May 2, 2000
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
RE: File No. SR-NYSE-99-48
Dear Mr. Katz:
Herzog Heine Geduld appreciates the opportunity to comment on the SEC's concept release regarding possible increased fragmentation in the securities markets in light of the proposed elimination of Rule 390 by the New York Stock Exchange, and whether any additional Commission rulemaking is needed. We have been a market maker in securities for more than 70 years, and we were one of the original participants in the first Nasdaq system. By participating first-hand in the development and evolution of the Nasdaq marketplace, which continues to experience rapid, continual and dramatic growth, we believe we have a unique perspective on competition in the securities markets.
In past letters to the Commission regarding Nasdaq regulatory proposals, we have expressed our strong opposition to central limit order book proposals for the Nasdaq market, because we believe that competition among competing market makers is the best way to ensure the deepest and most liquid markets, most vigorous price competition, and the best service to investors. We believe strongly that the same approach should be taken with respect to markets generally. We respectfully urge the Commission to take those actions necessary to preserve competitive opportunities for market makers and other competing market centers. Markets should be encouraged to innovate and develop by being able to keep and execute the order flow they generate consistent with best execution.
The securities markets are in a state of rapid evolution. Recent changes in the markets, including the greater use of technology in order delivery and execution and the explosion in volume, have challenged market participants and securities industry systems in ways that were unforeseeable just a short time ago. The Commission has responded to these dramatic changes by reexamining market structure issues and long-standing, anti-competitive rules such as Rule 390. Strong and enlightened regulation in this area is imperative to ensure that, notwithstanding significant changes in market structure, investors receive fair treatment from all market participants. The Commission's regulations have been most effective in protecting investors when their effect has been to encourage greater competition among market participants.
Market intermediaries, like Herzog Heine Geduld, play a vital role in the furtherance of a national market system by maintaining fair and orderly markets. We commit significant amounts of capital and provide an important source of liquidity to our securities markets, especially during periods of market stress. But these important market functions are not provided out of altruism. Instead, they result from our desire to provide better service to our customers and thereby maintain a profitable business from the orders they send to us.
Market makers recognize the importance of customer order flow for the success of their business. In that respect, the business of market making resembles other familiar dealer markets. The grocer, for example, who offers milk to the public hopes to profit by filling customer orders from inventory. The market making business, like the grocery business, thrives on significant customer order flow and perishes without it.
Because of the importance market makers place on customer orders, we vigorously compete for order flow on many different levels. First, we continually seek to provide the best possible execution for our customers, and at a minimum this means the best price reasonably available in the markets to which we have access. In addition, Herzog Heine Geduld has consistently been at the forefront of technological innovation by market makers. In that regard, we were the first Nasdaq market maker to offer automated execution to customers. In turn, our customers, retail brokerage firms and institutional investors, leverage our innovations by building complementary innovations and passing along lower costs to their customers. Internet trading is possible today only because of the automated execution system pioneered by Herzog Heine Geduld and imitated by its competitors. We constantly strive to improve our customers' access to our trading services by developing superior order execution, delivery and reporting systems.
We are able to make significant investments in the technology that supports these systems because the several hundred thousand orders sent to us each day, and the order flow they represent, provides a critical mass of business that enables us to provide high quality execution while still making a reasonable and acceptable level of profit. This includes being a price leader in Nasdaq markets and providing substantial price improvement opportunities to orders sent to us for execution.
Our competitors have also devoted significant resources on technological improvements in efforts to attract and retain essentially the same customer base. The driving force for all of this competitive innovation has been the desire of each market maker to attract valuable orders that may be profitably filled from inventory. Herzog Heine Geduld and other wholesale market makers have pioneered innovative order execution techniques, discovered new ways to distribute market information and engineered expensive and complex interfaces to a multitude of trading systems. None of this explosive innovation was inspired by regulatory requirements. Instead, market makers responded to the forces of competition and their desire to maintain viable businesses. If a market maker does not raise the bar with innovative enhancements to its trading systems, a competing market center will inevitably lure that market maker's customers away. This healthy competition and the resulting improvements in technology ultimately benefit the investor in the form of tighter spreads, quicker and more efficient executions, more sophisticated services and tools, and lower execution costs.
The Commission suggests in its concept release that the existence of competing market centers, however, may have the effect of isolating orders and reducing the opportunity for interaction of all buying and selling interest in a particular security. We disagree. We believe that vigorous competition, rather than regulation, quickly eliminates any perceived inefficiencies in our market structure.
To the extent that any fragmentation effects exist in a competitive multi-dealer market, it is worthwhile to consider that we live in a world of trade offs. Benefits are associated with costs, rewards with risks. The Commission's efforts to improve the transparency of the Nasdaq market place in its order handling rules, for example, appear to be associated with lower liquidity and greater volatility. Transparency is a worthy goal of any market, but so is liquidity. Both are necessary to a properly functioning efficient market. But since more of one means less of the other, choices must be made to balance the two goals.
We believe that the market structures proposed in the Commission's release would address the theoretical fragmentation issue by greatly limiting and perhaps eliminating any opportunity for a market maker to profit from orders by filling them from inventory. This would necessarily reduce and perhaps eliminate any incentive for market makers to compete for order flow. A similar result would surely follow from requiring grocers to fill their customers' shopping carts with inventory from a competing grocer. We submit that solving the theoretical fragmentation problem, which at worst seems to discourage certain types of orders, is not a good reason to eliminate competition among market makers, a force that has proven to yield substantial benefits to investors as a whole.
In this regard, we continue to oppose a central limit order book (CLOB) based on time and price priority. A CLOB would, in our view, replace a robust, competitive, multi-dealer market with a governmentally owned and operated central market, completely stifling competitive market incentives to develop innovative order handling and execution services. Central markets will never be as nimble and responsive as markets based on competition. Whereas today, many different market centers are constantly trying to build a better trading platform to attract and retain customer orders, a time-price priority centralized market would destroy any economic incentives to innovate. The superior prices and highest levels of service currently provided to investors would ultimately deteriorate in the absence of competitive incentives.
Similarly, any time and price priority rule that would forbid a market maker from matching the best price available in the market and instead require the market maker to send its orders to a competitor would have negative effects on competition. Certainly price is important; price discovery is the most important function of a market. That being said, efficient pricing results from vigorous competition among market makers on many fronts that are indirectly related to price. As noted above, today's various and diverse market centers compete on, among other things, order execution techniques, efficiency and quality, market information distribution capabilities, and the development of superior order execution and order handling services and tools, all of which inevitably translate into better prices. The proposed rule would prohibit competition on all grounds other than order pricing. Market makers would not be rewarded for innovation. The same market centers that are responsible for much of the innovation in today's markets that result in lower transactions costs, tighter spreads and better quality pricing will have no incentive to make additional investments in better technology. Without the benefit of competing market makers, investors will ultimately pay higher prices and will suffer from lower quality executions.
We strongly believe that competition results in superior pricing and improves the efficiency and quality of any market and particularly our securities markets. The theoretical possibility that orders will be isolated in a highly competitive multi-dealer system is, in our view, no excuse to strip market intermediaries of their incentive to compete and to innovate, thereby eliminating the benefits to the investing public resulting from competition and innovation. We urge the Commission to reject the centralized market solutions to the supposed order isolation problem set forth in its most recent concept release on market fragmentation.
We very much appreciate this opportunity to explain our position on the potential negative effects of using centralized market solutions to cure the supposed ills of market fragmentation. Please call me at (201) 418-4100 if you have any questions.