April 20, 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 is pleased to offer its comments to the Securities and Exchange Commission (the "Commission") on a recent amendment to a proposed rule change by the National Association of Securities Dealers, Inc. (the "NASD") relating to the establishment of a new order display facility (referred to herein as the "SuperMontage") for the Nasdaq Stock Market ("Nasdaq").2 As we noted in our SuperMontage Comment Letter, the structure of the U.S. equity markets must give investors the freedom to choose how their orders are displayed and executed while providing all investors and market participants with access to the marketplace on equal terms. In particular, the Commission must not permit any self-regulatory organization ("SRO") to use its regulatory authority to force orders into a less efficient, less transparent execution mechanism or to favor one class of market participants or investors over others - a result wholly inconsistent with the mandate of the Securities Exchange Act of 1934 (the "Exchange Act").
The SuperMontage proposal, however, would effectively use the NASD's regulatory authority to create an inefficient, anticompetitive, mandatory central limit order book ("CLOB") in the over-the-counter ("OTC") marketplace. A CLOB bearing the "Nasdaq" name, into which market makers and ECNs must display their best-priced orders under Commission rules, would threaten to drain liquidity from ECNs and other market participants - thereby significantly impairing the positive competitive force they have played in the OTC markets. As a result, investors would have fewer choices for the display of their orders, would receive inferior executions, and would remain prey to internalization and other practices that perpetuate fragmentation of the securities markets.
The NASD's proposed SuperMontage is particularly anticompetitive because it singles out ECNs for unfair treatment in a manner that hurts all investors. The SuperMontage proposal would - rather than enhance "best execution" - deny Nasdaq participants opportunities for price improvement by dropping ECNs that charge access fees to the bottom of the queue. Moreover, the proposed CLOB would particularly disadvantage investors that choose to place their orders with ECNs - and seek to avoid dealing with market makers engaged in proprietary trading - by allowing market makers and other market participants to trade ahead of their orders. In our view, the NASD should devote its efforts to projects that benefit investors - e.g., a transition to decimal trading - instead of projects like the SuperMontage that exclusively serve its commercial interests.3
Part I sets out Instinet's concerns regarding the NASD's use of its regulatory authority to create a government-mandated CLOB for the OTC marketplace. Part II discusses Instinet's more specific concerns regarding the anticompetitive aspects of the SuperMontage proposal, particularly with regard to its treatment of ECNs and their customers. Part III states Instinet's views regarding the need for the NASD to focus its efforts more effectively on promoting the interests of investors, rather than its own commercial objectives.
I. The NASD Should Not Be Permitted to Use Its Regulatory Authority to Create
an Inefficient, Anticompetitive, Mandatory CLOB in the OTC Marketplace
A. The "SuperMontage" Is a Government-Mandated CLOB that Would Reduce
the Transparency, Efficiency, and Flexibility of the OTC Marketplace
The SuperMontage proposal, if approved, would permit the NASD to use its privileged regulatory status to create a government-mandated CLOB for all investors' orders in OTC securities. Market makers and ECNs must, under Commission and NASD rules, make their quotes and best-priced customer orders available for execution through the CLOB.4 Moreover, the NASD would give market makers significant inducements to direct their remaining customer order flow to the SuperMontage - e.g., automatic priority over most ECNs. At the same time, it would encourage internalization by market makers of their customer order flow at the national best bid and offer ("NBBO").
Government-mandated CLOBs, unlike private sector systems, have no incentive to devote resources to developing efficient, flexible trading facilities that give investors maximum control over how their orders are displayed and executed. CLOB proposals have come under significant criticism from the securities industry, as well as members of Congress and senior government officials, for their lack of flexibility and their impact on investors' willingness to display their trading interest.5 An inefficient, inflexible CLOB would drive institutions and other sophisticated investors to direct their market sensitive orders to less transparent venues - thereby encouraging market fragmentation and reducing retail investors' opportunity to interact with institutional order flow.
Instead of approving an NASD-operated CLOB, the Commission should encourage the formation of voluntary linkages among market participants that promote intermarket transparency and accessibility without stifling competition or innovation. Advances in networking technologies have, in recent years, substantially improved the visibility and accessibility of investors' orders across markets - e.g., through the development of financial communications protocols. These efforts would, if competitive forces are permitted to operate without interference from the NASD, ultimately compel market participants to make their proprietary limit order books visible and accessible to the entire marketplace in a fair and efficient manner.6
B. The NASD Should Not Use Its Self-Regulatory Power to Enhance
Nasdaq's Commercial Value Before the Nasdaq Private Placement
in a Manner that Would Hurt Investors and Reduce Competition
The Commission must not allow the NASD to use its self-regulatory authority to promote its own commercial interest in a manner that would undermine investor choice and preempt private-sector initiatives to create a more transparent and flexible marketplace. The SuperMontage would put Nasdaq into direct competition with ECNs and other market participants and, as described in Part II below, simultaneously subject ECNs to a significant competitive disadvantage in the OTC marketplace by impairing public access to their quotations. As a result, investors would feel significant pressure to abandon ECNs and other innovative trading systems - where their chances of obtaining an execution could be severely diminished - and to direct their orders to Nasdaq market makers for a potentially unfavorable execution.7
Moreover, the SuperMontage would frustrate industry efforts to create efficient private-sector intermarket trading systems by imposing a single, mandatory order collection and execution facility on the marketplace. "Smart" order routing systems, for example, take a variety of factors into consideration - such as price improvement, speed, certainty of execution, and cost - in making routing decisions to ensure that their customers receive the best possible execution. The NASD's proposal, by effectively requiring all orders to pass through SuperMontage, would eliminate market participants' ability to utilize these smart systems. Instead, the NASD would force all orders to be processed using Nasdaq's algorithm - which would lead to inferior executions, as described in Part II below.
The use of the "Nasdaq" brand name to promote the SuperMontage further underscores the NASD's efforts to exploit its privileged regulatory status to create commercial value for Nasdaq shareholders. For the past several decades, the "Nasdaq" trademark has been associated with a neutral "market of markets" created at the Commission's behest through which NASD members fulfill their quotation and order display obligations under Commission rules. The "Nasdaq" brand name has, moreover, come to be identified with those OTC securities for which quotation and transaction information is collected and disseminated through Nasdaq's facilities. Based on this understanding, Instinet and other NASD members have devoted significant resources to enhancing the "Nasdaq" brand name. The NASD has now determined to use the name recognition of the "Nasdaq" market to promote a for-profit business venture that intends to compete with its own members.
The SuperMontage initiative - like other recent initiatives in which NASD regulatory proposals have advanced Nasdaq's commercial interests (e.g., TRACE) - appears designed to ensure that Nasdaq does not face serious competition from ECNs or other market participants in the OTC marketplace when it becomes a shareholder-driven company. If ECNs are unable to play a competitive role in the OTC marketplace, investors would have no choice but to deal with market makers or other less transparent trading venues. There would consequently be little incentive for market makers to curtail practices, such as internalization and payment for order flow, that reduce transparency in the marketplace and result in inferior execution of investors' orders; indeed, the NASD would firmly ingrain such practices by building them into the SuperMontage architecture. The Commission must not permit the NASD to use its regulatory authority to undermine investor choice and aggressive quote competition in the OTC marketplace.
II. The SuperMontage's Anticompetitive Bias Against ECNs and Their Customers
Would Result in Inferior Executions and Reduced Choice for All Investors
A. The NASD's SuperMontage Proposal, by Discriminating Against
ECNs, Would Deliver Inferior Executions to Investors
The NASD would deny investors the opportunities for price improvement ECNs regularly provide by proposing to amend its order processing algorithm to execute orders displayed by ECNs that charge access fees after all other market maker and ECN orders displayed at the same price. According to the Proposing Release, an ECN access fee "represents an increase in trading costs and clearly an inferior price," and any other prioritization of such orders would be inconsistent with the statutory mandate of providing investors with "best execution."8
The NASD's assertion, however, is patently incorrect as a factual matter - since ECNs frequently offer a better price than market makers at the NBBO even after access fees have been fully deducted from the execution price.9 Because ECNs typically permit investors to trade in finer increments than Nasdaq (e.g., 1/64 or smaller), a significant number of ECN customer orders must be rounded for public display.10 Under Commission guidance, however, these orders must be executed at the actual, unrounded price.11 For example, if an ECN customer enters a buy order at 10 3/64 (or if its market order or marketable limit order is rounded down to 10 3/64 to avoid locking or crossing the market), the ECN could only display a price of "10" in the Nasdaq montage. A Nasdaq counterparty, however, who sought to "hit" the ECN buy order would receive an execution at the actual, unrounded price - i.e., 10 3/64. In such circumstances, Nasdaq counterparties would receive up to $0.03 per share in price improvement over the display price even after subtracting the maximum access fee permitted by the Commission.12
In other words, the NASD asks the Commission to approve - based on a wholly unfounded factual premise - a regulation that is anticompetitive and discriminatory on its face.13 The NASD is wrong to assume that ECNs that charge access fees "clearly" provide inferior executions - and to demote such ECNs' orders in the Nasdaq montage across the board - especially when it has undertaken no effort to make ECN customers' true trading interest known to the marketplace. Had the NASD, for example, developed a rounding indicator - as the Commission instructed the SROs to do over three years ago - all market participants would have access to better information regarding potential opportunities for price improvement.14 In addition, the NASD fails to take into account the more general negative impact on "best execution" that would result from this impermissible and anticompetitive regulatory discrimination against ECNs.
Contrary to the NASD's assertions that its proposed prioritization scheme is "consistent with common industry practice today," market participants appear to give greater importance to such opportunities for price improvement than to ECN access fees. As noted above, "smart" routers and other advanced order management applications tend to give more weight to factors such as price improvement, speed, and certainty of execution in making order routing decisions. Moreover, Instinet's data regarding customer behavior suggest that SelectNet access fees have not significantly affected investors' trading decisions. For example, Instinet's broker-dealer clients currently send a significant percentage of their orders (16%) to Instinet through SelectNet - despite fee incentives to submit those orders directly to Instinet.
In this connection, it would be especially unfair, in our view, for the NASD to demote ECNs that charge access fees while allowing its own "quote" (i.e., the SIZE MMID) to enjoy full price/time priority.15 Not only does the NASD propose to preserve its ability to charge fees for access to unattributed orders represented in the SIZE quote, but, unlike ECNs, the NASD can also use NMS revenues collected from its own members - including its ECN "competitors" - to subsidize SuperMontage operations.16 If ECNs were entitled to participate in NMS plans and share in market data revenues based on the volume of trades they generate, as Instinet and other market participants have previously requested, the need for ECNs to charge access fees would be substantially lessened.
B. The NASD's Proposed Treatment of ECNs in the SuperMontage Would
Significantly Reduce Investor Choice and Facilitate Internalization of
Market Maker Customer Orders
The NASD would place investors who choose to place their orders with ECNs at a significant disadvantage in the OTC marketplace. ECNs and other agency brokers do not commit capital to the marketplace and avoid many of the conflicts of interest that market makers face when handling customer orders. Many investors choose to place their orders with agency brokers precisely to avoid revealing their trading interest to market makers - and thereby permitting market makers to use such information to predict trading patterns and generate profits for their proprietary trading activities.17
The NASD's proposal would punish such investors by allowing their orders to sit indefinitely on the SuperMontage display while market makers trade ahead of such orders without quoting a better price. If ECNs do not enjoy equal price/time priority with other market participants, market makers can indefinitely monopolize incoming Nasdaq order flow - i.e., "non-directed" orders that are not preferenced to any specific market participant - merely by displaying a quote at the NBBO. The SuperMontage proposal thus effectively "internalizes" Nasdaq order flow for the benefit of market makers - and prevents ECN customer orders from interacting with other investor orders. As a result, ECN customers would ultimately be forced to take their orders to a market maker to obtain an execution.
More importantly, the NASD's proposal would create no incentive for market makers ever to post a quote more aggressive than an ECN customer order. Chairman Levitt has suggested that, to encourage quote competition, it may well be desirable to prohibit dealers from trading with customer orders for their own account without attempting to execute investor orders previously displayed to the marketplace at the same price. The SuperMontage proposal, in contrast, would guarantee market makers the opportunity to trade with their customer orders at the NBBO before allowing those orders to interact with other investors' orders.
III. The NASD Should Devote Its Resources to Implementing Initiatives
that Serve Investors' Interests, Rather than Building the SuperMontage
for Its Exclusive Commercial Benefit
Instead of pursuing initiatives like the SuperMontage that serve its exclusive interest, the NASD should devote its resources to implementing initiatives that truly serve the needs of investors. For example, initiatives such as decimalization - which was delayed due to Nasdaq's inability to convert its systems by the deadline originally ordered by the Commission - are necessary to ensure that the U.S. markets retain their competitiveness in an increasingly global trading environment. The General Accounting Office has cited studies suggesting that decimal pricing could save U.S. investors as much as $2 billion per year, and every major securities market in the world other than the U.S. equities market already trades in decimals.18 Instead of pursuing such initiatives, the NASD has chosen to divert its resources to building a system that would monopolize order flow, undermine its competitors' ability to compete in the marketplace, and reduce price competition and liquidity - all to the detriment of the investing public.
More generally, the NASD's failure to implement decimal trading - even while pursuing self-serving initiatives like SuperMontage - aptly illustrates the drawbacks of centralizing market systems through SRO monopolies. The NASD and other SROs have little incentive to modernize their order display and execution facilities for the benefit of investors as long as they can use their regulatory power to restrict how their competitors participate in the marketplace. The Commission should, in the context of its concept release on market fragmentation, consider whether the U.S. equity markets would be better served by ending the SROs' monopoly on securities trading - as exemplified by initiatives like the SuperMontage - and permitting voluntary intermarket mechanisms to evolve to meet investors' needs.
* * * *
For the reasons described above, we strongly urge the Commission not to approve the NASD's SuperMontage proposal. We appreciate the Commission's continuing efforts to improve the efficiency of the national market system and look forward to working with the Commission in connection with its concept release on market structure issues.
We would be pleased 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 (212.310.7405), Peter Rich, our Washington representative (202.789.8550), or Giovanni Prezioso or Onnig H. Dombalagian (202.974.1500) of Cleary, Gottlieb, Steen & Hamilton, counsel to Instinet.
Executive Vice President and
Chief Executive Officer, Global Equities
|cc:||The Honorable Arthur Levitt, Chairman
The Honorable Norman S. Johnson, Commissioner
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
Elizabeth K. King, Associate Director, Division of Market Regulation
Katherine A. England, Assistant Director, Division of Market Regulation
|1||Instinet, a member of 18 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. 42,573 (Mar. 23, 2000), 65 Fed. Reg. 16,981 (Mar. 30, 2000) (the "Proposing Release") (amending the NASD proposed rule change published in Exchange Act Release No. 42,166 (Nov. 22, 1999), 64 Fed. Reg. 68,125 (Dec. 6, 1999)). Instinet submitted comments to the Commission on the original proposed rule change in a letter dated February 16, 2000. See Letter to Jonathan G. Katz, Secretary, Securities and Exchange Commission, from John Oddie, Executive Vice President and Chief Executive Officer, Global Equities, Instinet Corporation (Feb. 16, 2000) ("SuperMontage Comment Letter").|
|3||The NASD's proposal, for the reasons discussed herein - as well as in the letters of several other commenters, e.g., Bloomberg L.P. - does not satisfy the statutory requirements applicable to rules of national securities associations under the Exchange Act. See, e.g., Exchange Act Section 15A(b)(6) (requiring that association rules be designed to remove impediments to and perfect the mechanism of a free and open market and a national market system, and not be designed to permit unfair discrimination between customers, issuers, and broker-dealers, or to fix rates of commission or other fees to be charged by its members) and (b)(9) (requiring that association rules not impose any unnecessary or inappropriate burden on competition).|
|4||See, e.g., Exchange Act Rule 11Ac1-1(c); Rule 301(b)(3) of Regulation ATS.|
|5||See, e.g., Testimony of Chairman Alan Greenspan, Board of Governors of the Federal Reserve System, Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs (Apr. 13, 2000) ("I would caution against the implementation of a government mandate for any particular form of central limit order book. Given the pace of change in our markets, it is difficult to contemplate how a government mandate could be implemented; systems might well be obsolete before we were half-way through the planning process.").|
|6||Instinet intends to set out its views on market structure in greater detail in its comment letter on the Commission's market fragmentation concept release. Exchange Act Release No. 42,450 (Feb. 23, 2000), 65 Fed. Reg. 10,577 (Feb. 28, 2000).|
|7||Moreover, the SuperMontage would be subsidized by fees collected from its ECN "competitors" under national market system ("NMS") plans and NASD rules - e.g., execution fees, trade reporting fees, market data fees, and other assessments - that only SROs like the NASD can charge.|
|8||Proposing Release at 16,991.|
|9||Under Commission no-action relief, an ECN may not charge an access fee more than the fee the ECN "charges a substantial proportion of its active broker-dealer subscribers, and in any event, no more than $0.015 per share." Letter from Annette L. Nazareth, Director, Division of Market Regulation, to Douglas M. Atkin, Chief Executive Officer, Instinet Corporation (Mar. 3, 2000). A SelectNet counterparty that receives as little as 1/64 in price improvement from an ECN ($0.015625 per share) may therefore receive a better execution than the displayed price even if it is charged an access fee.|
|10||While it is conceivable that some of these issues could be addressed by a transition to decimal trading, the NASD has not given any indication that it will delay implementation of the SuperMontage proposal until after decimalization, nor has it offered for comment any suggestions as to how such issues would be resolved even in a decimal trading environment.|
|11||Exchange Act Release No. 37,619A (Sept. 6, 1996), 61 Fed. Reg. 48,290, 48,316 (Sept. 12, 1996) ("Order Handling Rules Adopting Release"). In this connection, we note that ECNs would not be able to offer such price improvement through Nasdaq's facilities if they were forced to receive automatic executions, instead of liability orders.|
|12||Notably, many ECN customers pay less than the maximum access fee.|
|13||See Exchange Act Section 19(b)(2) (requiring the Commission to disapprove a proposed SRO rule change if it does not make a finding that the proposed rule change is consistent with the requirements of the Exchange Act and applicable rules and regulations thereunder); footnote 3 supra.|
|14||Order Handling Rules Adopting Release at 48,315 n.283 ("In order to facilitate compliance with the [ECN Display Alternative], it will be necessary for SROs to provide a means for rounded prices to include a `rounded' identifier that makes clear that a better price is available in the ECN.").|
|15||See Part II.A of the SuperMontage Comment Letter.|
|16||See footnote 7 supra.|
|17||See, e.g., Greg Ip, "Catbird Seat: Nasdaq Market Maker, Seeing All the Orders, Becomes Canny Trader," Wall St. J., Mar. 3, 2000 at A1 (describing the "informational advantage" large market makers enjoy as a result of their exclusive access to the orders collected in their proprietary trading books).|
|18||Securities Pricing: Actions Needed for Conversion to Decimals 11 (GAO/T-GGD-98-121, May 8, 1998) (testimony of Thomas J. McCool, Director, Financial Institutions and Markets Issues, General Accounting Office, before the Subcomm. on Finance and Hazardous Materials of the House Comm. on Commerce).|