Speech by SEC Commissioner:
Remarks Before the Security Traders Association's
74th Annual Conference and Business Meeting
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
Boca Raton Resort & Club
Boca Raton, Florida
October 4, 2007
Good morning. I am honored that you have invited me to this 74th Annual Conference of the Security Traders Association. As usual, before I begin, I am required to point out that the views I express are my personal views and not those of the Securities and Exchange Commission or other individual members of the Commission or its staff.1
This is the eighth time I have addressed the STA, counting both the Annual Conference and the Washington Congressional Conference that you hold each year. That impressive number is not only a testament to my longevity, but more importantly to the very close relationship we have developed through our joint work on some of the most important issues facing our markets. In preparing these remarks, I have had a chance to reflect on the dramatic developments in market structure and trading that have occurred since I first addressed the STA back in 1999. As you well know, tremendous changes have occurred over these past eight years. One cannot help but be amazed at the remarkable progress we have made. Overall, I believe that these changes have been beneficial to investors and to the markets. Competition among trading venues has never been so robust. Spreads have significantly declined. And innovative products and services available to investors continue to proliferate. However, I recognize that some of these changes have been difficult for the securities industry to absorb and they certainly have impacted some existing business models more than others. During this transformative process, some chose to complain or to advocate for the status quo. But you were different. You offered invaluable assistance to help inform the debate. You have been generous with your time by explaining trading issues and how proposed rule changes would impact your businesses. I believe that your thoughts and insights have contributed to better regulation. We have had a long journey together over the years. And, the successes are, in large part, due to our collaborative efforts and your hard work.
II. Transformation of the Equities Markets
A. NYSE and Off-Board Trading
It is hard to imagine that, as recently as 1999, the New York Stock Exchange had a rule — Rule 390 — that prohibited members from effecting principal transactions in listed equities off an exchange. To be sure, there was some logic to the rule. It ensured that order interaction occurred on exchanges leading to competitive price formation. It precluded broker-dealer internalization practices and mitigated market fragmentation. But these policy benefits came at a great cost. The rule artificially limited competition by favoring the organized exchanges and arguably imposed unnecessary costs in the trading of listed equity products. As you know, it was only after considerable pressure from the SEC and industry participants that the NYSE voluntarily rescinded Rule 390. This significant change was just the first of many that promoted competition in the trading of listed equities.
In 1999, markets that traded listed equities were linked through the Intermarket Trading System ("ITS"). The mere mention of ITS probably musters images of dust and cobwebs. ITS was characterized by slow and inefficient execution procedures. Its rules were designed with traditional exchange floor auction trading in mind and highlighted the inherent differences in electronic trading and traditional floor-based auction trading. For example, the ITS trade-through rule initially permitted a response time of one or two minutes to inbound indications of interest. It was a huge advancement when the response time was reduced to 30-seconds. But, for electronic traders, even 30 seconds was an eternity. For all intents and purposes, the business models of alternative trading systems and electronic communication networks — which were based on lightening quick execution speeds — made it impossible to operate within the ITS system, and thus they were unable to compete in the trading of listed products. ATSs and ECNs were not on a level playing field with the exchanges. Today, ITS is no more. Rather, as a result of the adoption of Regulation NMS, ITS has been replaced by a system of private linkages. Market participants are now able to obtain access to quotes displayed at a trading center through the members, subscribers, or customers of that trading center. In addition, the old ITS trade-through rule that had the effect of protecting legacy systems and participants has been replaced by the Order Protection Rule. The Order Protection Rule eliminated the artificial competitive advantage that the old rules had given traditional markets, thereby placing manual and automated markets on a level playing field. A market participant is no longer required to wait as long as 30 seconds for a response. Instead, to comply with the Order Protection Rule, the market participant may choose to only route to markets displaying quotes that are immediately and automatically accessible. Of course, the impact of all these changes was felt far beyond the Order Protection Rule. In order to compete effectively in the national market system today under our updated regulatory framework, virtually every market has invested heavily in technology upgrades and has updated its rule set and protocols to meet the needs of its customers.
When we first met, there was one dominant equity market and multiple, but much smaller regional markets that traded listed equities. ATSs and ECNs were virtually nonexistent in the listed space for the reasons I have mentioned. Today, the landscape has changed dramatically. In August of this year, for example, NYSE's market share in NYSE-listed equities was approximately 45.8%. For the first time, ATSs and ECNs are now competing head-on with the listed markets. Even Nasdaq has begun trading NYSE-listed stocks and has achieved a matched market share in NYSE-listed equities of approximately 18.9% in August of this year. What a difference true competition makes!
In 1999, trading on the NYSE and on the regional markets was largely manual and floor-based. Those of you who were on the exchange floors might fondly recall feeling the pulse of capitalism on those floors — the chaotic waving and shouting and paper strewn everywhere. In contrast, today, all exchanges are operating trading systems that are largely electronic. Those exchange floors that still exist are vastly different today — they are populated by many computers and by traders using handheld devices. And, of course, trading on many other exchanges, as well as the ECNs and ATSs, is completely electronic. And most importantly, in the market as a whole we have faster execution speeds and much lower execution costs.
B. Nasdaq Market
Nasdaq, too, is vastly different today. Back in 1999, Nasdaq was an interdealer quotation system for the OTC market and was owned and operated by the NASD. Nasdaq basically served as a "big tent" for the trading of non-listed equities, thanks to the Order Handling Rules, which allowed ECNs to be linked to Nasdaq and to display their best market maker quotes or institutional orders. In essence, Nasdaq electronically linked market makers around the country. In 1999, market makers in Nasdaq National Market securities were required to participate in the Small Order Execution System ("SOES"), which provided automatic executions for small customer orders. At that time, SelectNet was the means by which market makers, ECNs and broker-dealers traded with one another. SOES and SelectNet, however, were not integrated, which limited access to liquidity and resulted in market makers facing potential dual liability.
In the past few years Nasdaq has been dramatically transformed. On the corporate front, Nasdaq is no longer owned and operated by the NASD. It is now a publicly-traded company. Nasdaq also has become a registered securities exchange and, as an SRO, has assumed responsibility for regulating its own market. On the trading front, in 2001, SOES and SelectNet were integrated into SuperSoes. Then, in 2002, Nasdaq launched its SuperMontage electronic trading platform, which replaced the old SOES and SelectNet System. SuperMontage permitted the display of trading interests at the BBO and two levels below the BBO. A few years later, Nasdaq merged with two ECNs — Brut first and then Inet. And, just last year, Nasdaq adopted the Inet trading technology as part of Nasdaq's single-book initiative. This technology further increased the speed of order executions and decreased latency. Today, instead of being the "big tent" for ECNs, Nasdaq and the ECNs are fierce competitors. Indeed, ECNs have achieved significant market shares in Nasdaq-listed stocks. In particular, BATs Trading, which was founded in 2005 in response to Regulation NMS and to the consolidation of markets, recently achieved approximately an 8.2% matched market share in Nasdaq-listed issues. Moreover, even the NYSE has now begun trading Nasdaq stocks.
C. SRO Governance
In 1999, all self regulatory organizations ("SRO"s) were structured as mutual, not-for-profit organizations owned by their broker-dealer members; none had public shareholders. Today, most SROs have demutualized. Demutualizing allows an SRO to more easily raise capital, to make necessary investments in technology, and even to make acquisitions of other markets.
Back then, all regulators were embedded within each SRO. When an SRO has a dual role of regulating its members, as well as serving them, conflicts may arise. These conflicts can result in poorly targeted SRO rulemaking, less extensive SRO rulemaking, and under-zealous enforcement of SRO rules against members. Today, the regulatory functions of each SRO is headed by a Chief Regulatory Officer and the board of each SRO is composed of a majority of independent directors. The recent merger of the NASD with the member regulatory function of NYSE Regulation is a shining example of the metamorphosis of market regulation. The merged entity, known as FINRA, is not faced with the tension between regulatory needs and commercial needs. FINRA also eliminates inefficient, duplicative, and conflicting regulation of the largest U.S. securities firms. So far, under the superb leadership of Mary Schapiro, the merger appears to be going well.
D. Global Alliances
In 1999, no U.S. market was affiliated with a foreign market. Today, our markets have become increasingly globalized. NYSE Group, the parent company of the NYSE, has combined with Euronext, to form NYSE Euronext. NYSE Euronext now comprises seven exchanges in six countries. One telling indicator of the importance of globalization is the fact that NYSE Euronext has an office in Paris — headed by Cathy Kinney, a Co-President of the NYSE. NYSE Euronext has even looked to Asia. Earlier this year, the NYSE purchased a five percent share in India's National Stock Exchange and also announced a strategic alliance with the Tokyo Stock Exchange. In addition, Nasdaq, after its unsuccessful attempt to purchase the London Stock Exchange, has recently joined with Borse Dubai to make a bid for OMX, which owns and operates exchanges in Sweden and six other countries. OMX also develops and markets systems for financial transactions used by the OMX Exchanges, as well as by other stock exchanges around the world. Given all of these changes, it is clear that the current pace of globalization will not end.
I am sure none of you will forget that, back in 1999, we were still the only country whose securities were quoted in fractions rather than decimals. Clearly the move to decimals was about much more than optics. While decimals were undoubtedly easier to comprehend, they more importantly permitted quotes at narrower increments, with resultant benefits to retail customers. This change also posed challenges to the industry. Traders had to adapt to a world in which there was far less liquidity at each price point. This made trading larger-sized orders more of a challenge. But, according to a study by the Government Accountability Office, overall trading costs for large investors have also declined. This quite significant infrastructure change came at a very opportune time, in retrospect. Given the steady march toward global trading, it is not difficult to imagine the problems and confusion we would have encountered if securities were trading in both decimals and fractions in a single venue.
F. Order Execution Quality
It is also hard to believe that just eight years ago, when a brokerage firm wanted data from a market center on the quality of the execution of the firm's orders, it was directed most often to the marketing department. There was no notion of execution quality statistics back then. All that changed in 2000 when the Commission adopted a rule that required market centers to make available to the public monthly electronic reports that include statistical measures of market quality and another rule that required routing broker-dealers to prepare quarterly reports that, among other things, identify the venues where orders are routed for execution. By providing this information, these reports have contributed to increases in execution quality and increased competition based on price. Moreover, these reports have provided data that has proved useful to regulators and academics in their study of trading and the impact of new rules.
G. Other Challenges Identified by the STA
Other challenges to the national market system identified by STA, in your very thoughtful White Paper, also were addressed over the past eight years. For example, there was concern that ECN access fees were hidden costs to accessing ECN quotations. These access fees distorted the true price available in the marketplace because they were not reflected in ECN published quotations. ECN access fees also impact the ability of market makers and order routing firms to obtain best execution, especially when the fees were passed along to customers. Now, Regulation NMS limits the fees that any trading center can charge for accessing protected quotations or manual quotations that are at the best bid or offer.
In 1999, STA members noted that locked and crossed markets were becoming "a problem of growing proportions in the NASDAQ market." At that time, locked markets often occurred when a market participant deliberately posted a locking quotation to avoid paying a fee to access the quotation of another market and to receive a liquidity rebate for an execution against its own displayed quotation. To address this inefficient behavior, Regulation NMS required each SRO to establish and enforce rules that prohibit its members from engaging in a pattern or practice of displaying quotations that lock or cross the protected quotations of other trading centers.
III. Transformation of the Options Markets
A. Multiple Listings
The changes in the options markets over the past eight years have been equally remarkable. Eight years ago, most actively traded options were listed on only one exchange. As a result, firms had no choice as to where to send a customer's order for singly listed options. This significant competitive issue was only resolved through the joint efforts of the Commission and the Department of Justice's Antitrust Division, as well as the timely entry of a new competitor — the International Securities Exchange. As a result, the options markets became more competitive, providing more efficient trading services and reducing transaction costs for customers. Today, all actively traded equity options trade on multiple markets.
The entrance of the International Securities Exchange in May 2000 — the first new exchange in over two decades — intensified competition in options. In addition to initiating intermarket competition by multiply-listing all of the most-actively traded equity options, the ISE introduced intramarket competition to the U.S. options market by permitting multiple market makers on the exchange to quote independently.
Greater competition among and within options exchanges for order flow has manifested itself in many ways. Most significantly, spreads are narrower. In addition, all of the options exchanges implemented new, electronic options trading systems, which enhance the efficiency, transparency, and liquidity of their markets. Exchange transaction fees for customers have all but disappeared. Spreads are narrower. Markets have expanded and enhanced the services they offer and introduced innovations to improve their competitiveness. In addition to narrowing spreads, multiple trading has led the options markets to implement market structure innovations designed to attract more order flow. In addition, the exchanges expanded access, allowed the automatic execution of broker-dealer orders as well as customer orders, and displayed the size of trading interest in quotations.
Before the multiple listing of options, there was no need for the options markets to be linked. Once multiple listing began, however, the lack of a linkage impeded price discovery and the ability of firms to obtain best execution of orders. Our work helped address this issue. In 1999, the Commission directed the options exchanges to file a national market system plan for linking the options markets. Then, in early 2003, the options exchanges began sending orders through a linkage designed to facilitate the routing of orders between exchanges. The intermarket linkage is based on the national market system principle that brokers should have the ability to reach easily a better price in another market to encourage efficient pricing and best execution of customer orders. The linkage provides market participants with an automated means for accessing the best prices in the options markets, no matter which exchange is offering those prices at a given time. Moreover, by discouraging market participants from trading at prices inferior to the NBBO, the linkage enhances price competition across markets. Therefore, the linkage helps to ameliorate some of the competitive and best execution concerns that payment for order flow and internalization raise.
C. Quote Rule
Market transparency in the options markets also has been enhanced in recent years. For example, in December 2000, the Commission amended the Quote Rule to apply it to options. Applying the Quote Rule to options was needed because broker-dealers needed to be able to rely on quotation information in order to make best execution decisions for their customers' orders and so that customers are able to make order entry decisions.
Another example where transparency has been enhanced is the display of information about the size of options quotes. Since its inception in May 2000, the ISE displayed quotations accompanied by size within its market. At that time, the Options Price Reporting Authority did not collect from the options exchanges and disseminate to quotation vendors the sizes associated with options quotations. In addition, the floor-based options exchanges did not independently display the sizes of their market participants' quotations. In response to the increased transparency offered on ISE's electronic system, the floor-based exchanges began to implement technology to disseminate quotations with size. OPRA enhanced its systems to collect and disseminate quotations with size from the options exchanges. In 2001, each of the options exchanges began disseminating the size associated with their quotations through OPRA.
So how did we make such tremendous strides in the past few years? It was done though a lot of hard work and cooperation and interaction between the regulators and the business side, who knew and understood the challenges. This cooperation and interaction resulted in key regulatory changes that arguably unleashed competitive forces and caused what may be a period of greatest change in the marketplace.
So, finally turning to the future — which is, of course, the focus of this conference — the question remains, what do all these events foretell about the future of the markets? It seems quite clear that the marketplace will continue to transform in countless ways. We will continue to experience enormous changes both domestically and abroad. And our challenge will be to remain vigilant in responding to those changes, while being especially mindful of the competitive challenges that U.S. markets face.
Surely one focus in the near future will be recognition of certain foreign regulators and relying, to a greater extent, on their oversight of exchanges doing business in the U.S. In recognition of the inevitable globalization of the markets, we will consider how foreign markets will be permitted to conduct business in the U.S. without registering with the Commission. These reforms have the potential to be very good for the markets and for investors. But we also must focus on our own regulations and be sensitive to any competitive disadvantages our rules may have on U.S. firms. There is certainly an opportunity to review our regulations and to minimize the costs and burdens to the extent possible. For example, we currently have a rule filing process for our registered exchanges that subjects most major proposals, including trading rules, to an approval process that requires full notice and comment. To the extent this rule filing process is slow, it potentially interferes with innovation or places the registered U.S. exchanges at a competitive disadvantage vis-à-vis ECNs and foreign markets. The Commission will need to carefully reconsider this process, perhaps by proposing changes that would provide for expedited treatment of proposed trading rule changes by the exchanges so that these securities markets will be able to innovate more quickly. And, finally, we will see continued focus in the future on the convergence of accounting standards (GAAP and IASB), as well as auditing standards, as global trading occurs.
I encourage you to continue to comment on these and other proposed initiatives. Continue to help regulators understand your trading models and the practical day-to-day trading operations. Continue to discuss broad concepts and principles. Continue to do what you are doing. And, most important, continue to innovate. You are a resilient group and I can confidently predict that your future looks bright.