Date: 10/2/97 5:31 PM Here are my comments on the Concept Release. I am also sending a hard copy to the commission. Comments of Professor James J. Angel Georgetown University on the Concept Release; Request for Comments File S7-16-97 Summary of Comments: 1. Be careful. The U.S. equity markets are the best in the world, so don*t mess up a good thing. The reforms suggested in the Release are so broad that there may be unintended consequences that hurt our markets. 2. Reforms should move in the direction of deregulation, not increased regulation. There has been a major paradigm shift in thinking about equity markets. The old view was that *the stock market* was a natural monopoly that needed to be regulated like an old fashioned utility. Every exchange rule needed to be approved by the omniscient government. The modern view (reflected in the passage of NSMIA) is that equity markets are businesses that should be allowed to compete on a level playing field with a minimum of government interference. 3. Turning Nasdaq into an auction market would be a mistake. Many of the firms that list on Nasdaq could easily list on auction markets such as the regional exchanges, the AMEX, and the NYSE, yet they choose not to. This *market test* indicates that the complex Nasdaq system (including the ECNs who are an important part of providing liquidity to the system) is doing something right. Thus, regulations designed to make Nasdaq more like the traditional exchanges may deprive firms and investors of something that they are freely choosing now. 4. The standard for new products, new market systems, and new rules should be *Innocent until proven guilty, not *Guilty until proven innocent.* Micromanagement of the industry hurts the ability of markets to innovate and compete. SEC should encourage innovation by approving most innovations immediately and use its broad power only if it later finds abuses. 5. The SEC should switch to a company-based enforcement model in which firms themselves decide which markets may trade their stock. The firms themselves have the proper incentives to monitor the trading in their stock and to decide where their stocks may trade. Thus, if a firm thought that a particular market mechanism was harmful to the overall market for its stock, it could withhold its approval. Comments of Professor James J. Angel Georgetown University on the Concept Release; Request for Comments File S7-16-97 I commend the Commission for opening a dialog on the important issues raised in the Concept Release. The Commission rightly recognizes that the changes in global equity markets are forcing a fundamental rethinking of regulation. The breadth of the proposed changes in the Release is so large that it makes sense to open a careful debate on what changes are needed and how the reform process should proceed. Rather than provide a tedious response to each of the 143 questions in the Concept Release, I would like to make a few major points: 1. Be careful of unintended consequences. We should be proud of the fact that the United States has financial markets that are the envy of the world. International comparisons of equity execution costs by Plexus and well as Birinyi Associates show that transaction costs for trading in the U.S. are among the lowest in the world. Our markets are also experiencing substantial growth in their efforts to promote international listings. I believe that one of the main reasons for the success and global competitiveness of the U.S. equity markets has been that the U.S. has fostered competition between markets and between market mechanisms for both listings and order flow. This success of the U.S. equity markets means that extreme caution should be used in deliberating changes of the magnitude that discussed in the Release. As the old adage goes, *If it ain*t broke, don*t fix it.* In particular, the U.S. has been successful in creating liquid primary and secondary markets not only for the largest firms, but also for smaller firms. The rest of the world has been particularly unsuccessful in creating liquid markets for smaller firms. Most of the second-tier markets that have been launched in Europe have been unsuccessful, as chronicled by Rasch (1994) and Bannock (1994). For this reason, the commission should be particularly careful in deliberating changes that affect Nasdaq. As a finance professor who has spent a decade studying the nuts and bolts details of market microstructure, I can attest that the financial markets are extremely complex. The basic functions of a market seem simple at first glance: a market matches buyers and sellers and discovers a price. However, buyers and sellers are acting on the information that they believe they possess, which makes trading an information game. The market mechanism not only matches buyers and sellers and produces price information about past trades, but it also produces information about the willingness of participants to trade again. Furthermore, in order for market prices to be worth anything, the securities industry has to produce sufficient fundamental information about the relative values of various investments. Not only does the market mechanism need to produce this information, it also needs to disseminate and market this information in order for it to do any good. The information that one is willing to trade is valuable price sensitive information that few investors wish to give away; they naturally seek to execute their trades in manners that reduce the market impact of their activities. The information flows that occur in our financial markets are quite complex as a result. Because markets are not as simple as they first appear, great caution should be taken with such major reforms as those contemplated in the Release. While entered into with the best of intentions, such major changes could easily have major unintended consequences which could seriously hurt our financial markets. 2. Reforms should move in the direction of deregulation, not regulation of new entrants. There have been three noticeable phases of thought about the proper role of the government in the equity market that have affected government policy. The first phase was laissez-faire: The primary role of the government was to enforce contracts and prosecute fraud. This thinking was behind the *hands off* policy followed by the federal government prior to 1933. The second phase was one of regulation. Following the stock market crash of 1929 and the ensuing financial convulsions, this second wave of thought was the intellectual force behind the pivotal Securities Act of 1933 and the Exchange Act of 1934: The equity market was a den of thieves that had to be watched carefully by the benevolent regulators. Furthermore, the market itself was a natural monopoly just like an electric utility, and it had to be watched closely by the regulators or it would abuse its position. The third and current phase is one of deregulation. This stage views equity markets as firms that compete with one another. The goal of the regulator is not to design the details of the market system, but to allow the forces of competition to do so. This deregulation phase in the intellectual force behind the National Securities Market Improvement Act of 1996 (NSMIA) which granted broad exemptive powers to the Commission. In order to fully comply with the letter and spirit of NSMIA, the Commission should be seeking ways of reducing the overall regulatory burden it places on the industry, not placing increased regulatory burdens on the dynamic innovators. 3. Turning Nasdaq into an auction market would be a mistake. One of the great advantages of the U.S. equity markets is that a company has many choices as to where its stock trades. Depending on whether it meets listing requirements, a stock could trade in the Pink Sheets, on the regional U.S. exchanges, on the Nasdaq Small-Cap Market, the AMEX, the Nasdaq National Market, or the NYSE. Approximately 900 firms that meet NYSE listing requirements have chosen to stay on Nasdaq rather than list on the NYSE, despite the well publicized investigations and numerous studies which find higher bid-ask spreads on Nasdaq. Why? Thousands more could list on the AMEX, which also has substantially lower bid-ask spreads than Nasdaq. Why? Even more small companies could list on the auction markets run by the regional U.S. exchanges, yet comparatively few companies do. These firms appear to be run by sophisticated CEOs who have access to the best advice that money can buy. The fact that Nasdaq is passing the market test by attracting thousands of firms that could easily list on auuction markets is evidence that it is providing something that the listing firms find valuable. Rule changes that would turn Nasdaq into another auction market would be a mistake. Firms that want auction markets with low bid-ask spreads can get them now. Forcing Nasdaq to become an auction market would deprive U.S. companies of a choice that they are freely choosing now. 4. The standard for new products, new markets, and new rules should be *Innocent Until Proven Guilty, not *Guilty Until Proven Innocent.* Practitioners privately relate to me many horror stories about the length of time needed to get approval for routine new products and rule changes. To extend this type of micromanagement to ECNs and newer trading systems would be a great step backward. I feel that the commission should concentrate on lowering the regulatory burden on existing exchanges rather than increasing it for new entrants. The Release speaks with pride about how the commission has reduced the average number of days needed to rule on an exchange rule filing from 349 days at the beginning of fiscal year 1994 to 74 days at the end of fiscal year 1996. However, this period is still far too long. Regulatory delays hurt the ability of innovators to provide new financial products, and delays hurt the ability of the heavily regulated exchanges to respond to competitive pressures. My recommendation: Go from a *Guilty Until Proven Innocent* to an *Innocent Until Proven Guilty* standard. Allow all proposed rule changes to go into effect immediately but retain the power to undo the new rules if it later seems necessary. This could probably be done within the framework of existing legislation by expanding the types of rules which can take immediate effect. 5. Let companies decide where their stock may be traded. The Commission is right to consider the impact of different market mechanisms, both existing and proposed, on the fairness and quality of markets. Yet the Commission has limited resources to figure out what type of market structure is best and to police existing markets. Many of the policy questions that are raised with respect to market transparency, market fragmentation, and so forth are subtle and complex issues on which reasonable people, including those without a direct economic interest, may disagree. There is a simple proposal eloquently espoused by Amihud and Mendelson, among others: Let the companies themselves decide where their stock may be traded. If a company feels that the practices of a given market mechanism are harming their shareholders, then they could prevent that particular market from trading their stock. For example, if a company thought that payment for order flow was wrong, then it could prevent its stock from trading in markets that pay for order flow. If a company thought that a new market mechanism would fragment and hurt the market for its equity, it could prevent its stock from trading there. The companies that issue securities have a vested interest in assuring a fair and orderly market for their stock. They have greater economic incentives than government employees to make sure that the trading in their stock is fair and orderly. The threat of loss of listings would be a great incentive to different markets to make sure that their markets are fair. By delegating decisions of market design to the markets and the listed companies, this proposal would allow the Commission to devote fewer of its scarce resources to the micromanaging of market mechanisms and to redeploy those resources in other, more productive areas.