December 6, 2000
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: File No. SR-NASD-99-53
Ladies and Gentlemen:
The BRUT ECN, L.L.C. ("BRUT") welcomes the opportunity to provide the Securities and Exchange Commission (the "Commission") with its comments on the eighth amendment ("Amendment No. 8")1 to proposed rule changes filed by the National Association of Securities Dealers, Inc. (the "NASD") designed to permit its wholly-owned subsidiary, the Nasdaq Stock Market, Inc. ("Nasdaq") to implement additional functionality with respect to the display, collection and management of the trading interest of Nasdaq participants, commonly referred to as "SuperMontage."2 SuperMontage is Nasdaq's primary competitive effort as it attempts to evolve from an informational utility into a for-profit execution mechanism, attempting to provide the marketplace with "a central forum"3 for the routing and execution of order flow in over-the-counter ("OTC") securities.
Given the short period for public comment and BRUT's prior comments on SuperMontage,4 BRUT offers just two sets of observations with respect to Amendment No. 8. First, no matter how much the NASD and Nasdaq alters any particular aspect of the system's operation, SuperMontage continues to threaten the competitive balance in the OTC marketplace so long as Nasdaq continues to enjoy its current regulatory privileges and affiliations. Second, the Commission should consider how Nasdaq's overhaul of SuperMontage deviates from the original intent of the system and how Commission approval of SuperMontage would implicitly endorse and enshrine certain market practices in lieu of allowing the competitive marketplace to pass judgment on the trade-execution environment that Nasdaq proposes.
I. Nasdaq and Competition
Despite an apparently good-faith effort on the part of the NASD and Nasdaq to eliminate some of the more egregious anti-competitive aspects of SuperMontage, Amendment No. 8 does not, and in fact can not, eliminate the fact that Nasdaq seeks to enter the market for comprehensive execution services while it still: (i) holds a government-granted informational monopoly; and (ii) is affiliated with the regulator of the market makers and ECNs it seeks to compete against. This situation should be eliminated prior to SuperMontage's approval and implementation.
Nasdaq's traditional role in OTC market structure has been as a consolidator of market information with a regulatory franchise as an exclusive securities information processor (a "SIP"). Market makers and ECNs face regulatory mandates to provide Nasdaq with "top of the file" quotation information.5 NASD and Nasdaq allusions that ECNs have alternatives to Nasdaq participation (such as complying with the Commission's Order-Handling Rules by providing order information to a regional stock exchange or other market center)6 ignore the practical reality that no other meaningful display alternative currently exists, and that in order to provide Nasdaq market-maker subscribers with an ECN Display Alternative under the Order-Handling Rules, ECNs must provide not only for display of ECN order prices in the public quotation system, but access to such order prices "equivalent to the access that would have been available for the relevant security if these prices had been published in the market makers'... quotation."7 With respect to market makers, the regulatory ties to Nasdaq are even stronger. Characterizing participation in Nasdaq or SuperMontage as "entirely voluntary"8 is disingenuous so long as Nasdaq maintains SIP status.
In the past, Nasdaq's exercise of its monopoly position as an exclusive SIP (and an SRO-affiliated industry utility) has served the OTC market well. By acting as the exclusive consolidator of cross-market order price information, Nasdaq's existence has allowed market makers and ECNs to experiment and evolve, competing for transactions while offering distinct and diverse pools of liquidity, without the accompanying negative effects of de-centralization and fragmentation of information that is a potential unintended consequence of open and fair competition for order flow. This has allowed OTC market structure to maintain its efficiency while providing each segment of the financial community with the requisite trade-execution alternatives to meet their diverse needs. This has also disciplined Nasdaq itself, as it has embraced technology in fulfilling its utility function as member firms have increasingly relied on electronic methods of order-routing and trade execution. As a result, the OTC market has matured into a market with features that exchange-based markets are seeking to replicate.
As it strives to become a comprehensive for-profit execution mechanism in its own right, however, it is no longer appropriate for Nasdaq to continue to provide this function, because it can not fulfill the congressional directive that a SIP "function in a manner which is absolutely neutral with respect to all market centers."9 The reason why is clear - once Nasdaq enters the execution business, it itself becomes a market center, making neutrality impossible. Orders are no longer information to be collected and disseminated, but liquidity that enhances competitiveness. Market makers and ECNs are no longer "member firms", but potential competitors and customers of their execution services. Whereas BRUT, other ECNs and market makers must compete for customers and order flow daily on the basis of the benefits and costs of our respective trading environments, Nasdaq's role as an exclusive SIP would give SuperMontage a captive audience of customers and order flow as a matter of birthright. Such anti-competitive consequences are thus potentially much more explicit and profound than the continuation of Nasdaq's affiliation with the NASD, which derives from concerns of implied regulatory pressure as opposed to outright mandatory participation.
It appears as if Nasdaq and the NASD are aware of, and taking the initial steps to remedy, these inherent competitive concerns in preparing to transition Nasdaq to a for-profit execution center.10 To approve SuperMontage before such steps are fully implemented, however, would give Nasdaq an insurmountable lead over market makers and ECNs as it strives to become the central execution vehicle in the OTC market. Accordingly, approval of SuperMontage should only be granted in the context of a broader program of reform of Nasdaq's role in OTC market structure that leaves Nasdaq to compete solely on the merits of its technology and vision with other market participants, with none of the artificial regulatory advantages that are the vestige of its prior life as a central industry utility.11 To do otherwise would guarantee Nasdaq's success as a for-profit entity at the expense of its former members and future competitors, and ultimately dampen the competition and innovation necessary to advance investor interests in a dynamic market environment.
II. The Evolution of SuperMontage
BRUT notes that the tortuous history of SuperMontage has seen many changes to basic aspects of the system's functionality. A system originally designed to promote price/time priority now has potentially five different methodologies by which an order can be assigned to a market center for execution.12 A platform in which all market centers would equally compete for executions based on price has been replaced with a trading environment where internalization and preferential order-routing will potentially become commonplace. A proposal that originated in part due to market-maker demand to avoid double liability from multiple mandatory execution points has produced a result that will effectively roll back the resolution of this problem soon to be addressed by the implementation of SuperSOES.13 With every new SuperMontage amendment, Nasdaq appears to address the concerns of some market participants while opening itself to criticism from others.
BRUT is not so much in opposition to these features of SuperMontage as it is in favor of preserving the ability of market participants to "vote with their feet," that is accept or reject SuperMontage based on its merits and turn to other trade execution alternatives if they provide superior service. Where Nasdaq is simply another execution alternative within a competitive field, we believe the current aspects of SuperMontage operation would not be problematic, given that market participants will have meaningful
choice as to how their orders are executed. Institutions who believe that the preferencing and internalization aspects of SuperMontage deny them best-execution opportunities will turn to alternatives for order display and routing. Market makers and other broker-dealers who feel Nasdaq is not responsive to their order-management needs will provide liquidity to the market through other vehicles. Nasdaq's current regulatory privileges, however, would work to remove such alternatives by inhibiting meaningful competition, forcing market participants to accept what Nasdaq offers.
Recent market events evidence how artificially-restrained competition can frustrate market needs and threaten to undermine investor confidence. Nasdaq's quote-engine outage on November 29, 2000 highlights the potential negative consequences of a dominant provider of quotation-management and trade-execution services.14 The pending implementation of SuperSOES, marred by numerous delays and concerns regarding the system's functionality, gives insight as to the flaws arising from the development of market structure in the absence of competition. Nasdaq has recently begun to position SuperSOES as an "intermediate step" to a more comprehensive revision of Nasdaq systems, as reflected in SuperMontage, that would address market-maker concerns with certain SuperSOES functionality.15 BRUT rejects the argument that SuperMontage is the answer to any problem with SuperSOES because the core problem is not any specific system functionality, but rather the institutionalization of an imperfect, uniform market structure in an environment devoid of meaningful competition.
BRUT urges the Commission to consider how, it fails to eliminate Nasdaq's regulation-derived competitive advantages, its approval of SuperMontage will preserve the system's characteristics as core components of OTC market structure. Nasdaq's package of execution services as embodied in SuperMontage should not be allowed to become the industry standard to the detriment of market participants who believe this is a sub-optimal offering. While Nasdaq is attempting to serve certain needs of the investing and trading community with SuperMontage, it will likely not be a panacea for all segments of the financial community, despite Nasdaq's assertions to the contrary. If SuperMontage is approved without the important prerequisite steps of revising Nasdaq's regulatory role in market structure, the Commission is implicitly adopting Nasdaq's vision for the national market system as its own. The varying needs of each segment of the financial community, as expressed through fair competition, should dictate the evolution of market structure, as opposed to the structural characteristics of SuperMontage being imposed on investors due to unnatural forces.
BRUT accepts and welcomes the inevitable head-to-head competition with Nasdaq that SuperMontage embodies. We believe such competition needs to take place in the arena of the marketplace, with winners and losers being determined based on each entity's discernment of customer needs and delivery of solutions to meet those needs in a cost-effective manner. In evaluating SuperMontage the Commission should ensure its actions promote an environment where the battle for market share will take place on a fair and level playing field, and not confer inequitable advantages on one competitor that pre-ordain a particular competitive outcome. Moreover, the Commission should consider how certain characteristics of SuperMontage's operation may impact the nation's investors in the event that regulatory factors lead to the system's competitive dominance.
BRUT appreciates this opportunity to offer comments to the Commission. If the Commission or its staff would find further discussions or other assistance helpful, please do not hesitate to contact me at (917) 637-2560.
Senior Vice President & General Counsel
The BRUT ECN, L.L.C.
cc: The Hon. Arthur Levitt, Chairman
The Hon. Norman S. Johnson, Commissioner
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Associate Director, Division of Market Regulation
|1||Exchange Act Release No. 43514 (November 3, 2000), 65 Fed. Reg. 69084 (November 15, 2000). File No. SR-NASD-99-53.|
|2||See Exchange Act Release No. 42166 (November 22, 1999), 64 Fed. Reg. 68125 (December 6, 1999) (the "Proposing Release") (publishing the NASD's original SuperMontage proposal); Exchange Act Release No. 42573 (March 23, 2000), 65 Fed. Reg. 16981 (March 30, 2000) (publishing NASD amendments to the proposal); Exchange Act Release No. 43138 (August 10, 2000), 65 Fed. Reg. 49842 (August 15, 2000) (publishing further amendments).|
|3||Amendment No. 8, supra note 1, at 69108.|
|4||See letter from William O'Brien, Senior Vice President and General Counsel, BRUT, to Jonathan G. Katz, Secretary, Commission, dated September 13, 2000 ("Original Comment Letter").|
|5||See Prior Comment Letter, supra, note 4, at 2.|
|6||See Amendment No. 8, supra note 1, at 69108|
|7||Exchange Act Release No. 37619 (September 5, 1996), 61 Fed. Reg. 48290 (September 12, 1996), at 48314 n. 272.|
|8||Amendment No. 8, supra note 1, at 69108.|
|9||U.S. Code Cong. & Ad. News at 189. See also, S. Rep No. 94-75. 1st Session. 11-12 (1975).|
|10||Richard Ketchum, President, The Nasdaq Stock Market, Inc., Address at the Securities Industry Association Annual Conference (November 10, 2000) (outlining Nasdaq's schedule for separation from the NASD and full-scale privatization, as well as the "removal of any appearance of conflicts of interest."); Dean Furbush, Managing Director, Nasdaq Stock Market, Inc., Remarks at the Investment Company Institute 2000 Equity Markets Conference (October 26, 2000) (acknowledging that Nasdaq may have to spin off its SIP function in the course of its application for exchange registration).|
|11||See, e.g., letter from the Honorable Phil Gramm, Chairman, United States Senate Committee on Banking, Housing and Urban Affairs, to Arthur Levitt, Chairman, Commission, dated September 15, 2000 (outlining "the minimum steps that would be needed... to preserve SuperMontage as a step forward for investors.)|
|12||An order-entry firm could utilize one of the three "non-directed order" algorithms, direct an order to a particular market maker or ECN, or preference an order to a market maker or ECN. See Proposed NASD Rule 4710.|
|13||As scheduled to be implemented on January 22, 2001, Nasdaq's transition to SuperSOES will eliminate the potential for market makers to suffer double liability in instances where a market maker simultaneously receives a SOES execution and a SelectNet liability order (due to revisions to SelectNet rules requiring all SelectNet orders to be non-liability). See NASD Notice to Members 00-30. SuperMontage, however, would re-introduce the ability to route directed orders outside of SuperMontage's automatic-execution environment to consenting market makers "much like SelectNet operates in the current environment." Amendment No. 8, supra note 1, at 69105. See also Proposed NASD Rule 4706(b).|
|14||See Quote Engine Outage, Nasdaq Head Trader Alert #2000-92 (November 29, 2000), available at http://www.nasdaqtrader.com/Trader/News/headtraderalerts/hta2000-92.stm.|
|15||Dean Furbush, Managing Director, Nasdaq Stock Market, Inc., Remarks at Meeting of the Securities Traders Association of New York (December 4, 2000).|