October 22, 2003
Mr. Jonathan G. Katz
Re: File No. SR-NASD-2003-128
Dear Mr. Katz:
Introduction and Summary
Instinet Corporation ("Instinet") and The Island ECN, Inc. ("Island"), wholly owned subsidiaries of Instinet Group Incorporated,1 appreciate the opportunity to share with the U.S. Securities and Exchange Commission ("Commission") their comments on the proposal submitted by the NASD, on behalf of its subsidiary The NASDAQ Stock Market, Inc. ("NASDAQ"). The Proposal seeks to establish a $0.003 cap per share on access fees charged by ECNs that display quotations in NASDAQ's SuperMontage system and to eliminate the SuperMontage execution algorithms that consider ECN access fees and order size in determining execution priority among SuperMontage participants.2
Instinet and Island recommend that the Commission approve the Proposal in its entirety. Instinet and Island believe that, consistent with past Commission practice, the Commission should closely evaluate any SRO proposal that would impose caps or floors on fees charged for services provided by market participants, especially in those instances where the SRO directly competes with such market participants in providing the service at issue. In this instance, however, Instinet and Island believe that NASDAQ's adoption of an ECN access fee cap is a legitimate step for NASDAQ to take to preserve the integrity of its market, given the experience of certain ECNs extracting profits in excess of competitive levels, or "economic rents," from their participation in SuperMontage - by charging access fees for orders they receive and execute through the SuperMontage non-directed order process at levels significantly beyond which they could charge in the open marketplace. Instinet and Island further believe that this behavior is at the heart of the current agitation among some market participants over the issue of ECN access fees. As a result, Instinet and Island believe that the adoption of the Proposal will have the additional benefit of enabling any consideration of the issue of access fees generally in the context of the Commission's ongoing review of U.S. market structure to occur without the undue distraction of this problematic, yet readily correctable, operational issue inherent to the SuperMontage system.
In addition, Instinet and Island support the elimination of the SuperMontage execution algorithms that consider ECN access fees and order size in assigning execution priority among SuperMontage participants. In particular, Instinet opposed the algorithm that considers ECN access fees when it was first proposed as anticompetitive in nature. Instinet and Island believe that its elimination is particularly appropriate in the context of the implementation of a cap on ECN access fees within SuperMontage.
I. Imposition of a $0.003 Per Share Access Fee Cap on ECNs Participating in SuperMontage
NASDAQ is proposing to amend NASD Rule 4623, which governs the participation of ATSs and ECNs in NASDAQ, to impose a cap of $0.003 per share on the access fees that ATSs and ECNs participating in SuperMontage can charge broker-dealers in transactions resulting from orders or executions delivered to such ATSs and ECNs by SuperMontage.
NASDAQ states in its filing that a substantial disparity exists in the level of access fees charged by ECNs participating in SuperMontage, with some charging fees three times as high as other participating ECNs. Instinet's own experience confirms this statement, with the range of access fees Instinet is charged by participating ECNs ranging from approximately $0.003 to $0.009 per share.
NASDAQ further states that such gross fee disparities are of particular concern in a system like SuperMontage that automates the matching of buying and selling interest through the use of execution algorithms, limiting the ability of users to select or anticipate who their counterparties to a particular trade will be, and resulting in users executing against a variety of market participants, including ECNs that charge access fees significantly higher than others. Again, Instinet's own experience with executing orders through the SuperMontage non-directed order process confirms this statement.
Instinet believes that NASDAQ has an appropriate basis for adopting an ECN access fee cap within SuperMontage. Certain ECNs are charging access fees in SuperMontage that bear no relation to the market's value of the service they are providing, as clearly evidenced by the fact that as a result of competition, the significant entities in the provision of this service (i.e., Archipelago Exchange, BRUT, Instinet, Island, and NASDAQ) all charge access fees at a level equal to or below $0.003 per share. In effect, certain ECNs on SuperMontage are taking advantage of SuperMontage's order processing behavior to extract economic rents from other SuperMontage users.3
The Commission and its staff previously have expressed the view that SROs generally possess the authority to regulate access fees charged by ATSs and ECNs for executions resulting from their participation on the SRO markets to meet their order display and access obligations under the ECN Display Alternative and Regulation ATS. For example, Rule 301(b)(4) of Regulation ATS states that ATSs must not charge any fees for access to the ATS required by Regulation ATS that are prohibited by SRO rules "designed to ensure consistency with standards for access to quotations displayed on the market operated by such [SRO]."4 In its release adopting Regulation ATS, the Commission stated that an SRO "could establish a standard for what constitutes a fair and reasonable fee for non-subscriber access to the [ATS]" or "may also require [ATS] fees to be charged in a manner consistent with the [SRO's] market."5 The Commission further stated that any such rules "must be consistent with the goals of promoting competition and protecting investors" and "must be necessary to maintain consistency within the SRO's market."6
As a result, the concept of an ECN access fee cap appears to be within the Commission's contemplation of an appropriate matter for SRO rulemaking. While Instinet and Island believe that the imposition of price caps and floors should be avoided as a matter of policy and economics, in this particular circumstance, where certain ECNs' behavior is the result of a market distortion and is having a clearly adverse affect on the integrity of NASDAQ's market, Instinet and Island believe that the adoption of an ECN access fee cap by NASDAQ is a legitimate response. That said, given the centrality to agency markets, such as ECNs, of their ability to charge an appropriate fee for access to their liquidity services and the fact that NASDAQ directly competes in the order matching business with ECNs that use SuperMontage, Instinet and Island believe that the level of the cap is a critical question for the Commission to assess in determining whether the Proposal is consistent with the terms of the Securities Exchange Act of 1934 ("Act"), particularly Section 15A(b)(6) of the Act.
Instinet and Island believe that the level of the ECN access fee cap proposed by NASDAQ is consistent with Section 15A(b)(6) of the Act in the context of current market conditions. The $0.003 per share cap is equal to, or slightly higher than, the access fees currently charged by each of the major competitors in the electronic agency order matching business for NASDAQ-listed securities (i.e., Archipelago Exchange, BRUT, Instinet, Island, and NASDAQ). As a result, the concern does not appear to exist that NASDAQ is attempting to misuse its authority to punish competing ECNs by setting a cap at a level below that which was arrived at through open competition in the marketplace. Moreover, unlike the situation that existed at the time of the consideration of the SuperMontage proposal, NASDAQ is no longer effectively the only SRO facility that ECNs can use to comply with their order display and access requirements under the ECN Display Alternative and Regulation ATS. ECNs that seek to charge access fees higher than $0.003 per share will have the ability to use the NASD's Alternative Display Facility or enter into an arrangement with another SRO market to meet these regulatory requirements.
II. Impact of the Proposal on the Current Debate over ECN Access Fees
Instinet and Island believe that the approval of the Proposal will have a salutary effect on the ongoing debate over the issue of access fees. In Instinet's view, the ability of certain ECNs to charge and collect access fees through their participation in SuperMontage at levels unrelated to what they could obtain through competition in the open market is driving much of the current agitation over ECN access fees on the part of some market participants - whether they recognize it or not. Chairman Donaldson recently indicated that the issue of access fees generally is one of the primary issues under consideration in the Commission's ongoing initiative relating to U.S. equity market structure.7 If this is indeed the case, Instinet believes that the adoption of the Proposal will have the additional benefit of enabling any further consideration of the issue of access fees to proceed without the undue distraction of this problematic, yet easily correctable, operational issue inherent to the SuperMontage system.
III. Elimination of Two SuperMontage Order Execution Algorithms
NASDAQ is proposing to amend NASD Rule 4710 to eliminate two of the three order execution algorithms available to SuperMontage users, specifically a price/time algorithm considering ECN access fees and a price/size algorithm. With the approval of the Proposal, the sole remaining order execution algorithm available on SuperMontage will be a price/time priority algorithm.
Instinet and Island fully support the elimination of these algorithms, particularly the algorithm considering ECN access fees, in conjunction with the adoption of the ECN access fee cap. Instinet opposed the initial adoption of the algorithm considering ECN access fees as being unfairly discriminatory against ECN subscriber orders displayed on SuperMontage. Instinet and Island believe that any justification for the continued existence of this algorithm will be eliminated with, as NASDAQ characterizes it, the "rationalization" of access fees on SuperMontage through the contemporaneous adoption of the ECN access fee cap under the Proposal.
In this regard, NASDAQ charges SuperMontage users an access fee of $0.003 per share for shares executed against SuperMontage participants other than access fee charging ECNs and an access fee of $0.001 per share for shares executed with the participation of an ECN that charges access fees. With the adoption of the Proposal, the maximum difference in total transaction fees (i.e., NASDAQ and ECN access fees) in a SuperMontage transaction involving both non-access fee charging participants and access fee charging ECNs will be reduced from the current $0.007 per share to $0.001 per share.8 Under such circumstances, Instinet and Island believe that the continued retention of the algorithm considering ECN access fees would only heighten its discriminatory impact on ECNs vis-à-vis other SuperMontage participants, clearly rendering it inconsistent with the provisions of Section 15A of the Act.
Instinet recommends that the Commission promptly approve the Proposal in its entirety. Please do not hesitate to contact the undersigned at 212.310.4511, or Paul Merolla, EVP and General Counsel, Instinet Corporation, at 212.310.7548 if you should have any questions regarding this matter.