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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
The Internet -- Will It Be the End of the Stock Market as We Know It?

Remarks by

Laura S. Unger

Commissioner, U.S. Securities & Exchange Commission

Business Week Panel
National Press Club,
Washington, DC

June 22, 1999

The views expressed herein are those of Commissioner Unger and do not necessarily represent those of the Commission, other Commissioners, or the staff.

Thank you, Mike. Iím happy to be here today to discuss the impact the Internet and electronic trading are having on market structure. Itís a slight change of focus from my most recent efforts, which have been to explore how the Internet, particularly online brokerage, is changing the brokerage industry. Just last week, I completed a series of three roundtables on the subject, and I am preparing a report to the Commission on my findings. I hope to present the report to the Commission early in the fall and make it publicly available shortly thereafter.

Today, Iíll start out by highlighting some of the ways electronic trading technology is affecting U.S. stock markets. Then, Iíll briefly outline the regulatory framework the Commission recently put in place to allow U.S. stock markets to take better advantage of the benefits of technology. Finally, Iíll offer a few observations on this new environment.

Impact of Electronic Trading Technology on the Markets

Electronic trading technology is cost efficient -- it greatly lowers the start-up costs for new trading systems, which is why weíve seen such an explosion in the number of systems available. In addition, the operating costs of electronic trading systems are lower: an electronic trading system has a fraction of the overhead costs of a traditional bricks-and-mortar exchange.

Electronic trading technology changes the dynamics of the marketplace. It removes at least three physical constraints imposed on markets. The first is physical space. On a traditional exchange, the floor members have time and place advantages over those off the floor, which is why we have placed limitations on their proprietary trading activities. On an electronic trading system, however, everyone is in the same cyberspace, so time and place advantages disappear. I have been told that in Europe, some exchange members try to locate their servers as close as possible to an exchangeís premises believing that it gives them a few milliseconds advantage in response time.

The second constraint is the number of participants a market can have. Electronic trading technology lessens the need for a market to be a membership organization. The third constraint is geography. Market participants can be geographically dispersed since they donít have to be located on the premises. Electronic trading technology has made foreign markets increasingly vocal about wanting to provide direct electronic access to U.S. investors.

Electronic trading technology also has a great potential for disintermediating the markets. It provides a means for natural buyers and sellers to meet directly, without intermediaries like market makers or specialists. It doesnít mean that intermediaries will disappear, although they may fade in importance for the most liquid stocks under normal market conditions, where there are both buyers and sellers. Intermediaries will still play a critical role maintaining orderly markets where trading interest is concentrated on one side of the market (e.g., in a downturn).

Finally, electronic trading technology has blurred the distinction between broker-dealers and exchanges. Over the years, broker-dealersí systems have become increasingly automated. Broker-dealers developed electronic trading systems that function very much like exchanges: bringing customer buy and sell orders together, and providing a means for customers to interact with each othersí orders. These alternative trading systems, or ATSs, as we call them, became real competitors of the traditional markets -- yet operated largely outside of our regulatory framework for exchanges.

New Regulatory Framework

How did that happen? The Commission wasnít asleep at the switch. Back in 1997, we put out for comment a concept release on exchange regulation. Last year, the Commission proposed and adopted a new regulatory scheme for exchanges and ATSs, which went into effect this past April.

The idea behind Regulation ATS is simple: let each trading system choose the regulatory scheme that best fits its business plan. A trading system can register as an exchange or be regulated as an ATS. How did we do this? First, we expanded the interpretation of "exchange" to cover ATSs. Second, we exempted ATSs from exchange regulation if they agreed to comply with the conditions of newly-adopted Regulation ATS.

For a start-up or low volume ATS, the conditions are minimal. Basically, the ATS has to register as a broker-dealer, become a member of a self-regulatory organization, cooperate with Commission and SRO inspections, file a plan describing the system with us 20 days before beginning operations, keep certain trading records, and file quarterly system activity reports.

Regulation ATS lowers the barriers to entry. New competitors can take advantage of new technologies to bring innovative systems online without being overburdened by regulation. Once an ATS gets substantial volume though, it has to comply with several other conditions that more closely tie it into the national market system.

The final thing we did was make it easier for ATSs to register as exchanges. By clarifying that exchanges could be for-profit and adopt more flexible corporate governance structures, the Commission recognized that the traditional non-profit membership organizational model may not be the most appropriate one in an economy operating on triple-paced ĎInternet time.í

Answers to Rhetorical Questions

Iíll share a few observations on this new environment.

Is the End Near for Floor-Based Exchanges?

Are floor-based exchanges like the NYSE on their way out? Just looking at whatís happened overseas, you would probably answer yes. In Europe and Asia, wherever electronic and floor-based systems went head-to-head, the electronic systems have (pardon the pun) swept the floor clean with their traditional competitors.

But the floor-based exchanges already do most of their trading electronically now. All of the floor-based exchanges have electronic order routing networks and limit order books. The NYSEís SuperDOT order routing and trade reporting system is a huge electronic network that broker-dealers across the country can access from their desktops. Meanwhile, the regional exchanges receive well over 90% percent of their order flow electronically, and automatically execute most of it without any human intervention.

As a result, itís mostly liquidity that determines the success or failure of any trading system. Someone can always build a better mousetrap. In this case, the mouse is liquidity. Without it, a trading system will end up on the trash heap of trading system history.

And liquidity is a sticky thing. Once it has settled somewhere, it is hard to pry away. Liquidity would migrate away from a primary market only when the costs of accessing it become extreme relative to other markets.

The emerging all-electronic exchanges will have to show significant efficiencies and cost savings to users to attract a substantial amount of liquidity away from the NYSE. If the NYSE closes its floor in the next couple of years, it is just as likely to be because it is moving to New Jersey than going completely electronic.

How is Online Brokerage Affecting the Markets?

Online brokerage is having several effects on market structure. First, itís helped increase individual investor participation in the markets. Increased direct participation has come with a decrease in the average trade size, but an increase in the amount of message traffic per trade -- adding to the marketsí systems capacity concerns.

Online brokerage has affected order routing practices as well. Online brokers recognize the value of their customersí order flow. Recently, several online brokers have bought interests in ECNs (a particular type of ATS). Why? The reasons include: (1) getting payment for order flow for limit orders (which some market makers donít give); (2) a share of the ECNís execution revenue; and (3) access to better prices available on the ECN. These online brokerages are beginning to shift some order flow to ECNs and away from the traditional markets. Whether these arrangements will become commonplace remains to be seen.

Finally, as Iíve said before, the order flow entered with online brokerages overnight has made widespread after-hours trading a near-reality for individual investors. In the emerging after-hours market, ATSs may have an important advantage over their floor-based and market maker competitors. It should cost little for ATSs to keep the machines running several more hours. On the other hand, operating a floor or a market-making desk, and finding the people to do it, may be quite an expensive (and exhausting) proposition.

Thank you for your attention, and Iíll be happy to answer any questions at the end of the presentations.