Exchange Governance and Securities Market Structure
April 22 – 23, 2003
The New York Stock Exchange has joined corporate America in the spotlight of governance practices as a result of the controversial compensation package for Dick Grasso, former Chairman of the NYSE. The questions raised are many: How should an exchange be organized and regulated? Is an exchange a business or a public institution? Should exchanges demutualize? Can regulatory policy continue to be implemented through self regulatory organizations (SROs) or must alternative approaches be sought?
Independent of the Grasso affair, questions have arisen regarding the future of the specialist system. Is the specialist system outmoded? Should the function of the specialist be automated? Should the SEC change the rules under which the NYSE and its competitors operate? How should markets be linked? In addition to the NYSE, another respected institution – the mutual fund – has come under fire. How can the problems with mutual fund trading and valuation be solved? Are mutual fund expenses excessive?
These issues and others were examined at a conference on Exchange Governance and Securities Market Structure held at Vanderbilt University on April 22nd and 23rd, 2004.
The conference was the 17th annual conference of the Financial Markets Research Center and was sponsored by a special grant from the New York Stock Exchange.
The conference was attended by industry practitioners, academics, regulators, and students. The opening day’s events were held at the facilities of Center member Caterpillar Financial Corporation located next to the campus, while the sessions for the second day took place at the Owen School. Hans Stoll, director of the Center, Ed Scott, executive vice president of Caterpillar Financial, and Bill Christie, Dean of the Owen School, welcomed conference participants.
The Thursday morning session dealt with the issues of how exchanges should be governed and regulated and whether changes are needed in the national market system. Richard Lindsey, President of Bear Stearns Securities Corporation, introduced the topics by discussing progress toward the goals of a national market system as stated in the 1975 Securities Act Amendments. He then introduced Richard Ketchum, Chief Regulatory Officer of the New York Stock Exchange and former president of the Nasdaq Stock Market. Ketchum’s remarks focused on the changing governance structure of the NYSE and on the independence of the self-regulatory function in that structure. Ketchum advocated the SRO approach to regulation under an appropriate governance structure. Self regulation works because the self regulator is close to the market, is knowledgeable, and commits the industry to the task of regulation. At the same time the Securities and Exchange Commission (SEC) still maintains vigilant oversight.
Lindsey then introduced Annette Nazareth, Director of Market Regulation at the SEC. Lindsey noted that he had preceded Nazareth as the director of Market Regulation and that Ketchum had been Director of Market Regulation before him. Nazareth discussed the SEC agenda, noting that implementation of Sarbanes Oxley was near completion and that the Commission is now turning to the regulation of market structure and of exchanges. With regard to market structure, she discussed the SEC’s recent Regulation NMS proposal which calls for modifications in the trade-through rules, fair access fees, and revisions in the way market data fees are distributed. With regard to exchange regulation, she discussed alternative approaches to the regulation of exchanges, ranging from a super SRO that oversees all exchanges to a variety of approaches for self regulation by each exchange. She noted the central importance of maintaining the independence of the regulatory function.
Jack Lavery, the head of the Lavery Consulting Group and former head of corporate and policy research at Merrill Lynch, offered the conference participants a change of pace with an insightful analysis of election year economics. He reviewed the unemployment rate in the key election battleground states, noting that while the economy is improving, helped by household wealth increases, there are a few key states that are lagging. While the economic issues are important, he argued that in the end, Iraq will be the determining issue in the election.
After a break for lunch, the conference resumed with a panel on ownership, governance, and regulation of derivatives markets, chaired by Duke Chapman, Vice Chairman of ABN-AMRO Financial Services and former chairman of the Chicago Board Options Exchange. Jim Overdahl, Chief Economist of the Commodity Futures Trading Commission (CFTC), contrasted the regulatory structure in derivatives markets that is based on 18 core principles (since the Commodity Futures Modernization Act of 2000), with the structure in the stock markets that is based on detailed rules and regulations. Three core principles (14, 15, and 16) deal with governance and self regulation. Overdahl described the current review of self-regulation being conducted by the CFTC and noted that the next focus of the review would be on governance issues, including conflicts of interest, disciplinary committees and the overall role of the board of a futures organization. James Falvey, General Counsel of Eurex US, which began operation as a U.S. futures exchange in February 2004, contrasted the structure of the Eurex US to that of “bricks and mortar” futures markets, such as the CME, and to pure “Dot Com” markets, such as the Intercontinental Exchange. Richard DuFour, Executive Vice President of the Chicago Board Options Exchange (CBOE) discussed developments at the CBOE, such as the new hybrid trading system that integrates electronic and traditional floor trading. He noted that the CBOE has made governance changes to increase the representation of independent directors.
John Damgard, President of the Futures Industry Association (FIA), commented on a variety of issues in the futures markets. In his view, dual regulation was adversely affecting single stock futures. On the governance side, he criticized the board composition of certain futures exchanges and wondered why futures commission merchants (FCMs) were not more adequately represented. He lauded the competition introduced by the entry of the Eurex in U.S. markets. He questioned whether inspection of FCMs should be carried out by exchange SROs, since exchanges and FCMs are frequent competitors.
The day’s final panel dealt with mutual fund issues, and was chaired by Ron Masulis, Professor at the Owen School. Eric Zitzewitz, Assistant Professor at the Stanford Graduate School of Business on leave to Columbia Business School, presented his paper, “How Widespread is Late Trading in Mutual Funds?” Zitzewitz distinguished the stale price problem (where 4 pm mutual fund prices don’t accurately reflect the value of the fund) and the late trading problem (where certain investors are able to buy or sell mutual funds at 4 pm prices but delay submission of trades until after 4 pm). He finds empirical evidence of late trading and concludes that late trading is widespread. To solve the late trading problem, he recommends tighter controls at the fund level and, in particular, a clear requirement that funds receive all orders before 4 pm.
Ned Elton, Professor at NYU, presented a study (co-authored with Jeff Busse and Martin Gruber), “Are Investors Rational?: Choices among Index Funds.” Since the index funds in their study all held the same stocks, one can predict that index funds with low expense ratios will outperform those with high expense ratios. Yet Elton and his co-authors find that new funds do not flow to the lower cost funds to the degree one might expect, which suggests the fund investors are not entirely rational. Gabe Butler, of ITG Corp, presented methods for fair value pricing for funds, such as international funds, in which certain stocks have stale prices. The panel concluded with a discussion by David B. Jones, Senior Vice President of Fidelity Management and Research Corporation, who commented on a number of issues. On stale prices, he favored some form of fair value pricing. On mutual fund fees, he noted that fees are different to reflect the different services provided to different investors. He favored disclosure of soft dollar payments and quantification of what was received in return for soft dollars. On mutual fund governance, he questioned the need for an independent chairman for funds, noting that funds with independent chairmen don’t necessarily have the lowest expenses.
On Friday morning the conference reconvened at the Owen School to hear from a panel on the specialist system and a panel on bond market microstructure. The chairman of the first panel, Thomas Peterffy, Chairman of Interactive Brokers Group, introduced the topic by questioning the need for a specialist and for the special rights given to specialists.
Roger Huang, Professor at Notre Dame, presented a paper written with Jerry Liu entitled “Do Individual Specialists Subsidize Illiquid Stocks?” They find evidence in support of cross-subsidization since the short run variability of illiquid stocks and the cost of trading such stocks are reduced if the specialist trading them also handles a very liquid stock. Larry Harris, Chief Economist of the Securities and Exchange Commission, reported the results of a study co-authored with Jay Coughenour titled “Specialist Profits and the Minimum Price Increment.” Decimalization (completed January 29, 2001) has potentially offsetting effects on specialist profits. On the one hand, decimalization reduces spreads and thereby reduces specialist profits. On the other hand, decimalization makes it less costly for specialists to step in front of limit orders to compete for desirable order flow. Harris and Coughenour conclude that specialist profits increased in the low priced stocks where the reduced tick size had the greatest effect. In other stocks, measured profits have declined.
Robert Jennings, Professor at Indiana University, commented on changes in pennying behavior on the NYSE. The frequency with which a trade occurs one penny better than the quote has not changed materially with the advent of decimal pricing, but the specialist’s involvement in penny trading has declined.
George Sofianos, Vice President at Goldman Sachs, discussed the challenges facing the NYSE and the specialist system. He noted that the NYSE hybrid system that combines electronic trading with a trading floor has the potential to serve the needs of both individual and institutional traders. What makes the NYSE different from other markets is the presence of undisplayed liquidity that can be harnessed by floor brokers. He argued that the specialist should shift market making to provide liquidity for difficult trades rather than to trade in small amounts at the inside quote.
The conference’s final session on the topic of bond market microstructure was chaired by Bill Christie, Professor and Dean of the Owen School. Michael Piwowar, Visiting Academic Scholar at the Securities and Exchange Commission, presented a paper, “Municipal Bond Liquidity,” (written with Larry Harris). He described the lack of transparency in the bond market, the lack of publicly available quotes and timely trade reports, the large number of different securities, and the infrequency with which municipal bonds are traded. Despite these obstacles, Harris and Piwowar provide estimates of transaction costs inferred from transaction reports made by dealers to the Municipal Securities Rate Making Board. They estimate an effective spread averaging about 2% to trade a representative municipal bond.
The session concluded with a very informative description of electronic bond trading systems by Christopher Perry, former Head of E-Commerce for the Americas at HSBC and a veteran of the fixed income markets. He discussed the issue of liquidity in these markets, noting that the lack of short selling is partly to blame.
Sean Arp, Thales Fund Management
Clifford A. Ball, Owen School, Vanderbilt University
Robert W. Blanning, Owen School, Vanderbilt University
Nicolas P.B. Bollen, Owen School, Vanderbilt University
G. Geoffrey Booth, Michigan State University
Jim Bradford, Owen School, Vanderbilt University
Gabe Butler, ITG, Inc.
Kathryn Camp, National Futures Association
Gaston F. Ceron, Dow Jones Newswires
Paul Chaney, Owen School, Vanderbilt University
Alger B. (Duke) Chapman, ABN AMRO Financial Services
Anchada Charoenrook, Owen School, Vanderbilt University
William G. Christie, Dean of Owen School, Vanderbilt University
Mark Cohen, Owen School, Vanderbilt University
Rick Cooper, CTN Strategic Investments
Jay Coughenour, University of Delaware & SEC
J. Dewey Daane, Owen School, Vanderbilt University
John M. Damgard, Futures Industry Association
Jim Duensing, Caterpillar Financial Services Corp.
Richard DuFour, Chicago Board Options Exchange
Edwin J. (Ned) Elton, Stern School, NYU
Preston Estep, Eclipse Capital Management, Inc.
Mara Faccio, Owen School, Vanderbilt University
James Falvey, EurexUS
Greg Faulk, Belmont University
Amar Gande, Owen School, Vanderbilt University
Frank Hansen, TradeLink, LLC2
Oliver Hansch, Penn State & NASDAQ
Lawrence Harris, US Securities & Exchange Commission
Frank Hatheway, NASDAQ
Hans G. Heidle, University of Notre Dame
Thomas S.Y. Ho, Thomas Ho Company
Roger Huang, University of Notre Dame
Vladimir Ivanov, Owen School, Vanderbilt University
Pankaj K. Jain, University of Memphis
Robert Jennings, Indiana University
Debra Jeter, Owen School, Vanderbilt University
David B. Jones, Fidelity Management & Research Corp.
Richard Ketchum, New York Stock Exchange
Veronika Krepely, Owen School, Vanderbilt University
Jack W. Lavery, Lavery Consulting Group, LLC
Gemma Lee, Owen School, Vanderbilt University
Craig Lewis, Owen School, Vanderbilt University
Richard Lindsey, Bear Stearns Securities Corp.
Wenjiu (Jerry) Liu, Purdue University
Ronald W. Masulis, Owen School, Vanderbilt University
Beth Matter, Alumni Publications, Vanderbilt University
Rajarishi Nahata, Owen School, Vanderbilt University
Annette Nazareth, US Securities & Exchange Commission
James Overdahl, Commodity Futures Trading Commission
David Parsley, Owen School, Vanderbilt University
Thomas Peterffy, Interactive Brokers Group
Michael Piwowar, Iowa State University & SEC
Charu Raheja, Owen School, Vanderbilt University
Christoph Schenzler, Owen School, Vanderbilt University
Christian Schlag, Owen School & Goethe University, Frankfurt
Ed Scott, Caterpillar Financial Services, Corp.3
Jamie Selway, White Cap Trading, LLC
Todd Silverberg, Esq., Susquehanna International Group, LLP
Joe Smolira, Belmont University
George Sofianos, Goldman Sachs & Co.
Hans R. Stoll, Owen School, Vanderbilt University
Sharon Su, Goldman Sachs & Co.
Kenneth Sutrick, Murray State University
Kent Syverud, Dean of Law School, Vanderbilt University
Randall Thomas, Law School, Vanderbilt University
Robert Thompson, Law School, Vanderbilt University
Van Tucker, Crowe Chizek & Co. LLC
Kumar Venkataraman, Southern Methodist University
Cong Wang, Owen School, Vanderbilt University
H. Martin Weingartner, Owen School, Vanderbilt University
Fei Xie, Owen School, Vanderbilt University
Eric Zitzewitz, Stanford University
Dewey Daane Invitational Tennis Tournament
For the first time in the tournament’s history Dewey Daane was unable to play, a result of a nagging shoulder injury. The others fought valiantly for the contents of the Daane Cup, which were won by Hans Stoll in tie-breaker playoff against Hans Heidle, who did not easily succumb to take the runner-up position.