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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Technology Bytes the Securities Industry: The New Millennium Brings New Investors and New Markets

Remarks by

Commissioner Laura S. Unger

U.S. Securities & Exchange Commission

Before the Securities Industry Association
Palm Desert, California

March 14, 2000


Thank you very much for inviting me to be the keynote speaker at the SIA’s Legal and Compliance Conference this year. I know this conference is a very important one for the industry.

In fact, I had been wondering whether I would ever receive an invitation to speak at this annual event. A couple of weeks ago, an invitation letter was finally hand delivered to me by one of the Chairman’s staff people.

Although it seemed a little late for SIA to be inviting the keynote for one of their most widely attended conferences, I thought maybe they were just confident that I would accept. After reading halfway through the invitation letter, I saw that I would also be receiving an award. Now I thought, this conference was worth waiting for. Sign me up.

Many an investor has made the same mistake. The truly material information was at the bottom of the letter. The award was for longest standing chairman. As forward thinking as Dave DeMuro may be, I would not qualify for that award by March 14 -- at least not in the year 2000.

As we at the Commission warn investors -- if it sounds to good to be true, it usually is. Irrespective of the circumstances, I am truly honored to deliver the keynote here today.

Speaking of the Commission, as you know I do not speak for them, or the staff – or anybody else for that matter.

Usually when the Chairman speaks at these events, he takes the opportunity to announce a new program or express a policy position. So when I was preparing today’s remarks, I asked the Chairman if there was anything he was planning that I could tell the conference attendees.

And actually, it turns out there is something. Most of you have probably been following the newest technology driven debate over market fragmentation. This issue is actually the confluence of a number of factors: (1) the proliferation of electronic trading systems (ECNs or ATSs); (2) the SEC’s adoption of Regulation ATS, allowing electronic trading systems to register as ATSs or exchanges; (3) the repeal of the NYSE’s off-board trading restrictions, Rule 390; and (4) the lack of effective and efficient linkages among the various market centers.

As you know, the ‘75 Act Amendments to the ‘34 Act grant the Commission the broad authority to eliminate all unnecessary or inappropriate burdens on competition and to pursue a national market system in the interest of efficiency and investor protection.

Last week, the Financial Times presciently reported: "[T]he U.S. stock markets have crossed into that realm where almost anything that can be imagined is possible." The Chairman told me that he was in the middle of a recent browse session on E-Bay when he put it all together.

So today, while you all enjoy the sunshine and this conference, the Chairman is sitting down with the exchanges and the NASDAQ to deregister them and create a new central trading platform on E-Bay. To respond to people’s concern that the SEC is lagging in regulation, there will be a 24-hour comment period. But don’t worry; we will accept e-mails.

I know all of this sounds somewhat Orwellian, but in point of fact, thanks to technology almost anything imagined and not yet imagined is possible. The speed and breadth of the Internet has opened up a new frontier – to all market participants. Among other things, technology has changed the way investors trade securities and the way trading systems execute those trades. Technology also challenges the Commission to apply our regulatory principals to accommodate rapid changes in the marketplace.

Technology and the Retail Investor

The number of and volume from investors trading online has certainly caught the collective interest of the industry and the Commission. Online trading volumes accounted for 37% of all retail trades for the first half of 1999, up from 30% the year before. In 1998, about 10% of U.S. investors traded online. One year later, that number nearly doubled to 18%

The number of online accounts has steadily climbed in the last few years, from 3.7 million in 1997, to 7.3 million in 1998, to 9.7 million in 1999. As of about six months ago, assets in these accounts added up to $608 billion, more than the GDP of Canada. Although analysts disagree over how many online accounts there will be in the new three years, at least two predict that online brokerage assets will reach $3 trillion by 2003.

As many of you know, I conducted a series of roundtables last June and last November published a report that included my findings and certain recommendations to the Commission. You can find the report, "Online Brokerage: Keeping Apace of Cyberspace," on the SEC’s website, www.sec.gov.

The expected trend towards online trading has raised a number of issues, many of which are covered in the report. One of the more interesting questions for the industry is how technology changes the way firms compete.

Discount firms made the first foray into online brokerage, mostly because it was easy for them to adapt their business model – execution providers – to the Internet. But in order to compete for online market share, many full service firms have unbundled advice from execution to offer their customers a wider range of services. It appears that firms are now competing for value added services.

In terms of follow up to the report, I will briefly touch on a few priority issues, namely: (1) suitability, (2) investor education, and (3) best execution.


Suitability requires that a broker who recommends securities to a customer first determine whether the securities are "suitable" given the customer’s financial status and investment objectives.

Some firms argue that suitability does not attach to online trading because those investors are making investment decisions without a broker’s advice. Most at the Commission – at least those I don’t speak for – would argue that suitability attaches to a recommendation irrespective of where that recommendation is made. Circling back to a point I made earlier – the industry trend seems to be heading in the direction of more advice. Some firms have also been developing algorithms to conduct a suitability analysis.

Certain "customer relationship management" product development and data mining products add a new dimension to the suitability discussion. Data mining enables brokerage firms to track a customer’s behavior, both in the securities and – depending on the firm’s affiliates – the non-securities context. The firm could then direct specific investment information to the customer depending on the customer’s behavior.

In that case, the analysis of whether the information was actually a recommendation would depend on how finely the firm segmented its customer base and information. As a result, determining when a firm provides information to its clients and when that information is actually a recommendation becomes more prickly in light of these technological capabilities.

For example, a firm could use data mining to determine that women in the thirty to forty age range, who earned between $75,000 and $125,000, and had a dog and two young children tended to invest in small cap stocks and technology stocks – or wished she could. If the firm then sent that category of its customers information on a group of small cap and technology stocks, it would most likely not trigger a suitability obligation.

On the other hand, a firm could track a single individual’s investment behavior and determine that the customer tended to invest in small cap and technology stocks. If then the firm e-mailed that customer press headlines or other relevant information about a particular company that the customer should invest in, that would most likely trigger a suitability obligation.

My report runs through seven scenarios, discussing when a suitability obligation would or would not attach and the relevant analysis. As a follow up to the report, I am working with the NASDR to learn about firms’ data mining products by visiting a cross-section of firms in the next few months. After that, we will sit down with the industry and continue the suitability dialogue, possibly using the report scenarios as a starting point.

Let me mention something more specific about suitability as it relates to compliance. A firm cannot abdicate its suitability duties by simply not asking its customers for certain information. Lately, conversations with firms about suitability frequently generate the reply "we don’t collect that information." In case firms need a reminder, suitability requires "reasonable efforts" to collect information before making a recommendation. Adopting a practice to avoid collecting information relevant to a suitability analysis does not prove the absence of a recommendation or a suitability obligation online.

Investor education

The other priority area for report follow-up is investor education. The vast amount of information on the Internet and the disintermediation of brokers and investors afforded by online trading has raised concerns about investors who really are trading on their own.

Since this agency has become very investor education orientated under the leadership of Chairman Levitt, I thought it would be helpful to conduct a study to find out if and how we need to modify our investor education efforts for online investors. Some of the questions I think should be addressed include:

  • Are online investors different from offline investors?
  • What type of information, if any, do online investors consult before making an investment decision?
  • What do investors need to know about online investing? Are there any particular risks in trading online that investors should know about?
  • What or who is the best source for online investor education? In what format should that information be provided?

I have begun to sit down with the industry and our Chief Economist’s office to work out the precise parameters of such a study and how best to obtain the relevant information. Once the study is underway, it will take about six months or so to complete.

Best Execution

Advances in technology, particularly the rise in online trading, also have implications for the duty of best execution. As you all know, there is no specific statutory definition of "best execution." The duty of best execution requires a broker to seek the most advantageous terms available under the circumstances for a customer’s transaction. The broker must take into account opportunities for price improvement along with a number of factors, including: (a) size of the trade; (b) speed of execution; (c) the likelihood of execution; (d) the type of security; (e) information about and access to competing markets; and (f) cost of access.

The best execution duty continues to evolve with changes in technology and market structure. What does that mean for the industry given today’s rapid advancements in technology and proposed changes in market structure?

First, it means that maybe now is a good time to rethink how we interpret the duty of best execution in light of recent developments. Technology has dramatically increased the number of online investors. The bull market, marked in part by 108 months of economic expansion, has made these investors eager to participate in the market.

For many online investors, time is of the essence. Do online investors have different expectations about what constitutes best execution? Some would say that online investors would rate speed and certainty of execution as the number one factor in achieving best execution. Others would say speed and price improvement are both attainable goals.

The technology also exists for firms to provide customers with the ability to route orders to the market of their choice. If firms adopt this approach, how would that change the way they fulfill their customer best execution obligations?

Second, how do the changes we all see today in market structure – also as a result of technology – affect how a firm makes a best execution analysis? Even without resolving the price improvement versus speed and certainty of execution discussion, if customers do have the ability to choose where they want their orders routed, they will need ready access to information about price improvement opportunities among the market centers.

In a fragmented market, it will be difficult to obtain this information. A fragmented market will certainly impact best execution in other ways. Technology has made market structure a front burner issue.

Market Structure

As I mentioned earlier in my remarks, the Commission is taking a close look at how technology has impacted market structure.

Like online brokerages, ECNs have disintermediated trading. With a click of the mouse, investors can enter orders to trade without talking to a broker. Similarly, market participants can choose to send order flow to a number of different electronic trading venues, apart from the traditional markets.

Technology has raised the visibility of execution costs for both online brokerages and market centers. By many accounts, technology has reduced these costs substantially. According to one discount brokerage firm, in 1975, the cost of trading 1,000 shares of IBM was $800. Today, that trade costs $29.95. (Now I have revealed that firm’s identity.)

Without the expensive infrastructure costs borne by the traditional market centers, ECNs have become a competitive force for those markets’ order flow. Right now, approximately nine ECNs have captured about 30% of NASDAQ’s listed market share. So far, these ECNs execute only about 4% of NYSE’s market share.

Only a relatively small percentage of NYSE’s volume is executed on ECNs mostly because of NYSE’s Rule 390. This rule restricts NYSE members from trading in NYSE listed securities anywhere other than on an exchange. Another reason for ECNs’ small share of NYSE order flow comes from their lack of access to the Intermarket Trading System.

Repealing Rule 390 will remove a significant barrier to true marketplace competition. It will also remove a significant barrier to internalization. With Rule 390, about 70% of NASDAQ order flow – but only 10% of NYSE’s order flow – is internalized.

Without Rule 390 creating a check on internalization, significant NYSE order flow can be dispersed among separate markets without the benefit of interaction and competition. As the number of market centers increase, so does the potential for significant fragmentation of the marketplace.

The Commission has focused on this issue and last month put out for comment a concept release to encourage price competition among the markets.

The fragmentation concept release

In case the Chairman’s E-Bay proposal doesn’t work out, the Commission needed a plan B to encourage greater price competition among the markets and ECNs.

The release proposes six basic approaches to dealing with market fragmentation. The six options provide a sort of sliding scale of alternatives to resolving market fragmentation, starting with disclosure and ending with price/time priority. I am somewhat partial to Option # 1 since it incorporates one of my report’s recommendations – disclosure – to the Commission on best execution. Each alternative, however, merits a careful evaluation.

As we move to repeal one of the last barriers to true marketplace competition, Rule 390, we must take care to do so in a way that encourages quote competition without creating new barriers to marketplace competition.


Clearly, the current of new technology is sweeping across every segment and participant of our markets. While the industry is focusing on new business models and unbundling its services, trading centers are providing stiff competition for order flow to the traditional markets. Technology is challenging the way these entities compete.

Likewise for the Commission, for whom I cannot speak, technology is challenging the way we regulate. Fortunately, the basic regulatory principals: full disclosure, price transparency, effective linkages, and best execution will continue to light the path ahead. The challenge for us is how we apply those principals in a way that enhances competition and encourages further innovation in the marketplace.

Part of meeting that challenge lies in a candid, direct and thoughtful dialogue between the industry and regulators. As new frontiers are forged, new opportunities created, and new investors served, I know we all look to a future marketplace defined by integrity as much as it is by innovation.

Thank you very much for this opportunity to speak and I will be happy to answer any questions.