Speech by SEC Commissioner:
Remarks before the Security Traders Association
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
October 16, 2003
Thank you, John. It is a pleasure to be here in such a beautiful place and to be talking about market structure -- one of my biggest interests at the Commission. John Giesea, John Hughes and other STA representatives have visited me in Washington a number of times, and I found the STA's Special Report on Market Structure very interesting reading. Let me get my disclaimer out of the way first: the views I express here today are my own and not necessarily those of the Commission or the staff.
Today I want to talk about some things the Commission needs to do in the current environment and about some of the things your firms need to do. The dramatic events at the New York Stock Exchange have focused the public's attention on corporate governance and conflicts of interests in the SRO structure in much the same way that the nation was horrified by the financial scandals of the past two years. Investor confidence in corporate America plummeted, and Sarbanes-Oxley was the result. Companies are in the process of implementing the new corporate governance reforms, and indications overall are that investor confidence is beginning to come back, although there are other factors involved as well.
I believe the stakes for our securities markets are just as high today as they have been for the corporate sector. The Commission needs to deal with allegations of conflicts of interest in the mutual fund industry and at the New York Stock Exchange quickly and aggressively. And financial services firms need to re-examine their businesses from top to bottom, look for potential conflicts of interest and take steps to avoid their potentially harmful consequences. In other words, you need to put your customer first. Investor confidence in the integrity of market participants and the fairness of our markets is not a luxury - it is an absolute necessity.
Let me turn first to what the Commission has to do. I wish I could report to you today that we have resolved all of the market structure issues we've been talking about over the nearly two years since I joined the Commission - issues I know you've been concerned about for far longer than that. This Commission, together with the Division of Market Regulation, continues to work on market structure issues, and we are making progress.
To refine my thinking on market structure, I've had several visits and meetings with exchanges, Nasdaq, ECNs, broker-dealers and trade groups, including, of course, STA, and I've had discussions with academics and economists. An exercise that has been helpful to me has been developing a framework - or a matrix, as I call it. Those of you who've visited me in my office may recall my asking you what the goals of market structure reform should be. Making sure I have a clear view of our goals is critical to my analysis. As an economist, I'm used to analyzing policy choices by identifying a goal and then evaluating whether a particular policy choice furthers the goal or impedes the goal, taking into account existing impediments to achieving the goal and possible intended and unintended consequences.
The additional complication with market structure, of course, is that all of the goals and most of the policy issues - from access, to access fees, to trade-through rules, to market data revenue, just to name a few - are interrelated and need to be considered all together, rather than one at a time. I often use the "bean bag" analogy: wherever you push, it comes out on the other side. This is why I've been saying that we must address market structure issues holistically. Our decisions will be better and more internally consistent if we have a context in which to make them and a clear endgame against which to measure our success.
The ultimate goal of market structure regulation - in addition to investor protection - is to promote fair and efficient capital markets. We've done a good job of encouraging transparency, interconnectivity and competition in our securities markets. Competition among equity market centers is intense, and quotes and transaction prices are widely available to all market participants. Direct and indirect linkages among competing market centers help ensure that brokers have access to the best quotes. Market centers of all types have an incentive to offer improvements in execution quality and to reduce trading costs to attract order flow.
To make sure that we continue to have the world's most competitive and efficient capital markets, we need to focus our policy decisions on maximizing liquidity within a competitive framework For me, this means that in deciding each specific issue, my first question is: would this action add to - or detract from - market liquidity? Enhanced liquidity derives from integrity and transparency. Key elements of integrity and transparency are
- fairness and efficiency of pricing,
- reliability and efficiency of execution,
- a level playing field among the markets and market participants, and
- effective intra- and inter-market regulation.
In my view, these elements are what we should be striving for as we address market structure issues. Having said that, my general philosophical preference is for market, rather than regulatory, solutions. In my view, the Commission shouldn't decide who should compete in the market or how they should compete or which business model is better. Competition among market participants and among markets drives innovation and progress, so long as there are no natural or artificial barriers to competition. But our rules do affect competition. On the one hand, they set the standards for all to compete fairly and, on the other hand, they may promote or entrench certain business models. Our focus should be on getting rid of rules that bias competition.
Let's look at some specific issues. Take access fees, for example. Many market centers charge fees for using their systems to access the quotes displayed in their markets, including the exchanges and Nasdaq. Some of these fees are trivial; some are nearly a cent a share. In the context of ECN access fees, depending on whether an ECN or a market maker is posting a quote, the displayed price may represent the actual price that the customer will pay or it may represent only a base price to which an undisclosed access fee will later be added. It has been argued that these pricing disparities impede access between competing markets, raise trading costs and create confusion about the true price.
These assumptions may be valid, but I want to make sure we have all the facts. How do access fees affect liquidity and transparency? Some have noted that ECNs that charge access fees have added to liquidity. Others have suggested that access fees are more transparent than they might appear. Although the fees are not in the quote, I'm told that many market participants know who charges access fees and how much they are.
If the problem is hard to evaluate, the solutions are even more elusive. Putting access fees into the quote may improve transparency, but implicitly raises the issue of subpenny pricing. Eliminating or capping access fees would reduce transaction costs and thus maximize liquidity, but would put the Commission in the position of a rate-setter. We also need to evaluate whether the market may be handling this problem on its own, especially given Nasdaq's recent rule filing which, if approved by the Commission, would cap access fees in its market.
Turning to other issues, we also need to make sure that all our rules are creating the right incentives. Current market data revenue formulas allocate revenue to the SROs largely based on their reported trade volume. However, if we want to encourage the display of limit orders and improve price discovery as a means of maximizing liquidity, what we should be doing is changing the formula to reward better, more aggressive quoting. This would encourage market centers to provide better services to display better prices and thus contribute to market efficiency.
The same goes for trade-through rules. As the national market system was being developed, when technology was still in the Dark Ages, trade-through rules played an important structural role in ensuring compliance with best execution obligations. But I'm not convinced that the current rules are effective in today's environment, where direct electronic access is the norm among traders in the Nasdaq market and is getting a toehold in the listed market.
The technology now exists for customers to get the information they need to ensure that they are getting best execution. Best execution means different things to different customers - whether price, speed, cost or liquidity. I believe that there are strong arguments for modifying - or even eliminating -- the trade-through rule. First, it would remove barriers for customers for whom best execution means something other than the best price. Second, it would focus attention on the broker's best execution analysis. It is the broker who is in the best position to know what his customer means by best execution. The availability of execution quality statistics for broker-dealers and market centers informs the broker's decision as to where to send his customer's order.
I recognize that trade-through rules are also meant to serve the important goal of protecting public limit orders. But the trade-off is that in their current incarnation, trade-through rules permit slow markets to halt fast markets for an order for a very small number of shares, which prevents competition in fast markets. So for me, the questions are: Who are the trade-through rules really protecting? Do they in fact protect limit orders in the penny environment? Or are we entrenching slow markets? What have we learned from the de minimis exemption for the QQQs from the ITS trade-through rule?
In the category of creating a more level playing field, the Commission will consider next week a proposal to liberalize short sale regulation by moving from a tick test to a bid test. Most economists - and I am one of them - believe that short selling provides valuable services to the market and that current restrictions on short selling, at least with respect to highly liquid securities, are unnecessary. In the last few years, we've seen how much money investors can lose when bubbles cause prices to get out of line. Short sellers trading in these circumstances push prices back, and their efforts thereby limit the investor losses associated with these events. I have seen some preliminary results of a study by our Office of Economic Analysis showing the important role short sellers play in reducing the volatility that can lead to investor losses. So I am pleased to see that Market Reg is proposing a pilot program that would suspend the price test for a group of highly liquid securities. If we do a pilot, the results of the pilot will help inform our decisions going forward - we will be able to see if the theory works in practice.
Another goal of the staff proposal is to rationalize short sale regulation across markets. Currently, exchange-listed stocks are subject to the tick test of Rule 10a-1, and Nasdaq National Market System securities traded by NASD members are subject to a bid test, although Nasdaq NMS securities are not subject to short sale rules when trading on Archipelago. Under the proposal, a bid test would apply to all exchange-listed and National Market System securities, wherever they are traded. No short sale rules would be proposed for securities not currently subject to them, pending the outcome of the pilot.
And in the category of effectiveness of intra- and inter-market regulation, the Commission is especially sensitive right now to the self-regulatory model. As I mentioned, we have all watched the drama unfolding at the New York Stock Exchange that has raised serious questions about self-regulation. Clearly, we expect the SROs to set the standard for good governance and to embrace corporate governance standards no less rigorous than they require of their listed companies.
I don't know how - or even whether - the current developments will lead to changes in the self-regulatory model. But the Commission has a window of opportunity on this issue right now, and I don't want us to squander it. There are advantages and disadvantages to each of the current self-regulatory models - the NYSE model, with market and regulatory functions combined in a single entity, and the NASD/Nasdaq model, in which regulatory and market functions have been separated within a holding company structure. We need to look at ways in which conflicts of interest can be minimized and be open to new options and new solutions. I'm sympathetic to ideas about consolidating SRO regulatory functions. I'm also interested in exploring the creation of one or more independent entities - somewhat akin to the Public Company Accounting Oversight Board -- that would carry out the SROs' regulatory functions, but without the "self" -- it would be an SRO without the "S"! Whether organized as an affiliate of an SRO but operating under separate management or an entirely separate entity, these bodies would operate subject to SEC oversight. Under the current SRO models, competition has acted to minimize regulatory costs. Under the ideal model, a competitive regulatory apparatus would maximize regulatory effectiveness.
Now let me turn to you as STA members and give you my ideas on things to be thinking about and doing. Given the regulatory and reputational risk to which financial services firms are subject in the current environment, it is in your own best interest to re-examine your compliance programs from a risk-based perspective, with a specific focus on identifying potential conflicts of interest.
The director of our Enforcement Division, Steve Cutler, recently challenged financial services firms to conduct systematic, top-to-bottom reviews of their business operations to identify conflicts of interest, disclose them and attempt to minimize their potentially harmful consequences. There are conflicts everywhere we look these days: from various forms of analyst conflicts; to recent allegations that some mutual funds and fund managers permitted a hedge fund to engage in trading practices that benefited fund management, but disadvantaged their retail investors; to conflicts within the SROs. Generally speaking, you should be looking for conflicts in your profit centers or in situations in which your firm could be in the position of favoring the interests of some customers over others, or favoring the firm's or its employees' interests over customers' interests. This kind of preventive maintenance is not just a way of instilling a culture of compliance in your firms, but is also prudent business practice.
If this environment has taught us anything, it's that we can no longer assume that the way things have always been done is necessarily the right way to do them. Doing a risk-based review of your business will put you and your firm in the best position to adjust quickly to changes in the regulatory environment, but more importantly, to do the right thing for your customers.
So I will leave you with this thought. When I became a commissioner, people often asked me what the biggest surprise was. My answer then, and my answer now, is the same: the number and scope of enforcement actions. I am constantly amazed at what perpetrators think they can get away with, and I'm constantly asking, "What were they thinking?" Obviously, they weren't thinking about doing the right thing or the consequences of doing the wrong thing. So what does this have to do with you? Think about what you are doing from the perspective of your customers. Are you doing the right thing for them? If you are, then I won't ever be asking about you - in an enforcement action - "What were they thinking?"
Thank you. I'm happy to take your questions.