Preserving and Strengthening
the National Market System for Securities in the United States
By Arthur Levitt, Chairman
U.S. Securities & Exchange Commission
Before the Senate Committee on Banking, Housing, and Urban Affairs
May 8, 2000
Chairman Gramm, Ranking Member Sarbanes, and Members of the Committee:
I am pleased to testify today on behalf of the Securities and Exchange Commission ("Commission") concerning the structure of the U.S. securities markets and the regulatory environment in which they operate. The Commission welcomes the Committee's continuing interest in these issues. Twenty-five years ago, Congress, with the leadership of this Committee, mandated the establishment of a national market system for securities. Prior to that time, securities had been traded in a number of different markets that were largely isolated from one another. The concerns of Congress in 1975 were remarkably prescient and well worth restating today:
The securities markets of the United States are indispensable to the growth and health of this country's and the world's economy. In order to raise the enormous sums of investment capital that will be needed in the years ahead and to assure that capital is properly allocated among competing uses, these markets must continue to operate fairly and efficiently. The increasing tempo and magnitude of the changes that are occurring in our domestic and international economy make it clear that the securities markets are due to be tested as never before. Unless these markets adapt and respond to the demands placed upon them, there is a danger that America will lose ground as an international financial center and that the economic, financial and commercial interests of the Nation will suffer.
The rapid attainment of a national market system as envisaged by this bill is important, therefore, not simply to provide greater investor protection and bolster sagging investor confidence but also to assure that the country maintains a strong, effective and efficient capital raising and capital allocation system in the years ahead.1
Since those words were written, the U.S. securities markets have flourished far beyond what perhaps even the most visionary person in 1975 could have predicted. In 1975, there were approximately 3000 stocks listed on an exchange with trading volume of 6.4 billion shares; in 1999, there were more than 3800 exchange-listed companies with trading volume of approximately 259 billion shares. In 1975, Nasdaq was still a fledgling automated market with approximately 2600 issues and trading volume of 1.4 billion shares; in 1999, Nasdaq included more than 4800 companies with trading volume of 273 billion shares.2 Investor transaction costs have dropped dramatically since 1975 -- commissions have fallen and execution quality has risen. But most importantly, investor confidence in the fairness and integrity of the securities markets has been restored. By 1998, nearly one-half of U.S. families held stock, directly or indirectly, in publicly-traded companies, and their stockholdings represented more than one-half of their total financial assets.3
As many Members of this Committee recently have noted, however, past success provides no guarantee of success in the future. In an increasingly competitive international environment, no industry can afford to stand pat or rest on its laurels. Moreover, the increased stockholdings of American families heighten the importance of maintaining the integrity and stability of the price discovery mechanism that the securities markets provide for the economy as a whole. The Commission recognizes the stewardship responsibility it owes to current and future generations to preserve and strengthen the securities markets as an irreplaceable national asset. My testimony today is intended to highlight the enlightened laws, as well as the regulatory approach implementing those laws, that have contributed to the success of our markets in the past and will help ensure continued success in the future.
I. Congressional Objectives for a National Market System
In Section 11A of the Securities Exchange Act of 1934,4 Congress directed the Commission to facilitate the establishment of a national market system. To guide the Commission, Congress set forth objectives that it believed must be incorporated into a national market system. Although its ultimate goals for the securities markets were to serve the public interest, protect investors, and maintain fair and orderly markets, Congress provided more specific guidance on how to reach these goals with the following five objectives:
- Efficiency -- assuring the economically efficient execution of securities transactions.
- Competition -- assuring fair competition among broker-dealers, among exchange markets, and between exchange markets and markets other than exchange markets.
- Price transparency -- assuring the availability to investors and broker-dealers of information with respect to quotations for and transactions in securities.
- Best execution -- assuring the practicality of brokers executing investors' orders in the best market.
- Order interaction -- assuring an opportunity for investors' orders to be executed without the participation of a dealer.5
In addition, Congress made two basic findings to guide the Commission: first, that advancing technology created the opportunity for more efficient and effective market operations and, second, that the linking of all markets through communications and data processing facilities would further each of the five objectives of the national market system. Thus, the era of isolated, private securities markets in the United States was over. All market centers were to be linked together in a national market system that was to serve the public interest.
Finally, Congress chose not to mandate the specific components of a national market system or otherwise attempt to impose a fixed market structure. This approach was "designed to provide maximum flexibility to the Commission and the securities industry in giving specific content to the general concept of a national market system."6 Consequently, there is no single definition of a national market system -- each of the five objectives is an integral element of a comprehensive regulatory approach. In implementing these objectives, the relevant issue is never whether to choose one objective to the exclusion of another, but to facilitate the implementation of a market structure that adequately incorporates and advances each of the five objectives.
The flexible approach adopted by Congress has sometimes been criticized by those who believe that the five objectives are not consistent with each other in every respect. And this criticism is partly correct -- in evaluating any particular market structure issue, they may not always point in precisely the same direction. But the flexible and multi-faceted nature of the national market system approach adopted by Congress also represents its genius. It may seem simpler to focus on a single objective, but such a simplistic approach would not do justice to the complex nature of the securities markets and the investors who use those markets. There are many different types of investors, and investors themselves may have many different investment and trading strategies. A national market system must be sufficiently flexible and robust to meet the varying needs of the investors it serves.
II. Commission's Regulatory Role in Implementing a National Market System
Congress directed the Commission to "facilitate the establishment" of a national market system in accordance with the findings and objectives of Section 11A. Accordingly, the Commission's regulatory role has not been to dictate the ultimate structure of the securities markets. Instead, private initiative, fair competition, and advancing technology must lead in giving concrete form to the individual components of a national market system. The Commission's role has been to establish, monitor, and strengthen a regulatory environment that gives the forces of competition sufficient room to flourish. The Commission remains committed to allowing the forces of competition to shape market structure in the first instance.
In implementing this strategy, the Commission has acted when necessary to address problems or practices that could stand in the way of achieving the objectives that Congress has set for a national market system. Determining the specific instances that warrant Commission action often can be quite difficult. A heavy-handed regulatory approach that intervened frequently would do more harm than good. Perhaps the best way to understand the Commission's proper role in facilitating the establishment of a national market system is to examine briefly a number of specific examples of Commission action over the last 25 years. Such an examination can help reveal basic principles for when and how the Commission has exercised its regulatory authority to further national market system objectives.
A. Implementing Price Transparency and Intermarket Linkages
In 1975, the initial focus of Commission action was to implement price transparency. Assuring the wide availability to investors of a national best bid and offer ("NBBO") and a consolidated stream of transaction reports in a security from all the market centers that trade the security is the minimum essential element of a truly national market system. Prior to the 1970's, no statute or Commission rule required market centers to disseminate market information to the public or to consolidate their information. Each market center acted individually and disseminated information on its own terms. They decided what information to disseminate, who would be entitled to receive the information, and the amount of fees to charge. The result was that dominant market centers, with the most valuable information, restricted public access to their information. Such practices are inherently inconsistent with the concept of a national market system as set forth in Section 11A. Restricted or discriminatory access to information not only is incompatible on its face with the objective to assure the availability of quotation and transaction information, but also detracts from the efficient execution of transactions and the ability of brokers to obtain best execution of their customer orders.
Congress therefore recognized that "communication systems, particularly those designed to provide automated dissemination of last sale and quotation information with respect to securities, will form the heart of the national market system."7 It rejected the proposition that any market center should have the right to compete by withholding access to its information or charging fees that might unreasonably restrict the availability of its information. Section 11A(c)(1)(C) charges the Commission with assuring that all "exclusive processors" of market information make their information publicly available on terms that are "fair and reasonable."8 Moreover, Congress specifically noted that implementing price transparency likely would require the Commission to use its regulatory authority:
The conferees expect, however, in those situations where competition may not be sufficient, such as the creation of a composite quotation system or a consolidated transactional reporting system, the Commission will use the powers granted to it in this bill to act promptly and effectively to insure that the essential mechanisms of an integrated secondary trading system are put in place as rapidly as possible.9
To achieve the price transparency objective of a national market system, the Commission has adopted rules requiring that all market centers make their basic quotation and transaction information publicly available, that such information be consolidated, and that it be made available to investors on a real-time basis.10 As a result, investors have ready access to an NBBO and a consolidated transaction stream for each of the thousands of equity securities actively traded in the U.S. markets. Price transparency has become the hallmark of the U.S. securities markets. Nearly unanimously, market participants credit price transparency as being responsible for much of the success of the U.S. markets over the last 25 years.
But price transparency alone is not sufficient to achieve the national market system objectives. Providing access for executions against those prices also is essential to achieve the efficient execution of transactions and the best execution of investor orders, no matter where they may have originated in the national market system. Brokers provide the primary means of access to the markets. But once a broker has routed an order to a market, a better price may arise in another market. The Commission therefore has used its regulatory authority to prompt the securities industry to create intermarket linkages that provide access between market centers to the best displayed prices. These include the Intermarket Trading System for listed equities and Nasdaq's National Market Execution System (formerly the SelectNet System) for Nasdaq securities. The options markets only last year began the multiple trading of options in earnest (thereby allowing options investors for the first time to reap the benefits of a truly national market system with competing market centers). The Commission has played a major role in recent months in encouraging and facilitating the development of an options intermarket linkage system. Currently, the Commission is reviewing comment letters submitted in response to linkage plans submitted by the various options exchanges.11 It intends to move quickly toward approving and facilitating the implementation of a plan that will further the interests of options investors.
B. Promoting Order Interaction and Best Execution of Limit Orders
The Commission also has exercised its national market system authority to promote the opportunity for investor orders to interact without the participation of a dealer, particularly in the Nasdaq market. It may seem inconceivable today, but up through the early 1990s, Nasdaq market makers routinely traded ahead of public limit orders. As a result, it was nearly impossible for individual investors to use limit orders effectively in the Nasdaq market. Market makers accepted the limit orders of customers, but generally did not execute them until they had become marketable and therefore were substantially equivalent to a market order. For example, assume the best bid and offer in a security was $10 and 10¼, and an investor submitted a limit order to buy at $10. Market makers would continue to buy for their own accounts at a bid of $10 or even less without executing or displaying the limit order. They took the position that the limit order was not entitled to an execution until the offer price had dropped from $10¼ to $10 (so that, for example, the best bid and offer was 9¾ and 10). This effectively denied an opportunity for individual investor limit orders to compete with dealer quotations.12 At the Commission's strong urging, the NASD changed its rules to prohibit this practice for customer orders held by a market maker.13 In approving an NASD proposed rule change, the Commission emphasized that protecting public limit orders would enhance both the efficiency of the Nasdaq market and the opportunity for best execution of investor limit orders:
The rule change also will improve the price discovery process in Nasdaq securities. Limit orders contribute to price discovery by disclosing preferred customer trading prices and by tightening the spread between the bid and ask price of a security. In the past, customers may have refrained from placing limit orders because of the uncertainty of and difficulty in obtaining an execution for such orders until the inside price reached the limit order price. The practice of delaying executions until the inside price reaches the customer's limit order price also impedes price discovery by artificially delaying or preventing execution and reporting of customer limit orders.14
One year later, the Commission took further action to enhance price transparency and the best execution of investor limit orders when it adopted the Order Handling Rules.15 Until then, the NBBO for Nasdaq securities generally reflected only market maker quotations. Such quotations did not reflect limit orders of any kind, whether submitted by investors to market makers or submitted by market makers or investors to ECN limit order books, even when these orders would improve the NBBO. In addition, the ECNs with the best prices did not make their prices publicly available in the consolidated quotation stream, but generally granted access only to their subscribers.
As a result of these practices, the NBBO disseminated to investors was not a truly "national" best bid and offer. Under the two-tiered market that had developed, it was retail investors who suffered -- they frequently received prices at the published NBBO and were denied an opportunity for execution at the truly best price. These practices were directly contrary to the national market system objectives of efficient execution of transactions, the public availability of market information, the best execution of investor orders, and an opportunity for investor orders to interact.
To remedy these practices, the Commission exercised its national market system authority under Section 11A to require market makers to include in their quotes (or send to ECNs) customer limit orders that improve a market maker's published quotations. The Commission also required market makers to publish their best displayed prices either in their quote or through an ECN. In adopting these requirements, the Commission emphasized the contribution they would make to maintaining investor confidence and furthering national market system objectives:
The Commission recognizes that investors will lose confidence in the fairness of the markets unless market structures and practices treat all investors fairly. The regulatory initiatives adopted today address current market practices that hinder competition among markets and affect the prices at which customer orders are executed. The [Limit Order] Display Rule and Quote Rule amendments enhance transparency and facilitate best execution of investor orders in a manner that preserves maximum flexibility for the markets to design and implement trading and communications systems that are consistent with the objectives of the national market system. These rules contribute to the achievement of the full potential of the national market system envisioned by Congress. They represent one more step to facilitate the development of an efficient, competitive and transparent national market system in which all market participants can achieve best execution of their orders.16
C. Promoting Market Center Competition
In 1998, the Commission adopted Regulation ATS, which is designed to promote fair competition among market centers, along with a variety of other national market system objectives.17 First, it provides a streamlined regulatory structure for ECNs that choose to be regulated as alternative trading systems ("ATSs") rather than national securities exchanges and thereby enhances the opportunity for innovative market center competition. Second, Regulation ATS improves price transparency by requiring ATSs with significant trading volume to display publicly their "top-of-book" trading interest in the consolidated national quote stream, regardless whether that interest is associated with a market maker. ATSs also are required to provide reasonable access for executions against their best prices through intermarket linkage systems.
Finally, only last week the Commission approved the rescission of NYSE Rule 390. The Rule's off-board trading restrictions long had been questioned by the Commission and others because they directly restricted a certain type of market center competition -- competition between exchange markets and markets other than exchange markets. Rule 390 therefore ran directly counter to the national market system objective to assure fair market center competition. Last October, in testimony before this Committee's Subcommittee on Securities, the Commission called for the elimination of the Rule 390.18 Subsequently, the NYSE, although stating that the Rule was intended to promote the interaction of investor orders without the participation of a dealer (and particularly to address broker-dealer internalization practices), filed a proposed rule change to rescind the Rule. In approving the rule change, the Commission found that the Rule was overbroad, in part because it restricted the competitive opportunities of ECNs, which operate agency markets that offer investors a high degree of order interaction.19 The future success of market centers trading listed equities will depend on competitive forces, particularly the extent to which market centers can provide the highest quality trading services at the lowest possible cost.
D. Principles for Commission Oversight of the National Market System
What general principles, then, can be extracted from these examples of past Commission action to further national market system objectives? First, the Commission has been reluctant to impose specific components for the facilities and systems of the national market system. Instead, it has focused whenever possible on enhancing the opportunity for competition, particularly competition by innovative market centers and by investor limit orders. When required to act, the Commission has eliminated practices that detract from national market system objectives, or set necessary marketwide standards, while preserving maximum flexibility for the markets to design, implement, and govern any needed facilities or systems.
Second, the interests of investors are preeminent, not those of any individual market center or its participants. The secondary securities markets exist to facilitate the transactions of investors. Investor interests should be protected; investor orders should receive best execution; and investor orders should have an opportunity to interact without the participation of a dealer. Any rules or practices that place the interests of intermediaries ahead of those of investors are incompatible with the national market system mandated by Congress.
Third, the fact that a practice may further the competitive self-interest of any individual market center or type of market center is not determinative of whether that practice is consistent with the national market system objectives. If such a practice hampers the efficient execution of transactions, damages price transparency, interferes with the best execution of investor orders, or isolates those orders from an opportunity for meaningful interaction, the practice warrants careful examination by the Commission to determine whether competitive forces alone will be sufficient to address its negative effects. In the past, for example, market centers with the best prices have attempted to restrict access to those prices (such as by disseminating their quotations only to members or subscribers). Even though this practice may be in the competitive self-interest of the individual market center, it is directly contrary to the price transparency objective of the national market system (as well as efficient execution of transactions and best execution of investor orders).
Finally, there have been times when the collective result of individual market participants acting in their own self-interest has not been sufficient to address practices that are harmful to the national market system and impair investor confidence (such as dealers trading ahead of, or neglecting to display, customer limit orders). In these unusual situations, the only effective course of action is for the Commission to exercise its regulatory authority to adopt uniform "rules of the road" that benefit the national market system as a whole. By adopting or encouraging self-regulatory organizations to adopt narrowly-tailored rules that set standards, address the harmful effects of specific practices, or knock down barriers to competition, the Commission can achieve benefits for the national market system that could not be obtained through any other means.
IV. Future of the National Market System
The Commission believes that the statutory framework and objectives established by Congress for the national market system in 1975 continue to be just as relevant today. They have stood up well to the toughest test of all -- time. Consistent with this framework, the Commission intends to continue its longstanding strategy of relying first and foremost on competitive forces to achieve national market system objectives. To fulfill its oversight responsibilities, it will monitor the performance of the national market system, inquire into potential problems, and, only if necessary, act to address those problems.
Currently, the Commission is inquiring into three broad areas of concern. First, it appears that there may be considerable opportunity for updating certain of the national market system plans, systems, and facilities to better reflect advancing technology, changing market conditions, and new self-regulatory organization structures (such as for-profit exchanges). If there are better, more efficient tools with which to achieve national market system objectives, they should be explored and adopted. Indeed, one of the greatest benefits of the regulatory approach adopted by Congress in Section 11A is the flexibility it allows for adapting individual components of the national market system. In the months ahead, the Commission intends to explore opportunities for more efficient and effective national market system operations.
Second, the Commission is concerned about certain broker-dealer practices -- internalization and payment for order flow -- that may substantially reduce the opportunity for investor orders to interact and thereby contribute to harmful fragmentation of the national market system. The Commission outlined and requested comment on these issues in its release publishing notice of the NYSE's proposed rule change to rescind Rule 390 ("Concept Release").20 Reduced order interaction, if pervasive, may hamper price competition, interfere with the process of public price discovery, and detract from the depth and stability of the markets.
Currently, brokers that handle customer orders have a strong financial incentive either to internalize their orders by trading against them as principal or to route their orders to dealers that will trade against them as principal and share a portion of the profits with the broker. Internalization and payment for order flow arrangements provide dealers with a guaranteed source of order flow, eliminating the need to compete aggressively for orders on the basis of their displayed quotations. Instead, the dealers can merely match the prices that are publicly displayed by other market centers. These prices in many cases will represent investor limit orders that are displayed by agency market centers (such as the NYSE or an ECN). The investor limit orders may be denied an opportunity for an execution if dealers choose not to route orders to the market center displaying the limit orders and instead match the limit order prices.21
Price-matching dealers thereby take advantage of the public price discovery provided by other market centers (which must make their best prices publicly available pursuant to Exchange Act price transparency requirements), but need not contribute to the process of public price discovery. Moreover, if a substantial portion of the total order flow in a security is subject to dealer price-matching arrangements, it reduces the ability of other dealers to compete successfully for order flow on the basis of their displayed quotations. In both cases (unfilled limit orders and disregarded dealer quotations), those market participants who are willing to participate in public price discovery by displaying firm trading interest at the best prices are not rewarded for their efforts. This creates disincentives for vigorous price competition, which, if extensive, could lead to wider bid-asked spreads, less depth, and higher transaction costs. If these occur, all orders could receive poorer executions, not just the ones that are subject to internalization and payment for order flow arrangements. Consequently, a loss of execution quality and market efficiency may not be detectable simply by comparing the execution prices of orders that are subject to such arrangements with those that are not.
Moreover, an agent-principal monitoring problem may tend to perpetuate rather than alleviate the isolation of investor orders that are subject to internalization and payment for order flow arrangements. It can be very difficult for retail customers to monitor the quality of execution provided by their brokers, particularly in fast-moving markets. Given the difficulty of monitoring execution quality, the most rational strategy for any individual customer may be simply to opt for the lowest commission possible (which may be low in part because the broker is receiving payment for order flow, part of which is passed on to the customer). If many individual customers choose brokers based on commission rates rather than the broker's ability to obtain a better price, it could blunt the forces that otherwise would reward market centers that offer high quality executions.
Finally, the concerns raised in the Concept Release are not limited to assuring that investors receive at least the best displayed prices, whatever they happen to be. Assuring that investors receive the best prices displayed anywhere in the national market system is crucial, but it is not sufficient to assure that the best prices displayed in the system are the most efficient prices reasonably possible. For example, the spread between the best displayed bid and the best displayed offer may be wider than it otherwise would be if a market structure fails to promote vigorous price competition.22 In addition, some market centers offer investors an opportunity for price improvement -- an execution at a price better than the best displayed prices. To meet their best execution responsibilities, brokers must take these price improvement opportunities into consideration in deciding where to route customer orders.
In many important respects, the Commission's review of these internalization and payment for order flow practices simply represents the continuation of its longstanding concerns to promote investor order interaction and to improve the opportunity for best execution of investor limit orders. Limit orders repeatedly have demonstrated what a powerful force they can be in enhancing price competition and the efficiency of the securities markets. The Concept Release is intended to explore whether further action is needed to secure all of their potential benefits for a national market system.
The comment period for the Concept Release recently was extended two weeks and now expires on May 12, 2000.23 In extending the comment period, the Commission urged commenters not to limit their attention to a single option raised in the Concept Release for addressing fragmentation, particularly the option of establishing comprehensive price/time priority for all displayed trading interest. This option has been widely referred to in the press as a "CLOB" -- a central limit order book. Five other options were included in the Concept Release specifically to afford commenters an opportunity to submit their views on alternatives to a CLOB that would be more focused on specific practices or problems that may isolate investor orders, discourage quote competition, or impair public price discovery.
Of these five options, for example, one would require greater public disclosure concerning the execution quality of individual market centers (such as the various exchanges, market makers, and ECNs) and the order-routing practices of brokers. Such disclosures, by facilitating more informed decision-making by investors and brokers, potentially could strengthen the competitive forces that would lead to more efficient markets and the best execution of investor orders. Under any of the other four options, the Commission would not impose a fixed structure or system on the markets, but would adopt an intermarket trading rule designed to enhance the opportunity for price competition and best execution of investor orders. The markets therefore would be afforded maximum flexibility to design and implement any systems or linkages that might be needed to implement the trading rule. In recent years, advancing technology has opened up new horizons in terms of the types of communications systems and linkages available for achieving national market system objectives. Giving the private sector maximum flexibility to take advantage of innovative technology on an ongoing basis would be clearly superior to any approach under which the government attempted to impose a fixed solution that soon could be obsolete.
Accordingly, the Commission hopes to receive the benefit of commenters' views on these other five options, as well as the CLOB option. Commenters are strongly encouraged to provide any specific examples, data, or analyses that would serve to illustrate their views. It also would be helpful if commenters addressed the extent to which future changes in market conditions, such as the advent of decimal-pricing, might address fragmentation concerns without the need for Commission action. After reviewing review the comment letters submitted in response to the Concept Release, the Commission will determine what, if any, further action is warranted.
A third area of concern is decimal trading. I can safely say that virtually all market participants agree that decimal trading is the way of the future, and should be implemented soon. Our concern is that the transition to decimals occurs in a way that reduces, not exacerbates, customer confusion. In light of the Nasdaq market's inability to trade in decimals until next year, we have sought industry comment on starting decimal trading in listed stocks without Nasdaq stocks in the Fall, either through a small pilot or for all listed stocks at once.
V. Shad-Johnson Accord and the Ban on Single Stock Futures
Let me now turn to another fundamental structural issue facing the markets and Congress -- the ban on single stock futures. Current U.S. law prohibits the trading of futures on single stocks and on narrow based stock indices. This ban is the result of the Shad-Johnson Accord ("Accord")24
between the SEC and the Commodity Futures Trading Commission ("CFTC"), which Congress codified in 1982. Under the Accord, only broad-based stock index futures that meet certain criteria are permitted to trade, subject to the Commodity Exchange Act and CFTC supervision. The Commission believes that the ban on single stock futures and futures on narrow based stock indexes should be lifted. But it is critical that the introduction of these products be accompanied by the regulatory safeguards that apply to the trading of other securities and that the regulation of these products be harmonized with the regulation of stocks, bonds, and options in order to avoid harming those markets.
Our view is consistent with the views of the President's Working Group on Financial Markets ("Working Group"). In November 1999, the Working Group released its report on OTC Derivatives ("Report"), which discussed the Shad-Johnson Accord among other issues. The unanimous findings of the Working Group reiterate the Commission's position that although single stock futures may possess elements of traditional futures contracts, they also function as a very close substitute for the underlying security and an option on a future is virtually identical to an option on an underlying security. Accordingly, when considering the Shad-Johnson Accord's ban on single stock futures, one must recognize that regulatory issues associated with the introduction of such products would be complex. Indeed, the members of the Working Group agree that numerous issues -- including margin levels, insider trading, sales practices, real-time trade reporting, floor broker activities, and CFTC exclusive jurisdiction over futures contracts -- would have to be resolved before the ban could be reconsidered.
The CFTC and the SEC are working diligently to prepare a legislative recommendation that would accomplish the goals set out in the Working Group Report -- lifting the ban on single stock futures, while ensuring that investors have adequate protection. In response to the request of Chairmen Gramm and Lugar that the SEC and the CFTC report back to their respective committees on issues associated with modifying the Shad-Johnson Accord,25
Chairmen Rainer and Levitt provided a preliminary response by letter on March 2, 2000.26 In this letter, both the SEC and the CFTC recognize the significant interests of the other agency in administering their respective statutes and regulations with regard to single stocks. While consensus has not been reached on all issues, the Commission and the CFTC together agree that, to assure that these products can be offered broadly by both U.S. securities and futures exchanges, legislation should authorize both agencies to regulate single stock futures, intermediaries, and markets that offer single stock futures. In developing a flexible system of joint regulation, both agencies recognize the need to avoid imposing any unnecessary costs, burdens or duplicative regulation on securities or futures markets or on market participants.
To this end, the staffs have pursued an innovative concept of "notice registration" for intermediaries and markets already registered with either the SEC or the CFTC. To avoid duplicative regulation, notice registration would allow already-registered intermediaries and markets to transact business in single stock futures without being required to go through the registration process under both the Securities Exchange Act of 1934 ("'34 Act") and the Commodity Exchange Act ("CEA"). We also are considering whether the agency accepting notice registration could defer to the "principal" regulator's equivalent regulation in areas such as routine inspections and examinations, segregation of customer funds, the application of the net capital rule, books and records, audit trails, and routine disciplinary action against registrants.
The CFTC and SEC staffs also have reached tentative agreement on initial standards for trading single stock futures such as harmonizing margin requirements, restricting dual trading, testing sales and supervisory personnel, and establishing uniform listing standards. In the area of insider trading, we have agreed that the SEC would take the lead in detecting, deterring, and prosecuting insider trading involving single stock futures. In addition, we have begun to discuss the issues of whether to foster intermarket competition through multiple trading of single stock futures. This would require linked or coordinated clearing, which has not traditionally been required in futures markets.
The Commission staff continues to work diligently with their counterparts at the CFTC to resolve the relevant issues. The resolution of these issues is not an easy task. This review must take into account the major disparities between securities and futures regulation in a variety of areas, such as customer protection, market structure, margin and authority to regulate. These differences arise in part because of historical differences between securities and futures market participants -- differences that will be erased with the introduction of single stock futures. The Commission believes that repealing the Accord without addressing these disparities will work to the detriment of our capital markets and investors in those markets. We believe the integrity of our securities markets would be jeopardized if disparities between securities and futures regulation were used to undermine the securities law provisions that serve to maintain fair and orderly markets for stocks and bonds. Therefore, the staffs of both agencies are working to resolve these disparities in a manner that will reach a complete and workable understanding that permits innovation and competition, reduces unnecessary regulatory burdens, prevents regulatory arbitrage, ensures liquidity and transparency of trading, and protects the integrity of the markets and those customers who use them. In order to achieve this, many technical and philosophical differences must be worked out. The Commission feels strongly that one of the strengths of the securities laws is the ability to protect investors. We believe the record speaks for itself in this area, and that it is essential to consider the application of these customer protections to a product like single stock futures.
Given the complexities of the issues, the interest of both the CFTC and the SEC in single stock futures and futures on narrow based indexes, and the potential consequences if the legislation or regulation is not drafted comprehensively and correctly, it is not surprising that the two agencies have not ironed out all of the details in four months. Nonetheless, the CFTC and SEC have made great strides in achieving this goal.
Notwithstanding the many challenges that we face, we believe it is possible to craft a strong yet flexible regulatory framework for single stock futures. It is of vital importance, that the two agencies be given an opportunity to work together to resolve these issues. Agency to agency cooperation and coordination is necessary to protect the integrity and customers that use the securities and futures markets, as well as to ensure the long-term viability of these products and other creative innovations yet to be envisioned. It is therefore important that these issues be thoughtfully resolved in a way that will not require further congressional action in a short period of time.
The Commission appreciates this opportunity to submit its views on the structure and regulation of the securities markets. It looks forward to continuing to work closely with this Committee in strengthening the national market system and assuring that the U.S. securities markets meet the needs and earn the confidence of investors.
1Conference Report, Securities Acts Amendments of 1975, H.R. Rep. No. 94-229, at 91 (1975).
2Sources: 42nd Annual Report of the SEC 194 (1976); NASD Economic Research, http://www.marketdata.nasdaq.com; NYSE; Amex.
3Federal Reserve Board, "Recent Changes in U.S. Family Finances: Results from the 1998 Survey of Consumer Finances," Fed. Res. Bulletin (Jan. 2000).
415 U.S.C. 78k-1. Section 11A was added to the Exchange Act by the Securities Acts Amendments of 1975, Pub. L. 94-29, 89 Stat 97 (1975).
5The objective of investor order interaction is explicitly conditioned on its being consistent with the objectives of efficiency and best execution. It is not conditioned on consistency with the objective of fair competition among market centers. Thus, dealer participation in securities transactions is warranted only to the extent that it leads to more efficient execution of transactions or the best execution of investor orders.
6Report, note 1 above, at 92.
7Conference Report, note 1 above, at 93.
8"Exclusive processor" is defined in Exchange Act Section 3(a)(22)(B) as any securities information processor or self-regulatory organization that distributes information on an exclusive basis on behalf of a self-regulatory organization. This definition recognizes, for example, that an individual securities exchange necessarily controls access, in the first instance, to the quotation and transaction information generated through its facilities.
9Conference Report, note 1 above, at 93.
10Market centers are allowed to charge fair, reasonable, and non-discriminatory fees for this valuable information. They are not permitted to charge fees that would restrict the wide availability of their information to investors.
11 See Securities Exchange Act Release No. 42456 (Feb. 24, 2000), 65 FR 11401.
12Large, institutional investors had sometimes been able to have their orders included in market maker quotations, as well as take advantage of the limit order books offered by ECNs to submit their limit orders. As discussed below, ECNs at that time were not incorporated into the consolidated quotation stream.
13 See, e.g., Securities Exchange Act Release No. 35751 (May 22, 1995), 60 FR 27997 ("Manning II"). As discussed below in section IV, market makers are not now prohibited from trading ahead of limit orders held by another market center. One of the issues that the Commission is considering in its review of market fragmentation issues is whether market makers should be prohibited from trading ahead of previously displayed limit orders, no matter where they are located in the national market system.
Id., section IV.A.
15Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290.
16 Id., section II.
17Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 63 FR 70844.
18Testimony of Arthur Levitt, Chairman, Securities and Exchange Commission, Concerning Market Structure Issues Currently Facing the Commission, before the Subcommittee on Securities, Committee on Banking, Housing, and Urban Affairs, U.S. Senate (Oct. 27, 1999), at 14-15.
19The Commission also recently approved a proposed rule change by the NASD that would enable ECNs to participate in the Intermarket Trading System that links market centers trading listed equities. Securities Exchange Act Release No. 42536 (March 16, 2000), 65 FR 15401.
20Securities Exchange Act Release No. 42450 (Feb. 23, 2000), 65 FR 10577 ("Concept Release").
21In February 2000, the agency markets operated by ECNs executed approximately 19% of the share volume in Nasdaq securities, a drop of 3% from September 1999. See NASD Economic Research Dept., http://www.marketdata.nasdaq.com (visited April 10, 2000) (In February 2000, ECNs that are ATSs collectively accounted for 19.2% of Nasdaq share volume, 25.1% of Nasdaq dollar volume, and 24.6% of Nasdaq trades.); NASD Economic Research Dept., http://www.marketdata.nasdaq.com (visited Dec. 11, 1999) (In September 1999, ECNs that are ATSs collectively accounted for 22.2% of Nasdaq share volume, 29.2% of Nasdaq dollar volume, and 28.0% of Nasdaq trades.). In calculating the market share of ATSs, the NASD adds orders executed internally on an ATS and the orders routed to an ATS for execution. Orders routed out to another market participant are not included.
22The spread between the best bid and offer is an indication of the premium that must be paid by investors seeking liquidity and therefore of the efficiency of the market. See Concept Release, note 21 above, at n.20 and accompanying text.
23Securities Exchange Act Release No. 42723 (April 26, 2000).
24Futures Trading Act of 1982, Public Law No. 97-444, 96 Stat. 2294-97
25Letter from the Honorable Phil Gramm, Chairman, Senate Committee on Banking, Housing and Urban Affairs and Honorable Richard G. Lugar Chairman, Senate Committee on Agriculture, Nutrition and Forestry, Unites States Senate, to the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William Rainer, Chairman, CFTC (December 17, 1999).
26Letter from the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William Rainer, Chairman, CFTC, to the Honorable Phil Gramm, Chairman, Senate Committee on Banking, Housing and Urban Affairs and Honorable Richard G. Lugar Chairman, Senate Committee on Agriculture, Nutrition and Forestry (March 2, 2000).