Subject: SR-NASD-99-53 Date: 12/07/2000 5:10 PM December 6, 2000 Jonathan Katz Secretary U.S. Securities and Exchange Commission 450 5th St. NW Washington D.C. 20549 RE: Amendment No. 8 to File No. NASD-99-53 Dear Mr. Katz: The Island ECN, Inc. ("Island") appreciates the opportunity to comment on the NASD's Amendment No. 8 to the SuperMontage Proposal (the "Proposal"). The NASD, through its subsidiary Nasdaq, initially submitted the Proposal in November of 1999. The NASD has filed a number of amendments to the Proposal to modify or further clarify the original proposed rule filing. Island has reviewed the most recent amendments to the Proposal and strongly believes that they fail to address the anti-competitive concerns raised by SuperMontage. In addition to the anti-competitive issues, Island believes there are serious flaws in the operation and legal reasoning behind SuperMontage's order execution algorithm. Under the proposed order execution algorithm, within a given price level, a non-directed order from an ECN that charges a separate quote-access fee would be executed after orders from market makers, ECNs that do not charge a quote-access fee, and non-attributable agency interest of UTP Exchanges. Pursuant to the algorithm, if the price improvement offered by the ECN is equal to or exceeds the quote-access fee, SuperMontage would give equal priority to that order with identically-priced orders of other market participants. The NASD justifies the algorithm's inferior treatment of ECN orders under a theory of "best execution." The NASD argues that "best execution" dictates that orders that result in fees for broker-dealers, not necessarily the customer, must be given a lower priority in SuperMontage than identically-priced orders. While such an application of "best execution" may be appropriate in SuperMontage, the Commission must consider the implications that SEC approval of such an extension of "best execution" will have on market practices in general. SEC approval of the NASD's "best execution" theory suggests that brokers must now consider market access fees charged to broker in connection with their order routing decisions. Market access fees exist in all markets, not only ECNs, and come in a variety of forms and sizes. While not yet disclosed by the NASD, SuperMontage itself will have a market access fee. The NYSE has a variety of market access fees (i.e., DOT fees, membership fees, seat prices, etc.). Nasdaq currently maintains a number of market access fees (i.e., ACT fees, SelectNet fees, SDP fees, SOES fees, Workstation II fees, etc.). If the Commission approves the NASD's "best execution" theory, the Commission must apply that same theory to its "best execution" considerations across the entire market. It would be inappropriate for the SEC to accept that theory in a vacuum of SuperMontage exclusively. The Commission must consider additional complications that are raised by such an extension of "best execution" precedence. For example, where price is not a factor, this "best execution" theory dictates that a broker-dealer route orders to a market center that charges the broker-dealer the lowest access fee. Such a theory could therefore require a broker to route its orders to a market center that pays for order flow because of the resulting reduction of the access fees. Such an application of best execution would be inconsistent with the Commission's current view on best execution and payment for order flow. More troubling under the NASD's theory of "best execution" is that while the NASD stresses the need to give lesser priority to ECN orders when the associated access fees allegedly result in inferior prices, its proposed algorithm fails to give greater priority to ECN orders that offer "net" price improvement (after taking into account access fees) over other orders displayed at the same price. Thus, the NASD is arbitrarily applying its "best execution" theory in order to favor certain market participants. For example, assume that there are two identically-priced orders for 1,000 shares being displayed in SuperMontage; one order is from a Nasdaq market participant and the other order is from an ECN that charges an access fee of $0.0025/share or $2.50 for 1,000 shares. Assume that the ECN's internal quote is 1/64th better than the displayed quote in SuperMontage, which results in a price improvement of $15.63. Although the ECN order offers "net" price improvement (the price improvement exceeds the access fee), the ECN order would only be given equal, not greater, priority as the market maker order. Such an arbitrary application of this "best execution" theory embedded within an SRO's priority scheme is highly inappropriate and inherently unfair to ECN orders. Similarly, the proposed algorithm does not distinguish between ECNs that charge different quote-access fees. While Island charges an access fee of $0.0025/share, another ECN may charge the maximum permissible fee of $0.015 per share. Although that ECN's access fee is six times greater than Island' s access fee, under the current Proposal, identically-priced customer orders from Island and the other ECN would be accorded the same priority in SuperMontage. Such a result would discourage competition between ECNs with respect to access fees and lead to higher fees overall. Accordingly, in light of the obvious inconsistencies in the Proposal, Island requests that the NASD be required to further amend its Proposal to apply its theory of "best execution" in a consistent and appropriate manner. Thus, SuperMontage must (1) rank an ECN customer order ahead of other orders displayed at the same price if the price improvement offered by the order exceeds the quote-access fee charged by the ECN; and (2) rank an ECN customer order ahead of another ECN's customer order displayed at the same price if the access fee charged by the first ECN is lower than the second ECN. In addition, Island requests that the Commission carefully consider the implications of approving the NASD's extension of "best execution" outside of the SuperMontage context. The Commission can no longer analyze access fees as though they only exist in the context of an ECN. Island thanks the Commission for its consideration. Sincerely, Chris Concannon V.P. and Associate General Counsel The Island ECN