TCS Daily


New Regulations make Markets Friendlier for Investors

By James K. Glassman - November 27, 2000 12:00 AM

Market volatility other problems will smooth out with time, says Robert Colby, Deputy Director of Market Regulation for the Securities and Exchange Commission, about new rules against selective disclosure and decimalization.

Glassman: Wall Street analysts and companies seem to be having some trouble trying to cope with the Security and Exchange Commission's new Regulation FD, which basically requires companies that distribute information from senior management to analysts to also disclose it at the same time to the public. Analysts' jobs, according to some stories, are becoming much more difficult, with huge conference calls stretching on forever. And companies are not giving out any information in many cases. So, how is this beneficial to investors?

Colby: I think that we are at the very earliest stages. It's a new requirement that the issuers don't have any experience with and they are being extremely cautious. I think that many of the difficulties that are arising now will be worked out with time and experience. And keep in mind that many analysts do not like the concept of Reg FD and they have difficulties with it. But once we're over these early pains, I think mechanisms will be developed where the information can be made available on a wide basis rather than on selective basis so that investors will have not just an immediate but better and more consistent information about issuers, instead of wondering which particular analyst was more insightful or better informed -- or wrong -- if they diverge from other analysts. This will ensure that information is available on a widespread and equal basis for investors.

Glassman: Dan Groves, who is an author of financial books and articles, wrote in The New York Times that while he supported Reg FD for reasons of fairness, there was no doubt in his mind that it will increase the volatility of the market. That seemed to me to be true as well because companies can't give guidance, and all of a sudden earnings get reported in a kind of a shocking way. First, do you think that it is increasing volatility?

Colby: There have been particular cases where it appeared to be a jolt and then a recovery. I think it is too early to tell whether it has increased volatility. But let's pick apart the volatility argument and point out the unfairness of it. What the argument has been is that the people who had the information and getting it out selectively had the ability to trade in a way that moved the price gradually to a new equilibrium level rather than quickly to a new equilibrium level. In other words, instead of the price jumping when news comes out, some people knew so they started buying, raising the price gradually to that equilibrium amount, or selling and sending the price down. The old question, and one that we don't know the answer to, is whether the price moves beyond the equilibrium level because the information couldn't be digested in a way that people could decide on a realistic price. That is still an open question, I think. But the idea that we want to slow information so some people outdo other people is the sort of more recent question of unequal treatment that the regulation was intended to address.

Glassman: But what is really wrong with the company putting out nonmaterial information to some people as opposed to all people? It is a system that seemed to have worked very well. It's not as if something was broken.

Colby: You're right. The chief concern of the rules is the material information, and I think that what we are in is a period in which the rough edges have not been smoothed out. But I would expect that it will be, as people become more accustomed to the system and companies more aware of the extent they can talk with analysts about some item and then they really need to make the information available to all investors at once.

Glassman: Technology is changing everything about the way we do business and about the way we conduct our lives, and yet there seems to be a good deal of resistance among the established exchanges to technological change. Why can't you have the same kind of transparent display of trades for the New York Stock Exchange companies as is done for Nasdaq companies?

Colby: There are only transitional reasons why they can't. We very much want to make sure that their quotes are public and visible for New York Stock Exchange listed stocks. In fact, they usually didn't want to make them available. We adopted rules and said they needed to. We are. Would you like to know the details of why they are not available at this moment?

Glassman: Well, I actually do know, but I thought you might, maybe briefly, tell our viewers exactly why there is a distinction between the Nasdaq and the New York Stock Exchange.

Colby: For the New York Stock Exchange, there has been a set of criteria for many years for listed stocks that were designed to try to protect customer prices. If you are going to quote prices over the exchange then the quotes all have to be comparable, meaning that they have to represent a similar thing to everyone that looks at them. For brokers to be able to take those quotes into account, there needs to be a good way for them to reach those quotes. To do that, they built a set of wires among all the established markets at the time. The new electronic markets would like to come in. We're very sympathetic to that idea. But we're still trying to figure out what conditions would be necessary in order to make sure that when a price quote is published by an electronic market that it means the same thing as a quote published by all the other markets that people are accustomed to. Second, when that quote is published, there needs to be an ability to have quick and effective access to the market publishing the quote. And, third, there needs to be something to ensure that people weren't given quotes that ignored better prices displayed in other markets, and thus end up with customers in end up with a worse price than they otherwise would. The electronic markets don't want to live under the existing conditions because it's not simple, given their business model. But we haven't yet figured out what we'd do to replace those standards in order to achieve the same ends.

Glassman: A year ago, you notified E-trade that they should police their chat rooms, keep representatives from guiding stock purchases there. Has the FCC uncovered any improper activity in chat rooms and bulletin boards that involved self-dealing that we should be aware of?

Colby: You know there had been a string of cases in which allegations were made that people put out false and misleading statements in chat rooms in order to move the prices of stock.

Glassman: But what about broker dealers? Are they guiding stock purchases in any way?

Colby: Some of these cases as I remember, I'm trying to remember. I thought I remember something being registered, but it was not clear that that was in behalf of a firm.

Glassman: Do you actually monitor chat rooms and bulletin boards, or do you wait till something happens to go in?

Colby: We have a group that searches the net looking for situations that are a problem. And some people think the universe is infinitely expanding, and so our ability to be confident that we have hit everything, and it's also on 24-hours-a-day - and we don't work 24 hours a day. But we do try to monitor it. We do have a, pardon the label, cyber-force within the agency, up to 250 people, and we try to proactively survey chat rooms. But we're not everywhere all the time.

Glassman: Do these people disguise their identity?

Colby: Yes, they do. They just watch. They don't entrap, if that's what you mean.

Glassman: O.K. let me ask you about decimalization. First of all, you know, the SEC generally has had the attitude to let technology lead and regulation will follow. However, in the case of decimalization, you seem to kind of aggressively put the burden on the exchanges. Why was that? What was wrong with fractions, even 64ths? Why do we have to have decimals or, more precisely, hundredths?

Colby: Well, if you don't mind a slightly long-winded answer to this one, our philosophy of regulation is that the Commission needs to be involved in the market where there is a situation that can't rectify itself, and there are a variety of situations where that may occur. One is where there is an imbalance in the interests between investors and traders. So a number of our rules, such as our penny stock rules, are designed to protect investors. More central to the market, sometimes collective action is needed but without a regulator participants are unwilling or unable to take it. There's a variety of areas where this comes up, where each individual market participant acting in their own interest will not result in an outcome that is best for the market as a whole, or where they cannot do it because of chaos or antitrust limitations on collective actions.

Decimals I think fall in the latter category. The industry could not really do it without doing it together because it's prohibitively expensive to run systems for the same stock or other security with two different formats. And so if anyone was going to trade significantly in stocks in decimals, they all needed to. That's why the SEC was involved. Now, you were really asking, is this a good idea?

Glassman: Right.

Colby: It actually was driven by Congress. If you remember Reps. Tom Bliley, R-Va., and Michael Oxley, R-Ohio, a bill, dollars and common cents, or something like that, in which they mandated that the industry go to decimals, subject to commission rulemaking. And it was at that point the SEC said that if they wanted that done, O.K., there are some good reasons to do it, but do it by regulation. And then the New York Stock Exchange said that they were going to go to decimals at that time. Ultimately, though, we had to order the markets to do it because antitrust laws kept the markets from getting together to work it out.

Glassman: But is decimalization a good idea?

Colby: I think decimals are a good idea, an indisputably good idea. I think the question is what the right trading should be? As you pointed out, we're heading towards trading in hundredths. Decimalization is good because, frankly, many of us have to take off our shoes to figure out 64ths. Furthermore, the rest of the world does not trade in 64ths, and there is more and more trading of securities internationally. So, at some point, somebody loses out you have two sets of systems, or you can't trade in foreign securities here because they are trading in decimals. That doesn't make sense. Sooner or later, given the way the international market is going, we have to have consistency, and foreign markets were not about to change to fractions.

Glassman: What are the other advantages?

Colby: Another thing is that when we were trading in eighths, there were substantial increments of 12½ cents in the prices stocks could trade at. So, we went down to 16ths. The over-the-counter markets quote in 16ths but are allowed to trade in any increment they want, so if you look at the tape you will see these 256ths come out sometime. It's legal and similar electronic markets you mentioned traded in those increments. And so it was really going to a level that didn't make sense to stay in fractions anymore. There is still I think an open issue about what is the right increment in trading increment is, from a theoretical sense. From a practical sense, I don't think there is because I think the New York Stock Exchange is committed to pennies at this point, and it's still so significant that I think that most of the other markets will follow if they can.

Glassman: One last question. A year ago you were worried about getting the industry ready for the year 2000, remember that?

Colby: Oh, do I remember that.

Glassman: But it a bigger technological worry for investors these days may be the security of their accounts online. We just had a story about Microsoft reporting to the FBI that hackers had broken into very delicate Microsoft systems over a six-week period. Are you doing anything to protect investors? Or is that beyond your limits or are you particularly concerned about investors having the privacy of their accounts violated?

Colby: We are concerned about it. Our interest in the industry on this one is almost perfectly. So this is not one of those areas of regulation where the strongest arguments for regulation exist. Having said that, we're doing two things. We've proposed what we call an operational capability rule that would require brokers to do planning and develop a system with both adequate capacity and adequate security measures. We have not adopted that yet, we're still trying to get it right.

Second of all, when we examine brokers, we try to assess what they are doing in order to make sure that they have an adequate planning, development, and security processes and policies and procedures. Again, this is one where we're going to establish the standards not because the firms are ignoring the area or cutting corners, but in order to just save costs, and not leave the customer at risk.

Glassman: But is it something that the average investor should worry about?

Colby: Ultimately, it's not because there are several levels of protection. If somebody gets in and hacks somebody's account -- and either moves money out or trades in the account -- it's ultimately the broker's liability. And the broker needs to make it up to the customers, assuming that the customer was not negligent by giving out his or her account numbers or something like that. If somebody hacks the broker's system, it's the broker that is liable. It would be the same as someone walking into their office and taking money out of their vault, and they would have to make that up to their customer. If it's an enormous scam and the broker goes down, then the securities would be protected by the Securities Investors Protection Corporation. It's only to a certain level -- up to $500,000 overall and $100,000 in cash. A number of brokers have private insurance to cover this.

The greatest risk is inconvenience, assuming that the customer does not have an enormous amount there, so much that the broker goes down, the assets can't cover it, and insurance specifically does not cover. As you know, most people likely to have that much also have custodians and managers, so their funds and securities are not at a dealer, they're at a bank. And that raises the question, how are the banks doing, which I would not even try to find out.

Glassman: That's great, Bob, thank you very much.
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