Speech by SEC Commissioner:
Remarks before the Open Meeting to Consider the Reproposal of Regulation NMS
Paul S. Atkins
U.S. Securities and Exchange Commission
December 15, 2004
This rulemaking raises a fundamental policy question with important symbolic and practical implications for the future of the United States capital markets: should the secondary markets of the greatest capital market system in the world be governed by competitive forces or be centralized through government regulation? In its present form, this rulemaking could undermine the fundamental principles that make our markets strong, including innovation, competition, and ever-increasing efficiency. Short term goals of automating the manual markets must be balanced against the long term health of our securities markets, which must compete for listings and liquidity among the world's securities markets.
The Commission is repreposing this rule to obtain comment on whether the trade through rule should be extended to each market's depth-of-book or whether it should apply only to the markets' best bid or offer. This proposal takes a completely different practical and philosophical approach from the proposal that was issued in February. I am happy that the Chairman decided to seek more comment, rather than move directly to adoption.
My objections to this proposal have 3 bases: philosophical, practical and procedural. First, the reproposal is more than just a discussion on the scope of protection offered by the trade-through rule and seems to reflect potential policy determinations made by the staff and Chairman between the time of the supplemental release and the current reproposal. If we adopt these policy choices, I fear that this regulatory path may logically lead the Commission to an artificial centralization of the markets and commoditization of a sector of the economy that has been marked by fierce competition and technological innovation. These forces have benefited investors enormously. As Milton Friedman has said about the failure of government measures to guide competition, "the invisible hand has been more potent for progress than the visible hand for retrogression." My second basis for objection is that the Commission adopts this approach, it risks permanently entrenching the Commission's judgment into every aspect of the market through price-regulation, standard setting and serving as the official market referee. Finally, this rulemaking raises procedural concerns in addition to substantive ones.
As I stated when voting to approve the first version of Regulation NMS, competition rather than the Commission should be the final judge as to which business model survives and which business model fails. In marked contrast, this rule proposal will quickly and unfairly determine winners and losers. Some conclude that this reproposal must be good because everyone is unhappy about it. Such a glib conclusion cannot be relied upon to justify a rulemaking that might cause good capital to be wasted, and trust in the regulatory certainty of our market system to be undermined.
I have tried unsuccessfully to identify the problem that the Commission is hoping to solve with this complicated experiment. The release notes that the current market structure has "been so successful in promoting growth, efficiency, innovation, and competition" and that "trading volume [has] exploded, [and] competition among market centers [has] intensified." The release also boasts that penny increments clearly have benefited many investors, particularly retail investors because the trading costs have dropped dramatically. If these benefits are present in the current market then why are we proposing such radical changes?
The initial call for market structure reform was focused on opening the competitive floodgates in the listed market. The Commission initially proposed to do this by extending the trade-through rule. Why should the Commission now propose a major change to Regulation NMS that may, in the end, reduce the efficiency and the overall competitive nature of our markets? The choice of forcing market structure changes might temporarily increase competition and ease investors' frustrations, but I question whether it will benefit investors or the economy in the long run.
The Commission's initial motivation for adopting a trade-through rule was to level the competitive playing field in exchange-listed markets. Since then, it appears that the Commission is now motivated by the desire to fix a perceived lack of depth and liquidity within the Nasdaq market. It is not clear whether this sudden shift is due to true policy changes or a solution trying to find a problem to fix. The concern stated in this release regarding the Nasdaq market's lack of liquidity and depth was not prominently set forth as a reason for adopting the trade-through rule in the initial proposing release or the subsequent supplemental release. Furthermore, a substantial number of the commenters on Regulation NMS did not believe that the trade-through rule should be extended to the Nasdaq market nor did they raise concerns about the available liquidity or depth within the Nasdaq market.
The answer to why we would now support the adoption of a trade-through rule in an attempt to increase the depth and liquidity within the Nasdaq market may lie in a shift of focus from attempting to fix competition to now attempting to fix investors' frustrations. This shift reflects a value judgment to discriminate between short and long term investors.
Because of that value judgment, the re-proposal chooses to structure the markets for the benefit of long-term retail and institutional investors as opposed to all investors. If we take this path, we should keep in mind that all investors, including market intermediaries and sophisticated traders, commit capital and assume risk when they purchase or sell securities. A fundamental question is whether the determination that long-term investors may be more important than short term investors will upset the fragile balance of liquidity within the market and impact its overall efficiency.
The proposed depth-of-book trade-through rule is intended to provide investors with the incentive to display additional limit orders in the market and improve the execution quality of large orders. In fact, the repreposal raises the free-riding economic externality concern as the major reason for requiring intermarket price protection. The reproposal states (and I hope that Commenters focus on this statement)
to achieve the full benefits of intermarket price protection, all investors must be governed by a uniform rule that encompasses their individual trades. For any particular trade, an investor may believe the best course of action is to bypass displayed quotations in favor of executing larger size immediately. The Commission believes, however, that the long-term strength of the NMS as a whole is best promoted by fostering greater depth and liquidity and it follows from this that the Commission should examine the extent to which it can encourage the limit orders that provide this depth and liquidity to the market at the best prices. Allowing individual market participants to pick and choose when to respect displayed quotations could undercut the fundamental reason for displaying the liquidity in the first place.
I question whether the reproposed rule will achieve the objective of improving depth and liquidity if we do not address the issue of internalization. Internalization occurs when a market participant provides liquidity to a customer order by executing it for its own account at the current market price. The reproposing release only requires that orders entered into the market be routed to the best priced quotations. The release continues to allow, however, the practice of internalization as long as the internalizers match the best prices displayed in the market. This would mean that internalizers would continue to "free-ride" off of the prices established by the limit orders. I question whether this current thinking will lead the Commission in the future to nationalize order flow in order to prevent "free-riding" and achieve its goal of protecting investor limit orders. Congress in 1975 directed us to help foster a National Market System, not a Nationalized Market System.
If that is the case, the Commission's objective for proposing and implementing the intermarket trade-through rule may not be achieved unless, as the reproposal suggests, we reexamine whether we promote fostering greater depth and liquidity by requiring internalizers to route orders into the market prior to taking a proprietary position. If so, should the Commission address this issue at this time and request comment on whether the Commission's main objective of increasing depth and liquidity would be met if we failed to nationalize order flow by including internalization in this proposal? Shouldn't the Commission ask whether the proposed rule structure is the best solution for promoting depth and liquidity in the market or if market based solutions would prove to be more successful?
The question remains as to whether this rule proposal can achieve its intended goal of increasing depth and liquidity without nationalizing order flow? The release avoids dealing with this problem by waving the investor protection flag. The release indicates that the trade through rule is also needed to address the "significant" number of trade-throughs. This significant number amounts to a "whopping" 2-3% of the total trades in both the Nasdaq and NYSE. The staff represents that the absence of a stronger trade-through rule cost American investors a total of $326 million in 2003. This amount represents roughly .002% of the approximately $17 trillion in total dollar share volume that traded in both markets last year. But, just last month in our SRO Concept Release we said that the $410 million market data cost to the securities industry was minimal. I question what the true cost to American investors will be if the proposed reform instead negatively affects the efficiency of the markets, increasing spreads and internalization, and thereby, increasing transaction costs for investors.
Although the reproposal does not mandate price-time priority, this approach lays the ground work for the nationalization of order flow and the future creation of a central limit order book. After reading the release, I am comfortable in characterizing the reproposal's half-way approach as a virtual CLOB. The reproposed rule ties the markets together by forcing their depth-of-book information through a government sponsored consolidator that will distribute the protected quotations. Market participants' order routing decisions that are now based upon fiduciary duties and competitive pressures would be replaced with a government mandate to route orders based on its own rigid definition of what constitutes the best price. So, although the re-proposal does not require that orders be executed on price and time priority, it does require that orders be routed based upon price priority. In my opinion, the tying of the markets together and replacing the investor's routing decision with a government mandate should be viewed as a central market. Mandating price priority alone may forestall the continued drive of competitive forces that have been so effective over the years in increasing market efficiency and innovation. I am concerned that the expansion of the trade-through rule will indeed freeze future market structure development just as the ITS plan froze the listed market structure for over 25 years. A greater concern is that we do not know how this regime will ultimately impact the markets and what market structure we will be carving in stone.
Choosing this approach requires the Commission to entrench its own judgment for the market's on issues relating to market data, access standards and trading techniques. First, trading centers can only comply with the rule if they can see the quotations that they cannot trade-through. Reproposed Regulation NMS nationalizes depth-of-book data by requiring market centers to funnel protected quotations through a government recognized distributor of market information. The Commission would be responsible for setting the price that broker-dealers will be required to pay for that data in order to comply with the rule. Currently, the depth-of-book information distributed by several ECNs is free. As stated in the release, the standards to be utilized by the Commission when determining a fair and reasonable fee for the data will be established at a later date. I believe that this increase in revenue for SROs will further aggravate the problems associated with the SRO market data revenue slush fund. We are providing the market centers with additional market data revenue and approving the ability of SROs to cross-subsidize operational and regulatory expenses without sufficient accountability. Regulation NMS mandates a single processor approach and rules out competitive solutions in this arena.
Second, the Commission would need constantly to address issues relating to access standards. Reproposed Regulation NMS is vague and does not provide the objective specifications for complying with the access provisions. The trade-through rule requires access standards because market participants are forced to access the market centers offering the best displayed price. The reproposal indicates that the staff will provide interpretive relief during the implementation phase. The interpretive relief would be required for standards associated with everything from response times to the specific details on how to comply with the locked/crossed market prohibition. For example, the trade-through rule requires the Commission to act as a rate setter by capping access fees to market centers at $.003.
Finally, this approach inserts the Commission's judgment on the approach on the appropriate form of trading. The Commission granted very limited exceptions to the trade-through rule. Like the access standards, the exceptions are extremely vague and would require interpretive guidance by the Commission staff for proper compliance and implementation. The exceptions to the trade-through rule prescribe the specific instances in which a trading center may ignore a protected quotation. This rule structure, in effect, establishes the government's determination of the appropriate manner for trading securities.
The Commission should start off with the principle that its regulations should do no harm. In this instance, no one can tell me what either approach in this release will do to the market. Market professionals, economists, and Commission staffers all proffer different scenarios for the impact on the markets. Should we be concerned about the lack of consensus? That must mean that someone is wrong-and whose opinion is it? Others believe that this proposal will not be different from how the market operates today. Then I would ask why we are expending the resources and exposing ourselves to the risk of unintended consequences if that is the case. I hope the commenters can provide us with a clearer picture. We must remember that nine ECNs found a lucrative business model from one footnote in the Limit Order Handling rules adopted in the 1990s.
Last, I want to address some of the procedural aspects of this rulemaking. Two and a half years ago we granted a temporary 3-cent de minimis exemption from the trade-through rule for three heavily traded exchange traded funds. The problems apparent in the trade-through rule in these securities led Chairman Pitt to direct the staff to prepare a term sheet for us to address issues regarding market structure. Although a term sheet was prepared, it was moved to the back-burner.
Independently, the New York Stock Exchange, in response to its customers and events affecting the Exchange's leadership and governance, launched its own self-examination and restructuring that includes a proposal called a "hybrid market" - a floor-based auction system that co-exists with an automated marketplace. From every indication that I have gotten, the New York Stock Exchange has worked long and hard on this rule - conceptualizing it, proposing it, studying similar existing systems, designing systems requirements and process flows, seeking and getting comments from the Commission and the public, reacting to those comments in two substantial iterations of the rule, and being on track toward getting the rule effective and implemented. The rule has been rather controversial among Exchange members, but has succeeded in gaining approval of all the necessary constituencies at the Exchange - no easy task for the Exchange's leadership, and an accomplishment on which I highly compliment them. This is an exciting and diligently constructed proposal, one that promises to be an evolutionary (if not quite revolutionary) change to the Exchange. I am very much interested in seeing it implemented so that we can see how it works in actual practice and how the marketplace will react to it. The New York Stock Exchange deserves to be allowed to respond to its marketplace and to develop and implement these sorts of innovations that they think will address their customers' needs.
We proposed Reg NMS in February and held hearings in New York in April. We issued a supplemental release seeking comment on fast and slow quotes (versus fast and slow markets) in May. Then, the staff in a memo to the commissioners dated 13 October basically said that they would recommend the adoption of a market-wide trade-through rule with no opt-out provision.
Then, on 10 November, the staff distributed a package for adoption as a final rule that would have instituted the voluntary depth-of-book trade-through rule that is in this package before us today. This was the first time that the Commission was informed about this approach. The meeting to consider the rule was scheduled for 8 December, and I learned in internal discussions that changing the approach was not an option. I was informed that:
- no reproposal was contemplated nor deemed desirable or necessary,
- there had been enough discussion of these issues already,
- the public had had sufficient notice of a depth-of-book rule through the couple of questions posed in our proposing release and through a couple of comment letters that addressed the issue, and
- it was time for the Commission to act expeditiously on this issue.
As word leaked out, a storm of controversy erupted. I certainly would not want to speak for the New York Stock Exchange, but after they spent months and months, much effort, and certainly many dollars on developing their hybrid model, they must have been completely dismayed and discouraged. They had proceeded in good faith to develop their model and work closely with our staff on it. The depth-of-book trade-through rule will render the hybrid model dead on arrival. The brewing discontent ultimately caused us to relent and put this rule out for comment.
I commend the Chairman for ultimately deciding to repropose Regulation NMS. I previously voted to approve going out for comment on the initial rule proposal and the subsequent supplemental release. I agreed that we would benefit from public discussion of these ideas even though I had, and raised, substantive concerns. Unfortunately, I cannot support going out for comment on this newest iteration of Regulation NMS. The reproposal makes too many sweeping and conclusive statements about Commission findings, preliminary findings and Commission policy that I cannot in good conscience sign on to.
I hope the commenters will address some of my substantive concerns about the proposal. It appears to impose tremendous costs on the markets, impede their efficiency, and unnecessarily determine the winners and losers. I am interested in specific comments as to whether this proposal will require the centralization of all orders, and thereby, lead to the stifling of innovation and competition. In addition, it is important to hear the market participants' opinion as to whether the lack of depth and liquidity in the Nasdaq market is a significant weakness and whether the extension of the full depth-of-book to the Nasdaq market will cause more harm than good.
We are publishing this proposal in December, in the midst of the holiday season, with a meager 30-day comment period. In characterizing its request for comment the release states: "Given the advanced stage of this rulemaking initiative, the Commission anticipates taking further action as expeditiously as possible after the end of the comment period. It therefore strongly encourages the public to submit their comments within the prescribed comment period. Comments received after that point cannot be assured of full consideration by the Commission." I have to wonder aloud, as many in the public will surely do as well, just how seriously are we seeking public comment?
I have worked at and around the Commission for more than twenty years, and have never seen language like that in a release. Just what is the rush? This complex issue has been around for a decade or more. We have encouraged commenters to focus for 10 months on one approach. Now, we have a markedly different rule - one that could change the US markets beyond recognition - but we are basically telling the public that their considered, temperate reflections of the implications of this rule will not necessarily be taken into account if they come in late.