Comments on the Draft Report of the SEC Advisory Committee on Market Information
August 27, 2001
Via Electronic Mail
Mr. Joel Seligman
Re: Comments on the Draft Report of the SEC Advisory Committee on Market Information
Dear Dean Seligman:
Knight Trading Group, Inc. ("Knight") welcomes this opportunity to provide the Securities and Exchange Commission's (the "Commission") Market Data Advisory Committee (the "Committee") our views on the Committee's Second Draft Report (the "Draft Report"). Knight appreciates the hard work of the members of the Committee, you and the Commission staff in the preparation of the Draft Report. As you requested and in the hope of ensuring the accuracy of the report, we offer the following comments on the Draft Report for your consideration.
Knight, headquartered in Jersey City, New Jersey, is the parent company of Knight Securities, L.P., Knight Capital Markets, Inc. (formerly Trimark Securities, L.P.), Knight Financial Products, L.L.C. (formerly Arbitrade Holdings, L.L.C.), and Knight Securities International, Ltd.1 Knight's subsidiaries make markets2 in equity securities listed on Nasdaq, the OTC Bulletin Board, the New York Stock Exchange, American Stock Exchange, Nasdaq Europe and in options on individual equities, equity indices, fixed income instruments and certain commodities in the United States and Europe. The Company is included in Fortune's "e-50 Stock Index," an elite collection of companies that are shaping the new Internet-based economy. Currently, the six-year-old company employs more than 1400 people worldwide.
I. Background and Summary of Knight's Position
Twenty-five years ago Congress instructed the Commission to facilitate the development of a national market system. The Commission engineered national market system served America's financial markets well for nearly two decades. In the past five years, however, the national market system has impeded competition between markets. While the structure created by the Commission may have been appropriate for the market of the past, sweeping technological changes require many of the rules governing the operation of the national market system be amended or rescinded.
Moreover, while the market of 25 years ago may have required the Commission being actively involved in the development of the national market system, such is not the case today. Knight believes the Securities Acts Amendment of 1975 (the "1975 Amendments") do not grant the Commission the authority to establish the mechanism for the compilation and dissemination of market data.3 Congress envisioned competition rather than regulation as the guiding force in the development of the national market system.4
Knight believes the national market system plans (the "Plans") and exclusive processors of securities information ("SIPs") that are owned and operated by certain exchanges and Nasdaq (collectively the "exchanges"), should be opened to competition and innovation. We support the competing consolidator model proposed by the Committee and believe the proposal will encourage competition and innovation.5 Knight, however, believes that the full benefits of a competing consolidator model cannot be realized as long as the national market system is premised on the current versions of the Quote Rule and the Display Rule and the Transaction Reporting Plan. Knight encourages the Commission to repeal the Display Rule and amend the Quote Rule and the Transaction Reporting Plan to reflect the market of today.6 We also encourage the Commission to reject the suggestion that the Plans are public utilities and reject the suggestion that the Plans should be treated as such "for the public good." Finally, Knight encourages the Commission to heed the instruction of Congress to facilitate the development of a national market system and not to attempt to act as its chief architect or as an "economic czar."
II. Knight Supports Creating a Fair Field of Competition
In 1936, Congress noted that a major responsibility of the Commission in the administration of the securities laws is to "create a fair field of competition."7 The consolidation of quotations and last sale information envisioned by Congress in 1975 was meant to promote fair competition.8 The consolidated, real-time stream of market data has been a key tool for enhancing transparency, for addressing fragmentation of buying and selling interest among different market centers, and for facilitating the best execution of customers' orders by their broker-dealers.9 We believe the Commission engineered national market system no longer creates a fair field of competition. Rather, the current national market system protects antiquated market centers from competition, while subsidizing their members' operations.
A. Creating a fair field of competition
In 1975, Congress instructed the Commission to develop a national market system in which "competition, rather than regulation, should be the guiding force."10 The Commission is mandated by Congress to facilitate the development of a national market system not to be its chief architect. The two paramount goals of the national market system are the "centralization of all buying and selling interest so that each investor will have the opportunity for the best possible execution of his order, regardless of where in the system it originates," and "the maintenance of stable and orderly markets."11 To achieve these objectives, Congress recognized that "communication systems . . . designed to provide automated dissemination of last sale and quotation information with respect to securities, will form the heart of the national market system."12 In establishing this mandate, Congress identified five criteria that should guide the Commission's role in the establishment of a national market system, including: the promotion of the development of mechanisms that allows for economically efficient execution of securities transactions; the promotion of fair competition; promotion of transparency; the improvement of investor access to the best markets; and the development of mechanisms that allow for investors' orders to be executed without the participation of a dealer.13
The national market system Congress envisioned that was unattainable in 1975 due to a lack of suitable technology is now attainable. However, the governance structures and technology of the current Commission engineered national market system are ill suited to achieve these goals. We believe the current national market system no longer serves to promote the development of mechanisms that allow for economically efficient executions of securities transactions. Knight believes the current national market system impedes fair competition and reduces market transparency.
B. Obstructions to fair competition
The reason the Commission engineered national market system fails to meet its Congressional mandate is because the governance structures of the national market system are in need of significant reform. Currently, the boards of these plans are composed of representatives from each exchange. Any change to the rules governing the operation of the Plans, such as the very rule changes necessary to accommodate the proposed competing consolidators of market data, require the unanimous consent of the participants. Consequently, the national market system is unable to effectuate the necessary changes because any member can block changes that threaten their antiquated market or technology.
III. Competition Should Drive the Development of the New National Market System
Congress granted the Commission broad powers under Sections 11A(b) and (c)(i) over any SIP to ensure the neutrality and the reasonableness of its charges in practice as well as in concept.14 Congress, however, did not grant the Commission unfettered power over the national market system. Rather, the Commission was given the authority to remove barriers to competition that would unjustifiably hinder the market's natural economic evolution, while ensuring fair competition and investor protection.15 Congress chose to rely on an "approach designed to provide maximum flexibility to the Commission and the securities industry in giving specific content to the general concept of the national market system."16 Congress implemented this approach by adding Section 11A to the Exchange Act. This section directs the Commission to facilitate the establishment of a national market system in accordance with specific congressional findings and objectives.
While Knight supports the goals articulated by Congress in 1975, we oppose the continuation of the Commission engineered model for the consolidation and dissemination of market data. We believe the current approach is beyond the scope of the authority granted to the Commission. In 1975 Congress clearly stated the Commission would not have:
either the responsibility or the power to operate as an "economic czar'" for the development of a national market system. Quite the contrary . . . the initiative for the development of the facilities of a national market system must come from private interests and will depend upon the vigor of competition within the securities industry . . .17
This is not to say that the Commission does not have an important role in the national market system. As Congress recognized in 1975:
Although the SEC's basic role would be to remove burdens to competition which would unjustifiably hinder the market's natural economic evolution and to assure that there is a fair field of competition consistent with investor protection, in situations in which natural competitive forces cannot . . . be relied upon, the SEC must assume a special oversight and regulatory role.18
The anti-competitive nature of the current national market system requires the intervention of the Commission. The Commission can correct this market inefficiency by opening the national market system to new participants and by eliminating and amending obsolete rules.
IV. Knight Supports Eliminating the Display Rule
One of the cornerstones of the Commission designed national market system is the Display Rule.19 Under the Display Rule, a vendor or broker-dealer that provides market information to customers must include, at minimum, a consolidated quotation display and consolidated last sale display. If quotation information is provided with respect to a particular subject security, the vendor or broker-dealer must include either the national best bid and offer ("NBBO") or a quotation montage for the security from all reporting market centers.20 If transaction reports or last sale data are provided with respect to a particular reported security, the vendor or broker-dealer must include the price and volume of the most recent reported transaction, and an identification of the market center in which such transaction took place.
To facilitate the development of a new national market system, the Commission must review, amend and eliminate antiquated rules and structures that impede the fair field of competition. Knight believes the Display Rule should be eliminated because it impedes the development of a new national market system.21 While the Display Rule may have been necessary to accomplish the goals of the 1975 Amendments, it has outlived its usefulness. The Display Rule does not reflect the reality of the market of 2001. The rule is no longer necessary because market forces and the duty of best execution ensure that broker-dealers provide high-quality executions to their customers. These rules also encourage broker-dealers and market centers to widely disseminate market information to the public in increasingly accessible formats. Moreover, the continuing value of the Display Rule is questionable in an environment with the execution quality disclosure rules recently adopted by the Commission.22 Like Congress in 1975, Knight believes market forces rather than regulation should determine the structure of the national market system.
V. Knight Supports Amending the Transaction Reporting Plan and the Quote Rule
Under the Transaction Reporting Rule23 each exchange is required to file with the SEC a plan for the dissemination of transaction information for listed equity and Nasdaq securities traded through its facilities. The Rule also requires the NASD to file a plan for the dissemination of transaction information for such securities executed by its members otherwise than on an exchange. These plans must address, among other things, the consolidation of information and require every broker-dealer to transmit to any exchange of which it is a member or the NASD all information required by that SRO's transaction reporting plan.
Under the Quote Rule, each exchange is required to collect, process, and make available to vendors the best bid, the best offer, and aggregate quotation sizes for each subject security listed or admitted to unlisted trading privileges that is communicated on that exchange.24 The NASD is required to collect, process, and make available to vendors the best bid, the best offer, and aggregate quotation sizes for each subject security communicated otherwise than on an exchange by any OTC market maker, as well as the identity of that market maker. In addition, every broker-dealer is required to promptly communicate to the applicable exchange or the NASD its best bids, best offers, and quotation sizes for any subject security.
Knight opposes retaining the current Transaction Reporting Rule, with SIAC and Nasdaq acting as exclusive consolidators of market information pursuant to the Plans.25 Knight supports offering other entities the opportunity to provide market information to market participants.26 To ensure the national market system accomplishes the goals of the 1975 Amendments, Knight supports requiring all broker-dealers to send their quotes to at least one exchange. However, broker-dealers should also be permitted to send their quotes to any exchange, market center, or vendor they choose. Broker-dealers should be permitted to negotiate their compensation for the quotes they send to these destinations. Broker-dealers should also be permitted to publicly display any portion of their quote on their own electronic mediums subject to Commission oversight. However, to protect against anti-competitive practices, broker-dealers should be prohibited from sending quotes to any destination in a manner that would give certain market participants a competitive advantage over other market participants.
VI. Knight Opposes Retaining the Current Market Data Revenue Distribution Mechanisms
The Exchange Act grants rulemaking authority to the Commission to ensure that: all SIPs may obtain market information from an exclusive processor of that information on terms that are "fair and reasonable"; and all persons may obtain market information on terms that are "not unreasonably discriminatory."27 The user fees charged by each Plan for its market information typically are negotiated with vendors, broker-dealers, and other users. These fees must be filed with the SEC as proposed rule changes, and are subject to public notice and comment procedures. Under the CTA and CQ Plans, after payment of operating expenses, fee revenues are distributed among the exchange participants in accordance with their proportional share of total transaction volume. Under the Nasdaq/UTP Plan, after payment of operating expenses, revenues are distributed among the exchange participants based on an average of the percentage of total transaction volume and the percentage of total share volume, subject to certain floors and caps.
Knight opposes retaining the existing mechanisms for determining user fees and allocating revenues among the exchange participants because they are unfair and violate the spirit and the of the 1975 Amendments. Specifically, Knight supports opening the national market system plan operating committees to participation by representatives of other constituencies, vendors, broker-dealers, and the public. We support modifying the voting and governance provisions of the Plans. Knight encourages the Commission to eliminate the unanimous voting provisions.28 These changes are needed to permit the Plan operating committees to more easily modernize their technologies and to replace a SIP. This is currently impossible due to the unanimous voting requirements. Knight encourages the Commission to establish general standards for evaluating the fairness and reasonableness of fees and for distributing market information revenues. Finally, Knight supports permitting each entity providing information to a SIP to negotiate fees for its market information directly and separately with the SIP, subject to SEC oversight.
VII. Ancillary Matters
A. Disclosure of the Use of Market Data Revenues
In enacting the 1975 Amendments, Congress addressed the issue of funding for national market system facilities. Sections 6(b)(4) and 15A(b)(5) require that the rules of a national securities exchange or national securities association "provide for the equitable allocation of reasonable dues, fees, and other charges among members and issuers and other persons using" the exchange's or association's facilities. Congress intended that the fees collected from persons using a self-regulatory organization's facilities be directed to funding the "costs associated with the development and operation of a national market system."29
Knight believes Congress granted the Commission the authority to ensure that market data revenues from the national market system do not subsidize the exchanges' competitive activities. We believe requiring the national market system plans and the exchanges to disclose information regarding market data revenues and regulatory costs will promote a fair field of competition.
B. Administrative Issues
Knight believes the Commission should explore ways to improve the operational efficiency of the Plans to reduce the administrative costs of market data users, including opening the administrative functions to competitive bidding. Knight supports standardizing and streamlining the agreements, policies, billing procedures, and reporting requirements that the various Plans apply to vendors, broker-dealers and subscribers.
C. Technological Issues
Knights believes opening the governance structures of the Plans and opening the consolidator functions to competition will enhance transparency and promote technological improvements. These new competing consolidators will ensure that the system has adequate capacity with improved accuracy and reliability. Moreover, by infusing competitive pressures into the market data business, the Committee will ensure that technological advancements continue. Finally, by amending the governance structures of the Plans and by eliminating the unanimity requirement of the Plan operating committees, the Commission will enable the national market system to introduce new competing SIPs.
D. Pilot Programs
Knight is concerned with the Plans that use their "pilot program" provisions to implement fee structures for periods of time beyond that which the provisions originally were intended to cover. Knight recommends placing strict limits on the use of pilot programs and the length of those pilot programs.
New technologies have made the development of the national market system envisioned by Congress in 1975, a reality. There are now private networks that can satisfy the goals of the national market system without the Commission having to act as an "economic czar." These innovations ensure that markets are more transparent than ever and that data costs are subject to competitive forces for this first time. However, the markets are also encumbered by antiquated Commission mandated rules and structures that were needed to promote transparency in 1975, but are no longer necessary. The only way to fully realize the national market system envisioned in 1975 is to reform the Plans. The Commission should eliminate antiquated rules like the Display Rule, and amend other rules like the Quote Rule and the Transaction Reporting Rule. These steps will open the national market system to new constituencies and promote competition, while enhancing market transparency and innovation.
I hope that you, the other members of the Committee and the Commission and staff find these comments helpful. If Knight or I can be of further assistance to you on this matter, please do not hesitate to contact me at 201-557-6910 or Richard B. Levin at 201-356-1389.
Very truly yours,
Michael T. Dorsey
cc: Harvey Pitt, Chairman
1 Throughout the draft report, Knight is referred to as Knight/Trimark. While originally known as Knight/Trimark, Knight no longer uses this name and is known as Knight Trading Group. Knight would appreciate the deletion of all erroneous references to Trimark from the final report.
2 Like specialists, market makers "act as agent[s] for buy and sell orders . . . " Draft Report at 12.
3 Pub. L. No. 94-29, 89 Stat. 97 (1975).
4 H.R. Conf. Rep. No. 94-229, 94th Cong., 1st Sess. 92 (1975) (noting that "[i]t is the intent of the conferees that the national market system evolve through the interplay of competitive forces as unnecessary regulatory restrictions are removed.").
5 Draft Report n225.
6 Draft Report n214.
7 Pub. L. No. 94-29, 89 Stat. 97 (1985).
9 See 64 Fed. Reg. 70613 (Dec. 17, 1999).
10 See H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 92 (1975).
11 See S. Rep. 94-75, 94th Cong., 1st Sess. 7 (1975).
12 H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975).
13 Section 11A(a) of the Securities Exchange Act of 1934.
14 Pub. L. No. 94-29, 89 Stat. 97 (1975).
16 H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 92 (1975).
17 S. Rep. 94-75, 94th Cong., 1st Sess. 7 (1975).
19 Rule 11Ac1-2.
20 The best bid and best offer, with size, from any reporting market centre, and an identification of the applicable market center.
21 Draft Report n214.
22 Rule 11Ac1-5 and Rule 11Ac1-6.
23 Rule 11Aa3-1.
24 Rule 11Ac1-1.
25 Draft Report n254.
26 Draft Report n219.
27 See Section 11A(c)(1)(C)&(D).
28 Draft Report n257.
29 H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 92, 93 (1975). See, e.g., S. Rep. No. 94-75 (1975), reprinted in 1975 U.S.C.C.A.N. 179 (SEC "must assume a special oversight and regulatory role" to remove burdens on competition caused by exclusive processors and other SRO projects "which enjoy an effective monopoly, or which are merchandised to members on a basis other than cost and quality of services."). H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975).