Request for Rulemaking under the Securities Exchange Act of 1934 Concerning Trading of Nasdaq-Listed Securities
April 11, 2003
Mr. Jonathan G. Katz
Re: Petition for Commission Action Concerning the Trading of
The Nasdaq Stock Market, Inc. ("Nasdaq") respectfully petitions the Securities and Exchange Commission ("Commission") to take immediate action to protect investors. Specifically, Nasdaq requests that the Commission: (1) exercise its authority under Section 19(c) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 192 of the Commission's Rules of Practice to amend the rules of all markets that trade Nasdaq securities to establish uniform trading rules, and to ensure equal surveillance and enforcement of those rules; (2) exercise its authority under Section 11A(a)(3)(B) of the Exchange Act and SEC Rule 11Aa3-2(b)(2) to order that the exchanges' costs of regulation -- from proper data collection to surveillance to enforcement -- be aggregated and deducted from the market data revenue collected pursuant to the Nasdaq UTP Plan; and (3) exercise its authority under Section 12(f)(2) and (f)(3) of the Exchange Act to prohibit the launch or continuation of Nasdaq trading by any market that fails to protect investors as required under the Exchange Act.
The securities industry and the investors that rely upon it are currently facing a regulatory problem: unequal and inadequate regulation by some markets that trade securities listed on Nasdaq. The problem arises from a series of incremental changes in market structure that, taken together, have created an inequality of regulation that if uncorrected could undermine investor confidence in the nation's second largest stock market, at a time of historic investor insecurity. As we argue in our January 23, 2003 White Paper, "A Call for a Fairer Allocation of Responsibilities and Costs in a Fragmented Market" (attached hereto as Exhibit A), neither Nasdaq nor any other market can overcome this problem alone - or even all together. Only the Commission can address the problem of unequal regulation, using its authority under Section 11A of the Exchange Act to facilitate the establishment of a national market system "having due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets."
Until recently, almost all trading in Nasdaq securities was regulated by the National Association of Securities Dealers ("NASD"). The NASD, with guidance from the Commission, developed a comprehensive, coordinated regulatory framework to provide superior investor protection in an open trading environment with multiple market makers. The heart of that system is market data collected by the Order Audit Trail System ("OATS") and Automated Confirmation Transaction service ("ACT"), and fed into automated surveillance systems that help the NASD monitor broker-dealers' handling of customer orders at every stage of trading, from origination to execution to clearing. The NASD systems continuously sift through millions of trading records, using multiple algorithms to detect potential rule violations.1 After detecting potential violations, the NASD then rigorously examines the firms' books and records to establish whether a violation has occurred.2 Through these systems and examinations, the NASD had a sweeping view of all trading in Nasdaq stocks and the ability to respond quickly and effectively to protect investors.
In the last twelve months, substantial trading in Nasdaq securities by national and regional exchanges unaccustomed to operating in the decentralized environment unique to Nasdaq has caused the regulation of Nasdaq trading to become fragmented and uncoordinated, threatening to erode investor protection and to disrupt the fair and orderly operation of the markets. This fragmentation has created harmful disparities in the regulation of trading in Nasdaq-listed securities. In particular, several exchanges have no approved rules for gathering detailed trading data such as the information the NASD gathers using OATS and ACT (see NASD Rules 6951 through 6957), information that is vital to detecting fraud, manipulation, insider trading, and countless other violations that harm investors. Moreover, it is unclear whether self regulatory organizations ("SROs") other than the NASD have comparable algorithmic systems and examinations focused on detecting violations of SEC and SRO investor protection and trading rules.3 In addition, while trading on Nasdaq is subject to strict short sale regulation (NASD Rule 3350), several exchanges trade Nasdaq-listed securities with no short sale regulation. As a result of such disparities, the level of regulatory protection an investor receives depends almost entirely on the market to which the investor's order is routed.
Due to today's fierce competitive environment, there is pressure for some markets to slash execution and reporting fees to lure trading away from Nasdaq. To hold down their fees they must avoid incurring new regulatory costs, such as the costs of properly adapting their existing rules and regulatory systems to the unique structure and patterns of Nasdaq trading. Despite the Commission's actions to prohibit market data revenue sharing in Nasdaq securities, some markets attract order flow with mutualization pricing or naked profit sharing that effectively do just that.4 These markets use the savings from reduced regulation to lure trading away from the NASD's strict regulatory scheme to less regulated markets, to the detriment of investors.
This problem is in its early stages and can be rectified by prompt Commission action. Nasdaq asks the Commission to exercise its authority under 19(c) of the Exchange Act of 1934 and Rule 192 of the Commission's Rules of Practice5 to amend the rules of all markets that trade Nasdaq securities to establish uniform trading rules, and to ensure equal surveillance and enforcement of those rules. If a comprehensive order audit trail remains vital to investor protection, as it appeared to be in 1996,6 then all markets that trade Nasdaq securities must have rules requiring the submission of data comparable to OATS and ACT data. If automated surveillance and examinations are important, then all markets must perform them, or contribute to having them performed. If it is important to protect all investors from manipulative short selling, as it has been for listed securities since 1938, then all exchanges that trade Nasdaq stocks must have rules to regulate short sales akin to NASD Rule 3350.
The Commission should also exercise its authority under Section 11A(a)(3)(B) of the Exchange Act,7 and SEC Rule 11Aa3-2(b)(2) to combat the "buying" of trade reports at the cost of under funding regulation. As long as one market can free ride on other markets' regulation, without losing the Commission's imprimatur that its trading is adequately regulated, there will be limited incentive to correct regulatory inequalities. Even assuming that each market can quickly ramp up its regulatory capabilities and infrastructure, there would still exist regulatory gaps stemming from inter-market trading, as described in Nasdaq's White Paper. Nasdaq asks that the Commission immediately order that the exchanges' costs of regulation -- from proper data collection to surveillance to enforcement -- be aggregated and deducted from the market data revenue collected pursuant to the Nasdaq UTP Plan.8
Finally, Nasdaq asks the Commission to identify the markets that trade Nasdaq securities without approved rules, order audit trails, surveillance, and examination programs sufficient to protect investors that buy and sell Nasdaq securities on those markets. For those that do not, Nasdaq asks the Commission to exercise its authority under Section 12(f)(2) and (f)(3) of the Exchange Act to prohibit the launch or continuation of Nasdaq trading by any market that fails to protect investors as required under the Exchange Act.9 Investors deserve that protection.
II Request for Commission Action
The Exchange Act requires each exchange and association market to have in place rules and regulatory systems that allow it to protect investors from fraud, manipulation, and other behavior prohibited by the Exchange Act.10 In a self regulatory system such as ours, equality of regulation is a critical component of investor protection because regulation across markets is only as strong as the weakest regulator. Nasdaq believes that there are serious flaws in the regulation of Nasdaq trading by other markets, and that the Commission should address those flaws quickly in order to protect investors.11
A. The Commission Should Amend The Rules Of All Markets To Establish Uniform Rules Governing Nasdaq Trading
Section 19(c) of the Exchange Act grants the Commission broad authority to protect investors by amending the rules of self regulatory organizations:
Given the potential harm to investors from the lack of uniform trading rules and from unequal surveillance and enforcement of rules that has accompanied the rapid expansion of trading of Nasdaq securities in multiple venues, we believe that the Commission must act immediately.
In its White Paper, Nasdaq highlighted the harmful regulatory arbitrage that occurs when markets apply different trading rules to the same conduct. Nasdaq attempted, unsuccessfully, to persuade the other exchanges that trade Nasdaq stocks to act jointly to adopt uniform market rules and surveillance and enforcement mechanisms to eliminate that arbitrage.12 Specifically, Nasdaq asked that the Nasdaq UTP Plan be amended to prohibit certain defined conduct. Under that proposal, so-called Prohibited Conduct would have included, without limitation: any activity that is prohibited by any provision of the Act or rule adopted under the Act, market manipulation, illegal short selling, insider trading, fraud, frontrunning, marking the open or the close, limit order display, and firm quote compliance.13 Nasdaq continues to believe that eliminating regulatory arbitrage requires that all SRO rulebooks contain the uniform rules specified above, as well as equal surveillance and enforcement of those uniform rules.
Today there are vast disparities in the rules of markets that trade Nasdaq securities. Disparities in the regulation of short selling are particularly troubling. Since 1938, the Commission has considered it important to regulate short selling of exchange-listed securities. Nasdaq voluntarily adopted a short sale rule that mirrors, to a great extent, SEC Rule 10a-1, to protect investors from the potential for manipulative short selling such as "bear raids," and Nasdaq is working with Commission staff to strengthen that rule after Nasdaq registers as an exchange. Yet, simultaneously, several UTP Exchanges trade Nasdaq issues with no short sale regulation whatsoever. Industry participants readily admit that they route short sale orders to venues that have no short sale rules specifically to avoid NASD surveillance and rule restrictions. Indeed, it appears to Nasdaq that certain exchanges exploit this disparity to attract order flow to their markets. 14
In addition, based upon our review of various markets' rulebooks, it does not appear that any market currently executing trades in Nasdaq securities, other than Nasdaq, possesses a Commission-approved order audit trail, or rules requiring its members to report order audit trail information.15 As described in Nasdaq's White Paper, Nasdaq collects order audit trail information through OATS and through its Automated Confirmation Transaction ("ACT") service. The NASD uses this data to create a fully integrated audit trail of quotes, trades, and orders to run its surveillance programs to detect insider trading, fraud, best execution violations, spoofing, purposeful late trade reporting, short sale violations, untimely execution of market orders, and a wide variety of other potential rule violations.
For transactions reported away from Nasdaq, the NASD eventually receives the quotes and trade reports of the regional exchanges through ISG. The ISG audit trail, however, only provides trade information at the clearing firm level (as opposed to both the clearing firm and the executing firm levels). In addition, the time fields in the data are not generated by clocks subject to uniform synchronization protocols, as is the case with OATS data. Moreover, ISG data is not provided in a format that is conducive to integration into NASD's automated surveillance systems, thereby requiring time-intensive, manual processing. Furthermore, this data is not received until two days after trade date. Such a delay can significantly hinder NASD's ability to investigate unlawful trading activity on a real-time basis and can prevent NASD from obtaining non-stale regulatory information in an ongoing investigation. The NASD uses this information to detect violative behavior involving wash sales, fraud, insider trading, marking the close, best execution, riskless principal trade reporting, Regulation M, firm quote compliance, and limit order protection, among others.16
At a more fundamental level, Nasdaq believes that consolidated regulation protects investors better than the coordinated regulation that ISG facilitates. Moreover, ISG merely facilitates regulation by transferring information to SROs that request it, but ISG does not address instances where SROs do not initiate regulation. Finally, Nasdaq believes that consolidated regulation should be crafted by the entities that will be governed. ISG is a voluntary organization whose membership includes domestic SROs (only some of which trade Nasdaq securities) but also domestic non-SROs, as well as foreign entities that are not regulated as SROs by the Commission.
Regional markets that are beginning to trade Nasdaq securities may attempt to retrofit regulatory programs that were originally designed for overseeing trading on floor-based, specialist markets.17 The shortcomings of such regulatory frameworks for overseeing electronic, competing dealer markets have already begun to become apparent. We believe that further failings in the regulatory systems of these markets will become more apparent over time.
To combat these problems, the Commission should, at a minimum, add to the rules of all SROs that trade Nasdaq securities, rules requiring an electronic audit trail identical to the NASD's OATS Rules (NASD Rules 6951 through 6957) and short sales restrictions similar to NASD Rule 3350. If the Commission's review of other markets' rules, surveillance, or enforcement reveals other inequalities that can be addressed through the adoption of uniform rules, the Commission should add those rules as well, to ensure that there are no inequalities and to ensure that the Commission and the public can be confident of that fact.
B. The Commission Should Order That The Markets' Aggregate Costs Of Regulating Nasdaq Trading Be Deducted From The Revenue Collected Pursuant To The Nasdaq UTP Plan
Section 11A(a)(3)(B) of the Exchange Act grants the Commission broad authority to require the markets to act jointly with respect to the trading of Nasdaq-listed securities. Specifically, the Commission is authorized:
(emphasis added). SEC Rule 11Aa3-2(a)(1) states that a national market system plan includes the "planning, development, operation or regulation of a national market system (or a subsystem thereof) or one or more facilities thereof." It also includes the "development and implementation of procedures and/or facilities designed to achieve compliance by self-regulatory organizations and their members with any section of this subpart promulgated pursuant to Section 11A of the Act."
Nasdaq urges the Commission to act now to re-establish an equitable allocation of regulatory costs across markets to ensure that price competition does not come at the cost of adequate regulation. As set forth in Nasdaq's White Paper, Nasdaq believes that equal regulation is not only a goal of the Commission, but also a shared responsibility of all markets that trade the same securities. In Nasdaq's view, these shared responsibilities include the uniform rules, surveillance, and enforcement described in Section II.A above. Nasdaq is hopeful that the Commission will critically examine the regulatory voids that Nasdaq identified in its Regulation White Paper, particularly those that develop when firms trade Nasdaq-listed issues in multiple venues.
In the absence of a framework for adopting uniform order audit trails and for uniform enforcement of marketplace rules, Nasdaq is forced to subsidize other markets' regulatory costs, creating a classic free-riding dilemma. For example, Nasdaq continues to fund the NASD's OATS to collect trading information from all NASD members whether or not the trades are reported to Nasdaq. The Island ECN, an NASD member, reports 15% of all Nasdaq trades to the Cincinnati Stock Exchange, and then, where Island is the reporting party, sends detailed information about those trades to OATS. Although Cincinnati receives the market data revenue attributable to those trades, the NASD and Nasdaq bear the costs of receiving and storing Island's OATS data as well as the costs of regulating Island's conduct as an NASD member.18
Nasdaq believes that the fairest way to allocate the costs of regulating the trading of Nasdaq stocks is to aggregate the exchanges' costs of regulation -- from surveillance to enforcement, both human and technological -- and to deduct that amount from the market data revenue collected pursuant to the Nasdaq UTP Plan. The Commission can apply this allocation method to today's regulatory environment, as well as in the future to the Single Regulator, ISG, and DEA regulatory models that Nasdaq identified in its White Paper.19 Allocating aggregate regulatory costs will counter the existing economic incentives that are leading markets to reduce their regulatory costs in order to compete for order flow. Quite the opposite, it should highlight the markets' collective regulatory redundancies, and encourage the markets to cooperate to eliminate those redundancies.
The Commission has broad authority to address the current problems facing investors that trade Nasdaq securities. Nasdaq urges the Commission to take action under Sections 11A, 12(f), and 19(c) of the Exchange Act, as well as SEC Rule 11Aa3-2(b)(2) and Rule 192 of the SEC Rules of Practice to address these problems and protect investors. Nasdaq is concerned that markets have begun trading Nasdaq securities
without the resources, rules or regulatory infrastructures needed to protect investors. The framework for regulating trading in Nasdaq securities across markets must be reexamined and refocused to protect investors better and to allocate regulatory responsibilities and costs more fairly across all markets.
cc: Chairman William H. Donaldson