Speech by SEC Chairman:
The National Market System:
A Vision That Endures
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
January 8, 2001
When I travel to this part of our country, I am continually struck by two powerful forces that operate here, almost in unison, like no other place in the world: the breathtaking, often fearsome force of the natural world, and the ever formidable drive of the entrepreneurial spirit. My own life has been greatly enriched by striving to reach some of the great peaks of the West, and crossing its precipitous ridges. At the same time, having spent a lifetime in business, I cannot help but marvel at the talent and raw energy this region's companies have injected into our economy over the last two decades.
In both contexts, we tend to celebrate the individual, and look with wonder and a bit of curiosity at what must motivate him or her whether it be the twenty-something visionary who strikes out with little more than an unshakeable belief in a novel business model or technology, or the solo alpinist, reaching with near frost-bitten fingers for the next handhold. To be sure, the image of the lone climber on the summit vividly captures the splendor of the endeavor. But the sight of a climbing team, roped together in its ascent, perhaps tells us even more that the flourishing of individuals often rests on the foundation of cooperation and collective effort.
The same is true of our securities markets. Certainly, there is no more potent catalyst in America's economy and markets than the indefatigable drive of the individual. But the truly remarkable growth of our markets is rooted firmly in the standards and structures we have created together, and the public confidence they have engendered. Amidst the most dynamic competition our markets have ever seen, I want to talk about what binds all market participants in our collective effort to ensure the continued ascent and global preeminence of America's capital markets.
An Enduring Framework
More than twenty-five years ago, Congress established the framework for a National Market System to connect the growing number of different markets. This framework, set forth in the 1975 Amendments, has served our markets well. But today, as our markets undergo unprecedented technological and competitive changes, some question its viability. In a time when the ground beneath our markets is shifting so, it's a fair question to consider. But as we do, look at the fundamental vision of the '75 Amendments.
It is a vision rooted not in orthodoxy, but rather, in a practical recognition that investors are best served when diverse markets exchanges, dealers, and alternative markets compete for business; a vision where the best prices in any market are visible and accessible to all; a vision that embraces the goals of competition, transparency, market connectivity, and best execution, but is mindful of the inherent tensions among them.
The wisdom and coherence of the framework lies in a single-minded focus: protecting investors. It embodies a basic recognition that public confidence makes markets possible. As such, this vision of competing, transparent, and interconnected markets continues to be the reliable guide for markets of today and tomorrow.
Yet the Amendments' flexibility in approach and implementation allows a constant reevaluation of the course to achieving a true National Market System. Without question, some aspects of our markets' governance mechanisms and technology could benefit from substantial revision. In this vein, I would like to offer my views on the way ahead in some important and pressing areas.
But, I do so with a cautionary note. In these fiercely competitive times, when the survival of time-honored institutions is in question, when the viability of business models is up for debate, when careers and fortunes hang in the balance, crafting markets that serve the public interest presents an even greater challenge. Market participants threatened by change may seek refuge in reform they believe will simply buy them time. And market reformists likewise may advocate changes artfully crafted to suit their unique business interests. Prudence is critical as we consider changes to a market system that must never cease to function, day in and day out, for the benefit of America's investors not for any one institution or interest.
And that prudence extends to the Commission's role. The SEC's objective or function is not to dictate a particular market model, but rather, to allow the natural interplay of market forces to shape markets according to the demands of investors. Put another way, the Commission has been charged by Congress to facilitate the development of a National Market System. And this begins by providing the catalyst for market infrastructure refinements that serve the investing public.
Infrastructure that Serves the Public
Now, when someone mentions infrastructure to you, I suspect what comes to mind are roads, electricity lines, maybe even telephone wires. While the topic tends to produce heavy eyelids and wide yawns, it's easy to envision the result of neglect. Potholes produce traffic. Broken water mains flood buildings. Downed phone lines leave us stranded. Each of these exacts a toll. They waste our time. They throw us off schedule. One way or another, they cost us money.
The same is true of our markets. The central components of our markets' infrastructure are the system through which quotes and prices are disseminated to the overall market, and the connections through which prices are accessed. If this public quote stream goes down, the ability to see prices across the market is virtually eliminated. Similarly, if connections between markets are overloaded, a displayed quote is relegated to the world of theory. A price you can't get to is little better than no price at all.
Now, for those inclined to write odes to the power of market forces and I include myself in that group history and experience presents a stubborn fact about market infrastructure: individual competitive interests cannot always be relied upon to produce a basic framework for competition that serves the public. Indeed, the elevation of individual interests at the expense of public investors has led to some of the most serious problems our markets have ever experienced, which our securities laws were created to address.
Consider the context in which Congress crafted the 1975 Amendments. Dominant markets held pricing data close to the vest and wielded it like a club in competition with other markets. Connections between markets were primitive or even non-existent, making it virtually impossible to access better prices in other markets that is, if you knew they were there. In the words of Congress, investor confidence was "sagging." Like those of you here tonight with a bit of gray hair, I remember those markets a far cry from those we enjoy today.
To be sure, there are structural features that are in need of modernization. And the technological challenges that all market participants face are formidable. New entrants and new breeds of competitors rightly demand a level playing field with more established players. Take, for instance, the debate over the dissemination of market data.
Pricing Data Oxygen to our Markets
The discussion of how, not whether, to reform the current system of ownership and payment for quote data is both crucial and timely. It is difficult to dispute many of the core criticisms. The decision-making process of those markets that collect and distribute the data should indeed, in my view, be more open and transparent. Alternative markets, broker-dealers and consumers should have meaningful input in critical decisions. And the ability of one market to veto decisions that bear directly on the public interest such as how much to charge for data, and whether to upgrade the technology for disseminating it should certainly be a thing of the past.
What's more, I see no divine right of any one organization to perform the function of collecting and disseminating market data to the public. A number of private sector information providers would like a shot at offering this service, and investors may well benefit from the effects of more competitive bidding.
Last summer, under the leadership of Dean Joel Seligman, who has probably forgotten more about securities regulation than most of us have ever known, the SEC established an Advisory Committee to consider these and other pressing issues. It is hard to imagine a more experienced, balanced and diverse group to tackle the issues at hand. Whatever the committee's recommendations, I suspect there will be broad support for certain key reforms.
There is no avoiding, however, a fundamental dilemma: allowing unfettered market forces to dictate the cost of pricing data is in direct tension with the mandate for market transparency. Put another way, if market forces allow a dominant market to name the price for its data, this also means the market can withhold the data if it does not get its price. Suffice to say, the implications are not only in conflict with Congress' mandate, but wholly unacceptable for America's investors. Too many investors would be forced to price orders in the dark. The current pricing standard the NBBO, or national best bid and offer could be supplanted by scattered patches of varying prices, visible to only a few.
Could today's communications revolution reunite these patches into a national pricing mechanism? Certainly. But the real issue is whether individual competitive interests would ultimately lead back to full transparency. In the meantime, the uncertain outcome and threat to public confidence might very well take their toll. It is critical that we allow the Committee to perform the work it was charged to do. I, for one, would welcome an approach that avoided an active Commission role yet, at the same time, did not compromise transparency. It is not clear to me, though, that such a plan can be found.
Yet whatever the flaws of the current regime, consider what is available to today's investors. For less than the price of a good cup of coffee, individual investors have access for a full month to the best current prices in more than 3,000 NYSE listed securities. For about the same price, they get data for more than 4,000 Nasdaq securities.
We should not take for granted the benefit of the current systems, and must approach modernization with both creativity and caution. We would be derelict if, in these innovative times, we did not search in earnest for ways to bring investors the full benefits of market forces. On the same token, we would be na´ve to pretend that a commitment to transparency does not demand tradeoffs.
Modern Connections in the Listed Market
It is not enough to develop mechanisms and structures that simply display the best prices across markets; a system of competing markets must also support a network of connections that allows prices in one market to be accessed from anywhere in the overall system.
As some of you know, the Commission has long been focused on the issues relating to linkages, whether it be the linkage mechanism in the listed market, known as the Intermarket Trading System, ITS, or the options market linkage which is now on the horizon after more than ten years of nudging and cajoling by the Commission.
Still, many are asking the fundamental question: Why must the Commission involve itself in intermarket linkages at all? Why can't market forces produce these market connections? Once again, part of the answer rests with market forces themselves: a dominant or entrenched market has little or no interest in opening its doors to its competitors. Connections to a market mean access to that market. The Commission needs to continue to ensure that access is a reality for all market participants.
In recent months many market participants have urged the Commission to intervene more aggressively by ordering more up-to-date connections in the listed market. In particular, they believe the SEC should impose a requirement on listed markets to accept automatic executions.
In my view, this would strike the wrong balance between the imperative for interconnected markets, and the ability for individual markets to choose a model that best suits their competitive interests. Ensuring that a market is open to orders from other markets is one thing dictating the way they execute the orders is another. I believe the way ahead is to further free electronic markets to compete in the listed market. And progress is being made. A number of ECNs now display quotes in the listed markets through NASD sponsorship. Unfortunately, these markets have been forced to accept ITS as a linkage to slow their lightening fast systems down to an outdated system.
It is difficult, however, to enable electronic markets to compete fully in the listed market without eroding what many investors have come to expect price priority. Because of ITS, investors today are ensured they will get the best price offered on any exchange, regardless of where their order was originally routed. ECNs argue their customers will forgo a better price elsewhere to achieve immediate execution. This may be true for some investors. But trading price for speed must be rooted in the customer's interest, not the ECN's.
Instinct tells me that the way to market based reform is not to graft automatic execution onto the ITS plan. Rather, ECNs should be allowed to display listed quotes without being forced into ITS. Should ITS markets that participate be required, then, to seek superior prices in markets outside of ITS? And should ECNs be required to seek superior prices in markets that offer immediate executions? Again, the interests of the customer who placed the order should determine the answer. But, if a market is open and immediately accessible, I'm not sure how one could justify not seeking the better price.
Of course, this raises questions which a centralized link, such as ITS, currently resolves. On what terms must ECNs and exchanges provide access to one another? What mechanisms will be used? Any answers, of course, must accommodate the possibility that not just alternative markets, but the NYSE will operate outside of ITS. Without a doubt, the issue of access in the listed market will confront my successor sooner rather than later.
The Dividends of Enforcement
No role of the Commission is more important than ensuring that self-regulatory organizations do their job.
In the last few years, the Commission has taken action on three occasions against self-regulatory organizations. First, in 1996 against the NASD for its failure to surveil for collusive practices among Nasdaq dealers. Second, in 1999 against the New York Stock Exchange for its failure to enforce rules against self-dealing by its floor-brokers. And third, just last year, against the Chicago Board Options Exchange, the Amex, the Pacific Stock Exchange and the Philadelphia Stock Exchange for anticompetitive conduct in listing practices.
The resulting remedies have been substantial and, in some ways, profound. It is hard to imagine adopting perhaps the most important modern structural reform to date the Order Handling Rules without the knowledge garnered from the Nasdaq investigation. Spreads in that market soon declined by more than 30%, transferring billions of dollars from dealers to investors. In the NYSE's case, critical surveillance enhancements were put in place to ensure that floor brokers honor their duties to the investing public.
The constructive actions the markets have taken following these actions have helped lay the groundwork for ever-improving markets. The NASD, for example, invested tens of millions of dollars to develop a system that allows customer orders to be traced from the time they are received until the time of execution. The data collected by the system will, in turn, facilitate the dissemination of uniform market quality statistics later this year. I believe these statistics will stimulate fundamental advances in competition and efficiency in the equity markets.
We expect similar advances in our options markets. Currently, the options markets are developing an order tracing system that will lay the foundation for more meaningful execution quality data. At the same time, working with the Commission, the markets will be developing a consolidated pricing standard a market-wide best bid and offer that not only improves the quality of pricing data but also may offer substantial relief from capacity stresses. In my judgment, with the new standard in sight, the Commission should move quickly to require disclosure of uniform market quality statistics similar to those now applied to our equity markets.
Speaking Plainly About the State of Our Markets
There have been times, over these last almost eight years, that I have looked out during a talk like this and caught a rolling eye or two, accompanied by the kind of fatigued expression you might see when lecturing one of your children. The truth is, I haven't much enjoyed the role of markets' Scolder-in-Chief all right, maybe just a little bit.
Though, my experiences these past years have convinced me that the Commission has few more important responsibilities than speaking plainly and openly about the problems and challenges our markets face. It goes far beyond a question of market regulation it's really about how society reforms itself and, in the process, makes lives better. Perhaps Louis Brandies captured it best when he spoke of the "continuous remedial pressure" of public discourse.
The Effect of Order Interaction
In this spirit, over the last year or so, the Commission has sharpened its focus on the evolving structure of our markets. In particular, we have struggled with the issue of whether widespread quote-matching and internalization are reducing price competition in our National Market System. We have considered whether these practices increase the implicit costs in the form of wider spreads paid by investors. While these are questions without easy answers, it is our duty to face them squarely.
Last year, urged by the Commission, the NYSE removed anti-competitive restrictions on its members trading listed stocks away from an exchange. I commend them again for this action. What's more, it directly raised the prospect that the listed market with centralized liquidity and a high degree of order interaction could very well look more like the dealer market in the future. The question, then, is unavoidable what is order interaction worth to investors?
Earlier today, our Office of Economic Analysis released a study as part of this ongoing inquiry. The study compares spreads over a five-day period between Nasdaq stocks and NYSE stocks, controlling for market capitalization, share price, volatility, and trading volume. The study also measures execution speeds.
On orders between 100 and 500 shares, effective spreads the actual costs paid by investors were nearly equal for pairs that included the very largest Nasdaq stocks. In the remaining categories of large, middle and smaller stocks, spreads were between 5.7 and 11 cents wider for the Nasdaq stocks. And on a 300 share market order, the difference in execution costs outside of the very large stocks amounted to between $8.55 and $16.50 a trade. It is worth noting, of course, that Nasdaq volume is relatively concentrated in these very large stocks. Average execution times for Nasdaq stocks were faster in each of the four categories 13.7 seconds less for the very largest stocks, and between 9.8 and 18.7 seconds less for the other three categories. The Nasdaq speed advantage appears to be limited to orders at less than 500 shares.
It is important to put the results in context. For starters, there are inherent limitations to any comparison of trading in two different securities, in two different markets. There is no single Holy Grail when it comes to standards that measure market quality, and no single gauge that captures every dimension. The study is not intended to indict or endorse Nasdaq, the NYSE or, for that matter, the dealer or auction market models.
That said, the study is a careful, independent attempt to apply an established methodology to data not previously available. And I believe the study also provides important indicators of the answer to the question it was designed to address. Its findings suggest that order interaction improves the prices received by customers. More broadly, it provides context for the question of what immediate executions are worth to investors. For Nasdaq, it confirms a challenge it faces and quantifies what most traders freely acknowledge the ability to trade inside the best displayed quotes is substantially limited. For the NYSE, it sheds further light on the time it takes for incoming orders to interact with trading interest on the floor time its customers have long pressed this market to reduce.
One doesn't need a crystal ball to predict some degree of convergence of the two market models, each attempting to develop strengths of the other. Indeed, both have concrete plans to do so. Yet if the study does nothing more than increase pressure on both markets to respond to the longstanding demands of investors, it will have served the public well.
The Nasdaq Opening
It's also the Commission's responsibility to bring attention to systemic issues that impact the prices investors pay. Opening market prices are one such area. Currently in the listed market, there is a single opening price for investors who wish to buy and sell stocks, saving them money by preventing wide pricing disparities. But many investors may not be aware that, in the Nasdaq, there is no single "first price" that applies to all investors who place orders to trade at or before the market's opening. As a decentralized market, Nasdaq has no one focal point at which supply and demand can coalesce to generate a reliable opening price. Instead, in Nasdaq's words, it is a market made up of markets.
The Commission has pushed Nasdaq hard over the last year to meet this challenge, and Nasdaq management and its members have made honest efforts at progress. Some dealers have also begun executing their customers' opening orders at a single price, forgoing a spread and matching customers directly.
Now, there is nothing wrong with dealers earning a spread. Quite frankly, it is difficult to imagine a workable market structure that does not reward liquidity providers. But circumstances at the market opening often have little to do with dealers assuming risk; it's more an instantaneous and, in many respects, risk-free function of matching buy and sell orders. As the Commission emphasized in November, those market participants who route opening orders to dealers who do take a spread should think long and hard about their best execution obligations.
Recent discussions with Nasdaq suggest it has developed a conceptual approach that uses a "distributed call" mechanism at the opening. In a nutshell, dealers would pair off buyers and sellers in their books, expose imbalances to other dealers in the market, and provide all opening orders with a single price. This would also clear the way for index products on Nasdaq stocks, which have been thwarted by the scattered opening. And it may encourage broader participation by institutions that currently avoid opening trading.
There are details to be worked out and I expect that some will feel it does not go far enough. But my sense is that the distributed call moves us in the right direction. In any event, the challenge of the opening should be addressed by Nasdaq prior to becoming an exchange. In the meantime, I have asked our examiners to look into current dealer pricing practices at the opening, and the impact on America's investors.
As you have gathered, the regulatory challenges presented by the evolution of America's markets are indeed formidable in their complexity. Now consider that foreign markets with wholly distinct structures and regulatory frameworks are pushing to establish a presence here. A host of issues arises: How might we accommodate these markets without altering the standards we apply to our own? Would more direct access by American investors to foreign securities of companies that do not apply Generally Accepted Accounting Principles ultimately threaten the standards for US issuers?
These are thorny, bedeviling questions that force a trade-off between two core missions of the agency questions that increasingly global markets make clear are ultimately unavoidable. But these are questions, my friends, best left for my successor.
Over a century ago, the poet and wanderer John Muir first set sight on the landscape you Westerners call home. Moved as he had never been before, he wrote that great Central Valley of California appeared as a "lake of pure sunshine." Beyond the valley, he said, rose "the mighty Sierra, miles in height, and so gloriously colored and so radiant, it seemed not clothed with light, but wholly composed of it, like the wall of some celestial city." He called the smooth blending the sky's colors, the stone, the snow, and the forest a "wall of light ineffably fine." It is a grandeur I am sure you all know well, but one that can sometimes too easily be overlooked as we run the race of our daily lives.
Few would call Washington a "celestial" city, but in its own right, it has a beauty I have come to care for deeply during my almost eight years there. It is composed of a different kind of stone and sculpted by a different source of light. And yet, it's often only when I see a visitor marveling at it for the first time, that I am reminded of the symmetry and simple majesty of our illuminated monuments on a cold, clear night. Both of these visions are, in a sense, a testament to the importance of what we do together, to our enduring search for the public good. Whether it be the conservation of Yosemite, or preserving the skyline of our nation's capitol our collective commitment forms an enduring bedrock for the beauty we enjoy today.
In many respects, we must approach the structure of our markets in the same way, and with a steadfast attention to their own foundation enduring public confidence. It cannot be said too often: the demands of America's investors are the most potent force in our markets. Fortunate for us, the behavior of investors is not a force of nature beyond our ability. Rather, it is a product of our fellow citizens' state of mind, buffeted at times by emotion, foolishness and greed.
Yet by and large, over time, the source of their pressure on our markets stems from plain common sense applied to cold, hard facts. Today, more than ever, investors figure out when they are being treated unfairly, and whether the system is rigged in another's interest. And they soon punish those who abuse their trust. All of us charged with the health and care of America's markets market participants, regulators, legislators must fear the possibility of investors ever feeling disillusioned, disgusted, or betrayed. And that should serve as our greatest threat and most compelling motivator. Only then do we lay a lasting foundation for investor confidence. Only then do we craft markets that truly serve investors. Only then can we all lift our gaze, as America's capital markets continue to remain the most resilient and respected in the world.