Hearing of the Senate Committee on Banking, Housing and Urban Affairs - Regulation National Market System and Development in Market Structure, Part 1

Federal News Service

HEADLINE: HEARING OF THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS SUBJECT: REGULATION NATIONAL MARKET SYSTEM AND DEVELOPMENT IN MARKET STRUCTURE, PART I

CHAIRED BY: SENATOR RICHARD SHELBY (R-AL)

WITNESSES PANEL I: WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION;

PANEL II:

ROBERT GREIFELD, PRESIDENT AND CEO, NASDAQ STOCK MARKET, INC.; DAVID HARRIS, SENIOR VICE PRESIDENT, STRATEGIC PLANNING, AMERICAN STOCK EXCHANGE;

EDWARD NICOLL, CEO AND DIRECTOR, INSTINET GROUP, INC.;

GERALD PUTNAM, CEO, ARCHIPELAGO, LLC;

JOHN THAIN, CEO, NEW YORK STOCK EXCHANGE

LOCATION: 538 DIRKSEN SENATE OFFICE BUILDING, WASHINGTON, D.C.

TIME: 10:00 A.M.

BODY:
SEN. PAUL S. SARBANES (D-MD): Thank you very much, Chairman Shelby. The United States has the most sophisticated infrastructure in the world through which investors can trade securities. Our market structure includes stock exchanges, electronic stock markets, broker dealers and internalized trades and alternative display facilities. In many cases, a company's stock can be traded in any of several competing marketplaces.

Modern computer technology has changed trading dynamics and hence market efficiency. New investment strategies are developing which take advantage of such technology. New fully electronic marketplaces which process transactions in a fraction of a second have developed and compete with auction markets which historically have served investors well.

The SEC has a responsibility to monitor these developments and to ensure that the federal regulatory structure promotes the efficient and fair operation of the secondary securities markets while not stifling competition. I commend Chairman Donaldson and the Division of Market Regulation and the commission for proceeding carefully in their consideration of this complex subject with very full input from the interested parties.

As the proposal notes, the commission's review of these issues has included multiple public hearings and roundtables, an advisory committee, four concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives and a constant dialogue with industry participants and investors.

On February 26th of this year, the SEC proposed Regulation NMS which address four subjects: the trade through rule, access fees, prohibiting stock quotes and increments finer than one penny and changing the formula for distributing data fees to markets. The commission gave the public an appropriately long comment period, which extended until June 30th of this year. It has received over 220 comment letters including many thoughtful comments from market participants that would be affected by the rule. The commission is now in the process of reviewing these statements.

Mr. Chairman, I join with you in looking forward to hearing the testimony of Chairman Donaldson. We are always pleased to have the chairman with us and the testimony of the representatives of the equity marketplaces which will follow on the impact of the SEC proposals on the systems and on investors.

Thank you very much.

BREAK IN TRANSCRIPT

SEN. SARBANES: Well, thank you very much, Mr. Chairman.

First of all, Chairman Donaldson, I've been struck by how open and comprehensive your examination of this issue has been. As I indicated at the outset, it is quite a complex issue but you've held these hearings and roundtables. As I understand it, as a consequence of some of the hearings, you did a supplemental request for comment which went out. Have you gotten any complaint from any source that the SEC has not been fully open and accessible with respect to drawing comments, because we want to be certain that no one comes along later and says, well, you know, we weren't included in the hearing process? My perception is that there's not a problem in that regard but have you gotten any complaints?

MR. DONALDSON: I think this has been the most incredibly complete process. It is a process that has really been going on for a number of years, if you will. I mean, it really preceded the actual focus we're bringing to it. You know, in the last year or so there has been incredible outreach on the part of the SEC. There's been I think great participation by the industry and panels and open discussions and so forth, and now it's been augmented by studies that have been done and now augmented by comment letters. I think it would be pretty impossible for anybody to say that they haven't been heard.

SEN. SARBANES: Well, that leads, of course, to the next question, so to speak. I notice in your statement towards the end you say, although I cannot predict the outcome of the commission's proposed rulemaking, I do believe it is extremely important that there be an outcome and that the outcome be reached in a timely manner. What's your view of what a timely manner encompasses?

MR. DONALDSON: I knew you were going to ask that question. (Laughter.) Well, we have-as I say, we have 600 comment letters, we have all the testimony and data that's come from meetings and so forth. We're digesting that. I believe that we should be in a position to boil this down and come up with some sort of refined proposed rules before the end of the year.

Now, having said that, when we get down to refining these rules and get down to plugging in on some of the contentious areas that they're at, that does not mean that there will not be, you know, even more focused attempt on the part of commentators to judge those rules. But in terms of the desires of the commission is to try and bring this thing to fruition, you know, just as soon as we can.

SEN. SARBANES: Now, in recent years, the securities markets have seen the consolidation of some electronic communication networks and market centers. What effect do you believe the proposal will have on the structure or consolidation of the securities marketplaces?

MR. DONALDSON: Well, there's already been some consolidation, as you know, in the markets and particularly the electronic markets. There is this tradeoff between the diversity and spread of marketplaces. Fractionalization is the buzzword, the fractionalization of the markets, and basically the pure theory of the best market in economic terms, this is when buyers and sellers get together and compete with each other. I mean, that's the definition. I mean, in theory, the best market in the world would be where everybody is competing, all the buyers and sellers are together, and that's true price discovery.

Insofar as you fractionate that, you lose something. Now, you gain something too. You gain some service aspects of these markets, some innovation and so forth that's come from competing markets, but you lose, and so it's a tradeoff. And to answer your question specifically, I believe that the natural forces, first of all, have caused some electronic markets to go out of business because they haven't got a good model, and I think it's taken some other electronic markets into a merge mode with other electronic markets, and I think that's healthy because that moves it toward all buying and selling in one place, but it doesn't move it completely. We still have the benefit of the competing market factor.

SEN. SARBANES: Now, let me ask you this question. I'm trying to understand these issues, and I don't pretend to be an expert in them, but the electronic marketplace would have the-you wouldn't be able to have the specialist abuses which occurred and which prompted the New York Stock Exchange and the SEC to take these enforcement actions.

Would that be correct?

MR. DONALDSON: Well, you know, you're asking a question that's not that easy to answer, the second part of it, which is the abuses that occurred on the floor of the stock exchange. And I guess my attitude toward that is, is the model wrong or was the policing of the abuses wrong? And that to me is the issue.

SEN. SARBANES: Would such abuses be possible in an electronic marketplace?

MR. DONALDSON: Different kinds of abuses, yes.

SEN. SARBANES: I mean, but of the ones that we encountered here?

MR. DONALDSON: Yeah. I mean, there are a whole series of practices, let's say, that prevail. And I don't mean to damn them all, but there is a series of practices that prevailed that give monetary incentives, if you will, to bringing orders to an electronic market-ugly word is the rebate-but, in essence, to attempt to get and induce buyers and sellers to get together in the electronic market. And one would question whether some of those payments are valid payments.

SEN. SARBANES: So the fact that it is executed automatically without human hands, which presumably on its face would address these questions that were raised on the stock exchange with its specialist where they said executing orders for their dealer accounts ahead of executable public customer agency orders and therefore violating the basic obligation to match its executable public customer buy-and-sell orders, and not to fill customer orders through trades form the firm's own account when those customer orders could be matched with other customer orders, thereby profiting from it, disadvantaging customer orders. On an electronic exchange with an instantaneous execution, this sort of abuse cannot happen, but you're telling me other abuses can take place.

Is that correct?

MR. DONALDSON: Yeah. And, again, without excusing in any way violations on the floor of the stock exchange of the trading rules, I would simply say that decimalization and all of the things that I referred to before in terms of changes brought about by new trading strategies and so forth, and the reduction of spreads to pennies and so forth has severely tested the sort of price improvement backbone of the New York Stock Exchange, severely tested the speed of all of this, has tested the ability of the specialists to do their thing. And the problem --

SEN. SARBANES: So that raises therefore I guess a question now about whether they can perform their function in terms of affecting volatility. As I understand it, the arguments for the traditional exchange is you get better price-or at least the argument is made that we get better price-and also that you're able to ease the volatility issues. Now, is that argument being undercut or weakened by the development of this very fast transaction?

MR. DONALDSON: Yes. I think that, in the following way, that if we had only electronic markets and didn't have the liquidity improving and price improving capabilities of the so-called "slow market" or "auction market" or "specialists market" or whatever name you want to put on it, I think that our central market would lose a great deal. In other words, if-and particularly in times of stress-particularly in times of violently up markets, or more particularly or more importantly, violently down markets where liquidity can be created, not only by the specialist himself or herself, but also the liquidity that the specialist brings to bear on the marketplace. You have a human being and human beings involved in a real-time situation.

I'm going to say something now that I hope is not misinterpreted, but it's too easy to turn off an electronic market. It's too easy to have gaps, particularly under times of stress. And this gets to also the difference in the way stocks are traded. I mean, there are stocks on the NASDAQ market, on the New York Stock Exchange that, as the expression goes, "trade like water"-I mean, there really is no intervening function here. That's very different than the great bulk of stocks that have wider spreads, have less liquidity on both sides of the market, have less trading volume and require the gathering together of liquidity to make an orderly market.

And having an orderly market is so important to our system. I mean, the multiples that stocks sell at, the quality of the stock and so forth is dependent on the orderliness, the relative orderliness, of the market. And it's particularly in times of stress that this is so important.

SEN. SARBANES: Thank you, Mr. Chairman.

BREAK IN TRANSCRIPT

SEN. SARBANES: Okay. Very good.

Mr. Thain, I'd like to ask you, is the-the New York Stock Exchange is, I take it, the first line of defense in dealing with the practices of the specialist firms. Am I correct in that regard?

MR. THAIN: Yes.

SEN. SARBANES: And then the SEC is, as it were, a backup to that or an overseer to that, or how would you describe that relationship?

MR. THAIN: Yes. The SEC has oversight of the New York Stock Exchange.

SEN. SARBANES: Uh-huh. Now, has the-what changes has the stock exchange put into place following this March settlement of SEC enforcement actions for about a quarter of a billion dollars to prevent future abuses and to enhance the ability of its regulatory function or prevent misconduct?

MR. THAIN: Thank you. There have been quite a number of changes to the New York Stock Exchange really over the last year. As everyone knows, we have a new chairman. We also have almost an entirely new board of directors. We also have a new structure whereby the regulatory functions have been separated from the business functions of the exchange. So I, as the CEO of the New York Stock Exchange, run the business side and Rick Ketchum, who is new, who's our chief regulatory officer has the regulatory side. So we've separated the business of the exchange from the regulatory functions of the exchange.

Those regulatory functions run by Rick Ketchum report up to a subcommittee of the board of directors that is chaired by Marsh Carter and which is also totally independent directors and then ultimately up to the board itself. This structure, the separation of the regulatory functions from the business of the exchange, was approved unanimously by the SEC in December.

SEN. SARBANES: Well, that describes sort of the structure, but what substantive changes have been instituted to address this question with respect to the specialty firms that resulted in this major settlement?

MR. THAIN: Well, besides a complete revamp of the leadership of the regulatory side and the replacement of those individuals responsible for the enforcement part of the exchange's regulatory side, we've also invested substantially in the system's capability to monitor the behavior of the specialist. And so the most egregious forms of the behavior of the specialist the computer systems would no longer allow to happen. And we are spending a substantial amount of funds, both on the systems side and on the people side, to enhance the enforcement capability. Just to give you an idea, of the 1,500 employees of the New York Stock Exchange, 500 work in the regulatory and enforcement side.

SEN. SARBANES: I'd say to the other members of this panel, Mr. Thain in his statement says this is no time to put personal interests ahead of investor interests. What's your response to that in terms of your activities, whether they, in fact, put personal interest ahead of investor interest? I mean, what do you make of that argument?

MR. GREIFELD: Well, I think Mr. Thain was taking a position as if we had substantial differences. As I said in my testimony, we certainly believe limit order protection is paramount. We believe that individual investors have to be protected and we believe best price is of particular importance. Our difference is not on those items, our difference is how to get there. We fundamentally believe that an opt-opt represents market forces that allow competitors to compete and make sure investors are well taken care of.

If you go with a rules-based approach, you are subject to gaming, and we have very smart people at this table and very smart people at this industry. And if the rule is not perfectly cast, there is gaming opportunities that exist. If you have a market-based approach, you have to respect the customers' wishes. If you have a rules-based approach, you have to figure out how to work within the construct of the rule.

SEN. SARBANES: Does anyone else want to --

MR. PUTNAM: I would. I mean, certainly our view is protection of investors and not personal interests. And no one else has asked the question, so I will. Does the New York Stock Exchange plan call for protecting limit orders on competitors' systems beyond the NBBO? So will you protect firm orders through depth-of-book under that plan and in a competitor's marketplace.

MR. THAIN: As Mr. Putnam knows very well, there is no protection anywhere in the marketplace on anyone's system other than at the best bid or the best offer.

So there's neither protection for better limit orders on the floor of the exchange, which of course also exist, nor is there any protection in any of the market linkages.

MR. NICOLL: If I can just add, we clearly have been consistent in our position. We believe in competition. Competition has had a very-it's been very difficult for Instinet. Instinet, through competition, has seen its revenue capture in its ECN go from $3 for every thousand shares that it trades three years ago to under 40 cents today. The biggest beneficiaries of competition are the consumers, not the producers. And we have seen rigorous competition in our marketplace to the detriment of our bottom line. But we believe-we very much believe that competition is in the best interest of the consumers.

This debate that just played out is a very interesting one. There's lots of difficulties here in connecting these marketplaces in a way that's fair. Only the best bid and offer is ever shown. So if we're going to require that somebody go to the highest best bid and offer but we're not going to require them to honor the better priced limit orders beyond the best bid and offer, then we're going to create enormous gaming opportunities for people to show small, little bids and offers at the highest price and then fill the balance of the orders at prices which are much worse than that which is shown.

We could have a system which Jerry is talking about where when we go to one exchange and we hit the highest bid, we then stop the trading and look around and see, okay, now who's the next highest bid? Now, let me go out to Archipelago, let me execute that portion of my order at Archipelago. Wait, now the New York Stock Exchange is now the best bid. Let me turn around and go back to the New York-these are very difficult questions. They create a kind of-when you're trying to connect these markets to a rule-based approach, as Bob said, they're very gameable, they're very complex, and as Senator Corzine said, it's a very difficult task.

But there is actually an easy and a clean solution, and it is to rely upon competition. Competition works, it's played out in the NASDAQ marketplace to the consumers' benefit, to the investors' benefit. I don't believe your offices or the SEC is getting enormous complaints from people placing limit orders in the NASDAQ marketplace from being traded through. They are not.

What we need here-and with respect to fragmentation, if I could just-your indulgence on one last point. Fragmentation is not the fact. Doesn't occur because trading occurs in different venues. Fragmentation occurs when those different venues create inefficiencies because they are not-people trade at inferior prices in one venue because they get trapped in one venue, and they can't see that there's a better price in another venue.

When, through technology and communications, we can show all the marketplaces simultaneously and people can see where the liquidity is and where the best prices are, it doesn't matter that a third is traded in one place and a third in another place, as long as it's accessible and that people can see those prices and they can choose to go where the best price is. So in a marketplace that we have today through technology, we can eliminate much of the downside of so-called fragmentation, and we think that the better public policy is to let these markets compete. Investors and consumers will benefit from that competition.

SEN. SARBANES: Does anyone else want to add anything?

MR. GREIFELD: One thing I'll add is when we compete, we're saying-we're still under the watchful eye of the SEC. This is not unfettered market competition. We all are subject to their regulation and we are well-regulated, so we want to compete within that construct.

SEN. SARBANES: I agree.

Well, thank you, Mr. Chairman.