May 12, 1998
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: SEC File No. SR-NASD-98-17
Ladies and Gentlemen:
Bloomberg L.P. appreciates the opportunity to comment, in response to the Commission's request in Securities Exchange Act Release No. 34-39718 (March 4, 1998) (the "Release"), on the proposed rule change submitted by the National Association of Securities Dealers, Inc. (the "NASD"), through its wholly owned subsidiary, The Nasdaq Stock Market, Inc. ("Nasdaq"). The proposed rule change (referred to below as the "proposal" or the "proposed rule change"), would establish an integrated order-delivery and -execution system (the "System" or the "Next Nasdaq System") featuring a voluntary limit order book and market maker-sponsored direct access by non-members of the NASD.
Implementation of certain aspects of the proposed rule change, in particular the delivery of executions for quantities of 1,000 shares or less, not only would adversely affect Bloomberg's business but also would be anti-competitive and inconsistent with the public interest. For the reasons stated below, we believe that aspect of the proposed rule change is inconsistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to the NASD and that the NASD has failed to give the Commission a legally sufficient basis to approve the proposal.
Basic elements of the proposal. Under the proposal, the Nasdaq market would be altered in a number of significant respects. SOES and SelectNet would be replaced by a system that would incorporate features of both, including the delivery of executions rather than orders in the case of "directed orders" (that is, orders directed to a particular market maker, ECN or UTP Exchange), and "non-directed orders", of 1,000 shares or less, both to market makers and to electronic communications networks ("ECNs"). NASD members seeking executions would be permitted to avail themselves of such electronic delivery for both proprietary orders and customer orders. Larger orders would be delivered as orders rather than executions and both market makers and ECNs would have a set number of seconds within which to respond or else have the orders executed against them.
A new electronic limit order file (the "Limit Order File") would be created with the following features, among others: (i) all non-directed orders that match against an order in the Limit Order File would be executed automatically; (ii) the Limit Order file would display the "Top of the File", ranked in price/time sequence with all other quotations and orders entered into Nasdaq, which would be dynamically updated, would calculate the inside quotations and would provide a Full File display to Nasdaq workstations. The Limit Order File would be anonymous: participants viewing the Limit Order File or hitting a bid or taking an offer in the Limit Order File would not be able to learn the identity of the order entrant until after their trades were effected. Nasdaq is considering additional anonymity features as well. In addition to these features, the proposal would permit non-NASD members, including institutional investors, to obtain electronic access to the System if they are sponsored by an NASD member.
Orders vs. executions. The NASD stated in the Release that it believes that restructuring the marketplace to allow Nasdaq to send executions instead of orders to ECNs and market makers would be beneficial for all investors. The NASD's stated reasons for delivering executions rather than orders are as follows:
In the current environment, quotes of linked ECNs that are displayed in Nasdaq are accessible only through Nasdaq's SelectNet system, a system which is not an automatic execution system like SOES. Market makers, however, are accessible through both systems. As proposed, Nasdaq believes that quotes of linked ECNs should also be automatically executed against by other market participants on the same terms as market makers. Without an equivalent execution mechanism, ECNs would have an unfair advantage. Market makers are thus placed at a competitive disadvantage with respect to the display and execution of limit orders. Further, the disparity in executions may provide market makers with an incentive to change their status from market makers to ECNs, at a cost to market liquidity. Customers seeking to obtain executions quickly may be placed at a disadvantage if one customer receives an automatic execution against a market maker, while another customer may have to wait for an ECN to respond.
Problems with NASD reasoning. The NASD's assertions and arguments are illogical and wrongheaded on several counts, including the following:
Example: Customer A places an order in an ECN to buy 1,000 shares of stock at 20. It is the best bid in the ECN and is published in the Next Nasdaq System as the Nasdaq best bid. Customer B, a participant in the ECN, enters a priced sell order into the ECN for 1,000 shares at 20 with the intention of hitting Customer A's bid. Shortly thereafter, Customer C enters an order through a dealer into the Next Nasdaq System to hit Customer A's bid.
Analysis: Customer B is assured of an execution because its order was first in time. Customer C, however, also is assured of an execution because its order will be delivered to the ECN as an execution. As a result, it would appear that Customer A may be exposed to the risk of double execution. Customer A, however, is not responsible for the second execution because it has held itself out in the ECN as being responsible for only 1,000 shares. The ECN will have to absorb the liability for the execution delivered to it by the Next Nasdaq System.
As the above example shows, the New Nasdaq System would likely put ECNs out of the automated execution business because they could not provide automatic executions to ECN participants without risking double or multiple executions via the New Nasdaq System. That outcome would likely cause ECNs to exit the execution business because they would have no alternative but to send their participants' orders on an agency basis to Nasdaq; ECNs would thereby cease to be ECNs for orders of 1,000 shares or less within the SEC's definition in the Order Execution Rules. And then there would be only Nasdaq.
Only SOES has broken the tradition that a market participant commits to a trade, and puts its capital on the line, only when the trader says "Done", or the equivalent, in response to a bid or offer. Effectively, the assignment of executions by a self-regulatory system that does not make markets or commit capital is not consistent with a market economy, one in which market players are allowed within the limits of appropriate behavior to determine whether they will indeed commit to transactions. The poor choice of SOES a decade ago to address a problem of retail access of the markets, which it neither addressed nor solved in fact, should not be a basis for expanding that failed experiment or for exacerbating the problems it caused.
The NASD's arguments for its proposed system are unconvincing. The principal effect, and very likely the deliberate but unspoken design, of this feature of the Next Nasdaq System would be to discriminate in favor of Nasdaq and against the ECNs. In practical effect, the Next Nasdaq System would have been rigged to give a permanent, commanding preference to orders entered through Nasdaq rather than into an ECN. The ECN order would always be queued behind the simultaneously entered Nasdaq order and the ECN participant who entered its order into the ECN instead of into the Limit Order File would create the risk of multiple executions for that ECN.
Abuse of regulatory power. Such a result, if derived from technical superiority or a more competitive system, would be a fair one. In the case of the Next Nasdaq System, however, it results from the use of regulatory power to perfect a monopoly. In effect, the NASD is using its quasi-governmental regulatory power, backed up by the "friendly persuasion" that NASD Regulation, Inc. ("NASD-R") can apply, to enhance the competitive posture of the NASD's wholly owned cash cow, Nasdaq, at the expense of its competitors and of the public interest. The Commission should not allow this to occur.
Creditworthiness of liquidity makers. The proposed rule change would increase the credit risk that ECNs and market makers currently bear in responding to SelectNet and telephone orders from non-participants. The Central Limit Order File would give all NASD members the opportunity to display anonymously customer limit orders as well as proprietary orders. As a result, an ECN or a market maker that facilitated its own customer orders by going to the ECNs and market makers whose quotations were at the NBBO would have the added credit risk of taking liquidity without having any way of knowing who the counterparty was until the trade had been executed, or at the end of the trading day. Many of Tradebook's broker-dealer and institutional participants are willing to trade in the anonymous Tradebook market only if they have satisfied themselves that there is reasonable assurance of the financial integrity of the Tradebook System, most importantly that sound credit criteria are imposed for access to the System by other Tradebook participants. Unlike an ECN, Nasdaq does not propose to bear any credit risk for the trades done in the proposed Limit Order File and is undecided as to when, after the trade is executed, the taker of liquidity will learn the identity of its counterparty.
This approach is inconsistent with that of the Order Handling Rules as they are interpreted and applied by the Commission. The Commission has made it clear that both ECNs and market makers can condition their willingness to accept transactions from non-customer counterparties on credit considerations.
Bloomberg has previously addressed the issue of credit controls in the national marketplace, in our response to the Commission's Concept Release on Exchange Regulation. We continue to encourage the Commission to reduce counterparty risk by requiring the National Securities clearing Corporation ("NSCC") to assume responsibility for trades from the moment of execution. If the NSCC were required to guarantee trades ab initio, it would establish credit criteria of its own, and ECNs such as Tradebook would not be involved in managing the creditworthiness of non-participant broker-dealers, regardless of whether the broker-dealers were taking or supplying liquidity.
Suggested approach. ECNs should be considered separately from market makers. To be "compliant ECNs" under the Order Execution Rules, ECNs have to publish certain quotations entered by market makers and other broker-dealer participants, but ECNs do not make markets in any real sense. They process orders entered by others and they match and effect automatic executions. As the SEC knows, as a compliant ECN, Tradebook does not take principal positions and does not publish quotations for its own account. Accordingly, it is not equipped to accept the multiple executions that would result from the NASD's proposal.
ECNs should receive orders, not execution messages from Nasdaq. In addition to the unfair competitive disparities the NASD's proposals would impose, there are several practical reasons why Tradebook and other similarly constituted ECNs should not be subject to receiving executions from Nasdaq. Such a change is unnecessary since Tradebook already meets high standards of responsiveness and transparency. Tradebook responds virtually instantaneously to orders sent to it by Nasdaq via SelectNet. Indeed, Tradebook is required to do so under the terms of its no-action letter from the Commission and under the terms of the ECN Addendum to the Nasdaq Workstation Subscriber Agreement between Bloomberg Tradebook and Nasdaq.
Non-participants do not currently "have to wait for an ECN to respond," as the NASD states in its proposal. Non-participants may have to wait, however, for Nasdaq to inform them of the ECN's prompt response. If such a problem exists, Nasdaq should invest in improvements to its messaging infrastructure instead of penalizing ECNs for Nasdaq's own technological shortcomings.
If the NASD finds it difficult to obtain sufficient responsiveness among market makers, either the NASD or the Commission should require that market makers be subject to the same response obligations as ECNs. Market makers should be required to respond to orders received via SelectNet as quickly as they respond to orders from their customers and proprietary orders. ECNs have already proven that this type of regulation is effective and viable. Without such a provision, market makers would continue to be harmed by the proposed rule change, as they have been by SOES, because they could not connect electronically to anyone else without the risk of receiving double or multiple executions. The proposed rule would create no benefit to counterbalance or outweigh the harm caused to market makers, especially in light of the fact that there are alternative means to address the stated problem without causing the same harm.
Standard setting. The NASD should not be allowed to set standards for the automated processing of orders unless those standards give to electronic market participants fair recognition of the benefits of their superior technology. ECNs, and market makers' automated systems, should be required to execute or decline orders received within one-half of one second. Market makers would have an exception for orders automatically routed to the trader, based on internal algorithms, for response, based on the size of the order, as outlined in the proposal. On the other hand, basing response standards on market makers' procedures for handling orders in a non-automated fashion (by telephone or from a Nasdaq workstation) impedes liquidity and market efficiency by holding ECNs and other automated systems to the lowest common denominator, that of the non-automated market-maker. It would subject to human inefficiency a marketplace that is rapidly moving toward greater automation and integration of electronic communications and order processing and would inevitably hold back the public benefits to be derived from the introduction of state-of-the-art technology.
We are not suggesting that the market makers that operate manually should all be held to the standards of performance one might expect from a totally electronic environment such as an ECN—market makers that choose not to meet electronic response standards could still receive execution messages from Nasdaq, as proposed. Rather, we are saying that the NASD should not be able to use its regulatory power to establish unfair competitive disparities between ECNs and Nasdaq itself. The Commission should seriously examine the NASD's conduct in this regard and reject its effort to use its regulatory power to obtain a stranglehold over the over-the-counter equity markets.
Enforced centrality not a virtue. Establishing the NASD by governmental fiat as the "market center" to collect orders and redistribute executions would be detrimental to the operation of the financial markets. Relying on a monopoly market center will disadvantage the market because the proposed technology is not state-of-the-art. With the proposed rule change, Nasdaq is attempting to change the rules of the road but is not investing adequately in new technology. Building new rules around out-dated or insufficiently modernized technology is not logical, effective or efficient.
Recent Nasdaq behavior. The NASD has recently exhibited a distressing willingness to use the defects of its own technology to impose a lowest common denominator on the ECNs. On two occasions during the last few weeks, the NASD's SelectNet linkage has crashed for significant periods of time. The NASD's immediate response has been to take the ECN quotations out of Nasdaq on the pretext, unsupported by Commission policy or rule, that the ECNs are per se incapable of providing sufficient access to their own quotations during such periods to be considered compliant ECNs at such times.
Neither the Commission's Order Execution Rules, nor the NASD Workstation Agreements, nor common sense support such a claim. While SelectNet is down, Tradebook and probably at least one or two other ECNs are fully capable of maintaining electronic communications with both NASD members and non-members via their private networks, as well as over the telephone. During a period of crisis when SelectNet is down, it is doubtful that many market makers that are at the top of the Nasdaq file can handle, without stress or queuing, the volume of telephone orders that will result. In any event, the NASD did not stop to consider whether it was doing a disservice to the market by pulling the ECN quotations at such times. It did not conduct any inquiry whatever into either the ECNs' actual capacity, or that of the market makers, to respond to telephone or electronic inquiries. Notably, it left the market makers' quotations in place, without having any objectively justifiable reason for making that distinction.
The NASD's conduct is a disturbingly parochial, commercially motivated response to the failure of the Nasdaq technology. However motivated, it shows that the NASD has too much power. This is but one demonstration of the public dangers of allowing a private body to use quasi-governmental regulatory power to restrain trade among other market participants with which the NASD competes aggressively.
The ten-second slow pitch. In the case of orders that exceed 1,000 shares, the proposed rule change would stipulate a minimum life of ten seconds for directed and non-directed orders. This rule was implemented in 1997 to prevent a SelectNet order from being sent and immediately canceled, leaving the market maker or ECN with the risk of executing the order at the same time the sender canceled it. A continuance of this rule indicates an unwillingness to upgrade the technology Nasdaq proposes to use in the marketplace.
The proposal provides, inappropriately, for different response times from market makers and ECNs based on the size of orders sent. In reality, Tradebook and several other ECNs have automated systems which receive and process orders, generally in much less than a second. Many market makers also have implemented automated systems to process orders very quickly. Nasdaq could design a new order delivery system to handle issues such as cancellations in a much more effective manner for both fully automated and other destinations, without a blanket rule to meet the needs of the lowest common denominator.
The proposal is silent on the subject of new technology. The proposed continuance of the ten-second minimum life for orders, however, is a red flag that Nasdaq is not committed to replacing its out-dated applications to meet the industry's requirements.
Nasdaq's current technology does not meet current standards. Nasdaq's communications systems require a substantial modernization to bring them up to current industry standards, standards the ECNs themselves have incorporated into their systems. The existing SelectNet technology, moreover, is inadequate. Tradebook has experienced losses in instances where execution messages returned through SelectNet were not received, and the order-entry firm canceled the order. Using other protocols, the Tradebook System would have detected the absence of an acknowledgment from SelectNet and automatically re-sent the message.
Systems can be built to address this problem in a much better way. A new order-delivery system could track whether a message is being sent to an automated execution point, such as an ECN or a market maker’s computer, or to a Nasdaq workstation. A minimum-life rule for orders sent to a workstation, where manual intervention is required, would continue to be needed. Orders sent to automated destinations, however, would be handled under protocols that would give the receiving application the ability to respond, in a very short time, as to whether the order has been executed or canceled.
Nasdaq's failure to meet the minimum standards required of ECNs and the standards set by private firms is another indication of the problems with the proposed rule change. The marketplace is rapidly moving to greater levels of automation, and the proposed system should be leading that movement, not holding it back. If Nasdaq is allowed to enforce by rule its wish to be the exclusive market center, it will hold everyone back to its own levels of inefficiency and the U.S. markets will not keep pace with the technology that is being put in place in other world markets.
Mandatory bases for disapproval. In light of the matters discussed above, the Commission cannot find that the proposed rule change is consistent with the requirements of the Exchange Act applicable to the NASD as a registered securities association. The proposed rule change is inconsistent with those requirements in at least the following respects:
1. Section 15A(b)(6). The proposed rule change violates this section of the Exchange Act in several ways:
a. Market effects. Section 15A(b)(6) requires that the NASD's rules be designed "to remove impediments to and perfect the mechanism of a free and open market and a national market system . . . ." The proposed rule change does not advance that objective, and indeed impedes it, by discriminating unfairly against ECNs through the delivery of executions rather than orders in sizes of 1,000 shares or less and by holding back the benefits of technology to the lowest common denominator of Nasdaq technology in the regulation of response times in the case of orders exceeding 1,000 shares.
b. Unfair discrimination. Section 15A(b)(6) requires that the NASD's rules not be designed "to permit unfair discrimination between . . . customers, brokers, or dealers . . . ." The proposed rule change violates that directive by discriminating unfairly between customers that enter orders into an ECN and those that do not, as discussed above, and by unfairly burdening ECNs, a class of broker-dealer, to advance the competitive posture of Nasdaq.
c. Improper purposes. Section 15A(b)(6) requires that the NASD's rules not be designed "to regulate by virtue of any authority conferred by [the Exchange Act] matters not related to the purposes of this title or the administration of [the NASD]." The proposed rule change violates this standard by using regulatory power to advance the competitive position of Nasdaq, which amounts to inappropriate economic regulation and interference with the competitive position of ECNs.
2. Section 15A(b)(9). This section of the Exchange Act provides that the rules of the NASD must not "impose any burden on competition not necessary or appropriate in furtherance of the purposes of [the Exchange Act]." The anti-competitive features of the proposed rule change, discussed above, are not appropriate and cannot stand. The NASD has not provided any sufficient justification for the burdens the proposed rule change would impose and, indeed, it is highly doubtful that any such justification could ever be adduced.
Effects on competition. As discussed above, the proposed rule change will have significant competitive implications, including major adverse effects on competition between Nasdaq and ECNs. Tradebook and the other ECNs like Tradebook already have an economic incentive to encourage order flow and provide liquidity. Under the proposed rule change, however, Nasdaq would be poised to compete with the participants it is supposed to regulate and it would essentially duplicate the role of the ECNs. Tradebook provides to Nasdaq, over an operative electronic linkage, the requisite data concerning best prices and sizes that exchange specialists and OTC market makers have entered in securities quoted on Nasdaq. Tradebook complies with the provisions of the ECN Addendum to its Nasdaq II Workstation Subscriber Agreement and responds to orders entered into it through SelectNet access no slower than Tradebook responds to subscribers who enter orders directly into Tradebook, and in any event, no more than a few seconds.
Regulation, moreover, if it negatively affects the competitive balance of the marketplace, should be evaluated against the pro-competitive policies that underlie federal antitrust law. In Silver v. New York Stock Exchange, the Supreme Court held that anti-competitive securities regulation supersede antitrust law "only if necessary to make the Securities Exchange Act work, and even then only to the minimum extent necessary." The Congress was attentive to that principle in 1975 when it amended Section 15A of the Exchange Act to require the Commission to analyze burdens to competition caused by NASD rulemaking. Accordingly, a proposed rulemaking initiative must contain an analysis of the need for, and potential competitive and anti-competitive effects of, the initiative, and the Commission's rationale for determining why the competitive balance weighs in favor of approving the initiative.
This is not the first time the Commission has been confronted with an effort by a self-regulatory organization to use regulatory coercion improperly to stem erosion of its market share or to capture or retain order flow. It was just such an effort by the New York Stock Exchange (the "NYSE") to prevent volume from going to other markets that led the Commission in 1941 in the Multiple Trading Case to bar the NYSE from prohibiting its members from trading in NYSE-listed securities on other national securities exchanges. Similarly, some thirty-five years later, the NYSE tried without success to limit the ability of member organizations to direct order flow to the regional exchanges. The NYSE argued in that regard that its proposed Public Limit Order Protection Rule (known as the "PLOPR"), which would have required NYSE member organizations to satisfy limit orders on the NYSE before taking their trades to regional exchanges, protected the integrity of the NYSE market and promoted the protection of investors and the public interest. In rejecting those arguments, the Commission concluded that those alleged purposes, even if genuine, did not cure the basic illegality of the NYSE's rule. It stated in the order commencing disapproval proceedings that the fact that an NYSE proposed rule change would limit the ability of member organizations to effect transactions on other market centers within the United States was, per se, a ground for disapproval of the proposed rule change. As in the Multiple Trading Case, the NYSE's arguments about the need to have the rule to promote market integrity and customer protection were irrelevant to that basic statutory issue.
The NASD's effort to use regulatory coercion in this instance has the same improper purpose, to limit the ability of NASD members and other market participants to choose freely the market to which their orders will be sent. The NASD's proposal is anti-competitive and represents an illegal effort to perfect a Nasdaq monopoly on order flow. The Commission should condemn and reject this aspect of the NASD's proposal.
Procedural infirmities. In addition to the substantive problems the proposed rule change presents, there are several procedural infirmities in the filing. In particular, the NASD has failed to address in more than a curt and peremptory fashion the question of burdens on competition notwithstanding an affirmative requirement that all such burdens be fully explained and justified. In its filing on Form 19b-4 with respect to the proposed rule change, the NASD's response to item 4, "Self-Regulatory Organization's Statement on Burdens on Competition," is simply as follows:
Nasdaq does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act, as amended.
This assertion, unsupported by facts or any demonstration at all, does not satisfy the requirements of the Commission's Form 19b-4 that such burdens be explained in detail. The NASD simply restates the language of Section 15A(b)(9). No mention of any specific competitive effect, positive or negative, is made. The NASD does not explain for the benefit of the public or the Commission its balancing of burdens on competition against beneficial effects in achieving Exchange Act goals, or why any anti-competitive effect is necessary to achieve the purposes of the Exchange Act.
As the Commission is aware, the General Instructions to Form 19b-4 are explicit on the point. They provide as follows with respect to "Information to be Included in the Completed Form," in item 4, "Self-Regulatory Organization's Statement on Burden on Competition":
State whether the proposed rule change will have an impact on competition and, if so, (i) state whether the proposed rule change will impose any burden on competition or whether it will relieve any burden on, or otherwise promote, competition and (ii) specify the particular categories of persons and kinds of businesses on which any burden will be imposed and the ways in which the proposed rule change will affect them. If the proposed rule change amends an existing rule, state whether that existing rule, as amended by the proposed rule change, will impose any burden on competition. If any impact on competition is not believed to be a significant burden on competition, explain why. Explain why any burden on competition is necessary or appropriate in furtherance of the purposes of the [Exchange] Act. In providing those explanations, set forth and respond in detail to written comments as to any significant impact or burden on competition perceived by any person who has made comments on the proposed rule change to the self-regulatory organization. The statement concerning burdens on competition should be sufficiently detailed and specific to support a Commission finding that the proposed rule change does not impose any unnecessary or inappropriate burden on competition [emphasis added].
In a context where the competitive impacts are undoubtedly trivial or inconsequential, an elaborate discussion is not warranted. That is not the case here, however, particularly given the NASD's effort to curtail the competitive position of the ECNs. The NASD's statements do not elucidate the issue and, as a result, the NASD's filing does not provide a sufficient basis for public comment on, or Commission approval of, the proposed rule change. Given the inadequacy of the record, the public is effectively deprived of a meaningful opportunity for comment on the proposed rule change. The Commission, in turn, is denied the benefit of the comments that could arise from the fully informed dialogue and genuine interchange of data, views and arguments the Congress envisioned in fashioning the rule-approval process embodied in Section 19(b) of the Exchange Act.
Fair and sufficient notice. Since the NASD's statements in the proposed rule change fail in significant ways to comply with the requirements of Form 19b-4 under the Exchange Act, the Release fails to provide adequate notice. Those who read the NASD's filing are not given a sufficient basis to understand the issues involved and to make meaningful comment to assist the Commission in its consideration of the proposed rule change.
Inadequate factual record. As noted above, the Congress intended that self-regulatory rulemaking provide the same procedural safeguards that are required of the Commission in its own rulemaking. As the Commission knows, Section 553(c) of the Administrative Procedure Act states that, "[a]fter notice required by this section, the agency shall give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments." The courts have underscored that accuracy in the notice given to the public is critical to the achievement of the objectives and policies underlying Section 553:
The purpose of the comment period is to allow interested members of the public to communicate information, concerns, and criticisms to the agency during the rule making process. If the notice of proposed rule making fails to provide an accurate picture of the reasoning that has led the agency to the proposed rule, interested parties will not be able to comment meaningfully upon the agency's proposals . . . . In order to allow for useful criticism, it is especially important for the agency to identify and make available technical studies and data that it has employed in reaching the decisions to propose particular rules. To allow an agency to play hunt the peanut with technical information, hiding or disguising the information that it employs, is to condone a practice in which the agency treats what should be a genuine interchange as mere bureaucratic sport.
The purpose, moreover, behind the notice-and-comment procedure is "(1) to allow the agency to benefit from the expertise and input of the parties who file comments with regard to the proposed rule and (2) to see to it that the agency maintains a flexible and open-minded attitude towards its own rules . . ." The notice of proposed rulemaking must "fairly apprise interested parties of all significant subjects and issues involved," thereby allowing the public to "effectively participate in the rulemaking process."
Obligation to provide factual support. The Proposing Release contains no factual support, empirical or otherwise, for the NASD's expectation that the proposed rule change would "respond to the demands of investors and the NASD members for a marketplace that provides for fast and efficient access to the best prices in the market and effective integration of price discovery, execution and trade reporting."
The NASD's requirement not to impose burdens on competition that are not necessary or appropriate in furtherance of the Exchange Act's purposes implies an obligation to act on the basis of facts showing that a proposed regulation is likely to further the purposes of the Exchange Act. The scope of this obligation is explained in Timpinaro v. SEC, in which the U.S. Court of Appeals for the District of Columbia Circuit remanded an SEC-approved rule to the Commission for failure to substantiate its belief that the rule would achieve the desired objective.
The rule in question in Timpanaro was an NASD-proposed rule to limit use of SOES by parties determined to be "professional traders" in order to eliminate market-maker exposure to being "picked off" by such traders when quotations were not promptly updated, which the Commission claimed would eventually lead to wider spreads and/or fewer market makers. The court, however, found that the Commission "failed to substantiate its assertions that failure to restrict professional traders would cause market makers to cease making markets or widen spreads." Furthermore, the Commission did not provide sufficient factual support for its belief that the rule would effectively prevent market makers from being picked off, rather than merely prevent the practice via SOES. Timpinaro thus stands for the proposition that, in an informal adjudicatory proceeding to approve an SRO rule, the Commission needs to provide a factual basis for its opinion that a proposal would further the purposes of the Exchange Act.
The Proposing Release states that "the System will bring together a broad range of participants into a single, integrated electronic system that will maximize the role of each participant to the ultimate benefit of all participants in the Nasdaq Stock Market as a whole—individual and institutional investors, order-entry broker-dealers, market makers and ECNs." This statement implies that certain existing market structures and/or practices bar certain market professionals from participating. While the Proposing Release expresses the NASD's concerns that (1) an ECN could effectively halt executions in SOES for a security and (2) some traders may be using ECNs to affect the way the system handles automatic executions in that system, it does not provide enough factual justification to demonstrate that the proposed rule change would solve these issues.
Furthermore, the NASD will need to provide factual support for its assertion that the proposed rule change would remedy the market imperfections that allegedly spurred its formulation. On the basis of the record amassed to date, it appears to be far from certain that establishing an integrated order delivery and execution system, featuring a voluntary limit order book and market maker sponsored direct access by non-members, would result in improved order sending and execution. Market participants have substantially varying views as to whether these proposals—separately or in combination—would be helpful or harmful. These proposals are likely to exert direct impacts on Tradebook and other market participants and amount to an imposition of competitive burdens by the NASD that have the effect, and it appears the design, of favoring the commercial interests of Nasdaq over those of Nasdaq's private sector competitors, including Tradebook.
It is here, we suggest, that the Commission should strike down efforts by the NASD to exploit a conflict of interest between its regulatory powers and responsibilities on the one hand and its commercial interests on the other. The Commission has been asked to lend its support, and the governmental power it wields, to affect the allocation of valuable market franchises and to prefer the interests of one competitor, at its behest, over those of others. The Commission, if it were ever to approve the NASD's proposed rule change, would need sound factual support for the NASD's theory that the proposed rule change would be a regulatory improvement and that the strongly anti-competitive impacts the proposal would have are necessary or appropriate in furtherance of the purposes of the Exchange Act. The record before the Commission in this proceeding surely lacks a basis on which such a finding could be made, if indeed it could ever be made.
For the reasons set forth above, the Commission cannot find, on the basis of the record in SR-NASD-98-17, that the NASD's proposed rule change is consistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to the NASD. The Commission, therefore, should invite the NASD to either withdraw or amend the filing or the Commission should commence proceedings pursuant to Section 19(b)(2)(B) of the Exchange Act to determine whether the proposed rule change should be disapproved.
If members of the Commission or of the staff believe we may be of further assistance in these matters, please let us know.
Very truly yours,
By: /s/ Lou Eccleston _________________________
By: /s/ Kevin M. Foley _________________________
Kevin M. Foley
cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Norman S. Johnson, Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Dr. Richard R. Lindsey, Director,
Division of Market Regulation
Robert L. D. Colby, Esq., Deputy Director,
Division of Market Regulation
Howard Kramer, Esq., Associate Director,
Division of Market Regulation
Mr. Richard G. Ketchum, National Association of
Securities Dealers, Inc.0433865.10