The issues that confront the Securities and Exchange Commission (SEC) and the U.S. equity markets are highly complex and while the SEC has not set a timetable to resolve these issues, Venkatesh Panchapagesan, Ph.D., a professor of finance at the Olin School of Business at Washington University in St. Louis, says that speedy resolution is imperative for the survival of many markets. In a recent paper, excerpted below, Panchapagesan suggests that markets must evolve, and regulators must provide an environment in which the fittest survive. Other markets could, and should, learn from the U.S. experience, he says, as the pressing issues transcend national boundaries.
Regulatory Challenges Facing U.S. Equity MarketsBy Venkatesh Panchapagesan
It is the best of times; it is the worst of times for investors in the stock market. We are in the midst of the longest economic slump since the Great Depression and are at war with Iraq. Corporate scandals routinely top our news stories, and we can no longer rely on accountants and analysts to present an impartial picture of the workings inside corporations. Yet, despite the gloom, investors who trade securities in U.S. markets have never had it better.
The U.S. equity markets still remain the most active in the world. Investors traded more than 3 billion shares, or roughly $67 billion daily, as recently as in November 2002. Technology has brought the markets within a click of a mouse to ordinary investors who once were dependent on more costly intermediaries.
Investors can now trade round the clock from anywhere in the world. Transaction costs and commissions have plummeted, and stocks now trade and quote in pennies and sometimes sub-pennies.
Though most stocks continue to be listed in the nation’s two primary markets – the New York Stock Exchange (NYSE) and the Nasdaq Stock Market – investors have a choice of trading them in an impressive set of locations, some of which are electronic and some that depend on human interaction. Investors can also evaluate the quality of their executions vis-à-vis executions in other market centers, and be privy to any private deals entered into by their brokers. These scenarios were unimaginable a few years ago and could not have happened without a regulatory environment keen on promoting competition and innovation. The U.S. Securities and Exchange Commission (SEC) has intervened repeatedly to allow newer trading systems to compete with more traditional markets, to strike down rules that favor one set of participants over another, and to arm investors with more information on what goes on behind the doors of investment houses.
Though these measures have had the intended consequence of leveling the playing field, they also produced unintended consequences that now threaten the structure and stability of the U.S. equity markets. The SEC recently held public meetings to solicit ideas and opinions from regulators, market participants, and academics who examined issues involving regulation, market integration, and the organization of exchanges.
Under the SEC’s oversight, Self Regulatory Organizations (SROs) regulate trading in U.S. equities. The New York Stock Exchange, the National Association of Securities Dealers (NASD), and regional stock exchanges such as the Cincinnati Stock Exchange set and enforce rules that regulate their members. These rules, though unique to each SRO, must complement the nation’s securities laws and the various directives issued by the SEC over time. However, it is the cost of market regulation, especially of Nasdaq, that has become contentious in recent times. SROs recover market regulation costs from the various market centers that report trades in their listed stocks. These market centers are able to pay these costs from tape revenues – revenues from selling real-time trade and quote information in their market to the public.
Historically, Nasdaq dominated trading in its listed securities and paid all of the cost of regulating its market.* Recent competitive trends have reduced Nasdaq’s market share to around 85 percent because some market participants have chosen to print their trades in other markets. Given its fixed nature, it is unlikely that cost of regulation would have declined to offset the loss in Nasdaq’s share of the tape revenue. While Nasdaq’s competitors have lower cost structures, it is not obvious whether their lower cost is derived through efficiency gains or through less stringent regulatory environment.
Increased competition for trading volume has also diminished the effectiveness of market regulation. It is difficult to monitor trading in a stock if the stock trades in multiple markets with different SROs such that each SRO has access to only a part of the audit trail. Moreover, it is possible for some market centers to dilute their regulatory structure to enhance their competitive advantage, wreaking havoc in the marketplace as a whole. Recently some market centers have explicitly started competing for trading volume with a promise to share most of the tape revenues with participants who generate the volume. To prevent regulatory lapses in the future, the SEC has started discussion on the overhaul of the current regulatory system. Possible solutions include establishing a single regulatory body for all stocks and inviting multiple parties to compete on price and regulation quality for the business of regulating the markets.
Market Integration Issues
When securities trade in multiple markets, there must be a mechanism that links these markets so as to ensure that investors get the best price, among all market centers, for their orders. The Intermarket Trading System, or ITS, was promoted by the SEC to provide that link for trading in NYSE-listed stocks. It was designed to lower the possibility that one market could trade through another market’s superior price. Markets that quote an inferior price should either match the superior price or route their orders to the market that quotes the superior price.
For Nasdaq-listed stocks, there is no such organized link, and the responsibility for ensuring best execution is left, rather vaguely, to the brokers who receive investor orders.** Market centers that trade Nasdaq stocks have the choice to create their own bilateral and multilateral private linkages to ensure that orders received by them get the best possible price. Without an SEC mandate, dominant markets are less likely to initiate linkages with less dominant markets. For example, some electronic markets (ECNs), such as Instinet and Island, have chosen not to participate in Nasdaq’s new proprietary trading system, called SuperMontage. Without a universal linkage, it is impossible to determine whether investors get the best execution for their orders.***
Other issues in market integration persist. First, some markets are based on floor trading, and therefore by design, are slower than electronic markets. Integrating faster markets with slower ones is problematic. Do we hasten the response time of the slower market or slow down the faster market to synch with the slower market? Second, integration becomes difficult if the faster market accommodates automatic execution and the slower market does not. Third, the price grids adopted by ECNs are finer than those adopted by the traditional markets such as the NYSE and the Nasdaq. While the latter trade in pennies, the former often trade in sub-pennies. Inferior-priced orders in these traditional markets may, therefore, trade ahead of superior-priced orders in the ECNs.
Yet another issue—that of access fees charged by some market participants—has become problematic. Some market participants, such as the ECNs, charge a fee to traders to access liquidity in their system. These access fees are usually charged separately and are not included in the best price that comes from that market center. It is possible that in a linked marketplace, some traders may access ECNs for a best price even when they are not subscribers or do not want to pay its access fees.
The Nasdaq stock market is the first U.S. equity market to become a publicly traded company. Other markets such as the NYSE have similar plans as well though not in the immediate future and not without great deliberation. Can publicly traded stock markets be run as for-profit entities? What is the role and responsibility of owners and users of such markets? Can profit motive dilute regulatory responsibility of these markets? Would smaller players have any say in the decision making of these entities?
Along with its decision to go public, the Nasdaq market applied to become an exchange as defined in the Securities and Exchange Act of 1934. By becoming an exchange, it hopes to retain data revenues from its market activity and to compete effectively with other electronic marketplaces. However, a large proportion of its trades are internalized -the buy and sell orders are squared off internally within a member’s system before they reach the market at large – and run counter to the spirit of an exchange as defined in the 1934 Act. Other traditional exchanges such as the NYSE oppose any dilution of the original standards that may favor Nasdaq. Moreover, a precedent such as this could allow other exchanges to allow internalization, resulting in lesser interaction among public orders.
The issues that confront the SEC and the U.S. equity markets are highly complex. While the SEC has not set a timetable to resolve these issues, it is clear that speedy resolution is imperative for the survival of many markets. Markets must evolve, and regulators must provide an environment in which the fittest survive. Other markets could, and should, learn from the U.S. experience as the pressing issues transcend national boundaries.
*This represents Nasdaq’s share of tape revenues in the latter part of 2002 and not the revenues it derives from its proprietary trading systems.
**It should be noted that trading interest across different venues are still consolidated in the Nasdaq quote montage though linkages to route orders to a preferred venue are voluntary.
*** To ease determination of best execution, the SEC has mandated market centers to report summary statistics on their speed and quality of executions, and brokers to report their order-routing practices. These reports are commonly called Rule 11Ac1-5 and Rule 11Ac1-6 reports.
I thank Jeff Smith at Nasdaq for his comments on this manuscript as well as for the numerous discussions on the issues faced by the US equity markets. This article borrows on an earlier work of mine for the Institute of Chartered Financial Analysts of India.
Venkatesh Panchapagesan, assistant professor of finance at Olin, is on a one-year assignment as visiting academic fellow at Nasdaq. His research focuses on the competition among security markets and on the design of trading systems. At Nasdaq, he works on projects that concern financially distressed firms and the markets in which they trade.