April 21, 2000
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street NW
Washington DC 20549-0609
RE: File No. SR-NYSE-99-48
Proposed Rescission of Rule 390
Concept Release on Market Fragmentation
Dear Mr. Katz:
Let me introduce myself. I am Wayne Wagner, the Chairman of Plexus Group, Inc. Plexus Group evaluates trade executions for our client base of 146 of institutional money managers, investment sponsors, brokers and exchanges. The managers alone are responsible for over $1.7 trillion of equity assets.
I am also a member of the AIMR Best Execution Task Force and also participated in the AIMR Soft Dollar Task Force.
Several of our clients have requested that Plexus comment on the proposed rules changes and how it affects institutional investors. Despite this impetus, the views we present here do not represent client views nor my colleagues at AIMR. The views, however reflect our honest appraisal derived from direct measurement and observation of how well the markets seem to be working, especially for institutional investors.
By way of background, Plexus Group has popularized the "implementation shortfall" approach to evaluating trading cost and effectiveness. This approach addresses the question: ¨How much value is lost during the process of implementing trades?" Simply stated, if the ideas are worth X dollars before implementation starts and Y when the execution is completed, the cost of implementing the ideas is X-Y. It is the approach most accepted by knowledgeable academics and practitioners.
Implicit in this approach is the idea that searching for liquidity is a cost as real as commission and impact. The data our large institutional clients submit to us indicates that the average dollar traded is part of an order that represents over a full day's volume. Most of these trades are not completed within a day, much less within a tick.
These delay costs arise because the liquidity isn't readily available to satisfy this lumpy demand. We measure these hidden liquidity costs in the range of three times the size of the combined commission + impact costs. (See The Official Icebergs of Transactions Costs under Commentaries at www.plexusgroup.com.) By our observation, these costs truly hamper performance, and seem to be getting worse by our measurements.
Needless to say, these large institutional trades represent giant pools of natural liquidity that everyone wants to trade with. Unfortunately, they are also the large pools of potential trading that everybody wants to "shoot against," to front-run - to sop up ready liquidity in hope of selling back to the big institution at a better price. As a result, institutional sized orders are seldom displayed for public view in any market, leading to burgeoning liquidity costs. Often, the features that seem to improve the market for individuals, such as thin spreads, maximal exposure and trading immediacy have little appeal to institutions seeking reasonably priced bulk liquidity and as little exposure as possible.
As an example of how seemingly beneficial market innovations can have an opposite effect, consider the effect of forcing the Instinet book to be exposed to NASDAQ. Because institutions were not willing to let individuals peek at their intentions, the result was a significant diminution in size being shown. This rule change resulted in lower costs for individual traders but higher costs for institutional traders. The amount of money institutions manage funds for the benefit of individuals investors dwarfs the assets traded by individual traders. Thus it is not obvious that the rule benefited the average investor at all.
We are great fans of innovation in markets. Over the last 30 years, innovation has forced change on self-satisfied exchanges and trading procedures. Without innovation from the outside, surely the pace of change would have been much slower.
Note that much of the innovation flows from emerging technology. The results are often unexpected and unpredictable, and often fail. Yet the result of this experimentation has surely been a vastly accelerated pace of innovation, a clear example of the chaotic but beneficial results of "creative destruction."
Without the freedom to innovate, the process of change would be slow, reactive, and excessively political. It would be concerned with balancing the needs of identified "stakeholders." But how could the eTraders, whatever one might think of their activity, be represented as a stakeholder when they didn't even exist? Rather than trying to define the ideal market, we would argue to let the innovators innovate. Their success or failure will reveal which efforts actually represent value to investors.
Of course, openness in rule making means that all markets will not necessarily operate under the same rules. Enforced uniformity can lead to anti-competitive situations, often sanctimoniously described as "a level playing field." The concept of level playing field make less sense when inhabited by ants and elephants.
We find it hard to identify what an "ideal" market is, when traders strongly differ in their taste for best price, best time, surest clearing, highest fidelity, computer accessibility, hours of trading, and other ancillary services. The best mix of facilities will result in an ability to draw liquidity and capture volume.
One need only review the episode of the Paris Bourse to understand the negative effects of ill-conceived innovation. When the rules implemented did not suit the block traders, that portion of the market moved wholesale to London. Only when the rules were changed was the Bourse able to reinstate itself as the primary French market.
Don't think it couldn't happen here! For the cost of a few more broadband trans-Atlantic communications lines, the entire institutional market could move to London, virtually overnight. That would be a serious setback for US markets and US retail investors.
We also firmly believe that there is no such thing as a naturals-only market, as the early years of Instinet amply proves. Markets needs to be made; they need market-makers to put up their quotes and "stand still" - wait so the world can observe what the current executable prices are. The Social Good of standing still grants a costless option to the other side to determine when and whether a trade will execute. This valuable option, whether provided by a market maker or a natural, needs to be encouraged for markets to flow freely.
A market maker will only put up a quote with the expectation of profit over time. Rulings that inhibit that profit may have the adverse effects of thinner quotes and the resultant more volatile markets. An example of an inhibiting ruling is decimalization. Razor-thin quote increments allow someone to step in front of the quotes without significantly improving the price, lessening the incentives for "standing still."
Finally, we'd like to address the issue of fragmentation. We wonder whether it is a real problem or a stalking horse, an excuse to buttress the traditional structures? Ask yourselves why we don't hear of fragmentation between the futures market and the equities market. For one simple difference: any differences that arise are quickly arbitraged out. Arbitrage is the simultaneous buying of an asset in one market and the selling of it in another market for the attainment of a profit of the difference in price. With screen-based markets scattered throughout the world, there are thousands of investors and market functionaries able to squeeze out differential pricing between markets. The market centralizes naturally on these traders desks. We believe it is more effective to rely on this simple natural force than to try to establish complicated rules and interconnections to try to solve fragmentation.
1. Rule 390 is anti-competitive. It has long outlived its usefulness.
2. Liquidity is encouraged by price and time priority, which encourages limit orders to thicken the quote. However, razor-thin quote increments allow someone to step in front of the quotes, lessening the incentives for "standing still."
3. Disclosure is the best cure for many ills, including potential problems with internalization.
4. Similarly, all markets' BBO and executions should continue to be promptly distributed.
5. Let market innovation deal with any problems of fragmentation.
Thank you for the opportunity to comment on these vital issues.
Wayne H. Wagner
Chairman of the Board
Plexus Group, Inc.