Division of Donaldson, Lufkin & Jenrette Securities Corporation
One Pershing Plaza, Jersey City, New Jersey 07399 - (201) 413-2000
September 29, 2000
Mr. Jonathan Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Disclosure of Order Routing and Execution Practices
(Release No. 34-43084, File No. S7-16-00
Dear Mr. Katz:
The Pershing Division of Donaldson, Lufkin & Jenrette Securities Corporation ("Pershing") respectfully submits its comments on the Commission's above referenced rule proposals.
Pershing is a leading provider of correspondent clearing services. In this role, Pershing serves over six hundred broker-dealers encompassing over 50,000 financial consultants and 3,500,000 individual customer accounts. Market structure is a critical issue for Pershing and its customers.
While Pershing generally supports the idea of greater disclosure of order routing and execution practices, we are troubled by the scope of the proposed rules. We have outlined our concerns below.
We believe the Commission, if it adopts the proposals being considered, may impose changes to the equity market's structure. While the industry has repeatedly rejected the idea of a central limit order book and a price-time priority rule, we believe that the effect of the proposed rules would be the practical equivalent of implementing these changes.
Rule 11Ac1-5 - Disclosure by Market Centers
We are concerned that the disclosure requirements for market centers attempt to boil down a firm's best execution decision into only two elements - price and time. The Commission seems to be trying to create a quantitative definition of best execution. We are troubled by this approach since the guidance that the Commission has consistently given the industry is that broker-dealers, in making their routing decisions, should consider price and time, as well as other factors such as the overall market quality, the size of the order, the trading characteristics of the security, the availability of accurate information affecting choices as to the most favorable market in which executions might be sought, the availability of economic access to the various market centers, the level of service provided by the market center and the cost and difficulty associated with achieving an execution in a particular market center.1 If the Commission is trying to change the definition of best execution, we believe that it should go through a separate rulemaking process.
We believe that the data being requested may also confuse the investing public. The Commission itself acknowledges that the average investor will not readily understand much of the information being requested.2 Market participants are being asked to provide untold thousands of lines of data each month which will then be, presumably, boiled down to something that is useful to the investing public. The Commission is counting on consultants, broker-dealers and the financial press to make these statistics understandable to the average investor. The problem is that parties that may often be biased will interpret the information. Consultants and the broker-dealers that hire them may attempt to dissect the statistics to make their own performance seem better than the rest. In addition, the financial press may not be better suited to interpret the statistics than the average investor. We believe that the group that will actually benefit the most from these rules will be trial lawyers. Lawyers will now have information courtesy of the SEC to use in creating class action lawsuits on behalf of investors whose orders may or may not have actually been treated fairly.
Furthermore, because the Commission has no plans to audit the information being provided by market participants, the validity of the statistics may be called into question.
Rule 11Ac1-6 - Disclosure by Brokers
Pershing is equally concerned with the proposed disclosure rules for brokers routing orders as agents. We are primarily concerned with the requirement that brokers disclose payment for order flow and profit sharing arrangements, which by definition includes internalization.
We believe that payment for order flow arrangements may not be adequately disclosed. SEC Rule 10b-10 defines payment for order flow to include not only monetary payments, but also items such as clearance, custody, reciprocal arrangements, adjustments of errors, offers to participate as an underwriter in public offerings, stock loans, and discounts. However, most broker-dealers only understand payment for order flow to mean monetary payments. While almost every routing decision has some sort of economic incentive behind it, we believe that many brokers do not understand the broad definition of payment for order flow and thus will not properly disclose such practices. We suggest that the Commission provide explicit guidance to the broker-dealer community regarding the definition of payment for order flow and their disclosure responsibilities.
Pershing is also troubled by the Commission's negative comments about internalized orders. The term "internalization" refers to the practice of routing orders to an affiliated specialist or market maker. Pershing guarantees that our customers will always receive either the national best bid or offer or better when their orders are routed to our affiliated specialists and market makers. If the regional specialist cannot offer his customer best execution on his own exchange, he will route the order to the market with price priority. Thus, effective linkages are a critical part of an efficient market. Without them, order flow would default back to the primary exchanges, diminishing the price and quality competition now underway that benefits all participants.
We do not understand why the Commission is attempting to require disclosure of a practice that it has never found to have negative effects on the market. In 1997, the Commission thoroughly studied the practice of internalization and at that time, found no evidence that investors were being harmed. In fact, limit orders internalized on the Cincinnati Stock Exchange were found to have higher fill rates than orders routed to the New York Stock Exchange.3 We are not aware of any study done since 1997 that has found otherwise.
Pershing believes that internalization is the most efficient way to execute retail order flow. The Commission's 1997 report affirmed our belief. The Commission acknowledges that it does not have any subsequent empirical evidence showing that internalization detracts from the ability of customers to get best execution. However, by requiring disclosure of internalization, we are concerned that the Commission will be stigmatizing a legitimate practice. We do not believe that the Commission should be requiring disclosure of a practice that does not detract from order execution quality.
In this regard, the Commission has proposed that its Office of Economic Analysis compare trading on the New York Stock Exchange with trading on Nasdaq. We believe that this is not a proper comparison. A proper comparison would look at the way the same security trades in an internalized market like Cincinnati or Boston compared to the primary market.
Further Action to Strengthen Competition in the Markets
We applaud the Commission's efforts to attempt to improve the existing national market system by strengthening price competition and price priority within the existing market structure. We do not believe, however, that a trade through disclosure rule, similar to the one that the Commission has proposed for equity options is the best way to strengthen our markets. Instead, we outline our suggestions for improving the structure of the market below.
I. Improve Mandated Linkages
Chairman Levitt and numerous other commentators have noted that effective linkages are critical to the success of our national market system.4 We were therefore surprised and alarmed that the Commission is now suggesting that linkages may no longer be mandated.5 The New York Stock Exchange has stated that intermarket order routing linkages should be eliminated.6 The primary exchanges apparently are concerned that they may be the source of the best prices, but increasingly will not be the location where the trade is executed because existing linkages facilitate trading in more cost efficient venues. While the New York Stock Exchange still executes the vast majority of the share volume in NYSE-listed securities, more and more broker-dealers are trading in these more efficient venues. In fact, Pershing executes most of its retail orders in NYSE-listed securities on various regional exchanges. These regional exchanges are able to offer faster executions at a lower cost than a similar order sent to the primary exchanges. The solution for the primary markets is to adopt the necessary business practices, technologies, and cost reductions to compete. We are concerned that the primary exchanges will instead attempt to eliminate their competition by refusing to allow other market centers access through linkage. Mandated linkages are the only way to ensure fair access across markets.
We believe that the Commission should modernize the existing Intermarket Trading System ("ITS") by pursuing the following three policies:
First, ITS should provide immediate, if not automatic, executions of trades received from other market centers. Investors today demand prompt and efficient executions of their trades. ITS must be able to provide this function if it is to serve the needs of today's investors and markets. If ITS were to offer immediate executions, its current trade through rule would be vastly improved. The current rule is severely limited in practice because of the time lag between order entry and response time.
Second, the ITS governance plan must be altered. The current system requiring unanimity for any changes does not work because that requirement has operated to effectively block any efforts to modernize ITS without Commission intervention. We would support requiring either a simple-majority or a super-majority vote for any changes.
Third, we agree with Chairman Levitt's position that he does "not envision direct ITS participation by ECNs (other than registered exchanges), but rather believe(s) that ECNs should gain access through an SRO."7 Every ITS participant must be confident that those linked with ITS are subject to adequate market surveillance and that the ITS rules will be enforced. In order to instill that confidence, the ITS plan should continue to require that ITS participants be self-regulatory organizations. ECNs can become participants in ITS by choosing to register as exchanges and thereby assuming SRO responsibility. Those ECNs that choose to remain broker-dealers can participate in ITS through their SRO when their quote is at the top of that SRO's book.
II. Impose Price Priority
Pershing agrees with the Securities Industry Association that the best way to ensure fair and efficient markets while preserving competition is through a price priority rule.8 We support price priority in both the listed and over-the-counter markets. A price priority rule would require a market center receiving an order to route the order to a market displaying a better price or to match the better price that was displayed in the other market center. Such a rule would ensure that investors always received the best possible price available from any market center, while preserving a broker-dealers right to consider a variety of factors when making its order routing decision.
While ITS currently has a trade through rule, the Nasdaq market should be required to adopt a similar rule in order to protect the investing public. By imposing price priority, the Commission can enforce rules against trade throughs, instead of merely requiring that trade throughs be disclosed.
III. Treat Market Makers and ECNs the Same
Under the current system ECNs can charge market participants that access their quotes, but market makers cannot. This is unfair and must be changed. ECNs should not be allowed to charge non-subscribers who access their market, when their market represents the national best bid or offer. If ECNs are allowed to charge access fees, such fees must be added to and embedded within the ECNs quote.
IV. Provide customers with useful information about how their orders are executed
While Pershing supports the general idea of providing customers with more information, we believe that disclosure should be limited to information that can be easily understood and utilized. Instead of adopting the proposed rules, we believe that broker-dealers should be required to provide their customers with a plain English description of how and why their orders are routed and executed on a quarterly basis. The Commission could then help the investing public make better-educated decisions without creating wholesale market structure changes that would not benefit the public.
Pershing wishes to thank the Commission for this opportunity to express its views. We would be pleased to offer our assistance to the Commission as the process continues. Please do not hesitate to contact me if you have any questions regarding these comments.
Chief Operating Officer
1 See SEC Release No. 34-37619A (August 29, 1996).
2 Disclosure of Order Routing and Execution Practices, Release No. 34-43084; File No. S7-16-00; at 13.
3 Report on the Practice of Preferencing Pursuant to Section 510c of the National Securities Market Improvement Act of 1996 (April 11, 1997).
4 Letter from Arthur Levitt, Chairman of the SEC, to the Honorable Charles E. Schumer (December 22, 1999).
5 Disclosure of Order Routing and Execution Practices; at 29.
6 Market Structure Report of the New York Stock Exchange, Special Committee on Market Structure, Governance and Ownership (April 2000).
7 Letter from Levitt to Schumer.
8 Letter from Mark B. Sutton, Chairman, SIA Market Structure Committee, to Jonathan G. Katz, Secretary, Commission, dated May 5, 2000.