Commentary: Sec Regulation That Doesn't Choke Innovationby
With little fanfare, the Securities & Exchange Commission on Apr. 20 unfurled a new proposal that could revolutionize stock trading. The agency that stifled experimentation for decades with its viselike grip on markets voted 4 to 0 to get out of the way of new electronic trading systems. The SEC will allow the systems to exist with minimal oversight, and will let the market decide which ones do the best job of matching buyers and sellers at the lowest cost. That took soul-searching, but with this rule, the agency has found the right mix of regulation to protect investors on the one hand, and encourage innovation on the other.
The SEC is proposing that alternative trading systems can choose to be regulated either as an exchange or a broker-dealer. Among them, Reuters Holdings PLC's Instinet is the oldest and largest, but Bloomberg's Tradebook and 48 others now compete against it. The rule means that Bill Gates, for example, could forsake the NASDAQ stock market and opt to use his own network to trade Microsoft Corp. shares as long as he pays a self-regulatory organization, such as the National Association of Securities Dealers, to monitor his market to prevent investor fraud. He also must maintain an audit trail so regulators can review individual trades that look suspicious.
Experts say that, in many cases, new systems could be up and running within 24 hours. Already, the 50 alternate systems operating today are double the number of a year ago. They account for 20% of NASDAQ and 5% of New York Stock Exchange trades. "This is a very dramatic change for the SEC," says Richard R. Lindsey, director of the agency's market regulation division. "We are encouraging innovation, which will increase competition. And if there's more competition, we don't really need to regulate as much." He previews new trading systems at least once a week.
OVERNIGHT O.K. But the SEC is not letting go entirely. To guard against fragmentation of the national market system, an electronic trading system handling 10% of the volume of a stock must display its orders for that stock on a traditional exchange, such as NASDAQ or the NYSE. And to protect the overall market from disruptions that may be caused by one large electronic system's outage, large-volume electronic exchanges must meet certain standards for capacity and system failure.
There's even something for traditional exchanges in the proposal. The SEC is giving the NYSE, NASDAQ, and other traditional exchanges a two-year exemption from certain filing rules. That gives them the freedom to experiment--without tipping off their competitors to their new mousetraps.
The entrepreneurs creating these electronic exchanges are elated. Fredric Rittereiser, chief executive of Philadelphia-based Ashton Technology Group Inc., says that the rules "will accelerate all the trading systems on our drawing board," including one that will electronically trade equity options. Under the old regulatory framework, Ashton is awaiting SEC approval to operate a new trading system for index funds as an affiliate of the Philadelphia Stock Exchange. Says Rittereiser: "I could apply to the SEC and get an O.K. overnight."
Until now, most new electronic systems failed even before they left the drawing board, but not because they weren't designed properly. They lacked that essential ingredient--liquidity--which is the measure of how much buying and selling interest there is in a stock. By encouraging new trading systems that threaten the business of established exchanges and Wall Street investment banks, but at the same time requiring everyone to display their orders in one place, "the commission is saying that liquidity belongs to the public," says Kevin Foley, manager of electronic trading at Bloomberg. That's a bold statement for what was once a hidebound agency.