Speech by SEC Chairman:
Visible Prices, Accessible Markets,
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
at the Northwestern University School of Law,
Kellogg Graduate School of Management
March 16, 2000
Thank you very much Dean Van Zandt for that generous introduction. And while he can't be here today, I'd like to thank David Ruder for his important work on so many issues that affect America's investors and its capital markets.
Standing in the well of this stately hall, one could easily be lulled into forgetting that the very ground beneath our markets is undergoing seismic shifts. Amidst the greatest technological revolution America's markets have ever seen, many are asking whether the open outcry -- the mainstay of stock exchanges for centuries -- will be consigned to a by-gone era, rendered purposeless by the computer's silent screen.
While that question remains unsettled, one need look only a few miles down the road to witness the scale and pace of today's change. Just this week, barely three-year-old Chicago-based Archipelago -- an electronic communications network -- and the 118-year-old Pacific Stock Exchange announced a union to create a new, totally electronic stock exchange in the United States. Subject to Commission approval, this new breed of market will trade both listed and OTC shares under the auspices of a traditional exchange -- but without a trading floor. It plans to compete directly with every major exchange and market center.
Competition and innovation continue to drive the development of America's capital markets. Seven months ago, I talked about a regulatory framework that I believe will continue to give competition the space and sustenance to flourish. In it, multiple market centers compete with one another to produce faster and cheaper executions of securities transactions. A few months later, I addressed a broker's duty of best execution, which serves as a guardian of competition among our markets. Tonight, I want to talk about the two remaining pillars of our National Market System: transparency and linkages.
For securities markets, transparency means that prices across our National Market System are visible to all market participants. Linkages, on the other hand, provide the means to access those prices. In recent years, we have taken important steps towards more transparent, better linked markets. Today, by and large, the best dealer quotes and customer limit orders can be seen and accessed by all market participants, fueling price competition. Transparency and linkages, however, are not a finish line to be crossed, but rather part of the endless race towards better markets. This race presents new imperatives, new challenges and sometimes -- like today -- they come at us with relentless frequency.
How do we ensure that limit orders continue to be a driving force for healthy price competition? What impact will decimalization have on price transparency, and more specifically, on limit orders? Are buyers and sellers in our National Market System interacting in a way that ensures investors the full benefits of price competition? These are just a few of the questions we must squarely face today.
To those who think that these concepts sound academic, consider this: If your order is executed at one increment away from the best price -- 1/16th -- that's $62.50 out of your pocket on a 1000 share order. That's more than four times the commission that many on-line brokers advertise today. Execution quality takes some effort to consider, but it is more than worth it for most investors.
Limit Orders -- The Building Blocks of Transparency
To better understand the implications and the importance of transparency in our markets, and the price competition it fosters, I would like to view it through the lens of its most powerful agent -- the limit order.
There are essentially two types of customer orders: market orders and limit orders. When an investor places a market order, a broker executes the trade at the best current price in the market. In this way, investors can be viewed as price-takers. In contrast, limit orders -- orders to buy and sell a security at a specified price or better -- enable investors to compete for better prices than the market is offering. Limit orders, in other words, allow investors to be price-setters. And that's a unique opportunity. Makes you wish we had limit orders for buying gasoline.
Limit orders serve a critical market function by helping reveal the supply and demand for a security. More simply put, they show how many shares of a particular stock customers are willing to buy or sell, and at what price. As a result, limit orders increase the information available to the overall market and allow all market participants to better determine prices.
But limit orders have done more than just promote price discovery; they have begun to level the playing field between dealers and the investing public. There was a time when investors had no choice but to accept the price set by dealers in the OTC market. But through the use of limit orders, investors now have become an integral part of the price setting process, allowing prices to be determined by the forces of competition.
In the late 90s, however, the Commission found that market makers were concealing from the public limit orders that would have improved the market price for a security. By preventing these limit orders from interacting with other buyers and sellers, market makers were paralyzing an important driver of price competition.
In 1997, the Commission responded with the Limit Order Display Rule. It simply stated that dealers holding customer limit orders that are equal to or better than the market price must either execute the orders immediately or display them to the market. The point of the rule was to make the most motivated buyers and sellers visible to the broader market -- increasing the chance that those who stood up and improved the price would be rewarded.
Almost overnight, the investing public benefited from greater competition and more fully realized price transparency. It is now clear that the Order Handling Rules -- which include the Limit Order Display Rule -- are largely responsible for narrowing spreads by over 30%. Most of that decrease in spreads -- the difference between a dealer's bid and offer -- is due to the display of customer limit orders.
Given the plain importance of limit orders to investor confidence and market efficiency, you would expect that ensuring their visibility would be an unyielding imperative of our marketplace. But information gathered this past year by SEC examiners indicates just the opposite.
In far too many cases, limit orders are being mishandled by market intermediaries. Deficiencies are being uncovered by our examiners with our equity exchanges, options exchanges, and over-the-counter dealers. On one of our equity exchanges, for example, at least one out of six limit orders was not properly displayed, according to preliminary examination results.
I am deeply troubled by this apparent disregard for customer orders and systemic competition. I have asked our Office of Compliance Inspections and Examinations, together with our Office of Economic Analysis, to prepare within the next 45 days a public report that analyzes the display of limit orders in our equity and options markets. In particular, I have asked that the staff report on the adequacy of the markets' surveillance and disciplinary programs for the Limit Order Display Rule. Neither investors nor the pursuit of a true National Market System can afford to have one of the most potent forces driving price competition paralyzed.
Moving to Decimals -- Implications for Transparency
Any complete discussion of limit orders and transparency in our markets cannot ignore an event on the horizon that will truly be a watershed for our markets: the move to decimal pricing. Amidst the changeover, vigilance on all of our parts, and a sharp focus on the maintenance of orderly markets, have never been more important.
What will decimals mean for our markets? The reality is, many of the most seasoned market veterans disagree in their predictions. But most agree that, in the end, investors will clearly benefit -- particularly small investors using market orders. The theory is straightforward: As prices are quoted in smaller and smaller increments, there are more opportunities and less cost for dealers and investors to improve the bid or offer on a security. As more competitive bidding ensues, naturally the spread becomes smaller. And this means better, more efficient prices for investors.
With the greater opportunity of decimalization also come new challenges. Some postulate that the incentive to place limit orders will be undermined as market makers and other professionals "step ahead" of existing orders. For example, say a dealer is holding a customer limit order to buy a stock at 20 1/16, which happens to be the best offered price. Assume the dealer then receives an order to sell that same security. As it stands, the dealer cannot trade with the selling customer until that open limit order to buy is filled -- that is, unless he pays a higher price to "step ahead" of the limit order.
With increments of 1/16, the cost to the dealer of stepping ahead is a little over 6 cents a share. But if the increment is a penny, theoretically, the cost is just that: a penny. This lower cost might make it attractive for the dealer, as a matter of course, to step ahead and take the order. Of course, this benefits the seller, as he gets a better price for the sale. But, if stepping ahead becomes routine and investor limit orders go unexecuted, investors' incentives to place limit orders could be diminished.
We should not forget how this could impact transparency and the price-setting mechanism. Fewer limit orders means that the market has fewer indicators of buying and selling interest. And this could mean dilution of the benefits of price competition which limit orders provide.
There are other concerns. Some argue liquidity will be obscured by the changeover to decimals. In theory, the larger the quoting increment -- or, the fewer number of prices at which a customer can place an order -- the greater the quantity of stock that is available to be bought and sold at each price. In the same way, the smaller the pricing increment, the smaller the quantity.
Currently, most market participants can see only the "top" of a market's limit order book -- that is, the single best quote available. But as quote increments move to pennies, this top layer represents a thinner slice of the total buying or selling interest for that security. In fact, in going from fractions to pennies, market participants could now see a sliver of customer demand that is about 1/6-th the size currently visible.
In many respects, when it comes to price transparency today, seeing the top of the book is like seeing the tip of an iceberg -- and having no idea how much rests below. Without more transparency, ascertaining supply and demand below the top of the book could become more difficult in a world of pennies.
Towards an Open Book
Displaying the demand only at the best quoted price has been a market standard for decades. But today, investors, intermediaries, and the marketplace as a whole are demanding more. And our markets are beginning to respond.
The NYSE has proposed making the specialist's book of limit orders visible to its members and the broader public. The Nasdaq has submitted a plan to create a SuperMontage that will aggregate and display orders and quotes of all participating market makers -- not only at the current best prices, but several increments away from the best price. Some ECNs already make their entire book visible to the public via the Internet on a real-time basis. These are all forward looking initiatives that answer the investor's call for greater transparency and more efficient pricing.
With the impending changeover to decimalization, and the more narrow view of the supply and demand that will accompany it, price transparency below the top of the book becomes critical to the price setting mechanism.
Now is the time to embrace a broader and deeper transparency. Now is the time for all market participants to move toward open books across all markets. Now is the time for a voluntary private sector initiative in this important area -- one that does not require major systems engineering.
If our markets -- exchanges, dealers, and ECNs -- were to make their limit order books available to the public, vendors could consolidate this data and package it in a form that would be most useful to their customers. Presumably, nearly all market participants would want to purchase this data and broker-dealers would make it available to investors including retail investors. Of course, some customers would prefer not to have their limit orders displayed, and I am not suggesting they be forced to do so. But the choice should rest with investors -- not market intermediaries.
The ability of all investors to see the depth of supply and demand in any stock would be a giant step towards a true National Market System. And it is a step that our markets should take now, before the uncertainty of decimalization is upon us.
Towards this end, I have asked the Division of Market Regulation to take the lead in facilitating a dialogue on this issue by hosting a public roundtable with representatives of all markets, dealers, market data vendors and other interested parties. I look forward to the industry following suit and holding similar discussions on the feasibility of this initiative. I want to emphasize that the merits of this idea are separate and distinct from other possible reforms under consideration. We simply must not allow decimalization to obscure liquidity in our markets.
Some may suggest that greater transparency of limit order books would primarily benefit institutions, as it would allow their professional money managers to develop sophisticated strategies. But the dichotomy between a market structure that serves retail investors, and one that serves institutional investors, is a superficial one.
There is, of course, a difference in the sophistication and the resources between the average portfolio manager and the average retail customer. But there is also a fundamental similarity. The median household income of mutual fund shareholders is $55,000. The median total mutual fund assets held per household is $25,000. In other words, when a portfolio manager goes into the market to buy or sell a stock, he or she is often acting not on behalf of the well-heeled private banking client, but on behalf of middle America.
We can all agree that a market structure tilted toward the needs of hedge fund managers should not be our goal. At the same time, we should not foster a system bent toward day traders. Our future markets must serve the diversity of America's investors.
Linkages -- Reviewing the Basics
Now, even if all market participants could see the best quotes in any market, there must be a way for customers to access them. Today, the primary route for reaching these quotes is through brokers. And I expect that brokers will continue to play an essential role in connecting our markets. Brokers provide access to the various competing markets and carry the solemn responsibility of seeking high quality executions for their customers. Through the Order Handling Rules, the Commission attempted to ensure that brokers have real access to newly transparent markets so that they can carry out their obligation to achieve high quality executions for their customers.
Of course, if we had a single, monolithic market, fulfilling this responsibility to customers would be much simpler. But, I believe Congress was visionary in choosing not to mandate such a market. Over the last 25 years, our system of competing market centers has been the driving force behind faster and cheaper executions, spawning new trading systems that provide anonymity and greater liquidity.
Even in a world of competing markets linked by brokers, however, the need for direct intermarket linkages is compelling. If quote prices are changing rapidly, often the market where the broker routes an order may no longer offer the best price by the time that order arrives. Intermarket linkages help assure that the order still gets the best price at the point of sale. In doing so, linkages further one of Congress' National Market System goals: making it practical for brokers to achieve best execution. Intermarket linkages also help promote price equilibrium across markets, thereby enhancing our markets' efficiency.
Historically, the Commission has played an active, but limited role in promoting better intermarket linkages. The linkages that the Commission has insisted upon have been basic connections that protect customers from pricing disparities. And while the SEC has prodded, it has not dictated the details of the linkage. In considering reforms to the current linkage system, we should be mindful of certain fundamentals.
Market centers, in a dynamic National Market System, must be able to hone a niche, develop a brand, or offer value-added features. Any linkage must accommodate innovation and the imperative to compete on the basis of value. Moreover, intermarket linkages are not intended to promote unlimited free access to a competitor's market. Why, for example, would anyone purchase a seat on the NYSE if a connection to ITS -- the listed market linkage -- offered equivalent benefits?
At the Commission, we know well that ITS has not kept pace with the technological change sweeping our markets. Its archaic structure and cumbersome governance provisions are not fit for today's market, let alone the market of the future. The over-the-counter linkage, SelectNet, continues to be plagued with shortcomings, delays during heavy trading volume, and even outages. Given the decentralized nature of the Nasdaq market, this is a critical and core flaw -- and one that must receive intense scrutiny and committed resources until resolved. We expect to exercise increasingly active oversight of these linkages in the near term.
Let me say this. With today's unprecedented volumes and new demands, it's the obligation of every market institution to commit their resources first to technology -- before marketing campaigns or dealer benefits. If today's leadership looks back on this formative period for our markets having neglected the imperatives of technology, they will leave an unfortunate legacy.
On a more positive note, the Commission today approved an NASD proposal to link ECNs to the listed market through ITS. I firmly believe that investors will be the winners as fuller, more robust competition between ECNs and our equity exchanges unfolds.
In addition, earlier this year our options markets made important progress towards an intermarket linkage plan. The consensus of the different proposals included automatic execution of orders routed between options markets, the prevention of trade-throughs -- that is, executions at prices inferior to those available in another market -- and more streamlined entry for new participants. While there is still some debate on broader options linkage issues, the areas of agreement on the fundamentals of linkage are promising. As we wait for public comment on these plans, I urge the leadership of options exchanges to use this time to prepare for prompt implementation of a linkage.
The sophistication of brokers in providing connectivity to competing markets will only expand as technology reveals new possibilities. We can expect similar advances in linkages between markets as cutting-edge private sector connections between ECNs, for example, continue to develop. For now, however, basic intermarket linkages still have a role to play. But the truth is, today's systems -- ITS and SelectNet could be changed or replaced. Indeed, improvements are sorely needed. In any event, we must continue to insist on basic connectivity between markets in pursuit of a more effective and more efficient National Market System.
Interaction of Buyers and Sellers Across Our Markets
Together, transparency and linkages provide the possibility of buyers and sellers across markets interacting with one another. To say that interaction among buyers and sellers is possible though, is not to say that it is necessarily occurring. I worry that some of our markets are instead becoming increasingly isolated from buyers and sellers in other markets.
In particular, I am concerned that broker dealers who buy and sell from their retail customers, and wholesale firms that pay for order flow, may have little meaningful incentive to compete through quotes with the rest of the market. Rather than vying for individual orders, they instead buy privileged access to those orders. Then, they trade at prices set, for the most part, elsewhere in the market.
Meanwhile, a customer or dealer who posts the best price anywhere in the market has no real ability to trade with those orders captured by the internalizing firm. Few would disagree that -- on some level -- this creates an isolation of buyers and sellers and that it may discourage aggressive quote competition. There is a sharp difference of opinion, however, on what course should be taken. This is the core of the debate framed in the Commission's recent concept release on market fragmentation.
As the debate intensifies, let me reiterate that the Commission has not yet determined what, if any, regulatory action should be taken to address fragmentation. Moreover, we at the Commission do not view ourselves as the grand architects of the future market. Our job, rather, is to maintain and monitor a framework in which the forces of true competition shape fair, efficient, and orderly markets.
Above all, we must eliminate barriers that inhibit competition. Where necessary, we should set standards to encourage fair and efficient markets. Finally, whatever steps the Commission considers towards greater order interaction must pass one acid test: competition among market centers must remain vigorous and dynamic.
I realize that some of the concepts I've covered today can be the source of some confusion, if not a few heavy eyelids. So I thought I would conclude with a more accessible image.
I've spent a good deal of time on some of this country's greatest rivers, I know well that they are not monolithic forces proceeding uniformly and directly to the sea. Rather, they twist and meander, creating pools along the way adjacent to their central currents. Their grandeur, it always seemed to me, lies in their many moods, the very diversity of their forms.
But there is a difference between a pool in a mighty river -- vibrant with life, refreshed by the current -- and a puddle on the river's bank. The ultimate fate of a puddle is stagnation. The demands of today's investors are too nuanced to be accommodated by a monolith, and the competitive forces that they drive are too productive to ever be isolated.
This is our collective mandate. And we should not allow that mandate to become mired in arguments designed more for the defense or denunciation of a business model than for markets worthy of our future. The opportunity and challenge that confronts our markets and investors must rise above shallow debates.
This is not a debate about big firms versus small firms. This is not a debate about institutional interests versus retail interests. This is not a debate about a monolithic market versus a splintered market. And this is not about human intelligence versus the quiet hum of the computer.
Rather, it is a debate about how best to let unburdened competition and unbridled innovation drive the future of the market. It is a debate about how best to meet the needs of all investors. It is debate about how to best equip our markets to compete and win in an increasingly globalized electronic market. It is, I believe, the most important debate our capital markets face.