Speech by SEC Staff:
Remarks before the Fourth Annual Securities Industry Association Conference on Market Structure
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
New York City
June 13, 2003
Good morning. I am delighted to be here to talk to you about some of the significant market structure issues the Commission is facing today. My expectation is that the Commission will be focusing with increased intensity in the coming months on the structure of the U.S. markets, and the appropriate Commission role in facilitating their fairness and efficiency. This morning, I'd like to share with you some of the staff's thinking as it evaluates these complex issues and presents them for Commission consideration. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.1
As you know, the Commission has been focusing on market structure and the creation of a national market system since the early 1970s. When today's markets are compared to those of thirty years ago, the national market system must be considered a resounding success by nearly any measure. Most importantly, investors have expressed their own verdict on the markets by voting with their wallets - over the past three decades, trading volume has skyrocketed and investor participation has expanded greatly. The success of the national market system is attributable to many causes, with economic and other non-regulatory factors no doubt being the most significant. Effective regulation alone cannot cause markets to succeed; ineffective or inadequate regulation can, however, obstruct their success, particularly if it contributes to an investor perception that markets are inefficient or unfair.
In recent years, a variety of markets, firms, and commentators have questioned one or more aspects of the national market system. Many believe that times have changed significantly since the establishment of the national market system - particularly because of advancing technology - and that the Commission's regulation of market structure has not kept pace with these changes. Even those concurring with the fundamental elements of the national market system have questioned whether there are better ways to implement them. And the application by Nasdaq to register as a national securities exchange squarely presents the issue of how the exchange and over-the-counter markets should be regulated in the future.
Today, the Commission is at a crossroads in its oversight of the U.S. markets, and is faced with a range of decisions that will fundamentally impact the structure of our markets for years to come. Significant issues include: (1) what it means to be an exchange; (2) the self-regulatory model of market supervision; (3) access to markets; and (4) the proper regulatory framework for market data. I'd like to address each of these in turn.
I. Definition of an Exchange
Let me begin with the definition of a national securities exchange. Is an exchange an order interaction facility where buyers and sellers meet subject to price priority? Or can it also be a facility where trades that took place in multiple venues are reported, without the requirement of intramarket price priority? This is one of the threshold issues raised by Nasdaq's exchange application. In Nasdaq's view, exchange registration is essentially a label change - from being a "stock market" to being an "exchange." Its business as one of our major securities markets will not change, and Nasdaq maintains that exchange status is warranted because its track record as an SRO is as good as any registered national securities exchange. The market structure issues presented for the Commission are much more complex, however, and the precedent is more significant. The Commission has heretofore always required exchanges to have a limit order book in which better-priced orders take precedence. This is inconsistent with the Nasdaq model in which each dealer can interact exclusively with its own order flow, while ignoring the book. Thus, approval of Nasdaq's application would signal a shift in the Commission's view away from intramarket price priority, with the likely result that other markets would begin moving toward this model as well. In my opinion, there is little doubt that the amount of internalization of orders across all markets would significantly increase were Nasdaq's exchange application to be approved in its current form.
That having been said, the registered exchanges are in direct competition with Nasdaq, and it is difficult to explain - without sounding positively metaphysical - why it is permissible to trade Nasdaq securities one way in the Nasdaq market, and yet not permissible to trade those securities the same way on an exchange. And certainly, over the last several years, with new rulemaking initiatives such as the Order Handling Rules, there has been a greater convergence of the exchange and Nasdaq models. Nasdaq also correctly points out that many of their execution quality statistics are as good as, and sometimes better than, those of the exchange markets.
So the Commission has some difficult decisions to make in determining what markets to register as an exchange in today's market. Certainly, the Commission has a regulatory interest in encouraging facilities that promote order interaction and price competition. At the same time, there is a recognition that the public can benefit from competing market models. There are a number of possible outcomes that the Commission could pursue, and I expect that they will turn their full attention to this issue shortly. My sense is that the Commission will resolve the definitional issues relating to an exchange in one comprehensive action, however, so that similar issues that may be raised in the rule filings of other securities exchanges would be addressed at the same time and not in a piecemeal fashion.
II. Self-Regulatory Model
Another issue of great interest to the Commission - and especially to our Chairman - is the effectiveness and efficiency of the self-regulatory model of market supervision, particularly with the advent of for-profit exchanges. As you may know, the Commission recently published as a Concept Release a Nasdaq petition asking that the burden of regulation for Nasdaq securities be more evenly shared among all the markets trading those securities. Among other things, the Concept Release asked whether the current cross-market regulatory systems are working effectively in the Nasdaq, listed, and options markets.
The trend toward demutualization and public ownership of exchanges raises several issues that merit further analysis, as do recent questions as to the vibrancy of SRO oversight. For example, does the fiduciary responsibility of a board member to maximize shareholder value conflict with his or her duty to run a well-funded and vigorous self-regulatory operation? What steps can be taken to mitigate any potential conflicts? How can we ensure that for-profit exchanges adequately fund self-regulation, and foster an atmosphere that values and encourages the rigorous fulfillment of SRO obligations? More generally, since the adoption of Regulation ATS, have the regulatory distinctions between ECN markets and the more highly-regulated SRO markets led to untenable strains in the SRO model, or do the advantages of exchange registration still appropriately balance the burdens?
Once again, the Nasdaq exchange application, as well as the potential restructuring of other exchanges into shareholder-owned organizations, is causing the Commission to examine these and other issues relating to the SRO model in more depth. I expect the Commission will be devoting substantial resources to assuring that our system of self-regulation evolves to reflect market developments, and continues to act as an effective and efficient means of securities market oversight.
III. Access to Markets
A. Access Fees
The treatment of access fees is another difficult market structure issue that continues to plague the Commission staff. It is remarkable to me that, in such a highly-regulated and developed securities market, we find ourselves without a common convention for quoting bids and offers. Without belaboring how we got to this state, let it suffice to say that it is critical we address this unenviable situation in which a price may or may not be a price - it may be a net price, but it may also represent the price with an unstated access fee to be added on top. This disparity - this lack of a uniform convention - causes innumerable difficulties in our national market system, such as a higher incidence of locked and crossed markets, and competitive inequalities between ECNs and market makers. As a result, I believe the Commission will address this issue sooner rather than later.
Obviously, there are a number of potential solutions - from adding the fees to the quote, to permitting fees of a de minimis level to, finally, banning access fees outright. The first potential solution, adding the fees to the quote, is the most problematic in my view. For example, the various concerns market participants have raised with the advent of penny spreads would be magnified many times over by the subpenny pricing that would result were access fees simply added to the quote. I take a somewhat simplistic view of subpenny pricing - we don't subscribe to it for virtually any transactions in this country, save for gasoline purchases - but I do believe in this case the burdens would far exceed the benefits. I personally find the other potential solutions to the access fee issue more promising, and I look forward to working with the Commission and the industry to examine them in more depth.
B. Fair Access
Another structural issue on the Commission's agenda is the development of a fair and efficient system of intermarket access. If best execution is to be achieved in an environment characterized by multiple competing markets, broker-dealers must be able to identify the location of the best available prices and access those prices routinely and efficiently. A lack of access among market centers, on the other hand, has the potential to create an inefficient and unfair marketplace.
Once again, Nasdaq's exchange application brings this issue to the fore inasmuch as it led to the creation of the NASD's Alternative Display Facility, which has been approved by the Commission on a pilot basis. As you probably know, access to the ADF is provided through the establishment of access standards, rather than through a "hard" ITS-type linkage. The Commission is evaluating the NASD's approach to determine whether, as a practical matter, such a decentralized linkage will achieve the purposes of the national market system.
In conjunction with considering alternatives to hard ITS-type linkages, the Commission will need to consider the continued appropriateness of the "trade-through" rule, and the extent to which it should apply both to the listed and Nasdaq markets. Obviously, the trade-through rule has come under a great deal of pressure in recent years, particularly as market models have continued to diverge. When that rule became part of the ITS plan, of course, the market models of the ITS participants were very similar, floor-based models. Today, there is a wide range of market models - from fully-electronic markets, to markets that provide for automatic executions when accessed by other markets, to markets that provide for automated delivery, yet provide for a floor-based execution once the order is delivered. The challenge before us is to devise a framework where both the faster markets and the slower markets cooperate in one practical system of intermarket access.
Since the ITS rules were written at an earlier time when all the markets were floor-based, faster markets now are effectively required to "yield" to the slower markets, as the ITS provides for a wait of upwards of 30 seconds for an execution or, worse, a non-execution message in the market quoting for best price. Today, for many market participants, a wait of 30 seconds is an eternity, and to require a market to subject an order to such a slow execution process is anathema. So, in my view, the Commission must rethink its notions of fair and efficient access in light of modern technologies and investor demands. Our responsibility as regulators demands nothing less.
IV. Market Data
I'd like to wrap up my overview of market structure issues with a few words about market data. As you know, the current regulatory structure for market data was created in the 1970s and has changed little over the last 30 years, despite sweeping changes in the markets. I do believe it has fully achieved its primary goal - assuring that investors have access to real-time information from all U.S. market centers that is accurate, reliable and affordable. Indeed, the enormous public appetite for market data in recent years, along with the increasing number and diversity of U.S. market centers, has fueled the pressure for modernization of the current regulatory structure. Over the years, the revenues generated by fees for market data have become a crucial source of funding for the SROs, ranging from 15% to 45% of their total revenues.
Efforts by market participants to secure a larger share of market data revenues, however, have increasingly led to distortions in U.S. market structure. Under the current system, revenues are distributed based solely on an SRO's reported trades. Thus, the incentive created by the existing regulatory structure is for SROs to report as many trades as possible, rather than to offer better services to investors, such as higher quality information, or to display better prices. Last summer, the Commission went so far as to temporarily abrogate proposals by several markets to extend rebates of market data revenues to market participants, out of concern that the availability of large rebates may be creating incentives for traders to engage in transactions with no economic purpose other than to receive market data fees. Clearly, taking steps to reduce distortions such as these - and realigning incentives by rewarding the production of valuable market information - will be an important component of the Commission's review of market structure issues.
Finally, while I have focused almost exclusively on equity market structure issues this morning, I'd like to mention some of the steps currently being taken to improve debt market transparency. Historically, the bond markets have operated in a parallel universe and have not been included in any national market facilities. As you know, last July, in response to Commission urging, the NASD launched its TRACE system, which collects specified corporate bond transaction information from NASD members within one hour and 15 minutes of trade execution, and makes that information publicly available in a consolidated format. Today, transaction reports are available for approximately 75% of the dollar value of trading activity in investment grade corporate bonds. As to the municipal markets, the MSRB has made substantial progress with respect to price transparency. The MSRB currently makes publicly available, on a next-day basis, transaction reports for "frequently traded" municipal securities, and subscribers can obtain information on all municipal securities transactions.
While significant strides have been made in improving the transparency of both the corporate and municipal debt markets, more remains to be done both in terms of the scope and speed of transaction reporting. I want to assure you that, notwithstanding our focus on equity market structure issues, the Commission remains committed to increased transparency in the fixed income markets, and will be working diligently with the NASD and MSRB to this end.
Let me conclude with a few words about two high-profile Commission initiatives that do not bear directly on market structure issues: research analyst conflicts of interest and the investment bank holding company framework.
A. Research Analysts
The staff has devoted significant time over the past year to addressing research analyst conflicts of interest. As you know, in the wake of recent scandals, and in order to improve the objectivity and reliability of information that analysts provide to investors, the Sarbanes-Oxley Act requires rulemaking to address conflicts of interest that can arise when analysts recommend securities in research reports and public appearances. These rulemaking requirements complemented work already underway by the Commission and the SROs to address potential analyst conflicts of interest. In fact, substantial SRO rulemaking relating to analyst conflicts was implemented in May of last year. In essence, these rules can be divided into two substantive groups: (1) those that require structural changes in securities firms that separate research analysts from investment banking and inappropriate personal financial influences; and (2) those requiring disclosure of remaining potential conflicts of interest. Last month, the SROs proposed additional rulemaking designed to fulfill the Sarbanes-Oxley mandate, and I expect these rules to be approved before the July 30 Congressional deadline. The Commission's Regulation AC and the Global Settlement also have contributed to the regulatory web relating to analyst conflicts.
To rationalize the patchwork of rules in this area, the securities industry has expressed an interest in comprehensive Commission rulemaking that would create one consistent national standard and supercede SRO rules. The staff is seriously considering this approach. We also are studying whether certain provisions of the Global Settlement should be incorporated into new rules that would be applicable to the entire securities industry.
B. Investment Bank Holding Companies
Turning briefly to the Commission's investment bank holding company initiative, as you may know, the staff is formulating rules, for Commission consideration, that would establish a new regulatory framework for large broker-dealers that choose to be supervised on a consolidated basis. The impetus for these new rules comes from two sources-the Gramm-Leach-Bliley Act and the European Union's directives relating to consolidated supervision.
The Gramm-Leach-Bliley Act authorized a new type of holding company - an "investment bank holding company" - that would be subject to consolidated Commission supervision, and directed the Commission to adopt rules to implement a voluntary registration and supervision regime for these entities. Importantly, however, this regulatory regime in not available to broker-dealers that are affiliated with an insured bank or savings association. More recently, the EU adopted new directives that would require consolidated supervision of all securities firms operating in their jurisdiction. Under these directives, a securities firm will either have to demonstrate that it is subject to consolidated supervision at the holding company level in its home country that is "equivalent" to the consolidated supervisory regime in the EU, or it will have to establish and separately capitalize an intermediate holding company in the EU that would be subject to EU supervision. The latter alternative worries major U.S. firms with securities operations in the EU, as such a requirement could substantially increase their cost of doing business and make it difficult for them to compete with their European counterparts.
While Commission staff believes its existing "risk assessment" and other programs should be deemed to provide supervision "equivalent" to the consolidated regime in the EU, implementation of the investment bank holding company regime should make this case all the more apparent. The staff has been working diligently on this effort, and my hope is that the Commission will be in a position to issue proposed rulemaking within the next 30 - 60 days.
In conclusion, I hope I've given you a sense of some of the key initiatives currently underway in the Division of Market Regulation. As I've indicated, some of the most important and challenging of these involve fundamental market structure issues, the outcome of which I expect to shape the nature of the national market system for years to come. These issues have the attention of our Chairman and the other Commissioners, and I expect there to be significant progress in this area in the coming months. The industry, of course, has contributed greatly to the market structure discussions thus far, and I look forward to your continued input - and a lively debate - as we move forward on these critical issues. Thank you.
1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.