Securities and Exchange Commission
450 Fifth Street
Washington, DC 20549-0609
A Comment on the SuperMontage proposal
Visiting Assistant Professor (Economics)
Stanford Business School
518 Memorial Way
Stanford, CA 94305-5015
This comment critiques specific answers that have been provided by the SEC Chairman Arthur Levitt to questions posed by Chairman Bliley1 with respect to the proposed rule change by the National Association of Securities Dealers Inc. (NASD) relating to the establishment of the NASDAQ Order Display Facility (a.k.a. SuperMontage.) We also provide some general commentary on the modifications of the NASDAQ Trading Platform that have been published in the Federal Register (Release No. 34-43133; file no. SR-NASD-99-53.)
Comments on Chairman Levitt's Letter via Annette L. Nazareth's (ALN) memo
These comments are organized in the same order as the answer in the above letter.
Q#2. To what extent does the SuperMontage change the role of the NASDAQ from a mechanism for displaying quotes, routing orders, and reporting trades for over-the-counter stocks to an order execution system that directly competes with its members?
Although ALN is factually correct in saying that SOES and NNMS have done some level of executions already, SuperMontage proposal takes this to an entirely new level because the level of automation in SuperMontage makes executions a transparent, fluid, and, therefore, ultimately integral part of the process. This is a key point - the fact that the tight integration significantly alters the character of the system from before.
Q#3. How is the SEC ensuring that the NASD does not use its existing regulatory authority to secure advantages for NASDAQ as a commercial entity? Could this problem be exacerbated as NASDAQ moves in the for-profit area as a private company?
This proposal hands over a significant advantage to soon-to-be-a-commercial entity NASDAQ. In fact, as discussed below, it hands over to NASDAQ an effective monopoly in a market that is still nascent. This would certainly not be in the interest of consumers because the overwhelming advantages being discussed for NASDAQ here will permanently cripple other players who might want to compete in this market space.
Q#5. To what extent is the SuperMontage similar to an ECN operated by NASDAQ? Will NASDAQ be advantaged in generating executions in the SuperMontage in comparison to other NASDAQ participants given the existence of governmental rules effectively requiring all NASDAQ participants to post their best quotes in NASDAQ? Please explain your answer.
This is fundamentally the most important question. While it is true that the participation in SuperMontage is voluntary, the more important fact here is that SuperMontage will have the backing of NASDAQ - which will instantly give it a large customer base because customers will perceive it will as a Brand Extension of NASDAQ product portfolio. This means that smaller ECN's will be effectively forced to participate in SuperMontage - simply because it will, from Day One, be the largest guerilla on the block.
Now, this situation of one-overwhelmingly-dominant-player-in-a-market-segment would be an entirely acceptable one if it had evolved over a period of time in a free market. However, to hand this kind of power over to NASDAQ right from the beginning, particularly in a market that is still nascent, is to change all the fair-play rules of a free market system. Moreover, it is also incredibly unfair to the already existing, smaller ECN's that have been innovating aggressively in the past two or three years to develop this new market segment.
Q#7. One witness in the New Markets hearings remarked that the SuperMontage proposal carries many of the downsides of a traditional Central Limit Order Book." He explained, "the proposal would convert NASDAQ from a largely decentralized market, which has been its major strength for thirty years, to one in which virtually all executions take place centrally." Separately, Frank Zarb remarked that the SuperMontage offers 95% of the benefits of a Central Limit Order Book ("CLOB"). In what specific ways is the SuperMontage a form of a CLOB, and in what ways is it not?
We agree that the SuperMontage proposal will effectively create a centralized CLOB.
Also, as widely accepted, we do agree that an Automated Cross-ECN LOB (ACLOB, my term) would add immense speed, accuracy and liquidity to the market, and would, therefore, increase the efficiency of the market as a whole.
But a more important question is whether SuperMontage should be the keeper of such an ACLOB, or, should this centralization be done independent of the SuperMontage proposal? The problem of generating centralized transactions (orders, as well as other types of transactions) has been satisfactorily resolved in many other markets and industries without resorting to the automatic bequeathing of the whole operation to one player. In this regard, the centralized inter-bank check clearing system and the inter-airline clearing systems come to mind for not having a one-private-player scenario.
Q#9. Is it appropriate for a self-regulatory organization rather than investors themselves to order execution priorities among market participants based on their business models or pricing structures? Are there circumstances in which SuperMontage order execution algorithm may cause investors to receive inferior prices? Please explain your answer.
There is no reason to force all competitors to use the same pricing structures. As long as the details of the pricing structures are transparent, allowing all the players in the market to innovate and compete on an unrestricted basis would appear to be far more preferable than trying to invent order execution algorithms up front. This would provide additional motivation to the players to develop new and innovative products in the true spirit of a free market.
1 See letter from Chairman Tom Bliley dated June 20, 2000 and memo from Annette Nazareth, Director to Chairman Arthur Levitt dated July 25, 2000 which is enclosed in response by Chairman Levitt to Chairman Bliley.