SEC Speech: Toward Markets Driven by Footsteps (A. Levitt)
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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Toward Markets Driven
By Footsteps

by  Chairman Arthur Levitt

U.S. Securities & Exchange Commission

67th Annual Conference and Business Meeting
Security Traders Association
Boca Raton, Florida

October 12, 2000

Thank you. Over the past seven years, I have had the good fortune to address dozens of industry groups. And the feedback I have received at conferences such as today's, and at Investor Town Hall meetings like the one I attended last night in Ft. Lauderdale, has been so vital to my thinking about our markets. I simply cannot imagine regulating a marketplace as dynamic as ours without the insights I gain every day from market participants and America's investors.

As traders, you have a first-hand view of the most dramatic unfolding of competition our markets has seen in over twenty-five years. But I know that working in the eye of the storm is not always an easy task – that as traders, you feel the full and sometimes painful force that competition demands and enforces. Your performance is judged every minute of every day. The real-time discipline you face yields insight like no other. For that reason among others, I am particularly pleased to be here today.

Amidst the far-reaching change sweeping our markets, one issue in particular requires our continued focus – the efficiency of our market's price-setting mechanisms. Our relentless commitment to protecting America's investors, systemic competition, and our global competitive edge demands that we perpetually ask, "Are our markets delivering to the public the best possible prices?"

A little over one year ago, I raised the question of whether we should embrace greater interaction among orders in our national market system as a way to enhance price competition. In raising the question, I made clear that any reform must pass a critical acid test – it must not stifle the incentive for market centers to innovate. Several months later, the Commission issued a concept release soliciting comment on whether customer orders were being isolated by structural impediments such as internalization and payment for order flow, and whether price competition was being threatened as a result. The reaction was far from unanimous, but most investors who commented felt strongly that order interaction was being substantially impaired.

Many of them encouraged the Commission to act, believing the time is now for regulatory action that would stimulate greater order interaction in our marketplace. I share the concerns about order flow arrangements eroding efficient pricing. And I strongly believe that if we ever reached a point where structural obstacles were significantly compromising price competition – and market forces were not sufficient to address those impediments – the case for more direct regulatory action would be compelling. It is not clear to me, however, that we have arrived at such a point. Today, then, I would like to explain why.

Fundamentally, I believe it is imperative that the Commission explore more fully three basic questions before determining whether additional regulatory action is warranted. First, is the matching model of internalization in fact eroding price competition, and if so, what impact is it having on investors? Second, what effect will full-scale decimalization have on price competition? And third, to what extent would greater disclosure of execution quality fuel more competitive pricing?

What Is the Impact of Quote Matching?

One central issue in today's market structure debate is the growth of the quote-matching model used by those who "internalize" order flow. As most of you know, it works more or less like this: Brokers route customer orders to a market maker based not on the market makers' competitive quote, but rather, on the market makers' agreement to "match" the best quoted price in the overall market. The broker either owns the market maker, or gets paid by the market maker for sending these orders. Either way, the broker "internalizes" the difference between the price at which the buy and sell orders are executed. These internalized orders have little or no opportunity to interact with customer orders placed through other firms.

There are strong indications that these arrangements have, by and large, undercut aggressive quoting as an effective means of attracting order flow. Simply put, those dealers willing to stand up and improve upon the quote, and those investors who place aggressive limit orders, often are going unrewarded today. To this point, the Commission's Office of Economic Analysis, based on a sample of 200 Nasdaq stocks examined in June of this year, found that nearly 85% of customer market orders were routed to market centers that were not quoting the best price in the market.

Still, there is a clear difference of opinion over whether such arrangements are in fact undermining systemic price competition. Many investors, both retail and institutional, would answer "yes." But a lot of firms engaging in market-making functions disagree strongly. They suggest the concern over order interaction might be better suited for the faculty lounge, that the real world of competing dealers sufficiently drives prices to efficient levels.

What's more, some dealers claim that internalization arrangements actually benefit investors, allowing firms to segment more profitable order flow and pass a portion of the profits on to investors. I must say, that's an interesting theory, but you will forgive the Commission for wanting to test that one a bit. Whatever else we know about the matching model of internalization, it is clear that in recent years it has been a turbo-charged profit engine for those who employ it, producing returns on equity that are the envy of the financial services sector even in these prosperous times. In short, we need to know more about internalization's effect on the market today and what impact it could have tomorrow, particularly in the listed market.

Fortunately, our ability to assess the relationship between order interaction and price competition has greatly improved. Earlier this year, the Commission's economists began analyzing data on Nasdaq orders that was not previously available. As a result, we are now closer to an apples to apples comparison between trading in the listed market, which is characterized by a central pool of liquidity with a high degree of order interaction, and the Nasdaq market, where order interaction is substantially more limited.

No study, to be sure, can claim to have the final word on a subject as complex as comparing two fundamentally different markets. But, I firmly believe that the report will provide us with important insight into the relationship between order interaction and price competition. I look forward to the study's publication in the coming weeks.

Decimalization – The Big Moving Part

Without a doubt, the most profound variable affecting the evolution of price competition today is the advent of decimal trading. The theory is straightforward: As prices are quoted in smaller and smaller increments, there are more opportunities and less cost for dealers and investors to improve the bid or offer on a security. As more competitive bidding ensues, the spread becomes smaller, particularly in actively traded stocks. This means better, more efficient prices for investors who can trade at the quote. It may also result in a reduction in trading profits in some stocks, and therefore, a smaller pool of funds available for payment for order flow.

At the same time, decimalization may mean that less liquidity will be visible to the market. Put another way, the smaller the quoting increment, the smaller the quantity of stock that is available to be bought and sold at each price. As a result of penny increments, then, the top layer of the book may display a much thinner slice of the total buying and selling interest for a given stock.

In preparing for decimals' impact, we have all anticipated these and other effects. We considered the possibility that volumes would increase substantially; that specialists and other market insiders might more frequently "step ahead" of existing customer orders by trading at just a penny better than those orders; that such "penny-jumping" would undermine the incentive for customers to enter limit orders, threatening the most vital driver of price competition. We also considered the possibility that a decrease in spreads would make internalization less profitable.

No doubt, it is far too early to reach even tentative conclusions about the accuracy of these projections. But there are some indicators in the data available thus far, and certainly insights to be gained. A recent preliminary comparison, performed by the NYSE research department, of trading in sixty-three NYSE pilot stocks, before and after the switch to decimals indicates that effective spreads decreased by almost 20 percent in the first week of decimal trading. Depth at the NYSE quote shrunk by about 70 percent. Note that the sample is dominated by AOL and Compaq, which are by far the two most active of the pilot stocks. In AOL and Compaq, effective spreads dropped by nearly 37 percent and the depth at the quote by more than 75 percent.

One intriguing result of the comparison is that the percentage of market orders executed inside the prevailing NBBO more than doubled – jumping from approximately 30 percent to nearly 65 percent. Remember, though, that while the frequency of this price improvement has increased, the value of it has decreased with the move to pennies. At first blush, you might attribute this increase in trading inside the NBBO to an increase in specialist participation, or to put it bluntly, specialists stepping-ahead of customer limit orders. But specialist participation has not followed this same trend line, increasing by just a little more that 2 percent. Also interesting is the fact that, contrary to some predictions, we have experienced no dramatic increases in trading volume to date.

As usual, the market has thrown us a few curves, suggesting forces at work that few predicted. None of us, as if we need reminding, has a crystal ball. But together, we do have the ability to anticipate a good deal of what lies ahead. In this vein, I spoke awhile back about the need to embrace a deeper transparency in our markets, enabling investors to reap the benefits of narrower spreads but without sacrificing the ability to gauge trading interest. Since then, the Commission hosted a roundtable discussion that drew broad participation from traditional markets, electronic markets, dealers and buy-side professionals. And from our discussions we learned that every sector of the market, when questioned in a public forum with the financial press in attendance, was fully supportive of increased limit order transparency, if you can believe it. In fact, the idea is so universally accepted, I am sure that if I polled this room, each and every one of you would support greater transparency of limit order books – other than your own, of course.

Seriously, I know there are important differences of opinion about how, and for some, even whether to move towards deeper pricing transparency in our markets. But decimal trading is now upon us. Within a few months, penny increments will prevail market wide. We all know that without greater transparency of limit orders, the ability to price orders of any meaningful size effectively will become increasingly difficult. If, as a marketplace, we fail to embrace a level of transparency clear enough for penny increments, there will be no good excuse behind which we can hide.

I see two significant facets to this challenge. The first is ensuring that our markets have the tools to make the real depth of buying and selling interest visible to the market. On this point, I am hopeful and encouraged by steps our markets – both traditional and electronic – are taking to build and enhance platforms offering greater visibility. The second challenge is more difficult, which is encouraging competing market participants to use available platforms to display buying and selling interest.

Now, all of us are aware of the standoff that the transparency issue produces between market makers and the buy-side. The buy-side criticizes market makers for holding their own customers' limit orders like a hand of poker, profiting from their exclusive view at the expense of public price discovery. Market makers, on the other hand, charge that the buy-side wants to see all of the supply and demand in the market, but not show any of their own hand. Most would agree, however, that everyone would be better off if both market makers and the buy-side displayed more trading interest to the market, particularly as we move to a world of pennies.

This is all not to say there shouldn't be a place for undisplayed trading interest in our markets. But pennies force us to face squarely the systemic implications of widespread private price discovery.

Personally, I believe there is a middle ground, fertile enough for compromise that improves the market without neglecting important interests. I know that leaders from both communities have devoted substantial efforts to reaching this ground, and I commend them for looking beyond the old standoff.

The Promise of Execution Quality Disclosure

For a few years now, I have been repeating a number of simple messages to retail investors. One in particular which I have highlighted this past year embraces a concept so fundamental to what most of you in this room do every day, that I suspect it is simply second nature. Succinctly put, that message is: execution quality matters.

Unfortunately, for even those investors who are reasonably informed about our markets, this concept still comes as somewhat of a news flash. Too many investors today will devote time and energy searching for the lowest commission around, but know virtually nothing about what happens to their orders once they click "submit." Too few investors recognize that an order executed just pennies away from the best price can dwarf the commissions charged by most discount firms.

The truth is, though, there is virtually no meaningful way today for the average retail investor to compare the order execution quality of different market centers. In my mind, this is simply unacceptable in a national market system founded on the principle of competition among markets. The relentless demands of informed investors are, and will always be, the most potent force in our marketplace. The shroud that currently surrounds execution quality leaves investors in the dark. It also undermines systemic competition.

For this reason, this past July, the Commission proposed rules, which call for greater transparency of execution quality. The rules operate on two levels. Market centers, including traditional markets, electronic markets and dealers, would make key statistical data on the quality of their order executions available to the public on a monthly basis. Brokers would also disclose which market centers they route orders to, and any relationship they have with these markets, on a quarterly basis. Currently, the Commission staff is reviewing the comments generated by our proposal.

Now, let me take a moment to get down in the weeds on one of the metrics used in the rule. At the core of the proposal is a statistical measure known as the effective spread. It is an essential tool, as I am sure you realize, for institutions and their consultants to measure the quality of the prices provided by a particular market center. The rule would make this measuring stick available to the public, enabling retail investors to drive a more competitive race for execution quality.

Effective spread measures, on a share-weighted basis, the prices at which market centers actually execute trades. The quoted spread, on the other hand, simply measures the difference between the average quoted bid and ask in the overall market. By measuring actual trades and the prices at which they occur, the average effective spread also takes into account the liquidity a given market center provides at a particular price. In that way, it fully rewards those market centers that provide liquidity guarantees to order routing firms. Along with other data that would be required by the rule, including speed of execution, the average effective spread facilitates a meaningful comparison of different markets on the basis of execution quality.

In my judgment, there is simply no alternative to shining sunlight on the too-long hidden element of execution quality, to exposing the performance of market centers for public view. America's investors deserve no less than a national market system where each and every market is driven by footsteps: the fast approaching footsteps of competitors improving execution quality, the fading footsteps of customers leaving if it fails to measure up.


As I was thinking this morning of how best to capture my thoughts on the Commission's role in this important issue, I kept coming back to the image of a guardian. A guardian whose resolute pledge is to serve the interests of America's investors above all others, whose willingness to act when these interests are threatened is beyond doubt. But, a guardian whose duty is imbued with deference toward the genius that it is charged to protect the natural genius of market forces.

It probably comes as no surprise to you that my best instincts tell me that today, there are indeed obstacles to price competition at work in our national market system. But acknowledging the problem does not mean that regulatory action must follow in lockstep. Rather, we honor our commitment to America's investors by treading carefully and prudently where we risk unwanted implications from our best intentions. In an era where market forces – driven by innovation, globalization, and new technologies – are crafting the markets of the future, we simply cannot take measures without careful consideration of what's at stake.

As our limited exposure to decimalization has shown us, unforeseen forces have only begun to shape our market structure in fundamental ways – forces which present real possibilities for ushering in profound advances in our market's efficiency. But the most potent force our markets have or will ever know is the power of informed investors. By embracing our commitment to providing investors with transparent, competitive, and efficient pricing, we embrace another commitment – preserving America's markets as the most robust, resilient, and more respected capital markets in the world.

Thank you.