August 29, 2001
Mr. Jonathan G. Katz
Securities and Exchange Commission
Mail Stop 5-1
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Nasdaq Stock Market, Inc., Exchange Application: Release No. 44396; File No. 10-131
Dear Mr. Katz:
The Island ECN, Inc. ("Island") appreciates the opportunity to comment on the Nasdaq Stock Market's Exchange Application ("Nasdaq Filing"). In general, Island is supportive of Nasdaq's effort to become a registered national securities exchange. As an entity that itself has filed an application to be a registered exchange, Island believes that the Commission should act expeditiously on all such applications. Ultimately, vibrant competition between multiple market centers will ensure our Nation's equity markets will continue to lead the world
Nevertheless, the Commission has a duty to ensure fair competition between markets and eliminate any unfair advantages that do not serve the best interests of investors. The Nasdaq Filing raises two issues of significance for the Commission in maintaining fair competition between markets. First, given that the proposed Nasdaq Exchange does not have a central limit order book and, therefore, promotes the internalization of customer orders by its members, the Commission must either change its longstanding position that exchanges must have a central limit order book or force Nasdaq to substantially revise its rules. If the Commission approves the Nasdaq Filing, the failure to immediately permit other exchanges to adopt similar rules would unfairly bestow on the Nasdaq Exchange a regulatory granted monopoly. Second, the Nasdaq filing raises important questions regarding what constitutes a transaction on any particular market.
Central Limit Order Book
To date, every registered national securities exchange has been required to maintain a central limit order book that generally ensures time/price priority for all orders sent to the exchange for execution. While the Commission allowed some exchanges to introduce what are essentially competing dealer markets, the Commission still required those markets to maintain central limit order books. Thus, orders routed to registered exchanges are first required to match with any resting limit order on the exchanges' central limit order book.
In contrast, the Nasdaq market has always operated using a decentralized competing market maker system. Executions can occur on Nasdaq without first interacting with orders held by other Nasdaq market participants. Thus, Nasdaq members that internalize customer order flow by either trading as principal (e.g. market makers) or by matching orders (e.g. ECNs) can operate with a degree of autonomy not possible in traditional exchange markets. The primary value of the Nasdaq market is that it allows multiple market participants to trade the same security without being forced, by rule, to interact with orders held by competing market participants within Nasdaq. This feature is critical to ECNs and market makers, and if other markets could operate similarly there would immediately be competition for Nasdaq.
The significance of Nasdaq's lack of a central book is best understood through a short example:
Nasdaq Market Maker A receives a customer order to buy at 50.
Nasdaq Market Maker B receives a customer order to sell at 50.
Market Maket Maker B buys from the customer at 50 while the customer order to buy at 50 held by Market Maker A remains unexecuted.
This simple example illustrates the value of Nasdaq to market makers and specialists. Note that although Market Maker A held a customer order to buy at 50, the customer order to sell received by Market Maker B was not required to be matched with the customer order held by Market Maker A. Instead, Market Maker B was able to interact with (i.e. internalize) its customer's order. If Nasdaq had a central limit order book, the customer order held by Market Maker A would have been matched against the customer sell order received by Market Maker B. Any change to this structure would undermine a market maker's ability to interact with orders that, in many cases, the market maker may have acquired through a payment for order flow arrangement.
Nasdaq is now seeking to become a registered stock exchange but without creating a central book or adopting rules that prevent its members from internalizing its order flow in the same security as do current exchanges. If the Commission approves the Nasdaq Filing in its current form, then the Commission is required, by its mandate to ensure fair competition between markets, to allow each exchange marketplace that wishes to compete on level playing field with Nasdaq, to adopt similar rules. Indeed, it is important to note that the Commission recently denied the Philadelphia Stock Exchange's proposal to increase the ability of its members to internalize options orders similar to how Nasdaq operates in the equity context.
Island supports the approval of the Nasdaq Filing without requiring Nasdaq to implement a central limit order book so long as the current exchanges can adopt similar rules. Island believes that such an environment would create competition between markets, benefiting investors. Currently, the vast majority of the competition between markets for Nasdaq securities occurs within Nasdaq. While this has produced benefits for investors, this has created a virtual monopoly for Nasdaq. By allowing all exchanges to adopt Nasdaq-style trading rules, there will be competition between markets to attract the key revenue generators within Nasdaq: ECNs and market makers. One area of likely competition between exchanges will be the sharing of market revenue with its participants. At present, not only are market participants required to pay Nasdaq for submitting transaction data, but Nasdaq then re-sells the market data for hundreds of millions of dollars. Once a level playing field is established, markets will be forced to share market data revenues with their participants that actually produce the data, lowering costs for market participants and investors alike.
Defining Where An Execution Takes Place
The market structure differences between Nasdaq and traditional exchanges also raise important issues as to what constitutes a transaction in a particular market. These issues are critical to every market since where the transaction takes place determines which market can generate revenues by receiving and reselling the transaction data. On a traditional exchange, transactions occur when the specialist executes the order. Nasdaq, however, is unique since there is no central execution. Island, for example, operates very autonomously within the Nasdaq structure. The vast majority of executions that occur on Island do not involve Nasdaq systems. Island subscribers access Island's trading system via private lines (rather than a Nasdaq system) and are executed by Island's proprietary matching engine (rather than any Nasdaq system). It is only after the execution occurs on Island that Nasdaq becomes involved in the transaction process, as Island is required as a Nasdaq member to report the transaction to Nasdaq. Thus, for a large majority of trades executed on Nasdaq, Nasdaq is only the print facility through which registered broker-dealers can fulfill their SEC imposed trade reporting obligations. To the extent that existing exchanges are permitted by the Commission to change their rules to more closely resemble Nasdaq's proposed rules, these exchanges can begin to compete with Nasdaq by attempting to lure away many of Nasdaq's market makers and ECNs to their competing print facilities.
The Nasdaq Filing reflects Nasdaq's understanding of its rather tenuous value proposition if current exchange markets are permitted to compete on a level playing field for transaction reports. Specifically, in its proposed rules, Nasdaq has proposed a very expansive definition of what constitutes a transaction that must be reported to Nasdaq. By using a very expansive definition, Nasdaq is trying to prevent members from reporting internal crosses or matches to another exchange, preserving hundreds of millions of dollars in transaction and market data revenue. Specifically, proposed rule 4630-1 in the Nasdaq Filing states that a transaction must be reported to Nasdaq if:
Finally, the rules state that a transaction is not effected on Nasdaq and does not have to be reported to Nasdaq if another exchange or the OTC market is the destination, executing market, and liquidity provider.
Since many market participants and commentators find it difficult to penetrate the "legalese" that rules are typically written, it is important to go through a simple example that explains the issue raised by Nasdaq's trade reporting rules cited above.
Market Maker A is a member of both Nasdaq and a Regional Exchange
Market Maker A is registered as a market maker in Microsoft on Nasdaq.
Market Maker A receives an order in Microsoft through a private connection from a broker-dealer and executes the order as principal using its own proprietary system.
In the above example, where should Market Maker A report its transaction? The transaction itself was not effected using the facilities of either Nasdaq or the Regional Exchange. Under Nasdaq's proposed rules, Market Maker A is required to report the trade to Nasdaq by virtue of the fact that Market Maker A is registered as a market maker in that security with Nasdaq. What if the rules of the Regional Exchange permitted or even required Market Maker A to report the transaction to the Regional Exchange? Which market's rules control? More generally, what makes a transaction a Nasdaq trade or a Regional Exchange trade especially when the transaction was an internal cross or match by a broker-dealer? Whatever the answer, the Commission cannot permit Nasdaq rules to answer that question.
Through its proposed rules, Nasdaq is attempting to claim every internal cross or match by a Nasdaq registered market maker or ECN as a Nasdaq transaction, irrespective of whether a Nasdaq system is involved or whether the market maker or ECN is also a member of another exchange. If, in the example above, the Nasdaq Market Maker was simultaneously registered in the same security on the Regional Exchange as well as Nasdaq, Nasdaq still requires the member to report the trade to Nasdaq.
In addition, Nasdaq's Filing defines a Nasdaq trade in terms of what does not need to be reported to Nasdaq. Specifically, the proposed rules state that Nasdaq members are not required to report transactions if another exchange is the: 1) destination; 2) executing market; and 3) liquidity provider. In short, the proposed rules define what constitutes an exchange transaction. Nasdaq, itself, however, does not meet its own definition of what constitutes an "exchange" transaction. As noted above, many of the transactions reported to Nasdaq are internal crosses or matches. In such cases, Nasdaq cannot be characterized as the destination, executing market or liquidity provider.
Finally, the effect of the proposed trade-reporting rule is to define what is an exchange transaction for Nasdaq members. Allowing Nasdaq to define in its own rules what constitutes a transaction on another market, however, is beyond the authority of Nasdaq and the Commission must abrogate any such rule.
From the perspective of the Commission, whose mission is to protect investors, it should not make any difference to which market a transaction is reported. Each market is required to comply with Commission rules and fulfill obligations to ensure compliance with federal securities laws. Thus, the issue of where a transaction takes place becomes an economic issue for market participants. The Commission must not interfere with market forces and should only act to prevent any exchange from adopting rules forcing a member to report internalized crosses or matches to a specific market such as Nasdaq has proposed in its exchange filing. An internal cross or match does not occur on any market but on the facilities of that member. In fact, this is recognized by the Commission's Order Execution Disclosure Rules. Therefore, the solution to the issue of where a transaction occurred is to give the market participant discretion to report the transaction to whichever exchange it deems appropriate.
Island supports the approval of the Nasdaq Filing without requiring Nasdaq to implement a central limit order book so long as the current exchanges can adopt similar rules. Further, the Commission should not approve the Nasdaq filing unless Nasdaq amends its trade reporting rules to allow Nasdaq members that are also members of other exchanges to report internal crosses or matches to the marketplace chosen in the sole discretion of that member. Such a regulatory scheme will foster competition between markets, lowering costs for market participants and investors alike.
The Island ECN, Inc.
cc: Honorable Harvey Pitt, Chairman
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation