June 19, 2003
Jonathan G. Katz
Re: Securities and Exchange Commission Release No. 34-47849; File No. S7-11-03
Dear Mr. Katz:
The New York Stock Exchange (the "NYSE") is pleased to respond to the Securities and Exchange Commission (the "Commission") request for comments regarding certain regulatory concerns involving Nasdaq-listed securities and whether the same regulatory concerns raised by Nasdaq for Nasdaq securities, such as regulatory fragmentation and arbitrage, exist for exchange-listed stocks and options.1
Most relevant to the NYSE, the Commission requested comment on whether there exists unequal regulation of exchange-listed securities among the markets trading such securities, and on the relevance for NYSE-listed securities of Nasdaq's proposal to establish uniform trading rules across markets in order to ensure equal surveillance and enforcement of those rules. As to those securities, we believe that Nasdaq has not made a case for the type of Commission action sought by the Petition.
Summary of the NYSE Position
Maintaining and funding an effective examination, surveillance and enforcement regulatory program is the obligation of every registered exchange and association under the federal regulatory scheme. This obligation has never mandated one market center, structure, model or self-regulatory organization ("SRO"). The competitive mandates of the federal regulatory scheme afford the opportunity for additional entrants that meet the statutory requirements. Achieving effective regulation is one aspect of competition. The federal regulatory scheme provides for rules appropriate to each market, enforcement of the federal securities laws across all market centers, uniform books and records and anti-fraud provisions, as well as limit order display and firm quote rule requirements. As to NYSE-listed securities, SROs have found various ways to cooperate and coordinate joint investigations and intermarket surveillance in important areas such as insider trading and market manipulation.
Uniform Trading Rules and Surveillance
As to matters unique to Nasdaq securities, the NYSE offers no comment (Questions 1-4, 9-10). As to questions addressed to all securities, we have the following comments:
Q5. What other trading rules should be uniform across all markets?
The Commission has long taken the position that all exchanges and associations should regulate the conduct of their members to standards consistent with just and equitable principles of trade, have rules to protect the public interest and promote the national market system. In the past trading rules have generally not been imposed uniformly on all markets because of the differences in market structures and the competition these differences afford.
Under the Securities Exchange Act of 1934 (the "34 Act"), all SROs trading NYSE-listed securities have the uniform obligation to enforce the federal securities laws, including the provisions relating to fraud, insider trading, illegal short selling and market manipulation.2 Sections 6(b), 15A and 19(a) of the 34 Act require that any registered national securities exchange or association to carry out the purposes of the 34 Act and to comply and enforce compliance by its members with the 34 Act.
The 34 Act further requires SROs to adopt rules to govern their members and to enforce these rules.3 All markets trading NYSE-listed securities have rules that regulate market manipulation, illegal short selling, insider trading, fraud, front running, marking the open or the close, the limit order display rule and firm quote rule.
Differences in market structures across the securities industry necessitate different implementation of universal principles to accommodate competitive differences among those markets. For example, rules that regulate specialists in the Exchange's auction market are not applicable to markets with no market-making function. The "single regulator" - the Commission - serves to ensure, via the inspection and rule making process, that all markets have appropriate levels of regulatory effectiveness for the protection of investors.
Q6. How should the Commission address any regulatory gaps that can arise when trading in the same security is fragmented across different SROs?
In the markets for NYSE-listed securities, various methods have been employed to avoid both regulatory gaps and the other side of the coin, regulatory duplication. Some SROs have filed Rule 17(d)(2) agreements, e.g., in the options sales practice area. As to insider trading and manipulation investigations, the Intermarket Surveillance Group ("ISG") facilitates coordination of joint investigations and intermarket surveillances. In 1983, the U.S. SROs created ISG as a forum to share surveillance information and coordinate investigations that impact intermarket surveillance.
Q7. To what extent is ISG a useful mechanism for coordinating intermarket regulatory efforts? Does ISG fully address the regulatory gaps Nasdaq contends exist? Does the fact that the Commission does not have direct oversight of ISG limit the sufficiency of the ISG framework in ensuring adequate regulation of violative conduct in the trading of Nasdaq securities that can occur across markets, such as insider trading or certain market manipulations?
The ISG has been successful in coordinating intermarket surveillances and investigations of insider trading and manipulation across markets in NYSE-listed securities. It has grown to include every domestic exchange and association, as well as many foreign affiliates. The ISG filed a comment letter to the Petition that addresses this question.4
The Commission has direct oversight over each exchange and association that is a full member of the ISG. The ISG participants utilize the ISG framework or protocol for sharing information for regulatory purposes. Membership in the ISG does not relieve the participant of its statutory regulatory responsibilities; rather, it facilitates their discharge. All SROs in the United States and in the foreign markets must, in order to participate as members or affiliates of the ISG, have rules and regulations prohibiting market manipulation, insider trading, fraud, front running, marking the open or the close, as well as sharing information for regulatory purposes.
Q8. Are there models sufficient to address potential concerns raised by fragmentation of regulation by multiple SROs trading Nasdaq securities?
The ISG has been an effective model for NYSE-listed securities traded across diverse markets. ISG participants have concurrent jurisdiction over intermarket surveillance investigations. As of the end of May 20035, there were 24 open investigation dealing with insider trading, one dealing with trading ahead of research, one dealing with short sale/ market manipulation; all involve cooperation between the NYSE, NASD and a regional exchange, in NYSE-listed securities. Responsibility is assigned among ISG members in order to ensure that SROs adequately share surveillance information and coordinate inquiries and investigations designed to address potential intermarket manipulation and trading abuses. Furthermore, one ISG participant can obtain information from any other participant such as pertinent market data or identity of the beneficial owner of an account, needed in the course of an investigation. Such information can be shared with a requesting ISG member without any legal barriers, such as bank secrecy laws or "blocking statutes." Furthermore, the ISG coordinates surveillance, investigations and the exchange of market data among the SROs, such as daily audit trail information, short interest data, and other surveillance information for regulatory purposes.
The system of self-regulation, with layered regulatory responsibilities cascading from the federal government to self-regulatory organizations and member firms, has proven effective for NYSE-listed securities. This interaction of industry regulation and government has been effective in the past and has adapted responsibly and quickly when abuses have been detected.
Allocation of Regulatory Costs
The Commission seeks comments on the following matters:
Q1. Should proceeds from the Nasdaq UTP Plan be withheld to pay for regulatory costs?
The funding of regulation should be independent of the market data consortia. SROs have a variety of ways of assessing the costs of regulation against their members and other constituents.
Q2. Would Nasdaq's proposal to aggregate and deduct regulatory costs from market data revenue result in adequate regulation? If so, what costs would appropriately be considered regulatory costs and therefore, appropriately deducted from the market data revenue?
Each market is responsible for a fair allocation of costs among its members and other constituents. Regulation should not be limited by market data revenues. The NYSE, for example, funds regulation by assessing regulatory fees on its members and broker-dealer member organizations. In contrast, market data fees are paid by non-member broker-dealers and institutional investors as well as member broker-dealers. Tying the funding of particular costs to particular revenue sources at other than the SRO level would create rigidities that may lead to misallocation of resources.
Q3. Should other methods of fairly allocating regulatory costs be considered?
The Commission, through oversight and joint regulatory programs with SROs, assures a regulatory agenda to fulfill statutory responsibilities. To that end each SRO is obligated to allocate sufficient funding of human and technology resources. This model, in place since 1934, has worked well for NYSE-listed securities.
Q4. Should the NASD be required, as suggested by the CSE, to alter its systems to include more data from inter-market trading to improve inter-market surveillance? If so, who should pay for this enhancement?
Enhancements to audit trails have been suggested in the past and agreed to within the ISG framework, with development costs and production costs allocated according to agreed distribution based on usage. This framework might provide a model.
Q5. Who would determine what are legitimate regulatory costs? On what basis should such a determination be made?
The Commission has previously taken the position that adequate staff and funding for regulation is the responsibility of each SRO. Any market that advertises a sum spent on regulation should be able to document the classification of regulatory costs. In the listed market, there is no need to pool regulatory costs.
Regulation of Exchange-Listed Securities
The Commission seeks comments on the following matters:
Q1. Do commenters believe that there is unequal regulation of exchange-listed securities among the markets trading such securities? If so, do commenters believe that the proposals made by Nasdaq with respect to Nasdaq securities would address such unequal regulation in the listed markets? If not, what other approaches do commenters recommend?
There is significantly less fragmentation in NYSE-listed securities than in the over-the-counter market. Accordingly, there is no basis for attributing either the problems or the proposed solutions of the over-the-counter market to the much larger market for NYSE-listed securities. With respect to the markets in NYSE-listed securities, the NYSE serves as the designated examining authority with respect to all its member firms. We would certainly accept the responsibility of being the sole examining authority with respect to our member firms.
Alternatives such as competitive bidding do not align institutional motivations with regulatory efficacy and productivity, distance market regulation from market function and attenuate accountability from the federal regulatory framework of SROs.
Consolidated Order Audit Trail
Q2. Should the Commission require an intermarket consolidated order audit trail system for Nasdaq-listed and exchange-listed securities, other than options?
The Commission has previously approved order audit trail systems for the NASD Order Audit Trail System ("OATS")6 and the NYSE Order Tracking System ("OTS"). 7 The Commission approved the NYSE OTS to provide an accurate, time-sequenced record of orders, quotations and transactions, beginning with the receipt of an order by any NYSE member firm, and documenting the life of the order through the process of execution or cancellation of that order. The NYSE understands that the NYSE order tracking rules approved by the Commission are comparable to NASD rules approved by the Commission.
Since the Commission believes this is an effective and necessary regulatory tool, it can require other market centers to systematize tracking of orders. In the event all market centers are required to similarly track orders, the order audit trail could be linked in the same fashion as the transactions audit trail is linked in the ISG consolidated audit trail. The ISG Consolidated Equity Audit Trail ("Equity Audit Trail") was developed by the ISG participants to provide a consolidated view across all markets not only of quotes and trades, but also of the clearing information for each of those trades. As recently as March 2003, Nasdaq securities were added to the ISG Consolidated Audit Trail. The ISG Equity Audit Trail provides a useful supplement to individual market's data.
If you have any questions, please feel free to call Catherine R. Kinney, President, at (212) 656-8330 or Edward A. Kwalwasser, Group Executive Vice President (212) 656-6537.
c: Chairman William Donaldson