Speech by SEC Chairman:
Remarks at the Annual Options Industry Conference
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Palm Beach, Florida
May 5, 2000
Thank you very much. Iíve been talking quite a bit these last few months about the profound changes sweeping our markets. Along the way, Iíve tried to use different metaphors to capture many of the issues and challenges facing our markets. Iíve gone from mountains to earthquakes; rivers to roads; compasses to currents; and even, if you can believe it, icebergs.
Today, competition between market centers has never been more vibrant or intense. New, fully electronic trading platforms now offer a broadening array of execution alternatives to an increasingly connected web of investors and brokers. Traditional markets -- both auction and dealer-based -- must now compete head-to-head for order flow. All markets and all market participants must consider new ways to add value in a more energized and competitive arena.
Amidst the transformation of our markets, the Commission remains committed to removing anti-competitive obstacles and unleashing even greater, more vigorous competition. Just this morning, the Commission approved the NYSEís proposed elimination of Rule 390. Dating back to the 18th century, the rule has long restricted the ability to trade NYSE-listed securities away from a national securities exchange. Upon publication of the Commission order, NYSE members will be free to execute orders in NYSE-listed stocks away from a stock exchange.
Nowhere has the power of competition been more pronounced than in our options markets. Earlier this year, for example, the Commission approved the application of the International Securities Exchange to become a registered exchange -- the first to register since the CBOE 27 years ago. In just a few weeks, this new breed of options market -- entirely screen-based -- will begin matching buyers and sellers electronically and automatically without a trading floor.
Greater competition has served investors well. Over this past year, exchange fees have been dramatically reduced. And the ISEís intention to trade 600 active options classes appears to have helped spur multiple listing of options, reducing effective spreads between 15 and 42 percent between August and October of last year. And soon, I hope, investors will benefit from a true linkage in our options markets, ensuring that orders routed to any market will receive the best price available in any other market.
But as markets transform, the fundamentals of our approach remain demonstrably sound. The core of the Commissionís framework -- competing market centers, transparency of prices, linkages between markets, and the brokerís duty of best execution -- continues to provide the space and sustenance for competition to flourish and to protect Americaís investors.
The technological advances driving our economy -- particularly those fueling the growth of the Internet -- are transforming and validating this framework. Upstart electronic markets are leveraging technology to challenge traditional exchanges. Dramatic increases in bandwidth now bring a broader, deeper market transparency within our reach, making it possible to transmit more pricing data through fewer channels. A fast expanding web of connections between customers, brokers, and markets seems destined to weave our many and diverse markets into a true National Market System.
Today, I want to underscore what I believe to be the bedrock of both this framework and our capital markets -- public confidence. At the most basic level, investors today commit capital because they have confidence in the quality and the integrity of Americaís markets. That faith does more than fuel markets -- it makes markets possible. I know of only one way to promote and preserve such confidence -- a commitment to scrupulous fairness and enduring efficiency in our marketís mechanisms. It begins with a very simple exercise: listening and responding to customers.
The Profile of Todayís Options Investor
Today, investors are demanding more information and faster, cheaper, more reliable connections with intermediaries. Options investors, in particular, are likely to be at the leading edge of the demand for quality in our markets. New data, which will be presented to you tomorrow, indicates that options investors are younger, more sophisticated, and trading more than ever before. According to one survey, options traders spend a weekly average of 3 more hours on-line than those who do not invest in options.
This increased knowledge and greater depth of experience will no doubt result in heightened pressure for broader transparency and more seamless links to brokers and market centers. With more and more execution choices available to investors, those markets that fail to measure up to ever heightened standards will soon be left behind.
Nowhere is the imperative to listen to customers more evident than in the area of technology. Much of the effort undertaken by the options markets during the last several years reflects recognition of this fact. Hand-held computer terminals the size of a pocket calendar electronically connect floor brokers of the CBOE to a central point of sale. Other markets have made significant investments and advances in order delivery systems. And our newest options exchange has leveraged technology to combine screen-based trading with auction principles.
Meanwhile, the leading options brokers continue to develop front-end connections to the markets and apply new order routing technologies that identify and access liquidity. These innovations by individual markets and market participants are important steps towards maintaining the efficiency and quality of our markets.
Towards More Transparent Pricing Of Options
The rich history of markets teaches us that nothing engenders public confidence more effectively than opening up reliable price information to all investors. In transparent markets, investors see the buying and selling interest for a particular security. Unfortunately, in todayís options markets, a crucial piece of market information is obscured -- the size of the position available for purchase or sale at the quoted price.
Currently, market makers are not required to display the size of the position they are willing to buy or sell at the price they want. Investors and professionals alike are unable to see the total trading interest available at quoted levels. Instead, just one category of market users -- public customers -- is guaranteed the quote up to certain sizes.
Now I know that the current capacity crisis in the options markets prevents a prompt removal of this impediment. But quotes without size are simply an intolerable fog surrounding todayís options prices and restricts competition among orders on the basis of price. Clearing this fog should be a top priority for the options markets the moment the present capacity crunch is resolved.
The Power of Limit Orders
Limit orders have been a powerful agent of transparency in our markets today. They serve a critical market function -- increasing information and improving the price setting mechanism.
This past March, I asked the Commission staff to prepare a report on the display of limit orders. Released yesterday, the Report confirms that limit orders have become building blocks of transparency in our markets, and proven stimulants of price competition in the options markets as well as the equity markets. Limit orders now constitute approximately three quarters of all automated orders on two of our options exchanges.
At the same time, the examination results indicate that our options markets can do more to ensure that limit orders are not mishandled. It is important to recognize, of course, that there is currently no Commission rule requiring the display of customer limit orders in the options market. Rather, each of the options markets has rules or policies governing the handling of limit orders that improve a market maker or specialist quote. All the same, compliance efforts seem to be falling well short of the mark.
Three of the four exchanges examined lacked the most basic data needed for an effective surveillance effort. Moreover, the quality of surveillance efforts observed was plainly inadequate. At the time of our inspections, three of the four exchanges examined relied solely on customer complaints to identify potential display failures. Listening to your customers is one thing, but letting them determine the scope of your surveillance is another entirely. Failings such as these can foster problems that, in time, erode confidence. I look forward to substantial enhancements of the limit order surveillance programs of the four markets examined. Trust in our national options market system demands nothing less.
The Imperative of Linkage
On a more positive note, among the most important steps the options markets have taken to instill investor confidence over the last year is the movement toward an intermarket linkage. The markets have submitted plans for a linkage reflecting fundamental agreement on a number of issues critical to the protection of investors, including automatic execution of orders routed between markets, the prevention of inferior executions, and streamlined entry for new participants.
I know many of you in this room devoted hours to developing the linkage plans and that you stand committed to a prompt implementation of intermarket connections. I commend you for your efforts. It may well be that your work will provide indicators of the road ahead as your colleagues in the equity markets strive for connections worthy of todayís market. At the same time, some question the Commissionís insistence that the markets maintain basic links that ensure prices in one market can be accessed from another. Why not, they ask, simply rely on connections between brokers and markets?
If quote prices are changing rapidly, often the market where the broker routes an order no longer offers the best price by the time that order arrives. Linkages between markets help ensure that the order still gets the best price at the point of sale. If a market is not quoting the best price when it receives an order, it must be able to match the best price or ship it to the market with the best price. I continue to believe that these basic connections are an important guardian of confidence in our markets.
Now, I have heard some suggest that the Commission should step aside and rely on market forces alone to correct pricing disparities across markets -- that there is no need for the government to prod our markets to link. It may be that the private sector will soon produce adequate connections in our markets without any action from the SEC. I look forward to that day. But the truth is some of our markets have, at times, been unable or unwilling to develop these basic connections between markets. In my judgment, it would be a profound mistake -- not to mention a dereliction of our statutory duty -- to permit the isolation of any significant market from the rest of our National Market System.
None of this is to say that todayís linkages in the equity markets must be maintained in anything like their current form. In particular, the markets should be able to take advantage of new, smarter, and more flexible technology.
But unconnected markets and the pricing disparities they can produce have the power to erode investor confidence in our market system. Over these last almost seven years, I have had the pleasure of speaking with literally thousands of investors. And itís become increasingly clear that a new breed of investor -- more informed, more inquisitive, and more in touch with financial activity than ever before -- is emerging from the Information Age. Sure, I can imagine some tolerating pricing inefficiencies for a while, particularly in good times like these. But the risk of neglect is grave. Like a summer squall, the erosion of confidence can sneak up on us, strike quickly and leave severe damage in its wake.
Competition and Confidence
In stressing the importance of investor confidence in our marketís mechanisms, my point is not to call attention to the simple truth that when investors lose confidence in a market, they vote with their feet. Rather, it is to highlight the way that confidence and price competition encourage one another. It is true, of course, that price competition is the surest path to efficient prices, and that efficient prices inspire confidence. At the same time, the confidence inspired by efficient prices fuels more price competition, which begins the cycle anew.
In our equity markets, it is investors, not market intermediaries, who are driving price competition today. It is investors, not intermediaries, who most often establish the best bid or offer with limit orders. It is investor limit orders, not market maker or specialist quotes, that are supplying the bulk of the displayed trading interest at the best quotes. But the question remains, what are they getting in return?
I worry that their orders may often remain unexecuted. I worry that the experience of an investor watching the market trade thousands of shares at a price that he established -- without ever getting an execution -- undermines his incentive to use limit orders. If so, the cycle of competition and confidence loses force. Or worse, confidence is eroded, leading to less competitive behavior and less efficient prices.
This, in my view, is the crux of the concern about market fragmentation. Unfortunately, it is a concern that has been obscured at times by caricatures. Such as "Do we want central planning, or free-market competition?" or "Should the technology connecting our markets be designed by government bureaucrats or private industry?" With all respect, these are just not the choices we face.
We have made explicit that any proposed market reform must pass an acid test: competition among market centers must remain vigorous and dynamic. And we have made as clear as words can that our role is not to design the market of the future. If action is needed to address market fragmentation, we could consider adopting disclosure rules and a basic trading rule. The implementation of any such rule, if needed, would be left to market participants.
One risk of fragmentation is a world of private markets with captive order flow. I suppose it is possible that the demands of informed investors would prefer such a market structure, but I am skeptical. The image of isolated pools of liquidity gives me great pause. In any event, I firmly believe it is the Commissionís solemn duty to guard against a market structure where the interests of intermediaries are elevated over those of investors.
You in this audience know especially well that we are living in a time when investors are increasingly able to shift their capital in and out of markets cheaply and easily; it may not always happen overnight, but we all know that it can happen quickly. And the road to restoring lost confidence is a long one indeed. As those of you in the room with a bit of gray hair know well, no market has a divine right to the savings of Americaís investors -- we have seen capital move from stocks, to gold, to oil and gas, to real estate, and these days, back to stocks.
And investors today, as a practical matter, have access not only to U.S. markets but almost any market in the world. If the integrity of the mechanisms of our market ever lose their luster in the eyes of Americaís investors, those markets that vigilantly guard a reputation for quality will draw them away wherever they are located. It takes discipline -- particularly in these prosperous times -- to remain focused on guarding integrity and maintaining confidence. There is simply no substitute for steadfast vigilance.
Thank you very much.