SEC Market Data Advisory Committee Oct. 10 Meeting Tackles Question of Transparency and Information Consolidation

November 29, 2000

Below is the FISD Summary and Analysis of the SEC Advisory Commitee on Market Information Tuesday, October 10, 2000 meeting at the Securities and Exchange Commission offices in Washington DC.

PARTICIPANTS:

• MICHAEL ATKIN Vice President, Financial Information Services Division, Software and Information Industry Association
• HAROLD S. BRADLEY Senior Vice President, Investment Management, American Century
• ROBERT G. BRITZ Group Executive Vice President, New York Stock Exchange
• ANDREW M. BROOKS Vice President, Head of Equity Trading, T. Rowe Price
• ROBERT COLBY Deputy Director, Division of Market, Regulation, SEC
• MATTHEW S. DeSALVO Managing Director, Morgan Stanley Dean Witter
• CARRIE E. DWYER General Counsel and Executive Vice President, Charles Schwab
• ROBERT H. FORNEY President and CEO, Chicago Stock Exchange
• JOEL GREENBERG Managing Director, Susquehanna Partners
• WILLIAM R. HARTS Managing Director, Salomon Smith Barney
• GEORGE K. JENNISON Senior Managing Director, Retail Equity Group, First Union Securities
• SIMON JOHNSON Sloan School of Management, Massachusetts Institute of Technology
• EDWARD J. JOYCE President and Chief Operating Officer, Chicago Board Options Exchange
• RICHARD KETCHUM President and Chief Operating Officer, National Association of Securities Dealers
• DONALD C. LANGEVOORT Georgetown University Law Center
• ARTHUR LEVITT Chairman, SEC
• BERNARD L. MADOFF Bernard L. Madoff Investment Securities
• MARK A. MINISTER President and CEO, Bridge Training
• ANNETTE L. NAZARETH Director, Division of Market Regulation, SEC
• EDWARD NICOLL Chairman and CEO, Datek Online Holdings
• KENNETH D. PASTERNAK President and CEO, Knight/Trimark Group
• GERALD D. PUTNAM Chief Executive Officer, Archipelago
• PETER QUICK President, American Stock Exchange
• ERIC D. ROITER Senior Vice President and General Counsel, Fidelity Management & Research Company
• JOEL SELIGMAN Chair/Moderator, Washington University School of Law
• DEVIN WENIG Executive Vice President of Marketing, Reuters America

Overview

According to SEC Chairman Levitt, market information is the core of price transparency and one of the pillars of the national market system. In light of the fundamental importance of market information, the Commission believes that the issues relating to the public availability of market data need to be explored in greater depth. It has given the committee a broad mandate to explore both fundamental matters, such as the benefits of price transparency and consolidated market information, and practical issues such, as the most effective methods of consolidating market data.

The June 1999 petition urging the SEC to review the CTA market data fee structure was only one inspiration for the SEC's immediate interest in this set of topics. In fact, the issue of market data fees (along with other topics such as governance and pilot programs raised in the Concept Release) was not on the agenda of the first meeting.

Rather the focus was squarely on the question of the merits of transparency and the question of should information be consolidated (and if so how). The core question was whether the current framework for consolidation in each of the three systems was (1) appropriate and in need of a series of reforms or (2) flawed and needing an entirely new model. It was also clear that this was not designed to be a theoretical discussion. The Chairman reminded all participants that we were dealing with the most effective securities markets in the world and to make sure we dwell in the appropriate level of operational detail to be sure that the recommendations are thoughtful and wise.

Legal Framework

Annette Nazareth (Director, Division of Market Regulation) gave a thorough overview the legal and statutory issues related to market data.

The Advisory Committee originated with the Commission's December 1999 Concept Release. The comments demonstrated a lack of consensus on the issues that were raised by the Concept Release, such as the fees charged for market information and the role of revenues derived from those fees in funding the SROs. There was widespread agreement that the availability of consolidated market information is an essential feature of our securities markets. It is the principal tool for providing transparency, offsetting fragmentation, and for facilitating the best execution of customers' orders. However several comments expressed fundamental concerns with the current system of consolidating and disseminating market information.

The concept of transparency (i.e. real-time public dissemination of trade and quotation information) is one of the central components of our national market system. A regulatory framework that promotes transparency helps ensure that prices across our national market system are available to all market participants and contributes to efficient price discovery and the best execution of customer orders.

This has not always been the case. Prior to the 1970s no statute or rule required market centers to disseminate market information to the public. Each market center acted individually and disseminated information on its own terms -- deciding what information to disseminate, who would be entitled to receive the information, and the amount of fees that would be charged for that information. The result that was dominant market centers with the most valuable information restricted public access to their quote information. This limited the ability of investors to know where the best prices were, and to ensure the best execution of their orders.

To address this, the Commission developed the concept of a transparent national market system in the early 1970s culminating in the restructuring of the equity markets in the United States (including the way in which market information is disseminated). It recommended that a strong central market system be created for securities of national importance in which all buying and selling interests could participate and be represented under a competitive regime. It emphasized that an essential feature of the central market system would be the availability to all investors of information on transaction prices, volume and quotes for all securities.

When Congress enacted the Securities Act amendments of 1975, it unequivocally endorsed the development of the national market system and its essential component of transparency. In particular, by adding Section 11A to the Exchange Act, Congress directed the Commission to ensure, among other things, the availability to broker-dealers and investors of quotation and transaction information in securities. Congress specifically charged the Commission with assuring that market information be available on terms that are fair and reasonable, and not unreasonably discriminatory. That's the current statutory standard.

To achieve the price transparency objective, the Commission adopted rules requiring that all market centers make their basic quotation and transaction information publicly available to investors on a real-time basis. The Commission went further and stated that consolidation of market information is also required to achieve the goals of efficient price discovery and best execution.

The SEC's Advisory Committee on Market Disclosure concluded that it was imperative for every trade in a security to be displayed on the same terminal regardless of the market center in which the transaction took place. The committee also recommended the implementation of a composite quotation system so that an investor or his broker dealer could determine at any given time where a particular transaction in a security could be effected at the most favorable price. To help achieve the goal of making consolidated market information available to all investors, the Commission, in 1972, proposed two rules under the Exchange Act that would provide for the reporting and consolidated display of quotations and transactions.

The transaction reporting rule required each exchange and the NASD to file with the Commission a plan for the dissemination of consolidated transaction information for securities traded through its facilities. The Commission expressed its intent to vigorously pursue regulatory action for the implementation of a composite quotation system. The reason was that while broker dealers were willing to expend the time and effort necessary to search out the best bid or offer for those sizeable investors whose volumes justified such expenditures, they were unlikely to perform such services for the small investors. With a composite quotation system, however, broker dealers were able to perform the same functions economically for all investors, including smaller investors. In 1974, the Commission proposed a revised rule to provide for a consolidated quotation system.

The legislative history makes it clear that the paramount objective of the national market system was the centralization of all buying and selling interest so that each investor would have the opportunity for the best possible execution of his order, regardless of where in the system it originates.

In 1978 the Commission took steps to ensure the nationwide disclosure of quotation information by adopting the quote rule. Soon afterwards the Commission approved the first consolidated quotation plan, which led to the dissemination of a single quotation stream for all exchange markets.

The Commission realized that there were significant deficiencies in the manner in which vendors were displaying market information. In 1980, the Commission adopted the display rule, which requires any vendor or broker dealer that displays quotation information for a security to display the NBBO for that security. It also requires any vendor or broker dealer that provides transaction reports for a security to display consolidated transaction information from all reporting market centers. The display rule ensures that broker dealers and customers have readily available the quotes and trades from all regulated markets, so they are fully aware of the best prices when deciding what orders to enter and where to route their orders.

The idea for our current model for disseminating and consolidating market information originated with the Commission's Advisory Committee on Market Disclosure from 1972. That report recommended a system, in which each regulated market center would collect and validate its own data and then transmit it to a central processor for sequencing. The processor would process the quotes from all participants even-handedly. The legislative history of the 1975 amendments makes clear that Congress shared the committee's view that any central processor of market information be neutral.

Any exclusive processor of market information, in effect, would be like a public utility, and must function in a manner that is absolutely neutral with respect to all market participants. Section 11A granted the Commission broad powers over any exclusive processor of market information in order to assure, among other things, the processor's neutrality and the reasonableness of its charges.

NYSE Seeks to Withdraw from CTA

NYSE's presentation began with them continuing to question the need for the Consolidated Tape Association. Mr. Britz informed the Committee that the NYSE Board has authorized them to withdraw from the CTA and they are actively pursuing that withdraw subject to regulatory approval. The underlying reasons behind NYSE's interest in withdrawing from CTA were not fully articulated. I suspect there are four primary reasons:

1. The governance structure of CTA (one vote per participant, majority rule for most actions but unanimous approval for some actions) is overly restrictive on NYSE innovation.
    
2. CT/CQ revenues are distributed along the lines of market share of trades rather than to market share of volume. NYSE is likely under the belief that the other participants aren't contributing value equal to revenue. I also suspect that the burden of revenue sharing among CTA participants would also be a negative as NYSE seeks to craft linkage relationships such as GEM.
    
3. NYSE is in competition with the other exchanges. Continuing to participate in CTA will require NYSE to continue share its business plans with its competitors. That's not necessarily how a soon-to-be demutalized, for-profit exchange would want to operate.
    
4. Technology has evolved to a point where CTA is no longer needed to facilitate the collection and consolidation of data. In essence, NYSE believes it has become unnecessary.

Whatever the outcome, there seemed to be complete agreement among the participants that revenue-sharing by static formula and that single-veto voting structures are unworkable and must be fundamentally changed. NYSE is scheduled to present its operational plan for withdrawing from CTA at the next meeting. It will be interesting to find out the answers to a couple of core questions such as: (1) Are there other motivations, besides those above, underlying the request for withdraw? (2) Are the motivations legitimate? (3) Will NYSE withdraw have a negative impact on the objectives of the Commission for transparency and protection of the individual investor? (4) Are there any possible unintentional negative implications that could/should worry vendors, user firms or the Commission? (5) If so, and if they are legitimate concerns, what can be done to mitigate the unintentional negatives?

NYSE also announced that investors will soon be able to navigate through a virtual trading floor to the point of sale in any individual stock to view the level of trading activity, view the limit order book and make online queries of the NYSE order database.

Rave Reviews for Nasdaq's Super-Montage

The NASDAQ/UTP plan stems out of the desire of exchanges to begin trading NASDAQ securities. The participants include the Boston Stock Exchange Chicago Stock Exchange, Cincinnati Stock Exchange, Nasdaq Stock Market, Pacific Stock Exchange, and Philadelphia Stock Exchange. The revenue distribution plan is calculated as a blend of share and dollar volume (with a floor and a cap), as opposed to trades. The voting structure looks like the CTA plan. While many votes are majority basis, there are areas that require unanimous vote. NASDAQ operates as the plan processor.

The NASDAQ's proposal to create a Super-montage display was supported by virtually everyone. The Super-montage involves a consolidation of all NASDAQ quote information as well as any other exchange information and provides the ability to know what people are interested in buying or selling to the extent they voluntarily provide it away from the best bid and the best offer.

Transparency and Consolidation

Most of the discussion among the committee participants centered around the two fundamental questions posed by Professor Seligman:

1. Should we continue to have a transparent system where relevant market information is available to all individuals on terms that are fair, reasonable and non-discriminatory?
    
2. What is the mechanism by which information is conveyed (i.e. should we retain the current systems of consolidation?

Without exception, everyone agreed that transparency and consolidation are critical to the integrity of the market. There was also agreement that the means of processing the data should be done in the most neutral, efficient and economical way possible. There was some minor praise for SIAC and a general feeling that competition among security information processors could be encouraged.

There was a significant amount of debate about transparency. The keys to the discussion were (1) the definition of transparency, (2) the importance of actionable data, (3) the benefits of information competition, and (4) the capacity problems stemming from decimalization (along with other factors).

The Definition of Transparency

It was clear from the discussion that transparency is about a view of the world. That view is based on how the dynamics of the market are presented to an investor. For example, transparency means something different to an individual investor looking at their account on the web at 8:00 in the evening, then to a hedge fund running a proprietary-trading model at 8:30 in the morning. Transparency is not about shipping around large amounts of useless data. It's about getting close to the market and competing on providing the best view of the world.

One clear opinion was that the value of transparency must be measured against ability to assimilate the data, make investment decisions and execute trades. Information is not scarce. Useful information is scarce. Ultimately, information without being able to produce an actual event is viewed to be of minimal value.

As a general principle, markets, price discovery and the investing public are best served when you have the maximum confluence of orders interacting. There is a dilemma between execution and transparency that occurs as people try to siphon off order flow and match it up with orders held in closed systems. And, of course, not everyone wants complete transparency. Large institutional investors don't want to expose all their buying and selling interest because indications of interest alone can move the market. Transparency is great when the customer wants it, but many want anonymity and everyone wants asymmetry of transparency (i.e. I can see what you're doing, but you can't see what I'm doing).

Are Mandated Levels of Transparency Required?

There was a significant amount of discussion about whether there should be mandated levels of transparency. It was generally accepted that the national best bid/offer (NBBO) --- as well as any other bid/offer that investors are prepared to expose in an inter-market system -- of quotes and real-time dissemination of last sale is a minimum (and is still useful even in a decimal environment). But clearly, transparency should go beyond the NBBO. There seemed to be agreement that the NBBO plus the limit order book (greater depth of liquidity to reflect the actual buying/selling interest) was going to be critical.

Overall, participants were not supportive of mandated levels of transparency. In fact, there was an overwhelming demand for unrestricted competition to determine the information that is most useful to the investment community. Most participants felt that the industry should be able to compete from a transparency standpoint (and be able to charge for their data) without restrictions. The general opinion was that while some minimum baseline of information could be established, mandated levels of transparency were unnecessary because the marketplace itself will demand that market participants reveal multiple levels of liquidity.

The final point the belief that the SEC has already indirectly mandated transparency through the order handling rules. It was pointed out that because of the order handling rules, it might not be required to even mandate consolidation of the best quote. The hypothesis suggests that since the Commission has mandated order handler to give the best price that's available, an order handler will have to consolidate the information themselves in order to fulfill their statutory obligation.

Level Playing Field is Essential

While the general feeling was that participants should be able to compete from a transparency standpoint, one clear message that shouldn't be lost is the concept of a level playing field -- where everyone can see the same amount of information -- under the same terms and conditions.

For example, if one exchange decides that the only price it's going to show to any participant on that exchange is just the bid and offer -- then no one should get to see more. However, if that exchange has a specialist or market maker that feels it's in their competitive advantage to display more information (i.e. indications of interest or the entire depth of book) they should be allowed to do so as long as that same level of information is exposed to the entire marketplace.

Capacity Has a Big Impact on Transparency

Capacity was a huge issue of discussion. And while, Professor Seligman limited most of the discussion to the equities markets, it was frequently noted that seventy percent of the data is options related. Decimalization, and particularly penny increments, was clearly cited as the number one driver of the problem. But it was pointed out that capacity is further compounded with auto-quoting and multiple listings. The increasing number of automatic execution systems -- with instantaneous information being displayed on all system -- were also cited as contributing factors.

The key conclusion was that decreased depth of the inside quote, quotations that change multiple times per second, massive updates that create a blur on the screen, and the limited snapshot of the current quote are not useful to investors. It was also clear that simply adding capacity is not the solution. Increased transparency and decimalization carry a cost and are forcing many vendors to unbundle [OPRA] data and process it on a per-demand basis.

From the vendor perspective, flexibility to determine what information is relevant, is the ideal. There seems to be a strong undercurrent of support for the notion of abbreviation, summarization and selectivity. The value proposition for the vendor is more about competition and about enabling market participants to have the flexibility to provide alternative data views, rather than mandating a set of information or a specific type of consolidation that may not equally fit all segments of the market.

The other side of the capacity issue is the fact that there is a lot of information disseminated by the plans that is less than useful. There are a variety of prices that are so far away from the market as to be unhelpful. There are a variety of other prices that reflect auto-quoted prices on secondary markets for a small number of shares (usually 100 shares) that are timed and designed to move away from the market as soon as the market price reaches that point. That situation generates a tremendous percentage of the total quotations that the plan processors have to handle and that the vendors have to pass through. On an option side it's even more complicated. The key point was the belief that the marketplaces are putting out a lot of information that is being literally ignored.

One additional point for consideration is the importance of understanding the capacity and ability of the vendors to accurately disseminate market data -- particularly as it relates to decimalization. The question was raised that if the vendors can't process the data in a decimal environment, should the Commission consider minimal increments? The clear feeling was that we shouldn't jeopardize the market structure simply to disseminate penny increments.