Professional Investment Management, Inc.
301 South Missouri Avenue
Clearwater, Florida 33756
Facsimile (727) 441-8880
Via Electronic Mail
Mr. Jonathan G. Katz,
Office of the Secretary
United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. SR-NASD-99-53
Dear Secretary Katz:
Professional Investment, Management, Inc. ("PIM"), the parent company of NexTrade, Inc. ("NexTrade"), respectfully submits the following comments regarding the National Association of Securities Dealers, Inc. ("NASD") and its wholly owned subsidiary, the Nasdaq Stock Market, Inc.'s ("Nasdaq") proposed rule change, SR-NASD-99-53. NexTrade's comments focus on whether the proposed rule change is consistent with the Securities Exchange Act of 1934 (the "Act").
NexTrade is opposed to the proposed Nasdaq Order Display Facility described in SR-NASD-99-53 because it is not consistent with the provisions of Section 15A of the Act and because the proposed Nasdaq Order Display Facility is not designed to enhance the protection of investors or to provide the fairest and most efficient mechanism for transactions in the Nasdaq market.
NexTrade is one of the nine original Electronic Communications Networks ("ECNs") approved by the United States Securities and Exchange Commission (the "Commission"). As a member of the group of ECNs which account for approximately thirty percent of the Nasdaq's volume, NexTrade believes the Commission will find NexTrade's comments useful in its consideration of the proposed Nasdaq Order Display Facility.
Implementation of certain aspects of the Proposed Rule Changes and the creation of the Nasdaq Order Display Facility could substantially affect NexTrade's business. NexTrade operates a proprietary electronic communications network ("ECN") pursuant to a no-action letter from the staff of the Commission's Division of Market Regulation. Through the NexTrade ECN, NexTrade offers its institutional and broker-dealer customers, and other broker-dealers that access the NexTrade system via Nasdaq's SelectNet system, the opportunity to trade securities via the NexTrade ECN System.
II. The Proposed Nasdaq Order Display Facility Should Not Be Approved
NexTrade appreciates the opportunity to comment on the proposed Nasdaq Order Display Facility and to express its concerns that a centralized execution mechanism operated by a single exchange, such as the proposed Nasdaq Order Display Facility, would be harmful to the market. By promoting reliance on a single source for order flow, execution, and communications technology, the proposed Nasdaq Order Display Facility causes the National Market System to be dominated by the Nasdaq's market design. Moreover, by promoting the development of the proposed Nasdaq Order Display Facility, the Commission will limit the development of the National Market System by requiring market participants to rely on the Nasdaq's antiquated technology which is substantially behind that of other service providers in the industry.
Specifically, NexTrade opposes the proposed Nasdaq Order Display Facility for the following reasons:
For these reasons, NexTrade cannot support the Nasdaq's proposed Order Display Facility and Modifications to the Nasdaq Trading Platform.
1. The Nasdaq's systems are too unreliable to support the proposed Nasdaq Order Display Facility without first requiring improvements to the existing systems.
NexTrade supports the Nasdaq's ongoing efforts to improve its trading systems, including its SelectNet system which has been overwhelmed by the level of trading activity on the Nasdaq over the past six months. However, NexTrade believes that it is essential that the Nasdaq address the inadequacies of its existing trading systems, including SelectNet, before embarking on the implementation of the proposed Nasdaq Order Display Facility because the proposed facility will represent a radical modification and expansion of services which the Nasdaq's trading system are already poorly equipped to handle.
Support for this conclusion is based on well publicized Nasdaq system failures which have seriously endangered the National Market System over the past year. Despite the important role that the Nasdaq plays in the National Market System, Nasdaq systems, such as SelectNet have repeatedly suffered system failures. Some of the most notable and publicly acknowledged recent Nasdaq system failures include the following:
A fair assessment of this record indicates that Nasdaq's system which are operating at over 90% of capacity , are simply inviting a system failure with the next spurt in trading. Nevertheless, despite the centrality of the Nasdaq's systems to the National Market System, the Nasdaq has made minimal data about system capacity available to the marketplace.1
Therefore, until such time as the Nasdaq makes information regarding the stability of its systems, including SelectNet, available to the members of the NASD and the public, and until such information establishes that the Nasdaq systems which will serve as the core components of the proposed Nasdaq Order Display Facility are capable of handling the increased volume generated by the proposed rule changes, NexTrade cannot support the Nasdaq's proposed Order Display facility.
2. The proposed Nasdaq Order Display Facility is merely a thinly veiled attempt by the Nasdaq to create a central limit order book dominated by a single exchange
Nasdaq has proposed the Nasdaq Order Display Facility on several occasions in several forms. The proposed Nasdaq Order Display Facility, or Central Limit Order Book ("CLOB"), has met with substantial opposition and concern among market participants, many of whom urged the Commission to conduct a full fact-finding investigation of the proposal's effects on competition, the marketplace, the securities industry and investors. The proposed Nasdaq Order Display Facility is the most recent incarnation of the CLOB.
The Commission should not approve the proposed Nasdaq Order Display Facility, which would combine SelectNet and SOES and create the Nasdaq National Market Execution System. The proposed Nasdaq Order Display Facility is inhospitable to ECNs and is highly unlikely to promote participation by ECNs in the "full" proposed Nasdaq Order Display Facility because the proposed Nasdaq Order Display Facility would place ECNs at a competitive disadvantage. The proposed Nasdaq Order Display Facility would impose substantial burdens on competition. The Nasdaq has not demonstrated that those burdens are necessary or appropriate or serve to advance the purposes of the Act. As a result, the proposed Nasdaq Order Display Facility and the proposed rule changes would violate Section 15A(b)(9) of the Exchange Act.
The proposed Nasdaq Order Display Facility would create a central market execution system composed of two tiers of "Quoting Market Participants." Participation would be mandatory for market makers and "voluntary" for ECNs. Nasdaq states that two types of participation would be offered to ECNs: "full" and "order entry". "Full" participation would require ECNs for the first time to be subject to automatic executions, which would put ECNs at a severe competitive disadvantage. Order-entry participation would be a continuation of current SelectNet linkage and functions, but would marginalize the contribution ECNs could make to the marketplace. Consequently, the proposed Nasdaq Order Display Facility is fundamentally flawed in that it would become increasingly ineffective as ECNs continued to grow.
Full Participation in the proposed Nasdaq Order Display Facility leaves ECNs with a Hobsons choice. Full participation in proposed Nasdaq Order Display Facility would allow ECNs to connect with proposed Nasdaq Order Display Facility and allow the proposed Nasdaq Order Display Facility to "sweep" the ECNs' top-of-the-file orders into the proposed Nasdaq Order Display Facility, a function that would hit or take all market-maker, ECN or proposed Nasdaq Order Display Facility quotations at the best bid or ask price. Access to the "sweep" function in the proposed Nasdaq Order Display Facility, however, would involve a trade-off for ECNs because of the disadvantages associated with full participation by ECNs in the proposed Nasdaq Order Display Facility. Specifically:
Market makers and institutional customers of ECNs often prefer to trade on an ECN because of the additional services and features offered on ECNs. Through competition, ECNs have developed a variety of innovative capabilities to allow traders to customize their trading methods to meet their needs. One such feature is a reserve quotation. Nasdaq has stated that in the proposed Nasdaq Order Display Facility any ECN reserves would be bypassed, but the reserve feature of proposed Nasdaq Order Display Facility itself on proposed Nasdaq Order Display Facility would function. As a result, Nasdaq would in effect preference its own additional functions in proposed Nasdaq Order Display Facility, at the expense of those ECNs that do not want to "agree" to become Nasdaq Quoting Market Participants.
Nasdaq states in the Nasdaq Order Display Facility proposal that the Order Display Facility would eliminate potential "dual liability" of market makers. However, the proposed Nasdaq Order Display Facility modifications to Nasdaq's negotiation and automatic execution systems would not eliminate potential dual liability for ECNs, nor would it limit dual liability for any market maker that automatically executed customer orders immediately, as an ECN does. The proposed Nasdaq Order Display Facility would subject full participant ECNs to executions instead of orders. Consequently, ECNs could receive double executions resulting from the time lag between execution of an order (or an update of a quotation) on the ECN's own system and receipt of an execution for the same order from Nasdaq some time later. Market makers have reported that, in some cases, SOES messages can be delayed up to 15 seconds. Since Nasdaq does not propose to update its core technology in connection with the proposed Nasdaq Order Display Facility, the response time of the proposed Nasdaq Order Display Facility would probably be just as slow as Nasdaq's current technology and would not remove this liability problem for ECNs.
A third disadvantage to an ECN "agreeing" to be a "full" Nasdaq Quoting Market Participants is that the proposed Nasdaq Order Display Facility would require ECNs to provide access to brokers that refuse to pay ECN access fees, thus reducing the incentive of any broker to pay access fees. Since a full participant ECN would receive executions from proposed Nasdaq Order Display Facility instead of orders, an ECN would have no recourse if a broker did not pay the appropriate access fee. In effect then, an ECN would have to provide its services and liquidity for free. This would result in a significant negative impact on competition. For the reasons outlined above, NexTrade believes that few ECNs would "agree" to become "full" Nasdaq Quoting Market Participants in the proposed Nasdaq Order Display Facility.
If an ECN wished to avoid the pitfalls of "full" participation in proposed Nasdaq Order Display Facility, it would be penalized for that choice. Order-entry participation would omit from the proposed Nasdaq Order Display Facility "sweep" all orders in the ECN. An ECN that chose this level of participation could be marginalized by not having its full range of available liquidity accessible via the sweep.
On the other hand, it may be the proposed Nasdaq Order Display Facility that would be marginalized. If, as the NASD expects, most ECNs were to elect to be "order-entry" rather than full-entry participants in proposed Nasdaq Order Display Facility, the proposed Nasdaq Order Display Facility "sweep" would shut down during the significant amount of time that an ECN is alone at the best bid or offer, just as the SOES system does today. As ECNs grow, the proposed Nasdaq Order Display Facility would become increasingly ineffective. Accordingly, NexTrade believes that the proposed Nasdaq Order Display Facility is inherently flawed in its design.
The proposed Nasdaq Order Display Facility is also Anti-Competitive. If Nasdaq and the NASD, as the applicable self-regulatory organization, mandate a monopolistic central execution system, such as the proposed Nasdaq Order Display Facility, with which all NASD-regulated broker-dealers must comply, ECN innovation could be eliminated. Such a dearth of innovation would not serve the goals of the Act, the National Market System, or the public. Under the NASD's own statutory mandate in Section 15A(b) of the Exchange Act, and the legislative intent underlying those requirements, the NASD is not free to use its quasi-governmental power to damage its own members that are also competitors of the Nasdaq.
Rather than developing a system that would reduce innovation by ECNs and other market participants, and halt the development cutting-edge technology and capabilities that provide additional liquidity and transparency, the Commission should encourage a new and equitable type of market structure. The combination of private and public linkages that has formed the market network since the advent of the Order Handling Rules is the best model for growth and development of the United States capital markets in the future. The Commission laid the groundwork for this new and equitable type of market structure when it set forth the Order Handling Rules. The Commission should not allow one segment of the market which has in the past hindered advancement to reverse the progress that the markets have made since the advent of the order Handling Rules towards the creation of a open , efficient and equitable market.
If the Nasdaq believes it is important for the sweep to work, the only appropriate solution would be to send SelectNet order messages to those entities, like ECNs, that respond immediately and automatically to orders entered, and are audited by the Commission and the NASD for their responsiveness to such orders, and to send SOES messages to market makers that do not respond immediately and automatically. Under this approach, if an ECN or market maker did not respond immediately to all orders, it would open itself up to receiving executions. This decentralized market model would allow innovation and competition to flourish, resulting in a more efficient marketplace.
The Commission should encourage the Nasdaq to upgrade its technology and to replace SelectNet with modern order-routing technology. SelectNet was originally designed as a negotiation and communications tool for market participants, not as a order routing system. While the Nasdaq has occasionally modified SelectNet to add additional capabilities, the Nasdaq has not developed a new more vigorous software system that is fully capable of handling SelectNet's current role in the market. If Nasdaq were to replace SelectNet in its entirety with a new system, Nasdaq would be able to eliminate anachronisms such as the ten-second rule that exists solely because SelectNet cannot properly handle order flow in today's markets.
3. The NASD has not fully addressed the interaction and effect of the Proposed Nasdaq Order Display Facility with other NASD proposals
The proposed Nasdaq Order Display Facility proposal does not consider the interaction with, or effect of, other adopted and pending rule changes on the Nasdaq Order Display Facility proposal. The Nasdaq has not updated the Nasdaq Order Display Facility proposal to reflect these developments. Moreover, the Nasdaq has not offered guidance on the effect the proposed Nasdaq Order Display Facility would have when coupled with other approved and pending rule changes. In this respect, Nasdaq has not complied with Form 19b-4 under the Exchange Act. Accordingly, Nasdaq's filing is materially deficient as a matter of law.
For example, in connection with the market-maker dual acronym and access fee proposal (SR-NASD-99-16 and SR-NASD-99-09), it is not clear whether market makers and ECNs that submit orders to the proposed Nasdaq Order Display Facility would be allowed to charge access fees on these agency orders. If not, members that wish to continue to charge access fees would effectively be denied the proposed Nasdaq Order Display Facility. In such cases, the proposed Nasdaq Order Display Facility would not be a tool for NASD members, but rather a direct competitor with certain NASD members, both market makers and ECNs.
In the absence of a specific discussion of these issues, market participants and the public are unable to make fully informed judgments about the proposed Nasdaq Order Display Facility. Without that full consideration, the proposed Nasdaq Order Display Facility is procedurally and substantively inadequate. The Commission should require the Nasdaq to provide additional information and research for the public's benefit and review prior to approving any such changes.
4. There is insufficient justification for approving the proposed Nasdaq Order Display Facility
The proposed Nasdaq Order Display Facility proposal would create a fundamental structural realignment of the Nasdaq and the NASD's role in the marketplace. The vice inherent in the proposal is that it would present imposing and unjustified competitive obstacles to market makers and ECNs. The NASD cannot reconcile the goals of the Proposed Nasdaq Order Display Facility with the statutory standards of Section 15A(b)(6) of the Exchange Act, that the NASD's rules be designed to remove impediments to and perfect the mechanism of a free and open market, and Section 15A(b)(9) of the Exchange Act, that the NASD's rules not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.
5. The proposed Nasdaq Order Display Facility is unnecessary and will have a negative impact on the market
The proposed Nasdaq Order Display Facility is unnecessary because ECNs and market makers have invested significant funds and resources to create their own limit order books and provide efficient order handling capabilities. Following the implementation of the Order Handling Rules, market makers and ECNs have developed tools that provide easy access to the market for customers and investors through limit order display and ECN display. The proposed Nasdaq Order Display Facility would not provide additional capability to the market and the Nasdaq does not provide any factual basis for a belief that the current system of linked networks is not adequate. Indeed, the proposed Nasdaq Order Display Facility would cause serious market disruptions and unintended negative consequences for market liquidity, transparency, competition and transaction costs, ultimately hurting the investing public. The proposed Nasdaq Order Display Facility's centralization would have a negative impact on the market and would undermine the continuing development of the private network linkage system that have developed following the implementation of the Order Handling Rules.
6. The Proposed Nasdaq Order Display Facility will have anti- competitive effects
NexTrade is concerned about the NASD's ability to establish the proposed Nasdaq Order Display Facility with the financial support of its members, which include market participants and ECNs that the proposed Nasdaq Order Display Facility would place at a severe competitive disadvantage. The Commission and the Congress have repeatedly recognized the value of competition instead of a centralized, single service provider to ensure innovation, service, capacity, value and efficiency. The proposed Nasdaq Order Display Facility would undermine this competition.
Nasdaq plans to provide advantages for the proposed Nasdaq Order Display Facility that it will not permit for market makers and ECNs. The proposed Nasdaq Order Display Facility would display the full book rather than the top of the file or best bid or offer, providing users more visibility and greater trade-through protection. In its Form 19b-4 filings, the NASD does not provide reasons for giving its own system this advantage over NASD members' own competitive quotations and over the existing private sector ECNs. The proposed Nasdaq Order Display Facility would also give a time advantage to orders in its own book that are below the top-of-file. This inequity could give time priority to inferior-priced orders in fast markets because of the time it takes market makers and ECNs to update their quotations.
Unlike the Order Handling Rules, which improved liquidity and tightened the markets, the proposed Nasdaq Order Display Facility would draw order flow away from market makers and ECNs and substantially reduce liquidity. The proposed Nasdaq Order Display Facility would discourage market makers from committing capital to thinly-traded issues. Moreover, the proposed Nasdaq Order Display Facility could not provide the substantial liquidity function provided by ECNs. ECNs anonymously and electronically access all liquidity in the Nasdaq market and immediately display customer limit orders or execute marketable limit orders. Using innovative trading technologies, ECNs achieve superior order handling and executions.
The greatest negative effect that would result from the implementation of the proposed Nasdaq Order Display Facility would be that the entire market for Nasdaq securities would become dependent on the capacity, integrity and security of a single, largely antiquated system, which has proven to be unreliable. NexTrade believes investors and the market benefit from a variety of alternative systems that route, display and execute orders.
While in the past, the Commission endorsed the concept of a consolidated limit order book as a means of exposing all supply to all demand for a given security and providing for system-wide protection of customers' limit orders, new technology has made it no longer necessary to envision a single, monopolistic limit order book operated by a single exchange to achieve those objectives. The rapidly declining costs of telecommunications technology has made it possible to build and maintain redundant, competitive systems to handle orders without the need for a single monolithic service provider. Consequently, there is no need or reason for the Commission to grant the NASD a governmentally mandated monopoly through its proposed Nasdaq Order Display Facility.
7. The Proposed Nasdaq Order Display Facility represents an inherent conflict of interest
NexTrade also questions the propriety of the NASD's use of its members' funds, including those of ECNs and ECN owners, to subsidize, develop and operate the proposed Nasdaq Order Display Facility which will compete with its members. The NASD by definition would be placed in the untenable position of monitoring and disciplining its members with respect to order-routing obligations and of operating and profiting from the proposed Nasdaq Order Display Facility. While NexTrade has the utmost confidence in the integrity of the directors, officers and staff of the NASD and its subsidiaries, it is inappropriate to place those individuals in the position where the conflict between the regulatory function and business function, represent an ongoing risk.
8. The NASD's filings are deficient and non-compliant
The NASD's statements regarding the burdens on competition with respect to the proposed Nasdaq Order Display Facility are grossly inadequate. Self-regulatory organizations such as the NASD must comment pursuant to Rule 19b-4 on the specific and detailed effects and burdens on competition of any proposed rule change. The Congress has emphasized the importance of these findings to the Commission's obligations in approving rule changes and overseeing the marketplace. The proposed Nasdaq Order Display Facility proposal, the NASD merely restates the language of Section 15A(b)(9) of the Exchange Act with a cursory conclusion that these proposal will have no effect or burden on competition. In this respect the proposal is materially inadequate and cannot serve as the basis for adequate public comment or for Commission review and approval. These statements do not provide the Commission with a legally sufficient basis to approve the proposed rule changes.
The Commission should reject the proposed Nasdaq Order Display Facility because the proposal offers no additional benefits, and only serves to impede competition. NexTrade believes that the current system of market makers and ECNs offers the best solution in a naturally competitive environment. The current system which is not dominated by a single exchange and its technology promotes the continuing development of innovative trading tools that electronically process orders in an efficient and reliable manner across multiple sources of liquidity.
PIM and its subsidiary NexTrade, appreciate the opportunity to make our views known to the Commission and the staff. Should members of the Commission or of the staff believe we may be of additional assistance in these matters, please do not hesitate to contact us at the telephone number above.
John M. Schaible
Professional Investment Management, Inc. and
|1||Office of the New York State Attorney General, Eliot Spitzer, From Wall Street to Web Street: A Report on the Problems and Promise of the Online Brokerage Industry (citing Dow Jones, "Computer Problems Disrupt the NASDAQ," N.Y. Times, March 6, 1999 at p. C3); see also Ewing, "Volume and Volatility Rise Up to Slow Down an Important NASDAQ Communication System," Wall St. J., April 14, 1999, at p.C7; Lillington, "New Technology Underpins NASDAQ Ambitions for Exponential Growth," Irish Times, December 4, 1998, at p. 60 (quoting NASDAQ's chief technology officer, John Hickey, "the system turns at 90% of capacity before the opening peak subsides.")); "Big Board System Slowed AOL Investors Monday," Wall St. J.,, April 21, 1999 at p. C15); Ewing, "NASDAQ Glitch Causes Quotes to Disappear," Wall St. J.,, October 7, 1999 at p. C1; Task, "SelectNet Slowdown Affects Investors Big and Small," TheStreet.com, November 9, 1999, www.thestreet.com/pf/comment/taskmaster/816170.html (Knight/Trimark Group's CEO, Kenneth Pasternak, observed that SelectNet has been "totally dysfunctional" around the opening and the closing of trading "for a couple of weeks.")); Ewing, "Problem at NASDAQ Disrupts Trading as Volume Swells," Wall St. J., November 17, 1999, at p. C16 ("NASDAQ officials have conceded that there are regular problems despite efforts to fix SelectNet with network, switching and software upgrades.")).|