Speech by SEC Staff:
|The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Ms. Nazareth and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.|
Good morning. I am delighted to be here to talk to you about some of the significant market structure issues facing us today. 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.
I have been asked to speak today about the market structure for the year 2000 and beyond. This is a topic that, quite remarkably, nearly everyone is interested in today. Our financial markets, driven by the longest bull market in history, have captured the imagination of Main Street as well as Wall Street. Whenever I speak to industry participants I am invariably asked to predict what tomorrow’s markets will look like. Before I fall into that trap I remind myself of the comments made by a contemporary of the Russian revolutionary leader Trotsky, who noted, "Proof of Trotsky’s farsightedness is that none of his predictions have come true yet."
Fortunately for us, the authors of the ‘34 Act did not attempt to design a national market structure based on their vision of the future. Does anyone here believe that they would have envisioned: electronic communications networks, on-line trading, after-hours trading, global trading, or the myriad of other changes that have occurred over the past 65 years? And even if they had – could they then have designed a market structure that addressed these technological changes and accommodated further innovation? To the contrary, the Congress had the foresight to design a flexible regulatory structure that addressed the pressing need of the nation – investor confidence. Let’s face it, our markets are driven not by technology, but by investor confidence – and as Chairman Levitt has observed and as the Congress understood, once that confidence is lost it is not easily regained. Investor confidence was the issue in 1934 and it is the issue today. Fortunately, Congress saw the issue clearly and mandated that the markets be allowed to develop on their own, provided they were fair – orderly – and protected investors.
For the most part, the evolution of the securities markets has been consistent with the congressional mandate. However, as technology advanced and as competition between markets became the norm, it became apparent that we needed to readdress the issues of fair and orderly markets and investor protection. By 1975 it was obvious that the markets’ most precious asset – investor confidence – would soon erode if our markets did not become more efficient, continue to promote competition between markets, provide for price transparency, facilitate best execution, and enhance order interaction. Once again, Congress stepped in, not to rewrite the Exchange Act, but to reinforce its core values. The result, as you know, was the National Market System legislation.
As the debate over the market structure of the future continues, virtually every facet of our market structure is being called into question. Some even question the continued legitimacy of the principles of our National Market System. I firmly believe that while technology makes it not only possible but in many instances preferable to alter the way we apply the National Market System principles, the principles themselves are as valid as ever. We simply cannot expect investors to remain confident in the inherent fairness of a marketplace that does not promote competition, transparency, price discovery, best execution, or efficiency. These principles are not only valid; they are the very foundation of our industry!
Each of the five pillars is an integral element of a comprehensive regulatory approach. In implementing these objectives, the relevant issue for the Commission is never whether to choose one objective to the exclusion of another, but to facilitate the development of a market structure that adequately incorporates and advances each of the five objectives. The Commission’s job is to promote a regulatory environment that allows the industry and technology to develop on their own, consistent with the principles of the National Market System. Quite clearly – any market system dictated by the government would be obsolete before it was fully implemented.
The U.S. securities markets have developed remarkably well since 1934 using this regulatory approach. Today, investors have unprecedented access to information about securities and the markets, and enjoy narrower spreads, lower execution costs, and faster execution speeds. As we face today’s challenges, I believe there is consensus both at the Commission and in the industry that this flexible framework will continue to serve us well in the years ahead. Of course, regulators and the industry will have disagreements from time to time about particular means of achieving these objectives. And there is no doubt that our industry stands at a historic crossroads. Technology continues to revolutionize our marketplace and much of our original "plumbing" if you will, established after the National Market System legislation, is in need of serious repair. And the debate rages on – should we patch or should we tear out and start anew? Some major structural challenges that currently face us include: our model of self-regulation; the linkage between market centers, how market data is collected and disseminated; and fragmentation of the marketplace. These structural questions clearly focus the debate – patch or tear down. Regardless of our decisions with respect to the future structure of our marketplace, the foundation of our market structure – the core principles enunciated by Congress in 1975 – have amply demonstrated their durability and merit in guiding the development of our securities markets.
Let’s look at some of the challenges we currently face.
I’ll begin with market center competition. Much of the innovation in our marketplace today is due to competition. Indeed, much of the success of our securities markets has been achieved through the incentives created by multiple, competing market centers.
To promote market competition while recognizing the role that ECNs were playing as new market centers, the Commission in 1998 adopted Regulation ATS. As you know, Regulation ATS provides a streamlined regulatory structure for ECNs that choose to be regulated as alternative trading systems rather than national securities exchanges, and thereby enhances the opportunity for innovative market center competition. Since the adoption of Regulation ATS, the competition generated by ECNs has continued to thrive, and we are making progress in integrating them into our National Market System. Through their successful creation of electronic agency trading venues, ECNs today account for almost 20% of the share volume, and approximately 25% of the dollar volume, in Nasdaq stocks.
A significant market structure challenge facing us today is how to level the playing field between ECNs and the SROs. SROs, unlike ECNs, serve a unique self-regulatory function. They have the power to discipline members. They must provide fair access to members and they must submit most rules to the Commission for review. Many of the SROs argue that the latter process stifles competition by impairing the SROs’ ability to respond to competitive pressures. Because ECNs do not submit their trading rules to the Commission for approval, they may have a competitive advantage over registered securities exchanges. Thus, we are exploring ways to streamline our exchange regulation and, specifically, to expedite the process through which SRO trading rules become effective. We are seeking to do this in a way that will allow market innovation without sacrificing market integrity or investor protection.
I am pleased to note that with the elimination of NYSE Rule 390 yet another competitive impediment has been eliminated. That Rule’s off-board trading restrictions long had been questioned by the Commission and others because they directly interfered with a certain type of market center competition – competition between exchange markets and other markets. The success of market centers trading listed equities should depend on competitive forces, particularly the extent to which they can provide the highest quality trading services at the lowest possible cost.
Despite the numerous beneficial effects of market center competition, problems such as excessively fragmented markets can result in reduced opportunity for order interaction. The Commission has taken action in the past to promote the opportunity for investor orders to interact without the participation of a dealer. It may seem inconceivable today, but up through the early 1990s Nasdaq market makers routinely traded ahead of public limit orders. As a result, it was nearly impossible for individual investors to use limit orders effectively in the Nasdaq market. Market makers accepted the limit orders of customers, but generally did not execute them until they had become marketable and therefore were substantially equivalent to a market order. This effectively denied an opportunity for individual investor limit orders to compete with dealer quotations. To address this problem, and at the Commission’s strong urging, the NASD in 1995 changed its rules to prohibit a market maker from trading ahead of its customer limit orders.
One year later, the Commission took the further step of adopting the Order Handling Rules. Until then, the NBBO for Nasdaq securities generally reflected only market maker quotations. Such quotations did not reflect limit orders of any kind, whether submitted by investors to market makers or submitted by market makers or investors to ECN limit order books, even when these orders would improve the NBBO. In addition, the ECNs with the best prices did not make their prices publicly available in the consolidated quotation stream, but generally granted access only to their subscribers.
To remedy these practices, the Commission exercised its National Market System authority to require market makers to include in their quotes (or send to ECNs) customer limit orders that improve a market maker’s published quotations. The Commission also required market makers to publish their best displayed prices either in their quote or through an ECN.
Of course, these rules must be enforced to be effective. As you may know, earlier this month the Commission’s Office of Compliance Inspections and Examinations issued a staff report that revealed problems in the display of limit orders in both the equities and options markets, as well as inadequacies in the markets’ surveillance and disciplinary programs for limit order display. In light of this, the Commission expects market participants to redouble their commitment to ensure that the full power of limit orders is felt in our markets. Chairman Levitt also has asked SEC examiners to increase their scrutiny of compliance with the limit order display rule.
Today, the Commission is concerned about certain broker-dealer practices – internalization and payment for order flow – that may substantially reduce the opportunity for investor orders to interact and thereby contribute to harmful fragmentation of the National Market System.
This past February, the Commission issued its much-anticipated Concept Release on Market Fragmentation, which was published together with the notice of the NYSE’s proposed rescission of Rule 390. This provided an appropriate context for the Fragmentation Concept Release because of concerns about the potential for increased fragmentation of trading interest once NYSE members were permitted to conduct transactions in all listed securities off an exchange.
Brokers that handle customer orders currently have a financial incentive either to internalize their orders by trading against them as principal, or to route their orders to dealers that will trade against them as principal and share a portion of the profits with the broker. Internalization and payment for order flow arrangements provide dealers with a guaranteed source of order flow, eliminating the need to compete aggressively for orders on the basis of their displayed quotations. Instead, dealers can match the prices that are publicly displayed by other market centers, which in many cases represent investor limit orders that are displayed by agency market centers (such as the NYSE or an ECN). These investor limit orders may be denied an opportunity for an execution if dealers choose not to route orders to the market center displaying the limit orders and instead match the limit order prices.
Price-matching dealers receive the benefits of the public price discovery provided by other market centers without contributing to that price discovery process themselves. Moreover, if a substantial portion of the total order flow in a security is subject to dealer price-matching arrangements, it reduces the ability of other dealers to compete successfully for order flow on the basis of their displayed quotations. In both cases – unfilled limit orders and disregarded dealer quotations – those market participants who are willing to participate in public price discovery by displaying firm trading interest at the best prices are not rewarded for their efforts. This creates disincentives for vigorous price competition, which, if extensive, could lead generally to wider bid-asked spreads, less depth, and higher transaction costs.
The concerns raised in the Fragmentation Concept Release are not limited to assuring that investors receive at least the best displayed prices, whatever they happen to be. Assuring that investors receive the best prices displayed anywhere in the National Market System is crucial, but additional considerations need to be taken into account. For example, the spread between the best displayed bid and the best displayed offer may be wider than it otherwise would be if a market structure fails to promote vigorous price competition. In addition, some market centers offer investors an opportunity for price improvement – an execution at a price better than the best displayed prices. To meet their best execution responsibilities, brokers must take these price improvement opportunities into consideration in deciding where to route customer orders.
Price transparency is another key pillar of the National Market System identified by Congress. It formed the initial focus of Commission action in 1975. The wide availability to investors of an NBBO and a consolidated stream of transaction reports from all the market centers that trade a security is a minimum essential element of a truly National Market System. To achieve the price transparency objective, the Commission adopted rules requiring that all market centers make their basic quotation and transaction information publicly available, that such information be consolidated, and that it be made available to investors on a real-time basis. As a result, investors have ready access to an NBBO and a consolidated transaction stream for each of the thousands of equity securities actively traded in the U.S. markets. Price transparency has become the hallmark of our securities markets, and many market participants credit it for much of their success over the last 25 years.
The fundamental objective of price transparency – assuring that investors have ready access to high-quality consolidated data – remains just as important today as it was 25 years ago. Some, however, have questioned whether the arrangements that have been set up to disseminate consolidated data are in need of updating. For example, some suggest that greater competition could be introduced into the system if we abandoned the model under which a single processor consolidates and distributes the data. They argue that advancing technology allows for new models for consolidating and disseminating data. In the months ahead, we intend to explore whether there are better, more efficient tools with which to achieve the National Market System objectives.
But with the rapidly changing structure of the markets, even more is necessary in the way of price transparency. With the impending changeover to decimalization, and the more narrow view of supply and demand that will accompany it, price transparency below the top of the book will become critical to the price setting mechanism. If our markets – exchanges, dealers, and ECNs – were to make their limit order books publicly available, vendors could consolidate this data and package it in a form that would be most useful to their customers. Chairman Levitt recently called for a voluntary private sector initiative to improve the transparency of limit order books across all U.S. markets, and earlier this month the Commission hosted a public roundtable with representatives of a diverse group of market participants – including representatives of several SIA-member firms – to discuss this issue. We are pleased that the SIA and ICI have agreed to form a joint industry group to follow-up on the ideas discussed at the roundtable.
Price transparency alone, however, is not sufficient to achieve the National Market System objectives. Providing access for executions against those prices, no matter where they may have originated in the National Market System, also is essential in order to address the objectives of efficiency and best execution. Brokers provide the primary means of access to the markets. But once a broker has routed an order to a market, a better price may arise in another market. The Commission therefore has used its regulatory authority to prompt the securities industry to create intermarket linkages that provide access between market centers to the best displayed prices. These include the Intermarket Trading System for listed equities and Nasdaq’s National Market Execution System for Nasdaq securities.
Another challenge is the integration of alternative trading systems into the quote and linkage mechanisms for listed securities. This past March, the Commission approved a proposed rule change by the NASD that will permit ECNs to link to the listed market through the ITS/CAES linkage. Although additional ECN linkage issues remain, the NASD rule is a significant step in the right direction. We also expect the participants in the ITS plan to negotiate in good faith and work diligently to bring new exchanges into the ITS plan.
Some have suggested that advancing technology now has made it possible for brokers to meet their best execution responsibilities through direct links with market centers and that intermarket linkages such as ITS are no longer necessary. As with the arrangements for disseminating consolidated data, it is worth exploring whether there are better, more efficient tools with which to achieve the National Market System objectives. It is critically important, however, that the objectives themselves are not impaired in the process.
While linking alternative trading systems to the listed market is a step in the right direction, there is much more that can be done. Today we have an opportunity to update certain of the National Market System plans, systems, and facilities to better reflect advancing technology, changing market conditions, and new SRO structures (such as for-profit exchanges). If there are better, more efficient tools with which to achieve National Market System objectives, they should be explored and adopted. Indeed, one of the greatest benefits of the regulatory approach adopted by Congress is the flexibility it allows for adapting individual components of the National Market System. In the months ahead, the Commission intends to explore opportunities for more efficient and effective National Market System operations.
With respect to the options markets, only last year did they begin the multiple trading of options in earnest. This allowed options investors for the first time to reap the benefits of a truly National Market System with competing market centers. Currently, the staff is reviewing comment letters submitted in response to linkage plans filed by the various options exchanges. The Commission intends to move quickly toward approving and facilitating the implementation of a plan that will further the interests of options investors.
What general principles, then, can be extracted from these examples of Commission action to further National Market System objectives? First, the Commission has been reluctant to impose specific components for the facilities and systems of the National Market System. Instead, it has focused whenever possible on enhancing the opportunity for competition, particularly competition by innovative market centers and by investor limit orders. When required to act, the Commission has eliminated practices that detract from National Market System objectives, or set necessary market wide standards, while preserving maximum flexibility for the markets to design, implement, and govern any needed facilities or systems.
Second, the interests of investors are preeminent, not those of any individual market center or its participants. The secondary securities markets exist to facilitate the transactions of investors. Investor interests should be protected; investor orders should receive best execution; and investor orders should have an opportunity to interact without the participation of a dealer. Any rules or practices that place the interests of intermediaries ahead of those of investors are incompatible with the National Market System mandated by Congress.
Third, the fact that a practice may further the competitive self-interest of any individual market center or type of market center is not determinative of whether that practice is consistent with the National Market System objectives. If such a practice hampers the efficient execution of transactions, damages price transparency, interferes with the best execution of investor orders, or isolates those orders from an opportunity for meaningful interaction, the practice warrants careful examination by the Commission to determine whether competitive forces alone will be sufficient to address its negative effects. In the past, for example, market centers with the best prices have attempted to restrict access to those prices (such as by disseminating their quotations only to members or subscribers). Even though this practice may be in the competitive self-interest of the individual market center, it is directly contrary to the price transparency objective of the National Market System, as well as efficient execution of transactions and best execution of investor orders.
Finally, there have been times when the collective result of individual market participants acting in their own self-interest has not been sufficient to address practices that are harmful to the National Market System and impair investor confidence (such as dealers trading ahead of, or neglecting to display, customer limit orders). In these unusual situations, the only effective course of action is for the Commission to exercise its regulatory authority to adopt uniform "rules of the road" that benefit the National Market System as a whole. By adopting or by encouraging self-regulatory organizations to adopt rules that set standards, address the harmful effects of specific practices, or knock down barriers to competition, the Commission can achieve benefits for the National Market System that could not be obtained through any other means.
Let me assure you that my passion for the principles of the National Market System is not some Quixotic adventure – we are not tilting with windmills, rather we are defending principles that run to the very core of our industry – investor confidence.