[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]




 
                     REGULATION NMS: THE SEC'S VIEW

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                    GOVERNMENT SPONSORED ENTERPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                             MARCH 15, 2005

                               __________

       Printed for the use of the Committee on Financial Services

                            Serial No. 109-9


                    U.S. GOVERNMENT PRINTING OFFICE
23-736                      WASHINGTON : 2005
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana          PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio                  MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, Jr., North          HAROLD E. FORD, Jr., Tennessee
    Carolina                         RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
VITO FOSSELLA, New York              STEVE ISRAEL, New York
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TIBERI, Ohio              JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
TOM FEENEY, Florida                  STEPHEN F. LYNCH, Massachusetts
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina   AL GREEN, Texas
KATHERINE HARRIS, Florida            EMANUEL CLEAVER, Missouri
RICK RENZI, Arizona                  MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania            DEBBIE WASSERMAN SCHULTZ, Florida
STEVAN PEARCE, New Mexico            GWEN MOORE, Wisconsin,
RANDY NEUGEBAUER, Texas               
TOM PRICE, Georgia                   BERNARD SANDERS, Vermont
MICHAEL G. FITZPATRICK, 
    Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina

                 Robert U. Foster, III, Staff Director
  Subcommittee on Capital Markets, Insurance and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

JIM RYUN, Kansas, Vice Chair         PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              DENNIS MOORE, Kansas
FRANK D. LUCAS, Oklahoma             MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
EDWARD R. ROYCE, California          RUBEN HINOJOSA, Texas
SUE W. KELLY, New York               JOSEPH CROWLEY, New York
ROBERT W. NEY, Ohio                  STEVE ISRAEL, New York
VITO FOSSELLA, New York,             WM. LACY CLAY, Missouri
JUDY BIGGERT, Illinois               CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
J. GRESHAM BARRETT, South Carolina   BRAD MILLER, North Carolina
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
TOM FEENEY, Florida                  NYDIA M. VELAZQUEZ, New York
JIM GERLACH, Pennsylvania            MELVIN L. WATT, North Carolina
KATHERINE HARRIS, Florida            ARTUR DAVIS, Alabama
JEB HENSARLING, Texas                MELISSA L. BEAN, Illinois
RICK RENZI, Arizona                  DEBBIE WASSERMAN SCHULTZ, Florida
GEOFF DAVIS, Kentucky                BARNEY FRANK, Massachusetts
MICHAEL G. FITZPATRICK, 
    Pennsylvania
MICHAEL G. OXLEY, Ohio


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    March 15, 2005...............................................     1
Appendix:
    March 15, 2005...............................................    31

                                WITNESS
                        Tuesday, March 15, 2005

Donaldson, Hon. William H., Chairman, U.S. Securities and 
  Exchange Commission............................................    14

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    32
    Brown-Waite, Hon. Ginny......................................    34
    Fosella, Hon. Vito...........................................    35
    Gillmor, Hon. Paul E.........................................    37
    Hinojosa, Hon. Ruben.........................................    38
    Kanjorski, Hon. Paul E.......................................    40
    King, Hon. Peter T...........................................    41
    Donaldson, Hon. William H....................................    42

              Additional Material Submitted for the Record

Donaldson, Hon. William H.:
    Written response to questions from Hon. Judy Biggert.........    80
    Written response to questions from Hon. Ginny Brown-Waite....    82


                     REGULATION NMS: THE SEC'S VIEW

                              ----------                              


                        Tuesday, March 15, 2005

             U.S. House of Representatives,
        Subcommittee on Capital Markets, Insurance,
               and Government Sponsored Enterprises
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:13 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ryun, Shays, Manzullo, 
Royce, Oxley, Fossella, Biggert, Kennedy, Tiberi, Barrett, 
Feeney, Hensarling, Davis of Kentucky, Fitzpatrick, Kanjorski, 
Ackerman, Sherman, Moore, Ford, Crowley, Israel, Baca, Lynch, 
Scott, Velazquez, Wasserman Schultz, and Maloney.
    Mr. Baker. [Presiding.] Good morning. I would like to call 
the meeting of the Subcommittee on Capital Markets to order.
    Today, the committee meets to receive comments from the 
chairman of the SEC on a proposed initiative now under review 
known as Reg NMS.
    I must confess to the committee that I do not come to this 
issue with my usual passionate neutrality. I have a 
predetermined perspective, and my testimony this morning will 
reflect that.
    This is the committee's sixth market structure hearing over 
the past 18 months. Needless to say, we all understand that 
this is a vitally important subject for U.S. investors and the 
capital markets generally. Philosophically, I have always been 
a very market-based person and to support new regulatory 
intervention is something that should be viewed as a last 
resort in my opinion. This fundamental approach is particularly 
relevant when considering the issue before us today.
    Reg NMS addresses four principal areas. Understandably, 
most of the discussion has centered on its one most 
controversial aspect, the trade-through rule. I have opposed 
the trade-through rule based on free market principles and have 
been an advocate for its repeal. It may have made sense at 
times in the past, but today it is a relic of a bygone era. I 
believe it to be basic protectionism, and in the 21st century, 
investors should be able to choose speed, anonymity and 
certainty over what is generally seen as an advertised, but not 
a guaranteed best price. I do not believe that choice should be 
taken away from the investors.
    Moreover, the trade-through rule has not been enforced on a 
consistent basis. Indeed, the New York Exchange, the rule's 
most ardent supporter, is also one of the more frequent 
violators. The commission has been presented with what I 
believe to be clear data supporting this claim, but is poised 
to act in the face of the clear facts to the contrary. The 
trade-through rule has certainly accomplished at least one 
thing. It has helped the New York Exchange maintain about 80 
percent market share in listed securities. By contrast, the 
Nasdaq, which operates without such a rule, has about 20 
percent market share in Nasdaq securities, with the rest 
divided up among INET, ARCA and others.
    From this fact alone, it is clear who is subject to 
competitive forces and which market is protected. The bottom 
line is the trade-through rule is anticompetitive, anti-
investor, and antiquated. So what is being proposed in the face 
of the evidence? Not to repeal it, but amazingly to extend it 
to other market participants as well. I cannot come to a 
conclusion that makes this suggestion make sense. In a very 
similar or basic observation, it is like selling your car and 
buying two horses, based on the view you will save money on 
parking fees. I would not think that a well-advised strategy.
    The Nasdaq market has never been part of the inter-market 
trading system and therefore does not have a trade-through 
rule. According to some independent observers, it has developed 
into the most competitive marketplace for trading stocks. The 
Nasdaq has thrived since the adoption of the over-handling 
rules and the advent of ECNs in the late 1990s. Three major 
markets, INET, ARCA and Nasdaq all compete to trade the same 
securities without a trade-through rule. There are more limit 
orders with Nasdaq and roughly the same number of trade-
throughs as compared to the listed markets.
    Two arguments are offered by the SEC in support of the 
trade-through expansion: that the rule is needed to increase 
limit orders and to reduce trade-throughs, both laudable goals 
which I support. There is only one problem I find with the 
analysis: This plan will not achieve that end. It is as if 30 
years of trading history mean nothing and 3 months of 
rulemaking is everything. Competition in Nasdaq stocks is 
intense. No market has more than 30 percent share, and the 
competition has been proven worthwhile for investors. As Matt 
Andresen stated before the committee last month, based on our 
own experience trading large volumes of both Nasdaq and listed 
equity securities, we believe strongly that execution quality 
of the Nasdaq is significantly better than that of the listed 
marketplace.
    The commission justifies the re-proposed Regulation NMS 
with various studies conducted by the Office of Economic 
Analysis, known as the OEA. Several commenters have clearly 
outlined the basics which are flaws of these studies. That is, 
the analysis had a predetermined outcome to make the Nasdaq 
appear inferior in operations to the NYSE. As to the trade-
through study, with the acquisition of brute technologies and 
the smart-order routing capabilities, Nasdaq has been able to 
lower trade-through rates in Nasdaq stocks from 2.5 percent in 
2003 to the figure of 1.5 percent today.
    In addition to many trade-throughs that were incorrectly 
accounted for as trade-throughs, actually involved lock and 
cross-market or block trades, according to one commenter, 
excluding large trades during cross-markets, the trade-through 
rate would drop to .08 percent. Additionally, studies rely on 
stale quotes, which traders rightly trade through. If 
accessible quotes had been utilized and excluded stale quotes, 
the trade-through rate would have been even lower. Also, the 
OEA overestimated the shares traded-through by, including the 
entire size of the order that traded through when calculating 
the size of the trade-through, rather than the size of the 
displayed quote, which was actually traded through.
    The OEA used a statistically biased example of 4 uncommonly 
volatile days. Even if 4 days were studied, the scope of the 
study is very limited. With regard to the match pair study, the 
study actually shows Nasdaq market quality is on par with the 
NYSE. Over one-quarter of the stocks in the sample are not 
eligible for NYSE listing, and only 10 percent are from the 
Nasdaq 100. The S&P Index study overstates the effective 
spreads of Nasdaq stocks and thus concludes that the Nasdaq has 
inferior execution, but the OEA employs a methodology that 
favors high-priced NYSE stocks and also uses statistics from a 
single month.
    The volatility study includes results that at least one 
commenter has attempted and failed to be able to reproduce. The 
SEC's short-term volatility estimates are more than three-times 
higher than that of the Nasdaq, and even higher than those in 
an NYSE study upon which the SEC findings are based.
    These are the four studies cited by the SEC to support the 
trade-through. For all the reasons I have outlined, I will 
follow our hearing today with a letter to Chairman Donaldson 
requesting information pertinent to these documents, and 
respectfully request the committee be granted sufficient time 
to review the information before the Commission moves to final 
promulgation.
    In addition to the flawed studies, there is nothing even 
approaching an industry consensus on the advisability of 
expansion of the trade-through. Market participants including, 
but not limited to, Nasdaq, Instinet, ARCA, TIAA-CREF, 
Bloomberg, Fidelity, Schwab, Ameritrade, UBS, Morgan Stanley, 
J.P. Morgan Chase, I-Trading and Securities Traders Association 
have all openly opposed extending the flawed regulation to the 
Nasdaq marketplace. We should not be imposing new regulatory 
regimes under these circumstances.
    Along with substantive concerns, the process itself has 
troubled me. When the original NMS was issued, the Commission 
requested public comment, whether there even ought to be a 
trade-through. The comments ran, from reports, about three to 
one against the trade-through in any form. So how does it make 
sense to not only keep it, but now extend it? Further, the re-
proposal was issued 90 days ago, and appears to be on the verge 
of adoption. As you contrast this with the process for the 
Nasdaq to have its exchange application considered, it was 
filed in March 2001 and yet there is no action to move forward 
on that application.
    There are recommendations now pending that the Commission 
adopt which equate to the most sweeping reforms our markets 
have experienced in 30 years, resulting from only a 3-month 
public comment period. I do not understand why the SEC has 
disregarded the results of its own ETF pilot fashioning 
Regulation NMS. Under the pilot, the SEC granted a deminimus 
exemption to current trade-through rules for three ETFs. Never 
has the trading been more liquid and efficient. It has been an 
overwhelming success by any measure. Indeed, it accomplished 
everything trade-through opponents predicted it would, but the 
Commission has ignored this result.
    Paradoxically, less than 2 weeks before the SEC proposed 
Regulation NMS where it extends the trade-through to Nasdaq, it 
extended for a third time the terms of this pilot that 
technically removes the trade-through. I am not aware of any 
public adverse comment concerning the success of these pilots 
or their continuing extension. It appears the Commission is 
having it both ways: on the one hand saying that a trade-
through is needed throughout the market; and on the other, 
removing it from the trading of certain securities. This needs 
to be made clear.
    When Congress created the National Market System in 1975, 
the stated congressional intent was to ensure economically 
efficient execution of securities transactions and fair 
competition among brokers and dealers, and between exchange 
markets and markets other than exchange markets. Any fair 
reading would suggest that Reg NMS with its preservation and 
expansion of the trade-through rule is inconsistent with these 
underlying principles.
    Regrettably, I feel I must say it. Regulation NMS ranks up 
there with the worst public policy I have seen proposed for the 
securities markets in my tenure in Congress. I would hope that 
there would be serious consideration, at least to some of the 
concerns I have recited, before the Commission acts in this 
matter. I sincerely do appreciate the Chairman's willingness to 
appear here today to listen to our concerns and make comments 
as to the direction the Commission may take. I hope we are able 
to work together going forward to address the concerns raised.
    Mr. Kanjorski?
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Chairman, we meet once again to discuss the important 
issue of the regulation of our capital markets generally, and 
the trade-through rule specifically. This time we will hear 
again from the chairman of the Securities and Exchange 
Commission.
    The ongoing deliberations over our national market system 
have engendered strong emotions and considerable debate. As my 
colleagues already know from our extensive investigations into 
these matters, market structure is also an extremely complex 
subject.
    We are, Mr. Chairman, at a crossroads. A variety of agents 
in our equity markets have questioned one or more aspects of 
the regulatory system governing our national markets during the 
last several years. Technological advances and competitive 
developments are also forcing us to confront a number of 
important decisions.
    During his previous testimony before our panel concerning 
these matters, SEC Chairman Donaldson noted that in pursuing 
any plan to fix those portions of the national market system 
experiencing genuine strains, we must ensure that we do not 
disrupt those elements of our markets that are working well. 
Chairman Donaldson knows that I share his views in these 
matters. We should not pursue change for change's sake.
    In his recent testimony before the Senate Banking 
Committee, Chairman Donaldson also offered some insights into 
the Commission's deliberations regarding its broad set of 
proposals to update the regulatory structure of our stock 
markets. He focused his comments last week on the trade-through 
rule. In particular, he noted that the regulation advances 
three important policy goals: it ensures best execution; it 
promotes fair and orderly markets to get the best price; and it 
advances market depth and liquidity.
    Chairman Donaldson will, as I understand, expand on those 
views today by providing us with more analysis and detail about 
his thinking regarding these matters. In his comments today, I 
hope that Chairman Donaldson will once again express his 
support for the trade-through rule. From my perspective, this 
standard is one area of our regulatory structure that has 
worked well for nearly three decades. As one of the foundations 
of our national market system, this rule has ensured that all 
investors get the best price that our securities markets have 
to offer regardless of the location of a trading transaction.
    Today, I also suspect that many of my colleagues will focus 
on the Commission's newest proposal to alter the trade-through 
rule when asking questions of Chairman Donaldson. In addition 
to applying the trade-through rule to all securities 
marketplaces, the Commission's latest plan for updating the 
national market system includes two alternatives for 
implementation: the market best bid or offer alternative and 
the voluntary depth alternative.
    The voluntary depth alternative would almost certainly 
result in only one way for markets to differentiate themselves, 
namely, how much they are willing to pay other market 
participants for their order flow. In my view, promoting 
competition based on payment for order flow will prove 
detrimental in the long term to average retail investors 
because of the conflicts of interest it creates. This issue is 
one that the Commission should carefully study.
    The incremental approach contained in the market best bid 
or offer alternative is therefore the preferable option going 
forward. The adoption of this alternative will also help to 
ensure that the United States maintains its global leadership 
in our financial markets.
    In closing, Mr. Chairman, it is my very strong hope that 
the Commission in working to finalize any changes in the market 
structure rules will make certain that any regulation it 
promulgates will provide an improvement over the existing 
regulatory regime and protect the interests of retail 
investors.
    I look forward to receiving the testimony of Chairman 
Donaldson.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 40 in the appendix.]
    Mr. Baker. I thank the gentleman for his statement.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    Chairman Donaldson, welcome back to the committee. In case 
you do not get enough of us today, you will be coming back for 
more when you return in April to talk to us about Sarbanes-
Oxley. We look forward to having you there again.
    Today, our topic is Reg NMS, and I want to begin by 
commending Chairman Baker's outstanding leadership on the 
important and difficult issues raised by the proposal before us 
today, Regulation NMS. I have found the Financial Services 
Committee's five previous hearings on this Securities and 
Exchange Commission initiative to be extremely informative. I 
am only sorry that I missed the famous hearing in New York. 
Perhaps we could have an instant replay of that at some point.
    The threshold questions for me are, what kind of 
marketplace do we want to create for the 21st century? And in 
what direction do we want the markets to go as they evolve and 
adapt to technology?
    My approach to these complex issues is governed by the 
belief that Congress should work to reduce or eliminate any 
regulatory advantages that inhibit competition and artificially 
preserve market share. As an advocate of free markets, I 
believe that we should move the National Market System toward 
more robust competition, more investor choice, and greater 
investor protection. Of course, we must be guided by best 
execution for the investor. If an investor misses the best 
price, that is not best execution. If a trade cannot be 
completed, that is not best execution.
    At the subcommittee's spirited hearing last month, six 
major market participants, Nasdaq, Instinet, Bloomberg, Knight, 
Schwab, and Citadel, all expressed opposition to the portion of 
the Reg NMS proposal that would preserve and expand the trade-
through rule. As a matter of applying free-market policy, I 
share that view. While the trade-through rule had its purpose 
in an earlier era, today's technology has rendered it 
regulatory and anti-competitive. As I discussed at the last 
hearing, let's remember the broker's fiduciary duty to obtain 
best execution of his clients' orders is a more efficient way 
of ensuring investor protection.
    Therefore, it does not make sense, it seems to me, to 
extend the trade-through rule to the Nasdaq market, which has 
operated efficiently and competitively without it. I can think 
of no compelling reason to expand the rule, with its associated 
and quite significant compliance costs, to the vibrant Nasdaq 
marketplace.
    If the SEC were to modify the proposal so that the trade-
through rule is not expanded, that is an outcome that I think 
most interested parties could support. It strikes me as a 
sensible compromise that would improve the status quo. A final 
rulemaking that resists the urge to over-regulate the Nasdaq 
market would include significant improvements over the existing 
regulatory structure. The Reg NMS trade-through provision as 
applied to only exchange-listed stocks would be more 
enforceable than the current rule and would recognize the 
difference between automated and manual markets.
    Reg NMS, as modified, would encourage the New York Stock 
Exchange to continue to modernize its market. The hybrid 
proposal crafted by the exchange is an important step in this 
direction. I want to commend John Thain for his leadership and 
vision. I know he is committed to serving investors in this age 
of rapidly changing technology.
    We are nearing the end of a long process. I would like to 
commend the Commission and its staff for their hard work over 
the past several years. This is a difficult and complex area, 
and I certainly recognize the good intentions and good will of 
people on all sides of this important issue.
    Mr. Chairman, I thank you again for your leadership and I 
yield back.
    Mr. Baker. I thank the Chairman.
    Mr. Ackerman?
    Mr. Ackerman. No, thank you.
    Mr. Baker. Mr. Ford?
    Mr. Crowley?
    Mr. Crowley. Thank you, Mr. Chairman.
    I would like to thank Chairman Baker and ranking member 
Kanjorski for holding this hearing today on Reg NMS. I also 
want to welcome Chairman Donaldson here today who will discuss 
with us where the SEC is in their process of completing Reg NMS 
and how they plan to modernize and strengthen the regulatory 
structure of the U.S. equity markets.
    The Chairman and I were able to speak briefly privately a 
few weeks back where I expressed to him my concerns about the 
SEC's proposed voluntary depth alternative. Without getting 
into depth here on the subject, I do hope that in the final 
rule this voluntary depth alternative will be rejected.
    Additionally, I welcome the discussion of applying the 
market BBO alternative across all markets and to all NMS 
stocks, under the guise of ensuring that investors will be 
treated the same regardless of the stocks they are trading. 
While I know some argue that the trade-through rule is 
antiquated and impedes competition by forcing their businesses 
to operate at the speed of the slowest market, I disagree.
    I agree with your comments before the Senate Banking 
Committee on the 9th of this month where you stated, ``The 
trade-through rule is designed to promote fair and orderly 
markets and investor confidence by providing greater assurance 
that limit orders displaying the best prices are not bypassed 
by trades at inferior prices.''
    Additionally, I was concerned with the comments in your 
prepared testimony for this morning whereby you reference an 
SEC staff study found that trade-through rates are significant 
for Nasdaq stocks; that approximately 98,000 Nasdaq trades per 
day receive a price that is inferior to a displayed and 
accessible quotation. I share your concerns that thousands of 
retail investors each day may unwittingly be receiving an 
inferior execution of their orders in the Nasdaq stocks.
    I also agree with your testimony whereby you stated, ``The 
relevant data does not support any sweeping claim that trading 
in Nasdaq stocks now is generally more efficient than trading 
in the New York Stock Exchange stocks.''
    Finally, I believe that if the SEC does not apply the 
trade-through rule across all markets, regulatory arbitrage 
will be the result. While professional traders will profit in a 
market with no prohibitions, those profits will not be passed 
on to our consumers. This issue is about the uniformity of 
markets. If price protection is good for investors trading 
General Motors on the New York Stock Exchange as a New York 
Stock Exchange-listed stock, then it should also be extended to 
investors trading Microsoft, a Nasdaq-listed stock. Again, this 
highlights the need for the extension of the trade-through 
protections to all U.S. equity markets. The trade-through rule 
has helped smaller investors smooth the path from Main Street 
to Wall Street.
    Finally, Mr. Chairman, in the Chairman's opening statement, 
I would appreciate him, if he could, comment on his thoughts on 
the New York Stock Exchange's hybrid proposal and if he 
believes it represents a dramatic and positive change; and is 
it consistent with the principles behind Reg NMS? The hybrid 
model demonstrates that once approved, the New York Stock 
Exchange will marry the best of electronic trading and the 
auction market. Investors will have choices. If they want 
speed, certainty and anonymity of execution, they will have it. 
If they want the opportunity for price improvement, they will 
have that as well.
    I look forward to your testimony, Mr. Chairman, this 
morning. With that, I yield back the balance of my time.
    Mr. Baker. I thank the gentleman.
    Mr. Ryun?
    Mr. Ryun. Thank you, Mr. Chairman. I appreciate your 
scheduling this hearing to discuss the important issue of 
market structure, and specifically the SEC's proposed Reg NMS.
    Chairman Donaldson, thank you for being with us today. We 
look forward to hearing your expertise on this particular 
issue. I look forward to your unique perspective on the pending 
proposal. I am especially interested to hear your thoughts on 
the merits of expanding the trade-through rule to the Nasdaq.
    While I certainly support the careful governance of the 
securities industry and am mindful of the oversight of Congress 
and this panel, I am generally inclined to only look for 
additional government intervention or regulation when something 
is not functioning properly.
    There is an old adage that says if it is not broke, don't 
fix it. I am afraid that expanding the trade-through rule at 
this time could be failing to heed that advice. It seems to me 
the Nasdaq market has functioned quite well without the rule 
and I am curious about the reasons that the SEC would look to 
expand that rule now.
    I applaud the New York Stock Exchange for the steps it has 
taken to modernize its marketplace. I am also pleased to see 
the other items and the Reg NMS that they are widely agreed 
upon. However, I am afraid that expanding the controversial 
trade-through rule without allowing the changes that without 
wide support would be implemented, that could lead to 
problematic results.
    I also feel that it would be prudent to allow the New York 
Stock Exchange's new hybrid system some time to operate before 
injecting another dramatic change into the marketplace. I look 
forward to your thoughts and your expertise on these issues, 
and I yield back my time.
    Mr. Baker. I thank the gentleman.
    Mr. Israel?
    Mr. Israel. Thank you, Mr. Chairman.
    Obviously, we have already heard quite a diversity of 
opinion on the trade-through rule, so let me offer my own as 
briefly as I can.
    Let me begin by welcoming Chairman Donaldson and stating 
that I certainly appreciate the importance and the enormity of 
the task that the SEC has undertaken. Clearly, our markets must 
be modernized if they are to maintain their status as the most 
competitive and most dynamic in the world.
    I do, however, have several significant concerns about the 
regulation as proposed, and also regarding recent movement to 
change the application of the trade-through rule. In the past 
in this committee, I have gone on record expressing my 
reservations about the proposed virtual consolidated limit 
order book structure, and those reservations still stand.
    However, I do want to weigh in on the conversation that we 
have already had today about the importance of maintaining the 
integrity of the trade-through rule. I fear that any weakening 
of the trade-through rule would take away investors' assurances 
that their representatives are working to execute their trades 
at the best price. As we are all aware, the difference between 
the best price and the second-best price can be very 
significant, more than four cents per share for the S&P 100 
stocks listed on the New York Stock Exchange.
    These additional expenses would affect all investors large 
and small. But the brunt of them would be borne by small 
investors who are less able to monitor closely execution costs 
and to question their brokers or agents about prices received. 
Investors deserve and demand the highest quality order 
executions and the best price on all transactions.
    I want to emphasize the word ``all,'' as I am concerned by 
recent talk of a carve-out for the Nasdaq. Simply put, I 
believe that the trade-through rule is good for investors and 
therefore all investors deserve the benefits of it, whether the 
stocks they seek to purchase are New York Stock Exchange-listed 
or Nasdaq-listed.
    I want to particularly note that I believe that one of the 
strongest protections available today is the ability for 
investors to be made whole when a trade-through occurs. Today, 
this protection is available on the New York Stock Exchange, 
but not on the Nasdaq where there is no trade-through rule. The 
SEC's current proposal to extend this protection to investors 
in Nasdaq-listed securities makes sense, and I would strongly 
urge us not to yield to recent calls to create a Nasdaq carve-
out.
    The New York Stock Exchange has been the most prominent 
symbol of capitalism in the world. I believe that seeking to 
emulate its reputation for transparency in all transactions and 
ensuring the best price for all investors, large or small, at 
all of our markets can only improve our national economy.
    I look forward to a continuing discussion of these and 
other issues. Thank you, Mr. Donaldson, for joining us today, 
and I yield back the balance of my time.
    Mr. Baker. I thank the gentleman.
    Ms. Biggert?
    Mrs. Biggert. Thank you, Mr. Chairman, for holding this 
very important hearing today.
    Thank you, Mr. Donaldson, for being here today.
    As we all know, the Securities and Exchange Commission is 
charged with protecting investors and maintaining the integrity 
of the securities market. Today we will examine whether a 
proposed rule by the SEC follows the SEC's mission and vision. 
As we conduct an analysis of the proposed rule, let us keep in 
mind that the Government is not in the business of innovation. 
Innovation is birthed out of the genius of our entrepreneurs 
and market participants. It is a response to investor demand.
    I am pleased that the SEC has moved forward with its work 
on this regulation, and I would argue that probably 90 percent 
of the proposal would benefit our markets, market participants 
and investors. I also believe that the SEC should approve the 
New York Exchange's hybrid proposal. However, I cannot at this 
time understand the rationale for the trade-through rule that 
we have heard so much about.
    I understand that the vast majority of the Commission is 
not in agreement over the rule and the rule has sparked healthy 
discussions and debate, but it appears that the critics' view 
of the rule is unnecessary at this point in time. It has been 
brought to my attention that some of the SEC intends to apply 
the trade-through to the Nasdaq marketplace which currently has 
no trade-through rule, as well as the New York Stock Exchange, 
which currently does have the rule.
    As the SEC's statistics show, there are only a small number 
of trade-throughs in the Nasdaq marketplace, about 2.5 percent 
of the trades. More than half of these trades, though, are 
outside the quote for only one penny per share, and the Nasdaq 
market is already dominated by limit orders. In addition, Mr. 
Chairman, I am concerned that the trade-through rule would not 
enhance competition in the marketplace or prove effective in 
any way. I understand that the SEC has worked on this issue for 
quite some time, but I also understand that the broader mission 
of the SEC, this committee and Congress should be first and 
foremost to uphold free market values: competition, rules that 
are fair, and effective enforcement of those rules because that 
is what makes America the most economic leader in the world.
    In this vein, I have great concern about the anti-
competitive nature of the trade-through rule. The Nasdaq market 
is exhibit number one on why we do not need the Government-
mandated trade-through rule. Operating without trade-through, 
it is a fiercely competitive marketplace that provides 
investors with superior trade execution. Equally important, we 
should ensure that the investors are protected. Market 
participants are charged with the mission of providing 
investors the best possible service. Investors should be able 
to trust the systems and businesses in which they can easily 
and intelligently invest and move their money.
    A modernized U.S. market structure should enhance 
competition, foster the development of safe and sound business 
products and practices, allow for innovation, and maintain an 
efficient and transparent system.
    I look forward to hearing from our witness today regarding 
Reg NMS and how elements of the current proposed regulation 
will foster or hinder competition in the U.S. equity markets.
    Thank you very much. I yield back.
    Mr. Baker. I thank the gentlelady.
    Mr. Scott?
    Mr. Scott. Thank you, Chairman Baker.
    Good morning, Chairman Donaldson. It is good to have you 
before the committee once again to discuss the Securities and 
Exchange Commission's proposal to modernize the national market 
system.
    I understand that the proliferation of electronic computer 
networks have changed the way that investors trade in the 
markets, which is the reason the SEC needs to update the 
current national market system. The witnesses from the hearing 
held last month provided a wide range of opinions on the best 
approach for assuring inter-market price protection. The SEC 
has heard comments on its proposed rule from more 
constituencies than have appeared before this committee.
    So I look forward to your testimony to better understand 
how the SEC is balancing the often-contradictory comments about 
the proposed rule. One question that I would like to focus on 
today is, if the ultimate policy decision is to try to 
strengthen and expand existing trade-through protection, would 
not it make sense to do so in an incremental fashion?
    Also, I would like to weigh the potential costs to 
participants in relation to the benefits that these new rules 
would provide to the markets. As this committee reviews these 
proposed regulations, we must keep in mind the need to have an 
efficient national system that provides the best prices for a 
wide variety of investors. Considering the concerns with 
inadequate retirement savings of Americans, this rule should 
certainly protect the interests of long-term investors.
    So I look forward to your testimony today and certainly 
getting involved in some of these important questions and 
getting your very important answers.
    Thank you, Mr. Chairman.
    Mr. Baker. I thank the gentleman.
    Mr. Barrett?
    Mr. Davis?
    Mr. Fitzpatrick?
    Does another member have an opening statement? Mr. 
Hensarling?
    Mr. Hensarling. Thank you, Mr. Chairman. Mr. Chairman, 
thank you for holding this hearing. This is an important matter 
that deserves the attention that you have given it.
    I also want to welcome Chairman Donaldson to this committee 
and take a minute to express some concerns that I have about 
the SEC's currently proposed Reg NMS. Clearly, this is a 
controversial matter among many well-established and well-
respected parties in the market who represent a wide variety of 
both small and large individual and institutional investors.
    It is my hope that any final rule issued by the SEC might 
achieve greater consensus among the Commissioners with every 
commissioner's concerns being properly considered. While I 
understand that consensus does not come easy, I hope that we 
are not again looking at another three-to-two vote on a matter 
of this magnitude.
    As I have mentioned before in this committee, I continue to 
have great concerns about any expansion to other markets of a 
rule that appears to be antiquated and the potential impact 
that further regulation might have on private sector 
innovation. Since an investor has a 98 percent chance of not 
being traded through, I hope we are not considering a remedy in 
search of a problem.
    I hope this debate continues to focus on what might 
strengthen competition, and thus what is best for the American 
investor.
    Thank you, Mr. Chairman. I yield back.
    Mr. Baker. I thank the gentleman for his statement.
    Ms. Velazquez?
    Ms. Velazquez. I have no statement.
    Mr. Baker. Thank you.
    Mr. Lynch?
    Mr. Lynch. Thank you, Mr. Chairman.
    Thank you, Chairman Donaldson, for being here today to help 
this committee with its work and discuss Reg NMS. I appreciate 
the efforts that you have put in to restore and maintain the 
integrity of the financial markets.
    I also want to thank the Chairman and the ranking member 
for holding the hearing today, which is just one in a series of 
hearings focusing on the potential impact of Reg NMS proposals.
    Chairman Donaldson, there are a number of issues that I 
hope that your testimony will address today. I hope that we 
come away from this hearing with a clear understanding of the 
goals of the SEC in moving forward with this proposed change to 
the national market system. I appreciate the SEC in taking a 
thoughtful approach in addressing these issues.
    When dealing with matters like this that are so complex, I 
think it is critical that all parties come to the table and 
talk through the potential impacts of such rule changes, 
especially ones that will have a broad-based impact on the 
financial markets. I believe through this series of hearings, 
the committee will establish an important forum for such 
discussions to take place.
    I hope above all that the SEC will be sensitive to the 
concerns that are raised in these hearings, and that they will 
pay attention and will move forward thoughtfully and work 
toward developing a consensus approach to the controversial 
issues on the table.
    Chairman Donaldson, it is my understanding that the SEC 
views the current trade-through rule as outdated. I understand 
that, but I am interested in learning from you today whether 
you believe that there is value in the SEC moving forward 
incrementally, rather than in one swell swoop. Just last week, 
Commissioner Atkins delivered remarks to security traders in my 
district in Boston expressing his view that the concern about 
unintended consequences is justified, given that there ``has 
never been a trade-through rule on Nasdaq and the trade-through 
rule has never been enforce in exchange-listed markets,'' close 
quote. He went on to ask if ``we are putting at risk the 
world's best security markets.''
    Chairman Donaldson, I am very interested in hearing your 
response to the concerns raised by Commissioner Atkins. 
Specifically, I am interested in learning more about the 
deliberation process for the scope of the rule. Did the SEC, 
for example, consider trying a pilot version that would apply 
only to the New York Stock Exchange or some subset of the 
markets? It would seem to make sense for us to determine the 
potential impacts of these changes on a smaller scale before 
engaging in a broad-based expansion on all markets.
    With that approach, we could minimize the unintended 
consequences and the potential disruption to the financial 
markets. If a pilot program has not been previously considered 
by the SEC, I would like to hear from you in your testimony 
whether this is something that the SEC is willing to look at.
    In a related area, I understand that the New York Stock 
Exchange is in the process of expanding the New York Stock 
Exchange direct, to expand the availability of automatic 
execution of limit orders without human intervention. I would 
be interested also in learning more about this hybrid market 
and how it will be impacted in Reg NMS.
    Again, Mr. Chairman, I want to thank you for your 
willingness to come here before this committee to help us with 
our work. I hope that many of the questions that we raise here 
today will eventually be answered. Thank you for being here 
today.
    Thank you. I yield back, Mr. Chairman.
    Mr. Baker. I thank the gentleman.
    Mr. Tiberi, did you have a statement?
    Mr. Fossella?
    Mr. Fossella. Thank you, Mr. Chairman.
    Since the start of the SEC's proposed Regulation NMS, it 
was clear that the cornerstone of debate would be centered on 
the trade-through rule. Although at first glance it would 
appear obvious that an investor large or small should get his 
or her order filled at the best price available, we learned 
that there is a lot more to this debate than just getting the 
best price. With new technologies, three other variables have 
become increasingly important: speed, certainty and size of 
execution. In fact, these three variables have been what have 
driven debate to the point of SEC action.
    The trade-through rule was established, an ITS rule, in an 
effort to both increase the connectivity between and among 
markets and to ensure that traders captured the best available 
execution price for their clients. Thus, if a broker on the 
floor of the Boston Exchange needs to buy 2,000 shares for a 
client, if the national best bid or offer is at the 
Philadelphia Exchange, the rule forces the broker to execute at 
the Philadelphia Exchange so that the investor is assured the 
best representation.
    The result was a national market system with competition 
and order competition throughout. While this rule was clearly 
of good intentions when first implemented, as the Nasdaq and 
ECN grew, an increased number of market participants found that 
the internal rules of the four base exchanges, particularly the 
New York Stock Exchange, prohibited them from obtaining the 
best price for their clients or investors. The first of the 
rules allows a specialist to hold an order up for 30 seconds 
before confirming or denying order execution. The second limits 
the size of an order that can be sent through the New York 
Stock Exchange electronic order submission to no more than 
1,099 shares.
    With these rules in place, I agree that a trader sitting at 
a trading desk outside the walls of the New York Stock Exchange 
has every right to be frustrated when they could be executing a 
trade immediately with certainty of execution in whatever size 
is available, but instead must either break the order up into 
lots of 1,099 shares, or hire a representative on the floor of 
the exchange who can execute the size their client is looking 
for. In one simple method, Reg NMS will eliminate the 
limitations experienced by traders outside the walls of the 
four base exchanges, allowing them to build and operate a 
marketplace with speed, certainty and size.
    In addition, Reg NMS allows investors not wanting to 
participate within a slow quote to trade around that quote. 
With the elimination of these rules, the trade-through rule 
will once again work in favor of the investor, with increased 
enforcement from the SEC.
    Finally, I believe the trade-through under Reg NMS when 
properly enforced will be a net plus for both the confidence of 
the individual investor that has grown skeptical of Wall Street 
during the past 5 years, and for the confidence of foreign 
investors who desire to invest money in the United States. The 
influx of capital from foreign investors has doubled over the 
past decade, and while likely to continue to increase as 
foreign countries become wealthier and as foreign companies 
decide to access U.S. capital by listing on the U.S. exchanges, 
I believe it is important that the United States provide a 
vibrant marketplace where all investors in all companies 
looking to participate in them can do so with confidence that 
there are regulatory backstops in place to protect them from 
being unfairly disadvantaged.
    In conclusion, I want to thank Mr. Donaldson, and I want to 
thank the SEC for their efforts. I think the staff has found a 
good balance in these proposals. It would open up the 
marketplace to competition, while maintaining principles that 
ensure the investor remains protected.
    Thank you. I yield back.
    Mr. Baker. I thank the gentleman.
    Mr. Moore? Mr. Moore stepped out.
    Mr. Baca?
    If no member seeks recognition for purposes of an opening 
statement, at this time I would like to turn to our witness 
today, Mr. William Donaldson, the chairman of the Securities 
and Exchange Commission.
    Your formal statement will be made part of the record. 
Please proceed at your own leisure, sir.

    STATEMENT OF HON. WILLIAM H. DONALDSON, CHAIRMAN, U.S. 
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Donaldson. Chairman Baker, ranking member Kanjorski and 
members of the subcommittee, thank you for inviting me to 
testify today on proposed Regulation NMS.
    All of the proposals included in Regulation NMS are 
designed to benefit and protect investors in the U.S. equity 
markets and to facilitate efficient capital formation by 
modernizing and strengthening the national market system. The 
national market system encompasses the stocks of more than 
5,000 listed companies which collectively represent more than 
$14 trillion in U.S. market capitalization held by investors.
    The commission is committed to assuring that investors and 
public companies have the fairest and most efficient markets 
possible for the these stocks. I welcome your continuing 
interest in an issue of such vital importance to investors and 
the economy.
    Given where we are in the process of considering Regulation 
NMS, my testimony today reflects my own views and not 
necessarily those of my fellow commissioners. In this regard, I 
must point out that the Commission and its staff are currently 
in the final stages of deliberation on the NMS proposals and 
the individual commissioners continue to weigh the complex 
policy considerations presented by the proposals. I have not 
reached a final judgment on how to balance these considerations 
myself.
    Regardless of what the Commission ultimately decides, this 
subcommittee and the public should have full confidence that 
the Commission has systematically and responsibly analyzed the 
relevant data and carefully considered the views of all 
commentators.
    Hopefully, my testimony today will convey some measure of 
the enormous amount of careful consideration that the 
Commission has devoted to these issues over the last several 
years, and indeed continues to devote today. In my written 
remarks, I have described this intensive and comprehensive 
process. Prior to formulating the specific Regulation NMS 
proposals, the Commission's review included multiple public 
hearings and roundtables, an advisory committee, three 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.
    This process continued after the Commission published the 
proposal for public comment in February of 2004. We held a 
public hearing on the proposals in April 2004, following which 
we published a supplemental request for comment to give the 
public an opportunity to respond to important developments at 
the hearing. The public submitted more than 900 comment letters 
on the original proposals, encompassing a wide range of views. 
The insights of the commentators on the proposals, as well as 
those of the NMS hearing panelists, contributed to significant 
improvements in our initial proposal.
    Consequently, rather than immediately adopting rules, the 
Commission re-proposed Regulation NMS in its entirety in 
December 2004 to afford the public an additional opportunity to 
review and comment on the details. In response, the Commission 
has received more than 1,500 additional comments which we are 
now in the process of analyzing. I might add that 1,400 of 
those comments were form letters with the same substance in 
them.
    In my written remarks for the record, I provided a brief 
overview of the four principal components of the regulation. I 
have also attempted to place the Commission's efforts in the 
broader context of fulfilling the mandate that Congress gave us 
in 1975 when it directed us, ``With due regard to the public 
interest, the protection of investors and the maintenance of 
fair and orderly markets, to use our authority under the 
Exchange Act to facilitate the establishment of a national 
market system for securities.''
    In particular, I discuss the insightful comment in the 
accompanying House report that emphasized, ``Investors must be 
assured that they are participants in a system which maximizes 
the opportunities for the most willing seller to meet the most 
willing buyer.'' Because I understand that the subcommittee is 
interested primarily in the trade-through aspect of our 
proposal, I will confine my oral remarks to this component.
    I would like to make three basic observations on this 
topic, and then I would be happy to elaborate further on these 
and the other aspects of Reg NMS if that would be helpful.
    First, I would observe that throughout the Commission's 
deliberations over the trade-through rule we have kept our eye 
on one overriding objective: the protection of investors, with 
particular attention to the concerns of small investors who may 
not have the resources to monitor the behavior of their agents, 
the brokers. The thrust of the proposed trade-through rule is 
actually quite simply stated. When an investor sends an order 
to a market, the market can either execute the order at the 
best price then being quoted on the national market system, or 
the market must send the order to the best quoting market.
    What does this mean? Two things. It means that a broker 
executing an order will be required to give that order the best 
price then available in any electronically accessible market 
even if the broker internalizes the order or would prefer to 
trade in another market that may offer the broker itself, if 
not the customer, an advantage. And second, it means that an 
investor who is willing to place an aggressively priced limit 
order on the book will not have his order ignored in favor of a 
less aggressively priced order. This second point is sometimes 
overlooked, so let me just expand on it a bit.
    The investor who is willing to post a limit order supplies 
liquidity to the marketplace. The limit order shows the market 
where trading interest lies and helps to establish the best 
price for stock trading. This investor provides a public 
service and the market as a whole benefits. But this investor 
acts at a cost to himself, for he reveals his trading interest. 
In effect, he offers an option that any other investor can 
exercise simply by placing a market order. He risks having that 
option exercised only when the market is moving against him, 
and losing the trade when the market is moving away from him. 
His only compensation is the ability to trade when his quote is 
the best quote available. If he does not get an execution, then 
he is not compensated and he will soon question why he posted 
the limit order.
    Worse, if he only gets an execution when the market is 
moving against him, we can begin to understand why he might 
choose not to offer the option to the market in the first 
place. A trade-through rule helps protect that investor for his 
willingness to supply liquidity to the market. So the trade-
through rule is in the most fundamental sense a rule that 
protects investors.
    This simple point can get lost in all of the sound and fury 
unleashed by vested interests for whom a market-wide trade-
through rule will require new ways of doing business. I know 
that members of this subcommittee have been lobbied just as 
hard as I have on this issue. I am sure that you have asked 
yourself, as I have myself, just exactly whose interests are 
being advocated.
    The second broad observation I would like to make is that I 
think it is useful to note that much of the hue and cry over 
the trade-through rule is somewhat wide of the mark. The most 
strident criticism that we hear about the trade-through rule 
appears to focus on the existing ITS rule, the intermarket 
trading system, a 35-year-old anachronism that has plainly 
outlived its usefulness. Let me be absolutely clear. The 
commission is not proposing to validate or extend the ITS rule. 
Quite the contrary, the Commission has proposed a strengthened 
and modernized trade-through rule, one that will work.
    The ITS rule is like a horse and buggy driving down the 
runway at Reagan Airport. That is because the key weakness of 
the ITS rule is that it does not distinguish between an 
electronic quote, one that can be executed immediately, and a 
manual quote, one that requires human beings to negotiate. The 
ITS rule has made it difficult for electronic marketplaces to 
compete with floor-based exchanges. In the process, it has 
helped floor-based markets maintain their competitive 
dominance. The commission has proposed to fix that problem.
    The only quotes entitled to protection under the proposed 
trade-through rule are electronic quotes, quotes that are 
immediately and automatically accessible. As so structured, the 
proposal addresses the main criticism that one hears about the 
ITS rule: that when a market is forced to send an order to New 
York or another floor-based market, it languishes while the 
specialist decides whether to trade with it. That cannot happen 
under the rule the Commission has proposed. If the quote is not 
automatic, then it is not protected.
    The proposal addresses other legitimate criticisms of the 
old ITS rule, such as the block-trade exception that results in 
the bulk of trade-throughs in listed stocks, and the weak and 
cumbersome satisfaction remedy that the old rule provides. In 
effect, the old rule does not prohibit trade-throughs. It 
merely tells a market that is traded through that it can go and 
complain to the other market and demand ``satisfaction.'' As 
you can imagine, such a weak remedy is weakly enforced.
    The commission's proposed rule would eliminate the broad 
block exemption in favor of more tailored benchmark and 
intermarket sweep exceptions, and we require market centers 
actually to install policies and procedures to prevent trade-
throughs, instead of merely providing for an after-the-fact 
satisfaction remedy.
    To my final observation, I want to emphasize that the 
trade-through rule that the Commission has proposed is pro-
competitive in the best tradition of the market reform 
initiatives that the Commission has spearheaded over the last 
number of years. As I explain in more detail in my written 
remarks, much of the public debate over the trade-through rule 
has focused on one type of competition: competition between 
markets. But we must remember that there are two kinds of 
competition that Congress has directed us to foster. One is 
competition between markets, like the competition between 
Nasdaq and Instinet, for instance. The other is competition 
between investors, or as it is usually called, competition 
between orders. Both kinds of competition are essential for 
vibrant and healthy remarks, as Congress recognized in 1975 
when it told us to perfect the national market system.
    Some of the powerful market centers and professional 
traders most vocal in this debate seem to downplay order 
competition. But the Commission has not forgotten that one of 
the great strengths of the U.S. markets, which do not exist in 
markets in other places in the world, is that trading interests 
of all types and sizes of investors is integrated to the 
greatest extent possible into a unified market system. Such 
integration ultimately works to benefit both retail and 
institutional investors. Retail investors will participate 
directly in the U.S. equity markets, however, only to the 
extent they perceive that their orders will be treated fairly 
and efficiently.
    I am concerned about retail investors' perception of 
unfairness when they display an order representing the best 
price for a stock, yet see that price bypassed by trading in 
other markets. A trade-through rule such as the one the 
Commission has proposed would help maintain the confidence of 
all types of investors in the U.S. equity markets.
    I will conclude by offering a few thoughts on the future of 
the Regulation NMS rulemaking process. Although I cannot 
predict the final outcome, I do believe it is extremely 
important that there be an outcome and that the outcome be 
reached soon. Many of the issues raised by Regulation NMS 
proposals have lingered for many years and caused serious 
discord among market participants.
    These issues have been studied and 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 many 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 in public companies.
    Although Nasdaq stocks are part of the national market 
system, some have suggested that the Commission should at this 
point adopt a trade-through rule only for exchange-listed 
stocks. Although this approach would preclude the possibility 
of unintended consequences in the Nasdaq market, no approach 
would have drawbacks that the Commission would need to consider 
carefully.
    One of the Commission's goals in its year-long review of 
market structure has been to formulate rules for the national 
market system that adequately reflect current technologies and 
trading practices and to promote equal regulation of stocks and 
markets. This goal does not reflect a simple desire for 
uniformity, but is identified in the exchange act itself as a 
vital component of a truly national market system.
    The trade-through rule objective of promoting best 
execution of customer orders would be a particularly difficult 
benefit to set aside for Nasdaq stocks. I question whether 
ordinary investors should have to remember that their orders 
are protected by a commission rule for exchange-listed stocks, 
but that caveat emptor still prevails in the Nasdaq market. The 
commission will need to carefully consider whether if a trade-
through rule is indeed appropriate for the exchange-listed 
stocks, its best execution and liquidity-enhancing benefits 
should not be extended to Nasdaq stocks.
    I can assure you that the Commission fully 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 those concerns. If the Commission chooses to adopt 
the rules, we will work closely with the industry on 
implementing them. As I have emphasized, the Commission is 
still considering Regulation NMS proposals, including all of 
the issues that I have discussed today.
    I look forward to hearing your views and answering 
questions on the market structure issues facing the Commission, 
with a simple caveat. As I am sure you appreciate, it would be 
inappropriate for me to attempt to pre-judge where the 
Commission will arrive in its deliberations on these complex 
subjects.
    Thank you again for inviting me to speak, and I would be 
very happy to answer any of your questions. Thank you.
    [The prepared statement of Hon. William H. Donaldson can be 
found on page 42 in the appendix.]
    Mr. Baker. Thank you, Mr. Chairman.
    I will start with just a question about observations of the 
performance of the Nasdaq.
    Is it your opinion, based on the lack of trade-through 
provisions for the Nasdaq, that investors have not been 
appropriately or efficiently treated by Nasdaq performance?
    Mr. Donaldson. Let me try and answer that. The question you 
ask is complex. I believe there are a number of answers to it. 
The incidence of trade-throughs in the Nasdaq market is higher 
than has been advertised by some advocates. The incidence of 
trade-throughs in the Nasdaq market is concentrated in the 
small end of the market. It is concentrated in the 500-share 
end of the market, the individual investor end of the market.
    So in that sense, although the Nasdaq market has made 
tremendous strides in bringing itself to the level that it has 
brought itself to now, there are large dollars being missed by 
traded-through best bids and offers on the Nasdaq market.
    Mr. Baker. I read somewhere I believe, I do not think it 
was in your printed testimony or an SEC document, that the 
guesstimated inefficiencies as they were making reference to 
would equate to something in excess of $300 million in lost 
value, according to some study, I think it was within the 
Office of Economic Assessment. It seems to me if that is the 
focus, we ought to be concerned about market data fees. I mean, 
that is well over $400 million.
    I am taking your answer to mean that the Nasdaq is less 
efficient than the New York, and there are efficiencies to be 
gained by the application of the trade-through.
    Mr. Donaldson. I would not use the word ``efficient,'' 
Congressman. I would say that in terms of trade-throughs there 
are more trade-throughs as a percentage of trading than there 
are on the New York Stock Exchange.
    Mr. Baker. I understand your position. We will follow up to 
understand the way in which that position is reached with more 
detail. Will the trade-through be made applicable to ETFs?
    Mr. Donaldson. I am sorry?
    Mr. Baker. Will the trade-through be made applicable to 
ETFs?
    Mr. Donaldson. To ETFs?
    Mr. Baker. Yes.
    Mr. Donaldson. We already have a special rule for ETFs, 
yes.
    Mr. Baker. Well, today there is a pilot which was renewed 
in December which allows a three cent deminimus trading band, 
which has been extraordinarily successful by all accounts, I 
believe. On the one hand, we are setting aside the ETFs not 
subject to trade-throughs, and on the other we are going to 
propose that the trade-through be made applicable to the 
Nasdaq. Is that sort of the policy outcome?
    Mr. Donaldson. I am hesitating to make a conclusion for the 
Commission, but I will tell you that the rule will apply to 
ETFs.
    Mr. Baker. That would seem to be inconsistent with the 
three pilots that have been previously entered into. I will 
follow up on that a little bit later.
    Going to the particular interests of the Nasdaq, I 
understand the argument being made is that it really will be a 
question of better service to consumers who now engage with the 
Nasdaq in executing a trade. In your discussion of the ITS 
provision, you indicated that electronically based systems 
today are at a competitive disadvantage with the auction 
exchanges, and that application of the trade-through rule as 
proposed by the Commission will actually equalize competitive 
opportunities.
    Is that a fair summary of your position?
    Mr. Donaldson. Let me try and re-summarize. The Nasdaq 
market has great strengths and it certainly has improved over 
the few years. I just ask you to keep in mind that the 
regulatory action has been an incredibly significant driver for 
improvement in the Nasdaq market, such as our adoption of the 
order-handling rules and the Department of Justice's 
investigation into collusion by Nasdaq market makers, and our 
mandate that the markets trade in penny increments. I think 
that basically we have spurred competition through regulation 
with the order-handling rules that we helped Nasdaq institute. 
We are doing the same thing here.
    Mr. Baker. I just have one question. My time has expired.
    So you are suggesting to me that the application of the 
trade-through to Nasdaq with the Nasdaq now having more limit 
orders placed than the New York exchange, the Nasdaq has no 
trade-through; New York does.
    Nasdaq has more limit orders than New York, that the 
consequence of the application of the trade-through rule as 
modified in the re-proposal will actually enhance the number of 
limit orders placed?
    Mr. Donaldson. The comparison must be made with the 
improvements that we are trying to make in the marketplace. We 
are comparing New York Stock Exchange postings, if you will, 
with the old and ineffectual ITS system. We are comparing 
Nasdaq as it exists today.
    You have to make the comparison of what this market will 
look like with the new rules, when there is a trade-through 
rule in both markets, and the one market is not depending upon 
the trading system.
    Mr. Baker. But you feel it will result in an increase in 
limit orders at the Nasdaq?
    Mr. Donaldson. I think it will result in the increase of 
posted limit orders, yes.
    Mr. Baker. My time has expired.
    Mr. Kanjorski?
    Mr. Kanjorski. Thank you, Mr. Chairman.
    First of all, Mr. Chairman, let me say that I have full 
appreciation of the pressures you must be under and the other 
commission members. We appreciate your holding your position as 
to what is best for the retail investors.
    It is my understanding that the majority of the comment 
letters received by the SEC concerning Reg NMS from 
institutional and retail investors such as the Investment 
Company Institute, T. Rowe Price, Vanguard, Barclays, Global 
Investors that manages the Federal First Savings Plan, the Bank 
of New York, the Consumer Federation of America, the National 
Association of Investors Corporation, favor a trade-through 
rule. And many, including the ICI, support the rule being 
applied across all markets in all NMS securities to protect 
each market's best bid and offer.
    Is this accurate? If so, why do you believe that some 
intermediaries have been so vocal in opposition to the desire 
of their customers?
    Mr. Donaldson. Well, I think that one would get back to the 
fundamental principle that we have to keep asking ourselves at 
the SEC, and that is investor protection. Then comes the 
efficiency of the intermediaries and the particular platforms 
that they have.
    This whole situation is immensely complicated. There are 
lots of different views, but when you reduce them down and keep 
asking yourself what is the effect on individual investors, 
then that becomes the prevailing mandate, if you will, when 
there are a lot of compromises available. It becomes the 
prevailing mandate when a change in the system may change the 
way some of the intermediaries are organized.
    Mr. Kanjorski. I appreciate your work. I hope you hold a 
stiff upper lip and we will see you when the rule gets through.
    Mr. Chairman, I am going to return my time so that others 
may have some questions.
    Mr. Baker. I thank the gentleman.
    It is the Chair's intention at this point, since we have a 
vote pending, to recognize Mr. Royce for his full time, and 
then recess for about 15 minutes so members could vote and come 
back.
    Mr. Royce?
    Mr. Royce. Thank you, Mr. Chairman.
    Chairman Donaldson, I too would like to thank you for being 
here with us today. It is good to have you back in front of the 
committee. I want to thank you and I want to thank the entire 
commission. I think you all are to be commended for taking on 
the daunting task of reopening Regulation NMS.
    It is clear to me that there is a great deal of consensus 
on many of the issues in this most recent NMS rule. With that 
said, it is also apparent that there is not a great deal of 
consensus around the trade-through component of NMS. I wanted 
to indicate that I appreciate your concern and desire to 
protect the interests of small investors. One of my concerns 
which I wrote to you about in January is that the U.S. equity 
markets remain innovative and dynamic. I have heard many say 
that the trade-through proposal could hinder the ability of 
markets and market-makers to innovate.
    I would like to get your views about how the trade-through 
proposal will affect innovation in our markets going forward. 
In other words, do you think the incentive to create a better 
trading platform will be diminished in any way?
    Mr. Donaldson. Let me say to begin with that the suggestion 
of the new trade-through rule is the result of innovation. In 
other words, the trade-through rule that has existed before in 
effect was being monitored by the ITS. That was designed 25 
years ago and totally inadequate to the speed with which 
transactions take place today. So the new trade-through rule as 
proposed is the result of technological innovation.
    It is the result that now these markets can be connected 
with each other and with their customers by a web, a spider web 
of communications which can transmit orders from anywhere in 
the country or in the world, for that matter, to the best bid 
or offer instantaneously. That really could not be done before. 
When they were transmitted less than instantaneously, the gap 
that it took, the time that it took to execute the order made a 
lot of faster trading people miss their markets.
    So I would say that this technology that can be used today, 
which has been developed, and some of it developed only in 
recent years, is a giant leap forward that will make our 
markets more competitive.
    Mr. Royce. Thank you, Chairman Donaldson.
    I will yield back the balance of my time.
    Mr. Shays. [Presiding.] I thank the gentleman.
    We are going to have a slight recess. The Chairman has 
already gone to vote, so he might be back sooner. Thank you.
    [Recess.]
    Mr. Baker. [Presiding.] I do not want to inconvenience the 
Chairman any more than is absolutely necessary. I am convinced 
that there will be some members returning in a moment.
    Mr. Hensarling is here, and he was prepared with his 
questions.
    The gentleman is recognized.
    Mr. Hensarling. Thank you, Mr. Chairman.
    Chairman Donaldson, again thank you for appearing before us 
today. The first question I have, Mr. Chairman, I am curious as 
opposed to relying on the trade-through rule why the SEC is not 
relying upon the duty that brokers and investment managers have 
to their clients, the duty to obtain best execution for their 
clients' orders.
    Are we not seeing this take place in the marketplace? Is 
best execution not happening presently?
    Mr. Donaldson. Well, there are lots of statistics on 
whether best execution is actually being achieved. I think 
generally speaking it is, but there is still a large amount 
that is not consistent with best execution. That depends upon 
the nature of the stock being traded and the rapidity with 
which it is traded. You get trade-throughs, as I mentioned 
earlier, in both markets in rapidly trading stocks. They trade 
so fast they get trade-throughs. It is hard to track them.
    Mr. Hensarling. Let me ask you this question, Mr. Chairman. 
You have so many large institutional investors in mutual funds 
that seemingly are on the other side of this issue and are 
concerned about the expansion of the rule to Nasdaq. Many firms 
like Schwab and Fidelity have indicated a preference to trade 
on Nasdaq over the New York Stock Exchange.
    Prior to coming to Congress, what little meager wealth I 
might have is tied up, for example, in a number of Fidelity 
mutual funds. I have long since learned that I was not smart 
enough to trade in individual stocks and bonds. But I guess I 
would be concerned not so much as a member of Congress, but as 
an investor when the keeper of my children's college fund 
indicates a real amount of anxiety over the expansion of this 
rule.
    So why are so many of the mutual fund companies and 
institutional investors on the other side of the issue?
    Mr. Donaldson. You know, you have to look at the business 
of these different mutual funds and where it is concentrated. I 
think the thing that one has to keep in mind is that there is a 
tradeoff here between attempting to get the best price, the 
best bid and offer, but at the same time to maintain 
competition between markets. In effect, there are a very large 
number of funds, perhaps the largest aggregation of funds is 
the ICI, the Investment Company Institute, which has written a 
strong letter supporting us.
    But you are asking why do some not support us, some 
institutional investors not support us? I guess you would have 
to ask them. If you look at the concentration of trade-throughs 
in the small 500-share part of the market, I think there is 
somebody from Schwab here and they can tell me whether I am 
wrong or not, but that is where a lot of their order business 
is. At that small end of the market, you have the least, 
generally speaking, sophisticated investors who have trouble 
keeping up with knowing exactly at what price their trade is 
going to be done.
    So I suspect you could go down to each one of the people 
who have written us letters. As the old expression goes, where 
you stand is where you sit.
    Mr. Hensarling. I think, Mr. Chairman, that you had 
indicated on a previous occasion that at least one of the 
reasons we have a trade-through rule is to try to bring 
institutional orders into the market. There is some concern by 
others that the institution of this rule could actually have 
the opposite effect in that traders may take their money in 
trading activities offshore.
    Am I to assume that you do not share those concerns?
    Mr. Donaldson. That is a very good question. I think that 
to date, we have the best markets in the world. Part of the 
reason for that is the ability in our market for institutions 
and individuals to trade in the same marketplace. In other 
countries around the world, in Germany for instance, the large 
blocks are not done on the exchange. That has to do with the 
changing patterns of ownership in Germany.
    But the fact of the matter is, I believe that people will 
continue to pick our markets and to list here and to trade here 
if we have the most competitive markets in the world. And I 
think we do, and we are trying to improve that. And if we hold 
to very high standards, listing standards and accounting 
standards and so forth, so that people know that when they buy 
a U.S. security that the numbers are correct. That is what we 
are striving for in other areas of our responsibility.
    So it is not just the trading market, but it is the stamp 
of approval, if you will, the stamp of reliability that people 
count on with our accounting systems.
    Mr. Hensarling. I see I am out of time. Thank you for your 
testimony.
    Mr. Baker. Mr. Chairman, it is my intention to go a little 
further with my questions, hoping that we will have members 
come back from the vote, because there were several members 
indicating they would like to follow up with a question. I was 
assured that we were only going to have one vote, and 
unfortunately the price was not as advertised by the time I 
closed the deal. So I have been misled a little bit.
    Let me ask one more question and we will wait and see what 
happens. I may have to recess again and run over and vote and 
come back. Do you have constraints on your time today?
    Mr. Donaldson. I am delighted to be here as long as you 
want me.
    Mr. Baker. You said that with real sincerity, too.
    [Laughter.]
    Mr. Baker. One of the other areas that have come to my 
attention that I do not know what the disposition is in 
discussions at this point, with regard to fees for market data. 
It appears from published discussions of the matter that the 
SROs are collecting about ten times the estimated costs of 
collection. Under Reg NMS, I am understanding that there is a 
new methodology being proposed for distribution of the 
revenues, but there is not a recommendation as to the 
underlying legitimacy of collecting that much revenue in 
relation to the actual cost.
    It seems that is such an essential component of the trading 
operation that it is almost like a utility part of the system. 
Is there contemplating given to any limitation, restructure, 
any discussion about the fee side?
    Mr. Donaldson. Yes. As you know, we have a release out 
right now which is, excuse me, a proposed rule is out right now 
which had been reflected upon, dealing with the structure of 
the SROs; dealing with how they are to be organized, the 
independence and so forth; dealing with the clarity of their 
transparency in terms of how they are spending their money and 
so forth.
    To our way of thinking, a more important long-term decision 
on just how expensive tape revenues should be will depend upon 
a better determination of how the independent SROs, 
particularly as some of them become publicly held, how they are 
going to pay for their regulatory obligations. The major source 
of revenue for most of the SROs is tape revenues.
    So we have chosen to take this in two steps. Number one, we 
want to get at a fair distribution of those revenues before we 
get at the absolute size. There are a number of practices now 
in terms of determining what those revenues are, so-called 
``tape shredding,'' people that break up trades and put many, 
many trades on in order to get more revenues coming. There are 
a lot of bad practices out there. Those are the first order we 
want to address. When we have a better feel for revenue sources 
for these SROs, then we will have a better feel for how high or 
low those supporting revenues are. I might also add that the 
costs of producing those revenues are only one part of the 
equation.
    Mr. Baker. I understand there is an element of the market 
data reforms that the Commission's proposal would require 
market centers to send protected quotes through some yet to be 
selected government-recognized distributor of market 
information. The commission in its oversight role would then 
establish the price that brokers would pay for this data.
    On two levels, just the Government engaged in setting 
prices for this activity is problematic, but is that the way in 
which you intend to see the Commission's role in exerting some 
influence over this pricing schedule?
    Mr. Donaldson. You know, we have a release out right now on 
SRO structure, as I mentioned, and it raises all these market 
data issues. I have just tried, in my inarticulate way, to 
divide this into two parts: the distribution or how the 
revenues are arrived at; and then as a second part, the 
absolute size of them.
    Is that getting at what your question is?
    Mr. Baker. I can perhaps, for the sake of time, it does not 
look we are going to have someone to take over. Let me suggest 
I am going to follow up with more clarity in a written question 
for you.
    I am going to ask your indulgence one more time. I am going 
to run over there, and I think I can get back in 10 or 15 
minutes at the max, find out if we have other members who are 
going to come back, and answer questions. If we do not have 
members back by the time I arrive, then we will consider our 
work done here.
    But let me run over to the floor to make sure. We had a 
number of members on all sides of this issue that expressed 
interest in having comments. Let me just move cautiously before 
we adjourn. I will be right back.
    Mr. Donaldson. Okay.
    Mr. Baker. Thank you.
    [Recess.]
    Mr. Baker. I would like to reconvene our meeting and 
proceed with Mr. Fitzpatrick.
    Mr. Fitzpatrick. Thank you, Mr. Chairman.
    Chairman Donaldson, thank you for your testimony today. I 
found it very helpful for me.
    I understand that the SEC's published studies had some 
flaws in their calculations in the numbers and the underlying 
assumptions. You had indicated last week that you had 
reanalyzed some of the statistics.
    I was wondering if you could just give me an update as to 
what you found, what the statistics were, and whether or not 
there will be additional reports forthcoming, and if so does it 
make sense that we wait for the additional reports before we 
make any major policy changes.
    Mr. Donaldson. Which reports are you referring to?
    Mr. Fitzpatrick. The SEC published reports. Did you refer 
to them last week and indicate that you had thought that there 
were some statistical problems?
    Mr. Donaldson. There were a number of economic calculations 
that were made, and when we first put forth NMS and in the re-
proposing document, some commentators challenged some of those 
numbers. We have been hard at work verifying those numbers. 
Basically, we stand by those numbers.
    I might add that the effort that the SEC has put forth has 
been under two different heads of our Office of Economic 
Analysis, so that the whole work has been reviewed in a way by 
two different people at the top, as well as by the 
organization. And I think that it is comforting to know that 
there has been agreement there and disagreement with some of 
the comments that were made by commentators.
    Mr. Fitzpatrick. Are you referring to the OEA study, the 
four studies?
    Mr. Donaldson. I am talking about the OEA studies that were 
in our original release on NMS, those numbers and figures and 
judgments which have been re-reviewed as a result of the re-
proposal.
    Mr. Fitzpatrick. I just have one additional question, Mr. 
Chairman. Doesn't the SEC believe that using this sort of 
common-law standard of best trading practices, best execution 
practices, isn't that sufficient to protect the investors both 
large and small?
    Mr. Donaldson. I am sorry?
    Mr. Fitzpatrick. Best execution practices?
    Mr. Donaldson. Yes.
    Mr. Fitzpatrick. Isn't that a better standard going 
forward?
    Mr. Donaldson. You mean execution standards, the execution 
based on the size of the transaction?
    Mr. Fitzpatrick. There is a standard that exists that 
brokers and traders should use best execution practices to 
protect their clients. Isn't that a better standard going 
forward than a trade-through rule?
    Mr. Donaldson. I see. I do not think so. I think this is an 
area in which the responsibility that a broker has for best 
execution is a very important thing. Insofar as that can be 
monitored, it is very important. But I think that, in terms of 
the kind of markets that we are operating in and the 
instantaneous transactions that take place, it is very 
important that there be a formalized set of rules that 
guarantee through the trade-through rule that the best bid and 
offer will be honored. I think it is a combination of those two 
things that will make for the system being as fool-proof as it 
can be.
    Mr. Fitzpatrick. Do you believe that brokers are living up 
to their fiduciary obligation?
    Mr. Donaldson. I think that you have to be very careful 
when you make generalizations. I think that most brokers are 
attempting to live up to the responsibilities they have. On the 
other hand, the technology is such and the communication system 
is such that it is very hard for the broker and most 
particularly the broker's customer to really feel with 
confidence that they are getting the best execution.
    Mr. Fitzpatrick. Other than generally speaking, let's talk 
specifics. Is the SEC taking any enforcement action against 
brokers who are failing to uphold their fiduciary obligation of 
best execution?
    Mr. Donaldson. We do the best we can. We have a complicated 
oversight system and we do the best we can to determine that. 
But it is a complicated subject because there are trade-
throughs and there are trade-throughs. There are trade-throughs 
that are caused by technical conditions in the marketplace, et 
cetera, et cetera. It is very hard to evaluate that going back, 
huge amounts of data. So that we do the best we can. I think we 
do a pretty good job. I think brokers do a pretty good job, 
within the context of it being increasingly difficult to know 
that you are getting the best execution.
    Mr. Fitzpatrick. But in the SEC's judgment, are there 
brokers out there who are not living up to best execution 
standards and their fiduciary obligation to their clients, such 
that the SEC has instituted enforcement actions against them?
    Mr. Donaldson. Again, this is a subject of concern for us 
and we are currently looking at best execution in terms of 
certain periods of time where we see there may be some 
question. That would be most particularly at the opening of the 
markets, at the opening of the markets where we are looking 
right now intensely at whether best execution is being 
exercised.
    Mr. Fitzpatrick. Okay.
    Thank you, Mr. Chairman.
    Mr. Baker. I thank the gentleman.
    Mr. Sherman?
    Mr. Sherman. Thank you, Mr. Chairman.
    It would seem like investors might have different 
objectives, and some would want the top of the book; some the 
depth book; some might be impressed by the software of this or 
that brokerage company. I would think that in many of these 
decisions you are not really retaining a broker, you are 
retaining a broker's software to execute the transaction.
    I would wonder, is the SEC going to in effect prohibit 
investors from making the choice that they may want to make? In 
other words, he may want depth of the book. I want a top of the 
book. Somebody else is impressed with proprietary software that 
tries top of the book for 3 seconds, and then shifts to depth 
of the book. Are investors going to be able to retain the 
software strategy they want for the particular transaction? Or 
is it all going to be one-size-fits-all?
    Mr. Donaldson. I would answer that in two ways. One is that 
I think the effect of an effective trade-through regulation 
will assure that the best prices are available and can be 
reached by the investor.
    Mr. Sherman. But sometimes I want the best prices. 
Sometimes I want the fastest executions. Sometimes I want the 
most anonymity. Can I pick the strategy I want? Or is the quote 
``best price,'' which may end up being the best price available 
5 minutes after I make the decision, which may end up being the 
wrong best price or the worst best price, am I stuck with one-
size-fits-all if this regulation goes through?
    Mr. Donaldson. No, I do not think so. I think that 
basically, to get back to what I said earlier, that this is a 
compromise, if you will, between two goals. One is the 
protection of the best bid, and the other is to protect those 
who want to trade rapidly, for whatever reason.
    By putting this together in a system where we are taking 
basically trade-through controls and so forth off of slow 
markets and putting it into what is a revolutionary change for 
the listed markets, the New York Stock Exchange, the dual 
system that they propose. You now have an interface where you 
are allowing people to have a best of both worlds, speed of 
execution and best price.
    Mr. Sherman. What if I call my broker and I say, ``Look, I 
do not want you to execute this transaction on the New York 
Stock Exchange for this or that reason--I think they are cruel 
to bunnies or something; I only want you to execute this on 
Nasdaq,'' is that now an illegal transaction? It could be the 
other way around.
    Mr. Donaldson. Yes. I think what you also have to consider 
is that there is another side to every transaction. There is a 
responsibility to the marketplace.
    Mr. Sherman. Look, my broker represents me. I want my 
broker to go to the New York Stock Exchange and execute the 
transaction there. Does that become illegal?
    Mr. Donaldson. No. There is a public good aspect to this.
    Mr. Sherman. Mr. Chairman, I am not asking you to defend 
why you are making it illegal. Stripped away of the reasons why 
it might be a good idea to force me to----
    Mr. Donaldson. Why it would not be a good idea is that you 
leave out there, if I want to do my own trade and I want to do 
it in a closet somewhere or I want to do it off the market, you 
thereby deprive the people who are using the market and----
    Mr. Sherman. Mr. Chairman, I am not asking for 
justification. I am asking a yes-no question.
    Mr. Donaldson. What is the yes-no?
    Mr. Sherman. Under the proposed regulation, if I instruct 
my broker to execute the transaction on this or that exchange 
or medium and to ignore all others, am I in violation of the 
law, or can I have it done the way I want it done?
    Mr. Donaldson. If the market is assessible----
    Mr. Sherman. Mr. Chairman, I am asking a very simple 
question. Can I instruct my broker to execute the transaction 
only on Nasdaq or only on the New York Stock Exchange, or is 
that an illegal transaction?
    Mr. Donaldson. No is my simple answer.
    Mr. Sherman. No, I cannot do it?
    Mr. Donaldson. No. No. If you do not like the price that is 
there, you can ignore it and send your order elsewhere to a 
market quoting a worse price if you want to. But all market 
centers must have procedures reasonably designed to avoid 
trade-throughs, and that could result in the market either 
matching the best price or your order being sent to another 
market quoting the best price.
    Mr. Sherman. So I can call a broker and say, execute this 
transaction only on Nasdaq and execute this other transaction 
only on the New York Stock Exchange and that is what he or she 
will do, and that will not be in violation of the regulation.
    Mr. Donaldson. Yes. Subject to what I just said, you can 
choose to send your order initially to any specific market 
center.
    Mr. Sherman. Okay. So as long as we are preserving the 
investor choice, I have spent the last 3 minutes satisfying my 
concerns. Thank you.
    Mr. Donaldson. Okay.
    Mr. Baker. The gentleman yields back.
    Mr. Crowley?
    Mr. Crowley. Thank you, Mr. Chairman.
    Thank you again, Chairman Donaldson.
    There has been an ongoing discussion about the need to 
apply the trade-through rule to all U.S. equity markets, 
including the Nasdaq. Do you believe that if the SEC does not 
apply the trade-through rule across the board on all markets, 
regulatory arbitrage will be the result, whereby the 
professional trader will trade and profit in a market which has 
no prohibitions, and those profits will not be passed along to 
small investors?
    Mr. Donaldson. Yes, I do believe that one of the dangers of 
not extending the new trade-through rule to all NMS stocks is 
the potential for regulatory arbitrage. As I tried to say 
earlier, I do not think it is wise public policy to have an 
individual customer decide that in trading at one market he is 
being protected, but if he goes to another market the rules are 
different, and it is caveat emptor.
    Mr. Crowley. I appreciate that. If you have answered the 
question before, I am sorry I was not here when you did it. You 
and I have had a private conversation. I thought it might be 
appropriate to get some of those comments down on the record.
    Mr. Donaldson. Sure.
    Mr. Crowley. Since Congress since 2002 and the SEC have 
tightened the corporate governance rules, tightened rules on 
mutual funds, hedge funds, expensing stock options, corporate 
disclosure, I was wondering why then would a new SEC rule apply 
to half the market and treat investors differently? You have 
just answered that question, that you do not believe they 
should be treated differently, depending on where they trade. 
Correct? For example, on the New York Stock Exchange or the 
Nasdaq market, is that correct?
    Mr. Donaldson. If I understand your question, I believe 
that the proposed rule here should be extended to the over-the-
counter market, to the Nasdaq market. I believe that if it is 
not, there is this potential for regulatory arbitrage, but that 
is of course a decision the Commission has to make.
    Mr. Crowley. Mr. Chairman, just one final question. It is 
my understanding that the vast majority of the comment letters 
you have received on the Reg NMS proposals were in opposition 
to the mandatory depth book routing due to the practical 
implications. If that is so, how much weight do you put on 
those comments?
    Mr. Donaldson. I put a considerable amount of weight on 
those comments. I think a great preponderance of the comments 
did not believe that we should go to the depth of book. I think 
there again is a fear at this stage of the development of the 
marketplace that that is close to being a CLOB, consolidated 
limit order book. It is not a CLOB, but it has aspects of a 
CLOB. I think it has been shown through years and years of 
debate that that sort of centralization of the system would not 
be to the advantage of the system.
    Mr. Crowley. Can you give us any indication where the 
Commission might be heading on depth of book?
    Mr. Donaldson. I am sorry?
    Mr. Crowley. Can you give us any indication of where the 
Commission might be heading on the issue of depth of book?
    Mr. Donaldson. Well, there is overwhelming support for the 
top of the book, and I would say that in our second round of 
comments, very few proposed that we go to depth of book.
    Mr. Crowley. I thank the Chairman.
    I thank you, Chairman, for the time.
    I yield back.
    Mr. Baker. Mr. Chairman, I want to express my appreciation 
for your generous grant of time today and your willingness to 
come to the committee and discuss these proposals. I just want 
to make clear for most members the depth of feeling about this 
is enhanced because markets have indeed changed dramatically, 
where hundreds of millions of individual investors are now 
placing their hard-earned dollars into the markets hoping to 
grow their personal wealth for the first home, the children's 
education, whatever it might be.
    Because of that greatly expanded number of working families 
now engaged in active market investing, it has enhanced the 
sensitivity of members of Congress to better understand and to 
ensure that those individuals are treated as best as can be 
practically achieved. No market system is perfect. All will 
have their flaws.
    We also have an obligation in this committee to recognize 
that this capital market function is very essential to the 
ongoing economic vitality of this country, and not to take ill-
advised steps that may put any of that in the slightest 
jeopardy.
    I only make these comments because there were widely 
disparate views this morning about which direction we should 
go. I certainly respect the Commission's work and your 
leadership. I just have expressed in my own view the concerns 
about going forward and perhaps a very careful continued 
evaluation for the short term would be helpful to us all.
    To that end, I do intend to follow up today with a letter, 
and some of the members have indicated a desire with their own 
questions. We will try to consolidate our limit order here and 
get it all in one letter, and get it over for your comment. It 
will be helpful for us in understanding the implications of the 
next step. I think it would be helpful to the Commission's 
reception as they go forward as well.
    So I appreciate your courtesies extended and we do look 
forward to working with you as we head down the road. Unless 
you have further comment, I would like to call our meeting 
adjourned.
    Thank you very much, sir.
    [Whereupon, at 12:32 p.m., the subcommittee was adjourned.]


                            A P P E N D I X



                             March 15, 2005


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