September 22, 2006

Dear SEC:

In my August 3, 2006 comment letter on the above-referenced rule submission, I made the following observation about how the NYSE usually attempts to "respond" to criticisms of its "hybrid" market proposal: "In 'responding' to public comments, it [the NYSE] typically 'cherry-picks' only a handful, and its 'responses' are little more than reiterations of its original positions. As I have pointed out in specific detail, the NYSE often ignores altogether the most serious criticisms."

The NYSE's attempted "response" of September 13, 2006 could well stand as Exhibit A in support of the above proposition. (I refer to the NYSE's comment as an "attempted 'response'" because, as demonstrated below, it fails to join issue in any serious way with the actual substance of public commentator criticisms).

The bulk of the NYSE's attempted "response" purports to defend its bizarrely misnamed e/d quotes as "discretionary orders" which merely "replicate" the way a floor broker represents orders in the physical auction. The NYSE further asserts that this mere "replication" of the physical auction does really alter the current informational "playing field", and that its hidden order trading methodology simply mirrors "reserve features" in other markets.

As I demonstrate in specific detail below, the NYSE's positions in these regards are not only untenable, they are an absolute intellectual embarrassment.

In its typical fashion, the NYSE has chosen to ignore many of the most serious criticisms of its proposal. The NYSE refuses to acknowledge, much less discuss, such anti-competitive features of its proposal as the exclusive franchise being given to floor brokers to enter electronic orders for automated execution and the fact that e/d quotes do not obviate in most respects the exclusive competitive advantages enjoyed by the specialist's algorithm. As it has throughout the "hybrid" rule submission process, the NYSE simply offers garbled technical exposition, and, though challenged, makes no attempt whatsoever to justify anything under clearly applicable law, such as Section 11A of the Securities Exchange Act and the negative obligation. The NYSE's dogged determination to avoid all the tough issues raises serious questions as to the good faith/bona fides of its attempts to "respond" to public criticism.

Independent professional judgment by the SEC staff is clearly called for here. My comments herein are not simply reiterations of my original positions (although some reiteration appears of necessity for points of emphasis). Rather, my comments rebut the NYSE's positions and point out where the NYSE has failed to respond at all. The SEC staff must see through the sham of the NYSE's "responses", critically weigh my rebuttal against the NYSE's "positions", and reach their own independent conclusions here in asserting the public interest. The SEC staff simply cannot assert that the NYSE has "responded" to criticisms where it is demonstrated in specific detail exactly how inadequate the attempted "responses" really are.

The NYSE's Misleading Terminology Is A Substantive Defect

The NYSE's attempted "response" dismisses criticisms of its use of "e/d quote" terminology, and its references to e/d quotes as creating "discretionary orders", as "non-substantive", and therefore unworthy of discussion.

The NYSE's position, however, could not be further from reality. When terminology is highly misleading to investors in its turning of conventional language on its head, and when terminology affirmatively misrepresents that which it purports to describe, the resulting defect is highly substantive. This is not simply a matter of word choice/editorial preference. While an SRO has to be given latitude in developing proposals, the exercise of such latitude cannot cross over into affirmative misrepresentation.

The NYSE's use of e/d quote and discretionary order terminology is clearly intended to suggest that a trading process which is largely hidden is in fact a replication of its historic open-outcry auction. But terms such as "quote" and "quotation" have a single, consistent meaning/connotation in both NYSE rules (e.g., Rule 61), and the Securities Exchange Act and SEC rules (see, in particular Section 11A and rules thereunder), namely the public dissemination of information about the price and size of orders available for execution. Indeed, the entire thrust of major portions of Section 11A and the rules thereunder is to emphasise the transparency of "quotation" information.

The NYSE's e/d quotes are obviously not "quotes" as that term is used in NYSE and SEC rules and the 1934 Act, and they are certainly not "quotes" as that term is understood by the professional trading community and investors generally. The NYSE is using a term synonymous with transparency to describe the exact opposite, a hidden order. It is as though the NYSE were suddenly announcing that "up" really means "down", and that "black" really means "white."

Quite obviously, the NYSE's use of the term "quote" in this context is a highly misleading, affirmative misrepresentation. As with so much of the "hybrid" proposal, this reeks of the NYSE's lawyers', who surely know better, being steamrollered by the NYSE's hyper-aggressive marketing machine.

The Commission cannot possibly accept the NYSE's self-serving assertion that this matter is non-substantive. But if for some unfathomable reason the Commission does accept that position, it must explain in detail why the NYSE can get away with calling something a "quote" when it is entirely hidden from public view, a position 180 degrees at variance from the Commission's historic use of such terminology.

The second, substantively objectionable feature of the NYSE's terminology is the suggestion that e/d quotes are the functional equivalent of a "discretionary order" represented by a floor broker in the physical auction. Not only is there no equivalency here, the e/d quotes are functionally the absolute opposite of a discretionary order.

The e/d quote is simply a hidden conditional go along limit order. No more, no less. The fact that the floor broker sets the conditions on the order does not make the resulting order itself "discretionary" in any sense commonly understood by the professional trading community and investors generally.

As footnote 5 of its letter makes clear, the NYSE is using the term "discretion" in a particularly disingenuous sense. The footnote suggests that "discretionary" refers simply to a floor broker's deciding what conditions to place on an order. It is obviously a meaningless truism that any trader could be said to exercise "discretion" in this sense, but this has never been meant to suggest that the resulting order itself is thereby a "discretionary order" simply because a trader has appended conditions to it.

An order itself is considered to be "discretionary" only when (regardless of the conditions placed on the order)the floor broker can decide whether or not to actually execute the order in response to the arrival of contra side interest into the market (which is why a "discretionary order" is one that involves the exercise of price and/or time discretion in response to contra side interest).

But the NYSE rather too conveniently blurs the distinction between setting conditions versus discretionary order execution, and throughout its comment letter and rule submission refers to "discretionary orders", even though it plainly is not creating such an order type. Rather, the NYSE is using the term "discretionary order" with respect to e/d quotes to suggest that somehow classic auction market discretion is being carried over into the "hybrid" market. But this is certainly not the case. Once the broker attaches the conditions, the resulting order is entirely non-discretionary. It absolutely must receive an automated execution when the order's conditions are met, in the same way that any other type of automated conditional order (e.g., buy minus or sell plus) would receive an execution. There is no discretion whatsoever being exercised by the floor broker in the execution of the conditional order. The broker doesn't even actually execute the order, as this task is performed by an NYSE computer.

The notion that e/d quotes are "discretionary orders" is an affirmative misrepresentation by the NYSE. The NYSE has created a hidden, conditional go along limit order. In fairness to the investing public, the NYSE must be made to call this order what it is, not what it is not. This is clearly a substantive issue.

I want to be clear here that there is nothing pejorative whatsoever in simply calling the order a hidden, conditional go along limit order. Such an order may, in fact, prove quite useful, provided that it can be entered onto a competitively level playing field. But that, alas, is the problem, as I demonstrate below.

The NYSE's Assertions about E/d Quotes

The essence of the NYSE's attempted "response" to criticisms is that the e/d quote proposal merely "replicates" the physical auction. In the NYSE's view, the proposal does not modify the existing competitive playing field, nor does it change the mix of information currently available to investors.

The NYSE's attempted "response" thus talks about brokers being "able to perform a function similar to that which they perform today" (p. 3). The proposal, we are told, "is intended to replicate, as far as possible, how floor brokers traditionally operate" (p. 3). Further, the NYSE would have us believe that "d-quotes essentially replicate that which occurs in the manual auction market and do not provide any more or any less information than was previously available in the Exchange market" (p. 4).

The NYSE asserts that the e/d quote proposal will not negatively impact the price discovery process(p. 4), will provide a better opportunity for price improvement, will moderate volatility, and will attract liquidity "as a consequence of the increased competition with specialists and other floor brokers that d-quotes provide" (p. 5).

The NYSE maintains that e/d quotes do not create "unequal or unfair advantages for any market participant" (p. 5), and there is "no merit to the suggestion that limit orders on the display book will have less access to information" as a result of e/d quotes. In the NYSE's view, "those entering limit orders will be privy to the same information as is available to them today" (p. 5).

In sum, the NYSE stops just short of proclaiming e/d quotes to be the golden pathway to the New Jerusalem. Breathtaking stuff, really, so divorced from reality that, and I'm being charitable, one can only describe the attempted "response" as the sophistry of the truly ignorant. I don't think the NYSE is engaging in intentional misconduct here in its bizarre representations. The overall cluelessness of its attempted "response" suggests that it was prepared by individuals largely unfamiliar with how the NYSE market actually works, much less with the likely real world implications of a proposal that, stripped of self-aggrandising propaganda about "enhancing competition", actually "rigs the game" entirely to the benefit of the NYSE's trading floor constituency.

At the risk of bursting the NYSE's bubble, I develop below the following points:

  • Far from "replicating" the physical auction, the NYSE is obviously introducing a radically new form of trading. The NYSE's position on this point is little more than self-serving marketing fluff, as it seeks to perpetuate the illusion that it is maintaining the traditional benefits of auction market trading, even as it rescinds or effectively "re-defines" out of existence the very rules that provided such benefits.

    This point hardly requires detailed analysis, as even a cursory review of before-and-after market structure features makes manifest that the "hybrid" market has virtually nothing in common with the NYSE's traditional auction. In the auction, everything is transparent. Brokers may have "discretionary orders" that are not known to the public, but the trading interest represented by such orders is inactive. A broker can trade pursuant to such an order only after making a public bid/offer, known to all in the trading crowd. Other brokers, or the specialist, can then compete by bidding higher (offering lower). Everything is transparent, as the previously "hidden" discretionary order must be disclosed prior to a trade, and, even after it is disclosed, is not guaranteed an opportunity to trade if competing market participants then bid higher (offer lower).

    In the "hybrid" market, the fully transparent auction market process, in which trading interest must be disclosed prior to a trade, is replaced by an entirely hidden trading dynamic in which no information is disclosed to the market prior to a trade, the hidden order is overhangs the market and is pre-programmed for automatic execution, and no market participant has an opportunity to provide a better price immediately prior to a trade as they can in the auction.

    What the NYSE is proposing, going from fully transparent trading in which everything is disclosed prior to a trade to hidden trading in which nothing is disclosed is about as fundamental a sea-change in trading philosophy and dynamics as it gets. One wonders why the NYSE is not being straight forward here, as pure electronic trading is not only defensible but highly desirable. But the answer is obvious: the NYSE promotes the fiction that it is simply "replicating" the auction to mask the unfair and inherently anti-competitive advantages it is giving its trading floor intermediaries in the "hybrid" market.

    The Commission will deeply embarrass itself if it accepts the NYSE's self-serving fiction that it is merely "replicating" the physical auction.

  • Far from "replicating" the floor broker's traditional function, the NYSE proposal virtually eliminates it. The NYSE's position on this point is, as with much of the attempted "response", a true intellectual embarrassment. In reality, given the likely pace of automated trading, floor brokers will be effectively reduced to clerks entering electronic orders, as physical representation of orders will be a gold-plated invitation to "miss the market." And the NYSE's notion that floor brokers will "electronically represent" orders is particularly bogus. A floor broker simply enters an electronic order, which then lies inert, and hidden, in an NYSE computer until the computer reads that the order's conditions are satisfied, and electronically executes the order. The broker is no more "electronically representing" the order than an institutional trader is "electronically representing" a Superdot order that lies inert in the NYSE's computer. In neither case do the floor broker or institutional trader participate in the trading process. Both, of course, can modify, cancel, replace, etc. the order, but this is a meaningless truism that hardly suggests "electronic representation."

    As I discuss further below, the NYSE is simply propagating a self-serving fiction here to mask the anti-competitive, exclusive franchise being given to floor brokers to function in this order-entering capacity.

  • The NYSE's apple-and-oranges equating of auction market discretionary working orders with e/d quotes is clearly a false analogy. The NYSE contends, though it it is difficult to believe it is doing so with a straight face, that a floor broker's undisclosed order in a trading crowd is the functional equivalent of the hidden, conditional go along limit orders ( the misnamed e/d quotes) being proposed in the "hybrid" market.

    As I discussed above, there are huge differences here. The "discretionary order, regardless of size, limit price (if any), conditions, etc., is entirely inert unless and until a broker discloses all or part of it to the market, and gives other market participants an opportunity to react to the trading interest the broker has disclosed. The physical auction is classic "fishbowl" trading, with no market participant having a "reserved" trading opportunity, and all market participants (as represented in a trading crowd) have an opportunity to compete in terms of better prices, etc. The broker's "discretionary order" is fully subject to competition as it is disclosed to the market, and the disclosed portion may not even trade in the face of such competition. This is the NYSE's classic, historic auction market trading dynamic.

    The hidden, conditional go along limit orders proposed for the "hybrid" market are clearly a different animal. Unlike the inert quality of an undisclosed auction market "discretionary order", the hidden go along order is "active" in that it is disclosed to the NYSE computer, overhangs the market, is pre-programmed to trade, will absolutely trade when its conditions are met, and, because it is hidden, will face no price betterment competition in reaction to it.

    The Commission cannot possibly accept the NYSE's position here, given the clear and obvious differences between auction market discretionary orders and hidden, conditional go along limit orders. This is simply another of the NYSE's self-serving fictions designed to mask the anticompetitive advantages being given to floor brokers.

  • The e/d quote proposal, by its plain terms, creates a far less transparent market, which can only have serious negative implications for price discovery in the National Market System. The NYSE has proceeded by self-serving assertion here, and has not seriously joined issue with the substance of public criticisms. The NYSE maintains that the interaction of fully disclosed public limit orders, hidden, conditional floor broker go along limit orders, and the specialist's hidden algorithm "ensures that the price discovery mechanism will exist" (p. 4). This has to be an all time classic instance of setting the lowest possible bar imaginable: mere "existence."

    As I pointed out in my June 22, 2006 comment letter, the NYSE proposal, in actuality, has serious, negative price discovery implications. The NYSE has buried its head in the sand about the likely implications for a public limit order book that must co-exist with a universe of hidden orders. The professional trading community has largely concluded (see, e.g., comments in the June issue of Traders Magazine) that the effect of the NYSE proposal is that the NYSE is not a market in which they will choose to post liquidity (i.e., enter limit orders).

    The professional trading community perceives the obvious: public limit orders will be seriously disadvantaged by competition from hidden orders. But the Commission itself, in its Regulation NMS releases, has identified public limit orders as the critical element in the National Market System's price discovery process, and repeatedly emphasised the importance of public limit order protection. The NYSE is asserting the logically impossible here: it cannot both disincent the placement of limit orders and maintain at the same time that it is enhancing price discovery. The Commission must absolutely stick to its guns on this most critical point about price discovery.

    Even leaving aside the above absurdity of the NYSE's position, its contentions make no sense otherwise. It is axiomatic that liquidity begets liquidity, and that direct public order competition will ensure that the fairest prices are discovered. This is the entire thrust of Section 11A of the 1934 Act. But the NYSE is taking the absolutely bizarre and counterintuitive position that somehow the floor broker and specialist hidden orders (which the NYSE has painstakingly ensured will face very little competition from public orders) can promote price discovery even though they are entirely hidden. This is just not the way the real world works. The world cannot react to trading interest it doesn't know about. In the brave new world of the "hybrid" market, the NYSE will be faced with barren public limit order books and a nest of hidden orders that "compete" (on highly advantageous terms) only with themselves. Doubtless, the world will be looking elsewhere for liquidity. And the NYSE wonders why it is losing significant market share. Hint: the world has seen through the NYSE's shameful promotion of floor constituency self-interest.

    In my June 22, 2006 comment letter, I noted that hidden order trading is a very serious matter that requires independent analysis by the Commission because of the serious adverse consequences for price discovery in the National Market System. In the event, the NYSE's positions obviously run counter to the Commission's views on public limit orders, and the need for transparency about "quotation" information.

    The Commission simply cannot accept the NYSE's unsupported, and unsupportable, positions at face value, but rather must seriously question how the NYSE's proposal can possibly maintain, much less enhance, a primary market's price discovery mechanism. This is a hugely serious issue, as any weakening in National Market System price discovery will be seriously detrimental to public investors. The stakes for the public investing community are far too high here, and the interests of that community must supersede the interests of the NYSE's trading floor constituency.

  • E/d quotes do not provide increased opportunities for actual "price improvement" because they are pre-programmed for mandatory execution and overhang the market, and thus constitute the real NYSE market, as opposed to the essentially irrelevant "published" market. The NYSE's position here is the most objectionable form of sophistry imaginable, as the NYSE is effectively re-defining "price improvement" to the point of meaninglessness. It is hardly the point to say that an incoming order, by trading with a hidden, in-between-the-quote go along order, will be receiving a price that is "improved" from the published price (represented by the hapless public limit order on the public limit order book). The hidden order overhangs the market, and is pre-programmed to trade automatically. This order is, in essence, the "real", non-discretionary NYSE market, because that is the pre-existing (though hidden) price at which the NYSE market absolutely will trade. The incoming order is not really receiving "price improvement." It is merely receiving an execution at the real, pre-existing NYSE price.

    I am confident the Commission will easily see through the NYSE's ruse on this point.

  • E/d quotes cannot "attract" liquidity because they are hidden, nor, for the same reason, can they "enhance competition." This point is obvious and does not require much elaboration, as it is related to the discussion on price discovery above. Hidden orders cannot "attract" liquidity because no one knows about them, and no one can compete with something whose existence is unknown. Will the NYSE continue to attract some orders anyway? Of course, because traders will take a chance that liquidity "may" exist. But by and large, the "hybrid" market will certainly not be proactively attracting liquidity, nor will it proactively "enhance competition" with the real world beyond 11 Wall Street.
  • E/d quotes obviously result in less information being available to public limit order customers, particularly when one compares automated executions in the current market with automated executions in the "hybrid" market. In an attempted "response" filled with misstatements, the NYSE position in this regard may well be the most egregious. Let me give the most obvious example (there are many I could give) of where the NYSE has flatly misrepresented its market. This example is a direct, apples-to-apples comparison of how orders receive automated executions in today's auction, and how automated executions will work in the "hybrid" market.

    In today's market, incoming automated orders (Direct plus in NYSE-speak) are executed automatically against interest reflected in the NYSE's published quotation. A public limit order customer can understand whether or not its order has priority (it constitutes the published quote) and thus will receive an execution against an incoming Direct plus order (assuming no intervening trades, change in quote, etc.). All things being equal, the customer has this information. A floor broker, with an inert (undisclosed) discretionary order cannot participate in an execution against the incoming Direct plus order. If the broker wants to participate in such executions, he or she must publicly announce a bid or offer, and that bid or offer must be reflected in the NYSE's published quotation. If the broker's bid or offer is at a better (for the incoming order) price than the public limit order customer's order, that customer will see this reflected in the published quotation. The public limit order customer, armed with this information, is then in a position, if it so chooses, to respond to this floor broker competition by changing the limit price on the limit order.

    This is how the NYSE market works. The "informational playing field" is level, because the public limit order customer knows about, and can react to, floor broker competition.

    The "hybrid" market, in contrast, tilts the "informational playing field" entirely in the direction of the floor broker. The broker can see the fully disclosed public limit order, and can enter a hidden order at a better price. Unlike in today's market, the public limit order customer has no opportunity to react to this competition and change its limit.

    This is the clearest possible instance of how the NYSE is changing the "informational mix" to the detriment of public limit order customers.

    It is unconscionable for the NYSE, which surely knows better, to contend that the "hybrid" market does not change the "informational mix." Clearly, in certain instances, the public receives less information, to its detriment, but to the entire advantage of the NYSE's trading floor constituency.

    The Commission, in asserting the public interest, must seriously challenge the NYSE on this point.

  • E/d quotes obviously confer unfair competitive advantages on floor broker orders vis-a-vis the public limit order book, and deny executions to the very orders that, in fact, attract contra side liquidity in the first place. This is another matter that is hardly in dispute, and the NYSE's position is little more than a resort to sophistry. Clearly, a floor broker can enter an order with knowledge of the public limit order book, but public limit order customers cannot respond (as they can today) to the floor broker's action. This is unfair, and anti-competitive, per se.

The public limit order is the one that "attracts" liquidity (this is what the world can see and react to) but the hidden order gets to trade, with no opportunity for the public limit order to respond to the hidden competition.

The NYSE "response" on this point is an intellectual abomination: "nothing prevented the limit order from being entered at {a] better price" (p. 6). Where does one begin with such a contemptuous insult to the public's intelligence? Obviously, the public limit order can only react to publicly available information, which is the way any truly fair market should operate. If the publicly available information suggests that its public limit order, as reflected in the published quotation, has priority, why would the customer then compete itself by bidding higher or offering lower? The NYSE should be ashamed of itself for trying to pass this garbage off as "responsive" argumentation.

Clearly, the NYSE's hidden order proposals effectively deny executions to orders on the public limit order book. As I have pointed out in other contexts (see, e.g., my November 8, 2005 comment letter on SR-NYSE-2004-05, and my September 10, 2006 comment letter on SR-NYSE-2006-65), the NYSE's egregious "splitting" rules clearly have this effect with respect to transactions at the published quotation, and in "sweep" transactions. And the hidden, conditional go along limit orders at issue here have the same practical effect. Clearly, to deny a public limit order customer information about order competition, which effectively precludes response to that competition, is to deny that customer opportunities for execution at prices superior to that represented by the hidden competition. The customer cannot respond to that which the customer cannot see.

It is difficult to imagine a more competitively "unlevel" playing field than what the NYSE is proposing.

The Commission must obviously give an SRO latitude in designing its trading rules. But the SRO must exercise that latitude in a manner that is consistent with the Securities Exchange Act. The NYSE proposal is as clear-cut a "burden on competition" and a "discrimination" among investors as one could possibly conceive.

If the Commission is nonetheless determined to approve the NYSE proposal, it manifestly owes the public a detailed discussion as to why the proposal is not anti-competitive.

The Floor Brokers' Exclusive Franchise to Enter Hidden, Conditional Go Along Limit Orders Clearly Violates the Securities Exchange Act

In my June 22, 2006 comment letter, I demonstrated, at length, why the NYSE's proposal to give floor brokers, and only floor brokers, the exclusive ability to enter hidden, conditional go along limit orders was anti-competitive under the 1934 Act, and directly impeded the economically efficient effecting of securities transactions, also in direct violation of the Act.

Not surprisingly, I suppose, the NYSE did not even acknowledge this most obvious and fundamental of issues in its attempted "response", perhaps the most singular failing in a "response" studded with inadequacies. How can it defend the manifestly indefensible? The NYSE has yet to explain why market participants, who are permitted to enter other types of electronic orders directly themselves, must nonetheless retain the services of a floor intermediary to simply enter an order for intermediary-less execution. As I pointed out in my June 22, 2006 letter, this should be a matter of choice. Institutions that wish to use a floor broker should be free to do, but institutions who wish to enter these types of orders for electronic execution should be permitted to do so as well.

The NYSE proposal is clearly anti-competitive, because it operates entirely to the (needless)benefit of one class of market participant (the floor broker) at the expense of all other market participants. And it imposes unnecessary expense, and delay, in forcing market participants to retain the services of what is simply an order entry clerk, when market participants, with their own market strategies and their own ability to manage their orders, can easily enter such orders themselves.

The NYSE's entire discussion of "competition" in its attempted "response" absolutely reeks of self-interest. The only "competition" the NYSE really speaks of is that which exists as between its two privileged classes of trading floor intermediaries. The notion that off-floor market participants (the public) ought to be able to compete for intermediary-less executions on equal terms is a matter the NYSE studiously avoids dealing with.

The Commission's "hybrid" market order alluded to the floor broker's exclusive franchise in passing in purporting to summarise public comments, and did not deal with it analytically at all. Regardless of what the Commission thought it was approving in the "hybrid" market approval order, the Commission is far more bound by the clear requirements of the 1934 Act.

If the Commission is going to permit this most blatantly anti-competitive aspect of the NYSE's proposal to go forward, it owes the public a detailed explanation of why they must endure the time and expense of hiring a privileged order entry clerk to perform a function they are easily capable of performing themselves.

The Commission will seriously erode its credibility if it does not deal decisively with this issue.

The NYSE Is Not Merely "Replicating" Hidden Order (Reserve) Trading As It Is Conducted on Other Markets

The NYSE takes the position that the sort of hidden order trading it is advocating is comparable to "reserve" (a popular euphemism for hidden order) trading on other markets. Nothing could be further from the truth.

Yes, hidden order trading takes place on other markets. Such trading is a fact of life, but, as I noted in my June 22, 2006 comment letter, the Commission needs to independently assess the implications for such trading for the future evolution of the National Market System. The proliferation of hidden order trading, side-by-side with trading of fully disclosed orders, raises serious issues of fundamental fairness to the least sophisticated investors, and tends to lessen overall market transparency, disperse liquidity and fragment efficient price discovery. There are no "simple" answers, but the Commission needs to pro-actively get ahead of the curve here, or it will find that progress toward a true National Market System has seriously regressed.

Be that as it may, the NYSE proposal is not really comparable to hidden order trading in other markets. Such markets tend to "niche" off of prices discovered in a primary market such as the NYSE, so the threat of implosion of National Market System price discovery does not arise to anywhere near the extent it does with hidden order trading on the NYSE. Other markets generally respect the price/time priority of all orders (unlike the NYSE, which allows hidden orders to effectively usurp the price/time priority of the public limit order book), and other markets do not have the NYSE's egregious "splitting" rules, which seriously disadvantage public limit orders, which may have been entered earlier in time, and which triggered the entry of the very hidden orders that then deny them executions, or seriously degrade the quality of any executions they do receive.

But there is an even more fundamental difference: other markets do not discriminate in terms of order entry, but permit any qualified market participant to enter a hidden order. Other markets do not require the needless hiring of an "intermediary" for an intermediary-less automated execution. But, of course, the NYSE neglected to mention this most obvious of points.

The nub of the issue is this: to the extent hidden order trading is permitted on the NYSE, the only way the Commission can ensure a "level" competitive playing field is to require the NYSE to remove its arbitrary and artificial constraint on order entry.

Specialist Hidden Order Trading Clearly Violates the Securities Exchange Act

In my June 22, 2006, I demonstrated that specialist algorithmic trading on "parity" with a floor broker's hidden go along orders, entered on behalf of public customers, clearly violates Section 11A of the Securities Exchange Act, as it mandates dealer intervention when public orders can trade without such intervention, and it makes securities transactions less economically efficient by forcing an incoming order to settle a trade with an additional, and unnecessary, party. In typical fashion, the NYSE did not even acknowledge this point. Regardless of what it thought it was approving in its "hybrid" market approval order, the Commission remains bound by clear-cut, black letter law here.

If the Commission is determined to approve the NYSE proposal as is, it owes the public a detailed explanation of why such trading can be reconciled with Section 11A.

Both the NYSE's floor broker community (as represented by the Independent Broker Action Committee, or IBAC) and the Investment Company Institute were on record with the Commission as being strongly opposed to specialist go along competition with their public orders. (No one is on record as supporting it, hardly surprising as it benefits no one but the specialist). In a comment to the Commission on the instant proposal, IBAC urged that the Commission require the NYSE to modify the proposal so that it mirrored a protection the NYSE (grudgingly) adopted in support of its "long-standing interpretation" of Rule 108 that specialist parity trading is permissible. (This was the subject of extensive comment, and the NYSE's "long-standing interpretation", which the NYSE was singularly unable to document, is generally perceived as bogus). This protection is simple: the specialist cannot go along with a broker's public order if the broker objects.

The NYSE, apparently in a total sell-out to the specialist community on this point, limits the floor broker's ability to object solely to conventional auction market transactions. The NYSE designed the "hybrid" market so as to eliminate a broker's ability to object to the specialist's go along trading in direct competition with a floor broker's public customer e/d quotes.

The NYSE made a big deal about the importance of the floor broker objection mechanism as a significant public protection when it sought approval of its Rule 108 interpretation. But the NYSE has never made any case whatsoever as to why this protection is not being carried over into the "hybrid" market. The recent IBAC comment urges that floor brokers have this ability to object in the "hybrid" market so as to protect their public customers.

The "best" the NYSE can do is assert a position that borders on outright duplicity. The NYSE states (p. 9), "To the extent that floor brokers want to prevent specialists from trading on parity with their orders in the Hybrid Market, they retain the right to send those orders for execution through SuperDot."

This is another egregious insult to the public's intelligence. As a practical matter, floor brokers must participate in the "hybrid" market. Sending orders through SuperDot (permitted by off-floor traders today)means not only that floor brokers would probably not get the order to begin with, but to the extent that they did, they wouldn't be able to participate in the "hybrid" market.

There couldn't possibly be a clearer example of a false choice, and the NYSE knows this. As a practical matter, the NYSE is not providing any feasible means for a broker to protect his or her public customers from unnecessary specialist competition (which degrades the quality of public order execution), notwithstanding the NYSE's self-righteous assertions in the context of Rule 108 about the importance of a floor broker having a meaningful right to object. This is absolutely sickening stuff, hypocrisy entirely unworthy of the NYSE.

Section 11A clearly precludes specialist go along trading. But if the Commission somehow determines to permit it in the face of the statutory proscription, the Commission must, at a bare minimum, demand that the NYSE allow a floor broker objection mechanism in the "hybrid" market so that floor brokers may protect the public.

The other serious legal bar to specialist hidden order trading is the negative obligation. In its rule submission, the NYSE made the brazen suggestion that floor broker e/d quotes somehow ameliorated the distinct competitive advantage enjoyed by the specialist's algorithm in its exclusive franchise to electronically intercept incoming automated orders. In my June 22, 2006 comment letter, I pointed out that e/d quotes, which interact only with incoming limit orders, did not ameliorate the specialist's competitive advantage at all with respect to incoming marketable order traffic, which will probably constitute the bulk of incoming order flow.

As is typical when it cannot defend the indefensible, the NYSE simply ignored this point, as it ignored any discussion of the negative obligation whatsoever. But this is an issue the Commission cannot ignore.

In another one of its statements that is absolutely breathtaking in its ignorance, the NYSE seeks to reassure us that specialists have no informational advantages in the "hybrid" market because they "will be able to view only total aggregated broker agency interest at each price" (p. 5). In other words, the only information the specialist has (exclusively) is the only information that is really material to the specialist's algorithmic trading decisions. Nice work if you can get it!! And what's insider trading among friends?

In the current market, the public limit order book is transparent, so the specialist has no unique informational advantages in that regard. And while the specialist may have information about general trading crowd interest, he or she certainly does not have information about hard-wired, pre-programmed, good-to-go floor broker interest, because that doesn't exist. "Hybrid", however, is open sesame for the specialist. Historically, the specialist, whatever his or her degree of "predictive" knowledge, was constrained by the negative obligation. The specialist could trade, whether providing "price improvement" or otherwise, only after all trading interest was exposed to other market participants, and only when no other market participant wanted to trade.

The "hybrid" market de facto repeals the negative obligation (notwithstanding the NYSE's formulaic pabulum about "surveillance")because the legally-mandated "trader of last resort" gets to jump to the head of the queue (or is the only one permitted on the queue in the first place), regardless of whether other market participants would trade if given a fair opportunity (the historic test for whether the specialist's trade is "necessary", the keystone of the negative obligation).

Specialist algorithmic trading, as currently proposed by the NYSE, is inherently inconsistent with the negative obligation because it completely obviates the historic "necessity test." This is in no sense a matter that can be resolved by self-serving "interpretation" that feathers the nest of the specialist community to the detriment of the broad investing public.

The Commission's silence to date on the negative obligation has been deafening. It borders on dereliction of duty.


The Commission cannot simply accept the NYSE's attempted "response" as an adequate rejoinder to very specific, substantive public criticism. The Commission must exercise independent professional judgment here, with a detailed analysis of all applicable legal and regulatory considerations.

The Commission is bound by clear, black letter law on the issues raised. Any attempt by the Commission to simply default to some of its prior "hybrid" approval orders will be widely perceived as the intellectual equivalent of a street hustler's shell game. No matter what shell one looks under, there is no pea. And so it is with the "hybrid" approval orders. No matter where one looks, there is no independent legal analysis or justification. All one finds are in-passing, substantively meaningless conclusory assertions, the functional equivalent of turning over an empty shell.

The Commission must assert that the interests of public investors take precedence over the interests of the NYSE's trading floor intermediaries, and that the clear-cut law of the land means what it says and will be enforced.

It really is that simple.

Sincerely yours,

George Rutherfurd
Consultant (to two institutional trading organisations)

[I will take this opportunity to note another matter.

On August 2, 2006, I sent a letter to the Commission commenting on its approval of SR-NYSE-2005-38, which reduced specialist capital requirements, relative to trading volume, to levels below the universally disparaged capital levels of pre-crash 1987. At the time I sent in the comment, the SEC's website contained the notation "Click here to submit comments", an invitation for public comment. My letter was critical of the SEC staff's work product in this matter. On September 12, 2006, I noticed that the SEC had not published my August 2, 2006 letter on its website. I asked that the SEC do so, and noted that, as of that date, the SEC website was still inviting public comment. Apparently in response, the SEC removed the invitation for public comment from its website, but, to date, has still declined to publish my August 2, 2006 letter. I reiterate my request that the letter be published.]