Speech by SEC Staff:
The Securities Traders Association
70th Annual Conference and Business Meeting
"THE NATIONAL MARKET SYSTEM: FULFILLING THE PROMISE"
Annette L. Nazarethi
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
October 17, 2003
Good morning. I am delighted to be here to share my perspective of the critical market structure issues that the Securities and Exchange Commission is currently considering. As always, my remarks represent my own views and do not necessarily reflect the views of the Commission or my colleagues on the staff.1
As many of you know, the Commission is focusing its attention on the structure of the U.S. equities markets, with particular regard to the fairness and efficiency of those markets. In the 1970s the Commission received the Congressional mandate to develop and oversee the National Market System. In recent years, a spirited debate has developed concerning whether the current regulatory scheme has kept pace with advances in technology and changing market conditions. The question has squarely been raised - does the National Market System itself need to be completely retooled or simply modernized?
Recognizing the need to address this question fully and systematically, in late 2002 the Commission invited a full roster of investors, investment professionals, and academics to participate in a series of open hearings focused on market structure. The participants offered widely divergent views about the market structure challenges confronting the Commission today. The public hearings amply demonstrated that the Commission must make critical decisions in four key areas: (1) access to markets; (2) market data; (3) the self-regulatory model; and (4) the function of an exchange in the modern era.
Let me begin by saying that while there are important market structure issues to be addressed, I firmly believe our system of multiple, competing markets - on balance - has worked remarkably well. We have the world's most competitive and efficient markets. Competition among markets has fostered innovation and led to the creation of a broad array of trading platforms designed to meet the needs of different types of investors. New entrants, particularly those with fully electronic platforms, keep the pressure on established markets to innovate. New entrants also challenge our existing regulatory structures, however, much of which was created in the 1970s. Today, we are exploring whether vastly improved communications and processing technologies have opened up new possibilities to achieve our regulatory goals in a more efficient manner. As has always been the case in our competing markets model, our challenge as regulators is to promote the benefits of competition, while at the same time mitigating the negative effects of the fragmentation that can result when multiple markets simultaneously trade the same securities.
The optimal equity market structure, in my view, is based on several fundamental principles. First, I believe we should seek to achieve the benefits of competition while countering the effects of fragmentation through widely available market data, ready access among markets, price protection principles, and best execution standards.
Second, to the greatest extent possible, I believe we should let market forces determine outcomes by seeking to have the marketplace, rather than the government or its regulators, choose the "winners" and "losers." We must seek to provide a level playing field in which all markets can compete fairly and aggressively. That having been said, regulation is necessary in certain situations, such as when an exchange exercises monopoly power, or when externalities such as principal/agent conflicts obstruct otherwise competitive outcomes. Regulation is also appropriate when its benefits to the marketplace justify its costs and reduce market frictions, such as when settlement date standards or quoting conventions were established.
Finally, I believe that market transparency, fairness, and integrity are the sine qua non of our marketplace. These principles are fundamental. The importance that we place on regulation (including self-regulation), as well as the priority we place on investor confidence in our markets, is consistent with these principles.
With these general principles in mind, I will now discuss in some detail each of the major areas the Commission likely will consider in evaluating market structure: access to markets; market data; the self-regulatory model; and the nature of a national securities exchange.
II. Access to Markets
The overarching concept of access to market centers can best be understood in terms of three basic questions. First, what terms should we consider fair when imposed by market centers for granting access to their displayed quotations? Second, what fees should we allow these market centers to charge for granting access to their displayed quotations? Finally, when should we require that displayed quotations of market centers be accessed in order to protect the competitiveness of their displayed quotations?
A. Fair Access
One of the most important market structure issues on the Commission's agenda is continuing to ensure that access to markets is as fair and as efficient as possible. If best execution is to be achieved in an environment characterized by multiple competing markets, broker-dealers must be able to identify the location of the best available prices and obtain access to those prices routinely and efficiently. In contrast, a market center that is inaccessible does little to promote efficiency and fairness in the marketplace. We are evaluating means to update the National Market System so that investors can benefit from the rich diversity of trading systems and trading venues available, while enjoying the benefits of a truly National Market System where the best prices are available to all.
The Commission's approval of the NASD's ADF pilot program has brought the issue of fair access to the forefront. Rather than mandating access through "hard" linkages directly between markets, in the way that competing markets access each other in exchange-listed securities through ITS, competing ADF market centers obtain access to each other directly through privately negotiated access agreements. The ADF rules also contemplate market centers accessing each other indirectly through subscribers. Commission staff is evaluating whether such a rules-based linkage strikes the appropriate balance between the competing goals of fostering efficiency by establishing a centralized National Market System and at the same time enhancing competition among market centers. If this approach proves effective, the Commission could explore the possibility of applying it market-wide.
B. Access Fees
Inextricably linked with the issue of fair access is the issue of fees charged to reach the displayed quotations of market centers. As you know, through adoption of the Order Handling Rules and Regulation ATS, the Commission permitted ECNs to charge access fees to non-subscribers that access the displayed quotes of ECNs. In contrast, because of their ability to profit through proprietary trading, market makers have traditionally been prohibited from imposing additional access fees. Therefore, 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.
Many industry observers have questioned whether this disparity is still warranted for a variety of reasons. For instance, some argue that decimalization has compressed the NBBO and, in the process, converted many market makers from proprietary traders into agency traders. Thus, market makers should not be treated differently from ECNs, because the agency trading model resembles the ECN order-matching model in many ways.
Others have argued that, when the NBBO is set by an ECN and the ECN's quote does not reflect the access fee attached to it, the NBBO is artificially narrow. Market makers have expressed the concern that an artificially narrow NBBO hampers their ability to route an order to the market center that is, in fact, offering the best price.
It is also noteworthy that, because access fees have gradually shrunk to less than one cent per share in most markets, the imposition of the fees raises numerous concerns with respect to subpenny pricing. Many market participants have posited that the addition of subpenny access fees to displayed quotations would further encourage trading in subpennies, thus, exacerbating many of the problems that have recently been faced with respect to decimal pricing.
In short, many are concerned that pricing disparities caused by access fees may impede access between competing markets, raise trading costs, and create confusion about quoted prices. There are a number of potential solutions that the Commission may adopt, such as requiring that all fees be added to the displayed quotations of market centers, permitting fees of only a de minimis amount, or banning access fees outright. Be assured that whichever solution the Commission pursues, the ultimate goal will be to assure that access fees do not distort trading activity.
C. Price Protection
The third question concerning access that I posed earlier was: when should we require that displayed quotations of market centers be accessed in order to protect the competitiveness of their displayed quotations. Of course, I am referring to the issue of inter-market trade-throughs, which occur when orders are executed in one market at prices inferior to the prices displayed on another market. With respect to the trading of exchange-listed securities, the ITS rules apply, while no such inter-market price protection rules apply to the trading of Nasdaq-listed securities.
The ITS trade-through rule fosters interaction of orders between the exchange markets by providing one market a remedy if another trades at a price worse than the first market's displayed quote. Moreover, it provides traders some limited comfort that their displayed limit orders will not be disregarded by other markets and ensures that traders have an incentive to post increasingly competitive quotations in the National Market System.
Unfortunately, the ITS trade-through rule, as it currently stands, is fraught with problems. It was crafted at a time when the models of the competing markets were substantially similar, i.e., floor based. Today, it serves to favor legacy systems over faster, more innovative models. ECNs have consistently argued that their business model, which depends on the ability to execute matching subscriber orders in sub-seconds, is fundamentally incompatible with the 30-second turnaround time permitted by the ITS trade-through rule. They assert that sophisticated traders should be given the opportunity to minimize the market impact of large trades by choosing to trade immediately at a price that is inferior to the best displayed price in the National Market System.
The Nasdaq market is struggling with the mirror image of the same problem. Specifically, the Nasdaq marketplace has traditionally linked over-the-counter market makers electronically and guaranteed executions in a matter of seconds, if not sub-seconds. With the recent introduction of traditional floor-based exchanges into this market, such as the American Stock Exchange, the same types of issues have surfaced - how to integrate trading among competing market centers in a fair and efficient manner when the same securities are traded under radically different trading models.
I believe there is value in a trade-through rule that encourages a market to ship an order to another market to obtain a superior price. It promotes the posting of ever more competitively priced orders in the National Market System and it provides price improvement to investor orders that would otherwise be executed at inferior prices. The rule, however, should not be overly rigid and decidedly favor one market's business model over another. In my view, the rule should allow markets that offer immediate automated execution some flexibility through a de minimis rule to trade through the quotations of markets that do not offer immediate automated execution. Markets that offer immediate automated execution could not be traded through. Some consideration might be given to a customer "opt out" of the trade-through rule, although some believe that the benefits of encouraging the display of limit orders and protecting those orders should take precedence over an "opt out" option for sophisticated traders. As I noted, these principles are equally important for the inter-market trading of exchange- and Nasdaq-listed securities.
Thus, the challenge before the Commission is to devise a regulatory framework that allows faster markets and slower markets to co-exist within a single interconnected system. The Commission is currently examining a variety of solutions that would address trade-through issues for both the listed and Nasdaq marketplaces. I can say with some certainty that whichever route the Commission selects to take, it will not favor one market's business model over another.
III. Market Data
Another significant market structure issue that the Commission is considering deals with the collection and dissemination of market data and the impact of the market data regulatory scheme on market structure. The current system of market data collection and dissemination has been highly successful since its inception in 1975. It has assured that investors have real-time access to accurate, reliable, and affordable information from all significant U.S. market centers.
Since the 70's, we have seen a dramatic increase in the number of sources that produce valuable market data - that is, the number of market centers, including ECNs, that quote and trade exchange- and Nasdaq-listed securities has grown. In addition, the demand by both retail and professional traders for greater access to more data has surged. Despite these sweeping changes, the regulatory structure for market data, including how it is collected, disseminated, and priced, has changed very little. The end result is that the current regulatory structure is in need of modernization.
The Commission is sensitive to the important role that market data plays in our securities markets. It enables traders to make appropriate order-routing decisions and it has traditionally provided SROs with revenue to fund their self-regulatory operations. Under the current regulatory regime, market data revenues are distributed to SROs based solely on their reported trade volume. Indeed, in recent years, SROs have drawn as much as 45% of their total revenues from market data. This compensation scheme has created a financial incentive for SROs to capture market data revenue by reporting as many trades as possible. To compete for trades, SROs have offered aggressive rebates, which potentially distort the trade reporting function. Moreover, overly aggressive rebating by SROs has raised the concern that they could be left with insufficient revenue to regulate their markets effectively.
In 2002 the Commission determined that programs for rebating market-data fee proceeds to market participants were creating harmful incentives for traders to engage in transactions with no economic purpose other than to increase the amount of the market data revenues that they received. The Commission went so far as to abrogate the more extreme proposals of several markets that had sought to extend rebates of market data revenues to other market participants.
The Commission is in the process of analyzing these complex issues and hopes to put forth a proposal to modernize the system for collecting, disseminating, and pricing market data by late this year or early next year. We need to reward those markets and market participants that create and disseminate valuable data - particularly those that quote aggressively. The guiding principle will be to create a system that is as free as possible from economic distortions, while preserving the benefits of price transparency.
IV. The Self-Regulatory Model
Another matter of great importance that has received a significant amount of media attention of late is the effectiveness of the self-regulatory system of securities markets. A number of concerns have been raised about the current state of self-regulation, including SRO conflicts of interest, SRO governance, and inefficiencies in self-regulation.
Congress recognized through the Securities Exchange Act of 1934 that self-regulation has many potential benefits. Probably the most important is the synergy that can result from having regulatory staff imbedded within an SRO. Due to the complexities of securities trading and the speed with which potential problems can develop, it can be invaluable for regulatory staff to be immersed in the trading activity and immediately available to provide guidance on compliance issues. An SRO, however, has a considerable conflict of interest between its role as a market and as a regulator. The SROs compete with each other for order flow, members, and issuers, but at the same time serve as a critical link in the federal securities regulatory regime.
The Commission is currently in the process of reviewing the efficacy of self-regulation. Notwithstanding recent events, I believe we will remain fully committed to the notion of securities industry self-regulation. The Commission will look to the SROs to craft regulatory structures that leverage the benefits of having compliance personnel integrated within SROs, while creating sufficient barriers between commercial pressures and regulatory staff. Regardless of the structures adopted by SROs, they must vigorously fulfill their obligation to enforce their own rules and the federal securities laws and rules. The advent of for-profit, shareholder-owned exchanges introduces an additional level of complexity to the self-regulatory issue. Their objective of furthering the financial interests of their shareholders must not be allowed to impede their duty to protect investors by vigorously regulating their markets.
As part of the review of the self-regulatory structure and in light of recent events at the New York Stock Exchange, I believe the Commission must also undertake a thorough review of the SROs' governance practices. Because SROs are the front line enforcers of the federal securities laws and SRO rules, it is important that they lead by example. There are several governance issues that warrant further examination, including board composition and independence of directors; the independence and function of key Board committees; the transparency of the SRO's decision-making process; and the diligence and competence required of board and committee members.
V. Exchange Criteria
The last topic that I would like to address is what it means to be registered as a national securities exchange. An exchange is generally understood to be an order interaction facility where buyers and sellers of securities meet. The Commission has a strong regulatory interest in encouraging trading facilities to promote order interaction and price competition. For instance, the Commission has always required exchanges to have a limit order book in which better-priced orders take precedence and orders are, generally, exposed to the trading crowd for potential price improvement.
In contrast, the Nasdaq over-the-counter model features inter-dealer quoting competition and does not guarantee precedence to the best-priced dealer quote. Notwithstanding this market structure difference, Nasdaq has consistently asserted that it self-regulates its market as well as any exchange and that the public perception is that the Nasdaq Stock Market offers the same execution quality as any exchange.
The Commission is currently reflecting upon intra-market price priority in the context of Nasdaq's pending application to become a national securities exchange. There is some concern that, if Nasdaq is permitted to operate as a national securities exchange without intra-market price priority, other national securities exchanges will surely follow. Thus, the question that must be addressed now is whether intra-market price priority is important and whether investors' interests would be served if it was no longer offered by national securities exchanges. Clearly, these are key market structure issues that have implications well beyond Nasdaq's exchange application.
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In closing, I would like to reiterate that the market structure challenges that I have discussed today may shape the national market system for years to come. I look forward to continued dialogue with you and with the industry as a whole, which has contributed greatly to the Commission's consideration of these issues thus far.