Speech by SEC Commissioner:
Remarks Before the Securities Industry Association Market Structure Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
Grand Hyatt Hotel
New York, New York
May 24, 2006
Good morning. I am delighted to have been invited to speak again at the SIA's Market Structure Conference. It amazes me that every year the SIA attracts an ever-increasing number of people to a program whose title sounds like a convention of shopping mall builders. Who can explain it? Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
I thought I would speak to you first about the impact Regulation NMS has had on the markets and my thoughts on the recently-announced cross-border exchange combinations. I will then turn to regulatory and structural developments in the options markets and my wish list for the future.
Impact of Regulation NMS
As you know, last year the Commission modernized the regulatory framework governing our equity markets by adopting Regulation NMS. The benefits to the markets are already being seen, well before full implementation. Since the adoption of Regulation NMS, we have witnessed changes in the New York Stock Exchange's (NYSE's) auction market that were previously unimaginable. The new regulatory framework has intensified competition between Nasdaq and the listed markets and has provided an impetus for exchanges to adapt their systems to a fast market environment. Further, almost every exchange and trading venue is in the midst of revamping its operations to improve speed and reliability and is reconsidering its business model and trading rules in the hopes of reaping some competitive advantage once Regulation NMS is implemented. For instance, various regional exchanges have crafted proposals designed to provide trading venue alternatives to the two dominant markets and major firms are making significant equity investments in regional exchanges to ensure a competitive alternative. New ECNs have been formed and some existing markets are expanding into new products not currently traded on their exchanges.
As a result of pursuing both business innovation and Regulation NMS compliance, there currently are a great many moving parts. However, the transition thus far has been extremely positive. The industry's competitive, and creative, response to Regulation NMS has raised the baseline for all securities markets. Going forward, I trust the Commission will support an implementation process that will be as predictable, smooth, and cost-effective as possible. It is critical that an implementation process have clear goals and timeframes for achieving the necessary systems changes and integration of the markets under Regulation NMS. At the same time, I urge that you keep in mind that proposed market changes, whether driven by Regulation NMS or for competitive reasons, should not displace any class of market participant or result in a disruption to the markets, even on a temporary basis.
Now, I would be remiss if I did not speak about the business combinations that have followed on the heels of Regulation NMS and the recent proposals by some U.S. exchanges to join forces with their exchange counterparts across the Atlantic. Domestically, we have recently witnessed several mergers that combined traditional with "new" models of exchanges combinations of Electronic Communications Networks (ECNs) and traditional exchanges. Specifically, the NYSE has merged with Archipelago and Nasdaq with Instinet. The driving force behind these mergers appears to be the prospect of building stronger, more diverse, and more competitive marketplaces. In each case, the parties expect to combine the best features of each other's market and infrastructure to improve liquidity, executions, and, of course, profits. Both the NYSE and Nasdaq arrangements will take advantage of system efficiencies to boost processing speed, lower costs, and make the combined markets more adaptable to market developments yet to come.
I expect, going forward, that exchanges will be driven by the business need to seize competitive advantage, increase revenues, reduce costs, and provide value to their shareholders. I also believe combinations of exchanges will be driven by the opportunity to trade different types of products, such as equities, bonds, options, futures, and other derivative products, in a single venue. Cross-border combinations of exchanges are a logical extension of this trend as well.
Needless to say, some members of the Commission's staff have been thinking about these issues for some time. In fact, even when I was Director of the Division of Market Regulation, this was acknowledged as a likely trend and we considered the issues that may arise. Not all of the issues likely to arise are new. The SEC for years has grappled with issues concerning foreign access, that is, how to allow U.S. investors access to foreign markets. Today, U.S. investors have access to foreign markets but, with few exceptions, such access is through their U.S. brokers who are responsible for complying with U.S. law. But a true consolidation and integration of U.S. and foreign markets ultimately will raise a myriad of issues that U.S. and foreign regulators will need to address.
Now, the time for a transatlantic combination of securities exchanges appears to be at hand. As you know, Nasdaq has acquired a significant interest in the London Stock Exchange and just this week the NYSE has announced a potential business combination with Euronext. Both initiatives seek to expand the geographic reach and product offering of the parties and to leverage this into future opportunities for growth. Ultimately, these markets, through synergies, want to offer investors the ability to transact and move assets seamlessly across continents and time zones, which also means across different regulatory jurisdictions.
I hope, and expect, that any such combination would take place over a more extended period of time and in stages. For example, the two exchanges seeking to combine might set up a holding company, with each exchange as a separate entity operating independently within that holding company.
So initially, not much would change.
Eventually, however, the separate entities likely would seek to operate via a common computer platform. The ultimate goal for the marketplace would be the reduction of cross-border trading costs through overhead savings and increased access to investors in the respective markets for all of the products offered in the combined marketplace. From a regulators standpoint, issues concerning our ability to perform automation reviews and to access books and records would have to be addressed.
It is clear that electronic technology fosters commerce that knows no geographical boundaries and investors continue to be interested in accessing trading opportunities beyond their domestic regulatory and geographic boundaries.
At the same time, this potential creates unique challenges for national regulators. How can we maintain national standards as our respective borders start to break down and as consolidation among entities in multiple jurisdictions becomes more attractive financially to the market participants? The challenge for the regulators in the relevant jurisdictions will be to work through the rules under which these transactions will take place and sort out the means by which they would clear and settle as well as the standards that would apply to market participants.
Listing standards in the cross-border context provides a good example of the subtle and important considerations regulators would need to address if a unified exchange market were to operate. Traditionally in the U.S., many corporate governance requirements are controlled by state law. However, many broad, widespread reforms have been achieved through listing standards, which are approved by the SEC. Additionally, U.S. listing standards incorporate our reporting and disclosure regime. If, in an international market, the jurisdiction in which a company lists becomes less important, the SEC may not be able to impact corporate governance or effect other reforms through listing standards. And, even if foreign jurisdictions have strong corporate governance requirements, fundamental differences exist between U.S. and foreign reporting and disclosure regimes.
What will also require discussion among regulators are the rules to apply to the markets and market participants. The U.S. has certain investor protections built into our exchange rules including the principles that limit orders are protected and that agents may not trade ahead of their customers. We also work to ensure that our clearinghouses operate efficiently, are resilient and financially sound, and we regulate broker-dealers on a variety of fronts from sales practices to net capital and customer protection requirements. Other countries may or may not have similar standards and protections concerning such significant market participants.
I believe that cross-border affiliations are a net positive for the markets, and as regulators we should facilitate these affiliations. At the same time, we must maintain the protections inherent in our regulatory structure as we move forward with cross-border consolidations.
I'd like to speak now about the options markets.
Options exchanges have undergone a sea-change in the last several years and continue to innovate and improve trading efficiency. Since at least 2000, we have witnessed several fundamental market reforms. These include listing products on multiple exchanges, the entrance of new, and fully-electronic markets, such as ISE, establishing an inter-exchange linkage system, reforms increasing inter- and intra-market market maker quote competition, and approval of price improvement mechanisms such as BOX. More recently, new classes of market makers are able to participate from off the trading floor at several exchanges. Further, the options markets continue to integrate systems and expand their automation such that the vast majority of orders and quotes are entered and executed electronically. As a result of these and other developments, the quality of the options markets has improved considerably, with narrower spreads and increased liquidity contributing to better customer executions.
In introducing structural changes that increase inter and intra-market competition, the options markets have followed in the footsteps of the equities markets and, not surprisingly, have achieved similar results that is, competition has increased, spreads have narrowed, and liquidity and executions have improved. However, the options markets have yet to make the leap to quoting in penny increments. In 2001, the U.S. stock markets changed from fractional to decimal pricing and introduced smaller trading increments. At that time, the options exchanges convinced Congress and the SEC that quoting in penny increments would overwhelm the capabilities of the systems that collect and disseminate options quote and trade data (OPRA), as well as exchange, broker- dealer, and vendor systems.
Initial feedback on penny trading in equities showed reduced spreads. Critics, such as institutional investors, claimed the smaller increments made trading more challenging and costly and warned this could precipitate consolidation of market intermediaries. Liquidity remained, but appeared at multiple price levels, which required market participants to adjust their trading strategy. Several years have passed since these initiatives were first implemented and liquidity remains robust as does the competition among numerous market intermediaries.
Today, the options markets continue to quote in five and ten-cent increments, which limits the prices that can be disseminated and, I believe, maintains an artificially wide spread. Pricing inefficiencies caused by nickel and dime minimum increments correspond to a proliferation of payment for order flow practices and internalization arrangements. A move to quoting in penny increments in options could substantially reduce or eliminate payment for order flow. That is, as dealer profits decline, so too does the amount of money that dealers are willing to pay to attract order flow. The move to penny increments in equities greatly reduced spreads in those securities resulting in a commensurate decrease in payment for order flow.
This is not to say that the options markets have not made progress in the area of price competition. Several exchanges now offer special "auctions" through which customers may be able to trade in penny increments at prices better than the quote. These "auctions," however, do not affect the NBBO, and so, they do not affect the majority of retail trades. Since the prices available in the auctions cannot be seen or accessed by other options exchanges, they can be traded-through as well. Exchanges have recently proposed price improvement mechanisms that do not require a sponsor to guarantee the improvement, and so, would expand the universe of orders that may obtain penny price improvement. While I encourage expanding such price improvement opportunities, I believe these price improvement mechanisms in no way substitute for exchanges quoting options in penny increments, where such quotes are transparent, accessible, and subject to trade-through restrictions.
Brokers must make critical yet nuanced decisions when determining where to route their orders to satisfy their best execution obligations. Specifically, the duty of best execution requires broker-dealers to seek the most favorable terms reasonably available under the circumstances for a customer's order. Such determinations involve a variety of considerations. This duty may be satisfied with the automated routing or execution of orders, and does not require automated routing on an order-by-order basis to the market with the best quoted price. Rather, the duty of best execution requires brokers to periodically assess the quality of competing markets considering a variety of factors to assure that order flow is directed to the markets providing the most beneficial terms overall for their customer orders. This periodic assessment must take into account price improvement opportunities across markets. As I mentioned, competitive market forces have led to trading rules and systems that provide opportunities to trade options at prices better than the displayed NBBO. Brokers therefore must consider that executing customer orders at the best displayed price alone may not satisfy these best execution obligations. Brokers cannot simply ignore opportunities for price improvement when making their best execution determinations with respect to customer options orders. And, brokers certainly cannot permit the receipt of payment for order flow or internalization arrangements to interfere with their best execution responsibilities and determinations.
In 2000, following the listing of many options on more than one market, Commission staff found increased competition for options orders, but also found that the introduction of payment for order flow (including exchange-sponsored programs), internalization, and other inducements to firms to route their customer orders to particular markets had an impact on order routing decisions.2 In fact, the staff found that firms that accepted payment for order flow rerouted orders to specialists that paid for order flow more frequently than firms that did not. The staff also found inadequacies in the comparability of data that limited the ability of order routing firms to measure the quality of competing markets. In its report, the Commission expressed concern that payment for order flow and internalization in the options markets contributed to an environment in which quote competition is not always rewarded, thereby discouraging the display of aggressively priced quotes, and impeding better prices for investors.
The Commission's recent examinations on options order routing and best execution practices revealed significant improvements over the last five years in firms' options order routing processes and showed an increased use of "smart router" technology to ensure that marketable retail customer options are directed to the market displaying the best price. Because more than one exchange frequently displays the best price, however, firms continue to rely on competitive factors other than price to determine where to route customer orders. That is, payment for order flow, internalization, reciprocal arrangements, and other inducements appear to have increased since 2000 and continue to play a substantial role in broker-dealers' order routing decisions. Also, it is not clear that brokers are taking full advantage of the price improvement mechanisms offered through some exchanges for a meaningful amount of their order flow.
The Commission has several regulatory tools at its disposal to foster greater competition in options quoting, reduce inefficiencies, such as payment for order flow, and improve transparency of the options exchange execution quality. My preference would be to start by implementing as soon as practicable execution quality statistics for the options markets similar to those we have for the equity markets. A lack of transparency concerning execution quality impairs the ability (and motivation) of broker-dealers to trade between the quote. Execution quality statistics would provide brokers the information to assess and compare execution quality across exchanges and modify their order routing practices based on current information about exchange performance. Further such statistics would enable customers to monitor their broker's handling of their orders, should they so desire. I think published uniform information about a market's execution quality would facilitate comparison across the options exchanges and ultimately inform market participants about the results of their routing choices.
Although it is not without consequences that must be addressed, I also believe it is time for the options markets to move to quoting in penny increments. Even without penny quotes, exponentially increasing option quote traffic currently burdens all market participants' systems. Over the years, the exchanges and SIAC have worked diligently to keep the OPRA system capacity ahead of demand. Nonetheless, during volatile periods, system capacity has been exhausted, resulting in quote queuing, or delayed market data. Fundamental to the problem of system capacity is the seeming business need to make and have available firm quotes on a broad range of strike prices for each underlying stock or index. Other options markets developments, such as electronic trading, remote market-making, and introduction of actual size quotes has increased quote traffic as well. While efforts to secure additional OPRA capacity should continue, it is equally important that data can be timely distributed to large market data vendors and ultimately to their customers. Vendors have observed that substantial quoting in series with no or little open interest contributes to taxing OPRA system capacity and data feeds with a lot of useless information.
Attempts to reduce quote traffic growth through quote mitigation strategies to date have not yielded an agreed upon solution. But I believe if there is a will there is a way. The options exchanges could formulate a fair and efficient means of reducing their respective quote traffic and vendors as well could craft alternative services for customers that filter options quote data. I urge options exchanges to undertake a pilot program, one that quotes and trades in a representative sample of option series, to test the impact of quoting in pennies on intermarket systems capacity as well as on exchange, broker and vendor systems. After the pilot has been operating for a suitable period of time, the industry and the Commission could assess its operation and use the lessons learned to formulate a recommendation on quoting in penny increments. While the Commission could mandate such a pilot, I would encourage the exchanges to review their market rules and make proposing a pilot program to quote options in pennies a priority. I would encourage, along with submitting a proposal for a pilot program to the Commission, that the exchanges formulate and propose a plan for mitigating quote traffic.
For our part, in considering moving to pennies, the Commission will need to address how or whether a market not quoting in pennies could comply with the Options Intermarket Linkage Plan. The Plan currently requires exchanges to avoid trading at prices inferior to those offered at another exchange and provides a means for correcting the trade through a Satisfaction Order.
I hope my remarks today have highlighted some big picture trends concerning our trading markets and given you some sense of my aspirations for further market reforms. These are particularly exciting times for trading markets both in the U.S. and abroad. I look forward to speaking about the developments yet to come at next year's conference.