[House Hearing, 112 Congress]
[From the U.S. Government Publishing Office]

HOW ROADBLOCKS IN PUBLIC MARKETS PREVENT JOB CREATION ON MAIN STREET

=======================================================================

HEARING

before the

SUBCOMMITTEE ON TARP, FINANCIAL SERVICES
AND BAILOUTS OF PUBLIC AND PRIVATE PROGRAMS

of the

COMMITTEE ON OVERSIGHT
AND GOVERNMENT REFORM

HOUSE OF REPRESENTATIVES

ONE HUNDRED TWELFTH CONGRESS

FIRST SESSION

__________

NOVEMBER 15, 2011

__________

Serial No. 112-121

__________

Printed for the use of the Committee on Oversight and Government Reform

Available via the World Wide Web: http://www.fdsys.gov
http://www.house.gov/reform

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COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM

DARRELL E. ISSA, California, Chairman
DAN BURTON, Indiana ELIJAH E. CUMMINGS, Maryland,
JOHN L. MICA, Florida Ranking Minority Member
TODD RUSSELL PLATTS, Pennsylvania EDOLPHUS TOWNS, New York
MICHAEL R. TURNER, Ohio CAROLYN B. MALONEY, New York
PATRICK T. McHENRY, North Carolina ELEANOR HOLMES NORTON, District of
JIM JORDAN, Ohio Columbia
JASON CHAFFETZ, Utah DENNIS J. KUCINICH, Ohio
CONNIE MACK, Florida JOHN F. TIERNEY, Massachusetts
TIM WALBERG, Michigan WM. LACY CLAY, Missouri
JAMES LANKFORD, Oklahoma STEPHEN F. LYNCH, Massachusetts
JUSTIN AMASH, Michigan JIM COOPER, Tennessee
ANN MARIE BUERKLE, New York GERALD E. CONNOLLY, Virginia
PAUL A. GOSAR, Arizona MIKE QUIGLEY, Illinois
RAUL R. LABRADOR, Idaho DANNY K. DAVIS, Illinois
PATRICK MEEHAN, Pennsylvania BRUCE L. BRALEY, Iowa
SCOTT DesJARLAIS, Tennessee PETER WELCH, Vermont
JOE WALSH, Illinois JOHN A. YARMUTH, Kentucky
TREY GOWDY, South Carolina CHRISTOPHER S. MURPHY, Connecticut
DENNIS A. ROSS, Florida JACKIE SPEIER, California
FRANK C. GUINTA, New Hampshire
BLAKE FARENTHOLD, Texas
MIKE KELLY, Pennsylvania

Lawrence J. Brady, Staff Director
John D. Cuaderes, Deputy Staff Director
Robert Borden, General Counsel
Linda A. Good, Chief Clerk
David Rapallo, Minority Staff Director

Subcommittee on TARP, Financial Services and Bailouts of Public and
Private Programs

PATRICK T. McHENRY, North Carolina, Chairman
FRANK C. GUINTA, New Hampshire, MIKE QUIGLEY, Illinois, Ranking
Vice Chairman Minority Member
ANN MARIE BUERKLE, New York CAROLYN B. MALONEY, New York
JUSTIN AMASH, Michigan PETER WELCH, Vermont
PATRICK MEEHAN, Pennsylvania JOHN A. YARMUTH, Kentucky
JOE WALSH, Illinois JACKIE SPEIER, California
TREY GOWDY, South Carolina JIM COOPER, Tennessee
DENNIS A. ROSS, Florida

C O N T E N T S

----------
Page
Hearing held on November 15, 2011................................ 1
Statement of:
Noll, Eric W., executive vice president of NTS Management,
NASDAQ OMX Group, Inc.; and Joseph Mecane, executive vice
president and chief administrative officer for U.S.
Markets, on behalf of NYSE Euronext........................ 8
Mecane, Joseph........................................... 18
Noll, Eric W............................................. 8
Letters, statements, etc., submitted for the record by:
Mecane, Joseph, executive vice president and chief
administrative officer for U.S. Markets, on behalf of NYSE
Euronext, prepared statement of............................ 20
Noll, Eric W., executive vice president of NTS Management,
NASDAQ OMX Group, Inc., prepared statement of.............. 10
Quigley, Hon. Mike, a Representative in Congress from the
State of Illinois, prepared statement of................... 5

HOW ROADBLOCKS IN PUBLIC MARKETS PREVENT JOB CREATION ON MAIN STREET

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TUESDAY, NOVEMBER 15, 2011

House of Representatives,
Subcommittee on TARP, Financial Services and
Bailouts of Public and Private Programs,
Committee on Oversight and Government Reform,
Washington, DC.
The subcommittee met, pursuant to notice, at 9:48 a.m., in
room 2203, Rayburn House Office Building, Hon. Patrick T.
McHenry (chairman of the subcommittee) presiding.
Present: Representatives McHenry, Guinta, Gowdy, and
Quigley.
Staff present: Drew Colliatie, staff assistant; Gwen
D'Luzansky, assistant clerk; Linda Good, chief clerk; Peter
Haller, senior counsel; Christopher Hixon, deputy chief
counsel, oversight; Devon Hill, minority staff assistant;
Jennifer Hoffman, minority press secretary; Brian Quinn,
minority counsel; and Steven Rangel, minority senior counsel.
Mr. McHenry. The committee will come to order. This is the
Subcommittee on TARP, Financial Services and Bailouts of Public
and Private Programs. Our hearing is entitled, ``How Roadblocks
and Public Markets Prevent Job Creation on Main Street.''
It is the tradition of this subcommittee to begin with the
reading of the Oversight and Government Reform Committee's
mission statement.
Oversight Committee Mission Statement: We exist to secure
two fundamental principles: First, Americans have a right to
know that the money Washington takes from them is well spent;
and, second, Americans deserve an efficient, effective
government that works for them. Our duty on the Oversight and
Government Reform Committee is to protect these rights. Our
solemn responsibility is to hold government accountable to
taxpayers because taxpayers have a right to know what they get
from their government. We will work tirelessly in partnership
with citizen watchdogs to deliver the facts to the American
people and bring genuine reform to the Federal bureaucracy.
This is the mission statement of the Oversight and Government
Reform Committee.
With that, I will recognize myself for 5 minutes for an
opening statement.
Over 2 years into our economic recovery, America's labor
and capital markets continue to face unprecedented challenges.
Tens of millions of Americans remain unemployed or
underemployed, economic growth is anemic, and small business
continues to struggle to access capital, all of which exists
despite an endless number of government initiatives.
Recently, our subcommittee examined barriers to small
business capital formation, particularly focusing on the pre-
IPO market. We heard from market participants and experts who
explained the repercussions that outdated SEC regulations have
on the formation of startup companies. I am proud to say that
earlier this month the House passed with broad bipartisan
support--which is often rare in Washington and right now
exceedingly rare--we passed several pieces of legislation to
roll back these out-of-date and burdensome regulations. Now the
next move goes to the U.S. Senate, where we hope that they will
take positive action.
Today's subcommittee hearing takes the next step of
examining the life of small- or medium-sized businesses, this
time in the post-IPO world. While some might associate the IPO
market with people becoming overnight billionaires or ringing
the bell at the New York Stock Exchange, or the bell at NASDAQ,
the reality is that the health of our Nation's IPO market is a
signal of its economic growth, innovation, and job creation.
Businesses use the capital that they raise through an IPO to
grow and expand, which means investing and hiring. In fact,
over 90 percent of jobs created by a company are done after it
goes public. That is important to note. This is not about the
founders putting money in their pockets. It is about giving the
company the capital it needs to grow and expand and innovate.
Recognizing today's dismal unemployment rate and job
numbers, it is no surprise that America's IPO market is
suffering. Experts point to market structure and liquidity
issues for small- and medium-sized companies as a primary
reason. For one, the rapid increase in high-frequency trading
has directed money toward the established liquidity of the
higher cap companies. This trend has discouraged the kind of
attention startup companies used to garner from investors who
used to target them and other small businesses that showed
promise of hidden value. Another mentioned item is the abrupt
reduction in equity research. Even if investors are intent on
finding a diamond in the rough, the lack of information
discourages this effort.
These market realities and others are why we have invited
two of the world's major stock exchanges, the New York Stock
Exchange and NASDAQ, to explain the importance of liquidity for
small-cap companies and what can be done to strengthen the U.S.
IPO market.
Our focus is not to reverse market expansion or
efficiencies. Instead, our aim is to understand why small- to
medium-sized companies have second thoughts about going public
and the influence that hesitation has on our economy and job
creation. With small companies out to fend for themselves in
the public market, experts and academics have suggested the
formation of agreements between companies and brokers or even
exchanges to create a market in the issuer's security. Such
agreements would allow small companies the ability to produce
an orderly liquid market for their stocks that is observed for
many household brands. As the saying goes, liquidity begets
liquidity. Research has shown that these agreements, already
permitted overseas, have led to a positive influence on
liquidity for small public companies.
However, like most new ideas, such a direct agreement
requires a change in regulation, this time by both FINRA and
the SEC. Today is an opportunity to learn the purpose and
effects of these regulations and where there is room for
improvement. Orderly markets are one of our Nation's greatest
strengths. Providing capital, access to businesses, and choice
to investors is obviously at the heart of this. In the midst of
our slow recovery, it is imperative that we continue to improve
our markets to spur innovation and job creation.
I am interested to hear from both our witnesses and both
exchanges today about the challenges our small, public
companies face and what can be done to fortify our post-IPO
world. I appreciate their attendance and I look forward to
their testimony.
With that, I recognize the ranking member, Mr. Quigley of
Illinois for 5 minutes.
Mr. Quigley. Thank you, Mr. Chairman.
Today's hearing will examine how roadblocks in public
markets prevent job creation on Main Street. It will focus on
how newer and smaller publicly traded companies encounter
problems accessing capital from U.S. equity markets. The stock
of smaller publicly traded companies often suffers lower
trading liquidity. This means that small companies often cannot
offer enough shares at prices that are acceptable to buyers or
that companies cannot sell their shares quickly enough. Small
publicly traded companies do not have brand name recognition
and often have difficulties attracting investors. Some suggest
that the U.S. market structure itself is a roadblock for small
companies.
In a statement prepared for a joint CFTC-SEC Advisory
Committee on Emerging Regulatory Issues meeting, David Weild, a
former vice chairman of NASDAQ, stated, ``The stock market
structure today is disastrous for the vast majority of small
capitalization stocks with asymmetrical order books. Who is
there to create liquidity for the small capitalization stocks?
The answer is often no one.''
I think it is important that our examination seeks to
answer why no one is there to create liquidity for small
capitalization stock. I also believe we should be innovative in
finding ways to create liquidity for small-cap stock in the
United States to ensure equity markets are competitive and
attractive for both issuers and investors. Improving small
publicly traded companies' access to capital will contribute to
the growth of these companies and their ability to create jobs.
Any solutions we explore today must also permit our U.S.
markets to function effectively and help ensure investor
confidence in U.S. markets. However, while I favor bold action
in bringing capital to American businesses, we must not
sacrifice investor protection. Only a couple years ago in 2008,
we witnessed how inadequate financial oversight led to fraud,
recklessness, unscrupulous behavior, and manipulation in the
market which caused the greatest financial crisis since the
Great Depression. That is precisely why Congress passed the
Dodd-Frank Wall Street Reform and Consumer Protection Act, to
reform the U.S. financial regulatory system and to address the
lack of accountability for Wall Street firms that caused the
crisis or helped cause the crisis.
Mr. Chairman, I thank you for holding this important
hearing and I look forward to the testimony of our two
witnesses. I yield back.
Mr. McHenry. I thank the ranking member.
[The prepared statement of Hon. Mike Quigley follows:]

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Mr. McHenry. The full committee chairman has joined us and
has requested 2 minutes, and the chairman is recognized for 2
minutes.
Mr. Issa. I thank you chairman, and I thank you for holding
this important hearing. Your leadership in this area has been
essential, whether it is public companies reforming the
mistakes made under Dodd-Frank, including the DATA Act and
other essential reforms that were never included in that act.
As we all know, Bernie Madoff succeeded in the largest Ponzi
scheme in American history because of an absence of
transparency that could have easily made not just a few smart
people who pushed the SEC on behalf of the investors, but the
entire public very aware that he was trading in nothing. So I
know that the work you are doing there, along with crowd
funding, is essential.
I join with Mr. Quigley on the need to have small capital
funds not become orphans. But at the same time it is very clear
that a great many companies should be allowed to have a broad
group of sophisticated investors without the need for full
public scrutiny and full public access. Often institutional
investors, knowledgeable and with their own resources, given an
audited financial statement, will make a wiser, more informed,
and larger contribution. So there are many ways in which we can
help reform the capital markets.
I share with Mr. Quigley the need to make sure we never
again have a meltdown, and that is where the work that you and
others on the committee have done to try to get at Fannie and
Freddie, very much the causes of moneys not being traceable or
accountable had a root in that collapse that we all suffer from
to this day.
So, Mr. Chairman, thank you for the continued work. I might
note the presence of the House Chaplain who has seen fit to
begin looking at the work of our committee, and perhaps that is
the best sign of all. I yield back.
Mr. McHenry. Thank you, Mr. Chairman.
Father, we ask for your prayers.
Members will have 7 days to submit opening statements for
the record. We will now recognize the panel of witnesses.
We have Mr. Eric Noll, who is the executive vice president
of NASDAQ OMX Group. We have Mr. Joseph Mecane, executive vice
president and co-head of U.S. Listings in Cash Execution and is
testifying on behalf of NYSE Euronext.
It is the policy of this committee that all witnesses be
sworn in before they testify. If you will please rise and raise
your right hands.
[Witnesses sworn.]
Mr. McHenry. Let the record reflect the witnesses answered
in the affirmative. Thank you. You may be seated.
With that, we will recognize you each for a period of 5
minutes to summarize your opening statements. We have a simple
light system. It is a traditional light system. Green means go;
yellow means whoa up and sort of wrap it up; and red, go as
fast as you can, says Mr. Quigley. So at the yellow light that
means you have 30 seconds to wrap it up.
We will now begin with Mr. Noll.

STATEMENTS OF ERIC W. NOLL, EXECUTIVE VICE PRESIDENT OF NTS
MANAGEMENT, NASDAQ OMX GROUP, INC.; AND JOSEPH MECANE,
EXECUTIVE VICE PRESIDENT AND CHIEF ADMINISTRATIVE OFFICE FOR
U.S. MARKETS, ON BEHALF OF NYSE EURONEXT

STATEMENT OF ERIC W. NOLL

Mr. Noll. Thank you, Chairman McHenry and Ranking Member
Quigley. At NASDAQ OMX we believe the challenges that we face
in today's equity markets around liquidity and capital
formation can be addressed by actions in four areas: one,
addressing market structure weaknesses and their concurrent
effect on price discovery; two, changing the lack of regulatory
focus on rules and trading venues that would assist in the
development of vibrant small company growth; three, removing
regulatory barriers to small- and mid-cap companies that impede
the IPO process and raise the cost of being public for those
companies; and, finally, not directly related to liquidity and
capital formation, but to assist companies in building their
business, the development of an H1B and other immigration
reforms to assist those companies in their internal hiring and
growth plans. We believe that addressing these issues is
critical for generating job creation and growth in the U.S.
economy.
Today's U.S. markets, the engine of economic growth, are
increasingly fragmented and volatile. Liquidity in U.S. stocks
is disbursed across 13 exchanges and over 40 other execution
venues. Nearly one-third of public company stocks trade 40 to
50 percent of their volume away from the organized exchanges.
In the past 2 years the percentage of U.S. market share traded
in those systems that do not post their bids and offers rose
from 20 percent to over 30 percent. Many retail and core
investor orders are executed away from those primary exchanges.
While we identify market fragmentation as the source of
some of the issues in regard to capital formation in the United
States, there have been many benefits of that fragmentation.
They have reduced investor costs and improved execution
qualities in already listed securities. However, the unintended
consequences of that market fragmentation have been a lack of
liquidity and price discovery in listed securities outside of
the top 100 traded names and a disturbing absence of market
attention paid to small-growth companies by all market
participants, including exchanges.
Although recent market volatility has led to a slight
movement toward exchange markets, trading in shares of public
companies on these private trading systems accounts for more
volume than on NASDAQ and the NYSE combined. Price discovery
and available transparent liquidity are essential parts of
vibrant market systems.
Just as our markets continue to evolve and adapt, so must
the regulatory structure of our markets. We support the
development of a consolidated audit trail with real-time market
surveillance and new regulatory tools to help regulators keep
pace with technology advances and other changes in the markets.
Between 2003 and 2007, the amount of capital raised by
private equity funds increased by 300 percent. Issuing private
equity allows companies to avoid disclosure and governance
obligations created to protect investors. 2008 and 2009 were
the worst years for IPOs since at least 1980. In 2009, there
were just 12 venture-backed IPO's, raising $1.6 billion, and
270 acquisitions with disclosed deals totaling $14.1 billion.
U.S. stock listings are on the decline. In 1995, there were
around 8,000 U.S. listings. Today, there are around 5,000.
Meanwhile, the number of listing on non-U.S. exchanges has
increased from around 23,000 in 1995 to over 40,000 today.
Exchange listings help companies raise capital, both
directly and indirectly. In addition to selling shares,
exchange trading establishes a fair transparent price for a
company. A company that has a clear price and many potential
buyers will attract further investors and lenders to help them
fund growth.
It is well recognized that companies that do not trade on
exchanging are valued at a discount. Financial experts, the
U.S. IRS, the SEC and courts, recognize that discounts for lack
of marketability range from 30 percent to as high as 75
percent. A company valued 30 percent or more below its true
value will not be able to invest, grow, or create jobs as
quickly. Plainly stated, the higher the number of bidders for
an asset, the higher the sales price.
Academic research has estimated that between 2000 and 2005,
a $50 billion drop in foreign IPOs on U.S. markets cost the
U.S. $3.3 billion in lost annual trading-related revenues for
U.S. brokers. These revenue losses mean jobs in financial
services and related industries, and are moving from the United
States to foreign markets.
In any free market society, the number one source of job
creation is entrepreneurship. Canada, the United Kingdom, and
Sweden have successful venture markets with significant numbers
of listed companies and substantial capital-raising success.
These markets list hundreds of small companies that create jobs
at a fast rate. Venture market companies regularly grow and
then graduate to the main markets in those countries.
The United States has no equivalent U.S.-supported and
U.S.-organized venture market. NASDAQ OMX has received approval
to create such a market on the former Boston Stock Exchange.
The companies listed on BX will be smaller companies and the
availability of the BX market will facilitate their ability to
raise capital to continue and expand their business, creating
jobs and supporting the U.S. economy.
In conclusion, we would also like to quickly address the
regulator barriers for IPOs. We ask the SEC be open to market-
based solutions to create competitive solutions to market
problems. We also think that Sarbanes-Oxley reform is critical
as we go forward to help small companies go public and remove
some of the impediments to their ability to go public.
Thank you for inviting me to testify. I look forward to
responding to your questions.
[The prepared statement of Mr. Noll follows:]

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Mr. McHenry. Mr. Mecane.

STATEMENT OF JOSEPH MECANE

Mr. Mecane. Chairman McHenry, Ranking Member Quigley and
members of the subcommittee, I want to thank you for inviting
NYSE Euronext to discuss whether new and smaller public
companies suffer from liquidity issues as a result of our
current market structure and whether the current structure
contributes to a lower level of IPOs.
I intend to focus my attention on three main topics. First,
I will focus on the importance of liquidity for companies with
small market capitalizations and a proposal we believe may help
small-cap issuers. Second, I will discuss liquidity
fragmentation in the marketplace. And last, I will address the
subcommittee's question regarding liquidity payments to market
makers.
Before I jump into the points previously outlined, I would
like to give some background about smaller issuers and why it
is important to focus on this segment of the market. Small- and
medium-sized enterprises, so-called SMEs, are the backbone of
the American economy, and in previous economic downturns
entrepreneurs and small businesses have been the main source of
job creation. In fact, 18 of the 30 Dow Jones Industrial
Average companies were founded during economic downturns.
However, in order to enable SMEs to reach their full
potential, capital must be easily accessible. In that effort,
NYSE Euronext has been vocal in its support for Congress to
adopt legislation to increase the threshold for Regulation A
offerings as well as to adopt a larger exemption for SMEs from
Sarbanes-Oxley, section 44-B. Each of these and other efforts
are with a keen eye toward not only capital formation, but also
job creation, which increases significantly as companies move
through the capital formation process. To echo some of the
remarks by Chairman McHenry at the beginning, over 90 percent
of jobs in a company are created after a company goes public.
There is one reason that liquidity is so vital for new and
smaller issuers. Companies with small capitalizations
consistently raise two concerns about going public as it
relates to market structure. First, whether there will be
sufficient liquidity in my stock; and second, will I have
sufficient analyst coverage?
As the Securities and Exchange Commission recognized in its
2010 concept release on equity market structure, small-cap
stocks can and often do trade differently than large-cap
stocks. In particular, we have observed less liquidity at the
national best bid and offer for small-cap stocks which we
believe may be hampered by too narrow of a spread increment of
a penny. While narrower spreads are generally a very positive
result for investors, we believe that a penny minimum tick size
may counterintuitively reduce the amount of liquidity at the
best price, thus resulting in smaller quoted sizes and thinner
markets.
Accordingly, NYSE Euronext has advocated that a market-wide
pilot with wider spread increments for less liquid securities
could be a worthwhile exercise. During the pilot period, market
participants and the Commission can review data to determine
whether the impact is providing added investor benefits to less
liquid securities. This could help increase the appetite for
research coverage which declined after the global research
settlement, and should be combined with a separate review of
the restrictions around IPO communications.
Liquidity concerns for emerging growth companies transcend
the public markets with volumes fragmented across multiple
exchange and non-exchange venues. While we believe that
competition has been a positive factor for the marketplace, we
have noted that the level of off-exchange participation in less
liquid stocks is frequently above average. However, price
discovery is dependent on interaction among a diverse set of
market participants.
In this vein, we have recently filed for approval of our
newly created Retail Liquidity Program. This program will allow
for superior execution prices for retail investors and
encourage additional price competition for retail orders from
liquidity providers, and we believe this program could help
consolidate and potentially increase the liquidity in less
liquid securities.
Finally, the committee requested comment regarding what if
any additional incentives could be adopted to incent market
makers to post liquidity in less liquid stocks, including the
allowance of issuers to pay market makers to provide liquidity
directly. The committee has discussed the creation of a program
where small-cap companies could enter into agreements directly
with broker-dealers. NYSE Euronext believes the idea discussed
warrants further review from both FINRA and the SEC and it is a
topic that we have been separately pursuing. We would note, to
echo Chairman McHenry's comments, that this is a process that
exists in Europe and has shown beneficial effects on the
liquidity of smaller issuers.
In closing, NYSE Euronext believes that Congress and the
appropriate regulatory authorities should work together with
the industry to identify appropriate steps that can be taken to
increase the level of liquidity for smaller public companies.
Even if only on a pilot basis, trying new things will allow the
market to determine which approaches could have the greatest
impact on increasing the level of liquidity in illiquid stocks.
Jobs are the number one issue facing our Nation, and
although only part of a broader solution, we believe that
adopting some of the approaches previously outlined will have a
positive impact in reversing some of the negative trends we
have recently seen.
Thank you for the opportunity to present.
[The prepared statement of Mr. Mecane follows:]

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Mr. McHenry. I certainly appreciate your testimony. This is
very helpful and instructive.
I want to begin this way. There is a lot of discussion
about what our public markets actually do and it is missed on a
lot of individual Americans what the public markets are really
all about. So I want to ask you, what net benefit do you
provide to society through your exchange, through the public
markets? I will just begin there. Mr. Noll?
Mr. Noll. I think we provide several. The first one is what
I will call the ability to discover prices for assets. So if a
key tool for investors of all types, retail and institutional,
is to understand the real value of an asset that they are
investing in and the willingness to risk their own capital by
investing in that, understanding the true price of that
underlying asset is critical. So the ability of exchanges to
discover that price for all investors on a fair and transparent
way where everyone has access to that same price is critical
for the determination of the underlying value of those assets.
Linked to that price discovery formation is what I will
call liquidity discovery. So just as important as discovering
the price, is the size at which I can transact at. So exchanges
perform a valuable function in gathering together all of the
available buying and selling interest that is out there so that
investors not only can discover price, but they can discover
the size in which they can transact at, at that price.
Ultimately that price discovery and that liquidity
discovery enables companies not yet public to help themselves
determine how they will be valued when they become public and
provide a framework and a platform in which they can in fact
bring their asset forward, attract investor interest, and see
the liquidity in that investor interest develop and therefore
raise prices to create jobs and grow their own businesses.
So if I were to summarize, those are the big three that I
think add value from the exchange side.
Mr. McHenry. Mr. Mecane?
Mr. Mecane. I will echo Mr. Noll's comments. I will also
add that one of the primary purposes of an exchange are to
match companies who are looking to raise capital in a public
venue with potential investors who may look to invest in that
company, help it grow and expand.
Clearly companies that do want to go public or want to
raise capital have a number of different options that they can
pursue in order to do that. They can look to private investors
and do a private capital raise. They can look to be acquired,
either through a traditional M&A transaction or through a
private equity or venture capital-type transaction, or they can
choose to raise capital in a public format.
Obviously the theme of this panel is talking about why
companies may choose to go one of those other routes instead of
going the public company route, and that is obviously a complex
question, but I would view that last piece as being the primary
responsibility of a public market.
Mr. McHenry. With IPOs, it is about accessing capital in
order to grow your business and it is a choice that you
described, Mr. Mecane, between the various options. Many small
businesses put it on a credit card to get started or get a
loan. Probably not right now. They probably put it on their
credit card more so. And then once they grow, they can get to
the stature by which they can go to the public markets to
access capital to more fully grow their business and take leaps
and bounds. It also provides investors, individual small mom-
and-pop investors, the average American, to access this type of
equity-side upside benefit of companies going public.
I think it is important to begin there, because a lot of
discussion about financial service products right now isn't
related right back to what their net benefit is. It isn't a
benefit as a product, it is a benefit of price discovery and
accessing capital to grow a business.
So I wanted to begin there. I would hope that we can come
back for other rounds of questions. But with that, I would like
to recognize Mr. Quigley for 5 minutes.
Mr. Quigley. Thank you, Mr. Chairman. It is interesting the
chairman brought this up to the 30,000-foot level. Sometimes we
have questions that are more specific. I guess I would like to
ask a specific question, but then get back to a larger 30,000-
foot perspective.
My initial question had to do with Mr. Mecane. In your
written testimony I think the quote is, ``Although the FINRA
Rules adopted in 1997 prohibit any direct or indirect payment
by an issuer to a market maker, NYSE Euronext believes the idea
discussed may warrant review by both FINRA and the SEC and it
is a topic we have been pursuing.'' Obvious concerns are
because the rule in the first place dealt with manipulation, it
dealt with the potential that executives of a company are
incentivized to have their stock valued very high so it creates
an opportunity for inappropriate activities.
That question, and I would like you to both address it,
really gets to the core of the issue here with what we try to
do here. Put yourself in our place. What we are really dealing
with for yourselves and for ourselves is faith and trust both
with the American public and with potential investors.
Investors have to have faith that there won't be a
manipulation, but also the larger issue of giving you the
opportunities to do what needs to happen to create jobs when
the American public still has a gaping hole in faith and trust.
Can you address that as a larger issue?
Mr. Mecane. Sure. It is a very good point, and we echo your
concerns about ensuring that investors have full faith and
confidence in our public markets. Part of why my words were
chosen carefully is because I don't think it is a very
straightforward topic, and there are different sides to the
same equation.
The reason the restriction was originally put in place was
to avoid exactly the point that the Congressman raised, that
there is a conflict inherent in a situation where a company
itself is paying a liquidity provider to make a market in the
stock. So it is part of why, while we believe it may be a
worthwhile discussion and experiment to try, it would need to
be done in a way where there was sufficient disclosure and
discussion around the conflict itself and whether it could be
addressed.
When I specifically stated that it is an avenue that we
have been pursuing separately, part of our thought--and where
we have been looking at this as an opportunity--is specifically
in the ETF market. While that is not a topic of this committee,
it is relevant because with ETF products, which are generally
linked back to the underlying securities, there is less
opportunity for manipulation because there is an arbitrage
between the ETF price and the stock price.
My point is that one avenue to try is an experiment
specifically with ETFs with this type of a program to see if it
actually helps with liquidity in those names, and that could
then give more support and documentation as to whether it would
be worth trying in the public markets also. So it could be done
in a two-step process to try and minimize the conflict that you
raised, Congressman.
Mr. Noll. Thank you, Congressman. Like the New York Stock
Exchange, this has been an issue that we have been paying
attention to for a while. NASDAQ OMX in Stockholm operates a
market called True North which is a venture market in which
market makers do receive payments from issuers, and we have
seen some great success in that platform in developing
liquidity in the Nordic markets.
Here in the United States, I think our concerns are echoed
by you and by the New York Stock Exchange that the ability to
create conflict or have conflicts in this area is something
that we have to be very careful about. We are proposing, not
unlike the New York Stock Exchange, to come forward with our
own set of rules around this kind of process. One would be for
our BX venture market in which we would create a structure by
which the exchange in an open and transparent way would collect
payments from issuers and then use them to provide to market
makers to provide liquidity. So we are preparing a rule filing
now to submit to the SEC that would allow us to do that.
I think it brings two very good benefits to us by doing
that, not only to us but to the marketplaces. One is that it is
a rule set that would be transparently argued, debated, and
approved by the SEC, and therefore monitored by them on an
ongoing basis and the rules would be available and open to
everyone to see and to participate in.
Then I think it would address a problem that this committee
has identified, which is that there is a lack of liquidity in
these small-cap stocks. And I think it is fair to say and
important to say that market makers will respond to economic
incentives, so passing a rule that says that market makers need
to make markets in small-cap stocks won't add any more
liquidity. What will add liquidity to them is creating economic
incentives to them to benefit by providing liquidity, and we
think that this program will do that.
Likewise, on the ETF side, NASDAQ is preparing a rule
filing to do the same thing as well, which is to stimulate
market maker interest in less active, less interesting ETFs, or
not less interesting, but less followed ETFs to help stimulate
liquidity in those as well. And I agree with Mr. Mecane that in
both cases I think that these are valuable experiments for the
Commission to try.
Mr. Quigley. Thank you.
Mr. McHenry. Mr. Guinta, the vice chair of the committee,
is now recognized for 5 minutes.
Mr. Guinta. Thank you very much, Mr. Chairman. Thank you
both for coming here today.
In a series of subcommittee hearings that we have been
having over the last several weeks, we have been focusing a lot
on how to create access to a stronger job market in this
country. Obviously, the country is concerned about that
primarily, and it has a dramatic effect on just about
everything we do nationally and internationally.
My focus is more narrow in scope, and I want to talk a
little bit about the IPO market, I want to talk a little bit
about the decline of IPOs that we have seen recently in this
country, and I want to ask you both to focus a little bit on,
number one, why you think we have had a decline in IPOs, where
those IPOs are being listed, and what the negative effect of
that is in terms of job creation here in America.
Mr. Mecane, if you want to begin.
Mr. Mecane. Sure. Thank you for the question. I will borrow
from a report that was recently issued which the committee may
or may not have seen, but it is a series of recommendations
from the IPO task force which tried to tackle this issue and
did, I think, do a good job of generating some data to support
the issues that were being discussed.
What seems to be the prevailing trend around the decline in
IPOs is specifically concentrated in the smaller part of the
market, so the sub-$50-million-type companies, and it does not
appear that those companies are not being created or that they
are actually going public on other venues. What appears to be
the trend is that they are choosing to, when they get to a size
where they are at a decision point about what the next step is
for them to proceed, they are choosing increasingly to go
through a private M&A-type transaction, either being acquired
by a larger firm or a private equity-type firm, instead of
going the route of the public market.
I would say that has been the very broad trend over the
last 20 years, where the first decade of the last 20 years was
marked by a very high level of capital issuance by those
smaller companies and the last decade of the last 20 years has
been marked by more of these private M&A transactions.
Obviously, it is an important question from a job creation
standpoint, because as we noted earlier, much of the job
creation that does happen in a company's life cycle occurs
after they go public when they do have access to all these
additional funds to expand their business and to hire and to go
into new business lines.
So the question as to why companies are choosing that
private route instead of the public route is an important one.
It is also, I believe, a complex one with a number of different
dynamics occurring simultaneously.
To paint one side of the equation, clearly the private
equity and private capital part of the market has become a lot
stronger in the last decade, and so some of what we are seeing
could just be the evolution of that part of the market and an
increasing ability to have another option other than going
public. But at the same time, I think it is hard for us to
ignore the fact that the cost of going public and the oversight
of being a public company, especially for a smaller $50-million
to $100-million-type company, has been increased significantly
over the course of the last few years.
Obviously it is a balancing act post-Sarbanes-Oxley and
other types of reforms to make sure that there is confidence in
our companies and willingness of investors to know that the
company that they would be putting money into is safe. But at
the same time it does call into question whether there are
things that we can do to make it easier, less costly,
especially for the first few years of a company being public,
to be able to go public more easily.
Mr. Guinta. I want to get to Mr. Noll, but just one final
question. Would you agree with the statement that an M&A
transaction, rather than an IPO, is missing an opportunity for
job creation?
Mr. Mecane. I don't want to over-generalize too much, but I
would agree in a lot of M&A transactions the focus tends to be
on synergy opportunities as opposed to expansion opportunities,
and that is an over-generalization. It is not always true, but
I do generally agree.
Mr. Guinta. Generally speaking, yes.
Mr. Noll, can you just maybe add to what Mr. Mecane said?
Mr. Noll. Sure. Following up on Mr. Mecane's comments about
M&A, which I generally would agree with, I think one of the
issues that we are facing as an exchange and as an economy is
that when that becomes increasingly the only avenue, it creates
limitations on the way companies can grow their business, the
way they can ask for capital, and the way they can use that
capital to grow their businesses.
So it isn't so much that M&A represents a bad way for
companies to grow their business or private equity is a bad way
for companies to grow. Quite to the contrary, those are all
valid and very good ways to grow businesses. But as the IPO
window for those businesses has closed, it removes some of the
optionalities for what companies can do in a way that is most
ideal for them, so that we become very worried about that and
making sure we are developing that market for that small-cap
company.
You had asked earlier as well where a company is going. So
the small companies are clearly going to the private markets.
Foreign issuers, who traditionally had come to the United
States to raise capital, are choosing not to list here, and a
lot of that is compliance with our Sarbanes-Oxley rules, which
may create additional costs for them that they would not like
to face. I think the costs of market fragmentation are
expensive for them.
It is an interesting day when Manchester United, a very
large U.K. sports team, chooses to list its stock on Singapore,
and, quite frankly, never considered a U.S. listing. Twenty
years ago, they would have come to the United States almost by
default. So how we think about those issues I think is
important as we go forward.
So I think it is critical that we try to clear up the IPO
calendar and the IPO structure for those small-cap companies
and those foreign issuers.
Mr. Guinta. I see my time has expired. I appreciate the
chairman's indulgence.
Mr. McHenry. All right. Thank you. Now we will begin a
second round.
So the bid-ask spreads have tightened, but out of that
order flows have gone way up. I mean, the volume has gone way
up. That is correct, right? So what does that do for exchange
revenue? Does that mean exchange revenue goes up with the order
flow? Mr. Mecane?
Mr. Mecane. Sure. I would make two points. One is that
there has been two separate dynamics going on in the industry.
One is that clearly as bid-ask spreads have compressed, we have
seen an increase in volume. But I would also highlight the
point that in that same period of time, part of why those two
trends happened is because there has been increasingly
aggressive competition in the space, and the prices that
exchanges and other venues have charged has also declined
commensurate or even in excess of the spread decline. So I will
just highlight that. Even though there is higher volume,
because of those trends we are actually, frankly, making less
money than we were in the prior periods.
But it also leads to a second point, which is more specific
to the small- and mid-cap part of the market. A lot of the
spread compression and increased competition that we have seen
has been in the very large liquid stocks where you have seen a
lot of algorithmic-type trading, high-frequency-type trading,
which tends to narrow the spread and make it very cheap and
efficient and fast for the large-cap stocks to trade.
The unfortunate reality is those same trends haven't
occurred in the small- and mid-cap part of the market. Those
stocks don't have sufficient liquidity for the high-frequency-
type automated traders to traffic in those names, and as a
result, you have not seen a commensurate level of volume or
liquidity or spread compression that you have seen in some of
the large-cap names. And that is part of why we have suggested
the experiment with perhaps wider spreads, as counterintuitive
as that is, for those names.
Mr. McHenry. Okay. So there is less revenue of a new
listing based on competition.
Mr. Mecane. Correct.
Mr. McHenry. Okay. But order flow has gone way up, the
volume has gone way up. So part of that is with the spreads
compression but with the order flow going up. In those terms,
spread compression, order flow going up, have they offset each
other roughly?
Mr. Mecane. I think probably, roughly.
Mr. McHenry. Roughly. Is that how you see it with NASDAQ?
Mr. Noll. I do, although I would note that volumes have
actually come down in the last year, year and a half. And while
I think there is a great deal of truth to the statement that
tighter spreads and lower costs have driven volumes up, I think
one of the things to remember about volumes and participation
in the marketplace, it is ultimately about confidence in the
market and it is market structure, and it is also about the
ability of investors to transact in an effective way. So we
have seen some of that confidence impaired.
Quite frankly, we have seen volumes come down. And some of
that confidence isn't necessarily in exchanges or exchange
systems, but in the strength of the U.S. economy. So we have
seen much higher volume days 2 or 3 years ago than we have in
the last year. So while there certainly is a link between low
costs and higher volumes, it isn't the only driver for volumes.
So I think that is an important thing to know.
Mr. McHenry. So order flow is more important than new
listings though; is that fair to say, as a business concern?
Mr. Noll. Well, I think two things about new listings that
are critical for us and why we are starting to pay a lot of
attention to this sector. One is this is where the new
companies are going to come from, and we as exchanges, and
particularly at NASDAQ, if we can't get those companies to be
public and listed on one of our platforms for trading as they
grow up to be big companies and very important companies in the
U.S. economy, we won't be performing our function in the way
that we hope to be performing it.
Mr. McHenry. So therefore your investment on what used to
be the Boston exchange.
Mr. Noll. Right. So the creation of the BX venture market,
try to look at market maker structures to try to provide
liquidity there, which for us is a long-term investment in the
development of new companies, because ultimately we think that
is where the future growth is going to come from and we need to
participate in that.
Mr. McHenry. Okay. So you get an IPO. Immediately, because
of fragmentation, the market fragmentation, liquidity
fragmentation, you have a substantial amount of your order flow
off your exchange, right? Am I correct?
Mr. Mecane. Yes.
Mr. Noll. Yes.
Mr. McHenry. Okay. So what you do to incentivize liquidity
instantly benefits these folks. It doesn't benefit you. It
benefits this order flow off your exchanges; is that correct?
Mr. Mecane. Yes.
Mr. McHenry. So this is part of the challenge, is what that
incentive is for you, actually benefits not your companies.
Mr. Mecane. Yes.
Mr. McHenry. To be clear, I mean you have both accessed the
public markets in a very unique way as an exchange, so you do
have to be concerned about your revenue. So as a policymaker I
look at this and am trying to figure out how to incentivize
you. But instantly, how much of the order flow after an IPO
goes off your exchange? Mr. Mecane?
Mr. Mecane. It is roughly--in a given name we will have
roughly 30 percent of the market share across our different
venues, 30-35 percent of the market share on our exchange, and
then the rest will be fragmented across other exchanges and
non-exchange venues.
To your point, a lot of the focus, and clearly we are self-
interested in that argument also, but a lot of the focus is
in--it is twofold. One is attracting as much liquidity to our
market as possible; and, second, it is creating as much
liquidity in general from that name. Clearly that benefits us
from a revenue standpoint, but I think the more important point
is to really take a particular company or their stock to the
next level, it needs to be a name that institutional investors
and long-term investors are comfortable investing in. And
unless there is enough liquidity available, they are not going
to be comfortable putting their funds into that particular
company.
Mr. McHenry. Mr. Noll? And then I will pass off to Mr.
Quigley. I have gone over my time.
Mr. Noll. Thank you, Chairman.
So I think the competition between marketplaces has
actually been very healthy. It has been very healthy for us as
an institution. I think it has been healthy in many ways for
the marketplace. And I agree with Mr. Mecane that when we take
a company public, we retain post-IPO about 30-35 percent of the
volume in that name on an ongoing basis.
But the competition between markets has actually helped us
to innovate. In many ways it created the success of NASDAQ over
the long term. And so as we go forward and we start to think
about what we need to do for small cap companies, it is not the
competition with other venues that I worry about, it is the
ultimate market structure that we put in place that will
enhance the development of getting those companies to be
public.
I think the competition between venues is a very healthy
one. It inspires us to do better. It inspires us to work
harder. And I think for us to compete for volume and for us to
compete for success in this marketplace is not a bad thing. I
think that is going to spur us to do a better job of it going
forward, and we would fully expect to win more than our fair
share of that business back in that kind of competitive
environment.
So I am less worried about that kind of functionality than
I am in the overarching market structure that would enhance
small companies being able to go public.
Mr. McHenry. Thank you.
Mr. Quigley.
Mr. Quigley. Thank you, Mr. Chairman. So we want to help.
We recognize that this is about striking a balance, to protect
investors and the public and creating jobs.
Mr. Noll, you started off on a bit of a pessimistic note,
which I appreciate and respect. But give me a little glimmer
here. I am reading quotes from Renaissance Capital about 2010
being not so bad, that it was the first year since 2007 where
the number of IPOs was back in the triple digit range.
Obviously, it is not just the number that matters, but their
performance. But they also quote and say IPOs didn't have just
a good year in terms of numbers; their performance was strong,
too. The average U.S. IPO rose 25 percent, the best returns for
IPOs since 2006.
Do you agree with those numbers, see a trend or some hope
along the future?
Mr. Noll. Well, I think clearly there has been a lot of
successes in this past year. On NASDAQ, of course, we look at
Groupon and Zillow that have recently listed on our marketplace
and done very well for investors, and in many ways those are
both household names that many investors are very familiar
with. So we have seen some repair in the IPO market from the
depths of the financial crisis in 2008 and 2009.
I think what concerns us less is whether the household
names go public, right, who have grown, they are big, they have
significant revenues, they have a share of mind in the
investing public because of their success off exchange. What
concerns us much more than that is we are not seeing support
either for going public or to, in the after-market for small
companies who may not be as big as Groupon or may not be as big
as Zillow, to go public. So small biotech companies, small
green-energy companies who need to access capital and are
struggling to find ways to do so.
So while there has certainly been a very positive change
from the depths of the financial crisis to today in terms of
IPOs, I still think that there are issues around those smallest
capital companies and their ability to access capital.
Mr. Quigley. Mr. Mecane?
Mr. Mecane. I would echo that comment. There has been a
fairly robust IPO market in 2011. We have had a number of very
large companies go public with us this year, Kinder Morgan,
Linked-In, Pandora. The issue, as Mr. Noll said, is we are
seeing much of that IPO activity concentrated with the large-
cap stocks and not with some of the small- and mid-cap stocks
that we have seen historically.
Mr. Quigley. You alluded earlier to rules and concerns and
issues. I look forward to the continued discussion. The devil
is in the details. So on an ongoing basis we would encourage
and appreciate your participation. Thank you.
I yield back.
Mr. McHenry. The vice chair, Mr. Guinta, for 5 minutes.
Mr. Guinta. Thank you, Mr. Chairman.
Mr. Noll, I want to touch a little bit on what the chairman
was talking about and relate it to market structure. I guess I
wonder, there is obviously competition between the New York
Stock Exchange and NASDAQ. But I guess I would start to ask the
question this way: Who do you really see as your competition? I
mean, I have great concern about market structure, I have great
concern about the willingness of an IPO to occur on an exchange
here in America. And I see a lot of these either M&As or
listing overseas, I see that as a fundamental long-term problem
economically, not just for job creation but for the potential
and future investor.
So we are talking about the benefits that one exchange
would have over the other, but I worry that we are focusing too
much on you--not you, but NASDAQ focusing too much on the New
York exchange or the New York Stock Exchange focusing on NASDAQ
and the benefits that one would get from services provided by
the other, when I think the longer term and the larger problem
is a different competitor.
So how do you see it? Do you see the person sitting next to
you as the competitor or do you see some other exchange as the
real competitor?
Mr. Noll. Clearly, Mr. Mecane and I are colleagues and
respect one another's ability tremendously. And, yes, the New
York Stock Exchange is a competitor of ours. But I think in
fairness to where we really view competition is not just the
New York Stock Exchange. In many ways it is a global
competition, so we compete with other marketplaces, other
venues around the world.
We also compete domestically, not necessarily against the
New York Stock Exchange, but alternatives for capital raising.
And what I mean by that is when a company is looking to raise
capital or grow its business, who are we competing with for
that capital raise? Oftentimes it is with a private equity firm
or some other alternative for raising capital.
So, yes, there is a vigorous competition for listings
between the New York Stock Exchange and NASDAQ in the United
States on a daily basis, but our competition is much broader
than that on the listing side.
On the trading side, it is even more robust than that. So
clearly the New York Stock Exchange is one of our key
competitors on providing a transaction platform, but we compete
with transaction platforms among 13 other exchanges in the
United States and 40-plus other trading venues, plus broker-
dealers, plus foreign trading there. So we view our competition
on the trading side in a much more robust way as well. And
essentially what we are hoping to do in responding to that
competition is with innovation, things like the BX Venture
Market and other things that we have done that will help us
gain trading volume and share by doing a better job. So our
competition is very broad competition, not a very specific one.
Mr. Guinta. So how much are you concerned about the
services that you provide benefiting a competitor?
Mr. Noll. I am much less concerned about the services we
provide benefiting the New York Stock Exchange or, quite
frankly, any of our other exchanges. I view that as state of
being. We have a competitive environment out there and we have
to respond to it by being better at our jobs.
I do think, though, that one of the critical things that we
are going to have to think about in terms of going forward is
how do we provide liquidity, whether it is on NASDAQ, whether
it in the marketplace as a whole for these small-cap companies.
So ultimately the market structure that has to be put into
place is one that identifies that, not necessarily benefiting
one market over another market.
Mr. Guinta. What about off-exchange equity trading venues?
Mr. Noll. They exist. They provide value in many ways. So I
think it is important that off-exchange trading venues continue
to exist where they can do things that we can't do or they do
things for customers that we have been unable do. One of those
is provide price improvement. One of those is to retain the
ability to not have a large institutional order exposed to the
marketplace; in other words, solve the information leakage
problem. And, ultimately, if they are contributing to price
discovery, you know, we have less issues with those things.
I think where we do have issues is when we as an exchange
are barred or otherwise restricted in our ability to compete in
that marketplace because of SEC rules or other strictures that
allow us or prevent us from competing effectively and where
those off-exchange venues are not contributing to a fair
transparent market and to price discovery.
Mr. Guinta. So liquidity is dispersed, you say, over 13
different exchanges. Are you suggesting that that is part of
the liquidity problem?
Mr. Noll. No, it is a fact. What I am noting is in those
large-cap names, liquidity is scattered across 13 venues and
40-plus more off-exchange. Those venues aren't trading small-
cap stocks though. All of that liquidity, all of that trading
is taking place in what are essentially 100 very large names.
Mr. Guinta. Okay. So if we want to grow the IPO market,
should we be focusing on a small-cap----
Mr. Noll. I think large companies to a large extent take
care of themselves. Where we need help is in that small- and
mid-cap sector, and I think that is where we should focus on
our market structure rules, is how do we help those companies
get liquidity, get research analyst coverage and access the
public markets.
Mr. Guinta. That is where I think we ought to be focusing
as well. So through either a further line of questioning or
additional future testimony, I would be very interested to know
what you feel the two or three or four things that we can be
doing to enhance that and augment that are. Because I think
that is the direct nexus to job creation, whether it is in my
home State of New Hampshire or anywhere in the country, but
that is going to greatly benefit the local economy and I think
the national economy.
Thank you, again, Mr. Chairman, for allowing me to extend
my remarks.
Mr. McHenry. I certainly appreciate it. With the panel's
indulgence, I would like to go for another round, if that is
all right.
To be honest with you, at this point I started with the
broad concept, why do the public markets matter, right? I mean,
to the point where most--your hardworking American looks at the
public markets and thinks it doesn't have relevance to them.
But it does, because it brings in capital to the United States,
lowers the cost of capital in a competitive marketplace, makes
capital more available and cheaper. That is sort of the ideal
here.
It also means that as opposed to private equity, that the
hardworking American can put their money, whether it is $500 or
$5,000 or $5 million, into the public markets and actually have
proper price discovery and at the same time, hopefully, over a
period of decades, get a nice return. But we are also talking
about this challenge with small cap companies.
So one of the challenges is liquidity. So to discuss this,
we begin with liquidity. What can you do as an exchange legally
now to provide these small cap companies a measure of
liquidity? Mr. Mecane?
Mr. Mecane. Sure. The primary mechanism that we as an
exchange can use to incentivize liquidity is we have various
market maker programs on our exchange where we incentivize
those liquidity providers to meet certain liquidity and quoting
obligations. In exchange for that, we share a portion of the
economics that we obtained through our transaction services.
We have actually skewed some of those payments to the point
where in some of the small cap names we are actually sharing
almost more, or all or more of the revenue that we are able to
get in the transaction part of the business just to try and
incentivize further liquidity creation.
Mr. McHenry. The transaction part of the business, meaning
the IPO, or is that the----
Mr. Mecane. Meaning the trading piece. So we're able to use
some of the revenue that we generate from the trading part of
the business, and we use that to subsidize the market making
community.
One of the circular issues is that there's, in some of
these names, not--we're paying out all the revenue that we
generate and it's not necessarily enough to help get the
liquidity to where we would like it to be.
Mr. McHenry. Uh-huh.
Mr. Mecane. That's part of the reason for why we think the
experiment of also letting issuers compensate market makers
could help, because in some circumstances, we're already paying
all the revenue we have because most of that is on a per-
transaction basis and these issues don't trade very frequently.
It doesn't generate enough revenue to necessarily incentivize
the liquidity providers.
Mr. McHenry. Okay, so the company goes through the whole
process of going to the public markets. When they go to the
public markets oftentimes what their broker dealer will say,
well, we want to have price support for the first month or 6
months or year, whatever that may be, right? So the broker
dealer provides price support.
Mr. Mecane. Correct. That's generally very specific around
the IPO time when there is Reg M exemptions and permitted
activities that broker-dealers can use too. But there isn't
necessarily an economic relationship going forward after that
specific IPO event.
Mr. McHenry. Okay, sure. The reason why I bring that up is
structurally there is a level of support that currently exists
in the marketplace legally.
Mr. Mecane. Correct.
Mr. McHenry. So what are the possible solutions? Let's just
talk about some of the solutions?
Mr. Mecane. On the liquidity side, again, there's the idea
of creating a different spread environment for small- and mid-
cap stocks. It's hard to know in a perfect world whether that
would actually work or not, that's why we've advocated perhaps
a controlled experiment. But one of the dynamics of a penny
spread environment, which, again, has been very beneficial in
the large-cap stocks, is that when you have stocks that will
trade with a wider spread of a nickel or a dime, something
along those lines, but there's the ability for another market
participant to come into the marketplace and better whatever
prices are there by just a penny, so not significantly
narrowing the spread, but just narrowing it by a small
increment.
We think that by actually holding wider spreads in discrete
intervals of a nickel or a dime, it could actually incentivize
people to put more liquidity into the market because they will
be more confident that someone won't step in front of their bid
or their offer with a de minimis amount. Again, it wouldn't be
the only fix to the issue that we're talking about. I think
anything we do has to be part of a comprehensive package.
Mr. McHenry. So that actually--on its face, that increase
is then efficiency.
Mr. Mecane. That's why it is very counterintuitive. In a
way, we think it could actually improve efficiency. And that's
why we are not saying it should be nickels or dimes with the
very liquid stocks where a penny works very well. If the
natural spread for a stock is a penny, then it makes sense that
the stock should trade at a penny. What we are more targeting
is where the natural spread for a stock looks like it's more in
the $0.05 or $0.10 range, but you're still allowing very small
increments to be quoted in the marketplace and whether that's
actually efficient, even though it appears inefficient.
Mr. McHenry. So is that spread differential based purely on
volume?
Mr. Mecane. I think there are a number of factors, and it
would be need to be debated by the industry and the SEC what
the right framework would be. But I think it would be some
combination of volume, market cap, perhaps the price of the
stock. I think there are a number of factors that would go into
determining the right intervals.
Mr. McHenry. And so could you create--I mean, conceptually,
could you create a system by which the competition would
determine what that spread is? So as the volume goes up and the
market cap goes up, the spread could tighten?
Mr. Mecane. Correct. And I think it would need to be a
collaborative industry solution. Part of why we haven't done
something like this on our own and why we can't on our own is
because if we're the only ones quoting in different increments
but everyone else is quoting in penny increments, it just
doesn't work. It needs to be an industrywide solution. When the
SEC put their concept release out in early 2010, this was one
of the items that they raised. We, in our comment letter,
indicated that this would be a good market-wide experiment to
help the trading and small- to mid-cap stocks, but it would be
an industry wide solution.
Mr. McHenry. Mr. Noll, would you like to touch on some of
these areas?
Mr. Noll. Sure. You know, I think I go back to an earlier
statement I made, which is what's critical here is that market
makers have to be incented in the right way to provide
liquidity. So they will not do so at the risk of their own
capital where it's not economically viable for them. What's
important is to create that viable platform for us to be able
to incent market makers. Some of that may be tick sizes in
making the spread more viable for them to provide liquidity
there. Some of it may come from liquidity payments directly
from issuers or through exchanges. And some, quite frankly, is
what I would call a time and place advantage, which is under
our current market construct, you know, every market maker
starts out evenly, and it's best price that wins and oftentimes
the first at that best price of what we call price time
allocation system.
So for smaller cap stocks what might be more important is
creating a time and place advantage for market makers rewarding
them by providing liquidity at that--in those small-cap
companies. So by ensuring that they get a larger piece of the
trade, not necessarily because they were there first. So within
that mix of ideas, I think there are many things that exchanges
can do to provide liquidity in these small-cap companies.
Mr. McHenry. So you both mention the benefits--well, you
mention the positive nature of market fragmentation. What if
you took these small-cap companies and there was--and you were
only to market, there was no market fragmentation, walk me
through that.
Mr. Noll. Well, if there was no market allocation----
Mr. McHenry. Is that objectionable to you or positive to
you or----
Mr. Noll. I think the critical thing would--to make sure
that that would not be permanent. I think there is a certain
benefit for what I would call a runway period of time. So if
you had a small-cap listing on your venue and you had a runway
to establish liquidity, incent market makers to create that
liquidity and build a marketplace there, I think that could
have some very positive effects.
I think where it starts to become dangerous is if that
looks like it could be a permanent state of being. And so where
I think we would want to see the market go is if that was a
market structure and a mission it was developed to help
concentrate liquidity and IPOs and small-cap companies, we
would want to make some very clearly delineated lines around
that whereby other advantages could start to compete for that
business as well, because ultimately, I think that competition
is necessary.
So if you want to give companies runways, I think that's an
interesting idea and one that we'd be certainly willing to
explore, but I'd want to see an end date for that.
Mr. McHenry. Mr. Mecane, do you want to touch on that? I'm
not trying to create a bunch of controversy, but we're throwing
out concepts to--on this problem and----
Mr. Mecane. It is a very good question, and it's one that
does get a significant amount of debate in the industry,
obviously given that there isn't a clear-cut solution. There is
obviously a balancing act between concentrated liquidity and
the whole liquidity begets liquidity argument, about, you know,
having as much robust price discovery, having it in one place
versus the benefits of competition, and having diverse
competing venues also trying to generate liquidity and market
share, etc. And the question is, where's the tipping point
between the healthy level of fragmentation and, you know, when,
if any, does it go too far?
One of the factors that we highlighted is that while
there's an average level of activity that happens away from the
primary market or away from exchanges, it tends to be much,
much higher in the small and mid-cap stocks. There's a lot of
reasons for that, it is not necessarily clear, but one reason
is because the spreads are wider, so there's an increased
incentive to trade those names proprietarily if firms can. Some
of it is because a lot of those names tend to have a higher
proportion of retail investors in them, so they tend to get
traded away from the exchanges.
One of the things that we've done, as I mentioned, is we've
launched a program recently which isn't in effect yet but it's
out for comment, to try and attract retail orders specifically
to exchanges where we think in mid- and small-cap stocks, it
will be beneficial.
Again, the theory there being that perhaps if we
concentrate more liquidity together, especially in those small-
and mid-cap names, perhaps there could be a feedback loop in
terms of also generating additional liquidity. It is unclear
what the result will be, but again, we are just trying
different things to get at the problem.
Mr. McHenry. Sir, you mentioned in your opening remarks the
ability to purchase liquidity support. Explain to us how that
functions?
Mr. Mecane. Sure. So right now in many European markets,
including the ones we operate, private companies have the
ability to contract with brokers to offer a certain amount of
liquidity support for their stocks. In general, the academic
research has shown that it is beneficial, and it helps improve
the spread in liquidity in the name. The one distinction is
that those programs do exist in a very different market
structure where--than the one we exist in, especially the
periods of time that have been studied in those academic
studies tended to focus on more monopolistic-type environments
and----
Mr. McHenry. Less fragmented.
Mr. Mecane. Less fragmented. And so the only point I'm
raising is that I am hesitant to draw a direct analogy, but
think it's worth an experiment.
Mr. McHenry. Worth----
Mr. Mecane. Trying.
Mr. McHenry. Seeing if it works.
Mr. Mecane. Right.
Mr. McHenry. Thank you for your indulgence. And I now
recognize the vice chair, Mr. Guinta.
Mr. Guinta. Thank you, Mr. Chairman. I want to go back a
little bit to the competitive issue, and how ultimately we
ought to be providing flexibility and options for small-cap
companies. I guess I should be a little more specific in my
line of questioning.
The first question I would have is the services that you
provide--I will ask Mr. Mecane first, the services that you
provide, would you say that they help a competitor once a
company's listed?
Mr. Mecane. I do think there is a certain level of that
because of the nature of our industry where it is a very
competitive market, and anything that we create can be
generally replicated or copied by other venues. I don't think
it is necessarily a bad thing in that the--there is a benefit
to first mover advantage, but clearly, it could be--you know,
there's a certain negative result when everyone else ends up
doing the same thing.
Where I do think, though--but generally, the competition
that we're talking about, whether it is price competition or
new product competition, even though it might not be as
beneficial for us as venues, ultimately the consumer benefits
from that. It generally will result in more product choice, or
it will result in lower prices. Where I do think that
competition becomes unhealthy or a problem is where it becomes
regulatory competition to use a different phrase. One of the
things that we advocated for is that all participants in the
marketplace were performing similar functions should be subject
to similar regulation. I think that also fits into surveillance
and oversight theme. One of the initiatives that the SEC has
advocated is this creation of a consolidated audit trail, and
what that will do is aggregate together all the activity in the
marketplace and give a consolidated view of all the trading and
all the activity that's happening, not just on exchanges, but
on other venues. And I think that type of consolidation is very
important, especially as it relates to people's confidence in
the public markets.
Mr. Guinta. What about the idea, or the notion of a new
issuer paying for their own services or designating some of
their funds for that--for that specific service. I know earlier
you said that you utilize the revenue that you gained for that
to provide that service, but you also--I don't know if you said
it, but I will assume it that you don't have enough revenue.
Therefore, should we be exploring the opportunity of allowing a
new issuer?
Mr. Mecane. Yes. To link all those things together,
everything you said is correct. We do share the revenue that we
generate in incentivizing liquidity providers. One of the
challenges with small and mid cap stocks is that in a lot of
cases, we're paying everything that we make. And so
supplementing that with a direct payment from the issuer is, we
think, a worthwhile experiment. Clearly, there's issues that
need to be tackled.
Mr. Guinta. Sure.
Mr. Mecane. One of the things I said earlier is there is a
conflict inherent in that relationship. And one of the things
that we've explored and been pushing is that the ETF market,
where you don't have that same conflict, but you still have
some of the liquidity concerns with newly created products
could be an area to conduct an experiment and see whether you
get beneficial liquidity in some of the less liquid ETFs as a
result of this type of program. And then assuming we can
document positive results, we can then try a second experiment
with some stocks and see if it has the same effect.
Mr. Guinta. There are a number of ways we could meet that
objective that ensure the conflict of interest is mitigated.
Mr. Mecane. Correct.
Mr. Guinta. Talk to me a little bit about, you mention the
regulatory concerns. What are some of the regulatory issues
that we should try to address?
Mr. Mecane. One just general topic that has been discussed,
and is a frequent topic of the SEC's agenda and one of the
things that they are working on is around the level of
disclosure for different activities and filings that have to be
made. Clearly exchanges have a very high level of public
disclosure about our activities and how we handle orders and
our pricing. And one of the topics is whether that level of
disclosure should be applicable to all market participants. And
there is valid reasons on both sides of the argument, but
clearly from our standpoint, we think that a similar level of
disclosure is warranted.
Mr. Guinta. Okay. Thank you, Mr. Chairman.
Mr. McHenry. Thank you. Thank you, the discussions about
the consequences or potential negative consequences of this
liquidity support. So walk me through this, if liquidity
support agreement required these following couple of things,
four things, the agreement is publicly disclosed, the liquidity
provider does not provide hedging service to third parties, the
liquidity provider does not trade on a proprietary basis of the
issuer's security, and the liquidity provider does not reveal
its trading strategy or the plan transactions to the issuer. Do
you think that would be sufficient to counter the possible
negative consequences?
Mr. Mecane. I think that's definitely a good place to
start.
Mr. McHenry. Are there additional things you would require?
Mr. Mecane. There could be a public disclosure of the terms
of the arrangement. We could, through the exchange or SEC,
there could be a mechanism to, you know, disclose exactly
what's being done. There might be confidentiality concerns
around that. So we could debate at what level, but I think
perhaps some additional public disclosure of certain terms
could be helpful.
Mr. McHenry. And duration.
Mr. Mecane. What the obligations are, what the payment
structure is.
Mr. McHenry. Okay. Mr. Noll.
Mr. Noll. I agree with Mr. Mecane, those are very good
places to start. A couple areas perhaps to pay a little more
attention to, when you talk about proprietary trading, clearly
as a market maker, the market maker is going to be taking
positions in the security, that's one of the things that
providing liquidity means----
Mr. McHenry. Yes.
Mr. Noll [continuing]. So delineating what is a market
maker position and what is market maker behavior from what is a
speculative proprietary position.
Mr. McHenry. That can't be too complicated, how many pages
is the simple Volcker rule? It adds what, 300 pages?
Mr. Noll. I think you could burn a lot of brain cells
trying to find that line. Those are the areas that I think we
would have to spend some attention on.
One possible area to look at, I think as an addition is
what is the definition of market called that you're looking
for, and having that be a transparent part of this proposal
which is, this is our expectation as a company for what we
expect to see, from supporting this kind of market maker
support system, spreads of X percent and depth of Y securities.
As part of that overall process, I think maybe a healthy area
as well.
Mr. McHenry. Okay, okay, interesting. This has been very
helpful. I know we've touched on a number of things here, you
know, global competition is certainly a concern, obviously you
both touched on that to some degree, and the importance of
really bringing capital to the United States. I mean, that's
really what our capital markets are about, it is sort of being
a sponge to bring in capital. Are there any things you want to
add additionally, just in this broad concept we're talking
about? Ideas, solutions problems we haven't touched on in this
hearing? Mr. Noll.
Mr. Noll. We have touched on almost everything, but I do
want to emphasize I think the problem here is not just about
liquidity and not just about market structure. There is clearly
regulatory impediments for companies going public. You could
group them most largely in what I will call Sarbanes-Oxley, but
there are more than those. I think addressing those I think is
also going to be critical to making the success if we are going
to improve the IPO market for small----
Mr. McHenry. Do you want to talk about anything in
particular with Sarbanes-Oxley?
Mr. Noll. Well, clearly the 404 restrictions and allowing
that market to have companies that are exempt from that to be
higher than it is today.
Mr. McHenry. Uh-huh.
Mr. Noll. We agree with the billion dollar mark that we've
seen out there. And we think that that's something that would
be very useful for companies as they go forward. You know,
implementing perhaps a time or a grace period for companies
after they go public may also be very beneficial.
And then we are very concerned about the new PCAOB
requirement that companies change auditors as we go forward,
because it feels to us, in many ways, like an unnecessary
expense. One of the benefits of working with an auditor over
time is that they know the company and they become very
familiar with the way the company works. And so the cost of the
audit actually goes down. To hit the switch, auditors on a
frequent basis to bring new auditors in creates a very
expensive proposition for companies, and yet another reason why
a company may not want to go public. So I think it's important
that we think about those in this context as well.
Mr. McHenry. Mr. Mecane.
Mr. Mecane. I will echo what Mr. Noll said and the point I
made earlier which is that any type of reform that we do needs
to be part of a broader package, I don't think any market
structure fixes, in and of themselves, are going to necessarily
fix the problem. I point again to the IPO task force report
which I thought did a very good job of coming up with very
discrete, concrete recommendations that are reasonably
implementable as a path forward for increasing potentially
research coverage, making it easier for companies to go public,
and perhaps palatable, regulatory relief that could help loosen
up some of the trends that we've been seeing.
Mr. McHenry. What about securities class action lawsuit
reform?
Mr. Mecane. As a non lawyer----
Mr. McHenry. I like the stare off here.
Mr. Mecane. It is something we can certainly get back to
you on.
Mr. McHenry. That is a creative answer. Let me ask this in
a different way, because that wasn't even--it was an open-ended
statement really. Do security class action lawsuits and the
structure and form and the payment and expense, do they
disincentivize the public markets?
Mr. Mecane. What I would say very broadly is that I believe
that when companies are evaluating their different future
options that there's a perception of a cost of being public,
some of that being the oversight of quarterly earnings, and
complying with the different rules. Some of it is, to your
point, chairman, subjecting yourself to potential lawsuits from
investors, etc. I think that goes into the evaluation and the
equation whether conscious or subconscious about whether
people's best path forward is a public or a private one. I
think anything that potentially increases the cost of going
public is negative.
Mr. McHenry. Mr. Noll.
Mr. Noll. I would agree with Mr. Mecane there. We would
have to also get back to you with our opinion about securities
litigation reform. I do want to emphasize that one of critical
things that exchange markets do do by being transparent markets
is create a set of rules by which all companies have to abide
by, both in their listing standards and in the trading of those
rules. And so keeping investor protection in the front of our
minds is also important. So to the extent that anything that
supports investor protection in this process is something that
we wouldn't want to give up as we go forward.
Mr. McHenry. Okay, well on that area of agreement you'll
both get back to us. I certainly appreciate your willingness to
have the conversation here this morning. This is the roadblocks
to public markets and the impact that has on job creation. I
mean, this is not something we touched on, but obviously, when
companies are able to go to the public markets, access capital,
they are able to greatly expand their work force and what their
able to do in terms of offering a product or their service.
And so having a vibrant public market goes right along with
vibrant labor markets and modern societies around the world
historically, but I appreciate your willingness to have the
conversation about these ideas, about these concerns, potential
solutions, but also the current struggles that we're facing
right now.
I appreciate your ability to have that conversation and
sort of engage in a broader range of subject matters this
morning. We very much appreciate it. And as policymakers here,
those watching from their offices and those of us that are
trying to craft legislation to free up capital formation in
this country, this is very helpful. Thank you for your time.
With that, you'll have--you'll each have--I've got my final
script here, you'll have 7 days to add additional comments to
the record, as do Members. With that, this meeting stands
adjourned. Thank you.
[Whereupon, at 11:18 a.m., the subcommittee was adjourned.]