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THE SEC PROPOSAL ON MARKET
STRUCTURE: HOW WILL INVESTORS FARE?

Tuesday, May 18, 2004
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 2:03 p.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ryun, Fossella, Hart, Brown-Waite, Kanjorski, Ackerman, Inslee, Moore, Hinojosa, Lucas of Kentucky, Crowley, Baca, Miller of North Carolina and Velazquez.
    Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Markets Subcommittee to order. This is the subcommittee's fourth hearing in this Congress on the subject of U.S. capital market structure. Our first hearing on corporate governance issues was conducted in New York and examined the regulatory role of the exchanges and the potential conflicts of interest that are created by self-regulation.
    The second examined reforms that potentially would enhance competition in the securities markets. The third focused on reform efforts at the New York Exchange and the role of the specialist system in a technologically revolutionized marketplace. The 211-year-old NYSE is the leading auction market in the United States. In my judgment, it has worked very effectively throughout the years in providing for capital expansion needed for our economic growth.
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    The NASDAQ market is an inter-dealer quotation system established in 1971. Over-the-counter securities and NYSE-listed stocks may also trade through NASDAQ. Dealers quote, bid and ask prices and the NASDAQ computer system integrates the quotations, calculates the best bidder offer, and displays the prices on screens. The development of electronic communications networks, ECNs, that link institutional investors so they can trade directly with each other revolutionized equity markets. They diminished the role of the specialist by allowing users to enter orders at specific prices and execute them automatically against other orders.
    The trade-through rule is the subject of discussion and a somewhat controversial provision that has been recently addressed by the SEC. The rule states one market cannot trade at prices inferior to a price displayed by another market. Critics of the rule analogize it to requiring a consumer to purchase ice cream at a store across town which sells ice cream at a slightly lower price than a store located closer to the consumer. Opponents of the trade-through argue the NYSE holds a dominant position in the global marketplace not because of superiority of service, but because of the coercive power of this rule.
    Instead of instantaneous computer-to-computer transactions, the trade-through rule causes a delay for up to 30 seconds in the execution of investor orders, in some cases a very significant delay to the consumer's best interest. In fast-moving trading, brokers find that the NYSE price fluctuates during the time it takes for execution. The reality is that the inferior price that calls the order to be routed to the exchange may be a better price once the order is received by the NYSE specialist.
    The SEC proposed a reform of the rule that expands the reach to include NASDAQ, but would relax the rule in ways that would favor, could possibly, electronic markets. The theory behind the proposal is that speed and anonymity of execution should take precedence in trading and competing markets should be able to ignore potentially superior price if it slows down execution. So far, even the New York Exchange appears amenable to the modification that would allow for fast markets to trade through slower markets within certain limits, because they hope to bring greater automation to its own trading floor so it can fall within the definition of a fast market.
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    However, the NYSE is opposed to allowing consumers to opt out of the trade group. They argue that the opt-out may compromise the quality of executions that investors receive. ECNs argue that the opt-out is necessary because the so-called ''best available price'' is not always accessible.
    The conclusion I have reached is that executing an order at the best price is certainly a laudatory goal and should be the principal mission which the exchanges engage in regardless of the site of execution. However, it is clear to me that in today's marketplace, trades executed through the NYSE do not always automatically reflect best price. In fact, on as many as thousands of occasions in a given week's trading, best price may be offered on a competing exchange and the order not appropriately routed, given current technological constraints.
    And in my judgment, the buyer should be the determining factor in how the trade is executed. Whether best price is the most important to their trading perspective or whether other considerations take precedence should be left to the consumer's best judgment on an informed basis.
    For these reasons, I am anxious to hear the testimony of those who have agreed to participate in today's hearing. I believe this to be a most important issue facing the committee and the Congress. It is certainly significant in the overall capital formation of our American capitalistic system and we hope to come to the most appropriate conclusions based on the best advice we can receive.
    With that, I call on Mr. Kanjorski.
    Mr. KANJORSKI. Thank you, Mr. Chairman.
    We meet for the fourth time in the 108th Congress to review the organization of our capital markets and evaluate the need for further reforms in light of technological advances and competitive developments. This hearing seeks to examine how the market structure changes recently proposed by the Securities and Exchange Commission will affect investors.
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    As I have regularly observed at our previous hearings, a variety of agents in our equities markets have questioned one or more aspects of the regulatory system during the last several years. We have also, in my view, come to a crossroads in the securities industry, confronting a number of decisions that could fundamentally alter its organization for many years to come.
    We have elaborately interconnected systems and relationships in our equities markets. I therefore believe that we should heed the philosophy of Edmund Burke and refrain from pursuing change for change's sake. We should only modify the structure of our securities markets if it will result in improvements for investors. The Chairman of the Securities and Exchange Commission has recently observed that in pursuing any change to fix those portions of our markets experiencing genuine strain, we must ensure that we do not disrupt those elements of our markets that are working well.
    In February, the Commission put forward for discussion four interrelated proposals that would reshape the structure and operations of our equities markets. Because these proposals have generated considerable debate, the Commission announced last week that it would extend the public comment period until the end of June.
    In adopting the Securities Acts Amendments of 1975, the Congress wisely decided to provide the Commission with a broad set of goals and significant flexibility to respond to market-structure issues. From my perspective, this legal framework has worked generally well over the last three decades. It is also appropriate for the commission at this time to review its rules governing market structure and for our panel to conduct oversight on these matters.
    Mr. Chairman, as you already know, I have made investor protection one of my highest priorities for my work on this committee. Although many of the agents in our securities markets have called for adopting market-structure reforms and some of them may benefit from these changes, the commission must thoroughly examine the effects of its reform proposals on average retail investors before approving any change.
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    Today, I suspect that many of our witnesses will discuss the Commission's proposal to alter the trade-through rule. Retail investors are guaranteed the best price that our securities markets have to offer regardless of the location of a trading transaction under our present regulatory system. By ensuring fair treatment, this best-price guarantee has significantly increased confidence in our securities markets. I also believe that this directive has served most investors generally well.
    The Commission, however, has issued a proposal to permit participants in our capital markets to opt out under certain circumstances of this best-price guarantee. Some have suggested that this proposal could potentially produce unintended consequences like fragmenting our securities markets, decreasing liquidity, and limiting price discovery. Because such results could prove harmful for small investors, I will be monitoring this issue very closely in the weeks and months ahead.
    A recent survey of older American investors also found that 86 percent of the respondents agreed that they should be alerted before the completion of a transaction in which the best available price is not the top priority. I would consequently like to learn from our witnesses how unsophisticated investors should be notified if their mutual fund manager, stockbroker, or pension fund adviser decides to opt out of the present best-price mandate. For example, it would be helpful to debate whether such opt-outs should be completed via a blanket disclosure or on a per-trade basis.
    In sum, Mr. Chairman, we should continue to conduct vigorous oversight of our equities markets to determine whether or not the present regulatory structure is working as intended or to study how we could make it stronger. The observations of today's witnesses about these complex matters will further help me to discern how we can maintain the efficiency, effectiveness and competitiveness of our nation's capital markets into the foreseeable future.
    Thank you, Mr. Chairman.
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    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 35 in the appendix.]
    Chairman BAKER. I thank the gentleman.
    Mr. Fossella, did you have an opening statement?
    Mr. FOSSELLA. I will just submit mine for the record and look forward to hearing the testimony of these witnesses.
    [The prepared statement of Hon. Vito Fossella can be found on page 30 in the appendix.]
    Chairman BAKER. Without objection.
    Ms. Velazquez, did you have an opening statement?
    Ms. VELAZQUEZ. No, Mr. Chairman, but I will ask unanimous consent for my opening statement to be inserted into the record.
    Chairman BAKER. Without objection, all Members's opening statements will be included in the record.
    At this time, I would proceed to our distinguished panel of witnesses. First to give testimony today is Mr. Matthew Andresen, former president and chief executive officer of The Island ECN. Welcome, sir.
    By way of customary practice, we would request if possible each statement be constrained to 5 minutes. Your entire official statement will be made part of the record. And make sure your button is on and pull the mike close. With that, take off.
STATEMENT OF MATTHEW ANDRESEN, FORMER PRESIDENT AND CEO, THE ISLAND ECN, INC.
    Mr. ANDRESEN. Thank you, Chairman Baker, Ranking Member Kanjorski, members of the subcommittee. Thank you for holding this hearing and for inviting me to speak before you today.
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    We are at a crucial juncture in the evolving equity market structure of the United States. For decades, the electronic and traditional market structures continued their respective evolutions in relative isolation from each other. However, the furious pace of technological innovation, which I was privileged to be part of in my days at Island, has driven the electronic trading realm further and further away from the traditional human-driven markets of the NYSE-listed world.
    The proponents of electronic markets believe that the results of this process have been purely positive. The champions of traditional markets believe that these rapid enhancements have sacrificed crucial elements of price discovery. I am certain, given the amount of legroom I have here today, that we will be hearing our fill today from both sides.
    What is not in dispute, however, is that the rapid evolution of technology is forcing these two disparate worlds back together. The two competing market structures can no longer live in isolation from one another. This has manifested itself in several ways. First, the introduction of sophisticated technology tools to the brokerage and trading community has made it simple to deliver orders to either an electronic OTC market or to the NYSE through one common interface. This has facilitated the broad trend of sectorization whereby Wall Street firms reorganize their trading desks based not on where stocks might be listed, but rather based on what industry the companies themselves are in.
    Secondly, the rise of automated and so-called ''program'' trading has blurred the distinction between listed and over-the-counter trading by often grouping orders together into lists of trades to be executed as a group. Third, the electronic markets have evolved into significant enterprises who view the big market cap stocks of the NYSE with jealous eyes. They know well the opportunity available. Despite their dominance of OTC trading, alternative trading systems and electronic exchanges account for only a tiny percentage of trading in NYSE-listed stocks.
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    It has long been my contention that this is due not only to the NYSE's significant liquidity advantage, but also the existence of the trade-through rule. This rule is an unfortunate relic of an age before fully electronic markets were in fact even contemplated. Obviously, they are commonplace today. But while the markets have evolved, the trade-through rule lives on in its original form. The essential issue with this rule is that it attempts to distill all of the value in a potential transaction down to one factor: advertised price. But advertised price is but one factor in determining the best execution for a customer. Factors such as time, implicit costs, fees, adverse selection and reliability can often make a much greater difference to a customer's quality of execution.
    In my opinion, the debate over trade-through has been consistently misstated as one of speed versus price. To me, that is not wholly correct. The correct date is about true price versus advertised price, because in the stock market as in other transactions there are a myriad of factors that can lead to significant variance between the true and advertised price.
    The aforementioned factors of time, certainty of execution, fees, adverse selection or reliability makes advertised prices only one small part of the execution story. We must have a regulatory structure that recognizes this face. I commend the committee for moving to address this issue.
    Thank you, Mr. Chairman.
    [The prepared statement of Matthew Andresen can be found on page 37 in the appendix.]
    Chairman BAKER. Thank you very much, sir.
    Our next witness is Mr. Larry Leibowitz, executive vice president, co-head of Equities Division, Schwab Soundview Capital Markets. Welcome, sir.
STATEMENT OF LARRY LEIBOWITZ, EXECUTIVE VICE PRESIDENT, CO-HEAD OF EQUITIES DIVISION, SCHWAB SOUNDVIEW CAPITAL MARKETS
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    Mr. LEIBOWITZ. Chairman Baker, Ranking Member Kanjorski, distinguished members of the committee, my name is Larry Leibowitz. I am executive vice president and co-CEO of Schwab Soundview Capital Markets, the institutional trading, research and retail execution arm of The Charles Schwab Corporation. Thank you for the opportunity to speak today on the vital market structure reforms proposed by the Securities and Exchange Commission.
    Before I jump into my main statement, I would like to make a brief point. One thing that we on the panel here can all agree on is that these are relatively arcane topics. Talking about market linkages makes even my eyes glaze over so I can imagine yours. But in the end, they all impact the transparency and openness of the markets, and therefore contribute to investor confidence and the integrity and fairness in the largest and most successful system for capital formation in the world. Helping that system reflect the reality of today's information age is what this is all about.
    Schwab Soundview Capital Markets, as the largest NASDAQ market-maker by volume, and Charles Schwab & Company, with its millions of retail customers, believe that the time is ripe for modernization of our national market system. We process millions of orders a day and those orders are directly impacted by the conflict between modern technology and human interaction when trading securities. These rules primarily serve to insulate outdated and inefficient manual markets from competition and actually harm, rather than protect, investors.
    For too long, competition has been stifled in the market for NYSE-and Amex-listed securities. Given the very limited time available, I will focus my comments on the two main impediments: the trade-through rule and the market data charging system.
    The trade-through rule purportedly protects investors from inferior prices, but has actually insulated the NYSE and its specialist system from competition and protected its privileged position. Given the NYSE's role in the creation of the original trade-through rule, the rule has worked as intended to protect its monopoly profits.
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    Being forced to route orders to manual markets for execution lowers efficiency and in some cases actually undermines a broker's duty of best execution. Moreover, investors attempting to cancel orders often find themselves in limbo waiting for an exchange response and discovering that their orders have been executed against their wishes. A better alternative is available. When securities are traded in an automated environment without a trade-through rule, as they are in NASDAQ today, investors obtain greater order protection, faster executions and better prices. Investors are protected by the broker-dealer's overriding legal obligation to provide best execution to customers.
    In addition, when a market is efficient, you do not need a rule prohibiting trade-throughs. They simply do not happen. And you do not have to take my word for it. The Commission's own order-handling statistics, the so-called 11ACL-5 numbers, prove that automatic markets that are free of trade-through restrictions provide investors with better results, better prices, and faster executions.
    The appropriate reform is obvious. Eliminate the ITS trade-through rule and allow competition to flourish as it does in the NASDAQ market. Short of full and outright repeal, Schwab proposes alternatively that the Commission first act to improve the interaction among markets trading listed securities. Then, after appropriate analysis of listed trading data, determine whether to eliminate the trade-through rule in its entirety.
    Specifically we believe the Commission should take the following steps. Investors should be given the choice to ignore slow and inefficient market centers. Therefore, we urge the Commission to support a fast market/slow market exception to the trade-through rule. Such an exception will induce markets to implement automatic execution and automatic quote trading, thereby benefiting investors through the ensuing efficiency.
    Second, the Commission should require specific disclosure of trade-throughs as part of 11AC 1-5 reporting, thereby allowing investors to determine the execution quality of their orders and allowing regulators to determine if the brokers are fulfilling best execution obligations.
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    Finally, Schwab believes that customers should be allowed to decide for themselves what constitutes best execution. Therefore, Schwab urges the Commission to amend the ITS plan to include an opt-out provision so that investors, rather than one-size-fits-all rules, can determine how to execute orders.
    With regard to market data, Schwab believes that the current SEC proposal simply misses the real problem. Rather than treat the symptoms, the Commission should focus on reforming a monopoly-based system that wildly increases the cost to investors for trading information.
    Investors have heard lots of stories about why market data is so expensive. We heard 2 weeks ago that it costs the NYSE $488 million per year to generate market data. That is hard to believe given that as the commission described in its reform proposal, last year the Plan Networks made $424 million in revenue and incurred only $38 million in expenses. That is a monopoly markup of 1,000 percent.
    Further, NASDAQ, operator of one of the data networks, recently stated that it believes it can cut its monopoly data prices by 75 percent and still provide a sufficient return to shareholders. Clearly, there is excess market data money sloshing around the exchanges, which manifests itself in everything from tape shredding to market data rebates, to exorbitant pay packages for executives. This excess revenue is extracted from average investors who pay inflated charges to the exchanges to see their own limit orders displayed.
    The government-created market data cartels should be asked to justify their cost. Until there is transparency in cost and governance, the market data cartels will never change and investors will continue to subsidize markets. Schwab believes that markets should fund their own regulatory and operational functions directly and transparently themselves, rather than indirectly through opaque market data charges to investors.
    Schwab has three recommendations. First, price information relating to the NBBO be based on its cost, thereby facilitating widespread availability. Second, simplify and standardize network accounting so that the expenses relating to market data consolidation are transparent, available to individual investors and independently audited. Finally, require public representation on network operating committees. A toothless advisory committee is a status quo proposal. Today, everyone acknowledges the need for independent members on the boards of public companies, mutual funds, and even SROs. Governance of market data should be no different.
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    In closing, Schwab commends this committee for exercising its oversight role and examining these important issues. To sum up, Schwab hopes the SEC repeals the trade-through rule, or at a minimum institutes meaningful reforms, thereby unleashing a wave of modernization in the listed market. Furthermore, we urge the Commission to reexamine its market data proposal to end monopoly profits and ensure that all investors have access, at a reasonable price, to the most basic trading information.
    Thank you again for the opportunity to testify today. I look forward to any questions you may have.
    [The prepared statement of Larry Leibowitz can be found on page 75 in the appendix.]
    Chairman BAKER. Thank you, sir.
    Our next witness is Mr. Daniel McCabe, chief executive officer, Bear Hunter Specialty Products. Welcome.
STATEMENT OF DANIEL MCCABE, CEO, BEAR HUNTER SPECIALTY PRODUCTS
    Mr. MCCABE. Thank you. Good afternoon and thank you, Mr. Chairman, for the opportunity to testify in front of the committee.
    A little bit of background first for the committee. I am the CEO of Bear Hunter Structured Products LLC. We are liquidity providers in derivative products such as options, futures and exchange-traded funds. Bear Hunter is a wholly owned subsidiary of Bear Wagner, which is one of the five major specialist firms on Wall Street. We represent more than 350 listed companies, including such household names as Pepsi, Aetna, Alcoa, Xerox and Kimberly-Clark to name a few. Bear Wagner is a member of the NYSE, Amex, CME, ISE, CBOT, and CBOE and actively trades in all venues.
    Mr. Chairman, I am sincerely worried about the impact of the proposed changes, not only on the individual investor, but also on our listed companies and on the New York Stock Exchange itself. I am deeply concerned because the thrust of these new regulations is focused on speed only, and speed will ferment both price and temporal volatility in the market, scaring off individual investors, destroying confidence and over time driving down the market capitalization of our listed entities. Since the introduction of decimal pricing, the markets have already experienced a 126 percent growth in program trading, much to the detriment of the individual investor.
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    Allow me to elaborate. Excessive volatility serves no one but professional investors. Over the last 2 years, some 39 NASDAQ-listed companies have chosen to move to the New York Stock Exchange in order to reduce their volatility. They have, on average, experienced a 50 percent reduction in inter-day volatility. They made this choice to facilitate the raising of capital. After five years of market softness and financial scandals, is volatility really going to help lure investors back into the market, or are we creating a market dominated by professional program traders?
    What is driving the focus on speed? Certainly not the majority of investors in this country. When AARP recently surveyed nearly 2,000 of its members, two-thirds of them said price is the top priority when engaging in a market transaction. The second consideration was brokerage fees. Speed barely registered in the survey.
    Chris Hansen of AARP, representing that organization's 35 million voters, said, ''The SEC needs to proceed carefully in proposing changes that could undermine the ability of individual investors to get the best price for the lowest transaction cost.'' I could not agree more.
    Some of our competitors say everything should be done in nanoseconds, same-second executions should be the driving force in markets. I do not think we want the NYSE looking like an ECN, where stocks flicker excessively while attempting to discover price, nor do I understand why the markets with excessive volatility will be rewarded through the proposed changes in reg NMS.
    In addition, I think the logical outcome of these proposed rules will be dramatic fragmentation and internalization of orders, where sophisticated investors opt out and the common person is left behind. The solution is not to develop a bifurcated market for insiders and small investors, but to instead link the markets together. Define a reasonable time frame, say five or six seconds, where orders must be executed or else face a penalty. Mandate that all parties compete on price.
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    Today, many people have the vision of the NYSE from a bygone era, with brokers wandering the floor, hand-writing orders on tiny scraps of paper. Over 85 percent of the orders are executed in less than 10 seconds. Specialists only provide liquidity roughly 15 percent of the time to smooth out short-term volatility, which helps stabilize the market for both investors and our listed companies. I think the real motive behind much of this debate has nothing to do with the individual consumer, but rather an attempt by failing business models to gain an advantage through regulations.
    Here is a recent quote from Steve Pearlstein of The Washington Post: ''The fact that these parties are trying to divert more trading away from the exchange raises suspicions that their lobbying campaign may have less to do with protecting the interests of the investing public than with gaining competitive advantage or taking over the market-making function themselves.''
    Again, let's look at NASDAQ. Five years ago, the exchange handled more than 90 percent of the market in their own stocks. Today, it is less than 20 percent. Currently, the NASDAQ and all of its electronic competitors move at the same speed. So why have they lost market share? Simply because of practices like payment for order-flow or the sharing of tape revenue. Those practices must be disbanded for the mere health of the market.
    Individual investors buy and sell based on price. When millions of investors get home tonight and check on their 401(k) programs, they will carefully watch the prices of their stocks and mutual funds. I cannot believe a single one of them will wonder whether their shares traded in 5 seconds or 8 seconds. Moreover, most will have no knowledge of which exchange traded their security or under what rules they were traded.
    In conclusion, sir, the NYSE can move faster and yes, it should. But price and transparency are equally important principles this committee and the SEC must not abandon.
    Thank you for your time and consideration.
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    [The prepared statement of Daniel McCabe can be found on page 78 in the appendix.]
    Chairman BAKER. Thank you very much, sir.
    Our next witness is Mr. John Giesea, president and chief executive officer, Security Traders Association. Welcome, sir.
STATEMENT OF JOHN GIESA, PRESIDENT AND CEO, SECURITY TRADERS ASSOCIATION, INC.
    Mr. GIESEA. Good afternoon, Chairman Baker, Ranking Member Kanjorski and members of the committee. Thank you for the opportunity to testify this afternoon.
    The Security Traders Association, or STA, is comprised of some 6,000 professionals engaged in the purchase, sale and trading of securities, representing individuals and institutions. In the context of today's topic, how will the investor fare, I would comment that I believe that investors have benefited greatly over recent years given improved market efficiencies and regulation. Proposed Regulation NMS, if properly implemented, will further these gains through improved linkages, liquidity and competition.
    The STA is currently in the process of completing its formal comment on proposed Regulation NMS. This has involved input from more than 60 professional traders representing both the buy side and the sell side. I will highlight the major points of Regulation NMS where STA has preliminarily reached consensus with regard to the trade-through. The STA believes that a fully linked market with automatic execution capability will substantially diminish the need for a trade-through rule.
    One way to address the trade-through proposal would be to execute it in a phased approach and implement it only after a comment period for review. Phase one, define automated and a non-automated markets; phase two, oversee the creation of linkages to ensure a high degree of connectivity and access; phase three, reexamine the need for a trade-through rule as such a rule may be impossible to enforce as well as unnecessary given the competitive forces driving best execution standards. The result of this phase-in approach would be a major step towards the envisioned national market system and beneficial for market participants and investors.
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    The current proposal would extend the trade-through rule to the NASDAQ market. We question why when there have not been problems regarding price protection the rule should be imposed upon the NASDAQ stock market. It would be incorrect to impose this rule at the onset. Although there may be some practical and other drawbacks to an opt-out, we would support an opt-out exception on an interim basis for the purpose of driving greater automation in or access to markets. This would provide incentive for change. However, if automatic execution and economic access to quotes were achieved, an opt-out provision would become unnecessary.
    A key determination is the definition of an automated market. STA believes that a market must provide for an automatic execution, coupled with an immediate refresh capability. With regard to access fees in lock and cross markets, the Commission has correctly identified access fees as a critical component of any discussion regarding best execution. The SEC's proposal to cap fees at $0.001 per share is a very positive step towards reducing the current problems in the marketplace. However, we believe the preferred action is complete elimination of access fees, which would also eliminate the economic, or at least one of the economic incentives which cause lock and cross markets. The SEC's proposal appropriately calls upon markets to create and enforce rules eliminating lock and cross markets which STA strongly supports.
    With regard to sub-penny quotes, sub-penny quotations create a number of problems, and we are against the introduction of decimals as originally proposed, and we strongly support the Commission's recommendation that sub-penny quotations be eliminated. We do distinguish between quotation and transaction as there are some common needs to have a transaction that creates a sub-penny, but quotations should be limited to two decimals.
    With regard to market data, the STA is not in a position to comment on the precise formula to be used for the distribution of market data revenues. We are, however, supportive of the market data allocation proposals that lead to rewarding quality quotes at the same time eliminating the practices only designed to gain the revenue stream.
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    With regard to liquidity providers, I would also note the importance of liquidity providers, namely specialists and market-makers, to the capital formation and the efficient functioning of the markets. The trend in rulemaking has been to encourage the matching of buyers and sellers without an intermediary. Highly liquid stocks do not under normal circumstances require a liquidity provider to facilitate the execution of trades. However, the need for liquidity providers becomes important in stress situation, be they stock-specific or general market conditions.
    In conclusion, I thank the members of the subcommittee for your continued interest in ensuring that U.S. markets are efficient and liquid. Such characteristics are important to a robust capital formation process, benefit the U.S. economy, and ultimately benefit all investors.
    The STA views the national market system principles established in the Securities Acts Amendments of 1975, namely the maintenance of efficient, competitive and fair markets, as both a measure and a goal. The SEC proposed Regulation NMS is a step toward the goal of a true national market system.
    Thank you.
    [The prepared statement of John Giesea can be found on page 70 in the appendix.]
    Chairman BAKER. Thank you very much, sir.
    Our next witness is Dr. Benn Steil, the Andre Meyer Senior Fellow in International Economics, Council on Foreign Relations. Welcome.
STATEMENT OF BENN STEIL, ANDRE MAYER SENIOR FELLOW IN INTERNATIONAL ECONOMICS, COUNCIL ON FOREIGN RELATIONS
    Mr. STEIL. Thank you, Mr. Chairman, members of the committee.
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    Although the SEC's proposed Regulation NMS covers a wide range of important issues related to market linkages, access fees and market data, I will confine my brief prepared remarks to the specific matter of the trade-through rule, changes in which have the greatest potential to improve the ability of our securities markets to service investors.
    Although the idea of having a simple market-wide rule to ensure that investors always have access to the best price is an attractive one, in practice the trade-through rule has operated to force investor orders down to the floor of the New York Stock Exchange irrespective of investors's wishes. The rule therefore operates to discourage free and open competition among marketplaces and market structures, the type of free and open competition which has in Europe produced a new global standard for best practice both in trading technology and exchange governance.
    The trade-through rule should therefore be eliminated, as it serves neither to protect investors nor to encourage vital innovation in our marketplace. Those who support the maintenance of some form of trade-through rule, most notably the New York Stock Exchange, have raised five main arguments in its defense. The most effective way to illustrate why the rule is undesirable is to address each of these directly.
    First argument: Why should speed be more important than price? According to this view, eloquently presented by Mr. McCabe, the whole debate is about whether traders should be allowed to sacrifice best price in pursuit of speed. But the notion that investors would ever sacrifice price for speed is nonsensical. In the marketplace, it is always about price. It is about the price for the number of shares the trader wants to trade, not just the 100 shares advertised on the floor of the New York Stock Exchange, and it is about the price that is really there when the trader wants to trade. Statistics from competing marketplaces about fill rates, response times and the like make very nice input into a trader's decision, but they are not substitutes for a decision.
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    Argument two: But the rule is necessary to protect market orders. The normal fiduciary principle says that the agent must act in the customer's interest, but the trade-through rule says that the agent must ignore the customer's interest. In other words, to eliminate any possibility that a broker may abuse his discretion, regulators should forbid not only his discretion, but his customer's discretion. This cannot be sensible, Mr. Chairman.
    To illustrate, an investor may wish to buy 10,000 shares at $20 a share done at a keystroke on market X. The trade-through rule, however, would oblige that investor instead to buy only 100 shares at $19.99 at the New York Stock Exchange and then submit to a floor auction there, so that exchange members on the floor may profit from knowledge of his desire to buy many more shares. Tellingly, the same people who insist that brokers will abuse discretion or that their customers should not be entitled to it, will defend to the death the right of specialists to use discretion. This view, curiously, is entirely unburdened by knowledge of the $241.8 million in fines paid by five of the seven NYSE specialist firms for improper discretionary trading.
    Argument three: But the rule is necessary to protect limit orders. According to this argument, it is not the market orders that have to be protected, but rather 100-share limit orders. But this is a strange principle for the NYSE to defend, given that the floor could not even exist were it not for the ability of specialists and floor brokers to trade in front of limit orders. Indeed, the most frequent complaint of institutional investors about trading on the floor is precisely the fact that limit orders are revealed to the crowd, who are then allowed to use that information to trade in front of them. In a marketplace, Mr. Chairman, it takes two to trade. The fellow who puts down a limit order in market X has no moral standing over the gal who sees a better package deal in market Y. Appeals to fairness favor neither one over the other.
    Fourth argument: But if limit orders are traded through, no one will place them. If limit orders are traded through on market X, they just will not be placed on market X. They will move to market Y, where they will not get traded through.
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    Fifth and final argument: But a fair compromise is to have a trade-through rule among fast markets. The NYSE has stated repeatedly that in the fast exchange of the future, there must be a role for the floor action. To be clear, this means that the NYSE will only be fast for as few shares as the SEC will let them get away with. So to go back to the example of an investor wanting to buy 10,000 shares available on market X at $20 a share, if the NYSE is designated a fast market it means only that the NYSE might sell him a fast few hundred shares at $19.99, but then just like old times, Mr. Chairman, the exchange will force him into a floor auction.
    More fundamentally, do we really want the government to be in the business of determining which markets are fast enough for all investors, now and in the future, and doling out protection from competition on that basis? My judgment is that we do not.
    To conclude, I do not believe that any of these arguments for a trade-through rule are compelling. Moreover, the rule is not even enforced at present against its leading supporter and only systematic violator, the New York Stock Exchange, which trades through other markets hundreds, even thousands of times every day. Since the SEC is silent on the question of how the rule will actually be enforced in the future, it must be assumed that if perpetuated it will continue to operate solely to force investors to trade on the New York Stock Exchange, even if they desire to do otherwise.
    The SEC should, of course, be concerned to see that intermediaries do not abuse their discretion in handling investor orders, but given that the focus of recent SEC disciplinary action has been improper discretionary trading by specialists, it cannot be in the interest of investors to oblige them to trade with specialists if they do not wish to do so. After all, the SEC emphasizes in its proposal that a trade-through rule, and I am quoting, ''in no way alters or lessens a broker-dealer's duty to achieve best execution for its customers's orders.'' If this is truly the case, Mr. Chairman, then a trade-through rule is neither necessary nor desirable.
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    I thank you for the opportunity to testify this afternoon and I look forward to assisting your deliberations in any way possible.
    [The prepared statement of Benn Steil can be found on page 83 in the appendix.]
    Chairman BAKER. Thank you, sir.
    Our next witness is Dr. Daniel G. Weaver, visiting associate professor of finance, Department of Finance, Rutgers School of Business. Welcome, sir.
STATEMENT OF DANIEL G. WEAVER, VISITING ASSOCIATE PROFESSOR OF FINANCE, DEPARTMENT OF FINANCE, RUTGERS SCHOOL OF BUSINESS
    Mr. WEAVER. Thank you.
    Mr. Chairman, let me state unequivocally that I am against repeal of the trade-through rule. If the rule is repealed, it will further fragment our markets and hurt investors. It will be a large step backward in the modernization of U.S. markets, effectively taking us back to pre-Manning rule days. The history of the Manning rule has reverse parallels to the proposed repeal of the trade-through rule. Prior to Manning I, which was enacted in 1994, if an individual investor sued their broker, NASDAQ dealers could simply ignore customer limit orders. Customers learned that limit orders were not executed and did not submit them.
    Manning I prevented NASDAQ dealers from trading through customer limit orders at better prices, much like current trade-through rules do today. However, after the passage of Manning I, NASDAQ dealers could still trade ahead of their customer's limit orders at the same price. There was no public order priority rule.
    Manning II enacted about a year later gave public limit orders priority, but only within a dealer firm. In other words, a customer submitting a limit order to dealer X could still see trades occurring at other dealers at the same price or worse than the customers's limit order. Thus, Manning II still discouraged public limit order submission. It took the order handling rules enacted by the SEC in early 1997 to unleash the potential of public limit orders in the NASDAQ market. After the OHR, spreads dropped dramatically. ECNs, which despite customer limit orders, grew in market share from about 10 percent to 80 percent today. ECNs allow public limit orders to compete with NASDAQ market-maker quotes.
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    The lesson is clear. If limit orders stand a chance of execution, they will be submitted and can then become an important source of liquidity for markets. We need liquidity in our markets. Limit orders are shock absorbers for liquidity events. Without limit orders to absorb trades from liquidity demanders, large orders will increasingly push prices away from current prices. While it may be argued that price impact is a fact of life for large institutional traders, I am more concerned about the small trader that submits an order at the same direction, but just behind the large order. The small order will execute at an inferior price before sufficient liquidity can be sent back to the market by traders.
    Repeal of the trade-through rule, then, would take us back to pre-Manning rule days. It will discourage limit order submission and in turn increase volatility in affected stocks. This will result in a higher effective execution cost for the average investors. A few large players will benefit, but it will be at the expense of the majority of long-term investors. It has been shown time and time again that investors factor execution costs into the required cost of supplying funds to firms. Therefore, higher execution costs will translate into higher costs of capital for firms and stock prices will fall. This will make it more difficult to raise capital and hence provide a drag on the economy.
    As an example, on April 11 of 1990, the Toronto Stock Exchange, TSX, enacted rules that resulted in the effective execution costs increasing by about .025 percentage points. Within a week, prices declined by over 6 percent and stayed there. This impact on prices will happen if the trade-through rule is repealed. It will set us back 10 years and put us dead last in the modernization of markets among industrial nations.
    Other nations have seen the value of routing orders according to price. The TSX affected rules that require brokers receiving market orders of 5,000 shares or less to either improve on price or send the order to the TSX for execution against public limit orders. Following that action, affected stocks experienced an immediate increase in depth and reduction in spread. Evidence from U.S. markets finds the same result. When Merrill Lynch decided to stop routing their orders to regional stock exchanges and instead routed them directly to the New York Stock Exchange, spreads narrowed and customers obtained better executions. Recently, the EU has passed the investment services directive II, which is similar to TSX concentrates on rules and requires orders that occur off exchanges to be improved-on price; not worse price, not same price, better price.
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    The above are examples of the adage that liquidity begets liquidity. In other words, limit order traders will submit limit orders where market orders are. It is similar to the fact that the more traffic exists on a highway, the more gas stations will exist. If the traffic goes away, so will the gas stations. Similarly, if market orders get routed away from the venue with the best price, limit orders will leave that venue as well. Going back to the gas station example, it does not matter how cheap your gas is. You will not sell much at the back of a dead-end street.
    If markets want to truly compete, they should do so on price, which is the current structure. However, the entire notion of markets competing is problematic. True competition is between natural buyers and sellers. I doubt if any member of the public ever received a call from the Chicago Stock Exchange asking them to send their orders in NYSE-listed stocks to them, but their brokers did.
    Allowing orders to be routed for reasons other than best price will increase the incidence of preferencing, again taking us a big step backward in efforts to modernize our market. I am generally against allowing traders to give blanket opt-outs of the best price rule. Most investors do not know their bid from their ask, and I am afraid will quickly agree to allow their brokers to opt out of their accounts. This opens the floodgates for abuse by brokers, undoing years of regulatory mandated improvements in our markets. There may be something to be said for allowing some large traders to make an informed decision to opt out on a trade-by-trade basis. However, I would suggest that this can be accomplished through the changes to the rule for block trades.
    Therefore, I really do not see a need for an opt-out ability. If enough investors opt out, then market orders can be routed away from current venues and executed at inferior prices. This will discourage traders from providing liquidity, leaving more volatility in the markets, higher execution costs, and higher costs of capital for U.S. firms. Repealing the trade-through rule in listed markets will result in fragmentation for listed stocks similar to that on NASDAQ. The fragmentation of NASDAQ has led to an increased usage of order routers to find liquidity. The creation and sale of order routers is perhaps the biggest growth segment of the securities industry today.
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    Companies like ITG do a big business selling trading firms their order routing services. Now, these order routing firms are not charitable organizations, but for-profit. Therefore, it costs money to find liquidity in the OTC market today. This further adds to execution costs, therefore increasing the fragmentation of markets by allowing opt-outs to the trade-through rule and will result in higher execution costs because of the increased cost of finding liquidity.
    Thank you for inviting me today, Mr. Chairman.
    [The prepared statement of Daniel G. Weaver can be found on page 96 in the appendix.]
    Chairman BAKER. Thank you, sir.
    Our next witness is Mr. Kim Bang, president and chief executive officer, Bloomberg Tradebook. Welcome.
STATEMENT OF KIM BANG, PRESIDENT AND CEO, BLOOMBERG TRADEBOOK LLC
    Mr. BANG. Thank you, Mr. Chairman and members of the subcommittee. My name is Kim Bang and I am pleased to testify on behalf of Bloomberg Tradebook.
    In early market structure hearings, Chairman Oxley asked, why does the New York Stock Exchange control 80 percent of the trading volume of its listed companies, when NASDAQ controls only about 20 percent of the volume of its listed companies? The answer is simple. There has been and continues to be numerous impediments to electronic competitors. The NASDAQ price-fixing scandal of the mid-1990s resulted in sanctions by the SEC and the Department of Justice and decisions on market structure intended to enhance transparency and competition in the NASDAQ market.
    Specifically, the SEC's 1996 issuance of the order-handling rules permitted electronic communication networks, ECNs, to flourish, benefiting investors and enhancing the quality of the market. NASDAQ spreads narrowed by nearly 30 percent in the first year following the adoption of the order-handling rules. These and subsequent reductions in transactional costs constitute significant savings that are now available for investments that fuel business expansion and job creation.
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    The question confronting the SEC and Congress is whether equity markets can be reformed to bring the same benefits to the New York Stock Exchange investor as they have to the NASDAQ investor. The trade-through rule is the foremost impediment to that opportunity.
    Currently, the inter-market trading system trade-through rule protects inefficient markets, while depriving investors of the choice of anonymity, speed or liquidity by mandating instead that investors pursue the advertised theoretical best price, instead of the best available firm price. Ending the trade-through rule would allow investors to choose the markets in which they wish to trade, which would in turn promote competition and benefit investors. The results would be greater transparency, greater efficiency, greater liquidity and less intermediation in the national market system, which are precisely the goals of the Securities Acts Amendment of 1975.
    Rather than introducing a complex new trade-through rule that would be expensive to implement and unlikely to be enforced, we suggest launching a pilot program similar to the ETF de minimus exemption for a cross-section of listed stocks. With no trade-through rule restriction, the Commission could then monitor and measure the results of these three competitive forces.
    I cite in my testimony a study appraising a real-world experience in which market quality did not diminish, but actually improved in the ETFs with the relaxation of the trade-through rule. This is no surprise, as the second largest market in the world, namely NASDAQ, functions very effectively without a trade-through rule.
    As to market data, the Financial Services Committee has long held that market data is the oxygen of the markets. Ensuring that market data is available in a fashion where it is both affordable to retail investors and where market participants have the widest possible latitude to add value to that data are high priorities. In its 1999 concept release on market data, the Commission noted that market data should be for the benefit of the investing public. Indeed, market data originates with specialist market-makers, broker-dealers and investors. The exchanges and the NASDAQ marketplace are not the sources of market data, but rather the facilities through which market data are collected and disseminated.
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    In that 1999 release, the SEC proposed a cost-based limit to market data revenues. We believe the SEC was closer to the mark in 1999 when it proposed making market data revenues cost-based, rather than in its Regulation NMS proposal which proposes a new formula for dispensing market data revenue without addressing the underlying question of how effectively to regulate this public utility function.
    In addition to questions regarding who owns market data and who shares in the revenue and the size of the data fees, we believe the Commission ought also to revisit how much market data should be made available to investors. Here, decimalization has been the watershed event. Going to decimal trading has been a boon for sure to retail investors. It has been accompanied, however, by a drastically diminished depth of displayed and accessible liquidity. With 100 price points to the dollar, instead of eight or sixteen, the informational value and available liquidity at the best bid and offer have declined substantially. In response to decimalization, the Commission should restore lost transparency and liquidity by mandating greater real-time disclosure by market centers of liquidity, at least five cents above and below the best prices.
    I would like to touch briefly on one other aspect of Regulation NMS, namely access fees. Bloomberg has long believed that access fees should be abolished for all securities in all markets. While we applaud the SEC's efforts to reduce access fees, we are concerned that the complexities inherent in curtailing these fees without eliminating them are likely to create an uneven playing field.
    In conclusion, this committee has been at the forefront of the market structure debate and I appreciate the opportunity to discuss how these seemingly abstract issues have a real concrete affect on investors. Regulation NMS is a bold step to bring our markets into the 21st century. However, we believe there is a risk that Regulation NMS may reshuffle, rather than eliminate current impediments to market efficiency. Elimination of the trade-through rule, elimination of access fees, to restore lost transparency lost to decimalization, and to control the cost of market data would help promote a 21st century equity market that best serves investors.
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    Thank you very much.
    [The prepared statement of Kim Bang can be found on page 46 in the appendix.]
    Chairman BAKER. Thank you, sir.
    Our next witness is Mr. Peter J. Wallison, resident fellow, American Enterprise Institute. Welcome.
STATEMENT OF PETER J. WALLISON, RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE
    Mr. WALLISON. Thank you very much, Mr. Chairman. I am pleased to have this opportunity to offer my views on the SEC's proposed Regulation NMS.
    Regulation NMS is a complex proposal with elements that address different aspects of the national market system. I will only discuss the basic question of market structure, which is implicated by the regulation's proposed changes in the applicability of the trade-through rule.
    The U.S. securities market today consists of two entirely different structures, a centralized market for the trading of New York Stock Exchange-listed securities; and a set of competing market centers for the trading of NASDAQ securities. One of these models and only one is likely to be best for investors, and hence the best market structure. But Regulation NMS does not help us decide which it is. In fact, by allowing some investors and markets to trade-through prices on the New York Stock Exchange and by attempting to impose the trade-through rule on the trading of NASDAQ securities, Regulation NMS further confuses the issues.
    The fundamental question of market structure is whether investors are better off when securities trading is centralized in a single dominant market, or when it is spread among a number of competing market centers. If the SEC is interested in reforming securities market structure, it must address this question. Regulation NMS does not do so.
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    Accordingly, I believe the regulation should be withdrawn until the SEC has done sufficient study and analysis of market structure to make an appropriate recommendation.
    There are two basic models for organizing a securities trading system. In the first, trading in specific securities is centralized so that, to the maximum extent possible, all orders to buy and sell meet each other in a central market. In economic theory, this produces the greatest degree of liquidity and thus the best prices and narrowest spreads.
    This model has two potential large-scale deficiencies, however. It forces all trading into a single mode—one size fits all—and thus will not meet the trading needs of some investors; and it does not create incentives for innovation or encourage accommodation to the changing needs of investors. The second model is a decentralized structure that contemplates competing market centers. Any security can be traded in any market. The advantages of this structure are that it can potentially meet the trading requirements of the greatest number of investors, and because the markets are in competition with one another, it provides adequate incentives for innovation and change.
    The disadvantage of this structure is that is breaks up liquidity and thus could potentially interfere with price discovery. It also could result in investors getting different prices for the same security, executed at the same time, which some regard as unfair. The reason for the difference between competitive conditions in the two markets is probably the trade-through rule, which is applicable to New York Stock Exchange-listed securities, but not, for historical reasons, to those listed on NASDAQ.
    The trade-through rule requires that customer orders to buy or sell NYSE securities be forwarded to the market center where the best price for those securities has been posted, usually the NYSE. The purpose of the rule in conformity with the SEC's longstanding policy, is to increase the chances that buyers and sellers of a security will get the best price available in the market at the time they want to trade, even if the security is traded in different markets.
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    It appears that if the trade-through rule were eliminated entirely, much of the trading in New York Stock Exchange securities would move to the automated markets such as the ECNs. This seems likely because in the NASDAQ market, where the trade-through rule was not applicable, ECNs have been able to capture much of the trading from NASDAQ market-makers themselves. There are good reasons for this, especially for institutional investors, detailed in my prepared testimony. From the perspective of institutional investors, electronic markets may offer the best available prices because they allow trading in large amounts with relatively low market impact.
    Thus, one way to state the question before the SEC is whether the trade-through rule should remain applicable to trading in New York Stock Exchange securities. If the SEC believes that overall, taking into account its advantages and disadvantages, the centralized trading on the New York Stock Exchange is superior to the decentralized structure of the NASDAQ market, then it should retain the trade-through rule. On the other hand if it believes that the decentralized structure of the NASDAQ market overall is superior, then it should eliminate the trade-through rule entirely so that all market centers could trade all securities.
    In Regulation NMS, the SEC has done neither and both. It is proposing to eliminate the trade-through rule in some circumstances, and to impose it in others where it does not currently apply. This indicates to me that the SEC is unwilling or unable to grapple with the central question of market structure—whether to favor a centralized trading model like the New York Stock Exchange, or a market that consists of competing trading venues.
    Without deciding this question, there is no point in adopting another regulation. Instead, I would suggest that the SEC withdraw the regulation and do the necessary work to decide how the securities market should be structured in the future.
    That is my testimony, Mr. Chairman.
    [The prepared statement of Peter J. Wallison can be found on page 88 in the appendix.]
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    Chairman BAKER. Thank you, Mr. Wallison.
    Mr. McCabe, much of your testimony is based on the principle that execution at the best price should be the stalwart principle from which we should not retreat. To that extent, I think most would agree that coming down on the side of the consumer is always a good choice. But can you represent to me that today all trades are executed at the best price available on the New York Exchange at the time of execution?
    Mr. MCCABE. Sir, first off I have to say that I do not represent the New York Stock Exchange. I work for a subsidiary broker-dealer. On the New York Stock Exchange, we have rules that say that we must attempt always to get the best price for a customer. If for any reason we fail at that, there are methods for people to redress that. But I would say that the vast majority of the time, yes, they do get the best price.
    Chairman BAKER. I do not know if there is someone who chooses to offer the counter view. I have received information from other exchange representatives who allege as to the frequency of thousands of times a week that there are executions that occur on the New York exchange, not by necessarily adverse intent, but due to technological limitation that the executions do not occur at the best price. That is, in fact, what is driving my review of the matter is that I believe the current system is faulty in that regard, and that you do not necessarily attain best price.
    But let's move past that. Assume for the moment you are correct and some investor has reason to want to have some other principle guiding his investment decision. Dr. Weaver, you indicated that most investors do not know bid from ask, but let's assume for a moment we have one who has gotten pointed out in the right direction. If he has some other strategic reason to want to execute, why should not that consumer be given his choice as opposed to the mandatory rule?
    Mr. WEAVER. Are we only going to worry about that consumer? Or are we going to worry about the market as a whole? If orders get routed away from a market center, then people realize that their limit orders are not going to get executed and they are not going to submit them. Too long in this country, the SEC has focused on coming up with the smallest spread, but we need to worry about providing liquidity to the marketplace. Liquidity is a shock absorber. You need to have them there. You do not want to have your shock absorbers at home in the garage right before you get into a pothole.
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    Chairman BAKER. That assumes that once the order would not be placed, that the demise of the western civilization follows because the liquidity disappears, as opposed to going to perhaps another exchange. You are saying it parks on the sideline and forever disappears from the economic system? How do we get to that conclusion?
    Mr. WEAVER. No, sir, I am not saying that at all. First of all, you are assuming there is another exchange for them to go to. What if it is a market-maker who is operating proprietarily and does not accept customer limit orders to compete for the other customer's order? There is no way for that limit order to get there.
    Chairman BAKER. I am not arguing that the role of the specialist is not needed.
    Mr. WEAVER. No, I am not talking about the role of the specialist either, sir.
    Chairman BAKER. I am saying that where there is a liquid market for a publicly traded stock, where someone has an alternative reason for exercising other than best price, which by the way we do not get in the New York Exchange anyway, why don't we let the customer choose? We can put a big bumper sticker, the surgeon general says this could be hazardous to your health, whatever we want, but let people make choices. I think that is more the inherent in the free market system than something that says you must do this in order to participate.
    Mr. MCCABE. Mr. Chairman, if I may address that just quickly.
    Chairman BAKER. Sure.
    Mr. MCCABE. The point you have just made is that you do not get the best price on the New York Stock Exchange. I have not seen anyone publish data that says that, other than some of these competitors sitting around here, and quite frankly I question some of that data. The most recent 11(a)(c)1-5 report shows that actually the fill rate on the New York Stock Exchange for marketable limit orders is 72.3 percent. The highest competitor below that for market orders is the NASDAQ. They are at 60 percent, sir. All the other RCNs go down from there.
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    Chairman BAKER. So it would be, not easy, it takes some work for folks to determine it, but based on that we will get the SEC working to find out.
    Let me ask another question though. The Philadelphia model has competitive specialists, as opposed to the New York Exchange which has the dedicated specialist. Is there something wrong with the Philadelphia model that would not make sense? If we are going to have limited competition, can't we at least have it among the specialists on the trading floor?
    Mr. MCCABE. I think it is always good to know if you have a problem you have to address, so I do think it is important that you have one person in control. I do agree that there are different market structures and some of them work rather well. I think that the market structure on the Chicago Mercantile Exchange with comparative market-makers and also the new futures that they are rolling out have what they call DPMs, that market structure even in the futures is a very interesting market structure. It may actually sometime in the future be what the New York Stock Exchange evolves into.
    Chairman BAKER. But you do not necessarily see the Philadelphia model as a flawed model?
    Mr. MCCABE. I do not quite frankly know the percentages of trades that are going on there, nor do I know enough about that model to speak appropriately on it.
    Chairman BAKER. We will just say possibly could be, but we need to have further examination.
    My time has expired, and I know we are going to have to break for votes here shortly. I want to make sure other members get their chance to make their statements.
    Mr. Hinojosa is next, then you, Mr. Crowley.
    Mr. HINOJOSA. Thank you, Chairman Baker. I want to thank you for holding an additional hearing to review the structure of our capital markets, in particular the SEC's proposed national market system regulation and how investors would fare under that proposal.
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    My first question is for Dan Weaver. Dr. Weaver, what impact would the SEC's proposed national market system rule have on limit orders?
    Mr. WEAVER. Which part of the NMS are you referring to? I am sorry. The trade-through rule?
    Mr. HINOJOSA. Yes, the trade-through.
    Mr. WEAVER. It encourages limit order submission. Right now, there is a trade-through rule on NASDAQ. It is on a firm-by-firm basis. It does not apply across the market. The SEC is suggesting that we should apply it across the market. I strongly support that. It will encourage limit order submission. The reason ECNs were started on NASDAQ was because limit orders were being ignored by the market-makers, and anything that we can have that will give limit orders some priority in the marketplace will help our markets.
    Mr. HINOJOSA. Dr. Weaver, how will all investors, not just the sophisticated ones, be notified that their mutual fund manager, their broker or pension fund manager, is opting out of the trade-through rule?
    Mr. WEAVER. I do not know how they would be notified because I am against them opting out, really.
    Mr. HINOJOSA. Who can tell me how that notification would occur? Anybody on the panel? Yes, sir.
    Mr. LEIBOWITZ. It is my understanding that the intention would not be for mutual fund managers to notify specific investors. Remember that mutual fund managers first of all have a great degree of discretion in execution anyway. They also have a fiduciary responsibility to the client, and it is their job as a sophisticated investor themselves to get the best prices for their client. That is part of what they do as a money manager.
    Mr. MCCABE. If I may also, today currently I believe Charles Schwab, working the best execution for their customers, internalizes 95 percent of the order flow in NASDAQ securities. I would question whether or not all those customers are guaranteed best price.
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    Mr. HINOJOSA. Okay.
    Mr. LEIBOWITZ. I would like to respond to that, if you do not mind.
    Mr. HINOJOSA. Certainly, go ahead.
    Mr. LEIBOWITZ. I can tell you that it is our best execution obligation and that we would be examined and fined if we did not provide it. If you look at our best execution stats, they are actually superior to the New York Stock Exchange in almost every instance, and you not only get better prices, but it is at a faster speed.
    Mr. MCCABE. I agree with Larry you can do things quickly, but he did not say that they guarantee best price.
    Mr. LEIBOWITZ. No. In fact, I am saying we do guarantee them the best price.
    Mr. HINOJOSA. The next question would be for Dan McCabe. Mr. McCabe, what is the fundamental difference between the electronic commercial networks and the exchanges?
    Mr. MCCABE. Quite frankly, sir, the ECNs are just what they state. They are electronic communication networks. They match orders that happen to be in the system. If there are no buyers or no sellers on one side, a trade cannot occur. There is nobody in any of these platforms that is mandated or required to provide liquidity. On the exchanges, whether it be on Philadelphia or the New York or out in Chicago, there are people who are given the responsibility of making fair and orderly markets. That is the difference between the exchanges.
    Mr. HINOJOSA. This last question is for Dan Weaver and Daniel McCabe. What would happen if in the end, the SEC were to withdraw the proposed NMS rule?
    Mr. MCCABE. If I may, I think the New York Stock Exchange quite frankly has changed. I think the proposed rules have caused people to address things that needed to be addressed for some time. I am very happy to see that. I think those changes will continue because of people like Mr. Thain coming into the exchange and bringing the appropriate people with him.
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    If it is withdrawn, I think that there are certain portions that we are still going to have problems with, most notably not the trade-through rule, but the payment-for-order flow and the sharing of tape revenue that really needs to be addressed in these markets.
    Mr. WEAVER. Let me follow up on that, if I may. I think if they withdrew the proposal, it would keep us near the back of the pack in the modernization of markets. In particular, the portion of the NMS that refers to decimalization and attempting to ban sub-penny quoting would continue to further fragment our markets and discourage limit order submission. I am afraid that a down market of the ilk of 1987 could be more disastrous because there is a lot less liquidity in the marketplace than their used to be.
    Mr. HINOJOSA. Chairman Baker, I look forward to hearing investors's opinions of the SEC's proposal in the near future. I found you always to be inclusive, so we have no doubt that you will allow us to hear from investors before this is over, before the end of this session. Finally, I ask unanimous consent that my opening remarks be made a part of the record because I was on the floor and I could not be here for the beginning.
    [The prepared statement of Hon. Rubén Hinojosa can be found on page 33 in the appendix.]
    Chairman BAKER. Mr. Hinojosa, your statement will be incorporated as part of the record, and I assure you will hear a great deal more about this subject.
    Mr. Crowley?
    Mr. CROWLEY. Thank you, Mr. Chairman. I, too, want to thank you for holding these series of hearings on market restructuring reform.
    I, too, have an opening statement that I would also submit for the record.
    [The prepared statement of Hon. Joseph Crowley can be found on page 28 in the appendix.]
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    Chairman BAKER. All members's statements will be made part of the official record.
    Mr. CROWLEY. Thank you, Mr. Chairman.
    I would first of all want to, in the sense of truth in advertising, follow up on what Mr. Hinojosa just spoke about, the hearing is entitled ''The SEC Proposal on Market Structure.'' How will investors fare? I am struggling as best I can, and I can certainly make arguments, and this is not disparaging of the panelists before us, but I am trying to determine who here really represents the interests of the investor. The investor today has taken on many, many new forms, and especially mom-and-pops who in the past were not necessarily in the market, but who are in there today.
    So I would also like to include for the record someone who does represent, at least in some capacity, the investors. That is the public advocate for the city of New York, Betsy Gotbaum, who in a letter representing more than eight million New Yorkers, many of whom are mom-and-pops, as well as others who are invested in the markets today, who is offering her opinion in opposition to any change in the trade-through rule. I would offer that for the record.
    Chairman BAKER. Without objection.
    [The following information can be found on page 102 in the appendix.]
    Mr. CROWLEY. Just one more point, again truth in advertising, and again, Mr. Steil, this is toward you, I note that on the witness list it says that you are a Andre Meyer Senior Fellow in International Economics at the Council for Foreign Relations. Are you representing the Foreign Relations Council here today?
    Mr. STEIL. No one can represent the Council on Foreign Relations in terms of representing its views. The Council on Foreign Relations has no institutional position on any subject matter whatsoever. Even the president of the Council on Foreign Relations cannot state a view on policy of the Council on Foreign Relations.
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    Mr. CROWLEY. I appreciate that. You are probably right. But are you not also the director of the London-based stock exchange Virt-x, an ECN that would clearly benefit if the trade-through were eliminated or at least provided with an opt-out provision?
    Mr. STEIL. In fact, I was discussing this matter with Dan Weaver before we started the testimony here today. Virt-x is a stock exchange, not an ECN. It trades primarily Swiss SMI stocks. The biggest beneficiary in the world that I know of, of a trade-through rule would be Virt-x, the reason being that Virt-x, being a new competitor in the pan-European trading market was trying to generate liquidity in non-Swiss stocks when it did not have it in the first place.
    In its first year of operation, it was quite successful in achieving very narrow spreads on a limited number of high-volume European stocks. For example on Deutsche TeleKom, on many months Virt-x had a narrower inside spread on most days than the home market Deutsche Borse, yet Virt-x got very little order flow in Deutsche Telekom. So Virt-x would be an enormous beneficiary of a European trade-through rule.
    Mr. CROWLEY. I am not so sure where your conflict comes in. It is either with Virt-x, or for the panel today in terms of your discussion.
    Mr. STEIL. You are making my argument for me. I am not here to represent Virt-x in any capacity whatsoever. I am a non-executive director of Virt-x. I do not come here speaking for Virt-x in any capacity whatsoever. I am speaking here today solely for myself.
    Mr. CROWLEY. Fair enough. Let me just move on.
    A number of years ago, a number of firms represented here today were making the argument that the New York Stock Exchange was a dinosaur, that it was outmoded, that it was not performing in essence in a fair way towards its investors in providing fast enough or expedited movement. They were making the argument that the lack of speed was the downfall of the stock exchange. I, for one, and many in the committee have made the point that we believe that price needs to be the issue over speed.
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    Now that it appears as though the exchange is moving ever so quickly towards a more competitive, if not almost identical rate of speed, what does that do to the argument?
    Chairman BAKER. That will need to be the gentleman's last question, so I can get to Mr. Inslee before we leave for votes. Someone please pick up wherever you might.
    Mr. GIESEA. I will quickly respond to that to suggest that should that occur, that is what the objective of the national market system is, in my opinion. It envisions a market that can be seen and accessed on an immediate basis. That is I think the overall envisionment of the national market system.
    Mr. CROWLEY. So if you have speed and you have price, there is really no need to change the trade-through rule. Is that correct?
    Mr. GIESEA. And accessibility.
    Mr. CROWLEY. Thank you.
    I yield back.
    Chairman BAKER. Mr. Inslee? The gentleman passes.
    I will just do some quick follow-ups, and by way of explanation, I would really like to stay for considerably longer and have an exchange. We have either four or five votes, I am not sure which, in a series, so we are going to be over there for a bit. I think it unreasonable to expect you to remain here while we go do that stuff.
    I will follow up in written form to a number of you with regard to specific questions. I do believe it the case that the trade-through rule does no in effect result in execution at best price. I do believe that consumers ultimately are the ones we should be concerned about and should be able to act at their instruction since the markets are actually facilitators of a transaction which is initiated by the initial investor.
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    To that end, I do not believe that the opt-out rule properly constructed is a bad thing. I will follow these observations up with questions about the triple-Q trade and the ETF transactions in which the SEC eased the rules for a bit, de minimus opportunity to conduct business, and ask for your perspectives on that versus the transitions that occurred in Europe. I am not at all interested in contributing to the demise of our economic system, which has been portrayed as a consequence of looking at facilitated trading. We really do need to have careful consideration, time to do the analysis, and even with Mr. Hinojosa's requests for additional hearings, we certainly will. In the interim, I hope to ask the SEC specifically to help us navigate through this maze with specific data that would be helpful in our insights.
    I regret that I do not have time to engage you in more thoughtful discussion today, but given the flow of votes, I think it more appropriate to release you at this point and ask for your response in writing to questions we will formulate over the coming days.
    I express my deep appreciation to each of you for your participation here. It has been helpful to the committee's deliberations.
    We stand adjourned.
    [Whereupon, at 3:21 p.m., the subcommittee was adjourned.]