Speech by SEC Staff:
Remarks before the SIA Market Structure Conference
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
New York, NY
May 20, 2005
Thank you. It is a pleasure to have the opportunity to address you again this year on market structure issues. There is much to talk about today. Before I begin, I will make the usual disclaimer that the views I will express today are my own and not necessarily those of the Commission or my colleagues on the staff.1
So much has happened since last year's conference. On April 6 of this year the Commission adopted Regulation NMS, a series of initiatives to modernize and strengthen the national market system for equity securities. I think it is fair to say that Regulation NMS represents the most significant market structure reforms since the '75 Act Amendments. Just two weeks after the Commission's action, on April 20, the New York Stock Exchange and the Archipelago Exchange announced an agreement to merge and become a publicly held company. And as if that was not enough excitement for one week, two days later the Nasdaq Stock Market announced an agreement to purchase the Inet ECN. The significance of these announcements cannot be overstated. Not only are our four major equity markets seeking to merge, but the competition that this will unleash across the listed and Nasdaq markets is unprecedented. It is indeed a dynamic period in our securities markets, and I believe that Regulation NMS has positioned us extremely well to accommodate these changes while fostering deep and liquid markets and the protection of America's investors.
I would like to acknowledge the contributions of the SIA and many of its members who are in this room today who so constructively contributed to these market structure reforms. This represented the most open and deliberative process that I can ever recall by the Commission, and the resulting rulemaking was refined and improved based on the input we received from many thoughtful and expert market participants such as yourselves. One of the greatest strengths of our democratic process is also its most challenging aspect-the opportunity for vigorous disagreement and debate-and the process of promulgating Reg NMS was no exception. But one must expect that given the complexity of the issues and the multiplicity of business models and business interests affected by the regulatory reforms, that there could never be consensus. As you know, the Commission was urged by some commenters to slow down the process or repropose the rules for a second time before final adoption. Having studied and debated the issues for nearly five years, the Commission resisted these calls and decided to call the question.
The events that unfolded two weeks after the adoption of Regulation NMS amply demonstrate that our markets agreed on one fundamental point-the need for certainty on the regulatory structure of our equity markets. The proposed market consolidations seem to indicate that there was a need to maximize economies of scale, reduce excess capacity and respond to market forces that were demanding more automated trading at the New York Stock Exchange. Our outdated regulatory framework, as well as uncertainty over the much discussed reforms, clearly had a chilling effect on the ability of market participants to formulate and implement their business strategies. Thus, delay was an unacceptable option. By adopting Regulation NMS, the Commission made way for the business changes that market participants deemed advisable. And the recent announcements make clear that those changes are indeed quite far reaching.
I won't revisit today the rationale for all of the policy decisions embodied in Regulation NMS, since they have been publicly discussed many times and the adopting release articulates them quite clearly. I would like to comment, though, on one aspect of the rulemaking that received a good deal of attention-the application of the Order Protection Rule across all markets.
The antiquated ITS Trade Through Rule, which protected the quotes of floor based markets ultimately at the expense of immediately accessible automated quotes, had the effect of creating a two tier equity market structure in the U.S. The market for Nasdaq stock, which had no Trade Through Rule, saw significant competition from fully electronic ECNs, whose innovative technologies and order types captured the significant market share in Nasdaq stocks. But in the listed market, where the ITS rule applied, these ECNs found an inhospitable environment in which they could not coexist, given their speedy automated executions. Both markets were characterized by a significant volume of trade-throughs of the best prices-in NYSE stocks because of gaps in the ITS rules and in Nasdaq stocks because of the absence of any restrictions on trade-throughs. The need was evident for stronger protection of investor orders and for reaffirming the principle of best price.
The recent announcements of market consolidations amply demonstrate the rational underpinning of Regulation NMS. By leveling the playing field and applying uniform rules across all markets, the Nasdaq and listed markets will now compete directly under rules that ensure three inalienable principles-best price, open access, and transparency. Through full scale competition and adherence to these principles, our equity markets will continue to develop in any number of ways that will benefit investors.
I realize that as I speak to you about the final rulemaking, you are all wondering exactly what the final release says. As you know, there has been some delay in the publication of the rulemaking. This process may appear to you like the rollout of a Harry Potter sequel. You expect the next book by a certain date, only to be told that Ms. Rowling is taking a bit longer than expected. The expectations mount and excitement builds. Indeed I have fantasies of sending a mass email to the industry the day of Reg NMS' publication, inviting everyone to meet at midnight in Times Square wearing capes and horn rimmed glasses to celebrate its debut. But trust me when I say that it will all be quite anticlimactic, because you have already seen the December reproposal on which the release overwhelmingly is based. There are of course some changes, but they were made largely to accommodate commenters' requests for additional flexibility or to make the meaning clearer. You will not be surprised by the final result.
And on that note, I must say that the anticipation has clearly caused imaginations on trading floors all over New York to run wild. Some of the rumors that we have heard are even more fantastic than Harry Potter's magical powers. Take for example the rumor that either through rule text or by staff action, it is our intention to limit or discourage the number of new ECNs or ATS entrants into the marketplace. I find this rumor preposterous, frankly. The Commission has for years taken steps that fostered the development of ECNs to the tremendous benefit of our marketplace. The notion that this policy would be reversed by the Commission or its staff, or that anything would be imbedded in the footnotes of Reg NMS to make this so, is simply incorrect.
Next, we have heard that certain ATSs such as Liquidnet were exempted from the Order Protection Rule in the final Reg NMS release. This is simply not true. Since the Order Protection Rule applies to block transactions, it would make no sense to exempt a block trading system from its application. Rather, Liquidnet requested an exemption from the new 5% fair access standard because it does not publish quotations. The release will indicate that the Commission sees some merit in this logic and will consider issuing an exemption from the new 5% standard during the implementation period for any entity that essentially operates as an electronic block trading desk and does not disseminate public quotations.
Another notion that has made the rounds is that the Order Protection Rule was modified in the final release to require the protection of reserve size. You cannot imagine how many panicked calls the staff received on this issue. Just stop and think for a moment. The republished Reg NMS had two Order Protection Rule alternatives-the so-called "Top of Book" alternative and the "Depth of Book" alternative. Even the "Depth of Book" alternative, which was considered the more aggressive of the two alternatives and was not adopted by the Commission, never called for the protection of undisplayed reserve size. Imagine mandating the protection of an order you cannot see. I must say that this type of prepublication hype may work wonders for Scholastic Press's bottom line, but it really has no place in the more staid world of our financial markets.
All that said, there is no question that there is much detail for us to absorb and much effort to be devoted in the next year to implementation of Reg NMS. To reach good decisions on implementation issues, it is vitally important that we receive the full and considered views of securities industry participants. Experience with implementing previous NMS rules has shown the great value of participation in the implementation process by the personnel actually responsible for developing the policies and procedures and programming the systems necessary for compliance. This type of detailed participation cannot be obtained through comment letters prior to rule adoption, which (like the rules themselves), typically focus on broad policy questions and not on more specific implementation issues.
Consequently, we anticipate working closely with any industry participants and groups that offer assistance in the implementation process. This assistance can be both informal, such as through meetings or telephone calls, or more formal through the participation of the Commission staff and industry participants in "user groups" established to address key implementation problems faced by a wide range of industry participants. For instance, it may be useful to have one group that discusses issues relating to SRO implementation of the rules, while another focuses on issues faced by full service broker-dealers.
Experience has shown that, at some point in the implementation process after issues have been sifted and analyzed to a fair degree, a defined set of key issues that warrant formal and consistent resolution come to the forefront. The Commission anticipates issuing interpretive guidance that sets forth these key issues and their resolution.
Without being exhaustive, I thought I would touch on a few of the issues that I foresee having to address during the implementation period of the Order Protection Rule.
For one, we will need to address the issues concerning automated markets and automated quotations that are raised by Reg NMS. I assume that all markets will make the necessary changes to qualify as automated. In handling rule filings from the SROs, I anticipate that the approval orders will indicate whether the rules themselves would prevent the market from qualifying as automated. If the staff has reason to believe the assumption is not justified for a particular trading center, it can contact the market to discuss the operation of the market's systems and rules in light of the requirements. If necessary, after consultation with the Commission, the staff could issue guidance to the industry that a trading center does not qualify as automated. Such guidance would provide other trading centers the ability to bypass the non-automated trading center for purposes of the Order Protection Rule.
A key element of the requirements for an automated trading center, especially with regard to hybrid markets, is whether the trading center has implemented objective standards for switching from automated to manual quotations, and vice versa. The staff will review these standards for SROs through the rule filing process, similar to the review that we have undertaken with respect to the NYSE's proposed changes to its Direct+ trading system, and we believe the Commission would indicate in the approval order whether the rules prevent the SRO from meeting this requirement. This process also provides the opportunity for industry participation through the public notice and comment process.
I also expect that there will be focus on the policies and procedures necessary to comply with the Order Protection Rule. Although I envision that the Commission will provide consistent industry-wide guidance with respect to the requisite parameters of the policies and procedures necessary for compliance with the Order Protection Rule, I do not believe that consistency necessarily means that all trading centers will need to have identical policies and procedures. Given the different types of trading centers - hybrid markets with specialists (NYSE and Amex), fully electronic markets (ArcaEx, NASDAQ, Inet, Bloomberg, Brut, other ECNs), retail market makers, block positioners (Goldman Sachs, Morgan Stanley), and crossing systems (Posit, Liquidnet) - I believe that the exact nature and extent of the policies and procedures should be commensurate with the structure of the different types of trading centers. The underlying policy, however, should be the same.
Some other issues that will arise include surveillance procedures. The Commission will expect trading centers to engage in regular and periodic surveillance to determine the extent to which trade-throughs are occurring without an applicable exception and how the trading center's policies and procedures can be strengthened to prevent such trade-throughs. This surveillance by the trading center could include examining quotations and trades for particular time periods and closely evaluating the results to ascertain whether any trade-throughs occurred that were not excepted from the Rule and that reasonably could have been prevented.
In determining the frequency and scope of required surveillance of compliance with the Order Protection Rule, it will be beneficial to have the input of industry participants as to existing procedures and methods available and currently employed by different types of trading centers to surveil their own or their customers' or members' trading activities, including surveillance for compliance with best execution obligations.
As to manual executions, the policies and procedures for block positioners (as well as hybrid markets) will need to address the requisite standards for manual executions, as well as fully automated trading. I expect that to take advantage of the intermarket sweep exception to the Order Protection Rule, trading centers will need to automate their execution process so that at the time they are executing an order, their systems evaluate existing protected quotations and route accordingly. In addition, such policies and procedures should include the ability to record the time of execution separately from the trade reporting time (if they are different). Further, practical issues raised by commenters for reporting block trades executed in compliance with the Order Protection Rule could be resolved in a variety of ways. I believe that the input of the industry during the implementation period will be the best way to achieve the most appropriate resolution.
I also envision that we will provide guidance to trading centers as they develop objective standards to implement the self-help exception. Industry participants likely will ask how many failed responses would be required before they could elect to use the "material delay" exception, as well as when the exception "expires.' They also likely will want further guidance on the use of the exception when there are repeated, major systems problems that go beyond slow responses by a trading center. Prior to providing more specific guidance on the scope of this exception, it would be beneficial for the staff to discuss with the industry the different problems they currently experience, the duration of the problems, and how they are resolved.
There will be other questions as well. Some will likely include the scope of the "benchmark" exception to the Order Protection Rule. Some have raised various "contingency" transactions, "arbitrage" transactions, "spread" transactions, and transactions priced with reference to derivatives. Given the very specific and detailed nature of the different trading strategies, I believe that industry input is essential to gain a full understanding of the need for, and impact of, granting such exemptions.
And through it all, there is best execution. While the Order Protection Rule backstops the brokers' duty of best execution, that overarching duty continues. Some brokers have asked whether they are still held responsible for manual quotes in light of Regulation NMS's focus on automated quotes. I believe it is too early to decide that all manual quotes are worthless for best execution purposes. But I expect the Commission to say in the NMS release that when trading in a stock is largely automated, a broker could reasonably determine to bypass manual quotes of a non-primary market, if its experience demonstrated that an attempt to access the market would not be in its customers' best interests.
All in all, it is fair to say there is much to do, and only a year to get it all done before the implementation date. I wish I could wave Harry Potter's wand and make all of this happen with little or no effort. But that is not possible. What is possible is for us to work together constructively and cooperatively as we have in the past to achieve the best results for our markets and for investors. Thank you.