American exchanges are working furiously to develop winning strategies and products to compete in the global capital market. Closely watching – and always guiding – this interesting evolution is the Securities & Exchange Commission (SEC). With a larger view of how the US market should be shaped, the SEC is following up on its now-famous Market 2000 study, fine-tuning the market mechanism to allow corporations smoother access to capital.
One SEC leader who is key in this process is Howard Kramer, associate director of the market regulation division. The thick Market 2000 report issued by Kramer’s division in 1994, which now sits ruffled on the desks of US securities professionals, is the bible of reform. Its publication marked the first comprehensive study of the US securities market since the era of deregulated commission rates began back on May Day in 1975. The SEC’s regulatory authority has been greatly increased over the two decades since then, making it possible for nearly all Market 2000’s goals to be accomplished without legislation from Capitol Hill.
Kramer notes that out of the 17-odd proposals put forward in Market 2000, the four demanding SEC action were taken care of in short order. Back in 1993, even before Market 2000 was released, the SEC increased disclosure of payment-for-order-flow arrangements between dealers and specialists. Then, in December 1994, the review period for market-generated rules was streamlined. During the same month the commission took action on proprietary trading systems (PTS). Indeed, the only SEC initiative that remains unresolved is the one covering the rules for more disclosure of soft dollar arrangements for investment companies, but these are expected soon.
Before the release of Market 2000, suspense grew over whether the SEC would favour the Big Board and its specialist firms, or third-party traders, soft dollar brokers and PTSs – such as Instinet’s Crossing Network. When the study was released, many believed third party traders and PTSs came out ahead. The general feeling was that the SEC had taken the advice of the large investors who have most to gain from increased competition by PTSs, rather than from the exchanges, which claim that off-exchange trading actually damages investor interests by fragmenting the market. Notably, the study’s recommendations did not demand that third- and fourth-party trading networks be regulated as exchanges, despite the NYSE’s suggestion that it should.
‘Most PTSs resemble highly automated brokers, but some exchanges argued that PTSs compete for order flow like an exchange and should be regulated as such,’ says Kramer. ‘Such a move would have made the barriers to entry and regulatory burdens extremely high. Instead, we recommended a flexible approach, with additional information to monitor PTS activities and growth.’ A rule, imposing stricter record-keeping requirements on PTSs, was approved in December 1994.
‘Technology will continue to drive the evolution of equity markets,’ Kramer says. ‘Eventually, investors may obtain access to markets directly, perhaps via their desktop. Technology will continue to keep markets on their toes, ensuring real value-added service. Still, given the technological changes in the past 20 years, markets have shown that they can meet the challenge.’
Only a few Market 2000 recommendations directed at stock markets have been adopted. Most exchanges have dragged their feet, with Nasdaq proving the most compliant.
Faced with an SEC edict aimed at prohibiting market makers from front-running customer limit orders, the NASD introduced a proposal banning member firms from trading for their accounts at the same or a better price than the limit orders they hold. Then, coverage was expanded to limit orders sent to market makers from another member firm. Final approval on this came down from the SEC in May. But Nadsaq went a step further, proposing an automated national limit-order facility, Naqcess, and suggesting that member firms be prohibited from trading ahead of research reports.
Market 2000 also took aim at the Big Board, recommending it loosen its ban on after hours trading. When the NYSE is open, its members can trade NYSE-listed stocks on a domestic or foreign exchange. While closed, stocks can only trade on a foreign exchange or OTC market, which in practice means a broker faxes trades to its foreign desk. ‘It’s silly to force trades overseas when the market is closed,’ says Kramer. ‘Those trades could be repatriated without any real loss in volume to the exchange.’
Another recommendation suggests the move from eighths to decimals in stock pricing. While Nasdaq and Amex have raised the dollar threshold for stocks that trade in 1/16ths, no other markets have made a move. ‘Decimal pricing, or at least 1/16ths, would make for tighter more accurate spreads,’ says Kramer. ‘Institutions clearly want to trade in finer increments than 1/8ths. There must be a balance. With too fine an increment, the incentive for positioning and market making may disappear.’
Though not a specific recommendation of Market 2000, the SEC has thrown a bone to regional exchanges. In April, it changed the rule on when regionals can begin trading stocks listed on other exchanges. Previously, regionals had to wait six to eight weeks to trade a new NYSE or Amex stock, regardless of whether the company concerned was an IPO or a Nasdaq emigrant. In October 1994, the Unlisted Trading Privileges (UTP) act eliminated the wait, but set a period of two days. The SEC has since changed the wait to one day.
However, the SEC compromise leaves both, primary and regional markets in the lurch. The Big Board, along with Lehman Brothers and CS First Boston, wrote the SEC saying immediate access to IPO stocks for regionals would further increase the price volatility in the days after an IPO. Nonsense, countered the regionals, who insisted that the NYSE had no direct evidence that regional markets contributed to price volatility. For their part, the regionals obviously wanted to be let in on the heavy trading volumes in IPOs from the point of flotation.
The SEC announced initiatives in June. A White House conference on small business listened as SEC chairman Arthur Levitt told of the Commission’s plans to revise rules giving small businesses a break in raising capital. By shortening the holding period for when a private placement buyer can sell to one year from two to three years, the SEC is responding to small businesses complaining they have to pay too high a premium in non-public offerings.
The new proposals build on the Commission’s 1992 Small Business Initiatives, which introduced a process allowing companies to solicit indications of interest in their securities before undertaking an offering under Regulation A. Other plans currently under public review reduce the amount of information required in documents sent to share holders, letting companies skip many of the complex footnotes now required in annual reports, prospectuses and proxy documents.
The SEC is also working to encourage companies to raise capital in the US by reducing the risk of litigation. At the end of June, the Senate passed the Private Securities Litigation Reform Act which would create a ‘safe harbour’ from private prosecution for companies making ‘forward looking statements’ about performance. The Senate bill follows a more sweeping one passed by the House of Representatives in March, which, among other things, would compel losing plaintiffs to pay defending companies’ legal costs. The two chambers must now agree on the final product for Bill Clinton’s approval.
Meanwhile, the House Republicans are proposing a sweeping overhaul of federal securities law that could shift the balance of power on Wall Street, giving securities firms more freedom and the SEC greater rule-making leeway. Under the plan, introduced in late July, securities firms would find it easier to fight claims by investors; state laws protecting investors would be discarded; and corporations would have an easier time selling stocks and bonds.
While the SEC is looking at the idea of eliminating prospectuses for seasoned companies that want to tap capital markets, some industry analysts say the Republican bill may go too far by dropping a requirement that investors get a prospectus before buying a security. The bill would make it easier for on-line services to deliver prospectuses. Still, CFOs support the idea of streamlining IPOs by doing away with disclosures involved in taking a company public. Another controversial section of the proposal would undo federal disclosure laws for corporate takeovers, requiring SEC filings whenever investors take large stakes in companies. Since 1970, the rules have helped alert investors to hostile takeover efforts.
Looking ahead, Kramer sees the SEC’s task as being to protect investors from securities fraud; to improve disclosure for investors; to educate investors; to raise standards for brokers; to improve capital formation efficiency; to monitor the evolving equity market structure; and to respond to developments in and growth of the derivatives markets.
But, as Kramer points out, ‘Regardless of what the SEC suggests, there are trends that will drive markets. Technology is one. Another is the institutionalisation of investment. As these investors account for growing volumes, alternative markets will continue to emerge to serve their needs. Meanwhile, the SEC has an ambitious programme to encourage foreign companies to list in the US, and is eager to persuade foreign markets to be hospitable to US listings. Finally, derivatives markets are a growing force and an ongoing challenge.’
