May 22, 2000
U.S. Securities and Exchange Commission
450 5th St. NW
Washington D.C. 20549
RE: Release No. 34-42573; File No. SR-NASD-99-53
Nasdaq is quite blatant about its plans to recoup the trading flow it has lost. "Our intent, by improving trading interest information and enabling more automatic executions, is to reconsolidate some of the trading and liquidity that has been flowing to ECNs lately," says Robert Bannon, director of institutional services at Nasdaq. "Super Montage would commoditize that information and ability, and will require ECNs to compete on a different issue, such as their user interface."
Investment Dealer's Digest - March 6, 2000 at page 21.
(B) Self-Regulatory Organization's Statement on Burden on Competition
The NASD and Nasdaq do not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.
Nasdaq Super Montage Proposal as Filed With the Securities and Exchange Commission - November 22, 1999.
Dear Mr. Katz:
I. Executive Summary
The Island ECN, Inc. ("Island") is pleased to have the opportunity to comment on the NASD's Super Montage Proposal ("Proposal"). The NASD, through its subsidiary Nasdaq, initially submitted the Proposal in November of 1999 and now has proposed certain amendments.1 Since the amendments to the Proposal fail to address or even acknowledge the issues raised by Island's previous comment letter, it is necessary for Island to reiterate our concerns.
The so-called "Super Montage" has been marketed as an attempt to increase transparency for Nasdaq listed securities by reflecting, not only the best price of each market participant, but two price levels away. In addition, however, the Proposal would create the "Order Collector Facility" that would serve as a single point of order entry and delivery of liability orders or executions for Nasdaq securities. As Nasdaq acknowledges in its rule filing, albeit by carefully referring to the rule number, the Order Collector Facility, in combination with the Order Display facility, would create a Nasdaq sponsored ECN. The NASD has made its intentions quite clear in its public statements, in its proposal, and in the specific mechanics of the Super Montage. The NASD intends to leverage its current government granted monopoly to directly compete against what it perceives as potential competition from the ECNs.
The NASD's Super Montage Proposal, however, raises far-reaching competitive issues. Its adoption would create a regulatory monopoly for the trading of Nasdaq listed securities and risks undermining certain key benefits of our Nation's equity markets. As Nasdaq's Mr. Bannon indicated in the passage quoted above, the Super Montage represents an attempt by Nasdaq to take market share from ECNs. The NASD, an entity that regulates ECNs and earns substantial revenue from ECNs due to its regulatory derived monopoly, is now proposing a new trading platform to extinguish its sole source of potential competition - the ECN. Therefore, we urge the Commission to (i) reject the Super Montage Proposal until such time where the NASD and Nasdaq no longer maintain their government mandated monopoly; and (ii) immediately begin taking steps toward the creation of a market structure that ensures fair and vigorous competition between market centers for U.S. equity securities.
In just three years time, ECNs have dramatically changed the nature of our equity markets. Prior to the creation of ECNs, the NASD and the Nasdaq market was the subject of Securities and Exchange Commission and Justice Department investigations into fraud, price fixing and collusion. In response to the investigative findings, the Commission adopted the Order Handling Rules that paved the way for ECNs to bring competition to the Nasdaq market. Competition from ECNs has contributed to increased transparency, reduced trading costs, and narrower spreads. As a result, Nasdaq is a stronger market today than it was prior to the introduction of ECNs.
B. Competitive Implications of Super Montage
Despite these contributions to the Nasdaq market, the Proposal is designed to take away, in the words of Nasdaq, ECNs "liquidity and order flow." In short, the Proposal is designed to put ECNs out of business.2 While Island believes in the benefits of competition, Nasdaq maintains a regulatory created and protected monopoly. In fact, Nasdaq currently faces no direct competitors and enjoys a virtual monopoly over the trading of shares in Nasdaq listed companies. The only competition that exists for Nasdaq securities exists between the various market centers within Nasdaq. Despite viewing ECNs as competition, every share traded by an ECN is also a share traded by Nasdaq. In fact, ECNs are among Nasdaq's largest customers and pay Nasdaq millions of dollars each month in order to comply with Commission regulations regarding connectivity, quotation display and trade reporting. ECNs also are a leading generator of market data that in turn generates tens of millions of dollars of market data each year exclusively for Nasdaq. Based on our approximately 10% market share, Island alone accounts for approximately $20 million of Nasdaq's $200 million in market data revenues for 1999. Not satisfied with its monopoly on market data, Nasdaq now proposes to take that revenue and create a trading platform that competes directly with ECNs.
An analogy is useful to better understand the significance of the NASD's Proposal. Assume the New York Stock Exchange submitted a rule filing proposing that the Commission designate it as the sole regulator for all the regional exchanges. Assume further that the NYSE proposes that it be granted rulemaking authority over all listed securities trading, that it be the sole recipient of market data revenue irrespective where the trade was executed, and that all trades must be executed and reported through its systems. The Commission would immediately reject such a proposal because of its devastating impact on competition between markets.
The NASD's Proposal is no different. The only reason that it seems different is because of the historic regulatory labels such as "exchange" and "ECN" that obscure the competitive impacts. Rather than think in such terms, it is useful to view exchanges, ECNs, and market makers as competing market centers. The goal of the Commission should be to increase transparency through the facilitation of competition between such market centers. Any proposal that unfairly inhibits or extinguishes such competition should be rejected because of the predictable impact it will have on market efficiency. As in the analogy above, Nasdaq's Proposal is an attempt by Nasdaq to become the central market center for all Nasdaq listed securities and to secure its current monopoly. Consistent with NASD history, the Proposal is carefully crafted, however, not to interfere with Nasdaq's core constituency - market makers. Market makers will still be able to internalize and pay for order flow under the Proposal. Further, Island expects that Nasdaq will actually begin sharing market data revenue with market makers that put orders on the Nasdaq sponsored ECN. Thus, market makers are likely to support the Proposal because it was developed to benefit them. The Commission should also be mindful of the fact that many of the largest market making firms will receive the largest share allocations in Nasdaq's ongoing private placement. In short, only ECNs and, of course, investors would be adversely affected by the Super Montage Proposal.
Contrary to assertions by the NASD, the conflict of interest in Nasdaq competing with entities it regulates is not ameliorated by the separation of Nasdaq from NASD's Regulatory Division known as NASD-R. None of the conflicts cited above have any connection with the duties of NASD-R. Indeed, many of the prospective concerns that Island has raised in this letter already exist today. These conflicts, however, would only be exacerbated by the creation of a Nasdaq sponsored ECN. ECNs have already experienced these conflicts with respect to Nasdaq's actions in connection with Optimark, another Nasdaq facility.
The NASD, through its Nasdaq subsidiary, also asserts that it needs to compete with ECNs on a level playing field. The NASD publicly complains that it must have the flexibility to be able to respond to the market's competitive pressures and more effectively compete with ECNs. For example, the NASD has identified a demutualization process as one approach in which Nasdaq will be better able to compete with ECNs on a level playing field. The obvious flaw in this position is that, as it asks for more flexibility in responding to perceived competitive threats, the NASD continues to maintain its Commission granted monopoly over quotations and executions of Nasdaq listed securities. Until such time as Nasdaq relinquishes its Commission granted and protected monopoly, the Commission should refrain from handing Nasdaq additional tools to strengthen its monopoly position.
C. Alternative to the Current Proposal
Nasdaq asserts that the purpose of the Proposal is to increase transparency in the Nasdaq market, provide more automated executions, and eliminate double liability for market makers. In order to achieve such goals, Nasdaq should be permitted to create its proposed Order Display Facility that would reflect the best price and two price levels away. Island believes the Order Display Facility will provide the increased transparency that the Commission is striving to encourage.3 Nasdaq should not be permitted, however, to implement the Order Collector Facility or allow unattributed quotes, since these two specific features give rise to many of the competitive concerns identified in this letter.
With respect to the Order Display Facility, Island already gives such information away for free and in real-time over the Internet and would similarly provide such data to Nasdaq. To allow for more automatic executions on Nasdaq, Nasdaq should substantially upgrade the capacity and performance of SelectNet and require market makers, as ECNs are currently required, to respond instantaneously to incoming orders, in other words, require truly firm quotes. SOES could be subsequently discontinued, thus eliminating the possibility of double executions for market makers. More importantly, this alternative would prevent Nasdaq from directly competing with its members, and preserve competition in Nasdaq listed securities.
D. Access Fees
Finally, one aspect of the Nasdaq Proposal warrants specific attention. In its amendment, Nasdaq has proposed that ECNs that charge an access fee should lose priority to market participants that do not charge an access fee (i.e., market makers). Nasdaq states that giving priority to a market participant charging an access fee "would be inconsistent with the statutory mandate of providing investors with best execution of their orders." If true, then for the past three years, Nasdaq has operated inconsistently with this statutory mandate. Specifically, if the de minimus access fee that ECNs typically charge warrants consideration under principles of best execution, then Nasdaq has violated its statutory mandate by failing to provide a rounding indicator for ECN quotations that better the inside market. Without a rounding indicator, which the Commission specifically requested but the Nasdaq failed to provide, market participants have been prevented from knowing when an ECN is quoting a better price. Even if the amount of price improvement available in some cases is small, investors and market participants should be provided with adequate information to determine for themselves whether the level of price improvement available should effect their order routing decision. Similarly, Nasdaq's Super SOES (NNMS) system also violates its statutory mandate to provide best execution since that system also fails to take into account better prices of ECNs.
Island, however, does not believe that the level of price improvement is small. In fact, in many cases, it far exceeds the access fee that is now labeled a determining factor in Nasdaq's order routing algorithm. Specifically, Island's minimum trading increment is 1/256th. Thus, Island's internal best bid or offer can regularly be 1/256th better than Island's displayed quotation in Nasdaq's NBBO. A 1/256th on 1,000 shares is $3.90. Nasdaq's refusal to provide a rounding indicator, as requested by the Commission, suggests that Nasdaq (or the Commission) believes $3.90 is a de minimus amount and, therefore, need not be considered in one's best execution analysis. However, inconsistent with this current best execution analysis, Nasdaq is now suggesting that an ECN's access fee of $2.50 on 1,000 shares (based on $0.0025/share) is material and thus dictates the Super Montage best execution/priority algorithm. We request that the Commission or Nasdaq please explain this inconsistency with regard to the "statutory mandate of providing investors with best execution of their orders." In fact, Island believes that Nasdaq's "selective" regulatory position on access fees and the rounding indicator is another example of the NASD's anti-competitive efforts.
In light of the regulatory created and protected monopoly currently enjoyed by Nasdaq, Island urges the Commission to: (i) reject the Super Montage Proposal until such time that Nasdaq no longer maintains its government mandated monopoly; and (ii) immediately begin taking steps toward the creation of a market structure that ensures fair and vigorous competition between market centers for U.S. equity securities.
cc: Honorable Arthur Levitt, Jr.
Honorable Norman Johnson
Honorable Isaac C. Hunt, Jr.
Honorable Laura S. Unger
Honorable Paul R. Carey
SEC and NASD staff distribution list
1 Exchange Act Release No. 42573 (March 23, 2000), 65 Fed. Reg. 16981 (March 30, 2000).
2 Although Mr. Bannon stated that ECNs could still compete on the basis of their user interface, Nasdaq's recent purchase of Tools of the Trade assures that Nasdaq is leveraging its monopoly in that market as well. See Exchange Act Release 42713 (May 1, 2000).
3 SEC Limit Order Transparency Roundtable (May 3, 2000).