Speech by SEC Commissioner:
Regulation of U.S. Equity Markets:
Implications for Innovation, Competition, & Efficiency
Laura S. Unger
Commissioner, U.S. Securities & Exchange Commission
At the Baruch Conference
March 17, 1999
Thank you, Professor Schwartz. I appreciate having the opportunity to talk about the Commission's role in regulating the U.S. equities markets.
Before I begin, however, I must dispense with the obligatory SEC disclaimer: The remarks I am about to give are my own, and do not necessarily reflect the views of the Commission or its staff. And if you don't like what I say, they don't really reflect my views either.
Background for Regulation: the Commission's Dual Role
I thought I would first give a little bit of context to the Commission's rulemaking activities by discussing some general philosophies underlying our policy making.
In my mind (and remember the disclaimer, only mine), the Commission has two overarching missions: to protect investors and to promote fair and efficient markets. When a rulemaking or some other matter comes before the Commission, however, the analysis often focuses on addressing investor protection concerns.
This happens particularly when the rulemaking or matter is controversial. Rarely, and then usually only as an afterthought, does the staff or a Commissioner justify a course of action primarily on the basis that "it promotes fair and efficient markets."
Why is this? I can think of at least a couple of reasons.
For one, investor protection has a great deal of populist appeal. Announcing that we're doing something because it promotes fair and efficient markets, however, has no such appeal. At best it appears coldly technocratic; at worst, anti-populist -- we're siding with Wall Street against Main Street.
A second reason might lie in how the two missions are accomplished. Protecting investors requires us to take an affirmative act, generally by layering on an additional level of regulation. On the other hand, promoting fair and efficient markets may require the Commission to refrain from imposing regulations. In fact, it may actually require us to roll back regulation.
Third, when the Commission undertakes an action, it is a lot more difficult to articulate the benefits of promoting fair and efficient markets. So, investor protection is the easier and more likely stated justification for Commission action.
So what comes first, the chicken or the egg? Obviously today's investors are anything but chickens and the market is not as fragile as an egg.
Nonetheless, the analogy is appropriate -- we need investors to have a market and a certain kind of market to have investors.
How do we get investors to participate in the securities markets? By having the deepest, most liquid markets that are efficient and markets with integrity that are fair. Promoting fair and efficient markets is a sine qua non to achieving investor protection. But it is more than that -- it is critical to the global economy, the nation's capital-raising process, and the securities industry generally.
The Topic for Today: Regulation of the Equities Market and Regulation ATS
Now that we have gotten that little bit of philosophy out of the way, I will speak briefly about my views on how the Commission actually undertakes its obligation to promote fair and efficient equity markets.
First, I'll explain the underpinnings of the three principles that guide our regulation of the equities markets: creating linkages among the equities markets; eliminating anticompetitive practices; and promoting the use of technology to foster competition and innovation.
Next, I'll explain from my perspective how we applied these principles in our recent rulemaking on alternative trading systems.
Finally, I'll look ahead and highlight future issues for the Commission -- some from Regulation ATS and others from more general market changes.
Principles Guiding U.S. Equity Market Regulation
In the 1975 Amendments to the Exchange Act, Congress directed the Commission to facilitate the development of a National Market System for securities. Congress did not dictate the structure of a NMS. Instead, Congress set out the goals for a NMS, which were to assure:
- efficient execution of transactions;
- fair competition among brokers, dealers, exchanges, and other markets;
- the availability of quote and trade information to market participants and investors;
- the best execution of investors' orders; and
- consistent with the other goals, the opportunity for investors' orders to be executed without dealer intervention.
The 1975 Amendments added Section 11A to the Exchange Act. Section 11A contains the three principles that have guided the Commission's regulation of the equity markets over the last quarter century.
First, Congress believed that linking together the markets trading NMS securities was a precondition to a NMS. Congress gave the Commission broad authority to create and oversee these linkages.
Second, Congress believed that a competitive playing field had to be maintained among NMS participants. Congress charged the Commission with the continuing obligation both to assure the equivalent regulation of NMS participants and to review SRO rules for anticompetitive impacts.
Third, Congress wanted the Commission to encourage the use of technology in order to link the markets and promote innovation and competition in the NMS. This only underscored the Commission's longstanding support for the application of technology to the markets, which went back at least as far as our 1963 Special Study of Securities Markets.
Regulation of Alternative Trading Systems
Unfortunately for me, but fortunately for you, I don't have the rest of the afternoon to justify twenty-five years of regulatory policy. I'm afraid you'll have to take my word on it -- we've been very consistent. I'll limit my remarks to demonstrating how these principles explain:
- why the Commission waited until now to adopt a regulatory scheme for alternative trading systems; and
- why the Commission chose the regulatory scheme it did.
ATSs Took a While to Become Popular Trading Mechanisms
Although ATSs remained an insignificant factor in the NMS into the 1980s, they became increasingly popular towards the end of the decade for a number of reasons. Most significantly, they provided anonymity to their participants and were largely brokerage systems.
The combination of these two factors provided a solution to the dealer conflict of interest problem, which made ATSs attractive to institutions. This fueled market makers' and specialists' interests, who began to use ATSs as a source of liquidity and a place to anonymously put their better-priced orders.
Moreover, the technology used by ATSs had matured to the point where it was dependable and cost-effective. In addition, being outside the exchange regulatory framework made ATSs nimble competitors, able to rapidly offer new services without waiting for regulatory approval.
1989: Why Rule 15c2-10 Was Premature and Inappropriate for ATSs
In 1989, faced with the rapid growth of ATSs, the Commission dusted off and reproposed Rule 15c2-10 (it was originally proposed in 1969 as a response to Instinet). Rule 15c2-10 would have imposed exchange-like regulation on ATSs serving market functions. Although I was not there at the time, the Commission acted wisely and resisted the impulse to adopt what would have been a premature regulatory scheme.
But why allow ATSs to operate largely outside the regulatory framework for exchanges? Because for all their growth, ATSs still comprised a relatively small part of trading in the NMS. Regulating them like exchanges would have provided few benefits to the markets, while imposing substantial burdens on ATSs.
In addition, the Commission wanted to encourage ATSs' growth as a source of significant potential competition for the primary markets. In the spirit of nurturing technological innovation and competition, the Commission instead adopted a quarterly reporting requirement for ATSs. This enabled the Commission to collect data on ATSs, which allowed us to better understand their operations and, if and when necessary, have a sound basis for their regulation.
1997: TheTime Became Ripe for an ATS Regulatory Scheme
ATSs Needed to be Better Linked to the NMS
As you well know, by 1997, ATSs comprised at least 20% of the volume of Nasdaq securities and around four percent of listed volume. However, the Order Handling Rules did not complete the job of fully integrating ATSs' orders into the NMS; a significant percentage of the best-priced orders in ATSs remained outside of the NMS, available only to ATS subscribers.
ATSs Needed Equivalent Regulation
At the same time, regulating ATSs on an ad hoc basis, through "exchange" and "compliant ECN" no-action letters, was not providing a coherent regulatory scheme to guide the future growth of ATSs.
Moreover, given their emergence as full-blown competitors to traditional exchanges, the regulatory disparities between ATSs and exchanges had become more pronounced. Traditional exchanges saw themselves disadvantaged vis-a-vis ATSs. The Exchange Act imposed a business model on exchanges that made internal approval of changes to their trading systems a significant undertaking -- which then still needed Commission approval.
ATSs Needed to be Regulated but Not Stifled
Up to this point, the Commission had in its pocket only the blunt tool of exchange regulation to deal with ATSs. As the experience with Rule 15c2-10 showed, the Commission was unwilling to use it, for fear of imposing inappropriate burdens on ATSs.
The Commission could have enlisted Congress's help in the form of legislation -- with unpredictable results. The exemptive authority contained in the National Securities Markets Improvement Act of 1996 finally gave the Commission what it needed to craft an appropriate regulatory scheme for ATSs -- one that incorporates them into the existing market structure without stifling innovation and competition.
1998: Regulation ATS and the Underlying Equity Market Regulatory Structure
Regulation ATS embodies the Commission's three regulatory principals contained in Section 11A. It better links markets, equalizes competition, and improves transparency.
Regulation ATS improves linkages by requiring ATSs to become self-regulatory organization members. ATSs with more than five percent of the volume in any security must make all their best-priced orders in those securities available to the public quote stream and accessible to non-subscribers.
Regulation ATS will make all the best prices for the significant markets in any equity security available in the NMS. I support the concept of pre-trade price transparency -- but not at any cost. This part of Regulation ATS is one example where I was and am still not entirely convinced that the costs of investor protection (i.e., price transparency), outweigh the regulatory burden on the markets.
The Order Handling Rules wrought significant changes to market structure, some of which are still being worked out. Following so quickly on its heels with a requirement that might significantly impact institutional trading behavior concerned me. In spite of these concerns, I voted for Regulation ATS for two reasons. The Commission agreed to phase-in the institutional display requirement and overall, it improves the regulatory scheme -- at least in the context of today's market structure.
Regulation ATS equalizes competition by leveling the playing field between ATSs and exchanges. Either entity will be able to choose between registering as an exchange or a broker-dealer and complying with Regulation ATS.
Finally, Regulation ATS encourages competition through technological innovation. It doesn't take much to register as an ATS -- submit a Form ATS; report material changes; register as a broker-dealer; become a SRO member; permit Commission and SRO inspections; maintain certain records, make quarterly reports; ensure the protection of subscribers' confidential trading information; and refrain from calling yourself an "exchange." No one really complained about these requirements.
The other requirements -- order display and access; fair access; capacity, security, and integrity standards -- only apply to high-volume ATSs.
Accordingly, Regulation ATS allows new competitors to take advantage of technological developments without being overly burdened by regulation. Once they become significant competitors in the NMS, of course -- all bets are off.
I'd like to wrap up my remarks by briefly mentioning some issues that each merit an entire speech -- but I mention them to outline issues which may attract the Commission's attention in the future. At the very least, they are on one Commissioner's list.
Conflicts between ATSs and Their SROs. By tying member ATSs closer to the SRO that regulates them, Reg. ATS may heighten the conflict of interest for an SRO that operates a competing trading system. While we made clear in the ATS Adopting Release that we will exercise our oversight responsibility to minimize such conflicts, it will require a great deal of vigilance on our part going forward.
We also will have to keep the exchange registration option a viable one for ATSs as one possible solution to this conflict of interest. Let me make clear, however, that registering as an exchange and becoming a SRO will be a significant undertaking, not for the faint of heart.
ATS Access Fees. Regulation ATS basically left this difficult question open for another day. As you know, the Commission never wants to be a rate maker. Of course, my hope is that the markets provide a equitable solution to the problem. Implicit and explicit pricing of access fees are two possible solutions.
Indications of Interest. Distinguishing between "orders" and "indications of interest" will be critical to determining whether or not a system is an exchange. The Commission will have to closely monitor systems that purport to merely display indications of interest to make sure they are not really functioning as exchanges.
Access by ATSs to the Intermarket Trading System. ATSs have not been able to capture a significant portion of the volume in listed securities, most likely because they do not have access to the listed markets via ITS. I anticipate that the ITS Participants will act reasonably to avoid the Commission mandating such a linkage.
ITS as an Intermarket Linkage. Speaking of ITS more generally, I believe that the Commission needs to closely evaluate whether today's ITS should be the intermarket linkage to take us into the next millennium. Having an inappropriate linkage could impede the natural evolution of market structure. Is ITS sufficient given the changes in market structure since its creation in 1978 and the movement towards fully electronic markets?
Trading Restrictions. There are a number of rules that restrict trading by one or another group of market participants in NMS securities.
The principal ones, of course, are off-board trading restrictions, such as NYSE Rule 390. The Commission adopted Rule 19c-3 to merely maintain the status quo until we could decide whether or not to abolish off-board trading restrictions completely. That was almost twenty years ago. Do off-board trading restrictions serve a legitimate purpose today?
At the least, should the Commission consider lifting them after the close of the primary trading session -- as the Division of Market Regulation recommended in its Market 2000 Study?
Market Data Review. As you may be aware, the Commission is presently undertaking a review of the fee structure for market data and the role of data revenue in the operation of the markets.
This is a difficult, bottom line issue -- especially for the regional exchanges. However, technology and online investing have significantly impacted the demand for market data. As a result, the Commission will review whether it is meeting its responsibility to ensure that quote and trade information is available on terms that are "fair and reasonable" and "not unreasonably discriminatory."
Options Market Review. Although technically outside the scope of today's conference, I thought I'd make a passing reference to the Commission's current review of the options markets. The 1975 Amendments gave the Commission the ability to decide whether certain classes of securities were ripe for inclusion in the NMS. Has the options market matured sufficiently to do so? We'll find out.
Given the pace of change today, the ink isn't even dry on Regulation ATS and I've already begun to wonder how long this regulatory scheme will last. One thing I'm sure of is that when the time comes to reconsider it, the Commission will apply the same principles we always have in regulating the equity markets since 1975.
Thank you for your attention, and I'd be glad to take a few questions.