By Amy Borrus
Back in 1975, Congress ordered the Securities & Exchange Commission to link all of the nation's stock markets into one seamless trading system. The goal: Make sure that an investor in Boise, Idaho, has the same shot at getting the best price for a stock as a trader on the New York Stock Exchange floor. But the promise of a "national market system" has never panned out -- in large part because the NYSE has used its enormous clout to keep trades captive in its own system.
Now, trading and governance scandals at the Big Board have put it on the ropes -- and the SEC is seizing the opportunity to put investors' interests ahead of the exchange's. On Feb. 24, the agency unveiled a raft of initiatives aimed at modernizing the markets and leveling the playing field for competing stock-trading systems.
Good for investors? It should be. But SEC Chairman William H. Donaldson will have to tread carefully. His plan to prod the NYSE to open up could backfire, undermining a level playing field if the changes are implemented correctly.
The core of the SEC's reform is an overhaul of stock-handling rules. Currently, every market trading stocks listed on the Big Board -- such as regional exchanges or electronic communications networks (ECNs) -- must get orders to buy or sell at the best price, even if that means sending the order to another market.
Often, the best prices are on the NYSE. But the Big Board's floor traders are slow. Rivals, especially traders for big institutions, say prices often become more favorable elsewhere while they're waiting for New York to complete a trade. Also, some ECNs charge that the NYSE refuses to send orders to other markets with better stock prices. The net result of this "trade-through" rule: The NYSE still commands 80% of trades in its stocks.
Rather than ditch the rule, the SEC wants to reform it. "Fast" markets -- those that execute trades automatically -- would have to honor one another's best prices. But a fast market could bypass a better price on a "slow" nonautomated market as long as the investor gets a price within 1 cent to 5 cents of the best available.
That would put ECNs on a more competitive footing, the theory goes, while placing the onus on the NYSE to modernize so it can be deemed a "fast" market. By not eliminating the rule altogether, as ECNs want, the SEC preserves the long-cherished principle that best prices should be encouraged and rewarded. "These rules go a long way toward making [the NYSE] realize that if it doesn't compete, it will die," says Harold S. Bradley, a chief investment officer at American Century Investments, a global asset-management firm in Kansas City.
Electronic competitors aren't yet convinced, however. They worry that the NYSE, which has announced plans to improve its automated execution, will once again build a one-way street that routes orders onto the Big Board -- but never lets any out. Before giving the NYSE fast-market designation, the SEC must "hold the NYSE's feet to the fire to ensure they are as good at reaching out to other markets as they are at executing orders internally," says Joseph C. Lombard, president of Wave Securities, a unit of Archipelago Holdings, which is also parent of the Archipelago exchange that competes with the Big Board.
SPRINGING A LIQUIDITY LEAK?
Donaldson wants the SEC to consider letting investors "opt out" of the best-price rule by instructing brokers to put speed ahead of price on an order-by-order basis. This provision would give institutional investors another way to move trades away from the Big Board if reforms there fall short.
Here's the rub with this opt-out approach, however: Some institutions worry that such a provision would curtail the amount of trading interest, or liquidity, by discouraging limit orders, which are orders to buy or sell a stock at a specified price. "If we create disincentives for limit orders, then in five years, we may say, 'Where did all the liquidity go?'" says Gus Sauter, Vanguard Group's chief investment officer.
The SEC still must fine-tune its proposals, but at least it's moving in the right direction. Strong incentives for the NYSE to become a faster, more open market -- backed by the threat of an opt-out for big investors -- can only get U.S. investors closer to their long-cherished dream of a true national market.
Borrus covers financial regulation from BusinessWeek's Washington bureau
Edited by Douglas Harbrecht