July 25, 2003
Jonathan G. Katz, Secretary
Re: File No. S7-11-03; Release No. 34-47849
Goldman, Sachs & Co. ("Goldman Sachs") and Spear, Leeds & Kellogg, L.P. ("SLK") each a broker-dealer registered with the Securities and Exchange Commission (the "Commission" or the "SEC"), are pleased to respond to the Commission's request for comments on issues raised by the "Petition for Commission Action Concerning the Trading of Nasdaq-Listed Securities" filed by The Nasdaq Stock Market, Inc. ("Nasdaq").
Nasdaq's Petition asked for Commission action to address the lack of uniformity in trading rules applicable to Nasdaq-listed securities and the nature and burden of regulation of markets trading those securities. In its Petition, Nasdaq raised important questions at a critical time in the development of our markets, and we applaud the initiative. It deserves the Commission's prompt consideration. In addressing the issues raised by Nasdaq, we ask that the Commission (1) require that antifraud and antimanipulation rules be applied uniformly across all markets and be modernized to reflect the current state of the markets, (2) standardize and simplify electronic audit trail rules as a means of achieving more efficient and effective regulation, (3) increase transparency of regulatory costs, and (4) clarify trade reporting rules to eliminate the current distortions arising out of some market participants' desire to capture market data fees.
Before responding to the questions posed by the Commission, we would like to share our view of the regulatory landscape from the broker-dealer perspective.1When Goldman Sachs receives a customer order to buy or sell a security, it immediately becomes subject to a panoply of regulatory obligations. These include knowledge of all of the relevant terms of the order;2data capture to comply with the audit trail rules of the NASD (commonly called "OATS")3or of the New York Stock Exchange ("NYSE") front-end systemic capture rule4("FESC"); compliance with books and records, order handling, and best execution obligations, as well as compliance with NYSE and NASD rules such as NYSE Rule 92, NYSE Rule 97 and NASD's Manning rules. If the transaction involves a short sale, additional obligations may apply, including compliance with the "bid test"5or "up-tick"6rules. Upon execution, trades must be reported promptly, confirmations sent to customers, appropriate entries made to the firm's books and records, trades settled and customer protection rules observed.7 The broker-dealer must keep records of all of these operations.
I. Adoption of Uniform Rules Across Markets.
One could reasonably expect that, given the myriad of obligations placed on broker-dealers with regard to every customer order they accept and execute, there would be a very high degree of uniformity and consistency across the equity market regarding market surveillance and a broker-dealer's responsibilities to provide surveillance information. In addition, given that market manipulation is not a marketplace-specific concept, one could also expect a uniform antimanipulation rule set across markets. Regrettably, this is not the case, and, instead, we see a marketplace characterized not only by market center fragmentation, but also by regulatory fragmentation.
For example, as Nasdaq observed, while the "bid test" rule applies to short sales of Nasdaq-listed securities traded in the Nasdaq and ADF markets, the rule may be avoided when the same securities are sold short on certain exchanges. In addition to raising opportunities for regulatory arbitrage, this outcome presents significant problems for broker-dealers, particularly when attempting to execute a large customer order. If the broker-dealer sources shares to fill a portion of an order in a market in which a short sale rule does not apply, the broker-dealer may find itself unable to pass through those executions to the client when it adds those shares to others for a single execution in a market in which the rule does apply. These problems cannot be addressed through the application of technology given the difficulties of programming execution algorithms that apply not to the security, but to the market where executed. Another problem for broker-dealers with respect to short sale compliance is that ECNs have varying practices for handling short sale orders received from broker-dealer subscribers on behalf of their customers. At least one major ECN explicitly disclaims any obligation to apply the "bid test" rule to a Nasdaq-listed security marked "short" in its system unless it has explicitly agreed to apply an algorithm to assure compliance. Other ECNs undertake to handle orders marked "short" in accordance with the "bid test" rule.
We agree with Nasdaq that different antifraud and antimanipulation rules should not apply based on where a transaction is executed. Although internal rules of a market, such as whether reserve size is displayed or whether specialists are entitled to participate in customer orders, may differ for competitive and structural reasons (e.g., floor-based vs. electronic markets), there is little justification for the different application of core antimanipulation rules from one market to another. The conduct defined as "Prohibited Conduct" in Nasdaq's proposed UTP Plan would be a good starting point for the Commission to use in determining which antrifraud and antimanipulation rules should apply market-wide.
We urge the Commission to use its authority to require the uniform application of rules it considers essential to protect the integrity of the markets. However, we also urge the Commission to carefully consider whether some of the rules - and the short sale rule is a case in point - should be re-examined in light of the substantial environmental changes that have occurred in the markets in the past few years.8
II. Standardize and Simplify Electronic Audit Trail Rules
As noted above, broker-dealers are subject to substantial record-keeping requirements with respect to all customer orders. Technological developments have made it possible for all of this information to be assembled and transmitted directly to a self-regulatory organization ("SRO") on a daily or real time basis, as compared to the previous practice of requiring this information to be compiled and sent when requested by an SRO.
Both the NASD and the NYSE have taken advantage of technology to enhance their capabilities to surveil for compliance by their members with order handing and antimanipulation rules by adopting the OATS and FESC audit trail requirements. As trading of equity securities continues to spread across market centers,9the disparity of surveillance requirements imposed by SROs on intermediaries becomes more apparent. Indeed, Nasdaq now urges the Commission to extend its audit trail rules to all markets that trade Nasdaq-listed securities. None of these markets currently has electronic audit trail rules comparable to OATS or FESC. This disparity raises not only the policy question of whether to extend OATS to all SROs that trade Nasdaq-listed securities, but also whether to require all SROs to adopt a uniform program for surveilling and enforcing market-wide rules regardless of where securities are listed.
Goldman Sachs and SLK believe that any decision in this regard should take into account the costs imposed on SROs, market intermediaries and the markets as a whole if market-wide electronic audit trails are mandated. The industry expressed concerns at the time the OATS requirements were proposed about the cost to implement and comply with these complex rules. These requirements have become, since their inception, even more complex. Such complexity makes continuous error-free compliance difficult and expensive.
While we sympathize with the desire of Nasdaq to make the requirements of SRO surveillance uniformly applicable, we are extremely concerned about the costs to the industry of doing so - particularly if this results in an increased number of SROs requiring electronic delivery of essentially the same information in differing formats.
Once broker-dealers have implemented the systems necessary to comply with an audit trail requirement, it should not be incrementally significant from a cost perspective, including human and technology resources, to supply the same data in a common format to assist additional SROs in carrying out their surveillance responsibilities for trades executed in their markets. There is, however, a significant incremental cost if the data to be captured and the methods of encoding and delivering data differ from market to market.
In complying with the NASD's audit trail procedures, we (like all other NASD members) must follow a highly complex technical specification of approximately 300 pages. While the NYSE's FESC rules, as recently amended, will require a trade history similar in scope and complexity to the NASD's rules, the format of the reports, the designations and fields to be completed as well as the timing and method for submitting the data differ significantly. These differences require Goldman Sachs and SLK each to have separate teams of programmers and systems maintenance and compliance personnel for each SRO. The technology and human resource costs to install and maintain these systems have been significant. The possibility that other exchanges and market centers will adopt their own audit trails requiring the submission of new and different information assembled under differing specifications is daunting. Multiple, competing formats and data capture requirements would present firms with real economic costs that may compromise the firms' incentives and abilities to provide liquidity in multiple venues - a distortion that does not benefit the broker-dealer community, its customers, or the market as a whole.
The Commission should mandate a single standard for real time electronic trade and audit trail reporting to surveil for violations of market-wide market integrity rules that are applicable to all equity securities traded in the national market regardless of where listed, or whether traded on an electronic or floor-based market.
At the same time, the Commission should critically review the information requested. We believe that OATS and FESC require the submission of much more data than is necessary for the SROs to perform the task of identifying questionable activity. Once detected, the SROs will always be able to ask for and obtain additional information, since firms are required in any case to maintain this data internally. We believe the sheer size and amount of data now submitted on a real time or same day basis makes technical, error-free compliance extremely difficult, requires costly systems maintenance, and leads to an increased number of "false positives", triggering significant numbers of inquiries by the SROs that ultimately show that no substantive rule violations occurred. These inquiries also inappropriately divert compliance resources from more productive uses.
Accordingly, if the Commission requires all market centers to adopt audit trail requirements, it should ensure that these requirements are uniform and standardized. We further urge that this information be simplified, captured in a central depository, aggregated and made immediately available to each relevant market center, possibly through direct electronic data feeds.
We appreciate that the activity on traditional floor-based auction markets must be surveilled for compliance with market integrity rules designed to prevent abuse by market participants with privileged information access, and that audit trail rules for these markets may require additional elements. The data collection process should nevertheless be as integrated as possible with the information collected for the securities traded in other market centers, and the Commission should ensure that the audit trail requirements are consistent across the floor-based markets.
III. Fairly Allocate Market Surveillance Costs Among Execution Venues
Just as Nasdaq calls for market-wide uniformity in core antifraud and antimanipulation rules and a common approach to surveilling the markets, Nasdaq correctly highlights the need to reform the way in which this surveillance is paid for and conducted. We agree with Nasdaq that the Commission should act to allocate equitably to market centers the costs of surveilling trading in the national market system. We also believe that these costs should be completely transparent. Currently, they are opaque. Although we do not agree with Nasdaq that market data revenue should directly subsidize the cost of consolidated regulation, we are concerned that the current method of allocating tape revenue has led to practices that offer a distorted picture of where trades occur. As the Director of the Commission's Division of Market Regulation ("Market Regulation") noted in a recent speech,
We believe that a viable structural solution to deal with those concerns is possible only if the Commission re-evaluates comprehensively the way in which market-wide regulation is conducted and financed. Using tape revenues alone to fund the surveillance process does not, in our view, advance a comprehensive approach to the problem. In fact, it may compromise the Commission's freedom to deal with the broader recommendations of the SEC Advisory Committee on Market Information. 11
At the same time, the Commission should address the tape revenue issue. This will inevitably require a new methodology for determining where "internalized" trades, including orders matched on an alternative trading system ("ATS") or matched by a broker-dealer's internal system or facilitated by a broker-dealer's commitment of capital should print.
Our view is that where trades print should reflect the true, accessible liquidity of the printing SRO. The informational role of a trade report attributable to an SRO is to indicate to market participants that liquidity in the size of that trade report was available on that SRO. If a trade report is allowed to be attributed to an SRO without execution in that venue, that report's information value to investors is impaired. Applying this principle in its purest form would mean that a trade executed using the facilities of an SRO to access a quote on that SRO should print on that SRO. Also based on this principle, trades (such as block facilitations) entirely negotiated "upstairs" and never exposed to an auction market or electronic system for potential price improvement should print on the ADF, as should trades matched internally on an ATS.12
It follows from this principle that quotes posted on the facilities of an SRO must be "liability quotes" - i.e., bona fide quotes against which an execution can occur. The role of an SRO's quote is to indicate the true liquidity available if an order is sent to that venue in response to the quote. If an SRO is allowed to post a quote that is also simultaneously posted on another venue, the SRO's quote may not be available because that quote is only good for a single execution, and the single execution can occur on the other venue, then the SRO's quote is not bona fide and its public information value is also impaired. The requirement of liability quotes would not prevent multiple quotes by a single market participant, so long as each quote was accessible for execution independently of whether that participant's quote received an execution in another venue. It would also not prevent broad dissemination of quote information. It would only prevent use of quotes posted to an SRO as a "no-liability" means of allowing trade reports to occur on that venue. This requirement of liability quotes would also address instances of backing away or from system delays that result when a quote is only good if it has not been hit or taken on another venue, a fact that in today's market is not known until an attempt to access a quote fails.
This theoretical model for trade reporting would have to be examined to assure that implementation could be accomplished at reasonable cost and with certainty of result.
We further urge the Commission to require that the costs of market regulation be more transparent. One way this can happen is if audit trail data is collected at a single point by one SRO and shared with relevant market centers when questionable activity is identified.13 If electronic audit trail data is collected and surveilled in a single entity, the costs associated with that function can be audited, made public and allocated to markets based on their market share of executions of the securities included in the audit trail collection system. Markets will therefore have an incentive to make the costs as low, and the system as efficient, as possible.14
As the Commission studies alternatives to funding market regulation, it will need to consider the kinds of fees and charges currently collected by SROs, in particular the recent controversial proposals of the NASD such as the NASD's trading activity fee. In this regard we consider it critical for SROs to be required to unbundle and make transparent the fully-loaded costs of regulation. These costs are ultimately borne by the industry and the investing public, and market users should be informed of those costs. The Commission, in consultation with the industry and SRO's, then should determine which costs (market-wide surveillance being one) are appropriate to be shared and which costs are unique to a market and should be borne 100% by that market.
We have identified four goals: (1) requiring that antifraud and antimanipulation rules be applied uniformly across all markets and be modernized to reflect the current state of the markets, (2) standardizing and simplifying electronic audit trail rules as a means of achieving more efficient and effective regulation, (3) increasing transparency of regulatory costs and (4) clarifying trade reporting rules to eliminate the current distortions arising out of market participants' desire to capture market data fees. In order to accomplish these goals, we advocate that the Commission:
We applaud Nasdaq for filing its petition. It has focused attention appropriately on several consequences of the competitive forces that are the result of improved technology and the current regulatory framework. Addressing the issues raised in the petition is an important step to restore investor confidence in our markets. Bold action is necessary. By taking such action the Commission is in a position to improve the quality of market regulation while making compliance more efficient and cost effective.
We would be happy to address any questions the Commission may have concerning this letter.
Very truly yours,
cc: William H. Donaldson, Chairman