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physical location, and has historically been characterized by virtually complete freedom of entry. There are no formal procedures for commencing or terminating trading in a particular security. Any brokerdealer registered with the SEC can act as a dealer (buying and selling to others as principal) or broker (buying or selling for customers as their agent) or both in any OTC security. Market-making in OTC stocks ranges from sporadic activities of individual dealers in inactive local stocks to continuous competition among thirty or more dealers in the largest, most active issues.
Prior to 1971, the only formalized means of communication of quotations in the OTC market was through the publication of daily "sheets”, listing the bid and asked prices of each dealer in each stock at the close of the previous day. On February 8, 1971, the National Association of Securities Dealers (NASD) put into operation an automated quotation system-NASDAQ—by which continuously updated price quotations are displayed on a real-time basis on cathode ray terminals located in subscribers' offices.
NASDAQ is at present only a quotation system. After obtaining a quotation, a subscriber must consummate the transaction by telephone communication with the market-maker. Nor does the NASDAQ system provide reports of transactions, although suggestions have been made that NASDAQ could serve as the nucleus of an automated system for the execution and clearance of securities transactions.3. The NASD does require all NASDAQ market-makers to report their trading volume at the end of each day, so that total daily volume in all NASDAQ stocks has been available since November 1971. Total volume in the 3,470 NASDAQ issues in the twelve months ended October 27, 1972 (the first annual period for which figures were available) was 2.2 billion shares, about twice as great as the share volume on the American Stock Exchange and slightly more than halfi as great as the share volume on the New York Stock Exchange.
NASDAQ is presently furnishing to over 800 subscribers, with approximately 27,000 terminals, quotations of more than 600 marketmakers in approximately 3,470 securities which meet NASD requirements for inclusion in the system.” b. The Exchange Market
The market for listed securities includes primarily the approximately 1,400 common stocks listed on the NYSE and the approximately 1,200 common stocks listed 6 on the AMEX. The NYSE and AMĚX are complementary, rather than competing, markets. Since its organization as the New York Curb Market Association in 1910, the AMEX has forsworn trading in any issues traded on the NYSE, serving principally as an avenue to NYSE listing for companies that do not
3 See Mendelson, Nostalgia vs. the Computer: The_Issue of Stock Market Reform, Wharton Q., Fall 1971. reprinted in 6 House Hearings at 3423. The NASD Board of Governors has authorized the operator of the NASDAQ system to develop specifications for a system of reporting trades through the system, and expects to receive those specifications in January 1973. See Wall Street Journal, Jan. 26, 1973, p. 2, col. 3. 4 Wall St. J., Oct. 28, 1972.
5 Figures supplied by NASD. To be eligible for inclusion in NASDAQ, a security must meet the requirements for registration under the Securities Exchange Act of 1934 (i.e., it must be issued by a company with at least $1,000,000 in assets and 500 shareholders),
and must have at least two dealers making a market in it. To enter quotes for a security
in NASDAQ, a dealer must register as a market maker in that security and must maintain net capital of not less than $5,000 for each security in which he is so registered (up to a maximum requirement of $50,000). He must also stand
ready to execute a trade for at least one normal unit of trading (ordinarily 100 shares) at the price he is currently quoting.
This figure includes approximately 60 stocks admitted to "unlisted trading privileges” on the AMEX. See Section B. 6, below.
yet meet the higher NYSE listing requirements. The AMEX is at present effectively prohibited from offering an alternative market for NYSE stocks, since 87% of its member firms are also members of the NYSE, and the NYSE Constitution provides for suspension or expulsion of any NYSE member who "is connected . with another exchange or similar organization in the City of New York which permits dealings in any securities dealt in on the [N YSE].” 8
In addition to the 2,600 NYSE and AMEX listed issues, there are also about 300 issues traded solely on one or more regional exchanges. These issues, however, account for less than 3% of regional exchange volume and less than 4 of 1% of all trading in listed securities. As noted below, however, certain regional exchanges have become important alternative markets for NYSE-listed issues. c. Growth of Competing Markets in NYSE-Listed Securities
The differences in the nature of the securities listed on the NYSE and on the AMEX has in recent years led to divergence in the patterns of trading in NYSE- and AMEX-listed issues.
The AMEX, whose list consists generally of lower-priced stocks in smaller companies, has remained primarily a market for individual investors. While institutional activity in AMEX issues has shown a steady increase, individuals still accounted for 85.9% of the public (non-member) orders, 74.3% of the share volume, and 66.1% of the dollar volume in 1971.10 On the other hand, institutions have come to dominate the activity in NYSE-listed stocks. While individuals accounted for almost 75% of the public (non-member) orders on the NYSE in the first half of 1971, their orders accounted for only 40% of the share volume and 32% of the dollar volume during that period, compared with 67% of the share ,volume and 61% of the dollar volume 10 years earlier. 11 ?
The SEC's Institutional Investor Study in 1971 found that 96% of the common stock held by institutions consisted of issues listed on the NYSE.12 This is not surprising, since institutions, which often buy and sell in large blocks, tend to favor issues in which there are large numbers of shares outstanding. The average NYSE issue has approximately 6 times as many shares outstanding as the average AMEX issue, and the aggregate market value of all NYSE issues is approximately 16 times as great as the aggregate market value of all AMEX issues. In fact, the aggregate market value of the shares of one NYSElisted company-IBM-is approximately as great as the aggregate market value of all the shares listed on the AMEX.13
Concurrently with the increasing dominance of institutional activity in NYSE issues, there has been a steady growth in the
? See Doede, The Monopoly Power of the New York Stock Exchange 15 (unpublished dissertation 1967), reprinted in Tearings on s. 3169 Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs, 92d Cong., 2d Sess. (1972) (hereinafter cited as "Commission Rate Hearings"') at 405, 422. According to information furnished by the AMEX, over the 4 years 1968-1971, between 30 and 40 stocks each year moved from the AMEX to the NYSE. As of September 1972, there were 118 companies which could meet all NYSE listing requirements but which continued to be listed on the AMEX. 8 NYSE Const., Art. XIV, $ 8.
Based on figures furnished by SEC. The growth and subsequent decline of the regional exchanges as markets for solely-listed issues is described in 2 Report of the Special Study of the Securities Markets of the SEC, H. Doc. No. 95, 88th Cong., 1st Sess. (1963) (hereinafter cited as "Special Study") at 912-25. 10 AMEX, Sources and Characteristics of Public Activity 3, 4, 5, (1971). 11 NYSE, Public Transaction Study 12 (1971). 12 3 Institutional Investor Study of the SEC, H. Doc. No. 92-64, 92d Cong., 1st Sess. (1971) (hereinafter cited as "Institutional Investor Study") at 1323. 13 Figures derived from NYSE Fact Book and AMEX Databook.
percentage of NYSE-listed issues traded in other markets. In 1971, more than 17% of the voluune in common stocks listed on the VISE represented transactions in other markets, of which approximately 10% represented regional exchange transactions and approximately 79 represented transactions in the "third market”-the over-thecounter market in listed securities.14 On the other hand, there has been a relatively small amount of trading in ATEX issues in other markets. AMEX officials estimated, on the basis of an informel survey in 1970 and 1971, that trading in AVEX issues on regional exchanges amounts to about 14% of total AMEX volume, and between 3% and 4% of the volume in the issues actually traded on regional exchanges. Similarly, there has been extremely limited activity in AMEX stocks in the third market.16
The percentage of trading in NYSE-listed issues which takes place on regional exchanges and in the third market is even higher in the case of the most actively traded stocks. Figures compiled by the SEC show that in the fourth quarter of 1971, 30.3 percent of the total trading in 50 of the most active VYSE issues took place on other exchanges or in the third market."7 This figure compares with 23.7 percent in the fourth quarter of 1966. Figures for individual issues rangec from 13.0 percent (American Electric Power) to 52.6 percent (Procter & Gamble). The figures for the 10 most active issues were as follows:
There is no single reason for the increasing use of other markets for transactions in NYSE-listed stocks. The most important factor has been uneconomically high fixed commission rates on large transactions, which have led institutions to utilize the third market, where all securities are purchased and sold on a net basis and, therefore, no cornmissions are charged, or regional exchanges, where they have been permitted to become members and thus recapture or redirect all or part of the commission. Similarly, broker-dealers who are not NYSE members, and who were required until recently to pay a full commission on all NYSE transactions,18 find it economically advan
14 NYSE, 1972 Fact Book 15, 16. 1. Infor:nation supplied by AMEX.
18 Figures compiled by the SEC in 1965 and 1966 indicated that between 97 and 99 percent of third market trading each quarter was in NYSE issues. In view of the limited third-market trading in issues listed on the AMEX or solely on regional exchanges, the SEC has not compiled comparable figures for more recent periods.
11 Figures derived from SEC', Statistical Bulletins. Comp:arable figures for the first and second quirters of 1972 were 32.1 percent and 31.4 percent, resp.ctively.
In 1972, the NYSE rules were amendad, at the insistence of the SEC, to permit members to allow up to a 40% discount to non-member broker-dealers. NYSE Const., Art X1, 32(h).
tageous to join regional exchanges or execute their customers' orders in the third market. With the phasing out of fixed commissions on
over $100,000, which is now expected to be completed early in 1974, this artificial distortion of choice of markets should be greatly reduced.
A second factor in the migration of institutional orders to regional exchanges and the third market has been that there are cases in which an institution believes that a better market is available off the NYSE in that security at that time and that the institution can therefore get a better net price on its transaction if it is handled in another market. A third factor has been the alleged desire in certain cases, to execute an order off the NYSE to avoid exposure to public orders on the VYSE specialist book and the market effect of printing the transaction on the NYSE tape.19
Regardless of what combination of factors has been at work, the fact remains that, for economic reasons, about one-sixth of the trading in NYSE-listed issues, and almost one-third of the trading in the most actively traded of those issues, takes place outside the NYSE. d. Consequences of Use of Other Markets
Vany members of the NYSE, quite naturally, disapprove of this development. The Chairman of the NYSE, in a recent speech, said that this "fragmentation" was "the major problem facing our industry today" and "is the root of all current ills.” 20 While the NYSE has not renewed its 1940 attempt to prevent its members from trading NYSE-listed stocks on any other exchange, it has led the fight to bar institutions from membership on regional exchanges, and has now asked for Congressional legislation to put the third market out of existence.21
It is not hard to find the source of this concern. The migration of orders to other markets has meant a substantial loss of income to NYSE members-perhaps on the order of half a billion dollars a year. In considering the development of a "central market system,” however, the goal of the Congress is not to protect the income of the members of the NYSE, but to protect the interests of public investors. In that connection, it is necessary to analyze the detriments—and the benefits—that have come to public investors as a result of the diversion of transactions from the NYSE to other markets.
The principal harms which are alleged to have been inflicted on public investors are (1) that transactions in listed stocks can be effected without public disclosure, and without exposure to public orders, and (2) that dealers in other markets can operate free of salutary restrictions imposed on NYSE specialists.22 The Subcommittee believes that these are important considerations, and its recommendations set forth below in this chapter are designed to deal with them. At the same time, recognition must be given to the benefits to the public that have flowed from the development of these competing markets. Chief among these are the traditional benefits of competition-lower charges and better performance. It is clear that the ex19 See, e.g. 7 House Hearings at 3648. 20 Address by James J. Needham at the Securities Industry Ass'n. Convention, Boca Raton, Fla., Dec. 1, 1972, at 2.
21 Address, supra note 20, at 9. 22 See, generally, address, supra note 20.
istence of competing markets was a major factor in obtaining NYSE acceptance of the concept of competitive commission rates 23_indeed, it is quite possible that in the absence of competitive markets, it would have required litigation under the antitrust laws to commence the movement to competitive rates.24 There is also evidence that where competing market-makers are operating in NYSE-listed stocks, the spread between bid and asked prices has been lessened, with consequent benefits to public buyers and sellers.25
For this reason, the Subcommittee approaches the question of a "central market system” not from the point of view of returning all trading iu N YSE-listed stocks to the NYSE and subjecting all participants in that trading to NYSE rules and procedures, but from the point of view of preserving the competing markets that have developed, breaking down barriers to communication and competition. between them, and imposing those rules—and only those ruleswhich are necessary to protect public investors. The objective of a "central market system' is to provide a better market, with greater liquidity and depth, to meet the present and future needs of the public—those who invest directly and those who invest through the medium of institutions.
2. STEPS TOWARD THE CREATION OF A CENTRAL MARKET SYSTEM a. Alternative Approaches
In transmitting the Report of its Institutional Investor Study to Congress in March 1971, the SEC stated:
A major goal and ideal of the securities markets and the securities industry has been the creation of a strong central market system for securities of national importance, in which all buying and selling interest in these securities could participate and be represented under a competitive regime.
Until comparatively recently there were serious technological limitations on creating a system where all interests of investors could be represented in a central market. This is no longer the case. Recent advances in communications and electronic data processing make such representation technically feasible if the necessary systems are developed and used. . .
In summary, our objective is to see a strong central market system created to which all investors have access, in which
all qualified broker-dealers and existing market institutions 23 See Remarks of Robert W. Haack, President, NYSE, at the Economic Club of New York, Nov. 17, 1970, at 12-13:
I submit that no entity, not even the New York Stock Exchange, can forever ward off competition from a noncompetitive stance so far as pricing is concerned. Unless the New York Stoek Exchange is willing to compete effectively with markets where commission fees are presently negotiuted it faces a continued reduction in its share of overall trading, and at an accelerated pace. 24 The two major commodity exchanges in Chicago recently agreed to phase out fixed rates in settlement of eight antitrust treble damage actions. These private actions followed a suit by the Justice Department to end fixed rates on commodity exchanges. See Wall St.J., Nov. 24, 1972, p. 4, col. 2. 25 The NASD study of the results of including third-market quotations for listed securities in NASDAQ. found that "the high degree of competition between NASDAQ and exchange quotations has had a small but significant effect in reducing dealer spreads.” NASD, The NASDAQ-Third Market Study 1, 17-18 (1972). The Subcommittee's case study of the circumstances surrounding the inclusion of listed stocks in NASDAQ is set forth in 3 Study Hearings at 3-17.