Market 2000: SEC study seeks greater investor protection.

In late January, the Securities and Exchange Commission (SEC) released its long-awaited study of the securities markets entitled, "Market 2000 Report." The objective of the extensive and highly detailed study was to review the current state of the industry and to determine what new regulations might be appropriate in order to achieve fair treatment for all investors, ensure continued capital raising and keep pace with the changing dynamics of the secondary markets.

1975 REVISITED

The last time such an extensive study of the securities industry was launched was in 1975. This led to Congress enacting legislation establishing a "national market system" for U.S. securities. This and subsequent actions by the SEC and such organizations as the National Association of Securities Dealers (NASD) helped increase competition in the brokerage industry, generating better customer pricing, increased disclosure of market information and has made the U.S. markets the world's most liquid and efficient.

Since 1975, however, the investment world has changed dramatically in response to advances in technology, new product development, and global economic expansion. These changes can be illustrated by examining just a few statistics. For example, in the mid-1970s a daily volume of 16 million shares trading on the New York Stock Exchange (NYSE), was considered a record! Today, 300-million-share trading days aren't that unusual. Additionally, the implementation of NASDAQ as the electronic "trading floor" of choice for over-the-counter stocks, has created the world's second largest securities market after the NYSE. There was no NASDAQ in 1975. The velocity of the securities markets is also evidenced by the amount of revenue that broker/dealers are deriving from trading stocks, bonds and other instruments. In 1975, broker/dealers had revenues of $1.3 billion. In 1992 that number had grown to over $22.5 billion. The last twenty years have also seen the so-called "institutionalization" of the stock market. In 1975, 70% of securities in the U.S. were in private hands; today, institutions (pension funds, insurance companies, banks etc.) own approximately 50% of all U.S. equities. This does not mean individuals have abandoned the stock market, far from it. What they've done is invest heavily in mutual funds leading to the explosive growth in that market segment. As an example, the total dollar value of equity mutual fund assets rose from $34 billion in 1975 to $585 billion at the end of 1992. At the end of 1993, there were over $2 trillion in total mutual fund assets!

MANAGING CHANGE

Given all of the above and other issues such as globalization, the trading of options and futures, etc., the advent of the Third Market (the trading of listed stocks off an exchange), and the expansion of private trading systems, the SEC believed it was time to re-examine whether the regulatory framework was effectively managing the change process. Happily, the basic findings of the "Market 2000" study support the contention that U.S. equity markets continue to operate efficiently under the existing regulatory structure -- even with the explosion of trading activity. Further, that the markets continue to effectively perform their primary functions of raising capital, providing a wide array of investment and trading options, and protecting the public interest. Given this fact, the SEC isn't recommending major revisions in its oversight process. However, it is concerned with four areas in which it believes improvement is needed. These are:

* The fair treatment of investors.

* Disclosure of market information.

* Fair competition among market participants.

* Open market access.

FAIR TREATMENT OF INVESTORS

The SEC believes that the broadest possible investor participation, both individual and institutional, is vital to the health of the market. To achieve this, the Commission is recommending a series of steps directed towards protecting brokerage customers, securing the best possible buy and sell prices for those customers and providing greater disclosure by broker/dealers and others in the securities industry. Among the specific recommendations are that there be more extensive disclosure by broker/dealers when they receive compensation for retail "order flow," and when "soft dollar" arrangements are provided for institutional order flow.

Payments for retail or individual order flow are common in the securities industry. These are cash and other in-kind payments or compensation made by dealers and specialists to brokers to induce them to send small orders (under 3000 shares) to the dealer for purchase or sale. This practice may, the SEC believes, limit the ability of the retail customer to get the best price when trading his stock. Similarly, on the institutional side of the business, an investment adviser may have an arrangement whereby the broker, in return for commissions generated through the adviser, will provide research and other "soft dollar" services. Adequate disclosure of both the above issues, will allow brokerage house customers to see how their commissions are being used and alert them to potential conflicts of interest.

DISCLOSURE OF MARKET INFORMATION

The SEC believes that there needs to be more timely and comprehensive disclosure of market information on such issues as stock quotations, trading volume, and price. Currently, in some instances, there is selective or partial disclosure which weakens the ability of markets to compete and prevents customers from monitoring the quality of their stock executions. Among the specific practices mentioned in the Report is the practice of broker/dealers who trade for their own accounts at prices better than those of their customers who have placed limit orders (an order to buy or sell a stock at a specific price). The Commission believes that broker/dealers should be prohibited for engaging in this practice of trading ahead, as it known.

FAIR MARKET COMPETITION

As mentioned earlier, over the past few years, there has been a geometric expansion in the number of market participants engaged in the trading of securities. These include Proprietary trading systems, O-T-C Third Market systems, and the trading of U.S. securities in foreign markets. In many cases, these automated systems allow for computer screen-based activity, which is outside the traditional purview of the SEC. This had led to concerns of potential market manipulation and the unleveling of the existing playing field for the purchase and sale of securities by investors with differing levels of sophistication. The Commission will be examining additional regulations aimed at promoting fair competition while offering greater investor protection.

OPEN MARKET ACCESS

The final SEC recommendation in the "Market 2000 Report," is that open market access needs to be expanded. It notes that restrictions on where users of the markets can transact business limits competition. Specifically cited it the NYSE Rule 500, which makes it extremely difficult for companies wishing to withdraw their securities from the Exchange, to do so, and the analogous American Stock Exchange (AMEX), Rule 18. The Commission is recommending that the NYSE revise its Rule to lower the barrier to delisting, and that the AMEX add more specificity to its Rule which is now too vague. The Commission also believes that the current NYSE restriction on the off-board trading of listed securities under its Rule 390, should be lifted for after-hours trading.

What we have discussed here are some of the major recommendations of the "Market 2000 Report," and those which will effect investors directly. But in the final analysis, the Securities and Exchange Commission has given the securities market a passing grade for its ability to adapt to the demands of a rapidly evolving and highly complex environment.

James H. Hugar, is a partner in the Financial Services Group of Deloitte & Touche, Los Angeles, he specializes solely in broker/dealers and investment companies.