December 20, 2000
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention Jonathan G. Katz, Secretary
Re: Securities Exchange Act Release No. 43616, File No. SR-NASD-99-65
Ladies and Gentlemen:
Charles Schwab & Co., Inc. submits the following comments in response to amendments nos. 2 and 3 to the National Association of Securities Dealers, Inc.'s ("NASD") proposed Trade Reporting and Comparison Entry Service ("TRACE") for the reporting and matching of trades in eligible corporate bonds and the dissemination of trade reports, as recently submitted to the Securities and Exchange Commission.1
Although Schwab strongly endorses the bond market transparency purposes underlying TRACE, the NASD's current proposal is destined to repeat the failures of the equities market data collection and dissemination system. The Commission itself recently documented these failures in its concept release on market data.2 In particular, the Commission should refrain from granting yet another monopoly franchise over market data under a framework that accepts, rather than prevents, conflicts of interest inherent when the same entity plays the multiple roles of regulator, securities market, data processor, and market data vendor. Under the auspices of the Commission's Advisory Committee on Market Information (chaired by Dean Joel Seligman),3 a consensus appears to be emerging for a competitive, market-based solution. Schwab respectfully urges the Commission to refrain from granting final approval to the TRACE proposal in its current form pending the outcome of the Advisory Committee process.
I. Anti-Competitiveness and Market-Data Monopoly Concerns
A. TRACE Ownership Structure and Monopoly Implications
As an initial matter, Schwab opposes the exclusive ownership of the market-data collection and dissemination functions for the debt markets by a single entity that the TRACE proposal establishes. This structure fails to recognize the tremendous value that broker-dealers, institutional and retail investors and others contribute to the production of market-wide transaction data.
We are even more concerned, however, that the entity that would assert such "ownership interest" is the NASD, the self-regulatory organization ("SRO") for the over-the-counter markets, including the vast majority of the debt markets. All broker-dealers that do business with the public are required Exchange Act Section 15(b)(8) to be NASD members. The TRACE model, as currently proposed, would bestow a monopoly franchise over the data for the corporate debt market to the governing SRO - a result replete with conflict-of-interest implications. In particular, because the current TRACE proposal would make trade reporting in covered debt instruments mandatory, the proposal would give the NASD an instant lock on market data generated in the corporate debt market. No other data vendors could compete on an equal footing with TRACE for the collection and dissemination of trade data in this market.
In addition, while TRACE would be mandatory for all NASD members, the NASD nonetheless would have the ability to terminate a member's use of TRACE based on standards that are created by the NASD board of governors and are subject to NASD interpretation. For example, if the NASD determined that a member failed to comply with TRACE rules, policies or fees or NASD or Nasdaq contracts, the NASD could unilaterally cut off that member's use of TRACE. This creates the potential for overreaching - the NASD could use this power to enforce contracts with the NASD and Nasdaq or to ensure adherence to arbitrary rules, policies or interpretations without imposing a counterbalance to help NASD members ensure their rights.
These anti-competitive concerns are exacerbated by the plans to convert Nasdaq into a for-profit exchange, which would be majority-owned by the NASD, the governing SRO. SROs must be disassociated from competitive pressures in the market in order to effectively discharge their obligations as fair and impartial regulators under the Exchange Act.
To alleviate concerns regarding its ownership of TRACE's data collection and dissemination functions raised in response to the initial TRACE proposal,4 the NASD has offered to register as an exclusive securities information processor ("SIP"). In addition, it has noted that day-to-day operation of TRACE will be subject to rules and policies that are subject to approval by the NASD's board of governors. Further, NASD Regulation, Inc. ("NASDR") will play a role in establishing regulatory standards for TRACE while Nasdaq will act as the exclusive processor of the data. We do not believe these measures adequately respond to the conflicts of interest posed by the TRACE system. To the contrary, we believe that establishing an exclusive SIP for corporate debt information will perpetuate and expand the current monopoly model for the collection and dissemination of market data, with all its attendant problems, by legitimizing the NASD's exclusive franchise through a regulatory mechanism. Under this model, the NASD would effectively have unilateral "control over the collection of the information, the fees charged, the selection of vendors, and other important administrative and regulatory matters."5 The role of the NASD board of governors will not ensure a more democratic operation of this function; rather it will further erode steps that have been taken to encourage innovation and represent cross-market interests in the market-data process. Similarly, the use of subsidiaries of the NASD to assist in the regulatory and processing functions will not infuse needed market discipline in the data collection and dissemination system, because the interests of NASD, NASDR and Nasdaq will be substantially united.
If the monopoly model is selected, Schwab opposes the selection of Nasdaq as the exclusive processor for TRACE data, because the role provides an exclusive franchise for operation of a market utility. Consequently, this role of exclusive processor, if it is to be adopted, should be open to competitive bidding and justified on reasonable and measurable bases. Summarily awarding this role to Nasdaq, a subsidiary of the NASD and an affiliate of its regulatory arm, NASDR, would deprive market participants from having a meaningful voice in TRACE's operation. Awarding this role to Nasdaq would deprive information vendors of the opportunity to provide truly competitive and innovative information products for the corporate debt market.
We are further troubled that approval of TRACE as proposed would be inconsistent with the principle that the provision of market data under a monopoly scheme must be cost-based. The requirement that an exclusive SIP's fees must be cost-based pursuant to section 11A of the Exchange Act is a longstanding one, articulated by the Commission in the 1984 Instinet case6 and upheld by the U.S. Court of Appeals for the D.C. Circuit.7 The Commission further endorsed this view in the concept release, and most commenters concurred that this was the appropriate measure of fees for the utility services provided by the exclusive SIPs. The TRACE proposal would undermine inroads made to achieve a better cost-based fee structure by failing to set any standards for the establishment of TRACE fees. Moreover, the fact that one half of TRACE proceeds will be shared with the Bond Market Association indicates that TRACE fees will not be cost based. The inevitable result of allowing excessive TRACE fees not based on a simple cost-recovery model will be to deny to retail investors the most accurate, up-to-date market data for debt, just as it has been in the equities markets.
For these reasons, we believe the TRACE proposal, as it currently exists, is anti-competitive vis-à-vis other market-data vendors that could also disseminate debt trade data. Products currently being developed or contemplated by private organizations should be encouraged and afforded the opportunity to compete on a level playing field with TRACE. The viability of such products is certain to be hampered by implementation of TRACE as presently contemplated. In addition, because TRACE would confer a monopoly to the principal SRO, and would give that SRO the power to terminate access to TRACE upon certain determination, we believe the TRACE proposal also presents a conflict of interest between the NASD and its members. The TRACE fee structure exacerbates this conflict by failing to account for the costs incurred by NASD members who will be required to contribute corporate debt trade data to TRACE without compensation.
Consequently, we believe that the NASD should be required now to articulate how it would disseminate TRACE data to vendors, NASD members and others on fair, reasonable and non-discriminatory terms consistent with sections 11A and 15A of the Exchange Act. Moreover, if trade reporting in TRACE is ultimately required by regulatory mandate, we urge the Commission to ensure that contributing broker-dealers either (1) are entitled to receive a proportionate share of TRACE revenues, or (2) are entitled to receive consolidated TRACE data and retransmit it to their customers without charge. Either step will account for the substantial costs broker-dealers would be obliged by regulatory mandate to incur in complying with the TRACE reporting obligations and will account for the economic value of that contribution. Moreover, either step would allow broker-dealers to provide the best possible debt market data to their clients at the lowest possible price.
B. TRACE Governance
In addition to our concerns about the monopoly implicit in TRACE, Schwab also opposes TRACE's proposed governance structure. Governance of TRACE will reside exclusively with the NASD, subject to the approval of its board of governors and input from NASDR. Instead, we encourage the Commission to require that TRACE governance include direct and meaningful representation from all debt-market participants, with equal representation from both the buy and sell sides as well as meaningful public representation. Broad representation will ensure the fairness of the operation of the data-dissemination portion of the proposal, which is critical to achieving the NMS goals with respect to debt instruments.
We recognize that the proposed Bond Transaction Reporting Committee ("BTRC") is a positive step towards integrating broad market views into TRACE's governance process; however, BTRC will assist the NASD board solely in an advisory capacity and BTRC evidently will focus on the liquidity issues relating to the phase-in of bond categories and not more fundamental and lasting governance issues.8 Moreover, 50% of the BTRC members will be selected directly by the NASD, potentially undermining the full independence of the BTRC from the interests of the NASD. Without sufficient authority and independence to implement fundamental changes, BTRC cannot be expected to incorporate effectively broad market views into TRACE governance and operation.
C. A Network Model
By modeling after the current market-data regime for equities, the TRACE proposal presumes the outcome of the forthcoming report of the Advisory Committee on Market Information. The Advisory Committee will examine whether the existing structure of market-data collection and dissemination systems should be improved or replaced with alternative models. The NASD, and the Commission, instead should focus on creating minimum standards for the market-data collection and dissemination services, rather than taking over such functions wholesale. By implementing uniform standards for this function, an open-architecture network model could emerge. This model is vastly preferable to the monopoly model as it fosters innovation and competition, minimizes the need for regulatory oversight of fees and can eliminate the conflicts-of-interest inherent in the current model. It also ensures that the most valuable market data is delivered to market participants in the most efficient and effective means possible by preventing the rise of a single proprietary monopoly to which all industry participants and systems must conform. Instead, it allows competitive service providers the opportunity to experiment with new services and systems that promote overall technical advancements within the securities market, rather than burden the market with an outmoded, inflexible system.
In the network model, multiple competing vendors could obtain trade reports and issue market-data for corporate bonds, provided that adequate baseline standards are implemented. These standards should establish the format of the data, ensure the timeliness, accuracy and security of the data, articulate the minimum data elements that must be provided, and require competitors to share their data with SROs and clearing agencies to facilitate surveillance and processing functions. In addition, fees charged by any information vendor to a competitor must be made on terms no less favorable than those charged to any other persons. This will ensure fair, reasonable and non-discriminatory access to critical market data by all market participants and other members of the public.
Given these baseline standards, competing vendors could offer a variety of services that would enhance the basic information and respond to market participants' needs that is unlikely to happen if these services are positioned within a single organization, particularly one owned and operated by the governing SRO. A network approach would also provide technical redundancy to protect against capacity limitations and other operational failures that have plagued the equity market information system. We note that in arguing for the monopoly scheme underlying the TRACE proposal, the NASD indicated that while competition is an important goal, the goals of equal access, reasonable fees, and sufficient capacity and security are equally important.9 We completely agree; however, we believe that these goals can more effectively be met through a competitive model than perpetuation of the monopoly model. Absent fair competition in the reporting, collection and dissemination of market data, cost and technological efficiencies cannot be maximized. Only an open architecture model based on principals of fair competition within a framework of common standards can truly do this.
Accordingly, Schwab urges the Commission to require modifications to the TRACE proposal to achieve this result. Specifically, we request that the NASD, through its operation of TRACE, not be granted an exclusive franchise over the market-data functions for the corporate debt market.
II. Trade Matching and Processing Services
As noted in the filing, trade processing mechanisms and initiatives, such as T+1 clearance and settlement cycles and straight-through processing, are critical enhancements being developed for the securities markets. We applaud the NASD's commitment to ensure that TRACE will be configured to accommodate these initiatives. We are also pleased by the addition of yield data to the core TRACE data due to its importance in determining debt prices.
We are concerned, however, that by operating a trade matching and comparison service, TRACE would gain a competitive advantage over privately-operated bond trading and processing systems currently in existence or in development. Because TRACE would be owned and operated by the NASD, it would be perceived as having a regulatory seal of approval. The fact that participation in TRACE's reporting service is mandatory coupled with the fact that the data required by TRACE is identical to that required by the relevant clearing agency further seals this advantage. Because members must use TRACE's reporting services, members will find it more convenient to use TRACE's trade processing services as well, rather than those of a private competitor that lacks the regulatory authority to require use of any portion of its systems. If TRACE did become a predominant processing facility due to this inherent market advantage, a significant risk is that it would not be as sensitive over time to market pressures to improve its facilities as it would be operated under regulatory auspices rather than subject to the full force of market competition.
III. Standard of Review
The Commission's review of the TRACE proposal must include a review of the statutory basis supporting the NASD's particular proposal to meet the goals of bond market transparency. The NASD's submission, however, does not appear to include the necessary analysis and support. In light of Schwab's comments and the comments of others, we urge the Commission to consider, among other things, the competitive implications of the proposal and its potential impact on efficiency and the public interest, as required by Exchange Act section 3(f). The Commission must consider the impact of the proposal on "fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets" as required by Section 11A(a)(1)(c)(ii) of the Exchange Act. Finally, the Commission must consider whether the proposal "assure[s] the prompt, accurate, reliable, and fair collection, processing, distribution, and publication of information with respect to quotations for and transactions in such securities and the fairness and usefulness of the form and content of such information," consistent with Section 11A(c)(1)(B) of the Exchange Act. In view of the fact that a pro-competitive model is available and easily achievable, Schwab does not believe the Commission could permissibly conclude that the TRACE monopoly proposal meets either the "fair competition" or "accurate and reliable quotations" standard. Nor do we believe that the TRACE monopoly standard can be justified in terms of its impact on competition or efficiency.
Moreover, implementation of TRACE as proposed (i.e., a monopoly-provider for debt transaction reporting operated by an SRO) would impose a new, mandated transaction-reporting and dissemination scheme for the debt market, where none had previously existed. SROs are currently required to file transaction-reporting plans under Exchange Act Rule 11Aa3-1 for equity securities that meet basic standards enumerated under that rule. If the Commission is committed to creating a new transaction-reporting and dissemination scheme operated by an SRO to apply to the debt markets, it should take steps to ensure that such a scheme is governed by the same principles that currently govern transaction reporting plans for the equities markets.
Schwab believes that transparency is equally important to the debt markets as it is to the equity markets. However, we believe that initiatives which will confer a monopoly on data collection and dissemination (and perhaps effectively for trade processing) are inconsistent with competitive, open-architecture solutions. Any initiative that does not take advantage of these competitive solutions would be inconsistent with the Exchange Act mandates to foster competition and innovation. Ultimately a monopoly market data monopoly disserves investors' interests, both by reducing incentives for businesses to provide enhanced market-data services and by ensuring that the cost of those services results in unnecessary limits on the distribution of the best real-time data to the most investors. Finally, we believe an insufficient showing has been made whether or how the current TRACE proposal meets the required standards for Commission review and approval. The Commission should not allow the market data architecture of the equities market - which may have been appropriate in 1975 but is woefully outdated and counterproductive today - to be replicated in the debt markets. Schwab urges the Commission to defer decision on the TRACE proposal until the Commission's Advisory Commission on Market Information is able to prepare a pro-competitive model for market data distribution in both the debt and equity markets.
Very truly yours,
W. Hardy Callcott
Senior Vice President & General Counsel
cc: Arthur Levitt, Chairman
Isaac C. Hunt, Jr., Commissioner
Paul R. Carey, Commissioner
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
Katherine A. England, Assistant Director, Division of Market Regulation
|1||Exch. Act Rel. No. 43616, File No. SR-NASD-99-65 (Nov. 24, 2000), 65 Fed. Reg. 71174 (Nov. 29, 2000) ("filing").|
|2||Exch. Act Rel. No. 42208 (Dec. 9, 1999), 64 Fed. Reg. 70613 (Dec. 17, 1999)("concept release").|
|3||See Securities and Exchange Commission press release, SEC to Establish Advisory Committee on Market Information, July 25, 2000. The Advisory Committee was established to assist the Commission in answering many of the fundamental question posed by the Commission in its concept release on market-data structures.|
|4||Exch. Act Rel. No. 42201, File No. SR-NASD-99-65 (Dec. 3, 1999), 64 Fed. Reg. 69305 (Dec. 10, 1999).|
|5||Filing, at 71179.|
|6||In re Institutional Networks Corp., Exch. Act Rel. No. 20874 (Apr. 17, 1984), 1984 WL 52727 (The Commission noted in this case that cost-based fees "ensure against monopoly distortions and preclude any service from inappropriately subsidizing other services").|
|7||National Ass'n of Securities Dealers, Inc. v. Securities and Exchange Comm'n, 801 F.2d 1415 (D.C. Cir. 1986).|
|8||Given the serious liquidity concerns raised by dissemination of trade data for lower-rated, less actively-traded issues, BTRC should have more authority in ensuring that their recommendations are followed. In addition, a more democratic process for inclusion of broad industry views in the formation of those recommendations is warranted.|
|9||Filing, at 71179.|