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Thursday, October 30, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
    The subcommittee met, pursuant to call, at 10:07 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Gillmor, Bachus, Royce, Oxley (ex officio), Kelly, Fossella, Biggert, Hart, Tiberi, Brown-Waite, Renzi, Kanjorski, Sherman, Meeks, Inslee, Hinojosa, Lucas of Kentucky, Crowley, Clay, Matheson, Emanuel, Scott and Maloney.
    Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Market Subcommittee to order.
    Committee is convened to receive comment and testimony with regard to the adequacy of our current market structure regulatory environment.
    The inexorable press of technology combined with the effects of decimalization, have brought about changes in the market that are not entirely clear to be beneficial at the moment.
    At this point, artificial rules that constrain where a customer might execute the best trade to their own personal advantage, does not, in itself, lead one to conclude that the current system enables that to occur on every occasion.
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    Also recent unfortunate events surrounding corporate governance issues at the New York Exchange, have opened the entire debate as to whether the specialist system continues to serve the highest and best purpose of the American investor.
    And, at the same time, raises issues as to whether regulation and compliance can be subservient to the same board which has responsibilities for operation of a for-profit, shareholder-owned corporation.
    All of these issues raise the whole discussion to an important level. ''What do we do and when do we do it?'' I do believe that the SEC, over the years, has conducted a number of evaluations and studies, and I think, because of the unique circumstance we now find ourselves in, it is appropriate to consider taking some action.
    Whether it is statutory or whether by SEC regulation, I do believe the forces of technology are bringing about the potential for significant market structure changes that will be in the best interest of the individual investor.
    With now over 50 percent of American homeowners invested directly in the marketplace, this is no longer an issue which can be relegated to a second-tier importance. It is a principle importance, not only for those individual investors, but for the success and growth of our own economic systems, and the exchanges and the capital markets are at the core of our opportunity for economic growth.
    To that end, I am anxious to hear from the Chairman this morning as to their observations and recommendations and hope that we can come to relatively quick closure on an action plan, not only from the commission's perspective, but for this Committee to consider as well.
    With that, I recognize Mr. Kanjorski.
    Mr. KANJORSKI. Mr. Chairman, we meet today for the second time in the 108th Congress to review the structure of our capital markets and evaluate reforms that might enhance competition in light of recent technological advances and marketplace developments.
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    In recent years, a variety of participants in the securities industry have questioned one or more aspects of the regulatory system.
    Today's proceedings will, therefore, help us to better understand these issues and their concerns. In my view, we have come to a crossroads in the securities industry, facing a number of decisions that could fundamentally alter its structure for many years to come.
    As I did in our last market structure issues hearing, I must caution my colleagues on both sides of the aisle to move carefully and diligently in these matters. Because we have elaborately interlocking systems and relationships in our securities markets, I believe that we should refrain from pursuing change for change's sakes.
    Moreover, in pursuing any change to fix those portions of the system experiencing genuine strain, we must also ensure that we do not disrupt these elements of our market that are working well.
    In adopting the Securities Act Amendments of 1975, the Congress wisely decided to provide the Securities and Exchange Commission with a broad set of goals and significant flexibility to respond to market structure issues. From my perspective, this system has worked generally well, over the last three decades, in adapting to technological changes and other developments.
    This legal framework ought to continue to provide the commission with the flexibility that it needs to consider and adopt further reforms in the future.
    In testimony before the Senate earlier this month, SEC Chairman Donaldson indicated that the Commission would be focusing on increased intensity on the structure of our securities markets in the upcoming months.
    I, therefore, look forward to learning from the Chairman, later this morning, about his current views on these matters. I want him to know that it is my hope the Commission will move expeditiously and methodically in its deliberations.
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    Mr. Chairman, I have made investor protection an important issue of mine in this Congress, and during my opening statement at our last hearing in market structure issues, I outlined some of my thoughts regarding self-regulation in the securities markets.
    Today, I would like to focus on another important investor protection issue: transparency.
    For our securities markets to work well and advance the interest of investors, I believe, as a general rule, that we should seek to promote transparency to the maximum extent possible.
    Transparency helps to ensure that all participants in the marketplace have access to the same information for making decisions. Transparency, therefore, ensures that no participant in a marketplace is either advantaged or disadvantaged because of their access to information.
    For these reasons, I have apprehensions about any market structure reform proposal that would limit access to information, including those that would allow for internalization of market orders.
    In my view, such proposals have the potential to jeopardize the transparency of our markets and harm investors.
    During their tenures, the two most recent former commission chairmen have expressed concerns about the internalization of market orders by broker dealers.
    Additionally, the current SEC Chairman has previously observed that internalization can discourage markets from competing on the basis of price and pose a conflict of interest for broker dealers.
    As we deliberate on market structure issues this morning, it is my expectation that he will comment further on the importance of further enhancing transparency in the securities industry.
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    In closing, Mr. Chairman, I believe our Committee must continue to conduct vigorous oversight of the securities industry to determine whether its regulatory structure is working as intended and to examine how we could make it stronger.
    The observation of today's witnesses about these complex matters will also help us to discern how we can maintain the efficiency, effectiveness and competitiveness of our nation's capital markets into the foreseeable future.
    I look forward to this hearing, Mr. Chairman.
    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 71 in the appendix.]
    Chairman BAKER. Thank you, Mr. Kanjorski.
    Chairman Oxley?
    Mr. OXLEY. Thank you, Chairman Baker, for holding this important hearing.
    There are a few issues that come before this Committee that are as fundamental as how investors buy and sell securities. I want to particularly welcome our distinguished witnesses today; Chairman Donaldson and Annette Nazareth, for appearing.
    This Committee's first market structure hearing earlier this month, I think all the members would agree, was quite encouraging. I was pleased with John Reed's candid and forthright testimony.
    There is no question that he has volunteered for a difficult job, under trying circumstances, but I believe he is the right leader, at the right time, to right the ship at the New York Stock Exchange.
    And even more importantly, I also believe that the recent controversies at the New York Stock Exchange present a real opportunity to enact significant and long overdue reforms to our market structure. An opportunity like this does not come around often, and we must not squander it.
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    I have long taken the position that investors benefit from multiple market centers that engage in vigorous competition based on speed and certainty of execution, anonymity and price.
    The government should not decide which markets prosper. In fact, it is our obligation to ensure that no market have regulatory advantages that inhibit competition and artificially preserve market share.
    Accordingly, it is imperative that we revisit the rules and regulations that have governed the markets for more than a quarter of a century.
    What Congress did in 1975, may have made sense at the time, but those policy decisions were made prior to the greatest technological advances in human history.
    It makes no sense, whatsoever, for these outdated regulations, which preceded, for example, the advent of Netscape by two decades, to be controlling in today's high-tech environment.
    With a change in leadership at the NYSEC, I believe we are at a crossroads with an important opportunity to implement changes that will foster competition and make our markets even more efficient.
    The Intermarket Trading System is an outdated construct that has outlived its usefulness. It is time to revamp the system that links our markets so that market forces and modern technology can replace bureaucratic, restrictive regulatory systems.
    There has been a great deal of talk about the need to reform the ITS's trade-through rule. I expect we will hear from virtually all of our witnesses here today about this issue.
    It is clear to me the time for reform is long overdue. Price simply is not the only factor to be considered for the purposes of best execution. The trade-through rule, as it stands, is standing smack in the way of more efficient, competitive markets.
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    The viability of the SRO model depends on whether it is one that uses regulation to protect investors and promote confidence or to hamper competition. We will examine many of these rules today.
    Central to today's discussion, will be the role of the specialist. It has been widely criticized as monopolistic, anachronistic and unnecessary in today's highly-evolved technological environment.
    John Vogel, who has appeared before this Committee several times, calls it, ''A dinosaur that maintains as much of a monopoly as you can get in this world.''
    Even more alarming are the allegations of wrongdoing that call into question the integrity of this model and whether it creates an irresistible opportunity to put the specialist's interests ahead of investors.
    Critics of decimal pricing argue that decimal pricing has led to front-running and other trading violations.
    I would argue that these abuses are symptomatic of a flawed structural system, not the result of decimal pricing which has resulted in what one commentator has called a, ''Billion-dollar tax cut for investors.''
    It is time to review the specialist system. Today's hearing is an important step toward that end.
    I have long argued that market data, the fundamental information about securities prices that is the oxygen of our marketplace, needs to be free from ownership interest that could restrict access to that data.
    It is essential that we ensure that investors have guaranteed full access to this information.
    I am eager to hear from SEC Chairman Donaldson, this morning and, particularly, I look forward to learning how he intends to expedite consideration of all the pending issues before the Division of Market Regulation.
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    As many petitioners know all too well, the failure to make a regulatory decision is often worse than the adverse decision.
    Again, I want to commend you, Chairman Baker, for putting together an excellent and balanced second panel of witnesses and I look forward to hearing their testimony as well.
    And I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be found on page 64 in the appendix.]
    Chairman BAKER. Thank you, Mr. Chairman.
    Do members have—further members have opening statements? If not, at this time, I would like—I am sorry, Mr. Emanuel, did you have?
    Yes. All members may submit their opening statements in writing for the record, without objection.
    If there are no members seeking recognition at this time, I would like to welcome back Chairman William Donaldson, who is no stranger to the hearing room, unfortunately for him, I guess.
    But we certainly do appreciate the courtesy of your appearance and we look forward to receiving your testimony this morning, Sir.
    Mr. DONALDSON. Thank you very much.
    Good morning Chairman Baker, Ranking Member Kanjorski, and members of the Subcommittee. I am very pleased to be here to discuss some of the significant market structure issues that we are facing in the U.S. equities market today.
    Our markets are comprised of intricately-interwoven systems and relationships.
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    While the Commission recognizes the importance of addressing market structure issues expeditiously, the extent to which structural changes are needed, and what those changes should be, are complicated problems to say the least and not subject to quick and easy resolution.
    We must take care not to disrupt those areas of our market that are working well in our haste to fix those areas which we think are not.
    The Commission staff has made significant progress in analyzing the structure of the securities markets, identifying the sources of the strains to which it is increasingly subject, and formulating a road map for responding to these concerns.
    The staff is now in the process of drafting concrete proposals to address the root causes of the stresses on the U.S. market structure. I have asked the staff to produce, in the coming months, a plan that includes proposals to respond to several of the more pressing market structure issues.
    As you know, Congress formally directed the Commission to address market structure when it enacted the Securities Act Amendments of 1975.
    That legislation instructed the SEC to facilitate the creation of a national market system for securities that would maintain fair and orderly markets and tie together all buying and selling interest so that investors would have the opportunity for the best possible execution of their orders, regardless of where in the system they originate.
    Rather than attempt to dictate the specific elements of the U.S. market structure, however, Congress chose to rely on an approach designed to provide maximum flexibility to the Commission and the securities industry in its development.
    The 1975 amendments to the Exchange Act created a framework for fostering transparency, interconnectivity and competition in our securities market.
    As a result, today, equity market centers compete with one another in an environment where quotes and transaction prices are widely available to all market participants.
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    Direct and indirect linkages among competing market centers help ensure that brokers can access the best quotes available in the market for their customers.
    Market centers, including exchange markets, over-the-counter market-makers and alternative trading systems have an incentive to offer improvement in the execution quality and to reduce trading costs in order to attract order flow away from other market centers.
    Taking a step back and looking at the market as a whole, our National Market System has worked remarkably well for the past quarter century and, in recent years, it has become increasingly efficient.
    At the same time, we recognize that this very efficiency, arising from the technological and other market developments, has put strains on existing national market structures.
    One significant change has been the proliferation of the new electronic markets, such as the ECNs, that offer fast executions and have spurred competition among market centers, but, at the same time, exacerbated concerns about market fragmentation, the feasibility of integrating different market models into the National Market System, and maintaining a level regulatory playing field among the functionally-equivalent market participants.
    The implementation of decimal pricing in 2001 and the concurrent move to a minimum tick of one penny in the equity markets have narrowed spreads and enhanced the efficiency of the price discovery process but, at the same time, reduced the liquidity available at each price point, made it easier to step ahead of limit orders, and placed economic strains on the dealer business.
    Decimal pricing has also put a premium on swift access to displayed prices so investors can quickly reach these smaller quotes before they change.
    The trend toward demutualization of exchanges and their conversion to for-profit enterprises has heightened concerns about the inherent tensions in the self-regulatory model, in particular the concern that the funding and vigor of the regulatory function might be sacrificed in favor of delivering returns to shareholders.
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    As noted, over the last several years, the Commission has taken a number of steps to address concerns facing our National Market System.
    In the Order Handling Rules and Regulation ATS, for example, the Commission broadened the class of market centers required to make their quotations and orders publicly accessible. In doing so, it sought to redefine the idea of an exchange to include, not just traditional exchanges, but also trading systems where orders interact according to specified trading rules.
    The Commission also adopted rules to improve the disclosure by market centers of execution quality data and the disclosure, by broker-dealers, of their order routing practices in order to enable investors to comparison shop among the myriad market centers and to stimulate competition on the basis of execution quality.
    There is no doubt that there are issues regarding our National Market System that call for our attention; and, indeed, the Commission and its staff have been increasingly focused on addressing these issues and resolving perceived conflicts in a timely manner.
    Commission staff is in the midst of developing proposals that address, in a comprehensive fashion, the various market structure issues.
    I would like to focus the remainder of my testimony on the four key areas of the Commission's market structure initiative: access to markets; market data; the self-regulatory model itself; and the nature of a securities exchange.
    Fair access: a significant market structure issue on the Commission's agenda is making sure that access between markets is as fair and as efficient as it can be.
    If best execution is to be achieved in an environment characterized by multiple competing markets, broker-dealers must be able to identify the location of the best available prices and obtain access to those prices routinely and efficiently.
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    The Commission's approval, last year, of the NASD's Alternative Display Facility as a pilot program has heightened the issue of intermarket access.
    Rather than obtaining access through ''hard'' linkages directly between markets, in the way that competing markets can access the New York Stock Exchange, in the Alternative Display Facility competing market centers obtain access to each other directly through privately-negotiated access agreements and indirectly through subscribers.
    The Commission is evaluating this decentralized access approach to determine whether, as a practical matter, it would be an appropriate model for the National Market System, and this could be applied to other market centers.
    Access fees: access fees charged to reach a quote create another difficult market structure problem. Some markets charge varied per-share transaction fees for access to their quotes.
    Therefore, a displayed price may represent the true price that a customer will pay, or it may represent only a base price to which an undisclosed access fee will later be added.
    To ensure real access to public quotes between competing markets, it is important that quotes be accessible to other market participants on clear and fair terms.
    Price protection: as a part of our examination of intermarket linkages, we also are actively reevaluating the question of intermarket trade-throughs, which occur when orders are executed in one market at prices inferior to the prices disseminated on another market.
    The challenge before the Commission is to devise standards that allow faster markets and slower markets to thrive within a single system of interconnected markets while, at the same time, providing order executions to customers that display prices for those customers who desire the best price on their order.
    Market data: an additional market structure challenge facing the Commission involves the collection and reporting of trading information and the influence of the market data revenues on market structure.
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    Under the current system, distributions of market data revenues to self-regulatory organizations are based primarily on each self-regulatory organization's reported trade volume.
    This compensation scheme has created a financial incentive for self-regulatory organizations to report as many trades as possible.
    As a result, markets are vying for ECNs and market-makers to report their trades through them, as this allows markets to tap more deeply into the pool of available market data revenue and to rebate substantial portions of the additional revenue to the entity reporting the trade.
    All of this calls into question whether the current method of distributing market data revenue creates appropriate economic incentives and whether it furthers the goal of rewarding markets that make valuable contributions to the market data being disseminated.
    The self-regulatory model: another matter of great importance is the effectiveness of the self-regulatory system of our securities markets.
    The principle of self-regulation is based on the idea that regulation can be best done as close as possible to the regulated activity. However, an SRO that operates a market has a potential conflict of interest between its role as a market and as a regulator.
    The advent of for-profit, shareholder-owned exchanges creates additional issues, including ensuring that self-regulatory obligations do not take a back seat to the interests of shareholders.
    The challenge for the Commission and the SROs is to ensure that, as the securities markets grow more competitive, the SROs continue to dedicate their energies and resources to surveillance and enforcement.
    We also must prevent fragmentation of trading from creating gaps in the SRO oversight of the markets.
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    As a part of our review of the self-regulatory structure, I believe the Commission must thoroughly review the SROs governance. Recent events at the New York Stock Exchange point to the need for this review.
    SROs play a critical role as the standard setters for sound government practices. Just as SROs have demanded that their listed companies strengthen their governance practices, we must demand that, at a minimum, SROs match the standards they set for listed companies.
    There are several topics that merit our consideration, including board composition and the independence of directors; the independence and function of key board committees; the transparency of the SRO's decision-making process; and the diligence and competence required of board and committee members and ensuring their focus on the adequacy of regulation.
    The last topic I would like to touch upon is what it means to be registered as a national securities exchange.
    All currently-registered exchanges have a limit order book in which better-priced orders take precedence. But a mandatory order book system is not easily reconciled with a dealer model, such as the NASDAQ stock market, in which there is no central limit order book.
    I spoke earlier about the merits of price protection across markets. NASDAQ's application to register as an exchange places squarely before the Commission, the issue of whether price protection, within a market, is a requirement of an exchange registration.
    One issue is customer expectations. I suspect that customers generally expect their better-priced orders to be protected within an exchange.
    We do not expect all exchanges to be identical, much less to replicate any market's faults. Yet, until now, all exchanges have given their limit orders priority throughout their marketplace.
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    If the Commission were to approve NASDAQ's application, other exchanges would likely seek to eliminate intra-market price priority from their rules. As a result, the protection of limit orders within markets would decrease. For this reason, NASDAQ's exchange application raises overall market structure issues that transcend the particular question of whether NASDAQ, or any other particular market, should be registered as an exchange.
    In conclusion, I would like to reiterate that the market structure challenges that I have discussed today may shape the National Market System for years to come. The Commission recognizes the importance of addressing these challenges in an effective and timely manner.
    At the same time, however, we have got to be mindful not to rush to judgment but, instead, take a deliberate and reasoned approach to reach the right result.
    That said, we fully acknowledge the need to resolve the conflicts, and it is my expectation to be able to review proposals from Commission staff, in the coming months, with an eye towards publishing proposals soon thereafter.
    I look forward to continued input from this Subcommittee on those important matters throughout this process. Thank you again for inviting me to speak on behalf of the Commission.
    I would, obviously, be happy to answer any questions that you may have. Thank you.
    [The prepared statement of Hon. William H. Donaldson can be found on page 73 in the appendix.]
    Chairman BAKER. Thank you, Mr. Chairman.
    We do have announced a series of votes; there are three now pending.
    First is a 15-minute vote. It would be my intention to proceed with my questions, perhaps those of Mr. Kanjorski, if—well, at least I will go through mine, if that is the case.
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    And then the Committee would stand in recess for about 15 minutes to complete the remaining part of the first 15-minute vote and the other two fives.
    Mr. Chairman, it is my understanding the SEC is in preparation of a concept release on the trade-through rule.
    When do you anticipate some product being ready to release for public consideration?
    Mr. DONALDSON. Well, it is implied in my comments. We are looking at a number of issues that we believe are inter-related.
    We believe the trade-through rule is a very critical rule now, in terms of any modifications, eliminations or, whatever, that we might make on that rule.
    I believe we want to consider that within the context of a couple of other issues that I have mentioned.
    As I say, I hope that—we are working on it right now; we have taken testimony; we have talked, and now is the time for action. I think it is a matter of months, not years, but not weeks, either.
    Chairman BAKER. I posed that question in light of what, I understand, was the pilot in August of last year, which looked at relief from the trade-through rule.
    And the reported observations about the success or failure of the pilot indicated that it seemed to work very, very well and that there were efficiencies, other than best price, that were of material importance to investors.
    And it just seems, from my perspective, that it is a very significant first step in providing more efficient functioning of markets to either expand the pilot or to take some further definitive action as quickly as possible, given the benefits of, at least reported benefits of, that pilot effort.
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    What is your opinion with regard to the specialist system? And I make the observation, perhaps not in a sophisticated way but, in Louisiana, as a former realtor, if I were to represent a buyer and a seller and I knew that the seller would take $100 thousand for the house, and I knew the buyer would pay $125,000; if I exercised an option or bought the property for my own account and then turned around and sold it to the buyer I knew of, by virtue of my fiduciary position, for $125 thousand, it is not only unethical; it is illegal, and I would go to jail.
    How is that illustration different from what the specialist may do when he trades for his own account, given that market knowledge?
    Mr. DONALDSON. The specialist system, as practiced on the New York Stock Exchange, has, in the structure and the rules, a negative and a positive obligation, if you will.
    Specialists have a positive obligation to make a market in the stock and to provide liquidity when there is not a ready buyer or seller for the other half of a trade——
    Chairman BAKER. And I think that is very valuable, and I don't want to lose that in the mix but, often, there is not concurrent disclosure and the time—if there is a liquidity reason to act, that is a great thing.
    And I could buy that house and sell that house as long as I made concurrent simultaneous disclosure to both parties, and if they both agreed it was okay for me to make the $25,000, fine. But I couldn't do it without providing that notice.
    Mr. DONALDSON. Right. Well, the other part of the specialist obligation is not only to the positive obligation to step in and provide liquidity but also the negative obligations to not step ahead of the customer account, and this is the very essence of the auction system.
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    And I believe that there are issues associated with that which have to do with what I referred to before, which is the advent of technology and the ECNs, which are able to transact instantaneously.
    And, I might add that, in many of the ECNs, they are not that instantaneous unless there happens to be a matching order on their books. I mean, an order can sit there for minutes or hours.
    That does not happen on the New York Stock Exchange because of the liquidity provided by the specialist.
    Chairman BAKER. Understood, and there is value to the system. I just think there are some areas of concern that, perhaps, need to be thoughtfully examined by the commission——
    Mr. DONALDSON. Absolutely. That is exactly what we are doing——
    Chairman BAKER. If the trade-through rule, recommendations, analysis of the specialists concerns or modifications of rules governing practice, all of this, as you indicate, is part of a larger market structure recommendation.
    Would that go to the point of the regulatory model of the New York Exchange? Is that viewed as being essential in this package of recommendations that might be later forwarded?
    And I make that observation in light of this thought: what if someone were to come to the Congress and say, ''The SEC ought to own a securities firm or the Federal Reserve ought to own a large national bank?''
    You probably wouldn't get many co-sponsors, and the hearing date would probably be a long time in the future.
    But, at the same time, we have the CEO of the for-profit enterprise often as the Chairman of the regulatory body, investment bank analyst—you know the litany of subjects we have dealt with in the Committee over past years has always generally resulted in very clear-cut separations of authorities between regulation and for-profit decisions.
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    Do you have a view today as to the appropriateness of maintenance of the current structure or should we really be thinking through perhaps a more radical modification?
    And what will the SEC actions likely—will that be a consideration in the package of issues that the SEC is now considering?
    Mr. DONALDSON. Critical consideration; bottom line. Clearly, the responsibility of an SRO for running a marketplace, as well as the responsibility for the regulation of that marketplace, brings into the forefront a potential conflict of interest.
    And we are concerned about that conflict of interest.
    There are a number of different ways of addressing that, ranging all the way from a total separation of the regulatory function to a partial separation to an internal structure that separates the reporting function and financing of the regulation inside an SRO.
    I think this is what John Reed, the Acting Chairman of the New York Stock Exchange, is wrestling with right now, in terms of coming up with a corporate governance structure that addresses those issues.
    But I think the point you are making is right on, which is, we must pay attention to the independence of the regulatory function.
    And we must pay attention to the financing of the regulatory function, the adequacy of its financing. And we must separate, either by the way it is organized internally or totally externally, we must separate that potential conflict.
    Chairman BAKER. Mr. Chairman, we are down to about three minutes on the vote. We are going to have to excuse ourselves.
    Just one final, sort of, comment from my perspective.
    Your observation was that we don't expect a recommendation or a package from the SEC within days or weeks; we don't expect it to take years; we are kind of in the months range.
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    So this might well be something pursuant to the Exchange action early next year, early spring; we might have some recommendations that would give us a global picture of where you think we should go.
    Mr. DONALDSON. Right. I think the first indication of an approach and whether it is an acceptable approach will be the governance structure proposed by the New York Stock Exchange.
    Chairman BAKER. We are in recess. Thank you.
    Chairman BAKER. I would like to reconvene our meeting.
    Mr. Chairman, I just have one more, sort of, follow up from our earlier line of questions, not on the principle subject of the hearing today, but on the related matter of mutual fund governance.
    I read, with interest, some comments by Mr. Spitzer in the morning news about his perspective of SEC actions in relation to his findings, which were troubling to me, a bit.
    But, more importantly, in our last hearing in which you appeared, I had expressed interest in having Agency comment with regard to H.R. 2420, which is still pending, on any modifications or improvements that might be considered to that act, with regard to mutual fund governance.
    And in light of the developments reported in the media by actions of the Attorneys General, your own agency, I just renew that request in light of current market circumstances if the Agency could review and forward any comment that might be appropriate.
    Certainly, we don't expect immediate action on H.R. 2420, but it is within that weeks range; not days, but not years, kind of, category.
    And whenever you could get us something, it would be very helpful.
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    Mr. DONALDSON. We would be glad to do that.
    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. Kanjorski?
    Mr. KANJORSKI. Thank you, Mr. Chairman. Welcome back, Mr. Chairman. We look forward to having you here, particularly in these trying times.
    I think one of the things I am trying to organize, in my mind, is recognizing some of the threats of investor confidence that exists as a result of the continuum of things that have happened over the last year, year and a half.
    Is there any method or methodology that should be employed by the regulator, by the Commission, to get all of this out on the table, once and for all, instead of the slow bleeds and the information coming forth, whether it is the mutual fund industry, or whether it was the governance at the New York Stock Exchange, or whether it was the inappropriate activities of some of the huge corporations?
    Can't we find some method to bring this to an end?
    And, in light of that, what I am thinking of is, in the past, the Chairman of the SEC has always said he really doesn't need a larger budget. We tried to give him one a couple of years ago, and there was always some hesitation of taking it.
    Do you think you are sufficiently staffed now?
    And the one reason that brings that to my mind—and I know we will have another hearing on this subject—but I am really disappointed with the whistleblower that brought, apparently, timing evidence in the mutual fund industry to the Enforcement Office of the Commission back in March and had an attorney follow up on a monthly-weekly basis.
    And it wasn't until the State Attorney Generals took action that anything happened.
    On the face of that, it certainly makes it appear that perhaps the federal regulator is not ahead of the game. I know the pressures that the Commission has been under and the wide range of activity they have to do.
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    But while you are reviewing all these governance issues and other issues involved in the exchanges, are you going to also look at your enforcement regulation budget and what you need so that we can make sure that we can, once and for all, say to the American people that this is the bottom line and draw our two lines and close this out?
    Or, other than that, we are just going to go on and on, internally bleeding and, every time we seem to have an uptake in the market or in the economy, we get hit with another investor confidence question.
    Mr. DONALDSON. Let me confine my remarks, I think, to the central thrust of your question which is the issues with the mutual fund industry right now.
    You are talking about other issues, too, that are on our docket but, most recently, the issues that have come to the fore on market timing and late trading, and so forth.
    I could give you a number of answers but first and foremost, there is no doubt about the fact that we can improve our methodology.
    We have a huge universe of funds, some 5,000 mutual funds with over 8,000 portfolios of securities, and over 7,000 advisers in which we are expected to conduct inspections.
    We have to have a set of priorities, if you will, in terms of what we are looking for, and I believe that the issue of risk assessment, if you will, is one that we are addressing right now, in the Commission, in terms of how we determine exactly what we are looking for. And I think that can be improved, and we are working toward that end.
    We are working toward a better synergy, if you will, between our divisions of investment management, our divisions of inspections and so forth.
    But we do have new troops coming in: a substantial increase from, I think, 350 people in our inspection group to almost increasing that by 50 percent so we will have more bodies.
    But the real issue is how we determine where the risks are, and we, I think, probably have not had the issues of market timing as high in our priority as we should have.
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    We are taking steps now, I might add, to do something about that and do something about it quickly.
    The other thing is that, in the case of some of these issues that have come to the fore, you had, basically, an alleged collusion between two entities; the Canary Hedge Fund and the mutual fund that they were doing business with.
    And unless you have a direct tip, unless you have a direct insight, it is very hard to find collusion, particularly in the case of Canary when we didn't have the authority to go in and examine them.
    Mr. KANJORSKI. If that is the case, I can understand that being the case, then part of this argument on a totally electronic market raises a lot of questions in terms of how are we going to pick these transactions up.
    Those of us that aren't informed on the technology assume that, with computers today, everything is seen. And when there is improper activity it would set off some sort of a tilt so that regulators would look at it.
    And you have layers of regulation, as you pointed out. The SRO is the first responsible party to know what is going on but then you, over them, have some idea.
    Now, this last weekend—and Monday I was in Chicago looking at the markets and trying to understand what they are doing—and they brought me aware of the fact of what internalization may or may not do, and some of the advantages of it, and some of the deference of it.
    But one of the things that we talked about with quite seriousness, that you referred to in your testimony, is this idea of the penny market and how that can interfere with another market that deals in more than pennies and 10 cents, as the Chicago markets do.
    And how that delays a transaction until someone filters through that 10-cent spread.
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    And that goes to the question of that unique characteristic on the New York Stock Exchange of the specialist. They drive and create that market and it doesn't get as delayed.
    But I was most impressed about a meeting I recently had with John Reed, in terms of what the specialists did during the 1987 crash and that, without their existence there—and if we had a totally electronic market—we potentially would have no buyers when the market was falling as rapidly as it was.
    Could you tell us whether or not their—because we hear of all the negatives, everything from extraordinary income, which all of us know is impossibly true, or General Electric; own all the specialist positions on the market—a lot of misinformation is out there but it is having an effect on people because it is misinformation. But a lot of us aren't sufficiently knowledgeable about these exchanges and how they work.
    What is your impression, really, of whether, one: we have a problem in the specialist field in the New York Stock Exchange particularly?
    And, two: do they, in your estimation, fulfill a necessary function?
    Mr. DONALDSON. Clearly, I think that you have to draw a distinction between the rules and regulations under which the specialists operate. And the enforcement of those rules and regulations, which I believe is a separate issue from the function of the specialist system itself.
    I think John Reed was absolutely correct when he referred to the effectiveness of the auction market system as, ''A deliverer of liquidity in times of stress.''
    And I think we have seen that time and time again over the course of my business career, where in turbulent markets the liquidity pool is developed on the floor of the New York Stock Exchange.
    It is a tremendously valuable national asset.
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    Now, the game has changed a bit, as you correctly say, with the advent of penny spreads and decimalization and, the fact that, although you have narrower spreads, you have less of the true size of the market displayed.
    In other words, there is a bid and an ask that are separated by a penny, but that doesn't really disclose what the real depth of the market is behind that bid and offer. And I think that has been to the detriment of informed trading.
    The trick here, as far as I am concerned personally, and I believe as far as the Commission is concerned, is to get an interface between this rapid trading and possible price improvement. In an environment where you only have a penny spread, a case can be made by some, that they, the customer, the client, the broker, doesn't want to wait for a penny improvement. They want to get a trade done; they are interested in speed.
    But I don't think you can apply that across the board to the fundamental concept of price improvement and the customer getting the best price that he or she can possibly get.
    And I think we tread on thin ice when we suggest that we are not going to get the best price for somebody. And I think that is the beauty of our market.
    Chairman BAKER. Thank you, Mr. Kanjorski.
    Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman.
    Chairman Donaldson, I ought to call your attention to the lead editorial in today's Wall Street Journal, and it tracks very closely, the views that I expressed earlier in my opening remarks.
    And we operate on a separate track; I don't write the editorials for the Wall Street Journal, nor do they write my opening statements.
    But I want to quote from that editorial.
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    ''We hope he, that John Reed and especially folks in Washington, don't ignore the largest public policy issue at stake: the rules and regulations governing the national market for stock trading. Specifically, the monopoly created for the New York Stock Exchange by the Intermarket Trading System.''
    ''The heart of this system is a prohibition mandated by the Securities and Exchange Commission against trade-throughs. In theory, this sounds like good market organization and practice; it allows the New York Stock Exchange an artificial market advantage.''
    Do you disagree or agree with those sentiments? And how does the Commission intend to address those thorny issues?
    Mr. DONALDSON. I think, in the testimony upcoming, you are going to see the disagreement that exists out there.
    If I have correctly read some of this testimony that you are about to get, you have people arguing violently on the side of what that editorial said; that there ought to be a total elimination. There are equally strong arguments on the other side.
    I believe the answer is probably somewhere in between, as it always is in many disputes where there are extremes.
    I think we have to be very cognizant of the tradition of the central market structure that says the customer, the client, the small investor, the large investor ought to be able to get at the best price.
    And when you get into defining execution as something other than best price, such as speed, or a number of other criteria, you get a little bit on slippery ice. This isn't to say that there aren't certain customers that would sacrifice price improvement for speed. We have to come up with a system whereby in a unified market, we can satisfy both kinds of customers. And that is our challenge.
    Mr. OXLEY. Has the SEC looked at the—I guess, for want of a better term—the European model? Virtually all of the bourses in Europe have gone to all-electronic trading.
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    Is there any evidence over there that there is a lack of liquidity or failure of folks to make a market? It appears that they have totally abandoned the auction system there. Does that give the SEC any guidance one way or the other?
    Mr. DONALDSON. I don't want to comment generally on the quality of pan-European markets, except to say that I think I could make the generality that our markets are still the envy of the free world; that there is no market system that operates as efficiently and effectively in the interest of individual customers, as well as institutions, as the U.S. markets do.
    Now, that is the basic premise from which we start, which is, we are still the best. And I think all evidence indicates that. Can we improve it? Can we adjust the technology? Yes. I believe we can, and that is what we are working on right now.
    The system—if you want to go into the history of the formation of the auction market system long before technology was designed to create a market that, as much as possible, eliminated dealer interface and allowed natural customers to meet each either directly with no intermediary. And that system was developed over a number of years and has worked pretty well.
    However, if you are starting up new systems, which are characteristic of many of the European markets, they are basically started by dealers who want to get a dealer spread and want to interpose themselves in between natural buyers and sellers.
    Now, that is the fundamental clash, if you will, between those systems and our systems. And now you add onto that the new technology that has come in.
    And, again, I would say that we do not want to lose the benefits of the auction market of which the specialist is a primary part, but we also do not want to deny the speed that is available in some of our electronics markets.
    So the trick is bringing them both together and having an option for customers.
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    Mr. OXLEY. But is there evidence, that you know of, that there is a severe lack of liquidity in the European markets as a result of having an all-electronic system of trading?
    Mr. DONALDSON. Well, I will give you one man's view, and that is I think our markets are much deeper, much more liquid and particularly so in times of stress.
    It is easy to have functioning markets when you are in a relatively calm period. It is a little more difficult to assemble liquidity to offset imbalances when markets are turbulent. And I think that is when the auction market really works the best.
    Mr. OXLEY. If I may, just one more, Mr. Chairman.
    In regard to SROs, do you think that there is an essential function—I am not talking now about structure or design, but just in a general sense—do you agree that there is a need for SROs to exist?
    Mr. DONALDSON. Yes, I do.
    Mr. OXLEY. Okay.
    Mr. DONALDSON. I believe that the original decision that was made back in the 1930s, to create an SRO structure, was a very sound decision.
    And that, fundamentally, was based on the idea that, if you set up a government agency, such as the SEC, and gave it the responsibility for totally regulating the markets, you would create a bureaucracy, you would create a federal expense, and you would create a lack of being in touch with the marketplace that would impede our markets.
    So, I think that the concept of a self-regulatory organization, which gets the regulation down to people who are familiar with the marketplace, is a very sound concept.
    It also gets the expense of regulation down where it should be, on our participants in a marketplace.
    Then, the question is, ''Can you structure that self-regulation so it is totally unbiased?'' So that it is uninfluenced by the responsibility for running a market as a business. And, that is the trick.
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    How do you get that self-regulation independent so that it is not being influenced in any way by those who are trying to build the marketplace?
    Mr. OXLEY. Do you think the NASD model fits that description?
    Mr. DONALDSON. I think the NASD model is an interesting model.
    I think that it still has the need to regulate the NASDAQ market, itself. It is being done by NASDR, I think is one approach. I think there are other approaches.
    Mr. OXLEY. Thank you. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. Emanuel?
    Mr. EMANUEL. Thank you, Mr. Chairman.
    I was intrigued by what you said earlier to the Chairman. I think the way you said it is that the SEC was caught a bit flat-footed by the market timing and late-trading scandal. And this is part question as well as part statement—my hope here is that the mutual fund industry investigation doesn't become a turf battle between the New York Attorney General and the SEC.
    Although the Attorney General has been leading the effort, I would like to see a coordinated strategy without any dispute over ''real estate.''
    Because given how many Americans are invested in mutual funds, the integrity of that industry and its managers is essential. As much as we discuss market regulation, with 96 million Americans investing in mutual funds, it is essential that that investigation be done without any squabbling between the States and the SEC.
    With that said, how widespread do you think this market timing issue is in the mutual fund industry and among its managers?
    Mr. DONALDSON. Let me address the first part of your observation there.
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    Mr. EMANUEL. Sure.
    Mr. DONALDSON. Which is this should not be a competitive situation between regulators.
    Mr. EMANUEL. Good.
    Mr. DONALDSON. This should not be a competitive situation between the federal regulators or any of the State regulators. We have worked with the State regulators for years.
    We have recently formed a joint committee between the State regulators and ourselves to try and iron out cooperative attitudes; how we can help each other; how we can improve that cooperation.
    I think that the spectacle of one regulatory agency criticizing another is not healthy. We look to cooperate, the New York Attorney General, we have tried to cooperate with him, we are cooperating with him right now on a number of issues.
    We have a much broader responsibility, a much larger staff. The whole investigative thing is going on now as we enable it not to be a rifle shot but to be a broad-gauged investigation.
    To answer the second part of your question, we believe, as a result of a net that we have cast, that the market timing and late-trading issues are quite widespread.
    We are still gathering data on this. But we think it is more widespread than we originally anticipated.
    Mr. EMANUEL. Mr. Chairman, we have worked on an agreement that we are going to be holding hearings on the mutual fund industry in the not-too-distant future. Correct?
    Chairman BAKER. That is our intention.
    Mr. EMANUEL. Okay.
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    To me, what is critical here is the integrity of the financial markets in the United States, and the trust investors have in the markets. I feel strongly that these scandals have become for mutual funds what Enron, Tyco, and WorldCom were to corporate America.
    And I think we are all vested in making sure that everybody's level of confidence is restored to the highest level, as quickly as possible.
    So, I applaud you for creating this joint task force. Please let this Committee know if there is anything we can do to help you on the funding level, because I think what is happening, as evidenced by today's news about the Strong funds, is an unparalleled threat to the public's confidence in this sector of the financial markets.
    Thank you for you leadership on these issues. I look forward to continuing to work with you on meaningful reform.
    Mr. DONALDSON. Thank you.
    Mr. EMANUEL. No further questions.
    Chairman BAKER. Thank you, Mr. Emanuel.
    Mr. Bachus?
    Mr. BACHUS. Thank you. Does someone need to put something in the record?
    Chairman Baker, I understand.
    Chairman BAKER. Thank you, Mr. Bachus. I didn't realize Mr. Fossella wanted to put a statement in the record.
    Mr. FOSSELLA. Yes, Mr. Chairman, I have been asked by the Organization of Independent Floor Brokers to have their statement submitted for the record.
    Chairman BAKER. Without objection. Thank you, Sir.
    [The following information can be found on page 196 in the appendix.]
    Mr. Bachus?
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    Mr. BACHUS. Thank you, Mr. Chairman. Chairman Donaldson, Chairman Oxley asked you about the trade-through rule and you indicated that there is consideration for reforming that rule. Is that correct?
    Mr. DONALDSON. Yes.
    Mr. BACHUS. That would go from anything from abolishing the rule to maybe establishing the same practices we have for the queues and the spiders today, is that correct?
    Mr. DONALDSON. Yes. Let me just make a couple of comments on the trade-through rule.
    The trade-through rule was designed to force executions to be done at the best available bid or ask. And it was a rule that was put in to make sure that, no matter where listed stocks were traded, the customer would be afforded the opportunity of the best bid or the best offer.
    What has changed the scene now is two things.
    The first is the speed of electronics with some of the ECN markets, and the second is decimalization.
    The speed is so fast that it is hard to monitor the trade-through rules, and you have trade-throughs going on where, in the name of speed, the customer may be getting a worse price.
    It may well be that because the worst price is only a penny, as opposed to an eighth, or a quarter, or a half, that some class of customers say that, ''I don't care. I would rather have the speed.''
    But to design a market that just throws out the ability to match at the best bid or offer is quite a move.
    So as we look at this rule and try to contend with it, in terms of the modern clash that we are having, I think we have to be very careful what we do with that rule. And that is just what we are looking at right now.
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    Mr. BACHUS. Thank you.
    Do you know when you will maybe disclose the results of, at least, your preliminary findings?
    Mr. DONALDSON. The timing of this and several other market structure issues, as I intimated earlier, is——
    Mr. BACHUS. Months; not days.
    Mr. DONALDSON.——in months now, not days or weeks. And not years.
    Mr. BACHUS. Thank you.
    Earlier, in response to a question from the other side, you mentioned the orderly markets and the fact that one thing specialists do is they stabilize the market and supply liquidity.
    There was an article in the Wall Street Journal yesterday that actually said—I am sure you probably read it—that actually said that, ''The NYSE apparently does not have any data demonstrating that their specialists actually step in and provide capital to stabilize the trading on a particular security during times of market stress.'' That was the Wall Street Journal, yesterday.
    Do you know if those press reports are accurate? I have also heard that Mr. Reed had requested that information and it wasn't available.
    Mr. DONALDSON. I don't know that study. Did you?
    Ms. NAZARETH. Yes. I take it they know how much they bought or sold in times of stress, but they are having difficulty retracing how much capital they committed at the time.
    Mr. BACHUS. When they determine that, will they determine their profits? Are you seeking that information? Is that an area that you are inquiring or examining?
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    Mr. DONALDSON. Yes. Sure. Yes.
    Ms. NAZARETH. Yes.
    Mr. DONALDSON. Yes.
    Mr. BACHUS. Do you know what the status of that inquiry is?
    Mr. DONALDSON. I don't want to give you a direct answer on that because I don't know the exact status. It is under way.
    I will come back to you with just how far we are into it.
    Mr. BACHUS. But you are also trying to gain that same information?
    Mr. DONALDSON. Yes.
    Mr. BACHUS. Yes, Okay.
    In Trader magazine—I guess it is a magazine—I want to just read to you a quote.
    They said that, ''The NYSE's recent release of SEC-mandated order execution qualities statistics actually suggest that investors don't get the best possible execution on the floor of the NYSE, despite the NYSE's claims.''
    And this is really of particular concern, ''The NYSE's public claim is consistent with complaints by large NYSE members that when such members have considered routing investor order flow to alternative market centers away from the NYSE, the NYSE regulatory arm has threatened the members with best execution investigations.''
    You have probably heard some of those allegations? And let me put another question on top of that.
    What disturbs me about that is that the regulatory arm of the NYSE could be used to stifle competition, if that is true. And I would just like your comment on that.
    Chairman BAKER. And that will have to be the gentleman's last question. His time has expired, but please respond, Mr. Chairman.
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    Mr. DONALDSON. Let me just put newspaper articles and studies in context. What we are dealing with here is a competitive situation.
    As a former academic myself, there are studies, and there are studies, and there are studies that are sponsored by groups—I am not referring to any particular study——
    Mr. BACHUS. Absolutely.
    Mr. DONALDSON.——but I think that you have a right to believe that the studies being done by the SEC are non-biased, straight down the middle, with one purpose in mind: the effective structure of the marketplace.
    And I think it is very hard for people to separate out the competitive markets that are out there today and the prejudices associated with that, including, but not limited to, the New York Stock Exchange, the American Stock Exchange, the ECNs, et cetera.
    They are trying to promote a marketplace. And so, I take some of these studies with a grain of salt.
    Mr. BACHUS. I guess I would just say, would you agree that if they were using the regulatory arm to stifle competition that would be improper?
    Mr. DONALDSON. Well, I think that this gets to the issue of where the locus of the regulation is, and I am sure that there are accusations on all sides about the regulation being biased or not being biased, or being used for other purposes.
    I think the solution to that is to have the regulation independent of those that are trying to build the market itself and to have it be a truly independent entity.
    And that goes to, as I said before, a number of different ways of doing it: internally structured or externally and totally separated, or a mixed mode, such as NASDAQ has.
    Mr. BACHUS. I thank you.
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    Chairman BAKER. Gentleman's time is expired.
    Mr. Hinojosa?
    Mr. HINOJOSA. Thank you, Chairman Baker and Ranking Member Kanjorski.
    I want to thank you for holding this second hearing on market structure. I recall that the first hearing on this series was on governance issues at the New York Stock Exchange, including the potential conflicts of interest created by regulators.
    This leads me to my question. Chairman Donaldson, what role can the public equity markets, specifically, real estate investment trust equity funds, play in providing capital to invest in affordable multi-family and home ownership efforts?
    For example, can the public equity markets play a role in providing capital the same way Citigroup and Fannie Mae announced yesterday that $100 billion of financing through the end of the decade to help lower-income families obtain mortgages to buy homes?
    Is that something you would support?
    Mr. DONALDSON. My answer to your statement or question is that the equity markets, in this country in particular, are highly liquid. And they are highly transparent. And, because of the liquidity and the transparency, they give people an opportunity to set the cost of capital, if you will, by the multiples of earnings, or whatever, that stocks sell at.
    So it is a great capital-generating machine. The equity ownership has, inherent in it, the raising of new equity and the raising of new capital.
    As far as what vehicles are better for distributing it to one industry: housing or whatever, we could sit here and talk about that for a long time.
    Mr. HINOJOSA. Well, that answer is a little bit unclear.
    It seems to me that you and I and many in this room, understand that the housing industry is the one that is helping keep unemployment rates down to the point that they are.
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    Otherwise, it would probably be one or two points higher.
    So it seems to me that there needs to be a boost in terms of monies available, particularly for working families who want an opportunity to have their first home.
    Are you saying that you don't favor one industry over another?
    Mr. DONALDSON. No.
    There are many mortgage security mutual funds to begin with, but I think the political issue of how money is directed to different parts of the economy is not really my function or the SEC's.
    I may have personal views on it, but I think it really is not in our mission.
    Mr. HINOJOSA. Okay.
    Chairman Baker, I look forward to learning more about our capital markets from today's and, hopefully, future witnesses.
    I also look forward to working with you and with Ranking Member Kanjorski should this Subcommittee conclude that it needs to formulate legislation to change corporate governance, or possibly encourage the exchanges to adopt certain best practices.
    With that I yield back.
    Chairman BAKER. I thank the gentleman for his good statement.
    Ms. Biggert?
    Mrs. BIGGERT. Thank you, Mr. Chairman.
    Just to follow up on Mr. Bachus's question for a moment. You were saying that you are moving expeditiously on the market structure issues and that would be within months.
    Do you have a list of how you are going to proceed and what issues will the Commission tackle first?
    Mr. DONALDSON. Yes. There are a number of issues that are on our agenda.
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    Obviously, the issues we have been discussing this morning: trade-throughs; trade-through rules and other rules; access; market access; the openness or lack, thereof, of access. And we have a number of concerns about the way the market data tape revenues are determined and distributed. Those are a few of the categories that are on our agenda right now.
    Clearly, governance is a part of that and regulation.
    Mrs. BIGGERT. One of the issues that I am particularly interested in is internalization.
    And it just seems like, with all of the recent conflict of interest scandals, that little has been said about the internalization which, obviously, involves the brokerage firms trading against their own customers' orders.
    And I have concerns that this practice in the listed options markets may soon be systematic and taken to a new level if the SEC approves the pending proposal from the Boston Stock Exchange, called BOX.
    Could you comment on the timeframe for completing that proposal? And could you also comment on what the SEC is currently doing to study the beneficial, or the adverse, effects of internalization?
    Mr. DONALDSON. As you intimate, the proposed BOX system was proposed to the SEC. We had a number of questions about various aspects of that proposal.
    We received answers from not only the BOX promoters but also answers from the public. We are in the process now.
    I think our cut-off date was less than a month ago?
    Ms. NAZARETH. Yes.
    Mr. DONALDSON. Yes, less than a month ago.
    And so we are now examining the comments. Clearly the internalization aspect of that proposed system is one that concerns us, as does internalization generally, not just in the option markets, but the potential for internalization in the equity markets.
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    Again, the negative potential of capturing buy and sell interests inside an entity—as opposed to exposing them to buy and sell interests across the country, and the world for that matter.
    Mrs. BIGGERT. Would the impact of the one-cent trading have any effect on that issue as well? On the BOX?
    Mr. DONALDSON. I am sorry, I didn't hear that.
    Mrs. BIGGERT. Would the one-cent trading have any effect in the listed options industry?
    Mr. DONALDSON. Well, as you know, options are traded at nickel increments and that spread has a lot to do with the dangers of internalization. Yes.
    Mrs. BIGGERT. Okay.
    Thank you. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Ms. Biggert.
    Mr. Scott?
    Mr. SCOTT. Thank you very much, Chairman Baker.
    Chairman Donaldson, I would like to ask you a couple of questions about the National Security Clearing Corporation. There is a proposed rule change.
    This rule change will allow the National Security Clearing Corporation to enter into services that are already being given and serviced very effectively and efficiently by the private sector.
    It would, basically, if you are not familiar with it, it would create a new service for the NSCC that would provide its current members with other data services, only for members, would specifically propose to provide a service for its members that would enable the NSCC to provide a messaging hub for the communication of information among sponsors of Separately Managed Accounts, or SMAs, and the investment managers participating in this program.
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    If that rule goes into effect, it would historically change the basic statutory purpose of the NCA.
    And it seems to me that given the current level of private competition present in a marketplace, it could very well be a violation of the NSCC's mandate and would be inappropriate from a policy perspective, for any SOR, including NSCC, to become an active participant in an existing competitive market.
    So it seems, to me, Mr. Chairman, as a matter of policy, that the fundamental role of self-regulatory organizations, or SROs, subject to SEC supervision, should be to facilitate the efficient operation of the markets, as an extension, if you will, of the Commission itself.
    I am very concerned, though, that the National Securities Clearing Corporation, long an essential link in the securities payment process, may be trying to meddle in the kind of function that has been exclusively reserved for the private sector alone.
    What do you know specifically about this rule change that the NSCC is in the process of proposing to the SEC?
    And what assurances can you give to this Committee, and the nation, and to the private sector, that SROs, because of their inherent competitive advantages that accompany their status as quasi-government entities, ought not to be in the business of competing in the private sector with established businesses?
    Mr. DONALDSON. Congressman, I will begin by saying that I am not familiar with the issues that you have just brought up. I just checked with Ms. Nazareth, who, likewise, is not familiar with the particular issues you have brought up.
    But I would like to come back to you with answers to your statement and will do so.
    Mr. SCOTT. That is very good. Thank you, Sir. And I will look forward to getting that information.
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    There are a lot of companies who are involved in this area that are very much impacted and would like to get some answers to that. So I look to get that from you.
    Thank you.
    Chairman BAKER. Thank you, Mr. Scott.
    Mr. Chairman, I don't know if you have previously announced time constraints, but we have several members who are still indicating an interest in asking questions, and we would return right after a brief break with Ms. Kelly on our side.
    And there are several other members on the Democrat side who would like to have the ability to ask questions.
    We have two votes, we think. One for sure that is down now to about six, seven minutes, and possibly a procedural motion would keep us over there another 10, 15 minutes, and we would be right back.
    Mr. DONALDSON. That is fine.
    Chairman BAKER. If that doesn't present a problem, then we will stand in recess for about another 15 minutes.
    Thank you, Sir.
    Chairman BAKER. I would like to reconvene our meeting of the Capital Market Subcommittee.
    And at this time, I would recognize Ms. Kelly for her questions.
    Mrs. KELLY. Thank you very much, Mr. Chairman.
    Mr. Donaldson, my neighbor, I am delighted to have you here today. Thank you very much for coming and for your patience and answering our questions.
    A couple of things that I was interested in: one of the things we have been talking about—I, also, don't know if anybody has noted the fact that we are pretty close to October 29th, Black Tuesday, and this is the 75th anniversary of the market, so I am glad you are here and we have a strong market and I hope it stays that way, but—you were talking about the buyer of last resort.
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    And I would like your thoughts on the practice of the buyer of last resort has played in providing liquidity and in preventing disturbances and how the market structure reforms might have an impact on that principle.
    Mr. DONALDSON. Well, I think if I understand your question, I did make comments earlier about the liquidity that is available in the concept of the auction market and the ''crowd'' and so forth; liquidity that seems to appear at times of stress.
    There is a mechanism there for drawing out that liquidity and putting it together; that I think has served the country well.
    Mrs. KELLY. I am sorry, sir, I wasn't able to be here earlier, I had to go out to the Pentagon, so I didn't hear that at that prior discussion. But thank you for answering that question. I am sorry it was redundant.
    Have you also discussed naked short-selling?
    Mr. DONALDSON. I am sorry, did we——
    Ms. NAZARETH. No. Naked short-selling, we did not discuss that.
    Mr. DONALDSON. No, we did not discuss naked short-selling.
    Mrs. KELLY. I would be very interested in what you plan to do in that area.
    Mr. DONALDSON. Yes.
    We have just put out a new proposed rule that deals with naked short-selling. It deals with short-selling, in general, but as a part of that, naked short-selling.
    And, in the proposed rule, we have proposed that there be new restrictions on naked short-selling.
    I will give you, in general terms, the concept. It would be the obligation of the short seller's agent to identify where the certificates were for the short sale.
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    In other words, it would not prohibit short-selling, but it would severely restrict the short-selling where the short seller can't deliver the certificates. And there are certain leverage advantages to doing that, but it is something we think should be eliminated.
    Mrs. KELLY. And you have a plan to do that is that what I understand?
    Mr. DONALDSON. Yes we have. We have put out a rule on that.
    Mrs. KELLY. Good. Thank you very much for doing that.
    Mr. DONALDSON. Right.
    Mrs. KELLY. I think that will help market stability and trust for the public.
    I am going to ask one other question and that is when the market went to decimalization it went to a penny on the spread.
    I am wondering if we have the opportunity now to take a look, if we are going to standardize, across the board, a certain number of things, whether or not it would behoove us to maybe not take action, but at least evaluate the effect on that regarding the depth of the market.
    And whether or not it might be prudent for us to move to a five-cent, rather than a penny spread. I will give you some leeway to answer that, but I would like to hear.
    Mr. DONALDSON. Yes. Well, I think there has been a lot of examination of just exactly what the effect of the decimalization has been.
    Clearly, part of what you imply is true, in my view, which is that the liquidity or the displayed liquidity is hidden, if you will. There can be a penny spread, but that can be for a hundred shares.
    And you really don't know what liquidity is there,I think that is a disadvantage.
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    In terms of the monies either saved or not saved by the reduction—going to decimalization and all the way down to penny spreads—I think that is a debatable item.
    There are studies that have been done that say this has been to the advantage of the individual investor and to the disadvantage of institutional investors.
    Again, I think that the more light we can shed on just exactly what the implications of decimalization have been, the better.
    In terms of increasing the spread, I think it is probably premature to do that unless and until we have evidence that negative aspects of penny spreads are hurting the liquidity in a marketplace.
    Mrs. KELLY. Are you examining that? Is anyone tasked with an examination of what that effect was on the market and continues to be?
    Mr. DONALDSON. Yes.
    A lot of it is hard to identify in the sense that you have, with the reduced spread, reduced profitability.
    It is quite possible that we have had a reduced liquidity in lesser-traded stocks that market-makers are less inclined to commit their capital with less of a profit margin available to them.
    There are other issues on the other end of the scale: the sub-penny spread issue, which is, ''How far does this go? Do we now get down into not just pennies, but fractions of pennies?''
    You didn't ask me that question, but I will give an answer to it. I think it would be counter to the public interest to get into sub-penny spreads, and that is one of the things we have to address in our market study.
    Mrs. KELLY. Would you also be including commodities markets in that?
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    Mr. DONALDSON. Right.
    Mrs. KELLY. In that study?
    Mr. DONALDSON. Yes. Right.
    Mrs. KELLY. Thank you very much. I yield back.
    Chairman BAKER. I thank the gentle lady.
    Mr. Inslee?
    Mr. INSLEE. Thank you, Mr. Chair.
    Two questions. I have a quote, Mr. Chair, I believe is yours.
    You said, at one point, to the Senate Banking Committee, you said, ''Like payment for order flow, internalization can discourage markets from competing on the basis of price and pose a conflict of interest for broker dealers,'' which, I think, evinces a concern that many of us have.
    But, we are told that you are actively considering this proposal by the BOX, which would, in its essence, increase, as I understand it, the practice of internalization from a structural standpoint.
    Given your apparent concern about internalization, why are you actively considering this? And in what circumstances would you consider approval to try to reduce or eliminate those concerns about internalization?
    Mr. DONALDSON. Well, we, as I said, we have the BOX proposal. We put it out for comment. We got a lot of comments back.
    The most negative comments had to do with the internalization aspect of the BOX procedure. We have asked additional questions based on the earlier responses. We now have this new wave of responses back, and we are looking at the situation.
    We are concerned about internalization, and we are concerned about the spread of internalization, not just from that market, if it were allowed to exist, but the spreading into other markets.
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    Mr. INSLEE. Well, just by way of editorial comment, on our main street on the hustings of the small towns we represent, credibility really is an issue and we hope that you will focus on that and give this very exquisite care.
    Second question. I have spoken recently to some leading managers of leading hedge funds and they have expressed real frustration at timeliness of execution of their orders.
    Sometimes they believe that the exchanges have ignored orders, sometimes they have cited inefficiencies. And so I, kind of, have two questions.
    Is it time for some changes to the pass-through rule?
    And secondly, why has the SEC not responded to, what I understand—I haven't seen the paper on this, but I have been told—there are hundreds of complaints regarding unfulfilled orders, particularly with Amex?
    If that is not correct, perhaps you can tell me. And if so, tell us how we get those complaints responded to.
    Mr. DONALDSON. Yes.
    Well, again, this gets to the heart of the analysis that we are doing now, in terms of the viability of that rule and the negative aspects of the rule given the trade-throughs that are occurring.
    Also, the positive aspects of that rule that ensure that the best price is available no matter what the market is; and I think you are right at the heart of the debate, if you will, and we are aware of some orders that don't get executed.
    We are also aware of orders that, because of the system, have gotten the best price that they otherwise probably might not have gotten.
    So, we have to work at that interface and figure out how it should be adopted, given the circumstances we are in right now.
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    Mr. INSLEE. How can such a basic situation not get remedied?
    Just getting an order executed, if there are hundreds of these, how can the SEC not solve problem in a timely fashion?
    It is an honest question, because what I am told is that there are hundreds of these without a resolution of this. Maybe you could help me understand why that can't get resolved, number one.
    And number two: why don't you attempt to resolve these complaints and get to the heart of what has happened here before you go forward on the BOX situation?
    Mr. DONALDSON. Again, I think you have to put the whole situation within the context of our overall marketplace and how it is functioning.
    With all the hundreds that may not get executed, there are millions that do get executed in the best interests of the public.
    I think it is not that we were not looking at this, it is not that we were not paying attention to it; it is just that it is a very tough question.
    And we have got the best brains that we can assemble, not just at the SEC, but elsewhere, in terms of trying to figure out what is the right answer.
    Mr. INSLEE. Clearly, we are hoping now we do see aggressive action. I come from Washington State where William O. Douglass got the bowl rolling on the SEC and we would like to see that tradition followed. And we hope that you move in that direction.
    Thank you, Mr. Chair.
    Chairman BAKER. Thank you, Mr. Inslee.
    Mr. Crowley?
    Mr. CROWLEY. Thank you, Mr. Chairman for the hearing today. Thank you, Chairman, for coming before us and spending the better part of the morning with us.
    I would like to redirect the focus, just a bit, of the hearing away from the issues like speed and intermediaries and refocus back to the special interests of the investor.
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    I am not speaking of the professional investor, something I think the New York Stock Exchange has done remarkably well and demonstrated throughout its prestigious history of 211 years.
    As you can tell, I am from New York City, and I am a little jealous about the Exchange and concerned about the image that has been portrayed of it most recently. What basically the tenet behind the trade-through rule, as I understand it, was to produce the best price.
    Do you, Mr. Chairman, believe that that has been successful, as far as the public interests are concerned? And, has it worked? I would like to have your personal, maybe, your opinion about this.
    And additionally, in light of the emerging ECNs and the speed, again, would you favor amending or discarding the trade-through rules so that speed could take precedence over price?
    And do you believe that such an action, again, would be in the interest of the investing public?
    Mr. DONALDSON. As I said before, the trade-through rule is one that we are looking at right now. What the trade-through rule does do is to encourage the display of limit orders.
    And the display of limit orders is what makes for depth in the market. So that the trade-through rule also assures, or helps to assure, that the best price is being received.
    Now, when you get to the definition of some other definition of best price, such as best execution, then you bring into play a more complex attitude as to what is the best execution.
    And that kind of attitude might have with it somebody that is willing to have a fast execution and sacrifice price. And that is the issue we are talking about. That is the issue of the goals and desires of different types of investors.
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    I would be very hesitant to sacrifice the opportunities to getting the best price entirely in order to have fast execution. But it is a trade-off. It is a compromise. And that is what we are working towards.
    Mr. CROWLEY. That is a fair answer. I appreciate that.
    At the last market structure hearing we had, you mentioned that the floor-based market, such as the NYSE, often enjoy greater liquidity than non-floor-based markets. Could you expand on that and just give some examples and cite some examples of that?
    Mr. DONALDSON. Yes, I can expand on it colloquially, if I may, in the sense that, if we were in a market where there are large amounts of stock for sale, let's say, and there are not enough bids around, I think the floor has a mechanism for creating liquidity to offset the temporary imbalance between sell pressure and buy pressure there.
    And I think that that liquidity is, in many instances, the liquidity that is created by human beings, if you will, whether it be the specialists, their floor brokers or whatever, who bring that liquidity in the marketplace to offset an imbalance.
    And I think that creates a market that has less fluctuation to it and that is in the interests of the investors. So I think that that is really what I am talking about.
    And, again, not to repeat myself, I think that the trick here is to create a New York Stock Exchange, if you will, or a marketplace, that is able to have the speed associated with, let us say, an ECN, but yet has this liquidity aggregating capability that the auction market has.
    Mr. CROWLEY. You would also take by this sort of the discussion that has gone on that the stock exchange has not invested in technology, none by the huge—you are stating that—but it is almost—and they have invested billions of dollars in upgrading technology at the stock exchange.
    Mr. DONALDSON. There is a lot of rhetoric about technology, and I think there have been—in the competitive juices flowing out there—characterizations of an antiquated system with people running around and no technology. And, of course, that is not so.
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    Mr. CROWLEY. And it isn't that you all are very competitive.
    Mr. DONALDSON. There is tremendous technology at the New York Stock Exchange. And it happens to be blended with human judgment. And I think that characterization of the stock exchange is pretty unfair in this day and age.
    Mr. CROWLEY. Thank you.
    Chairman BAKER. Gentleman's time has expired.
    Mr. Meeks?
    Mr. MEEKS. Thank you, Mr. Chair. And being last and knowing that I am in the way between letting the Chairman go about his busy day, or keeping him here with us, I will be very brief, so that we can get to the next panel.
    I have, basically, two quick questions.
    And like Mr. Crowley indicated, I am from New York and both the New York Stock Exchange and NASDAQ are very important to me and to the city, and I do believe the station.
    But as we move on, the key to a lot of this is transparency and credibility and to make sure that there is confidence from the investors, et cetera.
    And I know that the New York Stock Exchange is currently investigating several specialists for getting in between trades for their own profit.
    My question basically is, ''Do you see this as just an isolated incident, something that will be a rarity? Or something that is occurring on a frequent basis?''
    Mr. DONALDSON. I think you bring up an important point. I am being reminded that there is a pending investigation on this issue that I will be directly involved in as a member of the Commission.
    But let me just say that I think there is a difference between an attack on the specialist system as a system versus the specialist system when some of their rules have been violated.
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    In other words, if the allegations in the investigation are true and there has been a breaking of the rules, that is one thing. That goes to enforcement of the rules and perhaps it goes to changing the rules.
    But in terms of throwing out the whole system because the rule has been broken, that is something that, I think, one has to examine very, very carefully.
    Mr. MEEKS. In essence, throw the baby out with the bath water.
    My other question is that we know that recently John Reed announced that he is reforming the Board of the Directors of the New York Stock Exchange.
    And he is reforming it so that no members will be on the board of directors and securities industry's representatives will be only on an advisory panel with no jurisdiction over regulatory or compensation issues.
    To what extent will you; will the SEC be weighing in at all on the restructuring of the New York Stock Exchange board? What role would you play in that, if any? Will you oversee it? Have any comments in that regard?
    Mr. DONALDSON. Yes. The bottom line is that the SEC has to approve the rules that will come from the reorganization of the stock exchange. Net, net, that is what has to happen.
    Now we have tried to be of what help we can be in helping John Reed contend with, what are, I believe, necessary changes in the governance system of the stock exchange, that is to attempt to address this issue of separating out by virtue of reporting mechanisms: the regulatory side of the house with the market side of the house.
    And I think that John Reed and his advisers are moving in a direction that seems to make sense, I haven't seen the final proposal yet, but the direction that they are moving in is to, in essence, have a totally independent board without any attachments or alliances or to listed companies or floor members or floor brokers or seat holders and have the reporting mechanism of the regulatory side of the house, plus some other reporting mechanisms: compensation, director selection and so forth, report into that entity.
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    And then to have an entity on the side that would have representation from all the constituencies that would serve as an advisory board to the independent board.
    That is a general thrust of what is being proposed, I believe. But we will have to see the details of that because we, in the final analysis, have to approve the implementing rules that will come from these suggestions.
    Mr. MEEKS. But will you be involved and how then will you, Mr. Chairman? Will you be involved?
    Are you going to just wait until you see what the proposal is before you either approve or not approve it? Will there be conversations in between, which I think that I am hearing is taking place?
    And you will be giving some guidance as to what you think is acceptable or not acceptable, while they are trying to develop the plan?
    Mr. DONALDSON. We are anxious to get involved, we are anxious to be of what help we can be in looking at proposals before they go out for votes.
    And I think that has been the tradition of the SEC: to try and anticipate objections, if you will, that we might have before they are out to be objected to in a general publishing of the rules. So that is the route that we hope we are on.
    Mr. MEEKS. Thank you, Mr. Chairman.
    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Meeks.
    Mrs. Maloney?
    Mrs. MALONEY. Thank you, Mr. Chairman. It is always an honor to welcome an outstanding New Yorker to the committee and to congratulate you on your public service. It has been an outstanding one throughout your life, and private service.
    I would like to touch on a part of market structure that I don't believe has been talked about in this hearing.
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    And that is the recently issued report from the SEC on the hedge fund industry. And it was reported that they are now roughly 6,000 to 7,000 of these unregulated investment tools and some have suggested that there should be a register at the SEC.
    And I agree with the commentators that these funds do make a positive contribution in greatly increasing the liquidity in the markets.
    But at the same time, I am concerned about the increasing trend towards hedge funds which lower the financial resources needed to get into the hedge funds and the movement into retail of the hedge funds.
    I want to know, do you support making hedge funds available to retail investors?
    Mr. DONALDSON. As you may know, we have had the hedge fund industry under review for over a year. We have done as much research as we could accomplish.
    We have had groups of hedge fund people brought together on all sides of the issue: advisers, hedge fund managers and so forth.
    And as a result of all of that, the staff has presented the commission with a report and with a series of recommendations, perhaps the most prominent of which is that we register the advisers to these funds under the Investment Advisers Act.
    And I think that that recommendation is based on several considerations.
    Number one is, what you say, which is that there are upwards of 6,000 to 7,000 of these funds out there right now. They account for somewhere around $600 billion to $700 billion; they are growing like a weed.
    And we have no right in most of these funds to go in and find out what is going on. Why do we want to go in and find out what is going on?
    Two reasons: one is we want to understand the accounting that is being used, we want to understand the pricing that is being used. We don't want to interfere with investment techniques or disclose those to other people; proprietary techniques, but we need to have the right to go in.
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    Perhaps more important than that, in my view, is we need to understand what impact these funds are having on the marketplace itself.
    It has been said that hedge fund investors are wealthy investors and they can take care of themselves.
    That may or may not be so, but what we can't afford to have is a hidden impact, if you will, in terms of some of these techniques that act against the best interests of our functioning markets. And that is why that proposition was put forward.
    We have put it out for further comment to address the issue of small investors without a means test investing in hedge funds.
    I think a good case can be made for that, if there is complete transparency within the hedge fund itself.
    And, as we move toward these so-called funds of funds, funds of hedge funds, where you have weekly or monthly pricing, it is all the more important to assure that the small investor knows what he is or she is buying. And knows how the internal holdings are being priced, et cetera.
    Mrs. MALONEY. But that is pretty much important that transparency. And I truly do believe that our capital markets run on trust as much as they do on money.
    And therefore, your position is incredibly important to the country and the trust the country will have in financial markets.
    So, as one who represents the New York Stock Exchange, I have been there many times and I have met with some incredibly impressive people and the technology and oversight into the building, I would say, is State of the art.
    And you have touched on this earlier, but I would like to have it clarified; given the controversies at the exchange, you stated earlier, I believe, that you support this self-regulation model in general.
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    But my question is, ''Should the job of regulating the Exchange be separate from the job of running the Exchange's business?''
    I know that the NASDAQ is split from the NASD, possibly these are different models, but you, I believe said you support self-regulation, but do you believe the head of the exchange should also be the head regulator?
    Mr. DONALDSON. Well, again, I think that the issue is the definition of separation. And to me, separation can run a gamut. It can be a physical; an ownership separation with a regulator out there, somewhere.
    Or it can be an internal structure that separates the reporting function such that the regulators are reporting to an independent board and reporting not to the same people that are running the exchange market, as a business.
    And, I think, the stock exchange is now wrestling with where they come down on that.
    And I think we have an open mind toward a solution that solves the issue of potential conflict of interest between the business side and the regulatory side.
    Mrs. MALONEY. Well, my time is up and I thank you, Mr. Chairman.
    Thank you, Mr. Donaldson.
    Chairman BAKER. I thank the gentle lady.
    Mr. Chairman, we express our appreciation for your courtesy of your time today. It has been very helpful for the Committee's considerations.
    I am advised that a number of members, who could not come back, that wish to ask additional questions requested that the record remain open so their submission of questions to you could be, perhaps, responded to by correspondence at a later time, but would be made part of the official committee record.
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    With that one caveat, and I also will forward my own correspondence relative to a question concerning the window during which some of these ongoing analyses may be completed for the Committee's planning for next year.
    Understanding that we would very much like to have the Commission's recommendations finalized, in order, for the Committee to act upon where it is needed to be acted upon within a reasonable time constraint, next congressional year.
    So, we do appreciate your courtesies and your willingness to participate. Thank you very much, Sir.
    Mr. DONALDSON. All right. Thank you.
    Chairman BAKER. Thank you.
    And I would ask that the participants in our second panel, please, come on down.
    I welcome each of you to the Committee's hearing today. All of your formal statements will be incorporated into the official record. We would request that your oral testimony be limited as best possible to five minutes.
    And I do expect members in and out as the course of the hearing proceeds, but all of your recommendations will be reviewed by members of the Committee as we go forward.
    At this time, I would like to recognize Mr. Robert H. McCooey, Jr., President and Chief Executive Officer of the Griswold Company. Welcome, sir.
    Please proceed at your leisure.
    Mr. MCCOOEY. Thank you, Chairman Baker.
    Chairman Baker, Ranking Member Kanjorski and members of the Subcommittee. My name is Robert McCooey.
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    I am a proud member of the New York Stock Exchange and President and Chief Executive Officer of the New York Stock Exchange member firm The Griswold Company.
    Griswold is an agency broker executing orders for some of the largest mutual and pension funds in the United States.
    Thank you for inviting me here today to testify in connection with your review of the capital market structure here in the U.S. I would like to highlight some aspects of my previously submitted written testimony.
    As a floor broker, I know the important role that we play in the price discovery process. The competition between orders represented by brokers at the point of sale on the floor helps to ensure fair, orderly and liquid markets.
    The floor broker serves as a single point of accountability and information not found in dealer markets and ECNs, and who employs the most advanced technology to support his or her professional judgment.
    The floor broker relies upon a digital hand-held communication device which receives the orders, transmits the reports, and engages in an ongoing dialogue with the client through the use of digital images.
    All this is done without ever leaving the trading crowd.
    With regard to the trade-through rule, when trading is allowed to occur outside of the National Best Bid and Offer, the NBBO, two investors are being disadvantaged. The bid, or offer, that has been posted, as well as the buyer or seller who receive the inferior price to the NBBO.
    To amplify this, I would like to offer the following example. A buyer posts a bid of $49.05 to buy 5,000 shares of XYZ.
    In the absence of a trade-through rule, a 5,000 share trade might occur at $49. In this instance, two investors are not being afforded the full protection that they deserve in the marketplace.
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    The seller who sold the stock at $49 did not receive the highest price that was bid for those shares in the market. Further, the buyer with the $49.05 bid was left unfilled.
    This investor posted the best bid in the marketplace and was ignored.
    I do not believe that this is the message that we want to disseminate to the investing public. Unfortunately, this is a message that is being promoted by some of our competitors.
    In my opinion, some of those who have sat here before you prior to today, have engaged in competitive positioning rather than factual presentation. Simply stated, the facts do not support their contention of the unfair system that stifles competition.
    At the New York Stock Exchange, we welcome competition. However, that competition must be one that ends with the customer's order being executed at the best available price.
    The reality is that the NYSE posts the best price nearly 94 percent of the time in all listed securities. That is the single reason why we have been successful.
    With 30 co-sponsors, Chairman Mike Oxley sponsored H.R. 1053 to eliminate legal impediments to the quotation in decimals for securities transactions in order to protect investors and to promote efficiency, competition and capital formation.
    So what happened along the way to the penny? Has something changed in these few short years? Do investors no longer deserve to save money?
    Is it acceptable for fiduciaries to accept a worse, though speedier, price for stocks that they are buying and selling on behalf of the millions of shareholders who have entrusted them with their hard-earned money.
    There is, however, an answer to these questions about the penny.
    I think that somewhere between common sense and today client interests have been abandoned and replaced with those that are self-interested.
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    During our difficult period for both the financial markets and broker dealers, client interests have been secondary to the economic interests of firms and market centers.
    It is not time to encourage or reward this type of behavior. Quite the contrary, the message of the investor first should be quickly and firmly reinforced.
    And pennies add up. If fiduciaries are advocating their responsibility to achieve the best price available, the impact to their shareholders is very significant.
    If an investment manager decides to forego better, available and accessible prices for the sake of speed, the negative cost impact to the fund shareholders is in the millions of dollars.
    For a fund trading average of 10 million shares a day, to receive that incremental penny of price improvement on all those shares, multiplied by 250 trading days in a year, the savings are $25 million.
    This is the shareholder's money, the investor's money. Furthermore, I am giving you only one example, from one fund manager. Across thousands of funds and billions of shares traded, the negative impact to investors cannot be ignored.
    Finally, how do we ensure that the national market system benefits all investors? We begin with what has worked for years and continues to work today.
    At the NYSE, we provide investors with the best price, liquidity, transparency, accessibility, the highest certainty of an execution, protection of customers' orders and their interests.
    At the NYSE, we will continue to change, adapt and innovate to best serve our customers and to fulfill our commitment to producing the highest levels of market quality.
    In all that we do, we take pride in the fact that we always place the investor first.
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    Thank you.
    [The prepared statement of Robert H. McCooey can be found on page 155 in the appendix.]
    Chairman BAKER. Thank you very much, sir.
    Our next witness is the President and Chief Executive Officer, Security Traders Association, Mr. John Giesea.
    Welcome, sir.
    Mr. GIESEA. Thank you, Chairman Baker and members of the Subcommittee.
    I would like to take opportunity to introduce the Security Traders Association to you, which we refer to, and I will refer to, as STA, which is a 70-year-old organization comprising 6,000 individual professionals involved in the purchase and sell of equities securities.
    Representatives of our organization are on the buy side and the sell side and participation is included amongst members of ECNs and exchanges.
    Myself: my background is simply 23 years at Kidder, Peabody, 10 years with Advest in senior trading and management positions and two years in the current position as President and CEO of STA.
    Our sole focus as an organization is market structure.
    And the imposition, or the hosting, of the market structure hearings held by the SEC in November and December of last year, formed the basis for a desire on our part to comment on issues that we felt we could add value through our experience and expertise.
    The outcome of that process was this report, ''Fulfilling the Promise of the National Market System,'' which I have asked to be submitted along with my written testimony.
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    In preparation for this report, we examined the origin of the National Market System in 1975 and discovered the five principles that this National Market System was built upon are as valuable today as they were at its inception.
    And the Congress got it right: those include transparency, economic efficiency, ease of the best execution, fair competition and the opportunity to transact without need of an intermediary.
    The fact is, 28 years later, we need to update, but we need to retain those principles, but update market structure.
    Three areas I would like to touch on quickly and that are included in our testimony include fragmentation, regulation and access fees.
    We have heard mention of fragmentation a couple of times today, and in and of itself, we would represent that fragmentation is not positive. On the other hand, competition is the foundation upon which our business has been built.
    We have succeeded in encouraging and thriving on competition. And competition in the area, particularly NASDAQ stocks, through use of the UTP, Unlisted Trading Privileges, has created fragmentation in the marketplace.
    Excuse me.
    Alone, fragmentation represents a hurdle to overcome. The hurdle is overcome through linkage and connectivity. We believe that there should be linkage to all markets, that includes automatic and immediate execution.
    In the area of regulation, we are pleased with the SEC's SHO short sell regulation, which promotes and suggests the rule that crosses markets.
    This is the principle that STA recommends for basic customer protection rules, as well as basic trading rules, such as short sell and sub-penny quotations. Market share gains by a market center should not have root in less regulation.
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    Thirdly: access fees. We have long opposed, our association has long opposed, the imposition of access fees which was done as part of the 1996 Order Handling Rules by way of a footnote.
    This footnote allowed one segment of the market to charge a fee for accessing its quotes. We think this is unfair and represents a hidden cost to investors and should be eliminated.
    We praise the NASD, on behalf of NASDAQ, for putting a cap of three mils, a suggested cap of 3 mils, 0.003, on an access fee; though we believe we are still three mils away from where it should be in order to be transparent and fair.
    Next, I would just like to make a quick mention of the area of liquidity. Through my conversations and my work, we need to be sure that when we talk about liquidity we make no assumptions.
    And another thing the SEC did in their short-sell rule is they allowed for a provision for the most liquid, 300 stocks, to be exempt from the bid test. It recognizes there is a difference in the trading of stocks.
    G.E. on the New York, Intel on the NASDAQ seldom, if ever, need an intermediary. They trade efficiently and transparently.
    But those other stocks that are less active benefit greatly through the activity of the liquidity provider, called a specialist or a marketmaker. And I think that this is something that the SEC needs to be careful of in putting regulation in place, not to assume that all stocks trade alike.
    Then, lastly, in terms of the ability for young, worthy companies to raise capital, we believe liquidity is an important part of that.
    And we believe that with issues involving investment banking and research over the past year, together with liquidity, issues and lessons, liquidity, date of market structure, that the underwriting and the ability to raise equity capital is challenged and we don't want that to happen for the U.S. economy or for job growth within the United States.
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    STA is honored to be present today and is proud of its tradition of representing the principle, ''What is good for investors of all kinds, is good for our market and good for our members.''
    Thank you, to the Committee for the important work that you do and, in particular, Chairman Oxley, Chairman Baker, Ranking Member Frank and Congressman Fossella for having joined STA in its spring conference earlier in this year.
    And we appreciate the opportunity to be before you today.
    [The prepared statement of John Giesea can be found on page 111 in the appendix.]
    Chairman BAKER. Thank you, sir.
    Our next to be heard is Mr. Thomas M. Joyce, President and Chief Executive Officer, Knight Trading Group.
    Mr. JOYCE. Chairman Baker, Ranking Member Kanjorski, members of the Subcommittee, thank you for inviting me to participate in this hearing regarding the structure of the U.S. equity markets.
    My name is Tom Joyce. I am the CEO and President of the Knight Trading Group, the largest, independent market maker in the industry. To give you some sense of context, on a typical day, we do over a million trades and well over a billion shares of equity trading.
    I have been a member of the securities industry for the past 25 years, including 15 years at Merrill Lynch. I have been both a student of and an active participant in the debate over market structure for over a decade.
    In fact, many of the issues you are hearing about today were examined back when I was the Chair of the Quality of Markets Committee of NASDAQ, and when I served as a member of the New York Stock Exchange's Market Performance Committee.
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    Having worked both in the option model and the electronic model, I believe I can bring to you a unique perspective on market structure.
    Although U.S. equity markets remain the most vibrant and liquid markets in the world today, they are facing severe problems.
    The conversion to decimals has successfully narrowed spreads, but it has also sparked a series of unintended consequences that have resulted in new trading challenges for investors.
    It is our hope that these hearings will lead to a fair market structure in an even-handed application of rules that we all seek.
    There are three main points I would like to convey to the Committee today. The first is on the issue of best execution.
    We at Knight strongly believe that the definition of best execution resides with our clients. To attempt to define a single standard of best execution is simply wrong footed. Each client has different needs at different moments. It is our job to know our clients and to perform accordingly.
    Thus, the standard of best execution should be defined by competition on a level playing field with the proper transparency associated with it.
    As for transparency, each month we publish on the web data regarding the quality of our executions, scored against statistics such as speed and price improvement. They are located in the 1-5 and 1-6 statistics.
    This public disclosure, linked to our competitive efforts, is the right approach. Ultimately, if we fail to give our clients what they want, they will vote with their feet. And conversely, as we do a good job for our clients, they will reward us with more business.
    The second main point I would like to make is that there needs to be certain high standards established across the various trading venues.
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    Again, decimal trading has been a success on many fronts, but many of the trading rules that are being applied to our markets today date from the era of eighths.
    I would suggest action on the following issues: sub-penny trading; flatly, it should be banned.
    Virtually no other retail product in the United States trades in units below a penny. The only beneficiaries of sub-penny trading are professional traders who can use it to game the system.
    I would submit to you, you couldn't find a single traditional retail investor who would ask for sub-penny trading.
    If people complain about so-called penny jumping that supposedly takes place in the New York Stock Exchange, think about how divisive mil-jumping, tenth of a penny, jumping is in NASDAQ.
    To me, this is a race to the bottom. Therefore, I strongly suggest we go back to penny spreads and establish it as a standard of our markets.
    The trade-through rule: it exists today to protect price priority across markets. The time has come to adapt the rule to the common market dynamics. When volume aggregated at an eighth or a sixteenth, it made sense.
    Now, however, in an era of decimal trading, we see volume dispersed over 100 price points, thus, aggregating it is more difficult.
    More importantly, the speed at which many markets trade today make the quote literally flicker. It is not uncommon in highly liquid stocks, like Microsoft, for example, to see 50 quote changes in a second.
    In an environment like this, we firmly believe that a de minimis exception of three cents around the quote should be the core component of a new trade-through rule.
    Third, we also believe that it is time to establish standards for intermarket access.
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    The best examples of the need to introduce change here are the unlisted trading privileges NASDAQ and the Intermarket Trading System in the listed market. In each case, you often see the conflict between electronic trading and the old, open-outcry manual systems.
    We believe, if markets are expected to interact, then certain minimum standards of connectivity must exist which would allow for electronic access up to some practical trade size.
    And the third, and last, point I would like to make is that market-makers matter.
    For too long now, ECNs and other ATSs have been receiving most favored nation status in certain regulatory circles, highlighted by the abilities of ECNs to charge fees, while we as market-makers cannot.
    We would like to see changes to the current status quo that favors this class of execution providers. A privileged class protected not by competitive superiority, but by regulatory authority.
    Now many stocks, particularly the largest stocks, do benefit when trading on ECNs. Admittedly, they do a fine job there.
    But as one gets further down the liquidity spectrum without capital committed by market-makers, many nit cap and small cap stocks would trade with much greater volatility and much less liquidity.
    This in turn, diminishes the ability of these companies to see additional, or initial, capital through the U.S. Capital Market System.
    Marketmakers supply an enormous amount of liquidity in this segment of the market. We believe that if they continue to walk away from this segment of the market, it is a long term negative for the market, for issuer companies and investors.
    If it continues unabated, I would argue that ultimately, the capital formation process of the economy could be negatively affected.
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    In conclusion, give us a level playing field in which to compete in different market centers and a regulator who will establish the appropriate rules set and apply it evenly.
    In any market we believe we can compete with any model any time. And ultimately, it is the investor, our end user, who will dictate which service provider succeeds and hopefully, in our case, flourishes.
    So on behalf of Knight, I would like to thank you for the consideration of our testimony. And, of course, we would welcome any comments and questions at the appropriate time.
    [The prepared statement of Thomas M. Joyce can be found on page 119 in the appendix.]
    Chairman BAKER. Thank you, Mr. Joyce.
    Our next witness is Mr. Michael LaBranche, Chairman, Chief Executive Officer and President of LaBranche and Company, Incorporated.
    Welcome, Sir.
    Mr. LABRANCHE. I would like to make some general observations about the New York Stock Exchange; what it means to the American economy and especially in light of all the press that is being given to it.
    One of the things about the New York Stock Exchange that many people do not understand that it is the world's largest electronic stock exchange.
    People don't realize how much technology goes into a trade on the New York Stock Exchange. More than 90 percent of the orders that are delivered to the New York Stock Exchange are delivered on our Super DOT system.
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    We also have a specialist system which is coupled with that which adds capital to the system, which has human capital as well as financial.
    We have a market that has the most liquidity of any market in the world. You can see statistics about how many orders get executed in certain markets.
    I can tell you that 100 percent of the market orders that are transmitted to the New York Stock Exchange are executed. That is unparalleled liquidity that has not been equaled in any other marketplace.
    The United States Capital Markets are by far the best capital markets in the world and the New York Stock Exchange has played a very large part in the development of the Capital Markets.
    It has a direct effect on everybody in this country, in terms of the development of the economy and the standard of living.
    One of the things that we hear about very often, especially in the press today, is about the importance of speed versus price. And that is a very important concept to us, and I think it is a lot more complex than simply the trade-through rule.
    Remember that speed is really access to the market, but the price is by far the most important thing.
    Even for large institutions they are ultimately representing individuals and they are representing individuals that go about their work, or go about go on vacations, or do things in their daily routine.
    They don't know if their orders are being executed in two seconds or 12 seconds or 20 seconds. What they care about is what their returns are at the end of the year. And so, to them, the most important thing is to have a mechanism that gives them the best price.
    So, when we talk about the trade-through rule, I think it really goes beyond simply talking about a trade-through rule.
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    I think the most important thing that we have to talk about here today is the fact that we have to be able to send the message to the investment community and investors that their interests are being looked after.
    That broker's primary responsibility is to always find the best price for the people they represent.
    I think if we go down the road where people believe that their brokers are not necessarily looking for the best price, but more broker-convenient, then I think we are going down a path that might lessen investor confidence.
    So, whether the trade-through rule gets reformed, I think it is very important that the message remains that brokers are looking after the interests of their clients.
    When we talk about speed, one of the things about the New York Stock Exchange that people tend not to realize is that it really is a much more efficient and quick execution platform.
    It is, to me, irrational to think that anybody would want to give up a better price for five or 10 seconds, but the fact is that 50 percent of all orders 500 shares or less that are executed on the New York Stock Exchange are executed within five seconds.
    Beyond that, institutional orders that run between 2,000 and 10,000 shares on the New York Stock Exchange are executed on an average of 18.7 seconds. Now, that would compare to the same execution and time span on an ECN of 61 seconds.
    So we are a very efficient market, we are a quick market. And we are always looking for the best possible price.
    The other important thing that I think we should talk about here—the point I would like to make—is the talk about what does the auction mean. Now the auction is very often confused with a busy trading crowd. But the auction is not an anachronism.
    The auction is what allows investors of all kinds, whether or not they have a 100 shares to buy or sell, or a million shares to buy or sell, the auction is what allows them to interact in the market in a fair way.
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    It means that if you are willing to pay the highest price for a stock, if you have one share to buy or a million shares to buy, you get the first chance to buy it. If you have one share to sell, or a million shares to sell, you get the first chance to sell it.
    That is the basic benefit that the public derives from the auction.
    And I think that if you think about it that way, people take that basic right for granted, but the auction, in essence, represents the Bill of Rights for investors.
    I think the New York Stock Exchange works very hard to make sure that that auction is adhered to in a way that protects investors in all circumstances, whenever possible.
    The specialist, we are a very important part of that auction, but we are one piece of the puzzle. We represent one constituency on the New York Stock Exchange.
    We are an important part of it, but we function within that community working to make sure that people get the best possible price.
    So, thank you.
    [The prepared statement of Michael LaBranche can be found on page 145 in the appendix.]
    Chairman BAKER. Thank you very much, sir.
    Our next participant is Mr. Kevin Foley, Chief Executive Officer, Bloomberg Tradebook.
    Mr. FOLEY. Thank you, Mr. Chairman, members of the Subcommittee.
    My name is Kevin Foley, and I am pleased to testify on behalf of Bloomberg Tradebook.
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    Bloomberg Tradebook is owned by Bloomberg L.P. Bloomberg L.P. provides multimedia, analytical and news services to more than 175,000 terminals used by a quarter of a million financial professionals in 100 countries worldwide. Bloomberg News is syndicated over 350 newspapers and on 550 radio and television stations around the world.
    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 representing, through pension funds, mutual funds and other vehicles, the savings of millions of ordinary Americans.
    Bloomberg Tradebook specializes in providing innovative tools that subdivide large orders into small orders and eliminate the traditional barrier between the upstairs market and the trading floor market.
    Through that technique we bring upstairs liquidity directly into contact with small retail orders, with the options market-makers and with program trading order flow.
    In the process, we consolidate what has been a fragmented market and we increase the efficiency of the market.
    Our clients have rewarded our creativity and our service by trusting us with their business, allowing us regularly to trade more than 180 million U.S. shares a day, about 20 percent of that in listed shares; and a third again as much business in international shares.
    We have consistently been among the top five providers of liquidity to NASDAQ's supermontage.
    And a large percentage of our listed order flow is executed using our technology and through New York Stock Exchange members on the floor of the New York Stock Exchange.
    The House Financial Services Committee has long been concerned with potential conflicts that might lessen market efficiency or compromise investor protections.
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    The Committee has devoted significant time and effort to addressing some of these conflicts in the context of analysts, accountants and others.
    Recent conflicts relating to the New York Stock Exchange provide an opportunity to make the U.S. equity markets more competitive.
    New York, in 2003, looks strikingly like NASDAQ in 1995. The SEC made decisions on market structure in the mid-1990s intended to combat conflicts of interest in the NASDAQ market by enhancing transparency and competition.
    Specifically, the SEC's 1996 issuance of the Order Handling Rules permitted electronic communications networks to flourish, benefiting consumers and the markets generally.
    Indeed, the increased transparency promoted by the SEC's Order Handling Rules and the subsequent integration of ECNs into the National Quotation Montage contributed to NASDAQ spreads narrowing by nearly 30 percent.
    These, and subsequent reductions in transaction costs, constitute significant savings that are now available for investment that fuels business expansion and job creation.
    Chairman Oxley has asked, ''Why does New York control 80 percent of the trading volume in its listed companies when NASDAQ controls only about 20 percent of the volume in its listed companies?'' And we think the answer is simple.
    There have historically been a series of barriers to competition in the New York listed markets that have the effect of centralizing order flow and impairing intermarket competition, and depriving the market of the opportunity to test whether competitors could bring the same benefits to the New York Stock Exchange investor as they have to the NASDAQ investor.
    To unleash competition and promote an efficient market, we believe Congress and the Commission should consider the following: repeal the trade-through rule.
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    This 20-year-old rule protects inefficient markets while depriving investors of choice. Today's lead editorial in the Wall Street Journal, we believe, is on target.
    Facilitate display of New York listed stocks in the Alternative Display Facility. The ADF has been providing a competitive spur to the NASDAQ's supermontage and serving as a check on anti-competitive behavior.
    We believe the ADF could provide a similar tonic for the New York Stock Exchange listed market.
    Ensure the oxygen supply. The Financial Services Committee has long accurately held that market data is the oxygen of the markets, but the oxygen supply has been imperiled in the past and is imperiled today.
    Before the 1970s, no statute or rule required self-regulatory organizations to disseminate market information to the public or to consolidate information with information from other market centers.
    Indeed, New York claimed an ownership in market data and severely restricted access to that market information. Congress responded by enacting Securities Act Amendments of 1975.
    These amendments empowered the SEC to facilitate the creation of a National Market System for securities, with market participants required to provide, immediately and without compensation, information for each security that would then be consolidated into a single stream of information.
    Bloomberg, in consultation with two distinguished economists, has submitted to the SEC a discussion paper entitled, ''Competition, Transparency and Equal Access to Financial Market Data.''
    The paper delineates the ways in which exchanges, in the absence of structural protections, may abuse their monopoly power over the collection of market information to the detriment of consumers.
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    Those concerns were borne out this year when the New York and its liquidity quote ''proposal'' sought to make available data that had inadvertently been made less transparent by decimalization, but only under contractual terms that would have required vendors to display it in a way that disadvantaged other market centers, as well as prohibiting data vendors from integrating it with data from other markets.
    The promise of enhanced transparency at the heart of decimalization would have been thwarted.
    Under Chairman Oxley's leadership, the Congress has pushed hard for decimals, and that additional transparency has indeed, benefited investors. We applaud the SEC for striking down New York's restrictive contracts and liquidity quote.
    The controversy underscores, however, that policymakers should give strong consideration to updating the vendor display rule. Otherwise, investors will actually have less useful information than existed prior to decimalization.
    Ensuring the oxygen supply also entails greeting efforts to create new property rights in data, with a measure of skepticism.
    As this Committee well knows, in past Congresses, both New York and NASDAQ have supported legislation which would create a new and unprecedented property right in factual data, including even government-sponsored monopoly market data.
    In hearings in the last Congress, the Financial Services Committee heard a number of market participants express strong opposition to this proposal.
    A few weeks ago, H.R. 3261, the Database and Collections of Information Misappropriation Act, was introduced and referred to the House Judiciary Committee.
    The legislation is sufficiently contentious that an incredibly diverse array of public and private entities; ranging from the U.S. Chamber of Commerce to the American Civil Liberties Union, the Eagle Forum to the Consumers Union, have already voiced strong opposition.
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    While some market data has been exempted out of the proposed legislation, the bill continues to potentially bar access to much other information critical to market participants, hence, may well have important ramifications for market transparency.
    Finally, in the NASDAQ market: access fees. Bloomberg has long believed that ECN and NASDAQ access fees should be abolished for all securities and all markets. And we have urged the SEC to take this important step.
    In conclusion, this Committee has been in the forefront of the market structure debate. I appreciate the opportunity to discuss how these seemingly abstract issues have real-world impact on investors.
    Policymakers should set rules, but encourage competition and let the market do the rest. And the New York Stock Exchange will successfully adapt, as it has for more than 200 years, and investors will benefit.
    Thank you.
    [The prepared statement of Kevin Foley can be found on page 88 in the appendix.]
    Chairman BAKER. Thank you, Mr. Foley.
    And our next witness is Mr. Edward J. Nicoll, Chief Executive Officer, Instinet Group, Incorporated.
    Mr. NICOLL. Thank you, Mr. Chairman. I will be mercifully brief.
    Mr. Chairman, Ranking Member, members of the Subcommittee; thank you for inviting me to testify today on the issue of how to reform our market structure and promote competition in a changing market environment.
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    Americans have long known the value of competition and that without it, a monopoly can strangle innovation and lead to higher prices. This is, after all, why we have anti-trust laws.
    But when it comes to securities markets and trading in New York Stock Exchange-listed securities in particular, we have a regulatory regime that stifles competition and undermines investor choice.
    Let me be clear, I am not here to tell you how the New York Stock Exchange should change. Rather, I am here to tell you that we must modernize the regulations that govern listed trading, so that there are finally robust and competitive alternatives to the NYSE.
    If investors want to use a system of floor-based trading, conducted through specialists, they should have that option. If they would prefer to take advantage of modern technology that has led to more efficient electronic marketplaces, they should have that choice as well.
    So what impact would real competition have on our capital markets? Fortunately, we have two real-world examples to use as our guides.
    First, when NASDAQ dealers effectively wielded exclusive control of the NASDAQ market, it ultimately resulted in the Justice Department's allegations of fraud, price fixing and collusion by these dealers.
    To address the situation, the SEC wisely avoided micromanaging the existing NASDAQ structure and, instead, in 1997, opened the NASDAQ and its dealer system to competition.
    The defenders of the old system argued that the dealers provided a valuable public service by providing liquidity and they questioned how investors would benefit from increased competition.
    But the impact of the new competitive marketplace imposed upon them by the new SEC rules is lower spreads in the NASDAQ stocks, as well as lower overall transaction costs that have saved investors hundreds of millions of dollars in just a few short years.
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    Here is the second example. Up until 1999, each options exchange exclusively controlled trading in a given option.
    For example, Dell options were traded on the Philadelphia Stock Exchange and nowhere else, while IBM options were traded exclusively on the floor of the CBOE.
    While there was competition on each floor, there was no competition between markets. These monopolistic practices led the Justice Department to seek to enjoin the options markets from colluding to restrict competition.
    Again, the defenders of the status quo said that the so-called fragmentation that would result from competition between exchanges would ultimately hurt consumers.
    But independent studies conducted after competition between exchange was imposed showed that spreads in the options market decreased by between 30 and 40 percent practically overnight, while transaction costs also dropped; both to the benefit of consumers.
    Today we find ourselves facing a similar situation: the NYSE enjoys a monopoly on trading NYSE-listed securities. But as recent events indicate, this monopoly may harm investors.
    Past experience shows us how to solve this problem: we must identify and eliminate barriers to competition.
    In the case of the NYSE, the single, greatest barrier to competition is the trade-through rule. The overall effect of the trade-through rule is to undermine the competitive advantages of an electronic marketplace: speed and certainty of execution.
    Those who would preserve this regulatory advantage for the NYSE make two basic arguments in defense of the trade-through rule.
    First, consumer protection: defenders of the status quo argue that the trade-through rule ensures that investors will receive the ''best price.'' But then how do you explain the superior execution quality in NASDAQ market where there is no trade-through rule?
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    Indeed, SEC-mandated statistics indicate that overall execution quality for investors is higher in NASDAQ-listed stocks like Microsoft, where there is no trade-through rule, than it is for IBM in other New York Stock Exchange-listed securities where the rule is in place.
    One other reason that investors still receive quality executions in NASDAQ stocks is that brokers have a duty to get their customers best execution. In fact, due to the existing broker duty of best execution, the trade-through rule is unnecessary.
    And ironically, actually contributes to investors seeing the inferior prices and inhibiting beneficial competition.
    The second defense of trade-through is that there is nothing wrong with the short delay that it engenders if investors receive a better price.
    But the supposed trade-off between speed and price is based on a faulty premise. And that is, that the best advertised price is the best price. Often, it is not.
    As I discuss in my written testimony and in the attached documents, it is often the case that investors will end up with a worse price if they delay their execution attempting to chase the best-advertised price.
    Sure, if investors know with certainty that they are going to get a better price in 30 seconds, they would always accept the delay.
    The problem is that there is only the possibility of receiving a better price. If there is only a possibility, what should an investor do? The answer is it depends on the investor.
    Once again, investor choice and competition should be our guiding principles. Moreover, the SEC has already provided us with a glimpse of what a more competitive future in listed trading would look like.
    Specifically, we have, in effect, been without the trade-through rule on three Exchange-Traded Funds, or ETFs, for over a year, including the most widely traded security in the country: the QQQs.
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    The SEC's 2002 decision to ease the trade-through rule on ETFs has been an unqualified success. It has fostered competition without producing any of the harmful effects that defenders of the trade-through rule so often complain.
    As this Committee knows, Congress set out two clear principles in 1975 market reform legislation that are as important today as they were nearly three decades ago.
    The National Market System must not favor any particular market, or market structure, and it should foster competition between markets. Through such competition and the innovation it drives, investors receive the best value.
    As we have seen with NASDAQ and the options market, allowing any one market to exercise monopoly control, ultimately leads to abuse and increases transactions costs for investors.
    Competition on the other hand, leads to narrower spreads, lower transaction costs and investor choice. That is why we urge the repeal of the trade-through rule.
    Thanks again for the opportunity to testify and I would be happy to answer any questions.
    [The prepared statement of Edward J. Nicoll can be found on page 163 in the appendix.]
    Chairman BAKER. Thank you, Mr. Nicoll.
    Mr. LaBranche, I understand your statement in defense of the trading practices at the New York exchange is centered primarily on assuring investors in 96 percent of the cases, that they are actually executing the sale at the best price available in the market at the time.
    Rarely do I rely on newspaper accounts to ask a question but, the Journal, in its editorial, raises a point that I would like your opinion on because it goes to the heart of that defense of the Exchange.
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    Specifically, in referencing the New York exchange and, ''The frustrating opportunity for mischief occurs when the best price appears on another exchange,'' meaning not the New York.
    ''Instead of routing the order to that exchange, specialists on the NYSE have been known to ignore it. The number of NYSE trade-through violations is huge.''
    Again, this is the paper.
    ''ArcaEx, an electronic exchange that competes with the big board has found the NYSE has ignored better prices on ArcaEx up to 7,500 times in a single week.''
    Is there any legitimacy to that claim? Or how do you respond to that accusation?
    Mr. LABRANCHE. I would——
    Chairman BAKER. Hey, Mick, get your mike on.
    Mr. LABRANCHE. Thank you.
    Well, I think that that editorial brings up some very important, interesting points.
    One of the things about the trade-throughs that exist is that ITS was designed 25 years ago. It has really outlived its usefulness.
    And what I think we have today is much better technologies available to us that would allow, say, smart order routing systems to take the place of ITS. But, still it would be kept in mind that you are still trying to get the best price.
    On ITS, we have to wait up to 30 seconds to execute a trade. Now, in the investment world when we are trading in pennies, that makes it almost impossible to keep the market going; to wait 30 seconds for someone to give you an answer.
    Chairman BAKER. So, you are now saying speed is the most important asset?
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    Mr. LABRANCHE. No, I am saying that I think that speed, when it is possible, is important, but obviously, most important price is there.
    But what happens is that during that 30 second interval, the market moves and the other market cancels. The cancel rate on these trade-throughs, or what you are referring to, is very high and other markets tend to cancel because the markets move during that 30 seconds.
    Chairman BAKER. But as to the principle-based statement of this section in the article—and I am just trying to get at the core—that I agree, I am defensive of the individual shareholder's right to buy or sell in the most advantageous, transparent opportunity we can construct and whether the current body of regulation enhances or inhibits that capability.
    I see a value in the specialist system, I truly do. I don't know that the value occurs in every transactional relationship, however. I do believe speed is important.
    But at the very core of it all, if I know of another opportunity to sell someone shares at a higher price and I am on the New York exchange and I don't exercise that fiduciary responsibility, is that occurring? Is it a rarity? Or is it commonplace?
    What is your view of that world?
    Mr. LABRANCHE. Well, specialists make every effort to get to another marketplace if there is a better price. And that is a fact and that is a rule.
    Chairman BAKER. And, if that is the case, then this editorial, or article, must be——
    Mr. LABRANCHE. Because markets change very quickly. And I think that Mr. Joyce referred to how quotes blur in decimals, and that happens.
    And we are talking about pennies and it makes—remember, we have moved from trading in eighths to sixteenths to decimals fairly quickly.
    We moved from eighths to sixteenths, which lowered the spreads by 50 percent and then in one day we made a transformation to decimals. So, instead of having 16 points of price entry for every dollar, there are 100.
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    And we are, largely, using some of the same systems. The ITS system was put in place 25 years ago when we traded in eighths. And, in my opinion, it has really not kept up with the times.
    In some ways, I think that the Journal makes a very good point. I think they should probably scrap it.
    It is not up to me to do it, but I think that we need a better technology.
    I think smart order routing systems would be much better for investors, much better for the marketplace. Then you just choose what is the best market from on top of the markets.
    Chairman BAKER. Thank you.
    Mr. McCooey, again, your general disposition to view the exchange, obviously and understandably, is the best place to do business as an individual investor, within the NASDAQ where there isn't a trade-through rule effective.
    How do those two worlds sit side by side?
    Does that mean—in a careful reading of your statement—that the NASDAQ, therefore, is inefficient and those who trade through its avenues are not getting their best price on trades?
    Mr. MCCOOEY. Well, Chairman, I want to preface it by saying that we are not here to say that one market is better than the other. We support the NASDAQ market and obviously, support the New York Stock Exchange market.
    We think that for the equity markets to be as strong as they are in the United States, we need both markets to be as strong as they can be and to try to enhance them through the use of technology, through the use of regulation, where necessary, and to be able to make those markets as transparent and as investor-friendly as they possibly can be.
    The NASDAQ market, I believe, grew up in an age and a time that allowed certain regulatory changes, regulatory—it allowed things to happen on the NASDAQ market that would never have been permitted on the New York Stock Exchange.
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    NASDAQ also has a lot of stocks that we like to talk about: the Microsofts and Intels and Oracles of the world.
    But as Mr. Joyce alluded to, there are plenty of other stocks that are secondary and tertiary stocks where market-makers are necessary, and best price is what the investor is looking for. And market-makers compete based upon best price.
    So when you begin to compare apples to apples, if we want to compare the highest, most liquid stocks on New York versus ones on NASDAQ, we may have an argument and a comparison there.
    But I think we need to make sure that we are serving the investor across all markets, across all stocks the best we possibly can.
    And I know that we do that on the New York Stock Exchange, since I don't trade on NASDAQ, I can't, necessarily, comment as to how they do or do not function, in terms of making sure that they are getting the best price for their customers.
    But I still think they should be.
    Chairman BAKER. Well, and even with that explanation, I don't understand how elimination of the trade-through rule, if you had an order flow requirement to the best price, wherever that occurs, would operate to the detriment of the individual investor nor represent any significant challenge to the New York exchange, because of the breadth and liquidity of that market.
    You are a winner now; you would still be a winner no matter what the rules are.
    Mr. MCCOOEY. Oh, I don't think that that is the case at all. I respectfully disagree.
    In the example that I gave you in my oral testimony, we will begin to have things such as court d'arbitrage; people that know that there is a nickel bid and buy it from a customer for $49, while at the same time, using electronic systems to hit the $49.05 bid.
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    We will have more internalization, we will have more fragmentation. We will have broker dealers using this as an opportunity to use customer orders for their benefit, not for the investor's benefit.
    I think that one of the things we are missing here is that we are giving the intermediary the choice in this case; where that order goes to, how it gets executed, not the customer.
    And I have also heard about things such as, opt-out, so that customers in their opening documents for accounts can decide that the broker decides where the order goes to, whether they want speed, or they can opt-out of price.
    The other side of that argument is the contra-side. In my argument: $49.05 bid. That person didn't sign an opt-out document. That person had the best price in the marketplace, that person was ignored. Is that the message that we want to send?
    Chairman BAKER. I am going to come back to this, but I don't want to go far beyond my time.
    Mr. Kanjorski?
    Mr. KANJORSKI. I don't disagree with you very often, Mr. Chairman, but I can think of examples, exactly as he put it there.
    Part of our problem we are all talking about it and not getting down to it. For instance, we are all wanting to do the best things for the investor, and we think we can define the investor as one singular entity making up investments.
    We know that is not true. You have institutional investors, you have smart investors, you have dumb investors, you have rich investors, poor investors. You have got investors that may be fragments of people's imagination for all we know.
    We can't sit with that simpleton.
    But the thing that disturbs me most: it seems to me the reason we are into this issue is that we have had some significant, substantial problems.
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    Everything from Enron on through to Mr. Glasso's problem recently that have shaken up—and the mutual fund industry—they have shaken up confidence in the market, and the investors is a large class in the market. I am interested in that.
    On the other hand, I am starting to see some problems here that everybody who has a pet peeve or a pet advantage that they can thrust into this has now gotten the attention of the Congress.
    And it is all nice and good and I am interested in all your competitiveness problems, but quite frankly, that is not what this Committee has been addressing itself to.
    What we are trying to do is make sure that the end of the day we can clean all the laundry of all the markets, all the exchanges, to have it reflect its excellence as the best commercial and capital market in the world. And I think it does that.
    And when we have this interplay suggesting that you are not getting the best price here, you are not getting the best price there, unless we do this or that, it confuses respect for the marketplace.
    Now my question is—toward anybody that wants to take it—do we have a technology problem here that can be handled within the institutions themselves? Or do we have a substantive value problem here?
    Have we had a breakdown of morality, of ethics, in the system? And that would go a long way to just how much time and how it has evolved.
    And the reason I am asking this is, look, I keep referring back to this: you fellows are all capitalists and free marketeers. And maybe with the exception of one or two of you, you are all asking the government to come in and be the big brother here and regulate the capital markets of this country. You may get your wish and be damned for it.
    I mean, be very careful what you are asking for here.
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    You are giving us a tremendous opening here to rush in and start to decide some, I think, competitive issues; that there are going to be winners and losers simply because one person relies on one technology over customer tradition in another technology.
    And I want to use—I am not much at football or sports, but I do, while I was thinking here—if I have got a good passing team and speedy ends, I am going to want five plays on my side of the team.
    If I have got a heavy, chunky line and a damned good heavy runner, I am going to want three downs. And we are going to argue that all night.
    The rules are drawn. That is not up to the Congress to constantly change the rules because of some—unless it is substantial electronic change, which, if you don't address the rules—and then, we shouldn't be changing the rules—unless you want us to take over the exchanges, unless you want government in your boardrooms, then reexamine what you are doing.
    So I say again, take it easy on this. Take getting any comparative advantage because it will service your industry or what you can do.
    I am interested—any of you want to say—do we have a substantive ethics or moral question in our markets today that we haven't had before?
    Or is just this the squeeze of the bubble, and everybody wants to find fault and try and get themselves in a reorganized position? And that the market is still fairly good or very good and it will work itself out.
    And the institutions themselves and the existing authority, the SEC, will be able to handle all these things.
    Anybody want to take that question?
    Mr. JOYCE. Yes, I will.
    Mr. KANJORSKI. Yes, Mr. Joyce you were—and I was going to say when you were speaking, you introduced yourselves and said 15 years ago you were sitting on all these committees and everything—boy you must have really done a hell of a poor job, because, you know.
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    Mr. JOYCE. That is why my hair is gray. Jet black 10 years ago.
    Mr. Kanjorski, thank you for introducing those topics. I would like to briefly address both of them.
    First of all, I don't know—clearly, technology has changed. As Mr. LaBranche referenced, the ITS system literally hasn't changed that much. Clearly technology is leaps and bounds ahead of where it was 10 to 20 years ago.
    The issue isn't so much around what kind of technology is being or isn't being utilized. Clearly, depending upon the rule set that is engaged, you can find the technology to cure your problems.
    So the issue, I would suggest, is that in the past few years, we have changed the way we trade equities in the United States: from eighths to sixteenths to decimals.
    And when I say that the quote flickers, I literally mean the quote flickers. If you tried to get that nickel bid that Mr. McCooey referenced, by the time you go for it, it is gone. And then it is back and then it is gone.
    So the issues around the market that, I think, in the rule set that we are addressing today and would like to see the SEC get engaged on it, is the fact that fundamentally, the way equities trade have changed, and most due to the fact that decimals have been introduced into the process.
    Decimals have provided an enormous amount of benefits, but they simply change the way you trade. So, rule sets should, I think, be adapted to take that into account.
    As for your second question about ethics, I would strongly, strongly emphasize that I have not seen, in any dealings, any kind of change or diminished ethics that are applied to this industry.
    When you look at what happened with the corporate world a year or so ago—was it 10 or 15 institutions; I would bet it wasn't a whole lot more than that—and yet, there are 3,000 companies listed on New York, there are 3,000 more listed on NASDAQ.
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    I think the statistical selection you are looking at is very small compared to the thousands and thousands of companies that are run extraordinarily ethically.
    And when it comes to members of this industry and how they run their business, once again, you are looking at, so far, I have seen a handful of mutual funding complexes that have done things they regret, no doubt.
    There are more mutual funds available to the investor than I think there are equities available. I think there are at least 3,000 mutual funds available.
    So once again, we have a case where there is a small, small subset of people behaving improperly.
    And to me, where I sit, and having watched this industry over the past several years, the amount of ethical behavior that is evident everyday is one that you would be very proud of.
    Mr. KANJORSKI. Very good. Congratulations.
    I think we need more of that. We are scaring the hell out of that public out there. They are starting to look at Wall Street like nothing but a bunch of gangsters.
    ''You belong in Lewisburg, not in New York.'' And that is not true, that is not my impression. I have been looking at this part.
    The one thing is that—maybe the third part of my question—I have a hard time figuring out what my question was too, so I don't doubt that anyone up there on the panel would—but, what I am asking is—I recognize the technological changes and the conflicts that that causes, potentially in deciding, particularly in the competitive range—but would you rather the Congress of the United States take it upon itself to decide things like whether we are going to replace the ITS lines or whether we are going to let the exchange make that decision?
    Do you really want us in your bedroom?
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    Mr. JOYCE. Sir, to be completely honest with you, I think it is the SEC's responsibility to do that.
    I was very encouraged to see Chairman Donaldson here today discussing his thoughts and some of the issues they are willing to address. I think it has long been the mandate of the SEC to deal with this.
    Having said that, I think some congressional oversight is often a good thing. It can often move issues forward.
    And I think for that, I applaud you in getting involved.
    Mr. KANJORSKI. Mr. Foley?
    Mr. FOLEY. Yes, thank you.
    I agree with what Tom said that we heard—I thought a tremendous amount of wisdom from the Chairman earlier today and it, I think, gives one great confidence that the SEC is taking its time, but not taking too much time, to address a number of complicated issues, that sort of weave together and are best addressed together.
    So, I think, we are not here before you today to ask the Congress to ask, but I had noted some people jotting things down when members of this Committee said, ''Weeks, not months'' or ''Months, not years'' and so forth.
    And the very fact that we are holding hearings today focuses attention on some of these issues.
    I don't think you see people here debating whether the offense should receive three downs or five downs, based on——
    Mr. KANJORSKI. Yes we are. You would be one of them, Mr. Foley.
    Mr. FOLEY. No.
    Mr. KANJORSKI. You talked about the policy rule.
    The policy rule is important because you are primarily in the electronic business in an electronic market. And I understand that, and there is nothing wrong with that.
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    But if you are on the other side of a more conventional market, traditional market, that seems to be fair to have a pass-through rule. It protects, quote, the investor, whoever that six-pack carrying guy is out there.
    But the reality is why shouldn't we make it a principle that all equity trades on all markets are considered before a buy or a sell is made, if it is technologically possible?
    Mr. FOLEY. Well, if it is technologically possible to do it in a way that does promote finding the best execution.
    Here is the thing: yes, everyone responded to an incoming message from another market center, immediately. I don't think there would be anyone against a trade-through rule and against the obligation to find the best price.
    I know of no market-makers, ECNs, exchange system that doesn't seek the best price in its own system. And it doesn't, for those of us whose systems go out to each other, doesn't seek the best price that is available in a reasonable timeframe.
    Mr. KANJORSKI. But——
    Mr. FOLEY. Technology has evolved. It appears to benefit, not investors, but to some players in the market, for the rules which existed for one purpose that is not relevant anymore.
    Mr. KANJORSKI. Okay. And I tend to agree with that.
    And what I am asking you under self-regulatory authority, do you guys have the capability of being mature enough to regulate yourself, or do you need a cop, or do you need the federal government there to do it?
    I would like to think, as a lawyer, that the bar association can throw out the rascals. I would hope that in the exchanges and in the broker trading business you can identify the rascals.
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    And you, incidentally, have a great tool in a new electronic revolution to find out who they are, either before or after the act occurs and the evidence is not destroyable. Why can't you self-regulate and get the people out?
    But there are a lot of good people. Hard, honest working people are doing their best in all these markets and throughout this country that are getting injured now by this over-tow that there is something evil. ''There are evildoers.''
    Gee, I heard that expression somewhere. But there are evildoers on Wall Street.
    And that doesn't play to my side of the aisle here, but I am just saying I am not a big person that likes to identify capitalism as the enemy of the people. I don't think it is. And on the other hand, I don't think regulation should always be the mantel of the Democratic Party.
    I think there is a good reason to believe that in mature people, regardless of what business or what profession they are in, they can generally police themselves.
    And we should only come into play when there is a breakdown of that reality and that we have to get involved, then we have to be heavy cop. Other than that, get the hell out of the way and let the place handle itself.
    Mr. FOLEY. I couldn't agree more.
    And we believe strongly in self-regulations and believe that the level of ethics and integrity in our industry is very high.
    You are going to need a light touch but, nevertheless, a role to play from the SEC for addressing issues that fall between the different markets.
    And I think one of the things that has gone on over the past couple of years is that a number of the issues regarding market structure, that is, rules that say you can't do certain things, that many of us don't think are necessary anymore.
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    Those issues have, sort of, taken a back seat, while other issues that have gained more attention in the newspapers have occupied the policymakers and the lawmakers and the press.
    And many of the issues that we are raising here today are issues that have been sitting on the back burner and come forward now that the Commission appears to have the time and the focus to devote to them.
    And we are all very happy—I think I speak for all the panelists—we are going to be very happy to see a resolution, one way or another, on a number of these issues that have been outstanding for the past couple of years.
    Mr. KANJORSKI. Good enough.
    Chairman BAKER. Ms. Hart?
    Ms. HART. Thank you, Mr. Chairman.
    I want to let Mr. Kanjorski go on, I liked some of his comments. This is good.
    Thank you for your patience, I know today's hearing has been going on for a while. I just have one question I want to ask of two of you: Mr. Joyce and Mr. LaBranche.
    If the New York Stock Exchange were allowed, or were forced, excuse me, to require multiple specialists for each security, can you tell me your thoughts about that? Do you think it would be harmful?
    Do you think it might bring more competition to the market and alleviate some of the concerns that Mr. Joyce raised in his testimony?
    We can start with Mr. Joyce.
    Mr. JOYCE. Thank you, Ms. Hart.
    In point of fact, as you can imagine, as the largest dealer in the NASDAQ market, and frankly, one of the larger dealers in the New York Stock Exchange-listed arena, we clearly believe that competing specialists, competing dealers—specialist is a dealer as a marketmaker fundamentally—provide a lot of benefit.
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    They particularly provide an enormous amount of benefit as you get into the secondary and tertiary stocks. That liquidity segment needs more, not less, sponsorship.
    So we do believe that the competing specialist model is a successful one, as is evidenced by the success of NASDAQ. As an old, listed block trader, incredibly enough—the back of my hair was black, I actually traded listed equities with Mike on a regular basis—I think the specialist system itself, is fine too.
    To introduce competing specialists: I wouldn't necessarily leap to do that, unless there was a better body of knowledge on it. But speaking from the NASDAQ model, clearly the NASDAQ competitive model works well, and I would suggest it would work equally well in the New York Stock Exchange system.
    Ms. HART. Okay. Mr. LaBranche?
    Mr. LABRANCHE. Yes, well, it gets clearer that markets are going to be competing against each other. And I think one of the things we heard today was that technology should be allowed to access pools of liquidity.
    It should be allowed to compete. And I certainly embrace that concept.
    When it comes to the New York Stock Exchange as a model, we do use a specialist model, but the most important thing about the Stock Exchange is that orders compete with each other and they are centralized to one point of sale.
    So they interact with each other and that is a very important concept. It is the one market that has orders competing with each other.
    Now the specialist is charged with the responsibility to make sure that those orders compete with each other in a fair way; that they aren't being ignored or anything else. So, that is our charge.
    That is what the New York Stock Exchange has designated a specialist to do. He has to buy when no one else wants to and sell when no one else wants to.
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    So if you had competing specialists, who are you going to pick? You buy it, or you buy it or something like that. And that might be something to consider.
    But what we really don't want to do is fragment the order flow. Because when you fragment order flow, you lose sight of what the best price is currently. And I think that is important.
    In terms of ECNs, for example, we hear a lot about ECNs. We are not anti-ECN, we are pro-ECN. We receive a lot of order flow from ECNs. ECNs look to us as a resource.
    It is our job to be price competitive so they can access our markets in a very cheap way.
    There is one large ECN that is very famous that sends 90 percent of their listed business through us. They send it to us because we do it so cheaply.
    So, that is order flow that is competing with each other.
    So, in answer to your question, I think that what we really need to focus on is making sure that we have a centralized market where orders compete with each other.
    Mr. JOYCE. Ms. Hart, if I could just elaborate a little bit.
    Ms. HART. Sure.
    Mr. JOYCE. When you asked the question, I was conceptualizing competing specialists on the floor of the New York Stock Exchange.
    You should be aware that the third market that NASDAQ sponsors—in which we are actually a very large participant—we do, for example, make markets in IBM and in AOL.
    So, we, within the third market realm, under NASDAQ's banner, we do make markets and listed equities that directly compete with the specialist making markets on the floor of the New York Stock Exchange.
    So that competing specialist model, you could say, currently does exist.
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    Ms. HART. Just not on the floor.
    Mr. JOYCE. It is not within the floor, it is not intra, it is inter.
    Ms. HART. It is inter. Okay.
    Thank you.
    I yield back.
    Chairman BAKER. Thank you, Ms. Hart.
    Ranking Member Crowley?
    Mr. CROWLEY. Ranking by default, I will accept. There are many ways of obtaining positions of leadership.
    Thank you all for your testimony today and for your spending a better part of your day here.
    I have been following this issue very closely, as probably many of you know.
    I had a couple of questions and I would also, if I can, make some reference to the Wall Street Journal editorial that appeared today.
    Mr. McCooey, we have all heard reports questioning the value of the specialist and whether they offer a value or not.
    And as an agency broker executing trades on behalf of your clients, do you feel a disadvantage by specialists? And do you believe specialists add a value to you or to your clients or not?
    Mr. MCCOOEY. I don't believe specialists disadvantage me at all. In fact, it is the advantages of the specialist at the point of sale, providing liquidity and acting as a catalyst that allows me to get my business done on behalf of my customers.
    And let me elaborate a little bit on that.
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    When I talk about liquidity, what I mean, is when I have a buy order coming in and finding that I have 25,000 shares to buy, and there are only 15,000 shares residing on the specialist book at the offer price, that the specialist will be able to step in there and provide the liquidity: the other 10,000 shares that I need to complete my order; to be able to be satisfy my customer at that price.
    That is important when they put their capital up.
    But even more important and really undisclosed to the world, because they don't understand what dynamics sometimes happen at the point of sale, is the fact that the specialist acts as the catalyst in disseminating valuable information to every party that comes into that trading crowd: who the buyers and sellers are and have been, but even more than that, is able to find the contra-side to my trade.
    And what I mean contra-side, if I am a buyer, the specialist will, instead of having me immediately trade with the offer side of the market, would inform me that a brokerage firm may have been a seller for the past hour, day, week.
    And we can contact that brokerage firm very quickly; allow them the opportunity to sell stock for their customer, a natural seller, where natural buyer and seller are meeting in the marketplace with very little market impact.
    And we are able to get that trade consummated.
    And I am using my digital and hand-held device at the point of sale, communicating with my customer, telling them exactly what I am doing. I am using my cellular telephone from the point of sale; communicating with my customer.
    And we were able to get that done for the benefit of my client, as well as the for the benefit of the seller, who was willing to sell stock at that price, but may have just completed their sell order and may just be getting more stock for sale and doesn't want to be disadvantaged by dislocation in the market that may happen very quickly.
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    If I go in and the last sell is $49 and the liquidity is at $49.25, I may not want to purchase that right away, but I want to give my buyer the opportunity to do better. And that is what we do each and every day.
    And the specialist is an important part of that. And my customers find his information and his liquidity very valuable in the executing of my orders.
    Mr. CROWLEY. Thank you.
    Mr. LaBranche, in the evolution of the stock market, and there has been a lot of discussion about the ECNs and their, one day potentially, replacing the New York Stock Exchange as we know it today in terms of human touch, in many respects, and a lot of discussion about specialists being dinosaurs in this evolutionary process.
    Can you comment on that?
    Mr. LABRANCHE. Well, I have been hearing that——
    Mr. CROWLEY. You don't look like a dinosaur, but I——
    Mr. LABRANCHE. Well, thanks.
    But, I have been hearing that comment for a long time.
    In fact, there was a very widespread discussion back in the 1970s about how the New York Stock Exchange only had a few months left to go and seats went down to $35,000 back in 1978.
    So when you think of it in those terms, you realize there is always going to be challenges.
    What the New York Stock Exchange needs to do is listen to its customers, its constituencies. Make sure that the buy side, for example, is getting their say of what they think needs to be done; the sell side as well.
    We need to integrate our system, take technology, ECNs, other ATFs and incorporate them so they can access our pool liquidity. And, I think, that is a very important concept.
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    A lot of people think of ECNs as crossing networks, but they are communication networks, and they allow people to communicate with pools of liquidity. And we are a very large pool of liquidity.
    So, to get back to where we were before: if we make those transitions, if we are a resource to everybody that we can be, we will be around for a long time.
    If we just dig in and don't change, then that is going to be a different question. But we don't have any intention of not changing or listening to people and we are going to keep changing to make sure that we are able to be a resource for almost everybody.
    Mr. CROWLEY. You are adapted to the evolution.
    Mr. Chairman, I know my time is up, but can I just make a comment about the editorial that you alluded to?
    In the very next paragraph—and again, we are taking out of context, some of these things—the editorial went on to say, ''Best price is only one of the many ways of best execution. The issue of speed and best price, et cetera, and what companies may be are looking for, what the professional trader is looking for.''
    But this experiment that is taking place, I know that Chairman Donaldson, not once in his three hours of testimony mentioned the success story that the Wall Street Journal is alluding to.
    And, I think if you ask my constituents and the investors in your markets that are my constituents; I think if you ask them, the bottom line is price to them. At the end of the day, the retiree, the pensioner, wants to know that they are getting the best price for what they are paying. And I think that is the bottom line for our constituency.
    I understand we have broader constituencies here in this Committee, as well. And the industry is important to us. But the bottom line is the investors.
    And people who are making up more and more, a larger portion, of the investment in your markets are the average mom and pops that we represent.
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    So, I just wanted to make that point for the record.
    And I thank you all for your testimony today.
    Chairman BAKER. Thank you, Mr. Crowley.
    Just welcome, come back at it one more time, from the perspective, not necessarily of just the editorial or news article, ''Reference by Numbers.''
    Maybe try just a different team this time, Mr. Nicoll. In reading through your written testimony, it is pretty clear, at least to me, that you believe that the current system does not automatically result in the best price for the individual, given the regulatory constraints which within the market must now function.
    You referenced the SEC trade-through rule suspension on the three ETFs in 2002 and that the QQQ is now the single most actively traded security in the entire U.S. marketplace as evidence that it must somehow meet the needs of investors.
    It seems, to me, that you should view the market, not as a particular exchange or a group of premier exchanges, but the entirety of every trading opportunity is the marketplace.
    It also appears to me that there are rules or regulatory constraints that keep information even from flowing but, perhaps where it does flow, it may not be a requirement to act on that information.
    Am I reading your testimony correctly that your presentation of the trade-through rule or some of the other constraints, if they were, at least modified, if not entirely eliminated, would facilitate trading at the best price as opposed to what now is the consequence of trading under the current regulatory body of rule?
    Mr. NICOLL. I think that is exactly what we are saying.
    And, what we are saying is, and we want to push back at everybody that keeps repeating this mantra that the choice is between speed and price.
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    When you choose not to avail yourself of what appears to be the best price in an advertisement because you wonder whether you will get to the store or you will get to the place where it is advertised, whether or not you will actually get the best price, but you may, perhaps, choose to buy the product at what appears to nominally be a higher price someplace else.
    Because of your ability to actually execute the transaction, you are acting in your best interest and buying the product at what you believe is the actual best price.
    And what we are saying here is that the trade-through rule requires that people go after the best advertised price and leave behind what they know to be the best price. Our customers are not intentionally trying to execute their orders through our system at a worse price.
    They believe that by executing an order for a penny less than an advertised price on the New York Stock Exchange, that they are, in fact, representing their customer's interest, performing their fiduciary duties in accord with their best execution responsibilities and doing their best job.
    And, in fact, when they are precluded by regulation from accessing the best price and are forced to chase what appears to be the best price but what is, in fact, often not, they feel that the regulations are out of date and don't serve their needs as fiduciaries in performing their duties to get best execution on behalf of their customers.
    There isn't a trade-off between price and speed. Speed is an element in evaluating what the best price is in a trade.
    Chairman BAKER. One other piece that I picked up out of your written comment, with regard to definition of fragmentation; as opposed to that being necessarily an adverse market consequence, others might define it as more stringent competition.
    And that if we are looking for the free flow of information so that all market participants meet the needs of their customers in the most efficient and timely manner, but yet required to pursue the highest price offered in the broader market.
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    I think that is what I hear members saying, both sides of the aisle, pro-New York Exchange, pro-ECN, whatever the deal perspective might be, we all want one thing.
    We want the market to function efficiently, we also want it to function fairly and we also want to assure, that when Customer X or Customer Y pursues an opportunity in the marketplace, that they get the best terms available at the time of that execution.
    Now, if those are the precepts on which we all agree, then we can do the critical analysis if the current system really provides for that. And that, Mr. LaBranche, was the reason why I brought up that article in the first place.
    It appeared on the surface of the article. It was going at the heart of the Exchange's line of defense, was that in most cases, 94 percent, the individual gets the best price of execution.
    And it seems to me it ought to be a factual determination, whether they do or whether they don't, we ought to be able to get to the bottom of it, dig it out, and then ask the SEC to come up with a plan that is responsive.
    And I agree with Mr. Kanjorski, we don't want to put a board, I think, governmental representative on every board in America. I am a strong advocate of a whole lot less government than what we pay for.
    But I do believe that this discussion, today, and the Committee's review of this, may help facilitate broader market changes that, otherwise, may be very difficult to achieve.
    And let me offer Mr. Crowley, or Ms. Hart, any further comment?
    And let me express my deep appreciation to each of you. This has been a long day.
    And I appreciate your patience in hanging in there and we certainly will leave the record open for a few days if you have further comments or recommendations to the Committee, we would be most appreciative to receive them.
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    Thank you.
    Our meeting is adjourned.
    [Whereupon, at 2:26 p.m., the subcommittee was adjourned.]