[Senate Hearing 109-904]
[From the U.S. Government Publishing Office]
S. Hrg. 109-904
REGULATION NMS AND
RECENT MARKET DEVELOPMENTS
=======================================================================
HEARINGS
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
ON
EXAMINATION OF REGULATION NATIONAL MARKET SYSTEM (NMS) DESIGNED TO
STRENGTHEN OUR NATIONAL MARKET SYSTEM FOR EQUITY SECURITIES, FOCUSING
ON RECENT MARKET DEVELOPMENTS
__________
MAY 18 AND 19, 2005
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Mark Oesterle, Counsel
Bryan N. Corbett, Counsel
Alex M. Sternhell, Democratic Professional Staff
Dean V. Shahinian, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
C O N T E N T S
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WEDNESDAY, MAY 18, 2005
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Allard............................................... 2
Prepared statement....................................... 27
Senator Hagel................................................ 2
Senator Crapo................................................ 2
Prepared statement....................................... 27
Senator Sarbanes............................................. 16
Senator Carper............................................... 23
Senator Schumer.............................................. 26
WITNESSES
John A. Thain, CEO, New York Stock Exchange...................... 2
Prepared statement........................................... 27
Robert Greifeld, CEO And President, The Nasdaq Stock Market...... 3
Prepared statement........................................... 31
Gerald D. Putnam, Chairman & Chief Executive Officer Archipelago
Holdings, Inc.................................................. 7
Prepared statement........................................... 34
Edward J. Nicoll, CEO, Instinet Group............................ 18
Prepared statement........................................... 37
Meyer S. Frucher, Chairman and Chief Executive Officer,
Philadelphia Stock Exchange, Inc............................... 11
Prepared statement........................................... 39
Kim Bang, President And Chief Executive Officer Bloomberg
Tradebook LLC.................................................. 46
Scott Evans, Chief Investment Officer, TIAA-CREF................. 70
Thomas M. Joyce, Chairman and Chief Executive Officer, Knight
Capital Group, Inc............................................. 71
Marc E. Lackritz, President, Securities Industry Association..... 75
George U. ``Gus'' Sauter, Chief Investment Officer and Managing
Director, The Vanguard Group................................... 82
----------
THURSDAY, MAY 19, 2005
Opening statement of Chairman Shelby............................. 85
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 85
Senator Crapo................................................ 87
Senator Dodd................................................. 87
Senator Reed................................................. 87
Senator Allard............................................... 96
Senator Hagel................................................ 99
Senator Schumer.............................................. 103
Senator Bunning.............................................. 106
Senator Stabenow............................................. 106
WITNESS
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission..................................................... 88
Prepared statement........................................... 107
Response to written question of Senator Bunning.............. 114
REGULATION NMS AND RECENT MARKET DEVELOPMENTS
----------
WEDNESDAY, MAY 18, 2005
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:07 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing shall come to order.
This morning, the Committee will hold the first of two
hearings examining Regulation NMS and the impact of two
recently announced mergers involving leading market centers.
Today, we will hear from representatives of a number of market
participants and tomorrow, the Committee will hear from
Chairman Bill Donaldson at SEC.
Since Chairman Donaldson last appeared before this
Committee in March, much has transpired concerning our national
market structure. On April 7, the SEC approved Regulation NMS
by a 3 to 2 vote. Then within weeks of the adoption of the
regulation two major transactions were announced. These mergers
will lead to the creation of two dominant market centers. On
April 20, the New York Stock Exchange announced that it would
merge operations of Archipelago to form a new public company.
Next, on April 22, Nasdaq announced that it would buy
Instinet's electronic trading platform.
The equities trading industry is clearly in the midst of a
significant transition. The convergence of a new regulatory
framework created by Regulation NMS and the impact of the
proposed mergers creates a new dynamic for our markets. The
implementation of Regulation NMS will be a challenge for all
market participants, and the long-term effect of the regulation
remains to be seen. Combined with this evolving regulatory
landscape, the merger announcements raise questions about
industry consolidation and competition, the future direction of
our equities markets, and the ultimate impact on investors.
These are all issues that need to be examined.
This Committee will continue active oversight of Regulation
NMS and will closely monitor new market developments. I think
it is important for this Committee to understand the impact of
these changes for all investors and for the efficiency of our
securities markets.
To discuss these issues with us this morning we have a
number of leading industry experts. On the first panel we will
hear from Mr. Sandy Frucher, Chairman and Chief Executive
Officer, Philadelphia Stock Exchange; Mr. Robert Greifeld,
President and Chief Executive Officer, Nasdaq Stock Market,
Inc.; Mr. Edward Nicoll, Chief Executive Officer and Director,
Instinet Group, Inc.; Mr. Gerald Putnam, Chairman and Chief
Executive Officer, Archipelago Holdings, Inc.; and Mr. John
Thain, Chief Executive Officer, New York Stock Exchange.
On the second panel we will hear from Mr. Kim Bang,
President and Chief Executive Officer, Bloomberg Tradebook,
L.L.C.; Mr. Scott Evans, Executive Vice President and Chief
Investment Officer of TIAA-CREF; Mr. Thomas Joyce, Chairman and
CEO, Knight Trading Group, Inc.; Mr. Marc Lackritz, President,
Securities Industry Association; and Mr. Gus Sauter, Chief
Investment Officer and Managing Director of the Vanguard Group.
I want to thank all of you for appearing here this morning,
and we look forward to your testimony.
Senator Allard, do you have an opening statement?
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, I do have an opening
statement. It is very brief, and would like to make that part
of the record.
Chairman Shelby. Without objection, so ordered.
Senator Allard. And just take this opportunity to thank the
panels for coming forward and being willing to share their
thoughts with this Committee.
And thank you, Mr. Chairman, for holding this hearing.
Chairman Shelby. Thank you.
Chairman Shelby. Senator Hagel.
STATEMENT OF SENATOR CHUCK HAGEL
Senator Hagel. No opening statement, Mr. Chairman. I look
forward to our witnesses' testimony. Thank you.
Chairman Shelby. Mr. Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman. I will
look forward to hearing the witnesses today.
Chairman Shelby. We will start with you, Mr. Thain.
All of your written testimony will be made part of the
hearing record in its entirety. If you will sum up your main
points. Thank you and welcome.
STATEMENT OF JOHN A. THAIN
CHIEF EXECUTIVE OFFICER, NEW YORK STOCK EXCHANGE
Mr. Thain. Mr. Chairman, Members of the Committee, thank
you for giving me the opportunity to be here today. We
appreciate your Committee's oversight of our national market
system, and we share with you I think a common challenge to
maintain the competitive position of the U.S. financial markets
in the world, and to ensure the interests of investors are
protected.
The New York Stock Exchange stands at the center of the
U.S. financial markets. We serve 90 million investors. We have
over 2,700 companies listed on the New York Stock Exchange, and
those companies have a market capitalization of $20 trillion.
We take great pride in providing our customers the highest
standards of market quality, the deepest liquidity, the lowest
volatility, the tightest spreads, and the best prices.
But we also recognize that the rapid pace of change in our
industry demands that we, the New York Stock Exchange, do
better in terms of speed and innovation. That is why we are
building our hybrid market, to offer investors a choice between
sub-second speed of electronic execution and the price
improvement and lower volatility of our auction market. It is
also why we are taking the historic step to become a public,
for-profit company by merging with Archipelago, which is an
outstanding entrepreneurial company that has pioneered leading
edge platforms and products.
And finally, it is why we strongly support Reg. NMS,
because it protects and promotes the interests of U.S.
investors and U.S. competitiveness. Let me briefly talk about
each of those issues starting with Reg. NMS.
We believe Regulation NMS is good for investors and good
for U.S. markets. It is designed not to favor one market over
another, but to strengthen competition among all markets to
create the best possible national market, for investors, for
issuers, and for our economy.
How will it do this? By preserving the best price rule and
by extending it to all markets and updating it to encourage
innovation and competition. We believe the new best price rule
advances these essential goals three ways. First, it is
indisputably pro-investor. It will strengthen the integrity of
markets and it enhances U.S. competitiveness. The new best
price rule ensures that any one of your constituents can invest
and trade on an equal footing with large institutions. It does
so by requiring that intermediaries, such as brokerage firms
and mutual funds find the best price for investors' orders by
selling their shares at the highest possible prices or buying
them at the lowest price.
Second, it ensures that stocks are priced at their true
value, that the best price rule improves the transparency and
the price discovery process. Our markets are certain to be fair
and honest.
And third, markets will be more competitive, because as
investors are encouraged to maintain and increase their limit
orders, liquidity will deepen.
Critics have from time to time complained that the old
trade-through rule was flawed because it did not distinguish
between fast and slow markets and prices could change in the
time it took to trade in our auction market. The new trade-
through rule protects only prices that are available for
immediate electronic execution. This is a very significant
change. What it means is that the New York Stock Exchange must
deliver on our hybrid market. We must make our quotes
immediately electronically accessible, and we are going to do
that.
Our goal is to offer a choice between that immediate
electronic execution or the possibility of getting a better
price through the auction process on the floor of the exchange
with the specialists and the floor brokers.
We believe that our trading floor continues to offer
superior market quality. We outperform electronic exchanges on
opens and closes, during order and balances, and in earning
surprises. We provide the best prices in our New York-listed
stocks 89 percent of the time, and companies, when they
transfer from the purely electronic markets to the New York
Stock Exchange get better executions in the marketplace. Price
volatility is cut in half, quotes are narrowed, and execution
costs fall.
Finally, investor groups, representing millions of
investors and investor companies, support the SEC's decision to
extend the best price rule to all markets. Investors agree that
once trading conditions for speed are comparable, there is no
justification in any market for providing customers anything
less than the best price.
Let me talk a moment about our proposed merger with
Archipelago to become a public, for-profit company, the NYSE
Group. Our merger is about meeting global competition. The
competition for capital today is global, and our major
competitors are public, for-profit exchanges that are well-
capitalized, have a multiplicity of products, and they are
attempting to gain footholds in the U.S. marketplace. We have
to compete and we have to have the means to compete to the
fullest extent or our abilities, and we have to be world class.
We have to be an exchange that offers investors the strongest
platforms with cutting-edge products, and that is what
Archipelago brings with a new expanded menu of equity products,
options, exchange-traded funds, and fixed-income securities.
With a more robust and innovative business model we can
better serve our customers, and as a profitable public company
we will offer an opportunity for investors, institutions,
listed companies, and members to share in our growth and
success as stockholders. As a stronger and more competitive
exchange we will enable the United States to respond and
prevail in the world financial market competition.
Let me also assure this Committee that the new structure of
the New York Stock Exchange Group will not only protect but
also strengthen the independence and oversight of our
regulatory functions. So to sum up, we believe that Reg. NMS,
the completion of our hybrid market, and our combination with
Archipelago represent a comprehensive response to the twin
challenges that we face to build the world's best marketplace
for our customers and to preserve the leadership and
preeminence of the U.S. capital markets in the world.
Thank you.
Chairman Shelby. Mr. Greifeld.
STATEMENT OF ROBERT GREIFELD
CHIEF EXECUTIVE OFFICER AND PRESIDENT,
THE NASDAQ STOCK MARKET
Mr. Greifeld. Chairman Shelby, distinguished Members of the
Senate Banking Committee, I thank you for inviting me to
discuss Reg. NMS and the recent industry developments.
When I last appeared before this Committee on July 21,
2004, I stated that the current trade-through rule is the
primary obstacle to competition amongst our Nation's equity
markets, and competition is the driving force in making the
U.S. markets the strongest in the world, the best for investors
large and small and accountable to the public. I also stressed
that the markets had uncovered a fundamental truth. Today,
electronic trading is best for investors.
After well over a year of hearings, discussion and
comments, on April 6 of this year the SEC approved Regulation
NMS. NMS replaces the old ITS trade-through rule that protected
the listed market from competition with a new trade-through
rule which will be applied uniformly across all markets to
protect a market's top-of-the-book quote if it is automatically
accessible. Regulation NMS also includes needed restrictions on
sub-penny trading, establishes uniform market access rules, and
updates the formula used to allocate market data revenue.
I believe Regulation NMS does remove a substantial obstacle
to competition among our Nation's equity markets and
establishes incentives for floor-based markets to move to
electronic trading. The new rule will bring benefits to
investors and it will enhance the ability of our Nation's
capital markets to face growing international competition.
Nasdaq commends the work of the SEC, as well as the
constructive oversight of this Committee and the entire
Congress throughout the rulemaking process.
As you know, Nasdaq and many others urged the Commission to
eliminate the trade-through rule entirely. Our position
reflects the belief that market forces and best execution
responsibilities should serve as the bedrock principles in the
securities market. We are proud of the market quality
experienced by investors every day on the Nasdaq Stock Market
which does not have a trade-through rule. Given our experience
and the cost of implementation, we believe the extension of the
rule to Nasdaq represents an unnecessary tax on our market
participants.
Nonetheless, although Nasdaq does not believe the
application of a trade-through rule to Nasdaq is necessary, we
are pleased by the fact that the new trade-through rule
approved by the Commission will force floor-based markets to
follow the path to automated trading that has been blazed by
Nasdaq since 1971.
Specifically, the distinctions between fast and slow
markets will force manual floor-based markets to automate in
order to compete effectively with the faster electronic
exchanges. The rule acknowledges the value of speed and
certainty of execution, and allows electronic markets to
compete for the trading of New York Stock Exchange-listed
securities. Manual markets will no longer be the weak link in
the national market system, slowing down faster markets, while
humans--some with a very distinct time and place advantage on
the floor--attempt to execute orders.
As you know, the rule will be rolled out in a limited
manner next April and will take full effect in June 2006. Even
before NMS was approved, the New York Stock Exchange was
compelled by market pressure to move to modernize their market
structure as seen with the proposed hybrid model. As a result
of NMS, the American Stock Exchange and the regional exchanges
have strong incentives to modernize their markets, and are
poised to emerge as competitors. There is no doubt that this
will be good for competition and for investors.
The Committee has also asked about our recent acquisition
of the Instinet Group. On April 22, Nasdaq announced the
acquisition of Instinet Group and concurrently entered into a
definitive agreement to sell Instinet's Institutional Brokerage
division to Silver Lake Partners. As a result, Nasdaq will own
only Instinet's electronic communications network, their ECN
called INET.
This deal proceeded from a public competitive process.
Reuters, Instinet's parent company, announced in November 2004
that it was selling Instinet. In January, Nasdaq first
submitted a proposal to acquire Instinet. We understand that
several industry participants considered bids for Instinet.
Nasdaq acquired Instinet to enhance our trading environment
to serve investors better and respond to the increasing
competition across global capital markets. It is a synergistic
deal that will create a fast, high-performing, low-cost
platform for trading U.S. securities. Given the compatibility
of the two platforms, the real-time market surveillance by a
well-respected regulator, the NASD, and Nasdaq's proven
technological reliability, this transaction will position
Nasdaq to compete more effectively with U.S. and other
international market centers. This acquisition will result in
more cost efficiency and improve quality of execution in our
market, qualities that today's individual and institutional
investors demand. Nasdaq will continue to innovate and will
also have the ability to tap new opportunities in other asset
classes.
The rapid structural changes sweeping through our Nation's
securities markets are being propelled by a convergence of
several forces. The principal regulatory force is Regulation
NMS. Its most direct impact, greater competition in the trading
of New York Stock Exchange securities, will be felt when the
rules take effect. However, the indirect impact of Reg. NMS is
already being felt as the NYSE is poised to become a competitor
in the trading of Nasdaq securities. That combined with the
expected rise in the trading of Nasdaq securities by the
regional exchanges creates a national market structure in which
market centers no longer specialize in the equities of a single
market.
Another important force is the rapid globalization of
capital markets. Companies around the world are seeking access
to capital and stock markets are the key facilitator in this
process. When a company in China or Russia seeks to bring
capital from outside its country's borders, it typically
considers the major markets in Europe as well as in the United
States. As such, we are now competing not only with the U.S.
exchanges but also, for example, with the Europeans. Enhanced
competition for listings also encourages competition in the
quality of trading as companies seek to list in a country and a
market that offers the best trading for their securities.
Finally, it is becoming increasingly necessary for stock
markets to be mindful of competition from venues that trade
derivatives and other instruments that are not equity
securities. If trading quality in equities is inferior, or the
costs of trading are relatively high, then some investors will
focus on a type of securities that trade more efficiently.
Again, all investors are potential winners in this competition.
Recent developments in the marketplace also offer the
opportunity to improve and make more efficient the regulation
of the securities market. As part of its transaction, the NYSE
announced their intention to further separate its regulatory
function into a nonpublic, not-for-profit entity governed by an
independent board of directors. This follows the lead
established by the Nasdaq/NASD relationship. Nasdaq supports
separating the regulator from the regulated market, and in
fact, once the Commission approves our application to register
as an exchange, Nasdaq will completely separate from our
regulator, the NASD.
In this regard, I am pleased to report that the Commission
has been working closely with us on our exchange application
and we are hopeful that the application will be approved
shortly. With Reg. NMS codifying uniform rules for trading of
all equities, exchange status for Nasdaq will achieve a level
playing field. A Nasdaq exchange will be good for competition,
good for regulatory framework, and good for market quality, and
ultimately good for investors.
I appreciate your time here today, and welcome Senator
Sarbanes. Thank you.
Chairman Shelby. Mr. Putnam.
STATEMENT OF GERALD D. PUTNAM
CHAIRMAN AND CHIEF EXECUTIVE OFFICER,
ARCHIPELAGO HOLDINGS, INC.
Mr. Putnam. Good morning, Chairman Shelby, Ranking Member
Sarbanes, and other distinguished Members of the Committee.
The headline for this hearing I think would be
consolidation, and I would like to start by congratulating two
of my toughest competitors, Bob Greifeld and Ed Nicoll on their
merger.
I know the saying goes the best offense is a good defense,
but I think if you are sitting in my shoes today you have to
turn that around the other way and say the best defense is a
good offense. We have had a few disagreements with the New York
Stock Exchange over the years, and I am not actually sure--I
will take that back--I am sure they were not happy about it,
but we have agreed with them on a couple of things, on a few
occasions.
Specifically, we disagreed with the trade-through
provision, Reg. NMS, as adopted by the SEC. This Committee and
the House Financial Services Committee asked the SEC to tackle
pretty tough questions, some thorny issues over our national
market system. In the end, while we did not agree on
everything, we do now have certainty in the rules.
I think also the consolidation that we are seeing is
bringing our markets closer together here in the United States,
and the distinction between them is starting to fade.
I would like to talk a little bit about our merger, and
specifically negotiations that John and I had starting back in
January. We have disagreed, as I said, on some things in the
past, but one thing was certain to me after those negotiations,
is that we do share a common vision, and that is to leverage
the respective strengths of the NYSE and ArcaEx and to develop
a world-class exchange. We are going to do this by listening to
our customers and responding with high-quality service,
products, and choice.
Our merger will represent the largest ever among securities
exchanges. It will combine the world's largest, most liquid and
reliable, the New York Stock Exchange, with the most
successful,
totally open, fully electronic one in ArcaEx.
And I believe the combination is going to bring us several
benefits, specifically: Strengthen America's leadership and
boost our global competitiveness in capital markets; better
server all investors and traders; support the continued growth
and global leadership of the NYSE; it will help us maintain the
highest standards of integrity, transparency, and disclosure;
produce efficiencies; drive innovations; create new business
and revenue opportunities; and finally, enable the public to
own shares in the world's leading exchange.
Now, competition is changing things once again and today it
is on a global scale. These recent consolidations, I believe,
are about our ability to compete in the globalization and
convergence of exchange models. Past exchanges in the United
States have traded either stocks, options, or futures. But
today, as you look around the world--let us start in Europe--
the Deutsche Borse, Euronext, and the LSE are bringing
different products together under one roof to create one-stop
shopping. In Asia, exchanges like the Singapore Exchange and
the Hong Kong Exchange are commingling equities and derivatives
under one umbrella. The Tokyo market is one of the most
integrated, if not the most integrated, in the world.
Here in the United States, the Chicago Mercantile Exchange,
it is a public company, they advertise nearly round-the-clock
trading and boast customers around the world. The Chicago Board
of Trade has plans to go public this year. The Boston Stock
Exchange teamed up with the Montreal Exchange to create the
Boston Options Exchange or the BOX. The ISE, another public
company, is an all electronic options exchange born in the late
1990's and is already the largest options exchange in the
United States and in the world.
Finally, the Chicago Mercantile Exchange, the Chicago Board
of Trade, and the Chicago Board Options Exchange teamed up to
create OneChicago, an all electronic single stock futures
exchange.
The competitive trend is very clear: To stay competitive
exchanges are looking to trade not stocks, options, or futures,
but stocks, options, and futures on a single platform, and the
competition is global.
Before concluding, I would like to say how proud I am of
all the employees. There is 250 of them now at ArcaEx that made
our company the success that it is today. We all look forward
to our future with John Thain and the rest of the team at the
New York Stock Exchange.
Thank you.
Chairman Shelby. Mr. Nicoll.
STATEMENT OF EDWARD J. NICOLL
CHIEF EXECUTIVE OFFICER, INSTINET GROUP
Mr. Nicoll. Chairman Shelby, Ranking Member Sarbanes, and
Members of the Committee, I appreciate this opportunity to
discuss the role that I believe regulation and legislation will
play in the future of our Nation's securities markets.
While others on the panel today may begin by looking ahead
and outlining the challenges and opportunities facing our
markets, I would like to begin with an appreciative glance back
at how we got here. I do so because I think it is worth
remembering, indeed, quite important to remember, on whose
shoulders we stand here today and why so much of the recent
discussion has been about building better and stronger
electronic markets.
From my perspective, the story begins with a company called
Island ECN, which was one of the first of the so-called
``Electronic Communications Networks'' or ECN's.
In the wake of scandals in the mid-1990's the SEC adopted
regulations known as the Order Handling Rules, designed to
introduce competition and greater transparency into the U.S.
equity markets, which led directly to the creation of ECN's.
Island seized this opening and offered investors a less
expensive, faster, and more reliable forum for trading. From
Island's inception we counted on the fact that investors, when
given the choice, would always demand a more accessible and
transparent marketplace. To reach that goal we focused on what
we considered the glaring gap in the traditional model, the
inability of investors to meet directly in the marketplace
without having to rely on professional intermediaries.
The Island story was about fighting for a chance to compete
in new markets and allowing investors to vote with their feet.
We fully understood that if we could not offer a better
product, we should be out of business. But investors welcomed
our products and services, and Island enjoyed explosive growth,
eventually merging with Instinet, the company which I serve as
CEO today.
For these reasons, Mr. Chairman, I doubt you will find a
witness today who is a greater champion of our Nation's free
markets and the individual's ability to profit from hard work
and innovation.
But more than anything else, my experience at Island gave
me the privilege to meet some of the most insightful traders
and software programmers on the street, individuals who grasped
a magnificently simple and elegant truth: The markets could be
made far more rational and fair if investors were allowed
access to the same type of information that were, at the time,
uniquely available to market professionals.
On my first day as Chairman of Island, I walked into the
office--and we were literally just a handful of employees in
one office--and sat down with gifted individuals such as Josh
Levine and Matt Andresen. The one thing we all shared, beside a
broken-down desk with four folding chairs, was a commitment to
provide investors with an unprecedented degree of
accountability, openness, and transparency in the marketplace.
I recall how many market professionals had insisted that making
arcane, real-time market data widely available would be at best
a distraction, and probably a nuisance for investors. How wrong
they were.
As we know, investors today demand access to real-time
data, and the latest research reports, as well as the ability
to enter orders more efficiently and at a fraction of the cost
once paid for such transactions. Yet, while the investor had
been empowered to know what and when to buy, a key component of
this equation had been missing: How to buy it.
That is where Island jumped in. Traditionally, investors
had only been provided with the highest bid and the lowest
offer in a security. The depth of the market, which gives an
indication of the true supply and demand for a security, had
been the exclusive province of market professionals.
That lack of accountability, in other words, denial of
information to the investor, was unacceptable to us. To provide
the best resource possible to the investor we became the first
marketplace to provide a free, real-time display of all of its
orders through the Island Book Viewer.
There is probably nothing I am more proud of, Mr. Chairman,
than to know that the technology that we built for the Island
ECN, which then became the technology behind Instinet Group's
INET ECN, is now expected to become the technology platform for
the merger Nasdaq-INET platform.
With this history in mind, Mr. Chairman, let me try to
summarize some lessons we can learn from those experiences that
are particularly relevant as we look ahead at the issues we
will face in our markets over the coming years, lest we be
doomed to repeat the mistakes of the past.
First and most important are the benefits resulting from a
regulatory environment that encourages true competition among
marketplaces. It is true that much of the original electronic
marketplace story was about harnessing technology to provide
investors with a more efficient, faster and lower-cost forum
for trading. Yet Island's success and the success of other
electronic markets like Archipelago and Nasdaq is much more
than a technology story, it is about the tremendous benefits
that redound to the investor when the securities laws and
regulations allow our markets to compete; when one marketplace
can challenge another with a dizzying array of innovations and
offer the investor unprecedented opportunities to leverage
technological breakthroughs.
The Island story and the rise of ECN's embody the benefits
of competition. The dramatic changes in technology have allowed
new competitors to offer new services at a lower cost and
capture market share from traditional market participants in a
relatively short period of time. Just one example: I can
remember when it cost some individuals as much as $200 per
trade. Today, you can pay as little as $7. There has never been
a better time to be an individual investor.
A second lesson from our experience concerns the policing
and surveillance of markets. By eliminating the informational
disparities of the traditional floor-based manual markets, many
of us built a marketplace that is inherently safer, fairer, and
importantly, easier to surveil, all issues I know, Mr.
Chairman, that this Committee takes very seriously. For
example, participants on the floor of an exchange generally
possess more trade and order information than the average
investor sitting at home.
Through surveillance and the implementation of restrictions
on the activities of those in the trading crowd, regulators
attempt to prevent the misuse of this information. As recent
events have shown, however, no amount of surveillance or
regulation can completely prevent or eliminate the potential
for its misuse. With that in mind, Mr. Chairman, I note that
electronic markets reduce the opportunities for improprieties
by eliminating informational disparities.
Finally, Mr. Chairman, let me at least raise for the
Committee's consideration one of the most enduring public
policy issues we face. Now that electronic markets have done so
much to empower the investor by providing an open and
transparent marketplace, there remains one final challenge: How
do we unleash these benefits on as wide a scale as possible
without sacrificing investor protection or the integrity of our
capital markets? How can we continue the process of
democratizing the markets?
Long before electronic markets were even a glimmer in
anyone's eye, Congress anticipated exactly what rules should
guide us. In 1975, Congress created a national market system
with the goal of creating a more efficient and transparent
market. We could not have asked for a better building block.
Over the subsequent decades, the SEC has worked hard to
strengthen and improve this regulatory structure. While
Instinet had particular concerns with some of the elements in
the recently approved Regulation NMS, I do commend Chairman
Donaldson for finally resolving many of the outstanding market
structure issues and setting forth a clear and definitive
regulatory roadmap for the U.S. equities as a whole.
There are many different models currently used in the
equity markets, and with entry becoming even cheaper and
easier, over the coming months and years I have no doubt more
will emerge. Each model has its supporters and detractors. But
what history does teach us is that regardless of the model, two
principles must hold into the future. First, competition must
continue to be permitted to flourish between the different
models, but in a manner that safeguards the integrity of our
markets.
Second, market structure must remain free from unfair
advantages and unreasonable barriers.
While much has changed since I sat in that small downtown
office with my young colleagues, we must remain vigilant in the
protection of our free markets from over-regulation. As
Chairman Donaldson said, ``We need to identify real problems,
consider the practice consequences of the possible solutions
and then move pragmatically and incrementally toward the goals
Congress staked out.''
My own rule, Mr. Chairman, would be that regulatory action
should only be taken when it is clear that the market is
failing and less drastic remedies are inadequate. In all other
cases, let us embrace free competition and always work toward
greater openness, transparency, and accountability in the
marketplace. In so doing, we can continue to leverage our
Nation's technological superiority in a manner consistent with
the best aspects of America's entrepreneurial capitalism. There
is too much at stake to do otherwise.
Thank you for this opportunity to again testify before your
Committee. It has been a great pleasure to work with you and
your colleagues on this issue.
Chairman Shelby. Mr. Frucher.
STATEMENT OF MEYER S. FRUCHER
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
PHILADELPHIA STOCK EXCHANGE, INC.
Mr. Frucher. Chairman Shelby, Senator Sarbanes, Members of
the Committee, my name is Sandy Frucher, and I am Chief
Executive Officer and Chairman of the Philadelphia Stock
Exchange, and I would like to say that the Philadelphia Stock
Exchange appreciates the opportunity to participate in today's
very, very important hearings.
A century ago there were more than 100 regional stock
exchanges in the United States. They served the needs of local
issuers and investors. Several of the descendants of those
exchanges survive in the United States today. Although still
referred to as regionals, in fact we are competing parts of our
national market system. We trade stocks listed by the New York
Stock Exchange and Nasdaq.
PHLX is the oldest securities exchange in the United
States. We trade over 2,000 stocks listed on the New York and
American Stock Exchanges, as well as over 1,000 individual
equity and industry sector options.
Today, the smaller U.S. exchanges, including PHLX, account
for a very small percentage of the trading of the New York and
Nasdaq stocks. Frankly, the ability of the competing exchanges
to survive was an open question even before the mergers were
announced. The competing exchanges will not be able to continue
in their current form. To survive, we must continue to innovate
in terms of ownership structure, trading systems, fees, and so
on.
The question for the SEC, this Committee, and the broader
marketplace is, should we be concerned about the survival of
competing exchanges? The answer should be a resounding yes.
Without competition, the two great markets emerging from these
proposed combinations will have little reason to innovate, to
improve services, and to keep fees down. We heard it in the
testimony today. They had 82 percent market share of the New
York and 100 percent of the Nasdaq stock market. But without
the competitors that they faced, an Island that morphed into an
Archipelago, that has now morphed into a continent, was not
enough. They have to effectively have competition in order to
compete.
The competing exchanges have played a role in the U.S.
markets greater than their share of stock trading would
suggest. We have repeatedly served as laboratories of
innovation. We were the first to adopt clearinghouses, to adopt
net settlements of trades, to allow automated execution of
small orders, all improvements that the New York later
embraced.
And, frankly, we have helped our competitors. The SEC's
adoption of Reg. ATS in 1998 gave new force to nonexchange
alternative trading systems. These firms use new technology to
offer investors rapid, cheap, anonymous electronic trading
without a dealer acting as middle man. Two leading ATS's,
Instinet and Archipelago, developed relationships with smaller
exchanges as part of their growth strategy, respectively with
the National Stock Exchange, formerly known as Cincinnati, and
the Pacific Stock Exchange. They took advantage of the
regulatory and trading infrastructure of the exchanges in order
to compete better with New York and Nasdaq. They were so
successful that they are now in effect being bought out by the
incumbents they challenged.
The proposed mergers look like smart moves from the
perspective of the owners and members of the four organizations
represented at this table, and I think they were. They are
brilliant deals. But it is too soon for investors to celebrate.
Competition will be enhanced only if the resulting duopoly
competes vigorously for listings and to trade each other's
listed stocks. If they do not, investors will really suffer.
Policymakers must be aware of the elimination of
competitors. My colleague, John Thain, has recently said that
the United States has too many exchanges and needs
consolidation. The clear implication is that he believes that
the number of competitors must shrink. PHLX does not believe
that issuers and investors are best served by a market with
just two competing exchanges. To keep trading costs for
investors low, to keep the quality of execution high, to ensure
future innovation, additional competition is essential.
The SEC's Chief Economist said recently, ``Requiring
markets to expose orders to competing prices offered on
alternative platforms forces platforms to address how they
compete for business.'' In plain English, competition between
market forces them to constantly improve, which is good for
investors.
Unfortunately, the SEC's recent actions have tended to
limit competition. Regulation NMS will likely reduce the
competing exchanges' share of market data revenues, a critical
source of our funding. We actually do not know the formula,
because notwithstanding the fact that the rule has been
approved, it has not been published. It will also raise
barriers to entry for new ATS's, and the pending rulemaking on
governance, ownership, and administration of exchanges could
raise costs and limit flexibility of the existing exchanges
that compete with New York and Nasdaq. The SEC must ensure that
its regulatory process does not unintentionally create a
monopoly for these business entities.
In order to survive, the smaller exchanges must innovate.
We will have to strike alliances and embrace new trading
systems to stay alive. At each step, we will have to make rule
and fee filings with the SEC. Regulatory actions like
Regulation ATS can promote competition. Regulatory actions and
inactions can also inhibit competition.
To ensure competition, the SEC must be open-minded to the
approval of new and innovative structures that will allow
smaller exchanges to compete, and the Commission must act on
those competitive actions quickly, frankly, by the first
quarter of 2006, given the timetables announced by the merger
participants. These mergers are anticipated to become complete
before the new Reg. NMS becomes the law.
In that time frame, if that time frame is not met, if
alternative systems are not allowed to be online and become
effective at that time, the potential for competition frankly
may be lost forever.
In conclusion, the smaller exchanges will be the only
competitive vehicle to challenge the duopoly. Our survival is
already under threat from changes the SEC has adopted in Reg.
NMS and has under consideration in the exchange governance
rulemaking. Reg. NMS has made a lot of improvements in the
system. I agree that it has rationalized the system in a lot of
ways. But underneath it, it also has the seeds for the
elimination of competition, and those have to be watched very
carefully.
The regulator will control the survival of competition in
our marketplace. For our survival and the continuation of the
competition that is so essential for investors, the SEC must
process promptly the proposals that smaller markets are
hopefully likely to file to introduce new rules, trading
facilities, fee structures, and affiliations. Only in this way
can we continue to offer innovative alternatives to ensure the
potential for competition in the new duopoly.
Thank you very much.
Chairman Shelby. I thank all of you. Much of the debate on
Regulation NMS focused on how to best modernize the national
market system to account for new technologies and efficiencies.
Aside from the legal certainty provided by the final adoption
of Regulation NMS, is there a correlation between the adoption
of the regulation and the recent merger announcement? Are these
mergers a direct result of the new regulatory environment? Are
they a necessary reaction? Are these transactions evidence of
larger market trends? They seem to be.
Mr. Thain.
Mr. Thain. Yes, Mr. Chairman. I would answer that the
following way. The changes in the market are in line with the
expectations of the SEC when they applied Reg. NMS across all
of the marketplaces. I do not think I would say that the
combinations are a result of Reg. NMS, but I think Reg. NMS
anticipated the type of combinations that you have seen. In the
case of the New York Stock Exchange and Archipelago, you have a
combination of New York-listed trading with a significant
position in the over-the-counter trading market.
I think Reg. NMS, as it was adopted, is quite consistent
with that more global or more national marketplace. It would be
very inconsistent to have one set of rules apply to the trading
of IBM and a different set of rules apply to the trading of
Microsoft, particularly where both of those stocks will be
traded under the same umbrella. So, I think actually Reg. NMS
did a very good job, and Chairman Donaldson should get credit
for that, in anticipating the developments in the marketplace.
Chairman Shelby. Mr. Putnam, do you have anything to add to
that?
Mr. Putnam. I agree with John. I would say though that the
pressure on a consolidation was there, and as I thought about
what to do next, Reg. NMS and the trade-through rule was not
hanging over my head as, oh, we have to do something
specifically because of that. I think our view, as we looked
around the world and thought about how things would change in
the United States, as we have to compete with foreign
competitors. The idea of combining products, meaning trading
futures, options, and stocks on a single platform is my vision
for where we are headed in the future, and there are certainly
signs of that from the competition abroad.
So the real driving factor for me was we needed some scale
and some size to be able to compete globally.
Chairman Shelby. Mr. Frucher, you have a different view?
Mr. Frucher. No, actually, I do not, but I just have a
slight modification. I think we should not confuse internal
competition with a need for vertical integration. I think what
has been stated, for us to compete globally we have to have the
ability under one roof to trade equities, options, futures, and
maybe even look at clearing, and certainly technology, to be
competitive. That is not the issue. The issue is whether or not
we have internal competition to spur the innovation and that
kind of vertical integration.
Chairman Shelby. Mr. Nicoll, you agree with that?
Mr. Nicoll. I do. I mean I do not think there is any large
disagreement here. My own view, running a company, was the
pressures to deliver profitability and in an extremely
competitive environment where our ability to charge per unit
had drastically declined over the past 5 years. The price that
Instinet was able to get to trade 100 shares in the 3 years
prior to this merger agreement had gone down by 80 percent. So
those are enormous economic pressures on an organization, and
we needed to have scale. I think this would have happened with
or without the regulatory changes. I do agree with John that
they are concordant with the changes that have been passed.
Chairman Shelby. Mr. Greifeld, you have a comment?
Mr. Greifeld. I agree with everybody.
[Laughter.]
Chairman Shelby. Our national market system tries to strike
a balance between competition among orders, and competition
among market centers. If the mergers are finalized, there will
essentially be two dominant players in the equity markets
controlling most of the liquidity. How will this consolidation
affect the balance between order and market competition? How
will the mergers alter the competitive dynamic that we have?
Should we be concerned that a duopoly will emerge? Mr. Frucher,
I will ask you.
Mr. Frucher. I actually think that strong market centers
are very important for competition, but we should not be
looking at Eurex and Euronext really as the paradigm of what we
want in markets. Those are monopolies. They trade in their own
silos. They are not as transparent as our markets. They are not
as liquid as our markets, and we can face that competition. I
am sure every Member of this Committee got a ton of mail last
year urging them to keep Eurex out of the futures market in
Chicago, and look what happened? They came in and they got
their butts whipped. But the investor got much cheaper fees
because of the competition.
The SEC does not look at it as a threat. The SEC has
lowered the barrier to entry and it now allows foreign markets
to come in and effectively buy U.S. markets.
The question really is not whether or not we have a
duopoly, we do. The question is, will they be challenged by the
next generation of Islands, Instinets, and Archipelagoes? And
if we use regulation to inhibit, to restrict, or to preclude
competition within our markets, that duopoly will atrophy.
Chairman Shelby. Mr. Nicoll.
Mr. Nicoll. I totally agree with Sandy. What the Committee
has to understand is there are two real components in NMS which
would lower barriers to competition for new people to come in.
There are two guiding principles, fair display and fair
accessibility. Now, if you have the highest bid in the United
States, your bid is going to be displayed throughout the entire
country, and that gives anybody, even the smallest market, the
ability to come in, offer the highest price, and get access to
this national market system.
Moreover, the largest markets cannot unreasonably
discriminate against anybody who wants to access their
marketplace, so they do not have the ability to use their scale
to allow people not to get into their marketplaces.
Chairman Shelby. Information changes everything, does it
now?
Mr. Nicoll. That is correct.
Chairman Shelby. Mr. Thain, you have any comment?
Mr. Thain. Yes. I think there are two important points, one
of which Ed was talking about, which is the Reg. NMS actually
protects the smaller markets, and there are very low barriers
to entry into our marketplace. Archipelago is only an 8-year-
old company. The ISE and the options market was created 5 years
ago from zero and has a 35 percent market share. So there is
plenty of room for new competitors to come in, and Reg. NMS
actually protects them from being ignored. I think that is one
point.
But on the second point, which is you have heard a number
of people talking about global competition. I think that from
the perspective of the United States, where we do today have
the dominant position in the world in terms of our financial
markets, we do face competition from those much more
diversified global competitors. So you have heard the talk
about Euronext or Deutsche Borse who trade a much broader range
of products.
Deutsche Borse has a market cap of about $8 billion, so
they have a tremendous amount of financial flexibility. They
have a currency to make acquisitions, and yes, it is true that
they have not been all that successful so far, but we are going
to have to compete on a global scale and we need entities who
are competitive on that basis.
Chairman Shelby. Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Mr. Chairman. I want
to welcome the panel.
I am interested in how the self-regulation would proceed
under these proposed arrangements. The SEC concept released
concerning self-regulation, published December a year ago said:
The SRO demutualization raises a concern that the profit
motive of a shareholder-owned SRO could detract from proper
self-regulation.
And just a few weeks ago The New York Times had an article,
``Big Changes at the Exchanges Bring Their Self-Regulation into
Question,'' and went on to say:
The New York Stock Exchange's plan to acquire an electronic
trading system has called into question the future of the self-
regulation system that exchanges use to oversee their markets
and the conduct of their members.
I understand that the exchange and the plans to reorganize
the regulatory function as a not-for-profit organization, but I
understand that this organization would be under the board of
the for-profit merged entity. Is that correct?
Mr. Thain. That is substantially correct. It would not
include any nonindependent members of that board, so it would
be a subset of the board.
Senator Sarbanes. What consideration was given to spinning
off the regulatory function to a totally independent body and
why was that approach, which would seem to avoid at least some
of the problems that people perceive, not followed?
Mr. Thain. Ranking Member Sarbanes, we believe that the
best structure for the regulatory functions of a marketplace is
one that balances the independence of the regulatory functions,
and so that we have to keep the regulatory functions separate
from the business of the exchange, but keeps the regulatory
functions close to the marketplace, so it does not in fact spin
it off totally. Because we think that by being close to the
marketplace there is an expertise and an understanding and a
sophistication that allows them to do their job better.
And so the structure that we are proposing is actually an
extension of the structure that we have today that was approved
by the SEC a little over a year ago, whereby the regulatory
functions, which are led by Rick Ketchum, report up to a
subcommittee of our board of directors, and as you know, our
board of directors is now new, and with the exception of
myself, is totally independent. So the board members are not
members of the regulated firms. They are not CEO's of listed
companies. They do not have interests in the operations of the
exchange. And so the regulatory functions report up to a
subcommittee of our board that is completely independent, so I,
as the CEO of the exchange, run the business, I have nothing to
do with the running of the regulatory side.
What we are proposing in this structure is an extension of
that. In some ways even more separate, where we are taking
those regulatory functions, which are currently inside the
exchange. We are putting them in a not-for-profit, not-public
entity, and the board structure will be similar. So the board
of that new regulatory entity will be comprised of members of
our current board, who again are totally independent. It will
not include me, as well as some third-party independent
individual. So in some ways it is slightly more separate, but
we do believe that keeping it close to the business of the
exchange, keeping it close to the marketplace, allows it to be
a better regulator.
Senator Sarbanes. Mr. Greifeld, how does Nasdaq propose to
deal with this?
Mr. Greifeld. Senator Sarbanes, how Nasdaq handles it today
is certainly different than what Mr. Thain is recommending. We
have our regulatory services performed by the NASD. The NASD is
separately capitalized. They are separately funded, and they
have a separate board from Nasdaq. The NASD, I think, is
certainly widely recognized as the gold standard for
regulation, and they are incredibly close to the business and
understand it.
In our relationship, we contract with them for regulatory
services. We do not have any input in terms of how they go
about conducting regulation. If they choose to conduct a
intensive investigation of a member firm which happens to be a
very large customer of the for-profit Nasdaq entity, we have no
control and/or knowledge of it, and we believe that is the best
way to operate.
We do have the ability to go in and audit for waste with
respect to how they discharge their regulatory function without
knowing precisely who they are regulating, and we certainly
take that opportunity. We are happy to see that the NASD
certainly has become a very lean and effective regulator.
So they are close to the business, but it is a separately
funded board, and I think this set up came about as Nasdaq
evolved to a for-profit company, and they do not have to look
to us for any input or control in their finances.
Senator Sarbanes. Mr. Chairman, my time is up. Thank you.
Chairman Shelby. Senator Hagel.
Senator Hagel. Mr. Chairman, thank you.
Gentlemen, welcome. You all have spoken this morning about
global competition and I want to focus my few minutes in
questions on that large issue.
Mr. Thain, in your prepared testimony, you talked about
Part 2 consolidation of securities markets, and you go on to
say, ``While the SEC has streamlined the rules and structure
for our national market system, it is up to the U.S. markets
themselves to respond to a rising global challenge. The players
must now perform on a new playing field.'' You go on to talk
about today equity and capital markets are global, competition
for capital is global. All five of you have noted that.
A couple of questions I would like to present to all of you
and would appreciate each of your answers. One, when we talk
about, as Mr. Frucher has, the consolidation of exchanges, is
the consolidation of exchanges, as we see that developing, is
that good for global competition? And the broader question is,
what is, in each of your opinions, the greatest challenge to
our markets when we factor in the global dynamic of options,
now that we have global competition for capital? The options
and opportunities are far wider and deeper than they ever have
been, and I suspect will continue to increase in the depth and
width of those opportunities for investors.
Mr. Thain, start with you.
Mr. Thain. Senator Hagel, thank you. If you look at our
foreign competitors today, they, in one platform, trade cash
equities, they trade options, they trade futures, they trade
certain derivative products, and they trade certain fixed
income products. So they have a much greater product
diversification, and they gain great advantage by being able to
trade those multiple products, both in terms of their earnings
power and their growth prospects, as well as increasing the
overall level of trading in their marketplace because of that.
And so that is probably the single biggest competitive
factor today, is that our markets are for the most part
fragmented. So the cash equity markets are separate from the
options market, which are separate from the futures markets.
And that is a competitive disadvantage to us.
The second factor is that some of our foreign competitors,
particularly Euronext and Deutsche Borse, are vertically
integrated. So not only do they run the exchanges, but they
also run the clearing, the settlement, and the custody
functions, and that gives them much greater earnings power, and
therefore greater financial power in the world.
In the United States in cash equities, the clearing and
settlement functions are in industry utility, DTCC and NSCC,
which is good from an investor point of view because they are
much lower cost, but is a negative from a competitive point of
view of having to compete with these global marketplaces.
I think that when we look at the world competitive
landscape, we will seek to be more product diversified because
we really cannot be more vertically integrated, and really
making sure that as our markets develop, that we increase the
overall level of activity by allowing, for instance, cash
equities and options to be traded in the same place. That will
both diversify our businesses, but also allow for more trading.
Senator Hagel. Thank you.
Mr. Greifeld.
Mr. Greifeld. I agree with a lot of what John said. I do
believe that our foreign competitors do not actually run on one
platform but they are under one holding company, and they are
all characterized by having monopoly positions within their
home market and can use that monopoly position to cross-
subsidize international efforts, and certainly we saw that
happen with Eurex coming to the United States.
But what I think will be our calling card and our ability
to compete is the fact that we are battle tested, we compete
very aggressively here in the United States, and our markets
are very efficient. So to the extent that we have foreign
competition, and we will, and it will be real, I would not sell
short the ability of the people at this table and others
representing the capital market system to be able to compete.
We are battle tested and we know how to win in this scenario.
Senator Hagel. Thank you.
Mr. Putnam.
Mr. Putnam. I will start with the greatest challenge. Those
are technology and capital. On the technology front, I believe
that we are going to get to a point where we can have
multiproduct, single platform type trading which will increase
demand for trading, as John pointed out, but it will take some
real innovation for us to get there.
On the capital front, both of those things actually lead to
what I think motivated these mergers, which is to get scale. As
Ed pointed out, the prices that we can charge have dropped
dramatically. We do have highly automated systems that we run
today, and if you just add volume to it, you can actually
survive. So technology capital leads to scale.
Senator Hagel. Thank you.
Mr. Nicoll.
Mr. Nicoll. I do think there is real benefit for
derivatives and cash markets to trade in the same system. I
think the derivatives markets are very positive. These are
markets in which people are exchanging risks in the world, and
it is very important that risks are held by the parties that
can most tolerate those risks, they are priced properly in that
sense.
Part of that, of having good derivatives markets is having
very low cost between the derivatives markets and the cash
markets because the higher the arbitrage costs of those
markets, the less efficient the derivatives markets are.
So, I think we will evolve toward one of the promises and
one of the real changes that I think will occur over the next
10 years, is you will see both derivatives and cash markets
trading over one platform because it is more efficient. We can
lower the cost of the derivatives markets and we can more
efficiently exchange risks than we can in the current scenario.
So that is one of the real promises of these mergers and
real promises of the electronic marketplace as a whole.
Senator Hagel. Thank you.
Mr. Frucher.
Mr. Frucher. Thank you, Senator. I agree with Mr. Greifeld.
The European competition, the big markets, Eurex and Euronext,
they do not trade on the same platform and we should not
confuse competition with a business structure. They, in fact,
have vertically integrated. That is the right business
structure. You should trade equities, options, and futures,
regardless of your size, under one roof and ultimately on one
platform. That is an aspiration that we really all, whether big
or small, have to achieve to be competitive, and actually go
ahead of the European competition. So the business structure,
vertical integration is necessary.
But the only way we are going to be competitive with those
European markets and those bigger markets is to have internal
competition.
I disagree, respectfully, with Jerry Putnam, who actually
has been a genius in developing his structure by merging with a
regional exchange. This is not a question of scale. If it was a
question of scale we should have been very happy with New York
having 82 percent of the market and Nasdaq having 100 percent
of its existing market. That was scale.
What changed them and brought them into the position to now
toast the ability to compete internationally, is the fact that
they had competition who pushed them forward technologically,
who pushed them forward in a heck of a lot of different ways.
And if we eliminate, as NMS can--and I believe it can--create
barriers to entry by taking what was a 20 percent standard to a
5 percent standard for new competitors in the marketplace, by
changing the formula so regional exchanges cannot get the tape
revenue, then Mr. Nicoll and Mr. Putnam who came to be at this
table through their affiliation with regional stock exchanges
who were able to use their tape revenue to lure them in is what
sustained it.
So the biggest threat is the elimination of internal
competition because duopolies will atrophy without internal
competition and make them unable to compete against the global
competition.
Senator Hagel. Thank you.
Mr. Chairman, thank you.
Chairman Shelby. Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman.
Before I get into the main area I want to talk about, I
want to go back to the question that the Chairman first asked,
which was the relationship between the mergers that we are
looking at here today, between the four companies that we have
here at the table, and Reg. NMS. And if I understood your
answers to the Chairman's question, it was that Reg. NMS had
nothing to do with these mergers, which is interesting to me
because there has been a lot of speculation about that, as you
know. There are those who were opponents of Reg. NMS, who said,
look, this is proof, soon as Reg. NMS was adopted, we see these
mergers and it is proof that Reg. NMS is going to crimp down
competition and Archipelago and Instinet saw that their future
was bleak, and so they had better merge. Others said, no, this
is proof that Reg. NMS is working just the way we wanted it to
work because there is too much internal competition and this is
starting to consolidate markets in the United States, and it is
just exactly what we should have happening, but all of those
explanations were that there was a connection between the
adoption of Reg. NMS and these mergers.
Now, is there or is there not?
Mr. Greifeld. I certainly believe that there is, and I
think that is what the panelists commented on, but it is not a
100 percent correlation. Clearly, the certainty that Reg. NMS
expressed to the marketplace made it more comfortable I think
for the participants to enter into very significant
transactions. The fact that the New York Stock Exchange would
have to go electronic to compete in their post-Reg. NMS world
gave me comfort to consummate the transaction with Instinet,
knowing that we will then be in a better position to compete in
that world.
Senator Crapo. Mr. Nicoll.
Mr. Nicoll. I think the question is, I mean much of the
debate centered around the trade-through rule and Reg. NMS. So
the question is, did the SEC's final trade-through rule force
these mergers? I do not believe that to be the case. They were
all being negotiated well before that had been decided one way
or another.
If the question is, does Reg. NMS create a competitive
environment which helped to spur these mergers, I agree that
the answer is yes. I mean, realize that these exchanges are
without two major sticks in the bundle of private ownership.
When you own your house, you get to exclude somebody from
coming in and sitting down in your living room. Neither the
Nasdaq nor the New York Stock Exchange nor INET, nor anybody up
here actually has that right. Anybody can come into our living
room because we cannot unreasonably discriminate in terms of
our competitors. So if the New York Stock Exchange wanted to
use its monopoly power under Reg. NMS, it cannot. It cannot
keep people out from its marketplaces.
Also any small person, the smallest competitor under
Regulation NMS, under the display rules, gets to participate in
the national market system, and this is a major spur toward
competition. I believe that that competition was a background
condition which helped to make the argument for further
consolidation in the marketplace. So to that extent I agree,
but I disagree with the notion that because of the trade-
through rules, that is what created these mergers.
Senator Crapo. Thank you. My time is running out, so for
the others who may want to jump in on this, maybe you can add
your comments to this next question, because it is related, and
that is, one of the rationales for Reg. NMS seems to be--and
Mr. Frucher has talked about this--the notion that there is too
much competition internally in the United States and that we
need to consolidate, and that will strengthen us for
international competition.
And I know that I have worded it in a way that might cause
it to be a little bit of a scary proposition, to be approaching
our market by saying we have too much competition and trying to
say it is better in the United States to have regulatory policy
that discriminates against competition. There is concern out
there about whether Reg. NMS does that.
Could you discuss with me--and any of you can jump in on
this--is that correct? Are we concerned that there is too much
competition or there are too many competitors internally, or
just what is it that is the rationale behind the notion that we
need to try to drive consolidation in our markets?
Mr. Greifeld. The one thing I would like to say is that
there is two types of competition, and Chairman Shelby kind of
touched on it before. We need in this market to have
competition between limit orders, and that is introducing a
time competition. And these mergers will definitely increase
the competition among limit orders to get executed. As you put
more limit orders in one place, you have increased competition
among limit orders, not so much against markets, so that is a
positive of these markets.
I think what Ed was speaking about, under Reg. NMS you will
have a lower barrier to entry. Now, Ed, Jerry, and myself have
spent a substantial portion of our careers as entrepreneurs,
and I would say here this is a best entrepreneurial activity,
to come in and try to compete against the largest players, in
that all you have to do is have one customer post one order and
the larger markets cannot trade through you at this point.
When you think about what Jerry and Ed accomplished under
the old rule set, it is a lot easier today for new competitors
to come in.
Senator Crapo. Mr. Thain.
Mr. Thain. Yes. I would reinforce what Mr. Greifeld said,
which is Reg. NMS, in its current form, encourages competition.
It protects competition. It protects small markets from being
ignored. It requires orders to be routed to whatever
marketplace has the best price, and if that is a little start-
up entity, that is who the order goes to. So it does in fact
allow for and protect competition.
I also do not agree that there is too much competition in
the United States. I think there is a lot of competition, and I
think that is good. I think that the consolidation is not being
driven by too much competition in the United States, that
consolidation is being driven by the desire to compete with
those global players that are in fact more diversified.
Senator Crapo. Mr. Frucher.
Mr. Frucher. Let me say that in order to compete, you have
to be there. And you cannot just look at Reg. NMS in isolation
and say, well, you know, Reg. NMS does in fact have features
that enhance competition. In fact, the single most important
part of Reg. NMS is that it in effect will hopefully spur the
two large behemoths to compete with each other, but I do not
believe economic entities do that unless they are forced to do
that by competition.
Yes, NMS makes it possible to have competition, but if you
add Reg. NMS with the concept release that the SEC has out, and
the various changes that they are compelling regional markets
to make, you price them out of business. So you will not have
competitors.
And in fact, I disagree, respectfully, with the notion that
NMS has made it easier for new entrants. Reg. ATS did in fact
open up the door for competition. This is ATS-2. We call it
NMS, but this cleans up some of the problems and unanticipated
problems created by Reg. ATS, and I do not want to get into
jargon, but effectively there were issues like tape shredding
and other kinds of issues that it needed to address and to
force cross-market debate.
But in fact when you drop the barrier from 20 percent to 5
percent, you are not enhancing the ability for somebody to
enter the market to be competitive. You are going up against
significant giants. The fact of the matter is that the two
successful ATS's who are sitting in the table, who are
celebrating their success by consolidation, that was made
possible by the fact that they were able to team up with the
regional exchanges. Take my word for it, regional exchanges are
endangered entities.
I am not looking for protectionist legislation. If we do
not come up with ideas to present to the SEC, then we do not
have a right to exist. But the process is almost monumental in
some instances to get rules.
I love the fact that Mr. Greifeld said that he is expecting
to get his rule through for it to become an exchange. Ask him
how long he has been expecting that rule to get approved? Four
and a half years. And I have submitted rules in which I have
been told, well, we will deal with your rule after we deal with
that rule. How do you compete?
Senator Crapo. Mr. Putnam, my time is way over. If the
Chairman will allow, Mr. Putnam wanted some response to this.
Is that all right, Mr. Chairman?
Chairman Shelby. Go ahead.
Mr. Putnam. I will be quick. In response to Sandy's point
about the behemoths not wanting to compete, today the New York
Stock Exchange has zero market share trading Nasdaq stocks. The
acquisition of ArcaEx will put it in a new competitive game,
competing with Nasdaq for trading Microsoft and Intel and those
securities.
Bob's deal with Ed is going to add an electronic component
to his marketplace for trading in NYSE-listed stocks. Both of
us traded everything going into this.
The last thing I would say is with respect to the trade-
through rule, if you looked at the New York Stock Exchange's
position with 80 percent market share in trading its stocks, no
trade-through rule would have allowed it to ignore every other
smaller marketplace, including ours, when it came to trading
IBM, and just simply under this rule they cannot, and I do not
see how that in any way restricts competition. Anyone can come
in, as Bob pointed out, with one order for 100 shares and going
forward you are going to have to trade with it. Thank you.
Senator Crapo. Thank you, Mr. Chairman.
Chairman Shelby. Senator Carper.
STATEMENT OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman.
Gentlemen, welcome. It is good to see you. Thanks for
spending your morning with us. I think maybe Senator Sarbanes
may have asked a question similar to the one that I am going to
ask, and I think maybe Mr. Thain and Mr. Greifeld had a chance
to respond to it. I am going to ask my neighbor from the north,
up in Philadelphia, if he would not mind responding to the
question. Let me just set the stage.
We have seen in the last month or so some interesting even
exciting changes in our Nation's market system. The New York
Stock Exchange is now merging with Archipelago. We have seen
Nasdaq announcing acquisition of I think it is Instinet Group.
These mergers are going to result in a need we note for a
change in regulation.
In this new environment, Mr. Frucher, let me just ask, do
you think it is critical that there be effective regulation to
keep our market strong and to protect investor confidence? If
you do not mind, just comment for the record on your views on
what the new regulatory structure of these marketplaces should
be. And finally, are you satisfied with the suggestions of
others, including maybe some we have heard here this morning?
Mr. Frucher. I think both marketplaces have responded very
well in terms of ensuring the integrity of their markets. I
think the most important point has to be made that a monopoly
in regulation is as bad as any other monopoly. You will simply
have an increase in fees and an increase in cost, and bringing
the FBI in to do local law enforcement is not exactly the best
model.
Self-regulation does not connote sole regulation. I think
the structure or the concept of the structure that we have now,
which is self-regulation of your marketplace and a regulator
that sits over them, is an effective structure. It just has to
be staffed adequately, it has to be funded adequately, and it
has to be made to work.
I think Nasdaq chose to divest itself, or NASD chose to
divest itself of Nasdaq and separate themselves completely. New
York is approaching this in a very intelligent and systemic
way. Gerry Putnam, when he made his deal with the Pacific
Exchange, created a very good structure, where he separated the
regulation from the operations of the stock market. So, I think
the key here is that you can have a diversity of regulatory
structures. It is not a sole structure. They all have to be
funded. They all have to be vigilant. But one single regulator
is not a good structure.
Senator Carper. Thanks. Anybody else have a comment on
this? Yes, sir? He took your name in vain, is it?
Mr. Putnam. It would not be the first time.
[Laughter.]
I believe in competitive regulators for the same reasons
that Sandy pointed out. If you do not have competition among
the regulators, you are going to see costs rise and the quality
of the service diminish.
That said, a marketplace doing its own regulation, I mean
the brand is about quality regulation within your marketplace.
So whether it is done by a completely separate regulator like
our relationship with the PCX or one that is a little bit
closer like the one that the New York Stock Exchange is
proposing, each market is going to really have to, especially
in the information age and the willingness of the press to
report on any bad deeds among regulators, it is a process that
I think is going to work regardless of how it is structured.
Senator Carper. I apologize for not being here sooner. I
have three Committee hearings going. You are probably wondering
where is everybody? We have a lot of things. We are trying to
be in three or four places at once, so just bear with me on
this question. One of the great advantages for having a panel
like this, smart, well-informed people, is to get a diversity
of opinion and find out where they disagree, but maybe even
more importantly, to find out where they agree. Let me just ask
you for a take-away for me from this hearing. Is it Nicoll,
your last name Nicoll?
Mr. Nicoll. Yes.
Senator Carper. Mr. Nicoll, what would be a good take-away
for me with respect to where do you all agree?
Mr. Nicoll. I think we all agree that Regulation NMS has
moved us forward. We do not agree with every aspect of it, but
we agree that finality has enormous value to all of us and that
the SEC has done all in all a good job at addressing a very
comprehensive, very difficult issue, and making decisions about
it.
We all agree that there are many procompetitive elements to
it. Sandy is concerned about some elements to it, but we all
believe that it is pretty competitive, and I think we all agree
that competition going forward is going to continue, and that
it is a good thing. And I suppose one of the things that we
could all agree on is that we do not know the future, and if we
come back 5 years from now or 2 years from now and we do find
that competitive forces are not continuing to shape the
innovation in the marketplace, that we might have to take
another look at it. But right now it looks to us like all in
all it is a pretty procompetitive environment out there.
Senator Carper. Mr. Thain and Mr. Greifeld, do you agree
with anything that Mr. Nicoll just said about your----
[Laughter.]
Mr. Thain. I basically agree with everything that Ed said.
Mr. Greifeld. I agree we do not know the future.
Mr. Thain. Yes. I certainly agree that Reg. NMS, as it was
passed, is a good rule and we want it to stick, and we do not
want to disrupt it because it is good for the marketplace, it
is good for investors, it is good for competition, and it is
also good to know what the answer is.
I think all of us collectively are happy with the rule. Not
everyone is happy with every single aspect of it, but people
are generally happy with the rule and want it to stick, so that
is absolutely one important take-away.
The only thing that I would add is I think there is pretty
clear consistency that we do have to worry about global
competition. We have to worry about the competition among the
players outside the United States that are more diversified,
that do have a broader product mix, that do have a different
business model, particularly being vertically integrated, and
who have great financial strength both in terms of earnings
power, market capitalization.
Senator Carper. Thank you.
Mr. Greifeld. I would agree with that. Just to kind of make
the point, on my stock watch screen at my office I have up the
Chicago Mercantile Exchange, the International Securities
Exchange here domestically, in addition to, obviously, ArcaEx
and Instinet, and internationally, I watch every day what is
happening to the LSE, Euronext, and Deutsche Borse. So that is
what we look at. That is what we know where the competition is
coming from.
Senator Carper. Thank you all.
Chairman Shelby. Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Mr. Chairman, thank you.
I apologize to all of the witnesses, particularly our two
New Yorkers, Mr. Thain and Mr. Greifeld, for being a little
late. It is a very busy day, as you have probably heard.
I want to thank you, Mr. Chairman, for holding this
important hearing. I think we are in a totally different place
than we were last time we discussed this. Regulation NMS has
passed, and I think, in a sense, a certain wisdom of NMS has
been shown by developments since then. We are going to have
some real competition in terms of major players, two at least,
who are going to be up and down the line trading stocks in ways
that their customers want them to trade, and I think that is
all to the good. As somebody who is worried about the liquidity
of the markets and the depth, and worried about fragmentation,
and yet like every American, I love competition, I do not think
you can draw a better structure to try and see how this works.
So, I am very laudatory of what has happened so far in the
markets, as somebody who cares about them both parochially--New
York's point of view--but also in a more catholic way, because
we care as Americans and as citizens of the world about having
deep markets, as Mr. Greifeld mentioned. They are always
looking over their shoulder now and if we fall here in America,
those markets will go before you can say whoopie.
I am excited about the markets. I think they are going to
promote competition. They are going to be orderly, but they are
going to be transparent, and they are going to be liquid, and I
think both mergers have ended up being a very good idea as
well, which will fortify both of those markets.
Now we have a few other things we have to look for, NYSE's
hybrid. I think that is excellent, and Mr. Thain has really
performed close to miracles in a very difficult situation. We
have a tough job. I guess one of the few jobs that might be
even tougher is right now to be head of the NYSE with all the
pushes and pulls in there, and I want to say I think you have
handled it very well. You know, I think we are in pretty good
shape. I think we can watch and see what happens. We have to
make sure that things roll out as people appear, and I also
want to compliment--he will be here tomorrow--Chairman
Donaldson, who I think took the bull by the horns, and----
Chairman Shelby. Senator, it is past 11:30. There has been
an objection under the rules to us meeting by a Democratic
leader, and so we are going to have to----
Senator Schumer. I would ask unanimous consent to submit my
questions in writing?
Chairman Shelby. Without objection, so ordered.
I want to thank the first panel for being here.
More than that, I want to thank the second panel, and note
that we have to recess under the rules, but your testimony will
be made part of this hearing record in its entirety, your
written testimony.
We are in recess according to the rules of the Senate.
[Whereupon, at 11:33 a.m., the Committee was recessed.]
[Prepared statements supplied for the record follows:]
PREPARED STATEMENT OF SENATOR WAYNE ALLARD
I would like to thank Chairman Shelby for holding this hearing to
discuss the Securities and Exchange Commission's recently adopted
Regulation NMS and other recent developments in the U.S. equities
markets.
I applaud the Chairman and Ranking Member's commitment to examining
this proposal, as it has broad reaching implications for the way in
which the U.S. equities markets will operate going forward.
In fact, we have already seen some of the implications of this rule
in the New York Stock Exchange's recent acquisition of Archipelago, and
the Nasdaq's acquisition of Instinet.
I have been encouraged by the haste of these recent transactions
that healthy competition will continue to thrive among U.S. market
centers.
Reg. NMS is likely the most substantive SEC proposal many of us
have seen during our tenure as Members of this Committee. It also
generated a great amount of debate amongst industry participants,
Commissioners, and even Members of this Committee.
The U.S. markets will now operate under a new regulatory framework
that I am hopeful will address the needed changes resulting from
technological developments in the markets.
I would like to thank our witnesses for appearing before the
Committee this morning. I know this has occupied a great amount of your
time and energy over the past several years. I look forward to your
testimony.
----------
PREPARED STATEMENT OF SENATOR MIKE CRAPO
I am disappointed and troubled that the Commission was unable to
proceed with one voice on Regulation NMS (National Market Structure).
Instead, a divided Commission, with deeply held convictions both for
and against the rule, voted 3 to 2 in favor of the 500 page rule.
Although Regulation NMS covers four primary topics, the majority of
the debate centered around the trade-through rule. The lack of
consensus inside or outside the commission on the need for a trade-
through rule at all, let alone extending the trade-through rule, raises
many red flags
Additional red flags were raised due to the fact that there was
very little proof that this was something required in the markets.
According to the SEC Office of Economic Analysis, approximately 2
percent of all trades on Nasdaq and NYSE were traded through in 2003
and the majority of trade-throughs only trade-through by a penny or
two.
These numbers are also curious since the NYSE market currently has
a trade-through rule, while the Nasdaq market does not. These numbers
do not demonstrate to me that the market is not working and that more
regulation is the answer. I am interested in whether our witnesses
believe this rule will substantially stop trade-throughs and what will
be the cost of implementing this rule.
While investors clearly care about price, other attributes like
anonymity, trade size, and execution speed also factor into an
investor's trading decisions. An investor might be willing to forgo
best price, at times, if that anonymity, or some other factor, helps
him or her to protect a valuable trading strategy, for example.
It is unfortunate that the Commission decided against developing a
more consensus-based alternative to Regulation NMS, rather than forcing
such divisive mandates with so many experts unconvinced of the
benefits. A credible alternative was available that would have allowed
for more evaluations and then a future Commission vote to determine if
the rule should apply to the Nasdaq market.
Thank you, Mr. Chairman for holding this important hearing, and I
look forward to hearing the testimony of the panels.
----------
PREPARED STATEMENT OF JOHN A. THAIN
CEO, New York Stock Exchange
May 18, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee. I am John Thain, Chief Executive Officer of the New York
Stock Exchange, Inc. Thank you for inviting me to participate in
today's hearing. I am grateful for the opportunity to speak to you.
Mr. Chairman, we appreciate your Committee's leadership and
oversight of our national market system. We view our Nation's financial
markets from different vantage points, but I believe that our
respective responsibilities unite us in a common challenge: Put simply,
how can we best serve the interests of U.S. investors and issuers, and
how can we strengthen the competitive position of U.S. markets in the
world.
For its part, the New York Stock Exchange stands at the center of
our Nation's financial system. We are a $20 trillion market
facilitating the capital-raising process in the Nation's ongoing quest
to create new jobs and to fuel strong and sustained economic growth.
Our leadership was built upon a commitment spanning over two centuries
to gain the confidence of our customers. Today, they include America's
90 million investors, the institutional community, market
professionals, and over 2,700 of the world's leading corporations.
Since I assumed the position of Chief Executive Officer last year,
the New York Stock Exchange has initiated a transformation that has
reached into every corner of our business. Following a difficult
period, we are doing everything possible to restore trust in the
Exchange and to better serve our customers. Today, we have an entirely
independent board, with the exception of me, a new governance structure
with regulation independent from the business side, and new and higher
levels of disclosure and transparency. In short, we are on the right
track.
At the same time, we have renewed our commitment to deliver the
highest standards of market quality. Day-in, day-out, customers can
expect that the New York Stock Exchange will provide them with the
deepest liquidity, the lowest volatility, the tightest spreads and the
best prices. We offer the best price to customers in stocks of our
listed companies 89 percent of the time. That we are able to provide a
market of this caliber for listed securities significantly enhances the
position of U.S. financial markets in the global competition for
capital.
We have built our reputation upon a great tradition of service.
However, what we have not offered to a sufficient degree is speed and
innovation. Speed is important to a segment of our customers,
particularly on the buy-side. So, too, is innovation, by which I mean
providing our customers more options on how they can trade, and from
which products they can choose.
Just as importantly, we recognize that only by offering customers--
investors and issuers alike--a better marketplace, and only by
providing them with more choices, can the New York Stock Exchange
strengthen its ability to grow and to compete both domestically and
globally.
Meeting these twin challenges--to provide the world's best
marketplace for customers, and to strengthen the position of U.S.
capital markets in the world--defines and drives the mission of the New
York Stock Exchange.
This is why we are building the Hybrid market, to offer investors a
choice between the sub-second speed of electronic trading, and the
opportunity for price improvement that distinguishes the auction
market.
This is why we are taking the historic step to become a public,
for-profit exchange, by merging with Archipelago, an outstanding,
entrepreneurial company that is pioneering leading-edge platforms and
products.
Our initiatives to embrace electronic trading and provide investors
with the ability to choose the way their trades are executed are very
much complementary with the value that the specialists and floor
brokers will continue to provide investors and our listed companies.
Finally, this is why we urged that Regulation NMS (Reg. NMS) set as
its paramount purpose the protection and promotion of the interests of
U.S. investors and U.S. competitiveness, while modernizing the rules
for America's 21st century national market system.
I will touch briefly on each of those topics. Let me begin with
Reg. NMS.
Regulation NMS
Mr. Chairman, the regulatory environment governing our market and
all of the U.S. securities markets is undergoing dramatic change. In
adopting Regulation NMS on April 6, the Securities and Exchange
Commission established rules that will strengthen the protection of
U.S. investors, while fostering robust competition and innovation in
the U.S. markets.
The rule accomplishes these goals in the right way, not by favoring
one marketplace over another, but, rather, by strengthening competition
among all markets to create the best possible national market system
with a deep pool of liquidity for all investors, for all issuers, and
for our economy.
In addition, the process was carried out in a manner that was open,
thorough and solicitous of all views. The decision follows over a year
of hearings and multiple rounds of Congressional testimony, as well as
comments from thousands of investors, leaders, and members of our major
equity markets and financial services industry.
The centerpiece of the regulation, which is strongly supported by
U.S. investors, is the modernization of the trade-through rule.
We believe that the new trade-through rule will advance the cause
of three critically important national goals:
It will be proinvestor; it will strengthen the integrity of our
markets; and, it will enhance the competitiveness of U.S. markets
globally.
First, the new rule will make certain that an investor's order,
regardless of the market it is sent to, has the right to be executed at
the best price.
It will require that intermediaries, such as brokerages and mutual
funds, find the best price for investors, either by selling their
shares at the highest possible price or by buying them at the lowest
possible price.
This means that any of this Committee's constituents--from Toledo
to Tucson, and from Atlanta to Anaheim--can invest and trade on an
equal footing with the largest institutions. Their displayed limit
orders cannot be traded through.
Second, as the Investment Company Institute has observed, the new
rule will increase investor confidence in the markets by helping to
eliminate an impression of unfairness that is created when an
investor's order executes at a price worse than the displayed quote.
Third, the new rule will advance U.S. competitiveness. As more
investors are encouraged to display their limit orders, collectively,
they will have the effect of deepening liquidity and invigorating the
entire capital formation process.
In the past, critics charged that the trade-through rule inhibited
innovation and favored the New York Stock Exchange by failing to
distinguish between fast and slow markets. They pointed out, and with
some justification, that prices can change in the time that it takes a
trade to occur in the auction market.
The Securities and Exchange Commission has seen fit to address that
criticism directly. It has updated the old trade-through rule, and the
new rule will protect only prices that are available for immediate
electronic execution.
This is a significant change that will serve to promote greater
competition among all markets. Just as important, the onus is now on
the New York Stock Exchange to make our Hybrid market a reality, a
responsibility we welcome.
Mr. Chairman, we are ready for the challenge. We are moving forward
toward completion of the Hybrid market and we hope for expeditious
approval of our proposal by the Commission.
Our goal is to offer investors the choice of two investor-friendly
paths--an immediate, electronic and anonymous execution, or the
possibility of price improvement that is the hallmark of specialists
and floor brokers working in tandem in the auction market.
Our floor offers superior market quality, and demonstrates daily
its ability to out-perform purely electronic exchanges during opens and
closes, order imbalances and unforeseen, outside events. I am speaking
of the value of human judgment in an auction market process. It is this
market model that generates real price discovery, and creates the best
prices on 89 percent of all trades compared to other markets that
compete for order flow in NYSE-listed stocks.
Stocks that have switched from the Nasdaq to the NYSE exhibit
markedly improved executions. For example, 39 stocks that we reviewed
saw their price volatility cut by half, their quotes narrowed by over a
third and their execution costs cut in half. In addition, the SEC
staff's analysis found that ``transitory volatility is significantly
higher for Nasdaq stocks than for NYSE stocks,'' noting that ``retail
investors, in particular, tend to be relatively uninformed concerning
short-term price movements and are apt to bear the brunt of the trading
costs associated with excessive transitory volatility.'' These
statistics translate into real savings for investors who buy these
stocks, and real value for companies seeking to raise capital in a
cost-efficient manner.
Finally, Mr. Chairman, now that the SEC has ensured comparable
trading conditions for speed, we believe that there can be no remaining
justification for giving investors anything less than the best price.
In sum, we strongly support the new market-wide trade-through rule.
So, too, does a broad base of investor groups that represent millions
of investors and investor companies.
They include the Investment Company Institute, the Consumer
Federation of America, Vanguard, T. Rowe Price, Bank of New York, and
the National Association of Investment Clubs (NAIC).
A typical viewpoint was expressed by NAIC, which represents over
21,000 investment clubs. NAIC stated that the new trade-through rule ``
. . . will ensure that investors' quotes will not be compromised when
sending quotes to the markets of their choice. This will produce
tighter spreads, improve liquidity and provide equal treatment of all
investors who seek a fair and level playing field--while ensuring
market competition based upon best price.''
We believe the new rule will empower investors and remove barriers
to innovation. We believe that the U.S. markets now have the
opportunity to become more robust, dynamic, competitive and efficient
than ever before in our history.
Now, let me conclude with comments on the proposed merger between
the New York Stock Exchange and Archipelago.
Consolidation in the Securities Markets
While the SEC has streamlined the rules and structure for our
national market system, it is up to U.S. markets themselves to respond
to a rising global challenge. The players must now perform on a new
playing field.
On April 20, I announced the decision of the New York Stock
Exchange to merge with Archipelago, and to become a public, for-profit
marketplace. As I stated then, we are in a competition with great
stakes for the future of U.S. financial markets.
Today, equity and capital markets are global.
Competition for capital is global.
Stock exchanges across Europe and Asia today are increasingly well-
capitalized. Most are public and for-profit companies, and many have
very high profit margins. And many have set their sights for further
growth on the United States, seeking to take U.S. market share from
domestic U.S. exchanges.
Mr. Chairman, we believe that to sit passively would be to
surrender to the competitors who challenge us. This is not the course
that we choose to follow. We believe that the merger of the New York
Stock Exchange with Archipelago will help us compete head-to-head with
these global players. We believe that consolidation among other market
centers will also improve the competitive position of the U.S.
financial system. For our part, we are determined that our new company,
the NYSE Group, will become a world-class competitor that can maintain
and, indeed, enhance our leadership, in every possible respect. This
will begin, as I noted earlier, with providing customers greater choice
on the type of execution venue that they prefer.
The merger with Archipelago promises to add to and enrich customer
choices by introducing new platforms for new investment products that
will include equities, options, exchange-traded funds (ETF's), and
bonds.
Let me point out that these products not only present us with
significant growth opportunities, but also give retail investors
valuable investment opportunities. Investors in some of these products
must currently pay higher spreads and transaction costs because markets
are fragmented and inefficient. Through our merger, the New York Stock
Exchange will provide a platform that is well suited to offer these
products efficiently and expeditiously to our customers. We believe
this will be a great benefit to our customers, America's investors.
ETF's are attractive to retail investors because they provide the
benefits of diversification with generally very low fees. In the fixed
income area, there is little transparency in that market; by growing
this platform through our merger, we expect to increase transparency
and reduce spreads for investors. And our addition of an options
platform will further increase product and market choice for investors.
We are confident that a more robust and innovative business model will
be good for our customers. As a public company, we look forward to
having our individual investors, institutions, listed companies, as
well as our members all participate in our success and our growth as
stockholders. And as a stronger, more competitive exchange, the NYSE
Group will fortify the U.S. position globally at a time when the
Deutsche Borse, Euronext, and the Toronto Stock Exchange are offering a
multiplicity of products, attempting to gain a foothold in the United
States, and looking hungrily to seize further advantage.
With its new, for-profit status, the NYSE Group will increase its
capability to invest in future growth to a much greater degree than we
had as a not-for-profit entity.
In addition, we anticipate that our merger will boost competition
in the trading of over the counter stocks and in the listing of smaller
companies that do not yet meet the New York Stock Exchange's listing
standards.
Let me assure this Committee that the new structure of the NYSE
Group will not only protect but also strengthen the independence and
initiative of our regulatory functions. The holding company will have
separate subsidiaries for the NYSE and Arca markets. These markets will
continue to operate as separate markets with separate listings and
offer different trading platforms. The structure we will propose for
the regulatory function for the two markets will remain inside a not-
for-profit, not publicly traded entity providing reliable, independent
regulation. We envision that the new Board of the regulatory entity
will consist of independent members of the NYSE Group Board, along with
several other independent directors with no affiliation with the NYSE
Group holding company. Preserving the regulatory responsibilities in a
separate but related entity will strengthen its independence, while
retaining proximity to the business it is regulating. That proximity,
together with the unique expertise our regulatory group has developed,
will enable it to continue performing effectively.
It is worth noting that the consolidation in the financial services
arena that has taken place since the approval of Reg. NMS illustrates
two points. First, the rule's new best-price policy applied across all
markets is the right one: The new NYSE Group will be a market that
caters to customers of both over-the-counter stocks and listed stocks.
There is no reason that our customers should receive different
protections based on which stock they happen to be trading in. Under
the new rule, all our customers will receive the same protections.
Second, the certainty created by the final rule enabled the markets
to take steps to innovate and grow.
Conclusion
Mr. Chairman, this is an important time for U.S. financial markets.
New competitors have arisen with broad product mixes, diversified
earnings streams, and access to public capital. They seek to challenge
the United States as the global leader in financial markets. We must
respond to this challenge--decisively, wisely, and effectively.
The New York Stock Exchange is eager to take the next, critical
steps to help the United States retain its global leadership. We will
ensure that our customers are advantaged by the highest market quality,
the best investment executions and the greatest, possible choice in
investment products. The result, we are confident, will be a win-win--
for investors in U.S. markets, and for U.S. markets in the world.
Thank you again Mr. Chairman, for inviting me to testify before
this Committee. I look forward to responding to your questions.
----------
PREPARED STATEMENT OF ROBERT GREIFELD
CEO and President, The Nasdaq Stock Market
May 18, 2005
Chairman Shelby, Senator Sarbanes, and distinguished Members of the
Senate Banking Committee, thank you for inviting me to discuss
Regulation NMS and the recent industry developments.
Regulation NMS
When I last appeared before this Committee on July 21, 2004, I
started my testimony by stating that: ``[t]he trade-through rule is the
primary obstacle to competition amongst our Nation's equity markets,
and competition is the driving force in making the U.S. markets the
strongest in the world, the best for investors large and small, and
accountable to the public.'' I also stressed that the markets had
uncovered a fundamental truth: ``Today electronic trading is best for
investors.''
After well over a year of hearings, discussion, and comments, on
April 6, 2005, the Securities and Exchange Commission (the SEC or the
Commission) approved Regulation NMS. Regulation NMS replaces the old
ITS trade-through rule that protected the listed market from
competition with a new trade-through rule which will be applied
uniformly across all markets to protect a market's top-of-the-book
quote if it is automatically accessible. Regulation NMS also includes
needed restrictions on sub-penny trading, establishes uniform market
access rules that will insure that all market participants can access
each others' quotes, and updates the formula used to allocate market
data revenue amongst the SRO's.
I believe that Regulation NMS does remove a substantial obstacle to
competition amongst our Nation's equity markets and establishes
incentives for floor-based markets to move to more electronic trading.
The new rule will bring benefits to investors and it will enhance the
ability of our Nation's capital markets to face growing international
competition. Nasdaq commends the work of the SEC as well as the
constructive oversight of this Committee and the entire Congress
throughout the rulemaking process.
As you know, Nasdaq, joined by many others representing both
industry participants and investors, urged the Commission to eliminate
the trade-through rule entirely. Our position reflected, and still
reflects, our belief that market forces and best execution should serve
as the bedrock principles in the securities markets. We are proud of
the market quality experienced by investors every day on the Nasdaq
Stock Market, which does not have a trade-through rule. Given our
experience and the costs of implementation, we believe the extension of
the rule to Nasdaq imposes a tax on market participants.
Nonetheless, although Nasdaq does not believe the application of a
trade-through rule to Nasdaq is necessary given our highly efficient
electronic market, we are pleased the new trade-through rule approved
by the Commission will force floor-based markets to follow the path to
automated trading that has been blazed by Nasdaq since 1971.
Specifically, the Commission's decision to allow investors to make
distinctions between fast and slow markets will force manual floor-
based markets to automate in order to compete effectively with the
faster electronic exchanges. The rule acknowledges the value of speed
and certainty of execution, and allows electronic markets to compete
for the trading of NYSE-listed securities. Manual markets will no
longer be the weak link in the national market system, slowing down
faster markets while humans--some with a distinct time and place
advantage on the floor--attempt to execute orders.
As you know, the Commission has announced that the rule will be
rolled out in a limited manner next April and is not scheduled to take
full effect until June 2006, so that markets have time to make and test
the necessary system changes. Even before Regulation NMS was approved,
however, the NYSE was compelled by market pressure to move to modernize
their market structure, and they developed and proposed an electronic-
floor hybrid model. Now, as a result of Regulation NMS, the American
Stock Exchange and the regional exchanges have strong incentives to
modernize their markets and, if they proceed, are poised to emerge as
competitors to both Nasdaq and the NYSE in the national market system.
There is no doubt that this will be good for competition and for
investors.
Nasdaq Acquisition of Instinet
On April 22, 2005, Nasdaq announced the acquisition of Instinet
Group and, concurrently, entered into a definitive agreement to sell
Instinet's Institutional Brokerage division to Silver Lake Partners. As
a result, Nasdaq will own only Instinet's electronic communications
network, INET.
This deal proceeded from a public, competitive process. Reuters,
the parent company of Instinet, announced in November 2004 that it was
selling Instinet. We understand that several industry participants
considered bids for Instinet. As early as January 25, 2005, as part of
a registration statement filed at the SEC, Nasdaq disclosed that we had
submitted a nonbinding proposal to acquire ``a major ECN.''
Nasdaq acquired INET to enhance Nasdaq's trading environment to
serve investors better and respond to the increasing competition across
the global capital markets. It is a synergistic deal that will create a
fast, high-performing, low-cost single platform for trading U.S.
securities. Given the compatibility of the two platforms, the real-time
market surveillance by a well-respected regulator, the NASD, and
Nasdaq's proven technological reliability, this transaction will
position Nasdaq to compete more effectively with other U.S. and
international market centers. The acquisition will result in more cost
efficiency and improved quality of execution in our market--qualities
that today's individual and institutional investors demand. Nasdaq will
continue to innovate and also will have the ability to tap new
opportunities in other asset classes.
The combination of Nasdaq and the INET ECN will bring technology
enhancements that optimize our electronic trading platform. It will
provide greater cost efficiencies to the benefit of investors and
improved quality of execution. Nasdaq will be able to offer investors
increased limit order interaction. In addition, the INET transaction
will allow Nasdaq to continue its market innovation leadership. We will
offer faster time-to-market on new products and services that will
benefit market participants, investors, and our listed companies.
The efficiencies of one integrated platform and single router will
provide other benefits as well. Critically, it will enable Nasdaq to
maintain its status as the low cost provider for execution services for
equities. In addition, by constantly improving and innovating for the
benefit of investors, Nasdaq will continue to provide a superior
listing venue for public companies and their investors.
Dynamic Marketplace
The rapid structural changes sweeping through our Nation's
securities markets are being propelled by a convergence of several
forces, some of which are regulatory in nature, while others are
market-driven.
The principal regulatory force is Regulation NMS. Its most direct
impact--greater competition in the trading of NYSE securities--will be
felt when the rule takes effect. However, the indirect impact of
Regulation NMS is being felt already, as the NYSE is poised to become a
competitor in the trading of Nasdaq securities. That, combined with the
expected rise in the trading of Nasdaq securities by the regional
exchanges, which Regulation NMS will serve to encourage, creates a
national market structure in which market centers no longer specialize
in the equities of a single market. Rather, the NYSE will trade Nasdaq
as well as NYSE securities; Nasdaq will be able to more effectively
trade NYSE securities; other exchanges and market centers will trade
Nasdaq-, NYSE- and American Stock Exchange-listed equities; and large
market makers will likewise internally match trades in all of these
securities.
Another important force is rapid globalization of capital markets.
Companies around the world are seeking access to capital, and stock
markets are the key facilitator in this process. When a company in
China or Russia seeks to bring capital from outside its country's
borders, it typically considers the major markets in Europe as well as
in the United States. As such, we are now competing not just with the
U.S. exchanges but also, for example, with the Europeans. Enhanced
competition for listings also encourages competition in the quality of
trading, as companies seek to list in a country and a market that
offers the best trading for their securities.
Finally, it is increasingly necessary for stock markets to be
mindful of competition from venues that trade derivatives and other
instruments that are not equity securities. If trading quality in
equities is inferior or the costs of trading are relatively high, then
some investors may prefer to focus on the types of securities that
trade more efficiently. Again, all investors are potential winners in
this competition.
Improved Regulation
Recent developments in the marketplace offer the opportunity to
improve and make more efficient the regulation of the securities
markets. First, as part of the NYSE-Archipelago transaction, the NYSE
announced their intention to further separate its regulatory function
into a nonpublic, not-for-profit entity governed by an independent
board of directors. Nasdaq supports separating the regulator from the
regulated market and, in fact, once the Commission approves our
application to register as an exchange, Nasdaq will completely separate
from our regulator, the NASD.
Broker-dealers who operate on both the NYSE and Nasdaq often become
members of the NYSE and the NASD. Accordingly, they face duplicative
regulation and costs associated with the regulation. Some companies,
like the Charles Schwab Corporation, are moving to eliminate this
duplication by dropping their NYSE membership.
Last November, the Commission published a concept release
concerning the self-regulatory system of the securities industry. One
of the options offered by the Commission in its concept release is the
establishment of a hybrid regulator model which would simplify and
streamline the current regulatory model. Under this alternative, a
market neutral single self-regulatory organization would surveil and
enforce rules related to broker-dealers nonmarket specific activity,
such as their financial condition and registered representative
representation, while SRO's that operate markets would regulate broker-
dealers' activities within those markets.
This approach would offer substantial benefits to broker-dealers
and investors alike by eliminating the costs associated with
duplicative member regulation. At the same time, each market would be
in the best position to surveil activity on its own systems and would
therefore retain authority over market regulation. The quality of
market regulation, moreover, could be enhanced through adoption of
intermarket surveillance and audit trail enhancements, and through
targeted Commission efforts to promote greater uniformity in SRO market
rules in areas where problematic disparities exist. Accordingly, Nasdaq
supports the proposal in the SEC's concept
release on SRO governance for a single regulator to administer broker-
dealer membership rules.
Nasdaq Exchange Registration
Finally, even with Regulation NMS codifying uniform rules for the
trading of all equities, there is an additional element necessary to
achieve a level playing field--granting Nasdaq status as a national
securities exchange. I am pleased to report that the Commission has
been working closely with us on our exchange application and we are
hopeful that the application will be approved shortly. A Nasdaq
exchange will be good for competition, good for the regulatory
framework, good for market quality and integrity, and, ultimately, good
for investors.
PREPARED STATEMENT OF GERALD D. PUTNAM
Chairman & Chief Executive Officer Archipelago Holdings, Inc.
May 18, 2005
Good morning Chairman Shelby, Ranking Member Sarbanes, and other
distinguished Members of the Committee. As Chairman and CEO of
Archipelago Holdings, Inc. (Archipelago) and the Archipelago Exchange
(ArcaEx), and on behalf of our shareholders, directors, and employees,
it is a privilege and a great honor to be provided the opportunity once
again to testify before the Committee. I request that my written
statement on today's topic, ``Regulation NMS and Recent Market
Developments,'' be submitted into the record. Thank you.
A Tale of Two Rivals
Let me take you back for a moment to the events of April 20, 2005.
For much of that day, the focus of the business news was analysis of
Yahoo's first quarter financial results and reporting on market jitters
brought about by volatile oil prices and interest rates. In Chicago,
the Cubs' victory over the Reds the night before lifted their record to
an even .500, although our Cubbies have unfortunately backslid since
then. Our White Sox, however, still remain the best team in baseball!
Later on April 20, of course, something else was about to be
announced, something very big: At exactly 4:30 p.m. (EDT), two rivals
decided that the world had changed and that the time had come to join
together to meet increasing demands of investors and issuers. It would
be akin to the New York Yankees and the Boston Red Sox agreeing to put
down their bats and balls, terminate their blood feud, and join forces.
Two days later, on April 22, other famous rivals decided to follow
suit, as if the Alabama Crimson Tide and Auburn Tigers announced the
end of the Iron Bowl rivalry. (I can see Senator Shelby with head in
hands exclaiming, ``No, it can't be true, it can't be . . . .)
Like my fictional examples, I am sure that many people were quite
surprised to hear the news of the respective intentions of the NYSE and
Archipelago on April 20 and Nasdaq and Instinet on April 22 to merge.
What's next: The Wall Street Journal endorsing Democrats and The New
York Times endorsing Republicans?! What in the world is going on here?
Well, let me do my level best to provide some insight on the strong
business logic that underlies both transactions.
Before doing so, however--if I may for a moment--I would like to
symbolically extend my hand in warm congratulations to Bob Greifeld and
Ed Nicoll on their announcement to merge Nasdaq and the Instinet ECN.
ArcaEx--and before it, the Archipelago ECN--has been knocking heads
with Nasdaq and Instinet for years now, and we have the battle scars to
prove it. Both Nasdaq and Instinet under Bob's and Ed's respective
leadership have commanded my personal respect in what has been and
continues to be a ferociously competitive, fast-paced, and dynamic
business. Upon consummation of these mergers, we would expect even
greater competitive vigor from the combined Nasdaq-Instinet.
Congratulations again to both of you.
A Common Vision Built On A Simple Premise
Let me take you back to last winter, when John Thain and I began
talking about a potential business combination between the NYSE and
Archipelago. I must frankly admit that I was a little skeptical
entering our discussions; not because of John, mind you, who I have
known for several years now and who I regard as a very astute business
man. Rather, I perceived differences between the NYSE and ArcaEx that I
was not sure could be overcome. I will not sit here and pretend that
Archipelago has not had some disagreements with the NYSE over the
years. And, as you know, we have not been shy about expressing our
displeasure when the NYSE took actions that we did not like. That said,
what I quickly discovered from my conversations with John is that he
and I share a common vision that is built on a simple premise. Our
vision: To build upon the respective strengths of the NYSE and ArcaEx
to develop a world-class exchange that provides topnotch services to
U.S. and international consumers of execution, data and issuer
services. The premise: To listen
intently to customers and respond with the highest quality products and
services with choices that fit the needs of different kinds of
customers. At times, and to their detriment, this simple premise has
been ignored or forgotten by many business leaders. We promise not to
forget. Today's global consumer, who demands excellence and flexibility
from exchanges, will not let us forget.
Starting from our common vision, the NYSE and Archipelago
ultimately negotiated and announced a merger which, upon consummation,
will result in a new entity called the NYSE Group, Inc. (NYSE Group).
The merger will combine the world's largest, most liquid, most reliable
equity marketplace in the NYSE with the most successful totally open,
fully electronic one in ArcaEx. We believe the combination will deliver
high quality products and services to investors, traders, and issuers,
and create long-term value for NYSE Group shareholders as a public
company. It will allow us to provide diverse platforms for the trading
of listed and OTC securities, options and other derivative products,
including ETF's, under a single umbrella, which is what customers want.
Further, in my view, this combination will:
Strengthen America's leadership in financial services and
boost our global competitiveness in capital markets;
Better serve investors, traders, and issuers;
Maintain the highest standards of integrity, transparency, and
disclosure; and,
Produce efficiencies, drive innovations, and create new
business and revenue opportunities.
Without wanting to sound overly dramatic, I believe the merger
between the NYSE and Archipelago is a bold one, but 21st century
competition requires boldness. The merger represents the best of both
worlds: Respecting and taking the best from the past while embracing
the future. It marries the 24 entrepreneurs of the Buttonwood Era with
the Archipelago entrepreneurs of the Information Society. I imagine
that Nasdaq and Instinet share many of these same aspirations for their
merger. I know that I speak for Archipelago's shareholders, directors,
and employees when I say that we are thrilled to join forces with the
NYSE to build on what both organizations have accomplished to date in
an effort to create something truly great for our customers.
Globalization and Convergence Cause Reinvention of Exchange Models
One of the hallmarks of Archipelago has been its nonstop drive to
come up with new ideas, product offerings and technology. And for good
reason: Investors, traders, and issuers continually require better
services and more sophisticated products to satisfy their needs. If
capital markets in this country do not fulfill these needs for
customers, then almost certainly the markets in London, Frankfurt, Hong
Kong, and elsewhere will. A failure to keep pace with the times poses
serious risks for us all.
One of the most striking trends in capital markets around the world
over the last decade or so has been the convergence of both exchanges
and products. In Europe, enterprising initiatives at the Deutsche
Borse, Euronext, and the London Stock Exchange are bringing different
products and services together under one roof. In response to clear
customer demand, our competitors overseas are creating ``one-stop
shopping.'' The Deutsche Borse sees ``a clear trend toward convergence
between trading on the cash and derivatives markets, as well as between
equity and bond trading.'' \1\ Euronext, which is an organization
resulting from the merger of the exchanges in Amsterdam, Paris, and
Brussels, also acquired a controlling interest in LIFFE and announced
plans to integrate its derivatives markets. In Asia, too, exchanges
like the Singapore Exchange combine equities and derivatives under one
umbrella. The same is true in Hong Kong. The Tokyo Stock Exchange is
one of the most integrated exchanges in the world, trading stocks,
bonds, derivatives, and futures.
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\1\ Deutsche Borse Group. Partner of Global Customers, Annual
Report 2004, (Frankfurt: Deutsche Borse Group, 2005), p.18.
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Furthermore, almost all of the world's significant exchanges have
reorganized and are no longer membership organizations. Many of these
de-mutualized exchanges have issued shares and gone public to finance
their development of new and improved product offerings as well as
their geographic expansion. The Deutsche Borse, which went public in
2001 and commands a market capitalization over $8 billion, now competes
with ``marketplace operators in London, Paris, Chicago, and New York.''
\2\
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\2\ Deutsche Borse Group website. ``Deutsche Borse Group--The
Company.'' May 16, 2005.
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Exchanges in the United States are responding to these global
challenges. Some examples: The Chicago Mercantile Exchange (CME) went
public in 2002 and trades futures on physical commodities like pork
bellies and lumber, and trades futures on financial products like the
S&P 500 and the Nasdaq-100 as well. The CME advertises that it has
``customers around the world, a global product line, nearly around-the-
clock electronic trading and strategic alliances with other
exchanges.'' \3\ The
Chicago Board of Trade, which has filed to go public, recently signed a
multiyear technology and services contract with Euronext.liffe, under
which the Chicago Board of Trade is licensing the Euronext.liffe
trading system and buying support and maintenance services from them.
The Boston Stock Exchange teamed up with the Montreal Exchange to
create the Boston Options Exchange, a fast-growing electronic options
exchange. Several U.S. equities exchanges, including the Philadelphia
Stock Exchange, have restructured and de-mutualized their ownership.
The International Securities Exchange, born only in the late 1990's, is
already the largest equity options exchange in the United States (and
the world).
---------------------------------------------------------------------------
\3\ Chicago Mercantile Exchange website. ``Global Marketplace'' in
``About CME.'' May 16, 2005.
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Finally, options and futures exchanges are converging on equity
trading through single stock futures trading. OneChicago, a joint
venture of the Chicago Board Options Exchange, the Chicago Board of
Trade, and the Chicago Mercantile Exchange, now trades futures on over
130 stocks and ETF's. From the standpoint of sophisticated investors
and traders, all of these exchanges provide alternatives to executing
trades of cash equities on the NYSE and Nasdaq--or ArcaEx or Instinet
for that matter.
The competitive trend is very clear: Historically, exchanges
typically traded stocks, options, or futures within a single Nation's
borders. Today, to stay competitive and serve customer demands,
exchanges need to trade stocks, options, and futures on a single
platform and to do so with a global footprint. I believe that the
recently announced mergers of NYSE-Archipelago and Nasdaq-Instinet fit
squarely within the context of this competitive dynamic. It is my
strong belief that both mergers are necessary for the United States to
remain competitive in capital markets globally.
The Secret Of ArcaEx's Success: Its People
No statement today would be complete without a quick retrospective
of Archipelago's history and business successes. I know this may sound
formulaic, but at the center of that history and at the heart of that
success are our people, the employees of Archipelago. We have achieved
what we are today because of the sweat, blood, and tears expended by
our employees, who now number about 250. I cannot tell you how proud I
am of them, and I cannot thank them enough for their contributions.
You may not recognize these names, but here are just a few
representative examples of people who have worked so hard and
contributed so mightily. Our version of Paul Bunyon is Paul Adcock, who
has headed our trade support desk from day one. Paulie, as he is
affectionately known, grew up on a working farm in central Illinois,
and still rises at 4 a.m. daily to begin his workday. Paul is highly
respected by our customers and traders around the country.
My assistant and our office manager, Therese Wallace, came to
Chicago via New York from Jamaica. The attraction of Chicago must be
pretty strong to pull a woman away from a tropical paradise of white
beaches to a city known more for another type of white, as in snow and
lots of it. Therese was one of Archipelago's first employees, and from
time-to-time she reminds me who really built the company.
One of our top technologists, Dave Weiss, arrived at Archipelago by
way of the Nutmeg State of Connecticut while riding a bicycle for a
messenger service. Today, Dave is Archipelago's ``Lance Armstrong''
when it comes to providing our customers with high-speed connectivity,
yet somehow finds the time to continue his high-speed cycling in long
distance charity rides.
Our lead software developer is Tom Haller, who grew up in a Chicago
neighborhood, but moved to Florida several years ago so his kids would
be close to their grandparents. Tom is an incessant tinkerer. After
coming home from work at night, Tom used to go into his garage and . .
. tinker. Tom joined Archipelago in 2002, where his development team
has tinkered their way to producing the technological guts of ArcaEx,
which is a marvel in my view.
Finally, I would be remiss if I did not give a special mention to
Archipelago's cofounders along with me, MarrGwen and Stuart Townsend,
both of whom were University of Chicago Ph.D. candidates and are
software developers. In January 1997, we launched the Archipelago ECN--
financed by my mortgage broker and supported by the eternal patience of
my family--with no customers and no trades. In 2001, we graduated to
exchange status when the Securities and Exchange Commission (SEC)
approved our transaction with the Pacific Exchange, and in 2002, we
launched ArcaEx. In the first quarter of 2005, Archipelago reported
that ArcaEx handled 23.5 percent of the share volume in the OTC
marketplace, 25.5 percent of AMEX-listed share volume (mostly ETF's),
and 2.5 percent of NYSE-listed share volume. On behalf of everyone at
Archipelago, we feel lucky and blessed to have achieved these
successes.
The Aftermath of Regulation NMS
Before concluding, I would like to comment, as requested by the
Committee, on the recent approval of Regulation NMS and, in particular,
on the adoption of the modification of the trade-through rule. This
Committee and the House Financial Services Committee have conducted
oversight of and pressed the SEC to address some of the thorny market
structure issues that had been lingering for some time. Since
Regulation NMS was first publicly proposed in early 2004, a lot of
smart people have engaged in a good faith debate about its implications
and would-be effects. While Archipelago supported parts of Regulation
NMS, we did not support the trade-through rule as it was adopted by the
SEC. That said, the SEC has now addressed many of the market structure
issues that Congress and our capital markets had asked them to
confront. In my view, although not always in agreement with the SEC, we
will now have regulatory certainty. Furthermore, the concept of ``trade
through'' and the practical reality of trading through another
marketplace become much less germane if and when the mergers recently
announced are consummated.
It is worth noting that we will vigilantly review the final release
of the Regulation NMS rules, which are not yet public.
Conclusion
No, the Yankees and Red Sox have not ended their century's long
feud; and, yes, the Iron Bowl between Alabama and Auburn is scheduled
to occur again next fall, like it does every year. Ending those old
rivalries would never make sense.
In sharp contrast, the merger between the NYSE and Archipelago
makes a whole lot of sense. Above all else, it makes sense because of
our shared vision to maintain America's leading position in the global
capital markets by creating a world-class exchange that provides U.S.
and international consumers with first-rate execution, data and issuer
services. In a world where both exchanges and financial products are
fast converging, we believe the NYSE Group will be positioned to better
serve all traders, investors and issuers by producing efficiencies,
driving innovations, and creating new business and revenue
opportunities, while maintaining the highest standards of integrity,
transparency and disclosure.
America cannot be left behind in a world of tectonic shifts in
financial markets. History so clearly, if cruelly, teaches us that
societies, nations, governments, and businesses that are unwilling to
embrace and shape change are relegated, over time, to the failed
forgotten. In all sincerity, we believe that the NYSE-Archipelago
merger (and, yes, the Nasdaq-Instinet one) reflects an acceptance of
change in our global capital markets, and the NYSE Group intends to
engage constructively and positively in that change.
This Committee has had the foresight to be mindful of the
importance of market competition and market integrity. Our capital
markets need your continuing leadership if we are to maintain our
global preeminence in financial services. We at Archipelago look
forward to working with the Committee throughout its review of the many
changes occurring in today's capital markets, and we look forward to
becoming part of the NYSE Group. Thank you again for providing me this
opportunity, and I will be happy to respond to your questions at the
appropriate time.
----------
PREPARED STATEMENT OF EDWARD J. NICOLL
CEO, Instinet Group
May 18, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, I appreciate this opportunity to discuss the role that I
believe regulation and legislation will play in the future of our
Nation's securities markets.
While others on the panel today may begin by looking ahead and
outlining the challenges and opportunities facing our markets, I would
like to begin with an appreciative glance back at how we got here. I do
so because I think it is worth remembering--indeed, quite important to
remember--on whose shoulders we stand here today and why so much of the
recent discussion has been about building better and stronger
electronic markets.
From my perspective, the story begins with a company called Island
ECN, which was one of the first of the so-called Electronic
Communications Networks, or ECN's. I am proud to have been the first
and only Chairman of that company.
In the wake of scandals in the mid-1990's, the SEC adopted
regulations (known as the Order Handling Rules) designed to introduce
competition and greater transparency into the U.S. equities markets--
which led directly to the creation of ECN's. Island seized this opening
and offered investors a less-expensive, faster, and more reliable forum
for trading. From Island's inception, we counted on the fact that
investors--when given the choice--would always demand a more accessible
and transparent marketplace. To reach that goal, we focused on what we
considered the glaring gap in the then traditional model: The inability
of investors to meet directly in the marketplace without having to rely
on professional intermediaries.
The Island story was about fighting for a chance to compete in new
markets and allowing investors to vote with their feet. We fully
understood that if we could not offer a better product, we should be
out of business. But investors welcomed our products and services, and
Island enjoyed explosive growth--eventually merging with Instinet, the
company where I serve as CEO today.
For these reasons, Mr. Chairman, I doubt you will find a witness
today who is a greater champion of our Nation's free markets and the
individual's ability to profit from hard work and innovation.
But more than anything else, my experience at Island gave me the
privilege to meet some of the most insightful traders and software
programmers on the Street--individuals who grasped a magnificently
simple and elegant truth: The markets could be made far more rational
and fair if investors were allowed access to the same sorts of
information that were at that time uniquely available to market
professionals.
On my first day as Chairman of Island, I walked into the office--
and we were, literally, just a handful of employees in one office--and
sat down with gifted individuals such as Josh Levine and Matt Andresen.
The one thing we all shared--beside a broken-down desk with four
folding chairs--was a commitment to provide investors with an
unprecedented degree of accountability, openness, and transparency in
the marketplace. I recall how many market professionals had insisted
that making ``arcane'' real-time market data widely available would be
at best a distraction, and probably a nuisance for the investor. How
wrong they were.
As we know, investors today demand access to real-time data and the
latest research reports as well as the ability to enter orders more
efficiently and at a fraction of the cost once paid for such
transactions. Yet while the investor had been empowered to know what
and when to buy, a key component of this equation had been missing: How
to buy it.
That is where Island jumped in. Traditionally, investors had only
been provided with the highest bid and lowest offer in a security. The
depth of the market, which gives an indication of the true supply and
demand for a security, had been the exclusive province of market
professionals.
That lack of accountability--in other words, denial of information
to the investor--was unacceptable to us. To provide the best resource
possible to the investor, we became the first marketplace to provide a
free, real-time display of all its orders, through the Island
BookViewer TM.
There is probably nothing I am more proud of, Mr. Chairman, than to
know that the technology we built for the Island ECN, which then became
the technology behind Instinet Group's INET ECN, is now expected to
become the technology platform for the merged Nasdaq-Inet platform.
With this history in mind, Mr. Chairman, let me try to summarize
some lessons we can learn from those experiences that are particularly
relevant as we look ahead to the issues we will face in our markets
over the coming years--lest we be ``doomed'' to repeat the mistakes.
First and most important are the benefits resulting from a
regulatory environment that encourages true competition among
marketplaces. It is certainly true that much of the original electronic
marketplace story was about harnessing technology to provide investors
with a more efficient, faster, and lower cost forum for trading. Yet
Island's success and the success of other electronic markets like
Archipelago and Nasdaq is much more than a technology story--it is
about the tremendous benefits that redound to the investor when the
securities laws and regulations allow our markets to compete; when one
marketplace can challenge another with a dizzying array of innovations
and offer the investor unprecedented opportunities to leverage
technological breakthroughs.
The Island story and the rise of ECN's embody the benefits of
competition. The dramatic changes in technology have allowed new
competitors to offer new services at a lower cost and capture market
share from traditional market participants in a relatively short time
period. Just one example: I can remember when it cost some individuals
as much as $200 per trade. Today, you can pay as little as $7. There
has never been a better time to be an individual investor.
A second lesson from our experience concerns the policing and
surveillance of markets. By eliminating the informational disparities
of the traditional, floor-based manual markets, many of us built a
marketplace that is inherently safer, fairer, and easier to surveil--
all issues, I know Mr. Chairman, that this Committee takes very
seriously. For example, participants on the floor of an exchange
generally possess more trade and order information than the average
investor sitting at home.
Through surveillance and the implementation of restrictions on the
activities of those in the trading crowds, regulators attempt to
prevent the misuse of this information. As recent events have shown,
however, no amount of surveillance or regulation can completely prevent
or eliminate the potential for its misuse. With that in mind, Mr.
Chairman, I note that electronic markets reduce the opportunities for
improprieties by eliminating informational disparities.
Finally, Mr. Chairman, let me at least raise for the Committee's
consideration one of the most enduring public-policy issues we face.
Now that electronic markets have done so much to empower the investor
by providing an open and transparent marketplace, there remains one
final challenge. How do we unleash these benefits on as wide a scale as
possible, without sacrificing investor protection or the integrity of
our capital markets? How can we continue the process of democratizing
the markets?
Long before electronic markets were even a glimmer in anyone's eye,
Congress anticipated exactly what rules should guide us. In 1975,
Congress created the National Market System, with the goal of creating
a more efficient and transparent market. We could not have asked for a
better building block. Over the subsequent decades, the SEC has worked
hard to strengthen and improve this regulatory structure. While
Instinet had particular concerns with some of the elements in the
recently approved Regulation NMS, I do commend Chairman Donaldson for
finally resolving many of the outstanding market structure issues and
setting forth a clear and definitive regulatory roadmap for the U.S.
equities markets as a whole.
There are many different models currently used in the equity
markets, and, with entry becoming even cheaper and easier, over the
coming months and years I have no doubt more will emerge. Each model
has its supporters and detractors. But what history does teach us is
that, regardless of the model, two principles must hold into the
future: First, competition must continue to be permitted to flourish
between the different models, but in a manner that safeguards the
integrity of our markets. Second, market structure must remain free
from unfair advantages and unreasonable barriers.
While much has changed since I sat in that small downtown office
with my young colleagues, we must remain vigilant in the protection of
our free markets from over-regulation. As Chairman Donaldson said, ``We
need to identify real problems,
consider the practical consequences of the possible solutions and then
move pragmatically and incrementally toward the goals Congress staked
out.''
My own rule, Mr. Chairman, would be that regulatory action should
only be taken when it is clear that the market is failing and less
drastic remedies are inadequate. In all other cases, let us embrace
free competition and always work toward greater openness, transparency,
and accountability in the marketplace. In so doing, we can continue to
leverage our Nation's technological superiority in a manner consistent
with the best aspects of America's entrepreneurial capitalism. There is
too much at stake to do otherwise.
Thank you for this opportunity to again testify before your
Committee. It has been a great pleasure to work with you and your
colleagues on this issue.
----------
PREPARED STATEMENT OF MEYER S. FRUCHER
Chairman and Chief Executive Officer, Philadelphia Stock Exchange,
Inc.,
May 18, 2005
On behalf of Philadelphia Stock Exchange, Inc. (the PHLX), I
appreciate the opportunity to participate in this hearing on the
implementation of the Securities and Exchange Commission's (SEC)
recently adopted Regulation NMS and the consolidation of the U.S.
securities markets. This is a historic juncture for our markets. Future
generations of investors, economists, lawyers, and commentators may
view 2005, as they do 1934 and 1975, as being a point in time where
decisions made and paths taken changed the character and quality of
securities trading in the United States for decades to come.
Introduction
Adoption of Regulation NMS and the combinations of the New York
Stock Exchange (the NYSE) and Archipelago (Arca) and of the Nasdaq
Stock Market (Nasdaq) and Instinet Group (Instinet) could very well
result in a sound and healthy market structure and two strong
organizations capable of competing to serve the needs of issuers and
investors. However, conditions also exist for the development of an
anticompetitive duopoly. For all the talk in recent years of market
fragmentation, the fact is that the marketplace for trading stocks is
dominated by a small number of venues--particularly the NYSE. The
survival of the smaller exchanges that challenge the NYSE and Nasdaq is
by no means assured. The SEC must act by the first quarter of 2006 on
proposals by competing exchanges to ensure that the benefits of
vigorous inter-market competition in the securities markets,
particularly for equity securities, are not lost. Because there are
significant and growing regulatory and other barriers to entry for new
exchanges, if this competition is weakened, it may be gone forever.
Therefore, it is important that this Committee in
exercising its oversight responsibility be vigilant that the SEC takes
action to ensure competition.
Role of the Competing Equity Markets
To better understand the PHLX's perspective on competition, this
statement provides information first about the smaller securities
exchanges that compete with the NYSE and Nasdaq and second about the
PHLX in particular.
The Competing Securities Exchanges
A century ago, there were more than 100 local and regional stock
exchanges in the United States. They served the capital needs of
companies and investors in their area by listing local companies for
trading. Although today's smaller securities exchanges are the
descendants of those exchanges and are still often referred to as
``regional exchanges,'' they are no longer regional markets. They do
not list local companies or serve local investors. Instead, they are
competing parts of our national capital market and collectively form an
essential pillar of the national market system.\1\
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\1\ This testimony refers to the smaller U.S. securities exchanges
that trade equities, namely the American, Boston, Chicago, National,
and Philadelphia Stock Exchanges.
---------------------------------------------------------------------------
While they differ in many respects and with regard to many aspects
of their business models, the competing stock exchanges share an
important role: They all make markets in stocks listed by the NYSE;
some also trade Nasdaq-listed stocks. They thus provide competition to
the Big Board and Nasdaq. Of particular significance is that the NYSE's
share of trading in the stocks it lists has regularly exceeded 80
percent, a dominance that almost surely would invite government
scrutiny in any other industry. The PHLX believes this dominance is
unhealthy for investors.
Today's competing stock exchanges have survived because the
competitive environment in which they operate forces them to be
innovators. The PHLX and a number of the other securities exchanges
employ an electronic system of remote
competing specialists, described below. On some of the exchanges, many
stocks have three or four specialists competing to offer the best
price, rather than a single specialist setting a price as on the Big
Board.
Most importantly from the perspective of investors, the smaller
securities exchanges have repeatedly served as ``laboratories of
invention.'' They were the first to adopt innovations as essential as
the securities clearing house, continuous net settlement of trades and
automated execution of small orders--all improvements that the NYSE
embraced after other exchanges had first paved the way. The PHLX
believes that investors would be best served if competition continued
to spur the NYSE and Nasdaq to innovate. However, as described in
greater detail below, the continued survival of competing exchanges is
far from certain.
Background on the Philadelphia Stock Exchange
The PHLX is the oldest securities exchange in the United States.
The PHLX is both a stock and an options exchange. It trades over 2,000
stocks listed on the NYSE and American Stock Exchange (Amex) and over
1,500 equity options, as well as industry sector options created by the
PHLX and currency pairs.
While the PHLX is comparable to the NYSE in age and tradition, its
method of equity trading differs from the NYSE's in an important
respect. While both the NYSE and the PHLX use a floor-based specialist
system, the PHLX employs competing specialists rather than a single
specialist per stock. The Remote Competing Specialist System
implemented by the PHLX in 2002 lets specialists make markets and trade
from the PHLX equity trading floor or from remote sites. This secure
communication network expands trading beyond a fixed number of
specialists to enable qualifying firms to operate from their offices.
It means that more than one equity specialist can make a market in an
eligible stock, so order flow providers can direct orders to the
specialist of their choice. The result is a boundless market center
permitting virtually unlimited access to qualified specialists and
customers alike.
Need for Competition
The PHLX is not advocating some form of protection for itself and
other stock markets that compete with the NYSE and Nasdaq. Instead, the
PHLX merely asks that the SEC take all steps to ensure that it and
other venues are allowed to compete vigorously and aggressively, and
that the smaller exchanges be allowed to do what they have always done,
namely to innovate and find new products and trading technologies.
After all, if the smaller exchanges do not step up and offer
competitive alternatives, where will competition to the NYSE and Nasdaq
come from?
To ensure competition, the SEC must quickly and with an open mind
address proposals submitted by smaller exchanges to establish new
facilities, rules and fees. If the SEC does not do so, any hope of
competition from existing participants will very quickly be
extinguished. Put another way, if the SEC focuses all of its attention
on analyzing and approving the rule changes and other actions necessary
to facilitate the completion of these two historic mergers and their
post-merger market operations, and does not listen receptively and
process expeditiously proposals from the other exchanges, there will be
no other competitors. This is an urgent problem that affects the entire
market system.
To allow actual and potential competition from smaller markets to
wither would be inconsistent with decisions already made by Congress.
In 1975, when it amended the Securities Exchange Act of 1934 (the Act),
Congress authorized creation of the National Market System (NMS),
specifically noting the importance of the securities markets as ``an
important national asset'' and declaring an intention to foster
technological innovation and intermarket competition.\2\
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\2\ See Section 11A(a)(1)(A)-(C) of the Act.
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If the SEC Approves These Mergers, It Must Also Act to Preserve
Competition
NYSE-Arca and Nasdaq-Instinet: Great Deals for Shareholders and Seat
Owners. What about Investors?
From the perspectives of the owners, members and other constituents
of the NYSE, Arca, Nasdaq, and Instinet, these transactions look like
smart moves. The NYSE becomes a public company, takes a quantum leap
into electronic trading, positions itself to benefit from Regulation
NMS, reenters the world of options trading, and gains a strong presence
in the trading of Nasdaq stocks. Arca shareholders
become important stakeholders in a liquidity-rich and resource-laden
combined enterprise of global scope. Arca itself will have access to
the powerful listings and regulatory infrastructure of the NYSE.
Instinet and Nasdaq also have bright prospects for their combined
enterprise. While less transformational, in that Nasdaq and Instinet
both focus on Nasdaq stocks, the combined entity should be a formidable
force to be reckoned with. And to the extent the NYSE-Archipelago and
Nasdaq-Instinet entities compete to trade each others' listed
securities, competition will be enhanced.
In principle, small and large investors alike may benefit from the
evolution of these markets. Yet, legislators and the responsible
regulatory authorities should not lose sight of the fact that these
mergers will result in a huge concentration of trading volume and
resources in these two entities. For example, the combined NYSE-Arca
will have an 81 percent market share in the trading NYSE-listed shares,
based on adding the current market shares of both markets. Likewise
Nasdaq-Instinet will have a 56 percent market share of Nasdaq-listed
issues. Depending upon how these enterprises integrate their
operations, virtually all shares traded in the United States will be
traded on 1 of 2 trading systems and under 1 of 2 fee structures, and
subject to the self-regulatory oversight of 1 of 2 self-regulators. The
lion's share of market data revenues for NYSE and Nasdaq securities
will accrue to these two markets on a combined basis, both because of
their sheer size and in the NYSE's case because it may have three
chances at any given moment of posting the national best bid or offer
(namely on the floor, on the NYSEDirect+ electronic ``hybrid,'' and on
Arca).
Indeed, presumably one of the main points of these mergers is to
eliminate competition through ``consolidation.'' On May 9, NYSE Chief
Executive John Thain was quoted as saying: ``"The U.S. has too many
exchanges--it is too fragmented. . . . The U.S. financial marketplace
needed to be rationalized and consolidated . . . .'' The implication is
clear that he believes the number of competitors should shrink.
Rather than reduce the number of competitors to two, PHLX believes
that additional competitors are needed, both to ensure that investors
and traders have alternatives, and to force these two behemoths to keep
trading costs low and the range and quality of execution and other
services high. And we are not alone. The SEC's Chief Economist
explained it as follows: ``Requiring markets to expose orders to the
competing prices offered on alternative platforms forces platforms to
address how they compete for business.'' \3\ In layperson's
terminology, competition between markets forces markets to constantly
improve, which is good for investors.
---------------------------------------------------------------------------
\3\ Chester S. Spratt, Address at the Market Microstructure Meeting
of the National Bureau of Economic Research (May 6, 2005) (the ``Spratt
Microstructure Address).
---------------------------------------------------------------------------
Also relevant is the fact that the NYSE will, as part of this
process, become a ``for profit'' institution, and as Nasdaq completes
its separation from the NASD, it will no longer operate in the shadow
of a ``not-for-profit'' enterprise. Though the PHLX has no quarrel with
for profit markets--having become one itself by demutualizing in 2004--
PHLX believes that the SEC must be particularly mindful that its
regulatory process does not unintentionally become an instrument of
monopoly creation for these business entities.
In short, while the announced mergers may result in greater returns
for the institutions involved and their constituents, we believe that
investors may ultimately be disadvantaged.
The SEC Should be Congratulated on the Success of Its Promotion of
Innovation By Electronic Markets. But in This Very Success are There
the Seeds of Failure?
The SEC, too, should be congratulated on having addressed in
Regulation NMS many of the criticisms that have been levied over the
last decade regarding the operation of the markets. Although the PHLX
does not agree with every aspect of the final product (recognizing that
the Regulation, as approved, has not yet been published), we believe
that the SEC has tackled many of the perceived systemic issues--by
adopting clear and uniform trade-through protection in the listed and
Nasdaq markets, limiting access-fees and barriers to cross-market
access, restricting subpenny quoting and bringing greater transparency
to NMS Plan governance. Regulatory reform of the rules for interaction
between competing marketplaces will not end with Regulation NMS, but
the system as a whole should benefit from the reforms that it embodies.
In an important way, the SEC should be praised for its vision and
openness to innovation for reasons beyond Regulation NMS. After all,
the two transactions being discussed today are really the culmination
of actions taken by the SEC just a few years ago.
In 1997, under the leadership of then Chairman Arthur Levitt, the
SEC issued a Concept Release concerning the Regulation of Securities
Exchanges \4\ and in 1998 approved the seminal rulemaking concerning
Regulations of Exchanges and Alternative Trading Systems, which
included the adoption of Regulation ATS.\5\ At issue in these releases
was the fact that some market participants, including Instinet, were
using new technology to offer new types of financial services that had
many of the aspects of exchanges. In particular, these entities, which
have become known as ``alternative trading systems,'' permitted
institutions to trade with each other, in many cases without the
involvement of a securities dealer, cheaply, anonymously and rapidly.
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\4\ Release No. 34-38672 (May 23, 1997).
\5\ Release No. 34-40760 (December 8, 1998).
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As alternative trading systems have many of the characteristics of
securities exchanges, the SEC was faced with a dilemma regarding how
such entities should be regulated. National securities exchanges and
national securities associations are subject to comprehensive--some
might say onerous--regulation, as compared with the regulatory regime
for broker-dealers that applied to nonexchange trading systems. In
particular, virtually every material aspect of the operation of a
securities exchange or association must be filed with the SEC as a
proposed rule change under Section 19 of the Act. In most cases, such
proposed rule changes must be approved by the SEC, following a notice
and public comment period. In practice, such approval can take many
months, and in some cases even longer. The substance of proposed rules
must also meet certain statutory criteria.\6\
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\6\ See Section 6(b) and 15A of the Act.
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The SEC was (and is) aware that this approval process can delay
significantly the introduction of new products and services, thereby
stifling innovation. However, the SEC was concerned that, without some
safeguards, the unchecked growth of alternative trading systems could
result in the fragmentation of liquidity, a lack of transparency,
discrimination against certain market participants, and systemic risk
associated with having some market centers that did not meet standards
of technical capacity and integrity reliability. The SEC was very
innovative in determining ultimately to permit alternative trading
systems to elect to be regulated either as broker-dealers or as
exchanges, subject to some additional requirements for systems that
represent a significant percentage of the trading activity in a given
security.
At the same time, recognizing that this structure would potentially
give a competitive edge to alternative trading systems, the SEC adopted
a rule that would, in theory permit exchanges to introduce certain
``pilot trading systems'' with relatively limited regulatory
interference.\7\
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\7\ Rule 19b-5.
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Alternative trading systems thrived under Regulation ATS--proving
the recent assertion of the SEC's Chief Economist that ``well placed
regulatory changes can
affect innovation.'' \8\ Their growth is partly attributable to the
alternative trading systems' ability to be nimble in both introducing
new products and services and in responding to competition. In fact, it
can be said that Regulation ATS allowed Instinet and Arca to challenge
the industry incumbents--perhaps even making the transactions that we
are discussing today inevitable.
---------------------------------------------------------------------------
\8\ See Spratt Microstructure Address at p.3.
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By contrast, for many reasons, some economic, some political, some
historical and some regulatory, the exchanges and Nasdaq did not evolve
as rapidly. The SEC's structure for leveling the playing field and
permitting the rapid introduction of pilot trading systems did not
accomplish that end. In PHLX's experience (and it is believed that of
other markets), the SEC has generally been extremely cautious about
permitting exchanges to flexibly respond to competitive challenges from
alternative trading systems.
In the intervening years since 1998, as the alternative trading
systems expanded, and the SEC and the marketplace got a view of the
full potential of the all-electronic matching engine and (in some
cases) electronic routing capabilities that are the hallmark of
alternative trading systems, pros and cons emerged. No doubt, the
flowering of this model gave rise to challenges, including some that
the SEC envisioned as possibilities--discrimination, inaccessibility,
fragmentation and discrimination--and some that were perhaps not so
clearly foreseen, such as issues raised by sub-penny trading, ``tape
shredding,'' technical problems and worse caused by access fees, and
concerns about regulation of this diffuse marketplace. However, despite
these perceived flaws, it is clear that the SEC strongly favors the
electronic trading model that is the hallmark of alternative trading
systems.
In many ways, Regulation NMS should be viewed as ``Regulation ATS--
Part 2.'' It addresses many of the criticisms of how the equities
market has evolved since 1998, but also, in effect, powerfully endorses
an electronic trading model, especially in relation to its definition
of which quotations are ``protected'' in the ``order protection'' (that
is, trade-through) rule and the new methodology for calculating
critically important market data revenues. It may be that these reforms
will ultimately doom other modalities of trading in the equities
market, including trading floors manned by specialists and floor
brokers.
Whether for good or ill, in some respects the market combinations
that we discuss today are also a consequence of the success of the
alternative trading systems that the SEC's vision helped to foster.
Many commentators feel that NYSE's decision to merge with Arca is in
large measure a hedge against the future and a recognition of the power
of the electronic trading business model. Similarly, Nasdaq clearly
perceives that the best way for them to grow stronger quickly is by
absorbing their alternative trading system competitors--first Brut ECN
and now Instinet.
So, how do we evaluate the success of Regulation ATS, which in
effect culminates in 2005 with the advent of Regulation NMS and the two
mergers? Surely we must say that the SEC did well in fostering the
innovations that have been so successful, and in forging Regulation
NMS, which will correct some flaws that have developed over the years
in the NMS. However, not only can regulatory actions foster innovation,
they can impede innovation as well--as can regulatory inaction. The
PHLX thinks that regulatory actions often actively shape business
outcomes in the securities markets they can determine winners and
losers. PHLX notes that both Instinet and Arca developed relationships
with smaller exchanges (the Cincinnati (now known as the National) and
Pacific Stock Exchanges, respectively) as part of their growth
strategy. So successful were they that they are now, in effect, being
bought out by the incumbents they challenged. Investors will suffer if
future innovators are not able to collaborate with smaller exchanges.
Other SEC Initiatives that May Burden Competition
At the same time as it completes its work on Regulation NMS, the
SEC is (i) proposing fundamental changes to the governance, ownership
and administration of exchanges \9\ that will both add considerably to
the cost of operating an exchange and limit flexibility in terms of
joint ventures and other structures pertaining to exchange
``facilities,'' \10\ and (ii) questioning the role of exchanges as
self-regulators and funding for regulatory operations in the context of
a recent concept release concerning self-regulation.\11\ Together,
these initiatives have the potential to increase costs and reduce
flexibility for competitors to the NYSE-Arca and Nasdaq-Instinet
duopoly.
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\9\ Release No. 34-50699 (November 18, 2004).
\10\ See letter dated March 8, 2005 from Meyer S. Frucher, Chairman
and CEO of the PHLX, to Jonathan G. Katz at 3 (for a discussion of the
implications of the ownership of exchange facilities) and pages 14-21
(for a discussion of the costs and burdens of additional proposed
requirements).
\11\ Release No. 34-50700 (November 18, 2004).
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Competing Exchanges Have Much To Do If They Are To Remain Viable:
All Roads Lead Through The SEC
For the future of inter-market competition, this means smaller
exchanges and their members need to adapt quickly if competition is to
be preserved in the equities markets. The NYSE hopes to close on its
transaction by the first quarter of 2006. Nasdaq and Instinet hope to
complete their merger by the end of this year. Note that both of these
are prior to the announced implementation of Regulation NMS, which the
SEC does not intend to implement fully until June 2006. Competing
exchanges therefore must seek out the strategic alliances, develop the
technologies, and submit the rule changes they will need to remain
competitive before the first quarter of 2006. And the SEC must act on
those proposals before the first quarter of 2006. If that timeframe is
not met, the potential for competition to the NYSE and Nasdaq may be
lost forever.
The PHLX believes that it and other competing exchanges will have
to do the following to remain viable:
If smaller exchanges are to continue to attract orders in the
new world, they must modify their systems and trading rules so that
they respond to incentives and disincentives contained in
Regulation NMS. Failure to adapt will mean that orders sent to
floor-based exchanges will be subject to being traded through on
electronic markets--a risk that firms routing customer limit orders
will not want to take;
The new market data revenue allocation formula adopted in
Regulation NMS rewards a particular type of business model, namely
electronic SRO's. The PHLX believes this will direct market data
revenues away from floor-based and smaller
exchanges. Failure to adapt will also mean the loss of significant
revenues from the sale of market data, which is critical to funding
and maintaining our regulatory programs and limiting our members'
costs of doing business on competing markets;
We will need to find new and innovative revenue sources and
also operating cost efficiencies in order to sustain the
significantly increased ongoing regulatory and reporting costs
implied by the SEC's proposed rulemaking on SRO governance,
ownership, and administration;
We may be forced to cede, or may voluntarily relinquish, some
or all of our self-regulatory functions--functions that many may
argue are essential characteristics of each market--either because
they will become economically unsustainable or as a result of
initiatives that may flow from the SEC's Concept Release on Self-
Regulation; and
Perhaps most importantly, we will have to supercharge our
systems, develop creative trading rules and reinvent our fee
structures in order to convince our customers, the trading
community and the investing public that we offer a clear cut
alternative to the impressive trading facilities to be offered by
the combined NYSE-Arca and the combined Nasdaq-Instinet.
The PHLX is willing to adapt, and to fight for its survival in
these ways. However, at each step we will need to file our rules and
fees with the SEC, and if they do not handle these quickly and
flexibly, we will not be able to do what is objectively necessary to
survive, and no amount of creativity, efficiency, or technological
proficiency will make any difference.
The Commissioners and the staff of the Commission--particularly in
the Division of Market Regulation, which processes SRO rule filings--
are highly knowledgeable, professional and hard working. Moreover, they
intend to process rule filings and other requests for the markets in an
even handed way. However, they have limited resources. To ensure
competition, the SEC must vigorously process the filings of competing
markets, and be open minded to the approval of new and innovative
structures that will allow markets to compete--fairly and consistently
with the mandates of the Act.
Of course, one might argue that the regulatory structure under the
Act permits prolonged agency consideration, and provides the potential
for discretionary (and therefore conservative) handling of SRO
proposals to modify their rules and systems. Because of the importance
of innovation, however, Congress and the Commission should consider
revising the Act or the regulations under it to permit more
proposals to become ``effective on filing'' without prior staff
review.\12\ The Commodity Futures Modernization Act of 2000 may offer
an example. In that legislation, Congress gave futures exchanges
greater flexibility to introduce new products and new trading systems
through ``self-certification'' of proposed rules' compliance with
statutory requirements.\13\ These changes appear to have enhanced the
degree of competition in the futures markets, as evidenced by the
number of new entrants to the
marketplace. The PHLX suggests that Congress and the SEC must grant
similar flexibility to securities exchanges to ensure the survival of
competition.
---------------------------------------------------------------------------
\12\ See Section 19(b)(3)(A) of the Act.
\13\ See Section 5c(c)(1) of the Commodity Exchange Act.
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Conclusion
Regulation ATS allowed for the blossoming of the alternative
trading system electronic model, which can in effect declare victory
today, because alternative trading systems were allowed to innovate
without undue regulatory friction. Considering that the smaller
exchanges will be the only remaining competitive challenges to NYSE-
Arca and Nasdaq-Instinet, and that there are numerous other threats to
their survival, the reduction or elimination, consistent with the
principles of the Act, of regulatory roadblocks is a significant public
policy objective.
PHLX believes that it is critical to the survival of competition
that the SEC process promptly and with an open mind proposals from all
markets, and particularly smaller markets, to introduce new rules,
trading facilities and fee structures, and to engage in affiliations,
so as to permit them to continue to offer innovative competitive
alternatives that will be attractive to the marketplace. We would
respectfully urge this Committee to keep itself appraised of
developments in this regard during the weeks and months to come. If it
is necessary to streamline the process by which such initiatives may be
introduced, then we would likewise submit that such reforms would be
worthwhile in the interest of keeping competition alive, before it is
too late to do so.
PREPARED STATEMENT OF SCOTT EVANS
Chief Investment Officer, TIAA-CREF
May 18, 2005
Chairman Shelby, Senator Sarbanes and Members of the Banking
Committee, my name is Scott Evans, and I am the Chief Investment
Officer at TIAA-CREF. I appreciate your invitation to appear here today
to express my company's opinion on how recent regulatory and structural
changes in the U.S. market will impact all market participants,
including individual investors.
TIAA-CREF has been focused on the financial welfare of individuals
since Andrew Carnegie formed the Teachers Insurance and Annuity
Association of America (TIAA) in 1918 as a fully funded retirement
system to help colleges attract talented teachers. Our mission is ``to
aid and strengthen'' the institutions we serve and to provide financial
products that best meet their unique needs. TIAA created the College
Retirement Equities Fund (CREF), a stock-based fund and the world's
first variable annuity, in 1952. CREF is registered with the SEC as an
investment company and TIAA is a life insurance company.
With over $340 billion in assets under management, TIAA-CREF is a
leading financial services organization, a major institutional
investor, and one of the world's largest private retirement systems
with more than 3.2 million participants at more than 15,000
institutions. We serve the direct economic interest of these members of
the academic, medical, cultural, and research fields without profit to
our company. Our customer reach extends to every State in the Nation.
We have over 13,000 participants from 98 institutions in Alabama;
nearly 40,000 participants at 395 institutions in Maryland.
In addition to our pension activities, TIAA-CREF also serves the
general public by providing mutual funds, financial counseling, and 12
State-sponsored 529 college savings programs. Each of our clients
relies on us to invest their money wisely in the U.S. financial
markets.
I commend the Committee for its forward-looking concern with the
issues surrounding the rapid evolution of the U.S. equity markets.
Both the recently enacted SEC Regulation NMS and the proposed
mergers involving our two major domestic stock exchanges represent
seismic shifts that require careful scrutiny. As consumers become more
aware of these issues, they will be most appreciative of your proactive
oversight.
As background, we would like the committee to be aware that our
CEO, Herb Allison, is on the NYSE Board, and he did participate in the
vote on the merger. He did not attempt to influence the company's
position on Regulation NMS.
Although we, at TIAA-CREF, do not pretend to be able to predict the
future, we have a long history of large scale participation in the
equity markets that may be helpful in understanding the implications of
all this change for the American investor. We hold equity shares of
more than 3,000 U.S. companies on behalf of our clients. This broad
involvement requires us to use the full spectrum of trading venues in
today's markets, including listed exchanges, Nasdaq, Electronic
Communication Networks (ECN), and Alternative Trading Systems (ATS). We
conduct about half of our trading activities using traditional
physically intermediated methods (floor
brokers or upstairs dealers) and the other half through anonymous
electronic transactions. The traditional methods are used primarily for
large trades and the electronic techniques for smaller lot sizes. Since
we regularly use both types of trading, we share the perspectives of
both index funds who conduct most of their activity electronically and
active managers who spend the bulk of their time doing traditional
trades.
When we filed our comments with the SEC on Regulation NMS, our
concern was that a trade through rule which requires brokers to always
honor the best posted price may sometimes have the unintended effect of
making it more difficult for investors to get the best deal available
for all of their shares. This is because it is more important to get
best execution on the whole order than the best price on every trade.
The trade through rule in NMS essentially mandates that all large
trades done at prices necessary to move large volumes of stock also
include shares posted publicly on better terms. For our trades that are
large enough to warrant private negotiations, we fear that such
restrictions may impede our ability to conclude satisfactory agreements
for large blocks of stock.
For example, should we desire to quickly sell a multimillion share
stock holding, it would be impractical for us to use electronic limit
orders to accomplish our objective since the volume of such limit order
activity is usually inadequate to handle such a large order. Therefore,
in order to trade our entire volume for the best price, we would
usually turn to a broker-dealer or alternative peer to peer trading
system like Liquidnet to assemble a block trade. These trading venues
allow us to obtain sufficient quantity of shares without distorting the
market price for normal sized trades. Block trades are difficult
transactions that require customized attention. The cost and complexity
of linking the small trades on the public limit order books to these
large private transactions is likely to be prohibitive. Furthermore, it
is likely that the mandatory inclusion of trade volumes from the public
limit order books might reduce the incentive for brokers to participate
in these large trades. If institutional traders are not able to obtain
the best price possible for the large trades that they seek, then the
millions of individuals that they serve will be harmed as the returns
on mutual funds and other institutionally managed savings vehicles are
negatively impacted.
The U.S. equity market is increasingly dominated by large
institutions who regularly conduct these types of large block trades.
According to the Federal Reserve, over 50 percent of total equity
assets in the U.S. market are now held by mutual funds and other
institutional intermediaries on behalf of individual investors. In
1980, these same institutions controlled only 36 percent of equity
assets. This is why the protection of institutional trading
efficiencies is of growing importance to the American consumer. From
our perspective, individuals investing directly in the markets would be
better served if regulators redoubled their efforts to ensure that
retail brokers fulfill their duties to provide best execution to
individual traders than by establishing pricing rules on our stock
exchanges that favor small volume retail trades. While we think it is
too soon to conclude that regulation NMS will snuff out the encouraging
trend toward increased innovation and competition in U.S. equity
markets, the devil is in the details.
We also think it is premature to draw conclusions regarding the
likely impact of recently announced mergers involving the NYSE and
Nasdaq. The parties involved will build a system that best meet the
needs of their customers and we would hope that the regulatory
landscape will continue to support the innovation and competition that
is needed to keep our equity market system world class. Thanks to a
healthy environment for innovation in the past, U.S. investors now have
Instinet and Archipelago to execute small limit orders quickly and
Posit, Liquidnet, and Pipeline to execute large trades anonymously and
efficiently. They exist precisely because we have had a regulatory
framework that encouraged entrepreneurial activities. We support any
regulatory rule or business consolidation that will enhance this
atmosphere of innovation and competition. Individual investors and
savers, whether direct or indirect participants in the market, are
better for this free market, and ultimately, so is the American
consumer.
I would like to thank the Committee for inviting TIAA-CREF to share
our views on this important topic. I look forward to answering any
questions you may have.
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PREPARED STATEMENT OF THOMAS M. JOYCE
Chairman and Chief Executive Officer, Knight Capital Group, Inc.
May 18, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, thank you for the opportunity to participate in this hearing
regarding the Securities and Exchange Commission's market structure
rule, Regulation NMS, and recent market developments in the industry.
Knight Capital Group, through its affiliates, makes markets in
equity securities listed on Nasdaq, the OTC Bulletin Board, the New
York Stock Exchange, and American Stock Exchange, both in the United
States and Europe.\1\ On active days, Knight executes in excess of one
million trades with volume exceeding one billion shares.
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\1\ Knight is the parent company of Knight Equity Markets, L.P.,
Knight Capital Markets, Inc., and Knight Equity Markets International,
Ltd., all of whom are registered broker-dealers. Knight also owns an
asset management business for institutional investors and high net
worth individuals through its Deephaven subsidiary. Knight is a major
liquidity center for the Nasdaq and listed markets. As a dealer, we
make markets in nearly all equity securities. Knight's
clients include more than 850 broker-dealers and 600 institutional
clients. Currently, Knight employs nearly 700 people. Recently, Knight
announced its acquisitions of Direct Trading Institutional, Inc. (DTI),
based in Irving, Texas, and the ATTAIN ECN which is based in Montvale,
NJ. DTI is a registered broker-dealer and was founded in 1998 to
provide institutional investors trade executions and reduced trading
costs. DTI now provides execution services to roughly 300 institutions
that are trading in excess of 2 billion shares per year. ATTAIN is a
registered electronic communications network (ECN) pursuant to
Regulation ATS and currently provides facilities for broker/dealer
customers to quote Nasdaq listed and OTC Bulletin Board securities.
Both acquisitions are currently pending regulatory approval.
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Regulation NMS
For several years Knight has called on the SEC to address several
problems in the equity markets, namely the lack of market linkages and
efficient access to quotes, the ability of ECN's to charge access fees
to nonsubscribers, and the negative impact of sub-penny quotations. By
adopting Regulation NMS, the SEC took an important step to address some
of these issues, which have long been areas where potential gaming or
distortion create inefficiencies in the markets.
Knight supports the ban on sub-penny quotations and the rule
prohibiting locking the quotation of an automated market included as
part of Regulation NMS.
Sub-penny quotations diminish liquidity at each price point and make it
easy for professionals to jump ahead of limit orders. By capping ECN
access fees for nonsubscribers, Regulation NMS will help to establish
more integrity and transparency of the quote. The rule will also
address the market distortions such fees cause, mitigating the economic
incentive of certain market participants to lock and cross markets,
which can lead to confusion in the marketplace.
Knight applauds the SEC for its action in these areas. However,
Knight continues to believe that there is no need to extend any form of
trade-through rule to all markets due to competitive forces and the
lack of data supporting such a rule. As we noted earlier this year in
testimony before the Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises of the House Financial Services
Committee on February 15, 2005, there is no evidence to suggest that an
intermarket trade-through rule will increase limit orders, one of its
stated goals. However, various data sources reveal that retail
investors use limit orders on Nasdaq-listed stocks (with no trade-
through rule) much more often than on exchange-listed stocks (with a
trade-through rule).\2\ Additionally, we believe that the typical U.S.
retail investor prefers the use of market orders, as opposed to limit
orders, as it provides them the opportunity to immediately gain access
to the displayed price and size they see in the market. Further, the
SEC's data on trade-through rates is
nearly the same for Nasdaq, which currently has no trade-through rule,
and the NYSE, which already has a form of the trade-through rule.
Finally, we are also concerned that a trade-through rule may have the
unintended consequence of further reducing liquidity in the market,
particularly if large block-sized prints move offshore.
---------------------------------------------------------------------------
\2\ See letter from Jeffrey T. Brown, Senior Vice President,
Charles Schwab, to Jonathan G. Katz, Secretary, Securities and Exchange
Commission, February 1, 2005.
---------------------------------------------------------------------------
Knight instead has advocated repeatedly that competition, rather
than mandated and prescribed paths to trading, benefits market
participants and all investors. For example, the SEC's Rule 11Ac1-5
(Rule 5) is an excellent example of regulation that increases
competition by promoting transparency and comparability. The rule
requires market participants to post their execution statistics in
accordance with standardized reporting metrics, thus enabling order
routing firms to make more informed routing decisions to meet their
clients' needs. This has increased competition and pressured market
participants to continue to improve the execution of customer orders,
while resulting in dramatically reduced costs for investors. We believe
the dramatic decrease in brokerage commissions and the split-second
executions for most marketable trades in recent years is a direct
result of these competitive forces, not regulatory fiat. Therefore,
Knight still believes that a regulatory approach encouraging
competition such as Rule 5, coupled with strengthened linkage
requirements mandating that all markets connect so all displayed
quotations can be immediately accessible and executable, would provide
a far less disruptive and less costly way to achieve the goals of a
trade-through rule.
With the adoption of Regulation NMS, Knight is focused on
implementation to ensure compliance and a smooth transition to the new
rules. The trade-through rule in particular has numerous exceptions and
other requirements that will make implementation extremely challenging.
The vetting process which has taken place to date has produced numerous
comments, many of which have raised critical issues for this Committee
and the SEC. The SEC and its staff should be commended for their hard
work in reviewing all of the various comment letters, conducting
numerous industry meetings, and for their efforts at drafting the final
Rule. As the ``devil is always in the details,'' it will be important
to carefully examine the final Rule once published to ensure we fully
understand its nuances and then work closely with the SEC staff to
address any questions.
I will briefly identify some areas that warrant significant
attention as Regulation NMS is implemented.
1. The need for clear guidance from the SEC and an incremental
phase-in. We encourage the SEC staff to continue to work with industry
on implementation of the rules in a transparent and open manner to
achieve consensus on the technical details of Regulation NMS.
The SEC should gradually phase-in and implement the rules,
particularly the trade-through rule, in a methodical manner. Regulation
NMS provides a limited phase-in of the trade-through rule, beginning
with a small group of representative NMS stocks on April 10, 2006, with
full implementation by June 12, 2006.
Knight recommends a more incremental phase-in to help ensure that
market participants have the system capacity necessary for successful
implementation. For example, we suggest that 100 stocks be part of the
first phase-in stage, which should last one month, followed by
additional phases of 500 stocks per month thereafter. This incremental
phase-in approach will allow for a more reasonable implementation
schedule and will permit market participants to conduct the proper
stress testing on their trading systems for those changes associated
with the new requirements.
There is adequate precedent for such a phased-in implementation of
major changes to market rules. For example, the implementation of
decimal pricing began with a phase-in of decimal pricing in August 2000
and ended with full implementation in April 2001. There are other
examples, such as the move from Nasdaq's SelectNet to SuperMontage and
the implementation of Regulation SHO, where the SEC took a deliberate
and careful approach to implementing new rules. The transition to
SuperMontage took several years to implement and included testing the
trading systems on weekends for many months. The implementation of
Regulation SHO governing short sales includes a one year pilot
consisting of stocks of varying liquidity and size. These examples
demonstrate that when the regulators and industry work carefully
together on complicated matters, it helps to smooth the transition to
the new rules with the least disruption to market participants and
investors.
2. Improve connectivity. Regulation NMS permits private linkages to
promote more connectivity among the markets. However, the SEC should
mandate minimum standards for such linkages and ensure that quotes can
be accessed immediately. Knight believes that this requirement alone
would have prevented the need for any trade-through rule and provided
for a more efficient national market system. Although Regulation NMS
encourages connectivity, these provisions should be strengthened to
ensure that the markets are linked and accessible, especially in light
of the new trade-through rule.
3. Trade-through rule design. The most complex aspect of Regulation
NMS will be the implementation of the new intermarket trade-through
rule. A number of questions remain regarding how to program trading
systems for the new trade-through rule. Although the rule provides an
exemption from the trade-through rule for flickering quotes, there
remain questions as to how this will work in practice. For example, in
a flickering quote environment, would the execution of a trade that
occurred two cents from the ``best price'' be considered a trade-
through?
With automatic and electronic trading, fast response times are
critical for an efficient trading environment. If rules establish
specific response times of 1-2 seconds, it may create a safe harbor for
markets to respond within that time frame rather than promoting
innovation and sub-second response standards. These latencies will
ultimately harm the investors, and only serve to reduce transparency
and to decrease liquidity.
Rules for response times should be dynamic, reflecting the current
state of technology at any point in time. The Securities Exchange Act
of 1934 (the ``Exchange Act) states that the securities markets are an
``important national asset which must be preserved and strengthened.''
\3\ Further, and by way of analogy, when considering unlisted trading
privileges, Congress directed the SEC to take into account many
factors, including `` . . . the character of trading, the impact of
such an extension on the existing markets for such securities, and . .
., the progress that has been made toward the development of a national
market system'' (emphasis added).\4\ The message from Congress is
clear. The implementation of rules should take into account the impact
on ``existing markets.'' Consequently, in existing markets that
benchmark executions in sub-seconds, rules should not be promulgated
which encourage or permit much slower executions. To do so, would not
only ignore the state of technology in existing markets, but could also
hinder the continued ``development of a national market system.''
---------------------------------------------------------------------------
\3\ See, Section 11A(a)(1) of the Exchange Act, 15 U.S.C. Sec. 78k-
1(a)(1).
\4\ See, Section 12(f) of the Exchange Act, 15 U.S.C. Sec. 78I(f).
---------------------------------------------------------------------------
The issues relating to defining ``fast'' and ``slow'' markets are
equally complex and challenging. For example, who determines whether a
quote is fast or slow? Additionally, as currently drafted, the rule
applies to ``quotes.'' Thus, market participants will have to develop
processes to monitor each stock traded in each market venue. To
illustrate the complexity, there are roughly 6,000 securities that
trade on Nasdaq and the NYSE. Imagine needing a stopwatch to time the
response times of all market participants in those 6,000 issues,
clicking on and off with each trade, in each security, by each market
participant, every second of the trading day. As you can imagine, there
are a number of possible outcomes if there is not sufficient
specificity or a bright line to set forth the standards.
Another concern about implementation of the rule lies with the
exemption of trade-through protection for slow quotes. Regulation NMS
does not exempt trade-throughs of manual quotes from best execution
obligations. Knight recommends some form of a safe harbor from best
execution obligations for slow quotes. If there is no safe harbor, it
could create significant uncertainty and inefficiencies in the markets
and it could ultimately defeat the incentives for slow markets to
become fast markets.
4. Potential gaming opportunities. Careful and poised
implementation will be vital in preventing potential gaming
opportunities of professional traders who may seize upon unintended
opportunities resulting from a rapid roll-out of the rule. A lesson can
be learned from the retired Nasdaq Small Order Execution System (SOES)
system. SOES was initially designed, in part, to remedy the problems
experienced after the 1987 stock market crash to ensure the small
orders of many investors could be executed automatically. SOES allowed
small orders to be executed automatically against dealer quotes;
however, an eventual unintended consequence was the creation of a
cottage industry of professional traders, often called ``SOES
bandits,'' that took advantage of small quote differences using rapid
trading. It took several years to take action against these abuses,
some of which impacted small investors by disadvantaging pension and
mutual funds. In a similar way, care should be taken not to create
gaming opportunities for certain professionals at the expense of most
investors.
Recent Market Developments
Competition helps to foster innovation, creativity, and greater
efficiencies to the benefit of the individual investor. Knight has
always been an advocate of policies that foster competition. For
instance, Knight was a proponent of rules that increase transparency
and comparability of execution quality. The SEC later adopted Rule 5,
which as I described earlier, has provided transparency and
comparability of execution statistics. This has increased competition
and pressured markets to continue to improve execution and reduce costs
of customer orders.
Regulation NMS, to the extent practicable, should avoid prescribing
specific paths to trading, which may limit the ability to innovate and
to enter markets. Additionally, we need to be mindful of the fact that
costs associated with complying with a very intricate rule could create
barriers to entry. The current uncertain business and regulatory
environment impacts profitability and tends to encourage more
consolidation. Clear and effective regulation will help to reduce some
of these uncertainties. Although a degree of consolidation is
inevitable as firms strive to gain efficiencies and economies of scale,
it is unclear to what extent investors may benefit as further
consolidation of the markets takes place.
Conclusion
Knight appreciates the constructive role this Committee has played
in the oversight of the markets and the rulemaking process. Regulation
NMS represents the first fundamental rewrite of the market system rules
in 30 years. Therefore, we urge the Committee to continue its oversight
role as the industry and the SEC work on implementation of Regulation
NMS. Your involvement helps to ensure that the U.S. capital markets
remain competitive and innovative, thus benefiting all investors.
Thank you for your interest in these issues and for the opportunity
to contribute to this important dialogue.
PREPARED STATEMENT OF MARC E. LACKRITZ
President, Securities Industry Association
May 18, 2005
Introduction
Chairman Shelby, Senator Sarbanes, and Members of the Committee, I
am Marc E. Lackritz, President of the Securities Industry
Association.\1\ SIA commends you for holding this hearing and
appreciates the opportunity to testify on the implementation of
Regulation NMS, as well as on issues related to the proposed mergers
between the New York Stock Exchange (NYSE) and Archipelago Holdings,
Inc., and The Nasdaq Stock Market (Nasdaq) and Instinet, LLC.
---------------------------------------------------------------------------
\1\ The Securities Industry Association brings together the shared
interests of nearly 600 securities firms to accomplish common goals.
SIA's primary mission is to build and maintain public trust and
confidence in the securities markets. At its core: Commitment to
Clarity, a commitment to openness and understanding as the guiding
principles for all interactions between
investors and the firms that serve them. SIA members (including
investment banks, broker-dealers, and mutual fund companies) are active
in all U.S. and foreign markets and in all phases of corporate and
public finance. According to the Bureau of Labor Statistics, the U.S.
securities industry employs nearly 800,000 individuals, and its
personnel manage the accounts of nearly 93 million investors directly
and indirectly through corporate, thrift, and pension plans. In 2004,
the industry generated an estimated $227.5 billion in domestic revenue
and $305 billion in global revenues. (More information about SIA is
available at: www.sia.com.)
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Our Nation's securities markets are the most transparent, liquid,
and dynamic in the world. New forms of competition, technological
advances, globalization, and broader investor participation have driven
phenomenal changes in the capital markets and the securities industry
over the past decade. Indeed, we only have to look at developments over
the last month to see that this continues to be the case. Both the NYSE
and Nasdaq proposed major restructurings and the Securities and
Exchange Commission (SEC or Commission) adopted Regulation NMS after a
vigorous and healthy debate over the future trading structure of our
securities markets.
SIA does not have a position on the proposed mergers, but we
strongly believe they raise two critical regulatory issues that the
Commission should address. First, they highlight the need, and present
the opportunity, to bring the structure of self-regulation into the
21st century. Although the current model of self-regulation has
generally worked well to protect investors, we believe the time has
come for a major restructuring of the self-regulatory system. SIA
supports the adoption of a hybrid self-regulatory model, which would
embody regulation into two types of organizations that would be divided
by function. Each marketplace would have its own SRO, which would
regulate and enforce all aspects of trading, markets, and listing
requirements. The other type of organization would be a Single Member
SRO that would handle regulations relating to the operations of broker-
dealers. By eliminating unnecessary regulatory duplication and inherent
conflicts of interest, a revamped self-regulatory structure can
strengthen investor protection and increase the competitiveness of the
U.S. capital markets.
Second, the proposed mergers heighten concerns about the potential
for consolidated market centers to develop an unchecked monopolistic
hold on market data to the detriment of investors and markets. We have
urged the SEC to address market data issues comprehensively, and we are
disappointed that the SEC has not done this yet. The Commission has
indicated, however, that it intends to address the remaining issues in
the context of SRO reform. We urge the Commission to consider the
recent plans for consolidation of market centers in addressing the
outstanding market data issues.
The periodic reevaluation of market structure is vital to
maintaining our global preeminence and to ensuring that investors are
fully protected. SIA commends the Commission and its staff for tackling
such difficult issues and for their continued efforts to engage all
market participants in the debate. The SEC has acted diligently and in
good faith to explore reforms that will strengthen the U.S. capital
markets. Although many of the solutions are controversial and not
necessarily what SIA would prescribe, the policy debate has been
necessary and productive. The trade-through rule was particularly
divisive, as evidenced by the unusual 3-2 split among the Commissioners
on final adoption of the rule. However, it is important to note that
the issues raised in Regulation NMS are inherently complex, and finding
consensus is an enormously difficult task.
Since the text of Regulation NMS has not yet been released, we have
not identified the full range of implementation problems yet. We are in
the process of forming working groups with our member-firms to address
all operational and compliance implementation issues, and plan to work
with the self-regulatory organizations (SRO's) over the next 14 months.
Given the significant systems and other changes that will be necessary
to implement the new rules, we are grateful that the Commission has
provided lengthy implementation periods for most of the rules.
Regulation NMS
Guiding Principles
SIA believes any regulatory approach to market structure should:
Protect investors.
Ensure the markets are fair, orderly, and honest.
Be sufficiently flexible to adapt to the development of new
trading practices and technological innovations by competing market
centers.
Foster effective intermarket executions and enhance market
access to ensure that all investors' orders--both retail and
institutional--are executed in the manner most beneficial to the
investor.
Assure equal, fair, and consistent regulation across market
centers.
Ensure quality, fairly priced, cost-effective market data.
The SEC's Action on Regulation NMS
The newly adopted Regulation NMS includes new or revised rules for
trade-through regulation, intermarket access, quoting in sub-penny
increments, and market data reforms. Although we agree with many of the
SEC's decisions, there are a few significant areas where we differ and/
or had offered refinements.
Intermarket Price Protection (Trade-Through Rule). The Commission
proposed two alternatives for the trade-through rule, a ``top-of-book''
option and a voluntary ``depth-of-book'' alternative. SIA member-firms
were not convinced that either approach was appropriate and recommended
putting in place the National Best Bid and Offer (NBBO) model before
considering implementing either of the options. The SEC, however,
adopted the top-of-book approach, which will protect the best bids and
offers of each exchange, Nasdaq, and the NASD's ADF. Trading centers
will have to establish and enforce written policies and procedures that
are reasonably designed to prevent trade-throughs.
Given the vital importance and the extreme complexity of the trade-
through rule, we argued that it would be more prudent to take a
methodical approach to implementation to ensure we get it right from
the start. Using the NBBO model as a first step would strengthen
existing trade-through protection and extend it beyond the listed
market to cover the entire Nasdaq market as well. Such a strategy would
provide greater investor protection and facilitate competitive,
innovative markets while avoiding the unnecessary, burdensome
regulatory effects or unintended consequences that could result from
the more extensive trade-through rules.
SIA supported the adoption of many of the Commission's proposed
exceptions to the trade-through rule and offered some fine-tuning of
others. Although the rule did not contain a general ``opt-out''
exception that would have allowed market participants to disregard
displayed quotations, the rule included several exceptions to help
ensure its workability with, among others, intermarket sweep orders,
quotations displayed by markets that fail to meet the response
requirements for automated quotations, and flickering quotations with
multiple prices displayed in a single second.
The Commission did not adopt, however, our suggestion for a new
liquidity exception for the most actively traded, highly liquid
securities. We recommended this exception because the manner in which
these securities trade already affords investors with effective
protection. Trade-through regulation should be focused on those
securities for which it would have the greatest benefit in protecting
investors--less liquid securities, for example. The adoption of such an
exception would have allowed the SEC to study the effect of having a
trade-through rule versus not having one for a specified period of time
(such as a year). The SEC would then have been able to consider the
necessity for any further action, in much the same manner as it plans
to do with the pilot program for Regulation SHO (short-sale rule).
We are also concerned about the treatment of manual quotes in the
new trade-through rule, and discussed these concerns and our
recommendations for addressing them in our comment letters.
Intermarket Access. SIA supported adoption of the Commission's
proposed access standards for private linkages and the proposed rule to
minimize locked and crossed markets. The private-linkage approach
establishes uniform market access for all by promoting
nondiscriminatory access to quotations displayed by SRO trading
centers. We suggested, however, that the antilocking and anticrossing
rule include two of the proposed exceptions to the trade-through rule--
flickering quotes and systems malfunctions.
SIA supported the Commission's efforts to craft a market-wide
solution to the access fee problem, but we still have concerns about
excessive fees related to unprotected quotations, the administrative
difficulties of tracking whether quotations are protected or not, and
the broad definition of access fees.
Sub-Penny Quoting. We endorsed the Commission's ban on sub-penny
pricing as a way to help prevent ``stepping-ahead'' of customer limit
orders for an economically insignificant amount. This practice, over
time, could discourage investors from placing limit orders, an
important source of market liquidity.
Market Data. We are deeply disappointed that the SEC did not deal
with all of the market data issues in the context of the Regulation NMS
debate, but the Commission has indicated it intends to address the
remaining issues in the context of SRO reform. We strongly believe the
resolution of these issues--sooner than later--is of the utmost
importance for the integrity of the markets, particularly now in light
of the proposed NYSE and Nasdaq mergers.
The Commission adopted rules to revise formulas for the allocation
of market data revenues to: Create advisory committees to the joint
industry plans composed of non-SRO representatives; authorize markets
to distribute their own data independently, while still providing their
best quotations and trades for consolidated dissemination through the
plans; and, streamline the requirements for the display of
market data to investors. According to the SEC, these changes will help
correct the flaws of the current formulas, reward SRO's that contribute
to public price discovery by dividing market data revenues equally
between trading and quoting activity, and improve the transparency and
effective operation of the plans.
Those revised reallocation formulas, however, do not address a
number of other critical market data issues--such as opaque fee-setting
practices--that have resulted in unwarranted and excessive market data
fees. We had recommended that the Commission consider all of the
following market data related issues as a whole:
Current and future fees should be accounted for transparently,
and supported by independent audits of the networks and annual
filings that cover expenses, revenues, and projections;
Unlike the SEC's rule filing process, fees should be set and
changed through a collective process that involves market
participants, operates transparently and permits real challenge;
Fees should be limited to the cost of collecting and
disseminating market data, thereby rendering rebates unnecessary;
The networks' contractual and usage requirements should be
reduced, streamlined, and made uniform, which will assist in
lowering fees and associated administrative burdens;
Plan governance also should be transparent, with any advisory
committee structured to reflect industry and investor involvement
and empowered beyond the merely cosmetic;
Most firms believe that information should be channeled
through a single securities information processor (SIP);
Any fees chargeable for noncore data such as depth-of-book
should be subject to market forces; \2\ and,
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\2\ The SIA believes, however, that the Commission should undertake
a study of the impact of different levels of transparency among market
participants (for example, between retail and institutional investors)
in this era of decimalization where depth of book data is not readily
available to all.
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Market data provisions, including definitions and applications
of fee categories such as ``professional'' and ``nonprofessional''
and limitations on the redistribution of data, should be the
subject of a fresh review and uniform rulemaking.
We believe Congress did not intend for market data to generate
revenues for SRO's to subsidize their regulatory obligations or to fund
competitive business activities, as it does today. The purpose of
disseminating market data is to create transparency in the prices that
investors receive for buying and selling securities and, where there
are competing market centers, to increase investor choice and
opportunity. For that reason, SIA advocated a revised method for
funding regulation that does not depend on revenue from market data
fees.
We do not believe our proposed cost-based approach for establishing
market data fees puts the SEC in a role of rate maker, but instead
relies upon its oversight role over SRO's to ensure that access to this
information is available on terms that are ``fair and reasonable'' and
``not unreasonably discriminatory.''
Our proposed cost-based approach will minimize many of the
conflicts of interest related to market data fees that SRO members of
the plans face now. The conflicts arise from control over a monopoly
product with the ability to use the monopoly revenue to subsidize other
activities. By limiting the market data revenue, the business incentive
to seek greater data revenue is restricted as well. We believe the
narrow cost-based approach is the most straightforward method to
accomplish this, and is most closely aligned with the congressional
purposes underlying the Exchange Act.
Of course, in determining the reasonableness of fees under the
cost-based approach, the SEC also must consider whether the fee limits
fair and reasonable access to market data, particularly where such
access is imperative for compliance with regulatory requirements, such
as proposed Regulation NMS. We need to recognize that decimalization
has decreased the value of consolidated market data even though the
price has remained the same. Prior to decimalization, the consolidated
data reflected in the NBBO signaled the depth in the market up to 12
cents. Today, the depth of the market reflected in the NBBO is only a
penny or two, generally representing very few shares.
The valuable data that used to be reflected in the NBBO is now in
the nonconsolidated data that the SRO's are distributing on their own,
at an additional charge. This trend is continuing and, indeed,
sanctioned by the Commission's recent amendments. The Commission should
not only look at the high cost of producing such data, but also whether
market data fees are in fact cross-subsidizing the production of
proprietary market data products. We believe a cost-based approach to
all market data would ensure the availability of both depth-of-book and
NBBO information at a reasonable cost.
The proposed NYSE and Nasdaq mergers only heighten our concerns in
these areas. Indeed, some member-firms are apprehensive that the SRO's
will have an even greater monopolistic hold on market data with the
consolidation of the markets, which could work toward the detriment of
both our markets and investors. We therefore strongly encourage the
Commission to review all of these market data issues with these new
concerns in mind.
The Need for Structural Reform of Self-Regulation
Guiding Principles
The proposed NYSE-Archipelago merger further heightens the
importance of examining the securities industry's self-regulatory
system. SIA has thought a great deal about the structure of self-
regulation over many years. Five years ago, when the NYSE and Nasdaq
first proposed to become for-profit entities, SIA commissioned a White
Paper titled ``Reinventing Self-Regulation.'' The White Paper examined
the effectiveness of self-regulation in a rapidly changing environment,
and considered the advantages and disadvantages of different models for
regulation of our Nation's securities markets.\3\
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\3\ The White Paper is available at http://www.sia.com/
market_structure/html/siawhitepaperfinal.htm.
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Our reviews of self-regulation include a set of guiding principles,
many of which are listed in the previous section addressing market
structure issues. Two additional principles, however, should be
considered in the debate over the self-regulatory system. First, the
regulatory system should ensure the primacy of the SEC as a strong
national regulator, but should include appropriate roles for, and
coordination with, the SRO's, the States, and market participants, to
achieve uniform national standards. Second, the regulatory staff
overseeing day-to-day activities must possess the requisite expertise
necessary to perform their duties. This can best be achieved if the
regulator has: (i) effective industry input into the regulatory
process; (ii) the power and prestige to attract talented staff; and
(iii) the ability appropriately to tailor regulation to fit the
diversity of entities that it regulates, rather than relying upon a
``one-size-fits-all'' approach.
Based on our experience with these issues, we have concluded that
the time has come for a major restructuring of self-regulation.
Although we believe the current model of self-regulation has generally
worked well to protect investors, concerns about regulatory conflicts
of interest and regulatory duplication have taken on new significance
as market centers combine and competition--both domestically and
internationally--intensifies. In that vein, we propose consolidating
regulation of broker-dealers into one ``hybrid'' SRO, while each
marketplace retains separate SRO's to regulate and enforce all aspects
of trading, markets, and listing requirements. We describe this
proposal in more detail later.
Strengths and Weaknesses of the Current SRO System
The success of today's self-regulatory governance is directly
related to member involvement in the process.\4\ For example, member
expertise and involvement in SRO rulemaking processes has led to more
effective, less costly rules. In addition, self-policing by
professionals who have the requisite working knowledge and expertise
about marketplace intricacies and the technical aspects of regulation
creates a self-regulatory system with valuable proper checks and
balances. Supplemented by government oversight, this tiered regulatory
system can provide a greater level of
investor protection than the government alone might be able to achieve.
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\4\ See generally S. Rep. No. 94-75, at 22 (1975) (accompanying S.
249, 94th Cong., 1st Sess. (1975)) (In enacting the Exchange Act,
Congress balanced the limitation and dangers of permitting the
securities industry to regulate itself against `the sheer
ineffectiveness of attempting to assure [regulation] directly through
the government on a wide scale.' ''); SEC Report of Special Study of
Securities Markets, H.R. Doc. No. 88-95, Part 4 (1963) (Special Study).
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Because self-regulators have an intimate knowledge of industry
operations, trading, and sales practices, they can develop and revise
rules more quickly and frequently. Similarly, self-regulation utilizes
the insight of those who are on the frontline of marketplace
developments, meaning they can be more forward-looking and up-to-date
with market realities than traditional government regulators. In
addition, SRO rules often are designed to set ethical standards that
exceed the legal minimums. For example, the NASD requires that its
member firms adhere to ``just and equitable principles of trade,'' a
standard that in many instances exceeds the antifraud requirements of
SEC statutes and rules.
In spite of how well self-regulation has worked, both market
participants and governmental bodies have recognized in recent years a
growing need for structural
reform of self-regulation. This view is based on three concerns: (1)
increased competition among SRO's and their members for customer orders
could cause conflicts of interest due to the SRO's' roles as both
market operators and regulators; \5\ (2) ``multiple SRO's can result in
duplicative and conflicting SRO rules, rule interpretations, and
inspection regimes, as well as redundant SRO regulatory staff and
infrastructure across SRO's;'' \6\ and, (3) the profit motive of a
shareholder-owned SRO could detract from self-regulation.\7\
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\5\ ``Securities Markets: Competition and Multiple Regulators
Heighten Concerns about Self-Regulation,'' General Accounting Office,
May 2002, GAO-02-362, available at http://www.gao.gov/new.items/
d02362.pdf, at 1-2 (GAO SRO Report). The GAO also noted, ``Heightened
competitive pressures have generated concern that an SRO might abuse
its regulatory authority--for example, by imposing rules or
disciplinary actions that are unfair to the competitors it regulates.''
The SEC shares this concern. ``As intermarket competition increases,
regulatory staff may come under pressure to permit market activity that
attracts order flow to their market. . . . Also, SRO's may have a
tendency to abuse their SRO status by over-regulating members that
operate markets that compete with the SRO's own market for order
flow.'' Concept Release Concerning Self-Regulation, 69 Fed. Register
71256, 71262 (Dec. 8, 2004) (SEC SRO Concept Release).
\6\ SEC SRO Concept Release at 71264. The GAO has noted similar
``inefficiencies associated with SRO rules and examinations.'' GAO
Report at 2.
SIA has recently had productive discussions with the NYSE and NASD,
as well as the SEC's Office of Inspections and Examinations (OCIE), on
improving coordination among these three regulators' examination
programs. An overview of the results to date of those discussions is
available at http://www.sia.com/RegulatoryCoordination/index.html.
\7\ ``Another significant conflict of interest for SRO
responsibilities is with SRO shareholders. SRO demutualization raises
the concern that the profit motive of a shareholder-owned SRO could
detract from self-regulation. For instance, shareholder-owned SRO's may
commit insufficient funds to regulatory operations or use their
disciplinary function as a revenue generator with respect to member
firms that operate competing trading systems or whose trading activity
is otherwise perceived as undesirable.'' SEC SRO Concept Release, at
71263.
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Significance of the NYSE-Archipelago Merger
Because several of our large members have divergent views on the
proposed NYSE-Archipelago merger, it would be inappropriate for us to
comment on its merits as a business transaction. We do, however,
strongly believe that the proposed merger represents an important
opportunity to address the concerns outlined previously. The following
are some observations about the NYSE-Archipelago merger.
(1). The merger both illustrates and accelerates the trend toward
increased consolidation of, and competition between, market centers.
While this competition is in most respects a very healthy development,
it does raise questions about the NYSE's continued regulation of
broker-dealers that could be potential competitors for order flow or
for development of new investment products. The very fact that NYSE
apparently seeks to maintain regulation of its broker-dealer members
under the NYSE name and the oversight of some of its directors, rather
than spin it off into a separate entity under a different name with
entirely separate directors, suggests that the NYSE sees value in
continued ``branding'' of its regulatory authority over broker-dealers.
The measure of any value that may be perceived in retaining broker-
dealer regulation within the NYSE brand is also the measure of the
problem of the NYSE regulating potential competitors.
(2). The merger underscores the significance of increased
competition, not just narrowly between U.S. market centers, but also
globally among all capital markets. This competition applies to
securities exchanges and financial intermediaries of all stripes.
Unnecessary regulatory duplication is a weight around the ankles of
financial intermediaries in the United States that has a real cost in
terms of the future competitiveness of our capital markets. The merger
represents an opportunity to address this regulatory duplication.
(3). The merger raises exactly the issues about conflicts between
shareholders' interests and regulatory authority about which the SEC
and SIA have both voiced concerns.
In fairness, it appears that the NYSE sshould address several of
these issues in structuring the merger. The NYSE stated that it would
take steps to separate the NYSE's regulatory arm from its business
side, which should help ameliorate concerns about the possible misuse
of the NYSE's regulatory authority to benefit its business side and its
shareholders.\8\ However, the NYSE's proposal does not appear to
address the critical issue of regulatory duplication between itself and
the NASD in regulating dually registered broker-dealers. While the NYSE
is, appropriately, focused on strengthening the competitiveness of its
own business position, the proposed merger represents an opportunity to
reconfigure the self-regulatory system so that the competitiveness of
the overall U.S. capital markets is also strengthened.
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\8\ Joint NYSE-Arca/Ex News Release, April 20, 2005, available at
http://www.nyse.com/pdfs/joint_release.pdf, at 2.
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The Hybrid SRO: Toward a Better System of Self-Regulation
Last winter, the Commission sought comment on a variety of self-
regulatory models as possible alternatives to the current structure of
self-regulation. Of the seven models the SEC proposed, SIA believes the
Hybrid self-regulatory model offers the best alternative regulatory
structure for preserving competitive, innovative markets while
fostering more efficient and effective regulation. Under this model,
self-regulation would be embodied in two types of organizations that
would be divided by function. Each marketplace would have its own SRO,
which would regulate and enforce all aspects of trading, markets, and
listing requirements. The other type of organization would be a Single
Member SRO that would handle regulations relating to the operations of
broker-dealers (sales practices, financial responsibility requirements,
qualification of personnel, recordkeeping, etc.).
The Hybrid model will require the SEC to designate a Single Member
SRO to regulate all SRO members with respect to membership rules such
as financial condition, margin, registered representative qualification
testing, customer accounts, sales practices, and supervision. Each SRO
operating a market would be responsible for the oversight of its market
operations regulation (for example, its trading rules), including
enforcement of those trading rules. The creation of the Single Member
SRO addresses the two primary areas of weakness in the current self-
regulatory structure. First, it eliminates the inefficiencies in
rulemaking and examinations, and the potential for inconsistent
regulation that exists in a multiple SRO system. Second, it eliminates
conflicts of interest between an SRO's regulatory and market functions
with regard to membership rules.
A Hybrid Will Give Better Regulatory Mileage. Most broker-dealer
compliance resources currently are devoted to complying with rules of
multiple SRO's. For example, conduct rules--the area of the most
duplicative SRO rules--have the same regulatory purpose but require
different compliance efforts.\9\ The Hybrid model would strengthen the
effectiveness of compliance resources by creating a single
comprehensive regulatory oversight structure. At the same time, the
existence of multiple-market SRO's, each with responsibility over those
regulations applicable to its unique trading structures, will keep
market expertise where it is most useful. Much of the innovation that
makes the U.S. markets so strong occurs in market operations, so the
maintenance of separate market SRO's will foster continued competition
and innovation and preserve U.S. capital market dominance.
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\9\ For example, the NYSE and NASD have different order audit trail
requirements, each of which requires unique programming and compliance
efforts that are costly, and both of which are intended to provide
similar information for surveillance purposes.
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In general, the SEC has already begun moving toward more universal
capital market rules. For instance, Regulation SHO creates a uniform
definition of what constitutes ownership of securities, specifies
aggregation of long and short positions, and requires broker-dealers to
mark sales in all equity securities ``long,'' ``short,'' or ``short
exempt'' to establish a uniform system across markets.\10\ Parts of
Regulation NMS, such as the ban on sub-penny quotations for securities
priced over one dollar,\11\ also reflect a convergence of rules. The
Hybrid model will continue this consolidation and streamlining of
regulations to increase efficacy and efficiency, and to eliminate
redundancies and gaps in regulatory coverage.
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\10\ See Exchange Act Release No. 50103 (Jul. 28, 2004), 69 Fed.
Reg. 48008 (Aug. 6, 2004) (Regulation SHO).
\11\ See Regulation NMS.
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Overseeing the Hybrid. We realize the Single Member component of
the Hybrid model would concentrate regulatory power and authority in
one entity. Therefore, and notwithstanding our advocacy of the Hybrid
model, this regulatory structure will function effectively only if the
SEC provides attentive and cost-effective regulatory oversight. This
oversight should include the SEC's vigilant review of the
Single Member SRO's costs and fee structures to ensure that the SRO is
providing sufficient regulatory oversight without imposing excessive
fees and budget demands. Similarly, the Commission's robust review of
the Single Member SRO's final disciplinary proceedings will counter any
possible self-serving interest by the Single Member SRO in levying
excessive enforcement fines that would be paid into its own
coffers.
Additionally, strong member involvement will become even more
important to prevent the Single Member SRO from becoming an
unresponsive entity with prohibitive cost structures. The Single Member
SRO will need substantial member input--especially from smaller cost-
sensitive members--to effectively oversee regulation across a diverse
group of members with divergent needs and business models.\12\ Member
involvement and SEC oversight of the Hybrid SRO also will be necessary
to identify and harmonize any ``boundary'' issues between conduct rules
subject to the Single Member SRO's regulatory oversight, and market
rules subject to the continued oversight of the various market SRO's.
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\12\ The needs of fixed-income markets differ from those of
equities markets, for instance. The knowledge members have about the
ramifications of these differences is essential to ensure that a self-
regulatory system works well for all participants.
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The Commission should develop increased transparency requirements
for the Single Member SRO, particularly concerning funding and
budgetary issues. Making the Single Member SRO's operations transparent
to both members and the investing public will place appropriate checks
on the Single Member SRO and will enhance accountability to its
constituents.
To further foster the regulatory efficiency offered by the Hybrid
structure, market SRO's should be permitted to continue to outsource
their market enforcement activities. We understand that the ability to
outsource such activities, while retaining ultimate responsibility as
an SRO, has worked well for various existing SRO's.\13\
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\13\ For example, the American Stock Exchange (Amex) and Nasdaq
have delegated regulatory activities to the NASD. See, for example,
Exchange Act Release No. 37107 (Apr. 11, 1996), 61 Fed. Reg. 16948
(Apr. 18, 1996) (creating the NASDR and Nasdaq as two operating
subsidiaries of NASD); SEC Set to Release Proposals on SRO Governance,
But Details Are Still Thin, Securities Week, Nov. 8, 2004, available at
2004 WLNR 14154116 (quoting NASD chairman and CEO Robert Glauber's
statement that the NASD ``will continue to regulate Nasdaq and Amex
under contract.).
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Fueling the Hybrid. The final issue for the SEC to resolve is how
to fund the Single Member SRO. SIA believes that any future self-
regulatory structure must be adequately funded and that fees for
regulation should be apportioned to the industry on a fair and
reasonable basis. The fees should be unbundled and cost-justified
whenever possible. Imposing regulatory fees on the securities industry
that exceed the true costs of regulation acts as a tax on capital and
imposes undue harm on the capital-raising system. SIA recommends that
the SRO's define the costs necessary to meet their self-regulatory
obligations, prepare and make public a budget to meet those
obligations, and then fairly apportion those costs among members by
making periodic filings with the Commission subject to public notice
and comment.
As stated earlier, we are convinced that market data fees should
not be used to fund regulation and should instead fund only the
collection and dissemination of market data.\14\ Cost-based market data
fees will not reduce regulatory funding, but will provide greater
accountability and transparency in the way market data fees are
assessed and self-regulation is funded. Explicitly tying market data
fees to the cost of producing the data, while requiring the SRO's to
prepare public regulatory budgets and charge specific fees for
regulation, will fully meet regulatory funding needs without over-
charging for market data.
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\14\ In 2003, the Plans spent $38 million on Plan expenses and
collected $424 million in market data revenue. The revenue exceeds
costs by a significant margin. See Exchange Act Release No. 49325 (Feb.
26, 2004), 69 Fed. Reg. 11126 (Mar. 9, 2004) (initially proposing
Regulation NMS).
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Of course, eliminating market data fees as a source of regulatory
revenue may produce a shortfall of regulatory funding.\15\ To address
this possibility, and to underscore how strongly we feel about (i) the
need for a hybrid SRO approach, and (ii) the need to move away from
market data fees as a source of regulatory funding, the industry is
willing to pay higher regulatory fees to the Single Member SRO than it
now pays to the NYSE and NASD. Our only qualification is that any
increase in regulatory fees on member firms should be, with the SEC's
assistance, allocated in a fair manner among all member firms such that
there is not an undue burden on smaller firms.\16\ Notwithstanding the
potential for increased regulatory fees for members of the Single
Member SRO, we believe the benefits of the Hybrid model should exceed
the costs.
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\15\ We note, however, that the increase may be less than one-for-
one because, although SRO's may use market data fees to fund regulation
today, it is equally likely that SRO's use market data revenues to fund
competitive or proprietary activities such as rebates for trade prints,
advertising and brand marketing, and to attract listings.
\16\ For example, such fees might be based on any number of factors
designed to approximate the degree of resources required of the Single
Member SRO in overseeing a particular firm, such as the number of
registered representatives of a firm, or the scope and nature of its
customer base or operations.
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SIA also believes that a fair and reasonable portion of the Single
Member SRO's funding should come from issuers and other constituents of
the trading markets. Trading markets will benefit significantly from
regulatory oversight of broker-dealers and the various examination and
continuing education programs conducted by the Single Member SRO under
a Hybrid model. Such regulation and education initiatives foster the
market integrity and investor confidence that bring so much business to
the U.S. capital markets. Under the Hybrid model, markets would receive
these benefits, and market SRO's should assume some of the associated
regulatory and administrative costs.
Conclusion
America's securities markets are the envy of the world, but we
cannot take it for granted that they always will be. Maintaining the
preeminence of our capital markets in an increasingly globalized
economy will require sustained efforts to remove unnecessary regulatory
inefficiencies that hinder our ability to compete. SIA is eager to work
with Congress, the SEC, the SRO's, and all other interested parties to
ensure that our markets remain the most transparent, liquid, and
dynamic, with unparalleled levels of investor protection.
Thank you.
----------
PREPARED STATEMENT OF GEORGE U. ``GUS'' SAUTER
Chief Investment Officer and Managing Director, The Vanguard Group
May 18, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, my name is Gus Sauter. I am the Chief Investment Officer and
a Managing Director of The Vanguard Group. I oversee the management of
approximately $600 billion in mutual fund assets. I am very pleased to
be here representing The Vanguard Group. We have been working with
various marketplaces over the past decade to improve the quality of the
markets to meet investors' needs.
I would like to thank the Committee for having this hearing on
Regulation NMS and recent market developments. The issues surrounding
market structure are very important issues for investors to ensure a
fair and efficient marketplace. We believe that Regulation NMS,
specifically the trade-through rule, will promote direct investor order
interaction and support the best execution of investor orders.
National Market System Principles
The national market system (the NMS) was created in 1975 through
amendments to the Securities Exchange Act. These amendments set forth
Congress' findings about our securities markets and directed the
Securities and Exchange Commission (the SEC) to facilitate the
establishment of an NMS. Congress recognized that new data processing
and communications technology created the opportunity for the more
efficient operation of markets. It also found that the linking of all
markets would enhance competition, increase information available to
intermediaries and investors, facilitate the offsetting of investors'
orders and contribute to best execution.
Specifically, Congress directed the SEC to use its authority to
assure the following five principles:
Economically efficient securities transactions (efficiency);
Fair competition among brokers and dealers and among markets
(competition);
The availability of quotation and transaction information
(price transparency);
The practicability of brokers executing investors' orders in
the best market (best execution); and
The opportunity for investors' orders to be executed without
the participation of a dealer (direct investor order interaction).
I would like to focus on two of the principles set forth in these
amendments: (1) best execution and (2) the promotion of direct investor
order interaction.
Best Execution
What is best execution? Some say it is obtaining the best price.
Others say it is obtaining speed of execution and certainty. We believe
it is a combination of both into something we call the expected best
price. It is the best price an investor thinks he or she can obtain for
the entire trade at the instant the investor decides to buy or sell
securities. This enables investors to minimize transaction costs and
maximize returns.
What is the optimal market environment for achieving best
execution? A perfectly liquid limit order book. Ideally there would be
an infinite number of limit orders willing to buy or sell a stock with
a very small spread between the bid and offer prices.
Limit Orders
The ideal national market system encourages a perfectly liquid
limit order book by creating rules that entice investors, market
makers, and other market participants to place limit orders on an order
book.
Limit orders are the building blocks of transparent price
discovery. Although there may be many market participants willing to
trade at a certain price, it is only the limit order on the book that
enables transparent price discovery. Without a book of limit orders,
market orders have no meaning. Limit orders frame the market-clearing
price of a stock.
Transparency of limit orders promotes competition among them. In
order to improve the likelihood of execution investors are incented to
enter limit orders at improved prices. This creates narrower spreads
and additional depth of book, both of which serve to reduce transaction
costs for investors.
Displaying limit orders is crucial to promoting liquidity. But
displaying limit orders runs contrary to most traders' instincts. Like
a poker player, they desire to see everyone else's cards without
revealing their own. Economically, a limit order grants a free option
against which traders can execute their orders. This free option
creates a profitable opportunity for traders who are allowed to step in
front of a limit order with the knowledge that they are protected from
adverse price movement by the book of limit orders. If the market moves
against their position, they can always ``put'' their position to the
book of limit orders. Since one trader's gain (from taking advantage of
the free put) is another trader's loss (from providing the free put),
there is an economic disincentive to place limit orders.
Trade-Through Rule
All of this points to the need to overcome the inherent impediments
to creating limit orders. These types of orders should be encouraged.
We believe that with a uniform trade-through rule, limit orders are
protected and therefore encouraged.
We believe that those who opposed the Regulation NMS trade-through
rule placed too much emphasis on the short-term goal of satisfying
market orders. This disregards the longer-term effects on the markets
of diminishing limit orders. If executions outside of the NBBO are
permitted, the investor that placed the limit order at the NBBO is
disadvantaged by not receiving an execution. Why would an investor
place subsequent limit orders when they can simply be circumvented? Of
course, the order taking the liquidity is immediately filled in a
fashion that is satisfactory to the trader, but why should the order
taking liquidity out of the market be favored over the order
contributing to liquidity in the marketplace? We believe this creates
an unintended consequence of significantly negatively impacting
liquidity, and the ability to fill market orders efficiently, in the
future.
Competition and Free Markets
Much concern has been expressed over competition and free markets
versus regulation. We absolutely think competition is imperative. But
the competition that is most important for investors is the competition
among orders--bids competing against bids driving the willing purchase
price higher, and offers competing against offers encouraging the sale
at a lower price. This promotes the perfectly liquid limit order book
we desire.
Our obligation is to get best execution for our trades. We execute
against other orders. We do not execute against exchanges. Exchanges
only provide services. They are a venue through which we execute our
trades. The trade-through rule will have the effect of linking the
exchanges into a more central marketplace. In this respect, the
national market system will be analogous to the internet. The internet
is a centralized repository of information with hundreds of internet
service providers (ISP's) that compete on speed, price, and other
services. But ultimately, each ISP provides its subscribers with access
to the same internet as every other ISP. Similarly, each exchange is a
portal into the national market system, and they can compete on speed,
price and other services.
Concern also has been expressed about the extension of any trade-
through rule to Nasdaq stocks. I would like to make two points about
this. First, although Nasdaq does not formally have a trade-through
rule, it operates as though it does. Applying the uniform trade-through
rule to it will not be a large burden. Second, different types of
markets may trade the same NMS stocks, regardless of where the stocks
are listed. For example, today Nasdaq stocks are traded on Nasdaq's
SuperMontage, ECN's and ``listed'' exchanges. And several NYSE listed
stocks are traded on Nasdaq. This cross trading of stocks will
certainly increase in the future. In this environment, it only makes
sense that there should be intermarket protection against trade-
throughs for all NMS stocks.
Recent Market Developments
Two recent developments will intensify competition between markets
and, hopefully, investor orders. The NYSE and Archipelago recently
announced their proposed merger, followed a few days later by Nasdaq's
agreement to purchase Instinet's electronic trading network.
On the surface, any contraction in the number of market centers
could be worrisome. The devil is in the details, but these mergers will
result in two major markets pitted against one another. Our view is
that investors will be better served by two strong competitors fighting
with more automated processes.
The consolidation of the order book on Nasdaq should reduce order
fragmentation and increase competition among orders. Competition for
listings and unlisted trading privileges will also increase.
In the case of New York and Arca, we will have to wait and see the
details of the proposed merger. We would like to see the best aspects
of both merged together. However, we understand that the platforms may
not be merged together. If this is the case, there would be little
upside advantage of the merger. There would not be a negative effect,
but a significant opportunity to reduce order fragmentation and
increase order interaction would be lost.
We want to see a competitive environment where various marketplaces
offer value as venues into a more centralized market. Just as ISP's
that offer cutting edge services are able to compete against the
Comcasts of the world, we believe there will be opportunities for
smaller exchanges that offer a value proposition to thrive. And, there
will be sufficient competition between exchanges to keep each other in
check and reduce order fragmentation. Depending on how the mergers play
out, they could end up satisfying the Regulation NMS objective of
promoting limit order competition.
Again, I would like to thank the Committee for allowing me to
express our views. I would be pleased to answer any questions you may
have.
REGULATION NMS AND RECENT MARKET DEVELOPMENTS
----------
THURSDAY, MAY 19, 2005
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:10 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing shall come to order. This
morning, the Committee continues its examination of Regulation
NMS and the recent industry consolidation. This morning, the
Committee will hear from Chairman Bill Donaldson of the
Securities and Exchange Commission.
At yesterdays hearing, a number of leading market
participants addressed the changing dynamic of our equities
markets. The convergence of a new regulatory framework
established by Regulation NMS and the impact of the proposed
mergers between the New York Stock Exchange and Archipelago and
Nasdaq and Instinet has significantly altered the marketplace.
We look forward to continuing this discussion with Chairman
Donaldson this morning.
I would also like to remind Members of the Committee and
also Chairman Donaldson that we will likely be operating under
some time restrictions this morning due to the Minority
Leader's objection to hearings continuing 2 hours after the
Senate is in session. It might not affect us. It depends on how
long we go and if that objection is made. But, Mr. Chairman, I
thank you for appearing here today, and we look forward to your
testimony, and a lot of things have happened in the last
several months in this area.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Mr. Chairman.
This is the second of 2 days of Committee hearings on the
subject of Regulation NMS and recent market developments. The
third week of April brought two announcements of significant
changes to the U.S. securities markets. The New York Stock
Exchange announced its merger with Archipelago in what The Wall
Street Journal called: ``A historic transaction that will turn
the 212-year-old Big Board into a public company and help it
expand electronic training.'' Nasdaq announced its acquisition
of Instinet in what the Journal called: ``A reflection of, and
a result of, seismic changes in the business of being a stock
market.''
These mergers hold the potential for benefits such as
greater market efficiency, transaction costs to investors,
narrower trading spreads, increased depth of book and
liquidity, and more choice in terms of trading multiple types
of securities: Stocks, options, exchange-traded funds on the
same platform. However, some questions and concerns have arisen
about the resulting organizations, and the SEC's review of
these transactions will, of course, determine how these
concerns are addressed.
I want to make reference to one issue in particular, which
I addressed yesterday at the panel that was here. The SEC's
concept release concerning self-regulation published in
December 2004, not quite a year and a half ago, pointed out,
``SRO demutualization raises the concern that the profit motive
of a shareholder-owned SRO could detract from proper self-
regulation.'' I think as we move forward with respect to market
structure, we must carefully consider what is the best
structure for a regulator of a for-profit exchange so that we
can be assured that it will exercise independent and effective
judgment, and we heard two different models yesterday, and I
think that is an issue to which attention needs to be paid.
Passing Reg. NMS was the culmination of painstaking work by
the Commission. For more than 5 years and during the tenure of
four Chairmen, the Commission has heard the concerns of
industry and investors about market structure, formulated
proposals, held hearings, meetings, and read over 2,000 comment
letters so that all interested parties could be heard. Chairman
Donaldson said in acting, we have our eye on one overriding
objective, the protection of investors, with particular
attention to small investors.
I welcome the indication by the Commission and its staff
that it will engage in robust and ongoing communications with
industry to assist in implementation of Regulation NMS and to
closely monitor whether the rule is having any unintended
consequences. In sum, the SEC has issued a rule that is, as
Investment Company Institute President Paul Schott Stevens
described, an important step in the development of a market
structure that best serves all investors and advances the key
goal of modernizing the U.S. securities markets.
Chairman Shelby, I join with you in welcoming Chairman
Donaldson. This is Chairman Donaldson's third appearance here
before the Committee this year, I believe, which follows on 11
appearances before the Committee in the last Congress. You are
a regular visitor, Mr. Chairman. We are pleased to have you
here touching a whole range of security issues, and as always,
I look forward to your testimony this morning.
Finally, I want to take this opportunity to note the
completion of the successful tenure of your Director of
Enforcement Stephen Cutler. Mr. Cutler served at the Commission
during an historic time, faced very significant challenges and,
in my view, did an outstanding job. I congratulate him and the
dedicated staff of the Enforcement Division for their many
impressive achievements during the period he headed the
Division. I certainly wish him well in the future.
And likewise, I would like to express my appreciation for
the fine work done by Paul Roye, the recently departed Director
of the Division of Investment Management and his staff and wish
him the very best. All of these dedicated SEC employees a great
debt of gratitude, and we thank them for their dedicated
service to the public interest.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman.
I appreciate these hearings that you are holding, and I
will submit an opening statement for the record.
Chairman Shelby. Without objection, it will be part of the
record.
Chairman Shelby. Senator Dodd.
STATEMENT OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you, Mr. Chairman for holding these
hearings, and welcome to Chairman Donaldson before the
Committee. I associate myself with the comments of Senator
Sarbanes. I think he covered the waterfront pretty well here. I
mean, we come back to the words over and over again, and that
is investor protection. It is what our job is up here, and it
is certainly job of the SEC. I think we have to watch all the
time. This is obviously a period of transition that is
occurring.
I think the SEC did a very thorough job. This was not a
decision reached hastily at all, to put it mildly, after 4 or 5
years, and obviously, there is a significant debate about it,
and I know my colleague Senator Crapo and others have strong
feelings, and there are arguments to be held, so it is
worthwhile to go through this process as we go forward, but I,
for one, think the SEC is fulfilling its historic obligation
here, and that is dealing with investor protection, and it is
awkward, these changes, but to do otherwise, I think, would be
to fail on our responsibility collectively.
So, I welcome the opportunity to listen to what you have
been through, the rationale and the arguments. I know it was
contentious on the Commission itself, highly divided. That is
not normally the case on like this that come before the
Commission, and so, I commend all of the Commissioners for the
work and time they put in on this effort to reach the
conclusion they did. I look forward to hearing your testimony.
Chairman Shelby. Senator Reed.
STATEMENT OF SENATOR JACK REED
Senator Reed. Thank you very much, Mr. Chairman.
Let me welcome Chairman Donaldson, and let me commend you
and Senator Sarbanes for holding this hearing on a very
important topic of national market structure, and as Senator
Dodd pointed out, we have an obligation collectively to ensure
the protection of investors and confidence in the markets. And
these markets are changing dramatically because of technology
and other forces.
And interestingly enough, the national market structure is
the title, but really, it is an international market today in
securities, so many of the changes that are being pursued have
to be pursued in the context of not just our markets but world
markets. And so, I look forward to your testimony, Chairman
Donaldson. I thank you and commend you for the work you have
done so far.
Chairman Shelby. Mr. Chairman, your written testimony will
be made part of the record in its entirety. You may proceed as
you wish. Welcome to the Committee again.
STATEMENT OF WILLIAM H. DONALDSON
CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Chairman Donaldson. Chairman Shelby, Ranking Member
Sarbanes, and Members of the Committee, thank you once again
for inviting me to testify today concerning the important
recent developments in the equity markets that occurred last
month. As you all know, on April 20, the New York Stock
Exchange and Archipelago agreed to merge and become a publicly
held company, and 2 days later, Nasdaq announced an agreement
to purchase Instinet's electronic trading network.
These are, of course, the four largest markets trading
equity securities in the United States, and the importance of
these transactions, if completed, can hardly be overemphasized.
Today, I will touch on some of the broader policy implications
of the proposed consolidations. I will start by placing these
transactions in the context of the Commission's market
structure initiatives and particularly Regulation NMS. Next, I
will offer some thoughts about how the consolidations may
impact competition in the markets going forward. And then,
finally, I would like to highlight some important issues
relating to industry self-regulation that the Commission will
be addressing in the coming months. As many of the details of
the proposed transactions are not yet clear, and my
observations are necessarily preliminary, my testimony today
reflects my own views and not those of my fellow Commissioners.
As I have discussed with you in prior hearings, one of my
highest priorities over the last 2 years has been to complete
the Commission's extended review of market structure
regulation. Last month, the Commission took a critical step
forward in adopting Regulation NMS, a comprehensive set of
reforms designed to strengthen and modernize our national
market system. In my view, subsequent events in the marketplace
have only reconfirmed the importance of this Commission
initiative.
The fact that the two transactions were announced only
weeks after the Commission acted on Regulation NMS may not have
been entirely coincidental. To be sure, the transactions were
driven primarily by economic and competitive forces in the
marketplace, but prior to Regulation NMS, uncertainty about the
regulatory landscape may have hindered the ability of markets
to plan for the future.
Of course, certainty could have come with any Commission
decision on market structure, but I believe the choices we made
were the right ones. By adopting consistent rules of the road
that apply to exchange-listed and Nasdaq stocks alike, the
Commission made sure that market consolidation can take place
against a regulatory background that protects investors at the
same time as it levels the playing field for competitors. This
new level playing field will, in turn, facilitate competition
between the New York Stock Exchange and Nasdaq.
The new trade-through rule expands opportunities for
electronic markets to compete with the New York Stock Exchange
floor for order flow and ratchets up the pressure for the New
York Stock Exchange to implement its hybrid market proposal. In
addition, if it merges with Archipelago, the New York Stock
Exchange will have a formidable electronic platform for
acquiring market share in Nasdaq stocks.
Under the new regulatory framework, competition in all
national system stocks will be based on three basic principles:
The best price, open access, and transparency. First, the new
trade-through rule underscores the principle that no matter
where a customer order is routed, it should receive the best
price that is immediately and automatically available anywhere
in the national market system. The best price principle also
will promote vigorous competition among individual market
centers by ensuring that smaller markets displaying the best
price cannot be ignored by larger, dominant markets.
Second, competition will be governed by the principle of
open access to these displayed prices. Markets will be
permitted to compete across a wide range of services, but they
cannot penalize their competitors by unfairly restricting
access to their displayed quotations.
Third, markets must be transparent. All significant markets
must make their displayed quotations and trade reports
available on terms that are fair and not unreasonably
discriminatory.
Turning to the proposed consolidations themselves, I would
focus on two basic questions: First, what effect are these
transactions likely to have on competition among markets and
among orders? Second, how will the new consolidated markets
meet their responsibility to assure effective regulation?
The national market system is premised on promoting fair
competition among individual markets while, at the same time,
assuring that all markets are linked together in a unified
system that promotes interaction among the orders of buyers and
sellers. It thereby incorporates two distinct forms of
competition: Competition among markets and competition among
orders. The Commission's challenge has been to maintain an
appropriate balance between these two vital forms of
competition. Generally speaking, I believe the effect of the
proposed consolidations combined with the new trade-through
rule should be to increase market depth and liquidity and
enhance order competition.
Moreover, I do not agree, as some may fear, that the
consolidations represent the death knell for competition among
the markets. Although at first glance, it appears that the New
York Stock Exchange and Nasdaq will dominate the landscape, I
believe that competition among markets should continue to
thrive. The New York Stock Exchange will have to battle to
maintain its market share, given the expanded opportunities for
fully electronic markets to compete in New York Stock Exchange
stocks after implementation of NMS. This competition, I
believe, promises substantial benefits for investors and
faster, more efficient trading, particularly in the most active
New York Stock Exchange stocks.
Similarly, I anticipate a continued battle for market share
in Nasdaq stocks. The new trade-through rule will require
trading to interact with the best displayed prices on the
electronic limit order books, and this is likely to produce
deeper, more liquid markets and more efficient pricing. In
addition, as I noted earlier, the trade-through rule will
enhance the ability of smaller markets to attract order flow by
simply offering the best price, and I believe market
participants will have an interest in sending them order flow
to preserve multiple options for order executions.
The proposed consolidation should also be viewed against
the backdrop of the changing structure of industry self-
regulation. Last December, the Commission published for comment
a series of new rules designed to strengthen the current system
of industry self-regulation. Among other things, these rules
would ensure the independence of SRO boards and restrict the
ownership interest of any SRO member to no more than 20
percent. At the same time, the Commission also published a
concept release seeking comment on a range of longer range
issues, including the conflicts of interest between an SRO's
business and regulatory functions, the potential costs and
inefficiencies of multiple SRO model and the manner in which
SRO's fund regulatory operations.
With the announcements of the proposed market center
consolidations last month, I believe it is even more critical
that the Commission act promptly on the SRO proposals.
With respect to the proposed consolidations, very few
details are available regarding the plans for self-regulation.
At this point, I can simply highlight a few issues that will be
examined prior to reaching any decision. First, the New York
Stock Exchange would, for the first time in its history, become
a publicly held company, raising at least the potential for
conflicts of interest between the profit maximizing interests
of its shareholders and the need for effective self-regulation.
Second, the proposed consolidation of the Instinet trading
platform into Nasdaq preliminarily would appear to streamline
the overall regulation of trading on the combined Nasdaq-
Instinet platform.
The regulation of such trading would be consolidated into
two regulatory entities: The NASD and Nasdaq. Any examination
of the Nasdaq-Instinet transaction would occur in the context
of Nasdaq's application for registration as a national
securities exchange; and, in this regard, I believe the staff
has resolved all of the major issues with Nasdaq, and I expect
Nasdaq to file an amended exchange application early this
summer.
Finally, given the potential competitive clout of the two
consolidated entities, the Commission's role in reviewing their
rule filings will be extremely important. The issues addressed
in these rule filings will include the fairness of market data
fees and other fees as well as potentially discriminatory rules
against competitors or market participants.
I have covered all of these topics, as you know, in much
greater detail in my written statement, and I would be pleased
to elaborate further. I look forward to hearing your views and
trying to answer your questions and, again, thanks for having
me back.
Chairman Shelby. Thank you, Mr. Chairman.
Chairman Donaldson, some people still remain troubled by
the SEC's three to two vote on Regulation NMS. There was a
concern that the lack of consensus undermines the SEC's
credibility and establishes an unfortunate precedent. Despite
the potential for consensus, the rule was adopted on a split
vote.
Should such fundamental policy changes as extending the
trade-through rule to Nasdaq not be supported by a greater
consensus, and are you troubled as Chairman by lack of
consensus on this regulation and what it means for the SEC
going forward, or is that just part of the turf that you work
under?
Chairman Donaldson. Good question. Let me just spend a
minute trying to answer it.
First of all, during my Chairmanship, there have been close
to 3,000 Commission votes. Of these, just slightly over 98
percent of 3,000 votes were unanimous votes. Of the 2 percent
that were not unanimous votes, in one case, two Democratic
Commissioners voted in the minority. In eight cases, one
Democratic Commissioner voted in the minority. In 15 cases, two
Republican Commissioners in the minority; in 44 cases, or about
two-thirds of our nonunanimous votes, a single Republican
Commissioner voted in the minority.
I suppose that you could draw a lot of conclusions from
these statistics, but let me just try and say how I feel about
this, and that is that I believe that the structure of five
Commissioners and three to two with the three being from the
party of the Administration sets the stage for decisionmaking,
and again, even as you all are debating differences of opinion
right now in other areas, there will be differences of opinion
at the SEC, particularly when we are dealing with the kind of
contentious, complicated, and highly technical issues
associated with a central marketplace.
My own personal view is that the common denominator here is
the investing public, that constantly, we have to remind
ourselves that we are going to do what is best for the public
investor, and with that thought in mind, I believe that you
leave your party credentials at the door, and again, speaking
personally, that is what I have tried to do in all of the
decisions that we have made.
I might also add that you try to bring to bear, and I am
sorry to elaborate on this, but I do feel strongly about it,
because the press has made such a big point about this, and I
am trying to put it in context. But we all try to bring our
experience to bear on the issues before us, and I have tried to
bring my experience based on far too many years in the markets,
if you will, to make decisions based on that experience.
I might also add, just in terms of historic content, and
then, I will be quiet, under my predecessor, Chairman Pitt, I
understand that 99 percent of the votes were unanimous, so we
are not that far off the recent track record.
Chairman Shelby. Mr. Chairman, it has been over a month
since you at the SEC approved Regulation NMS, yet the SEC has
not issued the final rule. When do you contemplate that?
Chairman Donaldson. We expect that the final rule will be
coming down within the next couple of weeks at the most. It is
a very detailed rule, very complicated, and we are just about a
week or so away from it.
Chairman Shelby. Do you contemplate substantial changes to
what you have published?
Chairman Donaldson. No.
Chairman Shelby. Okay; the Nasdaq exchange application: We
heard testimony yesterday regarding market participants' needs
to innovate quickly and to adapt to changing market conditions
in order to compete. You alluded to some of this. The witnesses
stated that their ability to compete is directly linked to the
SEC's timely approval of proposed rule changes at the market
centers. It was pointed out that rule changes often linger
before the SEC for months or even years without any action. For
example, Nasdaq's exchange application has been pending before
the SEC, I believe, for over 4 years.
Why does it take so long, Mr. Chairman, to obtain SEC
approval? Is this inaction here fair to market participants who
need to respond quickly to market changes? And is the Nasdaq
exchange application more complicated than Reg. NMS? I know it
is different.
Chairman Donaldson. It is very different, and let me try
and dispel the image of the Nasdaq application to become an
exchange as something that has been lying on the desk, and
people are sitting with their feet up and doing nothing about
it. There is a fundamental principle having to do with
requirements for an exchange to have price priority built into
their operation. Nasdaq has refused to do that. And therefore,
we have not moved on their application until recently.
Recently, I suspect as a part of all this consolidation
going on, they now are prepared to include time and price
priority in one of their operations which qualifies them now to
become an exchange, and I would expect that their application
will be approved fairly shortly. As far as the other
implication here of the rapidity or lack thereof of passing
rules, I have to say that this area of the national market
system is extremely complicated, detailed, and filled with all
sorts of pitfalls, and I think that, in effect, the staff and
the SEC have been pondering this for years, if you will, taking
testimony, talking to all parties, et cetera, et cetera.
But I think, that in the last 2 years and particularly the
last year, we have decided that something must be decided,
because the technology continues to escalate. So, I think that,
now that we have taken a whole package of rules, and we have
addressed a whole system here. There will be rule changes
applied for coming down the pike, and if we are now able to
simply act or be asked to act upon a single modifying thing, I
think the complexity will be a lot less, and hopefully, the
speed will be a lot faster.
Chairman Shelby. I agree with you that what you deal with
is very complex issues, and they have to be done right, and
they have to be thought out and the implications, but sooner or
later, as you have just mentioned, there should be a decision
made, should it not, one way or the other?
Chairman Donaldson. Yes.
Chairman Shelby. Most applications.
Chairman Donaldson. Well, I agree. And this goes for
everything that we are dealing with. Where we can, where the
issues are simple, we need to act swiftly. It takes a little
longer when things are complex.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
Chairman Donaldson, we are pleased to have you before us. I
just want to follow up very briefly on the first question that
Chairman Shelby asked. My understanding, as I was listening to
the figures you gave close to 3,000 votes that the Commission
has taken that in all but 68 of them, they were unanimous votes
and that of the 68, 52 of those had just one Commissioner
dissenting, so that it seems to me a pretty impressive record
in terms of developing consensus, and I know that in the past,
the Commission has had split votes.
In fact, David Ruder once observed to us that on tough
decisions, sometimes, you just have split votes. People see
things differently. But I think in looking at these figures,
the number of real close divisions is pretty minimal, as a
matter of fact, in the context of the decisions that you have
been making.
Let me address the regulatory structure issue, because I am
quite interested in this. You addressed it in your statement,
particularly the critical issue of addressing conflicts of
interest between SRO business and regulatory functions. What is
the Commission's plan or course of consideration moving forward
with respect to this a rather critical issue?
Chairman Donaldson. It is a critical issue, and again, if
you go back into history, I think the decision was made quite
correctly by the new SEC and the new securities law rules back
in the 1930's to go to a system of self-regulation, and that
was based, as I understand it, on the thought that the closer
you could build the regulation to the actual operating
entities, the more effective that regulation would be. And so,
the decision was that the SEC would be the national regulator
but would delegate self-regulation to the markets and to people
acting in the markets.
Fast forward to where we are now. Clearly, there has been a
breakdown of self-regulation. It reached its zenith 2 years ago
when the governance of the New York Stock Exchange was brought
into question, and, at that time, I wrote a letter to all of
the exchanges and asked them to review their self regulatory
structure and their governance structure and to come back to us
with their thoughts on how this should be organized.
And the New York Stock Exchange responded with the
organizational structure that you now see, which in effect took
the whole self regulatory side of the exchange, the whole
enforcement side, and had it report into an independent
subcommittee; in other words, the regulatory mechanism was
taken out of the chain of command, and no longer reports to the
chief executive officer of the exchange. It reports to an
independent committee. That is one model.
There are other models that have been suggested and we will
have under review as we go forward. The other models will range
all the way from a total separation of regulation and placing
of that in an independent body that would regulate all
exchanges down to several other models.
I think you are absolutely right when you point out that,
in addition to the business regulatory conflict that exists in
the exchange markets now, the difference between being in a
business and regulating that business, now, you interject a
third dimension of public owners, and again, that is another
potential conflict.
So we have to address this. We have reached no conclusions
on it. We have gotten all the advice we possibly could from the
industry itself, and we are at the point now where we are
wrestling with what the best model should be.
Senator Sarbanes. Yes, I think as you wrestle with that
issue, I just want to observe that in considering these various
models, I think, it is important to look at the issue of the
appearance of a conflict of interest as well as the reality of
a conflict of interest. I say that for this reason: After all,
what is at stake is people's confidence in the workings of the
market, and it may be that if you go through a careful analysis
and everything, you can reach a conclusion there really is not
a reality of a conflict.
But if there is the appearance of a conflict, which the
ordinary person on looking at the thing would be what he or she
would be struck with, it may well create a confidence issue,
and of course, that is one of the things we are very anxious to
make sure those questions do not arise. So, I think this issue
of the independence of the regulator and the assurances that
particularly when you go from nonprofit to profit, and then,
the concern begins to be that there is a benefit that accrues,
depending on the regulatory decisions.
We know the Commission is working very closely on this
issue, and we simply commend your efforts. We will be following
it very closely as you move ahead.
Mr. Chairman, I see my time is up. Thank you very much.
Chairman Shelby. Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman.
Chairman Donaldson, I want to just cover actually a couple
of issues that both of the previous Senators have covered with
you. I was very pleased to hear your testimony with regard to
the Nasdaq exchange application, and as I understood you, you
have indicated that all of the remaining issues from your point
of view have been resolved, and you expect it to be addressed
promptly.
Can you give me any kind of an idea as to how quickly we
could expect to see this issue resolved?
Chairman Donaldson. I think that I will be vague enough to
say in early summer. I mean, for all intents and purposes, we
are almost there, and we are now just putting the final touches
on it.
Senator Crapo. All right; well, I do appreciate that. I
think that is a piece of a lot of what is going on that many of
us have been focused on and wondering if there was some kind of
delay that we could figure out a way to get around, and your
testimony today is very welcome.
The other thing I wanted to talk to you about is, again,
the issue of the split votes on the Commission. And I realize
that there have been, as you indicated, 3,000 votes, with 98
percent of them unanimous. But we cast a lot of votes around
here, too, and there are a lot of votes that are pretty much
unanimous or not controversial. And then, there are some
seriously controversial issues, of which we have a few on the
floor right now.
And I was just thinking back as you were testifying over
some of the major three-two votes on the Commission which have
happened recently which seem to be on issues that impact our
markets in very broad ways. There is Reg. NMS, the hedge fund
regulatory decision, the decision with regard to mutual funds,
on independent chairmen and the like.
It seems to me that although one can argue that there is a
lot of unanimity when you look at the broad array of issues
that the Commission is dealing with, it also seems to me that
on the three biggest issues that I can remember coming to the
attention of this Committee in the last period of months, every
one of them has been a three-two decision. I think that is why
the impression out there is that there is getting to be a lack
of consensus on the Commission that is disturbing. Can you
respond to this, please?
Chairman Donaldson. Sure, I will try to.
You are absolutely right in terms of some of the major
issues here, there has been the three-two vote. I think that
there is a tradeoff here between reaching consensus and
reaching a decision. The issues we have been dealing with are
so important and so time-sensitive that we have, or I would say
I have, because it has been my vote, resolved the issue in the
interests of not delaying and watering down what needs to be
done in months and months if not years of discussion and back
and forth and not making a decision. And then we could have end
up with a decision that is not what should be done and a
decision that is reached after way too much time.
Now, I think that the process at the SEC is a very open and
fair process; in other words, there is a tremendous amount of
work that is done, and then, an open debate on the record of
people's positions. And I think that because of the nature of
the times we live in now, I think there has been a
deterioration, if you will, of that process. After the debate
has gone on and after a decision has been made and after a
majority has decided, then, there is a follow on of minority
dissent. A minority dissent, by the way, which could have been
brought out in the open arena but a minority dissent that is
out there with no comment on it, no ability for comment. And I
think that, frankly, is a serious step in the wrong direction.
We are not the Supreme Court. We are not in the business of
giving a majority and minority dissents, but maybe that is what
we are headed for. But I believe that the traditional way that
the Commission functions is the best way of resolving
differences. I think you are quite correct in that this
particular period here, the last couple of years, we have been
facing up to some very important issues, and it is on those
issues that we have had the disagreements.
Senator Crapo. Well, I appreciate your grappling with that
issue. As you were describing the dynamic at the Commission,
which raises concerns about process and how the Commission is
working out, I was thinking about the very issues that we are
grappling with here in the Senate with similar kinds of process
conflicts.
Chairman Donaldson. Yes.
Senator Crapo. So, we are certainly not immune to the same
kind of thing that you are talking about or that you are
discussing there, and I just wanted to wrap up my comments by
saying it has been no secret; I have been very open in public
about my disagreement with some of the stands that you have
taken and the direction that the SEC has gone on some of these
rulings.
I have appreciated you getting back to me and working with
me personally on it, and I will state publicly what I have
stated to you: My interest here is to see if we cannot work
toward improving the process and improving the ability to
develop greater consensus. And again, I appreciate you
personally as well as your staff being willing to work on that,
and I will continue to work with you as we try to work through
these difficult issues.
Chairman Donaldson. If I could just comment on that and I
appreciate your comments. I just want to assure you that we
have worked very hard to get consensus, very hard; and, as you
know, we welcome working with you and the rest of this
Committee. I mean, these are important things. We need all the
judgment we can get.
Senator Crapo. Thank you.
Chairman Donaldson. Thank you.
Chairman Shelby. Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Thank you, Mr. Chairman. Yesterday, we
heard testimony from both Nasdaq as well as the New York Stock
Exchange group, and there was, you know, some interesting
testimony I thought there. For example, Mr. Thain said that
Reg. NMS did a good job in anticipating changes in markets, and
then, Mr. Putnam said that Archipelago felt the pressure to
consolidate. And further, with regard to competition among the
order and market centers, Mr. Thain said that Reg. NMS protects
the smaller markets and provides room from competition.
Then, we had testimony from Mr. Frucher, who, on the other
hand said that Reg. NMS will create significantly more barriers
to entry for smaller markets. And could you share with the
Committee your thoughts on these dissenting views and
ultimately how you see Reg. NMS impacting the scope of U.S.
market centers?
Chairman Donaldson. Right; let me say that I believe that
Reg. NMS is procompetition for both the large markets and the
small markets. And the reason I say that is that the smaller
markets have an unbeatable weapon, if you will, to compete with
the big guys, and that is to offer the best price. And if they
offer the best price, that is where the order will go.
Now, the best price trade-through aspect of what we have
proposed here is extremely important, because it says that, in
an electronic environment, you must honor the best price, and
you must honor that in a market that is instantaneous and has
eliminated from it the delays that made it difficult to compete
with particularly the floor-based markets, New York and so
forth.
I believe that, if you step back and look at the history of
these electronic markets, they are not that old. I mean,
Archipelago was founded, I think, 8 or 9 years ago, and because
they competed with a then even more dominant New York Stock
Exchange, they were able to insert themselves into the
competitive fray, and I predict that we are going to see, as
time goes on, ways of doing business that we cannot imagine
today, and I predict that the entrepreneurial, small entities
either out there now or which are going to be out there will be
very competitive in this new environment.
Senator Allard. In Bloomberg's testimony, I think Mr. Bang
expressed their concern that some of the hybrid proposals put
forth by the New York Stock Exchange might undermine Reg. NMS.
Do you see any potential there?
Chairman Donaldson. Again, the concept here is that those
who want speed will get it in the electronic part of the
hybrid. On the other hand, the structure will accomodate those
who voluntarily value other aspects of trading, and that would
be specifically the capital that the specialist brings to the
game; it would be the capital that can be accumulated in times
of stress to step in and moderate violently moving markets and
the human judgment involved in executing an order in a
tumultuous time. I believe that the alternative to go into that
kind of a market and to have it available as we move into the
electronic age preserves what has been a pretty valuable part
of our national market system.
I might comment that this is going to be a much more
competitive world for both of these emerging duopolies, if you
will. There is going to be competition for capital. There is
going to be competition for having a business that works and
makes a process, and I think that it will remain to be seen
just how people decide which one of these two markets they want
to operate in, and I think anybody that predicts exactly what
is going to happen has got more insight than I do in terms of
how it is all going to work out. But I think we are headed in
the right direction.
Senator Allard. Mr. Chairman, I see my time has expired.
Chairman Shelby. Thank you.
Chairman Donaldson, yesterday, we received testimony
concerning how the proposed mergers would have an impact on the
regulation of market data. What issue do the mergers raise with
respect to the cost, collection, and allocation of market data,
and will the SEC need to take further action on market data to
account for the proposed industry consolidation?
Chairman Donaldson. Market data and our proposals on market
data are basically a first step to rationalize the
inefficiencies and inequalities in the way market data is
gathered and allocated. And by that, I mean as a result of the
morass, if you will, of different ways of competing in the
system that has been prevalent for quite awhile, 5 years if not
10, there have grown up a number of practices that serve no
economic benefit other than to create revenues for certain
trading centers. And we refer to such things as tape shredding
and so forth, where orders are broken up in order to have more
prints on the tape in order to get the revenues. And our
initial thing here is to try to eliminate that and try to
reward revenue sharing, if you will, for centers which are
actually contributing to the liquidity in the marketplace.
There is a second step here which we have not addressed,
and that is the absolute level of revenues. And again, this is
inextricably involved with how the new institutions are going
to dedicate their revenue flows; in other words, we now have
businesses, if you will, who will have a profit motive, but we
also have regulatory responsibilities which are not money
making; they are money using.
And so, the issue becomes how these institutions will
protect the revenues that need to be protected to support the
regulatory side. And I think that the next step here once we
get through our organizational structures, once we get the
structure right--is that then we will be able, because of the
new transparency that we will demand of these exchanges, to get
a better feel for just what those revenues should be in an
absolute way.
Chairman Shelby. Should that not be very positive from your
standpoint?
Chairman Donaldson. I think that there will be a judgment
factor here. I mean, there are those who say that those tape
revenues should be strictly priced on the cost of developing
them, some cost-plus kind of thing, and I do not think you can
cross that bridge until you really get an idea of what the
regulatory side of things is going to cost. And there are a lot
of different ways of financing the regulation in terms of
direct taxes, if you will, or fees, and I think we have to take
a look at the whole package. For those who feel those fees,
tape revenues are too high right now, I understand that; we all
understand that. It is just a matter of phasing in our
attention to it.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. I will be very brief, Chuck.
Mr. Chairman, I will be very quick.
First of all, I note that the testimony we got yesterday,
everyone thought that what you have done is an improvement over
the current situation, so that some still have some concerns,
but everyone thought depending on their different points of
view how far of a great step forward it was, but they were all
in agreement that it was a step forward.
I have to tell you, I think the traditional process of the
SEC has contributed to this. One of the things you did not
mention when you were outlining it that I have always been very
impressed with is the receipt of letters of comment on your
proposals when you put them out there in tentative form, which
enables all interested parties to come back to the SEC with
well thought-out, well-considered responses to what the SEC is
thinking of doing and therefore enables the Commission to take
all that into account as it moves toward shaping a final rule.
And I want to underscore that, because this process in some
ways is very special that the SEC has established over the
years and that it has followed. I think it is very important
for reaching wise decisions and particularly decisions that
people are willing to support. I am struck now by the growing
degree of acceptance or support of the NMS regulation compared
to what was being said not too long ago. So in that sense, we
are certainly moving ahead.
I do again want to emphasize again, I think, the need to
focus on how this, the regulation, is done, and being clear of
any sense of conflict of interest, and that would, of course,
also involve how the regulation is financed so that the people
who finance it cannot cut off the financing if they are unhappy
with the decision. That was one of the big decisions we faced
with the PCAOB and FASB, and of course, they now have assured
financing, which gives them an independence of decisionmaking,
which I think is very helpful.
Let me just close on one point, and I take it from what you
are saying you are sensitive to this concern: Sandy Frucher of
the Philadelphia Stock Exchange yesterday said that the smaller
securities exchanges have repeatedly served as laboratories of
invention, and then, he mentioned the number of innovations
that they had adopted, all of which were then adopted by the
larger exchanges. They had paved the way.
And he asked in his statement that the SEC take all steps
to ensure that it and other venues are allowed to compete
vigorously and aggressively, and the smaller exchanges be able
to innovate and find new products and trading technologies. I
take it that squares with what the SEC wishes to do. You are
not out to establish a duopoly here with respect to the working
of the markets and the exchanges.
And so, I take it that you are already sensitive to these
comments, but I just thought I should ask you that for the
record.
Chairman Donaldson. Absolutely. I think that we are
extremely conscious, aware of, and applauding the
entrepreneurial changes that come along here from competition,
and we have experienced that now, as I say, with the rise of
these electronic exchanges. I think that the one thing we do
worry about is competition that is improper competition, I
mean, competition that basically serves no economic purpose and
undermines the fundamental principle of best price for the
individual client, and there has been some of that that has
grown up here in recent years.
I think the rules we put in, this is repeating myself, but
I do believe they set the stage for even the smallest most
entrepreneurial new exchange who has the right technology to
come in and compete with the big guys.
Senator Sarbanes. If people in the industry do not place
the investor first and foremost and therefore run the risk of
undercutting investor confidence, they are going to kill the
goose that lays the golden egg, and they more so than anyone
since they benefit from the investor involvement should be
concerned to provide the appropriate protections.
Thank you very much.
Chairman Donaldson. Exactly.
Chairman Shelby. Senator Hagel.
STATEMENT OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, thank you.
Chairman Donaldson, I am sorry I was not here for your
statement. We have been holding other hearings, and I wanted to
make certain that I did get some time with you, and I again
appreciate your appearing here this morning, and I will read
your statement.
Two sets of questions I would like to address this morning:
One, you may have addressed some of these issues in your
statement or in the question and answer period with my
colleagues, but I want to ask a couple of questions on Fannie
Mae and then talk about implementation of regulations in a
general sense. You, of course, are aware that in December 2004,
the SEC informed Fannie that it did not properly apply an
accounting derivatives standard known as FAS 133. Last week,
Fannie May disclosed that it will delay its 2005 first quarter
financial report with the SEC and that it misapplied another
accounting standard, FAS 115, which it uses to classify its
mortgage-backed securities.
A couple of questions: Will Fannie's misapplication of FAS
115 cause Fannie to further restate its earnings? If it would
further cause a restatement of earnings, by how much?
Chairman Donaldson. This is something that I think I
probably cannot comment on in that we are in there now in the
midst of an investigation, and I do not want to prejudge where
we come out on that. Clearly, just as you understand for sure,
you know, our function here with Fannie is not the overall
structure of Fannie Mae; ours is the accounting and reporting
systems, and we are right in the midst of looking at that, even
though our first ruling was that their accounting was improper.
Senator Hagel. Do you have any sense of when you would
complete these investigations? There are other dynamics, other
parts of this investigation.
Chairman Donaldson. Sure. I do not want to mislead you. If
you will, I would like to get back to you with a time judgment
on that. I do not want to say something I will regret.
Senator Hagel. And what I will do is not at a public
hearing present some specific questions; maybe if we could talk
privately on some of these issues, and I know that you are in a
difficult spot with an ongoing investigation, but these are
very serious matters that continue to dribble out every other
week, it seems, as to what is going on, and obviously, you know
this Committee is most likely going to be looking seriously at
a markup of a GSE reform bill which is focused much on these
kinds of issues as to how did they happen, why did they happen,
and, of course, the SEC's involvement, and I will ask for some
time with you whenever it works.
Chairman Donaldson. I would be delighted to do that.
Senator Hagel. I want to go to the implementation of
Sarbanes-Oxley, which you have been reviewing, and you have
been laying out new regulations and refined regulations to try
to make it work and adjust in the way that it was intended to
work. I suspect that I am not alone in being a U.S. Senator and
a Member of Congress, who has heard from especially small
businesses saying that the implementation of Sarbanes-Oxley has
been a huge burden on these companies.
I have talked, met with several of these companies about
what they consider excessive costs and regulatory burdens for
complying with the requirement. I have got, which I will not go
through now, but I will give to you later about five pages of
individual companies, specific companies, specific issues, and
problems. I know these are imperfect systems and processes, and
you are trying to seek some equilibrium. And I know you have
issued new guidelines addressing some of these overall
concerns.
But can you address these in a general way without us
taking the time, since we do not have it, to go into going
through each of these companies' specific problems that they
are having?
Chairman Donaldson. Sure.
Senator Hagel. This is a burden. I mean, I think it is very
real. I used to be a small businessman. I have some sense of
this. What is the SEC doing here to deal with this? The big
companies are the big companies, and they have the resources;
they have the law firms, and they can margin in some way. The
little guy, the medium-sized companies cannot.
Chairman Donaldson. Let me try to address that in two ways.
First of all, in terms of the overall Sarbanes-Oxley, I
believe that it is working very well in a cost-efficient way,
and by that, I mean the shifting of power to the boards of
directors, independent committees, the new authority that
Sarbanes-Oxley gave the SEC for fines and our ability to give
those fines back to damaged or injured shareholders and fair
funds. I think all of that is tremendously positive, and I
believe that this law, if you will, will progressively be
realized as a very important piece of legislation.
Now, on the particular part of it that you are talking
about, so-called ``Section 404,'' which has to do with the
obligation of senior management, the CEO and chief financial
officer, to basically sign their name on a line with the data
that they are giving to the public, I think that there have
been two things that have caused expenses that do not need to
be there.
First, is the overall application of this to all companies
in general and second, is a kind of one-size-fits-all approach
taken by some so that a small company has to shoulder the
expenses. Disproportionately, those expenses mean a lot; and it
is not just the expenses. It is not that easy to get a lot of
independent directors, for a small company to have committees
filled with directors that are independent.
We are addressing this in two ways: One is we had this
roundtable discussion a month and a half ago. We had six
different
panels. We brought together people who were involved from all
different points of view: Heads of companies, accountants,
accounting firms, and so forth. And by the way, the kind of
horror story that I am sure you had in front of you, we asked
everybody to put their horror stories on our website so that
they could get that out so that we could devote the day to
constructive thought.
It was very constructive. And out of that have come the two
pieces of interpretation that we just put out this week, the
PCAOB and the SEC and, basically, what we said, the guidance
that we have given to the accounting profession and to the
corporate world is, if I can say it in simplest terms, use your
common sense in applying these rules. Have a risk-based
approach to detail and understand where you have to apply this.
If you use your common sense and have a risk-based approach,
you will not be in trouble with us if you do it that way.
Senator Hagel. The common sense rule that you just noted,
has that also been directed at the regulators?
Chairman Donaldson. Absolutely, and that is a very good
point. And there again, I think by the very publishing of this
guidance, we are saying that implicit in that guidance.
Now, just to finish, on the small company side, we formed a
panel, a committee not just for 404 but for the whole Sarbanes-
Oxley panoply for small companies, and it is a very good
committee. They will be in existence for a year. Their charge
is not just to address the particular problems of small
companies vis-a-vis 404 but also to take a look at all of
Sarbanes-Oxley and see if there are any ways that the rules can
be modified to accommodate smaller companies. So, I think help
is on the way.
Senator Hagel. Thank you.
Mr. Chairman, thank you.
Chairman Shelby. Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman, and thank
you, Chairman Donaldson.
As I mentioned in my opening remarks, this is a national
market situation in an international environment. And
yesterday, some of the witnesses claimed that an advantage
shown by some foreign exchanges that they trade not just in
equities but also in options, derivatives, and fixed-income
products and all on one market. Do you think it confers an
advantage on these foreign exchanges? Is there anything that we
should do to think about altering the current statutory and
regulatory arrangements?
Chairman Donaldson. Are you saying will there be a
convergence of other kinds of instruments?
Senator Reed. No, I am thinking about the instruments that
could be traded on our markets in the one-stop shopping.
Chairman Donaldson. Yes, yes, I think that, as the world of
finance has gotten more complex, as these different instruments
have come into being, options and futures and so forth, I think
you are going to see not just domestically but globally, and we
are already seeing it, multiple instruments being traded on the
same platform. And there is good reason for that, because these
instruments are interdependent, if you will; one moves, the
other one has to move kind of thing.
So, I think that, as the exchanges both go public and raise
money and use that money to invest in the technology to trade
other instruments, I think you will see this happening here and
overseas.
Senator Reed. Are there things that we should be thinking
about now in terms of proposed statutory changes that would
either assist convergence or somehow make sure it is done
appropriately?
Chairman Donaldson. I believe that what we are proposing
right now is just the first step in a new global competitive
situation. I think that as you know, American investors are
investing increasing amounts of their money overseas, dealing
in markets around the world; vice versa: Markets around the
world, whether it be in the European Community or out in the
Far East, are serving huge populations and huge industrial
bases, and I think you are going to see global competition
coming in, and I think that what we have proposed here sets the
stage for two things: For U.S. competition that can compete
with the rest of the world and the preservation of the capital-
raising integrity, if you will, of our markets, which hopefully
will preserve the dominance that we have right now.
Senator Reed. Thank you, Mr. Chairman.
Let me switch gears dramatically. We have talked to your
staff about a particular issue that has come up in the context
of the CDC's immunization program for vaccines. We are told
that because of accounting rules, vaccine makers cannot claim
as revenue sales to CDC under the Pediatric Vaccine Stockpile
Program because they have to do that only upon a delivery, but
the contracts call for them to buy it and hold it until the
crisis erupts. And I am wondering if there is anything that you
can do, because apparently, this is causing some difficulty to
the CDC and to the vaccine program.
Chairman Donaldson. We are on the case, Senator.
Senator Reed. Good.
Chairman Donaldson. Basically, the issue, not to get into
too much detail, has to do with the structure of the
transaction, the business structure of the transaction, which
makes it impossible to report a closed sale, because there is a
lot of product that goes through that never really closes. And
so, we are trying to resolve with HHS the nature of the
contracts that they are writing, and we think that it can be
done.
And, in the event that it cannot be done, we definitely are
not going to stand in the way of these vaccines getting where
they should go. But we do not think the real issue is going to
be our accounting rule. We think it is going to be the
structure of the deal that is struck with the pharma companies.
Senator Reed. Thank you, Mr. Chairman.
Thank you.
Chairman Shelby. Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman, for holding the
hearing, and I want to thank Chairman Donaldson for coming.
Once again, he has been most accessible to this Committee. I
think we see you more than we have seen most of the SEC
Chairmen in the past.
And I first want to congratulate you on the reforms that
you have made in modernizing the national market system. We
have had a difficult problem here: We want to have efficient
markets. We want to have competition. But we also want depth
and liquidity in markets. And all of that is complicated by the
fact that only in the last 10 or 15 years can international
markets not governed by any American rules can trade equities
like anybody else. The technology did not allow that.
And so, the question is how do you keep the basically sound
structure that we have had in this country, which relies
primarily on disclosure and openness and at the same time deal
with competition and change? And as you know, I have been
greatly worried about fragmentation in the markets, about six
different centers of trading occurring. I know some of the big
interests wanted that, I think because they wanted to either
own their own trading mechanisms, or they wanted opacity. They
did not want people to know what they were doing, which is not
good for the markets.
Well, you came up with Regulation NMS, and, at least to my
liking and I think to most people's, kept the trade-through
rule so small investors like my father would not be
disadvantaged by the big boys, and when it came out, yes, there
was a three to two vote, although the bipartisan vote was on
the side of NMS, obviously, but I think what we have seen since
then is a vindication of what the SEC has done. When the NYSE
took over Archipelago or announced that it was intending to
take over Archipelago; when the NASD and Nasdaq decided they
would take over Instinet, it basically said that we could
almost have it all.
We could have deep liquid markets; we can have best price;
and at the same time, we can have some competition. And so, I
think that the events of the last month or month and a half
have vindicated the SEC's approach, and the great worry that I
have had, the fragmentation of the markets, the opacity of the
markets, is much less of a worry today than it was 2, 3 months
ago, and I think you have to give the SEC credit for that. So,
I thank you for that.
And it really, what has happened has taken away most of my
questions. I have here some nice softball ones on best price,
but I think we are getting a nice consensus on that.
[Laughter.]
I would say this: I mean, could you comment? There has been
some talk, not so much in this body but the other body, of
Congress intervening and trying to either overturn or modify
what has happened. One of the worries that I have is now that
we have settled into a good place, and we can compete with
Europe and everything else is that if we were to have that out
there, it could interfere with the progress that we have made
in the last while. Could you comment on that?
Chairman Donaldson. You do not want me to walk into that,
do you, in terms of the other body?
[Laughter.]
Senator Schumer. I know you will do it in your usual
diplomatic and deft way.
Chairman Donaldson. No, seriously, I think we are going to
work very hard, have and will continue to talk to anybody that
will talk to us about why we think what we are doing is the
right thing, and we will not give up until we have convinced
the very last person.
I do think that this business of the global position of our
markets is coming over the horizon rapidly, and again, my own
view is that if we have the most transparent markets, and if we
can maintain what is unique to our market, which is that small
investors do get to trade side-by-side with giant institutions,
if we can maintain that, if we can move on global accounting
standards, if you will, that people will come to our markets
because it will be the lowest cost of capital here, and we will
be able to compete on a worldwide basis.
Senator Schumer. And that is how it has been, and let us
hope and pray--I say this as a New Yorker and as an American--
that it stays that way.
Okay; I just wanted to follow up. It is interesting that
Senator Reed had a question very similar to mine, because I
have been notified in New York of the shortage of the vaccines.
And it seems to me that to make the vaccine maker put the costs
on their books before the vaccine is actually sold does put
them in a kind of catch-22 situation, and as I understand it,
this happened only since I think it is 1999 when the SEC passed
a rule that was far more aimed, and aimed correctly, in my
opinion, at larger companies and financial services companies,
and nobody paid attention to how it would affect vaccine
makers, because the Government has a stockpile which they put
into.
Why would it not just make sense to make an exception not
with the words vaccine makers in it, but when you have this
stockpile that is not used because of an emergency that occurs,
a health care emergency or something or some other kind, but it
would not be a financial emergency in the mind of the user that
you just undo it or just exempt the vaccine area? It does not
sound to me like when you say, well, they will change the way
their contracts are written as the easiest solution, since the
recognition of income or revenue recognition was never intended
to deal with this situation?
Chairman Donaldson. I do not intend it as a flip remark to
say it is just the nature of the contracts, but it is. There is
a way, I believe, for the companies to adjust the way they
sell, loan, or whatever they do with these vaccines to not have
to be concerned with our accounting.
Senator Schumer. But will CDC do that? That is the issue.
As I understand it, the SEC says to CDC you do it our way, and
CDC says to SEC do it our way, and the twain have not met for
quite awhile.
Chairman Donaldson. Well, I hope that is not so. I can
assure you that we are on top of this. We are working at it. We
are talking to HHS. We are talking to the companies. We are
trying to work it out. I would be very pleased to try and give
you a report on the exact stage of where we are with it.
Senator Schumer. Thank you very much.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Sarbanes, we have a minute.
Senator Sarbanes. I have no further questions.
Chairman Shelby. Mr. Chairman, we appreciate your
appearance here today. We appreciate your candor, and we will
continue to bring you back up here from time to time. I think
you like it here.
Thank you.
Chairman Donaldson. Thank you.
[Whereupon, at 11:30 a.m., the hearing was adjourned.]
[Prepared statements, resposne to written questions, and
additional material supplied for the record:]
PREPARED STATEMENT OF SENATOR JIM BUNNING
Thank you Mr. Chairman for holding this hearing and I would like to
thank Chairman Donaldson, for testifying today.
I appreciate your coming up here as often as you do. As you know I
do have some serious criticisms of some of the policies you have been
pushing at the SEC. I cannot however, criticize your accessibility to
the Committee and I want you to know how much I appreciate you making
yourself available to the Committee. I would also like to take this
opportunity to publicly thank 3 members of your staff, Jane Cobb, Allen
Beller, and Paula Dubberly for their help and technical expertise in
working toward an agreement to bring the Tennessee Valley Authority
under SEC enforcement. As you know, this is a very important investor
protection development. This agreement with the TVA will help protect
bondholders all over the country. I would also like to thank the
Chairman's staff, Kathy Casey, Doug Nappi, Bryan Corbett, and Paul
Doerrer who served Chairman Shelby on Appropriations and now is with
the full Committee. As well as Libby Jarvis of Majority Leader Frist's
office and T.A. Hawks, Jenny Reeves Manley and Marie Thomas of Chairman
Cochran's office for working so hard to accomplishing this worthwhile
task.
That was the good part. Here is the bad. I still do not agree with
your rule on mutual funds. Obviously, 2 of your commissioners do not
either, or they would not have sent a letter to the Appropriations
Committee. I never remember seeing a letter like this from the SEC. It
makes me have great concerns about the fairness and accuracy of the
study that was put together by the SEC. I hope you will not take
Commissioner Atkins and Commissioner Glassman's concerns lightly. I do
not. Mr. Chairman, I would like to submit a copy of this letter for the
record.
I also have concerns about the recent Reg. NMS passed by the
Commission. I guess we have a difference in philosophy. To get to the
end you wanted, a consistent rule governing the markets, you could have
gone with increasing regulation or deceasing regulation. Obviously, you
did not trust the free market and you opted for increasing regulation.
I believe you should have decreased regulation to ensure a level
playing field.
The regulation itself seems to have been accepted by the industry,
they want certainly more than anything, and they have moved on. But I
am still concerned about the process. It used to be, a majority of the
votes by the SEC were unanimous or, on a bad day, 4-1. Very rarely were
their 3-2 votes. Unfortunately, 3-2 votes, on major issues, now seem to
have become the norm, and there seems to be open hostility during these
votes. Now I know you cannot always get consensus, believe me. We have
a perfect example of this on the floor of the Senate as we speak, but
these recent votes and open hostility concern me greatly. The Committee
looks heavy handed. It looks, to this Senator anyway, that you are more
interested in steam rolling opposition, than reaching consensus.
I am also very concerned about how long it is taking the Commission
to act at times. While I feel you rushed through a bad rule on mutual
funds' independent chairman, market timing, an actual abuse, has not
been addressed. Even more worrisome, Nasdaq has had an application
before the Commission for 4\1/2\ years. That seems excessive to me. I
am not as concerned about whether you approve the application or not,
as I am with them not getting an answer one way or the other for so
long.
In yesterday's hearing, Sandy Frucher of the Philadelphia Exchange
testified before us. To paraphrase his comments, he felt the regional
exchanges, to compete with the large, recently merged markets, will
need to be innovative. But they will also need quick approval of those
innovations. When they see applications taking 4\1/2\ years, it makes
them very nervous.
I hope you will take these comments to heart and in the way they
are intended. Investors need a strong SEC. But they need one that works
together, not one that has controversy and distension on every major
issue.
Thank you again for holding this hearing Mr. Chairman and I thank
you Chairman Donaldson for coming before us again today.
----------
PREPARED STATEMENT OF SENATOR DEBBIE STABENOW
Thank you, Chairman Shelby. Welcome, Chairman Donaldson. I
appreciate that you are taking the time to come before us today to
discuss the important issue of your recently approved Regulation NMS.
I know that approval of Reg. NMS has been somewhat controversial.
I, like others, would prefer to see unanimous decisions coming from the
SEC for no other reason than it would give comfort and a sense of
certainty to the markets.
We, here on the dais, are aware more than most that unanimous
decisions are frequently difficult to come by.
Of course, the approval of NMS was not a unanimous decision. But, I
do not believe that this should cast a cloud over the soundness of the
SEC's decision.
At the heart of Reg. NMS is the trade-through rule. The trade-
through rule can be summed up as a mandate that stocks traded on more
than one exchange cannot be bought and sold for prices that are worse
than those offered elsewhere.
Anything that we can do to promote fair markets and provide
assurances to the public that they are obtaining the best execution for
a market order should be encouraged. Fairness and dependability should
be at the root of our securities markets . . . these amazing engines of
growth in this country. And, I will do everything I can to support
every movement we take in that direction.
This is not say, however, that I support every decision made by the
SEC. I am still troubled by your planned implementation of the ``push-
out'' provisions of Title II of the Gramm-Leach-Bliley Act.
The small and medium-sized banks in my home State of Michigan are
very concerned about the costs and consequences of having to implement
a regulation that they feel runs counter to the intentions of the
Gramm-Leach-Bliley Act.
While you have agreed to suspend implementation of the ``push-out''
regulation until September 30 of this year at the urging of Senator
Bunning, myself, and others, I am still not convinced that industry
concerns will be fully addressed. I look forward to continuing our work
on this issue.
Mr. Chairman, I am generally happy with the progress that the SEC
is making under your leadership and look forward to your testimony.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF WILLIAM H. DONALDSON
Chairman, U.S. Securities and Exchange Commission
May 19, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, thank you for inviting me to testify today concerning the
important developments in the equity markets that occurred last month.
On April 20, the New York Stock Exchange and the Archipelago Exchange
agreed to merge and become a publicly held company--the NYSE Group. Two
days later, the Nasdaq Stock Market
announced an agreement to purchase Instinet's electronic trading
network and consolidate their trading platforms. These are the four
largest markets trading equity securities in the United States, and the
importance of these transactions, if completed, can hardly be over-
emphasized.
Today, I will touch on some of the broader policy implications of
the proposed consolidations. I will start by placing these proposed
transactions in the context of the Commission's market structure
initiatives, particularly Regulation NMS. Next, I will offer some
thoughts about how the consolidations might impact competition in the
markets going forward. Finally, I will highlight some important issues
relating to industry self-regulation that the Commission will be
addressing in the coming months. As many of the details of the proposed
transactions are not yet clear and my observations are necessarily
preliminary, my testimony today reflects my own views and not those of
my fellow commissioners.
Market Structure Reform
As I have discussed with you in several prior hearings, one of my
highest priorities over the last 2 years has been to complete the
Commission's extended review of equity market structure regulation. In
recent years, the equity markets have experienced sweeping changes,
ranging from new technologies, to new types of markets, to the
initiation of trading in penny increments. The pressing need for an
up-to-date regulatory structure that properly reflects these changes
has been inescapable. Last month, the Commission took a critical step
forward in adopting Regulation NMS--a comprehensive set of reforms
designed to strengthen and modernize our national market system.
In my view, subsequent events in the marketplace have only
reconfirmed the importance of this Commission initiative. The fact that
the two transactions were announced only weeks after the Commission
adopted Regulation NMS may not have been entirely coincidental. To be
sure, the transactions resulted primarily from economic and competitive
forces in the marketplace. Even when markets are closely linked,
individual markets compete on the basis of size, because size offers
greater liquidity for executing customer orders. Thus, natural market
forces tend toward consolidation of markets. In addition to this basic
driver, other economic and competitive forces likely laid the
groundwork for these transactions, such as the need to maximize
economies of scale, reduce excess capacity, and, in the case of the New
York Stock Exchange, respond to a growing demand for more automated
trading and, at the same time, position itself to tap the public
capital markets to fund future expansion opportunities.
But prior to Regulation NMS, uncertainty about the regulatory
landscape may have hindered the ability of markets to plan for the
future. They knew that regulatory change was bound to occur, but were
unsure as to when and what form it would take. Therefore, while the
adoption of Regulation NMS did not cause the corporate consolidations
to occur, it may have helped create the conditions under which the
forces of competition and innovation--rather than uncertainty--can
drive decisionmaking.
Of course, certainty could have come with any Commission decision
on market structure, but I believe the choices we made were the right
ones. By adopting consistent rules of the road across all national
market system stocks--which include all stocks listed on an exchange or
Nasdaq--the Commission made sure that market consolidation can take
place against a regulatory background that protects investors at the
same time that it levels the playing field for competitors.
Prior to Regulation NMS, the lack of consistent intermarket trading
rules for all NMS stocks had divided the equity markets into halves: A
market for exchange-listed stocks and a market for Nasdaq stocks. For
historical reasons, including the history of the NYSE as an auction
market and Nasdaq as a dealer market, these stocks traded in quite
different regulatory structures. Exchange-listed stocks were subject to
the Intermarket Trading System, or ITS, rules. These rules include
trade-through restrictions, restrictions on locking or crossing
quotations, and participation in a ``hard'' linkage system. In
contrast, the market for Nasdaq stocks was just beginning to develop
when the ITS was created and has never been subject to the ITS rules.
In recent years, the result of this bifurcation has been a less
than optimal regulatory environment for both exchange-listed and Nasdaq
stocks. The old ITS trade-through provisions were an anachronistic
holdover from the era of primarily manual markets that hampered
competition from automated markets in exchange-listed stocks. On the
other hand, the markets trading Nasdaq stocks were characterized by
contentious disputes relating to the fees that can be charged for
access to quotations, as well as the common practice of posting locking
or crossing quotations. Moreover, both markets were characterized by a
significant volume of trade-throughs of the best prices--in exchange-
listed stocks mainly because of gaps in the ITS rules, and in Nasdaq
stocks because of the absence of any restrictions on trade-throughs.
From a purely economic standpoint, there should be no significant
difference between trading exchange-listed and Nasdaq stocks: Assuming
equal regulatory treatment, a market for a large-cap NYSE stock could
look very similar to a market for a large-cap Nasdaq stock, and a
market with active trading in one should also be able to host active
trading in the other. In adopting Regulation NMS, the Commission swept
away the outdated and inconsistent existing rules and resisted calls to
perpetuate major disparities in the regulatory environment for
exchange-listed and Nasdaq stocks. As a result, Regulation NMS
effectively unites the market for trading equity securities in the
United States. Market participants will no longer need to adopt trading
mechanisms and strategies for one regulatory structure that applies to
approximately one-half of NMS stocks, while adopting different
mechanisms and strategies for another regulatory structure that applies
to the other half of NMS stocks. Instead of basing their strategies on
regulatory differences, investors will be able to focus on fundamental
economic differences between stocks and markets.
One important ramification of this new level playing field is that
it will facilitate competition between the NYSE and Nasdaq across all
NMS stocks. By eliminating the advantage the old ITS rule might have
given floor-based exchanges, the new trade-through rule expands the
opportunities for electronic markets to compete with the NYSE floor for
order flow and ratchets up the pressure for the NYSE to implement its
Hybrid Market proposal in a way that will truly facilitate automated
trading. Moreover, if it merges with Archipelago, the NYSE Group will
have a formidable electronic platform for acquiring market share in
Nasdaq stocks.
Under the new regulatory framework, competition in all NMS stocks
will be based on three basic principles--best price, open access, and
transparency.
First, the new trade-through rule underscores the principle that,
no matter where a customer order is routed, it should receive the best
price that is immediately and automatically available anywhere in the
national market system. The trade-through rule prevents markets from
ignoring better priced automated quotes displayed by their competitors.
As competition heats up, the best price principle will protect
investors, particularly retail investors, by assuring that
intermediaries act in accordance with the interests of their customers.
The trade-through rule will function as a critical backstop to a
broker's duty of best execution, violations of which can be difficult
to prove and which generally does not apply to retail orders on an
order-by-order basis.
The best price principle also will promote vigorous competition
among individual market centers. As markets consolidate to build
liquidity, they are apt to be reluctant to ship orders to competing
markets. By ensuring that smaller markets displaying the best price
cannot be ignored by larger, dominant markets, the new trade-through
rule will make it easier for all markets to compete on the basis of
price. Moreover, the continued existence of the consolidated market
data system assures smaller markets that their quotes will be widely
distributed to all market participants and investors.
Second, competition in the new regulatory structure will be
governed by the principle of open access to displayed prices. Markets
will be permitted to compete across a wide range of services, but they
cannot attempt to penalize their competitors by adopting unfairly
discriminatory rules or practices that restrict access to their
displayed quotations. Markets also cannot charge exorbitant fees for
access to their quotations that effectively would create barriers to
access.
Third, markets must be transparent. All significant markets must
make their displayed quotations and trade reports available to all
interested parties on terms that are fair and reasonable and not
unreasonably discriminatory. Once again, markets cannot attempt to
hamper competitors by restricting the dissemination of essential market
information to all market participants and investors.
By following these three basic principles--best price, open access,
and transparency--I am confident that our equity markets will continue
to develop in ways that benefit investors.
Proposed Consolidations--Competition and Industry Self-Regulation
Turning to the proposed consolidations themselves, I would focus on
two basic questions. First, what effect are these transactions likely
to have on competition--among markets and among orders? Second, how
will the new consolidated markets meet their responsibility to assure
effective self-regulation?
Promoting Market Competition and Order Competition
The national market system is premised on promoting fair
competition among individual markets, while at the same time assuring
that all of these markets are linked together in a unified system that
promotes interaction among the orders of buyers and sellers in
individual stocks. It thereby incorporates two distinct forms of
competition--competition among markets and competition among orders.
Vigorous competition among markets promotes more efficient and
innovative trading services, while vigorous competition among orders
promotes more efficient pricing of individual stocks for all types of
orders, large and small. Together, they produce markets that offer the
greatest benefits for investors and public companies.
Accordingly, the Commission's primary challenge over the years in
facilitating the establishment of a national market system has been to
maintain an appropriate balance between these two vital forms of
competition. It particularly has sought to avoid the extremes of: On
the one hand, isolated markets that trade an NMS stock without regard
to trading in other markets and thereby fragment the competition among
buyers and sellers in that stock; and on the other, a totally
centralized system that loses the benefits of vigorous competition and
innovation among individual markets.
The United States is fortunate to have equity markets characterized
by extremely vigorous competition among a variety of different types of
markets. These include: (1) traditional exchanges with active trading
floors, which even now are evolving to expand the range of choices that
they offer investors for both automated and manual trading; (2) purely
electronic markets, which offer both standard limit orders and
conditional orders that are designed to facilitate complex trading
strategies; (3) market-making securities dealers, which offer both
automated execution of smaller orders and the commitment of capital to
facilitate the execution of larger, institutional orders; (4) regional
exchanges, many of which have adopted automated systems for executing
smaller orders; and (5) automated matching systems that permit
investors, particularly large institutions, to seek counterparties to
their trades anonymously and with minimal price impact.
At the same time, competition among multiple markets trading the
same stocks can detract from the most vigorous competition among orders
in an individual stock, thereby impeding efficient price discovery. The
importance of competition among orders has long been recognized.
Indeed, when Congress mandated the establishment of an NMS, it
succinctly stated this basic principle: ``Investors must be assured
that they are participants in a system which maximizes the
opportunities for the most willing seller to meet the most willing
buyer.'' \1\
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\1\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975).
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To the extent that competition among orders is lessened, the
quality of price discovery for all sizes of orders can be compromised.
Impaired price discovery could cause market prices to deviate from
fundamental values, reduce market depth and liquidity, and create
excessive short-term volatility that increases the cost of capital for
public companies. More broadly, when market prices do not reflect
fundamental values, resources will be misallocated within the economy,
and economic efficiency--as well as market efficiency--will be
impaired.
Accordingly, the proposed corporate consolidations must be
evaluated in the context of their effect on these two forms of
competition. Generally speaking, I believe the effect of the proposed
consolidations, combined with the new trade-through rule, should be to
increase market depth and liquidity and enhance order competition.
Moreover, I do not agree, as some may fear, that the consolidations
represent the death-knell for competition among markets. To accurately
assess the impact of the proposed transactions, one must endeavor to
predict what the markets, and the nature of competition, might look
like a year or two from now when Regulation NMS has been implemented
and the consolidations have been completed, assuming the necessary
steps for approval have been obtained.
At first glance, it appears that the two proposed consolidated
entities--the NYSE Group and the new Nasdaq--will dominate the
landscape for national market system stocks. Based on reported share
volumes in March 2005, the NYSE Group and the new Nasdaq would
respectively encompass approximately 49 percent and 47 percent of
trading in NMS stocks. But in spite of these large market shares, I
believe that competition among markets should continue to thrive.
The NYSE currently executes approximately 78 percent of share
volume in NYSE stocks, most of which is executed manually. Many believe
that the old ITS trading rules have helped the NYSE maintain its
dominant market share. Regulation NMS will transform the competition in
these stocks by protecting only automated quotations that are
immediately accessible. Recognizing that change was coming, the new
management of the NYSE has worked steadily over the last year to
develop its Hybrid Market proposal, which is designed to give investors
a choice of executing their orders automatically or sending them to the
floor for manual execution. Nevertheless, even if the Hybrid Market is
approved and implemented, the NYSE will have to battle to maintain its
market share, given the expanded opportunities for fully electronic
markets to compete in NYSE stocks after implementation of Regulation
NMS.
The two most formidable competitors of the Hybrid Market are likely
to be the new Nasdaq, which currently reports approximately 15 percent
of share volume in NYSE stocks, and the Hybrid Market's proposed new
corporate sibling--the Archipelago Exchange--which is a fully
electronic market that currently reports only 2 percent of share volume
in NYSE stocks. Notably, management of the NYSE and Archipelago have
stated that both the Hybrid Market and the Archipelago electronic
market would continue to exist and to trade NYSE stocks. The stage
therefore would be set for continued competition for market share in
NYSE stocks between the Hybrid Market and the electronic markets,
promising much greater automated trading and, I believe, quite
substantial benefits for investors in faster, more efficient trading,
particularly in the most active NYSE stocks.
Of course, NYSE stocks also are traded on regional exchanges and
other types of market centers that will continue to compete for market
share. These include automated matching systems that seek to facilitate
the large trades of institutional investors with anonymity and without
telegraphing their trading interest to the broader market. They also
include securities dealers in the business of providing liquidity for
the large trades of institutional investors. All in all, the battle for
market share in NYSE stocks promises to be quite heated.
The situation for Nasdaq stocks appears at first glance to be a
mirror-image of the situation for NYSE stocks. Giving effect to the
Instinet transaction, new Nasdaq would currently report 81 percent of
the share volume in Nasdaq stocks. But this summary figure conceals
more than it reveals. Approximately 30 percent of Nasdaq share volume
currently is executed by dealers and is merely reported, not routed or
executed, through Nasdaq facilities. A more accurate depiction of
market share is approximately 50 percent in the combined Nasdaq/
Instinet market, and 17 percent in the Archipelago market, with most of
the balance executed by securities dealers.
In the future, I anticipate a continuation of the longstanding
battle for market share in Nasdaq stocks, particularly after
implementation of the new trade-through rule. Currently, order flow in
Nasdaq stocks is fragmented among many market centers, and there is a
significant volume of trade-throughs, particularly trade-throughs by
block trades of displayed limit orders on the Nasdaq, Instinet, and
Archipelago limit order books. For example, many block trades in Nasdaq
stocks trade through the best displayed prices, and the total share
volume of trade-throughs in many of the most active Nasdaq stocks
reaches 9 percent and higher. In 2003, the total dollar volume of
trades that bypassed displayed and accessible quotations in Nasdaq
stocks was approximately $561 billion. After the trade-through rule is
implemented, this enormous volume of trading will be required to
interact with the best displayed prices on the electronic limit order
books. This heightened competition among orders is likely to produce
significant benefits for investors in the form of deeper, more liquid
markets and more efficient pricing. Indeed, it was this very prospect
that led so many institutional investors to support the application of
the trade-through rule to all NMS stocks, including Nasdaq stocks.
In addition, as I noted earlier, I would expect smaller, innovative
markets to continue to compete effectively even after the
consolidations. The trade-through rule will enhance the ability of
smaller markets to attract order flow by offering the best price, and I
believe market participants will have an interest in sending order flow
to these additional markets to preserve multiple options for order
executions.
To summarize, it appears at this point that the vital national
market system objective of promoting both competition among markets and
competition among orders should not be compromised if the proposed
consolidations were approved against the backdrop of the new NMS rules.
Again, however, I caution that any final conclusions will have to await
review of the full details of the proposed transactions.
Assuring Strong Industry Self-Regulation
The proposed market center consolidations should also be viewed
against the backdrop of the changing structure of industry self-
regulation. The strength of our national market system is critically
dependent on the effectiveness of the SRO's as regulators, and in this
regard, the Commission has undertaken over the last 2 years a
comprehensive examination of the current structure of industry self-
regulation. This examination was initiated in March 2003, when I sent
letters to all of the SRO's requesting that they review the adequacy of
their governance practices.
In recent years, both the NYSE and Nasdaq have changed
significantly their governance and self-regulatory structures.
Following the well-publicized controversy relating to the compensation
of the former NYSE Chairman, the NYSE created a new, independent board,
and established an autonomous regulatory unit that reports directly to
a fully independent regulatory oversight committee of the board. I
believe that these changes significantly improved the NYSE's governance
and regulatory functions.
I also believe that the governance and self-regulatory structure
implemented by Nasdaq in the 1990's has worked relatively well. In
particular, the market operation functions of Nasdaq have been
separated from the NASD, with the NASD now operating as an independent
organization focused exclusively on its regulatory functions as a
national securities association.
That said, there is clearly room for improvement in industry self-
regulation. The well-publicized events that led to the governance
changes at the NYSE and NASD have been quite troubling, as have recent
enforcement actions that found serious deficiencies in the regulatory
programs at several SRO's. To address these problems, the Commission
published for comment last December a series of new rules designed to
strengthen the current system of industry self-regulation. Among other
things, these rules would ensure the independence of the board of
directors and certain board committees, restrict the ownership interest
of any member of an SRO to no more than 20 percent, require SRO's to
maintain their books and records within the United States, and
significantly increase the amount of information that SRO's must
publicly disclose concerning their governance, regulatory programs,
finances, and ownership structure. Finally, the proposals would enhance
the Commission's oversight of the SRO's by requiring them to generate
detailed periodic reports on their regulatory programs in an electronic
format that would be readily reviewable by the Commission.
At the same time that it published specific proposals to strengthen
industry self-regulation, the Commission published a concept release
seeking public comment on a wide range of issues relating to the
overall structure of self-regulation. These issues include: (1) the
potential conflicts of interest between an SRO's regulatory obligations
and the interests of its members, its listed issuers and, in the case
of a demutualized SRO, its shareholders; (2) the potential costs and
inefficiencies of the multiple SRO model; (3) the challenges of
surveillance across markets by multiple SRO's, and (4) the manner in
which SRO's generate revenue and fund regulatory operations.
With the announcements of the proposed market center consolidations
last month, I believe it is even more critical that the Commission act
promptly on the SRO proposals. The transactions would give rise to
important issues of governance and self-regulation, and it is vital
that the Commission reach a decision on the standards that will govern
its review of the consolidations. Indeed, I believe that many of the
proposed rules on SRO governance and transparency would help address
issues raised by the proposed transactions, particularly the critical
issue of addressing conflicts of interest between SRO business and
regulatory functions.
With respect to the proposed consolidations themselves, very few
details are available thus far regarding their plans for self-
regulation. All of these details will have to be clarified prior to any
action on the proposed rule changes that the various entities will be
required to file with the Commission for notice and public comment
prior to completion of the transactions. I assure you that the
Commission will listen to the views of the public and closely
scrutinize the proposed transactions to assure that the interests of
investors and the public are fully upheld. We will also be sensitive to
the concerns of other regulators, including the Department of Justice.
At this point, I can simply highlight a few issues specific to the
proposed transactions that will be examined prior to reaching any
decisions.
First, the NYSE would, for the first time in its history, become a
publicly held company, raising the potential for conflicts of interest
between the profit-maximizing interests of its shareholders and the
need for effective self-regulation. The new NYSE Group will have to
assure the genuine independence of its regulatory staff and full
funding for its regulatory function. I expect we will carefully review
the organization of the regulatory function within the new NYSE Group,
including its responsibilities for regulating the new Hybrid Market,
the Archipelago Exchange, and member firms. We also will assess the
NYSE Group's financial arrangements to assure that all of these
regulatory responsibilities can be reliably and fully funded in the
future.
Second, the proposed consolidation of the Instinet trading platform
into Nasdaq preliminarily would appear to streamline the overall
regulation of trading on the combined Nasdaq/Instinet platform. The
regulation of such trading would be consolidated in two regulatory
entities--the NASD and Nasdaq. In contrast, regulation of Nasdaq and
Instinet trading currently is split among the NASD, Nasdaq, and the
National Securities Exchange, through which Instinet displays
quotations and reports trades. In particular, the National Securities
Exchange is responsible for regulating Instinet trading on the
exchange, while the NASD regulates Instinet as a member. In the future,
Nasdaq likely would continue performing the market surveillance
function for trading on the combined Nasdaq/Instinet platform, while
the NASD likely would be responsible for all other regulatory
functions.
Any examination of the Nasdaq/Instinet transaction would occur in
the context of Nasdaq's pending application for registration as a
national securities exchange. In this regard, I believe the staff is
close to resolving the remaining issues with Nasdaq. The staff has
worked with Nasdaq to resolve its concern about Nasdaq's current lack
of price priority rules. These rules promote order interaction and
price discovery, and are required by all other U.S. exchanges. Last
December, Nasdaq filed a proposal that would modify the rules of its
execution service, known as SuperMontage, so that all trades would be
executed in price/time priority, and this proposal appears to be a
significant step in Nasdaq's exchange application process. In addition,
the staff is working with Nasdaq to resolve remaining issues relating
to the reporting of over-the-counter trades. Once these issues are
resolved and reflected in an amendment to Nasdaq's exchange
application, the Commission will be in a position to act on the
application. At this point, we are expecting Nasdaq to file an amended
exchange application early this summer.
Finally, given the increased market share and potential competitive
clout of the two proposed consolidated entities, the Commission's role
in reviewing their rule filings will be quite important. The issues
addressed in these rule filings will include the fairness and
reasonableness of fees of all kinds, including for proprietary sales of
market data, as well as potentially discriminatory rules against
competitors or market participants who trade in other market centers,
all of which are required to be considered under the Exchange Act. For
example, the NYSE Group would encompass two separate SRO trading
facilities--the Hybrid Market and the Archipelago electronic market. No
unfairly discriminatory advantages would be allowed between the
separate trading facilities that would violate the open access
principle of Regulation NMS.
Conclusion
The Commission will have many important decisions to make in the
coming months. I look forward to hearing your views and answering your
questions on the market structure and self-regulatory issues facing the
Commission, with the simple caveat that, as I am sure you appreciate,
it would be inappropriate for me to attempt to prejudge where the
Commission will arrive in its deliberations on these complex subjects.
Thank you again for inviting me to speak.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM WILLIAM H. DONALDSON
Q.1. Do you have any comments about the study on the
independent chairman rule and the letter sent by Commissioners
Atkins and Glassman to the Appropriations Committee?
Q.2. Do you have any response Mr. Frucher, of the Philadelphia
exchange's concerns that the delays on issues before the
commission will hinder innovation by the smaller, regional
exchanges and jeopardize their very survival?
Answer: Due to the resignation and departure from the
Commission of Chairman William Donaldson, his response to these
questions is not available.