Subject: comments on market fragmentation Date: 03/24/2000 3:13 PM March 24, 2000 Mr. Jonathan G. Katz, Secretary Securities and Exchange Commission 450 Fifth Street N.W. Washington, D.C. 20549-0609 RE: Release No. 34-42450; File No. SR-NYSE-99-48 Dear Mr. Katz: I am pleased to provide these comments in response to the Commission "Request for Comment on Issues Relating to Market Fragmentation". I believe that issues related to fragmentation can best be addressed by ensuring that customers are provided with the information they need to make informed choices, and by improving incentives for liquidity providers to compete for order flow. I propose the following enhancements: (1) Customers should, for each trade, receive a report identifying the trade execution costs they paid. Currently, commission charges are generally reported to customers, but trade execution costs are not. Trade execution costs for sell orders are the difference between the underlying value of the asset and the weighted average trade price received by the seller, multiplied by the number of shares sold. For buy orders the trade execution cost is determined analogously as the difference between the weighted average trade price paid and the underlying value of the asset, multiplied by the number of shares purchased. A standardized procedure would be needed for estimating the underlying share value the midpoint of the best bid and offer at the time of order submission might suffice as the estimate of underlying value. With actual trade execution costs reported, customers would be able to make informed choices based on their total trading costs (commission plus execution cost). (2) All investors or market makers who choose to supply liquidity in the form of limit orders or firm quotations should be rewarded by having their orders and quotes placed in a central limit order book (CLOB) that observes strict price and time priority. Market orders directed to the CLOB would be matched against the most favorably priced limit orders and quotes. If there are multiple limit orders at the same price, those posted earliest would be executed first. The enforcement of price and time priority provides incentives for liquidity suppliers to compete for market orders by displaying their trading interest and by improving on existing prices. (3) Customers should be free to choose whether their market orders are routed to the CLOB for automatic execution, or are sent to alternate market centers to be executed based on rules and procedures specified by that market center. Alternate venues might be able to provide better executions, since some liquidity providers may prefer to not publicly disseminate their trading interest in the form of limit orders or firm quotes. (4) To aid customers in their choice, the state of the CLOB should be continuously disseminated to the investing public. The information disseminated should not be limited to the highest bid and lowest offer. One possibility would be to disseminate a "weighted average price" schedule that reflects the average price that would be received by market buy or paid by market sell orders of various sizes as they "walked up the book". The importance of information regarding the state of the CLOB beyond the inside quotes is likely to be enhanced in the wake of decimalization, as the number of shares that can be transacted at the inside quote is likely to decrease along with the minimum price increment or "tick size". Discussion: There is no perfect solution to the issue of market fragmentation. Concerns related to market fragmentation stem in part from the idea that orders and trades generate positive externalities, so that individual orders benefit from being exposed to as many other orders as possible. This externality problem would be cured by a requirement that all orders in a given security be sent to a single market center for execution. But this approach would have its own costs: substantial regulatory oversight would likely be required, and competition for order flow across market centers would be eliminated. The only competition remaining would be across market centers for listings. The proposals made here do not eliminate fragmentation, since they allow for orders to be routed to and trades to be completed at multiple markets. Instead, the proposals rely on the notion that informed choices and competition for order flow are the key to improving the efficiency of the U.S. equity markets. The reporting of actual trade execution costs and the dissemination of information regarding the CLOB will allow customers to make informed choices as to where their orders are routed. The enforcement of price and time priority among limit orders and quotations gives incentives for liquidity providers to display their trading interest, and to compete by providing better prices and quantities. At the same time, these proposals respect the fact that not all liquidity providers wish to make their trading interest public. Market centers would compete for non-public indications of trading interest on the basis of whether they meet those traders' needs, and would compete for market orders by offering the possibility of trade executions at better prices than offered in the CLOB, or by competing on dimensions other than price. Displaying a quote or limit order provides a public service, which is rewarded by a CLOB that enforces price and time priority. Under these rules improving on existing prices is rewarded by an increased likelihood of order execution. However, displaying trading interest publicly involves costs as well, as the limit order provides potentially useful information about future price changes. Large investors in particular may be hesitant to display publicly their trading interest, fearing that other traders will use the information they display to the detriment of their own execution quality. The proposal made here would allow traders to choose among four strategies: (1) they can submit market orders and direct that they be sent to the CLOB for execution, (2) they can submit market orders to a specific market center to be executed based on rules and procedures established by that center, (3) they can enter a limit order, which will be publicly displayed in the CLOB, or (4) they can express their trading interest to one or more market centers, in a mutually agreeable manner. The reporting of actual trade execution costs will allow investors to ascertain which strategy best meets their needs. Competition among publicly displayed limit orders and quotes will benefit traders who submit their market orders to the CLOB. At the same time, market centers can compete with each other and with the CLOB by designing methods for market orders directed to their venue to interact with other market orders or trading interest that is not publicly displayed. The market structure described here has potential to improve the competitiveness and efficiency of the equity markets. However, the CLOB could fail. If the CLOB does not attract a certain critical volume of orders then there would be little incentive to transact there, and the markets would remain substantially fragmented across market centers. If an alternate market center were able to offer a guarantee of a weighted average trade price that matched or bettered the CLOB, the CLOB would fail since most or all market orders would be diverted. Even so, investors would benefit from being able to make better-informed choices as to where their trades are executed. In practice it seems unlikely that any market center could offer such a guarantee, as limit order competition is likely to lead to very narrow CLOB spreads, particularly for small trades. A possible outcome is that smaller market orders and orders in the most liquid securities will tend to be directed to the CLOB, while investors seeking to complete larger trades or trades in less liquid securities will rely more on alternate market centers. The main appeal of this proposal is its reliance on competition and informed private decisions. Fragmentation would not be totally eliminated, but investors would be able to choose where their orders are routed and would know the trade execution costs they paid. Those who are willing to enter aggressive limit orders or quotations would be rewarded with an increased likelihood of trade execution. Market centers that specialize in meeting the needs of those who prefer to not formally display their trading interest would also have a chance to compete. Sincerely, Hendrik Bessembinder Professor of Finance Goizueta Business School Emory University 1300 Clifton Road Atlanta, GA 30322.