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December 1, 1998

A Plea for Less Market Regulation: What Is an Exchange? The Automation, Management, and Regulatio

By Brandon Becker

In arriving at this position, it is important to reiterate that Lee is not saying transparency is bad. His argument is that in view of the inconclusive economics literature concerning the benefits and costs of transparency, the marketplace not the government should determine the appropriate balance. Nevertheless, Lee does believe that in particular circumstances there in fact is a trade-off between greater "efficiency and liquidity," and greater transparency.

Moreover, he also argues that mandatory (i.e. government-imposed) transparency has costs because "it restricts the types of order- execution algorithms that trading systems are free to adopt, and thus implicitly imposes a regulatory view as to what are the optimal types of market structure."

Once Lee has set trade and quote information free, he is ready to tackle the issue of what is an exchange, because "in order to require trading systems to publish details of their prices and quotes, it is necessary to define what a trading system is. This, however, is difficult to do in a consistent manner." Lee believes the three "key market functions" of a trading system are "order routing, order execution and information dissemination." In large part, Lee argues that competition alone should "regulate" market structure, i.e. order routing, order execution and information dissemination. Government or self-regulation should focus on questions of "market conduct," like price manipulation and insider trading.

The distinction between market structure and market conduct is critical for Lee. If, as Lee believes, a separation can be drawn between structural and conduct issues, then "there should be no distinction in the regulation of any market-structure questions between institutions which are now classified as exchanges and those which are now classified as brokers."

In other words, Lee proposes to cut the Gordian knot of what is an exchange by demonstrating that it is the wrong question. Let markets and intermediaries however defined compete with one another in the provision of trading services (i.e. order routing and execution) and price dissemination (i.e. market transparency). Regulation should concentrate on preventing price manipulation and insider trading by market participants. As one might expect, therefore, Lee views the SEC's continued effort to define alternative trading systems as "fundamentally flawed."

Lee's arguments are forceful and cogently presented. Nevertheless, as frustrating as the current regulatory regime can be at times, I am not persuaded that it is necessary to embrace such dramatic change. At base, we look to our capital markets and their regulation to achieve three objectives: to provide funds for new investments in order to facilitate economic growth; to allocate capital among existing enterprises; and to provide a reasonable environment for the investment of funds which increasingly reflect the security of society, notably retirement savings and institutional endowments.

While we all argue, sometimes vociferously, about the various costs both explicit and implicit (i.e., regulatory) of the current system, in large part it has fulfilled these objectives. Record amounts of capital have been raised, and people have a wide range of investment alternatives. These results may have been achievable without the high cost of regulation, and better results still may be obtained by revising aspects of the regulatory structure. But it is difficult to make the case, based on the American experience, for radical reform.

Moreover, although we always can argue about the details of what is mandatory regarding market transparency, it is hard to envision a world where more than 50 million Americans are supposed to play hide and seek to determine the value of their mutual funds.

Lee and I have debated these issues for about ten years now. He has yet to convince me, and I have not yet convinced him. He has, however, written a terrific book. He not only proposes an answer to the question of "What Is an Exchange?" he challenges us all to answer why we should bother asking the question.