October 24, 2003
Securities and Exchange Commission
Attention: Jonathan G. Katz, Secretary
Re: File No. SR-NASD-2003-128
Ladies and Gentlemen:
Brut, LLC ("Brut")1 appreciates the opportunity to provide its views to the Securities and Exchange Commission (the "Commission") in response to Exchange Act Release No. 48501 (the "Proposing Release"),2 in which the Commission solicits comment regarding a proposal of the Nasdaq Stock Market, Inc. ("Nasdaq"), an affiliate of the National Association of Securities Dealers (the "NASD") to: (i) establish a cap on the access fee charged by ECNs that participate in Nasdaq's SuperMontage trading system; and (ii) eliminate certain SuperMontage execution algorithms. These proposals would bar ECNs that charge access fees of higher than $.003 (three mils) per share from participating in SuperMontage as they currently do, and eliminate execution algorithms that previously took access fees into account.
Brut thinks the Nasdaq proposals represent a fair and balanced effort to resolve an issue that has been the source of contention in the nation's equity markets since the Commission's adoption of the Order-Handling Rules in 1996.3 Nasdaq has, after seven years, exercised its authority to limit access fees within its market in a productive and positive manner.4 The proposals do not challenge the validity of a fee-based agency business model that Nasdaq itself is pursuing, reflect the greater set of compliance and connectivity alternatives available to ECNs that wish to pursue higher-rate business models, and would discard legacy execution priorities that no longer make sense once the fees of the remaining ECNs are on par with the charges of other SuperMontage participants. Brut urges prompt Commission approval of these proposals in order to achieve closure on this long-standing issue, allowing focus to turn to the other topics requiring prompt regulatory action.
Access Fees Generally
The legitimacy of the fee-based business model - for ECNs, other alternative trading systems, more traditional broker-dealers and exchanges - need be re-affirmed before commenting on Nasdaq's proposal in detail, given the hotly-contested nature of such fees in the ongoing dialogue over market structure. By charging a fee for the handling of an order on a strict agency basis, brokers and markets can offer a service free from the potential conflicts of interest that can often accompany a business model reliant on profits from proprietary trading activity. While trading-based business models - with their willingness to provide immediacy, commit capital, and lend market expertise - are undeniably of value for certain types of trades, investors (especially institutional investors) and traders clearly need and demand alternatives whereby their execution service provider is not simultaneously trading for its own account. The growth of ECNs and other ATSs in recent years, in addition to other increases in broker-dealer facilitation on a pure agency basis, only confirms this.
Over the years, the regulatory framework has impartially balanced the need for commercial flexibility on rate structures with the desire for transparent market information. With the adoption of the Order Handling Rules, the Commission integrated the order prices of ECNs, which had grown into the large aggregators of agency limit orders, into the national best bid and offer ("NBBO") and self-regulatory organization ("SRO") access facilities while preserving the right to charge fees equivalent to those ECN operators would have received had such liquidity remained only privately accessible.5 With ECN no-action letters and Regulation ATS further cementing the standards of fairness and non-discrimination,6 the combined rule-set allowed for commercial flexibility while pro-scribing conduct inconsistent with just and equitable principles of fair trade. Over time vicious rate competition and technology allowing for greater order-flow portability have kept fees at reasonable levels for the vast majority of volume transacted by electronic agency brokers.
To the extent additional reform is needed regarding these issues, it should be based on two principles. First, the Commission should be involved solely to the extent that market forces and the self-regulatory structure are inadequate remedies. Second, any new regulation should focus on directly prohibiting the particular conduct that is inconsistent with national market system principles, rather than engaging in rate-setting when other more narrowly-tailored methods are available. Adherence to these two tenets will preserve needed commercial freedom while improving market quality.
An examination of how best to eliminate locked and crossed markets shows how these philosophies can be applied. Current Nasdaq, exchange, and ECN rate structures undeniably incentivize the locking and crossing of the NBBO, given the disparities between fees for accessing and the rebates for providing liquidity. The multi-market nature of this practice means that no single private entity can police this practice, and would endure significant commercial risks if attempting to do so. The Commission is the proper entity to effect change in this instance.
A conduct-based approach to eliminating locked and crossed markets is vastly preferable to rate-fixing methods, with the score of unintended consequences such an approach would bring. The fee-rebate business model has been vital in allowing market centers to vigorously battle for the order flow of the divergent constituencies of liquidity providers and takers. This has given rise to increased price competition among market centers, driving firms to lower their costs, both organically and through consolidation.7 Combined with market aggregation technologies, this drive towards scale has curtailed the risks of excessive fragmentation, as only a small number of firms can attract and retain a meaningful amount of liquidity in such a competitive environment. Moreover, the existence of rebates properly rewards firms willing to provide price discovery to market participants with reactive trading strategies, incentivizing emerging firms to provide needed liquidity and immediacy to the marketplace. This liquidity was a critical bulwark as the shocks of market decline and decimalization shattered the confidence and willingness to trade of other market segments.
Accordingly, rather than eliminating rebates and mandating lower fees to rid the market of locked and crossed quotes, a simple prohibition on the practice of "quoting through" or at the prices posted on other market centers would be tactically effective and strategically prudent. Such a rule would eliminate a market practice that reduces efficiency and deters the prompt execution of investor orders through NBBO-driven automated systems, but in a narrowly-tailored fashion that does not have broader unintended adverse consequences. Brut urges the Commission to consider such a proposal when dealing with the issues surrounding inter-market linkages and access as previously stated,8 and adopt a similarly market-oriented approach to other issues as it deals with market structure reform on an omnibus basis.
Within the context of access-fee regulation, absent the issue of locked and crossed markets Brut sees little Commission intervention that is necessary to improve upon the changes that other market participants are now beginning to effectuate. Nasdaq, with its dual MPID offering,9 now allows market makers to further pursue agency business models and answer the long-standing cry of some to level the playing field. Nasdaq's chairman and CEO has commented that this offering will be a "pivotal event" in the development of the Nasdaq market.10 Combined with measures outlined in the Proposing Release, strong evidence exists that market forces are working properly to improve market efficiency through competition and product evolution.
SRO Authority and Responsibility
The authority of SROs to police access fees in the facilities they operate is well established. In approving the Order Handling Rules, the Commission stated that it "believes an SRO that accepts the prices provided by an ECN for publication should be authorized to impose reasonable rules related to the public dissemination of those prices."11 In approving Regulation ATS in 1998, the Commission was even more explicit, requiring ECNs "to comply with the rules or standards governing fees established by the [SRO] through which non-subscribers have access."12 At that time, the Commission set a standard for approval of such rules where they were "necessary to maintain consistency within the SRO's market, as well as be designed to promote just and equitable principles of trade, fair competition... and, in general, protect investors and the public interests."13 While SROs are further required to comply with various Exchange Act provisions with respect to uses of their rule-making authority,14 provided those standards are met SROs have the ability to set standards for the access fees of ECNs that use their quotation-display facilities.
Until now, Nasdaq has failed to exercise this authority in a responsible manner, as its own internal transformation has placed its commercial interests at odds with its duties as a regulator. In particular, Nasdaq has evolved from a collectively-owned and funded regulatory compliance facility into an admittedly for-profit operation in competition with the market makers and ECNs it was originally created to serve. Throughout this process, Nasdaq pursued a variety of initiatives that discriminated against ECNs, while at the same time moving to a similar price structure and business model.15 As the relationship between Nasdaq and a variety of significant ECNs deteriorated over time, Nasdaq efforts to fairly utilize its power to regulate access fees were perhaps untenable given the innumerable conflicts of interest that existed. All the while, changes in the economic climate and equities market regulation have caused ebbs and flows in the debate over access fees and the nature and powers of SROs within market structure.
Throughout this period, Nasdaq's legacy as the monopoly provider of OTC quote-display and trade-reporting services made ECNs reliant on Nasdaq from a compliance perspective, further complicating efforts at access-fee reform. From the time of the Order Handling Rules' adoption until the implementation of SuperMontage - and the corresponding Commission directive to create the Alternative Display Facility (the "ADF") - Nasdaq offered the only meaningful alternative for ECNs wishing to comply with the ECN Display Alternative, an imperative to attract the business of brokers with limit-order display obligations. This meant that ECNs faced significant risk should Nasdaq proposals, regarding access fees or otherwise, threaten to interfere with their business models. Without a meaningful alternative in existence, Nasdaq encountered numerous difficulties in striking a balance between concerns regarding access fees and ECN dependence on Nasdaq systems. This produced a regulatory paralysis where the lowest common denominator often prevailed.
The Power of Competition
The Commission's insistence on creation of the ADF is perhaps the critical piece of the market structure puzzle, allowing the Nasdaq proposals to be consistent with national market system principles. While Brut does not use the ADF, its mere existence serves to protect Brut and other ECNs when their commercial interests diverge from Nasdaq. With Nasdaq no longer holding a virtual monopoly over quote-display and trade-reporting services in Nasdaq-listed stocks, ECNs are not hostage to Nasdaq rules in deploying their business models. Should an ECN wish to cease using Nasdaq altogether, it can do so in a meaningful fashion through the ADF. The emergence of exchange-based alternatives, such as the Cincinnati Stock Exchange, only augment this flexibility.
In the context of the Proposing Release, the availability of alternatives empower Nasdaq, as well as ECNs. Nasdaq now, perhaps unlike ever before, has the ability to establish access fee standards for its market free from allegations of jeopardizing an ECN's commercial viability through an unfair exercise of monopoly power. ECNs also have the power to make practical, realistic choices with regards to how they operate under the new Nasdaq rule set. All ECNs are free to adapt their rate structures to come into compliance with Nasdaq standards, as Brut intends to do. Those that wish to continue charging access fees higher than $.003 per share can depart from SuperMontage and utilize the ADF or other available alternatives, surviving and/or thriving based on the attractiveness of the services they offer to traders and investors.
This is the precise regulatory approach - one of reasonably diverse intra-market regulation within the context of strong inter-market competition - that the Commission should attempt to perpetrate in all areas of market structure. Vibrant competition among market centers has the positive consequence of amplifying each market's ability to innovate, cater to divergent market needs, and improve the overall level of alternatives available in the market place. By creating conditions that allow such competition to flourish, the Commission uses its regulatory authority in a manner that is both pro-active and productive.
Analysis of Nasdaq's Proposal
With the Proposing Release, Nasdaq appears to have seized the opportunity of a changed competitive landscape, overcoming the regulatory and psychological challenges that have heretofore prevented it from responsible efforts to limit access fees in its market. By suggesting a cap on such fees of $.003, Nasdaq's proposal: (i) reflects a rate structure already in place for the vast majority of the customers of ECNs and similar facilities on a volume-weighted basis; (ii) preserves consistency with Nasdaq's own access fee of $.003 for removing market-maker liquidity; and (iii) recognizes that with fees equalized, the last remaining vestiges of disparate treatment of ECN orders should be eliminated. The fundamental fairness of these three tenets, implemented collectively, is why Commission approval is warranted.
The establishment of $.003 as the cap on ECN fees in SuperMontage is appropriate because it reflects a rate that has wide industry recognition, allowing the rate structures of the large majority of ECN volume to be unaffected, while at the same time providing assurances to SuperMontage users as to the limit of the transaction charges they will endure. Brut, as the provider of a low-cost execution utility for the trading community, actually charges high volume customers an even lower rate - $.0027 per share - which it plans to continue upon approval of the Proposing Release. On a volume-weighted basis, most other ECN and market center access charges for Nasdaq-listed securities are at the $.003 level. Thus, a balance is struck between the need for economic certainty regarding access fees among broker-dealers but without causing seismic shifts in the nature of large ECN participation within market structure. Both consequences improve market efficiency and thus, market quality.
The consistency between the proposed cap and Nasdaq's own rate structure is also an important component of the Proposing Release, as it reflects compliance with Nasdaq's requirement under the Exchange Act to treat all brokers equally. SuperMontage currently allows participating market makers to charge an access fee of $.003 for access to their quotations, with Nasdaq collecting this fee and deducting $.001 from what market makers receive in order to recoup its costs for the exclusive connectivity, administration, fee collection and other services provided with respect to this liquidity.16 To the extent that ECNs were denied the opportunity to charge a similar fee for access to their own orders, Nasdaq would be in violation of its obligations as an SRO to avoid "unfair discrimination... between brokers or dealers."17 While Nasdaq is allowed under Regulation ATS to limit access fees, broader Exchange Act provisions mandate that SROs promulgate such rules in an impartial manner. By allowing ECN access fees to be on par with access fees collected on behalf of other SuperMontage participants, Nasdaq fulfills this requirement.
The elimination of the "price/fee" algorithm simultaneously with implementing the fee cap is likewise a leveling of the playing field between market-maker and ECN orders within SuperMontage. With the access fees charged for all SuperMontage orders now equivalent, there is no rational justification for depriving ECN orders of equivalent standing in Nasdaq systems.18 Nasdaq acknowledges that "having rationalized ECN access fees... it is also now appropriate" to eliminate priority rules that place ECN users at a competitive disadvantage.19 Brut likewise sees these measures as inexorably connected, and will combine to reduce trading costs and provide best execution for all Nasdaq users.
Brut believes the rule changes outlined in Proposing Release should be approved quickly by the Commission, as they reflect a fair and balanced approach to resolution of an issue that has long been a thorn in the side of many in the trading community. The need for different business models within the financial community, and thus disparate rate structures, is undeniable. Only through such variation can market participants meet a broad array of customer needs and provide a diverse set of services. With these proposals, Nasdaq has done an admirable job reconciling the differences among SuperMontage participants while at the same time exercising its regulatory authority in a non-partisan fashion. SRO rule-making such as this allows the Commission to pursue a macro-regulatory approach based on regulated competition rather than micro-managing market structure. With several other significant market structure issues yet to be decided, approval would allow the Commission to direct resources to other areas and continue the Herculean task of adapting market structure to the technology and business environment of the 21st century.
Please do not hesitate to contact me at (917) 637-2560 regarding this letter, or how Brut can assist the Commission and the staff in evaluating these issues in the future.