Speech by SEC Commissioner:
Remarks before the Open Meeting regarding Regulation NMS
Cynthia A. Glassman
U.S. Securities and Exchange Commission
April 6, 2005
Thank you. This final rule proposal has four main elements: access, subpennies, market data revenue, and the trade-through rule. While I have some concerns about the first three, I will address those last, and focus my comments on the trade-through rule.
As I understand it, the ultimate goal of Regulation NMS is to make sure buyers and sellers of stock meet at the most advantageous price for each of them. That is an excellent goal, but one that does not require this rule. We could get the same result by relying on fair access standards, real connectivity, the duty of best execution, and competition. It appears to me that we have those elements on the Nasdaq market - a robust and competitive market, so I consider the Nasdaq market an excellent pilot for testing whether these elements are sufficient for meeting our goal. Based on our own research study as well as a number of very compelling comment letters, my view is that we can meet the goal without imposing a new layer of regulatory oversight and the compliance costs that go along with any regulation and are ultimately paid for by investors. Implicit in that view is the elimination of the ITS trade-through rule, which clearly does not work.
Our Office of Economic Analysis conducted a study that suggests that trade- throughs on NASDAQ and the NYSE are really pretty low. I believe the study was very well done - although, like most economic studies, there are some limitations, especially on the data. OEA found that approximately 2% of all trades on Nasdaq and the New York Stock Exchange were traded-through in 2003 and between 2% and 8-9% of total shares traded, with the top end of the range of total shares traded-through being an acknowledged overestimate. Commenters identified possible flaws in the OEA studies, suggesting that trade-through rates were lower than OEA's 2% estimate, in fact slightly less than 1% on each market. In any case, the OEA data showed that the majority of trade-throughs only trade-through by a penny or two.
Whether the correct estimate is 1% or 2%, this means that between 98% and 99% of all trades are not traded-through. Contrary to the staff's interpretation, these numbers tell me that trade-throughs are not a significant problem. Furthermore, commenters have suggested, unless trading systems are perfectly synchronized, we will always have trade-throughs, even with a trade-through rule.
Despite its lofty rhetoric about enhancing market efficiency by promoting the display of limit orders, the Reg NMS adopting release is careful to lower expectations about the modest scope of its hoped-for benefits. And for good reason. The cost savings to investors from the rule is estimated at a mere $321 million. This number represents the harm to retail and institutional investors whose market orders were executed at prices worse than the best available bid - likely a penny or two worse -- on the Nasdaq and NYSE markets combined in 2003. Given that dollar value of trading on both markets totaled $18.7 trillion in 2003, with the dollar value of market and marketable limit order trading totaling $11.9 trillion, $321 million is only a rounding error. As a percent of the total dollar value of trading, the $321 million benefit is less than 1/100th of one percent.
Even such modest benefits will come at a very high price. Some of the costs of Regulation NMS will be measured in terms of the dollars it will cost trading centers to modify their policies and procedures and internal systems and monitor compliance with the trade-through rule on an ongoing basis. The cost-benefit analysis estimates start-up costs at $143.8 million, with average annual ongoing costs of approximately $22 million. But market participants will also experience significant costs in terms of the time and effort they will spend negotiating with our staff on the numerous interpretive issues that will come up in the rule and in explaining to our examination staff that apparent trade-through violations are not really violations. Thus, even if there are no trade-throughs, there will still be a burden on trading centers to prove the absence of trade-throughs. A belt and suspenders approach is costly. And money spent on Reg NMS compliance will be money taken away from the development of innovative products and systems.
Given the relatively insignificant scope of trade-throughs, the modest benefits of the rule, which at best are largely speculative, and the significant costs involved, which include not just dollars, but the loss of investors' ability to choose how they want to trade, I cannot support the trade-through rule in either the listed market or on Nasdaq.
There are many statements in the release that I find biased, unsupportable, internally inconsistent and exaggerated, but I will mention just a few. First, the release minimizes the extent of commenters' opposition to the trade-through rule. At the last open meeting on Regulation NMS, I urged commenters to go beyond the questions raised in the reproposal about top of book vs. depth of book and address the need for any trade-through rule at all. A number of commenters submitted compelling letters, including firms representing retail investors such as Fidelity, TIAA-CREF, Schwab, and Ameritrade, essentially all of the electronic markets, a wide range of other market participants, and most academics. I do not believe that the release addressed these comments in a manner commensurate with the thoughtfulness with which they were written. Rather, the imposition of this trade-through rule appears to be another fait accompli.
Further, in the initial discussion of the comments, the release mischaracterizes the extent of the opposition to the trade-through rule. The release states that approximately 1,689 commenters favored a uniform trade-through rule without an opt-out, while only 435 commenters either opposed a trade-through rule without an opt-out or opposed a trade-through rule altogether. While the release points out that 179 of the 435 comments generally opposing a trade-through rule were form letters, it fails to mention that the vast majority of comments in favor of a top of book trade-through rule were various types of anti-CLOB form letters.
Second, I am aware of no legitimate basis for the rationale for distinguishing between the interests of long-term investors and short-term traders for purposes of making decisions on market structure. Short-term traders are active participants in the price discovery process, and provide liquidity to the market. Impeding trading by short-term traders, which could easily include institutions representing retail clients, would be a negative development for the markets, not a positive one.
Third, the release fails to provide any convincing reason for extending the trade-through rule to Nasdaq. In fact, in attempting to justify why it would not be costly to impose a trade-through on Nasdaq, the release actually makes an excellent case for why a trade-through rule isn't needed on Nasdaq. "With respect to Nasdaq stocks, connectivity among many trading centers already is established through private linkages. Routing out to other trading centers when necessary to obtain the best prices for Nasdaq stocks is an integral part of the business plan of many trading centers, even when not affirmatively required by best execution responsibilities or by Commission rule." So why do we need to impose a trade-through rule on Nasdaq? And to those who argue that the markets need uniform regulation, my answer is simple: we don't need the trade-through rule on either the New York Stock Exchange or Nasdaq.
Although the release focuses on allegedly low fill rates on Nasdaq, this concern is misplaced. As I understand it, the use of oversized orders - referred to as "pinging" -- is a common practice used on electronic markets to ferret out trading interest and reserve size. This is simply an electronic version of the same behavior that occurs on the New York Stock Exchange - only on the NYSE, this information must be ferreted out from the specialist system where some people have more access than others.
Fourth, when I first joined the Commission and started working on market structure issues, one of the first problems I heard about was the outdated ITS trade-through rule that slowed the speed of the electronic markets to the pace of the slowest manual market. To get Island's quotations in certain ETFs into the public quote, the Commission developed a 3-cent de minimis exemption from the ITS trade-through rule for the ETFs, facilitating the integration of automated and manual markets. The temporary exemption, which we have extended twice, has apparently been successful. It has increased competition, spreads have tightened, and trade throughs are down significantly.
Yet, instead of using the results of the de minimis pilot as the basis for further experiments with trade-through restrictions, the Commission has ignored the results of the pilot and has decided instead to impose the trade-through rule on all markets and all NMS securities. Regulation NMS is a massive regulatory intrusion into the operation of the markets that limits investor choice and impedes innovation and competition. A rule with as many provisions and exceptions as Reg NMS - and the interpretations it will entail -- will be costly to comply with, and its policies and procedures-based "reasonably designed to avoid" standard will be difficult to enforce. Having the government becoming involved in market activity to the extent envisioned under the new rule will undoubtedly lead to unintended consequences.
While we may all agree with the goals of increasing liquidity and the fairness of our markets, the fact is that no one knows whether this massive regulation will work. It has never been clear to me why we need a trade-through rule rather than letting the market work. The underlying rationale of the proposal is that it is better to rely on our staff's interpretation and oversight to manage competition. My rationale is that I would prefer competitive market forces to determine the outcome.
As far as the other parts of Reg NMS, we would not need a cap on access fees if we weren't saddled with the trade-through rule - the markets could take of the problem. And as for the changes to the market data allocation formulas, this is only a stopgap measure. We need to revaluate the entire market data system in the SRO governance context
To conclude, even though I am highly skeptical of the need for a trade-through rule, preferring that we focus on improving access and connectivity, I would have considered a phased-in implementation approach that would have permitted us to gain experience on how or whether the rule was working before full implementation on all markets. We could have begun with a subset of stocks on the listed market and evaluated the results before going to full implementation on the listed market. If results proved positive, we could have decided then whether to extend the rule to the Nasdaq market. Given my reluctance to support any trade-through rule, my suggestion to the Chairman that we discuss such an approach was a considerable compromise on my part. I felt that my proposed compromise was not as good as having no trade-through rule, including no ITS rule, but it was better public policy than this rule. My compromise offer was rebuffed. The Chairman came back with a proposal to delay implementation of the trade-through rule on Nasdaq for three months. That was a compromise in name only, and could not be seriously considered. I would note that if there is no doubt about the success of Regulation NMS, my compromise, including the ongoing evaluation, should not have raised serious concerns. The proof would have been in the pudding.
Therefore, I dissent from the adoption of Regulation NMS, and I will be preparing a written dissent. Nonetheless, I want to thank the Market Regulation staff as well as the staff of the Office of Economic Analysis for their hard work.