Division of Donaldson, Lufkin & Jenrette Securities Corporation
One Pershing Plaza, Jersey City, New Jersey 07399 (201) 413-2000
May 12, 2000
Mr. Jonathan Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Commission Request for Comment on Issues relating to Market Fragmentation (Release No. 34-42450, File No. SR-NYSE-99-48)
Dear Mr. Katz:
The Pershing Division of Donaldson, Lufkin & Jenrette Securities Corporation ("Pershing") respectfully submits its comments on the Commission's concept release on issues relating to market fragmentation.
Pershing is a world-leading provider of correspondent clearing services. In this role, Pershing serves over six hundred broker-dealers encompassing over 50,000 financial consultants and 3,500,000 individual customer accounts. Market structure is a critical issue for Pershing and its customers.
The Commission's Role in Modernizing the Markets
Pershing appreciates the efforts of the Securities and Exchange Commission in helping our national market system become the model for the rest of the world. Our markets are the most liquid, most efficient, and best regulated.
The question now before the Commission is how best to modernize and continue to strengthen the operations and linkages of the markets in the face of increased investment, increased liquidity and increased competition from around the world. We outline several changes below that build upon the existing market structure and will provide critical and needed improvements to the national market system.
Our proposals are evolutionary in nature, and build on the successful course the Commission has helped to set over the past quarter-century. Quite simply, our markets are not broken. Radical changes are not necessary. Consequently, we do not now support any initiatives that would significantly change the manner in which the markets operate, such as a central limit order book. Instead, we look for solutions that further improve the ways the markets operate within the existing, democratized structure.
Generally, we urge the Commission to mandate improved electronic linkages, greater price transparency and price priority across market centers. In addition, we support greater disclosure of order routing practices and the quality of trade executions by market participants and market centers.
Improving Electronic Linkages
Chairman Levitt and numerous other commentators have noted that effective linkages are critical to the success of our national market system. Pershing argued in support of linkages in the options markets in an April 5, 2000 letter to the Commission, which is incorporated herein by reference.
The most important way that the Commission can improve the operation of the markets is by mandating improved linkages in the equities markets. The existing Intermarket Trading System ("ITS") was a good idea when it was first introduced in 1975. However, ITS must be substantially improved if it is to continue to serve as the Commission intended.
Three policies must be pursued by the Commission to effectively modernize ITS:
First, ITS should provide immediate, if not automatic, executions of trades received from other market centers. Investors today demand prompt and efficient executions of their trades. ITS must be able to provide this function if it is to serve the needs of today's investors and markets.
Second, the ITS governance plan must be altered. The current system requiring unanimity for any changes does not work because that requirement has operated to effectively block any efforts to modernize ITS without Commission intervention. We would support requiring either a simple-majority or a super-majority vote for any changes.
Third, we agree with Chairman Levitt's position that he does "not envision direct ITS participation by ECNs (other than registered exchanges), but rather believe(s) that ECNs should gain access through an SRO."1. Every ITS participant must be confident that those linked with ITS are subject to adequate market surveillance and that the ITS rules will be enforced. In order to instill that confidence, the ITS plan should continue to require that ITS participants be self-regulatory organizations. ECNs can become participants in ITS by choosing to register as exchanges and thereby assuming SRO responsibility. Those ECNs that choose to remain registered as broker-dealers can participate in ITS through their SRO when their quote is at the top of that SRO's book.
These policies must be mandated by the SEC; voluntary participation will not achieve the goals of effectively modernizing ITS.
The Commission should reject the arguments of those that believe that anything less than full modernization of ITS serves the interests of the investing public. For example, the New York Stock Exchange ("NYSE") has stated that intermarket order routing linkages should be eliminated.2 The primary exchanges apparently are concerned that they may be the source of the best prices, but increasingly will not be the location where the trade is executed because existing linkages facilitate trading in more cost efficient venues. While the New York Stock Exchange still executes the vast majority of the share volume in NYSE-listed securities, more and more broker-dealers are trading in these more efficient venues. In fact, Pershing executes most of its orders in NYSE-listed securities on various regional exchanges. These regional exchanges are able to offer faster executions at a lower cost than a similar order sent to the primary exchanges.
The solution for the primary markets is to adopt the necessary business practices, technologies, and cost reductions, not to insulate themselves completely by withdrawing from existing linkages.
The Primary Exchanges' Attacks on Competition
Pershing executes orders in NYSE-listed securities on the Cincinnati, Boston, and Pacific Stock Exchanges using its own affiliated specialists. This practice has become known as internalization. It is attacked by the primary exchanges, which would have the Commission and the public alike believe two diametrically opposed propositions: that competition benefits the customer, but that market stability depends on the greatest possible routing of orders through the primary exchanges.
The primary exchanges' attack on internalization is really an attack on competition itself. It exposes the primary exchanges' real goal: to protect their market share. The Commission should allow competition to flourish in many venues.
The primary exchanges compete with dealers that are executing orders on fully linked, recognized national securities exchanges - not, as the primary exchanges would have the Commission and the public alike believe, companies that randomly execute trades off the sides of their desks. The primary exchanges also fail to acknowledge that the Commission in a 1997 study mandated by Congress conducted a thorough empirical analysis of regional specialist programs on the Boston and Cincinnati Stock Exchange and found no evidence that investors were being harmed by these practices.3 We are not aware of any study done since 1997 that has found otherwise.
Full competition in order execution provides substantial benefits to the customer. Orders sent to our regional specialists will always receive either the national best bid or offer or better. Our customers will often receive prices better than those prices quoted on the primary exchanges because the regional specialist has the opportunity to interact with that order. If the regional specialist cannot offer his customer best execution on his own exchange, he will route the order through ITS to the market with price priority. Thus, effective linkages are critical to participants on the regional exchanges. Without them, order flow would default back to the primary exchanges, diminishing the price and quality competition now underway in the securities markets that benefits all participants.
Moreover, routing orders to affiliated, regional specialists actually increases the opportunity for investor orders to interact and enable the markets to work more efficiently and effectively. The Commission itself has found this to be the case: for example, in the 1997 report referred to previously, the Commission found that orders executed on the Cincinnati Stock Exchange were found to have higher limit order fill rates than orders routed to the New York Stock Exchange.4
The Commission also has stated in this concept release that a critical factor for non-marketable limit orders is that they be routed to the market center that provides the greatest likelihood of execution.5 We conclude from our experience that orders routed to our affiliated specialists on regional stock exchanges have the greatest likelihood of being filled. Brokers who route their orders to agency markets where they will not receive any interaction, such as an ECN, might be better serving their customers if they sent them to an affiliated specialist on a regional exchange.
Contrary to the Commission's assertions, orders sent to affiliated specialists on a regional exchange are neither dependent on the primary exchanges for price discovery nor merely match those prices that these exchanges set. We agree that a great deal of pricing information comes out of the primary exchanges by virtue of the huge market shares that these exchanges currently enjoy. However, these specialists do not rely solely on the primary exchanges for price discovery and they certainly do not merely match the prices. In fact, the New York Stock Exchange has acknowledged that regional specialists often provide their customers with price improvement.6 The Commission appears to favor price-time priority through a central limit order book as a means of solving the problem it perceives. We believe that a central limit order book would be much less likely to provide investors with price improvement. In a central limit order book environment, investors would not benefit from any interaction with their orders. However, price priority, as outlined below, would allow customers to receive the best price possible and have the benefit of potential price improvement through a competitive, not monopolistic, market structure.
Pershing supports price priority in both the listed and over-the-counter markets. A price priority rule would require a market center receiving an order to route the order to a market displaying a better price or to match the better price that was displayed in the other market center. Such a rule would ensure that investors always received the best possible price available from any market center, while preserving a broker-dealers right to consider a variety of factors when making its order routing decision. To ensure that a broker is achieving best execution for its customer the Commission has said that the broker should consider price, as well as other factors such as: the overall market quality, speed of execution, the size of the order, the trading characteristics of the security, the availability of accurate information affecting choices as to the most favorable market in which executions might be sought, the availability of economic access to the various market centers and the cost and difficulty associated with achieving an execution in a particular market center.7
While ITS currently has a trade through rule, the Nasdaq market should be required to adopt a similar rule in order to protect the investing public. Also, the dispute resolution process for trade through violations must be fair and efficient. The current process in the listed market is neither.
Payment for Order Flow
There is almost always some sort of economic incentive involved when a broker determines where to send an order. Pershing would be in favor of eliminating payment for order flow in all forms. However, the Commission defines payment for order flow so broadly8 that eliminating it would be next to impossible. In the absence of a complete ban, brokers should remain able to participate in the efficiencies of dealers to whom they route orders. While vertically integrated full-service brokerages are able to take advantage of their size to obtain efficiencies in the order processing and execution system, the only way small and medium size firms can obtain similar efficiencies is through payment for order flow.9
Establish Greater Transparency
In addition, Pershing supports greater transparency in all markets. As long as effective linkages are in place to access other markets, all markets should be required to display more information to the investing public. We do not believe, however, that market participants should be required to display their entire limit order books. There is a point where information is no longer useful. We believe that Nasdaq's SuperMontage proposal which would display two levels below the best bid and offer is a step in the right direction.
Treat Market Makers and ECNs the Same
Under the current system ECNs can charge market participants that access their quotes, but market makers cannot. This is unfair and must be changed. ECNs should not be allowed to charge non-subscribers who access their market, when their market represents the national best bid or offer.
Fully Disclose Order Routing Practices
Lastly, Pershing supports greater disclosure of order routing practices by broker-dealers and disclosure of the quality of trade executions by market centers. We believe that these disclosures can help investors make more informed decisions about where their orders are routed. We encourage the Commission to set uniform, standardized measures of these factors so that the information is useful and not mere marketing material. We strongly believe that if the public was aware of the high quality of trade executions by the regional exchanges, more orders would be sent there.
Pershing wishes to thank the Commission for this opportunity to express its views. We would be pleased to offer our assistance to the Commission as the process continues. Please do not hesitate to contact the undersigned should you have any questions regarding these comments.
Chief Operating Officer
1 Letter from Arthur Levitt, Chairman of the SEC, to the Honorable Charles E. Schumer (December 22, 1999).
2 Market Structure Report of the New York Stock Exchange, Special Committee on Market Structure, Governance and Ownership (April 2000).
3 Report on the Practice of Preferencing Pursuant to Section 510c of the National Securities Markets Improvement Act of 1996 (April 11, 1997).
5 SEC Release No. 34-42450 at 14.
6 See Supra, No. 2.
7 See SEC Release No. 34-37619A, (August 29, 1996).
8 Securities Exchange Act, Rule 10b-10 defines Payment for order flow to include not only monetary payments, but also items such as clearance, custody, reciprocal arrangements, adjustments of errors, offers to participate as underwriter in public offerings, stock loans, discounts and rebates.
9 As noted above, Pershing clears for over 600 broker-dealers. Many of our customers are these small and medium size firms that support payment for order flow.