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January 1, 2004

Monopolies and Propaganda

By David Colker

The securities industry has experienced a significant number of market structure changes since 1996. These changes, and a three-year bear market, have combined to irrevocably transform the business dynamics of broker dealers and stock exchanges. These dynamics have caused great difficulties, but also have provided opportunities to improve the efficiency, quality and fairness of the securities markets. However, to ensure that sound market structure decisions are made, it is important

that we first identify the underlying beliefs that have influenced opinions and decision-making. It is important to acknowledge that some of these beliefs do not reflect current reality. If this is not recognized, then future decisions will be counterproductive and ineffective. Here are a few examples of outdated thinking that may still be influencing decision-making.

Some believe that stock exchanges are a natural monopoly because price discovery can only occur efficiently on a centralized physical auction market. They believe investors receive the best price only if all order flow is concentrated on one exchange because this permits maximum order interaction. The truth is that price discovery is centralized electronically today on everyone's personal computers. The combination of SEC order handling rules, easily accessible market data, and electronic order routing now provides a highly efficient national price discovery and order execution process across multiple exchanges. This environment has the added advantage of encouraging competition between exchanges, which results in technological innovation and cost reductions. That would never occur if there was only one exchange. The only weak links in the price discovery process today are the manual markets, which are slow to update quotes, report trades, and execute or cancel ITS commitments. This makes the NBBO an unreliable indicator of best price.

Although it may appear counterintuitive, the SEC 11Ac1-5 execution quality data, available on every exchange's Web site, empirically demonstrates that decentralized internalizing markets actually provide better execution quality than auction markets with intra-market price/time priority. In fact, because of exceptions like outsize rules and market-on-close crosses, no market can claim to be a pure auction market today.

The reality is that a monopoly serves the securities industry no better than it does any other industry. A monopoly destroys all incentive to innovate technologically or to reduce costs. In fact, many of the problems faced today are the result of a concentration of power. One exchange remains a monopoly today only because laws like the ITS trade-through rule protect it from having to compete for order flow. The ending of Nasdaq's monopoly over the trading of Nasdaq-listed stocks led to enormous cost savings and better service for brokers and public investors. It's time to take the pejorative word "fragmentation" out of the debate on market structure and acknowledge the value of competition in the exchange world.

Another old belief is that the public investor has to choose between automatic execution and price improvement. The reality is that many in the industry now employ technology that provides investors with both automatic executions and price improvement.

Finally, there remains the belief that the ITS trade-through rule still serves its original purpose of ensuring national price protection. The reality is that manual markets now prevent brokers from meeting their fiduciary obligation to provide public investors with the best possible execution. In addition, because of new trading technology and decimal pricing, the concept of best execution has evolved from a simple execution at the NBBO, to a variable set of investor expectations that, in a decimal world, include many factors other than price. No other change would do more to force true inter-exchange competition for order flow than modification of the trade-through rule.

Recognition that antiquated beliefs have no validity in the current environment is the first step towards developing sound public policies - and competitive practices - that will effectively respond to today's market challenges and opportunities.

David Colker is CEO and President of the National Stock Exchange.