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From: George Rutherfurd
December 4, 2006 Dear SEC: I am writing with regard to the NYSE's November 29, 2006 comment letter on the above-referenced matter. As is typically the case, the NYSE has simply ignored the most significant criticisms of its proposal, and grossly distorted those criticisms to which it condescends to respond. It is a measure of the NYSE's sheer desperation to have this proposal approved that it must resort to easily demonstrable, intelligence-insulting misrepresentations to attempt to "support" its position. There is no easy way to say this, and I take no pleasure in saying it, but the NYSE's continued refusal to acknowledge and discuss the manifest applicability of Section 11A of the 1934 Act to its proposal appears to be, if not a possible fraud on the Commission, a serious breach of legal ethics. At a bare minimum, a proponent of a proposal is expected to present "contra legal authority" and attempt to distinguish it. Yet the NYSE refuses to discuss this matter, even though I have clearly raised, and demonstrated, the applicability of Section 11A as being fundamentally inconsistent with the NYSE's proposal. There is not a single reference to Section 11A's intent to minimise dealer trading in either the NYSE's rule submission or its two comment letters. And the SEC staff's treatment of this proposal defies comprehension. I will not repeat my prior observations about the procedural abomination that the SEC staff have created here, but I must re-emphasise that the SEC staff have yet to expose this matter properly for public comment. And the SEC staff's treatment of the Section 11A issue is approaching public scandal. They have stood idly by while the NYSE ignores the issue. The NYSE presumably responds to public criticism only at the insistence of the SEC staff. Yet the SEC staff have demanded nothing from the NYSE on the Section 11A question. And, as I pointed out in my December 1, 2006 comment letter, the SEC staff continue to hide behind an approval order that did not properly discuss how specialist "parity" (go along) trading can be reconciled with either the negative obligation or Section 11A. One expects more from the SEC staff than one expects from the NYSE. This is hardly the SEC staff's finest hour. The Manifest Applicability of Section 11A In my prior correspondence, I have set forth the relevant provisions of Section 11A and demonstrated in specific detail how it is inconsistent with the NYSE proposal. I will not repeat the argument here, but will simply note that Section 11A is intended to minimise dealer interference with public order execution in the national market system, particularly in the context of fast, efficient electronic trading. As I demonstrated in specific detail in my November 14, 2006 comment letter, the market "evolution" that the NYSE complains of, one in which public orders are executed electronically without dealer intervention, is exactly what Congress envisioned should be happening, and spelled out specifically in the statute. The real issue here couldn't be simpler: either a specialist's trade is necessary to maintain a fair and orderly market by offsetting a short-term disparity in supply and demand, or it isn't. If the trade is necessary, it can readily be effected under current rules, and the specialist's algorithm can easily be programmed to facilitate this in an electronic environment. (The NYSE has refused to deal with this most obvious of points). But if the specialist's trade is not necessary to maintain a fair and orderly market (meaning no supply/demand disparity, and public orders can be readily executed against one another), why should the specialist be permitted to trade nonetheless? Section 11A provides a clear, unambiguous answer: the specialist should not be permitted to trade, and the NYSE has made no case whatsoever to the contrary. So where is the need to overturn a fundamental tenet of specialist regulation? In the event, the NYSE proposal is an absolute conceptual mudpuddle, regulatory incoherence run rampant. The NYSE originally proposed a "pattern or practice" test that really is relevant only to the affirmative obligation, then appeared in its November 6, 2006 comment letter to be invoking the trade-by-trade necessity test of the Saperstein interpretation, the cornerstone of the negative obligation, which would obviate the need for the NYSE's proposal in the first place. And, as to be expected, the NYSE had no response whatsoever to my rather obvious criticisms in this regard. Given the recent NYSE specialist trading scandal, which involved the NYSE's failure to properly interpret, surveil and enforce the negative obligation, one would have expected both the Commission and the NYSE to be strengthening the negative obligation so as to protect public investors. But, for all intents and purposes, the NYSE is proposing its de facto rescission, and the SEC staff are apparently seriously entertaining the thought. One would not have thought it possible to make this up. In their various "hybrid" market approval orders, the SEC staff have appeared content to accept the NYSE's bloated, self-serving jargon at face value, and have not appeared to appreciate the practical implications of the NYSE's proposals as to actual trading in that market. If specialists are permitted to trade regardless of necessity, it simply means that they are not really acting in the capacity of a market maker (as limited by Section 11(a) of the 1934 Act) but rather are simply effecting proprietary trades unrelated to the market making function, with unique competitive advantages over other market participants. (See discussion below). If the NYSE were intellectually honest here, it would acknowledge this, propose appropriate rules, and an entirely different (though highly fraught) discussion could then ensue. It is safe to assume that Congress meant what it said in Section 11A. As the need for dealer intervention naturally declines, so should specialist dealer trading rates, all to the good of public investors. But the NYSE proposal artificially interferes with this natural, and Congressionally-mandated, evolution, by permitting specialist interference with direct public order execution any way. As I pointed out in specific detail in my November 14, comment letter, the negative obligation, in its historic, time-tested form with the Saperstein interpretation, is an essential complement to Section 11A. The existing negative obligation is intended to assure that specialists trade only when necessary, and do not otherwise interfere with direct public order execution, which Congress clearly identified as an essential component of the national market system. The SEC staff should be discussing with the NYSE the strengthening of the negative obligation, not its effective elimination. The NYSE's Distorted Picture of Specialist "Halcyon Days" The NYSE continues to refer, without apparent embarrassment that its terminology, if true, suggests egregious rule violations, to halcyon days of yore when the specialist could "dominate and control" trading on the NYSE. The NYSE fails to explain how specialists subject to the negative obligation's strict trade-by-trade necessity test, were nonetheless dominating and controlling the market. Trading only when reasonably necessary to maintain a fair and orderly market is hardly synonymous with domination and control. Is the NYSE acknowledging that specialists have been "dominating" the market by unnecessary trading? One has to remember that the NYSE had to be recently slapped down for failing to restrain specialist trading under the negative obligation. One can only marvel (with both wonder and disgust) at what the NYSE had probably let specialists get away with over the years. But perhaps I am being unduly harsh. Notwithstanding the NYSE's assertion of halcyon days of specialist domination and control, specialist dealer participation rates have been, historically, extremely low, and most public orders have been executed against one another without dealer intervention, as they should have been. The NYSE needs to fairly and accurately represent the historic picture here, and, if it wishes to be taken seriously as a regulator, it needs to clean up its language. (Or perhaps the NYSE is simply being unintentionally, and witlessly, honest). This should hardly need saying: it has never been, under applicable law and rules, the specialist's function to "dominant and control" the market. One will search high and low, and entirely in vain, for any statements by either the Commission or the NYSE to the contrary. In obvious fact, both regulators have taken pains over the years to emphasise the minimisation of dealer trading on the NYSE, and the minimal role played by specialists in interfering with public order execution. Indeed, this has been the centerpiece of the NYSE's marketing of the "advantages" of the specialist system. Have we all been lied to all these years? The SEC staff and the Commission will deeply embarrass themselves, and repudiate their own long and honourable history, if the they accept the NYSE's ludicrous representations at face value here. And assuming there are no statute of limitations problems, perhaps the SEC's Division of Enforcement may want to take a long, hard look at what the NYSE is now calling specialist "domination and control" of trading. The Competitive Picture In prior correspondence I have discussed in detail the 1975 legislative history excerpt relied on the NYSE, and demonstrated how neither condition stated therein (market maker competition and the elimination of specialist trading privileges) has been met. I will not reiterate in detail my points on competition, as the SEC staff can readily reconstruct the relevant historical comparisons. But one point is obvious: regardless of how "bleak" a picture the NYSE paints of current competitive factors, the fact remains that the NYSE's competitive picture, and dealer trading rates, are superior to those which existed in 1975. (I will note in passing an obvious error made by the NYSE in attempting to make a historical comparison. The NYSE states that under its former off-board trading rule "NYSE members were prohibited from trading NYSE-listed securities in the over-the-counter markets." This is typical of the NYSE's many misrepresentations. In fact, NYSE members were precluded only from dealer trading and in-house agency crosses, but could freely send agency orders to the third market. This factor played a large role in the NYSE's extremely adverse competitive picture in the early 1970s). The Specialists Informational and Trading Advantages The 1975 legislative history required that both the competition and trading privileges issues be satisfied. As noted above, the competitive issue is definitely not satisfied when relevant historical comparisons are made. The NYSE has steadfastly refused to make these comparisons, as they are entirely adverse to the NYSE's position. But the informational advantage/trading privileges issues is even more adverse to the NYSE's position. In its November 29, 2006 comment letter, the NYSE attempts to maintain that the woe-is-made specialist no longer has no such advanatges/privileges. The problem for the NYSE here is that its November 6, 2006 comment letter clearly acknowledged that the specialist did indeed have unique informational advantages and trading privileges, but sought to characterise them as "slight." It hardly needs saying that a "slight informational advantage" in a rapid fire electronic trading environment is an oxymoronic concept. In my prior comment letters, I have demonstrated in specific detail the ways in which the NYSE has given the specialist competitively unfair informational and trading advantages. In the face of my specific, detailed objections, the NYSE has responded with only the vaguest generalities, presumably because it is unable to offer point-by-point rebuttal. The best the NYSE can muster are references to the ways in which others can function in the "hybrid" market, and babble about how other market participants receive the same information as the specialist's algorithm, and that the "delay time" built into the NYSE systems mitigates the specialist's informational advantages. I have clearly demonstrated the falsity of the NYSE's positions here. If the NYSE could have rebutted my specific critique, it would have done so. The fact that it cannot speaks volumes about the accuracy of the NYSE's representations. I will briefly summarise my prior points: only the specialist, of all NYSE market participants, gets to have an algorithm embedded in the NYSE systems. This algorithm gets to read incoming orders the instant they enter NYSE systems, whereas other market participants learn of such orders only after they are "published." I have pointed out, in specific detail, how the "delay time", which applies only to non-marketable orders, is a meaningless fiction, and the NYSE has had no answer to this whatsoever. I have pointed out how the specialist's algorithm gets exclusive first shot at trading with all marketable orders (there is not even the fiction of a "delay time") as these orders are never "published." Again, the NYSE's silence in the face of this specific critique speaks volumes, particularly as to the NYSE's misrepresentations about d-quote trading. And the specialist is clearly a "monopolist", as the NYSE employs a unitary market maker system, and the advantages noted above accrue only to the specialist. If the SEC staff would focus on the practical effect of the NYSE's proposals, they would understand that the specialist is being given non-public market information, and can trade on it before other market participants can see and react to it. The NYSE's bloated jargon masks this otherwise most obvious fact, and when challenged, the NYSE is unable to offer specific rebuttal. But the NYSE would further compound the problem (which is really insider trading based on material, non-public market information) by effectively rescinding the negative obligation, and additionally allowing the specialist to directly influence the market's price trend. In other words, what we have here is largely unconstrained specialist trading, regardless of the need for dealer intervention. Mr. Saperstein must be turning over in his grave. Conclusion I will not note all of my very substantive comments to which the NYSE has not even attempted a response, but I would urge the SEC staff to simply lay-out, on a spreadsheet, the very specific objections, and the NYSE's feeble (where atempted) responses.Presumably, the SEC staff are as appalled as I am by the NYSE's manifest arrogance in refusing to acknowledge the specific problems with its proposal, to offer specific rebuttal to detailed criticisms, and to defend the proposal in intellectually honest terms. Evolution of the national market system will in its natural course reduce the need for dealer intervention. The NYSE's insistence that specialists should be allowed to trade anyway simply flies in the face of Section 11A and the negative obligation. If specialist trading is unnecessary (and necessity can only be determined on a trade-by-trade basis, as demonstrated both historically and by the recent specialist trading scandal), it should not be permitted, as it interferes with direct public order execution, thereby making markets less efficient and imposing additional trading costs on public investors. The Commission and the SEC staff will suffer a serious loss of credibility, and the matter may have to be resolved in a different forum, if the NYSE's self-serving assertions are accepted at face value after their falsity has been amply demonstrated. It is time for the Commission to assert that Section 11A means what it it says, and that the historic negative obligation is a critical complement. It really is that simple. Sincerely yours,
George Rutherfurd |