December 8, 2004
Jonathan G. Katz, Secretary
Securities Exchange Commission
450 Fifth Street
Washington, DC 20549-0609
Re: File # S7-10-04
Dear Mr. Katz,
This comment letter reflects the views of three undergraduate students currently studying the structure and function of equity markets. We met as part of a class project to study the proposed Regulation NMS and to understand the implications it would have on markets and market participants. As very interested students approaching the end of our undergraduate experience and getting ready for careers in the financial world, we feel that our letter will be productive for both us and for the Commission.
We argue against the adoption of Regulation NMS in its current form because of the negative implications it would have for the equity markets in the United States. We argue against the current proposition for two main reasons, both related to the trade-through prohibitions. First, we believe that the prohibition of trading through is problematic and restrictive, especially for experienced and institutional investors, and, thus, an opt-out provision is essential for these investors. Second, we believe that the high costs of implementation and the problems associated with enforcement of prohibition of trade-throughs outweigh potential benefits.
It is our argument that trade-through prohibitions are problematic because of their restrictiveness for investors seeking other attributes aside from best-price. Certain experienced and institutional investors seeking to execute trades might not be concerned with getting the best possible price in the market at the time, but instead might be looking to meet other trading objectives, such as moving large size or getting more certain execution from a preferred broker or venue. Essentially, we feel that the electronic linkages of markets as a result of best-price would create markets where the vast majority of floor brokers, important liaisons for helping investors get desired or optimal execution, would cease to exist. Because of the nature of equity markets, immediate execution at the best price might not always be the best execution possible. Brokers who work trades for investors might be able to provide them better execution by working their orders in a more shrewd fashion.
In order protect certain investors while allowing others to trade at the prices they want, we feel that Regulation NMS should allow an opt-out provision. This provision would allow experienced and institutional investors to specify that they would like to pursue certain other trading objectives and forgo the best-price priority that might restrict their objectives. We argue for this for two reasons. First, as mentioned earlier, we believe that traders may value different product attributes besides price to reflect the nature of the trade that they are trying to execute. Second, we feel that forcing participants to trade at certain prices is inconsistent with the objectives of free markets and, in a broader sense, our economic system. If two willing participants mutually agree to a given set of terms, their exchange should take place at the agreed-upon price.
Even if Regulation NMS is accepted with an opt-out provision in place, we still feel that the costs of the proposition relative to its benefits are too high for market participants. In order to create the linkages between markets that would be necessary to enforce prohibition of trade-throughs, firms that engage in trading securities would have to spend vast funds to create a network and update technology to make it possible. Spending such funds to justify protection of investors is an economic anomaly although the best price regulation would ensure better execution of certain orders, it is difficult to imagine that the benefits that individual investors would gain in aggregate somehow outweigh the potential losses of investors in equity markets and shareholders of financial companies, as the Commission and these firms could certainly put their capital to better use.
Although we realize that Regulation NMS proposes to provide individual investors protection and inspire confidence in markets, we are unconvinced that the current regulation adequately addresses the problems with trade-through prohibition and the potential costs of its enforcement. Although investors are gaining from improved execution in certain instances, it seems that a greater universe of people lose from the time, labor, and financial cost necessary to implement the necessary framework. Until the SEC clarifies its plans for the proposition in more detail, we will remain opposed to the adoption of Regulation NMS.
Students, University of Notre Dame