Speech by SEC Commissioner:
Remarks Before the STA Annual Conference1
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
October 13, 2006
Good afternoon. I am delighted to have been invited back this year to address the Securities Traders Association. I have enjoyed joining you at your annual conference for several years now and I always come away with a better understanding of developments in the marketplace. As you all well know, change is a hallmark of your industry, and this past year has been especially noteworthy. We are witnessing significant shifts in our industry from floor-based exchanges to more fully electronic markets, from fragmented national markets to potentially more consolidated international platforms and through it all, you have adeptly adapted to these new market structures. Today, I would like to highlight the market changes and then touch on a few issues that may be of particular interest to you as traders in adjusting to the post-NMS equity markets.
Before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.2
You are all quite familiar with the sea change we are witnessing in our domestic exchanges. Most of our exchanges have demutualized. They are now shareholder-owned, for-profit operations. Their members are the participants, or users, of their market, but they do not necessarily have an ownership stake in the exchange. Their stock provides the exchanges with a currency with which to make strategic investments in other businesses, including other domestic and international markets.
We are also witnessing tremendous innovation in our domestic equity market structure, some of which was unleashed in response to Regulation NMS. No sooner had Regulation NMS been adopted then the NYSE announced its intended merger with the fully automated Arca Exchange. These two markets now operate as separate exchanges that simultaneously trade NYSE stocks on different platforms. Similarly, Nasdaq has merged with Inet, registered as an exchange, and moved toward adopting the Inet trading technology as part of its Single-book initiative. The Amex, much like the NYSE, is transforming a traditional floor-based market to a hybrid market that offers fully automated trading. I discern a theme running through all these developments, namely traditional markets are strategically modernizing, whether through acquisitions or internal system overhauls. The new regulatory framework has also intensified competition between Nasdaq and the listed markets and has provided an impetus for exchanges to upgrade their systems. That is, of the ten national securities exchanges in the U.S., currently nine of the ten are in the midst of near total transformations of their equity trading systems. And the NYSE and Amex are introducing hybrid market structures to accommodate both electronic and manual trading.
Two of the Commission's primary goals for Reg NMS are to promote vigorous competition among markets and to remove any competitive advantages that the old rules may have given manual markets. All evidence to date indicates that these goals are well on their way to being met. Many of the regional exchanges believe that they now have their best opportunity in many years to compete effectively with the larger exchanges. In addition, all the exchanges intend to be "fast" markets that are eligible to display quotes that are protected against trade-throughs and locking or crossing quotes on other markets. The effect of competition has opened all exchanges to new opportunities and the prospect of gaining market share. Major firms wary of a potential NYSE/Nasdaq duopoly have infused capital into the four traditionally "regional" exchanges Boston, Chicago, National, and Philadelphia. The two traditionally options exchanges CBOE and ISE have decided to expand into equities and are adopting new automated equity trading systems. So I think it is fair to say competition and opportunity are abounding in the trading markets these days.
Given all these ongoing market changes, the Commission extended the Reg NMS compliance dates last spring. The extended dates are intended to give the exchanges the time they need to develop and test their new systems. The new implementation deadlines also will give the securities industry additional time to adjust to the new systems and gain some experience trading on them. One key compliance date is October 16th. This "Specifications Date" is when the markets that will display protected quotes the exchanges and participants in the NASD's ADF must post publicly the final technical specifications for interfacing with their Reg NMS-compliant trading systems. Another key compliance date is February 5th. This "Trading Phase Date" is when the markets that will display protected quotes must commence full operation of their Reg NMS-compliant trading systems.
Obviously, the extensive changes in trading rules and trading systems are likely to greatly affect how you do your jobs as traders. I'd like to speak briefly about some aspects of Regulation NMS that you should be mindful of as you undertake implementation.
An aspect of the Regulation NMS trading environment worth noting is the self-help remedy applicable when trading markets experience systems problems. This is particularly useful given that so many markets are changing their trading systems so extensively. Such systems work may well increase the risk that one or more trading systems may not always operate the way they are supposed to. Regulation NMS permits a trade-through of a protected quotation if the trading center displaying the protected quotation was experiencing a failure, material delay, or malfunction of its systems or equipment when the trade-through occurred. The exception gives trading centers a self-help remedy if another trading center repeatedly fails to provide an immediate response (within one second) to incoming orders attempting to access its quotes. It would undermine the principles of a national market system if market participants were required to continue routing orders to markets experiencing systems problems such that the market was unable to meet the "immediate response" requirements for incoming orders. As an initial matter, you should remember that Regulation NMS affirmatively requires a market experiencing systems problems to stop identifying its quotes as automated. At this point, when the market's quotes would no longer be protected, market participants would not be required to route orders to that market. The self-help remedy, however, provides an additional safety valve. That is, as long as there is objective evidence that a market has a systems problem, industry participants can engage in "self-help" and bypass a market's quotes. With this remedy, the market having a systems problem would bear the brunt of consequences for their operational problems, not the industry in general.
Regulation NMS will also introduce a new order type that is likely to be very important in post-NMS trading that is, the intermarket sweep order, or "ISO." The basic function of an ISO is to tell the destination market that it is free to trade the order without regard to protected quotes displayed by other markets. By marking it as an ISO, the sender of the order represents that either: (1) there were no better-priced protected quotes at other markets at the time of routing, or (2) there were better-priced-protected quotes and it has simultaneously routed additional ISOs to hit those quotes. The ISO order type is an extremely flexible trading tool that is likely to be used in a variety of situations, including best-price routing, sweeping multiple price levels, and executing block trades at prices away from the NBBO. Some have estimated that 50% or more of all orders will be ISOs in the post-NMS trading environment.
You may also recall that Regulation NMS provides a choice to order routers in terms of how to comply with the Reg NMS order protection rule. Unlike the old ITS trade-through rule, the new NMS rule allows order routers themselves to assume responsibility for trade-through protection and thereby control the handling of their own orders. The key tool here is the ISO, which can be sent by both the markets themselves and order routers. Order routers that want to control their own orders will need to adopt the necessary systems and procedures to route ISOs to all markets displaying protected quotes.
Finally, I would like to remind you of the timing of NMS implementation in general. I noted earlier that the February 5th Trading Phase Date applies directly only to the markets that will display protected quotes that is, the exchanges and ADF participants. As a practical matter, however, February 5th is an important date for all industry participants who wish to control the handling of their own orders. On this date, the exchanges and ADF participants will not trade through the protected quotes of other exchanges and ADF participants. This change is likely to be greatest for Nasdaq stocks, where trade-through restrictions will apply for the first time ever. If you are content to let the exchanges do whatever routing of ISOs is necessary to comply with Reg NMS, you will be fine because all of the exchanges plan to offer this outbound routing service. But if you wish to control the handling of your own orders, you will need to have systems and procedures in place by that time in order to properly route ISOs to hit protected quotes. In other words, while the February 5th Trading Phase Date does not apply directly to all industry participants, it affects them indirectly by changing how the exchanges currently operate, particularly for Nasdaq stocks.
I thought I would turn to another topic for a few minutes, namely, the prospect of transatlantic combinations of exchanges. As you well know by now, the NYSE announced an intention to merge with Euronext this past June and Nasdaq has acquired a significant interest in the London Stock Exchange. John Thain has described the historic move to consolidate with Euronext as the manifestation of a vision of building a truly global marketplace with great breadth of product and geographic reach that will benefit investors, issuers, and shareholders alike. From the outset, the Commissioners have expressed their willingness to work with our regulatory counterparts across the globe to establish a cooperative approach to the proposed combination that will benefit investors of all the affected countries. In fact, just in late September, Chairman Christopher Cox and the Chairman's Committee of the Euronext regulators met in Lisbon, Portugal, in anticipation of a potential combination between the NYSE Group, Inc. and Euronext N.V. into NYSE Euronext. They discussed the development of a possible framework for consultation, information sharing, and mutual cooperation in the interest of meeting their respective regulatory mandates in the areas of investor protection, orderly functioning and integrity of the markets. The regulators also affirmed that joint ownership or affiliation of markets alone would not lead to regulation from one jurisdiction becoming applicable in the other and also affirmed their shared belief in the importance of local regulation of local markets.
The NYSE/Euronext merger, as proposed, would appear to call for a common technology strategy but not a common exchange platform. It contemplates multilateral regulation similar to what is currently inherent in the Euronext structure. At base, this means that Euronext will not register as a U.S. exchange and will not offer its products directly in the U.S. Indeed, under this model, while the holding company for the markets will be under U.S. jurisdiction and the NYSE will continue to be a U.S. registered exchange, the non-U.S. markets will not. As a result, there would not be mandatory registration of the non-U.S. markets' listed companies in the U.S., nor would our federal securities laws necessarily apply to the non-U.S. exchanges. This would include, of course, the Sarbanes-Oxley Act (Sarbanes Oxley). U.S. regulation only applies to markets that transact business in the U.S. and mere affiliation with a U.S. exchange does not subject a non-U.S. exchange to U.S. law.
None of these developments should come as a surprise to any of us. Technology seems to not only have flattened the world, but also literally to have made it demonstrably smaller in many respects. Technological innovation has spurred globalization. It has created a more tightly knit world in which cross border commerce can potentially occur in a seamless manner. It has unleashed the possibility that products and services might be offered across the globe at lower cost and with greater efficiency. On the securities side, these benefits could be reached through mergers of markets that operate from common technology platforms and that provide greater liquidity over a wider variety of products. These are clearly positive developments, and we should embrace the possibilities. Mergers of stock exchanges located in different jurisdictions may make business sense to shareholders of exchanges and to the investors they serve.
Whether the first transatlantic market merger is NYSE/Euronext or another combination, our position as regulators is to be rather agnostic. Regulators recognize that it should and will be the shareholders who will ultimately decide on whether the proposed combination will go forward. Rather, it is incumbent on regulators in all applicable jurisdictions to anticipate how the framework for regulatory cooperation would come into effect once shareholders and relevant authorities have given their final decisions on the merger.
Regulators have long been conscious that markets are globalizing, to the potential benefit of investors everywhere. This activity makes increased international cooperation of regulators essential. We all know this type of progress challenges some of our traditional notions of regulation based on national law and regulation. While all national regulators have a legitimate policy interest in maintaining high quality standards in their own jurisdictions, nonetheless, supervisory authorities have long recognized the inevitability of globalization, and with it, the need to move toward common regulatory standards. Thus, there have been a whole host of efforts to achieve cooperation among such authorities as well as to further the goal of consistent international standards. Ultimately, even greater synergies and efficiencies will be achieved in the marketplace as the differences among regulatory approaches give way to consistent, high quality standards that are internationally recognized.
Over the years, the Commission has participated in numerous international fora alongside foreign regulators, international markets, and their participants. Through our participation we have gained invaluable insights and close working relationships with our counterparts all over the world. We have engaged in joint efforts with supervisory authorities in many jurisdictions on regulatory and enforcement issues that have facilitated, among other things, cross-border securities activities while advancing market integrity and investor protection. With such experience under our belts, and having forged relationships with foreign regulatory counterparts and market participants, the SEC is extremely well poised to undertake a cooperative dialogue with regulators abroad on any issues relating to market consolidations.
I hope my remarks today have described how many competitive benefits have been realized even before implementation of Regulation NMS. Now, as actual implementation draws near, I expect we will witness greater trading efficiencies and a growth in trading volume, all beneficial for the markets and investors. Similarly, the dialogue among supervisory authorities prompted by the proposed combination of U.S. and European exchanges have been most productive and underscores that while each supervisor has national policy interests, they have an equal interest in supporting economic development, financial stability, and investor protection worldwide. As capital markets continue to evolve and challenge our historic notions, cooperation must become the rule if the needs of investors are to be well-served and the capital markets are to flourish. These are most exciting times, indeed. I look forward to working with my regulatory counterparts and market participants around the world as we enter a new era in global trading.