Speech by SEC Commissioner:
Remarks Before the Brooklyn Law School Symposium On The Structure Of Securities Markets
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
Brooklyn, New York
November 10, 2006
Good afternoon. I am delighted to have been invited to address Brooklyn Law School's Symposium on the Structure of Securities Markets. Roberta Karmel invited me to participate in this program and I have never been able to turn Roberta down. She is a role model to many, but particularly to me because she was the SEC's first woman Commissioner. I always remember Roberta's story about being chosen by President Carter to serve on the Commission. Roberta knew that she was being considered, but the President for some reason was taking his time making his final decision. When Roberta finally met with the President, she was polite but firm. She explained that she was the mother of several children and if the President was going to appoint her it would be very helpful if he would do it promptly, because she needed to move her children to Washington and get them settled into new schools pronto! I think the President was so taken with Roberta's refreshing directness that he announced his decision within a matter of hours!
Today, I would like to explore the role of regulation in enhancing competitive market forces in certain circumstances. I will discuss some specific examples in securities regulations that are intended to illustrate the Commission's rationale in taking the actions it did and the salutary effects that those actions had on the markets.
Before I begin, I must remind you that my remarks are my own and do not necessarily represent those of the Commission, my fellow Commissioners, or the staff.1
There seems to be much discussion these days about the negative effects of regulation. Indeed, today speaking at all positively about the benefits of regulation is not for the faint of heart. It is downright unpopular. And certainly we can all point to poorly crafted, excessive, or badly implemented regulations. But well-conceived, balanced regulation does serve an important role and I will attempt today to describe some of the contexts in which I believe regulation has indeed enhanced the competitive marketplace.
One area in which regulation may play a key role is in the context of a dominant market. Simply put, markets with very significant power may use that power to act anticompetitively. Obviously, this notion is at the heart of our antitrust regulations. In the case of our securities markets, Congress recognized back in 1975 that there were benefits to having a system of multiple, competing markets. A single, dominant market may discriminate against its competitors in the setting of prices or the provision of services. It could use its market power to extract high transaction fees from users, or it may limit the availability of its market data in order to benefit those who operate exclusively in its market. In our system of multiple, competing markets, Congress sought to capture the benefits of competition while mitigating the effects of market fragmentation. Thus, Congress directed the Securities and Exchange Commission to facilitate the establishment of a national market system for securities. The goal was to use regulation to enhance competition in the securities markets in a manner that would also promote price transparency and price competition. Indeed, Congress articulated the goal as one designed to "foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors' orders, and contribute to the best execution of such orders." Thus Congress recognized that regulation in this important area could be used to enhance competition where natural market forces would not do so.
The Commission has used this legislative authority over the years in a host of ways to enhance the competitiveness of our markets. Take, for example, the inter-market linkages we mandated in the options markets. There has been so much positive progress in the options markets that it is difficult to remember that just a few years ago there were neither intermarket linkages nor multiple listing of products. Each market had a virtual monopoly in each of the options classes it sold, and there was no facility enabling the markets to trade across markets when a better price was offered in another market. As you know, all of that changed due to regulatory intervention in 1999. With the encouragement of the Commission and the Department of Justice, the options markets moved to full-scale multiple listing of nearly all of their products and they established an intermarket linkage in order to facilitate the ability to obtain a better price on another market, if available. The results of the benefits of multiple listing were staggering - spreads dropped by nearly 40%, to the benefit of investors and the exchanges who traded these products. And how could the exchanges possibly have benefited? Not surprisingly, volumes went through the roof once the pricing became more competitive. This clearly represents a "win-win" for everyone.
As an aside, we continue to see some challenges to this principle of multiple listing of options, and a recent legal dispute again demonstrates the competitive significance of this important regulatory principle. McGraw-Hill and Standard & Poor had claimed exclusive property rights in the issuance and trading of options on index-tracking securities such as DIAMONDS and SPDR products. Up until this case, options on SPDRs, for instance, did not trade widely because S&P refused to grant licenses to anyone other than the CBOE, which had an exclusive license to trade options on the S&P 500 index. In a decision in the Southern District of New York, Judge Baer rejected plaintiffs' assertions that the creator of an ETF based on an index retained a proprietary or other protectable interest when options on the ETF are offered in the secondary market.
I believe the District Court's decision was correct and was terribly important because the result is consistent with the SEC's strong policy of promoting multiple listing and trading of products in our national market system. Illustrating the powerful effect of competition in these markets, just one day after Judge Baer issued his opinion, DIAMOND options began trading on multiple exchanges. As a result, the CBOE aggressively reduced the transaction fees it charges customers to trade DIAMOND option contracts. The result is that trading volume in these products has mushroomed, even on the CBOE. What better evidence of the salutary benefits of competition on the markets could there be?
Another market inefficiency where regulation plays an important role concerns the area of principal-agent conflicts. Market intermediaries face significant conflicts of interest when acting on behalf of customers. In the absence of an efficient means for customers to negotiate for and enforce basic protections, market intermediaries may seek to use their privileged position in a manner that disadvantages their customers and undermines the efficiency of the marketplace. There are numerous instances where market intermediaries could engage in self-dealing when acting as an agent. A classic example is payment for order flow arrangements. An agent may direct customer order flow to a market with a higher price if the market is willing to rebate a fee to the agent, even if it results in the principal getting a worse price. Externalities such as this traditionally have been addressed by the Commission through mandatory conflicts of interest disclosure. Armed with information, principals can better evaluate the activities of their agents.
Another well-known example of Commission intervention to mitigate principal/agent conflicts was in the order handling area. The Commission acted 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. This effectively denied an opportunity for individual investor limit orders to compete with dealer quotations. At the SEC's strong urging, the NASD changed its rules to prohibit this practice for customer orders held by a market maker.
One year later, the SEC took further action to enhance price discovery and transparency and the best execution of investor limit orders when it adopted the Order Handling Rules. Until then, the NBBO for Nasdaq securities generally reflected only market maker quotations. Such quotations did not reflect limit orders of any kind, where submitted by investors to market makers or submitted by market makers or investors to limit order books of electronic communication networks (ECNs), 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. To remedy these practices, the SEC intervened by requiring market makers to include in their quotes (or send to ECNs) customer limit orders that improve a market maker's published quotations. The SEC also required market makers to publish their best displayed prices either in their quote or through an ECN. The Order Handling Rules had an immediate impact on the securities markets. The spreads between bids and offers narrowed dramatically, which resulted in significant cost savings for investors - specifically, spreads in Nasdaq stocks narrowed by over 30%.2
Another area where regulatory authorities can positively influence market forces occurs when there are collective action issues - that is, when individual market participants lack bargaining power to negotiate standards or protections. It also arises when any market participant who tries, individually, to enforce a standard with its counterparties, risks being undercut by the competition. Thus as much as market participants may welcome change, they, themselves, cannot achieve it.
One recent example where our regulatory intervention provided an impetus for change relates to the serious issues arising from inaccurate, incomplete, or unsigned documentation and confirmation of OTC transactions, as well as certain practices in assigning these contracts. The problem of incomplete or unsigned agreements virtually industry-wide means fundamental disputes over the terms of the transaction could occur. Such uncertainty regarding the terms of the transaction enormously increases risk to the parties, since hedging and risk management is based on certain economic assumptions related to the understood terms of the transaction. Also, the practice of assigning transactions without notice to the counterparty is fundamentally problematic, making it impossible for market participants to know their counterparty for risk management purposes.
In response to this issue, the Federal Reserve Bank of NY, the SEC, and other regulators met with fourteen of the largest credit derivatives dealers and reached agreement on key practices and target dates for reducing the backlog in confirmations. With the assistance of the regulators, the dealers also developed guidance to implement the ISDA Novation Protocol to ensure evidence of consent is received by the date of novation.
This group of regulators and dealers had met against a backdrop of concern with the risk management and processing capabilities of the credit derivatives market in the face of exponential growth in demand. All of the dealers recognized the current weaknesses of their methods and were desirous of change. However, no individual dealer could have unilaterally adopted procedures without the cooperation of the broader group. Today, after the intervention of the regulators, the infrastructure that supports the credit derivatives market is substantially stronger.
The use of regulatory authority to create common protocols has also been critical in the area of clearance and settlement. Common settlement procedures, common settlement periods, and centralized operations are critical for the smooth exchange of money and securities among dispersed counterparties and their intermediaries. In a similar vein, regulation also created common standards for industry behavior, leading to greater, more consistent levels of customer protection. Common standards also eliminate the need for smaller players to attempt to negotiate for protections, especially when they are not well positioned to do so. Such standards ultimately lead to greater market integrity and investor confidence.
Regulation, as you know, has been used extensively to mandate transparency. This enhanced market information enables investors to make more informed, market efficient decisions. Our experience over the years in the equity and options markets has confirmed the Commission's fundamental belief that price transparency promotes fairness and efficiency in the US trading markets. Price transparency is essential for efficient price discovery and for obtaining the best execution of customer orders. Transparency also enhances market efficiency by counterbalancing the effects of market fragmentation. Price transparency mitigates the potentially negative effects of market fragmentation by making market participants aware of trading interest no matter where it arises in the national market system. In addition, price transparency promotes investor protection by allowing investors to monitor the quality of executions they receive from their broker-dealers. Finally, price transparency may enhance market liquidity. Because transparency promotes market integrity and fosters investor confidence, it encourages greater investor participation in a market.
As you know, we have had mandatory price transparency in the equity and options markets for many years, but these principles were only recently applied to the corporate bond and municipal markets, with tremendous resultant benefits. In January of this year, the Commission's approval of the immediate dissemination by the NASD of TRACE trade data became effective. TRACE, short for the Trade Reporting and Compliance Engine, is the NASD's system for reporting and disseminating last sale information on corporate bonds not traded on an exchange. Today, the NASD immediately disseminates price and transaction data within 15 minutes after execution. On an average day TRACE provides information on approximately 21,000 transactions representing $19 billion in volume.3 TRACE data is broadly available to institutions via market data vendors, to newspapers and through the NASD and TBMA (now SIFMA). Similarly for municipal securities, pricing data is also widely available through the SIFMA website and is available to market professionals via several data vendors (e.g., Bloomberg, BondDesk, and MuniCenter).
Over the last few years, Commission staff in the Office of Economic Analysis, as well as academics, have analyzed the transaction data for corporate and municipal securities, with a view to understanding the impact of trade reporting and transparency on transaction costs and liquidity. These studies consistently observe that increased transparency reduces transaction costs and does not negatively impact liquidity.
OEA staff has studied the effect of the introduction of transaction price transparency to the OTC secondary corporate bond market and its findings will be published in a future issue of the Journal of Finance.4 Using corporate bond transaction data, from January 2003 to January 2005, OEA found costs are lower for bonds with transparent trade prices. Because OEA could observe transaction costs in bonds before and after transaction reporting, they were able to estimate the change in transaction costs when the TRACE system started to publicly disseminate their transaction prices. Not surprisingly, transaction costs dropped, by about five basis points. When you consider that approximately 2 trillion dollars in bonds trades were not transparent in 2003, it has been estimated investors might have saved an additional 1 billion dollars annually were there transparency in these bonds.5
In the securities markets, there are a many instances where market forces, acting alone, may fail to achieve an efficient outcome. In such cases, regulatory intervention is justified to the extent that it does not impose undue burdens on the marketplace. Regulators must ensure that proposed approaches to dealing with market inefficiencies are the least intrusive possible and are based on sound competitive principles, so that market forces, and not regulation, ultimately shape the structure of the marketplace. In particular, regulators must ensure that the means used to address potential instances of market failure are well-tailored to achieve the regulatory objectives. The results of instances in which these principles have been followed have benefited our markets and investors handsomely.