May 5, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: File No. SR-NYSE-99-48 (Issues Relating to Market Fragmentation)
Dear Mr. Katz:
Net2000 Communications, Inc. ("Net2000") appreciates the opportunity to participate in the commentary on the proposed rule change by the New York Stock Exchange ("NYSE") to rescind Exchange Rule 390, and the larger related issues regarding market fragmentation. As a newly publicly traded company on The Nasdaq Stock Market and a participant in the highly competitive telecommunications industry as a competitive local exchange carrier, Net2000 is keenly interested in providing its investors the most competitive and fair market for its equity securities.
Net2000 applauds the SEC in its effort to carry out its mandate as the investor's advocate by addressing the issues relating to market fragmentation outlined in its Concept Release. Net2000 is pleased to present a viewpoint to the Commission that, we believe, is free from many of the self-serving interests that cloud the current debate on equity market structure.
Net2000 supports the objectives set forth in the Exchange Act to assure "fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets" while also providing for "an opportunity...for investor orders to be executed without the participation of a dealer". Notably, however, these objectives for a national market system, for which the SEC was granted enabling powers, have seen little progress since they were set forth in 1975. It would appear the economic interests of broker-dealers and the exchanges and markets that they control are taking priority over the best interest of investors, both retail and institutional.
As Net2000 and its customers have benefited from the removal of monopoly powers by the Telecommunications Act of 1996, we believe our investors will benefit from the removal of monopoly-like powers currently possessed by some entrenched broker-dealers and established exchanges. Moves such as the removal of Exchange Rule 390, creation of an enhanced central market linkage system, and the creation of price/time execution priority rules with automatic execution will level the playing field for all investors and intermediaries and force competition based on the most desirable attributes - the price and time of orders.
In short, Net2000 endorses the proposed market structure plan laid out by financial industry leading firms Goldman Sachs, Merrill Lynch, Morgan Stanley, and others in their "white paper" submitted to the SEC in January 2000. There is obviously significant debate over these issues, and there are many entities that remain interested in preserving their franchises. In evaluating comments from these participants, I believe the Commission should keep in mind the comment by Frank Zarb, Chairman of the NASD, after hearing testimony to the Senate Banking Committee on February 29, 2000, that if there were a flag for the securities industry, it would carry the Latin translation for "What's in it for me?"
Net2000 believes if the SEC focuses on what others have missed, "What's in it for the investor?", the debate should become more clear, and the move towards a true national market system envisioned over 25 years ago can finally be realized.
Market Fragmentation Issues
Net2000 believes the SEC has correctly identified the issues relating to market fragmentation in its request for comment as described below:
The Commission is concerned, however, that customer limit orders and dealer quotes may be isolated from full interaction with other buying and selling interest in today's markets. As a result, vigorous quote competition may go unrewarded.
Thus, the current market structure allows price-matching rather than requiring that orders be routed to the market center that is displaying the best price, thereby isolating the orders of different market centers.
One need look no further for evidence of the magnitude and scope of the problem of market fragmentation than the March 3, 2000 Wall Street Journal article highlighting the trading practices of the largest Nasdaq market making firm, Knight Securities. The glaring inefficiencies and investor costs in allowing a market participant to not only internalized order flow and isolate that flow from orders setting the best prices, but to also use their "information advantage" to trade profitably for their own account ahead of those other price-setting orders is disturbing at least.
To be sure, intermediaries, and market makers specifically, provide great benefit to the Nasdaq market, other markets, and to issuing companies. Firms that truly risk capital for the liquidity needs of investors, help to find the other side to large block transactions, or help to work orders for buy side clients who would rather focus their attention on other transactions are adding value and should be compensated for that value. Firms such as Goldman Sachs, Merrill Lynch, and Morgan Stanley provide these value-added services and are vitally important to their customers and public companies such as Net2000. I find it no surprise that these are the firms that have endorsed the concepts put forth in the white paper.
Firms that are providing the service of delivering executions for small brokers and order entry firms under the label of "providing liquidity" are providing the same services a price/time priority system would deliver, and their information advantage results in trading practices that add volatility to the market. One would have to think that all investors would be better served with an automatic price/time priority system which would deliver executions directly to those who have competed most aggressively for executions, rather than to those who have paid the most for the information they can obtain from the orderflow.
Firms that would be disenfranchised by the existence of a limit order file have suggested that without the "liquidity" they provide, market makers would drop stocks, liquidity and trading activity would drop, investors would lose confidence, firms would not be able to raise capital, the U.S. and global economies would suffer, and financial life as we know it would cease to exist. These are the same arguments that were put forth in objection to the Commission's Limit Order Handling Rules in 1997, and they are as hollow now as they were then. Can anyone truly think that the markets would be worse off without the kind of trading practices bragged about in the Journal article of March 3, 2000?
The clear issue is that most retail investors have no idea how the financial markets work, or how their order is being handled. Issues such as who is capturing the inherent value of the market order and who is trading based on the information that they glean from seeing orderflow is lost on the small investor. This is where the SEC needs to exhibit leadership and protect the interests of the market participants who will not be heard in this debate.
How Fragmentation Issues are Solved under Price/Time Priority
1. Enhanced price competition
With the reward of capturing the next available marketable order, and the inherent value present in that order, a CLOB will encourage investors and market participants to display their trading interest.
2. Increase market transparency
With all trading interest consolidated in one location where all orders are visible, investors and market participants will be able to get a full picture of trading interest. Presently, many of these non-best priced orders are not displayed to the market or are only displayed to subscribers of each system.
3. Maximum order interaction
Currently, a large percentage of orderflow is not able to interact with the best available prices in the market. As market makers, wholesalers and ECN's are all attempting to trade with their orderflow before it is sent to the market, orders setting the best prices are only exposed to residual orders. With price/time priority, all orders would interact on equal terms.
4. Increased ability to regulate, decreased need to regulate
With price/time priority, regulators will have increased information with which to conduct regulatory oversight, but more importantly, system-wide execution parameters will decrease the need for after-the-fact regulation. Issues relating to backing away, front running, etc., can be addressed by system protocols rather than requiring extensive detection and analytical resources.
In conclusion, Net2000 supports the concepts put forth in the "white paper" submitted to the SEC in January 2000. Namely, (1) Improving existing linkages across market centers (including the recession of Rule 390), (2) Adopting price/time priority rules, and (3) Adopting automatic execution. It would seem to me the operational implementation of these principles should be left to market competition, much like the SEC order handling rules set forth the requirements for limit order display and execution but did not dictate structure.
Market participants should be allowed to compete within this new regulatory framework in serving the needs of customers. With the new execution parameters set forth by the SEC, market participants should work to develop a "virtual" consolidated limit order book, whereby orders from all market centers would be centrally displayed and available for execution based solely on the price and time of entry. A virtual CLOB solution would be preferable for both redundancy and also to foster the innovation that we have seen from many of the newer market entrants like ECNs.
Net2000 believes the SEC's authority to facilitate these needed reforms should be exercised expeditiously. Current market participants are taking advantage of inaction only to increase the volatility of U.S. equity markets. Foreign markets are consolidating, offering market structures that embody these principles of fair play and will be increasingly attractive alternatives to U.S. markets if changes are not made.
Inaction threatens to further fragment the equity markets, and further increase the cost of trading for U.S. investors. Coming from an industry that has seen marked improvement in innovation and cost savings from the increased competition resulting from the removal of monopoly powers in the Telecommunications Act of 1996, I believe similar reforms to the U.S. equity markets will prove equally beneficial. U.S. markets have been described as "the envy of the world," we have gotten here based on the fundamentals of competition and embracing necessary change. Twenty-five years is too long to wait for changes that any unprejudiced observer would see are obvious.
Robert Bannon, CFA
Director, Investor Relations
Net2000 Communications, Inc.
2180 Fox Mill Road
Herndon, VA 20171