Pressures for Reform

Moderator,
Joel Hasbrouck:

The Nasdaq Stock Market is experiencing currents of change stronger than those that have prevailed at any time since the electronic system was initiated in 1971. For a perspective on these forces we turn in this session to emissaries from market constituencies: regulators, exchanges, investment institutions ("the buy side"), and the fourth estate of this particular realm, academia.

William Christie (together with co-author Paul Schultz) first documented clustering in Nasdaq quotes and aired in this connection the word "collusion." In a sense, this study launched a thousand ships and set in motion the judicial and legal process of reform. Yet Bill’s remarks take a broader perspective, citing the pressures that had been building up largely unvoiced until a rallying point or catalyst arose.

Holly Stark speaks to the buy side’s demand for access to markets, not as liquidity-seeking customers of dealers, but as providers of liquidity, in some respects as competitors of dealers. Buy-side traders demand this access, not because they seek to become dealers, but because they seek to minimize trading costs. She reminds us that large traders perceive that they have choices in where and how to trade.

These choices are felt as competitive pressures on existing exchanges. Bengt Ryden describes the process of institutional reform at the Stockholm Stock Exchange. This reform follows a shift in perspective regarding the customers of an exchange, from the narrow traditional view that the customers were the exchange's members (a local and parochial community), to the modern broad view that the ultimate customers are actual and potential traders of the listed securities.

The overseers of reform are, of course, the regulators. Robert Colby offers a perspective on the role of price transparency, quote transparency, and "best execution" requirements in U.S. regulatory thinking. His remarks are particularly apt because, despite the technology that brings the ultimate user closer to the inner workings of the marketplace, the route of an order from potential trading desire to executed transaction is often indirect and beset with multiple agency relationships that are difficult to monitor.

Bill Christie:
What were the pressures for reform? There was negative publicity. There were civil law suits, a Department of Justice investigation, an SEC investigation and the Rudman Commission appointed by the National Association of Securities Dealers, Inc. (NASD® ). You have litigation, regulators and the press, all bearing down on you at once and for a prolonged period of time. There is clearly pressure for reform!

Why did investors need an advocate in this market? It stems back largely to the fact that Nasdaq had been so successful. The market value of Nasdaq trading had skyrocketed. By any measure it had been a very successful market.

The Nasdaq market grew quickly, rapidly and successfully in terms of new listings, retaining listings, and dollar volume. Some of the problems that existed did not have the impact that they would have had in an industry where growth was a lot more stable, since the inefficiencies would have been more readily apparent.

One of the groups that may have been disenfranchised from the market were the buy-side traders (and to some extent active individual investors). On the buy-side, you are facing wider spreads than you would expect to see, you worry about execution costs, and quotes do matter if you cannot get inside the spread. If you are forced to pay those quotes, they matter a lot!

The second group I would say are options traders. An options trader will post a limit order and it will be totally ignored. Thus the public has had to trade at inferior prices. The options traders themselves had a distaste for having to deal with Nasdaq Market Makers.

The third group are the SOES (Small Order Execution System) activists. Love them or hate them, they were for a long time one of the only sources of competition that Nasdaq Market Makers had to face, because the public was not able to place limit orders. You now have individual investors, buy-side traders, options traders, and SOES activists, all having an inherent dislike of this market, but with no way to vent it, or to be able to do anything about it.

Then Instinet came along. It served as a source of competition for Nasdaq. Instinet allowed institutional traders an opportunity to bypass the dealer market. Why did that not cause this inefficiency to break down? Well again, partly because this market was growing so rapidly. Instinet was taking a larger portion of an ever expanding pie. There was still a lot of market share left for existing Market Makers.

The reform that has taken place in the last two or three years has made Nasdaq much better and as the former President of The Nasdaq Stock Market, Joseph Hardiman, said in a letter to me, the integrity of the market is one of its greatest assets.

Holly Stark:
A few years ago the customers were revered in a much greater way than they are today. There is a greater divergence in opinions between the buy- and the sell-side today. Sometimes it looks like people are going to break out into fist fights because of differing opinions on how people should access markets.

Initially, the pressure for reform from the buy-side was a quiet pressure. Buy-side traders could see the problems that were in the marketplace. They encounter them every day when they sit and trade.

The big issue is time. I sit on my trading desk and trade every day when the market is open, as do most buy-side traders. To leave the desk and take time to think about the overall structure of the market, to see what is a better way for the markets to work, is very difficult. Right now there are many traders on the buy-side that are concerned about equity market structure, especially as it relates to how business can best be done to maximize performance for their clients. That is one thing we on the buy-side can never forget. If we do not please our clients, if we do not give them superior performance, the clients will not stick around very long.

The overwhelming majority of firms on the buy-side realize that trading is intrinsically part of the investment process. They see that superior trading can mean the difference between top quartile performance and mediocrity. It is no surprise that traders have become more knowledgeable today about how equity markets work and about the regulations that govern the markets. We are focusing on what the concerns of the buy-side are.

The most dramatic change has been the implementation of the SEC Order Handling Rules. The introduction of the order handling rules is the culmination of investigations by the Commission and the Justice Department into the activities of so many member firms and of The Nasdaq Stock Market for anti-competitive business practices. The ensuing reforms allowed the buy-side to gain significant representation on key Nasdaq committees.

The order handling rules effectively require Nasdaq and the exchanges to enforce the display of limit orders by all Market Makers, making those orders immediately available to all members in the investing public on a non-discriminatory basis. The buy-side has reaped an enormous benefit in that the rules gave us the ability to drive the inside quote, or the national best bid and offer (NBBO). We can do this by electing to display limit order books over compliant Electronic Communications Networks (ECNs), or by asking a Market Maker to display our limit order. We are not sure that everyone on the buy-side is fully aware of the rules and are taking advantage of the benefits provided by the rules.

Buy-side traders may continue to look for a different market structure, one that affords them anonymity, liquidity, and control over their orders. Buy-side traders are comfortable with technology and the benefits it provides them. They look to technology to enhance current market structure. Many buy-side traders have also come to realize that their input in shaping market structure is critical to ensure a fair and equitable process. They have gone beyond letting the sell-side be their representative in the deliberations and have taken an activist voice in the decision-making process.

The buy-side voice, though it may not be entirely welcome, is now a viable one. It is a voice that is present and is not going to go away. It is a voice that is ready to take steps to define the market structure that we need to satisfy our fiduciary obligations for the investors whose assets we manage.

Bengt Ryden:
You may have noted that today, because of the upcoming European Monetary Union and because of other things happening within the European Union during the nineties, the drive towards structural change of European exchanges has been enormous.

Two important areas at the Stockholm Stock Exchange need to be pointed out. The first one is the customer. When I started to talk about customers at the exchange, people really got horrified because we had members not customers. Who are the customers? When I asked my board who are the customers, they said the members. I replied, what about the issuers? We take care of the issuers. What about the investors? We take care of them, too. However, there are conflicts of interest between the members, the intermediaries, and a big variety of investors.

Secondly, the concept of competition had not entered the Stockholm Stock Exchange, nor the other European exchanges until the last few years. Who are our competitors? Any information vendors who have the potential of setting up execution facilities can be tremendous competitors.

The heart of the matter is, how should an exchange be managed and in whose interest should it be managed? The big issue is governance. Who has the impact, the power, over the strategic decisions of an exchange? We made a reform five years ago in Sweden, where we changed the structure. Based on a new law that was enacted in 1993 in Sweden, anybody would have the right to buy and to sell shares of the exchange.

An exchange can be owned by anybody, but it must behave in accordance with the law to offer a sound market and to protect the integrity of the market. A new company was formed and we invited all members and all issuers to participate in the new issue of shares, where these shares should be freely transferable. The company has been extremely profitable. We have increased our own equity something like tenfold in five years. We have distributed dividends to the shareholders at an amount which is about three times more than what they paid for the shares. We have cut our fees. It is quite a success story.

To satisfy the different needs of different customers in the late 1980s, we introduced electronic order-driven trading with an open electronic order book. Completely transparent, pre-trade, and post-trade. The electronic trading system has also made it possible for us to enter into international trading on our market since the law made it possible for potential members outside the Swedish jurisdiction to trade with us. We now have several members trading directly out of London, Frankfurt, Zurich, Berlin, and, of course, the Scandinavian countries. We have completely changed the concept of the market.

Robert Colby(4):
When you have competition, you are going to have a lack of centralization of orders. You are going to have fragmentation and that comes with a cost. It comes with orders interacting with people who do not necessarily know what is going on in the market. Where the U.S. Securities and Exchange Commission has come to historically is, if you are going to have the kind of competition needed in the markets, you have to have some fundamental structures with that. You have to have post-trade transparency (last-sale reporting). This way, people can tell where trades are actually taking place and can try to assess where they should be trading and how good a deal they got.

We also need to have pre-trade transparency (some display of quotes). If people are trying to decide where trades should take place in the future and where they should route the orders to, they must have some sense of what the prices are out there. We need a best execution obligation. The people that are responsible for sending the order flow to the various markets have a duty to try to send an order to the best market.

The best execution interpretation is where we tried to drive home to firms that they have this duty of trying to find the best price. That is not just finding the quote. It also includes searching out price improvement. The order handling rules were a pragmatic response to a particular problem. They did not address fully the larger question about how to encourage competition within the current structures.

Nasdaq is a competing dealer market. For a long time, there was relatively little price competition among those dealers. This was because most of the uninformed order flow was locked up through payment for order flow arrangements, internalization, and reciprocal practices. There was no limit order competition.

There are now five recognized Electronic Communication Networks. Our experience with the ECNs is that they do not always function as we would like them to. Alternative trading systems are distinct from traditional broker/dealers and require distinct oversight.

There is a question about the larger picture. How do the ECNs fit into pre-trade, post-trade transparency? How should they be linked? What do you do about foreign markets that are functionally here, although their computers may be located just about anywhere? It is all part of a seamless process that you have to address together.

(4) The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author’s colleagues on the staff of the Commission.