the end, most of the 
stuff washes out.
    We think that there are undue costs on the floor. When a 
specialist price-improves a seller, there is a buyer left 
behind who had a stated bid who is not getting filled. There is 
a cost associated with that that is not in anyone's numbers. We 
want free access to go where we want, when we want, how we 
want, and we think it all works out in the end.
    Chairman Shelby. Ms. Esposito.
    Ms. Esposito. Mr. Chairman, Ameritrade is an agency broker, 
meaning that 100 percent of all of the orders that flow through 
Ameritrade are up for interaction in the marketplace. We have 
no preference as to what exchange, what ECN, or what market 
maker our orders flow to.
    We certainly have a best ex responsibility, and we have a 
responsibility from a business point of view to serve our 
clients well. If there are markets where, in executing best 
execution, we, in fact, at the same price have two different 
venues, one willing to execute with payment for order flow and 
one unwilling to do that, then, we take that payment for order 
flow, because, as I mentioned before, we are an online discount 
broker, and we like to try to save money and pass it along to 
our clients. So we are very happy to participate on that basis.
    Chairman Shelby. Mr. Madoff.
    Mr. Madoff. Let me start from the beginning by saying that 
our firm does not pay for order flow and has not for the last 2 
years. That being said, we have always defended the practice of 
payment for order flow, providing that the order was provided 
best execution. Interestingly enough, the SEC's own statistics, 
since they started producing these 11(a)(5)(c) statistics for a 
number of years have demonstrated that the marketcenters, 
whether they be exchanges or whether they be dealers that did 
pay for order flow had better execution quality provided to 
their clients than those that did not pay for order flow. It 
has not been demonstrated in any way over the years that 
payment for order flow disadvantages investors. I would take 
the position that it probably helps them.
    And payment for order flow, as David Colker has said, has 
been going on for many years and takes various forms. That is 
not to say that certain types of payment for order flow may 
need to be addressed.
    As to any abuses in the marketplace, this Committee, I 
believe, is dealing with Regulation NMS.
    Chairman Shelby. That is right.
    Mr. Madoff. And the trade-through rule in particular. As I 
said in my opening statements, as far as we are concerned, 
although we applaud the SEC's decision to try and address this 
issue, it is a complex issue, and I am not sure that a rule is 
necessary at this stage or certainly not necessary until you 
would link the markets.
    In the linkage of the marketplaces, an automated execution 
is the solution to this problem. Now, the problem is forcing 
the participants to link the markets. I have been trading for 
43 years, and I participated in the original formation of the 
ITS, which was the first attempt at a national market system to 
link markets. It is a very difficult situation.
    The problem, I might add, is not necessarily the mechanics 
of the linkages. It is the governance of those linkages where 
everything breaks down. Unfortunately, the industry itself, as 
much as I would love to not have the SEC or any regulator 
interfere with how the markets operate and let the industry 
work this out itself, there comes a time when the industry has 
to be pushed down the path to do what is best for the investor.
    And I think that requiring markets to link and requiring 
them to have automatic execution is the issue that has to be 
addressed.
    Chairman Shelby. Thank you.
    Mr. McCooey.
    Mr. McCooey. I think the question was dealing with some of 
the abuses in the marketplace, and I think Chairman Shelby, 
that there is a perfect market. There have been problems across 
all markets. Most recently, there was a significant Nasdaq 
market maker that was just fined about $60 million by the NASD 
for abuses in front-running.
    So there is no perfect market, and we need a strong 
regulatory apparatus across all markets to make sure that they 
function correctly, and we make sure that investors are well-
served.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Mr. McCooey, you said we need a strong regulatory apparatus 
to make sure investors are well-served, correct?
    Mr. McCooey. Yes, sir.
    Senator Sarbanes. Does the rest of the panel agree with 
that?
    Mr. Madoff. Yes.
    Mr. DeSano. Yes, sir.
    Mr. Cronin. Yes.
    Mr. Colker. Absolutely, yes, absolutely.
    Senator Sarbanes. Good; I just want to get that on the 
record. Thank you very much.
    Now, the next question I want to askput is to all the 
panelist is, do you feel that the process that the SEC has been 
pursuing in considering proposed Regulation NMS has allowed you 
ample opportunity to present your views to the SEC and 
constitutes a fair and balanced process?
    Mr. Colker.
    Mr. Colker. Senator, I believe that the process so far has 
been fair. I would just suggest that because new issues are 
coming up, particularly this fast versus slow distinction; this 
is a relatively new idea that if the SEC decides to do 
something formal on that that they should put that out for 
comment again.
    Senator Sarbanes. All right; Mr. Cronin.
    Mr. Cronin. Yes, sir, I think the SEC has been very fair in 
this process. I also think it is noteworthy that in Reg NMS, 
they do assert that the development of the national market 
system and what the role of the SEC is in that development is 
to facilitate, not to dictate, its form. It is a very difficult 
situation we find ourselves in with many disparate views, but I 
think the process has been very fair in general.
    Senator Sarbanes. Mr. DeSano.
    Mr. DeSano. Yes, sir, I think thus far, we are quite happy 
with how it has gone, but there are other offerings that are 
being made out there and discussions going around with respect 
to hybrid markets and the like which could change the status of 
the New York with respect to it being a fast market. And should 
that become more formalized, we would appreciate the 
opportunity for the SEC to allow us to comment on that as well.
    Senator Sarbanes. Ms. Esposito.
    Ms. Esposito. Senator, we do believe it has been a fair and 
open process. We applaud the SEC for looking into this. We 
support their opinion that the markets need to be modernized. 
We appreciate a seat at the table with the SEC and here today. 
Thank you.
    Senator Sarbanes. Good; Mr. Madoff.
    Mr. Madoff. Yes, I would second all of those. The SEC 
process has been a very involved and fair process on all their 
rulemaking proposals.
    Senator Sarbanes. Good, Mr. McCooey.
    Mr. McCooey. I believe the Commissioners as well as the 
staff have done an excellent job of engaging the market 
participants and soliciting their views, and I think the 
process has gone along very well, and I believe that they are 
going to continue a very deliberate and thoughtful process to 
create the best market structure possible.
    Senator Sarbanes. I might also note that the oversight 
hearings which Chairman Shelby is holding also contribute to 
this process and provide an opportunity to get the benefit of a 
range of views on these issues.
    I would like to ask the question again to all members of 
the panel about the importance of the volatility factor as we 
look at market structure. It is asserted, of course, that 
things should be done a certain way because it helps to dampen 
down volatility; that it is a good thing to dampen down 
volatility, and then, we even had some testimony yesterday 
about some of the impact of that. I would like to hear from 
each of you on how you assess the volatility factor.
    Mr. Colker. I think the markets in general do a good job 
with that. I believe that the electronic markets have shown 
statistically that the competition between market makers has 
led to narrower volatility than in a single specialist model. I 
also worry to the extent, God forbid, we have another national 
disaster whether, you know, an exchange with a physical trading 
floor and no separate physical site could come up quickly 
enough to maintain the stability of the financial system.
    Senator Sarbanes. Mr. Cronin.
    Mr. Cronin. Volatility is obviously of interest to all of 
the investing public. We want to dampen as best we can that 
volatility, and again, we believe the best way to do that is to 
provide protections for limit orders to come back. Currently, 
we are in a situation where people are not given the proper 
incentive to put their limit orders on the various exchanges or 
market centers. We need more rules in place, and I do not mean 
to be overburdensome with these rules, but with time and price 
priority, that is not only the best price be protected, but 
also the person who is there displaying the best price first, 
those kinds of protections, I think, facilitate people's 
interest, engender confidence, and will likely result in 
greater liquidity being displayed. And ultimately, the 
attendant cost of that will be that there will be less 
volatility.
    Senator Sarbanes. Mr. DeSano.
    Mr. DeSano. Yes, I am not sure that volatility is all that 
bad to begin with. Take a scenario; say a stock is trading at 
$20, and some news comes out, and they are going to reduce--
they lost a contract or something, and, you know, the stock is 
actually worth $15 when all is said and done and all the 
analysis is done. Then, that is what the stock is worth, and 
that is where the stock should trade.
    Why should somebody walk it down in the interests of 
dampening volatility? What do you do to the individual investor 
who is buying it at $18 and $17 and $16 when it is really worth 
$15? You know, stocks are worth what they are worth. They are 
worth what the market thinks they should be worth, and that is 
who should price it.
    Mr. Cronin. Sir, just to be clear, if I might add: 
Volatility based on information is clearly a different concept 
than volatility based on inefficient markets. So we think that 
the inefficiencies of markets and the volatility that is 
commensurate with that is what needs to be addressed, not the 
volatility of the information-based trades.
    Senator Sarbanes. All right.
    Ms. Esposito. Sir, volatility is a characteristic that 
retail understands as part of investing in the marketplace. I 
would say that what the retail investor does not want to see is 
artificial dampening of volatility through the use of a 
specialist. One of the things that they look to and one of the 
preferences why they are in the over-the-counter market is that 
there is transparency and competition and that there is an 
immediate movement toward the equilibrium set by other 
investors like themselves in the bids and the offers that are 
quoted.
    So, I would say that the artificial dampening of volatility 
is not good for the marketplace; is not good for the retail 
investor. A lack of a quote or a halt in trading is not good. 
It does not give them confidence in the market, but certainly, 
the transparency and the competitiveness in some of the 
automated markets with quotes coming from investors like 
themselves gives them credibility in the marketplace.
    Mr. Madoff. I do not believe that volatility has been 
demonstrated to be a problem. I think historically, if you look 
at volatility today, with the Dow over 10,000 as compared to 
what it was years ago at 1,000 or 2,000, and you compare a 100-
point move to a 10-point move, I do not think there is much 
difference.
    Number one, I do not think anyone can control or should 
attempt to control volatility. The best way to deal with 
volatility if you deem it to be a problem is just to link the 
markets. Markets will seek their own levels. The only time it 
is a problem is when orders cannot interact, and people cannot 
come into the marketplace efficiently to offset that 
volatility. Let buyers and sellers meet as efficiently and as 
quickly as possible, and volatility to itself goes away for the 
most part.
    Mr. McCooey. A significant number of companies have moved 
from Nasdaq to the New York Stock Exchange over the past few 
years, and one of the primary reasons that they have moved is 
because of reduced volatility. And we also have statistics that 
show that once they have moved to the agency auction market on 
the floor that the volatility in their stocks has been reduced 
by about 50 percent.
    That is one of the major reasons why CEO's and CFO's, when 
they do their analysis, decide that they want to move to the 
New York Stock Exchange. One of the things I would just like to 
touch on is that when Mr. DeSano was talking about walking a 
book down when a stock may be trading at $20 and that people 
may get hurt if they buy it at $18 and $17 if the real price is 
$15. That kind of volatility is dampened by a regulatory 
process that we have at the New York Stock Exchange, which is 
the halt in trading, where we allow all investors to understand 
the news that has been disseminated about a company, and then, 
we reopen the stock at the appropriate price where buyers and 
sellers are able to aggregate their information.
    And if the true price is $15, and that is where the price 
is, then, we will have one trade where all of the people who 
were bidding $18 and $17 will get $15, and we do not allow that 
kind of volatility to happen at the New York Stock Exchange.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you very much.
    It is very interesting to hear all of the diverse opinions 
about this, particularly people protecting their turf. Let me 
ask you a general question: Do you believe an opt out on trade-
through will lead to internalization? Could internalization 
disadvantage small investors, or do you believe the 1940 Act 
has the safeguards to prevent that?
    You can go right across.
    Mr. Colker. The Nasdaq marketplace is a 100 percent 
internalizing market, at least among the market makers. And if 
you look at, again, the empirical data, you see that, in fact, 
customers often get better executions than they do in a single 
specialist model. I do not think an opt out where people are 
given a choice is going to in any way disadvantage the quality 
of their service.
    Mr. Cronin. I think internalization is clearly an issue, 
and it is unclear what kind of impact opt out will have. What I 
would say is the general premise of an opt out is that it is 
antithetical to the proposition of orders that would protect 
limit orders, and I think again----
    Senator Bunning. In other words, if I put a limit order in 
all or nothing on 10,000 shares, I have protected myself.
    Mr. Cronin. You are opting in to the market by displaying 
your limit order, essentially.
    Senator Bunning. That is find, but you cannot trade it; no 
one can unless I get my price.
    Mr. Cronin. That is right.
    Senator Bunning. All or nothing.
    Mr. Cronin. If you are bidding $20 in this prior example 
for 10,000 shares, should it be fair for someone the trade it 
at $19.98 on a different exchange?
    Senator Bunning. If you cannot get all my 10,000 or 20,000 
shares, yes; the answer is yes.
    Mr. Cronin. Right, so should the market structure allow a 
trade to take place at $19.98 when there is a superior bid 
displayed? An opt out provision would give that ability to 
trade at $19.98. We think that is a dangerous slope to pursue. 
We understand it, and as my neighbor up the street can tell 
you----
    Senator Bunning. Yes, but I am protecting my own order.
    Mr. Cronin. That is right. In the interests of protecting 
your order and investors' interests in general, an opt out is a 
very difficult thing to accept as a proposition.
    Senator Bunning. There are many large institutional traders 
and many other traders that protect themselves with their own 
orders. Are you saying that is a bad thing?
    Mr. Cronin. No, sir, I am saying that putting your own 
order out there, by displaying your order, by opting into the 
marketplace, you should have some protection conferred upon 
you. Opt out basically takes that protection away from you.
    Senator Bunning. Okay; thank you.
    Mr. DeSano. Back to internalization, I do not see opt out 
impacting that. Because of the 1940 Act, we are not allowed to 
trade with our funds as principal, and so, it has absolutely no 
effect on that.
    Ms. Esposito. Senator Bunning, we support the auto-
execution alternative, which would largely eliminate the need 
for an opt out in the marketplace. We believe that all market 
centers, if they are required to display an automated quote, 
there will be no need for that. I should say that we also 
support that all orders be displayed before, in fact, they are 
internalized. This is good for price discovery, for 
transparency, and indeed for competition. We would not want to 
see an opt out where there was an opt out for the institutional 
market at the disadvantage of the retail investor.
    Senator Bunning. Yes, sir. Mr. Madoff.
    Mr. Madoff. Yes, sir. Senator Bunning, there are instances 
where an opt out is necessary. There must be limited opt outs, 
but certainly, I do not see any reason why someone should opt 
out of an automated, accessible market for most non-block size 
orders.
    Mr. McCooey. There are significant negative impacts to an 
opt out. I refer to opt out as trade-through lite, because it 
ends up with the same negative impacts to the marketplace, the 
same negative impacts to people that are displaying limit 
orders. It makes them feel like, if they are traded through 
that they are ignored. They will not come back into the 
marketplace, because they feel that they have no standing. That 
will reduce the number of limit orders. It will widen spreads. 
It will increase costs to companies to raise capital. There are 
significant negative impacts to an opt out.
    Senator Bunning. I strongly disagree with that, but that is 
okay.
    Another question: Is the current trade-through rule ever 
violated? If so, how often?
    Mr. Colker. Senator, if you look closely, you will see that 
the marketplace that appears to most strongly support a trade-
through rule and is most concerned about it going away is, in 
fact, the greatest violator of that. Probably thousands times a 
day, the primary market trades through other nonprimary 
markets.
    Mr. Cronin. Yes, sir, it does happen. I know the Exchange 
is aware of the problem and have said implemented some 
procedures to correct it. I guess what I would say is by 
conferring a trade-through to only automated markets, only 
those markets that provide immediate execution on firm bids and 
offers, much of that problem can go away. ITS status and the 
commiserate trade-through rule that exists today is not really 
a true trade-through rule, because it is not being followed.
    If a trade-through rule is established again for only 
automated markets, I think that much of this goes away.
    Mr. DeSano. We get traded through fairly often. I have 
shared examples of that with Chairman Donaldson and with 
Chairman Thain. And to go back to the institution that is 
supporting the trade-through, which violates it, is also 
probably the largest internalizer in the world. When a market 
order comes into there, and there is a better bid away or a 
better offering away, they will match it as opposed to routing 
it to that location, so they are the largest internalizer in 
the market.
    Senator Bunning. In other words, the specialist on the 
floor----
    Mr. DeSano. Yes, sir.
    Senator Bunning. --will take the----
    Mr. DeSano. Yes, sir.
    Senator Bunning. Go ahead.
    Ms. Esposito. Yes, Senator, there are violations of the 
trade-through rule.
    Senator Bunning. Okay; thank you.
    Mr. Madoff. Yes.
    [Laughter.]
    Senator Bunning. Yes, there are?
    Mr. Madoff. There are violations of the trade-through rule. 
However, there is a procedure in place in the listed market 
today where if another market center, trades through our 
market, which does happen regularly, we have the right to 
complain through ITS to correct that price, and in fact, when 
we do complain, which is most of the time, they do correct the 
price.
    Mr. McCooey. There are trade-throughs. There are trade-
throughs in all markets. When Bob Greifeld sat here yesterday 
and said that there are no trade-throughs in Nasdaq, that is 
absolutely not correct. There are trade-throughs in Nasdaq; 
there are trade-throughs in New York Stock Exchange-listed 
issues. Every single valid complaint of a trade-through on the 
New York Stock Exchange, we honor, and we satisfy.
    Senator Bunning. One last question.
    Chairman Shelby. Go ahead, Senator.
    Senator Bunning. If the current trade-through rule is 
violated so often, why do we have it? Anyone? Why do we have 
it?
    Mr. Colker. We have it because inertia is a powerful force, 
you know. It has been there since 1982.
    Senator Bunning. Well, I know it has been there a long 
time.
    Mr. Colker. I think it served a useful purpose when it 
first came out. Conditions have changed to where it is an 
anachronism now.
    Senator Bunning. To look at it now in a different view 
would be the correct thing to do.
    Mr. Colker. Yes, in an electronic market, where you have 
complete market information at the customer level and multiple 
competitors and advanced trading systems, it is really an 
impediment rather than an advantage.
    Senator Bunning. Let me tell you: for people who are very 
up on being sophisticated investors, I think they can protect 
themselves from all of you.
    [Laughter.]
    And I say that as kindly as I can. If you know what you are 
doing when you are investing, you never get stuck with that. 
And when the trade is past your bid or your asking price, you 
understand that they could not fill your order because it was 
too big, and there were not enough shares bid, or there were 
not enough shares offered at your price. And so, trade-through 
and all these things are just extra things that are not 
presently necessary in the market, because I will tell you: You 
all trade an awful lot of stock, and you protect your investor. 
If you do not protect your investor, you have a big problem.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Senator Bunning.
    Mr. DeSano, there seems to be a split within the mutual 
fund industry on Regulation NMS. How do these issues affect 
mutual fund investors? You are a trader for the biggest.
    Mr. DeSano. Well, the split would be looking for price and 
time priority across markets, and we do not have it within the 
New York Stock Exchange to begin with. So if we could 
accomplish that, we can have the discussion about the across 
market issue. That is really the split.
    Chairman Shelby. Ms. Esposito, are you familiar with the 
Frankfurt Exchange?
    Ms. Esposito. I am.
    Chairman Shelby. Is that totally electronic?
    Ms. Esposito. Yes, to my knowledge, it is.
    Chairman Shelby. Just tell me in a second, how does that 
work compared to the New York Stock Exchange?
    Ms. Esposito. Well, I can only comment on the experience of 
our investors and that they prefer automated transactions, and 
I think that kind of a model is what, with their pocketbooks, 
they are voting for here in the United States for us to follow.
    Chairman Shelby. It works pretty well there, does it not?
    Ms. Esposito. Yes, sir.
    Chairman Shelby. How many years, how long have they been 
running it in Frankfurt?
    Mr. DeSano. I believe it is about 5 years, sir.
    Chairman Shelby. It is a pretty good size market, is it 
not?
    Mr. DeSano. Yes.
    Ms. Esposito. It is, Senator.
    Mr. Cronin. Mr. Chairman, if I might add real quick----
    Chairman Shelby. Sure.
    Mr. Cronin. --as another mutual fund participant, I think 
the split philosophically is not as wide, perhaps, as it is 
portrayed in the media. I think most mutual funds would agree 
that the ultimate outcome we would like for the market 
structure is for more efficiency, more price discovery, and 
above all the other things, competition, because competition 
will truly create the kind of innovation, the differentiation 
of product and, frankly, prove to investors what the different 
paradigms of tradings present in terms of a value added 
process. And they are free to choose, should be free to choose, 
how they want to pursue their order flow.
    Chairman Shelby. We received notice that we have three 
stacked votes. We are going to try to get into the second 
panel. We appreciate your testimony. We appreciate what you are 
telling us, and we are listening. You can tell that.
    Mr. Cronin. Thank you.
    Ms. Esposito. Thank you very much.
    Chairman Shelby. We will call up the second panel, and we 
will try, because you are here, and you have waited patiently, 
to move it as fast as possible, because I do not know if we can 
get back here today.
    Because we are so pressed for time on the floor with three 
stacked votes, what I will do is forego asking questions, 
submit my questions to you for the record. Your testimony has 
been made part of the record, and if each one of you will take 
a couple of minutes and just touch. You heard the first panel. 
I apologize for having to do this, but this is the Senate.
    Mr. Bang, we will start with you. Just take a couple of 
minutes, if you would, because time is a problem.

                     STATEMENT OF KIM BANG

          PRESIDENT AND CEO, BLOOMBERG TRADEBOOK, LLC

    Mr. Bang. Mr. Chairman and Members of the Committee, my 
name is Kim Bang, and I am pleased to testify on behalf of 
Bloomberg Tradebook.
    Let me state first that we do not see ourselves as a 
competitor of the New York Stock Exchange. We are basically 
liquidity-agnostic. Our challenge is to provide the best 
possible tools to our clients and empower them to find the best 
price in the marketplace, whether it is at the New York Stock 
Exchange or any other venue, including the 40 exchanges we 
route to globally.
    Market participants and policymakers have often asked, why 
does the New York Stock Exchange control 80 percent of the 
trading volume of listed companies, when Nasdaq controls only 
about 20 percent of the volume of its listed companies, and the 
answer to us is simple: It is an anticompetitive, antiquated, 
and protectionist trade-through rule that we have today.
    The Nasdaq price-fixing scandal of the mid-1990's resulted 
in the SEC's 1996 issuance of the order-handling rules, and 
those rules have enhanced transparency and competition in the 
Nasdaq, and we believe the same evolution should take place in 
the New York Exchange. We believe that the trade-through rule 
is protectionist, inefficient, and that essentially, it should 
be abolished.
    Chairman Shelby. Anti-market?
    Mr. Bang. I am sorry?
    Chairman Shelby. Anti-market oriented, the trade-through 
rule? It is an impediment to the market?
    Mr. Bang. It is an impediment to the national evolution of 
the market, yes.
    If manual markets are to continue in New York when they do 
not exist anywhere else in the world, we think that they should 
earn that position and that right as the result of competition 
and investors' choice, choosing to go there. The rule should 
certainly not be extended to the Nasdaq marketplace, because 
let us remember the depressing question here today and what 
drives Reg NMS is not how do we improve the Nasdaq market, but 
the question really is how do we go about modernizing the New 
York Stock Exchange?
    Let us bring the New York Stock Exchange market into the 
21st century and not impose, without empirical basis and 
evidence what we believe is a more antiquated and extremely 
costly proposal onto the Nasdaq market. Rather than 
introducing--I am going to skip through because of time--let me 
talk about market data for a moment.
    I believe that market data is the oxygen of the markets and 
the public good created by every investor. Historically, the 
exchanges have exploited this Government-sponsored monopoly to 
overcharge investors a sum many times the actual cost of 
aggregation and disseminating of market data, which is forcing 
investors to subsidize other activities. The Securities 
Exchange Commission proposes a new, complicated formula for 
distributing these monopoly market data overcharges without 
really addressing the underlying question of how to effectively 
regulate this monopoly function.
    And by contrast, in its 1999 concept release on market 
data, the Commission noted that market data should be for the 
benefit of the investing public and proposed a cost-based limit 
to market data. Okay; one other thing we believe regarding 
market data is we believe that more is better and that as a 
result of decimalization, which has been a watershed event, 
going to decimal trading has for sure been a boon to the retail 
investor.
    But it has also been accompanied by drastically diminished 
depth of display and accessible liquidity. With 100 price 
points to a dollar instead of 8 or 16, the informational value 
and available liquidity at the best bid and offer have declined 
substantially. In response to decimalization, Congress should 
urge the Commission to restore lost transparency and liquidity 
by mandating greater real-time disclosure by market centers of 
liquidity, at least by penny above and below the best prices.
    Given the incentive of a slow market such as the New York 
Stock Exchange to hide quotational information and block direct 
access to liquidity, the real-time disclosure of liquidity 
should not be left to market forces, which can work in this 
instance only if disclosure is mandated. This should restore 
the transparency lost as a result of decimalization.
    Chairman Shelby. You are over your time. I am sorry, 
because----
    Mr. Bang. Let me make one more comment.
    Chairman Shelby. Otherwise nobody else will have a chance 
to say something.
    Mr. Bang. All right.
    Chairman Shelby. Your written testimony is made part of the 
record.
    Mr. Bang. Thank you.
    Chairman Shelby. Thank you.
    Ms. D'Agostino.

                STATEMENT OF DAVI M. D'AGOSTINO

                DIRECTOR, FINANCIAL MARKETS AND

                      COMMUNITY INVESTMENT

             U.S. GOVERNMENT ACCOUNTABILITY OFFICE

    Ms. D'Agostino. Yes, I have a 5-minute oral summary. Would 
you like me to cut it back?
    Chairman Shelby. I would like you to cut it to 2.
    Ms. D'Agostino. Okay; I am pleased to be here today to 
discuss GAO's preliminary observations on subpenny pricing 
issues.
    In its proposed changes to Reg NMS, SEC included a proposal 
to ban market participants from pricing stocks in increments of 
less than one penny, as some markets do today. Our preliminary 
observations are based on our work to date, including 
interviews with regulators and market participants and a 
limited review of comment letters to SEC.
    First, although data across all of the markets are not 
routinely reported or readily available, the extent to which 
stocks are quoted in subpenny increments appears to be limited. 
Major markets do not allow subpenny quoting, and only some 
electronic trading venues do, and they have severely curtailed 
or cut back the number of stocks that they allow it in. Limited 
scope studies by regulators and one market center found that 
subpenny prices were used for 15 percent or less of trades.
    A second point I would make is that some cited advantages, 
and some cited disadvantages of subpenny pricing. The 
advantages included getting order priority, price improvement, 
and more competitive and efficient markets. The disadvantages 
included the fact that mostly professional traders such as 
hedge funds have the systems that can display subpenny prices, 
and the general investing public do not have access to these.
    Another disadvantage cited was that there is greater 
propensity to step in front of orders and thereby discouraging 
the submission of limit orders and reducing overall 
transparency. Others said that subpenny quotes reduced market 
transparency by spreading the available shares across more 
price points, which, in turn, makes it more difficult to fill 
large orders.
    Finally, most of the participants we contacted so far and 
most commenting on SEC's proposal appear to support a ban on 
subpenny pricing for stocks priced above $1. Basically, those 
who oppose the ban say that it will reduce opportunities for 
traders to offer better prices and that although some ECN's 
support the ban, others said that it should be determined by 
market forces, and that as technology advances, more market 
participants will find it more useful to quote in subpennies.
    Others have noted that banning subpenny quotes could stifle 
incentives to invest in better technology, and they noted that 
certain problems cited as being caused by subpennies will 
continue with trading in full pennies.
    With that, I will end my oral statement.
    Chairman Shelby. I am sorry about the time. We have about 3 
minutes before our vote, and we have three stacked votes. I 
have no control, so you have to be real quick. Just tell me 
your top points fast.

                STATEMENT OF ROBERT B. FAGENSON

           VICE CHAIRMAN, VAN DER MOOLEN SPECIALISTS

    Mr. Fagenson. Mr. Chairman, I am Robert Fagenson. I am a 
specialist; I have been for my whole career.
    We support the trade-through rule because it is not 
antimarket; it is procustomer. And people who drag in here and 
whine about it because their business models do not work are 
seeking weaker regulation, and if they think they cannot get 
you to buy into this one, they will go for opt out, which 
really should be cop out. It is a way to distort and gut the 
entire system.
    We listen to our customers; we believe in customer-driven 
markets. Mr. Thain told you what we are doing, what we are 
about. We are going to get there as sure as I am sitting in 
front of you with a minute to talk. We are going to get there 
for all the right reasons: Because our customers deserve no 
less, and the integrity and liquidity of our markets is a 
national treasure that deserves protection, and we believe in 
that: Not protectionism but protection.
    You have to be the FAA here, Mr. Chairman. Yes, the plane 
will land, but it has to land safely, and we believe that the 
trade-through rule is an absolute essential for customer 
protection for my constituents and for your constituents.
    Chairman Shelby. Yes, sir.

                  STATEMENT OF JOHN C. GIESEA

        PRESIDENT AND CEO, SECURITY TRADERS ASSOCIATION

    Mr. Giesea. John Giesea, President and CEO of Security 
Traders Association, which represents some 6,000 professionals 
involved in the purchase and sale of securities.
    Chairman Shelby. What is your view on this?
    Mr. Giesea. Very quickly, we have a phased approach----
    Chairman Shelby. Okay.
    Mr. Giesea. Which we think there are four corners to the 
foundation of NMS. Those four corners are full connectivity, 
access without fee, fully automatic transactions, and fully 
automatic refresh of quotes, which allow for continuous, 
automatic trading. You have those four things, and you go a 
period, and then, you will be in a position through experience 
to determine the importance or lack thereof of imposing any 
changes to the trade-through rule.
    Chairman Shelby. How long do you envision a phase-in?
    Mr. Giesea. Well, Mr. Thain has mentioned that before the 
NMS comes out, he can be in a position to have automatic 
transactions, so it would seem to me this could be perhaps a 6-
month period where you could gain that experience.
    Chairman Shelby. Mr. Leven, you are last, but I am sorry 
again about the time.

                   STATEMENT OF CHARLES LEVEN

VICE PRESIDENT, BOARD GOVERNANCE ANDCHAIR, BOARD OF DIRECTORS, 
                              AARP

    Mr. Leven. Well, if I clear my throat, we will be done, 
right?
    [Laughter.]
    Chairman Shelby. Yes, sir. Well, maybe. Just tell me how 
you feel about all this very quickly.
    Mr. Leven. From an investor's point of view, an individual 
investor who has both mutual funds and individual investments, 
their concern mostly, primarily, is price. The second concern 
is the cost of the transaction: speed, confidentiality, while 
they are important, are not really significant to them.
    The other thing that I think we should say, at least, is 
there is a definite negative perception of this industry. It 
runs through our entire survey. There is dishonesty, a lack of 
accountability, and a lack of consumer protection. The 
respondents feel there are big problems for the industry.
    Chairman Shelby. The integrity goes right to the central 
part of the market, does it not?
    Mr. Leven. Yes, absolutely. And the other point is that 
they feel more Governmental supervision is necessary.
    Chairman Shelby. We appreciate all of your participation 
here, and we are going to continue our oversight on this, and I 
apologize again for having to run. Thank you. The hearing is 
adjourned.
    [Whereupon, at 11:20 a.m., the hearing adjourned.]
    [Prepared statements supplied for the record follow:]

                   PREPARED STATEMENT OF DAVID COLKER
             CEO and President, The National Stock Exchange
                             July 22, 2004

    Chairman Shelby, Ranking Member Sarbanes, and other Members of the 
Committee, thank you for inviting me to testify before you today. I 
appreciate the opportunity to provide the Committee with my thoughts on 
important market structure issues.
    The publication of proposed Regulation NMS by the Securities and 
Exchange Commission has given the securities industry a unique 
opportunity for improvement. If we are thoughtful enough, if we are 
committed enough to the idea of competition, then we can reshape the 
regulatory environment in a way that will have significant positive 
benefits for the public investor.
    One such opportunity for improvement is the Intermarket Trading 
System's trade-through rule. Originally, this rule was put in place to 
require the New York Stock Exchange to honor better prices that were 
being displayed on nonprimary exchanges. Since the establishment of the 
trade-through rule in 1982, the nonprimary exchanges have led the way 
in automating the trading process, which has reduced trading costs, 
enhanced market efficiency, and created opportunities for new types of 
electronic participants. Because of these innovations, however, the 
trade-through rule has now become a barrier to competition, an 
unintended instrument for unfair Government protection of the NYSE's 
manually intensive monopoly. Because of the trade-through rule, 
exchanges that provide automatic executions are required to slow their 
service and send an order to an NYSE quote that, though it may appear 
to be the best price in the country, may not actually be available. 
Even if that NYSE quote is available, a more efficient marketplace may 
have to wait up to 30 seconds to get an NYSE execution, and that 30 
second wait could result in losses due to changes in market valuations 
during that time. Even worse, the NYSE's execution price is often 
inferior to the NYSE quoted price that induced the order to be sent to 
New York in the first place.
    The SEC's own execution quality statistics (Rule 11Ac1-5) clearly 
reveal that the trade-through rule is a major barrier to competition: 
NYSE-listed stocks subject to the trade-through rule have wider 
spreads, get slower executions, and impose higher costs on investors. 
In contrast, Nasdaq-listed stocks, which are not subject to the trade-
through rule, provide investors with increased transparency, greater 
access to liquidity, faster executions, higher fill rates, and better-
priced executions. In addition, experience with the SEC's exception to 
the trade-through rule for exchange-traded funds demonstrates that 
quote spreads narrowed and trade volume grew 
significantly after the trade-through rule was modified to allow trade 
throughs in the top three ETF products.
    The trade-through rule has become unnecessary and counterproductive 
as a result of easy access to complete market data, technological 
advancements in trading systems, the increase in market competitors, 
and the implementation of decimal trading. The obvious solution, then, 
is to allow an investor to forego the trade-through rule and let 
competition between exchanges drive best execution. It is time for the 
Government to stop telling the American public where it has to conduct 
its business.
    Although a consensus is building about the necessity for a trade 
through opt out for manual or ``slow'' markets, there is still a lot of 
debate about whether the choice of an investor to opt out of the trade-
through rule should extend to automated or ``fast'' markets. For two 
reasons, I believe that it is important to preserve opt out flexibility 
for fast markets as well as slow markets. First, there are definitional 
concerns. The definition of ``fast'' will be arbitrarily determined 
based on the lowest common denominator solution that will be acceptable 
to the most politically powerful marketplace. Defining ``fast'' will 
become a slippery slope that will force the SEC to regulate more and 
more aspects of market technology. Second, fiduciary duty and economic 
self-interest obviate the need for any Government-imposed trading 
rules, and therefore the Commission does not need to condition the 
flexibility given by an opt out provision, even when a market is 
characterized as ``fast'' for regulatory purposes. If there really is 
no incentive to avoid a fast market, then a rule is not needed to 
require an investor to act in its economic self-interest. The SEC 
should allow exchanges and brokers the opportunity to compete, to 
operate without the constraints of intermarket order routing 
requirements, until it is empirically proven that the imposition of a 
trade-through rule is necessary.
    If the Commission decides not to extend the trade-through rule to 
the Nasdaq market when it trades Nasdaq-listed securities, then, in 
order to ensure equal 
regulation, the SEC needs to grant exchanges the ability to trade 
Nasdaq-listed securities without intramarket or intermarket trade 
through requirements. To do otherwise would be to allow Nasdaq to 
retain a significant regulatory advantage over its competitors. NSX has 
had for over 2 years a rule change proposal in front of the SEC--its 
``voluntary book'' proposal--that would eliminate this regulatory 
advantage. Now is the time to either approve NSX's voluntary book 
filing or to eliminate the ability of broker-dealers to trade through 
better-priced orders in Nasdaq's marketplace. Only in this manner can 
the mandate of the Securities and Exchange Act of 1934 that self-
regulatory organizations be subject to equal regulation be fulfilled.
    On the issue of market data revenue, I would like to challenge the 
assumption in proposed Regulation NMS that the current system for 
market data revenue distribution needs to be changed, and I would like 
to caution the Commission against making a change that could prove to 
be far worse than any problem that exists today.
    It is important to place the issue before us in historical context. 
The current market data revenue distribution method has been in place 
for over 25 years. For most of that time, the method has been perceived 
to be fair, easy to administer, and effective. It was first questioned 
2 years ago by Nasdaq for competitive reasons because the National 
Stock Exchange had captured significant order flow in Nasdaq-listed 
securities as a result of NSX's cost initiatives that involved the 
sharing of market data revenue with members. The fact is that, because 
other market centers that trade Nasdaq and Amex-listed issues were 
forced by NSX's competitive initiative to share their market data 
revenue, investors have been saving over $100 million annually, and 
they now have the opportunity today to choose from multiple broker-
dealers offering automated, price-improved executions for under $10. 
These benefits were created through competition, not regulatory 
mandate. If, as Regulation NMS suggests, the SEC is not going to 
address the explicit cost of market data by lowering the overall size 
of the market data revenue pool, then it is important that the SEC 
preserve a competitive environment among SRO's in order to continue to 
indirectly bring down the cost of market data for the brokerage 
community and the public investor.
    The premise that a trade-based formula creates economic 
distortions, regulatory distortions, or inappropriate incentives to 
engage in fraudulent behavior has not been sufficiently proven to 
warrant the proposed change to market data revenue distribution. Even 
if one believes that fraudulent actions are encouraged by the current 
distribution model, such actions represent rule violations that are 
already being regulated by effective SRO enforcement programs. The 
potential for such malfeasance no more justifies the adoption of 
Regulation NMS's proposed costly solution than the potential for 
speeding justifies shutting down the highway system.
    The proposed formula amendment is unnecessarily complex, misguided 
in its price discovery value judgment, and expensive to administer. The 
complexity of the formula has made it a poster child in the industry 
for the inherent limitations of regulation. The position that trades 
less than $5,000 have no price discovery value favors the exchange with 
the most block activity, and it defies logic. For example, the new 
formula includes a 100-share trade of a $56 stock like JNJ but excludes 
a 1,200-share trade of a $4 stock like SUNW, even if the SUNW trade 
creates a new high or low of the day. The fact is that all trades have 
price discovery value. Finally, in a world that is generating eighteen 
million NBBO quote changes daily across eight market centers, imagine 
the annual cost of determining how many thousands of quote credits each 
particular quote is due for each of the 23,400 seconds in every trading 
day. The calculation becomes particularly ludicrous if you consider 
that, in one example provided in the SEC release, a single quote that 
equaled the national best bid or offer for three seconds would be 
entitled to 12,000 credits. While NSX respects the desire of the 
Commission to encourage quote competition, the benefits of doing so 
through the proposed formula amendment simply do not come close to 
outweighing the new formula's administrative costs.
    Given all of the reasons above, NSX does not believe that the 
adoption of Regulation NMS's proposed market data reallocation formula 
would be sound public policy.
    Finally, whatever action the SEC ultimately takes, it is important 
to combine such action with changes that require NBBO and trade report 
market data to become real-time. This means that the Consolidated Quote 
Plan's 60-second quote update provision and the Consolidated Tape 
Plan's 90-second trade reporting provision must be significantly 
reduced. Given the electronic nature of the trading world today, real-
time market information--which is the stated purpose of the CQ and CT 
Plans--means automatic execution, automatic quote updating, and 
automatic trade reporting. Therefore, no quotes or trades should be 
given credit for market data revenue unless they emanate from a 
``fast'' automated market.
    Thank you again for the opportunity to present my views on these 
important subjects. I look forward to answering any questions that you 
may have.

                   PREPARED STATEMENT OF KEVIN CRONIN
          Senior Vice President and Director of Equity Trading
                            AIM Investments
                             July 22, 2004

Introduction
    My name is Kevin Cronin. I am Senior Vice President and Director of 
Equity Trading at AIM Investments in Houston, Texas. AIM Investments 
was founded in 1976 and had $148 billion in assets under management and 
approximately 11 million shareholders as of March 31, 2004. I would 
like to thank the Committee for providing me with the opportunity to 
testify on the SEC's Regulation NMS proposal and developments in the 
structure of the U.S. securities markets. While I am speaking today on 
behalf of AIM Investments, I am also expressing the views of the 
Investment Company Institute, the national association of the American 
investment company industry. I am a member of the Institute's Equity 
Markets Advisory Committee, which consists of approximately eighty 
senior traders at various large and small mutual fund firms. The 
Institute submitted a comment letter on the Regulation NMS proposal, 
which was the product of much discussion among Equity Markets Advisory 
Committee members and which expresses a consensus view of those 
members. I also currently serve as Chairman of the New York Stock 
Exchange's Institutional Traders Advisory Committee, which provides 
comment and recommendations to the Exchange on methods to improve its 
trading systems.
    Although Regulation NMS consists of four substantive proposals 
addressing a wide variety of issues impacting the structure of the U.S. 
securities markets, I will focus my comments on Regulation NMS's trade-
through proposal, which arguably could have the most impact on the 
structure of the securities markets going forward. Before I discuss 
some of the specific issues relating to the trade-through proposal, 
however, I would like to discuss why the issues raised by Regulation 
NMS and the debate over market structure is important to investors and, 
in particular, the mutual fund industry. Increased efficiencies in the 
markets will significantly benefit mutual fund shareholders in the form 
of lower costs. Mutual funds, therefore, have a vested interest in 
ensuring that the securities markets are highly competitive, 
transparent and efficient, and that the regulatory structure that 
governs the securities markets encourages, rather than impedes, 
liquidity, transparency, and price discovery.
    How do we create the optimal market structure for investors? We 
believe the SEC must focus its efforts on the principles of a national 
market system that Congress itself found appropriate over 30y years ago 
for the protection of investors and the maintenance of a fair and 
orderly market--efficiency, competition, price transparency, and the 
direct interaction of investor orders. As the SEC noted in the 
Regulation NMS proposing release, possibly the most serious weakness of 
the national market system is the relative inability of all investor 
buying and selling interest in a particular security to interact 
directly in a highly efficient manner. This weakness, in turn, creates 
a disincentive to investors to publicly display their limit orders, 
which are the cornerstone of efficient, liquid markets and, as such, 
should be afforded as much protection as possible.
    In order to provide investors with the incentive to publicly 
display their orders and to create a market structure in which these 
orders can effectively interact, several changes must be made to the 
structure of the securities markets. Most significantly, price and time 
priority should be provided for displayed limit orders across all 
markets; strong linkages between markets should be created that make 
limit orders easily accessible to investors; and standards relating to 
the execution of orders should be created that provide the opportunity 
for fast, automated executions at the best available prices.
    It is important to note that problems surrounding the lack of order 
interaction, its causes, and its impact on the securities markets are 
not new. Mutual funds have, for many years, recommended changes to the 
structure of the securities markets to facilitate greater order 
interaction and, in turn, more efficient trading. While much has been 
made about how various industry participants may or may not have 
aligned themselves with various competing market centers in the market 
structure debate, I want to make one point clear. AIM's and ICI's sole 
interest in this discussion is in ensuring that proposed market 
structure changes promote competition, efficiency and transparency for 
the benefit of all market participants and not for a particular market 
center or exchange. Market centers should compete on the basis of 
innovation, differentiation of services, and ultimately on the value 
their paradigm of trading presents to investors.

Trade-Through Proposal
    Although Regulation NMS and the trade-through proposal would not 
implement all of the components we believe necessary for investors' 
orders to fully interact in an efficient manner, a uniform trade-
through rule would be a significant step forward in providing 
protection for limit orders and, by affirming the principle of price 
priority, should encourage the display of limit orders. We believe, if 
appropriately instituted and enforced, a uniform trade-through rule 
also would increase investor confidence in the securities markets by 
helping to prevent an investor's order executing at a price worse than 
the displayed quote. We therefore support the establishment of such a 
rule.
    In order for a trade-through rule to fully achieve its objectives, 
it is extremely important that only ``automated'' quotes, that is, 
quotes that can be executed against automatically and promptly without 
any manual intervention, be protected and that markets provide prompt 
automatic updates of those quotes. It is for this reason that we 
support an exception to the trade-through rule that would permit an 
automated market to trade through a manual market for an unlimited 
amount or, as has been discussed recently by the SEC, an automated 
quote to trade through a manual quote for an unlimited amount. Such an 
exception would correctly focus the trade-through rule on providing 
protection only to those quotes that are truly firm and immediately 
accessible and not quotes that require manual execution and are, in 
effect, only ``maybe'' quotes or difficult or slow to access. We also 
support the creation of strong standards to accompany such an 
exception, which would delineate when an ``automated'' quote would be 
permitted to move into a manual execution mode and then back again to 
an automatic execution mode. We believe an exchange should only be 
permitted to ``turn off'' the automation feature of its quote, if at 
all, in extremely limited circumstances and only in critical 
situations.
    While most trading venues provide the opportunity for true 
automatic execution, certain exchanges still do not offer such a choice 
for institutional investors. The New York Stock Exchange has stated 
recently that they intend to provide automatic execution to at least 
the best bid and offer on the Exchange and has been discussing plans to 
transform their market into a ``hybrid'' market. It is important, 
however, that any automation on the NYSE not be wrought with exceptions 
that would, in effect, make claims of automation folly. Too often, 
institutions have heard plans to automate NYSE trading systems only to 
find out, after examining details of those plans, that they did not go 
nearly far enough toward implementing the necessary automation on the 
Exchange. We therefore urge the NYSE to move expeditiously to implement 
true automation in its market that would provide investors with much 
needed automatic execution of their orders. Such changes should be 
implemented regardless of whether the SEC's Regulation NMS proposal is 
adopted. One thing, however, is certain. Until the NYSE provides true 
automatic execution on its market, manual quotes on the New York Stock 
Exchange should not receive the protections of any trade-through rule 
adopted by the SEC.
    The proposed trade-through rule also contains another exception, 
the ``opt out'' exception, which would permit a person for whose 
account an order is entered to opt out of the protections of the trade-
through rule by providing informed consent to the execution of their 
orders in one market without regard to the possibility of obtaining a 
better price in another market. We oppose the opt out exception. In 
principle, the SEC's proposal to allow an exception to the trade-
through rule in the form of an opt out seems antithetical to the 
proposition of providing greater protection for limit orders. 
Institutions and other informed investors opting out would undermine 
the display of liquidity, which would likely result in less efficient 
markets. Therefore, we believe that protecting the integrity of the 
trade-through rule outweighs any flexibility an opt out provision would 
provide. While there is no doubt that, at times, investors may 
determine that speed and/or certainty is more important than price in 
executing an order, and while investors may be best served on a 
particular trade by opting out from executing against the best price 
placed in another market, we believe that in the long-term, all 
investors will benefit by having a market structure where all limit 
orders are protected and investors are provided with an incentive to 
place those orders into the markets. We are therefore dubious of any 
regulation that would tacitly approve the pursuit of ``inferior'' 
prices to the detriment of those who are willing to display best 
prices.
    While there is clearly no consensus among market participants, and 
even among some institutional investors, on whether an opt out 
exception is necessary, there does seem to be agreement that if the SEC 
does not restrict trade-through protection to only automated markets or 
automated quotes, and does not create a strong definition of what would 
be considered ``automated,'' some flexibility should be provided to 
investors to permit them to trade through markets that cannot provide 
the highest order of certainty and speed. In such a case, we believe a 
block trade exception to the trade-through rule may be necessary in 
order for institutional investors to efficiently trade large amounts of 
stocks. In any case, we believe that a block trade exception would be 
preferable to an opt out exception to facilitate these types of 
transactions. Most significantly, a block trade exception would be more 
limited in nature than an opt out exception and would be more feasible 
to employ.

Market Linkages
    It is important that another key aspect of improving the structure 
of the U.S. securities markets be considered in the debate over the 
proposed trade-through rule. In particular, we believe that in order 
for a uniform trade-through rule to operate effectively, strong 
linkages and minimum access standards must first be put into place. 
Otherwise, we are concerned that it will be an exercise in futility to 
require that a market send an order to another market to execute 
against a better priced order on that market if that better priced 
order cannot be accessed easily and with certainty. We therefore 
believe that prior to implementing the proposed trade-through rule, the 
SEC should ensure that effective linkages and minimum access standards 
between markets are in place to support such a rule.
Conclusion
    It is noteworthy that the SEC reaffirms, through statements in 
Regulation NMS, that its role is to facilitate the development of the 
national market system and not dictate its form. We believe that 
competition should largely define the structure of the capital markets. 
In the end, such competition will promote innovation and 
differentiation, which will benefit shareholders of all sizes. Also, it 
will ensure that the U.S. capital markets retain their rightful place 
as the most liquid, transparent, and efficient markets in the world.
    Thank you again for providing me with the opportunity to share my 
thoughts on Regulation NMS and the trade-through proposal. I would be 
happy to answer any questions that you may have.

                               ----------
                  PREPARED STATEMENT OF SCOTT DESANO*
           Head of Equity Trading Desk, Fidelity Investments
                             July 22, 2004

    I am Scott DeSano, Head of the Equity Trading Desk of Fidelity 
Investments. I thank Chairman Shelby, Ranking Member Sarbanes, and the 
other distinguished Members of this Committee for the opportunity to 
offer our views regarding proposed rulemaking at the SEC that has 
important implications for the future role of competition in this 
Nation's equity securities trading markets. I am speaking for Fidelity 
as the investment manager and fiduciary for its 190 mutual funds that 
invest in equity securities, which have aggregate assets of over $597 
billion. Our call for trading reforms is motivated solely by our duty 
to meet our fiduciary obligation to our mutual fund investors. As a 
matter of fiduciary principle, reinforced by the provisions of the 
Investment Company Act of 1940, Fidelity does not trade as principal 
with its funds. On any given trading day, the trading by the Fidelity 
funds in NYSE-listed and Nasdaq securities can account for 3-5 percent 
of the total trading volume of each market center and at times has been 
40-50 percent of an individual security.
---------------------------------------------------------------------------
    * All attachments included with the witness's statement are held in 
Committee files.
---------------------------------------------------------------------------
    By far the most important rule proposal that the SEC has included 
in its proposed Regulation NMS is the socalled ``trade-through'' rule. 
The trade-through rule, absent an exception, would deny a willing buyer 
and willing seller the freedom to choose the marketplace at which to 
trade and the price at which they are willing to trade.
    The SEC has identified two cases where its proposed trade-through 
rule would not apply. First, the rule would not apply to buy and sell 
quotes on a ``slow'' or nonautomated market. The SEC recognizes that it 
is fundamentally unfair to force an investor to send his buy or sell 
order to a slow market because there is a high risk that the supposedly 
better quoted price may disappear by the time his order finally 
receives an execution on that slow market. To protect investors from 
this unfair 
result, the SEC would allow an investor to disregard the slow market 
and the frequently illusory prices quoted on that market. Under the 
SEC's proposed rule, the NYSE is a slow market.
    Second, the SEC proposes to give investors an ``opt out'' right. 
This would allow informed and willing buyers and sellers in Market A to 
trade with one another at an agreed-upon price even though Market B or 
Market C might be quoting a higher offer to buy or a lower offer to 
sell. If this sounds like the American way, it is--for two very 
important reasons. It gives freedom of choice to investors to decide 
for themselves what is in their best interests and it provides 
incentives to market centers to compete and to innovate to attract 
order flow.

Fidelity's Positions
    Let me clearly state the positions of Fidelity Investments on the 
proposed trade-through rule and the opt out right, as we have set forth 
in our comment letter submitted last month (Attachment I) to the SEC:

 We urge the SEC not to adopt the proposed trade-through rule 
    because it will impede competition among market centers. The 
    Government should permit market centers to compete based upon a 
    wide range of factors that are important to investors and bear upon 
    best execution, including efficiency, reliability, transaction and 
    data costs, transparency, quality of market self-regulation, 
    fairness, and innovative use of technology to lower costs to 
    investors. These factors all bear upon best overall prices for 
    investors and hence ``best execution.''
 A trade-through rule is not necessary to promote best 
    execution in the equity markets. Order flow will naturally 
    gravitate to market centers that respond to investors' needs. This 
    is not a matter of conjecture or theory. It has been clearly shown 
    by the vigorous competition that has been taking place for several 
    years among different market centers trading in Nasdaq securities. 
    Economic self-interest and fiduciary duty will lead investors to 
    the markets providing the best combination of low transactional and 
    access costs, speed, reliability, liquidity, and innovation.
 If the SEC adopts the trade-through rule, we strongly urge 
    retention of the ``opt out'' right that the SEC has proposed. An 
    opt out provision is crucial to allow investment managers, such as 
    Fidelity, to perform their fiduciary duties to the fullest extent 
    in seeking best execution for the mutual funds or other accounts 
    under their management.
 To address unfairness that hurts investors large and small, we 
    have urged the SEC to focus on reforming rules within the NYSE's 
    own market that confer informational and trading privileges on NYSE 
    members solely by virtue of their physical presence on the trading 
    floor. Today, investors are deterred from sending limit orders to 
    the NYSE's specialist book because these orders under the NYSE's 
    rules are not given time priority over bids and offers made later 
    in the day at the same price by brokers in the trading crowd or by 
    the specialist trading for his own account.
 To avoid unfairness for investors, the SEC should also require 
    changes to the NYSE's rules that today prevent a willing buyer or 
    seller from automatically ``sweeping'' the limit order book at 
    prices that the investors who placed the limit orders already 
    freely committed to accept. Let us say, for example, that different 
    investors have sent limit orders to the NYSE committing to sell the 
    stock of Company A at prices ranging from $10 per share to $10.25 
    per share. The NYSE's rules today do not allow a willing buyer to 
    sweep the specialist's limit order book at one time and pay the 
    highest price--$10.25 per share--to all investors. This is simply 
    unfair to the investors who want to sell and have committed to do 
    so. It is also unfair to the buyer who is willing to pay the best 
    price to all of them.

Why the Trade-through Rule Should Not Be Adopted
    Those who advocate a trade-through rule raise the specter of 
``fragmentation.'' This is a value-laden word, because it suggests that 
something is broken and needs to be fixed. But on its face, 
fragmentation does not tell the interested observer anything that helps 
him or her to come to an informed judgment. What is meant by 
fragmentation? Often it is short-hand for the supposition that trading 
of the same security in separate markets is an unhealthy thing because 
it leads to wider spreads between buy and sell quotes, which in turn 
supposedly leads to greater volatility and less liquidity in that 
stock.
    There is nothing in the laws of economics or the way that markets 
work that compels that result. Let us bear in mind that competition 
among broker-dealer firms acting as market makers in stocks leads to 
greater liquidity and narrower spreads. This competition is not 
achievable on the NYSE, because its business model calls for the award 
of a monopoly right to a single broker-dealer member firm to act as the 
sole market maker on the NYSE floor. So, for competition among market-
makers to take place in NYSE-listed stocks, it is a necessary condition 
market makers in other market centers trade in those stocks. 
Fragmentation of markets in that sense is necessary to counter the 
monopoly of the NYSE specialist. That is a good thing.
    Trading in Nasdaq securities among competing market centers 
demonstrates that so-called fragmentation need not, and should not, 
lead to inefficient pricing or less liquidity. Quite the contrary is 
true. Given the widespread and timely disclosure of quoted bids and 
offers in competing equities markets, a trade-through rule is simply 
not necessary. Fragmentation is a problem only when prices are hidden 
from public view, not when they are widely disclosed and all market 
participants can make informed decisions about the prices at which they 
are willing to trade and are able quickly and easily to reach those 
prices.
    Another argument made by supporters of a trade-through rule is that 
such a rule is necessary to prevent mutual fund managers and pension 
fund managers from somehow taking advantage of captive order flow by 
``internalizing'' their funds' trades, that is, by taking the other 
side of those trades for their own account. This is simply incorrect. 
The Investment Company Act flatly prohibits a mutual fund adviser from 
selling securities to or buying securities from any mutual fund under 
its management. The same is true for any affiliate, including any 
brokerdealer of the fund adviser. ERISA imposes the same prohibitions 
on pension fund managers.
    We are urging the SEC to drop its proposed trade-through rule--or 
at least to keep the full opt out right it has proposed if a trade-
through rule is adopted--in the name not only of fairness but also best 
execution as well. We understand that market centers with a vested 
interest in preserving their market share of trading volume may contend 
that support for an opt out provision is antithetical to the goal of 
best execution. The argument is that by supporting a rule that allows 
us to choose among competing market centers, we somehow favor speed or 
certainty of execution at the expense of best price. We categorically 
reject this contention. Speaking for Fidelity, let me make one thing 
clear: In seeking best execution in trades for our funds (which consist 
of millions of small investors), we have one objective--and only one 
objective in mind. That objective is to obtain the best overall price 
for our funds' trades. Best execution, that is, best all-in pricing, 
takes into account a number of factors that an investor would be denied 
the opportunity to consider if the SEC were to adopt a trade-through 
rule without an opt out right. For example:

 What is the quality of a market center's program of self-
    regulation? How well does a market center monitor the trading 
    activities of its members and how strong or consistent is its 
    record of disciplining members who violate its trading rules? In 
    making these assessments, we place little weight on a market 
    center's press releases or public relations campaigns. Rather, we 
    place weight on a market center's record of self-regulation, 
    reinforced by our first-hand experience based upon trading in 
    competing market centers every day.
 What are the out-of-pocket costs that a market center imposes 
    on investors? These include brokerage expenses, access fees, 
    transaction fees, and market data fees. From the investor's 
    standpoint, best execution involves not only the price at which a 
    security is bought or sold but also other costs which investors 
    must pay to enter into and clear their trades. It is important to 
    note that SEC rules allow funds under common management to buy and 
    sell stocks from each other rather than send all their orders to an 
    external market. This allows the funds to avoid paying brokerage 
    commissions--a cost saving for both the buying fund and selling 
    fund.
 What is the liquidity and depth of any particular market 
    center? Again, if a market center charges a fee to an investor for 
    the ``privilege'' of seeing the depth of quotes away from the best 
    bid and offer, should investors view this market as offering 
    liquidity comparable to that of another market center that 
    discloses the depth of its quotations for no fee or lower fees?
 How fair are the market center's trading rules? Does a market 
    center confer special privileges on some of its members that give 
    them an advantage over public investors?
 How competitive is a market's own trading venue? For any given 
    security, does it allow for competing market makers or does it 
    confer a monopoly market-making privilege on a single member?
 How efficiently, quickly and reliably does a market center 
    confirm and report trades occurring in its trading venue? The 
    advantage to an investor of being able to enter into automated 
    trades on a given market can be undermined if confirmations or 
    reports of those trades are marked by delay or uncertainty.
 How quickly does a market center refresh its quoted prices 
    after a trade occurs? This is crucial to investors seeking to 
    effect large transactions in stages.

    Investors should be free to take these and other factors into 
account in seeking best execution, rewarding market centers that 
promote best execution and disciplining those that do not.

Why an Opt-Out Rh!ht Is Essential if a Trade-Through Rule is Adopted
    We strongly believe that an opt out right is crucial to enable us 
to serve as a fiduciary to the mutual funds under our management. An 
opt out right ensures that we will remain free to reach our own 
informed judgment regarding the market center where our funds' trades 
are to be executed. That right is particularly important when delay may 
open the way for exchange floor members and others to exploit an 
informational advantage, one that arises not from their greater 
investment or trading acumen but merely from their privileged presence 
on the physical trading floor. This is true regardless of whether 
competing markets are ``fast'' or ``slow.''
    I must emphasize that support for an opt out provision in no way 
contradicts the goal of best execution. The argument is made by those 
who oppose an opt out right that we somehow favor speed or certainty of 
execution at the expense of best price. We categorically reject this 
contention. In seeking best execution in trades for our funds we have 
one objective--and only one objective--in mind. That objective is to 
obtain the best overall price for our funds' trades. We view speed and 
certainty of execution as means to an end, and that end is overall best 
price.
    Experience has taught us a very clear lesson. Given the dynamics of 
our trading markets and the rapid and sudden shifts in stock prices, 
the overall best price for the purchase or sale of stocks for our funds 
often depends upon our ability to lock in a price at a given moment for 
all or a significant part of our trade. If we are compelled, against 
our better judgment, to break up our orders and execute them over an 
extended period of time, in many cases this will lead to inferior all-
in prices for our funds. The opt out provision the SEC has proposed 
will not subordinate best price to certainty or speed of execution. We 
value certainty and speed of execution precisely because these factors 
play an indispensable role in obtaining best price for our funds' 
trades.

The SEC Should Focus on Reforming the NYSE's Own Trading Rules
    Those who advocate an intermarket trade-through rule presuppose 
that such a rule will strengthen protection for limit orders and 
thereby encourage more investors to place limit orders in market 
centers competing with the NYSE. That supposition, however, overlooks 
trading rules within the NYSE's own market which deny time priority to 
limit orders against later orders from the floor or the specialist at 
the same price.
    For example, under the NYSE's rules, a limit order entered at 10:30 
a.m. to buy 500 shares at $20 per share does not have time priority 
over a bid to buy 500 shares from a floor broker first made at 2:30 in 
the afternoon at the same price. If a sell order for 500 shares at $20 
arrives at the NYSE at 2:30, the investor who has entered the limit 
order 4 hours earlier is not entitled to buy all 500 shares. The 
investor will receive only 250 shares and the floor broker will be 
allowed to buy the other 250 shares.
    It is widely assumed, by those not fully aware of how the NYSE's 
trading rules operate, that the NYSE's trading market is built upon 
strict price and time priority for all orders. This is simply not the 
case. Rather, limit orders on the NYSE's specialist book are given 
second-class status under the NYSE's ``auction'' rules. If the SEC 
seeks to encourage the placing of limit orders by investors, including 
institutional investors, the most effective way to do so would be to 
reform the trading rules of the NYSE to provide within the NYSE's own 
market time priority for limit orders over later bids and offers by 
floor brokers and specialists at the same price.
    Our experience tells us very clearly that an intermarket trade-
through rule will not encourage investors to place limit orders either 
on the NYSE or on markets seeking to compete with the NYSE. In the 
absence of intermarket time priority, the NYSE specialist effectively 
has a right of first refusal before any order is sent from the NYSE to 
another market which was first in time to quote a superior bid or 
offer. Also, as noted above, the trade-through rule leaves untouched 
rules of markets, such as the NYSE, that deny intramarket time priority 
for limit orders over later bids and offers at the same price from the 
trading crowd. (Attachment II to this testimony illustrates the second-
class treatment of limit orders on the NYSE).
    The NYSE's trading rules also deny a willing buyer or seller the 
ability to ``sweep'' the limit order book, even when the buyer or 
seller is willing to sweep all limit orders at the same, most favorable 
price. Finally, limit orders are not protected against ``pennying'' by 
specialists, who take advantage of their physical presence on the 
floor. For every ``penny jumping'' trade by a specialist that ``price 
improves'' one side of a trade, another investor, whose limit order has 
been bypassed, has been denied a trade because the specialist has taken 
advantage of his physical presence on the trading floor to grant 
himself a right of first refusal.
    Nasdaq has never been subject to a trade-through rule and we are 
not aware of any significant incidents of trade-throughs in that 
market. While Nasdaq technology has had some shortcomings, Nasdaq is 
basically an automated market and, in general, there is little 
incentive to trade through the competing market makers' quoted prices.
    The efficiencies introduced by the ECN's have driven all the Nasdaq 
market makers to increase their speed of response. The effects have 
been salutary. Trading in Nasdaq's fast market is driven by competition 
for order flow among market makers and the best execution obligation 
among order-entry firms. Those two factors have combined to provide 
greater benefits for investors in Nasdaq securities than the ITS trade-
through rule provides for investors in NYSE-listed securities. In the 
absence of a trade-through rule, Nasdaq has operated efficiently and 
well.

Conclusion
    In conclusion, we have urged the SEC, and we urge this Committee, 
to allow competition to shape the future of our equity securities 
markets, buttressed by widely available and accessible quotes and other 
market data and reinforced by the fiduciary duties that investment 
managers, like Fidelity, owe to the funds and accounts that they 
manage. Investors, including fiduciaries acting for their managed 
funds, armed with real-time information on prices available in 
competing markets, will seek out those markets that are most responsive 
to their needs and are best suited to provide best all-in pricing for 
their trades. This results in lower trading costs and better returns to 
mutual fund and public investors generally.

                               ----------
                PREPARED STATEMENT OF PHYLIS M. ESPOSITO
          Executive Vice President and Chief Strategy Officer
                     Ameritrade Holding Corporation
                             July 22, 2004

Introduction
    Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, 
my name is Phylis Esposito. I am Executive Vice President and Chief 
Strategy Officer at Ameritrade Holding Corporation, an online discount 
broker based in Omaha, Nebraska.
    At the outset, Ameritrade would like to commend Chairman Richard 
Shelby and the entire Senate Banking Committee for conducting a 
thorough, deliberate examination of Regulation NMS and market structure 
issues.
    Ameritrade Holding Corporation (Ameritrade Holding) has a 29-year 
history of providing financial services to self-directed investors. 
Ameritrade Holding's wholly owned subsidiary, Ameritrade, acts as a 
self-directed broker serving an investor base comprised of 
approximately 3.5 million client accounts. Ameritrade does not solicit 
orders, make discretionary investments on behalf of our clients, or 
provide proprietary research or advice regarding securities. Rather, Ameritrade empowers individual investors by providing them with tools they need to make their own investment decisions. In exchange for a low 
commission, we accept and deliver the order to buy or sell securities to 
the appropriate exchange, market maker, electronic communications network 
(ECN), or other alternative market for execution. In addition, we 
provide our clients with the ability to route their orders to certain 
market destinations that they can choose. Ameritrade does not trade for 
its own account or make a market in any security.
    Ameritrade is an advocate for the retail investor. Ameritrade 
brings a unique perspective to the current debate concerning market 
structure in that we are one of the largest broker-dealers that does 
not internalize order flow. As a result, Ameritrade's position as a 
pure agency broker allows us to comment on the Securities and Exchange 
Commission's (SEC) proposals without concern for how today's proposals 
may impact an affiliated market maker or ECN. We believe this business 
model positions Ameritrade as qualified to speak with unwavering 
dedication for the clients that we serve and retail investors as a 
whole.
    Ameritrade believes in a market structure that treats all investors 
fairly. We believe that both the largest institutional investor and the 
average retail investor deserve a market structure that enables orders 
to be filled in their entirety, as fast as possible, at the price they 
are quoted upon order entry, or better. Ameritrade opposes the creation 
of a bifurcated national market system of fast and slow markets or 
quotes in which institutional investors trade with privilege, while 
retail investors trade at a disadvantage. Ameritrade believes a 
bifurcated market could lead to investor confusion and cause investors 
to lose faith in the integrity of the market. It is Ameritrade's belief 
that orders should interact on a level playing field where quotes are 
real, costs are transparent, and liquidity is accessible. Such a market 
structure requires that investor orders drive price discovery, rather 
than having manual systems interfere with the workings of the 
marketplace.

Ameritrade's Positions on Regulation NMS
Trade-Through Proposal
    As evidenced by the competitiveness of the Nasdaq marketplace, 
Ameritrade does not believe a trade-through rule is necessary and, in 
fact, such a rule creates impediments to competition and market 
efficiency. Ameritrade believes that market center competition combined 
with a broker's duty of best execution result in a national market 
system providing the best combination of efficient pricing, low costs, 
and liquidity.
    If a trade-through rule is adopted, Ameritrade believes investors 
are best served by a rule that requires market centers to provide 
automated execution of their quotes. In the national market system of 
the 21st century, ``quoting should be synonymous with trading.'' If a 
market center aggressively quotes, market participants must have the 
ability to access these quotes. A quote that is unavailable undermines 
the integrity of the marketplace and leads to investor confusion and 
frustration. As a result, Ameritrade strongly supports the ``Automated 
Execution Alternative,'' which would require all market centers to always provide automated access to their quotes.
    Ameritrade also believes that to promote a greater level of order 
interaction and transparency to the investor, the SEC should require 
the display of internalized orders before execution.

Non-Discriminatory Access and Access Fees
    Ameritrade supports requiring nondiscriminatory access for market 
participants, as it will further the goal of ensuring that investors 
can access displayed quotes. Ameritrade further believes that requiring 
market centers to provide automated execution to their quotes and 
banning sub-penny quoting will alleviate the need for the SEC to act as 
a rate setter in regard to access fees.

Sub-Penny Quoting
    Ameritrade supports banning sub-penny quoting as the Firm believes 
retail investors are harmed by professional traders who step ahead of 
competing limit orders for an insignificant amount to gain execution 
priority and arbitrage opportunities.

Market Data
    Ameritrade's position on market data is that the SEC should take 
steps to ensure that the costs of providing market data to investors 
are transparent and the revenues collected are reasonably related to 
the cost of producing the data. Ameritrade believes that transparency 
could be achieved by requiring self-regulatory organizations (SRO's) to 
disclose publicly audited financials detailing the cost of market data. 
It is the Firm's belief that aligning costs and revenues ultimately 
will result in reduced fees to investors.
    Ameritrade also believes that in a decimal trading environment 
where liquidity may exist beyond the best-displayed prices, investors 
should have low-cost access to both the NBBO and the depth-of-book (for 
example, Level II quotes).

Discussion
Trade-Through Proposal
    Ameritrade agrees that the current national market structure is in 
need of reform and that maintaining the status quo is unacceptable. In 
particular, we strongly believe the current ITS trade-through rule is 
antiquated and must be significantly revamped or repealed. Briefly, the 
ITS trade-through rule is unfair in that it requires advanced 
electronic systems to compete with manual, floor-based exchanges on the 
exchange's terms--the speed at which orders can be handled with human 
intervention. The ITS trade-through rule simply has no place in the 
modern national market system.
    As with the Nasdaq market, we believe the listed market can operate 
efficiently without the presence of a trade-through rule. We believe 
that repeal of the trade-through rule would lead to greater intermarket 
competition, increased connectivity and transparency, which would 
propel the listed market to greater efficiency, all to the benefit of 
the investing public.
    The manner in which our clients trade necessarily informs our 
position. When placing their orders, our clients consistently tell us 
that they expect three things: (1) Firm Quotes: Our clients want the 
price they see; (2) Immediate Execution: So they get the price they 
see; and (3) Personal Choice: The right to choose for themselves the 
market where they trade (opt out). In addition, our clients' actions 
speak for themselves--74 percent of Ameritrade client trades are in 
Nasdaq securities. As a result, we believe that our clients are clearly 
stating their preference for a market that trades without a trade-
through rule in which quotes are firm, executions are fast, and 
competition is intense.
    The SEC has proposed and requested comment on three alternatives 
regarding the proposed trade-through rule:

 Fast Market/Slow Markets: Market centers would be considered 
    either ``fast markets'' or ``slow markets.'' Fast markets would be 
    allowed to trade through slow markets in certain limited 
    situations. In addition, investors could ``opt out'' of trade 
    through protection, on an order-by-order basis to obtain the 
    certainty of a fast execution. There also would be an exception for 
    ``de minimis'' trade throughs.
 Automated Execution Alternative: This Alternative would 
    require all market centers to provide an automated response to 
    electronic orders at their quote.
 Fast Quotes/Slow Quotes: Market centers would be allowed to 
    identify which quotes are automated or ``fast'' and which ones are 
    nonautomated or ``slow.'' Market centers would be allowed on a 
    quote-by-quote basis to trade through ``slow quotes.''

    We believe it is important to emphasize that the debate over the 
trade-through rule has wrongly been simplified as the choice between 
fast executions versus slower executions at better prices. Rather, the 
debate should focus on the fact that better prices may or may not be 
available by the time the order is filled. As a result, it does not 
necessarily follow that the slower execution always gets the better 
price, and the fast execution gets the worse price--the pursuit of fast 
executions is a means to achieve a higher degree of certainty of 
execution at a specific price.
    If an intermarket trade-through rule is adopted, Ameritrade's 
position is as follows:

 First, Ameritrade strongly supports the Automated Execution 
    Alternative proposal that would require market centers to provide 
    an automated response to electronic orders at their quote. 
    Ameritrade believes that requiring market centers to provide 
    automated trading access to their quotes will resolve many 
    difficult issues such as the opt out and de minimis exceptions, and 
    will eliminate the necessity of defining what qualifies as a 
    ``fast'' market. The goal should be to create a national market 
    system in which ``quoting is synonymous with trading.'' In 
    addition, access and protection should be expanded to the entire 
    book, not just the best bid or offer.
 Second, Ameritrade believes that the trade-through proposal 
    must preempt existing anticompetitive rules such as the ITS trade-
    through rule, and clarify that SRO's shall not adopt varying 
    standards.
 Third, if the Automated Execution Alternative is not adopted, 
    the SEC should consider revising the opt out exception to allow 
    consent on a global basis and eliminate the de minimis exception.
 Finally, Ameritrade believes that to promote a greater level 
    of order interaction and transparency to the investor, the SEC 
    should require the display of internalized orders before execution.

Automated Execution Alternative
    As part of the trade-through proposal, the SEC requested comment on 
an Automated Execution Alternative, whereby ``all market centers would 
be required to provide an automated response to electronic orders at 
their quote.'' Ameritrade strongly believes this Alternative is in the 
best interests of the investing public, and at the same time, resolves 
many difficult issues surrounding the trade-through proposal.
    As noted, our experience is that many investors demand the 
certainty of fast execution at the specified price, over the 
possibility of a delayed execution at a better or, for that matter, 
worse price. Ameritrade believes that retail investors would be best 
served by a rule that requires market centers to provide automated 
execution of electronic orders at their quote. If such an approach were 
adopted, market centers would be required to either execute an 
electronic order at its quote, or if the market center's quote is not 
at the best price, route the order to a market center that was 
displaying the best price. In this way, Ameritrade believes retail 
investors will be more likely to receive the price displayed at the 
time they submitted their order.
    As the SEC notes, the Automated Execution Alternative also resolves 
potential flaws contained in its proposal. Requiring market centers to 
provide an automated execution facility largely would eliminate the 
necessity of having the ``opt out'' and ``de minimis'' exceptions. If a 
market center was required to fill an order at its quote, or route it 
to another market center displaying the best price, there would be less 
need for investors to opt out and executions away from the best price 
would be less likely. We submit that if the Automated Execution 
Alternative were adopted, there would remain the need to opt out for 
those investors who choose to directly route orders to specific market 
destinations (for example, direct access trading).
    In addition, requiring automated access to quotes would allow the 
SEC to avoid determining what qualifies as a ``fast'' versus a ``slow'' 
market, which could lead to definitional gamesmanship. Moreover, 
creating the fast/slow market continuum would necessarily create a 
marketplace for arbitrageurs who will seek to profit from the pricing 
discrepancies that will occur between the two markets.
    In response to the April 21 hearing, the SEC requested comment on 
an additional alternative whereby market centers would be required to 
designate automated and nonautomated quotes and to allow for the trade 
through of nonautomated quotes. Ameritrade does not believe that the 
SEC's proposed ``fast quote/slow quote'' alternative is the panacea 
that other participants have proposed. Rather, Ameritrade believes the 
fast quote/slow quote proposal, is simply a refinement of the flawed 
fast market/slow market approach. That is, the fast quote/slow quote 
approach will create bifurcated markets and necessarily require a 
determination of what qualifies as ``fast'' and ``slow.'' In addition, 
Ameritrade believes the fast quote/slow quote approach would be 
confusing to investors. For example, what happens if both the best bid 
and offer are slow quotes? In such a case investors accessing the NBBO 
will see two manual quotes that may not be available. Moreover, as 
noted above, it is Ameritrade's experience that clients expect to 
receive the price that is displayed to them when they submit their 
order--they will not appreciate that the quote they saw was a 
``manual'' one and unavailable at the time of order routing.
    The use of fast and slow quotes seemingly would allow market 
centers to decide when to turn off their automated fast quote execution 
as the markets became more volatile--which, in turn, likely would 
increase volatility. Moreover, the Firm believes such an approach would 
allow market participants the ability to trade at the detriment of 
retail order flow (for example, front-running).
    Ameritrade believes that market centers offering automated 
executions would compete with each other on all measures of best 
execution, including, but not limited to, speed of execution, price, 
and liquidity. It is Ameritrade's position that such a market structure 
would lead to greater intermarket competition, transparency and price 
discovery--all to the benefit of the investing public.
    In requiring automated markets, our position is that the SEC should 
not disadvantage new technology and faster markets, as what may be a 
fast response time today may be slow tomorrow. Currently, Ameritrade 
believes a one second response time is appropriate. At the same time, 
Ameritrade believes the SEC should consider requiring that market 
centers include response time with their Rule 11Ac1-5 disclosures. Such 
disclosure would provide order routing firms another data point by 
which to compare market centers when completing ``regular and 
rigorous'' best execution reviews. The SEC also could utilize the data 
to revise performance standards as technology evolves. Finally, the 
SEC's examination staff could examine market centers to ensure that 
their response times are consistent with required standards.
    The SEC also requested comment on whether the scope of the proposed 
trade-through rule should include protection beyond the best-displayed 
bid or offer. In the post-decimalization world where there often is a 
lack of size quoted at the top-of-book, we believe it is in the best 
interests of investors for the SEC to require access to the entire book 
or, at the very least, to a certain depth beyond the best prices.

Existing SRO Rules
    The SEC's proposal would allow SRO's to maintain more restrictive 
trade-through plans, such as the current ITS plan. Ameritrade believes 
that, if a trade-through rule is extended to all markets, the SEC 
should abrogate existing trade-through rules in order to create a 
uniform rule. Allowing different trade-through rules, even if 
participants can withdraw from them, will result in uneven regulation 
and regulatory arbitrage. Moreover, the existence of different trade-
through rules will most certainly result in investor confusion over 
what standard applies.

Opt Out and De Minimis Exceptions
    Ameritrade believes that requiring market centers to provide 
automated execution of electronic orders largely will eliminate the 
need to have opt out and de minimis exceptions. If the SEC, however, 
decides to adopt the trade-through proposal, Ameritrade strongly 
believes that the proposed opt out should be amended and the de minimis 
exception should be eliminated.
    Ameritrade believes the proposed opt out is flawed because it is 
intended for institutional investors, and not retail investors. We are 
proud of our business model of providing services to retail investors 
that historically were only available to institutional investors. We 
are concerned that the opt out, as proposed, turns back toward the 
provision of services in the old two-tiered manner. Ameritrade believes 
it is inherently unfair to limit the opt out in this way.
    Ameritrade has extensive experience in providing investors with the 
ability to decide how they want their orders executed. Ameritrade 
currently offers its clients the ability to directly route their trades 
to certain market destinations. ``Direct access'' routing, while 
utilized by only a small percentage of Ameritrade clients, is important 
to these investors. Before an Ameritrade client may directly route 
orders to a market destination, the client must execute a standing 
consent to terms and conditions that address the SEC's concerns, 
including disclosure that they might not receive the best possible 
price and that the speed of execution might be worse than they would 
otherwise experience if they used Ameritrade's auto-routing.
    Once a client agrees to the terms and conditions of direct access 
routing, he or she can use Ameritrade's electronic order ticket to send 
orders to certain market destinations. The SEC's proposal of imposing 
an order-by-order informed consent requirement on direct access clients 
would effectively emasculate this offering. That is, requiring client 
consent on an order-by-order basis, and imposing on the broker that it 
``must be confident that the customer fully understands this disclosure 
and the nature of the consent,'' would unnecessarily complicate 
seamless electronic trading systems offered by brokers, and place an 
impossible standard on brokers to know whether a client actually 
understands the disclosure that he or she is reading. Ameritrade's 
experience is that investors use direct access routing in order to 
display their limit orders on ECN's. Ameritrade submits that the SEC 
should promote, not prohibit, such activity. Moreover, Ameritrade 
believes that clients understand the risks of direct access routing, 
and we note that it has not been the subject of customer complaints. We 
urge the SEC to clarify how, as a practical matter, the order-by-order 
decisionmaking process could be implemented to enable electronic retail 
investors to utilize the opt out.
    In addition, Ameritrade questions whether the benefits of requiring 
brokers to disclose the NBBO at the time of execution for those clients 
who have opted-out justify the costs of the exception. First, it is 
unclear what purpose such a disclosure serves as the NBBO at the time 
of the trade may or may not be available. In many ways the disclosure 
is tantamount to saying to investors, ``there was possibly a better 
price out there at the time of execution which we may or may not have 
been able to access on your behalf.'' Ameritrade submits that such 
disclosure is of little relevance if a quote is inaccessible. Second, 
the SEC estimates that this disclosure will result in a one-time cost 
of $193 million, with an annual cost of $148 million. Given the size of 
these numbers, which may even be understated, we strongly encourage the 
SEC to carefully consider whether the benefits outweigh the significant 
costs to be imposed on the securities industry, which in turn could be 
transferred to the retail client in the form of higher fees.
    Ameritrade does not oppose requiring additional disclosure along 
with a global consent approach whereby clients would consent once 
before using direct access routing, as Ameritrade does today. The SEC 
also could supplement this approach with a mandatory annual notice 
being sent to clients in much the same way privacy policy notices are 
annually required.
    If a trade-through rule is adopted, Ameritrade believes the SEC 
should not adopt the proposed de minimis exception. Ameritrade opposes 
the SEC's proposed de minimis exception, as it will result in 
artificial spreads and investor confusion. That is, if ``fast'' markets 
are allowed to trade through ``slow'' markets by 1 to 5 cents, these de 
minimis amounts will necessarily act to widen the spread. Moreover, as 
occurs today, professional traders will attempt to arbitrage by selling 
at a higher price, and buying to cover in a market displaying the best 
price--at the expense of retail investors.
    As proposed, we also believe the de minimis exception will be 
unduly complicated and result in investor confusion. Retail investors 
demanding executions at specified prices generally do not appreciate 
rules that allow market centers to fill their orders as long as they 
are ``close'' to the best price. Moreover these investors may not be 
receiving the executions at the price they are quoted, as demonstrated 
by published 11Ac1-5 data, which shows that since the de minimis 
program began, quoted spreads have narrowed while trading spreads have 
widened.\1\ The de minimis exception, as proposed by the SEC, adds a 
further layer of confusion by establishing a range of permissible trade 
throughs based on the price of the security. Overall, Ameritrade 
believes that the proposed de minimis exception will harm price 
transparency and discovery. As a result, if the trade-through rule is 
adopted, the SEC should not adopt the de minimis exception.
---------------------------------------------------------------------------
    \1\Source: Public SEC 11Ac1-5 data comparing effective/quoted 
spreads prior to the de minimis and after the implementation of the de 
minimis pilot program on the QQQ security.
---------------------------------------------------------------------------
Internalization and Limit Order Display
    Although not part of Regulation NMS, Ameritrade strongly believes 
that true price transparency and discovery will not be achieved until 
internalized orders are subject to public display and available for 
interaction prior to execution. Requiring firms that internalize order 
flow to publicly display those orders and to make them available for 
interaction with other orders prior to execution would increase 
transparency for all investors. The benefits would be twofold: (1) 
investors using a broker that internalizes order flow will be ensured 
that these orders will interact with the market as a whole; and (2) 
other investors will have the opportunity to interact with these 
orders. Ameritrade believes that extending limit order protection in 
this way will greatly increase order interaction, again, to the 
ultimate benefit of the investing public.
    This principle has been used in the options markets for many years, 
and is easily applied in an electronic trading environment. For 
example, the newest approved exchange, the Boston Options Exchange, or 
BOX, requires the display of an order for 3 seconds prior to 
internalization. Ameritrade strongly encourages the SEC to consider 
adopting a similar rule in the equities markets.

Non-Discriminatory Access and Access Fees
    Ameritrade supports the proposal to require market centers to 
provide nondiscriminatory access to market participants. As noted 
earlier, Ameritrade strongly believes that all market centers should be 
required to provide electronic access to allow participants to trade at 
the price they are being quoted. If a market center aggressively 
quotes, market participants must have the ability to access these 
quotes. A quote that is unavailable undermines the integrity of the 
marketplace and leads to investor confusion and frustration. In 
addition, market centers presumably will be less able to cherry-pick 
uninformed order flow, while avoiding aggressive limit orders.
    As for access fees, Ameritrade believes that if the SEC requires 
market centers to provide automated executions to their quotes and bans 
sub-penny quoting, free competition among market centers will eliminate 
the need for the capping of fees. That is, if free competition is 
allowed, order flow will naturally gravitate to the automated market 
centers that provide the best combination of speed, reliability, costs, 
and liquidity.

Sub-Penny Quoting
    We applaud the proposal to prohibit market participants from 
accepting, ranking or displaying orders, quotes or indications of 
interest in increments less than a penny. Given the evidence that sub-
penny quoting is being used by professional traders at the expense of 
the investing public, we believe that the elimination of sub-penny 
quoting can help to further restore investor confidence in the market 
and result in increased transparency and higher liquidity. Furthermore, 
participants at the April 21 hearing noted almost universal support for 
such a proposal.
    As for the proposed exception for securities trading under $1.00, 
Ameritrade's experience is that most of the sub-penny quoting occurs in 
those exact securities. We note that the answer to this problem is for 
the NYSE and Nasdaq markets to uniformly enforce listing standards, 
which generally require a security to trade above $1.00. Ameritrade 
also urges the SEC to act quickly on this aspect of Regulation NMS.

Market Data
    Four years have passed since the SEC issued its Concept Release 
concerning market data structure, and the SEC has not moved any closer 
to addressing the central issue--whether the costs imposed by the 
current system are justified. In this regard, Ameritrade is 
disappointed that: (1) the SEC did not use Regulation NMS to address 
market data and related revenues in a comprehensive fashion; and (2) 
the SEC has failed to take the step of requiring transparency by 
requiring SRO's to 
disclose publicly the cost of providing market data to the public. By 
comparative example, Rules 11Ac1-5 and 11Ac1-6 have contributed greatly 
to transparency and competition in the order flow arena. Similar market 
data transparency would increase competition and potentially reduce 
costs for end users.
    Ameritrade is interested in first gaining an understanding of the 
costs associated with providing market data, and then determining the 
appropriate structure to allow for either a return of excess revenues 
back to investors, or a model in which market data revenues simply 
equal the costs of providing such information to the investing public.
    Not only are market participants forced to pay the costs of the 
very data they provide, but also the participants do not know whether 
the fees are reasonable given that there is no transparency concerning 
the costs that the SRO's incur in providing this vital service to 
investors. We note that such an approach enjoys wide support as 
evidenced by the Securities Industry Association (SIA) comment letter, 
which is being submitted to the SEC at the same time.
    Any broker or vendor who conducts business in the current 
environment will tell you that the structure is costly, complicated, 
and burdensome. For retail brokers like Ameritrade, the administration 
of market data contracts is onerous and costly. SRO's require detailed 
information about how a firm will use market data, the type of services 
the firm provides, the firm's use of technology and how a firm monitors 
its users. Ultimately, brokers must share confidential and 
competitively sensitive materials with the SRO's.
    SRO's also require individual investors to consent to an agreement 
that requires the payment of discriminatory fees and is replete with 
legalese and confusing terms and conditions. Ameritrade spends an 
inordinate amount of time and money simply complying with the 
administrative burdens of tracking market data use by its customers, 
and maintaining two separate systems, one for real-time data and one 
for delayed data. The SEC's proposal does nothing to address these 
issues.
    Under the current system, the SRO's are granted monopoly powers, 
and wield these powers at will both in terms of the fees charged and 
the control over the dissemination of the data. Moreover, market data 
fees are imposed in an entirely discriminatory fashion. First and 
foremost, investors accessing real-time quotes through an account 
executive by telephone, from devices in branch offices, and from media 
distributors do not incur market data fees. If the same investor, 
however, uses an online brokerage account to access real-time quotes, 
market data fees are charged based on each instance a real-time quote 
is accessed. In this case, either the brokerage firm pays the fee, or 
passes the cost onto the investor. Either way, costs to investors are 
higher.
    The SEC notes that out of the $424 million in revenues derived from 
market data fees, $386 million was distributed to SRO participants. 
Unfortunately, although the SEC previously has said, ``the total amount 
of market information revenues should remain reasonably related to the 
cost of market information,'' \2\ there is no transparency to determine 
whether it actually costs anywhere near $424 million to provide the 
data to investors.
---------------------------------------------------------------------------
    \2\ ``Regulation of Market Information Fees and Revenues,'' SEA 
Rel. No. 42208 (Dec. 9, 1999).
---------------------------------------------------------------------------
    This issue is vitally important to both Ameritrade and its retail 
clients. Ameritrade currently is paying approximately $1.44 million per 
month for market data, or an estimated $17 million for the current 
year. These fees are paid by investors directly in the form of charges 
for quotes, or indirectly, in the form of commissions or other fees.
    Ameritrade submits that the only way to determine whether there has 
been an equitable and reasonable allocation of costs is to require each 
SRO to publicly provide audited financials regarding the costs of 
providing market data to end users. Ameritrade recommends that these 
financial statements should be made available to the investing public 
through the SEC's (or particular SRO's) website. Given that investors 
ultimately pay these fees, either directly or indirectly, we clearly 
believe requiring the transparency of such information is in the 
public's best interest. Only then can such cost data be analyzed and 
act as the basis and direction for future market data reform, both in 
terms of pricing and, ultimately, in the distribution of such revenues.
    As evidenced by the SIA comment letter, Ameritrade believes there 
is widespread support for the SEC requiring that market revenues be 
reasonably related to the costs of providing the data. Moreover, 
Nasdaq, which receives approximately 25 
percent of its total revenues \3\ in the form of market data fees, 
agrees with the brokerage industry that market data costs are too high. 
Robert Greifeld, CEO and President of Nasdaq, has stated that the cost 
to professional traders could be reduced approximately 75 percent (from 
$20 to $5-7 per month).
---------------------------------------------------------------------------
    \3\ See The Nasdaq Stock Market, Inc. Annual Report (Form 10-K) for 
the period ended December 31, 2003.
---------------------------------------------------------------------------
    Ameritrade applauds Mr. Greifeld's statement and joins Nasdaq in 
seeking to reduce market data revenues so that such revenues are 
reasonably related to the costs of providing the data to investors. We 
strongly support reductions in market data costs across the board, not 
just specific to those investors who are deemed professional. We think 
it is important that both the revenues related to not only the NBBO, 
but also the depth-of-book (for example, Level II quotes), be 
reasonably related to the actual costs. Ameritrade believes that market 
data revenue reductions will clearly inure to the benefit of retail 
investors, as retail brokers compete aggressively on the ultimate costs 
charged to investors.\4\
---------------------------------------------------------------------------
    \4\ This is especially true for the online brokerage industry that 
focuses heavily on the value of the product offered to investors. 
Ameritrade prides itself on being a leading low-cost provider. We note 
that reduced costs due to competition are often passed directly onto 
investors. For example, over the past few years increasing competition 
in the options market have led online brokers to reduce commissions 
charged to investors.
---------------------------------------------------------------------------
    Given the widespread support within the industry and by Nasdaq, one 
of the very recipients of market data revenue, Ameritrade believes that 
it is clearly in the public interest for the SEC to take steps to 
ensure that investors are receiving what they are paying for and to 
ensure that the costs of market data are reasonably related to their 
costs.
    Finally, we note that the SIA is commenting that multiple 
securities information processors (SIP's) compound market data 
inefficiencies and that a consolidated SIP would result in considerable 
cost and timesavings at no risk to the investor. Although Ameritrade 
agrees that multiple SIP's utilizing nonstandard technologies 
result in considerable additional costs to the industry, the Firm has 
concerns regarding the creation of a consolidated SIP. First, 
Ameritrade believes that before a single SIP is considered, the SEC 
must address the fact that such an organization would represent a 
single point of failure for all market data provided by the markets. 
Second, we question granting monopoly powers to such an organization 
and thereby removing the ability for price comparison and the innate 
drive to innovate. We support, however, the standardization of 
technologies across SIP's.

Conclusion
    In conclusion, Ameritrade opposes any trade-through rule as an 
unnecessary impediment to competition. Ameritrade is, however, a strong 
advocate for the Automated Execution Alternative whereby all market 
centers would be required to provide an automated response to 
electronic orders at their quote. Furthermore, Ameritrade supports the 
SEC's efforts to address market access and sub-penny quoting. Finally, 
the Firm strongly believes that the SEC should not focus on market data 
revenue allocation, but rather, on whether market data revenues are 
reasonably related to the actual costs to produce such data.
    Ameritrade believes that the adoption of a comprehensive Regulation 
NMS requiring automated markets that provide nondiscriminatory access, 
quotations in penny increments, and a transparent market data structure 
will be a tremendous improvement to the current national market system, 
with retail investors reaping the ultimate benefits.
    Thank you for the opportunity to share my ideas on behalf of 
Ameritrade and its clients. I would be pleased to answer your questions 
at the appropriate time.

                               ----------
                  PREPARED STATEMENT OF BERNARD MADOFF
       Chairman and CEO, Bernard L. Madoff Investment Securities
                             July 22, 2004

    Bernard L. Madoff Investment Securities is pleased to participate 
in the Senate's hearing on Regulation NMS. We applaud the SEC's 
proposal to address this complex set of issues. One of the great 
difficulties we face in addressing these issues is that so many of them 
are inextricably linked. In order to support a trade-through rule that 
would truly benefit investors, it is critical to implement a system 
that includes seamless linkages and a fee structure that does not 
interfere with price discovery.
    Madoff Securities has long held the position that the integrity of 
the quote is instrumental to the efficient functioning of a national 
market system (NMS). Investors must be assured that regardless of where 
their orders are routed, they will be in a position to reap the 
benefits of the NMS. It is our belief that the foundation of this 
system should be publicly displayed quotes that are firm and 
accessible.
    The best way to insure this result would be to require all 
``quoting'' market centers to employ an automated order execution 
facility for ``intermarket'' orders seeking to satisfy those ``quotes'' 
deemed to be firm and accessible and, therefore, eligible for 
intramarket and intermarket price protection. A quote is deemed to be 
firm and accessible when it is subject to automatic and immediate 
execution or cancellation on a computer-to-computer basis with no human 
intervention for up to its total displayed size.
    Accessibility of the quote is a critical component to the integrity 
of an NMS. The need for efficient linkages to assure accessibility is 
an absolute imperative in an NMS predicated on investor protection. 
Effective linkages, both public and private, must be in place and the 
price displayed must truly reflect the actual cost of trading. Market 
participants should only be allowed to be part of the National Best Bid 
or Offer (NBBO) and receive price protection if those quotes are deemed 
firm and accessible through either a public or private linkage. The SEC 
must define the scope and minimum standards for a public intermarket 
linkage. Individual markets would also be free to define and enter into 
private linkages in addition to the public linkage requirement.
    In the absence of a mandatory automated order execution facility 
for all ``quoting market centers'', it is critical to the success of 
any ``trade-through'' proposal that those markets unwilling to 
implement such a mechanism be subject to an unfettered ``opt out'' for 
those quotes deemed to be nonautomated or inaccessible. The proposed 
requirements for such an ``opt out'' of nonautomated or inaccessible 
quotes should only be governed by the fiduciary requirements of ``best 
execution.''
    Thank you for allowing us the opportunity to contribute to the 
discussion.

                               ----------
              PREPARED STATEMENT OF ROBERT H. McCOOEY, JR.
                 President and Chief Executive Officer
                   The Griswold Company, Incorporated
                             July 22, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me here today to testify in 
connection with your review of the capital markets structure here in 
the United States. My name is Robert McCooey. I am a proud Member of 
the New York Stock Exchange (NYSE) and am honored to serve as one of 
the three agent representatives from the Floor to the NYSE's Board of 
Executives. In my primary job, I am President and Chief Executive 
Officer of a New York Stock Exchange member firm, The Griswold Company, 
Incorporated. Griswold is an agency broker executing orders for 
institutional clients on the Floor of the NYSE. As an agency broker, we 
execute trades on behalf of our customers. We do not make markets in 
securities or engage in proprietary trading. Our clients include some 
of the largest mutual and pension funds in the United States.
    Chairman Shelby, I am also very pleased that you chose John Thain, 
to address the Committee yesterday. Six short months ago, John joined 
an organization that was desperate for new leadership to implement 
change and address important customer needs. What John has accomplished 
in just this short period of time coupled with the work of Chairman 
John Reed is nothing short of remarkable. I think that it is clear to 
all that there has been a dramatic change at the NYSE. The membership 
is hopeful that regulators and legislators will support these new 
changes for the continued benefit of all who trade at the New York 
Stock Exchange.
    My focus today will be on the major market structure issues that 
are currently under review by the Securities and Exchange Commission 
articulated in Release No. 34-49325, Regulation NMS (Reg NMS). The 
discussions that we engage in today should focus on how to enhance the 
national market system for the benefit of all investors. In the process 
of answering that charge, we should also promote the aspects of the 
current national market system that provide positive results in the 
execution of investors' orders. I would contend that the agency-auction 
market model at the New York Stock Exchange is one of these important 
competitive aspects of the national market system. I also believe that 
it would be most helpful for the Committee to focus on the future and 
not dwell on the miscues of the past. We cannot change what has 
happened but with new leadership at the NYSE coupled with a dedicated 
Floor willing to embrace change for the benefit of our clients, the 
time is ripe for a new beginning.
    As an agent on the Floor of the NYSE for the past 16 years, I have 
seen the evolution of the responsibilities of Floor brokers from 
providing outsourced executions for the major broker-dealer firms to 
establishing themselves as strategic partners for institutional 
clients. Increasingly, the goal for clients has been to find ways to 
gain efficiencies in the execution process by getting closer to the 
point-of-sale. Independent agents working on behalf of these customers 
now furnish real time market information coupled with tremendous costs 
savings to these institutional customers. The assets that are managed 
by my institutional customers are owned by the small retail customer: 
The pensioner, the parent saving for college, the worker funding their 
IRA, and all the others who invest in equities traded here in America. 
Today in the United States, when we talk about doing what is right for 
the marketplace and the participants in that market, we must realize 
that the retail customer and the institutional customer are often one 
in the same.
    Floor brokers play an important role in the price discovery 
process. The competition between orders represented by brokers at the 
point-of-sale on the Floor of the NYSE helps to ensure fair, orderly, 
and liquid markets. It is the Floor broker who will seek out contra 
side liquidity for an order as well as make decisions based upon 
rapidly changing market dynamics. The Floor broker serves as a point of 
accountability and information, with the flexibility to represent large 
orders over time at the point of sale--not found in dealer markets and 
ECN's--and employs the most advanced technology to support his or her 
professional judgment. The interaction between the Floor broker and the 
specialist provides the flow of information necessary to keep customers 
informed about changing market conditions. That information flow is 
more often than not the catalyst that provides incentives for traders 
to provide liquidity in a way that reduces execution costs. The 
combination of best price and intelligent information flow is the 
backbone of the NYSE. This makes for fair and orderly markets.
    Superior technology will continue to be the NYSE's advantage. 
During the past decade, the NYSE has invested billions of dollars in 
technology for our trading floor, data centers, and new product and 
service development. Over 98 percent of all orders sent to the NYSE are 
delivered electronically to the point-of-sale every day. Brokers no 
longer write on little slips of paper and have ``pages'' transport the 
information from point-of-sale to a phone clerk for relay to our 
clients. The agent relies upon a digital handheld communication device, 
which receives the order, transmits the reports directly to the 
customer, and engages in an ongoing dialogue with the client through 
the use of digital images. We are electronically connected to our 
customers all over the world. All of this is accomplished without ever 
leaving the trading crowd.
    Electronic execution options are also not new to us at the NYSE. 
Direct+, our automatic execution product, was introduced in 2000 and 
since then has grown from 1 percent to approximately 10 percent of the 
average daily volume.
    Allow me to speak briefly about the important role of the other 
participant in the agency-auction model at the NYSE--the specialist. As 
an agent on the Floor of the NYSE, I have seen the role of the 
specialist evolve over my 16 years. A fundamental principle is to place 
the interests of the customer first and provide each customer with the 
best experience trading at the New York Stock Exchange. The specific 
value that accrues to investors can be broken down into two major 
categories: Information as an important part of a specialist's catalyst 
function and liquidity provided to the marketplace.
    As I speak with my customers about the multiple marketplaces in 
which they trade, one theme about the NYSE is consistently voiced. 
Customers appreciate the fact that the floor based NYSE provides the 
participants in that market with valuable information that aids buyers 
and sellers in making market entry and exit decisions. Through this 
information, specialists act as catalysts, proactively bringing buyers 
and sellers together thus creating trades that otherwise would not have 
occurred. Responding to a buyer for example, a specialist may recall 
selling interest on the part of a particular agent and call that agent 
to the crowd to help effect a trade. The buyer can then negotiate 
directly with the agent representing the seller. This results in 
natural buyers meeting natural sellers over 80 percent of the time with 
minimal market impact. Without the specialist as the catalyst for 
providing that information, the trade may have occurred at the wrong 
price or worse, never happened at all. This kind of information flow is 
impossible in electronic markets. Furthermore, the information gathered 
from the specialist at the point of sale is available impartially to 
all who ask.
    The second and equally important function to customers is the 
liquidity that the accountable specialist adds to the marketplace. It 
is important to remember that specialists do not set the price for 
stocks. At the NYSE, that pricing function is reserved for the buyers 
and sellers. The important role of the specialist is to provide the 
liquidity necessary to the market to assist agents, like myself, in 
getting orders executed correctly for their clients. What specialists 
do is risk their capital to add market depth and stabilize prices. They 
inject liquidity by bridging temporary gaps in supply and demand. Each 
of these trades for the specialist is a one-sided risk transaction. The 
best method for me to explain the value that accrues to customers is to 
give you an example:

        The market is $28 bid for 25,000 shares and 18,000 shares 
        offered at $28.05. My customer entrusts me with an order to 
        purchase 25,000 shares--this may be all the customer wants to 
        purchase or the beginning of a much larger order. My goal is 
        always to execute that order at the best possible price with 
        the minimum of market impact. I want to purchase all my stock 
        at $28.05, the whole 25,000 shares. That outcome will be in my 
        client's best interest. The only way for this to happen is if 
        the specialist is there to add the necessary liquidity--the 
        other 7,000 to make 25,000--to complete my client's order. In 
        the absence of a specialist, my natural buyer customer would 
        have to reach to the next price point where that liquidity was 
        available to purchase those shares. For the sake of the 
        argument, let us assume that the customer would have had to pay 
        $28.10 to purchase those shares. Without the capital that the 
        specialist injected into the market to complete my client's 
        order, the cost to that institution (and the hard working 
        investors in that fund) would have been an additional $350. 
        That may seem like a very small amount but multiply that 
        savings by the thousands of times that it happens daily and the 
        millions of dollars add up very quickly. These are savings that 
        accrue to investors--your constituents.

    Trading technology has allowed people at both the customer and 
broker-dealer level to work more efficiently as the markets have grown. 
From the late 1980's, when an average trading day's volume was 100 
million shares, today we trade well over 1.5 billion shares on a 
regular basis. Occasionally, technology can have its' problems. There 
have been several occasions over the past few months that illustrate 
the need for professionals working in concert with the technology. A 
number of months ago, a large NYSE member firm initiated a ``program 
trade'' for a customer involving a basket of large cap stocks. 
Unfortunately, someone added an extra zero to the dollar amount of the 
trade and what was supposed to be a $40 million basket ballooned to 
$400 million. On the Floor, those trades were quickly identified as 
possible errors and the firm was contacted. Realizing the problem, the 
firm was able to cancel the vast majority of those trades before 
execution. In another scenario, another member firm entered an order to 
sell 1 million shares of XRX. While preparing to trade the stock at the 
appropriate price in the market where demand met this supply, the firm 
was contacted and an error was again prevented. The order was supposed 
to be for 1,000 shares only. This course of action could not occur in 
an electronic market where there is no one designated to recognize a 
potential problem such as the ones I described. More importantly, these 
trades could have been executed quickly--with the primary focus on 
speed that some have been asking for--but the outcome to the customer 
would have been quite negative. Only through human intervention and 
immediate dialogue between market participants were huge losses to 
investors prevented.
    Alternatively, in competing markets, we have recently seen examples 
of how electronic markets function in the face of stress or incorrect 
order entry. In early December 2003, the stock of Corinthian Colleges 
Inc. (COCO) plummeted 19 points in just a matter of minutes. The full 
details surrounding that event, the halting of the stock, trading in 
other markets and the canceling of trades made in good faith by 
investors are still unclear. Recognizing that different market models 
yield different results, I believe that in this case human 
participation through an agent or specialist would have prevented such 
a precipitous decline.
    Finally, this past February we observed the trading in the stock of 
Imclone (IMCL). In three minutes, the stock dropped more than 20 
percent from $42 to $33.50 for no apparent reason before being halted. 
After a 2 hour and 40 minute halt, IMCL finally reopened electronically 
at 4:20 p.m.--20 minutes after the Nasdaq closed. In after hours 
trading, Imclone immediately rose 35 percent, back to the levels prior 
to its' decline and halt. However, this market serves and benefits only 
institutions--not individual investors.
    One of the four major areas for comment contained in Regulation NMS 
was the ``trade-through'' rule. I believe that customers always deserve 
the best price. Price matters to my customers and at the end of the 
day, they do not ask how long it took me to execute their trade but 
they do focus on the price that they received. The ``trade-through'' 
rule protects the best prices and rewards the market centers that post 
them.
    The ``trade-through'' rule was designed to convert multiple 
competing markets into a national market system. The rule turns each 
market into a gateway to every other market and ensures that investors 
will not be disadvantaged by virtue of having bids or offers displayed 
in one market versus another.
    When trading is allowed to occur outside of the National Best Bid 
and Offer (NBBO), two investors are being disadvantaged--the bid or 
offer that has been posted as well as the buyer or seller who received 
an inferior price to the NBBO. To amplify this, I would like to offer 
the following example: A buyer posts a bid of $49.05 to buy 5,000 
shares of XYZ, the stock is offered at $49.10. In the absence of a 
``trade-through'' rule, a trade of 5,000 shares might occur at $49.00. 
In this instance, two investors are not being afforded the full 
protection that they deserve in the marketplace. The seller who sold 
stock at $49.00 did not receive the highest price that was bid for 
those shares in the market. Further, the buyer with the $49.05 bid is 
left unfilled. This investor posted the best bid in the marketplace and 
was ignored. In a time of skepticism and as we try to restore 
confidence in our markets, I do not believe that this is the message 
that we want to disseminate to the investing public.
    There are other parts of the trade-through equation that are 
overlooked. Trade-throughs cause the mis-pricing of equity securities 
in the marketplace. When a trade is allowed or sanctioned to occur 
outside of the NBBO, the rest of the market becomes unsure as to the 
true price at that moment in time. Investors are now worried about what 
might be ``going on'' as a trade takes place away from the best bids 
and offers. That broker-dealer may now engage in a riskless principal 
transaction, through the use of sophisticated technology and market 
intelligence undisclosed to that fiduciary's ultimate customer, to not 
only accrue a commission but also to profit in the firm's principal 
trading account. The firm will buy outside of the NBBO and then hit the 
bid or take the offer at the NBBO on the NYSE or another market to 
offset their position. This activity denies customer the opportunity to 
engage in the full price discovery process. Moreover, the riskless 
trading by broker-dealers disrupts the markets and damages the overall 
pricing mechanism. One of the guiding principles from the SEC is that 
customer orders should interact without unnecessary dealer 
interference. I agree.
    The most important starting point for any trade-through discussion 
must be the facts, and how the facts impact every investor. Some 
proponents of weakening or eliminating the trade-through rule do so out 
of self-interest, not with the interests of all investors in mind. 
Simply stated, the facts do not support their contention that investor 
protection provided by the rule stifles competition. At the New York 
Stock Exchange we welcome competition. However, that competition must 
be one that ends with the execution of a customer's order at the best 
price available in the marketplace. The reality is that the NYSE posts 
the best price well over 90 percent of the time in our listed 
securities. We think that competition should be based upon price. This 
is not an artificial barrier to competition. Other markets can compete 
by simply matching or bettering our prices. Certainly, our customers 
agree with that value proposition every day as we receive approximately 
80 percent of the volume in NYSE listed securities. We do not think 
that any marketplace should receive regulatory relief from a rule that 
benefits investors. By ensuring that best price is paramount to 
markets, customers as well as the competitiveness of the U.S. 
securities markets will be well served.
    Tremendous competition between markets exists today. Order 
competition, as the critical factor in price discovery, is based upon 
protecting those who display best prices. This process promotes the 
entry of limit orders that narrow quote spreads and reduce execution 
costs. Eliminating the trade-through rule would produce inferior prices 
and increased costs, increase market volatility, and reduce 
accountability and transparency. This is not the way to promote 
investor trust and confidence.
    At the New York Stock Exchange, we embrace change. Providing 
choices to our customers has been the hallmark of the New York Stock 
Exchange for as long as I have been a member and we are again 
addressing the needs of our customers who have asked us to provide more 
choice. If fact, one of the goals of Regulation NMS was to promote 
competition among marketplaces in order to encourage innovation.
    The New York Stock Exchange, in keeping with its pattern of market 
improvements, committed to being a ``fast'' market with immediately 
accessible quotations even before the release of Regulation NMS. With 
that in mind, I support the Commission's suggestion as articulated in 
the Supplemental Release (No. 34-49749) for a ``fast'' market to be 
designated on a security-by-security basis rather than as a whole.
    Some customers have asked for the ability to immediately, 
anonymously access the liquidity that they see displayed in the 
quotation. Currently, customers can only access Direct+ for 1,099 
shares or less and are constrained by a rule that prohibits multiple 
orders within a 30 second window. We have proposed the removal of those 
restrictions so that customers have the ability to access all of the 
displayed liquidity. The NYSE will also continue to provide the choice 
of price improvement for those who avail themselves of that option. We 
recognize that the market is not a ``one-size-fits-all'' proposition 
and we look forward to working with the SEC and Congress to make the 
New York Stock Exchange the best possible market for all participants.
    At the NYSE, we will continue to change, adapt, and innovate to 
best serve our customers and to fulfill our commitment to producing the 
highest levels of market quality. We will continue to provide the fair 
and level playing field that investors want and expect from us. We will 
compete on the basis of discovering and delivering the best price 
coupled with the highest levels of transparency. The interaction of 
specialists and agency Floor brokers creates a value proposition in 
which the NYSE delivers to its customers the best prices, the deepest 
liquidity, the narrowest quote spreads, and the lowest volatility. That 
results in multimillions of dollars of savings to your constituents 
each year. In all that we do, we take pride in the fact that we always 
place the investor first.
    Thank you. I will be happy to answer any questions that you may 
have.

                               ----------
                     PREPARED STATEMENT OF KIM BANG
                 President and Chief Executive Officer
                        Bloomberg Tradebook, LLC
                             July 22, 2004

    Mr. Chairman and Members of the Committee, my name is Kim Bang, and 
I am pleased to testify on behalf of Bloomberg Tradebook regarding 
``Regulation NMS and Developments in Market Structure.'' The topic is 
both important and timely.
    Bloomberg Tradebook is owned by Bloomberg L.P. and is located in 
New York City. Bloomberg L.P. provides multimedia, analytical, and news 
services to more than 200,000 terminals used by 250,000 financial 
professionals in 100 countries worldwide. Bloomberg tracks more than 
135,000 equity securities in 85 countries, more than 50,000 companies 
trading on 82 exchanges and more than 406,000 corporate bonds. 
Bloomberg news is syndicated in over 350 newspapers, and on 550 radio 
and television stations worldwide. Bloomberg publishes magazines and 
books on financial subjects for the investment professional and 
nonprofessional reader.
    Bloomberg Tradebook is a global electronic agency broker serving 
institutions and other broker-dealers. We count among our clients many 
of the Nation's largest institutional investors representing--through 
pension funds, mutual funds, and other vehicles--the savings of 
millions of ordinary Americans.
    Bloomberg Tradebook specializes in consolidating what has been a 
fragmented market by increasing transparency and access to liquidity. 
Our clients have rewarded our creativity and our service by trusting us 
with their business, enabling us to regularly trade more than 150 
million shares a day.
The Underlying Issue Driving Regulation NMS is the Near Monopoly the
NYSE Enjoys Over the Trading Volume in its Listed Securities
    The Senate Banking Committee has long understood how seemingly 
abstract market structure issues have a direct bearing on the 
efficiency and competitiveness of our markets and the interests of 
investors. The Committee's interest in the SEC's Regulation NMS 
proposal is welcome and warranted.
    Proposed Regulation NMS is an ambitious effort to engage 
policymakers, market participants, and the public in a debate over how 
best to promote the long overdue modernization of the U.S. equity 
markets.
    Market participants and policymakers have often asked ``why does 
the NYSE control 80 percent of the trading volume of its listed 
companies when Nasdaq controls only about 20 percent of the volume of 
its listed companies?'' The answer is simple--regulatory barriers to 
competition.

The OTC Market as a Model for a Competitive Market
    The Nasdaq market since 1996 presents the opposite picture--it is a 
market into which regulation introduced and encouraged competition. The 
Nasdaq price-fixing scandal of the mid-1990's resulted in the SEC's 
1996 issuance of the order-handling rules. Those rules enhanced 
transparency and competition in the Nasdaq market and permitted 
electronic communications networks--ECN's--to compete for order flow, 
benefiting investors and enhancing the quality of the market.
    Indeed, the increased transparency promoted by the SEC's order-
handling rules and the subsequent integration of ECN's into the 
national quotation montage narrowed Nasdaq spreads by nearly 30 percent 
in the first year following adoption of the order-handling rules. 
These, and subsequent reductions in transactional costs, constitute 
significant savings that are now available for investment that fuels 
business expansion and job creation.
    The question confronting the SEC and the Congress is whether our 
markets in listed securities can be reformed to bring the same benefits 
to the NYSE investor as they have to the Nasdaq investor. Now that the 
NYSE has been forced to give up its Rule 390 (restricting order flow to 
the OTC market) and Rule 500 (restricting the ability of listed 
companies to delist), the existing trade-through rule remains the 
foremost impediment to that reform.

The Trade-Through Rule is Protectionist Regulation
    The 20-year-old trade-through provision of the intermarket trading 
system plan states that when the specialist or market maker receives an 
order, it cannot execute it at a price inferior to any found on another 
market without giving a ``fill'' to the better-priced order. But there 
is a gap between the rule's principle and its practice. Under the rule, 
orders are not protected so much as they are held hostage.
    Consider, for example, the American Stock Exchange. Bloomberg 
Tradebook does not send orders in Nasdaq stocks to the Amex even though 
they are traded there. It takes at least 10 to 15 seconds before we get 
a response from the Amex. That is just too slow. In today's electronic 
markets, in which markets move in milliseconds, a delay of 10 to 15 
seconds is an eternity. We face the same problem with the NYSE when it 
displays the best price. An order sent to NYSE is routinely delayed for 
22 seconds while the specialist decides whether to expose the order to 
the trading floor for price improvement. In the meantime, the market 
moves. And the wait for price improvement, if any, is a lost 
opportunity investors can ill afford. The clear disadvantage to 
investors is not only in having their orders held up on Amex or the 
NYSE, but also in being deprived of pricing opportunities represented 
in other markets.

The Trade-Through Rule does not Protect Limit Orders
    Currently, the intermarket trading system trade-through rule 
protects inefficient markets by mandating that investors pursue the 
advertised theoretical ``best price'' instead of the best available 
firm--immediately executable--price.
    Both the existing rule--and the SEC's proposed rule--fail to 
protect limit orders in at least three ways:

 They do not accord time priority to limit orders that have 
    already been placed--even limit orders placed on the NYSE. That is 
    like a restaurant where you stand patiently in line for a table but 
    you have no priority over patrons who come in after you do. In the 
    securities markets, in addition to being annoying, there is an 
    economic cost. Not having time priority denies limit order entrants 
    the reward they should get for, in effect, having granted the 
    market free ``options'' (puts in the case of a limit order to buy, 
    calls in the case of a limit order to sell).
 Also, there is no intermarket time priority. The trade-through 
    rules permit another market center to ``match'' preexisting limit 
    orders entered in another market. That permits exchanges such as 
    the NYSE to match and then internalize 
    orders rather than to ship them to other market centers offering 
    better prices--again the limit order entrant is denied a reward.
 Limit orders are not protected against ``pennying''--by which 
    NYSE specialists and other floor members jump ahead of orders by 
    trivial amounts--a penny or two. This is one of the negative 
    fallouts of the move to decimal markets.

A Trade-Through Rule: Protecting Investors or Protecting the NYSE
Floor?
    We share with sincere proponents of trade-through rules a vision of 
a national market system that promotes order interaction and treats all 
orders and all investors fairly. We embrace wholeheartedly a market 
structure that protects all participants, large and small. Were a 
trade-through rule effective and necessary to achieve these ends, we 
would support it without reservation.
    The reality, however, is that the existing trade-through rule does 
not provide any meaningful investor protection. It is, instead, an 
impediment to achieving best execution. It has stood in the way of 
innovative technology and competition and has deterred investors from 
obtaining direct access to market data and liquidity. As Archipelago's 
Gerald Putnam has testified:

        Empirical data shows that the NYSE trots out the trade-through 
        rule when it suits its competitive purposes, but ignores it 
        when it does not. Here are some facts: ArcaEx runs software 
        (aptly named Whiner) that messages alerts when exchanges trade 
        through an ArcaEx quote in violation of the its plan. The 
        whiner database reflects that ArcaEx customers suffered up to 
        7,500 trade-through violations in a single week by the NYSE. In 
        fact, trade-through violations have actually risen most 
        recently despite the glare of the regulatory spotlight on the 
        NYSE. Since just this last . . . Fall (2003), the annualized 
        cost to investors of the NYSE specialists trading through 
        ArcaEx's quotes has increased 3-fold from approximately $1.5 
        million to $5 million. On any given day, ArcaEx has a billion 
        shares on or near the national best bid or offer. Yet on any 
        given day, the NYSE sends only 2 million shares to ArcaEx over 
        its when we have the best price.
        We have confronted the NYSE with our voluminous data but to no 
        avail. If, in the NYSE's own words, the trade-through rule 
        ``serves to protect investors,'' then the NYSE has some 
        ``splaining'' to do and needs to take corrective action 
        forthwith to enforce and comply with the trade-through rule in 
        its own marketplace.\1\
---------------------------------------------------------------------------
    \1\ Written statement of Gerald Dean Putnam, Chairman & Chief 
Operating Officer, Archipelago Holdings, L.L.C., concerning ``Market 
Structure III: The Role of the Specialist in the Evolving Modern 
Marketplace'' before Committee on Financial Services--Subcommittee on 
Capital Markets, Insurance and Government Sponsored Enterprises, U.S. 
House of Representatives, 108th Cong., 2d Sess., February 20, 2004, at 
p.6.

    The trade-through rule in practice has been a one-way street, with 
the NYSE itself as the heavy-handed traffic cop. To be sure, the NYSE 
goes after its own members that trade through NYSE prices. Nonetheless, 
the NYSE's specialists routinely trade through better prices on other 
markets and, as a practical matter, they do so with impunity. Their own 
routine violations of the trade-through rule, which to our knowledge 
have never been thoroughly investigated or prosecuted, have surely cost 
investors millions of dollars.
    For their part, the regional market centers tend to comply with the 
current trade-through rule while at the same time they are not able to 
protect their client limit orders from being traded through by the 
primary market. They are further disadvantaged because they are not 
permitted to execute incoming orders routed for execution against their 
customer limit orders when those orders are displayed and available, 
but away from the best quoted prices.

What Hybrid Market?
    We now read press reports about a new market wrinkle the NYSE is 
devising. The original Regulation NMS proposal envisioned a system of 
fast and slow markets, that is, auto-execution and manual markets, and 
proposed an opt out that would permit ``fast'' markets to trade through 
``slow'' markets within a set range of increments. In response, the 
NYSE apparently has been closeted with the Commission, discussing an 
as-yet-nonpublic proposal for a market that would qualify as ``fast'' 
but still preserve the manual operations that are at the core of the 
NYSE's profitability--and its near monopoly.
    In its supplemental release, the Commission has proposed, and the 
NYSE has embraced, replacing the fast versus slow market with fast 
versus slow quotations as the basis for the proposed trade-through 
rule. Under the revised proposal, quotes would be designated fast or 
slow and fast quotes could trade through slow quotes. The resulting 
rule, if adopted, would not expose the NYSE to competition so much as 
to continue sheltering it.
    Neither we nor anyone else is privy to the private discussions 
between the Commission and the NYSE, even though they are central to 
the shape any final NYSE rule will take and therefore essential to 
informed public discussion and debate.
    An outcome that would once again protect the NYSE from real 
competition from outside would be against the public interest and would 
not protect investors. If manual markets are to continue to be a 
significant part of our market system, they must earn that position as 
the result of competition, not because of regulations that protect them 
from competition.
    We suspect from reading the AARP's recently published report on 
investor preferences that the NYSE sold the AARP a bill of goods. The 
AARP based the questionnaire used in its study on the notion that the 
30-second delay investors experience in getting orders executed on the 
NYSE is designed ``to increase the chance that the buyer or seller will 
get the best possible listed price.''
    Of course, people in the know understand that is just not the case. 
The NYSE slows down executions to give its floor members a chance to 
trade alongside investors' orders and to keep everyone not on the 
exchange floor in the dark as to what is going on. The NYSE's stealth 
market--which is the essence of the privileged time-and-place 
advantages its floor members enjoy is the opposite of transparency and 
openness that an investor-friendly market would provide. By assuming 
that investors benefit from the NYSE's 30-second delay, which the SEC 
is pressuring the NYSE to give up, the AARP drew its members to a false 
conclusion. We think entities like CalPER, CalSTERS, Ameritrade, 
Schwab, and Fidelity are closer to the mark as to where the interests 
of small investors reside.

The Markets would be Better Served if the Trade-Through Rule were
Eliminated
    In the case of Nasdaq-listed stocks, we at Bloomberg Tradebook have 
plenty of practical experience with how and when our clients choose to 
trade through published prices. In our experience, the only market 
centers our clients regularly choose to trade through or around are the 
Amex and certain ECN's. Our clients trade around the Amex because the 
Amex posts indicative quotations and is slow to respond to orders. Some 
of our clients trade around one or two smaller ECN's that charge 
exorbitant access fees.
    Experience with Nasdaq provides convincing evidence that a trade-
through rule is not necessary to protect investors. The Commission 
provides no evidence in support of extending a trade-through rule to 
the OTC market. The proposed rule is not only unnecessary, but also 
would impose significant costs upon the markets and ultimately upon 
investors. Indeed, the Commission's own preliminary estimates of the 
securities industry's costs of compliance with the proposed trade-
through rule are eye-popping. Start-up costs are projected to exceed 
$540 million, while annual, ongoing costs of compliance are projected 
at nearly $224 million.
    The NYSE has tried to persuade its listed companies that they 
benefit from lower volatility. The NYSE has argued that volatility is 
perceived to be greater in Nasdaq-listed stocks than in NYSE-listed 
stocks and that the elimination of the trade-through rule would 
increase volatility.
    I would suggest that the greater volatility perceived in the Nasdaq 
market, as contrasted with the NYSE market, may be the consequence of 
Nasdaq's not having floor members to dampen volatility by using their 
time-and-place advantages to jump ahead of public limit orders by a 
penny or joining limit orders on behalf of orders the floor members 
hold for others.
    One question that should be asked in that regard is whether 
volatility per se is good or bad. It may well be the case that slowing 
the market down, as a floor-based system does, dampens volatility 
because it gives the specialist the opportunity to find the other side, 
which a fast market cannot as readily do. Assuming that to be the case, 
the question is whether slowing the market down is appropriate at all, 
even if it does reduce volatility. If greater volatility, which may 
look more substantial in a decimalized market than it did in an eighth-
point or sixteenth-point market, naturally results in a market that is 
not artificially slowed down, that may be an economically acceptable or 
even beneficial result.
    What the NYSE really is up to is preserving investor cost, measured 
by the profits the NYSE floor members extract from the market. The 
public pays a dear price for the NYSE specialists' affirmative 
obligation, which may well be a code word for jumping ahead of public 
investors to take advantage of superior market information known only 
to those on the NYSE floor. The operating ratios of the specialists in 
most years is evidence enough of their privileged positions. The 
market, if suffused with greater competition, would quickly eliminate 
these excessive returns.
    If the trade-through rule were abolished for stocks listed on the 
NYSE, we expect our clients would preference the fast-market venues 
(firm quotations), but would not ignore slow markets (indicative 
quotations) to the extent they afford available liquidity. Fast markets 
would automatically execute against their limit order books and refresh 
their quotations immediately and thereby earn proportionately more 
order flow over time. Orders residing on the slow markets beyond the 
top-of-file and hidden orders in the crowd would be traded through, and 
rightly so. If the trade-through rule were eliminated, the option that 
specialists currently enjoy, which is both riskless and free, to 
intercept incoming orders, to jump ahead by a penny or to ``go along'' 
with institutional orders, would be diminished. Specialists would then 
have to compete on a more even basis with other market participants to 
satisfy investors' demands for best execution.
    Removing the trade-through rule would allow investors to choose the 
markets in which they wish to trade which would, in turn, promote 
competition and benefit investors. The results would be greater 
transparency, greater efficiency, greater liquidity and less 
intermediation in the national market system, which are precisely the 
goals of the Securities Acts Amendments of 1975.
    There is no empirical evidence to suggest that extending the trade-
through rule to Nasdaq securities is needed or would be useful. Indeed, 
it might well generate many of the ills that currently affect the NYSE 
market.

There is an Alternative--the Commission could Launch a Pilot Program
Exempting Stocks from the Existing Trade-Through Rule
    This is no evidence to support the imposition of a trade-through 
rule. Rather than introducing a complex and expensive new trade-through 
rule that would be difficult to enforce, we suggest launching a pilot 
program similar to the ETF de minimis exemption from the trade through 
for a cross section of listed stocks, with no trade-through 
restrictions. The Commission could then monitor and measure the results 
of free competitive forces.\2\ it would determine whether there is a 
problem and whether a trade-through rule would address the problem.
---------------------------------------------------------------------------
    \2\ See Hendershott and Jones, ``trade-through prohibitions and 
market quality,'' unpublished working paper (April 8, 2004) at p.8, 
available at http://faculty.haas.berkeley.edu/hender/ (``there is no 
evidence that market quality worsens when the trade-through rule is 
relaxed. In fact, overall effective spreads actually fall for all three 
ETF's, and the fall is statistically significant for DIA and QQQ.) The 
Commission would be able to monitor the execution quality from filings 
under Rule 11ac1-5.
---------------------------------------------------------------------------
    Such a program would simply involve exempting a class of securities 
from the existing intermarket trading system trade-through rule, to see 
what happens. The stocks to be selected could be, for example, 200 or 
250 of the listed stocks in the S&P 500 stocks, as in the Commission's 
Regulation SHO pilot program, where one-third of the Russell 3,000 
stocks are to be exempted from short-sale regulation. Frankly, 
particularly given the uneven enforcement of the existing rule, we 
doubt granting such an exception would do anything measurable except to 
improve the quality of the markets in those securities as a result of 
subjecting the NYSE specialists to real competition in the affected 
securities. All the negative prophesies some have advanced about the 
absence of a trade-through rule would be tested and, we believe, 
exploded.
    In any event, particularly given the remarkable absence of any 
demonstrated purpose or need for the market-wide rule the Commission 
has proposed, a pilot-program exemption for 1,000 of the Russell 3,000 
stocks would provide a real test case, one that would demonstrate the 
wisdom of what many of the thoughtful commenters on the Commission's 
proposal are saying, that the trade-through rule provides illusory 
benefits and should be rescinded, not expanded.

If There is to be a Trade-Through Rule, It should Apply only to
Immediately Touchable Quotations and there should Continue to be a
Block Exception
    If the Commission nevertheless continues to proceed toward adopting 
a market-wide trade-through rule, the rule should apply only to 
quotations that are immediately, electronically ``touchable,'' that is, 
accessible and executable without any delay at all. Quotations that 
involve a delay in execution, or that cannot be immediately accessed 
and taken, with confirmation that a trade has occurred being 
simultaneously relayed to the order entrant, should not have standing. 
The NYSE and the Amex may wish to continue the old ways, but those old 
ways should no longer hold anyone or any order hostage.
    If the Commission adopts a market-wide trade-through rule, it 
should not adopt the opt out provisions it proposed but should simply 
retain the existing block exception in the intermarket trading system 
rule.\3\ the block exception has been around for a long time. The sky 
has not fallen as a result of that exception. A block trading exception 
would not relieve institutional investors or their brokers of the duty 
of best execution, but it would avoid limiting their choices, which a 
trade-through rule without such an exception would do.
---------------------------------------------------------------------------
    \3\ See, for example, NYSE Rule 15a(e): ``this Rule shall not apply 
to . . .(2) any `block trade' as defined in the Exchange's its block 
trade policy.'' Consideration should be given to whether the exchange's 
ITS block trade policy should be carried over into an SEC Rule. It may 
well be that a simpler exemption, based solely on a trade's being of 
block size, would suffice.
---------------------------------------------------------------------------
    This is not a question of favoring one group of investors over 
another--such as institutions over the ``small investor.'' If it were, 
one might well question which group the Government should favor--the 
wealthy stock picker or corporate executive or doctor who puts 
individual trades into the market or the fireman, policeman, school 
teacher, or factory worker whose State or union pension fund, or mutual 
fund, is invested by CalPERS or another institutional manager.
    But in fact that is not the question. The Government need not make 
that choice. Instead it should choose to let investors make their own 
choices as to how to execute blocks without governmental compulsion. In 
the case of institutions, we doubt their duties of best execution will 
cause them to bypass readily accessible and immediately executable 
prices as a routine matter. In any event, we are not aware of any 
evidence that the existing block exception has been deleterious.
    If the Commission were instead to provide only its fast-to-slow opt 
out from a trade-through rule not having a block exception, we think 
the result would be to force investors to choose between speed and 
price. That would run exactly counter to the Commission's notion of 
what best execution is all about. The alternative opt out provision, 
for fast markets opting out of slow markets within a stated price band, 
raises substantial implementation and compliance issues. Just as the 
short sale rule presents practical problems in a decimalized market 
characterized by flickering quotes, we believe the fast-to-slow opt out 
would present an even greater problem of implementation. The sliding 
scale of permissible trade-through pricing is just too complicated, 
particularly as it would present multiple moving targets and invite all 
sorts of gamesmanship. A market-driven determination might well rely on 
competition among market centers to embrace technology in place of a 
Government mandate.

The Market Data Proposals
    Market data is the ``oxygen'' of the markets. Ensuring that market 
data is available in a fashion where it is both affordable to retail 
investors and where market participants have the widest possible 
latitude to add value to that data are high priorities.
    Before the 1970's, no statute or rule required self-regulatory 
organizations (SRO's) to disseminate market information to the public 
or to consolidate information with information from other market 
centers. Indeed, the NYSE, which operated the largest stock market, 
claimed an ownership interest in market data, severely restricting 
access to market information. Markets and investors suffered from this 
lack of transparency.
    At the urging of the SEC, Congress responded by enacting the 
Securities Acts Amendments of 1975. These Amendments empowered the SEC 
to facilitate the creation of a national market system for securities, 
with market participants required to provide--immediately and without 
compensation--information for each security that would then be 
consolidated into a single stream of information.
    At the time, the Congress clearly recognized the dangers of data-
processing monopolies. The report accompanying the 1975 Amendments 
expressly warns that:

        Provision must be made to insure that this central processor is 
        not under the control or dominion of any particular market 
        center. Any exclusive processor is, in effect, a public 
        utility, and thus it must function in a manner which is 
        absolutely neutral with respect to all market centers, all 
        market makers, and all private firms.\4\
---------------------------------------------------------------------------
    \4\ Report of the Senate Committee on Banking, Housing, and Urban 
Affairs to accompany S. 249, S. Rep.no. 94-75, 94th Cong., 1st Sess. 11 
(1975).
---------------------------------------------------------------------------
Current Fees for Market Data are Excessive--They should be Cost-Based
    Even as not-for-profit entities, SRO's historically have exploited 
the opportunity to subsidize other costs (for example, executive 
compensation, cost of market operation, market regulation, market 
surveillance, member regulation) through their Government sponsored 
monopoly on market information fees. While this subsidy is troubling 
enough, the incentive to exploit this monopoly position will be even 
stronger as SRO's contemplate for-profit futures and new lines of 
business.
    In its 1999 concept release on market data, the Commission noted 
that market data should be for the benefit of the investing public. 
Indeed, market data originates with specialists, market makers, broker-
dealers, and investors. The exchanges and the Nasdaq marketplace are 
not the sources of market data, but rather the facilities through which 
market data are collected and disseminated. In that 1999 release, the 
SEC proposed a cost-based limit to market data revenues. We believe the 
SEC was closer to the mark in 1999 when it proposed making market data 
revenues cost-based, than in its Regulation NMS proposal, which sets 
forth a new formula for dispensing market data revenue without 
addressing the underlying question of how to effectively regulate this 
monopoly function.
    Every investor who buys and sells stocks has a legitimate claim to 
the ownership of the data and liquidity he or she provides to market 
centers. Funneling exclusive liquidity information to exchange members 
and funneling market data revenues to exchanges and Nasdaq and not to 
investors shifts the rewards from those who trade to those who 
facilitate trading. The benefits should be conferred upon the public.
    Under the current system, market data revenues provide SRO's with 
funds to compete with other execution centers. For example, Archipelago 
Holdings recently filed an IPO registration statement with the 
Commission in which it reported some $23 million for 2003 revenue from 
market data. This was net of $7.5 million paid to the Pacific Stock 
Exchange for market regulation services. Archipelago further stated 
that it uses this revenue to compete with Nasdaq, the NYSE and ECN's, 
such as Bloomberg Tradebook. That is, the market data revenues 
Archipelago receives as an exchange are, in effect, Government 
sanctioned subsidies that confer a special--and we believe unfair--
competitive advantage on Archipelago and similarly situated SRO's.
    The Commission's proposal with respect to market data would 
perpetuate the exclusive and lucrative franchise SRO's enjoy over the 
collection, dissemination, and sale of market data. As such, the 
Commission has a statutory duty to engage in ratemaking proceedings 
with respect to these Government sanctioned monopolies. It is truly 
necessary for the Commission to assess the fairness and reasonableness 
of the NYSE and Nasdaq market data fees--fees for what are essentially 
monopoly services. If those fees are excessive or poorly structured, 
they may have created market distortions and allowed those entities to 
extract monopoly rents from the investing public for over a generation.
    Significantly, Nasdaq's Robert Greifeld candidly admitted at the 
Commission's Regulation NMS hearing on April 21 that the existing data 
fees are too high:

        [w]e believe the Government should only be involved where the 
        Government must be involved. So we must limit the monopoly to 
        the data that is part of the public good, and provide it at a 
        low cost . . .
        With the current structure . . . Data is not provided at a low 
        enough cost and it does create . . . Unintended results and 
        distortions in our market. The market centers today are the 
        beneficiaries of that excessive rent . . . .\5\
---------------------------------------------------------------------------
    \5\ statement by Robert Greifeld, President and CEO of the Nasdaq 
Stock Market, Inc. At SEC hearings on Regulation NMS (April 21, 2004), 
available at http://www.sec.gov/spotlight/regnms/nmstrans042104.txt 
(pp. 223-4).
---------------------------------------------------------------------------
Mandatory Market Data should be Expanded
    In addition to questions regarding who owns market data and who 
shares in the revenue and the size of data fees, we believe the 
Commission ought also to revisit how much market data should be made 
available to investors. Here, decimalization has been the watershed 
event. Going to decimal trading has been a boon to retail investors. It 
has been accompanied, however, by drastically diminished depth of 
displayed and accessible liquidity. With a hundred price points to the 
dollar, instead of eight or sixteen, the informational value and 
available liquidity at the best bid and offer have declined 
substantially.
    Particularly given the effects of decimalization, allowing the 
NYSE, for example, to hold market data and liquidity back for the 
benefit of its floor members is against the public interest. The 
Commission has heard complaints before about the NYSE auction 
procedures that allow hidden agency and specialist orders held in the 
crowd to have price-time priority over orders displayed via the public 
quotation system. These floor procedures give NYSE members an unfair 
opportunity to jump ahead of, or to ``penny,'' publicly displayed limit 
orders and to ``go along,'' or hitch a ride, on large institutional 
marketable orders.
    In response to decimalization, the Commission should restore lost 
transparency and liquidity by mandating greater real-time disclosure by 
market centers of liquidity at least five cents above and below the 
best prices. Given the incentives of a slow market such as the NYSE to 
hide quotation information and to block direct access to liquidity, the 
real-time disclosure of liquidity should not be left to ``market 
forces,'' which can work in this instance only if disclosure is 
mandated. This would restore the transparency and direct access 
investors had before the advent of decimal-ization.
    We remain concerned that the promise of decimalization will be 
frustrated if the NYSE is granted greater rights to data that 
represents trading interest in a decimalized environment--in the 
context of market data fees, access fees, or control of uses of 
information--than the NYSE enjoyed when trading interest was expressed 
in eighths and sixteenths.

Access Fees should be Abolished
    There are two basic issues in the debate over access fees, how they 
affect quotations and how they are paid. The access fee debate could be 
resolved with two simple measures: (1) adjust quotations to reflect 
access fees, and (2) do not automatically route orders to venues that 
force payment of hidden access fees. If these conditions were met, 
there would be no reason to regulate access fees. Free markets would 
find appropriate fee levels. Current SEC regulation does not adequately 
address the issue and although the Commission takes positive steps in 
the Regulation NMS proposal, it misses an opportunity to fully address 
the issue.
    Because of their distorting affects upon the markets, Bloomberg 
Tradebook has long believed that access fees should be abolished for 
all securities and all markets. While we applaud the SEC's efforts to 
reduce access fees, we are concerned that the complexities inherent in 
curtailing these fees without eliminating them are likely to create an 
uneven playing field.
    We are also concerned that the proposed limitations on access fees 
in Regulation NMS apply only to the top of the file, that is, to the 
best bid and offer. While ECN's' fees will be limited by the amount 
permitted under their current no-action letters, by contrast, the 
Commission's access fee proposal does not apply to access fees for 
quotes beyond the NBBO.
    Normally, we would be totally in favor of letting a business 
determine its own pricing without governmental interference--with some 
obvious exceptions such as public utilities and others who enjoy 
monopolies of one sort or another. In the case of ECN access fees, 
however, there are two important factors--first, an important question 
is at what point should an ECN have to adjust its published quotations 
to reflect the access fees it will tack on to investors' trades. That 
is important to avoid bait-and-switch problems arising from hidden 
charges. The second is a related question. With SuperMontage, brokerage 
firms entering orders have them executed against the best reported 
quotation--which may be an ECN that charges access fees. In effect, 
they are forced to pay the fees even if they would have chosen not to. 
It is like being forced to eat at a luncheonette where you do not like 
the prices. Those two factors justify capping and indeed prohibiting 
access fees outright.
    We suggest that, in any event, it makes little sense to expand the 
universe of market participants who can charge access fees. With the 
exception of one ECN--iNET--we are not aware of any significant support 
for the continuation of access fees. Broker-dealers, exchanges, ECN's, 
SRO's should all compete on the basis of the merit of their service, 
not on the basis of access fees. Access fees encourage internalization 
of orders, undisplayed orders, and payment for order flow. The 
Commission should look to stamp them out.

Subpenny Quoting
    The Commission clearly opted for the right choice in proposing to 
ban subpenny quoting. The virtually universal consensus among 
commenters applauded that move. Subpenny quoting would further reduce 
transparency and encourage jumping ahead of orders.

Conclusion
    This Committee has been in the forefront of the market structure 
debate and I appreciate the opportunity to discuss how these seemingly 
abstract issues have a concrete real-world impact on investors.
    Regulation NMS is a bold step to bring our markets into the 21st 
century. The SEC is to be commended for prompting what has already been 
a productive debate. In an effort to accommodate a diverse array of 
interests, however, we believe there is a risk that Regulation NMS may 
reshuffle, rather than eliminate, current impediments to market 
efficiency.
    Elimination of the trade-through rule, elimination of access fees, 
and greater efforts to enhance the transparency and control the costs 
of market data would help promote a 21st century equity market that 
best serves investors.




                PREPARED STATEMENT OF ROBERT B. FAGENSON
               Vice Chairman, Van der Moolen Specialists
                             July 22, 2004

    I am Robert B. Fagenson, Vice Chairman of Van der Moolen 
Specialists, the fourth largest specialist firm on the New York Stock 
Exchange (NYSE). I also served as a Floor Official and later Floor 
Governor of the NYSE from 1985 through 1993, on the Board of Directors 
of the NYSE from 1993 through 1999, and as the Board's Chairman in 1998 
and 1999. After a 4-year absence, I was reelected to the NYSE Board in 
2003, but resigned upon reconstitution of that Board to consist solely 
of public Directors. I currently serve on the NYSE's Technology 
Planning and Oversight Committee.
    I appear today on behalf of my firm and on behalf of The Specialist 
Association (Association), of which my firm is a member and which I 
have served for over a decade, currently as Chairman.
    The Securities and Exchange Commission, in its proposed Regulation 
NMS release (Release) and supplemental release (Supplemental Release), 
attempts to address and solve a number of complex, inter-related 
problems affecting our markets--problems, that, in my view, stem 
primarily from technological change in a regulatory environment that 
was created for a slower world. The Release attempts to provide 
solutions to virtually all of these problems in an integrated way. The 
SEC and its staff are to be congratulated for this timely and important 
effort.
    As I see it, at the heart of the regulatory proposals advanced in 
the Release and Supplemental Release are three issues. First, now that 
technology has advanced to the point where it is truly possible to 
ensure that no investor's displayed order to buy or sell at a price 
better than any other price shown in our markets can be ignored, are we 
nevertheless going to permit transactions at a worse prices to occur 
without filling or at least matching that better price? Second, is 
there something about the speed with which transactions, as a 
technological matter, can occur that matters enough to override the 
basic principle in our markets that trades always should occur at the 
best available price? Third, are we going to compel each market that 
wishes to have its own buying and selling interest be protected by an 
anti trade-through rule to trade exclusively on the basis of bids and 
offers displayed in the consolidated quotation system (CQS) that can be 
filled or taken instantaneously by electronic means? Or will investors 
who wish to seek a better price, as an alternative to buying or selling 
at displayed prices, still be permitted, as they are today, to 
participate in an auction process like that on the NYSE that discovers 
and provides a better price much of the time?
    What has brought these issues to the forefront? Primarily, in my 
view, three factors:

 The growth of electronic markets--so-called alternative 
    trading systems or ATS's, electronic communications networks or 
    ECN's, and in-house electronic order crossing systems of large 
    brokerage firms. These electronic markets insist, for purely 
    competitive reasons, that there are customer constituencies who 
    value speed of execution over best price and that those 
    constituencies should be permitted to trade without regard to other 
    markets and other market participants that offer, at the time of 
    trade, better prices.
 The failure to ensure, before now, that each market affords 
    fair access by all market participants to the best bid and offer 
    prices available in that market and to do so on a basis that is as 
    efficient as today's technology permits.
 The need to reaffirm and adapt antitrade-through principles to 
    the faster markets of today in a way that makes it feasible to 
    insist, unequivocally, that all markets and all market participants 
    must trade at all times in a manner consistent with those 
    principles.

    The most important proposal in the Release and Supplemental 
Release, in my view, is a rule that would require all markets, 
including electronic trading markets, to adopt and enforce their own 
antitrade-through rules. Each market's antitrade-through rule would 
have to prevent trade-throughs from occurring in that market at prices 
inferior to any price displayed in the CQS and made available by 
another market on an immediately accessible basis (which I shall refer 
to as a ``fast quoting'' market), with very limited exceptions. In this 
regard, the SEC is to be especially commended for modifying its 
original proposal to recognize that within each market some quotes will 
be ``fast'' while others may not be, and that quotes in the same stock 
may be ``fast'' much of the time, but at others ``slow.'' The SEC has 
proposed that all ``fast quoting'' markets should receive the full 
protection provided by antitrade-through rules for all of its ``fast'' 
quotes. (Originally, the SEC had proposed that each market as a whole 
would be categorized as either ``fast'' or ``slow,'' with only the 
former being entitled to absolute trade-through protection.) A 
companion rule proposal would ensure fair access by all markets and 
market participants to all quotations displayed in the CQS. The SEC 
also proposes an ``opt out'' exemption from its antitrade-through rule 
that would permit any broker-dealer and any consenting customer to 
decide, ostensibly on a trade-by-trade basis, to forego the protections 
of the trade-through rule--that is, to trade without regard to better-
priced bids or offers displayed from any market.
    The NYSE and the Association have submitted comment letters 
responding to most of the issues and proposals discussed in the Release 
and the Supplemental Release, including those that I have described. I 
agree with the positions articulated in those letters and commend them 
to your attention. Today, I will limit my testimony to what I regard as 
the three primary issues described above.
    I am mostly concerned about what is at risk in the debate begun by 
self-interested electronic markets concerning the value of speed of 
execution compared to the value of price of execution. In particular, I 
am alarmed by the prospect of what would be lost from today's markets 
if fascination with what is technologically possible in terms of 
execution speed were to be permitted to reshape the regulatory 
landscape, diminishing or even eliminating the idea that best price and 
order interaction between customers without the intervention of a 
dealer should continue to be dominant factors in the regulation of our 
markets. In simple terms, just because we can do something does not 
necessarily mean we should. My view is that regulation should take into 
account both developments in technology and the continuing need for the 
exercise of human judgment in the trading process. That is, regulatory 
policy should not imagine that technology alone can support the genius 
and vitality of our trading markets.
    The NYSE has made it plain that it intends to provide customers 
with a choice of a ``fast quoting'' market. The NYSE even now has begun 
modifications to its systems and rules to ensure that result, and will 
continue to do so as the SEC moves to adoption in final form of the 
Regulation NMS rules. In this regard, my primary concern is that the 
SEC must make sure that whatever ``fast quoting'' market standard it 
ultimately adopts permits the NYSE to continue its traditional auction 
trading process for those who wish to avail themselves of that process 
to obtain better prices rather than woodenly accepting whatever prices 
happen to be displayed in the CQS at the time of the trade.
    I also believe that the SEC would make a great mistake if it were 
to adopt any variation of the ``opt out'' exemption. Adoption of that 
exception, in my view, could undermine or even destroy a trading 
process that continues to be the envy of the world because it provides 
enormous liquidity, day after day, in a fair and orderly manner. What 
adoption of such an exemption would not do is improve the markets in 
any respect.

Speed of Execution Is Not a Paramount Value
    It is well-known that the NYSE today enjoys a market share of 
approximately 80 percent in the trading of its listed stocks. Lately, 
we have heard with regularity that the NYSE's market share is the 
result of the anticompetitive effects of the trade-through rule. The 
trade-through rule, we are told, impedes electronic markets from 
realizing their full potential as markets and stands between at least 
some investors and their preference as to execution quality (that is, 
achievement of an immediate execution rather than one at the best 
price). In short, the electronic markets seek to persuade us that 
trade-through rules are old-fashioned and must go. To help them realize 
their potential, the electronic markets argue, the basic rules of the 
road in our markets should be changed to acknowledge the special 
importance of their only real product--speed. If done properly, which 
means to these electronic markets eliminating the trade-through rule 
altogether, they then could offer something more--the ability to trade 
in isolation, free from interaction with other market participants.
    While the NYSE does have 80 percent of the trades in its listed 
stocks (understandable to me since the NYSE shows the best quotes in 
its listed issues more than 90 percent of the time), it should be noted 
that its competitors have succeeded in attracting the remaining 20 
percent of those trades. Further, they have done so notwithstanding the 
NYSE's acknowledged quality as a marketplace and the existence of the 
trade-through rule. This has occurred in an environment where the goal 
of obtaining the best price governs the conduct of brokers, and the 
market that provides the best prices is rewarded with trades. That is, 
the NYSE's competitors know how to offer what securities customers 
want, and have been rewarded by customers when they do, in terms of 
efficiency, economical access, and best price. They have not needed 
regulatory change to do these things. Just because someone's business 
model is not working does not entitle them to regulatory relief.
    Second, I ask you to consider just who is demanding increased speed 
of execution and why. That is, can any set of investors be identified 
to whom it matters whether an execution takes place in one second or a 
nano-second--and to whom it matters enough to sacrifice a penny or more 
in the price paid or accepted on the trade? I do not believe that there 
is any such set. There are, however, electronic markets and sponsors of 
electronic trading who have little else to offer besides their 
execution speed. They would prefer being spared costs that attend 
operation in today's markets where order interaction and best price are 
prized and fostered by current regulatory policy and rules. Finally, 
they realize that, if they could avoid interacting with other markets 
and trade for their own accounts without regard to better prices 
offered by others, new opportunities to profit would present 
themselves. These markets, I suspect, are the only real advocates of 
the speed factor.
    The SEC's proposed Regulation NMS would do a great deal to 
modernize the existing regulatory regime by addressing the need for 
fair and efficient access to 
displayed quotations and could, if the proposed trade-through rule is 
adopted in appropriate form without the ``opt out'' exemption, go far 
in realizing the objective of stopping intermarket trade-throughs of 
better prices. The SEC's new trade-through rule, however, does not and 
should not be changed to elevate speed of execution over other values 
now embedded in our regulatory system, the most important of which, in 
my view, is that no trade should occur at a price inferior to the best 
price displayed in the CQS.

The ``Opt-Out'' Exemption
    The proposed ``opt out'' exemption from the trade-through rule 
would swallow the rule itself. Adoption of such an exemption would 
destroy rather than advance intermarket price protection in our 
markets. To do that would be an incalculable error and inflict more 
harm on investors than those who support such action seem capable of 
imagining.
    Adoption of the ``opt out'' exemption would permit trading by 
broker-dealers for their own accounts and for customers without regard 
to the existence at the time of their trades of better bid or offer 
prices displayed in the CQS. In such an environment, not only would one 
side of the trade receive a worse price than a better price known to 
the broker-dealer handling their order or trading with it as principal 
at the time of the trade--namely, the customer side of the trade--but 
also such trades would leave stranded and unexecuted the better bids or 
offers made by others. This would be so even though those better prices 
would have to be accessible ``immediately'' and on fair terms if the 
rules contemplated by proposed Regulation NMS were adopted. That the 
SEC would suggest such an apparent step backward, in light of the 
formidable reasons mounted in the Release for proposing adoption of a 
universal trade-through rule for all markets, is confusing.
    Two principles tend to force intermarket price protection today: 
``Best execution'' in the case of orders of a size that reasonably can 
be expected to be executed at the best displayed bid or offer price or 
better; and, in the case of listed securities, self-regulatory 
organization trade-through rules (even where the size of the trade is 
such that the prices of displayed bids and offers do not necessarily 
establish a sound guide to what ``best execution'' requires under the 
circumstances). The ``opt out'' 
exemption would overthrow both principles and, in so doing, threaten to 
capsize fairness and orderly trading in our markets. In our markets to 
permit the kind of conduct that adoption of the ``opt out'' exemption 
would endorse would, in my judgment, snuff out public confidence in the 
fairness and integrity of our markets, confidence on which our capital 
raising process depends.
    Public confidence in our markets exists today because those markets 
operate fairly as to the most basic and important element of a 
securities transaction--price. This is so without regard to the size or 
influence of the buyer or seller. The rule at all times should be that 
the best price gets the trade. The ``opt out'' exemption would turn 
this on its head. Instead, the SEC (and thus our markets) would tell 
the world that the biggest player gets what he wants regardless of 
price and regardless of the little guy and any better price at which he 
is willing to buy or sell. This is the opposite of the message that has 
made our markets the best and the most trusted in the world.
    The ``opt out'' exemption is a terrible idea and the SEC should 
disown it.

``Fast Quoting'' Market Status: Effects on the Auction Process and
Price Discovery
    Today, the NYSE executes virtually all orders submitted within a 
very few seconds after submission. This includes, most of the time, 
responding to commitments to trade submitted through the admittedly 
antiquated Intermarket Trading System. Some trades, however, take 
longer.
    Sometimes, this is because adverse news affecting the issuer of a 
particular stock is released. In other cases, it is merely the 
coincidental confluence of a lage number of orders on one side of the 
market at the same moment. In such cases, after exhaustion of the 
existing displayed bids, the bid-ask spread is likely to be widened to 
forestall sequential short sales at successively lower ticks (when the 
occasional up-tick occurs) and to discover the new price at which 
buyers and long sellers generally, after absorbing the news, believe is 
appropriate for that stock.
    In certain instances, the specialist may be aware of contra-side 
interest in a stock that a customer seeks to buy or sell. By quickly 
reaching out to such interest, and bringing it to the post. The trade 
then can achieve a price better than any displayed bid or offer price. 
Through this process of price discovery orders presented for execution 
often receive price improvement, but not instantaneously.
    In other cases, customers may wish to establish or dispose of very 
large positions--something that will occur at a negotiated price away 
from the level of the currently displayed bid or offer. Strictly 
speaking, the interest in assembling such a trade does not take the 
form of a market or other type of executable order. The conduct and 
completion of both a search for contra-side interest in a trade of size 
and negotiations between the prospective parties to such a trade as to 
price depends on stability of the bid or offer price for a brief period 
to permit that to occur. The NYSE auction process accommodates such 
pending transactions today without triggering trading halts and by 
including rather than excluding all trading interest at the time of the 
transaction. I believe that doing so performs a valuable service to the 
markets as a whole.
    The ability to perform in the foregoing ways--to adjust to bad 
news, provide price improvement, and permit the negotiation and smooth 
execution of very substantial trades--could be lost if, as the price of 
winning characterization as a ``fast quoting'' market under the new SEC 
trade-through rule, the NYSE must give up entirely its existing 
auction/agency process. The NYSE is addressing this challenge and 
working toward the objective of assuring that the virtues of our 
existing trading system and the benefits that they confer on market 
participants can be preserved side by side with making available to 
other markets the bid and offer prices on the NYSE displayed in the CQS 
that are immediately accessible and assuring that no transaction occurs 
on the NYSE that trades through a better price displayed in the CQS by 
another ``fast quoting'' market. I hope and expect that the definition 
of what constitutes a ``fast quoting'' market under the trade-through 
rule ultimately adopted by the SEC will accommodate the NYSE's effort.
    I appreciate the opportunity to express these views and would be 
pleased to respond to any questions that you might have.

                               ----------
                  PREPARED STATEMENT OF JOHN C. GIESEA
            President and CEO, Security Traders Association
                             July 22, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, on behalf of the Security Traders Association (STA) thank 
you for the opportunity to testify regarding the structure of the U.S. 
equities markets, and more specifically the Securities and Exchange 
Commission's (SEC) proposed Regulation NMS.

Security Traders Association
    The STA is a worldwide professional trade organization that works 
to improve the ethics, business standards, and working environment for 
our members. We have approximately 6,000 members, all engaged in the 
buying, selling, and trading of securities. Our members participate in 
STA through 28 national and international 
affiliate organizations and represent the interests of the trading 
community and institutional investors. The STA provides a forum for our 
traders, representing institutions, broker dealers, ECN's, and floor 
brokers to share their unique perspectives on issues facing the 
securities markets as they work together to promote their shared 
interests in efficient, liquid markets as well as investor protection.
    Given the disciplines represented by the STA, one would expect that 
they often have differing perspectives on market structure issues. We 
have diligently worked through the issues presented by the Commission 
in proposed Regulation NMS, and have in most instances reached 
consensus on recommendations that we believe are beneficial for the 
market as a whole, not the individual interests of our constituencies. 
I request that the STA's comment letter on Regulation NMS be included 
as part of the hearing record.

STA White Paper
    The Securities Acts Amendments of 1975 direct the facilitation of a 
national market system and set forth objectives for the ``protection of 
investors and the maintenance of fair and orderly markets.'' \1\ 
Technological advancements and innovations, and the dramatic increase 
of individual investor participation, continue to transform the US 
equities markets.
---------------------------------------------------------------------------
    \1\ Securities Exchange Act of 1934, Section 11A(a); (15 U.S.C. 
78k-1)
---------------------------------------------------------------------------
    The STA has consistently called for SEC action to address these and 
other developments in the markets. In August 2003, we issued a White 
Paper entitled ``Fulfilling the Promise of the National Market 
System,'' in which the STA made three key recommendations:

 Improve intermarket linkages and trading rules.
 Require consistency of core trading rules across markets.
 Eliminate access fees.

    The White Paper discussed in detail the STA's views on the current 
state of the U.S. markets and the issues it felt must be dealt with in 
order to make those markets stronger and more liquid. While not a one-
for-one parallel with the Commission's Regulation NMS proposal, our 
concerns are remarkably similar to those addressed by the Commission in 
the Proposing Release. At that time, we expressed the view that the new 
environment led to issues for market structure that met at the fulcrum 
of technology and access. Similarly, the four proposals promulgated in 
Regulation NMS and the supplemental release deal with various facets of 
a fundamental problem: Inadequate access to the best priced quotes of 
all market centers, on market neutral terms.

Proposed Regulation NMS
    The STA commends the Commission for its efforts in addressing these 
structural problems. The White Paper addresses many of the same issues 
discussed in 
Proposed Regulation NMS, and we believe the SEC's proposal is an 
important and positive step toward advancing the objectives of the 
national market system as envisioned by Congress in 1975. Since we see 
the current problems as arising from access to quotes on market neutral 
terms, I will address those issues first, followed by the various 
issues related to sub-penny quoting, trade through, and market data.

Access Fees Should be Eliminated
    Best execution obligations are negatively impacted by access fees. 
Since access fees are not included in the quotations that ECN's display 
in the consolidated quotes through an SRO trading facility, they 
undermine transparency of prices and represent hidden costs. Access 
fees distort the true price offered through that SRO facility and 
complicate a nonsubscriber broker-dealer's best execution obligations.
    Access fees for nonsubscribers do not provide choice. It is 
important to understand the differences between access fees charged to 
subscribers of ECN systems and nonsubscribers attempting to access a 
quotation displayed in the consolidated quotes. Subscribers to an ECN 
have affirmatively chosen to pay the access fees for access to the 
system. Conversely, nonsubscribers have not chosen to pay for such a 
service, but may instead be required, in order to fulfill best 
execution obligations, to interact with an ECN quote and pay an access 
fee.
    The STA has consistently maintained that access fees for 
nonsubscribers of ECN systems should be eliminated. An ECN should be 
limited to charging fees to its subscribers just as a market maker may 
only charge fees to its customers. Elimination of access fees would end 
the rebate schemes and economic incentives causing locked and crossed 
markets.
    The Commission's proposal to permit all markets to charge access 
fees would only serve to exacerbate the problems. While we appreciate 
the thoughtfulness behind the Commission's proposal to permit all 
markets to charge access fees, we believe that this will exacerbate the 
problem rather than lessen it. We believe a far more effective approach 
would be to simply ban ECN's from imposing access fees when their best 
priced quotes are traded through an SRO execution facility such as 
Nasdaq's SuperMontage. At the same time, the STA believes it is 
unnecessary for the Commission to ban or restrict the access fees that 
an ECN may charge its subscribers for providing them with direct 
trading access to its quotations, including depth of book displays.

Ban Sub-penny Quotations
    The STA fully supports the Commission's proposal to eliminate sub-
penny quotations. It is important that the Commission act now to 
prevent the negative impacts of sub-penny quoting.
    The STA has consistently called for the elimination of sub-penny 
quoting. One of the principal benefits of the transition to decimals 
was clarity and simplicity in the market information provided to public 
investors. Further, the international decimal standard provided a 
reference and comparison standard for investors both in the United 
States and abroad. These goals have been achieved, and the Commission's 
mandate to switch to decimals has, after some adjustment by 
participants, been recognized overall as a positive development. A move 
to sub-penny quoting will substantially undermine the benefits of 
decimals, and will not improve markets, but will lead to greater 
inefficiency and confusion.
    We concur with the Commission's description of the problems of sub-
penny quoting. Among the negative impacts, sub-penny quoting results in 
a decrease in market depth at the NBBO and incentives to step ahead of 
limit orders. For example, an SEC staff study concluded that sub-penny 
trades cluster at the $0.001 and $0.009 price points, suggesting 
stepping ahead behavior.\2\ In addition, sub-penny trading increases 
the number of price points available, resulting in less liquidity at 
each price point and negating any perceived benefits to investors.
---------------------------------------------------------------------------
    \2\ Securities Exchange Act Release No. 49325 (February 26, 2004) 
69 FR 11126.
---------------------------------------------------------------------------
Trade-Through and Best Execution
    Based on our analysis and understanding of the current problems in 
the market structure, and the Congressional mandate that we move toward 
a true NMS, our view is, as we recommended in the White Paper, that we 
achieve `` . . . adequate, efficient, and appropriate connectivity 
between, and access to all market centers and their platforms . . . .'' 
We believe that if traders have access to all quotes with immediate 
execution and refresh capability, the problem of trading-through might 
simply go away.
    In light of that, our recommendations are as follows:
    Phased Approach: The Commission should adopt a phased 
implementation schedule for the proposal. We have, and continue to 
assert that access lies at the heart of achieving an NMS.
    Specifically, in Phase One, the STA recommends that the SEC adopt a 
rule requiring all market centers to provide automated access to their 
publicly displayed quotes. This should include standards for automated 
execution, access on economically efficient terms (including the 
elimination of access fees), and automated quote refresh capabilities. 
These standards of connectivity, access, and immediate execution are 
key components to achieving the objectives of the national market 
system.
    After this Phase is fully implemented and the empirical evidence of 
the effects are analyzed, the Commission will be in a position to 
determine whether a uniform trade-through rule is necessary. Finally, a 
phased approach would provide greater opportunity to identify whether 
adjustments to the proposal are necessary, and in doing so, would 
reduce the potential for unintended consequences.
    Exclusion of manual quotes: The rule should exclude manual, or 
slow, quotes from the consolidated national best bid and offer (NBBO).
    Since manual quotes would not support automatic execution 
capabilities, excluding them from the NBBO would provide an incentive 
for markets to become fully automatic. But to encourage consistent 
behavior, it is important that the Commission limit the ability of a 
market from switching between manual and automated quotes.
    As discussed above, the trade-through rule should not be extended 
to other markets unless it determines, based upon empirical evidence, 
that connectivity and automation are insufficient to protect against 
inferior trades.
    Safe Harbor: Adoption of a safe harbor would recognize that a 
broker-dealer may, consistent with its best execution duties, trade 
through a quote that is not accessible for automated execution.
    SEC policy on best execution is consistent with this standard as it 
recognizes that factors other than price may be considered when 
evaluating best execution. Certain State regulators and the NASD; 
however, have sometimes focused on price as the only measure of 
compliance, ignoring the fact that some quotes may not have neutral 
economic or access terms. For example, certain transactions may appear 
to be executed at something other than the ``best price.'' However, if 
a quote at the NBBO is not immediately accessible, it is unfair to have 
standards that would require a broker-dealer to execute against such a 
quote. Such a safe harbor would protect a broker against best execution 
liability under State law in situations permissible by the Commission.
    Trade-Through Exemptions: If the Commission determines that a 
trade-through rule is necessary, the STA supports, to varying degrees, 
the automated order execution, flickering quote, and limited opt out 
exemptions.
    The automated order execution exemption, without limitation, is 
desirable to provide an incentive for slow markets to become more fully 
automated. The SEC's Supplemental Release questions whether the 
exemption should distinguish between automated and manual quotes 
(rather than markets as initially proposed). Such an approach could be 
acceptable, but only if manual quotes are excluded from the NBBO, as 
discussed above.
    Some stocks display quotes that change at such a rapid pace that 
they ``flicker.'' As such, a flickering quote exemption should be 
adopted, recognizing that an apparent trade-through of such quotes is 
not an actual trade-through (but rather a ``false'' trade-through).
    If the SEC requires connectivity and automated execution, an opt 
out becomes less necessary. The STA cautiously favors a limited opt out 
exemption if the Commission moves forward with a trade-through rule. In 
this case, there may be certain instances that require an opt out for 
specific types of trades, such as large block or volume weighted 
average price (VWAP) trades.
    Importantly, rather than the proposed varying de minimis amount at 
which a trade-through can occur, there should be no limit placed on 
trading through a manual market.

Market Data
    There are substantial problems regarding the allocation of market 
data revenues that need to be addressed. While we are not in a position 
to comment on the details of the precise formula proposed for 
distribution of market data revenues, the STA supports the allocation 
of market data revenues to reward providing quality quotes that are 
tradable and improve price discovery and the NBBO. The formula should 
only reward automated quotes accessible for trading, rather than 
inaccessible quotes of manual markets. In addition, the formula should 
not reward a market's quote-related revenue share if it has a high 
ratio of quote changes to actual prints. We recommend that the 
Commission reconsider its proposed market data revenue formula, 
possibly by creating an industry working group, to take into account 
these and other factors to reward price discovery.

Conclusion
    Proposed Regulation NMS, with appropriate modifications, is a much 
needed step toward achieving the objectives of the national market 
system set forth by Congress in 1975. The STA recommends a phased 
implementation of a connectivity-based approach mandating automated 
access to quotations on market neutral terms. Only then should the 
Commission proceed with a trade-through rule across all markets.
    The STA appreciates the Committee's oversight role and interest in 
promoting efficient, competitive and fair U.S. markets. On behalf of 
the individual members of the STA, I thank you for the opportunity to 
participate in this important dialogue.

                               ----------
                  PREPARED STATEMENT OF CHARLES LEVEN
                    Vice President, Board Governance
                    Chair, Board of Directors, AARP
                             July 22, 2004

    Good morning Chairman Shelby, Ranking Member Sarbanes, and Members 
of the Committee on Banking, Housing and Urban Affairs. My name is 
Charles Leven. I am AARP Vice President for Board Governance and Chair 
of our Board of Directors. I appreciate this opportunity to testify on 
our shared interest in, and concern for, the maintenance of a ``fair 
and orderly'' national equity marketplace.
    Since the creation of the national market system (NMS) in 1975, 
registered exchanges and national associations have been required to 
publish immediately the details of almost all trades, and also the best 
quotes, for most securities.\1\ Over the years this policy has been 
extended, by enlarging the range of securities for which transparency 
is obligatory, and by widening the types of trading systems required to 
publish price and quote information. Full price and quote transparency 
is fundamental to effectively regulating exchanges and markets, 
enhancing investor protection, competition, fairness, market 
efficiency, liquidity, market integrity, and investor confidence.\2\ We 
believe that when ordinary investors think or speak of the stock market 
it is the NMS that is being assumed, if not directly referenced or 
understood.\3\
---------------------------------------------------------------------------
    \1\ The national market system (NMS) came into existence in the 
United States as an explicit public policy objective in the form of a 
1975 set of Amendments to the Securities Exchange Act (SEA) of 1934. 
The NMS Amendments established as a purpose of the SEA the need to 
``remove impediments to and perfect the mechanisms of a national market 
system for securities,'' and directed the Securities and Exchange 
Commission (SEC) to ``facilitate the establishment of that system.''
    \2\ Core expectations for the mandatory transparency called for by 
the NMS are outlined in SEC (1/1/94: IV-1 to IV-5), and release No. 34-
37619 (29/8/1996).
    \3\ The 1975 NMS Amendments directs the SEC, ``having due regard 
for the public interest, the protection of investors, and the 
maintenance of fair and orderly markets, to use its authority . . . to 
facilitate the establishment of a national market system for 
securities.'' The SEC identified in 1978 a number of market reforms 
necessary for the establishment of the NMS and has subsequently 
promulgated a number of rules and developed key institutions to 
implement the NMS goals.
    Among the key rules are those that relate to: Dissemination of 
price and quote information; improving the handling and execution of 
customer orders by broker and dealers; and displaying price and volume 
data of the most recent transaction from all reporting market centers.
    Three key institutions were developed to bring about the NMS: The 
Consolidated Quotation System (CSQ), that is a mechanism for making 
available to data vendors information about the bid and offer 
quotations and associated volumes; the Consolidated Tape Association 
(CTA), that was established to consolidate the last sale reporting of 
all trades in exchange listed securities; and the Intermarket Trading 
System (ITS), that is an intermarket communications linkage.
---------------------------------------------------------------------------
    Clearly, the securities markets are an important national asset 
which must be preserved and strengthened. The proposals under 
consideration by the U.S. Securities and Exchange Commission (SEC) to 
enhance and modernize the regulatory structure of the NMS are both 
important and fundamental.\4\ And we believe that a stable but robust 
NMS is fundamental to our national economy, the financial well-being 
and economic security of the investing public, as well as for the 
business vitality of the market.
---------------------------------------------------------------------------
    \4\ See the proposed rule for regulation of NMS, U.S. Securities 
and Exchange Commission [Release No. 34-49325; File No. S7-10-04]. The 
Commission is proposing changes that would affect NMS participant 
trade-throughs, market access to quotations and execution orders, 
minimum market pricing increments, and plans for disseminating market 
information to the public.
---------------------------------------------------------------------------
Survey Findings
    My remarks today summarize the views collected from a 2004 AARP 
survey of individual investors toward selected stock market conditions 
and practices.\5\ It was conducted to examine investor perceptions of 
selected securities industry practices, the stock market, and financial 
services professionals. This survey did not attempt to focus on the 
technical aspects of NMS rules and institutions that have been created 
to deliver and maintain an operational national market system.
---------------------------------------------------------------------------
    \5\ A copy of the full report, ``Investor Perceptions and 
Preferences Toward Selected Stock Market Conditions and Practices: An 
AARP Survey of Stock Owners Ages 50 and Older'', published March 2004, 
is available at: http://research.aarp.org. See Appendices A and B: 
Conducted from February 13 to February 20, 2004, the survey was fielded 
to panel members who met each of the following criteria: (i) are age 50 
or older, (ii) own stocks, either as individual stocks or in mutual 
funds, and (iii) have primary or joint responsibility for making 
household financial investment decisions. A total of 1,917 households 
participated in the survey.
---------------------------------------------------------------------------
Best Available Price vs. Speed
    We understand the importance of the debate over the fate of the so-
called ``trade-through'' rule.\6\ The challenge of finding a market 
mechanism that will maximize the probability that the NMS will secure 
the best available price per transaction (for the individual as well as 
for the institutional investor) in a given time frame is a difficult 
one. Credible arguments and research have been advanced that call for 
no change, an opt out provision, or total elimination of the existing 
rule. We believe most stakeholders in the issue will agree that--
however the ``trade-through'' conundrum is addressed--it will likely 
have a profound financial impact on the different market centers. 
Ultimately, it will also have an impact on public confidence, based 
upon perceptions of market credibility and fairness.
---------------------------------------------------------------------------
    \6\ Technically, a ``trade-through'' occurs when a participant 
either buys a security at a higher price than the lowest offer quoted 
among participating markets, or sells a security at a lower price than 
the highest bid quoted amount the participating markets. The SEC is 
proposing a uniform trade-through rule for both exchange (for example, 
NYSE) listed and Nasdaq-listed securities.
---------------------------------------------------------------------------
    Our 2004 investor survey did not ask respondents to assess the role 
that the concept of ``certainty'' would play in their determination of 
what would be the best price available. However, we did ask respondents 
to weigh their preference for obtaining best price against 
circumstances that might warrant consideration of other trading 
criteria and options, that is, speed, fees, and confidentiality.
    When presented with two opposing views related to the importance of 
obtaining the best available stock price versus the importance of other 
issues such as speed of transaction, approximately two-thirds (66 
percent) of respondents indicated that they agreed with the view 
stating that best available price should be the top priority when 
conducting transactions.

                     Best Available Price vs. Speed
                                (n=1,917)
------------------------------------------------------------------------

------------------------------------------------------------------------
View A: Best available price should be top priority.....      66 percent
------------------------------------------------------------------------
View B: Important to balance need for price with speed        31 percent
 and other issues.......................................
------------------------------------------------------------------------
Refused to answer.......................................       3 percent
------------------------------------------------------------------------

    Certain individuals, such as those who conduct few transactions per 
year, women, those who are older, those with lower incomes, and those 
with less education were more likely to feel that best available price 
should be a top priority. Likelihood to agree with View A (best price) 
did not vary based on any of the other demographic variables tested, 
including race, employment status, and martial status.
    When asked how strongly they agreed with their selection, close to 
three in four (74 percent) respondents indicated that they somewhat 
agreed. Approximately one in four (26 percent) indicated that they 
strongly agreed. Those who felt that best price should be the top 
priority (``View A'' supporters) and those who felt that the need for 
best price should be balanced with speed and other issues (``View B'' 
supporters) were equally likely to indicate that they strongly agreed 
with their respective viewpoints. Specifically, among View A 
supporters, 74 percent indicated that they somewhat agreed with View A, 
while only 26 percent indicated that they strongly agreed. Similarly, 
among View B supporters, 74 percent indicated that they somewhat agreed 
with View B, while only 26 percent strongly agreed with View B.
    When those respondents who selected View A were asked if there were 
any circumstances under which best available price would not be their 
highest priority, almost half (48 percent) said that best available 
price would not be their top priority if obtaining the best price meant 
that they would have to pay high fees. Another 41 percent pointed to 
the need to conduct transactions quickly. Close to one in six (17 
percent) reported that best available price would always be their 
highest priority.

   When Price Would Not Be the Top Priority for ``View A'' Supporters
                                (n=1,274)
------------------------------------------------------------------------

------------------------------------------------------------------------
If getting the best available price meant I would have        48 percent
 to pay high fees.......................................
------------------------------------------------------------------------
If I needed to buy or sell shares quickly...............      41 percent
------------------------------------------------------------------------
If I wanted to complete the transaction on the Internet       11 percent
 rather than go through a stockbroker...................
------------------------------------------------------------------------
Other (specify).........................................       2 percent
------------------------------------------------------------------------
Under no circumstances..................................      17 percent
------------------------------------------------------------------------

    Of all respondents, more than eight in ten (86 percent) agreed that 
their stock broker or mutual fund manager should notify them before 
completing a transaction in which best available price is not the top 
priority.

Important Considerations When Investing in Mutual Funds or Individual 
        Stocks
    When respondents were asked to rate the importance of price, fees, 
speed, and confidentiality, the cost-related issues of price and fees 
received significantly more very important ratings than did speed and 
confidentiality. Between 70 percent and 80 percent of respondents 
perceived price and fees to be very important in both mutual fund 
transactions and individual stock transactions. Approximately 60 
percent perceived confidentiality to be very important, while fewer 
than 30 percent perceived speed to be very important.
Confidence in Financial Services Professionals
    The majority of respondents (74 percent) reported that they prefer 
to have others manage their investments for them, although they do like 
to be involved in major investment decisions. In fact, close to two in 
three (66 percent) indicated that they rely on either a personal 
broker/financial advisor, an employer-sponsored broker/financial 
advisor, or a banker when making investment decisions.

             Confidence in Financial Services Professionals
                                (n=1,917)
------------------------------------------------------------------------
                                                             Strongly or
                                     Strongly     Somewhat     Somewhat
                                      agree        agree        agree
                                    (percent)    (percent)    (percent)
------------------------------------------------------------------------
I am confident that the financial           24           52           76
 institutions that handle my
 money manage my accounts
 according to what is in my best
 interests.......................
------------------------------------------------------------------------
I have more confidence in the               32           44           76
 abilities of mutual fund
 managers than I have in my
 ability.........................
------------------------------------------------------------------------
I prefer to have others manage my           35           39           74
 investments for me, but I like
 to be involved in major.........
------------------------------------------------------------------------
I have more confidence in the               30           42           72
 abilities of stock brokers than
 I have in my ability to buy and
 sell individual stocks on my own
------------------------------------------------------------------------
I prefer to make investment                  9           28           37
 decisions on my own without the
 assistance of others............
------------------------------------------------------------------------
I am confident in my ability to              9           24           33
 buy and sell individual stocks
 without the assistance of stock
 brokers.........................
------------------------------------------------------------------------

    While investor reliance on financial services professionals may 
stem in part from a desire to reduce demands on their own time, most 
investors appear to lack confidence in their ability to conduct trades 
and make investment decisions without the assistance of financial 
services professionals. Specifically, close to three in four 
respondents (72-76 percent) have more confidence in the abilities of 
mutual fund managers or stock brokers to conduct transactions for them 
than they have in their own abilities to conduct transactions. In 
contrast, only one in three (33 percent) are confident in their own 
ability to buy and sell individual stocks without the assistance of 
stock brokers.
    Subsequent sections of the survey reveal widespread concerns about 
the securities industry on issues such as a lack of ethics and a lack 
of accountability, although most respondents (76 percent) indicate that 
they are at least somewhat confident (only 24 percent are strongly 
confident) that ``the financial institutions that handle my money 
manage my accounts according to what is in my best interest.'' This 
apparent contradiction may reflect differences in interpretations of 
the terms ``financial institutions'' and ``securities industry'' as it 
is likely that the term ``securities industry'' brings to mind 
entities, such as brokerage firms, mutual fund firms, and stock 
exchanges, whose primary functions involve trading stocks. In contrast, 
it is likely that respondents interpret ``financial institutions'' more 
broadly to include banks, which are likely to be perceived as separate 
from the securities industry. Another possibility is that respondents 
are more confident about their own banks and investment firms than they 
are about the industry as a whole, which may contribute to this 
relatively high level of confidence in institutions that ``handle my 
money.''

Concerns and Worries About the Stock Market
    Fear of losing money (63 percent), lack of ethics (61 percent), and 
general concerns about the state of the economy (55 percent) top the 
list of respondent concerns about the stock market. More than half of 
respondents selected these items when asked to select from a list of 
eight possible concerns. In contrast, fewer than one in three (29 
percent) are concerned about the impact of future terrorist attacks on 
the stock market.

              Concerns and Worries About the Stock Market *
                                (n=1,917)
------------------------------------------------------------------------

------------------------------------------------------------------------
Fear of losing money.......................................   63 percent
------------------------------------------------------------------------
Lack of ethics in the marketplace..........................   61 percent
------------------------------------------------------------------------
The state of the economy...................................   55 percent
------------------------------------------------------------------------
Significant stock market declines..........................   46 percent
------------------------------------------------------------------------
Accuracy of published financial statements.................   38 percent
------------------------------------------------------------------------
Lack of confidence in the stock market generally...........   31 percent
------------------------------------------------------------------------
Fear that future terrorist attacks may cause...............   39 percent
------------------------------------------------------------------------
No concerns................................................    4 percent
------------------------------------------------------------------------
Other (specify)............................................    3 percent
------------------------------------------------------------------------
* Multiple responses accepted.

Problems for the Securities Industry
    Negative perceptions of the industry run wide and deep. Dishonesty 
(62 percent), lack of accountability (62 percent), and lack of consumer 
protection and means of recourse for harmed investors (60 percent) are 
those issues respondents are most likely to view as ``big problems'' 
for the industry. Over half view insider trading (57 percent) and lack 
of internal controls and checks (52 percent) as ``big problems.''

                                      Problems for the Securities Industry
                                                    (n=1,917)
----------------------------------------------------------------------------------------------------------------
                                                                                                   Don't know/
                                                Big problem     Small problem    Not a problem       Refused
                                                 (percent)        (percent)        (percent)        (percent)
----------------------------------------------------------------------------------------------------------------
Dishonesty..................................               62               28                2                8
----------------------------------------------------------------------------------------------------------------
Lack of accountability......................               62               25                3               10
----------------------------------------------------------------------------------------------------------------
Lack of consumer protection and means of                   60               27                3               11
 recourse for harmed investors..............
----------------------------------------------------------------------------------------------------------------
Insider trading.............................               57               30                2               11
----------------------------------------------------------------------------------------------------------------
Lack of internal controls and checks........               52               28                4               15
----------------------------------------------------------------------------------------------------------------
The poor economy............................               47               33               11                8
----------------------------------------------------------------------------------------------------------------
Insufficient disclosure of risks to                        46               33                9               12
 investors..................................
----------------------------------------------------------------------------------------------------------------
Lack of confidence from the public..........               44               39                6               12
----------------------------------------------------------------------------------------------------------------
Incompetent fund managers...................               44               39                5               12
----------------------------------------------------------------------------------------------------------------
Incompetent brokers.........................               42               41                4               13
----------------------------------------------------------------------------------------------------------------
Conflict of interest between fund managers                 42               34                6               18
 and fund shareholders......................
----------------------------------------------------------------------------------------------------------------
Transaction fees that are too high..........               42               40                7               13
----------------------------------------------------------------------------------------------------------------
Conflict of interest between brokers and                   40               37                7               21
 shareholders...............................
----------------------------------------------------------------------------------------------------------------
Conflict of interest between fund board of                 40               32                5               23
 directors and fund managers................
----------------------------------------------------------------------------------------------------------------
Market volatility...........................               31               43               13               13
----------------------------------------------------------------------------------------------------------------

Need for Changes in Regulations
    Of all respondents, close to eight in ten (78 percent) feel that 
the regulation of the securities industry should be stronger than it is 
today. One in three (33 percent) feel that it should be much stronger, 
while 45 percent feel that it should be somewhat stronger. Only 1 
percent feel that it should be looser. Approximately one in five (21 
percent) report that they do not know whether regulation of the 
industry should be stronger or looser than it is today.

         Should Regulation of the Securities Industry be . . . ?
                                (n=1,917)
------------------------------------------------------------------------

------------------------------------------------------------------------
Much stronger..........................................       33 percent
------------------------------------------------------------------------
Somewhat stronger......................................       45 percent
------------------------------------------------------------------------
Somewhat looser........................................        1 percent
------------------------------------------------------------------------
Much looser............................................        0 percent
------------------------------------------------------------------------
Don't know.............................................       21 percent
------------------------------------------------------------------------
Refused................................................        1 percent
------------------------------------------------------------------------

Conclusion
    Our 2004 survey of 50 and older investors was conducted in order to 
examine perceptions of selected securities industry practices, the 
stock market, and financial services professionals. Our survey reveals 
that most investors feel that the cost-related issues of price per 
share and fees are more important in stock transactions than are other 
issues such as speed of transaction. Findings also reveal widespread 
concerns among investors related to dishonesty in the securities 
industry, lack of ethics, lack of accountability, and lack of consumer 
protection, suggesting that much remains to be done to restore investor 
confidence.
    As difficult as it is to enact and promulgate corrective 
legislation and regulation, it will take additional time to arrest 
investor anxiety, to restore public confidence in the industry, and to 
measure the consequences of efforts to modernize the NMS structure. We 
believe that the SEC has taken a number of concrete steps to address a 
range of market performance issues that had been neglected in recent 
years. But additional prudent steps are clearly needed.
    I would be happy to answer any questions you may have.
