Remarks at the STA Annual Conference
President, NASD Regulation, Inc.
Boca Raton, Florida
Good morning, and thanks very much for inviting us to speak with you. In the past, I might have made a joke along the lines of ‘thanks for inviting me to place my head in the lion’s mouth,’ but in the years that have passed the relationship between the trading community and NASDR has gotten, well, a little boring.
In fact, one major development I would like to discuss, the separation of NASD and Nasdaq, should only contribute to our good relations. In addition, in the limited time we have, I would like to update you on significant developments in the OTC Bulletin Board market and give you some insights into our thinking about current market issues. Steve and Tom and I would be happy to answer questions on any area of regulation of interest to you but, we will leave all of the prognostication about the future of the SuperMontage to our colleagues from Nasdaq who are joining you tomorrow.
The trading community often has articulated a concern that the market and the regulator should not be the same entity. And although I have been comfortable with the arrangement that greeted me when I arrived at the NASD 4½ years ago, with Nasdaq and NASDR being separate subsidiaries, the market has changed dramatically during that period. A variety of developments, both technological and regulatory, really have made defining the concept of "market" more difficult. And with that, the possibilities that the market and its members could be in genuine competition has become more reality and less fantasy. So, the benefits to Nasdaq of it spinning off aside, we at the NASDR strongly believe that it is a positive development for the regulator as well.
What does it mean to be an independent regulator, separate from Nasdaq? It means still, a fully independent staff and Board of Directors will continue to drive policymaking, but the NASD Board will no longer have to reconcile the interests of Nasdaq with NASDR. It will still reconcile the interests of Amex, the remaining market within NASD, but that is an issue of lesser significance, since NASDR does not regulate the activity of Amex and its members.
Being an independent regulator means that we have formalized our relationship with Nasdaq through a detailed, carefully negotiated multi-year contract to provide regulatory services to Nasdaq, which reinforces the arms-length nature of our relationship. The important part here, though, is making sure that the contractual distance does not lead to substantive distance. To regulate conduct on the market effectively, we must understand the markets intimately. That was the central benefit of our close structural relationship with Nasdaq and, in fact, one of the strengths of self-regulation, generally. We have been there during the formulation of policy, the implementation of market structure changes, and the recognition of new trading strategies and issues. We are keenly aware of the importance of this proximity to being an effective regulator, and are developing processes to ensure that we do not lose this benefit of self-regulation.
Being a separate regulator means that we can pursue other regulatory relationships with increased vigor. As most of you know, when the SEC approved Reg ATS, it opened the door for non-traditional markets to become exchanges. It, likewise, made it possible for exchanges to contract away some or all of their regulatory responsibilities to third parties. Along with Nasdaq, we currently have just such an arrangement with the International Securities Exchange. The ISE is the first new exchange in nearly 30 years, and we perform some of their regulation pursuant to contract, while they internalize the rest. I do believe that our clearly independent status makes market participants feel more comfortable in choosing to do business with us.
And finally, being an independent regulator may move the single regulator debate ever so slightly forward. Or it may not, because there are a number of forces beyond our control and it continues not to be one of our highest priorities. But if we demonstrate that we can effectively monitor markets with which we are unaffiliated, we may prove that there are benefits and savings readily available with the single SRO structure and no attendant costs.
As I just said, the markets and the regulator need to remain closely aligned if the market is to be fair and the regulator efficient. Our recent joint efforts to adjust to dramatic change in the Bulletin Board is an example of this, and I am confident that the approaches and actions would be the same if Nasdaq and NASDR were in different companies.
Although the OTCBB, currently, is operated by the Nasdaq, as you know it is not a listed market at this time. Instead, the OTCBB is a quotation medium for subscribing NASD members. The market does not maintain a relationship with quoted issuers or impose quantitative listing standards as Nasdaq does. Also, the OTCBB has different quotation obligations than Nasdaq and does not currently provide a method for automated trade executions and only a limited automated order delivery mechanism.
Over the past several years, the OTCBB has evolved considerably. While the prices in OTCBB securities have remained relatively low, the share volume has increased more than ten-fold from 1994. In 1999, the average daily volume on the OTCBB had grown to more than 300 million shares and trading volume in February 2000 averaged more than 1.2 billion shares per day. By comparison, during the same month, Nasdaq averaged over 1.8 billion shares per day, while the New York Stock Exchange averaged 1.06 billion share per day. This activity on the OTCBB can be attributed to increased participation by individual investors, online trading, and a proliferation of stock information provided through the Internet, trends that can be good and scary at the same time.
In short, the OCTBB is far different today than it was at its inception years ago. Such activity and investor interest demands market structure and regulatory attention. As a result, Nasdaq and NASD, together and individually, recently have moved forward with several policy initiatives, some of which are still in the proposal stage, that affect member and investor trading on the OTCBB. Looking to the future, there are two profound changes you will likely see. The first is to make the OTCBB a listed market. The listing standards will be designed to provide an opportunity for the greatest number of current OTCBB issuers to continue to trade in the new listed environment, while offering qualitative standards to provide enhanced investor protection. The current thinking is not to impose any quantitative or minimum share price standards. In addition to the benefits to investors of certain minimum qualitative standards, this should provide the market with meaningful trading halt authority, something it has long lacked due to the lack of a contractual relationship between it and the issuers on the Bulletin Board.
The second, equally significant, is progress toward the development of an order delivery mechanism along the lines of SelectNet. I personally have heard from many of you in this room about the need for just such a system. Anyone trying to trade the more liquid Bulletin Board stocks, especially during times of volatility or during periods like we saw last winter when volume really skyrocketed, knows how ineffective the combination of telephones and limited proprietary systems can be. In addition to making posted quotes reachable on a consistent basis, such a system should make other market structure developments and improvements possible, like a locked and crossed market rule, and a broader, more contemporaneous limit order protection rule.
Finally, last week, the NASD Board approved the creation of a repository of Form 211 filings that would be accessible to the public via the Internet. By way of background, SEC Rule 15c2-11 requires that a firm review and retain certain documents and information regarding non-listed, non-Nasdaq issuers that the firm intends to quote in a quotation medium. Firms demonstrate compliance with the SEC Rule by filing a Form 211 with the NASD.
The database operated by NASDR would provide the Form 211 for reporting and non-reporting companies and also would include certain financial information for non-reporting companies where such information would not otherwise be available through EDGAR or via a banking or insurance regulator. We believe that by making the Form 211 information easily accessible, investors and other market participants will at least have a starting point in learning more about issuers quoted on the over-the-counter market, where previously there had been little or no public information available. However, there clearly are limitations on the value of the information that will be available via the Form 211 database and we intend to emphasize to users of the information that the NASD is not the source of this information and has not reviewed or verified the information to ensure its accuracy.
These three proposals, although each in the developmental stage, will dramatically alter the nature, and hopefully safety and efficiency, of the investor-Bulletin Board experience. Taken as a whole, they demonstrate that initiatives already undertaken by NASD, such as the Eligibility Rule, the Limit Order Protection Pilot, amendments to the Three Quote Rule, and limited trading halt authority, while helpful, were really building blocks toward more significant changes.
Let me update you briefly on additional changes to the Three Quote Rule. As you know, prior to the SEC approval of amendments last month, the Three Quote Rule required members executing customer transactions in non-Nasdaq securities to contact a minimum of three dealers and obtain quotations in determining the best inter-dealer market. The intent of the Three Quote Rule is to create a standard to help ensure that members fulfill their best execution responsibilities to customers in non-Nasdaq securities, particularly in transactions involving relatively illiquid securities with non-transparent prices. The Three Quote Rule is a minimum standard, and compliance with the rule, in and of itself, does not necessarily mean a member has met its best execution obligations.
With the significant increases in volume in the OTC markets, members have raised concerns about the ability to reach market makers during the trading day and have indicated that the price of the security could change significantly while the firm is attempting to contact additional market makers to comply with the Three Quote Rule. Members had indicated that compliance with the Three Quote Rule could in fact hinder best execution rather than furthering it, where contacting additional dealers would not necessarily provide additional price discovery information, while delaying executions.
Effective in mid-November, the amendments eliminate the requirement that members contact and obtain quotations from three dealers, if two or more priced quotations are displayed in an inter-dealer quotation system that permits quotation updates on a real-time basis (such as the OTCBB or the Electronic Pink Sheets). This is a reflection of the informational value of two transparent, firm quotes in terms of obtaining best execution for customers as compared to three telephone quotes.
Members will also be relieved of certain recordkeeping burdens where NASD Regulation can validate and confirm compliance with applicable requirements directly through its internal historical data.
In addition, the NASDR Board last week approved a proposal to eliminate the Three Quote requirements when trading foreign stocks when the home, price discovery market is open and prices there can be verified.
In the few remaining moments, I thought I would identify some of the issues we will focus on in the coming months:
First, the focus on member firm order routing decisions and the search for price improvement opportunities. New alternatives, whether Nasdaq-sponsored or not, may provide more opportunities for public investors to obtain better executions and underscores the requirement that a firm conduct a regular and rigorous review of its customer orders for execution quality.
Second, the effects of decimalization on the best execution of customer orders. Regulators will have to scrutinize closely any efforts of member firms to trade ahead of customer orders.
Third, enforcement of the OATS Rules is critical to ensure that NASDR receives accurate information for use in its automated surveillance and examination programs. As OATS is more fully implemented, the NASDR will use this information to review more areas through the use of automated surveillance and reduce our reliance on sampling and examinations. This information will also serve as a fundamental part of the NASDR’s preventive compliance efforts by alerting member firms to potential compliance problem areas prior to an examination or the implementation of disciplinary action.
Finally, NASDR will continue to scrutinize closely trading and quoting activity at the opening and closing of the market. This focus will ensure that within the current market structure, not only are customers receiving best execution but that member firms are complying with all trading and market making rules.
I know this is a bit of a whirlwind tour of current regulatory initiatives, we are of course happy to take your questions here—and always available to you at the office. Thank you