27 April 2000
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
RE: Notice of Proposed Rule Change to Rescind Exchange Rule 390; Commission Request for Comment on Issues Relation to Market Fragmentation (File No. SR-NYSE-99-48)
The Advocacy Advisory Committee (AAC) of the Association for Investment Management and Research (AIMR)1 is pleased to comment on the proposed rule change to rescind Exchange Rule 390 and issues related to market fragmentation. The AAC is a standing committee of AIMR charged with reviewing and responding to major new regulatory, legislative, and other developments that may affect AIMR's global membership and the efficiency and integrity of financial markets.
Proposal to Rescind Exchange Rule 390
The ACC supports the Commission's proposal to rescind Exchange Rule 390, the "Market Responsibility Rule." Although originally helpful, we believe this rule now (1) limits competition between markets and (2) creates market inefficiencies. Competition is hindered because securities listed on the New York Stock Exchange (NYSE) are prohibited from trading off the exchange. We believe that this prohibition introduces inefficiencies by potentially subjecting NYSE-listed securities to greater transaction costs and trade prices.
In supporting this proposal, however, we believe that the Commission is right to address the issue of market fragmentation. We remainder to our comments address those issues.
The AAC agrees with the concerns expressed by the Commission in its request for comment. We believe the issue of market fragmentation is a important one and further study is warranted before any of the proposed regulatory options should be endorsed. We, therefore, strongly recommend that the Commission empanel a Task Force on Market Fragmentation (Task Force) to (1) adequately study the current market structure, (2) understand and incorporate the interests of all market participants in the decision making process, (3) determine an ideal market structure and the methodology of achieving such structure considering likely future market changes, and (4) draft appropriate recommendations that will comprehensively support and enhance market effectiveness and deter market fragmentation. We recommend that the Task Force be comprised of representatives from all areas of the market. Broad representation will ensure a "wide scope" approach to the task force's review of the current structure, promote a diversity of opinions, and facilitate compromise among participants necessary for completing the task force's mandate.
Understanding the current market structure is an important and complex first step in evaluating any existing market fragmentation and understanding the effects of changes to that structure. Advances in technology (evidenced by the proliferation of electronic trading networks or ECNs) and recent regulatory changes (for example, the up-tick rule and decimalization) have had, or will have, a significant impact on both the trading process and on the role different market participants play in that process. Given the actual and potential effects of any change to the market structure, it is essential that the Task Force consider the views and interests of all market stakeholders.
As an extension to developing the AIMR Soft Dollar Standards, AIMR has already convened its own task force charged with clarifying the concept of best execution, to develop best execution practices, and to create benchmarks for best execution. Comprised of practitioners from all parts of the markets, including representatives of investment advisors, equity traders, institutional brokers, mutual fund managers, analysts, and academics, the AIMR Task Force on Best Execution would welcome the opportunity to serve on or support the work of a Commission task force on market fragmentation.
Internalization of Orders and Payment for Order Flow
The ACC agrees with the Commission's concern that internalizing orders and paying for order flow increases market fragmentation. To offset the effects of fragmentation, we support the proposal to subject limit orders that trade off the exchange to strict price and time trading priority. Those limit orders that improve a security's national best bid or offer (NBBO) price should trade first.
Traders who post limit orders add value to the market and, hence, to market participants. We believe they should be compensated for this added value. Limit orders increase market liquidity, provide information regarding the security to be traded, and offer a free put or call option to market participants. Giving limit orders trading priority with respect to both price and time rewards traders for posting them and, thus, encourages traders to post a greater percentage of their order book as limit orders. Increasing the number of known possible trades and offering the dealer market a base price on transactions improves market liquidity. Posting these orders also provides information about market depth and the reliability of the displayed prices.
Internalization and payment for order flow are both order-matching operations that decrease market liquidity because trades are executed off the exchanges. Though conceptually similar, internalization differs from payment for order flow in that internalized orders are never exposed to market competition. Broker/dealers bid against each order to purchase orders from a third party. When internalizing orders, the broker/dealer capitalizes on the integration of its own operations by routing orders to its internal trading desk. Payment for order flow involves selling order flow to a third-party trader and investor benefits result (1) elimination of clearing fees and (2) reduction of long-term overall trading costs. This practice created and sustains the discount brokerage industry today. These brokers are highly competitive and, to get or retain market share, they bid prices (or, in the case under discussion, transaction costs) lower.
It is currently permissible for broker/dealers to purchase order flow and trade as principals against these orders. Because we believe these practices benefit investors, we do not believe that any change should be made to this practice until the Task Force completes its review and recommendations. As long as broker/dealers are required to (1) disclose any order flow arrangements to investors and (2) improve the NBBO price. We believe that "sunlight" on the arrangements will be the best deterrent against broker/dealer abuses. Full disclosure protects investors and allows them to redirect their orders to the dealer offering the best terms and service. We believe that eliminating at this time the practice of paying for order flow would endanger the livelihood of discount brokers.
The AAC does not support allowing broker/dealers to internalize orders. We believe that internalization is different from payment from order flow and may "siphon" too much liquidity from the market and would jeopardize the efficiency of the primary market. Given the size of many broker/dealers, the number of orders that could potentially bypass the primary market would be significant. In addition, we do not support allowing broker/dealers to trade ahead of previously displayed limit orders. Such practice allows broker/dealers to engage in risk-free arbitrage by "gaming" the limit order price to their advantage. To eliminate such arbitrage opportunities, we recommend that the Manning Rules be applicable throughout the entire day and not solely when the market is open for business.
Recommendation for Task Force on Market Fragmentation
The following comments elaborate on our proposal to empanel a task force to study further our current market structure and to make appropriate recommendations to minimize or eliminate market fragmentation. Specifically, if the Commission elects to form such a task force, we suggest that it have the following purpose and address the following issues.
We suggest that the MFTF have the following three goals:
(1)Study and quantify the impact of technological advances as well as recent regulatory changes on the current market structure. This study should specifically consider the impact of the following:
(2) Determine an ideal market structure and the methodology of achieving such structure, fairly and effectively balancing the benefits of market competition against liquidity concerns. The Task Force should delineate the steps necessary to achieve this structure and discuss the consideration it has given to externalities.
(3) Draft appropriate recommendations that comprehensively support and enhance market effectiveness and deter market fragmentation.
Issues for Task Force Consideration
The Task Force should clearly establish the breadth of the market it will evaluate. The current request for comment only addresses the equity market. We believe the task force's review should encompass all financial markets: the fixed income, the futures/forwards, the options, and the equity markets. To promote an "level playing field," all financial markets should be subject to the same rules whenever possible. We believe there is significant convergence and interaction among these markets that support having similar regulatory requirements for all of them. Options, for instance, may be traded on both the Chicago Board Options Exchange and the NYSE.
The proposals contained in the request for comment, if implemented, have the potential to drastically change the roles and economic incentives of the various market agents. Changes in technology and regulatory requirements affect each market participant differently. For example, prohibiting payment for order flow would adversely impact discount brokers, requiring a central limit order book would eliminate the need for exchange specialists, and barring the internalization of orders would disadvantage large brokerage firms. Therefore, we believe that it is critical to identify and evaluate the roles, embedded interests, and incentives of all major market stakeholders before making changes to the market structure. At a minimum, we consider the following participants to be significant market stakeholders who must be considered:
Interaction among market participants has changed dramatically in the past three decades driven primarily by technology and the market globalization. In the mid-1970s, the NYSE was, for all intents and purposes, the only exchange. It had almost 90% of the volume of shares traded in the U.S. and broker/dealers competed with one another for order flow coming from the NYSE.
Current markets are vastly different. Though still the primary exchange, the NYSE no longer enjoys its prior control of share volume. NASDAQ and other local exchanges have seen trading volume increase significantly. Electronic trading venues have proliferated. Some of these new venues allow investors to match trades directly bypassing the services of specialists or market markers. Most important to the issue of market fragmentation, broker/dealers and market centers now compete for customer order flow. When market centers compete for order flow, liquidity at each market is reduced. This situation complicates the regulatory process because the exchanges increasingly behave more like competitive profit centers. Some (NYSE, NASDAQ, and AMEX) have become private organizations creating conflicts with their public function.
Therefore, it is important that the Task Force should balance the benefits of competition against externalities - namely, market fragmentation. Competition spurs innovation, which leads to new trading venues offering investors more order placement and trading alternatives. These alternative venues are better, faster, cheaper, and more accurate than those available in the past. In addition, they offer anonymity, an important benefit to many institutional investors or others who are perceived to trade on better knowledge.
The Task Force should closely review the flowing consequences of market fragmentation.
Displayed prices may not be indicative of true market supply and demand for a security. Orders that are internalized or purchased are not reflected in the market-driven price discovery process. Consequently, orders remaining in the market are subjected to an incomplete price discovery process as it excludes information on trades done off the exchange.
Unreliable market prices introduce market inefficiencies and impair transparency by creating greater price uncertainty. Investors, especially retail investors, generally rely on displayed prices in making investment decisions. They consider displayed prices to be the actual price for a security or the best available proxy. We believe that displayed prices should represent the entire market's supply and demand for individual securities at any given time but, because orders can be internalized or purchased, this is not always the case.
Internalization and payment for order flow decreases aggregate market liquidity. We are concerned that available liquidity may disappear when it is most needed, such as during periods of financial stress or a market downturn. When markets are fragmented, individual market centers offer less liquidity and, in the aggregate, there is less total liquidity than would be available by a more "fluid" and united market.
Market fragmentation adversely affects the best execution of trades. Thinner markets offer fewer counterparties. Consequently, it is more difficult for buy orders to find sell orders. Thus, transactions take longer to complete, particularly for limit orders.
Though its benefits are numerous, there is little doubt that technology has increased the market fragmentation. On the one hand, technology affords the investors better, and more timely, information. On the other, it provides investors more options as to where and how to execute a trade. This added flexibility creates and exacerbates market fragmentation.
The future technological advances and how they will affect markets is extremely important issue. The Task Force should consider the impact of likely technological changes on any proposed structure. Such changes could include (1) markets open 24 hours a day and seven days a week or (2) global exchanges that are increasingly more automated and interlinked.
Technological change and current regulatory actions affecting today's markets demand a comprehensive reassessment of the overall regulatory process. The Commission currently relies on Self-Regulatory Organizations (SROs), such as the NYSE and the NASD, to regulate their respective members. This regulatory process has lost some of its effectiveness, however, because these organizations are behaving more like profit centers (by competing for order flow) and as they privatize. In addition, although the SROs have a better understanding of their respective members, their oversight responsibilities creates regulatory and enforcement discrepancies that yield inconsistent regulatory costs to participants.
The current need for regulatory restructuring offers the Commission a unique opportunity to develop and implement an effective and consistent regulatory framework for all markets and applicable to all market participants. We believe that the Commission should seek an optimal framework that would promote the benefits of competition while avoiding its shortfalls. Such a framework would clearly identify its main objectives and then prioritize the interests of the market participants it strives to protect.
There currently exists little procedural and regulatory uniformity among market centers. To promote a "level playing field" for all market participants, the same rules should apply in all markets whenever practicable.
The Task Force should promote full disclosure to interested parties when such behavior (1) is competitive in nature and (2) benefits investors. We believe that full disclosure enhances market transparency and allows investors to take actions that are in their best interest. For example, requiring broker/dealers to disclose order flow arrangements to investors allows them to direct trades to those dealers offering the better service. Better service does not necessarily imply best price, but what best suits particular investors considering their circumstances and needs at the time of the trade.
The Task Force should consider how globalization of markets would affect U.S. markets. Markets in different parts of the world are becoming increasingly interrelated as technology improves and companies more often access markets outside their domestic market to raise capital. Just as non-U.S. companies are listed on U.S. markets, numerous U.S. companies are listed on the national exchanges of other countries. Foreign markets present a unique challenge because they are outside the Commission's jurisdiction yet these markets are increasingly available for trades by U.S. investors. In light of the regulatory difficulties international markets present, emphasizing full disclosure is important to reduce the likelihood of broker/dealers using arbitrage opportunities across fragmented foreign markets to their advantage.
Should the Commission not wish to pursue our recommendation to form an independent task force, we suggest that it endorse regulations that address the following concerns:
Limit orders should enjoy trading priority to other orders in terms of both price and time. That is, limit orders that improve the NBBO price should trade first. We believe that price and time trading priority improves overall market liquidity by encouraging traders to post additional limit orders. It also enhances the quality of displayed market prices because these additional orders provide greater market depth. Furthermore, limit orders provide a free put or call option to market participants thereby reducing price uncertainty from principal trades by establishing a price floor or ceiling.
Broker/dealers should only be allowed to trade as principals against purchased order flow if (a) order flow arrangements have been disclosed to investors, and (b) the NBBO price is improved by the trade. Full disclosure gives investors the ability to direct trades to those broker/dealers offering the best terms for their preferences and circumstances.
Broker/dealers should not be permitted to internalize orders. We believe that this practice can significantly hinder market liquidity by removing too many trades from the pool of securities available for trade on the exchange.
Whenever possible, the same rules should apply to all markets (equity, fixed income, futures/forwards, and option markets). We believe that greater regulatory convergence will improve market transparency by (a) making regulatory costs comparable across markets and (b) eliminating possible "loopholes" that allow market participants to behave differently from market to market. Having like rules will promote a "level playing field" for all market participants.
Broker/dealers should not be permitted to trade ahead of previously displayed limit orders. The Manning Rules should be amended so that they are applicable all day, whenever a trade might occur, and not only when the market is open.
In closing, we caution the Commission against hasty implementation of regulation to address market fragmentation without further study. We are concerned that the current request for comment on issues related to market fragmentation does not address these issues within the proper market context. We strongly recommend that an independent task force, adequately representing all stakeholders in the financial markets, be empanelled to make recommendations on regulatory action only after (1) quantifying the impact of technology and recent regulation on the current market structure and (2) determining an ideal market structure with a methodology of achieving it.
The AAC appreciates the opportunity to comment on these issues. Should you have questions or need additional information, please do not hesitate to contact Maria J. A. Clark by phone at 804.951.5314; by fax at 804.951.5320; or by e-mail at email@example.com.
Deborah A. Lamb
Advocacy Advisory Committee
Maria J. A. Clark
|Cc:|| AIMR Distribution List
Theodore R. Aronson, CFA, Chair, AIMR Best Execution Task Force
Michael S. Caccese, Senior Vice President, General Counsel & Secretary, AIMR
Patricia Doran Walters, CFA, Vice President, Advocacy, AIMR
Philippa B. Hughes, Associate, Advocacy, AIMR
1 The Association for Investment Management and Research is a global, non-profit organization of over 41,000 investment professionals from over 90 countries. Through its headquarters in the U.S. and 95 Member Societies and Member Chapters worldwide, AIMR provides global leadership in investment education, professional standards, and advocacy programs.