December 6, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: Securities and Exchange Commission File No. SR-NASD-99-53
Dear Mr. Katz:
Instinet Corporation ("Instinet")1 appreciates the opportunity to offer its comments to the Securities and Exchange Commission (the "Commission") on Amendment No. 8 to a proposed rule change by the National Association of Securities Dealers (the "NASD") that would create a new order display and matching facility (commonly referred to as "SuperMontage") in the Nasdaq Stock Market ("Nasdaq").2 This letter supplements our prior comment letters on SuperMontage, which we incorporate by reference rather than repeat in full, and focuses specifically on additional issues raised by Amendment No. 8.
In prior comment letters on the NASD's proposal, Instinet has underscored two central concerns regarding SuperMontage:
In its current form, Amendment No. 8 - while representing yet another change in SuperMontage - does not effectively address either of these central policy concerns. In fact, Amendment No. 8 adopts order matching rules that would be a step backward in protecting the standing of investor orders. Moreover, as in the case of prior versions of the proposal, its approval would contravene the requirements of the Exchange Act - most notably the statutory obligation to ensure that Nasdaq acts in a manner which is "absolutely neutral with respect to all market centers, all market makers, and all private firms." 4
The Commission notes in its discussion of Amendment No. 8 that the NASD has submitted a letter in which it "has agreed to provide an alternative quotation and transaction reporting facility for NASD members that effect transactions in the over-the-counter market but that choose not to participate in the SuperMontage."5 The reference to "over-the-counter" stocks in the underlying letter describing the NASD's commitment pointedly notes that stocks traded through Nasdaq, which would be newly registered as an exchange, would be excluded from the alternative NASD facility and that only the "residual" over-the-counter market would be covered by the facility.
While we would consider it fruitful to consider the creation of a viable independent facility to act as the neutral "exclusive securities information processor" for Nasdaq stocks, the proposed alternative facility described in the Release does not, even on its face, meet this objective. Until a meaningful alternative to Nasdaq's current monopoly status as the "exclusive securities information processor" for Nasdaq stocks has been established and made an explicit condition to implementation of SuperMontage, we do not think that the Commission - or the marketplace - can view it as satisfying the interests of investors or the statutory requirements of the Exchange Act.
Part I of this letter discusses the continuing involuntary nature of SuperMontage and the steps that should be taken to separate the SuperMontage matching facility from the NASD and the exclusive securities information processor for Nasdaq stocks. Part II describes the manner in which the new order matching priorities of Amendment No. 8 fail to meet the needs of the market and investors. Part III speaks to certain operational issues raised by the proposal in its amended form.
I. SuperMontage, As Proposed in Amendment No. 8, Harms Investors and the
Market and Must Be Separated From NASD and Made Voluntary
Amendment No. 8, like earlier versions of SuperMontage, does not resolve any of the significant anti-competitive issues posed by the creation of a regulatorily-sanctioned Nasdaq "SuperECN." Nasdaq's regulatory advantages over other market participants, as catalogued in our prior comment letters, include:
As submitted to the Commission, Amendment No. 8 does not address any of these anti-competitive features of SuperMontage. Indeed, notwithstanding the submission of numerous comment letters raising these issues and identifying the fundamental inconsistency of Nasdaq's regulatory position with the operation of a competitive matching facility, the NASD persists in its incorrect assertion that SuperMontage is "voluntary." Yet even Nasdaq, in defending its proposal, concedes that "an ECN or market maker may elect only to send its best bid and offer to the SuperMontage, and withhold the remainder of its order book from display on the SuperMontage."6 In other words, market participants are "free" to withhold their quotes - except for their best quotes, in which case they are not. Nasdaq's repetition of the assertion that SuperMontage is "voluntary" simply does not withstand scrutiny.7
Instinet recognizes the Commission's interest in disentangling Nasdaq's matching facility from the regulatory benefits Nasdaq has acquired in its years of operating as an arm of a self-regulatory body and exclusive securities information processor. In Instinet's view, however, the Commission should not allow SuperMontage to move forward until a neutral and viable alternative facility for all Nasdaq stocks has become a reality. A neutral exclusive securities information processor for Nasdaq stocks must, we believe, include the following key elements:
Notably, formation of a securities information processor along the lines described above8 - a processor that does not favor Nasdaq or any other comparable exchange, ECN or other market center - would lead to establishment of the neutral securities information processor envisioned by Congress at the time of the Securities Act Amendments of 1975.9
SuperMontage should not be permitted to proceed until after the creation of a viable neutral securities information processor for Nasdaq stocks. The Exchange Act does not contemplate that an exclusive securities information processor, such as Nasdaq, can abandon its neutrality merely based on "a hope and a promise" that a neutral processor will emerge in the future. The Commission has an obligation to ensure that no SRO rule change is approved unless the underlying mandates of the statute - including the mandate for absolute neutrality - have been met.
Moreover, as discussed in prior comment letters, one of the most valuable assets of any marketplace, whether organized as an ECN, an exchange or otherwise, is its liquidity. If Nasdaq is permitted to use its existing regulatory advantages to capture liquidity for SuperMontage before creation of a viable alternative securities information processor, substantial - and likely irreparable - damage will be done to the competitive environment for trading Nasdaq stocks.10
II. The SuperMontage Proposal Continues to Disadvantage Investors by Letting
Market Makers Step Ahead of Investor Orders on ECNs
The order matching priorities provided in Amendment No. 8, like those in each of the four prior versions of SuperMontage, fail to protect the standing of investor orders displayed on Nasdaq through ECNs. Standing is significant to investors because, when an investor places an order in the Nasdaq market, the investor is in effect "showing its cards" by giving valuable information away to all other market participants, including especially market makers who internalize order flow. As a result, standing is the single most important component of investors' total trading costs.11 Rather than protect investor standing as the reward for displaying orders on Nasdaq, Amendment No. 8 preserves - and in fact exacerbates - the central vice of the four prior "algorithms" proposed by the NASD: the ability of market makers to get a "free look" at investor limit orders displayed through ECNs and then trade ahead of those orders.
Amendment No. 8 purports to offer a "choice" between the discriminatory algorithm contained in Amendment No. 7 (with minor alterations) and two new algorithms, including a more neutral "default" algorithm.12 This "choice" - afforded solely to Nasdaq members and not to investors posting limit orders - is wholly illusory. As between an algorithm that puts investor orders entered on ECNs behind market maker orders and one that does not, Nasdaq market makers will, in all likelihood, choose the algorithm that allows them to avoid interacting with investor orders on ECNs that charge access fees. The end result is that SuperMontage will let market makers' orders trade ahead of investor orders entered on ECNs even if the investor order arrived first.13 Market makers would get the benefit of seeing investors' trading interest, but would avoid paying ECN access fees - their cost of doing business. 14
Amendment No. 8 would also revise SuperMontage to allow preferencing of orders to market makers offering automatic execution. This preferencing would be allowed even though all market maker orders will be executed automatically by Nasdaq - and thus will have identical execution qualities regardless of the market maker with whom the trade is executed. (This contrasts, of course, with preferencing among order delivery participants, where speed of execution, the possibility of price improvement and other considerations create significant differences that an executing party may want to take into account.) The effect of Nasdaq's new preferencing functionality for automatic execution participants is to open wide the door for market makers to use Nasdaq's central market facility to establish trading rules among themselves - trading rules that bypass every "algorithm" and any vestige of price/time priority in Nasdaq.
With this revision to SuperMontage, Nasdaq is giving market makers the "choice" to trade around investors not only "upstairs" through privately-operated linkages but also through Nasdaq's facilities. In contrast to the standard practice of every other major securities market in the world, the orders of investors in Nasdaq stocks not only will forfeit strict price/time priority, they will sacrifice any protection from market makers who wish to trade ahead of their orders. Remarkably, the NASD removes any doubt about its lack of concern for the standing of investor orders by actually proposing an alternative under which this "preferencing" could occur even when the preferenced market maker is not at the NBBO - a change that will permit market makers to trade around superior trading interest whenever it suits their business objectives.15
The only effective means of preserving investor standing on Nasdaq is adoption of a SuperMontage proposal that rejects biased order interaction priorities and precludes market makers from stepping ahead of investor orders on ECNs. In public markets around the world, the standard for investor priority is: "If yours is the first order entered into a stock market at a particular price, no market maker can have his or her orders traded ahead of you in the public market at that price." The NASD should revise the SuperMontage order matching priority to reflect this investor-friendly principle.
III. Nasdaq's Response Time Standards Should Be Revised
NASD's Amendment No. 8 includes specifications that would allow Nasdaq effectively to shut down an ECN or market maker for failing to meet certain response time standards. While we appreciate the expansion of the response time standard for individual orders to thirty seconds (for the reasons set out in our earlier comment letters), we have significant reservations regarding the proposed new provisions regarding ECNs that "regularly fail" to meet a five second response time.
First, the technological standard proposed by Nasdaq appears to be higher than the standards it has traditionally applied to its own systems. Indeed, based on the historical level of problems with Nasdaq's own systems, there is some doubt that Nasdaq itself could meet a requirement comparable to the "regular" five second standard that it proposes for other market participants.
Second, the determination of whether an ECN fails to meet a five second response time on a "regular" basis is fraught with difficult matters of interpretive judgment. Would problems in a single stock over a period of two or three days be sufficient to constitute a "failure" to meet the standard? Would the answer change if trading in that stock is unusually heavy or if virtually all ECNs were experiencing similar problems? Would sporadic problems over a period of several months constitute failure on a "regular" basis if there are currently no problems with an ECN? If problems in Nasdaq's systems are contributing to delays in a particular ECN's response times, how will that be taken into account?16
Third, under Amendment No. 8, the party exercising discretion over whether the "regularly fails" response time standard has been satisfied would not be a neutral arbiter - it would be Nasdaq. Yet Nasdaq is an avowed competitor of the very ECNs whom it could now, in its discretion, simply disqualify under Commission rules from acting as a display facility for market maker and other orders. Only an unbiased body, such as the Commission, should have this power.
Accordingly, in our view, the Commission should not approve the five second "regularly fails" response time standard.17 At a minimum, the Commission should require the development of an equitable standard, based on objective criteria, that Nasdaq itself would be required to satisfy and that the Commission (rather than an ECN's competitor such as Nasdaq itself) would apply.
The SEC should not approve SuperMontage in its current form. As discussed in our prior comment letters referenced above, SuperMontage does not meet the statutory standards regarding the promotion of a free and open market, not placing an unnecessary burden on competition and non-discrimination among market participants.18 In fact, the changes in Amendment No. 8 do not alter the fundamentals of the SuperMontage proposal. As a result, the institutionalization of SuperMontage would result in an anti-competitive and involuntary matching facility that is not neutral toward market participants, but actually harms the standing of investors.19
The pro-competitive solution, which must be achieved and proven prior to the implementation of SuperMontage, is the creation of a truly neutral and effective exclusive securities information processor for Nasdaq stocks. While currently there does not appear to have been significant progress made in developing a viable neutral alternative securities information processor for Nasdaq stocks, we would be glad to work with the Commission and other market participants to establish a framework for an alternative facility that would meet the needs of investors and the marketplace, as well as the mandates of the statutory framework established by Congress in 1975. At present, however, the SuperMontage proposal set out in Amendment No. 8 cannot proceed consistent with the Commission's obligations under the Exchange Act.
* * * *
We are available to discuss any of the comments in this letter with the Commission or its staff. If we can be of further assistance to the Commission in this regard, please do not hesitate to contact the undersigned (212.310.7728), Peter Rich, our Washington representative (202.789.8550), or Giovanni Prezioso (202.974.1500) or Alexandra Baj (202.974.1632) of Cleary, Gottlieb, Steen & Hamilton, counsel to Instinet.
Douglas M. Atkin
President and Chief Executive Officer
cc: The Honorable Arthur Levitt, Chairman
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul R. Carey, Commissioner
The Honorable Laura Simone Unger, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation, and Senior Advisor to the Chairman
Belinda Blaine, Associate Director, Division of Market Regulation
|1||Instinet, a member of 20 exchanges around the world, is a registered broker headquartered in New York City and has offices in eight international financial centers. Instinet is a pure agency broker, serving its global client base by consistently reducing transaction costs and thereby increasing investment performance for investors and their proxies.|
|2||Exchange Act Release No. 43,514 (November 3, 2000), 65 Fed. Reg. 69,084 (November 15, 2000) (as amended through Amendment No. 8) (the "Release"). The SuperMontage proposal (as amended by Amendment Nos. 1 and 2) was initially released for public comment in Exchange Act Release No. 42,166 (Nov. 22, 1999), 64 Fed. Reg. 68,125 (Dec. 6, 1999) ("First Proposing Release"). The proposal (as amended through Amendment No. 4) was re-released for public comment in Exchange Act Release No. 42,573 (Mar. 23, 2000), 65 Fed. Reg. 16,981 (Mar. 30, 2000) ("Second Proposing Release") and (as amended through Amendment No. 7) in Exchange Act Release No. 43,133 (Aug. 10, 2000), 65 Fed. Reg. 49,842 (Aug. 15, 2000) ("Third Proposing Release"). Instinet submitted comments on the First Proposing Release in a letter dated February 16, 2000, on the Second Proposing Release in a letter dated April 20, 2000 and on the Third Proposing Release in a letter dated September 14, 2000.|
|3||Comparable concerns have been echoed in numerous comment letters from investors and others. See, e.g., American Century comment letter dated September 13, 2000. See, also, Consumer Federation of America comment letter dated September 14, 2000; Renaissance Technologies Corp. comment letter dated October 12, 2000; Archipelago, LLC comment letter dated September 15, 2000; and T. Rowe Price Associates Inc. comment letter dated September 22, 2000. We have also identified below a number of specific operational and other issues posed by the proposal as it has evolved.|
|4||S. Rep. No. 94-75 at 11-12 (1975) (emphasis added).|
|5||Rel. No. 43,514 (November 3, 2000), 65 Fed. Reg. 69,084 (November 15, 2000) at 69,109 (emphasis added). See Letter dated October 30, 2000 from Frank G. Zarb, Chairman and Chief Executive Officer, Nasdaq, to Commission Chairman Arthur Levitt.|
|6||Rel. No. 43,514 (November 3, 2000), 65 Fed. Reg. 69,084 (November 15, 2000) at 69,108 (emphasis added).|
|7||Nasdaq's related assertion, that a market participant such as an ECN "may elect not to participate at all, and could choose to satisfy its obligations under the Order Handling Rules . . . by sending its best bid and offer to other market centers [such as UTP Exchanges]" is, as a practical matter, also entirely illusory. The theoretical "choice" of a UTP Exchange to participate in SuperMontage is wholly undermined by Nasdaq's continued operation of the exclusive securities information processor in a manner that ensures that such exchanges cannot effectively interact with the remainder of the market unless they use Nasdaq's non-UTP plan systems, which in the future, of course, would be operated as part of "SuperMontage."|
|8||Effective implementation of the changes described above would, of course, require amendment or adoption of a replacement for the existing Nasdaq/UTP Plan for the collection, consolidation and dissemination of quotation and transaction information.|
|9||Securities Act Amendments of 1975, 15 U.S.C. Sect. 78a (1994). See, also, Securities Act Amendments of 1975, Report of the Senate Comm. on Banking, Housing and Urban Affairs to Accompany S. 249, S. Rep. No. 94-75, 94th Cong., 1st Sess. 11-12 (1975).|
|10||In assessing compliance with this requirement, the Commission should carefully review the full range of benefits that accrue to Nasdaq through having its securities information processor (or "SIP") integrated into SuperMontage. These benefits include: (i) the operating costs of Nasdaq's trading facility and its pricing will be subsidized by Nasdaq's effective monopoly on market data revenues from the SIP; (ii) by integrating the SIP into Nasdaq's trading facility, the best-priced orders from other market centers will be forced to participate in Nasdaq's trading facility; (iii) Nasdaq will have a monopoly on the automatic execution of market maker quotes in the SIP, which will prevent market makers from entering those quotes in any competing ECN or exchange; (iv) Nasdaq could engage in exclusive joint ventures with other entities to have their systems hardwired into integrated SIP and trading facilities; and (v) Nasdaq's trading facility would be uniquely positioned to benefit from the availability of reserve size functionality in the SIP, a functionality which ECNs and exchanges are unable to use without making additional liquidity available for execution through the Nasdaq trading facility.|
|11||Comment letters from other market participants contain similar concerns. See, e.g., American Century comment letter dated September 13, 2000. See, also, Scudder Kemper Investments, Inc. comment letter dated September 19, 2000.|
|12||Even the "default" algorithm would not provide strict price/time priority on Nasdaq since it preserves the ability of market makers to "internalize" their own orders using Nasdaq's facilities.|
|13||As noted in our prior comment letters, these access fees generally are less than the minimum increment in Nasdaq and frequently are less than the price improvement offered by ECNs. Moreover, as discussed in our prior comments on the proposal, Nasdaq has consistently refused to let investor orders trade ahead of market maker orders - even where they offer price improvement net of access fees.|
|14||Amendment No. 8 also favors market makers insofar as it allows market participants to maintain priority simply by increasing the size of their quotes/orders, since market makers (who have a regulatory obligation to participate in the market at all times) will be in a better position than investors to take advantage of this functionality.|
|15||In addition, Amendment No. 8 preserves the anti-competitive "reserve" features contained in earlier versions of the proposal (which also injure investor standing by permitting undisplayed trading interest of Nasdaq members to trade ahead of investor interest displayed in ECNs charging access fees).|
|16||We understand that Nasdaq seeks to measure response times from the moment when an order leaves the "outer edge" of Nasdaq's system to the time of its return to that system. Nevertheless, it may often be the case that Nasdaq problems will contribute to delays (e.g., through the delivery of large accumulations of orders that have been held up in Nasdaq's system or through the failure of Nasdaq to publish promptly a price change, resulting in a flood of orders attempting to access an obsolete quote) or that intervening factors could result in significant delays.|
|17||As noted in our prior comment letters, we generally oppose Nasdaq's effort to adopt a practice under which a message is cancelled before either the receiving party has replied or the sending party has sent a subsequent cancellation message - a practice which is contrary to every other market in the world. See Instinet comment letter dated February 16, 2000 and Instinet comment letter dated September 14, 2000.|
|18||Our comment letter of September 14, 2000 elaborates upon the Exchange Act standards applicable in determining whether the Commission may approve the Nasdaq proposal (as do a number of other comment letters cited therein). See Instinet comment letter dated September 14, 2000 at 15-17.|
|19||We also consider it essential that the Commission, before approving SuperMontage, assess the substantive and procedural implications of a reported "agreement" between Bloomberg Tradebook LLC and Nasdaq. The existence of any formal or informal contractual commitment between these two competitors, especially if undisclosed in Nasdaq's filings with the Commission, would raise serious concerns under the Exchange Act requirements regarding rulemaking by self-regulatory organizations.|