|86 Trinity Place
New York, NY 10006
FAX (212) 306-2089
April 26, 2000
Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
Subject: File No. SR-NYSE-99-48
(NYSE's proposed rescission of Rule 390)
The Commission has done an excellent job in describing existing industry practices that have evolved as a result of changing regulation and technology. These practices have resulted in an increasing fragmentation of markets giving rise to a number of issues concerning fundamental fairness, market efficiency and the competitive position of our national markets in an evolving world economy.
We agree that the Commission should not impose a specific structure on the marketplace. However, we strongly support the Commission's role in ensuring fairness in the marketplace by reinforcing economic principles that support the evolution of efficient markets. The Commission must eliminate practices that interfere with and subvert the development of market structures that will truly be competitive on a world scale.
Flawed definitions of competition in the past have given rise to unacceptable trading practices that undermined both true free market principles and the evolution of the national market system envisioned by Congress.
The need for the Commission to impose new order handling procedures on the NASDAQ marketplace arose from a misunderstanding of the true nature of competition. In addition, "accepted industry practices" led to the corruption of free market principles by allowing agreements, such as payment for order flow and soft dollar arrangements, that disguised behavior that in any other industry would be unacceptable.
For twenty years, practices that the SEC and Justice Department have recently found unacceptable affected the market landscape and gave incentive to firms to create enormous profit centers that existed primarily because of structured inefficiency.
Structured inefficiency can only exist in a market where a limited number of participants have the ability to inordinately affect the form of the market (an oligopoly), where regulators are reluctant to take action that would significantly upset "industry practices," where access to the marketplace is limited and where lack of educational information place the customer at a significant disadvantage to the professional.
A major example of this scenario was the NASDAQ model where customer orders had little standing and major market makers controlled the spread in the issues they traded.
The definition of competition in that marketplace, as represented by a number of market makers, was a flawed definition because "competition" existed in a market with structured inefficiency designed to give the appearance but not the substance of true competition.
The effect of the new order handling rules was the introduction of some basic customer protection and auction market principles designed to introduce a higher level of competition. The unintended result of this modification was the movement to fragment the auction market model to create another market model with another version of structured inefficiency.
The issue of structured inefficiency is extremely relevant as we face the challenges of a changing marketplace and the prospect of true world competition.
Structured inefficiency is a major impediment to the realization of the promise of new technology and the evolution of a world class market; a world class market that will have to compete with markets established in other countries without the concern of protecting existing industry practices that impede true progress in achieving the Congressional mandate of a fair and open national market.
The Commission must consider the issues presented in the concept release in the context of structured inefficiency and the existence of questionable practices that undermine the objective of providing fair and efficient markets to the public investor.
A. Overview of Current Market Structure
The statement that "...although the objectives of vigorous competition on price and fair market center competition may not always be entirely congruous, they both serve to further the interests of investors and therefore must be reconciled in the structure of the national market system" is at the heart of the problem facing the markets today.
Fair market center competition is congruous with vigorous competition on price; it is not congruous with the structured inefficiencies of competing market centers designed to maintain excess costs which in no way further the interests of investors.
1. Investor Interests and Competition on Price
The issue of price and transaction costs is the fundamental point upon which disinformation and industry self interest have created an environment that places the public investor at an enormous disadvantage; an informational disadvantage that would not be permitted in any other area of commerce in this country.
Fairness and fiduciary responsibility take second place to the creation of systems and practices that are designed to maintain the highest level of structured inefficiency possible within a regulatory quagmire that seems reticent to apply common sense and basic customer protections on an industry obsessed with maintaining unsustainable margins.
The issue of "implicit costs" is the enabling factor in creating structured inefficiency. It is the enabling factor in misleading customers with the basic bait and switch mentality of low commissions for inferior executions; executions that can be justified by the creation of fragmented trading practices (dependent on structured inefficiency) that are allowed in the misguided interest of "fair competition among all types of market centers..."
Implicit costs are a form of hidden costs that require a level of sophistication to understand that is lacking across the entire spectrum of interested parties; from customers, both public and professional, regulators, both federal and local, and academics, who at times feel that transaction costs are an impediment to pure research on the markets.
Implicit costs may be difficult to address but the inability to clearly expose the nature of these costs to public scrutiny has been a major cause of the institutional inefficiency that undermines the capital raising system in this country.
The most obvious of implicit costs is the spread between bid and ask. The recent imposition of order handling rules on NASDAQ proved the point that exposing previously accepted practices to scrutiny resulted in significant increases in efficiency with no negative affect on the public markets.
It is also interesting to note than the level of structured inefficiency that was maintained by the participants in the NASDAQ market for twenty years would be hard to match in any other industry.
It would be hard to match in any other industry because a more efficient producer with access to the market would make a better product. The better product would be the result of using new technology to make the product less expensive and adding new features to make the product more efficient.
However, the product of NASDAQ was not the efficient pricing of stocks, it was the maintenance of a business of structured inefficiency where spreads were wider than they would have been if customers (with a small c) had direct access to the market.
Market making firms wanted to maintain higher profit margins. They were able to do so because of the oligopolistic influence of the major market participants and the lack of direct access to the market on the part of the public investor.
The NASDAQ example should be a point of reference in the reality check we must perform as we examine the issues covered by the concept release.
The education of the public is the most important element in any effort to address the effect on the markets of implicit costs that prevent rational decisions on the part of the public in directing their orders.
The understanding of different types of orders (market, limit, etc.) and the concept of liquidity as a determinant of efficient pricing are issues that must be addressed by the Commission and presented to the public investor in an effective and responsible manner.
The industry has become expert in packaging and creating all types of exciting bells and whistles to entice public business but the responsibility of the Commission is to cut through the fancy presentation and address the substance of the market issues.
As an example of responsible industry regulation in this regard, one can look to the grocery business where packaging became confusing to the public and the size or shape of the container was used to confuse the buyer. The response of the regulator was to require unit pricing on the package. The same can be said about the securities industry, you can use any structure you feel is appropriate as long as there is some type of unit pricing method to protect the public from industry driven structured inefficiency designed to artificially inflate profits.
Structures designed to take advantage of new technology and the evolving regulatory environment must be judged by how close they come to the objectives of the national market system; the major objective being the creation of markets where direct interaction of investors can occur without the intervention of a dealer.
Traditional broker/dealer functions of matching a buyer and seller are being supplanted by technology, especially in highly liquid stocks. The function that cannot be replaced by technology is the infusion of risk capital by market makers to increase the liquidity of stocks where necessary.
2.Market Center Competition, Internalization, and Payment for Order Flow
The concept of fair competition is an interesting one when applied to the securities industry and its many segments. It is most intriguing in the area of trading and how trading affects the other areas of member firms and indeed the actions of the firms' major customers.
If one were to define the objective of trading in the absolute, one would necessarily come to the conclusion that one would trade where one would get the very best execution possible.
However, as we are dealing with an industry where shades of meaning can result in enormous profit opportunities, we move away from the best execution possible to the best execution available.
We then go one more step and create the national best bid or offer ("NBBO") concept.
In the Commission's release, competition is described as follows: "Market centers (including exchange markets, over-the-counter market makers, and alternative trading systems) compete to provide a forum for the execution of securities transactions, particularly by attracting order flow from brokers seeking execution of their customers' orders." There is no mention of the best execution possible and the phrase "attracting order flow from brokers" is rather open ended in its vagueness.
This vagueness is what gives rise to fragmentation and the questionable determination of fair competition.
If the objective of the best execution possible were the objective of the marketplace, the ideal would be a central auction market where all orders would match, all interest would be displayed and competition would exist through the interaction of efficiently delivered public orders.
That would be the ideal and you would work from that to establish real markets where reasonable economic incentives would attract participants who would ensure the proper handling of public orders and where opportunities would exist to provide risk capital to improve liquidity when necessary.
However, the attraction of order flow from brokers is not dependent on the best possible execution of his customer's order but a combination of incentives that undermine the pure quest for that best possible execution.
The broker is tempted to settle for the best available execution if he can justify that execution to his customer based on accepted industry practices.
In fact, the broker may have no impact on how his firm executes the order and may be put in the position of receiving executions with which he is not comfortable due to relationships between his firm and another firm who executes the trade or internal agreements with his own trading department which may be a separate profit center.
This is where payment for order flow and internalization come into play and, in effect, make the best execution possible an unattainable goal.
Payment for order flow is an unethical rebate that should be prohibited by the Commission. It is clearly a payoff to a firm to route order flow with the understanding that money earned from executing their trades at the national best bid or asked will be shared with them.
Payment for order flow is an artificial incentive for firms to act in a manner to ensure that the best available bid and offer is as far away as possible from the best possible bid and offer. It eliminates the major economic force that causes business to become more efficient and cost effective, customer pressure. Customers (with a capital C - member firms) no longer value best execution possible and the implicit cost of a trade subtly increases for the customer (with a little c - the public).
Internalization is another example of the rarified experience of securities industry firms. Where most industries internalize certain functions in the production process to reduce the cost of the end product or maintain a quality level necessary to produce a superior product, the securities industry operates with such attractive margins, due to structured inefficiency, that firms and customers internalize not to reduce costs but to maintain and share in inflated profit opportunities.
A major negative effect of internalization is the elimination of large customers as a force for more efficient markets. With the fantastic growth of mutual funds and discount brokerage over the past decade, they should have been a natural force to demand better executions and more efficiency.
Instead, they recognized the enormous profit potential of participating in the structured inefficiency of the industry and set up separate profit centers for their own benefit. Implicit costs for the fund customers and discount brokerage customers were not reduced. Profits for the fund companies and discount brokerages were increased.
The issue of soft dollars should also be examined in the same light as payment for order flow and internalization. They are both artificial practices that undermine the establishment of market structures designed to satisfy customer needs.
2. Current Market Structure Components that Address Fragmentation
a. Price Transparency
Price transparency is a minimal essential component of a unified national market system but the issue of how the national best bid and offer is established is open.
b. Intermarket Linkages to Displayed Prices
Public order priority is a fundamental fairness issue and, whether or not it is convenient to establish parameters for ensuring that public orders are protected, it is a necessary element if the public is to have confidence in the markets.
c. Broker's Duty of Best Execution
Factors other than price as a measure of best execution are suspect due to artificial influences such as payment for order flow which fragment order flow by introducing conflicting economic incentives (i.e. the objective of best execution price vs. sharing in the excess implicit charges to customers if wider spreads can be maintained.)
B. Commission's Regulatory Role in Overseeing the National Market System
The Commission's regulatory role is difficult when one considers its implied mission of "maintaining and strengthening a national market system for securities."
The concept of "maintaining" can sometimes be in conflict with "strengthening" when misguided definitions of competition are used to prop up inefficient trading venues.
The objective of maintaining competition among marketplaces has led to policies that disadvantage the public investor (customer with a small c) and create the structured inefficiencies that give rise to excessive returns on the part of professional market participants (Customers with a big C).
The most glaring example of this phenomenon was the twenty-year history of NASDAQ before the new order handling rules were imposed.
The structured inefficiency of NASDAQ gave the natural impetus for firms to maximize their profit opportunities by operating within a flawed structure that allowed them to develop "industry practices" that upon any rational review were exposed as anti-competitive and inefficient.
The combined efforts of the Justice Department and the Commission exposed the reality of quasi-competition and began the evolution of the new market environment that has given rise to the fragmentation issues that exist today.
It is not surprising that the oligopolistic industry, having grown accustomed to structured inefficiency, looked not to the most efficient model of trade execution as a new objective but to the creation of a fragmented auction market model that was designed to control order flow, internalize executions and maintain the highest level of inefficiency allowed under current rules and regulations.
It is in this context that the Commission must assert itself to ensure that industry practices do not continue to subvert true competitive ideals.
It is in this context that the Commission must realize that the existence of practices that are inherently unfair change the decision process on the part of market participants.
The review of practices in the NASDAQ and the imposition of order handling rules was a first tentative step on the part of the Commission.
It must be followed by an unbiased review of the markets to determine what are fair practices, what practices exist to serve the public and which practices exist to perpetuate inefficiencies that would not be allowed in any other industry.
In a world market, the feeling that our capital markets are so important that they have to be treated differently is the ultimate danger.
It is exactly because our capital markets are so important that they must be treated as other industries, subject to the same business principles and customer protections that exist in other arenas and subject to the same level of competition and technological advances that have forced other industries to evolve into true world players able to succeed in the face of ever increasing foreign competition.
To do less is to position our markets for ultimate failure on the world stage.
The issuance of this concept release is an extremely important initiative and the comments that follow are intended to forthrightly address the issues so well defined by the Commission.
C. Requests for Comment
The question posed "...whether the efficiency of the markets for all or any particular category of securities could be substantially improved through market structure changes" is correctly answered by the Commission's statement that "Ultimately, only fair and vigorous competition can be relied upon to set efficient prices."
It is the role of the Commission to define and maintain the fair and open principles of competition that must exist in a capitalistic system to ensure true progress and nurture an environment that will support the evolution of our markets.
1. Effect of Fragmentation on the Markets
a. Fragmentation in General
-To what extent is fragmentation of the buying and selling interest in individual securities among multiple market centers a problem in today's markets? For example, has fragmentation isolated orders, hampering quote competition, reducing liquidity, or increasing short-term volatility? Has fragmentation reduced the capacity of the markets to weather a major market break in a fair and orderly fashion?
Fragmentation is a problem among multiple market centers and within the Nasdaq multiple market maker system (the original example of market fragmentation) because of the inherent economic interest of fragmented markets to interfere with the natural matching of investor orders in the widest and most open environment.
It is not a question of whether or not fragmentation has isolated orders, hampered quote competition, reduced liquidity or increased short-term volatility; it is a realization that it is the objective of fragmented markets to do so.
One has only to look at the fragmented multiple market maker system of Nasdaq which existed for twenty years to take advantage of exactly those opportunities and only through the recent imposition of order handling rules has the negative effects of this initial attempt to profit from market fragmentation been mitigated.
The potential for investor orders to have actual standing in Nasdaq and the increase in the potential for those orders to match in a more open environment led to the reduction in artificially wide spreads which were the intent, design and ultimate reason for the creation and growth of Nasdaq.
Firms naturally sought not the most efficient manner of executing customer trades but the most economically advantageous method.
The growth of ECNs that have led to increasing market fragmentation is an interesting result of the attempt to dealerize the auction market in the face of the Commission's actions to auctionize the dealer market.
It is interesting to note that the nature of an ECN is to isolate orders and that isolation hampers quote competition. In effect, it reduces liquidity and increases short-term volatility; the same dynamic of structured inefficiency that widened spreads in the fragmented Nasdaq dealer model.
The nature of fragmented markets absolutely reduces the capacity of markets to weather a market break in a fair and orderly fashion because one of the objectives of a fragmented market is to profit from artificial volatility.
-Is fragmentation in the listed equity markets likely to increase with the elimination of off-board trading restrictions, such as NYSE Rule 390?
Fragmentation in the listed market is likely to increase with the repeal of Rule 390 but competing with an auction market gives quasi auction markets (ECNs) less of a margin for profit in the absence of the defining structured inefficiency of the Nasdaq dealer market.
It is not a coincidence that the majority of ECN activity is Nasdaq related. There are a good number of listed securities that are currently free to trade but the economic incentive is not as great due to the innate efficiency of the auction market system.
Make no mistake. As we stated before, the fragmentation of the market is not the result of an industry wide initiative to make markets more efficient; it is an attempt to take advantage of structured inefficiency where it has been allowed to exist.
-In the over-the-counter market, what are the incentives for investors and dealers to quote aggressively?
In the over-the-counter market, investors have the same incentive as in any other market to aggressively quote to achieve the best possible execution. The dealer, on the other hand, will always have the conflicting economic incentive to receive the greatest possible economic reward for himself by executing at the widest possible spread and delivering the best available (NBBO) execution.
-If fragmentation is a problem, are competitive forces, combined with the existing components of market structure that help address fragmentation (price transparency, intermarket linkages to displayed prices, and broker's duty of best execution), adequate to address the problem?
Existing components of the market structure have been subverted by the overwhelming economic incentive to profit from artificial rewards such as soft dollar and payment for order flow arrangements and the success in creating the false impression of open competition in an oligolopolistic industry ripe for questionable cooperation at the expense of the public investor.
Price transparency, intermarket linkages and broker's duty of best execution have all been undermined by the enormous economic incentive on the part of firms to inhibit investor access to matching orders, to create an environment where speed is valued over price improvement and quality of execution and to promote the concept of best available price over the ideal of best possible price.
It is incredibly disturbing how speed has become such a valued characteristic for the professional market participant. Not only can the customer (with a small c) be subject to low quality executions, he can be subject to more of these low quality executions per minute to satisfy the professional participant's need for increased economic satisfaction.
Speed is not inconsistent with quality execution if your business model is designed for maximum efficiency.
-Will the greater potential provided by advancing technology for the development of broker order-by-order routing systems, or for informed investors to route their own orders to specific market centers, address fragmentation problems without the need for Commission action?
Advanced technology is only helpful if it operates in support of an efficient business model where the objective is to increase investor access to the markets and present investors with choices they can make in an educated manner.
The Commission must remember the example of Nasdaq where the perception of high technology was undermined by the reality of a number of market makers on phones influencing the competition.
It is the essence of the business model that is the important element to understand. Advanced technology will bring increased efficiency only if the economics of the industry reward efficiency.
b. Internalization and Payment for Order Flow
-What proportion of order flow currently is subject to internalization and payment for order flow arrangements in the listed equity and Nasdaq equity markets? Will the proportion increase in the listed equity markets as a result of the elimination of off-board trading restrictions?
The potential for internalization and payment for order flow is unlimited but dependent on the economic interests of market participants. The greater the level of structured inefficiency that is able to exist, the greater is the potential for payment for order flow and internalization to control the direction of order flow and increase the potential for increased fragmentation.
It is an insidious dynamic and it is most dangerous from the perspective of competition in a world market.
If artificial structures are reinforced by regulators' approval of questionable practices, the market model in the country where those practices are allowed will develop in a less efficient manner than in a country where those artificial influences are not allowed to exist.
The challenge of the Commission is to recognize the need to address industry practices that have grown over time to be major determinants of market structure and to take action where necessary; action that may cause major disruptions in the way firms currently conduct business.
-Is it possible for a non-dominant market center to compete successfully for order flow by price competition, without using internalization and payment for order flow arrangements? If not, is the inability to obtain access to order flow through price competition a substantial reason for the existence of internalization and payment for order flow arrangements?
Efficiency and price competition are the essence of a marketplace.
Inability to compete on these terms is no excuse to permit practices that undermine the efficiency of the market as a whole.
Allowing practices that are questionable corrupts the entire process.
In the past, it is understandable that the Commission may have thought that there might have been some justification on the part of regulators to permit actions that were unacceptable in other competitive environments in order to ensure that there was competition for the NYSE.
However, it is important to note that as a result of that philosophy, a fragmented dealer market, with the support of firms that capitalized on the structured inefficiency of the market, grew to a size where Nasdaq volume often surpasses the NYSE on a daily basis.
Firms directed public companies and IPOs to the Nasdaq environment where the firms' trading operations made markets in the stocks and became increasingly more important profit centers for the firms.
The economic interests of the firms overwhelmed their ideal of efficient executions and questionable practices led to a billion dollar fine and the imposition of order handling rules; order handling rules designed to narrow spreads, give customers (with a small c) standing in the marketplace and impose a higher level of efficiency.
The lessons of the past reinforce the message that efficiency will not be the objective of the market if practices are allowed that create greater economic reward for those who subvert market efficiency and ignore their fiduciary responsibility to their public customers.
Advanced technology and increased public access to the market have solved the dilemma faced by the Commission in the past when it was concerned with the lack of competition for the NYSE. Industry practices that may have been acceptable in the past because of this concern are no longer beneficial to market development.
-To what extent can brokers compete as effectively for retail business based on execution quality (or implicit transaction costs), as opposed to commissions (or explicit transaction costs) and other services?
Brokers can compete based on the value added that they bring to any transaction. Execution quality is the paramount value a broker brings to the customer. Education is the package in which it should be delivered.
Technology has severely impacted the function of a broker to match buyers and sellers.
There are two possible reactions to this environment: 1.) Create obstacles for the customer by establishing trading systems with structured inefficiencies that impede customer access or 2.) Educate the customer to the possibilities available through a broker who can maximize the satisfaction of the customer by the proper method of interaction with an efficient market.
-Do investor market orders that are routed pursuant to internalization and payment for order flow arrangements receive as favorable executions as orders not subject to such arrangements? Even if these orders subject to internalization and payment for order flow arrangements receive comparable executions, does the existence of such arrangements reduce the efficiency of the market as a whole (by, for example, hampering price competition) so that all market orders receive less favorable executions than they otherwise would if there were no internalization or payment for order flow?
Internalization and payment for order flow, by definition, limit the interaction of order flow and therefore reduce the possibility of receiving the best execution possible.
These arrangements absolutely reduce the efficiency of the market by creating a strong economic incentive to prevent open competition and interaction.
-Even if internalization and payment for order flow arrangements increase the fragmentation of the markets, are any negative effects of increased fragmentation outweighed by benefits provided to investors, such as speed, certainty, and cost of execution?
Speed, certainty, and cost of execution are not mutually exclusive to market efficiency.
The opportunity for increased speed, certainty and reduced cost of execution are enhanced in an efficient market and only impaired by practices that create artificial economic incentives to interfere with efficiency.
c. Best Execution of Investor Limit Orders
Does increased fragmentation of trading interest reduce the opportunity for best execution of investor limit orders?
Any impediment to the free interaction of orders reduces the possibility of best execution and concepts of best available executions replace the ideal of best execution.
-Does the opportunity for brokers to share in market maker profits through internalization or payment for order flow arrangements create an economic incentive to divide the flow of investor limit orders from investor market orders among different market centers? If so, does this adversely affect the opportunity for investor limit orders to be executed fairly and efficiently?
Artificial economic incentives available to those that control order flow replace the desire on the part of the broker to receive the best execution for his customer with a desire to participate most fully in the "acceptable" rewards available by settling for a lesser quality of execution.
Separating orders and directing them based on the possible economic rewards of payment for order flow or internalization with no possibility of price improvement artificially limit the interaction of orders and, by definition, adversely affect the opportunity for investor limit orders to be executed fairly and efficiently.
-Is it consistent with national market system objectives (such as efficiency, best execution of investor orders, and an opportunity for investor orders to meet without the participation of a dealer) for market makers to trade ahead of previously displayed investor limit orders held by another market center (that is, trade as principal at the same price as the limit order price)? Does this practice significantly reduce the likelihood of an execution for limit orders by reducing their opportunity to interact with the flow of orders on the other side of the market? Does the practice offer any benefits that outweigh whatever adverse effects it might have on limit order investors?
The concept of public order priority is central to the level of confidence necessary for the continued growth of public participation in the capital markets.
The accepted practice of professional positioning at the expense of investor orders is a significant contributor to the economic rewards of fragmentation and a central factor in the payment for order flow equation.
The practice is also a significant contributor to public suspicion and dissatisfaction with the markets for those investors who are knowledgeable enough to understand the practice.
The practice is definitely not consistent with national market system objectives and does significantly reduce the likelihood of executions for limit orders.
The ultimate action of disadvantaging the public order is at the center of the issue of fragmentation, payment for order flow and soft dollar arrangements.
No economic benefit on the part of professional market participants can outweigh the adverse effects on the public investor.
2. Possible Options for Addressing Fragmentation
Options for addressing fragmentation must be considered from the perspective of ensuring fair and open competition.
Industry practices that add to inefficiency and create the economic incentive to subvert the development of the most efficient markets possible to compete in a worldwide economy must be eliminated.
a. Require Greater Disclosure by Market Centers and Brokers Concerning Trade Executions and Order Routing
-The Commission could require greater disclosure by market centers and brokers concerning their trade executions and order routing. Such disclosures could enable investors to make more informed judgments concerning the quality of executions provided by their brokers, as well as enable brokers and the general public to make more informed judgments concerning the quality of trade executions at all market centers.
For example, all market centers could be required to provide uniform, publicly available disclosures to the Commission concerning all aspects of their trading and their arrangements for obtaining order flow. These disclosures could include the nature of their order flow (for example, the ratio of limit orders to market orders), their effective spreads for market orders for different types of securities (for example, securities that have different levels of trading), their percentage of market orders that receive price improvement, their speed in publicly displaying limit orders, their fill rates for different types of limit orders (for example, those with between-the-quotes and at-the-quotes limit prices), and their average time-to-fill for different types of limit orders. In addition, market centers could be required to make available comprehensive databases of raw market information that will allow independent analysis and interpretation by brokers, academics, the press, and other interested parties.
Brokers, in turn, could be required to provide disclosures to their customers (and to the Commission for public availability) concerning the proportion and types of orders that are routed to different market centers, their arrangements with market centers for routing customer orders, and the results they have obtained through these arrangements.
What would be the advisability and practically of this option? Would it effectively address the problems presented by market fragmentation?
Information is of utmost importance in the evaluation of the effects of market fragmentation, however, information is not a substitute for understanding and a common sense review of basic business practices.
For twenty years, enormous amounts of information and academic studies supported the efficiency of the Nasdaq market. It took common sense and the gathering of real world evidence to support the implementation of order handling rules.
Disclosure of technical information to customers is always a problem because the true level of understanding on the part of customers is not at the level where such information is meaningful.
Full disclosure is a cop out when one of the major accomplishments of the industry is the maintenance of the high degree of ignorance on the part of the customer, both public and professional.
In addition, the disclosure of unfair practices to the customer does not make the practices right.
-Is there an effective and practical way to provide clear and useful disclosure to retail customers concerning execution quality? If not, does the difficulty of providing such disclosure preclude brokers from competing effectively on the basis of execution quality?
Effective disclosure can only be made in the context of an educated customer base.
It is the obligation of the industry and the Commission to advance an education agenda that will raise the level of understanding in the marketplace to enable rational decisions to shape future market structure.
It is the fiduciary responsibility of a broker to obtain the best quality execution for his customer. Undermining the ability of the market as a whole to provide the best and most efficient execution, in order to support the business of brokers who choose to be less efficient providers, is a perversion of capital market principles.
b. Restrict Internalization and Payment for Order Flow
-The Commission could restrict internalization and payment for order flow arrangements by reducing the extent to which market makers trade against customer order flow by matching other market center prices. Market makers would thereby be less assured of the profits that can be earned by trading against directed order flow and that are used to fund the economic inducements offered to brokers for their customers' order flow. For example, the NYSE has requested that the Commission take this type of action to address internalization. Under the NYSE proposal, broker -dealers would be limited in the extent to which they could trade as principal with their customers' market and marketable limit orders. A broker-dealer could buy from or sell to its customer only at a price that was better than the NBBO for that particular security. This type of prohibition could be extended to all market centers that receive orders pursuant to a payment for order flow arrangement, in addition to internalizing broker-dealers.
What would be the advisability and practicality of this option? Would it effectively address the problems presented by market fragmentation?
Elimination of payment for order flow, not restriction, is a necessity. It is enormously troubling that the Commission has not recognized the critical need to eliminate a practice that will continue to subvert fair market practices and place the entire industry under a deserved cloud of ethical suspicion.
In addition, the reluctance of firms to provide price improvement is exacerbated by the existence of payment for order flow, soft dollar arrangements and internalization.
The Commission should require that all markets be limited in the extent they can trade as principal with their customers' market and marketable limit orders, not just those who internalize or receive orders pursuant to payment for order flow arrangements.
-Would restricting internalization and payment for order flow arrangements unduly interfere with competition among market centers to provide trading services based on factors other than price, such as speed, reliability, and cost of execution?
Price is the ultimate measure of the efficiency and value of a marketplace.
Internalization and payment for order flow obstruct the process of efficient pricing and support practices designed to confuse and deceive the customer into assuming that execution quality is a given.
Customers will direct their business based on a number of personal preferences for specific services and perceptions of value.
Market centers can compete on various levels of service and customer sensitivity but to open the customer to questionable practices to prop up markets that cannot compete on the fundamental issue of price is unacceptable.
c. Require Exposure of Market Orders to Price Competition
-As a means to enhance the interaction of trading interest, the Commission could require that all market centers expose their market and marketable limit orders in an acceptable way to price competition. As one example of acceptable exposure, an order could be exposed in a system that provided price improvement to a specified percentage of similar orders over a specified period of time. As another example of acceptable exposure, a market maker, before executing an order as principal in a security whose quoted spread is greater than one minimum variation, could publish for a specified length of time a bid or offer that is one minimum variation better than the NBBO. The Commission proposed such a rule for public comment in 1995 at the time it proposed the Order Handling Rules. Although it believed that an opportunity for price improvement could contribute to providing customer orders with enhanced executions, the Commission chose not to adopt the proposed rule at the time it adopted the Order Handling Rules. Instead, it stated that it was deferring action to provide an opportunity to assess the effects that the Order Handling Rules would have on the markets.
What would be the advisability and practicality of this option? Would it effectively address the problems presented by market fragmentation?
Order exposure is an integral part of an efficient market. However, the imposition of extensive rules can create an unwarranted burden on all market participants.
If questionable practices were prohibited, the need to impose artificial rules or automatic execution parameters would be eliminated.
True competition would lead to individual markets offering features that would be designed to satisfy customer requirements not potentially misguided regulatory guidelines.
-Are there effective means of representing undisclosed orders in markets in which trading interest is divided among many different market centers? Would exposure of market orders through the quote mechanism provide a viable means of allowing the holders of undisclosed orders (particularly large orders) to interact with market orders? What other means to facilitate the interaction of undisclosed and disclosed orders is feasible and practical?
Evolving technology is making the process of order entry more flexible and the responsibility of directing orders to the most efficient market should move to the firms. However, this movement is dependent on the maintenance of fair trading principles and free customer access to the markets.
-Would requiring the exposure of market orders to price competition unwarrantedly delay the execution of those orders? If so, should order exposure be offered as a choice to customers?
Customers should always have a choice but they must understand the implications of their actions.
Speed of execution and flexibility are important elements in the order handling process and rules imposed must facilitate the efficiency of execution.
-How would implementation of this option affect the opportunity for execution of displayed trading interest at the NBBO.
The majority of orders would still be executed at the NBBO but the possibility for improvement in the quality of the NBBO would increase.
d. Adopt an Intermarket Prohibition Against Market Makers Trading ahead of Previously Displayed and Accessible Investor Limit Orders
-The Commission also could establish intermarket trading priorities as a means to address fragmentation. One option would be to adopt an intermarket prohibition against market makers (including exchange specialists) using their access to directed order flow to trade ahead of investor limit orders that were previously displayed by any market center and accessible through automatic execution by other market centers. Under this option, each market center would be responsible for providing notice to other market centers of the price, size, and time of its investor limit orders that were entitled to priority, as well as participate in a linkage system that allowed automatic execution against the displayed trading interest. To execute a trade as principal against customer order flow, market makers would be required to satisfy, or seek to satisfy, investor limit orders previously displayed and accessible at that price (or a better price) in all market centers.
Market makers (including specialists) and all broker/dealers should not trade ahead of disclosed public orders.
Public order priority must be a benchmark of the evolving market place and the fiduciary responsibility of market makers, specialists and brokers to their customers must be recognized and supported by the Commission.
-To reward market makers willing to add liquidity to the markets through aggressive quote competition (as well as participate in public price discovery), a market maker could be allowed to trade with customers at its quote ahead of a subsequently displayed investor limit orders under certain circumstances. For example, a market maker could trade as principal against a customer order if, at the time it received a customer order, its quote was at the NBBO; its quote was widely displayed and accessible through automatic execution at a size at least equal to the customer order; and the market maker satisfied, or sought to satisfy, all investor limit orders that were displayed prior to the market maker's quote.
The reward for market makers willing to add liquidity to the market through aggressive quote competition should be their ability to attract order flow based on their superior market quality not an advantage granted that indirectly disadvantages the public customer.
-What would be the advisability and practicality of this option? Would it effectively address the problems presented by market fragmentation?
Monitoring the application of this feature would be problematic raising questions of applicability to situations and confusion in the market place. As a result, it would not efficiently address the problem of fragmentation.
-Would prohibiting market makers from trading ahead of investor limit orders, regardless of where the order entered the national market system, facilitate a broker's ability to obtain best execution of its customers' limit orders?
-Would an intermarket prohibition against market makers trading ahead of previously displayed and accessible limit orders encourage price competition and thereby enhance the efficiency of the market as a whole?
-Would implementation of this option reduce the willingness or capacity of market makers to supply liquidity? If so, would the problem be addressed by allowing market makers to trade at their quotations after satisfying previously displayed investor limit orders?
As evidenced by the imposition of order handling rules on Nasdaq, enhanced efficiency does not reduce liquidity. It strengthens the market by increasing the confidence of market participants that fair practices are maintained.
-Would this option be feasible without the establishment of a single, intermarket limit order file?
e. Provide Intermarket Time Priority for Limit Orders or Quotations that Improve the NBBO
As another option for encouraging price competition, the Commission could establish intermarket trading priorities that granted time priority to the first limit order or dealer quotation that improved the NBBO for a security (that is, the order or quotation that either raised the national best bid or lowered the national best offer). To qualify for such priority, the limit order or quotation would have to be widely displayed and accessible through automatic execution. Only the first trading interest at the improved price ("Price Improver") would be entitled to priority. No market center could execute a trade at the improved or an inferior price unless it undertook to satisfy the Price Improver. Subsequent orders or quotations that merely matched the improved price would not be entitled to any enhanced priority. If, prior to satisfaction of the Price Improver, another order or quotation was displayed and accessible at an even better price, the existing Price Improver would be superseded and permanently lose its priority. The subsequent trading interest at the better price would be the new Price Improver.
To require orders to be routed based on any single characteristic is short sighted.
Intermarket time priority is an attempt to manage competition and as such imposes a limited criterion that fails to recognize the true dynamic of the public markets.
Successful markets should be determined by their own individual handling rules that will maintain public priority, protect time of order entry and provide the deepest level of liquidity as a competitive necessity.
However, in order to support this dynamic, the Commission must eliminate artificial practices such as payment for order flow and recognize the importance of an educated public investor.
-What is the advisability and practicality of this option? Would it effectively address the problems presented by market fragmentation? Would it discourage competition among market centers or reduce market makers' willingness to supply liquidity?
The practice is inadvisable because routing orders by time priority alone discounts all other quality characteristics and sets the stage for a battle of high speed processing chips not the evolution of superior markets.
-Would granting time priority only to the first trading interest to improve the NBBO provide an adequate incentive for aggressive price competition?
As stated before, the incentive for competition should be the market maker's ability to attract order flow based on the superior quality of his market; not an artificially imposed advantage.
The ability to match a competitive order is fundamental; the ability to step in front of a public order is another matter.
-How difficult would it be to implement this limited type of intermarket time priority? Would it require substantial modifications of currently existing linkage systems?
Setting up a system would be very difficult, if possible, and would require substantial modifications of currently existing linkage systems.
f. Establish Price/Time Priority for All Displayed Trading Interest
To assure a high level of interaction of trading interest, the Commission could order the establishment of a national market linkage system that provides price/time priority for all displayed trading interest. Under this option, the displayed orders and quotations of all market centers would be displayed in the national linkage system ("NLS"). All NLS orders and quotations would be fully transparent to all market participants, including the public. Orders and quotations displayed in the NLS would be accorded strict price/time priority. Market makers could execute transactions as principal only if they provided price improvement over the trading interest reflected in the NLS. Trading interest in the NLS could be executed automatically; however, the NLS would not be a market center itself: executions would continue to occur at the level of individual market centers. Public access to the NLS would be provided through self-regulatory organizations, alternate trading systems, and broker-dealers. The NLS could be administered and operated by a governing board made up of representatives from the public and relevant parts of the securities industry.
-What is the advisability and practicality of this opinion? Would it effectively address the problems presented by market fragmentation?
The more bureaucratic and complicated a system, the less effective the result. It would be very difficult to monitor.
-Has advancing technology and increased trading volume created more favorable conditions for the establishment of a national market linkage system at the current time than at any time in the past? What would be the respective benefits and costs of such a system?
Advancing technology and increased trading volumes have created an environment perfect for innovation and the creation of more efficient markets but the enormous economic benefits to major market participants from practices such as payment for order flow and internalization have overwhelmed the decision process.
The removal of these artificial practices would restore the normal evolution of efficiency that you would find in other industries facing the same economic environment.
As to the respective benefits and costs of any system, fair and open competition drive any market to higher levels of efficiency and structures evolve to support that movement.
To impose an artificial structure to force behavior modification, no matter how well intentioned (e.g. Nasdaq before order handling rules), is futile because individuals will make artificial decisions to satisfy the need to profit under that structure.
All market participants must operate under the same set of rules and no market makers, specialists or broker/dealers should be able to trade ahead of public orders.
In addition, artificial profit opportunities arising from payment for order flow, soft dollar arrangements and internalization must be eliminated to insure the evolution of a fair, efficient and truly competitive market structure.
-Would a national market linkage system with strict price/time priority and automatic execution provide the most efficient trading mechanism? If so, why have competitive forces failed to produce such a system without the necessity for Commission action? Are there any regulatory rules or industry practices blocking competitive forces that otherwise would produce such a system? If so, what are they and how should they be addressed.
The ability of this oligopolistic industry to maintain structured inefficiency (under rules that allow payment for order flow, internalization with no price improvement and soft dollar agreements) has changed the objective of the business. Efficiency is not the goal; the maintenance of excessive margins has been made too easy under current rules or, more clearly, in the absence of responsible rules of behavior.
-Would a mandated national market linkage system substantially reduce the opportunity for competition among market centers to provide trading services? If so, would the costs of reduced market center competition outweigh the benefits of greater interaction of trading interest?
Competition for competition's sake is destructive to principles of efficiency. The maintenance and support of inferior markets for the sake of the appearance of competition is at the heart of the fragmentation problem.
-Would implementation of a comprehensive national market linkage system effectively require the creation of a single industry utility? How should a national market linkage system be governed?
Implementation ("imposition") of a structure that is not supported by open, free and equal trading practices is detrimental to the evolution of an efficient world class market.
The greatest danger to the development of efficient and world competitive markets is the creation of structures that give the impression of fair treatment but include practices such as payment for order flow that effectively change the economic decision processes of market participants.
Advances in technology and the increased access to the market that is the result of this technology make the industry utility model less relevant than it would have been in the past.
The challenge is to eliminate artificial impediments and practices that interfere with the public empowerment that is the most meaningful result of technology.
Should there be any exceptions from the requirement that all orders yield price/time priority to trading interest reflected in a national market linkage system? For example, should there be an exception for block transactions or for intra-market agency crosses at the NBBO?
Market participants should be able to enter orders with special handling instructions based on their individual interests but those orders must not be handled in a manner to undermine the overall system which must maintain basic fairness principles.
Should a national market linkage system incorporate a reserve size function to facilitate the submission of large orders?
All orders are equal but some orders are more equal than others - doesn't work.
In considering the entire range of securities, the Commission should be concerned that the lower tiers of stocks are the most negatively affected by the current structure of the market place. Small appears to be suspect and respectable companies are precluded from trading in more efficient trading venues based on arbitrary numerical guidelines that significantly impair the capital raising process.
Markets have grown to be defined not by efficient trading characteristics but by marketing initiatives designed to define markets by the size and reputation of the companies they trade.
This has been an effective way both to confuse the public as to what elements are important to improve the efficiency of the market structure and to avoid the uncomfortable explanation of practices such as payment for order flow.
It is the responsibility of the Commission to ensure that smaller companies have access to the most efficient markets available and that issues of market efficiency are not isolated from the real world of asset allocation and corporate capital requirements.
Issues discussed in the context of the market as a whole are even more acute in the lower segments of the market.
Not to address this abandonment of small cap companies is to permanently damage the creation and growth of the very companies that provide the majority of jobs and innovation that is the backbone of our capitalistic system.
When smaller companies have to raise foreign capital because domestic markets are not structured to provide suitable opportunities, this country is on dangerous ground.
The Commission must also recognize the differences in the equity and options markets that require specific types of rules to ensure continued growth and innovation.
However, while rules may differ, the commitment to fairness must be maintained and artificial practices that interfere with market efficiency must be eliminated.
When the Commission states "...the Commission does not believe that its task is to ascertain whether the current quoted or effective spreads reflect an "optimum" or "ideal" level of efficiency", it must not use this proviso to avoid taking action against practices such as payment for order flow, soft dollar arrangements and internalization without price improvement that, in effect, guarantee that the "optimum" or "ideal" level of efficiency will never be met.
After reading the concept release, it is clear that the Commission understands the majority of the issues that have created such varied approaches to the market and such intense lobbying on the part of a number of market participants.
This release is a significant move in the direction of more realistically reviewing practices that, if allowed to continue, will cripple any possibility of the market maintaining, through the use of advanced technology and truly competitive economic principles, our leadership role in a world that will not hesitate to take advantage of weaknesses in our market structure.
The disease is a misguided view of true competition and the existence and acceptance of questionable industry practices that make fragmentation so economically attractive.