Speech by SEC Staff:
Remarks before the ICI Equity Markets Conference
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
New York City, NY
September 23, 2004
Thank you so much for the opportunity to address the Investment Company Institute's 2004 Equity Markets Conference. The nature and pace of change in U.S. equity markets have been nothing short of phenomenal and the input of institutional investors in helping regulators comprehend these developments has been essential. Before I begin my talk let me remind you that my remarks represent my own views and do not necessarily reflect the views of the Commission or my colleagues on the staff.
As you all know, the Commission is in the thick of a rulemaking process that could ultimately result in some of the most important refinements to the U.S. equity market structure since the Exchange Act was amended in 1975. In Regulation NMS, the Commission has proposed a number of discrete rules designed to address the dramatic changes our markets have undergone in the past several years. These changes have been brought about by major developments in trading technologies and the rapid rise of alternative trading venues. While this innovation has been extremely beneficial for our markets overall, it has also exposed the fundamental tension that exists when electronic trading models interact with the floor-based trading models of traditional exchanges within our national market system.
Recognizing that the goals of the National Market System may no longer be furthered by certain legacy rules, the Commission engaged in considerable fact-finding efforts over the past few years to determine which areas required modernizing. While there was not clear consensus on solutions, the areas ripe for review were clear: the ITS trade through rule, intermarket access requirements (including the fees charged by market centers to access their quotes), subpenny quoting, and the allocation of revenues produced by the consolidated data networks. Because you have all had time to consider the Commission's proposals and had an opportunity to express your views through the notice and comment process, I will not reiterate the details of the proposals for you today. Rather, I will give you my overall impression of what the commenters had to say. The divergence of these comments will demonstrate the challenges faced by the Commission as it strives to develop a level playing field for the market place of the future.
Before I highlight the views raised by commenters, however, I thought I would reflect upon the comment process generally. I have enormous respect for this process. It is a hallmark of our open, democratic form of government, and it provides us with invaluable insights into the effects of regulation on the marketplace. It also provides any member of the public a forum to express a personal viewpoint, without the constraint of balancing what is best for the public at large. And there is much truth to the old adage "where you stand depends on where you sit" - in other words - viewpoints are naturally influenced by one's business model. Trust me when I say that the Commission has ample experience with market participants speculating that any given rule proposal would alter the course of human history as we know it. Indeed, it is a rare rule proposal that does not elicit a comment that predicts "grass will grow on Wall Street" should the proposal be adopted. Does anyone remember that prediction? By the way, I should point out that in the future, if you intend to use the "grass will grow" comment, it has been updated. The new line is "your proposal will turn our market into a Starbucks." I thought it would be fun to take a few minutes to recall some dire predictions of the past to give you a feel for the difficult task we face at the Commission in assessing public comments. In the end, the predictions of doom for our markets, at least so far, have been grossly overstated and the results of the actions taken by the Commission and industry have generally resulted in a market place that is vibrant and creative -- a market place that remains the global leader known for dynamic innovations while remaining fair, orderly and protective of investors.
It is difficult to imagine today, but, when the Commission proposed the firm quote rule commenters argued that markets would be severely damaged because dealers would be less willing to supply liquidity. Moreover, in connection with the Commission imposing consolidated last sale trade reporting requirements on the OTC market, commenters argued that such action could "seriously impair the viability of the OTC market" and "might reduce the liquidity of the markets for [OTC stocks] because OTC market makers might be less willing to acquire a position" if their competitors could discover the size of their positions. Well the jury is in and the verdict is clear, both predictions fortunately were incorrect. Firm quotes have enhanced price discovery in our markets. In addition, I don't think any of us would argue with the contention that last sale trade reporting has significantly improved the OTC market and increased, rather than decreased, liquidity.
Perhaps the most notorious example of an initiative that generated significant consternation was the elimination of fixed commissions. Nothing short of the end of capitalism was predicted. Specifically, some contended that the existence of fixed commissions represented a primary incentive for being an NYSE member. Commenters argued that, if large members dropped their NYSE membership and engaged in upstairs dealer crossing, the specialist system would suffer an inexorable decline. In addition, certain economic studies purported to show that, without fixed commissions, price swings would grow more pronounced and sudden collapses on announcement of unexpected news could become commonplace. Some even foretold periods of "destructive competition," in which many efficient firms would be pushed out of business by larger less efficient (but more diversified) firms. While there have been many changes in the ranks of securities firms since 1975, the predictions of market chaos have proved unfounded. Rather, the elimination of fixed-commissions directly benefited investors through commissions being driven lower by competitive forces and benefited the industry by introducing real competition to the market place.
This next one is my favorite, given the benefit of hindsight. In connection with the adoption of the Order Handling Rules, we received a number of comments that predicted that the rules would lead to a loss of anonymity and liquidity in ECNs. This would badly harm the ECNs' ability to attract order flow and ultimately harm one of the major users of ECNs - institutional investors. Well, as we all know, this prediction has been proved to be way off the mark.
I mention these examples not to gloat (I dare not, having probably participated in the drafting of similar letters myself) but rather to provide a sense of the challenges the staff faces in assessing the opposing views we hear. In truth, most of the comments we receive are well conceived and thoughtfully articulated. The staff's challenge is to listen carefully to what commenters have to say, reflect on the comments, and use their guidance where appropriate in fashioning our recommendations to the Commission. In Reg NMS, we seek to balance the comments consistent with our guiding principles: to enhance best execution; improve market efficiency; enhance price discovery; provide competition; encourage display of limit orders; and above all, do no harm.
We have received many insightful comments on Reg NMS. As with virtually all rulemakings, there is a divergence of opinion on some points. As the Commission carefully considers the comments and crafts final rules for possible adoption its task will be no different from that of its predecessors - - to carefully balance the considered comments, along with its own analysis, crafting the most effective rules for the marketplace.
Reg NMS comments were perhaps most disparate with respect to the trade-through rule. Overall, the vast majority of commenters supported the principle of price protection. They expressed quite different opinions, however, on the best way to achieve that goal. Commenters were generally split into three groups regarding the need for, and structure of, a trade-through rule: (1) those who supported trade-through protection for automated markets' quotes and opposed any opt-out exception; (2) those who supported a trade-through rule but advocated an opt-out exception; and (3) those who did not believe any trade-through rule is necessary to protect the best prices and promote the display of limit orders.
Institutional commenters were nearly unanimous (with a few notable exceptions) in their strong support for a trade-through rule without an opt-out exception. They stressed that limit orders are the building blocks of public price discovery and efficient markets, and that an opt-out is contrary to the protection of limit orders. The major floor-based exchanges, many other regional exchanges, and two of the three associations representing individual investors agreed with the institutional investors on the need for a trade-through rule. These commenters emphasized that only automated quotes deserve trade-through protection, however, explaining that quotes that are not immediately executable are not firm and should not be protected. They also felt that an opt-out exception would be unnecessary if only automated quotes received trade-through protection. Commenters argued that an opt-out exception could hurt retail investors, and allow participants to bypass legitimate, automatically accessible limit orders. These commenters supported a strong trade-through rule in order to protect and thereby encourage the use of displayed limit orders, thus promoting transparency and liquidity in the NMS.
A second group of commenters supported a trade-through rule, but specifically conditioned their support on inclusion of an opt-out exception. Some commenters thought that a trade-through rule would provide valuable protection to retail investors, but institutional investors should be allowed to opt-out. These commenters further argued that an opt-out exception is an important tool for investors with different investing strategies, e.g. those that value speed and those that are working large blocks.
A last group of commenters did not believe that any trade-through rule was necessary. This group included nearly all of the electronic markets and electronic traders, as well as the major traders' organization and a number of market making firms. Finally, two large institutional commenters opposed the adoption of a trade-through rule. These commenters generally believe that if market centers provide immediate and automatic trade executions against their published quotes and hidden access fees are eliminated, price competition would become the most meaningful standard of execution quality and market forces would then ensure that customers would receive the best price.
Commenters were split on whether a trade-through rule should be extended to the Nasdaq market. Several of the securities industry trade groups, two of the three retail investor representatives, and several pension funds, institutional investors, and large brokerage firms supported applying a trade-through rule to Nasdaq. The major floor-based exchanges and their representatives, as well as nearly all regional exchanges concurred. These commenters supported a uniform trade-through rule, stating that, by affirming the principle of price priority, such a rule would encourage the display of limit orders in all markets which, in turn, would improve price discovery and contribute to increased liquidity. Further, these commenters thought affirming the principle of price priority in all markets would increase investor confidence in the markets. Finally, these commenters argued that a uniform trade-through rule would facilitate a broker-dealer's ability to achieve best execution.
Commenters that opposed an expansion of the trade-through rule to Nasdaq generally included the electronic markets, electronic traders, and retail brokers. These commenters cited a lack of empirical evidence justifying the need for trade-through protection in this market. They believed that competitive forces alone had already achieved the objectives of the proposed trade-through rule.
Certainly the most debated element of the trade-through proposal is the opt-out exception. Those who opposed the opt-out exception expressed concerns that it would allow block traders to by-pass limit orders at a better price posted by other investors, thereby discouraging the placement of limit orders and harming individual investors. Thus, these commenters believe that the opt-out exception would undermine the Commission's goal of price protection. Some commenters also suggested that the opt-out would degrade one of the core strengths of U.S. equities markets, the aggregation of retail and institutional investors' orders competing on the best price.
Many commenters also expressed support for the opt-out exception. These commenters believed that the opt-out exception would provide investors with needed flexibility to pursue their investment objectives. They also argued that an opt-out exception would promote greater competition among markets and would produce a more workable rule.
Several commenters discussed the relationship between the manual markets exception, the manual quote exception, and the opt-out exception, asserting that if the Commission were to adopt an exception to the trade-through rule for manual quotes, the opt-out exception would no longer be necessary. One of these commenters maintained that there was no justification for a customer not to get the best price if the quote is a firm, electronically accessible quote.
There was wide support for the concept of allowing automated or "fast" markets to trade through non-automated or "slow" markets. Commenters differed, however, on whether the Commission should set specific time standards for what qualifies as "fast". Many commenters specifically expressed support for a "quote-by-quote" exception to the trade-through rule that would allow market participants to trade-through manual quotes. Some of these commenters felt the quote distinction would allow hybrid markets to thrive. As with those who favored a manual market exception, manual quote advocates were split on whether the Commission should set standards as to what constituted an automated quote. Those opposed to the manual market and manual quote exceptions seemed to do so because they favored the much broader opt-out exception (with fewer restrictions on the use than were set out in the Commission's proposal.)
Commenters seemed to agree that if the trade-through rule is adopted, it would be appropriate to have exemptions in a number of circumstances, such as for intermarket sweep orders. Other commenters suggested that the Commission consider exemptions for block trades, VWAP trades, stopped orders, and portfolio basket trades. Each of these suggestions raises different issues that will have to be carefully considered. Clearly, any trade-through rule applicable to markets as active as, say, the top 50 stocks in the Nasdaq and the NYSE markets must accommodate a frenzy of orders and rapidly changing quotes. A carefully crafted rule would have provisions to avoid chasing ephemeral quotes and permit fast trading, while still protecting limit orders seeking an execution from being passed over by trades at inferior prices. I believe this could be achieved for both the listed and Nasdaq markets.
All that being said, as you know, the trade-through proposal is not the only piece of this market structure puzzle. The NYSE's proposed enhancements to the exchange's Direct+ automatic execution system has received much attention and will be the subject of a lively panel discussion later this morning. If the Commission adopts a trade-through rule that incorporates the automated vs. manual quote approach, rather than the automated vs. manual market approach, then clearly the intent of the Direct + proposal is to satisfy the former requirement. The NYSE's stated intent is for the Direct+ enhancements to significantly broaden the parameters under which the exchange would offer automatic execution of those displayed quotes. The NYSE clearly hopes to position itself for a "fast/slow quote" trade through rule, if the Commission chooses that approach, by preparing to be in a "fast quote" mode the vast majority of the trading day for each of the securities it trades.
In those particular contexts when the NYSE's quotation is not accessible through automatic execution (such as to generate additional price discovery to handle an order imbalance), the expectation is that the quotation would be identified as such and order-routers could respond accordingly.
While the trade through component of Reg NMS has clearly generated the most comments, the other three proposals have also attracted significant attention. The subpenny proposal would prohibit market participants from accepting, ranking, or displaying orders, quotes, or indications of interest in a pricing increment finer than a penny, except for securities with a share price of below $1.00. The overwhelming weight of comment on this proposal appears to be in favor of the Commission's approving it as proposed.
With respect to inter-market access, Reg NMS would modernize the terms of access to quotations and execution of orders in the NMS by, among other things, establishing standards for direct and indirect access to quotes in the National Market System. Overall, the majority of commenters seemed to support this "soft linkage" approach, but some still noted concerns with respect to the ability of a market center to remain inaccessible by posting quotes outside of an SRO' execution system. Comments were decidedly split, however, with respect to the Commission's proposal on access fees, which would place a 1 mil access fee cap with an aggregated cap of 2 mils on quotes in the NMS. Many securities firms and SROs argued that all non-subscriber access fees should be prohibited. Nearly all electronic markets and electronic traders opposed any limitation on access fees, arguing instead that competitive forces were sufficient to address them. Institutional investors, some securities firms, and Nasdaq seemed to support the de minimis fee proposal as a worthwhile compromise approach on an extremely difficult issue. The SROs did not want their transaction fees to be subject to any limitation, beyond the current review of proposed rule filings by the Commission.
Finally, on the topic of market data, the Commission sought to address distortions caused by market data rebates by proposing amendments to the plans for disseminating market information to the public that, among other things, would modify the formulas for allocating plan revenues to reward markets for more broadly based contributions to public price discovery. While commenters generally believed there are serious problems with the current formulas, many did suggest that the proposed formula was a trifle complex. Many comments, however, focused on the current level of fees charged by the market data networks and questioned whether such fees remain reasonably related to the cost of market data. They argued for addressing this issue as part of the market data proposal.
As we all know, the Commission and the securities industry has devoted significant resources to this over the last five years. This record includes the Commission's 1999 Concept Release on market information fees and revenues, the public comments received in response to the Concept Release, and the 2001 report of the Commission's Advisory Committee on Market Information. These issues are enormously complex - they make our allocation formula look simple. Market data revenues impact several key areas. They play an important role in the current SRO funding scheme and, if changes are to be made to how SROs are compensated for market data, they must be made carefully. To effectively carry out their mission as front-line regulators and operators of market systems, SROs must have adequate funding. In the current competitive environment, with other traditional SRO revenue sources being squeezed, it is important to consider the broader SRO funding picture. Market data itself also plays a critical role in the U.S. securities markets. It is the information on which decisions to buy and sell securities are made. It also creates confidence in the fairness of the markets. Given its importance, we must strive to make market data widely available, which means it must be reasonably priced. We must also prevent dominant markets from abusing their market power in the pricing of this essential data. I plan to recommend that the Commission address the broader issues concerning market data in an SRO structure concept release that I will describe in a few moments, rather than in the approval phase for Reg NMS.
Whatever final Reg NMS rules the Commission may adopt, it is my belief that they will signal the Commission's continued belief in a core set of principles. The protection of limit orders across markets is essential to ensure that our markets attract deep liquidity. Wherever possible, rules should be designed to support and encourage the fulfillment of the agency duty of best execution. Furthermore, our National Market System is built on competition and so we must be vigilant to ensure that rules provide sufficient operational flexibility to allow the industry engine of innovation to continue driving the industry forward. It is my hope that the Commission will consider Reg NMS before year-end.
In addition to the many complex issues facing the Commission regarding the National Market System, the staff has recently spent considerable resources addressing the issues of SRO transparency, and governance, issues concerning SRO ownership, and the efficacy of the SRO system generally. As history tells us, without sufficient transparency, sound governance practices, and a structure that encourages the fulfillment of self-regulatory obligations, SROs can falter.
I expect in the next few months that the staff will recommend that the Commission consider issuing proposed rules that would pertain to the governance, administration, transparency, and ownership of SROs that are national securities exchanges or national securities associations, and the periodic reporting to the Commission of information by these SROs regarding regulatory programs. The rules we plan to recommend would improve governance standards that are generally akin to those required of public companies in the post Sarbanes-Oxley era. The rules would enhance the roles of independent directors, and encourage greater separation between the SRO's regulatory function and its market operations. In this era of for-profit, publicly traded exchanges, we believe the historical constraints on individual members exercising control over SROs should be made explicit. Furthermore, comments on the Commission's market data proposal called for greater transparency of SRO revenues and expenses. The staff concurs and will recommend expanded public reporting by SROs of their financial and ownership structure.
While these rule proposals we plan to recommend are designed to enhance the governance, transparency, and oversight of SROs, the staff recognizes that changing conditions have raised broader questions about the structure and role of SROs. Thus, I anticipate that we will also recommend for the Commission to consider issuing a separate concept release that seeks public comment on a wide variety of issues that relate to the efficacy of the self-regulatory system, including its structure and funding.
In closing, I will note my belief that this is an historic moment in market regulation. The Commission has an opportunity to make some pivotal changes that could guide our equity markets into the new century. Likewise, we also have a duty to oversee vigorously the self-regulatory process and, at the very least, make improvements that are designed to ensure that our markets maintain the level of integrity that we have come to expect. The markets are rapidly changing. While change is often unsettling, a failure to adjust to changing market conditions, and to adapt our supervisory structure to maintain fair and orderly markets, risks losing our preeminent position and reputation for fairness in the global market place. Thank you.