U.S. GOVERNMENT PRINTING OFFICE

63–803CC WASHINGTON : 2000

COMPETITION IN THE NEW ELECTRONIC MARKET

HEARINGS

BEFORE THE

SUBCOMMITTEE ON FINANCE AND HAZARDOUS

MATERIALS

OF THE

COMMITTEE ON COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

SECOND SESSION

PART I—MARCH 29, 2000

PART II—MAY 11, 2000

Serial No. 106–111

Printed for the use of the Committee on Commerce

(

2

COMMITTEE ON COMMERCE

TOM BLILEY, Virginia, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

MICHAEL G. OXLEY, Ohio

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

Vice Chairman

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

STEVE LARGENT, Oklahoma

RICHARD BURR, North Carolina

BRIAN P. BILBRAY, California

ED WHITFIELD, Kentucky

GREG GANSKE, Iowa

CHARLIE NORWOOD, Georgia

TOM A. COBURN, Oklahoma

RICK LAZIO, New York

BARBARA CUBIN, Wyoming

JAMES E. ROGAN, California

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ED BRYANT, Tennessee

ROBERT L. EHRLICH, Jr., Maryland

JOHN D. DINGELL, Michigan

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

RON KLINK, Pennsylvania

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

TOM SAWYER, Ohio

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

JAMES E. DERDERIAN, Chief of Staff

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS

MICHAEL G. OXLEY, Ohio, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

Vice Chairman

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

STEVE LARGENT, Oklahoma

BRIAN P. BILBRAY, California

GREG GANSKE, Iowa

RICK LAZIO, New York

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ROBERT L. EHRLICH, Jr., Maryland

TOM BLILEY, Virginia,

(Ex Officio)

EDOLPHUS TOWNS, New York

PETER DEUTSCH, Florida

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

FRANK PALLONE, Jr., New Jersey

BOBBY L. RUSH, Illinois

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

3

C O N T E N T S

Page

Hearings held:

March 29, 2000, Part I ..................................................................................... 1

May 1, 2000, Part II ......................................................................................... 71

Testimony of:

Andresen, Matthew, President, The Island ECN .......................................... 6

Atkin, Douglas M., CEO and President of Instinet ....................................... 75

Dorsch, Shawn A., President and COO, DNI Holdings, Inc ......................... 20

Foley, Kevin, CEO, Bloomberg Tradebook ..................................................... 13

Jenkins, Peter W., Director of Equity Trading, Scudder Kemper Investments ............................................................................................................. 106

Kamen, Kenneth A., President, Princeton Securities Corporation .............. 110

Ketchum, Richard G., President, National Association of Security Dealers,

Inc .................................................................................................................. 100

McSweeney, Robert J., Senior Vice President, Special Committee on Market Structure, Governance, and Ownership, New York Stock Exchange,

Inc .................................................................................................................. 97

Schaible, John M., Founder and President, NexTrade .................................. 24

Stark, Holly A., Director of Trading, Kern Capital Management ................ 92

Wheeler, John J., Manager Equity Trading, American Century Investments ............................................................................................................. 80

Material submitted for the record by:

Andresen, Matthew, President, The Island ECN, letter dated May 2,

2000, to Hon. Tom Bliley, enclosing response for the record .................... 64

Foley, Kevin, CEO, Bloomberg Tradebook, responses for the record ........... 50

Galbraith, Steven, Senior Investment banking and Brokerage Analyst,

Sanford G. Bernstein & Co., prepared statement of .................................. 163

Ketchum, Richard G., President, National Association of Security Dealers,

Inc., responses for the record ....................................................................... 264

McSweeney, Robert J., Senior Vice President, Special Committee on Market Structure, Governance, and Ownership, New York Stock Exchange,

Inc., letter dated June 8, 2000, to Hon. Thomas Bliley, enclosing response for the record ..................................................................................... 270

Putnam, Gerald D., CEO, Archipelago, letter dated March 28, 2000, to

Hon. Michael G. Oxley .................................................................................. 49

Schaible, John M., Founder and President, NexTrade, letter dated April

21, 2000, to Hon. Tom Bliley, enclosing response for the record .............. 55

(III)

(1)

COMPETITION IN THE NEW ELECTRONIC

MARKET: PART I

WEDNESDAY, MARCH 29, 2000

HOUSE OF REPRESENTATIVES, COMMITTEE ON COMMERCE, SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS, Washington, DC.

The subcommittee met, pursuant to notice, at 10 a.m., in room

2123, Rayburn House Office Building, Hon. Michael G. Oxley

(chairman) presiding.

Members present: Representatives Oxley, Tauzin, Gillmor,

Bilbray, Ganske, Shimkus, Wilson, Fossella, Ehrlich, Towns, Engel,

Barrett, Luther, Capps, Markey, and Rush.

Also present: Representatives Burr and Rogan.

Staff present: David Cavicke, majority counsel, Linda Dallas

Rich, majority counsel; Brian McCullough, professional staff; Robert Simison, legislative clerk; and Consuela Washington, minority

counsel.

Mr. OXLEY. The subcommittee will come to order. The Chair will

recognize himself for an opening statement.

Technology is changing our lives dramatically as our economy

continues to evolve into an information-based society. In one decade, we realize the tangible benefits of the convergence of telecommunications, the computer industry and the emergence of the

Internet. Wireless technology allows us to communicate, conduct

commerce through cell phones or hand-held PCs and perform other

tasks with breathtaking efficiency. Information is easier to access

than we could have ever imagined just a few years back. The Internet is providing global competition that has lowered cost to consumers and businesses.

Our capital markets are experiencing a similar technological evolution. Better and more readily available information is changing

the composition of the markets. Self-directed investors now have

access to securities professionals research analysis graphs and

quotes from which they can make informed decisions. Not to commend any particular market participants’ TV commercials, but you

know the world has changed when you see Ringo Starr talking

about asset allocation and portfolio diversification.

Today we begin a series of hearings on competition in the new

electronic marketplace. This is a subject that is as challenging and

as interesting as anything we have examined in this subcommittee

heretofore. Just a couple of years ago, electronic communication by

the Internet and through the proprietary systems of electronic communications networks, or ECNs, began a revolutionary and astonVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 E:\HEARINGS\63803 pfrm07 PsN: 63803
2

ishingly rapid transformation of our financial markets. Even before

the advent of the Internet, technology fostered competition within

the markets. Technology led to the development of the dealer market, which was conceived as an alternative to the traditional auction market of the exchanges. That competition has served the

markets well.

More recently, the emergence of ECNs has provided additional

competition in the markets and a possible glimpse into the future.

ECNs vary in their business models, but all offer an alternative

trading mechanism for investors to execute their trades. ECNs provide investors with many benefits, including reduced trading costs,

faster execution and more choices of where to trade stock. Some

commentators have raised concerns that multiple venues competing

for order flow will fragment the market, but couldn’t fragmentation

be just another word for competition? This is an issue that we will

learn more about through the hearing.

The markets will determine the best price available for a stock.

One of our jobs here in Congress is to make sure that the rules

that govern our markets allow price discovery to happen in the

fairest and most efficient way. I believe competition should determine the best structure for the financial markets. The government

is notoriously bad at predicting the future and designing marketplace or picking winners and losers. What we can do is make sure

that the rules we have put into place foster competition, not monopolistic behavior.

I look forward to learning about how ECNs are reshaping our

markets. One of the questions that has been raised is whether multiple markets can function efficiently in a market in which they are

competing for liquidity. While ECNs initially catered to institutional clients, we are seeing a move into the retail marketplace. I

look forward to learning more about these developments as well as

how these trading models compare with the traditional auction and

dealer markets. We will hear from these traditional markets at an

upcoming hearing on this subject. I am pleased to welcome today’s

witnesses who hail from four very different ECNs, and I will introduce them before they begin their testimony.

The Chair yields the balance of his time and now recognizes the

ranking member, the gentleman from New York, Mr. Towns.

Mr. TOWNS. Thank you very much, Mr. Chairman.

Let me also thank you for holding this very important hearing.

The U.S. securities markets, which is the heart of the subcommittee’s jurisdiction, is undergoing rapid change. While I do not believe that any legislative action is necessary to address these revolutionary changes at this time, I do think that it is vital for the

subcommittee to closely monitor these changes. We must educate

ourselves on changes in the market and responsible oversight over

the SEC’s responses to these changes. We must ensure that neither

our actions nor the actions of the SEC accidentally threatens the

phenomenal success of the U.S. securities markets, which just happens to be centered in New York City, which I happen to be from.

That is an important issue.

I have not reached any conclusion on many of these issues raised

by the fundamental changes of our securities markets. However, I

have followed the debate on these issues with interest. For examVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 E:\HEARINGS\63803 pfrm07 PsN: 63803
3

ple, some have stated that the changes in the securities markets

require the introduction of a central limit order book. This contention raises a number of questions in my mind. Who would set the

rules of a CLOB? Who would enforce these rules? Would a CLOB

deter innovation? The kind of innovation that is changing our markets for the better today?

We need to be concerned about that. Would all customers’ orders

or just retail orders be required to be submitted to a CLOB? If only

retail orders must be submitted to a CLOB, would this disadvantage these customers? I think these questions need to be answered,

Mr. Chairman, and I think we need to get answers on these questions before we move forward. Would it threaten the extremely

high level of retail participation that make our securities markets

the envy of the world?

There has also been much discussion of the role of ITS, the intermarket trading system. In the future, again, I haven’t come to any

conclusion, Mr. Chairman, but I do have many questions. As I understand it, ITS was created at a time when there was no linkage

between securities markets at all. ITS made it possible for brokerdealers to ensure that they were getting the best price for their

customers. In a way, the markets relieved broker-dealers from

their best execution obligation. While ITS technology has advanced,

questions still remain, many questions. Is the technology available

today for broker-dealers to take complete responsibility for fulfilling their best execution obligation without the help of ITS? If it

isn’t available, will it be available soon? How will this change the

debate about the structure of ITS? And even the need for ITS.

Again, Mr. Chairman, thank you for calling this hearing. I look

forward to the testimony of the witnesses today, and at the other

hearing that I understand that you intend to call in the very near

future, and I think that it is important that we do have that hearing because we are dealing with a situation where there is a lot

of changes, and I think we need to be on top of them, and I don’t

think that we need to do something without really having all of the

information before we move forward.

Thank you, Mr. Chairman, for having these hearings.

Mr. OXLEY. Are there any other opening statements?

Hearing none——

Mr. SHIMKUS. Mr. Chairman.

Mr. OXLEY. The gentleman from Illinois.

Mr. SHIMKUS. I think this hearing is timely and I have to remark

about the young pups we have now testifying who are CEOs and

presidents of these companies. I think that really speaks to the industry. So the basic question we have to ask is does the existing

regulatory structure encourage or discourage and questions of safety and soundness. I appreciate you all coming, and I yield back the

balance of my time.

[Additional statements submitted for the record follow:]

PREPARED STATEMENT OF HON. W.J. ‘‘BILLY’’ TAUZIN, A REPRESENTATIVE IN

CONGRESS FROM THE STATE OF LOUISIANA

Thank you Mr. Chairman.

With the advent of the Internet, we have seen an unprecedented growth of new

goods and services that Americans have simply never had before.

4

There are, of course, many benefits to the array of new choices now provided in

competitive marketplaces, but what excites me most about the way new technologies

are changing our lives is that now, more than ever, the American consumer is empowered to make fully informed purchasing and investing decisions.

There is no denying that the Internet is transforming traditional relationships between merchant and buyer... between fiduciary and beneficiary... and between institutional investors, issuers, retail investors, and securities exchanges.

In telecommunications marketplaces, the deployment of ‘‘backbone infrastructure,’’

‘‘advanced data services over DSL lines and cable modems,’’ ‘‘interactive software,’’

and ‘‘fixed and mobile wireless technologies,’’ has, ALMOST OVERNIGHT, given life

to an e-commerce kingdom over which the consumer reigns. Today, consumers can

access tremendous amounts of quality content... run businesses... shop at almost

any store... communicate with friends, family, and colleagues ALL WITHOUT

LEAVING HOME.

In the securities marketplace, we are finding that a similar phenomenon is taking

place. Because of the Internet, retail investors can now trade securities at home

without paying traditional commissions, they can access analyst research reports

that were once available only to institutional investors, and they can also now invest in new IPOs at initial offering prices as opposed to higher prices resulting from

trading in secondary markets.

The point I’m trying to make here is that now, more than ever, new technological

advances, as well as Internet-centric business models, are forcing us to re-examine

the roles played by market intermediaries who for so long have dictated the pace

of business . . . of investing.

Today, we are here to learn more about the way that the so-called ‘‘ECNs’’ (Electronic Communication networks) are implementing changes in securities markets.

Like nothing we have seen before, ECNs provide a forum for online trading of

stocks, derivatives, and options by capitalizing upon recent advances in computing

power and bandwidth capacity.

The ECNs (Electronic Commerce Network) are slowly but surely allowing investors to buy securities from and sell securities to one another in true auction fashion

without having to go through broker-dealers to execute trades and without having

to buy or sell at a price listed on an exchange.

Because of what they propose to do, ECNs, are no doubt, exciting new creations

of technological advance, and I am looking forward to hearing more about them

from our witnesses today.

However, I want to point out that we have to proceed with caution when we begin

discussing altering life as we know it. While I am very interested in bringing full

investing choice to investors via new trading forums, it is not time to simply disregard the undeniable value and importance of current market intermediaries, such

as broker-dealers registered with the NASD and the exchanges.

For purposes of this debate, it is important for me, and for all the members of

this Committee, to understand the full impact of sweeping market structure changes

sought at this point before we can completely pass judgment on the pending ECN

applications for exchange status.

Ultimately, we have to rely on our process to come up with a recommendation to

the SEC that enables new trading opportunities for retail investors while affording

a fair degree of deference to longstanding NASD and NYSE policies at the same

time.

With that, Mr. Chairman, I yield back. Thank you.

PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE

Good morning, thank you Chairman Oxley. The youth on the panel before us at

today’s hearing is a testament to the changes new technology has brought to our

markets. New ideas are transforming the marketplace in ways that would have

been unimaginable a few years ago.

Indeed innovation is an engine that will outdo even the most visionary of prophets. Theodore Vail, the chairman of AT&T at the turn of the century, had the dream

of a phone in every town in America. That was thinking big. He could not have

imagined that folks in our hearing room today would be carrying a phone in their

pocket—never mind that that phone would not only make calls but also access the

Internet, e-mail, and heaven knows what else by now.

What is happening in our financial markets today reminds me of the change in

our telecommunications markets after the enactment of the Telecommunications

Act. New entrants to the marketplace had been stymied by regulatory barriers that

impeded fair competition. Our Committee developed the Act to eliminate those barVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00008 Fmt 6633 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
5

riers. As a result, new entrants are flourishing, and old stalwarts are being forced

to innovate.

Today, new entrants to our financial marketplace are shaking up the status quo.

The standard-bearers are innovating. Technological advances and new trading

mechanisms are improving price discovery and the quality of trade executions. Our

markets—and investors—are thriving.

But, there is work to be done to ensure that market forces and innovation in the

financial marketplace are not hampered by old regulations. As one of our witnesses

today notes, back in 1975 Congress instructed the Securities and Exchange Commission, in developing a National Market System, that ‘‘competition, rather than regulation, should be the guiding force.’’ Those are words to live by.

I believe we should examine the need for regulatory changes in order to free up

the forces of competition. For example, I am curious to learn more about the impact

of changing the rules that limit membership in the Intermarket Trading System.

Today, the ITS does not include representation by non-exchange marketplaces. And

any single member can veto proposed rule changes. Is this really the best structure

for our modern financial markets?

No blueprint exists for the marketplace of the future. Our task is to ensure that

rules allow the best marketplace to evolve. We may not be able to imagine what

the world will be like when ‘‘a phone in every pocket’’ sounds as quaint as ‘‘a phone

in every town.’’ But we can take action to make sure the rules are flexible enough

to work in years to come.

I thank our witnesses today for participating in this most important initiative of

the Subcommittee, and look forward to hearing from the exchanges and other market participants who will be testifying at our subsequent hearings.

Mr. OXLEY. The Chair would now recognize a distinguished visitor from another subcommittee, the gentleman from North Carolina, for the purposes of introducing one of our witnesses.

Mr. BURR. I thank the Chair for the opportunity to be here. I am

amazed that the gentleman from Illinois would compare the age of

the chairman to our witnesses in calling them young pups, only in

comparison to the chairman’s age. That would never happen in another subcommittee.

Mr. OXLEY. That is why you’re not on this subcommittee.

Mr. BURR. I think clearly the world is changing, as everybody

has said in their opening statements. There is a North Carolina influence to that, Shawn Dorsch. Shawn is the founder, president,

COO of Blackbird in Charlotte, North Carolina. He was a former

derivative and technology expert at J.P. Morgan and First Union

Bank. He has an degree in economics from North Carolina State

University and I am surprised after last night’s game in the NIT

semifinals, since I am a Wake graduate, he is allowing me to introduce him. Blackbird was co-founded in 1996 by Shawn Dorsch and

Raymond May. Clearly it is a new and emerging business. It is the

first system of its kind and has significant momentum in the marketplace having signed up 32 financial institutions as customers.

Blackbird offers its customers a number of advantages, including

significantly lower fees, superior execution, increased market liquidity and greater operational efficiency. Gosh, I hope we stay out

of the way of what they are accomplishing. Blackbird was designed

with input from leading derivative dealers. Blackbird is now setting its sites on revolutionizing the global market by opening offices in London and Tokyo later this year.

Mr. Chairman, thank you for having this hearing and more importantly, thank you for inviting who I believe is one of the best,

and I welcome Shawn.

Mr. OXLEY. I thank the gentleman. Let me now introduce with

a lot less fanfare the rest of the panel. Mr. Matthew Andresen,

president of The Island ECN. Mr. Kevin Foley of Bloomberg

6

Tradebook, the aforementioned Mr. Dorsch from Blackbird, and

Mr. John Schaible, founder and president of NexTrade. Gentlemen,

thank you for your appearance today. I see we are going to have

some interactive participation here which is always good for the

committee. We always enjoy that. We will begin with Mr.

Andresen.

STATEMENTS OF MATTHEW ANDRESEN, PRESIDENT, THE ISLAND ECN; KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK;

SHAWN A. DORSCH, PRESIDENT AND COO, DNI HOLDINGS,

INC.; AND JOHN M. SCHAIBLE, FOUNDER AND PRESIDENT,

NEXTRADE

Mr. TOWNS. Mr. Chairman, may I interrupt for 1 second. We

have two New Yorkers on here, and when I am chairman next

year, I am going to allow you to introduce panel members from

your State.

Mr. OXLEY. If you had just asked.

Mr. Andresen.

Mr. ANDRESEN. I would like to thank Chairman Oxley and members of the subcommittee for holding these important and timely

hearings on the structure and the future of our equity markets. As

this subcommittee begins its deliberations on these critical public

policy issues, we have already heard two distinct proposals.

On the one hand, the traditional human intermediaries, uneasy

with the effects of enhanced competition, have called for direct Federal intervention to create a new central public utility in our dynamic markets.

On the other hand, the new electronic markets like Island have

led the charge to instead knock down the remaining historic barriers to competition, thereby bringing the benefits of speed, reliability and transparency that have defined the ECN model to the

market for New York Stock Exchange listed stocks.

My name is Matt Andresen and I am the president of The Island.

We are a network of over 290 brokerage firms trading over 200 million shares a day. Island does 12 percent of NASDAQ’s trades.

That is one in every eight transactions. Last year Island matched

over 26 billion shares of stock directly without the spread or time

loss associated with traditional market participants. These shares

accounted for a dollar amount last year of $1.6 trillion. At this time

we have unprecedented numbers of investors in the marketplace,

as noted by the distinguished members already, in 1980 only one

in 10 Americans participated in our markets.

Today that number is over 52 percent. While these investors

have new-found access to market research and market data, some

proposed taking a giant step backwards from these innovations by

calling for a central limit order book or so-called CLOB. Its advocates claim that the CLOB would cure the fragmentation allegedly

attributable to those in front of you today. I argue that ECNs have,

in fact, consolidated the markets. If you look at the stock market

in 1996 before ECNs, the top four participants on NASDAQ accounted for 40 percent of the volume. Yet now in this era of enhanced competition and alleged fragmentation, the top four participants on NASDAQ now account for over 60 percent of the volume

illustrating the degree to which open competition facilitates invesVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00010 Fmt 6633 Sfmt 6602 E:\HEARINGS\63803 pfrm07 PsN: 63803
7

tors consolidating in the most efficient place. What would the effect

be of a government-installed CLOB? One of the most immediate effects would be to eliminate a market participant’s ability to compete on the basis of speed, reliability and cost, in essence, dumbing

down the innovative technology, which has so benefited investors.

It is precisely because of these advantages that investors have

voted with their feet now sending one out of every 3 NASDAQ

trades to ECNs. What can we do to extend this competitive environment on NASDAQ to the market for New York Stock Exchange

listed stocks where competition does not now exist? There is perhaps no better place to start than with the 1975 congressional

mandate for the creation of a National Market System which gives

us the road map. Congress called for the meeting of two goals: No.

1, competition between marketplaces; No. 2, accessibility of information to investors.

Today consistent with this mandate, ECNs have their best prices

included in the NASDAQ quote. Island actually goes so far as to

not only include this best price to NASDAQ, but actually to give

all of their prices at all of the price levels out over the Internet for

anyone with a browser. As Chairman Levitt noted last week, it is

terribly important not just to show investors the tip of the iceberg,

but also the entire iceberg under the water, show them the depth

of all of the supply and demand. We have a demonstration that we

will go through in the Q and A, which shows how someone who has

access to the Internet can have access to the information heretofore, the province only of traditional market participants.

Isn’t it ironic that 25 years later the industries’ very initiatives

put in place to meet these two congressional goals are the very historical franchises now preventing competition. Island is not able to

compete in the market for New York Stock Exchange listed stocks

and is unable to provide their information to investors.

Mr. Chairman, it is an honor to have had this chance to present

Island’s perspective on these critical public policy issues. These

hearings present all of us with a compelling opportunity to shape

the future of our Nation’s equity markets and ensure their continued strength and prosperity. We must be wary of those proposals,

which too quickly embrace Federal intervention in our free markets

and commit us to risky regulatory schemes. We must not squander

the position of financial strength that we have achieved at great

cost and commitment over the past two centuries. Instead, let us

work toward greater openness and greater transparency and greater accountability in the market. There is too much at stake to do

otherwise. Thank you.

[The prepared statement of Matthew Andresen follows:]

PREPARED STATEMENT OF MATTHEW ANDRESEN, PRESIDENT, THE ISLAND ECN

I commend the Chairman and the Members of the House Commerce Finance and

Hazardous Materials Subcommittee for holding these hearings on the future of our

Nation’s equity markets and the benefits of electronic markets. Electronic markets—

fueled by the revolution in communications and computing power—are today driving

some of the most profound developments in the history of markets and investing.

Most significantly, we are witnessing a rapid and sweeping democratization of the

markets. As a result of these changes, we have an historic opportunity to create

fairer, more competitive markets and ensure that America’s role as the financial

center of the world continues into the next millennium.

8

As the pioneer in bringing the advantages of electronic markets to individual investors, Island greatly appreciates the opportunity to share its views on these important public-policy issues. Recent events, including the publication of the SEC

Concept Release on fragmentation, present all of us with the chance to discuss several proposed dramatic changes to the structure and operation of our markets. As

SEC Chairman Arthur Levitt stated in his Northwestern University speech last

week, today’s debate is really about ‘‘how best to let unburdened competition and

unbridled innovation drive the future of the market. It is a debate about how best

to equip our markets to compete and win in an increasingly globalized electronic

marketplace.’’

The success of our markets is based on innovation spurred by competition. By remaining committed to such entrepreneurial capitalism, we can secure and extend

our global, financial leadership role. Yet some in today’s debate have chosen an alternative model: their uneasiness with the effects of enhanced competition prompts

them to seek Federal intervention in the marketplace. For example, the proposed

consolidated limit order book would eliminate the incentive for different marketplaces to innovate and deliver superior technology and service. Such a monopolistic

utility would certainly fail to meet the investor’s needs.

Consequently, we urge the Committee to resist embracing any of the proposed

risky regulatory schemes, and instead seize the chance to strengthen our markets

by unleashing greater competition. I look forward today to beginning a dialogue

with the Committee about knocking down the remaining barriers to competition between markets; bringing the benefits of cutting-edge technology into the marketplace; and empowering the individual investor with greater access to the market.

THE ISLAND STORY

I am Matthew Andresen, President of The Island ECN (‘‘Island’’). Island is an

automated trading system for equity securities. It gives brokers the power to electronically display customer orders. We function as a pure auction market—directly

matching buy and sell orders. We currently have more than 280 broker-dealer subscribers. Island was founded approximately three years ago with the intent of providing all market participants—from individual investors to large financial institutions—with the ability to execute transactions on a level playing field, at an extremely low cost without the presence of intermediaries or dealers.

On an average day, Island trades over 200 million shares—approximately 12 percent of the transaction volume on Nasdaq. We keep our market open every trading

day, from 8am-8pm. All this is done on a single, off-the-shelf Dell computer about

the size of a large briefcase. For the year 1999, Island trading volume was over 26.5

billion shares, with a total dollar volume of $1.56 trillion. Overall, Electronic Communications Networks (so-called ECNs) account for approximately 30 percent of the

Nasdaq average daily transaction volume.

The Island story—from our founding to the present day—is about fighting for a

chance to compete in new markets and allowing investors to vote with their feet.

If we cannot offer a better product, then we should be out of business. Fortunately,

investors have welcomed our products and services, and Island has enjoyed explosive growth. For example, we heard investors ask for greater flexibility in managing

their finances, and we delivered our superior services earlier and later each trading

day. Specifically, Island’s extended-hours trading session (8am-9:30am. And 4pm8pm) began mid-1999 with only about 1 million shares traded; today, we are regularly doing over 20 million shares during this session—when the traditional markets

are closed, Island is open for business. For these reasons, Mr. Chairman, I doubt

you’ll find a witness today who is a greater champion—or beneficiary—of our Nation’s free markets and the individual’s unfettered right to profit from hard work

and innovation.

I learned early in my financial career that there are two things you can never

overestimate: the amount of market information denied the individual investor, and

the eagerness with which the investor uses this information once provided. Virtually

right out of college and needing a job, I initially landed at the commodities desk

of a major New York investment bank. Yet I found myself frustrated and disturbed

by many of the market’s hidebound operations and the market professionals’ advantages over the individual investor. Needless to say, I was not long in that job.

Soon thereafter, I was fortunate enough to meet some brilliant software programmers at Island—individuals who grasped a magnificently simple and elegant truth:

the markets could be made far more rationale and fair if investors were allowed access to the same sorts of information uniquely available to market professionals. Not

only would our markets be strengthened and investors derive more value, but there

would be an unprecedented degree of accountability, openness, and transparency.

9

On my first day as President of Island, I walked into the office—and we were,

literally, just four employees in one office—with little more than a passion for market structure and a steadfast commitment to cracking wide open the monopoly on

information enjoyed by market professionals at the expense of the individual investor.

We watched carefully as investors consumed real-time market data for the first

time. And we recalled how many market professionals had insisted that such ‘‘arcane’’ information would be at best a distraction, and probably a nuisance for the

investor. How wrong they were. As we know, investors today demand access to realtime data and the latest research reports as well as the ability to enter orders more

efficiently and at a fraction of the cost once paid for such transactions. Yet while

the investor had been empowered to know what to buy and when to buy it, a key

component of this equation has, until recently, been missing: how to buy. That’s

where Island jumped in.

Traditionally, investors have only been provided with the highest bid and lowest

offer in a security. The depth of the market, which gives an indication of the true

supply and demand for a security, has been the exclusive province of market professionals. More specifically, what happens to an order after it is placed with your

broker? What sort of accountability exists? At Island, we urge investors to ask themselves what just happened to their order after they click on the ‘‘Submit’’ button.

After all that thorough and careful research, why is the investor—at this final stage

of the process—essentially staring into a black box—or at best a screen with the

words ‘‘Your Order Has Been Placed.’’

That lack of accountability—in other words, denial of information to the investor—was unacceptable to us. To provide the best resource possible to the investor,

we became the first marketplace to provide a free, real-time display of all its orders,

through the Island BookViewer TM. Such transparency is precisely what SEC Chairman Levitt recently called for in his Northwestern University speech: ‘‘Now is the

time to embrace a broader and deeper transparency. Now is the time for all market

participants to move toward open books across all markets...These are forward

looking initiatives that answer the investor’s call for greater transparency and more

efficient pricing.’’ Island couldn’t agree more. That’s why orders received by Island

for display on the limit order book are immediately visible to anyone with a web

browser regardless of whether the order was received from an individual investor

or a large institution. Why is this important? Investors can use the additional information provided by Island to more accurately price their orders. The Island

BookViewer TM also reduces the informational and temporal advantages traditionally

enjoyed by floor brokers, market makers, and specialists. In other words, the average investor is not disadvantaged because of a lack of access to, for example, the

floor of an exchange. By eliminating these time and place disparities—in essence,

putting the investor ‘‘virtually’’ right next to the market maker or specialist—Island

helps lower the hidden costs associated with higher spreads and inferior executions.

In fact, according to the Securities and Exchange Commission, spreads—the difference between the highest price to buy and the lowest price to sell—have narrowed substantially since the time ECNs were given access to the Nasdaq market,

saving investors hundreds of millions of dollars per year.

Island’s mission is to provide investors with an open, transparent market so that

they can know precisely what happens to an order after sending it to their broker.

Traditionally, the markets have conferred what are called ‘‘time-place’’ advantages

on certain of its professionals. For example, the specialist on the floor of the New

York Stock Exchange responsible for a specific stock has unique access to all the

buy and sell orders for that stock; only that person knows what the true supply and

demand is for that stock. Consequently, that individual has both an informational

advantage and the opportunity to take advantage of that information in order to

make a profit for himself and his firm. A perfectly legal business, but one that clearly leaves the average investor at a disadvantage.

WHEN COMPETITION FAILS, AND WHEN IT WORKS

It is certainly true that much of the Island story is about using technology to provide investors with a more efficient, faster, and lower cost forum for trading. Yet

Island’s success is much more than a technology story—it is about the tremendous

benefits that redound to the investor when our markets compete; when one marketplace can challenge another with a dizzying array of innovations and offer the investor unprecedented opportunities to leverage technological breakthroughs.

As described above, recent advances in computing power and bandwidth deployment made it possible for Island to provide investors with new and powerful reVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00013 Fmt 6633 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
10

sources to access to the marketplace. We simply needed the right legal and regulatory opening to offer our services and roll out our product.

How such an opportunity came about tells us much about how markets succeed

and fail. About three years ago, as many on this Committee will recall, Nasdaq was

the subject of a scathing Securities and Exchange Commission’s 21(a) report about

improper market practices; the Justice Department had launched an investigation

that revealed widespread collusion and price fixing; and a billion dollar investor,

class-action lawsuit against Nasdaq was in the works. More than anything else, the

problems plaguing Nasdaq were the unfortunate result of what happens when a

marketplace lacks competition. As we now know, Nasdaq was fenced off from any

true competition, and the investor had no recourse in terms of finding a better marketplace to seek the best execution. Yet rather than micromanage the overhaul of

Nasdaq, the SEC adopted rules (known as the Order Handling Rules) designed to

introduce competition and greater transparency into Nasdaq—all of which led directly to the creation of Electronic Communication Networks.

Island seized this opening and offered investors a faster, cheaper, and more reliable forum for trading. From Island’s inception, we counted on the fact that investors—when given the choice—would always want a more accessible and transparent

marketplace. To reach that goal, we focused on what we considered the glaring gap

in the Nasdaq model: the inability of investors to meet directly in the marketplace

without having to rely on professional intermediaries.

Moreover, by eliminating the informational disparities discussed above, we built

a marketplace that is inherently safer, fairer, and easier to surveil. For example,

participants on the floor of an exchange generally possess more trade and order information than the average investor sitting at home. Through surveillance and the

implementation of restrictions on the activities of those in the trading crowds, regulators attempt to prevent the misuse of information. As recent events have shown,

however, no amount of surveillance or regulation can completely prevent the misuse

of information.

ECNs, such as Island, reduce the opportunities for improprieties by eliminating

informational disparities. ECNs empower all investors by allowing them to step into

a virtual trading crowd and compete directly. Since all orders are delivered to the

virtual trading crowd and instantaneously displayed to everyone, no single person

has an informational advantage that needs to be regulated or surveilled. That

means we have been able to deliver to investors the benefits of lower cost, more

transparent, fairer markets, while still complying with strict Commission standards

designed to ensure the integrity of our trading systems. Island, for example, must

comply with regulatory standards concerning the security, capacity and reliability

of our system. In fact, due to its use of the latest, most advanced technology as well

as its proprietary architecture, Island has a superb record for reliability and performance. For example, during the past year when the Nasdaq market has periodically experienced system delays due to the tremendous surges in trading volume,

Island has never experienced a capacity-related problem. Even during peak trading

periods. Island’s average turnaround time is approximately three one-hundredths

(.03) of a second—exponentially faster than our nearest competitor. By combining

the latest technology with our advanced system architecture, Island has created a

scalable, robust trading system with virtually no capacity limitations.

Finally, we have never taken our eye off the bottom-line for the investor; we have

always believed that any money funneled out of the marketplace—whether to pay

for high commissions or to outfit an exchange with brass and mahagony—comes directly out of the investors’ pockets. Consequently, Island has sliced its margins razor

thin. Island, for example, only receives $.00075 per share per side on every transaction executed on its system; in other words, a trade for 1,000 shares of stock

means only seventy-five cents for Island. I like to point this out to my staff when

others question our spartan offices—like a recent New Yorker magazine profile noting that we have ‘‘upgraded our offices from grungy to nondescript. ‘‘ I like to believe

that there are millions of investors across the country benefiting from the fact that

Island has the least stylish offices on Wall Street.

THE FUTURE OF THE MARKETS

Once we have empowered the investor by providing an open and transparent marketplace, there remains one final challenge. How do we unleash these benefits on

as wide a scale as possible, without sacrificing investor protection or the integrity

of our capital markets? How can we further promote competition between markets

and ensure that our Nation maintains its leadership role in finance and technology?

Addressing some of these issues, the Securities and Exchange Commission published its Concept Release on Fragmentation. In its Release, the Commission raised

11

the concern that the U.S. equity markets are becoming more fragmented and, thus,

less efficient. One key concern for the Commission is that the practices of internalization and payment for order flow may increase with the repeal of Rule 390. In

addition, the Commission is concerned that since many market participants are assured of receiving order flow either from an affiliate or by paying for the order flow,

market centers may have little incentive to compete based on their quoted price.

The Commission also questioned whether the practices of payment for order flow

and internalization result in some brokers routing orders to marketplaces providing

inferior executions. In response to these concerns, some market participants support

the adoption of a consolidated limit order book (the so-called ‘‘CLOB’’) to eliminate

the negative impacts of fragmentation, internalization and payment for order flow.

Island’s Position on Current Proposals

As stated at the outset, Island believes that the issues raised in the SEC Concept

Release give us an opportunity to shape the future financial marketplace in a manner consistent with the best aspects of America’s entrepreneurial capitalism. If we

choose wisely today, we can avoid the mistakes of the past when we embraced risky

regulatory models proposed by Federal agencies.

The Island story and the rise of ECNs embody the benefits of competition. The

dramatic changes in technology have allowed new competitors to offer new services

at a lower cost and capture market share from traditional market participants in

a relatively short time period. As a result, there has never been a better time to

be an investor. Interestingly, many of the same traditional firms that have long benefited from an environment favoring market professionals are now calling for drastic

changes to the market—at the very time when investors are finally starting to take

more control over their own financial decision-making. For example, to solve the

‘‘problem’’ of fragmentation, some market professionals have suggested proposals

that would inhibit the ability of new entrants to challenge the traditional markets.

Embarking upon some of these risky regulatory schemes would undermine many of

the technological breakthroughs pioneered by the ECNs and discourage any future

innovation.

To understand why rules mandating price-and-time priority between markets

and—in their most extreme form—the Consolidated Limit Order Book would eliminate competition, consider the following example:

Assume that ECN A is a market that provides its members with the fastest and

most reliable trading system in the industry. In addition, assume that Traditional

Market B utilizes obsolete technology that lacks adequate capacity. If, under a regime of price/time priority, Market B is the first to display the best offer of $100

in stock XYZ, any order to buy XYZ at $100 received by ECN A must be routed

to Traditional Market B—despite its inferior technology. Thus, even if you as an investor intentionally sent your order to ECN A to take advantage of its superior

speed of execution, ECN A would be required to route your order to Traditional

Market B. Thus, ECN A would be completely dependent on a response back from

Traditional Market B in order to fill your order.

This simple scenario demonstrates why price/time priority fails to serve the investor:

1.) It is impossible for ECN A to offer a faster execution or better service in its competition with Traditional Market B, since Market A will always be dependent

on Traditional Market B for execution and service; and vice versa;

2.) ECN A and Traditional Market B are dependent on the linkage between them

and cannot offer service any faster or more reliable than permitted by the linkage; or each other’s interaction with the linkage;

3.) In light of the first two points, investors will become insensitive to which market

the order is entered, leaving no basis for competition between markets.

In sum, not only do we prevent markets from competing with one another on any

basis beside price, but we actually undermine the very technological breakthroughs

that have strengthened our Nation’s equity markets.

To appreciate the real-life consequences of mandating price priority between markets, consider the current state of the listed market. The listed market has operated

a so-called ‘‘trade-through rule’’ since the implementation of the National Market

System more than 20 years ago. During this entire period, the NYSE has dominated

the listed market and to this day still controls approximately 75% of the share volume. The Commission has long recognized that, despite the existence of the regional

exchanges, there has never been vigorous quote competition between the exchanges.

One key barrier to competition in listed stocks is the mandating of price priority

via the trade through rule. The trade through rule states that one market cannot

trade at a price inferior to a price displayed by another market. Although each market is prohibited from trading at an inferior price displayed by another market, a

12

market sending an order as required to the best priced market must wait up to two

minutes for a response. Even after two minutes, however, it is still possible not to

receive an execution from the other market. In such instances, the investor is worse

off than if he purchased the security at the ‘‘inferior’’ price to begin with. As in the

example with price/time priority above, the trade through rule prevents one market

from offering services that are substantially different or better than the other markets. Price again becomes the only competitive factor.

Fragmentation and Internalization

The proponents of a consolidated limit order book or rules mandating price/time

priority insist that their initiatives are a response to the threat of fragmentation.

They tell us that fragmentation is increasing and that Federal intervention is needed to reverse the trend. In fact, when competition is permitted to flourish, orders

will gravitate to only a few market centers. This is best exemplified by the Nasdaq

market. Prior to 1997, volume was spread among numerous market makers, and

spreads, the difference between the bid and the ask, were very wide. Due to the increased competition from ECNs, spreads have narrowed dramatically and the

Nasdaq market has actually become less fragmented. The intense competition has

eliminated numerous market makers and forced dramatic consolidation. Moreover,

according to a recent Sanford Bernstein study, the top 4 Nasdaq market participants (Instinet, Island, Knight Securities, and Mayer & Schweitzer) combined account for approximately 60% of the Nasdaq market today compared to 40% a decade

ago. With the introduction of decimalization, the Nasdaq market should consolidate

further.

It is also important to note that Nasdaq does not have a trade-through rule or

rules requiring price-time priority. If Nasdaq did have such rules, it is doubtful that

ECNs would have been able to effectively compete. By adopting free-market solutions that promoted competition, we not only delivered greater value to the investor,

but fundamentally strengthened the overall marketplace and set the stage for the

technological breakthroughs exemplified by the ECNs.

The Commission is also concerned about the possibility that the repeal of NYSE

Rule 390 will lead to more internalization, and thus may harm investors. Island believes that the best way to address these concerns, as with those of fragmentation,

is to increase competition. Internalization is more likely in a non-competitive environment where spreads are wide and thus, dealers can more easily profit from the

difference between the bid and ask prices. As competition increases and spreads

narrow, it will become increasingly difficult for dealers to intrernalize order flow.

This is especially true with decimalization, where spreads will narrow to just fractions of a penny in many of the most active securities. That is why Island is proud

to have led the way in building a decimal-based marketplace. In fact, Island’s market has always gone down to ten decimal points.

Competition between brokers will also reduce any negative impacts of internalization. With the availability of real-time quotes and innovations such as the Island

BookViewer TM, investors are better able to monitor their execution quality. As investor sophistication increases, brokerages will increasingly begin to advertise how

they execute orders. Competition will force brokers to make the right decisions with

respect to where they send their order flow.

A Free-Market Model

Island believes that the U.S. Congress has already designed the roadmap for ensuring the continued success of our capital markets. In 1975, Congress created the

National Market System, with the goal of constructing a more efficient and transparent market. We could not ask for a better building block.

The mandate of the NMS, as envisioned by Congress, is defined by two objectives:

first, to promote competition between markets (fair competition between exchange

markets and markets other than exchange markets); and second, to make quotation

and transaction information available to investors (assure the availability to brokers, dealers, and investors of information with respect to quotations for the transactions in securities.).

Consistent with this mandate, the SEC adopted rules that permitted ECNs to

have their quotations included in the Nasdaq best bid and offer that is disseminated

to the entire marketplace. As described earlier, competition between markets flourished (with ECNs having captured 30 percent of the Nasdaq transaction volume),

and Nasdaq itself was significantly reformed. When provided a level playing field,

ECNs can compete for market share and bring the benefits of competition to the

investor.

This situation contrasts sharply with the rules and regulations governing Island’s

ability to compete in NYSE-listed stocks. Ironically, almost 25 years later, the rules

13

and market structure implemented to achieve the goals of a National Market System are now inhibiting competition between markets and restricting the information

available to investors. Regulatory obstacles block Island from having its quotation

information included in the two main components of the National Market System—

the Consolidate Quotation System (CQS) and the Intermarket Trading System

(ITS).

I would pose two questions for this committee:

First, what public-policy benefits are served by stifling competition and barring

Island from sharing its pricing information?

I cannot imagine there are any. Consider that when Island trades the stock of

America Online, at various times during the trading day, Island would have the

best quote in the National Market System. Unfortunately, due to the current regulatory structure, market participants (other than Island subscribers) are denied the

opportunity to see and access the better price on Island. This pure fragmentation

is completely inconsistent with the spirit of the National Market System.

Second, what public-policy benefits would be served by promoting competition and

integrating Island into the NYSE’s pricing mechanism?

Most importantly, Island’s price information would no longer be fragmented from

the rest of the marketplace. The market for NYSE-listed stocks would immediately

become more integrated and efficient. The resulting competition between marketplaces (again, a central goal of the National Market System) would result in benefits

for the investor.

In light of the proven benefits to investors and the efficiency of the market, it is

time to take immediate action to give ECNs access to the Consolidated Quotation

System. ECNs, such as Island, must be permitted to disseminate their quotation in

listed stocks to all market participants. Yet in moving forward on this issue, we

must still confront and deal with a version of price-time priority currently operating

for the listed market. As discussed earlier, under the plan governing the operation

of the Intermarket Trading System, each participant exchange is prohibited from

trading at a price inferior to another participant.

Just as the Federal government does not negate customer choice by requiring consumers to buy goods from the lowest price merchant, market participants should not

be required to buy from the best-priced market. As long as market participants

know the price in each market and have the ability to access each market, there

is no need for the Federal government to require the market participant to favor

any one market. Accordingly, in addition to allowing ECNs to disseminate their

quotations directly through the consolidated quote, the elimination of the tradethrough rule is another important step toward more fully realizing Congress’s objectives in the National Market System.

CONCLUSION

Mr. Chairman, it is an honor to have had this chance to present Island’s perspective on these critical public-policy issues. These hearings today present all of us with

a compelling opportunity to shape the future of our Nation’s equity markets and ensure their continued strength and prosperity. As we consider the various proposals

under discussion, we must be careful of those proposals that too quickly embrace

Federal intervention in our free-markets and commit us to risky regulatory

schemes. We must not squander the position of financial strength we achieved at

great cost and commitment over the past 200 years. Instead, let us always work towards greater openness, transparency, and accountability in the marketplace. There

is too much at stake to do otherwise.

Mr. OXLEY. Thank you. I now recognize Mr. Foley.

STATEMENT OF KEVIN FOLEY

Mr. FOLEY. Thank you, Mr. Chairman and members of the committee. My name is Kevin Foley. I am chief executive of Bloomberg

Tradebook, and I am pleased to have the opportunity to testify regarding competition in the new electronic market. Bloomberg

Tradebook is located in New York City. We are an electronic agency broker. And one of the things that distinguishes us among ECNs

is that our focus is serving institutions and other broker-dealers

who typically serve institutions themselves. We count among our

clients many of the Nation’s largest institutional investors and the

14

millions of individuals whose pension funds and retirement savings

and so forth are pooled in institutional investors assets.

We specialize in providing innovative tools that allow our clients

to step directly into the electronic crowd, both the National Market

System such as it is today to find liquidity for themselves and to

provide their institutional liquidity for others, the retailer that is

now enfranchised in finding itself moving directly into the marketplace. Our clients rewarded our creativity and service by trusting

us with their business. We are the third largest ECN by volume.

We had our first day of over 100 million shares and we are grateful

to our clients for that. Competition in the new electronic marketplace is doing today what competition does. It is benefiting consumers, it is benefiting investors, it is revolutionizing our markets,

and it is also generating opposition from some who may feel that

their position could be threatened by revolutionary changes.

Those who have sought to halt these changes have argued for a

massive and intrusive regulatory intervention that would roll back

the clock. They have sought to justify these steps by claiming that

fragmentation is a threat to our markets. This is a traditional refrain of virtually every industry when change threatens established

players. The telecommunications industry is one that comes to

mind. When the status quo laments harmful fragmentation, it is

time for all of us to be careful. Often it is really the sound of beneficial competition being bemoaned by those who prefer and enjoy

the status quo. Some have urged support for a time priority central

limited order book, CLOB, centralizing orders in a single black box.

The technology of today makes a centralized order book unnecessary.

It is possible to have transparency and linkages in the markets.

The central black box runs contrary to the operation of state-of-theart modern telecommunications, the Internet being the best model.

The innovations that ECNs have brought to the market like, for example, one called Reserve from Bloomberg Tradebook which we can

talk about later, could not occur under an industry sponsored

CLOB, an industry-sponsored black box or one sponsored by

NASDAQ, for example, which they have currently proposed in their

SuperMontage proposal before the SEC. The pending SuperMontage proposal carries many of the downsides of a traditional CLOB.

If you are against a CLOB, you’ve got to be against the NASDAQ

SuperMontage proposal, and it is happening now. It creates a centralized single point of failure, and it creates a single decisionmaking apparatus that is resistant to change. The public would be

much better served if the NASD focuses resources on the capacity

issues critical for the implementation of decimalization, as championed for years by this committee.

Prior to focusing on securing what we believe to be an anticompetitive beachhead in anticipation of the transparency to a forprofit entity, Congress and the SEC should not entertain significant structural changes to NASDAQ or to the equity markets in

general until after decimalization has been completed and the full

range of its benefits have been assessed. Congress should oppose

the imposition of a CLOB, and it should oppose the imposition of

a structure that gives you 95 percent of what a CLOB will give you

as NASDAQ has claimed the SuperMontage proposal will do. It is

15

something that Congress needs to look at immediately. I am looking forward to the rest of the hearings and the questions and answers afterwards. Thank you, Mr. Chairman.

[The prepared statement of Kevin Foley follows:]

PREPARED STATEMENT OF KEVIN FOLEY ON BEHALF OF BLOOMBERG TRADEBOOK

INTRODUCTION

Mr. Chairman and Members of the Subcommittee. My name is Kevin Foley, and

I am pleased to testify on behalf of Bloomberg Tradebook LLC regarding competition in the new electronic market.

We commend this Committee for its efforts to bring the benefits of competition

to our markets and the investing public. To ensure the continuation of an environment in which competition flourishes, we urge the Committee to oppose efforts to

create a Consolidated Limit Order Book (CLOB) whether run by the industry itself

or by NASD. We specifically urge the Committee to oppose SEC approval of the

NASD’s proposed CLOB known as the SuperMontage. We also urge the Committee

to consider carefully the implications of privatization of the dominant national exchanges. Allowing a government-mandated monopoly to enter the markets as a forprofit entity raises enormous concerns, including concerns regarding the availability

of real-time market data—the ‘‘oxygen’’ of our markets. We commend this Committee’s efforts to protect the availability of market data and prod the industry on

decimalization. We urge that significant structural changes to the market not be

considered until after decimalization has been completed and the full range of its

beneficial impact assessed.

Bloomberg Tradebook LLC is owned by Bloomberg L.P. and is located in New

York City. Bloomberg Tradebook is an electronic agency broker serving institutions

and other broker-dealers. We count among our clients many of the nation’s largest

institutional investors. Bloomberg Tradebook specializes in providing innovative

tools that allow our clients to step unobtrusively into the electronic ‘‘crowd’’ of the

national market system to find liquidity for themselves and, in the process, provide

it for others. Our clients have rewarded our creativity and our service by trusting

us with their business.

We are the third largest electronic communications network (ECN) by volume. Indeed, two weeks ago we saw the day on which the orders matched on Bloomberg

Tradebook exceeded 100 million shares, a landmark representing a more than tenfold increase over the past year-and-one-half.

ECNS—A MARKET SOLUTION TO A MARKET PROBLEM

Some have lamented the existence of ECNs, suggesting that we are an unwanted

development. It’s worth asking the question, exactly what are ECNs, and how do

consumers and investors benefit from the competition ECNs bring to the new electronic marketplace?

ECNs are distinguished by three characteristics—neutrality, transparency and

fairness. Neutrality? By definition we are agency brokers and take no positions for

our own accounts. Thus, we are neutral in the marketplace and exist only to serve

our customers’ need to buy or sell shares. Transparency? We publish not only our

entire book of quoted prices electronically for all our customers to see, but also all

other available pricing information. Unlike some of our ECN competitors, we take

advantage of this transparency to route our customers to the best available price,

even if that is outside of Bloomberg Tradebook. Fairness? ECNs are required by

SEC rules to respond immediately—and I mean immediately—to orders in the order

they are received, whether they come from our best customers or from our competitors. That’s probably the highest standard in the industry.

Among the innovations Bloomberg Tradebook has brought to the market is the

beneficial mixing of small retail order flow and institutional order flow. For the first

time, small retail customers have gained direct unfettered access to the liquidity of

institutional order flow represented directly in the market. Likewise, institutional

investors are, for the first time, able to find liquidity for their orders by interacting

directly with small order flow.

Along with neutrality, transparency, fairness and innovation, add lots of enthusiasm and creativity from people passionately devoted to serving their customers

and you have a picture of who we are and why we exist.

In a statement before the Senate Banking Committee, Frank Zarb, the Chairman

of the National Association of Securities Dealers, stated that ‘‘. . . I guess I sum up

16

the answer as to why we have ECNs as the fact that the national stock exchanges

around the world haven’t been keeping pace with the needs of the market.’’

Mr. Zarb is a an accomplished leader in business and public service. Investors are

fortunate for his leadership at this time, but I respectfully submit that the reason

ECNs exist is not only because of what national stock exchanges failed to do, but

also because of what we innovating broker-dealers have done, in the heat of competition.

Mr. Chairman, it’s worth pondering why the stock exchanges didn’t keep pace, as

Mr. Zarb says. I would submit that a government-sponsored monopoly ultimately

cannot provide the innovative ideas and customer service of the best ECNs precisely

because they are a government-sponsored monopoly. NASD’s CLOB proposal for the

Nasdaq market—known as the SuperMontage—is an effort by the NASD to ‘‘keep

pace’’ not by moving themselves forward, but by drastically slowing down all market

participants. To spur future innovation, I’d rather place my faith, not in the exchange, but in its members—the marketplace of competing innovative broker-dealers.

What are ECNs? At Bloomberg Tradebook we see ourselves as a market solution

to our customers’ market problems. This should be kept in mind as Congress and

the SEC consider whether and how to react to the growth of ECNs.

Bloomberg Tradebook intends to remain a broker-dealer and an ECN. We believe

it’s the most effective way for our customers to obtain liquidity and best execution.

While we are proud to be and remain a broker-dealer/ECN, we are also supportive

of the efforts of some of our ECN brethren to either affiliate with or become exchanges. Just as competition among ECNs has been good for investors and the market, competition among stock exchanges also benefits all. We think the national

stock exchanges should have to compete against each other for our business and the

business of any other broker-dealer. Bloomberg Tradebook looks forward to the day

when some of our ECN colleagues will be—as new exchanges—competing with the

established exchanges for our business.

COMPETITION IN THE NEW ELECTRONIC MARKETPLACE

Competition in the new electronic equity marketplace is doing what competition

generally does. It is benefitting consumers and investors while revolutionizing markets. It is also generating opposition from those who may believe their position is

threatened by these revolutionary changes.

Those who have sought to halt these changes have argued for massive and intrusive regulatory intervention to roll back the clock. They have sought to justify these

steps by arguing that ‘‘fragmentation’’ is a threat to our markets.

This is a traditional refrain, sung in virtually every industry when change threatens established players. It is a refrain that this Committee—given its preeminent

role in deregulating markets—has repeatedly heard in extended-play versions and

wisely greeted with a skeptical ear.

In 1975, when Congress and the SEC deregulated brokerage commissions, there

was much anxiety on Wall Street. Critics charged that the unfixing of rates would

damage and fragment America’s capital markets. Instead, commission rate competition reduced prices for investors and helped spur explosive growth in the market.

In deregulating the telecommunications industry, Congress—this Committee in

particular—and the courts were regularly warned that then-upstarts like MCI were

‘‘fragmenting’’ the telephone market, destroying the world’s greatest communications system. When the status quo laments the impact of ‘‘harmful fragmentation’’

be careful—often it is really bemoaning beneficial competition.

In fact, the Nasdaq market today is consolidated, not fragmented. Customers’ orders are displayed to all and interact freely among market-makers, ECNs, orderentry firms and even regional exchanges. ECNs in Nasdaq participate in the least

fragmented market of all time, thanks to this system of customer order display and

electronic linkages that provide instant access to those orders.

In a very significant speech delivered recently at Northwestern University, SEC

Chairman Levitt called on market participants to make publicly available all customer bids and offers, not just their best bids and offers. Chairman Levitt called

for a competitive, free market solution to seize this opportunity for greater transparency. Bloomberg Tradebook wholeheartedly supports this increased market

transparency.

Useful linkages have yet to be developed for the New York Stock Exchange listed

market. Our customers would like us to act as their agent for New York Stock Exchange listed stocks, as we do in Nasdaq stocks. Recently the SEC has approved

an NASD proposal to allow ECNs access to the Intermarket Trading System (ITS)

through Nasdaq. This is helpful, but not nearly sufficient since ITS remains crippled

17

by both its technological ineffectiveness and an unworkable governance structure

that makes any movement nearly impossible.

THE THREAT OF A CENTRAL LIMIT ORDER BOOK (CLOB)

Those who would stifle change in the markets have urged support for a time priority central limit order book (CLOB) as the panacea necessary to deal with the alleged ‘‘problem’’ of fragmentation. The notion behind the CLOB is that if you centralize orders in one place, a single ‘‘black box’’, maximum order interaction and perhaps better prices might be achieved.

TECHNOLOGY MAKES A CLOB UNNECESSARY

There are a number of very serious problems with this concept. When this concept

was first broached some thirty years ago, our markets lacked the technology to

achieve order interaction without centralization. Now, technology allows the advantages of maximum order interaction without the downside of centralization.

In short, the technology of today makes a centralized order book unnecessary.

These technological advances have revolutionized other industries, and despite protests, they are revolutionizing our equity markets. At a time when even public utilities like telephones and electric power are abandoning their ‘‘black boxes’’ for decentralized structures, does it make sense to threaten innovation by centralizing the

stock markets? State-of-the-art telecommunications systems like the Internet don’t

rely on a single monopoly channel—rather they rely on networked webs of multiple

private competing linkages. Why should the securities markets work differently?

Centralized systems are resistant to change. The innovations that ECNs have

brought to the market could not occur under a CLOB system, including under the

SuperMontage Proposal of the NASD.

A centralized system also provides the significant downside of a central point of

failure. Those of us who deal regularly with Nasdaq’s SelectNet system know only

too well how cumbersome and inefficient a centralized system can be. Like

SelectNet, the ITS system is conceded even by the sympathetic to be technologically

outmoded, with a bureaucracy that thwarts change. Why make those failed systems

the model?

THE CLOB IS COMING—SUPERMONTAGE

Indeed, the pending SuperMontage Proposal carries many of the downsides of a

traditional CLOB. The proposal would convert Nasdaq from a largely decentralized

market, which has been its major strength for thirty years, to one in which virtually

all executions take place centrally. Of the concerns which the Nasdaq market faces

today, capacity limitation is certainly the greatest. In recent years Nasdaq’s systems

have become an increasingly serious messaging bottleneck. Yet the proposal would

convert Nasdaq to a central execution utility only months before the U.S. markets

are scheduled to grapple with the intensifying volume expected with decimalization.

This CLOB-like centralization would create a government-sponsored monopoly that

would deter today’s decentralized market innovators from adding market capacity

and from introducing further innovations. Recent press reports that the SEC wants

to move quickly to approve the SuperMontage concern us and, we respectfully submit, should concern Congress.

CLOB CZAR

While there are serious technological problems with the CLOB, there are equally

troubling political problems. Someone or some entity will have to decide how the

CLOB will work, who gets access and how, and what innovations are to be allowed.

That gatekeeper and CLOB czar is certain to be enormously influenced by those

who are already in the club. Will those who are already in the club allow the emergence of innovators who potentially threaten their business? We don’t think so. Is

innovation likely to occur when the potential innovator must raise his or her hand

to seek permission from the powers-that-be in order to innovate? We don’t think so.

NASD Chairman Zarb told the Senate Banking Committee during its CLOB hearing that 95% of everything CLOB proponents sought could be had under the SuperMontage. That’s accurate, and underscores that we are looking in part at a political

battle for control of this centralized entity. I don’t know who will win, but I know

who will lose in this kind of battle—markets and consumers.

RISK TO INNOVATION

There are always those who worry about regulation driving industries offshore.

What will drive industry offshore faster than anything else would be depriving that

18

industry of the ability to innovate in the United States. Under a CLOB or SuperMontage, the greater risk is that industry will leave the States for shores where it

can innovate.

HUMILITY BEFORE THE MARKETS

The most significant problem with a CLOB is that, even if we get it ‘‘right’’ for

now, it’s not clear we will have gotten it ‘‘right’’ for all time. Over the past three

years, Bloomberg Tradebook has devised a number of innovations that have come

to be industry standards. I’d like to mention one briefly.

At its inception in 1996, Bloomberg Tradebook introduced the concept of ‘‘Reserve’’

to the U.S. equity markets. ‘‘Reserve’’ is a process that controls the release of orders

into the market, enabling clients to trade large orders more efficiently.

Like all innovations, the ‘‘Reserve’’ gave us a leg up on our competitors for a brief

period of time. Soon it was adapted by others. Today no one would introduce a system without it, including Nasdaq in its SuperMontage Proposal. Any edge we gain

is a momentary one—and we are forced to continue to innovate. We have done so

continually in the three years since.

If a CLOB had been imposed three years ago, clearly this innovation wouldn’t

exist. Are we confident that further innovation won’t be needed? That we can’t do

what we do more efficiently? I’d argue that the innovation is just beginning, and

we need to maintain the incentives that make that innovation possible. Innovations

occur in a dynamic competitive market. They won’t occur in a centralized black box.

THE MARKETS NEED DECIMAL PRICING

It is a pleasure to address this Committee on the subject of pricing in decimals.

It is a natural segue from our expressions of concern regarding the industry CLOB

and the Nasdaq SuperMontage Proposal.

Over a period of years, this Committee has rendered an enormous public service

by spearheading the effort to convert to decimalization. As this Committee well

knows, the United States is the only major country whose stock markets still trade

in fractions. Presenting quotes in 1⁄8ths and 1⁄16ths has reduced competition and liquidity in our markets. It is a system both archaic and anti-competitive.

Bloomberg Tradebook has allocated significant time and resources to

decimalization. As a result, we will be ready for decimal pricing as scheduled in

July. Thus, Bloomberg Tradebook and our customers were extremely disappointed

by the NASD’s recent request to delay decimalization. Decimalization would create

such an enormous benefit to investors and the markets that implementation should

be the top priority.

The NASD appears to be focusing significant resources on initiatives—like the

SuperMontage Proposal—that have as its primary objective securing an anti-competitive beachhead prior to NASD’s desired transformation into a for-profit entity.

While we believe SuperMontage is terrible public policy, even those who might be

more sympathetic would have to concede that the public would be infinitely better

served if the NASD focused its finite resources as other market participants have

had to—namely on timely preparation for prompt conversion to decimals.

Putting aside resource allocation concerns, we’d also argue that SuperMontage

and any other CLOB proposal should be tabled until market participants have an

opportunity to assess the impact of a successful conversion to decimals. The

decimalization championed by the Commerce Committee will significantly change

our markets for the better. It will result in lower trading costs. It will result in

greater market efficiencies. In short, it may well address many of the issues raised

in the SEC’s recent Concept Release. The Congress and the SEC should not entertain significant structural changes to the Nasdaq market until after decimalization

has been completed and the full range of its beneficial impact assessed.

I’d like to conclude the discussion of decimalization with a relevant, personal

aside. When my boss, Mike Bloomberg, wants something done, he often says to me

‘‘get it done or I’ll find someone who can’’. Our customers often send us the same

message. The phrase ‘‘get it done, or else . . .’’ is the humble seed from which many

giant redwoods of innovation have sprung. The Commerce Committee’s journey with

NASD on decimalization is a cautionary tale of how hard it is to prod movement

from a government-sponsored monopoly. It will be infinitely harder to prod change

from an industry CLOB or a CLOB like the SuperMontage.

OPPOSITION TO PRIVATIZATION OF THE STOCK EXCHANGES

Allowing a government-mandated monopoly to enter the markets as a for-profit

entity raises enormous concerns for a host of regulatory and enforcement reasons.

19

I’ll focus on one that is very familiar to this Committee as both an historic and current controversy, namely the issue of access to market data.

A quarter century ago, this Committee spearheaded the effort to enact the Securities Acts Amendments of 1975. That legislation established the goal of producing a

national market system. To this day, that remains the correct goal. In furtherance

of that objective, Congress mandated a consolidated system for distributing market

data in an effort to ensure that stock-market information was accurate and accessible. The securities markets were allowed to charge a reasonable rate for gathering

and distributing that information.

When the Commission, in 1972, first proposed rules to provide for the consolidated reporting of transactions and quotations, the New York Stock Exchange asserted that the SEC not only lacked authority under the securities laws to adopt

the quotations rule, but also such action would deprive the Exchange of property

in violation of the due process provisions of the Constitution of the United States.

Despite these objections, Congress and the SEC were determined to achieve the goal

of public access to consolidated market information.

Even in this day of on-line investing, the exchanges continue to argue that they

‘‘own’’ or ought to own quote information. Indeed, during the last Congress the dominant national exchanges were major proponents of legislation reported from the

House Judiciary Committee—the ‘‘Collections of Information Antipiracy Act’’—which

would have created an unprecedented ownership interest in facts, including stock

quotes. Though well-intentioned, this legislation—which has also been reported from

the House Judiciary Committee this Congress— would create a property right in

facts that extends not only to presently existing markets, but also, incredibly, to hypothetical, presently non-existing markets.

We applaud the bi-partisan leadership of the Commerce Committee for crafting

critical competing legislation, the ‘‘Consumer and Investor Access to Information

Act’’. That legislation, which was reported from the Commerce Committee last year,

would also provide additional protections for databases but would do so while assuring that consumers and investors have continued access to factual information.

Chairman Oxley has observed that real-time stock data is like ‘‘oxygen’’ to investors. We worry about the prospects of a government-mandated monopoly over the

most important information in the market—truly the markets’ oxygen—being controlled by a for-profit entity that not only believes it ‘‘owns’’ data our clients create,

but also wants to control the downstream uses of that data in currently non-existing

markets outside of the real-time market window.

At the core of this market data debate is the outmoded concept that market participants should continue to provide market data to a government-sponsored monopoly and then pay to see it. We endorse an alternative model recently proposed by

SEC Chairman Levitt in the context of market depth. During his March 16th speech

at Northwestern, Chairman Levitt urged our markets—exchanges, dealers, and

ECNs—to make their limit order books available to the public where vendors could

consolidate this data and repackage it in a form that would be most useful to their

customers. A similar model allowing the establishment of private quote aggregators

to which one could report market data— breaking the SRO monopoly on data—

would certainly improve the quality, comprehensiveness, reliability and capacity of

this information while reducing its cost.

REGULATORY CHANGES NEEDED FOR FULL COMPETITION IN THE EQUITY MARKETS

A few years ago, the Nasdaq market was rocked by a scandal when Nasdaq market-makers were found to be colluding to keep spreads artificially high. The SEC’s

response in issuing its Order Handling Rules helped launch ECNs while narrowing

Nasdaq spreads by nearly 30% in a year.

Chairman Levitt has stated that the three components of a successful U.S. equities market are quote transparency, market linkages, and the obligation of brokers

to seek best execution on behalf of their customers. All these goals can be promoted

without risking the enormous negative ramifications of an industry CLOB or SuperMontage. Congress should support the SEC’s actions in promoting transparency and

in insuring linkages in the Nasdaq market, as well as in exporting the germ of reform to the listed markets, which have been so resistant to change. Congress has

already vastly improved the opportunities for best execution with its decimalization

initiative. Congress should oppose privatization of the exchanges while working to

fashion a means of providing more ready access to the market data which is the

‘‘oxygen’’ of the marketplace.

Congress should oppose the imposition of a unitary CLOB. Congress should oppose such a CLOB whether sponsored by industry or by Nasdaq as the SuperMontage Proposal.

20

CONCLUSION

Every advance in our markets in recent years—from the elimination of brokerage

fee schedules, to the emergence of off-hour trading and ECNs—has been greeted by

the cry of ‘‘fragmentation’’ by the powers-that-be. Our equity markets are the finest

in the world because we’ve established a regulatory structure that rewards innovation. As soon as the U.S. regulatory structure stops rewarding innovation our markets will go abroad. We shouldn’t allow those who are threatened by change to encourage us to freeze in place a system which then won’t be subject to innovation

and improvement—and thinking outside the black box.

Changes in market structure will have implications for the American people that

are just as significant—if not more—than those of the landmark banking reform legislation enacted last year. We very much appreciate the diligence of the Members

and staff of this Committee in tackling these issues of complexity and importance.

Mr. OXLEY. Mr. Dorsch.

STATEMENT OF SHAWN A. DORSCH

Mr. DORSCH. Thank you, Mr. Chairman and members of the committee. My name is Shawn Dorsch. I am the President and Chief

Operating Officer of DNI, the builders of the Blackbird. I am

pleased to have the opportunity to appear before the subcommittee

and discuss our experience as the company which has brought electronic trading to what is perhaps the world’s most complex and

most dynamic financial sector, namely, the inter-dealer, privately

negotiated interest rate and currency derivatives transactions business, more commonly referred to as the ‘‘SWAPS’’ business.

I would like to make clear that we are not in the securities business, but it is a very important financial market for this country.

It is vital to the U.S. public interest that our markets, including

our financial markets, remain the most competitive fair and efficient in the world. This will only be the case if we succeed in harnessing the power and efficiency of new electronic technologies in

the service of these markets. DNI is a corporation based in Charlotte, North Carolina. It was formed in 1996 to build and operate

a computerized communications information system known as

Blackbird. The Blackbird was built to help major financial institutions, primarily banks, find, negotiate and agree to custom-tailored

SWAPS transactions directly with each other.

The founders of DNI are experienced SWAPS professionals, the

Blackbird system is operational and successfully serving the major

SWAP dealers in the United States. The Blackbird is not open to

the public.

Blackbird is designed to compete with so-called voice brokers who

charge dealers commissions for arranging SWAPS transactions

over the telephone. The fundamental goal of the Blackbird is to

provide its financial institutions clients with a computerized system that will bring greater speed, precision, safety and security

and lower cost to the very same interest rate and currency risk

management activities that are now taking place every day in numerous U.S. financial institutions on the telephone.

In spite of this goal, we initially found ourselves subject to a

searching regulatory review by the Commodity and Futures Trading Commission, and harsh criticism from some of the traditional

exchanges that were subject to the CFTC’s jurisdiction. It was and

remains our understanding that the types of transactions that may

be negotiated on Blackbird are exempt from CFTC jurisdiction

under the Commodity Exchange Act.

21

In April 1999, when we were on the verge of making Blackbird

operational, we received a letter from the CFTC asking us to provide certain information so that the CFTC could make an assessment of its own jurisdiction over Blackbird. Certainly, the CFTC is

not to be faulted for making due inquiry to assure itself that it is

fulfilling its regulatory responsibilities. This CFTC, however, was

the same CFTC which issued a concept release read by many as

proposing that it take jurisdiction over the SWAPS community.

This was the same CFTC which was at loggerheads with the Treasury, the SEC and the Federal Reserve Board, and which was admonished by Congress not to take action following from its concept

release.

Fortunately, we do not have the same CFTC today. If we did, we

might be speaking of the Blackbird as a U.S. entity in the past

tense as we would have been forced to relocate to London. The details of the public controversy we faced are less interesting than

the deeper effects of the controversy. Senior company personnel

had to shift their attention from building a business to explaining

and defending that business. Obviously, substantial financial resources had to be focused on the regulatory situation. Potential clients needed to be reassured that transactions negotiated through

the Blackbird would not be void as a legal off exchange futures contracts.

Potential investors also needed to be held to a level of comfort

with the regulatory situation. What was really wrong about all of

this? It all came about simply because Blackbird offered SWAPS

dealers the opportunity to do the same business as before but via

new media. It was the medium of computerized communication

when viewed through the lens of a poorly drafted statute, the Commodity Exchange Act, which provided the basis for a CFTC assertion of jurisdiction, not some risk to the public. Fortunately, the

new CFTC reinvented itself under Chairman Rainer and has participated in the President’s Working Group Report and has put

forth a new regulatory proposal that attempts to build afresh on

the positions of policy and principles and that attempts to encourage the use of electronic systems.

Congress also seems to be well focused on the fact that the existing statutory and regulatory regimes may not adopt readily to the

promise and challenges of new technologies. The efforts of this committee and others will be invaluable in determining the direction

for a redesign of our Nation’s statutes and regulations. We encourage Congress to watch closely to be sure that new regulatory constructs are sufficiently resilient to weather changes in administration as well as changes in technology.

Our message is not that all electronic systems should be unregulated. Our message is that regulatory concerns should be focused

not on the medium of communication, or for that matter, on the

medium of the transaction execution. Concern should be focused on

the activities accomplished with that medium and should be coupled with consideration of the inherent market discipline likely to

shape those activities. If, as the case with Blackbird, those activities do not raise serious concerns, great care should be taken to

protect them from the very, very serious countervailing threats of

overly broad or anticompetitive regulation.

22

Thank you, Mr. Chairman, and members of the committee for

giving me an opportunity to present this testimony.

[The prepared statement of Shawn A. Dorsch follows:]

PREPARED STATEMENT OF SHAWN A. DORSCH, PRESIDENT AND CHIEF OPERATING

OFFICER, DNI HOLDINGS, INC.

DNI Holdings, Inc. (‘‘DNI’’) is pleased to have the opportunity to deliver this written statement to the Subcommittee on Finance and Hazardous Materials of the

Committee on Commerce.

The matter before the Subcommittee, competition in the new electronic markets,

is a very important one. It is vital to the US public interest that our markets, including our financial markets, remain the most innovative, fair and efficient in the

world. This will be the case only if we succeed in harnessing the power and efficiency of new electronic technologies in the service of our markets.

We have been asked to focus our testimony on regulatory impediments to electronic systems used in trading financial instruments. DNI has indeed seen some

regulatory impediments to the development of its own business. Although DNI’s

business is not the securities business of primary concern in today’s hearing, DNI’s

experience may be easily generalized. Even before introducing itself, DNI would like

to offer three propositions that are as applicable to the securities markets as to

DNI’s own business in interest rate and currency derivatives. First, if the mere introduction of electronic systems use threatens to bring regulation where there was

none before, the need for regulation should be closely examined. (DNI’s own electronic system, for example, merely allows sophisticated dealers to do among themselves via the internet virtually the same business they previously did on the telephone; yet DNI was nearly the subject of an entirely novel Commodity Futures

Trading Commission regulatory effort.) Second, if existing statutory and regulatory

language fails to correspond to evolving commercial reality, that language must be

re-examined and, if necessary, re-cast in light of fundamental public policy goals—

before it stifles commerce. Third, those advantaged by the status quo may raise regulatory concerns about the use of new technology as a means of defending their competitive position—which may require careful winnowing of legitimate public policy

concerns from less worthy efforts to limit competition. The following will explain

how we have arrived at these propositions.

DNI hails from different venues than many of our fellow witnesses, both in terms

of geography and commerce. DNI is a corporation based in Charlotte, North Carolina. It was formed in 1996 to build and operate a computerized communications

and information system (known as ‘‘Blackbird’’ or the ‘‘Blackbird system’’) to help

major financial institutions find, negotiate and agree to custom-tailored interest rate

and currency derivatives transactions (for ease of reference, ‘‘swaps’’) directly with

each other. The founders of DNI are experienced swaps professionals. The Blackbird

system is operational and successfully serving major swaps dealers in the U.S.

The fundamental goal of DNI is to provide its financial institution customers with

a computerized system that will bring greater speed, precision, safety and security,

and lower costs, to the very same interest rate and currency risk management business activities that are now taking place every day in numerous U.S. financial institutions.

In spite of this goal, DNI initially found itself subject to searching regulatory review by the CFTC and harsh criticism from some of the traditional exchanges subject to the CFTC’s jurisdiction. It was (and remains) DNI’s understanding that the

types of transactions that may be negotiated on Blackbird are exempt from CFTC

jurisdiction under the Commodity Exchange Act. Nonetheless, DNI was to learn two

lessons. First, DNI learned that the computerized enhancement through Blackbird

of services now commonly provided over the telephone by swaps brokers unregulated by the CFTC might lead to an assertion of CEA jurisdiction, even though there

existed no plausible regulatory structure applicable to Blackbird and no demonstrated need for any regulation of Blackbird. Second, DNI found that certain entities actually subject to CEA jurisdiction would do all they could to focus CFTC attention on DNI. These entities did so even though they never have offered the kinds

of transactions that might be negotiated through Blackbird.

In April 1999, DNI was on the verge of making Blackbird operational. DNI received a letter from the CFTC asking DNI to provide certain information so that

the CFTC could make an assessment of its own jurisdiction over Blackbird. Certainly, the CFTC is not to be faulted for making due inquiry to assure itself that

it is fulfilling its regulatory responsibilities. This CFTC, however, was the same

CFTC that had issued a ‘‘concept release’’ read by many as proposing that it take

23

jurisdiction over the swaps community. This was the same CFTC which was at loggerheads with the Treasury, the SEC and the Federal Reserve Board and which was

admonished by Congress not to take action following from its concept release. Fortunately, it is not the same CFTC today. If it were, we might now be speaking of DNI

as a U.S. entity in the past tense. U.S. banks and investment banks, which presently occupy a leadership role in providing interest rate and currency risk management products, might have been deprived of access to leading edge technology that

will help them compete.

DNI recognized the potential difficulties in its situation with the CFTC. What followed, however, was truly bewildering. DNI, a small North Carolina company, and

its computer system were mentioned in multiple Congressional hearings, only one

of which DNI attended. The fact of the CFTC inquiry became general industry

knowledge. Even our product name, ‘‘Blackbird’’, which had resulted from one of our

principal’s admiration, as an amateur pilot, for a fast, high-flying U.S. airplane, was

publicly ridiculed as an indication of evil, evasive intent.

The details of the public controversy we faced are less interesting than are some

of the deeper effects of the controversy. Perhaps most importantly, senior DNI personnel had to shift their attention from building a business to explaining and defending that business. Obviously, substantial financial resources had to be focused

on the regulatory situation. Potential customers needed to be reassured that transactions negotiated through Blackbird would not be void as illegal off-exchange futures. Potential investors also needed to be helped to a level of comfort with the regulatory situation. The net effect was that the CFTC inquiry and attendant public

attention significantly slowed our growth for a time.

Perhaps there is little surprising in all this until one stops to consider what was

mentioned above: most, if not all, of what the Blackbird system does is now done

by ‘‘voice brokers’’, human beings using telephones and squawk boxes, and operating

without threat of sanction or illegality.

In fact, Blackbird fulfills the same functions as the voice brokers, but with far

greater efficiency and benefit to the financial system. Blackbird is not an exchange

or a clearing house. Blackbird does not enter into transactions, provide credit support or take or add credit risk. Blackbird does not change the individual customized

nature of swaps. Blackbird does not introduce preference or bias into negotiations.

Blackbird simply provides sophisticated dealers (and not the public) with a computer-based electronic communications alternative for the direct negotiation and

agreement of bilateral transactions.

Blackbird offers an improved electronic method for a dealer to identify other dealers who may, subject to the resolution of credit and other terms, be willing to enter

into a transaction having particular economic terms desired by the first dealer. Use

of Blackbird promotes competition, improves transparency, record-keeping and risk

control, and reduces costs. Blackbird brings substantial private and public benefit,

without changing any meaningful feature of custom-tailored swaps activities as they

currently operate, and without creating any need for novel regulation.

If Blackbird brings all these benefits, why did it encounter the problems described

above? It may be helpful to the Subcommittee to consider for a moment the underlying legislative and regulatory causes of DNI’s predicament. First, there is the archaic language of the Commodity Exchange Act itself. This language was stretched

far beyond its originally intended use (even before the advent of new electronic technology) as ‘‘commodity’’ exchange-traded contracts have moved from the agricultural

into the financial. This inadequate statutory language has led to the situation, bewildering to the uninitiated, where Congress has directed the CFTC to exempt certain swaps from its jurisdiction without Congress’s ever deciding that these swaps

were ‘‘futures’’ subject to the CEA to begin with. Build on top of this rickety legislative base a regulatory exemptive structure struggling for words to describe what

might and might not be exempt and you have all the makings of a roadblock to

progress in an era of technological innovation.

When words and reality no longer mesh, it is time to restore direction by returning to basic principles. Fortunately, in the Commodity Exchange Act context, we

have seen this recognized on several fronts. First, the Report of The President’s

Working Group on Financial Markets entitled ‘‘Over-the-Counter Derivatives Markets and the Commodity Exchange Act’’ explicitly recognized that the ‘‘method by

which a transaction is executed has no obvious bearing on the need for regulation

in markets, such as the markets for financial derivatives, that are not used for price

discovery.’’ The Report went on to note that there is no ‘‘demonstrable need for regulation’’ of certain electronic systems. Second, the new CFTC, reinventing itself under

Chairman Rainer, has participated in the President’s Working Group Report and

has put forth a new regulatory proposal that attempts to build afresh on positions

of policy and principle, and that attempts to encourage use of electronic systems.

24

We are encouraged by Chairman Rainer’s very constructive attitude. Finally, the

Congress now seems to be well-focused on the fact that existing statutory and regulatory regimes may not adapt readily to the promise and challenge of the new technologies. The efforts of this Committee and others will be invaluable in determining

the direction for a redesign of our nation’s statutes and regulations. We encourage

Congress to watch closely to be sure that new regulatory constructs are sufficiently

resilient to weather changes in administration, as well as changes in technology.

DNI’s message is not that all electronic systems should be unregulated. DNI’s message is that regulatory concern should be focused not on the medium of communication or, for that matter, the medium of transaction execution. Concern should

be focused on the activities accomplished with the medium, and should be coupled

with consideration of the inherent market discipline likely to shape those activities.

If, as is the case with Blackbird, those activities do not raise serious concerns, great

care should be taken to protect them from the very, very serious countervailing

threats of overbroad or anticompetitive regulation.

Mr. OXLEY. Thank you.

Next is John Schaible of NexTrade.

STATEMENT OF JOHN M. SCHAIBLE

Mr. SCHAIBLE. I would like to thank you, Mr. Chairman, and

members of the subcommittee. I am John Schaible, president and

co-founder of NexTrade Holdings. I have been asked by the committee to address the following questions: What regulatory changes

are needed to promote full competition in our equity markets?

Would a central limit order book be desirable? What are the implications of privatization of stock exchanges? And finally, is

NexTrade ready for decimalization.

In 1995 NexTrade was founded with the goal of providing technological innovation to the financial services industry. The little company started in 1995 has applied to become a stock exchange, now

employs nearly 60 people developing technology for other brokerage

firms across the globe. Before we can answer the first question, we

must define full competition. Full competition is not a market

where two participants handle 95 percent of the shares traded in

this country. In order for the financial markets to become fully

competitive, we must promote competition between exchanges. This

competition can only be encouraged by the approval of new for-profit exchanges. The Commission is currently considering two applicants to become new fully electronic exchanges. NexTrade notified

the Commission of its intention to become an exchange in 1998,

and worked in draft mode with the Commission in 1999 in preparing its formal exchange application. Despite having filed this

application, NexTrade has no clear timeframe for approval.

NexTrade fully appreciates the important role the Commission

serves in protecting the public. Nevertheless we fear that inadequate staffing due to inadequate funding has, in this tidal wave

of change, overwhelmed the Commission. We fear that the Commission’s inability to review the applications is one of the greatest

risks to the continued supremacy of America’s capital markets. Recently, a third applicant decided to halt its application in favor of

becoming a facility of an existing exchange. This decision may have

been based in part on a perceived lack of progress by the Commission.

The need for new electronic exchanges has been exacerbated by

NASDAQ’s failure to be ready for decimals. This demonstrates that

we cannot rely on the existing nonprofit exchange model to be the

standard bearer in a new electronic environment. The for-profit

25

model has always been the hallmark of efficiency and progress in

our economy. Consequently, new for-profit exchanges must be approved to promote full competition in our equity markets.

Turning to the second question, a central limit order book, or

CLOB, would not be desirable. Like any centralized marketplace,

it would represent a single point of failure. It would not enhance

the marketplace, but harm innovation and reduce the competitiveness of our markets. In comparison, the competitive for-profit

model exemplified by ECNs has had a proven, beneficial impact on

our markets. In 1998 alone, the cost of a trade on NASDAQ fell 23

percent and spreads fell 41 percent. While ECNs have helped investors, this progress is minimal in comparison to the benefits that

will be derived from the privatization of stock exchanges.

Privatization will result in exchanges that are more competitive

and will respond better to the needs of the investors. New for-profit

exchanges will enable the United States to maintain its position as

the preeminent global market. Critics may claim that the drive to

be the most profitable exchange will result in a race to the bottom

in terms of quality of surveillance and investor protection. This

claim is without merit, because the exchanges with the best investor protection will attract the best issuers, thereby securing the

most formidable competitive advantage.

Finally, NexTrade is disappointed that the move to decimalization which may save the public up to $2 billion a year

may be delayed because some traditional marketplace participants

have failed to take appropriate steps to modernize their technology.

NexTrade applauds NASDAQ officials for their concern for the integrity of the financial markets and also appreciates NASDAQ’s

candor in admitting that its systems lack the capacity to handle

the projected increase in message traffic that will result from

decimalization.

Nevertheless, NASDAQ’s failure to be decimal ready is of great

concern. It may be due to NASDAQ’s antiquated technology, which

is systematically flawed, or that rather than concentrating on being

ready for decimals, the NASDAQ has invested substantial resources in developing the proposed SuperMontage. The prudence of

allocating resources to such a project in lieu of decimal compliance

is questionable, particularly in light of the vigorous industry opposition to the proposed SuperMontage.

In contrast, NexTrade has been ready for decimal trading since

1997. Chairman Oxley, Ranking Member Towns and members of

the committee, we are in danger of falling behind foreign competitors in modernizing our capital markets. If America is to retain its

primacy in this critical area, we must implement decimalization

and we must foster competition by approving new electronic exchanges. Moving forward, we must remove our commitment to the

principles that has served us in the past. The best way to protect

the investor is through vigorous competition. We thank you very

much.

[The prepared statement of John M. Schaible follows:]

PREPARED STATEMENT OF JOHN M. SCHAIBLE, PRESIDENT, NEXTRADE HOLDINGS,

INC. AND NEXTRADE, INC.

Chairman Oxley, Ranking Member Towns, and Members of the Subcommittee:

My name is John M. Schaible. I am the President and Co-founder of NexTrade

26

Holdings, Inc. I commend the Chairman and the Members of the Finance Committee for holding these hearings on Competition in the New Electronic Market. As

an innovative force in bringing about positive changes to the financial services industry, NexTrade appreciates the opportunity to share our views on these important

public-policy issues. I have been asked by the Committee to address the future of

the securities markets and regulation of those markets. Specifically, I will address

the following questions:

A. What regulatory changes are needed to promote full competition in the equity

markets?

B. Would a Central Limit Order Book be desirable?

C. What are the implications of privatization of the stock exchanges?

D. NexTrade’s readiness for decimalization?

NexTrade’s vision of the future of the financial markets is deeply rooted in the

entrepreneurial spirit of its founders. In 1995, Mark Yegge, NexTrade’s C.E.O., and

I founded a new technology driven brokerage firm with the goal of promoting technological innovation of the financial services industry.

The little company we founded in the living room of Mark Yegge’s apartment in

1995, now develops technology for the financial services industry that is used by

firms in this country and sought by firms around the world. NexTrade Holdings also

develops the systems for its own subsidiaries, including the NexTrade Electronic

Communications Network (the ‘‘NexTrade ECN’’) and the proposed NexTrade Exchange. NexTrade has invested millions of dollars in creating one of the most sophisticated and robust transaction systems in the world. This new technology will

be the engine behind the NexTrade ECN and the proposed NexTrade Exchange.

The NexTrade ECN is an automated trading system for equity securities. It gives

brokers the power to electronically display customer orders. As an electronic auction

market, the NexTrade ECN directly matches buy and sell orders. The NexTrade

ECN currently has more than 60 broker-dealer subscribers and is used by many

more non-subscriber members of the National Association of Securities Dealers. On

an average day, NexTrade executes orders representing millions of shares. All of the

NexTrade ECN’s orders are processed by computers in a room the size of a large

walk-in closet.

The proposed NexTrade Exchange is an example of the future of the financial

markets in that it makes use of innovative technology and new regulatory structures as part of a for-profit exchange. The proposed NexTrade Exchange plans to

make available for the benefit of its members and their customers an electronic

trading system (the ‘‘NexTrade Exchange System’’) to effect the purchase or sale of

securities listed or admitted to trading on the proposed Exchange and on other exchanges. The proposed exchange, however, will not maintain a physical-trading

floor. Members will access the NexTrade Exchange System from their own computer

terminals and communicate with the NexTrade Exchange System over commercial

information services and networks.

As a member of the group of ECNs which account for approximately 35 percent

of the Nasdaq’s volume, as the developer of innovative new technologies for the financial services industry, and as one of only two ECNs currently seeking approval

to operate new electronic stock exchanges, NexTrade hopes the Committee will find

my comments useful in its consideration of the future of the financial services industry.

LET TECHNOLOGY LEAD THE CHANGES IN THE FINANCIAL SERVICES MARKETS

As the Chairman of the Securities and Exchange Commission, Arthur Levitt, recently stated, ECNs ‘‘have been one of the most important developments in our markets in years—perhaps decades.’’ Innovation and new technology developed by ECNs

and non-traditional market participants are promoting the rapid and sweeping democratization of the markets. Some experts predict that ECNs will represent 50 percent of the volume on the Nasdaq by 2001. As a member of this group, NexTrade

is very proud of the role we have played in creating positive change that has saved

the public billions of dollars. Despite the great progress that has been made, we still

must strive to create fairer, more competitive markets and to ensure that America

maintains its position as the financial center of the world.

In considering the future of the financial markets, lawmakers and the Commission should heed the advice of Senator Gramm who recently noted ‘‘Let technology

lead.’’ As a technology leader, NexTrade believes this approach will best serve the

public. Lawmakers and the Commission should resist the temptation to divine

where the market is going in a misguided attempt to conceive a new regulatory

structure.

27

THE NEED FOR A NEW COMPETITVE NATIONAL MARKET SYSTEM

NexTrade believes with respect to regulation of the securities markets, it is incumbent upon the Commission and Congress to question each component of our current regulatory structure and ask this question: ‘‘Does the additional cost of the regulation outweigh its benefit to the market and the individual investor?’’ Rules that

add benefit should remain in effect and rules that detract from the market or impede competition should be eliminated. While most components of our current regulatory structure pass this test, certain components, such the National Market System (‘‘NMS’’) do not.

NexTrade believes the Commission and Congress should strive to remove artificial

barriers to competition. An important step in promoting greater competition would

be the reform of the NMS. In framing the 1975 amendments to the Act, Congress

instructed the Commission that in developing a National Market System, ‘‘competition, rather than regulation, should be the guiding force.’’ The Commission is mandated by Congress to facilitate the development of a national market system not to

be its chief architect. In establishing this mandate, Congress identified five criteria

that should drive the Commission’s role in the establishment of a NMS:

1. promotion of the development of mechanisms that allows for economically efficient execution of securities transactions;

2. promotion of fair competition;

3. promotion of transparency;

4. improvement of investor access to the best markets; and

5. the development of mechanisms that allow for investors’ orders to be executed

without the participation of a dealer.

There are numerous barriers to competition between markets, including the NMS.

The governance structures of the NMS plans are in need of significant reform. Currently, the boards of these plans are composed of representatives from each exchange. Any change to the rules governing the operation of the NMS systems, such

as the very rule changes necessary to accommodate new electronic exchanges, require the unanimous consent of the participants. The governance structures of the

NMS plans should be amended to include a broad constituency of market participants including the existing exchanges, new electronic exchanges, ECNs, brokerdealers and the investing public.

NexTrade believes the technology driving the NMS should also be replaced. Two

of the current plan participants, through the Securities Industry Automation Corporation (‘‘SIAC’’), develop and operate the computer systems that perform the responsibilities outlined in the NMS plans. SIAC operates all of the NMS technologies,

other than the Nasdaq Unlisted Trading Privileges Plan, which is administered by

the Nasdaq. The American Stock Exchange and the New York Stock Exchange own

SIAC. Coupled with the anti-competitive governance structure of the NMS plans,

SIAC’s administration of the NMS technologies allows two members of the NMS

plans to effectively impede the integration of new electronic markets and the implementation of new technologies into the NMS.

To address these issues, NexTrade recommends the modification and opening of

the NMS plans. NexTrade does not support the Commission or Congress designating

a third party that will operate the new NMS systems. Rather, NexTrade believes

that by opening the NMS plans to new participants and by consolidating the functions of the NMS plans into a single plan, market forces would ensure that the new

plan could not be used to protect antiquated markets from competition. Moreover,

such a structure would force SIAC, for the first time in nearly twenty-five years,

to compete with new firms that are interested in developing the technologies that

drive the new NMS.

A CENTRAL LIMIT ORDER BOOK WOULD NOT ENHANCE THE MARKETPLACE AND WOULD

ONLY HARM INNOVATION, ADD BUREAUCRACY, AND REDUCE THE COMPETITIVENESS

OF OUR MARKETS

There are those with less confidence in the economic efficiencies produced by competition who continue to express concerns about fragmentation when trading is

spread across competing markets. The same people that have contributed to fragmentation have also supported the centralization of all trading in a time-priority

central limit order book, or CLOB. Academics and the Commission have debated

this vision of transforming America’s financial markets into a CLOB in the past,

only to be rejected each time as a bad idea.

The notion behind the CLOB is that technology can be employed to centralize orders in one place, thus resulting in maximum order interaction and perhaps even

better prices. A CLOB, however, will sacrifice the innovation that has made our

markets the best in the world. Research has shown that competitive markets are

28

better equipped to implement technological innovations to address market inefficiencies. Centralized markets, no matter how well intentioned their architects, will typically be obsolete by the time they commence operation. Competition creates incentives for markets to upgrade and innovate. Centralized markets do not. Unlike open

markets, centralized markets serve to impede the ability of innovative firms to develop new technologies and mechanisms that promote better execution. Proponents

of a CLOB typically rely on claims that the markets are fragmented and that this

fragmentation can only be addressed by means of a CLOB.

FRAGMENTATION IS BEST ADDRESSED BY COMPETITIVE MARKETS AND TECHNOLOGICAL

INNOVATION

Fragmentation has always been a problem for our markets. It is not a question

of if fragmentation exists, but rather a question of degree. In the past, fragmentation was severe and was compounded by inadequate information technology. As

technology evolved, the degree of fragmentation has diminished while the number

of market participants has skyrocketed. However, the level of fragmentation in our

markets could be greatly reduced by reforming the NMS.

Statistical evidence supports the conclusion that ECNs produced more efficient

and less fragmented markets. Since the arrival of qualified ECNs, evidence reveals

dramatic improvements in the costs of trading stocks in the United States. The average cost of executing a trade on the Nasdaq Stock Market fell by 23 percent in

1998, spreads fell 41 percent, and volume increased substantially. If left to competitive devices, the degree of fragmentation within the markets will continue to be reduced despite the introduction of a multitude of market participants.

There has always been a tension between the efficiencies of centralizing order

flow and the benefits of competition between markets. Currently, the markets are

linked by the NMS plans. One plan that is very important in reducing market fragmentation is the Inter-market Trading System (‘‘ITS’’), which allows orders to be

routed to the best market regardless of which market originally received the order.

Unfortunately, the technology and the rules governing the operation of the system

are, in Chairman Levitt’s words, ‘‘archaic.’’ Market participants using ITS to route

orders to other markets may wait as long as two minutes to receive a response and,

even then, may not receive an execution.

Historically, the traditional market participants were opposed to technological innovations that could undermine their hegemony over the markets. This resistance

to technology has resulted in fragmentation. However, competitive market participants have responded to perceived fragmentation and inefficiencies with marketbased innovative solutions. A variety of ECNs and other trading systems have responded with systems that consolidate and provide efficient access to the best prices

among competing markets. One firm has connected all nine original ECNs, the

NYSE and the Nasdaq to their system. Similarly, when the current Nasdaq linkage

(SelectNet) proved too expensive and inefficient to handle record volumes, market

participants forged links with one another to create trading networks that bypass

SelectNet for faster and more reliable access to the best market prices.

A CENTRAL LIMIT ORDER BOOK IS ANTI-COMPETITIVE AND HARMS THE PUBLIC

The proposed CLOB is anti-competitive and would impede the development of new

for-profit electronic stock exchanges. If the Commission mandates a monopolistic

central execution system, such as the proposed CLOB, with which all market-participants must comply, innovation could be eliminated. Such a dearth of innovation

would not serve the goals of the Act, the NMS, or the public. Rather than developing a system that would reduce innovation by new for-profit electronic exchanges,

ECNs and other market participants, and halt the development of technologies that

provide additional liquidity and transparency, the Commission should encourage a

new and equitable NMS.

Government imposed centralization will cost all investors in terms of less competition, less choice, and ultimately less efficiency. The expensive new infrastructure

and bureaucracy required to support a CLOB would impose significant costs on new

electronic for-profit exchanges, the market and ultimately issuers. Most importantly,

a CLOB will result in worse prices for ordinary retail investors.

The amount of price improvement available in new and traditional markets is obviously an important factor in this equation. NexTrade supports new ways to get

better prices for customers, but this should be achieved through competition, not

legislation. More importantly, we caution against adoption of a single structure or

price improvement formula at the expense of competition and innovative alternatives. The proposed CLOB offers no additional benefits, and only serves to impede

competition and the development of new electronic markets.

29

1 Exchange Act Release No. 34-42360, 65 Fed. Reg. 5003 (Jan. 28, 2000).

A CLOB PRESENTS A CENTRAL POINT OF FAILURE THAT WOULD THREATEN AMERICA’S

FINANCIAL MARKETS

Like any centralized marketplace, a CLOB would have substantial dangers. Most

importantly, a CLOB would represent a single point of failure that could jeopardize

the global economy. The danger of such centralization is apparent in light of recent

well-publicized attacks on some of the largest Internet web sites and service providers. It is economically impracticable to design a centralized marketplace that

would be completely free of vulnerability to attacks by cyber-terrorists. The implausibility of designing a totally safe CLOB will become increasingly apparent in the

future as warfare and terrorism move from city streets to the Internet. In contrast,

the currently developing network of trading facilities, much like the Internet, mitigates these potential dangers through numerous alternative trade destinations.

The greatest negative effect that would result from the implementation of the proposed CLOB would be that the entire NMS would become dependent on the capacity, integrity and security of a single, largely antiquated system, which has proven

to be unreliable. NexTrade believes investors and the market benefit from a variety

of alternative systems that route, display and execute orders. The rapidly declining

costs of telecommunications technology has made it possible to build and maintain

redundant, competitive systems to handle orders without the need for a single monolithic service provider.

The currently developing network of electronic exchanges and market participants

offers the best solution in a competitive environment. A reformed and more open

NMS that is not dominated by a single exchange and its technology will promote

the continuing development of innovative trading tools that electronically process orders in an efficient and reliable manner across multiple sources of liquidity.

NEXTRADE IS READY FOR DECIMALS AND IS DISAPPOINTED THAT THE MOVE TO

DECIMILZATION WHICH WILL SAVE THE PUBLIC UP TO TWO BILLION DOLLARS A YEAR

MAY BE DELAYED BECAUSE SOME TRADITIONAL MARKET PARTICIPANTS HAVE FAILED

TO TAKE APPROPRIATE STEPS TO MODERNIZE THEIR TECHNOLOGY

Like most ECNs and Alternative Trading Systems designed in the past five (5)

years, the technology behind the NexTrade ECN and the proposed NexTrade Exchange is ready for trading in decimals. As a member of the National Association

of Securities Dealers (‘‘NASD’’) trading on the Nasdaq, the NexTrade ECN System

currently has to convert orders that are in decimal increments into fractions for execution. Like many members of the Nasdaq, NexTrade has eagerly awaited the arrival of decimalization.

In order to ensure that NexTrade’s linkages to the NMS and the Nasdaq are

ready for decimalization, NexTrade is planning on participating in the industry wide

decimalization testing. Unfortunately, as a member of the NASD and a Nasdaq participant, any delays by the Nasdaq in implementing decimalization will impact

NexTrade’s ability to conduct this testing and will delay the introduction of decimal

pricing for our subscribers.

On January 28, 2000, the Commission ordered the securities markets to begin

trading in decimals on July 3, 2000.1 The transition to decimals will save investors

anywhere from $300 million to almost $2 billion annually. The transition to decimals, however, must be delayed because some traditional market participants have

failed to invest in technology that will enable them to handle the increased quote

traffic resulting from the switch to decimals from fractions.

A recent study conducted by SRI Consulting projected that message traffic for

stock and options quotes would likely rise dramatically when decimal trading begins. The SRI study projected that options trading in decimals could lead to a 3,000

percent increase in peak message traffic by December 2001. The study also noted

that even if decimals were not introduced, message traffic would rise 779 percent.

According to SRI, the transition to decimals will mean that Nasdaq message traffic

could rise as much as 700 percent by December 2001. Even without decimals, the

peak message traffic for Nasdaq stocks could be 174 percent higher. Message traffic

for securities traded on the exchanges would be 50 percent higher by the end of

2001 from its December 1998 levels without any impact from decimal trading.

NexTrade applauds Nasdaq officials for their concern for the integrity of the NMS

and for having informed the Commission that their market would not be ready until

the first quarter of 2001 to accommodate the increased message traffic expected

from decimal trading. NexTrade, however, is troubled by the Nasdaq’s failure to

take the necessary steps to ensure that it would be ready for the implementation

30

of decimalization. Nasdaq, however, is not alone in its failure to address systems

capacity problems associated with the conversion to decimals.

According to the General Accounting Office, the Options Price Reporting Authority

(‘‘OPRA’’) will also face considerable difficulties as it attempts to handle the increased message traffic. OPRA, the NMS system used to disseminate trade and

price quote messages for equity and index options industry wide, is currently incapable of handling the increased volume levels that will result from the transition

to decimals. OPRA officials have admitted that upgrading their systems to handle

the increased options traffic expected from decimalization is a major challenge. In

order to address the current and projected message traffic volumes, OPRA and SIAC

intend to begin increasing system capacity. OPRA plans to increase system capacity

by December 2000 from its current maximum of 3,000 messages per second to

12,000 messages per second. It is unclear if this additional capacity is sufficient to

accommodate the volume levels projected in the SRI study.

NexTrade is concerned that the delays requested by traditional market partici- pants that are not ready for decimalization will cost the public the $300 million to

almost $2 billion dollars in annual savings that will be the result of the transition

to decimals. The market structure that has resulted in the delay in the implementation of decimal pricing is in need of fundamental restructuring. The opening of the

NMS to greater public and non-traditional market participant involvement will help

to promote innovation and greater competition. Such competition and innovation

will result in more efficient markets that benefit the public.

CONCLUSION

Mr. Chairman, and members of the House Subcommittee on Finance and Hazardous Materials, we have the unique opportunity to create fairer and more competitive markets. While it is unclear what the future holds for the development of

the financial markets, we must remember that the Internet empowers entrepreneurs and the public like no other vehicle has in the past. If we are to retain

our primacy in the capital markets we must embrace two concepts: (1) the Internet

will transcend our ability to regulate the markets, and (2) the future of finance does

not have a Wall Street address, it has an IP address.

As this Committee works its way through these various public-policy issues,

NexTrade would welcome the chance to elaborate on the proposals put forth today,

and to contribute in the most constructive way possible to this important dialogue.

Thank you very much.

Mr. SHIMKUS [presiding]. I think what we will do for the benefit

of members who have gone to the floor for the vote, I will ask a

few questions, which will allow the chairman and the ranking

member time to get back so they can see both demonstrations.

So if I may, a question for all of you is what percentage of limit

orders placed on each of your systems is completed in the very impressive 1300 of a second that I have heard discussed?

Mr. ANDRESEN. On The Island, it is benchmarked around 1 millisecond, as you’ve noted, but it is difficult to quantify the percentage

of limit orders that are executed because Island encourages the

submitting of limit orders such as buying Dell at a dollar or selling

Amazon at $200. I used to laugh at both of those. Now I just laugh

when people are selling Amazon too early. With limit orders because you are placing a specific price limit on what you are willing

to buy or sell, you can only quantify the percentage that get to the

market and then are executed. And because ECNs are included

within the national market system for NASDAQ stocks, all orders

represented on ECNs like Island are executed that become marketable.

Mr. SHIMKUS. Let’s just go down the panel.

Mr. Foley.

Mr. FOLEY. 3⁄100 of a second, that is a technical question that requires a technical answer. ECNs are, by regulation——

Mr. SHIMKUS. And let me just clarify. The direction of this question is obviously there is great, quick equally matching when you

31

have a buyer and a seller. What percentage of that is in that rapid

response? What percentage is not within that quick reaction time,

and probably the vast majority if you take the majority of transactions?

Mr. FOLEY. When you have a buyer and a seller that matches,

it is 100 percent. That is the business that we are in. We match

immediately. We are agents only. We have no other business with

that information except getting our customers’ trades done. That

includes orders that come from noncustomers, from the outside. We

have an obligation to our customers to execute the trades immediately and we do so. It is another matter—I would say the amount

of time it may take a noncustomer’s order to get to us if it goes

through NASDAQ technology, for example, but many of the ECNs

have connected to each other privately in order to maintain rapid

communications between ECNs, which is an obvious addition to

your ability to respond instantaneously. So the direction of technology is to do things rapid fire. Where technology is allowed to

compete in an unfettered fashion, you have greater speed, greater

reliability and greater customer satisfaction. That is what we are

committed to.

Mr. SHIMKUS. And I will let this question evolve as I go through

the panel. The various published reports state that this happens

approximately 25 percent of the time. So the question that is

emerging is what happens to the 75 percent, and if they are executed because they are sent elsewhere?

Mr. DORSCH. I think this question is probably more geared to the

other members of the panel today. In our arena, SWAPS trading

and negotiation is done differently. We don’t match orders, per se.

It is an electronically negotiated process. Having said that, to

quantify how much we have speeded up the process is a little bit

like somebody who was once walking and now they are flying in

a jet fighter. We have added that much speed to the process.

Mr. OXLEY. Mr. Schaible?

Mr. SCHAIBLE. I will take the question to mean what happens to

the order if the ECN does not have a match inside the book.

In that circumstance, and I am speaking for NexTrade, we have

invested millions of dollars in order routing technology that will

allow us to handle market orders and orders that do not have a

match inside our system to go to the best destination as quickly as

possible. We have found that is to other ECNs quite frequently.

Mr. FOLEY. I didn’t interpret the question referring to that issue,

and it is an important issue. What we do at Bloomberg Tradebook

is show the best prices to our customers from any place we can get

them, from the market makers in NASDAQ, from other ECNs, and

we present our clients with the opportunity to route directly to the

best price, wherever it may be, and that is not something that

every ECN does, and it is an important part of the service that we

provide for our customers because they need to know more than

just what the best price is among our customers.

As we have grown, that becomes more and more important information. The success in our markets, both the market in general

and also for our customers, the individual participants, means the

ability to see where everybody else who may be the other side of

your trade is and that is transparency, and the ability to get there.

32

And that is the market linkage, and that is what we promote. It

is an important value to our clients at Bloomberg Tradebook.

Mr. SHIMKUS. Let me throw out this question to the panelists.

You all talk about immediate access to the Intermarket Trading

System. Why should you be able to access the ITS in a manner

that is different from all of the other broker-dealers?

Mr. ANDRESEN. I don’t think that we should have any different

access as long as we meet the regulatory obligations of the structure within which we exist. Island is regulated as a broker-dealer

itself by the NASD, and also as an alternative trading system or

ATS by the SEC. I believe that if a broker-dealer, whether electronic or otherwise, can make itself accessible to investors, they

should have the opportunity to compete. One thing that ECNs do

differently than traditional marketplaces is allow for instant information and instant access.

If you see something on an ECN, you can get to it immediately

because it is, in fact, a live order, in The Island’s case, a retail

order. If there is a traditional intermediary, the one problem with

that is if they don’t make themselves immediately accessible, everyone’s systems have to slow down to the lowest common denominator.

Mr. FOLEY. I would like to be explicit about this. We don’t believe

that ECNs need to have direct access to the ITS. We understand

the argument, and some have used the analogy of the NFL. There

is the NFL or you can start your own league. You can’t demand

entry into this league.

The issue is this: We want there to be competition among the exchanges because if there is competition among the exchanges, then

we know that exchanges who want the order flow from our customers are going to be responsive to our needs for innovation and

so forth. The ITS committee in our view, the way ITS is governed,

restrains and discourages competition among exchanges.

It has been more than a year and a half since the Director of the

Division of Market Regulation, then the Director, Richard Lindsay,

wrote a letter to the ITS committee expressing concern over how

ITS is governed. They make decisions by a blackball method. If

anybody is opposed, then change can’t happen. That has made it

difficult for the NASD to bring ECNs in, and it makes any kind of

technological change all but impossible.

Our issue is that the Congress should be concerned. The Commission should follow up on this question of how ITS is governed

because if ITS is allowed to make decisions on the basis of what

the exchanges themselves feel is in their best interest and exchange competition can flourish, we think that there will be exchanges that want a home for us and innovative broker-dealers and

will provide services for us and our clients that we currently can’t

get in the listed markets.

Mr. OXLEY. Thank you, and thank you to the gentleman from Illinois for sitting in the chair. This will be an appropriate time to

have our show and tell.

Mr. Andresen, if you would proceed with that, we would appreciate that.

Mr. ANDRESEN. What you are looking at here is the wide market

in the stock Cisco Systems which is the largest stock by market cap

33

in the world. All of those colors that you see, and I understand that

it is hard to make out from up on the dais, all of those changes

that you see are retail investors putting in indications to buy or

sell, live accessible orders. And this is important in our minds for

two reasons: one, because people can now make better investing decisions. Chairman Levitt has said over and over again that the best

investor protection tool is the use of a priced order. The reason why

people place market orders in the stock market is because they

lack knowledge of what the order is. You would never place a market order for an automobile or a box of Cheerios, but in my mind

it is even more distressing that you place one for your life savings

or pension into a stock market with no knowledge of what you are

going to pay.

And as an example, the price line IPO, one of the hot IPOs of last year, the investment bankers priced that deal at $9 a share.

The opening price was at $90 a share, which is where all of those

market orders got filled. The investors found out about those executions when the stock was back down at $60 a trade. The use of

limit orders hinges on your ability to know the prices. And it is not

good enough to be able to look the next day in the Wall Street

Journal or The Washington Post in the stock tables. You must be

able to know right now what everyone is doing. Just looking at the

last sale in the stock is like driving a car down the road by looking

over your shoulder and saying wow, this road sure is straight. Not

seeing the orders, what everyone else wants to do in the stock is

very dangerous.

The other thing that seeing the entire limit order book enables

you to do is have accountability for your order. Right now, in traditional marketplaces, they will only tell you the best price. That

means they will tell you the highest price anyone is willing to buy

Cisco at is $77. The lowest price someone is willing to sell is $771⁄2. That is interesting information, but not being able to see what is

behind those orders, who wants to buy at $763⁄4 or $75 is damaging. In addition, not seeing your order within that list of orders

is very dangerous.

What we have given with the Island Book viewer is pure instant

accountability for your broker. Instead of talking to your broker 3

years ago and saying gee, Broker Bob, I would like to buy Dell and

have him say you can buy it at $38, having him tell you that a day

later. Now the conversation is gee, Bob, I put my limit order in to

buy Dell at $381⁄16 when it was $381⁄8 by $385⁄16, and it traded

down to $3731⁄32, and I didn’t get an execution. What are you doing

over there? And that is an empowered investor, an investor who

has the tools to be able to judge the service that they are given.

Everyone knows about commissions, margin lending rates and access to research. Until now, they have not been able to know about

execution quality. Execution quality, the price your trade is actually given to you at is far more expensive, a dead weight loss to

the investor. Seeing your order in there with everyone else’s is the

kind of transparency that is essential for investor protection.

Thank you.

Mr. OXLEY. Thank you. Mr. Schaible.

Mr. SCHAIBLE. Actually, I am going to need the phone cord from

Matt’s machine to do the connection. In the interim, I want to reVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00037 Fmt 6633 Sfmt 6602 E:\HEARINGS\63803 pfrm07 PsN: 63803
34

turn to a question that the gentleman had asked before you came

back into the room about whether or not we believe that all brokerdealers should have access to ITS equal to what ECNs are asking

for, and I want to agree with what Matt had said with one important caveat.

I think that anybody who has access to the National Market System should have to pass a validation of some kind with respect to

the level of technology that they can bring and that certainly, that

level of technology should be held to the current ITS. If Matt participated in ITS on the way orders are executed today, they would

absolutely expose themselves to double, triple, quadruple execution

for a single order. The current ITS system holds single orders alive

for up to 2 minutes because their technology is so antiquated. I

think it is an important topic.

Mr. OXLEY. Who would determine that capability, that technological capability?

Mr. SCHAIBLE. We have suggested that we broaden the governing

structuring of the National Market System plans, particularly ITS,

to get in a wider representation base. Currently only exchange

members can be part of the ITS governance board. We think there

should be broker-dealers, members of the public, issuers, representing a board similar to the structures of an exchange and that

board can make the decision what the standard should be and submit it to the Commission for approval.

This will take me just 1 minute. What you see on the screen on

the left-hand side is information on the current NASDAQ operating

environment. It is structured to display what are called level 2

quotes, which shows essentially the best prices of every market

maker or ECN today on Dell computers. This system is a system

that a lot of our broker-dealer clients utilize to connect to the

NexTrade ECN.

On the right-hand side of the screen is the NexTrade order book,

and we anonymously show the interest of every order inside on the

NexTrade ECN so that any investor or market participant can see

the complete depth of NexTrade’s book. This is an important difference from left to right. On the left-hand side the NASDAQ, you

see only the top of the book of the market participants, and to get

access to this information you must pay a professional fee of $50

a month to the NASDAQ.

For the information on the right you see the entire depth of book

in real time for free. And that is something that I think NexTrade

is doing. I believe Island offers their quote depth for free as well,

and it is something that we do as a competitive tool because we can

show that depth and we do that to attract market share away from

the NASDAQ. This system can do everything that NASDAQ can do

with respect to executing orders and more, and we can do it over

the Internet. We can trade like the NASDAQ in 20 seconds, and

that is what competition will do for the market.

Mr. FOLEY. Mr. Chairman, I wonder if I can give you a verbal

demonstration of some of the differences in the ECN space. One of

the things that we think is really important for our clients is to

show the full depth of the market, including all of the quotes from

NASDAQ and combine them with the orders of our clients and

route our client’s orders to the best market, the best market maker,

35

or the best ECN to satisfy our best execution obligations. And let

me put it this way. If you look at the display that shows the depth

of book from a single participant, even a large one, 12 percent of

the market, for example, you are still missing out on the other 88

percent of where the best price may be and the best place to execute a brokers—customer’s trade.

And so the display that we provide for our customers is one that

shows the complete information and we are enthusiastic advocates

of public displays that combine rather than having to go from one

place to other, that combine the aggregate market depth. We enthusiastically endorse the proposal that SEC Chairman Levitt put

forth at Northwestern a couple of weeks ago that the industry

should work toward a free market solution for this.

We enthusiastically oppose NASDAQ’s proposal, which you will

find presents depth of market information, but it takes our names

off the source of the quotes and replaces it with NASDAQ’s name.

Hence, centralizing not just the display but the execution into a

black box because you have to go through them to get to that socalled anonymous quote.

I just wanted to lay out a couple of distinctions that we think it

is in the best interest of the investing public to see all of the information in one place, and all of the places where you can execute

with the ability to get there. We do that for our clients. We support

Chairman Levitt’s initiative that will do that for the investing public in general, and we oppose the SuperMontage which purports to

do that, but we think is an anticompetitive positioning of NASDAQ

as a government-sponsored monopoly technology provider in advance of their privatization.

Mr. OXLEY. The Chair recognizes himself for 5 minutes for some

questions.

Mr. Foley, and maybe some others, could you help me with this

issue, that is the SuperMontage idea versus central limit order

book. Explain to the uninitiated, are they competing concepts or

are they similar from your perspective and how should this committee perceive both of these initiatives?

Mr. FOLEY. The distinguishing characteristic of the CLOB is that

someone or some entity is in charge, and some of the debates you

might hear at the top about this proposal versus that, this is not

a CLOB and this is, really the debate comes down to who is in

charge. NASDAQ’s SuperMontage proposal, has all of the centralizing aspects of a generic CLOB proposal, but it has a specific characteristic that NASDAQ is in charge of it.

One of the issues that came up earlier had to do with the compelling of orders into a CLOB? Would retail orders be compelled but

institutional orders not be compelled? We think that orders that

are displayed to anyone should be displayed to everybody and that

should be a requirement. But what particular technology you go

into should be a matter for the free market to decide, and that is

the danger of a CLOB. No matter what you call it, if it centralizes

the black box, you are going to have a single point of failure. You

are going to have a single point that is resistant to change. You are

going to have to have people like us on this panel raising our hands

for permission to innovate in the future, and that is not the way

36

that we have managed to serve our customers and grow our businesses over the last few years.

Mr. OXLEY. May I interrupt. If all of these impediments are out

there, how have you been so successful so far?

Mr. FOLEY. That is a great question. A lot of these issues can be

confusing because there are different things going on. I boil it down

to this.

The NASDAQ market is a market where new nimble competitors

can come in and introduce innovations and thrive. It is consolidated and not fragmented. Where NASDAQ’s linkages don’t suffice,

ECNs can connect privately to each other and replace those

outworn solutions with state-of-the-art solutions.

The SuperMontage proposal says there is a lot of chaos here.

There is a lot of change. Things are going on. Let’s take an example. Bloomberg Tradebook’s innovation of reserve, which allows for

the handling of large orders in an electronic marketplace, is incorporated into the NASDAQ SuperMontage proposal. You wouldn’t

introduce an electronic trading system today without the innovation that we introduced 3 years ago. You know, the issue in the

NASDAQ market is when you say this is the institutionalized, centralized level of innovation, do we really know that we don’t need

any more innovation, that there are not customers that we can

serve better with new competitors. I would argue if you hold this

panel 3 or 4 years from now, if a central limit order book or the

CLOB takes hold, it will be the same innovators here. We will be

talking about innovations that we had 5 years ago in the year

2000.

Because of the NASDAQ market maker collusion scandal in

1996, it was much more open to the reforms of the SEC than the

listed markets have been. But we think what makes the U.S. securities markets the best in the world and what is going to keep U.S.

securities markets in the U.S., is transparency. Now we are defining transparency and we are thrilled to see this debate move forward as the full market depth for everyone to see. Linkages. You

see the best prices. Do you have the ability to get there, and the

best execution obligations that brokers such as ourselves should

take advantage of the linkages to do the right thing for our clients.

We have been able to innovate on NASDAQ, not so much on the

listed side. We don’t want to see NASDAQ innovation stopped and

we would like to see it started up on the listed side.

Mr. OXLEY. Thank you.

Mr. ANDRESEN. I think it is sometimes instructive to look at

what NASDAQ is. We are all interested in making sure that investors get all of the information that they can. That, in fact, is

NASDAQ’s core competency. NASDAQ is not a central meeting

place at all. Instead, it is a collection of different participants, three

of whom you see represented today. Others like Goldman Sachs or

Morgan Stanley also participate in NASDAQ.

What the SEC did in 1997 was say this NASDAQ world, if you

think of it perhaps as a shopping mall, the shopping mall doesn’t

buy or sell things. They provide the roof for the different stores to

transact their business. NASDAQ ensures, just as a shopping mall

does, that you have a map of where to go, and if you lack the ability to get there, give you the communication path to be able to buy

37

whatever you want from the prices they give you. ECNs were not

in that shopping mall in 1996. The SEC insisted in their order handling rules that they should be so you now have different types of

stores within this mall applying slightly different wares.

The issue before you today is not so much what is going on in

the shopping mall, in NASDAQ. Maybe NASDAQ through the

SuperMontage wants to open its own store. I am not afraid of competing with NASDAQ on the basis of service, cost and reliability.

If they can do a better job than Island, they are welcome to the

business. On the listed side, however, their shopping mall is a collection of the 10 established stock exchanges: The New York Stock

Exchange, Am Ex, Philadelphia Boston, Cincinnati Chicago, et

cetera.

The ECNs are just like Burlington Coat Factory. We are stuck

on the other side of the expressway, hoping that people stop by our

stores on the way to the centralized meeting place. We ask for a

chance to share our prices with the other marketplaces. Let’s let

investors vote with their feet and select the marketplaces which

adds the most valuable.

Mr. OXLEY. Thank you. The gentleman from New York.

Mr. TOWNS. Thank you, Mr. Chairman. Who is proposing a

CLOB? And why?

Mr. FOLEY. The CLOB is not a formal proposal before the public

at this point. We understand that there is a white paper that is

in draft form drafted by some of the leading brokerage firms on

Wall Street that formulates the notion of a CLOB and why markets

need a CLOB today.

The second place where you see evidence of the debate over a

CLOB is with a paper that the SEC recently released. It was a concept release asking for public comment on various issues of market

structure and the first and most important issue that they ask for

is do we need a central limit order book to address issues of market

structure.

Finally, it has been raised by panelists who have testified on the

Senate side before the Senate Banking Committee on market structure. I say this about the debate. If you really want to boil it down

to one thing that we think is the most important, there is a lot of

concern about how our equity markets are going to be structured

to be the most competitive for the world in the future. There is a

lot of debate around decimalization and the Commerce Committee

championed decimalization, and I congratulate the chairman on the

issue of decimalization.

On one level it was a question of I buy my groceries in dollars

and cents and I would like my stock purchases to make sense as

well. You have academicians weighing in saying decimalization carries with it so many beneficial effects that address a lot of the complicated issues in market structure.

Our issue is simply this: We don’t know what decimalization is

going to solve until we have decimalization, and we don’t think

that we should be looking at intrusive, sweeping regulatory

changes in a marketplace that is going to change for the better

once we see decimalization. As I think someone else on the panel

mentioned, we think everyone’s first priority should be getting to

38

decimalization, and we will see what the benefits are and we then

can see what else we need in the marketplace.

Mr. TOWNS. You anticipated my second question.

Mr. ANDRESEN. I think any time you look at Wall Street or any

other industry, you have to look at underlying motivations. What

is in it for me. Those who propose a CLOB are people that stand

to benefit.

I used to be a big fan of the Price Is Right when I was sick and

staying home from school—a couple of years ago. I remember always feeling really sorry for the first poor guy that had to make

the first bid. He would say $300 for that laptop, and everyone else

would be $301, $299. He would just sit up there all morning and

people would sandwich him on either side.

If you look at Morgan Stanley, Merrill Lynch and Goldman

Sachs, who are the ones who proposed this most directly on the

Senate side in their hearings in New York, these companies don’t

really control much retail order flow. That has gone to places like

Island or market makers like Knight Trimark. They control institutional order flow. So they propose having a public utility, being the

initial transparent venue for all retail investors for them to make

that first bid. Their customers can come in through their gateway

and pick off the retail investors as they see fit.

I believe transparency is not about holding up retail investors for

them to be cherry-picked. It is about creating a truly level playing

field where everyone has access to everyone else’s information at

the same time.

If you look at the CLOB, inevitably there are those little carveouts. They want a CLOB but not for our customers, because in the

end, a market is about asymmetric information. If I know the final

score between Wake Forest and Notre Dame, I will make a lot of

money betting on it. If everybody knows the final score, it is

uninteresting information to have. Everyone wants to see what everyone else is doing without showing their own cards. When you

look at someone else’s proposal, you should see that through the

lens of their own business model.

Mr. TOWNS. Thank you very much. One more question, Mr.

Chairman.

What can this subcommittee do to foster reform of the ITS? What

can we do?

Mr. ANDRESEN. Well, I think the most important thing is just to

make this a debate. I think market structure is something which

has been very opaque to retail investors. I remember reading an

article in the Wall Street Journal about an investor that lost a tremendous amount of money in the Palm Pilot IPO because the market center had held his order for a substantial amount of time. And

I was struck and the reporter was struck by what did you think

happened to your order when you submitted it? Didn’t you think

that it was sold to someone else who was going to trade against

it? He said I just thought they sent it to the stock market, and this

illustrates the degree to which the investors have become knowledgeable about individual stocks and the market direction, but

have not thought about market structure.

As long as we look to create in ITS an environment where new

competitors can come in and actually compete, we will have an effiVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00042 Fmt 6633 Sfmt 6602 E:\HEARINGS\63803 pfrm07 PsN: 63803
39

cient system. If this committee considers the structure right now

which is, as alluded to before, the old U.N. Security Council situation where one person can veto a change. It is really a situation

where if we are soda manufacturers and I have to go with my new

soda pop to Coke and Pepsi for permission to compete, and they

can say yes, just serve it at 120 degrees Fahrenheit, it makes the

benefits of that new soda obsolete.

ECNs are new markets that are as revolutionary and as innovative as the light bulb was to the candlestick, but we are being

asked by the existing candlemakers to screw our light bulb into

their candlestick.

Mr. OXLEY. The gentleman’s time has expired. The gentleman

from Iowa, Mr. Ganske.

Mr. GANSKE. Thank you, Mr. Chairman. While I have learned a

lot in your presentation, I appreciate your testimony. Mr. Chairman, I have here some remarks by Chairman Levitt on a speech

that he gave at Northwestern University on March 16, and I am

going to skip around a little bit but read part of this, and then my

question will be to get each of your remarks on what Chairman

Levitt had to say.

Chairman Levitt said, ‘‘We can all agree that a market structure

tilted toward the needs of hedge fund managers should not be our

goal. At the same time, we should not foster a system bent toward

day traders. Our future markets must serve the diversity of American investors. Of course, if we have a single monolithic market fulfilling this responsibility to customers would be much simpler, but

I believe Congress was visionary in choosing not to mandate such

a market. Over the last 25 years, our system of competing market

centers has been the driving force behind faster and cheaper executions spawning new trading systems that provide anonymity and

greater liquidity.’’ He goes on to say, ‘‘Market centers in a dynamic National Market System must be able to hone a niche, develop a brand or offer

value-added features.’’ I think that is some of what you are talking

about in your testimony. ‘‘Any linkage must accommodate innovation and the imperative to compete on the basis of value. Moreover,

inner market linkages are not intended to promote unlimited free

access to a competitor’s market. Why, for example, would anyone

want to purchase a seat on the New York Stock Exchange if a connection to ITS offered equivalent benefits. At the Commission we

well know that ITS has not kept pace with the technological

change sweeping our markets. Its archaic structure and cumbersome governmental provisions are not fit for today’s market, let

alone the market of the future. The over-the-counter linkage,

SelectNet, continues to be plagued with shortcomings and delays

during heavy trading volume and even outages. Given the decentralized nature of the NASDAQ market, this is a critical and core

flaw and one that must receive intense scrutiny and committed resources until resolved. We expect to exercise increasingly active

oversight of these linkages in the near future.’’

Mr. Levitt continues, ‘‘In a more positive note, the Commission

today,’’ that was March 16, ‘‘approved a NASDAQ proposal to link

ECNs to the listed market through ITS. I firmly believe that investors will be winners as fuller, more robust competition between eqVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00043 Fmt 6633 Sfmt 6602 E:\HEARINGS\63803 pfrm07 PsN: 63803
40

uity exchanges unfolds.’’ Then Mr. Levitt finished by saying ‘‘This

is not a debate about big firms versus small firms. This is not a

debate about institutional interests versus retail interest. It is not

a debate about a monolithic market versus a splintered market. It

is not a debate about human intelligence versus the quiet hum of

a computer. Rather, it is a debate about how best to let unburdened competition and unbridled innovation drive the future of the

market. It is a debate about how best to meet the needs of our investors, it is a debate about how best to equip our markets to compete and win in an increasingly globalized electronic market. It is,

I believe, the most important debate our capital markets face.’’

I wonder if each of you can comment on those selected remarks

of Chairman Levitt or focus on any particular part of those parts

that I read. Maybe we can start with Mr. Andresen.

Mr. ANDRESEN. Thank you. I think Chairman Levitt has,

throughout his entire tenure, worked to foster competition within

the markets. Island’s very existence is owed fully to the SEC’s

intervention in 1997. Without that, Island would never have had

the chance to differentiate ourselves as a marketplace from everyone else.

I am sure it would not be surprising for you to know that the

people in front of you today are not really friends. When we go

back to New York or Florida, we will scratch and claw and fight

to try to find some tiny advantage over the other person. That is

the healthy aspect of competition. Without competition you have

stagnation. Our phone company in 1981 was certainly the envy of

the world, but there were busy signals and rotary dial phones.

Today in the era of robust competition, we have tremendous

breadth of service at incredibly lower cost. The equity markets are

the same way. Island was designed to be fully decimalized. Island

doesn’t go to nickels or pennies but actually to tenth of a tenth of

a tenth. We go to 10 decimal places.

Mr. GANSKE. Let me ask each of you to try to limit your remarks

to 30 seconds or a minute so that all of the other members have

a chance also.

Mr. ANDRESEN. Because we exist in a noncompetitive structure

we have to take our fine increments and pound them away to

NASDAQ’s chubby price increments.

Mr. FOLEY. Congressman, those are great remarks by Chairman

Levitt. I agree that the SEC has been an important influence for

guiding competition. You pull out a couple of things from those

statements. One, when you are relying on a central single point of

failure in technology, you have problems finding alternatives.

When Mike Bloomberg, my boss, wants something done, he will say

to me, all too often, get it done or I will find someone else who can.

If this committee could say that regarding decimalization in the

NASDAQ market, get it done or I will find someone who can.

We think that the market structure of the future should not be

one in which everyone gets a free call on all of the services of the

New York Stock Exchange without having to pay for them. There

should be a market structure where we look for free market competing solutions because we will have the best chance of having reliable ones and alternatives to turn to when we need them. It is

41

the same thing with the model of a CLOB. There is a central black

box that you have to go to and that is a basic problem.

I would sum up on the ITS question this way. We don’t believe

that it is a monolithic club, the members of the ITS committee. We

would like to see competition unleashed among the exchanges, and

regarding the linkages between the exchanges, we call for one basic

reform and that is the governance of the ITS committee. A lot of

good things will flow from that. One member of the committee can

veto any action on the part of the committee. Want to improve the

technology? One guy can vote against it. I am concerned about this.

So that is a fundamental issue. As I mentioned earlier, the Commission took a look at that issue a year and a half ago, and we

think that this committee would be well served to ask the Commission how that issue is progressing.

Mr. DORSCH. In order for this country to maintain its preeminent

position in the financial arena, I think competition is absolutely

necessary and I don’t think any one group or entity should be allowed to stand in the way of innovation.

Mr. SCHAIBLE. Access to ITS is not enough. NexTrade would like

the opportunity to compete for the National Market System technology business. We are forced by regulation to deal with the technology that is rather antiquated and that the previous exchange

members already paid for. That is not a technology that we can

easily interact with because it can result in double executions.

Something else that Chairman Levitt talked about is the crisis

that the Commission is facing with respect to flight of talent. Ranking Member Towns asked earlier what this committee could do to

help foster competition. I think one of the best things you could do

is to look to fund the Commission more fully. Their hands are tied.

They have exchange applications in front of them. They have National Market System issues pending. They are in a complete personnel crunch over there. I understand that SEC fees generate 5

times what the SEC actually sees. It is likely that we could take

some of the funding and direct that to the Commission to allow

them to deal with this crisis.

Mr. GANSKE. I thank you all.

Mr. EHRLICH [presiding]. Mr. Barrett.

Mr. BARRETT. In January 1997, were you all sitting around and

you saw this order came through and said hey, let’s try something?

Mr. FOLEY. Island and Bloomberg Tradebook and InstaNet existed prior to the order handling rules, and it changed the nature

of our business models dramatically. It became possible to display

your customers orders so that the rest of the world could see them.

Why did that come about? It came about because previously there

had been a private market inside the best bid and the best offer

that the public saw, and while large volume is trading inside the

prices that you can see on the screen, and market orders as Matt

referred to before, were getting executed at this published bid off

the spread that had nothing to do with where the market was really trading. People were writing to Congress complaining about

that, I might add.

The upshot was that, with the new order handling rules, you

couldn’t keep your market private to yourself and say I am just

going to match my customers’ orders with each other.

42

Mr. BARRETT. How long did it take you to realize that?

Mr. FOLEY. Three seconds.

Mr. BARRETT. For us Neanderthals—you can see there are more

Republicans here than Democrats. We don’t have as much to invest.

Mr. FOLEY. This happens so frequently. When you go back to deregulation of commissions or various issues, and decimalization is

going to be another issue like that, there is a lot of hand wringing

about what the change is going to be, and the way things have operated before which has been very profitable for the operators going

to have to change. The reality is in many of these issues, it brings

about new opportunities to do business and service your clients,

and we market participants, reformulate our strategies for how we

are going to serve our customers.

Now these customers have new rights and it turns out there are

a hundred new ways to serve your customers and differentiate

yourself from your competitors, and that is sort of what has

brought us to this point. Our business models existed before, but

it really changed the rules of the game that favored innovators.

Mr. BARRETT. How did you sort of glom onto this?

Mr. ANDRESEN. The good thing about competition is that you

never know where the next competitor is going to pop up. I always

say there is an annoying amount of ease of entry and exits in the

marketplace, and that is healthy. Back in 1996 when this happened, as you point out there was only one competitor, InstaNet,

where most of the trading was done. What we saw was an opportunity to serve people that InstaNet did not want to help, the retail

brokerages.

We said if we can do this at a cost level, we can change the

world. It doesn’t take long to figure out an on-line broker that make $10 a trade, and has to pay $15 to execute it, even on the

Internet, is a bad business model. If we can make it 75 cents and

make it cost effective and give good service to the customers, we

would be able to grow with the on-line brokage industry.

Mr. SCHAIBLE. NexTrade is predominantly a technology house,

and in late 1996, we had brokerage firms that were asking us to

develop matching systems because the clearing costs were lower.

Instead of having to send two trades to their clearing company and

pay two costs, if they could match a system in-house, match a trade

in-house, they would pay one clearing cost. So we started developing the technology in late 1996 to be an ECN. And in 1997 with

the order handling rules, we began the approval process which took

NexTrade about 18 months until they could become a qualified

ECN.

Mr. DORSCH. Our business is different. Having said that, we

were able to introduce decimalization in our business at the very

get-go and the results for our clients have been phenomenal.

Mr. BARRETT. The other thing listening to all of you, this world

is changing so quickly. What is it going to look like in 5 years?

What is the New York Stock Exchange going to look like in 5

years?

Mr. ANDRESEN. I think it is difficult to predict how anything will

turn out. Everything will be cheaper and faster and more transparent. I am sure that the day that the New York Stock Exchange

43

is forced to compete, they will change their business model to meet

that competition. I do not believe in 5 years you will have floors

where people transact. You will instead have everything done electronically.

Mr. FOLEY. I don’t think anyone can say for sure who are going

to be the dominant competitors. It was remarked earlier about the

two largest players, New York and NASDAQ being 95 percent of

the market. And I have to say that I don’t think that it is necessarily a bad thing that large entities dominate our marketplace.

They just simply need to have to compete to take on that role. A

naturally forming monopoly has to compete to maintain its position

in the marketplace, and a government-sponsored monopoly does

not have to compete and serve consumers’ needs.

Mr. DORSCH. I think the scope and speed of change is going to

be faster, and I think it will reach further and I think the complexity of transactions that will be able to be done electronically

will stagger people’s mind. It is going to be beyond stocks and

bonds.

Mr. SCHAIBLE. We talk about the future of capital markets resembling the Web, a number of portals interacting through a national market system with true transparency and quality of assess.

The New York Stock Exchange has a lot of smart people, and when

they are forced to compete, they will be one of the larger portals.

Mr. BARRETT. If I can take a minute for Mr. Ganske. He wanted

a minute.

Mr. EHRLICH. Without objection.

Mr. GANSKE. I think a lot of people would see the services your

companies offer as great for individuals. We just passed a financial

services bill, which I think will bring many more players into this.

Are some of the large financial institutions utilizing your company’s services?

Mr. FOLEY. That is a space where Bloomberg Tradebook excels.

What we have done is introduce innovations that make it possible

for the larger orders that are handled directly by institutions or by

broker-dealers who handle large institutional orders, to bring these

orders directly into the National Market System instead of having

them hang back and be worked upstairs and so forth.

And one of the revolutions in the marketplace right now is that

we are coming directly into contact with institutional order flow for

the first time. We make that possible by building tools that maintain the anonymity of the participant because if your fund managers spend a lot of time researching this stock, you want to make

sure that he gets to buy it before everyone else knows about the

idea and to allow those orders to participate in the market leaving

a footprint of a lot of small orders rather than the footprint of one

big order. That is where our 100 million shares come from.

Mr. DORSCH. Our business only serves large financial institutions. I don’t think we have ever had a transaction under $50 million. It is hundreds of millions of dollars in a chunk.

Mr. OXLEY. I recognize the gentleman from Illinois, Mr.

Shimkus.

Mr. SHIMKUS. Mr. Andresen, the central limit order book, how

does it affect your analogy of the shopping mall? What would hapVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00047 Fmt 6633 Sfmt 6602 E:\HEARINGS\63803 pfrm07 PsN: 63803
44

pen in simplistic terms if you turned that shopping mall into a

CLOB.

Mr. ANDRESEN. I remember when I was 18 I was on the national

fencing team and we went to Hungary. This was 1988, and I remember going shopping in Hungary and they had a big place called

Store, and you went into Store and it had stuff and you could buy

food and clothes and other generic things. While it seemed for me

coming from America like some sort of Orwellian nightmare, I believe this is exactly what you would have with a central limit order

book. Make everything generic. All of the technology would converge at one point. You could never be any faster than the slowest

participant. Everything gets dumbed down to the lowest common

denominator.

My concern with the central limit order book is even if you went

today and said let’s find the best technology, let’s say that Island

is lucky enough to be selected as the central limit order book, it is

pretty good right now, a millisecond is pretty fast, but what happens in the future when that is not enough. What happens when

instead of 2 billion shares a day, the market wants to trade 20 billion shares a day. You will call me and I am going to be working

4 hour days instead of 16 hour days, and I will tell you I will get

around to it when I can. I believe to ensure we don’t have that kind

of stagnation, you must provide incentive.

Mr. SHIMKUS. Thank you. I yield back the balance of my time.

Mr. OXLEY. The gentleman from Illinois, Mr. Rush.

Mr. RUSH. I yield my time to the gentleman from Wisconsin.

Mr. OXLEY. The gentleman from Wisconsin.

Mr. BARRETT. Thank you, Mr. Rush. I know so little about this,

I figured I can learn something here this morning. If this is a form

of a CLOB, if you can explain what it is and what the problem is.

Mr. ANDRESEN. One of the rules of an efficient marketplace is

sort of the law of the playground, the best price wins. If two people

have the same price, whoever was first in line wins. People call

that price-kind priority, and it is something at Island that we believe very strongly in. We have built our entire system around that

idea. Even if you are only a one-share retail order, you are in first

or better price, you win, you get the trade.

But it is very difficult, I believe, in fact, impossible to ensure

time price parity, not just in a system but across systems. My concern is when you go back to the shopping mall analogy, when you

try to ensure that kind of protection between markets, you actually

undermine it and if you would indulge me with a quick hypothetical. What would happen if Kevin was trying to use Island to

buy Cisco at $79 a share? He places his intention to buy on Island.

Now, let’s say that the two distinguished gentlemen up there both

make the decision roughly at same time that you want to trade

with Kevin on Island. So you both send an intention to sell to that

order. If Island was the best price this is easy. Whichever one of

you happened to type a little faster would win. But let’s take the

hypothetical where we have a trade-through rule. Let’s say that

you are just a little faster than him, and you send the order and

I say I can’t let you trade with Kevin because the Pacific Coast

Stock Exchange out in Los Angeles has a penny better price.

45

I am going to reroute your order through the intermarket trading

system for the next 2 minutes. Now, you are second in line and

should be punished by being behind you, but you end up getting

an immediate execution from Mr. Foley. You wait for the next 2

minutes to find out what happened. During that time, if it happens

to be the Palm Pilot IPO that I mentioned before, during that 2

minutes, that stock will move 12 points.

Now 2 minutes later, you find out from ITS, I’m sorry, you didn’t

get an execution. Start over again. So despite the fact that you had

time and price priority, because of the trade-through rule, you lack

the ability to actually win.

Mr. BARRETT. Why does it exist?

Mr. ANDRESEN. I believe it is to protect the existing markets. If

you have the biggest market you don’t want to have true competition or accessibility to your marketplace. Island is a very big ECN.

We make ourselves available to every other ECN because we believe that is the only way to run a marketplace.

Mr. BARRETT. How long has it been in existence?

Mr. ANDRESEN. Since ITS was implemented back in 1979. When

Congress laid down their goals in 1975, they insisted that the industry come up with a National Market System. They insisted on

the meeting of two goals: competition between markets and the

sharing of price information for the benefit of investors.

When they did this, the industry took these goals and said we

will meet them and they set up the Intermarket Trading System.

So it was up to them to work out the details. Unfortunately, those

details while at least on the surface in some ways, meeting those

goals actually interfere with the meeting of those goals.

Mr. BARRETT. Back in 1977, when the SEC came down with the

order handling rule, what did that apply to and what did it not

apply to?

Mr. ANDRESEN. That applied most aggressively to NASDAQ.

They said New York and ITS had some unspecified time to figure

out how to meet these goals. On NASDAQ they were forced to implement it directly.

Mr. BARRETT. Why the difference?

Mr. ANDRESEN. I don’t know.

Mr. BARRETT. Anybody? Any speculation?

Mr. ANDRESEN. I believe that the New York Stock Exchange controlling 80 percent of the market in that stock would want to, as

any good business, would want to protect that market share. Having the method of linkage and the method of sharing of price information be less than perfect, you must go to the place where you

have the best chance of meeting, thereby forcing all market people

to stay in the place that happens to be at that moment the largest.

Mr. BARRETT. I yield back to Mr. Rush.

Mr. OXLEY. The gentleman’s time has expired. The gentleman

from Staten Island, Mr. Fossella.

Mr. FOSSELLA. I have one quick question and that is just out of

curiosity, do you guys see any benefits to the central limit order

book?

Mr. ANDRESEN. I think that the theoretical benefit is very profound. If everyone is meeting in one place, you are assured of having the positive effects of consolidation. I think that you can see

46

that benefit on the New York Stock Exchange where you have a

huge number of buyers and sellers meeting. You can see it certainly in the market on Island, and I think the idea is very compelling. The idea of getting all of those people together in one place.

I worry that by accomplishing that the other effect will be that

the technology that keeps these people together will eventually,

and I believe by pretty much 12 hours after you put it in, be obsolete.

Mr. SCHAIBLE. I have to agree with Matt in the short term, there

could be some benefits with respect to protection of investors and

the quality of markets, but without the impetus that is competition

that drives innovation, then you will see what we believe in this

country is monopolies lead to stagnation, and the free market generally will lead to better pricing.

Mr. DORSCH. I would concur with those remarks.

Mr. FOSSELLA. The theory then seems sound to you, but the practical effect of it is not. Is there any way that you could take it to

your theoretical conclusion?

Mr. ANDRESEN. Like I said, I agree with the end result.

Mr. FOSSELLA. How would you do it?

Mr. ANDRESEN. I believe you can do it by letting competition

reign. We have many long-distant companies but only a few big

ones. We have many ECNs but just a few big ones. We have many

stock exchanges but only one big one. The natural economic forces

which give those benefits from a consolidation, they will be

wrought in a much more efficient way than government action

could possibly bring them about.

The market centers that have the best markets will win. Look at

E.bay. E.bay has a tremendous market for collectibles and other

things. I once saw a human kidney bid on. I saw a half eaten bag

of Fritos with over 700 bids in 1 hour. You might say that is just

a joke product, but it is an incredibly powerful network where you

have many people wasting their time putting in a fake bid.

We can start an auctionsite ourselves, but we would have trouble

getting people to use it because they are never going to find that

seller or buyer. We will always be driven to the largest place because of the efficiencies commensurate with those economies of

scale and those kinds of network economies.

Mr. SCHAIBLE. Chairman Levitt refers to a virtual CLOB, and I

think the reference is similar to what we discuss, a web of portal

executions coming together that allow functionally the transparency of a central limit order book, but also foster competition,

and I think that is what Matt was also saying.

Mr. FOLEY. Mr. Chairman, on the question of the trade-through

rule, in our view the most important issue is the linkage and the

ability to get to the best price. One of the things that we talked

about during the demonstration portion is what differentiates

ECNs from one other, do you show the best price outside of your

market and do you allow your customers to go hit the best bid or

take the best offer.

The trade-through rule in our view is consistent with investor

protection, but it makes no sense without a technology linkage that

is state-of-the-art, and allows you, in fact, to get to that price at

a reasonable timeframe and not in the terminology of the financial

47

markets right to a particular exchange a free option on your order

for the 2 minutes that they have.

In our mind, with transparency, linkages, and best execution of

brokers, you will have the strongest market structure in the world.

Mr. GANSKE [presiding]. Mr. Engel is recognized for 5 minutes.

Mr. ENGEL. I understand that all of my questions were asked by

my colleague from New York and other people. I want to thank the

chairman for holding this hearing. I think that ECNs are very exciting, and it is one of the things that makes this committee so exciting because of all of the new technology that we discuss and we

are able to question. I am delighted that two of the four panelists

are from my hometown, New York, and it just shows the vibrancy

of how New York continues to be a leader in the financial world.

I just think that this is only part one on this hearing. We are going

to have more hearings. I have some questions about decimalization

and restructuring, but I understand that those have already been

asked. So let me just say that I look forward to continuing the dialog. The dialog emergence of ECNs is certainly exciting. Anything

that can enhance competition is a plus for everyone concerned.

I yield back the balance of my time. I am delighted to see the

gentlemen here today and it makes me realize how old I am when

I see how young they are. They are making money and we are not,

Mr. Chairman. Something is wrong somewhere.

Mr. GANSKE. I point out that my farmers and small town businessmen can get on the Internet and trade like crazy.

The gentleman from California is recognized for 5 minutes.

Mr. BILBRAY. I am sure that my colleague wasn’t implying that

we want to get back to the good old days when politicians were

able to make a lot of money in the field. My wife is from New Orleans and she always says if you want to do that, go back to Louisiana where half of the State is underwater and the other half is

under indictment.

Mr. ENGEL. I don’t think politicians should make money, but I

don’t think that people need to make money before they come to

Congress. We ought to have a mix of people.

Mr. BILBRAY. I agree with you coming from that same background. I really came here as a parent, not as a Member of Congress. I watch my 13-year-old daughter buy her Qualcomm and

Home Depot over the Internet, and I think there is a whole issue

that we are missing, and that is, this whole access of a whole different population and that population not just being the farmer in

Iowa, but also teenagers and young people getting interested in the

market and a field that may have a whole cultural change, and

hopefully will have a security, financial security change in the next

generation. Rather than my daughter thinking about what new

shoes or dress to buy, she is looking at which stocks to invest in,

rather than going to the mall.

That is a real culture shock for someone who spent his time at

the beach rather than worrying about computers or TVs. I would

like for you to comment on this access issue and especially how we

are starting to see a new generation get into this, because I am not

going to call a stockbroker, I am going to talk to my daughter. She

is now culturally getting into that though she does worry about the

new rock stars, if you can call them that nowadays. But can you

48

articulate about this whole issue of the access component and average citizens and young people getting into a field that they feel

comfortable with and that is the Internet?

Mr. ANDRESEN. Two things that enfranchise people is information and cost. Those two things have certainly come under tremendous pressure within the last several years. In 1975, the SEC

unbundled advice from commission so that people no longer had to

pay $500 a trade as if they were paying for help in making that

decision. It doesn’t take a rocket scientist to know if you have $600 invested at the end of the month and you spent $500 on commissions, you probably end up going to the mall or the track. If you

are given the chance to pay only $15 in commission, suddenly this

has opened up the stock market not just to the wealthy and the

elite, but to anyone. I know when I graduated no one explained the

stock market or how to balance my checkbook with predictable results. And what I believe—— Mr. BILBRAY. That is why you get married so someone does it for

you. Go ahead.

Mr. ANDRESEN. I won’t comment on that.

But I believe that information is a great empowering factor. People become aware of the fact that it is cost-effective. When your

daughter is able to make those decisions, not because she pours

over dense tables in the paper but because it is presented in a real

time manner over the Internet, and I think that trend, as noted

earlier by some of my other colleagues, that is only going to increase. The level of information, the speed of that information increases is just going to enfranchise more people.

Mr. FOLEY. I would add to that a couple of points. One, we have

long in this country believed that homeownership promotes good

citizenship, and we have policies to try to encourage individuals to

own their homes, and I think a similar phenomenon, that individuals owning the assets of the U.S. economy really has to ultimately

promote good citizenship and have positive effects in many directions.

Mr. BILBRAY. Are you talking about the tearing down of the barrier between the proletariat and the bourgeois?

Mr. FOLEY. Yes. More and more employees own shares directly

of the companies that they work in, and more and more individuals

are concerned about their 401(k)s and IRAs and pension plan and

mutual fund investment. We ought not to forget the revolution

going on in institutional trading and the empowerment of institutions who, after all, represents millions of individuals who are by

pooling their resources investing just as much in our economy and

safely and soberly and so forth, and the opportunity to innovate,

to compete, to serve the interest of institutional clients is actually

flat out delivering better returns for individual investors, and it is

lowering the cost of capital for issuers, which is why issuers from

around the world want to come to the United States to have their

stocks traded, and it is providing employment for the U.S. securities industry in the U.S. which we think is the most important

issue.

Mr. DORSCH. I think both of them gave great answers.

Mr. BILBRAY. What is the defense about having young people get

into the market, not that I think it is a bad thing, but obviously

49

1Gerald D. Putnam is the co-founder and Chief Executive Officer of Archipelago. Archipelago

is a leading electronic communication network, or ‘‘ECN,’’ that serves a varied client base and

executes over 60 million shares per day. 2Frank G. Zarb, NASDD Chairman and CEO, submitted this request to Securities and Exchange Commission (‘‘SEC’’) Chairman Arthur Levitt in a letter dated March 6, 2000.

my wife had to participate in the setting up of the account. Now

I say that and then I say obviously, why couldn’t my daughter have

done the same thing? Is that because of credit cards or credit numbers or some kind of account?

Mr. ANDRESEN. Whenever an introducing broker, like e-trade,

any time they open up an account, they must meet suitability obligations, they must have money in the account and experience and

they have to have those things set out. I anticipate one of the

things that the SEC will continue to look at very closely is the obligations of those brokerage firms to ensure that the people that they

are talking to are really there.

Mr. DORSCH. In our environment we service the institutional environment, and suitability is a big concern for us and our users.

Mr. BILBRAY. I want to clarify my comment about my marriage

and keeping the books clean is I married an accountant so it came

in very handy. I yield back the balance of my time, Mr. Chairman.

Mr. GANSKE. I would entertain any additional questions from

any of the panel members?

Seeing none, I want to thank you gentlemen for coming today.

Anyone who wishes to submit comments for the record are welcome

to do so, and that’s the end of the hearing.

[Whereupon, at 12:05 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

ARCHIPELAGO

100 S. WACKER DR., CHICAGO IL 60606

March 28, 2000

Honorable MICHAEL G. OXLEY

Chairman, Subcommittee on Finance & Hazardous Materials

Committee on Commerce

United States House of Representatives

2125 Rayburn House Office Building

Washington, DC 20515

Re: Decimal Pricing for the U.S. Securities Markets

DEAR CHAIRMAN OXLEY: I am writing to thank you for inviting me to testify before

the House Subcommittee on Finance and Hazardous Materials at your hearing on

‘‘Competition in the Evolving Electronic Market.’’ Unfortunately, as I have previously communicated to your staff, I will be unable to testify because of a prior

commitment to my wife and children. In connection with your hearing, however, I

do want to respectfully express the concern of Archipelago, LLC1 (Archipelago) over

the recent request by the National Association of Securities Dealers, Inc. (‘‘NASD’’)

to delay implementation of decimal pricing in our securities markets.2

While we agree with the NASD that market changes should not put markets and

investors at risk, we also believe that the implementation of decimalization should

be priority number one at the NASD. In our view, decimalization would create such

a tremendous benefit for investors that its implementation should be the first priority, not the last. The NASD, while requesting a delay in the implementation of

decimalization, is proposing at the same time other complex structural changes that

would affect the Nasdaq market. Also, the NASD has been pouring enormous

amounts of resources into international joint venture projects. Finally, the NASD

has been on notice of this issue for more than three years and had, in essence, entered into a good faith bargain with investors, Congress, and the SEC to implement

decimals immediately after Y2K. The NASD is now attempting to breach that good

faith bargain. At a minimum, the NASD should delay the implementation of their

other proposed changes and ventures and should focus all of its resources on

decimalization.

50

On January 28, 2000, the SEC issued an order requiring the U.S. securities markets to shift to decimal pricing no later than July 3, 2000. The SEC described the

many potential benefits of decimal pricing in its order requiring the markets to

adopt decimal pricing, and the NASD reiterated these points in its March 6 letter

to Chairman Levitt. Probably the most important of these benefits is that decimal

pricing would significantly increase quote competition, and this competition would

save investors potentially tens of millions of dollars almost overnight. Further, decimal pricing will improve price efficiency in our securities markets through the

mechanisms of the free market.

As a leader in this effort for many years, you are fully aware of the potential benefits that decimalization will bring to our markets as reflected by your recent statements:

I wanted to [convert from fractions to decimals] for three reasons: (1) I

believed the free market, not the government, should determine stock

prices; (2) decimals would make the markets more accessible, because they

are easier to understand than fractions; and (3) decimals would promote the

competitiveness of the U.S. stock markets, because the rest of the world

was already trading in decimals.

In addition, the SEC presented a number of potential changes in market structure

in a recent concept release on market fragmentation (‘‘SEC Concept Release’’). We

are of the view that many of the concerns that the SEC is attempting to address

through the SEC Concept Release may be mitigated, if not eliminated, by the shift

to decimal pricing. Once decimalization is implemented, competition in the free market may naturally resolve the issues underlying the Concept Release. We support

the SEC’s efforts to encourage lower trading costs and greater market efficiencies.

Like the SEC, we are of the view that decimalization is paramount to producing

these results.

For all of the foregoing reasons, we encourage you to monitor the NASD’s request

to change the implementation schedule for decimalization. In response to any

change in the implementation date, please consider communicating to the NASD

that it should also delay mandating additional market structure changes until the

benefits of decimal pricing are realized by investors. However, the best result would

be no delay in implementing decimal-based pricing so that the investing public

would reap its benefits more quickly.

Thank you for your consideration.

Very truly yours,

GERALD D. PUTNAM

RESPONSES FOR THE RECORD OF KEVIN FOLEY, CEO, BLOOMBERG TRADEBOOK

1. How do ECNs increase transparency?

ECNs are distinguished by three characteristics—neutrality, transparency and

fairness. Like market-makers, ECNs maintains an electronic book of customers’ bids

and offers. Unlike market-makers, however, Bloomberg Tradebook publishes our entire book of quoted prices electronically for all our customers to see, as well as publishing all other available pricing information. That’s the ultimate in transparency.

I’d add that, unlike some of our ECN competitors, we empower our customers to

take the fullest advantage of this transparency by actually routing them to the best

available price, even if that is outside Bloomberg Tradebook. That’s the ultimate in

best execution.

As a practical matter, those who provide transparency within a system while not

routing to the best available price are often providing benefits that are more illusory

than real. As the largest ECN offering customers this ability to have their orders

executed at the best price—even outside of our ECN—Bloomberg Tradebook is

known as a ‘‘Best-Execution ECN’’.

In the final analysis, however, it is up to the government-sponsored market centers like the New York Stock Exchange and the Nasdaq Stock Market to make ECN

transparency available to the entire national market system. These governmentsponsored market centers can enhance transparency by incorporating ECNs into

their market display, as Nasdaq did early in 1997. Or they can reduce transparency

by seeking to block ECN display linkages, or roll them back, as seems to be the current effort.

2. Are your systems decimal ready?

Over a period of years, the Commerce Committee has rendered an enormous public service by spearheading the effort to convert to decimals. Decimalization would

51

create such an enormous benefit to investors and the markets that implementation

should be the top priority for all market participants.

Accordingly, Bloomberg Tradebook has allocated significant time and resources to

the capacity issues surrounding decimalization. As a result, we will be ready for decimal pricing as scheduled in July. Thus Bloomberg Tradebook and our customers

were extremely disappointed by the NASD’s recent request to delay decimalization.

Again, the benefits of decimalization are such that the public would be best served

if the NASD focused its resources on the capacity issues critical for implementation

of decimalization prior to focusing on ill-advised efforts like the SuperMontage.

I’d conclude by noting that conversion to decimals will change our markets radically for the better. Congress and the SEC should not entertain significant structural changes to the Nasdaq market—like the SuperMontage—until after

decimalization has been completed and the full range of its beneficial impact assessed.

3. What can you do to facilitate trading in decimals even though Nasdaq is not decimal ready?

As discussed above, Bloomberg Tradebook has allocated significant time and resources to decimalization and, as a result, we will be ready for decimal pricing as

had been previously scheduled in July. We and our clients understand that presenting quotes in 1/8ths and 1/16ths has reduced competition and liquidity in our

markets to the serious detriment of investors.

Ultimately, however, there is precious little additionally that can be done by us

to facilitate trading in decimals in light of Nasdaq’s failure to adhere to the conversion schedule negotiated among the Congress, SEC and the NASD. As the

decimalization experience makes clear it is hard to prod movement from a government-sponsored monopoly even when it is clearly acting as a counterproductive bottleneck. This should be kept in mind as the Congress contemplates Nasdaq’s SuperMontage proposal which would require that virtually all executions take place centrally, creating an enormous bottleneck that would further stifle innovation.

4. What structural changes should accompany the demutualization of NYSE and

Nasdaq to ensure a competitive market?

Allowing a government-mandated monopoly to enter the markets as a for-profit

entity raises enormous concerns for a host of regulatory and enforcement reasons.

I’ll focus on one that is very familiar to the Commerce Committee as both an historic and current controversy, namely the issue of access to market data.

A quarter century ago, the Commerce Committee spearheaded the effort to enact

the Securities Acts Amendments of 1975. That legislation established the goal of

producing a national market system. To this day, that remains the correct goal. In

furtherance of that objective, Congress mandated a consolidated system for distributing market data in an effort to ensure that stock market information was accurate

and accessible. The securities markets were allowed to charge a reasonable rate for

gathering and distributing that information.

When the Commission, in 1972, first proposed rules to provide for the consolidated reporting of transactions and quotations, the New York Stock Exchange asserted that the SEC not only lacked authority under the securities laws to adopt

the quotations rule, but also such action would deprive the Exchange of property

in violation of the due process provisions of the Constitution of the United States.

Despite these objections, Congress and the SEC were determined to achieve the goal

of public access to consolidated market information.

Even in this day of on-line investing, the exchanges continue to argue that they

‘‘own’’ or ought to own quote information. Indeed, during the last Congress the dominant national exchanges were major proponents of legislation reported from the

House Judiciary Committee—the ‘‘Collections of Information Antipiracy Act’’—which

would have created an unprecedented ownership interest in facts, including stock

quotes. Though well-intentioned, this legislation—which has also been reported from

the House Judiciary Committee this Congress—would create a property right in

facts that extends not only to presently existing markets, but also, incredibly, to hypothetical, presently non-existing markets.

We applaud the bi-partisan leadership of the Commerce Committee for crafting

critical legislation, the ‘‘Consumer and Investor Access to Information Act’’. That

legislation, which was reported from the Commerce Committee last year, would also

provide additional protections for databases but would do so while assuring that

consumers and investors have continued access to factual information.

It has been observed that real-time stock data is like ‘‘oxygen’’ to investors. We

worry about the prospects of a government-mandated monopoly over the most important information in the market—truly the market’s oxygen—being controlled by

52

a for-profit entity that not only believes it ‘‘owns’’ data our clients create, but also

wants to control the downstream uses of that data in currently non-existing markets

outside of the real-time market window.

At the core of this market data debate is the outmoded concept that market participants should continue to provide market data to a government-sponsored monopoly and then pay to see it. We endorse an alternative model recently proposed by

SEC Chairman Levitt in the context of market depth. Chairman Levitt has urged

our markets—exchange, dealers, and ECNs—to make their limit order books available to the public where vendors could consolidate this data and repackage it in a

form that would be most useful to their customers. A similar model allowing the

establishment of private quote aggregators to which one could report market data— breaking the SRO monopoly on data—would certainly improve the quality, comprehensiveness, reliability and capacity of this information while reducing the cost.

5. What benefits will electronic exchanges provide that traditional exchanges do not?

In a statement before the Senate Banking Committee, Frank Zarb, the Chairman

of the National Association of Securities Dealers, stated that ‘‘. . . I guess I sum up

the answer as to why we have ECNs as the fact that the national stock exchanges

around the world haven’t been keeping pace with the needs of the market.’’ It’s worth pondering why the stock exchanges didn’t keep pace, as Mr. Zarb says.

We would submit that a government-sponsored monopoly ultimately cannot provide

the innovative ideas and customer service of the best ECNs precisely because they

are a government-sponsored monopoly.

Simply put, as is the case with ECNs, the primary benefit that electronic exchanges will provide is that of an entity that keeps pace with the needs of the market and, by doing so, prods traditional exchanges to improve their performance, thus

benefitting all market participants.

6. Is the Nasdaq super-montage an ECN? What types of problems do you anticipate

in a market in which your regulator competes with you?

The Nasdaq SuperMontage is not an ECN. Nasdaq would remain a marketplace,

but would be transformed from a largely decentralized market—its major strength

for 30 years—to a market in which virtually all executions take place centrally. Of

the concerns which the Nasdaq market faces today, capacity limitation is certainly

the greatest. In recent years Nasdaq’s systems have become an increasingly serious

messaging bottleneck. Yet the proposal would convert Nasdaq to a central execution

utility only months before the U.S. markets are scheduled to grapple with the intensifying volume expected with decimalization.

This CLOB-like centralization would create a government-sponsored monopoly

that would deter today’s decentralized market innovators—ECNs—from adding

market capacity and from introducing further innovations. In short, the major

threat to competition from the SuperMontage is the fact that it would preclude

ECNs from competing among themselves.

Let me offer one brief example. In 1996, Bloomberg Tradebook introduced the concept of the ‘‘Reserve’’ to the U.S. equity markets. ‘‘Reserve’’ is a process that controls

the release of orders into the market enabling clients to trade large orders more efficiently. Like all innovations, the ‘‘Reserve’’ gave Bloomberg Tradebook a leg up on

our competitors for a brief period of time. Soon it was adapted by others. Today no

one would introduce a system without it, including Nasdaq in its SuperMontage proposal.

Any edge we gain is momentary, and we are forced to continue to innovate. If a

CLOB like the SuperMontage had been imposed three years ago, clearly this innovation wouldn’t exist. Innovations occur in a dynamic competitive market. They won’t

occur when innovators need to seek permission to innovate.

7. Which regulations most inhibit ECNs from competing with exchanges?

The pending SuperMontage proposal is far and away the pending regulation that

will be most destructive of ECNs. It will harm investors and the markets by severely undermining the ability of ECNs to compete with each other.

A word is in order about ECNs competing with exchanges. Bloomberg Tradebook

does not compete against the NASD or the New York Stock Exchange. We compete

against exchange members and, in the case of the NASD, we are one.

It’s possible that the national stock exchanges see us as a competitor because of

our independence—i.e. we could take our customers and order flow to another stock

exchange. That would mean the exchanges would have to do something they haven’t

historically done—namely compete against each other to keep that customer order

flow. While they may think that order flow is theirs rather than their customers,

investors have clearly indicated that ECNs are an important part of their market

structure.

53

Unfortunately, when confronted with ECNs the first response of the dominant national stock exchanges has not been to compete against each other for the business

of this new kind of broker/dealer. It seems the dominant exchanges would rather

avoid the whole headache by passing a few rules in an attempt to hold order flow

captive. Little wonder some ECNs would rather become exchanges themselves.

In short, we think the national stock exchanges should have to compete against

each other for our business or the business of any other broker-dealer.

8. What is the Intermarket Trading System (ITS)? How should it be changed?

The Intermarket Trading System (ITS) theoretically allows orders to be routed to

the best market regardless of which market originally received the order. Unfortunately, as Chairman Levitt has observed, the technology and rules governing the operation of the system are ‘‘archaic’’. Market participants using ITS to route orders

to other markets may wait as long as two minutes to receive a response and, even

then, may not receive an execution. An ineffective ITS has long allowed the NYSE

to dominate the regional exchanges and is also a potentially effective tool for blocking newcomers like ECNs.

Bloomberg Tradebook is eager to see ITS reform and improved market linkages.

We’d warn that, just as centralization and self-interest have created an ITS system

that doesn’t serve the market or public—the same destructive dynamic would be

present in an exaggerated form in a CLOB, whether industry run or run by Nasdaq

as SuperMontage.

9. What is the Consolidated Quotation System (CQS)? How should it be changed?

The Consolidated Quotation System is a key component of our current arrangement for disseminating ‘‘market information’’—information concerning quotations

for and transactions in equity securities and options that are actively traded in the

U.S. markets. The information is ‘‘consolidated’’ in that it is continually collected

from the various market centers that trade the security and then disseminated in

a single stream of information.

This system is premised on the outmoded concept that market participants should

continue to provide market data to a government-sponsored monopoly and then pay

to see it. We would endorse an alternative model recently proposed by SEC Chairman Levitt in the context of market depth. Chairman Levitt has urged our markets—exchanges, dealers, and ECNs—to make their limit order books available to

the public where vendors could consolidate this data and repackage it in a form that

would be most useful to their customers. A similar model allowing the establishment of private quote aggregators to which one could report market data—breaking

the SRO monopoly on data—would certainly improve the quality, comprehensiveness, reliability and capacity of this information while reducing its cost.

10. Has the current regulatory structure of the National Market System (NMS) actually created market fragmentation by disallowing ECNs to share pricing information?

Yes. The current regulatory structure of the National Market System has actually

created fragmentation by disallowing ECNs to share pricing information, especially

as it relates to listed stocks. The NMS impedes access to pricing information by

mandating a monopoly in data gathering. Access is further impeded by the

monopoly’s settled habit of charging the public fees for market data that far exceed

the actual costs associated with the collection and dissemination of that data. The

cumulative impact of unnecessarily centralizing, and then overcharging for, market

data is to retard significantly the sharing of pricing information while increasing

market fragmentation. This result cries out for remedy as this kind of centralized

monopoly routing and collection of data is no longer technologically necessary to facilitate a National Market System. Indeed, as your questions suggests, this regulatory structure is an obstacle to the realization of the most beneficial and effective

National Market System.

The current regulatory structure of the NMS, premised as it is on the technology

and markets of a quarter century ago, is clearly a poor way of disseminating critical

market information. Again, we would urge an alternative model recently proposed

by SEC Chairman Levitt in the context of market depth when he urged our markets—exchanges, dealers, and ECNs—to make their limit order books available to

the public where vendors could consolidate this data and repackage it in a form that

would be most useful to customers. A similar model allowing the establishment of

private quote aggregators to which one could report market data—breaking the SRO

monopoly on data—would certainly improve the quality, comprehensiveness, reliability and capacity of this information while reducing its cost.

54

11. Have you applied to become an Exchange? What is the status of your application?

Bloomberg Tradebook has not and does not intend to become an Exchange. We

intend to remain a broker-dealer and a ‘‘Best Execution ECN’’. We believe that is

the most effective way for our customers to obtain not only liquidity but also the

best execution that comes from Bloomberg Tradebook’s policy of routing our customers to the best available price—even if that is outside Bloomberg Tradebook.

While we are proud to be and remain a broker-dealer/ECN, we are also supportive

of the efforts of some of our ECN brethren to either affiliate with or become exchanges. Just as competition among ECNs has been good for investors and the market, competition among stock exchanges also benefits all. We think the national

stock exchanges should have to compete against each other for our business and the

business of any other broker-dealer. Bloomberg Tradebook looks forward to the day

when some of our ECN colleagues will be—as new exchanges—competing with the

established exchanges for our business.

12. How is Nasdaq’s super-montage like a Central Limit Order Book (CLOB)?

The Nasdaq SuperMontage proposal carries most of the major downsides of a traditional CLOB. It would convert Nasdaq from a largely decentralized market, which

has been its major strength for thirty years, to one in which virtually all executions

take place centrally. As with the CLOB, this centralization runs counter to the spirit of the age in which even public utilities like telephones and electric power are

abandoning their ‘‘black boxes’’ for decentralized structures. It would not only impose a technology that is already outmoded, but also preclude the prospects of exploiting advancing technology in the future. As with a traditional CLOB, SuperMontage would create an enormous messaging bottleneck—and do so at the time that

the U.S. markets are scheduled to be grappling with the intensified volume expected

with decimalization.

Indeed, NASD Chairman Zarb illuminated precisely how the Nasdaq SuperMontage is like a CLOB when, in testimony before the Senate Banking Committee, he

observed that 95% of everything CLOB proponents sought could be had under the

SuperMontage. That’s accurate, and underscores that we are looking in part at a

political battle for control of this centralized entity. I don’t know who will win, but

I know who will lose this kind of battle—markets and consumers.

I’d add that the effort to create this Nasdaq CLOB—the SuperMontage—is a critical component of the for-profit picture Nasdaq envisions for itself. In its recent private placement memorandum/proxy statement distributed to NASD members asking

members to vote to make Nasdaq a private, for-profit entity, the NASD cites the

SuperMontage as its most prominent business plan for Nasdaq and warns quite candidly that the threat to Nasdaq’s monopoly position is one of the most significant

risk factors:

‘‘SelectNet is Nasdaq’s automated market service that enables securities firms

to route orders, negotiate terms, and execute trades in Nasdaq securities. If

pairs of market makers or ECNs determine that they do enough order routing

traffic in a day so as to justify setting up an alternative proprietary network

for their traffic, Nasdaq may be forced to reduce its fees or risk losing its share

of the order routing business. A reduction in the order routing business could

have an adverse effect on Nasdaq’s business, financial condition and operating

results.’’

From Nasdaq’s perspective—looking towards a future as a for-profit entity

charged with maximizing value for shareholders—the SuperMontage CLOB makes

great sense. The forced centralization of electronic messaging will indeed eliminate

the risk that ECNs seeking more efficiency or better service for our customers might

set up an ‘‘alternative proprietary network for their traffic.’’

From the perspective of the public, however, the SuperMontage is enormously

harmful. Like all CLOBs, this centralization will harm the marketplace by creating

a single point of failure and by eliminating innovation. This CLOB capacity to extract monopoly profits from market participants is exactly what benefits prospective

Nasdaq shareholders while disadvantaging the public and the markets.

13. What are the key problems with a Central Limit Order Book (CLOB)?

The notion behind the CLOB is that if you centralize orders in one place, a single

‘‘black box’’, maximum order interaction and perhaps better prices might be

achieved.

There are a number of very serious problems with this concept. When this concept

was first broached thirty years ago, our markets lacked the technology to achieve

order interactions without centralization. Now, technology allows the advantages of

maximum order interaction without the downside of centralization.

55

The technology of today makes a centralized order book unnecessary. These technological advances have revolutionized other industries, and despite protests, they

are revolutionizing our equity markets. At a time when even public utilities like

telephones and electric power are abandoning their ‘‘black boxes’’ for decentralized

structures, does it make sense to threaten innovation by centralizing the stock markets? State-of-the-art telecommunications systems like the Internet don’t rely on a

single monopoly channel—rather they rely on networked webs of multiple private

competing linkages. Why should the securities markets work differently?

Centralized systems are resistant to change. The innovations that ECNs have

brought to the market could not occur under a CLOB system, including the SuperMontage Proposal of the NASD.

A centralized system also provides the significant downside of a central point of

failure. Those of us who deal regularly with Nasdaq’s SelectNet system know only

too well how cumbersome and inefficient a centralized system can be. Like

SelectNet, the ITS system is conceded even by those who are sympathetic to be technologically outmoded with a bureaucracy that thwarts change. Why make those

failed systems the model?

14. In what ways is a Central Limit Order Book anti-competitive?

As described previously, from a technological perspective the CLOB is inherently

anti-competitive. Beyond the serious technological problems with the CLOB, there

are equally troubling political problems that underscore the enormous threat to

competition posed by a CLOB. Someone or some entity will have to decide how the

CLOB will work, who gets access and how, and what innovations are to be allowed.

That gatekeeper and CLOB czar is certain to be enormously influenced by those

who are already in the club. Will those who are already in the club allow the emergence of innovators who potentially threaten their business? We don’t think so. Is

innovation likely to occur when the potential innovator must raise his or her hand

to seek permission from the powers-that-be in order to innovate? We don’t think so.

15. Recently we have seen an increase in message bottlenecking due to capacity problems with individual systems. Would the existence of a Central Limit Order Book

(CLOB) exacerbate the capacity problems we have been witnessing?

Absolutely. The centralization that—as both a technological and political matter—

precludes innovation would exacerbate capacity problems. It should also be stressed

that the CLOB’s central point of failure would dramatically exacerbate capacity

problems, whether we are talking of an industry CLOB or a CLOB like the Nasdaq

SuperMontage.

16. The idea of a Central Limit Order Book (CLOB) was first tossed around in the

1970s when fragmentation was high because technology could not facilitate efficient order interaction without centralization. Has current technology rendered

the notion of a CLOB obsolete?

Absolutely. Current technology has rendered the notion of a CLOB obsolete,

whether we are talking of an industry CLOB or a CLOB like the Nasdaq SuperMontage. State-of-the-art telecommunications systems like the Internet don’t rely on a

single monopoly channel—rather they rely on networked webs of multiple private

competing linkages. The equities markets should benefit from the same telecommunications advances that have revolutionized other industries—to the enormous benefit of the public.

NEXTRADE HOLDINGS, INC.

CLEARWATER, FLORIDA 33756

April 21, 2000

Honorable TOM BLILEY

U.S. House of Representatives

Committee on Commerce

Room 2125, Rayburn House Office Building

Washington, D. C. 20515-6115

Re: Responses to questions for the record for the Competition in the New Markets

Hearing: Part I

DEAR CHAIRMAN BLILEY: NexTrade Holdings, Inc., the parent company of the

NexTrade Electronic Communications Network (‘‘ECN’’) and the proposed NexTrade

Exchange, is pleased to submit the following responses to the questions set forth in

your letter of March 29, 2000, as part of the Competition in the New Markets Hearing: Part I.

56

1. How do ECNs increase transparency?

ECNs increase transparency in a number of ways. One way that ECNs increase

transparency is by allowing individual investors direct access to the Nasdaq. This

access empowers investors with the ability to post their limit orders instantaneously

for review by other Nasdaq market participants. ECNs also increase transparency

through their proprietary networks that link alternative trading systems, marketmakers, and other ECNs outside of Nasdaq for the purposes of redundancy, speed,

and greater reliability. Some ECNs even display all of their orders, instead of merely the highest bid and lowest offer in a security, on their systems or the Internet.

This enables investors to see the depth of the market and helps them to more accurately price their orders.

Statistical evidence supports the conclusion that ECNs have helped to produce

more transparent, less fragmented and more efficient markets. Since the arrival of

qualified ECNs, there have been dramatic reductions in the costs associated with

trading stocks. The average cost of executing a trade on the Nasdaq fell by 23% in

1998, spreads fell 41%, and volume increased substantially. If left to competitive devices, the degree of fragmentation within the markets will continue to be reduced

despite the introduction of a multitude of market participants.

2. Are your systems decimal ready?

Like most ECNs and Alternative Trading Systems designed in the past five (5)

years, the technology behind the NexTrade ECN and the proposed NexTrade Exchange is ready for trading in decimals. As a member of the National Association

of Securities Dealers (‘‘NASD’’) trading on the Nasdaq, the NexTrade ECN System

currently has to convert orders that are in decimal increments into fractions for execution. In order to ensure that NexTrade’s linkages to the National Market System

(‘‘NMS’’) and the Nasdaq are ready for decimalization, NexTrade is planning on participating in the industry wide decimalization testing. Unfortunately, as a member

of the NASD and a Nasdaq participant, the delays by the Nasdaq in implementing

decimalization will impact NexTrade’s ability to conduct this testing and will delay

the introduction of decimal pricing for our subscribers.

3. What can you do to facilitate trading in decimals even though Nasdaq is not decimal ready?

NexTrade plans to work in conjunction with other industry participants including

the Nasdaq, other ECNs and broker-dealers in order to expeditiously move forward

with decimal trading. NexTrade, however, is concerned that certain industry participants apparently seeking nothing more than to gain favorable press coverage have

elected to move forward with the implementation of decimal trading in an uncoordinated manner. While NexTrade has been ready to trade in decimals for some time,

we appreciate the importance of working with other industry participants, including

those which are not prepared to trade in decimals, in order to ensure a smooth and

efficient transition to decimal trading.

4. What structural changes should accompany the demutualizations of NYSE and

Nasdaq to ensure a competitive market?

While NexTrade has the utmost confidence in the integrity of the directors, officers and staff of the New York Stock Exchange (‘‘NYSE’’) and the Nasdaq, it is inappropriate to place individuals in a situation rife with potential conflicts of interest.

The directors, officers and personnel of new for-profit exchanges that have regulatory responsibilities could be placed in situations that interfere with their ability

to satisfy their regulatory responsibilities. In order to avoid such potential conflicts

of interest, NexTrade believes there must be a suitable level of separation between

the business and regulatory groups of all for-profit exchanges. While NexTrade does

not believe that this separation necessarily requires the creation of a distinct corporate subsidiary to house the regulatory functions of the exchange, any exchange

electing not to do so should be subject to heightened scrutiny to ensure that the necessary separation does in fact exist.

5. What benefits will electronic exchanges provide that traditional exchanges do not?

Electronic exchanges will provide numerous benefits that traditional exchanges

cannot provide. Like ECNs, electronic exchanges will utilize technology to provide

faster and more accurate executions than traditional exchanges. Unlike traditional

exchanges, electronic exchanges will allow orders to interact without a market

maker or specialist. This ability to execute orders without an intermediary will result in lower transaction fees for investors. Additionally, by decreasing the number

of personnel involved in processing transactions, electronic exchanges will reduce

the likelihood of abuses by trading personnel. Moreover, by reducing the number of

personnel involved in processing transactions and by reducing the number of potenVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00060 Fmt 6633 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
57

1Pub. L. No. 94-29, 89 Stat. 97 (1985).

2See 64 Fed. Reg. 70613 (Dec. 17, 1999). 3Pub. L. No. 94-29, 89 Stat. 97 (1985).

4Section 11A(a)(1).

tial trading abuses, electronic exchanges will reduce the amount of resources that

the Commission and the exchanges must spend on surveillance and enforcement. Finally, electronic exchanges will function with a lower degree of errors in processing

trades and will enable customers’ orders to be executed at the best price by means

of linkages between new electronic exchanges.

6. Is the Nasdaq super-montage an ECN?

Yes, the Nasdaq super-montage is an ECN.

What types of problems do you anticipate in a market in which your regulator competes with you?

Although NexTrade has confidence in the integrity of the directors, officers and

staff of the NASD and its subsidiaries, there would be an inherent conflict of interest if the Nasdaq was allowed to operate the super-montage while regulating competing ECNs. Accordingly, NexTrade believes that the regulatory group of the

NASD, NASD Regulation must operate as a distinct and fully autonomous entity

from the Nasdaq before the Nasdaq should be allowed to compete with the ECNs

it currently regulates. NexTrade also questions the propriety of the NASD’s use of

fees paid by members, including those paid by ECNs and ECN owners, to subsidize,

develop and operate the proposed Nasdaq Super-Montage which will compete with

these members.

7. Which regulations most inhibit ECNs from competing with exchanges?

Although there are numerous regulations that inhibit ECNs from competing with

exchanges, the most significant barrier to competition is the current structure of the

National Market System (‘‘NMS’’). The current structure of the NMS impedes the

entry of new market participants that would introduce new technology. Under the

current regulatory structure, the boards of the NMS Plans are composed of representatives from each exchange. Any change to the rules governing the operation

of the NMS systems, including the very rule changes necessary to accommodate new

market participants, require the unanimous consent of the participants. Accordingly, if one board member feels threatened by an ECN’s technology, that board

member can prevent the ECN from participating.

In 1936, Congress noted that a major responsibility of the Commission in the administration of the securities laws is to ‘‘create a fair field of competition.’’ 1 The current national market system does not create a fair field of competition. Rather, the

current national market system protects antiquated participants from competition,

while subsidizing its members’ operations.

The consolidated, real-time stream of market information has been an essential

element in the success of the America’s equities markets. It is the principal tool for

enhancing the transparency of the buying and selling interest in a security, for addressing the fragmentation of buying and selling interest among different market

centers, and for facilitating the best execution of customers’ orders by their brokerdealers.2 The consolidation of quotations and last sale information was an important

goal of the Securities Acts Amendments of 1975.3 Congress believed that the need

for market effectiveness and efficiency required that a neutral central processor be

organized and responsible for collecting and distributing market data to market participants. Section 11A called for the Commission to use its authority to facilitate the

establishment of a national market system which has, as one of its objectives, the

availability of quote and transaction information for brokers dealers and investors.4

The national market system that Congress meant to promote equal access, market

transparency, and fair competition, is now attainable because of twenty-first century

technology. However, the governance structures and technology that modernized our

markets in 1975 are ill suited to achieve the goals of the national market system

for the next century. Market data that was once the property of a few and was only

available to market participants, is now in the hands of the public. This liberation

of information has been the result of the development of the Internet. Over the last

decade, the Internet has revolutionized the way people access and use information.

The current National Market System no longer serves to promote the development

of mechanisms that allow for economically efficient executions of securities transactions. The current National Market System impedes fair competition and reduces

market transparency. The current National Market System prevents large pools of

liquidity contained in ECN order books from interacting with other market participants. These deficiencies result in decreased investor access to the best markets.

58

5See, e.g., Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding

the NASD and The Nasdaq Market (August 8, 1996); Order Granting Approval to Philadelphia

Stock Exchange Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997) (requiring 50

percent board representation by public governors). 6This approach was also discussed in the SIA Report on Market Data Pricing, which noted

that SIA would also like to explore/encourage an alternative governance structure for market

data that would include a broader exchange, industry, and public representation. See Report on

Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999). 7 Exchange Act Release No. 14416 (January 26, 1978) (‘‘1978 Statement’’), at 26, 43 FR 4354,

4358. Previously, on June 23, 1977, the Commission had indicated that a national market system would include those ‘‘regulatory and technological steps [necessary] to achieve a nationwide

interactive market system.’’ See Exchange Act Release No. 13662 (June 23, 1977), at 20, 42 FR

33510, 33512. 8 1978 Statement, supra note 5, at 4358. 9 In this connection, the Commission specifically indicated that ‘‘qualified markets’’ would include not only exchanges but OTC market makers as well. Id. 10

11 Exchange Act Release No. 42212 (Dec. 9, 1999). 12 Id. (emphasis added).

In order to ensure that the National Market System meets its congressional mandate, the governance structure of the national market system should be amended.

The NMS governing boards should be eliminated and replaced with a new national

market system board. This new National Market System board should include representatives from the existing exchanges, new electronic exchanges, ECNs, brokerdealers, issuers and the public. The new NMS board should be structured in such

a way as to ensure that at least 50 percent of the representatives are not industry

participants. This structure is similar to the structure endorsed by the Commission

in recent years with respect to public representation on the boards of self-regulatory

organizations.5 Industry associations such as the Securities Industry Association

and the Security Traders Association could select broker-dealer representatives from

firms of various sizes.6

8. What it the Intermarket trading system (ITS). How should it be changed?

Currently, the markets are linked by the National Market System Plans. One

plan that is very important in reducing market fragmentation is the Intermarket

Trading System (‘‘ITS’’), which allows orders to be routed to the best market regardless of which market originally received the order. Unfortunately, the technology

and the rules governing the operation of the system are, in Chairman Levitt’s words, ‘‘archaic.’’ Market participants using ITS to route orders to other markets

may wait as long as two minutes to receive a response and, even then, may not receive an execution. NexTrade believes that the traditional markets participants’ opposition to technological innovations has resulted in unnecessary market fragmentation. Accordingly, NexTrade believes the technology behind the ITS should be updated.

On January 26, 1978, the Commission issued a statement on the national market

system calling for the prompt development of comprehensive market linkage and

order routing systems to permit the efficient transmission of orders among the various markets for qualified securities, whether on an exchange or over-the-counter.7

In particular, the Commission stated that an intermarket order routing system was

necessary to ‘‘permit orders for the purchase and sale of multiply-traded securities

to be sent directly from any qualified market to another such market promptly and

efficiently.’’ 8 The Commission further stated that ‘‘[t]he need to develop and implement a new intermarket order routing system to link all qualified markets could

be obviated if participation in the ITS market linkage currently under development

were made available on a reasonable basis to all qualified markets and if all qualified markets joined that linkage.’’ 9

Unfortunately, the goals of the ITS, have not come to fruition. Originally, designed to link the existing exchanges, ITS currently handles a relatively small proportion of trading in listed equities. In September 1999, for example, ITS volume

represented 2.2% of total NYSE-listed trades.10 One of the primary reasons for the

anemic performance of ITS, is its failure to include ECNs and its slow and inefficient technology.

On December 9, 1999, in an apparent attempt to open the ITS, the Commission

adopted amendments to the ITS Plan. The amendments expand the ITS/Computer

Assisted Execution System linkage to all listed securities.11 The Commission also

noted that:

in order to further the goals of the national market system, ECNs trading in

listed securities should be linked to ITS. ITS should not prevent efficient electronic routing between markets.12

59

13See, e.g., Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding

the NASD and The Nasdaq Market (August 8, 1996); Order Granting Approval to Philadelphia

Stock Exchange Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997) (requiring 50

percent board representation by public governors). 14This approach was also discussed in the SIA Report on Market Data Pricing, which noted

that SIA would also like to explore/encourage an alternative governance structure for market

data that would include a broader exchange, industry, and public representation. See Report on

Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999). 15 CTA Plan, Sections I(p) and VII(a)(i). 16 An Operating Committee that is substantially the same as the CTA administers the CQ

Plan. 17SIAC is jointly owned by the NYSE and Amex and is a registered SIP under Section 11A(b). 18 CTA Plan, Sections I(q) and VII(a). 19See, e.g., Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding

the NASD and The Nasdaq Market (August 8, 1996); Order Granting Approval to Philadelphia

Stock Exchange Proposed Rule Change, Exch. Act Rel. No. 38960 (Aug. 22, 1997) (requiring 50

percent board representation by public governors).

While the opening of ITS to ECNs is a step in the right direction, the value of such

a step will be minimized as long as the current governance structures of the ITS

and other NMS Plans remain in place.

The ITS Plan should be opened to new constituencies, including ECNs, brokerdealers, issuers and the public. In order to ensure that the new National Market

System meets its congressional mandate, the governance structure of the NMS

should be amended. The NMS governing boards should be eliminated and replaced

with a new National Market System board. This new NMS board should include

representatives from the existing exchanges, new electronic exchanges, ECNs,

broker-dealers, issuers and the public. The new National Market System board

should be structured in such a way as to ensure that at least 50 percent of the representatives are not industry participants. This structure is similar to the structure

endorsed by the Commission in recent years with respect to public representation

on the boards of self-regulatory organizations.13 Industry associations such as the

Securities Industry Association and the Security Traders Association could select

broker-dealer representatives from firms of various sizes.14

9. What is the Consolidated Quotation System (CQS)?

The Consolidated Quotation System (‘‘CQS’’) enables the regional exchanges and

the Nasdaq to jointly disseminate quotation information available to market participants and investors. The Consolidated Tape Association Plan (‘‘CTA Plan’’) and the

Consolidated Quotation Plan (‘‘CQ Plan’’) operate a data network commonly known

as Network A that disseminates market information for any common stock, longterm warrant, or preferred stock admitted to dealings on the NYSE.15 All of the

SROs are participants in the CTA Plan and CQ Plan.

The Consolidated Tape Association (‘‘CTA’’) is a committee made up of one representative of each of the participants. The CTA Committee administers the CTA

Plan and is registered as a securities information processor (‘‘SIP’’) under Section

11A(b) of the Exchange Act.16 The administrator of Network A’s day-to-day operations is the NYSE, and its information processor is the Securities Industry Automation Corporation (‘‘SIAC’’).17

The CTA Plan and the CQ Plan also operate a second network commonly known

as Network B. This network disseminates market information for any common

stock, long-term warrant, or preferred stock admitted to dealings on the Amex or

the regional exchanges, but not also admitted to dealings on the NYSE or included

in the Nasdaq market.18 Its day-to-day administrator is Amex, and its information

processor is SIAC.

How should it be changed?

Like the other NMS Plans, the CQS Plan should be opened to new constituencies,

including ECNs, broker-dealers, issuers and the public. In order to ensure that the

new National Market System meets its congressional mandate, the governance

structure of the NMS should be amended. The NMS governing boards should be

eliminated and replaced with a new National Market System board. This new NMS

board should include representatives from the existing exchanges, new electronic exchanges, ECNs, broker-dealers, issuers and the public. The new National Market

System board should be structured in such a way as to ensure that at least 50 percent of the representatives are not industry participants. This structure is similar

to the structure endorsed by the Commission in recent years with respect to public

representation on the boards of self-regulatory organizations.19 Industry associations

60

20This approach was also discussed in the SIA Report on Market Data Pricing, which noted

that SIA would also like to explore/encourage an alternative governance structure for market

data that would include a broader exchange, industry, and public representation. See Report on

Market Data Pricing, Prepared by Arthur Andersen, LLP (June 1999). 21 NexTrade re-filed its exchange application in March 2000, in order to address issues raised

by Commission staff.

such as the Securities Industry Association and the Security Traders Association

could select broker-dealer representatives from firms of various sizes.20

10. Has the current regulatory structure of the National Market System (NMS) actually created market fragmentation by disallowing ECNs to share pricing information?

The governance structures of the NMS Plans and the antiquated technologies that

drive those plans have unnecessarily increased the level of fragmentation of America’s financial markets by preventing competition and the participation of ECNs.

The current regulatory structure of the NMS is an impenetrable barrier to entry to

new market participants that would enhance competition. If one NMS participant

does not want an ECN to participate or is threatened by an ECN’s technology, the

ECN is precluded from participating. Accordingly, NexTrade believes that broader

industry and public participation is needed in the governance of the NMS to ensure

the access of new market participants.

While fragmentation has always been a problem for our markets, it is not a question of if fragmentation exists, but rather a question of degree. In the past, fragmentation was severe and was compounded by inadequate information technology.

As technology evolved, the degree of fragmentation has diminished while the number of market participants has skyrocketed. However, the level of fragmentation in

our markets could be greatly reduced by reforming the NMS.

Statistical evidence supports the conclusion that the introduction of ECNs produced more efficient and less fragmented markets. Since the arrival of qualified

ECNs, evidence reveals dramatic improvements in the costs of trading stocks in the

United States. The average cost of executing a trade on the Nasdaq Stock Market

fell by 23 percent in 1998, spreads fell 41 percent, and volume increased substantially. If left to competitive devices, the degree of fragmentation within the markets

will continue to be reduced despite the introduction of a multitude of market participants.

Traditional market participants, including the members of the NMS Plans, are opposed to technological innovations that could undermine their hegemony over the

markets. This resistance to technology has resulted in unnecessary fragmentation.

Competitive market participants, however, have responded to fragmentation and inefficiencies with market-based innovative solutions. A variety of ECNs and other

trading systems have responded with systems that consolidate and provide efficient

access to the best prices among competing markets. One firm has connected all nine

original ECNs, the NYSE and the Nasdaq to their system. Similarly, when the current Nasdaq linkage (SelectNet) proved too expensive and inefficient to handle

record volumes, market participants forged links with one another to create trading

networks that bypass SelectNet for faster and more reliable access to the best market prices. These are just a few examples of the types of solutions produced by innovation and competition that could reduce fragmentation.

11. Have you applied to become an Exchange?

NexTrade Holdings, Inc., the parent company of the NexTrade ECN, has applied

to operate a new electronic for-profit exchange, known as the NexTrade Exchange.

In November 1998, NexTrade began discussions with the Commission regarding applying to operate an electronic exchange. Rather than filing its exchange application

without speaking with Commission staff, NexTrade spent nearly one year working

with Commission staff in draft mode in order to facilitate meaningful discussion of

NexTrade’s exchange application. Only after determining the draft exchange application discussions had exhausted their usefulness, did NexTrade formally file its exchange application with the Commission in December 1999.21

The proposed NexTrade Exchange is an example of the future of the financial

markets in that it makes use of innovative technology and new regulatory structures as part of a for-profit exchange. The proposed NexTrade Exchange plans to

make available for the benefit of its members and their customers an electronic

trading system (the ‘‘NexTrade Exchange System’’) to effect the purchase or sale of

securities listed or admitted to trading on the proposed Exchange and on other exchanges. The proposed exchange, however, will not maintain a physical-trading

floor. Members will access the NexTrade Exchange System from their own computer

61

terminals and communicate with the NexTrade Exchange System over commercial

information services and networks.

What is the status of your application?

When NexTrade notified the Commission of its desire to operate an exchange, the

Commission advised NexTrade that it could not provide a specific time frame with

respect to an approval date. NexTrade was only told that the process could take two

(2) to three (3) years to complete and that there was no guarantee that the application would be approved. NexTrade has been advised on several occasions by Commission staff that the Commission is struggling with issues regarding the governing

structures of new for-profit exchanges that had to be addressed before the Commission could move forward with NexTrade’s exchange application. NexTrade has also

been advised on several occasions by Commission staff that the Commission was attempting to address issues relating to the performance of regulatory functions by

for-profit exchanges. As of the date of this response, NexTrade has received no information regarding either issue from the Commission despite having provided an application that includes viable solutions to both issues.

Commission staff recently advised NexTrade that it could be another 12 to 18

months before the Commission issues a decision on NexTrade’s exchange application. Although NexTrade fully understands the importance of the exchange approval

process, we do not believe that a two (2) to three (3) year review process is warranted or necessary in order to make a decision regarding new electronic exchanges.

NexTrade appreciates that Commission staff are over worked and underpaid in comparison to their colleagues in other federal regulatory agencies, however, the failure

to reach a decision on pending exchange applications serves only to penalize the

public by unnecessarily shielding antiquated exchanges from competition that would

benefit the public.

12. How is Nasdaq’s super-montage like a Central Limit Order Book (CLOB)?

The Nasdaq’s proposed super-montage is like a Central Limit Order Book or

CLOB in that the super-montage anonymously centralizes all limit orders into an

order consolidation facility. These centralized orders do not reflect the market participants acting as agent or principal of the transactions. The super-montage will

not reflect the identity of the market participant that posted the order. This function coupled with the reserve function of the proposed super-montage, bear a striking resemblance to the functions of most ECNs.

The proposed Nasdaq super-montage would create a central market execution system composed of two tiers of ‘‘Quoting Market Participants.’’ Participation would be

mandatory for market makers and ‘‘voluntary’’ for ECNs. Nasdaq states that two

types of participation would be offered to ECNs: ‘‘full’’ and ‘‘order entry’’. ‘‘Full’’ participation would require ECNs for the first time to be subject to automatic executions, which would put ECNs at a severe competitive disadvantage. Order-entry participation would be a continuation of current SelectNet linkage and functions, but

would marginalize the contribution ECNs could make to the marketplace. Consequently, the proposed Nasdaq super-montage is fundamentally flawed in that it

would become increasingly ineffective as ECNs continued to grow.

Full Participation in the proposed Nasdaq super-montage leaves ECNs with a

Hobson’s choice. While Full Participation in the proposed Nasdaq super-montage

would allow ECNs to connect with the proposed Nasdaq CLOB, it would also allow

the proposed Nasdaq CLOB to ‘‘sweep’’ the ECNs’ top-of-book orders into the proposed Nasdaq CLOB. This function would hit or take all market-maker, ECN or proposed Nasdaq CLOB quotations at the best bid or ask price. Access to the ‘‘sweep’’

function in the proposed Nasdaq CLOB, however, would involve a trade-off for

ECNs because of the disadvantages associated with full participation by ECNs in

the proposed Nasdaq Order Display Facility.

Market makers and institutional customers of ECNs often prefer to trade on an

ECN because of the additional services and features offered on ECNs. Through competition, ECNs have developed a variety of innovative capabilities to allow traders

to customize their trading methods to meet their needs. One such feature is a reserve quotation. Nasdaq has stated that in the proposed Nasdaq CLOB any ECN

reserves would be bypassed, but the reserve feature of the proposed Nasdaq CLOB

would function. As a result, Nasdaq would in effect preference its own additional

functions, at the expense of those ECNs that do not want to ‘‘agree’’ to become

Nasdaq CLOB participants.

The proposed super-montage is also like a CLOB in that market participants

would be forced to link through a central location, the Nasdaq. This kind of forced

linkage diminishes the competitive advantages of ECNs by making them dependant

on the capacity, integrity and security of a single, largely antiquated system, which

62

has proven to be unreliable. NexTrade believes investors and the market benefit

from a variety of alternative systems that route, display and execute orders.

13. What are the key problems with a Central Limit Order Book (CLOB)?

The notion behind the CLOB is that technology can be employed to centralize orders in one place, thus resulting in maximum order interaction and perhaps even

better prices. A CLOB, however, will sacrifice the innovation that has made our

markets the best in the world. Research has shown that competitive markets are

better equipped to implement technological innovations to address market inefficiencies. Centralized markets, no matter how well intentioned their architects, will typically be obsolete by the time they commence operation. Competition creates incentives for markets to upgrade and innovate. Centralized markets do not. Unlike open

markets, centralized markets serve to impede the ability of innovative firms to develop new technologies and mechanisms that promote better execution.

Like any centralized marketplace, a CLOB would have substantial dangers. Most

importantly, a CLOB would represent a single point of failure that could jeopardize

the global economy. The danger of such centralization is apparent in light of recent

well-publicized attacks on some of the largest Internet web sites and service providers. It is economically impracticable to design a centralized marketplace that

would be completely free of vulnerability to attacks by cyber-terrorists. The implausibility of designing a totally safe CLOB will become increasingly apparent in the

future as warfare and terrorism move from city streets to the Internet. In contrast,

the currently developing network of trading facilities, much like the Internet, mitigates these potential dangers through numerous alternative trade destinations.

Moreover, a CLOB is anti-competitive. If the Commission mandates a monopolistic central execution system, such as the proposed CLOB, with which all marketparticipants must comply, innovation could be eliminated. Such a dearth of innovation would not serve the goals of the Act, the NMS, or the public. Rather than developing a system that would reduce innovation by ECNs and other market participants, and halt the development of technologies that provide additional liquidity

and transparency, the Commission should encourage a new and equitable NMS.

A CLOB would also impede the development of new for-profit electronic stock exchanges. If the Commission mandates a monopolistic central execution system, such

as the proposed CLOB, with which all market-participants must comply, innovation

could be eliminated. Such a dearth of innovation would not serve the goals of the

Act, the NMS, or the public. Rather than developing a system that would reduce

innovation by new for-profit electronic exchanges, ECNs and other market participants, and halt the development of technologies that provide additional liquidity

and transparency, the Commission should encourage a new and equitable NMS.

Finally, a CLOB would inevitably operate at the speed of its slowest participant.

While many ECN’s execute their transactions in milliseconds, the New York Stock

Exchange proudly stated in its address to Congress in September 1999 that its average transaction time was 22 seconds. Accordingly, a CLOB would likely execute

transactions at speeds much slower than many ECNs.

14. In what ways is a Central Limit Order Book (CLOB) anti-competitive?

A CLOB would be anti-competitive and would impede the development of new forprofit electronic stock exchanges for several reasons. By mandating that market participants link to a CLOB, the Commission would create a monopolistic central execution system. A CLOB with its specified technology would reduce innovation. A

CLOB would be anti-competitive in that it would require all market participants to

utilize uniform government mandated technology. A CLOB would also impose significant costs on new electronic for-profit exchanges, the market and ultimately

issuers, in order to off-set the costs of the new infrastructure and bureaucracy.

A CLOB would also be anti-competitive because there would be no competition for

order flow. Without competition for order flow, there would be little incentive for

firms to develop technologies that provide additional liquidity and transparency.

The CLOB would also be anti-competitive because the system would dictate where

a broker-dealer sends an order. A CLOB would not allow market participants to develop technological linkages with other market participants and take suitable steps

to ensure that they satisfy their best execution responsibilities when handling orders. Rather, than allowing for innovation by market participants that can reduce

costs for their clients, a CLOB would dictate an order routing regimen. Such a

dearth of innovation would not serve the goals of the Act, the NMS, or the public.

Rather than developing a system that would reduce innovation by new for-profit

electronic exchanges, ECNs and other market participants, and halt the development of technologies that provide additional liquidity and transparency, the Commission should encourage a new and equitable NMS.

63

15. Recently we have seen an increase in message bottlenecking due to capacity problems with individual systems. Would the existence of a Central Limit Order Book

(CLOB) exacerbate the capacity problems we have been witnessing?

The existence of a CLOB would only exacerbate the capacity problems we have

been witnessing. Under such a facility, the entire NMS and all market participants

would be dependent on the capacity, integrity and security of a single system. The

dangers associated with such a strategy are discussed in greater detail above. However, a CLOB that relies on a single technology could jeopardize our financial markets if it fails for any of a variety of reasons. A CLOB that relies on a single technology would also eliminate the positive effects of innovation by requiring all firms

to adopt a uniform technology and order routing regimen for linking to the CLOB.

This lack of innovation would reduce the positive gains that are being made by innovative market participants to minimize the message bottlenecks currently occurring

on well established markets.

The dangers of a CLOB and its reliance on a single technology are apparent upon

examining the record of the current order routing technology used by the Nasdaq.

The level of trading activity on the Nasdaq over the past year has overwhelmed the

Nasdaq’s SelectNet system. Over the past year, the Nasdaq SelectNet system has

suffered several well-publicized failures that have seriously endangered the National Market System. Some of the most notable and publicly acknowledged recent

Nasdaq system failures include the following:

• (March 6, 1999, 9:41 a.m. to shortly after 11:00 a.m. ET, Nasdaq SOES (Small

Order Execution System) and SelectNet Equipment failed.

• (April 1-13, 1999, Nasdaq SelectNet has higher volume of SelectNet orders (a 25%

increase over 1998) and suffers from the capacity impact on systems, leading

to slowed trading in the first half hour of trading as systems labored to clear

orders that accumulated overnight.

• (October 6, 1999, Nasdaq SelectNet’s system, triggered by a software change made

overnight to allow the market to extend hours for its trade-reporting and

quotation systems, runs slowly for hours and the Instinet, Island and Brut

ECNs are removed from Nasdaq’s quote display.

• (November 16, 1999, Nasdaq SelectNet and SOES fail during a mid-day software

upgrade that was attempted during a record 1.46 billion share trading day causing a black out of SelectNet and SOES from 3:40 EST to 3:57 EST. Nasdaq has

claimed that it has adequate capacity for a four billion shares trade day, however, this claim is seriously suspect based on the aforementioned system failures.

The failings of the Nasdaq’s SelectNet system are but one example of the dangers

of America’s financial markets relying on a single technology such as a CLOB.

16. The idea of a Central Limit Order Book (CLOB) was first tossed around in the

1970’s when fragmentation was high because technology could not facilitate efficient order interaction without centralization. Has the current technology rendered the notion of a CLOB obsolete?

Current technology has rendered the notion of a CLOB obsolete. The rapidly declining costs of telecommunications technology has made it possible to build and

maintain redundant, competitive systems to handle orders without the need for a

single monolithic service provider. Consequently, there is no reason to compel market participants to participate in a government designed CLOB. Advocates of the

CLOB claim that it is the only means of addressing fragmentation. Such claims are

without merit.

Fragmentation has always been a problem for our markets. It is not a question

of if fragmentation exists, but rather a question of degree. In the past, fragmentation was severe and was compounded by inadequate information technology. As

technology evolved, the degree of fragmentation has diminished while the number

of market participants has skyrocketed. However, the level of fragmentation in our

markets could be greatly reduced by reforming the NMS.

Rather than developing a CLOB that would reduce innovation by ECNs and other

market participants, the Commission should encourage the development of a new

and equitable NMS. The combination of private and public linkages that has formed

the market network since the advent of the Order Handling Rules is the best model

for growth and development of the United States capital markets in the future. The

Commission should not allow market participants that rely on antiquated technologies to undermine the positive gains that have been made since the advent of

the Order Handling Rules towards the creation of a open, efficient and equitable

market.

64

Should you have any questions regarding this or any other matter, please do not

hesitate to contact me at the telephone number above.

Sincerely,

JOHN M. SCHAIBLE

President, NexTrade Holdings, Inc. and NexTrade, Inc.

THE ISLAND ECN., INC.

May 8, 2000

Mr. TOM BLILEY, Chairman

U.S. House of Representatives

Committee on Commerce

Room 2125

Rayburn House Office Building

Washington, DC 20515-6115

DEAR MR. CHAIRMAN: Please find the enclosed answers to the questions you had

posed regarding the role ECNs and Island in particular are playing in the evolving

financial marketplace. I look forward to working with you and the rest of the Commerce Committee on these important issues. If I can be of any further assistance,

please let me know.

Sincerely,

MATTHEW ANDRESEN, President

The Island ECN., Inc.

Enclosure (1)

FOLLOW-UP QUESTIONS FOR THE RECORD FOR THE COMPETITION IN THE NEW MARKETS

HEARING: PART I

Question 1. How do ECNs increase transparency?

Response: ECNs increase transparency by making more information available to

the investor. Traditionally, investors have only been provided with the highest bid

and lowest offer in a security. The depth of the market, which gives an indication

of the true supply and demand for a security, has been the exclusive province of

market professionals. More specifically, what happens to an order after it is placed

with your broker? What sort of accountability exists? At Island, we urge investors

to ask themselves what just happened to their order after they click on the ‘‘Submit’’

button. After all that thorough and careful research, why is the investor—at this

final stage of the process—essentially staring into a black box—or at best a screen

with the words ‘‘Your Order Has Been Placed.’’

That lack of accountability—in other words, denial of information to the investor—was unacceptable to us. To provide the best resource possible to the investor,

we became the first marketplace to provide a free, real-time display of all its orders,

through the Island BookViewer TM. Such transparency is precisely what SEC Chairman Levitt recently called for in his Northwestern University speech: ‘‘Now is the

time to embrace a broader and deeper transparency. Now is the time for all market

participants to move toward open books across all markets...These are forward

looking initiatives that answer the investor’s call for greater transparency and more

efficient pricing.’’ Island couldn’t agree more. That’s why orders received by Island

for display on the limit order book are immediately visible to anyone with a web

browser regardless of whether the order was received from an individual investor

or a large institution. Why is this important? Investors can use the additional information provided by Island to more accurately price their orders. The Island

BookViewer TM also reduces the informational and temporal advantages traditionally

enjoyed by floor brokers, market makers, and specialists. In other words, the average investor is not disadvantaged because of a lack of access to, for example, the

floor of an exchange. By eliminating these time and place disparities—in essence,

putting the investor ‘‘virtually’’ right next to the market maker or specialist—Island

helps lower the hidden costs associated with higher spreads and inferior executions.

In fact, according to the Securities and Exchange Commission, spreads—the difference between the highest price to buy and the lowest price to sell—have narrowed substantially since the time ECNs were given access to the Nasdaq market,

saving investors hundreds of millions of dollars per year.

Question 2. Are you decimals ready?

Response: Yes. See answer below.

Question 3. What can you do to facilitate trading in decimals even though Nasdaq

is not decimal ready?

65

Response: The Island ECN, Inc., has announced that, consistent with the U.S.

Congress’s deadline for conversion to decimals for trading of stocks, on July 3, 2000,

Island shall be the first U.S. equity marketplace to offer investors the ability to

trade in decimals. As the U.S. Congress has made clear, decimalization is one of the

most important initiatives for creating a fairer, simpler, and more accessible marketplace for the individual investor. Investors should not be burdened with the cost

of industry-established increments that limit investors’ ability to obtain the best

possible price.

The Island decimalization plan is completely voluntary and allows all participants

to transition into the program in a fair, orderly, and clear fashion. Brokers and investors can select their preferred trading environment—decimals or fractions. Another key aspect of the Island plan is that it provides market participants with a

competitive and economic incentive to progress to decimals as quickly as practicable.

By providing market incentives, the Island plan ensures a timely transition to decimals that will benefit investors. We expect that investors will save hundreds of millions of dollars a year as the industry moves toward decimal trading, and we are

proud to be one of the catalysts for this change.

Island’s decimalization plan is consistent with the current relationship between

Nasdaq and Island. Island already trades in increments finer than the Nasdaq market as a whole and is required to round its quotation information prior to transmission to Nasdaq. Different quote increments already exist within Nasdaq and

have not been the source of any system problems or investor confusion. By progressing to decimals, we are further simplifying the market for millions of investors.

Question 4. What structural changes should accompany the demutualization of

NYSE and Nasdaq to ensure a competitive market?

Response: Island believes that the U.S. Congress has already designed the roadmap for ensuring the continued success of our capital markets. In 1975, Congress

created the National Market System, with the goal of constructing a more efficient

and transparent market. We could not ask for a better building block.

The mandate of the NMS, as envisioned by Congress, is defined by two objectives:

first, to promote competition between markets (‘‘fair competition between exchange

markets and markets other than exchange markets’’); and second, to make quotation

and transaction information available to investors (‘‘assure the availability to brokers, dealers, and investors of information with respect to quotations for the transactions in securities.’’).

Consistent with this mandate, the SEC adopted rules that permitted ECNs to

have their quotations included in the Nasdaq best bid and offer that is disseminated

to the entire marketplace. As described earlier, competition between markets flourished (with ECNs having captured 30 percent of the Nasdaq transaction volume),

and Nasdaq itself was significantly reformed. When provided a level playing field,

ECNs can compete for market share and bring the benefits of competition to the

investor.

This situation contrasts sharply with the rules and regulations governing Island’s

ability to compete in NYSE-listed stocks. Ironically, almost 25 years later, the rules

and market structure implemented to achieve the goals of a National Market System are now inhibiting competition between markets and restricting the information

available to investors. Regulatory obstacles block Island from having its quotation

information included in the two main components of the National Market System—

the Consolidate Quotation System (CQS) and the Intermarket Trading System

(ITS).

We do not believe that any public-policy benefits are served by stifling competition

and barring Island from sharing its pricing information. Consider that when Island

trades the stock of America Online, at various times during the trading day, Island

has the best quote in the National Market System. Unfortunately, due to the current regulatory structure, market participants (other than Island subscribers) are

denied the opportunity to see and to access the better price on Island. This is completely inconsistent with the spirit of the National Market System.

In addition, we would witness significant public-policy benefits by promoting competition and integrating Island into the NYSE’s pricing mechanism. Most importantly, Island’s price information would no longer be fragmented from the rest of

the marketplace. The market for NYSE-listed stocks would immediately become

more integrated and efficient. The resulting competition between marketplaces

(again, a central goal of the National Market System) would result in benefits for

the investor.

In light of the proven benefits to investors and the efficiency of the market, it is

time to take immediate action to give ECNs access to the Consolidated Quotation

System. ECNs, such as Island, must be permitted to disseminate their quotation in

listed stocks to all market participants. Yet in moving forward on this issue, we

66

must still confront and deal with a version of price-time priority currently operating

for the listed market. As discussed earlier, under the plan governing the operation

of the Intermarket Trading System, each participant exchange is prohibited from

trading at a price inferior to another participant.

Just as the Federal government does not negate customer choice by requiring consumers to buy goods from the lowest price merchant, market participants should not

be required to buy from the best-priced market. As long as market participants

know the price in each market and have the ability to access each market, there

is no need for the Federal government to require the market participant to favor

any one market. Accordingly, in addition to allowing ECNs to disseminate their

quotations directly through the consolidated quote, the elimination of the tradethrough rule is another important step toward more fully realizing Congress’s objectives in the National Market System.

Question 5. What Benefits will electronic exchanges provide that traditional exchanges do not?

Response: Electronic exchanges provide investors with a faster, cheaper, more reliable, and transparent method of trading equity securities. Prior to the introduction

of ECNs, investors did not have any choice but to send their orders to market makers for execution. Following the SEC’s 21(a) Report detailing collusion and fraud by

market makers as well as the Justice Department’s investigation into similar conduct, the SEC adopted the Order Handling Rules which permitted ECNs to display

customer orders directly in the market without the participation of a traditional

intermediary. By placing a limit order on an ECN, investors are empowered to determine their own price at which they want to buy or sell or security. In addition,

by eliminating the traditional intermediaries, ECNs provide faster and lower cost

executions than traditional market centers. Due to their rather simple business

model and state of the art technology, ECNs are also able to provide services that

traditional markets cannot or, in order to protect their franchises, will not provide.

For example, Island was the first equity market in the United States to make its

limit order book available for free over the Internet. Island was also the first equity

market in the United States to announce its intention to trade in decimals on the

Congressionally mandated deadline of July 3, 2000.

Moreover, by eliminating the informational disparities, ECNs are inherently safer,

fairer, and easier to surveil. For example, participants on the floor of an exchange

generally possess more trade and order information than the average investor sitting at home. Through surveillance and the implementation of restrictions on the

activities of those in the trading crowds, regulators attempt to prevent the misuse

of information. As recent events have shown, however, no amount of surveillance

or regulation can completely prevent the misuse of information.

ECNs, such as Island, reduce the opportunities for improprieties by eliminating

informational disparities. ECNs empower all investors by allowing them to step into

a virtual trading crowd and compete directly. Since all orders are delivered to the

virtual trading crowd and instantaneously displayed to everyone, no single person

has an informational advantage that needs to be regulated or surveilled. That

means we have been able to deliver to investors the benefits of lower cost, more

transparent, fairer markets, while still complying with strict Commission standards

designed to ensure the integrity of our trading systems. Island, for example, must

comply with regulatory standards concerning the security, capacity and reliability

of our system. In fact, due to its use of the latest, most advanced technology as well

as its proprietary architecture, Island has a superb record for reliability and performance. For example, during the past year when the Nasdaq market has periodically experienced system delays due to the tremendous surges in trading volume,

Island has never experienced a capacity-related problem. Even during peak trading

periods. Island’s average turnaround time is approximately three one-hundredths

(.03) of a second—exponentially faster than our nearest competitor. By combining

the latest technology with our advanced system architecture, Island has created a

scalable, robust trading system with virtually no capacity limitations.

Furthermore, because electronic markets automatically capture and store all information, a complete audit trail is available for every order entered into the system. Accordingly, electronic markets can monitor a much larger and complete

dataset for trading abuses such as price manipulation. At Island, we are able to

monitor not just completed transactions, but all open orders in the system. This

gives us the ability to not only detect violations that have already occurred, but also

to prevent future violations.

Finally, we have never taken our eye off the bottom-line for the investor; we have

always believed that any money funneled out of the marketplace comes directly out

of the investors’ pockets. Consequently, Island has sliced its margins razor thin. Island, for example, only receives $.00075 per share per side on every transaction exeVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00070 Fmt 6633 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
67

cuted on its system; in other words, a trade for 1,000 shares of stock means only

seventy-five cents for Island. I like to point this out to my staff when others question our spartan offices—like a recent New Yorker magazine profile noting that we

have ‘‘upgraded our offices from grungy to nondescript.’’ I like to believe that there

are millions of investors across the country benefiting from the fact that Island has

the least stylish offices on Wall Street.

Question 6. Is the Nasdaq supermontage an ECN? What types of problems do you

anticipate in a market in which your regulator competes with you?

Response: When evaluating the Super-Montage Proposal, it is important to understand that there are two aspects to the proposal. First, there is the initiative that

would allow market participants to display greater depth to the market on a voluntary basis. Strangely hidden in the proposed rule, however, is a proposal for the

creation of something named the ‘‘Order Collector Facility.’’ Although Nasdaq has

gone to great lengths to trumpet the benefits of the greater transparency, it has ignored the competitive implications of the combination of the Order Display Facility

(the system that will actually display the orders of market participants) with the

Order Collector Facility (the system for the execution of orders displayed on the

Order Display Facility). Yet, the Super-Montage Proposal states that the Order Collector Facility would be established as the ‘‘single point of order entry and single

point of delivery of liability orders and executions.’’ By creating a platform for both

the display and execution of orders, Nasdaq is essentially proposing the functional

equivalent of a consolidated limit order book. One of the key attributes of the system is that, as Nasdaq states in a footnote, it would meet ‘‘the requirements of the

Display Alternative, Exchange Act Rule 11Ac1-4(c)(5).’’ In other words, the Super

Montage proposal would create a Nasdaq sponsored ECN.

To understand the competitive implications of the new system it is important to

understand how Nasdaq operates today. Currently, Nasdaq operates as a communications system that links the various market participants by: 1) consolidating the

quotation information of the various market participants; and 2) operating the

SelectNet system that allows market participants to electronically access the orders

displayed in Nasdaq’s consolidated quote. SelectNet allows Nasdaq market participants to route orders to the best price with the subsequent execution occurring on

the system of the market participant receiving the order. The Super-Montage Proposal, however, would require executions to occur, not on the system of the ECN

or market maker that receives the order, but on the Nasdaq operated Order Collector Facility. As a result, every market participant would become dependent on

Nasdaq technology. Island strongly believes, however, that both competition and investors would be better served if, instead of trying to become the execution point

for all Nasdaq market participants, Nasdaq substantially upgraded the SelectNet

system. This upgrade, in conjunction with new rules requiring all market participants respond to orders in an automated fashion, would heighten competition on

Nasdaq and, thus, bring greater benefits to investors.

It is also important to note that regardless of whether the Super-Montage proposal is approved, the current regulatory structure is tilted in favor of Nasdaq. Not

only does Nasdaq have the authority to pass and interpret rules governing the activities of ECNs but, Nasdaq uses the revenue it makes from ECNs to finance initiatives intended to compete with ECNs. For instance, all Nasdaq market participants,

including ECNs such as Island, are required by Commission rules to report every

transaction to Nasdaq. Not only does Nasdaq charge Island a fee for every transaction that Island is required by regulation to report to Nasdaq, but Nasdaq then

sells that same trade information for hundreds of millions of dollars. In fact, Island

believes that it is one of Nasdaq’s largest sources of revenue. The fact that the

Nasdaq may separate itself from the NASD-R is irrelevant to these issues. Even

after the separation, Nasdaq still would retain the ability to adopt rules that could

disproportionately impact ECNs and use its monopoly position to disadvantage

ECNs. For example, ECNs are required by SEC rules to maintain connectivity to

Nasdaq. Yet, Nasdaq dictates the price and quality of that connectivity. If ECNs encounter problems with their Nasdaq operated connections they must call Nasdaq for

assistance. This conflict of interest has already created problems and will only intensify if the relationship between Nasdaq and ECNs is not re-structured to ensure

fair competition. By heightening competition and spawning innovation, ECNs have

played a major role in strengthening the Nasdaq market. The Super-Montage proposal risks undermining these accomplishments.

Question 7. Which regulations most inhibit ECNs from competing with exchanges?

Response: See answer to question 4 above.

Question 8. What is the Intermarket Trading system. How should it be changed?

Response: The Intermarket Trading System (‘‘ITS’’) is the system that links all

exchange markets. For instance, if an investor sends an order to buy shares of IBM

68

to the Chicago Stock Exchange when there is a better price available on the NYSE,

ITS allows the Chicago Stock Exchange specialist to route that order to the NYSE

to obtain the better price. As has been recognized by the Securities and Exchange

Commission itself, however, ITS is based on obsolete technology, outmoded miles,

and a dysfunctional governance structure. The best solution is to completely replace

ITS and rethink many of the assumptions that underlie its creation. Island will be

submitting a comment letter to the Commission in the near future that will provide

a detailed proposal with respect to the future of ITS. It is important to note, however, that ITS is not the key competitive barrier that prevents ECNs from effectively competing in NYSE listed stocks. Instead, the key issue is representation. Island must be able to disseminate its quotation as part of the consolidated quotation

in order to compete on a level playing field in NYSE listed securities.

Question 9. What is the Consolidated Quotation System? How should it be

changed?

Response: The Consolidated Quote System is the system that displays the best

quotation from all 8 Self-Regulatory Organizations that trade listed securities.

ECNs, however, due to regulatory barriers do not have their quotes represented in

CQS. While Island, for example, has developed a robust business in trading Nasdaq

securities (accounting for approximately 1 in every 8 transactions), the inability of

Island to disseminate its quotations through CQS have prevented Island from capturing a significant share of the volume in securities listed on the NYSE. By preventing fair competition between ECNs and traditional markets for listed securities,

the current regulatory scheme harms investors.

The Commission must take immediate action to allow ECNs to include their

quotation information in the Consolidated Quotation for listed securities. Traditionally, ECNs have resisted posting their quotation in CQS because, by posting a quote

in CQS, ECNs would be required to participate in ITS. Given the consensus that

ITS is obsolete, Island recently the order of an ECN, such quote would contain an

identifier indicating that it is the quote of an ECN not accessible through ITS. In

turn proposed that the SEC take steps that would allow ECNs to immediately begin

representing their quotations for NYSE-listed stocks in CQS without participating

in ITS until a more permanent long-term solution is found. Specifically, Island proposed that ECNs be permitted to immediately begin displaying their quotations in

listed stocks through Nasdaq. If the Nasdaq quote in CQS reflected, other markets

could access the ECN quote by linking directly to the ECN or by simply contacting

the phone desk of the ECN. The phone desk would provide at least the same quality

of access that is currently provided by ITS. More importantly, the inclusion of ECN

quotes in CQS would bring true competition to the listed market and allow investors

to obtain better prices.

Question 10. Has the current regulatory structure of the National Market System

actually created market fragmentation by disallowing ECNs to share pricing information?

Response: The two main goals of the National Market System were to heighten

competition between markets and increase the amount of quotation information

available to investors. Ironically, almost 25 years later, the rules and market structure implemented to achieve the goals of a National Market System are now inhibiting competition between markets and restricting the information available to investors. Regulatory obstacles block Island from participating in the two main components of the National Market System—the Consolidate Quotation System (CQS) and

the Intermarket Trading System (ITS).

Consider that when Island trades the stock of America Online, at various times

during the trading day, Island has the best quote in the National Market System.

Unfortunately, due to the current regulatory structure, market participants (other

than Island subscribers) are denied the opportunity to see and to access the better

price on Island. This is completely inconsistent with the spirit of the National Market System.

Instead, we should promote competition and integrate Island into the NYSE’s

pricing mechanism. Most importantly, Island’s price information would no longer be

fragmented from the rest of the marketplace. The market for NYSE-listed stocks

would immediately become more competitive and efficient. The resulting competition

between marketplaces (again, a central goal of the National Market System) would

result in benefits for the investor.

Question 11. Have you applied to become an Exchange? What is the status of your

application?

Response: Island applied to the SEC become a registered securities exchange on

June 28, 1999. Island is in regular dialogue with the SEC on the status of the application, and awaits specific recommendations from the SEC.

Question 12. How is Nasdaq’s super-montage like a Central Limit Order book?

69

Response: See answer to question 6 above.

Question 13. What are the key problems with a Central Limit Order Book?

Response: The debate over the creation of a Consolidated Limit Order Book

(CLOB)—a government-mandated, central order book, based on strict time-price priority between markets—has highlighted many of the problems with a CLOB. Its advocates insist that a CLOB is now necessary because ECNs have ‘‘fragmented’’ the

marketplace. In fact, the rise of ECNs has, by increasing competition, have led to

consolidation of the marketplace. A decade ago, the top four market participants (before ECNs were around) accounted for 40 percent of the total Nasdaq volume; today,

the top four (now including ECNs) account for 60 percent. Building upon this suspect fragmentation claim, the traditional market professionals then seek to impose

a CLOB across markets.Interestingly enough, the immediate and most important effect of a CLOB is to deny an ECN’s ability to compete with traditional players on

the basis of speed, technology, and reliability. The CLOB inhibits competition by

forcing markets to route orders to other marketplaces for execution. The resulting

inter-dependence between the markets would prevent any one market from distinguishing itself on the basis of speed, reliability and quality of service. For example,

if an order is sent to Market A for execution but Market B was displaying a better

price, Market A would be required to send the order to Market B for execution. As

a result, the quality of service that Market A could offer its customer is only as good

as the quality of service of Market B. The basis for competition between markets

would be eliminated since the only factor that would determine which market received the order would be price.

Question 14. In what ways is a CLOB anti-competitive?

Response: To understand why rules mandating price-and-time priority between

markets and—in their most extreme form—the Consolidated Limit Order Book are

anti-competitive, consider the following example:

Assume that ECN A is a market that provides its members with the fastest and

most reliable trading system in the industry. In addition, assume that Traditional

Market B utilizes obsolete technology that lacks adequate capacity. If, under a regime of price/time priority, Market B is the first to display the best offer of $100

in stock XYZ, any order to buy XYZ at $100 received by ECN A must be routed

to Traditional Market B—despite its inferior technology. Thus, even if you as an investor intentionally sent your order to ECN A to take advantage of its superior

speed of execution, ECN A would be required to route your order to Traditional

Market B. Thus, ECN A would be completely dependent on a response back from

Traditional Market B in order to fill your order.

This simple scenario demonstrates why price/time priority fails to serve the investor:

1.) It is impossible for ECN A to offer a faster execution or better service in its competition with Traditional Market B, since Market A will always be dependent

on Traditional Market B for execution and vice versa;

2.) ECN A and Traditional Market B are dependent on the linkage between them

and cannot offer service any faster or more reliable than permitted by the linkage.

3.) In light of the first two points, investors will become insensitive to which market

the order is entered, leaving no basis for competition between markets.

In sum, not only do we prevent markets from competing with one another on any

basis beside price, but we actually undermine the very technological breakthroughs

that have strengthened our Nation’s equity markets.

Question 15. Recently we have seen an increase in message bottlenecks due to capacity problems with individual systems. Would the existence of a CLOB exacerbate

the capacity problems we have been witnessing?

Response: Yes. The very definition of a CLOB is a centralized system where all

market participants are dependent on such system for the execution of orders. Since

the system’s development must be a cooperative effort led by the government, there

is every reason to believe that the end result would be a system that was technologically obsolete before it was even completed. Given the advances in technology,

our markets can only maintain their technological lead by constantly innovating. To

the extent that one monolithic system was created, innovation would be extinguished.

Question 16. The idea of a Central Limit Order Book (CLOB) was first tossed

around in the 1970s when fragmentation was high because technology could not facilitate efficient order interaction without centralization. Has current technology

rendered the notion of a CLOB obsolete?

Response: Yes. Given the tremendous advances in technology, market participants

are now able to route orders to the best market without a CLOB performing such

a function. There are many proprietary systems available today that allow traders

70

to determine and subsequently route an order to the best market. In fact, many systems do this in an automated fashion. As the level of investor sophistication has

increased, these systems will continue to proliferate and become more efficient.

(71)

COMPETITION IN THE NEW ELECTRONIC

MARKET: PART II

THURSDAY, MAY 11, 2000

HOUSE OF REPRESENTATIVES, COMMITTEE ON COMMERCE, SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS, Washington, DC.

The subcommittee met, pursuant to notice, at 10:05 a.m., in room

223, Rayburn House Office Building, Hon. Michael G. Oxley (chairman) presiding.

Members present: Representatives Oxley, Greenwood, Shimkus,

Towns, Stupak, Engel, Luther, and Rush.

Staff present: Linda Dallas Rich, majority counsel; David

Cavicke, majority counsel; Brian McCullough, professional staff,

Shannon Vildostegui, professional staff; Robert Simison, legislative

clerk; and Consuela Washington, minority counsel.

Mr. OXLEY. The subcommittee will come to order. The Chair

would indicate that I am instructed the House will have a series

of six votes on the floor beginning almost immediately, and so it

would be the idea to give my opening statement and if the ranking

member is here, his opening statement; and we will recess until we

can get those votes out of the way and then return. The Chair

apologizes for that inconvenience, but some of you have been

around long enough to know how things work around here. So the

Chair would recognize himself for an opening statement.

I am pleased to convene this, our second hearing, to examine the

implications of how technology is transforming our capital markets.

Indeed, technology has completely rewritten the rules of competition and survival in the new electronic marketplace. As we learned

at the subcommittee’s last hearing on this subject, barriers to entry

are falling as knowledge, creativity, and the Dell computer can

make a couple of young guys in a basement office a significant

force in the equities market. But not all barriers to entry have fallen, and they remain regulatory anachronisms that stand in the

way of optimum efficiency and fairness for all participants in these

new markets.

At our last hearing, we heard from representatives of the new

ECNs who are pioneering changes and gaining a hold on the market through the innovative use of technology. At that hearing, we

learned about some of the regulatory anachronisms and barriers

that remain such as the intermarket trading system. I look forward

to hearing today’s witnesses point of view on how ITs should be

changed or replaced to address the problems of outdated technology

and inefficient and unfair market access.

72

This morning we will hear from market participants who have

been around since the prehistoric times when faxes were considered high-tech. Technology has had no less impact on these players.

Their business models are changing as we speak, the direct result

of the forces of innovation and computation.

Increased competition is translated into reduced transaction

costs, faster executions, and more choices in trading venue for retail and institutional investors. Retail investors can now trade online with e-brokers at a fraction of the cost of the commissions they

would pay a traditional full service broker. Even the most stalwart

of the traditional brokers have followed suit offering investors the

option of trading on-line.

One thing that concerns me, however, is that investors can be

better served by not only lower commissions but better executions

of their trade. On a 1,000 share trade, one-sixteenths of a point,

which is currently the thinnest spread available on an exchange,

amounts to $166.67. That is more than 23 times the cheap $7 commission that some firms charge.

As I have said for some time now, when the markets move to

decimal pricing, investors will save bills in the form of narrower

spread. I can’t emphasize enough how important it is that the markets move expeditiously to pricing in dollars and cents and join the

rest of the world. The decimal pricing alone will not ensure that

investors get the best execution of their trades.

We will hear from our witnesses today, and in particular the

fund companies here today that invest on behalf of investors, about

how the rules of today’s markets work or don’t work to ensure that

investors get the best possible price on their trades.

Technology has also forced the reevaluation of the role and structure of traditional exchanges. Indeed one commentator suggested

in Monday’s Wall Street Journal that there is no reason to have

stock exchanges at all. James Glassman, the author who has testified before this committee, observed that the Internet can instantly

link buyers and sellers around the world, so why is there a need

for a place for buyers and sellers to physically get together to come

to terms on shares of stock or carloads of wheat? That anybody is

even asking this question illustrates how fundamentally the sweeping changes of technology have affected our markets.

ECNs, best described as hybrids of exchanges in brokers, have

led the challenge to the exchange structure. Because the linkage

provided by the current SROs was, in their view, inefficient, they

connected their own order books and pools of liquidity. In fact, last

fall the ECNs links with one another allowed continuous trading

even when NASDAQ systems were stressed by trading volume.

This linkage did not, however, address the question of how to ensure the public is informed of the better prices for listed stocks that

might exist on ECNs. In response, traditional exchanges are contemplating introducing their own ECNs dissolving current linkage

systems and planning privatization. I doubt we will recognize their

business models even a year from now. These new proposals raise

important questions about the proper role of regulation by self-regulatory organizations that compete with the entities they regulate.

I look forward to addressing some of these questions today.

73

Though these changes are stunning, I believe they are just the

beginning of a complete revolution in the securities industry. I did

not call this series of hearings to contemplate a future design for

the market. That is surely not the role of government. I am confident competition will shape the market more liquid, transparent,

and efficient than one we can structure. However, this can only

happen if we ensure that regulations that govern our market foster

competition in response to the changing landscape of the industry.

I am pleased to welcome today’s witnesses. We have an extensive

and distinguished panel of experts representing many sectors of the

marketplace including traditional brokers, institutional investors,

the first ECN, and traditional exchanges. With all points of view

represented today, I look forward to a lively debate on how best to

promote competition, efficiency, and fairness to investors in our

electronic marketplace.

The Chair now is pleased to yield to the ranking member, the

gentleman from New York, Mr. Towns.

Mr. TOWNS. Thank you very much, Mr. Chairman. I also want

to thank you for holding this hearing this morning. As I have observed at previous hearings, the securities market are important to

the State of New York and vital to the New York City economy.

Therefore, they are very, very important to me. I really want to

make that clear.

This subcommittee is front and center on the debate about how

markets are changing, how competition and efficiency can be enhanced and how investors can benefit. We must look carefully at

all the changes which are occurring. And let me pause here and

say, Mr. Chairman, I salute you. And let the record reflect that I

remain committed to market-oriented solutions to the changes that

are taking place in the securities markets.

The hearings we are holding on these issues provide an important platform for the industry, the regulators, and the investing

public to be heard. I particularly want to welcome Bob McSweeney,

the senior vice president of the New York Stock Exchange this

morning. Since the subcommittee’s last hearing on these issues, the

Exchange has released its market structure report. The report

makes recommendations on expanded choices of investors of the

New York Stock Exchange. Building on the existing strength of the

SEC floor system, these expanded choices will include automatic

electronic execution and opening the specialist book to on-line investors through the Internet.

The report also supports elimination of the intermarket trading

system in favor of a private sector technological initiative. One of

the most important recommendations is improving the education of

investors about order execution and market-structure issues.

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

would also like to express my concerns about the SEC concept release on securities market data. I strongly disagree with the idea

raised by some broker dealers that investors do not have cheap access to real-time market data. In fact, free quotes are available on

cable television and the Internet. I support the New York Stock Exchange’s decision to leave the Consolidated Tape Association.

I believe that with careful supervision by the SEC, each exchange can sell its own data and allow market forces to determine

74

who offers the best product. The SEC should not regulate market

data fees through cost base rating making procedures like a public

utility does. That method of regulation would add new levels of bureaucracy to the SEC and would distract the agency from more urgent investor protection issues. So, Mr. Chairman, I look forward

to hearing from all the witnesses, and on that note I yield back.

[Additional statement submitted for the record follows:]

PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE

I commend the Chairman for holding this hearing today on competition in our

new electronic capital markets.

More than half of all Americans now have an ownership stake in our economy

through investments in the stock markets. I am optimistic that the number of investors in our markets will continue to rise and will allow every citizen to participate.

It is no coincidence that this trend corresponds directly to improvements in technology.

Personal computers are as powerful as the old mainframes, and combined with

the Internet investors now have real time access to information and to the markets.

The speed and efficiency offered by these developments have increased competition

and reduced trading costs for both institutional and individual investors.

Technology has brought our markets new forms of trading, perhaps most dramatically illustrated by the evolution of electronic communication networks (ECNs). This

and other technological developments have led to questions about the utility and efficiency of the existing regulatory model of our securities markets, including the concept of a traditional exchange.

At the last hearing we heard some of the newest ECNs describe their ability to

match customer orders electronically without human intervention. Today we will

hear from the pioneer in that field, Instinet, the broker-dealer that brought us the

first ECN. We will also hear from the traditional auction and dealer markets, as

well as the users of both newfangled and oldfangled markets—the buy side.

The National Association of Securities Dealers and the New York Stock Exchange

are contemplating changes to their business models and regulatory structure to better compete with ECNs and foreign competitors. I suspect some of these changes

would not have been contemplated a few years ago absent the development of the

electronic trading facilities. I am very interested to learn more about the proposed

changes and their impact on competition.

In particular, the New York Stock Exchange has suggested that the Intermarket

Trading System (ITS) may have passed its time in this age of instantaneous execution. I congratulate them on recognizing the need to improve outdated systems and

technology, and am curious to learn how that system might be changed or replaced

to provide fairer and more efficient markets.

Additionally, the NASD has proposed a centralized trading system. I am concerned about possible conflicts that could arise when a Self Regulating Organization

enters into competition with the very entities it regulates.

We are not here to decide which business model is correct. Competition is the

force that best serves investors and our markets. But biased or outdated regulatory

restrictions get in the way of that positive force. Today we will learn what steps

are necessary to ensure that the rules of the game actually permit competition to

flourish.

I welcome our witnesses today.

Mr. OXLEY. I thank the gentleman and the Chair does indicate

there is a series of six votes on the floor of the House, and so, reluctantly, we will have to stand in recess until we return. I would

hope it would be within a half-hour or so. So enjoy yourselves. The

committee stands in recess.

[Brief recess.]

Mr. OXLEY. The subcommittee will reconvene. Once again the

Chair apologizes for the delay. I hope you enjoyed our hospitality

here at the Commerce Committee during our absence. Let me introduce our distinguished panel, Mr. Douglas M. Atkin, CEO and

president of Instinet; Mr. John J. Wheeler, manager, equity trading

of American Century Investments from Kansas City; Ms. Holly A.

75

Stark, director of trading, Kern Capital Management in New York;

Mr. Robert J. McSweeney, senior vice president of special committee on market structure, governance, and ownership, New York

Stock Exchange; Mr. Richard G. Ketchum, president, National Association of Securities; Mr. Peter Jenkins, director of equity trading, Scudder Kemper Investments in New York; and Mr. Kenneth

Kamen, president, Princeton Securities Corporation in Princeton,

New Jersey. Mr. Steven Galbraith, senior analyst for Sanford C.

Bernstein & Co. was expected to be here, was taken ill; but I ask

unanimous consent that his statement be made part of the record.

All of your formal statements will be made part of the record.

So let us begin with Mr. Atkin, and again we appreciate your patience with the committee. Mr. Atkin?

STATEMENTS OF DOUGLAS M. ATKIN, CEO AND PRESIDENT OF

INSTINET; JOHN J. WHEELER, MANAGER EQUITY TRADING,

AMERICAN CENTURY INVESTMENTS; HOLLY A. STARK, DIRECTOR OF TRADING, KERN CAPITAL MANAGEMENT; ROBERT J. McSWEENEY, SENIOR VICE PRESIDENT, SPECIAL

COMMITTEE ON MARKET STRUCTURE, GOVERNANCE, AND

OWNERSHIP, NEW YORK STOCK EXCHANGE, INC.; RICHARD

G. KETCHUM, PRESIDENT, NATIONAL ASSOCIATION OF SECURITY DEALERS, INC.; PETER W. JENKINS, DIRECTOR OF

EQUITY TRADING, SCUDDER KEMPER INVESTMENTS; AND

KENNETH A. KAMEN, PRESIDENT, PRINCETON SECURITIES

CORPORATION

Mr. ATKIN. Thank you, Mr. Chairman, and members of the subcommittee. First of all, the last time that I enjoyed recess I think

was about 32 years. I was a bit disappointed we weren’t able to use

the gym to shoot baskets. I hear it is for Members only. It is a

pleasure to be here. My name is Doug Atkin, and I am president

and CEO of Instinet Corporation. We are the world’s largest agency

broker. We trade over 300 million shares a day in U.S. markets.

We operate in 40 markets overseas and earned over $1 billion a

year in revenues in 1999.

Only in the NASDAQ market, I think it’s important to understand, do we operate as an ECN due to the unique nature of that

market. To date, this subcommittee has heard a lot of arguments

made by market intermediaries or the middlemen who trade

against their customers’ principle. We have also heard from the

NASD and New York Stock Exchange’s self-regulatory organizations currently operated as quasi-government utilities but with

firm plans to become for-profit competitors in the near future.

I think, today, the subcommittee will hear not just from the

intermediaries but from the real parties at interest, the investors,

the people really providing capital to the markets. After all, markets exist to serve issuers and investors, not the middlemen. When

I talk about investors, I just don’t mean Wall Street professionals.

Everyone who buys and holds a mutual fund or is involved in a

State pension plan is an investor. For over 30 years, we have allowed buyers and sellers of securities to meet electronically and unlike dealers, we are a pure agent meaning we don’t trade for our

own account. We never buy or sell securities for our own account,

and we have provided this service to investors such as mutual

76

funds and pension plans and have recently expanded our service

directly to retail investors as well.

In the last year alone, according to outside studies, Instinet has saved investors over $2 billion in transaction-cost savings. However, just as competition is beginning to make real inroads, the old

order, as in any time of transition, is trying to rewrite the rules

of the game to preserve its advantage. NASDAQ SuperMontage is

just one example of this type of anticompetitive behavior.

In the Internet age, rather than carry forward outdated structures, rules, and practices, we would be far better off by introducing competition. Some would say more competition. I would say

some competition into our markets. Currently the NASDAQ, under

NASDAQ, controls 100 percent of the trading in its market. Those

that trade NASDAQ stocks have to use its infrastructure and publish its quotes to its market.

We believe U.S. investors are not getting what they want and

need out of the present market structure. We think what they want

is inefficient market which lowers their total trading costs. Let me

identify just two examples of what I mean. Certainly trading in

decimals would make markets easier for investors to understand.

It would also allow spreads between buy and sell orders to narrow

allowing investors to get better prices.

We operate, as I said, in 40 markets. We operate in decimals in

39 markets. The only market we don’t is the United States, and we

don’t think that that is the best market for investors. Also, today

when an investor improves the price for its security, that is, an investor is the first one willing to pay more than another buyer or

accept less than any other seller, their order can sit unfilled all day

while others’ orders get filled at the very price that they set. I don’t

believe that is the best for the market, best market for investors

either.

I think today’s network technology is bringing buyers and sellers

together directly in industry after industry. The Internet is changing the way travelers buy airline tickets, the way car manufacturers buy auto parts, the way utilities buy electricity. Compared to

these examples, the way people buy and sell stocks has hardly

changed particularly at the market level. In our industry, mainframe-era rules and structures continue to protect middlemen to

the detriment of investors.

Mr. Chairman, you mentioned the Wall Street Journal article. I

too found that very interesting calling into question this very fundamental issue. For example, the self-regulatory organizations, at

present, are able to use their regulatory authority to write rules

that keep themselves and the dealers in the middle and capture

the benefits of other people’s innovations.

I would also say, though, again this isn’t just an SRO issue. It

is also an SEC SRO issue. There is a lot of issues that are intertwined between the SEC and NASDAQ for example. I think the

members of this committee have worked extremely hard to end monopolies and introduce greater competition as in the telecommunications industry fostering innovation and reducing consumer costs.

To achieve this result in the industry, I believe we must dismantle

the outdated rules written in the 1970’s based on 1960’s technology

that protects the entrenched interest.

77

Let me offer three examples of the kind of change I am talking

about. First we cannot allow one competitor to write the rules for

another competitor. That is like allowing the pitcher to determine

the size of the strike zone. It just is not a level playing field. If the

pitcher were able to determine the size of the strike zone, I don’t

think Sammy Sosa or Mark McGwire would have hit 50 or 60 home

runs.

Mr. OXLEY. Could you sum up. We are trying to stick to the 5-

minute rule since we have so many on the panel.

Mr. ATKIN. Certainly. The new world of competitive opportunity

created by technology is not limited to our shores. Trading U.S.

stocks overseas was not possible 25 years ago, but it is possible

today. I think European exchanges are already offering more efficient operations than their U.S. counterparts; and I think, to sum

up, what we really need in this country is to make sure that before

NASDAQ or any other SRO is able to build, in essence, a competing order matching functionality or system, what we need is to

allow ECNs who are really frustrated stock exchanges to operate

on a level playing field and to be able to compete fairly or have

that choice.

[The prepared statement of Douglas M. Atkin follows:]

PREPARED STATEMENT OF DOUGLAS M. ATKIN, PRESIDENT AND CHIEF EXECUTIVE

OFFICER, INSTINET CORPORATION

I. MARKETS SERVE ISSUERS AND INVESTORS

Mr. Chairman and members of the Subcommittee, thank you for the opportunity

to appear before you today. My name is Doug Atkin and I am the President and

Chief Executive Officer of Instinet Corporation.

There is an exciting transformation now underway in the securities markets, as

new competitors to the old, established brokerage firms and technological innovations are offering investors benefits and advantages once reserved only for market

‘‘insiders,’’ leveling what has long been an uneven playing field. Over the past several years, the National Association of Securities Dealers (NASD) and the New York

Stock Exchange have faced increasingly vigorous competition from electronic brokers like Instinet. By empowering investors to trade directly with one another, we

have brought competition to stock trading, which ensures that investors get the best

price at the lowest transaction cost by driving down spreads.

Two months ago, this Subcommittee started hearings on the future of the markets. To date, you have heard a lot of arguments made by market intermediaries—

the ‘‘middlemen’’ who trade against their customers as principal, and the NASD and

NYSE—self-regulatory organizations currently operated as quasi-governmental nonprofit utilities, but with plans to become for-profit competitors in the very near future.

Today, the Subcommittee will hear not just from the intermediaries but from the

real parties at interest: the investors, the people providing capital. After all, markets exist to serve issuers and investors, not to serve the middlemen. And when I

talk about investors, I don’t just mean Wall Street professionals. Everyone who buys

and holds a mutual fund is an investor.

For over 30 years, Instinet has allowed buyers and sellers of securities to meet

electronically. Unlike middlemen, we are a pure agency broker—we never buy or

sell securities for our own account. We have provided this service to investors such

as mutual funds and pension funds and will very shortly expand our service directly

to retail investors as well.

Given the bull market of recent years, it may seem strange to suggest that the

U.S. stock markets are not as efficient as they should be. But the fact is, our markets remain dominated by monopoly competitors still using mainframe technologies.

And, just as competition is beginning to make real inroads, the old order—as in any

time of transition—is trying to rewrite the rules of the game to preserve its advantage. Nasdaq’s ‘‘SuperMontage’’ is just one example of this type of anticompetitive

behavior. In the Internet Age, rather than carry forward outdated structures, rules

and practices, we will be far better off by introducing more competition into our

78

markets. This will serve investors better, as well as maintain our global competitiveness.

II. INVESTORS ARE NOT GETTING AN EFFICIENT MARKET

Today U.S. investors are not getting what they want and need: an efficient market. Let me identify a few examples of what I mean:

• Trading in decimals would make markets easier for investors to understand. It

also would allow the spreads between buy and sell orders to narrow, allowing

investors to get better prices. However, because of a market structure that has

a single point of failure, we don’t even know when trading in decimals will

begin. That’s not the best market for investors.

• Today, trading takes place around the world 24 hours a day. Investors demand

information about prices and trades before the traditional markets open and

after they close. This information is generally not available to investors today.

That’s not the best market for investors.

• Today, when an investor improves the price for a security, that is, is the first one

willing to pay more than any other buyer or accept less than any other seller,

his order can sit unfilled all day while others’ orders get filled at the very price

he set. That’s not the best market for investors.

III. REMOVE OBSTACLES TO MAKE MARKETS MORE EFFICIENT FOR INVESTORS

As Members of this Committee know well, today’s network technology is bringing

buyers and sellers together directly in industry after industry. The Internet is

changing the way travelers buy airline tickets, the way car manufacturers buy auto

parts, the way utilities buy electricity. In financial markets, futures, derivatives and

bonds are increasingly traded over electronic systems. We recently launched Instinet

Fixed Income, which will bring better performance and cost effectiveness to trading

in fixed-income securities.

Compared to these examples, the way people buy and sell stocks has hardly

changed. In our industry, mainframe-era rules and structures continue to protect

middlemen to the detriment of investors. For example, the self-regulatory organizations are able to use their regulatory authority to write rules that keep themselves

in the middle and capture the benefits of other people’s innovations.

The members of this Committee have worked hard to end monopolies and introduce greater competition in the telecommunications industry. The Committee currently is reviewing monopolies and barriers to competition in the energy market. As

in telecommunications, as in energy, we need to introduce more competition in the

securities markets, to unleash the benefits of technology, speed, efficiency and lower

costs. Our markets need to work for issuers and investors rather than the middlemen. To achieve this, we must dismantle the outdated rules written in the 1970’s,

based on 1960’s technology, that protect the entrenched interests.

Let me offer three examples of the kind of change in thinking I am talking about.

First, we cannot allow one competitor to write the rules for another competitor.

That’s like allowing the pitcher to determine the strike zone—even Sammy Sosa or

Mark McGwire would have a tough time in that situation! And yet it is happening

in our securities markets. The New York Stock Exchange and the NASD write the

rules that all competitors must play by. And they are planning to become for-profit

competitors themselves.

When you write the rules and play in the game, you face an inherent conflict of

interest. As an example, consider the NASD’s proposed ‘‘SuperMontage.’’ Today, the

NASD runs a system that lets market participants control who they send orders to.

In SuperMontage, the NASD is proposing to control who market participants send

their orders to. It would give the NASD an unfair advantage over its competitors,

ultimately harming investors.

Instinet’s April 20, 2000 comment letter to the SEC on the NASD’s SuperMontage

proposal is attached to this testimony in exhibit. Let me briefly explain why SuperMontage really should be called ‘‘SuperMonopoly’’:

• It is not really voluntary. The proposal requires all markets trading Nasdaq

stocks to submit their quotes to SuperMontage. In addition, brokers will feel

tremendous pressure to use the order execution system run by their regulator—

ultimately reducing investor choice.

• It could give investors worse prices than they get today. As currently designed,

the algorithm at the heart of SuperMontage coupled with Nasdaq’s pricing conventions would put certain ECNs last in line to execute orders entered through

Nasdaq, even when those ECNs offer the best prices for investors. This would

inappropriately disadvantage certain market participants, particularly those

79

who have brought down spreads and helped provide investors with the best

price.

• It could provide investors with less information than they get today. As James

Glassman described in the Wall Street Journal this week, ECNs already expose

their entire limit order books to their subscribers and some even to the public

over the Internet. SuperMontage displays only the three best price levels. If

SuperMontage draws order flow away from ECNs because of its privileged regulatory status, that will be a step backward in transparency.

To eliminate this inherent conflict, we must end the ability of one competitor to

regulate another. Regulation must be carried out by independent, unbiased regulators. 100% separation of the Nasdaq from the NASD and NASD Regulation should

be an absolute precondition for the privatization of the Nasdaq.

Second, we must remove outdated and biased trading rules that serve the middlemen rather than investors. Current rules allow unfair trading practices such as ‘‘internalization.’’ Internalization allows middlemen to profit from the difference between their customers’ buy orders and sell orders, without ever exposing those orders to the market. This reduces competition, which in turn produces worse prices

for investors. Not only that, the order placed by an investor who first sets the best

price can go unfilled. One possible solution to internalization is to prevent any intermediary from trading against its customers as principal unless it improves the best

available price in the market.

Finally, we must promote fair competition. Competition breeds innovation, and innovation benefits investors. This Committee wrote the law requiring the Baby Bell

phone companies to allow competition for local service before they can offer long distance service. If not for this requirement, the Baby Bells would be using their monopoly revenues from local service to subsidize their long distance business. As Congress realized, monopoly subsidies are unfair, inefficient and stifle innovation. The

current monopoly on revenues from market data illustrates these risks.

Today, the rules allow the self-regulatory organizations to engage in exactly this

type of unfair and inefficient behavior. For example, all brokers must report their

market data to their SROs. The SROs then enjoy exclusive rights to revenues from

the sale of that data. They earn monopoly revenues in this area and can use it to

subsidize other areas of business—including efforts to compete with their own members.

The solution to this problem is to allow innovators to keep the benefits of their

innovations. To continue the example I gave, Instinet and other market participants

already use their data as important parts of their business strategy. The monopolies

should not be able to dictate the terms on which their competitors may use their

data.

IV. CONCLUSION

The new world of competitive opportunity created by technology is not limited to

our shores. Trading U.S. stocks overseas was not possible 25 years ago, but it is

possible today. European exchanges are already more efficient than their U.S. counterparts. They have been free to trade one another’s shares without having first to

get approval from their competitors. For example, the London Stock Exchange set

up the electronic SEAQ International to trade French, German and Swiss stocks.

SEAQ International captured a significant share of trading from the traditional exchanges. This competition forced European exchanges to respond by adopting more

efficient electronic systems, benefiting issuers and investors across Europe. If SEAQ

International had been required to go to the European exchanges for permission to

trade their stocks, or forced to operate through their systems—as the ECNs must

today with the NYSE and Nasdaq—the European exchanges likely never would

have innovated. The recently-announced merger of the London Stock Exchange and

the Deutsche Boerse will create an efficient all-electronic stock market that rivals

U.S. markets in size.

By contrast, in the United States competition to the Nasdaq for trading Nasdaq

stocks is limited. ECNs essentially are frustrated exchanges that are not able to

compete with the Nasdaq on an equal footing. Even those ECNs that have applied

to become exchanges have not been able to. This is even more important, now that

the Nasdaq is becoming a for-profit competitor and is proposing to use its regulatory

authority to hobble its competitors before competition even begins.

If the U.S. markets do not become more efficient, securities trading could easily

move overseas. I have argued for a change in thinking, to allow more competition

in securities trading. This will be good for issuers, good for investors, and will maintain the international competitiveness of the U.S. markets. If we build a market

that best serves investors, we can continue to control our destiny. If we try to erect

80

barriers around an inefficient market, we will harm investors and lose control to

others.

Mr. OXLEY. Thank you.

Mr. Wheeler?

STATEMENT OF JOHN J. WHEELER

Mr. WHEELER. Thank you. Chairman Oxley, distinguished representatives of the subcommittee, my name is John Wheeler; and

it is an honor to be here today representing 2 million shareholders

at American Century Investors with over $110 billion in assets. I

am the manager of the domestic trading operation at American

Century. I have been with the firm for over 9 years; and previous

to that time, I spent 5 years in the over-the-counter marketplace

as a market maker.

[Slide.]

I would like to start this morning with a little bit of historical

perspective. This slide represents a survey taken at Trader Forum,

a buyside organization, done over 5 years ago. If you focus in on

the three qualities of a marketplace that the institutional investors

said that they wanted exchanges to adopt, three responses garnered more than 90 percent positive votes. That would be order anonymity, full but anonymous disclosure of supply and demand

schedules, basically a depth of book argument, and integration of

price discovery, execution and transaction reporting.

Second, a little bit of historical perspective on what we have done

at American Century. We started doing business with Mr. Atkin’s

firm, Instinet, over 10 years ago; and as you can see by the blue

line represented here, our average commission rate paid by our

mutual fund shareholders has dropped precipitously over the last

10 years from a rate above 6 cents a share to most recently below

3 cents a share on average. If you look at the bottom line, electronic brokers that we do business with at American Century, rates

have dropped on a very dramatic percentage basis from over 3

cents a share to right now at a penny a share on average for our

electronic brokers.

There has been a lot of talk recently about fragmentation. It is

our view at American Century that ECNs like Instinet, Archipelago, Bloomberg’s B-Trade product do not fragment markets.

They have invested a lot of money in technology into integrating

linkages between markets. We believe that ECNs link markets to

the benefit of our investors.

Last year, one out of three NASDAQ trades were made by wholesalers who were free riding on ECN quotes in our view. There is

currently not an incentive in NASDAQ nor at the New York Stock

Exchange for an investor, small or large, to disclose a trading interest to the rest of the remaining investing public. There is, in fact,

an incentive to withhold quotes and withhold orders, withhold limit

orders from the public because they are preyed upon by the intermediaries of those market plays in today’s world.

Internalization runs rampant at the New York stock exchange

and regional exchanges, as well as NASDAQ currently. Large block

trading houses internalize order flow. Retail firms pay for order

flow and internalize that order flow at great, great profit to their

81

particular firms at the expense of investors large and small. We

view this as a very serious problem.

Preferencing arrangements between competing intermediaries,

we should be competing with each other again is a very big concern

at American Century. As documentation of a previous point, this

is a snapshot of four stocks, Friday January 8, 1999. Just to take

a brief look at how those stocks are quoted within NASDAQ, who

is driving the inside market? Who is telling the world their best

bid? Who is displaying to the world the best offer and price? You

can see it is predominantly the ECNs alone at the inside marketplace and those four stocks. If you look at the next column, market

makers alone at the inside, on average about a quarter of the time

with ECNs half the time or more.

Mr. OXLEY. Before you switch that, I am not quite sure I follow

that.

Mr. WHEELER. Percentage of time throughout the trading day

that the inside quote was only in an ECN as the best bid or only

in an ECN as the best offering, in other words, Archipelago,

Instinet, e-trade driving the inside market not NASDAQ market

makers not NASDAQ member firms. Predominantly it is the ECNs

that are driving the inside market because NASDAQ dealers have

the ability to free ride off of the quotes of limit orders that are

inputted by the investing public.

Mr. OXLEY. Thank you.

Mr. WHEELER. At the expense of going over and not being able

to complete the rest of my testimony, I want to spend a little bit

of time on this particular slide. This I just prepared last week. This

is a snapshot of our over-the-counter trading at American Century

for the last 12 months of data. I compared our trading on two

ECNs, our two largest ECNs, Archipelago and B-Trade, and I compared that to our over-the-counter trading at the infamous MGM,

Morgan Stanley, Goldman Sachs, and Merrill Lynch.

Mr. Chairman, actually you touched earlier on the difference between explicit commission rates and the true cost of execution. I

think this slide graphically illustrates that point. Our average trading costs with those three Wall Street firms average 286 basis

points of round trip overall cost to our shareholders and would be

commission costs, the explicit commission costs plus the market impact costs through linkages of information et cetera, et cetera.

Compared to the cost incurred by Archipelago and B-Trade of just

98 basis points. We saved our shareholders over $220 million in

marketing impact costs by executing over $11 billion in transactions on these two ECNs last year alone.

I would like to touch on decimals, if time allows. Where are decimals right now? The marketplace has been calling for them for

years. Regulators have been calling for decimals for years. Trades

are occurring on ECNs and in our marketplaces at 1⁄256ths of a

point currently, and we currently restrict our investing public to

display their limit orders in fractions of a 1⁄16th of a point. It is

very discouraging for us to see that the day traders and professional traders all day long can quote stocks in 1⁄256 and gain standing a step ahead of customers’ limit orders or 1⁄256th of a point

when we tell the investing public that they must abide by 1⁄16ths.

82

Last, ACIM thinking about our markets, investors have long

been ignored by traditional intermediaries. The biggest point we

would like to drive home is that ECNs force brokers and exchanges

to compete by meeting those needs that investors ask for. New

technology platforms give investors anonymity, full disclosure of

supply and demand schedules and integration of price discovery,

execution, and transaction reporting, features long requested by

mutual fund investors.

Competition from cost-efficient ECNs has lowered our commission rates and will save our shareholders $35 million in explicit

commission costs this year alone. When you look at overall market

impact costs, we are looking at a number approaching $500 million

this year alone saved at American Century through cost-efficient

ECNs.

[The prepared statement of John J. Wheeler follows:]

PREPARED STATEMENT OF JOHN J. WHEELER, MANAGER OF EQUITY TRADING,

AMERICAN CENTURY INVESTMENT MANAGEMENT

Chairman Oxley, Rep. Markey and other distinguished members of the Subcommittee, thank you for the opportunity to share my vision for the securities markets and the regulatory environment needed to accommodate that vision. I am John

J. Wheeler, and as an active voice for two million investors entrusting more than

$100 billion to American Century mutual funds and retirement programs, I’m excited to participate in this dialogue. For too long, the voices at hearings like this

have represented the deep pockets and economic interests of entrenched financial

intermediaries—and not the direct voice of investors who daily face the arcane, archaic and anti-competitive rules of member-owned exchanges.

As Manager of the domestic trading desk at American Century Investment Management (ACIM), now recognized as one of the earliest and most aggressive users

of electronic trading technologies, I oversee a staff of ten traders responsible for executing equity trades for our forty equity mutual funds. I was a Market Maker of

NASDAQ traded OTC stocks for five years before joining ACIM as a Senior Trader

in 1991. During my tenure at ACIM, I have served as a member of the New York

Stock Exchange’s Institutional Traders Advisory Committee (ITAC) and various

NASDAQ committees as well. My immersion into the complexity of the ‘‘rules of engagement’’ at both the NYSE and NASDAQ has been both educational and troubling.

I serve on these committees because the method and costs for securities trading

directly affect investment performance for our investors, whose portfolios reflect

prices after trading costs are paid. Both large and small investors suffer equally and

proportionately when there are marketplace inefficiencies and inequalities.

Investor Benefits from Emerging Trading Technologies

Our 1992 response to the Securities and Exchange Commission’s Market 2000

Concept Release was one of only four filed by investor constituents. The issues in

that release are eerily similar to those contained in the Commissions’ recent request

for comment on market fragmentation. In the early 90’s study, opponents to newly

emerging and efficient technology platforms spawned language that asked whether

such systems threatened ‘‘fragmentation,’’ ‘‘segmentation,’’ and ‘‘balkanization’’ of

the nation’s securities markets. I remain convinced now, as I was then, that such

language reflects the howls from entrenched exchanges and brokers who have been

insulated from competition by rules that masquerade as investor-friendly safeguards.

Our data indicates that ACIM’s overall trading costs, including commissions and

market impact have fallen steadily and progressively throughout the 1990s. (see exhibit 4) The enactment of the Order Handling Rules in mid-1997 generated significant additional savings. We can attribute virtually all of the cost savings—which go

right into our investor’s pockets—to the use of ECN’s and other electronic trading

technologies. The data suggests that new ways to trade have saved our investors

as much as $110 million each year for the past 10 years as compared to our costs

for traditional brokerage services. (see exhibits 3) In the last year alone, our traders’

83

1 Extrapolation of most recent 6-month OTC trading costs at Goldman Sachs as compared to

Archipelago 2Many trading consultants now evaluate the efficacy of trading by measuring how closely

trades approximate the day’s volume weighted average price for all trades in a given stock. 3 Source: NASDAQ Stock Market data

use of more efficient platforms have saved our investors more than $500 million 1— the size of a pretty good-sized mutual fund. Consequently, our traders rely on alternative trading systems for about 40% of the dollars traded by ACIM on behalf of

investors.

The efficiency of such systems appears to extend only to NASDAQ-registered securities. The NYSE somehow escapes obligations under the Order Handling Rules and

continues to refuse direct electronic access by investors to the specialist order book.

That would appear to contravene the spirit of the 1975 amendment to the Exchange

Act that calls for markets to provide buyers and sellers an opportunity to discover

prices ‘‘without the intermediation of a dealer.’’

Internalization and Payment for Order Flow

While we do not perceive a ‘‘fragmentation’’ threat from the emergence of new

automated transaction systems since they match, cross and route orders automatically, we are nonetheless troubled by the ‘‘fragmentation’’ foisted upon the market by

dealer intermediaries who either internalize or pay for order flow. Many wholesale

broker dealers and exchange markets engaged in internalization practices rely on

the national market’s disclosure of visible, limit orders to price and trade market

orders generated by captive constituencies. Investors who display the desire to trade

by using limit orders instead subsidize internalization practices. Ultimately, I expect

to see internalization practices constrict the number and size of limit orders in the

marketplace with a likely increase in volatility. Internalization and payment for

order flow threaten transparency of trading processes. For instance, brokers now

regularly receive so-called ‘‘VWAP’’ orders for specific securities—sometimes hundreds of thousands of shares—on both sides of the market.2 Potentially millions of

shares are now internalized at the VWAP price, without ever participating in the

market’s price discovery processes and without any semblance of order interaction

with other investor orders. Many of these orders are now ‘‘book entered’’ overseas

by U.S. brokers.

Major wholesale market-making firms, whose business models rely on payment

for order flow, were engaged in about one-third of all trades in NASDAQ securities

last year (see exhibit 5) and have seen increasing market share gains as more and

more retail investors trade individual stocks. At the same time, market makers

often are represented in the market as the ‘‘best’’ buying or selling price only 25%

of the time in many high profile, actively traded stocks while ECNs typically represent the market’s best price more than 50% of the time.3 (see exhibit 6)

Internalization practices prove anti-competitive in a host of trading venues—and

the traditional exchange markets retain ‘‘members-only’’ benefits, marketing agreements and other ‘‘practices’’ that erode our confidence in trading on even the most

well branded exchanges.

Internalization at the NYSE

The NYSE suggests that fragmentation caused by internalization might be mitigated by a market-wide price improvement rule. In other words, orders could only

be internalized by dealers who pay a price ‘‘better’’ than the national market’s best

prices for both buys and sells. In principal, we believe that this simple change in

intermarket rules would be favorable for investors. At the same time, we can’t understand how the NYSE might impose that rule on other exchanges or dealers when

much of the physical, floor-based model of that exchange depends on layers of such

internalizing rules:

• Price and time priority exists in only one place at the NYSE—on the specialist’s book. If one customer sends a buy order to the exchange and a second

customer sends an additional buy order to the floor at the same price, the first

customer’s order must be filled before the second customer’s receives attention.

This would appear to be a fundamentally fair outcome. However, third and

fourth in-line buyers could place an order with member firms represented in the

floor ‘‘crowd’’ and they are granted the right to share pro-rata in every trade

at the first customer’s price. The second customer must wait patiently. Where

is the notion of price improvement in this circumstance?

• The ‘‘clean cross’’ rule allows member brokers to ‘‘internalize’’ blocks of 25,000

shares or more at the same price as smaller, pre-existing orders on the specialist book without satisfying those orders that established the price of the

84

4 American Century Companies (ACC), along with a number of major Wall Street firms, owns

a small equity position in the OptiMark auction utility.

trade. How is this functionally different than the practices employed by wholesale dealer firms who only match prices set in other markets when they pay

for order flow? How does the small investor benefit by posting limit orders if

they are afforded no protection when a ‘‘clean cross’’ occurs at their price? • ‘‘Participate’’ orders are instructions given to floor brokers (and even specialists)

on the NYSE floor that ask them to passively ‘‘go along’’ with other trades until

an order is complete. The rules of the NYSE give these orders standing in the

markets even though they do not contribute to price formation. No information

is transmitted about these trades because they can only occur when someone

else commits to make a trade at mutually agreeable prices. How does one ever

‘‘price improve’’ a participate order at the NYSE? • ‘‘Freezing the book’’ is a little understood specialist practice used to manage the

trading process. If an electronic order arrives to buy a stock at the offered price

on the book, the specialist may ‘‘freeze’’ the book to enable the floor crowd to

make the trade at that price. After the trade is completed, he then ‘‘unfreezes’’ the book to allow the new electronic order to take its place in queue. Discussions with exchange officials suggest that this is a ‘‘practice’’ rather than a ruleenabled function of the specialist. • The NYSE has resisted institutional calls for years to show more than the market’s best bid and offer—to create a supply and demand schedule for the market. The NYSE has created rules that actively discourage the use of technology

to trade there. Simply put, if you want equal (or advantageous) standing on the

NYSE, you are required to hire a NYSE floor broker. There is no alternative

choice.

Competition and the NYSE

At the New York Stock Exchange, our orders cannot be traded without the intervention of a dealer—the specialist. Not much data exists about the profitability of

specialist operations but the recent prospectus offering by LaBranche, the second or

third largest NYSE specialist firm, provided a glimpse at the following:

• LaBranche consistently earns more than 75% of profits from dealer trading activity; • That specialist unit has been profitable every quarter for 22 years; that would include the market’s record single day drop in 1987, the major bear markets in

1980 and 1982, and other periods of market ‘‘distress.’’ • The company averages consistent returns on capital and equity of more than 70%; • The company posts consistent profit margins of about 70%;

How do they earn such economic rents? I would suggest that the designation of

the NYSE as the ‘‘primary’’ market on which all other pricing should be based has

established the NYSE as the principal ‘‘operating system’’ for the market. That status

has been conferred upon member-owned exchanges by the Congress and by SEC

regulatory interpretations over time.

It strikes me that an analogous situation might be the establishment by Congress

of Microsoft as the official operating standard for the computer. Obviously Microsoft

was the first to discover the true power of a standard operating system for the desktop computer. Recent events here and in the courts would suggest that Microsoft

also discovered that bundling increasing numbers and kinds of software applications

into the operating system pleased consumers—but displeased those who believe that

competition spurs innovation.

The NYSE sits as the sole arbiter on a number of shared exchange operating committees like the Intermarket Trading System—the effective operating system for the

nation’s exchanges. The use of veto power in a number of these venues successfully

stymies efforts to stimulate interconnectivity of markets. And the NYSE has, over

the years, incorporated innovations begun at regional markets only after a concept

is proven and is considered a potential threat to the established hierarchy of exchanges.

Innovation by Regional Exchanges

The recent launch of the OptiMark trading utility of the Pacific Stock Exchange

(PSE) provides needed insight into the anti-competitive practices at both the primary and regional exchange markets.4 OptiMark’s system relied on effective linkages between markets—as promised by the Intermarket Trading System (ITS). The

historical record reflects that the SEC was forced to broker a compromise between

competing parties on the ITS operating committee after principals exhausted more

than a year in fruitless, back room debate on how OptiMark could or should be

85

5 Archipelago Holdings, LLC built such a linkage to the PSE which allowed us to send large

orders to that market for posting by the specialist there. ACC subsequently purchased a small

and indirect economic interest in Archipelago through JP Morgan Capital.

linked to the NYSE market. That process helped draw down a new competitor’s intellectual and economic resources required to compete effectively. The final solution

reflected the economic staying power of NYSE monopoly position rather than a rational attempt to further the goals of a National Market System.

Shortly after effective launch of the new system, the NYSE effectively shut down

ITS access to the OptiMark utility—based on arbitrary volume limitations. As an

early user of the utility, our company documented numerous failures by NYSE specialists to abide by conventions of the ITS agreement and filed that report with both

the Commission and exchange officials. In several documented cases, we were unable to execute orders sent from the Pacific Exchange to New York that were subsequently and immediately executed when sent through the NYSE proprietary Super

DOT, order delivery system.

Our experience with the OptiMark utility also produced an eye-opening understanding of the marketing arrangements of regional exchanges that subvert competitive quote-making among exchanges. ACIM recognized early that the Pacific

Stock Exchange (PSE), in combination with the OptiMark utility, might provide an

effective mechanism to generate competing quotes with the NYSE. We asked ECNs

with whom we do business to build an order display link to the PSE such as that

already in existence at the NYSE.5 American Century traders subsequently sent orders to the PSE that ‘‘improved’’ the NYSE best bids and offers. Those orders were

intended to serve as an advertisement on the Consolidated Quote System of potentially larger block trading opportunities available through the OptiMark utility. Instead, we found that PSE specialists almost immediately sent these ‘‘price improving’’ limit orders across ITS from the West Coast to the NYSE specialists’ books.

In trying to provide price competition, we discovered that PSE specialists have

marketing obligations to a number of broker-dealers who internalize order flow. To

protect those firms’ ability to internalize customer orders, the specialist offers ‘‘primary market protection’’ on the regional floors. That protection essentially promises

‘‘internalizing’’ firms that if stocks trade at the retail order’s price on the ‘‘primary’’

exchange, the PSE specialist would use his capital to execute the order at that price

on the regional exchange. There were three problems with the new competing orders

that we were sending for display to the PSE. One, the large size of the orders on

the PSE book meant that small retail orders, previously internalized, had to wait

in queue until the larger block traded. When ACIM offered to forego ‘‘primary market protection,’’ the specialists requested that we also allow small retail orders to

be traded in front of the large order, even if they arrived at a later time. The PSE

could not excuse one firm from that ‘‘marketing arrangement’’ without compromising the entire business model of the exchange. Two, the large size of the orders

provided an unacceptable risk to undercapitalized specialists who did not wish to

‘‘protect’’ our orders against trades in other markets. And three, it narrowed the

spread that could be internalized by PSE firms that sent listed orders to that venue

for trading—thereby cutting the profitability of that practice.

This, to us, is prima facie evidence that regional exchanges—under current

rules—provide neither competitive quoting nor innovation. We are inspired by the

recent announcement that the PSE and Archipelago will attempt to create a truly

competitive and automated stock exchange. We can only hope that promises of price/

time priority and electronic and non-dealer intermediated access to the PSE will not

be perpetually stalled by entrenched and dominant exchanges, operating committees

and member firms—all wrapped in concerns about investor protection.

Regulatory Requirements

The SEC has long sought to respond to the language of the 1975 Amendment to

the Exchange Act and its call for markets that:

• maximize the opportunity for investors’ orders to interact in an agency auction

and;

• for buyers and sellers to execute without the intervention of a dealer.

A recent survey of more than 40 traders of major institutions showed strong consensus that ‘‘ideal market’’ attributes would include:

• Anonymity of orders entered within a system;

• Time priority of orders entered at a price;

• Full, but anonymous, disclosure of the supply and demand schedule;

86

6 Economides and Schwartz, ‘‘Assessing Asset Managers’ Demand for Immediacy: Equity Trading Practices and Market Structure’’ substantiates the institutional traders’ desire for such rules

of engagement. 7See Domowitz and Steil, ‘‘Automation, Trading Costs and the Structure of the Securities Industry

• Integration of price discovery, execution and transaction reporting.6

We support the call for markets with transparency and ‘‘quote’’ competition. The

current state of affairs in the NASDAQ market, with wholesale market makers and

even at the NYSE fails to meet the minimum standards that the buyside requires

to best protect investor interests. (see exhibit 2) The explosive growth of ECNs in

the U.S. marketplace and across Europe validates such surveys of investor preference. If ECNs were allowed to compete directly with the NYSE, we think sizeable

economic benefits would accrue to investors.

For years, ACIM has advocated a strict price and time priority intermarket linkage. We continue to believe that the best market for investors would foster maximum order interaction and transparency. At the same time, recent experience with

the ITS trading system, the rules of trading at the NYSE and the structural problems related to ECNs and mandated SelectNet linkages suggests that the SEC focus

first on order disclosure, priority and interaction rules within individual markets.

How Can We Get There?

The explosive growth of the Internet in part provides the solutions to these vexing

issues. Electronic, non-intermediated auctions on-line are drawing huge resources

and attention from buyers and sellers of Beanie Babies, airline tickets and auto

parts. Ford, Chrysler and GM seek such a venue to reduce supplier costs. Why do

member firms of the major exchanges resist the major virtues that their own securities analysts extol as ‘‘beneficial’’ to the economy in enterprises outside of securities

trading?

We believe that the Commission should regulate the form of individual markets

and refrain from regulating the technology that might be used to integrate markets.

Already, eight ECNs are building a virtual private network to link order books and

dispersed pools of liquidity. These robust networks tie together systems that already

incorporate the four major tenets of the buyside investor’s ‘‘ideal market’’ without

creating a single point of technology failure—a virtual limit order book. The systems

recognize that the ‘‘market’’ no longer is limited by access to the physical trading

floor on Wall Street.7

The government’s time is misspent trying to regulate the technology capacity of

markets. If competitively-limiting linkages like ITS were simply eliminated, one

must consider whether the market would not quickly establish network linkages as

a direct response to customer demand. These linkages would recognize and penalize

inefficient systems—like those currently operated by the NASDAQ stock market—

where legacy systems impede the delivery and reliability of trading information.

Insight into the regulator’s role over tariff setting within the securities markets

can also be gained from the implementation of the Order Handling Rules. The sudden mixing of dealer systems (where all customer charges are implicit) and of agency auction systems (ECNs who explicitly charge for access) squarely placed the Commission in the role as a rate-setter. Dealers argued they should not have to pay for

access to ECNs because dealer-to-dealer trade in NASDAQ is ‘‘free.’’ However, dealer trading is free only if dealers have zero profitability in the business model. Rather, dealer trading imputes hidden tariffs. As an investor, I would rather see charges

assessed explicitly. Why should the SEC sit as judge as to what constitutes reasonable charges?

One could argue that competing venues should be able to charge whatever fee for

access to a proprietary pool of liquidity would be economically competitive. That

would imply that linkages could not be forced upon centers but that such centers

must be compelled to accept orders from other markets or exchanges. I would expect

that technology integrators would quickly create algorithms allowing me to choose

a trading venue based on price, time and cost of access metrics. If one market’s cost

of access were too high or the system’s response too slow, I would expect liquidity

to migrate to the most dependable, lowest cost, and most secure venue.

The Role of Decimals

The markets currently are digging their heels in on the issue of decimal trading

increments. We remain the only market in the world that continues to rely on centuries old pricing conventions—pieces of eight. At the NYSE, an immediate move

to decimals combined with price time priority, would create significant competitive

pressure on payment for order flow and internalization business models that rely

87

on ‘‘fixed price spreads’’ to support the economics of the business. Within NASDAQ,

we are deeply concerned about the ongoing practice of disseminating public quotes

and customer limit orders in 16’s while professional investors can post limit orders

in increments as fine as 256’s. If Mr. Daytrader can have limit order protection for

one 256, shouldn’t we allow Mr. Smith to buy the same protection for one penny?

We would argue that a move to decimals would simplify NASDAQ and once again

unify quotes, trades and trade reports at the same increment while lowering trading

costs for all investors. (see exhibit 8)

Summary and Conclusions

We believe that true competition among markets and among quotes may be

harmed by mandated linkages—without the complete reform of anti-competitive

structures like ITS and the elimination of order internalization practices by dealers,

brokers and exchanges.

We believe that a ‘‘hard CLOB’’ or central limit order book which consolidates all

orders in disparate venues is undesirable and would be subject to a single point of

technology failure. That said, we encourage the virtual development of a market

that guarantees investors:

• Anonymity of orders entered within a system;

• Time priority of orders entered at a price;

• Full, but anonymous, disclosure of the supply and demand schedule;

• Integration of price discovery, execution and transaction reporting.

We believe that price and time priority structures within markets and an intermarket ‘‘price improvement’’ feature would be beneficial to investors. That rule

would allow internalization of market orders only at prices better than those quoted

among competing market centers—even a penny of price improvement changes the

economics of the payment for order flow business.

We believe that truly competing markets and exchanges should be required to accept non-intermediated, electronic orders from other exchanges or markets; furthermore each market center should be free to establish the cost for access to that market.

True competition often creates fear and uncertainty. We must not fear such competition in the structure of the capital markets. Thank you for the opportunity to

share my thinking with this subcommittee.

88


G:\GRAPHICS\63803.001
89


G:\GRAPHICS\63803.002
90


G:\GRAPHICS\63803.003
91


G:\GRAPHICS\63803.004
92

Mr. OXLEY. Thank you.

Ms. Stark.

STATEMENT OF HOLLY A. STARK

Ms. STARK. Chairman Oxley, I would like to thank you and the

other distinguished members of the subcommittee for allowing me

the opportunity to share my views on the evolving structure of the

U.S. equities markets.

My name is Holly Stark, and I serve as the director of trading

for Kern Capital Management, LLC, a privately held investment

advisor in New York, managing in excess of $2 billion. Our specialty is small and microcap growth investing. We act as subadvisor

for a number of mutual funds as well as manage assets for a roster

of clients ranging from ERISA plans to college endowments.

I would like to talk a little bit about fragmentation, internalization, and transparency. Fragmentation has emerged recently as a

major issue in the equities markets with the SEC publishing a concept release soliciting the views of market participants on the subject. Fragmentation occurs when orders trade in multiple market

venues without interaction with each other. Some have argued that

fragmentation has increased with the emergence of multiple ECNs,

as an investor must search out many market places including those

of ECNs where a stock might trade to determine the best price and

access sufficient liquidity to complete the trade.

In a fast-moving volatile market, this exercise becomes extremely

difficult, and the difficulty increases with the size of the trade.

However, functionality has been introduced by a number of ECNs

to permit a trader to access orders across multiple venues so that

those fragmented bids or offers are readily available to execute


G:\GRAPHICS\63803.005
93

against. What these tools do not offer is the ability to access orders

that are internalized by broker dealers.

Internalization occurs when broker dealers do not expose their

orders to the marketplace. They are able to buy on the prevailing

bid or sell on the offer capturing the posted spread while never accessing or interacting with limit orders displayed in the marketplace. The investor who has posted the limit order has in effect set

a price for other investors to trade at, though he himself will not

participate in any volume that trades at his displayed price. The

limit order investor may even have set a new bid or offer when entering his order, but internalization practices preclude him from receiving an execution. The stock will, in effect, trade around him;

and he may never fill his order at his publicly displayed price.

Have the investors whose orders are internalized received best

execution? Has the limit order investor been treated equitably?

Such practices more so than the existence of multiple ECNs reduce

market efficiency and serve to fragment the market. If an investor

is hesitant to display a limit order for fear that his order may

never be executed, market transparency, depth and liquidity may

well be compromised.

Certainly broker dealers are not required to display market orders. They must execute the order at the best available price in the

market. With the adoption of the display rule by the SEC in 1996,

broker dealers and market makers are required immediately upon

receipt of a customer’s qualified limit order to display the order in

their quote if it improves the price or adds to the size of their

quote. If the order is not displayed, it must be executed or routed

to other market centers for display or execution.

But on May 4, 2000, the SEC released a report describing violations by both market makers and specialists in their handling of

customer limit orders. The violations included failure to display

proper order size and failure to display orders within 30 seconds

after receipt. Surprisingly, the report concluded that the SROs’ surveillance and enforcement of limit order handling was not up to

par. Without required limit or display, limit order buyers and sellers might be dissuaded from placing such orders, compromising

market transparently and ultimately liquidity.

An investor who publicly displays limit order is not guaranteed

an execution even if a stock trades at his price because provisions

for price and time priority across markets do not exist. In

NASDAQ, the first dealer displaying the best bid offer has no priority over other dealers displaying the best bid or offer—the same

bid or offer. On the New York Stock Exchange, orders on the specialist book do receive price and time priority status, but floor brokers may participate in executions that would satisfy orders on the

book, in effect jumping the cue that is on the specialist book.

The floor brokers standing in the crowd do not have to publicly

display to the greater market place their trading intention. They

can merely go along with other participants and benefit from the

price discovered by limit order investors. Because of such actions,

some have called for the creation of a central limit order book, or

CLOB, that would consolidate all orders in one trading venue with

strict time and price priority. Launching a national CLOB would

be problematic. Who would create it and maintain it? Who would

94

1 Securities Exchange Act Release No. 42450 (February 23, 2000) 65 FR 10577 (February 28,

2000) (‘‘Concept Release’’)

pay for it? Who would regulate it? If all market participants were

required to participate, would reliance on a single point of entry

risk market failure should that point of entry be disabled? Would

the fostering of innovation in market structure be compromised?

Instead, a more workable solution would be to encourage intermarket linkages that provide for strict price and time priority and

preclude any one market center or participant from controlling the

linkages.

Technology would allow for the creation of a virtual limit order

book that could satisfy the need for price/time priority across markets without relying upon a single entity to establish and maintain

the linkage.

I would like to make one comment about decimals. U.S. markets

have the dubious distinction of being the only markets in the world

that still trade in fractions. Decimals are far easier to comprehend.

Decimals are already the preferred means of operating on many institutional trading desks. Prices reported in fractions are immediately converted into decimals when executions are entered into

order management systems. Realtime prices flow from quote vendors into order blotters in decimals. Stocks are cleared in decimals

and the trades are cleared in decimals. While it is critical that all

market systems are able to handle anticipated increase message

and quote traffic, every reasonable effort should be made to move

ahead on decimal pricing sooner rather than later.

Thank you.

[The prepared statement of Holly A. Stark follows:]

PREPARED STATEMENT OF HOLLY A. STARK, DIRECTOR OF TRADING, KERN CAPITAL

MANAGEMENT, LLC

I would like to thank Chairman Oxley and the other distinguished members of

the Subcommittee for allowing me the opportunity to share my views on the evolving structure of the US equities markets. My name is Holly Stark, and I serve as

the Director of Trading for Kern Capital Management LLC, a position I have held

since the end of February. Kern Capital is a privately held investment advisor in

New York managing in excess of $2 billion. Our specialty is small and micro cap

growth investing. We act as sub-advisor for a number of mutual funds as well as

manage assets for a roster of clients ranging from ERISA plans to college endowments. My trading experience spans 18 years, and I have served on advisory committees at the New York Stock Exchange, the American Stock Exchange, and

Nasdaq. I currently serve on Nasdaq’s Quality of Markets Committee and the Investment Company Institute’s Equity Advisory Task Force.

The US equities markets have changed dramatically during my tenure as a trader, with many positive changes taking place in the last few years. However, as I

have become more familiar with the intricacies of market structure and the sometimes-arcane rules that govern our markets, I strongly believe that more change is

necessary, especially if we are to maintain our global preeminence versus other

world equities markets. While some may consider the changes to be seismic, others

view it as evolutionary. Whatever the characterization, the impact of technology,

competition, and new rules that govern our markets will result in profound changes

that will result in meaningful reform.

Market Fragmentation, Internalization and Transparency

Fragmentation has emerged recently as a major issue in the equities markets,

with the SEC publishing a concept release 1 soliciting the views of market participants on the subject. Fragmentation occurs when orders trade in multiple market

venues without interacting with each other. Some have argued that fragmentation

has increased with the emergence of multiple ECN’s, as an investor must search out

many marketplaces, including those of ECN’s, where a stock might trade to deterVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00098 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
95

mine the best price and access sufficient liquidity to complete the trade. In a fastmoving, volatile market, this exercise becomes extremely difficult, and the difficulty

increases with the size of the trade. However, functionality has been introduced by

a number of ECN’s to permit a trader to access orders across multiple venues, so

that those ‘‘fragmented’’ bids or offers are readily available to execute against. What

these tools do not offer is the ability to access orders that are internalized by brokerdealers.

Internalization occurs when broker-dealers do not expose their orders to the marketplace. They are able to buy on the prevailing bid and sell on the offer, capturing

the posted spread, while never accessing or interacting with limit orders displayed

in the marketplace. The investor who has posted the limit order has in effect set

a price for other investors to trade at, though he himself will not participate in any

volume that trades at his displayed price. The limit order investor may even have

set a new bid or offer when entering his order, but internalization practices preclude

him from receiving an execution—the stock will ‘‘trade around’’ him, and he may

never fill his order at his publicly displayed price. Have the investors whose orders

are internalized received best execution? Has the limit order investor been treated

equitably? Such practices, more so than the existence of multiple ECN’s, reduce

market efficiency and serve to fragment the market. If an investor is hesitant to

display a limit order for fear that his order may never be executed, market transparency, depth and liquidity may well be compromised.

Certainly, broker-dealers are not required to display market orders; they must

execute the order at the best available price in the market. With the adoption of

the Display Rule by the SEC in1996, broker-dealers and market makers are required to immediately, upon receipt of a customer’s qualified limit order, display the

order in their quote if it improves the price or adds to the size of their quote.

If the order is not displayed, it must be executed or routed to other market centers for display or execution. On May 4, 2000, the SEC released a report (Press Release 2000-59) describing violations by both market makers and specialists in their

handling of customer limit orders. The violations included failure to display proper

order size and failure to display orders within 30 seconds after receipt. Surprisingly,

the report concluded that the SRO’s surveillance and enforcement of limit order

handling was not up to par.

SEC Chairman Levitt has been a consistent supporter of limit orders and their

proper display. He is quoted in the release, ‘‘Limit orders have been a powerful force

for competition in our markets—narrowing spreads, increasing transparency, and

supplying liquidity. The report’s findings of neglect and inattention on the part of

some market participants to display requirements should be a wake-up call. Market

participants must redouble their commitment to ensure that the full power of limit

orders is felt in our markets. Their effect on the price setting process simply cannot

be compromised.’’ Without required limit order display, limit order buyers and sellers might be dissuaded from placing such orders, compromising market transparency and ultimately liquidity.

Central Limit Order Book and Price/Time Priority

As discussed above, an investor who publicly displays a limit orders is not guaranteed an execution, even if stock trades at his price, because provisions for price and

time priority across markets do not exist. The order has no priority over other orders entered later, and market centers are not obligated to route orders that would

fill the investor limit order to another market center. In Nasdaq, the first dealer

displaying the best bid or offer has no priority over other dealers displaying the

same bid or offer. On the New York Stock Exchange, orders on the specialist book

do receive price and time priority status, but floor brokers may participate in executions that would satisfy orders on the book, in effect jumping the queue that is on

the specialist book. The floor brokers, standing in the crowd, do not have to publicly

display to the greater market their trading intention. They can merely ‘‘go along’’

with other participants and benefit from the price ‘‘discovered’’ by limit order investors.

Because of such actions, some have called for the creation of a central limit order

book, or CLOB, that would consolidate all orders in one trading venue, with strict

price/time priority in force. Nasdaq’s proposed Super Montage is a laudable initial

step in the right direction to provide price and time priority for limit orders, and

to permit display of a more complete picture of trading interest, not only at the inside quote, but at prices several increments away from the best bid or offer. Most

ECN’s already permit a complete ‘‘look at the book’’ for their users, and all market

centers and trading venues should be required to permit such information to be

readily disseminated to investors. While the institution of the Super Montage will

96

help to further transparency and fairness in the Nasdaq market, it is not a panacea,

as it permits internalization of customer orders by broker-dealers

Launching a national CLOB would be problematic. Who would create and maintain it? Who would pay for it? Who would regulate it? If all market participants

were required to participate, would reliance upon a single point of entry risk market

failure should that single point of entry be disabled? Would the fostering of innovation in market structure be compromised? Instead a more workable solution would

be to encourage intermarket linkages that provide for strict price and time priority—and preclude any one market center or participant from controlling the linkages. Technology would allow for the creation of a ‘‘virtual’’ limit order book that

could satisfy the need for price/time priority across markets without relying upon

a single entity to establish and maintain the linkage.

Web sites currently exist that will search other sites for the best price on a particular book or model of computer, with the purchase of the book or computer completed with several mouse clicks. A buyer might choose one web site over another

because one is easier to navigate, or has a better delivery timetable. It is not hard

to envision similar tools, with appropriate regulatory safeguards in place, available

to all investors. Investors would be able to access all market centers and pools of

liquidity, without necessitating the intervention of a dealer. Would physical trading

floors still be needed? If they can provide innovative trading solutions for market

participants while not hampering fair and equal access, there is no reason that

physical trading floors cannot coexist with electronic markets. The key, however is

to ensure that price/time priority is afforded to all participants.

Decimal Pricing

The phase-in of decimal pricing beginning July 3, 2000 that was ordered by the

SEC at the end of January has been suspended due to Nasdaq’s lack of preparedness to accommodate decimal prices in their systems by the target date. In requesting the delay, NASD Chairman Frank Zarb pointed out that Nasdaq volume levels

have more than doubled and Nasdaq quote message traffic that has more than tripled since 1998.

US markets have the dubious distinction of being the only markets in the world

that still trade in fractions. Decimals are far easier to comprehend—not many know

the decimal equivalent of 17/32’s or 59/64’s without resorting to a calculator. Decimals are already the preferred means of operating on many institutional trading

desks. Prices reported in fractions are immediately converted into decimals when

executions are entered into order management systems employed by the buy side.

Real-time prices that flow from quote vendors into electronic blotters appear as decimals, not fractions, and end-of-day average prices are reported in decimals. Trades

are cleared in decimal prices. While it is critical that all market systems are able

to handle anticipated increased message and quote traffic, every reasonable effort

should be made to move to decimal pricing sooner rather than later.

Conclusion

Technology can and should play an important role in determining the future

structure of our markets. Market integration using technological innovation should

be a priority, and regulatory bodies must weigh carefully their role to oversee and

regulate markets while not hampering market reform. Entrenched practices that

are detrimental to fair access of markets by all participants must be reformed. Systems and linkages that allow for true price and time priority across markets, full

but anonymous display of supply and demand, and a means of allowing unfettered

price discovery must be encouraged. Internalization, without price improvement,

must be discouraged, while the display of limit orders that add depth and transparency to the market must be afforded the opportunity to interact with all participants.

Perhaps the changes we face are in fact seismic and not evolutionary. It is conceivable that a better, faster, fairer and cheaper exchange platform that is owned

by a foreign entity could become a significant force in the trading of US equities.

We must not let that earthquake happen, but if significant changes are not made

in the structure of markets as they exist today, we run the risk of losing our place

as the world’s leader in equities trading.

Thank you for the opportunity to share my views with this subcommittee, and I

would be pleased to answer any questions that you may have.

Mr. OXLEY. Thank you.

Mr. McSweeney.

97

STATEMENT OF ROBERT J. McSWEENEY

Mr. MCSWEENEY. Chairman Oxley and members of the subcommittee, thank you for the opportunity to testify this morning.

The New York Stock Exchange appreciates the leadership on these

complex issues and remains committed to assisting in your deliberations. This ongoing debate is extremely important and will

strengthen the competitive position of our Nation’s equity markets.

Chairman Oxley, much of my testimony will focus on issues that

are discussed in detail in the exchanges market structure report.

A copy of that report is appended to my testimony, and I ask that

it be included in the record as part of my complete statement.

Mr. OXLEY. Without objection.

Mr. MCSWEENEY. A special committee of the NYSE’s board of directors composed entirely of public directors produced the report

which lays out a blueprint that will allow the NYSE to evolve into

a platform for customer choice. We have labeled this continuous

process of reinvention ‘‘network NYSE.’’ The NYSE must provide a

market structure that offers investors the best execution of their

orders. One which is flexible enough to accommodate multiple investor objectives including best price, the opportunity for price improvement, and low costs as well as speed and certainty of execution.

By next year, the NYSE will unveil two order execution systems

that will empower investors with greater choices as to how to access the NYSE’s unrivaled depth of liquidity, Institutional Xpress

and NYSE Direct+. Institutional Xpress will allow institutional investors new ways of accessing the NYSE floor. NYSE Direct+ will

make available automatic execution of smaller trade.

A related initiative will soon be on-line which is virtual NYSE,

a realtime virtual representation of the exchange floor. A fourth

initiative will provide investors access to each specialist book of

limit orders. The NYSE supports the phasing out of three components of the National Market System, NMS. The Intermarket Trading System, commonly referred to as ITS, should be replaced by industry initiatives to ensure investor access to the best available

price.

Second, the Consolidated Tape Association, or as it is known,

CTA; and the Consolidated Quotation System, commonly referred

to as CQ, should be replaced by market-based initiatives. ITS,

CTA, and CQ have all played an important role in fostering intermarket competition, and we are not suggesting the elimination of

the consolidated data or connectivity.

While the NYSE remains dedicated to the goals of the National

Market System, we no longer believe that ITS, CTA, and CQ are

needed to secure those goals. The philosophy of competing markets

embodied in the National Market System have served investors

well. We believe, however, that developments in communications

technology have eliminated the need for a government-mandated

intermarket order routing system such as ITS. The combination of

21st century technology with the fiduciary obligation of brokers to

achieve best execution, warrants a different approach today from

the solutions from a quarter of a century ago. Today, the electronic

systems developed by broker dealers themselves make equities

98

trading a global operation. When there are insufficient linkages,

market participants will create their own superior linkages.

To the extent policymakers believe that ITS continues to be needed, membership should require self-regulatory status as approved

by the SEC. Broker dealers should link to ITS only through SROs

participating in the ITS plan. This is essential in maintaining the

integrity of our markets, and governance should be consistent with

allowing each market to retain control over its own business model.

In addition, if a market executes a majority or even a substantial

minority of its orders through the ITS, it is probable that those entering orders on the alternative system are doing so primarily to

free ride the liquidity of the competing markets. The NYSE and

other ITS participants should not be subject to free riding. NYSE

membership is valuable because of the benefits it confers, namely,

access to the world’s most liquid marketplace.

CTA and CQ are two other NMS systems that we believe should

be phased out. Market data must be consolidated and should be

done at the vendor level by competing consolidation services. At the

same time, each market should have the right to market its data

based upon the inherent value of that data. While we believe that

the SEC has a continuing role in ascertaining that these prices are

fair and reasonable, we believe that the market participants are

best suited to judge the value of that information for themselves.

The NYSE continues to be concerned about practices like payment for order flow and internalization. We believe that these practices promote unproductive fragmentation, diminished price discovery, and can benefit intermediaries at the expense of investors.

Much of the debate over the future of the markets has focused on

CLOBs. The NYSE would not support such a monolithic trading

system. We believe it would result in two separate pools of liquidity

for retail and investor order flow and would increase market volatility.

We should maintain our primary goal, the achievement of marketplace connectivity, with competing arenas for order flow and

guaranteeing best system-wide pricing as our standard. It is essential that best execution fostered by connectivity and transparency

dictate where a customer’s order is executed. The NYSE is committed to the plan of action they have outlined for you. Our competitive position demands nothing less. Implementation of cutting

edge technology is part of the plan. Equally important is permitting

technology to provide market-based answers to problems that once

demanded government solutions.

Mr. Chairman, I ask that my complete statement be entered in

the record and of course would gladly answer whatever questions

you or the members may have.

[The prepared statement of Robert J. McSweeney follows:]

PREPARED STATEMENT OF ROBERT J. MCSWEENEY, SENIOR VICE PRESIDENT, NEW

YORK STOCK EXCHANGE, INC.

Chairman Oxley, Congressman Towns, and Members of the Subcommittee, thank

you for the opportunity to testify this morning. The New York Stock Exchange appreciates your leadership on these complex issues, and remains committed to assisting your deliberations. This ongoing debate is extremely important and will

strengthen the competitive position of our nation’s equities markets.

99

Network NYSE—a platform for customer choice

Chairman Oxley, much of my testimony will focus on issues that are discussed

in detail in the Exchange’s Market Structure Report. A copy of that Report is appended to my testimony and I ask that it be included in the record as part of my

complete statement.

A Special Committee of the NYSE’s Board of Directors, composed entirely of public directors produced the Report, which lays-out a blueprint that will allow the

NYSE to evolve into a platform for customer choice. We’ve labeled this continuous

process of reinvention ‘‘Network NYSE.’’ The NYSE must provide a market structure that offers investors the best execution of their orders; one which is flexible

enough to accommodate multiple investor objectives—including best price, the opportunity for price improvement and low costs, as well as speed and certainty of execution.

By next year, the NYSE will unveil two order execution systems that will empower investors with greater choices as to how to access the NYSE’s unrivalled

depth of liquidity—Institutional Xpress and NYSE Direct+. Institutional Express will

allow institutional investors new ways of accessing the NYSE floor. NYSE Direct+

will make available automatic execution of smaller trades. A related initiative that

will soon be online is Virtual NYSE, a real-time virtual representation of the Exchange floor. A fourth initiative will provide investors access to each specialist’s book of limit orders.

The National Market System

The NYSE supports the phasing-out of three components of the National Market

System (‘‘NMS’’). The Intermarket Trading System (commonly referred to as ‘‘ITS’’)

should be replaced by industry initiatives to ensure investor access to the best available price. Second, the Consolidated Tape Association (or as it known ‘‘CTA’’) and

the Consolidated Quotation System (commonly referred to as ‘‘CQ’’) should be replaced by market-based initiatives. ITS, CTA and CQ have all played important

roles in fostering inter-market competition, and we are not suggesting the elimination of consolidated data or connectivity. While the NYSE remains dedicated to

the goals of the National Market System, we no longer believe that ITS, CTA and

CQ are needed to secure those goals.

The philosophy of competing markets embodied in the National Market System

has served investors well. We believe, however, that developments in communications technology have eliminated the need for a government-mandated intermarket

order-routing system such as ITS. The combination of 21st Century technology with

the fiduciary obligation of brokers to achieve best execution warrants a different approach today from the solutions of a quarter century ago.

Today, the electronic systems developed by broker-dealers themselves make equities trading a global operation. When there are insufficient linkages, market participants will create their own superior linkages.

To the extent that policy makers believe that ITS continues to be needed, membership should require self-regulatory status as approved by the SEC. Broker-dealers should link to ITS only through SROs participating in the ITS plan. This is essential to maintaining the integrity of our markets, and governance should be consistent with allowing each market to retain control over its own business model.

In addition, if a ‘‘market’’ executes a majority, or even a substantial minority, of

its orders through the ITS, it is probable that those entering orders on that alternate system are doing so primarily to ‘‘free-ride’’ the liquidity of competing markets.

The NYSE and other ITS participants should not be subject to free-riding. NYSE

membership is valuable because of the benefit it confers—namely, access to the

world’s most liquid marketplace.

CTA and CQ are two other NMS systems that we believe should be phased-out.

Market data must be consolidated—but that can and should be done at the vendor

level by competing consolidation services. At the same time, each market should

have the right to market its data, based on the inherent value of that data. While

we believe that the SEC has a continuing role in ascertaining that these prices are

fair and reasonable, we believe that market participants are best-suited to judge the

value of that information for themselves.

Other issues

The NYSE continues to be concerned about practices like payment for order flow

and internalization. We believe that these practices promote unproductive fragmentation, diminished price discovery, and can benefit intermediaries at the expense of investors.

Much of the debate over the future of the markets has focused on ‘‘CLOBs.’’ The

NYSE would not support such a monolithic trading system. We believe that it would

100

result in two separate pools of liquidity for retail and institutional order flow, and

would increase market volatility. We should maintain as our primary goal the

achievement of marketplace connectivity—with competing arenas for order flow and

guaranteeing best system-wide pricing as our standard. It is essential that best execution, fostered by connectivity and transparency, dictate where a customer’s order

is executed.

Conclusion

The NYSE is committed to the plan of action that I have outlined for you. Our

competitive position demands nothing less. Implementation of cutting-edge technology is part of the plan. Equally important is permitting technology to provide

market-based answers to problems that once demanded government solutions.

Mr. Chairman, I ask that my complete statement be entered in the record, and

of course, would gladly answer whatever questions you or the members may have.

Mr. OXLEY. Thank you, Mr. McSweeney.

Mr. Ketchum?

STATEMENT OF RICHARD G. KETCHUM

Mr. KETCHUM. Thank you, Chairman Oxley. I want to thank

very much the committee for giving me the opportunity to testify

on the competition of the new electronic market, and I want to

compliment you, Mr. Chairman, on focusing attention on these

critically important issues.

In today’s trading environment, investors want to know in

realtime the prices at which securities can be bought and sold.

They want that information simple and in one place, and they want

rapid executions at the lowest cost possible. The NYSE believes

that transparency, execution quality, and competition among intermediaries and markets will propel the market overall to fulfill

these fundamental principles.

The SEC’s order-handling rules took a major step in enhancing

market transparency by requiring the customer limit orders be displayed immediately. In the NASDAQ market, these rules have

helped to enhance transparency, increase competition, narrow

quotation spreads and meet market makers and ECNs and their

customers. NASDAQ’s market structure also provides open, efficient, and quick access to deep pools of liquidity. NASDAQ promotes price discovery through a system where multiple market

makers risk their capital and compete for order flow.

We believe that this competition combined with immediate electronic executions has been critical to NASDAQ’s ability to respond

to the speed and market liquidity demands posed by the explosion

of on-line trading. NASDAQ is also the only market in the United

States which fully integrates ECNs, those entities which open their

electronic books to investors and allow them to advertise prices at

which they are willing to trade. Investors benefit directly from this

innovation and competition through dramatically reduced commissions and other trading costs.

In fact, I also want to compliment you and indicate how pleased

I am to participate on this panel with representatives from both

the investor community and the broker community, all of which either directly or through their firms provide an important contribution to the NASD and NASDAQ in evaluating many of these issues.

While NASDAQ has been successful in integrating both ECNs

and market makers into a single highly transparent high speed environment, additional progress should be made. That is why

NASDAQ has proposed the addition of an order display window,

101

often referred to as the Super Montage. In today’s market environment of multiple ECNs, lower trading increments, and on-line trading, it is not enough to provide a consolidated picture of just the

best bids and offers. The Super Montage, which is pending approval by the SEC, will allow market participants to view the best

bid and offer and two price levels away.

Market makers and ECNs will be permitted, but not required, to

display their customer and proprietary orders at each of these price

levels. Super Montage also will be open to any exchange wishing

to compete in NASDAQ securities. The Super Montage should help

to reduce fragmentation and enhance transparency by encouraging

investors to show greater size in the NASDAQ market and allowing

market participants to see a more complete view of the depth of

that market. I should note in that connection that, indeed, as was

stated earlier, with respect to the real parties at interest, the investors, it is interesting to note that a recent independent study developed and conducted by the institutional committee of the Stock

Traders Association, 89 percent of those responding to the study,

those institutional investors, favored the implementation of the

Super Montage without suggesting that they may also favor additional market structure changes in the market.

The Super Montage is built on the general premise that orders

placed in the system should be executed based on price and time

priority. I would believe that strict adherence to price time priority

across all markets, market makers, and ECNs would unnecessarily

limit broker dealers flexibility to provide a complete mix of execution services to meet their customers’ needs. This flexibility is particularly critical in the new on-line trading world where investors

demand immediacy, low cost, and liquidity. The NASD believes the

Super Montage will provide, at least as a first step, a preferable

market structure solution to fragmentation than more radical

structural changes such as proposals to implement a consolidated

limit order book, or CLOB, which would remove some of the flexibility to innovate the market professionals now have.

In sum, we believe that to satisfy investors needs in the e-commerce world, market structure must be both open and inclusive,

not closed and exclusive. NASDAQ Super Montage is open and inclusive and, therefore, responds to investors’ needs.

Again, I want to thank the subcommittee for allowing me to come

here today, and I would be happy to answer any questions.

[The prepared statement of Richard G. Ketchum follows:]

PREPARED STATEMENT OF RICHARD G. KETCHUM, PRESIDENT, NATIONAL ASSOCIATION

OF SECURITIES DEALERS, INC.

INTRODUCTION

I want to thank the Committee for giving me the opportunity to testify on competition in the new electronic market. As a pioneer of electronic commerce, Nasdaq

has been at the forefront of the electronic commerce revolution. It is no coincidence

that many of the companies that are leading this revolution—Intel, Microsoft, Cisco

Systems, Yahoo!, Dell, and Amazon.Com—to name just a few, choose to list on

Nasdaq. These pioneers of the electronic age understand that for electronic commerce to flourish, it must be conducted in an atmosphere that promotes robust competition and innovation. What is true for the marketplace at large is equally true

for U.S. capital markets. To promote vibrant capital markets, we must ensure that

they remain transparent, provide a fair and efficient means for investors to access

deep pools of liquidity and remain open to innovation.

102

I believe that Nasdaq’s success is a testament to its ability to provide such a market structure. Indeed, Nasdaq currently accounts for more than one-half of all equity

shares traded in the nation and is the largest stock market in the world in terms

of dollar value of shares traded. Nasdaq lists the securities of over 4,700 domestic

and foreign companies, more than all other U.S. stock markets combined. There are

over 70 million investors in Nasdaq companies. In the first quarter of 2000 Nasdaq’s average daily volume reached a record of 1.8 billion shares, an increase of 81.8 percent from the first quarter of 1999 and a gain of 33.6 percent from the fourth quarter of 1999. On February 17, 2000, Nasdaq’s volume exceeded two billion shares for

the first time. Subsequently, Nasdaq experienced nine additional days in the first

quarter of 2000 when daily volume surpassed 2 billion shares.

I believe that Nasdaq has achieved this success by providing a high speed, electronic market that is open to all market participants, is transparent, encourages

competition, and promotes innovation. I posit that these attributes should serve as

yardsticks by which we measure how successful our securities markets are in promoting the capital formation that is fueling the electronic age. Today I will discuss

some of the ways in which I believe that Nasdaq’s current market structure helps

to promote competition in the electronic market. In addition, I will discuss some of

the innovations Nasdaq is developing to better serve the needs of all market participants.

OVERVIEW—WHAT DO INVESTORS WANT

In today’s trading environment, as always, investor interests are paramount. Investors want to know in real time the prices at which securities can be bought and

sold. They want that information assembled in one place, so that they have complete

information on which to make a trading decision. When an investor decides to trade,

he or she expects to be able to obtain a rapid execution at the best displayed price

and at the lowest cost possible. Thus, the markets and their intermediaries need

to create structures and systems that facilitate these investor demands. The NASD

believes that transparency, execution quality, and competition among intermediaries

and markets will propel the market overall to fulfill these fundamental principles.

The NASD firmly believes that, as explained below, Nasdaq provides to investors

today what others are trying to build for tomorrow.

TRANSPARENCY

Transparency is one of the keys to Nasdaq’s success. Transparency is the ability

of market participants to determine from all markets the best available price and

the size or depth of that interest. Transparency is critical to the maintenance of fair

and orderly markets and is a key to the success of any market structure. The SEC’s Order Handling Rules require that customer limit orders be displayed immediately.

The enhanced transparency brought about by these rules has increased competition

in the Nasdaq Stock Market by allowing customers that choose to do so to set the

inside quotation spread. This increased competition naturally reduces quotation

spreads and allows investors to obtain better prices for their securities.

The Order Handling Rules also help to ensure that no matter where a limit order

is displayed, whether it be in Nasdaq or in an Electronic Communications Network

or ECN, that order will be accessible to all investors. Gone are the days when ECNs

stood as ‘‘private markets’’ for the fortunate few where large institutions and market

professionals could access better prices than were available to the public at large.

The Order Handling Rules have helped Nasdaq to link market makers and ECNs

and all of their customers to ensure that the best prices for Nasdaq securities are

publicly disseminated.

OPEN, EFFICIENT AND QUICK ACCESS TO LIQUIDITY

Another key component of Nasdaq’s market structure that promotes competition

and capital formation is its ability to provide open, efficient and quick access to deep

pools of liquidity. It is not enough that investors see the best prices that are available in the market. They must also be able to obtain those prices and do so quickly

at a low cost. Nasdaq’s market structure provides all of these benefits. Nasdaq was

founded on the premise that the best way to promote price discovery in the securities markets is through a system where multiple market makers risk their capital

and compete for order flow. This competition combined with every broker-dealer’s

responsibility to obtain best execution for its customers’ orders was viewed as the

optimal way to create a fair and efficient marketplace. Nasdaq’s system is also open

to ECNs, which open their electronic order books to investors and allow those investors to advertise prices at which investors and market professionals are willing to

trade. No other market in the world has set up a structure like this.

103

By linking competing dealers and ECNs electronically rather than through a

physical trading floor, Nasdaq helps to ensure that spatial considerations alone are

not a factor in determining the number of firms that may provide liquidity to the

Nasdaq market. As a result, Nasdaq has dozens of competing market makers and

ECNs in many of its most actively traded stocks, which provide dozens of sources

of liquidity and dozens of opportunities for innovation. Investors have benefited directly from this innovation and competition through dramatically reduced commissions and other trading costs.

Moreover, through its various facilities, Nasdaq provides a broad array of choices

for investors to access the pools of liquidity provided by Nasdaq’s multiple market

makers and ECNs. For over a decade, investors have been able to obtain what is

often an instantaneous electronic execution of an order at the best publicly displayed price through Nasdaq’s Small Order Execution System or SOES. Since 1997,

Nasdaq’s SelectNet system has allowed market participants to rapidly and electronically reach the quotations displayed in Nasdaq’s deep and abundantly populated

Quote Montage. This year, Nasdaq is enhancing SOES to provide for automatic execution of orders up to 9900 shares and to allow market professionals to enjoy automatic executions. We are confident that SuperSOES will be a great boon to investors by helping them to receive automatic executions for large orders at a single

price.

But investors that wish to obtain a rapid automatic execution are not limited to

the SOES system. Under Nasdaq’s approach to its market structure, individual market makers have the flexibility to offer their own automatic execution guarantees

and often are willing to do so for size that exceeds that which is displayed in the

market. In this way, market liquidity and efficiency of execution are enhanced dramatically for investors using the services of these market makers.

For investors who are more interested in seeking price improvement than an

automatic execution at the best publicly displayed price at a given time, Nasdaq will

continue to provide SelectNet, its facility for negotiating prices. SelectNet will also

continue to play the important role of linking ECNs to the Nasdaq market. Like

market makers, ECNs provide an important source of liquidity for Nasdaq stocks.

ECNs also provide innovative means for moving securities positions, not the least

of which is anonymity. By trading anonymously institutions and other large investors, such as pension funds, can trade in and out of large positions without signaling

other market participants and thereby risk impacting a security’s price to the investor’s detriment.

SUPER MONTAGE

While I believe that Nasdaq’s market structure is the best suited for promoting

competition in an electronic age, I also understand that its continued success depends on its ability to remain innovative and adapt to the ever-changing marketplace. To help Nasdaq stay at the forefront of e-commerce, it is developing a number

of innovations that are designed to improve Nasdaq’s market structure. One of the

more important of these is known as the ‘‘Super Montage.’’

The Super Montage, which is pending approval by the SEC, will allow market

participants to view the best bid and offer and two price levels away from the best

bid and offer in Nasdaq securities. Market makers and ECNs will be permitted but

not required to display their customer and proprietary orders at each of those price

levels. The Super Montage also will permit exchanges granted Unlisted Trading

Privileges to Nasdaq securities (‘‘UTP Exchanges’’) to display their customer orders

at each of those price levels.

The Super Montage also will permit market participants to indicate a reserve size

for an order, which is additional depth that is ‘‘in the wings’’ so to speak, waiting

for the right market conditions before it will be available for interaction with other

trading interest. Reserve size should help to bring larger orders, which are now

often executed ‘‘upstairs,’’ down to interact with the rest of the marketplace.

While participation in the Super Montage is voluntary, Nasdaq is confident that

its many advantages will encourage a broad range of market participants to use the

system. For instance, the system should help to reduce fragmentation by allowing

market participants to transmit to Nasdaq multiple levels of orders and aggregate

and dynamically display all orders at the inside price and two price levels away.

The system’s ‘‘non-attributable’’ order feature encourages market participants to

show greater size in Nasdaq, rather than disbursing that size over several trading

venues to avoid adverse market impact. Moreover, market participants will see for

the first time in the Super Montage a more complete view of the depth of the inside

market and two price levels away, thereby enhancing transparency.

104

The SuperMontage is built on the general premise that orders placed in the system should be executed based on price/time priority. At the same time, however, we

believe that strict adherence to the principle of price/time priority across all markets, market makers and ECNs would unnecessarily limit broker-dealers’ flexibility

to provide a creative mix of execution services to meet their customers’ needs in a

manner that is consistent with the duty of best execution. It is Nasdaq’s belief that,

as long as no order is executed at a price worse than that which is publicly displayed, market makers and ECNs should continue to have the flexibility to interact

with their own order flow. We believe that this flexibility is particularly critical in

the new on-line trading world where investors demand immediacy, low cost, and liquidity. Some market makers have responded to these demands by providing guaranteed executions up to two thousand shares at the best bid or offer or better regardless of the displayed quotation size. Some ECNs have responded to these needs

by providing low cost crossing executions in their systems and sophisticated order

routing algorithms into Nasdaq for orders that the ECN cannot execute. These innovations benefit investors daily and care should be taken with respect to any actions

that might deprive investors of these valuable execution services.

With the addition of the Super Montage, Nasdaq will be able to link all markets,

including UTP exchanges, that trade Nasdaq securities. In this way, the Super Montage should encourage competition by providing an open and inclusive model in

which competing market centers may operate. While the Super Montage proposal

provides a central means for accessing liquidity in Nasdaq securities, it in no way

establishes the Nasdaq system as the sole means for providing or accessing liquidity. NASD members (including market makers, ECNs and order entry firms), individual investors, and members of other exchanges will be free to route their orders

to, and access pools of liquidity in, any linked market center trading Nasdaq securities. We believe that all of these attributes make the Super Montage a strong means

for combating what many perceive as a fragmenting of our securities markets.

In this connection, the NASD believes that the Super Montage will provide a preferable market structure solution to fragmentation than more radical structural

changes, such as a composite CLOB. Many variations of a CLOB have been discussed over the past several months. One such approach would effectively link all

markets’ limit order books and dealer quotations by requiring that all displayed

trading interest be executed according to strict price and time priority. Although in

theory executions could occur at the local market level, we believe that in practice

such a proposal would require the creation of a national utility, which would sacrifice marketwide competition at a cost that would outweigh the benefit to be derived from such a proposal.

It is our belief that a system based on strict price/time priority may disadvantage

investors by funneling all market orders toward a single liquidity source, whether

it be a customer limit order or a dealer quotation. Investors would be required to

wait to determine whether they had received an execution. If they did not, they

would be forced to route their orders to the next trading venue that displayed the

best price with time priority. This process of chasing liquidity would slow down the

trading process and greatly reduce the likelihood of obtaining an automatic execution.

A proposed solution to this problem, which we believe would be even more

chilling, would be the creation of a composite CLOB. Unlike Nasdaq’s current market structure and the structure it will enjoy with the Super Montage, however, a

strict price time priority CLOB could not by its nature offer the flexibility for multiple competing liquidity sources, all of which could offer an automatic execution at

a guaranteed minimum size at the best publicly displayed price. Moreover, strict

time priority would preclude market makers from interacting with their own order

flow and therefore remove an important incentive for risking capital and providing

an innovative service mix that includes automatic execution at a minimum guaranteed size.

We believe that Nasdaq’s current market structure and the proposed Super Montage will address many of the concerns raised about fragmentation while continuing

to provide incentives to liquidity providers and choices for liquidity seekers. Because

the Nasdaq system provides incentives for market makers to continuously display

quotations and provide immediate guaranteed executions in size to investors, it has

been able to respond to the revolutionary demands of the online trading world. Mandatory CLOBs and system-wide time priority requirements do not effectively incorporate or provide incentives for multiple market makers and ECNs who now provide

liquidity and immediate executions on Nasdaq, and who thus help to ensure that

investors have quick and easy access to the markets in good times and in bad. In

sum, our view is that to satisfy investor needs in an e-commerce world, market

105

structure must be open and inclusive, not closed and exclusive. Nasdaq’s Super

Montage is open and inclusive and, therefore, responds to investor needs.

OTHER INITIATIVES

In our view, the Super Montage will provide the most benefits to investors and

to market participants if it is carried out under a corporate structure that can respond nimbly to competitive and technological changes in the marketplace. That is

why the NASD Board and its members approved a restructuring plan that is designed to enhance the competitiveness of Nasdaq, while reducing members’ regulatory costs and strengthening NASD Regulation.

Nasdaq is also committed to building on our successful domestic stock market

model internationally. As a result, we continue to explore overseas ventures and alliances with market participants abroad with the ultimate goal of providing investors with rapid, open, low cost access to deep pools of liquidity around the world.

ITS, CQA AND CTA PARTICIPATION BY NON-SROS

Now I would like to turn to two related issues addressed in the Subcommittee’s

invitation letter: the desirability of opening the Intermarket Trading System to

membership by non-self-regulatory organization market participants and whether

the Consolidated Quotation Association and Consolidated Tape Association should

permit competition in market data by non-SROs. First, we share the general frustration of all market participants with ITS, which is clearly technologically outmoded, a trading hindrance that Nasdaq and the Cincinnati Stock Exchange have

been able to reduce somewhat by offering automatic executions for ITS commitment.

As the Subcommittee may know, Nasdaq and its members were hampered for over

twenty years with limited access to all of the securities traded through ITS. Recently, however, the rules restricting Nasdaq’s access to ITS as well as NYSE Rule

390 (which restricted off-board trading of certain listed companies) were rescinded,

thereby creating a more level playing field between Nasdaq and the listed markets.

Therefore, the NASD believes that it is time to make a concerted effort to improve

the way markets access each other. For its part, the NASD has already adopted

rules and developed technology to open its NYSE-listed trading facilities to a broader array of market participants. The NASD has opened its facilities to ECNs as well

as registered market makers and thus opened access to ITS and the Consolidated

Quotation System to ECNs, which may now participate in these systems.

The question raised by the Subcommittee, however, is whether individual brokerdealers, including ECNs, should directly display their quotes and trade in these national market systems. ITS membership is currently limited to the NASD and registered national securities exchanges, all of which are registered with the SEC as

SROs. As such, the SROs are required to establish and maintain regulatory programs to ensure that their members act in accordance with the requirements of the

ITS Plan and the federal securities laws, including the rules of the SROs, which are

adopted under those laws. To open membership to the ITS to entities that are not

subject to those same regulatory safeguards could create a regulatory gap for orders

that are routed through ITS to a non-SRO.

With respect to CTA and CQA membership, the fees that are generated from such

membership are used to offset the costs of regulation. Marketplaces that are not

subject to the same regulatory burden but that enjoy the fees derived from CTA and

CQA membership would enjoy a windfall. The NASD is not, as a matter of principle,

opposed to expanded membership in these National Market System plans, but it

must be done on a level playing field. Thus, if an entity providing a trading venue

wants to operate as a registered SRO, like the other National Market System Plan

participants, it should be able to participate fully in CTA, CQA and ITS. On the

other hand, if that entity determines that its business model is better served by

being a broker-dealer, it should only participate in these plans as a member of one

of the SROs that is a direct participant.

DECIMALS

Finally, I wanted to address the possible benefits that the move to decimals is

likely to have for investors. First, let me say that the NASD’s decision to request

an extension of the SEC’s July 3, 2000, target date for starting the implementation

of decimals was not one that we took lightly. As you know, the NASD supports the

move to decimals. I believe that it should benefit investors by making securities

prices easier to understand and by keeping the U.S. securities markets competitive

with major markets abroad, which quote in decimals already. Therefore, I wanted

to give you my assurance that the NASD is committed to building the necessary caVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00109 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
106

pacity enhancements to ensure that the move to decimals occurs as quickly and

safely as possible.

CONCLUSION

Again I wanted to thank the Subcommittee for allowing me to come here today

to share the NASD’s views on competition in the electronic market. It is a subject

that is at the very core of the existence of the NASD and the Nasdaq Stock Market.

I believe that Nasdaq’s market structure is the best model for continuing to promote

the type of capital formation that has been so important for the development of our

electronic age. I would ask that you join me in encouraging the transparency, openness, and accessibility that have been the hallmark of Nasdaq.

Thank you, and I will be happy to answer any questions that you may have.

Mr. OXLEY. Thank you.

Mr. Jenkins?

STATEMENT OF PETER W. JENKINS

Mr. JENKINS. Chairman Oxley and members of the subcommittee, thank you. I would like to thank you for this opportunity to express my views on competition in the new electronic

marketplace and the structural changes taking place in the equity

markets today. I am director of Global Equity Trading at Scudder

Kemper Investments, managing approximately $280 billion. With

the limited time, though, I have today before this committee, I

would like to focus my attention on three areas that I believe are

most important in shaping the future of the electronic marketplace.

First is protection of limit orders, second is transparency of markets, and the third, of course, is the linkage of the trading venues

and exchanges.

On the protection of limit orders, limit orders are the basis for

pricing securities in the markets today. On the New York Stock Exchange and the regional exchange, limit orders reside on the specialist book. These orders allow for floor brokers to determine

strong levels of supply and demand. They allow specialists and position traders off the floor to make bigger markets for their customers, who allow for greater liquidity for institutional and retail

customers.

The institutional buyside traders rely on the limit orders to help

price blocks of stocks for their clients. These limit orders allow the

institutional trader a reference so we can be realistic when approaching upstairs position traders or specialists when we request

the use of their capital. Limit orders also offer quantitative traders

the ability to size up a market and offer traders over entire portfolios because these orders are firm and real.

In the over-the-counter market, the success of the ECNs was

built on limit orders. Traders from both the buyside and sellside

migrated to these systems because of the existence of those orders

and rules protecting them. Because of the limit order facility, ECNs

have captured greater than 20 percent of the over-the-counter market. Why don’t we try to protect these orders in all venues? These

orders are the backbone of the future virtual marketplace. If protected these orders could be successful in increasing the depth and

structure of the market.

Today, in the listed marketplace when an offer is too large on

one exchange, we allow trades to take place at the same price on

an exchange where there is less depth. On the New York Stock Exchange, we have created rules such as the Clean Cross Rule that

107

allows the trader to shut out a bid or an offer as long as the size

you want to trade is greater, and this rule was actually put in

place to try to keep block flow on that exchange. On the floor of

the New York Stock Exchange after a hundred shares trade at a

specific price, the crowd splits evenly afterwards. Nothing to support price improvement.

In the over-the-counter market, the best bids and offers displayed by dealers as well as the best bids and offers posted on

ECNs is not protected. This practice is known as internalization of

order flow, as stocks are crossed outside of those markets. Close to

a third of all NASDAQ orders are internalized. Wholesalers are

paying for the order flow to trade against the limit orders and markets exposed. This practice has become very profitable for the

wholesalers.

The SROs seem to be protecting this practice instead of encouraging order interaction. If institutional limit orders were given

greater protection, traders would populate these limit order books.

Limit order transparency has been argued for many years. I served

on the New York Stock Exchange Institutional Traders Advisory

Committee as chairman in the early 90’s. A look at the specialist

book was the No. 1 focused topic on that committee for my tenure.

We are just getting around to this issue today. As the markets

move to decimalization, it will be imperative for the institution to

see below the top of the book.

The ECN success is also due to its transparency. The trading information gained through seeing orders interact on the limit order

book allow for the institutional trader to make a more informed

trading decision. Decimalization will move the most liquid stocks to

one penny spreads over time. The volumes will increase as the

spreads tighten. The need to see where the large orders reside will

be most important to the institutional trader. With this depth of

book, inefficiencies of access will erode the competitive positions of

the primary exchange.

Last, linkages, Scudder Kemper Investments supports the concept of a virtual global limit order facility. To achieve this, the most

important aspect of efficient market structure will be the linkage

between the ECNs, the exchanges, and the crossing networks.

Competition will force systems with weak linkage out of business.

Firms with less than adequate technology should not be subsidized

by the industry. To move to a virtual limit order book and to protect limit orders in the different trading venues, linkages need to

be efficient and meet minimum technological standards.

I applaud the New York Stock Exchange for its proposed automatic execution system through Institutional Xpress. Although it is

just the start, institutions as well as retail investors need direct

electronic access to these limit order facilities. If the inefficient

Super Dot system has been a problem and often when transmitting

an order, you do not receive what you expect. ITS links the various

exchange quotes, but does not allow for time priority across its

markets. With the Archipelago and Pacific Coast Stock Exchange

combination, we hope to see the first steps in efficient linked market with price/time priority without the involvement of specialists

or the dealer.

Mr. OXLEY. Would you summarize.

108

Mr. JENKINS. In the long term, Scudder Kemper Investments

would like to see protection across all markets of all limit orders

and price time priority. If the linkages do not allow interaction, we

at the very least would like to see price time priority in each trading venue with trade through rules.

We support a regulatory focus on order interaction. We are concerned with the wholesalers’ increased practice of internalization

without price improvement. This trend could undermine transparency and support for limit order exposure. The fragmentation of

the equity markets is the product of technological innovation and

competition. The industry is dealing with this through electronic

connectivity.

We support speedy conversion to decimals, but decimals without

a fully transparent book will be problematic. The quick move to

decimals will allow for less confusion, tighter spreads, and may

help generate a stronger limit order book. Depth of book use is

needed and should be made available to all market participants.

Thank you very much.

[The prepared statement of Peter W. Jenkins follows:]

PREPARED STATEMENT OF PETER W. JENKINS, MANAGING DIRECTOR, HEAD OF

GLOBAL EQUITY TRADING, SCUDDER KEMPER INVESTMENTS,

Chairman Oxley and members of the subcommittee on Finance and Hazardous

materials, my name is Peter Jenkins, I am the Director of Global Equity Trading

at Scudder Kemper Investments. I would like to thank you for this opportunity to

express my views on competition in the new electronic market place and the structural changes taking pace in the equities markets.

Scudder Kemper Investments leads the Global Investments management business

of the Zurich Financial Group. With more than $280 billion currently under management and almost 80 years of experience Scudder Kemper Investments is among

the world’s largest and most experienced asset managers. Scudder Kemper’s client

base includes institutions, individual investors and financial intermediaries worldwide. We trade equities in sixty-nine different markets around the globe and staff

a 22-hour trading desk out of our offices in New York City.

I have been involved in equity market structure issues since 1988 when I was

asked to be on the NYSE market performance committee, and the NASDAQ institutional Committee. I served as Chairman for both the NYSE Institutional Traders

Advisory Committee and the STA Institutional Committee. I have been trading equities since 1980 and have experienced a great deal change.

With the limited time I have before this committee I would like to focus my attention on three areas that I believe are most important in shaping the future electronic market: 1. Protection of Limit Orders; 2. Transparency of markets; and 3.

Linkage of trading venues and exchanges.

PROTECTION OF LIMIT ORDERS

Limit orders are the basis for pricing securities in the markets today. On the New

York Stock Exchange and the regional exchanges limit orders reside on the specialist book. These orders allow for floor brokers to determine strong levels of supply

and demand. They allow specialists and position traders off the floor to make bigger

markets for their customers who allow for greater liquidity for institutional and retail customers.

Institutional Buyside traders rely on limit orders to help price blocks of stocks for

their clients. These limit orders allow the institutional trader a reference so we can

be realistic when approaching ‘‘upstairs position traders,’’ or specialists when we request the use of their capital.

Limit orders offer quantitative traders the ability to size up a market and offer

trades over entire portfolios, because these order are firm and real.

In the over the counter market the success of the ECN’s was built on limit orders.

Traders from both the buyside and the sellside migrated to these systems because

of the existence of those orders and rules protecting them. Because of the limit order

facility, ECN’s have captured greater than 20 percent of the Over the Counter Market.

109

Why don’t we try to protect these orders in all venues? These orders are the backbone of the future virtual market place. If protected these orders could be successful

in increasing the depth and structure of the market.

Today in the Listed market place, when a bid or offer is too large on one exchange

we allow trades to take place at the same price on an exchange where there is less

depth.

On the New York Stock Exchange we have created the ‘‘clean cross rule’’ that allows a trader to ‘‘shut out’’ a bid or offer as long as the size you want to trade is

greater. This rule was actually put in place to try to keep block order flow on that

exchange. On the floor of the New York Stock Exchange after 100 shares trade at

a specific price where there are limit orders the crowd splits each new trade at that

price equally.

In the Over the Counter market the best bids and offers displayed by dealers, as

well as the best bids and offers posted on ECN’s, are not protected. This practice

is known as internalization of order flow. Close to a third of all NASDAQ orders

are internalized. Wholesalers are paying for order flow to trade against the limit

orders and markets exposed. This practice has become very profitable for these

wholesalers. The SRO’s seem to be protecting this practice instead of encouraging

order interaction.

If institutional limit orders were given greater protection traders would populate

the limit order books.

TRANSPARENCY OF MARKETS

Limit order transparency has been argued for many years. I served on the New

York Stock Exchange Institutional Traders Advisory Committee as Chairman in the

early 90’s. A look at the specialist book was the number one focus topic on that committee for my tenure. As the markets move to decimalization it will be imperative

for the institution to see below the top of the book.

The ECN’s success is also due to its transparency. The trading information gained

through seeing orders interact with the Limit book allow for the institutional trader

to make a more informed trading decision.

Decimalization will move the most liquid stocks to ‘‘one penny’’ spreads over time.

The volumes will increase as the spreads tighten. The need to see where the larger

orders reside will be most important to the institutional trader. Without this depth

of book, inefficiencies of access will erode the competitive positions of the primary

exchange.

LINKAGE OF TRADING VENUES AND EXCHANGES

Scudder Kemper Investments supports the concept of a virtual global limit order

facility. To achieve this, the most important aspect of efficient market structure will

be the linkage between the ECN’s, exchanges and crossing networks. Competition

will force systems with weak linkage out of business. Firms with less than adequate

technology should not be subsidized by the industry. To move to a virtual limit order

book, and to protect limit orders in the different trading venues, linkages need to

be efficient and meet minimum technological standards.

I applaud the New York Stock Exchange for its proposed automatic execution system through Institutional Express. Institutions as well as retail investors need direct electronic access to limit order facilities. The inefficient Super Dot system has

been a problem, and often when transmitting an order you do not receive what you

think you will get. ITS links the various exchange quotes but does not allow for

Price Time Priority, across the markets. With the Archipelago and Pacific Coast

Stock Exchange combination, we hope to see the first steps to an efficient linked

market with Price Time Priority without the involvement of the specialist as dealer.

The move by ECN’s to set up direct efficient linkages to pools of liquidity is a

promising step for buyside trading desks. Maybe these direct linkages will offer

competition to the NASDAQ SelectNet system, which to date has proven less than

adequate.

SOLUTIONS AND CONCLUSION

In the long term Scudder Kemper Investments would like to see protection across

markets of limit orders in Price Time Priority. If the linkages do not allow interaction we would at the very least like to see Price Time Priority in each trading

venue with trade through rules.

We support a regulatory focus on order interaction. We are concerned with the

Wholesalers increased practice of internalization without price improvement. This

trend could undermine transparency and support for limit order exposure. The fragVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00113 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
110

mentation of the Equity Markets is the product of technological innovation and competition. The industry is dealing with this through electronic connectivity.

We support a ‘‘speedy conversion’’ to decimals. But decimals without a fully transparent book will be problematic. The quick move to decimals will allow for less confusion, tighter spreads and may help generate a stronger limit order book.

Depth of book in all venues is needed, and should be made available to all market

participants.

Thank you very much for this opportunity to offer my views on market structure

to this sub-committee.

Mr. OXLEY. Thank you, Mr. Jenkins.

Mr. Kamen.

STATEMENT OF KENNETH A. KAMEN

Mr. KAMEN. I would like to thank Chairman Oxley, Mr. Towns,

and Mr. Greenwood for the opportunity to testify on these critical

issues. I am testifying today as the chairman of the board of the

Regional Investment Bankers association and on behalf of the

small issuer marketplace we service. While Wall Street’s largest

brokerage firms and investment banks have lobbied the Securities

and Exchange Commission to adopt a sweeping new market system, the voice of small regional firms and the small issuer market

they serve have gone largely ignored.

Amidst the euphoria surrounding the bull market and the proliferation of electronic communication networks and alternative

trading systems, certain investors, market practitioners, and regulators have abandoned the small business issuer. In the process,

they are potentially threatening the longest economic expansion in

the history of this country.

U.S. capital markets are preeminent because they enable entrepreneurs to raise capital efficiently and provide a reliable secondary market to investors. The U.S. securities industry is unique

in the degree of participation in capital provided by retail investors.

Indeed, these investors are the life blood of the small issuer marketplace. The vibrant small issuer equity market includes an estimated 22 million investors and small publicly traded companies,

approximately 9,000 small issuers, and tens of thousands of officers, directors and employees.

While some of these companies are speculative investments, informed investors accept these risks because of the opportunities

they offer. It is important to remember that the large cap companies driving our markets to record highs were in many cases at one

stage in their development small businesses. An efficient and liquid

small issuer market helps channel risk capital from investors to innovative emerging companies, affording them the opportunity to

expand, make acquisitions, and retire debt.

The companies listed on the NASDAQ Small Cap and the OverThe-Counter Bulletin Board are clear examples of the contribution

that small equity markets make to our company. While these companies represent all sectors of the economy, the information technology and biotechnology companies that are at the forefront of

current U.S. economic growth are listed overwhelmingly on these

markets. It is the small underwriters and broker dealers who commit their own capital and provide necessary liquidity to the small

issuer capital market.

111

Few if any ECNs or ATSs are operating in the lower tiers. Unlike the ECNs, market makers must maintain fair and orderly

markets at all times. In addition, they provide valuable liquidity to

the small issuer markets. The active support and services provided

by the Regional Investment Bankers Association member firms is

necessary. Their absence would threaten small issuer markets.

In the past few years, technology and regulatory change has

caused rapid, dramatic, and unprecedented changes in the equity

trading markets. While all these developments are worthy of appropriate regulatory reforms, the highly successful dealer markets

servicing small issuers must not be sacrificed. Too often, however,

regulatory reforms have been shaped almost exclusively by the

analysis of the top tier of the market, consisting mostly of the most

actively traded securities in U.S. equity markets.

Although the consequences are unintended to the lower-tier markets, we continue to suffer from this apparent benign neglect. The

potential erosion of the small issuer equity market is a growing

concern for small business entrepreneurs in every region of the

country. Failing to consider the contribution of the lower-tier markets may stifle the growth and innovation that is sustaining and

expanding our current booming economy.

Small issuers have recently enjoyed an enormous increase in the

funds received from venture capital firms and so-called angel investors who have made capital investments in anticipation of an initial public offering. These angel investors often evaluate companies

less on the long-term growth capabilities than on their short term

IPO prospects. If changes in market structure adversely affect the

small cap markets and the market makers ability to service them,

the venture capital stream will likely dry up.

I’d like to comment on some of the specific issues under consideration by the committee. First, I would caution regulators to consider the potential for large firms to dominate the self-regulatory

process in a new market structure. Under the influence of large

firms, for-profit self-regulatory organization can raise the cost of

regulation to levels that would force small firms out of the industry.

Second, the concept of single centralized markets such as a centralized limit order book also raises concern for individual investors

that may be handicapped by institutional investors who are able to

dominate markets by mobilizing vast amounts of capital instantaneously. Third, I would emphasize that pricing for market data

must be streamlined. Buying discounts favoring larger financial

service firms should not disadvantage regional brokerage firms

servicing the small issuer marketplace.

Fourth, the spate of recent proposals for new market linkages in

execution firms should prompt an examination of the practical impact on the lower-tier markets. Regulatory policymakers must ask

whether the future of ITS’, SelectNet, and Super SOES will provide

appropriate applications for lower-tier markets. Finally, I urge the

SEC to clarify its best execution standards and specify their application to the lower-tier markets.

In conclusion, I would like to take this opportunity to highlight

what I see as the most important issue, the benign neglect of the

lower-tier markets by regulators and policymakers. To avoid the

112

1Mr. Kamen has 20 years industry experience and is currently Executive Vice President of

Princeton Securities Corporation.

kind of adverse consequences I have discussed with you today, I

have two specific recommendations: first, I ask all policymakers

and regulators to move ahead more cautiously and deliberately in

considering the effects of future changes on all marketers. Second,

I urge to make good use of the expertise of the Regional Investment Bankers Association and the small issuers that rely on the

lower-tier markets for their lifeblood.

I would like to commend the full committee and its staff for

reaching out and soliciting the views of the small broker dealer

community. We hope that your leadership in creating a more inclusive debate becomes the standard rather than the exception. Thank

you.

[The prepared statement of Kenneth A. Kamen follows:]

PREPARED STATEMENT OF KENNETH A. KAMEN, EXECUTIVE VICE PRESIDENT,

PRINCETON SECURITIES CORPORATION

RIBA

I am testifying today as the Chairman of the Board of Directors of the Regional

Investment Bankers Association (RIBA) and on behalf of the small issuer marketplace we service.1 RIBA was organized in June, 1994 as a national association of

regional and independent broker-dealer and investment banking firms seeking to

improve conditions in our industry, strengthen the free-enterprise system and provide a vital source of information and education to RIBA members and the investing

public.

RIBA is committed to assisting regional broker-dealers in the syndication of their

capital formation projects. While our initial goal was to provide a forum for smallcap companies seeking public financings, we have since expanded our focus to address the overall concerns of the lower tier market. Toward this end, RIBA has represented the interests of smaller broker-dealers to the securities regulators who govern our industry and the policymakers in Washington, DC. RIBA now holds regularly scheduled conferences where member firms exchange ideas, voice opinions on

pending legislation and become educated on matters affecting the industry. As the

bonds among RIBA members continue to strengthen, we hope to enhance our contribution to regulatory and legislative matters.

INTRODUCTION

While Wall Street’s largest brokerage firms and investment banks have lobbied

the Securities and Exchange Commission (SEC) to adopt a sweeping new market

system, the voices of small regional firms and the small issuer market they serve

have gone largely ignored. Amidst the euphoria surrounding the bull market and

the proliferation of electronic trading systems such as electronic communications

networks (ECNs) and alternative trading systems (ATSs), certain investors, market

practitioners and regulators have abandoned the small business issuer. In the process, they are potentially threatening the longest economic expansion in the history

of this country. RIBA urges that any sweeping new market restructure consider its

impact on the small issuer marketplace. RIBA believes the failure to do so is irresponsible and risky economic policy. Unfortunately, the current dramatic proposals

to reform market structure may ultimately reduce liquidity and capital flow in the

small issuer market.

The U.S. capital markets are preeminent because they enable entrepreneurs to

raise capital efficiently and provide a reliable secondary market to investors. The

U.S. securities markets are unique in the degree of participation and capital provided by retail investors. Unlike our European and Asian competitors, the U.S. markets rely on a confident and vigorous retail investing public. These investors are the

lifeblood of the small issuer marketplace. The lower tier market functions are facilitated by the small underwriters who bring emerging companies to the public market

and by market makers who commit capital to maintain a market for these companies’ securities. The vibrant small issuer equity market includes an estimated 22

113

2Small Business Administration. Office of Advocacy.

3 Id.

million investors 2 in small publicly traded companies, approximately 9,000 3 small

issuers and tens of thousands of officers, directors and employees. While some of

these small companies are speculative investments, informed investors accept the

risks they pose because of the opportunities they offer. It is important to remember

that the large cap companies driving our markets to record highs were in many

cases, at one stage in their development, small businesses.

An efficient and liquid small issuer market helps channel risk capital from investors to innovative emerging companies, affording them the opportunity to expand,

make acquisitions and retire debt. Capitalizing these companies creates an enormous number of new jobs. The companies listed on Nasdaq SmallCap and the Over

The Counter Bulletin Board (OTCBB) are clear examples of the contribution that

small issuer equity markets make to our economy. Although the Nasdaq SmallCap

and the OTCBB companies represent all sectors of the economy, the information

technology and biotechnology companies that are at the forefront of current U.S.

economic growth are listed overwhelmingly on these markets.

It is the small underwriters and broker-dealers, not the ECNs and ATSs, who

commit their own capital and provide necessary liquidity to the small issuer capital

market. Few, if any, ECNs or ATSs are operating in the lower tiers. Unlike the

ECNs, market makers are obliged to maintain fair and orderly markets in both rising and falling markets. In addition, they provide valuable liquidity to the small

issuer markets through their buying and selling activities. Market makers temper

the price volatility of securities and preserve market integrity by identifying overvalued and under-valued companies, leading to pricing efficiencies in the market.

This dealer market should be preserved and enhanced as new securities regulatory

policy is developed. Small issuers continue to need the active support and services

provided by RIBA member firms. In the absence of their support, no market exists

for these small issuers.

RIBA recommends establishing a special small issuer capital market task force

to evaluate and shape market reform proposals unique to the small issuer. The SEC

and Nasdaq should also consider the negative impact of current rules and regulations on the small issuer market. RIBA is willing to take an active role in establishing this task force and will work with regulators, market practitioners, issuers

and investors to make recommendations that address the interests of the small

issuer capital market.

A SHORT HISTORY OF MARKET CHANGE.

The 1975 Amendments to Securities Laws: Creation of a National Market System.

Nearly 25 years ago, in response to new data processing and communication techniques, Congress amended the securities laws to create a fair and efficient national

market system. The amendments were designed to improve the execution quality of

securities transactions and foster fair competition among various participants in the

markets, including brokers, dealers, exchanges and markets other than the listed

exchange markets,

Congress believed that expanding the availability of quotation and transaction information would result in the execution of investor orders in the best market available, possibly without the participation of a dealer. To accomplish its goals, Congress ended fixed commissions on what is now known as ‘‘May Day’’. May Day referred to May 1, 1975, when the SEC eliminated the fixed commissions brokers were

charging for all securities transactions. This change allowed regional firms to compete on price and quality of service. Further, the inception and rise of discount

brokerages grew out of the ‘‘May Day’’ Proclamation. In this landmark legislation,

Congress also called for the development of a consolidated quotation system and

consolidated tape, as well as the creation of the inter-market trading system (ITS).

Finally and perhaps most significantly, a statutory directive ordered the SEC to

take steps to foster the development of a national market system consistent with

these goals.

1994: The SEC Market 2000 Study.

Almost twenty years after the 1975 Amendments, the SEC embarked on an ambitious project. After conducting several years of research, the SEC’s Division of Market Regulation issued its voluminous Market 2000 Report in 1994 (the Report). The

Report was several hundred pages long and summarized the state of the securities

markets and made several recommendations for substantive change. Despite its extraordinary length, the Report focused almost exclusively on the conclusion that furVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00117 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
114

4William G. Christie & Paul H. Schultz, Why Do NASDAQ Market Makers Avoid Odd-Eighth

Quotes?, 49 J. Fin. 1813, 1813-40 (1994) [hereinafter the ‘‘Christie-Schultz Study’’]. 5See SEC, Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding

the NASD and the Nasdaq Market (1996) [hereinafter the ‘‘NASD 21(a) Report’’]. 6See Proposed Rules on Order Execution Obligations, 60 Fed. Reg. 52792 (Sept. 29, 1995);

Adopted Rules on Order Execution Obligations, Securities Exchange Act Rel. No. 34-37619A

(Sept. 6, 1996). 7The SEC emphasized that the duty of best execution could require brokers to do more than

simply execute orders at the NBBO. It stated that brokers had a duty to ‘‘regularly and rigorously’’ assess the quality of the executions provided to customers.

ther changes in technology and product development had caused dramatic changes

in large-cap markets since the 1975 amendments. Unfortunately, the question of applicability of these findings to the small-cap markets went unnoticed.

Although the Report concluded that the equity markets were operating efficiently

and effectively, and that no major revision of equity market regulation was needed,

it did recommend several improvements. The Report found that securities professionals, for example, needed to devote greater effort to securing the best prices for

their customers and to the full disclosure of relationships that could interfere with

the customers’ interests. The Report also urged more timely and comprehensive information with respect to quotation, price and volume data. The Report also anticipated that the development of alternative trading vehicles required regulatory adjustments, and that increased market access for competitors was essential.

1996: Adoption of SEC Order Handling Rules.

Soon after the release of the Market 2000 Report, in the spring of 1994, a widely

publicized economic study suggested that the largest Nasdaq market makers implicitly colluded to maintain artificially wide inside spreads by avoiding odd-eighth

quotations in many stocks.4 In addition, media accounts reported widespread allegations that market makers routinely refused to trade at their published quotes, intentionally reported transactions late in order to hide trades from other market participants, and engaged in other market practices detrimental to individual investors.

Certain National Association of Securities Dealers (NASD) member firms, sometimes referred to as SOES Bandits, also alleged that the NASD had targeted them

for regulatory and disciplinary action because the largest market makers that dominated and controlled the NASD disapproved of the trading practices engaged in by

these firms. The Department of Justice and the SEC investigated the NASD and

the Nasdaq Stock Market for almost two years and then issued a series of enforcement actions alleging that activities by market makers had contributed to a twotier market in Nasdaq securities and had artificially maintained the size of spreads

paid by retail investors for Nasdaq securities.5

In September 1996, the SEC adopted Order Handling Rules designed to reduce

spreads and protect investor interests.6 Concurrently with the investigation of the

NASD and before drafting the rules, the SEC performed a comprehensive study of

top tier Nasdaq securities. However, the SEC did not study how the proposed Order

Handling Rules would affect the liquidity and volatility of small cap stocks. In hindsight this omission was a critical error. Despite the limited range of its evaluation,

the SEC adopted the Order Handling Rules and applied them to all stocks trading

on the Nasdaq market.

Subject to certain limited exceptions, the Order Handling Rules require market

makers to include customer limit orders in their own quotes and mandate that dealer orders in ECNs be included in the inside market. The enactment of these Order

Handling Rules reduced the spread between the best bid and best offer quoted on

Nasdaq.7

Since the adoption of the Order Handling Rules, RIBA members have noted a dramatic increase in market volatility in the small cap market. While RIBA recognizes

the effects of many factors, in addition to the Order Handling Rules, RIBA recommends that the SEC evaluate the unintended negative consequences of the application to the lower tier markets.

1998: Adoption of Regulation ATS.

The Adoption of Regulation ATS in December, 1998 by the SEC was a radical development whose impact is driving the current debate on market structure. The new

regulation put into place many of the changes first raised in the Market 2000 Report. The new regulation defined the registration and regulatory requirements for

alternative trading systems, including ECNs and exchanges, and floated the concept

of a ‘‘for-profit’’ exchange. Ultimately, Regulation ATS sparked the push by various

exchanges and the NASD for demutualization and contributed to the proliferation

and expansion of ECNs and ATSs. As was the case with the Order Handling Rules,

115

8 RIBA, 1993-1999 Underwriting Survey Totals.

Regulation ATS was adopted without the benefit of a comprehensive evaluation of

its impact on the lower tier markets.

The catalyst for the changes wrought by Regulation ATS has been the growth of

ECNs as market centers. Unfortunately, technological change has produced a degree

of uncertainty for some market participants. RIBA recognizes the tremendous potential that new technology brings to the capital markets. In order to be prepared for

uncertainties, however, new regulation must allow flexibility in deciding how to regulate the markets of the future. RIBA believes that what in theory looks sound may

in practice be less advantageous to all market tiers.

Very little, if any, of the underlying philosophy and the practical application driving the development of Regulation ATS concerned small tier markets. Because

ECNs were created to facilitate matching investor orders, ECNs are not reliable liquidity providers. Rather, ECNs are most efficient for the highly capitalized markets where there are large numbers of both buyers and sellers. As a result, Regulation ATS effectively discourages small broker-dealers from providing market liquidity. It remains to be seen who will provide liquidity to the lower tier capital markets

during a sustained downturn. RIBA believes this is a critical issue worthy of Congressional inquiry, as liquidity often dictates whether a fair and orderly market may

be maintained. For many ECNs, volume comes largely from retail orders and it is

instructive to note that the current stock market boom is fueled by retail investors.

However, even in today’s robust market, ECNs cannot efficiently trade in the less

capitalized markets, such as the Nasdaq SmallCap market and the OTCBB, as

small broker-dealers can. Given this reality, it seems poor public policy to embrace

a one-size-fits-all approach to regulating all market tiers.

RIBA members report the one-size-fits-all approach has added to the volatility discussed above. In addition, the current regulatory environment has greatly reduced

the number of RIBA underwritings. According to RIBA statistics, the number of

small underwritings has declined precipitously from 190 offerings totaling $2.3 billion in 1994 to just 38 totaling $221 million in 1999.8

It is critical for beltway policymakers to remember that small underwriters and

broker-dealers, not ECNs, provide the necessary liquidity to the small issuer capital

market through the comm’ ment of their own capital and through buying and selling

activity. One of the fundamental market principles is the obligation of market makers to maintain fair and orderly markets in both rising and falling markets. Market

makers temper the price volatility of securities and preserve market integrity by

identifying over-valued and under-valued companies, leading to pricing efficiencies

in the market. This lower tier market should be preserved and enhanced as new

securities regulatory policy is developed. Without support there is no market for

these small issuers.

CURRENT ISSUES.

Fragmentation.

Assuring fair competition among market centers is a principal objective for the

national market system. Market centers (including exchange markets, over-thecounter market makers, and ATSs) compete to provide a forum for the execution of

securities transactions, particularly by attracting order flow from brokers seeking

execution of their customers’ orders. One of the results of this fierce competition

among market centers, however, can be fragmentation of the buying and selling interest for individual securities. Due in large part to the regulatory reforms discussed

earlier, market fragmentation has stimulated healthy competition. In the past four

years, several ECNs and ATSs have successfully challenged traditional market centers and offered improved efficiency to investors. This positive development has yet

to be realized by the lower tier markets. However, substantial time, energy, analysis

and regulatory resources have already been expended to manage constructively the

fragmentation of the top tiers. RIBA believes a similar analysis and resources dedicated to the small issuer markets is overdue.

For-Profit Exchanges.

Under its current structure, the Nasdaq Stock Market is owned by the NASD, a

nonprofit membership corporation with over 5,500 members. In an effort to

strengthen its financial position without significantly burdening existing members,

the NASD has announced plans to restructure Nasdaq. Under the new regime, the

NASD would retain a minority stake in Nasdaq, while the majority would be owned

by current NASD members, security firms, issuers, buy-side firms, technology partners and the public. Control over the new entity would shift from the NASD to its

116

9 In reportedly the highest NASD member vote recorded, 4075 ballots were cast, 3423 in favor

and 652 against the restructuring. See Securities Week, April 17, 2000. 10Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, Timeless Principles, Columbia

Law School (September 23, 1999). 11Pub. L. No. 94-29, 89 Stat. 97 (June 4, 1975). See Sections 6(b)(4), 11A(c)(1)(C), 11A(c)(1)(D)

and 15A(b)(5) of the Exchange Act. 12S. Rep. No. 94-75, 94th Cong., 1st Sess. 7 (1975) (‘‘Senate Report’’). 13 H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975) (‘‘Conference Report’’). 14 Exchange Act, Section 11A(c)(1)(D).

new owners when Nasdaq is registered as an exchange with the SEC. The new plan

was approved by a membership vote on April 14, 2000.9

Any final plans will involve separating NASD-Regulation from the for-profit market. In prepared testimony before the Senate Committee on Banking, Housing and

Urban Affairs on September 28, 1999, Frank G. Zarb, the NASD Chairman explained that ‘‘early in the process we decided that an NASD-Regulation, independent from a for-profit marketplace, was the best means of maintaining our high

regulatory standards.’’ This view is consistent with that expressed by SEC Chairman Levitt in a major policy address at Columbia Law School that ‘‘strict corporate

separation of the self-regulatory role from the marketplace it regulates is a minimum for the protection of investors in a for-profit structure.’’ 10 RIBA supports an

independent Self-Regulatory Organization (SRO) as long as the SRO is charged with

recognizing the inherent differences in the various market tiers. As stated earlier,

one-size-fits-all regulation can be very harmful to small issuers andtheir shareholders.

Under a for-profit Nasdaq, RIBA is concerned about whether the Nasdaq

SmallCap market will receive the attention and resources it deserves. Resources

dedicated to small cap marketing and regulation in a for-profit environment must

take immediate priority. If the lower tier markets suffer from benign neglect today,

RIBA is very concerned that in the future, small issuers and small broker-dealers

will suffer and eventually individual investors and the economy will be negatively

affected as well.

RIBA also notes that it is unclear whether the OTCBB market is going to be part

of the new Nasdaq or remain under the NASD. There has been no announcement

about the OTCBB’s fate. In fact, the lack of information about the role of the

OTCBB in the Nasdaq demutualization plan underscores RIBA’s concern about the

future treatment of this market and its participants. The private placement memorandum circulated to the NASD members prior to the vote contained just 69 words

regarding the OTCBB. RIBA understands that the OTCBB is not the catalyst for

page one news stories of multinational business mergers. Nonetheless, thousands of

domestic small issuers rely on the OTCBB for their public capital. Recently, these

companies have been benefiting greatly from the investments made by venture capital and angel investors. If the NASD does not support the small tier market sufficiently, small broker-dealers will continue to abandon the market, potentially hurting small issuers, individual investors and the economy. If that were to happen it

remains to be seen what effect a shrinking IPO market will have on all private equity financing in the future. RIBA believes it is critical that the SEC and Congress

require the application of proper due diligence to such a fundamental restructuring.

Market Data/Fees.

Market information fees are addressed most directly by various provisions of the

Exchange Act, all of which were added to the Act by the 1975 Amendments discussed above.11 With the enactment of the 1975 Amendments, Congress granted the

SEC flexible reign in overseeing the establishment of a national market system for

securities. Consistent with the central market approach initiated by the SEC, the

two ‘‘paramount objectives’’ of the national market system were ‘‘the maintenance

of stable and orderly markets’’ and ‘‘the centralization of all buying and selling interest so that each investor will have the opportunity for the best possible execution

of his order, regardless of where in the system it originates.’’ 12 To achieve these objectives, Congress recognized that ‘‘communication systems, particularly those designed to provide automated dissemination of last sale and quotation information

with respect to securities, will form the heart of the national market system.’’ 13 The

Amendment provisions are designed to ensure the fair and reasonable dissemination

of market information on terms that are ‘‘not unreasonably discriminatory.’’ 14

Under the amended rules, national securities exchanges and national securities

associations must also allocate their fees equitably among members. The legislative

history of these provisions indicates Congress’ intent that the fees collected from evVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00120 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
117

15 Conference Report, at 92. 16See Regulation of Market Information Fees and Revenues, Securities Exchange Act Rel. No.

34-42208; File No. S7-28-99 (December 9, 1999). 17 Id. 18 Id.

eryone using an SRO’s facilities could appropriately be directed to funding the ‘‘costs

associated with the development and operation of a national market system.’’ 15

In 1975, Congress found that new data processing and communications techniques

created the opportunity for more efficient and effective market operations, and that

the linking of all markets through such data processing and communications facilities would increase the information available to brokerdealers and investors. Congress was particularly concerned about entities that would be exclusive processors

of market information to SROs. Unfortunately, Congressional intent did not lead to

the application of these improvements to the lower tier markets. Thousands of small

companies continue to trade solely over the phone among market makers willing to

commit risk capital. While readily available, efficient technological innovations have

yet to be universally applied. RIBA believes that the SEC should require a more

equitable distribution of resources and technology.

As noted above, Congress did not include a strict, cost-of-service standard in the

Exchange Act, opting instead to allow the SEC some flexibility in assessing the fairness and reasonableness of fees. Nevertheless, the fees charged by service monopolies (such as the exclusive processors of market information) need to be tied to some

type of cost-based standard to preclude excessive profits if fees are too high and to

prevent underfunding or subsidization if fees are too low. RIBA believes that the

total amount of market information revenues should remain reasonably related to

the cost of generating such market information. Today that is not the case; small

broker-dealers shoulder proportionately higher costs which are in turn passed along

to small issuers and their shareholders. RIBA feels strongly that this is wrong and

should be corrected.

The cost of member regulation should not be considered part of the cost of market

information. The financial soundness of broker-dealers is undoubtedly an essential

factor in the overall integrity of the markets; however, the connection between regulatory oversight of market integrity and the quality of market information is much

more attenuated than in the case of market operation and market regulation.16 An

SRO’s member regulation costs are more directly associated with the regulatory fees

charged to members than with any other source of funding. Also, the cost of market

information should omit costs that are directly associated with other SRO services,

such as advertising and marketing expenditures to obtain corporate listings.17 This

segregation is essential in today’s highly competitive environment. Failure to segregate will continue to disadvantage the small regional firms unfairly.

The arrangements for disseminating market information should be modified in

several respects. RIBA’s review of its membership has indicated the importance of

adapting market information fees to the increasing retail investor demand for realtime information and to the changing structure of the securities industry. RIBA endorses the concept of a flexible, cost-based approach to evaluating the fairness and

reasonableness of such fees and revenues. SROs should provide greater public disclosure of their fees, revenues and costs. The same standards of disclosure enforced

by the SROs should be applied to the SROs. Furthermore, vendors, broker-dealers

and users of market information should participate in the process of setting and administering fees. Failure to seek a more open process will continue the effective isolation of RIBA member interests.

Since the enactment of the 1975 Amendments, the SEC has relied primarily on

consensus among the SROs and the securities industry to resolve issues concerning

market information fees and revenues. RIBA believes that recent changes in the securities markets may require a revised approach that provides greater guidance to

the SROs and the rest of the securities industry. The advent of for-profit SROs,

whose financial objective will be generating profits for their owners, could result in

increased pressure to raise fees and revenues and to cut back on costs not directly

associated with a source of revenue. RIBA believes that SRO fees and financial

structures may warrant increased oversight by the SEC. RIBA members are very

concerned that failure to do so may result in regional firms being priced out of the

market due to open-ended fee increases.

Since market information fees cannot be unreasonably discriminatory, any disparities in fees should be justified by such legitimate factors as differences in relevant costs or degree of use.18 RIBA believes it is important to recognize that the

basic information stream will be the same, and will have the same production costs,

no matter how many vendors and subscribers receive the information. As the SEC

118

19 Id. 20 Id. 21See Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, Timeless Principles, Columbia Law School, (September 23, 1999).

states in its market data release, ‘‘although there may be differences in costs of disseminating information to different categories of vendors and subscribers (such as

the costs of administering a fee structure), it is vendors and broker-dealers who, for

the most part, bear the costs of receiving the data stream and passing it on to individual subscribers. These redistribution costs are not appropriately incorporated

into a fee structure.’’ 19

In order to assure the wide availability of market information, individual SRO

fees should be evaluated in terms of the objectives of the national market system.

RIBA feels that market data fees should not be set at levels that effectively restrict

the availability of real-time information. The current effect is anticompetitive and

disadvantages the smaller firms.

Fee structures often include various discounts that are based on the size of the

subscribing firm or on whether the firm is a member of an SRO that participates

in the particular network.20 RIBA believes these discounts are inconsistent with the

Exchange Act objective that exclusive processors of information should remain neutral in their treatment of firms and customers. Once again, disparities in fees should

be Justified by such legitimate factors as differences in relevant costs, degree of use,

or quality of service. Market data providers should demonstrate that the size of the

discounts corresponds with the size of the relative difference in administrative costs.

Today’s discounts clearly benefit the largest broker-dealers at the expense of RIBA

members. Additionally, the proportionally inflated fees paid by RIBA members subsidize the top tier markets. RIBA feels the SEC should address this inequity. Ultimately these unique costs are partially subsidized by the issuers and their shareholders.

RIBA is also concerned about the anti-competitive fees that ECNs charge non-subscriber users to access their quotes through Nasdaq. Nasdaq market makers do not

charge access fees. In order for a broker to comply with his best execution duties

it may be necessary to access the NBBO that is quoted on an ECN and pay the

access fees. We feel, and SEC Chairman Arthur Levitt has agreed, that the ECNs

should apply uniform charges to subscribers and non-subscribers alike eliminating

the access fees.21 Today’s regulatory regime is anti-competitive and anti-small business.

After-Hours Trading.

On October 25, 1999, Nasdaq began a voluntary pilot program extending the

availability of the Nasdaq quotation, trade reporting and communications until 6:30

p.m. Eastern time. As of February 7, 2000, Nasdaq calculates and disseminates the

inside market. Firms were initially called upon to input trade reports voluntarily

on a real-time basis for trades occurring between 5:15 and 6:30 p.m. Real time reporting became mandatory as of November 15, 1999. Although the application of

SEC and Nasdaq rules on the handling and protection of limit orders was temporarily deferred until December 6, 1999, the rules are now in effect during the extended trading hours. RIBA members report that the practical effect is that lower

tier market liquidity does not support after-hours trading. RIBA members who keep

their trading desks open in after-hours sessions are forced to assume operating costs

without the likelihood of offsetting revenue.

On October 8, 1999, three working groups delivered reports on issues relating to

extended trading hours: the Committee on Investor Protection and Education

(CIPE), the Committee on Clearance, Settlement and Operations (CCSO) and the

Working Group on Trading Conventions (WGTC). Unfortunately small, regional

broker-dealers were not represented on these committees. The reports of these

groups highlighted some of the issues that extended hours trading may present.

CIPE, for example, emphasized ‘‘complete and full disclosure of the nature and risks

of extended hours trading for investors,’’ and urged ‘‘that best practices be adopted

industrywide.’’

CIPE also noted that the risks of extended hours trading include lack of liquidity,

volatility, fragmentation of the market, impact of news announcements and the lack

of depth and breadth in the extended hours markets expected initially. CIPE suggested that investors should actively be required to ‘‘opt-in’’ to extended hours trading.

Nasdaq’s foray into extended hours is directed, in large part, toward West Coast

customers and traders. Although its after-hours entry had little effect on the first

night (Nasdaq reported only 27,000 shares traded compared to the 933 million

119

22Section 11A(a)(1) reads: ‘‘The interests of investors (both large and small) are preeminent,

especially the efficient execution of their securities transactions at prices established by vigorous

competition.’’ 23See, e.g., Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1; Exchange Act Rule 11Ac1-4, 17

CFR 240.11Ac1-4; NASD Rule 4613; NYSE Rule 60. 24Securities Exchange Act Release No. 34-42450; File No. SR-NYSE-99-48; Proposed Rescission of NYSE Rule 390 Commission Request for Comment on Issues Relating to Market Fragmentation; (February 23, 2000). 25 Arthur Levitt, Chairman SEC, ‘‘Visible Prices, Accessible Markets, Order Interaction’’,

Northwestern School of Law, (March 16, 2000).

shares traded overall that day) it is anticipated that the volume will grow despite

limited and costly access. Many ECNs currently operate even longer hours, including at least two ECNs that operate 24 hours a day. Small broker-dealers are often

unable to compete because of staffing costs associated with keeping extended hours.

Unfortunately, the SEC failed to consider adequately the negative effects on small

issuers and small broker-dealers that arise when investors lose money because of

price swing in less liquid stocks traded after hours. Stung by their losses, investors

are more likely to avoid the after-hours market, thus injuring the liquidity of some

small businesses.

Solutions.

The SEC’s attention to market fragmentation derives from its commitment to the

interests of investors pursuant to Section 11A(a)(1) of the Securities Exchange Act

of 1934.22 The market ideally should offer the greatest opportunity for interaction

among buyers and sellers while encouraging fair competition among market centers.

Fairness and efficiency translate into reduced transaction costs and more accurate

pricing of securities. This time-honored goal must be applied to all market tiers. The

SEC must expand its analysis and consider the opportunities for markets servicing

small issuers.

Fragmentation can occur when market forces combine to isolate investors’ orders

and hamper price competition. The potential decrease in liquidity and increase in

price volatility deprive investors of the benefits of fairness and efficiency. The market currently addresses fragmentation in three major ways: (i) price transparency,

(ii) intermarket links to displayed prices, and (iii) the brokers’ duty of best execution.

Price Transparency.

Price transparency is an essential component of a unified national market system.

All significant market centers are required to make available to the public their best

prices and the size of the order associated with those prices.23 The market centers

provide quote and trade information through central processors that are responsible

for collecting and disseminating the market information for different types of securities. The processors consolidate the information of individual market centers, determine the NBBO and distribute the information to broker-dealers and information

vendors who make the information available to the public. Due to the lack of dynamic quotes and the absence of electronic order execution, these technological advances improving transfers have yet to reach the OTCBB.

Linkages.

ITS and SelectNet.—As noted above, one component of the national market system designed to address fragmentation is the establishment of systems that link the

various market centers and provide access to the market center with the best displayed prices. The Intermarket Trading System (ITS) was created under the NMS

Plan as an attempt to link the country’s then existing markets. The ITS linkage

handles a relatively small proportion of trading in listed equities. In September

1999, for example, ITS volume represented 2.2% of total NYSE-listed trades.24 The

ITS linkage has weaknesses that must be addressed, including restricted ECN access and slow and inefficient execution procedures.

In recent speeches, SEC Chairman Levitt stated that the SEC is considering ways

to address the problem of market fragmentation: ‘‘At the Commission, we know well

that ITS has not kept pace with the technological changes sweeping our markets.

Its archaic structure and cumbersome governance provisions are not fit for today’s

market, let alone the market of the future.’’ 25 Such inefficient governance has led

to stagnated technology, requiring private market-based trading systems to address

inefficiencies. The growth of alternative trading systems such as ECNs has occurred

outside of ITS.

On December 8, 1999, the SEC took the first step toward reforming market linkage with the adoption of an amendment ITS plan, expanding the ITS/Computer AsVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00123 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
120

26 Non-Rule 19c(3) listed Securities are those listed pre-April, 1979 and subject to NYSE Rule

390. 27Third Market Makers such as Trimark Securities and Madoff Securities. 28 Id. 29Securities Exchange Act Rel. No. 42344 (Jan. 18, 2000), 65 FR 3987. 30See e.g. Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, Timeless Principles, Columbia Law School, (September 23, 1999). See also, Securities Exchange Act Rel. No. 34-42456:

File No. 4-429 (February 24, 2000). 31Securities Exchange Act Rel. No. 34-42450, File No. SR-NYSE-99-48, Proposed Rescission

of NYSE Rule 390 Commission Request for Comment on Issues Relating to Market Fragmentation, (February 23, 2000).

sisted Execution System (CAES) linkage to all listed securities. The amendment allows all members of ITS to trade non-Rule 19c(3) listed securities 26 thus enabling

non-exchange members of ITS 27 to trade in listed securities. This amendment also

paved the way for the admission of ECNs into the ITS, enabling ECNs to trade all

listed securities while linked to each other and to the exchanges. On March 16,

2000, the SEC approved the NASD proposal allowing ECNs to become part of CAES

and therefore linked with ITS. In reaction to these attempts at reforming ITS, the

NYSE has recently proposed to withdraw from ITS. Though ITS may not be the

ideal form of market linkage, RIBA believes that the NYSE must play a central role

in any future National Market System linkage plan and so recommends that the

SEC reject any unilateral withdrawal by the NYSE.

The market centers that trade Nasdaq equities currently are linked by the

NASD’s SelectNet system, by telephone and through private links. In September

1999, approximately thirty percent of trades in Nasdaq equities were routed through

SelectNet, a sharp reduction from just five years ago. Chairman Levitt stated that

SelectNet continues to be plagued with shortcomings, delays during heavy trading

volume, and even outages. Given the decentralized nature of the Nasdaq market,

this is a critical and core flaw—and one that must receive intense scrutiny and committed resources until resolved.28 The SEC recently approved a proposed rule

change by the NASD to establish a revised order delivery and execution system-the

Nasdaq National Market Execution System (NNMS).29 The new system, also known

as Super-SOES, will consolidate the Small Order Execution System or ‘‘SOES’’ and

SelectNet and allow delivery against the best prices displayed in the Nasdaq Display Window. Customers will enjoy virtually instant automatic executions against

market maker quotes. The system will provide, among other things, automatic execution for customer and market maker orders up to 9900 shares. Once again, it appears to RIBA that the new rules and new system have been developed for the top

thirty percent of the Nasdaq participants only.

RIBA believes that any proposals regarding linkages should be concerned with the

entire range of securities in the markets, not just the very top tier of actively-traded

issues. The relevant question is whether the efficiency of the markets for all or any

particular category of securities could be substantially improved through market

structure changes. Ultimately, only fair and vigorous competition can be relied upon

to set efficient prices.

The advent of decimal pricing introduces another example of the inherent differences among market tiers. The current momentum surrounding the conversion to

decimal pricing in the most liquid stocks, is certainly warranted. While most experts

agree that decimal pricing will substantially reduce spreads, perhaps down to a

penny in the most liquid stocks, RIBA suggests that in the lower tier markets its

effects may be unforeseen. A pilot program in the lower tier markets may be a constructive first step in evaluating the impact of decimal pricing in the lower tiers.

At present, there is no linkage of quotations or trading on the options markets.

This deficiency impairs the price discovery mechanism and makes it difficult for brokers to get the best price for their clients, particularly in light of the increased dual

listing of options. This is particularly difficult for regional firms with fewer resources and strategic business partners. SEC Chairman Levitt has on several occasions called for a linkage between the options markets, and has imposed a deadline

on the options exchanges to come up with a plan.30 An integrated options trading

market should present an opportunity for increased competition for regional brokerdealers.

Central Limit Order Book.—As a result of the tension between encouraging competition and having a centralized marketplace, the SEC has called for a study of

centralization of order flow through a centralized limit order book.31 Some proposed

market structure reforms would hurt small broker-dealers who engage in underwriting and market making. One such proposal is the centralizing of all trading in

one system, what is sometimes referred to as a time-priority central limit order

book, or CLOB. The CLOB would be fully transparent to all market participants.

121

32See Regulatory Costs in the Financial Marketplace of the Future Before the Senate Comm.

of Banking, Housing, and Urban Affairs (Feb. 29, 2000) (testimony of Charles R. Schwab, Chairman and CEO of Charles Schwab & Co., Inc.). 33Securities Exchange Act Release No. 34-42166 (Nov. 22, 1999), 64 FR 69125. 34Securities Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 FR 48290 (‘‘Order Handling

Rules Release’’), Section III.C.2. 35See id. at n.360 and accompanying text. 36See id. at nn.356-57 and accompanying text.

In other words, the public would have access to all CLOB orders and quotations,

including the size of transactions and the identity of the investor. Market makers

would only be able to trade as a principal if they provided price improvement to the

CLOB listings.

The prospect of transforming our markets into a single ‘‘black box’’ does not recognize the important role market makers play in the securities markets, especially the

smaller, less liquid securities. In testimony before the Senate, the NASD voiced its

disapproval of the CLOB system:

Because the Nasdaq system provides incentives for market makers to continuously display quotations and provide immediate guaranteed executions in size

to investors, it has been able to respond to the revolutionary demands of the

online trading world. On the other hand, mandatory CLOBs and system wide

time priority requirements do not effectively incorporate or incent the multiple

market makers who now provide liquidity and immediate executions on Nasdaq,

and who thus cushion the market when it is under stress.

As stated earlier, market makers provide liquidity to the market by guaranteeing

executions to their customers at the inside market price or better, often at low cost.

The willingness of market makers to provide investors with access to guaranteed

executions is critical to the ability of the entire dealer market to respond to the extraordinary demands of today’s trading. While proponents argue the CLOB would

certainly encourage maximum interaction among orders, it will likely do so at the

expense of competition. Faced with one centrally planned structure, market participants may lose any incentive to upgrade or create new technologies. Furthermore,

the CLOB’s inclusion of information such as transaction size and investor identity

may favor professionals and institutional investors with ‘‘time and place advantage’’

over retail investors.32 RIBA is concerned that the CLOB will allow professionals

and institutional investors, who regularly monitor trading activity literally second

by second, to place retail investors at a disadvantage by mobilizing vast amounts

of capital instantaneously. Individual investors comprise the overwhelming majority

of RIBA members’customers. RIBA opposes market initiatives that disadvantage individual RIBA clients.

NASD Electronic Order Display Window.—On November 22, 1999, the NASD filed

a rule change about Nasdaq’s proposal for a new and ‘‘revolutionary’’ order display

window to be launched this summer, assuming SEC approval.33 The new window

based on the NNMS operating system was designed to respond to the increased

fragmentation and loss of transparency resulting from having multiple, competing

market centers. Nasdaq expects that this change will make trading Nasdaq shares

more fair and efficient by giving investors a more complete picture of prices gathered from exchanges, market makers and ECNs.

The new system, sometimes referred to as Super-Montage, will utilize the recently

approved Super-SOES system and allow delivery against the best prices displayed

in the Nasdaq Display Window. As with other new linkage proposals discussed

above, the new system has developed according to considerations of the top tier markets only.

Broker’s Duty of Best Execution.—In accepting orders and routing them to a market center for execution, brokers act as agents for their customers and owe them

a duty of best execution. The duty, which derives from common law agency principles and fiduciary obligations, is incorporated both in self-regulatory organization

rules and, through judicial and SEC decisions, in the antifraud provisions of the federal securities laws. The duty requires a broker to seek the most favorable terms

reasonably available under the circumstances for a customer’s transaction.34

A broker’s duty of best execution applies to both customer market orders and limit

orders. Although obtaining the best price is the single most significant factor with

respect to market orders, limit orders are a different story since they are sensitive

to both time and price. The duty of best execution is therefore not fulfilled automatically by guaranteeing execution at the NBBO.35 For example, brokers should consider opportunities for ‘‘price improvement.’’ or execution at a better price than the

NBBO, when routing customer orders.36 Other factors, such as cost, the availability

122

37SEC, Report oil the Practice of Preferencing (April 11, 1997) (‘‘Preferencing Report’’), at 89

n.207. 38See Speech by Arthur Levitt, SEC Chairman, Dynamic Markets, Timeless Principles, Columbia Law School, (September 23, 1999). 39Speech by Frank Zarb, Chairman and CEO of the NASD, The Coming Global Digital Market (June 23, 1999).

of accurate information and the historical characteristics of the particular security

involved all affect the ability to provide best execution.37

RIBA is most concerned that the best execution standards articulated by the SEC

are ambiguous. This problem is especially acute for small broker-dealers specializing

in thinly traded stocks and dealing primarily with retail orders. RIBA believes the

SEC should clarify the Rules and specify the definitions as applied to best execution

for the lower tier markets. Clarity will ensure greater compliance, avoid creating

traps for the unwary and, ultimately, serve the investor well.

The Super-SRO.—Securities markets are now facing the question of how to perform SRO functions after demutualization of the exchanges. While SEC Chairman

Levitt did not take a definitive stance on this topic, he has suggested the intriguing

idea of having a single regulator for general issues such as net capital, financial responsibility, sales practices, etc., while allowing the exchanges to continue to regulate their own trading markets.38

The SEC has made it clear that strict corporate separation of the selfregulatory

role from the marketplace it regulates is a minimum threshold for SEC approval

of for-profit exchanges. The form this will take is open to several possibilities. One

would have each market be similar to the current NASD structure in which NASDRegulation is a separate entity within the NASD holding company. There is also the

possibility of one ‘‘Super’’ SRO for all the markets. Another hybrid model would

allow each market to maintain its own regulatory (i.e., trading rules) and surveillance function, while a single SRO would oversee member regulation, sales practice

and intermarket trading.

Whatever the model, the SRO must be adequately funded. RIBA also cautions regulators to consider the potential for large firms to dominate the self-regulatory process in a new market structure. Under the influence of large firms, for-profit SROs

could raise the costs of regulation to levels which would force small firms out of the

industry. In addition, RIBA is concerned that large firms could also dominate the

rule-making process resulting in impractical and unfair rules as applied to the

lower-tier markets and the firms that service those markets.

CONCLUSION.

In the past few years, technology and regulatory changes have caused rapid, dramatic and unprecedented changes in the equity trading markets. Online trading,

real time access to stock quotation, volume and trade execution data, a proliferation

of ECNs and extended trading hours are transforming the equity markets faster

than ever before. Changes in demographics are resulting in a larger pool of retail

investors with more money to invest. This democratization of the U.S. stock markets

has led to an explosive cash flow into the market. Increasing globalization is encouraging more foreign companies and investors to trade in the U.S. markets and forging greater numbers of international alliances and ventures.39

While all of these developments are worthy of appropriate regulatory reforms, the

highly successful dealer market servicing small issuers must not be sacrificed. Too

often, however, regulatory reforms have been shaped almost exclusively by analyses

of the top tier of the market consisting of the most actively traded securities in the

U.S. equities markets. Although the consequences are unintended, the lower tier

continues to suffer from this regulatory benign neglect.

The potential erosion of the small issuer equity market is a growing concern for

small business entrepreneurs in every region of the country. Failing to consider the

contribution of lower tier markets will stifle precisely the kind of new growth and

innovation that is sustaining and expanding our current booming economy. Small

issuers have recently enjoyed an enormous increase in the funds received from venture capital firms and so-called angel investors who have made seed capital investments in anticipation of an IPO as their investment exit strategy. These angel investors often evaluate companies less on their long-term growth capabilities than on

their short-term IPO prospects. If changes in market structure adversely affect the

small cap markets and the market makers’ ability to serve them, the venture capital

stream will likely dry up. Further, if market structure reforms harm the brokerdealer community the result may have a chilling effect on small business capital formation.

123

Respectfully, RIBA would like to make several suggestions for Congressional and

regulatory policymakers to consider.

First and foremost, RIBA implores Congress, the SEC and the SROs to consider

carefully and completely the impact of all rules, regulations and policy proposals on

the lower tier markets. It has been RIBA’s experience that when considering regulatory changes effects on all market tiers are not fully considered. As noted above,

these less liquid, more volatile markets have distinct needs and service a critical

aspect of our entrepreneurial industries.

Second, the spate of recent proposals for new market linkages and execution forums should prompt an examination of the practical impact on the lower tier markets. Regulatory policymakers must ask whether the future of ITS, SelectNet and

Super-SOES will provide appropriate applications for small market makers to compete effectively with their large counterparts.

Third, the concept of a single centralized market such as a CLOB also raises concerns for individual investors that may be handicapped by institutional investors

who are able to dominate markets by mobilizing vast amounts of capital instantaneously.

Fourth, as discussed earlier RIBA recommends establishing a small issuer capital

market task force to evaluate and shape market reform proposals unique to the

small issuers. RIBA is willing to take an active role in establishing the task force

and is committed to working with the regulators, market practitioners, the issuer

community and investors to make specific recommendations for constructive reforms.

Fifth, RIBA urges the SEC to clarify its best execution standards and specify their

applications to the lower tier markets. As new technologies continue to transform

the markets, it is imperative that regulations provide concise guidelines.

Last, RIBA would like to thank Chairman Oxley and Ranking Member Towns for

the opportunity to testify on these critical issues. RIBA commends the full Committee and its Staff for reaching out and soliciting the views of the small brokerdealer community. We hope that your leadership in creating a more inclusive debate

becomes the standard rather than the exception.

Mr. OXLEY. Thank you. Thanks to all of the panel.

The Chair will recognize himself for the first round of questions.

The fragmentation issue comes up time and time again. I think

it is worthy of some discussion. Many people say that ‘‘fragmentation’’ is just another word for ‘‘competition.’’

Why should we fight fragmentation? Don’t we really have fragmentation breaking out all over the place, and if it appears to be

competitive in nature, what is really wrong with that?

Let me begin with Mr. Atkin.

Mr. ATKIN. Thank you, Mr. Chairman.

I would say, looking on the fragmentation issue, it is in some

ways very complex and in some ways very simple. Looking at it one

way within Nasdaq, you could say there is a lot of fragmentation,

that there are multiple ECNs, multiple market makers, et cetera.

I would argue that Nasdaq has 100 percent market share within

its stocks, that all ECNs have to operate presently within Nasdaq,

and there is no alternative but for anyone who wishes to trade

Nasdaq stocks to go through the Nasdaq infrastructure.

Mr. OXLEY. Let me interrupt then, because at least at first blush

it would appear that the Super Montage could be considered a central limit order book. Is that your cut on that?

We will give Mr. Ketchum a chance.

Mr. ATKIN. It is certainly our view that the Nasdaq Super Montage is really an ECN. It is Nasdaq, in essence building a competing ECN, and the ECNs themselves are forced to operate under

Nasdaq’s infrastructure.

I think it would be like FedEx and UPS being forced to go

through the postal delivery system. We are forced to go through the

Nasdaq infrastructure, and what we believe is, they are building

124

their own competitive system, which will have the likely effect of

draining liquidity out of the ECNs into a less transparent marketplace.

Mr. OXLEY. Mr. Ketchum, do you have a different view on that?

Mr. KETCHUM. Well, probably a little bit, I guess.

Chairman Oxley, to get to your question first, no, I don’t think

Super Montage is anything like a composite limit order book. It is

an effort to recognize, particularly as we move, and positively so,

to a decimalized small increment world that is showing simply the

consolidated best bid and offer is of limited value, that in order to

understand what is happening in the market, you need to understand something, the depth going around both above the market

and below the market.

It is not intended to either compete directly or replace ECNs.

ECNs will continue to be the place that provides a separate, anonymous opportunity to allow buyers and sellers to connect, to match

orders beforehand and the like. What we think this will do is provide more substantial depth and transparency to the market.

We do recognize that these orders are the orders of ECNs and

market makers. They should receive compensation with respect to

it, and we expect to share both fees and tape data, because we

think that is the appropriate and fair way to do it.

With respect to Doug’s thoughts with regard to a single infrastructure, it is true that based on the SEC’s order handling the

rules, not on any NASD rules, if ECNs want to provide an environment where market makers show better prices anonymously than

they do in their quote, that they must be linked into Nasdaq in two

ways. Both from the standpoint of having their best quotes disseminated in the system and in providing a linkage so that people

who are not participants in that ECN have an ability to access the

best price.

I think those two reforms by the SEC allowed us just in the nick

of time to avoid a two-tier market environment and avoid a situation where institutions had access to better prices and liquidity

than individual investors.

So while I think, in fact, ECNs have plenty of choices in the markets, I think there does need to be sufficient linkage to assure that

individual investors are treated the same way as institutional investors.

Mr. OXLEY. Does anybody else want to comment on the fragmentation issue, as well as the Super Montage?

Mr. WHEELER. I would like to say a couple of things.

Our current view of Super Montage is flawed in a couple of ways.

The current proposal, as I understand it, is to display three levels

of price through the book. There is no trade-through protection to

address some of the issues that Holly spoke of. A retail investor,

willing to display a limit order at a particular price, has no protection that that limit order will be executed against, as a lot of stock

may trade at that particular price without an execution due to that

customer. It creates a single point of failure.

We have had that experience in the past with Nasdaq, the infamous squirrel that took the system down 10 years ago, and the arbitrary delays that Super Montage imposes on the rest of the marketplace.

125

As it is written right now, the way I understand it, the market

maker would have up to 5 seconds to decide whether they want to

execute against an incoming order or simply get out of the way and

let that order go on through the system. We are not in favor of anything like the 5-second rule as it stands right now.

Mr. OXLEY. My time has expired. We will get back to some other

issues.

Let me now recognize the gentleman from Michigan, Mr. Stupak.

Mr. STUPAK. Thank you, Mr. Chairman. Thank you for holding

this hearing.

Mr. McSweeney, could you elaborate on the New York Stock Exchange concern about CLOB? How would this affect the retail investor?

Mr. MCSWEENEY. The problem we have regarding the CLOB is

multifaceted. The major concern that we have is the fact that none

of the proponents of a CLOB could describe how the large order

flow would be handled in that type of an environment.

The CLOB is basically an environment in which you would nationalize the marketplace. All limit orders would be displayed and

executed automatically in terms of strict price-time priority. But

there was a recognition by each of the proponents that large-size

orders would have to be executed outside of the consolidated limit

order book because there would not be sufficient liquidity, and

those orders would not be fully disclosed because the market impact would result in the market moving away from those disclosed

orders. Therefore, you would have an environment in which there

would be less transparency.

Approximately 50 percent of the NYSE’s volume and about 45

percent of the consolidated volume is represented by transactions

of 10,000 shares or more. You would extract that order flow from

the price discovery process; it would result in a widening of the bid

and offer spreads. Therefore, it would increase volatility by the

widening of the spreads and the fact that there would be no specialties function in it; and it also would dampen intermarket competition based upon the strict price-time requirements of the

CLOB.

Actually, there was no agreement among proponents of the

CLOB exactly how that should be structured.

Mr. STUPAK. Could the CLOBs then do a two-tier system, like

one system for institutional and one system for retail investors?

Mr. MCSWEENEY. If they did that, Mr. Congressman, what would

take place is, you would have a significant diminution of the liquidity and price discovery process that takes place now. You would extract a significant portion of the price discovery represented by

larger orders from that process, and it would result in more volatility and less efficient markets.

Mr. STUPAK. Does the payment for order flow hurt the retail investor, the order flow?

Mr. MCSWEENEY. I believe it does, because payment for order

flow is a practice that does not include rebating that payment to

the ultimate customer, and it is closely aligned with internalization; and internalization is a serious concern, despite the fact that

we have 83 percent market share. The fact that a percentage of

that involves internalized order flow where public orders are not

126

afforded the benefit of the price discovery process and the potential

for price improvement is a concern, particularly the fact that we

have recently eliminated Rule 390. And we were gratified to see in

the SEC’s release that approved removal of 390 that the SEC

would be monitoring closely any significant change in order direction by member firms that would involve internalization.

Mr. STUPAK. Is your concern about the CLOBs related to your

concerns about payment of order flow, or are they separate issues?

Mr. MCSWEENEY. No, Mr. Congressman, that is a separate issue.

The issue is really one in which we believe that a market structure

that would nationalize the securities industry would not promote

competition, that would seriously impact liquidity of the market;

and as I mentioned, the most serious impact would be bifurcating

the institutional and the retail order flow and the price discovery

process.

Mr. STUPAK. Thank you.

I have nothing further, Mr. Chairman.

Mr. OXLEY. The gentleman’s time has expired.

The Chair now recognizes the gentleman from Pennsylvania, Mr.

Greenwood.

Mr. GREENWOOD. Thank you, Mr. Chairman. I am going to address the question to my constituent, Mr. Kamen.

Can you be specific about—what regulations that are in place

now do you think are limiting the ability of investors in the small

cap issue market from fully benefiting from technology, if there are

such regulations?

Mr. KAMEN. Well, a lot of it has to do with the systems. In the

lower-tier markets, mainly the OTC bulletin board, there is no

automatic execution electronically the way it happens in the upper

tiers. The Instanets and the ECNs don’t practice in those markets.

As a matter of fact, I had discussion with Mr. Ketchum earlier that

that is on the horizon.

I think the problem we face in the lower-tier markets is that

many of of the suggestions and policies that have been kicked

around and adopted have all been done with the consideration of

the largest tier of the marketplace. What is good for Microsoft

might not necessarily be good for a stock trading at $4 or $5 or

$10. Nor would one would argue that liquidity is the driving factor

of all securities. And in the lower-tier markets, where liquidity

tends to be less by the average daily volume of the securities, making rules that only look at the ramifications of the most liquid securities leaves the potential for a lot of unforeseen consequences in

the lower tier.

I think that is the overall picture that makes the most damage

to the smaller cap market, and that is why we need to take a look

every time we want to change something and do an analysis of how

that will affect the smaller cap stocks.

Mr. GREEN. Aside from coming and testifying here, what is necessary to get you and the folks you represent at the right table, besides this one, in order not to be left behind and be not considered?

Mr. KAMEN. I would certainly love for the NASD and the regulators to formally adopt, whether it is a small issue task force or

in some other type of venue, to allow the voice of the smaller markets to be heard. I mean, realistically, our issues don’t tend to be

127

front page news. I mean, we are not multinational and we are not

trading 20, 30, or 50 million shares a day. Our companies tend to

trade 200-, 300-, 400,000 shares a day, and in some cases, 800,000

shares a day. I think everyone needs to recognize that our voice

must be invited to the table, and we need to have specific debate

on these issues, starting with these types of things, and at the

NASD; that would be most helpful.

Mr. GREEN. Would any of the other panelists like to comment on

that?

Ms. STARK. Thank you. My firm manages microcap and small cap

assets, and in fact, I do trade bulletin board stocks and ECNs right

now. They are different animals than are the Microsoft and Dells

of the world, and they are predominantly Nasdaq-listed stocks.

I would have great difficulty indeed executing without ECNs.

The benefit of using ECNs is, especially in fast-moving markets,

the interlinkages they have created among themselves, so that I

can access other ECNs or bids and offers by broker-dealers who

might be active in those names. In fact, there are lots of names

that we have that don’t even open on any particular day.

But the dilemma is a real one, and we certainly would not want

to do anything that would discourage or hamper trading in them

further. But it is a reality right now, and I don’t think that anything being proposed today, and especially in Super Montage, is

going to hurt trading of the small and microcap stocks. In fact, I

think it will enhance it.

Mr. KETCHUM. Congressman Greenwood, I would just say that I

think Mr. Kamen makes some very sound points. We always try to

look, but it is always helpful to get greater input from interested

parts of the constituency of the impact on different parts of the

market. We do have a Small Firm Advisory Board. I think the concept of a Small Issuer Advisory Committee is a sound one we will

look very closely at.

I think Holly Stark makes a excellent point. I think that support

of the marketplace will be enhanced if there is greater ability to

display orders, and as indicated by Mr. Kamen, if there is an ability to provide more efficient execution and order routing systems

than exist in the bottom tier of the market. We are committed to

do that, and committed to ensure that this market is as liquid as

possible.

Mr. ATKIN. I would like to add a comment, Mr. Congressman,

and that would be, currently we are trading about 70 million

shares a day of bulletin board stocks, and I believe on Nasdaq they

are trading in the—700 or 800 million shares a day. We certainly

view the OTC bulletin board sector as an opportunity, as a big opportunity, to help lower costs for investors by providing an electronic means for investors to match stocks.

I also think that does need to be complemented by those who do

wish to commit capital. I think a lot of what we are talking about

today is, should people get privileges for committing capital to retail investors? And really, what is going on in many of the markets,

markets where the big American firms seem to be doing very well,

is that their capital commitment providers do not get any privileges.

128

I think, as most of the buy-side participants have been saying,

that orders have price-time priority, and if you wish to commit capital, you must satisfy—whether it is a retail investor’s order or an

institutional investor’s order—first before committing your capital;

and people are finding it very profitable to do it in that environment.

So we think it is important for both to occur, but not to advantage and give privileges to those who commit capital over individual investor’s orders or institutional orders.

Mr. OXLEY. The gentleman’s time has expired.

Mr. STUPAK. Could we have unanimous consent to enter opening

statements in the record?

Mr. OXLEY. Yes, it has already been done.

The gentleman from Chicago, Mr. Rush.

Mr. RUSH. Thank you, Mr. Chairman. On May 4, 2000, the SEC

released a report of a special study by both the Office of Economic

Analysis and the Office of Compliance, Inspection and Examination, regarding the display of customer limit orders. Mr. Chairman,

I ask unanimous consent that this report be included in the record.

Mr. OXLEY. Without objection.

[The report follows:]

129


G:\GRAPHICS\63803.006
130


G:\GRAPHICS\63803.007
131


G:\GRAPHICS\63803.008
132


G:\GRAPHICS\63803.009
133


G:\GRAPHICS\63803.010
134


G:\GRAPHICS\63803.011
135


G:\GRAPHICS\63803.012
136


G:\GRAPHICS\63803.013
137


G:\GRAPHICS\63803.014
138


G:\GRAPHICS\63803.015
139


G:\GRAPHICS\63803.016
140


G:\GRAPHICS\63803.017
141


G:\GRAPHICS\63803.018
142


G:\GRAPHICS\63803.019
143


G:\GRAPHICS\63803.020
144


G:\GRAPHICS\63803.021
145


G:\GRAPHICS\63803.022
146


G:\GRAPHICS\63803.023
147


G:\GRAPHICS\63803.024
148


G:\GRAPHICS\63803.025
149


G:\GRAPHICS\63803.026
150


G:\GRAPHICS\63803.027
151


G:\GRAPHICS\63803.028
152

Mr. RUSH. Mr. Chairman, the report reveals the problems and

violations in the display of limit orders in equities and options markets and the inadequacies in the market’s surveillance and disciplinary programs for limit order display. The violations include failures to display proper order size, failure to display orders within

30 seconds after receipt, and failure to properly transfer the order

display obligation to another exchange system or members.

As a matter of fact, Chairman Levitt said, ‘‘Limit orders have

been a powerful force for competition in our markets, narrowing

spreads, increasing transparency, and supplying liquidity.’’ He

went on to say, ‘‘Their effect on the price-setting process simply

cannot be compromised.’’ These are strong words and they are troubling findings.

We have heard testimony today about the importance of limit orders. I would ask Mr. McSweeney and Mr. Ketchum to respond to

the report’s findings and to indicate what they intend to do by way

of reform. Then I will ask the rest of the panel for their thoughts

about what should be done.

Mr. McSweeney and Mr. Ketchum.

Mr. MCSWEENEY. Congressman, I would like to agree with you

that the results of the SEC’s report were troubling, and give you

and this committee an assurance that the issues that were raised

in that report were not issues that related to the surveillance and

enforcement at the New York Stock Exchange.

As you would note, there were no exchanges or market centers

identified specifically in the report. The Exchange has a very robust and extensive surveillance program dealing with the issue of

limit order exposure, and our compliance rate is 99.997 percent. In

instances in which we believe that compliance is not being effectuated by the specialist or brokers, we will take enforcement action, as we have done in the past.

The New York Stock Exchange, in fact, had an order display rule

in place before the SEC’s adoption of the order handling rules,

which were adopted specifically to address specific abuses in the

over-the-counter market. Albeit our guideline was a 2-minute

guideline as opposed to the immediate and up to 30 second parameters that are in section 11(a) currently. But it is something we

take seriously and we enforce aggressively.

Mr. KETCHUM. Congressman, again, I would also like to assure

you that the NASD and the Nasdaq stock market take the order

display requirement extremely seriously. We believe they are indeed a critical part of our marketplace.

That is the reason why over the last 2 years NASD regulation

has brought 49 disciplinary actions with respect to violations of the

order display rules, and why we will be in the process in the next

month of moving from our examination program to being able to

use our now-available order information on timing to implement

more electronic surveillance systems that will allow us on a realtime basis to be able to respond to any failures for the expected

delay of information.

This is a critical issue for us. We have brought, I believe, more

disciplinary actions than all other markets combined, and we are

absolutely committed to provide every surveillance technique we

can to ensure that orders are properly exposed.

153

Mr. RUSH. So both the market witnesses here agree that the report is an accurate report. Do you agree with the findings of the

report?

Mr. KETCHUM. I think the SEC does a great credit in bringing

forward and focusing attention on this issue, and I think the issues

are extremely important.

It is probably useful to note with respect to some the percentages

noted with respect to large market makers, those characterized as

large market makers, that those percentages involve three market

makers that account for less than one-third of 1 percent of the

transactions in the Nasdaq market, so it is an unusual definition

of ‘‘large.’’

But the basic point that there is no acceptable level of noncompliance with respect to the order handling rules is absolutely correct,

and the Commission did a service to focus on that issue; and we

are absolutely committed to throw every regulatory and surveillance focus on it that we possibly can.

Mr. OXLEY. The gentleman’s time has expired.

The gentleman from Illinois, Mr. Shimkus.

Mr. SHIMKUS. Thank you, Mr. Chairman. I have been sitting

here wondering how I was going to gracefully admit to the fact that

this is pretty much over my head, even though I consider myself

a learned individual. So I am going to try to boil it down simply,

and then I have a few questions.

Is it safe to say that the exchanges are like traditional auctioneers in that the ECNs currently have to go through a gatekeeper, it is kind of a closed system, and the real debate is, should

the ECNs eventually be able to be their own auctioneer? If we are

going to boil this down simplistically, infantryman style, a ‘‘keep it

simple, stupid’’ proposal?

Mr. ATKIN. I think you have hit on the fundamental issue, and

that is, as I believe I said earlier, I think many ECNs, in essence,

are frustrated exchanges. ECNs do not exist in any other market

structure or in any other market around the world, except the U.S.

market. I believe the main reason for that is, other marketplaces

allow true competition to exist between auctioneers or between exchange entities.

I think what is going on in this marketplace right now, to go

with the analogy, is maybe Nasdaq and the New York Stock Exchange have been Christie’s and the Sotheby’s, but it is as if eBay

could go into business, but only if it abided by the rules set by

Christie’s or Sotheby’s.

What we are saying is, to promote competition and to promote

innovation in these markets, you need to set these companies free

and allow them to operate on a level playing field. The fact that

the Nasdaq has its SRO and the New York Stock Exchange has its

SRO, which gives it significant rulemaking advantages, we think

that that prohibits competition from truly blossoming in this marketplace.

Mr. SHIMKUS. Let me follow up, and I appreciate that, and I did

write eBay in some of my scribbled notes as I was thinking it

through, is it the Exchange’s argument that the investor is best

protected by the current, maybe partially monopolistic approach?

154

Mr. MCSWEENEY. Congressman, I would respond to that by saying regulation ATS presently provides an alternative for ECNs to

either register as broker-dealers, which the current nine ECNs are

presently broker-dealers registered with the NASD, or they can

register as exchanges with the SEC and meet the regulatory requirements that are appropriate for a self-regulatory organization.

In fact, three of the ECNs, Nextrade, Island and Archipelago, have

filed with the SEC for that status. It is moot with respect to Archipelago because of their proposed alliance with the Pacific Stock Exchange, but that option is open and available to ECNs if they wish

to choose that route.

Mr. SHIMKUS. Mr. Ketchum?

Mr. KETCHUM. I think Bob has hit an important point. Let me

say a couple of things in addition.

First, it is probably necessary to understand that ECNs don’t operate entirely within an exchange or Nasdaq infrastructure. They

have a separate technology infrastructure in which anyone who

wishes to be a participant with respect to what that ECN electronically connects to. They are enormously efficient from that standpoint, compete extremely well, and provide a great benefit to the

marketplace. They, as Bob indicates, have a choice now as to

whether to be a broker or an exchange environment, and gain some

of the benefits and yet costs and delays that are involved in having

to operate as a fully regulated exchange; and we support that

choice.

Given that environment, I don’t think that they are hampered in

any way with respect to their choices, particularly from a Nasdaq

situation in which we are committed to linking with an ECN that

wants to operate either as an exchange or an ECN in an open, inclusive environment.

Mr. SHIMKUS. Let me then move, Mr. Ketchum, and follow up.

Some of these may have been asked earlier.

Should the Nasdaq allow others to trade in decimals, even

though you have not moved to decimal trading yet?

Mr. KETCHUM. Well, that is a good question, Congressman. In

fact today, Nasdaq, unlike other markets in the United States, because of the manner in which it is structured, does allow anyone

to trade in decimals who operates on the Nasdaq market. Indeed,

we think that is an important right, and we think they should continue to be able to do that.

We are able to facilitate anyone who wishes to report in decimals

through the clearing system, and we are absolutely committed to

continuing to do that. We think people who are participating in the

market should respond to whatever their customer needs are.

Mr. SHIMKUS. When will you be prepared? When do you envision

being able to fully move? I think the committee, as a whole—I can’t

speak for all the members, but I think we are obviously—we really

want to see this happen, as you know.

Mr. KETCHUM. Congressman, I think that there is probably nobody in this this room that is more aware that this committee

wants to see this happen than me. Let me emphasize and say this

very, very clearly, that Nasdaq and the NASD strongly believe in

the implementation of decimalization as well, and we very much

want to see it happen.

155

We submitted a comment letter to the SEC this week in which

we have indicated our ability to be able to move and support, based

on whatever the SEC determines to do, either a pilot or full implementation of trading in listed securities in September of this year.

We will be able to support, in light of the explosion of volume on

Nasdaq, the implementation of decimalization in the Nasdaq marketplace, full implementation, beyond the ability to support anyone

who chooses to trade in decimals now, by the end of the first quarter of 2001.

I want to commit to you, sir, decimalization is our first priority.

We will let nothing stand in front of or let no resources not be dedicated that are necessary to meet those commitments.

Mr. SHIMKUS. Mr. Chairman, I would like Mr. Atkin to answer,

and then we can cut my time off.

Mr. ATKIN. I think going back to the choice issue of reg ATS, it

is a choice, but I would say it is a false choice. There is absoultely

no clear path for those ECNs who wish to compete on a level playing field with either Nasdaq or the New York Stock Exchange; or

if Goldman Sachs chooses to compete with Nasdaq and the New

York Stock Exchange, to do so. It is an extremely unclear process.

The last exchange to do it was the International Securities Exchange, which was a small options exchange. It took 3 years for

that to occur.

In the meantime, Nasdaq is building with its Super Montage proposal something that has very competitive aspects, I would say a

direct competitor to the ECNs that wish to get out from under its

infrastructure.

In my view, this is all about timing. I believe Nasdaq should be

allowed to do whatever it wants to its market, but only after those

who want to compete with it are able to do so on a level playing

field. Nasdaq cannot have the monopoly on regulation in its market, it can’t have the monopoly on market data and use of its infrastructure.

This is really a sequencing problem more than anything else.

Mr. SHIMKUS. Well, I appreciate that. I would just end up by saying we have a lot of education from all parties to work with with

members, and I look forward to learning more. I don’t watch much

TV, but the commercial I like is when the boss calls Stewart into

his office. This Gen-Xer comes in, rock and roll and trading stock.

He is the hero. And the guy gives him the Xerox copy of the party,

and the guy says ‘‘I think I might be there, Stewart.’’

So the world is changing, and I think we all need to get on board.

With that, I yield back my time.

Mr. OXLEY. Thank you. I was thinking about Ringo Starr, but

that is a whole different story.

The gentleman from New York, Mr. Engel.

Mr. ENGEL. Thank you, Mr. Chairman.

Ms. Stark, your testimony states, ‘‘Nasdaq’s proposed Super

Montage is a laudable initial step in the right direction to provide

price and time priority for limit orders and to permit display of a

more complete picture of trading interests, not only of the inside

quote, but of prices several increments away from the best bid and

offer.’’

156

You go on to concede that, ‘‘It is not a panacea as it permits internalization of customer orders by broker-dealers.’’ That is a practice you obviously condemn elsewhere in your testimony.

Mr. Atkin, on the other hand, calls Super Montage ‘‘super monopoly.’’ You say it will allow Nasdaq ‘‘to control who market participants send their orders to and give the NASD an unfair advantage over its competitors, ultimately harming investors.’’ That is

what you say.

You go on to say, ‘‘Because it is not really voluntary, it could give

investors worse prices than they get today and provide investors

with less information than they get today.’’ If I misquote you,

please correct me.

If I take the testimony of both of you, it is hard to believe that

you are talking about the same system. So my question to the two

of you, and then the rest of the panel, is, whose conclusion is correct and why?

Ms. Stark, if you would begin.

Ms. STARK. Thank you, Congressman. I sit on Nasdaq’s Quality

of Markets Committee and have spent many long committee hours

going through the creation of the proposal first of NAQsi.net, I believe. And usually these things have Q’s in them; for some reason,

Super Montage does not.

The Nasdaq marketplace is evolving, and the Nasdaq, or the

NASD, is made up of many different constituents with many different interests. Super Montage is the first proposal that I have

seen that Nasdaq has been able to successfully put out to its membership that actually has a chance of passing, and I think it is a

good step in the right direction in terms of opening up the marketplace for everyone to see what is going on there. I don’t think it

is the best step that could be made because, similar to what Doug

has said, there is an issue about whether or not you are forcing everyone into one switch.

I think on a short-term basis this might be our best shot to move

the market forward, perhaps to a better place and a better structure. But because of the varying interests of the people who make

up the NASD, who are NASD members, I don’t think it is realistic

to expect a sweeping change to make the major, major steps that

perhaps could be made.

Mr. ATKIN. First of all, Holly and I have known each other a long

time, and I think we share the same goal in getting the markets

as efficient as possible for investors. I think Holly hit on maybe the

area of perceived disagreement or disagreement, and that is, over

what time period are you looking at this proposal? In the short

term, given all the political issues within Nasdaq and, you know,

the market makers’ strong interest and their desires to internalize

order flow, I believe that this is the best that they can get out of

the current governing structure at Nasdaq.

What I would suggest, though, is that if you look at this, what

is likely to occur if this is implemented, if Nasdaq is building its

own ECN, Nasdaq, under its current proposal, is only willing to go

out to the three best bids and offers. The ECNs that exist, Instanet

included, show investors full depth of book.

157

If Super Montage is successful at draining liquidity out of the

ECNs, I think you are going to see market structure go backwards

and transparency go backwards.

Mr. KAMEN. I would just like to add, this is an example of the

type of benign neglect that I was talking about in the small-tier

markets. In very liquid markets where it is likely there will be

many participants posting bids and offers, the Super Montage

could certainly have its purpose. But in the lower-tier markets,

where it is mostly dominated by market makers that display 100

share bid-and-offer size and wait for the phone call, if you will, to

react to the real bid or offer that is being shown them, the Super

Montage just might display 300 shares bid at one level and 100 at

another and 400 at another, giving the false illusion that at the low

end there is no interest in these stocks, because the market markers would only put up these de minimis bids.

If I can, I would just like to clarify something I said earlier. In

the lower-tier markets, I can’t access as a small broker-dealer, if

I am not an Instanet access firm, the OTC bulletin board and the

order systems that they were talking about. Predominately, the regional investment banker association firms don’t enjoy some of the

access that the larger firms do to the systems of the private companies.

Mr. ENGEL. Mr. Ketchum.

Mr. KETCHUM. Thank you, Congressman. I would just like to

briefly hit on this issue, because I think the issues are important,

and I think the points made by both Ms. Stark and Mr. Atkin deserve a little response.

Undoubtedly, the market structure in the United States will continue to evolve for a long period of time. We, perhaps more than

any country, have to solve two different problems that relate. We

have to handle the largest institutional investing market in the

world, and we have to handle an explosive on-line trading environment of individual investors that result in literally hundreds of orders in a single stock focusing in a very short period. So I have no

doubt that, whatever occurs, the Super Montage display window

will not be the last step in the line.

I do believe that we need to do a good deal more talking with

our ECN friends and certainly with Instanet, which has been a

critical innovator and substantial liquidity support of the Nasdaq

market for some time.

I don’t believe Doug’s points are correct, and we will spend some

time trying to work through them, because in fact the intent is to

continue to allow the full display of ECN depth through the marketplace, to encourage additional display of market maker limit orders that are not seen today, and not to require ECNs to necessarily leave orders one way or another, whether they choose to

go with us for automatic execution or through communication with

our existing transaction link with the system now. We intend to

provide the alternative, and we would like them to be participants

in our market, if they choose as brokers, either way.

So we need to do our work in better communicating with the

ECNs, but I do believe this is a step, as Holly indicates, very much

in the right direction.

Mr. OXLEY. The gentleman’s time has expired.

158

Let me recognize myself for another round for 5 minutes.

Mr. McSweeney, at our last hearing, we had some folks from Island testify about their entire order book that is publicly available

in real time. Doesn’t this level of transparency help investors, and

why does the New York Stock Exchange refuse direct electronic access by investors to the specialist order book?

Mr. MCSWEENEY. Mr. Chairman, we agree that that level of

transparency does help investors, and we intend to make the entire

limit order book of each of our specialists fully available before the

end of the year.

Mr. OXLEY. Are we making news here today, Mr. McSweeney?

Mr. MCSWEENEY. No, I don’t believe so. We have indicated in the

past that that has been in our technology plans.

Mr. OXLEY. And that will be by the end of the year?

Mr. MCSWEENEY. Yes, sir.

Mr. OXLEY. Any reactions?

Mr. ATKIN. We welcome it. We think it would be great for investors, and showing more information to investors is critical for them

to lower their trading costs.

Mr. OXLEY. Does everybody else agree with that?

Good.

Mr. McSweeney how do you respond to the concerns raised by

Mr. Wheeler that the physical floor base model of the Exchange depends on layers of internalizing rules?

Mr. MCSWEENEY. Mr. Chairman, I don’t agree with that characterization. There is an ability for customers of our member firm

broker-dealers to access the floor of the NYSE through our

SuperDOT network. In fact, 93 percent of the orders and 50 percent of the volume that comes to the Exchange floor is coming to

the floor through an e-commerce electronic platform.

There clearly is a different market structure than an ECN market structure, which provides solely an automatic execution for the

order flow. It is an agency auction market. That really does not

amount to internalization, because internalization involves a situation in which orders are not provided an opportunity for price improvement. In fact, all of the order flow that comes to the NYSE’s

floor, including that coming through our systems, is afforded an opportunity at price improvement, which results in 35 percent of the

volume receiving price improvement; and if you move beyond 1

point spreads, it amounts to 52 percent of the volume receiving

price improvement.

So it is really not an internalized environment. It is an auction

environment that provides an opportunity for late interest, represented by brokers, to provide that price improvement.

Mr. JENKINS. Mr. Chairman, I just want to clarify something,

though, as an institutional trader.

If I go to the floor and I send through this SuperDOT system a

limit order, if a stock is offered at $20 and I send a limit order to

the floor, I am in agreement that I will buy that stock at $20.

In many cases, you do not buy the stock because, in the current

system, they put it out for auction and the floor-based traders who

have standing are able to go in and then take that offer, while I

am trying to bid for a price, at a price that I didn’t even agree to.

159

Does that not occur on the floor? Because I am willing to pay

that price, yet I can’t take the stock at that price. I have to give

others that are not even willing to pay that price on the floor the

ability to come up and compete with me.

Why do they get to compete? If I step in and I say, here is the

auction, we are offering it at this price; and I step in and say, I

will buy that stock, why then do I have to bid a lower price first

and allow everybody to step ahead of me before my order is executed?

Mr. MCSWEENEY. The point Mr. Jenkins is raising is an important one. The agency auction provides the opportunity for price improvement, but quite often we have seen situations in which large

orders that are brought to the marketplace result in latent interest

stepping up and participating on the same side of the market.

That is the reason why, later this year, we are going to be introducing a new institutional express product that includes express

order. What that will allow for is the entry of orders, initially for

25,000 shares or more, and then after 3 months, for 15,000 or

more, an opportunity to lock in to the contra-interest if that quote

has aged initially 30 seconds and, subsequently, 15 seconds in a

manner in which the opportunity for crowd interest to interact with

that contra-side of the market will not be available, but the order

be exposed for the possibility only of price improvement.

So I think the point he is raising is a good one, and I think the

product that we will be rolling out in the next several months will

address that specific issue.

Mr. OXLEY. Now, is that a viable solution, Mr. Wheeler and Mr.

Jenkins?

Mr. JENKINS. It is not, because 30 seconds in an electronic world

is an eternity. I guarantee you that you will not have orders available on the institutional express for institutions to take, because

they will disappear as you approach that 30-second limit.

Mr. WHEELER. A couple of points I would like to make in response to this:

No. 1, I think institutional express, the Exchange should be commended in that it is a positive step in the right direction, albeit in

our view a very small baby step, if you will.

Throughout the testimony, and I think Mr. Jenkins probably verbalized it best, limit orders are the backbone of trading throughout

the world. If you look at Mr. Atkin’s system and all the ECNs, they

thrive and are gaining market share because they protect limit orders. The New York Stock Exchange currently does not protect

limit orders, i.e., the investing public, who is willing to display to

the world that they are willing to buy a particular stock at a particular price. I would go so far as to say that members of these exchanges prey off of these limit orders.

Limit orders have an economic value. They are worth something.

There is a value to a limit order. No matter how far away from the

current market it is or how small a quantity that order is for, it

has an economic value. If you look at options to buy and sell a particular stock in the newspaper, options that are away from the

market all have a value; there is an economic value attached to

them.

160

Our exchanges do not recognize the economic value of those limit

orders. They need to be protected and the investors behind the orders that are willing to display their trading interest need to be

protected if our exchanges are going to compete in the global marketplace going forward.

In Mr. Jenkins’ example, if he is down on the floor willing to pay $20 for a stock and he is displaying that limit to the public and

he is the high bid in the ‘‘auction system’’ of the New York Stock

Exchange, and I come in to sell that stock to Mr. Jenkins, it is very

feasible for a member standing in the crowd, instead of allowing

me to sell stock to Mr. Jenkins at $20, that they just step in and

say, I will pay a ‘‘teenie’’ for American Century Stock. This gets

written off as ‘‘price improvement.’’ The New York Stock Exchange,

in a sense, wraps themselves in the American flag over price improvement.

We think the whole price improvement idea is flawed. Price improvement is nothing more than a short-term breakup of a clean

trade in order to get one side of that transaction to ultimately pay

a higher economic price than the minimum tic that they just

stepped ahead of that order for.

In this particular example, when I try to sell stock to Mr. Jen- kins at $20, but I am broken up—but I am broken up by a member

in the crowd who pays 1⁄16 for that, Mr. Jenkins still has a buy

ticket on his desk.

Our portfolio managers put in orders to buy and sell particular

stocks. They don’t give us orders that say buy IBM, Dell or

Compaq. They give us an order that says, buy IBM. The members

of the crowd know full well that if Mr. Jenkins can’t buy his stock at $20, he is going to have to pay 1⁄8 or 3⁄16 or 1⁄4 for that.

So what happens when someone takes that stock at 1⁄16? Yes, I

am price improved by 1⁄16 of a point. But what happens to Mr. Jenkins?

I will tell you what happens to him. The member turns around

and says, oh, Mr. Jenkins, I will sell you your stock at 1⁄4; and it

is like the infamous oil commercial, either pay me now or pay me

later.

Mr. OXLEY. So in that case, it would appear to always benefit the

seller versus the buyer. Is that too simple, or is that basically it?

Mr. WHEELER. That is basically it. The structure of the express

product benefits the responder to a trade, and that is where we

view that as fundamentally flawed. It does nothing to protect the

investor who is willing to display a trading interest by telling the

world they will pay the highest published price for a given stock.

No one else is willing to pay a higher price. Even though there may

be members in the crowd that are willing to pay 1⁄16 or 1⁄8, they

don’t have an economic interest in displaying that 1⁄16 or 1⁄8 to the

world to say the stock is not worth $20, this stock is worth 201⁄16

or 201⁄8.

Why? Because when I come in to sell it to them, they can just

sit back and say, I will take that stock at 1⁄16. Mr. Jenkins’ order

becomes a free option for everyone else in the crowd. This is why

seats at the New York Stock Exchange sell for $1.5 million or $2

million, because of this economic rent they are able to garner from

shareholders.

161

In our viewpoint, all the dollars made by the specialists in the

crowds are dollars that were at one time in the pockets of the public investors, retail or institutional, and those dollars are being siphoned off under the guise of price improvement every day, day in

and day out, on the floor of the Stock Exchange.

Mr. OXLEY. Mr. McSweeney, you were looking askance there at

that last comment. Could you defend yourself there?

Mr. MCSWEENEY. Mr. Chairman, I didn’t agree with the characterization, because even in Mr. Wheeler’s example, the customer for

whom he was entering that order was receiving the economic benefit of the price improvement, and in the example the customer

that was being represented by Mr. Jenkins was not willing to price

improve above the price that was being bid. It was somebody else

in the crowd that stepped up and provided that additional—— Mr. OXLEY. That is why it was a limited order, was it not?

Mr. MCSWEENEY. That is exactly right.

Mr. OXLEY. But in fact he has his whole soul out there for everybody to see. He has pretty much bared it all, and your guy comes

in there and moves ahead of him, but he hasn’t risked anything.

Mr. MCSWEENEY. Well, part of the price discovery process is

bringing out the latent interest to provide price improvement.

Mr. OXLEY. That is great for the guy that is selling, but what

about this poor guy that is sitting there thinking he is going to pick

this thing off at $40?

Mr. MCSWEENEY. Well, the NYSE direct cost product that we

will be rolling out before the end of the year will provide an opportunity for investors who want automatic execution to seek that

route initially for limit orders of 1,099 shares or less, and there will

be absolutely no crowd interaction except what was represented the

display bid and offer. So the opportunity for investors to send orders through the system sponsored by their broker-dealers to interact directly with the entire bid and offer without any crowd interaction will be available through the NYSE direct.

Mr. OXLEY. That will be transparent?

Mr. MCSWEENEY. That will be fully transparent.

Mr. OXLEY. My time has long expired.

The gentleman from New York.

Mr. ENGEL. Thank you, Mr. Chairman. I won’t be long. I know

everyone has been sitting here for a while. I just think it is a bit

unfair, some of the comments that have been made.

I am glad that Mr. McSweeney put the market structure report

into the record, because I think it is important that we have balanced testimony here. The report makes recommendations on expanded choices for investors at the New York Stock Exchange, and

it builds, as was said before, on the existing strengths of the New

York Stock Exchange floor system; and some of the expanded

choices include automatic electronic execution and opening the specialist’s book to on-line investors throughout the Internet. And the

report, of course, supports elimination of the intermarket trading

system in favor of a lot of different private sector initiatives.

Quite frankly, I have found the New York Stock Exchange willing to make the necessary changes in all the different subjects that

we have covered in this subcommittee and the committee through

the years. So I think some of the accusations are a bit unfair. I

162

want to give Mr. McSweeney a chance to perhaps respond further

to anything he might want to say.

Mr. MCSWEENEY. Well, I appreciate the compliment, Congressman, and I can assure you that our Special Committee worked very

long and hard over 6 months to receive a broad range of input and

put the recommendations in the light of what would be in the best

interests of the ultimate investors, as opposed to the interests of

the intermediaries. I think that is reflected in the recommendations.

Mr. ENGEL. Thank you.

Mr. Chairman, I have no further questions.

Mr. OXLEY. Thank you.

Thanks to all of our panel for your patience in waiting for those

floor votes and for a most interesting and lively debate on some

very, very important issues that face this subcommittee, as well as

the SEC.

With that, the subcommittee stands adjourned.

[Whereupon, at 12:52 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

163


G:\GRAPHICS\63803.029
164


G:\GRAPHICS\63803.030
165


G:\GRAPHICS\63803.031
166


G:\GRAPHICS\63803.032
167


G:\GRAPHICS\63803.033
168


G:\GRAPHICS\63803.034
169


G:\GRAPHICS\63803.035
170


G:\GRAPHICS\63803.036
171


G:\GRAPHICS\63803.037
172


G:\GRAPHICS\63803.038
173


G:\GRAPHICS\63803.039
174


G:\GRAPHICS\63803.040
175


G:\GRAPHICS\63803.041
176


G:\GRAPHICS\63803.042
177


G:\GRAPHICS\63803.043
178


G:\GRAPHICS\63803.044
179


G:\GRAPHICS\63803.045
180


G:\GRAPHICS\63803.046
181


G:\GRAPHICS\63803.047
182


G:\GRAPHICS\63803.048
183


G:\GRAPHICS\63803.049
184


G:\GRAPHICS\63803.050
185


G:\GRAPHICS\63803.051
186


G:\GRAPHICS\63803.052
187


G:\GRAPHICS\63803.053
188


G:\GRAPHICS\63803.054
189


G:\GRAPHICS\63803.055
190


G:\GRAPHICS\63803.056
191


G:\GRAPHICS\63803.057
192


G:\GRAPHICS\63803.058
193


G:\GRAPHICS\63803.059
194


G:\GRAPHICS\63803.060
195


G:\GRAPHICS\63803.061
196


G:\GRAPHICS\63803.062
197


G:\GRAPHICS\63803.063
198


G:\GRAPHICS\63803.064
199


G:\GRAPHICS\63803.065
200


G:\GRAPHICS\63803.066
201


G:\GRAPHICS\63803.067
202


G:\GRAPHICS\63803.068
203


G:\GRAPHICS\63803.069
204


G:\GRAPHICS\63803.070
205


G:\GRAPHICS\63803.071
206


G:\GRAPHICS\63803.072
207


G:\GRAPHICS\63803.073
208


G:\GRAPHICS\63803.074
209


G:\GRAPHICS\63803.075
210


G:\GRAPHICS\63803.076
211


G:\GRAPHICS\63803.077
212


G:\GRAPHICS\63803.078
213


G:\GRAPHICS\63803.079
214


G:\GRAPHICS\63803.080
215


G:\GRAPHICS\63803.081
216


G:\GRAPHICS\63803.082
217


G:\GRAPHICS\63803.083
218


G:\GRAPHICS\63803.084
219


G:\GRAPHICS\63803.085
220


G:\GRAPHICS\63803.086
221


G:\GRAPHICS\63803.087
222


G:\GRAPHICS\63803.088
223


G:\GRAPHICS\63803.089
224


G:\GRAPHICS\63803.090
225


G:\GRAPHICS\63803.091
226


G:\GRAPHICS\63803.092
227


G:\GRAPHICS\63803.093
228


G:\GRAPHICS\63803.094
229


G:\GRAPHICS\63803.095
230


G:\GRAPHICS\63803.096
231


G:\GRAPHICS\63803.097
232


G:\GRAPHICS\63803.098
233


G:\GRAPHICS\63803.099
234


G:\GRAPHICS\63803.100
235


G:\GRAPHICS\63803.101
236


G:\GRAPHICS\63803.102
237


G:\GRAPHICS\63803.103
238


G:\GRAPHICS\63803.104
239


G:\GRAPHICS\63803.105
240


G:\GRAPHICS\63803.106
241


G:\GRAPHICS\63803.107
242


G:\GRAPHICS\63803.108
243


G:\GRAPHICS\63803.109
244


G:\GRAPHICS\63803.110
245


G:\GRAPHICS\63803.111
246


G:\GRAPHICS\63803.112
247


G:\GRAPHICS\63803.113
248


G:\GRAPHICS\63803.114
249


G:\GRAPHICS\63803.115
250


G:\GRAPHICS\63803.116
251


G:\GRAPHICS\63803.117
252


G:\GRAPHICS\63803.118
253


G:\GRAPHICS\63803.119
254


G:\GRAPHICS\63803.120
255


G:\GRAPHICS\63803.121
256


G:\GRAPHICS\63803.122
257


G:\GRAPHICS\63803.123
258


G:\GRAPHICS\63803.124
259


G:\GRAPHICS\63803.125
260


G:\GRAPHICS\63803.126
261


G:\GRAPHICS\63803.127
262


G:\GRAPHICS\63803.128
263


G:\GRAPHICS\63803.129
264

RESPONSES FOR THE RECORD OF RICHARD G. KETCHUM, PRESIDENT, NATIONAL

ASSOCIATION OF SECURITIES DEALERS

Question 1. Should NASDAQ’s delay cause the entire market to delay trading in

decimals? Does the NASDAQ plan to develop a rounding indicator for those trading

in decimals? If not, will it be difficult for brokers to comply with best execution obligations?

Response: On May 10, 2000 the NASD responded to the SEC’s release on revising

the decimal implementation schedule. We stated in our comment that the NASD

will be ready to implement either of the alternatives suggested in the SEC’s release

for the exchange-listed market, full dual pricing or a pilot of dual pricing by September 4, 2000, as the SEC finds to be in the public interest in maintaining fair

and orderly markets and to protect investors. The NASD will also be ready to initiate decimal pricing in Nasdaq securities on March 31, 2001. There has been no

change to these dates.

Today, no rounding indicator is supported in the Nasdaq production software. If

an indicator were to be required, it would be a new requirement, with technical implications for our downstream systems as well as vendors. Adding this requirement

could jeopardize the planned implementation dates for decimals. This question has

arisen previously, specifically during the implementation of the SEC Order Handling Rules. At that time, the SEC did not require special rounding indicators.

Once the new software is implemented, firms will be allowed to enter prices up

to 4 decimal places. The system will round, according to pre-defined logic, to the

minimum price variation for the security (pennies or nickels). Screens will display

the rounded price. It should also be noted that our systems currently accept quote

entries in 64ths and round to 16th or 32nds, as required.

The issue of rounding is an important one that the SEC, the NASD, the other

markets, and the securities industry must carefully consider, because of, among

other things, the implications for best execution obligations. One of the benefits of

a decimalization pilot, if the SEC were to request one, would be to understand the

need for rounding conventions and how best to provide them.

Question 2. NASDAQ has recently announced alliances in Germany, England and

Japan. These are all decimalized markets. Why can’t NASDAQ use those countries’

decimalized systems here?

Response: The other international markets that Nasdaq has announced alliances

with now run on separate hardware platforms and networks, all of which handle

far lower message traffic and are not connected to U.S. clearance and settlement

systems. Moreover, none of these systems support either market makers or Electronic Communications Networks (ECNs). Conversion of any of these systems to

support Nasdaq Stock Market in the short term is simply impractical.

Question 3. When will NASDAQ be ready to trade all stocks in decimals?

Response: As stated in the answer to question 1 above, the NASD recently responded to the SEC’s release on revising the decimal implementation schedule. We

stated in that comment letter that the NASD will be ready to implement either of

the alternatives suggested in the SEC’s release for the exchange-listed market, full

dual pricing or a pilot of dual pricing by September 4, 2000, as the SEC finds to

be in the public interest in maintaining fair and orderly markets and to protect investors. The NASD will also be ready to initiate decimal pricing in Nasdaq securities on March 31, 2001. There has been no change to these dates.

Question 4. What is the single biggest market inefficiency investors are facing in

the market? What rule changes are/is necessary to eliminate this inefficiency?

Response: We believe that the single greatest inefficiency investors are facing in

the market today is fragmentation. In our opinion, fragmentation continues to pose

a tremendous and credible threat to the integrity of the U.S. securities markets. We

believe that this threat is not insurmountable and that the best way to address it

is through quick, decisive, cooperative efforts by the NASD/Nasdaq and the SEC

with Congress’ support.

As you are aware, electronic communications networks (ECNs) have become a significant force in the Nasdaq market. They collect hundreds of thousands of orders

from customers across the country, and perhaps, world. Thus, ECNs contain and

provide access to huge pools of liquidity. While recent rule and market-structure

changes have increased transparency and access to these pools of investor interests,

today it is still impossible to determine the entire depth of the market within the

ECNs and consequently, within Nasdaq. This, in turn, limits the quality and efficiency of the Nasdaq market and potentially harms the individual investor.

As I am sure you are aware, under the firm quote rule of the Exchange Act, a

market maker may place a better-priced order into an ECN and not update its quote

to reflect the better-priced order if the ECN disseminates the top of its file to

265

Nasdaq and the ECN provides broker/dealers equivalent access to these orders.

Thus, the public only sees the best-priced buy and the best-priced sell order (i.e.,

top-of-file) that resides in each of the nine ECNs in Nasdaq. The public does not

see the often significant liquidity in the ECN that is just below the ECNs’ top of

file. If a market maker places into an ECN an order that is priced better than the

market maker’s quote but is below the ECN’s top of the file, that order will remain

hidden from the market unless that order becomes the ECN’s top of file. Currently,

the only way for a market participant to monitor the full depth of the market is

to subscribe to each of the ECNs, which is costly, inefficient, and unmanageable.

This type of fragmentation makes it particularly difficult for institutions to conduct

business in Nasdaq because the institution cannot adequately determine the available liquidity at and near the inside market. In addition, because only the top of

the file of each ECN’s and market maker’s book is displayed in Nasdaq, it is possible for the market to trade through orders that reside on the market participant’s back book at a price away from the inside. Because there currently is no way in

Nasdaq to aggregate and display trading interest at multiple price levels, the current market structure fosters fragmentation.

In response to the second part of the above question, we believe that the best way

to address the problem of fragmentation is to allow the markets and market participants—fueled by the forces of competition and innovation—to provide a solution.

Specifically, we believe that the Nasdaq Order Display Facility, or SuperMontage,

which we submitted to the SEC last year, addresses the problem of fragmentation.

In essence the SuperMontage will build on Nasdaq’s strengths, as a collector and

aggregator of trading interests—the traditional role of a market. In addition, the

SuperMontage will be an inclusive model, in that it does not favor or a particular

business type (e.g., ECN, fully integrated market making firm, wholesale market

making firm). It will encourage innovation and competition while improving on

transparency and liquidity. Technology advances have for the first time allowed

Nasdaq to create a market where investors around the world can view and have

electronic access to virtually the full depth of the market and can have their orders

interact with one another virtually instantaneously.

The SuperMontage will show the best bid/best offer in Nasdaq and two price levels away, accompanied at each price level by the aggregate size of the ‘‘displayed’’ trading interest of market makers, ECNs, and exchanges granted Unlisted Trading

Privileges to Nasdaq securities (UTP Exchanges). Nasdaq market participants will

be able to designate an order as ‘‘attributable’’ or ‘‘non-attributable,’’ and also will

be able to indicate a reserve size for an order. Attributable orders will be displayed

next to the Nasdaq market participant’s acronym (Market Maker ID or MMID) in

the current Nasdaq quotation montage, and will also be displayed in the SuperMontage as part of the aggregate trading interest at the inside and two prices away).

Non-attributable orders will be displayed only in the Nasdaq Order Display Facility

as part of the aggregate trading interest at the inside and two prices away. In addition, Nasdaq market makers and ECNs will be permitted for the first time to give

multiple orders and orders at multiple price levels, which the system will manage

and display in Nasdaq when the order is eligible for display next to the market participant’s MMID and/or in the SuperMontage. Further, Nasdaq market participants

will be able to access orders in the SuperMontage virtually instantaneously using

a substantially-enhanced Nasdaq order delivery and execution system, which will be

built on an architecture that accommodates the technology needs of all Nasdaq market participants, market makers and ECNs alike. The system will route orders to

the market participant in queue and next eligible (based on a general time priority)

to receive an order/execution against its quote. Thus, the system will provide one

of potentially many links of all market participants trading Nasdaq-listed securities.

We believe that the SuperMontage provides substantial benefits to the individual

investor and improves market quality, while also encouraging innovation and competition. The system reduces fragmentation by allowing market participants to

transmit to Nasdaq multiple levels of orders and by aggregating and dynamically

displaying all orders at the inside and two price levels away. Market participants

will see for the first time in the SuperMontage the full depth of the inside market

and two price levels away, which will enhance transparency and liquidity, and will

also be able to view the full depth of the market in Nasdaq for all prices levels.

The ability to transmit and display multiple orders will reduce the possibility that

an order will be traded through in a fast moving market and also enhances best

execution, which directly benefits the individual investor. The order routing capability of SuperMontage will enable the system to effectively link all markets—including UTP Exchanges—that trade Nasdaq securities. We believe this will create,

for the first time, a national market system consistent with Congress’ mandate in

the 1975 amendments to the Exchange Act.

266

Question 5. What are the expected benefits decimalization will bring to investors?

Response: Potential benefits that decimalization may provide include more easily

understood numbers and investor savings. The least disputed benefit of decimal

pricing is that decimal pricing is easier for investors to understand.

Regarding savings for investors, there is an increased savings potential for investors if decimal pricing leads to smaller price increments and narrower bid-ask

spreads. Each price change (called an uptick or downtick respectively) would increase or decrease the price per share by 6.25 cents at a minimum. With decimals,

there is the potential to trade at a nickel or a penny increment. At a nickel increment, the uptick or downtick will be at 5 cents per share; a potential savings of 1.25

cents per share for investors. At a penny increment, investors could save up to 5.25

cents per share as the uptick or downtick goes one cent at a time. Narrower spreads

mean investors could save money as they are able to achieve a more precise price

for their trades. Of course, any calculation of benefits should recognize that in many

cases there will be relatively little depth at a penny increment and that most of the

buying and selling interest will likely be five to ten cents away from the displayed

price.

Question 6. What effect would the NASD’s SuperMontage proposal have on competition in the marketplace? How would use of the SuperMontage be voluntary if

the NASD retains any affiliation with the regulator of competitors of SuperMontage?

Response: We believe that the SuperMontage is a pro-competitive development

that will broaden competition and lead to further innovation. SuperMontage will

also permit Nasdaq to remain competitive in an environment of increased

globalization of the world’s securities markets. We firmly believe the proposal meets

the statutory requirements under the Exchange Act, and that the proposal responds

directly to Congress’ goal of establishing a true national market system. We believe

that the proposal protects investors and promotes the establishment of a free and

open national market system, in that it reduces fragmentation in the Nasdaq market and improves the efficiency of transactions in Nasdaq.

Specifically, the SuperMontage attempts to increase price transparency and alleviate fragmentation by providing a means for centralizing trading interest, displaying

this trading interest to investors, and providing an efficient means for accessing

such interest. We note that these are essential functions of an exchange. Every registered securities exchange in the United States has a limit order facility, which

serves as the point of order aggregation. Nasdaq is currently in the process of registering as an exchange. Nasdaq should be permitted to have a method of aggregating, displaying, and accessing investors’ interest to better serve investors in

Nasdaq-listed securities and in the spirit of equal regulation of similarly situated

market participants.

The SuperMontage encourages competition by providing an open and inclusive architecture in which competing market centers may operate. We are not, as some

have suggested, directly competing with our members. Rather, we recognize that

market centers that trade Nasdaq securities add value to the market and offer alternative services. For example, we are not offering through the SuperMontage certain

value-added services, such as anonymity through settlement, that ECNs offer today.

Moreover, while the proposal provides a central means for accessing liquidity in

Nasdaq and other market centers, it in no way establishes the SuperMontage as the

sole means for providing or accessing liquidity. NASD members, individual investors, and members of other exchanges are free to leave their orders with any market

center they chose. Moreover, subscribers of ECNs are free to use the execution services offered by the ECNs to access liquidity within those markets. UTP Exchanges

will continue to offer innovative execution services to their members. Orders will

continue to be handled by and executed in multiple trading venues. SuperMontage

thus provides a central, but not exclusive, means of accessing liquidity and of exposing trading interest to the market.

Competition will continue to flourish in the new regulatory environment that the

SEC has created through its recent regulatory initiatives, as shown by recent announcements by certain ECNs to link with one another (independent of the Nasdaq

network and systems) and plans of some broker/dealers to register as exchanges.

As the second part of your question, we reiterate the position that we have publicly articulated to our members and the SEC—the SuperMontage is completely voluntary. Nothing requires or compels market participants to give their order book to

Nasdaq. We understand that market participants may not wish to relinquish their

order book to Nasdaq and that they may provide valuable services away from the

central Nasdaq market. ECNs and market makers are free to give Nasdaq only

their best buy and sell orders, or they can chose to give Nasdaq all or some of their

orders. Nor does anything require that executions in Nasdaq securities occur

267

through the SuperMontage, or other Nasdaq facility. Any of these options for handling and executing orders would be consistent with NASD rules. This is similar to

the experience of exchanges. In the past every exchange has had a limit order facility, and that members of such exchanges have not been compelled by rule or regulation to leave their limit orders with the member’s resident exchange or the primary

market. To the contrary, the SEC has encouraged exchanges to actively compete for

order flow and avoided requiring members to leave orders with the primary exchange.

Finally, we reiterate that we in no way believe or intend for the SuperMontage

to be mandatory, regardless of the NASD and Nasdaq’s affiliation. NASD Regulation—a separate, wholly-owned subsidiary of the NASD—is vested with regulatory

authority over Nasdaq. Other than its role in establishing market policy and rules,

Nasdaq’s regulatory role is extremely limited. The separation between the regulatory function of NASD Regulation and the market function of Nasdaq is clear and

strong. The separation between these two corporations will become even greater

when Nasdaq recapitalizes, Nasdaq registers as an exchange, and the NASD becomes a minority owner of Nasdaq.

Question 7. I introduced a bill that passed the House and requires trade reporting

information to be disseminated to improve price transparency for corporate debt.

How will NASDAQ’s TRACE proposal impact the market? Is it more than just price

reporting? Is it in the interest of competition to have an SRO set the rules for trading that will be centralized with the NASD and benefit NASDAQ? Does this proposal use regulatory power to create a monopoly?

Response: The NASD is responsible for regulating virtually all securities trading

on Nasdaq and in the over-the-counter (OTC) market, including corporate bonds.

Section15A of the Securities Exchange Act of 1934 was adopted to expand the concept of self-regulation to the OTC market, and the NASD was formed to provide a

mechanism to supervise the conduct of broker-dealers participating in that market.

This authority includes the regulation of trading in corporate debt securities. The

NASD is the only self-regulatory organization (SRO) that has regulatory authority

over NASD broker-dealers that trade corporate debt securities over-the-counter, that

is, not on a registered securities exchange, and is thus the only SRO that can enhance the oversight of the operation of the OTC corporate bond market.

SEC Chairman Levitt called for increased transparency in the corporate bond

markets by requesting: rules requiring dealers in US corporate bonds to report all

transactions, systems to receive and distribute transaction prices immediately, a

regulatory database of bond transactions, and a bond market surveillance system

using that database.

The NASD filed a proposal with the SEC that both responded to Chairman

Levitt’s request and addressed the goals in your bill. The NASD’s proposal will provide: (1) a flexible trade reporting facility based upon standards all NASD members

must adhere to when trading over-the-counter; (2) a mechanism to give price disclosure to all market participants equally; and (3) an audit trail for NASDR to surveill

the market.

The NASD is responding to Congressional and SEC objectives by using facilities

that are in place and have worked well for the last decade. TRACE uses existing

linkages between the industry, Nasdaq, and NASDR, to solve the regulation and

transparency problems of the corporate bond market quickly and efficiently. The

NASD will use its wholly owned subsidiary, NASD Regulation, to regulate under

new trade reporting rules we have filed with the SEC. The NASD will enhance

transparency through trade reporting facilities also already in place and operated

by its other subsidiary, Nasdaq.

It is important to note that the system is not a bond trading system, and that

Nasdaq’s role will be simply that of providing a facility, not making rules or regulating the system. The NASD will in no way use its regulatory powers to enhance

the position of Nasdaq, and will not use regulatory power to create a monopolistic

situation. The NASD, not Nasdaq, has been charged by the SEC with collecting, disseminating, and policing the information on corporate bond trade reports. The

NASD, not Nasdaq, will be responsible for owning and operating the mechanism for

trade reporting and regulation of this market.

There has been confusion about the role of the NASD regarding the ownership

and revenue from the sale of the data collected. While others have suggested that

they should instead provide the data on a selective basis, the NASD, as it now does

with equity trade data, will distribute bond transaction data to all vendors on an

open, fair and independent basis, subject to SEC regulation. We expect a robust

market for resale of that data by vendors, just as now exists in equity trade data.

The NASD will use any revenues that it receives from the sale of TRACE data to

cover the NASD’s costs in operating the system, including NASDR’s regulatory acVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00271 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
268

tivities and the systems that collect and disseminate the trade information to the

public. Any revenue beyond these regulatory and technology costs will be shared

with the market participants that provided the data in the first place.

Finally, the TRACE proposal addresses the balance of market impact and market

transparency by setting dissemination caps for the investment grade and the below

investment grade markets. The NASD will also conduct liquidity studies to monitor

market impact. We have already begun discussions with firms and industry organizations to address their concerns on both the market impact and market data

issues.

Question 8. Given the technical difficulty that NASDAQ has had in converting to

decimals, why should we rely on NASDAQ to build a central point of failure for the

bond market through TRACE?

Response: The NASD is confident that Nasdaq will be able to implement TRACE

as a trade reporting facility. TRACE is based in large part on Nasdaq’s current

trade reporting system for equity securities—the Automated Confirmation Transaction Service (ACT). Every trading day ACT technology reliably processes hundreds

of thousands of last-sale trade reports in equity securities and accurately disseminates that information to market participants worldwide. This existing facility will

be tailored to handle the different data elements necessary for corporate bonds. It

should also be noted that corporate bonds trade less frequently than equities and

that the system hardware for TRACE is independent of equity trading hardware.

There must be a single mechanism that consolidates and validates the trade reporting information for regulatory and transparency purposes. Historically, the single mechanism for performing this task has been operated by an SRO that has the

statutory obligations to ensure that all information is properly collected, fairly disseminated, and closely scrutinized. The TRACE proposal follows that historical

model.

Question 9. A CLOB, based on price-time priority reduces best execution to the

NBBO. There are, however, many factors that could influence a decision to trade.

In your opinion, what factors should be considered for best execution?

Response: Although we believe that a CLOB based on strict (universal) price-time

priority would stifle market-wide competition and disadvantage investors, we also

note that Commission has stated that best execution cannot simply be reduced to

guaranteeing the NBBO (National Best Bid or Offer). Rather, a market participant

must also evaluate the opportunity for its customers to receive price improvement

or other value-added benefits.

As a general matter, however, best execution is a facts and circumstances determination. As the SEC has stated, there are a number of factors for market participants to consider in evaluating the quality of the executions they receive and whether they are providing best execution to their customers. Execution quality may involve the following: the opportunity for and likelihood of receiving price improvement; the speed and certainty of execution; the adequacy and certainty of accessible

liquidity, including liquidity beyond what is displayed; the nature of the security to

be traded; the type of order to be placed; the level of transactions costs; and the

scope of trading anonymity available. Individual investors may focus entirely on one

factor, or on several. For example, one investor may wish to receive a guaranteed

execution at the prevailing NBBO, while another may forego speed of execution in

favor of the opportunity for price improvement. Institutional investors may desire

to have their orders executed anonymously, regardless of speed or price improvement. The same investors may focus on different factors in different contexts. Finally, a member is obligated to make a routine and rigorous analysis of order routing arrangements to determine the quality of executions he or she is receiving for

customers.

Nasdaq aims to provide a broad array of choices for investors to access the liquidity provided by Nasdaq in the manner that best serves their needs.

Question 10. Should we call for the elimination of the Intermarket Trading System? Do we need to designate a replacement for that system, or would market forces

adequately fill the gap?

Response: While we share the general frustration of all market participants with

the Intermarket Trading System (ITS), which is clearly technologically outmoded

and which has raised concerns on the unanimous vote requirement, we do not believe it should be eliminated. While ITS technology and corporate governance are

in need of improvement, we do not believe this is the time to abandon a system that

links the markets. Instead, we believe it is time to make a concerted effort to improve the way markets access each other. The NASD has taken steps in this direction. In particular, the NASD has adopted rules and developed technology to open

its exchange-listed trading facility to a broader array of market participants. The

NASD has opened its facilities to ECNs as well to registered market makers and

269

thus opened access to ITS and the Consolidated Quotations System to ECNs, which

may now participate in these systems.

Even if improvements undertaken by the NASD and other participants are not

sufficient and a new system were introduced for accessing market liquidity, we do

not believe that ITS should be eliminated without a thorough assessment of the new

system’s efficacy in linking the markets.

Furthermore, under the ITS National Market System Plan approved by the SEC,

ITS membership is limited to the NASD and registered national securities exchanges, all of which are registered with the SEC as self-regulatory organizations

(‘‘SRO’’). As such, the SROs are required to establish and maintain regulatory programs to ensure that their members act in accordance with the requirements of the

Plan and the federal securities laws, including the rules of the SROs, which are

adopted under those laws. Any entity providing a trading venue that wants to operate as a registered SRO, like the other National Market System participants, should

be able to participate fully in ITS. Similarly, we believe that any entity that wants

to set up a competing system should also be required to register with the SEC as

an SRO, submit a National Market System Plan for the system to the SEC for approval, and be subject to SEC oversight.

Question 11. The NASD recently granted ECNs access to their market linkage

system through the Computer Assisted Execution System (CAES). Please explain

what CAES does and why this does or does not adequately address the problems

of efficient linkage among markets. Have any ECNs chosen to use CAES? Please

identify them.

Response: Nasdaq operates the Computer Assisted Execution System (CAES), a

trading system that allows NASD member firms to direct orders in exchange-listed

securities to NASD Market Makers for execution. Through CAES, NASD market

makers and ECNs are able to enter marketable limit orders in exchange-listed securities to be executed against other market makers and ECNs who are quoting in

those securities. CAES also serves as the NASD’s interface with the ITS, a trading

link between the Nasdaq system and U.S. stock exchanges, including The American

Stock Exchange, the New York Stock Exchange, and the regional stock exchanges.

Through CAES, all qualifying NASD members are able to effectively link to all

other ITS participant markets.

On March 16, 2000, the SEC approved an NASD rule filing that allows ECNs to

participate in CAES on an equal basis as market makers, and therefore, to link to

ITS. CAES will be open to all NASD member ECNs that are able to demonstrate

compliance with the CAES rules and system requirements. To date, several ECNs

have expressed interest in CAES participation and were recently provided with the

modified CAES system specifications that will allow them to assess any internal

system modifications necessary for participation in CAES.

The NASD believes that CAES will provide an efficient and well-regulated linkage

for market makers and ECNs to access other market centers. As with the ECNs

that participate in Nasdaq for Nasdaq-listed securities, customer orders of CAESparticipant ECNs will be afforded broad exposure to all other NASD members in

exchange-listed securities. Furthermore, any order displayed by a CAES-participant

ECN is broadly displayed through the Consolidated Quotation System to all vendors

and market participants. These displayed orders are then available to be accessed

by any ITS participant.

Although CAES is linked to ITS, CAES is itself a self-standing linkage that can

accommodate various market participants and competing market centers. CAES

also offers its participants distinct options in determining best execution, rather

than placing sole emphasis on global time priority. With the inclusion of ECNs,

CAES participants will be able to offer their customers an expanded range of desired execution characteristics, such as stock price, speed of execution, fill rate, commission cost, or some combination of the above.

By encouraging direct competition among participants, the Third Market via

CAES will assure service innovations that are not possible in the current ITS environment. Unlike ITS, the Third Market itself will continue to innovate and evolve

its market structure and technology to benefit all participants. The Third Market

has the potential to ultimately serve as the next-generation direct linkage for all

markets, rather than as a conduit to those markets through ITS.

Question 12. I understand both the NASDAQ and the NYSE are planning to become for-profit exchanges. Do you plan to spin off your regulatory arm entirely? If

not, why should you have any interest in the regulator of your competitors?

Response: The NASD currently operates in a structure where it is the parent to

the Nasdaq Stock Market, the American Stock Exchange, and NASD Regulation,

and is thus a full owner of these three subsidiaries. Under the current separately

operating subsidiary structure Nasdaq and NASDR, our regulatory arm, are more

270

widely separated than any other U.S. market and its regulator. When Nasdaq completes its recapitalization, the NASD will spin off about 80% of the ownership of

Nasdaq to NASD members, Nasdaq issuers, and other market participants who purchase shares in it. This will increase the separation between market and regulator—

and the potential for conflicts of organizational interest—to a degree not found in

any other market in the world, and allow the market and the regulator to function

independently. It is the NASD’s present intention to sell its remaining shares in

Nasdaq in the near term after the Nasdaq Board reaches a determination as to

whether to move forward on a public offering.

Question 13. What disclosure do you provide regarding your costs and revenues

associated with market data? Would you object to providing more information about

those costs and revenues to the public?

Response: As noted by the Commission in its recent market data concept release,

the NASD, through its consolidated financial statements, already provides detailed

information regarding its internal cost and revenue structures. In addition, Nasdaq,

as a registered Securities Information Processor (SIP), also files with the SEC a detailed financial statement that outlines the revenues received from the operation of

numerous Nasdaq systems and services, including those that distribute market

data. While the NASD fully supports the provision of complete and accurate market

data cost and revenue information to the public, the scope and manner of such disclosure should take into consideration SRO administrative costs and burdens in producing such information. As the acknowledged leader in SRO cost disclosure, the

NASD looks forward to working with Congress and the Commission in establishing

fair and reasonable uniform cost and revenue disclosure standards for all market

participants that consolidate and distribute market data.

NEW YORK STOCK EXCHANGE, INC.

June 8, 2000

The Honorable THOMAS BLILEY

Chairman

U.S. House of Representatives

Committee on Commerce

Room 2125, Rayburn House Office Building

Washington, D.C. 20515-6115

DEAR CHAIRMAN BLILEY, It was a pleasure to appear before the Finance Subcommittee of the House Commerce Committee. I appreciate the opportunity to respond to your follow-up questions. I would be pleased to meet with you or your staff

if I can be of any further assistance.

Sincerely,

ROBERT J. MCSWEENEY

Enclosures

RESPONSES FOR THE RECORD OF ROBERT J. MCSWEENEY

Question 1. Will the elimination of Rule 390 allow ECNs to compete directly with

the NYSE? If not, what other regulatory changes are needed? Will they be able to

compete if they become an exchange, as several have filed an application to become

an exchange?

Response. As NASD broker-dealers, ECNs were never subject to Rule 390. NYSE

members could always use ECNs for one-sided agency transactions (not ‘‘crosses’’).

Since ECNs are basically limit order matching files, the removal of Rule 390 permits our members to execute proprietary trades in the 23% of stocks previously covered by the rule.

The SEC’s Regulation ATS provides sufficient flexibility for ECNs to compete with

the NYSE as NASD broker-dealers, or by registering as an exchange with the SEC,

provided they meet the Commission’s regulatory infrastructure requirements to do

so.

Question 2. What is the single biggest market inefficiency investors are facing in

the market? What rule change(s) is (are) necessary to eliminate this inefficiency?

Response. The biggest single market inefficiency that investors face is internalization (and related payment for order flow economic inducement). A broker-dealer internalizes when it either trades as a dealer against a customer agency order or directs the order to an affiliated dealer for execution. Broker-dealers internalize agency market orders by buying from their customers at or near the bid price, and selling to their customers at or near the offer price. These agency orders do not interact

with other public orders, and they are often denied the opportunity to receive the

271

full degree of price improvement available at the NYSE. Internalization allows the

order-originating broker-dealer to profit at the expense of denying the customer the

ability to obtain a better price. In addition to the conflicts that internalization practices raise, these practices seriously threaten the price discovery process because the

internalized order flow is not exposed to, and therefore does not directly interact

with, the overall liquidity of the marketplace.

If a significant amount of internalization takes place, the agency auction, in which

75% of the price discovery represents customers meeting customers (rather than

dealer intermediation) would disappear and become a ‘‘dealerized’’ market, depriving

customers of the savings between the quotation spread associated with customerto-customer price discovery.

Therefore, we believe internalization should be banned. Absent that, broker-dealers should be required to provide customers with price improvement over the national best bid or offer. We have proposed that the SEC enact such a rule in our

filing to repeal Rule 390, as well as in our response to the SEC’s Concept Release

on Fragmentation.

Question 3. What are the expected benefits decimalization will bring to investors?

Response. Decimalization will result in narrower quotation spreads in many

stocks, providing significant savings to investors, presuming that the minimum

price variation is reduced to a penny rather than a nickel. It will certainly make

it easier for retail investors to track price movement and trading variations.

Question 4. What are the competitive implications of internalization?

Response. Because internalization deprives markets of optimal price discovery,

U.S. markets will be less competitive than they would be otherwise. To compete

with foreign markets, U.S. markets should be as robust as possible through the full

participation of both retail and institutional order flow in the price discovery process.Question 5. A CLOB, based on price-time priority reduces best execution to the

NBBO. There are however, many factors which could influence a decision to trade.

In your opinion, what factors should be considered for best execution?

Response. Best execution should be determined based upon each customer’s needs,

and we believe technology would enable that to be on an order-by-order basis. Factors that should be weighed in making order-routing decisions include: the bid and

offer prices; their size, in terms of depth of liquidity, and the probability of receiving

a complete ‘‘fill’’ (rather than partial execution); the probability of price improvement; the probability of receiving an execution in size greater than the displayed

bid or offer and the market impact of large orders; the speed of execution-, as well

as the cost of execution.

We believe that our platform of customer choice, called ‘‘Network NYSE’’ recognizes that ‘‘one size doesn’t fit all’’, and that a range of execution services will provide the optimal facility for best execution.

Question 6. Should we call for the elimination of the Intermarket Trading System?

Do we need to designate a replacement for the system, or would market forces adequately fill the gap?

Response. Yes, you should call for the replacement of the Intermarket Trading

System. It provides inappropriate free access to our market by competitors and its

quarter-century-old market-to-market linkage should be replaced with the more efficient and robust communications technology available today for linking broker-dealers and brokers to markets. A conversion period would be appropriate, during which

time we would work with the industry, similar to Y2K and decimalization, to ensure

that a sufficient time would be provided for broker-dealers and individual market

members to avail themselves of that technology. (Enclosed is a copy of our response

to the SEC’s Concept Release on Market Fragmentation.)

In that way, broker-dealers and brokers can exercise their best-execution responsibilities in a more efficient manner. If an order is routed to a market and a better

price becomes available on another market, the market where the order was routed

would match or the participant would electronically transmit the order to the market providing the opportunity for the best execution.

If ITS is not eliminated, an important prerequisite for direct access should be

SEC-approved self-regulatory organization status, as presently required, for reasons

outlined in the response to your next question.

Question 7. The NASD recently granted ECNs access to their market linkage system through the Computer Assisted Execution System (CAES). Please explain what

CAES does and why this does or does not adequately address the problems of efficient linkage among markets. Has CAES sufficiently linked ECNs with ITS?

Response. I would defer to the NASD for an explanation of the specific infrastructure of that interface. The NASD access is appropriate since ECNs are NASD

broker-dealers; however, some ECNs want direct linkage to the NMS without exVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00275 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
272

change status. That would create an unfair advantage vis-a`-vis other broker-dealers;

it would result in insufficient regulatory safeguards; and it would fragment liquidity

rather than consolidate order flow. It would suggest that countless entities technologically capable of creating an order file and interface network should proliferate

quotes, while retaining order flow in the hope of attracting a ‘‘match’’, resulting in

capacity and fragmentation inefficiencies.

Question 8. I understand both the NASDAQ and the NYSE are planning to become for-profit exchanges. Do you plan to spin off your regulatory arm entirely? If

not, why should you have any interest in the regulator of your competitors?

Response. No decision has been made regarding the advisability of

demutualization. Our Board formed a Special Committee on Market Structure, Governance and Ownership in October of 1999, comprised entirely of the public directors. Because market structure decisions can influence deliberations regarding governance and ownership, the Committee spent six months considering a broad spectrum of market structure recommendations. The result is the Market Structure Report embraced by our full Board in April. A copy is enclosed for your review.

The NYSE is recognized as the world’s pre-eminent self-regulator. We have invested more than any other market center in differentiating our regulatory brand

to our competitive advantage. Therefore, we do not intend to spin-off our regulatory

function.

Later this year, and hopefully with the benefit of an appreciation of the industry

impact of decimalization, the Committee will consider the issues of governance and

ownership. Within the context of the demutualization deliberations, we will assess

the issue of forming a separate NYSE regulatory entity within a holding company

structure and with separate governance.

As to the issue of regulating our competitors, the self-regulatory process presently

has that potential conflict in that we regulate members who compete for market

share through their equity in ECNs and ‘‘internalize’’ order flow on regional and

OTC markets. We do not regulate ECNS, since they are NASD broker-dealers, and

our members have been able to effect trades on regional exchanges for decades.

There has never been an allegation of inappropriate regulatory action based upon

that potential conflict. I am sure the SEC would expeditiously investigate and not

tolerate regulatory discrimination. The alternative of a single-self-regulatory body

suggested by some would result in greater broker-dealer expenses, since present regulatory funding is subsidized by the broader exchange revenues. In addition, it

would lack sufficient marketplace accountability, which could lead to an inappropriate expenses and bureaucracy.

Question 9. Mr. Atkin states that the SROs earn monopoly revenues in the area

of market data and use it to subsidize business activities they enter into in competition with their own members. Should the regulation of market data be changed to

provide for competition among market data providers, and, if so, how?

Response. SROs develop and maintain the order-routing infrastructure and capacity infrastructure necessary to create market data. Our market data revenues are

not ‘‘monopoly’’ revenues. They are subject to constituent consensus through Board

approval and SEC oversight in terms of their fairness. In fact, those fees have decreased significantly in conjunction with increased volume. The percentage of NYSE

market data revenues to our overall revenues has remained relatively constant over

the years, at 14-17 percent.

We have recently responded to a SEC release on market data (also enclosed) in

which we state our belief that, rather than the suggested ‘‘utility rate-making,’’ selfregulatory organizations should be permitted sell market data based upon

freemarket vendor pricing and consolidation, which would continue to be subject to

SEC review for fairness. We believe that supply and demand is the best regulator

of prices.

Question 10. Do current market information fees restrict the availability of realtime information?

Response. No. I have enclosed a copy of our market data fee structure. For public

investors, real-time data is free and ubiquitous.

Question 11. What disclosure do you provide regarding your costs and revenues

associated with market data? Would you object to providing more information about

those costs and revenues to the public?

Response. Our market data revenues, as well as our expenses for systems and related support are disclosed to the public in our Annual Report (enclosed). More detailed disclosure of the costs associated with the performance of each SRO function

would push each market into product-line accounting, would produce arbitrary results that are susceptible to second guessing, would require the Commission to establish uniform accounting standards and procedures, would require each market to

overhaul its accounting and auditing functions, and would require difficult allocaVerDate 19-MAR-2001 11:14 Apr 05, 2001 Jkt 010199 PO 00000 Frm 00276 Fmt 6601 Sfmt 6621 E:\HEARINGS\63803 pfrm07 PsN: 63803
273

tions of overhead and other costs. If the Commission were to mandate cost-based

ratemaking, than all of these burdens would represent unavoidable consequences of

that decision. If the Commission does not adopt a cost-based rate-making requirement, then such significant and expensive new burdens require careful thought and

the assessment of a cost/benefit analysis.

Question 12. At our last hearing, one of our witnesses, Island, demonstrated how

their entire order book is publicly available on their web site in real time. Doesn’t

this level of transparency help investors? You stated that the NYSE intends to provide such access to investors. Please describe exactly what information will be provided to investors and how they will access it.

Response. We agree that making the electronic limit order books available increases transparency to the advantage of investors. We are exploring three non-exclusive alternatives: a direct transmittal to member broker-dealers; a similar transmittal to vendors; and publication on our web site. The entering firm identity would

be blocked and broker-dealers and vendors would format the data as they choose.

A publication on our web site would provide total shares and number of orders at

several increments above and below the best bid and offer, with a summary-range

format beyond the designated level. We are in the process of identifying the needs

of broker-dealers and investors as to the most effective means of making that information available.

Æ