[Senate Hearing 108-828]
[From the U.S. Government Publishing Office]
S. Hrg. 108-828
THE FUTURE OF THE SECURITIES MARKETS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SECURITIES AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
ON
THE STRUCTURE OF THE U.S. EQUITIES MARKETS, WITH PARTICULAR REGARD TO
THEIR FAIRNESS AND EFFICIENCY
__________
OCTOBER 15, 2003
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /senate /senate05sh.html
______
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_____________________________________________________________________________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
______
Subcommittee on Securities and Investment
MICHAEL B. ENZI, Wyoming, Chairman
CHRISTOPHER J. DODD, Connecticut, Ranking Member
MIKE CRAPO, Idaho TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire JACK REED, Rhode Island
CHUCK HAGEL, Nebraska CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
ROBERT F. BENNETT, Utah DEBBIE STABENOW, Michigan
WAYNE ALLARD, Colorado JON S. CORZINE, New Jersey
RICK SANTORUM, Pennsylvania
Greg Dean, Staff Director
Alexander M. Sternhell, Democratic Staff Director
(ii)
C O N T E N T S
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WEDNESDAY, OCTOBER 15, 2003
Page
Opening statement of Senator Enzi................................ 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 3
Senator Bunning.............................................. 4
WITNESS
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission, accompanied by Annette L. Nazareth, Director,
Division of Market Regulation, U.S. Securities and Exchange
Commission..................................................... 5
Prepared statement........................................... 27
Response to written questions of:
Senator Hagel............................................ 32
Senator Johnson.......................................... 35
(iii)
THE FUTURE OF THE SECURITIES MARKETS
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WEDNESDAY, OCTOBER 15, 2003
U.S. Senate,
Subcommittee on Securities and Investments,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:10 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Michael B. Enzi (Chairman of
the Subcommittee) presiding.
OPENING STATEMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. I call to order the hearing on the future of
the securities market. This is the first hearing of the
Subcommittee on Securities and Investment. One of the reasons
it is the first hearing that we have held is that so many of
the hearings have been elevated to a Full Committee status, and
we have been pursuing a number of these things throughout the
year. In fact, Chairman Donaldson has been here several times
and testified. And in order for them to be able to do their
work, we hope that we can change that to maybe a once every 6
months thing instead of a weekly or monthly appearance here.
We do thank you for being here, and also for Annette
Nazareth, the Director of the Division of Market Regulation of
the SEC, for being here as well.
There is no doubt that the securities markets of the United
States are the best in the world. Over the years, our
competitive market system has brought the best of the floor-
based and electronic markets to the forefront. The laws that
are the underpinning of the structure of our securities market,
the Securities Exchange Act of 1934, and the provisions of the
Securities Acts Amendments of 1975 that created the national
market system, have held up fairly well in the face of constant
change. One of the things that has set our markets apart from
international markets has been our ability to foster innovation
and technology. Maintaining that competitive edge is an
absolute priority.
Several years ago, the securities market saw unprecedented
change. The bull market of the 1990's retreated, the arrival of
trading in decimals forever changed the markets, and then the
events of September 11 put tremendous stress on the system.
Then the accounting issues of a year-and-a-half ago added
stress and as a result, the system we have today appears to be
at a crossroads.
The Securities and Exchange Commission has recognized that
the changes in the market have caused issues of market
structure to become more complex and intertwined. In 2000, the
Commission created an Advisory Committee on Market Information.
In addition, it was exactly a year ago that Commissioner
Glassman chaired a series of Commission hearings on market
structure.
Just a few of the issues facing our markets include: One,
whether to update the Intermarket Trading System established by
the 1975 Act; two, whether to change the collection and
distribution of market data fees; and three, whether there
currently exists fair and equitable access to trading venues.
With respect to modernizing the Intermarket Trading System,
both traders on the floor-based and electronic markets have
concerns with the system and, in particular, with its trade-
through rule. When the Intermarket Trading System was
implemented in 1978, no one could have predicted the level and
speed of trading done today. Unfortunately, the national market
linkage that it was supposed to achieve has come to represent
the great divide between our competing market structures and
the diverse trading venues available to investors. Clearly,
fixing the system needs to be a priority.
With regard to market data fees, again, the system, as
originally intended, was to fairly and equitably collect and
distribute monies to facilitate the market data to investors
and to finance the regulation of the markets. Over the years,
the fees have been subject to a number of factors, including
being tied to incentives for trading platforms and to elements
to boost market shares.
While the underlying goal of the fees is to create market
data that is accurate, uniform, and available in real-time to
investors, the fees also must ensure a strong regulatory
environment. Today, I believe the system is not operating as it
was intended.
On a related matter, the access to and trading on the
various trading venues and markets also must be done in a fair
and equitable manner. Our current system has brought about
innovation and change to the market. However, as our markets
continue to evolve and mature, level playing fields are harder
to achieve. It has become even harder for market participants
to act in the best interests of their investors. Should all
fees and charges involved in a
securities purchase be fully taken into account toward the
price of securities, or should investors be given more
comprehensive information on how the markets perform prior to
placing an order are but two of the many questions that need to
be addressed to determine whether we have fair and equitable
markets.
In addition to these issues, we must also address whether
the self-regulatory structure that we rely upon for oversight
of the markets is in need of change. Recent events have shown
significant strains and weaknesses on that structure. I will be
interested to hear how the reforms that you implemented over
the summer are proceeding and what additional reforms will be
necessary.
With any review of the future of the securities markets, we
should take a look back to how our markets have evolved over
the past 20 or 30 years. The tremendous changes to the markets
are due, in large part, to how technology and innovation have
transformed not only the markets, but also our economy. For
example, the Nasdaq Stock Market was transformed by the
technology boom of Silicon Valley. As venture capitalists
invested money into the high-technology companies, they needed
a way to ``cash out'' their investments through initial public
offerings on Nasdaq. Today, the testaments to the high
technology market are household names. Today, not only are our
securities markets at a crossroads, but also our economy is at
a crossroads. Recently, numerous articles have appeared in the
news stating that many of the high technology jobs are being
transferred overseas. In addition, one article discussed how
many countries, including China, are spending lots of money to
create their own Silicon Valleys. While the U.S. initial public
offerings, IPO's, were at a standstill for the first 6 months
of this year. The Asian stock markets dominated the number of
IPO's.
Will overseas venture capitalists and investment bankers
transfer foreign securities markets to facilitate high
technology industries in a similar manner that happened with
Nasdaq? Time can only tell.
However, we must ensure that our securities market remain
the best in the world. In doing so, we must ensure that
technology and innovation are key to our evolving stock
markets. Currently, market participants are unwilling to invest
in infrastructure and technology without clear guidance from
the Securities and Exchange Commission of where the markets are
headed. If the securities markets are at a crossroads, then
they are looking to the SEC for guidance.
Chairman Donaldson, thank you again for being with us
today. I have to commend you for doing an excellent job in your
very short time on the Commission. There have been a lot of
issues vying for your attention during these past few months. I
also appreciate, Ms. Nazareth, the Director of the Division of
Market Regulation. We welcome both of you, and I look forward
to your testimony.
I will call on Senator Sarbanes for any comments.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Chairman Enzi. I
want to commend you and Senator Dodd on holding this morning's
hearing on the important subject of the structure of the
securities markets.
This subject inevitably raises important and complex
questions about market structure, among them what form should
self-regulation take; how can we assure fair access to the
securities markets; does an exchange need to provide time,
price, priority; what constitutes best execution of an
investor's stock order; and of course many others.
Because markets change over time in response to the needs
of investors and issuers, these questions recur. The answers
are not fixed in stone. Chairman Donaldson was quoted as saying
in The Wall Street Journal, markets experience ``operating
stresses and strains,'' similar to the experience of the
Chairman and those of us on the Committee, I might add.
[Laughter.]
It is, therefore, important for the Commission to resolve
these issues in a timely manner through rulemaking, ruling on
applications and working with self-regulatory organizations. It
falls to the Commission to adjust the regulation of the markets
to accommodate the legitimate needs of market participants,
while at the same time upholding its fundamental mandate to
assure the investor protection and market integrity mandated by
our securities laws.
I welcome SEC Chairman Donaldson and Ms. Nazareth before
the Committee. Chairman Donaldson returns to testify before the
Committee or one of its Subcommittees for the sixth time this
year and for the third time since the end of the summer recess.
This Committee and its Subcommittee hearings and Chairman
Donaldson's frequent appearance in them, underscore both the
central importance of the securities markets to the Nation's
economy and this Committee's concern that these markets operate
at the highest levels of transparency and efficiency.
Chairman Donaldson, I want to commend you for your
willingness to come before the Committee or its Subcommittees
repeatedly. I think it is a very important part of laying these
issues out for public discussion, and I think it contributes
markedly to enhancing the understanding of the Members of the
Congress, but also the members of the public on a range of
complex issues that are on the agenda of the SEC. We are
pleased to have you back before us today.
Thank you.
Senator Enzi. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman, for holding this
very important hearing. You picked a very important and timely
topic to which you hold your first Subcommittee meeting.
I would also like to thank Chairman Donaldson and Ms.
Nazareth for testifying today.
Our equity markets are the envy of the world. They have
obviously taken a beating and battering over the last few
years, but they are once again showing their resilience. Last
May, I had, in my Subcommittee, a hearing on economic policy,
increasing investment in the equity markets. Since that
hearing, the Dow has gone up 1,200 points----
[Laughter.]
--the Nasdaq 435 points. Now, there may have been a tax
bill that was passed that day, also. That may deserve some of
the credit for the rebound in the markets, but that is okay. I
can share the credit with the President.
Senator Sarbanes. We urge you to hold another hearing as
soon as you can.
[Laughter.]
Senator Bunning. Though the markets are looking stronger,
there can be improvement. I worked in the security industry for
25 years, so market issues have a special place in my heart.
There are many issues confronting the markets today--overall
structure, fragmentation, hedge funds, the impact of
decimalization, and we have to worry about market manipulations
and fraud.
I am very interested in hearing what you have to say about
the issue confronting our markets. It is no secret that there
has been a lot of turmoil at the SEC over the last couple of
years. It is my hope you will bring needed stability there. Our
markets need that stability.
Once again, Chairman Enzi, thank you for holding this
important and timely hearing and thanks to our witnesses for
their testimony today.
Senator Enzi. Any other statements?
[No response.]
If not, again, we thank you for coming, and I would mention
that of course when we do the full Committee hearings, those
are the ones where we get into concepts. When we get to
Subcommittee, we get into technicalities. So this may be as
easily understood as some of the accounting hearings that we
had last year.
[Laughter.]
But it is the technicalities that make the difference, and
so we do appreciate your being here to provide the testimony
that we can delve into and figure out what we, as Members of
Congress, need to do to aid you in your work.
Again, we thank you for coming.
You may begin Chairman Donaldson.
STATEMENT OF WILLIAM H. DONALDSON, CHAIRMAN
ACCOMPANIED BY ANNETTE L. NAZARETH
DIRECTOR, DIVISION OF MARKET REGULATION
U.S. SECURITIES AND EXCHANGE COMMISSION
Chairman Donaldson. Thank you, and good morning, Chairman
Enzi, and Ranking Member Dodd, and Members of the Subcommittee.
I am delighted to be here to discuss some of the significant
market structure issues that we are facing in the U.S. equities
market today.
In the coming months, the Commission will be focusing with
increased intensity on the structure of the U.S. equities
markets, with particular regard to their fairness and
efficiency. As you know, Congress formally directed the
Commission to address market structure when it enacted the
Securities Acts 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
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 markets. 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
improvements in execution quality and to reduce trading costs
in order to attract order flow away from other market centers.
The 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, this very efficiency,
arising from technological and other market developments, has
put strains on existing national market structures. One
significant change has been the proliferation of new electronic
markets, such as the ECN's, that offer fast executions and have
spurred competition among market centers, but at the same time
have 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 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, has narrowed spreads and
enhanced the efficiency of the price discovery process, but at
the same time reduced the liquidity available at each price
point and 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.
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 has 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. 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 four key
areas of the Commission's market structure initiative: First,
access to markets; second, market data; third, the whole self-
regulatory model; and, four, the nature of a securities
exchange.
Access to markets and 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 highlighted
the issue of intermarket access. Rather than obtaining access
through ``hard'' linkages directly between markets, in a 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 will be evaluating this
decentralized access approach to determine whether, as a
practical matter, it would be an appropriate model for the
national market system and thus 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 part of our examination of intermarket
linkages, we also intend to reassess 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 and for those
customers who desire the best price on their orders.
Market data. An additional market structure challenge
facing the Commission involves the collection and reporting of
trading information and 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 ECN's
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 method of
distributing market data revenue as we know it creates
appropriate economic incentives and whether it furthers the
goal of rewarding markets that make valuable contributions to
the market data being disseminated.
Third, the self-regulatory model. Another matter of great
importance is the effectiveness of the self-regulatory system
of securities markets. The principle of self-regulation is
based on the idea that regulation can best be done as close as
possible to the regulated activity. However, an SRO that
operates a market has an inherent conflict of interest between
its roles 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 SRO's
is to ensure that as the securities markets grow more
competitive, the SRO's continue to dedicate their energies and
resources to surveillance and enforcement. We also must prevent
fragmentation of trading from creating gaps in SRO oversight of
these markets.
As part of our review of the self-regulatory structure, I
believe the Commission must thoroughly review the SRO's
governance practices. Recent events at the New York Stock
Exchange point to the need for this review. SRO's play a
critical role as standard setters for sound governance
practices. Just as SRO's have demanded that their listed
companies strengthen their governance practices, we must demand
that, at a minimum, SRO's match the standards that they set for
listed companies. There are several topics that merit our
consideration, including board composition, independence of
directors, and independence and function of key board
committees, the transparency of the SRO's decisionmaking
process, and the diligence and competence required of board and
committee members and ensuring their focus on the adequacy of
regulation.
Exchange criteria. The last topic that 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 the better-price 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
the 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 exchange
registration. One issue is customer expectations. I suspect the
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
intramarket 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 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 may shape the
national market system for years to come. I look forward to
continued input from this Subcommittee on these important
matters.
Thanks again for inviting me to speak on behalf of the
Commission. I would be happy to answer any questions or hear
any observations.
Thanks very much.
Senator Enzi. Thank you, and I appreciate your taking a
very complex subject and making it relatively simple.
We are going to be interrupted by a vote. I believe it is a
stacked vote of two. I think that we should be able to get
through one round of questions before the lights show up for
the half-time of the vote, and at that time we can go vote on
two issues and then come back and continue with rounds of
questioning.
To begin the questioning, in 1975, Congress passed
legislation that established the national market system that
led to the creation of the Intermarket Trading System in 1978,
and the governance of that system requires there has to be a
unanimous vote of the system's participants before any changes
can be made to the system.
Currently, it appears that there is not an agreement by all
of the participants on how to amend the trade-through rule.
There is precedent of the SEC stepping in to fix the system
when not all of the parties agree. Will the SEC step in to
solve the trade-through problem?
Chairman Donaldson. Well, as I intimated in my formal
testimony, the issue of trade-through is a considerable one,
and it has to do, essentially with the different desires of
investors, and let me try and elaborate on that.
You have, as a result of the nanosecond capability of some
of the electronic markets, the ability to transact a
transaction in a nanosecond--so fast you can hardly see it with
your naked eye. And at the same time, we have had
decimalization of the spread, so that now we have a penny
difference, if you will, in markets, and price improvement
represents a penny improvement. So that we have created a new
desire, on the part of many investors, to give up the
opportunity for price improvement of only a penny in order to
achieve immediacy of execution and surety of execution.
And that is in contrast to some of our more particular
markets, and in particular the New York Stock Exchange, where
the guarantee of the best price requires a period of time to
search for that best price. And although that period of time
seems pretty fast, in terms of the current situation; for
example, 30 seconds or so, 30 seconds is an eternity for
somebody who trades in nanoseconds, and that is the problem.
And what you have seen is a strain on our trade-through
regulations, where people are willing to ``accept a less good
price'' to trade through a better bid in order to get immediacy
of action.
Senator Enzi. You think the Intermarket Trading System
needs to be completely overhauled?
Chairman Donaldson. Well, I think there needs to be a
reexamination of the trade-through rules. I think we need to
try and see if we cannot get a compromise between what I have
just been talking about. There are many different ways of
achieving that. Customers or clients could formally opt out of
seeking best execution and, in so doing, allow brokers to deal
in the faster market. There are a number of things that can be
done.
You might want to add to that, Annette.
Ms. Nazareth. Yes. I agree with everything you said. I
think, in response to the issue, the Commission, as you alluded
to, would probably have to take some action because, as you
said, the governance rules require unanimity, and it certainly
would be in keeping with what the Commission has done in the
past to step in when the markets cannot agree on a solution.
Senator Enzi. It has been argued that there is not enough
enforcement of that trade-through rule. For example, some
market participants believe offers to purchase securities
through the Intermarket Trading System are posted without the
intent of execution. A good indicator of this is when a posted
quote fades away, when the 30-second time limit to accept an
offer expires, how do the SEC and the self-regulatory
organizations police for market participants an attempt to
manipulate the market in this manner?
Chairman Donaldson. This is again one aspect of changes
that we are in the process of examining. I think the unanimity
rule, I did not answer your question directly, but that is
something we are going to have to take a good hard look at.
I think we are also going to have to take a good hard look
at the ability to monitor trade-through after we come up with
an approach to allowing perhaps some modification of the trade-
through rules.
Senator Enzi. My time has expired. I will do another
follow-up in writing on that one.
Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
The market structure issues you have discussed, and
contained in your statement, are complex. They obviously
require significant staff expertise to resolve. My first
question is whether the division of market regulation has been
given the additional staff to handle these new issues.
Chairman Donaldson. We have been through a rather intensive
process of evaluating where our additional hiring capability
should, how that should be divided between the various
competing divisions within the SEC. I believe that we have
allocated adequate resources to the market regulation, but let
me ask the Director of Market Regulation whether she agrees
with that.
Ms. Nazareth. Absolutely. Yes. We have been allocated a
substantial number of additional positions that we are in the
process of filling in order to meet the additional needs in the
Division.
Senator Sarbanes. Do you think the resources you are being
given are adequate to your tasks?
Ms. Nazareth. Yes, I do.
Senator Sarbanes. We will hold you to that.
The Wall Street Journal, Chairman Donaldson, on September
26--I am going to quote them a little at length--they talked
about Mr. Reed coming back to the United States to take on his
job.
He is dumping a draft report of corporate governance
changes prepared by the New York Stock Exchange board for the
SEC in favor of a new review that promises to recommend tougher
changes.
One of the main issues being reviewed, according to people
with knowledge of the matter, is whether issues such as pay,
corporate governance, and audits should be reviewed by board
committees, as they now are, or by the full New York Stock
Exchange board.
A number of broader issues facing the big board remain on
the table, among them, whether to split the chairman and CEO
posts, whether to split off the New York Stock Exchange's
regulatory function, and whether to issue shares to the public.
The scandal also has intensified the debate over whether
the New York Stock Exchange can continue as a human-dominated
system after most exchanges around the world have replaced
people with matchmaking software.
Is the Commission examining all of these issues that I just
referenced in the course of its oversight over the New York
Stock Exchange and what is your view of these issues and how
they should be resolved?
Chairman Donaldson. Let me begin by saying that, yes, we
are very much concerned with the governance structure of the
New York Stock Exchange. I wrote the then Chairman of the Stock
Exchange a number of months ago--I think in March I believe of
this year--asking him and, I might add, the heads of all of the
other exchanges to report to us on the governance structure of
their exchanges, to report to the SEC on the many issues
involved that you just brought up that fall in the general
category of governance issues: Salary setting, how new
directors are elected, basically how the place is run, from a
corporate governance point of view.
If you fast forward now to the time that we are in, John
Reed, and then if I can put my comments specifically to the New
York Stock Exchange, John Reed has, in a public-spirited way,
agreed to come out of retirement and come back to the New York
Stock Exchange in an acting role as a chief executive to
spearhead a thorough examination of the corporate governance
structure.
We are in touch with Chairman Reed. We want to be of
whatever help we can. However, at the first instance here, the
responsibility for the governance structure of the New York
Stock Exchange remains with the New York Stock Exchange. We
have an oversight responsibility. We will exercise that
oversight, but the first step here is for the Stock Exchange
itself to come up with whatever revisions they believe is
necessary in light of current circumstances.
Senator Sarbanes. I take it that means that the last step,
if necessary, though, is with the Securities and Exchange
Commission.
Chairman Donaldson. The last step will be the approval of
the governance structure by the SEC.
Now, you bring up a most important issue here which has to
do with not only the structure of the governance, but also the
definitions of independence that apply to that structure, what
is a truly independent director, can it be a member of the
securities industry, can it be a sitting executive of a listed
company, are these independent directors or are they not? Are
they true public directors?
The second issue is of course the structure of how that
board is elected, the structure of the nominating committee,
the compensation committee, the audit committee, all of these
things which pertain particularly to the New York Stock
Exchange, but also pertain to companies listed on the New York
Stock Exchange.
That raises some additional issues that you have touched
on, which has to do with the self-regulatory function of the
exchange. And, again, if I can oversimplify this, it seems as
though there are two main functions that a stock exchange
market like the New York Stock Exchange has.
One is the market itself, a competitive entity which is
competing with other market centers, and with ECN's, and with
broker dealers, and so forth; and the second is the regulatory
function that is there to make sure that the dictates or
competitive nature of the marketplace does not act to the
detriment of public investors, both institutional and
individual.
And I think the issue confronting the New York Stock
Exchange now and confronting Mr. Reed's efforts here are what a
structure can you come up with that, in effect, separates that
regulatory responsibility so that it does not get mixed up with
the competitive aspects of running the marketplace.
I would suggest that there are a number of different ways
of doing that, ranging all of the way from reporting structures
within the exchange framework that separate out a reporting
line for regulation that reports to a newly defined,
independent board, all of the way to taking regulation totally
away from the self-regulatory organization and putting it out
in space somewhere as a separate organization.
And this is an interesting issue. I think that traditional
thought has been that the regulation should be as close to the
marketplace as it can be and be effected by people who are
familiar with the marketplace, as opposed to some disengaged
bureaucracy. But I think that is the issue now that faces John
Reed and faces the board of directors of the Stock Exchange.
Senator Enzi. Senator Bunning.
Senator Bunning. Thank you. I have three questions. I am
going to ask one and submit two because we are on a--we have
got 10 minutes on a vote, and we have a 7-minute vote to
follow.
The first question I would like to ask, because of all of
the turmoil over at the SEC for the last few years, I am
concerned with the length of time it takes for an application
to be approved or disapproved. Do you agree that 2-plus years
is too long for an application decision, and are you doing
anything to speed up the process?
Chairman Donaldson. Well, I think, if you are referring to
an application such as the Nasdaq application to become a
market, if that is the----
Senator Bunning. That type of application or any other
applications that are submitted to the Securities and Exchange
Commission.
Chairman Donaldson. Yes. This is an extremely complex
subject. It is not just----
Senator Bunning. I understand that, sir. I am just asking
you over a period of 2 years seems to be plenty of time to make
a decision, even though it is complex.
Chairman Donaldson. I believe that the fact of the matter
is that the application by Nasdaq to become a market, to become
a stock exchange brings with it implications for the entire
market structure system. It is not a simple decision for them
alone; it is a decision that has ramifications for the entire
rest of the marketplace.
Senator Bunning. I understand that.
Chairman Donaldson. And that is an issue that the SEC has
been faced with long before I got there, and it is not a matter
of somebody dragging their heels or the application in an out-
basket or an in-basket; it is a matter that has been before the
Commission. There have been all types of panels, and discussion
groups and so forth. It is a tough question, Senator.
Senator Bunning. I understand that, but 2 years is too
long.
So, therefore, the decision should be made and all of the
consequences of the decision should have been considered, and
whether you like the application or whether you do not like the
application or whether you think of the unintended consequences
that come from the decision. Obviously, we know that it is
complex. It would not take 2 years to make a decision if it
were not complex. But I think somebody deserves an answer.
Chairman Donaldson. Well, I agree with you in the sense
that a certain amount of time has passed. On the other hand,
the stakes are tremendous. If you step back from our market
system, with all its warts and pimples, the U.S. market system
is the best in the world, and it is functioning the best.
If we make a quick decision that has implication for the
whole rest of the marketplace, we run the risk of doing great
damage to our central market system. I want to assure you that
there is nothing that we are looking at now that has a higher
priority than the restructuring of the central market system.
We have the best minds that we have in the SEC working on it.
We are reaching out to everyone we can, and I see it as a top
priority item for my tenure as Chairman of the SEC.
I do not know whether you want to add to that. You have
been in the midst of this, Annette.
Ms. Nazareth. I have. I guess I would just add the point
that if we are to be faulted for anything, it is that we do not
say, no, we keep saying maybe. Let us see if we can get to a
yes answer, and that unfortunately takes some time. It is very
easy to say, no, but I can fully appreciate the----
Senator Bunning. Ms. Nazareth, what is ``some time''?
Ms. Nazareth. What is?
Senator Bunning. What is ``some time''? What are you
considering that ``some time'' is? Is it 2 years, 4 years, 6
years, 10 years?
Ms. Nazareth. I think it would be normally something quite
short of 2 years.
Senator Bunning. Something short of 4 years?
Ms. Nazareth. Of 2 years.
Senator Bunning. Of 2 years.
Ms. Nazareth. Normally, it would be.
Senator Bunning. Some applications are sitting there over 2
years.
Chairman Donaldson. The issue has not just been sitting
there, Senator. It has been worked on.
Senator Bunning. But it is still not resolved. That is the
whole question.
Chairman Donaldson. That is absolutely right, and we have
it as a priority item, and we are going to resolve it.
Senator Bunning. I can be assured of that, the next time I
come back, if I ask the same question?
Chairman Donaldson. No.
Senator Bunning. Will you say it is less than 2 years?
Chairman Donaldson. I will have to ask the Chairman when he
is going to ask me back again.
[Laughter.]
Senator Bunning. You will be back before the full Committee
before you get back to the Subcommittee.
Thank you very much, and I will submit the other two in
writing.
Chairman Donaldson. Thank you.
Senator Enzi. We are in a very fortunate situation. Senator
Dodd has already voted, so we will have Senator Sununu ask his
questions, and then we will allow Senator Dodd to continue the
hearing while we go vote.
Senator Sununu. Thank you, Mr. Chairman.
I only have easy questions.
Mr. Donaldson, is the role of the regulator, I heard you
use the phrase ``price improvement'' and ``price protection,''
and it put a question in my mind, which is, is the role of the
regulator to guarantee the best price or to ensure a fair and
transparent system that is free from conflicts of interest?
Chairman Donaldson. As I tried to say, rather
inarticulately, the definition of what the participant in a
marketplace wants is changing, and it used to be that best
price was a sine qua non of the market, that small investors
were guaranteed, alongside large institutional investors, that
they would get the best price. But as I said, I think that in
the age of electronic markets, the very rapid transaction
times, and the decimalization, the best price is not always, in
some people's minds, worth waiting for.
Senator Sununu. I understand that point that you made,
which is that different investors have different needs and
different wants----
Chairman Donaldson. Right.
Senator Sununu. --from the exchange or the broker or the
system that they are using to execute a trade. I understand
that. But my question is what is the job of the regulator? Is
your job to ensure the best price or is your job to ensure a
fair and open system, free of conflicts of interest? And I
think that is a very important distinction because I can go to
an auction for furniture or go to buy a rug at auction and that
auctioneer may be working very hard to give the seller of that
coffee table the ``best possible price'' in a way that involves
people planted in the audience or someone working against
bidders or ensuring that the price is bid up in a way that
participants in the auction do not necessarily know, and I
think this is an important distinction.
My sense would be that, as an investor, I simply want to
make sure that we have the fairest possible process, the best
possible transparency, and of course a system that is free from
conflicts of interest. And I respect the fact that you brought
up the issue of conflict of interest in discussing the role of
SRO's. So that is just a distinction that I want to make, and I
imagine, and I hope, does carry through in the work that the
SEC does.
Let me talk about a specific example, and then you can
elaborate, because I want to ask you a question not just ask
you to make conceptual comments, and that is with the auction
specialist process used by the NYSE.
I read some articles recently that threw out two numbers
that I found to be interesting. One is the trend toward or the
increase in trades that are made on the specialist account.
Now, a specialist is there to act as a buyer or seller of last
resort when a market does not exist for a particular trade, but
over recent years the number of trades made on specialist
accounts has gone from 8 to 15 percent, and maybe even a more
impressive number is that I think that it was over 70 percent
of the profits made by specialist firms are on trades made for
their own accounts.
I think those numbers are right. If they are not right,
please correct me, and what thoughts or comments do those evoke
from you?
Chairman Donaldson. Let me go to your first line of
questioning in terms of the role of the regulator. I think that
our role is to make sure that the price discovery process, if
you will, is free from conflict and is as efficient as it
possibly can be.
I think that our role also is to effect rules such that
even the smallest knows that he or she has made the decision to
forego, let us say, price improvement in order to get speed,
that cannot be a decision made for them. There have to be rules
and regulations that allow the individual investor to
understand exactly what the executing broker is doing with that
order within the context of fairness of the marketplace itself.
In terms of your statistics on the option exchanges and the
specialists, I am going to ask Annette to comment on that.
Ms. Nazareth. I think the numbers were in the range, but
your question really went to do we have issues with this or are
we looking at the----
Senator Sununu. Well, if a specialist is intended to be a
buyer or seller of last resort, what market rationale is there
for a dramatic, 100-percent increase--I suppose that is pretty
dramatic--dramatic increase in the number of trades being
executed on their accounts? Are there market phenomena to
explain this, and why would it be that the lion's share of
trading profits come from trades executed on their own
accounts, again, if you are acting as a market of last resort?
I thought that the question or the point was a pretty clear
one.
In this line, could you also talk a little bit about
internalization and maybe provide me--I have only heard of the
term recently--and provide a little bit of a description about
the phenomena and whether that is problematic for investors.
The question with specialists is no big surprise. It is one of
front-running and whether or not this is a problem, whether or
not it exists, and nobody is for that, but can you talk about
internalization and whether or not that raises any similar
concerns about conflict of interests.
Chairman Donaldson. Go ahead.
Ms. Nazareth. I will go back for a minute to the
specialists. I mean, as you know, it is widely publicized that
we are looking, as is the New York Stock Exchange, at certain
issues in the specialist system, including how they satisfied
their affirmative and negative obligations. Obviously, to the
extent that there are any issues there, they will be addressed.
And the statistics that you point out do raise questions about
whether or not they needed to be stepping into the in-between
orders or interpositioning in situations where two customer
orders could meet. So, I can assure you that, to the extent
there are issues there, they will be acted upon.
In internalization, as you know, the concern that we have
with internalization really goes again to whether or not it has
some negative affect on the price formation process. To the
extent that many believe that the best way to achieve the most
efficient price is to have the most order interaction in a
single venue with the most, the greatest number of orders
competing on the basis of price.
When you have internalization, you have taken a whole
subset of those orders out of the equation and, as you know,
what they do is they mimic the price that was set in the more
price formation venue.
Senator Sununu. Does that suggest that your rulemaking or
approval or disapproval of rule changes would tend to favor the
elimination of internalization or a movement away from allowing
that to happen?
Chairman Donaldson. Are you referring now to options
exchanges?
Senator Sununu. Yes, that is where it has, again, been in
the news most recently, having to do with the options exchanges
and whether or not this is a good practice, a positive
practice.
Chairman Donaldson. I think that the competition that we
are looking for between natural buyers and sellers, in terms of
price discovery, can be severely impeded, if you will, by
internalization, where, in fact, orders are put together inside
a particular entity, firm, whatever, and are not exposed to the
general interests in those orders outside. And taken to its
extreme, you would have a less-efficient price discovery
mechanism. You would have orders that have had a fence put
around them and can only deal inside a firm, as opposed to
orders that rightly need to be exposed to outside the firm to
the broad market.
Senator Sununu. Now, how is that any different,
conceptually, than a specialist providing price improvement in
front of a book of limit orders?
Chairman Donaldson. Again, this gets to the price
improvement is part and parcel of a marketplace that exposes
the orders to the general market, as opposed to exposing those
orders just to a limited part of the market. You are depending,
in a fractionalized situation, on the price discovery coming
from only a fraction of the marketplace, a limited part of the
marketplace. This is not true in terms of the way that a pure
auction market works.
Ms. Nazareth. I think you are, if I gather what your point
is, your point is that if the specialist does not act in a
manner consistent with the way the affirmative and negative
obligations of the rules work, then what the specialist is
doing is akin to an internalizer who--I understand that point.
Senator Sununu. That is correct.
Ms. Nazareth. Yes, I understand the point. That is why the
rules prohibit that activity.
Senator Sununu. Thank you very much.
Thank you, Mr. Chairman.
Senator Dodd. [Presiding.] Thank you very much, Senator
Sununu. Excellent questions.
And I apologize to both of you for not being here at the
outset of your testimony. I was unavoidably absent. I will take
just a few minutes before the next vote occurs to raise a
couple of questions, if I may. I thank Senator Enzi for
allowing me to chair the Subcommittee for a few minutes. If I
look around, I might get away with some things here.
[Laughter.]
Anyway, just a couple of questions. First of all, let me
thank both of you. Ms. Nazareth, it is good to have you here.
The last time I was looking at you I think I saw you sitting in
the seat behind the witness we had.
Ms. Nazareth. That is right.
Senator Dodd. So it is a pleasure to have you sitting at
the witness table with us.
Mr. Chairman, I have said, on numerous occasions, that I
think we are very fortunate to have you in charge of the SEC.
You and I have known each other a long time, and I am very
confident you are going to do a very fine job.
A couple of questions come to mind. If these have been
raised, by the way, some of my colleagues have already brought
this up, stop me immediately, and I will go onto another
question. I am not aware of all of the questions that have been
raised, and not having been here to hear them, I do not want to
be duplicative.
I do not know if the issue of decimalization has been
raised with you this morning. Has that been raised?
Chairman Donaldson. Only tangentially.
Senator Dodd. Well, I am interested, if you might, just
give us a few questions I have associated with the issue.
Obviously, this was a big change and a lot of anticipation
about what the change and decimal pricing how it would change
the environment and the structure of our markets, and I wonder
if you might just give us some sense of what the anticipated
benefits have been. Have they been realized, such as price
improvement and the declining affect on spreads? Does it also
change the necessity to change rules, any rules changes or
regulations? And is there an appropriate minimum decimal
pricing increment that you think might be necessary?
And the last question I maybe should have raised first, and
that is has liquidity been reduced as a result of the increase
in the number of price points here?
Senator Dodd. Decimalization has resulted, at least insofar
as the markets are operating today, basically, with a
proliferation of price points, it has obscured in a way the
true size of the market. In other words, the amount of shares
offered at a particular point are not necessarily reflective of
the amount of shares offered or bid for at points only pennies
away from that.
Senator Dodd. Right.
Chairman Donaldson. So you have a proliferation of price
points.
In addition to that, because of some of the arrangements in
some of the markets, you have the threat of an explosion of
price points if we get into subpenny decimalization, and that
is why we have real trouble with subpenny decimalization.
In terms of the impact on the market, there are lots of
different judgments on this emanating from academic
institutions and so forth. I think it is clear that the
individual investor has been advantaged, if you will, in terms
of the efficiency of the marketplace and the functional cost of
doing business. I think it is equally clear that perhaps some
of the institutions are paying more. And then if you consider
an institution to be an amalgamation of individuals, if you
follow that through, individual holders of institutional funds
have been disadvantaged.
I think that there is some feeling that the depth of the
markets has eroded, particularly in thinly traded stocks, where
the profit motive, if you will, for the dealer, the profit
potential for the dealer is less, and therefore the liquidity
in that market is not what it used to be.
Senator Dodd. Yes.
Chairman Donaldson. But those are all things that we are
trying to get more information on and trying to make judgments
on. We read everything that is written and then try and make
judgments on it, but those are at least a partial answer to the
question you asked.
Senator Dodd. Let me, because you have raised, ask two
quick questions: One, are you anticipating any rule or
regulation changes to address some of these questions? For
instance, you have identified what I think is a very legitimate
point, and that is the minimum increment in the fractions. So
is there some idea here to set a minimum? That seems to be what
you are saying.
Chairman Donaldson. If you are talking about going back to
eighths, and quarters, and halves, and so forth, I do not think
so, Senator. I think that we are past that point. I think in
terms of subdeci-
malization, if you will, I, personally--and I do not speak for
the Commission, but speaking personally--I hope we can avoid
that because I think it will just cause an impossible not only
computer capability, but also an impossible marketplace if we
are dealing in subpennies.
Senator Dodd. And the issue of rules and regulations of
this at all, other than just conversation at this point or is
there any anticipation of changes necessary in the market
structure?
Chairman Donaldson. No, we had a brief discussion here
about exactly what the Commission is doing, and what we are
seeking to do is--you push this thing in one place, and it pops
out in another place, and we are trying to look at the whole.
Senator Dodd. Sure.
Chairman Donaldson. And we are trying to come up with some
rules and regulations that look at the whole structure, and
this is a top priority for the Commission. It is a complex
subject, but we are going to do something about it.
Senator Dodd. Let me jump--I gather Senator Sarbanes may
have raised some points here regarding the review of the SRO
structures, the functions of the New York Stock Exchange, but
also the functions of both Nasdaq and NASD.
In your testimony, I gather here, you reference the
numerous concerns about obviously the conflicts of interest,
governance, excessive compensation and the like, and I know
that you have responded in part, anyway, to Senator Sarbanes
about the SEC's role in the SRO review.
I wonder if you might give us some sense of timing with
regard to Nasdaq and NASD, where they are in some stage of
separating ownership and governance questions there, and I
wonder if you can tell us what the time line for the completion
of the complete separation would be.
Chairman Donaldson. Are you referring to the governance and
regulatory aspects of just Nasdaq or the New York Stock
Exchange or the other exchanges?
Senator Dodd. Just Nasdaq.
Chairman Donaldson. Just Nasdaq, yes. Well, the resolution
of the Nasdaq application to be treated as an exchange depends
upon the impact that recognition would have on other parts of
the marketplace.
As you know, each of the registered exchanges have priority
rules, and they are designed to promote order interaction. If
the Commission were to approve the Nasdaq application, as it
has been proposed, it would have to likewise permit other
exchanges to abandon priority rules, and thus the Nasdaq
application raises profound market structure issues that could
have implications for all of our registered exchanges and
ultimately the investors in the markets.
I could go through a whole list of other aspects of the
Nasdaq application which have profound implications for the
rest of the marketplace, and I would simply say that we are
trying to treat the Nasdaq application--it has not been
shelved, and gathering dust and so forth--within the context of
our overall market structure review.
And when you were not in the room, I said, and I will say
again, that we have market structure as the resolution of this
very high on our agenda, on our front burner, and I do not want
to put a specific time frame on it, but we recognize that some
final decisions must be made here. But we recognize that if we
make the wrong decisions and are precipitous and haven't tried
to anticipate the unanticipated consequences, we could do
severe damage to the whole system.
Senator Dodd. I think we all understand that because not
making a decision either has consequences, too.
Chairman Donaldson. Well, we are working on it.
Senator Dodd. You will be back before the Committee, and I
presume that this is a good answer you have right now of
dealing with the whole, but there is going to come a point when
people are going to want some answers on how these things, the
time lines and so forth are going to be there. So, I am not
telling you something you do not know.
Let me jump, last, to one other point I would like to raise
with you. In your prepared statement, you stated that the rise
of ECN's had exacerbated concerns, ``a number of concerns and
issues including the feasibility of integrating different
market models into the national market system.''
Now, it is not entirely clear to me from the statement
whether you believe that the existence of more than one market
model is a source of concern, something which would be
surprising to some of us, in a way, given our market's long
history of innovation and advance or whether you see the
concern as the current framework for integrating those
different models, in a sense, following the response, again,
trying to be more cautious and careful about how this all
works.
I wonder if you might offer us a little clarification on
which of those two points should I take as the reason for your
statement.
Chairman Donaldson. Well, we believe very strongly in the
innovation inherent in the many different market models that
have come into being, the electronic markets, et cetera.
I think what we are seeking here is an ability for all of
these different models to operate together in a national system
that allows for efficient price discovery and allows for the
individual investor and the large investor to operate side-by-
side, allows for transparency, and allows for the efficiency
inherent in true price discovery. I believe we encourage the
innovation of these new models and the new electronic markets,
but we want to be very careful, that they are not operating to
the detriment of those principles I just talked about.
Senator Dodd. Yes.
Chairman Donaldson. If they act to increase internalization
and fragmentation, that is not so good. If they act to somehow
deprive a customer or client of price improvement that that
customer wants, that is not so good either.
So we are trying to find a way to get a compatibility
between the, to put it in superficial terms, the ``fast'' and
``slow'' markets.
Senator Dodd. I do not disagree with that. I do not think
anyone on this side of the dais would at all either.
Obviously, there are some wonderful opportunities as well
emerging with the technologies to be provided, and we do not
want to miss the opportunity to provide the consumer with a
heightened degree of confidence, which is critical in this
area, but also recognizing what the consumer needs today in
light of the tremendous pressures they are under as well and
looking for efficiencies in these systems.
So, I would be very interested to see how this progresses.
There has been a lot of hostility in the past, at least
perceived hostility, merely because it was almost a threat, a
business threat, and that is not a good reason, in my view. And
if that is all it is, then it has no place in this debate or
discussion.
If it is as you have described it, very legitimate reasons,
then obviously proceeding with caution is necessary. But there
is a growing concern that maybe there is more of the former and
less of the latter, in some people's minds, and we want to move
through this if we can.
It is getting harder and harder to explain to the consuming
public, the investing public, why we cannot move in this
direction, given our ability to innovate in so many other
areas, and given the fact that our markets have been so
innovative over the years.
That is one of the reasons the world still comes here and a
reason we have been able to generate as much wealth and
strength in our economy is because of innovation. So we are
still interested in pursuing those goals, keeping in mind the
points you have raised, which I think are very legitimate.
Chairman Donaldson. I think it is not to protect individual
business models, but rather to protect the investor. And I
think there are a number of characterizations out there that
are put forth by those who want to push their model, and there
is the glorification of immediacy in electronics and so forth--
--
Senator Dodd. I agree.
Chairman Donaldson. --which is very appealing. There is,
also, for us old-timers, if you will, when we see markets----
Senator Dodd. What are you talking about now? Speak for
yourself there.
[Laughter.]
Chairman Donaldson. Not ``us'' old-timers, sorry. But there
are periods of stress where we sometimes are glad to have human
beings putting together trades in periods when there is stress,
and I think it is too easy to just discount that completely in
terms of the speed of electronics.
Senator Dodd. I do not disagree, and I feel the same,
whether that is because we both have gray hair or not, I do not
know. I certainly am conscious of those points. But I also
understand there are a lot of other things that can urge to do
as well, that there is wonderful ability to innovate so
effectively here that we can really make some wonderful changes
in the system, in the models.
Anyway, I see we have been joined once again by my good
friend and colleague from New Hampshire. I did not intend--
obviously, I can see you have your coat off. You thought you
were going to get out of here. I do not think you are yet, Mr.
Chairman.
Senator Sununu. I do have a couple more questions.
Senator Dodd. There you go.
Senator Sununu. Unless you wanted to pursue your tough line
that you had there.
Senator Dodd. No, no. We have covered--there are some other
questions here, but let me ask the Senator from New Hampshire
to proceed.
Senator Sununu. I just wanted to take a couple of minutes
to finish the line of questioning or the discussion we were
having. You indicated that you did not feel that
internalization was a positive thing for investors with regard
to options markets. My question is are there existing options
markets that allow this process and procedure? How commonplace
is it among the existing options exchanges?
Chairman Donaldson. Let me turn to our options expert here.
Ms. Nazareth. It is probably much more prevalent than you
would imagine.
Senator Sununu. Is it allowed? Are there options
exchanges----
Ms. Nazareth. It is a question of how it functions. If a
firm is bringing its own orders to the floor and is trading
against those orders as the market maker on the floor and
others are not participating in the trade, that is akin to
internalization, and that goes on a fair amount even in our
floor-based options markets today.
So it is not a notion that is foreign to our existing
options markets.
Senator Sununu. I believe former SEC Chairman Pitt had
raised this issue with a number of options. It said that he
wrote to the other exchanges and requested they eliminate rules
that guarantee members a portion of internalized orders. Has
any progress been made on this request? Is this something that
you are still pursuing?
Ms. Nazareth. We are working on a concept release on
internalization in the options markets that the staff is hoping
to bring to the Commission within the next several weeks. So we
are following up on the issues that were raised by Chairman
Pitt at the end of his tenure.
I should also point out that even embedded today in the
options markets' rules, order entry firms can basically cross
40 percent. They can keep 40 percent of the orders that are
above 50 contracts. So there are notions of internalization
currently embedded in, some notion, some amount of it. It does
not encourage full-blown internalization, but 40 percent, being
able to get a guarantee of 40 percent of the order flow that
you bring to the floor is a form of internalization.
Senator Sununu. When the staff brings forward this concept
paper, does it become public at that time?
Ms. Nazareth. Yes.
Senator Sununu. Excellent.
With regard to self-regulation, and in particular the
governance structure between the trading entity and the
regulatory entity, there has been some discussion and I suppose
there may be some markets that are actually engaging in
outsourcing of their regulation. I think this nice article with
the Chairman's picture in it that I showed him earlier, I think
that the Nasdaq is heading in this direction; that their long-
term goal is to have a formal break and then to contract, the
exchange to contract with the NASD--that is not an exchange, I
know--but for them to contract with the NASD. So it would be
effectively outsourcing their regulation.
My question is, is this a good trend? The concept or the
idea of outsourcing regulation where you engage with or
contract with a separate entity or separate party to enforce
regulation?
Chairman Donaldson. Well, I think it is an interesting
concept. I do not think it is the only concept, in terms of
this clash, if you will, between regulatory responsibility and
the responsibility for running a profitable market business.
There are, taken to its extreme, you could have a total
outsourcing of all regulation in an outsourced regulatory body
that would be a junior varsity SEC or you could take it all of
the way to the SEC if you want to. I mean, that is one extreme,
and I think that the bureaucratic aspects of that, and the
expense of doing that, would not be in the best interests of
keeping up with fast-paced markets. I think that bureaucracy
could not move fast enough, and I think that the original
concept of the self-regulatory organization or the delegation
of that responsibility to the market centers was a good
decision.
Now, I think we have to, in light of all that has gone on,
I think we have to examine whether there is not, are not other
ways of getting that regulation more independent, without
destroying the efficiency of having it close to the marketplace
itself. And this is, I think, one of the things that the New
York Stock Exchange is facing right now, and I think there are
a number of different models.
I would not say that the Nasdaq model is, it is fine for
Nasdaq, but it is not the only model.
Senator Sununu. Thank you.
Thank you very much, Senator Dodd.
Senator Dodd. Thank you, Senator.
I just wanted to ask a few more questions. I do not know if
enough time has elapsed to allow you to answer this question. I
would like to raise it with you anyway, and it has to go to the
issue that has been discussed, in broad terms. Over the last
number of months since the accounting scandals of Enron and
WorldCom and the worry that was raised, investor confidence. I
am wondering if there has been any assessment that the SEC has
been able to make about market volume and liquidity that you
have been able to detect, decline as a result of the accounting
scandals.
Also, the concern was raised that we might find, in fact,
investors moving off-shore or off-shore investors not coming
here. Have we seen any benefit accrue to foreign exchanges
because of any perceived loss of confidence in the U.S.
markets?
And, last, just the related, which would obviously be part
of your answer, I suspect, and that is whether or not the
market structures are operating efficiently enough to allow us
to maintain the global leadership we have historically prior to
these set of incidents.
Chairman Donaldson. To answer your last question first, we
do not see any movement off-shore in order to deal in better
regulated markets or to deal in markets that investors would
want to be operating in. As a matter of fact, the volumes that
are being done here in the United States continue to increase.
I think the ability of our markets to be competitive with
the rest of the world is again, in the biggest picture, a
trade-off between regulation that those who are regulated want
to deal in a market that is regulated, and that regulation
tends to inhibit, if you will, in certain instances, but people
are willing to accept that because of the positive aspects of
it.
And I think that, to date, if you ask most investors,
institutional and individual, they still have considerable
faith in our marketplace.
The confidence aspect that you are talking about, I think
we are making some considerable strides through the Sarbanes-
Oxley formation of PCAOB and the new standards in investigation
and so forth.
I think we are also making some progress, although it is
slow, in terms of reconciliation of foreign accounting schemes,
with our own accounting schemes, working toward an
international scheme, although that is going to be a while in
coming.
I think that my judgment is that the combination of all of
the things that are going on now, in terms of the independence
of audit committees and the restructuring of the responsibility
of a corporate entity, I think that is having is effect. I
think directors are paying more attention than ever.
Senator Dodd. Certainly.
Chairman Donaldson. I think confidence will slowly come
back, but unfortunately there continue to be evidences of
malfeasance, and rulebreaking, and so forth that undermine that
concurrently with it.
Senator Dodd. But in the meantime, we have not discerned
any shift.
Chairman Donaldson. I do not think so. No, I do not think
so.
Senator Dodd. Thank you.
John, anything else?
Senator Sununu. No. Thank you.
Senator Dodd. Well, listen, I thank both of you very, very
much. Obviously, we will stay very much in touch with you.
Chairman Enzi, I know, feels as I do. We need to stay in close
contact with you to see how things are progressing.
Chairman Donaldson. Thank you.
Senator Dodd. We are just recessing the hearing. Thank you.
[Recess.]
Senator Enzi. [Presiding.] I thank everybody for their
patience. The 15-minute vote took almost an hour, but we have
gotten the second one underway now, and I thank Senator Dodd
for voting early and keeping the hearing going.
To return to the questions, and I am not sure whether we
will have anyone else come back, but when we finish the round
of questions, we will leave the testimony open for a period of
10 days for submission of questions and to give you some time
to answer them.
Earlier this year, you sent letters to each of the self-
regulatory organizations requesting information concerning
their corporate governance practices. In response, several
SRO's initiated changes to their corporate governance
practices.
In light of the recent events at the New York Stock
Exchange, you stated that you will let Mr. Reed, as interim
Chairman, evaluate the New York Stock Exchange prior to the New
York Stock Exchange submitting changes to the SEC.
What I am interested in is will you move forward with the
other SRO's corporate governance reviews while you wait for the
New York Stock Exchange to complete its evaluation or will you
address all of the SRO corporate governance reviews at the same
time?
Chairman Donaldson. I believe it is a continuing process.
We have put out the original letter from me to the other
exchanges. We received responses from that. We asked them for
some more information subsequent to that. We have all of those
pieces of information under review right now. Clearly, front
and center is the New York Stock Exchange. This is not to say
we are looking for one universal corporate governance structure
or regulatory structure, and I think we are going to work on
all of them, with the New York Stock Exchange being number one
priority now for us.
Senator Enzi. Thank you. To change topics a little bit, a
review of the major foreign securities markets reveal these
markets primarily are electronic based and have demutualized
the regulatory functions from the business operations. In
addition, several of the markets operate on a for-profit basis.
It is apparent that these markets view their securities markets
as business operations, rather than as utilities for the
trading and securities.
As the SEC reviews the corporate governance structure of
the U.S. securities markets, should the SEC look at separating
out the business functions from the regulatory oversight?
Chairman Donaldson. Clearly, that is an issue, and it is
keyed or tied to the words ``separating out.'' Again, I think
that there are different ways of separating regulation from the
markets in themselves without putting the word ``out'' there.
It has to do I think with the independence of the regulatory
mechanism, as opposed to exactly where it is, either inside a
corporate structure, an exchange structure, or outside of it.
Senator Enzi. With respect to the market structure issues,
the Commission has already held a series of hearings and
received recommendations from an independent advisory
committee. What additional information does the Commission need
in order to start making decisions on the future of the
securities market and have you initiated a timetable or a
blueprint on how to resolve the significant issues?
Chairman Donaldson. Well, we have a number of issues not
pertaining to market structure on our agenda. As I said way
back in my confirmation hearing, I viewed market structure as
one of the more important and also more complex issues facing
the Commission, and it is very much on the front burner for us
right now.
In terms of the exact timing, I would rather not tie us to
a specific time, except to say that we are pretty much at the
end of the fact gathering. We are pretty much at the end of the
conversations that we have had through the various panels and
so forth, individual conversations, and we are going to be
working on an overall approach just as soon as we can, and it
is not years from now and it is not weeks from now.
Do you want to put a more definitive definition on that?
Ms. Nazareth. No, I think it is somewhere in between there,
which sounds like several months to me.
Senator Enzi. I know that in our work a lot of times if it
weren't for deadlines, we wouldn't get anything done. I can
understand a reluctance to want to put out a timeline for us,
but internally do you have more of a timeline than you are
giving us here at the hearings?
Chairman Donaldson. Absolutely. We are working on it just
as fast as we can. Again, I would refer back to the statement I
made earlier, which is that it is not a matter of it is not
being worked on, it is a matter of making some tough decisions
and trying to anticipate the unintended consequences of what we
are doing within the context of stepping back and saying that,
even with the stresses and strains, our system is working
pretty well.
And the thing we want to avoid is making some ad hoc
decisions that change the whole system rapidly for the worse.
And we are keeping our staff's feet to the fire, and we will be
keeping the Commission's feet to the fire here in the weeks and
months ahead.
Senator Enzi. I appreciate that. I know that if I tell my
staff that I want it as fast as I can, it is different than if
I say I want it by this afternoon.
[Laughter.]
I do fully appreciate your wanting to review the market
structures in a complete and comprehensive manner. However,
considering the reluctance of market participants to invest in
capital
infrastructure and technology until guidance is received from
the SEC, some forward movement on these issues is necessary.
With respect to the market structure issues, hearings have
already been held by the Commission and by the advisory
committee on market information, and that committee has issued
its recommendations to the Commission, as I understand it.
At a minimum, should you direct the SEC staff to come up
with a staff report on market structure in a similar manner
that was done very recently for the hedge funds? Will you be
doing that?
Chairman Donaldson. I think that would be a delaying thing,
Senator. I think that we feel more impetus than that to make
some decisions. I think that to enter into another study, you
know, and have months and months go by would not add much to
our knowledge base. I think we know the arguments pretty well
now, and it is just a matter of resolving this thing, which is
what we want to do.
Believe me, we are as eager as you are to see it done.
Senator Enzi. Well, the securities markets are the best in
the world, and in order for us to retain that distinction, the
evolution of the underlying structure of the market has to be
done to keep innovation, technology, and efficiency of the
markets at the forefront.
I thank you for your testimony today and your patience in
putting up with the votes. As Senator Sarbanes and I were
noting, as we waited for the subway to go over and do our vote,
your more relaxed appearance before us, after the practice that
you have had----
[Laughter.]
Senator Enzi. We knew you always had the capability, but
now you take this a little more in stride, remembering back to
the first hearing that you had here. You have given us a
greater understanding of what the most pressing market
structure issues are that we need to focus on. I am a little
disappointed that you did not set out more of a timetable on
how to address those concerns. I believe that it is essential
for the regulator of our securities markets to give guidance to
the markets when necessary and, accordingly, I would like to
address these issues again probably in about 6 months from now
by this Subcommittee and if possible earlier by the full
Committee.
I appreciate the fine job that you are doing at the
Commission since your tenure began earlier this year. You have
had to address a wide variety of issues. I think you have done
it well. I look forward to working with you and the rest of the
Commissioners and the SEC staff. And, Ms. Nazareth, I thank you
for being here as well.
The Committee record will be open for 10 days. If Members
wish to file additional questions, I would encourage them to
file them immediately so that the Chairman has time to answer
them. We would appreciate your cooperation in responding with
those answers.
The hearing is adjourned.
[Whereupon, at 11:54 a.m., the hearing was adjourned.]
[Prepared statement and response to written questions
supplied for the record follow:]
PREPARED STATEMENT OF WILLIAM H. DONALDSON
Chairman, U.S. Securities and Exchange Commission
October 15, 2003
Good morning Chairman Enzi, Ranking Member Dodd, and Members of the
Subcommittee. I am delighted to be here to discuss some of the
significant market structure issues that we are facing in the U.S.
equities market today.
In the coming months, the Commission will be focusing with
increased intensity on the structure of the U.S. equities markets, with
particular regard to their fairness and efficiency. As you know,
Congress formally directed the Commission to address market structure
when it enacted the Securities Acts 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 investors
would have the opportunity for the best possible execution of their
orders, regardless of where in the system they originate.
Congress specified five key objectives of the national market
system: (1) economically efficient executions of securities
transactions; (2) fair competition among markets and securities firms;
(3) the availability of market information to investors; (4) execution
of orders in the best market; and (5) direct interaction among investor
orders. To achieve these objectives, Congress recognized that
communication systems, particularly those designed to disseminate
market data, would form the heart of the national market system. Rather
than attempt to dictate the specific elements of 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 markets. 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
improvements in execution quality and to reduce trading costs in order
to attract order flow away from other
market centers. This competition among market centers encourages
ongoing innovation and the use of new technology. Within all existing
registered exchanges and a number of other markets, investor orders
have the possibility of interacting directly without the intervention
of intermediaries. This furthers Congress's fifth objective--direct
interaction of customer orders--allowing investors to obtain executions
at better prices than otherwise would be available.
The 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, this very efficiency, arising from
technological and other market developments, has put strains on
existing national market structures. One significant change has been
the proliferation of new electronic markets, such as ECN's, 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
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, has 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.
The issues surrounding intermarket access provide a good example of
some of the strains impacting U.S. market structure in recent years. In
a system with many competing market centers and pools of liquidity,
participants clearly need to know what the best prices are and where
they are available. But this information is of little use in the
absence of effective access to the market centers with the best prices.
Implementing market access, however, has raised a number of difficult
issues. Offering access to one's market to competitors can conflict
with the core business strategy and commercial self-interest of a
market. Over the years, markets have sought to maintain strict control
over access and often have erected barriers to achieve this objective.
These barriers historically have taken the form of direct bans,
restrictive membership requirements, discriminatory execution
priorities, fees, and information restrictions. Finally, even setting
aside intentional barriers to access, significant practical
difficulties must be overcome to ensure the availability of access in
an environment where scores of separate market centers--floor-based and
electronic, both fast and slow--may be actively quoting and trading a
security. The existing compulsory market-to-market linkage in stocks--
the Intermarket Trading System (ITS)--applies only to NYSE and Amex
stocks and, in the view of many, has been less than successful in
overcoming these obstacles to providing effective intermarket access.
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.
In addition, the Commission has developed ideas and solicited
public comment on some of the more difficult market structure issues,
such as the regulation of market data fees and revenues, the
fragmentation of the U.S. securities markets, and the regulation of
exchanges. A Federal advisory committee also was convened to address
market data concerns, and last year the Commission held public hearings
on the full range of market structure issues.
There is no doubt that there are issues regarding our national
market system that call for our attention. In my view, several aspects
of equity market structure raise pressing questions. These include: (1)
the implications of differences among markets in the means by which
their quotes may be accessed by nonmembers and of access of transaction
fees that are not included in displayed quotations; (2) the role of
trade-through rules in intermarket trading for very different types of
markets and systems; (3) the manner in which market data is
consolidated and distributed, and the resulting revenues allocated
among the markets; (4) whether a mixed dealer and auction market such
as Nasdaq should be allowed to register as a for-profit exchange; (5)
whether the fragmentation of markets that results from competition is
reducing the effectiveness of regulatory processes; and (6) the
effectiveness of the current self-regulatory system for the securities
markets.
That said, I firmly believe our system of multiple, competing
markets--on balance--has worked remarkably well. We have the world's
most competitive and efficient markets. Competition among markets has
fostered innovation and led to the creation of a variety of trading
platforms designed to meet the needs of different types of investors.
New entrants, particularly those with fully electronic platforms, keep
the pressure on established markets to innovate. However, new entrants
also challenge our existing infrastructure, much of which was created
in the 1970's before the dramatic advancements in technology.
As has always been the case in our competing markets model, our
challenge as regulators is to ensure fair and efficient markets through
a balance of competition and regulation. Fair and efficient markets, of
course, are the key goals of securities market regulation. But fairness
and efficiency are at least superficially different concepts, creating
tensions in our regulatory mandate. Fairness suggests the use of
regulation to ensure against unfair results. Efficiency, on the other
hand, suggests reliance on free markets and competitive forces to
achieve an efficient result, which may not necessarily be a ``fair''
one. Regulation and competition do not necessarily conflict, as
regulation often seeks to remove barriers to competition or promote
efficiency. In other cases, there will be a tension between regulation
and competition. Striking the appropriate balance is the responsibility
of the Commission.
The optimal equity market structure, in my view, is based on
several fundamental principles. First, I believe we should seek to
achieve the benefits of competition while countering the negative
effects of fragmentation from trading in multiple markets, through
widely available market data, ready access among markets, price
protection principles, and best execution standards.
Second, to the greatest extent possible, I believe we should let
market forces determine outcomes by seeking to have the marketplace,
rather than the Government or its regulators, choose the ``winners''
and ``losers.'' We must seek to provide a level playing field in which
all markets can compete fairly and aggressively. That said, regulation
is necessary in certain situations, such as when an exchange exercises
market power, or when externalities such as principal/agent conflicts
obstruct otherwise competitive outcomes. Regulation is also appropriate
when its benefits to the marketplace exceed its costs and reduce market
frictions, such as when settlement date standards or quoting
conventions are established.
Finally, I believe that market transparency, fairness, and
integrity are key to the strength of our marketplace. These fundamental
concepts underpin the Commission's approach to regulation, and
contribute substantially to investor confidence in our markets.
With these general principles in mind, I would like to focus the
remainder of my testimony on four key areas of the Commission's market
structure initiative: (1) access to markets; (2) market data; (3) the
self-regulatory model; and (4) the nature of a securities exchange.
Access to Markets
Fair Access
In our modern-day marketplace for securities, the New York Stock
Exchange, Nasdaq, the American Stock Exchange, the regional exchanges,
and numerous electronic communications networks, all compete with each
other to offer the deepest pools of liquidity to investors at the very
best prices. I believe that the Commission must resist the temptation
to force these diverse securities markets to mimic each other, but
rather to encourage them to compete over their differences within a
single, robust, national system. In the end, there is little doubt in
my mind that investors benefit from markets that compete, so long as
the competition is truly fair.
With that in mind, a significant market structure issue on the
Commission's agenda is making sure 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. In contrast, a market center that is
inaccessible does little to promote efficiency and fairness in the
marketplace.
Most brokers send orders directly to the market that they expect
will provide their orders best execution most of the time, and most of
these orders are executed in the market that receives them. At times,
however, the best price at that moment may be in another market. And
traders in one market may need to access prices in another market to
keep prices in line. For these reasons, markets need easy access to
each other, either directly or indirectly through brokers.
The Commission's approval last year of the NASD's Alternative
Display Facility pilot program has highlighted this issue. 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
will be evaluating this decentralized access approach to determine
whether, as a practical matter, it would be an appropriate model for
the national market system, and thus 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.
These pricing disparities can impede access between competing
markets, raise trading costs, and create confusion about the true
quoted prices. The absence of a uniform quoting convention across all
markets also raises the incidence of locked and crossed quotations. To
ensure real access to public quotes between competing markets, it is
important that these quotes be accessible to other market participants
on clear and fair terms.
I should also mention that, because access fees have gradually
shrunk to less than one-cent-per-share in most markets, the imposition
of the fees results in de facto subpenny pricing. Indeed, many market
participants have suggested that these access fees have precipitated
trading in subpennies, thus magnifying the strains caused by the move
to decimal pricing. The Commission intends to work closely with the
industry and investors to find appropriate solutions to the challenges
raised by access fees and subpenny pricing. Whatever solution the
Commission decides to adopt, we must assure that access fees will not
function as a tollbooth that snarls traffic along the national market
system.
Price Protection
As part of our examination of intermarket linkages, we also intend
to reassess 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. Today's highly competitive securities
markets include fully electronic markets that provide swift automatic
execution of customer orders, as well as traditional floor-based
markets that execute orders through human interaction. Although a
market participant that desires an opportunity for price improvement
may prefer that its order be routed to a floor exchange for execution,
an investor who values speed and certainty of order execution over a
marginally higher price may find such a delay intolerable. Accordingly,
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, at the same time providing order executions to
customers that display prices and for those customers who desire the
best price on their orders.
Market Data
Another significant market structure challenge facing the
Commission involves the collection and reporting of trading information
and influence of the resulting revenues on market structure. Our
existing market data system has strengthened the U.S. equity markets
and has assured that investors have real-time access to accurate,
reliable, and affordable information from all significant U.S. market
centers. And yet the increasing number and diversity of U.S. market
centers, has fueled demands for modernizing the current market data
structure. Despite the sweeping changes that have taken place in the
markets over the past 30 years, the structure for market data,
including the collection and dissemination of a market's best bid and
offer, the national best bid and offer, trading volume statistics, and
last-trade prices, has changed very little.
The Commission recognizes that market data revenue is very
important to our markets. Indeed, in recent years, self-regulatory
organizations have drawn as much as 45 percent of their total revenues
from market data revenue. In 2001, the Commission convened a panel of
experts, chaired by Dean Joel Seligman, that looked into the structure
of our market data system, as well as the compensation that markets
have been receiving for their market data. The Seligman Committee noted
that under the current system, securities information processors
distribute market data revenues to self-regulatory organizations 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 ECN's 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.
Significantly, in 2002 the Commission determined that programs for
rebating market-data fee proceeds to market participants were creating
incentives for traders to engage in transactions with no economic
purpose other than to increase the amount of the market data revenues
that they received. In this regard, the Commission abrogated several
more extreme proposals to extend rebates of market data revenues to
market participants, to allow more time for consideration of these
issues.
It is my belief that market centers should be rewarded for
providing better services. The recent developments call 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 securities markets. Recently, a number of
concerns have been raised about the current state of self-regulation,
including SRO conflicts of interest, SRO governance, and inefficiencies
in self-regulation.
Congress and the Commission have long recognized that self-
regulation has both benefits and weaknesses. The principle of self-
regulation is based on the idea that regulation can best be done as
close as possible to the regulated activity. However, an SRO that
operates a market has an inherent conflict of interest between its
roles as a market and as a regulator. I believe that the Commission
must continue its work in ensuring that SRO's vigorously fulfill their
obligation to enforce their rules and the Federal securities laws and
rules. The advent of for-profit, shareholder-owned exchanges creates
additional issues, including ensuring that self-regulatory obligations
do not take a backseat to the interests of shareholders. The challenge
for the Commission and the SRO's is to ensure that as the securities
markets grow more competitive, the SRO's continue to dedicate their
energies and resources to surveillance and enforcement. We also must
prevent fragmentation of trading from creating gaps in SRO oversight of
the markets.
As part of our review of the self-regulatory structure, I believe
the Commission must thoroughly review the SRO's' governance practices.
Recent events at the New York Stock Exchange point to the need for this
review. SRO's play a critical role as standard setters for sound
governance practices. Just as SRO's have demanded that their listed
companies strengthen their governance practices, we must demand that,
at a minimum, SRO's match the standards they set for listed companies.
There are several topics that merit our consideration, including board
composition and independence of directors; the independence and
function of key board committees; the transparency of the SRO's
decisionmaking process; and the diligence and competence required of
board and committee members and ensuring their focus on the adequacy of
regulation.
These are critical issues facing the SRO's and the Commission. I am
committed to ensuring that our system of self-regulation continues to
serve as an effective and efficient means of overseeing our securities
markets.
Exchange Criteria
The last topic that 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 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 intramarket 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 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 I have discussed today may shape the national market system
for years to come. I look forward to continued input from this
Subcommittee on these important matters.
Thank you again for inviting me to speak on behalf of the
Commission. I would be happy to answer any questions that you may have.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL
FROM WILLIAM H. DONALDSON
Q.1. What are the advantages and disadvantages of a floor-based
exchange versus an electronic exchange?
A.1. An evaluation of the relative strengths and weaknesses of
floor-based versus electronic exchanges clearly is an important
and difficult issue on which a great deal could be, and over
the years has been, written. Moreover, how one views these
relative strengths and disadvantages may vary significantly
based on the type of orders involved (for example, small retail
versus large institutional) or the type of stock involved (for
example, a well-seasoned stock in the top tier of trading
volume versus a relatively young stock with limited trading
volume). This response necessarily will attempt merely to set
forth an overview of the issue.
The primary difference between a floor-based and an
electronic exchange is the extent of involvement of human
beings in the floor-based model. Both models rely to a great
extent on technology to bring buying and selling interest
together, such as through electronic order delivery systems.
Even the NYSE offers the possibility of automated executions in
some circumstances (for example, for small orders pursuant to
the NYSE's Direct+ program). The NYSE clearly differs from
electronic systems, however, in the opportunity it provides for
human beings to interact face-to-face in a single, physical
location.
Perhaps the most significant potential strength of human
interaction in a trading model is that it enables the flexible
representation of very large orders submitted by institutional
investors.
Because of their size, these orders seldom can be disclosed
entirely to the market without significantly moving prices
against them. Brokers on the floor of an exchange may be able
to use their discretion in ``working'' these orders so as to
obtain favorable executions without significantly moving
prices. Notably, electronic trading systems also have developed
features that facilitate the working of undisplayed orders. One
of the significant issues that ultimately must be determined by
competitive forces is whether the electronic models offer a
superior level of flexibility and efficiency than the floor-
based model.
An exchange floor also facilitates face-to-face contact
between the specialist and brokers. This interaction
potentially is valuable in a variety of situations, including
when there is a short-term imbalance between buying and selling
interest in a stock. The specialist, because of his or her
intimate knowledge of trading in the specialty stock, could be
aware of brokers that might represent offsetting buying or
selling interest. If so, the specialist has the discretion to
call these brokers to the specialist's post. As a result, the
physical presence of the specialist and brokers on the trading
floor may help avoid sharp price swings that otherwise could be
caused by these short-term imbalances.
Finally, a potentially significant benefit of a floor-based
exchange is the accountability and responsibility it focuses on
those who act as market makers in a stock. During the toughest
market conditions, such as a severe price drop, the floor
specialist remains accountable in a most visible way--a human
being standing at the specialist post.
A potential weakness of a floor-based model, and
correspondingly a potential strength of an electronic model, is
cost of operation. A physical trading floor can be expensive to
maintain relative to an electronic trading system. In addition,
employing human floor brokers to represent orders on a trading
floor may be more costly than representing those orders
directly within an electronic trading system. Nevertheless, the
operational costs of a trading floor must be considered within
the larger picture of the total costs of trading in a
particular model. For example, the market for Nasdaq stocks in
the early 1990's collected quotes electronically, but was also
very inefficient and costly to investors because of, among
other things, the collusive practices of market makers.
Ultimately, competition and market forces must decide the
bottom-line efficiency of floor-based versus electronic
exchanges.
A potential strength of electronic trading systems, such as
those that operate electronic limit order books, is that they
facilitate direct interaction of investor buying and selling
interest without the participation of a dealer. Although floor-
based exchanges frequently match buying and selling interest
directly, the specialist also often has the option of taking
one side of an order. As discussed below, the NYSE rules are
intended to assure that the specialist only participates in
trading when it will contribute to the maintenance of a fair
and orderly market. Nevertheless, an electronic order book
affords no special advantage in trading to any particular
intermediary and thereby promotes the most direct interaction
of buying and selling interest.
Other issues are separate from, yet frequently linked with,
the issue of floor-based versus electronic exchanges. Examples
include auction versus dealer markets, and concentrated versus
fragmented markets. These linked issues reflect the historical
differences between the actual markets for NYSE and Nasdaq
stocks as they have developed in the United States. The NYSE
floor, for example, is known for its auction market, yet
electronic trading systems also have been developed that
implement an auction market. Conversely, Nasdaq historically
has been primarily a dealer market, yet the entry of ECN's
operating electronic limit order books has resulted in a
substantial percentage of agency trading in Nasdaq stocks.
Analogously, the market for NYSE stocks always has been highly
concentrated--approximately 80 to 90 percent of trading in NYSE
stocks is funneled through the NYSE floor. In contrast, the
market for Nasdaq stocks has been much more fragmented.
Q.2. How does the SEC define ``best execution?'' Are factors
other than price considered?
A.2. In accepting orders and routing them to a market center
for execution, brokers act as agents for their customers and
owe them a duty of best execution. The duty requires a broker
to seek the most favorable terms reasonably available under the
circumstances for a customer's transaction. Brokers must
regularly and rigorously review their order-routing practices
to assure that they are meeting their duty of best execution.
Although price is a very important term, the Commission
often has noted that price is not the sole relevant factor in
obtaining best execution of investor orders. Other factors also
are relevant, including: (1) the trading characteristics of the
security involved, (2) the availability of accurate information
affecting choices as to the most favorable market center for
execution and the availability of technological aids to process
such information, and (3) the cost and
difficulty associated with obtaining an execution in a
particular market center.
Q.3. Specialists are required to buy into a falling market and
sell into a rising market, even if they take a loss in doing
so. Do you keep track of how often specialists benefit and how
often they are hurt by their trading decisions?
A.3. The NYSE rules establish procedures for monitoring
specialists' performance of their duty to maintain, in so far
as reasonably practicable, a fair and orderly market in their
specialty stocks. The maintenance of a fair and orderly market
includes maintenance of price continuity with reasonable depth,
and the minimizing of the effects of temporary disparity
between buying and selling interest. Specialists report
quarterly on the quality of their performance.
The NYSE uses a number of different objective criteria to
monitor specialist performance. One is a specialist's
``stabilization rate''--the percentage of shares sold at a
price below the last different price, and the percentage of
shares purchased at a price above the last different price. The
stabilization rate thereby measures the extent to which
specialists buy and sell against the prevailing trend of the
market. For 2002 (the most recent year for which data are
publicly available), the overall NYSE stabilization rate was
80.2 percent. Another objective indicator of specialist
performance is ``price continuity''--the size of the price
variation, if any, from one trade to the next in the same
stock. Specialist trading is intended to limit the size of
price variations. In 2003, 95.1 percent of NYSE trades were
priced within 5 cents of the preceding trade, and 99.9 percent
were priced within 25 cents.
Whether any particular specialist trade is profitable or
unprofitable depends on a variety of factors, including the
status of the specialist's inventory at the time of the trade
and the volatility of price movements in a stock. Although the
NYSE monitors the dealer profit and loss of specialists in
their specialty stocks, its rules focus primarily on whether
the specialist has met its affirmative duty to maintain a fair
and orderly market. Assuming specialists fulfill this duty,
they are not prohibited from profiting from their trading.
Q.4. Why do we require specialists to have such a prominent
role in determining a stock's price? What would be the result
if the price of a security was determined by the market as a
whole rather than relying so heavily on the judgment of a
specialist?
A.4. The overall balance of buying and selling interest in a
security ultimately determines the price of NYSE stocks.
Specialist trading is intended only to smooth out the sharp
price fluctuations that otherwise might result from temporary
disparities between buying and selling interest. For example,
if selling interest in a stock heavily outweighs buying
interest at any particular time, the price of the stock is
going to drop. Specialist trading is intended to slow the rate
of the drop, perhaps allowing time for compensating buying
interest to mobilize and reach the NYSE floor.
RESPONSE TO A WRITTEN QUESTION OF SENATOR JOHNSON
FROM WILLIAM H. DONALDSON
Q.1. Chairman Donaldson, at the hearing before the Banking
Committee on September 30, Senator Carper asked if you intended
to seek the views of the President's Working Group on Financial
Markets before voting on any changes to the regulation of hedge
funds. You replied that you intended to do so. Have you
requested the input of the President's Working Group?
A.1. Over the past decade, there have been periodic calls for
increased regulation of hedge funds. In 1999, after the near
collapse of Long-Term Capital Management, the Commission
participated in the study of hedge funds conducted by the
President's Working Group on Financial Markets. The Working
Group's principal focus in that study was on the effect of the
exposure of large financial institutions, including broker-
dealers and banks, on the stability of the financial markets.
In June 2002, the Commission initiated an investigation
under Section 21(a) of the Exchange Act concerning the growth
of hedge funds. Unlike previous studies, which focused
primarily on market stability issues, this investigation
focused on the effect of hedge fund growth on investor
protection. On May 14 and 15, 2003, the Commission held a
roundtable on hedge funds, which included the participation of
senior staff members of the Commodity Futures Trading
Commission, a fellow Working Group member.
At the conclusion of the hedge fund roundtable, I asked the
Commission's Division of Investment Management to prepare a
report on the implications of the growth of hedge funds. I kept
the Working Group informed on the progress of the report and,
as you know, the report was issued on September 29, 2003. At
the last meeting of the Working Group, which took place on
December 3, 2003, hedge fund issues were included on the agenda
and I intend to keep the Working Group informed of the
Commission's efforts regarding hedge funds going forward.