January 11, 2000
Mr. Jonathan Katz
United States Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549
Re: File No. SR-NASD-99-53
Dear Mr. Katz:
This comment letter is submitted on behalf of the Electronic Traders Association ("ETA"), a national association of order entry and other related firms spread across the country. ETA members provide an opportunity for thousands of individual investors to trade electronically through the Nasdaq Stock Market's ("Nasdaq") Small Order Execution System ("SOES") and SelectNet Service ("SelectNet"), other electronic comunication networks ("ECNs"), and electronic systems sponsored by the exchanges.
ETA appreciates the opportunity to comment on the proposals currently before the Commission. As Chairman Levitt has recognized in his recent speeches and testimony before the Senate Subcommittee on Securities, significant changes are occurring in the capital markets that have greatly benefited investors. Greater competition has resulted in lower spreads, improved technology, and greater efficiency in order execution. ETA members have contributed greatly to these improvements by providing liquidity to the markets, demanding greater efficiency, and challenging the traditional notions of market access. No other non-governmental organization has spoken so forcefully as the ETA and its individual members to encourage market reforms that have benefited all investors.
ETA generally supports the concept of an Order Display Facility proposed by the National Association of Securities Dealers, Inc. ("NASD"). However, ETA maintains strong objection to aspects of the proposed system that bestow new privileges on market makers which are not available to all NASD members. In this same vein, ETA continues to reiterate support for a system that provides equal access to the Order Display Facility for all NASD members. 1
Notwithstanding these overarching concerns, ETA commends the NASD for striving to design a system that satisfies the needs of many of the wide range of market participants. ETA believes that the current proposals submitted by the NASD are part of a positive evolution of our markets spawned by the Commission's Order Handling Rules. These rules, coupled with the Commission's policies manifest in the ATS regulation, and the development of competing trading systems, have encouraged an atmosphere of robust competition between market makers and ECNs. It is in the context of this environment that ETA comments.
ETA views positively many of the proposed changes suggested by the NASD because they respond to competitive challenges of the marketplace. ETA feels strongly that not only must the procedures and rules support competition, but also technology and speed of access must meet the demands of the marketplace. In this regard, ETA supports some, but not all, of the changes proposed by the NASD relating to the Enhanced Display of Trading Interest, Reserve Size, and Order Collector Facility2 - for the very reason that they respond in a positive way to competitive market challenges.
I. General Concerns
A. Potential Conflicts of Interest
As suggested above, ETA's overriding concern is not with any particular provision of the proposal, but with the inherent conflicts of interest that confront the NASD in addressing the disparate interests of the market maker and order entry firms that comprise its membership, as well as implementing fairly linkages to the over-the-counter markets. The proposals mark an incremental movement toward the creation of a central limit order book. The potential conflicts need to be carefully examined by the Commission because of the economic interest of the NASD in one segment of market participants. Moreover, ETA believes that without careful scrutiny, latent conflicts of interest may become more pronounced as a result of the demutualization of Nasdaq and reallocation of control among major market makers.
As ETA, and others, have cautioned previously, the implementation of a central limit order facility, coupled with amendments proposed previously in the context of the "Agency Quote Proposal" 3 and the "Soes-SelectNet Combination Proposal"4 will promote an uneven playing field between market markers and order entry firms that will diminish competition.5 ETA also views these proposals in light of the proposed demutualization of Nasdaq that could further tilt the control of the organization in the direction of market makers. Thus, ETA encourages the Commission carefully to examine each and every aspect of proposed changes to the NASD's rules with a view to maintaining and intensifying the competition that currently exists.
B. Need to Avoid System Outages
In addition to the broad concerns about conflicts of interest, ETA believes that it is crucial that the NASD assure that any expansion of the current system be effected in a manner that will not disrupt the markets. As the Commission is aware, Nasdaq has experienced outages on multiple occasions during the past year. In addition, ETA is aware that Nasdaq has forced several ECNs from the market, without notice, at least twice in recent weeks. In addition, during peak volume periods in early morning trading, Nasdaq's SelectNet System often takes as long as 30 seconds to process an execution instruction and to deliver messages to the counter party.
Because of these system concerns, ETA tempers its overall approval of the modifications to the current system with the admonition that the NASD assure that increased traffic and functionality not come at the expense of additional system outages. ETA believes that it is critical to the overall integrity of the markets that the NASD shore up its technology and capacity prior to implementing changes.
II. New Nasdaq Order Display Facility, Enhanced Electronic Access, and Delivery of Multiple Quotes/Orders to Nasdaq.
Each of the principle provisions of the NASD's rule proposal, apart from the Order Collector Facility (which ETA comments on separately), strives to implement enhancements to the current system that will make it more robust. These enhancements provide more information to investors, and promote efficiency in executions. In addition, importantly, they begin to facilitate the kind of market transparency that was afforded only to specialists and that more recently can been found at ECNs. In fact, ETA notes that many of the features of the new system are reflective of attributes of ECNs that have been successful. For this reason, ETA believes that the correct implementation of the proposals will increase the efficiency of the markets and deserves support. ETA is also aware that some aspects of the proposal may need to be refined over time, with a view to adding further improvements to the system.6
III. Order Collector Facility
Subject to the concerns noted above with regard to potential conflicts of interest, ETA supports the creation of an Order Collector Facility ("OCF"). The concept of an OCF has been in place among firms routing orders to multiple ECNs for some period of time. ETA understands that the OCF would serve as a single point of order entry and single point of delivery of Liability Orders and executions. A market participant would be required to enter an order into the OCF, which would deliver either an automatic execution or a Liability Order to the next market maker, ECN, or UTP Exchange ("Quoting Market Participant") in the queue. The OCF would determine whether to deliver an order or an execution based on the manner in which the market participant receiving the order participates in the Nasdaq market (e.g., automatic execution for market makers, automatic execution for ECNs that agree to participate in the automatic-execution functionality of the system, order delivery for ECNs that choose to take order delivery, and order delivery for UTP Exchanges). However, it should be made explicitly clear that all market participants, whether market maker or order entry firms, should be allowed to enter orders into the new system on a proprietary basis.
A. Artificial Time Delays
ETA's greatest immediate concerns with the specific proposal relate to timing of order execution. As the Commission is aware, technology has significantly reduced the capacity of market systems to execute orders. In fast markets, the delay of even a few seconds can significantly affect the ability of an investor to obtain the best price. Indeed, in his testimony before the Senate, Chairman Levitt recognized the importance of faster and more efficient executions as a byproduct of vigorous competition among market centers to capture order flow.
While in most contexts, a span of centimeters may not be significant, in laser surgery and other exact endeavors that demand precision, even a single centimeter can carry tremendous importance. Today, participants in our markets should expect nearly instantaneous executions. ETA members, for example, evaluate order execution speed based in increments of fractions of a second around a mean time of a single second. Delays of five seconds are unnecessary and present significant potholes in the road toward greater market efficiency.
The NASD has proposed in the context of its new Order Collector Facility that delays be imposed to allow market makers, ECNs, and exchanges with UTP to decline to fill a non-liability order prior to accessing a quote at an inferior price. The NASD indicates that the purpose of this delay is to "give market participants time to adjust their quotes and trading interests before the market moves precipitously through multiple price levels, which may occur when there is news, rumors, or significant market events." ETA believes, however, that it is precisely in this market environment that rapid execution is warranted. As the Commission is aware, investors and traders now have the opportunity to make a conscious decision regarding the marketplace in which their orders will be transmitted. The ability of a market participant to consider whether to decline or accept an execution at a published quote interferes with an overarching need for certainty demanded by investors and traders, and may result in the receipt of inferior prices. For this, ETA thinks that even a delay of as little as five seconds is important and is inconsistent with the interest of investors and the evolutionary steps occurring in the markets. Moreover, ETA would seriously question whether, as the NASD states, this kind of delay would reduce the volatility in the markets.
IV. Grace Periods for Market Maker's Not Updating Quotes ("SOESed-out-of-the-box ")
The NASD's proposed rule changes also provide that if a market maker's quote/order is decremented to zero and does not update its principal quote/order via QR, transmit a revised attributable quote/order to Nasdaq, or have another principal (i.e., non-Agency Quote) attributable quote/order in the system, Nasdaq would place the market maker's quote (both sides) in a closed state for three minutes. At the end of that time, if the market maker has not voluntarily updated or withdrawn its quote from the market, Nasdaq would refresh the market maker's quote/order to 100 shares at the lowest market maker bid and highest market maker offer currently being displayed in that security and reopen the market maker's quote.
Nasdaq states that it believes "that in the proposed electronic environment, five minutes - the current grace period - is too long a period to have a quote closed on the Nasdaq screen." Nasdaq also believes that restoring the quote at the lowest ranked bid or highest ranked offer price will ensure that market makers maintain continued participation in the market and are available to provide liquidity in a manner consistent with their market making obligations.
ETA applauds Nasdaq's decision to truncate the grace period currently in effect. However, consistent with its earlier comments, ETA believes that even a three-minute excused withdrawal is too lengthy in current market environments. Information and access are central to the operation of an efficient market. A market maker is expected to quote a two-sided market "on a continuous basis." A three minute absence from the market in today's marketplace is inconsistent with the notion that the market maker is participating on a continuous basis in the market. Moreover, the new policy reflected in the proposed rules, which is to reinstate the quote at the 100 x 100 shares at the lowest bid and the highest offer, seems contrary to the NASD's own policy ban on autoquotes reflected in Rule 4613.7 ETA believes that market makers either have an obligation to affirmatively monitor their quotes, or that the current ban on autoquotes should be eliminated. Thus, ETA suggests that either the grace period be further truncated or the market maker's quote be restored to the inside market after three minutes.
For the reasons expressed above, ETA urges the Commission to give careful consideration to all of the changes proposed by the NASD. We believe that some of the proposed changes will be helpful to investors and move the NASD toward the creation of more efficient markets. However, ETA is mindful of the potential conflicts of interest faced by the NASD and the challenge of maintaining the vigorous competition among market participants that has prompted these changes. Most of all, ETA is concerned that the proposal is unfair and discriminatory to some NASD members.
As always, ETA would be pleased to speak with the Commission and its staff, and to provide a professional perspective, on any of the changes proposed by the NASD.
Richard Y. Roberts
Chairman and Commissioners
1 This comment letter incorporates by reference herein the December 26, 1999 letter from David K. Whitcomb, President and CEO of Automated Trading Desk, Inc., to Jonathan Katz, Secretary, Securities and Exchange Commission, regarding File No. SR-NASD-99-53 ("Whitcomb letter"). The Whitcomb letter details specific examples where equal access to NASD systems is not available to all NASD members meeting reasonable competence and capital standards.
2 For example, ETA is concerned about the aspect of the Order Collector Facility that provides market makers with price-time priority while ECNs and UTP Exchanges have price-only priority over the market makers and the SIZE quote. This is just one example of a conflict of interest spawning an anti-competitive approach.
5 ETA notes that in the discussion regarding delivery of multiple quotes, the NASD indicates that the system would accommodate Agency Quotes. As ETA expressed in its April 1, 1999 letter from Richard Y. Roberts to Jonathan Katz, Secretary, Securities and Exchange Commission, regarding File No. SR-NASD-99-09, ETA has serious concerns about the implementation of the Agency Quote Rule that would be magnified in the context of the current NASD proposal. Specifically, the proposed Agency Quote Rule raises its own fairness and discrimination issues. For example, the proposed Agency Quote Rule would not allow order entry firms to post quotes for their customers even though those same order entry firms would help pay for the creation of the Agency Quote system through fees.
6 With respect to the Agency Quote Rule proposal, ETA feels that the multitude of information submitted by member firms operating their own limit order books might overwhelm the market creating fragmentation. The Agency Quote Rule would essentially permit market makers quotes for every price level which could multiply the number of quotations in the system by a factor of five or even more. Given Nasdaq's technological record to date (as pointed out above), this may not be a sound approach. For this reason, ETA has suggested that a central limit order facility, such as that discussed previously by the NASD, and also reflected in the current Order Collector Facility, may be more appropriate.
7 Rule 4613 states that "[t]he ban is necessary to offset the negative impact on the capacity and operation of Nasdaq of certain autoquote techniques that track changes to the inside quotation in Nasdaq and automatically react by generating another quote to keep the market maker's quote away from the best market."