Speech by SEC Commissioner:
Remarks at Conference on Institutional Equity Trading
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
December 11, 2003
Thank you, Steve, for your introduction. It is truly a pleasure to be here with you today and to see so many familiar faces in the room.
Before I begin, I must note - as my staff always insists that I do - that the views I express here today are my own and do not necessarily reflect those of the SEC as an institution or of the other Commissioners.
Over the past couple of months, I have been fortunate enough to travel to Egypt and China as a representative of the Securities and Exchange Commission. I highly recommend trips to developing countries because they help to reinforce what we take so much for granted in the United States - particularly the developed state of our capital market system. These countries are in the complex process of building their own capital market infrastructure, and are confronting the challenges of building confidence in the integrity of that infrastructure and ensuring adequate investor protection. The evolution of our capital markets system was largely a natural process, built through competition and a strong legal foundation. We owe the strength of our own markets to the core concepts of private property, transparency, our laws of contract and ethical principles, and the free flow of information, all of which act as catalysts for capital formation. Developing countries that do not have that kind of foundation are facing an uphill battle.
I salute the New York Stock Exchange and Duke for putting on this conference. It is a timely discussion of issues that just cannot, and should not, be ducked any longer. I like to joke with my colleagues that there are only a handful of people in the country who know or care about these market structure issues. I am glad to see quite a bit of that handful here.
This evening I would like to take a closer look at our own system of market structure and discuss some of the issues that the SEC needs to address in order to ensure that our capital markets remain the most vibrant in the world. Before turning to the issues facing the U.S. market, let me first review some history that I believe will help put some of today's issues in perspective.
A Short History of Securities Regulation
Well… in the beginning there was the Securities Exchange Act of 1934. Actually, what I should say is that in the beginning there was the New York Stock Exchange, regardless of what the New Dealers would have you believe! The Exchange Act initially brought government oversight to the operations of the markets after the 1929 stock-market crash. This nearly 70-year old law remains the fundamental underpinning of our capital markets structure today.
Following the passage of the law, the SEC maintained a relatively hands off approach to regulating market structure issues for the next thirty years. The growing presence of institutional investors, the market break of 1962 and the existence of fixed commissions brought operations of the markets back into the SEC's sights. During the 1960s, institutional investors began to demonstrate their tremendous power to effect change in market structure. Institutional investors, acting in the best interests of their beneficiaries, entered into a battle against Wall Street to remove the fixed rate commission structure. At that time, the SEC was charged with approving rate increases for the brokerage industry if the SEC found them "reasonable".
The SEC conducted a Special Study in 1963 that identified the anticompetitive problem of fixed commission rates. But, the SEC took no immediate action. Institutions took matters into their own hands by entering into special arrangements with brokers to recoup a portion of the excessive brokerage costs-- they had the market power to demand a better deal. As institutional volume continued to grow, the NYSE intervened on behalf of its members and refused to allow member firms to participate in these special rebate arrangements with non-member firms. Institutions nonetheless found ways around these restrictions. They found that they could move their liquidity - their order flow - around to the regional exchanges and the third market to force brokerage firms to negotiate commission rates.
This breaking down of anticompetitive practices in the brokerage profession was just the first of many such changes that later hit other professions such as lawyers, physicians, accountants, and so on. Brokers just were the first to see their guild-like power come under attack and recede.
This seismic shift in relative power as between customer and agent, or buyer and seller, provided a glimpse of the growing power of consumer demand and competition. Institutions realized that the NYSE's overwhelming market share in trading NYSE-listed securities could not prevent them from obtaining cheaper, negotiated commissions.
The increasing amount of liquidity leaving the exchange set the stage for action that would be taken by Congress, the SEC and the NYSE to address the markets and the concept of competition. Some claimed that market fragmentation, caused when institutions moved liquidity off the NYSE, raised concerns about a broker's ability to fulfill its best execution obligation because the broker would not have access to the best available price in New York listed securities. The arguments raised by all market participants changed the landscape of the markets forever.
Soon after, Congress enacted the 1975 amendments creating the national market system and increasing the SEC's involvement in managing the interrelationships between the markets. The national market system was based upon the notion of competition. It required the consolidation of quotations and last sale reports of all market centers through the creation of the Consolidated Tape Association and Consolidated Quote Service. The distribution of this market data through vendors provided brokers with the transparency they required to determine the location of the best possible price in a security.
Despite these changes, the national market system was not yet complete. The final attempt to promote a national market system with competing market centers involved the creation of a linkage system, which was designed so that brokers in one market could electronically reach across to another market to fulfill their best execution duties and protect limit orders. However, market centers did not favor providing liquidity to other market centers for free and the current volume within the system still remains at a de minimis level.
The success of this well intended and revolutionary development in market structure is still being debated. Undoubtedly, the consolidation of quotes and last sale reports provided transparency of market pricing to the masses. However, the 1975 amendments' attempt to create a competitive regime among the regional exchanges, the third market and the NYSE may have created negative market reactions and over-reliance on the SEC as a mediator.
Among the issues that have grown along with the national market system include the retention of institutional directed brokerage and soft dollar arrangements; the emergence of payment for order flow programs in an effort to increase competition in NYSE securities; and the approval of market data rebate rules as a way of returning excess SRO market data revenues to market participants. These issues have created legitimate conflict of interest concerns and have put the SEC in a briar patch from which it has been difficult for the agency to extract itself. The only tentative "solution" adopted by the SEC to date is requiring disclosure of the apparent conflicts of interest.
I will grant you that this historical account of market structure developments may be a bit oversimplified, but I want to use it as general background to discuss the SEC's more recent market structure reforms. The Market 2000 study completed in 1994 was the SEC's most recent attempt at dissecting the state of the markets since the 1963 Special Study. In practice, since the '75 Amendments the SEC has generally addressed market structure issues only as they arise, without necessarily having an overall plan. For instance, the SEC adopted the Limit Order Handling Rules and Regulation ATS following the SEC's enforcement action against the NASDAQ and the 21a report on NASDAQ practices. You can argue that these are the two greatest achievements of Arthur Levitt's tenure. In 2001, the SEC also moved the industry to quoting in decimals when it became clear that Congress would act if the SEC did not.
As we saw with the market practices that developed from earlier regulations, the market responded to the most recent rules implemented by the SEC by creating new problems that the SEC can no longer avoid. First, the Limit Order Display and Regulation ATS rules provided the market much needed transparency. However, the proliferation of the ECNs and the inclusion of their quotes in the national market system brought from all sides allegations of anticompetitive behavior and unequal regulation.
The NASDAQ market experienced dramatic changes over the last five years, with the implementation of SuperMontage and the emergence of competition from other SROs and ECNs. The strong competition among SROs and the lack of inter-market trading rules raised issues involving locked and crossed markets, sub-penny pricing, short sales and access fees. These issues, although troubling, were manageable during the money making years. They have become serious concerns for the industry when its profitability dramatically dropped in the wake of decimalization, greater market efficiencies arising from electronic trading, and the sharp decline in market volumes during and after the year 2000.
Decimalization and the downturn in the market caused firms to focus on cost cutting, and resulted in the magnification of the equity market's imperfections. Institutional investors, trying to shoulder falling returns, became concerned with penny jumping and the lack of depth and liquidity. Other market participants soon were discussing the issues of penny jumping and access fees while demanding market data rebates.
Market makers and specialists claim that while investors may theoretically benefit from narrower spreads that are sometimes even in fractions of a penny, these narrower spreads lower trading revenues, and thereby decrease the amount of capital they are willing to commit to the market. They further claim that the ability of ECNs to charge access fees and trade in sub-pennies has further undermined their profitability, because access fees have added a cost that they claim is unexpected and at times unpredictable. This created a situation in which traditional market participants that were suddenly unprofitable began lobbying for reforms such as the elimination of access fees and sub-penny trading.
But yet, no one wants to discuss the real elephant in the room - whether wider spreads should be mandated to support market makers and specialists. The SEC's 1963 special study noted that buyers and sellers could probably meet together without the assistance of specialists in the most liquid securities. I think that premise would remain true today.
The outstanding issue is whether disintermediation in the most liquid securities would remove the incentive for market makers and specialists to provide liquidity in the most thinly traded securities. Although the specialist's affirmative obligation protects investors in a falling market, some parties claim that market makers and specialists are no longer needed because the low transaction costs and new technology brings investors and liquidity directly to the market.
Questions that must be asked are: What should be the role of specialists and market makers in the 21st century? Can a one-penny tick sustain an adequate number of market makers and specialists? Should the SEC maintain the status-quo penny spread for the benefit of the retail investors, or should we move the spreads back to a nickel to assist liquidity formation? Does the current clustering effect and increase in market data improve the depth of the market? Is the NYSE's Liquidity Quote a good market response to this situation, and shouldn't we let the market sort this out? Are the narrow spreads and lower transaction costs creating new forms of liquidity providers accessing the markets directly? If the NASDAQ serves one market niche and the NYSE another, is it possible that some of the largest market cap stocks can in turn be traded under different parameters by sophisticated and institutional investors? These are not simple questions and can be restated in many different ways.
Decreasing revenues also brought forth claims that unequal regulation created competitive advantages for some market participants or market centers. Examples of unequal regulation include the ability of some market participants to charge access fees, the absence of short sale rules in some market centers, different access standards between market participants, differing market data rebate programs and the applicability of the trade-through rule. The staff of the Division of Market Regulation are currently working on rule proposals to address these issues.
Next Steps in Market Structure Reform
It is important that the SEC's reform provide the markets with the right incentives and latitude for healthy competition while minimizing unintended consequences. Competition is the driver for the evolution of our capital markets by increasing transparency and efficiency, decreasing transaction costs, and improving customer service. Basically, if your business model does not deliver, it either adapts or it fails. The SEC would best serve investors by supporting this evolution. It should be nimble and adapt with the market and not stand in the way of competition's determining the appropriate structure for our markets. I think that the SEC put it well in the 1971 Commission Study on Institutional Investors:
"[W]e do not believe, however, that it is either feasible or desirable for the Commission or any other agency of the government to predetermine and require a particular structure, and still less to specify now particular procedures for the markets of the future. It is better to observe, and if necessary, to modify the structure which evolves through the ingenuity and response of the marketplace to the extent changes occur that appear inconsistent with the public interest."
All the same, we must balance as well the interests of current market participants, especially the stock exchanges, who do have valuable property rights in their own internal structure and organization - reflected in their brand and other natural market power - that have developed over the years, albeit at times with government protection.
The Commission's proper resolution of these issues must provide for the uniform application of the securities laws so that we not provide a preference for one market structure over another. I personally feel that some of the technical market structure issues are symptoms of a bigger problem. The current structure for selling market data and distributing revenues is the perfect example of a government-sanctioned system creating market distortions. Over time, the SRO's control of the dissemination of financial information provided SRO's with a monopoly over the revenue derived from the sale of market information. The growth in market data revenue and the difficulty in developing a logical revenue distribution formula created competitive incentives to gain market share by rebating the excess market data revenue to market participants. This behavior has been attributed to several market distortions including locked and crossed markets. Developing a revenue distribution formula that is not susceptible to gaming, and therefore market distortions, will be difficult. Resolution of this problem will be difficult both politically and systematically but, like other issues facing the SEC, the failure to address this matter will only ingrain it further into the market mechanisms.
Finally, I would like to discuss the need to establish standards for regulatory oversight by our SROs. There has been a lot of discussion lately about the effectiveness of self-regulation. I would like to see the SEC develop and articulate standards of self-regulation to the SROs. Lately, the answer to abusive or fraudulent activity seems to be to throw additional money at the oversight function. I am concerned that this may lead to an inefficient distribution of resources. We not only need to look at the amount of money spent on regulation, but we need to know the quality of regulation that that money is buying. We should be looking at the parameters of compliance reports and whether SROs continually try to improve their surveillance in order to make it more effective. SROs should be continually updating and improving oversight instead of maintaining static programs. Technology changes and trading patterns change as should regulatory oversight.
The litany of market imperfections faced by the Commission today are a lot different than the lack of transparency and fixed commission rates that led to the 1975 amendments. These issues involve the inner workings of the market and individual devices created through competition in response to regulation. I am concerned that the SEC is on the slippery slope to micromanaging the U.S. capital markets.
My preference would be to stay clear of micromanaging competition between the markets and allow innovation to meet the needs of investors. I am committed to addressing and resolving the current issues before the SEC, but we need to look ahead to the next thirty years. The globalization of the financial markets requires the SEC to address much larger market structure issues rather than being concerned about whether a market locks or crosses twice a day. The SEC must be prepared to outline the standards of what it means to be an exchange and whether we consider an exchange as a for profit entity, a public utility, or a quasi-public for-profit/not-for-profit entity. The SEC must provide guidance on the acceptable ownership structure so that investors are aware of all of the regulatory and business risks associated with investing in such a market center. The Commission itself must create a roadmap of basic principles.
Most importantly, the SEC must strive to reduce the regulatory risk associated with overseeing the markets by allowing markets to be more nimble so that they can innovate to meet investor's needs. Investors should be comfortable that investing money in new trading platforms will not be squandered in bureaucratic red tape. The SEC must address the hard issues and establish guidelines that will allow the market to compete successfully with their global counterparts.
The market speaks volumes about what investors want and need. The government should set up the traffic lights, the rules of the road, and help define and defend property rights. Government is not, and never should be, a merit regulator, a price setter, or a judge as between competitors. History shows that government - when it tries to substitute its judgment for the markets', can cause more harm than good.
I hope that you all, as market participants, economists, lawyers, . . . and investors, will help us arrive at the right answers - through this conference and others like it, your comment letters, and just plain agitation.
Thank you for your attention.