[Senate Hearing 109-904]
[From the U.S. Government Printing Office]



                                                        S. Hrg. 109-904


                           REGULATION NMS AND
                       RECENT MARKET DEVELOPMENTS

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

                                HEARINGS

                               before the

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

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

  EXAMINATION OF REGULATION NATIONAL MARKET SYSTEM (NMS) DESIGNED TO 
 STRENGTHEN OUR NATIONAL MARKET SYSTEM FOR EQUITY SECURITIES, FOCUSING 
                     ON RECENT MARKET DEVELOPMENTS

                               __________

                          MAY 18 AND 19, 2005

                               __________

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


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









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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

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

             Kathleen L. Casey, Staff Director and Counsel
     Steven B. Harris, Democratic Staff Director and Chief Counsel
                         Mark Oesterle, Counsel
                       Bryan N. Corbett, Counsel
            Alex M. Sternhell, Democratic Professional Staff
                 Dean V. Shahinian, Democratic Counsel
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                       George E. Whittle, Editor

                                  (ii)


















                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, MAY 18, 2005

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

Opening statements, comments, or prepared statements of:
    Senator Allard...............................................     2
        Prepared statement.......................................    27
    Senator Hagel................................................     2
    Senator Crapo................................................     2
        Prepared statement.......................................    27
    Senator Sarbanes.............................................    16
    Senator Carper...............................................    23
    Senator Schumer..............................................    26

                               WITNESSES

John A. Thain, CEO, New York Stock Exchange......................     2
    Prepared statement...........................................    27
Robert Greifeld, CEO And President, The Nasdaq Stock Market......     3
    Prepared statement...........................................    31
Gerald D. Putnam, Chairman & Chief Executive Officer Archipelago 
  Holdings, Inc..................................................     7
    Prepared statement...........................................    34
Edward J. Nicoll, CEO, Instinet Group............................    18
    Prepared statement...........................................    37
Meyer S. Frucher, Chairman and Chief Executive Officer, 
  Philadelphia Stock Exchange, Inc...............................    11
    Prepared statement...........................................    39
Kim Bang, President And Chief Executive Officer Bloomberg 
  Tradebook LLC..................................................    46
Scott Evans, Chief Investment Officer, TIAA-CREF.................    70
Thomas M. Joyce, Chairman and Chief Executive Officer, Knight 
  Capital Group, Inc.............................................    71
Marc E. Lackritz, President, Securities Industry Association.....    75
George U. ``Gus'' Sauter, Chief Investment Officer and Managing 
  Director, The Vanguard Group...................................    82
                              ----------                              

                         THURSDAY, MAY 19, 2005

Opening statement of Chairman Shelby.............................    85

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................    85
    Senator Crapo................................................    87
    Senator Dodd.................................................    87
    Senator Reed.................................................    87
    Senator Allard...............................................    96
    Senator Hagel................................................    99
    Senator Schumer..............................................   103
    Senator Bunning..............................................   106
    Senator Stabenow.............................................   106

                                WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission.....................................................    88
    Prepared statement...........................................   107
    Response to written question of Senator Bunning..............   114























 
             REGULATION NMS AND RECENT MARKET DEVELOPMENTS

                              ----------                              


                        WEDNESDAY, MAY 18, 2005

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

    The Committee met at 10:07 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing shall come to order.
    This morning, the Committee will hold the first of two 
hearings examining Regulation NMS and the impact of two 
recently announced mergers involving leading market centers. 
Today, we will hear from representatives of a number of market 
participants and tomorrow, the Committee will hear from 
Chairman Bill Donaldson at SEC.
    Since Chairman Donaldson last appeared before this 
Committee in March, much has transpired concerning our national 
market structure. On April 7, the SEC approved Regulation NMS 
by a 3 to 2 vote. Then within weeks of the adoption of the 
regulation two major transactions were announced. These mergers 
will lead to the creation of two dominant market centers. On 
April 20, the New York Stock Exchange announced that it would 
merge operations of Archipelago to form a new public company. 
Next, on April 22, Nasdaq announced that it would buy 
Instinet's electronic trading platform.
    The equities trading industry is clearly in the midst of a 
significant transition. The convergence of a new regulatory 
framework created by Regulation NMS and the impact of the 
proposed mergers creates a new dynamic for our markets. The 
implementation of Regulation NMS will be a challenge for all 
market participants, and the long-term effect of the regulation 
remains to be seen. Combined with this evolving regulatory 
landscape, the merger announcements raise questions about 
industry consolidation and competition, the future direction of 
our equities markets, and the ultimate impact on investors. 
These are all issues that need to be examined.
    This Committee will continue active oversight of Regulation 
NMS and will closely monitor new market developments. I think 
it is important for this Committee to understand the impact of 
these changes for all investors and for the efficiency of our 
securities markets.
    To discuss these issues with us this morning we have a 
number of leading industry experts. On the first panel we will 
hear from Mr. Sandy Frucher, Chairman and Chief Executive 
Officer, Philadelphia Stock Exchange; Mr. Robert Greifeld, 
President and Chief Executive Officer, Nasdaq Stock Market, 
Inc.; Mr. Edward Nicoll, Chief Executive Officer and Director, 
Instinet Group, Inc.; Mr. Gerald Putnam, Chairman and Chief 
Executive Officer, Archipelago Holdings, Inc.; and Mr. John 
Thain, Chief Executive Officer, New York Stock Exchange.
    On the second panel we will hear from Mr. Kim Bang, 
President and Chief Executive Officer, Bloomberg Tradebook, 
L.L.C.; Mr. Scott Evans, Executive Vice President and Chief 
Investment Officer of TIAA-CREF; Mr. Thomas Joyce, Chairman and 
CEO, Knight Trading Group, Inc.; Mr. Marc Lackritz, President, 
Securities Industry Association; and Mr. Gus Sauter, Chief 
Investment Officer and Managing Director of the Vanguard Group.
    I want to thank all of you for appearing here this morning, 
and we look forward to your testimony.
    Senator Allard, do you have an opening statement?

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I do have an opening 
statement. It is very brief, and would like to make that part 
of the record.
    Chairman Shelby. Without objection, so ordered.
    Senator Allard. And just take this opportunity to thank the 
panels for coming forward and being willing to share their 
thoughts with this Committee.
    And thank you, Mr. Chairman, for holding this hearing.
    Chairman Shelby. Thank you.
    Chairman Shelby. Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. No opening statement, Mr. Chairman. I look 
forward to our witnesses' testimony. Thank you.
    Chairman Shelby. Mr. Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman. I will 
look forward to hearing the witnesses today.
    Chairman Shelby. We will start with you, Mr. Thain.
    All of your written testimony will be made part of the 
hearing record in its entirety. If you will sum up your main 
points. Thank you and welcome.

                   STATEMENT OF JOHN A. THAIN

        CHIEF EXECUTIVE OFFICER, NEW YORK STOCK EXCHANGE

    Mr. Thain. Mr. Chairman, Members of the Committee, thank 
you for giving me the opportunity to be here today. We 
appreciate your Committee's oversight of our national market 
system, and we share with you I think a common challenge to 
maintain the competitive position of the U.S. financial markets 
in the world, and to ensure the interests of investors are 
protected.
    The New York Stock Exchange stands at the center of the 
U.S. financial markets. We serve 90 million investors. We have 
over 2,700 companies listed on the New York Stock Exchange, and 
those companies have a market capitalization of $20 trillion. 
We take great pride in providing our customers the highest 
standards of market quality, the deepest liquidity, the lowest 
volatility, the tightest spreads, and the best prices.
    But we also recognize that the rapid pace of change in our 
industry demands that we, the New York Stock Exchange, do 
better in terms of speed and innovation. That is why we are 
building our hybrid market, to offer investors a choice between 
sub-second speed of electronic execution and the price 
improvement and lower volatility of our auction market. It is 
also why we are taking the historic step to become a public, 
for-profit company by merging with Archipelago, which is an 
outstanding entrepreneurial company that has pioneered leading 
edge platforms and products.
    And finally, it is why we strongly support Reg. NMS, 
because it protects and promotes the interests of U.S. 
investors and U.S. competitiveness. Let me briefly talk about 
each of those issues starting with Reg. NMS.
    We believe Regulation NMS is good for investors and good 
for U.S. markets. It is designed not to favor one market over 
another, but to strengthen competition among all markets to 
create the best possible national market, for investors, for 
issuers, and for our economy.
    How will it do this? By preserving the best price rule and 
by extending it to all markets and updating it to encourage 
innovation and competition. We believe the new best price rule 
advances these essential goals three ways. First, it is 
indisputably pro-investor. It will strengthen the integrity of 
markets and it enhances U.S. competitiveness. The new best 
price rule ensures that any one of your constituents can invest 
and trade on an equal footing with large institutions. It does 
so by requiring that intermediaries, such as brokerage firms 
and mutual funds find the best price for investors' orders by 
selling their shares at the highest possible prices or buying 
them at the lowest price.
    Second, it ensures that stocks are priced at their true 
value, that the best price rule improves the transparency and 
the price discovery process. Our markets are certain to be fair 
and honest.
    And third, markets will be more competitive, because as 
investors are encouraged to maintain and increase their limit 
orders, liquidity will deepen.
    Critics have from time to time complained that the old 
trade-through rule was flawed because it did not distinguish 
between fast and slow markets and prices could change in the 
time it took to trade in our auction market. The new trade-
through rule protects only prices that are available for 
immediate electronic execution. This is a very significant 
change. What it means is that the New York Stock Exchange must 
deliver on our hybrid market. We must make our quotes 
immediately electronically accessible, and we are going to do 
that.
    Our goal is to offer a choice between that immediate 
electronic execution or the possibility of getting a better 
price through the auction process on the floor of the exchange 
with the specialists and the floor brokers.
    We believe that our trading floor continues to offer 
superior market quality. We outperform electronic exchanges on 
opens and closes, during order and balances, and in earning 
surprises. We provide the best prices in our New York-listed 
stocks 89 percent of the time, and companies, when they 
transfer from the purely electronic markets to the New York 
Stock Exchange get better executions in the marketplace. Price 
volatility is cut in half, quotes are narrowed, and execution 
costs fall.
    Finally, investor groups, representing millions of 
investors and investor companies, support the SEC's decision to 
extend the best price rule to all markets. Investors agree that 
once trading conditions for speed are comparable, there is no 
justification in any market for providing customers anything 
less than the best price.
    Let me talk a moment about our proposed merger with 
Archipelago to become a public, for-profit company, the NYSE 
Group. Our merger is about meeting global competition. The 
competition for capital today is global, and our major 
competitors are public, for-profit exchanges that are well-
capitalized, have a multiplicity of products, and they are 
attempting to gain footholds in the U.S. marketplace. We have 
to compete and we have to have the means to compete to the 
fullest extent or our abilities, and we have to be world class. 
We have to be an exchange that offers investors the strongest 
platforms with cutting-edge products, and that is what 
Archipelago brings with a new expanded menu of equity products, 
options, exchange-traded funds, and fixed-income securities.
    With a more robust and innovative business model we can 
better serve our customers, and as a profitable public company 
we will offer an opportunity for investors, institutions, 
listed companies, and members to share in our growth and 
success as stockholders. As a stronger and more competitive 
exchange we will enable the United States to respond and 
prevail in the world financial market competition.
    Let me also assure this Committee that the new structure of 
the New York Stock Exchange Group will not only protect but 
also strengthen the independence and oversight of our 
regulatory functions. So to sum up, we believe that Reg. NMS, 
the completion of our hybrid market, and our combination with 
Archipelago represent a comprehensive response to the twin 
challenges that we face to build the world's best marketplace 
for our customers and to preserve the leadership and 
preeminence of the U.S. capital markets in the world.
    Thank you.
    Chairman Shelby. Mr. Greifeld.

                  STATEMENT OF ROBERT GREIFELD

             CHIEF EXECUTIVE OFFICER AND PRESIDENT,

                    THE NASDAQ STOCK MARKET

    Mr. Greifeld. Chairman Shelby, distinguished Members of the 
Senate Banking Committee, I thank you for inviting me to 
discuss Reg. NMS and the recent industry developments.
    When I last appeared before this Committee on July 21, 
2004, I stated that the current trade-through rule is the 
primary obstacle to competition amongst our Nation's equity 
markets, and competition is the driving force in making the 
U.S. markets the strongest in the world, the best for investors 
large and small and accountable to the public. I also stressed 
that the markets had uncovered a fundamental truth. Today, 
electronic trading is best for investors.
    After well over a year of hearings, discussion and 
comments, on April 6 of this year the SEC approved Regulation 
NMS. NMS replaces the old ITS trade-through rule that protected 
the listed market from competition with a new trade-through 
rule which will be applied uniformly across all markets to 
protect a market's top-of-the-book quote if it is automatically 
accessible. Regulation NMS also includes needed restrictions on 
sub-penny trading, establishes uniform market access rules, and 
updates the formula used to allocate market data revenue.
    I believe Regulation NMS does remove a substantial obstacle 
to competition among our Nation's equity markets and 
establishes incentives for floor-based markets to move to 
electronic trading. The new rule will bring benefits to 
investors and it will enhance the ability of our Nation's 
capital markets to face growing international competition. 
Nasdaq commends the work of the SEC, as well as the 
constructive oversight of this Committee and the entire 
Congress throughout the rulemaking process.
    As you know, Nasdaq and many others urged the Commission to 
eliminate the trade-through rule entirely. Our position 
reflects the belief that market forces and best execution 
responsibilities should serve as the bedrock principles in the 
securities market. We are proud of the market quality 
experienced by investors every day on the Nasdaq Stock Market 
which does not have a trade-through rule. Given our experience 
and the cost of implementation, we believe the extension of the 
rule to Nasdaq represents an unnecessary tax on our market 
participants.
    Nonetheless, although Nasdaq does not believe the 
application of a trade-through rule to Nasdaq is necessary, we 
are pleased by the fact that the new trade-through rule 
approved by the Commission will force floor-based markets to 
follow the path to automated trading that has been blazed by 
Nasdaq since 1971.
    Specifically, the distinctions between fast and slow 
markets will force manual floor-based markets to automate in 
order to compete effectively with the faster electronic 
exchanges. The rule acknowledges the value of speed and 
certainty of execution, and allows electronic markets to 
compete for the trading of New York Stock Exchange-listed 
securities. Manual markets will no longer be the weak link in 
the national market system, slowing down faster markets, while 
humans--some with a very distinct time and place advantage on 
the floor--attempt to execute orders.
    As you know, the rule will be rolled out in a limited 
manner next April and will take full effect in June 2006. Even 
before NMS was approved, the New York Stock Exchange was 
compelled by market pressure to move to modernize their market 
structure as seen with the proposed hybrid model. As a result 
of NMS, the American Stock Exchange and the regional exchanges 
have strong incentives to modernize their markets, and are 
poised to emerge as competitors. There is no doubt that this 
will be good for competition and for investors.
    The Committee has also asked about our recent acquisition 
of the Instinet Group. On April 22, Nasdaq announced the 
acquisition of Instinet Group and concurrently entered into a 
definitive agreement to sell Instinet's Institutional Brokerage 
division to Silver Lake Partners. As a result, Nasdaq will own 
only Instinet's electronic communications network, their ECN 
called INET.
    This deal proceeded from a public competitive process. 
Reuters, Instinet's parent company, announced in November 2004 
that it was selling Instinet. In January, Nasdaq first 
submitted a proposal to acquire Instinet. We understand that 
several industry participants considered bids for Instinet.
    Nasdaq acquired Instinet to enhance our trading environment 
to serve investors better and respond to the increasing 
competition across global capital markets. It is a synergistic 
deal that will create a fast, high-performing, low-cost 
platform for trading U.S. securities. Given the compatibility 
of the two platforms, the real-time market surveillance by a 
well-respected regulator, the NASD, and Nasdaq's proven 
technological reliability, this transaction will position 
Nasdaq to compete more effectively with U.S. and other 
international market centers. This acquisition will result in 
more cost efficiency and improve quality of execution in our 
market, qualities that today's individual and institutional 
investors demand. Nasdaq will continue to innovate and will 
also have the ability to tap new opportunities in other asset 
classes.
    The rapid structural changes sweeping through our Nation's 
securities markets are being propelled by a convergence of 
several forces. The principal regulatory force is Regulation 
NMS. Its most direct impact, greater competition in the trading 
of New York Stock Exchange securities, will be felt when the 
rules take effect. However, the indirect impact of Reg. NMS is 
already being felt as the NYSE is poised to become a competitor 
in the trading of Nasdaq securities. That combined with the 
expected rise in the trading of Nasdaq securities by the 
regional exchanges creates a national market structure in which 
market centers no longer specialize in the equities of a single 
market.
    Another important force is the rapid globalization of 
capital markets. Companies around the world are seeking access 
to capital and stock markets are the key facilitator in this 
process. When a company in China or Russia seeks to bring 
capital from outside its country's borders, it typically 
considers the major markets in Europe as well as in the United 
States. As such, we are now competing not only with the U.S. 
exchanges but also, for example, with the Europeans. Enhanced 
competition for listings also encourages competition in the 
quality of trading as companies seek to list in a country and a 
market that offers the best trading for their securities.
    Finally, it is becoming increasingly necessary for stock 
markets to be mindful of competition from venues that trade 
derivatives and other instruments that are not equity 
securities. If trading quality in equities is inferior, or the 
costs of trading are relatively high, then some investors will 
focus on a type of securities that trade more efficiently. 
Again, all investors are potential winners in this competition.
    Recent developments in the marketplace also offer the 
opportunity to improve and make more efficient the regulation 
of the securities market. As part of its transaction, the NYSE 
announced their intention to further separate its regulatory 
function into a nonpublic, not-for-profit entity governed by an 
independent board of directors. This follows the lead 
established by the Nasdaq/NASD relationship. Nasdaq supports 
separating the regulator from the regulated market, and in 
fact, once the Commission approves our application to register 
as an exchange, Nasdaq will completely separate from our 
regulator, the NASD.
    In this regard, I am pleased to report that the Commission 
has been working closely with us on our exchange application 
and we are hopeful that the application will be approved 
shortly. With Reg. NMS codifying uniform rules for trading of 
all equities, exchange status for Nasdaq will achieve a level 
playing field. A Nasdaq exchange will be good for competition, 
good for regulatory framework, and good for market quality, and 
ultimately good for investors.
    I appreciate your time here today, and welcome Senator 
Sarbanes. Thank you.
    Chairman Shelby. Mr. Putnam.

                 STATEMENT OF GERALD D. PUTNAM

             CHAIRMAN AND CHIEF EXECUTIVE OFFICER,

                   ARCHIPELAGO HOLDINGS, INC.

    Mr. Putnam. Good morning, Chairman Shelby, Ranking Member 
Sarbanes, and other distinguished Members of the Committee.
    The headline for this hearing I think would be 
consolidation, and I would like to start by congratulating two 
of my toughest competitors, Bob Greifeld and Ed Nicoll on their 
merger.
    I know the saying goes the best offense is a good defense, 
but I think if you are sitting in my shoes today you have to 
turn that around the other way and say the best defense is a 
good offense. We have had a few disagreements with the New York 
Stock Exchange over the years, and I am not actually sure--I 
will take that back--I am sure they were not happy about it, 
but we have agreed with them on a couple of things, on a few 
occasions.
    Specifically, we disagreed with the trade-through 
provision, Reg. NMS, as adopted by the SEC. This Committee and 
the House Financial Services Committee asked the SEC to tackle 
pretty tough questions, some thorny issues over our national 
market system. In the end, while we did not agree on 
everything, we do now have certainty in the rules.
    I think also the consolidation that we are seeing is 
bringing our markets closer together here in the United States, 
and the distinction between them is starting to fade.
    I would like to talk a little bit about our merger, and 
specifically negotiations that John and I had starting back in 
January. We have disagreed, as I said, on some things in the 
past, but one thing was certain to me after those negotiations, 
is that we do share a common vision, and that is to leverage 
the respective strengths of the NYSE and ArcaEx and to develop 
a world-class exchange. We are going to do this by listening to 
our customers and responding with high-quality service, 
products, and choice.
    Our merger will represent the largest ever among securities 
exchanges. It will combine the world's largest, most liquid and 
reliable, the New York Stock Exchange, with the most 
successful, 
totally open, fully electronic one in ArcaEx.
    And I believe the combination is going to bring us several 
benefits, specifically: Strengthen America's leadership and 
boost our global competitiveness in capital markets; better 
server all investors and traders; support the continued growth 
and global leadership of the NYSE; it will help us maintain the 
highest standards of integrity, transparency, and disclosure; 
produce efficiencies; drive innovations; create new business 
and revenue opportunities; and finally, enable the public to 
own shares in the world's leading exchange.
    Now, competition is changing things once again and today it 
is on a global scale. These recent consolidations, I believe, 
are about our ability to compete in the globalization and 
convergence of exchange models. Past exchanges in the United 
States have traded either stocks, options, or futures. But 
today, as you look around the world--let us start in Europe--
the Deutsche Borse, Euronext, and the LSE are bringing 
different products together under one roof to create one-stop 
shopping. In Asia, exchanges like the Singapore Exchange and 
the Hong Kong Exchange are commingling equities and derivatives 
under one umbrella. The Tokyo market is one of the most 
integrated, if not the most integrated, in the world.
    Here in the United States, the Chicago Mercantile Exchange, 
it is a public company, they advertise nearly round-the-clock 
trading and boast customers around the world. The Chicago Board 
of Trade has plans to go public this year. The Boston Stock 
Exchange teamed up with the Montreal Exchange to create the 
Boston Options Exchange or the BOX. The ISE, another public 
company, is an all electronic options exchange born in the late 
1990's and is already the largest options exchange in the 
United States and in the world.
    Finally, the Chicago Mercantile Exchange, the Chicago Board 
of Trade, and the Chicago Board Options Exchange teamed up to 
create OneChicago, an all electronic single stock futures 
exchange.
    The competitive trend is very clear: To stay competitive 
exchanges are looking to trade not stocks, options, or futures, 
but stocks, options, and futures on a single platform, and the 
competition is global.
    Before concluding, I would like to say how proud I am of 
all the employees. There is 250 of them now at ArcaEx that made 
our company the success that it is today. We all look forward 
to our future with John Thain and the rest of the team at the 
New York Stock Exchange.
    Thank you.
    Chairman Shelby. Mr. Nicoll.

                 STATEMENT OF EDWARD J. NICOLL

            CHIEF EXECUTIVE OFFICER, INSTINET GROUP

    Mr. Nicoll. Chairman Shelby, Ranking Member Sarbanes, and 
Members of the Committee, I appreciate this opportunity to 
discuss the role that I believe regulation and legislation will 
play in the future of our Nation's securities markets.
    While others on the panel today may begin by looking ahead 
and outlining the challenges and opportunities facing our 
markets, I would like to begin with an appreciative glance back 
at how we got here. I do so because I think it is worth 
remembering, indeed, quite important to remember, on whose 
shoulders we stand here today and why so much of the recent 
discussion has been about building better and stronger 
electronic markets.
    From my perspective, the story begins with a company called 
Island ECN, which was one of the first of the so-called 
``Electronic Communications Networks'' or ECN's.
    In the wake of scandals in the mid-1990's the SEC adopted 
regulations known as the Order Handling Rules, designed to 
introduce competition and greater transparency into the U.S. 
equity markets, which led directly to the creation of ECN's. 
Island seized this opening and offered investors a less 
expensive, faster, and more reliable forum for trading. From 
Island's inception we counted on the fact that investors, when 
given the choice, would always demand a more accessible and 
transparent marketplace. To reach that goal we focused on what 
we considered the glaring gap in the traditional model, the 
inability of investors to meet directly in the marketplace 
without having to rely on professional intermediaries.
    The Island story was about fighting for a chance to compete 
in new markets and allowing investors to vote with their feet. 
We fully understood that if we could not offer a better 
product, we should be out of business. But investors welcomed 
our products and services, and Island enjoyed explosive growth, 
eventually merging with Instinet, the company which I serve as 
CEO today.
    For these reasons, Mr. Chairman, I doubt you will find a 
witness today who is a greater champion of our Nation's free 
markets and the individual's ability to profit from hard work 
and innovation.
    But more than anything else, my experience at Island gave 
me the privilege to meet some of the most insightful traders 
and software programmers on the street, individuals who grasped 
a magnificently simple and elegant truth: The markets could be 
made far more rational and fair if investors were allowed 
access to the same type of information that were, at the time, 
uniquely available to market professionals.
    On my first day as Chairman of Island, I walked into the 
office--and we were literally just a handful of employees in 
one office--and sat down with gifted individuals such as Josh 
Levine and Matt Andresen. The one thing we all shared, beside a 
broken-down desk with four folding chairs, was a commitment to 
provide investors with an unprecedented degree of 
accountability, openness, and transparency in the marketplace. 
I recall how many market professionals had insisted that making 
arcane, real-time market data widely available would be at best 
a distraction, and probably a nuisance for investors. How wrong 
they were.
    As we know, investors today demand access to real-time 
data, and the latest research reports, as well as the ability 
to enter orders more efficiently and at a fraction of the cost 
once paid for such transactions. Yet, while the investor had 
been empowered to know what and when to buy, a key component of 
this equation had been missing: How to buy it.
    That is where Island jumped in. Traditionally, investors 
had only been provided with the highest bid and the lowest 
offer in a security. The depth of the market, which gives an 
indication of the true supply and demand for a security, had 
been the exclusive province of market professionals.
    That lack of accountability, in other words, denial of 
information to the investor, was unacceptable to us. To provide 
the best resource possible to the investor we became the first 
marketplace to provide a free, real-time display of all of its 
orders through the Island Book Viewer.
    There is probably nothing I am more proud of, Mr. Chairman, 
than to know that the technology that we built for the Island 
ECN, which then became the technology behind Instinet Group's 
INET ECN, is now expected to become the technology platform for 
the merger Nasdaq-INET platform.
    With this history in mind, Mr. Chairman, let me try to 
summarize some lessons we can learn from those experiences that 
are particularly relevant as we look ahead at the issues we 
will face in our markets over the coming years, lest we be 
doomed to repeat the mistakes of the past.
    First and most important are the benefits resulting from a 
regulatory environment that encourages true competition among 
marketplaces. It is true that much of the original electronic 
marketplace story was about harnessing technology to provide 
investors with a more efficient, faster and lower-cost forum 
for trading. Yet Island's success and the success of other 
electronic markets like Archipelago and Nasdaq is much more 
than a technology story, it is about the tremendous benefits 
that redound to the investor when the securities laws and 
regulations allow our markets to compete; when one marketplace 
can challenge another with a dizzying array of innovations and 
offer the investor unprecedented opportunities to leverage 
technological breakthroughs.
    The Island story and the rise of ECN's embody the benefits 
of competition. The dramatic changes in technology have allowed 
new competitors to offer new services at a lower cost and 
capture market share from traditional market participants in a 
relatively short period of time. Just one example: I can 
remember when it cost some individuals as much as $200 per 
trade. Today, you can pay as little as $7. There has never been 
a better time to be an individual investor.
    A second lesson from our experience concerns the policing 
and surveillance of markets. By eliminating the informational 
disparities of the traditional floor-based manual markets, many 
of us built a marketplace that is inherently safer, fairer, and 
importantly, easier to surveil, all issues I know, Mr. 
Chairman, that this Committee takes very seriously. For 
example, participants on the floor of an exchange generally 
possess more trade and order information than the average 
investor sitting at home.
    Through surveillance and the implementation of restrictions 
on the activities of those in the trading crowd, regulators 
attempt to prevent the misuse of this information. As recent 
events have shown, however, no amount of surveillance or 
regulation can completely prevent or eliminate the potential 
for its misuse. With that in mind, Mr. Chairman, I note that 
electronic markets reduce the opportunities for improprieties 
by eliminating informational disparities.
    Finally, Mr. Chairman, let me at least raise for the 
Committee's consideration one of the most enduring public 
policy issues we face. Now that electronic markets have done so 
much to empower the investor by providing an open and 
transparent marketplace, there remains one final challenge: How 
do we unleash these benefits on as wide a scale as possible 
without sacrificing investor protection or the integrity of our 
capital markets? How can we continue the process of 
democratizing the markets?
    Long before electronic markets were even a glimmer in 
anyone's eye, Congress anticipated exactly what rules should 
guide us. In 1975, Congress created a national market system 
with the goal of creating a more efficient and transparent 
market. We could not have asked for a better building block. 
Over the subsequent decades, the SEC has worked hard to 
strengthen and improve this regulatory structure. While 
Instinet had particular concerns with some of the elements in 
the recently approved Regulation NMS, I do commend Chairman 
Donaldson for finally resolving many of the outstanding market 
structure issues and setting forth a clear and definitive 
regulatory roadmap for the U.S. equities as a whole.
    There are many different models currently used in the 
equity markets, and with entry becoming even cheaper and 
easier, over the coming months and years I have no doubt more 
will emerge. Each model has its supporters and detractors. But 
what history does teach us is that regardless of the model, two 
principles must hold into the future. First, competition must 
continue to be permitted to flourish between the different 
models, but in a manner that safeguards the integrity of our 
markets.
    Second, market structure must remain free from unfair 
advantages and unreasonable barriers.
    While much has changed since I sat in that small downtown 
office with my young colleagues, we must remain vigilant in the 
protection of our free markets from over-regulation. As 
Chairman Donaldson said, ``We need to identify real problems, 
consider the practice consequences of the possible solutions 
and then move pragmatically and incrementally toward the goals 
Congress staked out.''
    My own rule, Mr. Chairman, would be that regulatory action 
should only be taken when it is clear that the market is 
failing and less drastic remedies are inadequate. In all other 
cases, let us embrace free competition and always work toward 
greater openness, transparency, and accountability in the 
marketplace. In so doing, we can continue to leverage our 
Nation's technological superiority in a manner consistent with 
the best aspects of America's entrepreneurial capitalism. There 
is too much at stake to do otherwise.
    Thank you for this opportunity to again testify before your 
Committee. It has been a great pleasure to work with you and 
your colleagues on this issue.
    Chairman Shelby. Mr. Frucher.

                 STATEMENT OF MEYER S. FRUCHER

              CHAIRMAN AND CHIEF EXECUTIVE OFFICER

               PHILADELPHIA STOCK EXCHANGE, INC.

    Mr. Frucher. Chairman Shelby, Senator Sarbanes, Members of 
the Committee, my name is Sandy Frucher, and I am Chief 
Executive Officer and Chairman of the Philadelphia Stock 
Exchange, and I would like to say that the Philadelphia Stock 
Exchange appreciates the opportunity to participate in today's 
very, very important hearings.
    A century ago there were more than 100 regional stock 
exchanges in the United States. They served the needs of local 
issuers and investors. Several of the descendants of those 
exchanges survive in the United States today. Although still 
referred to as regionals, in fact we are competing parts of our 
national market system. We trade stocks listed by the New York 
Stock Exchange and Nasdaq.
    PHLX is the oldest securities exchange in the United 
States. We trade over 2,000 stocks listed on the New York and 
American Stock Exchanges, as well as over 1,000 individual 
equity and industry sector options.
    Today, the smaller U.S. exchanges, including PHLX, account 
for a very small percentage of the trading of the New York and 
Nasdaq stocks. Frankly, the ability of the competing exchanges 
to survive was an open question even before the mergers were 
announced. The competing exchanges will not be able to continue 
in their current form. To survive, we must continue to innovate 
in terms of ownership structure, trading systems, fees, and so 
on.
    The question for the SEC, this Committee, and the broader 
marketplace is, should we be concerned about the survival of 
competing exchanges? The answer should be a resounding yes. 
Without competition, the two great markets emerging from these 
proposed combinations will have little reason to innovate, to 
improve services, and to keep fees down. We heard it in the 
testimony today. They had 82 percent market share of the New 
York and 100 percent of the Nasdaq stock market. But without 
the competitors that they faced, an Island that morphed into an 
Archipelago, that has now morphed into a continent, was not 
enough. They have to effectively have competition in order to 
compete.
    The competing exchanges have played a role in the U.S. 
markets greater than their share of stock trading would 
suggest. We have repeatedly served as laboratories of 
innovation. We were the first to adopt clearinghouses, to adopt 
net settlements of trades, to allow automated execution of 
small orders, all improvements that the New York later 
embraced.
    And, frankly, we have helped our competitors. The SEC's 
adoption of Reg. ATS in 1998 gave new force to nonexchange 
alternative trading systems. These firms use new technology to 
offer investors rapid, cheap, anonymous electronic trading 
without a dealer acting as middle man. Two leading ATS's, 
Instinet and Archipelago, developed relationships with smaller 
exchanges as part of their growth strategy, respectively with 
the National Stock Exchange, formerly known as Cincinnati, and 
the Pacific Stock Exchange. They took advantage of the 
regulatory and trading infrastructure of the exchanges in order 
to compete better with New York and Nasdaq. They were so 
successful that they are now in effect being bought out by the 
incumbents they challenged.
    The proposed mergers look like smart moves from the 
perspective of the owners and members of the four organizations 
represented at this table, and I think they were. They are 
brilliant deals. But it is too soon for investors to celebrate. 
Competition will be enhanced only if the resulting duopoly 
competes vigorously for listings and to trade each other's 
listed stocks. If they do not, investors will really suffer.
    Policymakers must be aware of the elimination of 
competitors. My colleague, John Thain, has recently said that 
the United States has too many exchanges and needs 
consolidation. The clear implication is that he believes that 
the number of competitors must shrink. PHLX does not believe 
that issuers and investors are best served by a market with 
just two competing exchanges. To keep trading costs for 
investors low, to keep the quality of execution high, to ensure 
future innovation, additional competition is essential.
    The SEC's Chief Economist said recently, ``Requiring 
markets to expose orders to competing prices offered on 
alternative platforms forces platforms to address how they 
compete for business.'' In plain English, competition between 
market forces them to constantly improve, which is good for 
investors.
    Unfortunately, the SEC's recent actions have tended to 
limit competition. Regulation NMS will likely reduce the 
competing exchanges' share of market data revenues, a critical 
source of our funding. We actually do not know the formula, 
because notwithstanding the fact that the rule has been 
approved, it has not been published. It will also raise 
barriers to entry for new ATS's, and the pending rulemaking on 
governance, ownership, and administration of exchanges could 
raise costs and limit flexibility of the existing exchanges 
that compete with New York and Nasdaq. The SEC must ensure that 
its regulatory process does not unintentionally create a 
monopoly for these business entities.
    In order to survive, the smaller exchanges must innovate. 
We will have to strike alliances and embrace new trading 
systems to stay alive. At each step, we will have to make rule 
and fee filings with the SEC. Regulatory actions like 
Regulation ATS can promote competition. Regulatory actions and 
inactions can also inhibit competition.
    To ensure competition, the SEC must be open-minded to the 
approval of new and innovative structures that will allow 
smaller exchanges to compete, and the Commission must act on 
those competitive actions quickly, frankly, by the first 
quarter of 2006, given the timetables announced by the merger 
participants. These mergers are anticipated to become complete 
before the new Reg. NMS becomes the law.
    In that time frame, if that time frame is not met, if 
alternative systems are not allowed to be online and become 
effective at that time, the potential for competition frankly 
may be lost forever.
    In conclusion, the smaller exchanges will be the only 
competitive vehicle to challenge the duopoly. Our survival is 
already under threat from changes the SEC has adopted in Reg. 
NMS and has under consideration in the exchange governance 
rulemaking. Reg. NMS has made a lot of improvements in the 
system. I agree that it has rationalized the system in a lot of 
ways. But underneath it, it also has the seeds for the 
elimination of competition, and those have to be watched very 
carefully.
    The regulator will control the survival of competition in 
our marketplace. For our survival and the continuation of the 
competition that is so essential for investors, the SEC must 
process promptly the proposals that smaller markets are 
hopefully likely to file to introduce new rules, trading 
facilities, fee structures, and affiliations. Only in this way 
can we continue to offer innovative alternatives to ensure the 
potential for competition in the new duopoly.
    Thank you very much.
    Chairman Shelby. I thank all of you. Much of the debate on 
Regulation NMS focused on how to best modernize the national 
market system to account for new technologies and efficiencies. 
Aside from the legal certainty provided by the final adoption 
of Regulation NMS, is there a correlation between the adoption 
of the regulation and the recent merger announcement? Are these 
mergers a direct result of the new regulatory environment? Are 
they a necessary reaction? Are these transactions evidence of 
larger market trends? They seem to be.
    Mr. Thain.
    Mr. Thain. Yes, Mr. Chairman. I would answer that the 
following way. The changes in the market are in line with the 
expectations of the SEC when they applied Reg. NMS across all 
of the marketplaces. I do not think I would say that the 
combinations are a result of Reg. NMS, but I think Reg. NMS 
anticipated the type of combinations that you have seen. In the 
case of the New York Stock Exchange and Archipelago, you have a 
combination of New York-listed trading with a significant 
position in the over-the-counter trading market.
    I think Reg. NMS, as it was adopted, is quite consistent 
with that more global or more national marketplace. It would be 
very inconsistent to have one set of rules apply to the trading 
of IBM and a different set of rules apply to the trading of 
Microsoft, particularly where both of those stocks will be 
traded under the same umbrella. So, I think actually Reg. NMS 
did a very good job, and Chairman Donaldson should get credit 
for that, in anticipating the developments in the marketplace.
    Chairman Shelby. Mr. Putnam, do you have anything to add to 
that?
    Mr. Putnam. I agree with John. I would say though that the 
pressure on a consolidation was there, and as I thought about 
what to do next, Reg. NMS and the trade-through rule was not 
hanging over my head as, oh, we have to do something 
specifically because of that. I think our view, as we looked 
around the world and thought about how things would change in 
the United States, as we have to compete with foreign 
competitors. The idea of combining products, meaning trading 
futures, options, and stocks on a single platform is my vision 
for where we are headed in the future, and there are certainly 
signs of that from the competition abroad.
    So the real driving factor for me was we needed some scale 
and some size to be able to compete globally.
    Chairman Shelby. Mr. Frucher, you have a different view?
    Mr. Frucher. No, actually, I do not, but I just have a 
slight modification. I think we should not confuse internal 
competition with a need for vertical integration. I think what 
has been stated, for us to compete globally we have to have the 
ability under one roof to trade equities, options, futures, and 
maybe even look at clearing, and certainly technology, to be 
competitive. That is not the issue. The issue is whether or not 
we have internal competition to spur the innovation and that 
kind of vertical integration.
    Chairman Shelby. Mr. Nicoll, you agree with that?
    Mr. Nicoll. I do. I mean I do not think there is any large 
disagreement here. My own view, running a company, was the 
pressures to deliver profitability and in an extremely 
competitive environment where our ability to charge per unit 
had drastically declined over the past 5 years. The price that 
Instinet was able to get to trade 100 shares in the 3 years 
prior to this merger agreement had gone down by 80 percent. So 
those are enormous economic pressures on an organization, and 
we needed to have scale. I think this would have happened with 
or without the regulatory changes. I do agree with John that 
they are concordant with the changes that have been passed.
    Chairman Shelby. Mr. Greifeld, you have a comment?
    Mr. Greifeld. I agree with everybody.
    [Laughter.]
    Chairman Shelby. Our national market system tries to strike 
a balance between competition among orders, and competition 
among market centers. If the mergers are finalized, there will 
essentially be two dominant players in the equity markets 
controlling most of the liquidity. How will this consolidation 
affect the balance between order and market competition? How 
will the mergers alter the competitive dynamic that we have? 
Should we be concerned that a duopoly will emerge? Mr. Frucher, 
I will ask you.
    Mr. Frucher. I actually think that strong market centers 
are very important for competition, but we should not be 
looking at Eurex and Euronext really as the paradigm of what we 
want in markets. Those are monopolies. They trade in their own 
silos. They are not as transparent as our markets. They are not 
as liquid as our markets, and we can face that competition. I 
am sure every Member of this Committee got a ton of mail last 
year urging them to keep Eurex out of the futures market in 
Chicago, and look what happened? They came in and they got 
their butts whipped. But the investor got much cheaper fees 
because of the competition.
    The SEC does not look at it as a threat. The SEC has 
lowered the barrier to entry and it now allows foreign markets 
to come in and effectively buy U.S. markets.
    The question really is not whether or not we have a 
duopoly, we do. The question is, will they be challenged by the 
next generation of Islands, Instinets, and Archipelagoes? And 
if we use regulation to inhibit, to restrict, or to preclude 
competition within our markets, that duopoly will atrophy.
    Chairman Shelby. Mr. Nicoll.
    Mr. Nicoll. I totally agree with Sandy. What the Committee 
has to understand is there are two real components in NMS which 
would lower barriers to competition for new people to come in.
    There are two guiding principles, fair display and fair 
accessibility. Now, if you have the highest bid in the United 
States, your bid is going to be displayed throughout the entire 
country, and that gives anybody, even the smallest market, the 
ability to come in, offer the highest price, and get access to 
this national market system.
    Moreover, the largest markets cannot unreasonably 
discriminate against anybody who wants to access their 
marketplace, so they do not have the ability to use their scale 
to allow people not to get into their marketplaces.
    Chairman Shelby. Information changes everything, does it 
now?
    Mr. Nicoll. That is correct.
    Chairman Shelby. Mr. Thain, you have any comment?
    Mr. Thain. Yes. I think there are two important points, one 
of which Ed was talking about, which is the Reg. NMS actually 
protects the smaller markets, and there are very low barriers 
to entry into our marketplace. Archipelago is only an 8-year-
old company. The ISE and the options market was created 5 years 
ago from zero and has a 35 percent market share. So there is 
plenty of room for new competitors to come in, and Reg. NMS 
actually protects them from being ignored. I think that is one 
point.
    But on the second point, which is you have heard a number 
of people talking about global competition. I think that from 
the perspective of the United States, where we do today have 
the dominant position in the world in terms of our financial 
markets, we do face competition from those much more 
diversified global competitors. So you have heard the talk 
about Euronext or Deutsche Borse who trade a much broader range 
of products.
    Deutsche Borse has a market cap of about $8 billion, so 
they have a tremendous amount of financial flexibility. They 
have a currency to make acquisitions, and yes, it is true that 
they have not been all that successful so far, but we are going 
to have to compete on a global scale and we need entities who 
are competitive on that basis.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I want 
to welcome the panel.
    I am interested in how the self-regulation would proceed 
under these proposed arrangements. The SEC concept released 
concerning self-regulation, published December a year ago said:

    The SRO demutualization raises a concern that the profit 
motive of a shareholder-owned SRO could detract from proper 
self-regulation.

    And just a few weeks ago The New York Times had an article, 
``Big Changes at the Exchanges Bring Their Self-Regulation into 
Question,'' and went on to say:

    The New York Stock Exchange's plan to acquire an electronic 
trading system has called into question the future of the self-
regulation system that exchanges use to oversee their markets 
and the conduct of their members.

    I understand that the exchange and the plans to reorganize 
the regulatory function as a not-for-profit organization, but I 
understand that this organization would be under the board of 
the for-profit merged entity. Is that correct?
    Mr. Thain. That is substantially correct. It would not 
include any nonindependent members of that board, so it would 
be a subset of the board.
    Senator Sarbanes. What consideration was given to spinning 
off the regulatory function to a totally independent body and 
why was that approach, which would seem to avoid at least some 
of the problems that people perceive, not followed?
    Mr. Thain. Ranking Member Sarbanes, we believe that the 
best structure for the regulatory functions of a marketplace is 
one that balances the independence of the regulatory functions, 
and so that we have to keep the regulatory functions separate 
from the business of the exchange, but keeps the regulatory 
functions close to the marketplace, so it does not in fact spin 
it off totally. Because we think that by being close to the 
marketplace there is an expertise and an understanding and a 
sophistication that allows them to do their job better.
    And so the structure that we are proposing is actually an 
extension of the structure that we have today that was approved 
by the SEC a little over a year ago, whereby the regulatory 
functions, which are led by Rick Ketchum, report up to a 
subcommittee of our board of directors, and as you know, our 
board of directors is now new, and with the exception of 
myself, is totally independent. So the board members are not 
members of the regulated firms. They are not CEO's of listed 
companies. They do not have interests in the operations of the 
exchange. And so the regulatory functions report up to a 
subcommittee of our board that is completely independent, so I, 
as the CEO of the exchange, run the business, I have nothing to 
do with the running of the regulatory side.
    What we are proposing in this structure is an extension of 
that. In some ways even more separate, where we are taking 
those regulatory functions, which are currently inside the 
exchange. We are putting them in a not-for-profit, not-public 
entity, and the board structure will be similar. So the board 
of that new regulatory entity will be comprised of members of 
our current board, who again are totally independent. It will 
not include me, as well as some third-party independent 
individual. So in some ways it is slightly more separate, but 
we do believe that keeping it close to the business of the 
exchange, keeping it close to the marketplace, allows it to be 
a better regulator.
    Senator Sarbanes. Mr. Greifeld, how does Nasdaq propose to 
deal with this?
    Mr. Greifeld. Senator Sarbanes, how Nasdaq handles it today 
is certainly different than what Mr. Thain is recommending. We 
have our regulatory services performed by the NASD. The NASD is 
separately capitalized. They are separately funded, and they 
have a separate board from Nasdaq. The NASD, I think, is 
certainly widely recognized as the gold standard for 
regulation, and they are incredibly close to the business and 
understand it.
    In our relationship, we contract with them for regulatory 
services. We do not have any input in terms of how they go 
about conducting regulation. If they choose to conduct a 
intensive investigation of a member firm which happens to be a 
very large customer of the for-profit Nasdaq entity, we have no 
control and/or knowledge of it, and we believe that is the best 
way to operate.
    We do have the ability to go in and audit for waste with 
respect to how they discharge their regulatory function without 
knowing precisely who they are regulating, and we certainly 
take that opportunity. We are happy to see that the NASD 
certainly has become a very lean and effective regulator.
    So they are close to the business, but it is a separately 
funded board, and I think this set up came about as Nasdaq 
evolved to a for-profit company, and they do not have to look 
to us for any input or control in their finances.
    Senator Sarbanes. Mr. Chairman, my time is up. Thank you.
    Chairman Shelby. Senator Hagel.
    Senator Hagel. Mr. Chairman, thank you.
    Gentlemen, welcome. You all have spoken this morning about 
global competition and I want to focus my few minutes in 
questions on that large issue.
    Mr. Thain, in your prepared testimony, you talked about 
Part 2 consolidation of securities markets, and you go on to 
say, ``While the SEC has streamlined the rules and structure 
for our national market system, it is up to the U.S. markets 
themselves to respond to a rising global challenge. The players 
must now perform on a new playing field.'' You go on to talk 
about today equity and capital markets are global, competition 
for capital is global. All five of you have noted that.
    A couple of questions I would like to present to all of you 
and would appreciate each of your answers. One, when we talk 
about, as Mr. Frucher has, the consolidation of exchanges, is 
the consolidation of exchanges, as we see that developing, is 
that good for global competition? And the broader question is, 
what is, in each of your opinions, the greatest challenge to 
our markets when we factor in the global dynamic of options, 
now that we have global competition for capital? The options 
and opportunities are far wider and deeper than they ever have 
been, and I suspect will continue to increase in the depth and 
width of those opportunities for investors.
    Mr. Thain, start with you.
    Mr. Thain. Senator Hagel, thank you. If you look at our 
foreign competitors today, they, in one platform, trade cash 
equities, they trade options, they trade futures, they trade 
certain derivative products, and they trade certain fixed 
income products. So they have a much greater product 
diversification, and they gain great advantage by being able to 
trade those multiple products, both in terms of their earnings 
power and their growth prospects, as well as increasing the 
overall level of trading in their marketplace because of that.
    And so that is probably the single biggest competitive 
factor today, is that our markets are for the most part 
fragmented. So the cash equity markets are separate from the 
options market, which are separate from the futures markets. 
And that is a competitive disadvantage to us.
    The second factor is that some of our foreign competitors, 
particularly Euronext and Deutsche Borse, are vertically 
integrated. So not only do they run the exchanges, but they 
also run the clearing, the settlement, and the custody 
functions, and that gives them much greater earnings power, and 
therefore greater financial power in the world.
    In the United States in cash equities, the clearing and 
settlement functions are in industry utility, DTCC and NSCC, 
which is good from an investor point of view because they are 
much lower cost, but is a negative from a competitive point of 
view of having to compete with these global marketplaces.
    I think that when we look at the world competitive 
landscape, we will seek to be more product diversified because 
we really cannot be more vertically integrated, and really 
making sure that as our markets develop, that we increase the 
overall level of activity by allowing, for instance, cash 
equities and options to be traded in the same place. That will 
both diversify our businesses, but also allow for more trading.
    Senator Hagel. Thank you.
    Mr. Greifeld.
    Mr. Greifeld. I agree with a lot of what John said. I do 
believe that our foreign competitors do not actually run on one 
platform but they are under one holding company, and they are 
all characterized by having monopoly positions within their 
home market and can use that monopoly position to cross-
subsidize international efforts, and certainly we saw that 
happen with Eurex coming to the United States.
    But what I think will be our calling card and our ability 
to compete is the fact that we are battle tested, we compete 
very aggressively here in the United States, and our markets 
are very efficient. So to the extent that we have foreign 
competition, and we will, and it will be real, I would not sell 
short the ability of the people at this table and others 
representing the capital market system to be able to compete. 
We are battle tested and we know how to win in this scenario.
    Senator Hagel. Thank you.
    Mr. Putnam.
    Mr. Putnam. I will start with the greatest challenge. Those 
are technology and capital. On the technology front, I believe 
that we are going to get to a point where we can have 
multiproduct, single platform type trading which will increase 
demand for trading, as John pointed out, but it will take some 
real innovation for us to get there.
    On the capital front, both of those things actually lead to 
what I think motivated these mergers, which is to get scale. As 
Ed pointed out, the prices that we can charge have dropped 
dramatically. We do have highly automated systems that we run 
today, and if you just add volume to it, you can actually 
survive. So technology capital leads to scale.
    Senator Hagel. Thank you.
    Mr. Nicoll.
    Mr. Nicoll. I do think there is real benefit for 
derivatives and cash markets to trade in the same system. I 
think the derivatives markets are very positive. These are 
markets in which people are exchanging risks in the world, and 
it is very important that risks are held by the parties that 
can most tolerate those risks, they are priced properly in that 
sense.
    Part of that, of having good derivatives markets is having 
very low cost between the derivatives markets and the cash 
markets because the higher the arbitrage costs of those 
markets, the less efficient the derivatives markets are.
    So, I think we will evolve toward one of the promises and 
one of the real changes that I think will occur over the next 
10 years, is you will see both derivatives and cash markets 
trading over one platform because it is more efficient. We can 
lower the cost of the derivatives markets and we can more 
efficiently exchange risks than we can in the current scenario.
    So that is one of the real promises of these mergers and 
real promises of the electronic marketplace as a whole.
    Senator Hagel. Thank you.
    Mr. Frucher.
    Mr. Frucher. Thank you, Senator. I agree with Mr. Greifeld. 
The European competition, the big markets, Eurex and Euronext, 
they do not trade on the same platform and we should not 
confuse competition with a business structure. They, in fact, 
have vertically integrated. That is the right business 
structure. You should trade equities, options, and futures, 
regardless of your size, under one roof and ultimately on one 
platform. That is an aspiration that we really all, whether big 
or small, have to achieve to be competitive, and actually go 
ahead of the European competition. So the business structure, 
vertical integration is necessary.
    But the only way we are going to be competitive with those 
European markets and those bigger markets is to have internal 
competition.
    I disagree, respectfully, with Jerry Putnam, who actually 
has been a genius in developing his structure by merging with a 
regional exchange. This is not a question of scale. If it was a 
question of scale we should have been very happy with New York 
having 82 percent of the market and Nasdaq having 100 percent 
of its existing market. That was scale.
    What changed them and brought them into the position to now 
toast the ability to compete internationally, is the fact that 
they had competition who pushed them forward technologically, 
who pushed them forward in a heck of a lot of different ways. 
And if we eliminate, as NMS can--and I believe it can--create 
barriers to entry by taking what was a 20 percent standard to a 
5 percent standard for new competitors in the marketplace, by 
changing the formula so regional exchanges cannot get the tape 
revenue, then Mr. Nicoll and Mr. Putnam who came to be at this 
table through their affiliation with regional stock exchanges 
who were able to use their tape revenue to lure them in is what 
sustained it.
    So the biggest threat is the elimination of internal 
competition because duopolies will atrophy without internal 
competition and make them unable to compete against the global 
competition.
    Senator Hagel. Thank you.
    Mr. Chairman, thank you.
    Chairman Shelby. Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    Before I get into the main area I want to talk about, I 
want to go back to the question that the Chairman first asked, 
which was the relationship between the mergers that we are 
looking at here today, between the four companies that we have 
here at the table, and Reg. NMS. And if I understood your 
answers to the Chairman's question, it was that Reg. NMS had 
nothing to do with these mergers, which is interesting to me 
because there has been a lot of speculation about that, as you 
know. There are those who were opponents of Reg. NMS, who said, 
look, this is proof, soon as Reg. NMS was adopted, we see these 
mergers and it is proof that Reg. NMS is going to crimp down 
competition and Archipelago and Instinet saw that their future 
was bleak, and so they had better merge. Others said, no, this 
is proof that Reg. NMS is working just the way we wanted it to 
work because there is too much internal competition and this is 
starting to consolidate markets in the United States, and it is 
just exactly what we should have happening, but all of those 
explanations were that there was a connection between the 
adoption of Reg. NMS and these mergers.
    Now, is there or is there not?
    Mr. Greifeld. I certainly believe that there is, and I 
think that is what the panelists commented on, but it is not a 
100 percent correlation. Clearly, the certainty that Reg. NMS 
expressed to the marketplace made it more comfortable I think 
for the participants to enter into very significant 
transactions. The fact that the New York Stock Exchange would 
have to go electronic to compete in their post-Reg. NMS world 
gave me comfort to consummate the transaction with Instinet, 
knowing that we will then be in a better position to compete in 
that world.
    Senator Crapo. Mr. Nicoll.
    Mr. Nicoll. I think the question is, I mean much of the 
debate centered around the trade-through rule and Reg. NMS. So 
the question is, did the SEC's final trade-through rule force 
these mergers? I do not believe that to be the case. They were 
all being negotiated well before that had been decided one way 
or another.
    If the question is, does Reg. NMS create a competitive 
environment which helped to spur these mergers, I agree that 
the answer is yes. I mean, realize that these exchanges are 
without two major sticks in the bundle of private ownership. 
When you own your house, you get to exclude somebody from 
coming in and sitting down in your living room. Neither the 
Nasdaq nor the New York Stock Exchange nor INET, nor anybody up 
here actually has that right. Anybody can come into our living 
room because we cannot unreasonably discriminate in terms of 
our competitors. So if the New York Stock Exchange wanted to 
use its monopoly power under Reg. NMS, it cannot. It cannot 
keep people out from its marketplaces.
    Also any small person, the smallest competitor under 
Regulation NMS, under the display rules, gets to participate in 
the national market system, and this is a major spur toward 
competition. I believe that that competition was a background 
condition which helped to make the argument for further 
consolidation in the marketplace. So to that extent I agree, 
but I disagree with the notion that because of the trade-
through rules, that is what created these mergers.
    Senator Crapo. Thank you. My time is running out, so for 
the others who may want to jump in on this, maybe you can add 
your comments to this next question, because it is related, and 
that is, one of the rationales for Reg. NMS seems to be--and 
Mr. Frucher has talked about this--the notion that there is too 
much competition internally in the United States and that we 
need to consolidate, and that will strengthen us for 
international competition.
    And I know that I have worded it in a way that might cause 
it to be a little bit of a scary proposition, to be approaching 
our market by saying we have too much competition and trying to 
say it is better in the United States to have regulatory policy 
that discriminates against competition. There is concern out 
there about whether Reg. NMS does that.
    Could you discuss with me--and any of you can jump in on 
this--is that correct? Are we concerned that there is too much 
competition or there are too many competitors internally, or 
just what is it that is the rationale behind the notion that we 
need to try to drive consolidation in our markets?
    Mr. Greifeld. The one thing I would like to say is that 
there is two types of competition, and Chairman Shelby kind of 
touched on it before. We need in this market to have 
competition between limit orders, and that is introducing a 
time competition. And these mergers will definitely increase 
the competition among limit orders to get executed. As you put 
more limit orders in one place, you have increased competition 
among limit orders, not so much against markets, so that is a 
positive of these markets.
    I think what Ed was speaking about, under Reg. NMS you will 
have a lower barrier to entry. Now, Ed, Jerry, and myself have 
spent a substantial portion of our careers as entrepreneurs, 
and I would say here this is a best entrepreneurial activity, 
to come in and try to compete against the largest players, in 
that all you have to do is have one customer post one order and 
the larger markets cannot trade through you at this point.
    When you think about what Jerry and Ed accomplished under 
the old rule set, it is a lot easier today for new competitors 
to come in.
    Senator Crapo. Mr. Thain.
    Mr. Thain. Yes. I would reinforce what Mr. Greifeld said, 
which is Reg. NMS, in its current form, encourages competition. 
It protects competition. It protects small markets from being 
ignored. It requires orders to be routed to whatever 
marketplace has the best price, and if that is a little start-
up entity, that is who the order goes to. So it does in fact 
allow for and protect competition.
    I also do not agree that there is too much competition in 
the United States. I think there is a lot of competition, and I 
think that is good. I think that the consolidation is not being 
driven by too much competition in the United States, that 
consolidation is being driven by the desire to compete with 
those global players that are in fact more diversified.
    Senator Crapo. Mr. Frucher.
    Mr. Frucher. Let me say that in order to compete, you have 
to be there. And you cannot just look at Reg. NMS in isolation 
and say, well, you know, Reg. NMS does in fact have features 
that enhance competition. In fact, the single most important 
part of Reg. NMS is that it in effect will hopefully spur the 
two large behemoths to compete with each other, but I do not 
believe economic entities do that unless they are forced to do 
that by competition.
    Yes, NMS makes it possible to have competition, but if you 
add Reg. NMS with the concept release that the SEC has out, and 
the various changes that they are compelling regional markets 
to make, you price them out of business. So you will not have 
competitors.
    And in fact, I disagree, respectfully, with the notion that 
NMS has made it easier for new entrants. Reg. ATS did in fact 
open up the door for competition. This is ATS-2. We call it 
NMS, but this cleans up some of the problems and unanticipated 
problems created by Reg. ATS, and I do not want to get into 
jargon, but effectively there were issues like tape shredding 
and other kinds of issues that it needed to address and to 
force cross-market debate.
    But in fact when you drop the barrier from 20 percent to 5 
percent, you are not enhancing the ability for somebody to 
enter the market to be competitive. You are going up against 
significant giants. The fact of the matter is that the two 
successful ATS's who are sitting in the table, who are 
celebrating their success by consolidation, that was made 
possible by the fact that they were able to team up with the 
regional exchanges. Take my word for it, regional exchanges are 
endangered entities.
    I am not looking for protectionist legislation. If we do 
not come up with ideas to present to the SEC, then we do not 
have a right to exist. But the process is almost monumental in 
some instances to get rules.
    I love the fact that Mr. Greifeld said that he is expecting 
to get his rule through for it to become an exchange. Ask him 
how long he has been expecting that rule to get approved? Four 
and a half years. And I have submitted rules in which I have 
been told, well, we will deal with your rule after we deal with 
that rule. How do you compete?
    Senator Crapo. Mr. Putnam, my time is way over. If the 
Chairman will allow, Mr. Putnam wanted some response to this. 
Is that all right, Mr. Chairman?
    Chairman Shelby. Go ahead.
    Mr. Putnam. I will be quick. In response to Sandy's point 
about the behemoths not wanting to compete, today the New York 
Stock Exchange has zero market share trading Nasdaq stocks. The 
acquisition of ArcaEx will put it in a new competitive game, 
competing with Nasdaq for trading Microsoft and Intel and those 
securities.
    Bob's deal with Ed is going to add an electronic component 
to his marketplace for trading in NYSE-listed stocks. Both of 
us traded everything going into this.
    The last thing I would say is with respect to the trade-
through rule, if you looked at the New York Stock Exchange's 
position with 80 percent market share in trading its stocks, no 
trade-through rule would have allowed it to ignore every other 
smaller marketplace, including ours, when it came to trading 
IBM, and just simply under this rule they cannot, and I do not 
see how that in any way restricts competition. Anyone can come 
in, as Bob pointed out, with one order for 100 shares and going 
forward you are going to have to trade with it. Thank you.
    Senator Crapo. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Gentlemen, welcome. It is good to see you. Thanks for 
spending your morning with us. I think maybe Senator Sarbanes 
may have asked a question similar to the one that I am going to 
ask, and I think maybe Mr. Thain and Mr. Greifeld had a chance 
to respond to it. I am going to ask my neighbor from the north, 
up in Philadelphia, if he would not mind responding to the 
question. Let me just set the stage.
    We have seen in the last month or so some interesting even 
exciting changes in our Nation's market system. The New York 
Stock Exchange is now merging with Archipelago. We have seen 
Nasdaq announcing acquisition of I think it is Instinet Group. 
These mergers are going to result in a need we note for a 
change in regulation.
    In this new environment, Mr. Frucher, let me just ask, do 
you think it is critical that there be effective regulation to 
keep our market strong and to protect investor confidence? If 
you do not mind, just comment for the record on your views on 
what the new regulatory structure of these marketplaces should 
be. And finally, are you satisfied with the suggestions of 
others, including maybe some we have heard here this morning?
    Mr. Frucher. I think both marketplaces have responded very 
well in terms of ensuring the integrity of their markets. I 
think the most important point has to be made that a monopoly 
in regulation is as bad as any other monopoly. You will simply 
have an increase in fees and an increase in cost, and bringing 
the FBI in to do local law enforcement is not exactly the best 
model.
    Self-regulation does not connote sole regulation. I think 
the structure or the concept of the structure that we have now, 
which is self-regulation of your marketplace and a regulator 
that sits over them, is an effective structure. It just has to 
be staffed adequately, it has to be funded adequately, and it 
has to be made to work.
    I think Nasdaq chose to divest itself, or NASD chose to 
divest itself of Nasdaq and separate themselves completely. New 
York is approaching this in a very intelligent and systemic 
way. Gerry Putnam, when he made his deal with the Pacific 
Exchange, created a very good structure, where he separated the 
regulation from the operations of the stock market. So, I think 
the key here is that you can have a diversity of regulatory 
structures. It is not a sole structure. They all have to be 
funded. They all have to be vigilant. But one single regulator 
is not a good structure.
    Senator Carper. Thanks. Anybody else have a comment on 
this? Yes, sir? He took your name in vain, is it?
    Mr. Putnam. It would not be the first time.
    [Laughter.]
    I believe in competitive regulators for the same reasons 
that Sandy pointed out. If you do not have competition among 
the regulators, you are going to see costs rise and the quality 
of the service diminish.
    That said, a marketplace doing its own regulation, I mean 
the brand is about quality regulation within your marketplace. 
So whether it is done by a completely separate regulator like 
our relationship with the PCX or one that is a little bit 
closer like the one that the New York Stock Exchange is 
proposing, each market is going to really have to, especially 
in the information age and the willingness of the press to 
report on any bad deeds among regulators, it is a process that 
I think is going to work regardless of how it is structured.
    Senator Carper. I apologize for not being here sooner. I 
have three Committee hearings going. You are probably wondering 
where is everybody? We have a lot of things. We are trying to 
be in three or four places at once, so just bear with me on 
this question. One of the great advantages for having a panel 
like this, smart, well-informed people, is to get a diversity 
of opinion and find out where they disagree, but maybe even 
more importantly, to find out where they agree. Let me just ask 
you for a take-away for me from this hearing. Is it Nicoll, 
your last name Nicoll?
    Mr. Nicoll. Yes.
    Senator Carper. Mr. Nicoll, what would be a good take-away 
for me with respect to where do you all agree?
    Mr. Nicoll. I think we all agree that Regulation NMS has 
moved us forward. We do not agree with every aspect of it, but 
we agree that finality has enormous value to all of us and that 
the SEC has done all in all a good job at addressing a very 
comprehensive, very difficult issue, and making decisions about 
it.
    We all agree that there are many procompetitive elements to 
it. Sandy is concerned about some elements to it, but we all 
believe that it is pretty competitive, and I think we all agree 
that competition going forward is going to continue, and that 
it is a good thing. And I suppose one of the things that we 
could all agree on is that we do not know the future, and if we 
come back 5 years from now or 2 years from now and we do find 
that competitive forces are not continuing to shape the 
innovation in the marketplace, that we might have to take 
another look at it. But right now it looks to us like all in 
all it is a pretty procompetitive environment out there.
    Senator Carper. Mr. Thain and Mr. Greifeld, do you agree 
with anything that Mr. Nicoll just said about your----
    [Laughter.]
    Mr. Thain. I basically agree with everything that Ed said.
    Mr. Greifeld. I agree we do not know the future.
    Mr. Thain. Yes. I certainly agree that Reg. NMS, as it was 
passed, is a good rule and we want it to stick, and we do not 
want to disrupt it because it is good for the marketplace, it 
is good for investors, it is good for competition, and it is 
also good to know what the answer is.
    I think all of us collectively are happy with the rule. Not 
everyone is happy with every single aspect of it, but people 
are generally happy with the rule and want it to stick, so that 
is absolutely one important take-away.
    The only thing that I would add is I think there is pretty 
clear consistency that we do have to worry about global 
competition. We have to worry about the competition among the 
players outside the United States that are more diversified, 
that do have a broader product mix, that do have a different 
business model, particularly being vertically integrated, and 
who have great financial strength both in terms of earnings 
power, market capitalization.
    Senator Carper. Thank you.
    Mr. Greifeld. I would agree with that. Just to kind of make 
the point, on my stock watch screen at my office I have up the 
Chicago Mercantile Exchange, the International Securities 
Exchange here domestically, in addition to, obviously, ArcaEx 
and Instinet, and internationally, I watch every day what is 
happening to the LSE, Euronext, and Deutsche Borse. So that is 
what we look at. That is what we know where the competition is 
coming from.
    Senator Carper. Thank you all.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Mr. Chairman, thank you.
    I apologize to all of the witnesses, particularly our two 
New Yorkers, Mr. Thain and Mr. Greifeld, for being a little 
late. It is a very busy day, as you have probably heard.
    I want to thank you, Mr. Chairman, for holding this 
important hearing. I think we are in a totally different place 
than we were last time we discussed this. Regulation NMS has 
passed, and I think, in a sense, a certain wisdom of NMS has 
been shown by developments since then. We are going to have 
some real competition in terms of major players, two at least, 
who are going to be up and down the line trading stocks in ways 
that their customers want them to trade, and I think that is 
all to the good. As somebody who is worried about the liquidity 
of the markets and the depth, and worried about fragmentation, 
and yet like every American, I love competition, I do not think 
you can draw a better structure to try and see how this works.
    So, I am very laudatory of what has happened so far in the 
markets, as somebody who cares about them both parochially--New 
York's point of view--but also in a more catholic way, because 
we care as Americans and as citizens of the world about having 
deep markets, as Mr. Greifeld mentioned. They are always 
looking over their shoulder now and if we fall here in America, 
those markets will go before you can say whoopie.
    I am excited about the markets. I think they are going to 
promote competition. They are going to be orderly, but they are 
going to be transparent, and they are going to be liquid, and I 
think both mergers have ended up being a very good idea as 
well, which will fortify both of those markets.
    Now we have a few other things we have to look for, NYSE's 
hybrid. I think that is excellent, and Mr. Thain has really 
performed close to miracles in a very difficult situation. We 
have a tough job. I guess one of the few jobs that might be 
even tougher is right now to be head of the NYSE with all the 
pushes and pulls in there, and I want to say I think you have 
handled it very well. You know, I think we are in pretty good 
shape. I think we can watch and see what happens. We have to 
make sure that things roll out as people appear, and I also 
want to compliment--he will be here tomorrow--Chairman 
Donaldson, who I think took the bull by the horns, and----
    Chairman Shelby. Senator, it is past 11:30. There has been 
an objection under the rules to us meeting by a Democratic 
leader, and so we are going to have to----
    Senator Schumer. I would ask unanimous consent to submit my 
questions in writing?
    Chairman Shelby. Without objection, so ordered.
    I want to thank the first panel for being here.
    More than that, I want to thank the second panel, and note 
that we have to recess under the rules, but your testimony will 
be made part of this hearing record in its entirety, your 
written testimony.
    We are in recess according to the rules of the Senate.
    [Whereupon, at 11:33 a.m., the Committee was recessed.]
    [Prepared statements supplied for the record follows:]
               PREPARED STATEMENT OF SENATOR WAYNE ALLARD
    I would like to thank Chairman Shelby for holding this hearing to 
discuss the Securities and Exchange Commission's recently adopted 
Regulation NMS and other recent developments in the U.S. equities 
markets.
    I applaud the Chairman and Ranking Member's commitment to examining 
this proposal, as it has broad reaching implications for the way in 
which the U.S. equities markets will operate going forward.
    In fact, we have already seen some of the implications of this rule 
in the New York Stock Exchange's recent acquisition of Archipelago, and 
the Nasdaq's acquisition of Instinet.
    I have been encouraged by the haste of these recent transactions 
that healthy competition will continue to thrive among U.S. market 
centers.
    Reg. NMS is likely the most substantive SEC proposal many of us 
have seen during our tenure as Members of this Committee. It also 
generated a great amount of debate amongst industry participants, 
Commissioners, and even Members of this Committee.
    The U.S. markets will now operate under a new regulatory framework 
that I am hopeful will address the needed changes resulting from 
technological developments in the markets.
    I would like to thank our witnesses for appearing before the 
Committee this morning. I know this has occupied a great amount of your 
time and energy over the past several years. I look forward to your 
testimony.
                               ----------
                PREPARED STATEMENT OF SENATOR MIKE CRAPO
    I am disappointed and troubled that the Commission was unable to 
proceed with one voice on Regulation NMS (National Market Structure). 
Instead, a divided Commission, with deeply held convictions both for 
and against the rule, voted 3 to 2 in favor of the 500 page rule.
    Although Regulation NMS covers four primary topics, the majority of 
the debate centered around the trade-through rule. The lack of 
consensus inside or outside the commission on the need for a trade-
through rule at all, let alone extending the trade-through rule, raises 
many red flags
    Additional red flags were raised due to the fact that there was 
very little proof that this was something required in the markets. 
According to the SEC Office of Economic Analysis, approximately 2 
percent of all trades on Nasdaq and NYSE were traded through in 2003 
and the majority of trade-throughs only trade-through by a penny or 
two.
    These numbers are also curious since the NYSE market currently has 
a trade-through rule, while the Nasdaq market does not. These numbers 
do not demonstrate to me that the market is not working and that more 
regulation is the answer. I am interested in whether our witnesses 
believe this rule will substantially stop trade-throughs and what will 
be the cost of implementing this rule.
    While investors clearly care about price, other attributes like 
anonymity, trade size, and execution speed also factor into an 
investor's trading decisions. An investor might be willing to forgo 
best price, at times, if that anonymity, or some other factor, helps 
him or her to protect a valuable trading strategy, for example.
    It is unfortunate that the Commission decided against developing a 
more consensus-based alternative to Regulation NMS, rather than forcing 
such divisive mandates with so many experts unconvinced of the 
benefits. A credible alternative was available that would have allowed 
for more evaluations and then a future Commission vote to determine if 
the rule should apply to the Nasdaq market.
    Thank you, Mr. Chairman for holding this important hearing, and I 
look forward to hearing the testimony of the panels.
                               ----------
                  PREPARED STATEMENT OF JOHN A. THAIN
                      CEO, New York Stock Exchange
                              May 18, 2005
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee. I am John Thain, Chief Executive Officer of the New York 
Stock Exchange, Inc. Thank you for inviting me to participate in 
today's hearing. I am grateful for the opportunity to speak to you.
    Mr. Chairman, we appreciate your Committee's leadership and 
oversight of our national market system. We view our Nation's financial 
markets from different vantage points, but I believe that our 
respective responsibilities unite us in a common challenge: Put simply, 
how can we best serve the interests of U.S. investors and issuers, and 
how can we strengthen the competitive position of U.S. markets in the 
world.
    For its part, the New York Stock Exchange stands at the center of 
our Nation's financial system. We are a $20 trillion market 
facilitating the capital-raising process in the Nation's ongoing quest 
to create new jobs and to fuel strong and sustained economic growth. 
Our leadership was built upon a commitment spanning over two centuries 
to gain the confidence of our customers. Today, they include America's 
90 million investors, the institutional community, market 
professionals, and over 2,700 of the world's leading corporations.
    Since I assumed the position of Chief Executive Officer last year, 
the New York Stock Exchange has initiated a transformation that has 
reached into every corner of our business. Following a difficult 
period, we are doing everything possible to restore trust in the 
Exchange and to better serve our customers. Today, we have an entirely 
independent board, with the exception of me, a new governance structure 
with regulation independent from the business side, and new and higher 
levels of disclosure and transparency. In short, we are on the right 
track.
    At the same time, we have renewed our commitment to deliver the 
highest standards of market quality. Day-in, day-out, customers can 
expect that the New York Stock Exchange will provide them with the 
deepest liquidity, the lowest volatility, the tightest spreads and the 
best prices. We offer the best price to customers in stocks of our 
listed companies 89 percent of the time. That we are able to provide a 
market of this caliber for listed securities significantly enhances the 
position of U.S. financial markets in the global competition for 
capital.
    We have built our reputation upon a great tradition of service. 
However, what we have not offered to a sufficient degree is speed and 
innovation. Speed is important to a segment of our customers, 
particularly on the buy-side. So, too, is innovation, by which I mean 
providing our customers more options on how they can trade, and from 
which products they can choose.
    Just as importantly, we recognize that only by offering customers--
investors and issuers alike--a better marketplace, and only by 
providing them with more choices, can the New York Stock Exchange 
strengthen its ability to grow and to compete both domestically and 
globally.
    Meeting these twin challenges--to provide the world's best 
marketplace for customers, and to strengthen the position of U.S. 
capital markets in the world--defines and drives the mission of the New 
York Stock Exchange.
    This is why we are building the Hybrid market, to offer investors a 
choice between the sub-second speed of electronic trading, and the 
opportunity for price improvement that distinguishes the auction 
market.
    This is why we are taking the historic step to become a public, 
for-profit exchange, by merging with Archipelago, an outstanding, 
entrepreneurial company that is pioneering leading-edge platforms and 
products.
    Our initiatives to embrace electronic trading and provide investors 
with the ability to choose the way their trades are executed are very 
much complementary with the value that the specialists and floor 
brokers will continue to provide investors and our listed companies.
    Finally, this is why we urged that Regulation NMS (Reg. NMS) set as 
its paramount purpose the protection and promotion of the interests of 
U.S. investors and U.S. competitiveness, while modernizing the rules 
for America's 21st century national market system.
    I will touch briefly on each of those topics. Let me begin with 
Reg. NMS.
Regulation NMS
    Mr. Chairman, the regulatory environment governing our market and 
all of the U.S. securities markets is undergoing dramatic change. In 
adopting Regulation NMS on April 6, the Securities and Exchange 
Commission established rules that will strengthen the protection of 
U.S. investors, while fostering robust competition and innovation in 
the U.S. markets.
    The rule accomplishes these goals in the right way, not by favoring 
one marketplace over another, but, rather, by strengthening competition 
among all markets to create the best possible national market system 
with a deep pool of liquidity for all investors, for all issuers, and 
for our economy.
    In addition, the process was carried out in a manner that was open, 
thorough and solicitous of all views. The decision follows over a year 
of hearings and multiple rounds of Congressional testimony, as well as 
comments from thousands of investors, leaders, and members of our major 
equity markets and financial services industry.
    The centerpiece of the regulation, which is strongly supported by 
U.S. investors, is the modernization of the trade-through rule.
    We believe that the new trade-through rule will advance the cause 
of three critically important national goals:

    It will be proinvestor; it will strengthen the integrity of our 
markets; and, it will enhance the competitiveness of U.S. markets 
globally.
    First, the new rule will make certain that an investor's order, 
regardless of the market it is sent to, has the right to be executed at 
the best price.
    It will require that intermediaries, such as brokerages and mutual 
funds, find the best price for investors, either by selling their 
shares at the highest possible price or by buying them at the lowest 
possible price.
    This means that any of this Committee's constituents--from Toledo 
to Tucson, and from Atlanta to Anaheim--can invest and trade on an 
equal footing with the largest institutions. Their displayed limit 
orders cannot be traded through.
    Second, as the Investment Company Institute has observed, the new 
rule will increase investor confidence in the markets by helping to 
eliminate an impression of unfairness that is created when an 
investor's order executes at a price worse than the displayed quote.
    Third, the new rule will advance U.S. competitiveness. As more 
investors are encouraged to display their limit orders, collectively, 
they will have the effect of deepening liquidity and invigorating the 
entire capital formation process.
    In the past, critics charged that the trade-through rule inhibited 
innovation and favored the New York Stock Exchange by failing to 
distinguish between fast and slow markets. They pointed out, and with 
some justification, that prices can change in the time that it takes a 
trade to occur in the auction market.
    The Securities and Exchange Commission has seen fit to address that 
criticism directly. It has updated the old trade-through rule, and the 
new rule will protect only prices that are available for immediate 
electronic execution.
    This is a significant change that will serve to promote greater 
competition among all markets. Just as important, the onus is now on 
the New York Stock Exchange to make our Hybrid market a reality, a 
responsibility we welcome.
    Mr. Chairman, we are ready for the challenge. We are moving forward 
toward completion of the Hybrid market and we hope for expeditious 
approval of our proposal by the Commission.
    Our goal is to offer investors the choice of two investor-friendly 
paths--an immediate, electronic and anonymous execution, or the 
possibility of price improvement that is the hallmark of specialists 
and floor brokers working in tandem in the auction market.
    Our floor offers superior market quality, and demonstrates daily 
its ability to out-perform purely electronic exchanges during opens and 
closes, order imbalances and unforeseen, outside events. I am speaking 
of the value of human judgment in an auction market process. It is this 
market model that generates real price discovery, and creates the best 
prices on 89 percent of all trades compared to other markets that 
compete for order flow in NYSE-listed stocks.
    Stocks that have switched from the Nasdaq to the NYSE exhibit 
markedly improved executions. For example, 39 stocks that we reviewed 
saw their price volatility cut by half, their quotes narrowed by over a 
third and their execution costs cut in half. In addition, the SEC 
staff's analysis found that ``transitory volatility is significantly 
higher for Nasdaq stocks than for NYSE stocks,'' noting that ``retail 
investors, in particular, tend to be relatively uninformed concerning 
short-term price movements and are apt to bear the brunt of the trading 
costs associated with excessive transitory volatility.'' These 
statistics translate into real savings for investors who buy these 
stocks, and real value for companies seeking to raise capital in a 
cost-efficient manner.
    Finally, Mr. Chairman, now that the SEC has ensured comparable 
trading conditions for speed, we believe that there can be no remaining 
justification for giving investors anything less than the best price.
    In sum, we strongly support the new market-wide trade-through rule. 
So, too, does a broad base of investor groups that represent millions 
of investors and investor companies.
    They include the Investment Company Institute, the Consumer 
Federation of America, Vanguard, T. Rowe Price, Bank of New York, and 
the National Association of Investment Clubs (NAIC).
    A typical viewpoint was expressed by NAIC, which represents over 
21,000 investment clubs. NAIC stated that the new trade-through rule `` 
. . . will ensure that investors' quotes will not be compromised when 
sending quotes to the markets of their choice. This will produce 
tighter spreads, improve liquidity and provide equal treatment of all 
investors who seek a fair and level playing field--while ensuring 
market competition based upon best price.''
    We believe the new rule will empower investors and remove barriers 
to innovation. We believe that the U.S. markets now have the 
opportunity to become more robust, dynamic, competitive and efficient 
than ever before in our history.
    Now, let me conclude with comments on the proposed merger between 
the New York Stock Exchange and Archipelago.
Consolidation in the Securities Markets
    While the SEC has streamlined the rules and structure for our 
national market system, it is up to U.S. markets themselves to respond 
to a rising global challenge. The players must now perform on a new 
playing field.
    On April 20, I announced the decision of the New York Stock 
Exchange to merge with Archipelago, and to become a public, for-profit 
marketplace. As I stated then, we are in a competition with great 
stakes for the future of U.S. financial markets.
    Today, equity and capital markets are global.
    Competition for capital is global.
    Stock exchanges across Europe and Asia today are increasingly well-
capitalized. Most are public and for-profit companies, and many have 
very high profit margins. And many have set their sights for further 
growth on the United States, seeking to take U.S. market share from 
domestic U.S. exchanges.
    Mr. Chairman, we believe that to sit passively would be to 
surrender to the competitors who challenge us. This is not the course 
that we choose to follow. We believe that the merger of the New York 
Stock Exchange with Archipelago will help us compete head-to-head with 
these global players. We believe that consolidation among other market 
centers will also improve the competitive position of the U.S. 
financial system. For our part, we are determined that our new company, 
the NYSE Group, will become a world-class competitor that can maintain 
and, indeed, enhance our leadership, in every possible respect. This 
will begin, as I noted earlier, with providing customers greater choice 
on the type of execution venue that they prefer.
    The merger with Archipelago promises to add to and enrich customer 
choices by introducing new platforms for new investment products that 
will include equities, options, exchange-traded funds (ETF's), and 
bonds.
    Let me point out that these products not only present us with 
significant growth opportunities, but also give retail investors 
valuable investment opportunities. Investors in some of these products 
must currently pay higher spreads and transaction costs because markets 
are fragmented and inefficient. Through our merger, the New York Stock 
Exchange will provide a platform that is well suited to offer these 
products efficiently and expeditiously to our customers. We believe 
this will be a great benefit to our customers, America's investors. 
ETF's are attractive to retail investors because they provide the 
benefits of diversification with generally very low fees. In the fixed 
income area, there is little transparency in that market; by growing 
this platform through our merger, we expect to increase transparency 
and reduce spreads for investors. And our addition of an options 
platform will further increase product and market choice for investors. 
We are confident that a more robust and innovative business model will 
be good for our customers. As a public company, we look forward to 
having our individual investors, institutions, listed companies, as 
well as our members all participate in our success and our growth as 
stockholders. And as a stronger, more competitive exchange, the NYSE 
Group will fortify the U.S. position globally at a time when the 
Deutsche Borse, Euronext, and the Toronto Stock Exchange are offering a 
multiplicity of products, attempting to gain a foothold in the United 
States, and looking hungrily to seize further advantage.
    With its new, for-profit status, the NYSE Group will increase its 
capability to invest in future growth to a much greater degree than we 
had as a not-for-profit entity.
    In addition, we anticipate that our merger will boost competition 
in the trading of over the counter stocks and in the listing of smaller 
companies that do not yet meet the New York Stock Exchange's listing 
standards.
    Let me assure this Committee that the new structure of the NYSE 
Group will not only protect but also strengthen the independence and 
initiative of our regulatory functions. The holding company will have 
separate subsidiaries for the NYSE and Arca markets. These markets will 
continue to operate as separate markets with separate listings and 
offer different trading platforms. The structure we will propose for 
the regulatory function for the two markets will remain inside a not-
for-profit, not publicly traded entity providing reliable, independent 
regulation. We envision that the new Board of the regulatory entity 
will consist of independent members of the NYSE Group Board, along with 
several other independent directors with no affiliation with the NYSE 
Group holding company. Preserving the regulatory responsibilities in a 
separate but related entity will strengthen its independence, while 
retaining proximity to the business it is regulating. That proximity, 
together with the unique expertise our regulatory group has developed, 
will enable it to continue performing effectively.
    It is worth noting that the consolidation in the financial services 
arena that has taken place since the approval of Reg. NMS illustrates 
two points. First, the rule's new best-price policy applied across all 
markets is the right one: The new NYSE Group will be a market that 
caters to customers of both over-the-counter stocks and listed stocks. 
There is no reason that our customers should receive different 
protections based on which stock they happen to be trading in. Under 
the new rule, all our customers will receive the same protections.
    Second, the certainty created by the final rule enabled the markets 
to take steps to innovate and grow.
Conclusion
    Mr. Chairman, this is an important time for U.S. financial markets. 
New competitors have arisen with broad product mixes, diversified 
earnings streams, and access to public capital. They seek to challenge 
the United States as the global leader in financial markets. We must 
respond to this challenge--decisively, wisely, and effectively.
    The New York Stock Exchange is eager to take the next, critical 
steps to help the United States retain its global leadership. We will 
ensure that our customers are advantaged by the highest market quality, 
the best investment executions and the greatest, possible choice in 
investment products. The result, we are confident, will be a win-win--
for investors in U.S. markets, and for U.S. markets in the world.
    Thank you again Mr. Chairman, for inviting me to testify before 
this Committee. I look forward to responding to your questions.
                               ----------
                 PREPARED STATEMENT OF ROBERT GREIFELD
               CEO and President, The Nasdaq Stock Market
                              May 18, 2005
    Chairman Shelby, Senator Sarbanes, and distinguished Members of the 
Senate Banking Committee, thank you for inviting me to discuss 
Regulation NMS and the recent industry developments.
Regulation NMS
    When I last appeared before this Committee on July 21, 2004, I 
started my testimony by stating that: ``[t]he trade-through rule is the 
primary obstacle to competition amongst our Nation's equity markets, 
and competition is the driving force in making the U.S. markets the 
strongest in the world, the best for investors large and small, and 
accountable to the public.'' I also stressed that the markets had 
uncovered a fundamental truth: ``Today electronic trading is best for 
investors.''
    After well over a year of hearings, discussion, and comments, on 
April 6, 2005, the Securities and Exchange Commission (the SEC or the 
Commission) approved Regulation NMS. Regulation NMS replaces the old 
ITS trade-through rule that protected the listed market from 
competition with a new trade-through rule which will be applied 
uniformly across all markets to protect a market's top-of-the-book 
quote if it is automatically accessible. Regulation NMS also includes 
needed restrictions on sub-penny trading, establishes uniform market 
access rules that will insure that all market participants can access 
each others' quotes, and updates the formula used to allocate market 
data revenue amongst the SRO's.
    I believe that Regulation NMS does remove a substantial obstacle to 
competition amongst our Nation's equity markets and establishes 
incentives for floor-based markets to move to more electronic trading. 
The new rule will bring benefits to investors and it will enhance the 
ability of our Nation's capital markets to face growing international 
competition. Nasdaq commends the work of the SEC as well as the 
constructive oversight of this Committee and the entire Congress 
throughout the rulemaking process.
    As you know, Nasdaq, joined by many others representing both 
industry participants and investors, urged the Commission to eliminate 
the trade-through rule entirely. Our position reflected, and still 
reflects, our belief that market forces and best execution should serve 
as the bedrock principles in the securities markets. We are proud of 
the market quality experienced by investors every day on the Nasdaq 
Stock Market, which does not have a trade-through rule. Given our 
experience and the costs of implementation, we believe the extension of 
the rule to Nasdaq imposes a tax on market participants.
    Nonetheless, although Nasdaq does not believe the application of a 
trade-through rule to Nasdaq is necessary given our highly efficient 
electronic market, we are pleased the new trade-through rule approved 
by the Commission will force floor-based markets to follow the path to 
automated trading that has been blazed by Nasdaq since 1971.
    Specifically, the Commission's decision to allow investors to make 
distinctions between fast and slow markets will force manual floor-
based markets to automate in order to compete effectively with the 
faster electronic exchanges. The rule acknowledges the value of speed 
and certainty of execution, and allows electronic markets to compete 
for the trading of NYSE-listed securities. Manual markets will no 
longer be the weak link in the national market system, slowing down 
faster markets while humans--some with a distinct time and place 
advantage on the floor--attempt to execute orders.
    As you know, the Commission has announced that the rule will be 
rolled out in a limited manner next April and is not scheduled to take 
full effect until June 2006, so that markets have time to make and test 
the necessary system changes. Even before Regulation NMS was approved, 
however, the NYSE was compelled by market pressure to move to modernize 
their market structure, and they developed and proposed an electronic-
floor hybrid model. Now, as a result of Regulation NMS, the American 
Stock Exchange and the regional exchanges have strong incentives to 
modernize their markets and, if they proceed, are poised to emerge as 
competitors to both Nasdaq and the NYSE in the national market system. 
There is no doubt that this will be good for competition and for 
investors.
Nasdaq Acquisition of Instinet
    On April 22, 2005, Nasdaq announced the acquisition of Instinet 
Group and, concurrently, entered into a definitive agreement to sell 
Instinet's Institutional Brokerage division to Silver Lake Partners. As 
a result, Nasdaq will own only Instinet's electronic communications 
network, INET.
    This deal proceeded from a public, competitive process. Reuters, 
the parent company of Instinet, announced in November 2004 that it was 
selling Instinet. We understand that several industry participants 
considered bids for Instinet. As early as January 25, 2005, as part of 
a registration statement filed at the SEC, Nasdaq disclosed that we had 
submitted a nonbinding proposal to acquire ``a major ECN.''
    Nasdaq acquired INET to enhance Nasdaq's trading environment to 
serve investors better and respond to the increasing competition across 
the global capital markets. It is a synergistic deal that will create a 
fast, high-performing, low-cost single platform for trading U.S. 
securities. Given the compatibility of the two platforms, the real-time 
market surveillance by a well-respected regulator, the NASD, and 
Nasdaq's proven technological reliability, this transaction will 
position Nasdaq to compete more effectively with other U.S. and 
international market centers. The acquisition will result in more cost 
efficiency and improved quality of execution in our market--qualities 
that today's individual and institutional investors demand. Nasdaq will 
continue to innovate and also will have the ability to tap new 
opportunities in other asset classes.
    The combination of Nasdaq and the INET ECN will bring technology 
enhancements that optimize our electronic trading platform. It will 
provide greater cost efficiencies to the benefit of investors and 
improved quality of execution. Nasdaq will be able to offer investors 
increased limit order interaction. In addition, the INET transaction 
will allow Nasdaq to continue its market innovation leadership. We will 
offer faster time-to-market on new products and services that will 
benefit market participants, investors, and our listed companies.
    The efficiencies of one integrated platform and single router will 
provide other benefits as well. Critically, it will enable Nasdaq to 
maintain its status as the low cost provider for execution services for 
equities. In addition, by constantly improving and innovating for the 
benefit of investors, Nasdaq will continue to provide a superior 
listing venue for public companies and their investors.
Dynamic Marketplace
    The rapid structural changes sweeping through our Nation's 
securities markets are being propelled by a convergence of several 
forces, some of which are regulatory in nature, while others are 
market-driven.
    The principal regulatory force is Regulation NMS. Its most direct 
impact--greater competition in the trading of NYSE securities--will be 
felt when the rule takes effect. However, the indirect impact of 
Regulation NMS is being felt already, as the NYSE is poised to become a 
competitor in the trading of Nasdaq securities. That, combined with the 
expected rise in the trading of Nasdaq securities by the regional 
exchanges, which Regulation NMS will serve to encourage, creates a 
national market structure in which market centers no longer specialize 
in the equities of a single market. Rather, the NYSE will trade Nasdaq 
as well as NYSE securities; Nasdaq will be able to more effectively 
trade NYSE securities; other exchanges and market centers will trade 
Nasdaq-, NYSE- and American Stock Exchange-listed equities; and large 
market makers will likewise internally match trades in all of these 
securities.
    Another important force is rapid globalization of capital markets. 
Companies around the world are seeking access to capital, and stock 
markets are the key facilitator in this process. When a company in 
China or Russia seeks to bring capital from outside its country's 
borders, it typically considers the major markets in Europe as well as 
in the United States. As such, we are now competing not just with the 
U.S. exchanges but also, for example, with the Europeans. Enhanced 
competition for listings also encourages competition in the quality of 
trading, as companies seek to list in a country and a market that 
offers the best trading for their securities.
    Finally, it is increasingly necessary for stock markets to be 
mindful of competition from venues that trade derivatives and other 
instruments that are not equity securities. If trading quality in 
equities is inferior or the costs of trading are relatively high, then 
some investors may prefer to focus on the types of securities that 
trade more efficiently. Again, all investors are potential winners in 
this competition.
Improved Regulation
    Recent developments in the marketplace offer the opportunity to 
improve and make more efficient the regulation of the securities 
markets. First, as part of the NYSE-Archipelago transaction, the NYSE 
announced their intention to further separate its regulatory function 
into a nonpublic, not-for-profit entity governed by an independent 
board of directors. Nasdaq supports separating the regulator from the 
regulated market and, in fact, once the Commission approves our 
application to register as an exchange, Nasdaq will completely separate 
from our regulator, the NASD.
    Broker-dealers who operate on both the NYSE and Nasdaq often become 
members of the NYSE and the NASD. Accordingly, they face duplicative 
regulation and costs associated with the regulation. Some companies, 
like the Charles Schwab Corporation, are moving to eliminate this 
duplication by dropping their NYSE membership.
    Last November, the Commission published a concept release 
concerning the self-regulatory system of the securities industry. One 
of the options offered by the Commission in its concept release is the 
establishment of a hybrid regulator model which would simplify and 
streamline the current regulatory model. Under this alternative, a 
market neutral single self-regulatory organization would surveil and 
enforce rules related to broker-dealers nonmarket specific activity, 
such as their financial condition and registered representative 
representation, while SRO's that operate markets would regulate broker-
dealers' activities within those markets.
    This approach would offer substantial benefits to broker-dealers 
and investors alike by eliminating the costs associated with 
duplicative member regulation. At the same time, each market would be 
in the best position to surveil activity on its own systems and would 
therefore retain authority over market regulation. The quality of 
market regulation, moreover, could be enhanced through adoption of 
intermarket surveillance and audit trail enhancements, and through 
targeted Commission efforts to promote greater uniformity in SRO market 
rules in areas where problematic disparities exist. Accordingly, Nasdaq 
supports the proposal in the SEC's concept 
release on SRO governance for a single regulator to administer broker-
dealer membership rules.
Nasdaq Exchange Registration
    Finally, even with Regulation NMS codifying uniform rules for the 
trading of all equities, there is an additional element necessary to 
achieve a level playing field--granting Nasdaq status as a national 
securities exchange. I am pleased to report that the Commission has 
been working closely with us on our exchange application and we are 
hopeful that the application will be approved shortly. A Nasdaq 
exchange will be good for competition, good for the regulatory 
framework, good for market quality and integrity, and, ultimately, good 
for investors.
                 PREPARED STATEMENT OF GERALD D. PUTNAM
     Chairman & Chief Executive Officer Archipelago Holdings, Inc.
                              May 18, 2005
    Good morning Chairman Shelby, Ranking Member Sarbanes, and other 
distinguished Members of the Committee. As Chairman and CEO of 
Archipelago Holdings, Inc. (Archipelago) and the Archipelago Exchange 
(ArcaEx), and on behalf of our shareholders, directors, and employees, 
it is a privilege and a great honor to be provided the opportunity once 
again to testify before the Committee. I request that my written 
statement on today's topic, ``Regulation NMS and Recent Market 
Developments,'' be submitted into the record. Thank you.
A Tale of Two Rivals
    Let me take you back for a moment to the events of April 20, 2005. 
For much of that day, the focus of the business news was analysis of 
Yahoo's first quarter financial results and reporting on market jitters 
brought about by volatile oil prices and interest rates. In Chicago, 
the Cubs' victory over the Reds the night before lifted their record to 
an even .500, although our Cubbies have unfortunately backslid since 
then. Our White Sox, however, still remain the best team in baseball!
    Later on April 20, of course, something else was about to be 
announced, something very big: At exactly 4:30 p.m. (EDT), two rivals 
decided that the world had changed and that the time had come to join 
together to meet increasing demands of investors and issuers. It would 
be akin to the New York Yankees and the Boston Red Sox agreeing to put 
down their bats and balls, terminate their blood feud, and join forces. 
Two days later, on April 22, other famous rivals decided to follow 
suit, as if the Alabama Crimson Tide and Auburn Tigers announced the 
end of the Iron Bowl rivalry. (I can see Senator Shelby with head in 
hands exclaiming, ``No, it can't be true, it can't be . . . .)
    Like my fictional examples, I am sure that many people were quite 
surprised to hear the news of the respective intentions of the NYSE and 
Archipelago on April 20 and Nasdaq and Instinet on April 22 to merge. 
What's next: The Wall Street Journal endorsing Democrats and The New 
York Times endorsing Republicans?! What in the world is going on here? 
Well, let me do my level best to provide some insight on the strong 
business logic that underlies both transactions.
    Before doing so, however--if I may for a moment--I would like to 
symbolically extend my hand in warm congratulations to Bob Greifeld and 
Ed Nicoll on their announcement to merge Nasdaq and the Instinet ECN. 
ArcaEx--and before it, the Archipelago ECN--has been knocking heads 
with Nasdaq and Instinet for years now, and we have the battle scars to 
prove it. Both Nasdaq and Instinet under Bob's and Ed's respective 
leadership have commanded my personal respect in what has been and 
continues to be a ferociously competitive, fast-paced, and dynamic 
business. Upon consummation of these mergers, we would expect even 
greater competitive vigor from the combined Nasdaq-Instinet. 
Congratulations again to both of you.
A Common Vision Built On A Simple Premise
    Let me take you back to last winter, when John Thain and I began 
talking about a potential business combination between the NYSE and 
Archipelago. I must frankly admit that I was a little skeptical 
entering our discussions; not because of John, mind you, who I have 
known for several years now and who I regard as a very astute business 
man. Rather, I perceived differences between the NYSE and ArcaEx that I 
was not sure could be overcome. I will not sit here and pretend that 
Archipelago has not had some disagreements with the NYSE over the 
years. And, as you know, we have not been shy about expressing our 
displeasure when the NYSE took actions that we did not like. That said, 
what I quickly discovered from my conversations with John is that he 
and I share a common vision that is built on a simple premise. Our 
vision: To build upon the respective strengths of the NYSE and ArcaEx 
to develop a world-class exchange that provides topnotch services to 
U.S. and international consumers of execution, data and issuer 
services. The premise: To listen 
intently to customers and respond with the highest quality products and 
services with choices that fit the needs of different kinds of 
customers. At times, and to their detriment, this simple premise has 
been ignored or forgotten by many business leaders. We promise not to 
forget. Today's global consumer, who demands excellence and flexibility 
from exchanges, will not let us forget.
    Starting from our common vision, the NYSE and Archipelago 
ultimately negotiated and announced a merger which, upon consummation, 
will result in a new entity called the NYSE Group, Inc. (NYSE Group). 
The merger will combine the world's largest, most liquid, most reliable 
equity marketplace in the NYSE with the most successful totally open, 
fully electronic one in ArcaEx. We believe the combination will deliver 
high quality products and services to investors, traders, and issuers, 
and create long-term value for NYSE Group shareholders as a public 
company. It will allow us to provide diverse platforms for the trading 
of listed and OTC securities, options and other derivative products, 
including ETF's, under a single umbrella, which is what customers want.
    Further, in my view, this combination will:

 Strengthen America's leadership in financial services and 
    boost our global competitiveness in capital markets;
 Better serve investors, traders, and issuers;
 Maintain the highest standards of integrity, transparency, and 
    disclosure; and,
 Produce efficiencies, drive innovations, and create new 
    business and revenue opportunities.

    Without wanting to sound overly dramatic, I believe the merger 
between the NYSE and Archipelago is a bold one, but 21st century 
competition requires boldness. The merger represents the best of both 
worlds: Respecting and taking the best from the past while embracing 
the future. It marries the 24 entrepreneurs of the Buttonwood Era with 
the Archipelago entrepreneurs of the Information Society. I imagine 
that Nasdaq and Instinet share many of these same aspirations for their 
merger. I know that I speak for Archipelago's shareholders, directors, 
and employees when I say that we are thrilled to join forces with the 
NYSE to build on what both organizations have accomplished to date in 
an effort to create something truly great for our customers.
Globalization and Convergence Cause Reinvention of Exchange Models
    One of the hallmarks of Archipelago has been its nonstop drive to 
come up with new ideas, product offerings and technology. And for good 
reason: Investors, traders, and issuers continually require better 
services and more sophisticated products to satisfy their needs. If 
capital markets in this country do not fulfill these needs for 
customers, then almost certainly the markets in London, Frankfurt, Hong 
Kong, and elsewhere will. A failure to keep pace with the times poses 
serious risks for us all.
    One of the most striking trends in capital markets around the world 
over the last decade or so has been the convergence of both exchanges 
and products. In Europe, enterprising initiatives at the Deutsche 
Borse, Euronext, and the London Stock Exchange are bringing different 
products and services together under one roof. In response to clear 
customer demand, our competitors overseas are creating ``one-stop 
shopping.'' The Deutsche Borse sees ``a clear trend toward convergence 
between trading on the cash and derivatives markets, as well as between 
equity and bond trading.'' \1\ Euronext, which is an organization 
resulting from the merger of the exchanges in Amsterdam, Paris, and 
Brussels, also acquired a controlling interest in LIFFE and announced 
plans to integrate its derivatives markets. In Asia, too, exchanges 
like the Singapore Exchange combine equities and derivatives under one 
umbrella. The same is true in Hong Kong. The Tokyo Stock Exchange is 
one of the most integrated exchanges in the world, trading stocks, 
bonds, derivatives, and futures.
---------------------------------------------------------------------------
    \1\ Deutsche Borse Group. Partner of Global Customers, Annual 
Report 2004, (Frankfurt: Deutsche Borse Group, 2005), p.18.
---------------------------------------------------------------------------
    Furthermore, almost all of the world's significant exchanges have 
reorganized and are no longer membership organizations. Many of these 
de-mutualized exchanges have issued shares and gone public to finance 
their development of new and improved product offerings as well as 
their geographic expansion. The Deutsche Borse, which went public in 
2001 and commands a market capitalization over $8 billion, now competes 
with ``marketplace operators in London, Paris, Chicago, and New York.'' 
\2\
---------------------------------------------------------------------------
    \2\ Deutsche Borse Group website. ``Deutsche Borse Group--The 
Company.'' May 16, 2005.
---------------------------------------------------------------------------
    Exchanges in the United States are responding to these global 
challenges. Some examples: The Chicago Mercantile Exchange (CME) went 
public in 2002 and trades futures on physical commodities like pork 
bellies and lumber, and trades futures on financial products like the 
S&P 500 and the Nasdaq-100 as well. The CME advertises that it has 
``customers around the world, a global product line, nearly around-the-
clock electronic trading and strategic alliances with other 
exchanges.'' \3\ The 
Chicago Board of Trade, which has filed to go public, recently signed a 
multiyear technology and services contract with Euronext.liffe, under 
which the Chicago Board of Trade is licensing the Euronext.liffe 
trading system and buying support and maintenance services from them. 
The Boston Stock Exchange teamed up with the Montreal Exchange to 
create the Boston Options Exchange, a fast-growing electronic options 
exchange. Several U.S. equities exchanges, including the Philadelphia 
Stock Exchange, have restructured and de-mutualized their ownership. 
The International Securities Exchange, born only in the late 1990's, is 
already the largest equity options exchange in the United States (and 
the world).
---------------------------------------------------------------------------
    \3\ Chicago Mercantile Exchange website. ``Global Marketplace'' in 
``About CME.'' May 16, 2005.
---------------------------------------------------------------------------
    Finally, options and futures exchanges are converging on equity 
trading through single stock futures trading. OneChicago, a joint 
venture of the Chicago Board Options Exchange, the Chicago Board of 
Trade, and the Chicago Mercantile Exchange, now trades futures on over 
130 stocks and ETF's. From the standpoint of sophisticated investors 
and traders, all of these exchanges provide alternatives to executing 
trades of cash equities on the NYSE and Nasdaq--or ArcaEx or Instinet 
for that matter.
    The competitive trend is very clear: Historically, exchanges 
typically traded stocks, options, or futures within a single Nation's 
borders. Today, to stay competitive and serve customer demands, 
exchanges need to trade stocks, options, and futures on a single 
platform and to do so with a global footprint. I believe that the 
recently announced mergers of NYSE-Archipelago and Nasdaq-Instinet fit 
squarely within the context of this competitive dynamic. It is my 
strong belief that both mergers are necessary for the United States to 
remain competitive in capital markets globally.
The Secret Of ArcaEx's Success: Its People
    No statement today would be complete without a quick retrospective 
of Archipelago's history and business successes. I know this may sound 
formulaic, but at the center of that history and at the heart of that 
success are our people, the employees of Archipelago. We have achieved 
what we are today because of the sweat, blood, and tears expended by 
our employees, who now number about 250. I cannot tell you how proud I 
am of them, and I cannot thank them enough for their contributions.
    You may not recognize these names, but here are just a few 
representative examples of people who have worked so hard and 
contributed so mightily. Our version of Paul Bunyon is Paul Adcock, who 
has headed our trade support desk from day one. Paulie, as he is 
affectionately known, grew up on a working farm in central Illinois, 
and still rises at 4 a.m. daily to begin his workday. Paul is highly 
respected by our customers and traders around the country.
    My assistant and our office manager, Therese Wallace, came to 
Chicago via New York from Jamaica. The attraction of Chicago must be 
pretty strong to pull a woman away from a tropical paradise of white 
beaches to a city known more for another type of white, as in snow and 
lots of it. Therese was one of Archipelago's first employees, and from 
time-to-time she reminds me who really built the company.
    One of our top technologists, Dave Weiss, arrived at Archipelago by 
way of the Nutmeg State of Connecticut while riding a bicycle for a 
messenger service. Today, Dave is Archipelago's ``Lance Armstrong'' 
when it comes to providing our customers with high-speed connectivity, 
yet somehow finds the time to continue his high-speed cycling in long 
distance charity rides.
    Our lead software developer is Tom Haller, who grew up in a Chicago 
neighborhood, but moved to Florida several years ago so his kids would 
be close to their grandparents. Tom is an incessant tinkerer. After 
coming home from work at night, Tom used to go into his garage and . . 
. tinker. Tom joined Archipelago in 2002, where his development team 
has tinkered their way to producing the technological guts of ArcaEx, 
which is a marvel in my view.
    Finally, I would be remiss if I did not give a special mention to 
Archipelago's cofounders along with me, MarrGwen and Stuart Townsend, 
both of whom were University of Chicago Ph.D. candidates and are 
software developers. In January 1997, we launched the Archipelago ECN--
financed by my mortgage broker and supported by the eternal patience of 
my family--with no customers and no trades. In 2001, we graduated to 
exchange status when the Securities and Exchange Commission (SEC) 
approved our transaction with the Pacific Exchange, and in 2002, we 
launched ArcaEx. In the first quarter of 2005, Archipelago reported 
that ArcaEx handled 23.5 percent of the share volume in the OTC 
marketplace, 25.5 percent of AMEX-listed share volume (mostly ETF's), 
and 2.5 percent of NYSE-listed share volume. On behalf of everyone at 
Archipelago, we feel lucky and blessed to have achieved these 
successes.
The Aftermath of Regulation NMS
    Before concluding, I would like to comment, as requested by the 
Committee, on the recent approval of Regulation NMS and, in particular, 
on the adoption of the modification of the trade-through rule. This 
Committee and the House Financial Services Committee have conducted 
oversight of and pressed the SEC to address some of the thorny market 
structure issues that had been lingering for some time. Since 
Regulation NMS was first publicly proposed in early 2004, a lot of 
smart people have engaged in a good faith debate about its implications 
and would-be effects. While Archipelago supported parts of Regulation 
NMS, we did not support the trade-through rule as it was adopted by the 
SEC. That said, the SEC has now addressed many of the market structure 
issues that Congress and our capital markets had asked them to 
confront. In my view, although not always in agreement with the SEC, we 
will now have regulatory certainty. Furthermore, the concept of ``trade 
through'' and the practical reality of trading through another 
marketplace become much less germane if and when the mergers recently 
announced are consummated.
    It is worth noting that we will vigilantly review the final release 
of the Regulation NMS rules, which are not yet public.
Conclusion
    No, the Yankees and Red Sox have not ended their century's long 
feud; and, yes, the Iron Bowl between Alabama and Auburn is scheduled 
to occur again next fall, like it does every year. Ending those old 
rivalries would never make sense.
    In sharp contrast, the merger between the NYSE and Archipelago 
makes a whole lot of sense. Above all else, it makes sense because of 
our shared vision to maintain America's leading position in the global 
capital markets by creating a world-class exchange that provides U.S. 
and international consumers with first-rate execution, data and issuer 
services. In a world where both exchanges and financial products are 
fast converging, we believe the NYSE Group will be positioned to better 
serve all traders, investors and issuers by producing efficiencies, 
driving innovations, and creating new business and revenue 
opportunities, while maintaining the highest standards of integrity, 
transparency and disclosure.
    America cannot be left behind in a world of tectonic shifts in 
financial markets. History so clearly, if cruelly, teaches us that 
societies, nations, governments, and businesses that are unwilling to 
embrace and shape change are relegated, over time, to the failed 
forgotten. In all sincerity, we believe that the NYSE-Archipelago 
merger (and, yes, the Nasdaq-Instinet one) reflects an acceptance of 
change in our global capital markets, and the NYSE Group intends to 
engage constructively and positively in that change.
    This Committee has had the foresight to be mindful of the 
importance of market competition and market integrity. Our capital 
markets need your continuing leadership if we are to maintain our 
global preeminence in financial services. We at Archipelago look 
forward to working with the Committee throughout its review of the many 
changes occurring in today's capital markets, and we look forward to 
becoming part of the NYSE Group. Thank you again for providing me this 
opportunity, and I will be happy to respond to your questions at the 
appropriate time.
                               ----------
                 PREPARED STATEMENT OF EDWARD J. NICOLL
                          CEO, Instinet Group
                              May 18, 2005
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I appreciate this opportunity to discuss the role that I 
believe regulation and legislation will play in the future of our 
Nation's securities markets.
    While others on the panel today may begin by looking ahead and 
outlining the challenges and opportunities facing our markets, I would 
like to begin with an appreciative glance back at how we got here. I do 
so because I think it is worth remembering--indeed, quite important to 
remember--on whose shoulders we stand here today and why so much of the 
recent discussion has been about building better and stronger 
electronic markets.
    From my perspective, the story begins with a company called Island 
ECN, which was one of the first of the so-called Electronic 
Communications Networks, or ECN's. I am proud to have been the first 
and only Chairman of that company.
    In the wake of scandals in the mid-1990's, the SEC adopted 
regulations (known as the Order Handling Rules) designed to introduce 
competition and greater transparency into the U.S. equities markets--
which led directly to the creation of ECN's. Island seized this opening 
and offered investors a less-expensive, faster, and more reliable forum 
for trading. From Island's inception, we counted on the fact that 
investors--when given the choice--would always demand a more accessible 
and transparent marketplace. To reach that goal, we focused on what we 
considered the glaring gap in the then traditional model: The inability 
of investors to meet directly in the marketplace without having to rely 
on professional intermediaries.
    The Island story was about fighting for a chance to compete in new 
markets and allowing investors to vote with their feet. We fully 
understood that if we could not offer a better product, we should be 
out of business. But investors welcomed our products and services, and 
Island enjoyed explosive growth--eventually merging with Instinet, the 
company where I serve as CEO today.
    For these reasons, Mr. Chairman, I doubt you will find a witness 
today who is a greater champion of our Nation's free markets and the 
individual's ability to profit from hard work and innovation.
    But more than anything else, my experience at Island gave me the 
privilege to meet some of the most insightful traders and software 
programmers on the Street--individuals who grasped a magnificently 
simple and elegant truth: The markets could be made far more rational 
and fair if investors were allowed access to the same sorts of 
information that were at that time uniquely available to market 
professionals.
    On my first day as Chairman of Island, I walked into the office--
and we were, literally, just a handful of employees in one office--and 
sat down with gifted individuals such as Josh Levine and Matt Andresen. 
The one thing we all shared--beside a broken-down desk with four 
folding chairs--was a commitment to provide investors with an 
unprecedented degree of accountability, openness, and transparency in 
the marketplace. I recall how many market professionals had insisted 
that making ``arcane'' real-time market data widely available would be 
at best a distraction, and probably a nuisance for the investor. How 
wrong they were.
    As we know, investors today demand access to real-time data and the 
latest research reports as well as the ability to enter orders more 
efficiently and at a fraction of the cost once paid for such 
transactions. Yet while the investor had been empowered to know what 
and when to buy, a key component of this equation had been missing: How 
to buy it.
    That is where Island jumped in. Traditionally, investors had only 
been provided with the highest bid and lowest offer in a security. The 
depth of the market, which gives an indication of the true supply and 
demand for a security, had been the exclusive province of market 
professionals.
    That lack of accountability--in other words, denial of information 
to the investor--was unacceptable to us. To provide the best resource 
possible to the investor, we became the first marketplace to provide a 
free, real-time display of all its orders, through the Island 
BookViewer TM.
    There is probably nothing I am more proud of, Mr. Chairman, than to 
know that the technology we built for the Island ECN, which then became 
the technology behind Instinet Group's INET ECN, is now expected to 
become the technology platform for the merged Nasdaq-Inet platform.
    With this history in mind, Mr. Chairman, let me try to summarize 
some lessons we can learn from those experiences that are particularly 
relevant as we look ahead to the issues we will face in our markets 
over the coming years--lest we be ``doomed'' to repeat the mistakes.
    First and most important are the benefits resulting from a 
regulatory environment that encourages true competition among 
marketplaces. It is certainly true that much of the original electronic 
marketplace story was about harnessing technology to provide investors 
with a more efficient, faster, and lower cost forum for trading. Yet 
Island's success and the success of other electronic markets like 
Archipelago and Nasdaq is much more than a technology story--it is 
about the tremendous benefits that redound to the investor when the 
securities laws and regulations allow our markets to compete; when one 
marketplace can challenge another with a dizzying array of innovations 
and offer the investor unprecedented opportunities to leverage 
technological breakthroughs.
    The Island story and the rise of ECN's embody the benefits of 
competition. The dramatic changes in technology have allowed new 
competitors to offer new services at a lower cost and capture market 
share from traditional market participants in a relatively short time 
period. Just one example: I can remember when it cost some individuals 
as much as $200 per trade. Today, you can pay as little as $7. There 
has never been a better time to be an individual investor.
    A second lesson from our experience concerns the policing and 
surveillance of markets. By eliminating the informational disparities 
of the traditional, floor-based manual markets, many of us built a 
marketplace that is inherently safer, fairer, and easier to surveil--
all issues, I know Mr. Chairman, that this Committee takes very 
seriously. For example, participants on the floor of an exchange 
generally possess more trade and order information than the average 
investor sitting at home.
    Through surveillance and the implementation of restrictions on the 
activities of those in the trading crowds, regulators attempt to 
prevent the misuse of this information. As recent events have shown, 
however, no amount of surveillance or regulation can completely prevent 
or eliminate the potential for its misuse. With that in mind, Mr. 
Chairman, I note that electronic markets reduce the opportunities for 
improprieties by eliminating informational disparities.
    Finally, Mr. Chairman, let me at least raise for the Committee's 
consideration one of the most enduring public-policy issues we face. 
Now that electronic markets have done so much to empower the investor 
by providing an open and transparent marketplace, there remains one 
final challenge. How do we unleash these benefits on as wide a scale as 
possible, without sacrificing investor protection or the integrity of 
our capital markets? How can we continue the process of democratizing 
the markets?
    Long before electronic markets were even a glimmer in anyone's eye, 
Congress anticipated exactly what rules should guide us. In 1975, 
Congress created the National Market System, with the goal of creating 
a more efficient and transparent market. We could not have asked for a 
better building block. Over the subsequent decades, the SEC has worked 
hard to strengthen and improve this regulatory structure. While 
Instinet had particular concerns with some of the elements in the 
recently approved Regulation NMS, I do commend Chairman Donaldson for 
finally resolving many of the outstanding market structure issues and 
setting forth a clear and definitive regulatory roadmap for the U.S. 
equities markets as a whole.
    There are many different models currently used in the equity 
markets, and, with entry becoming even cheaper and easier, over the 
coming months and years I have no doubt more will emerge. Each model 
has its supporters and detractors. But what history does teach us is 
that, regardless of the model, two principles must hold into the 
future: First, competition must continue to be permitted to flourish 
between the different models, but in a manner that safeguards the 
integrity of our markets. Second, market structure must remain free 
from unfair advantages and unreasonable barriers.
    While much has changed since I sat in that small downtown office 
with my young colleagues, we must remain vigilant in the protection of 
our free markets from over-regulation. As Chairman Donaldson said, ``We 
need to identify real problems, 
consider the practical consequences of the possible solutions and then 
move pragmatically and incrementally toward the goals Congress staked 
out.''
    My own rule, Mr. Chairman, would be that regulatory action should 
only be taken when it is clear that the market is failing and less 
drastic remedies are inadequate. In all other cases, let us embrace 
free competition and always work toward greater openness, transparency, 
and accountability in the marketplace. In so doing, we can continue to 
leverage our Nation's technological superiority in a manner consistent 
with the best aspects of America's entrepreneurial capitalism. There is 
too much at stake to do otherwise.
    Thank you for this opportunity to again testify before your 
Committee. It has been a great pleasure to work with you and your 
colleagues on this issue.
                               ----------
                 PREPARED STATEMENT OF MEYER S. FRUCHER
  Chairman and Chief Executive Officer, Philadelphia Stock Exchange, 
                                 Inc.,
                              May 18, 2005
    On behalf of Philadelphia Stock Exchange, Inc. (the PHLX), I 
appreciate the opportunity to participate in this hearing on the 
implementation of the Securities and Exchange Commission's (SEC) 
recently adopted Regulation NMS and the consolidation of the U.S. 
securities markets. This is a historic juncture for our markets. Future 
generations of investors, economists, lawyers, and commentators may 
view 2005, as they do 1934 and 1975, as being a point in time where 
decisions made and paths taken changed the character and quality of 
securities trading in the United States for decades to come.
Introduction
    Adoption of Regulation NMS and the combinations of the New York 
Stock Exchange (the NYSE) and Archipelago (Arca) and of the Nasdaq 
Stock Market (Nasdaq) and Instinet Group (Instinet) could very well 
result in a sound and healthy market structure and two strong 
organizations capable of competing to serve the needs of issuers and 
investors. However, conditions also exist for the development of an 
anticompetitive duopoly. For all the talk in recent years of market 
fragmentation, the fact is that the marketplace for trading stocks is 
dominated by a small number of venues--particularly the NYSE. The 
survival of the smaller exchanges that challenge the NYSE and Nasdaq is 
by no means assured. The SEC must act by the first quarter of 2006 on 
proposals by competing exchanges to ensure that the benefits of 
vigorous inter-market competition in the securities markets, 
particularly for equity securities, are not lost. Because there are 
significant and growing regulatory and other barriers to entry for new 
exchanges, if this competition is weakened, it may be gone forever. 
Therefore, it is important that this Committee in 
exercising its oversight responsibility be vigilant that the SEC takes 
action to ensure competition.
Role of the Competing Equity Markets
    To better understand the PHLX's perspective on competition, this 
statement provides information first about the smaller securities 
exchanges that compete with the NYSE and Nasdaq and second about the 
PHLX in particular.
The Competing Securities Exchanges
    A century ago, there were more than 100 local and regional stock 
exchanges in the United States. They served the capital needs of 
companies and investors in their area by listing local companies for 
trading. Although today's smaller securities exchanges are the 
descendants of those exchanges and are still often referred to as 
``regional exchanges,'' they are no longer regional markets. They do 
not list local companies or serve local investors. Instead, they are 
competing parts of our national capital market and collectively form an 
essential pillar of the national market system.\1\
---------------------------------------------------------------------------
    \1\ This testimony refers to the smaller U.S. securities exchanges 
that trade equities, namely the American, Boston, Chicago, National, 
and Philadelphia Stock Exchanges.
---------------------------------------------------------------------------
    While they differ in many respects and with regard to many aspects 
of their business models, the competing stock exchanges share an 
important role: They all make markets in stocks listed by the NYSE; 
some also trade Nasdaq-listed stocks. They thus provide competition to 
the Big Board and Nasdaq. Of particular significance is that the NYSE's 
share of trading in the stocks it lists has regularly exceeded 80 
percent, a dominance that almost surely would invite government 
scrutiny in any other industry. The PHLX believes this dominance is 
unhealthy for investors.
    Today's competing stock exchanges have survived because the 
competitive environment in which they operate forces them to be 
innovators. The PHLX and a number of the other securities exchanges 
employ an electronic system of remote 
competing specialists, described below. On some of the exchanges, many 
stocks have three or four specialists competing to offer the best 
price, rather than a single specialist setting a price as on the Big 
Board.
    Most importantly from the perspective of investors, the smaller 
securities exchanges have repeatedly served as ``laboratories of 
invention.'' They were the first to adopt innovations as essential as 
the securities clearing house, continuous net settlement of trades and 
automated execution of small orders--all improvements that the NYSE 
embraced after other exchanges had first paved the way. The PHLX 
believes that investors would be best served if competition continued 
to spur the NYSE and Nasdaq to innovate. However, as described in 
greater detail below, the continued survival of competing exchanges is 
far from certain.
Background on the Philadelphia Stock Exchange
    The PHLX is the oldest securities exchange in the United States. 
The PHLX is both a stock and an options exchange. It trades over 2,000 
stocks listed on the NYSE and American Stock Exchange (Amex) and over 
1,500 equity options, as well as industry sector options created by the 
PHLX and currency pairs.
    While the PHLX is comparable to the NYSE in age and tradition, its 
method of equity trading differs from the NYSE's in an important 
respect. While both the NYSE and the PHLX use a floor-based specialist 
system, the PHLX employs competing specialists rather than a single 
specialist per stock. The Remote Competing Specialist System 
implemented by the PHLX in 2002 lets specialists make markets and trade 
from the PHLX equity trading floor or from remote sites. This secure 
communication network expands trading beyond a fixed number of 
specialists to enable qualifying firms to operate from their offices. 
It means that more than one equity specialist can make a market in an 
eligible stock, so order flow providers can direct orders to the 
specialist of their choice. The result is a boundless market center 
permitting virtually unlimited access to qualified specialists and 
customers alike.
Need for Competition
    The PHLX is not advocating some form of protection for itself and 
other stock markets that compete with the NYSE and Nasdaq. Instead, the 
PHLX merely asks that the SEC take all steps to ensure that it and 
other venues are allowed to compete vigorously and aggressively, and 
that the smaller exchanges be allowed to do what they have always done, 
namely to innovate and find new products and trading technologies. 
After all, if the smaller exchanges do not step up and offer 
competitive alternatives, where will competition to the NYSE and Nasdaq 
come from?
    To ensure competition, the SEC must quickly and with an open mind 
address proposals submitted by smaller exchanges to establish new 
facilities, rules and fees. If the SEC does not do so, any hope of 
competition from existing participants will very quickly be 
extinguished. Put another way, if the SEC focuses all of its attention 
on analyzing and approving the rule changes and other actions necessary 
to facilitate the completion of these two historic mergers and their 
post-merger market operations, and does not listen receptively and 
process expeditiously proposals from the other exchanges, there will be 
no other competitors. This is an urgent problem that affects the entire 
market system.
    To allow actual and potential competition from smaller markets to 
wither would be inconsistent with decisions already made by Congress. 
In 1975, when it amended the Securities Exchange Act of 1934 (the Act), 
Congress authorized creation of the National Market System (NMS), 
specifically noting the importance of the securities markets as ``an 
important national asset'' and declaring an intention to foster 
technological innovation and intermarket competition.\2\
---------------------------------------------------------------------------
    \2\ See Section 11A(a)(1)(A)-(C) of the Act.
---------------------------------------------------------------------------
If the SEC Approves These Mergers, It Must Also Act to Preserve
Competition
NYSE-Arca and Nasdaq-Instinet: Great Deals for Shareholders and Seat
Owners. What about Investors?
    From the perspectives of the owners, members and other constituents 
of the NYSE, Arca, Nasdaq, and Instinet, these transactions look like 
smart moves. The NYSE becomes a public company, takes a quantum leap 
into electronic trading, positions itself to benefit from Regulation 
NMS, reenters the world of options trading, and gains a strong presence 
in the trading of Nasdaq stocks. Arca shareholders 
become important stakeholders in a liquidity-rich and resource-laden 
combined enterprise of global scope. Arca itself will have access to 
the powerful listings and regulatory infrastructure of the NYSE. 
Instinet and Nasdaq also have bright prospects for their combined 
enterprise. While less transformational, in that Nasdaq and Instinet 
both focus on Nasdaq stocks, the combined entity should be a formidable 
force to be reckoned with. And to the extent the NYSE-Archipelago and 
Nasdaq-Instinet entities compete to trade each others' listed 
securities, competition will be enhanced.
    In principle, small and large investors alike may benefit from the 
evolution of these markets. Yet, legislators and the responsible 
regulatory authorities should not lose sight of the fact that these 
mergers will result in a huge concentration of trading volume and 
resources in these two entities. For example, the combined NYSE-Arca 
will have an 81 percent market share in the trading NYSE-listed shares, 
based on adding the current market shares of both markets. Likewise 
Nasdaq-Instinet will have a 56 percent market share of Nasdaq-listed 
issues. Depending upon how these enterprises integrate their 
operations, virtually all shares traded in the United States will be 
traded on 1 of 2 trading systems and under 1 of 2 fee structures, and 
subject to the self-regulatory oversight of 1 of 2 self-regulators. The 
lion's share of market data revenues for NYSE and Nasdaq securities 
will accrue to these two markets on a combined basis, both because of 
their sheer size and in the NYSE's case because it may have three 
chances at any given moment of posting the national best bid or offer 
(namely on the floor, on the NYSEDirect+ electronic ``hybrid,'' and on 
Arca).
    Indeed, presumably one of the main points of these mergers is to 
eliminate competition through ``consolidation.'' On May 9, NYSE Chief 
Executive John Thain was quoted as saying: ``"The U.S. has too many 
exchanges--it is too fragmented. . . . The U.S. financial marketplace 
needed to be rationalized and consolidated . . . .'' The implication is 
clear that he believes the number of competitors should shrink.
    Rather than reduce the number of competitors to two, PHLX believes 
that additional competitors are needed, both to ensure that investors 
and traders have alternatives, and to force these two behemoths to keep 
trading costs low and the range and quality of execution and other 
services high. And we are not alone. The SEC's Chief Economist 
explained it as follows: ``Requiring markets to expose orders to the 
competing prices offered on alternative platforms forces platforms to 
address how they compete for business.'' \3\ In layperson's 
terminology, competition between markets forces markets to constantly 
improve, which is good for investors.
---------------------------------------------------------------------------
    \3\ Chester S. Spratt, Address at the Market Microstructure Meeting 
of the National Bureau of Economic Research (May 6, 2005) (the ``Spratt 
Microstructure Address).
---------------------------------------------------------------------------
    Also relevant is the fact that the NYSE will, as part of this 
process, become a ``for profit'' institution, and as Nasdaq completes 
its separation from the NASD, it will no longer operate in the shadow 
of a ``not-for-profit'' enterprise. Though the PHLX has no quarrel with 
for profit markets--having become one itself by demutualizing in 2004--
PHLX believes that the SEC must be particularly mindful that its 
regulatory process does not unintentionally become an instrument of 
monopoly creation for these business entities.
    In short, while the announced mergers may result in greater returns 
for the institutions involved and their constituents, we believe that 
investors may ultimately be disadvantaged.
The SEC Should be Congratulated on the Success of Its Promotion of
Innovation By Electronic Markets. But in This Very Success are There
the Seeds of Failure?
    The SEC, too, should be congratulated on having addressed in 
Regulation NMS many of the criticisms that have been levied over the 
last decade regarding the operation of the markets. Although the PHLX 
does not agree with every aspect of the final product (recognizing that 
the Regulation, as approved, has not yet been published), we believe 
that the SEC has tackled many of the perceived systemic issues--by 
adopting clear and uniform trade-through protection in the listed and 
Nasdaq markets, limiting access-fees and barriers to cross-market 
access, restricting subpenny quoting and bringing greater transparency 
to NMS Plan governance. Regulatory reform of the rules for interaction 
between competing marketplaces will not end with Regulation NMS, but 
the system as a whole should benefit from the reforms that it embodies.
    In an important way, the SEC should be praised for its vision and 
openness to innovation for reasons beyond Regulation NMS. After all, 
the two transactions being discussed today are really the culmination 
of actions taken by the SEC just a few years ago.
    In 1997, under the leadership of then Chairman Arthur Levitt, the 
SEC issued a Concept Release concerning the Regulation of Securities 
Exchanges \4\ and in 1998 approved the seminal rulemaking concerning 
Regulations of Exchanges and Alternative Trading Systems, which 
included the adoption of Regulation ATS.\5\ At issue in these releases 
was the fact that some market participants, including Instinet, were 
using new technology to offer new types of financial services that had 
many of the aspects of exchanges. In particular, these entities, which 
have become known as ``alternative trading systems,'' permitted 
institutions to trade with each other, in many cases without the 
involvement of a securities dealer, cheaply, anonymously and rapidly.
---------------------------------------------------------------------------
    \4\ Release No. 34-38672 (May 23, 1997).
    \5\ Release No. 34-40760 (December 8, 1998).
---------------------------------------------------------------------------
    As alternative trading systems have many of the characteristics of 
securities exchanges, the SEC was faced with a dilemma regarding how 
such entities should be regulated. National securities exchanges and 
national securities associations are subject to comprehensive--some 
might say onerous--regulation, as compared with the regulatory regime 
for broker-dealers that applied to nonexchange trading systems. In 
particular, virtually every material aspect of the operation of a 
securities exchange or association must be filed with the SEC as a 
proposed rule change under Section 19 of the Act. In most cases, such 
proposed rule changes must be approved by the SEC, following a notice 
and public comment period. In practice, such approval can take many 
months, and in some cases even longer. The substance of proposed rules 
must also meet certain statutory criteria.\6\
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    \6\ See Section 6(b) and 15A of the Act.
---------------------------------------------------------------------------
    The SEC was (and is) aware that this approval process can delay 
significantly the introduction of new products and services, thereby 
stifling innovation. However, the SEC was concerned that, without some 
safeguards, the unchecked growth of alternative trading systems could 
result in the fragmentation of liquidity, a lack of transparency, 
discrimination against certain market participants, and systemic risk 
associated with having some market centers that did not meet standards 
of technical capacity and integrity reliability. The SEC was very 
innovative in determining ultimately to permit alternative trading 
systems to elect to be regulated either as broker-dealers or as 
exchanges, subject to some additional requirements for systems that 
represent a significant percentage of the trading activity in a given 
security.
    At the same time, recognizing that this structure would potentially 
give a competitive edge to alternative trading systems, the SEC adopted 
a rule that would, in theory permit exchanges to introduce certain 
``pilot trading systems'' with relatively limited regulatory 
interference.\7\
---------------------------------------------------------------------------
    \7\ Rule 19b-5.
---------------------------------------------------------------------------
    Alternative trading systems thrived under Regulation ATS--proving 
the recent assertion of the SEC's Chief Economist that ``well placed 
regulatory changes can 
affect innovation.'' \8\ Their growth is partly attributable to the 
alternative trading systems' ability to be nimble in both introducing 
new products and services and in responding to competition. In fact, it 
can be said that Regulation ATS allowed Instinet and Arca to challenge 
the industry incumbents--perhaps even making the transactions that we 
are discussing today inevitable.
---------------------------------------------------------------------------
    \8\ See Spratt Microstructure Address at p.3.
---------------------------------------------------------------------------
    By contrast, for many reasons, some economic, some political, some 
historical and some regulatory, the exchanges and Nasdaq did not evolve 
as rapidly. The SEC's structure for leveling the playing field and 
permitting the rapid introduction of pilot trading systems did not 
accomplish that end. In PHLX's experience (and it is believed that of 
other markets), the SEC has generally been extremely cautious about 
permitting exchanges to flexibly respond to competitive challenges from 
alternative trading systems.
    In the intervening years since 1998, as the alternative trading 
systems expanded, and the SEC and the marketplace got a view of the 
full potential of the all-electronic matching engine and (in some 
cases) electronic routing capabilities that are the hallmark of 
alternative trading systems, pros and cons emerged. No doubt, the 
flowering of this model gave rise to challenges, including some that 
the SEC envisioned as possibilities--discrimination, inaccessibility, 
fragmentation and discrimination--and some that were perhaps not so 
clearly foreseen, such as issues raised by sub-penny trading, ``tape 
shredding,'' technical problems and worse caused by access fees, and 
concerns about regulation of this diffuse marketplace. However, despite 
these perceived flaws, it is clear that the SEC strongly favors the 
electronic trading model that is the hallmark of alternative trading 
systems.
    In many ways, Regulation NMS should be viewed as ``Regulation ATS--
Part 2.'' It addresses many of the criticisms of how the equities 
market has evolved since 1998, but also, in effect, powerfully endorses 
an electronic trading model, especially in relation to its definition 
of which quotations are ``protected'' in the ``order protection'' (that 
is, trade-through) rule and the new methodology for calculating 
critically important market data revenues. It may be that these reforms 
will ultimately doom other modalities of trading in the equities 
market, including trading floors manned by specialists and floor 
brokers.
    Whether for good or ill, in some respects the market combinations 
that we discuss today are also a consequence of the success of the 
alternative trading systems that the SEC's vision helped to foster. 
Many commentators feel that NYSE's decision to merge with Arca is in 
large measure a hedge against the future and a recognition of the power 
of the electronic trading business model. Similarly, Nasdaq clearly 
perceives that the best way for them to grow stronger quickly is by 
absorbing their alternative trading system competitors--first Brut ECN 
and now Instinet.
    So, how do we evaluate the success of Regulation ATS, which in 
effect culminates in 2005 with the advent of Regulation NMS and the two 
mergers? Surely we must say that the SEC did well in fostering the 
innovations that have been so successful, and in forging Regulation 
NMS, which will correct some flaws that have developed over the years 
in the NMS. However, not only can regulatory actions foster innovation, 
they can impede innovation as well--as can regulatory inaction. The 
PHLX thinks that regulatory actions often actively shape business 
outcomes in the securities markets they can determine winners and 
losers. PHLX notes that both Instinet and Arca developed relationships 
with smaller exchanges (the Cincinnati (now known as the National) and 
Pacific Stock Exchanges, respectively) as part of their growth 
strategy. So successful were they that they are now, in effect, being 
bought out by the incumbents they challenged. Investors will suffer if 
future innovators are not able to collaborate with smaller exchanges.
Other SEC Initiatives that May Burden Competition
    At the same time as it completes its work on Regulation NMS, the 
SEC is (i) proposing fundamental changes to the governance, ownership 
and administration of exchanges \9\ that will both add considerably to 
the cost of operating an exchange and limit flexibility in terms of 
joint ventures and other structures pertaining to exchange 
``facilities,'' \10\ and (ii) questioning the role of exchanges as 
self-regulators and funding for regulatory operations in the context of 
a recent concept release concerning self-regulation.\11\ Together, 
these initiatives have the potential to increase costs and reduce 
flexibility for competitors to the NYSE-Arca and Nasdaq-Instinet 
duopoly.
---------------------------------------------------------------------------
    \9\ Release No. 34-50699 (November 18, 2004).
    \10\ See letter dated March 8, 2005 from Meyer S. Frucher, Chairman 
and CEO of the PHLX, to Jonathan G. Katz at 3 (for a discussion of the 
implications of the ownership of exchange facilities) and pages 14-21 
(for a discussion of the costs and burdens of additional proposed 
requirements).
    \11\ Release No. 34-50700 (November 18, 2004).
---------------------------------------------------------------------------
Competing Exchanges Have Much To Do If They Are To Remain Viable:
All Roads Lead Through The SEC
    For the future of inter-market competition, this means smaller 
exchanges and their members need to adapt quickly if competition is to 
be preserved in the equities markets. The NYSE hopes to close on its 
transaction by the first quarter of 2006. Nasdaq and Instinet hope to 
complete their merger by the end of this year. Note that both of these 
are prior to the announced implementation of Regulation NMS, which the 
SEC does not intend to implement fully until June 2006. Competing 
exchanges therefore must seek out the strategic alliances, develop the 
technologies, and submit the rule changes they will need to remain 
competitive before the first quarter of 2006. And the SEC must act on 
those proposals before the first quarter of 2006. If that timeframe is 
not met, the potential for competition to the NYSE and Nasdaq may be 
lost forever.
    The PHLX believes that it and other competing exchanges will have 
to do the following to remain viable:

 If smaller exchanges are to continue to attract orders in the 
    new world, they must modify their systems and trading rules so that 
    they respond to incentives and disincentives contained in 
    Regulation NMS. Failure to adapt will mean that orders sent to 
    floor-based exchanges will be subject to being traded through on 
    electronic markets--a risk that firms routing customer limit orders 
    will not want to take;
 The new market data revenue allocation formula adopted in 
    Regulation NMS rewards a particular type of business model, namely 
    electronic SRO's. The PHLX believes this will direct market data 
    revenues away from floor-based and smaller 
    exchanges. Failure to adapt will also mean the loss of significant 
    revenues from the sale of market data, which is critical to funding 
    and maintaining our regulatory programs and limiting our members' 
    costs of doing business on competing markets;
 We will need to find new and innovative revenue sources and 
    also operating cost efficiencies in order to sustain the 
    significantly increased ongoing regulatory and reporting costs 
    implied by the SEC's proposed rulemaking on SRO governance, 
    ownership, and administration;
 We may be forced to cede, or may voluntarily relinquish, some 
    or all of our self-regulatory functions--functions that many may 
    argue are essential characteristics of each market--either because 
    they will become economically unsustainable or as a result of 
    initiatives that may flow from the SEC's Concept Release on Self-
    Regulation; and
 Perhaps most importantly, we will have to supercharge our 
    systems, develop creative trading rules and reinvent our fee 
    structures in order to convince our customers, the trading 
    community and the investing public that we offer a clear cut 
    alternative to the impressive trading facilities to be offered by 
    the combined NYSE-Arca and the combined Nasdaq-Instinet.

    The PHLX is willing to adapt, and to fight for its survival in 
these ways. However, at each step we will need to file our rules and 
fees with the SEC, and if they do not handle these quickly and 
flexibly, we will not be able to do what is objectively necessary to 
survive, and no amount of creativity, efficiency, or technological 
proficiency will make any difference.
    The Commissioners and the staff of the Commission--particularly in 
the Division of Market Regulation, which processes SRO rule filings--
are highly knowledgeable, professional and hard working. Moreover, they 
intend to process rule filings and other requests for the markets in an 
even handed way. However, they have limited resources. To ensure 
competition, the SEC must vigorously process the filings of competing 
markets, and be open minded to the approval of new and innovative 
structures that will allow markets to compete--fairly and consistently 
with the mandates of the Act.
    Of course, one might argue that the regulatory structure under the 
Act permits prolonged agency consideration, and provides the potential 
for discretionary (and therefore conservative) handling of SRO 
proposals to modify their rules and systems. Because of the importance 
of innovation, however, Congress and the Commission should consider 
revising the Act or the regulations under it to permit more 
proposals to become ``effective on filing'' without prior staff 
review.\12\ The Commodity Futures Modernization Act of 2000 may offer 
an example. In that legislation, Congress gave futures exchanges 
greater flexibility to introduce new products and new trading systems 
through ``self-certification'' of proposed rules' compliance with 
statutory requirements.\13\ These changes appear to have enhanced the 
degree of competition in the futures markets, as evidenced by the 
number of new entrants to the 
marketplace. The PHLX suggests that Congress and the SEC must grant 
similar flexibility to securities exchanges to ensure the survival of 
competition.
---------------------------------------------------------------------------
    \12\ See Section 19(b)(3)(A) of the Act.
    \13\ See Section 5c(c)(1) of the Commodity Exchange Act.
---------------------------------------------------------------------------
Conclusion
    Regulation ATS allowed for the blossoming of the alternative 
trading system electronic model, which can in effect declare victory 
today, because alternative trading systems were allowed to innovate 
without undue regulatory friction. Considering that the smaller 
exchanges will be the only remaining competitive challenges to NYSE-
Arca and Nasdaq-Instinet, and that there are numerous other threats to 
their survival, the reduction or elimination, consistent with the 
principles of the Act, of regulatory roadblocks is a significant public 
policy objective.
    PHLX believes that it is critical to the survival of competition 
that the SEC process promptly and with an open mind proposals from all 
markets, and particularly smaller markets, to introduce new rules, 
trading facilities and fee structures, and to engage in affiliations, 
so as to permit them to continue to offer innovative competitive 
alternatives that will be attractive to the marketplace. We would 
respectfully urge this Committee to keep itself appraised of 
developments in this regard during the weeks and months to come. If it 
is necessary to streamline the process by which such initiatives may be 
introduced, then we would likewise submit that such reforms would be 
worthwhile in the interest of keeping competition alive, before it is 
too late to do so.
















                   PREPARED STATEMENT OF SCOTT EVANS
                  Chief Investment Officer, TIAA-CREF
                              May 18, 2005
    Chairman Shelby, Senator Sarbanes and Members of the Banking 
Committee, my name is Scott Evans, and I am the Chief Investment 
Officer at TIAA-CREF. I appreciate your invitation to appear here today 
to express my company's opinion on how recent regulatory and structural 
changes in the U.S. market will impact all market participants, 
including individual investors.
    TIAA-CREF has been focused on the financial welfare of individuals 
since Andrew Carnegie formed the Teachers Insurance and Annuity 
Association of America (TIAA) in 1918 as a fully funded retirement 
system to help colleges attract talented teachers. Our mission is ``to 
aid and strengthen'' the institutions we serve and to provide financial 
products that best meet their unique needs. TIAA created the College 
Retirement Equities Fund (CREF), a stock-based fund and the world's 
first variable annuity, in 1952. CREF is registered with the SEC as an 
investment company and TIAA is a life insurance company.
    With over $340 billion in assets under management, TIAA-CREF is a 
leading financial services organization, a major institutional 
investor, and one of the world's largest private retirement systems 
with more than 3.2 million participants at more than 15,000 
institutions. We serve the direct economic interest of these members of 
the academic, medical, cultural, and research fields without profit to 
our company. Our customer reach extends to every State in the Nation. 
We have over 13,000 participants from 98 institutions in Alabama; 
nearly 40,000 participants at 395 institutions in Maryland.
    In addition to our pension activities, TIAA-CREF also serves the 
general public by providing mutual funds, financial counseling, and 12 
State-sponsored 529 college savings programs. Each of our clients 
relies on us to invest their money wisely in the U.S. financial 
markets.
    I commend the Committee for its forward-looking concern with the 
issues surrounding the rapid evolution of the U.S. equity markets.
    Both the recently enacted SEC Regulation NMS and the proposed 
mergers involving our two major domestic stock exchanges represent 
seismic shifts that require careful scrutiny. As consumers become more 
aware of these issues, they will be most appreciative of your proactive 
oversight.
    As background, we would like the committee to be aware that our 
CEO, Herb Allison, is on the NYSE Board, and he did participate in the 
vote on the merger. He did not attempt to influence the company's 
position on Regulation NMS.
    Although we, at TIAA-CREF, do not pretend to be able to predict the 
future, we have a long history of large scale participation in the 
equity markets that may be helpful in understanding the implications of 
all this change for the American investor. We hold equity shares of 
more than 3,000 U.S. companies on behalf of our clients. This broad 
involvement requires us to use the full spectrum of trading venues in 
today's markets, including listed exchanges, Nasdaq, Electronic 
Communication Networks (ECN), and Alternative Trading Systems (ATS). We 
conduct about half of our trading activities using traditional 
physically intermediated methods (floor 
brokers or upstairs dealers) and the other half through anonymous 
electronic transactions. The traditional methods are used primarily for 
large trades and the electronic techniques for smaller lot sizes. Since 
we regularly use both types of trading, we share the perspectives of 
both index funds who conduct most of their activity electronically and 
active managers who spend the bulk of their time doing traditional 
trades.
    When we filed our comments with the SEC on Regulation NMS, our 
concern was that a trade through rule which requires brokers to always 
honor the best posted price may sometimes have the unintended effect of 
making it more difficult for investors to get the best deal available 
for all of their shares. This is because it is more important to get 
best execution on the whole order than the best price on every trade. 
The trade through rule in NMS essentially mandates that all large 
trades done at prices necessary to move large volumes of stock also 
include shares posted publicly on better terms. For our trades that are 
large enough to warrant private negotiations, we fear that such 
restrictions may impede our ability to conclude satisfactory agreements 
for large blocks of stock.
    For example, should we desire to quickly sell a multimillion share 
stock holding, it would be impractical for us to use electronic limit 
orders to accomplish our objective since the volume of such limit order 
activity is usually inadequate to handle such a large order. Therefore, 
in order to trade our entire volume for the best price, we would 
usually turn to a broker-dealer or alternative peer to peer trading 
system like Liquidnet to assemble a block trade. These trading venues 
allow us to obtain sufficient quantity of shares without distorting the 
market price for normal sized trades. Block trades are difficult 
transactions that require customized attention. The cost and complexity 
of linking the small trades on the public limit order books to these 
large private transactions is likely to be prohibitive. Furthermore, it 
is likely that the mandatory inclusion of trade volumes from the public 
limit order books might reduce the incentive for brokers to participate 
in these large trades. If institutional traders are not able to obtain 
the best price possible for the large trades that they seek, then the 
millions of individuals that they serve will be harmed as the returns 
on mutual funds and other institutionally managed savings vehicles are 
negatively impacted.
    The U.S. equity market is increasingly dominated by large 
institutions who regularly conduct these types of large block trades. 
According to the Federal Reserve, over 50 percent of total equity 
assets in the U.S. market are now held by mutual funds and other 
institutional intermediaries on behalf of individual investors. In 
1980, these same institutions controlled only 36 percent of equity 
assets. This is why the protection of institutional trading 
efficiencies is of growing importance to the American consumer. From 
our perspective, individuals investing directly in the markets would be 
better served if regulators redoubled their efforts to ensure that 
retail brokers fulfill their duties to provide best execution to 
individual traders than by establishing pricing rules on our stock 
exchanges that favor small volume retail trades. While we think it is 
too soon to conclude that regulation NMS will snuff out the encouraging 
trend toward increased innovation and competition in U.S. equity 
markets, the devil is in the details.
    We also think it is premature to draw conclusions regarding the 
likely impact of recently announced mergers involving the NYSE and 
Nasdaq. The parties involved will build a system that best meet the 
needs of their customers and we would hope that the regulatory 
landscape will continue to support the innovation and competition that 
is needed to keep our equity market system world class. Thanks to a 
healthy environment for innovation in the past, U.S. investors now have 
Instinet and Archipelago to execute small limit orders quickly and 
Posit, Liquidnet, and Pipeline to execute large trades anonymously and 
efficiently. They exist precisely because we have had a regulatory 
framework that encouraged entrepreneurial activities. We support any 
regulatory rule or business consolidation that will enhance this 
atmosphere of innovation and competition. Individual investors and 
savers, whether direct or indirect participants in the market, are 
better for this free market, and ultimately, so is the American 
consumer.
    I would like to thank the Committee for inviting TIAA-CREF to share 
our views on this important topic. I look forward to answering any 
questions you may have.
                               ----------
                 PREPARED STATEMENT OF THOMAS M. JOYCE
    Chairman and Chief Executive Officer, Knight Capital Group, Inc.
                              May 18, 2005
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for the opportunity to participate in this hearing 
regarding the Securities and Exchange Commission's market structure 
rule, Regulation NMS, and recent market developments in the industry.
    Knight Capital Group, through its affiliates, makes markets in 
equity securities listed on Nasdaq, the OTC Bulletin Board, the New 
York Stock Exchange, and American Stock Exchange, both in the United 
States and Europe.\1\ On active days, Knight executes in excess of one 
million trades with volume exceeding one billion shares.
---------------------------------------------------------------------------
    \1\ Knight is the parent company of Knight Equity Markets, L.P., 
Knight Capital Markets, Inc., and Knight Equity Markets International, 
Ltd., all of whom are registered broker-dealers. Knight also owns an 
asset management business for institutional investors and high net 
worth individuals through its Deephaven subsidiary. Knight is a major 
liquidity center for the Nasdaq and listed markets. As a dealer, we 
make markets in nearly all equity securities. Knight's 
clients include more than 850 broker-dealers and 600 institutional 
clients. Currently, Knight employs nearly 700 people. Recently, Knight 
announced its acquisitions of Direct Trading Institutional, Inc. (DTI), 
based in Irving, Texas, and the ATTAIN ECN which is based in Montvale, 
NJ. DTI is a registered broker-dealer and was founded in 1998 to 
provide institutional investors trade executions and reduced trading 
costs. DTI now provides execution services to roughly 300 institutions 
that are trading in excess of 2 billion shares per year. ATTAIN is a 
registered electronic communications network (ECN) pursuant to 
Regulation ATS and currently provides facilities for broker/dealer 
customers to quote Nasdaq listed and OTC Bulletin Board securities. 
Both acquisitions are currently pending regulatory approval.
---------------------------------------------------------------------------
Regulation NMS
    For several years Knight has called on the SEC to address several 
problems in the equity markets, namely the lack of market linkages and 
efficient access to quotes, the ability of ECN's to charge access fees 
to nonsubscribers, and the negative impact of sub-penny quotations. By 
adopting Regulation NMS, the SEC took an important step to address some 
of these issues, which have long been areas where potential gaming or 
distortion create inefficiencies in the markets.
    Knight supports the ban on sub-penny quotations and the rule 
prohibiting locking the quotation of an automated market included as 
part of Regulation NMS. 
Sub-penny quotations diminish liquidity at each price point and make it 
easy for professionals to jump ahead of limit orders. By capping ECN 
access fees for nonsubscribers, Regulation NMS will help to establish 
more integrity and transparency of the quote. The rule will also 
address the market distortions such fees cause, mitigating the economic 
incentive of certain market participants to lock and cross markets, 
which can lead to confusion in the marketplace.
    Knight applauds the SEC for its action in these areas. However, 
Knight continues to believe that there is no need to extend any form of 
trade-through rule to all markets due to competitive forces and the 
lack of data supporting such a rule. As we noted earlier this year in 
testimony before the Subcommittee on Capital Markets, Insurance and 
Government Sponsored Enterprises of the House Financial Services 
Committee on February 15, 2005, there is no evidence to suggest that an 
intermarket trade-through rule will increase limit orders, one of its 
stated goals. However, various data sources reveal that retail 
investors use limit orders on Nasdaq-listed stocks (with no trade-
through rule) much more often than on exchange-listed stocks (with a 
trade-through rule).\2\ Additionally, we believe that the typical U.S. 
retail investor prefers the use of market orders, as opposed to limit 
orders, as it provides them the opportunity to immediately gain access 
to the displayed price and size they see in the market. Further, the 
SEC's data on trade-through rates is 
nearly the same for Nasdaq, which currently has no trade-through rule, 
and the NYSE, which already has a form of the trade-through rule. 
Finally, we are also concerned that a trade-through rule may have the 
unintended consequence of further reducing liquidity in the market, 
particularly if large block-sized prints move offshore.
---------------------------------------------------------------------------
    \2\ See letter from Jeffrey T. Brown, Senior Vice President, 
Charles Schwab, to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, February 1, 2005.
---------------------------------------------------------------------------
    Knight instead has advocated repeatedly that competition, rather 
than mandated and prescribed paths to trading, benefits market 
participants and all investors. For example, the SEC's Rule 11Ac1-5 
(Rule 5) is an excellent example of regulation that increases 
competition by promoting transparency and comparability. The rule 
requires market participants to post their execution statistics in 
accordance with standardized reporting metrics, thus enabling order 
routing firms to make more informed routing decisions to meet their 
clients' needs. This has increased competition and pressured market 
participants to continue to improve the execution of customer orders, 
while resulting in dramatically reduced costs for investors. We believe 
the dramatic decrease in brokerage commissions and the split-second 
executions for most marketable trades in recent years is a direct 
result of these competitive forces, not regulatory fiat. Therefore, 
Knight still believes that a regulatory approach encouraging 
competition such as Rule 5, coupled with strengthened linkage 
requirements mandating that all markets connect so all displayed 
quotations can be immediately accessible and executable, would provide 
a far less disruptive and less costly way to achieve the goals of a 
trade-through rule.
    With the adoption of Regulation NMS, Knight is focused on 
implementation to ensure compliance and a smooth transition to the new 
rules. The trade-through rule in particular has numerous exceptions and 
other requirements that will make implementation extremely challenging. 
The vetting process which has taken place to date has produced numerous 
comments, many of which have raised critical issues for this Committee 
and the SEC. The SEC and its staff should be commended for their hard 
work in reviewing all of the various comment letters, conducting 
numerous industry meetings, and for their efforts at drafting the final 
Rule. As the ``devil is always in the details,'' it will be important 
to carefully examine the final Rule once published to ensure we fully 
understand its nuances and then work closely with the SEC staff to 
address any questions.
    I will briefly identify some areas that warrant significant 
attention as Regulation NMS is implemented.
    1. The need for clear guidance from the SEC and an incremental 
phase-in. We encourage the SEC staff to continue to work with industry 
on implementation of the rules in a transparent and open manner to 
achieve consensus on the technical details of Regulation NMS.
    The SEC should gradually phase-in and implement the rules, 
particularly the trade-through rule, in a methodical manner. Regulation 
NMS provides a limited phase-in of the trade-through rule, beginning 
with a small group of representative NMS stocks on April 10, 2006, with 
full implementation by June 12, 2006.
    Knight recommends a more incremental phase-in to help ensure that 
market participants have the system capacity necessary for successful 
implementation. For example, we suggest that 100 stocks be part of the 
first phase-in stage, which should last one month, followed by 
additional phases of 500 stocks per month thereafter. This incremental 
phase-in approach will allow for a more reasonable implementation 
schedule and will permit market participants to conduct the proper 
stress testing on their trading systems for those changes associated 
with the new requirements.
    There is adequate precedent for such a phased-in implementation of 
major changes to market rules. For example, the implementation of 
decimal pricing began with a phase-in of decimal pricing in August 2000 
and ended with full implementation in April 2001. There are other 
examples, such as the move from Nasdaq's SelectNet to SuperMontage and 
the implementation of Regulation SHO, where the SEC took a deliberate 
and careful approach to implementing new rules. The transition to 
SuperMontage took several years to implement and included testing the 
trading systems on weekends for many months. The implementation of 
Regulation SHO governing short sales includes a one year pilot 
consisting of stocks of varying liquidity and size. These examples 
demonstrate that when the regulators and industry work carefully 
together on complicated matters, it helps to smooth the transition to 
the new rules with the least disruption to market participants and 
investors.
    2. Improve connectivity. Regulation NMS permits private linkages to 
promote more connectivity among the markets. However, the SEC should 
mandate minimum standards for such linkages and ensure that quotes can 
be accessed immediately. Knight believes that this requirement alone 
would have prevented the need for any trade-through rule and provided 
for a more efficient national market system. Although Regulation NMS 
encourages connectivity, these provisions should be strengthened to 
ensure that the markets are linked and accessible, especially in light 
of the new trade-through rule.
    3. Trade-through rule design. The most complex aspect of Regulation 
NMS will be the implementation of the new intermarket trade-through 
rule. A number of questions remain regarding how to program trading 
systems for the new trade-through rule. Although the rule provides an 
exemption from the trade-through rule for flickering quotes, there 
remain questions as to how this will work in practice. For example, in 
a flickering quote environment, would the execution of a trade that 
occurred two cents from the ``best price'' be considered a trade-
through?
    With automatic and electronic trading, fast response times are 
critical for an efficient trading environment. If rules establish 
specific response times of 1-2 seconds, it may create a safe harbor for 
markets to respond within that time frame rather than promoting 
innovation and sub-second response standards. These latencies will 
ultimately harm the investors, and only serve to reduce transparency 
and to decrease liquidity.
    Rules for response times should be dynamic, reflecting the current 
state of technology at any point in time. The Securities Exchange Act 
of 1934 (the ``Exchange Act) states that the securities markets are an 
``important national asset which must be preserved and strengthened.'' 
\3\ Further, and by way of analogy, when considering unlisted trading 
privileges, Congress directed the SEC to take into account many 
factors, including `` . . . the character of trading, the impact of 
such an extension on the existing markets for such securities, and . . 
., the progress that has been made toward the development of a national 
market system'' (emphasis added).\4\ The message from Congress is 
clear. The implementation of rules should take into account the impact 
on ``existing markets.'' Consequently, in existing markets that 
benchmark executions in sub-seconds, rules should not be promulgated 
which encourage or permit much slower executions. To do so, would not 
only ignore the state of technology in existing markets, but could also 
hinder the continued ``development of a national market system.''
---------------------------------------------------------------------------
    \3\ See, Section 11A(a)(1) of the Exchange Act, 15 U.S.C. Sec. 78k-
1(a)(1).
    \4\ See, Section 12(f) of the Exchange Act, 15 U.S.C. Sec. 78I(f).
---------------------------------------------------------------------------
    The issues relating to defining ``fast'' and ``slow'' markets are 
equally complex and challenging. For example, who determines whether a 
quote is fast or slow? Additionally, as currently drafted, the rule 
applies to ``quotes.'' Thus, market participants will have to develop 
processes to monitor each stock traded in each market venue. To 
illustrate the complexity, there are roughly 6,000 securities that 
trade on Nasdaq and the NYSE. Imagine needing a stopwatch to time the 
response times of all market participants in those 6,000 issues, 
clicking on and off with each trade, in each security, by each market 
participant, every second of the trading day. As you can imagine, there 
are a number of possible outcomes if there is not sufficient 
specificity or a bright line to set forth the standards.
    Another concern about implementation of the rule lies with the 
exemption of trade-through protection for slow quotes. Regulation NMS 
does not exempt trade-throughs of manual quotes from best execution 
obligations. Knight recommends some form of a safe harbor from best 
execution obligations for slow quotes. If there is no safe harbor, it 
could create significant uncertainty and inefficiencies in the markets 
and it could ultimately defeat the incentives for slow markets to 
become fast markets.
    4. Potential gaming opportunities. Careful and poised 
implementation will be vital in preventing potential gaming 
opportunities of professional traders who may seize upon unintended 
opportunities resulting from a rapid roll-out of the rule. A lesson can 
be learned from the retired Nasdaq Small Order Execution System (SOES) 
system. SOES was initially designed, in part, to remedy the problems 
experienced after the 1987 stock market crash to ensure the small 
orders of many investors could be executed automatically. SOES allowed 
small orders to be executed automatically against dealer quotes; 
however, an eventual unintended consequence was the creation of a 
cottage industry of professional traders, often called ``SOES 
bandits,'' that took advantage of small quote differences using rapid 
trading. It took several years to take action against these abuses, 
some of which impacted small investors by disadvantaging pension and 
mutual funds. In a similar way, care should be taken not to create 
gaming opportunities for certain professionals at the expense of most 
investors.
Recent Market Developments
    Competition helps to foster innovation, creativity, and greater 
efficiencies to the benefit of the individual investor. Knight has 
always been an advocate of policies that foster competition. For 
instance, Knight was a proponent of rules that increase transparency 
and comparability of execution quality. The SEC later adopted Rule 5, 
which as I described earlier, has provided transparency and 
comparability of execution statistics. This has increased competition 
and pressured markets to continue to improve execution and reduce costs 
of customer orders.
    Regulation NMS, to the extent practicable, should avoid prescribing 
specific paths to trading, which may limit the ability to innovate and 
to enter markets. Additionally, we need to be mindful of the fact that 
costs associated with complying with a very intricate rule could create 
barriers to entry. The current uncertain business and regulatory 
environment impacts profitability and tends to encourage more 
consolidation. Clear and effective regulation will help to reduce some 
of these uncertainties. Although a degree of consolidation is 
inevitable as firms strive to gain efficiencies and economies of scale, 
it is unclear to what extent investors may benefit as further 
consolidation of the markets takes place.
Conclusion
    Knight appreciates the constructive role this Committee has played 
in the oversight of the markets and the rulemaking process. Regulation 
NMS represents the first fundamental rewrite of the market system rules 
in 30 years. Therefore, we urge the Committee to continue its oversight 
role as the industry and the SEC work on implementation of Regulation 
NMS. Your involvement helps to ensure that the U.S. capital markets 
remain competitive and innovative, thus benefiting all investors.
    Thank you for your interest in these issues and for the opportunity 
to contribute to this important dialogue.
                 PREPARED STATEMENT OF MARC E. LACKRITZ
               President, Securities Industry Association
                              May 18, 2005
Introduction
    Chairman Shelby, Senator Sarbanes, and Members of the Committee, I 
am Marc E. Lackritz, President of the Securities Industry 
Association.\1\ SIA commends you for holding this hearing and 
appreciates the opportunity to testify on the implementation of 
Regulation NMS, as well as on issues related to the proposed mergers 
between the New York Stock Exchange (NYSE) and Archipelago Holdings, 
Inc., and The Nasdaq Stock Market (Nasdaq) and Instinet, LLC.
---------------------------------------------------------------------------
    \1\ The Securities Industry Association brings together the shared 
interests of nearly 600 securities firms to accomplish common goals. 
SIA's primary mission is to build and maintain public trust and 
confidence in the securities markets. At its core: Commitment to 
Clarity, a commitment to openness and understanding as the guiding 
principles for all interactions between 
investors and the firms that serve them. SIA members (including 
investment banks, broker-dealers, and mutual fund companies) are active 
in all U.S. and foreign markets and in all phases of corporate and 
public finance. According to the Bureau of Labor Statistics, the U.S. 
securities industry employs nearly 800,000 individuals, and its 
personnel manage the accounts of nearly 93 million investors directly 
and indirectly through corporate, thrift, and pension plans. In 2004, 
the industry generated an estimated $227.5 billion in domestic revenue 
and $305 billion in global revenues. (More information about SIA is 
available at: www.sia.com.)
---------------------------------------------------------------------------
    Our Nation's securities markets are the most transparent, liquid, 
and dynamic in the world. New forms of competition, technological 
advances, globalization, and broader investor participation have driven 
phenomenal changes in the capital markets and the securities industry 
over the past decade. Indeed, we only have to look at developments over 
the last month to see that this continues to be the case. Both the NYSE 
and Nasdaq proposed major restructurings and the Securities and 
Exchange Commission (SEC or Commission) adopted Regulation NMS after a 
vigorous and healthy debate over the future trading structure of our 
securities markets.
    SIA does not have a position on the proposed mergers, but we 
strongly believe they raise two critical regulatory issues that the 
Commission should address. First, they highlight the need, and present 
the opportunity, to bring the structure of self-regulation into the 
21st century. Although the current model of self-regulation has 
generally worked well to protect investors, we believe the time has 
come for a major restructuring of the self-regulatory system. SIA 
supports the adoption of a hybrid self-regulatory model, which would 
embody regulation into two types of organizations that would be divided 
by function. Each marketplace would have its own SRO, which would 
regulate and enforce all aspects of trading, markets, and listing 
requirements. The other type of organization would be a Single Member 
SRO that would handle regulations relating to the operations of broker-
dealers. By eliminating unnecessary regulatory duplication and inherent 
conflicts of interest, a revamped self-regulatory structure can 
strengthen investor protection and increase the competitiveness of the 
U.S. capital markets.
    Second, the proposed mergers heighten concerns about the potential 
for consolidated market centers to develop an unchecked monopolistic 
hold on market data to the detriment of investors and markets. We have 
urged the SEC to address market data issues comprehensively, and we are 
disappointed that the SEC has not done this yet. The Commission has 
indicated, however, that it intends to address the remaining issues in 
the context of SRO reform. We urge the Commission to consider the 
recent plans for consolidation of market centers in addressing the 
outstanding market data issues.
    The periodic reevaluation of market structure is vital to 
maintaining our global preeminence and to ensuring that investors are 
fully protected. SIA commends the Commission and its staff for tackling 
such difficult issues and for their continued efforts to engage all 
market participants in the debate. The SEC has acted diligently and in 
good faith to explore reforms that will strengthen the U.S. capital 
markets. Although many of the solutions are controversial and not 
necessarily what SIA would prescribe, the policy debate has been 
necessary and productive. The trade-through rule was particularly 
divisive, as evidenced by the unusual 3-2 split among the Commissioners 
on final adoption of the rule. However, it is important to note that 
the issues raised in Regulation NMS are inherently complex, and finding 
consensus is an enormously difficult task.
    Since the text of Regulation NMS has not yet been released, we have 
not identified the full range of implementation problems yet. We are in 
the process of forming working groups with our member-firms to address 
all operational and compliance implementation issues, and plan to work 
with the self-regulatory organizations (SRO's) over the next 14 months. 
Given the significant systems and other changes that will be necessary 
to implement the new rules, we are grateful that the Commission has 
provided lengthy implementation periods for most of the rules.
Regulation NMS
Guiding Principles
    SIA believes any regulatory approach to market structure should:

 Protect investors.
 Ensure the markets are fair, orderly, and honest.
 Be sufficiently flexible to adapt to the development of new 
    trading practices and technological innovations by competing market 
    centers.
 Foster effective intermarket executions and enhance market 
    access to ensure that all investors' orders--both retail and 
    institutional--are executed in the manner most beneficial to the 
    investor.
 Assure equal, fair, and consistent regulation across market 
    centers.
 Ensure quality, fairly priced, cost-effective market data.
The SEC's Action on Regulation NMS
    The newly adopted Regulation NMS includes new or revised rules for 
trade-through regulation, intermarket access, quoting in sub-penny 
increments, and market data reforms. Although we agree with many of the 
SEC's decisions, there are a few significant areas where we differ and/
or had offered refinements.
    Intermarket Price Protection (Trade-Through Rule). The Commission 
proposed two alternatives for the trade-through rule, a ``top-of-book'' 
option and a voluntary ``depth-of-book'' alternative. SIA member-firms 
were not convinced that either approach was appropriate and recommended 
putting in place the National Best Bid and Offer (NBBO) model before 
considering implementing either of the options. The SEC, however, 
adopted the top-of-book approach, which will protect the best bids and 
offers of each exchange, Nasdaq, and the NASD's ADF. Trading centers 
will have to establish and enforce written policies and procedures that 
are reasonably designed to prevent trade-throughs.
    Given the vital importance and the extreme complexity of the trade-
through rule, we argued that it would be more prudent to take a 
methodical approach to implementation to ensure we get it right from 
the start. Using the NBBO model as a first step would strengthen 
existing trade-through protection and extend it beyond the listed 
market to cover the entire Nasdaq market as well. Such a strategy would 
provide greater investor protection and facilitate competitive, 
innovative markets while avoiding the unnecessary, burdensome 
regulatory effects or unintended consequences that could result from 
the more extensive trade-through rules.
    SIA supported the adoption of many of the Commission's proposed 
exceptions to the trade-through rule and offered some fine-tuning of 
others. Although the rule did not contain a general ``opt-out'' 
exception that would have allowed market participants to disregard 
displayed quotations, the rule included several exceptions to help 
ensure its workability with, among others, intermarket sweep orders, 
quotations displayed by markets that fail to meet the response 
requirements for automated quotations, and flickering quotations with 
multiple prices displayed in a single second.
    The Commission did not adopt, however, our suggestion for a new 
liquidity exception for the most actively traded, highly liquid 
securities. We recommended this exception because the manner in which 
these securities trade already affords investors with effective 
protection. Trade-through regulation should be focused on those 
securities for which it would have the greatest benefit in protecting 
investors--less liquid securities, for example. The adoption of such an 
exception would have allowed the SEC to study the effect of having a 
trade-through rule versus not having one for a specified period of time 
(such as a year). The SEC would then have been able to consider the 
necessity for any further action, in much the same manner as it plans 
to do with the pilot program for Regulation SHO (short-sale rule).
    We are also concerned about the treatment of manual quotes in the 
new trade-through rule, and discussed these concerns and our 
recommendations for addressing them in our comment letters.
    Intermarket Access. SIA supported adoption of the Commission's 
proposed access standards for private linkages and the proposed rule to 
minimize locked and crossed markets. The private-linkage approach 
establishes uniform market access for all by promoting 
nondiscriminatory access to quotations displayed by SRO trading 
centers. We suggested, however, that the antilocking and anticrossing 
rule include two of the proposed exceptions to the trade-through rule--
flickering quotes and systems malfunctions.
    SIA supported the Commission's efforts to craft a market-wide 
solution to the access fee problem, but we still have concerns about 
excessive fees related to unprotected quotations, the administrative 
difficulties of tracking whether quotations are protected or not, and 
the broad definition of access fees.
    Sub-Penny Quoting. We endorsed the Commission's ban on sub-penny 
pricing as a way to help prevent ``stepping-ahead'' of customer limit 
orders for an economically insignificant amount. This practice, over 
time, could discourage investors from placing limit orders, an 
important source of market liquidity.
    Market Data. We are deeply disappointed that the SEC did not deal 
with all of the market data issues in the context of the Regulation NMS 
debate, but the Commission has indicated it intends to address the 
remaining issues in the context of SRO reform. We strongly believe the 
resolution of these issues--sooner than later--is of the utmost 
importance for the integrity of the markets, particularly now in light 
of the proposed NYSE and Nasdaq mergers.
    The Commission adopted rules to revise formulas for the allocation 
of market data revenues to: Create advisory committees to the joint 
industry plans composed of non-SRO representatives; authorize markets 
to distribute their own data independently, while still providing their 
best quotations and trades for consolidated dissemination through the 
plans; and, streamline the requirements for the display of 
market data to investors. According to the SEC, these changes will help 
correct the flaws of the current formulas, reward SRO's that contribute 
to public price discovery by dividing market data revenues equally 
between trading and quoting activity, and improve the transparency and 
effective operation of the plans.
    Those revised reallocation formulas, however, do not address a 
number of other critical market data issues--such as opaque fee-setting 
practices--that have resulted in unwarranted and excessive market data 
fees. We had recommended that the Commission consider all of the 
following market data related issues as a whole:

 Current and future fees should be accounted for transparently, 
    and supported by independent audits of the networks and annual 
    filings that cover expenses, revenues, and projections;
 Unlike the SEC's rule filing process, fees should be set and 
    changed through a collective process that involves market 
    participants, operates transparently and permits real challenge;
 Fees should be limited to the cost of collecting and 
    disseminating market data, thereby rendering rebates unnecessary;
 The networks' contractual and usage requirements should be 
    reduced, streamlined, and made uniform, which will assist in 
    lowering fees and associated administrative burdens;
 Plan governance also should be transparent, with any advisory 
    committee structured to reflect industry and investor involvement 
    and empowered beyond the merely cosmetic;
 Most firms believe that information should be channeled 
    through a single securities information processor (SIP);
 Any fees chargeable for noncore data such as depth-of-book 
    should be subject to market forces; \2\ and,
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    \2\ The SIA believes, however, that the Commission should undertake 
a study of the impact of different levels of transparency among market 
participants (for example, between retail and institutional investors) 
in this era of decimalization where depth of book data is not readily 
available to all.
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 Market data provisions, including definitions and applications 
    of fee categories such as ``professional'' and ``nonprofessional'' 
    and limitations on the redistribution of data, should be the 
    subject of a fresh review and uniform rulemaking.

    We believe Congress did not intend for market data to generate 
revenues for SRO's to subsidize their regulatory obligations or to fund 
competitive business activities, as it does today. The purpose of 
disseminating market data is to create transparency in the prices that 
investors receive for buying and selling securities and, where there 
are competing market centers, to increase investor choice and 
opportunity. For that reason, SIA advocated a revised method for 
funding regulation that does not depend on revenue from market data 
fees.
    We do not believe our proposed cost-based approach for establishing 
market data fees puts the SEC in a role of rate maker, but instead 
relies upon its oversight role over SRO's to ensure that access to this 
information is available on terms that are ``fair and reasonable'' and 
``not unreasonably discriminatory.''
    Our proposed cost-based approach will minimize many of the 
conflicts of interest related to market data fees that SRO members of 
the plans face now. The conflicts arise from control over a monopoly 
product with the ability to use the monopoly revenue to subsidize other 
activities. By limiting the market data revenue, the business incentive 
to seek greater data revenue is restricted as well. We believe the 
narrow cost-based approach is the most straightforward method to 
accomplish this, and is most closely aligned with the congressional 
purposes underlying the Exchange Act.
    Of course, in determining the reasonableness of fees under the 
cost-based approach, the SEC also must consider whether the fee limits 
fair and reasonable access to market data, particularly where such 
access is imperative for compliance with regulatory requirements, such 
as proposed Regulation NMS. We need to recognize that decimalization 
has decreased the value of consolidated market data even though the 
price has remained the same. Prior to decimalization, the consolidated 
data reflected in the NBBO signaled the depth in the market up to 12 
cents. Today, the depth of the market reflected in the NBBO is only a 
penny or two, generally representing very few shares.
    The valuable data that used to be reflected in the NBBO is now in 
the nonconsolidated data that the SRO's are distributing on their own, 
at an additional charge. This trend is continuing and, indeed, 
sanctioned by the Commission's recent amendments. The Commission should 
not only look at the high cost of producing such data, but also whether 
market data fees are in fact cross-subsidizing the production of 
proprietary market data products. We believe a cost-based approach to 
all market data would ensure the availability of both depth-of-book and 
NBBO information at a reasonable cost.
    The proposed NYSE and Nasdaq mergers only heighten our concerns in 
these areas. Indeed, some member-firms are apprehensive that the SRO's 
will have an even greater monopolistic hold on market data with the 
consolidation of the markets, which could work toward the detriment of 
both our markets and investors. We therefore strongly encourage the 
Commission to review all of these market data issues with these new 
concerns in mind.
The Need for Structural Reform of Self-Regulation
Guiding Principles
    The proposed NYSE-Archipelago merger further heightens the 
importance of examining the securities industry's self-regulatory 
system. SIA has thought a great deal about the structure of self-
regulation over many years. Five years ago, when the NYSE and Nasdaq 
first proposed to become for-profit entities, SIA commissioned a White 
Paper titled ``Reinventing Self-Regulation.'' The White Paper examined 
the effectiveness of self-regulation in a rapidly changing environment, 
and considered the advantages and disadvantages of different models for 
regulation of our Nation's securities markets.\3\
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    \3\ The White Paper is available at http://www.sia.com/
market_structure/html/siawhitepaperfinal.htm.
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    Our reviews of self-regulation include a set of guiding principles, 
many of which are listed in the previous section addressing market 
structure issues. Two additional principles, however, should be 
considered in the debate over the self-regulatory system. First, the 
regulatory system should ensure the primacy of the SEC as a strong 
national regulator, but should include appropriate roles for, and 
coordination with, the SRO's, the States, and market participants, to 
achieve uniform national standards. Second, the regulatory staff 
overseeing day-to-day activities must possess the requisite expertise 
necessary to perform their duties. This can best be achieved if the 
regulator has: (i) effective industry input into the regulatory 
process; (ii) the power and prestige to attract talented staff; and 
(iii) the ability appropriately to tailor regulation to fit the 
diversity of entities that it regulates, rather than relying upon a 
``one-size-fits-all'' approach.
    Based on our experience with these issues, we have concluded that 
the time has come for a major restructuring of self-regulation. 
Although we believe the current model of self-regulation has generally 
worked well to protect investors, concerns about regulatory conflicts 
of interest and regulatory duplication have taken on new significance 
as market centers combine and competition--both domestically and 
internationally--intensifies. In that vein, we propose consolidating 
regulation of broker-dealers into one ``hybrid'' SRO, while each 
marketplace retains separate SRO's to regulate and enforce all aspects 
of trading, markets, and listing requirements. We describe this 
proposal in more detail later.
Strengths and Weaknesses of the Current SRO System
    The success of today's self-regulatory governance is directly 
related to member involvement in the process.\4\ For example, member 
expertise and involvement in SRO rulemaking processes has led to more 
effective, less costly rules. In addition, self-policing by 
professionals who have the requisite working knowledge and expertise 
about marketplace intricacies and the technical aspects of regulation 
creates a self-regulatory system with valuable proper checks and 
balances. Supplemented by government oversight, this tiered regulatory 
system can provide a greater level of 
investor protection than the government alone might be able to achieve.
---------------------------------------------------------------------------
    \4\ See generally S. Rep. No. 94-75, at 22 (1975) (accompanying S. 
249, 94th Cong., 1st Sess. (1975)) (In enacting the Exchange Act, 
Congress balanced the limitation and dangers of permitting the 
securities industry to regulate itself against `the sheer 
ineffectiveness of attempting to assure [regulation] directly through 
the government on a wide scale.' ''); SEC Report of Special Study of 
Securities Markets, H.R. Doc. No. 88-95, Part 4 (1963) (Special Study).
---------------------------------------------------------------------------
    Because self-regulators have an intimate knowledge of industry 
operations, trading, and sales practices, they can develop and revise 
rules more quickly and frequently. Similarly, self-regulation utilizes 
the insight of those who are on the frontline of marketplace 
developments, meaning they can be more forward-looking and up-to-date 
with market realities than traditional government regulators. In 
addition, SRO rules often are designed to set ethical standards that 
exceed the legal minimums. For example, the NASD requires that its 
member firms adhere to ``just and equitable principles of trade,'' a 
standard that in many instances exceeds the antifraud requirements of 
SEC statutes and rules.
    In spite of how well self-regulation has worked, both market 
participants and governmental bodies have recognized in recent years a 
growing need for structural 
reform of self-regulation. This view is based on three concerns: (1) 
increased competition among SRO's and their members for customer orders 
could cause conflicts of interest due to the SRO's' roles as both 
market operators and regulators; \5\ (2) ``multiple SRO's can result in 
duplicative and conflicting SRO rules, rule interpretations, and 
inspection regimes, as well as redundant SRO regulatory staff and 
infrastructure across SRO's;'' \6\ and, (3) the profit motive of a 
shareholder-owned SRO could detract from self-regulation.\7\
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    \5\ ``Securities Markets: Competition and Multiple Regulators 
Heighten Concerns about Self-Regulation,'' General Accounting Office, 
May 2002, GAO-02-362, available at http://www.gao.gov/new.items/
d02362.pdf, at 1-2 (GAO SRO Report). The GAO also noted, ``Heightened 
competitive pressures have generated concern that an SRO might abuse 
its regulatory authority--for example, by imposing rules or 
disciplinary actions that are unfair to the competitors it regulates.'' 
The SEC shares this concern. ``As intermarket competition increases, 
regulatory staff may come under pressure to permit market activity that 
attracts order flow to their market. . . . Also, SRO's may have a 
tendency to abuse their SRO status by over-regulating members that 
operate markets that compete with the SRO's own market for order 
flow.'' Concept Release Concerning Self-Regulation, 69 Fed. Register 
71256, 71262 (Dec. 8, 2004) (SEC SRO Concept Release).
    \6\ SEC SRO Concept Release at 71264. The GAO has noted similar 
``inefficiencies associated with SRO rules and examinations.'' GAO 
Report at 2.
    SIA has recently had productive discussions with the NYSE and NASD, 
as well as the SEC's Office of Inspections and Examinations (OCIE), on 
improving coordination among these three regulators' examination 
programs. An overview of the results to date of those discussions is 
available at http://www.sia.com/RegulatoryCoordination/index.html.
    \7\ ``Another significant conflict of interest for SRO 
responsibilities is with SRO shareholders. SRO demutualization raises 
the concern that the profit motive of a shareholder-owned SRO could 
detract from self-regulation. For instance, shareholder-owned SRO's may 
commit insufficient funds to regulatory operations or use their 
disciplinary function as a revenue generator with respect to member 
firms that operate competing trading systems or whose trading activity 
is otherwise perceived as undesirable.'' SEC SRO Concept Release, at 
71263.
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Significance of the NYSE-Archipelago Merger
    Because several of our large members have divergent views on the 
proposed NYSE-Archipelago merger, it would be inappropriate for us to 
comment on its merits as a business transaction. We do, however, 
strongly believe that the proposed merger represents an important 
opportunity to address the concerns outlined previously. The following 
are some observations about the NYSE-Archipelago merger.
    (1). The merger both illustrates and accelerates the trend toward 
increased consolidation of, and competition between, market centers. 
While this competition is in most respects a very healthy development, 
it does raise questions about the NYSE's continued regulation of 
broker-dealers that could be potential competitors for order flow or 
for development of new investment products. The very fact that NYSE 
apparently seeks to maintain regulation of its broker-dealer members 
under the NYSE name and the oversight of some of its directors, rather 
than spin it off into a separate entity under a different name with 
entirely separate directors, suggests that the NYSE sees value in 
continued ``branding'' of its regulatory authority over broker-dealers. 
The measure of any value that may be perceived in retaining broker-
dealer regulation within the NYSE brand is also the measure of the 
problem of the NYSE regulating potential competitors.
    (2). The merger underscores the significance of increased 
competition, not just narrowly between U.S. market centers, but also 
globally among all capital markets. This competition applies to 
securities exchanges and financial intermediaries of all stripes. 
Unnecessary regulatory duplication is a weight around the ankles of 
financial intermediaries in the United States that has a real cost in 
terms of the future competitiveness of our capital markets. The merger 
represents an opportunity to address this regulatory duplication.
    (3). The merger raises exactly the issues about conflicts between 
shareholders' interests and regulatory authority about which the SEC 
and SIA have both voiced concerns.
    In fairness, it appears that the NYSE sshould address several of 
these issues in structuring the merger. The NYSE stated that it would 
take steps to separate the NYSE's regulatory arm from its business 
side, which should help ameliorate concerns about the possible misuse 
of the NYSE's regulatory authority to benefit its business side and its 
shareholders.\8\ However, the NYSE's proposal does not appear to 
address the critical issue of regulatory duplication between itself and 
the NASD in regulating dually registered broker-dealers. While the NYSE 
is, appropriately, focused on strengthening the competitiveness of its 
own business position, the proposed merger represents an opportunity to 
reconfigure the self-regulatory system so that the competitiveness of 
the overall U.S. capital markets is also strengthened.
---------------------------------------------------------------------------
    \8\ Joint NYSE-Arca/Ex News Release, April 20, 2005, available at 
http://www.nyse.com/pdfs/joint_release.pdf, at 2.
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The Hybrid SRO: Toward a Better System of Self-Regulation
    Last winter, the Commission sought comment on a variety of self-
regulatory models as possible alternatives to the current structure of 
self-regulation. Of the seven models the SEC proposed, SIA believes the 
Hybrid self-regulatory model offers the best alternative regulatory 
structure for preserving competitive, innovative markets while 
fostering more efficient and effective regulation. Under this model, 
self-regulation would be embodied in two types of organizations that 
would be divided by function. Each marketplace would have its own SRO, 
which would regulate and enforce all aspects of trading, markets, and 
listing requirements. The other type of organization would be a Single 
Member SRO that would handle regulations relating to the operations of 
broker-dealers (sales practices, financial responsibility requirements, 
qualification of personnel, recordkeeping, etc.).
    The Hybrid model will require the SEC to designate a Single Member 
SRO to regulate all SRO members with respect to membership rules such 
as financial condition, margin, registered representative qualification 
testing, customer accounts, sales practices, and supervision. Each SRO 
operating a market would be responsible for the oversight of its market 
operations regulation (for example, its trading rules), including 
enforcement of those trading rules. The creation of the Single Member 
SRO addresses the two primary areas of weakness in the current self-
regulatory structure. First, it eliminates the inefficiencies in 
rulemaking and examinations, and the potential for inconsistent 
regulation that exists in a multiple SRO system. Second, it eliminates 
conflicts of interest between an SRO's regulatory and market functions 
with regard to membership rules.
    A Hybrid Will Give Better Regulatory Mileage. Most broker-dealer 
compliance resources currently are devoted to complying with rules of 
multiple SRO's. For example, conduct rules--the area of the most 
duplicative SRO rules--have the same regulatory purpose but require 
different compliance efforts.\9\ The Hybrid model would strengthen the 
effectiveness of compliance resources by creating a single 
comprehensive regulatory oversight structure. At the same time, the 
existence of multiple-market SRO's, each with responsibility over those 
regulations applicable to its unique trading structures, will keep 
market expertise where it is most useful. Much of the innovation that 
makes the U.S. markets so strong occurs in market operations, so the 
maintenance of separate market SRO's will foster continued competition 
and innovation and preserve U.S. capital market dominance.
---------------------------------------------------------------------------
    \9\ For example, the NYSE and NASD have different order audit trail 
requirements, each of which requires unique programming and compliance 
efforts that are costly, and both of which are intended to provide 
similar information for surveillance purposes.
---------------------------------------------------------------------------
    In general, the SEC has already begun moving toward more universal 
capital market rules. For instance, Regulation SHO creates a uniform 
definition of what constitutes ownership of securities, specifies 
aggregation of long and short positions, and requires broker-dealers to 
mark sales in all equity securities ``long,'' ``short,'' or ``short 
exempt'' to establish a uniform system across markets.\10\ Parts of 
Regulation NMS, such as the ban on sub-penny quotations for securities 
priced over one dollar,\11\ also reflect a convergence of rules. The 
Hybrid model will continue this consolidation and streamlining of 
regulations to increase efficacy and efficiency, and to eliminate 
redundancies and gaps in regulatory coverage.
---------------------------------------------------------------------------
    \10\ See Exchange Act Release No. 50103 (Jul. 28, 2004), 69 Fed. 
Reg. 48008 (Aug. 6, 2004) (Regulation SHO).
    \11\ See Regulation NMS.
---------------------------------------------------------------------------
    Overseeing the Hybrid. We realize the Single Member component of 
the Hybrid model would concentrate regulatory power and authority in 
one entity. Therefore, and notwithstanding our advocacy of the Hybrid 
model, this regulatory structure will function effectively only if the 
SEC provides attentive and cost-effective regulatory oversight. This 
oversight should include the SEC's vigilant review of the 
Single Member SRO's costs and fee structures to ensure that the SRO is 
providing sufficient regulatory oversight without imposing excessive 
fees and budget demands. Similarly, the Commission's robust review of 
the Single Member SRO's final disciplinary proceedings will counter any 
possible self-serving interest by the Single Member SRO in levying 
excessive enforcement fines that would be paid into its own 
coffers.
    Additionally, strong member involvement will become even more 
important to prevent the Single Member SRO from becoming an 
unresponsive entity with prohibitive cost structures. The Single Member 
SRO will need substantial member input--especially from smaller cost-
sensitive members--to effectively oversee regulation across a diverse 
group of members with divergent needs and business models.\12\ Member 
involvement and SEC oversight of the Hybrid SRO also will be necessary 
to identify and harmonize any ``boundary'' issues between conduct rules 
subject to the Single Member SRO's regulatory oversight, and market 
rules subject to the continued oversight of the various market SRO's.
---------------------------------------------------------------------------
    \12\ The needs of fixed-income markets differ from those of 
equities markets, for instance. The knowledge members have about the 
ramifications of these differences is essential to ensure that a self-
regulatory system works well for all participants.
---------------------------------------------------------------------------
    The Commission should develop increased transparency requirements 
for the Single Member SRO, particularly concerning funding and 
budgetary issues. Making the Single Member SRO's operations transparent 
to both members and the investing public will place appropriate checks 
on the Single Member SRO and will enhance accountability to its 
constituents.
    To further foster the regulatory efficiency offered by the Hybrid 
structure, market SRO's should be permitted to continue to outsource 
their market enforcement activities. We understand that the ability to 
outsource such activities, while retaining ultimate responsibility as 
an SRO, has worked well for various existing SRO's.\13\
---------------------------------------------------------------------------
    \13\ For example, the American Stock Exchange (Amex) and Nasdaq 
have delegated regulatory activities to the NASD. See, for example, 
Exchange Act Release No. 37107 (Apr. 11, 1996), 61 Fed. Reg. 16948 
(Apr. 18, 1996) (creating the NASDR and Nasdaq as two operating 
subsidiaries of NASD); SEC Set to Release Proposals on SRO Governance, 
But Details Are Still Thin, Securities Week, Nov. 8, 2004, available at 
2004 WLNR 14154116 (quoting NASD chairman and CEO Robert Glauber's 
statement that the NASD ``will continue to regulate Nasdaq and Amex 
under contract.).
---------------------------------------------------------------------------
    Fueling the Hybrid. The final issue for the SEC to resolve is how 
to fund the Single Member SRO. SIA believes that any future self-
regulatory structure must be adequately funded and that fees for 
regulation should be apportioned to the industry on a fair and 
reasonable basis. The fees should be unbundled and cost-justified 
whenever possible. Imposing regulatory fees on the securities industry 
that exceed the true costs of regulation acts as a tax on capital and 
imposes undue harm on the capital-raising system. SIA recommends that 
the SRO's define the costs necessary to meet their self-regulatory 
obligations, prepare and make public a budget to meet those 
obligations, and then fairly apportion those costs among members by 
making periodic filings with the Commission subject to public notice 
and comment.
    As stated earlier, we are convinced that market data fees should 
not be used to fund regulation and should instead fund only the 
collection and dissemination of market data.\14\ Cost-based market data 
fees will not reduce regulatory funding, but will provide greater 
accountability and transparency in the way market data fees are 
assessed and self-regulation is funded. Explicitly tying market data 
fees to the cost of producing the data, while requiring the SRO's to 
prepare public regulatory budgets and charge specific fees for 
regulation, will fully meet regulatory funding needs without over-
charging for market data.
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    \14\ In 2003, the Plans spent $38 million on Plan expenses and 
collected $424 million in market data revenue. The revenue exceeds 
costs by a significant margin. See Exchange Act Release No. 49325 (Feb. 
26, 2004), 69 Fed. Reg. 11126 (Mar. 9, 2004) (initially proposing 
Regulation NMS).
---------------------------------------------------------------------------
    Of course, eliminating market data fees as a source of regulatory 
revenue may produce a shortfall of regulatory funding.\15\ To address 
this possibility, and to underscore how strongly we feel about (i) the 
need for a hybrid SRO approach, and (ii) the need to move away from 
market data fees as a source of regulatory funding, the industry is 
willing to pay higher regulatory fees to the Single Member SRO than it 
now pays to the NYSE and NASD. Our only qualification is that any 
increase in regulatory fees on member firms should be, with the SEC's 
assistance, allocated in a fair manner among all member firms such that 
there is not an undue burden on smaller firms.\16\ Notwithstanding the 
potential for increased regulatory fees for members of the Single 
Member SRO, we believe the benefits of the Hybrid model should exceed 
the costs.
---------------------------------------------------------------------------
    \15\ We note, however, that the increase may be less than one-for-
one because, although SRO's may use market data fees to fund regulation 
today, it is equally likely that SRO's use market data revenues to fund 
competitive or proprietary activities such as rebates for trade prints, 
advertising and brand marketing, and to attract listings.
    \16\ For example, such fees might be based on any number of factors 
designed to approximate the degree of resources required of the Single 
Member SRO in overseeing a particular firm, such as the number of 
registered representatives of a firm, or the scope and nature of its 
customer base or operations.
---------------------------------------------------------------------------
    SIA also believes that a fair and reasonable portion of the Single 
Member SRO's funding should come from issuers and other constituents of 
the trading markets. Trading markets will benefit significantly from 
regulatory oversight of broker-dealers and the various examination and 
continuing education programs conducted by the Single Member SRO under 
a Hybrid model. Such regulation and education initiatives foster the 
market integrity and investor confidence that bring so much business to 
the U.S. capital markets. Under the Hybrid model, markets would receive 
these benefits, and market SRO's should assume some of the associated 
regulatory and administrative costs.
Conclusion
    America's securities markets are the envy of the world, but we 
cannot take it for granted that they always will be. Maintaining the 
preeminence of our capital markets in an increasingly globalized 
economy will require sustained efforts to remove unnecessary regulatory 
inefficiencies that hinder our ability to compete. SIA is eager to work 
with Congress, the SEC, the SRO's, and all other interested parties to 
ensure that our markets remain the most transparent, liquid, and 
dynamic, with unparalleled levels of investor protection.
    Thank you.
                               ----------
             PREPARED STATEMENT OF GEORGE U. ``GUS'' SAUTER
   Chief Investment Officer and Managing Director, The Vanguard Group
                              May 18, 2005
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, my name is Gus Sauter. I am the Chief Investment Officer and 
a Managing Director of The Vanguard Group. I oversee the management of 
approximately $600 billion in mutual fund assets. I am very pleased to 
be here representing The Vanguard Group. We have been working with 
various marketplaces over the past decade to improve the quality of the 
markets to meet investors' needs.
    I would like to thank the Committee for having this hearing on 
Regulation NMS and recent market developments. The issues surrounding 
market structure are very important issues for investors to ensure a 
fair and efficient marketplace. We believe that Regulation NMS, 
specifically the trade-through rule, will promote direct investor order 
interaction and support the best execution of investor orders.
National Market System Principles
    The national market system (the NMS) was created in 1975 through 
amendments to the Securities Exchange Act. These amendments set forth 
Congress' findings about our securities markets and directed the 
Securities and Exchange Commission (the SEC) to facilitate the 
establishment of an NMS. Congress recognized that new data processing 
and communications technology created the opportunity for the more 
efficient operation of markets. It also found that the linking of all 
markets would enhance competition, increase information available to 
intermediaries and investors, facilitate the offsetting of investors' 
orders and contribute to best execution.
    Specifically, Congress directed the SEC to use its authority to 
assure the following five principles:

 Economically efficient securities transactions (efficiency);
 Fair competition among brokers and dealers and among markets 
    (competition);
 The availability of quotation and transaction information 
    (price transparency);
 The practicability of brokers executing investors' orders in 
    the best market (best execution); and
 The opportunity for investors' orders to be executed without 
    the participation of a dealer (direct investor order interaction).

    I would like to focus on two of the principles set forth in these 
amendments: (1) best execution and (2) the promotion of direct investor 
order interaction.
Best Execution
    What is best execution? Some say it is obtaining the best price. 
Others say it is obtaining speed of execution and certainty. We believe 
it is a combination of both into something we call the expected best 
price. It is the best price an investor thinks he or she can obtain for 
the entire trade at the instant the investor decides to buy or sell 
securities. This enables investors to minimize transaction costs and 
maximize returns.
    What is the optimal market environment for achieving best 
execution? A perfectly liquid limit order book. Ideally there would be 
an infinite number of limit orders willing to buy or sell a stock with 
a very small spread between the bid and offer prices.
Limit Orders
    The ideal national market system encourages a perfectly liquid 
limit order book by creating rules that entice investors, market 
makers, and other market participants to place limit orders on an order 
book.
    Limit orders are the building blocks of transparent price 
discovery. Although there may be many market participants willing to 
trade at a certain price, it is only the limit order on the book that 
enables transparent price discovery. Without a book of limit orders, 
market orders have no meaning. Limit orders frame the market-clearing 
price of a stock.
    Transparency of limit orders promotes competition among them. In 
order to improve the likelihood of execution investors are incented to 
enter limit orders at improved prices. This creates narrower spreads 
and additional depth of book, both of which serve to reduce transaction 
costs for investors.
    Displaying limit orders is crucial to promoting liquidity. But 
displaying limit orders runs contrary to most traders' instincts. Like 
a poker player, they desire to see everyone else's cards without 
revealing their own. Economically, a limit order grants a free option 
against which traders can execute their orders. This free option 
creates a profitable opportunity for traders who are allowed to step in 
front of a limit order with the knowledge that they are protected from 
adverse price movement by the book of limit orders. If the market moves 
against their position, they can always ``put'' their position to the 
book of limit orders. Since one trader's gain (from taking advantage of 
the free put) is another trader's loss (from providing the free put), 
there is an economic disincentive to place limit orders.
Trade-Through Rule
    All of this points to the need to overcome the inherent impediments 
to creating limit orders. These types of orders should be encouraged. 
We believe that with a uniform trade-through rule, limit orders are 
protected and therefore encouraged.
    We believe that those who opposed the Regulation NMS trade-through 
rule placed too much emphasis on the short-term goal of satisfying 
market orders. This disregards the longer-term effects on the markets 
of diminishing limit orders. If executions outside of the NBBO are 
permitted, the investor that placed the limit order at the NBBO is 
disadvantaged by not receiving an execution. Why would an investor 
place subsequent limit orders when they can simply be circumvented? Of 
course, the order taking the liquidity is immediately filled in a 
fashion that is satisfactory to the trader, but why should the order 
taking liquidity out of the market be favored over the order 
contributing to liquidity in the marketplace? We believe this creates 
an unintended consequence of significantly negatively impacting 
liquidity, and the ability to fill market orders efficiently, in the 
future.
Competition and Free Markets
    Much concern has been expressed over competition and free markets 
versus regulation. We absolutely think competition is imperative. But 
the competition that is most important for investors is the competition 
among orders--bids competing against bids driving the willing purchase 
price higher, and offers competing against offers encouraging the sale 
at a lower price. This promotes the perfectly liquid limit order book 
we desire.
    Our obligation is to get best execution for our trades. We execute 
against other orders. We do not execute against exchanges. Exchanges 
only provide services. They are a venue through which we execute our 
trades. The trade-through rule will have the effect of linking the 
exchanges into a more central marketplace. In this respect, the 
national market system will be analogous to the internet. The internet 
is a centralized repository of information with hundreds of internet 
service providers (ISP's) that compete on speed, price, and other 
services. But ultimately, each ISP provides its subscribers with access 
to the same internet as every other ISP. Similarly, each exchange is a 
portal into the national market system, and they can compete on speed, 
price and other services.
    Concern also has been expressed about the extension of any trade-
through rule to Nasdaq stocks. I would like to make two points about 
this. First, although Nasdaq does not formally have a trade-through 
rule, it operates as though it does. Applying the uniform trade-through 
rule to it will not be a large burden. Second, different types of 
markets may trade the same NMS stocks, regardless of where the stocks 
are listed. For example, today Nasdaq stocks are traded on Nasdaq's 
SuperMontage, ECN's and ``listed'' exchanges. And several NYSE listed 
stocks are traded on Nasdaq. This cross trading of stocks will 
certainly increase in the future. In this environment, it only makes 
sense that there should be intermarket protection against trade-
throughs for all NMS stocks.
Recent Market Developments
    Two recent developments will intensify competition between markets 
and, hopefully, investor orders. The NYSE and Archipelago recently 
announced their proposed merger, followed a few days later by Nasdaq's 
agreement to purchase Instinet's electronic trading network.
    On the surface, any contraction in the number of market centers 
could be worrisome. The devil is in the details, but these mergers will 
result in two major markets pitted against one another. Our view is 
that investors will be better served by two strong competitors fighting 
with more automated processes.
    The consolidation of the order book on Nasdaq should reduce order 
fragmentation and increase competition among orders. Competition for 
listings and unlisted trading privileges will also increase.
    In the case of New York and Arca, we will have to wait and see the 
details of the proposed merger. We would like to see the best aspects 
of both merged together. However, we understand that the platforms may 
not be merged together. If this is the case, there would be little 
upside advantage of the merger. There would not be a negative effect, 
but a significant opportunity to reduce order fragmentation and 
increase order interaction would be lost.
    We want to see a competitive environment where various marketplaces 
offer value as venues into a more centralized market. Just as ISP's 
that offer cutting edge services are able to compete against the 
Comcasts of the world, we believe there will be opportunities for 
smaller exchanges that offer a value proposition to thrive. And, there 
will be sufficient competition between exchanges to keep each other in 
check and reduce order fragmentation. Depending on how the mergers play 
out, they could end up satisfying the Regulation NMS objective of 
promoting limit order competition.
    Again, I would like to thank the Committee for allowing me to 
express our views. I would be pleased to answer any questions you may 
have.
















             REGULATION NMS AND RECENT MARKET DEVELOPMENTS

                              ----------                              


                         THURSDAY, MAY 19, 2005

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

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

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing shall come to order. This 
morning, the Committee continues its examination of Regulation 
NMS and the recent industry consolidation. This morning, the 
Committee will hear from Chairman Bill Donaldson of the 
Securities and Exchange Commission.
    At yesterdays hearing, a number of leading market 
participants addressed the changing dynamic of our equities 
markets. The convergence of a new regulatory framework 
established by Regulation NMS and the impact of the proposed 
mergers between the New York Stock Exchange and Archipelago and 
Nasdaq and Instinet has significantly altered the marketplace. 
We look forward to continuing this discussion with Chairman 
Donaldson this morning.
    I would also like to remind Members of the Committee and 
also Chairman Donaldson that we will likely be operating under 
some time restrictions this morning due to the Minority 
Leader's objection to hearings continuing 2 hours after the 
Senate is in session. It might not affect us. It depends on how 
long we go and if that objection is made. But, Mr. Chairman, I 
thank you for appearing here today, and we look forward to your 
testimony, and a lot of things have happened in the last 
several months in this area.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman.
    This is the second of 2 days of Committee hearings on the 
subject of Regulation NMS and recent market developments. The 
third week of April brought two announcements of significant 
changes to the U.S. securities markets. The New York Stock 
Exchange announced its merger with Archipelago in what The Wall 
Street Journal called: ``A historic transaction that will turn 
the 212-year-old Big Board into a public company and help it 
expand electronic training.'' Nasdaq announced its acquisition 
of Instinet in what the Journal called: ``A reflection of, and 
a result of, seismic changes in the business of being a stock 
market.''
    These mergers hold the potential for benefits such as 
greater market efficiency, transaction costs to investors, 
narrower trading spreads, increased depth of book and 
liquidity, and more choice in terms of trading multiple types 
of securities: Stocks, options, exchange-traded funds on the 
same platform. However, some questions and concerns have arisen 
about the resulting organizations, and the SEC's review of 
these transactions will, of course, determine how these 
concerns are addressed.
    I want to make reference to one issue in particular, which 
I addressed yesterday at the panel that was here. The SEC's 
concept release concerning self-regulation published in 
December 2004, not quite a year and a half ago, pointed out, 
``SRO demutualization raises the concern that the profit motive 
of a shareholder-owned SRO could detract from proper self-
regulation.'' I think as we move forward with respect to market 
structure, we must carefully consider what is the best 
structure for a regulator of a for-profit exchange so that we 
can be assured that it will exercise independent and effective 
judgment, and we heard two different models yesterday, and I 
think that is an issue to which attention needs to be paid.
    Passing Reg. NMS was the culmination of painstaking work by 
the Commission. For more than 5 years and during the tenure of 
four Chairmen, the Commission has heard the concerns of 
industry and investors about market structure, formulated 
proposals, held hearings, meetings, and read over 2,000 comment 
letters so that all interested parties could be heard. Chairman 
Donaldson said in acting, we have our eye on one overriding 
objective, the protection of investors, with particular 
attention to small investors.
    I welcome the indication by the Commission and its staff 
that it will engage in robust and ongoing communications with 
industry to assist in implementation of Regulation NMS and to 
closely monitor whether the rule is having any unintended 
consequences. In sum, the SEC has issued a rule that is, as 
Investment Company Institute President Paul Schott Stevens 
described, an important step in the development of a market 
structure that best serves all investors and advances the key 
goal of modernizing the U.S. securities markets.
    Chairman Shelby, I join with you in welcoming Chairman 
Donaldson. This is Chairman Donaldson's third appearance here 
before the Committee this year, I believe, which follows on 11 
appearances before the Committee in the last Congress. You are 
a regular visitor, Mr. Chairman. We are pleased to have you 
here touching a whole range of security issues, and as always, 
I look forward to your testimony this morning.
    Finally, I want to take this opportunity to note the 
completion of the successful tenure of your Director of 
Enforcement Stephen Cutler. Mr. Cutler served at the Commission 
during an historic time, faced very significant challenges and, 
in my view, did an outstanding job. I congratulate him and the 
dedicated staff of the Enforcement Division for their many 
impressive achievements during the period he headed the 
Division. I certainly wish him well in the future.
    And likewise, I would like to express my appreciation for 
the fine work done by Paul Roye, the recently departed Director 
of the Division of Investment Management and his staff and wish 
him the very best. All of these dedicated SEC employees a great 
debt of gratitude, and we thank them for their dedicated 
service to the public interest.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman.
    I appreciate these hearings that you are holding, and I 
will submit an opening statement for the record.
    Chairman Shelby. Without objection, it will be part of the 
record.
    Chairman Shelby. Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you, Mr. Chairman for holding these 
hearings, and welcome to Chairman Donaldson before the 
Committee. I associate myself with the comments of Senator 
Sarbanes. I think he covered the waterfront pretty well here. I 
mean, we come back to the words over and over again, and that 
is investor protection. It is what our job is up here, and it 
is certainly job of the SEC. I think we have to watch all the 
time. This is obviously a period of transition that is 
occurring.
    I think the SEC did a very thorough job. This was not a 
decision reached hastily at all, to put it mildly, after 4 or 5 
years, and obviously, there is a significant debate about it, 
and I know my colleague Senator Crapo and others have strong 
feelings, and there are arguments to be held, so it is 
worthwhile to go through this process as we go forward, but I, 
for one, think the SEC is fulfilling its historic obligation 
here, and that is dealing with investor protection, and it is 
awkward, these changes, but to do otherwise, I think, would be 
to fail on our responsibility collectively.
    So, I welcome the opportunity to listen to what you have 
been through, the rationale and the arguments. I know it was 
contentious on the Commission itself, highly divided. That is 
not normally the case on like this that come before the 
Commission, and so, I commend all of the Commissioners for the 
work and time they put in on this effort to reach the 
conclusion they did. I look forward to hearing your testimony.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman.
    Let me welcome Chairman Donaldson, and let me commend you 
and Senator Sarbanes for holding this hearing on a very 
important topic of national market structure, and as Senator 
Dodd pointed out, we have an obligation collectively to ensure 
the protection of investors and confidence in the markets. And 
these markets are changing dramatically because of technology 
and other forces.
    And interestingly enough, the national market structure is 
the title, but really, it is an international market today in 
securities, so many of the changes that are being pursued have 
to be pursued in the context of not just our markets but world 
markets. And so, I look forward to your testimony, Chairman 
Donaldson. I thank you and commend you for the work you have 
done so far.
    Chairman Shelby. Mr. Chairman, your written testimony will 
be made part of the record in its entirety. You may proceed as 
you wish. Welcome to the Committee again.

               STATEMENT OF WILLIAM H. DONALDSON

       CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Chairman Shelby, Ranking Member 
Sarbanes, and Members of the Committee, thank you once again 
for inviting me to testify today concerning the important 
recent developments in the equity markets that occurred last 
month. As you all know, on April 20, the New York Stock 
Exchange and Archipelago agreed to merge and become a publicly 
held company, and 2 days later, Nasdaq announced an agreement 
to purchase Instinet's electronic trading network.
    These are, of course, the four largest markets trading 
equity securities in the United States, and the importance of 
these transactions, if completed, can hardly be overemphasized. 
Today, I will touch on some of the broader policy implications 
of the proposed consolidations. I will start by placing these 
transactions in the context of the Commission's market 
structure initiatives and particularly Regulation NMS. Next, I 
will offer some thoughts about how the consolidations may 
impact competition in the markets going forward. And then, 
finally, I would like to highlight some important issues 
relating to industry self-regulation that the Commission will 
be addressing in the coming months. As many of the details of 
the proposed transactions are not yet clear, and my 
observations are necessarily preliminary, my testimony today 
reflects my own views and not those of my fellow Commissioners.
    As I have discussed with you in prior hearings, one of my 
highest priorities over the last 2 years has been to complete 
the Commission's extended review of market structure 
regulation. Last month, the Commission took a critical step 
forward in adopting Regulation NMS, a comprehensive set of 
reforms designed to strengthen and modernize our national 
market system. In my view, subsequent events in the marketplace 
have only reconfirmed the importance of this Commission 
initiative.
    The fact that the two transactions were announced only 
weeks after the Commission acted on Regulation NMS may not have 
been entirely coincidental. To be sure, the transactions were 
driven primarily by economic and competitive forces in the 
marketplace, but prior to Regulation NMS, uncertainty about the 
regulatory landscape may have hindered the ability of markets 
to plan for the future.
    Of course, certainty could have come with any Commission 
decision on market structure, but I believe the choices we made 
were the right ones. By adopting consistent rules of the road 
that apply to exchange-listed and Nasdaq stocks alike, the 
Commission made sure that market consolidation can take place 
against a regulatory background that protects investors at the 
same time as it levels the playing field for competitors. This 
new level playing field will, in turn, facilitate competition 
between the New York Stock Exchange and Nasdaq.
    The new trade-through rule expands opportunities for 
electronic markets to compete with the New York Stock Exchange 
floor for order flow and ratchets up the pressure for the New 
York Stock Exchange to implement its hybrid market proposal. In 
addition, if it merges with Archipelago, the New York Stock 
Exchange will have a formidable electronic platform for 
acquiring market share in Nasdaq stocks.
    Under the new regulatory framework, competition in all 
national system stocks will be based on three basic principles: 
The best price, open access, and transparency. First, the new 
trade-through rule underscores the principle that no matter 
where a customer order is routed, it should receive the best 
price that is immediately and automatically available anywhere 
in the national market system. The best price principle also 
will promote vigorous competition among individual market 
centers by ensuring that smaller markets displaying the best 
price cannot be ignored by larger, dominant markets.
    Second, competition will be governed by the principle of 
open access to these displayed prices. Markets will be 
permitted to compete across a wide range of services, but they 
cannot penalize their competitors by unfairly restricting 
access to their displayed quotations.
    Third, markets must be transparent. All significant markets 
must make their displayed quotations and trade reports 
available on terms that are fair and not unreasonably 
discriminatory.
    Turning to the proposed consolidations themselves, I would 
focus on two basic questions: First, what effect are these 
transactions likely to have on competition among markets and 
among orders? Second, how will the new consolidated markets 
meet their responsibility to assure effective regulation?
    The national market system is premised on promoting fair 
competition among individual markets while, at the same time, 
assuring that all markets are linked together in a unified 
system that promotes interaction among the orders of buyers and 
sellers. It thereby incorporates two distinct forms of 
competition: Competition among markets and competition among 
orders. The Commission's challenge has been to maintain an 
appropriate balance between these two vital forms of 
competition. Generally speaking, I believe the effect of the 
proposed consolidations combined with the new trade-through 
rule should be to increase market depth and liquidity and 
enhance order competition.
    Moreover, I do not agree, as some may fear, that the 
consolidations represent the death knell for competition among 
the markets. Although at first glance, it appears that the New 
York Stock Exchange and Nasdaq will dominate the landscape, I 
believe that competition among markets should continue to 
thrive. The New York Stock Exchange will have to battle to 
maintain its market share, given the expanded opportunities for 
fully electronic markets to compete in New York Stock Exchange 
stocks after implementation of NMS. This competition, I 
believe, promises substantial benefits for investors and 
faster, more efficient trading, particularly in the most active 
New York Stock Exchange stocks.
    Similarly, I anticipate a continued battle for market share 
in Nasdaq stocks. The new trade-through rule will require 
trading to interact with the best displayed prices on the 
electronic limit order books, and this is likely to produce 
deeper, more liquid markets and more efficient pricing. In 
addition, as I noted earlier, the trade-through rule will 
enhance the ability of smaller markets to attract order flow by 
simply offering the best price, and I believe market 
participants will have an interest in sending them order flow 
to preserve multiple options for order executions.
    The proposed consolidation should also be viewed against 
the backdrop of the changing structure of industry self-
regulation. Last December, the Commission published for comment 
a series of new rules designed to strengthen the current system 
of industry self-regulation. Among other things, these rules 
would ensure the independence of SRO boards and restrict the 
ownership interest of any SRO member to no more than 20 
percent. At the same time, the Commission also published a 
concept release seeking comment on a range of longer range 
issues, including the conflicts of interest between an SRO's 
business and regulatory functions, the potential costs and 
inefficiencies of multiple SRO model and the manner in which 
SRO's fund regulatory operations.
    With the announcements of the proposed market center 
consolidations last month, I believe it is even more critical 
that the Commission act promptly on the SRO proposals.
    With respect to the proposed consolidations, very few 
details are available regarding the plans for self-regulation. 
At this point, I can simply highlight a few issues that will be 
examined prior to reaching any decision. First, the New York 
Stock Exchange would, for the first time in its history, become 
a publicly held company, raising at least the potential for 
conflicts of interest between the profit maximizing interests 
of its shareholders and the need for effective self-regulation. 
Second, the proposed consolidation of the Instinet trading 
platform into Nasdaq preliminarily would appear to streamline 
the overall regulation of trading on the combined Nasdaq-
Instinet platform.
    The regulation of such trading would be consolidated into 
two regulatory entities: The NASD and Nasdaq. Any examination 
of the Nasdaq-Instinet transaction would occur in the context 
of Nasdaq's application for registration as a national 
securities exchange; and, in this regard, I believe the staff 
has resolved all of the major issues with Nasdaq, and I expect 
Nasdaq to file an amended exchange application early this 
summer.
    Finally, given the potential competitive clout of the two 
consolidated entities, the Commission's role in reviewing their 
rule filings will be extremely important. The issues addressed 
in these rule filings will include the fairness of market data 
fees and other fees as well as potentially discriminatory rules 
against competitors or market participants.
    I have covered all of these topics, as you know, in much 
greater detail in my written statement, and I would be pleased 
to elaborate further. I look forward to hearing your views and 
trying to answer your questions and, again, thanks for having 
me back.
    Chairman Shelby. Thank you, Mr. Chairman.
    Chairman Donaldson, some people still remain troubled by 
the SEC's three to two vote on Regulation NMS. There was a 
concern that the lack of consensus undermines the SEC's 
credibility and establishes an unfortunate precedent. Despite 
the potential for consensus, the rule was adopted on a split 
vote.
    Should such fundamental policy changes as extending the 
trade-through rule to Nasdaq not be supported by a greater 
consensus, and are you troubled as Chairman by lack of 
consensus on this regulation and what it means for the SEC 
going forward, or is that just part of the turf that you work 
under?
    Chairman Donaldson. Good question. Let me just spend a 
minute trying to answer it.
    First of all, during my Chairmanship, there have been close 
to 3,000 Commission votes. Of these, just slightly over 98 
percent of 3,000 votes were unanimous votes. Of the 2 percent 
that were not unanimous votes, in one case, two Democratic 
Commissioners voted in the minority. In eight cases, one 
Democratic Commissioner voted in the minority. In 15 cases, two 
Republican Commissioners in the minority; in 44 cases, or about 
two-thirds of our nonunanimous votes, a single Republican 
Commissioner voted in the minority.
    I suppose that you could draw a lot of conclusions from 
these statistics, but let me just try and say how I feel about 
this, and that is that I believe that the structure of five 
Commissioners and three to two with the three being from the 
party of the Administration sets the stage for decisionmaking, 
and again, even as you all are debating differences of opinion 
right now in other areas, there will be differences of opinion 
at the SEC, particularly when we are dealing with the kind of 
contentious, complicated, and highly technical issues 
associated with a central marketplace.
    My own personal view is that the common denominator here is 
the investing public, that constantly, we have to remind 
ourselves that we are going to do what is best for the public 
investor, and with that thought in mind, I believe that you 
leave your party credentials at the door, and again, speaking 
personally, that is what I have tried to do in all of the 
decisions that we have made.
    I might also add that you try to bring to bear, and I am 
sorry to elaborate on this, but I do feel strongly about it, 
because the press has made such a big point about this, and I 
am trying to put it in context. But we all try to bring our 
experience to bear on the issues before us, and I have tried to 
bring my experience based on far too many years in the markets, 
if you will, to make decisions based on that experience.
    I might also add, just in terms of historic content, and 
then, I will be quiet, under my predecessor, Chairman Pitt, I 
understand that 99 percent of the votes were unanimous, so we 
are not that far off the recent track record.
    Chairman Shelby. Mr. Chairman, it has been over a month 
since you at the SEC approved Regulation NMS, yet the SEC has 
not issued the final rule. When do you contemplate that?
    Chairman Donaldson. We expect that the final rule will be 
coming down within the next couple of weeks at the most. It is 
a very detailed rule, very complicated, and we are just about a 
week or so away from it.
    Chairman Shelby. Do you contemplate substantial changes to 
what you have published?
    Chairman Donaldson. No.
    Chairman Shelby. Okay; the Nasdaq exchange application: We 
heard testimony yesterday regarding market participants' needs 
to innovate quickly and to adapt to changing market conditions 
in order to compete. You alluded to some of this. The witnesses 
stated that their ability to compete is directly linked to the 
SEC's timely approval of proposed rule changes at the market 
centers. It was pointed out that rule changes often linger 
before the SEC for months or even years without any action. For 
example, Nasdaq's exchange application has been pending before 
the SEC, I believe, for over 4 years.
    Why does it take so long, Mr. Chairman, to obtain SEC 
approval? Is this inaction here fair to market participants who 
need to respond quickly to market changes? And is the Nasdaq 
exchange application more complicated than Reg. NMS? I know it 
is different.
    Chairman Donaldson. It is very different, and let me try 
and dispel the image of the Nasdaq application to become an 
exchange as something that has been lying on the desk, and 
people are sitting with their feet up and doing nothing about 
it. There is a fundamental principle having to do with 
requirements for an exchange to have price priority built into 
their operation. Nasdaq has refused to do that. And therefore, 
we have not moved on their application until recently.
    Recently, I suspect as a part of all this consolidation 
going on, they now are prepared to include time and price 
priority in one of their operations which qualifies them now to 
become an exchange, and I would expect that their application 
will be approved fairly shortly. As far as the other 
implication here of the rapidity or lack thereof of passing 
rules, I have to say that this area of the national market 
system is extremely complicated, detailed, and filled with all 
sorts of pitfalls, and I think that, in effect, the staff and 
the SEC have been pondering this for years, if you will, taking 
testimony, talking to all parties, et cetera, et cetera.
    But I think, that in the last 2 years and particularly the 
last year, we have decided that something must be decided, 
because the technology continues to escalate. So, I think that, 
now that we have taken a whole package of rules, and we have 
addressed a whole system here. There will be rule changes 
applied for coming down the pike, and if we are now able to 
simply act or be asked to act upon a single modifying thing, I 
think the complexity will be a lot less, and hopefully, the 
speed will be a lot faster.
    Chairman Shelby. I agree with you that what you deal with 
is very complex issues, and they have to be done right, and 
they have to be thought out and the implications, but sooner or 
later, as you have just mentioned, there should be a decision 
made, should it not, one way or the other?
    Chairman Donaldson. Yes.
    Chairman Shelby. Most applications.
    Chairman Donaldson. Well, I agree. And this goes for 
everything that we are dealing with. Where we can, where the 
issues are simple, we need to act swiftly. It takes a little 
longer when things are complex.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Chairman Donaldson, we are pleased to have you before us. I 
just want to follow up very briefly on the first question that 
Chairman Shelby asked. My understanding, as I was listening to 
the figures you gave close to 3,000 votes that the Commission 
has taken that in all but 68 of them, they were unanimous votes 
and that of the 68, 52 of those had just one Commissioner 
dissenting, so that it seems to me a pretty impressive record 
in terms of developing consensus, and I know that in the past, 
the Commission has had split votes.
    In fact, David Ruder once observed to us that on tough 
decisions, sometimes, you just have split votes. People see 
things differently. But I think in looking at these figures, 
the number of real close divisions is pretty minimal, as a 
matter of fact, in the context of the decisions that you have 
been making.
    Let me address the regulatory structure issue, because I am 
quite interested in this. You addressed it in your statement, 
particularly the critical issue of addressing conflicts of 
interest between SRO business and regulatory functions. What is 
the Commission's plan or course of consideration moving forward 
with respect to this a rather critical issue?
    Chairman Donaldson. It is a critical issue, and again, if 
you go back into history, I think the decision was made quite 
correctly by the new SEC and the new securities law rules back 
in the 1930's to go to a system of self-regulation, and that 
was based, as I understand it, on the thought that the closer 
you could build the regulation to the actual operating 
entities, the more effective that regulation would be. And so, 
the decision was that the SEC would be the national regulator 
but would delegate self-regulation to the markets and to people 
acting in the markets.
    Fast forward to where we are now. Clearly, there has been a 
breakdown of self-regulation. It reached its zenith 2 years ago 
when the governance of the New York Stock Exchange was brought 
into question, and, at that time, I wrote a letter to all of 
the exchanges and asked them to review their self regulatory 
structure and their governance structure and to come back to us 
with their thoughts on how this should be organized.
    And the New York Stock Exchange responded with the 
organizational structure that you now see, which in effect took 
the whole self regulatory side of the exchange, the whole 
enforcement side, and had it report into an independent 
subcommittee; in other words, the regulatory mechanism was 
taken out of the chain of command, and no longer reports to the 
chief executive officer of the exchange. It reports to an 
independent committee. That is one model.
    There are other models that have been suggested and we will 
have under review as we go forward. The other models will range 
all the way from a total separation of regulation and placing 
of that in an independent body that would regulate all 
exchanges down to several other models.
    I think you are absolutely right when you point out that, 
in addition to the business regulatory conflict that exists in 
the exchange markets now, the difference between being in a 
business and regulating that business, now, you interject a 
third dimension of public owners, and again, that is another 
potential conflict.
    So we have to address this. We have reached no conclusions 
on it. We have gotten all the advice we possibly could from the 
industry itself, and we are at the point now where we are 
wrestling with what the best model should be.
    Senator Sarbanes. Yes, I think as you wrestle with that 
issue, I just want to observe that in considering these various 
models, I think, it is important to look at the issue of the 
appearance of a conflict of interest as well as the reality of 
a conflict of interest. I say that for this reason: After all, 
what is at stake is people's confidence in the workings of the 
market, and it may be that if you go through a careful analysis 
and everything, you can reach a conclusion there really is not 
a reality of a conflict.
    But if there is the appearance of a conflict, which the 
ordinary person on looking at the thing would be what he or she 
would be struck with, it may well create a confidence issue, 
and of course, that is one of the things we are very anxious to 
make sure those questions do not arise. So, I think this issue 
of the independence of the regulator and the assurances that 
particularly when you go from nonprofit to profit, and then, 
the concern begins to be that there is a benefit that accrues, 
depending on the regulatory decisions.
    We know the Commission is working very closely on this 
issue, and we simply commend your efforts. We will be following 
it very closely as you move ahead.
    Mr. Chairman, I see my time is up. Thank you very much.
    Chairman Shelby. Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    Chairman Donaldson, I want to just cover actually a couple 
of issues that both of the previous Senators have covered with 
you. I was very pleased to hear your testimony with regard to 
the Nasdaq exchange application, and as I understood you, you 
have indicated that all of the remaining issues from your point 
of view have been resolved, and you expect it to be addressed 
promptly.
    Can you give me any kind of an idea as to how quickly we 
could expect to see this issue resolved?
    Chairman Donaldson. I think that I will be vague enough to 
say in early summer. I mean, for all intents and purposes, we 
are almost there, and we are now just putting the final touches 
on it.
    Senator Crapo. All right; well, I do appreciate that. I 
think that is a piece of a lot of what is going on that many of 
us have been focused on and wondering if there was some kind of 
delay that we could figure out a way to get around, and your 
testimony today is very welcome.
    The other thing I wanted to talk to you about is, again, 
the issue of the split votes on the Commission. And I realize 
that there have been, as you indicated, 3,000 votes, with 98 
percent of them unanimous. But we cast a lot of votes around 
here, too, and there are a lot of votes that are pretty much 
unanimous or not controversial. And then, there are some 
seriously controversial issues, of which we have a few on the 
floor right now.
    And I was just thinking back as you were testifying over 
some of the major three-two votes on the Commission which have 
happened recently which seem to be on issues that impact our 
markets in very broad ways. There is Reg. NMS, the hedge fund 
regulatory decision, the decision with regard to mutual funds, 
on independent chairmen and the like.
    It seems to me that although one can argue that there is a 
lot of unanimity when you look at the broad array of issues 
that the Commission is dealing with, it also seems to me that 
on the three biggest issues that I can remember coming to the 
attention of this Committee in the last period of months, every 
one of them has been a three-two decision. I think that is why 
the impression out there is that there is getting to be a lack 
of consensus on the Commission that is disturbing. Can you 
respond to this, please?
    Chairman Donaldson. Sure, I will try to.
    You are absolutely right in terms of some of the major 
issues here, there has been the three-two vote. I think that 
there is a tradeoff here between reaching consensus and 
reaching a decision. The issues we have been dealing with are 
so important and so time-sensitive that we have, or I would say 
I have, because it has been my vote, resolved the issue in the 
interests of not delaying and watering down what needs to be 
done in months and months if not years of discussion and back 
and forth and not making a decision. And then we could have end 
up with a decision that is not what should be done and a 
decision that is reached after way too much time.
    Now, I think that the process at the SEC is a very open and 
fair process; in other words, there is a tremendous amount of 
work that is done, and then, an open debate on the record of 
people's positions. And I think that because of the nature of 
the times we live in now, I think there has been a 
deterioration, if you will, of that process. After the debate 
has gone on and after a decision has been made and after a 
majority has decided, then, there is a follow on of minority 
dissent. A minority dissent, by the way, which could have been 
brought out in the open arena but a minority dissent that is 
out there with no comment on it, no ability for comment. And I 
think that, frankly, is a serious step in the wrong direction.
    We are not the Supreme Court. We are not in the business of 
giving a majority and minority dissents, but maybe that is what 
we are headed for. But I believe that the traditional way that 
the Commission functions is the best way of resolving 
differences. I think you are quite correct in that this 
particular period here, the last couple of years, we have been 
facing up to some very important issues, and it is on those 
issues that we have had the disagreements.
    Senator Crapo. Well, I appreciate your grappling with that 
issue. As you were describing the dynamic at the Commission, 
which raises concerns about process and how the Commission is 
working out, I was thinking about the very issues that we are 
grappling with here in the Senate with similar kinds of process 
conflicts.
    Chairman Donaldson. Yes.
    Senator Crapo. So, we are certainly not immune to the same 
kind of thing that you are talking about or that you are 
discussing there, and I just wanted to wrap up my comments by 
saying it has been no secret; I have been very open in public 
about my disagreement with some of the stands that you have 
taken and the direction that the SEC has gone on some of these 
rulings.
    I have appreciated you getting back to me and working with 
me personally on it, and I will state publicly what I have 
stated to you: My interest here is to see if we cannot work 
toward improving the process and improving the ability to 
develop greater consensus. And again, I appreciate you 
personally as well as your staff being willing to work on that, 
and I will continue to work with you as we try to work through 
these difficult issues.
    Chairman Donaldson. If I could just comment on that and I 
appreciate your comments. I just want to assure you that we 
have worked very hard to get consensus, very hard; and, as you 
know, we welcome working with you and the rest of this 
Committee. I mean, these are important things. We need all the 
judgment we can get.
    Senator Crapo. Thank you.
    Chairman Donaldson. Thank you.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman. Yesterday, we 
heard testimony from both Nasdaq as well as the New York Stock 
Exchange group, and there was, you know, some interesting 
testimony I thought there. For example, Mr. Thain said that 
Reg. NMS did a good job in anticipating changes in markets, and 
then, Mr. Putnam said that Archipelago felt the pressure to 
consolidate. And further, with regard to competition among the 
order and market centers, Mr. Thain said that Reg. NMS protects 
the smaller markets and provides room from competition.
    Then, we had testimony from Mr. Frucher, who, on the other 
hand said that Reg. NMS will create significantly more barriers 
to entry for smaller markets. And could you share with the 
Committee your thoughts on these dissenting views and 
ultimately how you see Reg. NMS impacting the scope of U.S. 
market centers?
    Chairman Donaldson. Right; let me say that I believe that 
Reg. NMS is procompetition for both the large markets and the 
small markets. And the reason I say that is that the smaller 
markets have an unbeatable weapon, if you will, to compete with 
the big guys, and that is to offer the best price. And if they 
offer the best price, that is where the order will go.
    Now, the best price trade-through aspect of what we have 
proposed here is extremely important, because it says that, in 
an electronic environment, you must honor the best price, and 
you must honor that in a market that is instantaneous and has 
eliminated from it the delays that made it difficult to compete 
with particularly the floor-based markets, New York and so 
forth.
    I believe that, if you step back and look at the history of 
these electronic markets, they are not that old. I mean, 
Archipelago was founded, I think, 8 or 9 years ago, and because 
they competed with a then even more dominant New York Stock 
Exchange, they were able to insert themselves into the 
competitive fray, and I predict that we are going to see, as 
time goes on, ways of doing business that we cannot imagine 
today, and I predict that the entrepreneurial, small entities 
either out there now or which are going to be out there will be 
very competitive in this new environment.
    Senator Allard. In Bloomberg's testimony, I think Mr. Bang 
expressed their concern that some of the hybrid proposals put 
forth by the New York Stock Exchange might undermine Reg. NMS. 
Do you see any potential there?
    Chairman Donaldson. Again, the concept here is that those 
who want speed will get it in the electronic part of the 
hybrid. On the other hand, the structure will accomodate those 
who voluntarily value other aspects of trading, and that would 
be specifically the capital that the specialist brings to the 
game; it would be the capital that can be accumulated in times 
of stress to step in and moderate violently moving markets and 
the human judgment involved in executing an order in a 
tumultuous time. I believe that the alternative to go into that 
kind of a market and to have it available as we move into the 
electronic age preserves what has been a pretty valuable part 
of our national market system.
    I might comment that this is going to be a much more 
competitive world for both of these emerging duopolies, if you 
will. There is going to be competition for capital. There is 
going to be competition for having a business that works and 
makes a process, and I think that it will remain to be seen 
just how people decide which one of these two markets they want 
to operate in, and I think anybody that predicts exactly what 
is going to happen has got more insight than I do in terms of 
how it is all going to work out. But I think we are headed in 
the right direction.
    Senator Allard. Mr. Chairman, I see my time has expired.
    Chairman Shelby. Thank you.
    Chairman Donaldson, yesterday, we received testimony 
concerning how the proposed mergers would have an impact on the 
regulation of market data. What issue do the mergers raise with 
respect to the cost, collection, and allocation of market data, 
and will the SEC need to take further action on market data to 
account for the proposed industry consolidation?
    Chairman Donaldson. Market data and our proposals on market 
data are basically a first step to rationalize the 
inefficiencies and inequalities in the way market data is 
gathered and allocated. And by that, I mean as a result of the 
morass, if you will, of different ways of competing in the 
system that has been prevalent for quite awhile, 5 years if not 
10, there have grown up a number of practices that serve no 
economic benefit other than to create revenues for certain 
trading centers. And we refer to such things as tape shredding 
and so forth, where orders are broken up in order to have more 
prints on the tape in order to get the revenues. And our 
initial thing here is to try to eliminate that and try to 
reward revenue sharing, if you will, for centers which are 
actually contributing to the liquidity in the marketplace.
    There is a second step here which we have not addressed, 
and that is the absolute level of revenues. And again, this is 
inextricably involved with how the new institutions are going 
to dedicate their revenue flows; in other words, we now have 
businesses, if you will, who will have a profit motive, but we 
also have regulatory responsibilities which are not money 
making; they are money using.
    And so, the issue becomes how these institutions will 
protect the revenues that need to be protected to support the 
regulatory side. And I think that the next step here once we 
get through our organizational structures, once we get the 
structure right--is that then we will be able, because of the 
new transparency that we will demand of these exchanges, to get 
a better feel for just what those revenues should be in an 
absolute way.
    Chairman Shelby. Should that not be very positive from your 
standpoint?
    Chairman Donaldson. I think that there will be a judgment 
factor here. I mean, there are those who say that those tape 
revenues should be strictly priced on the cost of developing 
them, some cost-plus kind of thing, and I do not think you can 
cross that bridge until you really get an idea of what the 
regulatory side of things is going to cost. And there are a lot 
of different ways of financing the regulation in terms of 
direct taxes, if you will, or fees, and I think we have to take 
a look at the whole package. For those who feel those fees, 
tape revenues are too high right now, I understand that; we all 
understand that. It is just a matter of phasing in our 
attention to it.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. I will be very brief, Chuck.
    Mr. Chairman, I will be very quick.
    First of all, I note that the testimony we got yesterday, 
everyone thought that what you have done is an improvement over 
the current situation, so that some still have some concerns, 
but everyone thought depending on their different points of 
view how far of a great step forward it was, but they were all 
in agreement that it was a step forward.
    I have to tell you, I think the traditional process of the 
SEC has contributed to this. One of the things you did not 
mention when you were outlining it that I have always been very 
impressed with is the receipt of letters of comment on your 
proposals when you put them out there in tentative form, which 
enables all interested parties to come back to the SEC with 
well thought-out, well-considered responses to what the SEC is 
thinking of doing and therefore enables the Commission to take 
all that into account as it moves toward shaping a final rule.
    And I want to underscore that, because this process in some 
ways is very special that the SEC has established over the 
years and that it has followed. I think it is very important 
for reaching wise decisions and particularly decisions that 
people are willing to support. I am struck now by the growing 
degree of acceptance or support of the NMS regulation compared 
to what was being said not too long ago. So in that sense, we 
are certainly moving ahead.
    I do again want to emphasize again, I think, the need to 
focus on how this, the regulation, is done, and being clear of 
any sense of conflict of interest, and that would, of course, 
also involve how the regulation is financed so that the people 
who finance it cannot cut off the financing if they are unhappy 
with the decision. That was one of the big decisions we faced 
with the PCAOB and FASB, and of course, they now have assured 
financing, which gives them an independence of decisionmaking, 
which I think is very helpful.
    Let me just close on one point, and I take it from what you 
are saying you are sensitive to this concern: Sandy Frucher of 
the Philadelphia Stock Exchange yesterday said that the smaller 
securities exchanges have repeatedly served as laboratories of 
invention, and then, he mentioned the number of innovations 
that they had adopted, all of which were then adopted by the 
larger exchanges. They had paved the way.
    And he asked in his statement that the SEC take all steps 
to ensure that it and other venues are allowed to compete 
vigorously and aggressively, and the smaller exchanges be able 
to innovate and find new products and trading technologies. I 
take it that squares with what the SEC wishes to do. You are 
not out to establish a duopoly here with respect to the working 
of the markets and the exchanges.
    And so, I take it that you are already sensitive to these 
comments, but I just thought I should ask you that for the 
record.
    Chairman Donaldson. Absolutely. I think that we are 
extremely conscious, aware of, and applauding the 
entrepreneurial changes that come along here from competition, 
and we have experienced that now, as I say, with the rise of 
these electronic exchanges. I think that the one thing we do 
worry about is competition that is improper competition, I 
mean, competition that basically serves no economic purpose and 
undermines the fundamental principle of best price for the 
individual client, and there has been some of that that has 
grown up here in recent years.
    I think the rules we put in, this is repeating myself, but 
I do believe they set the stage for even the smallest most 
entrepreneurial new exchange who has the right technology to 
come in and compete with the big guys.
    Senator Sarbanes. If people in the industry do not place 
the investor first and foremost and therefore run the risk of 
undercutting investor confidence, they are going to kill the 
goose that lays the golden egg, and they more so than anyone 
since they benefit from the investor involvement should be 
concerned to provide the appropriate protections.
    Thank you very much.
    Chairman Donaldson. Exactly.
    Chairman Shelby. Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    Chairman Donaldson, I am sorry I was not here for your 
statement. We have been holding other hearings, and I wanted to 
make certain that I did get some time with you, and I again 
appreciate your appearing here this morning, and I will read 
your statement.
    Two sets of questions I would like to address this morning: 
One, you may have addressed some of these issues in your 
statement or in the question and answer period with my 
colleagues, but I want to ask a couple of questions on Fannie 
Mae and then talk about implementation of regulations in a 
general sense. You, of course, are aware that in December 2004, 
the SEC informed Fannie that it did not properly apply an 
accounting derivatives standard known as FAS 133. Last week, 
Fannie May disclosed that it will delay its 2005 first quarter 
financial report with the SEC and that it misapplied another 
accounting standard, FAS 115, which it uses to classify its 
mortgage-backed securities.
    A couple of questions: Will Fannie's misapplication of FAS 
115 cause Fannie to further restate its earnings? If it would 
further cause a restatement of earnings, by how much?
    Chairman Donaldson. This is something that I think I 
probably cannot comment on in that we are in there now in the 
midst of an investigation, and I do not want to prejudge where 
we come out on that. Clearly, just as you understand for sure, 
you know, our function here with Fannie is not the overall 
structure of Fannie Mae; ours is the accounting and reporting 
systems, and we are right in the midst of looking at that, even 
though our first ruling was that their accounting was improper.
    Senator Hagel. Do you have any sense of when you would 
complete these investigations? There are other dynamics, other 
parts of this investigation.
    Chairman Donaldson. Sure. I do not want to mislead you. If 
you will, I would like to get back to you with a time judgment 
on that. I do not want to say something I will regret.
    Senator Hagel. And what I will do is not at a public 
hearing present some specific questions; maybe if we could talk 
privately on some of these issues, and I know that you are in a 
difficult spot with an ongoing investigation, but these are 
very serious matters that continue to dribble out every other 
week, it seems, as to what is going on, and obviously, you know 
this Committee is most likely going to be looking seriously at 
a markup of a GSE reform bill which is focused much on these 
kinds of issues as to how did they happen, why did they happen, 
and, of course, the SEC's involvement, and I will ask for some 
time with you whenever it works.
    Chairman Donaldson. I would be delighted to do that.
    Senator Hagel. I want to go to the implementation of 
Sarbanes-Oxley, which you have been reviewing, and you have 
been laying out new regulations and refined regulations to try 
to make it work and adjust in the way that it was intended to 
work. I suspect that I am not alone in being a U.S. Senator and 
a Member of Congress, who has heard from especially small 
businesses saying that the implementation of Sarbanes-Oxley has 
been a huge burden on these companies.
    I have talked, met with several of these companies about 
what they consider excessive costs and regulatory burdens for 
complying with the requirement. I have got, which I will not go 
through now, but I will give to you later about five pages of 
individual companies, specific companies, specific issues, and 
problems. I know these are imperfect systems and processes, and 
you are trying to seek some equilibrium. And I know you have 
issued new guidelines addressing some of these overall 
concerns.
    But can you address these in a general way without us 
taking the time, since we do not have it, to go into going 
through each of these companies' specific problems that they 
are having?
    Chairman Donaldson. Sure.
    Senator Hagel. This is a burden. I mean, I think it is very 
real. I used to be a small businessman. I have some sense of 
this. What is the SEC doing here to deal with this? The big 
companies are the big companies, and they have the resources; 
they have the law firms, and they can margin in some way. The 
little guy, the medium-sized companies cannot.
    Chairman Donaldson. Let me try to address that in two ways.
    First of all, in terms of the overall Sarbanes-Oxley, I 
believe that it is working very well in a cost-efficient way, 
and by that, I mean the shifting of power to the boards of 
directors, independent committees, the new authority that 
Sarbanes-Oxley gave the SEC for fines and our ability to give 
those fines back to damaged or injured shareholders and fair 
funds. I think all of that is tremendously positive, and I 
believe that this law, if you will, will progressively be 
realized as a very important piece of legislation.
    Now, on the particular part of it that you are talking 
about, so-called ``Section 404,'' which has to do with the 
obligation of senior management, the CEO and chief financial 
officer, to basically sign their name on a line with the data 
that they are giving to the public, I think that there have 
been two things that have caused expenses that do not need to 
be there.
    First, is the overall application of this to all companies 
in general and second, is a kind of one-size-fits-all approach 
taken by some so that a small company has to shoulder the 
expenses. Disproportionately, those expenses mean a lot; and it 
is not just the expenses. It is not that easy to get a lot of 
independent directors, for a small company to have committees 
filled with directors that are independent.
    We are addressing this in two ways: One is we had this 
roundtable discussion a month and a half ago. We had six 
different 
panels. We brought together people who were involved from all 
different points of view: Heads of companies, accountants, 
accounting firms, and so forth. And by the way, the kind of 
horror story that I am sure you had in front of you, we asked 
everybody to put their horror stories on our website so that 
they could get that out so that we could devote the day to 
constructive thought.
    It was very constructive. And out of that have come the two 
pieces of interpretation that we just put out this week, the 
PCAOB and the SEC and, basically, what we said, the guidance 
that we have given to the accounting profession and to the 
corporate world is, if I can say it in simplest terms, use your 
common sense in applying these rules. Have a risk-based 
approach to detail and understand where you have to apply this. 
If you use your common sense and have a risk-based approach, 
you will not be in trouble with us if you do it that way.
    Senator Hagel. The common sense rule that you just noted, 
has that also been directed at the regulators?
    Chairman Donaldson. Absolutely, and that is a very good 
point. And there again, I think by the very publishing of this 
guidance, we are saying that implicit in that guidance.
    Now, just to finish, on the small company side, we formed a 
panel, a committee not just for 404 but for the whole Sarbanes-
Oxley panoply for small companies, and it is a very good 
committee. They will be in existence for a year. Their charge 
is not just to address the particular problems of small 
companies vis-a-vis 404 but also to take a look at all of 
Sarbanes-Oxley and see if there are any ways that the rules can 
be modified to accommodate smaller companies. So, I think help 
is on the way.
    Senator Hagel. Thank you.
    Mr. Chairman, thank you.
    Chairman Shelby. Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman, and thank 
you, Chairman Donaldson.
    As I mentioned in my opening remarks, this is a national 
market situation in an international environment. And 
yesterday, some of the witnesses claimed that an advantage 
shown by some foreign exchanges that they trade not just in 
equities but also in options, derivatives, and fixed-income 
products and all on one market. Do you think it confers an 
advantage on these foreign exchanges? Is there anything that we 
should do to think about altering the current statutory and 
regulatory arrangements?
    Chairman Donaldson. Are you saying will there be a 
convergence of other kinds of instruments?
    Senator Reed. No, I am thinking about the instruments that 
could be traded on our markets in the one-stop shopping.
    Chairman Donaldson. Yes, yes, I think that, as the world of 
finance has gotten more complex, as these different instruments 
have come into being, options and futures and so forth, I think 
you are going to see not just domestically but globally, and we 
are already seeing it, multiple instruments being traded on the 
same platform. And there is good reason for that, because these 
instruments are interdependent, if you will; one moves, the 
other one has to move kind of thing.
    So, I think that, as the exchanges both go public and raise 
money and use that money to invest in the technology to trade 
other instruments, I think you will see this happening here and 
overseas.
    Senator Reed. Are there things that we should be thinking 
about now in terms of proposed statutory changes that would 
either assist convergence or somehow make sure it is done 
appropriately?
    Chairman Donaldson. I believe that what we are proposing 
right now is just the first step in a new global competitive 
situation. I think that as you know, American investors are 
investing increasing amounts of their money overseas, dealing 
in markets around the world; vice versa: Markets around the 
world, whether it be in the European Community or out in the 
Far East, are serving huge populations and huge industrial 
bases, and I think you are going to see global competition 
coming in, and I think that what we have proposed here sets the 
stage for two things: For U.S. competition that can compete 
with the rest of the world and the preservation of the capital-
raising integrity, if you will, of our markets, which hopefully 
will preserve the dominance that we have right now.
    Senator Reed. Thank you, Mr. Chairman.
    Let me switch gears dramatically. We have talked to your 
staff about a particular issue that has come up in the context 
of the CDC's immunization program for vaccines. We are told 
that because of accounting rules, vaccine makers cannot claim 
as revenue sales to CDC under the Pediatric Vaccine Stockpile 
Program because they have to do that only upon a delivery, but 
the contracts call for them to buy it and hold it until the 
crisis erupts. And I am wondering if there is anything that you 
can do, because apparently, this is causing some difficulty to 
the CDC and to the vaccine program.
    Chairman Donaldson. We are on the case, Senator.
    Senator Reed. Good.
    Chairman Donaldson. Basically, the issue, not to get into 
too much detail, has to do with the structure of the 
transaction, the business structure of the transaction, which 
makes it impossible to report a closed sale, because there is a 
lot of product that goes through that never really closes. And 
so, we are trying to resolve with HHS the nature of the 
contracts that they are writing, and we think that it can be 
done.
    And, in the event that it cannot be done, we definitely are 
not going to stand in the way of these vaccines getting where 
they should go. But we do not think the real issue is going to 
be our accounting rule. We think it is going to be the 
structure of the deal that is struck with the pharma companies.
    Senator Reed. Thank you, Mr. Chairman.
    Thank you.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman, for holding the 
hearing, and I want to thank Chairman Donaldson for coming. 
Once again, he has been most accessible to this Committee. I 
think we see you more than we have seen most of the SEC 
Chairmen in the past.
    And I first want to congratulate you on the reforms that 
you have made in modernizing the national market system. We 
have had a difficult problem here: We want to have efficient 
markets. We want to have competition. But we also want depth 
and liquidity in markets. And all of that is complicated by the 
fact that only in the last 10 or 15 years can international 
markets not governed by any American rules can trade equities 
like anybody else. The technology did not allow that.
    And so, the question is how do you keep the basically sound 
structure that we have had in this country, which relies 
primarily on disclosure and openness and at the same time deal 
with competition and change? And as you know, I have been 
greatly worried about fragmentation in the markets, about six 
different centers of trading occurring. I know some of the big 
interests wanted that, I think because they wanted to either 
own their own trading mechanisms, or they wanted opacity. They 
did not want people to know what they were doing, which is not 
good for the markets.
    Well, you came up with Regulation NMS, and, at least to my 
liking and I think to most people's, kept the trade-through 
rule so small investors like my father would not be 
disadvantaged by the big boys, and when it came out, yes, there 
was a three to two vote, although the bipartisan vote was on 
the side of NMS, obviously, but I think what we have seen since 
then is a vindication of what the SEC has done. When the NYSE 
took over Archipelago or announced that it was intending to 
take over Archipelago; when the NASD and Nasdaq decided they 
would take over Instinet, it basically said that we could 
almost have it all.
    We could have deep liquid markets; we can have best price; 
and at the same time, we can have some competition. And so, I 
think that the events of the last month or month and a half 
have vindicated the SEC's approach, and the great worry that I 
have had, the fragmentation of the markets, the opacity of the 
markets, is much less of a worry today than it was 2, 3 months 
ago, and I think you have to give the SEC credit for that. So, 
I thank you for that.
    And it really, what has happened has taken away most of my 
questions. I have here some nice softball ones on best price, 
but I think we are getting a nice consensus on that.
    [Laughter.]
    I would say this: I mean, could you comment? There has been 
some talk, not so much in this body but the other body, of 
Congress intervening and trying to either overturn or modify 
what has happened. One of the worries that I have is now that 
we have settled into a good place, and we can compete with 
Europe and everything else is that if we were to have that out 
there, it could interfere with the progress that we have made 
in the last while. Could you comment on that?
    Chairman Donaldson. You do not want me to walk into that, 
do you, in terms of the other body?
    [Laughter.]
    Senator Schumer. I know you will do it in your usual 
diplomatic and deft way.
    Chairman Donaldson. No, seriously, I think we are going to 
work very hard, have and will continue to talk to anybody that 
will talk to us about why we think what we are doing is the 
right thing, and we will not give up until we have convinced 
the very last person.
    I do think that this business of the global position of our 
markets is coming over the horizon rapidly, and again, my own 
view is that if we have the most transparent markets, and if we 
can maintain what is unique to our market, which is that small 
investors do get to trade side-by-side with giant institutions, 
if we can maintain that, if we can move on global accounting 
standards, if you will, that people will come to our markets 
because it will be the lowest cost of capital here, and we will 
be able to compete on a worldwide basis.
    Senator Schumer. And that is how it has been, and let us 
hope and pray--I say this as a New Yorker and as an American--
that it stays that way.
    Okay; I just wanted to follow up. It is interesting that 
Senator Reed had a question very similar to mine, because I 
have been notified in New York of the shortage of the vaccines. 
And it seems to me that to make the vaccine maker put the costs 
on their books before the vaccine is actually sold does put 
them in a kind of catch-22 situation, and as I understand it, 
this happened only since I think it is 1999 when the SEC passed 
a rule that was far more aimed, and aimed correctly, in my 
opinion, at larger companies and financial services companies, 
and nobody paid attention to how it would affect vaccine 
makers, because the Government has a stockpile which they put 
into.
    Why would it not just make sense to make an exception not 
with the words vaccine makers in it, but when you have this 
stockpile that is not used because of an emergency that occurs, 
a health care emergency or something or some other kind, but it 
would not be a financial emergency in the mind of the user that 
you just undo it or just exempt the vaccine area? It does not 
sound to me like when you say, well, they will change the way 
their contracts are written as the easiest solution, since the 
recognition of income or revenue recognition was never intended 
to deal with this situation?
    Chairman Donaldson. I do not intend it as a flip remark to 
say it is just the nature of the contracts, but it is. There is 
a way, I believe, for the companies to adjust the way they 
sell, loan, or whatever they do with these vaccines to not have 
to be concerned with our accounting.
    Senator Schumer. But will CDC do that? That is the issue. 
As I understand it, the SEC says to CDC you do it our way, and 
CDC says to SEC do it our way, and the twain have not met for 
quite awhile.
    Chairman Donaldson. Well, I hope that is not so. I can 
assure you that we are on top of this. We are working at it. We 
are talking to HHS. We are talking to the companies. We are 
trying to work it out. I would be very pleased to try and give 
you a report on the exact stage of where we are with it.
    Senator Schumer. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sarbanes, we have a minute.
    Senator Sarbanes. I have no further questions.
    Chairman Shelby. Mr. Chairman, we appreciate your 
appearance here today. We appreciate your candor, and we will 
continue to bring you back up here from time to time. I think 
you like it here.
    Thank you.
    Chairman Donaldson. Thank you.
    [Whereupon, at 11:30 a.m., the hearing was adjourned.]
    [Prepared statements, resposne to written questions, and 
additional material supplied for the record:]
               PREPARED STATEMENT OF SENATOR JIM BUNNING
    Thank you Mr. Chairman for holding this hearing and I would like to 
thank Chairman Donaldson, for testifying today.
    I appreciate your coming up here as often as you do. As you know I 
do have some serious criticisms of some of the policies you have been 
pushing at the SEC. I cannot however, criticize your accessibility to 
the Committee and I want you to know how much I appreciate you making 
yourself available to the Committee. I would also like to take this 
opportunity to publicly thank 3 members of your staff, Jane Cobb, Allen 
Beller, and Paula Dubberly for their help and technical expertise in 
working toward an agreement to bring the Tennessee Valley Authority 
under SEC enforcement. As you know, this is a very important investor 
protection development. This agreement with the TVA will help protect 
bondholders all over the country. I would also like to thank the 
Chairman's staff, Kathy Casey, Doug Nappi, Bryan Corbett, and Paul 
Doerrer who served Chairman Shelby on Appropriations and now is with 
the full Committee. As well as Libby Jarvis of Majority Leader Frist's 
office and T.A. Hawks, Jenny Reeves Manley and Marie Thomas of Chairman 
Cochran's office for working so hard to accomplishing this worthwhile 
task.
    That was the good part. Here is the bad. I still do not agree with 
your rule on mutual funds. Obviously, 2 of your commissioners do not 
either, or they would not have sent a letter to the Appropriations 
Committee. I never remember seeing a letter like this from the SEC. It 
makes me have great concerns about the fairness and accuracy of the 
study that was put together by the SEC. I hope you will not take 
Commissioner Atkins and Commissioner Glassman's concerns lightly. I do 
not. Mr. Chairman, I would like to submit a copy of this letter for the 
record.
    I also have concerns about the recent Reg. NMS passed by the 
Commission. I guess we have a difference in philosophy. To get to the 
end you wanted, a consistent rule governing the markets, you could have 
gone with increasing regulation or deceasing regulation. Obviously, you 
did not trust the free market and you opted for increasing regulation. 
I believe you should have decreased regulation to ensure a level 
playing field.
    The regulation itself seems to have been accepted by the industry, 
they want certainly more than anything, and they have moved on. But I 
am still concerned about the process. It used to be, a majority of the 
votes by the SEC were unanimous or, on a bad day, 4-1. Very rarely were 
their 3-2 votes. Unfortunately, 3-2 votes, on major issues, now seem to 
have become the norm, and there seems to be open hostility during these 
votes. Now I know you cannot always get consensus, believe me. We have 
a perfect example of this on the floor of the Senate as we speak, but 
these recent votes and open hostility concern me greatly. The Committee 
looks heavy handed. It looks, to this Senator anyway, that you are more 
interested in steam rolling opposition, than reaching consensus.
    I am also very concerned about how long it is taking the Commission 
to act at times. While I feel you rushed through a bad rule on mutual 
funds' independent chairman, market timing, an actual abuse, has not 
been addressed. Even more worrisome, Nasdaq has had an application 
before the Commission for 4\1/2\ years. That seems excessive to me. I 
am not as concerned about whether you approve the application or not, 
as I am with them not getting an answer one way or the other for so 
long.
    In yesterday's hearing, Sandy Frucher of the Philadelphia Exchange 
testified before us. To paraphrase his comments, he felt the regional 
exchanges, to compete with the large, recently merged markets, will 
need to be innovative. But they will also need quick approval of those 
innovations. When they see applications taking 4\1/2\ years, it makes 
them very nervous.
    I hope you will take these comments to heart and in the way they 
are intended. Investors need a strong SEC. But they need one that works 
together, not one that has controversy and distension on every major 
issue.
    Thank you again for holding this hearing Mr. Chairman and I thank 
you Chairman Donaldson for coming before us again today.
                               ----------
             PREPARED STATEMENT OF SENATOR DEBBIE STABENOW
    Thank you, Chairman Shelby. Welcome, Chairman Donaldson. I 
appreciate that you are taking the time to come before us today to 
discuss the important issue of your recently approved Regulation NMS.
    I know that approval of Reg. NMS has been somewhat controversial. 
I, like others, would prefer to see unanimous decisions coming from the 
SEC for no other reason than it would give comfort and a sense of 
certainty to the markets.
    We, here on the dais, are aware more than most that unanimous 
decisions are frequently difficult to come by.
    Of course, the approval of NMS was not a unanimous decision. But, I 
do not believe that this should cast a cloud over the soundness of the 
SEC's decision.
    At the heart of Reg. NMS is the trade-through rule. The trade-
through rule can be summed up as a mandate that stocks traded on more 
than one exchange cannot be bought and sold for prices that are worse 
than those offered elsewhere.
    Anything that we can do to promote fair markets and provide 
assurances to the public that they are obtaining the best execution for 
a market order should be encouraged. Fairness and dependability should 
be at the root of our securities markets . . . these amazing engines of 
growth in this country. And, I will do everything I can to support 
every movement we take in that direction.
    This is not say, however, that I support every decision made by the 
SEC. I am still troubled by your planned implementation of the ``push-
out'' provisions of Title II of the Gramm-Leach-Bliley Act.
    The small and medium-sized banks in my home State of Michigan are 
very concerned about the costs and consequences of having to implement 
a regulation that they feel runs counter to the intentions of the 
Gramm-Leach-Bliley Act.
    While you have agreed to suspend implementation of the ``push-out'' 
regulation until September 30 of this year at the urging of Senator 
Bunning, myself, and others, I am still not convinced that industry 
concerns will be fully addressed. I look forward to continuing our work 
on this issue.
    Mr. Chairman, I am generally happy with the progress that the SEC 
is making under your leadership and look forward to your testimony.
    Thank you, Mr. Chairman.
                               ----------
               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                              May 19, 2005
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today concerning the 
important developments in the equity markets that occurred last month. 
On April 20, the New York Stock Exchange and the Archipelago Exchange 
agreed to merge and become a publicly held company--the NYSE Group. Two 
days later, the Nasdaq Stock Market 
announced an agreement to purchase Instinet's electronic trading 
network and consolidate their trading platforms. These are the four 
largest markets trading equity securities in the United States, and the 
importance of these transactions, if completed, can hardly be over-
emphasized.
    Today, I will touch on some of the broader policy implications of 
the proposed consolidations. I will start by placing these proposed 
transactions in the context of the Commission's market structure 
initiatives, particularly Regulation NMS. Next, I will offer some 
thoughts about how the consolidations might impact competition in the 
markets going forward. Finally, I will highlight some important issues 
relating to industry self-regulation that the Commission will be 
addressing in the coming months. As many of the details of the proposed 
transactions are not yet clear and my observations are necessarily 
preliminary, my testimony today reflects my own views and not those of 
my fellow commissioners.
Market Structure Reform
    As I have discussed with you in several prior hearings, one of my 
highest priorities over the last 2 years has been to complete the 
Commission's extended review of equity market structure regulation. In 
recent years, the equity markets have experienced sweeping changes, 
ranging from new technologies, to new types of markets, to the 
initiation of trading in penny increments. The pressing need for an 
up-to-date regulatory structure that properly reflects these changes 
has been inescapable. Last month, the Commission took a critical step 
forward in adopting Regulation NMS--a comprehensive set of reforms 
designed to strengthen and modernize our national market system.
    In my view, subsequent events in the marketplace have only 
reconfirmed the importance of this Commission initiative. The fact that 
the two transactions were announced only weeks after the Commission 
adopted Regulation NMS may not have been entirely coincidental. To be 
sure, the transactions resulted primarily from economic and competitive 
forces in the marketplace. Even when markets are closely linked, 
individual markets compete on the basis of size, because size offers 
greater liquidity for executing customer orders. Thus, natural market 
forces tend toward consolidation of markets. In addition to this basic 
driver, other economic and competitive forces likely laid the 
groundwork for these transactions, such as the need to maximize 
economies of scale, reduce excess capacity, and, in the case of the New 
York Stock Exchange, respond to a growing demand for more automated 
trading and, at the same time, position itself to tap the public 
capital markets to fund future expansion opportunities.
    But prior to Regulation NMS, uncertainty about the regulatory 
landscape may have hindered the ability of markets to plan for the 
future. They knew that regulatory change was bound to occur, but were 
unsure as to when and what form it would take. Therefore, while the 
adoption of Regulation NMS did not cause the corporate consolidations 
to occur, it may have helped create the conditions under which the 
forces of competition and innovation--rather than uncertainty--can 
drive decisionmaking.
    Of course, certainty could have come with any Commission decision 
on market structure, but I believe the choices we made were the right 
ones. By adopting consistent rules of the road across all national 
market system stocks--which include all stocks listed on an exchange or 
Nasdaq--the Commission made sure that market consolidation can take 
place against a regulatory background that protects investors at the 
same time that it levels the playing field for competitors.
    Prior to Regulation NMS, the lack of consistent intermarket trading 
rules for all NMS stocks had divided the equity markets into halves: A 
market for exchange-listed stocks and a market for Nasdaq stocks. For 
historical reasons, including the history of the NYSE as an auction 
market and Nasdaq as a dealer market, these stocks traded in quite 
different regulatory structures. Exchange-listed stocks were subject to 
the Intermarket Trading System, or ITS, rules. These rules include 
trade-through restrictions, restrictions on locking or crossing 
quotations, and participation in a ``hard'' linkage system. In 
contrast, the market for Nasdaq stocks was just beginning to develop 
when the ITS was created and has never been subject to the ITS rules.
    In recent years, the result of this bifurcation has been a less 
than optimal regulatory environment for both exchange-listed and Nasdaq 
stocks. The old ITS trade-through provisions were an anachronistic 
holdover from the era of primarily manual markets that hampered 
competition from automated markets in exchange-listed stocks. On the 
other hand, the markets trading Nasdaq stocks were characterized by 
contentious disputes relating to the fees that can be charged for 
access to quotations, as well as the common practice of posting locking 
or crossing quotations. Moreover, both markets were characterized by a 
significant volume of trade-throughs of the best prices--in exchange-
listed stocks mainly because of gaps in the ITS rules, and in Nasdaq 
stocks because of the absence of any restrictions on trade-throughs.
    From a purely economic standpoint, there should be no significant 
difference between trading exchange-listed and Nasdaq stocks: Assuming 
equal regulatory treatment, a market for a large-cap NYSE stock could 
look very similar to a market for a large-cap Nasdaq stock, and a 
market with active trading in one should also be able to host active 
trading in the other. In adopting Regulation NMS, the Commission swept 
away the outdated and inconsistent existing rules and resisted calls to 
perpetuate major disparities in the regulatory environment for 
exchange-listed and Nasdaq stocks. As a result, Regulation NMS 
effectively unites the market for trading equity securities in the 
United States. Market participants will no longer need to adopt trading 
mechanisms and strategies for one regulatory structure that applies to 
approximately one-half of NMS stocks, while adopting different 
mechanisms and strategies for another regulatory structure that applies 
to the other half of NMS stocks. Instead of basing their strategies on 
regulatory differences, investors will be able to focus on fundamental 
economic differences between stocks and markets.
    One important ramification of this new level playing field is that 
it will facilitate competition between the NYSE and Nasdaq across all 
NMS stocks. By eliminating the advantage the old ITS rule might have 
given floor-based exchanges, the new trade-through rule expands the 
opportunities for electronic markets to compete with the NYSE floor for 
order flow and ratchets up the pressure for the NYSE to implement its 
Hybrid Market proposal in a way that will truly facilitate automated 
trading. Moreover, if it merges with Archipelago, the NYSE Group will 
have a formidable electronic platform for acquiring market share in 
Nasdaq stocks.
    Under the new regulatory framework, competition in all NMS stocks 
will be based on three basic principles--best price, open access, and 
transparency.
    First, the new trade-through rule underscores the principle that, 
no matter where a customer order is routed, it should receive the best 
price that is immediately and automatically available anywhere in the 
national market system. The trade-through rule prevents markets from 
ignoring better priced automated quotes displayed by their competitors. 
As competition heats up, the best price principle will protect 
investors, particularly retail investors, by assuring that 
intermediaries act in accordance with the interests of their customers. 
The trade-through rule will function as a critical backstop to a 
broker's duty of best execution, violations of which can be difficult 
to prove and which generally does not apply to retail orders on an 
order-by-order basis.
    The best price principle also will promote vigorous competition 
among individual market centers. As markets consolidate to build 
liquidity, they are apt to be reluctant to ship orders to competing 
markets. By ensuring that smaller markets displaying the best price 
cannot be ignored by larger, dominant markets, the new trade-through 
rule will make it easier for all markets to compete on the basis of 
price. Moreover, the continued existence of the consolidated market 
data system assures smaller markets that their quotes will be widely 
distributed to all market participants and investors.
    Second, competition in the new regulatory structure will be 
governed by the principle of open access to displayed prices. Markets 
will be permitted to compete across a wide range of services, but they 
cannot attempt to penalize their competitors by adopting unfairly 
discriminatory rules or practices that restrict access to their 
displayed quotations. Markets also cannot charge exorbitant fees for 
access to their quotations that effectively would create barriers to 
access.
    Third, markets must be transparent. All significant markets must 
make their displayed quotations and trade reports available to all 
interested parties on terms that are fair and reasonable and not 
unreasonably discriminatory. Once again, markets cannot attempt to 
hamper competitors by restricting the dissemination of essential market 
information to all market participants and investors.
    By following these three basic principles--best price, open access, 
and transparency--I am confident that our equity markets will continue 
to develop in ways that benefit investors.
Proposed Consolidations--Competition and Industry Self-Regulation
    Turning to the proposed consolidations themselves, I would focus on 
two basic questions. First, what effect are these transactions likely 
to have on competition--among markets and among orders? Second, how 
will the new consolidated markets meet their responsibility to assure 
effective self-regulation?
Promoting Market Competition and Order Competition
    The national market system is premised on promoting fair 
competition among individual markets, while at the same time assuring 
that all of these markets are linked together in a unified system that 
promotes interaction among the orders of buyers and sellers in 
individual stocks. It thereby incorporates two distinct forms of 
competition--competition among markets and competition among orders. 
Vigorous competition among markets promotes more efficient and 
innovative trading services, while vigorous competition among orders 
promotes more efficient pricing of individual stocks for all types of 
orders, large and small. Together, they produce markets that offer the 
greatest benefits for investors and public companies.
    Accordingly, the Commission's primary challenge over the years in 
facilitating the establishment of a national market system has been to 
maintain an appropriate balance between these two vital forms of 
competition. It particularly has sought to avoid the extremes of: On 
the one hand, isolated markets that trade an NMS stock without regard 
to trading in other markets and thereby fragment the competition among 
buyers and sellers in that stock; and on the other, a totally 
centralized system that loses the benefits of vigorous competition and 
innovation among individual markets.
    The United States is fortunate to have equity markets characterized 
by extremely vigorous competition among a variety of different types of 
markets. These include: (1) traditional exchanges with active trading 
floors, which even now are evolving to expand the range of choices that 
they offer investors for both automated and manual trading; (2) purely 
electronic markets, which offer both standard limit orders and 
conditional orders that are designed to facilitate complex trading 
strategies; (3) market-making securities dealers, which offer both 
automated execution of smaller orders and the commitment of capital to 
facilitate the execution of larger, institutional orders; (4) regional 
exchanges, many of which have adopted automated systems for executing 
smaller orders; and (5) automated matching systems that permit 
investors, particularly large institutions, to seek counterparties to 
their trades anonymously and with minimal price impact.
    At the same time, competition among multiple markets trading the 
same stocks can detract from the most vigorous competition among orders 
in an individual stock, thereby impeding efficient price discovery. The 
importance of competition among orders has long been recognized. 
Indeed, when Congress mandated the establishment of an NMS, it 
succinctly stated this basic principle: ``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.'' \1\
---------------------------------------------------------------------------
    \1\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975).
---------------------------------------------------------------------------
    To the extent that competition among orders is lessened, the 
quality of price discovery for all sizes of orders can be compromised. 
Impaired price discovery could cause market prices to deviate from 
fundamental values, reduce market depth and liquidity, and create 
excessive short-term volatility that increases the cost of capital for 
public companies. More broadly, when market prices do not reflect 
fundamental values, resources will be misallocated within the economy, 
and economic efficiency--as well as market efficiency--will be 
impaired.
    Accordingly, the proposed corporate consolidations must be 
evaluated in the context of their effect on these two forms of 
competition. Generally speaking, I believe the effect of the proposed 
consolidations, combined with the new trade-through rule, should be to 
increase market depth and liquidity and enhance order competition. 
Moreover, I do not agree, as some may fear, that the consolidations 
represent the death-knell for competition among markets. To accurately 
assess the impact of the proposed transactions, one must endeavor to 
predict what the markets, and the nature of competition, might look 
like a year or two from now when Regulation NMS has been implemented 
and the consolidations have been completed, assuming the necessary 
steps for approval have been obtained.
    At first glance, it appears that the two proposed consolidated 
entities--the NYSE Group and the new Nasdaq--will dominate the 
landscape for national market system stocks. Based on reported share 
volumes in March 2005, the NYSE Group and the new Nasdaq would 
respectively encompass approximately 49 percent and 47 percent of 
trading in NMS stocks. But in spite of these large market shares, I 
believe that competition among markets should continue to thrive.
    The NYSE currently executes approximately 78 percent of share 
volume in NYSE stocks, most of which is executed manually. Many believe 
that the old ITS trading rules have helped the NYSE maintain its 
dominant market share. Regulation NMS will transform the competition in 
these stocks by protecting only automated quotations that are 
immediately accessible. Recognizing that change was coming, the new 
management of the NYSE has worked steadily over the last year to 
develop its Hybrid Market proposal, which is designed to give investors 
a choice of executing their orders automatically or sending them to the 
floor for manual execution. Nevertheless, even if the Hybrid Market is 
approved and implemented, the NYSE will have to battle to maintain its 
market share, given the expanded opportunities for fully electronic 
markets to compete in NYSE stocks after implementation of Regulation 
NMS.
    The two most formidable competitors of the Hybrid Market are likely 
to be the new Nasdaq, which currently reports approximately 15 percent 
of share volume in NYSE stocks, and the Hybrid Market's proposed new 
corporate sibling--the Archipelago Exchange--which is a fully 
electronic market that currently reports only 2 percent of share volume 
in NYSE stocks. Notably, management of the NYSE and Archipelago have 
stated that both the Hybrid Market and the Archipelago electronic 
market would continue to exist and to trade NYSE stocks. The stage 
therefore would be set for continued competition for market share in 
NYSE stocks between the Hybrid Market and the electronic markets, 
promising much greater automated trading and, I believe, quite 
substantial benefits for investors in faster, more efficient trading, 
particularly in the most active NYSE stocks.
    Of course, NYSE stocks also are traded on regional exchanges and 
other types of market centers that will continue to compete for market 
share. These include automated matching systems that seek to facilitate 
the large trades of institutional investors with anonymity and without 
telegraphing their trading interest to the broader market. They also 
include securities dealers in the business of providing liquidity for 
the large trades of institutional investors. All in all, the battle for 
market share in NYSE stocks promises to be quite heated.
    The situation for Nasdaq stocks appears at first glance to be a 
mirror-image of the situation for NYSE stocks. Giving effect to the 
Instinet transaction, new Nasdaq would currently report 81 percent of 
the share volume in Nasdaq stocks. But this summary figure conceals 
more than it reveals. Approximately 30 percent of Nasdaq share volume 
currently is executed by dealers and is merely reported, not routed or 
executed, through Nasdaq facilities. A more accurate depiction of 
market share is approximately 50 percent in the combined Nasdaq/
Instinet market, and 17 percent in the Archipelago market, with most of 
the balance executed by securities dealers.
    In the future, I anticipate a continuation of the longstanding 
battle for market share in Nasdaq stocks, particularly after 
implementation of the new trade-through rule. Currently, order flow in 
Nasdaq stocks is fragmented among many market centers, and there is a 
significant volume of trade-throughs, particularly trade-throughs by 
block trades of displayed limit orders on the Nasdaq, Instinet, and 
Archipelago limit order books. For example, many block trades in Nasdaq 
stocks trade through the best displayed prices, and the total share 
volume of trade-throughs in many of the most active Nasdaq stocks 
reaches 9 percent and higher. In 2003, the total dollar volume of 
trades that bypassed displayed and accessible quotations in Nasdaq 
stocks was approximately $561 billion. After the trade-through rule is 
implemented, this enormous volume of trading will be required to 
interact with the best displayed prices on the electronic limit order 
books. This heightened competition among orders is likely to produce 
significant benefits for investors in the form of deeper, more liquid 
markets and more efficient pricing. Indeed, it was this very prospect 
that led so many institutional investors to support the application of 
the trade-through rule to all NMS stocks, including Nasdaq stocks.
    In addition, as I noted earlier, I would expect smaller, innovative 
markets to continue to compete effectively even after the 
consolidations. The trade-through rule will enhance the ability of 
smaller markets to attract order flow by offering the best price, and I 
believe market participants will have an interest in sending order flow 
to these additional markets to preserve multiple options for order 
executions.
    To summarize, it appears at this point that the vital national 
market system objective of promoting both competition among markets and 
competition among orders should not be compromised if the proposed 
consolidations were approved against the backdrop of the new NMS rules. 
Again, however, I caution that any final conclusions will have to await 
review of the full details of the proposed transactions.
Assuring Strong Industry Self-Regulation
    The proposed market center consolidations should also be viewed 
against the backdrop of the changing structure of industry self-
regulation. The strength of our national market system is critically 
dependent on the effectiveness of the SRO's as regulators, and in this 
regard, the Commission has undertaken over the last 2 years a 
comprehensive examination of the current structure of industry self-
regulation. This examination was initiated in March 2003, when I sent 
letters to all of the SRO's requesting that they review the adequacy of 
their governance practices.
    In recent years, both the NYSE and Nasdaq have changed 
significantly their governance and self-regulatory structures. 
Following the well-publicized controversy relating to the compensation 
of the former NYSE Chairman, the NYSE created a new, independent board, 
and established an autonomous regulatory unit that reports directly to 
a fully independent regulatory oversight committee of the board. I 
believe that these changes significantly improved the NYSE's governance 
and regulatory functions.
    I also believe that the governance and self-regulatory structure 
implemented by Nasdaq in the 1990's has worked relatively well. In 
particular, the market operation functions of Nasdaq have been 
separated from the NASD, with the NASD now operating as an independent 
organization focused exclusively on its regulatory functions as a 
national securities association.
    That said, there is clearly room for improvement in industry self-
regulation. The well-publicized events that led to the governance 
changes at the NYSE and NASD have been quite troubling, as have recent 
enforcement actions that found serious deficiencies in the regulatory 
programs at several SRO's. To address these problems, the Commission 
published for comment last December a series of new rules designed to 
strengthen the current system of industry self-regulation. Among other 
things, these rules would ensure the independence of the board of 
directors and certain board committees, restrict the ownership interest 
of any member of an SRO to no more than 20 percent, require SRO's to 
maintain their books and records within the United States, and 
significantly increase the amount of information that SRO's must 
publicly disclose concerning their governance, regulatory programs, 
finances, and ownership structure. Finally, the proposals would enhance 
the Commission's oversight of the SRO's by requiring them to generate 
detailed periodic reports on their regulatory programs in an electronic 
format that would be readily reviewable by the Commission.
    At the same time that it published specific proposals to strengthen 
industry self-regulation, the Commission published a concept release 
seeking public comment on a wide range of issues relating to the 
overall structure of self-regulation. These issues include: (1) the 
potential conflicts of interest between an SRO's regulatory obligations 
and the interests of its members, its listed issuers and, in the case 
of a demutualized SRO, its shareholders; (2) the potential costs and 
inefficiencies of the multiple SRO model; (3) the challenges of 
surveillance across markets by multiple SRO's, and (4) the manner in 
which SRO's generate revenue and fund regulatory operations.
    With the announcements of the proposed market center consolidations 
last month, I believe it is even more critical that the Commission act 
promptly on the SRO proposals. The transactions would give rise to 
important issues of governance and self-regulation, and it is vital 
that the Commission reach a decision on the standards that will govern 
its review of the consolidations. Indeed, I believe that many of the 
proposed rules on SRO governance and transparency would help address 
issues raised by the proposed transactions, particularly the critical 
issue of addressing conflicts of interest between SRO business and 
regulatory functions.
    With respect to the proposed consolidations themselves, very few 
details are available thus far regarding their plans for self-
regulation. All of these details will have to be clarified prior to any 
action on the proposed rule changes that the various entities will be 
required to file with the Commission for notice and public comment 
prior to completion of the transactions. I assure you that the 
Commission will listen to the views of the public and closely 
scrutinize the proposed transactions to assure that the interests of 
investors and the public are fully upheld. We will also be sensitive to 
the concerns of other regulators, including the Department of Justice. 
At this point, I can simply highlight a few issues specific to the 
proposed transactions that will be examined prior to reaching any 
decisions.
    First, the NYSE would, for the first time in its history, become a 
publicly held company, raising the potential for conflicts of interest 
between the profit-maximizing interests of its shareholders and the 
need for effective self-regulation. The new NYSE Group will have to 
assure the genuine independence of its regulatory staff and full 
funding for its regulatory function. I expect we will carefully review 
the organization of the regulatory function within the new NYSE Group, 
including its responsibilities for regulating the new Hybrid Market, 
the Archipelago Exchange, and member firms. We also will assess the 
NYSE Group's financial arrangements to assure that all of these 
regulatory responsibilities can be reliably and fully funded in the 
future.
    Second, the proposed consolidation of the Instinet trading platform 
into Nasdaq preliminarily would appear to streamline the overall 
regulation of trading on the combined Nasdaq/Instinet platform. The 
regulation of such trading would be consolidated in two regulatory 
entities--the NASD and Nasdaq. In contrast, regulation of Nasdaq and 
Instinet trading currently is split among the NASD, Nasdaq, and the 
National Securities Exchange, through which Instinet displays 
quotations and reports trades. In particular, the National Securities 
Exchange is responsible for regulating Instinet trading on the 
exchange, while the NASD regulates Instinet as a member. In the future, 
Nasdaq likely would continue performing the market surveillance 
function for trading on the combined Nasdaq/Instinet platform, while 
the NASD likely would be responsible for all other regulatory 
functions.
    Any examination of the Nasdaq/Instinet transaction would occur in 
the context of Nasdaq's pending application for registration as a 
national securities exchange. In this regard, I believe the staff is 
close to resolving the remaining issues with Nasdaq. The staff has 
worked with Nasdaq to resolve its concern about Nasdaq's current lack 
of price priority rules. These rules promote order interaction and 
price discovery, and are required by all other U.S. exchanges. Last 
December, Nasdaq filed a proposal that would modify the rules of its 
execution service, known as SuperMontage, so that all trades would be 
executed in price/time priority, and this proposal appears to be a 
significant step in Nasdaq's exchange application process. In addition, 
the staff is working with Nasdaq to resolve remaining issues relating 
to the reporting of over-the-counter trades. Once these issues are 
resolved and reflected in an amendment to Nasdaq's exchange 
application, the Commission will be in a position to act on the 
application. At this point, we are expecting Nasdaq to file an amended 
exchange application early this summer.
    Finally, given the increased market share and potential competitive 
clout of the two proposed consolidated entities, the Commission's role 
in reviewing their rule filings will be quite important. The issues 
addressed in these rule filings will include the fairness and 
reasonableness of fees of all kinds, including for proprietary sales of 
market data, as well as potentially discriminatory rules against 
competitors or market participants who trade in other market centers, 
all of which are required to be considered under the Exchange Act. For 
example, the NYSE Group would encompass two separate SRO trading 
facilities--the Hybrid Market and the Archipelago electronic market. No 
unfairly discriminatory advantages would be allowed between the 
separate trading facilities that would violate the open access 
principle of Regulation NMS.
Conclusion
    The Commission will have many important decisions to make in the 
coming months. I look forward to hearing your views and answering your 
questions on the market structure and self-regulatory issues facing the 
Commission, with the simple caveat that, as I am sure you appreciate, 
it would be inappropriate for me to attempt to prejudge where the 
Commission will arrive in its deliberations on these complex subjects. 
Thank you again for inviting me to speak.
       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING 
                   FROM WILLIAM H. DONALDSON

Q.1. Do you have any comments about the study on the 
independent chairman rule and the letter sent by Commissioners 
Atkins and Glassman to the Appropriations Committee?
Q.2. Do you have any response Mr. Frucher, of the Philadelphia 
exchange's concerns that the delays on issues before the 
commission will hinder innovation by the smaller, regional 
exchanges and jeopardize their very survival?

Answer: Due to the resignation and departure from the 
Commission of Chairman William Donaldson, his response to these 
questions is not available.