May 16, 2000
Mr. Jonathan Katz
United States Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549
RE: File No. SR-NYSE-99-48
Dear Mr. Katz:
I. About Island
The Island ECN, Inc. ("Island") appreciates the opportunity to respond to the Securities and Exchange Commission's ("Commission") Request for Comment on Issues Relating to Fragmentation (hereinafter "Concept Release"). Island functions as a pure auction market - directly matching buy and sell orders. Island is the second largest Electronic Communications Network ("ECN") and has more than 300 broker-dealer subscribers. Island was founded approximately three years ago with the intent of providing all market participants - from individual investors to large financial institutions - with the ability to execute transactions on a level playing field, at an extremely low cost without the presence of intermediaries or dealers. In the first quarter of 2000, Island internally matched 12.2 billion shares. On an average day, Island trades over 200 hundred million shares, approximately 12 percent of the Nasdaq Stock Market Inc.'s ("Nasdaq") transaction volume.
II. Executive Summary
The Commission's Concept Release raised theoretical concerns regarding fragmentation and its current and potential impact on our equity markets. To address these theoretical concerns, the Commission requested comment on several possible regulatory responses. Rather than impose any of the regulatory schemes suggested in the Concept Release, the Commission should instead embrace the principles on which the Congressionally mandated National Market System is based: competition and transparency. The growth and innovation that has occurred on the over-the-counter market demonstrates that inefficiencies in the operation of a market can successfully be addressed by introducing these two key elements to the marketplace. In just the three years following the Commission's adoption of the Order Handling Rules, ECNs have captured approximately 30% of the Nasdaq market, contributed substantially to the narrowing of spreads, and caused market centers throughout the world to reconsider how they will function in the future. Nasdaq, itself, is now proposing sweeping changes to its trading system and corporate structure in an attempt to fend off the threat from ECNs. The important lesson from all the change and upheaval caused by ECNs is that none of it was predicted by market experts or contemplated by even the most enlightened regulators. When allowed to work, the market can achieve a level of efficiency and fairness that cannot be replicated by even the most thoughtful planning.
Through its Concept Release, the Commission is now considering the adoption of rules that would again dramatically alter the operation and structure of our equity markets. This time, however, the changes would not unleash competition or increase transparency but dictate outcomes. Rather than encouraging competition and innovation, the Commission would require market participants to obey strict rules of priority devised by the Commission and academics. Although the Commission may not be seriously considering the creation of a national Consolidated Limit Order Book ("CLOB"), any proposal that requires time or price priority between markets creates the functional equivalent of a CLOB and, therefore, has the same anti-competitive effects. Recent events in markets for other types of securities reflect, that if the new regulatory scheme is wrong, our markets could disappear literally overnight.
Given the potential impact of any regulatory action, the Commission must return to the successful theme of unleashing competition and promoting transparency. This time, however, the Commission must foster competition and transparency in the NYSE listed market. Currently, ECNs are prevented from effectively participating in the listed market by regulatory barriers. By removing these barriers and immediately allowing ECNs to reflect their quotations in the Consolidated Quotation System, the Commission can ameliorate the potential negative of impacts arising from the elimination of NYSE Rule 390. Finally, by relying on competition and transparency, the Commission will ensure that investors continue to benefit from innovations that were not even contemplated just a few years earlier.
III. The Concept Release
In its Concept Release, the Commission raised two main concerns: (i) that the U.S. equity markets are becoming more fragmented and, thus, less efficient; and (ii) that certain practices have a detrimental effect on quotation competition. In addition, with the proliferation of new electronic markets and the repeal of NYSE Rule 390, the Commission questions whether the threat of fragmentation is increasing. One key concern for the Commission is that the practices of internalization and payment for order flow reduce competition between markets. Specifically, since many market participants are assured of receiving order flow either from an affiliate or by paying for the order flow, the Commission believes that many market centers have little incentive to compete based on their quoted price. In addition, the Release suggests that the practices of payment for order flow and internalization may result in some brokers routing orders to marketplaces providing inferior executions.
In response to these concerns, the Commission included in the Concept Release six basic alternatives. The alternatives range from increasing the amount and quality of information available to investors to the introduction of market-wide time/price priority. The Commission also suggested intermediate measures such as restricting payment for order flow, requiring market orders to be exposed, and prohibiting market professional from trading ahead of customer orders.
A. Fragmentation and Internalization
The main reason that the Concept Release was issued is that many commentators, including the NYSE, believe that the listed market may become more fragmented due to the repeal of NYSE Rule 390. The fundamental premise that underlies this concern is that fragmentation is harmful and must be prevented. As Chairman Greenspan recently observed, however, fragmentation is "a necessary consequence of the process of competition in the provision of trading services."1 Any effort to restrict fragmentation would then, by definition, stifle competition and inhibit the development of an efficient market. In addition, the Chairman also noted that fragmentation would likely only be a short term phenomena and that in the longer term "unfettered competitive pressures will foster consolidation as liquidity tends to centralize in the system providing the narrowest bid ask spread."2 Therefore, the best way to address fragmentation concerns is for the Commission to eliminate barriers to "unfettered competition" and not add to the already substantial regulatory framework.
Another major premise that appears to underlie the Concept Release is that internalization harms the market and investors by reducing quote competition and order interaction. While Island does not believe internalization best serves investors, we recognize that there are many valid arguments in defense of internalization. Studies performed by the Commission itself have failed to reveal any major disparity between the execution quality of orders sent to the NYSE floor and those internalized by a broker-dealer. In fact, the Commission's own study revealed that for some order types, execution quality may actually be better than in the primary market. Island's success also indicates that quote competition is rewarded in today's marketplace. Island has no other way to attract order flow other than to post competitive quotes. Nevertheless, Island understands the Commission's discomfort with internalization and payment for order flow. The Commission, however, must rely on the market and not regulation, to determine where orders are routed. The Commission must have faith that, so long as it fosters competition and transparency, investors' orders will be sent to the most efficient venue. Island will continue to provide an alternative execution mechanism for investors and believes that, ultimately, investors will demand to have their orders sent to an open, fair and reliable market such as Island. This decision, however, must be left to investors.
B. CLOB versus Competition
In light of the rapid pace of change of our equities markets, Island believes that the adoption of rules that would dictate where and how orders must be executed solely to address theoretical concerns would unnecessarily risk the future of our capital markets. Island believes that there are only two theoretical approaches with respect to the proper path for the future. First, the Commission could oversee the development and operation of Consolidated Limit Order Book ("CLOB") on which all market participants would be required to place their limit orders. This system would have the benefit of centralization but the detrimental effect of eliminating innovation driven by competition between markets. In the alternative, the market could be structured to facilitate competition between multiple market centers. This system would have the benefits of competition but also have some degree of fragmentation. Although, it is likely that, if competition is unleashed, order flow will eventually gravitate to one venue. Island strongly supports the latter view.
Implicit in the Concept Release, however, is a belief in the existence of a compromise between the opposing approaches. It is assumed that a "middle of the road" approach will reduce the level of fragmentation while still retaining some of the benefits of competition. In fact, however, any proposal that requires time or price priority between markets creates the functional equivalent of a CLOB and therefore has the same anti-competitive effects of a CLOB. In the most restrictive form of priority, inter-market price/time priority, each marketable order must be routed to the market first to display the best price. While attractive in theory, price/time priority would eliminate the basis for competition between markets. This point is best understood through an example:
Assume that ECN A is a market that provides its members with the fastest and most reliable trading system in the industry. In addition, assume that Traditional Market B utilizes obsolete technology that lacks adequate capacity. If, under a regime of price/time priority, Market B is the first to display the best offer of $100 in stock XYZ, any order to buy XYZ at $100 received by ECN A must be routed to Traditional Market B - despite its inferior technology. Under price/time priority, ECN A would be required to route the order to Market B regardless if it also had an order to sell at $100. Thus, even if an investor, or its fiduciary, chose to send the order to ECN A to take advantage of its superior speed of execution, ECN A would be required to route the order to Traditional Market B. Thus, ECN A would be completely dependent on a response back from Traditional Market B in order to fill its members' order.
Four main points are illustrated by this example:
1) It is impossible for ECN A to offer a faster execution or better service in its competition with Traditional Market B, since Market A will always be dependent on Traditional Market B for execution and vice versa.
2) ECN A and Traditional Market B are dependent on the linkage between them and therefore cannot offer service any faster or more reliably than permitted by the linkage.
3) In light of the first two points, investors will become insensitive to which market the order is entered, leaving no basis for competition between markets.
4) Inter-market priority regulations prevent the fiduciary from making order routing decisions that are in the best interests of its customer.
In summary, not only do price or time priority regulations prevent markets from competing on any basis besides price, but price or time priority regulations actually undermine the very technological breakthroughs that have strengthened our Nation's equity markets and improved execution quality.
C. Trade-Through Rule
Island believes that the market for NYSE listed stocks demonstrates the anti-competitive effects of inter-market priority rules. Specifically, pursuant to the more than 25 year-old Intermarket Trading System ("ITS") Plan, each participating market is prohibited from trading at a price inferior to a price displayed in another market. This is known as the trade-through rule and this concept is supported by most of the traditional market participants. Pursuant to the trade-through rule, the market receiving the order must match a better price available in another market or route the order to the other market for execution.
While attractive in theory, it has not worked in practice. First, under the ITS Plan the receiving market has up to one minute to respond to an incoming order. Thus, the unfortunate customer whose order is routed to the other market for the "better" price may have to wait up to one minute and still not even receive an execution. Second, as described in the example above, requiring orders to be routed to another market makes both markets dependent on each other and inhibits competition. Finally, the trade-through rule assumes that price is the only factor in determining where to route an order. Presumably, nobody would support Congressional legislation requiring everyone that orders a book on-line to only order the book from the web-site with the best price. Most consumers would also correctly consider the integrity of the site and the probability that they would actually receive the book when selecting a site to order from. Similarly, by requiring an order to be sent to the market solely on the basis of price, the trade-through rule is inconsistent with the freedom of choice as well as a fiduciary's duty of best execution. Market participants should be free to assess the market and use their own judgment in routing orders in the best interests of themselves or their customers.
The promoters of a trade-through rule assert, however, that it is necessary to protect customers. It is claimed that absent the rule, unwary customers would not receive the best price. Interestingly, the Nasdaq market does not rely on a trade-through rule. Island is unaware of any widespread dissatisfaction among investors with their executions in Nasdaq securities. Further, the Commission has not presented evidence that customers are receiving inferior executions on Nasdaq. If investors were consistently receiving inferior executions outside the National Best Bid or Offer on Nasdaq, one would expect, especially given the increasing number of sophisticated customers that have access to real-time quotes and trade Nasdaq stocks literally hundreds of times a day, to have heard about such a problem. In addition to the trend toward increasingly more sophisticated customers, the reason that customers continue to receive quality executions is that brokers have a common law duty as a fiduciary, to provide their customer best execution. This fiduciary duty operates above any government imposed inter-market routing scheme. In light of this well-established duty to achieve best execution for their customers, the trade-through rule is unnecessary. Therefore, the trade-through rule must be eliminated.
Rather than protecting investors, the trade-through rule actually harms investors and the markets in general. By inhibiting competition, the trade-through rule, along with the entire Inter-market Trading System, has retarded the development of the listed market. For example, many of the sophisticated trading tools available for Nasdaq stocks simply do not exist for listed stocks. One reason that the NYSE has grown more slowly than Nasdaq is because NYSE stocks are just too cumbersome to trade. It is not only, as many may assume, due to the lack of technology stocks on the NSYE. The slow executions, absence of transparency, and the lack of alternative sources of liquidity cause many market participants to avoid trading listed stocks.
D. Island's Plan to Promote Competition
As Island has indicated several times throughout this comment letter, the best way to address the concern that the repeal of NYSE Rule 390 will increase fragmentation and the level of internalization is by promoting unfettered competition. To foster competition in the listed market, Island believes that the National Market System must be re-structured to allow innovative new markets, such as ECNs, to compete with the traditional market centers. The regulatory barriers that currently prevent ECNs from displaying their orders in the National Market System must be eliminated.
To facilitate the implementation of the Order Handling Rules in 1997, the Commission ensured that Nasdaq expeditiously made the system and rule changes to integrate ECNs into the Nasdaq market. Without the Commission's strong leadership, it may have taken ECNs years to be successfully integrated into the Nasdaq market.
The time has come for the Commission to again ensure that the necessary steps are expeditiously taken to integrate ECNs into the listed market. In the Approval Order for the Order Handling Rules were adopted in 1996, the Commission stated:
In order to ensure prompt implementation of the necessary changes before the effective date of the rule amendments, the Commission requests each SRO, individually or jointly as signatories to the CQS Plan, to notify the Commission in writing by [insert date 45 days from the date of publication in the Federal Register] regarding its willingness and its plan to afford ECNs the opportunity to communicate, for inclusion in the public quotation system, the prices of market makers and specialists.
In order to implement the changes to the Quote Rule under new subsection (c)(5), the prices sent to an ECN by market makers and specialists will have to be displayed in the public quotations disseminated by SROs, and order routing or access linkages will have to be in place. After hearing from the SROs, the Commission will determine whether it will be necessary to use its authority under Section 11A(a)(3)(B) of the Exchange Act to require the SROs to act jointly to provide means to accomplish these objectives.
Island is unaware of any submissions by the affected SRO's with respect to listed securities. To this day, the ECNs still do not have their quote reflected in NYSE listed securities and the Commission has yet to act. The main reason that ECN quotes have been unwilling to participate in the existing system is that the rules, governance structure and technology underlying ITS are anti-competitive. Given the fact that even Chairman Levitt has called ITS "obsolete," ECNs should not now be forced to link to a system that negates the advantages of ECNs and that has retarded competition in the listed market. Investors have waited three years for changes to be made to allow ECNs to bring their fairer, more efficient, and transparent trading environments to listed securities. They should not have to wait much longer.
To bring the benefits of ECNs to the listed market, the Commission must allow ECNs to immediately begin reflecting their best bid and offer on CQS through the Nasdaq market. An identifier can be assigned for each ECNs' quote that is disseminated through CQS. When an ECN is the best bid or offer in the National Market System, participants in other markets may access that bid or offer by either becoming a direct subscriber to that ECN, or by contacting the phone desk of the ECN.3 While direct access would be more efficient, the phone desk would provide access at least as good as currently provided by ITS. To reduce the burden on traditional markets, the trade-through rule would be made inapplicable with respect to ECNs. ECNs must also be able to trade-through the quotes of other markets.
Island believes that these immediate steps would further the goals of the National Market System by fostering competition between markets and increasing the amount of quotation information available to investors. More importantly, after more than 25 years since the creation of the National Market System, investors will finally have the benefit of true quote competition in the listed market. The inclusion of ECN quotes would also reduce fragmentation of the listed market that exists today since ECN quotes are specifically excluded from the National Market System. Currently, if an ECN has a better quote in a listed security, investors would be denied the opportunity to view that quotation. This represents pure fragmentation that the National Market System was created to eliminate.
While Island believes that our proposal will facilitate competition and transparency in the short term, a long-term solution is necessary for re-structuring the National Market System. Island believes that the Commission should simply give advance notice of the termination of operation of the ITS linkage. Although well intentioned, ITS has only served to protect the current market structure and has precluded the introduction of faster more efficient private sector solutions. By providing advance notice, the Commission would signal to the industry that there will be a need for the development of software and routing technology to access markets for listed securities. Island is confident that a number of companies will rush forward to develop the necessary systems in a relatively short period of time. The Commission could monitor the development efforts and simply terminate ITS when the new linkages are in place. The elimination of ITS would also result in the abrogation of the trade-through rule and the disbanding of a dysfunctional governance structure. In the ashes of ITS will rise a number of private solutions that will bring an unprecedented level of competition and transparency to the listed market.
During the past three years, we have seen an unprecedented level of change in our Nation's equity markets. Through dramatic improvements in technology, the market has become more accessible to all investors. The Commission must continue to adhere to the principles that have led to the strength of our markets and our Nation. Competition, and not regulation, must determine the future of our markets. The role of the Commission, as articulated by Congress in 1975, is to promote competition and transparency. Rather than adopting rules that mandate how orders are executed by market centers, the Commission must foster competition in the listed market by giving ECNs the immediate ability to post quotations in listed securities. The resulting competition will not only address the concerns raised by the Commission in the Concept Release but will lead to the creation of a robust and vibrant market that is far more efficient and fair than any regulator, academic or comment letter writer could have ever anticipated.
The Island ECN, Inc.
cc: Honorable Arthur Levitt, Jr.
Honorable Norman Johnson
Honorable Isaac C. Hunt, Jr.
Honorable Laura S. Unger
Honorable Paul R. Carey
1 Testimony of Chairman Alan Greenspan, "Evolution of our Equity Markets," Before the Committee on Banking, Housing, and Urban Affairs, US Senate, April 13, 2000.
3 Island notes that Nasdaq's ITS/CAES linkage was recently upgraded to allow for "order delivery." It remains to be seen, however, if all the technical changes necessary to accommodate ECNs will be successfully implemented.