August 28, 1998
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: SEC File No. S7-12-98
Ladies and Gentlemen:
Bloomberg L.P. 1 appreciates the opportunity to comment on the Commission's Release on Exchange Regulation, Securities Exchange Act Release No. 39884 (April 29, 1998) (the "Release"). Our comments on the Release arise out of the diversity of our business and stem from varied perspectives.
Three main areas of Bloomberg's business could be affected by the proposed rules. First, as the Commission knows, Bloomberg established a proprietary electronic anonymous trading system (the "Tradebook System") in 1996, which is operated by a subsidiary of Bloomberg, Bloomberg Tradebook LLC ("Tradebook"). Through the Tradebook System, Bloomberg offers its institutional and broker-dealer customers, and other broker-dealers that access the Tradebook System via Nasdaq's SelectNet, the opportunity to buy and sell equity securities via the BLOOMBERG service. As an electronic communications network ("ECN"), the Tradebook System would be required to register as an exchange or comply with Regulation ATS. Second, Bloomberg intends in the near future to offer its customers a service whereby they may respond electronically to dealers' indications of interest for government securities, known as Bloomberg BondTrader. Third, Bloomberg also has products that allow dealers to post indications of interest for equity securities to be viewed by their institutional customers.
Bloomberg values the Commission's recognition of the fact that recent technological innovations have substantially altered the way the securities markets function today. Bloomberg also applauds the Commission's ongoing efforts to improve the operation of both the U.S. and international securities markets, as well as foster the development of new technologies, by proposing new regulatory frameworks. It is important for the Commission's regulatory programs to keep pace with the patterns of change in the securities markets, both in the United States and abroad. The Commission has appropriately taken the opportunity to reassess its approach to regulation of U.S. market centers. We welcome the Release as an important step toward improving the financial markets in accordance with the statutory mandate granted the Commission, but we have a number of concerns relating to the specific approaches proposed by the Commission.
I. GENERAL OVERVIEW
Objective of the Concept Release. As the Commission knows, Bloomberg welcomed the ideas set forth in the Concept Release 2 and submitted a comment letter supporting the Commission's evaluation of the changes in the marketplace and the corresponding regulatory structures. 3 Because regulation of alternative trading systems ("ATSs") 4 has been developed on an ad hoc basis over the past several years, Bloomberg saw the Concept Release as an effort to tailor regulatory requirements to the specific needs of the new hybrid trading system, the ATS, while at the same time creating a uniform standard of regulation for all ATSs. We agreed with the Commission that the time was right to examine appropriate changes in regulation to match developments in the securities markets.
Many concerns and questions relating to market regulation and market structure that the Commission raised in the Concept Release, however, are not addressed in the Release and remain unresolved or unanswered. For example, regulation of ECNs by their competitor, the National Association of Securities Dealers, Inc. (the "NASD"), and overly broad, imprecise regulation of ECNs as broker-dealers, were among the ills cited in the Concept Release. A solution proposed in the Concept Release to those problems was to cease being a broker-dealer and to register as an exchange. The Concept Release described changes to the exchange registration procedure, such as tiers of exchange regulation and significant exemptions from typical exchange obligations. Under that scenario, registering as an "exchange-light" was a practical and useful alternative for ATSs to consider, and one that addressed the Commission's concerns. Regrettably, the Commission did not implement that scenario in the Release.
Despite the Commission's assertion in the Release that its proposal is intended to allow ATSs to "choose the market role that works best for them," 5 the Release sets forth alternative regulatory structures that are neither workable nor desirable for ATSs. The two market roles offered are as a registered national securities exchange and as a registered broker-dealer subject to Regulation ATS. If an ATS were to register as an exchange under the Release, 6 the ATS exchange would be subject to a variety of entrenched market forces that might well be more problematic and impractical for ATSs than operating as a broker-dealer under the status quo. On the other hand, the alternative structure of Regulation ATS could severely alter, and perhaps even eliminate, the role of ATSs in the marketplace, as discussed more fully below.
We therefore believe that the Commission has not achieved the objective stated in the Concept Release of providing ATSs with real alternatives for regulation and will fail in its revision of the regulatory scheme to foster innovation and competition. The innovation and responsiveness of ATSs have spurred the efficiency of the financial markets in the United States during the past several years and have benefited investors. It would be a step backwards in the development of the U.S. financial markets to impede their participation in those markets. The options presented to ATSs under the Release, however, do not offer a clearly workable pathway for ATSs to exist, let alone thrive, in the marketplace. Not only are the alternatives proposed by the Commission in the Release not practical or desirable for ATSs, but the proposed rules may make matters even worse.
Exchange Registration. Among the reasons why exchange registration and regulation is not an appropriate alternative for ATSs are the following: (i) it takes too long to register as an exchange; (ii) the statutory protections for ATS exchanges may well prove insufficient; and (iii) the process of implementing rule changes is unduly cumbersome. We discuss these in more detail below.
First, the process of registering as an exchange is extraordinarily protracted, particularly for a start-up entity but also, we expect, for an ATS that has been in business for some time. We understand it is not uncommon for an exchange application to require two years or more for approval. Unless a fast-track interim registration were available, an ATS that wished to remain in business, or to open for business, without waiting for that two-year period would effectively have to remain, or become, a registered broker-dealer during what would undoubtedly be an extremely expensive process of filing and refiling applications and rules during that two-year period.
Second, once registered as an exchange, an ATS would lose many statutory protections it now enjoys, including effective appeals to the Commission and the federal courts based on the statutory protections provided to exchange members and members of the NASD under the Exchange Act. In place of those protections, the ATS would have only the uncertain and amorphous protections from, e.g., predation by other market centers, that might be afforded it as an Intermarket Trading System ("ITS") member. Whether those protections are in fact effective may be a matter of some conjecture. 7 Before concluding that exchange registration might be a choice for ATSs, therefore, ATSs would want to know that the Commission would address inter-exchange relationships in a more detailed fashion and provide a regulatory environment conducive to fairness and growth.
Freeing ATSs from a self-regulatory organization ("SRO") control, the proffered cure for the problem of competitor oversight, does not solve ATSs' regulatory problems; in fact, it could actually make matters worse. While the Commission has expressed concern about the competitive consequences of subjecting an ATS to the regulatory jurisdiction of an SRO that may compete with it, at least that relationship is subject to the Commission's direct and potentially pervasive control and the application of clearly defined legal standards that are enforced by the Commission and, ultimately, the courts. Registered exchanges and national securities associations are required by statute to operate fairly with respect to members; 8 members and applicants for membership can seek redress if they have been denied access or treated unfairly. There is currently no statutory structure, however, that regulates or monitors behavior between and among exchanges and securities associations. 9 Whether the ITS benefits from a thorough Commission oversight or offers its members an effective appeal mechanism to address inequities or perceived discrimination is quite uncertain. To the extent it does not, that would deter full and fair entry into the ITS, especially in the case of an ATS that would be a relative newcomer to the system.
Finally, notwithstanding the Commission's Pilot Trading System proposal, most proposed rule changes, including changes to the systems offered by the ATS to its participants, would have to be filed with the Commission, and thereafter be published and subjected to comments, including those of competitors, in some cases several times, before they could be put into effect. The rulemaking initiatives of exchanges frequently devolve into protracted negotiations with the Commission's staff, notwithstanding the nominal statutory time deadlines for action on SRO rule proposals. 10 Not only does that process deter innovation, but it also provides ample opportunity for commercial rivals to usurp any competitive advantage of the exchange's new ideas. 11
To be truly effective, a Commission scheme for approving SRO rule filings, if ATSs were to register as exchanges, should permit automatic effectiveness of any rule filing establishing a new trading system or facility if the rule has an automatic sunset provision of, say, three years that could be accelerated if the Commission had a sufficient basis for doing so (e.g., if the rule proved to contravene statutory standards applicable to the SRO). Among the benefits ATSs have brought to the marketplace are innovation, responsiveness to market demand and transparency for investors. Subjecting ATSs to extended review of rule changes would erode creativity and stifle innovation. ATSs would no longer be able to offer the market the rapid changes that technology today makes possible.
II. REGULATION ATS
General. As an ATS, Tradebook supports regulation to protect the marketplace and promote transparency to rid the market of off-line systems, but Regulation ATS as currently configured raises some troublesome issues for ATSs. Most importantly, Regulation ATS could create a central market system that controls all order flow and distributes executions, not orders, to ATSs. Taken to its logical and practical conclusion, such centralization of the market could severely truncate, if not eliminate, the role of ATSs and stifle competition, restricting investors' opportunities.
More generally, the question we face is whether the regulatory superstructure proposed is sensible and practical given the facts and the configuration of the marketplace. Indeed, we point out that the Commission has a broad range of powers under the Exchange Act and need not impose such an elaborate scheme as is proposed in the Release. One alternative approach to the adoption of Regulation ATS would be for the Commission to amend the Order Execution Rules to provide for integration into the public quotation mechanisms of institutional orders entered into and displayed on ATSs. This amendment would entail amending the definition of "ECN Alternative" in the Order Execution Rules to provide that an ECN must publish its best bids and offers in the public quotation regardless of whether the quotation originated from a market maker or specialist or from another source, including an institution. If access to an ATS's quotations is facilitated, as it is under the Order Execution Rules today, and if the ATS is no longer able to prevent institutional order flow that is displayed on its system from being simultaneously displayed in the public market, concerns the Commission raised in the Release about the admissions policies of ATSs 12 should rapidly fall away.
Broker-dealer registration. Requiring an ATS that chooses to comply with Regulation ATS to register as a broker-dealer 13 is not necessary given the scope of the proposed regulation unless the ATS would independently meet the definition of a broker or a dealer (e.g., by accepting transaction-related compensation). Regulation ATS would require reporting to, and oversight by, the Commission on key issues and responsibilities of ATSs, such as access and capacity, which should suffice to regulate ATSs. Regulation of ATSs by the NASD as broker-dealers also raises issues of oversight of ATSs by the sister company of their competitor, The Nasdaq Stock Market, Inc. ("Nasdaq"). If the Commission nevertheless concludes it should require ATSs to register as broker-dealers, it should exempt them from those elements of broker-dealer regulation that are not pertinent, and therefore unduly burdensome, to them (e.g., net capital requirements, FOCUS reporting, etc.). 14
Direct connection/non-participant access. Given what we believe to be the danger that the delivery of execution messages to ATSs could cripple their ability to operate effectively in the market, we urge the Commission not to pursue that end. In its release announcing adoption of the Order Execution Rules, the Commission stated that for access to be "equivalent," an ECN must enable non-subscribing broker-dealers to execute against the ECN's published best price to the same extent as would be possible had that best price been reflected in the public quotation of a specialist or market maker. 15 The Commission also stated that, to be "equivalent," an ECN would have to be prepared to provide to non-participant broker-dealers who use the Nasdaq Small Order Execution System ("SOES") equivalent automated access, which might involve an automated linkage to SOES or some other method approved by the NASD by which SOES executions would be assigned to the ECN. 16
Notwithstanding that statement, ECNs have not been subject to execution messages to this point. The problems the Commission cited in the Release regarding the inability to access quotations and inefficiency in order handling result entirely from the inadequacy of Nasdaq's technology, particularly delays in transmitting orders. Those problems are not caused by ECNs and are best resolved by Nasdaq's improving its technology rather than by the Commission's burdening ECNs.
It is unnecessary to subject ECNs to executions. ECNs currently are required to respond immediately and automatically to orders received through SelectNet if, like Tradebook, 17 they respond immediately and automatically to participant orders. 18 This is an important point, one that can be easily missed. It is on this basis the ECNs are to be distinguished from market makers, which are not subject to these standards. 19 If the Commission has found problems relating to the enforcement of rules regulating ECNs, that may suggest a need to redouble the Commission's efforts to examine ECNs and enforce the standards for compliant ECNs under the Order Execution Rules rather than subjecting ATSs to the systemic problems that receipt of execution messages may cause.
Effects of Execution Delivery. It appears from both the Order Execution Rules Release and the Release that the Commission does not view the delivery of executions to ATSs as having any particularly adverse consequences for ATSs. The Commission did not state that it intended to discriminate in favor of broker-dealers entering or transmitting orders that would be delivered to an ATS as execution messages to the detriment of broker-dealers that enter orders as participants in the ATS. Nor does it appear that the Commission deliberately intended to impose regulation that would damage the ATSs or prevent them from competing on level ground with Nasdaq. 20
If the Commission, however, were to impose the SOES approach, that is, execution message delivery rather than order delivery, the result would in fact put customers dealing directly with an ATS at a disadvantage as against customers dealing through Nasdaq to reach that ATS and would adversely affect the ability of an ATS to conduct business. Three alternatives would be available to an ATS if it were required to receive executions and each of the three choices would adversely affect ATSs and the marketplace: (i) slow down its system response time; (ii) send its participants' orders to Nasdaq for retransmission back to the ATS; or (iii) risk receiving multiple executions.
To illustrate these three alternatives, we offer the following example:
ATS Participant A places an ask order in an ATS which is then displayed in the public quotation system. Participant B then places a matching bid order in the ATS and Broker C places a bid order at the same price through the proposed Nasdaq execution system that is routed to the ATS as an execution; the ATS is then subjected to the risk of multiple executions. In the time it takes for the execution to reach the ATS from Nasdaq, Participant B's order could be executed, leaving no corresponding ask order in the ATS.
In the above example, the ATS would have to absorb the liability for the execution delivered to it by Nasdaq's system. Because most ATSs are agency brokers and do not have inventories and proprietary trading accounts with which to absorb multiple trade exposures, it is not feasible for ATSs to be subjected routinely to multiple executions.
In the face of such a scenario, the first alternative available to an ATS would be to slow down its system response time. To avoid being subject to multiple executions, an ATS could intentionally offer its customers less efficient service. Using the above example, under the proposed rules, the ATS would need to wait for confirmation from Nasdaq, as the market center, that its quotation has been withdrawn before it could execute the quotation in its own system. If Nasdaq were the central clearing market, it would be irrelevant how quickly an ATS could respond to orders. The ATS would be required to wait for Nasdaq before it could act. 21 During this delay, an ATS order could receive an execution from the Nasdaq execution system after the order was executed in the ATS by Participant A, but before Nasdaq had canceled the quotation and messaged the ATS with the cancellation confirmation.
The same reasoning applies to Participant A's canceling an order in the ATS. Such a cancellation would not have immediate effect, but rather would remain pending while the ATS awaited confirmation of the cancellation from Nasdaq. The ATS would be competitively subservient to Nasdaq because it would have to wait for Nasdaq to respond. If ATSs were to decrease the speed of their systems to match that of Nasdaq, they would cease to offer their customers the speed, innovation and investing tools that the market has enjoyed in the past few years from ATSs. Under this scenario, linkages through Nasdaq to access an ATS would be faster than accessing that ATS directly. Unable to compete, ATSs could be driven out of business by Nasdaq. By mandating delivery of executions from a central market, the central market itself would become a monopoly and would set the market standard at the lowest common denominator for efficiency, technology and service. In the process, Nasdaq could extract monopoly rents from the market participants that were subservient to it and would not be disciplined by the threat of effective competition.
The second alternative for ATSs would be to send their participants' orders to Nasdaq. Such orders would come back to the ATS as executions, thereby eliminating the risk of multiple executions since Nasdaq would be the only source of order matching. There are three problems with this alternative, however. First, if an ATS were to implement this second alternative, ATS participants could very well decide to use Nasdaq to reach the ATS instead of absurdly using the ATS to transmit an order to Nasdaq that would then be sent back to the ATS. An ATS that chose this second alternative would substantially diminish its role in the marketplace. Second, if an ATS were to send all its orders to Nasdaq and all executions originated from Nasdaq, the ATS would fail to meet the definition of an ECN within the Order Execution Rules because it would no longer operate a system that matches orders and in which orders are widely disseminated. Since the Order Execution Rules grant the right to display the best bid and offer in the Nasdaq public quotation only to ECNs and market makers, an ATS would therefore forfeit its right to be considered an ECN in the first place.
Last, were an ATS to follow this second alternative, the ATS would become increasingly dependent on Nasdaq and Nasdaq's technology. Nasdaq as the mandatory gateway for order messaging and order interaction would establish the maximum permissible speed, reliability and flexibility. Innovators would be effectively stymied in their efforts to improve upon the technology Nasdaq chose to implement. Further, an ATS would have to pay fees to Nasdaq to match orders between its participants in Nasdaq, a slower service than the ATS could provide its participants on its own. Dependence on Nasdaq is a concern because (i) Nasdaq, a potential competitor of ATSs, would have a technological monopoly; (ii) ATSs would lose the ability to independently create a fast and reliable alternative for market participants; and (iii) such dependence would stifle innovation and creativity in the field of market-oriented software development.
The third alternative available to ATSs if the Commission were to adopt the market center execution model would be to decide to risk receiving multiple executions. As described above, receiving multiple executions for one order in an ATS would guarantee the ATS embedded losses. ATSs are agency brokers and do not have inventories of securities on which to draw should a multiple execution occur and additional securities be needed. Without dramatically altering the way ATSs structure their operations, this alternative would impose substantial unnecessary costs that ATS participants would bear.
Bloomberg's proposal. In the Release, the Commission discusses equivalent access. We agree with the first two conclusions the Commission set forth, i.e., that an ATS should allow non-subscribers to execute against its best priced order to the same extent as if the price had been reflected in the public quote by a national securities exchange or association and that an ATS should respond no slower to those orders than it responds to subscriber orders. The Commission's third conclusion in that regard, that ATS orders should be subject to SOES automatic executions, however, lacks a factual basis. ATSs that respond automatically and immediately to participant orders are required to respond to non-participant orders automatically and immediately. There is no need, therefore, for such ATSs to be subject to automatic execution from Nasdaq.
The Commission asks in the Release whether there is a feasible alternative to receiving execution messages and states 22 that Bloomberg's proposal of direct connections to an ATS set forth in the Bloomberg October Letter may not be feasible.
We believe our proposal is feasible for some market participants but maybe not all, unless Nasdaq upgrades its technology. In the case of large volume non-participants who can afford to invest in technology, direct connections provide an alternative to execution message delivery. In the case of other non-participants, Nasdaq can and should supply high-speed data links and automatic re-routing software to give them a feasible alternative to execution message delivery. 23 Using such technology, a "direct hit" through execution message delivery is not superior from the point of view of non-participants. If Nasdaq installs high-speed T-1 communications lines on a system-wide basis, the three-second delay that a non-participant currently experiences between transmission of a Nasdaq SelectNet order and the receipt of a response would practically disappear. 24
Our proposal set forth in the Bloomberg October Letter 25 asks the Commission to distinguish between those ATSs that respond to non-participant orders immediately and that provide direct connection to such non-participants on request, and those that do not. If an ATS responds immediately to non-participant orders and provides a direct connection on request, it should qualify to receive order messages, not executions. If T-1 lines are used, ATS responses to Nasdaq SelectNet orders will be virtually immediate. If an ATS sends a rejection to Nasdaq because the order has already been filled in the ATS, Nasdaq will have the opportunity to immediately resend the message order to another ATS or market maker. Re-routing of orders would be efficient and fast. On the other hand, if an ATS does not meet the standard of providing direct connections on request and responding immediately, that ATS should be subject to execution messages from Nasdaq.
Nasdaq should police this system on an order-by-order basis. If a qualifying ATS fails to respond to a particular order immediately, that ATS should be subject to an automatic follow-up message from Nasdaq that would cancel that order and deliver an execution in its place. Two or three seconds would probably be a reasonable time frame for triggering such an execution message.
The benefits to investors and the marketplace of this approach would be widespread. ATSs and Nasdaq would have an impetus to continue developing their respective technologies and the resulting competition would spur innovation. A free market framework would provide investors with a multitude of options to invest and trade, compared to a monopolistic "market center" that would eliminate competitors and impose monopolistic rates for its services. If the Commission were to adopt its proposal to establish Nasdaq as the market center and the sole source of executions, the chances of Nasdaq voluntarily upgrading its technology in the future become slim. The adverse effects on the securities market and market participants would be significant. The Commission, therefore, should abandon the requirement that ATSs be subject to execution messages. We believe our proposal, as expanded in this letter, is not only feasible, but also desirable.
Congressional intent. In the Release, 26 the Commission states the congressional objective set forth in section 11A of the Exchange Act to be "centralization of all buying and selling interest so that each investor has the opportunity for the best possible execution of his or her order, regardless of where the investor places the order." It further appears from the Release 27 that the Commission has interpreted this objective to mandate that all non-participant orders interact with all orders, not just those orders in a particular ATS, and that execution messages are the exclusive method of interaction between orders and the national market system.
The congressional statements in Section 11A of the Exchange Act do not support the proposition that the best market structure is one in which a single market center such as Nasdaq controls the allocation of orders and delivers execution messages to liquidity providers rather than displaying to liquidity takers what the liquidity makers publish as their bids and offers. Section 11A(a)(1)(D) of the Exchange Act sets forth the congressional finding that the "linking" of all markets for qualified securities through communications and data processing facilities will foster efficiency, enhance competition, increase the information available to brokers, dealers and investors, facilitate the offsetting of investors' orders, and contribute to best execution of such orders. The key to understanding that congressional finding is to understand that communications and data processing facilities need not be a message switch that delivers completed executions but could instead be a system of disclosure that would assist, through quotation montages and the like, competition among market centers and market participants.
As noted in the Release and as discussed above, the Congress established a "national market system" as the objective in enacting section 11A of the Exchange Act. The Commission's proposed interpretation and rules set forth in the Release, however, go beyond what the Congress intended. There are effective alternatives. The Commission's concern of order interaction would be met by our proposal, which we believe is more in line with the congressional intent. Orders of participants and non-participants would interact effectively if an ATSs were to elect, in order to avoid execution messages, to respond immediately, to have direct connections to all requesting non-participants and to have a connection to Nasdaq. In addition, were high-speed communications and re-routing software made available by Nasdaq, orders and executions would flow efficiently and automatically among market participants.
Disciplinary powers. Proposed Rule 300(a)(2)(ii) would severely restrict an ATS's ability to control and regulate its participants and its trading framework. Under the new rule, an ATS's only disciplinary power would be to exclude a potential participant from trading. The Commission does not describe or evaluate the problem or the abuse which the Commission would intend to remedy by adopting this provision. We question the meaning of this limitation and whether it is sensible. Would an ATS be allowed to prohibit or induce any type of conduct in its system? The scope of the definition is unclear to us and the resulting prohibition on an ATS's action needs to be clarified.
Practically, the proposed rule would eliminate any ability of an ATS to discourage or encourage behavior or practices in its trading system, since, for competitive reasons alone, measures as definitive as exclusion from trading would rarely, if ever, be imposed. We view this restriction as effectively precluding an ATS from exercising any disciplinary powers over its trading parties and leaving an ATS no alternative but to register as an exchange if it desires to have even a minimum amount of control over its participants and its own trading structure. While it is evidently the Commission's intention that ATSs not engage in disciplinary proceedings without registering as exchanges, and thus becoming subject to the "fair representation" standards in Section 6(b)(3) of the Exchange Act, they nevertheless retain whatever powers any private business has to deal with its customers. Section 6(b)(3) and the disciplinary machinery of Section 6(d) are concerned with the imposition of sanctions that have the force of federal law behind them. Private sanctions imposed by private businesses are quite another matter.
Capacity of ATSs. As we suggested in the Bloomberg October Letter, market forces should, over time, assure adequate expansion and maintenance of ATS capacity. Furthermore, the Commission has not made a sufficient showing of a need to regulate ATS capacity. If the Commission believes it more effective to regulate capacity, however, we would expect that such regulation would not be disadvantageous to the market place if coupled with even-handed and effective enforcement.
System security may well be different in that regard. It is understandable and reasonable for the Commission to regulate computer security. While we are not certain there is any reason to believe that computer security is a sufficient problem that in fact that requires affirmative Commission intervention and regulation at this point, it is certainly a valid subject for continuing Commission interest and surveillance.
Surveillance. We support the proposed requirement for an ATS to cooperate with the Commission's or an SRO's inspection or examination of an ATS or any of its subscribers. If the Commission believes it cannot prevent SROs from anti-competitive results, the Commission might consider exercising its authority under Section 19(g)(2) of the Exchange Act to relieve the NASD and other SROs from the obligation to regulate ATSs and impose the Commission's own direct regulation and surveillance over ATSs, without creating an involved program of regulation. 28
Order display/linkage. We note that the definitions of order display and linkage are not entirely clear in the Release. The Commission states that the linkage requirement (publicly disseminating the best priced orders into the public quotation stream) would not apply to ATSs that do not display participant orders to anyone. 29 Proposed Rule 301(b)(3), however, would require ATSs to publicly display a best priced order displayed to more than one person in the ATS.
Although we believe the Commission's test of "more than one person" is the right one, we suggest that it needs to be backed up with an effective and even-handed surveillance and enforcement procedure. Negotiation tools in ATSs could allow only two parties to view a quotation, but allow multiple (i.e., more than two) parties to trade the same quotation. Indeed, one could imagine that an ATS could even allow the participants to enter into one-on-one negotiations with several potential counterparties simultaneously in the same order. That might give the superficial appearance of dealing with only one person in each of several, separate negotiations, when, in fact, "more than one person" would be viewing and accessing the same order. Our concern is whether the Commission's definition permits multiple negotiation of this kind and we suggest that the interpretation of this definition be such that multiple negotiation/trading be regulated in the same manner as display. We would ask that the Commission clarify the scope and practical aspects of its interpretation of display.
Effects on competition. We respectfully disagree with the Commission's conclusion that the proposed rules would not impose any significant burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. As the Commission correctly points out in the Release, 30 Section 23(a) of the Exchange Act requires the Commission, when promulgating rules under the Exchange Act, to consider the anti-competitive effect of such rules, if any, and to balance any impact against the regulatory benefits gained in furtherance of the purposes of the Exchange Act. 31 In its analysis of the proposed rules' effects on competition in the Release, however, the Commission has not meaningfully substantiated its findings and has not given commenters an adequate basis to assess the impact of the proposed rules.
If the proposed rules were to be enacted as drafted, significant competitive implications, including major adverse effects on competition between Nasdaq and ATSs would follow. Given its prerogative of sending execution messages to ATSs under the proposed rules, Nasdaq could gain an inherent advantage over ATSs and become a monopoly market center. This is because the proposed rules could give a permanent, commanding preference to orders entered through Nasdaq rather than into an ATS. That would drive current and prospective ATS participants away from an ATS and into Nasdaq, forcing ATSs to modify their systems, as discussed above under three alternative examples. In short, by allowing a market center to centralize distribution of executions and thus forcing an ATS to offer better access to non-participants than its own customers, the proposed rule could effectively cripple, and then destroy, ATSs.
Volume thresholds/institutional orders. The 10% threshold in proposed Rule 301(b)(3)(B) seems artificial and arbitrary and does not address the issue at hand. In addition, such boundaries may fragment the market. Compulsory display of all widely disseminated orders would more effectively achieve the Commission's objectives. Furthermore, we would support a requirement that such display obligation be independent not only from the daily trading volume of a given security but, also, from the origination of the order. Thus, both market maker- and institution-originated orders would be displayed in the public quotation. In fact, as we stated in the Bloomberg October Letter, most institutional participants in the Tradebook System already do so voluntarily. 32
Unregistered securities. The Commission has asked for comment on whether securities traded on all ATSs, including those that choose to comply with Regulation ATS rather than register as exchanges, should be registered under Section 12 of the Exchange Act. We believe that, as long as the ATSs limit their trading to those ATS participants that are institutional investors or broker-dealers, there is no need to require Exchange Act registration of securities that trade on ATSs but not on exchanges. We believe that if ATSs trade only with qualified institutional buyers, within the meaning of Rule 144A under the Securities Act of 1933, as amended, ATSs should be allowed to publicize data from such trades, since those buyers are allowed to be initial purchasers of the subject securities. As we stated in the Bloomberg October Letter, we are not aware of any regulatory purpose served in denying them the opportunity to trade these securities in the secondary, transparent, publicized market in an ATS. Such trading would promote transparency and liquidity and increase the efficiency of the secondary markets. The added liquidity would increase the attractiveness of Rule 144A securities to purchasers and would likely reduce the issuers' costs of financing.
Trade reporting. The requirements in proposed Rule 302(b)(3) for ATSs to keep records of trading volume of securities are impractical in the case of an ATS that trades in debt securities for which there are no aggregate U.S. dollar market volume data. In the absence of such data to establish a denominator for the required calculation, an ATS would be unable to calculate its percentage of volume. We therefore propose to limit such requirements to those debt securities for which such data are generally available.
Access fees. We question whether an SRO is the correct party to set access fees. Public utilities, and analogous products for the good of the public, should be regulated by governmental agencies to promote public welfare most effectively. We believe the Commission is the better source of fee regulation and should continue to monitor and set ATS access fees, while considering lowering access fees or eliminating them entirely.
Program trades. Certain requirements of proposed Rule 302(c)(4) may be unworkable for an ATS. The proposed rule requires an ATS to make and keep time-sequenced records of order information in the ATS, including an identification of the order related to a program trade or an index arbitrage trade as defined in the New York Stock Exchange ("NYSE") Rule 80A. In our opinion, these requirements should be based on knowledge. Some ATSs may not know, and may not have any reasonable way of discovering, whether a participant is in fact working a program trade that would be subject to NYSE Rule 80A.
Rule 3b-12. Proposed Rule 3b-12 would create a new definition of "exchange" with respect to ATSs. In the proposed rule, the Commission discards the interpretation of "exchange" established in the Delta Order 33 for a new definition. The Commission observed in the Delta Order that the "distinguishing characteristic" of an exchange under Section 3(a)(1) of the Exchange Act is:
centralized trading and providing purchasers and sellers, by its design (whether through trading rules, operational procedures or business incentives), buy and sell quotations on a regular or continuous basis so that those purchasers and sellers have a reasonable expectation that they can regularly execute their orders at those price quotations (emphasis added).
Under the Delta Order, creation of mandatory liquidity through imposition of affirmative and negative obligations on its members and specialists is a defining aspect of being an exchange. Electronic bulletin board systems such as Autex were not treated as exchanges for good reason. Proposed Rule 3b-12, on the other hand, is so expansive as to capture all electronic trading systems, including those that may simply display information and prices to their customers without imposing "by design" an expectation of regular execution of orders. The standards established in the Delta Order still serve the valuable purpose of providing guidance to the marketplace while allowing innovation outside the scope of the interpretation; the Commission should not cast that aside.
III. RULEMAKING REQUIREMENTS
The Commission's proposed Regulation ATS is a truly significant rulemaking initiative and deserves a fuller opportunity for public evaluation and response in light of the likely impacts of these rules, including their impact on competition in the markets. Commenters have not been, but clearly should be, given an opportunity to reflect on the likely effects of the Commission's rule with respect to execution messages or to advise the Commission of their views; they may not be aware of the issue unless they happen to have noticed it on their own. Delivery of execution messages has not been subject to rigorous public comment since the amendment to SOES in 1987 because, at least in part, the use and abuse of SOES by professional traders were not anticipated or discussed at that time. 34
For the entire period since the adoption of the Order Execution Rules, the Commission has treated ECNs as being in compliance with the ECN Alternative in those rules even though delivery of execution messages to a market maker in Nasdaq has been available to a non-participating broker-dealer but not available with respect to the same market maker's bids and offers in the ECN. The statements in the Order Execution Rules Release on the subject, or the Release itself, do not reveal whether the Commission was ever aware of the likely consequences of its interpretation of "equivalent access". The Release also did not set forth any detailed consideration of the issues. Nor is it proposed that commenters address the question. Nevertheless, in view of its significance, the issue of execution messages deserves detailed consideration by the Commission before such messages are imposed on the ATSs.
The statutory standards applicable to Commission rulemaking require significant factual support of the determinations that underlie the Commission's adoption of a rule. That naturally must include a projection of the likely impacts of a rule on the entities being regulated. While the rules proposed in the Release do not require an on-the-record hearing under the Administrative Procedure Act (the "APA"), 5 U.S.C. 556 and 557, informal agency rulemaking under 5 U.S.C. 553 requires an agency to present cogent factual support for proposing and enacting rules, rather than merely a "belief". In Timpinaro v. Securities and Exchange Commission, 35 the U.S. Court of Appeals for the District of Columbia Circuit remanded a Commission-approved rule to the Commission for failure to substantiate its belief that the rule would achieve the desired objective.
The rule in question in Timpinaro was an NASD-proposed rule to limit use of SOES by parties determined to be "professional traders" in order to eliminate market-maker exposure to being "picked off" by such traders when quotations were not promptly updated, which the Commission claimed would eventually lead to wider spreads and/or fewer market makers. The Court, however, found that the Commission failed to substantiate its assertions that failure to restrict professional traders would cause market makers to cease making markets or widen spreads. Furthermore, the Commission did not provide sufficient factual support for its belief that the rule would effectively prevent market makers from being picked off, rather than merely prevent the practice via SOES.
Timpinaro stands for the proposition that, in an informal adjudicatory proceeding to approve an SRO rule, the Commission needs to provide a factual basis for its opinion that a proposal would further the purposes of the Exchange Act. The same standards apply to Commission rulemaking under the Exchange Act. In establishing the standards for Commission review of SRO rulemaking in the Securities Acts Amendments of 1975, the Congress made it clear that the two procedures were to be governed by the same procedural standards. 36
As noted above, ATSs today are not subject to executions from a central market system, such as Nasdaq. Instead, ATSs receive orders from participants and, those ATSs that are compliant ECNs under the Order Execution Rules, receive orders from non-participant broker-dealers through Nasdaq's SelectNet linkage.
Accordingly, if the Commission proposes to change the regulatory status quo and to require ATSs to receive executions instead of orders, the Commission must provide competent and persuasive factual support that will establish a sufficient basis for the rulemaking. That basis must find voice in the Exchange Act's purposes and must demonstrate that the Commission is addressing a real problem, and not merely a theoretical one. In its Comment Letter on the Release to the Commission dated July 31, 1998, the Securities Industry Association (the "SIA") observed that the "current regulatory framework has worked successfully to allow the development of innovative trading systems" 37 . The SIA also commented that it did not believe "the Commission has identified any abuses or dangers significant enough to warrant a wholesale revision" 38 of the Commission's current approach to regulating ATSs.
We suggest that, if the Commission has the factual support today for requiring ATSs to receive execution messages, it should publish the data for public consumption and review. As the Commission knows, Section 553(c) of the APA 39 states that, "(a)fter notice required by this section, the agency shall give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments." 40 The purpose, moreover, behind the notice-and-comment procedure is "(1) to allow the agency to benefit from the expertise and input of the parties who file comments with regard to the proposed rule and (2) to see to it that the agency maintains a flexible and open-minded attitude towards its own rules . . . ." 41 The notice of proposed rulemaking must "fairly apprise interested parties of all significant subjects and issues involved," thereby allowing the public to "effectively participate in the rulemaking process." 42
* * *
We appreciate the opportunity to make our views know to the Commission and the staff and we hope that our letter is helpful. If members of the Commission or of the staff believe we may be of further assistance in these matters, please let us know.
Very truly yours,
By: /s/ Lou Eccleston
By: /s/ Kevin M. Foley
Kevin M. Foley
cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Norman S. Johnson, Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Dr. Richard R. Lindsey, Director,
Division of Market Regulation
Robert L. D. Colby, Esq., Deputy Director,
Division of Market Regulation
Belinda Blaine, Esq., Associate Director,
Division of Market Regulation
Harvey J. Goldschmid, Esq.,
Brian J. Lane, Esq., Director,
Division of Corporation Finance
-- Bloomberg is engaged in the business of providing its customers with financial market information, news and analytics via its worldwide electronic network (the "BLOOMBERG service"). Bloomberg also services its broker-dealer and institutional customers' communications needs and facilitates their transaction of business by offering various additional services, including electronic messaging, non-anonymous offerings, bids wanted and equity order-routing and indications of interest, and linkages to certain exchanges within and outside the United States, e.g. , the Arizona Stock Exchange and Tradepoint Investment Exchange. More than one and a half million text messages and several billions of dollars of securities transaction messages are sent and received by Bloomberg customers across the BLOOMBERG service every business day. In addition, we expect in the future to provide access to additional points of liquidity as customer demand dictates.
-- Securities Exchange Act Release No. 38672 (May 23, 1997).
-- See Letter from Bloomberg L.P. to the Commission dated October 3, 1997 (the "Bloomberg October Letter").
-- In this letter, we use the term ECN in the context of Rules 11Ac1-1 and 11Ac1-4 (the "Order Execution Rules") under the Securities Exchange Act of 1934 (the "Exchange Act") and the term "ATS" in referring to the Release. We note that all ECNs are ATSs but not all ATSs are ECNs.
-- Release, in text preceding n. 7 (emphasis added).
-- The proposal of ATS exchange registration in the Release is significantly less attractive to ATSs than the structure initially proposed in the Concept Release.
-- The NASD possibly may have some views on this subject. We offer the following example as a case in point. Seventeen years had passed since the implementation of the Commission's order requiring linkage of third market makers in exchange-listed securities into the ITS, despite the NASD's many good faith attempts to work with ITS participants, before third market makers were permitted to use the linkage to trade a large number of ITS-eligible securities (only Rule 19c-3 securities, that is, those securities listed on an exchange after April 26, 1979, were required by the Commission's order to be subject to linkage). In 1991, the NASD appealed to the Commission to review the failure to remedy the situation by the ITS Operating Committee. See Letter from Richard G. Ketchum to the Commission, dated June 18, 1998. Until July 1998, however, there had been no progress on this appeal. On July 24, 1998, the Commission issued Securities Exchange Act Release No. 40260, containing proposed rules to amend the ITS Plan to expand the linkage to all listed securities and to eliminate the requirement that amendments to the ITS Plan be approved by a unanimous vote of all ITS Plan participants.
-- Sections 6(b) and 15A(b) of the Exchange Act.
-- Section 11A of the Exchange Act grants the Commission numerous powers to facilitate the establishment of a National Market System for securities and the Commission's Rule 192, 17 CFR 201.92, allows petitions to the Commission for the adoption of rules. The efficacy of these channels to provide exchanges with recourse on an ad hoc basis to exchanges appears to be insufficient to establish a level playing field among market centers.
-- Section 19(b)(2) of the Exchange Act requires the Commission to act on a proposed rule change filed by an SRO within 35 days of the filing, or within a longer period not exceeding 90 days if the Commission so designates. As a practical matter, however, the SROs are not in a position to insist on observance of the statutory time periods and the delays involved in resolving many rule filings stretch out into many months or in some few cases even years.
-- We recognize that receipt of tape revenues by exchanges that are ITS members may be an incentive to register as an exchange, but such benefit in our opinion would not counterbalance the negative aspects of registering as an exchange, including entering the ITS as a new member, because the tape revenues are dependent on an ITS member's market volume. For the reasons set forth above, becoming an exchange would not provide opportunity for growth but would instead impede an ATS's growth.
-- The Commission's concerns related in large measure to the privileged access of some market players to pricing superior to what was available to investors generally in the public markets.
-- See Release in text preceding n. 67.
-- For those ATSs that do not hold or handle customer funds and that do not take proprietary positions in the market, these requirements are not relevant to their regulation. As the Commission knows, the net capital rule originally was aimed at protecting customers' funds and securities with broker-dealers. Particularly since the Commission's net capital rule applies only to broker-dealers and not more generally to other market participants, it is not designed or indeed useful, nor did the Congress intend that it be used, as a general rule governing the solvency of market counterparties, or, a fortiori , the solvency of brokers whose customers are entirely institutional and that do not take principal positions. The Commission itself has noted that the rule would not have any necessary application to broker-dealers that did not accept or hold customer's funds or securities but simply acted as a counterparty in delivery-versus-payment and receipt-versus-payment transactions. See Securities Reform Act of 1975, Report of the House Comm. on Interstate and Foreign Commerce to Accompany H.R. 4111, 94th Cong., 1st Sess. 76-77 (1975).
-- Securities Exchange Act Release No. 37619A (September 6, 1996) (the "Order Execution Rules Release") at n. 272.
-- Id. in text at n. 274.
-- Tradebook already meets high standards of responsiveness and transparency. Tradebook responds virtually instantaneously to orders sent to it by Nasdaq via SelectNet. Indeed, Tradebook is required to do so under the terms of its no-action letter from the Commission and under the terms of the ECN Addendum to the Nasdaq Workstation Subscriber Agreement between Tradebook and Nasdaq.
-- See no-action letters from the Commission to various ECNs in 1997 and 1998, stating that the test of a "compliant ECN" requires a response time to non-participant orders no slower than that response time to participant orders. See also Section 2, Response Time, of the Electronic Communications Networks Addendum to Nasdaq Workstation II Subscriber Agreement.
-- The NASD overlooked this point in its proposal (the "Nasdaq Proposal") for its Integrated Order Delivery and Execution System (Securities Exchange Act Release No. 39718, March 4, 1998). The NASD stated it was unfair to market makers, who are required to receive executions, to allow ECNs to receive orders but not require them to receive executions. They omitted from their analysis that ECNs are held to a higher standard of order response.
-- In the context of commenting on the Nasdaq Proposal, we identified this problem as relating to Nasdaq's maximum execution size of 1,000 shares. See Letter from Bloomberg L.P. to the Commission, dated May 12, 1998 (SEC File No. SR-NASD-98-17), at page 5. We note, however, that all ECN orders would be affected, not just those orders for 1,000 shares or less. For example, if an ECN held an order for 50,000 shares, the ECN would be subject to 50 hits for 1,000 shares. Therefore, the proposed rules would cause problems for all ECN orders, not just those at or under 1,000 shares.
-- Nasdaq has informed Tradebook that ECNs will be receiving T-1 communication lines in the near future. By installing these lines, Nasdaq could mitigate the disadvantages to ATSs posed by being subject to execution messages because faster communication lines will speed the response and transmission time between Nasdaq and ATSs. The cost of dedicated bandwidth, especially in the case of large-volume consumers, continues to fall, making T-1 communications lines available for widespread business use. If and when Nasdaq installs T-1 lines for all order-entry firms and Nasdaq market makers, re-routing of orders from an ATS to Nasdaq or from an ATS to another ATS should proceed virtually immediately, with no perceptible delay. If the Commission's concern is one of immediate and automatic response, this improvement should mean that there is no reason to subject ATSs to execution messages. T-1 lines allow messages to be sent and received within a fraction of a second and are a significant improvement over the current delay of three seconds necessitated by Nasdaq's technology. If ATSs' responses to non-participant orders are transmitted by Nasdaq to order-entry firms within a fraction of a second, the speed concern will be resolved.
-- Release in text following n. 107.
-- Nasdaq is fully capable of providing this technology. It provides order-decrementing and quotation-management tools to market makers, and it is reasonable to expect that Nasdaq could add tools to aid in order transmission.
-- See discussion at n. 21 of this letter.
-- See the Bloomberg October Letter at page 6.
-- Release in text preceding n. 58.
-- Id . in text preceding n. 107.
-- The Commission has enacted similar oversight in the past, such as the SECO program. The SECO program was abolished in 1983. See Securities Exchange Act Release No. 20409 (November 22, 1983).
-- See Release at n. 12. Release at n. 12.
-- See Release in text preceding n. 367.
-- Section 23(a) of the Exchange Act provides in relevant part: The Commission and the Secretary of the Treasury, in making rules and regulations pursuant to any provisions of this title, shall consider among other matters the impact any such rule or regulation would have on competition. The Commission and the Secretary of the Treasury shall not adopt any such rule or regulation which would impose a burden on competition not necessary or appropriate in furtherance of the purposes of this title. The Commission and the Secretary of the Treasury shall include in the statement of basis and purpose incorporated in any rule or regulation adopted under this title, the reasons for the Commission's or the Secretary's determination that any burden on competition imposed by such rule or regulation is necessary or appropriate in furtherance of the purposes of this title.
-- See the last paragraph on page 8 of the Bloomberg October Letter. A majority of non-market-maker Tradebook participants voluntarily permit display of at least a portion of their orders in the Nasdaq public quotation. This choice is generally made on a "default" basis for all orders using software provided by Tradebook, but the choice can be made or overridden on an order-by-order basis. Tradebook has pioneered in developing tools to allow market participants, and in particular, institutions, to create a more transparent market. For example, the Tradebook System allows institutional participants to provide for a Reserve quantity attached to a displayed order quantity and price. A participant cannot enter a Reserve without displaying an attached order in the Tradebook System. Another feature of Tradebook that encourages institutions to opt for display of their bids and offers in the public quotation is Discretion. Discretion permits a participant to attach a set spread price and quantity above or below the displayed order and to interact with orders on the other side of the market that fall within that spread. Equipped with these and other tools of Tradebook and ATSs, institutions have been quite willing to contribute their price to the public quotation in the absence of a requirement to do so.
-- Delta Government Options Corp., Securities Exchange Act Release No. 27611, 45 SEC Docket 388, 394 (January 12, 1990), 55 Fed. Reg. 1890, 1894 (Jan. 19, 1990).
-- The issues that have been discussed for the past ten years have centered on markets makers, firm quotation obligations, backing-away complaints, etc. These issues are not relevant to the Release and rulemaking. Electronic trading and automatic routing and response systems have not been examined in the context of SOES. Therefore, the Commission needs to offer cogent factual support rather than merely a belief that ATSs should be subject to execution messages. If the Commission's belief is correct and should be implemented, why should not the same executions responsibility apply to exchanges? For example, should all the regional exchanges be required to accept execution messages sent to them by the NYSE over ITS? If the policy does not apply to exchanges, why should it apply to ATSs?
-- 2 F.3d 453 (D.C. Cir. 1993).
-- See Securities Acts Amendments of 1975 , Report of the Senate Comm. on Banking, Housing and Urban Affairs to Accompany S.249, 94th Cong., 1st Sess. 29-30 (1975): In order to facilitate expeditious Commission review and evaluation of (proposed rule changes) and to assure informed public comment on them, Section 19(b)(1) would require all self-regulatory organizations to file with the SEC in connection with any proposed rule change a "concise general statement of the basis and purpose" of the proposed rule change. It is the Committee's intention in adopting this standard to hold the self-regulatory organizations to the same standards of policy justification that the Administrative Procedure Act imposes on the SEC (emphasis added).
-- See Letter from the Securities Industry Association to the Commission, dated July 31, 1998 (SEC File No. S7-12-98), at 2.
-- Id. at 5.
-- 5 U.S.C. § 553(c).
-- The courts have underscored that accuracy in the notice given to the public is critical to the achievement of the objectives and policies underlying Section 553. See, e.g., Connecticut Light and Power Co. v. NRC , 673 F.2d 525, 530-31 (D.C. Cir. 1982).
-- National Tour Brokers Ass'n v. United States , 591 F.2d 896, 902 (D.C. Cir. 1978).
-- American Iron and Steel Institute v. E.P.A. , 568 F.2d 284, 291 (3d Cir. 1977).