January 22, 2001
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, NW
Washington, DC 20549-0609
Re: File No. SR-PCX-00-25
Dear Mr. Katz:
We appreciate the opportunity to comment on the captioned proposal of the Pacific Exchange ("PCX"). Nasdaq believes that this proposed rule filing raises serious concerns that, if not properly addressed, could undermine the statutory framework under which United States self-regulatory organizations ("SROs") currently operate. The PCX proposal undercuts the statutory framework for exchange registration. It also raises clear challenges to the regulatory structure for the trading of national market securities, including Nasdaq securities. Moreover, it is anticompetitive in that it actively mandates the use of a monopolistic broker-dealer. The proposal also strains the commonly understood definition of exchange, and it ignores the need for consolidated audit trail information and coordinated market surveillance. If the Commission approves the PCX rule filing without substantial revisions that are exposed for public comment, we believe that investor protection and fair competition in the United States securities markets will diminish.
Nasdaq wishes to emphasize at the outset that it concurs with earlier Commission statements that ECNs should be afforded the opportunity to operate as either brokers or exchanges, whichever model they choose. If they choose to operate as exchanges, however, it is imperative that they be required to satisfy the same regulatory standards that apply to other exchanges, including following the same procedures for becoming an exchange. 1 Nasdaq's views in this regard are not new.
As we noted in our October 10, 1997 comment letter on the SEC's ATS Concept Release:
We are concerned that the proposed tiered exchange approach is likely to promote a multiplicity of "ATS exchanges" and that such "ATS exchanges" will be subject to varying levels of regulation and oversight. Of particular concern is the possibility that multiple exchanges with varying levels of regulatory responsibility will create regulatory fragmentation that will be harmful to investors and will not promote fair markets.
For markets such as the Nasdaq Stock Market, where there is unified regulation and surveillance, introducing regulatory fragmentation would as a general matter threaten to create disparate enforcement standards (a regulatory race to the bottom), gaps in regulatory coverage, and increased costs resulting from the inability to continue to take advantage of economies of scale in developing and operating necessary enforcement, examination, and surveillance mechanisms and systems. In addition, we believe that the tiered exchange approach would subject regulated markets to an unfair competitive disadvantage while at the same time imposing unnecessary costs on ATSs, thus discouraging innovation by both fully regulated markets and ATSs.2
Yet, it is just this type of "exchange light" approach that PCX/ARCA is asking the SEC to revisit. In short, PCX proposes to eliminate its specialist-based system for equity securities and replace it with a competing market maker system to be operated by Archipelago Exchange L.L.C., which appears to be a wholly owned and heretofore unregulated subsidiary of Archipelago Holdings, L.L.C., itself an unregulated entity, pursuant to contracts the terms of which remain largely undisclosed. In effect, PCX invites the SEC to perform a type of regulatory alchemy by taking this patchwork of commercial contracts among PCX and an unregulated consortium of entities and turning it into a registered "exchange light" through the wholly inappropriate means of the SRO rule review process. Nasdaq strongly urges the SEC to reject this invitation.
Our concern with PCX/ARCA's avoidance of the statutorily required exchange registration process is not merely a complaint about form over substance. Because the proposal was improperly filed as an SRO rule filing the proposal provides insufficient information about the new exchange to permit interested parties to comprehend what is actually being proposed. Every other exchange, or proposed exchange, has been required to fully document its plans and structures and subject them to public comment and SEC scrutiny that is informed by meaningful comment.3 We contend that fundamental fairness demands nothing less of this proposal. Otherwise, the SEC would simply be allowing this new exchange to "slip in through the back door" and would be encouraging other prospective applicants to pursue this shortcut approach. 4
Should the SEC decide that the exchange registration process is no longer necessary to confer exchange registration status on an unregulated entity, however, an outcome we believe is wholly outside of the letter and spirit of the Exchange Act, as discussed below, we contend that the type of hybrid exchange that the ARCA Consortium proposes to develop (which is to say, one that is in effect, part ECN and part bulletin board) as well as its proposed regulatory structure, fall short of Exchange Act requirements for registered exchanges in several material respects.
PCX/ARCA is Short-Circuiting Exchange Registration through the SRO Rule Filing Process
As the SEC is well aware, in August of 1999, the ARCA Consortium filed a Form 1 with the SEC to establish as a registered securities exchange, Archipelago Securities Exchange, L.L.C. The system proposed in that application is substantially similar to the one that the ARCA Consortium now proposes to retrofit to PCX's specialist regulatory structure. That Form 1, although still pending with the SEC, was never published in the Federal Register. Now, however, perhaps to avoid SEC staff scrutiny and public comment regarding the original Form 1, ARCA has chosen for strategic business reasons to align itself with a registered exchange in the hope that it can achieve its ultimate goal of operating as an exchange without following the regulatory means that the SEC has mandated for this purpose (i.e., the Form 1 process). Although it is unclear whether ARCA will win this regulatory gamble by receiving truncated treatment of its exchange registration application, what is clear is that if it is permitted to do so, the investing public will be the ultimate loser.
One need only look at the current PCX equity market to understand why in substance, although not in form, the ARCA Consortium is asking the SEC to register a new exchange. Through its history PCX has operated a floor-based specialist market and as a result, its current rules, surveillance systems, capital structure, and regulatory expertise are focused solely on that type of market structure. The PCX/ARCA proposal would entirely eliminate PCX's competing specialist system and replace it with a competing dealer market - a type of market over which PCX has no expertise. This is not to say that had PCX chose to establish a competing dealer market sua sponte it could not have done so by amending its own Form 1 and making the necessary Rule 19b-4 filings. We believe that that would have been appropriate. Moreover, had PCX acquired ARCA it could have established it as a facility of PCX through the same process.5 Furthermore, had the SEC approved ARCA's Form 1, ARCA could have, as contemplated by Regulation ATS, contracted out its regulatory responsibilities to PCX or to another registered exchange or association with which it chose to affiliate itself, although ARCA itself would have been ultimately responsible for the regulatory decisions made on its behalf. What ARCA cannot do consistent with Section 6 of the Exchange Act is operate as a registered exchange under the auspices of the Pacific Exchange with no more regulatory cover than a commercial contract and a PCX Rule 19b-4 filing.6
A brief analysis of the PCX/ARCA proposal will shed light on the regulatory concerns that such an arrangement raises. As proposed,
[t]he PCX and PCXE have entered into various agreements with Archipelago Holdings, L.L.C., under which Archipelago Exchange, L.L.C., a subsidiary of Archipelago Holdings, L.L.C., would operate Arca as a facility of the PCXE. Pursuant to these agreements, PCX and PCXE would maintain responsibility for all regulatory functions related to the facility and Archipelago Exchange, L.L.C., would be responsible for the business of the facility to the extent those activities are not inconsistent with the regulatory and oversight functions of PCX and PCXE.
Pursuant to these agreements, the books, records, premises, officers, directors, agents, and employees of Archipelago Exchange would be deemed to be those of PCX and PCXE for purposes of the Exchange Act. The officers and directors (although not the agents, premises, books or records) of Archipelago Holdings would be deemed to be those of PCX and PCXE for Exchange Act purposes.
Although in theory, such an arrangement sounds almost as good as true regulation, on further analysis the arrangement raises many more questions than it answers. For instance, because the proposal is filed as a Rule 19b-4 proposal as opposed to a Form 1, there is no way to determine who the officers, directors, agents or employees of Archipelago Exchange and Archipelago Holdings might be, not to mention where their books, records and premises might be located.
It also is unclear from the proposal whether the broker-dealer affiliate of Archipelago Exchange (referred to in the Routing Agreement as "WAVE") and the only permissible means of routing orders to other markets, would be covered by this contractual "safe harbor." If WAVE is covered, certainly (although not addressed in the filing) any fees it charged and the rules governing its trading and order routing requirements would be deemed to be those of PCX and therefore subject to the Rule 19b-4 rule filing process. What is less clear is how this broker-dealer that presumably would be deemed to be an agent of a registered exchange for Exchange Act purposes would itself be regulated. It is unfathomable that such an entity could be regulated by the PCX due to the many direct conflicts of interest such an arrangement would raise. Yet, it is not at all clear how WAVE might be regulated by the NASD, the other logical choice. WAVE would be in a monopoly position because it would be the only permissible means through which a customer that chose to route its orders to ARCA could receive a better price offered by another market. As a result, WAVE could charge monopoly fees for performing the routing service. Yet, as a broker-dealer, wouldn't WAVE be subject to the same best execution obligations as other broker-dealers? How could the NASD be expected to oversee potential best execution violations by WAVE when doing so might be seen as overreaching by a competing market?
Furthermore, as discussed above, by contractual arrangement, PCX and PCXE would maintain responsibility for all regulatory and oversight functions related to the facility and Archipelago Exchange, the unregulated affiliate of the unregulated Archipelago Holdings, would be responsible for the business of the facility "to the extent those activities are not inconsistent with the regulatory and oversight functions of PCX and PCXE." This provision begs the following questions: (1) who determines whether any aspect of the business of operating an exchange is consistent or inconsistent with the regulatory and oversight functions of that exchange and (2) what is the regulatory impact of such a decision? For instance, presumably the day-to-day operation of the Archipelago Exchange would be deemed to be a business function under the PCX/ARCA agreement to be performed by Archipelago Exchange. What happens if PCX breaches the contract? Must Archipelago Exchange continue to fulfill its contractual duty to operate the market or may it cease to do so? What if the contract is voided by material breach or illegality and Archipelago Exchange continues to operate the market? Is it then subject to SEC enforcement action for operating an unregistered and unregulated exchange?
Moreover, what regulatory protections are in place to restrict overreaching by the agents and employees of Archipelago Holdings, which are not even subject to a commercial regulatory contract with PCX? Since neither Archipelago Holdings' agents, premises nor records are covered by the commercial contracts between PCX and the ARCA Consortium, does this mean that there is nothing prohibiting this unregulated holding company, which has an undisclosed but presumably substantial interest in Archipelago Exchange, from operating a shell in a jurisdiction outside the reach of the U.S. federal government? The rule filing does not address this issue, of course, but nothing, we contend, would prohibit it. Suppose the SEC suspected the employees of Archipelago Holdings headquartered in this unreachable jurisdiction of violating U.S. securities laws while performing business functions related to the operation of its affiliate, Archipelago Exchange and evidential records are stored outside the reach of the SEC. Does the SEC's Enforcement Division have any authority to order those employees to produce those records or must it rely on the good graces of the foreign jurisdiction's authorities for assistance? Could there be dual employees of Archipelago Holdings and Archipelago Exchange? Would their regulatory treatment differ from those employed solely by either Archipelago Exchange or Archipelago Holdings?
These unanswered questions suggest to us that there is a regulatory gap in the ownership structure of the proposed new exchange. We ask that the SEC eliminate this regulatory gap prior to approving this exchange application. We believe that this issue may be remedied by requiring PCX to obtain full ownership and control over the ARCA Consortium (including all employees and agents of Archipelago Holdings) or by requiring the ARCA Consortium itself to register as an exchange through the proper regulatory channel (i.e., the Form 1 process), at which time it could properly contract with PCX, or any other SRO, to perform its regulatory obligations.
PCX's Regulatory Structure is Statutorily Deficient for the Market it Proposes to Regulate
Even if the SEC does not require the ARCA Consortium to seek exchange registration through the Form 1 process, we contend that the fundamental changes in the regulatory responsibilities of PCX proposed in the filing require a de novo assessment of PCX's rules to meet the obligations it has contracted to fulfill. We believe that such a review will convince the SEC that the regulatory structure that PCX proposes for ARCA's competing dealer market structure is statutorily inadequate. Therefore, the SEC should require material revisions to the proposal prior to approval or, we contend, it will create the risk of a regulatory race to the bottom by providing an incentive for broker-dealers to flock to the market with the least stringent regulation.
PCX's Proposed Rules Would Codify an Anticompetitive Market Structure
Section 6 of the Act requires that all exchanges have rules designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to refrain from imposing any unnecessary or inappropriate burdens on competition, among other things. Yet, PCX has contracted to regulate a market structure that requires all participants to use a single broker-dealer to route orders to other markets. We contend that such a market structure is facially anticompetitive and therefore its runs afoul of Section 6 of the Act. Ironically, the Archipelago ECN has prided itself on its innovative "smart" routing algorithms and yet it has designed a market structure that precludes others from creating innovative means for routing orders outside of the Archipelago Exchange to other markets.7 What is more disturbing is that PCX, which, as an SRO, has quasigovernmental powers, is now asking the SEC to codify this anticompetitive market structure before regulatory safeguards have been put in place to ensure that ARCA's broker-dealer affiliate does not abuse its monopoly power. Indeed, should the SEC approve the proposal as filed, it would be authorizing and in fact requiring the PCX to enforce this anticompetitive structure.
A simple scenario should prove informative in highlighting the concerns raised by this issue. Assume that the SEC approves the PCX proposal and another ECN (through its affiliated broker-dealer) wishes to become an Equity Trading Permit (ETP) holder. Assume also that the other ECN itself has developed sophisticated order routing programs and established its own linkages that it wishes to use instead of those required by the ARCA broker. If this other ECN, as a PCX ETP holder, routes through its own linkages it risks an enforcement action by PCX for a violation of PCX rules. Such a possible result would have a chilling effect on innovation and therefore, in Nasdaq's view, the PCX rules on this issue, impose an unnecessary and inappropriate burden on competition in violation of Section 6(b)(5) of the Exchange Act.8
The Absence of OATS for ARCA Exchange Encourages Regulatory Arbitrage
As the Commission is aware, the NASD has adopted a comprehensive Order Audit Trail System ("OATS") that greatly assists the NASD as well as the Commission in surveilling trading and assessing execution quality by NASD members in the Nasdaq Stock Market. Under OATS, NASD members are required to record and report to the NASD information about orders received, originated, transmitted, modified, canceled, or executed. OATS is intended to bolster the NASD's efforts in surveilling broker-dealers' trading activity and its enforcement of investor protection rules, which helps maintain the integrity of the Nasdaq Stock Market. In addition, the NYSE is in the process of developing an order audit trail for its market.
We contend that in mandating the NYSE and NASD to develop such systems the Commission was inherently expressing the position that it is no longer practicable for SROs to adequately regulate their markets without such important regulatory tools. This contention is supported by statements in the SEC release adopting Regulation ATS in which the Commission noted that "[a] registered exchange would also be expected to maintain an audit trail of trading."9 Indeed, we would argue that an order audit trail has become the de facto industry standard for market regulation. Yet, OATS does not capture trading information for orders of non-NASD members (including UTP exchanges) and provides only limited information regarding orders that are routed from NASD members to non-members. As a result, we believe that there may be a regulatory gap with respect to some of the trading that could occur on the proposed ARCA Exchange. Therefore, we contend that the absence of a comprehensive order audit trail system in the PCX proposal to capture those orders in Nasdaq securities that are executed on the proposed ARCA Exchange but that are not captured through OATS indicates that PCX's proposed regulatory structure is insufficient to oversee the market structure it has contracted to regulate.
As discussed above, PCX's current regulatory structure for trading in equity securities is designed to address regulatory issues that could arise with respect to a floor-based specialist system. It is woefully inadequate, however, for the modified market structure and aggressive expansion Plan foreseen by ARCA. As the Commission knows, PCX has recently requested that the SEC expand the number of securities that would be eligible for trading pursuant to unlisted trading privileges to include all Nasdaq National Market Securities. Considering that PCX currently trades no Nasdaq securities pursuant to UTP privileges and that ARCA ECN currently trades nearly 3000 Nasdaq stocks, we think it is fair to assume that ARCA Exchange could greatly increase PCX's trading volume in Nasdaq securities while greatly increasing PCX's regulatory duties for surveilling this increased trading.10 In the absence of a comprehensive order audit trail system or integration of ARCA Exchange orders into OATS, we do not believe that PCX's regulatory structure is statutorily sufficient to fulfill its SRO obligations under the Exchange Act.11
Commission staff recently announced that it is investigating potential abusive quoting behavior by market participants that allegedly entered fictitious orders in Nasdaq securities and subsequently cancelled them intending to drive up stock prices and profit from the moves. Given that such abusive behavior could occur on any market where Nasdaq securities are traded it is essential that all such markets be operated under a level regulatory playing field to avoid creating a safe haven for abusive trading activity in the market with the most lax regulation. Otherwise, the greatly varying regulatory structures in the Nasdaq and ARCA markets would encourage regulatory arbitrage between ARCA and Nasdaq, which could undermine the national market system goal of promoting fair competition among trading markets. Therefore, we ask that the Commission require PCX/ARCA to work with the NASD to develop a regulatory framework to ensure that trading on the proposed ARCA Exchange is subject to the same audit and examination standards as are orders that are captured by OATS.
PCX Governance is Inadequate to Diminish Conflicts by its Affiliates
Furthermore, PCX's proposed governance structure lacks necessary safeguards to ensure that PCX/ARCA's affiliates do not receive preferential treatment over ETP holders. For example, it does not appear that the PCX regulatory arm will be segregated from the market operation arm of PCX/ARCA. The proposal provides no apparent mechanism for ensuring that the ARCA Exchange will be precluded from using the information that it collects in its capacity as a regulator to gain a competitive advantage over its users. The proposal also does not address what limitations will be placed on the business activities of WAVE, ARCA's affiliated broker-dealer. For instance, as a broker-dealer, WAVE presumably could trade proprietarily. If this were the case, being the central consolidator for all orders routed from PCX to other markets could place WAVE at a competitive advantage over other market participants.
Even if WAVE is permitted only to route orders, which is a function performed by many service bureaus, the SEC would certainly want to ensure that PCX had adequate safeguards in place to guarantee that other service bureaus were not placed at a competitive disadvantage. For example, without adequate safeguards, WAVE could use the information flowing through it to advise its customers about the order flow destinations of those customers' competitors, which, obviously, is very valuable information. We contend that PCX/ARCA should be required to eliminate the requirement that WAVE be the only means for routing orders to other markets and that PCX/ARCA be required to adopt safeguards to ensure that WAVE does not have a competitive advantage over other entities that might wish to offer routing services for PCX ETP holders.
The proposal also does not address whether ARCA ECN will continue to exist once the PCX proposal takes effect. If ARCA ECN continues to operate as a Nasdaq market participant, what would its relationship be with PCX and the ARCA Consortium? For example, could PCX/ARCA ETP holders receive preferential treatment (such as a waiver of the access fee) for orders that they routed to ARCA ECN?
Moreover, we urge the Commission to require PCX/ARCA to adopt a plan that clearly specifies which core entity will be delegated decision making responsibility for market operations, regulation, and corporate actions. Like the NASD Plan of Allocation of Functions to Subsidiaries, we believe that such a delegation plan is required by statute since PCX is the SRO of record but it appears to be delegating functions to corporate affiliates and other entities.
PCX/ARCA's Lack of Guaranteed Liquidity Strains Exchange Act Fair and Orderly Market Standards
Nasdaq believes that the proposal is inconsistent with the investor protection requirements of Section 6 of the Act and the principle of fair and orderly markets in Section 11A of the Act because the proposed PCX rules do not require that a market maker be assigned to each security traded on the proposed ARCA Exchange.
Perhaps the most fundamental requirement of a securities exchange is that it provide a ready source of liquidity to the buyers and sellers that it brings together. Recognizing the importance of this concept, to date each equities market in the United States has promulgated rules to require that a market maker or specialist be assigned to each security listed on that market and in effect act as the liquidity provider of last resort. In addition, each market has imposed stringent requirements on the assigned specialist or market maker to ensure that they meet their obligation to provide a regular source of liquidity.12 The basic purpose of these rules is simple -- to ensure that, particularly during times of market stress or volatility, there is always a well-capitalized broker-dealer (i.e., market maker or specialist) that is ready and willing to execute investor orders at the prevailing market price. In Nasdaq's view, PCX's proposal not to require that a market maker be assigned to each security traded on the ARCA Exchange is a clear statutory deficiency and in turn raises serious market quality and investor protection concerns, which the Commission has recognized in other contexts in the past.
For example, in its report following the 1987 Market Break the Commission staff analyzed the performance of the market and market participants during a period of extreme market stress and significant market decline.13 The Market Break Report found that during this period of downward market movement, many NASD market makers withdrew from their markets, widened spreads, reduced their depth of market, were not reachable by telephone, and withdrew from Nasdaq's Small Order Execution System (SOES). In response to these and other findings, the NASD implemented several changes to its rules and systems, such as limiting the type of acceptable reasons for excused withdrawal, increasing the penalty for unexcused withdrawal, and requiring that market makers participate in SOES. These improvements were intended to ensure that investors have a ready and accessible source of liquidity in Nasdaq stocks in good times and in bad. In our view, the Exchange Act demands nothing less.
Now, PCX/ARCA is proposing to become a significant player in the market for Nasdaq securities. Yet it offers few of the safeguards that the NASD has implemented and that the SEC found so crucial to guarantee liquidity in the event of a market downturn or excess volatility.14 Indeed, PCX/ARCA is proposing to permit trading in stocks where there is no guaranteed source of liquidity. Perhaps PCX/ARCA assumes that its users will always be able to access liquidity through Nasdaq or the NYSE in times of market stress. While this may be true, we do not believe that it frees PCX/ARCA from its own obligation to adopt rules that ensure the maintenance of a fair and orderly market in all stocks that are trading on that market. In practical terms this means requiring that market professionals provide a ready source of liquidity. Anything short of that requirement would allow registered exchanges to operate simply as bulletin boards, a result that short changes investors and one that Congress certainly did not intend in adopting Sections 6 and 19 of the Act.15
PCX/ARCA Order Types Raise Quote Rule, Best Execution and Denial of Access Concerns
Certain ARCA order types proposed in the filing raise regulatory issues. The ARCA proposal would permit market participants to enter "discretionary orders" into the system. A discretionary order is defined as "an order to buy or sell a stated amount of a security at a specified, undisplayed price (the discretionary price) in addition to at a specified, displayed price." As the Commission intimates in the Solicitation of Comments section of the proposal, under certain circumstances, the undisplayed portion of a discretionary order could violate the Quote Rule if the undisplayed price represents the broker-dealer's best price.
Furthermore, as discussed above, we believe that the requirement that all users of the ARCA Exchange enter into a Routing Agreement under which they agree to use the ARCA-affiliated broker-dealer to route orders outside of the ARCA system is facially anticompetitive, but it also raises other regulatory issues. Users of the system that choose not to enter into a Routing Agreement are precluded from entering all but a few order types. As discussed in the filing, "if an ETP Holder has not entered into a Routing Agreement, the ETP Holder and its Sponsored Participants could submit to ARCA only Fill-or-Return, Fill-or-Return Plus or PNP Orders." All of these order types require that the portion that can be executed on the ARCA Exchange be executed and the remainder be either cancelled (for the Fill-or-Return and Fill-or-Return Plus orders) or posted on the ARCA book (for the PNP or " Post No Preference" orders). Under no circumstances, may any portion of these orders be routed to another market, even if that other market is showing a better price. In our view, this sort of parochial order type greatly reduces the likelihood that the customer will receive best execution by requiring that the orders be cancelled and reentered through another means (e.g., through a broker-dealer that is authorized to route orders outside of the ARCA system) or posted on the ARCA book, where, depending upon the liquidity in that particular stock (and remember, there is no guarantee of liquidity for any stock in the ARCA Exchange), it may have a limited chance of ever being executed.
If our reading of the proposal is correct, ETP holders that do not agree to use ARCA's monopoly intermarket linkage could not even enter Primary Only Orders (i.e., market orders for exchange-listed securities that are routed as market-on-open orders to the primary market for participation in the primary market opening process). In our view, the very existence of Primary Only Orders suggests that the ARCA Exchange anticipates providing little if any liquidity at the opening. Yet, it would preclude its users from accessing the primary market at the opening (at least with respect to exchange-listed stocks) unless they agree to use ARCA's monopoly linkage facility. In our view, such a regulatory framework all but precludes this category of users from receiving a fair price for their customers' orders, which in turn raises the question of whether any broker-dealer can afford to choose this membership alternative in light of its best execution duties. Moreover, even if a broker-dealer can fulfill its best execution responsibilities while being subject to these onerous restrictions, we contend that PCX/ARCA's proposed order limitations effectively amount to a denial of access of exchange facilities to a class of its members. We believe that the only way to remedy this problem is to eliminate not only the Routing Agreement requirement but also to remove all order restrictions from those members that choose not to use the ARCA- affiliated broker-dealer to route their orders to other markets.
The Proposal Fails to Detail PCX's Regulatory Interaction with other Markets
Aside from short comings in its own market structure we also do not believe that PCX has sufficiently analyzed how its new market will interact with other markets. We believe that PCX has not, for example, adequately considered how the ARCA Exchange will be integrated into the national market system. For example, the proposed rule change does not appear to mandate adherence to the Intermarket Trading System ("ITS") rules during the pre-opening session. Moreover, there are certain aspects of ARCA's proposed market structure that raise unique questions with respect to PCX's participation in ITS generally. For instance, it is Nasdaq's position that ITS requires that participant markets maintain continuous two-sided quotes in those securities that are subject to the Plan, yet ARCA Exchange does not require that a market maker be assigned to all securities that are to be traded on the ARCA Exchange. As a result, it would appear that PCX/ARCA could not participate in ITS for those securities. If that is the case, then alternative means would need to be put in place to permit intermarket access for these securities. Although the ITS participants have begun exploring this and other issues, these issues have yet to be resolved. The resolution that PCX proposes may raise additional issues upon which the public deserves an opportunity to comment.
Another unresolved intermarket issue concerns the need to promote the integrity of market data across markets. The Intermarket Surveillance Group, which coordinates the exchange of market data among SROs, was intended to address these issues and, we contend, should be tasked with the responsibility of analyzing data integrity issues likely to arise from the PCX/ARCA affiliation. Therefore, we request that the Commission direct PCX to coordinate with other markets to address the many intermarket issues that the proposal raises before approving it.
* * *
Nasdaq again wishes to thank the Commission for this opportunity to convey to it its preliminary thoughts on the ARCA exchange application. As expressed above, we believe that it is incumbent upon the Commission to ensure that interested market participants be given a full and fair opportunity to comment on ARCA's proposal. In our view, the only means to accomplish that goal is to require ARCA to file a Form 1 discussing not only its proposed contractual relationship with PCX (which is the purpose of this filing) but also other fundamental issues such as its proposed governance and financial well-being (and that of PCX). Should the Commission decide not to require such a filing, we hope that the SEC will at least acknowledge the regulatory deficiencies in the current proposal and direct PCX/ARCA to submit a substantial amendment and give the public an adequate opportunity to comment on it.
Richard G. Ketchum
cc: Annette Nazareth, Director, Division of Market Regulation
Robert Colby, Deputy Director, Division of Market Regulation
John Polise, Senior Special Counsel, Division of Market Regulation
David Becker, General Counsel
|1||In the ATS Concept Release, the Commission explored the possibility of creating a new category of exchange under which ATSs could operate as exchanges without being subject to the full panoply of regulations that apply to traditional exchanges. In the release proposing Regulation ATS, however, the Commission decided not to pursue this tiered approach to regulation, in part, because it believed it would be required to draw arbitrary regulatory lines that could result in virtually identical systems being subject to different regulatory requirements. We believe that the Commission was right to abandon this "exchange light" concept, but caution that if it approves the PCX/ARCA proposal as filed it will in effect be reviving this aborted concept and inviting prospective exchanges to use it.|
|2||Letter from Joan C. Conley, Secretary, NASD, Nasdaq, NASD Regulation, to Jonathan G. Katz, Esq., Secretary, SEC, dated October 10, 1997.|
|3||The most recent case in point is the Nasdaq's SuperMontage proposal which was recently approved by the SEC after a year and nine amendments. In commenting on the proposal at the open Commission meeting in which the proposal was approved the SEC commissioners shared the uniform view that a full and open comment process, which, for SuperMontage, included a number of different opportunities for public comment, ultimately improved the proposed system. In this regard, we would like to reiterate our objection to the Commission's denial of Nasdaq's written request to extend the period for commenting on this proposal. We believe this proposal is extremely complicated and raises a number of regulatory issues that deserve more than the standard 21-day comment period, which, coincidentally, ran over the Christmas and New Year's Holiday.|
|4||We do not question the SEC's discretion to interpret the rules that it administers in a manner that is not arbitrary, capricious, or manifestly contrary to the statute. See U.S. v. O'Hagan, 521 U.S. 642 (1997), citing Chevron v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). We do think it is incumbent upon the Commission, however, to state its reasons for requiring certain exchange applicants, such as Nasdaq, to pursue the more burdensome Form 1 process, while permitting others, such as ARCA, to use the less burdensome Rule 19b-4 process.|
|5||Nasdaq does not suggest that in contracting with ARCA PCX did not receive valuable consideration, which could have included an ownership interest in the ARCA Exchange. We believe, however, that the degree of that ownership interest, if any, is a key component of this exchange application, and as such should be part of the public filing and should be noticed for public comment.|
|6||Should the SEC accept the ARCA Consortium's invitation to permit markets to register as exchanges through the Rule 19b-4 process we contend that Nasdaq could conceivably avail itself of the same process by contracting with any other registered exchange.|
|7||ARCA has criticized Nasdaq for developing the SuperMontage, which ARCA contends does not offer open access and operates as a monopoly. Yet, unlike SuperMontage, which is voluntary and allows market participants choice regarding their order routing decisions, ARCA's order router is mandatory and exclusive.|
|8||It might be useful to analyze this issue in terms of how the SEC would treat a proposal from the NASD that stated: "No NASD member (including an ECN) may use any link to another market for trading Nasdaq securities other than SelectNet." Nasdaq's contention is that such a proposal would be rejected out of hand. In the past the SEC has been keenly aware of the potential regulatory issues raised by markets that wish to own or affiliate with entities that provide services to that market's members and has conditioned approval of such alliances on implementation of a number of safeguards designed to ensure that the affiliate is not unfairly advantaged because of its relationship with the market. See Exchange Act Release No. 42713 (April 24, 2000), 65 FR 25401 (May 1, 2000) (regarding Nasdaq's acquisition of Tools of the Trade).|
|9||Exchange Act Release No. 40760 at text accompanying nn. 342-43.|
|10||Nasdaq contends that a comprehensive order audit trail is particularly important in a competing dealer market where orders are disbursed among many dealers.|
|11||A revamping of PCX's current regulatory structure, which we contend is necessary to fulfill its SRO obligations to ARCA, will not come without cost. For instance, the NASD was required to spend $100 million to make the necessary regulatory improvements to its regulatory structure following issuance of the NASD/Nasdaq 21a Report. In Regulation ATS, the Commission indicated that in assessing exchange applicants it would require a showing that the applicant has sufficient resources, including both staff expertise and capital, to support its surveillance function. Interestingly, the Commission cited audited financial statements from PCX and other exchanges showing that PCX's assets barely exceeded its expenses at that time, which was prior to PCX's announcement that it would be taking on the additional responsibility of regulating the ARCA Exchange. In light of this change in its regulatory duties, we believe that PCX should be required to provide a detailed explanation concerning the financial and human capital it plans to commit to modify, if not, rebuild its system to regulate the ARCA market.|
|12||These requirements include: firm quote requirements; two-sided quote requirements; rules governing the proper basis for withdrawing as a market maker from the security and related penalties for unexcused/improper withdrawals; and post allocation procedures for specialists.|
|13||The October 1987 Market Break, A Report by the Division of Market Regulation, SEC, February 1988 ("Market Break Report") and the Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market, SEC, August 8, 1996.|
|14||For example, proposed PCX Rule 7.23(d) regarding obligations of market makers that wish to withdraw temporarily from securities requires only that the market maker request permission from the PCXE to withdraw and to base its request on "demonstrated legal or regulatory requirements that necessitate its temporary withdrawal." The rule fails to state, however, what those requirements might be. As a result, the standard is so vague as to be meaningless.|
|15||Nasdaq believes there are legitimate policy reasons militating against requiring market makers to register in microcap stocks (i.e., encouraging greater participation in that segment of the market). We do not believe, however, that the same rationale applies to National Market Securities.|