Jeffry L. Davis

Senior Economist

Economists Incorporated

Suite 400

1200 New Hampshire Avenue, NW

Washington, D.C. 20036-6802


September 10 , 1998


Jonathan G. Katz


Securities and Exchange Commission

450 Fifth Street, N.W.

Washington, D.C. 20549


In regard to: File No. S7-12-98, "Regulation of Exchanges and Alternative Trading Systems"

Dear Mr. Katz:

The SEC’s massive release proposing solutions to the "problem" of alternative trading systems proves once more that regulation begets more regulation , or, stated more accurately, excessive regulation begets more excessive regulation.

The proposed extension of the SEC’s regulatory reach is rationalized as necessary to "update" the regulatory framework to deal with the changes wrought by technological developments. Things have changed, we are told, and the regulation must be changed to keep pace. The regulatory framework is old and must be modernized. Of course, the process of modernization never considers the option of chucking the old fixtures that were never needed and never worked properly.

In this case, the fixture that is causing most of the trouble is not even very old. It is the national market system. The SEC comes very close to admitting this in its release, stating:

"Because of the increasingly important role of alternative trading systems, these differences call into question not only the fairness of current regulatory requirements, but also the efficacy of the existing national market system (‘NMS’) structure." At p. 7.

Rather than concluding, however, that there may be something wrong with the NMS structure, the SEC sees the alternative trading systems as the problem. Given that the SEC created the NMS and is responsible for its development, it is not the least bit surprising that any challenge to its efficacy is viewed as a problem to be eradicated.

The problem with the alternative trading systems, as perceived by the SEC, is that they are not "fully integrated" into the national market system. This brings us to the root of the problem with alternative trading systems, from the SEC’s point of view. Put simply, the national market system has no place in it for any alternatives. In the grand vision of the national market system there is room for only one trading system. Any alternatives that develop must be "fully integrated," meaning their separate identities must be obliterated.

One of the sins of the alternative trading systems is that sometimes they produce prices that are better than the prices available through the "fully integrated national market system." Though some might view this as achieving the goal of competition, the SEC sees this as a failure of the national market system. The remedy, of course, is to force the alternative trading systems into the national market system. It does not matter if the better prices are no longer produced; the important thing is to make sure that there are none better outside the national market system. And, of course, if all alternatives are suppressed, the national market system can safely claim to offer the best prices.

I see little point in commenting on the specific proposals offered in the release, except to say that they are unnecessary, or would be unnecessary if the SEC would loosen its stranglehold. The release does its best to portray the SEC as fostering innovation in securities markets, patting the SEC on the back for making its regulation more flexible. But neither the release nor the SEC ever entertain the possibility that the nation might be better off with far less regulation of market structure. Neither the release nor the SEC seriously consider the possibility that the real problem is the pervasiveness of its regulation, not the inevitable gaps that arise. Alternatives to exchanges have popped up because the regulatory costs imposed on exchanges are excessive, and the SEC’s national market system policy is responsible.

The release provides some unintentional insight into these excessive costs. Explaining its proposal to ease the rule filing requirements for exchanges seeking to launch pilot trading systems, the release states that exchanges are at a disadvantage relative to alternative trading systems because only the exchanges are subject to the SEC’s rule filing requirements. These rule filing requirements were imposed by the Securities Acts Amendments of 1975, the same legislation that granted the SEC its authority to follow the yellow brick road to the national market system. Since 1975 the exchanges have been obliged to obtain the SEC’s prior approval for every sneeze or sniffle. Admittedly, the SEC has taken some steps to streamline the most routine rule filings, so that the exchanges are now allowed very small sneezes without prior approval. The fact remains, however, that the rule filing requirements and the SEC’s clout to back them up are severely stifling. In the case of the pilot trading sysstems proposal, the SEC has recognized that there is a problem, but it took the emergence of alternative trading systems to bring it to their attention. True, the SEC is offering some relief to the exchanges, but, at the same time, it is proposing to rein in the alternative trading systems to prevent any further spotlighting of such deficiencies in its regulation.

Easing the filing requirements for pilot trading systems is a good idea, but it is not enough, and it is a bad idea if the cost of doing so is to drag the alternative trading systems into the national market system quagmire. The filing requirements for pilot trading systems should be eased, if not eliminated, as part of a massive reduction in SEC regulation.





Jeffry L. Davis

Direct dial: (202) 833-5228