December 16, 2003
Jonathan G. Katz
By email to email@example.com
File No. SR-NASD-2003-128
Lek Securities Corporation ("LSC") wishes to comment on captioned release, which concerns a substantial issue of serious importance that should not be treated as a routine fee matter. If adopted, the proposed rule would not only put the NASD in business of regulating commissions, it would create an effective "tax" on an instrumentality of the exchange without any legitimate economic purpose except to unjustly enrich the ECNs that seek to impose it.
The proposed rule change would place a maximum fee of .003 cents per share (3 mils) on what ECNs may charge broker dealers that trade against their bids and offers posted on SuperMontage. It appears that the NASD is seeking to treat the question as a routine fee issue - thus avoiding the question of whether these "access" fees should be permitted in the first place. This treatment has prevented the proposed rule change from being adequately publicized or commented upon. We were unable to find a copy of the proposed rule change on the NASD's website, and a search of the Commission's website also failed to find the document. We are therefore concerned that this important matter is in danger of slipping through the cracks.
ECNs are organized either as national securities exchanges or as broker dealers1. Their function is to match their customers' buying and selling interest through electronic communications systems. ECNs originally operated as closed systems, i.e. they only matched buy and sell orders among their customers. Broker dealers that were not a customer of the ECN did not participate in the matching process. Like any broker dealer ECNs charged their customers a commission for finding the other side of their trades and executing their orders.
However under Section 11A(a)(1)(D) of the Act, Congress found that linkage of all markets through communication and data processing facilities would foster efficiency, enhance competition, increase information available to brokers, dealers and investors and facilitate the offsetting of investors' orders, and contribute to best execution of such orders. The Commission accordingly disallowed closed markets from continuing to operate and forced the ECNs to display their best bids and offers in a fashion that any broker dealer could interact with them.
In the closed system model both buyer and seller were a customer of the ECN and the ECN could rightfully charge both sides a commission for executing their orders. However, Congress and the Commission mandated an open and linked system and the ECNs found themselves in the same position as any other broker dealer, i.e. that their customer's orders could sometimes best be filled against orders of customers of other broker dealers. The open system greatly benefits investors, as quotations are now universally displayed leading to a more centralized market with greater liquidity, while maintaining competition between market centers.
However, the ECNs were apparently disappointed that in the open system model they could only charge on their customer's side of the trade, and they began billing unrelated non-customer broker dealers for commissions based upon the fiction that these broker dealers were if fact customers of the ECN and had agreed to pay such commissions. Of course, every broker dealer prefers to match orders in house and receive a commission on both sides of the trade. The same holds true for ECNs. However, when an in-house match does not result in the best possible execution for the customer, a broker dealer must fill his customer's order against orders of other broker dealers, and the broker can only earn a commission on his customer's side of the trade. This should also be the rule for ECNs.
Some ECNs have sought to justify their claim to fees by referencing "no-action" letters from the Commission. (These "no action" letters merely say that the Division of Market Regulation would not recommend enforcement action against an ECN for violation of Order Execution Rules (the firm quote rule and limit order display rule) provided, among other conditions, they did not charge non-subscribers a fee "more than the fee the ECN charges a substantial portion of its active broker-dealer subscribers, and in any event no more than $0.009 per share.") As the NASD's proposal hints, these letters are being severely misused by some ECNs, who have tried to use the cautionary no-action letters (stay under this bar and you will not be prosecuted for violating the securities laws) as affirmative grants of authority to charge to the limit stated in the no action letter.
LSC believes that these no action letters are not, as some ECNs contend, a carte blanche authorization to charge non-subscribers $0.009 per share. The Commission has not in our opinion taken any position that the fees sought by ECNs are reasonable or permissible. Consider, for example, a recent exchange between the Domestic Securities ECN and Robert L. D. Colby, Deputy Director of the SEC Division of Market Regulation and the official who signed Domestic's no action letters. On December 2, 2002, Domestic's general counsel Linda Lerner emailed the SEC asking that it confirm that its $0.009 fee was "presumptively valid" because the fee was within "the maximum parameter" imposed by the no action letter. By letter from Mr. Colby dated December 16, 2002, the SEC disagreed in no uncertain terms:
"In your e-mail, you asserted that any access fees that the Attain ECN charges at or below the $0.009 level are presumptively valid. The Division does not agree with this assertion. Indeed, the Division has not taken any position with respect to the appropriateness of specific per-share access fees such as your e-mail references." (Emphasis added).
Thus, whether and how much ECNs may charge non-subscribers is a question that has not been answered by the Commission.
LSC submits that ECNs should not be able to charge contra-party broker dealers at all, because such charges, unilaterally imposed without any contractual authority, cause an unfair and improper escalation of posted bids and offers, without any economic justification. Even if ECNs were permitted to charge any fee, the amount should be limited to a nominal amount, less even than the cap proposed by the NASD - which cap, history proves, will become the de facto charge for most ECNs. It is therefore necessary that the Commission state its position more clearly.
The Proposed Rule
Nasdaq proposes to amend NASD Rules 4623 and 4710 to establish a maximum level of quote/order access fees for ECNs that elect to participate in Nasdaq's National Market Execution System ("NNMS" or "SuperMontage"). The Association is concerned that there is substantial disparity in the fees charged by ECNs participating in SuperMontage, with some ECNs charging access fees, in some instances, three times as high as other participating ECNs. Nasdaq believes that these gross fee disparities are of particular concern in a system like SuperMontage that extensively automates the matching of buy and sell trading interest using neutral execution algorithms that limit the ability of users to select or anticipate exactly who their counter-party, or counter-parties, to particular trade will be. The result is that users enter orders into SuperMontage and end up executing against a variety of market participants including, in some cases, ECNs that charge access fees significantly higher than others. In turn, Nasdaq believes that the inability of system users to reasonably anticipate their trading costs, due to these large access fee disparities, discourage those users from entering their quote/orders into the SuperMontage system thereby depriving all SuperMontage participants of beneficial liquidity.
In response to the above, Nasdaq has determined to establish a maximum permissible quote/order access fee amount for ECNs that elect to participate and execute transactions in the SuperMontage system. Nasdaq proposes to establish the maximum SuperMontage ECN access fee amount at $ 0.003 (three mils) per share. Participating ECNs will be free to charge quote/order access fees less than the $ 0.003 maximum. Nasdaq believes that this access fee level is also generally in keeping with the level of access fee imposed by most ECNs today. In addition, Nasdaq believes that the $ 0.003 access fee cap retains transparency in the system by maintaining a reasonable nexus between displayed prices in the montage and actual execution prices obtained by market participants that interact with fee-charging ECNs. As such, Nasdaq believes that $ 0.003 maximum access fee is designed to maintain consistency in Nasdaq's market and provide equivalent and fair access to available quotes/orders.
Commissions that ECNs charge to unrelated broker dealers are not negotiated. They are dictated by the ECN and thus effectively constitute a tax on the industry. To make matters worse, many ECNs now rebate a portion of the "tax" back to their customers, giving them a competitive advantage to traditional broker dealers. The NASD proposal should be applauded for recognizing the "gross fee disparities" and abuses by some ECNs (which abuses are not being adequately resolved by NASD sponsored arbitration) and for seeking to impose a cap on the allowable fee. However, permitting any such charge is tantamount to fixing commissions and is not the answer. (If the Commission disagrees, we respectfully submit that the cap should be retroactive and that no ECN be permitted to collect any fee in excess of the new cap even for past executions). The maximum commission set by the NASD will quickly become the minimum commission and the country will soon revert to a system of fixed commissions, all to the detriment of investors and the public interest that Congress had sought to protect through the benefits of competition in the brokerage industry.
Nasdaq claims that Rule 301(b)(4) of Regulation ATS explicitly permits the regulation of commissions charged by ECN. We respectfully disagree. Although we find the rule difficult to understand, we see nothing therein that would allow to Association to regulate commissions. To the contrary, the rule simply prohibits ECN charges that would be "…inconsistent with any standard of equivalent access established by such rules [of the NASD]." Accordingly, rather than allowing ECNs to charge commission to unrelated parties, we believe that the rule prohibits it. When a broker dealer interacts with a posted bid or offer of another broker dealer, that broker dealer cannot charge a commission to the entering firm. Thus allowing the ECN to charge such a commission would be inconsistent with the standard of equivalent access, and is therefore prohibited.
More significantly there can be no doubt about the fact that with the Securities Act Amendments of 1975 Congress banned a system of fixed regulated commissions in favor of competition. ECN access fees are by their very nature not subject to competition and are therefore inappropriate. LSC believes when an ECN's customer participates in only one side of the trade, like any other broker dealer, the ECN should only be allowed to collect a commission from the customer on whose behalf the ECN acted as agent. We see no reason to place ECNs in a privileged position and allow the ECN to collect on both side of a trade, when it was only able to find either the buyer or the seller, but not both. Allowing an ECN to do this is tantamount to giving it taxing authority over the industry.
Nasdaq also states that it believes that the proposed rule change, as amended, is consistent with the provisions of Section 15A of the Act, in general, and with Section 15A(b)(6) of the Act, in particular, in that the proposed rule change is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principals 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.
We agree that ECNs imposing a tax on other participants as they see fit might constitute a fraudulent and manipulative act, and it certainly violates just and equitable principals of trade, but setting fixed commissions explicitly violates Section 16(e) of the Act and the Commission should not approve of it.
In its filing, Nasdaq also states that it does not believe that the proposed rule change, as amended, will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. We once again respectfully disagree. It is abundantly clear from the legislative history of the Securities Act Amendments of 1975 that Congress considers the fixing of commissions to inherently constitute an undue burden on competition.
For the reasons stated above, we recommend that the Commission:
Samuel F. Lek