Messrs. H. Carl McCall and Leon Panetta
Special Committee on Governance of the NYSE
New York Stock Exchange, Inc.
11 Wall Street
New York, NY 10005
Dear Messrs. McCall and Panetta,
I thank you for the invitation to contribute my comments on the NYSEs governance review. In my view, this is an important initiative with the potential to make a significant positive contribution to the development of the US equity markets.
A year ago, I commented widely in the press about the need for the NYSE to re-examine its governance structure and practices, particularly in the wake of the Exchanges highly desirable proposals for increasing the role of independent directors on the boards of its own listed companies. In particular, I called for an end to the practice of NYSE executives sitting on the boards of listed companies, and for an increase in the number of NYSE directors who would qualify as independent under the Exchanges own definition of that term. 1
The Initial Report of the Special Committee on Governance of the NYSE dated June 5, 2003 fully and satisfactorily addresses my concerns about NYSE executives sitting on listed company boards by recommending that the practice be prohibited (#3). It is my view that the Committee also made useful progress towards reducing the role of broker-dealer and specialist firm representatives in the governance of the Exchange through its recommendations to increase the role of so-called non-industry directors (#4-7). I understand that these measures were adopted by the NYSE Board at its meeting on June 5. I do believe, however, that the Committee should consider going further towards bringing its definition of non-industry directors in line with its definition of independent directors, as that term applies to its listed companies.
My reason for wishing to respond to your initiative, however, is not to press for further reforms within the Exchanges current ownership structure, but rather to advocate change in that structure from which positive governance reforms will flow both as a logical and legal consequence.
A member-owned cooperative is the most logical business structure for an exchange in which investor orders must be represented by human intermediaries transacting verbally within a geographically fixed space (as at the NYSE today), since there is no trading system distinct from these intermediaries themselves. Indeed, throughout almost the entire first two centuries of the Exchanges existence, its trading and governance structures were well aligned.
Given that modern technology can, however, now accommodate trading unlimited either by the number of participants or their location, it should not be surprising that demands from investors (particularly institutional) for disintermediation of the trading process are coming increasingly into conflict with the desires of the Exchanges owners to maintain the profitable aspects of intermediating trades on the floor. If the Exchange were to be transformed from a utility supporting its members brokerage operations to a self-standing commercial enterprise seeking profits from transactions, rather than brokerage, this endemic conflict of interest would be eliminated. Two positive effects would flow from its elimination.
First, the endless public and regulatory debate over whether the NYSEs chosen market structure exists to serve the interests of investors or those of the intermediaries that currently own the Exchange would become moot. A for-profit exchange whose ownership base is not dominated by intermediaries has an overwhelming commercial incentive to choose a trading structure that eliminates all costs of trading which do not accrue to the exchange itself as transaction revenue. My own work with Ian Domowitz found that a 10% decline in trading costs in the major US and European equity markets yields approximately 8% higher turnover. If this is even a modest approximation of reality, it is clear that a commercial NYSE would, in its own interest, choose a market structure which encouraged investors to trade by eliminating any unnecessary intermediation costs.
Second, the compromise and consensus that now dictates how the interests of the Exchanges owners are reconciled with those of the investing public would be replaced by a governance process which ensured that this conflict did not exist in the first place. If the Exchange itself were a public company, its board structure would be dictated by the standards applying to its own listed companies. The changes to such standards proposed by the Exchange last year include provisions to strengthen the role of independent directors. Such directors are vital to ensuring that public companies operate in the interests of their shareholders, rather than their management or other interested parties (like suppliers). In the case of the New York Stock Exchange, they would operate to ensure that the Exchange was offering a market structure that encouraged maximum investor order flow through the exchange, even if such a structure were adversely to affect the profitability of certain intermediaries.
Given the substantial and growing role of rapid-trading institutions in todays market, it is far from obvious that the floor-based environment favored by the NYSEs current member-owners is maximizing the Exchanges appeal to the broader trading public those that actually own the order flow. Whereas we can never know the answer for certain, we could have considerably more confidence in our judgment if the Exchange were to open up ownership not just a few more board or committee seats to nonintermediaries.
My recommendation to the Committee is, therefore, that it revisit the issue of demutualizing and listing the Exchange. Whereas Chairman Grasso and I may have different ideas regarding the optimal market structure for the Exchange, I would point out that demutualization and a public listing were initiatives championed by Chairman Grasso himself in 1999.
Some may question whether a demutualized New York Stock Exchange would remain capable of fulfilling its self-regulatory obligations. It is has been argued in some quarters that the investing public might be less well served by transferring SRO functions to a profit-seeking organization. Yet this presumes that a mutualized exchange is less self-interested than a demutualized one, which should be a transparent misapprehension. A mutualized exchange is a utility of its profit-seeking owners, not a charity. It is established by the members to serve the members interests, and will be reformed or disbanded when it ceases to serve them effectively. Indeed, the vast majority of exchanges that existed in the United States a century ago have been disbanded by the members or merged with other exchanges.
A demutualized exchange is also a creature of private interests. Yet these interests are better aligned with those of investors than in a mutualized exchange, as demutualization reduces the control of intermediaries over the exchanges operations. If a given practice is profitable for intermediaries while being unprofitable for investors, it is less likely to be maintained by a demutualized exchange.
The legal issues involved in such an ownership and governance transformation are clearly challenging, and will necessarily require a significant degree of cooperation from the Securities and Exchange Commission. Nevertheless, the success which similar initiatives have so far enjoyed in Europe, Canada and Australia should provide both encouragement and support to the Committee should it choose to place the question on its longer-term governance agenda. I would be pleased to be of further assistance should the Committee find merit in my proposal.
1 The NYSE specifies that for a director to be independent, the board must affirmatively determine that the director has no material relationship with the company, either directly or as a partner, stockholder or officer of an organization that has a relationship with the company. A majority of a boards directors, according to the Exchange, should be independent according to this definition.