November 2, 2006
I am writing to protest the continued short-sighted treatment by the SEC staff, acting under delegated authority, of the most fundamental tenet of specialist regulation, the negative obligation. The SEC's rule approval process is obviously being driven by the NYSE, not the Commission or its staff. No other conclusion is possible after witnessing the latest procedural abomination, SR-NYSE-2006-96, in which the SEC staff, acting without the "adult" supervision of the Commission itself, have been out-maneuvered yet again by the NYSE.
I will not repeat here all the arguments (entirely unrefuted by the NYSE) I have made in my prior correspondence on 2006-76. But the following points must be made:
- The NYSE, in what were virtually throw-away observations in 2006-82, proposed, in practical effect, to eliminate the negative obligation, about as fundamental a change to its market as one can imagine. (See discussion in my October 20, 2006 comment letter on 2006-76).
- With no opportunity for prior public comment, the SEC staff gave "temporary" approval (in 2006-82)to what is, effectively, the repudiation of the principal restraint on specialist proprietary trading for the past 70 years. (The notion that the public can meaningfully "comment" after matters have been "approved" does not warrant serious discussion).
- In 2006-96, again with no opportunity for prior public comment, and with no acknowledgment that serious issues with respect to the underlying subject matter had been raised, the "unsupervised" SEC staff have extended this "temporary" rescission (in practical effect) of the negative obligation.
- The "unsupervised" SEC staff's actions are not only profoundly offensive in their cavalier treatment of one of the NYSE's fundamental investor protection rules, but are absolutely inexplicable in their de facto amendment of the Commission's own Rule 11b-1.
(See my October 20, 2006 comment letter on 2006-76 for a discussion of how the Saperstein interpretation's "trade-by-trade" approach to the negative obligation is the only possible way to interpret the rule's language, and, as such, has been an integral aspect of Rule 11b-1 for roughly 70 years).
- This matter has not been properly characterised by the NYSE, which has not discussed how its proposed "re-interpretation" of the negative obligation (and its proposed, de facto rescission of stabilisation requirements) will actually operate in conjunction with the exclusive algorithmic trading franchise being given to the specialists. The reasons for the NYSE's reticence are obvious: specialists will be permitted to trade freely, so long as they do not "cause or exacerbate excess market volatility". (See my October 20, 2006 comment letter on 2006-76 for a discussion of why this is a meaningless regulatory standard).
- For more than 70 years, the negative obligation has precluded specialist trading unless reasonably necessary to offset short-term disparities in supply and demand. The concept is simple, and has well-served the public: either a particular dealer trade is "necessary" or it isn't. If the trade is not "necessary" from a market-making perspective, it is not really a "market maker" trade as that term has been historically understood, but is simply a proprietary trade unrelated to the market making function. This is what is so radical about the NYSE proposal (more radical, in terms of interference with public orders, than going from physical to electronic trading): the specialist is being given proprietary trading privileges unrelated to the specialist's historic, limited market making function. And not only is the specialist being given these privileges, the specialist, and the specialist alone, can exercise these privileges by means of an exclusive algorithm.
In practical effect, the specialist, unconstrained by the historic negative obligation and historic stabilisation requirements, gets first crack at virtually all incoming electronic order flow. (See my October 20, 2006 comment letter on 2006-76 for a discussion of the significant legal issues this raises).
- There are two egregious problems here. First, the NYSE proposal violates the 1934 Act and is anti-competitive per se because the "specialist" is being transformed into a privileged proprietary trader. But equally offensive is the trashing of the SEC's rule approval processes. The NYSE proposal is, conceptually, a fundamental change to the specialist's historic function, regardless of the absurd, intelligence-insulting word games the NYSE is trying to play by casting this as a matter of "re-interpretation." And the "unsupervised" SEC staff (obviously bullied by the NYSE's "implementation schedules") have been giving immediate, "temporary" effectiveness to this radical transformation, without these issues being properly "fleshed out" and meaningfully exposed for prior public comment. (And once the SEC staff have put their necks on the chopping block in granting "temporary" approval, one can pretty much bet the ranch that no one at the Commission will have the guts to let the axe fall by pulling that approval down the road).
- While many of the SEC's "hybrid" approvals have raised serious questions about whether the SEC staff really understand the issues/practical effect of the NYSE's proposals (see, e.g., my March 27, 2006 comment letter on 2004-05 and my October 11, 2006 comment letter on 2006-36), the instant matter is the most disturbing of all. The SEC's processes are completely breaking down, particularly where the "unsupervised" SEC staff's "immediate effectiveness" actions directly implicate an interpretation of a fundamental SEC rule dating back virtually to the founding of the Commission itself.
- At a bare minimum, the SEC staff need to demand that the NYSE submit, for prior public comment, an appropriate amendment to the text of the negative obligation. The NYSE must be made to discuss in detail the practical, trade-by-trade effect of that amendment in light of the exclusive algorithm and the proposed de facto elimination of stabilisation requirements. And the SEC staff must ensure that the matter is properly framed for public discussion in light of the Commission,s historic and consistent application of Rule 11b-1.
The extent to which a monopoly "market maker" on a primary market such as the NYSE can compete/interfere with public order execution is a matter of over-arching, fundamental importance. It is hardly the nagging administrative detail suggested by the NYSE's superficial and condescending treatment of the issue. A matter this significant must be addressed by the Commission at an open meeting.
Consultant (to two institutional trading organisations)