U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Via Hand Delivery and Electronic Mail
Attention: Mr. Jonathon Katz, Secretary
Re: File No. SR-NASD-2001-90 and File No. SR-NASD-2002-23
NexTrade Holdings, Inc., parent company of NexTrade, Inc. ("NexTrade"), welcomes the opportunity to provide the Securities and Exchange Commission (the "Commission") with its comments to the above referenced filings. The filings enumerated above describe the plans of the NASD to operate an Alternative Display Facility ("ADF") and to implement an "ECN Trade-Through Rule."
With respect to the ADF, NexTrade contends that the Commission has been presented with a unique opportunity to provide for the investing public a viable, competitive marketplace. Unfortunately, and as described in detail throughout this letter, the Proposed Rules as amended fall far short of achieving that goal, fail to uphold the standards clearly delineated for an Association under the Exchange Act, violate the Congressionally mandated goals of the National Market System ("NMS"), and will require substantial, additional amendments prior to approval.
With respect to the proposed ECN Trade-Through Rule, NexTrade strenuously objects to the unfounded assertions made by the NASD that ECNs undermine market quality and finds the proposed rule to be deleterious to the investing public. NexTrade contends that the proposed rule discriminates unfairly against ECNs, fails to further the purposes of the Exchange Act, and if adopted would unnecessarily expose the investing public to substantial spread risk and market instability.
With respect to the success of our Country's capital market structure, former Commission Chairman Arthur Levitt stated, "The wisdom and coherence of the framework lies in a single-minded focus: protecting investors. It embodies a basic recognition that public confidence makes markets possible."1 This confidence is grounded in the central components of our market's infrastructure, which according to Mr. Levitt are "the system through which quotes and prices are disseminated to the overall market, and the connections through which prices are accessed (emphasis added)."2
NexTrade believes that Rule 4300 as proposed is unworkable and unsubstantiated. The NASD's basic premise that competitive forces have created an interlocking web of order execution destinations sufficient to satisfy the Association's mandates under the Exchange Act without providing a direct link to executions through an SRO, is based in theory, or perhaps theology, rather than fact. Again citing Mr. Levitt, "Now, for those inclined to write odes to the power of market forces - and I include myself in that group - history and experience presents a stubborn fact about market infrastructure: individual competitive interests cannot always be relied upon to produce a basic framework for competition that serves the public...It is not enough to develop mechanisms and structures that simply display the best prices across markets; a system of competing markets must also support a network of connections that allows prices in one market to be accessed from anywhere in the overall system....Still, many are asking the fundamental question: Why must the Commission involve itself in intermarket linkages at all? Why can't market forces produce these market connections? Once again, part of the answer rests with market forces themselves: a dominant or entrenched market has little or no interest in opening its doors to its competitors. Connections to a market mean access to that market. The Commission needs to continue to ensure that access is a reality for all market participants."3 If approved as amended, Rule 4300 would be a significant step away from the Commission ensuring that all market participants have access to quotes.
In its recently submitted rule filing amending the proposed ADF, the NASD stated it believes that, "The ADF proposal is well within the Congressional framework. It provides a facility with everything necessary - quote collection, trade reporting and comparison services, a market neutral linkage rule, and integration with existing NMS systems - 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."4 NASD further stated in filing for the proposed rules to be approved, the SEC required that the NASD "offer a quote and trading reporting alternative that satisfies the Order Handling Rules, Regulation ATS, and other regulatory requirements for ATSs, ECNs, and market makers."5
Respectfully, NexTrade disagrees with the NASD in its assertion that the ADF proposal is well within the Congressional framework. In the opinion of NexTrade, the proposed ADF structure does not satisfy the Order Handling Rules, Regulation ATS, or the Association's obligations under the Exchange Act. Additionally, the proposed ADF structure will not allow ATSs, ECNs or market makers that choose to belong to the ADF to satisfy many of their regulatory requirements.
Specifically, the NASD's assertions that there exists a "private sector solution" to meet the needs of the marketplace is not true. Of the many elements that bind the Association in performance are those detailed by Congress in its requirements for a National Market System ("NMS"). The objectives set forth were to assure (1) economically efficient execution of securities transactions, (2) fair competition among broker-dealers, among exchange markets, and between exchange markets and markets other than exchange markets, (3) the availability to broker-dealers and investors of market information, (4) the practicability of brokers executing investors' orders in the best market, and (5) an opportunity for investors' orders to be executed without the participation of a dealer.6 NexTrade has addressed in previous comment letters7 to the Commission its view that Rule 4300 as then proposed and now amended does not satisfy any of the above requirements. Therefore, NexTrade will not reiterate those arguments in this letter.
However, as a practical matter, the existing "private sector solutions" NASD referred to in its filing by nature will violate the fifth objective of the NMS, that which requires an opportunity for investors' orders to be executed without the participation of a dealer. In the real world, the various "private sector solutions," including such systems as Lava, PowerNet and BRASS, have sophisticated order routing systems that allow the firms participating in the network to control both where the firm sends order flow and from whom it receives order flow.
Historically, the "endpoints" of these systems have been comprised of a few ECNs and a large number of market makers. With respect to the market makers, they have participated in these networks to receive order flow, almost exclusively, in stocks in which they make markets. In fact and in NexTrade's experience, the market makers to whom NexTrade has routed outbound order flow over private links have only EVER accepted stocks in which they made markets. NexTrade cannot envision a situation where a market maker would, or should, process an agency trade from another brokerage firm without the ability to make money. When the Commission looks at the functional structure of these "private sector solutions" it will recognize that investors having an opportunity for orders to be executed without the participation of a dealer while utilizing private links is an irreconcilable conflict8.
The Commission must first understand the nature of business functions over these links before it can agree with the NASD that Rule 4300 is acceptable. Under the proposed rule 4300, any market maker that wished to participate in the ADF would have to open itself up to accepting order flow from indirect links. As a consequence, the market maker would be exposing itself to accepting trade flow from a third party which could easily be another market maker in the same stock. As the Commission knows, when NexTrade has a marketable limit order it cannot match, it routes trades to other destinations, including market makers. Without exception, every market maker to whom NexTrade has ever routed trades has insisted that NexTrade not route market maker trades to another market maker over a private link. Nasdaq and the NASD both know that market makers will not open themselves up to indirect order flow from potential third party market makers. It is NexTrade's opinion that Rule 4300 has been specifically and artfully crafted to dissuade market maker participation in ADF through the creation of an untenable competitive environment.
The Commission must not overlook the fact that the largest providers of "private sector" broker-dealer connectivity are not themselves broker-dealers. As non-member, private companies, neither the Commission nor the SRO has the necessary authority to validate that the business practices or the pricing practices of these entities do not unfairly discriminate.
If, for example, one of the largest private connectivity providers also provides self-clearing systems, there is nothing to prevent said provider from enforcing greater tolls, or denying access entirely, to those users that do not also accept the self-clearing technologies. Alternatively, if one of the largest private connectivity providers also provides ECN services, there is nothing to prevent said provider from enforcing greater tolls, or denying access entirely, to those users that have competitive ECN services. NexTrade reminds the Commission that even the largest connectivity provider is connected to less than 5% of all broker dealers and that there are relatively few such "private sector solutions." If a firm is denied access to even one such provider, it dramatically increases the likelihood that the firm would not be able to satisfy the proposed ubiquitous connectivity requirement of Rule 4300. Under proposed Rule 4300, NexTrade asserts that neither the Commission nor the SRO has the legal authority to ensure the Association's compliance with its non-discriminatory obligations under the Exchange Act.
The Commission cannot simply accept the NASD's statement that "private sector solutions" exist.9 It may seem mundane, but the fact of the matter is there is not a single ADF participant linked to another ADF participant by virtue of its unapproved status. Nevertheless, the NASD continues to paint the picture with one hand that upon approval of the ADF, the network connectivity between ADF participants will somehow appear, while using the other hand to foil the ease of such connectivity with draconian contracts,10 poor project planning,11 and non-standard protocols.12
In previous letters to the Commission regarding ADF,13 NexTrade argued that Rule 4300 as proposed unfairly discriminated against smaller firms. In its recent filing, the NASD amended "its proposal to clarify that market participants must provide both direct electronic access to those who want it and also allow for indirect electronic access through their customer broker-dealers. In addition, NASD is amending the rule filing to require market participants to provide the same combination of direct and indirect electronic access to members of national securities exchanges that seek access to quotes in the ADF (emphasis added)."14 As a consequence of these amendments, the potential cost discrimination NexTrade articulated in previous letters has increased exponentially. As a consequence of these amendments, smaller firms that wish to participate in the ADF must stand ready to deliver direct lines to essentially every broker dealer in the country if so asked, and indirect lines to essentially every broker dealer in the country whether necessary or not. This is a burden too great for many mid-size firms and its effect will be to preclude many firms from considering ADF participation.15
NexTrade finds the following statement from the NASD's rule filing particularly edifying, "The rule is intended to ensure access to quotes displayed in the ADF for all broker-dealers and exchange members that are not market participants. NASD believes that this purpose can only be achieved effectively if broker-dealers have the option to access quotes through indirect electronic access. If indirect access were not available, the NASD believes it could be overly burdensome and prohibitively expensive on the members - particularly smaller broker-dealers - if they were obligated to link directly to every market participants (emphasis added)."16 How the NASD can argue that such burdens placed upon smaller broker dealers in other markets is unacceptable while such burdens placed upon smaller broker dealer members of its own market is acceptable confounds, but does not surprise, NexTrade. In fact and in form, Rule 4300 as proposed will prove to be "prohibitively expensive on the members - particularly smaller broker-dealers," and it has been intentionally structured to dissuade smaller firms from participating in the ADF. NexTrade strongly urges the Commission to analyze this admission of cost disparity on behalf of the NASD and asserts that it cannot be reconciled under the Association's obligations for equal treatment of members under the Exchange Act.17
The language within the filing from NASD clearly expresses its belief that belonging to the ADF will be an expensive proposition for its participants. The NASD states "Within the ADF, broker-dealers will be able to satisfy their best execution obligations because all market participants would be directly linked (emphasis added)."18 As articulated by the NASD itself, such a proposition could prove overly burdensome and prohibitively expensive. Moreover, the NASD asserts that it believes the ADF will be "predominantly an application programming interface ("API") environment,"19 which translates to an environment of firms with the necessary programming resources to participate. If rule 4300 is approved as amended, the ADF will prove to be an illusory alternative for smaller firms and that cannot be viewed as an acceptable alternative under the Exchange Act20 or the Commission's SuperMontage Approval Order.
The Commission must not lose sight of the fact that the additional costs the NASD cites as burdensome and prohibitively expensive, would be costs initially incurred by members of the ADF, but inevitably transferred to the investor. Moreover, such additional explicit costs on transactions contrast sharply with the objectives of the NMS. "Accordingly, one of the principal Exchange Act objectives for the national market system is to assure the `economically efficient execution of securities transactions.' Investor transaction costs can be divided into two categories - explicit costs, which are separately disclosed to investors, and implicit costs, which often can be greater, though less visible, than explicit costs."21
NexTrade carries strong concerns that under Rule 4300 it will be practically impossible for the ADF to permit new members. Assuming arguendo that the "private sector solutions" exist, the Commission must understand the cost and commitment of time necessary to successfully create a network of direct and indirect connections that has the potential to reach all ADF participants and all exchange member participants. In NexTrade's understanding, the largest order flow connectivity provider is connected to less than 5% of the potential ADF market. Therefore, any new participant in the ADF would likely be forced to connect to all of the largest order flow connectivity providers, which, to NexTrade's understanding, would not reach 80% of potential market participants. Making direct connections to that remaining 80% is an enormous, costly, time consuming, and difficult process.
NexTrade reminds the Commission that there exists a substantial difference between "connectivity only" providers, such as Radianz, TNS, and Savvis, versus "order-flow" connectivity providers such as PowerNet, Brass, and Lava. The "connectivity only" providers merely provide the network links, along the lines of MCI/Worldcom, without order flow translations. In simpler terms, they will "drop" in the lines, but the firms must still perform substantial coding in order to be able to transmit orders between firms. Establishing actual order flow transmissions via such networks when both parties speak FIX, the standard protocol, takes NexTrade an average of three months for a single endpoint. In the event the endpoints do not speak FIX, as is the case with ADF, the gestation period can be far longer. Over "connectivity only" providers, communications through a protocol must be individually established with each participant, and each case carries the requisite programming time. Whereas, with the "order-flow" connectivity providers, firms can connect and send order flow to multiple firms via a single connection. However, as detailed above, NexTrade does not believe these links will offer investors opportunities to execute orders without the participation of a dealer, and NexTrade does not believe "indirect" links to market makers through these systems will be possible.
In the opinion of NexTrade, Rule 4300 is not in conformity with the OHR or Regulation ATS, which clearly contemplated ECNs linking to the SRO for executions, not merely display. In the adopting release for OHR, the Commission stated "Specifically, the display of customer limit orders advances the national market system goal of the public availability of quotation information, as well as fair competition, market efficiency, best execution and disintermediation. The enhanced transparency of such orders increases the likelihood that limit orders will be executed because contra-side market participants will have a more accurate picture of trading interest in a given security. Further, this increased visibility will enable market participants to interact directly with limit orders, rather than rely on the participation of a dealer for execution.... Meeting this requirement may be achieved in a variety of ways, including a linkage between ECNs and one or more of the SROs (emphasis added)."22 Whereas, in Regulation ATS the Commission stated "The Commission agrees with those commentors who stressed the importance of equivalent access for non-participants and who stated that simply requiring alternative trading systems to display prices in the public quotation system does not go far enough to facilitate the best execution customer orders without a mechanism to access orders at those prices... Without a mechanism to access these orders, any public display requirement is insufficient." Under the proposed Rule 4300, the SRO would provide no link to the ECNs or ATSs, which is contrary to Commission's statements in the adopting release of Regulation ATS.23
In the opinion of NexTrade, Rule 4300 is not in conformity with Regulation ATS and if approved as proposed, would jeopardize the NASD's status as an Association. Specifically, Regulation ATS states, "The Commission proposed to define the term `alternative trading system' as any system that: (1) constitutes, maintains, or provides a marketplace of facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange under Exchange Act Rule 3b-16; and (2) does not set rules governing the conduct of subscribers other than the conduct of such subscribers' trading on such organization, association, person, group of persons, or system, or discipline subscribers other than by exclusion from trading. This proposed definition would have the effect of precluding any trading system that performs self-regulatory functions from opting to register as a broker-dealer, rather than as an exchange. Such a system would consequently be required to register as an exchange or be operated by a national securities association."24 As a consequence of the NASD setting governing rules, it would clearly have to be an Exchange or Association.25 However, the Commission further stated that, "In addition, systems that merely provide information to subscribers about other subscribers' trading interest, without facilities for execution, do not fall within paragraph (a) of Rule 3b-16 (emphasis added),"26 which means under Regulation ATS the proposed ADF cannot fall under the definition of an Exchange. If the NASD's system cannot fall under the definition of an Exchange, than NexTrade does not believe it can maintain its status as an Association.
In the opinion of NexTrade, Rule 4300 is not in conformity with the Commission's Order issued to NASD August 8,1996. Specifically, in that Order, the Commission called upon the NASD to "upgrade substantially the NASD's capability to enforce the firm quote rule."27 NexTrade does not believe that dispersing all of the transaction activities away from the auspices of the SRO will result in the NASD substantially upgrading its ability to enforce the firm quote rule. Nor does NexTrade believe that the Proposed Rule 4300 does anything to further the Commission's goal of creating an NMS that assures "the practicability of brokers executing investors orders in the best market."28
In its filing amending the proposed rules of the ADF, the NASD stated, "The NASD believes that once the ADF has successfully completed its own testing protocols, satisfied the SEC's ARP ("Automation Review Policy") requirements, and received rule approval, it will be ready to operate (emphasis added)."29 NexTrade agrees with the NASD that the proposed ADF must satisfy the Commission's ARP requirements, however, NexTrade contends that it will be functionally impossible for the NASD to do so under proposed Rule 4300 because Rule 4300 absorbs the entirety of the order execution "web" under its auspices. In simpler terms, as the "web" is the system through which NASD envisions satisfying it executions, that "web" and every firm with which it is comprised becomes part and parcel of the ARP requirements.
As the Commission knows, the ARP guidelines were detailed under two Commission releases, "ARP I"30 and "ARP II."31 Under ARP I, the Commission called for, "(F)irst, the Commission believes the SROs should formally establish current and future capacity estimates ("Capacity Estimates") for their automated order routing and execution, market information, and trade comparison systems. Second, the SROs should conduct capacity stress tests ("Stress Tests"), periodically, to determine the behavior of automated systems under a variety of simulated conditions. Third, we believe that SROs should contract with independent reviewers to assess annually whether these systems can perform adequately at their estimated current and future estimated capacity levels and whether these systems have adequate protection against physical threat."32 As predominantly a technology and software development company, NexTrade feels well qualified to express its opinion that the NASD will not be able to satisfactorily meet any of these three primary ARP I objectives without unfairly discriminating against smaller firms.
Generally, small firms are relatively more burdened in the creation of current and future capacity estimates. The Commission was specific in its expectations of these estimates. "The Commission believes that each SRO should formulate current Capacity Estimates for the maximum number of transactions its order handling and execution systems can process daily without unreasonable delays, the maximum number of transactions its system can handle over a fifteen minute surge in volume, and future capacity requirements based on projected volume figures. Similarly, the Commission believes that the SROs should formulate daily and fifteen-minute Capacity Estimates for their automated market information and trade comparison systems, along with future Capacity Estimates. In addition, the SROs should formulate contingency protocols ("Contingency Protocols") designed to provide back up facilities in the event of on-line system failures and additional processing capacity during high volume periods."33 If such costs are to be born by the firms, NexTrade does not believe the NASD can adequately satisfy these requirements without unfairly discriminating against small firms. Of course, if the NASD has plans as to how this objective of the ARP can be satisfied that adheres to the standards of the Exchange Act, NexTrade asserts that such plans should be published for public comment.
Moreover, smaller firms are relatively more burdened by a mandate to conduct periodic capacity stress tests, particularly under a variety of simulated conditions, which compound with the fact that these stress tests must encompass all members of the web simultaneously to achieve an accurate result. It is important to note that the Commission was clear on the point that all points in the system must be tested.34 The Commission also requested that the SRO conduct and submit "Vulnerability Studies... The Commission believes that such studies should address the susceptibility of automated systems to computer viruses, unauthorized use, computer vandalism, and failures as a result of catastrophic events (i.e., fire, power outages, earthquakes). In addition, the Commission requests that the SROs promptly notify the Division of any instances in which unauthorized persons gained or attempted to gain access to their systems, and follow-up with a written report of the problem, its cause, and the steps taken to prevent a recurrences."35 NexTrade would suggest that guidance would be necessary from either the Commission or the SRO as to the amount of detail that would be required from smaller firms that would comprise part of the ADF "web." As a rule, smaller firms are generally more vulnerable to all the above listed issues, and many other issues not contemplated by the ARP.
Third, smaller firms will be relatively more compromised to contract with independent reviewers to assess annually whether these systems can perform adequately at their estimated current and future estimated capacity levels and whether these systems have adequate protection against physical threat. As the Commission knows, the primary objective of ARP II was to clarify the standards of review. "In consideration of the importance of the automated trading and information dissemination systems of the SROs to investors, intermediaries, and other market participants, and after engaging in extensive discussions with the exchanges and the NASD about the nature and scope of review necessary to maintain the integrity of the systems, the Commission believes that it is appropriate for the exchanges and the NASD to obtain independent reviews of the general controls in place in the SROs' automated trading and information dissemination systems and risk analyses of those controls to determine the need for further reviews of or enhancements to those controls and applications controls. The Commission continues to believe that, as stated in ARP I, periodic, independent reviews of each SRO's systems should help to `identify potential weak points, and reduce the risk of serious failure.' We believe that the independent reviews and risk analyses should: (1) cover significant elements of the operations of the automation process, including the capacity planning and testing process, contingency planning, systems development methodology and vulnerability assessments; (2) be performed on a cyclical basis by competent and independent audit personnel following established audit procedures and standards; and (3) result in the presentation of a report to senior SRO management on the recommendations and conclusions of the independent reviewer, which report should be made available to Commission staff for its review and comment... Using either a review questionnaire developed by the Commission and SRO staffs or a similar review questionnaire that can be used to measure whether an SRO is meeting the guidelines of the ARP, the independent reviewer is to assess the SRO's general controls in the following areas of the SROs EDP operations: (1) computer operations and facilities; (2) telecommunications; (3) systems development; (4) capacity planning and testing; and (5) contingency planning. Under the Commission's approach as set forth in this Policy Statement, the purpose of the independent review is to have the reviewer evaluate, and report on, the degree to which:
To assure that the review accomplishes its intended objectives, we believe that any independent review should be performed by competent, independent audit personnel following established audit procedures and standards (emphasis added)."36 While all four of the above enumerated criteria inherently place a greater burden on smaller firms, the third criteria, "The SRO has implemented a standardized and documented systems development methodology, that the development documentation is maintained and available for review, that the methodology generally is followed," is impossible to satisfy. In reality, each firm that comprises part of the ADF transaction system has its own development methodology and will not alter its IT structure to bend to a universally applied standard. It is completely unrealistic to expect that all firms that comprise the ADF execution system have a standard development methodology. Above and beyond the fact that the criteria of ARP are impossible to meet for the ADF under Rule 4300, the costs of even attempting to satisfy the criteria are prohibitive. In fact, many smaller firms could be dissuaded entirely from participating in the ADF based on the costs of this independent audit alone.
Above all, however, the "System Change Notifications" of the ARP present the most compelling argument that the proposed ADF cannot satisfy ARP requirements due to Rule 4300. The Commission stated, "(S)ystem Change Notifications. Although the annual report process by itself should provide the Commission with a firm understanding of the general developments at an SRO, it also would assist the Commission if the SROs provided specific information on particular automated systems changes. Accordingly, the Commission believes that the SROs should provide the Commission with notifications of significant changes to automated systems. Specifically, the Commission believes that an SRO should provide notification of a significant or material system change that: (1) affects existing capacity or security; (2) in itself raises capacity or security issues, even if it does not affect other existing systems, (3) relies upon substantially new or different technology; (4) is designed to provide a new service or function for SRO members or their customers; or (5) otherwise significantly affects the operations of the SRO...In general, the notification should describe briefly: the system's functionality and configuration; capacity estimates; test plans and schedules; contingency protocols, i.e., plans for disaster recovery; vulnerability assessments, e.g., security measures; and production schedules. Specifically, as the Commission sees the process working, the presentation contained in the notification should be sufficiently detailed to explain the new system development process, including the systems development methodology employed, the new configuration of the system, its relationship to other systems, the timeframes or schedule for installation, any testing performed or planned, and an explanation of the impact of the change on the SRO's capacity estimates, contingency protocols, and vulnerability assessments."37 NexTrade asserts that the NASD will never be able to satisfy the specific criteria detailed above; (1) affects existing capacity or security; (2) in itself raises capacity or security issues, even if it does not affect other existing systems, (3) relies upon substantially new or different technology; (4) is designed to provide a new service or function for SRO members or their customers; or (5) otherwise significantly affects the operations of the SRO. The Commission must remember that large portions of this system will be controlled by private, non-member, non-broker-dealer entities that cannot be compelled to release such information to the SRO.
More compellingly, the Commission set standards that the SRO must provide advance notice of system changes because such changes could require 19b-4 notification. The Commission stated, "Consistent with its purpose of advising the Commission of changes to systems especially regarding the implications that such changes may have for SRO rules, a notification should be made sufficiently in advance of the planned production date so that the staff can evaluate the adequacy of the capacity estimates and tests, security measures and consider the need for a Rule 19b-4 filing. Generally speaking, the determination for when a rule filing is necessary must be made on a case-by-case basis depending in large part on what the staff learns about the system change in the systems notification. Given the generally lengthy lead time required for the planning and development of significant systems changes, most notifications could be submitted as a part of the annual EDP planning report (emphasis added)."38 NexTrade feels comfortable in its assertion that no private, non-member firm will agree to disclose all of its contemplated changes and await permission from the Commission to implement such changes that it may construe as an immediate business necessity. Furthermore, NexTrade does not believe that either the Commission or the SRO has the authority to compel such disclosures. NexTrade also feels comfortable in its assertion that if member firms that provide similar services are compelled to disclose all changes, in advance, and to await Commission approval prior to implementation, such an impediment to business development would effectively prohibit ALL SUCH FIRMS FROM PARTICIPATING IN THE ADF.
From NexTrade's review of the ARP requirements, it does not appear that the proposed ADF can possibly satisfy the standard set forth by the Commission or the Exchange Act. The NASD cannot enforce the standards under Rule 4300 without unfairly discriminating against smaller firms, and the NASD cannot compel the various private networks to comply. If the NASD has a plan that would allow for the proposed ADF to satisfy the ARP requirements, NexTrade contends that it must be revealed for public discourse prior to the approval of the ADF.
From a theoretical standpoint, Rule 4300 as proposed and if approved would appear to be a substantial departure from the Commission's previous position on the importance of execution linkages among markets. From NexTrade's perspective, there is a fundamental disconnect when the Commission mandates that execution linkages exist between exchanges but not within exchanges.
In a prepared testimony, Arthur Levitt stated "So, in 1975, Congress called on the Commission to facilitate the creation of a national market system to foster greater competition. This framework included three central components. The first was transparency -- exchanges and broker-dealers would publish both the prices at which they were willing to trade, and the prices at which stocks have traded. Second, linkages between exchanges would assist customers in obtaining the best prices available for their orders in any market, wherever first routed. And third, brokers would remain obligated to seek best execution of their customer orders.......Linkages between markets represent one of the principal tools for achieving both centrality and competition. The less close the linkage between markets, the greater the potential that different markets may be trading the same securities at different prices. If we hope to be fair to smaller investors in our markets, we can't afford inferior executions for these investors... To guide the Commission in establishing a national market system, Congress stated that one of its principal goals is "the practicability of . . . executing . . . orders in the best market" and that the means, generally, of achieving that goal is "the linking of all markets (emphasis added)."39
Finally, with respect to the proposed Rule 4300, NexTrade does not believe the Commission has made available for public comment sufficient data that demonstrates it is an approvable rule. In Timpinaro v. the SEC the Courts remanded a Commission order for not adequately substantiating a claim. Specifically, the court cited, "The SEC should have determined how much bid-ask spreads widened as a result of `professional SOES trading,' and whether that increase was large enough--in conjunction with the possibility that market makers would withdraw from some securities--to outweigh the benefit of more timely price changes that the Rule confers. In this vein, we note that the NASD recently issued a study using regression analysis to relate the proportion of trading in a security that is done by `SOES active trading' firms to the spreads quoted by firms making a market in the security.....We cannot say whether such a study could or should have been conducted before the Professional Trader Rule was adopted, but the apparent feasibility of such a study reinforces our conviction that the SEC has not adequately substantiated its implicit claim that the effect of `professional SOES trading' upon bid-ask spreads outweighs the beneficial effect of more timely pricing by market makers. We therefore remand this aspect of the case for the Commission to address the balance of benefits and costs associated with the Professional Trader Rule."40
Admittedly, NexTrade is not aware of any data that is readily available to the Commission to validate the NASD's claims that "private sector solutions" exist. In an attempt to find such data, NexTrade conducted an informal, confidential and anonymous survey of 20 small firms, none of which are Subscribers to NexTrade. Though NexTrade readily admits that it is not schooled in statistically valid sampling techniques, and the results from its survey cannot be construed as reliable, it determined that: 90% of respondents did not know the difference between SuperMontage and ADF, 80% of the respondents relied upon Nasdaq systems for satisfaction of best execution obligations, the average respondent had just over 2 direct connections, and none of the respondents belonged to Lava, PowerNet, or BRASS. If the Commission has data that validates NASD's assertion that "private sector solutions" exist, NexTrade thinks that such data should be published for public consumption. "As the Commission knows, Section 553(c) of the APA41states 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.'42 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 . . . .'43 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.'44"45
In totality, NexTrade is opposed to the proposed Rule 4300. NexTrade does not believe that "private sector solutions" exist to an extent that the Association can satisfy its obligations to promulgate rules that do not unfairly discriminate among members. NexTrade believes that proposed Rule 4300 does not conform with the OHR, Regulation ATS or the Exchange Act. Finally, NexTrade has not seen sufficient evidence from the Commission that the Commission has validated NASD's claim that such "private sector solutions" exist and if rule 4300 is approved as amended, NexTrade believes it will be vulnerable to legal challenge.
As a condition of the SuperMontage approval order, the Commission mandated that participation in SuperMontage must be voluntary. However, as NexTrade has articulated in the previous letters to the Commission,46 the NASD has conspired through a combination of impossible deadlines, anti-competitive price structures, and rules that create an unworkable and non-competitive trade environment to make participation in SuperMontage mandatory for all firms.
NexTrade is not alone in its contention that the NASD is enforcing a rushed and unachievable deadline that renders participation in the ADF impossible for a prudent firm. Other comments include:
The Commission must recognize that in order for a firm to program its technology systems to participate in a market, the firm must know the rules of that market. Simply, the rules to the ADF are not complete, nor in final form, and that renders it impossible for any firm to complete its preparation for the ADF. Historically, the Commission has been very cautious in its approach for implementing market-wide changes. In many cases, the Commission had the luxury of integrating rule changes, such as the OHR, in small steps. Unfortunately, this wholesale change to the market must occur instantly, and NexTrade thinks it would be in the best interest of the investor if market participants were prepared for this change. To that end, NexTrade respectfully suggests that the Commission consider setting a more tenable launch date for the ADF.
Commentors to the ADF have also noted that NASD's failure to share market-data revenue with its participants puts those participants at a significant disadvantage. If the NASD makes the economics of participation in the ADF unacceptable, then it cannot be construed that participation in the SuperMontage is voluntary. "In Instinet's view, the lack of a mechanism to share such revenue, together with other aspects of the NASD Display Facility Fee Proposal, make it very unlikely that the NASD Display Facility will be an economically feasible choice for potential participants and a viable over-the-counter alternative to Nasdaq's proprietary order-matching system.... Market data revenue sharing is a crucial feature of a realistically competitive fee schedule for the NASD Display Facility."50 NexTrade generally agrees with Instinet's position on the need for ADF to be economically competitive and Brut echoes this point, "The recently published Fee Release, which sets a rate structure that imitates the fees that Nasdaq currently charge, is silent on the one issue that would make ADF economics sub-standard: market-data revenue redistribution...Brut respectfully suggests the Commission thoroughly review the Fee Release and NASD efforts in creating the ADF and provide the market-place with guidance regarding the time-table for ADF and SuperMontage deployment to insure a transition of market structure that is both stable and sound"51
Finally, NexTrade finds that the market structure crafted for ADF by NASD creates an untenable trading environment for all potential participants, thereby rendering participation in SuperMontage involuntary. To begin, the ADF Rules as proposed place an unprecedented burden of system speed and reliability on even the smallest members of the ADF. Specifically, the ADF rule filing states, "Additionally, market participants will be required to have in place a system that can accomplish a `round trip' of an order from another market participant in three or fewer seconds, measured from the time an order is released by a market participant until the time notification of action taken on the order is received back by the market participant with which the order originated."52 NexTrade does not believe that a smaller firm, which may need to rely on several "hops" through indirect linkages, can possibly satisfy this criteria. NexTrade would suggest instead that a measurement be taken at each point in the chain as the order crawls it way through the web of indirect linkages. Further, NexTrade suggests that the "round trip" time be extended to at least five seconds, which is the burden of response time for ECNs under SuperMontage, and applied to each "hop" in the chain of linkage. To expect a small firm to be able to match the response time of the ECN community is unlikely enough, much less to demand the higher standards as detailed in the proposal.
Small firms cannot participate in the ADF because under the proposed ADF rules system instability could mean the death of a smaller firm. The filing states, "In addition, to further ensure the reliability of linkages and the integrity of the ADF, the NASD is proposing to suspend from quoting for 20 business days any market participant that experiences three unexcused, confirmed system outages during any period of five business days. NASD proposes to define system outages as (1) an inability to quote or (2) an inability to respond to orders. The proposal provides for a review and appeal process, where the burden will rest with the market participant to establish that a confirmed system outage was attributable to another party (emphasis added)."53 Put simply, no small firm could run the risk of being shut down from quoting for 20 business days in a "guilty until proven innocent" environment.
This rule is regressive in its discriminatory nature and it further illustrates the impracticability of the proposed rule 4300. Smaller firms cannot possibly match larger firms in terms of system reliability. It is a simple fact that network back-ups, redundant power, and swappable sites are the privilege of the resource-rich. By consequence and design, this proposal will render participation in the ADF too great a risk for many firms. NexTrade reminds the Commission that several months ago the NASD itself would have been shut down from quoting for 20 days due to its problems over SelectNet. It is unfair and unreasonable to expect a firm, which is a fraction of the size of the NASD, to meet a higher standard than that required for, and by, the NASD.
The system specification rules, however, are not the only rules that render participation in SuperMontage involuntary. As detailed above, NexTrade does not believe that any member of the market making community will be willing to expose itself to having to support third party links that may result in liability order flow from other market makers. More importantly, though, NexTrade believes that Rule 4300 renders the execution alternatives of ADF inherently more expensive and less practicable for ADF participants. In turn, Rule 4300 increases substantially the risk for broker-dealers that participation in the ADF will jeopardize that participant's ability to satisfy its best execution obligations for its customers.
The Commission has stated, "Price is not the sole factor that brokers can consider in fulfilling their duty of best execution with respect to customer market orders. The Commission has stated that a broker also may consider factors such as: (1) the trading characteristics of the security involved; (2) the availability of accurate information affecting choices as to the most favorable market center for execution and the availability of technological aids to process such information; and (3) the cost and difficulty associated with achieving an execution in a particular market center."54 The Commission has also stated, "A critical factor for non-marketable limit orders, however, is that they be routed to the market center that provides the greatest likelihood of execution."55 Under Rule 4300, ADF participants will not have a centralized execution mechanism by which they may assure the cost and difficulty of achieving execution remains standard. Nor will they be able to assert that trades routed to the ADF have even an equal, much less a greater, likelihood of execution.
Through a combination of impossible deadlines, anti-competitive price structures, and rules that create an unworkable and non-competitive trade environment, the NASD has rendered participation in SuperMontage mandatory for all firms. NexTrade respectfully submits that if the NASD is to satisfy its obligation to make such participation voluntary, then the Commission must force the NASD to provide an execution facility as called for under Regulation ATS and must also set a more tenable ADF launch date.
In a letter to the Commission the Philadelphia Stock exchange stated, "It would be inconsistent with the NASD's self-regulatory responsibility for the NASD to use its regulatory power to advance Nasdaq's market interests to the detriment of its members, and the Commission intends to be vigilant to prevent this. As a result, the NASD will not be able to use its regulatory authority to act in any manner in the preference to, or prejudice of, Nasdaq or any other stock market, marketplace, or market participant generally or specifically because of that entity's relationship to the SuperMontage or Nasdaq."56 While NexTrade agrees with the sentiments expressed in this statement, it appears from an outside perspective that the NASD is doing everything in its power to ensure Nasdaq is successful while ensuring ADF fails. Nasdaq gets the technology, the press, and the execution system while ADF gets unworkable rules, systems in non-standard protocols, untenable deadlines, greater costs, no execution system, and no market data revenue.
With respect to NASD's ownership interest in Nasdaq, it is NexTrade's understanding that, "Nasdaq will purchase the shares (from NASD) for approximately $440 million, payable in a combination of cash and the issuance to the NASD of two newly issued series of Nasdaq preferred stock."57 While NASD made a point of stating, "NASD no longer holds any common stock in Nasdaq, except the stock that underlies the warrants issued in the Nasdaq private placement,"58 NexTrade believes that the warrants and the preferred stock have substantial value. Consequently, NexTrade believes the NASD may be subject to financial conflicts that could improperly influence rulemaking. To avoid this potential conflict, NexTrade believes the Commission should force the NASD to completely divest itself of all Nasdaq holdings. This position has been articulated to the Commission by previous commentors.59
NexTrade believes that a prime example of this economic influence is illustrated in the NASD's insistence that certain trades through the ADF be reported to Nasdaq via ACT. In the rule filing the NASD states, "NASD believes that it will be more convenient and will speed implementation of the ADF for firms to use the existing ACT system to report trades in non-exchange listed securities because the lines and systems are already in place to accommodate these activities."60 Illogically, however, NASD continues, "The NASD believes it must establish a new system such as TRACS for reporting trades in ADF-eligible securities because Nasdaq will be trading many of the same securities and therefore conflicts could arise."61 Therefore, all firms that choose to participate in ADF must develop and purchase the lines and systems necessary to report to TRACS in any event. The NASD offers no evidence that TRACS could not report the same trades with equal convenience and speed. For the sake of separation, to prevent future potential economic conflicts, and to ease the burden of cost by eliminating functionally redundant systems, all reporting in the ADF should be accomplished over TRACS.
As evidenced, NexTrade is not alone in its concerns over the influence NASD's ownership has upon its efforts to make the ADF a viable alternative to the Nasdaq.62 Another simple example of this influence impacting NASD efforts to make the ADF viable is NASD's response to Instinet's request that the ADF be renamed the NASD Display Facility. NexTrade concurs that renaming the facility will heighten investor confidence in the facility, allow the facility to benefit from the goodwill and credibility of the NASD brand, and generally increase its attractiveness to potential participants. NASD's response, "NASD finds such a change unnecessary,"63 presents no lucid counterpoint as to why the facility should not be renamed. As such, commentors are left to speculate as to the rationale behind NASD's refusal to act on a valid suggestion that could improve the viability of the facility. NexTrade concludes that the decision may stem from conflicts of interest related to the economic relationship between NASD and Nasdaq.
Since the comment period on its Form 1 elapsed, the Nasdaq appears to have substantially altered the rules it filed with its original Form 1. Moreover, it also appears that the changes to these rules have been filed in the most covert manner possible with the evident intention to circumvent the public comment process. "When notices of the filings are published in the Federal register, it is too easy to mistake them as covering routine matters that do not warrant the degree of scrutiny they deserve. This impression is reinforced when the filings are not available through the SEC's postings of `Selected SRO Rulemakings' on its web site, as is the case for each of the Interim Rule Filings."64
As the Commission is aware, "An agency commits serious procedural error when it fails to reveal portions of the technical basis for a proposed rule in time to allow for meaningful commentary."65 Also, the Commission is aware that "An agency adopting final rules that differ from its proposed rules is required to renotice when changes are so major that original notice did not adequately frame the subjects for discussion."66 As other commentors have noted, the rule filings the Nasdaq has submitted since the comment period on its Form 1 elapsed appear both substantial and incomplete. The Philadelphia Stock exchange states, "Second, the public record available during the comment process for the Initial Exchange Filing contained materially incomplete and out-of-date information on Nasdaq's plans. Nasdaq officially submitted its Form 1 on November 9, 2000, and the Commission issued its notice soliciting public comment on the Initial Exchange Filing on June 7, 2001. Interested parties were asked to formulate their views on the basis of the original set of proposed rules included with the Nasdaq's application, which were largely modeled on the NASD Rulebook in effect at the time, without regard to any revisions to the NASD rules that occurred during the intervening seven months. Nasdaq finally indicated its intention to incorporate those pre-existing NASD rule changes into its proposed exchange rules on November 13, 2001, when it submitted Amendment 1 to its Form 1, but this occurred two and one-half months after the August 29, 2001 close of the comment period for the Initial Exchange Filing...We only learned of Nasdaq's supplemental filings through a search of the SEC's public reference room files. The only materials available through the SEC's web site are the original outdated Form 1 materials... Even the Public Reference Room files are incomplete. As of February 21, 2002, the attachment to Nasdaq's Amendment 1 to the Exchange Filing was missing. According to Nasdaq's transmittal letter, the attachment contains the text of Nasdaq's revisions to its proposed exchange rules, which we assume are extensive since they incorporate NASD rule changes that occurred over close to a one year period (footnote 7)."67
The American Stock Exchange ("AMEX") reiterated these issues by stating, "It is our understanding that Nasdaq has submitted three amendments to its initial Form 1 filing since the close of the public comment period on the application. The most recent amendment was filed just over two weeks ago, on January 8, 2002, and appears to contain material changes to Nasdaq's proposed exchange rules, notwithstanding Nasdaq's assertion that the changes are non-substantive."68 The AMEX letter continues, "The substantive change to Nasdaq's Form 1 was filed only recently, on January 8th, and underscores the challenge of evaluating the Filing when Nasdaq's plans are shifting, and the need to extend the comment period on the Filing and reopen public comment on Nasdaq's exchange application when an appropriate record is available on Nasdaq's plans."69
Furthermore, NexTrade asserts that when the Commission conditioned the approval of SuperMontage upon a viable ADF, it inextricably linked the ADF's comment period to both Nasdaq's Form 1 and the SuperMontage. Undeniably, the form and functionality of the ADF could have a significant impact on the competitive landscape for the Nasdaq. Consequently, in order for the Nasdaq to properly assess the competitive impacts of its rule filings, and therefore properly notify the Commission in its 19b-4 filing for SuperMontage, the rules of the ADF must be in final form. As the Commission is aware, the General Instructions to Form 19b-4, 5Fed. Sec. L. Rep. (CCH) ¶ 32,356. are explicit. They provide, with respect to "Information to be Included in the Completed Form," as follows:
4. Self-Regulatory Organization's Statement on Burden on Competition
State whether the proposed rule change will have an impact on competition, and if so, (i)state whether the proposed rule change will impose any burden on competition or whether it will relieve any burden on, or otherwise promote, competition and (ii) specify the particular categories of persons and kinds of businesses on which any burden will be imposed and the ways in which the proposed rule change will affect them. If the proposed rule change amends an existing rule, state whether that existing rule, as amended by the proposed rule change, will impose any burden on competition. If any impact on competition is not believed to be a significant burden on competition, explain why. Explain why any burden on competition is necessary or appropriate in furtherance of purposes of the [Exchange] Act. In providing those explanations, set forth and respond in detail to written comments as to any significant impact or burden on competition perceived by any person who has made comments on the proposed rule change to the self-regulatory organization. The statement concerning burdens on competition should be sufficiently detailed and specific to supports Commission finding that the proposed rule change does not impose any unnecessary or inappropriate burden on competition [emphasis added].70
In order for the Commission to properly satisfy its adjudicatory proceedings under the Exchange Act, "the NASD must provide an adequate basis for comment on its rule proposals and, where significant competitive issues are involved, must provide an opportunity for the public to comment meaningfully on the issues involved. Perfunctory recitals do not provide that basis. See Connecticut Light and Power Co. v. NCR 673 F.2d 525, 530-531 (D.C. Cir 1982)"71 With regard to the ADF, SuperMontage, and Nasdaq's Form 1, major competitive issues have been interlinked and an opportunity to comment on the filings, as a whole, must be granted.
Fundamental issues of market structure remained unresolved due to the potentially fluid nature of the ADF proposal. As the Commission knows, the SIA is an organization that is comprised of over 700 members and as an organization has submitted its concerns to the SEC that major market issues are uncertain, "For example, it is unclear how investors will continue to obtain best execution of their orders in a post-ADF world, given, for example, the lack of an order routing capability in the current proposal."72 NexTrade asserts that when members of a securities organization are not provided with rules that are clear enough to allow for an understanding of trade execution, then the Agency that submits the rules has committed a serious procedural error by failing to reveal the technical basis for a proposed rule in time to allow for meaningful commentary.
In fact, Nasdaq's SuperMontage proposal itself should be revisited under these parameters, since many of the changes that Nasdaq has incrementally made to the SuperMontage specifications themselves constitute substantial changes to the way that SuperMontage was intended to work, particularly when juxtaposed with recent rule filings such as the ECN Trade-Through Rule or the amended ADF filing. As the Commission knows, the SuperMontage specifications have a decrementation function which decrements a participant's quotation, which may be the lone Best Bid or Best Offer, regardless of whether there exists an execution, and also prevents that participant from re-entering the market at the same price. Alone, this decrementation function is, in NexTrade's opinion, a potential violation of the OHR. For example, if NexTrade holds an order out to both the ADF and the SuperMontage, and then receives orders from ADF and SuperMontage, if NexTrade satisfies ADF order first, and thereafter rejects the SuperMontage order, SuperMontage will remove ALL of NexTrade's quotes. From this point, if NexTrade receives another limit order at the same price of the previous order SuperMontage will not allow NexTrade to display that quote73, regardless of whether it would improve the market. Coupled with the proposed ECN Trade-Through Rule, NexTrade believes the rules create an environment where ECNs would be running private markets and market makers would be allowed to trade-through those private markets with severely gapped spreads. If so, it would be a return to the market of the early 1990's and an abuse of the OHR.
NexTrade and other market participants need an opportunity to review the final rules of the ADF, and the final rules of all the proposals the NASD has before the Commission, prior to the launch of ADF, SuperMontage, and the Nasdaq Exchange.
"For all the foregoing reasons, we request that the Commission reopen public comment on the Nasdaq Exchange Filing and the ADF Filing together, once a materially complete, fixed and current record is available for public review, so that the filings may be evaluated together...If the Commission proceeds without the benefit of informed public comment, its ultimate decisions whether to approve the ADF Filing or Exchange Filing could be vulnerable to legal challenge as procedurally deficient and `arbitrary and capricious'74"75 NexTrade agrees entirely with the position articulated by the Philadelphia Stock Exchange, and respectfully requests that the Commission reopen public comment following the finalization of the ADF rules.
NASD's recent filing to allow for the trade-through of ECN quotes violates the Association's obligations under the Act. Specifically, those obligations prevent the NASD from passing any rule that unfairly discriminates against members or that imposes any burden on competition not necessary or appropriate. This proposal discriminates unfairly against ECN members of the NASD, imposes a burden on competition that cannot be justified, unnecessarily installs impediments to the market, and serves to make the mechanism of free and open trade less perfect.
In its proposed rule filing, the NASD states, "During the period an ECN remains alone at the best price, the SuperSoes system, in effect, shuts down. The suspension of the Supersoes system's operation in this circumstance prevents other market participants from automatically accessing liquidity at and near the inside and significantly degrades market quality and functionality for the overwhelming majority of Nasdaq market participants, including public investors."76 Prior to addressing the credibility of this statement, NexTrade is compelled to remind the Commission that the NASD made the conscious, competitive decision to not route trades submitted into SuperSoes to ECN's. It would be a small programming effort on behalf of NASD to simply route the trades to an ECN when ECNs are on the inside rather than to hold its member's orders. In light of NASD SuperSoes access fees, NexTrade believes such a simple programming change may represent a workable solution to the issues put forward by the NASD.
In the simplest terms, NASD's implication that ECNs "significantly degrade(s) market quality and functionality" is without merit or evidence, and it is totally unjustifiable in the light of the overwhelming evidence that ECNs improve market quality and functionality. It has been demonstrated that:
Above and beyond the fact that ECNs unequivocally improve market quality, and that any rule designed to trade-through ECNs is therefore in contravention of the Congressional goals of the NMS,107 NexTrade alerts the Commission to the practical dangers such a rule, if approved, would create for investors. It is widely recognized that ECNs frequently establish the inside quote within the OTC market108 and are "integral"109 parts of the market. If SuperSoes is allowed to trade-through such prices, investors will be subject to spreads similar to the spreads they encountered in the early 1990's. As evidence, NexTrade has taken the liberty to enclose multiple screenshots from Nasdaq's own Workstation II Software that demonstrates the increased spread risks that will be associated with the proposed ECN Trade-Through Rule. The examples are attached as "Exhibit A." In the first example, a screenshot of UHAL ("AMERCO"), any buy order that would be allowed to trade through ECN quotes would end up being executed $1.30 per share above the bid, which would represent an implicit cost to the investor of 8.2%. In the next example, a screenshot of SCMM ("SCM Microsystems), any buy order that would be allowed to trade-through ECN quote would be bought $.63 above the bid, which represents an implicit cost to the investor of 7.1%. NexTrade has attached 50 such examples for the Commissions review. Such examples are extremely common, and this rule, if approved, would constitute an effective repeal of the OHR110 and an unacceptable return to the early 1990's Nasdaq market. Moreover, the Commission has previously needed to address rules from an SRO that limits the ability of member organizations to effect transactions on other market centers and found such rules to be, per se, grounds for disapproval of such rules.111
In the Adopting release of regulation ATS, the Commission stated, "Despite the impact on high volume alternative trading systems, integrating their best-priced orders into the public market is critical to the national market system. Section 11A of the Exchange Act directs the Commission to facilitate a national market system and to carry out Congress' objectives of, among other things, assuring `the practicability of brokers executing investors orders in the best market'."112 If approved as proposed, the ECN Trade-Through Rule would reduce by substantial degree the impetus for a broker-dealer handling a customer order to go to the best market. Rather, under the aegis of the ECN Trade-Through Rule, a broker-dealer could execute a customer order at a substantially inferior price, which would be a legitimate risk in a principal trade. As a result of this fact, the proposed ECN Trade-Through Rule is in contravention of the goals of Congress and it must not be approved.
When the NASD originally proposed to allow for the Trade-Through of UTP exchanges over SuperSoes, and as the NASD often exercises the strategy of breaking up rule filings into multiple rule filings that alone seem innocuous but combine to form significant market changes, NexTrade felt certain that a similar proposal to allow for the Trade-Through of ECNs was inevitable. In the UTP Trade-Through filing, however, the NASD specifically addressed that it required the ability to trade through UTP participants because they were not bound by the rules of the SRO, whereas an ECN Trade-Through Rule was unnecessary because the SRO could compel the ECN to respond in accordance with the Association's rules.113 In spite of this assertion, NexTrade is not surprised to now be responding to a proposed rule filing that would allow for the Trade-Through of ECN quotes because many NASD's recent filings seem to stress competitive issues over market quality issues.
Of course, as a matter of function within its filing for the ECN Trade-Through Rule, the NASD has not set forth any evidence114 that the proposed rule would further the purposes of the Exchange Act. Nor has the NASD included any evidence that the market "shut down" that occurs, of the NASD's own volition, in any way impairs market quality. Rather, the NASD has simply proposed a rule that discriminates exclusively against ECNs for competitive reasons, that exposes investors to great spread risk, and that subverts the goals of the NMS. Therefore, the ECN Trade-Through Rule must not be approved.
Since 1997, this Country's market structure has ridden an unprecedented wave of change. Since that year, the Commission has enacted the Order Handling Rules, Regulation ATS, and decimalization. In the wake of these changes, the competitive environment turned sharply against the market making community and many would argue that the current poor and extended market performance is a consequence of the diminishment of market maker presence.
Today, the Commission faces multiple rule filings from the NASD and Nasdaq, the degree, extent, and implications of which far outweigh the OHR, Regulation ATS and Decimalization combined. NexTrade urges the Commission to be cautious. The NASD is spinning off the Nasdaq exchange and building a new Association. In so doing, NexTrade believes the economic motivation for both the NASD and the Nasdaq is focused squarely on the proposed exchange, at the expense of the proposed Association. This is a logical competitive step since market-makers predominately comprise the ownership in the new Nasdaq Exchange. Obviously, any market changes which, under the guise of "better technology" or "a better marketplace" help the proposing agency, in this case the Nasdaq, to gain a competitive advantage, will help the economic interests of the new Nasdaq owners.
In the order approving SuperMontage, the Commission predicated the launch upon a viable, competitive ADF. Though contrite and simple, if the NASD truly believes that its Proposed Rule 4300 is competitive, NexTrade suggests that it asks the Nasdaq to trade it for SuperMontage. If Nasdaq is unwilling to do so, it would suggest that Nasdaq thinks providing an execution system is a competitive necessity for an exchange.
As discussed at length, NexTrade does not agree with the premise or the promise of proposed rule 4300. NexTrade does not believe it to be in a form that satisfies many of the Associations obligations under the Exchange Act or Regulations ATS, and NexTrade does not believe the Commission has substantiated the NASD claims that such a rule could work. Should the rule be approved as amended, NexTrade believes the decision would be vulnerable to legal challenge.
Moreover, NexTrade asserts that the NASD is operating outside of the SuperMontage approval order by making participation defacto mandatory. Through the imposition of impossible deadlines, anti-competitive price structures, and rules that create an unworkable and non-competitive trade environment in the ADF, no firm can "choose" to be an ADF participant.
Furthermore, the NASD and Nasdaq's habitual rule filing practices suggest that the Commission should provide another comment period for the entire set of rules recently promulgated by NASD and Nasdaq. Currently, several unapproved rule filings with substantial potential market impact have been submitted to the Commission. Coupled with the numerous changes to the Nasdaq's Form 1, NexTrade strongly believes that the public must be allowed to comment on the filings as a coherent whole.
Finally, the recently proposed ECN Trade-Through Rule proposal must not be approved. The NASD has submitted no evidence to substantiate its claims, the rule is unfairly discriminatory, and it does not further the purposes of the Exchange Act. As demonstrated, if this rule passes, investors can expect a return to the spreads of the early 1990's with no demonstrable benefit.
NexTrade sincerely appreciates the opportunity to provide the Commission with its comments. If the Commission staff would like to discuss these issues, please contact the undersigned at (727)446-6660.
John M. Schaible
NexTrade Holdings, Inc.
Cc: Katherine A. England, Esq., Division of Market Regulation, SEC
Stephanie M. Dumont, Associate General Counsel, Office of General Counsel, NASD Regulation, Inc.
|1||Speech by SEC Chairman: The National Market System: A Vision that Endures, January 8, 2001.|
|4||Proposed Rule Change Relating to Nasdaq Separation for the NASD and the Establishment of the NASD Alternative Display Facility; Withdrawal and Replacement of response to Comments and Amendment No. 2, on May 24, 2002.|
|6||SEC-REL, SEC-DOCKET 71 SEC-DOCKET 596-12, Regulation of Market Information Fees and Revenues, (Dec. 9, 1999).|
|7||See letters from NexTrade to the Commission dated January 18, 2002, and April 8, 2002.|
|8||See NYSE Rulemaking: Notice of Filing of Proposed Rule Change to Rescind Exchange Rule 390; Commission Request for Comment on Issues Relating to Market Fragmentation. February 23, 2000. "Section 11A(a)(1) of the Exchange Act expresses the Congressional mandate that investor protection and the maintenance of fair and orderly markets require assurance of economically efficient execution of securities transactions in the best market for those transactions, and, consistent with these considerations, for investors' orders to be afforded the opportunity to be executed without the participation of a dealer."|
|9||Timpinaro v. SEC, 2 F.3d 453 (DC Circuit 1993).|
|10||See Note 7, supra.|
|11||See letters from NexTrade to the Commission dated January 18, 2002 and April 8, 2002. See also letter to the SEC from William O'Brien (Senior Vice President and General Counsel) of Brut, LLC on March 20, 2002. See also letter to SEC from Instinet Group Incorporated on April 1, 2002.|
|12||NASD systems have been developed using a proprietary protocol from the OM Group. It is generally accepted industry practice to include the FIX protocol in such systems. To date, NASD has not included FIX.|
|13||See Note 7, supra.|
|14||See Note 4, supra.|
|15||"Even institutional investors, with economies of scale and technology budgets that allow use of multiple ATS's, will be paralyzed in their search for best price as they are forced to go from screen to screen to screen in an attempt to fulfill their fiduciary duty. The small investor, with limited technological resources will be at an even more distinct disadvantage." See letter to the secretary of the U.S. Securities and Exchange Commission from Mike Cormack at American Century Investments on August 12, 1998.|
|16||See Note 4, supra.|
|17||The rules of the association are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, to fix minimum profits, to impose any schedule or fix rates of commissions, allowances, discounts or other fees to be charged by its members, or to regulate by virtue of any authority conferred by this title matters not related to the purposes of this title or the administration of the association. (Emphasis added) See also, that the rules of the association do not impose any burden on competition not necessary or appropriate in furtherance of the purposes of this title.|
|18||See Note 4, supra.|
|20||See letter to SEC from Junius W. Peake (Monfort Distinguished Professor of Finance), April 24, 2000. "What is fair competition? Isn't it providing all market participants equal information and access to market facilities at equivalent cost for services?... The system must execute orders quickly, cheaply and accurately...The system must treat all market participants-brokers, market makers, investors and market center operators-equally.... The system must, by its design, allow all bids and offers in the same security to interact with each other to provide the lowest cost for the buyer and the highest sale proceeds for the seller."|
|21||See Note 8, supra.|
|22||See SEC Release No. 34-37619A, File No. S7-30-95.|
|23||"Accordingly, the Commission is adopting the requirement as proposed. Specifically, with respect to any security in which an alternative trading system is required to publicly display its best priced orders because it has five percent or more of all trading in that security, such alternative trading system must provide for members of the SRO with which it is linked the ability to effect a transaction with those orders (emphasis added)."|
|24||Release No. 34-40760; File No. S7-12-98. Final Rule of Regulation of Exchanges and Alternative Trading Systems.|
|25||"Because the requirements currently applicable to a registered securities association are virtually identical to the requirements applicable to registered exchanges..." Release No. 34-40760; File No. S7-12-98. Final Rule of Regulation of Exchanges and Alternative Trading Systems.|
|26||See Note 24, supra.|
|27||United States of America before the Securities and Exchange Commission in the matter of National Association of Securities Dealers, Inc. Release No. 37538/ August 8, 1996. File No. 3-905.|
|28||See Note 24, supra.|
|29||See Note 4, supra.|
|30||Policy Statement: Automated Systems of Self-Regulatory Organizations SECURITIES AND EXCHANGE COMMISION Release No. 34-27445; File No. S7-29-89 "Automated Systems of Self-Regulatory Organizations."|
|31||Policy Statement: Automated Systems of Self-Regulatory Organizations (II) SECURITIES AND EXCHANGE COMMISION Release No. 34-29185; File No. S7-12-91 "Automated Systems of Self-Regulatory Organizations."|
|32||See Note 30, supra.|
|34||"The SROs also should institute procedures to continue periodic Stress Tests of all of their automated systems and report the results of those tests to the Division (emphasis added)." Ibid.|
|36||See Note 31, supra.|
|39||Prepared Testimony of the Honorable Arthur Levitt Chairman Securities and Exchange Commission", at 10:00 a.m., Wednesday, October 27, 1999.|
|40||See Note 9, supra.|
|41||5 U.S.C § 553(c).|
|42||Connecticut Light and Power Co. v. NRC, 673 F.2d 525, 530-31 (D.C. Cir. 1982).|
|43||National Tour Brokers Ass'n v. United States, 591 F.2d 896, 902 (D.C. Cir. 1978).|
|44||American Iron and Steel Institute v. EPA, 568 F.2d 284, 291 (3rd Cir. 1977).|
|45||See Letter to the SEC from Kevin Foley, Bloomberg L.P., dated August 28, 1998.|
|46||See Note 7, supra.|
|47||See Note 11, supra.|
|49||See letter to the secretary of the U.S. Securities and Exchange Commission, Jonathan Katz, from Instinet Group Incorporated on April 1, 2002.|
|51||See Note 11, supra.|
|52||See Note 4, supra.|
|54||See Note 21, supra.|
|56||See letter from the Philadelphia Stock Exchange, Inc. to Mr. Katz of the Securities and Exchange Commission, on February 25, 2002.|
|57||See Securities Week January 28, 2002. See also URL http://www.nasdr.com/news/pr2002/release_02_007.html.|
|58||See Note 4, supra.|
|59||"Bloomberg and Brut commented that NASD should have to completely divest ownership of Nasdaq to avoid any perception of favoritism. Those firms also suggested that NASD should reveal how the ADF will be financed and to what extent it will be supported by Nasdaq trading volume. To that end, they requested details of NASD's contract to provide regulatory services to Nasdaq after Nasdaq becomes an exchange." Proposed Rule Change Relating to Nasdaq Separation for the NASD and the Establishment of the NASD Alternative Display Facility; Withdrawal and Replacement of response to Comments and Amendment No. 2, on May 24, 2002.|
|60||See Note 4, supra.|
|62||"These filings, in conjunction with the Interim Rule Filings, also raise serious conflict of interest concerns relating to the NASD's economic self-interest as a substantial shareholder in Nasdaq and its longstanding parent relationship to Nasdaq." A letter from the Philadelphia Stock Exchange, Inc. to Mr. Katz of the Securities and Exchange Commission, on February 25, 2002.|
|63||See Note 4, supra.|
|64||See Note 56, supra.|
|65||U.S.C.A. § 553(b)(3)|
|66||See Note 41, supra.|
|67||See Note 56, supra.|
|68||See letter to the secretary of the U.S. Securities and Exchange Commission, Mr. Jonathan Katz from the Member Associations of the American Stock Exchange on January 29, 2002.|
|70||See Footnote 22 from A Letter to Mr. Jonathan Katz from Bloomberg Tradebook LLC on September 12, 2000.|
|71||See Letter to Mr. Jonathan Katz from Bloomberg Tradebook LLC on September 12, 2000.|
|72||See letter to the secretary of the U.S. Securities and Exchange Commission from the Securities Industry Association on February 5, 2002.|
|73||See NasdaqTrader frequently asked questions. URL: http://www.nasdaqtrader.com/trader/hottopics/supermontage/smfaqs.pdf|
|74||See Note 9, supra.|
|75||See Note 56, supra.|
|76||See SR-NASD-2002-23, February 14, 2002.|
|77||See "Electronic Communication Networks and Liquidity on the Nasdaq," written by James P. Weston in April of 2001.|
|80||See "Institutional Trading Costs and Alternative Trading Systems," by Jennifer Conrad, Kevin M. Johnson, and Sunil Wahal, in November of 2001.|
|86||See "Competition on the Nasdaq and the Growth of Electronic communication Networks," by James P. Weston, in July of 2001.|
|92||See "The Quality of ECN and Nasdaq Market Maker Quotes," by Roger D. Huang.|
|97||See "Electronic Communications Networks and Market Quality," written by Michael J. Barclay, Terrence Hendershott, and D. Timothy McCormick on January 22, 2001.|
|107||The objectives set forth were to assure (1) economically efficient execution of securities transactions, (2) fair competition among broker-dealers, among exchange markets, and between exchange markets and markets other than exchange markets, (3) the availability to broker-dealers and investors of market information, (4) the practicability of brokers executing investors' orders in the best market, and (5) an opportunity for investors' orders to be executed without the participation of a dealer.|
|108||See Letter to Mr. Jonathan Katz from Bloomberg Tradebook LLC on September 12, 2000, "An ECN is at the best bid or the best offer about 75% of the time at both the best bid and best offer about 50% of the time, as the American Century data show..." See also letter to the Secretary of the U.S. Securities and Exchange Commission, from American Century Investments', on May 21, 2000, "At the same time, market makers often are represented in the market as the `best' buying or selling price only 25% of the time in many high profile, actively traded stocks while ECNs typically represent the market's best price more than 50% of the time..." See also "The Impact of Decimalization on the Nasdaq Stock Market," a final report to the SEC, which was prepared by Nasdaq Economic Research, The Nasdaq Stock Market, Inc. on June 11, 2001, "The chart shows striking increases in the percentage of the trading day that ECN(s) are alone at the inside."|
|109||"Alternative trading systems, known as ECNs, have become integral to the modern securities markets, providing investors with enhanced flexibility and reduced trading costs, as well as competition to the established securities exchanges and the Nasdaq Stock Market." Special Study: Electronic Communication Networks and After-Hours Market (SEC June 2000)|
|110||"If American Century instead of using ECNs, had traded that $11.6 billion using traditional intermediation during the past year, investors would have paid about $220 million more in effective trading costs for NASDAQ securities - more savings than the assets under management in the median U.S. mutual fund...The enactment of the Order Handling Rules in mid-1997 generated significant additional savings. During data periods from mid-1997, American Century's trading costs for NASDAQ securities have been steadily declining despite a period of relatively high stock price volatility. In three out of four periods since enactment of the Order Handling Rules, American Century experienced lower trading costs for NASDAQ securities than for NYSE-listed securities in marked contrast to our historical experience." See letter to the Secretary of the U.S. Securities and Exchange Commission, from American Century Investments', on May 21, 2000.|
|111||Matter of New York Stock Exch., Notice Proceeding to Consider Disapproval of Proposed Rule Change. Securities Exchange Act Release No. 12249 (SR-NYSE-76-5)(March 23, 1976), 1976 SEC LEXIS 2116.|
|112||See Note 24, supra.|
|113||See Release No. 34-45047; File No. SR-NASD-2001-77; November 8, 2001.|
|114||See Note 9, supra.|