Speech by SEC Commissioner:
Trading Floors Versus Computer Networks
Commissioner Laura S. Unger
U.S. Securities & Exchange Commission
January 29, 2001
Panel Description: Despite the wave of mergers, traditional stock exchanges still face a number of market challenges. The next battle will be with the electronic communication networks (ECNs), but will it be price or service that determines who will be the winner.
Good morning. Thank you for inviting me to speak to you today. I always welcome the opportunity to participate in discussions about what lies ahead for the securities markets. I just want to mention that I am here speaking on my own behalf. The views I express are my own and not those of the Securities and Exchange Commission, the Commissioners, or the staff.
Technology, regulatory changes and globalization have fueled new competition in the U.S. securities markets. Technology has created the opportunity for relatively new market participants, known as electronic communications networks (ECNs) or alternative trading systems (ATSs) to give the traditional markets a run for their money.
Traditional Exchanges vs. ECNs
In the U.S., we are lucky enough to have two major markets the exchange market and the over-the-counter market. Most people think of the New York Stock Exchange as the traditional exchange market and Nasdaq operates the OTC market. The differences between the exchange market and the OTC market are easy to spot. First of all, there is the physical element traditional exchanges are operated by human beings on a physical trading floor. Although they are generally slower to execute orders than their more technology-oriented brethren the OTC market, ECNs and ATSs traditional exchanges provide other benefits. Second, these benefits are derived in large part from the structure of a traditional exchange, which generally operates as an agency auction market. Auction markets offer (a) deep, centralized pools of liquidity, (b) opportunities for direct interaction among investor orders without the participation of a dealer, (c) opportunities for price improvement, and (d) price transparency. Finally, even traditional exchanges are working to integrate technology into their markets in an attempt to provide improved and faster service to investors.
The Nasdaq over-the-counter market provides for another means of trading in a more "traditional" venue. It consists of competing market makers, or dealers, in each security. Unlike an exchange auction market, Nasdaq's market structure does not feature a single market center (dealer) that accounts for a majority of trading in OTC securities. Since most of the trading is done inter-dealer, there is relatively little interaction between customer orders. That said, Nasdaq has made tremendous strides in automating OTC market making, which has resulted in increased efficiency and transparency in the OTC market. As I'm sure Al Berkeley will tell you, Nasdaq has taken more recent and even greater steps toward integrating technology into the OTC market.
Before I turn to how ECNs compete with these "traditional" markets, I thought it worth mentioning how these two markets perform for investors. The Commission recently issued a report entitled, "Report on the Comparison of Order Executions across Equity Market Structures" that considers whether order executions differ in markets with differing levels of fragmentation and customer order interaction. The Report compares the quality of customer order executions in securities listed on Nasdaq to the executions of customer orders in NYSE-listed securities routed to the NYSE. Factors considered include: execution costs (i.e., spreads) and order execution speeds allowing for separate analysis of different types of orders. The Report generally finds that "effective spreads" (measuring execution costs) were narrower on the NYSE than on Nasdaq, while executions on Nasdaq were generally found to be faster than on the NYSE.
What the Report illustrates best, however, is that these two types of market structures provide different types of benefits to investors. Not surprisingly, the New York Stock Exchange and Nasdaq have very different things to say about the Report. This audience can draw its own conclusions by reading the Report at www.sec.gov.
Returning to ECNs, ECNs provide yet another model and service to investors. ECNs are screen-based automated trading systems that facilitate order execution and allow participants to participate directly in price discovery. As a practical matter, participation in these systems is typically limited to institutional investors, broker-dealers, specialists, and other market professionals. ECNs have fostered greater price competition, improved speed of execution, narrower spreads and lower transaction costs. While their share of NYSE volume remains low, ECNs have succeeded in garnering a large share of the marketplace in Nasdaq stocks (approximately 30% of Nasdaq trading volume according to some estimates). It may only be a matter of time before ECNs make greater headway into the exchange-listed market. Part of the ECNs' success relates to the services they provide managing reserve size, anonymity, direct access for institutions, and, in some cases, speed. ECNs can also be a cheaper place to execute orders and a better place to find price improvement.
Role of the Government
So, which of these market structures best serve investors? You should be happy to know that I do not believe it is the role of the government to make this decision for investors or the markets. While the SEC must promote efficiency, innovation and competition in the securities markets and among market participants, we should not and do not dictate ultimately which specific market structure serves investors best. Rather, competitive forces will determine which markets should fail or flourish, sink or swim in today's economy.
Of course, even competitive forces need a little guidance. The SEC has sought to create and strengthen a framework that gives the forces of competition sufficient room to thrive and that allows markets to develop according to their own genius. For example, in adopting Regulation ATS, the SEC created a new regulatory framework for electronic trading systems. This new framework provides electronic trading systems with the flexibility to register as ATSs or exchanges which are treated very differently in terms of regulation. To facilitate marketplace competition, the SEC has recently proposed a regulatory simplification rule, Rule 19b-6, that would make it easier for exchanges to make changes to, or adopt, trading systems. Through these rulemakings, we strive to promote a level playing field upon which all market participants may fairly compete.
As market centers continue to grow in number, investors should be able to make informed decisions about which market best serves their needs. Until now, there has been very little information publicly available to the average investor or broker about what happens to an order in different marketplaces. Individual customers know the execution price of orders and in some cases may know where their order was routed for execution, but in many cases, particularly for Nasdaq and OTC trades, they will not know where their order was executed or how it would have fared in a different market. Customers have very few tools to evaluate the quality of execution that other brokers or market centers might have provided. Given this lack of information, brokers may make uniformed decisions as to where orders should be routed. Likewise, customers may simply opt for a broker that offers the lowest commission and a fast execution. As a result, brokers may think they are getting their customers a good deal and customers may think they are getting a good deal, when in fact they are not.
The Commission recently adopted new disclosure rules designed to arm investors with information about market centers and broker-dealers. Specifically, the rules require market centers, including exchange specialists, OTC market makers, and ECNs, to make publicly available monthly reports with uniform statistical measures of execution quality on a stock-by-stock basis. The rules also require brokers that route customer orders to prepare quarterly reports that describe their order routing practices.
At the very least, the hope is that improved disclosure will allow investors to know the differences between brokers and to make informed decisions in choosing a broker. Optimally, increased disclosure of execution quality could motivate brokers and order execution centers to seek continual improvement in service and better prices for investors, leading to a market-wide improvement in execution quality.
Technology has infused our securities markets and its participants with a new and greater drive to compete. Securities markets, new and old, are being challenged every day to reexamine their business models, to reevaluate their services, and, in some cases, to reinvent themselves. It seems clear that no market participant, new or old, is planning to give up the fight for market share.
While investors will be the ultimate determiners of who survives in this competitive environment, the Commission will remain guided by such basic regulatory principles as disclosure, price transparency, and best execution. Our challenge is to apply these principles in a way that enhances competition both domestic and global encourages innovation, and protects investors.
As for the fight for market share, armed with new information, investors will decide who wins that battle making investors the ultimate winner.