Robert C. Gasser
J.P. Morgan Securities Inc.
60 Wall Street
New York NY
Tel: 212 648-0167
October 5, 2000
Mr. Jonathan W. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street N.W. (Mail Stop 0609)
Washington, DC 20549-0609
Re: Rel. No. 34-43084; File No. S7-16-00
(Disclosure of Order Routing and Execution Practices)
Dear Mr. Katz:
J.P. Morgan & Co. Inc. ("J.P. Morgan") welcomes the opportunity to comment on the Securities and Exchange Commission's ("Commission's") proposals to encourage better execution in the equities markets by requiring new disclosures of market centers' execution and broker-dealers' order routing practices. We support the competitive goals and objectives of these disclosure proposals. The costs of such disclosure will be substantial, and thus, we hope the Commission will be able to streamline the proposals to make them as cost-effective as possible. In this regard, J.P. Morgan is in agreement with the Market Structure Committee of the Securities Industry Association and fully supports the concerns expressed in their recent comment letter on this release.1 In particular, we urge the Commission to clarify that new disclosure requirements do not create a basis for private rights of action, and to consider including pre-opening orders in market centers' disclosures. In addition, the Commission should go beyond requiring disclosure to further strengthen competition in the future, by such actions as creating a market-wide system of price-time priority and improved linkage. J.P. Morgan looks forward to a continuing dialogue on these issues. In the hope of contributing to that dialogue, we offer the following additional suggestions for equity market reforms.
Improve Market Linkage Directly and Mandate Price/Time Priority
The Commission's proposals to require disclosure of execution quality by market centers (Proposed Rule 11Ac1-5) and disclosure of order routing practices by broker-dealers (Proposed Rule 11Ac1-6) are only the first steps toward reducing equity market fragmentation and improving execution quality. While disclosure is useful, it alone will not improve market linkages. Even a trade-through disclosure rule with an exception for trades on linked markets will not improve the linkages as much, as quickly, or as cost-effectively as a direct mandate from the Commission. J.P. Morgan continues to believe, as stated in our comments on the Fragmentation Release,2 that the Commission should encourage market participants to propose a better linkage, and should mandate a market-wide system of price/time priority.3 Any other ranking system introduces inefficiencies into the markets, interfering with competition as well as best execution.
An Improved Linkage Would Treat All Quotes Equally
J.P. Morgan is particularly concerned that competing market centers be given equal and unfettered access to the quote. Thus, we believe that the Commission should insist that any new market linkage -- whether through a revised SuperMontage or some other model --display quotations on an equal footing, regardless of source. As last filed with the Commission, the SuperMontage proposal compromises the competitive benefits of a linkage by weighting the ranking so that electronic communications networks ("ECNs")4 drop to the bottom.5 In the short run, this ranking bias would compromise best execution by directing orders away from ECNs that may be faster, more liquid, or more willing to provide price improvement than the market makers at the top of the display. In the long run, the ranking bias would decrease the pressure on traditional market makers to innovate, potentially allowing them to offer slower executions and wider spreads. In this regard, we understand that the NASD intends to amend the SuperMontage proposal to better accommodate the quote disseminated by ECNs -- a step in the right direction, in our view.6 As we discuss below, we believe there are other ways to address potentially anticompetitive practices by ECNs without skewing the linkage so that it is less likely to access the best available quote.
ECN Access Fees Belong in the Quote
Fees charged by ECNs for access to their quotes can impair market liquidity as traditional brokerage commissions do not. Chairman Levitt has publicly criticized the lack of competitive pressure on ECN fees.7 Many, although not all, ECNs attempt to collect these fees through methods inconsistent with a market-wide goal of better execution -- such as turning off SelectNet access to their counterparties. Broker-dealers' duty of best execution often creates a dilemma between being charged an ECN fee to access a better quote for a client or bypassing the quote and facing criticism of their execution practices. If the Commission adopts a trade-though disclosure rule for the equities markets similar to proposed Rule 11Ac-7 for the options markets,8 these broker-dealers might also have to disclose to their customers that they had "traded through" an ECN quote, when the addition of the fee might mean that another quote was better overall.
The remedy for ECN fee abuses is to reflect the fee in the ECN's quote. Any access fee charged by any entity for access to its quote should be reflected in that quote, without reference to a standard of "materiality" relative to the spread. ECNs that charge different access fees to different broker-dealers should be required to display the maximum fee. Broker-dealers that have negotiated a lower fee should be responsible for tracking it themselves, so that they know whether the fee-adjusted quote would provide them with best execution.
Broker-dealers' duty of best execution should not be interpreted to force them to access an ECN quote unless the quote is adjusted to reflect any access fees that the broker-dealer must pay. ECNs that do not charge access fees should be granted equal access to the quote without any obligation of disclosure. Display of ECN fees in the quote is the only way to allow the broker-dealer to make optimally fast routing decisions without fear of mistakenly hitting an inferior quote.
Internalized Orders Should Improve Price by a Minimum Standard
J.P. Morgan continues to have serious concerns about increased market fragmentation and reduced execution quality caused by internalization of customer order flow.9 Market makers that intend to benefit from captive order flow owe their customers a minimum and material threshold of price improvement. We suggest that a required minimum price improvement of 10% of the spread before an order may be internalized provides customers with a significant benefit without imposing too great a burden on internalizing broker-dealers. Such a requirement is based on the spirit of the NASD's Customer Limit Order Protection (Manning) rules,10 but is less burdensome for broker-dealers because it requires a smaller improvement as a percentage of the spread. A smaller improvement requirement, such as the one we propose, may be of less value to the customer in an individual trade. Nevertheless, it should result in price improvement for a wider range of orders, because the internalizing broker-dealer will be able to afford to offer price improvement to that wider range of orders. Similarly, J.P. Morgan believes that NYSE specialist firms also should be subject to minimum price improvement requirements. This would substantially inhibit the practice of penny jumping, which is an abuse of time and place advantage.
Trade-Through Disclosure Should Not be Used to Force Linkage
J.P. Morgan supports the principle behind a trade-through disclosure rule for the equities markets. As we stated for the options markets, however, the Commission should not use a disclosure rule with an exception for trades executed by members of an approved linkage as a roundabout way to force the creation of that linkage. The Commission's position gives it unique advantages as a catalyst for regulatory change. It would ultimately be much faster and cheaper for the Commission to propose a structure for that linkage than to let it evolve by putting indirect pressure on participants through broker-dealers.
Trade-Throughs Should be Noted on the Consolidated Tape
In many instances, disclosure of trade-throughs on the confirmation would come too late for any meaningful complaint. If the Commission hopes to encourage a market in which participants police trade-throughs themselves, it needs a rapid response system, such as display on the consolidated tape. The Commission should encourage information vendors to work with the SROs to create a new system (and to make the necessary improvements in the underlying technology) so that a neutral market center, rather than individual broker-dealers, is responsible for administering an algorithm to identify and flag trade-throughs. All trade-throughs should be subject to the notation requirement. The notation system would be designed more to create an accurate diagnostic record of trade-throughs for use by market professionals than to serve as a "late warning" system for the small retail investor (although such an investor would be able to see the notation on the trade confirmation). For this reason, fewer exceptions would be needed than for a system of disclosure on the confirmation only. For example, large trades would not be exempt from the notation requirement, but trade-throughs resulting from system malfunction might well be. Such a system, like the recently approved Options Market Linkage Plan,11 would depend on complaints from broker-dealers whose orders were traded through. Both broker-dealers and their ultimate customers, if any, would have the data necessary to make a complaint, but we would expect that the most frequent and effective complaints would come from the market professionals themselves, who would be able to react immediately instead of depending on the confirmation for notice of the trade-through.
As the Commission recognized in this release and in its recent options market releases,12 disclosure is only one aspect of a total market improvement program. J.P. Morgan believes that the equities disclosure proposals, with certain amendments, will effectively complement future market reforms, improving transparency and execution quality for all equities investors. J.P. Morgan is pleased that the Commission is moving forward on these issues and looks forward to further dialogue on specific proposals.
1 Letter of Mark Sutton, Chairman, Market Structure Committee, Securities Industry Association (Sept. 26, 2000), commenting on Rel. No. 34-43084, 65 Fed. Reg. 48406 (Aug. 8, 2000).
2 Letter of Robert C. Gasser, Managing Director, J.P. Morgan Securities Inc. (May 15, 2000), commenting on Rel. No. 34-42450, 65 Fed. Reg. 10577 (Feb. 23, 2000) ("J.P. Morgan Market Fragmentation Letter.")
3 J.P. Morgan continues to believe, as it stated in the J.P. Morgan Market Fragmentation Letter, that the best price/time priority system for a market linkage would place customer orders ahead of broker-dealer proprietary orders.
4 "Electronic communications network" is defined in the Quote Rule (Rule 11Ac1-1(a)(8) under the Securities Exchange Act) as "any electronic system that widely disseminated to third parties orders entered therein by an exchange market maker or OTC market maker, and permits such orders to be executed in whole or in part," except for (i) systems that cross orders at set times at a single price and (ii) systems run by market makers that execute customer orders against the market maker's account as principal, other than riskless principal.
5 See Rel. No. 34-43133, 65 Fed. Reg. 49482 (Aug. 15, 2000).
6 See Gretchen Morgenson, "Market Watch: A New Plan Recalls the Old Nasdaq," Wall Street Journal at C1 (Sept. 17, 2000).
7 "Dynamic Markets, Timeless Principles," Remarks by Chairman Arthur Levitt, Securities and Exchange Commission, at Columbia Law School (Sept. 23, 1999).
8 See Rel. No. 34-43085, 65 Fed. Reg. 47918 (Aug. 4, 2000).
9 J.P. Morgan also continues to believe, as stated in our Market Fragmentation Comment Letter, that there should be an intermarket prohibition on stepping ahead of displayed limit orders, whether or not this is done in penny increments.
10 NASD IM-2110-2.
11 Rel. No. 43086 (July 28, 2000), 65 FR 48023 (Aug. 4, 2000).
12 Rel. No. 43085 (July 28, 2000), 65 FR 47918 (Aug. 4, 2000).