O P T I M A R K
530 Main Avenue, Durango, CO 81301 TEL: (970) 247-8800 FAX: (970) 247-8844
October 6, 1997
Jonathan G. Katz
U.S. Securities and Exchange Commission
(Mail Stop 6-9)
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Concept Release; File No. S7-16-97
Dear Mr. Katz:
OptiMark Technologies, Inc. ("OTI") appreciates the opportunity to provide the Securities and Exchange Commission ("Commission" or "SEC") with comments on the Commission's concept release regarding technological change and market regulation ("Release"). 1 We are a computer technology firm located in Durango, Colorado that has developed a new approach to the processing and handling of trading information known as "OptiMark TM" for application in the securities industry. In this context, we have been playing an instrumental role in developing a new trading system based on our technology on behalf of a U.S. registered securities exchange. 2
The Release represents an important step toward formulating an appropriate regulatory response to technological innovations that are changing our nation's securities markets. We commend the Commission and its staff for initiating a dialogue about these developments affecting domestic and cross-border trading. As discussed below, OTI believes that the issues raised by technology require a flexible solution that supports innovation and diversity in trading systems while maintaining minimum standards necessary to ensure investor protection and a fair field of competition. A regulatory approach based on rigid classifications between markets and intermediaries, and between onshore and offshore investment activities, will not provide an enduring framework for addressing new means of trading made possible by emerging technologies.
I. Domestic Markets
A. Policy Objectives and Regulatory Approach
The Commission long has sought to encourage and accommodate changes in the markets resulting from technological innovations. In a comprehensive study of the securities markets in 1963 ("Special Study"), it affirmatively embraced the application of automation technology to the over-the-counter market, thereby helping to guide the development of a new organized dealer market later known as the Nasdaq Stock Market. 3 The Special Study also laid the groundwork for the 1975 legislation mandating the development of a national market system ("NMS"). In adopting Section 11A of the Securities Exchange Act of 1934 ("Exchange Act"), Congress expressly found that "new data processing and communication techniques" furthered the NMS objectives. 4 Consistent with such earlier findings, the Release attributes the "phenomenal growth" in the U.S. securities markets to a "vastly greater number of investment and execution choices, increased market efficiency, and reduced trading costs" made possible by technology. 5
The phrase "national market system" is not specifically defined in the Exchange Act. Although Congress considered specifying the components of an NMS, it ultimately rejected such a proposal, granting instead "broad, discretionary powers" to the Commission to oversee the development of an NMS. 6 This mandate, however, was not intended to turn the Commission into an "economic czar." 7 Rather, its "basic role" would be to "remove burdens on competition which would unjustifiably hinder the markets natural economic evolution and to assure that there is a fair field of competition consistent with investor protection." 8
Consistent with the statutory framework, and in exercise of its broad discretionary authority, the Commission has determined in the past that certain computerized trading systems are best regulated as broker-dealers, rather than as exchanges, and that such treatment preserves their positive contributions to an NMS -- i.e., competition, innovation, and reduced costs. The Release seeks to re-evaluate the NMS implications of these "alternative trading systems" ("ATSs" ) 9 in light of their increased use and the perceived weaknesses with the current regulatory approach. In so doing, the Release discusses two alternative ways of regulating ATSs -- the tiered-exchange approach versus the enhanced broker-dealer approach.
OTI believes that both approaches may provide a useful regulatory framework, provided that they are structured and applied flexibly to support innovation and diversity in trading systems. Technology allows both broker-dealers and exchanges to experiment with new systems that provide more service at lower cost. 10 Neither the statute nor the legislative history suggests that securities transactions must be intermediated by, or exposed to, members of a registered securities exchange. 11 Indeed, quite to the contrary, the statute specifically seeks to maximize the opportunity for customer orders to be executed without any dealer intermediation in order to enhance the opportunity for economic efficiency and best execution. 12 Innovative trading systems furthering these objectives, irrespective of whether they are labeled broker-dealers or exchanges, are consistent with the public policy behind an NMS.
Accordingly, OTI believes that, subject to basic standards necessary to assure investor protection, market participants should be permitted in general to avail themselves of technological innovations without first obtaining regulatory approval. Under such a "standard-oriented" approach, sponsors of start-up systems would choose the regulatory classification that most suits their business objectives and marketing needs, in a manner consistent with investor protection. Traditionally, the broker-dealer regulatory framework has been viewed by many as an "appropriate way to regulate, and as a means of fostering the development of, these systems." 13 The new tiered-exchange approach, however, if it is accompanied by clear, objective criteria for exemption that can be readily applied and complied with, may serve as an alternative regulatory framework for those who find the cost associated with being a broker-dealer too high, given the particularities of their customer relationships and operational characteristics.
In short, we urge that the Commission allow sufficient flexibility in its future regulatory approach to support innovation and diversity in trading systems. 14 The traditional emphasis on the dichotomy between broker-dealers and exchanges -- whether it is based on their form or function -- overlooks the continually evolving nature of the securities industry as a whole. As dictated by the NMS principles, the Commission, instead, should emphasize the need for, and encourage development of, technological innovations, such as OptiMark TM, that maximize order interaction between retail and institutional investors without dealer intervention, all in a manner consistent with the ability of markets to obtain access to one another. Such systems enhance the opportunity for best execution for the benefit of the public. The question of their exact regulatory classification should continue to be informed and guided by recognition of this overriding public interest.
B. Regulation of ATSs and Specific Areas of Concern
Consistent with a standard-oriented approach discussed above, OTI believes that, to the extent that the operation of any particular system raises specific regulatory issues, they should be addressed on a case-by-case, or functional, basis. Such a solution would take into account the special aspects of the systems impact on and interaction with the existing markets. In this regard, OTI shares some of the concerns expressed in the Release about the existing ATSs and their regulation. While we agree that the current approach raises certain questions about how to ensure fair access, 15 transparency, 16 surveillance, 17 and capacity, 18 we also believe that not all of these issues require further regulation, as discussed in more detail below.
1. Fair Access. OTI believes that ATSs should not discriminate arbitrarily against any particular market participant. In particular, we believe that an unreasonable denial of access by an established system with a significant market share raises legitimate public policy concerns about anti-competitive behavior. At the same time, however, requiring all ATSs to allow any and all non-participants to execute against orders of system participants would have a chilling effect on the development of new technology.
Accordingly, it is important to strike an appropriate balance between the regulatory concern about unfair denial of access and the legitimate business need for monitoring customer relationships. Such monitoring allows the sponsor of new technology to limit credit, settlement and clearance exposure as well as to recover its costs and earn a reasonable profit. In other words, the Commission should not turn a legitimate concern regarding "unfair" denials of access by participants with market power into a new, expanded duty to serve any and all. Such an outcome will force essentially all ATSs into becoming public utilities.
2. Transparency. Transparency (i.e., public quotations and transaction reports) is often viewed as a way to obtain price discovery and facilitate order interaction to ensure best execution. In this regard, quote transparency, in our view, is sometimes treated as if it were the same as best execution -- especially in the context of a continuous auction market. Such usage, however, confuses a means with an end. Continuous auction trading principles and quote transparency represent important regulatory tools utilized to further the public interest. They are not ends in and of themselves, however. Indeed, maximizing order interaction, thereby facilitating price improvement, does not require that any and all trading interest -- e.g., block-size institutional orders, indications of interest, or contingent expressions of trading interest for a call market facility -- be included in the public quotation system. Nor does it require that any and all trading interest of every market participant, regardless of that participants wish, be readily accessible to every other participant.
Mandatory disclosure of pre-trade information could be both misleading and harmful. Block traders, for example, would be unable to execute their orders in an orderly and stable fashion. 19 In addition, because orders placed by professional money managers may reflect market-sensitive research recommendations, requiring pre-trade disclosure of such proprietary information would stifle the private incentive for conducting research. Over time, such an outcome would lead to reduced efficiency and liquidity. In fact, there are reports today that the very necessity of disclosing the trading intentions of institutions may have led, in some cases, to withdrawal of the very orders necessary for operation of efficient and liquid markets. 20
Accordingly, it is important to understand the legitimate need for, and role of, technological innovations, such as OptiMark TM, that assure confidentiality and anonymity to users. Designed to meet the institutional investors' need for a secure medium, OptiMark TM allows users to express the full extent of their trading interest without fear of provoking an adverse market effect. At the same time, it provides for increased order interaction by facilitating a (1) release of previously hidden trading interest of institutional investors and (2) mix between such newly released institutional trading interest and traditional retail order flow. The result of such order interaction is increased liquidity and enhanced opportunity for price improvement -- clearly, a desirable regulatory outcome made possible by technological innovation, not by mandatory disclosure of pre-trade information.
3. Surveillance and Capacity. OTI believes that, as a general matter, automated trading systems pose substantially less threat of market manipulation, because execution is based on a deterministic computer algorithm. The ready availability of detailed electronic information at every step of the trading process promises improved oversight to detect any patterns of abusive trading. Indeed, just the threat of detailed, after-the-fact data analysis and processing to detect improper conduct is a material deterrent to such conduct. To the extent that surveillance is a legitimate area of concern with some ATSs, OTI believes that it can be best addressed by requiring them to provide improved audit trails.
Similarly, we believe that there is sufficient market incentive already in place to assure adequate capacity for most new trading systems, because capacity is an integral part of customer service and market competition to attract order flow. Slow, repeatedly unavailable systems quickly will lose their customers. Moreover, given the insignificant market impact associated with the vast majority of ATSs, inaccessibility to such systems should not become a matter of significant regulatory concern. We believe that specific regulatory intervention is necessary only in the event that market forces actually are found to be inadequate due to the anti-competitive behavior by those with significant market effects. Imposing mandatory inspection and enforcement programs across the board as a prophylactic measure only will stifle competition and innovation, with no clear gains in transparency and access.
C. Other Areas of Domestic Market Regulation
In addition to addressing the issues raised by the ATSs, OTI believes that the Commission should examine the following areas in the current regulatory framework with a view toward revising outdated rules to reflect and accommodate technological innovations.
1. Simplifying the SRO Rule Filing Process. OTI agrees that the time-consuming process associated with soliciting and reviewing public comments for rule filings submitted by self-regulatory organizations ("SROs") may prevent them from responding to competitive pressure from ATSs. Although we very much appreciate the hard work and good-faith efforts by the Commission's staff in reviewing the proposals for new trading systems, when compared to the existing regulatory approach for ATSs (which are reviewed by the staff on a no-action letter basis), the SRO rule filing process is, without question, substantially more burdensome. Indeed, the legal and administrative cost associated with such a process may serve as a material deterrent to innovation. The Commission should act quickly in the future to take appropriate steps to expedite review of SRO programs that are designed to implement new trading systems -- in particular, during the developmental and initial operating stages. This approach will allow registered securities exchanges and associations to sponsor trading services based on important technological breakthroughs, such as that represented by OptiMark TM, on a level-playing field with broker-dealers.
2. Curbing Unfair Trading Practices. We support the recent efforts by various SROs to reduce the minimum price increment requirement, thereby removing artificially wide spreads. With the eventual transition to decimalization, even narrower spreads are expected in the future. While this is an important step intended to benefit investors in general, OTI believes that it also warrants enhanced oversight of market professionals who may seek to take advantage of the new rule in unexpected ways. For example, we are concerned that professional traders may take advantage of the steadily decreasing minimum price increment in the future to trade ahead of existing customer bids by purposefully submitting bids that are priced only slightly higher. Such abuse of the traditional price and time priority principles would be unfair to public investors whose orders are outbid by those that come much later in time but are able to adjust their bids more quickly. In general, OTI believes that the Commission should continue its vigorous efforts to ensure fair treatment of public investors.
II. Cross-Border Trading
A. Policy Objectives and Regulatory Approach
With increasing amounts of investment capital being placed globally, there is a growing need to conduct foreign securities transactions in an efficient manner. OTI believes that U.S. investors would benefit significantly from having clear guidelines whereby they could take advantage of new technology to enter and execute their orders electronically on foreign markets from the United States. As acknowledged by the Commission itself, the lack of regulatory guidance in this context has discouraged foreign markets from providing U.S. investors with electronic access to their trading systems. 21
From a purely market oversight perspective, we believe that there is no compelling public policy reason why electronic trading systems properly regulated overseas by a bona fide foreign regulatory authority should not be allowed to operate domestically, 22 when U.S. investors already are trading on that market. As expressly recognized by Congress in the 1975 legislation calling for an NMS, technology helps reduce the necessity and cost of interpositioning market intermediaries in the trading process. We urge that the Commission actively encourage cross-border trading activities by adopting a flexible regulatory approach that facilitates U.S. investors' direct access to foreign exchanges and their electronic trading systems.
B. Direct Access Providers and Foreign Securities
In providing regulatory guidance to address the activities of foreign markets and other providers of direct access, it is important for the Commission to strike an appropriate balance between the economic benefits of direct access and the traditional concerns of investor protection. The Commission should not impose any burdensome or unnecessary requirements that will deprive U.S. investors of opportunities to take advantage of technological innovations taking place outside the United States. OTI is concerned that such an outcome will place them at a competitive disadvantage to the detriment of our national interests.
In this regard, the investor's decision to automate the order routing process to a foreign market, (in contrast to traditional, manual access via telephone calls to a broker-dealer), should be supported because it achieves efficiency in order management and reduces overall transaction costs. Indeed, the Commission traditionally has favored such automation in the trading process, allowing, for example, orders to be routed electronically to the New York Stock Exchange -- e.g., through an electronic linkage to the SuperDOT system, rather than contacting a U.S. member firm by telephone. Likewise, OTI believes that the Commission should adopt a flexible approach in the future that will facilitate foreign markets and other access providers to offer these valuable automation services to U.S. investors.
OTI is mindful that the Commission's decision to enhance the opportunity for cross-border trading in this manner may raise questions about the risk associated with investing in securities of foreign issuers that do not meet the U.S. disclosure standards. With the continuing globalization in investment opportunities, more and more U.S. investors today are seeking out foreign markets in one form or another, raising concerns whether companies listed on such markets provide adequate corporate information. We agree that these concerns of investor protection are valid issues requiring further deliberation by the Commission. We also believe, however, that U.S. investors' access to improved technology and better communication should not be impeded in an effort to force foreign markets and issuers to comply with the U.S. disclosure standards. After all, the introduction of new electronic communications facilities that automate the order routing process does not, in and of itself, create new corporate disclosure questions.
In short, the Commission should not restrict the ability of U.S. investors to take advantage of technological innovations, based on the traditional notions of onshore versus offshore investment activities. As in the NMS context, "new data processing and communication techniques" providing U.S. investors with direct access to foreign markets will deliver more service at lower cost. OTI, therefore, urges the Commission not to impede the progress of technology and instead to support automation in the context of cross-border trading.
As confirmed by experience, no single market structure can best serve the needs of every type of investor and market participant. It is thus important for the Commission to adopt a flexible approach that encourages competition in execution services while responding to the specific consequences of that competition, both domestically and internationally. A regulatory approach based on rigid classifications between markets and intermediaries, and between onshore and offshore investment activities, will not provide an enduring framework for addressing new means of trading made possible by emerging technologies.
We hope that our comment will prove useful to the Commission and its staff in their
assessment of the impact of technology and their ongoing efforts to formulate an appropriate response. If the staff has any questions, please do not hesitate to contact us.
[ Optimark Logo ]
William A. Lupien Chairman and Chief Executive Officer
CC: Chairman Levitt
Commissioner Designate Carey
Commissioner Designate Unger
Richard R. Lindsey, Director of Market Regulation
Robert L. D. Colby, Deputy Director of Market Regulation
Howard Kramer, Associate Director of Market Regulation
Belinda Blaine, Associate Director of Market Regulation
Kristen Geyer, Special Counsel, Division of Market Regulation
Mark P. Tellini, Counsel to the Chairman
-- / See Securities Exchange Act Rel. No. 38672 (May 28, 1997), 62 Fed. Reg. 30485 (June 4, 1997).
-- / The Commission recently approved the proposal by Pacific Exchange, Inc. ("PCX") to operate the PCX Application of OptiMark TM . See Securities Exchange Act Rel. No. 39086 (Sept. 17, 1997), 62 Fed. Reg. 50036 (Sept. 24, 1997).
-- / See SEC, Report of Special Study of Securities Markets, reprinted in H.R. Doc. No. 95, 88th Cong., 1st Sess. (1963).
-- / See 15 U.S.C. § 78k-1 (a)(1). The NMS objectives as articulated by Congress are as follows: (1) economically efficient execution of securities transactions; (2) fair competition among broker-dealers, among exchange markets, and between exchanges and non-exchange markets; (3) the availability of information regarding quotations and transactions; (4) the practicability of best execution of investors' orders; (5) the opportunity, consistent with economic efficiency and best execution, for execution of investors' orders without any dealer participation. See id .
-- / See Release, 62 Fed. Reg. at 30486.
-- / See Senate comm. on Banking, Housing and Urban Affairs, Report to Accompany S. 249, S. Rep. No. 94-75, 94th Cong., 1st Sess. 7, reprinted in 1975 U.S. Code Cong. & Ad. News 179, 185 ("Senate Report").
-- / See id . at 195.
-- / See id . at 190.
-- / The term "alternative trading systems" refers to any "automated systems that centralize, display, match, cross, or otherwise execute trading interest, but are not currently registered with the Commission as national securities exchanges or operated by a registered securities association." See Release, 62 Fed. Reg. at 30485, n.1.
-- / As acknowledged by the Commission itself, at a practical level, most technological innovations "combine the functions of brokers and exchanges" such that their status eludes simple classification. See id . at 30508, n.134. Indeed, given the rapid pace of technological change, any attempt to classify them into one or the other will not prove to be an enduring approach, because it assumes that a given system will be regulated in one way or another because of certain limitations in the system. Such limitations ultimately will have no necessary technical basis.
-- / In empowering the Commission to oversee the development of an NMS, Congress did not specify whether innovations in technology should be classified as broker-dealers or exchanges.
-- / Section 11A of the Exchange Act specifically refers to "offsetting of investors' orders" and "markets other than exchange markets" in setting forth the framework for an NMS. See 15 U.S.C. § 78k-1(a)(1)(C).
-- / See Release, 62 Fed. Reg. at 30499 (citation omitted).
-- / In this regard, we are concerned that the Commission's proposed re-definition of the term "exchange" will force all ATSs into the "tiered-exchange" model. The more flexible, market-oriented framework that OTI favors would allow market participants the maximum flexibility to choose whether to operate as a broker-dealer or a tiered exchange.
-- / The Commission stated: "Under the current regulatory approach, . . . there is no regulatory redress for unfair denials or limitations of access by alternative trading systems, or for unreasonably discriminatory actions taken against, or retaliatory fees imposed upon, participants in these systems." See Release, 62 Fed. Reg. at 30492.
-- / The Commission stated: "Because a majority of trading interest on alternative trading systems is not integrated into the national market system, price transparency is impaired and dissemination of quotation information is incomplete." See id . at 30493.
-- / The Commission stated: "Although the broker-dealers that operate many of the alternative trading systems have certain obligations to individual customers, because these systems are not SROs, they do not have the same market-wide enforcement and surveillance obligations as registered exchanges and the NASD." See id .
-- / The Commission stated: "Even though they have significant trading volume, under the current regulatory scheme ECNs and other alternative trading systems are not required to have sufficient computer capacity to meet ongoing trading demand or to withstand periods of extreme market volatility or other short-term surges in trading volume." See id . at 30494.
-- / As recognized by the Commission, a trader seeking to execute a block reasonably may conclude that, by reason of the size of the order in relation to market conditions, "it is in the interest of the customer to search and negotiate for a matching interest on the other side of the market (including negotiating as principal with the customer), rather than to accept or submit a bid or offer in the ordinary course of the auction market." See Exchange Act Rel. No. 15533 (Jan. 29, 1979), 44 Fed. Reg. 6084 (Feb. 7, 1979) (adopting rules under Section 11(a) of the Exchange Act).
-- / See , e.g. , Greg Ip, " Trading Costs Rising Along with the Market ," Wall Street Journal, June 9, 1997, at C1.
-- / See Release, 62 Fed. Reg. at 30522 (noting that "the lack of regulatory guidance in this context has discouraged other parties from offering U.S. persons foreign market access").
-- / Of course, OTI understands that it may be necessary to ensure certain minimum standards -- such as consent to jurisdiction and information sharing -- are observed.