[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
REVIEWING U.S. CAPITAL MARKET
STRUCTURE--PROMOTING COMPETITION
IN A CHANGING TRADING ENVIRONMENT
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
OCTOBER 30, 2003
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-60
92-981 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North CHARLES A. GONZALEZ, Texas
Carolina MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona STEVE ISRAEL, New York
VITO FOSSELLA, New York MIKE ROSS, Arkansas
GARY G. MILLER, California CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota ARTUR DAVIS, Alabama
TOM FEENEY, Florida RAHM EMANUEL, Illinois
JEB HENSARLING, Texas BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona KEN LUCAS, Kentucky
JIM RYUN, Kansas JOSEPH CROWLEY, New York
VITO FOSSELLA, New York, STEVE ISRAEL, New York
JUDY BIGGERT, Illinois MIKE ROSS, Arkansas
MARK GREEN, Wisconsin WM. LACY CLAY, Missouri
GARY G. MILLER, California CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
October 30, 2003............................................. 1
Appendix:
October 30, 2003............................................. 63
WITNESSES
Thursday, October 30, 2003
Donaldson, Hon. William H., Chairman, Securities and Exchange
Commission..................................................... 5
Foley, Kevin, Chief Executive Officer, Bloomberg Tradebook LLC... 42
Giesea, John, President and Chief Executive Officer, Security
Traders Association............................................ 36
Joyce, Thomas M., President and Chief Executive Officer, Knight
Trading Group, Inc............................................. 38
LaBranche, Michael, Chairman, Chief Executive Officer, and
President, LaBranche & Co., Inc................................ 40
McCooey, Robert H. Jr., President and Chief Executive Officer,
The Griswold Company Inc....................................... 34
Nicoll, Edward J., Chief Executive Officer, Instinet Group
Incorporated................................................... 45
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 64
Clay, Hon. Wm. Lacy.......................................... 66
Emanuel, Hon. Rahm........................................... 67
Fosella, Hon. Vito........................................... 68
Hinojosa, Hon. Ruben......................................... 70
Kanjorski, Hon. Paul E....................................... 71
Donaldson, Hon. William H.................................... 73
Foley, Kevin................................................. 88
Giesea, John................................................. 111
Joyce, Thomas M.............................................. 119
LaBranche, Michael........................................... 145
McCooey, Robert H. Jr........................................ 155
Nicoll, Edward J............................................. 163
Additional Material Submitted for the Record
Fossella, Hon. Vito:
Organization of Independent Floor Brokers, prepared statement 196
Donaldson, Hon. William H.:
Written response to questions from Hon. Doug Ose............. 199
Written response to questions from Hon. Ruben Hinojosa....... 201
Written response to questions from Hon. David Scott.......... 203
Foley, Kevin:
``Competition, Transparency, and Equal Access to Financial
Market Data.''............................................. 204
Giesea, John:
Fulfilling the Promise of the National Market System, STA's
Perspective on U.S. Market Structure, Special Report,
August 2003................................................ 238
Written response to questions from Hon. Ruben Hinojosa....... 266
LaBranche, Michael:
Written response to questions from Hon. Ruben Hinojosa....... 269
Nicoll, Edward J.:
Written response to questions from Hon. Ruben Hinojosa....... 270
REVIEWING U.S. CAPITAL MARKET
STRUCTURE--PROMOTING COMPETITION
IN A CHANGING TRADING ENVIRONMENT
----------
Thursday, October 30, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:07 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Gillmor, Bachus,
Royce, Oxley (ex officio), Kelly, Fossella, Biggert, Hart,
Tiberi, Brown-Waite, Renzi, Kanjorski, Sherman, Meeks, Inslee,
Hinojosa, Lucas of Kentucky, Crowley, Clay, Matheson, Emanuel,
Scott and Maloney.
Chairman Baker. [Presiding.] I would like to call this
meeting of the Capital Market Subcommittee to order.
Committee is convened to receive comment and testimony with
regard to the adequacy of our current market structure
regulatory environment.
The inexorable press of technology combined with the
effects of decimalization, have brought about changes in the
market that are not entirely clear to be beneficial at the
moment.
At this point, artificial rules that constrain where a
customer might execute the best trade to their own personal
advantage, does not, in itself, lead one to conclude that the
current system enables that to occur on every occasion.
Also recent unfortunate events surrounding corporate
governance issues at the New York Exchange, have opened the
entire debate as to whether the specialist system continues to
serve the highest and best purpose of the American investor.
And, at the same time, raises issues as to whether
regulation and compliance can be subservient to the same board
which has responsibilities for operation of a for-profit,
shareholder-owned corporation.
All of these issues raise the whole discussion to an
important level. ``What do we do and when do we do it?'' I do
believe that the SEC, over the years, has conducted a number of
evaluations and studies, and I think, because of the unique
circumstance we now find ourselves in, it is appropriate to
consider taking some action.
Whether it is statutory or whether by SEC regulation, I do
believe the forces of technology are bringing about the
potential for significant market structure changes that will be
in the best interest of the individual investor.
With now over 50 percent of American homeowners invested
directly in the marketplace, this is no longer an issue which
can be relegated to a second-tier importance. It is a principle
importance, not only for those individual investors, but for
the success and growth of our own economic systems, and the
exchanges and the capital markets are at the core of our
opportunity for economic growth.
To that end, I am anxious to hear from the Chairman this
morning as to their observations and recommendations and hope
that we can come to relatively quick closure on an action plan,
not only from the commission's perspective, but for this
Committee to consider as well.
With that, I recognize Mr. Kanjorski.
Mr. Kanjorski. Mr. Chairman, we meet today for the second
time in the 108th Congress to review the structure of our
capital markets and evaluate reforms that might enhance
competition in light of recent technological advances and
marketplace developments.
In recent years, a variety of participants in the
securities industry have questioned one or more aspects of the
regulatory system.
Today's proceedings will, therefore, help us to better
understand these issues and their concerns. In my view, we have
come to a crossroads in the securities industry, facing a
number of decisions that could fundamentally alter its
structure for many years to come.
As I did in our last market structure issues hearing, I
must caution my colleagues on both sides of the aisle to move
carefully and diligently in these matters. Because we have
elaborately interlocking systems and relationships in our
securities markets, I believe that we should refrain from
pursuing change for change's sakes.
Moreover, in pursuing any change to fix those portions of
the system experiencing genuine strain, we must also ensure
that we do not disrupt these elements of our market that are
working well.
In adopting the Securities Act Amendments of 1975, the
Congress wisely decided to provide the Securities and Exchange
Commission with a broad set of goals and significant
flexibility to respond to market structure issues. From my
perspective, this system has worked generally well, over the
last three decades, in adapting to technological changes and
other developments.
This legal framework ought to continue to provide the
commission with the flexibility that it needs to consider and
adopt further reforms in the future.
In testimony before the Senate earlier this month, SEC
Chairman Donaldson indicated that the Commission would be
focusing on increased intensity on the structure of our
securities markets in the upcoming months.
I, therefore, look forward to learning from the Chairman,
later this morning, about his current views on these matters. I
want him to know that it is my hope the Commission will move
expeditiously and methodically in its deliberations.
Mr. Chairman, I have made investor protection an important
issue of mine in this Congress, and during my opening statement
at our last hearing in market structure issues, I outlined some
of my thoughts regarding self-regulation in the securities
markets.
Today, I would like to focus on another important investor
protection issue: transparency.
For our securities markets to work well and advance the
interest of investors, I believe, as a general rule, that we
should seek to promote transparency to the maximum extent
possible.
Transparency helps to ensure that all participants in the
marketplace have access to the same information for making
decisions. Transparency, therefore, ensures that no participant
in a marketplace is either advantaged or disadvantaged because
of their access to information.
For these reasons, I have apprehensions about any market
structure reform proposal that would limit access to
information, including those that would allow for
internalization of market orders.
In my view, such proposals have the potential to jeopardize
the transparency of our markets and harm investors.
During their tenures, the two most recent former commission
chairmen have expressed concerns about the internalization of
market orders by broker dealers.
Additionally, the current SEC Chairman has previously
observed that internalization can discourage markets from
competing on the basis of price and pose a conflict of interest
for broker dealers.
As we deliberate on market structure issues this morning,
it is my expectation that he will comment further on the
importance of further enhancing transparency in the securities
industry.
In closing, Mr. Chairman, I believe our Committee must
continue to conduct vigorous oversight of the securities
industry to determine whether its regulatory structure is
working as intended and to examine how we could make it
stronger.
The observation of today's witnesses about these complex
matters will also help us to discern how we can maintain the
efficiency, effectiveness and competitiveness of our nation's
capital markets into the foreseeable future.
I look forward to this hearing, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 71 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.
Chairman Oxley?
Mr. Oxley. Thank you, Chairman Baker, for holding this
important hearing.
There are a few issues that come before this Committee that
are as fundamental as how investors buy and sell securities. I
want to particularly welcome our distinguished witnesses today;
Chairman Donaldson and Annette Nazareth, for appearing.
This Committee's first market structure hearing earlier
this month, I think all the members would agree, was quite
encouraging. I was pleased with John Reed's candid and
forthright testimony.
There is no question that he has volunteered for a
difficult job, under trying circumstances, but I believe he is
the right leader, at the right time, to right the ship at the
New York Stock Exchange.
And even more importantly, I also believe that the recent
controversies at the New York Stock Exchange present a real
opportunity to enact significant and long overdue reforms to
our market structure. An opportunity like this does not come
around often, and we must not squander it.
I have long taken the position that investors benefit from
multiple market centers that engage in vigorous competition
based on speed and certainty of execution, anonymity and price.
The government should not decide which markets prosper. In
fact, it is our obligation to ensure that no market have
regulatory advantages that inhibit competition and artificially
preserve market share.
Accordingly, it is imperative that we revisit the rules and
regulations that have governed the markets for more than a
quarter of a century.
What Congress did in 1975, may have made sense at the time,
but those policy decisions were made prior to the greatest
technological advances in human history.
It makes no sense, whatsoever, for these outdated
regulations, which preceded, for example, the advent of
Netscape by two decades, to be controlling in today's high-tech
environment.
With a change in leadership at the NYSEC, I believe we are
at a crossroads with an important opportunity to implement
changes that will foster competition and make our markets even
more efficient.
The Intermarket Trading System is an outdated construct
that has outlived its usefulness. It is time to revamp the
system that links our markets so that market forces and modern
technology can replace bureaucratic, restrictive regulatory
systems.
There has been a great deal of talk about the need to
reform the ITS's trade-through rule. I expect we will hear from
virtually all of our witnesses here today about this issue.
It is clear to me the time for reform is long overdue.
Price simply is not the only factor to be considered for the
purposes of best execution. The trade-through rule, as it
stands, is standing smack in the way of more efficient,
competitive markets.
The viability of the SRO model depends on whether it is one
that uses regulation to protect investors and promote
confidence or to hamper competition. We will examine many of
these rules today.
Central to today's discussion, will be the role of the
specialist. It has been widely criticized as monopolistic,
anachronistic and unnecessary in today's highly-evolved
technological environment.
John Vogel, who has appeared before this Committee several
times, calls it, ``A dinosaur that maintains as much of a
monopoly as you can get in this world.''
Even more alarming are the allegations of wrongdoing that
call into question the integrity of this model and whether it
creates an irresistible opportunity to put the specialist's
interests ahead of investors.
Critics of decimal pricing argue that decimal pricing has
led to front-running and other trading violations.
I would argue that these abuses are symptomatic of a flawed
structural system, not the result of decimal pricing which has
resulted in what one commentator has called a, ``Billion-dollar
tax cut for investors.''
It is time to review the specialist system. Today's hearing
is an important step toward that end.
I have long argued that market data, the fundamental
information about securities prices that is the oxygen of our
marketplace, needs to be free from ownership interest that
could restrict access to that data.
It is essential that we ensure that investors have
guaranteed full access to this information.
I am eager to hear from SEC Chairman Donaldson, this
morning and, particularly, I look forward to learning how he
intends to expedite consideration of all the pending issues
before the Division of Market Regulation.
As many petitioners know all too well, the failure to make
a regulatory decision is often worse than the adverse decision.
Again, I want to commend you, Chairman Baker, for putting
together an excellent and balanced second panel of witnesses
and I look forward to hearing their testimony as well.
And I yield back.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 64 in the appendix.]
Chairman Baker. Thank you, Mr. Chairman.
Do members have--further members have opening statements?
If not, at this time, I would like--I am sorry, Mr. Emanuel,
did you have?
Yes. All members may submit their opening statements in
writing for the record, without objection.
If there are no members seeking recognition at this time, I
would like to welcome back Chairman William Donaldson, who is
no stranger to the hearing room, unfortunately for him, I
guess.
But we certainly do appreciate the courtesy of your
appearance and we look forward to receiving your testimony this
morning, Sir.
STATEMENT OF HON. WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES
AND EXCHANGE COMMISSION
Mr. Donaldson. Thank you very much.
Good morning Chairman Baker, Ranking Member Kanjorski, and
members of the Subcommittee. I am very pleased to be here to
discuss some of the significant market structure issues that we
are facing in the U.S. equities market today.
Our markets are comprised of intricately-interwoven systems
and relationships.
While the Commission recognizes the importance of
addressing market structure issues expeditiously, the extent to
which structural changes are needed, and what those changes
should be, are complicated problems to say the least and not
subject to quick and easy resolution.
We must take care not to disrupt those areas of our market
that are working well in our haste to fix those areas which we
think are not.
The Commission staff has made significant progress in
analyzing the structure of the securities markets, identifying
the sources of the strains to which it is increasingly subject,
and formulating a road map for responding to these concerns.
The staff is now in the process of drafting concrete
proposals to address the root causes of the stresses on the
U.S. market structure. I have asked the staff to produce, in
the coming months, a plan that includes proposals to respond to
several of the more pressing market structure issues.
As you know, Congress formally directed the Commission to
address market structure when it enacted the Securities Act
Amendments of 1975.
That legislation instructed the SEC to facilitate the
creation of a national market system for securities that would
maintain fair and orderly markets and tie together all buying
and selling interest so that investors would have the
opportunity for the best possible execution of their orders,
regardless of where in the system they originate.
Rather than attempt to dictate the specific elements of the
U.S. market structure, however, Congress chose to rely on an
approach designed to provide maximum flexibility to the
Commission and the securities industry in its development.
The 1975 amendments to the Exchange Act created a framework
for fostering transparency, interconnectivity and competition
in our securities market.
As a result, today, equity market centers compete with one
another in an environment where quotes and transaction prices
are widely available to all market participants.
Direct and indirect linkages among competing market centers
help ensure that brokers can access the best quotes available
in the market for their customers.
Market centers, including exchange markets, over-the-
counter market-makers and alternative trading systems have an
incentive to offer improvement in the execution quality and to
reduce trading costs in order to attract order flow away from
other market centers.
Taking a step back and looking at the market as a whole,
our National Market System has worked remarkably well for the
past quarter century and, in recent years, it has become
increasingly efficient.
At the same time, we recognize that this very efficiency,
arising from the technological and other market developments,
has put strains on existing national market structures.
One significant change has been the proliferation of the
new electronic markets, such as the ECNs, that offer fast
executions and have spurred competition among market centers,
but, at the same time, exacerbated concerns about market
fragmentation, the feasibility of integrating different market
models into the National Market System, and maintaining a level
regulatory playing field among the functionally-equivalent
market participants.
The implementation of decimal pricing in 2001 and the
concurrent move to a minimum tick of one penny in the equity
markets have narrowed spreads and enhanced the efficiency of
the price discovery process but, at the same time, reduced the
liquidity available at each price point, made it easier to step
ahead of limit orders, and placed economic strains on the
dealer business.
Decimal pricing has also put a premium on swift access to
displayed prices so investors can quickly reach these smaller
quotes before they change.
The trend toward demutualization of exchanges and their
conversion to for-profit enterprises has heightened concerns
about the inherent tensions in the self-regulatory model, in
particular the concern that the funding and vigor of the
regulatory function might be sacrificed in favor of delivering
returns to shareholders.
As noted, over the last several years, the Commission has
taken a number of steps to address concerns facing our National
Market System.
In the Order Handling Rules and Regulation ATS, for
example, the Commission broadened the class of market centers
required to make their quotations and orders publicly
accessible. In doing so, it sought to redefine the idea of an
exchange to include, not just traditional exchanges, but also
trading systems where orders interact according to specified
trading rules.
The Commission also adopted rules to improve the disclosure
by market centers of execution quality data and the disclosure,
by broker-dealers, of their order routing practices in order to
enable investors to comparison shop among the myriad market
centers and to stimulate competition on the basis of execution
quality.
There is no doubt that there are issues regarding our
National Market System that call for our attention; and,
indeed, the Commission and its staff have been increasingly
focused on addressing these issues and resolving perceived
conflicts in a timely manner.
Commission staff is in the midst of developing proposals
that address, in a comprehensive fashion, the various market
structure issues.
I would like to focus the remainder of my testimony on the
four key areas of the Commission's market structure initiative:
access to markets; market data; the self-regulatory model
itself; and the nature of a securities exchange.
Fair access: a significant market structure issue on the
Commission's agenda is making sure that access between markets
is as fair and as efficient as it can be.
If best execution is to be achieved in an environment
characterized by multiple competing markets, broker-dealers
must be able to identify the location of the best available
prices and obtain access to those prices routinely and
efficiently.
The Commission's approval, last year, of the NASD's
Alternative Display Facility as a pilot program has heightened
the issue of intermarket access.
Rather than obtaining access through ``hard'' linkages
directly between markets, in the way that competing markets can
access the New York Stock Exchange, in the Alternative Display
Facility competing market centers obtain access to each other
directly through privately-negotiated access agreements and
indirectly through subscribers.
The Commission is evaluating this decentralized access
approach to determine whether, as a practical matter, it would
be an appropriate model for the National Market System, and
this could be applied to other market centers.
Access fees: access fees charged to reach a quote create
another difficult market structure problem. Some markets charge
varied per-share transaction fees for access to their quotes.
Therefore, a displayed price may represent the true price
that a customer will pay, or it may represent only a base price
to which an undisclosed access fee will later be added.
To ensure real access to public quotes between competing
markets, it is important that quotes be accessible to other
market participants on clear and fair terms.
Price protection: as a part of our examination of
intermarket linkages, we also are actively reevaluating the
question of intermarket trade-throughs, which occur when orders
are executed in one market at prices inferior to the prices
disseminated on another market.
The challenge before the Commission is to devise standards
that allow faster markets and slower markets to thrive within a
single system of interconnected markets while, at the same
time, providing order executions to customers that display
prices for those customers who desire the best price on their
order.
Market data: an additional market structure challenge
facing the Commission involves the collection and reporting of
trading information and the influence of the market data
revenues on market structure.
Under the current system, distributions of market data
revenues to self-regulatory organizations are based primarily
on each self-regulatory organization's reported trade volume.
This compensation scheme has created a financial incentive
for self-regulatory organizations to report as many trades as
possible.
As a result, markets are vying for ECNs and market-makers
to report their trades through them, as this allows markets to
tap more deeply into the pool of available market data revenue
and to rebate substantial portions of the additional revenue to
the entity reporting the trade.
All of this calls into question whether the current method
of distributing market data revenue creates appropriate
economic incentives and whether it furthers the goal of
rewarding markets that make valuable contributions to the
market data being disseminated.
The self-regulatory model: another matter of great
importance is the effectiveness of the self-regulatory system
of our securities markets.
The principle of self-regulation is based on the idea that
regulation can be best done as close as possible to the
regulated activity. However, an SRO that operates a market has
a potential conflict of interest between its role as a market
and as a regulator.
The advent of for-profit, shareholder-owned exchanges
creates additional issues, including ensuring that self-
regulatory obligations do not take a back seat to the interests
of shareholders.
The challenge for the Commission and the SROs is to ensure
that, as the securities markets grow more competitive, the SROs
continue to dedicate their energies and resources to
surveillance and enforcement.
We also must prevent fragmentation of trading from creating
gaps in the SRO oversight of the markets.
As a part of our review of the self-regulatory structure, I
believe the Commission must thoroughly review the SROs
governance. Recent events at the New York Stock Exchange point
to the need for this review.
SROs play a critical role as the standard setters for sound
government practices. Just as SROs have demanded that their
listed companies strengthen their governance practices, we must
demand that, at a minimum, SROs match the standards they set
for listed companies.
There are several topics that merit our consideration,
including board composition and the independence of directors;
the independence and function of key board committees; the
transparency of the SRO's decision-making process; and the
diligence and competence required of board and committee
members and ensuring their focus on the adequacy of regulation.
The last topic I would like to touch upon is what it means
to be registered as a national securities exchange.
All currently-registered exchanges have a limit order book
in which better-priced orders take precedence. But a mandatory
order book system is not easily reconciled with a dealer model,
such as the NASDAQ stock market, in which there is no central
limit order book.
I spoke earlier about the merits of price protection across
markets. NASDAQ's application to register as an exchange places
squarely before the Commission, the issue of whether price
protection, within a market, is a requirement of an exchange
registration.
One issue is customer expectations. I suspect that
customers generally expect their better-priced orders to be
protected within an exchange.
We do not expect all exchanges to be identical, much less
to replicate any market's faults. Yet, until now, all exchanges
have given their limit orders priority throughout their
marketplace.
If the Commission were to approve NASDAQ's application,
other exchanges would likely seek to eliminate intra-market
price priority from their rules. As a result, the protection of
limit orders within markets would decrease. For this reason,
NASDAQ's exchange application raises overall market structure
issues that transcend the particular question of whether
NASDAQ, or any other particular market, should be registered as
an exchange.
In conclusion, I would like to reiterate that the market
structure challenges that I have discussed today may shape the
National Market System for years to come. The Commission
recognizes the importance of addressing these challenges in an
effective and timely manner.
At the same time, however, we have got to be mindful not to
rush to judgment but, instead, take a deliberate and reasoned
approach to reach the right result.
That said, we fully acknowledge the need to resolve the
conflicts, and it is my expectation to be able to review
proposals from Commission staff, in the coming months, with an
eye towards publishing proposals soon thereafter.
I look forward to continued input from this Subcommittee on
those important matters throughout this process. Thank you
again for inviting me to speak on behalf of the Commission.
I would, obviously, be happy to answer any questions that
you may have. Thank you.
[The prepared statement of Hon. William H. Donaldson can be
found on page 73 in the appendix.]
Chairman Baker. Thank you, Mr. Chairman.
We do have announced a series of votes; there are three now
pending.
First is a 15-minute vote. It would be my intention to
proceed with my questions, perhaps those of Mr. Kanjorski, if--
well, at least I will go through mine, if that is the case.
And then the Committee would stand in recess for about 15
minutes to complete the remaining part of the first 15-minute
vote and the other two fives.
Mr. Chairman, it is my understanding the SEC is in
preparation of a concept release on the trade-through rule.
When do you anticipate some product being ready to release
for public consideration?
Mr. Donaldson. Well, it is implied in my comments. We are
looking at a number of issues that we believe are inter-
related.
We believe the trade-through rule is a very critical rule
now, in terms of any modifications, eliminations or, whatever,
that we might make on that rule.
I believe we want to consider that within the context of a
couple of other issues that I have mentioned.
As I say, I hope that--we are working on it right now; we
have taken testimony; we have talked, and now is the time for
action. I think it is a matter of months, not years, but not
weeks, either.
Chairman Baker. I posed that question in light of what, I
understand, was the pilot in August of last year, which looked
at relief from the trade-through rule.
And the reported observations about the success or failure
of the pilot indicated that it seemed to work very, very well
and that there were efficiencies, other than best price, that
were of material importance to investors.
And it just seems, from my perspective, that it is a very
significant first step in providing more efficient functioning
of markets to either expand the pilot or to take some further
definitive action as quickly as possible, given the benefits
of, at least reported benefits of, that pilot effort.
What is your opinion with regard to the specialist system?
And I make the observation, perhaps not in a sophisticated way
but, in Louisiana, as a former realtor, if I were to represent
a buyer and a seller and I knew that the seller would take $100
thousand for the house, and I knew the buyer would pay
$125,000; if I exercised an option or bought the property for
my own account and then turned around and sold it to the buyer
I knew of, by virtue of my fiduciary position, for $125
thousand, it is not only unethical; it is illegal, and I would
go to jail.
How is that illustration different from what the specialist
may do when he trades for his own account, given that market
knowledge?
Mr. Donaldson. The specialist system, as practiced on the
New York Stock Exchange, has, in the structure and the rules, a
negative and a positive obligation, if you will.
Specialists have a positive obligation to make a market in
the stock and to provide liquidity when there is not a ready
buyer or seller for the other half of a trade----
Chairman Baker. And I think that is very valuable, and I
don't want to lose that in the mix but, often, there is not
concurrent disclosure and the time--if there is a liquidity
reason to act, that is a great thing.
And I could buy that house and sell that house as long as I
made concurrent simultaneous disclosure to both parties, and if
they both agreed it was okay for me to make the $25,000, fine.
But I couldn't do it without providing that notice.
Mr. Donaldson. Right. Well, the other part of the
specialist obligation is not only to the positive obligation to
step in and provide liquidity but also the negative obligations
to not step ahead of the customer account, and this is the very
essence of the auction system.
And I believe that there are issues associated with that
which have to do with what I referred to before, which is the
advent of technology and the ECNs, which are able to transact
instantaneously.
And, I might add that, in many of the ECNs, they are not
that instantaneous unless there happens to be a matching order
on their books. I mean, an order can sit there for minutes or
hours.
That does not happen on the New York Stock Exchange because
of the liquidity provided by the specialist.
Chairman Baker. Understood, and there is value to the
system. I just think there are some areas of concern that,
perhaps, need to be thoughtfully examined by the commission----
Mr. Donaldson. Absolutely. That is exactly what we are
doing----
Chairman Baker. If the trade-through rule, recommendations,
analysis of the specialists concerns or modifications of rules
governing practice, all of this, as you indicate, is part of a
larger market structure recommendation.
Would that go to the point of the regulatory model of the
New York Exchange? Is that viewed as being essential in this
package of recommendations that might be later forwarded?
And I make that observation in light of this thought: what
if someone were to come to the Congress and say, ``The SEC
ought to own a securities firm or the Federal Reserve ought to
own a large national bank?''
You probably wouldn't get many co-sponsors, and the hearing
date would probably be a long time in the future.
But, at the same time, we have the CEO of the for-profit
enterprise often as the Chairman of the regulatory body,
investment bank analyst--you know the litany of subjects we
have dealt with in the Committee over past years has always
generally resulted in very clear-cut separations of authorities
between regulation and for-profit decisions.
Do you have a view today as to the appropriateness of
maintenance of the current structure or should we really be
thinking through perhaps a more radical modification?
And what will the SEC actions likely--will that be a
consideration in the package of issues that the SEC is now
considering?
Mr. Donaldson. Critical consideration; bottom line.
Clearly, the responsibility of an SRO for running a
marketplace, as well as the responsibility for the regulation
of that marketplace, brings into the forefront a potential
conflict of interest.
And we are concerned about that conflict of interest.
There are a number of different ways of addressing that,
ranging all the way from a total separation of the regulatory
function to a partial separation to an internal structure that
separates the reporting function and financing of the
regulation inside an SRO.
I think this is what John Reed, the Acting Chairman of the
New York Stock Exchange, is wrestling with right now, in terms
of coming up with a corporate governance structure that
addresses those issues.
But I think the point you are making is right on, which is,
we must pay attention to the independence of the regulatory
function.
And we must pay attention to the financing of the
regulatory function, the adequacy of its financing. And we must
separate, either by the way it is organized internally or
totally externally, we must separate that potential conflict.
Chairman Baker. Mr. Chairman, we are down to about three
minutes on the vote. We are going to have to excuse ourselves.
Just one final, sort of, comment from my perspective.
Your observation was that we don't expect a recommendation
or a package from the SEC within days or weeks; we don't expect
it to take years; we are kind of in the months range.
So this might well be something pursuant to the Exchange
action early next year, early spring; we might have some
recommendations that would give us a global picture of where
you think we should go.
Mr. Donaldson. Right. I think the first indication of an
approach and whether it is an acceptable approach will be the
governance structure proposed by the New York Stock Exchange.
Chairman Baker. We are in recess. Thank you.
[Recess.]
Chairman Baker. I would like to reconvene our meeting.
Mr. Chairman, I just have one more, sort of, follow up from
our earlier line of questions, not on the principle subject of
the hearing today, but on the related matter of mutual fund
governance.
I read, with interest, some comments by Mr. Spitzer in the
morning news about his perspective of SEC actions in relation
to his findings, which were troubling to me, a bit.
But, more importantly, in our last hearing in which you
appeared, I had expressed interest in having Agency comment
with regard to H.R. 2420, which is still pending, on any
modifications or improvements that might be considered to that
act, with regard to mutual fund governance.
And in light of the developments reported in the media by
actions of the Attorneys General, your own agency, I just renew
that request in light of current market circumstances if the
Agency could review and forward any comment that might be
appropriate.
Certainly, we don't expect immediate action on H.R. 2420,
but it is within that weeks range; not days, but not years,
kind of, category.
And whenever you could get us something, it would be very
helpful.
Mr. Donaldson. We would be glad to do that.
Chairman Baker. Thank you, Mr. Chairman.
Mr. Kanjorski?
Mr. Kanjorski. Thank you, Mr. Chairman. Welcome back, Mr.
Chairman. We look forward to having you here, particularly in
these trying times.
I think one of the things I am trying to organize, in my
mind, is recognizing some of the threats of investor confidence
that exists as a result of the continuum of things that have
happened over the last year, year and a half.
Is there any method or methodology that should be employed
by the regulator, by the Commission, to get all of this out on
the table, once and for all, instead of the slow bleeds and the
information coming forth, whether it is the mutual fund
industry, or whether it was the governance at the New York
Stock Exchange, or whether it was the inappropriate activities
of some of the huge corporations?
Can't we find some method to bring this to an end?
And, in light of that, what I am thinking of is, in the
past, the Chairman of the SEC has always said he really doesn't
need a larger budget. We tried to give him one a couple of
years ago, and there was always some hesitation of taking it.
Do you think you are sufficiently staffed now?
And the one reason that brings that to my mind--and I know
we will have another hearing on this subject--but I am really
disappointed with the whistleblower that brought, apparently,
timing evidence in the mutual fund industry to the Enforcement
Office of the Commission back in March and had an attorney
follow up on a monthly-weekly basis.
And it wasn't until the State Attorney Generals took action
that anything happened.
On the face of that, it certainly makes it appear that
perhaps the federal regulator is not ahead of the game. I know
the pressures that the Commission has been under and the wide
range of activity they have to do.
But while you are reviewing all these governance issues and
other issues involved in the exchanges, are you going to also
look at your enforcement regulation budget and what you need so
that we can make sure that we can, once and for all, say to the
American people that this is the bottom line and draw our two
lines and close this out?
Or, other than that, we are just going to go on and on,
internally bleeding and, every time we seem to have an uptake
in the market or in the economy, we get hit with another
investor confidence question.
Mr. Donaldson. Let me confine my remarks, I think, to the
central thrust of your question which is the issues with the
mutual fund industry right now.
You are talking about other issues, too, that are on our
docket but, most recently, the issues that have come to the
fore on market timing and late trading, and so forth.
I could give you a number of answers but first and
foremost, there is no doubt about the fact that we can improve
our methodology.
We have a huge universe of funds, some 5,000 mutual funds
with over 8,000 portfolios of securities, and over 7,000
advisers in which we are expected to conduct inspections.
We have to have a set of priorities, if you will, in terms
of what we are looking for, and I believe that the issue of
risk assessment, if you will, is one that we are addressing
right now, in the Commission, in terms of how we determine
exactly what we are looking for. And I think that can be
improved, and we are working toward that end.
We are working toward a better synergy, if you will,
between our divisions of investment management, our divisions
of inspections and so forth.
But we do have new troops coming in: a substantial increase
from, I think, 350 people in our inspection group to almost
increasing that by 50 percent so we will have more bodies.
But the real issue is how we determine where the risks are,
and we, I think, probably have not had the issues of market
timing as high in our priority as we should have.
We are taking steps now, I might add, to do something about
that and do something about it quickly.
The other thing is that, in the case of some of these
issues that have come to the fore, you had, basically, an
alleged collusion between two entities; the Canary Hedge Fund
and the mutual fund that they were doing business with.
And unless you have a direct tip, unless you have a direct
insight, it is very hard to find collusion, particularly in the
case of Canary when we didn't have the authority to go in and
examine them.
Mr. Kanjorski. If that is the case, I can understand that
being the case, then part of this argument on a totally
electronic market raises a lot of questions in terms of how are
we going to pick these transactions up.
Those of us that aren't informed on the technology assume
that, with computers today, everything is seen. And when there
is improper activity it would set off some sort of a tilt so
that regulators would look at it.
And you have layers of regulation, as you pointed out. The
SRO is the first responsible party to know what is going on but
then you, over them, have some idea.
Now, this last weekend--and Monday I was in Chicago looking
at the markets and trying to understand what they are doing--
and they brought me aware of the fact of what internalization
may or may not do, and some of the advantages of it, and some
of the deference of it.
But one of the things that we talked about with quite
seriousness, that you referred to in your testimony, is this
idea of the penny market and how that can interfere with
another market that deals in more than pennies and 10 cents, as
the Chicago markets do.
And how that delays a transaction until someone filters
through that 10-cent spread.
And that goes to the question of that unique characteristic
on the New York Stock Exchange of the specialist. They drive
and create that market and it doesn't get as delayed.
But I was most impressed about a meeting I recently had
with John Reed, in terms of what the specialists did during the
1987 crash and that, without their existence there--and if we
had a totally electronic market--we potentially would have no
buyers when the market was falling as rapidly as it was.
Could you tell us whether or not their--because we hear of
all the negatives, everything from extraordinary income, which
all of us know is impossibly true, or General Electric; own all
the specialist positions on the market--a lot of misinformation
is out there but it is having an effect on people because it is
misinformation. But a lot of us aren't sufficiently
knowledgeable about these exchanges and how they work.
What is your impression, really, of whether, one: we have a
problem in the specialist field in the New York Stock Exchange
particularly?
And, two: do they, in your estimation, fulfill a necessary
function?
Mr. Donaldson. Clearly, I think that you have to draw a
distinction between the rules and regulations under which the
specialists operate. And the enforcement of those rules and
regulations, which I believe is a separate issue from the
function of the specialist system itself.
I think John Reed was absolutely correct when he referred
to the effectiveness of the auction market system as, ``A
deliverer of liquidity in times of stress.''
And I think we have seen that time and time again over the
course of my business career, where in turbulent markets the
liquidity pool is developed on the floor of the New York Stock
Exchange.
It is a tremendously valuable national asset.
Now, the game has changed a bit, as you correctly say, with
the advent of penny spreads and decimalization and, the fact
that, although you have narrower spreads, you have less of the
true size of the market displayed.
In other words, there is a bid and an ask that are
separated by a penny, but that doesn't really disclose what the
real depth of the market is behind that bid and offer. And I
think that has been to the detriment of informed trading.
The trick here, as far as I am concerned personally, and I
believe as far as the Commission is concerned, is to get an
interface between this rapid trading and possible price
improvement. In an environment where you only have a penny
spread, a case can be made by some, that they, the customer,
the client, the broker, doesn't want to wait for a penny
improvement. They want to get a trade done; they are interested
in speed.
But I don't think you can apply that across the board to
the fundamental concept of price improvement and the customer
getting the best price that he or she can possibly get.
And I think we tread on thin ice when we suggest that we
are not going to get the best price for somebody. And I think
that is the beauty of our market.
Chairman Baker. Thank you, Mr. Kanjorski.
Chairman Oxley?
Mr. Oxley. Thank you, Mr. Chairman.
Chairman Donaldson, I ought to call your attention to the
lead editorial in today's Wall Street Journal, and it tracks
very closely, the views that I expressed earlier in my opening
remarks.
And we operate on a separate track; I don't write the
editorials for the Wall Street Journal, nor do they write my
opening statements.
But I want to quote from that editorial.
``We hope he, that John Reed and especially folks in
Washington, don't ignore the largest public policy issue at
stake: the rules and regulations governing the national market
for stock trading. Specifically, the monopoly created for the
New York Stock Exchange by the Intermarket Trading System.''
``The heart of this system is a prohibition mandated by the
Securities and Exchange Commission against trade-throughs. In
theory, this sounds like good market organization and practice;
it allows the New York Stock Exchange an artificial market
advantage.''
Do you disagree or agree with those sentiments? And how
does the Commission intend to address those thorny issues?
Mr. Donaldson. I think, in the testimony upcoming, you are
going to see the disagreement that exists out there.
If I have correctly read some of this testimony that you
are about to get, you have people arguing violently on the side
of what that editorial said; that there ought to be a total
elimination. There are equally strong arguments on the other
side.
I believe the answer is probably somewhere in between, as
it always is in many disputes where there are extremes.
I think we have to be very cognizant of the tradition of
the central market structure that says the customer, the
client, the small investor, the large investor ought to be able
to get at the best price.
And when you get into defining execution as something other
than best price, such as speed, or a number of other criteria,
you get a little bit on slippery ice. This isn't to say that
there aren't certain customers that would sacrifice price
improvement for speed. We have to come up with a system whereby
in a unified market, we can satisfy both kinds of customers.
And that is our challenge.
Mr. Oxley. Has the SEC looked at the--I guess, for want of
a better term--the European model? Virtually all of the bourses
in Europe have gone to all-electronic trading.
Is there any evidence over there that there is a lack of
liquidity or failure of folks to make a market? It appears that
they have totally abandoned the auction system there. Does that
give the SEC any guidance one way or the other?
Mr. Donaldson. I don't want to comment generally on the
quality of pan-European markets, except to say that I think I
could make the generality that our markets are still the envy
of the free world; that there is no market system that operates
as efficiently and effectively in the interest of individual
customers, as well as institutions, as the U.S. markets do.
Now, that is the basic premise from which we start, which
is, we are still the best. And I think all evidence indicates
that. Can we improve it? Can we adjust the technology? Yes. I
believe we can, and that is what we are working on right now.
The system--if you want to go into the history of the
formation of the auction market system long before technology
was designed to create a market that, as much as possible,
eliminated dealer interface and allowed natural customers to
meet each either directly with no intermediary. And that system
was developed over a number of years and has worked pretty
well.
However, if you are starting up new systems, which are
characteristic of many of the European markets, they are
basically started by dealers who want to get a dealer spread
and want to interpose themselves in between natural buyers and
sellers.
Now, that is the fundamental clash, if you will, between
those systems and our systems. And now you add onto that the
new technology that has come in.
And, again, I would say that we do not want to lose the
benefits of the auction market of which the specialist is a
primary part, but we also do not want to deny the speed that is
available in some of our electronics markets.
So the trick is bringing them both together and having an
option for customers.
Mr. Oxley. But is there evidence, that you know of, that
there is a severe lack of liquidity in the European markets as
a result of having an all-electronic system of trading?
Mr. Donaldson. Well, I will give you one man's view, and
that is I think our markets are much deeper, much more liquid
and particularly so in times of stress.
It is easy to have functioning markets when you are in a
relatively calm period. It is a little more difficult to
assemble liquidity to offset imbalances when markets are
turbulent. And I think that is when the auction market really
works the best.
Mr. Oxley. If I may, just one more, Mr. Chairman.
In regard to SROs, do you think that there is an essential
function--I am not talking now about structure or design, but
just in a general sense--do you agree that there is a need for
SROs to exist?
Mr. Donaldson. Yes, I do.
Mr. Oxley. Okay.
Mr. Donaldson. I believe that the original decision that
was made back in the 1930s, to create an SRO structure, was a
very sound decision.
And that, fundamentally, was based on the idea that, if you
set up a government agency, such as the SEC, and gave it the
responsibility for totally regulating the markets, you would
create a bureaucracy, you would create a federal expense, and
you would create a lack of being in touch with the marketplace
that would impede our markets.
So, I think that the concept of a self-regulatory
organization, which gets the regulation down to people who are
familiar with the marketplace, is a very sound concept.
It also gets the expense of regulation down where it should
be, on our participants in a marketplace.
Then, the question is, ``Can you structure that self-
regulation so it is totally unbiased?'' So that it is
uninfluenced by the responsibility for running a market as a
business. And, that is the trick.
How do you get that self-regulation independent so that it
is not being influenced in any way by those who are trying to
build the marketplace?
Mr. Oxley. Do you think the NASD model fits that
description?
Mr. Donaldson. I think the NASD model is an interesting
model.
I think that it still has the need to regulate the NASDAQ
market, itself. It is being done by NASDR, I think is one
approach. I think there are other approaches.
Mr. Oxley. Thank you. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Chairman.
Mr. Emanuel?
Mr. Emanuel. Thank you, Mr. Chairman.
I was intrigued by what you said earlier to the Chairman. I
think the way you said it is that the SEC was caught a bit
flat-footed by the market timing and late-trading scandal. And
this is part question as well as part statement--my hope here
is that the mutual fund industry investigation doesn't become a
turf battle between the New York Attorney General and the SEC.
Although the Attorney General has been leading the effort,
I would like to see a coordinated strategy without any dispute
over ``real estate.''
Because given how many Americans are invested in mutual
funds, the integrity of that industry and its managers is
essential. As much as we discuss market regulation, with 96
million Americans investing in mutual funds, it is essential
that that investigation be done without any squabbling between
the States and the SEC.
With that said, how widespread do you think this market
timing issue is in the mutual fund industry and among its
managers?
Mr. Donaldson. Let me address the first part of your
observation there.
Mr. Emanuel. Sure.
Mr. Donaldson. Which is this should not be a competitive
situation between regulators.
Mr. Emanuel. Good.
Mr. Donaldson. This should not be a competitive situation
between the federal regulators or any of the State regulators.
We have worked with the State regulators for years.
We have recently formed a joint committee between the State
regulators and ourselves to try and iron out cooperative
attitudes; how we can help each other; how we can improve that
cooperation.
I think that the spectacle of one regulatory agency
criticizing another is not healthy. We look to cooperate, the
New York Attorney General, we have tried to cooperate with him,
we are cooperating with him right now on a number of issues.
We have a much broader responsibility, a much larger staff.
The whole investigative thing is going on now as we enable it
not to be a rifle shot but to be a broad-gauged investigation.
To answer the second part of your question, we believe, as
a result of a net that we have cast, that the market timing and
late-trading issues are quite widespread.
We are still gathering data on this. But we think it is
more widespread than we originally anticipated.
Mr. Emanuel. Mr. Chairman, we have worked on an agreement
that we are going to be holding hearings on the mutual fund
industry in the not-too-distant future. Correct?
Chairman Baker. That is our intention.
Mr. Emanuel. Okay.
To me, what is critical here is the integrity of the
financial markets in the United States, and the trust investors
have in the markets. I feel strongly that these scandals have
become for mutual funds what Enron, Tyco, and WorldCom were to
corporate America.
And I think we are all vested in making sure that
everybody's level of confidence is restored to the highest
level, as quickly as possible.
So, I applaud you for creating this joint task force.
Please let this Committee know if there is anything we can do
to help you on the funding level, because I think what is
happening, as evidenced by today's news about the Strong funds,
is an unparalleled threat to the public's confidence in this
sector of the financial markets.
Thank you for you leadership on these issues. I look
forward to continuing to work with you on meaningful reform.
Mr. Donaldson. Thank you.
Mr. Emanuel. No further questions.
Chairman Baker. Thank you, Mr. Emanuel.
Mr. Bachus?
Mr. Bachus. Thank you. Does someone need to put something
in the record?
Chairman Baker, I understand.
Chairman Baker. Thank you, Mr. Bachus. I didn't realize Mr.
Fossella wanted to put a statement in the record.
Mr. Fossella. Yes, Mr. Chairman, I have been asked by the
Organization of Independent Floor Brokers to have their
statement submitted for the record.
Chairman Baker. Without objection. Thank you, Sir.
[The following information can be found on page 196 in the
appendix.]
Mr. Bachus?
Mr. Bachus. Thank you, Mr. Chairman. Chairman Donaldson,
Chairman Oxley asked you about the trade-through rule and you
indicated that there is consideration for reforming that rule.
Is that correct?
Mr. Donaldson. Yes.
Mr. Bachus. That would go from anything from abolishing the
rule to maybe establishing the same practices we have for the
queues and the spiders today, is that correct?
Mr. Donaldson. Yes. Let me just make a couple of comments
on the trade-through rule.
The trade-through rule was designed to force executions to
be done at the best available bid or ask. And it was a rule
that was put in to make sure that, no matter where listed
stocks were traded, the customer would be afforded the
opportunity of the best bid or the best offer.
What has changed the scene now is two things.
The first is the speed of electronics with some of the ECN
markets, and the second is decimalization.
The speed is so fast that it is hard to monitor the trade-
through rules, and you have trade-throughs going on where, in
the name of speed, the customer may be getting a worse price.
It may well be that because the worst price is only a
penny, as opposed to an eighth, or a quarter, or a half, that
some class of customers say that, ``I don't care. I would
rather have the speed.''
But to design a market that just throws out the ability to
match at the best bid or offer is quite a move.
So as we look at this rule and try to contend with it, in
terms of the modern clash that we are having, I think we have
to be very careful what we do with that rule. And that is just
what we are looking at right now.
Mr. Bachus. Thank you.
Do you know when you will maybe disclose the results of, at
least, your preliminary findings?
Mr. Donaldson. The timing of this and several other market
structure issues, as I intimated earlier, is----
Mr. Bachus. Months; not days.
Mr. Donaldson.----in months now, not days or weeks. And not
years.
Mr. Bachus. Thank you.
Earlier, in response to a question from the other side, you
mentioned the orderly markets and the fact that one thing
specialists do is they stabilize the market and supply
liquidity.
There was an article in the Wall Street Journal yesterday
that actually said--I am sure you probably read it--that
actually said that, ``The NYSE apparently does not have any
data demonstrating that their specialists actually step in and
provide capital to stabilize the trading on a particular
security during times of market stress.'' That was the Wall
Street Journal, yesterday.
Do you know if those press reports are accurate? I have
also heard that Mr. Reed had requested that information and it
wasn't available.
Mr. Donaldson. I don't know that study. Did you?
Ms. Nazareth. Yes. I take it they know how much they bought
or sold in times of stress, but they are having difficulty
retracing how much capital they committed at the time.
Mr. Bachus. When they determine that, will they determine
their profits? Are you seeking that information? Is that an
area that you are inquiring or examining?
Mr. Donaldson. Yes. Sure. Yes.
Ms. Nazareth. Yes.
Mr. Donaldson. Yes.
Mr. Bachus. Do you know what the status of that inquiry is?
Mr. Donaldson. I don't want to give you a direct answer on
that because I don't know the exact status. It is under way.
I will come back to you with just how far we are into it.
Mr. Bachus. But you are also trying to gain that same
information?
Mr. Donaldson. Yes.
Mr. Bachus. Yes, Okay.
In Trader magazine--I guess it is a magazine--I want to
just read to you a quote.
They said that, ``The NYSE's recent release of SEC-mandated
order execution qualities statistics actually suggest that
investors don't get the best possible execution on the floor of
the NYSE, despite the NYSE's claims.''
And this is really of particular concern, ``The NYSE's
public claim is consistent with complaints by large NYSE
members that when such members have considered routing investor
order flow to alternative market centers away from the NYSE,
the NYSE regulatory arm has threatened the members with best
execution investigations.''
You have probably heard some of those allegations? And let
me put another question on top of that.
What disturbs me about that is that the regulatory arm of
the NYSE could be used to stifle competition, if that is true.
And I would just like your comment on that.
Chairman Baker. And that will have to be the gentleman's
last question. His time has expired, but please respond, Mr.
Chairman.
Mr. Donaldson. Let me just put newspaper articles and
studies in context. What we are dealing with here is a
competitive situation.
As a former academic myself, there are studies, and there
are studies, and there are studies that are sponsored by
groups--I am not referring to any particular study----
Mr. Bachus. Absolutely.
Mr. Donaldson.----but I think that you have a right to
believe that the studies being done by the SEC are non-biased,
straight down the middle, with one purpose in mind: the
effective structure of the marketplace.
And I think it is very hard for people to separate out the
competitive markets that are out there today and the prejudices
associated with that, including, but not limited to, the New
York Stock Exchange, the American Stock Exchange, the ECNs, et
cetera.
They are trying to promote a marketplace. And so, I take
some of these studies with a grain of salt.
Mr. Bachus. I guess I would just say, would you agree that
if they were using the regulatory arm to stifle competition
that would be improper?
Mr. Donaldson. Well, I think that this gets to the issue of
where the locus of the regulation is, and I am sure that there
are accusations on all sides about the regulation being biased
or not being biased, or being used for other purposes.
I think the solution to that is to have the regulation
independent of those that are trying to build the market itself
and to have it be a truly independent entity.
And that goes to, as I said before, a number of different
ways of doing it: internally structured or externally and
totally separated, or a mixed mode, such as NASDAQ has.
Mr. Bachus. I thank you.
Chairman Baker. Gentleman's time is expired.
Mr. Hinojosa?
Mr. Hinojosa. Thank you, Chairman Baker and Ranking Member
Kanjorski.
I want to thank you for holding this second hearing on
market structure. I recall that the first hearing on this
series was on governance issues at the New York Stock Exchange,
including the potential conflicts of interest created by
regulators.
This leads me to my question. Chairman Donaldson, what role
can the public equity markets, specifically, real estate
investment trust equity funds, play in providing capital to
invest in affordable multi-family and home ownership efforts?
For example, can the public equity markets play a role in
providing capital the same way Citigroup and Fannie Mae
announced yesterday that $100 billion of financing through the
end of the decade to help lower-income families obtain
mortgages to buy homes?
Is that something you would support?
Mr. Donaldson. My answer to your statement or question is
that the equity markets, in this country in particular, are
highly liquid. And they are highly transparent. And, because of
the liquidity and the transparency, they give people an
opportunity to set the cost of capital, if you will, by the
multiples of earnings, or whatever, that stocks sell at.
So it is a great capital-generating machine. The equity
ownership has, inherent in it, the raising of new equity and
the raising of new capital.
As far as what vehicles are better for distributing it to
one industry: housing or whatever, we could sit here and talk
about that for a long time.
Mr. Hinojosa. Well, that answer is a little bit unclear.
It seems to me that you and I and many in this room,
understand that the housing industry is the one that is helping
keep unemployment rates down to the point that they are.
Otherwise, it would probably be one or two points higher.
So it seems to me that there needs to be a boost in terms
of monies available, particularly for working families who want
an opportunity to have their first home.
Are you saying that you don't favor one industry over
another?
Mr. Donaldson. No.
There are many mortgage security mutual funds to begin
with, but I think the political issue of how money is directed
to different parts of the economy is not really my function or
the SEC's.
I may have personal views on it, but I think it really is
not in our mission.
Mr. Hinojosa. Okay.
Chairman Baker, I look forward to learning more about our
capital markets from today's and, hopefully, future witnesses.
I also look forward to working with you and with Ranking
Member Kanjorski should this Subcommittee conclude that it
needs to formulate legislation to change corporate governance,
or possibly encourage the exchanges to adopt certain best
practices.
With that I yield back.
Chairman Baker. I thank the gentleman for his good
statement.
Ms. Biggert?
Mrs. Biggert. Thank you, Mr. Chairman.
Just to follow up on Mr. Bachus's question for a moment.
You were saying that you are moving expeditiously on the market
structure issues and that would be within months.
Do you have a list of how you are going to proceed and what
issues will the Commission tackle first?
Mr. Donaldson. Yes. There are a number of issues that are
on our agenda.
Obviously, the issues we have been discussing this morning:
trade-throughs; trade-through rules and other rules; access;
market access; the openness or lack, thereof, of access. And we
have a number of concerns about the way the market data tape
revenues are determined and distributed. Those are a few of the
categories that are on our agenda right now.
Clearly, governance is a part of that and regulation.
Mrs. Biggert. One of the issues that I am particularly
interested in is internalization.
And it just seems like, with all of the recent conflict of
interest scandals, that little has been said about the
internalization which, obviously, involves the brokerage firms
trading against their own customers' orders.
And I have concerns that this practice in the listed
options markets may soon be systematic and taken to a new level
if the SEC approves the pending proposal from the Boston Stock
Exchange, called BOX.
Could you comment on the timeframe for completing that
proposal? And could you also comment on what the SEC is
currently doing to study the beneficial, or the adverse,
effects of internalization?
Mr. Donaldson. As you intimate, the proposed BOX system was
proposed to the SEC. We had a number of questions about various
aspects of that proposal.
We received answers from not only the BOX promoters but
also answers from the public. We are in the process now.
I think our cut-off date was less than a month ago?
Ms. Nazareth. Yes.
Mr. Donaldson. Yes, less than a month ago.
And so we are now examining the comments. Clearly the
internalization aspect of that proposed system is one that
concerns us, as does internalization generally, not just in the
option markets, but the potential for internalization in the
equity markets.
Again, the negative potential of capturing buy and sell
interests inside an entity--as opposed to exposing them to buy
and sell interests across the country, and the world for that
matter.
Mrs. Biggert. Would the impact of the one-cent trading have
any effect on that issue as well? On the BOX?
Mr. Donaldson. I am sorry, I didn't hear that.
Mrs. Biggert. Would the one-cent trading have any effect in
the listed options industry?
Mr. Donaldson. Well, as you know, options are traded at
nickel increments and that spread has a lot to do with the
dangers of internalization. Yes.
Mrs. Biggert. Okay.
Thank you. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Ms. Biggert.
Mr. Scott?
Mr. Scott. Thank you very much, Chairman Baker.
Chairman Donaldson, I would like to ask you a couple of
questions about the National Security Clearing Corporation.
There is a proposed rule change.
This rule change will allow the National Security Clearing
Corporation to enter into services that are already being given
and serviced very effectively and efficiently by the private
sector.
It would, basically, if you are not familiar with it, it
would create a new service for the NSCC that would provide its
current members with other data services, only for members,
would specifically propose to provide a service for its members
that would enable the NSCC to provide a messaging hub for the
communication of information among sponsors of Separately
Managed Accounts, or SMAs, and the investment managers
participating in this program.
If that rule goes into effect, it would historically change
the basic statutory purpose of the NCA.
And it seems to me that given the current level of private
competition present in a marketplace, it could very well be a
violation of the NSCC's mandate and would be inappropriate from
a policy perspective, for any SOR, including NSCC, to become an
active participant in an existing competitive market.
So it seems, to me, Mr. Chairman, as a matter of policy,
that the fundamental role of self-regulatory organizations, or
SROs, subject to SEC supervision, should be to facilitate the
efficient operation of the markets, as an extension, if you
will, of the Commission itself.
I am very concerned, though, that the National Securities
Clearing Corporation, long an essential link in the securities
payment process, may be trying to meddle in the kind of
function that has been exclusively reserved for the private
sector alone.
What do you know specifically about this rule change that
the NSCC is in the process of proposing to the SEC?
And what assurances can you give to this Committee, and the
nation, and to the private sector, that SROs, because of their
inherent competitive advantages that accompany their status as
quasi-government entities, ought not to be in the business of
competing in the private sector with established businesses?
Mr. Donaldson. Congressman, I will begin by saying that I
am not familiar with the issues that you have just brought up.
I just checked with Ms. Nazareth, who, likewise, is not
familiar with the particular issues you have brought up.
But I would like to come back to you with answers to your
statement and will do so.
Mr. Scott. That is very good. Thank you, Sir. And I will
look forward to getting that information.
There are a lot of companies who are involved in this area
that are very much impacted and would like to get some answers
to that. So I look to get that from you.
Thank you.
Chairman Baker. Thank you, Mr. Scott.
Mr. Chairman, I don't know if you have previously announced
time constraints, but we have several members who are still
indicating an interest in asking questions, and we would return
right after a brief break with Ms. Kelly on our side.
And there are several other members on the Democrat side
who would like to have the ability to ask questions.
We have two votes, we think. One for sure that is down now
to about six, seven minutes, and possibly a procedural motion
would keep us over there another 10, 15 minutes, and we would
be right back.
Mr. Donaldson. That is fine.
Chairman Baker. If that doesn't present a problem, then we
will stand in recess for about another 15 minutes.
Thank you, Sir.
[Recess.]
Chairman Baker. I would like to reconvene our meeting of
the Capital Market Subcommittee.
And at this time, I would recognize Ms. Kelly for her
questions.
Mrs. Kelly. Thank you very much, Mr. Chairman.
Mr. Donaldson, my neighbor, I am delighted to have you here
today. Thank you very much for coming and for your patience and
answering our questions.
A couple of things that I was interested in: one of the
things we have been talking about--I, also, don't know if
anybody has noted the fact that we are pretty close to October
29th, Black Tuesday, and this is the 75th anniversary of the
market, so I am glad you are here and we have a strong market
and I hope it stays that way, but--you were talking about the
buyer of last resort.
And I would like your thoughts on the practice of the buyer
of last resort has played in providing liquidity and in
preventing disturbances and how the market structure reforms
might have an impact on that principle.
Mr. Donaldson. Well, I think if I understand your question,
I did make comments earlier about the liquidity that is
available in the concept of the auction market and the
``crowd'' and so forth; liquidity that seems to appear at times
of stress.
There is a mechanism there for drawing out that liquidity
and putting it together; that I think has served the country
well.
Mrs. Kelly. I am sorry, sir, I wasn't able to be here
earlier, I had to go out to the Pentagon, so I didn't hear that
at that prior discussion. But thank you for answering that
question. I am sorry it was redundant.
Have you also discussed naked short-selling?
Mr. Donaldson. I am sorry, did we----
Ms. Nazareth. No. Naked short-selling, we did not discuss
that.
Mr. Donaldson. No, we did not discuss naked short-selling.
Mrs. Kelly. I would be very interested in what you plan to
do in that area.
Mr. Donaldson. Yes.
We have just put out a new proposed rule that deals with
naked short-selling. It deals with short-selling, in general,
but as a part of that, naked short-selling.
And, in the proposed rule, we have proposed that there be
new restrictions on naked short-selling.
I will give you, in general terms, the concept. It would be
the obligation of the short seller's agent to identify where
the certificates were for the short sale.
In other words, it would not prohibit short-selling, but it
would severely restrict the short-selling where the short
seller can't deliver the certificates. And there are certain
leverage advantages to doing that, but it is something we think
should be eliminated.
Mrs. Kelly. And you have a plan to do that is that what I
understand?
Mr. Donaldson. Yes we have. We have put out a rule on that.
Mrs. Kelly. Good. Thank you very much for doing that.
Mr. Donaldson. Right.
Mrs. Kelly. I think that will help market stability and
trust for the public.
I am going to ask one other question and that is when the
market went to decimalization it went to a penny on the spread.
I am wondering if we have the opportunity now to take a
look, if we are going to standardize, across the board, a
certain number of things, whether or not it would behoove us to
maybe not take action, but at least evaluate the effect on that
regarding the depth of the market.
And whether or not it might be prudent for us to move to a
five-cent, rather than a penny spread. I will give you some
leeway to answer that, but I would like to hear.
Mr. Donaldson. Yes. Well, I think there has been a lot of
examination of just exactly what the effect of the
decimalization has been.
Clearly, part of what you imply is true, in my view, which
is that the liquidity or the displayed liquidity is hidden, if
you will. There can be a penny spread, but that can be for a
hundred shares.
And you really don't know what liquidity is there,I think
that is a disadvantage.
In terms of the monies either saved or not saved by the
reduction--going to decimalization and all the way down to
penny spreads--I think that is a debatable item.
There are studies that have been done that say this has
been to the advantage of the individual investor and to the
disadvantage of institutional investors.
Again, I think that the more light we can shed on just
exactly what the implications of decimalization have been, the
better.
In terms of increasing the spread, I think it is probably
premature to do that unless and until we have evidence that
negative aspects of penny spreads are hurting the liquidity in
a marketplace.
Mrs. Kelly. Are you examining that? Is anyone tasked with
an examination of what that effect was on the market and
continues to be?
Mr. Donaldson. Yes.
A lot of it is hard to identify in the sense that you have,
with the reduced spread, reduced profitability.
It is quite possible that we have had a reduced liquidity
in lesser-traded stocks that market-makers are less inclined to
commit their capital with less of a profit margin available to
them.
There are other issues on the other end of the scale: the
sub-penny spread issue, which is, ``How far does this go? Do we
now get down into not just pennies, but fractions of pennies?''
You didn't ask me that question, but I will give an answer
to it. I think it would be counter to the public interest to
get into sub-penny spreads, and that is one of the things we
have to address in our market study.
Mrs. Kelly. Would you also be including commodities markets
in that?
Mr. Donaldson. Right.
Mrs. Kelly. In that study?
Mr. Donaldson. Yes. Right.
Mrs. Kelly. Thank you very much. I yield back.
Chairman Baker. I thank the gentle lady.
Mr. Inslee?
Mr. Inslee. Thank you, Mr. Chair.
Two questions. I have a quote, Mr. Chair, I believe is
yours.
You said, at one point, to the Senate Banking Committee,
you said, ``Like payment for order flow, internalization can
discourage markets from competing on the basis of price and
pose a conflict of interest for broker dealers,'' which, I
think, evinces a concern that many of us have.
But, we are told that you are actively considering this
proposal by the BOX, which would, in its essence, increase, as
I understand it, the practice of internalization from a
structural standpoint.
Given your apparent concern about internalization, why are
you actively considering this? And in what circumstances would
you consider approval to try to reduce or eliminate those
concerns about internalization?
Mr. Donaldson. Well, we, as I said, we have the BOX
proposal. We put it out for comment. We got a lot of comments
back.
The most negative comments had to do with the
internalization aspect of the BOX procedure. We have asked
additional questions based on the earlier responses. We now
have this new wave of responses back, and we are looking at the
situation.
We are concerned about internalization, and we are
concerned about the spread of internalization, not just from
that market, if it were allowed to exist, but the spreading
into other markets.
Mr. Inslee. Well, just by way of editorial comment, on our
main street on the hustings of the small towns we represent,
credibility really is an issue and we hope that you will focus
on that and give this very exquisite care.
Second question. I have spoken recently to some leading
managers of leading hedge funds and they have expressed real
frustration at timeliness of execution of their orders.
Sometimes they believe that the exchanges have ignored
orders, sometimes they have cited inefficiencies. And so I,
kind of, have two questions.
Is it time for some changes to the pass-through rule?
And secondly, why has the SEC not responded to, what I
understand--I haven't seen the paper on this, but I have been
told--there are hundreds of complaints regarding unfulfilled
orders, particularly with Amex?
If that is not correct, perhaps you can tell me. And if so,
tell us how we get those complaints responded to.
Mr. Donaldson. Yes.
Well, again, this gets to the heart of the analysis that we
are doing now, in terms of the viability of that rule and the
negative aspects of the rule given the trade-throughs that are
occurring.
Also, the positive aspects of that rule that ensure that
the best price is available no matter what the market is; and I
think you are right at the heart of the debate, if you will,
and we are aware of some orders that don't get executed.
We are also aware of orders that, because of the system,
have gotten the best price that they otherwise probably might
not have gotten.
So, we have to work at that interface and figure out how it
should be adopted, given the circumstances we are in right now.
Mr. Inslee. How can such a basic situation not get
remedied?
Just getting an order executed, if there are hundreds of
these, how can the SEC not solve problem in a timely fashion?
It is an honest question, because what I am told is that
there are hundreds of these without a resolution of this. Maybe
you could help me understand why that can't get resolved,
number one.
And number two: why don't you attempt to resolve these
complaints and get to the heart of what has happened here
before you go forward on the BOX situation?
Mr. Donaldson. Again, I think you have to put the whole
situation within the context of our overall marketplace and how
it is functioning.
With all the hundreds that may not get executed, there are
millions that do get executed in the best interests of the
public.
I think it is not that we were not looking at this, it is
not that we were not paying attention to it; it is just that it
is a very tough question.
And we have got the best brains that we can assemble, not
just at the SEC, but elsewhere, in terms of trying to figure
out what is the right answer.
Mr. Inslee. Clearly, we are hoping now we do see aggressive
action. I come from Washington State where William O. Douglass
got the bowl rolling on the SEC and we would like to see that
tradition followed. And we hope that you move in that
direction.
Thank you, Mr. Chair.
Chairman Baker. Thank you, Mr. Inslee.
Mr. Crowley?
Mr. Crowley. Thank you, Mr. Chairman for the hearing today.
Thank you, Chairman, for coming before us and spending the
better part of the morning with us.
I would like to redirect the focus, just a bit, of the
hearing away from the issues like speed and intermediaries and
refocus back to the special interests of the investor.
I am not speaking of the professional investor, something I
think the New York Stock Exchange has done remarkably well and
demonstrated throughout its prestigious history of 211 years.
As you can tell, I am from New York City, and I am a little
jealous about the Exchange and concerned about the image that
has been portrayed of it most recently. What basically the
tenet behind the trade-through rule, as I understand it, was to
produce the best price.
Do you, Mr. Chairman, believe that that has been
successful, as far as the public interests are concerned? And,
has it worked? I would like to have your personal, maybe, your
opinion about this.
And additionally, in light of the emerging ECNs and the
speed, again, would you favor amending or discarding the trade-
through rules so that speed could take precedence over price?
And do you believe that such an action, again, would be in
the interest of the investing public?
Mr. Donaldson. As I said before, the trade-through rule is
one that we are looking at right now. What the trade-through
rule does do is to encourage the display of limit orders.
And the display of limit orders is what makes for depth in
the market. So that the trade-through rule also assures, or
helps to assure, that the best price is being received.
Now, when you get to the definition of some other
definition of best price, such as best execution, then you
bring into play a more complex attitude as to what is the best
execution.
And that kind of attitude might have with it somebody that
is willing to have a fast execution and sacrifice price. And
that is the issue we are talking about. That is the issue of
the goals and desires of different types of investors.
I would be very hesitant to sacrifice the opportunities to
getting the best price entirely in order to have fast
execution. But it is a trade-off. It is a compromise. And that
is what we are working towards.
Mr. Crowley. That is a fair answer. I appreciate that.
At the last market structure hearing we had, you mentioned
that the floor-based market, such as the NYSE, often enjoy
greater liquidity than non-floor-based markets. Could you
expand on that and just give some examples and cite some
examples of that?
Mr. Donaldson. Yes, I can expand on it colloquially, if I
may, in the sense that, if we were in a market where there are
large amounts of stock for sale, let's say, and there are not
enough bids around, I think the floor has a mechanism for
creating liquidity to offset the temporary imbalance between
sell pressure and buy pressure there.
And I think that that liquidity is, in many instances, the
liquidity that is created by human beings, if you will, whether
it be the specialists, their floor brokers or whatever, who
bring that liquidity in the marketplace to offset an imbalance.
And I think that creates a market that has less fluctuation
to it and that is in the interests of the investors. So I think
that that is really what I am talking about.
And, again, not to repeat myself, I think that the trick
here is to create a New York Stock Exchange, if you will, or a
marketplace, that is able to have the speed associated with,
let us say, an ECN, but yet has this liquidity aggregating
capability that the auction market has.
Mr. Crowley. You would also take by this sort of the
discussion that has gone on that the stock exchange has not
invested in technology, none by the huge--you are stating
that--but it is almost--and they have invested billions of
dollars in upgrading technology at the stock exchange.
Mr. Donaldson. There is a lot of rhetoric about technology,
and I think there have been--in the competitive juices flowing
out there--characterizations of an antiquated system with
people running around and no technology. And, of course, that
is not so.
Mr. Crowley. And it isn't that you all are very
competitive.
Mr. Donaldson. There is tremendous technology at the New
York Stock Exchange. And it happens to be blended with human
judgment. And I think that characterization of the stock
exchange is pretty unfair in this day and age.
Mr. Crowley. Thank you.
Chairman Baker. Gentleman's time has expired.
Mr. Meeks?
Mr. Meeks. Thank you, Mr. Chair. And being last and knowing
that I am in the way between letting the Chairman go about his
busy day, or keeping him here with us, I will be very brief, so
that we can get to the next panel.
I have, basically, two quick questions.
And like Mr. Crowley indicated, I am from New York and both
the New York Stock Exchange and NASDAQ are very important to me
and to the city, and I do believe the station.
But as we move on, the key to a lot of this is transparency
and credibility and to make sure that there is confidence from
the investors, et cetera.
And I know that the New York Stock Exchange is currently
investigating several specialists for getting in between trades
for their own profit.
My question basically is, ``Do you see this as just an
isolated incident, something that will be a rarity? Or
something that is occurring on a frequent basis?''
Mr. Donaldson. I think you bring up an important point. I
am being reminded that there is a pending investigation on this
issue that I will be directly involved in as a member of the
Commission.
But let me just say that I think there is a difference
between an attack on the specialist system as a system versus
the specialist system when some of their rules have been
violated.
In other words, if the allegations in the investigation are
true and there has been a breaking of the rules, that is one
thing. That goes to enforcement of the rules and perhaps it
goes to changing the rules.
But in terms of throwing out the whole system because the
rule has been broken, that is something that, I think, one has
to examine very, very carefully.
Mr. Meeks. In essence, throw the baby out with the bath
water.
My other question is that we know that recently John Reed
announced that he is reforming the Board of the Directors of
the New York Stock Exchange.
And he is reforming it so that no members will be on the
board of directors and securities industry's representatives
will be only on an advisory panel with no jurisdiction over
regulatory or compensation issues.
To what extent will you; will the SEC be weighing in at all
on the restructuring of the New York Stock Exchange board? What
role would you play in that, if any? Will you oversee it? Have
any comments in that regard?
Mr. Donaldson. Yes. The bottom line is that the SEC has to
approve the rules that will come from the reorganization of the
stock exchange. Net, net, that is what has to happen.
Now we have tried to be of what help we can be in helping
John Reed contend with, what are, I believe, necessary changes
in the governance system of the stock exchange, that is to
attempt to address this issue of separating out by virtue of
reporting mechanisms: the regulatory side of the house with the
market side of the house.
And I think that John Reed and his advisers are moving in a
direction that seems to make sense, I haven't seen the final
proposal yet, but the direction that they are moving in is to,
in essence, have a totally independent board without any
attachments or alliances or to listed companies or floor
members or floor brokers or seat holders and have the reporting
mechanism of the regulatory side of the house, plus some other
reporting mechanisms: compensation, director selection and so
forth, report into that entity.
And then to have an entity on the side that would have
representation from all the constituencies that would serve as
an advisory board to the independent board.
That is a general thrust of what is being proposed, I
believe. But we will have to see the details of that because
we, in the final analysis, have to approve the implementing
rules that will come from these suggestions.
Mr. Meeks. But will you be involved and how then will you,
Mr. Chairman? Will you be involved?
Are you going to just wait until you see what the proposal
is before you either approve or not approve it? Will there be
conversations in between, which I think that I am hearing is
taking place?
And you will be giving some guidance as to what you think
is acceptable or not acceptable, while they are trying to
develop the plan?
Mr. Donaldson. We are anxious to get involved, we are
anxious to be of what help we can be in looking at proposals
before they go out for votes.
And I think that has been the tradition of the SEC: to try
and anticipate objections, if you will, that we might have
before they are out to be objected to in a general publishing
of the rules. So that is the route that we hope we are on.
Mr. Meeks. Thank you, Mr. Chairman.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Meeks.
Mrs. Maloney?
Mrs. Maloney. Thank you, Mr. Chairman. It is always an
honor to welcome an outstanding New Yorker to the committee and
to congratulate you on your public service. It has been an
outstanding one throughout your life, and private service.
I would like to touch on a part of market structure that I
don't believe has been talked about in this hearing.
And that is the recently issued report from the SEC on the
hedge fund industry. And it was reported that they are now
roughly 6,000 to 7,000 of these unregulated investment tools
and some have suggested that there should be a register at the
SEC.
And I agree with the commentators that these funds do make
a positive contribution in greatly increasing the liquidity in
the markets.
But at the same time, I am concerned about the increasing
trend towards hedge funds which lower the financial resources
needed to get into the hedge funds and the movement into retail
of the hedge funds.
I want to know, do you support making hedge funds available
to retail investors?
Mr. Donaldson. As you may know, we have had the hedge fund
industry under review for over a year. We have done as much
research as we could accomplish.
We have had groups of hedge fund people brought together on
all sides of the issue: advisers, hedge fund managers and so
forth.
And as a result of all of that, the staff has presented the
commission with a report and with a series of recommendations,
perhaps the most prominent of which is that we register the
advisers to these funds under the Investment Advisers Act.
And I think that that recommendation is based on several
considerations.
Number one is, what you say, which is that there are
upwards of 6,000 to 7,000 of these funds out there right now.
They account for somewhere around $600 billion to $700 billion;
they are growing like a weed.
And we have no right in most of these funds to go in and
find out what is going on. Why do we want to go in and find out
what is going on?
Two reasons: one is we want to understand the accounting
that is being used, we want to understand the pricing that is
being used. We don't want to interfere with investment
techniques or disclose those to other people; proprietary
techniques, but we need to have the right to go in.
Perhaps more important than that, in my view, is we need to
understand what impact these funds are having on the
marketplace itself.
It has been said that hedge fund investors are wealthy
investors and they can take care of themselves.
That may or may not be so, but what we can't afford to have
is a hidden impact, if you will, in terms of some of these
techniques that act against the best interests of our
functioning markets. And that is why that proposition was put
forward.
We have put it out for further comment to address the issue
of small investors without a means test investing in hedge
funds.
I think a good case can be made for that, if there is
complete transparency within the hedge fund itself.
And, as we move toward these so-called funds of funds,
funds of hedge funds, where you have weekly or monthly pricing,
it is all the more important to assure that the small investor
knows what he is or she is buying. And knows how the internal
holdings are being priced, et cetera.
Mrs. Maloney. But that is pretty much important that
transparency. And I truly do believe that our capital markets
run on trust as much as they do on money.
And therefore, your position is incredibly important to the
country and the trust the country will have in financial
markets.
So, as one who represents the New York Stock Exchange, I
have been there many times and I have met with some incredibly
impressive people and the technology and oversight into the
building, I would say, is State of the art.
And you have touched on this earlier, but I would like to
have it clarified; given the controversies at the exchange, you
stated earlier, I believe, that you support this self-
regulation model in general.
But my question is, ``Should the job of regulating the
Exchange be separate from the job of running the Exchange's
business?''
I know that the NASDAQ is split from the NASD, possibly
these are different models, but you, I believe said you support
self-regulation, but do you believe the head of the exchange
should also be the head regulator?
Mr. Donaldson. Well, again, I think that the issue is the
definition of separation. And to me, separation can run a
gamut. It can be a physical; an ownership separation with a
regulator out there, somewhere.
Or it can be an internal structure that separates the
reporting function such that the regulators are reporting to an
independent board and reporting not to the same people that are
running the exchange market, as a business.
And, I think, the stock exchange is now wrestling with
where they come down on that.
And I think we have an open mind toward a solution that
solves the issue of potential conflict of interest between the
business side and the regulatory side.
Mrs. Maloney. Well, my time is up and I thank you, Mr.
Chairman.
Thank you, Mr. Donaldson.
Chairman Baker. I thank the gentle lady.
Mr. Chairman, we express our appreciation for your courtesy
of your time today. It has been very helpful for the
Committee's considerations.
I am advised that a number of members, who could not come
back, that wish to ask additional questions requested that the
record remain open so their submission of questions to you
could be, perhaps, responded to by correspondence at a later
time, but would be made part of the official committee record.
With that one caveat, and I also will forward my own
correspondence relative to a question concerning the window
during which some of these ongoing analyses may be completed
for the Committee's planning for next year.
Understanding that we would very much like to have the
Commission's recommendations finalized, in order, for the
Committee to act upon where it is needed to be acted upon
within a reasonable time constraint, next congressional year.
So, we do appreciate your courtesies and your willingness
to participate. Thank you very much, Sir.
Mr. Donaldson. All right. Thank you.
Chairman Baker. Thank you.
And I would ask that the participants in our second panel,
please, come on down.
I welcome each of you to the Committee's hearing today. All
of your formal statements will be incorporated into the
official record. We would request that your oral testimony be
limited as best possible to five minutes.
And I do expect members in and out as the course of the
hearing proceeds, but all of your recommendations will be
reviewed by members of the Committee as we go forward.
At this time, I would like to recognize Mr. Robert H.
McCooey, Jr., President and Chief Executive Officer of the
Griswold Company. Welcome, sir.
Please proceed at your leisure.
STATEMENT OF ROBERT H. MCCOOEY, JR., PRESIDENT AND CEO, THE
GRISWOLD COMPANY
Mr. McCooey. Thank you, Chairman Baker.
Chairman Baker, Ranking Member Kanjorski and members of the
Subcommittee. My name is Robert McCooey.
I am a proud member of the New York Stock Exchange and
President and Chief Executive Officer of the New York Stock
Exchange member firm The Griswold Company.
Griswold is an agency broker executing orders for some of
the largest mutual and pension funds in the United States.
Thank you for inviting me here today to testify in
connection with your review of the capital market structure
here in the U.S. I would like to highlight some aspects of my
previously submitted written testimony.
As a floor broker, I know the important role that we play
in the price discovery process. The competition between orders
represented by brokers at the point of sale on the floor helps
to ensure fair, orderly and liquid markets.
The floor broker serves as a single point of accountability
and information not found in dealer markets and ECNs, and who
employs the most advanced technology to support his or her
professional judgment.
The floor broker relies upon a digital hand-held
communication device which receives the orders, transmits the
reports, and engages in an ongoing dialogue with the client
through the use of digital images.
All this is done without ever leaving the trading crowd.
With regard to the trade-through rule, when trading is
allowed to occur outside of the National Best Bid and Offer,
the NBBO, two investors are being disadvantaged. The bid, or
offer, that has been posted, as well as the buyer or seller who
receive the inferior price to the NBBO.
To amplify this, I would like to offer the following
example. A buyer posts a bid of $49.05 to buy 5,000 shares of
XYZ.
In the absence of a trade-through rule, a 5,000 share trade
might occur at $49. In this instance, two investors are not
being afforded the full protection that they deserve in the
marketplace.
The seller who sold the stock at $49 did not receive the
highest price that was bid for those shares in the market.
Further, the buyer with the $49.05 bid was left unfilled.
This investor posted the best bid in the marketplace and
was ignored.
I do not believe that this is the message that we want to
disseminate to the investing public. Unfortunately, this is a
message that is being promoted by some of our competitors.
In my opinion, some of those who have sat here before you
prior to today, have engaged in competitive positioning rather
than factual presentation. Simply stated, the facts do not
support their contention of the unfair system that stifles
competition.
At the New York Stock Exchange, we welcome competition.
However, that competition must be one that ends with the
customer's order being executed at the best available price.
The reality is that the NYSE posts the best price nearly 94
percent of the time in all listed securities. That is the
single reason why we have been successful.
With 30 co-sponsors, Chairman Mike Oxley sponsored H.R.
1053 to eliminate legal impediments to the quotation in
decimals for securities transactions in order to protect
investors and to promote efficiency, competition and capital
formation.
So what happened along the way to the penny? Has something
changed in these few short years? Do investors no longer
deserve to save money?
Is it acceptable for fiduciaries to accept a worse, though
speedier, price for stocks that they are buying and selling on
behalf of the millions of shareholders who have entrusted them
with their hard-earned money.
There is, however, an answer to these questions about the
penny.
I think that somewhere between common sense and today
client interests have been abandoned and replaced with those
that are self-interested.
During our difficult period for both the financial markets
and broker dealers, client interests have been secondary to the
economic interests of firms and market centers.
It is not time to encourage or reward this type of
behavior. Quite the contrary, the message of the investor first
should be quickly and firmly reinforced.
And pennies add up. If fiduciaries are advocating their
responsibility to achieve the best price available, the impact
to their shareholders is very significant.
If an investment manager decides to forego better,
available and accessible prices for the sake of speed, the
negative cost impact to the fund shareholders is in the
millions of dollars.
For a fund trading average of 10 million shares a day, to
receive that incremental penny of price improvement on all
those shares, multiplied by 250 trading days in a year, the
savings are $25 million.
This is the shareholder's money, the investor's money.
Furthermore, I am giving you only one example, from one fund
manager. Across thousands of funds and billions of shares
traded, the negative impact to investors cannot be ignored.
Finally, how do we ensure that the national market system
benefits all investors? We begin with what has worked for years
and continues to work today.
At the NYSE, we provide investors with the best price,
liquidity, transparency, accessibility, the highest certainty
of an execution, protection of customers' orders and their
interests.
At the NYSE, we will continue to change, adapt and innovate
to best serve our customers and to fulfill our commitment to
producing the highest levels of market quality.
In all that we do, we take pride in the fact that we always
place the investor first.
Thank you.
[The prepared statement of Robert H. McCooey can be found
on page 155 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next witness is the President and Chief Executive
Officer, Security Traders Association, Mr. John Giesea.
Welcome, sir.
STATEMENT OF JOHN GIESEA, PRESIDENT AND CEO, SECURITY TRADERS'
ASSOCIATION
Mr. Giesea. Thank you, Chairman Baker and members of the
Subcommittee.
I would like to take opportunity to introduce the Security
Traders Association to you, which we refer to, and I will refer
to, as STA, which is a 70-year-old organization comprising
6,000 individual professionals involved in the purchase and
sell of equities securities.
Representatives of our organization are on the buy side and
the sell side and participation is included amongst members of
ECNs and exchanges.
Myself: my background is simply 23 years at Kidder,
Peabody, 10 years with Advest in senior trading and management
positions and two years in the current position as President
and CEO of STA.
Our sole focus as an organization is market structure.
And the imposition, or the hosting, of the market structure
hearings held by the SEC in November and December of last year,
formed the basis for a desire on our part to comment on issues
that we felt we could add value through our experience and
expertise.
The outcome of that process was this report, ``Fulfilling
the Promise of the National Market System,'' which I have asked
to be submitted along with my written testimony.
In preparation for this report, we examined the origin of
the National Market System in 1975 and discovered the five
principles that this National Market System was built upon are
as valuable today as they were at its inception.
And the Congress got it right: those include transparency,
economic efficiency, ease of the best execution, fair
competition and the opportunity to transact without need of an
intermediary.
The fact is, 28 years later, we need to update, but we need
to retain those principles, but update market structure.
Three areas I would like to touch on quickly and that are
included in our testimony include fragmentation, regulation and
access fees.
We have heard mention of fragmentation a couple of times
today, and in and of itself, we would represent that
fragmentation is not positive. On the other hand, competition
is the foundation upon which our business has been built.
We have succeeded in encouraging and thriving on
competition. And competition in the area, particularly NASDAQ
stocks, through use of the UTP, Unlisted Trading Privileges,
has created fragmentation in the marketplace.
Excuse me.
Alone, fragmentation represents a hurdle to overcome. The
hurdle is overcome through linkage and connectivity. We believe
that there should be linkage to all markets, that includes
automatic and immediate execution.
In the area of regulation, we are pleased with the SEC's
SHO short sell regulation, which promotes and suggests the rule
that crosses markets.
This is the principle that STA recommends for basic
customer protection rules, as well as basic trading rules, such
as short sell and sub-penny quotations. Market share gains by a
market center should not have root in less regulation.
Thirdly: access fees. We have long opposed, our association
has long opposed, the imposition of access fees which was done
as part of the 1996 Order Handling Rules by way of a footnote.
This footnote allowed one segment of the market to charge a
fee for accessing its quotes. We think this is unfair and
represents a hidden cost to investors and should be eliminated.
We praise the NASD, on behalf of NASDAQ, for putting a cap
of three mils, a suggested cap of 3 mils, 0.003, on an access
fee; though we believe we are still three mils away from where
it should be in order to be transparent and fair.
Next, I would just like to make a quick mention of the area
of liquidity. Through my conversations and my work, we need to
be sure that when we talk about liquidity we make no
assumptions.
And another thing the SEC did in their short-sell rule is
they allowed for a provision for the most liquid, 300 stocks,
to be exempt from the bid test. It recognizes there is a
difference in the trading of stocks.
G.E. on the New York, Intel on the NASDAQ seldom, if ever,
need an intermediary. They trade efficiently and transparently.
But those other stocks that are less active benefit greatly
through the activity of the liquidity provider, called a
specialist or a marketmaker. And I think that this is something
that the SEC needs to be careful of in putting regulation in
place, not to assume that all stocks trade alike.
Then, lastly, in terms of the ability for young, worthy
companies to raise capital, we believe liquidity is an
important part of that.
And we believe that with issues involving investment
banking and research over the past year, together with
liquidity, issues and lessons, liquidity, date of market
structure, that the underwriting and the ability to raise
equity capital is challenged and we don't want that to happen
for the U.S. economy or for job growth within the United
States.
STA is honored to be present today and is proud of its
tradition of representing the principle, ``What is good for
investors of all kinds, is good for our market and good for our
members.''
Thank you, to the Committee for the important work that you
do and, in particular, Chairman Oxley, Chairman Baker, Ranking
Member Frank and Congressman Fossella for having joined STA in
its spring conference earlier in this year.
And we appreciate the opportunity to be before you today.
[The prepared statement of John Giesea can be found on page
111 in the appendix.]
Chairman Baker. Thank you, sir.
Our next to be heard is Mr. Thomas M. Joyce, President and
Chief Executive Officer, Knight Trading Group.
Welcome.
STATEMENT OF THOMAS M. JOYCE, PRESIDENT AND CEO, KNIGHT TRADING
GROUP, INC.
Mr. Joyce. Chairman Baker, Ranking Member Kanjorski,
members of the Subcommittee, thank you for inviting me to
participate in this hearing regarding the structure of the U.S.
equity markets.
My name is Tom Joyce. I am the CEO and President of the
Knight Trading Group, the largest, independent market maker in
the industry. To give you some sense of context, on a typical
day, we do over a million trades and well over a billion shares
of equity trading.
I have been a member of the securities industry for the
past 25 years, including 15 years at Merrill Lynch. I have been
both a student of and an active participant in the debate over
market structure for over a decade.
In fact, many of the issues you are hearing about today
were examined back when I was the Chair of the Quality of
Markets Committee of NASDAQ, and when I served as a member of
the New York Stock Exchange's Market Performance Committee.
Having worked both in the option model and the electronic
model, I believe I can bring to you a unique perspective on
market structure.
Although U.S. equity markets remain the most vibrant and
liquid markets in the world today, they are facing severe
problems.
The conversion to decimals has successfully narrowed
spreads, but it has also sparked a series of unintended
consequences that have resulted in new trading challenges for
investors.
It is our hope that these hearings will lead to a fair
market structure in an even-handed application of rules that we
all seek.
There are three main points I would like to convey to the
Committee today. The first is on the issue of best execution.
We at Knight strongly believe that the definition of best
execution resides with our clients. To attempt to define a
single standard of best execution is simply wrong footed. Each
client has different needs at different moments. It is our job
to know our clients and to perform accordingly.
Thus, the standard of best execution should be defined by
competition on a level playing field with the proper
transparency associated with it.
As for transparency, each month we publish on the web data
regarding the quality of our executions, scored against
statistics such as speed and price improvement. They are
located in the 1-5 and 1-6 statistics.
This public disclosure, linked to our competitive efforts,
is the right approach. Ultimately, if we fail to give our
clients what they want, they will vote with their feet. And
conversely, as we do a good job for our clients, they will
reward us with more business.
The second main point I would like to make is that there
needs to be certain high standards established across the
various trading venues.
Again, decimal trading has been a success on many fronts,
but many of the trading rules that are being applied to our
markets today date from the era of eighths.
I would suggest action on the following issues: sub-penny
trading; flatly, it should be banned.
Virtually no other retail product in the United States
trades in units below a penny. The only beneficiaries of sub-
penny trading are professional traders who can use it to game
the system.
I would submit to you, you couldn't find a single
traditional retail investor who would ask for sub-penny
trading.
If people complain about so-called penny jumping that
supposedly takes place in the New York Stock Exchange, think
about how divisive mil-jumping, tenth of a penny, jumping is in
NASDAQ.
To me, this is a race to the bottom. Therefore, I strongly
suggest we go back to penny spreads and establish it as a
standard of our markets.
The trade-through rule: it exists today to protect price
priority across markets. The time has come to adapt the rule to
the common market dynamics. When volume aggregated at an eighth
or a sixteenth, it made sense.
Now, however, in an era of decimal trading, we see volume
dispersed over 100 price points, thus, aggregating it is more
difficult.
More importantly, the speed at which many markets trade
today make the quote literally flicker. It is not uncommon in
highly liquid stocks, like Microsoft, for example, to see 50
quote changes in a second.
In an environment like this, we firmly believe that a de
minimis exception of three cents around the quote should be the
core component of a new trade-through rule.
Third, we also believe that it is time to establish
standards for intermarket access.
The best examples of the need to introduce change here are
the unlisted trading privileges NASDAQ and the Intermarket
Trading System in the listed market. In each case, you often
see the conflict between electronic trading and the old, open-
outcry manual systems.
We believe, if markets are expected to interact, then
certain minimum standards of connectivity must exist which
would allow for electronic access up to some practical trade
size.
And the third, and last, point I would like to make is that
market-makers matter.
For too long now, ECNs and other ATSs have been receiving
most favored nation status in certain regulatory circles,
highlighted by the abilities of ECNs to charge fees, while we
as market-makers cannot.
We would like to see changes to the current status quo that
favors this class of execution providers. A privileged class
protected not by competitive superiority, but by regulatory
authority.
Now many stocks, particularly the largest stocks, do
benefit when trading on ECNs. Admittedly, they do a fine job
there.
But as one gets further down the liquidity spectrum without
capital committed by market-makers, many nit cap and small cap
stocks would trade with much greater volatility and much less
liquidity.
This in turn, diminishes the ability of these companies to
see additional, or initial, capital through the U.S. Capital
Market System.
Marketmakers supply an enormous amount of liquidity in this
segment of the market. We believe that if they continue to walk
away from this segment of the market, it is a long term
negative for the market, for issuer companies and investors.
If it continues unabated, I would argue that ultimately,
the capital formation process of the economy could be
negatively affected.
In conclusion, give us a level playing field in which to
compete in different market centers and a regulator who will
establish the appropriate rules set and apply it evenly.
In any market we believe we can compete with any model any
time. And ultimately, it is the investor, our end user, who
will dictate which service provider succeeds and hopefully, in
our case, flourishes.
So on behalf of Knight, I would like to thank you for the
consideration of our testimony. And, of course, we would
welcome any comments and questions at the appropriate time.
[The prepared statement of Thomas M. Joyce can be found on
page 119 in the appendix.]
Chairman Baker. Thank you, Mr. Joyce.
Our next witness is Mr. Michael LaBranche, Chairman, Chief
Executive Officer and President of LaBranche and Company,
Incorporated.
Welcome, Sir.
STATEMENT OF MICHAEL LABRANCHE, CHAIRMAN, CEO AND PRESIDENT,
LABRANCHE & CO., INC.
Mr. LaBranche. I would like to make some general
observations about the New York Stock Exchange; what it means
to the American economy and especially in light of all the
press that is being given to it.
One of the things about the New York Stock Exchange that
many people do not understand that it is the world's largest
electronic stock exchange.
People don't realize how much technology goes into a trade
on the New York Stock Exchange. More than 90 percent of the
orders that are delivered to the New York Stock Exchange are
delivered on our Super DOT system.
We also have a specialist system which is coupled with that
which adds capital to the system, which has human capital as
well as financial.
We have a market that has the most liquidity of any market
in the world. You can see statistics about how many orders get
executed in certain markets.
I can tell you that 100 percent of the market orders that
are transmitted to the New York Stock Exchange are executed.
That is unparalleled liquidity that has not been equaled in any
other marketplace.
The United States Capital Markets are by far the best
capital markets in the world and the New York Stock Exchange
has played a very large part in the development of the Capital
Markets.
It has a direct effect on everybody in this country, in
terms of the development of the economy and the standard of
living.
One of the things that we hear about very often, especially
in the press today, is about the importance of speed versus
price. And that is a very important concept to us, and I think
it is a lot more complex than simply the trade-through rule.
Remember that speed is really access to the market, but the
price is by far the most important thing.
Even for large institutions they are ultimately
representing individuals and they are representing individuals
that go about their work, or go about go on vacations, or do
things in their daily routine.
They don't know if their orders are being executed in two
seconds or 12 seconds or 20 seconds. What they care about is
what their returns are at the end of the year. And so, to them,
the most important thing is to have a mechanism that gives them
the best price.
So, when we talk about the trade-through rule, I think it
really goes beyond simply talking about a trade-through rule.
I think the most important thing that we have to talk about
here today is the fact that we have to be able to send the
message to the investment community and investors that their
interests are being looked after.
That broker's primary responsibility is to always find the
best price for the people they represent.
I think if we go down the road where people believe that
their brokers are not necessarily looking for the best price,
but more broker-convenient, then I think we are going down a
path that might lessen investor confidence.
So, whether the trade-through rule gets reformed, I think
it is very important that the message remains that brokers are
looking after the interests of their clients.
When we talk about speed, one of the things about the New
York Stock Exchange that people tend not to realize is that it
really is a much more efficient and quick execution platform.
It is, to me, irrational to think that anybody would want
to give up a better price for five or 10 seconds, but the fact
is that 50 percent of all orders 500 shares or less that are
executed on the New York Stock Exchange are executed within
five seconds.
Beyond that, institutional orders that run between 2,000
and 10,000 shares on the New York Stock Exchange are executed
on an average of 18.7 seconds. Now, that would compare to the
same execution and time span on an ECN of 61 seconds.
So we are a very efficient market, we are a quick market.
And we are always looking for the best possible price.
The other important thing that I think we should talk about
here--the point I would like to make--is the talk about what
does the auction mean. Now the auction is very often confused
with a busy trading crowd. But the auction is not an
anachronism.
The auction is what allows investors of all kinds, whether
or not they have a 100 shares to buy or sell, or a million
shares to buy or sell, the auction is what allows them to
interact in the market in a fair way.
It means that if you are willing to pay the highest price
for a stock, if you have one share to buy or a million shares
to buy, you get the first chance to buy it. If you have one
share to sell, or a million shares to sell, you get the first
chance to sell it.
That is the basic benefit that the public derives from the
auction.
And I think that if you think about it that way, people
take that basic right for granted, but the auction, in essence,
represents the Bill of Rights for investors.
I think the New York Stock Exchange works very hard to make
sure that that auction is adhered to in a way that protects
investors in all circumstances, whenever possible.
The specialist, we are a very important part of that
auction, but we are one piece of the puzzle. We represent one
constituency on the New York Stock Exchange.
We are an important part of it, but we function within that
community working to make sure that people get the best
possible price.
So, thank you.
[The prepared statement of Michael LaBranche can be found
on page 145 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next participant is Mr. Kevin Foley, Chief Executive
Officer, Bloomberg Tradebook.
Welcome.
STATEMENT OF KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK
Mr. Foley. Thank you, Mr. Chairman, members of the
Subcommittee.
My name is Kevin Foley, and I am pleased to testify on
behalf of Bloomberg Tradebook.
Bloomberg Tradebook is owned by Bloomberg L.P. Bloomberg
L.P. provides multimedia, analytical and news services to more
than 175,000 terminals used by a quarter of a million financial
professionals in 100 countries worldwide. Bloomberg News is
syndicated over 350 newspapers and on 550 radio and television
stations around the world.
Bloomberg Tradebook is an electronic agency broker serving
institutions and other broker-dealers.
We count among our clients many of the nation's largest
institutional investors representing, through pension funds,
mutual funds and other vehicles, the savings of millions of
ordinary Americans.
Bloomberg Tradebook specializes in providing innovative
tools that subdivide large orders into small orders and
eliminate the traditional barrier between the upstairs market
and the trading floor market.
Through that technique we bring upstairs liquidity directly
into contact with small retail orders, with the options market-
makers and with program trading order flow.
In the process, we consolidate what has been a fragmented
market and we increase the efficiency of the market.
Our clients have rewarded our creativity and our service by
trusting us with their business, allowing us regularly to trade
more than 180 million U.S. shares a day, about 20 percent of
that in listed shares; and a third again as much business in
international shares.
We have consistently been among the top five providers of
liquidity to NASDAQ's supermontage.
And a large percentage of our listed order flow is executed
using our technology and through New York Stock Exchange
members on the floor of the New York Stock Exchange.
The House Financial Services Committee has long been
concerned with potential conflicts that might lessen market
efficiency or compromise investor protections.
The Committee has devoted significant time and effort to
addressing some of these conflicts in the context of analysts,
accountants and others.
Recent conflicts relating to the New York Stock Exchange
provide an opportunity to make the U.S. equity markets more
competitive.
New York, in 2003, looks strikingly like NASDAQ in 1995.
The SEC made decisions on market structure in the mid-1990s
intended to combat conflicts of interest in the NASDAQ market
by enhancing transparency and competition.
Specifically, the SEC's 1996 issuance of the Order Handling
Rules permitted electronic communications networks to flourish,
benefiting consumers and the markets generally.
Indeed, the increased transparency promoted by the SEC's
Order Handling Rules and the subsequent integration of ECNs
into the National Quotation Montage contributed to NASDAQ
spreads narrowing by nearly 30 percent.
These, and subsequent reductions in transaction costs,
constitute significant savings that are now available for
investment that fuels business expansion and job creation.
Chairman Oxley has asked, ``Why does New York control 80
percent of the trading volume in its listed companies when
NASDAQ controls only about 20 percent of the volume in its
listed companies?'' And we think the answer is simple.
There have historically been a series of barriers to
competition in the New York listed markets that have the effect
of centralizing order flow and impairing intermarket
competition, and depriving the market of the opportunity to
test whether competitors could bring the same benefits to the
New York Stock Exchange investor as they have to the NASDAQ
investor.
To unleash competition and promote an efficient market, we
believe Congress and the Commission should consider the
following: repeal the trade-through rule.
This 20-year-old rule protects inefficient markets while
depriving investors of choice. Today's lead editorial in the
Wall Street Journal, we believe, is on target.
Facilitate display of New York listed stocks in the
Alternative Display Facility. The ADF has been providing a
competitive spur to the NASDAQ's supermontage and serving as a
check on anti-competitive behavior.
We believe the ADF could provide a similar tonic for the
New York Stock Exchange listed market.
Ensure the oxygen supply. The Financial Services Committee
has long accurately held that market data is the oxygen of the
markets, but the oxygen supply has been imperiled in the past
and is imperiled today.
Before the 1970s, no statute or rule required self-
regulatory organizations to disseminate market information to
the public or to consolidate information with information from
other market centers.
Indeed, New York claimed an ownership in market data and
severely restricted access to that market information. Congress
responded by enacting Securities Act Amendments of 1975.
These amendments empowered the SEC to facilitate the
creation of a National Market System for securities, with
market participants required to provide, immediately and
without compensation, information for each security that would
then be consolidated into a single stream of information.
Bloomberg, in consultation with two distinguished
economists, has submitted to the SEC a discussion paper
entitled, ``Competition, Transparency and Equal Access to
Financial Market Data.''
The paper delineates the ways in which exchanges, in the
absence of structural protections, may abuse their monopoly
power over the collection of market information to the
detriment of consumers.
Those concerns were borne out this year when the New York
and its liquidity quote ``proposal'' sought to make available
data that had inadvertently been made less transparent by
decimalization, but only under contractual terms that would
have required vendors to display it in a way that disadvantaged
other market centers, as well as prohibiting data vendors from
integrating it with data from other markets.
The promise of enhanced transparency at the heart of
decimalization would have been thwarted.
Under Chairman Oxley's leadership, the Congress has pushed
hard for decimals, and that additional transparency has indeed,
benefited investors. We applaud the SEC for striking down New
York's restrictive contracts and liquidity quote.
The controversy underscores, however, that policymakers
should give strong consideration to updating the vendor display
rule. Otherwise, investors will actually have less useful
information than existed prior to decimalization.
Ensuring the oxygen supply also entails greeting efforts to
create new property rights in data, with a measure of
skepticism.
As this Committee well knows, in past Congresses, both New
York and NASDAQ have supported legislation which would create a
new and unprecedented property right in factual data, including
even government-sponsored monopoly market data.
In hearings in the last Congress, the Financial Services
Committee heard a number of market participants express strong
opposition to this proposal.
A few weeks ago, H.R. 3261, the Database and Collections of
Information Misappropriation Act, was introduced and referred
to the House Judiciary Committee.
The legislation is sufficiently contentious that an
incredibly diverse array of public and private entities;
ranging from the U.S. Chamber of Commerce to the American Civil
Liberties Union, the Eagle Forum to the Consumers Union, have
already voiced strong opposition.
While some market data has been exempted out of the
proposed legislation, the bill continues to potentially bar
access to much other information critical to market
participants, hence, may well have important ramifications for
market transparency.
Finally, in the NASDAQ market: access fees. Bloomberg has
long believed that ECN and NASDAQ access fees should be
abolished for all securities and all markets. And we have urged
the SEC to take this important step.
In conclusion, this Committee has been in the forefront of
the market structure debate. I appreciate the opportunity to
discuss how these seemingly abstract issues have real-world
impact on investors.
Policymakers should set rules, but encourage competition
and let the market do the rest. And the New York Stock Exchange
will successfully adapt, as it has for more than 200 years, and
investors will benefit.
Thank you.
[The prepared statement of Kevin Foley can be found on page
88 in the appendix.]
Chairman Baker. Thank you, Mr. Foley.
And our next witness is Mr. Edward J. Nicoll, Chief
Executive Officer, Instinet Group, Incorporated.
Welcome.
STATEMENT OF EDWARD NICOLL, CEO, INSTINET GROUP INCORPORATED
Mr. Nicoll. Thank you, Mr. Chairman. I will be mercifully
brief.
Mr. Chairman, Ranking Member, members of the Subcommittee;
thank you for inviting me to testify today on the issue of how
to reform our market structure and promote competition in a
changing market environment.
Americans have long known the value of competition and that
without it, a monopoly can strangle innovation and lead to
higher prices. This is, after all, why we have anti-trust laws.
But when it comes to securities markets and trading in New
York Stock Exchange-listed securities in particular, we have a
regulatory regime that stifles competition and undermines
investor choice.
Let me be clear, I am not here to tell you how the New York
Stock Exchange should change. Rather, I am here to tell you
that we must modernize the regulations that govern listed
trading, so that there are finally robust and competitive
alternatives to the NYSE.
If investors want to use a system of floor-based trading,
conducted through specialists, they should have that option. If
they would prefer to take advantage of modern technology that
has led to more efficient electronic marketplaces, they should
have that choice as well.
So what impact would real competition have on our capital
markets? Fortunately, we have two real-world examples to use as
our guides.
First, when NASDAQ dealers effectively wielded exclusive
control of the NASDAQ market, it ultimately resulted in the
Justice Department's allegations of fraud, price fixing and
collusion by these dealers.
To address the situation, the SEC wisely avoided
micromanaging the existing NASDAQ structure and, instead, in
1997, opened the NASDAQ and its dealer system to competition.
The defenders of the old system argued that the dealers
provided a valuable public service by providing liquidity and
they questioned how investors would benefit from increased
competition.
But the impact of the new competitive marketplace imposed
upon them by the new SEC rules is lower spreads in the NASDAQ
stocks, as well as lower overall transaction costs that have
saved investors hundreds of millions of dollars in just a few
short years.
Here is the second example. Up until 1999, each options
exchange exclusively controlled trading in a given option.
For example, Dell options were traded on the Philadelphia
Stock Exchange and nowhere else, while IBM options were traded
exclusively on the floor of the CBOE.
While there was competition on each floor, there was no
competition between markets. These monopolistic practices led
the Justice Department to seek to enjoin the options markets
from colluding to restrict competition.
Again, the defenders of the status quo said that the so-
called fragmentation that would result from competition between
exchanges would ultimately hurt consumers.
But independent studies conducted after competition between
exchange was imposed showed that spreads in the options market
decreased by between 30 and 40 percent practically overnight,
while transaction costs also dropped; both to the benefit of
consumers.
Today we find ourselves facing a similar situation: the
NYSE enjoys a monopoly on trading NYSE-listed securities. But
as recent events indicate, this monopoly may harm investors.
Past experience shows us how to solve this problem: we must
identify and eliminate barriers to competition.
In the case of the NYSE, the single, greatest barrier to
competition is the trade-through rule. The overall effect of
the trade-through rule is to undermine the competitive
advantages of an electronic marketplace: speed and certainty of
execution.
Those who would preserve this regulatory advantage for the
NYSE make two basic arguments in defense of the trade-through
rule.
First, consumer protection: defenders of the status quo
argue that the trade-through rule ensures that investors will
receive the ``best price.'' But then how do you explain the
superior execution quality in NASDAQ market where there is no
trade-through rule?
Indeed, SEC-mandated statistics indicate that overall
execution quality for investors is higher in NASDAQ-listed
stocks like Microsoft, where there is no trade-through rule,
than it is for IBM in other New York Stock Exchange-listed
securities where the rule is in place.
One other reason that investors still receive quality
executions in NASDAQ stocks is that brokers have a duty to get
their customers best execution. In fact, due to the existing
broker duty of best execution, the trade-through rule is
unnecessary.
And ironically, actually contributes to investors seeing
the inferior prices and inhibiting beneficial competition.
The second defense of trade-through is that there is
nothing wrong with the short delay that it engenders if
investors receive a better price.
But the supposed trade-off between speed and price is based
on a faulty premise. And that is, that the best advertised
price is the best price. Often, it is not.
As I discuss in my written testimony and in the attached
documents, it is often the case that investors will end up with
a worse price if they delay their execution attempting to chase
the best-advertised price.
Sure, if investors know with certainty that they are going
to get a better price in 30 seconds, they would always accept
the delay.
The problem is that there is only the possibility of
receiving a better price. If there is only a possibility, what
should an investor do? The answer is it depends on the
investor.
Once again, investor choice and competition should be our
guiding principles. Moreover, the SEC has already provided us
with a glimpse of what a more competitive future in listed
trading would look like.
Specifically, we have, in effect, been without the trade-
through rule on three Exchange-Traded Funds, or ETFs, for over
a year, including the most widely traded security in the
country: the QQQs.
The SEC's 2002 decision to ease the trade-through rule on
ETFs has been an unqualified success. It has fostered
competition without producing any of the harmful effects that
defenders of the trade-through rule so often complain.
As this Committee knows, Congress set out two clear
principles in 1975 market reform legislation that are as
important today as they were nearly three decades ago.
The National Market System must not favor any particular
market, or market structure, and it should foster competition
between markets. Through such competition and the innovation it
drives, investors receive the best value.
As we have seen with NASDAQ and the options market,
allowing any one market to exercise monopoly control,
ultimately leads to abuse and increases transactions costs for
investors.
Competition on the other hand, leads to narrower spreads,
lower transaction costs and investor choice. That is why we
urge the repeal of the trade-through rule.
Thanks again for the opportunity to testify and I would be
happy to answer any questions.
[The prepared statement of Edward J. Nicoll can be found on
page 163 in the appendix.]
Chairman Baker. Thank you, Mr. Nicoll.
Mr. LaBranche, I understand your statement in defense of
the trading practices at the New York exchange is centered
primarily on assuring investors in 96 percent of the cases,
that they are actually executing the sale at the best price
available in the market at the time.
Rarely do I rely on newspaper accounts to ask a question
but, the Journal, in its editorial, raises a point that I would
like your opinion on because it goes to the heart of that
defense of the Exchange.
Specifically, in referencing the New York exchange and,
``The frustrating opportunity for mischief occurs when the best
price appears on another exchange,'' meaning not the New York.
``Instead of routing the order to that exchange,
specialists on the NYSE have been known to ignore it. The
number of NYSE trade-through violations is huge.''
Again, this is the paper.
``ArcaEx, an electronic exchange that competes with the big
board has found the NYSE has ignored better prices on ArcaEx up
to 7,500 times in a single week.''
Is there any legitimacy to that claim? Or how do you
respond to that accusation?
Mr. LaBranche. I would----
Chairman Baker. Hey, Mick, get your mike on.
Mr. LaBranche. Thank you.
Well, I think that that editorial brings up some very
important, interesting points.
One of the things about the trade-throughs that exist is
that ITS was designed 25 years ago. It has really outlived its
usefulness.
And what I think we have today is much better technologies
available to us that would allow, say, smart order routing
systems to take the place of ITS. But, still it would be kept
in mind that you are still trying to get the best price.
On ITS, we have to wait up to 30 seconds to execute a
trade. Now, in the investment world when we are trading in
pennies, that makes it almost impossible to keep the market
going; to wait 30 seconds for someone to give you an answer.
Chairman Baker. So, you are now saying speed is the most
important asset?
Mr. LaBranche. No, I am saying that I think that speed,
when it is possible, is important, but obviously, most
important price is there.
But what happens is that during that 30 second interval,
the market moves and the other market cancels. The cancel rate
on these trade-throughs, or what you are referring to, is very
high and other markets tend to cancel because the markets move
during that 30 seconds.
Chairman Baker. But as to the principle-based statement of
this section in the article--and I am just trying to get at the
core--that I agree, I am defensive of the individual
shareholder's right to buy or sell in the most advantageous,
transparent opportunity we can construct and whether the
current body of regulation enhances or inhibits that
capability.
I see a value in the specialist system, I truly do. I don't
know that the value occurs in every transactional relationship,
however. I do believe speed is important.
But at the very core of it all, if I know of another
opportunity to sell someone shares at a higher price and I am
on the New York exchange and I don't exercise that fiduciary
responsibility, is that occurring? Is it a rarity? Or is it
commonplace?
What is your view of that world?
Mr. LaBranche. Well, specialists make every effort to get
to another marketplace if there is a better price. And that is
a fact and that is a rule.
Chairman Baker. And, if that is the case, then this
editorial, or article, must be----
Mr. LaBranche. Because markets change very quickly. And I
think that Mr. Joyce referred to how quotes blur in decimals,
and that happens.
And we are talking about pennies and it makes--remember, we
have moved from trading in eighths to sixteenths to decimals
fairly quickly.
We moved from eighths to sixteenths, which lowered the
spreads by 50 percent and then in one day we made a
transformation to decimals. So, instead of having 16 points of
price entry for every dollar, there are 100.
And we are, largely, using some of the same systems. The
ITS system was put in place 25 years ago when we traded in
eighths. And, in my opinion, it has really not kept up with the
times.
In some ways, I think that the Journal makes a very good
point. I think they should probably scrap it.
It is not up to me to do it, but I think that we need a
better technology.
I think smart order routing systems would be much better
for investors, much better for the marketplace. Then you just
choose what is the best market from on top of the markets.
Chairman Baker. Thank you.
Mr. McCooey, again, your general disposition to view the
exchange, obviously and understandably, is the best place to do
business as an individual investor, within the NASDAQ where
there isn't a trade-through rule effective.
How do those two worlds sit side by side?
Does that mean--in a careful reading of your statement--
that the NASDAQ, therefore, is inefficient and those who trade
through its avenues are not getting their best price on trades?
Mr. McCooey. Well, Chairman, I want to preface it by saying
that we are not here to say that one market is better than the
other. We support the NASDAQ market and obviously, support the
New York Stock Exchange market.
We think that for the equity markets to be as strong as
they are in the United States, we need both markets to be as
strong as they can be and to try to enhance them through the
use of technology, through the use of regulation, where
necessary, and to be able to make those markets as transparent
and as investor-friendly as they possibly can be.
The NASDAQ market, I believe, grew up in an age and a time
that allowed certain regulatory changes, regulatory--it allowed
things to happen on the NASDAQ market that would never have
been permitted on the New York Stock Exchange.
NASDAQ also has a lot of stocks that we like to talk about:
the Microsofts and Intels and Oracles of the world.
But as Mr. Joyce alluded to, there are plenty of other
stocks that are secondary and tertiary stocks where market-
makers are necessary, and best price is what the investor is
looking for. And market-makers compete based upon best price.
So when you begin to compare apples to apples, if we want
to compare the highest, most liquid stocks on New York versus
ones on NASDAQ, we may have an argument and a comparison there.
But I think we need to make sure that we are serving the
investor across all markets, across all stocks the best we
possibly can.
And I know that we do that on the New York Stock Exchange,
since I don't trade on NASDAQ, I can't, necessarily, comment as
to how they do or do not function, in terms of making sure that
they are getting the best price for their customers.
But I still think they should be.
Chairman Baker. Well, and even with that explanation, I
don't understand how elimination of the trade-through rule, if
you had an order flow requirement to the best price, wherever
that occurs, would operate to the detriment of the individual
investor nor represent any significant challenge to the New
York exchange, because of the breadth and liquidity of that
market.
You are a winner now; you would still be a winner no matter
what the rules are.
Mr. McCooey. Oh, I don't think that that is the case at
all. I respectfully disagree.
In the example that I gave you in my oral testimony, we
will begin to have things such as court d'arbitrage; people
that know that there is a nickel bid and buy it from a customer
for $49, while at the same time, using electronic systems to
hit the $49.05 bid.
We will have more internalization, we will have more
fragmentation. We will have broker dealers using this as an
opportunity to use customer orders for their benefit, not for
the investor's benefit.
I think that one of the things we are missing here is that
we are giving the intermediary the choice in this case; where
that order goes to, how it gets executed, not the customer.
And I have also heard about things such as, opt-out, so
that customers in their opening documents for accounts can
decide that the broker decides where the order goes to, whether
they want speed, or they can opt-out of price.
The other side of that argument is the contra-side. In my
argument: $49.05 bid. That person didn't sign an opt-out
document. That person had the best price in the marketplace,
that person was ignored. Is that the message that we want to
send?
Chairman Baker. I am going to come back to this, but I
don't want to go far beyond my time.
Mr. Kanjorski?
Mr. Kanjorski. I don't disagree with you very often, Mr.
Chairman, but I can think of examples, exactly as he put it
there.
Part of our problem we are all talking about it and not
getting down to it. For instance, we are all wanting to do the
best things for the investor, and we think we can define the
investor as one singular entity making up investments.
We know that is not true. You have institutional investors,
you have smart investors, you have dumb investors, you have
rich investors, poor investors. You have got investors that may
be fragments of people's imagination for all we know.
We can't sit with that simpleton.
But the thing that disturbs me most: it seems to me the
reason we are into this issue is that we have had some
significant, substantial problems.
Everything from Enron on through to Mr. Glasso's problem
recently that have shaken up--and the mutual fund industry--
they have shaken up confidence in the market, and the investors
is a large class in the market. I am interested in that.
On the other hand, I am starting to see some problems here
that everybody who has a pet peeve or a pet advantage that they
can thrust into this has now gotten the attention of the
Congress.
And it is all nice and good and I am interested in all your
competitiveness problems, but quite frankly, that is not what
this Committee has been addressing itself to.
What we are trying to do is make sure that the end of the
day we can clean all the laundry of all the markets, all the
exchanges, to have it reflect its excellence as the best
commercial and capital market in the world. And I think it does
that.
And when we have this interplay suggesting that you are not
getting the best price here, you are not getting the best price
there, unless we do this or that, it confuses respect for the
marketplace.
Now my question is--toward anybody that wants to take it--
do we have a technology problem here that can be handled within
the institutions themselves? Or do we have a substantive value
problem here?
Have we had a breakdown of morality, of ethics, in the
system? And that would go a long way to just how much time and
how it has evolved.
And the reason I am asking this is, look, I keep referring
back to this: you fellows are all capitalists and free
marketeers. And maybe with the exception of one or two of you,
you are all asking the government to come in and be the big
brother here and regulate the capital markets of this country.
You may get your wish and be damned for it.
I mean, be very careful what you are asking for here.
You are giving us a tremendous opening here to rush in and
start to decide some, I think, competitive issues; that there
are going to be winners and losers simply because one person
relies on one technology over customer tradition in another
technology.
And I want to use--I am not much at football or sports, but
I do, while I was thinking here--if I have got a good passing
team and speedy ends, I am going to want five plays on my side
of the team.
If I have got a heavy, chunky line and a damned good heavy
runner, I am going to want three downs. And we are going to
argue that all night.
The rules are drawn. That is not up to the Congress to
constantly change the rules because of some--unless it is
substantial electronic change, which, if you don't address the
rules--and then, we shouldn't be changing the rules--unless you
want us to take over the exchanges, unless you want government
in your boardrooms, then reexamine what you are doing.
So I say again, take it easy on this. Take getting any
comparative advantage because it will service your industry or
what you can do.
I am interested--any of you want to say--do we have a
substantive ethics or moral question in our markets today that
we haven't had before?
Or is just this the squeeze of the bubble, and everybody
wants to find fault and try and get themselves in a reorganized
position? And that the market is still fairly good or very good
and it will work itself out.
And the institutions themselves and the existing authority,
the SEC, will be able to handle all these things.
Anybody want to take that question?
Mr. Joyce. Yes, I will.
Mr. Kanjorski. Yes, Mr. Joyce you were--and I was going to
say when you were speaking, you introduced yourselves and said
15 years ago you were sitting on all these committees and
everything--boy you must have really done a hell of a poor job,
because, you know.
Mr. Joyce. That is why my hair is gray. Jet black 10 years
ago.
Mr. Kanjorski, thank you for introducing those topics. I
would like to briefly address both of them.
First of all, I don't know--clearly, technology has
changed. As Mr. LaBranche referenced, the ITS system literally
hasn't changed that much. Clearly technology is leaps and
bounds ahead of where it was 10 to 20 years ago.
The issue isn't so much around what kind of technology is
being or isn't being utilized. Clearly, depending upon the rule
set that is engaged, you can find the technology to cure your
problems.
So the issue, I would suggest, is that in the past few
years, we have changed the way we trade equities in the United
States: from eighths to sixteenths to decimals.
And when I say that the quote flickers, I literally mean
the quote flickers. If you tried to get that nickel bid that
Mr. McCooey referenced, by the time you go for it, it is gone.
And then it is back and then it is gone.
So the issues around the market that, I think, in the rule
set that we are addressing today and would like to see the SEC
get engaged on it, is the fact that fundamentally, the way
equities trade have changed, and most due to the fact that
decimals have been introduced into the process.
Decimals have provided an enormous amount of benefits, but
they simply change the way you trade. So, rule sets should, I
think, be adapted to take that into account.
As for your second question about ethics, I would strongly,
strongly emphasize that I have not seen, in any dealings, any
kind of change or diminished ethics that are applied to this
industry.
When you look at what happened with the corporate world a
year or so ago--was it 10 or 15 institutions; I would bet it
wasn't a whole lot more than that--and yet, there are 3,000
companies listed on New York, there are 3,000 more listed on
NASDAQ.
I think the statistical selection you are looking at is
very small compared to the thousands and thousands of companies
that are run extraordinarily ethically.
And when it comes to members of this industry and how they
run their business, once again, you are looking at, so far, I
have seen a handful of mutual funding complexes that have done
things they regret, no doubt.
There are more mutual funds available to the investor than
I think there are equities available. I think there are at
least 3,000 mutual funds available.
So once again, we have a case where there is a small, small
subset of people behaving improperly.
And to me, where I sit, and having watched this industry
over the past several years, the amount of ethical behavior
that is evident everyday is one that you would be very proud
of.
Mr. Kanjorski. Very good. Congratulations.
I think we need more of that. We are scaring the hell out
of that public out there. They are starting to look at Wall
Street like nothing but a bunch of gangsters.
``You belong in Lewisburg, not in New York.'' And that is
not true, that is not my impression. I have been looking at
this part.
The one thing is that--maybe the third part of my
question--I have a hard time figuring out what my question was
too, so I don't doubt that anyone up there on the panel would--
but, what I am asking is--I recognize the technological changes
and the conflicts that that causes, potentially in deciding,
particularly in the competitive range--but would you rather the
Congress of the United States take it upon itself to decide
things like whether we are going to replace the ITS lines or
whether we are going to let the exchange make that decision?
Do you really want us in your bedroom?
Mr. Joyce. Sir, to be completely honest with you, I think
it is the SEC's responsibility to do that.
I was very encouraged to see Chairman Donaldson here today
discussing his thoughts and some of the issues they are willing
to address. I think it has long been the mandate of the SEC to
deal with this.
Having said that, I think some congressional oversight is
often a good thing. It can often move issues forward.
And I think for that, I applaud you in getting involved.
Mr. Kanjorski. Mr. Foley?
Mr. Foley. Yes, thank you.
I agree with what Tom said that we heard--I thought a
tremendous amount of wisdom from the Chairman earlier today and
it, I think, gives one great confidence that the SEC is taking
its time, but not taking too much time, to address a number of
complicated issues, that sort of weave together and are best
addressed together.
So, I think, we are not here before you today to ask the
Congress to ask, but I had noted some people jotting things
down when members of this Committee said, ``Weeks, not months''
or ``Months, not years'' and so forth.
And the very fact that we are holding hearings today
focuses attention on some of these issues.
I don't think you see people here debating whether the
offense should receive three downs or five downs, based on----
Mr. Kanjorski. Yes we are. You would be one of them, Mr.
Foley.
Mr. Foley. No.
Mr. Kanjorski. You talked about the policy rule.
The policy rule is important because you are primarily in
the electronic business in an electronic market. And I
understand that, and there is nothing wrong with that.
But if you are on the other side of a more conventional
market, traditional market, that seems to be fair to have a
pass-through rule. It protects, quote, the investor, whoever
that six-pack carrying guy is out there.
But the reality is why shouldn't we make it a principle
that all equity trades on all markets are considered before a
buy or a sell is made, if it is technologically possible?
Mr. Foley. Well, if it is technologically possible to do it
in a way that does promote finding the best execution.
Here is the thing: yes, everyone responded to an incoming
message from another market center, immediately. I don't think
there would be anyone against a trade-through rule and against
the obligation to find the best price.
I know of no market-makers, ECNs, exchange system that
doesn't seek the best price in its own system. And it doesn't,
for those of us whose systems go out to each other, doesn't
seek the best price that is available in a reasonable
timeframe.
Mr. Kanjorski. But----
Mr. Foley. Technology has evolved. It appears to benefit,
not investors, but to some players in the market, for the rules
which existed for one purpose that is not relevant anymore.
Mr. Kanjorski. Okay. And I tend to agree with that.
And what I am asking you under self-regulatory authority,
do you guys have the capability of being mature enough to
regulate yourself, or do you need a cop, or do you need the
federal government there to do it?
I would like to think, as a lawyer, that the bar
association can throw out the rascals. I would hope that in the
exchanges and in the broker trading business you can identify
the rascals.
And you, incidentally, have a great tool in a new
electronic revolution to find out who they are, either before
or after the act occurs and the evidence is not destroyable.
Why can't you self-regulate and get the people out?
But there are a lot of good people. Hard, honest working
people are doing their best in all these markets and throughout
this country that are getting injured now by this over-tow that
there is something evil. ``There are evildoers.''
Gee, I heard that expression somewhere. But there are
evildoers on Wall Street.
And that doesn't play to my side of the aisle here, but I
am just saying I am not a big person that likes to identify
capitalism as the enemy of the people. I don't think it is. And
on the other hand, I don't think regulation should always be
the mantel of the Democratic Party.
I think there is a good reason to believe that in mature
people, regardless of what business or what profession they are
in, they can generally police themselves.
And we should only come into play when there is a breakdown
of that reality and that we have to get involved, then we have
to be heavy cop. Other than that, get the hell out of the way
and let the place handle itself.
Mr. Foley. I couldn't agree more.
And we believe strongly in self-regulations and believe
that the level of ethics and integrity in our industry is very
high.
You are going to need a light touch but, nevertheless, a
role to play from the SEC for addressing issues that fall
between the different markets.
And I think one of the things that has gone on over the
past couple of years is that a number of the issues regarding
market structure, that is, rules that say you can't do certain
things, that many of us don't think are necessary anymore.
Those issues have, sort of, taken a back seat, while other
issues that have gained more attention in the newspapers have
occupied the policymakers and the lawmakers and the press.
And many of the issues that we are raising here today are
issues that have been sitting on the back burner and come
forward now that the Commission appears to have the time and
the focus to devote to them.
And we are all very happy--I think I speak for all the
panelists--we are going to be very happy to see a resolution,
one way or another, on a number of these issues that have been
outstanding for the past couple of years.
Mr. Kanjorski. Good enough.
Chairman Baker. Ms. Hart?
Ms. Hart. Thank you, Mr. Chairman.
I want to let Mr. Kanjorski go on, I liked some of his
comments. This is good.
Thank you for your patience, I know today's hearing has
been going on for a while. I just have one question I want to
ask of two of you: Mr. Joyce and Mr. LaBranche.
If the New York Stock Exchange were allowed, or were
forced, excuse me, to require multiple specialists for each
security, can you tell me your thoughts about that? Do you
think it would be harmful?
Do you think it might bring more competition to the market
and alleviate some of the concerns that Mr. Joyce raised in his
testimony?
We can start with Mr. Joyce.
Mr. Joyce. Thank you, Ms. Hart.
In point of fact, as you can imagine, as the largest dealer
in the NASDAQ market, and frankly, one of the larger dealers in
the New York Stock Exchange-listed arena, we clearly believe
that competing specialists, competing dealers--specialist is a
dealer as a marketmaker fundamentally--provide a lot of
benefit.
They particularly provide an enormous amount of benefit as
you get into the secondary and tertiary stocks. That liquidity
segment needs more, not less, sponsorship.
So we do believe that the competing specialist model is a
successful one, as is evidenced by the success of NASDAQ. As an
old, listed block trader, incredibly enough--the back of my
hair was black, I actually traded listed equities with Mike on
a regular basis--I think the specialist system itself, is fine
too.
To introduce competing specialists: I wouldn't necessarily
leap to do that, unless there was a better body of knowledge on
it. But speaking from the NASDAQ model, clearly the NASDAQ
competitive model works well, and I would suggest it would work
equally well in the New York Stock Exchange system.
Ms. Hart. Okay. Mr. LaBranche?
Mr. LaBranche. Yes, well, it gets clearer that markets are
going to be competing against each other. And I think one of
the things we heard today was that technology should be allowed
to access pools of liquidity.
It should be allowed to compete. And I certainly embrace
that concept.
When it comes to the New York Stock Exchange as a model, we
do use a specialist model, but the most important thing about
the Stock Exchange is that orders compete with each other and
they are centralized to one point of sale.
So they interact with each other and that is a very
important concept. It is the one market that has orders
competing with each other.
Now the specialist is charged with the responsibility to
make sure that those orders compete with each other in a fair
way; that they aren't being ignored or anything else. So, that
is our charge.
That is what the New York Stock Exchange has designated a
specialist to do. He has to buy when no one else wants to and
sell when no one else wants to.
So if you had competing specialists, who are you going to
pick? You buy it, or you buy it or something like that. And
that might be something to consider.
But what we really don't want to do is fragment the order
flow. Because when you fragment order flow, you lose sight of
what the best price is currently. And I think that is
important.
In terms of ECNs, for example, we hear a lot about ECNs. We
are not anti-ECN, we are pro-ECN. We receive a lot of order
flow from ECNs. ECNs look to us as a resource.
It is our job to be price competitive so they can access
our markets in a very cheap way.
There is one large ECN that is very famous that sends 90
percent of their listed business through us. They send it to us
because we do it so cheaply.
So, that is order flow that is competing with each other.
So, in answer to your question, I think that what we really
need to focus on is making sure that we have a centralized
market where orders compete with each other.
Mr. Joyce. Ms. Hart, if I could just elaborate a little
bit.
Ms. Hart. Sure.
Mr. Joyce. When you asked the question, I was
conceptualizing competing specialists on the floor of the New
York Stock Exchange.
You should be aware that the third market that NASDAQ
sponsors--in which we are actually a very large participant--we
do, for example, make markets in IBM and in AOL.
So, we, within the third market realm, under NASDAQ's
banner, we do make markets and listed equities that directly
compete with the specialist making markets on the floor of the
New York Stock Exchange.
So that competing specialist model, you could say,
currently does exist.
Ms. Hart. Just not on the floor.
Mr. Joyce. It is not within the floor, it is not intra, it
is inter.
Ms. Hart. It is inter. Okay.
Thank you.
I yield back.
Chairman Baker. Thank you, Ms. Hart.
Ranking Member Crowley?
Mr. Crowley. Ranking by default, I will accept. There are
many ways of obtaining positions of leadership.
Thank you all for your testimony today and for your
spending a better part of your day here.
I have been following this issue very closely, as probably
many of you know.
I had a couple of questions and I would also, if I can,
make some reference to the Wall Street Journal editorial that
appeared today.
Mr. McCooey, we have all heard reports questioning the
value of the specialist and whether they offer a value or not.
And as an agency broker executing trades on behalf of your
clients, do you feel a disadvantage by specialists? And do you
believe specialists add a value to you or to your clients or
not?
Mr. McCooey. I don't believe specialists disadvantage me at
all. In fact, it is the advantages of the specialist at the
point of sale, providing liquidity and acting as a catalyst
that allows me to get my business done on behalf of my
customers.
And let me elaborate a little bit on that.
When I talk about liquidity, what I mean, is when I have a
buy order coming in and finding that I have 25,000 shares to
buy, and there are only 15,000 shares residing on the
specialist book at the offer price, that the specialist will be
able to step in there and provide the liquidity: the other
10,000 shares that I need to complete my order; to be able to
be satisfy my customer at that price.
That is important when they put their capital up.
But even more important and really undisclosed to the
world, because they don't understand what dynamics sometimes
happen at the point of sale, is the fact that the specialist
acts as the catalyst in disseminating valuable information to
every party that comes into that trading crowd: who the buyers
and sellers are and have been, but even more than that, is able
to find the contra-side to my trade.
And what I mean contra-side, if I am a buyer, the
specialist will, instead of having me immediately trade with
the offer side of the market, would inform me that a brokerage
firm may have been a seller for the past hour, day, week.
And we can contact that brokerage firm very quickly; allow
them the opportunity to sell stock for their customer, a
natural seller, where natural buyer and seller are meeting in
the marketplace with very little market impact.
And we are able to get that trade consummated.
And I am using my digital and hand-held device at the point
of sale, communicating with my customer, telling them exactly
what I am doing. I am using my cellular telephone from the
point of sale; communicating with my customer.
And we were able to get that done for the benefit of my
client, as well as the for the benefit of the seller, who was
willing to sell stock at that price, but may have just
completed their sell order and may just be getting more stock
for sale and doesn't want to be disadvantaged by dislocation in
the market that may happen very quickly.
If I go in and the last sell is $49 and the liquidity is at
$49.25, I may not want to purchase that right away, but I want
to give my buyer the opportunity to do better. And that is what
we do each and every day.
And the specialist is an important part of that. And my
customers find his information and his liquidity very valuable
in the executing of my orders.
Mr. Crowley. Thank you.
Mr. LaBranche, in the evolution of the stock market, and
there has been a lot of discussion about the ECNs and their,
one day potentially, replacing the New York Stock Exchange as
we know it today in terms of human touch, in many respects, and
a lot of discussion about specialists being dinosaurs in this
evolutionary process.
Can you comment on that?
Mr. LaBranche. Well, I have been hearing that----
Mr. Crowley. You don't look like a dinosaur, but I----
Mr. LaBranche. Well, thanks.
But, I have been hearing that comment for a long time.
In fact, there was a very widespread discussion back in the
1970s about how the New York Stock Exchange only had a few
months left to go and seats went down to $35,000 back in 1978.
So when you think of it in those terms, you realize there
is always going to be challenges.
What the New York Stock Exchange needs to do is listen to
its customers, its constituencies. Make sure that the buy side,
for example, is getting their say of what they think needs to
be done; the sell side as well.
We need to integrate our system, take technology, ECNs,
other ATFs and incorporate them so they can access our pool
liquidity. And, I think, that is a very important concept.
A lot of people think of ECNs as crossing networks, but
they are communication networks, and they allow people to
communicate with pools of liquidity. And we are a very large
pool of liquidity.
So, to get back to where we were before: if we make those
transitions, if we are a resource to everybody that we can be,
we will be around for a long time.
If we just dig in and don't change, then that is going to
be a different question. But we don't have any intention of not
changing or listening to people and we are going to keep
changing to make sure that we are able to be a resource for
almost everybody.
Mr. Crowley. You are adapted to the evolution.
Mr. Chairman, I know my time is up, but can I just make a
comment about the editorial that you alluded to?
In the very next paragraph--and again, we are taking out of
context, some of these things--the editorial went on to say,
``Best price is only one of the many ways of best execution.
The issue of speed and best price, et cetera, and what
companies may be are looking for, what the professional trader
is looking for.''
But this experiment that is taking place, I know that
Chairman Donaldson, not once in his three hours of testimony
mentioned the success story that the Wall Street Journal is
alluding to.
And, I think if you ask my constituents and the investors
in your markets that are my constituents; I think if you ask
them, the bottom line is price to them. At the end of the day,
the retiree, the pensioner, wants to know that they are getting
the best price for what they are paying. And I think that is
the bottom line for our constituency.
I understand we have broader constituencies here in this
Committee, as well. And the industry is important to us. But
the bottom line is the investors.
And people who are making up more and more, a larger
portion, of the investment in your markets are the average mom
and pops that we represent.
So, I just wanted to make that point for the record.
And I thank you all for your testimony today.
Chairman Baker. Thank you, Mr. Crowley.
Just welcome, come back at it one more time, from the
perspective, not necessarily of just the editorial or news
article, ``Reference by Numbers.''
Maybe try just a different team this time, Mr. Nicoll. In
reading through your written testimony, it is pretty clear, at
least to me, that you believe that the current system does not
automatically result in the best price for the individual,
given the regulatory constraints which within the market must
now function.
You referenced the SEC trade-through rule suspension on the
three ETFs in 2002 and that the QQQ is now the single most
actively traded security in the entire U.S. marketplace as
evidence that it must somehow meet the needs of investors.
It seems, to me, that you should view the market, not as a
particular exchange or a group of premier exchanges, but the
entirety of every trading opportunity is the marketplace.
It also appears to me that there are rules or regulatory
constraints that keep information even from flowing but,
perhaps where it does flow, it may not be a requirement to act
on that information.
Am I reading your testimony correctly that your
presentation of the trade-through rule or some of the other
constraints, if they were, at least modified, if not entirely
eliminated, would facilitate trading at the best price as
opposed to what now is the consequence of trading under the
current regulatory body of rule?
Mr. Nicoll. I think that is exactly what we are saying.
And, what we are saying is, and we want to push back at
everybody that keeps repeating this mantra that the choice is
between speed and price.
When you choose not to avail yourself of what appears to be
the best price in an advertisement because you wonder whether
you will get to the store or you will get to the place where it
is advertised, whether or not you will actually get the best
price, but you may, perhaps, choose to buy the product at what
appears to nominally be a higher price someplace else.
Because of your ability to actually execute the
transaction, you are acting in your best interest and buying
the product at what you believe is the actual best price.
And what we are saying here is that the trade-through rule
requires that people go after the best advertised price and
leave behind what they know to be the best price. Our customers
are not intentionally trying to execute their orders through
our system at a worse price.
They believe that by executing an order for a penny less
than an advertised price on the New York Stock Exchange, that
they are, in fact, representing their customer's interest,
performing their fiduciary duties in accord with their best
execution responsibilities and doing their best job.
And, in fact, when they are precluded by regulation from
accessing the best price and are forced to chase what appears
to be the best price but what is, in fact, often not, they feel
that the regulations are out of date and don't serve their
needs as fiduciaries in performing their duties to get best
execution on behalf of their customers.
There isn't a trade-off between price and speed. Speed is
an element in evaluating what the best price is in a trade.
Chairman Baker. One other piece that I picked up out of
your written comment, with regard to definition of
fragmentation; as opposed to that being necessarily an adverse
market consequence, others might define it as more stringent
competition.
And that if we are looking for the free flow of information
so that all market participants meet the needs of their
customers in the most efficient and timely manner, but yet
required to pursue the highest price offered in the broader
market.
I think that is what I hear members saying, both sides of
the aisle, pro-New York Exchange, pro-ECN, whatever the deal
perspective might be, we all want one thing.
We want the market to function efficiently, we also want it
to function fairly and we also want to assure, that when
Customer X or Customer Y pursues an opportunity in the
marketplace, that they get the best terms available at the time
of that execution.
Now, if those are the precepts on which we all agree, then
we can do the critical analysis if the current system really
provides for that. And that, Mr. LaBranche, was the reason why
I brought up that article in the first place.
It appeared on the surface of the article. It was going at
the heart of the Exchange's line of defense, was that in most
cases, 94 percent, the individual gets the best price of
execution.
And it seems to me it ought to be a factual determination,
whether they do or whether they don't, we ought to be able to
get to the bottom of it, dig it out, and then ask the SEC to
come up with a plan that is responsive.
And I agree with Mr. Kanjorski, we don't want to put a
board, I think, governmental representative on every board in
America. I am a strong advocate of a whole lot less government
than what we pay for.
But I do believe that this discussion, today, and the
Committee's review of this, may help facilitate broader market
changes that, otherwise, may be very difficult to achieve.
And let me offer Mr. Crowley, or Ms. Hart, any further
comment?
And let me express my deep appreciation to each of you.
This has been a long day.
And I appreciate your patience in hanging in there and we
certainly will leave the record open for a few days if you have
further comments or recommendations to the Committee, we would
be most appreciative to receive them.
Thank you.
Our meeting is adjourned.
[Whereupon, at 2:26 p.m., the subcommittee was adjourned.]
A P P E N D I X
October 30, 2003
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