oversight

Securities Trading: SEC Action Needed to Address National Market System Issues

Published by the Government Accountability Office on 1990-03-12.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               I.ttittd   Stattas (&net-al   Accotttttitrg   Oft’iw


&A0            Report t,o Congressional Committees




March   1990
               SECURITIES
               TRADING
               SEC Action Needed to
               Address National
               Market System Issues
General   Government   Division

B-219779

March 12,199O

The Honorable Donald W. Riegle
Chairman, Committee on Banking, Housing.
   and Urban Affairs
I’nited States Senate

The Honorable Christopher J. Dodd
Chairman, Subcommittee on Securities
Committee on Banking, Housing, and
   1:rban Affairs
I.-nited States Senate

The Honorable John D. Dingell
Chairman, Committee on Energy
  and Commerce
House of Representatives

The Honorable Edward J. Markey
Chairman, Subcommittee on Telecommunications
  and Finance
Committee on Energy and Commerce
House of Representatives

This report concerns U.S. securities market trading structure and, specifically, the goal to
achieve a national market system as outlined in the Securities Acts Amendments of 1975. It
is part of our follow-up work on the stock market crash of 1987. We are providing you with
copies because it is directed at the Securities and Exchange Commission.

We highlighted three areas for review: (1) exchange-imposed trading restrictions, (2) the
Intermarket Trading System, and (3) multiple listing of options. In each of these areas, we
make recommendations to the Commission.

This report was prepared under the direction of Craig A. Simmons, Director, Financial
Institutions and Markets Issues. Major contributors to the report are listed in appendix III. If
you have any questions on this report, please call Mr. Simmons on 275-8678.




Richard L. Fogel
Assistant Comptroller General
Executive Summ~


             The October 1987 stock market crash raised critical questions concern-
Purpose      ing the efficiency, competitiveness, and fairness of U.S. securities mar-
             kets. Many experts questioned the structure of the marketplace and its
             ability to both withstand periods of high stress and operate efficiently
             in ordinary times. Market experts and analysts have debated these ques-
             tions since the crash. Renewed volatility in the markets, as indicated by
             the 190-point drop on October 13, 1989, and the subsequent record gains
             the following week, has again created doubt about whether the financial
             markets are properly designed to meet the demands placed upon them.

             To identify market structure issues, GAO met with federal regulators,
             exchange and over-the-counter market officials, market professionals,
             institutional investors, and academics. GAO evaluated what should be
             done to address the most important issues identified through these dis-
             cussions -trading restrictions, market links, and options trading.


             In the 1975 Amendments to the Securities Exchange Act of 1934, Con-
Background   gress called for the establishment of a national market system. Congress
             sought market structure improvements that would provide efficient?
             fair, and competitive markets for securities investors. The Amendments
             set five objectives for the national market system to address: (1) eco-
             nomically efficient execution of securities transactions; (2) fair competi-
             tion among market participants; (3) the widespread availability of
             quotation and trade information; (4) the practicability of executing
             investors’ orders in the best market; and (5) the opportunity for inves-
             tors’ orders to interact without dealer participation. In addition, the
             Amendments mandated that the Securities and Exchange Commission
             (SEC) remove all securities exchange trading restrictions that impose an
             unnecessary burden on competition. (See pp. 14-15.)

             By focusing on the needs of investors rather than dictating a specific
             market structure, the 1975 Amendments established permanent goals
             for which the securities markets should strive. SEC is responsible for
             monitoring market structure to assure the Amendments’ goals are con-
             tinually addressed.

             The securities industry and SEC have made major regulatory and struc-
             tural changes towards achieving the legislative objectives. Fixed com-
             mission rates were eliminated in 1975. Exchange trading restrictions
             were eased to permit stocks listed since 1979 to be traded by exchange
             members off the exchange floor. In addition, the Intermarket Trading
             System was developed. This system links U.S. stock markets and enables
                                    .

             Page 2                                     GAO/GGD9042   National   Market   System
                            Executive   Summary




                            regional exchanges to compete with their primary counterparts in New
                            York. Recently, SECapproved multiple listing of stock options-allowing
                            an option to be traded on more than one exchange.


                            SEC needs to reevaluate several issues regarding securities market struc-
Results in Brief            ture to assure the markets continually meet the goals of a national mar-
                            ket system. Market participant opinion is divided about whether
                            industry and SEC action to change market structure have gone far
                            enough to achieve national market system goals. Questions remain about
                            the benefits of existing trading restrictions especially as they pertain to
                            after-hours trading, the effectiveness of the Intermarket Trading Sys-
                            tem, and the type of coordinated system needed to trade the same
                            options on different exchanges.

                            The marketplace, as evidenced by huge increases in trading volume,
                            unprecedented volatility, major technological advances, and growing
                            global competition, has changed considerably since SEC last reviewed
                            some of these market structure issues. Without continued SEC evaluation
                            and promotion of national market system goals, trading system innova-
                            tion may be hampered, marketmaking capital may be insufficient-
                            especially in times of stress, investors may pay higher transaction costs,
                            and some trading volume may be lost to overseas markets.



GAO Analysis

SEC Needs to Reopen the     Exchange-imposed trading restrictions, such as New York Stock
Trading Restriction Issue   Exchange Rule 390, prevent exchange members from executing trades
                            off an exchange floor. In response to the 1975 Amendments, SEC pro-
                            posed a rule in 1977 to eliminate these restrictions. However, because of
                            considerable objections to the proposed rule by market participants, SEC
                            withdrew the proposal in 1980. At the same time, SEC adopted a nar-
                            rower rule that eliminated trading restrictions, but only on stocks listed
                            on an exchange after April 1979. Many of the most actively traded
                            stocks were listed before April 1979-for example, 89 of the New York
                            Stock Exchange’s 100 most active stocks. Restrictions on these stocks
                            still remain. (See pp. 18-20.)

                             Trading restrictions help maintain the current market structure. Remov-
                             ing the restrictions could substantially alter the way exchange-listed
                                                      *

                             Page 3                                    GAO/GGDSO-52   National   Market   System
                          Executive   Summary




                          securities are traded, including the possible elimination of trading floors
                          and specialists. Market participant opinions are mixed on the benefits or
                          detriments of these restrictions. Critics contend that the rules are anti-
                          competitive because they restrict price competition and limit
                          marketmaking, and that the rules discourage development of new and
                          more automated trading systems. Supporters argue that the rules are
                          pro-competitive because they require trades to be made in a central loca-
                          tion where all bids and offers can interact, thereby preserving the bene-
                          fits of the auction market. By concentrating supply and demand for
                          stocks in a central market, they say that price efficiency is enhanced.
                          (See p. 23.)

                          Despite substantial changes in the marketplace since 1980, no compre-
                          hensive SEC reviews have been done to demonstrate whether remaining
                          trading restrictions impair market efficiency, fairness, or competitive-
                          ness. SEC’S only formal review of trading restrictions since 1980
                          occurred in 1986 and dealt exclusively with the New York Stock
                          Exchange’s restrictions on after-hours trading by its members. As a
                          result of these restrictions, exchange member brokers and dealers who
                          wish to trade exchange-listed stocks when U.S. markets are closed must
                          do so in foreign markets. In 1986, the Commission rejected its Division
                          of Market Regulation’s recommendation that SEC send a letter to the
                          New York Stock Exchange asking it to consider removing these restric-
                          tions on after-hours trading. Because of the substantial changes that are
                           occurring in the marketplace, SEC needs to reconsider trading restric-
                          tions, especially for after-hours trading, to determine whether they
                           should be further modified, removed, or reaffirmed. (See pp. 21-23. 32.)


Co&prehensive Review of    The Intermarket Trading System has electronically linked the trading of
the Intermarket Trading    stocks in various marketplaces around the country since 1978. The
                           exchanges designed the system to meet the 1975 Amendments’ goals to
System Is Needed           encourage competition and to allow customers to have their orders exe-
                           cuted at the best price available in any of the linked markets. In 1982,
                           SEC completed a comprehensive review of the system’s first 4 years of
                           operation, including an examination of trading volume, operating effi-
                           ciency, and effect on inter-market competition. Between 1982 and Sep-
                           tember 1989, SECcontinued to monitor the Intermarket Trading System
                           but made no further comprehensive studies of the system. However,
                           after the 1987 market crash, SEC and market participants made some
                           changes to system operations in response to problems experienced dur-
                           ing periods of stress such as the crash. (See p. 34.)



                           Page 4                                    GAO/GGD-90-52   National   Market   System
                              Executive   Summary




                              Since the beginning of 1979, share volume traded over the Intermarket
                              Trading System has increased over ten-fold. In addition, exchange offi-
                              cials and system users identified system operational weaknesses that
                              they said have limited competition and favored the primary markets-
                              the New York and American stock exchanges. SEC and market partici-
                              pants have recently addressed some of these concerns. In view of the
                              dramatic increase in trading volume and the number of incremental
                              changes made to the system since SEC'S last comprehensive evaluation,
                              SEC needs to look again at overall system effectiveness and the extent to
                              which the Intermarket Trading System is meeting its national market
                              system goals. (See p. 35.)


Development of Trading        In May 1989, SEC approved a major change to the way stock options will
                              be listed and traded at exchanges. Rather than the former procedure of
Linkage for Multiple          allocating an option on a listed stock to a single exchange, SEXnow
Listing of Options Requires   allows all exchanges to trade any new option listed after January 22,
SEC Monitoring and            1990. In addition, each options exchange is permitted to list 10 stock
Guidance                      options already traded on another exchange. Furthermore, beginning in
                              1991, SEC will allow any exchange to trade any option regardless of
                              where it was originally listed. SEC approved this change to increase com-
                              petition among exchanges and to improve options prices for investors.
                              Some exchanges disagree with SEC'S assessment of the benefits of listing
                              and trading options on more than one exchange. However, if increased
                              competition results and investors obtain better prices, SEC'S approval of
                              this change will be consistent with national market system goals. SEC is
                              taking an active role to implement this change. (See p. 42.)

                               SEC also noted that the benefits of multiple listing and trading of options
                               would be enhanced by developing a trading linkage system among the
                               exchanges. No such linkage exists. Options exchanges differ on what
                               type of linkage system is necessary. This lack of consensus among com-
                               peting exchanges makes it unlikely that a system will be developed
                               without active SEC intervention. In January 1990, SEC requested the
                               options exchanges to refrain from listing options already allocated to
                               another exchange for 6 months to allow for development of a market
                               linkage system. (See pp. 48-49 .)


                                    recommends that SEC reopen the issue of exchange-imposed trading
Recommendations                GAO
                               restrictions, such as New York Stock Exchange Rule 390, to determine if




                               Page 5                                     GAO/GGD!W-62   National   Market   System
                  ExecutiveSummary




                  these restrictions should be modified, removed, or reaffirmed. SEC'S eval-
                  uation should include whether trading restrictions hamper the develop-
                  ment and use of more innovative trading systems and limit
                  marketmaking capital. It should also assess the consequences of forcing
                  exchange members to conduct their after-hours trading in foreign mar-
                  kets. If SEC decides against removing the restrictions, GAO recommends
                  that SEC consider the effect of these restrictions on a periodic basis to
                  keep pace with the rapidly changing marketplace. (See p. 32.)

                  GAO  recommends that SEC do a comprehensive evaluation of the
                  Intermarket Trading System. SECshould address the system’s opera-
                  tional efficiency, effect on intermarket competition, and capability to
                  handle future market crises. (See p. 40.)

                  GAO recommends that SECclosely monitor the exchanges’ progress in
                  developing a market linkage system for options trading. If SECdeter-
                  mines that the exchanges are not making sufficient progress, GAO recom-
                  mends that SEC direct construction of a linkage system. (See p. 49.)


                  GAO  provided copies of a draft of this report to SEC for formal comment
Agency Comments   (contained in app. II) and to each market mentioned in the report for
                  informal review. In general, SEC noted that the report was well balanced.
                  SEXagreed that the issues raised in the report are important national
                  market system issues that require careful scrutiny. SEC agreed that the
                  effects of trading restrictions on after-hours trading should be reopened
                  but disagreed with the need for a review of the effect of trading restric-
                  tions during normal exchange hours. SECindicated that a review of the
                  restrictions’ effects during normal trading hours is complicated and was
                  done in 1979. SEC also indicated that it should not remove these trading
                  restrictions until market participants determine that the resulting mar-
                  ketplace will be better than the existing exchange marketplace. (See
                  pp. 56-61.)

                   GAO  believes that the trading restriction issue, both for after-hours and
                   normal hours trading should still be reopened. GAO agrees that the issue
                   is complex. However, the market has changed significantly since 1979
                   and market participants may not have the perspective needed to view
                   the US. marketplace as a whole.

                   Each market requested that minor changes be made to clear up a few
                   technical inaccuracies. In general, the exchanges did not endorse a
                   review of trading restrictions. However, officials from each market said


                   Page6                                      GAO/GGD!W52   National   Market   System
Executive   Summary




GAO used sound logic to reach its conclusions. In addition, market offi-
cials generally commented that the report was well balanced and fair.




 Page 7                                    GAO/GGD-90-52   National   Market   System
Contents


Executive Summary                                                                                         2
Chapter 1
Introduction              Market Crash Raised Questions Regarding the Efficiency
                              of US. Trading Systems
                          Congressional Mandate to Develop an Efficient,                                 14
                              Competitive, and Fair Trading System
                          Objectives, Scope, and Methodology                                             15

Chapter 2                                                                                                18
SEC Needs to              SEC Took Action to Remove Certain Trading Restrictions                         18
                          Significant Trading Restrictions Remain                                        20
Periodically Address      No Comprehensive Review of Trading Restrictions Since                          21
Effects of Trading             1980 Despite Major Changes in the Market
                          Extensive Disagreement About Effects of Trading                                23
Restrictions                   Restrictions
                          Conclusions                                                                    31
                          Recommendations to the Securities and Exchange                                 32
                               Commission
                          Agency Comments and Our Evaluation                                             32

Chapter 3                                                                                                33
Intermarket Trading       ITS Links the Markets                                                          33
                          No Comprehensive Evaluation of ITS Since 1982                                  34
System Needs a            ITS Volume Has Increased Dramatically                                          38
Comprehensive             Conclusions                                                                    39
Review                    Recommendations to the Securities and Exchange                                 40
                              Commission
                          Agency Comments and Our Evaluation                                             40

Chapter 4                                                                                                41
Trading Linkage           Multiple Listing of Options Attempts to Address National                       42
                               Market System Goals
System Development        Benefits of Multiple Listing of Options Have Been                              43
for Multiple Listing of        Questioned
Options Requires Close    Considerable Disagreement About a Market Linkage                               45
                               System
SEC Monitoring and        SEC Seeks Voluntary Delay in Implementing Multiple                             48
Guidance                       Trading of Existing Options
                          Conclusions                                                                    49



                          Page 8                                   GAO/GGD!W-52   National   Market   System
                       Contents




                       Recommendations to the Securities and Exchange                                49
                           Commission
                       Agency Comments and Our Evaluation                                             49

Appendixes             Appendix I: U.S. Securities Markets Today                                      50
                       Appendix II: Comments From the Securities and                                  56
                           Exchange Commission
                       Appendix III: Major Contributors to This Report                                63

Glossary                                                                                              64

Related GAO Products                                                                                  68

Tables                 Table 3.1: Distribution of ITS Share Volume Among                              39
                           Participant Markets (December 1989)
                       Table 1.1: Average Daily Volume of U.S. Stock Exchanges                        50
                           and NASDAQ (1989)
                       Table 1.2: Average Daily Stock Options Contract Volume                         55
                           of US. Options Exchanges (1989)
                       Table 1.3: Number of Stock Options Listed at Options                           55
                            Exchanges (December 1989)

Figures                 Figure 2.1: NOSE Block Trades (1975 to 1988)                                  25
                        Figure 3.1: ITS Volume - 1978 to 1989                                         39




                        Page 9                                  GAO/GGD-9062   National   Market   System
Contents




Abbreviations

 Amex   American Stock Exchange
 BSE    Boston Stock Exchange
 CBOE   Chicago Board Options Exchange
 CSE    Cincinnati Stock Exchange
 CAES   Computer Assisted Execution System
 CATS   Computer Assisted Trading System
 CORES  Computer-assisted Order Routing and Execution System
 Dm     Designated Order Turnaround system
 EST    Eastern Standard Time
 ITS    Intermarket Trading System
 MSE    Midwest Stock Exchange
 NASD   National Association of Securities Dealers, Inc.
 NASDAQ National Association of Securities Dealers Automated
            Quotations system
 NMS    h’ational Market System
 NSTS   Kational Securities Trading System
 NYSE   New York Stock Exchange
 OMINTS Options Market Integration System
 OTC    over-the-counter
 PHLX   Philadelphia Stock Exchange
 PSE    Pacific Stock Exchange
 SEC    Securities and Exchange Commission
 SOES   Small Order Execution System
 TSE    Toronto Stock Exchange


 Page 10                              GAO/GGD9@52   National   Market   System
Page 11   GAO/GGlBO-52   National   Market   System
Chapter 1

Introduction


                         The 1987 stock market crash raised questions regarding the efficiency,
                         liquidity, and fairness of the US. securities markets. Numerous reports
                         and articles criticized the performance of U.S. trading systems during
                         the crash. Some market experts commented that changes are needed to
                         address what they perceive as major structural and operational defects
                         highlighted by the crash.

                         Designing the appropriate trading structure for the U.S. securities mar-
                         ket has generally been left to the marketplace. However, the Securities
                         Acts Amendments of 1975’ (“1975 Amendments” or “Amendments”)
                         mandated sweeping changes in how the markets function and intro-
                         duced a concept called the national market system. U.S. trading systems
                         and operations have been significantly influenced by the actions the
                         markets and the Securities and Exchange Commission (SEC) have taken
                         in response to the 1975 Amendments.


                         Various studies of the 1987 market crash by GAO," a Presidential Task
Market Crash Raised      Force,:’ and SEC' criticized specialist” performance in exchange markets,
Questions Regarding      market maker” performance in the National Association of Securities
the Efficiency of U.S.   Dealers (KASD) over-the-counter (arc) market, and the overall perform-
                         ante of trading linkages among the various securities markets. The
Trading Systems          exchange markets and NASD have taken steps to address the deficiencies
                         highlighted in those reports, but the basic trading structure remains the
                         same. Some market participants and outside experts said the 1987 crash
                         exposed the need for major structural changes to address operational
                         defects, such as insufficient specialist and market maker capital, trading
                         halts resulting from buy and sell order imbalances, and reliance on inef-
                         ficient trading systems. Some have recommended an automated trade
                         execution system similar to those currently used for certain stocks in
                         foreign markets such as Toronto and Tokyo.

                         ‘Pub. L. No. 94.29,89 STAT. 97, *June 197.5,(codified, as amended, in scattered sections of 15 J.S.C.).

                         ‘Financial Markets: Preliminary Observations On the October 1987 Crash, (GAO/GGD-88-38. -Jan.
                         1988).
                         “Report of The Presidential Task Force on Market Mechanisms, January 1988. This is often referred
                         to as the “Brady Commission” report.

                         ‘The October 1987 Market Break, A Report by the Division of Market Regulation, U.S. Securities and
                         Exchange Commission. February 1988.

                         ‘Specialists are responsible for making fair and orderly markets in their assigned stocks on the
                         exchange floor.

                         “Market   makers, also referred to as dealers, execute all trades in the NASD over-the-counter market.
                                                        .


                         Page 12                                                    GAO/GGD90-52      National   Market   System
Chapter    1
Introduction




Market regulators have also expressed concern about the structure of
the markets. Officials from two of the three largest U.S. markets have
said the market crash experience and anticipated changes in the market-
place require a special study, similar to the one done by SEC in the early
 1960s.; In April 1988, the Chairman of the American Stock Exchange
(Amex)  called for appointment of a special commission to do a Z-year
study of U.S. securities markets, because each marketplace is nurturing
its own innovations without examining the whole trading system.’ In
July 1988, a special committee of NASD recommended that an indepen-
dent, congressionally sponsored special study of the securities markets
be undertaken, a position supported by i%4SD.s In December 1989, Phila-
delphia Stock Exchange (PHLX) and Pacific Stock Exchange (PSE) offi-
cials, when commenting on a draft of this report, said they supported a
similar comprehensive study. Also, in November 1989, the New York
Stock Exchange (NOSE) announced its creation of a “blue ribbon panel” to
study ways to control excess volatility in the marketplace.

Congress has also recommended a comprehensive study of the securities
markets. In 1988, Congress found that “federal securities laws, rules,
and regulations have not undergone a comprehensive and exhaustive
review since the advent of the modern international, institutionalized
securities market.“l” Congress required SEC to make a study and investi-
gation of the adequacy of federal securities laws, rules, and regulations
to protect the public interest and the interests of investors. Congress
further directed SEC to study the factors impeding the fairness and
orderliness of the securities markets and those impeding improvements
in the breadth and depth of the capital available to the markets. How-
ever, Congress made this study subject to the availability of funds
appropriated to it specifically. According to SEC officials, as of January
 1990, Congress had not appropriated the $5 million to SEC, as outlined in
the law, for this study.

The securities markets have continued to experience periods of signifi-
cant volatility since the October 1987 crash. On October 13, 1989, the

‘Report of the Special Study of Securities Markets of the Securities and Exchange Commission. April
3, 1963.

“Speech entitled “After the Crash - A Look Ahead” by Arthur Levitt, Jr., Chairman. Amencan Stock
Exchange, before the Kational Press Club. Washington, DC., April 5. 1988.

“Report of the Special Committee of the Regulatory Review Task Force on the Quality of Markets.
Sational Association of ,Securities Dealers, July 1988, p. 51.
“‘Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. lOO-iO4. 102 ST.AT.
4677, November 1988, (codified. as amended, in scattered sections of 15 L.S.C.).
                               l




 Page 13                                                 GAO/GGD90-52      National   Market   System
                                 Chapter 1
                                 Introduction




                                 Dow-Jones Industrial Average fell 190 points-the market’s second
                                 largest decline in history. On the next trading day, the Dow-Jones Indus-
                                 trial Average, after being down 63 points, closed up 88 points, the mar-
                                 ket’s fourth largest gain ever.


                         The most recent and significant legislative impetus for major change in
Congressional            the U.S. securities markets came by congressional directive in the 1975
Mandate to Develop an securities Acts Amendments. The Amendments resulted in Congress’
Efficient , Competitive, most comprehensive restructuring of the competitive and statutory
                         framework surrounding the securities markets, the securities industry!
and Fair Trading         and public investors since the 1930s.
System
                                 The Amendments addressed changing market conditions and regulatory
                                 deficiencies. These included the increasing role of the institutional inves-
                                 tor, the negative impact of a fixed-commission rate system, the fragmen-
                                 tation of the market,” and a financial crisis in which numerous broker/
                                 dealers failed due to their inability to handle increasing paperwork from
                                 the rapidly rising trading volume. More importantly, the legislation
                                 sought to improve the efficiency of the US. securities markets for
                                 future years. In passing the legislation, Congress recognized the securi-
                                 ties markets as an “important national asset” that must be preserved
                                 and strengthened. The conference report accompanying the legislation
                                 explained that

                                  “The increasing   tempo and magnitude of the changes that are occurring in our
                                  domestic and international economy make it clear that the securities markets are
                                  due to be tested as never before. Unless these markets adapt and respond to the
                                  demands placed upon them, there is a danger that America will lose ground as an
                                  international financial center and that the economic, financial, and commercial
                                  interests of the Nation will suffer.“‘”

                                  In the Amendments, Congress called for SEC to facilitate the establish-
                                  ment of an efficient, competitive, and fair national market system for
                                  securities. Congress considered the national market system to be an
                                  evolving concept that requires adjustments as market conditions and
                                  technology change. The Amendments set the following five broad objec-
                                  tives for the markets to address:

                                  “A market is fragmented when orders for the same stock are executed in unlinked markets where
                                  bids and offers are not exposed to each other. This fragmentation results in a market that does not
                                  reflect all buying and selling interest.

                                  ‘“H R Conf. Rep. No. 229, 94th Cong., 1st sess.91. reprinted in 1975 U.S. Code Cong. & Adm. News
                                  185: 268.



                                  Page 14                                                   GAO/GGD-SO-52     National   Market   System
                             Chapter 1
                             Introduction




                         l economically efficient execution of securities transactions;
                         l fair competition among market participants;
                         l the widespread availability of quotation and trade information;
                         . the practicability of brokers executing investors’ orders in the best mar-
                           ket; and
                         . the opportunity, consistent with the above provisions, for investors’
                           orders to be executed without dealer participation.

                             In addition, the Amendments called for SEC to review all existing and
                             proposed rules of national securities exchanges and to remove any rule
                             imposing a competitive restraint that was neither necessary nor appro-
                             priate in furtherance of the Securities Exchange Act of 1934. In this
                             regard, Congress specifically highlighted exchange rules limiting or put-
                             ting conditions on exchange members executing trades away from the
                             exchange floor.

                             These objectives are very broad and are subject to various interpreta-
                             tions. Generally, however, Congress wanted securities trading to occur
                             in the market with the lowest possible transaction costs and at the best
                             prices available. The securities industry and SEC embarked on major reg-
                             ulatory and structural changes to meet the objectives of the 1975
                             Amendments. These changes, which substantially influenced the current
                             market structure, included eliminating fixed commission rates charged
                             by broker/dealers; developing a consolidated tape system,‘” a consoli-
                             dated quote system,‘l a last-sale reporting system for NASD Automated
                             Quotations system (NASDAQ) stock, and the Intermarket Trading System
                             (ITS); and removing certain exchange-imposed trading rules that limited
                             competition. An overview of today’s securities markets is contained in
                             appendix I. I?


                             We undertook this review as an outgrowth of our work on the stock
Objectives, Scope, and       market crash of October 1987. Our objective was to identify whether
Methodology                  further actions are needed to enhance the efficiency, competitiveness,
                             and fairness of current trading systems as called for by the goals of a


                             ‘,iThe consolidated tape system collects and displays price and volume data for all trades of most
                             exchange-listed stocks. Some stocks listed only on a regional exchange are not in the system.

                             “The consolidated quote system collects quotations from all markets trading reported securities,
                             identifies which market has the best bid and offer, and disseminates the information,

                             “For a full description of VS. securities trading and regulatory structure, see Securities and Futures:
                             How the Markets Developed and How They Are Regulated, (GAO/?&D-86-26, May 1986).



                             Page 15                                                    GAO/GGDW52        National   Market   System
Chapter 1
Introduction




national market system. We reviewed the overall structure of the mar-
ket and the trading linkages connecting individual markets, rather than
the soundness of trading systems at any one market.

We discussed market structure issues with federal regulators, exchange
and over-the-counter market officials, market professionals, institu-
tional investors, and academics. We evaluated what should be done to
address the most important national market system issues they identi-
fied. These issues are: (1) whether existing exchange-imposed trading
restrictions need to be modified or removed; (2) whether the ITS operates
as efficiently and fairly as practicable; and (3) whether new systems are
needed to assure that the competitive benefits of multiple listing of
options are achieved. However, we recognize that other factors affect
market structure, such as the practice of broker/dealers paying for
order flow, the new “basket of stocks” products traded at certain
exchanges, the proposed trade-reporting plan to allow for exchange
trading of over-the-counter stocks, and the registration of proprietary
 trading systems. Although we discussed the potential effects of these
 issues with market officials and participants, we include them in this
 report only as they affect our three primary issues.

 In doing this review, we visited and interviewed senior officials at the
 &WE, Amex, Boston Stock Exchange (BSE), Cincinnati Stock Exchange
 (CSE),Midwest Stock Exchange (MSE), PSE, PHLX, NASD, and Chicago Board
 Options Exchange (CBOE) to ascertain their opinions on the current mar-
 ket trading structure. We also interviewed officials of the Toronto Stock
 Exchange (TSE) to inquire about their automated trading system. We
 interviewed specialists at each stock exchange and toured all the stock
 exchanges’ trading floors. We also spoke with exchange floor brokers
 and NASDAQmarket makers. We interviewed officials of firms doing busi-
 ness in the third and fourth markets. We reviewed the minutes of ITS
 meetings at which market participants and market officials discussed
 their concerns.

 We interviewed officials of SEC’S Division of Market Regulation and
 Office of Economic Analysis, an SEC Commissioner, and former SK offi-
 cials. We reviewed numerous SEC Dockets that identified SEC actions
 intended to facilitate the establishment of a national market system.

 We interviewed the heads of equity trading at 21 institutional investors
 in seven states, including money management firms, banks, and pension
 funds, to obtain the perceptions and experiences of those who are major
 market participants. We also interviewed the heads of equity trading of


 Page 16                                   GAO/GGDW-52   National   Market   System
Chapter 1
Introduction




many of the largest broker/dealer firms as well as those at some mid-
sized and regional firms. In addition, we interviewed officials of securi-
ties information processors and vendors.

We contacted some participants on the original panels that were organ-
ized by Congress or SEC to develop plans to meet the goals of the 1975
Amendments. We also contacted several people from the academic and
broker/dealer communities who have been associated with the national
market system concept since its inception.

We provided copies of a draft of this report to SEC for formal review and
comment. SEC’S comments and our response to them are contained in
appendix II; our evaluation of SEC’S comments is at the end of chapters
2,3, and 4. At the same time we provided a draft to SEC, we asked offi-
cials of NkSE, NASD, Amex, MSE, PSE, PHLX, BSE, CSE, and CBOE to RViW the
report draft and provide us with their reactions and informal comments.
We then discussed the draft report with officials from each organiza-
tion, either in person or by telephone.

The preponderance of comments we received concerned N’YSE Rule 390
and the multiple listing of options. One common component of the
exchanges’ and NASD’s comments was that we had tackled extremely
complex issues and produced a report that was fair and well balanced.
This point is reiterated by SEC in its formal comments to the report.

Our audit work was done between June 1988 and May 1989 in accord-
ance with generally accepted government auditing standards.




Page 17                                    GAO/GGD90-52   National   Market   System
SEC Needs to Periodically Address Effects of
Trading Restrictions

                       The 1975 Amendments mandated that SEC eliminate any exchange trad-
                       ing restriction imposing a burden on competition that did not serve a
                       regulatory purpose. In 1975, and again in 1980, SEC removed certain
                       trading restrictions, but significant restrictions still remain-most
                       predominantly NkSE Rule 390 and its equivalent on other exchanges-
                       which prevent exchange members from trading many stocks away from
                       the exchange markets.

                       These restrictions could (1) limit the amount of marketmaking capital
                       available to respond to heavy selling pressure such as was experienced
                       in October 1987; (2) limit price competition, thereby preventing inves-
                       tors from receiving better prices; (3) inhibit the development, and use of
                       more innovative trading systems; and (4) drive trading overseas. On the
                       other hand, these restrictions may be necessary to preserve a central
                       auction market, to prevent market fragmentation, and to continue effi-
                       cient and effective market operations. The markets have changed sub-
                       stantially since 1980, and SEC needs to reevaluate the effect of existing
                       trading restrictions now and, to the extent restrictions remain, on a peri-
                       odic basis in the future.


                       In response to the 1975 Amendments, SEC acted quickly to address the
SEC Took Action to     trading restrictions issue. In 1975, SEC allowed exchange member bro-
Remove Certain         ker/dealers to route customer orders to non-exchange member firms for
Trading Restrictions   execution? a practice formerly prohibited by exchange-imposed restric-
                       tions. i This rule provides exchange members with an alternative place to
                       execute agency trades,’ called the third market, rather than only execut-
                       ing such trades on the exchange floor. For example, Charles Schwab &
                       Co., a large discount broker and NYSEmember, may execute trades on
                       behalf of its customers, not only at NISE or a regional exchange, but also
                       at Bernard L. Madoff Investment Securities, a third market maker who
                       is not a NYSEmember.

                       In 1977, SEC proposed removing all remaining trading restrictions. j SEC
                       received over 200 comment letters on the proposal from the exchanges,
                       KASD, broker/dealers, investors, issuers, the Department of the Trea-
                       sury, and other interested market experts. The proposal was harshly

                       ‘SEC Rule 19c-1, 17 C.F R. 240.1W1 (1989).

                       ‘Agency trades are where a broker/dealer executes trades through another broker/dealer on behalf
                       of a customer.

                       -‘Proposed SEC Rule 19c-2. 42 Fed.Reg. 33510 (to be codified at 17 C.F.R. 240.19c-2)(proposcd .June
                       23. 1977; withdrawn June 18. 1980).



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criticized by most respondents, especially by the exchanges and
exchange broker/dealers. Kane of the exchanges-l submitting comments
to SEC favored the proposal. hex considered it to be “the most crucial
step the Commission has considered in four decades,” The consensus
 among the exchanges was that removal of the restrictions would cripple
 the existing exchange structure. The resulting marketplace, they pro-
jected, would be characterized by fragmented dealer markets where
 market makers internalized order flo~,~ best execution of orders would
 be nearly impossible to assure, and the resulting marketplace would cre-
 ate a significant regulatory challenge. While PHI3 was not opposed to
 removal of the trading restrictions, it stated that SEC’S decision to elimi-
 nate the restrictions was untimely because systems were not in place to
 adequately disseminate trade information.”

NASD and the Department of the Treasury argued in favor of the propo-
sal. NASD stated the rule would increase market making and competition
for exchange-listed stocks, although it suggested that substantial order
flow would probably remain on the exchanges. While the Department of
the Treasury supported the potential for increased marketmaking, it
cautioned SEC that removal of existing restrictions should be conditioned
on implementation of a nationwide quotation system, and that the
resulting marketplace should be closely monitored. SEC, citing the possi-
ble “dramatic and radical effects” of adopting this change, withdrew the
proposal in 1980.

 Instead, SEC adopted Rule 19c-3.; This SEC rule allows exchange member
 broker/dealers to execute trades off-board, sometimes referred to as “in-
 house,” in NOSEstocks listed after April 26, 1979. Therefore, a broker/
 dealer can execute a customer order for such a stock against the firm’s
 inventory or against another customer order, rather than take the order
 to the exchange floor for execution.

 SEC stated in 1980 that because Rule 19c-3 would only apply to a limited
 number of securities, it would not significantly affect the existing struc-
 ture of the securities markets. SEC’S forecast was accurate. Rule 19c-3

 ‘h%E, Amex, ME, PHLX. PSE. BSE. andCBOE.

 ‘Internalizing order flow refers to large broker/dealers executing customer orders by buying and
 selling from their own accounts without exposing the orders to bids and offers elsewhere.
 “Since that time, the composite tape and consolidated quote have been added to market trading
 structure.

 ’ 17 C.F.R. 240.19c-3



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                      has had little effect on trading patterns. Two explanations are com-
                      monly cited as reasons why broker/dealers have executed relatively few
                      trades in Rule 19c-3 securities. The first explanation is that brokerideal-
                      ers found that the rule did not encompass enough quality stocks to jus-
                      tify their changing established internal systems to accommodate trading
                      of newly listed stocks in-house. The second explanation is that broker:
                      dealers preferred to execute trades on the exchange floor rather than in-
                      house.


                      MSE Rule 390, Amex Rule 5, and similar rules at four regional stock
Significant Trading   exchanges impose restrictions on where their member firms may trade.”
Restrictions Remain   Simply stated, these rules prohibit exchange member broker/dealers”
                      from making markets in many exchange-listed stocks off the exchange
                      floor. These rules are generally referred to as off-board trading restric-
                      tions. An effect of these restrictions is to restrict exchange member bro-
                      ker/dealers from competing with exchange specialists in making
                      markets in exchange-listed stocks. Many of N’YSE’Sactive stocks, includ-
                      ing 89 of its 100 most active- such as Exxon, Ford, General Electric,
                      General Motors, and IBM-are covered by the Rule 390 restrictions.1”

                      One further consequence of iWE Rule 390 is that it prevents exchange
                      members from executing certain trades of exchange-listed stocks in the
                      domestic OTCmarket even when U.S. exchanges are closed. Yet,
                      exchange members are allowed to execute these trades in foreign mar-
                      kets. ME interprets Rule 390 to allow a member firm

                      “[to] trade as principal or as agent in any listed stock on any organized exchange in
                      any foreign country at any time;” and outside of exchange trading hours, [to] trade
                      as principal or agent in any listed stock in a foreign country over-the-counter.“”


                      ‘These restrictions are as follows: BostonStockExchange,Section23 of ChapterII; Midwest Stock
                      Exchange,Rule 9 of Article VIII; Pacific StockExchange,Rule XIII; and PhiladelphiaStockExchange,
                      Rule 132.For easeof presentationand becauseNOSEis the mostsignificant market,our discussionof
                      trading restrictions focuseson NYSE’s Rule 390.
                      “Broker/dealer membersof MSE include such firms as Merrill Lynch, MorganStanley,Shearson Leh-
                      man Hutton, First Boston,Alex. Brown, and Prudential-Bathe.
                      “‘Amex Rule 5 covers33 of its 100mostactive stocks.
                      ’ ‘The International StockExchange in Londonlisted 186U.S.stocksin 1989.Designatedmarketmak-
                      ers of the exchangeare required to makemarketsin stocksfrom 4:00a.m.to 12:00noon EST.The
                      Tokyo StockExchangelisted 70 U.S.stocksin 1989and is openfrom 800 p.m.to 10:00p,m. and from
                      12:00midnight to 200 a.m.EST,
                       ‘“NkSE Rule 390, Interpretation .lO.



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                        SEC stated in its public release adopting Rule 19c-3 that, because the
No Comprehensive        trading restrictions issue is important to the evolving national market
Review of Trading       system, SECexpected to reexamine the issue periodically in the light of
Restrictions Since      future market developments. SEC discussed the effect of trading restric-
                        tions on after-hours trading in 1986. However, SEC Division of Market
1980 Despite Major      Regulation and Office of Economic Analysis officials told us that SEC’S
Changes in the Market   1ast comprehensive review of the effect of trading restrictions on the
                        domestic market occurred in 1980 as part of the approval process for
                        Rule 19c-3.1:1The markets have changed significantly since then.

                        SEC’S 1980 action in approving Rule 19c-3 did not satisfy the House Com-
                        mittee on Interstate and Foreign Commerce. In its report reviewing SEC’S
                        actions to implement the national market system goals contained in the
                        1975 Amendments, the Committee stated that

                        “The Congress directed the SEC to report on the competitive impact of such rules,
                        and to begin proceedings to eliminate such restrictions. Placing the ultimate decision
                        in the Commission’s hands provided the flexibility to deal with problems that many
                        argued would arise upon elimination of the off-board restrictions. But, despite the
                        flexibility as to timing and the development of necessary related rules, it is nonethe-
                        less clear that Congress intended such anti-competitive rules to be eliminated.“’ 4

                        The Committee further noted in its 1980 report that “despite the funda-
                        mental purpose of the 1975 Amendments to eliminate unnecessary
                        restraints on competition, these restrictive rules and practices, although
                        modified, continue in place.” In the opinion of the Committee, SEC had
                        “failed to fulfill its obligations with respect to anti-competitive rules and
                        practices.” Despite this criticism, SEC has taken no further action on
                        these trading restrictions.

                        In 1986, SEC’S Division of Market Regulation, in responding to a Commis-
                        sion initiative concerning the increasing internationalization of the
                        securities markets, raised the issue of after-hours effects of NISE Rule
                        390. The Division recommended that the Commission send a letter to
                        NBE requesting the exchange to “consider lifting its off-board trading
                        restrictions (Rule 390) on after-hours trading.” The Division presented
                        this recommendation to the Commission at an open meeting on interna-
                        tionalization on May 22, 1986. Although no formal vote of the Commis-
                        sioners was taken, only one Commissioner supported the Division.

                         ‘.‘Although SEC reviewed market trading structure issues in its report on the 1987 market crash. it
                         did not analyze the effects of Rule 390 on the crash.

                         “House Comm. on Interstate and Foreign Commerce, 96 Cong., 2d Sess.,Kational Market System
                         Five Year Status Report 14 (Comm Print 1980).



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At this open meeting, one Commissioner was the most outspoken oppo-
nent of the Division’s recommendation. Among other points, he ques-
tioned whether the rule was anti-competitive, whether there was any
substantial demand for after-hours trading, and whether it should be
considered odd that an exchange should have a rule to control its mem-
bers’ trading even after-hours. The Division contended that SEC has
found Rule 390 to be anti-competitive for 10 years and the only question
about the rule was whether it was a justifiable burden on competition.
The Division further contended that $lOO-$150 million of daily after-
hours trading volume in U.S. securities occurs in overseas markets and
that it is odd to have a restriction in place when the market it suppos-
edly protects is not available for trading. They concluded by saying that
 Rule 390’s application to after-hours trading has “no perceived bene-
 fits.” The Commission rejected the Division’s recommendation to send
 the letter to NISE but, rather, instructed the Division to maintain a dia-
 logue with M3E on this issue.

In a recent speech, the Director of the Division of Market Regulation
revived the issue and questioned the wisdom of having Rule 390 apply
to after-hours trades.” He said that this after-hours trading, while only
a small percentage of U.S. daily trading volume, can be significant. He
further stated that these trades are done in foreign markets because
exchanges, through off-board trading rules, do not permit their members
to execute such transactions in the United States off an exchange floor.
Since no U.S. exchange is open at these times to accept trades, broker/
dealers execute the trades in foreign markets. In addition, these trades
 are never reported to SEC or the exchanges and, thus, are not subject to
U.S. regulatory oversight.

 These recent statements continue to support the Division’s 1986 position
 on Rule 390’s application to after-hours trading. In its 1986 memo to the
 Commission, the Division of Market Regulation, in calling for the
 removal of Rule 390 on after-hours trades, found “no justification for
 maintaining this artificial pressure on U.S. firms to trade with U.S.
 investors overseas.” The Division also stated that overseas trading is
 done in markets where U.S.-style investor protection and anti-manipula-
 tive rules are lacking. The Division further noted that these trades are
 beyond the surveillance reach of U.S. exchanges and SEC.



 “Speech by Richard G. Ketchum at a Business Week, Securities Week, and Hewlett-Packard seminar
 on “Challenges Facing the Securities Industry,” New York City, June 16, 1989, p. 12.
                               .

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                       Since SEC'S comprehensive review of trading restrictions in 1980, the
                       U.S. equity markets have changed substantially. Trading volume has
                       soared on the exchange and KASDAQ markets. In 1980, the total trading
                       volume on U.S. exchanges was 15.5 billion shares; in 1989, that volume
                       jumped to 53.5 billion shares. Similarly, trading volume in the NASDAQ
                        market rose from 6.7 billion shares in 1980 to 33.5 billion shares in
                        1989. In addition, institutional investors account for continually increas-
                        ing trading volume. In 1988, large block trading at the NkSE-a measure
                        of institutional participation-accounted    for almost 55 percent of QSE
                        share volume, up from about 29 percent in 1980. Also since 1980, the
                        growing use of derivative products, such as stock options and futures,
                        has contributed to a complex market structure in which sophisticated
                        investment strategies abound. As shown by the 1987 market crash, the
                        stock, options, and futures markets are inextricably linked. Finally, the
                        U.S. marketplace faces additional challenges as overseas financial mar-
                        kets grow in importance and the world’s financial markets become
                        increasingly interdependent.


                       Securities industry participants and outside experts have sharply differ-
Extensive              ent perspectives on the merits of trading restrictions. The issue is com-
Disagreement About     plex. However, there is no question that the restrictions help maintain
Effects of Trading     the current market structure and that removing the restrictions could
                       substantially alter the way exchange-listed securities are traded, includ-
Restrictions           ing the possible elimination of trading floors and specialists. Critics say
                       the restrictions have a substantial adverse effect on levels of
                       marketmaking capital, price competition, and incentives to develop and
                       use automated trading systems. In addition, critics assert that the
                       restrictions are forcing exchange broker/dealers who want to trade
                       after-hours to do so in foreign markets. Supporters of the restrictions
                       argue that the restrictions are pro-competitive because they concentrate
                       supply and demand for stocks in a central market and preserve an auc-
                       tion trading system. This, they argue, provides investors a better oppor-
                       tunity for receiving superior share prices on their stock trades.
                       Supporters also point to the trading system enhancements made in the
                       last decade as proof that system developments are not being retarded by
                       the restrictions.


Marketmaking Capital   Perhaps the most significant criticism of the specialist system relates to
                       the inadequate amounts of capital specialists had to handle extraordi-
                       nary trading demands during the market crash of 1987. SEC, in its report

                                                      .

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on the market crash.“, found that while specialists, in the aggregate, per-
formed satisfactorily, a disturbing number were either net sellers or
only small net buyers on October 19, 1987.‘; This performance was con-
trary to what many believed to be the specialists’ affirmative obligation
to buy when other buyers do not exist. The Brady Report concluded that
“from the final hours of trading on October 19 through October 20, a
substantial number of PiBE specialists appear not to have been a signifi-
cant force in counterbalancing market trends.“‘”

Two of the nation’s best capitalized exchange broker/dealers told us
they would commit more capital to make markets’” if NYSERule 390 was
removed. AXE Rule 390 restricts exchange broker/dealers from using
their capital to make markets in many stocks off the exchange floor.
This additional capital could increase competition for specialists in nor-
mal times and ease pressure on specialists in a crisis such as the October
 1987 market crash.

Supporters of NY3E Rule 390 emphasize that the rule does not prevent
large exchange broker/dealers from becoming specialists on primary or
regional exchanges and using their capital to make markets in their
assigned stocks. For example, Merrill Lynch, PaineWebber, and Bear
Stearns are specialists at NlSE.2” N‘tSE modified its rules after the market
crash to encourage large broker/dealers to be specialists. NksE’s rationale
was that broker/dealers, by becoming specialists, would bring additional
marketmaking capital to the exchange floor. In addition, after the mar-
ket crash, NOSEincreased the minimum capital requirements of special-
ists from $100,000 to $1 million and tripled minimum share position
requirements. NOSE also strengthened performance evaluation standards
for specialists.


 “‘The October 1987 Market Break, A Report by the Division of Market Regulation. ITS. Securities and
 Exchange Commission, February 1988, p. xvii.

 “SEC also detailed hXSDAQ market maker performance during the market crash. As with exchange
 specialists. market makers had significant problems in carrying out their marketmaking responsibili-
 ties. SEC found, among other things, that many market makers withdrew from using the NASD auto-
 matic execution system and, in some cases, withdrew from making markets in some stocks altogether.
 ‘“Report of The Presidential Task Force on Market Mechanisms. January 1988, p. 50.

 “‘Market making refers to broker/dealers using their own stock inventory and capital to trade with
 customers and other broker, dealers.

 “‘All exchanges with a specialist system now have large broker/dealer specialists. For example. 13%
 has Merrill Lynch, Dean Witter. and Pershing; Amex has Merrill Lynch and Bear Steams; MSE has
 Merrill Lynch and Pershing; PSE has Merrill Lynch, Shearson Lehman Hutton, and Painewebber. and:
 PHLX has Dean Witter and Pershmg.



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                                              Supporters also told us that Rule 390 does not prevent member firms
                                              from functioning as upstairs market makers” in block trades-large
                                              trades generally involving 10,000 shares or more-provided       that the
                                              trade is routed to an exchange floor for execution. These upstairs-that
                                              is, off-the-floor-market     makers find institutional customers to take the
                                              other side of a trade and commit their own capital, if necessary. to com-
                                              plete a transaction. NOSE granted broker/dealers this authority to
                                              arrange-but       not execute-block trades in the 1960s because specialists
                                              were experiencing difficulties handling the growing number of large
                                              orders due to insufficient capital. As shown in figure 2.1( block trades,
                                              an indicator of institutional participation, have grown significantly at
                                              NOSE since 1975.




Figure 2.1: NYSE Block Trades (1975 to 1988)

60   P8rc8nt8go
55

SO
                                                                                               ,    1          -r
46

40

38

30
                                          I




                                              Source: New York Stock Exchange.


                                              In addition, NOSE began trading a “basket of stocks” in October 1989.
                                              This basket product” trades in units valued at about $5 million. In a
                                              break from its reliance on specialists, NYSE primarily uses competing

                                              “‘Upstairs market makers are also referred to as block positioners. As of 1988. there were M regis-
                                              tered block positioners at the SYSE.

                                              “Known as Exchange Stock Portfolio.



                                              Page 25                                                   GAO/GGD-90-62    National   Market   System
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                    market makers to trade the new product. Exchange broker/dealers, act-
                    ing as competing market makers for the basket product, will be provid-
                    ing additional marketmaking capital to the hWE floor. NISE, in its
                    submission of this proposal to SEC, indicated that this additional capital
                    should help address concerns about exchange specialists not being able
                    to provide sufficient liquidity and depth to the market, particularly to
                    handle the large orders of institutional investors. As of January 3 1,
                     1990, trading volume in basket units totaled 187, an average of just
                    under 3 a day.


Price Competition   A major argument for removing trading restrictions is that they prohibit
                    member broker/dealers from competing with exchange specialists. Some
                    broker/dealers and academicians assert that these restrictions give spe-
                    cialists an unfair competitive advantage over exchange member broker/
                    dealers by eliminating their marketmaking competition. If member firms
                    were permitted to compete with exchange specialists in all exchange-
                    listed stocks. some broker/dealers and academicians assert that quotes
                    would be narrowed and investors would obtain better prices. Officials of
                    the I~ASD market, which is comprised of competing market makers, sup-
                    port the view that removing such restrictions as M3E Rule 390 would
                    increase the number of market makers, thereby creating a more compet-
                    itive market for listed securities.

                    Conversely, supporters of NBE Rule 390 argue that it is not anti-compet-
                    itive but, rather, pro-competitive. They contend the rule is pro-competi-
                    tive because it centralizes order flow in exchange-listed stocks. In 1988,
                    for example, 98 percent of domestic share volume in NBE stocks was
                    traded on linked markets. Officials of NOSE, Amex, and most of the
                    regional exchanges said trading restrictions limit the market fragmenta-
                    tion-the dispersion of orders among unlinked markets-that        would
                    occur if the orders were executed in-house by broker/dealers without
                    exposing them to the exchange market. They added that market frag-
                    mentation of order flow. in turn, can have a serious, adverse impact
                    upon price discoveryLzl by reducing the extent to which buy and sell
                    orders for a stock interact in one location or within a linked market-
                    place. This market fragmentation could result in investors not obtaining
                    the best prices available for their orders.



                    “{Price discovery is the process by which a market price for an asset is determined through rhv
                    interplay of supply and demand.



                    Page 26                                                  GAO/GGDS@52       National   Market   System
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                    Many primary and regional exchange officials, broker/dealers, and insti-
                    tutional investors also argue that if the restrictions were removed, the
                    auction market might be replaced by a dealer market because large
                    member firms might abandon exchanges and execute customer orders
                    themselves. If this occurred, the benefit of an auction market, which
                    allows investor orders to meet directly, without the intervention of a
                    dealer, would be lost. An auction market differs from a dealer marketi
                    in that a customer order is exposed to the buy and sell interest in the
                    marketplace and can be matched with other customer orders.

                    NOSEofficials point to the problems experienced recently at the Interna-
                    tional Stock Exchange in London as indicative of trading without a Rule
                    390. In October 1986, the London exchange experienced “Big Bang,”
                    which led to the virtual end of the trading floor in favor of an CJXtrad-
                    ing system. The result, NBE officials contend, is a severely fragmented
                    market with diminished liquidity and a lack of firm quotes.

                    Exchange officials and some market participants argue, therefore, that
                    customers in the exchange auction market have the opportunity to
                    obtain better prices than those quoted by dealers. The reason for this is
                    that trades are often executed between the bid-ask spread that the spe-
                    cialist is quoting. For example, NBE statistics show that about 32 per-
                    cent of WSE trades during the March 22 to May 30,1989, time frame
                    were executed between the quoted bid and offer prices.


Automated Trading   Trading restrictions may hamper the development and use of more effi-
Systems             cient automated trading systems than now exist. Automated trading
                    systems may result in lower trading costs and may expand the opportu-
                    nity for investors to trade directly with each other. Some broker/dealers
                    assert that the ability of member firms to make markets in all exchange-
                    listed stocks away from exchange floors would serve as an incentive to
                    the securities industry to create and use more highly automated trading
                    systems. Exchange broker/dealers might develop automated systems to
                    execute customer orders in-house, a trading practice that the restric-
                    tions prohibit. To respond to such a competitive challenge, the




                     “In a dealer market, customer orders are matched and executed against the dealer’s inventory. At
                     NOSE,although specialists under certain conditions act as dealers, specialists are involved in only
                     about 10 percent of the buying and selling activity.



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exchanges might develop more efficient, perhaps fully automated, trad-
ing systems. Some market participants consider efficient automated sys-
tems to be essential if US securities markets are to remain competitive
in an increasingly global and electronic trading environment.

Some market consultants proposed a fully electronic trading system that
does not require an exchange trading floor.?” While initially proposing
this system in response to the 1975 Amendments, these proponents
argued strongly after the crash that an electronic trading system would
have functioned much more efficiently and would have provided much
more liquidity and market information during the market crash by per-
mitting investors to trade automatically and continuously. Their pro-
posed system would allow all buyers’ and sellers’ orders to meet through
electronic intermediaries at all times; no trading halts resulting from
order imbalances would be declared.

Automated trading systems that allow off-the-floor trading are being
increasingly employed by major foreign securities markets. In a Febru-
ary 1989 speech, former SEC Chairman David Ruder observed that one
of the more notable foreign automated execution systems was instituted
at the Toronto Stock Exchange in 1977.?” Toronto’s Computer Assisted
Trading System (CATS)is a screen-based automated trading system. CATS
automatically matches and executes buy and sell orders based on the
prices stipulated and the time orders are received.‘; As of February 1,
 1990, CATSwas used for approximately 840 of the 1650 stocks listed at
Toronto and accounted for about 22 percent of overall trading volume.Jx

 The Tokyo Stock Exchange, which recently surpassed N%E as the largest
 stock exchange by volume in the world, has a system similar to CATS.
 Tokyo’s Computer Assisted Order Routing and Execution System (CORES)
 permits the automated execution of orders entered by traders from their
 offices. In 1989, this computer assisted execution feature covered 1566

 “Junius Peake. Morris Mendelson. and R.T. Williams Jr., The Peake-Mendelson-Williams National
 Book System, April 1976.

 ‘“Appendix to speech entitled “Automation of Information Dissemination and Trading in C.S. Securi-
 ties Markets” by SEC Chairman David S. Ruder at the 1989 Forum on Technology and Financial
 Markets in Washington DC., February 27, 1989, p. 27. Chairman Ruder also concluded that fully
 automated trading systems are unlikely and that a combination of automated trading and auction
 market is the most probable future course.

 “CATS also provides a feature by which a trader can add a “+” indication to an order, which com-
 municates to others that the trader is interested in buying or selling more shares of stock than speci-
 fied in the entered order. This can then lead to telephone discussions of larger transactions.

 ‘sData provided by the Toronto Stock Exchange.



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of the 1716 stocks listed at the exchange and accounted for 44 percent
of total trading volume. However, the 150 most active stocks are still
traded in the traditional way on the Tokyo trading floor.”

Dr. William Freund, a former NBE chief economist, argues that the lack
of more highly automated trading systems could put U.S. markets at a
disadvantage if 24-hour trading begins in foreign markets. In a Decem-
ber 1988 speech at an American Economic Association conference, he
said that

“The floor of the NOSE suffers from a major disadvantage in terms of international
stock trading. It is difficult to extend trading hours because of the people-intensive
nature of the operation.“‘“’

Exchange officials disagree that Rule 390 inhibits development of auto-
mated trading systems. These officials note that they have adopted
automated exchange trading features. For example, NISE has invested
more than $150 million in SuperDot-a network of electronic order
processing and post-trade systems that provides a communications link
between a member firm’s trading operations and the NYSEtrading floor.
Amex filed a rule change with SEC in May 1989 requesting, among other
things, approval to begin an automatic execution system for many of its
stocks. This aspect of the rule proposal is under SEC review. The five
regional exchanges have systems that automatically execute small
orders.‘” These orders are executed at the best bid or offer displayed in
the consolidated quotation system.

SEC officials point out that Rule 390 has not prevented fully automated
trading systems, such as CSE’S National Securities Trading System (NSTS),
from operating without a trading floor. Market makers in NSTS can be
located anywhere in the United States and do not require a physical
presence in Cincinnati. CSE member firms can have their orders executed
by these market makers instantaneously through the NSTS. In addition,
Instinet and Jefferies and Co. operate fully automated trading systems
that allow institutional investors to trade directly with each other.




“‘Data provided by the Tokyo Stock Exchange.

.“‘Speech entitled “Electronic Trading and Linkages in International Equity Markets” by Dr. William
Freund to the American Economic Association in New York City on December 30, 1988, p. Q.

.“Small orders are defined dlfferc,ntly at the various markets but generally are less than 1100 shares.



Page 29                                                   GAO/GGD90-52       National   Market   System
                            Chapter 2
                            SEC Needs to Periodically   Address Effects   of
                            Trading Restrictions




                            NISE Rule 390 does not prevent non-exchange members from implement-
                            ing automated systems. Bernard L. Madoff Investment Securities, a bro-
                            ker/dealer that is not a member of NYSE,makes markets in 250 of N’ISE’S
                            most active stocks. Madoff guarantees its customers automatic execu-
                            tion at the best advertised bid or offer price quoted on the consolidated
                            quote system for up to 3,000 shares.

                            In a June 16, 1989, speech, the Director of SEC’SDivision of Market Reg-
                            ulation questioned whether automated trading systems will become the
                            preferred manner of trading. He stated that

                            “Trading systems which provide for the automatic execution of quotations create
                            new market making risks which are not associated with face to face or telephone
                            trading. Automatic execution exposes market makers to the risk of being ‘picked
                            off’ by other market professionals before they can respond to news or changes in
                            other participant’s quotations. This ‘pick off’ risk may discourage market makers
                            from trading in size and, as a result, reduce the potential depth and liquidity of any
                            such system.““’

                            Investor preference may have a larger impact on automation than trad-
                            ing restrictions. SEC officials note that U.S. markets are not more auto-
                            mated because many institutional investors prefer negotiating trades
                            over the telephone. In the above cited speech, the Director of SEC’S Divi-
                            sion of Market Regulation said that many institutions like the flexibility
                            of working their orders gradually on an exchange floor without their
                            interest in the stock being disclosed all at once. If institutional investors
                            become dissatisfied with the exchanges, they are free to shift their trad-
                            ing to a proprietary trading system, such as Instinet, that provides fully
                            automated trading or eliminates broker/dealer intermediaries,


Restrictions May Force       As previously discussed, NBE Rule 390 prohibits exchange member bro-
Trades to Foreign Markets    ker/dealers from executing trades in the United States off an exchange
                             floor. As a result, when the exchanges are closed, member broker/deal-
                             ers execute these trades in foreign markets, a practice permitted by
                             exchange rules. Were it not for the restrictions, these member firms
                             could choose to execute after-hours trades as a market maker against
                             their own, or another broker/dealer’s inventory.




                             ‘“Speech by Richard G. Ketchum at a Business Week, Securities Week, and Hewlett-Packard seminal
                             on “Challenges Facing the Securities Industry,” hew York Uty, June 16, 1989. p.8.



                             Page 30                                                GAO/GGD90-52     National   Market   System
              Chapter 2
              SEC Needs to Periodically   Address   Effects   of
              Trading Restrictions




              Neither the exchanges or SECcollects information on the volume of after-
              hours trading of individual U.S. stocks by member firms overseas, How-
              ever, the trade volume has been significant enough to prompt MSE to
              develop an after-hours trading system. In addition, in May 1989, KISE
              officials announced their intention to study whether they should
              develop an after-hours system.

              MSE'S “Secondary Trading Session,” approved by SEC in October 1989, is
              designed to trade portfolios of stocks through an automated system
              from 4:30 to 6:00 p.m. EST. MSE stated in its proposal to SEC that the Sec-
              ondary Trading Session responds to the problem of brokers being forced
              by NBE Rule 390 to make after-hours portfolio trades for institutional
              investors in foreign markets. In supporting its proposal, MSE stated that
              overseas trades “take place without the benefit of SECor exchange over-
              sight and without the regulatory protections afforded participants in
              U.S. securities markets.” MSE'S system to trade this product became
              operational in January 1990, but, as of January 31, 1990, no trades had
              been made.

              NOSEis also considering developing a 24-hour trading process should
              member firms and institutional investors express interest in such a sys-
              tem. NBE officials indicated that they will be surveying these market
              participants to determine the extent of that interest. While the officials
              estimate that NYSEwill be studying this idea over the next 6 to 24
              months, they indicate that sufficient interest among market participants
              to justify developing such a system may be 5 or 10 years away.


              Exchange-imposed trading restrictions like NISE Rule 390 significantly
Conclusions   affect-some say negatively, some say positively-how       US. stocks are
              traded. Ten years ago, in a substantially different marketplace, SEC
              decided against totally removing the restrictions, choosing instead to
              periodically reevaluate them in light of market developments. However,
              despite the major market developments of the 1980s including a market
              crash, no such reevaluation has occurred or is planned.

              These restrictions influence: (1) the amount of marketmaking capital
              available; (2) the degree of price competition in the marketplace; (3) the
              development and use of more innovative and efficient trading systems;
              (4) the centralization of U.S. trading; and (5) the preservation of an auc-
              tion market. In addition, because of the restrictions, NOSE member bro-
              ker/dealers who wish to trade after-hours as a principal can only do so
              in foreign markets. Because of the potential effects of these restrictions,


              Page 31                                              GAO/GGD!WS2   National   Market   System
                      Chapter 2
                      SEC Needs to Periodically   Address   Effects   of
                      Trading Restrictions




                      SEC needs to reconsider whether they should be further modified,
                      removed, or reaffirmed.


                      We recommend that the SEC reopen the trading restrictions issue to
Recommendations to    determine whether these restrictions should be further modified,
the Securities and    removed, or reaffirmed. One potential modification of the restrictions
Exchange Commission   would be the elimination of their applicability to after-hours trading. If
                      SEC decides against removing any or all exchange-imposed trading
                      restrictions now, SEC should consider their continued appropriateness
                      periodically to keep pace with the rapidly changing marketplace.


                      SEC agreed with our recommendation that the after-hours implications of
Agency Comments and   NISE Rule 390 should now be reconsidered. However, SEC disagreed with
Our Evaluation        our recommendation for a comprehensive review of NBE Rule 390’s (and
                      similar rules at other exchanges) effects on the domestic market while
                      the exchange is open. Nevertheless, because of SEC's legislative mandate,
                      its own determination of the need to reevaluate trading restrictions peri-
                      odically, and the vast changes in the marketplace that have occurred in
                      the last decade, we continue to recommend such a review.

                      Most exchange officials did not endorse our recommendation that the
                      Rule 390 issue be revisited. They contended that a review of Rule 390
                      would be complex and that elimination of the rule might lead to a less
                      desirable marketplace. However, exchange officials agreed that the logic
                      used to arrive at our conclusion was sound. NASD officials supported our
                      recommendation. They contend that elimination of Rule 390 would lead
                      to a more desirable marketplace.




                                                     .


                       Page 32                                             GAO/GGD90-62   National   Market   System
Intermarket Trading System Needs a
Comprehensive Review

                        The Intermarket Trading System (ITS) has electronically linked the trad-
                        ing of stocks in various marketplaces around the country since 1978.
                        The exchanges designed ITSto meet the 1975 Amendments’ goals to
                        reduce market fragmentation, enhance competition, and allow custom-
                        ers to receive execution of their orders at the best price available in any
                        of the linked markets. Former SEC Chairman David Ruder characterized
                        ITS as perhaps the most visible by-product of the effort to establish a
                        national market system.

                        SEC’S last comprehensive review of ITS operations was completed in
                        1982. The review covered the system’s first 4 years of operation and
                        examined trading volume, operating efficiency, and effect on
                        intermarket competition. Since 1982, SEXand market participants have
                        changed system operations in response to problems experienced during
                        the 1987 market crash and more recently in response to ITS users’ con-
                        cerns. In addition, between 1979 and 1989, share volume trades over ITS
                        increased over ten-fold. The number of incremental changes made to the
                        system since SEC’S last comprehensive evaluation and the increasing
                        importance of ITS as shown by the dramatic increase in trading volume
                        indicates the need for SEC to again look at overall ITS effectiveness and
                        the extent to which it is meeting its national market system goals.


                        ITSlinks the two primary exchange markets (N’YSE and Amex)with five
ITS Links the Markets   regional exchange markets (BSE, CSE, MSE, PSE, and PHLX) and NASD. ITS is a
                        communication and order routing system designed to facilitate trading
                        of NYSE- and Amex-listed stocks among competing markets.’ Specialists,
                        floor brokers, and market makers can view the quotes in other markets
                        and transmit buy and sell orders-known      as “commitments to trade”-
                        through ITS to other markets that are offering a better or the same
                        price.” These orders may be accepted, cancelled, or allowed to expire by
                        the receiving market.”

                        Many market officials and experts stated that ITSenhances competition
                        among the various markets and benefits investors. ITS rules attempt to

                        ‘NBE Rule 390 does not prevent its members from trading NkSEllsted stock on regional exchanges.

                        ‘The best bid is the highest priced buy order while the best offer is the lowest priced sell order in the
                        market at a point in time.

                        .‘If orders are not accepted or cancelled, they automatically expire within 1 or 2 minutes, depending
                        on which market originated the order. A regional exchange specialist’s commitment to trade that is
                        not accepted or cancelled by the receiving market will expire after either 1 or 2 minutes as stipulated
                        by the regional specialist.
                                                          .


                         Page 33                                                    GAO/GGD-90-62      National   Market   System
                    Chapter 3
                    Intermarket   Trading System Needs a
                    Comprehensive     Review




                    assure that investors obtain the best price available in the system.
                    Although current measures of investor savings are unavailable, NOSE, in
                    its 1983 Annual Report, estimated that

                    “the opportunity    to obtain a better price in a different market, via ITS. may have
                    saved individual    and institutional investors as much as $150 to $170 million since
                    1980.”

                    Some regulatory officials and exchange specialists said that without I?‘&
                    the regional exchanges would have a difficult time competing with the
                    primary markets for order flow. Viable regional exchanges are impor-
                    tant because they enhance overall marketplace competition. One indica-
                    tion of the competition from regional markets is that NESE’S portion of
                    consolidated trades declined from 87.0 percent in 1978 to 73.0 percent in
                     1988. Former SEC Chairman Ruder has stated that ITSenhances the abil-
                    ity of regional exchange specialists to compete with the primary mar-
                    kets by providing them with an efficient method for transmitting what
                    they consider to be excess positions in a stock to other exchanges.’


                    SECpublished the results of its last comprehensive evaluations of the ITS
No Comprehensive    in two reports issued in 1981 and 1982.’ These reports examined trading
Evaluation of ITS   volume, operational efficiency, and the system’s effect on intermarket
Since 1982          competition during its first 4 years of operation. Since 1982, SEC has con-
                    tinued to monitor ITS. SEC’S standard monitoring activities include
                    attending ITS meetings, approving amendments to the ITSPlan,‘, and
                    maintaining informal contact with ITS participants. SEC also reviewed ITS
                    capacity problems experienced during the 1987 market crash. In addi-
                    tion? SEC and ITS participants have made other system changes to resolve
                    specific user concerns.

                    These incremental changes have been made without any further com-
                    prehensive evaluation of ITSoperations since 1982. Such an evaluation
                    could determine the effectiveness of changes already made, the need for


                     ‘Speech entitled “Automation of Information Dissemination and Trading in U.S. Securities Markets”
                     by SEC Chairman David S Ruder at the 1989 Forum on Technology and Financial Markets. Washing-
                     ton DC., February 27, 1989. p.8.

                     ‘4 Monitoring Report on the Operation of the Intermarket Trading System, Directorate of Economic
                     and Policy Analysis, I:.S Securities and Exchange Commission, February 1981; and A Report on the
                     Operation of the Intermarket Trading System: 1978-1981. Directorate of Economic and Policy Analy-
                     sis. Securities and Exchange Commission, June 1982.
                     “The ITS Plan sets forth the rules under which ITS operates



                     Page 34                                                  GAO/GGD-90-52   National   Market   System
                          Chapter 3
                          Intermarket   Trading System Needs a
                          Comprehensive     Review




                          any additional changes, and the extent to which                ITS   continues to meet
                          national market system goals.


Changes Since the Crash   SEC and ITS participants made changes to the system after they expe-
                          rienced problems during the 1987 market crash. SEC reported that the
                          high volume of trade commitments routed over ITS to PU’BE on October 19
                          and 20, 1987, caused capacity problems with the NYSE printers. There-
                          fore, numerous trades took more than the required 2 minutes to reach
                          NYSE specialists and, thus, expired.


                          In an effort to speed the process, NYSE has made several changes to the
                          way ITS commitments reach specialists. NYSE now routes orders received
                          through its automated order routing system7 directly to the specialists’
                          electronic display books, freeing up the capacity of its floor printers to
                          handle ITScommitments. The electronic display books show both market
                          and limit orders for each of the specialist’s assigned stocks on a com-
                          puter screen. As a further enhancement, NBE is planning by early 1990
                          to route ITS commitments directly to the electronic books, thereby bypas-
                          sing printers altogether. NOSE specialists could then receive, send, and
                          respond to ITScommitments using the display books. According to USE
                          officials, this change to the display books for ITS orders will shorten NEE
                          specialists’ response time to ITS commitments. In addition, NYSE did a
                          stress test of its ITS interface in September 1989. SEC also suggested that
                          ITS participants consider adopting default procedures so that, after 2
                           minutes, the commitment would be automatically executed rather than
                           cancelled.

                          SEC  reported that regional specialists expressed concern that the ITS Plan
                           did not require NOSE specialists to issue pre-opening notifications before
                           trading resumed after an order imbalance halt. SEC suggested that these
                           pre-opening notifications be given when trading resumes after a halt. ITS
                           participants have been negotiating this proposal.


Changes Being Made to      During our fieldwork, various ITS participants, including market offi-
Address User Concerns      cials, specialists, floor brokers, and market makers, told us changes were
                           needed to ITS pre-opening procedures, time-stamping requirements on
                           NYSE’S trading floor, automatic execution of ITS orders, and the resolution
                           process for r’rs-related complaints. After completion of our fieldwork,


                           ‘Designated Order Tumaroqd   system, also known as DOT or SuperDot.



                           Page 35                                              GAO/GGD!W-52      National   Market   System
                                Chapter       3
                                Intermarket       Trading System Needs a
                                Comprehensive         Review




                                SEC and ITS participants           made changes to resolve several of these
                                concerns.

Pre-Opening Procedures          Specialists and officials of regional exchanges said ITS rules limit
                                regional participation in the opening of ITS stocks. Before opening trad-
                                ing in their assigned stocks, NYSEand Amex specialists assess pre-opening
                                buy and sell interest to determine an opening price. Heavy trading vol-
                                ume frequently occurs at the opening of stocks. Under certain circum-
                                stances, ITS rules allow regional exchange specialists to participate in
                                opening ITS stocks by sending their buy and sell orders directly to SEE or
                                hex   specialists, thereby avoiding brokerage fees.

                                For example, according to the ITS Plan, if an ITS stock will open on SESE
                                at a price higher or lower than the previous day’s closing price by a
                                given amount, the NOSEspecialist must notify regional exchanges by
                                sending a “pre-opening notification” over ITS. At NBE, pre-opening noti-
                                fications must be sent if the specialist anticipates that the opening price
                                will be more than one-eighth of a point away from a closing price of
                                under $15, or more than one-quarter of a point away from a closing
                                price of $15 or more. Regional exchange specialists can respond by send-
                                ing orders to NYSEthrough ITS at no cost.

                                 If the opening price is within the parameters, the IQSE specialist need
                                 not notify the regional exchanges’ specialists. To participate in the open-
                                 ing in these cases, regional exchange specialists must send their orders
                                 through NESEbrokers, thus incurring brokerage fees. Consequently, the
                                 NOSEspecialists have a competitive advantage. Regional exchange spe-
                                 cialists said pre-opening price parameters in the ITSPlan are too wide;
                                 therefore, they cannot participate in most openings of ITS stocks.

Time-Stamping   of NOSE Floor    During our review, regional exchange specialists told us that floor bro-
Broker Orders                    ker’s orders at NYSEwere not time-stamped which may lead to an audit
                                 trail problem. Many regional exchange specialists and officials we met
                                 with voiced this concern. ITScommitments may be legitimately traded
                                 ahead of and cancelled if a specialist executes a floor broker’s order
                                 before the ITS commitment is received. However, these regional special-
                                 ists said that, since NBE specialists were not required to time-stamp
                                 floor brokers’ orders left with them for execution, it was difficult, if at
                                 all possible, to document whether an ITS commitment was cancelled for a
                                 valid reason.

                                  NYSE has taken steps to address some of these concerns. In September
                                  1989, SEC approved a MSE rule change requiring specialists to time


                                  Page 36                                            GAO/GGPsO-62   National   Market   System
                           Chapter 3
                           Lntermarket   Trading System Needs a
                           Comprehensive     Review




                           stamp floor brokers’ orders left with the specialist for execution. The
                           rule also requires floor brokers to time-stamp orders when they are
                           received at the floor broker’s booth.

Automatic Execution        NASD   is linked to ITS through an automated interface with its Computer
                           Assisted Execution System (CAES).ITSstocks that are not subject to NKF,
                           and Amex off-board trading restrictions8 can be traded over the ITS/CAL’i
                           linkage.!’ However, as stated in chapter 2, many of the more actively
                           traded NYSE stocks are covered by the trading restrictions and are ineligi-
                           ble for trading over the ITS/CAFS linkage. CAESautomatically executes
                           orders routed to NASD market makers from the exchangesI” However,
                           orders sent from NASD market makers to the exchanges (except CSE) are
                           not automatically executed by the receiving market. According to NASD
                           officials, the CAB automatic execution feature, though voluntarily used
                           by NASD for its ITS linkage, puts NASD market makers at a disadvantage
                           by exposing them to more risk than other ITSusers. This discourages
                           NASD market makers from using the link; about 90 percent of share vol-
                           ume over ITS/CAES can be attributed to one NASD market maker. NASD con-
                           tends that ITStrades should be automatically executed up to the number
                           of shares advertised for sale or purchase by the specialist or market
                           maker. CSE also supports automatic execution of ITS orders.

                           SEXhas recently discussed a possible need for automatic execution of
                           certain ITSorders. In June 1989, the Director of SEC’S Division of Market
                           Regulation, speaking before a group of industry professionals, recom-
                           mended that ITS public investor orders be guaranteed automatic execu-
                           tion. Without automatic execution, an ITS public investor order is not
                           assured immediate execution, posing a risk to the investor in a market
                           with rapidly changing prices. However, according to SEC officials and
                           some ITS participants, this proposal has not been well received by the
                           majority of the exchanges.

ITS Complaint-Resolution    The ITS Plan contains procedures for resolving complaints that result
Process                     from trading. During our review, however, many ITS users said the reso-
                            lution process is lengthy and cumbersome. Furthermore, they said they
                            believe the process to be biased against the complaining exchange mem-
                            ber. Two ITS users we spoke to said they were so dissatisfied with the

                            ‘NBE Rule 390 and Amex Rule 5. as discussed in chapter 2.

                            “Although 871 NBE- and Amex-listed stocks were eligible for trading through CAFS in December
                            1988. only 30 stocks were traded over the CAES system.
                            “‘The Cincinnati Stock Exchange has a similar automatic execution feature in its ho&up with ITS.



                            Page 37                                                 GAO/GGD-90-52    National   Market   System
                 Chapter 3
                 Intermarket   Trading System Needs a
                 Comprehensive     Review




                 complaint-resolution process that they stopped making trade com-
                 plaints. However, SECofficials said they have never received a formal
                 complaint Concerning  ITS.

                 Numerous types of ITStrade complaints are made. For example, an ITS
                 user may complain about not receiving a pre-opening notification when
                 one is required by the ITSplan. Also, an ITSuser might complain that a
                 commitment to trade was improperly cancelled by the receiving market.

                 The trade complaint resolution process has several stages, starting with
                 communication between the injured and alleged-offending specialists. If
                 the matter is not resolved, the complaint is reviewed by the alleged-
                 offending exchange. Complainants dissatisfied with the exchange’s reso-
                 lution of the complaint may file for arbitration with the alleged-offend-
                 ing exchange member. Exchange officials said that very few complaints
                 go to arbitration. The arbitration procedure is viewed as cumbersome,
                 and few specialists would pursue a complaint to this point unless it
                 involved a large trade or they felt it was a matter of principle.

                 Recently, the ITSparticipant markets agreed in principle to establish a
                 program in which ad hoc groups will do informal reviews of ITS-related
                 complaints. These groups would then issue non-binding decisions on the
                 day of the contested trading or soon thereafter.


                 The number of stocks traded over ITSand ITSannual share volume have
ITS Volume Has   increased steadily since the system’s inception. In 1989, 2,082 stocks
Increased        traded over ITScompared to 688 stocks in 1979. Of the 2,082 stocks
Dramatically     ‘traded over ITSin 1989, 1,633 were listed on NYSEand 390 were listed on
                 Amex.  The remaining 59 stocks were listed on regional exchanges. As
                 shown in figure 3.1, ITSannual volume has increased substantially, from
                 209 million shares in 1979 to 2.3 billion shares in 1989. Table 3.1 shows
                 the distribution of ITSshare volume among participant markets for
                  December 1989.

                  Although the 2.3 billion shares traded over ITSis not significant in terms
                  of the total share volume of NBE or IX&SD,this volume is significant rela-
                  tive to the shares traded on the other exchanges. For example, ITS’ 2.3
                  billion shares exceeds the individual 1989 trading volumes of PSE,IWX,
                  BSE,and CSE.




                  Page 38                                   GAO/GGD-90-52   National   Market   System
                                       Chapter 3
                                       Intermarket   Trading System Needs a
                                       Comprehensive     Review




                                       2!m           Mllllons ot sharr

                                       2250

                                       2ow

                                       1750

                                       lso0

                                       1250

                                       1000

                                        750

                                        500

                                        260




                                              1918        1979      1980          1981   1962   1989   1904       laa    lsm        1287       1988      1989



                                       Source New York Stock Exchange


Table 3.1: Distribution of ITS Share
Volume Among Participant Markets                                                                                             Percent of ITS share
(December 1989)                                                                                                                      volume
                                       Market                                                                                Receiving      Originating
                                       New York Stock Exchange                                                                      54.3%      -~___     30 1%
                                       Midwest          Stock Exchange                                                              17.8%                26 7%
                                       Pacific       Stock Exchanae                                                                 , , &,I -___~         ~~-~
                                                                                                                                                         18 1%
                                       Cmclnnatl          Stock Exchanqe                                                              5.7%                4 6%
                                       Amencan           Stock Exchange                                                               3.7%                2 0%
                                       Boston         Stock Exchange                                                                  3.2%                8 2%
                                       Philadelphia         Stock    Exchange                                                         2 1%                 7 8%
                                       National Assoclatlon              of                                                           1.4%                 2 4%
                                         Securltles Dealers
                                                                              -
                                       Total                                                                                         1OO%b                100%”
                                       aPercentages may not equal 100 percent when added due to rounding.
                                       Source New York Stock Exchange



                                        Effective trading linkages among the markets can enhance competition
Conclusions                             and may result in better prices for investors. ITShas helped reduce mar-
                                        ket fragmentation through its electronic linkages. SEC has been effective




                                        Page 39                                                               GAO/GGD90-62      National     Market    System
                       Chapter   3
                       Intermarket Trading System Needs a
                       Comprehensive          Review




                       in promoting ITS change when it acts aggressively to overcome market-
                       place inertia. However, in view of the number of incremental changes
                       made to the system since SEC’S last comprehensive evaluation and the
                       dramatic increase in trading volume, SEC needs to look again at overall
                       system effectiveness and the extent to which ITS is meeting its national
                       market system goals.


                       We recommend that SECdo a comprehensive evaluation of ITS, paying
Recommendations to     particular attention to the effects of recent system changes and
the Securities and     increased trading volume. SEC should address the system’s operational
                       efficiency effect on intermarket competition, and capability to handle
Exchange   Comission   future        market       crises




                       SEC noted in its comments that a continual assessment of the effective-
Agency Comments and    ness of ITSis an important aspect of SEC’S responsibilities and that SEC
Our Evaluation         has been continually reviewing ITS since the system’s implementation.
                       SEC further noted that a number of enhancements to ITS, all of which are
                       included in this chapter, are currently being considered or are in the
                       process of being adopted by the ITS participants. We believe that the
                       number of changes made since SEC'S last comprehensive review supports
                       the need for an overall assessment to determine whether the system
                       continues to meet national market system goals. While we continue to
                       believe that a comprehensive review of ITS is necessary, we understand
                       that the changes to the system currently being considered are important
                       and should continue. To the extent that a comprehensive review of ITS
                       would detract from resolving these issues in the near term, the overall
                       assessment could be delayed. However, such additional changes to ITS
                        further support the need for a comprehensive system review.




                        Page 40                                   GAO/GGD90-52   National   Market   System
Trading Linkage System Development for
Multiple Listing of Options Requires CloseSEC
Monitoring and Guidance
               In May 1989, SEC approved a major change to the way stock options’ will
               be listed and traded at exchanges. Rather than the former procedure of
               allocating an option on a listed stock to a single exchange, SEC now
               allows all exchanges to trade any new option listed after January 22,
                1990. In addition, each options exchange is permitted to list 10 stock
               options already allocated to another exchange. Furthermore, beginning
               in 1991, SEC will allow any exchange to trade any option regardless of
               where it was originally allocated. SEC approved this change to increase
               competition among exchanges and to improve options prices for inves-
               tors. Some exchanges disagree with SEC’S assessment of the benefits of
               multiple listing and trading of options. However, if increased competi-
               tion results and investors obtain better prices, SEC’S approval of this
                change will be consistent with national market system goals.

               SEC  noted that the benefits of multiple listing and trading of options may
                be enhanced by developing a trading linkage system among the
                exchanges. No such linkage currently exists. Options exchanges, in com-
                menting on SEC’s proposal, differed on whether a trading linkage system
                was needed or even feasible. The five options exchanges then commis-
                sioned two separate studies addressing the feasibility of an intermarket
                linkage system. One study, commissioned by PHLX, PSE, and NOSE, recom-
                mended that a linkage system similar to ITS be constructed. The other
                study, commissioned by CE3OEand Amex, recommended that a completely
                new system be developed to take advantage of modern technology.

                The lack of consensus among exchanges regarding a linkage system
                makes it unlikely that a system will be developed without active inter-
                vention by SEC. In January 1990, SEC requested the options exchanges to
                refrain from multiply listing existing options for 6 months to allow for
                development of a market linkage system. This type of guidance from SEC
                is necessary if a linkage system is to be built.




                ‘Stock options are contracts that give the holder the tight to buy or sell a stated number of shares of
                a particular stock at a fixed price within a predetermined time period. The two basic types of options
                are known as a “put” and a “call.” A put gives the holder of the option the right to sell, and a call
                gives the holder the right to buy.



                Page 41                                                    GAO/GGD-9@52 National       Market   System
                      Chapter 4
                      Trading Linkage System Development     for
                      Multiple Listing of Options Requires Close
                      SEC Monitoring   and Guidance




                      In May 1989, SEC Commissioners unanimously approved multiple listing
Multiple Listing of   of options on exchange-listed stock, thus making all stock options eligi-
Options Attempts to   ble for multiple listing within a specified timetable.’ SEC ruled that, as of
Address National      January 22, 1990, all new stock options would be eligible for trading on
                      more than one exchange. Under this rule, each options exchange would
Market System Goals   also be permitted to list 10 stock options already allocated to another
                      exchange. Furthermore, in January 1991, all stock options will be eligi-
                      ble for trading on any options exchange.

                      In proposing its rule allowing multiple listing of options, SEC stated that
                      options exchange rules prohibiting multiple trading may be inconsistent
                      with the Securities Exchange Act of 1934, particularly because the rules
                      may impose an unnecessary burden on competition. SECalso stated that
                      a continued postponement of multiple trading may be inconsistent with
                      the national market system goals requiring fair competition among bro-
                      kers and dealers, and the economically efficient execution of securities
                      trades.

                      Currently, most options on listed stock are subject to an allocation plan
                      under which one of the five options exchanges has exclusive rights to
                      trade individual stock options. The allocation plan was developed by the
                      nation’s options exchanges as a means of fairly allocating newly listed
                      options. This plan was instituted pending completion of a feasibility
                      study on market integration facilities, which SEC anticipated might facil-
                      itate multiple listing of options. Only options on OTCstocks and on 13
                      exchange-listed stocks were not subject to the allocation plan and. there-
                      fore, have been eligible for multiple listing. However, with the passage
                      of Rule 19c-5, the allocation plan was abolished for all options listed
                      after January 22, 1990. Therefore, all newly listed options are eligible
                      for trading on any exchange.

                      SEC based its decision to reconsider expansion of multiple trading of
                      options on improvements in options markets’ trading technologies since
                      the adoption of the allocation plan. SEC also found that multiple trading
                      of options on non-equity securities’ and OTC stocks was a largely positive
                      experience that did not result in any specific harm to the markets.




                      ‘SEC Rule 19c-5, 54 Fed. Reg. 23963 (1989) (to be codified at 17 C.F R. 240.19c-5) [Vol54. So. 1Oti
                      June .5, 19891.

                      “Options on Treasury securities, stock indexes, and foreign currencies



                      Page 42                                                   GAO/GGD9@52       National   Market   System
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                       Trading Linkage System Development     for
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                       SEC Monitoring   and Guidance




                       In 1986, SEC released two studies indicating that multiple listing may
                       narrow the spread between the highest bid and lowest offer for individ-
                       ual options. In one study, SEC’S Directorate of Economic and Policy Anal-
                       ysis did an econometric analysis of bid/ask spreads of multiply listed
                       options on OTCstock.4 This analysis found that the multiply listed Amex/
                       OTCoptions have bid/ask spreads that are 19.8 percent narrower than
                       spreads of options listed only on Amex. The narrower spreads of the
                       .hex/OTC   options, which the analysis attributes to their eligibility for
                       multiple listing, translated to a savings of $25 million to investors who
                       bought and sold options on crrc stock between June 1985 and May 1986.
                       The second study, by SEC’S Office of the Chief Economist, estimated that
                       preventing multiple listing of options costs investors approximately
                        $150 million annually.’


                       The opponents of multiple listing, including CBOE, PHLX, and PSE, dispute
Benefits of Multiple   the benefits attributed to multiple listing and point to potential draw-
Listing of Options     backs as well, Amex, the second most active options market, supported
Have Been Questioned   SEC’S elimination of the options allocation plan for new options on listed
                       stock but did not support expanded multiple listing of currently traded
                       options.

                       CBOE, PHLX,  and PSE each commissioned critiques of SEC’S 1986
                       econometric studies. These critiques noted numerous methodological
                       flaws and concluded that the studies’ findings were open to serious
                       question.ll For example, the critique commissioned by CBOE criticized the
                       SEC studies on several levels. The critique noted that SEC used a theoreti-
                       cal model developed for common stocks and questioned the applicability
                       of this model to the options market. It also noted that the studies may
                       not have controlled for all variables affecting bid/ask spreads. Finally,
                       the critique questioned whether the bid/ask spread is a reliable measure
                       of competition in the options market. We also found weaknesses in the
                       methodologies of these studies, which we reported by letter to the Chair-
                       man, House Committee on Energy and Commerce, on October 19, 1989.

                        ‘The Effects of Multiple Trading on the Market For OTC Options, Directorate of Economic t’cmc~y
                        Analysis, Securities and Exchange Commission, November 1986.
                        ‘Potential Competition and Actual Competition in the Options Market, Office of the Chief Economist.
                        Securities and Exchange Commission, November 1986.
                        ““Comment on SEC Staff Studies of Multiple Trading of Options,” Hans R. Stall (Owen Graduatc~
                        School of Management, Vanderbilt University), February 5, 1987: “Memorandum Concernmg 5EC
                        Staff Studies of Multiple Trading in Options,” Seymour Smidt (Johnson Graduate School of \lanage-
                        ment, Cornell LTniversity) February 9, 1987; and, “Competitivity of Options Trading I.-nder thus
                        Options Allocatmn Plan.” Gregory Connor (C’niverstty of California at Berkeley). March 4. 19X7



                        Page 43                                                  GAO/GGD90-52     National   Market   System
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CBOE and others have noted that prior experience with multiple listing of
options has not resulted in multiple trading. In other words, regardless
of the number of exchanges offering an option, a dominant market
emerges. Order flow gravitates to the one exchange and remains there
regardless of prices or services available on another exchange. These
critics contend that brokerage firms generally do not route orders to an
exchange on the basis of best available price. Rather, the firms use auto-
mated systems to transmit customer orders for multiply listed options to
the exchange that the firm has designated as its primary market.

Some market participants fear that this primary market phenomenon
may specifically disadvantage smaller regional exchanges. For example,
PHLX suggests that, when multiple listing commences, regional options
exchanges may lose market share to larger markets. In 1988 testimony
before SEC, the PHLX President stated that, in the absence of market inte-
gration facilities, “non-New York options markets will be dealt a serious
competitive blow for reasons that have nothing to do with the quality of
their options markets.” This, he stated, is incompatible with the goal of
a national market system in which markets compete on a fair and equal
footing.

Opponents also claim that multiple listing raises the possibility of mar-
ket fragmentation, which may impair the ability of brokerage firms to
discover and obtain the best price for their customers. If a dominant
market does not emerge for a multiply listed option, trades could occur
on one exchange at prices inferior to those quoted on another. Further,
the absence of an options market linkage system, similar in concept to
the stock markets’ ITS, will prevent routing of orders from one market to
another quoting a superior price.

 In approving multiple listing, SEC commented that unfair competition
 was unlikely in view of the experience of options trading in OTCstocks.
 In addition, SEC contended that, while brokerage firms generally
 preselect the market where they send retail order flow, these firms have
 increasingly emphasized market quality considerations. SEC also noted
 that it expects broker/dealers to make periodic assessments of the qual-
 ity of their designated market. In conclusion, SEC found that multiple
 listing would not result in a significantly fragmented options market.
 Xoting that markets that first list and trade an individual option have
 generally maintained the majority of order flow, SEC further concluded
 that a new market will not successfully challenge an existing market
 unless the latter is a significantly poorer market.



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                       SEC Monitoring   and Guidance




                       SEC recognized as early as 1980 that development of market integration
Considerable           facilities might create a fairer, more efficient market structure within
Disagreement About a   which multiple listing could occur. Nevertheless, SEC approved multiple
Market Linkage         listing of options without market integration facilities in place. In its
                       approval of multiple listing, SEC reported it could not indefinitely defer
System                 its consideration of the multiple listing issue until exchanges develop
                       such systems.

                       Since 1980, various market participants have expressed serious reserva-
                       tions regarding the feasibility of market integration facilities. In 198 1,
                       the options exchanges determined that effective market integration
                       facilities were not feasible at that time. More recently, the Information
                       Industry Association stated in 1988 that the rapid expansion of options
                       quotation and trading information has strained the electronic computer
                       systems and communication networks of financial service vendors. Not-
                       ing that options trading results in a far larger set of information and
                       records than stock trading, the Association recommended a detailed
                       study of the impact of expanded reporting requirements resulting from
                       multiple listing.

                       Market officials have also questioned whether competing exchanges
                       would be able to expeditiously coordinate development of a market
                       linkage system. The difficulty of having competing markets design mar-
                       ket integration facilities was demonstrated in the stock markets’ attempt
                       to design a transaction reporting plan to allow for exchange trading of
                       CJTCstocks on an unlisted basis. In 1985, SEC granted each exchange the
                       privilege of being able to trade in 25 OTCstocks. SEC took this action
                       because it would result in increased competition, thereby benefiting the
                       market and public investors. SEC conditioned exchange trading of UK
                       stocks on a number of factors. One factor required SEC approval of a
                       plan, agreed to by NASD and interested exchanges, that would consoli-
                       date the NASD and exchange quotation and trade reports in the OTC
                       stocks. SEC requested that the exchanges and NASD submit this plan by
                       December 1, 1985, for implementation by January 1, 1986. However. the
                       development of the plan was significantly delayed by disagreements
                       among the exchanges and NASD. The exchanges and NASD finally submit-
                       ted a plan to SEC in June 1989, for possible implementation in 1990, 3
                       years after SEC'S original time frame.

                        When SEC approved multiple listing of options, it also requested com-
                        ments on how to further integrate the nation’s options markets. In its


                                                      .

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request for public comment,; SEC reported that options exchanges should
carefully consider at least three possible measures to further link the
nation’s options markets: (1) an intermarket order routing linkage, (2) a
mechanism for order-by-order routing to the market with the best price,
and (3) a central limit order file.

The options exchanges differed significantly on the need for market
integration systems as well as the recommended type of trading linkage.
In their September 1989 responses to SEC'S request for comment, PHLX,
NISE, and PSE supported a market trading linkage while CBOE and Amex
questioned whether the need for a trading linkage had been
demonstrated.

Concerned that market disruptions could be caused by expanding multi-
ple trading before effective market integration facilities are in place,
NESE, PSE, and PHLX formed a task force to study the feasibility and costs
of linking the options markets.R The task force commissioned the Tellef-
sen Consulting Group to assess the technological feasibility of various
market integration facilities and submit a written report. The Tellefsen
report concluded that an rrs-style linkage, the proposed Options Market
Integration System (OMINS), is currently the only viable linkage alterna-
tive.!’ The report estimated that such a linkage would cost about $3.3
million and could be operational within 12 to 15 months.

Based on its assessment of the Tellefsen report and its own assessment
of the options markets, PHLX agreed that an ITS-type linkage is presently
the most viable way of integrating the options markets and would attain
each of the goals of a national market system. However? the PHLX Presi-
dent warned that, in contrast with the market benefits to be derived
from a linkage, expanding multiple trading without a linkage will frag-
ment the options markets, jeopardize brokers’ ability to obtain the best
execution of their customer orders, and weaken the regional exchange
system. PHLX recommended to SEC that the January 1990 start date for
multiple listing of options be delayed for 8 to 12 months to permit the
implementation of rrs-type linkage systems. It added that SEC could
reserve the authority to rescind this deferral at any time if it concluded
that sufficient progress was not being made. PHLx stated that the goal of

‘Exchange Act Release No 26871,54 Fed. Reg. 24058 (June 5,1989)

‘The PHLX President reported that Amex and CBOE were invited to participate in the task force, but
declined. Amex and CBOE later commissioned their own study.

!‘Options Intermarket Linkage System Feasibility and Conceptual Design, Tellefsen Consulting Group,
September 1989, p. 79.



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implementing a national market system in options can only be attained
if all the options exchanges participate and lend their financial support
to a trading linkage system. In this regard, PHLX called for SEC to take a
strong leadership role to assure there are no barriers to the establish-
ment of a linkage. PHLX concluded that “to expect that market forces
will prompt such a cooperative, industry-wide venture is to consign this
project to inevitable defeat.““’

NY3E  also supported an intermarket linkage facility similar to ITS. MSE
stated that this type of linkage would best protect investors and
promote competition among markets. NBE determined that, with SEC
support, the options exchanges will be able to establish an ITS-type
linkage system. However, NY3E cautioned that operation of such a sys-
tem before multiple trading of options commences is unlikely. NYSErec-
ommended that before such development, a limited linkage system using
existing options routing systems should be used.

PSE stated that a market integration mechanism is needed before multi-
ple trading is expanded. It added that without such facilities, multiple
trading will result in unfair competition, fragmented markets, price dis-
parities, and “second best” execution of public customer orders. PSE
stated that while it is not clear which market integration system would
be best, such systems appear technologically feasible. Although PSE con-
cluded that a copy of the ITS network would probably not work for
options! some modification of ITS may be feasible.

CBOE   and Amex, the two largest options exchanges, did not support the
 need for the immediate development of a market integration system.’ ; In
 responding to SEC, CBOE stated that it is the wrong time to attempt to
 decide whether market integration facilities will be necessary and how
 such facilities will be designed and paid for. In part, CBOE based its con-
 clusion on SEC’S statements that the problems that CBOE and other
 exchanges have raised as being potentially associated with multiple
 trading are likely to be minimal or insignificant.

 Amex  supported SEC’S position to eliminate the lottery system for options
 allocation. However, Amex noted that a need for a market linkage had yet

 “‘A NASD Options Committee also concluded that a linkage would only be feasible if all the optlons
 markets were participants. The Committee further stated that, given the lack of consensus that a
 linkage should be built. if a linkage is to be built., an SEC mandate may be needed.

 ’ ‘PHLX, in its response to SEC. stated that it is natural for the larger markets to resist hnkagex
 because of their desire to protect their market posltion.




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                        Trading Linkage System Development     for
                        Multiple Listing of Options Requires Close
                        SEC Monitoring   and Guidance




                        to be established should multiple trading be approved. Amex further
                        stated that before design and implementation efforts are undertaken, a
                        thorough study and analysis of the potential advantages and disadvan-
                        tages as well as costs of such market integration should be done. Amex
                        added that the nature of options trading makes it extremely difficult to
                        develop a system similar in design to ITS.

                        After submitting their comments to SEC, CE3OEand hex jointly funded a
                        study to assess existing communications technology and its applicability
                        to options markets. This study also assessed the feasibility of the Tellef-
                        sen study’s recommendations.‘”

                        The CBOE and Amex study disagreed with the findings of the Tellefsen
                        study. Its major point was that OMINTS was designed to “clone” ITS and
                        that ITS’technology is outdated. The study recommends constructing a
                        new system to integrate the options markets to take full advantage of
                        modern technology and recent market innovations, such as automatic
                        execution systems. The study notes that “trading systems in the securi-
                        ties markets need a major overhaul.” It further recommends that all
                        securities exchanges, not only options exchanges, should take advantage
                        of modern technology and fully integrate trading activities because full
                        integration will enable the US. capital markets to prepare “for the chal-
                        lenges of the year 2000 and beyond.“lz3


                        On January 9, 1990, SEC Chairman Richard Breeden sent a letter to the
SEC Seeks Voluntary     five U.S. options exchanges requesting that they refrain from listing
Delay in Implementing   options already allocated to another exchange until June 30, 1990. In his
Multiple Trading of     letter, the Chairman wrote that his request is based on comments from
                        the options exchanges, and the two studies commissioned by the
Existing Options        exchanges after the rule change was adopted. He determined that mar-
                        ket linkages for options trading could be achieved in the near term and
                        that a linkage system “should increase opportunities to ensure best exe-
                        cution of customer orders and improve the ability of members of every
                        options exchange to compete effectively in making markets for each
                        option.” The Chairman noted that SEC has the authority to require a spe-
                        cific linkage system, but he prefers that the options exchanges design it
                        themselves on a joint basis. Therefore, he wrote, it is premature for SEC
                        to direct the exchanges to build a specific linkage system. The Chairman

                         “Options Market Integration: An Evaluation, Yakov Amihud and Haim Mendelson, December 1989.

                         “‘Options Market Integration: An Evaluation, Yakov Amihud and Haim Mendelson, December 1989,
                         p. 61.



                         Page 48                                              GAO/GGD90-52    National   Market   System
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                      SEC Monitoring   and Guidance




                      also warned the exchanges that SEC would take “appropriate action”
                      against any exchange that attempts to stall efforts aimed at building a
                      linkage system.


                      To the extent it increases competition and improves prices for investors,
Conclusions           SEC'S approval to permit multiple listing and trading of options responds
                      to the congressionally mandated national market system goals. How-
                      ever, the full benefits of multiple trading of options, including national
                      market system goals, may not be realized without an effective trading
                      linkage system. Without SEC’S direction, it is unlikely that the markets
                      will develop a trading linkage system on their own. SEC'S January 1990
                      letter to each options exchange addresses the need for a market linkage
                      system and attempts to deal with potential competitive conflicts among
                      the exchanges that might stall development of a linkage facility. This is
                      an appropriate first step to ensure that a linkage system is developed in
                      the near term.


                      We recommend that SEC closely monitor the exchanges’ progress in
Recommendations to    developing a market linkage system for options trading. If SEC deter-
the Securities and    mines that the exchanges are not making sufficient progress, we recom-
Exchange Commission   mend that SEC direct construction of a linkage system.


                      SEC noted its Chairman’s letter to the options exchanges requesting that
Agency Comments and   they develop a joint plan for a market linkage facility and indicating
Our Evaluation        that SEC will consider ordering construction of a linkage system absent
                      agreement by the options exchanges within a reasonable time. They fur-
                      ther noted that the Chairman requested exchanges to refrain from trad-
                      ing any option that had been exclusively granted to another exchange
                      until June 30, 1990. We agree with the approach SEC has taken in regard
                      to the multiple listing of options and the need for a market integration
                      facility. We changed the text to account for the Chairman’s January
                       1990 letter.

                       Officials of the four major options exchanges each presented their opin-
                       ions on the need for and form of an intermarket trading linkage. Their
                       comments parallel each exchange’s official positions reported in this
                       chapter.




                       Page 49                                     GAO/CiGD9042   National   Market   System
Appendix I

U.S. Seeurities Markets Today


                                          In the United States, stocks are traded through two basic types of mar-
                                          ket structures: auction markets typified largely by exchanges, and
                                          dealer markets typified largely by the over-the-counter (arc) market.’
                                          The United States has eight stock exchanges, the largest being the New
                                          York Stock Exchange (NSE), and the O’PZmarket, which includes the
                                          National Association of Securities Dealers Automated Quotations system
                                          (NASDAQ). Table I.1 lists the markets by their 1989 average daily trading
                                          volume. Stock options, also classified as securities, trade on five U.S.
                                          exchanges.

Table 1.1: Average Daily Volume of U.S.
Stock Exchanges and NASDAQ (1989)                                                                                                           Volume
                                                                                                                                         (Shares in
                                          Market                                                                                           millions)
                                          New York Stock Exchange                                                                               165.5
                                          National     Association   of Securities   Dealers   Automated   Quotations   system                  1331
                                          American       Stock Exchange                                                                          124
                                          Midwest       Stock Exchange                                                                           11 6
                                          Pacific    Stock Exchange                                                                               68
                                          Philadelphia      Stock Exchange                                                                         3.8
                                          Boston       Stock Exchange                                                                              3.2
                                          Cincinnati     Stock Exchanae                                                                            10

                                          Note The Spokane Stock Exchange is not Included In this table because of mInImal market actlwty

                                          Source: Data prowded by each exchange and NASD.




Stock Markets and Trading                 The primary purpose of stock markets is to facilitate capital formation
Mechanisms                                for corporations. Corporations pay fees to the market where their stock
                                          is listed. While firms are technically “listed” on either an exchange or
                                          NASD market, the general term “listed stock” has evolved to mean only
                                          stocks listed on exchanges. Those listed through the NASD are generally
                                          referred to as OTCor NA~DAQ stock.

                                          Key participants in an exchange auction market are the specialists and
                                          floor brokers, while key participants in a dealer market are market mak-
                                          ers. Each of these participants plays a unique and different role in the
                                          auction and dealer markets.




                                          ‘For a full description of U.S. securities trading and regulatory structure, see Securities and Futures:
                                          How the Markets Developed and How They Are Regulated, (GAO/GGD-86-26, May 1986).


                                                                              .
                                          Page 50                                                          GAO/GGJHO-52    National   Market   System
                   Appendix I
                   U.S. Securities   Markets   Today




Exchange Markets   Specialists and floor brokers are key players in influencing how well
                   exchange markets operate. Exchange specialists, who are assigned
                   stocks by exchanges, are responsible for maintaining fair and orderly
                   markets in their assigned stocks. Each stock is assigned to only one spe-
                   cialist firm. Specialists act as brokers when they present customer
                   orders to the trading crowd of floor brokers and act as dealers when
                   they buy or sell stock for their own account.

                   In an auction market, investors’ buy and sell orders are usually matched
                   to execute trades. In their orders, investors either stipulate a price at
                   which they will buy or sell, or instruct their broker to execute a trade at
                   the current market price. Investor orders can reach the trading floor in a
                   number of ways. On NISE, broker/dealers can transmit an investor order
                   to the exchange floor by telephone to its trading booth or through an
                   electronic order routing system? to either its trading booth or the appro-
                   priate specialist’s trading post.

                   For orders reaching the floor at a firm’s trading booth, a floor broker
                   will either take the order to the specialist, who may execute it on the
                   floor broker’s behalf when it matches another order, or engage in an oral
                   bidding process in the crowd of floor brokers around the specialist post.
                   A trade is completed when a floor broker’s bid or offer matches an offer
                   or bid of another floor broker, the specialist, or an order on the limit
                   order book.

                    For orders reaching the floor at a specialist’s post, the specialist may (1)
                    match the order with other investor orders on the limit order book, (2)
                    match the order with a bid or offer from the trading crowd, or (3) take
                    the other side of the order as a dealer. Specialists act as dealers when
                    they take the other side of an order if no other buyers or sellers exist.
                    Their role as dealers in these cases helps maintain price continuity and
                    market stability, and is part of their responsibility to maintain fair and
                    orderly markets.

                    With the exception of the Cincinnati Stock Exchange, all the exchanges
                    employ the specialist system for stock trading. Cincinnati, the only fully
                    automated U.S. exchange, has no trading floor and uses a competing
                    market maker system.



                    ‘NkSE’s electronic order routing system is the Designated Order Turnaround system (DOT). also
                    known as SuperDot.



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              Appendix I
              US. Securities   Markets   Today




OTC Markets   In contrast to an auction market, the arc market is a competing dealer
              market. NASD market makers, also referred to as dealers, execute trades
              in the NASDAQ market. Customer orders do not interact with each other.
              Because all trades are executed by a dealer and are not subject to floor
              negotiation, it is not an auction market. Individual dealers compete with
              each other in making markets by quoting prices at which they will buy
              and sell a specified number of shares of a stock. The average number of
              market makers in NASDAQ/KMS:~stocks is 12, but some stocks have over
              50. Trades are made through a system of computers and telephones.
              NASD market makers are dealers who buy and sell stock for their own
               account and must quote a continuous two-sided market. Market makers
              are required to offer two-sided quotes- a bid and an ask price-to be
               able to trade. In other words, dealers must be willing to execute trades
              on both the buy and sell side to have their quote displayed.

              Market makers act as dealers and as agents. Most trades executed in the
              IL&D market are principal trades where market makers execute orders
              against their inventory. However, NASD rules require a market maker to
              execute trades at the best price in the NA~DAQ system or to offer the
              trade to the market maker that is advertising the best price. In these
              instances, the market maker acts as an agent by routing orders to the
              market maker with the best price.

              When a NAsD market maker functions as an agent for an order of less
              than 1000 shares, he or she may route the order through the small order
              execution system (~0~s). SOESautomatically executes the trade at the
              market maker firm quoting the best price for the customer in the sys-
              tem. NASD rules enacted after the crash require all NASD market makers
              to participate in SOF.S
                                    for all agency trades in NASDAQ/NMS stocks in which
              they make markets.

               In addition to the exchange and NA~DAQ markets, trades are executed in
               third and fourth markets which, like NASDAQ, are also classified as UK.
               The third market consists of firms, not belonging to an exchange, that
               trade exchange-listed stocks by matching customer orders or trading
               stocks out of their inventory. Bernard L. Madoff Investment Securities is
               a prominent third market maker. Fourth market trades are those made
               directly between institutional investors, usually facilitated through the



               "NASDAQ/NMSare stocks that NASD classifies as national market system stocks. These are NASD’s
               most highly capitalized stocks and attract the most volume.



               Page 52                                                  GAO/GGD-90-52   National   Market   System
                          Appendix I
                          U.S. Securities   Markets   Today




                          use of proprietary trading systems.-l Instinet and Jefferies and Co. both
                          operate fourth market trading systems.


Trading Market Linkages   Communication and trading among the securities markets are linked by
                          such systems as the Consolidated Transaction Reporting System (consol-
                          idated tape), the Consolidated Quotation System (consolidated quote),
                          the Intermarket Trading System (rrs), and NASD’S Automated Quotations
                          system (NASDAQ). Current quotation and trade information from the
                          exchanges and NASD is transmitted electronically over these systems to
                          video display screens that are available on exchange floors and else-
                          where for use by specialists, floor brokers, broker/dealers, NASD market
                          makers, and other subscribers. These systems are designed to centralize
                          and capture all trading volume and prices in stocks. ITS enables users to
                          direct orders to the market with the best available price.

                          The consolidated tape collects price and volume data for all trade execu-
                          tions made for listed stocks. This information is then disseminated in
                          sequence to exchange floors and other subscribers. The consolidated
                          quote system collects quotations from all markets trading reported
                          securities, identifies which market has the best bid and offer in each
                          security, and redistributes the information.

                          NASDAQ is the (JTCcounterpart of the consolidated tape and consolidated
                          quote. It collects and disseminates quotations of NASD market makers in
                          urc stocks. For the larger, more active UK stocks, NASDAQ also provides
                          trade reporting.

                          ITS is an electronic communication and order routing network that links
                          eight markets-NOSE, Amex, EISE, CSE, MSE, PSE, and PHLX, and NASD. ITS
                          allows regional exchanges” and the NASD to compete for investor order
                          flow in certain stocks listed on NYSE or Amex.” Specialists, floor brokers,
                          and market makers can transmit an order through ITS to the market


                          ‘Proprietary trading systems are computerized trading and information systems that allow subscrib-
                          ers to anonymously indicate their buy or sell interest, usually for blocks of stock, to other subscribers,
                          The system attempts to match orders between investors.

                           ‘BSE, CSE, MSE, PSE. and PHLX are referred to as “regional” exchanges. NOSEand Amex are
                           referred to as “primary” exchanges because all ITS stocks are listed on them. One regional exchange
                           official stated that the term “regional” is a misnomer because its market is both national and interna-
                           tional in scope.

                           “Stocks traded over ITS are listed at either N’YSEor Amex. Although it is not prohibited, as a matter
                           of practice NOSEdoes not trade Amex-listed stocks and Amex does not trade N8E-listed stocks.



                           Page 63                                                    GAO/GGD90-52       National   Market   System
                  Appendix I
                  U.S. Securities   Markets   Today




                  offering the best quote. This system provides a system by which special-
                  ists at the various exchanges can compete with one another in offering
                  the best price for shares of stock.


Options Markets   Stock options are contracts giving the holder the right to buy or sell a
                  stated number of shares of a particular stock at a fixed price within a
                  predetermined time period. Typically, a single option contract gives the
                  buyer the right to buy or sell 100 shares of a specific stock.

                  Options allow investors to pursue different trading strategies besides
                  the typical long-run investment position of buying a stock, holding it,
                  and hoping for price appreciation, or selling a stock short (i.e., selling a
                  stock before taking ownership) in anticipation of a decline in price. For
                  example, speculators can create highly leveraged positions with high
                  potential returns accompanied by substantial risk by using stock
                  options. Alternatively, investors can use options to create positions hav-
                  ing less risk of loss than the above described long or short positions in
                  the stock market.

                   Stock options are traded on CBOE, hex, PSE, PHLX, and NOSE.Options on
                   most listed stocks are allocated to a single exchange on a lottery basis. In
                   May 1989, SEC approved a major change to the way stock options will be
                   listed and traded on exchanges. Rather than the former procedure of
                   allocating an option on a stock to a single exchange, SECnow allows any
                   exchange to trade any new option listed after January 22, 1990. Under
                   current rules, multiple listing will be extended to cover all options begin-
                   ning in January 1991. Table 1.2 lists the 1989 average daily volume of
                   stock options contracts traded at each of the options exchanges. Table
                    1.3 lists the number of stock option contracts listed at each exchange as
                   of December 31, 1989.




                    Page 54                                   GAO/GGD-90-52   National   Market   System
                                         Appendix I
                                         U.S. Securities    Market-s Today




Table 1.2: Average Daily Stock Options
Contract Volume of U.S. Options                                                                                    Contract
Exchanges (1989)                         Exchange                                                                   volume
                                         Chicago    Board Options       Exchange                                       245,647
                                         Amencan        Stock Exchange                                                 164,998
                                         Pacific   Stock Exchange                                                       71,200
                                         Philadelphia      Stock   Exchanqe                                             66,536
                                         New York Stock Exchange                                                        14,309


Table 1.3: Number of Stock Options
Listed at Options Exchanges (December                                                                    Number of stock
1989)                                    Exchange                                                          options listed
                                         Chicago    Board Options        Exchange                                          217
                                         Amertcan       Stock Exchange                                                      189
                                         Pacific   Stock Exchange                                                          139
                                         Phtladelphia      Stock Exchanqe                                                   133
                                         New York Stock        Exchange                                                      44

                                         Source Data provided by each exchange




                                          Page 55                                   GAO/GGD90-52   National   Market    System
Appendix II

Comments From the Securities and
Exchange Commission

Note. GAO comments
supplementing    those In the
report text appear at the
end of this appendix                                                        UNITED    STATES
                                                        SECURITIES       AND    EXCHANGE           COMMISSION
                                                                      WASHINGTON       DC.     20549




                                                                                          January       26,     1990
                                Richard   L. Fogel
                                Assistant   Comptroller       General
                                General   Government     Division
                                U.S. General    Accounting       Office
                                Washington,    D.C.     20548
                                        Re:     General   Accounting               Office  Report,    Securities      Trading:
                                                SEC Action     Needed              to Address    National      Market    Svstem
                                                Issues
                                Dear Mr.      Fogel:
                                         The Securities          and Exchange      Commission        ("Commission")         has
                                authorized        me to respond to your request              for comments on a draft
                                report       to be issued          by the General         Accounting      Office     ("GAO")
                                entitled       Securities      Trading:     SEC Action Needed to Address National
                                Market        Svstem      Issues.         The   Division       of    Market      Regulation
                                ("Division")         has reviewed       the draft    report    and is submitting          this
                                letter      in response       to your invitation         to cilmment.
                                         In the draft          report      GAO concluded           that the Commission               needs
                                to re-evaluate            several      market structure             issues    to assure that the
                                markets        continually         meet the goals           of a National             Market     System.
                                Specifically,           GAO recommended that the Commission revisit:                              (1) the
                                appropriateness             of certain           exchange        rules     that      limit     members'
                                ability       to execute        trades      off the floor          of the exchange           (so-called
                                "off-board           trading        restrictions,"            u,          the      New York          Stock
                                Exchange's          Rule 390),        particularly          as they        apply      to after-hours
                                trading;         (2) the effectiveness               of the Inter-market               Trading     System
                                 ("ITS")      in meeting the National               Market System goals it was designed
                                to address:           and (3) whether            market     integration          facilities        should
                                be built        to accommodate           multiple      trading        of options.
                                       The     Division   agrees      that   the      issues      raised      by GAO are
                                important       National    Market     System      issues      that     require     careful
                                scrutiny.        Indeed,  these    issues    have been the subject               of an on-
                                going      assessment    by the      Commissio:         and its        staff    since     the
                                Securities       Acts Amendments of 1975              directed       the Commission         to
                                facilitate      the development      of a NatiDnal        Market System.
                                        The first      recommendation      in the draft       report                      was that    the
                                Commission      again     evaluate     the continued      validity                        of off-board
                                trading    restrictions.           The Division    agrees      that                     it now may be

                                                 Pub.    L. NO. 94-29,          88 Stat.          97 (June      4,     1975).




                                   Page 56                                                             GAO/GGIHO-52         National   Market   System
                      Appendix II
                      Comments From the Securities             and
                      Exchange Commission




                  Richard       L. Fogel
                  Page 2
                  appropriate            to re-examine               thf      application             of these        rules       to
                  members     ' after         hours trading.                   As you know, the volume of off-
                  shore trading              in U.S. securities                   in foreign           markets     after      U.S.
                  markets       close        has steadily            grown over the years.                      The Division
                  believes        that much of this volume is attributable                                 to institutional
                  trading        that      is booked          in London or other                     foreign     markets        not
                  because that            is where the counterparty                         was found but because                 of
                  exchange off-board                trading       restrictions             on the execution           of trades
                  in the U.S. OTC market.                     Two recent           initiatives          respond in part to
                  these market developments.                       First,       the Commission recently                 approved
                  a Midwesf. Stock Exchange proposal                          to develop an after-hours                  trading
                  system.            In addition,           the NYSE has proposed                   to permit      portfolios
                  to be crossed            after     the close at the closing                    price      on the exchange.
                  While these           initiatives           provide        some ability             for exchange         member
                   firms      to      effect         after-hours            trades,          that       ability       is    still
                  substantially            circumscribed.              Accordingly,            the Continued         expansion
                  of     international               trading          may dictate               that       the    after-hours
                  application           of off-board            trading          restrictions           once again be re-
                  evaluated         by the Commission.
                         The Division        believes,      however,       that the question           of removing
                  off-board        trading     restrictions          during      normal       trading       hours    is
                  substantially           more    complicated.              Traditionally,            commentators
See comment   1   opposing      the removal of off-board              trading      restrictions        have raised
                  a number of concerns               over the ability              of upstairs,          integrated
                  broker-dealers          to internalize       their      order flow.          Commentators       have
                  asserted       that the internalization               of order flow results              in market
                  fragmentation          and does not provide            a fair    opportunity        for exchange
                  markets      to compete.
                          Because Of concerns           Over the antiCOmpetitiVe         nature    of Off-
                  board trading       restrictions,       the Commission,       in 1979, prospectively
                  eliminated      the     application       of those     restrictions        through   the
                  adoption     of Rule 19c-3.         In recent  years,    however,     exchange member
                  firms generally        have not made markets         in Rule 19c-3 securities.
                            In the absence of any market determination    that the over-the-
                  counter      market  is preferable to exchange markets,     it would appear

                            2       The New York Stock Exchange ("NYSE") interprets          its Rule
                                    390 to prohibit       member trading     in the U.S. over-the-
                                    counter    (**OTC*') market even outside    the NYSE's hours of
                                    operation.      @-e NYSE Rule 390, Interpretation      .lO.
                            3       The Portfolio         Trading     System     ("PTS1')   is a secondary
                                    trading   system to be operated          from 3:30 p.m. to 5:00 p.m.
                                    Central   Time (4:30 p.m. to 6:00 p.m. Eastern                     Standard
                                    Time; after     the New York Stock Exchange close)                  for the
                                    purpose   of permitting         the execution        of transactions        in
                                    qualified    portfolios       of equity     securities.




                        Page57                                                                 GAO/GGD-90-52         National    Market   System
                       Appendix II
                       Comments From the Securities         and
                       Exchange Commission




                  Richard     L. Fogel
                  Page 3
                  undesirable       for the Commission to override                   the concerns       previously
                  expressed     by the vast majority             of commentators          and remove off-board
                  trading      restrictions           applicable        during       normal     trading        hours.
                  Accordingly,        while the Division           will   continue       to monitor       carefully
                  developments        in the trading          markets,      including       the development          of
                  new automated         trading      systems,     we believe       it would be premature             to
                  commence a formal           review of the removal of these off-board                       trading
                  restrictions        at this      time.
                         The second recommendation               was that the Commission         undertake
                  a comprehensive        review    of the ITS.         The Division      agrees with GAO
                  that    a continual      assessment         of the effectiveness          of the ITS in
See comment   2   achieving    the National        Market System goals is an important                 aspect
                  of the Commission's         responsibilities         under the Securities         Exchange
                  Act of 1934.        Indeed,    the Division        has been continually         reviewing
                  ITS, from both an operatiFna1                and a policy    perspective,       since the
                  system's    implementation.
                          The draft    report   noted          that    only "incremental     changes"    have
                  been made to the ITS since                  the system was implemented,          but that
                  there     are a few continuing                issues,      most of which the Division
                  believes      also are capable    of        solution      through what the draft    report
                  characterizes      as incremental             changes to the ITS.       Indeed,    several
                  of the changes are currently                being considered      or are in the process
                  of being adopted       by the ITS           participants.
                          Specifically,         the draft      report     noted:       (1) the lack of pre-
                  opening notifications             after   order-imbalance         trading      halts;    (2) the
                  lack of pre-opening             procedures      when the primary          market      opens the
                  stock within          a certain      range of the prior          day's     closing;      (3) the
                  lack of time-stamping             of floor      broker    orders     by NYSE specialists;
                  and (4) the lack of an effective                  dispute     resolution       mechanism.      In
                  addition,       the GAO noted the capacity                problems      experienced       by the
                  ITS during       the October        1987 Market      Break.      Finally,      GAO noted that
                  some commentators            have called        for an enhancement             to the ITS to
                  provide     automatic       execution      for some orders.
                         As noted in the report,          several     of these issues are currently
                  being   addressed        by the TTS participants           in conjunction           with    the
                  Commission.         For example,     the issue of pre-opening              notifications
                  after   order-imbalance        trading     halts     is close     to being         resolved.
                  The ITS participants           have nearly        reached    agreement        on proposed
                  amendments       to the ITS Plan to provide              procedures       for such pre-
                  opening    notifications.          In addition,       the participants          have begun
                  formal   discussions        on developing       an effective       dispute       resolution
                  system that would allow          the involved       ITS participants         to choose an


                                  As   noted   in the draft   report,                the Commission            issued
                                  studies    in 1981 and 1982 on the                operation of the           ITS.




                          Page 58                                                       GAO/GGD-W-52        NationalMarket   System
      Appendix II
      Comments From the Securities            and
      ExchangeCommission




Richard      L. Fogel
Page 4
independent  third ITS participant                       to decide disputes              arising      under
the plan that are above a certain                         dollar  level.
        Similarly,           the Division               believes       that      the self-regulatory
organizations            ("SROs") , in conjunction                    with the Commission,                have
addressed         a number of the capacity                      and operational            problems       that
arose       during      the October              1987 Market          Break.          The Market         Break
highlighted           the need for markets                     to maintain            systems       that    can
efficiently          process       a high volume of trading                   activity.         Since then,
the markets have taken numerous steps to improve their                                        computer and
communications            facilities.                For example,        the NYSE has implemented
system enhancements                  that       will     allow     it to handle            a 600-million
share day without                significant            delays     in its       order processing            and
information           dissemination              systems.         The regional            exchanges       also
have made substantial                      improvements           to their          order      routing      and
execution          systems.             These steps            range       from adding           additional
computer         hardware        to revising             software       protocols         and developing
additional           back-up          facilities.               In addition,             the     SROs have
conducted          several        stress        tests,       primarily         testing       the National
Market       Systems        (h,           ITS and the Consolidated                      Transaction         and
Quotation         Systems).
          The trading       experience       during     the market decline            on October
13, 1989, demonstrated              that the systems worked substantially                    better
than two years ago.              While the Commission believes                  that the SROs'
performance          on October        13, 1989, demonstrates               that     substantial
progress        has been made, it acknowledges                the continued        significance
of the capacity           and operational         issues     raised      in the report.           For
this      reason,    the Division        has encouraged         the ITS users to examine,
and        if    necessary      to      expand,      the     capacity        and     operational
capabilities           of    their5      systems       under      conditions        of      extreme
volatility         and volume.
        With respect      to the issue of whether            an automated       execution
feature     should be added to the ITS, the Division                  agrees that this
is a change that         the SROs should       now consider.            Such a feature
would increase        the certainty     of customer        order executions,         which
was a problem during        the October 1987 Market Break.               Currently,      the
ITS plan allows        NYSE specialists     one minute to respond after                they
receive      a commitment     to trade.       During      this    time,    however,      the
customer      order    is not assured      an execution           and is at risk           of
missing     the market.        While permitting         professional       investors       to
automatically       execute    against   a specialist's         guotation     may impose




         5
                 See e.ac, the Automation Review Policy     Statement   recently
                 issued   by the Commission.     Securities       Exchange      Act
                 Release No. 27445 (November 16, 1989),        54 FR 48703.




         Page 69                                                             GAO/GGD90-52          National   Market System
                        Appendix II
                        Comments From the Securities          and
                        Exchange Commission




                   Richard      L. Fogel
                   Page 5
                   unacceptable     risks    for specialists,     6 the Division    sees no clear
                   reason why specialists         should not be willing      to guprantee     quote-
                   based executions       for public    investor orders in ITS.       Accordingly,
                   the Division     expects    to review this    issue at future    ITS Operating
                   Committee    meetings.
See comment   3.           Finally,        the draft        report      discussed        the issue       of multiple
                   trading      of options        and t$e Commission's           recent promulgation             of Rule
                   19c-5 under           the Act.              The draft        report       concludes        that      the
                   Commission's         action      to remove impediments             (in other words,           certain
                   exchange rules)             to multiple      trading      of options       is consistent          with,
                   and, in fact,            "responds      to the congressionally                 mandated National
                   Market System goals."                 The draft      report    also recommended,            however,
                   that the Commission determine                    whether a trading           linkage     system for
                   options      is needed to realize              the objectives          of multiple       trading       of
                   options      and, if a linkage            is necessary,        that the Commission direct
                   the options          exchanges        to develop        the linkage.             As noted       in the
                   draft      report,         the Commission           has received           copies      of a study
                   prepared         on behalf          of the        NYSE, Pacific           Stock      Exchange        and
                   Philadelphia           Stock      Exchange       and copies       of a study          prepared         on
                   behalf     of the American Stock Exchange and the Chicago Board Options
                   Exchange.          The Division         has met with and discussed                  these matters
                   with     the options           exchanges       on a number of occasions                   since      the
                   adoption       of the rule.            On January        9, 1990, Chairman Breeden sent
                   a letter      to each of the options               exchanges     requesting        that they work

                           b
                                    Automatic      execution       exposes market makers/specialists                  to
                                    the      risk    of     being      "picked        off”       by other       market
                                    professionals        before they can respond to news or changes
                                    in other        participants'           quotations.            This    risk     may
                                    discourage      marketmakers/specialists                  from trading     in size
                                    and thus        reduce       the    market's         depth     and liquidity.
                                    Evidence      of this problem can be seen even in the National
                                    Association       of Securities          Dealers'       (*INASD'*) Small Order
                                    Execution       System      where      the      NASD had to expand              its
                                    prohibitions        against     professional         investor     usage because
                                    groups of traders           were employing          the system to pick off
                                    market maker quotes after               significant         news announcements
                                    in NASDAQ stocks.
                           7
                                    It is important    to note that the regional     specialists
                                    have for   some time    done so through    their   automated
                                    execution systems.
                           8        Rule    19c-5    amended the rules        of national         securities
                                    exchanges     to prohibit     (after  a one-year     phase-in     period)
                                    any exchange      from limiting      by any means its ability             to
                                    list   any stock option       class because that option          class is
                                    listed   on another      exchange.    w   Securities      Exchange Act
                                    Release No. 26870 (May 26, 1989), 54 FR 23963.




                                                         .


                          Page 60                                                         GAO/GGLHO-62        National   Market   System
                           Appendix II
                           Comments kom the Securities          and
                           Exchange Commission




                  -
                      Richard     L. Fogel
                      Page 6
                      together     to develop      a joint      plan for a market linkage                  facility,      and
                      indicating         that    the       Commission         will     consider           ordering        the
See comment   3       construction         of a linkage        system absent agreement                  by the options
                      exchanges       within   a reasonable            time.     To facilitate          the design        and
                      construction        of a linkage       facility,       the Chairman's          letter       requested
                      each of the options          exchanges         to refrain,      until    June 30, 1990, from
                      trading     any options      overlying         an exchange-traded           stock      that was the
                      subject     of options      trading       exclusively         on another        exchange before
                      January     22, 1990.       At the same time,              the Commission has abolished
                      the prior      system for allocating               monopoly option       trading        privileges,
                      and all new options           listed     for trading         henceforth        will     be open for
                      multiple      trading.
                             The Division    appreciates     this opportunity      to review the draft
                      report   and to provide      our comments.      We would like      to commend the
                      GAO on a well-balanced       assessment    of the competing     policy  questions
                      raised   by these important        market structure     issues.
                                                                              Sincerely,


                                                                              Richard      G. Ketchum
                                                                              Director




                                                                                                                                        J




                             Page 61                                                         GAO/GGIMO-SB        National   Market System
               Appendix II
               Comments From the Securities   and
               Exchange Commission




               The following are GAO’S comments on the Securities and Exchange Com-
               mission’s letter dated January 26, 1990.


               1. We have not recommended that off-board trading restrictions be
GAO Comments   removed. In fact, a reaffirmation by SECof the need for trading restric-
               tions would be as helpful as a conclusion that modification or elimina-
               tion is necessary to ensure that the competitiveness, fairness, and
               efficiency of U.S. markets is not being hindered. We disagree that it is
               premature to reevaluate trading restrictions. The legislative mandate,
               SEC’S own determination to reevaluate trading restrictions periodically,
               and the vast changes that have occurred in the securities markets in the
                1980s indicate to us that SECshould now review the continued applica-
               bility of exchange trading restrictions. Unlike market participants, who
               may not have the perspective needed to view the marketplace as a
               whole, SEC is in a unique position to make determinations or recommen-
               dations for change that benefit the entire US. marketplace. However,
               we agree with SEC that the first consideration of this issue should cover
                the after-hours effects of the trading restrictions.

               2. Our characterization of “incremental changes” is meant to show that
               many changes have been made to ITS on a piece-by-piece basis. The point
               is not that the changes made to the system have not been beneficial or
               necessary but, rather, that the number of changes made since SEC’S last
               comprehensive review indicates the need for an overall assessment to
               determine whether the system continues to meet national market system
               goals. While we continue to believe that a comprehensive review of ITS is
               necessary, we understand that the changes to the system currently
               being considered are important and should continue. To the extent that
               a comprehensive review of ITSwould detract from resolving these issues
               in the near term, the review could be delayed. However, such additional
               changes further support the need for a comprehensive system review.

                3. We agree with the approach SEC has taken in regard to the multiple
                listing of options and the need for a market integration facility. We
                changed the text in chapter 4 to account for the Chairman’s January
                1990 letter and the December 1989 study commissioned by CBOE and
                Amex.




                Page 62                                  GAO/GGD-90-62   National   Market   System
Appendix III

Major Contributors to This Report


                        Michael A. Burnett, Assistant Director
General Government      John J. Maurello, Co-Project Manager
Division, Washington,   Shirley A. Brothwell, Evaluator
                        Diane N. Morris, Evaluator


                        Thomas C. Bittman, Co-Project Manager
New York Regional       James R. Bradley, Deputy Project Manager
Office                  Preeti S. Jain, Evaluator
                        Daniel A. Fisher, Evaluator


                        Michael A. Hartnett, Sub-Project Manager
Chicago Regional        Steven C. Wagner, Evaluator
Office




                        Page 63                                    GAO/GGD96-6%   National   Market   System
Glossary


Ask                      The price at which a person is willing to sell a security at a given time.
                         Best ask is the lowest price sell order in the marketplace at a given
                         moment. Also referred to as offer.


Auction Market           A market that permits investors’ bids and offers to be matched with
                         each other and executed when they meet.


Best Execution           A transaction that is consummated at the best available price.


Bid                      The bid is the price investors declare they are willing to pay for a stock
                         or options contract at a given time. Best bid is the highest priced buy
                         order in the marketplace at a moment in time.


Bid/Ask Spread           The size or amount of the price difference between the bid and the ask
                         of a reported quote.


Block Trade              A purchase or sale of a large number of shares or dollar value of stock.
                         Although the term is relative, 10,000 or more shares, or any quantity
                         worth over $200,000, is generally considered a block.


Broker                   An agent who handles the public’s orders to buy and sell stocks or
                         options.


Consolidated Quotation   A nationwide computerized report of prices currently bid and offered on
System                   participating exchanges and in the over-the-counter market for the same
                         securities, and the number of shares sought or offered at these prices.


Dealer                   An individual or firm in the securities industry who buys and sells
                         stocks for his own account as a principal rather than as an agent.


Dealer Market            A market in which competing bids and offers are entered by dealers,
                         and customer orders are executed against a dealer’s portfolio.




                         Page 64                                     GAO/GGD90-52   National   Market   System
                           Glossary




Derivative                 An instrument whose value is determined primarily by the price at
                           which an underlying security is trading. Options and futures contracts
                           are derivatives.


Designated Order           An electronic order routing system at NY3E that allows NYSEmember
                           firms to transmit small orders in NBE-listed stock from their offices to
Turnaround System          the appropriate trading post on the floor.


Equity Security            -4 security representing an ownership right of its issuer, such as stock.


Fixed Commission Rate      A fixed schedule of fees paid by investors to broker/dealers for trade
                           execution services. These schedules were abolished in 1975.


Floor Broker               An employee of a member firm of a stock exchange who executes orders
                           on the exchange floor for the firm’s customers.


Hedging                    Taking a position in a derivative instrument, such as a futures or
                           options contract, opposite to a position held in the underlying asset to
                           minimize the risk of financial loss from an adverse price change.


Institutional   Investor   A corporate or organizational investor that is managed by professionals,
                           whose job is to earn income and capital gains by investing pools of capi-
                           tal. Examples of institutional investors are pension funds and mutual
                           funds.


Intermarket Trading        An electronic trading linkage among the primary and regional stock
System                     exchanges and NASD. The system allows brokers to seek best execution in
                           any market within the network.


Limit Order                 An order to buy or sell a stated amount of a security or a commodity at
                            a specified price, or at a better price if obtainable, after the order is
                            entered.


                                                     .


                            Page 65                                   GAO/GGD-90-62   National   Market   System
                   GlOSS2ll-y




Liquidity          The ease with which an asset may be converted to cash at a price close
                   to its last publicly traded transaction.


Listed Stock       The stock of a company which is traded on a securities exchange.


Market Maker       A dealer who specializes in trading financial products regularly,
                   intending to profit from the timing of trades and the spread between the
                   bids and offers.


Market Order       An order to buy or sell a stated amount of a security at the most advan-
                   tageous price obtainable in the market after the order is entered.


Member Firm        A firm, registered as a broker or dealer in securities, that conducts busi-
                   ness on and is subject to the rules of a stock exchange or a securities
                   association.


Multiple Listing   Listing of a stock or option contract on more than one exchange.


NASDAQ             The National Association of Securities Dealers Automated Quotations
                   system. NASDAQ is an interactive dealer-driven system for advertising
                   quotes and reporting transactions in OTCsecurities in the United States.


NASDAQ Stock       The stock of a company which is included in the NASDAQsystem.


NYSE Rule 390      A rule of the Kew York Stock Exchange that restricts trading of
                   exchange-listed stock by exchange members in over-the-counter mar-
                   kets; a successor to NOSERule 394.


Offer              The price at which a person is willing to sell a security at a given time.
                   Best offer is the lowest priced sell order in the marketplace at a given
                   moment. Also referred to as ask.




                   Page 66                                    GAO/GGIHO-52   National   Market   System
Option              A right to buy (call) or sell (put) a fixed amount of a given asset at a
                    specified price within a limited period of time.


Order Flow          The volume of buy and sell orders sent to a particular market during a
                    particular period of time.


OTC                 Over-the-counter. This encompasses all securities trading that does not
                    occur on an exchange. The primary example of urc trading occurs in the
                    NASDAQSySteI-tl.



Primary Exchange    Stock exchanges, which, as distinct from regional exchanges, are
                    exchanges of original listing of the stocks of a large number of geograph-
                    ically dispersed firms. In the United States, the New York Stock
                    Exchange and the American Stock Exchange are primary exchanges.


Quote               The price at which a given asset can be bought or sold at a given time.


Regional Exchange   Exchanges whose trading volume is dominated by stocks that are listed
                    on a primary exchange. They do this by virtue of unlisted trading privi-
                    leges granted by the SEC.


SEC                 The United States Securities and Exchange Commission, the federal
                    agency charged with regulating the US. securities industry.


Self-Regulatory     Designated groups of industry professionals equipped with quasi-gov-
Organization        ernmental powers to adopt and enforce standards of member conduct.
                    Their regulation is carried out under government supervision.
                    Exchanges and NASD are examples of SROs.


Specialist          A member of an exchange who handles transactions on the trading floor
                    for the stocks for which he or she is registered and who has the respon-
                    sibility to maintain an orderly market in these stocks. Specialists do this
                    by buying or selling a stock for his own account when there is a tempo-
                    rary disparity between supply and demand for the stock.



                    Page 67                                     GAO/GGD9@62   National   Market   System
Related GAO Products


               Financial Markets: Preliminary Observations on the October 1987 Crash
               (GAO/GGD-88-38, January 1988).

               Developments Since the Market Crash of October 1987 (GAO/T-GGD-88-33,
               April 1988).

               Financial Services Industry Issues (GAO/OCG-89-4TR, November 1988).

               Financial Markets: Status of Computer Improvements at the New York
               Stock Exchange (GAO/IMTEC-88-35, April 1988).

               Securities Regulation: Securities and Exchange Commission Oversight of
               Self-Regulation (GAO/GGD-86-83, September 1986).

               Securities and Futures: How the Markets Developed and How They Are
               Regulated (GAO~GGD-86-26,May 1986).




(233249)       Page68                                   GAO/GGD-90-62National Market System