From:  MarrGwen Townsend
        Sent:  Friday, October 03, 1997 10:33 PM 
        To:  'rule-comment@sec.gov'
        Subject:  S7-16-97
     
        To:  Jonathan G. Katz
        Regarding :  SEC File No. S7-16-97
        Reply from Gerald Putnam, MarrGwen Townsend of Archipelago, LLC
     
        The SEC Concept Release 34-38672 is a carefully considered study
of the regulatory issues raised by the new technological advances in 
trading.  The Commission has addressed the tradeoffs that exist between 
in choices of regulatory environment and expressed its well-founded 
desire not to stifle innovation.  There is probably no absolutely right 
answer to the question and the path chosen will have positive and 
negative impacts on the current and future participants including 
ourselves.  The Commission has covered the questions thoroughly and has 
asked for comments and suggestions.  We are neither qualified nor 
knowledgeable enough to address all the issues but are responding in the 
area with which we are familiar: alternative trading systems in the form 
of Electronic Communication Networks (ECN) as further defined by the SEC 
Rules of 1997.   We operate, under a no action letter from the SEC, an 
ECN, called Archipelago(tm).
     
        The ECN Display Alternative was defined in the SEC Order
Handling Rules of January 1997.  The rules stated that a market maker 
would be exempt from the limit order display rules if he posted the 
order in a qualified ECN. The first rule, the Limit Order Display Rule, 
requires a market maker which receives a customer limit order that is 
priced at or better than its current quote, and is not immediately 
executed, to display it to the entire marketplace. This means that 
customer orders may no longer be hidden from the market. As an 
alternative, a market maker may place the order into an eligible ECN, 
one that displays the order to the entire market in a consolidated quote 
and enables all market participants to access it (the ECN Display 
Alternative). The second rule requires a market maker entering a 
proprietary order into an ECN that is priced better than its published 
quote to display that order's price in its public quote. This means that 
market makers cannot have one price on NASDAQ and another better price 
on an ECN unless that ECN provides the ECN Display Alternative.
     
        Whereas most ECN's rely on their own liquidity to fill an order,
and reject an order if it locks or crosses the national market, 
Archipelago chooses to attempt to cross the order with other ECNs and 
market makers, through Select Net or post the order to the NQDS.  This 
means that through Archipelago, all market participants can post markets 
in the NQDS and through connections between Archipelago and other ECNs 
(via Select Net or via direct connections), have access to the liquidity 
of all ECNs.  This kind of access and price transparency was not 
available to anyone, even to large institutions, before January.  It is 
an example of how fair rules, combined with technological innovation by 
participants, acting in their own business interest, combine to provide 
a better result for market participants. These results could probably 
not have been totally anticipated by the rule makers. 
     
        The primary question we are addressing here is whether
alternative trading systems should be regulated, as they are currently, 
through the broker dealer regulations or under the rules governing 
exchanges.  Either choice would involve certain regulatory changes to 
accommodate the different needs of alternative trading systems.  A 
secondary question is what rules should be changed.
     
        Since an alternative trading system has elements of both a
broker dealer and an exchange as defined in the Exchange Act, either 
choice would be logically correct. We argue that alternative trading 
systems such as ECNs are an evolution of the agency side of traditional 
brokerage activities, and regulation of these entities should be an 
evolution of brokerage rules. 
     
        A broker, acting in his self-interest, brings buyers and sellers
together in a trade. The better job he does for his customers in terms 
of price, speed of execution, risk management, and cost of service, the 
better will be his business relative to other brokerage firms. Given a 
fair set of rules and regulations and the absence of any natural 
monopolies whether electronic or otherwise, competition among brokerage 
firms will result in the best execution for consumers.
     
        For instance, an ECN provides the same function as a traditional
broker, serving as an agent between a buyer and a seller, but does this 
electronically, without human discretion.  An ECN uses modern means of 
telecommunication to bring buyers and sellers together.  It has 
advantages above a traditional broker in the speed of display of an 
order, order entry and display of order execution. Many of the 
regulations that govern the agency functions of brokerage firms would be 
relevant to ECNs.  Due to the lack of human intervention and discretion 
in electronic systems, some of the rules would actually be easier to 
administer and monitor.  Other rules should be designed to handle the 
different behavior of electronic systems.
     
        An ECN does not naturally, and probably should not be allowed
to, conduct any of the principal business or dealing functions of a 
brokerage firm such as proprietary trading.  Such business belongs in 
the traditional broker dealer area.  Rules should be designed to ensure 
that such activity does not occur.
     
        An ECN resembles an exchange in that it provides consolidating,
display and matching of orders.  It also provides rules for agreeing to 
the terms of the trade.  However, it is unlike an exchange in several 
important ways.  It does not necessarily have both sides of the market. 
While an exchange is required by law to have a board of governors made 
up of its participants, the participants in an ECN are its customers and 
would not in generally be involved in its management. More importantly, 
rules of fairness and the essential public right to access govern the 
operation of exchanges.
     
        The essential and most important difference between the two is
that broker dealers are assumed to be profit maximizing businesses, 
whereas exchanges are organized as nonprofit organizations operating 
under guidelines for the public good. The First Alternative of the SEC 
proposal is that an alternative trading system would begin as one tier 
of exchange definition and regulation, and if volume growth is 
substantial, ultimately become a traditional exchange.   It would evolve 
from a profit maximizing business to an organization required to operate 
for the public good.  A normal business would resist this change in 
definition and pursue policies to avoid such an evolution.
     
        A natural question is whether a large alternative trading
system, by virtue of its size and effect on the market, should be 
regulated as an exchange for the public good.  We believe that as long 
as there is a set of rules, fairly applied and the antitrust rules that 
govern normal businesses, competitive forces will protect market 
participants.  
     
        We propose that the rules recognize the evolutionary aspect of
the alternative trading systems. A new association of such firms should 
be established, for instance, the National Association of Alternative 
Trading Systems, under the regulatory control of the NASD.  Such firms 
are a legitimate part of the Securities Dealer Association but different 
from market makers and traditional broker dealers.  As such they need 
different regulation, and separate and adequate representation on the 
NASD.   The Association would develop its own rules and guidelines to 
surveil trading activities of these systems, subject to the normal 
oversight of the NASD and the SEC.   People knowledgeable about and 
experienced in these issues would regulate the participants.  It would 
not be subject to inapplicable regulations that govern traditional 
brokerage operation.  Competition among existing firms and their voice 
in the regulation process would help assure the fairness of the process.
     
     
        The Association would develop guidelines for minimum levels of
performance and system capacity.  The people who created the systems are 
best able to decide how to judge performance. Members of the Associate 
would be allowed to conduct agency business electronically but not 
provide other traditional brokerage function such as trade proprietary 
systems or block trading activities.  Regulations should assure that 
nothing be done to slow down orders.  No activity would be authorized 
that would benefit from slowing down the discovery and execution 
process.  An oversight system should be put in to place to ensure that 
those with access to customer order flow do not use the information for 
their own benefit.  Institutions and broker dealers would be allowed to 
participate directly on an ECN, as they would be considered 
sophisticated investors.  Retail accounts would be allowed access to the 
ECN's through traditional broker dealers who are trained in advising 
customers on suitable investments and supervised in the traditional 
manner.  Members of the association would not be allowed to prohibit 
participants from trading with accredited members of the Association or 
the NASD.  
     
        There are advantages of using the NASD as the SRO for the
alternative trading systems.  NASD is familiar with the broker dealer 
structure and with NASDAQ, which is an integral part of the system.  The 
NASD worked with the ECNs and the SEC in implementing and releasing the 
ECN Display Rules.  The NASD has experience regulating a market.  There 
are economies in working with an existing institution as long as 
participants are fairly represented. The Association would provide an 
evolutionary structure which would allow it become its own SRO should its 
size demand it or should conflicts not be resolvable.
     
        The Concept Release anticipates problems if the NASD is
responsible for regulating alternative trading systems because the NASD 
operates the NASDAQ market, which in some ways competes with activities 
of the ECNs.   In the introduction and testing of the SEC display rules 
and during ongoing development and support of the ECNs the individuals 
at both the NASD and NASDAQ have worked very well with the ECNs. The 
report, however, anticipates that problems would arise as an inevitable 
result of competition for scarce resources at NASD and NASDAQ.  
     
        The NASD has already separated its market functions (NASDAQ)
from its regulatory function (NASD-R).  We propose further separation of 
the regulatory function into the regulation of traditional broker 
dealers and market makers, and the regulation of alternative trading 
systems.  
     
        In this proposal, the NASDAQ market would be one -- probably
always the largest -- but still only one of the markets regulated by the 
NASD.  NASDAQ would continue to provide access to its Select Net market 
to ECNs. 
     
        Integration of alternative trading systems into the National
Market System should be a goal of the rule changes. Alternative trading 
systems should be encouraged to integrate their systems to the extent 
that it makes business sense for them to do so. Integration should not 
be required. Rules should revised to allow the association or groups 
within the associations or its individual members to create linkages to 
NMS. Rules should be revised to allow the association or groups within 
the associations or its individual members to create linkages to the 
National Quotation System (NQS) and to the Intermarket Trading System 
(ITS). The suggested link to the system requires dependency on the 
NASDAQ link, which may not evolve as needed by the alternative systems, 
either because of requirements to support legacy systems at NASDAQ or 
the different needs of the alternative systems.
     
        One question concerns the numbers of  alternative trading
system.  It is easier to regulate fewer entities but the basic consumer 
protection comes from competition among ECNs, not from regulations. 
ECN's not providing the best prices and access will be outcompeted by 
those providing better prices and access.  The economics of ECN's are 
somewhat like the economics of phone companies.  In the absence of 
regulation, there will naturally be more than one, but the economies of 
scale available with today's technology and the exponential cost of 
interconnects means there will not be a multitude.  Regulations 
regarding system performance and monitoring established by the 
association can provide adequate protection against system failure. 
Integration between the ECN's will further protect participants from a 
failure or slowdown of one of the ECNs.  
     
        In fact, one of the most intriguing possibilities raised by the
changes is of a logically centralized national market with a single set 
of prices but with decentralized order accumulation and execution 
processes.  Such a system could prove to be more resilient than today's 
fully centralized systems.