|SMITH LODGE & SCHNEIDER|
|55 WEST MONROE STREET|
|RAYMOND J. SMITH||CHICAGO, ILLINOIS 60603||KIMBERLY L. AHLGRIM|
|KENNETH M. LODGE||TELEPHONE (312) 853-3230||THOMAS J. CUNNINGHAM|
|DAN W. SCHNEIDER||FACSIMILE (312) 853-3127||KRISTIN M. DAVIS|
|PATRICK J. CULLINAN||OF COUNSEL:|
|JEFFREY T. BROWN*||MICHAEL B. NASH|
|PAUL S. GERDING|
October 08, 1997
VIA ELECTRONIC TRANSMISSION
AND REGULAR MAIL
Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549
Re: File No. S7-16-97
Dear Mr. Katz:
We are writing on behalf of our client, Block Trading, Inc., ("Block") in response to the U. S. Securities and Exchange Commissions ("Commission's") Concept Release 1 and request for comment concerning the oversight and regulation of alternative trading systems or electronic communication networks (hereinafter "ATSs" or "ECNs"). 2 While the release discusses a broad range of issues related to the regulation of ATSs, this letter will focus on the issues raised by Questions 24, 25, 26, 49, 94, and 97 of the Concept Release. Specifically, the letter will address the business and competitive necessity of access to quotations displayed by significant ATSs, the lack of regulatory redress under the present structure for discriminatory actions of, and inequitable fees charged by, broker-dealer sponsors of ATSs, and the problems of denial of access by ATS operators, which impedes the ability to obtain the best execution of customer orders. 3
In addition, we will address how the recent Commission actions with respect to trading on the Nasdaq market relate to the issues raised by the Concept Release. Block believes that both the intent and effect of recent NASD rule changes related to Small Order Execution System ("SOES") executions continue the anticompetetive practices identified by the Commission in 1996. While the NASD has taken corrective measures, the expanding ability of Nasdaq market makers to avoid executions against orders of SOES customers though the use of Instinet Corporation ("Instinet") facilities perpetuates these anticompetitive practices. We believe that the present regulatory structure for "significant impact" ATSs fails to promote a competitive environment for brokers-dealers needing access to these ATSs and inhibits their ability to obtain the best execution of customer orders. These ATS must become subject to the regulatory structure applicable to self-regulatory organizations, which has led the U.S. exchange and securities association markets to become the greatest in the world.
1. Access to alternative trading systems as an important goal that the Commission should consider in regulating such systems.
In 1975, Congress directed the Commission to use its authority granted under the Securities Exchange Act of 1934 ("Exchange Act") to facilitate the development of a national market system ("NMS") for securities and to promote the goals of economically efficient securities transactions, fair competition, and best execution. Congress granted the Commission "broad, discretionary powers" and"maximum flexibility" to develop the NMS and to carry out these objectives. 4
With the technological advancements over the last twenty years, the NMS now offers efficient, low cost executions of orders through linked markets. Yet, as pointed out in the Concept Release, technological advancements have also led to public customer inability to obtain the best execution of their orders. Limitations on access through NMS facilities to ATSs which display better prices than are displayed in exchange or securities association systems have been and continue to be an impediment to the fulfillment of the congressional directive in the 1975 amendments. This problem is increasingly acute as significant ATSs control an expanding share of quote-and-order flow.
Last year the Commission acted on the growing concern about the treatment of customer orders within NMS facilities. The Commission adopted a new rule requiring the display of customer limit orders ("Display Rule") and amended the rule governing publication of quotations ("ECN Amendments") (together the "Order Handling Rules"). 5 In the Order Handling Rules, access to orders resident in ATSs for execution by customers of broker-dealers generally was a specific goal of the Commission. The dissemination of limit orders pursuant to the Display Rule fosters greater transparency and has lead to improved interaction of customer orders without the intervention of dealers. The ECN Amendments require a market maker or specialist to make publicly available the price of any order it places on an ECN if that price is superior to its own published quote. 6 The "ECN display alternative" to the ECN Amendments relieves the market maker from this requirement if the ECN that displays the superior quotations ensures that the superior quotations are communicated to the public quotation system and requires that non-participants in the ECN system be provided access to displayed orders. The Commission went further by requiring that access must be "equivalent access," i.e., access that would have been available for executions in the relevant security if the prices had been published in the market maker's or specialist's quotation. 7
We believe that the Commission addressed the issue of ATS access in the Order Handling Rules. 8 Whatever regulatory framework evolves out of the Concept Release, full and fair access to the best prices in order to achieve best execution for customer orders must drive Commission regulatory policy. "Closed" or exclusive ATS facilities where an ATS has a significant share of order quote activity is not consistent with a fair, orderly, and open market structure.
2. Criteria, if any, which alternative trading systems should be able to use to limit access.
The argument has been made that providing open access to ATSs will make trading system innovation prohibitively expensive. In general, Block believes the Commission should promote the development of innovative trading mechanisms by reducing regulatory costs for certain ATSs. If an ATS operator must comply with the full range of regulatory requirements from the origin of its business operations, it is likely that experimentation with new ideas will be stifled.
As discussed in the Concept Release, ATSs that have sufficiently low impact on the market, or that match or cross orders at prices that are primarily or wholly derived from trading on another market ("passive systems"), should not be subject to the same regulatory burdens as significant impact systems. Once ATSs attain significant levels of business or become active in price discovery, they should be required to meet the full range of applicable regulations, including the requirement of fair access. 9 Our comments focus on regulation of significant impact ATS.
3. The Commission should be concerned about the nature and degree of access to an alternative trading system that has arranged for its quotes to be displayed as part of the public quotation systems.
The mere inclusion of ATS prices in the public quotation system without a mechanism to access orders at those prices does not go far enough to facilitate the best execution of customer orders. We believe that the wording of the ECN display alternative to the Quote Rule makes this clear. The ECN display alternative permits a market maker or specialist to satisfy its public quotation obligations by using an ECN as an intermediary in communicating to the public quotation system the best prices and sizes entered by such market makers and specialists, provided the ECN ensures "equivalent access" to those prices. By way of example, the Commission stated that "because a market maker with the best price in a Nasdaq-NMS security is subject to SOES executions, this equivalent access condition would require the ECN to provide broker-dealers who use SOES with equivalent automated access to the best priced market maker orders in the ECN." 10 (Emphasis added.)
Unfortunately, ECNs, such as Instinet, are not required to participate in SOES as market makers. The NASD rules implementing the Commissions Order Handling Rules ("Implementing Rules") modified SOES such that if an ECN displayed the inside quote, SOES would return orders to the entering member unexecuted. As a result, ECN inside quotes are not accessible to SOES customers unless the SOES firm has direct access to the ECN. 11
As discussed in a comment letter submitted in response to the NASD proposals to expand the implementation of the Order Handling Rules, the effect of the NASD rule changes undercuts the Commissions actions to enhance Nasdaq pricing efficiency and reduces the ability of SOES customers to obtain best execution of their orders. 12 In the Implementing Rules Adopting Release, the Commission acknowledged the potential risk of the SOES rule change by stating that market makers could enter orders into ECNs to avoid SOES executions. Block believes that this is exactly what is happening en masse. The percentage of time that ECNs drive the inside quote grows with each passing day. According to NASD Preliminary Research, the figures stood at 6% in January, 8% in May, and now have grown to over 13%. At this level, a very material number of SOES customers are excluded from a significant portion of the inside quotes for the Nasdaq market. While the use of SelectNet linkage with Instinet has grown during the same period though to a lesser degree, as discussed below -- SelectNet does not provide "equivalent" access to Instinet, as is necessary for effective executions. Indeed, accessing ECN inside quotations, such as Instinets, through the slow and limiting SelectNet linkage does not meet the standards set forth by the Commission in the Order Handling Rules. 13
Our client believes that NASD market makers and Instinet intended this inefficient result when the SOES rule changes were drafted and when the SelectNet linkage with Instinet was implemented. Given the reported history of discriminatory practices towards SOES firms by the NASD 14 and the fact that approximately 90 percent of all trading activity on Instinet involves NASD market makers, 15 Instinet, without regulatory action, is reluctant to provide open and effective access for SOES firms that might trigger retaliation from Instinet's predominantly market maker participant base. While it is true that Instinet has accepted certain SOES firms as participants (primarily when the SOES firm purchases another broker-dealer that already had Instinet access), Instinet remains an aggressive contributor to the effort to restrict access to market maker quotations on Instinet by SOES firms. Therefore, Block believes that the Commission must be proactive in mandating open, non-discriminatory access to significant ECNs in order to facilitate fair competition among broker-dealers, effective interaction of customer trading interest, and the best execution of customer orders.
4. The Commission should review denial of access claims brought by participants and non-participants in significant impact alternative trading systems even if such systems are regulated as broker-dealers and are subjected to a fair access requirement.
If the Commission decides to maintain the present regulatory approach to broker-dealer-sponsored ATSs, but includes a requirement that the sponsor be subject to a fair access standard, fair access to the ATS in fact must include some mechanism for review of denials of access. Commission review would provide a means of appropriate, if not swift, redress for discriminatory, inequitable, or anticompetetive decisions of broker-dealer ATS sponsors. The availability of such review would promote reasoned, balanced access decisions by ATS sponsors. Conversely, lack of reviewability will leave the unfairly-denied applicant with no reasonable opportunity to rectify arbitrary or discriminatory denials except for costly and time-consuming legal actions through the courts.
Currently, broker-dealer ATS sponsors are required to comply with Exchange Act Rule 17a-23 when operating their trading systems. Rule 17a-23, among other things, requires that broker-dealer sponsors provide the Commission with a description of access criteria established by the sponsor, but does not require the sponsor to deliver information related to reasons for denying specific applicants access to their systems. The Division of Market Regulation ("Division") has recognized this deficiency by adding special conditions to no-action positions granted under Sections 5, 6, 11A(b)(1), and 17A(b)(1) of the Exchange Act. 16 In those letters, the Division has required the broker-dealer sponsor to provide the Staff with, "the identity of persons that have requested to use the System but have not been accepted as Trading Participants and the reasons therefor, as well as a description of the reasons for terminating any former Trading Participants' opportunity to use the System." 17 The additional conditions should have produced a public data base about the denial of access practices of ATS, though it may well be that ATS sponsors routinely do not comply.
If ATS sponsors do not comply, what can the Commission do to protect rejected applicants short of revoking the no-action position -- a measure made unlikely where an ATS, such as Instinet, is market-significant? Even if the no-action letter is revoked, can that action ensure the denied applicant the equitable access opportunity that is essential to its business?
In Block's view, greater predictability and fuller NMS participation could be achieved by treating ATSs as self-regulatory organizations rather than as broker-dealers. At best, maintaining the broker-dealer regulatory framework for ATSs, even with additional measures that permit appeals of unfair denials of access, can only be a stop-gap means of regulation. The more significant a broker-dealer-sponsored ATS becomes in the marketplace, the more the present regulatory structure loses its systemic validity. As a "broker-dealer" becomes a significant market system, the competitive pressures that normally would operate as an antidote to anticompetetive, inequitable, or discriminatory behavior tend to fail; users cannot look elsewhere to conduct business without suffering undue hardship or unreasonable costs. Significant ATSs may well be "essential facilities." Thus, under a broker-dealer regulation model, wherever a particular ATS is market-significant, Commission review decisions, like judicial antitrust regulation, would have to operate case-by-case, producing non-standardized consequences. If ATSs are subject to the exchange registration/regulation/oversight regime, fair access becomes a standard and recognizably administrable part of market structure oversight under the Exchange Act.
5. Unfair denials of access by broker-dealers operating alternative trading systems where there are no alternative trading venues available.
It is common knowledge that SOES firms face discrimination and anticompetetive behavior from trading system sponsors, such as Instinet, as well as from the NASD. It is not surprising then that Block has been unable to obtain access to Instinet facilities and services after nearly one year of fruitless overtures. Instinet, as a broker-dealer, has been able to establish arbitrary, diseconomic, and unacceptable restrictions and conditions on access with no real fear of regulatory oversight. This occurs because Instinets primary regulator, the NASD, reportedly for years engaged in a pattern of discriminatory behavior towards those broker-dealers most in need of access -- broker-dealers that seek legally to trade through the NASDs SOES automated execution system. 18
Our client recognizes that the NASD has taken significant steps to rectify its governance and regulatory structure to curb the activity cited in the 21(a) Report. The creation of NASD Regulation and the balance of industry and non-industry membership on the NASDs (or its subsidiaries') regulatory committees will surely improve the regulatory environment for SOES firms. However, as discussed above, Instinet continues to buttress and reflect the discriminatory behavior and attitude of its dominant participants, NASD market makers.
The issue of access to market maker or specialist quotations was underscored last year when the Commission adopted the Order Handling Rules, which are designed to ensure that comprehensive quotation information is available to the public. Theoretically, these amendments could have triggered changes in Instinet's discriminatory behavior. Indeed, Instinet claims to have provided access by linking with the NASDs SelectNet system, thereby giving non-participants who are NASD members an alternative venue through which quotations may be accessed. 19 Moreover, Instinet represented in its letter requesting no-action that "Instinet intends to respond to directed SelectNet orders as promptly as it now responds to orders directed by RTTS (Instinets trading service) customers to execute against orders displayed within the RTTS." 20 Unfortunately, however, the "equivalent" access that is required has not been achieved.
SelectNet access to Instinet fails to be "equivalent" in two ways. First, Block indicates that the Instinet response time to SelectNet orders directed to Instinet is materially slower than the response time for orders directed to Instinet by Instinet participants. In the Divisions letter dated June 30, 1997, extending Instinets no-action position as an ECN, the Division expressed particular concern with the response time representations made by Instinet regarding both the maximum response time and the equivalence of SelectNet and internal response time. 21 The Division sought an explanation of the response time problems and a demonstrable commitment to correct them. The record does not show either an explanation or a commitment.
The response time lag is confirmed by Andrew Baxter, Executive Vice President of Instinet, in an October 1996 article in Equities Magazine, where he discussed the availability of orders to non-customer broker-dealers, and stated that "they (non-customers) dont have the time advantage that somebody who is an Instinet customer has...." 22 Whether the differences are the product of Instinet's calculated non-compliance or not, the fact remains that there are anticompetetive differences in the two response times, that these differences are material, and that these differences contradict Instinets representations to the Division made earlier this year.
Second, the costs of directing orders through SelectNet to access Instinet are substantially higher. This is largely because non-participants are not granted volume price discounts, which are available only to Instinet participants, and because non-participants must pay an access fee of $2.85 each time SelectNet is accessed. Currently, only SelectNet links with Instinet and its link is not equivalent to that of direct Instinet participants. With Instinet handling nearly 20% of the Nasdaq volume, a non-participant broker-dealer that must access the Instinet system on a regular and continuous basis in volume to provide best execution for its customers faces substantial cost disadvantages relative to competing broker-dealers that are given both access and discounts as Instinet participants. A broker-dealer's ability to successfully compete and to comply with its best execution responsibilities, therefore, is placed in jeopardy at the hands of Instinet.
Instinets arbitrary and discriminatory access and pricing policies, coupled with the lack of effective regulatory redress available to denied applicants or terminated participants, makes it imperative that the regulatory structure be changed. In 1989, Instinet stated in its no-action request letter that its, "openness of access to market makers, specialists, broker-dealers, and issuers is a central distinction between Instinet and exchanges (which) much reduces the need to regulate Instinet as an exchange." 23 With "openness" non-existent on Instinet, the time has come to alter the regulatory structure to apply the exchange registration, regulation, and oversight requirements to Instinet and other significant-impact ATSs.
SMITH LODGE & SCHNEIDER, CHTD.
Jeffrey T. Brown
-- Securities Exchange Act Rel. No. 38672, 62 FR 30485 (June 4, 1997).
-- The term "alternative trading system" is defined by the Commission to refer to automated systems that centralize, display, match, cross, or otherwise execute trading interest, but that are not currently registered with or regulated by the Commission as national securities exchanges, registered securities associations, or facilities thereof. These systems have been referred to by the Commission in previous releases as "proprietary trading systems,""broker-dealer trading systems," and "electronic communications networks." Rel. No. 38672 at n. 1.
-- A broker-dealerís duty of best execution derives from common law agency principles and fiduciary obligations, and is incorporated both in SRO rules and through judicial and Commission decisions regarding the antifraud provisions of the federal securities law. The duty of best execution requires a broker-dealer to seek the most favorable terms reasonably available under the circumstances. Securities Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 FR 48290, at 48322 (Sept. 12, 1996) (hereinafter the "Order Handling Rules").
-- S. Rep. No. 75, 94th Cong., 1st. Sess., at 7 (1975) ("Senate Report").
-- The Commission stated that, "(I)ntegrating the better prices market makers quote in ECNs should significantly limit the types of uncompetitive practices identified in the investigation without limiting the usefulness of these systems as efficient alternative mechanisms for negotiating transactions." Order Handling Rules at 48308.
-- The Commission recognized that " limited access and transparency to the best prices available undermines the efficiency of our markets and jeopardizes public confidence in their fairness." Id. at Note 223 ( emphasis added) .
-- In the Senate Report, Congress stated that "(the 75 Amendments) would greatly expand the SEC's regulatory authority over the processors and distributors of market information. The goals of this pervasive authority would be to ensure the availability of prompt and accurate trading information, to ensure that these communication networks are not controlled or dominated by any particular market center, to guarantee fair access to such systems by all brokers, dealers, and investors, and to prevent any competitive restriction on their operation not justified by the purpose of the Exchange Act. Supra Note 4 at 9. Without addressing whether low impact or passive systems should be regulated as exempt exchanges or as broker-dealers, we believe such systems should be permitted to operate in a less regulated environment.
-- Supra Note 3, at 48,314.
-- Securities Act Release No. 38156 (January 10, 1997), 62 FR 2415 (January 16, 1997).
-- Comment Letter from Richard Y. Roberts, Reid & Priest to Jonathan Katz, Secretary, Commission (May 12, 1997).
-- For a detailed discussion of the SelectNet/Instinet linkage, see page 8.
-- Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996) (hereinafter the 21(a) Report).
-- Supra Note 3.
-- See, e.g., No-action letter from Sheila Slevin, Assistant Director, Division, to David E. Riggs, Howard & Howard, December 19, 1996.
-- Supra Note 14.
-- Letter from Charles R. Hood, Senior Vice President and General Counsel, Instinet Corporation to Richard R. Lindsey, Director, Division, Commission (Jan. 16, 1997).
-- Letter from Richard R. Lindsey, Director, Division, Commission to Charles R. Hood, Senior Vice President and General Counsel, Instinet Corporation (June 27, 1997).
-- Equities Magazine, Instinet Plays for Sunday , October 1996.
-- Letter from Daniel T. Brooks, Cadwalader, Wickersham & Taft to Richard Ketchum, Director, Division, Commission (April 23, 1989).