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Firms Propose Sweeping Change To Structure of the Stock Market

Broker-Dealers Seek a Single Regulator And Central Display of All Stock Quotes


Wall Street's largest broker-dealers have quietly lobbied the Securities and Exchange Commission to adopt a sweeping new market system that includes a central display of all stock quotes and a single self-regulating group.

While the proposal faces stiff opposition, and the SEC won't make any decision on changes to the market for months, it would, if adopted, reduce the importance of both the National Association of Securities Dealers' Nasdaq and the New York Stock Exchange by giving greater authority to broker-dealers and other market participants.

The proposals are outlined in a confidential "white paper" submitted to the SEC last month on behalf of five firms: Merrill Lynch & Co., Goldman Sachs Group Inc., Morgan Stanley Dean Witter, Edward Jones, and ABN Amro Holding NV's ABN Amro North America Inc. The 29-page document was submitted for the firms by Harvey Pitt, a prominent Washington attorney and a former SEC general counsel.

The document, drafted by firms calling themselves a "working group," was intended to offer the institutional Wall Street perspective to the SEC as it prepared to begin a dialogue with the industry on how the markets should be revamped. SEC Chairman Arthur Levitt has become increasingly concerned that today's markets are more fragmented because investors can place orders among a growing number of competing exchanges, electronic systems and stand-alone dealers. At issue is whether the proliferation is hindering investors' ability to get trades executed at the best price.

Opposition by Some Firms

Yet some securities firms such as Charles Schwab Corp. oppose a device that would centralize stock trading into a single electronic order book, arguing it could stifle innovation. The clash of views between the Wall Street constituencies will be on display Tuesday as members of the Senate Banking Committee listen to views on the future of markets from representatives of several major securities firms and stock exchanges.

Any moves to revamp the markets will need the support of lawmakers. But Banking Chairman Phil Gramm (R., Texas) has warned Mr. Levitt to err on the side of less regulation and not to impose a vast new market framework. "A central market structure could be very anticompetitive," he told The Wall Street Journal. "I'm concerned about it."

Last week, the SEC asked for comments in a concept release on six options for electronically linking markets together in ways that might make trading fairer. Mirroring the working group's proposal, the SEC said it might consider whether all price quotes should be visible to market professionals so that the best customer orders are executed first.

Some lawmakers are concerned that the SEC's thinking is being unduly guided by a few of the largest and most powerful Wall Street firms. "The SEC's concept release tracks a number of recommendations in the firms' paper," said a House Commerce Committee aide. "It gives us pause that the SEC would be contemplating market structure changes symbiotically with the biggest participants."

House Commerce Committee Chairman Thomas Bliley (R., Va.) said he has long had an interest in market structure and competition and likely will hold hearings soon on the relationship between the big firms and the SEC.

Secrecy Fuels Controversy

Fueling the controversy is the secrecy between the working group and the SEC. In a Jan. 14 cover letter to the draft, the firms requested that the SEC "keep this draft confidential, and that, once you receive the final version of this paper, you return (or otherwise dispose of) all copies of the draft."

Mr. Pitt said the request was made because the draft doesn't have the approval of all the members. The group's final proposal will be submitted as a comment letter responding to last week's SEC release, he said.

The debate over market structure isn't a simple one, pitting one side against another. There are several discrete groups of market participants with different agendas. The common thread is how each may be affected by rapid technological changes -- both at traditional exchanges confronted by newer rival trading systems, and at traditional securities firms confronted by the rise of online trading by individual investors.

The New York Stock Exchange, for example, faces a huge challenge to its franchise of running the trading for the biggest stocks in the U.S. from faster, cheaper electronic rivals called electronic communications networks, or ECNs. It already has been forced to drop a rule curtailing the trading of New York Stock Exchange-listed stocks by its own member firms. The Nasdaq Stock Market, the Big Board's longtime rival, has made more advances on this front because it is already an all-electronic system linking securities dealers which trade its stocks.

As evidenced by the working group proposals, leading the market-structure debate are the big three traditional Wall Street securities firms: Goldman Sachs, Merrill Lynch, and Morgan Stanley. These firms are looking for electronic order executions that are faster and cheaper than available at the New York Stock Exchange, and their proposals could help them keep their longtime domination of stock trading based on their ties to institutional investors such as mutual funds and pension funds.

'Inefficient and Obsolete'

In calling for an overhaul, the working group advocates updating the existing "inefficient and obsolete" system that links markets together -- the so-called Intermarket Trading System operated by the exchanges and Nasdaq. The working group proposes upgrading the ITS technology and governance to create a "Super National Market System."

The new market would be built around a central order book with price-time priority, which means orders to buy a stock at a particular price would be executed across different markets in the order received, no matter which trading system they are placed on. That could effectively force firms such as Schwab to give other firms more access to their orders.

The big firms complain that their customers' orders to buy or sell at prices posted publicly on the exchanges may remain unexecuted while online brokers execute their own customers' orders at the same prices, even if they are received later. The online brokers contend that the big firms want to withhold their own larger institutional orders from any central limit-order book as well.

The loudest voice against the central limit-order book proposals has come from Schwab, which has the biggest share of the burgeoning market for online trading at discount commissions by individual investors. Schwab and other online brokers keep control over their customers' order flow either by executing the orders within their own trading operations, or by shipping them out to firms that pay for such orders. Schwab executives have publicly compared a central limit-order book to a Russian-style collective that would stifle innovation driven by competition.

New Framework Is Proposed

The working group also proposes a new regulatory framework to govern the linked market. The current system is dominated by regulatory arms of the NYSE and NASD, which operates Nasdaq. The system presents an inherent conflict because all broker-dealers and new electronic markets, such as Island ECN, must be licensed members of the NYSE and NASD, which are competing with their own members for trading business, the big firms argue.

The working group advocates a central independent industry regulatory body organized as a corporation. The governing board members should be expanded from exchanges and the NASD members to include broker-dealers, new electronic markets, and public members. Furthermore, the group proposes that the SEC eliminate "redundant and inconsistent" rules imposed by each of the self-regulatory arms of markets.

Separately, Mr. Levitt is scheduled to meet this afternoon with Rep. Dan Burton (R., Ind.), who has asked the SEC chairman to supply documents explaining what was discussed at a series of nonpublic meetings he held last year with the heads of large investment firms. Mr. Levitt's aides dismiss the suggestion that certain firms have undue influence. "We solicited the opinions of a broad cross-section of the marketplace and look forward to an open dialogue in these issues," said Annette Nazareth, director of the SEC's market-regulation division.


  1. What is fragmentation and what are the advantages and disadvantages of fragmentation?
  2. What is a CLOB, and what are its advantages and disadvantages?
  3. Why do you think the broker-dealers who wrote up this report are in favor of a CLOB?
  4. Why is Schwab against the CLOB?
  5. Can you think of a reason why the interests of on-line brokers might be different from those of conventional brokers?
  6. Do you think the NYSE is more likely to go public with a CLOB in place or not?  Explain.
  7. If centralization of orders in the US is good, what about a US-Europe CLOB?  Would that be desirable?
  8. Would trading costs be lower with a CLOB?  Keep in mind that traders may not have as much of an incentive to provide liquidity under a CLOB.