Junius W. Peake
Monfort Distinguished Professor of Finance
Kenneth W. Monfort College of Business
1075 F Kepner Hall
Greeley CO 80639
Tel: 970-351-2737 Fax: 970-351-1062
By E-mail to: firstname.lastname@example.org
September 6, 2000
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington D.C. 20549-0609
Reference: File No. S7-16-00
Dear Mr. Katz:
I send these comments on the Commission's Release No. 34-43084, Disclosure of Order Routing and Execution Practices.
According to Greek legend, Tantalus so offended the gods that he was condemned in the afterlife to an eternity of hunger and thirst. Each time he reached down for the water that beckoned to his parched lips, it drained away. Overhanging the pool were boughs laden with luscious fruit. But each time Tantalus stretched to pluck this juicy sustenance, the boughs receded from his grasp.
The Securities and Exchange Commission ("SEC" or "Commission"), after receiving its charge in 1975 to "facilitate" the development of a national market system for securities, has still not completed its assigned task. "Facilitate" is defined as "to make easy." More than a quarter-century later, the Commission has made the development of a national market system anything but "easy." Instead, the SEC has managed to create a Byzantine arrangement of multiple market centers in which the same stock is traded at the same time in many places.
While present regulations require that all investor (and market maker) bids and offers be displayed, the myriad of places where a single stock-say Microsoft-is quoted presents a Tantalus-like dilemma for investors and their brokers. If an order is entered into system "A," and the broker enters a contra order into any system other than "A," there is no sure way the investor will be able to reach the counterpart with the best deal.
The Commission knows the system is badly flawed. How badly flawed, we found out very recently from the SEC's Chairman, Arthur Levitt, who stated on July 25:
"Promoting the interaction of orders remains one of the most difficult, but crucially important, challenges we face concerning our national market system. But not everyone shares this view. Some suggest that it is a concept best suited for faculty lounges. We must remember what's at stake: a robust price discovery mechanism that encourages market makers to quote aggressively and customers to place limit orders. Consider this fact: Approximately 85% of market orders executed on Nasdaq today are routed to markets that are not quoting the best price." [Emphasis in original.]
Mr. Levitt did not provide comparable information about non-Nasdaq stocks. But as a suggested remedy for this condition, he offered proposed new regulations (Release #34-43084) he described as follows:
"...the execution quality disclosure rules would function on two levels.
"First, market centers would disclose to the public, on a monthly basis, the critical components of execution quality; for example, where orders were executed in relation to the quoted spread, the speed of executions, and fill rates for limit orders.
"Second, brokers would report which market centers they sent orders to, any payment-for-order-flow or internalization arrangements they had with those markets, and the basis for their routing decisions."
Now, read the wonderful benefits Mr. Levitt said such a proposal would bring to investors:
"Academics would publish comparative analyses of execution quality achieved by market centers, institutional investors would hire consultants to analyze market center reports, and the financial and consumer press would offer side-by-side comparisons of, for example, speed and price improvement rates. Best of all, competitors would scrutinize each other's reports."
Whoopdedoo! The rules proposed by the Release (33,066 words long!) would create research publications for academics, jobs for consultants, stories for the print and electronic media, and extra work for analysts at brokerage firms. Guess who will pay for all this? Why, investors, of course! After all, they pay for everything! Best execution price guarantees? Don't be silly! (And can you imagine the cost, paperwork and confusion if investors every month, after reading their broker's "report card," decide to move their accounts to the new "#1," only to have to make a similar move the following month?)
Let me suggest an alternative plan: Structure the trading system so best bid, first entered, would always have the opportunity to meet best offer, first entered. That's what the Congress wanted so long ago. No longer would US markets have such bizarre anomalies as "locked" markets, where bids and offers equal each other, but no execution occurs, or "crossed" markets, where bids are higher than offers, or vice versa, and still no executions take place. With such a system, every trade execution would be guaranteed "best execution," and the Commission could finally write finis to the congressional mandate given them in the previous millennium. It would also be far simpler to build, operate and regulate.
The term "best execution" needs clarification. In securities markets, investors and other traders want only one thing: buyers want to pay the smallest total amount for each execution; sellers want to receive the greatest proceeds for each execution. The Commission has confused "best execution" of each trade with "best execution" of each order. Some orders can be executed with a single trade. In that case the terms are synonymous. But many orders-especially large orders for hundreds of thousands or millions of shares entered by institutional investors-require multiple trade executions, sometime over a day or more. This may be required to accrue the lowest overall cost or the highest proceeds. But is each and every trade execution at the time it is made is made at the highest bid (for a purchase) or the lowest offer (for a sale), the total cost or proceeds of the entire order will assure "best order execution."
So, too, the term "price improvement" is a misnomer. In every market, for a trade to take place, a bid must be hit or an offer taken. At the moment of execution, the spread must be zero. The issue is: Who get to see and reach the best bid or offer? If neither disclosed nor executable by all market participants, it is a Tantalus system.
Designing state-of-the-art trading systems is a task best left to the free market, not SEC lawyers who create Alice in Wonderland solutions. We have waited 25 years for the promised national market system. All we now have is a system in which up to 85% or more of over-the-counter trades are sent to market centers with inferior prices; who knows what percentage of listed stocks have the same result? Shame on the Commission! Can't they do better? If not, where is the Congress?
In proposing Rule 11Ac1-5, the Release states that its purpose is as follows:
The Commission anticipates that the proposed rule will help broker-dealers fulfill their duty of best execution. That duty requires a broker-dealer to seek the most favorable terms reasonably available under the circumstances for a customer's order. Routing orders to a market center that merely guarantees an execution at the best published quote does not necessarily satisfy that duty. A broker-dealer must consider several other factors affecting the quality of execution, including, for example, the opportunity for price improvement, the likelihood of execution (which is particularly important for customer limit orders), the speed of execution, the trading characteristics of the security, and any guaranteed minimum size of execution. While broker-dealers currently may be able to obtain order execution information from some market centers, that information may be of limited use and may not allow broker-dealers to compare execution quality among the different market centers. The Commission expects that the monthly reporting of uniform statistical measures required by the rule will provide broker-dealers with a clearer sense of execution quality among market centers, and will facilitate a broker-dealer's ability to obtain best execution for its customers.
As noted above, the Commission still confuses "order executions with "trade executions." If the Commission would correct its definition of "best execution," then sending an order to a system in which the best bid and offer are always available to be hit or taken would guarantee "best execution" per transaction. And that's what investors want.
For more than 25 years the author has communicated with the Commission through testimony at the Commission and to Committees of the Congress, and by comments on Commission Releases. I would think by now, the SEC would know my views on the subject of how a national market system should be designed, built and operated. It seems redundant to cite them once again.
But I would like to express my appreciation to the Commission and its Staff for creating the perfect texts annually for my senior seminar course on equity market microstructure. I can always be assured that during the summer the Commission will send out yet another legalistic, verbose, complicated, confusing Release that attempts through micromanagement to clarify and correct the mistakes made in their previous Releases. As usual, the newest version of their lawyer-like effort to craft the national market system has made it even more Rube Goldberg-like. Unfortunately the arrival of the new millennium has brought no change.
A system that brings together bids and offers of intangibles should be relatively simple to design, build and operate. To argue that the principal reason not to have a system with price-time priority is because it would be subject to failure is ridiculous. Mirror sites and multiple processors are commonplace. If a unitary site is such a threat, why doesn't the Commission require that floor-based exchanges like the NYSE have multiple floors to protect against catastrophe?
Even Chairman Greenspan, quoted by the Commission in its Release, recognizes that financial markets in intangibles are natural monopolies. As the Commission stated:
As Chairman Greenspan noted in his congressional testimony on market structure issues, "[i]n the long run, unfettered competitive pressures will foster consolidation as liquidity tends to centralize in the system providing the narrowest bid-offer spread at volume. Two or more venues trading the same security or commodity will naturally converge toward a single market . . . Of course, this process may not be fully realized if there are impediments to competition or if markets are able to establish and secure niches by competing on factors other than price."
Why does the "long run to achieve a national market system" have to have been a quarter-century or more? And aren't Chairman Greenspan's "impediments to competition" mostly the micromanagement by the Commission and its staff?
Very truly yours,