“Searching for a New Center: U.S. Securities Markets in Transition

1. “Searching for a New Center: U.S. Securities Markets in Transition Maureen O’Hara Cornell University Prepared for The Financial Markets Conference Federal Reserve Bank of Atlanta April 2004

2. “Things fall apart; the center cannot hold” Very difficult times for U.S. Equities Markets • The traditional markets are besieged. • Competition now involves new dimensions: execution speed, liquidity rebates, tape revenue rebates…. • Decimalization has changed pricing practices, while technology has rendered linkages problematic. • Even ownership of markets is changing, with Nasdaq (and the CME) publicly traded, and Philadelphia and ArcaEx headed that way.

3. The Evolving Structure of Markets The traditional market structure, which was the foundation of the NMS, envisioned: • A dominant exchange competing via market linkages with smaller regional exchanges • A single dealer market operating under the auspices of the NASD • Self-regulation undertaken by the cooperatively-run exchanges and the member-owned NASD. • Market structure is now vastly different The search for a new center beckons

4. The SEC and Regulation NMS • The SEC has a four-part proposal for changes to the current NMS. • I will argue that these changes do not go far enough. • Some important omissions – the future of self-regulation? • Piecemeal changes What is needed is a a new vision, one more consistent with the market structure of today’s markets.

5. What I will do in this talk • Discuss Old Visions and New Realities • Analyze three structural issues • How should markets compete? • How should markets be linked? • How should markets be regulated? • Offer some conclusions on market regulation, Reg NMS, and the “new center”.

6. Old Visions – New Realities • Establishment of the National Market System • Goals • How to link it all together? • CLOB vs ITS • Trade-through rules • But times have changed…… • Technology and the rise of ECNs • Are all orders to be treated equally? • Private ownership of trading venues • How to regulate corporate entities?

7. How should markets compete? • Priority rules – what determines who is first? • Price priority within markets and across markets • Speed of execution versus strict price priority • Regulation NMS retains and expands price priority, but • An automated or fast market can trade through a better price on a non-automated market • A trader can opt out of price priority for a specific trade • The good, the bad, and the ugly ……..

8. How should markets compete? • Tape revenue • The NMS allowed for trade data to be sold and the revenue shared amongst the SROs • New reality is competition over tape revenue • Reg NMS proposes a new sharing rule based on both trades and quotes • What activity is tape revenue intended to reward? • Should the data be sold at all? • Pennies, sub-pennies, and limit orders • Reg NMS bans sub-pennies • Flickering quotes?

9. How should markets be linked? • Access fees • ITS did not allow explicit access fees for sending or receiving orders. • ECNs work off of a different business model • Explicit access fees, not bid-ask spreads • Rebates for liquidity providers • Reg ATS – large ECNs must display quotes/ provide access • quote montage and best execution • Reg NMS allows access fees but sets a price ceiling • Anti-competitive? Why not let market set fees?

10. How should markets be linked? • Who can access markets? Nasdaq issue • Hard-wired ITS approach • Reg NMS requires market centers to make their quotations accessible to all market participants “on terms as favorable as its most preferred members” • Imposes direct access obligations • Indirect linkages through a member, customer or subscriber What does this imply for seat prices?

11. How should markets be regulated? • The U.S. model: Self-regulation • SROs and the “shotgun behind the door” • Recurring problems – NYSE, Nasdaq, Amex…. • The new reality – corporate exchanges and markets • Eight of the world’s 10 largest exchanges publicly traded • Stockholm Stock Exchange owned by OM • U.S. exchanges and markets will follow suit How to regulate in a world of corporate ownership?

12. Regulatory Solutions: Global Context • Government regulation • London Stock Exchange – regulatory authority transferred to the FSA • Deutche Borse – regulated by ESA • Stockholm Exchange – regulated by FI • Industry-run SRO • Toronto Stock Exchange regulated by Market Regulation Services, a national not-for-profit jointly owned by TSE and Investment Dealers Association of Canada • Self-regulation • Euronext has a two-tiered governance structure with a Supervisory Board and a Managing Board

13. Regulatory Alternatives: U.S. markets • Super-regulator • Do we want the dramatic expansion of government? • Industry-sponsored SRO • Is regulation a competitive dimension for markets? • Enhanced self-regulation • Can profit-seeking firms be trusted to regulate themselves?

14. Conclusions • Challenges confronting markets and regulators are substantial. • Reg NMS may bring improvements, but it is an incremental approach, retaining the basic structure of the NMS • What should the markets sort out and what should the regulators do?

15. A new vision • The NMS was crafted to deal with a world of dominant markets interacting with smaller competitors • Regulation needed at market level • New market structure is technology driven, often fragmented but highly competitive. • Competitive forces can handle market problems; regulation needed at firm level.

16. “The best lack all conviction, while the worst are full of passionate intensity” Dual perils of indecision and haste can equally undermine the prospects for success. The most important element to finding a new center may be the courage to make the necessary changes.