Speech by SEC Staff:
Remarks before the SIA Market Structure Conference
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
New York City
May 21, 2004
It is a pleasure to participate again this year in the Securities Industry Association's Market Structure Conference. This year's conference is particularly timely given the lively industry dialogue on the Commission's proposed Regulation NMS. Today I thought I would briefly summarize the proposals. I will then share with you my perspective on the Reg NMS Hearings that were recently held here in New York City and what I took away from that event. As you undoubtedly know, the Commission recently announced its intention to extend the comment period on Reg NMS to June 30 and issue a supplemental request for comment in order to give the public a fuller opportunity to reflect on ideas raised at the NMS Hearing. As always, my remarks represent my own views and do not necessarily reflect the views of the Commission or my colleagues on the staff.
Proposed Reg NMS incorporates four substantive proposals that are designed to enhance and modernize the regulatory structure of the U.S. equity markets. First, the Commission proposed a uniform Trade-Through Rule for all NMS market centers that, subject to two significant exceptions, would require a market center to establish, maintain, and enforce policies and procedures reasonably designed to prevent "trade-throughs" the execution of an order in its market at a price that is inferior to a price displayed in another market. Second, in the Access Proposal the Commission proposed a rule that would modernize the terms of access to quotations and execution of orders in the NMS. The third proposal the Sub-Penny Quoting Proposal would prohibit market participants from accepting, ranking, or displaying orders, quotes, or indications of interest in a pricing increment finer than a penny, except for securities with a share price of below $1.00. Finally, in its Market Data Proposal, the Commission proposed amendments to the rules and joint industry plans for disseminating market information to the public that, among other things, would modify the formulas for allocating plan revenues to reward markets for more broadly based contributions to public price discovery.
The reasons for the Commission's focus on these particular issues are well known to most of the market structure aficionados in this room. Over the past decade, we have witnessed significant developments in our markets that warrant revisiting the national market system regulatory structure. For instance, advances in trading technology have led to a dramatic increase in the number and availability of alternative trading venues, particularly ECNs, and a fundamental tension exists between how these electronic trading models interact with the floor-based trading models of traditional exchanges.
As quoting and trading activity has spread across market centers, many market participants have employed order routing technology that more quickly and efficiently searches out and routes orders to desired liquidity pools. These changes have resulted in an overall increase in the speed of trading. Thus, the speed with which one market can access the prices displayed on another market has taken on increased importance as market participants place greater value on being able to access displayed prices quickly and efficiently. Institutional investors have been particularly vocal in stressing the importance of efficient executions. They argue that their exposed orders can impact the market and result in inferior prevailing trade prices for large orders. While technological advances have helped improve the overall quality of the U.S. equity markets, they also have highlighted differences in the structures of competing markets with regard to the type of access and the speed of execution they provide, especially as between fully automated and non-automated markets.
Currently, market participants must gain access to a wide variety of market centers to ensure that they attain the best possible price for their customers. If market participants are unable to access displayed quotations on fair terms, they may be unable to obtain the best possible prices and unable to satisfy their "best execution" obligations. Thus, the efficiency with which published quotations can be accessed has become critical to the efficient operation of the National Market System.
Closely linked with the issue of fair access is the issue of fees charged to reach the displayed quotations of market centers. Depending on who has posted a particular quotation, a displayed price may represent the actual price that a customer will pay or it may represent only a base price to which an undisclosed access fee will later be added. Pricing disparities caused by access fees can impede access between competing markets, raise trading costs, and reduce the transparency of quoted prices.
With respect to market data, since the 1970s there has been a dramatic increase in the number of market centers that produce market data and a surge in demand for market data on the part of both retail investors and professional traders. Despite the sweeping changes that have occurred, the regulatory structure for market data, including how it is collected, disseminated, and valued, has changed very little. Of particular relevance is the fact that the market data compensation scheme has created a financial incentive for SROs to capture market data revenue by maximizing reported trade volume. The overall impact is that the current regulatory scheme for market data collection, dissemination, and valuation is sorely in need of modernization.
Finally, the conversion in April of 2001 to trading in pennies has benefited the public generally, but has given rise to a variety of concerns, including with regard to the practice of "pennying" by limit order users. The rapid growth in sub-penny trading has exacerbated this concern. Preliminary economic research suggests that market participants may use sub-penny quoting primarily as a means to "step ahead" of competing limit orders for an economically insignificant amount. Were the use of sub-penny quotes to become more widespread, it would raise concerns about market depth, the incidence of stepping ahead, and the incidence of so-called "flickering" quotes.
In addition to our general awareness of these market developments, the Reg NMS proposal resulted from considerable fact-finding efforts by the Commission. For example, the Commission issued concept releases on sub-pennies and market data. It also established a federal advisory committee on market data. And in late 2002 the Commission invited two panels of investors, investment professionals, and academics to participate in open hearings dedicated to market structure. In putting forth the proposal, Chairman Donaldson articulated very clearly that the Commission was proposing a complex set of regulations and that it was seeking active industry participation during the comment period. The Commission's public NMS hearing in New York City on April 21st gave the Commission the opportunity to hear directly from market participants the arguments and counter-arguments on the proposals.
In my view, a significant development at the NMS Hearing was the intention expressed by various representatives of exchanges with traditional trading floors to establish auto-ex facilities in the coming months that will offer automatic execution of orders seeking to interact with their displayed quotations. Panelists also stressed that the essential element of an effective auto-ex facility is an immediate automated response one without any manual intervention to the router of an incoming order. The response must be either that the order was executed (in full or in part) or that it could not be executed (because, for example, a prior incoming order already had executed against the displayed quotation). Although the exchange representatives acknowledged the challenges posed by developing an efficient hybrid market one that integrates an active trading floor with an auto-ex facility they emphasized that they were well advanced in their efforts. They indicated that such facilities are likely to become operational within a time frame that could precede any potential implementation date for Reg NMS, should the Commission decide to adopt the proposals.
In addition, panelists at the NMS Hearing noted that existing order routing technologies were capable of identifying, on a quote-by-quote basis, indications from a market center that a particular quotation was not accessible through an auto-ex facility. The ability to display such a quotation potentially would seem to give exchanges with trading floors flexibility to integrate effectively the trading floor with an auto-ex facility. Rather than being classified as "fast" or "slow," as was proposed, markets would be allowed to offer choices to investors. In those particular contexts, when a market's quotation was not accessible through an auto-ex facility (for example, to provide an opportunity for the floor to generate additional price discovery or price improvement), the quotation could be identified as such, enabling market participants to make order-routing decisions based on that information.
The near-term prospect that quotations displayed in the NMS may be predominantly accessible through auto-ex facilities, but with some flexibility for markets to offer investors the choice of manual trading, potentially has very significant consequences for the rules proposed under Reg NMS. Some of the most complex issues raised by the proposals, particularly those relating to trade-throughs, access, and market data, derive from the problem of accommodating both auto-executable and manual quotations within the NMS. To the extent these traditional exchanges with trading floors realize their intentions to establish automatic execution functionality, there could be a potential solution to this concern.
The NMS Proposal recognized that there are differences between the speed and certainty of response in electronic (or automated) versus manual (or non-automated) markets. To provide flexibility to market centers with different market structures, the Commission proposed an exception from the general trade-through rule to allow an automated market to trade-through a non-automated market up to a certain amount. Many panelists at the NMS Hearing agreed that the distinction between an automated and non-automated market a market that provides immediate access to its quotes through automatic execution and one that does not is important, and that market participants should be able to trade-through a manual market. Panelists at the NMS Hearing, however, expressed the view that the distinction could, and perhaps should, be made between manual and automated quotes, rather than manual and automated markets. This is an interesting variation on the Commission's proposal and one that I believe deserves further consideration.
Several panelists at the NMS Hearing expressed the view that the concept of an "automated" market or quote must encompass an immediate automated response to the order router as to what action was taken with respect to the order. In other words, certainty as to whether an order can immediately interact with a particular quote knowing instantaneously whether an order was executed (in full or in part) or cancelled is key. Some but not all panelists at the NMS Hearing also advocated imposing a maximum response time such as one second or a quarter of a second on automated order execution facilities.
In the proposing release, the Commission requested comment on the amount by which a market should be allowed to trade through a manual market. Some panelists at the NMS Hearing expressed the view that a market center should be allowed to trade-through a manual market by an unlimited amount. One panelist stated that the ability to trade-through a manual market has to be "unfettered" because of a concern with the practicality of complying with and surveilling for compliance with the tiered approach, given the incidence of flickering prices in today's market. Specifically, the tiered approach looks to the NBBO of the security at the time of execution for purposes of determining the allowable trade-through amount. The notion that there should be no limit on the ability to trade through a manual market is something that may merit further consideration.
Panelists at the NMS Hearing were split about the need for an opt-out exception. Some expressed the view that there would be no need, or valid policy reason, to allow a market to trade through an automated market or automated quote of another market. In addition, as I alluded to earlier, representatives of two floor-based exchanges have publicly expressed the intent to take the necessary steps to become automated for purposes of the proposed exception to the trade-through rule. Thus, some panelists raised questions as to whether, if the Commission were to adopt an exception to the trade-through rule for manual quotes, the proposed opt-out exception would still be necessary or desirable. I would be interested in knowing what others think of this idea.
The Access Proposal includes three primary parts: standards for market access, limitations on access fees, and standards to address locked or crossed quotations. Panelists at the NMS Hearing indicated that, in spite of the proposed changes, access could remain a problem at relatively inactive ATSs or market makers with little trading volume whose quotations were displayed only in the ADF. Market participants could obtain access to such quotations only through direct connections with the particular ATS or market maker. Panelists suggested that such an entity should be required to publish its quotation in an SRO order execution facility, at least until its share of trading reached a point where the cost of direct connections with multiple market participants would not be out of proportion to the entity's level of trading. I would be interested in knowing what others think about this issue. Alternatively, SROs without an order execution facility could be required to ensure that any potential quoting market participant has established direct connections to a critical mass of market participants, before publishing that quoting market participant's quotations.
In this regard, the proposing release requested comment on how other aspects of proposed Reg NMS would be affected if the Commission ultimately determined not to limit access fees to a de minimis amount. In the discussion of the trade-through proposal, for example, comment was requested on whether, if fees were not limited, quotations with fees of greater than a de minimis amount should be excluded from protection under the trade-through rule. In addition, the discussion of the market data proposal noted the close connection between the issue of limiting access fees and allocating market data revenues based on a market's quotations. Comment was requested on whether, if fees were not limited, quotations with greater than de minimis fees should be excluded from an allocation of market data revenues.
I would be interested in knowing what alternative measures others believe potentially could be adopted if the Commission determines not to limit access fees to a de minimis amount. In particular, should quotations with high fees be treated differently than quotations with de minimis fees for purposes of the other proposals? The differing treatment could reflect the fact that, for example, a $10.00 quotation with a high fee is not equal to a $10.00 quotation with a de minimis fee. Quotations with fees of more than a de minimis amount could be identified as such in the consolidated data stream, analogous to the identification of quotations not accessible through an auto-ex facility as I previously mentioned. Such high-fee quotations could be excluded from protection under the trade-through rule, eliminated from the allocation of market data revenues, and subject to locking quotations from market centers with de minimis fees.
As to the market data proposal, at the NMS Hearing, the market data panelists focused primarily on two issues -- the level of market data fees and the complexity of the proposed formula for allocating market data revenues to the SROs.
Several panelists at the NMS Hearing addressed the current level of fees charged by the market data networks and questioned whether such fees remain reasonably related to the cost of market data. They expressed concern that the market data proposal does not address this issue. As you know, an extensive public record has been developed on this issue over the last five years. This record includes the Commission's 1999 Concept Release on market information fees and revenues, the public comments received in response to the Concept Release, and the 2001 report of the Commission's Advisory Committee on Market Information. There continues to be interest in this issue, although, as the record indicates, it is a very complex issue and one that could have a substantial impact on the economics of self-regulation.
In addition, at the NMS Hearing, some panelists questioned the complexity and cost of the proposed formula for allocating market data revenues to the SROs. If in the future displayed quotes for NMS stocks may be predominantly accessible through auto-ex facilities, then there may be an opportunity for simplifying the formula. For example, as proposed, the calculation of an SRO's Quoting Share, which rewards markets for the time and size of their quotes at the NBBO, would include an automatic cut-off when quotes that are not fully accessible through automatic execution are left alone at the NBBO. The purpose of the automatic cutoff for manual quotes was to minimize the reward for quotes that could be stale if they are in the process of being manually updated. If only quotes accessible through an auto-ex facility were considered in the allocation of market data revenues, this might eliminate any need for the formula to include an automatic cutoff applicable to manual quotes.
My own view is that the difficulty and cost of implementing the proposed formula may have been overstated at the NMS Hearing. No additional data would be necessary to calculate the formula beyond the quote and trade data that already is disseminated by the network processors and stored by data vendors. The formula would not need to be calculated in real-time, nor would anyone other than the network processors and other industry participants need to deal with the formula directly. Consequently, it does not appear to me that adoption of the proposed formula would impose any additional "downstream" systems costs on vendors or broker-dealers. Nevertheless, it appears to me that many of the panelists were more focused on the level of the market data fees rather than how the fees currently are distributed among market centers.
While these market structure proposals have generated a great deal of attention, there are additional efforts ongoing at the Commission to address other market issues namely, the need for improved transparency and governance standards at our SROs. As many of you know, in March of 2003, Chairman Donaldson wrote each of the SROs, asking them to review their governance practices in light of the standards that had just been proposed for listed companies in connection with the Sarbanes-Oxley Act. In that letter, the Chairman noted that, just as the NYSE and Nasdaq were demanding that publicly-traded companies meet high governance standards in order to list on their markets, SROs must demand the same standards of themselves. Furthermore, each SRO was asked to undertake an exhaustive review of its governance procedures. In response, each SRO submitted a written report that detailed its governance practices and revealed some areas that appeared to be in need of improvement. Since that time, various SROs have convened special governance committees with mandates to examine the strengths and weaknesses of their SRO governance practices.
At about the same time, the NYSE's extension of its Chairman's employment agreement, as well as its substantial payout of his accrued compensation became widely publicized. In short, there appears to have been a lack of transparency at the NYSE regarding the operation of its Compensation Committee and the nature and substance of its review of compensation matters. It may be that had there been broader dissemination of information regarding executive compensation at the NYSE, the compensation would not have reached such extraordinary levels. Ultimately, late last year the Commission approved significant governance changes at the NYSE.
As the NYSE compensation issue unfolded, Chairman Donaldson again wrote to the heads of each of the SROs to ask for more details about the extent of public representation on their Boards and key Committees (including the Compensation Committee); the decision-making processes with respect to the nomination of directors, their assignment to Committees, and the compensation of executives; and the SROs' past practices and current plans for public disclosure of these processes and the compensation arrangements of key executives.
Additional concerns about the NYSE's regulatory function were raised by the recent findings of securities law violations by five NYSE specialist firms. The NYSE's and all SROs' substantial role, as a marketplace and as a regulator, makes it imperative that their own governance structure be a model of good governance practices. To address these issues going forward, Commission staff now has conducted a comprehensive review of SRO governance and transparency. It is my belief that SROs should comply with substantially all of the transparency and disclosure requirements of public, listed companies. We expect to develop a recommendation for the Commission's consideration in the near future regarding a proposed rulemaking that would address SRO governance and transparency, including Board independence, regulatory function independence, regulatory funding, governance processes, executive compensation, and management structure.
Another area related to transparency that the Commission staff is completing its review of relates to the amount and quality of surveillance data that the Commission receives on a regular basis from the SROs. By enhancing the regular flow of key information from the SROs, the Commission could potentially be in a better position to see red flags as they develop and sense when the self-regulatory process is breaking down.
In closing, I want to emphasize that the changes being proposed by Reg NMS, and indeed all of our market initiatives, are critical to our capital markets. An efficient and fair secondary market for equity securities is a vital component of our capital raising system, and investor confidence in the ability to get a "fair deal" underpins all other parts of our equity markets. With that in mind, I urge all of you to continue to play an active role in the policy-making process and to take advantage of the extended comment period for Reg NMS by letting the Commission know your thoughts on the issues I have touched upon today. I am heartened by the thoughtfulness of the dialogue that has taken place on these issues thus far. And I remain confident that together we can craft a regulation that will ensure the preeminence of our market structure for the years to come.