October 13, 2003
U.S. Securities and Exchange Commission
Attention: Mr. Jonathan Katz, Secretary
Re: File No. SR-NASD-2003-128
NexTrade Holdings, Inc., parent company of NexTrade, Inc welcomes the opportunity to provide the Securities and Exchange Commission (the "Commission") with its comments to the above referenced filing. The filing enumerated above describes the plans of the NASD, through its affiliate Nasdaq, to establish maximum fee rates that ECNs may charge for certain transactions the ECNs conduct through the Nasdaq's SuperMontage system. For the legal and anti-competitive reasons detailed herein, we recommend that the proposal not be approved.
I. The NASDAQ proposal does not promote fair competition.
The NASDAQ is effectively an ECN - with advantages.
Today, the NASDAQ's SuperMontage system looks like an ECN, smells like an ECN and quacks like an ECN. Therefore, the NASDAQ must be an ECN. It charges 3/10 of a cent for an execution. It matches orders when their prices are equivalent. It aggregates orders from its participants in an Order Book and uses an algorithm to sort and execute those orders. All of these are functions that have traditionally been associated with ECNs. Therefore, the NASDAQ is really not a market anymore and certainly not an "exchange" in the traditional sense of the word, but more likely an ECN. Logically, all rules should apply equally to ALL ECNs not just non-NASDAQ ECNs. For example, the NASDAQ is the only ECN that has the distinct advantage of Guaranteed Payment of its access fees. If a member is using the SuperMontage system to get an execution, then NASDAQ imposes the Removal of Liquidity charge of $.003 per share, like an ECN. If a participant does not pay the NASDAQ bill for these services at the end of the month, the NASDAQ disconnects them from the SuperMontage system. ECNs on the other hand, must deal with the issue of collections. Unfortunately, because the NASD does NOTHING to help ECNs collect access fees for the ECN services that are used by many of the NASD's own members, nearly all ECNs must arbitrate in order to collect their access fees. This is because of the SuperMontage ECN and its market-destabilizing decrementation feature that causes a firm to virtually violate its best execution obligations if it denies access to firms using its systems because of non-payment of ECN fees. As a consequence, NASDAQ has a significant advantage in collecting access fees for its ECN. Additionally, the NASDAQ charges other fees to its members who utilize its systems. These fees include reporting charges, ACT fees, cancellation fees, quote update fees, and a flurry of other transaction-related charges to its members. An unfair playing field and unfair advantages are created if the NASDAQ is allowed to charge fees beyond those of its competitors for use of its systems, and is also permitted to to use the proceeds of these fees to compete against its own members. In summary, the NASDAQ acts like an ECN, competes against ECNs unfairly, and is attempting to use its regulatory muscle - not to help the market or investors - but to harm its competitors, the ECNs. Under the Congressionally mandated goals of the Commission these actions are impermissible, which thereby requires the Commission to deny this proposal.
If such a proposal is to be passed, then the Commission must provide the competitors of the Nasdaq equal footing in the ability to collect access fees, to do otherwise would be blatant failure on behalf of the Commission to "promote competition". NexTrade forwarded a formal request for rulemaking to create such a rule to the Commission in a letter dated April 14, 2003.
The SEC has engendered fair competition as a creative stimulant of market structure, and has seen it work many times.
Ever since fixed commissions were deregulated in 1971, the SEC has embraced competition to improve services and find fair pricing in the securities markets. Commissions began decreasing almost immediately after passage of this sweeping initiative, and firms such as Schwab, E-Trade, and Ameritrade now compete with the traditional "wire-house" firms like Merrill Lynch, Kidder Peabody and Morgan Stanley. This competition spawned choices for American investors and it improved the securities markets of the United States.1 Fair competition is what the United States economic structure is based upon; it is what our securities markets are based upon; and in 1971 fair competition is what allowed our securities markets to grow exponentially. Allowing the market to determine services, pricing, and innovation is an efficient method of creating change. Fair competition works.
Up until 2002, Ameritrade Securities charged an advertised $8.00 per trade. There were many firms which charged less for securities transactions, but many pundits of the segment were of the opinion that $5 to $8 was a "fair charge" for a stock trade. Since that time, Ameritrade has raised its advertised commission from $8.00 per trade to $10.99 per trade. And Ameritrade is one of the most successful online brokerage firms in the industry. Imagine the effect it would have had if a proposal to limit commissions to $8.00 per trade were passed in 2000. Ameritrade would not have been allowed to operate its business within the competitive environment and likely would have abandoned the equities transaction business that made it so successful, since it would have not been allowed to raise its commission charges in order to remain viable. Imagine further that that proposal were put forth by one of its staunchest competitors. Would that have been fair?
NASDAQ is still owned by the NASD.
NexTrade has submitted to the Commission its concerns over the continuing failure known as "ADF" on many occasions. Should this proposal pass, NexTrade will be forced to move all of its business to the ADF, despite its perception that because it lacks a centralized execution mechanism, it is an inferior marketplace. From the Commission's perspective, this apparent death-sentence may be embraced as a welcome solution to the persistent complaints submitted by large firms about small ECNs.
However, it is the Commission's obligation to understand why such a forced migration would be akin to a death-sentence for small ECN's. Certainly, it is not because small ECNs fail to offer value. (NexTrade reminds the Commission that not long ago, Island was a small ECN.) NexTrade and other small ECNs introduced and brought to the market innovations such as after-hours trading, special reserve functions, and multiple-destination order routing for best execution. As the Commission knows, many of these innovations are now used by other ECNs and the SuperMontage ECN. Further, NexTrade pioneered simultaneous, cross-market posting in OTC securities, by being the first participant in both SuperMontage and the ADF. Finally, the Commission is aware of NexTrade's efforts to launch a whole new class of products, Expirationless Options ("XPOs"), which we believe will create a totally superior derivative class, ultimately to the enormous, untold benefit of the Individual Investor.
It is clear that the forced migration of small ECNs to alternate market centers is death-sentence not because small ECNs do not create and build value, but rather, because the Commission has permitted NASDAQ, in its drive for a superior market position, to shatter the foundation of market integrity in the name of profit. The OTC market is broken. Investors cannot get Best Execution on their trades. The Commission is to be held responsible for the market's failings. Former SEC Chairman Arthur Levitt said:
"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 (and competition) to that market. The Commission needs to continue to ensure that access is a reality for all market participants (emphasis added)."
NexTrade has submitted a petition for Rulemaking that would solve substantially all of the problems in the current OTC market, yet the Commission has not moved. The Rules proposed by NexTrade would create a modern equivalent of the ITS linkage currently found in the Listed market.
The need for a trade-through rule in the OTC market compounds daily as more market centers begin trading the same issues without a compulsory law to interact. The Commission recognized and addressed the risks of issues being "multiply-traded" across unlinked market centers when it approved the ITS plan in 1978 and again when it approved the Options Intermarket Linkage Plan in 2000.2
In the order approving the Options Intermarket Linkage Plan the Commission stated, "In 1975, Congress directed the Commission to oversee the development of a national market system.3 One of the principal purposes of the national market system is to assure `the practicability of brokers executing investors' orders in the best market.' 4 In the equity and options market, price transparency and the duty of the best execution owed by brokers to their customers are central to achieving this and other national market system goals." At this time, the Commission expressed concern over the change in the options market from a structure where specific contracts were solely trade on one market center to an environment where specific contract simultaneously traded on multiple market centers. The Commission continued, "The absence in the options markets of firm quotes and intermarket linkages make it more difficult for broker-dealers to ensure the best execution of customer order for multiply-traded options..... Since the establishment of the options exchanges, the Commission has repeatedly called for market integration facilities for the options markets to achieve the national market system goals. 5 In 1991, in response to these calls, four of the five options exchanges 6 submitted a proposal for the development linkage.7 The plan was never adopted, in part, because the exchanges did not agree on the feasibility of implementing a single linkage plan. Finally, because of the growing practice by the options exchanges of multiply trading options classes previously listed on a single exchange, the need for measures to ensure that such customer orders are not executed at prices inferior to prices quoted on another options exchange has become more acute."
From its discussions with the Commission, NexTrade believes that the Commission is aware and concerned about the prevalence of locked, crossed, and traded-through markets in the OTC space. NexTrade believes the Commission must measure the greater good in the exercise of its authority and should not consider the passage of the NASD's proposal until the Commission has acted on more pressing matters previously in front of the Commission.
Passage of the NASD's proposal would force a flight of ECNs to other market centers, including to the functionally deficient ADF. This would serve only to exacerbate the current Best Execution problems, rendering any decision of the Commission to pass the NASD's proposal as logically bankrupt and improper under the Commission's Congressional directives.
The proposal does not promote fair competition.
The NASDAQ has recently lost nearly 90% of its own transaction business. It should be trying to compete to get that business to return, as opposed to regulating it to return. Its goals should be to appeal to the SEC to consolidate the ever-growing fragmentation and best-execution problem that the NASDAQ itself has caused. Instead, it fills its cannons with the moldy balls of an anti-competitive, price-fixing regulation that if passed, just allows it to lazily drive a segment of its own members to another fragmented venue.8
Rather than seeking to compete on the merits of its SuperMontage ECN system, which has utterly failed to preserve NASDAQ's market share, the NASDAQ is trying to protect its market position by forcing its competition into an unhealthy "race to the bottom". Whereas this cliché is generally applied to the perceived quality of market regulation in this instance, it simply applies to the cash barrel. NASDAQ is trying to spend its competition into the dust.
Unfortunately, its efforts to date have substantially driven away competitors from its own systems, and while this is welcomed by many in the markets, it does not bode well for the investing public--which places trust in quasi-governmental markets to ensure integrity in the financial markets of the United States.
The SEC would be allowing the NASDAQ, through its own ECN, to charge more than its ECN competitors.
The proposal from the Nasdaq, through its allegedly separate parent company, NASD, will not foster competition and therefore must not be approved. In this proposal, the NASD seeks to limit its competitor's ability to charge access fees to $.003 per share.
What the Nasdaq fails to disclose, however, is the per-share rate it makes from such transactions in its own market. By NexTrade's calculations, the NASD had average revenues per share of $.005391884 for fiscal year 20029. If one knew the amount of revenues NASD derived from the $.001 per share ECN levy, plus the revenues collected from trades only reported to Nasdaq, then one could deduce the true transaction revenue rate for Nasdaq shares, which would be far higher than $.005391884. This figure grows again for smaller firms when one considers the relatively greater costs associated with trading for small volume firms. NexTrade is certain that the true transaction revenue rate realized by Nasdaq for some firms is in excess of $.01 per share. The proposed rule does more than contemplate the potentially greater burden that smaller ECNs would bear should it pass, it is relies on that anti-competitive fact to eliminate the smaller ECNs from NASDAQ.
It would be antithetical to the Congressional mandate that the SEC bears, to pass only those rules that promote competition for the Commission to validate this proposal. In passing this rule, the Commission would be agreeing that only the Nasdaq could make more than $.003 per share. This rule is merely a scheme forwarded by the NASD to force the competitors of the Nasdaq to make less money.
NexTrade has already forwarded a proposal to the commission that would solve the problems that the NASDAQ purports to "solve" with this proposal.
On April 14th, 2003, NexTrade forwarded a Petition for Rulemaking to the Commission. Basically, that rulemaking petition called for:
· An OTC Trade-Through rule with a 5 second response minimum for Trade-Through protection,
· An elimination of the ability of all market centers to assess access fees or pay rebates if that market center ignored the Trade-Through Rule,
· A mandate that ECN access fees must be paid timely.
While NexTrade does not assert that the language of its rules was flawless, NexTrade does assert that each of the three primary elements detailed above would serve to make a more perfect market, promote competition, and generally protect individual investors.
As NexTrade has pointed out to the Commission ad nauseum, that the ADF is fundamentally flawed because users do not get best execution. For the record, NexTrade still asserts all of its previous points about the failings of the ADF, including that the NASD specifically hampered its ability to succeed, thereby failing to promote competition. In fact, NexTrade is forced to regularly field complaints from customers of other brokerage firms that they cannot access NexTrade quotesi
The Trade-Through Rule NexTrade has proposed would eliminate virtually all of the instances of locked and crossed markets that now plague the OTC market. Additionally, the Commission must consider that NexTrade has forwarded a rule that would REDUCE NexTrade's near-term opportunities to make money for the long-term benefits of an improved market structure. Whereas, the Nasdaq has forwarded a rule to the Commission solely to impair its competitors and most certainly not a rule that is designed to promote competition.
Finally, the Commission should not dismiss one critical fact: the NASD has done NOTHING to assist its ECN members in collecting owed ECN access fees. The Commission certainly knows what would happen to a member if it failed to pay the Nasdaq's fees--its membership would be terminated. However, the ECNs have no such protection to enforce payment of properly rendered access fees.
As a consequence, many, many firms have decided that it is economically attractive to force ECNs to collect access fees through arbitration. As the Commission may know, NexTrade at one point had reduced its access fees for SuperMontage trades to the lowest in the industry, nonetheless, many, many firms still refused to pay.
The Commission must recognize the competitive disadvantage ECNs will have in relation to their competitor Nasdaq. The Nasdaq will be able to say, "Pay! or you will be cited, censured, and you will lose your NASD membership," ECNs will say "Pay!, or 18 months from now, after an expensive legal fight, an arbitration panel will probably rule that you have to pay what was originally charged, but in the interim go ahead and keep the cash flow."
The rule proposed by NexTrade would mandate that ECN access fees be paid, thereby promoting competition between ECNs and the Nasdaq. Whereas, the rule proposed by Nasdaq would totally distort the competitive field between Nasdaq and ECNs, failing utterly to promote competition.
The proposed rule the NASD has filed with the Commission fails in any way to promote competition and therefore should not be passed by the Commission. Alternatively, the rulemaking petition in front of the Commission submitted by NexTrade serves the Commission's congressionally mandated goals by promoting competition, by making the markets more perfect, and, most importantly, by protecting the individual investor.
Therefore, NexTrade asserts that the Commission is obligated to pass the proposed rulemaking filed by NexTrade to the Commission April 14th, 2003, or a substantially similar rule, as soon as possible.
Due to the competitive landscape over the last few years, many ECNs have been forced to bring down their pricing due to competition, the markets, and cost control. As this happened, and ECN access fees overall have declined significantly, the SEC stepped in and after studying the issue, determined that an access fee of no greater than 9/10 was acceptable and fair. The SEC, a respected body of the United States government, which employs many highly educated people whose main purpose is to protect Americans and preserve the integrity of the financial markets, studied the issue and agreed that, since stocks often traded with one cent between the bid and the offer, a fair access fee of under one penny was still a better alternative than the price that would be paid if the ECNs did not exist. In other words, without a viable access fee, the ECNs, who now provide the OTC markets with liquidity approximately 50% of the time, would not be present, and therefore the next best quote would cost investors at least $.01 per share extra instead of $.009 per share.
Since the 1997 Order Handling Rules were carefully considered and adopted in 1997 through January 2003, the SEC determined that $.015 per share was acceptable. After six years of the maximum allowable access fee charged at 1.5 cents per share, the SEC made a careful evaluation and determined that a fee which was less than one penny was fair and equitable. It made the decision to limit fees to $.009 per share and it should remain there for years to come. As shown in the examples below, a fee that does not allow an ECN to make a profit, such as the NASDAQ's 3/10 proposal, will remove most for-profit ECNs from the quote. Even with the 9/10 cents per share access fee, investors still pay less than if the ECN is removed from the quotation and the next-best execution tier is where the execution would take place.
II. The NASDAQ proposal violates SEC Rules and Requirements that were passed to protect investors.
The proposal does not meet the SEC requirement to ensure market integrity and investor protection.
According to the SEC's web site, referencing the Securities Exchange Act of 1934:
"SROs must create rules that allow for...establishing measures to ensure market integrity and investor protection."
This proposal, as demonstrated within this letter, would DECREASE investor protection and DESTABLIZE market integrity by jeopardizing the viability of ALL ECNs that trade through NASDAQ. In fact, because of the onerous financial burden already placed upon members by the NASDAQ's SuperMontage system, the NASDAQ has lost most of its own execution and reporting business (in NASDAQ OTC stocks) to other execution venues. Further, it has alienated nearly 85% of its own liquidity providers by driving ECNs away from SuperMontage. As a direct result of SuperMontage and its onerous cost structure as well as its unfair execution mechanisms, Instinet and Island, the two largest ECN providers of liquidity, have taken their business away from SuperMontage to the ADF and the Cincinnati Stock Exchange, respectively. This has severely increased the cost of execution to members, much more than the NASDAQ would propose to eliminate with its proposal. Fragmentation has increased as a direct result as well, which hampers fair and honest liquidity and pricing of securities. Before SuperMontage, NASDAQ and the American Investor enjoyed a platform whereby nearly all firm quotations of NASDAQ securities and subsequent executions were displayed on an aggregated price quotation for a security. In other words, Instinet, Island, other ECNs and market-makers all competed on one playing field for a particular stock. Then, largely because of its own greed and desire to run off the ECNs who were providing liquidity and innovation to its markets, the NASDAQ had to go and destroy its own market.
It did so first by sorting ECNs to an inferior position in the SuperMontage quotation, even though an ECN might have time priority AND a superior price INCLUSIVE of Access Fees10. It therefore discriminated against ECNs and alienated the liquidity of those very ECNs by placing the interests of other members above the fundamental tenets of fair price discovery: price/time priority. Some ECNs, such as NexTrade, believed that it was best for their customers to remain in SuperMontage because of the increasingly fragmented, but still more-desirable-than-the-alternative, liquidity source that SuperMontage purported to provide.
Then, in order to further drive off ECNs by using its regulatory might against them, the NASDAQ "slipped by" the critically discriminatory feature of decrementation11. The SuperMontage proposal was so broad (NASDAQ reportedly expended $107-million to build SuperMontage) that it buried language of decrementation within its proposal. Comments came regarding SuperMontage, but because of its complexity, the decrementation feature was largely overlooked because there were so many other aspects of this new and market changing system that were also worthy of comment. For example, the NASDAQ changed its nomenclature from the very simple "inbound SelectNet order" to very complex, hard-to-understand order types found in SuperMontage such as, "non-directed liability orders", "directed liability order", "preferenced order", etc. Further, it also placed a totally new burden on its participants and market vendors by requiring new quotation mechanisms to be used to quote its once-simple marketplace. Decrementation is a feature that is in SuperMontage today. Why? The issue of decrementation should be revisited. It's hard to see how the decrementation feature of SuperMontage does anything but destabilize the NASDAQ market (see footnote), and it is impossible to understand how decrementation does anything to help investors. In fact, NexTrade has been accumulating literally thousands of pages of evidence that the SuperMontage proposal, with its decrementation functions, its discriminatory sorting mechanisms, and onerous cost structure, has actually harmed the markets severely.
Finally, it is important to note that much of the NASDAQ's $107-million reengineering of its market was directed, not at the improvement of its markets, but at running off the ECNs, even though the NASDAQ is now considered an ECN on its own12. An anticipated consequence of this action was that the NASDAQ's own market is increasingly becoming destabilized and the NASDAQ is in jeopardy of losing its relevance. This proposal would continue that trend.
9/10 per share does not impact the investor
NASDAQ is blatantly wrong in their assertion in section 4 of their proposal when they represent that the proposed rule change "will not result in any burden on competition." Many ECNs, faced with the dire need to become profitable under the existing environment, will in fact decide to remove their liquidity from SuperMontage and take their business elsewhere. This will further fragment the already fragmented NASDAQ market and will remove liquidity and transparency from the delicate markets. All of this will worsen the harm that small investors are now experiencing, by widening spreads since fewer participants will be involved in providing liquidity to the NASDAQ market. Widening of spreads will be much greater than the "less than one-penny" maximum access fee charged today, and investors would me more harmed by this rule. As an example, if NexTrade's customer is the only market participant willing to offer $30.00 for XYZ stock and the next best offer is $30.0413, even if NexTrade charges 9/10 cents per share (less than one penny), the fee is still preferable to an investor over the price available in NexTrade's absence. Essentially, this works out to be a cost of $30,009.00 vs. $30,040.00 for the same purchase of 1000 shares of stock. In other words, with the ECNs, the investor benefits more - even with a $.009 per share access fee - than without the ECNs. This example is exacerbated if the stock trades with more than the average four-penny spread. For the example above, study what happens when the access fee is regulated to $.003:
1) NexTrade will remove their liquidity quote from the NASDAQ because it makes no financial sense to remain quoting there;
2) The investor in the above example will see the ASK/Offer on XYZ stock increase from $30.00 to $30.04;
3) The investor will end up PAYING $31.00 extra for his 1000 share execution!
Below is an actual example of a quotation on Oracle stock on September 3rd.
Notice that NexTrade's bid is actually higher than the best offer in the country on ORCL. It therefore shows a very large problem in the NASDAQ market -- a crossed market. Crossed markets cause disruption and violate the best-execution rules of the NASDAQ. Further, they damage the investor by giving them inferior fills. In other words, when a market participant comes to NexTrade for this execution at $13.78, they are receiving a substantially better execution than would be available at the bid by a full cent! Of course, this comes at the direct expense of the NexTrade customer, who should have been filled at a market price that is lower ($13.77). So while an investor is being harmed irreparably, the market participant is benefiting at his expense - in direct contravention of the Exchange Act, which does not allow investor's benefits to be placed below those of market makers or specialists. Further, it is obvious that even with an access fee, the market participant benefits by profiting an extra 1/10 cent per share even with the maximum access fee. (This happens thousands of times per day and NexTrade has commissioned a study of this harmful phenomenon, as well as the lack of enforcement action by both the NASD and the SEC. Proof is available at NexTrade's offices.)
It is therefore clear that the access fee is not material to the operation of the markets when the markets have much more serious problems of best-execution. The NASDAQ should be spending its time policing its markets and creating mechanisms that would help investors rather than attempting to create rules that would harm its ECN competition.
ECNs and the NASDAQ itself are already unprofitable.
If this proposal is adopted, NexTrade, which has the lowest operating cost structure among all ECNs, will likely choose to migrate its business to other venues. We are certain that other ECNs will follow in the short term. In fact, the largest ECN Instinet, and the second largest ECN, Island have already migrated their business away from the NASDAQ. We have knowledge of other ECNs that plan to do the same if this proposal passes. Further, it is probable that most ECNs, that would consider raising their access fee in the future due to lack of profitability, will follow in the next 12 to 24 months. In fact, due to competitive pressures in the industry, many ECNs HAVE ALREADY begun to raise access fees. Finally, NexTrade has already piloted a program where access fees were reduced to $.00275 per share. The result of this pilot program was that we experienced a drop in revenues and turned our business from a slightly profitable one to one that was guaranteed to lose money. The evidence is all around us: most ECNs don't make money at $.003 per share. Instinet14 can't seem to do it (Instinet has lost more than $700-million dollars since 2001), NexTrade hasn't been able to do it, and the NASDAQ itself hasn't been able to do it15.
NO ECNs have been able to consistently demonstrate profitability at 3/10 of a cent.
While the NASDAQ is acting as if it is reacting to the interests of some of its members, it is clearly acting in its own best interests. However, not even the NASDAQ itself is able to operate profitably in an environment where it charges 3/10 of a cent per share, which as cited above is not their true per share revenue rate (based on the NASD's most recent annual report, NexTrade believes their true per share revenue rate is north of $.005). In the second quarter of 2002, the NASDAQ lost $51.1-million! This after charging $.003 per share on its SuperMontage ECN, earning exchange revenue from market data, charging its members for execution services and reporting services, membership fees, etc.
Further, it is clear that the NASDAQ is putting a dagger in the securities markets of the United States. The NASDAQ is so zealous to use its regulatory might to eliminate ECNs so that it can be the lone ECN in its own market, that it has lost sight of its purpose - to help the small investor. It is SUPPOSED to do this by fostering a fair and efficient market where it places no impositions on trading firms that attract liquidity to its market. However, because of its own greed, the NASDAQ has now driven almost 90% of its own business to other venues (such as the Cincinnati Stock Exchange) and in fact since the introduction of SuperMontage has continued to steadily lose business. It should be appealing to the ECNs, not driving them away by regulating their fees. It seems if the NASDAQ is successful in imposing this price-fixing scheme on ECNs, that ECNs like BRUT, Bloomberg, Attain, and Track - the few remaining firms participating in SuperMontage, many of whom already have plans to migrate away from SuperMontage because of its onerous environment - will accelerate plans to migrate. Within 6 months of a possible passage of this onerous proposal, all but a very few ECNs will remain on SuperMontage and within 12 months the NASDAQ will be posturing to raise its rates on SuperMontage because it will find that it is unprofitable. By then it will be too late. The NASDAQ will have shot itself in the foot, will have proven that it cannot make money from SuperMontage, will have lost almost all of its transaction business, and will have irreparably harmed American investors--ALL in its own self-interests to become a for-profit exchange which has already driven more than 50% of its own liquidity to other venues just this year alone. The markets will then be far worse off because they will have fragmented creating several disparate and unlinked pools of liquidity and no investor will really know what the best price is on a stock at a given time.
The Track ECN in its most recent 10Q filing with the SEC iistated that because of SuperMontage (and their related access fee over SuperMontage of $.0029 per share):
"the Company does not presently anticipate significant revenues and profits from Track ECN in 2003."
Revenues AND profits! If a company publicly is disclosing that it cannot make revenue or profits from its ECN operations at the $.003 rate, this is certainly empirical evidence against approving the NASDAQ proposal - especially in light of the fact that Nasdaq did NO STUDIES (see below) on the proposal prior to publishing it. Further, actual market studies now show that few if any ECNs can sustain profits charging $.003.
The NASDAQ has offered no studies to show how a proposal to limit access fees will help the markets.
It is incumbent on the NASDAQ, in the interest of the public good, to show how limiting fees will help investors. It is easy to see how it will help the NASDAQ - by driving ECNs away from its markets allowing it to be a stand-alone ECN (where one day, in order to compete, it will have to raise its rates, by the way). Saving money does not always equate to better quality--in fact, quite the contrary. If saving money were always the prime directive of any business, then luxury automobiles, wine, food, etc. would have no place in this world. In the absence of such a study, intuitively, a profit-motive allows more incentive for a company such as an ECN to offer a service. More incentive leads to more companies putting efforts into competing. More companies competing leads to more choices for investors. And, as has always been the case, more choice leads to better liquidity, transparency, and price discovery in the securities markets. All of these things are good for the small investor. Limiting access fees limits choices available to investors.
The proposal will not help best execution
The proposal that NASDAQ put forth should, above all else, attempt to ensure that 1) the investing public is being considered and 2) no members are treated unfairly. The NASDAQ did not demonstrate a single shred of evidence in its proposal that best-execution deterioration in its own NASDAQ stocks is the cause of this proposal. Worse yet, the NASDAQ is a willing participant in the destabilization of the markets that it operates through its own efforts (or lack thereof) as well as through its regulatory sister entity, the NASD. Since the adoption of SuperMontage, investors have lost millions of dollars in poor executions due to the fragmentation that the SuperMontage ECN has caused16. Not since the anti-competitive and collusive findings of the 21a report have NASDAQ members, the NASDAQ, and NASD themselves----permitted investors to be taken advantage of so unfairly. Rather than taking the time to improve the stability of the securities markets by sponsoring a proposal that would establish a trade-through rule on multi-market trading of OTC NMS stocks, the NASDAQ instead postures to eliminate competition in its own self-interest. A trade-through rule would help best execution and would save investors millions of dollars that result from newly-fostered inter-market instability, caused not because of access fees, but rather, caused by competitive reasons resultant from the Supermontage ECN. Instead of competing against its members, the NASDAQ should be trying to help its investor constituents to improve execution of NASDAQ stocks and help the investing public.
The SEC is set up under a mandate from Congress to foster an environment of competition that ultimately helps the markets evolve and improve.
Using the SEC to fix pricing for the NASDAQ's own best interests can be compared to many anti-capitalism analogies including, but not limited to:
1) The Food and Drug Administration telling Drug companies the maximum amount that they can charge for their drugs. Economists are united in the belief that this would inhibit innovation and many drug companies would go bankrupt or refuse to sell drugs in this country. This would limit choices for patients and would certainly reverse the trend to longer and healthier lives.
2) The FDA telling McDonald's that since there are other companies selling hamburgers at 99 cents that ALL hamburgers must now sell for 99 cents.
3) Let's tell Starbucks that it is ridiculous to charge $5.00 for a cup of coffee when coffee only costs $.20 cents a cup to make. One would argue that even though $5.00 is still a lot of money to pay for coffee, there is a need for it since many people actually DO pay $5.00 for a cup of coffee.
As a reminder, one has to only look at the SEC's abolition of fixed commission rates in 1971 to see the effects of Deregulation. When the SEC essentially allowed for free and fair competition among brokerage firms on the basis of commissions in 1971, it allowed for open competition on commission charges. Today, average commissions have declined substantially and the landmark 1971 decision by the SEC to step out of the way and deregulate prices led to the rise of companies like Schwab, E-Trade, and hundreds of other "discount" brokerage firms that would have never been formed had the SEC stood in the way of competition by maintaining price-fixing. (Note that there are still many firms that charge rates that are much higher than the discounters--Merrill Lynch, Goldman Sachs, Smith Barney, etc.-- but the consumer has many more choices now than in 1971.)
Chairman Donaldson is already on the record on the issue of revisiting decimalization. It seems that in the Chairman's opinion, decimalization has actually increased trading costs to the individual investor and the amount of liquidity has decreased as a result. Access fees which are less than one penny have no correlation to increased trading costs, but if spreads are fixed at something more than one penny, for example at nickel increments, access fees will be even more inconsequential.
III. The NASDAQ is guilty of Unclean Hands
The NASDAQ is Guilty of Regulatory Maneuvering
Furthermore, this proposal is part of a sophisticated scheme enacted by Nasdaq to reduce their competitor's ability to respond to changes in the business environment. Once passed, ECN members of the SuperMontage could not raise their rates above $.003 cent without the express permission of the SEC following another 19 -b4 filing from the NASD. The NASD itself, however, could change its rates immediately, subject only to abrogation by the SEC.
The Commission must recognize that the Nasdaq has changed rates associated with trading, reporting, quoting, and canceling many, many times in the last 18 months. To permit only the Nasdaq to make rapid changes to its revenue source, while hamstringing its competition, would make a farce of the Commission's obligation to promote competition.
The proposal puts the NASDAQ first and investors last.
In NASDAQ's proposal, the NASDAQ puts forth a position that the access fee should be reduced to a maximum of $.003 per share. It primarily bases this proposal on the fact that "some ECNs are charging as much as three times that amount." While this might be a fact, the NASDAQ fails to establish any foundational evidence that the charges that they are wishing to curtail have a deleterious effect on investors or the markets. However, the NASDAQ does charge a guaranteed17 rate of $.003 per share and eliminating ECN competition for its own ECN services would be in its own financial best interests18. It can easily be concluded, therefore, that the NASDAQ is placing its own interests above those of the investing public and its members. NASD did not even solicit comments from its own members.
The NASDAQ and NASD cannot be trusted as authorities on what is best for investors or even for their own markets.
In the NASD's proposed language (3a) they cite that there are ECNs that charge "in some cases, three times as high as other participating ECNs." This is stated as a criticism rather than a postulate of good business. MOST of the ECNs that are charging 3/10 of a cent per share are in financial straits (See footnote 14: Instinet). Sound business logic would tell you that you should charge a rate at which you can make a profit or in the longer term, it will not matter what you charge because you will not be in business. The NASDAQ itself is guilty of unsound business practices, even with the blessing of the SEC and their quasi-governmental status. The NASDAQ itself operates an ECN and even with their market data, transaction fees, reporting fees, and other related fees involved in managing one of the largest markets in the world, has managed to mess up a good thing by losing millions of dollars from operations. They wasted their competitive position by:
1) buying and backing Optimark
2) spending $107-million on SuperMontage while losing 90% of their own market share,
3) investing millions of dollars in NASDAQ Europe (now defunct)
4) investing millions of dollars in NASDAQ Japan (now defunct)
5) investing in the American Stock Exchange, and then having to sell it off
6) Scrapping their costly Bulletin Board initiative, which would have helped the current BB marketplace, and other snafus.
Like its Exchange initiative, the NASDAQ's proposal thumbs its nose at the SEC's mandate for a viable and voluntary alternative to SuperMontage by making the migration to another venue INVOLUNTARY.
Without the existence of a vibrant, non-exchange operated alternative for compliance with these and other regulatory requirements, Nasdaq's exchange status would thus threaten the congressional directive that the National Market System promote "fair competition... between exchange markets and markets other than exchange markets."10 Exchange membership cannot be an implicit condition for compliance with Commission rules without undermining the feasibility of market-maker and ECN participation in the OTC market. While national securities exchanges, whether specialist or dealer-based, are currently an invaluable component of securities market structure, the ability to act as a broker or dealer solely in the OTC market is critical to avoiding the oligopoly that concentrating all power in the hands of a few exchanges would ultimately create.
The Commission previously recognized the potential anti-competitive consequences of Nasdaq's transition to SuperMontage when requiring that the NASD must implement "a quote and trade reporting alternative that satisfies... regulatory requirements for ATSs, ECNs and market makers". Now, with this proposal, the NASDAQ is attempting to drive the super-majority of ECNs away from SuperMontage by effectively Ratemaking, and essentially forcing ECNs to the ADF or other exchanges, thereby thumbing its nose at the SEC by making the shift INVOLUNTARY. (Footnote: SuperMontage Approval Order, supra note 3, at 8052-8054)
The NASDAQ is utilizing funds gained by the ECNs to essentially compete with them and is doing the opposite of promoting fair and open competition. If the NASDAQ wished to promote fair competition among its members, it would make itself subject to the same rules for its ECN that the other ECNs face, namely forcing the members who access ECNs over the NASDAQ or NASD systems, to pay for the services that they obviously need. When a stock is quoted at a penny spread (or more), accessing the ECNs quote NO MATTER WHAT THE ACCESS FEE (under one penny), IS ALWAYS a better price than if there is not an ECN at the inside quote and the price is inferior. Since the NASDAQ chose to include an algorithm that discriminates against other ECNs by placing their quotations at the bottom of the inside quotation tier, ANY time that an ECN is accessed, and the accessor pays the fee -- it is better than having to drop to the next-best tier. Therefore, the access fee is moot in the light of best-execution obligations. One can only conclude that with this proposal, the NASDAQ is not concerned about best-execution for its members' customers, but rather the perceived "annoyance" of an access fee that may be more than some members want to pay a perceived ECN competitor for execution services. It would rather limit the charge (and therefore the financial viability) of its fellow ECN competitors, than welcome a fair and open pricing competition among all ECNs. This is ratemaking and is illegal in this circumstance.
SuperMontage is flawed, discriminatory, anti-competitive and does not promote fair competition. It should therefore be revoked.
The following is a legal brief regarding SuperMontage and the Alternative Display Facility and is an opinion of counsel.
SUMMARY OF ARGUMENT
First, the approval of SuperMontage by NASDAQ violated NASDAQ's obligations with respect to competition, as required by the Securities Exchange Act of 1934, as amended (the "Exchange Act"), 15 U.S.C. §78a, and ignored well settled securities law, as well as common law, by creating a methodology by which broker dealers, who are fiduciaries to their customers, may avoid their obligation to obtain the best execution of their customers' securities transactions.
Second, the decrementation feature of SuperMontage effectively permits broker dealers to wrongfully eliminate the markets of ECNs, other than the NASD's own proprietary system, from the national market system even when those other markets are superior to the SuperMontage market, in violation of Section 11A of the Exchange Act, 15 U.S.C. §78k-1.
Third, the proffered Alternative Display Facility ("ADF") is a straw man which neither negates nor mitigates the defects in the NASDAQ's proceedings and Order because, contrary to the assertions of the SEC and Nasdaq, it does not work. It is effectively inaccessible to most ECNs and makes the ECNs, in effect, inaccessible to most market participants. Thus, the ADF should never have been authorized to begin operation in this condition.
Finally, the Order at issue here and the SEC's underlying proceedings did not provide adequate notice to the public or interested parties that the decrementation feature would permit the elimination of the quotes of ECNs and their customers from the SuperMontage screen without any justification permitted by the Exchange Act.
I. THE SECURITIES AND EXCHANGE COMMISSION FAILED TO ADEQUATELY ADDRESS THE ANTI-COMPETITIVE EFFECTS OF SUPERMONTAGE PRIOR TO ITS APPROVAL OF THE NASD RULES CHANGE
The decrementation feature of SuperMontage is per se anti-competitive. It provides the Nasdaq market and its market maker members with the ability to completely eliminate competition from any unaffiliated ECNs by automatically "zeroing out" an ECN quote and removing the quote from display in the SuperMontage system. See Brief of NASDAQ SEC brief ("SEC Brief") at 25. While addressing other controversial issues in its approval order,19 the SEC's lack of notice and discussion of this "feature" in the final approval order demonstrates that the SEC failed to adequately address the anti-competitive nature of SuperMontage, in violation of Congress's mandate contained in its enactment of the Securities Acts Amendments of 1975 (the "1975 Amendments").20
In 1975, Congress undertook "the most searching reexamination of the competitive, statutory and economic issues facing the securities markets, the securities industry, and ... public investors" and enacted the 1975 Amendments. See Bradford v. SEC, 590 F. 2d 1085 (D.C. Cir. 1978), quoting Conference Report on the Securities Acts Amendments of 1975, H. Rep. No. 229, 94th Cong., 1st Sess. 91 (1975). One of the goals of the 1975 Amendments was to facilitate the establishment of a national market system for securities, and to link all securities markets, so that "(i) information is equally available, and securities transactions may be completed equally cheaply and easily, anywhere in the nation, and (ii) `fair competition' may exist between all investors, brokers, dealers, and securities markets, no matter where they are located." See Id. at 1094 (emphasis added).
Congress was concerned, however, that the creation of new self-regulatory organizations ("SROs", and each an "SRO") and the movement of existing SROs into the national market system could result in the abuse of their powers, intentionally or unintentionally, by allowing them to introduce new rules or policies that would limit competition in contravention of the purposes of the Exchange Act. As a result, Congress enacted Section 6(b)(8) of the Exchange Act, 15 U.S.C. §78f(b)(8) which prohibits all SROs from issuing rules that would impose "any burden on competition not necessary or appropriate in furtherance of the Exchange Act." Under Section 6(b)(8), the SEC may not permit any rule or rules change that would result in the lessening of competition - unless the proposed rules further some other legitimate regulatory objective. With the enactment of Section 6(b)(8), the SEC was required to review and analyze the statements of each SRO regarding the impact that any proposed rules would have on competition. The SEC was also required to provide notice to the general public regarding specific aspects of the rules change proposed by a SRO to obtain public comment respecting the proposed rules change and to consider competition in its deliberations. See Section 19(b)(1) of the Exchange Act, 15 U.S.C. §78s(b)(1).
In the instant matter, the SEC recognized its obligation in its review of the initial SuperMontage rule filing and stated publicly that it "would be inconsistent ... 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." See Release No. 34-43863 (January 19, 2001). This acknowledgement, however, was only that - an acknowledgement of an obligation, not its fulfillment. The SEC's actual review of the NASD's SuperMontage Rules fell far short of its statutory obligations and its stated "vigilant" review and ultimately amounted to nothing more than lip service to the statutory requirement. In fact, the SEC was silent and failed to mention or discuss decrementation as one of the controversial issues in its approval order or the effect that decrementation would have on competition among SuperMontage participants and all of the other ECNs. Without any adequate, substantive rationale in the SEC's approval order, courts have concluded that the SEC has simply assumed away the anti-competitive effect.21
Here, the challenged aspects of the decrementation feature were discussed nowhere during the rulemaking itself. It was not until the summer of 2002 that some industry participants discovered this feature hidden in the algorithms and brought it to the attention of the SEC - well before the previously conditional approval of SuperMontage was made final on August 29, 2002. Neither NASD nor the SEC had disclosed that the decrementation feature would eliminate ECN quotes for nothing more than the imposition of standard, SEC-compliant ECN fees of less than a penny a share. At the same time, the SEC and NASD knew or ought to have known that, deprived of access to the market and of their source of income, ECNs would rapidly disappear, contrary to congressional intent, as expressed in the 1975 Amendments.
The current regulatory scheme makes competition inevitable between an unaffiliated ECN and its competitor/regulator, NASD.22 For example, the establishment of ECNs has a history of inherent conflicts not previously resolved by the SEC. For a broker-dealer to become recognized as an ECN, it must make a representation to the SEC that it has the capability to interface with the Nasdaq Market, the "exchange" arm of the NASD, via SelectNet (the predecessor to SuperMontage) and that it will be regulated by NASD Regulation, Inc., the regulatory arm of the NASD. It is only after both the SEC and the NASD are satisfied with the representations and the linkages that a No-Action Letter is issued to the ECN. And it is only under that regulatory scheme23 that an ECN is entitled to operate in competition with the NASD and its "exchange", the Nasdaq market.
The decrementation "feature" that was buried in the algorithms of the SuperMontage rules completely obliterates any ECN competition by simply eliminating from the SuperMontage display the quotes of ECNs other than Nasdaq's. This is the lynchpin in the preservation of the Nasdaq monopoly: one simply can eliminate the competition (in this case, the other ECNs) by completely removing their quotes from the centralized market quotes. Without the ability to publicly quote on the market, these other ECNs will not be able to attract order flow or contra parties to their quotes. Without the contra parties, current liquidity providers to the ECNs will cease to add liquidity because there will be no liquidity removal available in the ECN markets. Without liquidity providers and contra parties, the ECNs would cease to exist and control of the marketplace would revert from ECNs and their customers to Nasdaq's market maker constituency.
As a result, Nasdaq, through SuperMontage as approved by the SEC, will once again be a monopoly - limiting competition by the abuse of its powers in direct contravention of the purposes of the Exchange Act - the very result that Congress sought to prevent by the 1975 Amendments. Accordingly, the SEC's approval should be reversed for failure to follow the congressional mandate to scrutinize SuperMontage for its anti-competitive impact.
II. THE APPROVAL OF THE DECREMENTATION FEATURE OF SUPERMONTAGE PUTS THE CONCEPT OF "BEST EXECUTION" AT RISK
The relationship between a broker and its customer is a relationship of trust - the customer entrusts his or her order with the broker to execute at the best possible price available in the marketplace, and the broker honors that trust by surveying the marketplaces to find the best execution on behalf of its customer. In general, this is a fiduciary relationship. See e.g., Sinclair v. SEC, 444 F.2d 399, 400 (2d Cir. 1971) (a broker-dealer "was obligated as a matter of fiduciary duty to use due diligence to obtain the best available price for ... customers upon execution of orders placed by them for purchase or sale of securities"). The SEC also established, long ago, that a broker-dealer has a duty to buy or sell securities for its customers at the "best price discoverable in the exercise of reasonable diligence." See In the Matter of Arleen W. Hughes d/b/a E.W. Hughes & Company, Ex. Act. Rel. No. 4048, 27 S.E.C. 629, 634 (1948), aff'd sub nom. Hughes v. SEC, 174 F. 2d 969 (D.C. Cir. 1949).
The advent of ECNs generally assisted brokers in finding the "best price" for their customers because the proliferation of competing markets, with consolidated reporting, combines the greatest market competition with the ease of electronic display. The SEC wanted the best available quotes to be displayed on the market to provide public customers with the ability to access the best quotes that are on the market and to allow brokers to perform the "best executions" on behalf of their public customers. See generally, the discussions of the Order Handling Rules in Release No. 34-37691A (Sept. 12, 1996). Specifically, the SEC's Order Execution Obligation Rules, See Exchange Act Rel. No. 34-37619A (September 12, 1996), 61 Fed. Reg. 48290, mandate that once an order is displayed as a firm quote (either at the bid or ask side) and there is no better price displayed, then a market participant (such as a broker-dealer or ECN) must hit that bid or lift that offer at the best reasonably available price displayed in order to maximize benefit to the American investor in a manner consistent with the broker-dealer's duty of best execution. See Newton v. Merrill, Lynch, Pierce, Fenner & Smith et. al, 135 F.3d 266, at 270 (3d Cir. 1998).
However, as this new competition grew, certain NASD members who make markets in the Nasdaq system began complaining about the access fees that their competitors, the ECNs, charge to access the ECN quotes. Market makers are not allowed to charge access fees because, as dealers, they derive their profits (and losses) from their own trading activity - making money on the spread between the purchase price and the sales price of the various securities in which they make a market. See SEC Rule 11Ac1-1, 17 CFR 240.11Ac-1-1. NASD fees to members are not added to the quotes that are displayed in Nasdaq. In contrast, the ECNs do not "trade" in securities - they merely provide a matching service between market participants that desire to take advantage of the "best price" available on the market. Thus, the sole revenue stream for an ECN other than Nasdaq - including SuperMontage - is the transaction fee24, and the elimination of such fees would eliminate all or substantially all income to each ECN. Without the ability to collect their fees, all ECNs will ultimately be eliminated from competing in the over-the-counter market.
In the context of brokerage (i.e., customer) orders, ECN access fees are a straw man. Decimalization requires that markets are quoted no less narrowly than in pennies. See e.g., Release No. 34-42914 (June 8, 2000). The SEC has mandated that ECN access fees cannot be more than $0.009 per share.25 Since no ECN access fee can change or impact a quote by as much as a penny, an ECN's quote, which is otherwise the "best price" for a customer order, will necessarily remain the "best price" even with the inclusion of the ECN access fee.26
The decrementation feature27 of SuperMontage provides broker-dealers who would prefer not to pay ECN access fees (such as Nasdaq market makers) with the ability to obliterate the ECN's quotes from public display. This eliminates the potential "best quote" on the system in favor of potentially inferior quotes offered by those same Nasdaq market makers. The exercise of this option would essentially reverse all of the progress made since the advent of Regulation ATS and the establishment of the ECNs under the SEC's Order Handling Rules.
According to the NASD's Rules, decrementation, or the zeroing out of an ECN's display of a quote, can occur if the ECN declines to execute an incoming order for any reason. This feature provides a mechanism for market makers to completely eliminate their ECN competitors by simply refusing to pay ECN access fees - a critical point not disclosed anywhere by the NASD or SEC in the course of the rulemaking until acknowledged in mid-2002 during field testing. This declination to execute a non-access fee paying market maker's incoming order was an action the SEC initially suggested to the ECNs when fee disputes first arose. The consequence of the ECN's declination to trade with a non-access fee payer is decrementation: completely eliminating the ECN's quote as the best price for the market. In this scenario, the ECNs are left with only the choice of how they would prefer their extinction - they can refuse to deal with non-paying market makers and have their liquidity destroyed because they can no longer enter quotes on the national market system, or they can allow market makers to have free access to their system, and let the cost of running an ECN without offsetting revenue eventually destroy their business.
A broker-dealer with customer orders will also suffer consequences. If such a broker-dealer uses decrementation to obliterate an ECN's order display for any reason (but, particularly, its desire to avoid paying access fees), it eliminates the ECN's market, price and size from all consideration. In so doing, it acts in bald violation of both Section 10(b) of the Exchange Act as well as long standing common law on the duties of a broker-fiduciary to seek and obtain best execution for its customers.
As discussed above, the decrementation feature of SuperMontage does nothing more than eliminate ECN competition from NASD's own ECN, SuperMontage. The by-product caused by decrementation, however, has had severe impact on the investing public. By eliminating the ECN competition, access to the best price on the market that the ECNs were known to deliver is also eliminated. The elimination of access to the best price will cause broker-dealers with customer orders to violate both their fiduciary duty to their customers and their duty to obtain the best execution for their customers.
III. THE ALTERNATIVE DISPLAY FACILITY IS A NOT A VIABLE MECHANISM TO CURE THE DEFECTS OF SUPERMONTAGE
A. Backdrop for the Alternative Display Facility (the "ADF")
The SEC unambiguously asserted in its August 29, 2002 Order with Respect to Nasdaq's Implementation of its SuperMontage Facility ("August 29, 2002 Order") that on January 19, 2001, the SEC conditionally approved a proposed rule change that would establish SuperMontage. 28 The SEC conditioned its approval of SuperMontage on the implementation of an ADF by the NASD. More specifically, the SEC conditioned its approval of SuperMontage on the following: (1) that the NASD will offer a quote and trade reporting alternative that satisfies the Order Handling Rules, Regulation ATS, and other regulatory requirements for ATSs, ECNs, and market makers; (2) that NASD quotes disseminated through the exclusive securities information processor ("SIP") for Nasdaq-listed securities will identify the ATS, ECN, or market maker source of the quote; and (3) that participation in SuperMontage will be entirely voluntary, because NASD quotes will be included in the Nasdaq quotation management system while Nasdaq is the exclusive SIP, but only for display purposes, and the NASD will provide access to its quotes on a market-neutral basis.29 Even though the aforementioned legal conditions should have been fulfilled prior to or at the same time as the roll-out of SuperMontage, they were not. Rather, the ADF was authorized to begin operation as an unworkable and inefficient mechanism that violates Section 11A of the Exchange Act.30
B. How the ADF Really Works
The ADF currently displays quotes for only two market participants, Instinet and NexTrade, but their ADF quotes are funneled to, and then posted obligatorily on, SuperMontage. Once posted on SuperMontage, broker-dealers, in violation of the Order Handling Rules, Best Execution mandates, and their fiduciary duties, "trade through"31 NexTrade's quotes, rendering the ADF a wholly ineffective mechanism for accomplishing the very goals articulated by the SEC in promulgating it as the "fix" for any anti-competitive aspect of SuperMontage.
The ADF, instead of being a true alternative to SuperMontage, encourages and facilitates market participants to ignore well-established securities rules, including best execution obligations, and further fragments the over-the-counter market by allowing Nasdaq, through its "Super ECN" SuperMontage, to unfairly compete with smaller ECNs like NexTrade and purposefully exclude them from the over-the-counter market. All of this is to the detriment of the American investor, the very foundation of the securities market.
The Amici's arguments in Section II of this brief have shown that the SuperMontage rules foster the elimination of the ECNs ability to display their quotes and put the broker-dealers' obligation to obtain the "best executions" for their customers at risk. Such is the case here with the approved ADF rules. Presently, NexTrade's quotes, displayed through ADF via SuperMontage, are being routinely circumvented by broker-dealers, even when those quotes represent the best price in SuperMontage. NexTrade's quotes are being ignored not only because SuperMontage allows broker-dealers to "trade through" NexTrade's best market quote, but also due to the lack of electronic connectivity to NexTrade that effectively renders its ADF quote non-existent, a fatal technological deficiency of the ADF pointed out to the SEC often and emphatically prior to the SEC's final authorization for ADF to start operation.32 The net result is that the SEC ignored and continues to ignore its duty to enforce best execution for the American investor by allowing SuperMontage to obliterate NexTrade's quotations on ADF.
C. SEC Advised of ADF Shortcomings
NexTrade has repeatedly voiced its concerns to the SEC about the shortcomings of the ADF. On or about June 14, 2002, prior to the August 29, 2002 Order, it met with SEC personnel in Washington, D.C. At this time, it warned of the impending problems to be encountered with ADF, including the ADF's failure to satisfy the Order Handling Rules, Regulation ATS, and other regulatory requirements, as a result of the flawed ADF design which fails to provide an order routing facility (i.e., no connectivity), a discriminatory feature that leaves ECNs with no execution vehicle other than Nasdaq's SuperMontage. In fact, the Petitioner, both amici and several other ECNs all submitted timely comment letters to the SEC, objecting to SuperMontage generally and to the ADF specifically. Thus, the SEC knew of ADF's legal deficiencies well in advance of its August 29, 2002 Order, and yet chose to approve the ADF.33
More recently, on January 6, 2003, NexTrade met at the SEC's headquarters in Washington, D.C. with the Division of Market Regulation and several Commissioners.34 Among some of the concerns, NexTrade submitted that:
In addition to the foregoing shortcomings, the ADF fails to satisfy Regulation ATS, which requires, in pertinent part:
The majority of broker-dealers are not able to effect direct transactions with NexTrade's ADF-displayed orders because, as explained above, broker-dealers have no electronic connectivity to NexTrade's ADF-displayed quotes. In order to obtain the necessary electronic connectivity envisioned by ADF, broker-dealers must pay hefty access fees to the private firms that provide such electronic connectivity solutions. It goes without saying that this "proposition of payment" has been rejected by most broker-dealers, who are unwilling to pay hefty access fees and unwilling to become the subjects of arbitrary and capricious conditions imposed upon them by the private firms that provide the electronic connectivity solutions. Furthermore, NexTrade's quotes, whether by way of the highest-priced buy order or lowest-priced sell order displayed and entered into ADF and posted through SuperMontage, are either unexecutable or SuperMontage enables market participants (broker-dealers and other ECNs) to "trade through" NexTrade's ADF quotes.
Thus, the ADF violates Regulation ATS on its face, resulting in a scheme that allows the Nasdaq to reap ill-gained financial benefits through its exclusively owned SuperMontage.
D. Implications of ADF Shortcomings
The discriminatory practices of Nasdaq's SuperMontage are designed to provide Nasdaq with trading fees to the exclusion of other entities. While Nasdaq argues that the market benefits from the implementation of SuperMontage, it is actually Nasdaq that receives the benefit. Nasdaq's SuperMontage, like an ECN, attracts business by paying rebates to broker-dealers that add trade volume or liquidity to its SuperMontage Order Book38; however, Nasdaq discriminates against ECNs by not paying them rebates, even though ECNs either directly, or through ADF, add trade volume or liquidity to the SuperMontage Order Book. In spite of its duty to offer fair access to SuperMontage and treat all market participants equally, Nasdaq intentionally excludes ECNs from its rebate program in order to obtain a "free-ride" or "free benefit" from ECN trade flow. The motive behind Nasdaq's egregious discriminatory practices, which include the decrementation feature of SuperMontage, the exclusion of payment to ECNs for trade flow sent to SuperMontage and the allowance of "trade-through" quotes of ECNs on the ADF, is nothing but Nasdaq's well conceived plan to run ECNs out of business. This Court holds the ultimate power to right wrongs, especially when, as in this case, the SEC has looked the other way and allowed the foregoing illegal practices to occur. In the final analysis, the responsibility for the construction and enforcement of the securities laws must rest with the Court.
SuperMontage, as approved by NASDAQ's Order stands in bald violation of the entire panoply of federal securities regulation in place after the 1975 Amendments. It is anti-competitive on its face. NASDAQ failed in its statutory duties in its consideration of SuperMontage and later the ADF.
In conclusion, the NASDAQ and NASD proposal to limit access fees to $.003 per share should not be approved because of these reasons:
¬ The NASDAQ's egregious attempt to regulate its competition out of business,
¬ the NASDAQ's lack of study on the impact on best-execution,
¬ the proposal is anti-competitive and does not help foster competition
¬ the proposal will not help best execution
¬ the NASDAQ's SuperMontage ECN, hinders the securities markets, and is a competitor to the ECNs
¬ the NASDAQ and its co-proposer the NASD are have a financial incentive to eliminate ECNs from their marketplace,
¬ this proposal will damage the markets by removing crucial liquidity, and
¬ this proposal will hurt small investors.
If you have any questions, please contact me at (727) 446-6660.
Mark E. Yegge