Speech by SEC Commissioner:
Electronic Trading Technology's Impact on the Fixed-Income Markets
Commissioner Laura S. Unger
U.S. Securities & Exchange Commission
at the The Bond Market Association, Fifth Annual Legal and Compliance Seminar,
New York, New York
October 28, 1999
Thanks for the kind introduction, Marcy. I am honored to have the opportunity to be here today. I’d like to thank the Bond Market Association for reshuffling the program schedule so I could make it.
Before I begin, I have to give you the boilerplate SEC speaker’s disclaimer. The remarks I am about to give are my own, and do not necessarily reflect the views of the Commission, its staff, or the other Commissioners.
I had hoped to have finished my online brokerage report in time for the seminar and to use this opportunity to share my findings with you. Well, I have good news, bad news, and some more good news. The first piece of good news is that the report is almost done. I’ll be putting some of the finishing touches on it when I get back to Washington later today. I expect to get the report up to the Commission at the end of next week. Hopefully, the Commission will approve its public release shortly thereafter.
The bad news is that being an SEC Commissioner for almost two years has made me very conscious about little things like front running, quiet periods, and selective disclosure.
So, while I’ll talk about the report generally, I’m going to keep my findings and conclusions under wraps just a little bit longer.
The final piece of good news is that this will leave me some time to talk about how technology is reshaping market structure, focusing on the fixed income markets, of course. No one, not even the regulators, is immune from the changes technology is bringing about. So, I’ll include a few words on how the Commission has adapted its regulatory approach to this new era.
Online Brokerage Roundtables
The roundtables centered on online equities trading by retail investors. Of course, many broker-dealers also offer online bond trading. However, a much smaller percentage of bonds trade online than equities. As the Wall Street Journal reported last week, online trading accounts for almost 16% of equity trades, but only 2% of bond trading. This has a lot to do with the fact that retail secondary market trading is largely an equity market characteristic.
Because low-commission equity trading seems to have been the catalyst for the online brokerage revolution, and is the dominant securities product sold online, I decided to look at online trading through the lens of retail equity trading. But many of the issues addressed in the roundtables and report have implications across the securities markets.
In the first half of 1999, I held roundtables in San Francisco, New York, and Washington. Participants included representatives from online and full-service brokers, SROs, ATSs, securities counsel, academics, financial portals, investor advocates, and associations (including the Bond Market Association’s very own Paul Saltzman).
We covered a wide range of topics in the roundtables: industry trends; suitability; chat rooms and bulletin boards; best execution; market data; systems capacity; investor education; portals; and privacy. The report will include a section on each topic. The basic format of each section is: a brief background, a summary of the issues the Internet raises for each topic, a summary of roundtable participants’ views on the topic, supplemental information, conclusions we could draw, and recommendations for Commission action.
Impact of Electronic Trading Technology on the Securities Markets
I’d like to shift focus a little bit and share just a few thoughts on how electronic trading technology is impacting the securities markets. In a speech I gave this summer, I identified at least four ways that electronic trading technology was transforming the securities markets.
First, electronic trading technology is cost-efficient, both in the sense that it lowers start-up costs for new systems and reduces continuing operating costs substantially. Second, electronic trading technology changes the dynamics of the marketplace by removing physical constraints such as geography and the number of participants in a market. Third, electronic trading technology has a great potential for disintermediating the markets, allowing buyers and sellers to meet directly. Finally, electronic trading technology has blurred the distinction between broker-dealers and exchanges.
What does this mean for the fixed-income markets?
Cost-efficiency. In lowering the start-up costs for new systems, electronic trading technology will lead to a plethora of new systems in the coming years. The Association’s 1998 Review of Electronic Transaction Systems reported that the number of electronic systems increased from 11 to 26 between 1997 and 1998 alone. Since Regulation ATS went into effect -- and I think this is the first time we’ve made these numbers public -- 37 ATSs have filed with the Commission. Of these, 15 trade fixed-income products. This underestimates the actual number of fixed-income electronic trading systems since single-dealer systems and systems that only trade government securities are excluded from the definition of an alternative trading system.
Besides start-up costs, electronic trading technology greatly lowers continuing operation costs by bringing significant efficiencies to the trading process. As we’ve seen in other markets, lowering trading costs inevitably leads to a dramatic increase in trading volumes.
Removing physical constraints on markets. Electronic trading technology also removes physical constraints such as geography and the number of market participants. In the equities markets, this has put significant pressure on the traditional floor-based exchanges to go fully electronic and demutualize. Of course, the fixed-income markets are much more decentralized than the equities markets. Upstairs trading in fixed-income dwarfs the trading on exchanges. Even so, it is somewhat telling that the NYSE, that bastion of floor-based trading, closed down its bond trading floor and went fully electronic.
But where the removal of physical constraints really is important for the fixed-income markets is on the international side. Electronic trading technology is collapsing fixed-income trading into one global market, opening up competitive opportunities and challenges for all market participants.
Disintermediation. By providing a means for natural buyers and sellers to meet without a market intermediary, electronic trading technology has a great potential to disintermediate markets. In the equity side, the prime example is the ECNs, which now account for at least 30% of Nasdaq trading. Some question whether dealers will eventually be relegated to trading only the least liquid stocks, where their proprietary capital is still vital to maintaining a market in those stocks.
Industry analysts have pointed out that advances in trading software are making it easier to categorize and match types of bonds. Will the fixed-income markets eventually become segmented into two categories: (1) commoditized "plain vanilla" instruments that lend themselves to being traded electronically; and (2) the more complex ones that require intermediaries? While transaction services in most bonds aren’t in immediate danger of becoming commoditized, it’s a question worth paying attention to going forward.
But the current example on everyone’s mind of potential disintermediation on the fixed-income side is the City of Pittsburgh’s plan to sell its municipal bonds over the Internet. It is way too early to tell whether this represents the first step in a shift in how municipal bonds will be sold.
However, Pittsburgh’s move does point out something very important about e-commerce. Its nature is to ruthlessly search out and present alternatives to transactions involving intermediaries. The Internet’s transparency and broad reach exposes intermediaries that do not add value. Going forward, fixed-income market intermediaries continually will have to prove their value to clients, or risk being left in the dust by technology.
Blurring Regulatory Distinctions. Finally, electronic trading technology poses regulatory challenges for market participants and regulators alike. Electronic trading systems do not always fit neatly into the "broker-dealer" and "exchange" boxes set out in 1934. Market participants and regulators alike have an interest in creating a stable, easy to apply regulatory scheme. This scheme should encourage the development of new trading systems that can bring innovation and competition to the markets. Regulation ATS was the Commission’s attempt to establish such a scheme for all electronic trading systems.
Regulation ATS: The Commission’s Response to Electronic Trading Technology
In adopting the 1975 Amendments to the Securities Laws, Congress gave the Commission the authority to facilitate developing a national market system for securities. Not just equities, mind you, but all types, including fixed income securities. Congress recognized that many of the goals of a national market system were universal ones, such as transparency of quote and trade information, giving investors the opportunity for best execution, self-regulatory coordination, and strengthening Commission oversight of the markets.
At the same time, Congress made clear that it didn’t intend for the Commission to force all securities markets into a single mold. The Commission was to classify markets and take into account the differences among them in achieving the goals of a national market system.
As I alluded to earlier, over the years the Association has gently, yet insistently, reminded the Commission that the fixed income markets aren’t the same as the equity markets. The Association has cautioned the Commission against imposing equity market principles on bond market structure and the Commission has benefited from the Association’s input.
While the Commission has benefited from the Association’s input, from my perspective, we’ve exercised our national market system authority very much in accord with Congress’s intent. When we’ve used it, we’ve done so to pursue the universal national market system goals I mentioned earlier. We’ve accomplished these goals with the differences among markets in mind.
Regulation ATS shows how the Commission has responded to a challenge facing all markets while respecting the differences among them. The regulatory dilemma presented by alternative trading systems is the same for systems that trade equities and fixed-income securities. ATSs are private, for-profit entities that perform the functions of exchanges, but have been regulated as broker-dealers.
While broker-dealer regulation was insufficient to ensure the appropriate oversight of ATSs, the Commission was able to keep a more or less adequate ad hoc regulatory regime in place by supplementing it through conditions on the "exchange" no-action letters we issued to ATSs. Obviously, this approach was not going to provide a coherent long-term regulatory scheme to guide the future growth of ATSs.
What really made this approach untenable, however, was technology. Developments in electronic trading technology have made ATSs dependable and cost-effective trading venues. As a result, they have been able to wrest an ever-increasing amount of trading volume from traditional markets. As I mentioned earlier, technology has dramatically decreased the costs of entry for new ATSs, which is why we’re seeing new systems pop up all the time.
In adopting Regulation ATS, the Commission crafted a solution broad enough to address the challenge ATSs posed to the securities markets generally, but one sufficiently tailored to take into account the distinctions among different markets.
All ATSs have to: (1) register as broker-dealers; (2) become SRO members; (3) file a Form ATS, keep it updated, and submit quarterly volume reports; (4) cooperate with Commission and SRO inspections; (5) maintain certain records; (6) keep trading information confidential; and (7) refrain from calling themselves "exchanges" or "stock markets." This is hardly an onerous regulatory regime -- for any type of security.
Additional requirements apply to high-volume ATSs. Those trading equities have to provide their best-priced buy and sell orders to an SRO and give non-subscribers access to those orders on reasonable terms. These requirements reflect market structure concerns peculiar to the equities markets. In addition, high-volume equity and fixed-income ATSs have to comply with fair access standards and systems capacity requirements. The volume calculations reflect distinctions between equity and fixed-income markets. Volume levels are set security-by-security for equities, and by category for fixed-income securities.
As you can see, Regulation ATS is not a "one-size fits all" approach to the regulatory challenge posed by electronic trading technology. It is a measured approach, meant to provide the regulatory certainty necessary to encourage new entrants to introduce innovative trading systems in the equity and fixed-income markets alike.
Even with Regulation ATS in place, a number of significant market structure issues still need to be resolved. One of the most pressing, and certainly among the most important, is that of for-profit exchanges. Three entities have already filed applications to register as exchanges with for-profit structures. The NYSE and NASD are considering demutualizing and going public (or at least private) sometime next year.
One of the most difficult issues raised by for-profit exchanges is whether they can adequately carry out their self-regulatory responsibilities. Does a for-profit exchange have the proper incentives to dedicate sufficient resources to the regulatory function? Is there too much of a potential conflict of interest in a for-profit exchange regulating its owners? What about potential conflicts in regulating market participants who also may be a for-profit exchange’s competitors? In answering these questions, the Commission needs to consider whether the current SRO model is appropriate or if we need to partially or completely separate the trading and self-regulatory functions of exchanges. The Commission will seek the industry’s input as we move forward on this vitally important issue.
Thank you for your attention. And I’d be happy to answer a few questions.