March 1, 2001
Mr. Richard A. Grasso
Chairman
New York Stock Exchange
11 Wall Street
New York, NY 10005
Dear Mr. Grasso:
The Investment Company Institute1 is writing in
connection with certain problems
that mutual funds and other institutional investors have
faced when trading on the
New York Stock Exchange. As you know, since the
implementation of
decimalization on the Exchange, the execution of large
orders has been hampered
by reduced depth of the Exchange’s limit order book and
by increased instances
of market participants stepping ahead of orders by
increments of as little as one
penny.
Some market participants reportedly contend that the
problems noted above
have arisen solely as a result of decimalization and are
suggesting either that
decimalization be reversed, or that the Exchange
establish a minimum trading
increment of greater than one penny (e.g., a nickel). We
disagree.
Decimalization, by itself, is not the problem. Rather, it
has simply made more
apparent the difficulties that mutual funds and other
institutions commonly face
when trading on the Exchange.
In order to address these problems, we strongly recommend
that the NYSE
implement certain changes that would facilitate the
ability of mutual funds and
other institutions to trade large orders on the Exchange.
We recognize that the
NYSE has developed a system specifically designed for
these types of orders –
Institutional XPress. Unfortunately, as discussed below,
we do not believe that
Institutional XPress, as presently constituted, will
satisfactorily respond to the
difficulties that institutions are experiencing. With
certain changes, however,
Institutional XPress could achieve its objectives and, in
turn, allow all investors in
NYSE-listed securities to reap the benefits of
decimalization.
Our specific recommendations are set forth below. As a
preliminary matter, we
wish to stress the point that, while mutual funds are
correctly viewed as
institutional investors because they frequently execute
large-sized orders, mutual
funds do so on behalf of millions of predominantly
middle-income investors. The
median income of a U.S. mutual fund shareholder is
$55,000.2 Moreover, 45%
of all assets in Section 401(k) retirement plans are
invested in mutual funds.3
Thus, the principal beneficiaries of our recommended
changes will be
middle-income Americans.
Institutional XPress
In approving the rules implementing Institutional XPress,
the Securities and
Exchange Commission stated that "the XPress system should
encourage market
participants, particularly institutional investors, to
display orders of at least
25,000 shares, which may attract more order flow and
increase the depth and
liquidity of the Exchange’s market to the benefit of
investors and the public
interest."4 The Institute strongly supports this
objective. Unfortunately,
Institutional XPress, as currently structured, will do
nothing to achieve it and
instead represents a classic missed opportunity.
Our members consistently tell us that, without protection
for large limit orders
placed on the Exchange’s limit order book and the
assurance that they will be
able to interact with those orders, they will be
dissuaded from placing limit orders
on the Exchange, thereby reducing the market’s depth and
liquidity. This effect
has become more pronounced following the introduction of
decimalization. In
fact, preliminary data has shown that liquidity and depth
in the market have
already been reduced (reflected in a decrease in both the
amount of limit orders
on the Exchange and the amount of block trades being
executed on the
Exchange).
The Market Structure Report of the NYSE’s Special
Committee on Market
Structure, Governance, and Ownership stated that, in
connection with the
introduction of decimalization, "t is possible that
unanticipated trading strategies
may develop that will warrant or require adjustments to
[the NYSE] initiatives or
changes in regulation."5 The Report has proven to be
prescient, and the following
changes to are now warranted:
1. Eliminate the required displayed time for a quote to
qualify as an
XPress quote and reduce the number of shares required for
quotes and
orders to become XPress eligible. Under NYSE rules, an
XPress quote is
defined as a published bid or offer of at least 25,000
shares that is displayed at
the same price for at least 30 seconds. An XPress order
is defined as an order of
at least 25,000 shares to be executed against a displayed
XPress quote, or at an
improved price.
The 30-second display requirement is unnecessary, and is
especially
inappropriate in today’s fast-moving trading environment.
In its order establishing
XPress orders and quotes, the Commission stated that the
30-second
requirement would provide brokers and non-XPress orders
the opportunity to
interact with the quote before it becomes XPress
eligible. In practice, however,
this delay will only serve to provide a "free look" to
market participants who
want to step ahead of large orders. As a result,
institutional investors, knowing
that large limit orders on the book are not provided
protection and are likely to
be "penny jumped," have little, if any, incentive to
place large limit orders on the
Exchange. In this way, the required displayed time
defeats the purpose of
Institutional XPress. Eliminating it would reduce
stepping ahead, and thereby
attract order flow and increase the depth and liquidity
of the market.
The number of shares required for quotes and orders to
become XPress eligible
also should be reduced. A significant portion of the
orders that mutual funds and
other institutional investors typically place on the
Exchange for execution are
below the 25,000 share threshold established by the NYSE
for Institutional
XPress, especially in the case of smaller cap stocks.
Therefore, many of the
types of orders in which the XPress system was intended
to facilitate trading will
not be covered under the current rules. Reducing the
number of shares required
for a quote and order to become XPress eligible would
encourage the placement
of more orders on the Exchange’s limit order book,
further enhancing the liquidity
on the Exchange.6
2. Make XPress orders ineligible for price improvement,
i.e., XPress
orders should not be represented by the specialist to the
crowd. Under
Institutional XPress, a specialist must represent an
XPress order to the crowd
prior to that order executing against an XPress bid or
offer on the book. The
practical effect of this requirement is that while the
XPress order (i.e., the
responding order) may receive price improvement (which
could be by as little as
one penny in a decimal environment), the large limit
orders comprising the
XPress quote go unexecuted. Thus, in its desire to ensure
that the institution
responding to an XPress quote receives price improvement,
the NYSE has
created a regime that strongly discourages the entry of
those orders that would
comprise the XPress quote in the first place. For this
reason, those institutions,
including mutual funds, that would receive the "benefit"
of this price improvement
would gladly forego it. Our members report that it is far
more important for them
to receive protection for their displayed orders.
Consequently, notwithstanding
the NYSE’s commitment to continuing to offer price
improvement for smaller,
retail orders, the Exchange should revise Institutional
XPress so that XPress
orders placed by institutions would not be required to be
represented by the
specialist to the crowd. This would promote the placement
of limit orders on the
book by providing protection for, and rewarding the
placement of, those orders.7
3. Allow XPress orders to reach through to orders on the
book below the
best bid and offer and require all orders on the book at
prices better than
those orders to be executed and price improved.
Decimalization has led to
an increase in the number of price levels at which orders
are entered, as well as a
decrease in the volume represented at each price level.
Consequently, in order to
ensure that Institutional XPress will offer mutual funds
and other institutions the
ability to execute large orders on the Exchange, the
XPress system should allow
those institutions to reach through to orders on the book
that are below the best
bid and offer. For example, if a large limit order (at a
size that is XPress eligible)
is located two price levels below the best bid or offer,
an incoming XPress order
should be able to reach through and hit that limit order.
In order to ensure that
bids or offers on the book that are superior to the
XPress eligible quote are
protected, and to be consistent with the Exchange’s
desire to provide price
improvement opportunities to smaller orders, we would
further recommend that
all orders on the book at prices better than the XPress
eligible quote be required
to be executed and price improved to the price of the
XPress quote in these
circumstances.8
* * * * * * *
By enhancing Institutional XPress in the ways set forth
above, the NYSE could
help ensure that all investors – including millions of
mutual fund shareholders –
will realize the full benefits of decimalization. We
therefore strongly encourage the
Exchange to make these changes. We would be pleased to
discuss our
recommendations with you further. If you would like to do
so, or if you have any
questions regarding this letter, please contact the
undersigned at (202) 326-5815
or Ari Burstein at (202) 371-5408.
Sincerely,
Craig S. Tyle
General Counsel
cc: The Honorable Laura S. Unger, Acting Chairperson
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul R. Carey, Commissioner
Annette L. Nazareth, Director, Division of Market
Regulation
Robert L.D. Colby, Deputy Director, Division of Market
Regulation
Paul F. Roye, Director, Division of Investment Management
Securities and Exchange Commission
Catherine R. Kinney, Group Executive Vice President
Edward A. Kwalwasser, Group Executive Vice President
New York Stock Exchange
ENDNOTES
1The Investment Company Institute is the national
association of the American investment
company industry. Its membership includes 8,414 open-end
investment companies ("mutual
funds"), 489 closed-end investment companies and 8
sponsors of unit investment trusts.
Its mutual fund members have assets of about $6.937
trillion, accounting for approximately
95% of total industry assets, and over 83.5 million
individual shareholders.
2See Investment Company Institute Mutual Fund Fact Book
(40th ed.) at 46.
3See Fundamentals: Investment Company Institute Research
in Brief, Vol. 9, No. 2 (May
2000) at 7.
4Securities Exchange Act Release No. 43763 (December 21,
2000), 65 FR 83120 (December
29, 2000) at 83122.
5Market Structure Report of the New York Stock Exchange
Special Committee on Market
Structure, Governance and Ownership, p. 22.
6The Institute recognizes that the Exchange has indicated
that it may, in the future, reduce
the minimum size for XPress orders and quotes to 15,000
shares and reduce the minimum
required display time for XPress quote designation to 15
seconds. We believe, however,
that these types of changes are crucial to the workings
of Institutional XPress and should
be made prior to the implementation of the system. In
addition, for the reasons noted
above, we do not believe that any minimum required
displayed time is appropriate.
7The Institute also recommends that the NYSE eliminate
the 3:58 p.m. cut-off time for
entering XPress orders, because the cut-off, the purpose
of which is to allow sufficient time
for a specialist to represent the XPress order to the
crowd for price improvement, would no
longer be necessary if XPress orders were ineligible for
price improvement.
8In order to implement this change, it will be necessary
for the Institutional XPress rules to
allow a quote below the best bid or offer to become
XPress eligible and for the definition of
XPress order to be amended to eliminate the requirement
that an XPress order be for no
more than the displayed size of an XPress quote. |
