October 3, 1997
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Concept Release, Regulation of Exchanges, File No. S7-16-97
Dear Mr. Katz:
Charles Schwab & Co., Inc. ("Schwab") submits this comment letter in response to the Commissions Concept Release on Regulation of Exchanges and Other Markets. Schwab is the fourth-largest broker-dealer in the United States in terms of customer assets, and is the largest in some important market segments, for example (as most relevant to this release) electronic brokerage. An affiliate of Schwab, Mayer & Schweitzer, Inc. is a major market-maker in the Nasdaq market. Schwab also has several international affiliates, including Sharelink, the largest discount broker in the United Kingdom.
Schwab commends the Commission for its willingness to re-examine the fundamental regulatory constructs addressed in the release. As a technologically innovative company, Schwab believes it is very important that the Commission continue to explore proactively the regulatory implications of the electronic and communications revolutions that are transforming the worlds securities markets. We strongly endorse the Commissions insight that "regulation should not be static." As the Commission has recognized, continuing an existing regulatory scheme in a new technological and business environment sometimes may be just as inappropriate as imposing a poorly chosen new regulatory scheme. We believe the Commission should continue to focus on whether developments in the securities industry are making portions of the existing regulatory scheme unnecessary, burdensome or even contrary to the needs of investors. Schwab urges the Commission to consider even more broadly than does the Concept Release whether any current market regulation rules impede the introduction and use of new technologies. Such a review should include the rules of the SROs as well as the Commissions own rules.
Electronic Links to Foreign Markets.
We will address first the foreign markets portion of the Concept Release, which we believe is particularly important and may not receive adequate attention from other commentators. Schwab and its affiliates handle some orders from US customers for securities traded in overseas markets, and we anticipate this will be a growing business. We currently have a larger business routing orders from foreign customers (some from customers of Schwab, and some from customers of our foreign affiliates) to US markets. Although the Concept Release does not directly address the routing of orders from overseas customers to US markets, the Commission should consider the likely effect of its proposal on this business. Foreign securities regulators are likely to view the Commissions work in this area as a model. We believe foreign regulators are likely to impose restrictions on the routing of orders to the US equal to or greater than the restrictions the Commission places on orders routed to their countries. This issue of reciprocity should be of significant concern to the Commission. In framing any regulations on "outbound" US customer orders routed to foreign markets, the Commission should consider the impact of similar regulation that would likely be imposed on "inbound" orders from foreign investors routed to US markets.
It may be useful to set out some general principles first. In Schwabs view, the electronic and communications revolutions offer tremendous benefits and opportunities for investors. In particular, electronic order routing is a great advance for investors, who are using new technologies to execute orders more quickly, less expensively and at better prices than was ever before possible. Electronic order routing is also a great advance for capital formation, because it enables issuers access to broader sources of capital at lower cost and allows markets to provide greater liquidity and depth to participants. Electronic order-routing should be considered in the context of the rapidly expanding ability to obtain information electronically, which is giving ordinary investors access to data (about domestic and foreign markets, securities and other developments) that previously was available only to sophisticated market professionals.
It is for exactly these reasons that Section 11A of the Exchange Act directs the Commission to facilitate "new data processing and communications techniques." In our view, these benefits are equally present for cross-border electronic orders as for those within the United States. The capability to route orders internationally benefits US investors by allowing them to diversify their portfolios efficiently, and it benefits US issuers and markets by giving them more ready access to additional sources of capital. Portions of the Concept Release might be read to suggest that cross-border electronic trading poses greater dangers and requires greater regulation than other types of trading. 1 Not only would such a view be lacking in empirical support and wrong, in our view it would be inconsistent with the Exchange Act. We urge the Commission to focus on the benefits that technology is bringing investors, not solely on the problems technology may sometimes cause.
International electronic investing is already becoming a reality, and in Schwabs view the Commission should continue to facilitate this process. If the Commission were to create obstacles that impede US registered entities from participating in this market, then their places would be taken by foreign entities that are beyond the Commissions effective jurisdiction. The challenge that the Internet presents the Commission is that it is impossible to surveil communications and transactions between US investors and offshore businesses which are not registered with the Commission. It is in the national interest that US entities be allowed to compete for the international order-routing business.
The Concept Release suggests that the Commission is concerned that US investors may place orders in foreign markets without understanding the risks involved or the fact that the rules of foreign markets may be different from those in US markets. Apparently as a result of this concern, the Concept Release requests comment on whether cross-border electronic trading should be limited to sophisticated or institutional investors. Schwab believes the Commissions goal should be to make cross-border investing available to any investor who is adequately informed of the risks and is willing to accept those risks. We do not question the premise that international investing has different and usually greater risks than domestic investing. (Similarly, domestic equities have different and usually greater risks than domestic money market funds but this does not mean that investing in equities should be limited to sophisticated institutional investors.) However, we do not agree with the premise that significant numbers of US investors are likely to invest in foreign markets without an understanding of the attendant risks. Nor do we believe the benefit of protecting a small number of uninformed individuals from themselves outweighs the cost of preventing knowledgeable individual investors from pursuing their own investment strategies.
In our experience, most investors are well aware that foreign investments involve risks not present for US securities. Foreign securities carry US and foreign tax law complications that will continue to deter many US investors from investing directly in those securities. Relatively risk-averse US investors who wish to diversify by investing in foreign markets are able to do so through mutual funds, and most of these investors are not likely to switch to direct investments in foreign securities. We believe that the segment of US investors who would be interested in investing directly in foreign securities is of limited size, and for the most part these investors are relatively sophisticated and knowledgeable. The small number of unsophisticated investors who wish to access foreign markets can be educated through disclosure requirements (much like the disclosures the Commission has routinely reviewed for US mutual funds that invest in foreign securities). Indeed, the Commission itself can use its Internet Website, town meetings, and other means of communication to educate investors about the risks of investing in foreign markets.
Moreover, a bright-line test of who is sufficiently sophisticated to invest in foreign markets necessarily would be very inexact. As the Orange County bankruptcy demonstrated, some extremely wealthy institutional investors in fact are very unsophisticated in their investment decisions. By contrast, some middle class investors (e.g., academics or recent emigrants) may be highly knowledgeable about a particular foreign country and its securities markets. Schwab believes the Commission should strive to make investment opportunities available to all investors, rather than facilitating the creation of a two-tiered market in which some investors have a superior ability to diversify their portfolios and others, no matter how knowledgeable, are restricted to a smaller class of government-approved investment opportunities.
The Concept Release also suggests that the Commission is considering whether to limit cross-border electronic investing to foreign securities which have been registered in the United States. In Schwabs opinion, this restriction would completely defeat the purpose of cross-border securities trading. Securities that are registered in the US are almost always already traded on a US market; except for a few arbitrageurs, investors do not need access to international markets to be able to invest in these securities. As noted above, US investors have been able to invest in unregistered foreign securities for decades by traditional means such as telephone orders. We are not aware of any statutory authority that could be invoked to limit investors access to unregistered foreign securities, nor are we aware of any justification that could be advanced for treating electronic orders differently from traditional orders. The release reflects a legitimate desire to protect US registration and listing standards. However, foreign issuers will continue to have substantial incentives to meet these requirements so as to gain access to the many US investors who will continue to be unwilling to invest directly in a foreign market. In our view, it would be a terrible mistake for the Commission to attempt to limit cross-border trading to US registered securities.
The Concept Release suggests three possible paradigms for the regulation of international electronic orders. Schwab urges the Commission to give serious consideration to mutual recognition of home country regulation. We support broad extraterritorial jurisdiction for the Commission to combat cross-border fraud, and we support Commission jurisdiction over fraudulent sales practices directed at persuading US residents to invest in overseas markets. However, on purely regulatory issues, we believe it is appropriate to defer for the most part to home country regulation. 2 We urge the Commission to seek reciprocity so that foreign countries in turn would defer to US regulation of US markets. The Concept Release suggests several possible concerns about a mutual regulation approach. Certain foreign markets may provide so little protection to investors (in terms of the substantive content of their rules, the adequate surveillance and enforcement of their rules, or their rights of action for investors) that the Commission should deem them not comparable to US markets and should not recognize home country regulation. Also, the Commission could condition mutual recognition on execution of a Memorandum of Understanding which provides the Commission satisfactory ability to obtain information from a foreign securities market. Finally, as noted above, although foreign market rules differ from US market rules, we believe the Commission can deal with this fact in part through disclosure. The Commission could condition foreign market access to US investors on disclosure about the rules of that foreign market. We believe the concerns about the fairness of foreign markets are no different under a mutual recognition approach than under the foreign market SIP approach: if anything, the Commission (by declaring some markets to be comparable to US markets) may have more leverage to improve the fairness of foreign markets under the mutual recognition approach.
The Concept Release primarily discusses regulation of foreign markets rather than that of foreign broker-dealers. Schwab urges the Commission to consider both issues together, because in our view they present problems that can be most effectively solved at the same time. 3 For foreign broker-dealers as for foreign markets, we believe the Commission should consider recognizing home country regulation, at least in countries in which the regulatory scheme is adequate. Home country recognition is of course the European Economic Areas solution for cross-border trade in securities and other financial services. As is true in the European Economic Area, home country recognition should be reciprocal: while Schwab is willing and able to compete with foreign broker-dealers, such a competition should take place on a level playing-field. Primary reliance on home country regulation could of course be coupled with a limited notice filing with the Commission, as well as disclosure of the differences between a foreign broker-dealers home country regulation and SEC regulation. Certain other U.S. regulatory requirements may be appropriate even in a scheme relying primarily on home country recognition of broker-dealers, such as consent to service of process, disqualification of individuals suspended or barred in another jurisdiction, or loss of mutual recognition if specified disciplinary events occur. We note that the CFTC, in its Part 30 rules, has already adopted a procedure for granting exemption from registration for foreign entities in countries with adequate home country regulation.
The current pattern of international regulation requires a broker-dealer either to register in different foreign jurisdictions, to establish separate affiliates to register in those jurisdictions, or to rely on exemptions from registration that vary significantly from jurisdiction to jurisdiction. These regulatory barriers to entry are expensive and time-consuming to overcome and often serve more to protect inefficient local competitors and markets than to protect investors. In Schwabs view, the Commission should strive for a regulatory regime in which a broker-dealer or securities market located in one adequately regulated country can accept customers from other adequately regulated countries, without having to go through a costly and lengthy process of registering and conforming with local requirements in each separate jurisdiction. We believe that if the United States does not support such a regulatory scheme, the result will be that US broker-dealers and markets which make a serious attempt to comply with all applicable laws will be placed at a competitive disadvantage with less scrupulous foreign competitors. A mutual recognition regulatory scheme might result in some short-term loss of control for the Commission. However, we believe in the long run this approach is almost inevitable because of advances in technology, and will benefit investors through enhanced competition and expanded access to products and services.
Regulation of Alternative Trading Systems
Schwab concurs with what we believe to be the Commissions central insight in the domestic portion of the Concept Release: that the distinction is elusive at best between some electronic markets now regulated as exchanges (for example the Cincinnati Stock Exchange) and some electronic markets now regulated as broker-dealers. After the adoption of the Order Handling Rules, which Schwab supported, there is little practical distinction between the orders placed in an Electronic Communications Network (ECN) and the quotes published by a specialist or market maker. Schwab also shares the Commissions primary concern about these trends: some electronic markets now regulated as broker-dealers may become (and indeed may already be) so important as trading venues that some aspects of exchange regulation over those markets would be justified. From our perspective, the critical issues involve line-drawing. What alternative trading systems should be considered exchanges, and what components of exchange regulation should apply to them?
Once again, a brief discussion of regulatory philosophy might be useful. Schwab believes the Commission has a critically important role to play not only in detecting and prosecuting fraud, but also in ensuring that market structure rules are transparent, non-discriminatory and pro-competitive and that that these rules are applied consistently and fairly. For these reasons, Schwab supported the Order Handling Rules, and supports decimalization and OATS (on reasonable time-tables), even though each of these initiatives impose short-term costs on Schwab. At the same time, Schwab believes that the revolutions in electronic and communications technologies are fundamentally changing the nature of the financial services industries. These technologies offer tremendous opportunities to empower investors, and we believe the Commission should continue to facilitate their introduction and use. We believe the Commission should focus on disclosure-based solutions that allow fully informed investors to make their own decisions, rather than substantive regulations that dictate peoples choices. We also urge the Commission to focus on goal-oriented regulation, rather than attempting to prescribe specific standards that may become obsolete as technology continues to evolve. Finally, as discussed above, we believe the Commission should strive to make investment opportunities available to everyone, and should resist the temptation to create two-tiered structures in which a few institutions (defined by wealth rather than actual sophistication) have access to opportunities that are denied to everyone else.
Because Schwab strongly supports innovative new technologies, we hesitate to endorse new regulation of electronic trading systems beyond those areas in which new regulation is most necessary. Schwab and its affiliates sometimes use alternative trading systems to trade for our customers, and for some types of orders these systems generally provide our customers better-priced and quicker executions than could be obtained by simply telephoning different markets. To adopt regulation that hamstrings such trading systems, or deters the development of innovative new systems, would do a serious disservice to investors. We see no compelling need to increase or change the regulation of passively-priced trading systems, of low volume trading systems, or of systems that merely deliver orders to another market for execution. However, we agree with the Commission that systems that provide active price discovery and execute a very substantial percentage of the volume for a particular class of securities ought to be regulated as markets rather than merely as brokers. 4
Schwab believes the Exchange Act sets forth the proper goals for regulation of securities markets, including large, actively-priced trading systems. Markets should grant or deny access fairly, adopt and enforce rules that are transparent, non-discriminatory and pro-competitive, surveil for fraud or manipulation, coordinate with other markets for the same securities, and operate in a way that does not create unnecessary systemic risks to the markets as a whole. As a result, enhanced broker-dealer regulation, which would not provide the Commission with any authority to review denials of access or system rules, is not a complete substitute for exchange regulation. We agree that certain other aspects of exchange regulation do not represent "core" values of the Exchange Act and are appropriate candidates for the Commissions NSMIA exemptive authority. For example, the Commission should allow for-profit enterprises to own, manage and control the corporate governance of even the largest trading systems, and should allow all types of investors (not just broker-dealers) access to these systems. We believe the Commission should allow trading systems, even those regulated as exchanges, maximum design flexibility: for example, we agree with the Commissions recent decision to approve the PCXs Optimark system even though orders within the system are not fully transparent to other participants. Also, for the reasons discussed above concerning international order-routing, we believe alternative trading systems should continue to be able to trade foreign and other unregistered securities even if those systems are designated as exchanges.
With these goals in mind, we believe the Commission does not need to adopt the extremely broad definition of "exchange" discussed in the Concept Release, with the corresponding need to exempt out the large majority of systems that meet this definition. We believe the Commission could achieve most of its substantive goals for the systems about which it is most concerned with its present definition of "exchange," or a minor modification thereof. Such a course of action would avoid the legal authority and factual justification questions that a broader definition would present.
Although Schwab and its affiliates do not currently operate any trading systems that would fall into the broad definition of "exchange" discussed in the Concept Release (as we understand it), in the future we might develop systems that could fall within that definition. Schwab believes it is properly regulated as a broker-dealer, and having to operate one or more systems under a different regulatory scheme (such as the "exempt exchange" idea) would be difficult and undesirable. This is true even if the second regulatory scheme, viewed in isolation, seems reasonable. We believe the distinction between exchanges and broker-dealers should continue to be an either/or distinction, and the test for what is an exchange should be sufficiently high that it does not capture systems at firms such as Schwab that earn the large majority of their revenue from traditional broker-dealer activity.
We urge the Commission to consider carefully the systems burdens associated with a major reclassification of trading systems. Requiring a large number of trading systems to establish direct links with ITS, CQS, CTA and other inter-market systems, rather than linking through Nasdaq or other SROs, would be a major undertaking for inter-market systems that already face significant limits on their capacity. It would be complex for a firm such as Schwab to have some computer systems which continued to link through the SROs, and others which linked directly to the inter-market systems. As we have told the Commission before, the Year 2000 project, OATS, decimalization, and the Order Handling Rules all require (in varying degrees) important internal systems modifications as well as significant amounts of testing with the rest of the industry. While systems issues should not deter the Commission from making necessary regulatory changes, the Commission should choose the regulatory option that accomplishes those changes with the least possible systems burden and cost, and the Commission should adopt time-tables that allow the industry to complete and test the major systems changes that are already scheduled or in progress.
Regulation of Existing SROs
The Concept Release requests comments on the regulation of existing SROs, and asks whether existing SROs ought to have some rule proposals concerning new products or services become effective on filing. As a general proposition, Schwab is skeptical of this suggestion. In our recent experience, while the Commission usually considers the costs and burdens of new rules and regulations carefully, some of the SROs have not always been as thoughtful. As the Commissions recent enforcement cases have demonstrated, SROs sometimes may become dominated by certain groups of members who use them to create competitive disadvantages for other market participants, or to benefit members at the expense of investors. There is also a risk that SROs may adopt rules that harm competing markets rather than truly assisting investors.
For these reasons, we believe the Commission should take very seriously its Exchange Act mandate to ensure that SRO rule proposals do not have an anti-competitive effect. We believe it is far preferable for the Commission to make this evaluation rather than the Antitrust Division of the Department of Justice. Because of the natural tendency for trading to gravitate to markets where there already is volume, the concerns about SRO rules are particularly acute for SROs which are the primary markets for the securities they trade. An SRO dominant in a particular market segment may have incentives to tie access to its market to the use of products or services market participants otherwise would not desire. Equity products and services on the regional exchanges (for example the PCXs recent Optimark filing) are significantly less likely to be subject to abuse. If there were an area in which the Commission should examine SRO deregulation, it would be for products and services offered by secondary markets.
The Exchange Act grants governmental powers and immunities to the SROs and compels broker-dealers to become SRO members. For this reason, Schwab believes SRO rules as a general matter should be subject to the same process of justification and scrutiny as are Commission rules. We believe this was the intent that Congress expressed in the National Securities Markets Improvement Act when it amended Section 3(f) of the Exchange Act to require the Commission to make findings about efficiency, competition and capital formation when reviewing SRO rules.
Indeed, Schwab suggests a more comprehensive approach: the Commission should require the SROs periodically to review, justify and submit for public comment and SEC approval their existing rules. 5 Many SRO rules were adopted before the 1975 Act Amendments, and therefore have never been subject to Commission scrutiny or public comment. Others may have been justified at the time they were adopted but are no longer appropriate given the evolution of technology, business practices and market structures. For example, the NASDs recent overhaul of the rules in its Code of Procedure has resulted in what we believe will be substantial improvements in its disciplinary and enforcement process. The NASD might not have undertaken these improvements without the Commissions encouragement. We believe the SROs, the industry and the investing public would benefit from a more systematic process of comment on and review of the SROs existing regulatory structure.
In summary, we commend the Commission for its willingness to reexamine long-settled regulatory issues in light of recent technological and business developments. We urge the Commission to continue to engage in this type of beneficial self-examination. On the issue of international order-routing, the Commissions goal should be to give all investors access to as many foreign securities as possible. We suggest the Commission consider mutual recognition of adequate home country regulation of broker-dealers and markets. As for domestic alternative trading systems, we believe the Commission should focus only on those systems that have the greatest effect on third parties and the markets as a whole. These high-volume, actively-priced systems should be regulated as exchanges rather than broker-dealers, although they should be exempted from exchange requirements that would endanger their success. For SROs, we urge the Commission to take a leadership role in requiring the SROs to review their existing rules, and (except possibly for some low-volume regional exchanges) not to grant blank-check pre-approval for SRO rule filings. We would be glad to discuss these important and timely issues with you in greater depth, and we urge you to contact us if we can be of further assistance.
David S. Pottruck
-- Investors have long been able to place orders with US broker-dealers by telephone or other non-electronic means for securities traded in foreign markets. So long as the security is not currently (and has not recently) been in distribution, such transactions are exempt from registration under Sections 4(1), 4(3) and/or 4(4) of the Securities Act, even if the issuer has never filed registration statements or periodic reports in the United States.
-- This distinction between extraterritorial jurisdiction over fraud and territorial jurisdiction over regulatory and filing issues is a familiar one in the relevant cases. Compare Consolidated Gold Fields PLC v. Minorco, S.A., 871 F.2d 252 (2d Cir. 1989), as amended, 890 F.2d 569 (2d Cir. 1989) with Plessey Co. PLC v. General Elec. Co. PLC, 628 F. Supp. 477 (D. Del. 1986). Even in cases involving fraud, courts have increasingly held that where US investors purposefully avail themselves of a foreign market, it is appropriate for the laws of the foreign country, rather than US law, to apply to the transactions. See, e.g., MCG, Inc. v. Great Western Energy Corp. , 896 F.2d 170 (5 th Cir. 1990); cf. Butte Mining PLC v. Smith , 76 F.3d 287 (9 th Cir. 1996). The Supreme Court also recently has expressed a strong presumption against extraterritorial application of US law. This argues against attempting to expand the Commission’s extraterritorial jurisdiction beyond the core area of fraud. EEOC v. Arabian American Oil Co. , 499 U.S. 244 (1991).
-- In other words, Schwab urges the Commission to revisit Rule 15a-6, which currently regulates the activities in which foreign broker-dealers can engage in the United States. Although this regulation was a step forward when first adopted, we believe it needs to be rethought today. Schwab’s foreign affiliates are subject to this rule, and have found it burdensome in ways that do not promote investor protection. On Aug. 13, 1997, the PSA and SIA sent the Commission staff a letter proposing major revisions to Rule 15a-6, and urging the Commission to rely to a substantial extent on home country regulation. Without endorsing every particular of the PSA/SIA letter, we believe it provides a useful basis for discussing amendment of the rule. Indeed, we would go further than the PSA and SIA in that we would not limit the use of foreign broker-dealers to sophisticated customers.
-- The precise volume cutoff for what should constitute an exchange is a fair subject for debate: certainly systems that have a plurality of the volume for a class of securities should be included, as long as the system has at least 20% of that volume. Probably systems should also be included that have a quarter to a third of the volume for a class of securities, even if one or even two other venues have a greater market share for those securities. As the Concept Release points out, some trading systems already approach these volumes. We would view issuer bulletin boards with "chat" features as not providing price discovery analogous to that in alternative trading systems.
-- We believe the Commission’s existing statutory authority would allow such a requirement. If the Commission believes this proposal is inconsistent with Section 19c of the Exchange Act, then it should request Congress to provide the necessary authority.