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REGULATION NMS: THE SEC’S VIEW

HEARING

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTERPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

MARCH 15, 2005

Printed for the use of the Committee on Financial Services

Serial No. 109–9

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa 

RICHARD H. BAKER, Louisiana 

DEBORAH PRYCE, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

ROBERT W. NEY, Ohio 

SUE W. KELLY, New York, Vice Chair 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

JUDY BIGGERT, Illinois 

CHRISTOPHER SHAYS, Connecticut 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

PATRICK J. TIBERI, Ohio 

MARK R. KENNEDY, Minnesota 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

JIM GERLACH, Pennsylvania 

STEVAN PEARCE, New Mexico 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

MICHAEL G. FITZPATRICK, Pennsylvania 

GEOFF DAVIS, Kentucky 

PATRICK T. MCHENRY, North Carolina 

BARNEY FRANK, Massachusetts 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

BARBARA LEE, California 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

JOSEPH CROWLEY, New York 

WM. LACY CLAY, Missouri 

STEVE ISRAEL, New York 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

ARTUR DAVIS, Alabama 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

MELISSA L. BEAN, Illinois 

DEBBIE WASSERMAN SCHULTZ, Florida 

GWEN MOORE, Wisconsin, 

BERNARD SANDERS, Vermont

Robert U. Foster, III, Staff Director 

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE AND GOVERNMENT SPONSORED

ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

JIM RYUN, Kansas, Vice Chair 

CHRISTOPHER SHAYS, Connecticut 

PAUL E. GILLMOR, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

FRANK D. LUCAS, Oklahoma 

DONALD A. MANZULLO, Illinois 

EDWARD R. ROYCE, California 

SUE W. KELLY, New York 

ROBERT W. NEY, Ohio 

VITO FOSSELLA, New York, 

JUDY BIGGERT, Illinois 

GARY G. MILLER, California 

MARK R. KENNEDY, Minnesota 

PATRICK J. TIBERI, Ohio 

J. GRESHAM BARRETT, South Carolina 

GINNY BROWN-WAITE, Florida 

TOM FEENEY, Florida 

JIM GERLACH, Pennsylvania 

KATHERINE HARRIS, Florida 

JEB HENSARLING, Texas 

RICK RENZI, Arizona 

GEOFF DAVIS, Kentucky 

MICHAEL G. FITZPATRICK, Pennsylvania 

MICHAEL G. OXLEY, Ohio 

PAUL E. KANJORSKI, Pennsylvania 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

JOSEPH CROWLEY, New York 

STEVE ISRAEL, New York 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

ARTUR DAVIS, Alabama 

MELISSA L. BEAN, Illinois 

DEBBIE WASSERMAN SCHULTZ, Florida 

BARNEY FRANK, Massachusetts 

(V)

C O N T E N T S 

Page 

Hearing held on: 

March 15, 2005 ................................................................................................. 1

Appendix: 

March 15, 2005 ................................................................................................. 31

WITNESS 

TUESDAY, MARCH 15, 2005

Donaldson, Hon. William H., Chairman, U.S. Securities and Exchange Commission .................................................................................................................. 14

APPENDIX 

Prepared statements: 

Oxley, Hon. Michael G. .................................................................................... 32

Brown-Waite, Hon. Ginny ................................................................................ 34

Fosella, Hon. Vito ............................................................................................. 35

Gillmor, Hon. Paul E. ....................................................................................... 37

Hinojosa, Hon. Rube ́n ....................................................................................... 38

Kanjorski, Hon. Paul E. ................................................................................... 40

King, Hon. Peter T. .......................................................................................... 41

Donaldson, Hon. William H. ............................................................................ 42

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Donaldson, Hon. William H.: 

Written response to questions from Hon. Judy Biggert ................................ 80

Written response to questions from Hon. Ginny Brown-Waite .................... 82

(1)

REGULATION NMS: THE SEC’S VIEW 

Tuesday, March 15, 2005

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, 

AND GOVERNMENT SPONSORED ENTERPRISES

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to call, at 10:13 a.m., in Room 

2128, Rayburn House Office Building, Hon. Richard H. Baker 

[chairman of the subcommittee] presiding. 

Present: Representatives Baker, Ryun, Shays, Manzullo, Royce, 

Oxley, Fossella, Biggert, Kennedy, Tiberi, Barrett, Feeney, 

Hensarling, Davis of Kentucky, Fitzpatrick, Kanjorski, Ackerman, 

Sherman, Moore, Ford, Crowley, Israel, Baca, Lynch, Scott, Velazquez, Wasserman Schultz, and Maloney. 

Mr. BAKER. [Presiding.] Good morning. I would like to call the 

meeting of the Subcommittee on Capital Markets to order. 

Today, the committee meets to receive comments from the chairman of the SEC on a proposed initiative now under review known 

as Reg NMS. 

I must confess to the committee that I do not come to this issue 

with my usual passionate neutrality. I have a predetermined perspective, and my testimony this morning will reflect that. 

This is the committee’s sixth market structure hearing over the 

past 18 months. Needless to say, we all understand that this is a 

vitally important subject for U.S. investors and the capital markets 

generally. Philosophically, I have always been a very market-based 

person and to support new regulatory intervention is something 

that should be viewed as a last resort in my opinion. This fundamental approach is particularly relevant when considering the 

issue before us today. 

Reg NMS addresses four principal areas. Understandably, most 

of the discussion has centered on its one most controversial aspect, 

the trade-through rule. I have opposed the trade-through rule 

based on free market principles and have been an advocate for its 

repeal. It may have made sense at times in the past, but today it 

is a relic of a bygone era. I believe it to be basic protectionism, and 

in the 21st century, investors should be able to choose speed, anonymity and certainty over what is generally seen as an advertised, 

but not a guaranteed best price. I do not believe that choice should 

be taken away from the investors. 

Moreover, the trade-through rule has not been enforced on a consistent basis. Indeed, the New York Exchange, the rule’s most ardent supporter, is also one of the more frequent violators. The comVerDate 0ct 09 2002 10:16 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 G:\DOCS\23736.TXT FIN1 PsN: MICAH
2

mission has been presented with what I believe to be clear data 

supporting this claim, but is poised to act in the face of the clear 

facts to the contrary. The trade-through rule has certainly accomplished at least one thing. It has helped the New York Exchange 

maintain about 80 percent market share in listed securities. By 

contrast, the Nasdaq, which operates without such a rule, has 

about 20 percent market share in Nasdaq securities, with the rest 

divided up among INET, ARCA and others. 

From this fact alone, it is clear who is subject to competitive 

forces and which market is protected. The bottom line is the tradethrough rule is anticompetitive, anti-investor, and antiquated. So 

what is being proposed in the face of the evidence? Not to repeal 

it, but amazingly to extend it to other market participants as well. 

I cannot come to a conclusion that makes this suggestion make 

sense. In a very similar or basic observation, it is like selling your 

car and buying two horses, based on the view you will save money 

on parking fees. I would not think that a well-advised strategy. 

The Nasdaq market has never been part of the inter-market 

trading system and therefore does not have a trade-through rule. 

According to some independent observers, it has developed into the 

most competitive marketplace for trading stocks. The Nasdaq has 

thrived since the adoption of the over-handling rules and the advent of ECNs in the late 1990s. Three major markets, INET, ARCA 

and Nasdaq all compete to trade the same securities without a 

trade-through rule. There are more limit orders with Nasdaq and 

roughly the same number of trade-throughs as compared to the 

listed markets. 

Two arguments are offered by the SEC in support of the tradethrough expansion: that the rule is needed to increase limit orders 

and to reduce trade-throughs, both laudable goals which I support. 

There is only one problem I find with the analysis: This plan will 

not achieve that end. It is as if 30 years of trading history mean 

nothing and 3 months of rulemaking is everything. Competition in 

Nasdaq stocks is intense. No market has more than 30 percent 

share, and the competition has been proven worthwhile for investors. As Matt Andresen stated before the committee last month, 

based on our own experience trading large volumes of both Nasdaq 

and listed equity securities, we believe strongly that execution 

quality of the Nasdaq is significantly better than that of the listed 

marketplace. 

The commission justifies the re-proposed Regulation NMS with 

various studies conducted by the Office of Economic Analysis, 

known as the OEA. Several commenters have clearly outlined the 

basics which are flaws of these studies. That is, the analysis had 

a predetermined outcome to make the Nasdaq appear inferior in 

operations to the NYSE. As to the trade-through study, with the 

acquisition of brute technologies and the smart-order routing capabilities, Nasdaq has been able to lower trade-through rates in 

Nasdaq stocks from 2.5 percent in 2003 to the figure of 1.5 percent 

today. 

In addition to many trade-throughs that were incorrectly accounted for as trade-throughs, actually involved lock and crossmarket or block trades, according to one commenter, excluding 

large trades during cross-markets, the trade-through rate would 

3

drop to .08 percent. Additionally, studies rely on stale quotes, 

which traders rightly trade through. If accessible quotes had been 

utilized and excluded stale quotes, the trade-through rate would 

have been even lower. Also, the OEA overestimated the shares 

traded-through by, including the entire size of the order that traded through when calculating the size of the trade-through, rather 

than the size of the displayed quote, which was actually traded 

through. 

The OEA used a statistically biased example of 4 uncommonly 

volatile days. Even if 4 days were studied, the scope of the study 

is very limited. With regard to the match pair study, the study actually shows Nasdaq market quality is on par with the NYSE. Over 

one-quarter of the stocks in the sample are not eligible for NYSE 

listing, and only 10 percent are from the Nasdaq 100. The S&P 

Index study overstates the effective spreads of Nasdaq stocks and 

thus concludes that the Nasdaq has inferior execution, but the 

OEA employs a methodology that favors high-priced NYSE stocks 

and also uses statistics from a single month. 

The volatility study includes results that at least one commenter 

has attempted and failed to be able to reproduce. The SEC’s shortterm volatility estimates are more than three-times higher than 

that of the Nasdaq, and even higher than those in an NYSE study 

upon which the SEC findings are based. 

These are the four studies cited by the SEC to support the tradethrough. For all the reasons I have outlined, I will follow our hearing today with a letter to Chairman Donaldson requesting information pertinent to these documents, and respectfully request the 

committee be granted sufficient time to review the information before the Commission moves to final promulgation. 

In addition to the flawed studies, there is nothing even approaching an industry consensus on the advisability of expansion of the 

trade-through. Market participants including, but not limited to, 

Nasdaq, Instinet, ARCA, TIAA-CREF, Bloomberg, Fidelity, 

Schwab, Ameritrade, UBS, Morgan Stanley, J.P. Morgan Chase, ITrading and Securities Traders Association have all openly opposed 

extending the flawed regulation to the Nasdaq marketplace. We 

should not be imposing new regulatory regimes under these circumstances. 

Along with substantive concerns, the process itself has troubled 

me. When the original NMS was issued, the Commission requested 

public comment, whether there even ought to be a trade-through. 

The comments ran, from reports, about three to one against the 

trade-through in any form. So how does it make sense to not only 

keep it, but now extend it? Further, the re-proposal was issued 90 

days ago, and appears to be on the verge of adoption. As you contrast this with the process for the Nasdaq to have its exchange application considered, it was filed in March 2001 and yet there is no 

action to move forward on that application. 

There are recommendations now pending that the Commission 

adopt which equate to the most sweeping reforms our markets 

have experienced in 30 years, resulting from only a 3-month public 

comment period. I do not understand why the SEC has disregarded 

the results of its own ETF pilot fashioning Regulation NMS. Under 

the pilot, the SEC granted a deminimus exemption to current 

4

trade-through rules for three ETFs. Never has the trading been 

more liquid and efficient. It has been an overwhelming success by 

any measure. Indeed, it accomplished everything trade-through opponents predicted it would, but the Commission has ignored this 

result. 

Paradoxically, less than 2 weeks before the SEC proposed Regulation NMS where it extends the trade-through to Nasdaq, it extended for a third time the terms of this pilot that technically removes the trade-through. I am not aware of any public adverse 

comment concerning the success of these pilots or their continuing 

extension. It appears the Commission is having it both ways: on 

the one hand saying that a trade-through is needed throughout the 

market; and on the other, removing it from the trading of certain 

securities. This needs to be made clear. 

When Congress created the National Market System in 1975, the 

stated congressional intent was to ensure economically efficient 

execution of securities transactions and fair competition among brokers and dealers, and between exchange markets and markets 

other than exchange markets. Any fair reading would suggest that 

Reg NMS with its preservation and expansion of the trade-through 

rule is inconsistent with these underlying principles. 

Regrettably, I feel I must say it. Regulation NMS ranks up there 

with the worst public policy I have seen proposed for the securities 

markets in my tenure in Congress. I would hope that there would 

be serious consideration, at least to some of the concerns I have recited, before the Commission acts in this matter. I sincerely do appreciate the Chairman’s willingness to appear here today to listen 

to our concerns and make comments as to the direction the Commission may take. I hope we are able to work together going forward to address the concerns raised. 

Mr. Kanjorski? 

Mr. KANJORSKI. Thank you, Mr. Chairman. 

Mr. Chairman, we meet once again to discuss the important 

issue of the regulation of our capital markets generally, and the 

trade-through rule specifically. This time we will hear again from 

the chairman of the Securities and Exchange Commission. 

The ongoing deliberations over our national market system have 

engendered strong emotions and considerable debate. As my colleagues already know from our extensive investigations into these 

matters, market structure is also an extremely complex subject. 

We are, Mr. Chairman, at a crossroads. A variety of agents in 

our equity markets have questioned one or more aspects of the regulatory system governing our national markets during the last several years. Technological advances and competitive developments 

are also forcing us to confront a number of important decisions. 

During his previous testimony before our panel concerning these 

matters, SEC Chairman Donaldson noted that in pursuing any 

plan to fix those portions of the national market system experiencing genuine strains, we must ensure that we do not disrupt 

those elements of our markets that are working well. Chairman 

Donaldson knows that I share his views in these matters. We 

should not pursue change for change’s sake. 

In his recent testimony before the Senate Banking Committee, 

Chairman Donaldson also offered some insights into the CommisVerDate 0ct 09 2002 10:16 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 G:\DOCS\23736.TXT FIN1 PsN: MICAH
5

sion’s deliberations regarding its broad set of proposals to update 

the regulatory structure of our stock markets. He focused his comments last week on the trade-through rule. In particular, he noted 

that the regulation advances three important policy goals: it ensures best execution; it promotes fair and orderly markets to get 

the best price; and it advances market depth and liquidity. 

Chairman Donaldson will, as I understand, expand on those 

views today by providing us with more analysis and detail about 

his thinking regarding these matters. In his comments today, I 

hope that Chairman Donaldson will once again express his support 

for the trade-through rule. From my perspective, this standard is 

one area of our regulatory structure that has worked well for nearly three decades. As one of the foundations of our national market 

system, this rule has ensured that all investors get the best price 

that our securities markets have to offer regardless of the location 

of a trading transaction. 

Today, I also suspect that many of my colleagues will focus on 

the Commission’s newest proposal to alter the trade-through rule 

when asking questions of Chairman Donaldson. In addition to applying the trade-through rule to all securities marketplaces, the 

Commission’s latest plan for updating the national market system 

includes two alternatives for implementation: the market best bid 

or offer alternative and the voluntary depth alternative. 

The voluntary depth alternative would almost certainly result in 

only one way for markets to differentiate themselves, namely, how 

much they are willing to pay other market participants for their 

order flow. In my view, promoting competition based on payment 

for order flow will prove detrimental in the long term to average 

retail investors because of the conflicts of interest it creates. This 

issue is one that the Commission should carefully study. 

The incremental approach contained in the market best bid or 

offer alternative is therefore the preferable option going forward. 

The adoption of this alternative will also help to ensure that the 

United States maintains its global leadership in our financial markets. 

In closing, Mr. Chairman, it is my very strong hope that the 

Commission in working to finalize any changes in the market 

structure rules will make certain that any regulation it promulgates will provide an improvement over the existing regulatory regime and protect the interests of retail investors. 

I look forward to receiving the testimony of Chairman Donaldson. 

[The prepared statement of Hon. Paul E. Kanjorski can be found 

on page 40 in the appendix.] 

Mr. BAKER. I thank the gentleman for his statement. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Mr. Chairman. 

Chairman Donaldson, welcome back to the committee. In case 

you do not get enough of us today, you will be coming back for 

more when you return in April to talk to us about Sarbanes-Oxley. 

We look forward to having you there again. 

Today, our topic is Reg NMS, and I want to begin by commending Chairman Baker’s outstanding leadership on the important and difficult issues raised by the proposal before us today, 

6

Regulation NMS. I have found the Financial Services Committee’s 

five previous hearings on this Securities and Exchange Commission 

initiative to be extremely informative. I am only sorry that I 

missed the famous hearing in New York. Perhaps we could have 

an instant replay of that at some point. 

The threshold questions for me are, what kind of marketplace do 

we want to create for the 21st century? And in what direction do 

we want the markets to go as they evolve and adapt to technology? 

My approach to these complex issues is governed by the belief 

that Congress should work to reduce or eliminate any regulatory 

advantages that inhibit competition and artificially preserve market share. As an advocate of free markets, I believe that we should 

move the National Market System toward more robust competition, 

more investor choice, and greater investor protection. Of course, we 

must be guided by best execution for the investor. If an investor 

misses the best price, that is not best execution. If a trade cannot 

be completed, that is not best execution. 

At the subcommittee’s spirited hearing last month, six major 

market participants, Nasdaq, Instinet, Bloomberg, Knight, Schwab, 

and Citadel, all expressed opposition to the portion of the Reg NMS 

proposal that would preserve and expand the trade-through rule. 

As a matter of applying free-market policy, I share that view. 

While the trade-through rule had its purpose in an earlier era, today’s technology has rendered it regulatory and anti-competitive. 

As I discussed at the last hearing, let’s remember the broker’s fiduciary duty to obtain best execution of his clients’ orders is a more 

efficient way of ensuring investor protection. 

Therefore, it does not make sense, it seems to me, to extend the 

trade-through rule to the Nasdaq market, which has operated efficiently and competitively without it. I can think of no compelling 

reason to expand the rule, with its associated and quite significant 

compliance costs, to the vibrant Nasdaq marketplace. 

If the SEC were to modify the proposal so that the trade-through 

rule is not expanded, that is an outcome that I think most interested parties could support. It strikes me as a sensible compromise 

that would improve the status quo. A final rulemaking that resists 

the urge to over-regulate the Nasdaq market would include significant improvements over the existing regulatory structure. The Reg 

NMS trade-through provision as applied to only exchange-listed 

stocks would be more enforceable than the current rule and would 

recognize the difference between automated and manual markets. 

Reg NMS, as modified, would encourage the New York Stock Exchange to continue to modernize its market. The hybrid proposal 

crafted by the exchange is an important step in this direction. I 

want to commend John Thain for his leadership and vision. I know 

he is committed to serving investors in this age of rapidly changing 

technology. 

We are nearing the end of a long process. I would like to commend the Commission and its staff for their hard work over the 

past several years. This is a difficult and complex area, and I certainly recognize the good intentions and good will of people on all 

sides of this important issue. 

Mr. Chairman, I thank you again for your leadership and I yield 

back. 

7

Mr. BAKER. I thank the Chairman. 

Mr. Ackerman? 

Mr. ACKERMAN. No, thank you. 

Mr. BAKER. Mr. Ford? 

Mr. Crowley? 

Mr. CROWLEY. Thank you, Mr. Chairman. 

I would like to thank Chairman Baker and ranking member 

Kanjorski for holding this hearing today on Reg NMS. I also want 

to welcome Chairman Donaldson here today who will discuss with 

us where the SEC is in their process of completing Reg NMS and 

how they plan to modernize and strengthen the regulatory structure of the U.S. equity markets. 

The Chairman and I were able to speak briefly privately a few 

weeks back where I expressed to him my concerns about the SEC’s 

proposed voluntary depth alternative. Without getting into depth 

here on the subject, I do hope that in the final rule this voluntary 

depth alternative will be rejected. 

Additionally, I welcome the discussion of applying the market 

BBO alternative across all markets and to all NMS stocks, under 

the guise of ensuring that investors will be treated the same regardless of the stocks they are trading. While I know some argue 

that the trade-through rule is antiquated and impedes competition 

by forcing their businesses to operate at the speed of the slowest 

market, I disagree. 

I agree with your comments before the Senate Banking Committee on the 9th of this month where you stated, ‘‘The tradethrough rule is designed to promote fair and orderly markets and 

investor confidence by providing greater assurance that limit orders displaying the best prices are not bypassed by trades at inferior prices.’’

Additionally, I was concerned with the comments in your prepared testimony for this morning whereby you reference an SEC 

staff study found that trade-through rates are significant for 

Nasdaq stocks; that approximately 98,000 Nasdaq trades per day 

receive a price that is inferior to a displayed and accessible 

quotation. I share your concerns that thousands of retail investors 

each day may unwittingly be receiving an inferior execution of 

their orders in the Nasdaq stocks. 

I also agree with your testimony whereby you stated, ‘‘The relevant data does not support any sweeping claim that trading in 

Nasdaq stocks now is generally more efficient than trading in the 

New York Stock Exchange stocks.’’

Finally, I believe that if the SEC does not apply the tradethrough rule across all markets, regulatory arbitrage will be the result. While professional traders will profit in a market with no prohibitions, those profits will not be passed on to our consumers. This 

issue is about the uniformity of markets. If price protection is good 

for investors trading General Motors on the New York Stock Exchange as a New York Stock Exchange-listed stock, then it should 

also be extended to investors trading Microsoft, a Nasdaq-listed 

stock. Again, this highlights the need for the extension of the 

trade-through protections to all U.S. equity markets. The tradethrough rule has helped smaller investors smooth the path from 

Main Street to Wall Street. 

8

Finally, Mr. Chairman, in the Chairman’s opening statement, I 

would appreciate him, if he could, comment on his thoughts on the 

New York Stock Exchange’s hybrid proposal and if he believes it 

represents a dramatic and positive change; and is it consistent with 

the principles behind Reg NMS? The hybrid model demonstrates 

that once approved, the New York Stock Exchange will marry the 

best of electronic trading and the auction market. Investors will 

have choices. If they want speed, certainty and anonymity of execution, they will have it. If they want the opportunity for price improvement, they will have that as well. 

I look forward to your testimony, Mr. Chairman, this morning. 

With that, I yield back the balance of my time. 

Mr. BAKER. I thank the gentleman. 

Mr. Ryun? 

Mr. RYUN. Thank you, Mr. Chairman. I appreciate your scheduling this hearing to discuss the important issue of market structure, and specifically the SEC’s proposed Reg NMS. 

Chairman Donaldson, thank you for being with us today. We look 

forward to hearing your expertise on this particular issue. I look 

forward to your unique perspective on the pending proposal. I am 

especially interested to hear your thoughts on the merits of expanding the trade-through rule to the Nasdaq. 

While I certainly support the careful governance of the securities 

industry and am mindful of the oversight of Congress and this 

panel, I am generally inclined to only look for additional government intervention or regulation when something is not functioning 

properly. 

There is an old adage that says if it is not broke, don’t fix it. I 

am afraid that expanding the trade-through rule at this time could 

be failing to heed that advice. It seems to me the Nasdaq market 

has functioned quite well without the rule and I am curious about 

the reasons that the SEC would look to expand that rule now. 

I applaud the New York Stock Exchange for the steps it has 

taken to modernize its marketplace. I am also pleased to see the 

other items and the Reg NMS that they are widely agreed upon. 

However, I am afraid that expanding the controversial tradethrough rule without allowing the changes that without wide support would be implemented, that could lead to problematic results. 

I also feel that it would be prudent to allow the New York Stock 

Exchange’s new hybrid system some time to operate before injecting another dramatic change into the marketplace. I look forward 

to your thoughts and your expertise on these issues, and I yield 

back my time. 

Mr. BAKER. I thank the gentleman. 

Mr. Israel? 

Mr. ISRAEL. Thank you, Mr. Chairman. 

Obviously, we have already heard quite a diversity of opinion on 

the trade-through rule, so let me offer my own as briefly as I can. 

Let me begin by welcoming Chairman Donaldson and stating 

that I certainly appreciate the importance and the enormity of the 

task that the SEC has undertaken. Clearly, our markets must be 

modernized if they are to maintain their status as the most competitive and most dynamic in the world. 

9

I do, however, have several significant concerns about the regulation as proposed, and also regarding recent movement to change 

the application of the trade-through rule. In the past in this committee, I have gone on record expressing my reservations about the 

proposed virtual consolidated limit order book structure, and those 

reservations still stand. 

However, I do want to weigh in on the conversation that we have 

already had today about the importance of maintaining the integrity of the trade-through rule. I fear that any weakening of the 

trade-through rule would take away investors’ assurances that 

their representatives are working to execute their trades at the 

best price. As we are all aware, the difference between the best 

price and the second-best price can be very significant, more than 

four cents per share for the S&P 100 stocks listed on the New York 

Stock Exchange. 

These additional expenses would affect all investors large and 

small. But the brunt of them would be borne by small investors 

who are less able to monitor closely execution costs and to question 

their brokers or agents about prices received. Investors deserve and 

demand the highest quality order executions and the best price on 

all transactions. 

I want to emphasize the word ‘‘all,’’ as I am concerned by recent 

talk of a carve-out for the Nasdaq. Simply put, I believe that the 

trade-through rule is good for investors and therefore all investors 

deserve the benefits of it, whether the stocks they seek to purchase 

are New York Stock Exchange-listed or Nasdaq-listed. 

I want to particularly note that I believe that one of the strongest protections available today is the ability for investors to be 

made whole when a trade-through occurs. Today, this protection is 

available on the New York Stock Exchange, but not on the Nasdaq 

where there is no trade-through rule. The SEC’s current proposal 

to extend this protection to investors in Nasdaq-listed securities 

makes sense, and I would strongly urge us not to yield to recent 

calls to create a Nasdaq carve-out. 

The New York Stock Exchange has been the most prominent 

symbol of capitalism in the world. I believe that seeking to emulate 

its reputation for transparency in all transactions and ensuring the 

best price for all investors, large or small, at all of our markets can 

only improve our national economy. 

I look forward to a continuing discussion of these and other 

issues. Thank you, Mr. Donaldson, for joining us today, and I yield 

back the balance of my time. 

Mr. BAKER. I thank the gentleman. 

Ms. Biggert? 

Mrs. BIGGERT. Thank you, Mr. Chairman, for holding this very 

important hearing today. 

Thank you, Mr. Donaldson, for being here today. 

As we all know, the Securities and Exchange Commission is 

charged with protecting investors and maintaining the integrity of 

the securities market. Today we will examine whether a proposed 

rule by the SEC follows the SEC’s mission and vision. As we conduct an analysis of the proposed rule, let us keep in mind that the 

Government is not in the business of innovation. Innovation is 

10

birthed out of the genius of our entrepreneurs and market participants. It is a response to investor demand. 

I am pleased that the SEC has moved forward with its work on 

this regulation, and I would argue that probably 90 percent of the 

proposal would benefit our markets, market participants and investors. I also believe that the SEC should approve the New York Exchange’s hybrid proposal. However, I cannot at this time understand the rationale for the trade-through rule that we have heard 

so much about. 

I understand that the vast majority of the Commission is not in 

agreement over the rule and the rule has sparked healthy discussions and debate, but it appears that the critics’ view of the rule 

is unnecessary at this point in time. It has been brought to my attention that some of the SEC intends to apply the trade-through 

to the Nasdaq marketplace which currently has no trade-through 

rule, as well as the New York Stock Exchange, which currently 

does have the rule. 

As the SEC’s statistics show, there are only a small number of 

trade-throughs in the Nasdaq marketplace, about 2.5 percent of the 

trades. More than half of these trades, though, are outside the 

quote for only one penny per share, and the Nasdaq market is already dominated by limit orders. In addition, Mr. Chairman, I am 

concerned that the trade-through rule would not enhance competition in the marketplace or prove effective in any way. I understand 

that the SEC has worked on this issue for quite some time, but I 

also understand that the broader mission of the SEC, this committee and Congress should be first and foremost to uphold free 

market values: competition, rules that are fair, and effective enforcement of those rules because that is what makes America the 

most economic leader in the world. 

In this vein, I have great concern about the anti-competitive nature of the trade-through rule. The Nasdaq market is exhibit number one on why we do not need the Government-mandated tradethrough rule. Operating without trade-through, it is a fiercely competitive marketplace that provides investors with superior trade 

execution. Equally important, we should ensure that the investors 

are protected. Market participants are charged with the mission of 

providing investors the best possible service. Investors should be 

able to trust the systems and businesses in which they can easily 

and intelligently invest and move their money. 

A modernized U.S. market structure should enhance competition, 

foster the development of safe and sound business products and 

practices, allow for innovation, and maintain an efficient and transparent system. 

I look forward to hearing from our witness today regarding Reg 

NMS and how elements of the current proposed regulation will foster or hinder competition in the U.S. equity markets. 

Thank you very much. I yield back. 

Mr. BAKER. I thank the gentlelady. 

Mr. Scott? 

Mr. SCOTT. Thank you, Chairman Baker. 

Good morning, Chairman Donaldson. It is good to have you before the committee once again to discuss the Securities and ExVerDate 0ct 09 2002 10:16 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 G:\DOCS\23736.TXT FIN1 PsN: MICAH
11

change Commission’s proposal to modernize the national market 

system. 

I understand that the proliferation of electronic computer networks have changed the way that investors trade in the markets, 

which is the reason the SEC needs to update the current national 

market system. The witnesses from the hearing held last month 

provided a wide range of opinions on the best approach for assuring 

inter-market price protection. The SEC has heard comments on its 

proposed rule from more constituencies than have appeared before 

this committee. 

So I look forward to your testimony to better understand how the 

SEC is balancing the often-contradictory comments about the proposed rule. One question that I would like to focus on today is, if 

the ultimate policy decision is to try to strengthen and expand existing trade-through protection, would not it make sense to do so 

in an incremental fashion? 

Also, I would like to weigh the potential costs to participants in 

relation to the benefits that these new rules would provide to the 

markets. As this committee reviews these proposed regulations, we 

must keep in mind the need to have an efficient national system 

that provides the best prices for a wide variety of investors. Considering the concerns with inadequate retirement savings of Americans, this rule should certainly protect the interests of long-term 

investors. 

So I look forward to your testimony today and certainly getting 

involved in some of these important questions and getting your 

very important answers. 

Thank you, Mr. Chairman. 

Mr. BAKER. I thank the gentleman. 

Mr. Barrett? 

Mr. Davis? 

Mr. Fitzpatrick? 

Does another member have an opening statement? Mr. 

Hensarling? 

Mr. HENSARLING. Thank you, Mr. Chairman. Mr. Chairman, 

thank you for holding this hearing. This is an important matter 

that deserves the attention that you have given it. 

I also want to welcome Chairman Donaldson to this committee 

and take a minute to express some concerns that I have about the 

SEC’s currently proposed Reg NMS. Clearly, this is a controversial 

matter among many well-established and well-respected parties in 

the market who represent a wide variety of both small and large 

individual and institutional investors. 

It is my hope that any final rule issued by the SEC might 

achieve greater consensus among the Commissioners with every 

commissioner’s concerns being properly considered. While I understand that consensus does not come easy, I hope that we are not 

again looking at another three-to-two vote on a matter of this magnitude. 

As I have mentioned before in this committee, I continue to have 

great concerns about any expansion to other markets of a rule that 

appears to be antiquated and the potential impact that further regulation might have on private sector innovation. Since an investor 

12

has a 98 percent chance of not being traded through, I hope we are 

not considering a remedy in search of a problem. 

I hope this debate continues to focus on what might strengthen 

competition, and thus what is best for the American investor. 

Thank you, Mr. Chairman. I yield back. 

Mr. BAKER. I thank the gentleman for his statement. 

Ms. Velazquez? 

Ms. VELAZQUEZ. I have no statement. 

Mr. BAKER. Thank you. 

Mr. Lynch? 

Mr. LYNCH. Thank you, Mr. Chairman. 

Thank you, Chairman Donaldson, for being here today to help 

this committee with its work and discuss Reg NMS. I appreciate 

the efforts that you have put in to restore and maintain the integrity of the financial markets. 

I also want to thank the Chairman and the ranking member for 

holding the hearing today, which is just one in a series of hearings 

focusing on the potential impact of Reg NMS proposals. 

Chairman Donaldson, there are a number of issues that I hope 

that your testimony will address today. I hope that we come away 

from this hearing with a clear understanding of the goals of the 

SEC in moving forward with this proposed change to the national 

market system. I appreciate the SEC in taking a thoughtful approach in addressing these issues. 

When dealing with matters like this that are so complex, I think 

it is critical that all parties come to the table and talk through the 

potential impacts of such rule changes, especially ones that will 

have a broad-based impact on the financial markets. I believe 

through this series of hearings, the committee will establish an important forum for such discussions to take place. 

I hope above all that the SEC will be sensitive to the concerns 

that are raised in these hearings, and that they will pay attention 

and will move forward thoughtfully and work toward developing a 

consensus approach to the controversial issues on the table. 

Chairman Donaldson, it is my understanding that the SEC views 

the current trade-through rule as outdated. I understand that, but 

I am interested in learning from you today whether you believe 

that there is value in the SEC moving forward incrementally, rather than in one swell swoop. Just last week, Commissioner Atkins 

delivered remarks to security traders in my district in Boston expressing his view that the concern about unintended consequences 

is justified, given that there ‘‘has never been a trade-through rule 

on Nasdaq and the trade-through rule has never been enforce in 

exchange-listed markets,’’ close quote. He went on to ask if ‘‘we are 

putting at risk the world’s best security markets.’’

Chairman Donaldson, I am very interested in hearing your response to the concerns raised by Commissioner Atkins. Specifically, 

I am interested in learning more about the deliberation process for 

the scope of the rule. Did the SEC, for example, consider trying a 

pilot version that would apply only to the New York Stock Exchange or some subset of the markets? It would seem to make 

sense for us to determine the potential impacts of these changes on 

a smaller scale before engaging in a broad-based expansion on all 

markets. 

13

With that approach, we could minimize the unintended consequences and the potential disruption to the financial markets. If 

a pilot program has not been previously considered by the SEC, I 

would like to hear from you in your testimony whether this is 

something that the SEC is willing to look at. 

In a related area, I understand that the New York Stock Exchange is in the process of expanding the New York Stock Exchange direct, to expand the availability of automatic execution of 

limit orders without human intervention. I would be interested also 

in learning more about this hybrid market and how it will be impacted in Reg NMS. 

Again, Mr. Chairman, I want to thank you for your willingness 

to come here before this committee to help us with our work. I hope 

that many of the questions that we raise here today will eventually 

be answered. Thank you for being here today. 

Thank you. I yield back, Mr. Chairman. 

Mr. BAKER. I thank the gentleman. 

Mr. Tiberi, did you have a statement? 

Mr. Fossella? 

Mr. FOSSELLA. Thank you, Mr. Chairman. 

Since the start of the SEC’s proposed Regulation NMS, it was 

clear that the cornerstone of debate would be centered on the 

trade-through rule. Although at first glance it would appear obvious that an investor large or small should get his or her order filled 

at the best price available, we learned that there is a lot more to 

this debate than just getting the best price. With new technologies, 

three other variables have become increasingly important: speed, 

certainty and size of execution. In fact, these three variables have 

been what have driven debate to the point of SEC action. 

The trade-through rule was established, an ITS rule, in an effort 

to both increase the connectivity between and among markets and 

to ensure that traders captured the best available execution price 

for their clients. Thus, if a broker on the floor of the Boston Exchange needs to buy 2,000 shares for a client, if the national best 

bid or offer is at the Philadelphia Exchange, the rule forces the 

broker to execute at the Philadelphia Exchange so that the investor 

is assured the best representation. 

The result was a national market system with competition and 

order competition throughout. While this rule was clearly of good 

intentions when first implemented, as the Nasdaq and ECN grew, 

an increased number of market participants found that the internal 

rules of the four base exchanges, particularly the New York Stock 

Exchange, prohibited them from obtaining the best price for their 

clients or investors. The first of the rules allows a specialist to hold 

an order up for 30 seconds before confirming or denying order execution. The second limits the size of an order that can be sent 

through the New York Stock Exchange electronic order submission 

to no more than 1,099 shares. 

With these rules in place, I agree that a trader sitting at a trading desk outside the walls of the New York Stock Exchange has 

every right to be frustrated when they could be executing a trade 

immediately with certainty of execution in whatever size is available, but instead must either break the order up into lots of 1,099 

shares, or hire a representative on the floor of the exchange who 

14

can execute the size their client is looking for. In one simple method, Reg NMS will eliminate the limitations experienced by traders 

outside the walls of the four base exchanges, allowing them to 

build and operate a marketplace with speed, certainty and size. 

In addition, Reg NMS allows investors not wanting to participate 

within a slow quote to trade around that quote. With the elimination of these rules, the trade-through rule will once again work 

in favor of the investor, with increased enforcement from the SEC. 

Finally, I believe the trade-through under Reg NMS when properly enforced will be a net plus for both the confidence of the individual investor that has grown skeptical of Wall Street during the 

past 5 years, and for the confidence of foreign investors who desire 

to invest money in the United States. The influx of capital from foreign investors has doubled over the past decade, and while likely 

to continue to increase as foreign countries become wealthier and 

as foreign companies decide to access U.S. capital by listing on the 

U.S. exchanges, I believe it is important that the United States 

provide a vibrant marketplace where all investors in all companies 

looking to participate in them can do so with confidence that there 

are regulatory backstops in place to protect them from being unfairly disadvantaged. 

In conclusion, I want to thank Mr. Donaldson, and I want to 

thank the SEC for their efforts. I think the staff has found a good 

balance in these proposals. It would open up the marketplace to 

competition, while maintaining principles that ensure the investor 

remains protected. 

Thank you. I yield back. 

Mr. BAKER. I thank the gentleman. 

Mr. Moore? Mr. Moore stepped out. 

Mr. Baca? 

If no member seeks recognition for purposes of an opening statement, at this time I would like to turn to our witness today, Mr. 

William Donaldson, the chairman of the Securities and Exchange 

Commission. 

Your formal statement will be made part of the record. Please 

proceed at your own leisure, sir. 

STATEMENT OF HON. WILLIAM H. DONALDSON, CHAIRMAN, 

U.S. SECURITIES AND EXCHANGE COMMISSION 

Mr. DONALDSON. Chairman Baker, ranking member Kanjorski 

and members of the subcommittee, thank you for inviting me to 

testify today on proposed Regulation NMS. 

All of the proposals included in Regulation NMS are designed to 

benefit and protect investors in the U.S. equity markets and to facilitate efficient capital formation by modernizing and strengthening the national market system. The national market system encompasses the stocks of more than 5,000 listed companies which 

collectively represent more than $14 trillion in U.S. market capitalization held by investors. 

The commission is committed to assuring that investors and public companies have the fairest and most efficient markets possible 

for the these stocks. I welcome your continuing interest in an issue 

of such vital importance to investors and the economy. 

15

Given where we are in the process of considering Regulation 

NMS, my testimony today reflects my own views and not necessarily those of my fellow commissioners. In this regard, I must 

point out that the Commission and its staff are currently in the 

final stages of deliberation on the NMS proposals and the individual commissioners continue to weigh the complex policy considerations presented by the proposals. I have not reached a final 

judgment on how to balance these considerations myself. 

Regardless of what the Commission ultimately decides, this subcommittee and the public should have full confidence that the Commission has systematically and responsibly analyzed the relevant 

data and carefully considered the views of all commentators. 

Hopefully, my testimony today will convey some measure of the 

enormous amount of careful consideration that the Commission has 

devoted to these issues over the last several years, and indeed continues to devote today. In my written remarks, I have described 

this intensive and comprehensive process. Prior to formulating the 

specific Regulation NMS proposals, the Commission’s review included multiple public hearings and roundtables, an advisory committee, three concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives, and a constant dialogue with industry participants and investors. 

This process continued after the Commission published the proposal for public comment in February of 2004. We held a public 

hearing on the proposals in April 2004, following which we published a supplemental request for comment to give the public an 

opportunity to respond to important developments at the hearing. 

The public submitted more than 900 comment letters on the original proposals, encompassing a wide range of views. The insights of 

the commentators on the proposals, as well as those of the NMS 

hearing panelists, contributed to significant improvements in our 

initial proposal. 

Consequently, rather than immediately adopting rules, the Commission re-proposed Regulation NMS in its entirety in December 

2004 to afford the public an additional opportunity to review and 

comment on the details. In response, the Commission has received 

more than 1,500 additional comments which we are now in the 

process of analyzing. I might add that 1,400 of those comments 

were form letters with the same substance in them. 

In my written remarks for the record, I provided a brief overview 

of the four principal components of the regulation. I have also attempted to place the Commission’s efforts in the broader context of 

fulfilling the mandate that Congress gave us in 1975 when it directed us, ‘‘With due regard to the public interest, the protection 

of investors and the maintenance of fair and orderly markets, to 

use our authority under the Exchange Act to facilitate the establishment of a national market system for securities.’’

In particular, I discuss the insightful comment in the accompanying House report that emphasized, ‘‘Investors must be assured 

that they are participants in a system which maximizes the opportunities for the most willing seller to meet the most willing buyer.’’ 

Because I understand that the subcommittee is interested priVerDate 0ct 09 2002 10:16 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 G:\DOCS\23736.TXT FIN1 PsN: MICAH
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marily in the trade-through aspect of our proposal, I will confine 

my oral remarks to this component. 

I would like to make three basic observations on this topic, and 

then I would be happy to elaborate further on these and the other 

aspects of Reg NMS if that would be helpful. 

First, I would observe that throughout the Commission’s deliberations over the trade-through rule we have kept our eye on one 

overriding objective: the protection of investors, with particular attention to the concerns of small investors who may not have the 

resources to monitor the behavior of their agents, the brokers. The 

thrust of the proposed trade-through rule is actually quite simply 

stated. When an investor sends an order to a market, the market 

can either execute the order at the best price then being quoted on 

the national market system, or the market must send the order to 

the best quoting market. 

What does this mean? Two things. It means that a broker executing an order will be required to give that order the best price 

then available in any electronically accessible market even if the 

broker internalizes the order or would prefer to trade in another 

market that may offer the broker itself, if not the customer, an advantage. And second, it means that an investor who is willing to 

place an aggressively priced limit order on the book will not have 

his order ignored in favor of a less aggressively priced order. This 

second point is sometimes overlooked, so let me just expand on it 

a bit. 

The investor who is willing to post a limit order supplies liquidity to the marketplace. The limit order shows the market where 

trading interest lies and helps to establish the best price for stock 

trading. This investor provides a public service and the market as 

a whole benefits. But this investor acts at a cost to himself, for he 

reveals his trading interest. In effect, he offers an option that any 

other investor can exercise simply by placing a market order. He 

risks having that option exercised only when the market is moving 

against him, and losing the trade when the market is moving away 

from him. His only compensation is the ability to trade when his 

quote is the best quote available. If he does not get an execution, 

then he is not compensated and he will soon question why he posted the limit order. 

Worse, if he only gets an execution when the market is moving 

against him, we can begin to understand why he might choose not 

to offer the option to the market in the first place. A trade-through 

rule helps protect that investor for his willingness to supply liquidity to the market. So the trade-through rule is in the most fundamental sense a rule that protects investors. 

This simple point can get lost in all of the sound and fury unleashed by vested interests for whom a market-wide trade-through 

rule will require new ways of doing business. I know that members 

of this subcommittee have been lobbied just as hard as I have on 

this issue. I am sure that you have asked yourself, as I have myself, just exactly whose interests are being advocated. 

The second broad observation I would like to make is that I 

think it is useful to note that much of the hue and cry over the 

trade-through rule is somewhat wide of the mark. The most strident criticism that we hear about the trade-through rule appears 

17

to focus on the existing ITS rule, the intermarket trading system, 

a 35-year-old anachronism that has plainly outlived its usefulness. 

Let me be absolutely clear. The commission is not proposing to 

validate or extend the ITS rule. Quite the contrary, the Commission has proposed a strengthened and modernized trade-through 

rule, one that will work. 

The ITS rule is like a horse and buggy driving down the runway 

at Reagan Airport. That is because the key weakness of the ITS 

rule is that it does not distinguish between an electronic quote, one 

that can be executed immediately, and a manual quote, one that 

requires human beings to negotiate. The ITS rule has made it difficult for electronic marketplaces to compete with floor-based exchanges. In the process, it has helped floor-based markets maintain 

their competitive dominance. The commission has proposed to fix 

that problem. 

The only quotes entitled to protection under the proposed tradethrough rule are electronic quotes, quotes that are immediately and 

automatically accessible. As so structured, the proposal addresses 

the main criticism that one hears about the ITS rule: that when 

a market is forced to send an order to New York or another floorbased market, it languishes while the specialist decides whether to 

trade with it. That cannot happen under the rule the Commission 

has proposed. If the quote is not automatic, then it is not protected. 

The proposal addresses other legitimate criticisms of the old ITS 

rule, such as the block-trade exception that results in the bulk of 

trade-throughs in listed stocks, and the weak and cumbersome satisfaction remedy that the old rule provides. In effect, the old rule 

does not prohibit trade-throughs. It merely tells a market that is 

traded through that it can go and complain to the other market 

and demand ‘‘satisfaction.’’ As you can imagine, such a weak remedy is weakly enforced. 

The commission’s proposed rule would eliminate the broad block 

exemption in favor of more tailored benchmark and intermarket 

sweep exceptions, and we require market centers actually to install 

policies and procedures to prevent trade-throughs, instead of merely providing for an after-the-fact satisfaction remedy. 

To my final observation, I want to emphasize that the tradethrough rule that the Commission has proposed is pro-competitive 

in the best tradition of the market reform initiatives that the Commission has spearheaded over the last number of years. As I explain in more detail in my written remarks, much of the public debate over the trade-through rule has focused on one type of competition: competition between markets. But we must remember 

that there are two kinds of competition that Congress has directed 

us to foster. One is competition between markets, like the competition between Nasdaq and Instinet, for instance. The other is competition between investors, or as it is usually called, competition 

between orders. Both kinds of competition are essential for vibrant 

and healthy remarks, as Congress recognized in 1975 when it told 

us to perfect the national market system. 

Some of the powerful market centers and professional traders 

most vocal in this debate seem to downplay order competition. But 

the Commission has not forgotten that one of the great strengths 

of the U.S. markets, which do not exist in markets in other places 

18

in the world, is that trading interests of all types and sizes of investors is integrated to the greatest extent possible into a unified 

market system. Such integration ultimately works to benefit both 

retail and institutional investors. Retail investors will participate 

directly in the U.S. equity markets, however, only to the extent 

they perceive that their orders will be treated fairly and efficiently. 

I am concerned about retail investors’ perception of unfairness 

when they display an order representing the best price for a stock, 

yet see that price bypassed by trading in other markets. A tradethrough rule such as the one the Commission has proposed would 

help maintain the confidence of all types of investors in the U.S. 

equity markets. 

I will conclude by offering a few thoughts on the future of the 

Regulation NMS rulemaking process. Although I cannot predict the 

final outcome, I do believe it is extremely important that there be 

an outcome and that the outcome be reached soon. Many of the 

issues raised by Regulation NMS proposals have lingered for many 

years and caused serious discord among market participants. 

These issues have been studied and debated and evaluated from 

nearly every conceivable angle. Few would seriously oppose the notion that the current structure of the national market system is 

outdated in many respects and needs to be modernized. The commission must move forward and make decisions with regard to 

final rules if the U.S. equity markets are to continue to meet the 

needs of investors in public companies. 

Although Nasdaq stocks are part of the national market system, 

some have suggested that the Commission should at this point 

adopt a trade-through rule only for exchange-listed stocks. Although this approach would preclude the possibility of unintended 

consequences in the Nasdaq market, no approach would have drawbacks that the Commission would need to consider carefully. 

One of the Commission’s goals in its year-long review of market 

structure has been to formulate rules for the national market system that adequately reflect current technologies and trading practices and to promote equal regulation of stocks and markets. This 

goal does not reflect a simple desire for uniformity, but is identified 

in the exchange act itself as a vital component of a truly national 

market system. 

The trade-through rule objective of promoting best execution of 

customer orders would be a particularly difficult benefit to set 

aside for Nasdaq stocks. I question whether ordinary investors 

should have to remember that their orders are protected by a commission rule for exchange-listed stocks, but that caveat emptor still 

prevails in the Nasdaq market. The commission will need to carefully consider whether if a trade-through rule is indeed appropriate 

for the exchange-listed stocks, its best execution and liquidity-enhancing benefits should not be extended to Nasdaq stocks. 

I can assure you that the Commission fully recognizes the farreaching nature of many of the proposals. If adopted, some would 

require significant industry efforts to modify systems and otherwise 

prepare for the new regulatory structure. We are sensitive to those 

concerns. If the Commission chooses to adopt the rules, we will 

work closely with the industry on implementing them. As I have 

19

emphasized, the Commission is still considering Regulation NMS 

proposals, including all of the issues that I have discussed today. 

I look forward to hearing your views and answering questions on 

the market structure issues facing the Commission, with a simple 

caveat. As I am sure you appreciate, it would be inappropriate for 

me to attempt to pre-judge where the Commission will arrive in its 

deliberations on these complex subjects. 

Thank you again for inviting me to speak, and I would be very 

happy to answer any of your questions. Thank you. 

[The prepared statement of Hon. William H. Donaldson can be 

found on page 42 in the appendix.] 

Mr. BAKER. Thank you, Mr. Chairman. 

I will start with just a question about observations of the performance of the Nasdaq. 

Is it your opinion, based on the lack of trade-through provisions 

for the Nasdaq, that investors have not been appropriately or efficiently treated by Nasdaq performance? 

Mr. DONALDSON. Let me try and answer that. The question you 

ask is complex. I believe there are a number of answers to it. The 

incidence of trade-throughs in the Nasdaq market is higher than 

has been advertised by some advocates. The incidence of tradethroughs in the Nasdaq market is concentrated in the small end 

of the market. It is concentrated in the 500-share end of the market, the individual investor end of the market. 

So in that sense, although the Nasdaq market has made tremendous strides in bringing itself to the level that it has brought itself 

to now, there are large dollars being missed by traded-through best 

bids and offers on the Nasdaq market. 

Mr. BAKER. I read somewhere I believe, I do not think it was in 

your printed testimony or an SEC document, that the guesstimated 

inefficiencies as they were making reference to would equate to 

something in excess of $300 million in lost value, according to some 

study, I think it was within the Office of Economic Assessment. It 

seems to me if that is the focus, we ought to be concerned about 

market data fees. I mean, that is well over $400 million. 

I am taking your answer to mean that the Nasdaq is less efficient than the New York, and there are efficiencies to be gained by 

the application of the trade-through. 

Mr. DONALDSON. I would not use the word ‘‘efficient,’’ Congressman. I would say that in terms of trade-throughs there are more 

trade-throughs as a percentage of trading than there are on the 

New York Stock Exchange. 

Mr. BAKER. I understand your position. We will follow up to understand the way in which that position is reached with more detail. Will the trade-through be made applicable to ETFs? 

Mr. DONALDSON. I am sorry? 

Mr. BAKER. Will the trade-through be made applicable to ETFs? 

Mr. DONALDSON. To ETFs? 

Mr. BAKER. Yes. 

Mr. DONALDSON. We already have a special rule for ETFs, yes. 

Mr. BAKER. Well, today there is a pilot which was renewed in December which allows a three cent deminimus trading band, which 

has been extraordinarily successful by all accounts, I believe. On 

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throughs, and on the other we are going to propose that the tradethrough be made applicable to the Nasdaq. Is that sort of the policy 

outcome? 

Mr. DONALDSON. I am hesitating to make a conclusion for the 

Commission, but I will tell you that the rule will apply to ETFs. 

Mr. BAKER. That would seem to be inconsistent with the three 

pilots that have been previously entered into. I will follow up on 

that a little bit later. 

Going to the particular interests of the Nasdaq, I understand the 

argument being made is that it really will be a question of better 

service to consumers who now engage with the Nasdaq in executing a trade. In your discussion of the ITS provision, you indicated that electronically based systems today are at a competitive 

disadvantage with the auction exchanges, and that application of 

the trade-through rule as proposed by the Commission will actually 

equalize competitive opportunities. 

Is that a fair summary of your position? 

Mr. DONALDSON. Let me try and re-summarize. The Nasdaq market has great strengths and it certainly has improved over the few 

years. I just ask you to keep in mind that the regulatory action has 

been an incredibly significant driver for improvement in the 

Nasdaq market, such as our adoption of the order-handling rules 

and the Department of Justice’s investigation into collusion by 

Nasdaq market makers, and our mandate that the markets trade 

in penny increments. I think that basically we have spurred competition through regulation with the order-handling rules that we 

helped Nasdaq institute. We are doing the same thing here. 

Mr. BAKER. I just have one question. My time has expired. 

So you are suggesting to me that the application of the tradethrough to Nasdaq with the Nasdaq now having more limit orders 

placed than the New York exchange, the Nasdaq has no tradethrough; New York does. 

Nasdaq has more limit orders than New York, that the consequence of the application of the trade-through rule as modified 

in the re-proposal will actually enhance the number of limit orders 

placed? 

Mr. DONALDSON. The comparison must be made with the improvements that we are trying to make in the marketplace. We are 

comparing New York Stock Exchange postings, if you will, with the 

old and ineffectual ITS system. We are comparing Nasdaq as it exists today. 

You have to make the comparison of what this market will look 

like with the new rules, when there is a trade-through rule in both 

markets, and the one market is not depending upon the trading 

system. 

Mr. BAKER. But you feel it will result in an increase in limit orders at the Nasdaq? 

Mr. DONALDSON. I think it will result in the increase of posted 

limit orders, yes. 

Mr. BAKER. My time has expired. 

Mr. Kanjorski? 

Mr. KANJORSKI. Thank you, Mr. Chairman. 

First of all, Mr. Chairman, let me say that I have full appreciation of the pressures you must be under and the other commission 

21

members. We appreciate your holding your position as to what is 

best for the retail investors. 

It is my understanding that the majority of the comment letters 

received by the SEC concerning Reg NMS from institutional and 

retail investors such as the Investment Company Institute, T. 

Rowe Price, Vanguard, Barclays, Global Investors that manages 

the Federal First Savings Plan, the Bank of New York, the Consumer Federation of America, the National Association of Investors 

Corporation, favor a trade-through rule. And many, including the 

ICI, support the rule being applied across all markets in all NMS 

securities to protect each market’s best bid and offer. 

Is this accurate? If so, why do you believe that some intermediaries have been so vocal in opposition to the desire of their 

customers? 

Mr. DONALDSON. Well, I think that one would get back to the 

fundamental principle that we have to keep asking ourselves at the 

SEC, and that is investor protection. Then comes the efficiency of 

the intermediaries and the particular platforms that they have. 

This whole situation is immensely complicated. There are lots of 

different views, but when you reduce them down and keep asking 

yourself what is the effect on individual investors, then that becomes the prevailing mandate, if you will, when there are a lot of 

compromises available. It becomes the prevailing mandate when a 

change in the system may change the way some of the intermediaries are organized. 

Mr. KANJORSKI. I appreciate your work. I hope you hold a stiff 

upper lip and we will see you when the rule gets through. 

Mr. Chairman, I am going to return my time so that others may 

have some questions. 

Mr. BAKER. I thank the gentleman. 

It is the Chair’s intention at this point, since we have a vote 

pending, to recognize Mr. Royce for his full time, and then recess 

for about 15 minutes so members could vote and come back. 

Mr. Royce? 

Mr. ROYCE. Thank you, Mr. Chairman. 

Chairman Donaldson, I too would like to thank you for being 

here with us today. It is good to have you back in front of the committee. I want to thank you and I want to thank the entire commission. I think you all are to be commended for taking on the 

daunting task of reopening Regulation NMS. 

It is clear to me that there is a great deal of consensus on many 

of the issues in this most recent NMS rule. With that said, it is 

also apparent that there is not a great deal of consensus around 

the trade-through component of NMS. I wanted to indicate that I 

appreciate your concern and desire to protect the interests of small 

investors. One of my concerns which I wrote to you about in January is that the U.S. equity markets remain innovative and dynamic. I have heard many say that the trade-through proposal 

could hinder the ability of markets and market-makers to innovate. 

I would like to get your views about how the trade-through proposal will affect innovation in our markets going forward. In other 

words, do you think the incentive to create a better trading platform will be diminished in any way? 

22

Mr. DONALDSON. Let me say to begin with that the suggestion 

of the new trade-through rule is the result of innovation. In other 

words, the trade-through rule that has existed before in effect was 

being monitored by the ITS. That was designed 25 years ago and 

totally inadequate to the speed with which transactions take place 

today. So the new trade-through rule as proposed is the result of 

technological innovation. 

It is the result that now these markets can be connected with 

each other and with their customers by a web, a spider web of communications which can transmit orders from anywhere in the country or in the world, for that matter, to the best bid or offer instantaneously. That really could not be done before. When they were 

transmitted less than instantaneously, the gap that it took, the 

time that it took to execute the order made a lot of faster trading 

people miss their markets. 

So I would say that this technology that can be used today, 

which has been developed, and some of it developed only in recent 

years, is a giant leap forward that will make our markets more 

competitive. 

Mr. ROYCE. Thank you, Chairman Donaldson. 

I will yield back the balance of my time. 

Mr. SHAYS. [Presiding.] I thank the gentleman. 

We are going to have a slight recess. The Chairman has already 

gone to vote, so he might be back sooner. Thank you. 

[Recess.] 

Mr. BAKER. [Presiding.] I do not want to inconvenience the 

Chairman any more than is absolutely necessary. I am convinced 

that there will be some members returning in a moment. 

Mr. Hensarling is here, and he was prepared with his questions. 

The gentleman is recognized. 

Mr. HENSARLING. Thank you, Mr. Chairman. 

Chairman Donaldson, again thank you for appearing before us 

today. The first question I have, Mr. Chairman, I am curious as opposed to relying on the trade-through rule why the SEC is not relying upon the duty that brokers and investment managers have to 

their clients, the duty to obtain best execution for their clients’ orders. 

Are we not seeing this take place in the marketplace? Is best 

execution not happening presently? 

Mr. DONALDSON. Well, there are lots of statistics on whether best 

execution is actually being achieved. I think generally speaking it 

is, but there is still a large amount that is not consistent with best 

execution. That depends upon the nature of the stock being traded 

and the rapidity with which it is traded. You get trade-throughs, 

as I mentioned earlier, in both markets in rapidly trading stocks. 

They trade so fast they get trade-throughs. It is hard to track 

them. 

Mr. HENSARLING. Let me ask you this question, Mr. Chairman. 

You have so many large institutional investors in mutual funds 

that seemingly are on the other side of this issue and are concerned about the expansion of the rule to Nasdaq. Many firms like 

Schwab and Fidelity have indicated a preference to trade on 

Nasdaq over the New York Stock Exchange. 

23

Prior to coming to Congress, what little meager wealth I might 

have is tied up, for example, in a number of Fidelity mutual funds. 

I have long since learned that I was not smart enough to trade in 

individual stocks and bonds. But I guess I would be concerned not 

so much as a member of Congress, but as an investor when the 

keeper of my children’s college fund indicates a real amount of anxiety over the expansion of this rule. 

So why are so many of the mutual fund companies and institutional investors on the other side of the issue? 

Mr. DONALDSON. You know, you have to look at the business of 

these different mutual funds and where it is concentrated. I think 

the thing that one has to keep in mind is that there is a tradeoff 

here between attempting to get the best price, the best bid and 

offer, but at the same time to maintain competition between markets. In effect, there are a very large number of funds, perhaps the 

largest aggregation of funds is the ICI, the Investment Company 

Institute, which has written a strong letter supporting us. 

But you are asking why do some not support us, some institutional investors not support us? I guess you would have to ask 

them. If you look at the concentration of trade-throughs in the 

small 500-share part of the market, I think there is somebody from 

Schwab here and they can tell me whether I am wrong or not, but 

that is where a lot of their order business is. At that small end of 

the market, you have the least, generally speaking, sophisticated 

investors who have trouble keeping up with knowing exactly at 

what price their trade is going to be done. 

So I suspect you could go down to each one of the people who 

have written us letters. As the old expression goes, where you 

stand is where you sit. 

Mr. HENSARLING. I think, Mr. Chairman, that you had indicated 

on a previous occasion that at least one of the reasons we have a 

trade-through rule is to try to bring institutional orders into the 

market. There is some concern by others that the institution of this 

rule could actually have the opposite effect in that traders may 

take their money in trading activities offshore. 

Am I to assume that you do not share those concerns? 

Mr. DONALDSON. That is a very good question. I think that to 

date, we have the best markets in the world. Part of the reason for 

that is the ability in our market for institutions and individuals to 

trade in the same marketplace. In other countries around the 

world, in Germany for instance, the large blocks are not done on 

the exchange. That has to do with the changing patterns of ownership in Germany. 

But the fact of the matter is, I believe that people will continue 

to pick our markets and to list here and to trade here if we have 

the most competitive markets in the world. And I think we do, and 

we are trying to improve that. And if we hold to very high standards, listing standards and accounting standards and so forth, so 

that people know that when they buy a U.S. security that the numbers are correct. That is what we are striving for in other areas of 

our responsibility. 

So it is not just the trading market, but it is the stamp of approval, if you will, the stamp of reliability that people count on 

with our accounting systems. 

24

Mr. HENSARLING. I see I am out of time. Thank you for your testimony. 

Mr. BAKER. Mr. Chairman, it is my intention to go a little further with my questions, hoping that we will have members come 

back from the vote, because there were several members indicating 

they would like to follow up with a question. I was assured that 

we were only going to have one vote, and unfortunately the price 

was not as advertised by the time I closed the deal. So I have been 

misled a little bit. 

Let me ask one more question and we will wait and see what 

happens. I may have to recess again and run over and vote and 

come back. Do you have constraints on your time today? 

Mr. DONALDSON. I am delighted to be here as long as you want 

me. 

Mr. BAKER. You said that with real sincerity, too. 

[Laughter.] 

Mr. BAKER. One of the other areas that have come to my attention that I do not know what the disposition is in discussions at 

this point, with regard to fees for market data. It appears from 

published discussions of the matter that the SROs are collecting 

about ten times the estimated costs of collection. Under Reg NMS, 

I am understanding that there is a new methodology being proposed for distribution of the revenues, but there is not a recommendation as to the underlying legitimacy of collecting that 

much revenue in relation to the actual cost. 

It seems that is such an essential component of the trading operation that it is almost like a utility part of the system. Is there contemplating given to any limitation, restructure, any discussion 

about the fee side? 

Mr. DONALDSON. Yes. As you know, we have a release out right 

now which is, excuse me, a proposed rule is out right now which 

had been reflected upon, dealing with the structure of the SROs; 

dealing with how they are to be organized, the independence and 

so forth; dealing with the clarity of their transparency in terms of 

how they are spending their money and so forth. 

To our way of thinking, a more important long-term decision on 

just how expensive tape revenues should be will depend upon a 

better determination of how the independent SROs, particularly as 

some of them become publicly held, how they are going to pay for 

their regulatory obligations. The major source of revenue for most 

of the SROs is tape revenues. 

So we have chosen to take this in two steps. Number one, we 

want to get at a fair distribution of those revenues before we get 

at the absolute size. There are a number of practices now in terms 

of determining what those revenues are, so-called ‘‘tape shredding,’’ 

people that break up trades and put many, many trades on in 

order to get more revenues coming. There are a lot of bad practices 

out there. Those are the first order we want to address. When we 

have a better feel for revenue sources for these SROs, then we will 

have a better feel for how high or low those supporting revenues 

are. I might also add that the costs of producing those revenues are 

only one part of the equation. 

Mr. BAKER. I understand there is an element of the market data 

reforms that the Commission’s proposal would require market cenVerDate 0ct 09 2002 10:16 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 G:\DOCS\23736.TXT FIN1 PsN: MICAH
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ters to send protected quotes through some yet to be selected government-recognized distributor of market information. The commission in its oversight role would then establish the price that brokers would pay for this data. 

On two levels, just the Government engaged in setting prices for 

this activity is problematic, but is that the way in which you intend 

to see the Commission’s role in exerting some influence over this 

pricing schedule? 

Mr. DONALDSON. You know, we have a release out right now on 

SRO structure, as I mentioned, and it raises all these market data 

issues. I have just tried, in my inarticulate way, to divide this into 

two parts: the distribution or how the revenues are arrived at; and 

then as a second part, the absolute size of them. 

Is that getting at what your question is? 

Mr. BAKER. I can perhaps, for the sake of time, it does not look 

we are going to have someone to take over. Let me suggest I am 

going to follow up with more clarity in a written question for you. 

I am going to ask your indulgence one more time. I am going to 

run over there, and I think I can get back in 10 or 15 minutes at 

the max, find out if we have other members who are going to come 

back, and answer questions. If we do not have members back by 

the time I arrive, then we will consider our work done here. 

But let me run over to the floor to make sure. We had a number 

of members on all sides of this issue that expressed interest in having comments. Let me just move cautiously before we adjourn. I 

will be right back. 

Mr. DONALDSON. Okay. 

Mr. BAKER. Thank you. 

[Recess.] 

Mr. BAKER. I would like to reconvene our meeting and proceed 

with Mr. Fitzpatrick. 

Mr. FITZPATRICK. Thank you, Mr. Chairman. 

Chairman Donaldson, thank you for your testimony today. I 

found it very helpful for me. 

I understand that the SEC’s published studies had some flaws in 

their calculations in the numbers and the underlying assumptions. 

You had indicated last week that you had reanalyzed some of the 

statistics. 

I was wondering if you could just give me an update as to what 

you found, what the statistics were, and whether or not there will 

be additional reports forthcoming, and if so does it make sense that 

we wait for the additional reports before we make any major policy 

changes. 

Mr. DONALDSON. Which reports are you referring to? 

Mr. FITZPATRICK. The SEC published reports. Did you refer to 

them last week and indicate that you had thought that there were 

some statistical problems? 

Mr. DONALDSON. There were a number of economic calculations 

that were made, and when we first put forth NMS and in the reproposing document, some commentators challenged some of those 

numbers. We have been hard at work verifying those numbers. Basically, we stand by those numbers. 

I might add that the effort that the SEC has put forth has been 

under two different heads of our Office of Economic Analysis, so 

26

that the whole work has been reviewed in a way by two different 

people at the top, as well as by the organization. And I think that 

it is comforting to know that there has been agreement there and 

disagreement with some of the comments that were made by commentators. 

Mr. FITZPATRICK. Are you referring to the OEA study, the four 

studies? 

Mr. DONALDSON. I am talking about the OEA studies that were 

in our original release on NMS, those numbers and figures and 

judgments which have been re-reviewed as a result of the re-proposal. 

Mr. FITZPATRICK. I just have one additional question, Mr. Chairman. Doesn’t the SEC believe that using this sort of common-law 

standard of best trading practices, best execution practices, isn’t 

that sufficient to protect the investors both large and small? 

Mr. DONALDSON. I am sorry? 

Mr. FITZPATRICK. Best execution practices? 

Mr. DONALDSON. Yes. 

Mr. FITZPATRICK. Isn’t that a better standard going forward? 

Mr. DONALDSON. You mean execution standards, the execution 

based on the size of the transaction? 

Mr. FITZPATRICK. There is a standard that exists that brokers 

and traders should use best execution practices to protect their clients. Isn’t that a better standard going forward than a tradethrough rule? 

Mr. DONALDSON. I see. I do not think so. I think this is an area 

in which the responsibility that a broker has for best execution is 

a very important thing. Insofar as that can be monitored, it is very 

important. But I think that, in terms of the kind of markets that 

we are operating in and the instantaneous transactions that take 

place, it is very important that there be a formalized set of rules 

that guarantee through the trade-through rule that the best bid 

and offer will be honored. I think it is a combination of those two 

things that will make for the system being as fool-proof as it can 

be. 

Mr. FITZPATRICK. Do you believe that brokers are living up to 

their fiduciary obligation? 

Mr. DONALDSON. I think that you have to be very careful when 

you make generalizations. I think that most brokers are attempting 

to live up to the responsibilities they have. On the other hand, the 

technology is such and the communication system is such that it 

is very hard for the broker and most particularly the broker’s customer to really feel with confidence that they are getting the best 

execution. 

Mr. FITZPATRICK. Other than generally speaking, let’s talk specifics. Is the SEC taking any enforcement action against brokers 

who are failing to uphold their fiduciary obligation of best execution? 

Mr. DONALDSON. We do the best we can. We have a complicated 

oversight system and we do the best we can to determine that. But 

it is a complicated subject because there are trade-throughs and 

there are trade-throughs. There are trade-throughs that are caused 

by technical conditions in the marketplace, et cetera, et cetera. It 

is very hard to evaluate that going back, huge amounts of data. So 

27

that we do the best we can. I think we do a pretty good job. I think 

brokers do a pretty good job, within the context of it being increasingly difficult to know that you are getting the best execution. 

Mr. FITZPATRICK. But in the SEC’s judgment, are there brokers 

out there who are not living up to best execution standards and 

their fiduciary obligation to their clients, such that the SEC has instituted enforcement actions against them? 

Mr. DONALDSON. Again, this is a subject of concern for us and 

we are currently looking at best execution in terms of certain periods of time where we see there may be some question. That would 

be most particularly at the opening of the markets, at the opening 

of the markets where we are looking right now intensely at whether best execution is being exercised. 

Mr. FITZPATRICK. Okay. 

Thank you, Mr. Chairman. 

Mr. BAKER. I thank the gentleman. 

Mr. Sherman? 

Mr. SHERMAN. Thank you, Mr. Chairman. 

It would seem like investors might have different objectives, and 

some would want the top of the book; some the depth book; some 

might be impressed by the software of this or that brokerage company. I would think that in many of these decisions you are not 

really retaining a broker, you are retaining a broker’s software to 

execute the transaction. 

I would wonder, is the SEC going to in effect prohibit investors 

from making the choice that they may want to make? In other 

words, he may want depth of the book. I want a top of the book. 

Somebody else is impressed with proprietary software that tries top 

of the book for 3 seconds, and then shifts to depth of the book. Are 

investors going to be able to retain the software strategy they want 

for the particular transaction? Or is it all going to be one-size-fitsall? 

Mr. DONALDSON. I would answer that in two ways. One is that 

I think the effect of an effective trade-through regulation will assure that the best prices are available and can be reached by the 

investor. 

Mr. SHERMAN. But sometimes I want the best prices. Sometimes 

I want the fastest executions. Sometimes I want the most anonymity. Can I pick the strategy I want? Or is the quote ‘‘best price,’’ 

which may end up being the best price available 5 minutes after 

I make the decision, which may end up being the wrong best price 

or the worst best price, am I stuck with one-size-fits-all if this regulation goes through? 

Mr. DONALDSON. No, I do not think so. I think that basically, to 

get back to what I said earlier, that this is a compromise, if you 

will, between two goals. One is the protection of the best bid, and 

the other is to protect those who want to trade rapidly, for whatever reason. 

By putting this together in a system where we are taking basically trade-through controls and so forth off of slow markets and 

putting it into what is a revolutionary change for the listed markets, the New York Stock Exchange, the dual system that they propose. You now have an interface where you are allowing people to 

have a best of both worlds, speed of execution and best price. 

28

Mr. SHERMAN. What if I call my broker and I say, ‘‘Look, I do 

not want you to execute this transaction on the New York Stock 

Exchange for this or that reason—I think they are cruel to bunnies 

or something; I only want you to execute this on Nasdaq,’’ is that 

now an illegal transaction? It could be the other way around. 

Mr. DONALDSON. Yes. I think what you also have to consider is 

that there is another side to every transaction. There is a responsibility to the marketplace. 

Mr. SHERMAN. Look, my broker represents me. I want my broker 

to go to the New York Stock Exchange and execute the transaction 

there. Does that become illegal? 

Mr. DONALDSON. No. There is a public good aspect to this. 

Mr. SHERMAN. Mr. Chairman, I am not asking you to defend why 

you are making it illegal. Stripped away of the reasons why it 

might be a good idea to force me to——

Mr. DONALDSON. Why it would not be a good idea is that you 

leave out there, if I want to do my own trade and I want to do it 

in a closet somewhere or I want to do it off the market, you thereby 

deprive the people who are using the market and——

Mr. SHERMAN. Mr. Chairman, I am not asking for justification. 

I am asking a yes-no question. 

Mr. DONALDSON. What is the yes-no? 

Mr. SHERMAN. Under the proposed regulation, if I instruct my 

broker to execute the transaction on this or that exchange or medium and to ignore all others, am I in violation of the law, or can 

I have it done the way I want it done? 

Mr. DONALDSON. If the market is assessible——

Mr. SHERMAN. Mr. Chairman, I am asking a very simple question. Can I instruct my broker to execute the transaction only on 

Nasdaq or only on the New York Stock Exchange, or is that an illegal transaction? 

Mr. DONALDSON. No is my simple answer. 

Mr. SHERMAN. No, I cannot do it? 

Mr. DONALDSON. No. No. If you do not like the price that is 

there, you can ignore it and send your order elsewhere to a market 

quoting a worse price if you want to. But all market centers must 

have procedures reasonably designed to avoid trade-throughs, and 

that could result in the market either matching the best price or 

your order being sent to another market quoting the best price. 

Mr. SHERMAN. So I can call a broker and say, execute this transaction only on Nasdaq and execute this other transaction only on 

the New York Stock Exchange and that is what he or she will do, 

and that will not be in violation of the regulation. 

Mr. DONALDSON. Yes. Subject to what I just said, you can choose 

to send your order initially to any specific market center. 

Mr. SHERMAN. Okay. So as long as we are preserving the investor choice, I have spent the last 3 minutes satisfying my concerns. 

Thank you. 

Mr. DONALDSON. Okay. 

Mr. BAKER. The gentleman yields back. 

Mr. Crowley? 

Mr. CROWLEY. Thank you, Mr. Chairman. 

Thank you again, Chairman Donaldson. 

29

There has been an ongoing discussion about the need to apply 

the trade-through rule to all U.S. equity markets, including the 

Nasdaq. Do you believe that if the SEC does not apply the tradethrough rule across the board on all markets, regulatory arbitrage 

will be the result, whereby the professional trader will trade and 

profit in a market which has no prohibitions, and those profits will 

not be passed along to small investors? 

Mr. DONALDSON. Yes, I do believe that one of the dangers of not 

extending the new trade-through rule to all NMS stocks is the potential for regulatory arbitrage. As I tried to say earlier, I do not 

think it is wise public policy to have an individual customer decide 

that in trading at one market he is being protected, but if he goes 

to another market the rules are different, and it is caveat emptor. 

Mr. CROWLEY. I appreciate that. If you have answered the question before, I am sorry I was not here when you did it. You and 

I have had a private conversation. I thought it might be appropriate to get some of those comments down on the record. 

Mr. DONALDSON. Sure. 

Mr. CROWLEY. Since Congress since 2002 and the SEC have 

tightened the corporate governance rules, tightened rules on mutual funds, hedge funds, expensing stock options, corporate disclosure, I was wondering why then would a new SEC rule apply to 

half the market and treat investors differently? You have just answered that question, that you do not believe they should be treated differently, depending on where they trade. Correct? For example, on the New York Stock Exchange or the Nasdaq market, is 

that correct? 

Mr. DONALDSON. If I understand your question, I believe that the 

proposed rule here should be extended to the over-the-counter market, to the Nasdaq market. I believe that if it is not, there is this 

potential for regulatory arbitrage, but that is of course a decision 

the Commission has to make. 

Mr. CROWLEY. Mr. Chairman, just one final question. It is my 

understanding that the vast majority of the comment letters you 

have received on the Reg NMS proposals were in opposition to the 

mandatory depth book routing due to the practical implications. If 

that is so, how much weight do you put on those comments? 

Mr. DONALDSON. I put a considerable amount of weight on those 

comments. I think a great preponderance of the comments did not 

believe that we should go to the depth of book. I think there again 

is a fear at this stage of the development of the marketplace that 

that is close to being a CLOB, consolidated limit order book. It is 

not a CLOB, but it has aspects of a CLOB. I think it has been 

shown through years and years of debate that that sort of centralization of the system would not be to the advantage of the system. 

Mr. CROWLEY. Can you give us any indication where the Commission might be heading on depth of book? 

Mr. DONALDSON. I am sorry? 

Mr. CROWLEY. Can you give us any indication of where the Commission might be heading on the issue of depth of book? 

Mr. DONALDSON. Well, there is overwhelming support for the top 

of the book, and I would say that in our second round of comments, 

very few proposed that we go to depth of book. 

30

Mr. CROWLEY. I thank the Chairman. 

I thank you, Chairman, for the time. 

I yield back. 

Mr. BAKER. Mr. Chairman, I want to express my appreciation for 

your generous grant of time today and your willingness to come to 

the committee and discuss these proposals. I just want to make 

clear for most members the depth of feeling about this is enhanced 

because markets have indeed changed dramatically, where hundreds of millions of individual investors are now placing their hardearned dollars into the markets hoping to grow their personal 

wealth for the first home, the children’s education, whatever it 

might be. 

Because of that greatly expanded number of working families 

now engaged in active market investing, it has enhanced the sensitivity of members of Congress to better understand and to ensure 

that those individuals are treated as best as can be practically 

achieved. No market system is perfect. All will have their flaws. 

We also have an obligation in this committee to recognize that 

this capital market function is very essential to the ongoing economic vitality of this country, and not to take ill-advised steps that 

may put any of that in the slightest jeopardy. 

I only make these comments because there were widely disparate 

views this morning about which direction we should go. I certainly 

respect the Commission’s work and your leadership. I just have expressed in my own view the concerns about going forward and perhaps a very careful continued evaluation for the short term would 

be helpful to us all. 

To that end, I do intend to follow up today with a letter, and 

some of the members have indicated a desire with their own questions. We will try to consolidate our limit order here and get it all 

in one letter, and get it over for your comment. It will be helpful 

for us in understanding the implications of the next step. I think 

it would be helpful to the Commission’s reception as they go forward as well. 

So I appreciate your courtesies extended and we do look forward 

to working with you as we head down the road. Unless you have 

further comment, I would like to call our meeting adjourned. 

Thank you very much, sir. 

[Whereupon, at 12:32 p.m., the subcommittee was adjourned.] 

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