Sunday, May 22, 2005

Senators Hear From SEC, Exchanges and Investment Management Companies on Regulation NMS and Proposed Exchange Mergers

The US Senate Committee on Banking, Housing and Urban Affairs held two days of hearings on the impact of Regulations NMS, which was approved by the Securities and Exchange Commission by a 3-2 vote on April 7. The Committee also looked at the proposed merger of the New York Stock Exchange and Archipelago Exchange that was announced on April 20, as well as Nasdaq's proposed purchase of Instinet's electronic trading platform from Reuters that was announced on April 22.

The lineup of witnesses involved lots of people with an agenda. The panels on day one included John Thain, CEO, New York Stock Exchange; Robert Greifeld, President and CEO, Nasdaq Stock Market; Gerald Putnam, CEO, Archipelago; Edward Nicoll, CEO and Director, Instinet Group; Sandy Frucher, Chairman and CEO, Philadelphia Stock Exchange; Kim Bang, President and CEO, Bloomberg Tradebook; Scott Evans, EVP, TIAA-CREF; Thomas Joyce, Chairman and CEO, Knight Trading Group; Marc Lackritz, President, Securities Industry Association; and George Sauter, Chief Investment Officer; The Vanguard Group. SEC chairman Bill Donaldson held forth on day two.

Chairman Donaldson put some color on the proposed mergers stressing his testimony reflected his own views and not those of the other commissioners. He says the transactions resulted primarily from economic and competitive forces in the marketplace. Size matters, as does "the need to maximize economies of scale, reduce excess capacity, and, in the case of the New York Stock Exchange, respond to a growing demand for more automated trading and, at the same time, position itself to tap the public capital markets to fund future expansion opportunities."

Up to the formulation of Regulation National Market System (NMS), the lack of consistent intermarket trading rules for all NMS stocks had divided the equity markets into halves: a market for exchange-listed stocks and a market for Nasdaq stocks. For historical reasons, including the history of the NYSE as an auction market and Nasdaq as a dealer market, these stocks traded in quite different regulatory structures. Exchange-listed stocks were subject to the Intermarket Trading System, or ITS, rules that went into effect 30 years ago. These rules include trade-through restrictions, restrictions on locking or crossing quotations, and participation in a "hard" linkage system. In contrast, the market for Nasdaq stocks was just beginning to develop when the ITS was created and has never been subject to the ITS rules.

Donaldson says that with Regulation NMS, outdated and inconsistent existing rules will be eliminated. It will "facilitate competition between the NYSE and Nasdaq across all NMS stocks." Old rules, like ITS, gave floor brokers an advantage. The new trade-through rule expands the opportunities for electronic markets to compete with the NYSE floor for order flow and "ratchets up the pressure for the NYSE to implement its hybrid market proposal in a way that will truly facilitate automated trading." The new NYSE Group will have a "formidable electronic platform for acquiring market share in Nasdaq stocks."

Among the presenters, battle lines were drawn by whose ox was being gored. The various comments essentially are guesses as to what will happen when the final regulation is published later in the year.

I'll concentrate on the controversy about the flap about the new trade-through rule. (Interested readers can get all the testimony by clicking on the day one and day two links above.) When implemented, all best bids and best offers regardless of where they are will be required to interact with the best displayed prices on the electronic limit order books. Chairman Donaldson says it will "produce significant benefits for investors in the form of deeper, more liquid markets and more efficient pricing." Sounds logical to me.

The NYSE's Thain says the modernization of the trade through rule is the "centerpiece of the regulation." What's the trade-through rule? It was put in place in 1975 (before electronic trading I might add) to insure that an order would get the best available fill price before looking for the next best price. The rule essentially favors slow markets like the NYSE and in my mind is cumbersome and no longer useful now that orders can be executed electronically with a keystroke. Nasdaq does not have a trade-through rule which is to the liking of buy side institutions that are willing to trade through the best published price in order to get the order filled in the size they want.

Chairman Donaldson says the new trade-through rule "underscores the principle that, no matter where a customer order is routed, it should receive the best price that is immediately and automatically available anywhere in the national market system. The trade-through rule prevents markets from ignoring better priced automated quotes displayed by their competitors." He maintains that "smaller markets displaying the best price cannot be ignored by larger, dominant markets; the new trade-through rule will make it easier for all markets to compete on the basis of price." That should heighten competition between markets.

Kim Bang of Bloomberg's Tradebook disagrees. He says, the trade-through rule has functioned as "protectionist regulation" and has been "among the foremost impediments to competition and market efficiency." Electronic venues (like Tradebook) that offer firm bids and offers must take a detour to the NYSE for the best price. He says that while some price improvement might take place, the order runs the risk of being held or rejected as the market moves away or is filled at an inferior price. The new rule won't let orders get held on the floor eliminating the risk that specialists or others might trade around the order as they have so often in the past. He says the new rules are not to Bloomberg's liking but any change is welcome.

In my mind, the logical go to guy on trade-through is Gus Sauter the chief investment officer of The Vanguard Group. He puts his money and positions on the line every day. On the question of best execution, he told the Committee it's a combination of speed and certainty to get the expected best price, adding, "it is the best price an investor thinks he or she can obtain for the entire trade at the instant the investor decides to buy or sell securities." It minimizes transaction costs and maximizes returns. Isn't that what all this is about?

If you want a thoroughly irreverent look at trade-through, check this out.

Level playing field? Several panelists made reference to the establishment of a more level playing field once Regulation NMS is up and running. Chairman Donaldson in his Q&A sparring with the committee members brought it up repeatedly. In my years in this business, those that had been playing at the high end of the playing field at the onset of new rules and regulations invariably find themselves playing in a ditch when the changes are made. Anybody want to buy or leasse a large high-ceiling room at the southwest corner of Broad and Wall Streets in lower Manhattan?
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