Statement by SEC Chairman:
Opening Statement at Commission Open Meeting of April 6, 2005, re: Regulation NMS
Chairman William H. Donaldson
U.S. Securities and Exchange Commission
April 6, 2005
The next and final item on our agenda is a recommendation from the Division of Market Regulation that the Commission adopt Regulation NMS. Regulation NMS is an integrated set of reforms designed to strengthen our national market system for equity securities. The Commission is acting pursuant to the mandate Congress gave us in 1975 to use our rulemaking authority to further the goals of the national market system – among them to enhance competition among markets and to enhance opportunities for the interaction of investor orders.
Regulation NMS covers four primary topics: trade-throughs, access to markets, sub-penny quoting and market data. The trade-through proposal would reinforce the fundamental principle of obtaining the best price for investors when that price is represented by automated quotations that are immediately accessible. The market access proposal would promote fair and non-discriminatory access to quotations displayed by NMS trading centers. The sub-penny proposal would establish a uniform quoting increment of no less than one penny for quotations in most NMS stocks in order to promote greater price transparency and consistency. And the market data proposal would amend the allocation of market data revenues to SROs to better reflect their contributions to public price discovery.
Because so much of the debate over our proposals has revolved around the trade-through rule, I will focus my introductory remarks on this topic.
Overview of Process
Before turning to the specifics of the trade-through proposal, I’d like to comment on the process that has brought us to the adopting stage today.
Regulation NMS is the product of more than five years of thorough study and hard work by the Commission and its staff and an ongoing dialogue with investors, the industry and the public. Prior to formulating the specific proposals, the Commission’s review included multiple public hearings and roundtables, an advisory committee, three concept releases and the issuance of temporary exemptions intended in part to generate data on policy alternatives. This process continued after the Commission published the proposals for public comment in February 2004. We held a public hearing on the proposals in April 2004, following which we published a supplemental request for comment to give the public an opportunity to respond to important developments at the hearing. The public submitted more than 900 comment letters on the original proposals, encompassing a wide range of views.
The insights of the commentators on the proposal, as well as those of the NMS hearing panelists, contributed to significant improvements to our initial proposal. Consequently, rather than immediately adopting rules, the Commission reproposed Regulation NMS in its entirety in December 2004 to afford the public an additional opportunity to review and comment on the details. In response, the Commission received more than 1,500 additional comments, the great majority of which were generated by letter-writing campaigns. All of the comments received by the Commission have informed the proposal now before us.
Throughout this process, our proposal on trade-throughs has evolved in significant ways, although our objective has remained steady. Our objective all along has been to discard the outmoded Intermarket Trading System, or ITS, trade-through rule, which applies only to listed securities and which contains significant loopholes, and to examine whether the national market system would benefit from a consistently applied trade-through rule that remedies the existing rule’s failure to distinguish between electronic and human-intermediated quotations. This failure has, over the years, contributed to a lack of robust market-center competition in the listed market. This is an ironic and unintended consequence of the ITS rule, which, at the time it was adopted, was regarded as pro-competitive because it required the New York Stock Exchange to route an order to a regional exchange if the regional displayed a better quote.
In this regard, the first-level question before the Commission today is the same as that before the Commission in February 2004, and that is whether to act or to do nothing. The path of least resistance for us would have been to do nothing. That might have pleased the floor-based exchanges because it would have left the existing ITS rule in place, and it might have pleased the electronic marketplaces trading Nasdaq stocks and many in the broker-dealer community because they would continue to have been able to conduct business in the usual manner. The only losers would have been investors.
Regulation can enhance competition, and regulation can impede competition. A regulation like the ITS rule designed to enhance competition can, over time, turn into an obstacle to competition. This is no paradox; instead, it is a natural consequence of changing markets. It is the Commission’s continual duty to examine the rules and regulations that govern the markets and to ask whether they advance or inhibit competition. If we find that a rule inhibits competition for no good reason, then we must act to abolish or reform it. Reform is the appropriate course when we believe in the principles underlying the rule, and we can further those principles in a way that does not unnecessarily or heedlessly impinge on competition.
So in February 2004 we proposed to supplant the old ITS rule with a rule that would remedy the failure to distinguish between inaccessible, non-automated quotes and immediately accessible, automated quotes, that would close the gaping holes in the ITS rule’s coverage, and that would strengthen the weak “satisfaction” remedy provided in the ITS plan. The February 2004 proposal did this by including an “opt out” in order to give investors the power to bypass quotes that might not be truly accessible. We recognized that the opt-out remedy had a significant drawback, however, in that it was susceptible of being used to ignore quotes that were in fact immediately accessible, and thus could inadvertently create a disincentive for the display of aggressively priced limit orders. Nevertheless, we felt that an opt-out was an appropriate way to address the anti-competitive effects of the ITS rule and its tendency to shield floor-based markets from the need to innovate.
A few weeks later, at an April 2004 public hearing we held on Regulation NMS, representatives of the major floor-based exchanges announced plans to significantly increase the volume of electronic trading in their markets. The profound impact that this development will have on established ways of doing business on the floor-based exchanges has perhaps been underappreciated in the debate over the trade-through rule.
In response to this announcement, we issued a supplemental request for comment on whether an opt-out would be necessary if our trade-through rule only protected electronic, immediately accessible quotations. Although there was resistance from some brokers and traders, the overwhelming majority of investors approved of the idea.
So in December of last year we sought comment on two alternative forms that a trade-through rule could take: one that would protect only the best quotes of a market center – the “top-of-book” – and another that would protect quotes further down the book that are voluntarily displayed – the “depth-of-book.” The second option, known as the “voluntary depth alternative,” drew a mixed response. The Commission listened carefully to these comments, and today’s proposal reflects the top-of-book alternative – an approach that I believe strikes the right balance between market competition and order competition, while at the same time providing incentives to all market centers to improve their speed and efficiency.
The comprehensive, transparent and iterative process I have just described is in the best tradition of Commission rulemaking. We have done our work, and the time has now come for us to act.
Benefits of the Proposed Trade-through Rule
Turning to the specifics of the trade-through proposal before us today, I would like to make two basic observations.
First, in formulating this proposal, we have kept our eye on one overriding objective – the protection of investors – with particular attention to the concerns of small investors. The thrust of the proposed trade-through rule is actually quite simply stated: when an investor sends an order to a market, the market can either execute the order at the best price then electronically accessible in the national market system, or the market must send the order to the market that is quoting that price. There are two key implications of this rule. First, a broker executing an order will necessarily obtain for that order the best price then immediately available in the market, even if the broker internalizes the order or would prefer to trade in a different market with an inferior price. And second, it means that an investor who is willing to place an aggressive limit order on the book will not have his order ignored in favor of a less aggressive order. So the trade-through rule is, in the most fundamental sense, a rule that protects investors.
The second observation I’d like to make is that the proposed trade-through rule is pro-competitive – in the best tradition of the market-reform initiatives that the Commission has spearheaded over the last several years. Much of the public debate over the trade-through rule has focused on one type of competition – competition between markets. But there is another aspect of competition that is critical to the success of our markets, and that is competition between the orders of investors. Some of the powerful market centers and professional traders most vocal in this debate seem to downplay order competition. But one of the greatest strengths of the U.S. equity markets is that the trading interest of all types and sizes of investors is integrated into a unified market system. Such integration ultimately works to benefit both retail and institutional investors, which I believe is why they overwhelmingly favor today’s proposal. The proposed trade-through rule would strengthen the confidence of all types of investors in the U.S. equity markets.
Many of those who would prefer that we do nothing, or, alternatively, that we simply abolish the existing ITS trade-through rule, couch their arguments in free-market principles that, at an abstract level, are easy to agree with. It is argued that government should simply withdraw and let market forces operate, and that the market will drive to the optimal outcome for all.
Although this argument downplays market features such as the persistence of conflicts of interest, free-riding and unequal bargaining power among different kinds of investors, it is a point of view that we must always weigh carefully before intruding into market processes. But beyond the superficial appeal of this argument, it is important to realize just what a sweeping and indiscriminate proposition it is – particularly in the context of our securities markets – and to remember that public policy in this country has for more than 70 years taken a much more nuanced approach. In establishing the national market system, Congress recognized that government regulation can work in important ways to enhance competition among market participants. Indeed, many of the Commission’s rules have served investors by breaking down discriminatory barriers to competition. A good example is the Commission’s order handling rules, which we adopted a few years ago in the midst of similar controversy. It’s fair to say that the order-handling rules have been a remarkable success for investors by lowering the spreads they pay for order execution, and, despite the heated rhetoric of those days, the last time I checked there was no grass growing on Wall Street. It is ironic, to say the least, that many of the voices once raised in opposition to the order-handling rules are now rallying to denounce the trade-through rule. Structural change, even much-needed reform, is never easy and is never welcomed by all.
Response to Criticisms of the Trade-through Proposal
I’d like to offer a few thoughts about some of the commentators’ specific concerns over our trade-through proposal.
A number of commentators have argued that the Commission’s studies do not reveal a problem big enough to justify this reform. I have never thought that policymaking is as simple and straightforward as compiling a set of statistics and asking whether they unambiguously call for a new rule. Economic evidence must inform the policy judgments that we make, of course, but economic evidence isn’t a substitute for judgment itself. I have read the staff’s economic studies, and I have read the analyses and critiques of these studies offered by those who oppose our decision today. I believe the staff has the better of the argument. So what do these studies say? They tell me that while both primary equity markets have great strengths, they both have weaknesses that could be improved with enhanced incentives for order display. The studies also tell me that the problem of trade-throughs is a real one, particularly for small investors who cannot easily monitor the behavior of their agents.
I return to two simple propositions. First, I believe that investors, by and large, are most concerned with price when they buy and sell stocks. I know that there are some market professionals who, given the choice between a faster execution and a minor difference in price, will choose speed, but that does not mean that price is not the predominating factor. Our statistics show that nearly one in 40 Nasdaq trades, and one in 30 internalized trades, is executed at an inferior price. Broker-dealers frequently internalize trades for their retail clients, so it seems to me that small investors, particularly, would benefit from a rule that guarantees them the best price on every execution.
Some might say: so what? Is it really a problem if only one in 40 trades is poorly executed? To them I would say: yes, it is a problem. I can think of no other area of the securities laws where we would consider it beneath our care to focus on a problem that only occurs once in 40 times.
Second, I believe in encouraging limit orders, and I am concerned about the investor whose better limit order is bypassed by that fortieth trade. This occurs about 98,000 times a day in the Nasdaq market alone. Better protection for limit orders will result in increased displayed depth and liquidity in the markets and thereby reduce transaction costs for a wide spectrum of investors. While estimating the precise extent of these liquidity benefits is difficult, that is no reason to ignore the enormous potential benefit for investors and for the capital formation process that can be earned by improving the depth and efficiency of the national market system.
Another critique suggests that the Commission is choosing one business model over another. There is a grain of truth to this – the Commission is in fact rejecting business practices that are predicated on ignoring the best prices in the national market system or refusing to deal with immediately accessible quotes. But the argument that the Commission is mandating a one-size-fits-all trading model is simply another example of the exaggerated rhetoric that has accompanied this debate. Under the trade-through rule as adopted, exchanges, ECNs and order-routers will be free to compete with one another on any basis they wish so long as they continually respond to the best prices that are immediately available in the market. A market center’s response to the best price can take more than one form – it can improve its price to match the best immediately accessible price or it can route all or a portion of its order to interact with the better quotation. The only thing the market center must not do is ignore the better price.
A related argument is that the Commission is creating a ready-made business model for any market center that can display a better quote. If that quote is immediately accessible, then I question whether there is anything fundamentally wrong with encouraging aggressive quoting by as many competing market centers as possible.
Some commentators have cautioned us against the risk of unintended consequences. This is a real risk whenever we interfere with market processes and not a risk that we disregard or take lightly. As I will expand on in a few moments, we intend to monitor the implementation of the trade-through rule closely and we will fine-tune the rule if the need arises.
Other commentators have questioned the need for a trade-through rule so long as brokers have an independent duty of best execution. If brokers are serving the best interests of their clients, shouldn’t brokers and their clients be free to choose any execution venue they wish? The answer to this is that best execution and the trade-through rule are designed to address similar problems from different angles, and the trade-through rule provides a critical backstop to a broker’s duty of best execution. Although all brokers owe a duty of best execution to their customers, the interests of agents and their principals often conflict, and a broker may have a strong financial interest in routing orders to a particular market, even if it is offering an inferior price.
Moreover, the duty of best execution is not one that can easily be monitored by investors or enforced by regulators on an order-by-order basis – indeed, in recognition of this difficulty, neither we nor the SROs have ever done so. Thus the argument that we should focus on best execution instead of adopting a trade-through rule is really an argument that we should do nothing and let things continue as they are. By placing a separate duty on markets centers to prevent trade-throughs, the Commission’s rule would affirm the principle of best execution on an order-by-order basis and thereby strengthen the protection of investors.
Before concluding, I’d like to speak for a moment about the implementation process for the trade-through rule, and about our plans for administering it on an ongoing basis. Having set the minimum standard that, to the extent reasonably possible, ensures order interaction at the best available price, we do not believe it necessary or appropriate for the trade-through rule to further impact competitive decision-making by market participants or to further involve regulators in that process. This is a rule that should promote better outcomes for investor orders, enhanced liquidity in the marketplace and innovation in serving investors’ needs. We intend to implement and administer the rule with these goals firmly in mind. This will necessarily be an iterative process in which the Commission and the industry will work as partners to implement the rule in the most efficient and least disruptive manner possible.
In recognition of the importance of this partnership, we have not structured the rule as a flat prohibition of trade-throughs, because we understand that in a dynamic marketplace, some level of trading through better quotations may be unavoidable. We do not believe that a trading center should feel compelled to install over-inclusive barriers that could interfere with efficient trading in an effort to avoid every appearance of a trade-through With this concern in mind, we have structured the rule as a requirement that trading centers design and enforce policies and procedures that are reasonably designed to prevent trade-throughs. The emphasis is on the word “reasonable.”
As trading centers begin their implementation efforts, we fully expect that a variety of practical issues will arise. The Commission and its staff will work intensively with individual firms, industry associations and SROs in order to understand the practical problems encountered in upgrading systems in order to meet the rule’s requirements. We and the staff will communicate with the industry on a regular basis as we work through the process of identifying and establishing the parameters of the policies, procedures and system upgrades reasonably necessary to prevent trade-throughs. Given the multiplicity of trading venues, this will not be a one-size-fits-all solution, but all parties should benefit from robust and ongoing communications about problems being encountered and solutions being discovered.
In order to give all parties adequate time to plan, we have established a date in April 2006 to begin implementing the rule. The implementation will be staged to allow the Commission and the industry to watch for unforeseen problems before the rule applies to all stocks. As the roll-out progresses, the Commission will closely monitor whether the rule is having unintended consequences that give rise to a need to make modifications.
After the rule goes into effect, the Commission will also monitor the effectiveness of the rule in terms of reducing trade-throughs and enhancing displayed depth. It may not be realistic to expect immediate and dramatic improvements. Instead, we expect that the number of trade-throughs will decrease over time as trading centers gain experience with the circumstances that produce trade-throughs in their markets and are able to modify their systems, policies and procedures to prevent any patterns that develop. As trade-through rates gradually decline and investors begin to experience the certainty of enhanced order protection, we expect a gradual increase in the willingness of investors to place limit orders on the books.
In conclusion, I consider this is a signal day for the Commission. We are addressing a complex set of problems that have lingered in the marketplace for years, that have caused substantial discord among market participants and that have resulted in inferior outcomes for investors.
Our actions today will, I am certain, irritate a handful of influential interests who are able enough to couch their arguments in broad principles with which can all agree – the desire to avoid excessive government regulation; the desire to provide investors with choice; the desire to avoid unintended consequences. But beyond this high-minded rhetoric lies a core value of the Securities and Exchange Commission: protecting the interests of America’s investors. It is these interests that are reflected in the Commission’s rulemaking today.
I would like to thank the staff in the Division of Market Regulation, particularly Annette Nazareth, Bob Colby, David Shillman, Elizabeth King, Dan Gray, Heather Seidel, Steve Williams and Michael Gaw, for their unflagging efforts on these complex proposals. I would also like to thank the Office of Economic Analysis, the Office of the General Counsel, the Division of Enforcement and the Office of Compliance Inspections and Examinations for their contributions.
Annette, would you please give us the details of the proposals?
Check against delivery