Opening Statement by SEC Chairman:
Commission Open Meeting on Market Structure Initiatives in the Options Market and Public Disclosure of Order Routing Practices and Execution Quality
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
July 25, 2000
Good morning. We are here today to consider several significant items related to the structure of our options and equities markets. These proposals have grown out of the Commission’s and market participant’s consideration of the many complex issues presented by the dynamic change sweeping our capital markets. I firmly believe these initiatives represent a thoughtful and flexible approach that reinforces the Commission’s bedrock principles of fair and orderly markets and investor protection. Each of today’s proposals is bound by a common theme – market integrity. It cannot be said often enough – without market integrity there is no investor confidence, and without investor confidence there is no market.
First, for the options markets, we have before us recommendations to approve an intermarket linkage plan, a proposed Trade-Through Disclosure Rule, and a proposed amendment to the Quote Rule. Second, we will consider two proposed rules requiring disclosure of execution quality by market centers and order routing practices by broker-dealers in the equities markets. Today’s release also suggests an approach to strengthening the consolidated quote in the listed market and related linkage issues.
Before turning to the details of these initiatives, I want to say a word about what I believe to be one of the most pressing market structure issues we face – the level of order interaction in our markets. Simply put, order interaction is the ability of the most motivated buyers and sellers to reach each other across markets. I continue to worry that the objective of encouraging order interaction may be frustrated by certain practices proliferating in our market today.
Promoting the interaction of orders remains one of the most difficult, but crucially important, challenges we face concerning our national market system. But not everyone shares this view. Some suggest that it is a concept best suited for faculty lounges. We must remember what’s at stake: a robust price discovery mechanism that encourages market makers to quote aggressively and customers to place limit orders. Consider this fact: Approximately 85% of market orders executed on Nasdaq today are routed to markets that are not quoting the best price.
I believe we need to know more about the state of quote and price competition in our markets – about the possibility that structural features may be isolating limit orders. Toward this end, the Commission’s Office of Economic Analysis currently is conducting a comprehensive study of execution quality in our equity markets today. This analysis, along with the Office’s study of payment-for-order-flow and internalization in the options markets will, I hope, shed new light on the relationship between order isolation and execution quality.
In expressing concern about order interaction, however, I don’t wish to minimize the benefits of today’s robust competition – competition among market centers continues to drive the execution speed and cost to levels hardly imaginable just a few years ago. Indeed, some of the impending developments – such as decimal pricing, open trading platforms, or front-end order routing systems that allow order-by-order customer routing – may stimulate greater competition between orders.
Our collective challenge at this time is to ensure that competition in all its forms continues to define the structure of our markets. In my view, today’s measures are designed to establish more effective intermarket connections using the following elements:
First, the proposed Trade-Through Disclosure Rule, in conjunction with the amended Quote Rule, would reaffirm the commitment to price priority embodied in the 1975 National Market System legislation. Most investors expect – and have a right to expect – that they will receive the best price available in any market center of our national market system. Honoring that expectation is at the very core of preserving investor confidence and the most efficient pricing-setting mechanism.
The disclosure rule would, however, provide this protection without paternalism. It would not prohibit trades at prices inferior to published quotes, but rather, when trade-throughs occur, would require disclosure to the customer. So, for example, if a broker believed that a customer would forgo the chance of accessing a better quote in order to achieve a speedier execution, the broker would be free to exercise that discretion – assuming he or she is willing to disclose the trade-through and better price to the customer. Through disclosure, decisions to ignore quotes at superior prices are rooted in the interests of the customer.
Today’s proposal would also create enduring incentives for our options markets to link efficiently. Orders routed to markets joined in a linkage plan reasonably designed to limit trade-throughs would be exempt from the Trade-Through Disclosure Rule, creating a powerful incentive for markets to establish effective plans. At the same time, if a linkage plan participant believed that the technology or governance structure of a linkage had become obsolete, the market would be free to withdraw, and establish its own connections. Or, a market could choose to remain completely unconnected if brokers routing orders to this market were willing to comply with the Trade-Through disclosure requirements.
In this same vein, the proposed execution quality disclosure rules marshal the most powerful force in our market – the relentless demands of informed investors – to drive the most efficient order routing patterns and to stimulate market center competition based on superior executions.
We know that some major brokerage firms are frustrated in their efforts to get information from our markets about execution quality, while some personal finance journalists, trying to report on execution quality, have been stiff-armed by certain markets. How can it be that most investors today simply do not know what happens to their orders after they click "Submit"? It doesn’t make sense when you recognize that missing the best price by the minimum increment available – 1/16 – on a 1000 share order is worth $62.50, an amount that dwarfs the commission of most on-line firms.
The execution quality disclosure rules would function on two levels. First, market centers would disclose to the public, on a monthly basis, the critical components of execution quality; for example, where orders were executed in relation to the quoted spread, the speed of executions, and fill rates for limit orders. Second, brokers would report which market centers they sent orders to, any payment-for-order-flow or internalization arrangements they had with those markets, and the basis for their routing decisions.
The incentives created by this regime would, I believe, serve investors well. Academics would publish comparative analyses of execution quality achieved by market centers, institutional investors would hire consultants to analyze market center reports, and the financial and consumer press would offer side-by-side comparisons of, for example, speed and price improvement rates. Best of all, competitors would scrutinize each other’s reports. The day these incentives begin to affect behavior is a very good day indeed for investors. America's investors deserve a national market system where every market is driven by footsteps: the fast approaching footsteps of competitors improving execution quality, the fading footsteps of customers leaving if it fails to measure up.
Finally, execution quality and order routing disclosure rules may also prove to be an enlightened approach to linkage in the equities markets. Investors in listed securities, in my judgment, should not be forced to wait a moment more for unfettered quote competition. We should move swiftly to enable ECNs to post their best prices in the consolidated quote for listed securities. While issues related to access fees remain, I am confident they can be resolved. And consistent with the approach recommended for the options market, I believe that price priority is critical to investor confidence in the listed market, and that a trade-through disclosure rule, with an exemption for linkage plans reasonably designed to limit trade throughs, is the most flexible and enduring way to promote efficient connections in our equities markets.
In closing, I would like to extend my deepest appreciation for the countless hours and tireless effort that’s gone into making today possible. Having worked with so many of you in the Division of Market Regulation, I never cease to be amazed by your dedication, your remarkable knowledge about the workings and the history of our markets, and the wisdom and practical experience you bring to the tasks and the challenges you face every day. I’d also like to commend our Office of Economic Analysis, without whose significant contribution none of this would have been possible, and the continued guidance of our General Counsel’s Office. All of your talents have coalesced to produce an extraordinary team and superb work. You all have done the public’s work today, and you should be proud.
At this time, I’d like to turn it over to Annette Nazareth, our Director of Market Regulation.
http://www.sec.gov/news/speech/spch392.htm
