The Nasdaq Stock Market is experiencing currents of change
stronger than those that have prevailed at any time since the
electronic system was initiated in 1971. For a perspective on
these forces we turn in this session to emissaries from market
constituencies: regulators, exchanges, investment institutions
("the buy side"), and the fourth estate of this particular
William Christie (together with co-author Paul Schultz) first
documented clustering in Nasdaq quotes and aired in this connection
the word "collusion." In a sense, this study launched
a thousand ships and set in motion the judicial and legal process
of reform. Yet Billís remarks take a broader perspective, citing
the pressures that had been building up largely unvoiced until
a rallying point or catalyst arose.
Holly Stark speaks to the buy sideís demand for access to markets,
not as liquidity-seeking customers of dealers, but as providers
of liquidity, in some respects as competitors of dealers. Buy-side
traders demand this access, not because they seek to become
dealers, but because they seek to minimize trading costs. She
reminds us that large traders perceive that they have choices
in where and how to trade.
These choices are felt as competitive pressures on existing
exchanges. Bengt Ryden describes the process of institutional
reform at the Stockholm Stock Exchange. This reform follows
a shift in perspective regarding the customers of an exchange,
from the narrow traditional view that the customers were the
exchange's members (a local and parochial community), to the
modern broad view that the ultimate customers are actual and
potential traders of the listed securities.
The overseers of reform are, of course, the regulators. Robert
Colby offers a perspective on the role of price transparency,
quote transparency, and "best execution" requirements
in U.S. regulatory thinking. His remarks are particularly apt
because, despite the technology that brings the ultimate user
closer to the inner workings of the marketplace, the route of
an order from potential trading desire to executed transaction
is often indirect and beset with multiple agency relationships
that are difficult to monitor.
What were the pressures for reform? There was negative publicity.
There were civil law suits, a Department of Justice investigation,
an SEC investigation and the Rudman Commission appointed by
the National Association of Securities Dealers, Inc. (NASD®
). You have litigation, regulators and the press, all bearing
down on you at once and for a prolonged period of time. There
is clearly pressure for reform!
Why did investors need an advocate in this market? It stems
back largely to the fact that Nasdaq had been so successful.
The market value of Nasdaq trading had skyrocketed. By any measure
it had been a very successful market.
The Nasdaq market grew quickly, rapidly and successfully in
terms of new listings, retaining listings, and dollar volume.
Some of the problems that existed did not have the impact that
they would have had in an industry where growth was a lot more
stable, since the inefficiencies would have been more readily
One of the groups that may have been disenfranchised from the
market were the buy-side traders (and to some extent active
individual investors). On the buy-side, you are facing wider
spreads than you would expect to see, you worry about execution
costs, and quotes do matter if you cannot get inside the spread.
If you are forced to pay those quotes, they matter a lot!
The second group I would say are options traders. An options
trader will post a limit order and it will be totally ignored.
Thus the public has had to trade at inferior prices. The options
traders themselves had a distaste for having to deal with Nasdaq
The third group are the SOES (Small Order Execution System)
activists. Love them or hate them, they were for a long time
one of the only sources of competition that Nasdaq Market Makers
had to face, because the public was not able to place limit
orders. You now have individual investors, buy-side traders,
options traders, and SOES activists, all having an inherent
dislike of this market, but with no way to vent it, or to be
able to do anything about it.
Then Instinet came along. It served as a source of competition
for Nasdaq. Instinet allowed institutional traders an opportunity
to bypass the dealer market. Why did that not cause this inefficiency
to break down? Well again, partly because this market was growing
so rapidly. Instinet was taking a larger portion of an ever
expanding pie. There was still a lot of market share left for
existing Market Makers.
The reform that has taken place in the last two or three years
has made Nasdaq much better and as the former President of The
Nasdaq Stock Market, Joseph Hardiman, said in a letter to me,
the integrity of the market is one of its greatest assets.
A few years ago the customers were revered in a much greater
way than they are today. There is a greater divergence in opinions
between the buy- and the sell-side today. Sometimes it looks
like people are going to break out into fist fights because
of differing opinions on how people should access markets.
Initially, the pressure for reform from the buy-side was a
quiet pressure. Buy-side traders could see the problems that
were in the marketplace. They encounter them every day when
they sit and trade.
The big issue is time. I sit on my trading desk and trade every
day when the market is open, as do most buy-side traders. To
leave the desk and take time to think about the overall structure
of the market, to see what is a better way for the markets to
work, is very difficult. Right now there are many traders on
the buy-side that are concerned about equity market structure,
especially as it relates to how business can best be done to
maximize performance for their clients. That is one thing we
on the buy-side can never forget. If we do not please our clients,
if we do not give them superior performance, the clients will
not stick around very long.
The overwhelming majority of firms on the buy-side realize
that trading is intrinsically part of the investment process.
They see that superior trading can mean the difference between
top quartile performance and mediocrity. It is no surprise that
traders have become more knowledgeable today about how equity
markets work and about the regulations that govern the markets.
We are focusing on what the concerns of the buy-side are.
The most dramatic change has been the implementation of the
SEC Order Handling Rules. The introduction of the order handling
rules is the culmination of investigations by the Commission
and the Justice Department into the activities of so many member
firms and of The Nasdaq Stock Market for anti-competitive business
practices. The ensuing reforms allowed the buy-side to gain
significant representation on key Nasdaq committees.
The order handling rules effectively require Nasdaq and the
exchanges to enforce the display of limit orders by all Market
Makers, making those orders immediately available to all members
in the investing public on a non-discriminatory basis. The buy-side
has reaped an enormous benefit in that the rules gave us the
ability to drive the inside quote, or the national best bid
and offer (NBBO). We can do this by electing to display limit
order books over compliant Electronic Communications Networks
(ECNs), or by asking a Market Maker to display our limit order.
We are not sure that everyone on the buy-side is fully aware
of the rules and are taking advantage of the benefits provided
by the rules.
Buy-side traders may continue to look for a different market
structure, one that affords them anonymity, liquidity, and control
over their orders. Buy-side traders are comfortable with technology
and the benefits it provides them. They look to technology to
enhance current market structure. Many buy-side traders have
also come to realize that their input in shaping market structure
is critical to ensure a fair and equitable process. They have
gone beyond letting the sell-side be their representative in
the deliberations and have taken an activist voice in the decision-making
The buy-side voice, though it may not be entirely welcome,
is now a viable one. It is a voice that is present and is not
going to go away. It is a voice that is ready to take steps
to define the market structure that we need to satisfy our fiduciary
obligations for the investors whose assets we manage.
You may have noted that today, because of the upcoming European
Monetary Union and because of other things happening within
the European Union during the nineties, the drive towards structural
change of European exchanges has been enormous.
Two important areas at the Stockholm Stock Exchange need to
be pointed out. The first one is the customer. When I started
to talk about customers at the exchange, people really got horrified
because we had members not customers. Who are the customers?
When I asked my board who are the customers, they said the members.
I replied, what about the issuers? We take care of the issuers.
What about the investors? We take care of them, too. However,
there are conflicts of interest between the members, the intermediaries,
and a big variety of investors.
Secondly, the concept of competition had not entered the Stockholm
Stock Exchange, nor the other European exchanges until the last
few years. Who are our competitors? Any information vendors
who have the potential of setting up execution facilities can
be tremendous competitors.
The heart of the matter is, how should an exchange be managed
and in whose interest should it be managed? The big issue is
governance. Who has the impact, the power, over the strategic
decisions of an exchange? We made a reform five years ago in
Sweden, where we changed the structure. Based on a new law that
was enacted in 1993 in Sweden, anybody would have the right
to buy and to sell shares of the exchange.
An exchange can be owned by anybody, but it must behave in
accordance with the law to offer a sound market and to protect
the integrity of the market. A new company was formed and we
invited all members and all issuers to participate in the new
issue of shares, where these shares should be freely transferable.
The company has been extremely profitable. We have increased
our own equity something like tenfold in five years. We have
distributed dividends to the shareholders at an amount which
is about three times more than what they paid for the shares.
We have cut our fees. It is quite a success story.
To satisfy the different needs of different customers in the
late 1980s, we introduced electronic order-driven trading with
an open electronic order book. Completely transparent, pre-trade,
and post-trade. The electronic trading system has also made
it possible for us to enter into international trading on our
market since the law made it possible for potential members
outside the Swedish jurisdiction to trade with us. We now have
several members trading directly out of London, Frankfurt, Zurich,
Berlin, and, of course, the Scandinavian countries. We have
completely changed the concept of the market.
When you have competition, you are going to have a lack of centralization
of orders. You are going to have fragmentation and that comes
with a cost. It comes with orders interacting with people who
do not necessarily know what is going on in the market. Where
the U.S. Securities and Exchange Commission has come to historically
is, if you are going to have the kind of competition needed
in the markets, you have to have some fundamental structures
with that. You have to have post-trade transparency (last-sale
reporting). This way, people can tell where trades are actually
taking place and can try to assess where they should be trading
and how good a deal they got.
We also need to have pre-trade transparency (some display of
quotes). If people are trying to decide where trades should
take place in the future and where they should route the orders
to, they must have some sense of what the prices are out there.
We need a best execution obligation. The people that are responsible
for sending the order flow to the various markets have a duty
to try to send an order to the best market.
The best execution interpretation is where we tried to drive
home to firms that they have this duty of trying to find the
best price. That is not just finding the quote. It also includes
searching out price improvement. The order handling rules were
a pragmatic response to a particular problem. They did not address
fully the larger question about how to encourage competition
within the current structures.
Nasdaq is a competing dealer market. For a long time, there
was relatively little price competition among those dealers.
This was because most of the uninformed order flow was locked
up through payment for order flow arrangements, internalization,
and reciprocal practices. There was no limit order competition.
There are now five recognized Electronic Communication Networks.
Our experience with the ECNs is that they do not always function
as we would like them to. Alternative trading systems are distinct
from traditional broker/dealers and require distinct oversight.
There is a question about the larger picture. How do the ECNs
fit into pre-trade, post-trade transparency? How should they
be linked? What do you do about foreign markets that are functionally
here, although their computers may be located just about anywhere?
It is all part of a seamless process that you have to address
(4) The Securities
and Exchange Commission, as a matter of policy, disclaims responsibility
for any private publications or statements by any of its employees.
The views expressed herein are those of the author and do not
necessarily reflect the views of the Commission or the authorís
colleagues on the staff of the Commission.