September 25, 2000
Mr. Jonathan G. Katz, Secretary
U.S. Securities & Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Release No. 34-43084, File No. S7-16-00
Disclosure of Order Routing and Execution Practices
Dear Mr. Katz:
Datek Online Holdings Corp. ("Datek Online") is pleased to submit these comments on the Commission's proposals to enhance the information available to the public concerning the order routing practices of broker-dealers. Datek Online's principal securities units interested in these proposals are Datek Online Brokerage Services LLC ("DOBS"), a leading online brokerage firm, and The Island ECN, Inc. ("Island"). This letter will focus upon proposed Rule 11Ac1-6 calling for broker-dealers to submit a quarterly Report on Order Routing ("ROR"). Island will separately comment upon the proposed market center rule, Rule 11Ac1-5.
Datek Online has been an innovator and proponent of measures to improve the quality of executions for customers. To that end, DOBS has advocated actions to better inform investors and has been critical of payment for order flow practices. Further, DOBS has demonstrated its commitment to investors by rebating such payments to its customers. Throughout the first seven months of this year DOBS has rebated over $1,282,921 of such payments directly to its customers. DOBS has further demonstrated its commitment to investors by providing its customers with extended hours trading and promising them that if any marketable order in an exchange-listed or NASDAQ security is not executed within 60 seconds the commission will be waived.
I. Summary of Datek Online's Views on the Broker-Dealer Rule Proposal
We commend the SEC for undertaking these rule proposals, which will advance market transparency and enhance investor access to information about our markets, their own orders and trade executions. Our comments are matters of detail and not of spirit. In the sections below, we urge:
II. Report of Order Routing: SEC Proposed Rule 11Ac1-6
The text of proposed Rule 11Ac1-6(b)(iii) directs BDs to discuss "material aspects" of the BDs relationship to the destination market venue. The provision enumerates only payment for order flow and "profit sharing relationships" ("PSR") as elements to be discussed. In fact, certain destinations, (execution venues for listed securities being the foremost example) occasion costs, not profit sharing opportunities. For such destination venues, the BD should assess cost-weighted execution performance. Customers should assess the BDs performance from the same perspective. As drafted, a BD might elect to address such execution costs as a "material aspect" in fashioning its quarterly report. However, the uniformity and usefulness of the reports will suffer if the Rule fails to contain specific direction to all BDs to address costs as well as benefits.
The definition of a "profit sharing relationship" principally means "any share in any profits that may be derived from the execution of non-directed orders." This satisfactorily captures payment for order flow. However, we are uncertain whether it clearly captures equivalent arrangements that might be modeled upon soft-dollar arrangements. If, in lieu of payment for order flow, a market center provided free real-time quotations or a market-maker provided (or arranged for the delivery of) free research to the originating broker's customers, we would view both of these relationships as proxies for payment for order flow, and hence, as matters that should be equally disclosed in the proposed ROR. We suggest that the PSR definition should be expanded to include the provision by a market center of free or discounted services to a BD in connection with the market center's receipt of BD directed order flow.
Each BD ROR is required to contain a "comparison of the quality of executions actually obtained with those obtained by other venues." The implicit premise is that the data in the respective reports of the various market centers affords a judgment about "execution quality." We question whether the data in all instances will support accurate judgments about execution quality due to (i) differentiated service levels offered by market centers and (ii) the time differential between when BDs receive customer orders and the time of receipt of such orders at destination execution venues.
Market makers typically afford higher levels of service commitments to BDs who guaranty them a certain amount and type of order flow and direct that order flow over proprietary lines. Such order flow is readily distinguishable from SelectNet orders, which in our experience frequently receive inferior executions in terms of both price and time or no execution at all. We also perceive that market centers have a greater appetite for uninformed order flow than for informed order flow. Nonetheless, the 11Ac1-5 Proposed Rule does not require market centers to display data that accords with their differentiated service levels.
This problem could be remedied by requiring a market center's report to disclose whether it afforded any material variation in its order servicing procedures to the order flow of its most favored customers. In the event that the firm does employ variable service levels, the market center should be required to separately disclose performance data for one or more (at the firm's election) of such representative clients.
The market center's proposed monthly report will report data based on the amount of time that expired from the market center's receipt of the order until executed. The proposed rules contemplate that such market center data will be accessible to the public and will be evaluated by BDs in preparing their quarterly ROR. However, a market center's performance data will not always reflect the true quality of the executions of the various BDs that direct order flow to it.
For example, where an order originating firm has a manual, telephonic or order-batching process that precedes the routing of customer orders to a market center, the lapse of such indeterminate periods negates use of the market center's aggregate performance data as a proxy for the originating BDs "non-directed" (as defined by the proposal) order flow. Further, the BD rule even fails to require the BD to describe in its ROR instances where an overburdened or failed communication system, either belonging to the BD or the BDs contracted service bureau, causes orders to be significantly delayed in reaching the market center for execution. Unless Rule 11Ac1-6 is amended to require BDs to disclose the time elapsed and the effect, if any, of such periods on the quality of order executions, the public will be misled by the now contemplated BD reports.
As proposed, BDs will be required to report on the venues to which their orders were routed for execution. The report asks for the BDs total orders (11Ac1-6(b)(1)(i), the size of the pie) and the venues to which they were routed (11Ac1-6(b)(1)(ii), the size of each slice). However, Datek Online's experience is that a single order may be routed to multiple venues. Thus, under the proposal as framed, DOBS routed destination venues would be a total far exceeding the number of customer orders. If the Commission envisions a series of pie charts as a model for BD compliance (and the SEC should back-test its proposal by providing a model report) that permit comparisons between BDs, the proposed Rule will not achieve it. Below are some examples of DOBS' experience with multiple routing destinations for a single marketable order that will illustrate the problem. We expect a different practice at other order originating firms would result in similarly misleading reports.
A few investors and market commentators may find intermediate order routing data to be of interest. However, we suspect that more investors would be confused by the SEC's proposed inclusion of intermediate routing venues. The SEC's goal should be the publication of reports that are highly uniform in presentation and offer substantial opportunities for insightful comparisons between BDs. Accordingly, we urge that the Commission amend the proposed rule to require that all firms report data only for the venues where orders were actually executed.
DOBS investors are afforded the opportunity to transact NASDAQ orders in pre-market and post- market sessions that extend trading opportunities from 8:00 am to 8:00 pm EST. These sessions will likely lengthen in the near future. Only investors who have enabled their accounts for EHT, through a process in which we disclose the risks and circumstances applicable to EHT, are able to participate in these sessions. Only limit orders are accepted by DOBS in EHT. Approximately 5-7 % of Datek's daily trading volume occurs in EHT.
DOBS' customer disclosures make clear that EHT is a special case. We note that the proposed rule has excluded Bulletin Board securities in an apparent recognition of the liquidity and transparency issues that characterize that market. Similarly, we urge the Commission to exclude data from EHT from both the BD and market center reports. Failing that, we suggest that both the market center rule and the BD rule separately report EHT data.
Datek Online supports the SEC's proposal to create an explicit rule entitling an investor to disclosure of the execution venue of the customer's orders. As a matter of agency law, however, we doubt that any firm would presently fail to honor such a customer request. If the SEC believes it needs to carry this initiative farther in order for customers to be truly empowered, we support the initiative.
Finally, we renew the recommendation made in our comment letter to the Market Fragmentation Concept Release (Rel. No. 34-42450). The SEC should require the exchanges to devote some of the extraordinary profits that they derive from selling market data to the maintenance of an Internet accessible database in which investors could query to obtain time and sales data. Only if such data is available will investors truly be able to assess the quality of their own executions.
Very truly yours,
Edward J. Nicoll
Chairman and CEO