1333 H Street, NW - 6th Floor
Washington, DC 20005
July 1, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Release No. 34-45,991; File No. SR-NASD-2001-90
Dear Mr. Katz:
Instinet Corporation ("Instinet") 1 welcomes the opportunity to share with the Securities and Exchange Commission (the "Commission") its views on the rule changes proposed by the National Association of Securities Dealers, Inc. (the "NASD"), through its subsidiary The Nasdaq Stock Market, Inc. ("Nasdaq").2 The Amended ADF Proposal further develops and refines the rules for the NASD Display Facility (the "ADF") proposed by the NASD earlier this year.3 Nevertheless, it fails to resolve several commercial, operational, and technological issues that must be addressed if the ADF is to provide a meaningful alternative for market participants wishing to avoid dependence on Nasdaq's facilities. A viable ADF is essential to achieving the Commission's policy objectives in mandating its creation as a condition to Nasdaq's implementation of SuperMontage and the approval of Nasdaq's application to become a national securities exchange.4 Instinet's comments focus primarily on the proposed rules' impact on the Commission's goals.
To ensure that the Commission's mandate is meaningfully fulfilled, Instinet believes that the Commission must encourage the NASD to address successfully the following challenges:
The resolution of these issues will help transform the ADF into a viable alternative to Nasdaq, and maximize its contribution to the preservation of competition in the over-the-counter securities markets. The importance of addressing these issues in order to ensure that the ADF is competitive is heightened by the proposed discriminatory treatment of ECNs and ATSs within SuperMontage. As a result, until these issues are satisfactorily addressed, the Commission must not permit the launch of SuperMontage or the approval of Nasdaq's application for registration as a national securities exchange.
I. The NASD Has Failed to Design a Viable and Competitive ADF
Instinet continues to believe that the interests of investors in the U.S. securities markets would be best served by promoting effective competition and innovation among the nation's brokers, dealers, and markets - a belief Congress endorsed in adopting the 1975 Amendments to the Exchange Act.5 Recognizing the significance of quotation display to a viable marketplace and the promotion of competition between exchange and over-the-counter markets, Congress mandated that national securities associations adopt rules "to promote orderly procedures for collecting, distributing, and publishing quotations."6
The Commission itself has acknowledged the importance of a viable alternative to Nasdaq's facilities for the preservation and promotion of competition in the securities markets as mandated by the Exchange Act and the 1975 Amendments. To this end, the Commission specifically conditioned the approval of Nasdaq's SuperMontage proposal on the creation of "a quote and trade reporting alternative that satisfies the Order Handling Rules, Regulation ATS, and other regulatory requirements for ATSs, ECNs, and market makers."7 Recognizing that "Nasdaq's exchange registration has implications for the NASD which, as a national securities association, will continue to be required to collect bids, offers and quotation sizes for those entities seeking to trade listed securities, including Nasdaq securities, otherwise than on a national securities exchange," the Commission also made the existence of an operational ADF a prerequisite to the approval of Nasdaq's application to become a national securities exchange.8
It should be obvious that only a commercially viable and truly competitive NASD quotation display and trade reporting facility will satisfy the Commission's (and Congress's) mandate. However, the Amended ADF Proposal does not recognize this, stressing instead that the proposed ADF is sufficient to permit activity that does not violate the Order Handling Rules or Regulation ATS.9 Nowhere does the NASD express any concern about the practicality of its proposal and the viability of the ADF; indeed, the NASD's defense of the ADF as permitting mechanical and minimal compliance with the letter of Commission regulations was an explicit response to commenters' concerns regarding the ADF's viability.
Instinet believes that this is an insupportably narrow view. Instinet believes that when the Commission directed the NASD to build a viable facility it did not envision simply a theoretical means of complying with Commission rules on paper. Rather, it sought to promote the creation of a robust alternative to Nasdaq's inherited facilities that would permit market participants to compete with Nasdaq's SuperMontage system on equal footing. Whatever the precise phrasing of the SuperMontage Order, it is simply illogical to assert that the policy goals underlying the Commission's mandate can be met in any meaningful way by an ADF that ticks all the regulatory boxes but is, as a practical matter, commercially unattractive and non-competitive. To preserve and foster competition in the over-the-counter securities markets, the ADF must provide NASD members with the opportunity to continue effective competition in the trading of Nasdaq securities outside Nasdaq's facilities in the face of the launch of the SuperMontage system10 and Nasdaq's efforts to establish a for-profit exchange.11 An ADF that does not meet minimal commercial requirements does not provide such an opportunity to compete.
The significance of the NASD's lack of concern about the viability of the ADF is underscored by the fact that the Amended ADF Proposal was published only shortly prior to the expected launch date for the ADF.12 The timing of the proposal left no opportunity to implement the suggestions received by the Commission on the expected timetable. Moreover, aside from the commercial shortcomings of the ADF, important technology-related deficiencies make it impractical, if not impossible, for firms to establish the necessary interface with the ADF on the envisaged schedule. These are discussed more fully below.
In Instinet's view, the Commission's mandate, together with the statutory obligation of the NASD to create fair and orderly procedures for collecting, distributing, and publishing quotations relating to securities sold otherwise than on a national securities exchange,13 can only be fulfilled by the creation of a commercially sustainable, technologically sound competitive entity meeting the needs of a broad range of participants in the U.S. securities markets. Unfortunately, the Amended ADF Proposal does not even attempt to present a fully functional system, and unsurprisingly the proposed ADF falls short of providing a true alternative to competing market centers.
A. A Fee Structure Dominated by Lack of Market Data Revenue Sharing and Quote Update Fees Discriminating Against the ECN and ATS Business Models Render the ADF Financially Unattractive to Potential Participants
The clearest evidence that the NASD is uninterested in the commercial success of the ADF is the lack of market data revenue sharing - a feature that makes the ADF stand out in stark contrast to the overwhelming trend among existing trade reporting facilities, including SuperMontage, to offer market data revenue sharing. Nasdaq itself has recently recognized that market data revenue sharing has become an established and essential element of the over-the-counter market landscape and "a basis for competition,"14 and it has proposed to significantly expand the portion of market data revenue available to Nasdaq market participants.15 In Instinet's view, the failure of the NASD to offer future participants in the ADF the ability to share in market data revenues - even as Nasdaq and UTP Exchanges do just that - amounts to a deliberate decision to forego a key element of competition that will all but guarantee that the ADF will not succeed in its statutory and regulatory mission of sustaining a competitive over-the-counter alternative to Nasdaq's facilities.16 The NASD must structure its pricing competitively.17
The NASD's costs in building the ADF do not justify charging a net price that significantly exceeds competitive levels. As noted in our previous comments, its costs in building the ADF should have been more than compensated by the price of the existing facilities transferred to Nasdaq, and, if they were not, that shortfall in Nasdaq's supposedly arm's-length payment should not be shifted to ADF users.18
In addition, the NASD's decision to impose on each ADF participant a quotation update fee on updates exceeding three times the number of trades reported through the ADF19 will deter certain types of market participants from using the ADF. The proposed quotation update fee will have a disproportionate and anti-competitive effect on ECNs and ATSs, whose business models result in markedly higher levels of quote updates generated by their customer activity and regulatory display requirements in comparison to the quote activity of most other market participants. ECNs and ATSs, who are required under the Order Handling Rules and Regulation ATS to update the size or price of their quotes in a specific security each time an entry for that security is made in their order books, will quickly use up their `free' quotation upgrades and will have to pay extra merely to satisfy their obligations under the securities laws. The proposed quotation update fee structure will also discriminate against those who choose to join the ADF but report their trades elsewhere. The fee imposes significant financial burdens on market participants that utilize trade reporting services of other SRO markets without any indication that the quotation activity itself generates higher costs (i.e., the same level of quotation activity will generate much higher fees if conducted by a firm that reports trades elsewhere). Ironically, the NASD's quote update fee proposal is even more discriminatory against users with a relatively high level of quotation activity, such as ECNs and ATSs, than Nasdaq's equivalent fees in SuperMontage, given that other users will pay no fee at all. By failing to revise the proposed fees for the ADF, the NASD not only drives potential participants away from the ADF, but it also abandons its obligation under the Exchange Act to allocate fees equitably20 and in a non-discriminatory manner.21
B. Burdensome Technology Requirements and Incomplete Preparation Contribute to the Inability of the ADF to Provide a Real Alternative for Market Participants
The NASD's decision to require that participants in the ADF communicate with the ADF using the XTP protocol developed by OM will make the ADF less attractive to prospective participants for several reasons. The XTP protocol is not an industry standard and is not widely used in the United States. In fact, Instinet is not aware of any trading system or facility within the United States, other than the proposed ADF, that uses the XTP protocol. Thus, potential ADF participants who do not currently utilize the XTP protocol in their operations would have to incur significant programming and related costs to convert their systems and to prepare for participation in the ADF without any corresponding technological benefits.
The proposed XTP protocol raises numerous additional issues. The protocol is significantly more complex than other widely used protocols, such as FIX, or even the protocols used by Nasdaq. XTP message specifications also are not consistent with industry standards. Additionally, the XTP protocol currently does not define the data format specifications for order reports. As a result, at present it provides no ready means for ADF participants to transmit order information to the ADF. Equally troubling, other XTP programming specifications that have been provided to market participants are incomplete and, in some cases, incomprehensible. To our knowledge, XTP programming guides have still not been provided to potential participants. Under these circumstances even those firms who have determined to code to the XTP protocol will find it difficult or impossible to do so.
In response to concerns voiced by numerous potential participants, the NASD has announced that it may be developing a converter from the XTP protocol to the more widely used FIX protocol. This intention, expressed only weeks before the planned launch of the ADF, will have a considerable impact upon the viability of the ADF at its inception. Many prospective participants may choose to join only after the FIX converter becomes available; at the moment, there is no assurance when or even if this will occur. The initial reluctance to join the ADF will in turn make it a less attractive option even to prospective users who planned on joining upon launch and on using OM's XTP protocol. Even when the FIX converter technology becomes available, it is likely to result in additional costs and performance degradation in comparison to a system that simply uses the FIX protocol. The NASD's decision to require all potential users to adopt a new technological standard rather than creating a system that uses standards already in widespread use is profoundly uncommercial and another illustration of its lack of interest in the practical viability of the ADF.
In any event, firms confronted with the alternatives of committing significant developmental resources and incurring potentially substantial expenses to accommodate the XTP protocol, on the one hand, and waiting for the availability of the FIX converter, on the other hand, will understandably be inclined to avoid the uncertain and unnecessary costs associated with XTP. These practical commercial incentives mitigate against a launch of the ADF before market participants have the opportunity to develop a program code for, and to implement and test, the proposed FIX converter.
Finally, Instinet believes that the systems of the ADF must undergo industry-wide testing prior to its launch to assure that all participants have a reasonable opportunity to prepare technologically and to avoid post-launch operational problems. The Commission and Nasdaq have planned such industry-wide testing prior to the release of SuperMontage,22 to which the ADF is meant to provide an alternative; it would be irresponsible for the NASD not to permit potential participants an opportunity to ensure a smooth transition to the ADF given its mission-critical nature.
II. The NASD Must Revise the Proposed Order Access Rules to Provide Firms With More Flexibility to Choose Their Counterparties, to Establish Prices and to Avoid the Rules' Anticompetitive Effects
A. The NASD Should Only Impose Reasonable and Non-Discriminatory Fair Access Requirements
Instinet continues to believe that the proposed order access rule should be amended to afford firms using the ADF substantially greater flexibility in determining the prices and methods by which they grant access to their orders. Although reasonable and properly structured fair access requirements may be appropriate, excessively rigid constraints on fees and services will deter potential users from participating in the ADF on ordinary commercial terms and will detract significantly from its prospects for success.23
Instinet therefore disagrees with the NASD's proposal that ADF participants allow broker-dealers direct access to redistribute top-of-book access to other broker-dealers at set uniform rates.24 This requirement will deny ECNs the ability to limit redistribution of access to their most valuable asset, their best-priced bids and offers, and of the flexibility to choose with whom to deal.25 The NASD is concerned that requiring smaller broker-dealers to link directly to all market participants would be "overly burdensome and prohibitively expensive."26 However, Instinet does not believe that the solution to this problem is to require other ADF participants to surrender valuable commercial rights by allowing other broker-dealers to redistribute their liquidity without restriction. If anything, the NASD's concern undermines its rationale for failing to provide an order-routing mechanism serving the needs of smaller participants.
Furthermore, allowing the redistribution of top-of-book access eliminates a participant's flexibility in the pricing of its own services, since it requires that users charge uniform rates across customers for accessing their liquidity (otherwise, customers would simply seek redistribution from the lesser rate category). For instance, while the NASD claims that "ECNs may continue to charge more for `hit or take' access," it also requires that ECNs apply their fee for order flow that takes liquidity "to all such order flow, irrespective of its origin."27 These two statements cannot be reconciled; in fact, their practical cumulative effect is to foreclose completely the ability of ECNs to charge more for hit-or-take access.28 The NASD should unambiguously state the right of ECN NASD Display Market Participants to charge their hit-or-take customers more than subscribers for accessing liquidity.
This limitation is by no means offset by "the substantial flexibility to negotiate the terms of many other services, such as full book access, placing orders, and use of reserve sizes," as the NASD claims.29 Access to liquidity is the fundamental service offered by ECNs and ATSs, as the NASD is well aware, and its proposals place stringent and unjustified restrictions on key commercial decisions.
While the NASD rejects the current regulatory framework, it fails to explain how its own regulation of pricing ensures "integrity, accessibility, and reliability" of the quotes on the ADF. Moreover, contrary to the NASD's contention, the approach of the Order Handling Rules and Regulation ATS to liquidity access is also rule-based and ensures accessibility of quotes.30 Unlike the NASD's proposal, however, these regimes employ less intrusive and burdensome means of ensuring access. Regulation ATS, for example, prohibits only ATS pricing that constitutes an effective denial of access.31 These rules do not dictate the core commercial terms of access. It is not clear to us how the NASD's proposed regulation of the prices offered by ADF participants, on the other hand, can be reconciled with the provisions of section 15A(b)(6) of the Exchange Act.
B. ADF Participants Should Not be Forced to Subsidize the Connectivity Decisions of Other ADF Users
Instinet believes that, while it is reasonable for the NASD to ask that ADF participants pay for connections to other participants in the ADF, the newly proposed requirement that users share equally the costs of providing each other with direct electronic access (unless otherwise agreed among themselves) will produce inequitable results.32 In practice, the NASD's approach effectively compels participants to subsidize the connectivity costs of other parties without having any control over the decisions of such parties as to the type of connections they would want to establish. For instance, should an ADF participant choose to use a costly connection to Instinet, Instinet would be required to pay for that participant's expensive access even if Instinet required only a much simpler connection to the participant. The proposal's approach interferes both with the business judgement of participants as well as with related commercial incentives informing decisions about levels of connectivity.
In addition to interfering with the business judgement of participants, the proposed scheme is contrary to existing market practice, under which every market participant pays the full costs of establishing connectivity to other market participants. If participant A wants a T1 line connecting to participant B, but participant B is satisfied with a dial-up connection to Participant A, each pays for (and receives the benefits of) its own commercial decision.33 Should a party be unable to bear the costs of its desired type of connection, it can simply choose a more affordable type of linkage to its counterparty - and it is in the best position to assess and bear the costs and benefits of doing so.34
C. ADF Participants Must Have the Opportunity to Determine the Creditworthiness of their Counterparties Prior to Commencing Business With Them
Instinet also regards as inappropriate the NASD's decision to permit ADF participants to deny direct access to others "only in the limited circumstances where a broker-dealer fails to pay contractually obligated costs for access to a market participant's quotes."35 This limitation is narrower in scope than existing industry standards and, in Instinet's opinion, will potentially subject participants to unnecessary and unprecedented credit exposures. The current provisions of the Order Handling Rules and Regulation ATS, for example, permit broker-dealers to deny direct access to firms that do not meet creditworthiness standards.
If ADF participants will not be able to deny direct access to a participant - even when they have reasonable concerns that participant is unlikely to be able to pay transaction fees or settle trades (absent an actual default) - then it is incumbent on the NASD to perform the function of filtering out these firms who have not defaulted but who pose a credit risk to others in the ADF.
D. The Requirement to Provide Access to NASD Non-Members at no Additional Cost Amounts to a Subsidy of Such ADF Participants at the Expense of NASD Members
Proposed NASD Rule 4300(a)(2) would extend order access requirements to non-NASD member broker-dealers on terms equal to those offered to NASD members. As a result, participants in the ADF would be obligated to "provide members of a national securities exchange direct electronic access, if requested, and allow for indirect electronic access" without having the flexibility to determine the prices these non-NASD members must pay.
Instinet sees no basis for the proposed requirement. It is unlike the equivalent NASD proposed rules that would impose significantly higher charges on such non-NASD broker-dealers for accessing NASD member quotations via the Nasdaq National Market Execution System.36 The effect of this proposed requirement would be to subsidize the access of members of national securities exchanges to the ADF at the expense of NASD members. At the same time, the NASD has failed to provide any explanation or justification for this new requirement. Moreover, the proposed requirement creates a competitive imbalance between ADF participants and non-NASD members as non-NASD members would be under no obligation to provide reciprocal direct electronic access to ADF participants.37
E. The Order Information Requirements in Proposed NASD Rule 4300(b) Must Be Clarified
Proposed NASD Rule 4300(b) is unclear as to the orders subject to the order information requirements contained therein. In addition, the NASD still has not provided technical specifications for compliance. In these circumstances it is not possible to analyze in detail the rule's appropriateness or impact. Instinet reserves the opportunity to further comment on the rule once the NASD makes such information available.
However, it is in any event clear that it will be very difficult or impossible for users to implement whatever specifications are provided in the time allowed under the NASD's schedule. The operational issues involved in doing so are significant, and it is not possible to begin the necessary technical work and coding in the absence of detail about what the requirements are and which orders they apply to.38
III. The NASD Must Redress Practical Shortcomings in Several Facets of the Proposed ADF to Strengthen Its Viability and Attract Participants
A. The Proposed Rules on Trading Halts are Incompatible with ECN Obligations Under the Order Handling Rules
The NASD has amended its proposed rules on trading halts to clarify that the ADF will close to quotation activity whenever it cannot transmit real-time quotation or trade reporting information to the relevant securities information processors ("SIPs").39 Nevertheless, over-the-counter trading in ADF securities may continue despite the fact that the ADF will be closed to quotation activity. However, ECN participants in the ADF cannot meet their obligations under the Order Handling Rules or Regulation ATS during the time periods in which quotation reporting to the ADF is suspended, and the right to continue trading is therefore illusory.
It is also not clear why quotation activity must be suspended at all in circumstances where the NASD is able to report quotes to the relevant SIP and only trade reporting is halted. The Commission and the NASD should exempt ECN participants from these obligations during ADF trading halts or provide other relief enabling ECN business to continue during ADF halts in light of order handling requirements, short of maintaining expensive quote publication connectivity to another self-regulatory organization.
Finally, the NASD should also clarify that the imposition of automatic trading halts provided for in Proposed NASD Rule 5200(a)(1) and (2) does not apply in cases where a Nasdaq trading halt is triggered by extraordinary market activity in Nasdaq "caused by the misuse or malfunction of an electronic quotation, communication, reporting, or execution system operated by, or linked to, Nasdaq."40 Such situations where a competing market halts trading because of improper activity or technical malfunctions in its own systems should not result in a trading halt on the ADF. The imposition of a trading halt is these circumstances would impede fair competition among markets by shielding Nasdaq from consequences of its own systemic imperfections.
B. The Proposed Locked and Crossed Markets Prohibition Is Inconsistent with Promoting Quotation Competition Between Market Centers and Threatens the Decentralized Nature of the Over-the-Counter Markets
Instinet maintains its position that ADF participants should be free to display their actual bids and offers without the imposition of locked or crossed market requirements. The NASD should withdraw its proposal prohibiting, except in certain unlikely circumstances, ECN and ATS participants in the ADF from maintaining quotations that lock or cross those of other participants during business hours.41 This requirement amounts to an unnecessary and burdensome restraint on the ability of these ADF participants to display their actual bids and offers, especially in the decentralized trading environment of independent and competing market centers that the statute requires and the ADF is designed to promote.
Moreover, the "trade-or-move" rules in Proposed NASD Rule 4613(d)(2) should not be incorporated into the ADF environment. The proposal that the ADF participants send "trade-or-move" messages to each other is impractical in light of the ADF's reliance on direct connections among participants, as these messages are not supported by any industry-standard protocol or system currently in use among NASD market participants. While Nasdaq's SelectNet systems employ "trade-or-move" messages, Instinet sees no reason (and the NASD has not articulated any) why the ADF should not adopt a more flexible approach to the issue.
C. The Trade Reporting Obligations of ECNs Under the Proposed Rules of the ADF Should be Streamlined to Provide ECN Participants More Flexibility
Instinet continues to believe that the proposed ADF rules on the responsibilities of participants to report trades through the NASD's Trade Reporting and Comparison Service will unnecessarily complicate the trade reporting processes of ECNs without improving the ADF's functionality. Specifically, the NASD has declined to revise Proposed NASD Rule 6420(c)(2), which would obligate the seller to report a transaction between two ECNs effected through the ADF.42 In contrast, the current convention among ECNs is that the liquidity provider reports the trade. We can discern no advantage to changing this convention. Instinet therefore requests that the NASD clarify that ADF participants will have the ability to enter into Attachment II agreements continuing the market practice of allowing the liquidity provider to trade report in ECN-to-ECN trades.
IV. There Remain General Concerns About Various Aspects of the Design of the ADF that Should Be Addressed
Regardless of whether all ITS-related issues have been resolved, Instinet is concerned that the Commission not approve the ADF for Nasdaq-quoted securities only. Without a facility for exchange-listed securities, NASD members will have no alternative to Nasdaq to trade such securities otherwise than on an exchange. If the Commission nevertheless chooses to proceed with an approval of the ADF solely for Nasdaq-traded securities, it must ensure that the ADF is approved for exchange-listed securities prior to approval of Nasdaq's application to become a national securities exchange and the launch of SuperMontage for such securities. At the same time, Instinet welcomes the NASD's decision to keep participation of the ADF users in ITS optional and to amend the proposed rules of the ADF to eliminate the requirement that users continue to expose orders in the ADF for 30 seconds after they are first published before routing them as commitments to trade to the ITS.43
In addition, while the NASD agrees with Instinet's comment that ADF participants should be provided with a formal mechanism for participation in the governance of the ADF,44 it has not incorporated the idea into the Amended ADF Proposal. Instinet believes that the NASD must establish a formal venue for participation in the governance of the ADF prior to the ADF's launch. Doing so will contribute to the ADF's competitiveness by giving participants a stake in its success and ensuring that the ADF's design reflects market realities.
Furthermore, Instinet asks that the Commission require the NASD and the exclusive SIPs to develop the capability of the ADF to enable market participants to elect to display the depth of their books, given the value of such information in today's decimal trading environment. Such a requirement will not only make the ADF a more equivalent alternative to SuperMontage but will also enhance quality of execution for all market participants.
Finally, on a separate note, Instinet supports the NASD's determination to utilize the national best bid and offer as a basis for its proposed short sale rule.45
V. The Separation Between the NASD and Nasdaq Still Must Be Improved
Instinet is not persuaded by the NASD's contentions that there are no conflicts of interest between the NASD and Nasdaq and that the relationship between the two entities would not affect the viability of the proposed ADF. The NASD has rejected the requests of interested parties to release the terms of its contract for regulatory services with Nasdaq even though the contract constitutes a major source of revenue for the NASD and provides it with an ongoing vested interest in Nasdaq's success. Instinet believes that only the release of the contract's terms will clarify the NASD's incentives and confirm the NASD's claim that the contract was negotiated at arm's length.46
Furthermore, while the NASD is quick to point out that it has eliminated its common stock holdings in Nasdaq, it in fact continues to hold two series of preferred stock in Nasdaq.47 The NASD holds 1.338 million shares of Nasdaq Series A Cumulative Preferred Stock and the single share of Nasdaq Series B Cumulative Preferred Stock. The Series A Cumulative Preferred Stock pays a dividend and is generally non-voting, although it conveys limited voting rights in the event Nasdaq fails to pay a timely dividend. The Series B Cumulative Preferred Stock is a single share that provides the NASD with control over Nasdaq until it is registered as an exchange, at which time it must be redeemed. Obviously, the NASD's Series A Cumulative Preferred Stock holdings provide it with a continuing interest in Nasdaq's commercial success as long as it holds such shares, while its Series B Cumulative Preferred Stock holding provides it with responsibility over Nasdaq's affairs until such time as Nasdaq is registered as an exchange.
These contractual and ownership-related conflicts of interest cast a continuing pall over the NASD's actual and apparent independence from Nasdaq and its neutrality in designing and operating the ADF. These conflicts of interest must be addressed by the Commission and the NASD prior to the approval of the proposed rules for the ADF.
Instinet respectfully requests that the Commission delay the approval of the proposed rules for the ADF to provide the NASD with the opportunity to consider and resolve the numerous serious issues regarding the viability and operation of the ADF raised by Instinet and other market participants. The Commission should also urge the NASD to demonstrate that its proposed solutions to the important concerns discussed above are practical and not prohibitively expensive for potential participants to implement. Furthermore, the Commission should also decline to permit the launch of SuperMontage or to approve Nasdaq's application for registration as a national securities exchange until after the successful establishment of a smoothly working ADF. Only the creation of such a viable and financially stable ADF will enable the Commission and the NASD to fulfill their respective requirements under the U.S. securities laws and will promote the competition and innovation in the over-the-counter securities markets envisioned by Congress.
Please do not hesitate to contact the undersigned or Edward J. Rosen of Cleary, Gottlieb, Steen & Hamilton (212-225-2820), counsel to Instinet, if you should have any questions regarding this matter.
First Vice President,
cc: The Honorable Harvey L. Pitt, Chairman
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Cynthia A. Glassman, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Elizabeth K. King, Associate Director, Division of Market Regulation
John Polise, Senior Special Counsel, Division of Market Regulation
|1||Instinet is a registered broker headquartered in New York City. Together with its affiliates, Instinet currently trades in forty global markets and is a member of twenty exchanges around the world. Instinet is a pure agency broker, serving its global client base by consistently reducing transaction costs, and thereby increasing investment performance for investors and their proxies. More information about Instinet and its activities is available on Instinet's web site at www.instinet.com.|
|2||Securities Exchange Act Release No. 45,991 (May 28, 2002), 67 Fed. Reg. 39,476 (June 7, 2002) (File No. SR-NASD-2001-90) (the "Amended ADF Proposal") (amending the NASD proposed rule changes published in Exchange Act Release No. 45,156 (Dec. 14, 2001), 67 Fed. Reg. 388 (Jan. 3, 2002)).|
|3||Instinet submitted comments to the Commission on the original proposed rule change in a letter dated February 13, 2002. See Letter from Douglas M. Atkin, President and Chief Executive Officer of Instinet Corporation to Jonathan G. Katz, Secretary, Commission (Feb. 13, 2002) ("ADF Comment Letter").|
|4||NASD Rulemaking: SuperMontage, Exchange Act Release No. 43,863 (Jan. 19, 2001), 66 Fed. Reg. 8019, 8054 (Jan. 26. 2001) (the "SuperMontage Order"); The Nasdaq Stock Market, Inc., Notice of Filing of Application for Registration as a National Securities Exchange, Exchange Act Release No. 44,396 (June 7, 2001), 66 Fed. Reg. 31,952, 31,953 (June 13, 2001).|
|5||See the Senate Report accompanying the 1975 Amendments, which concluded that "the ability of individual firms as well as the various exchange and over-the-counter markets to compete with one another [would] be a critical element in the successful functioning of the national market system." S. Rep. No. 94-75, at 1. Similarly, Section 11A(a)(1)(C)(ii) of the Exchange Act encourages "fair competition ... between exchange markets and markets other than exchange markets" as a means to enhance the public interest, protect investors and maintain fair and orderly markets.|
|6||Section 15A(6)(11) of the Exchange Act.|
|7||SuperMontage Order, supra note 4, at 8054.|
|8||The Nasdaq Stock Market, Inc., Notice of Filing of Application for Registration as a National Securities Exchange, Exchange Act Release No. 44,396 (June 7, 2001), 66 Fed. Reg. 31,952, 31,953 (June 13, 2001).|
|9||See Amended ADF Proposal at 39,539 ("[T]he Commission's SuperMontage Approval Order does not require that the NASD build an alternative facility that replicates all of the capabilities and features of Nasdaq. Rather, the SEC requires only that the NASD `offer a quote and trading reporting alternative that satisfies the Order Handling Rules, Regulation ATS, and other regulatory requirements. . . .' The Commission's order does not require the NASD to provide an execution service, but instead mandates that the facility provide `access to its quotes on a market-neutral basis.' The NASD believes that the ADF proposal satisfies the Commission's order and all other applicable rules and statutory requirements. . . . It provides a facility with everything necessary . . . for market participants to trade over-the-counter and leaves it to the market participants to decide how to best utilize the facility and communicate with each other.").|
|10||The availability of a venue for trading over-the-counter stocks independent of SuperMontage is particularly important in light of Nasdaq's recently proposed SuperMontage fees. See Securities Exchange Act Release No. 45906 (May 10, 2002), 67 Fed. Reg. 34,965 (May 16, 2002) (File No. SR-NASD-2002-44). The proposed exclusive liquidity provider rebates for SuperMontage users who do not charge access fees are facially discriminatory against ECNs and ATSs who charge access fees. Equally importantly, the quotation replacement and cancellation charges based on levels of quotation activity translate into disproportionately higher total charges for ECNs and ATSs, whose business models incorporate higher levels of quotation updates.|
|11||For a discussion of the various competitive advantages Nasdaq has acquired during its affiliation with the NASD, see the ADF Comment Letter, supra note 3, at 3-4.|
|12||In fact, the original date the NASD proposed for the launch of the ADF was June 28, 2002. As of today, this date has not been re-set officially. Meanwhile, Nasdaq still expects to launch its SuperMontage system on July 29, 2002.|
|13||See Section 15A(b)(11) of the Exchange Act.|
|14||Securities Exchange Act Release No. 45916 (May 10, 2002), 67 Fed. Reg. 35,167, 35,168 (May 17, 2002) (File No. SR-NASD-2002-61).|
|15||According to Nasdaq, the purpose behind expanding market data revenue sharing is to "ensure that Nasdaq can effectively compete with exchanges that trade Nasdaq securities on an unlisted trading privileges basis." Id.|
|16||For a more detailed analysis of the proposed fee structure of the ADF, see Letter from Douglas M. Atkin, President and Chief Executive Officer of Instinet Corporation to Jonathan G. Katz, Secretary, Commission (Apr. 1, 2002).|
|17||Of course, the NASD should not be permitted to adopt an alternative scheme under which market data revenue sharing is accompanied by corresponding increases in other fees or charges payable by ADF participants. The cumulative effect of such a proposal would obviously provide a ready means of circumventing the competitive benefits of market data revenue sharing.|
|18||Letter from Douglas M. Atkin, President and Chief Executive Officer of Instinet Corporation to Jonathan G. Katz, Secretary, Commission (Apr. 1, 2002), at 5.|
|19||Proposed NASD Rule 7010(b) contained in Exchange Act Release No. 45501 (Mar. 4, 2002), 67 Fed. Reg. 10,942 (Mar. 11, 2002).|
|20||Under Section 15A(b)(5) of the Exchange Act, the NASD is required to provide, through its rules, for "the equitable allocation of reasonable duties, fees, and other charges among members ... using any facility or system which the association operates or controls."|
|21||Section 15(A)(b)(6) of the Exchange Act prohibits NASD rules "designed to permit unfair discrimination between customers, issuers, brokers or dealers."|
|22||SuperMontage Order, supra note 4, at 8030.|
|23||For a further discussion of Instinet's position on this issue, see ADF Comment Letter, supra note 3, at 5-9.|
|24||Amended ADF Proposal, supra note 2, at 39,540. Instinet would like to underscore that it is concerned with the redistribution of order access, not order data, as the NASD suggests. See id. at 39,541.|
|25||In contrast to exchanges, the Exchange Act generally affords broker-dealers significant latitude in selecting the counterparties with whom they deal.|
|26||Amended ADF Proposal, supra note 2, at 39,540.|
|27||Amended ADF Proposal, supra note 2, at 39,542. "Hit or take" customers are those who are not subscribers and never add liquidity to an ECN's order book; they merely take liquidity by responding to quotations that are at the inside of the national best bid and offer.|
|28||The order access rule as proposed will permit a hit-or-take customer of an ECN ADF participant to use indirect access through a customer broker-dealer to avoid hit-or-take fees while aggregating order flow. Thus, indirect access provides a backdoor to hit-or-take access - a problem that the NASD does not address in its Amended ADF Proposal.|
|29||Id. at 39,541.|
|31||The NASD's proposal is also significantly more restrictive than the Commission staff's ECN no-action letter which, like Regulation ATS, affords ECNs flexibility in their pricing of access to an ECN through Nasdaq facilities.|
|32||See Proposed NASD Rule 4300(a)(3).|
|33||Typically, there are two linkages in each bilateral connection, one for access to A's system initiated by B and one for access to B's system initiated by A.|
|34||Thus, there should be no concern that asking a participant to pay for its desired level of connectivity to others in the ADF could amount to a de facto denial of access. A refusal by one participant to subsidize the level of connection desired by the other may make it more expensive for the second party to connect to the first, but it will only make the cost commensurate with the expense of the connection it has selected.|
|35||Amended ADF Proposal, supra note 2, at 39,546.|
|36||See, e.g., Securities Exchange Act Release No. 44931 (Oct. 12, 2001), 66 Fed. Reg. 53,276 (Oct. 19, 2001) (File No. SR-NASD-2001-72).|
|37||For Nasdaq-quoted securities, the Nasdaq UTP Plan only requires UTP exchange members to provide telephonic access to NASD member market makers and ECNs. For exchange-listed securities, an ADF participant that is not also a member of an exchange would only have indirect electronic access to a non-NASD members' quotation through the Intermarket Trading System ("ITS") if such ADF participant chose to participate in ITS.|
|38||Furthermore, this burden is largely unnecessary with respect to ECN participants in the ADF. Since they are automated systems, the need for real-time monitoring of their compliance with NASD rules is largely reduced.|
|39||Proposed NASD Rule 5200(a)(3).|
|40||NASD Rule 4120(a)(6).|
|41||Proposed NASD Rule 4613(d)(1).|
|42||See Proposed NASD Rule 6420(c)(2).|
|43||See Proposed NASD Rule 6561; see also Amended ADF Proposal, supra note 2, at 39,544-45.|
|45||See Proposed NASD Rule 5100; see also Amended ADF Proposal, supra note 2, at 39,545.|
|46||Amended ADF Proposal, supra note 2, at 39,546.|
|47||See Securities Exchange Release No. 46060 (June 11, 2002), 67 Fed. Reg. 41558, 41560 (June 18, 2002) (File No. SR-NASD-2002-64) (discussing the NASD's preferred stock holdings in Nasdaq). The Restated Certificate of Incorporation of the Nasdaq Stock Market, Inc. allows the Nasdaq Board to issue up to 30 million shares of preferred stock in one or more series. Id.|