September 14, 2000 Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549-0609 Re: National Association of Securities Dealers' SuperMontage Rule Filings File No. SR-NASD-99-53 Dear Secretary Katz: I am writing on behalf of the Consumer Federation of America to express our concerns about certain aspects of the National Association of Securities Dealers' proposal -- commonly known as "SuperMontage" -- to modify Nasdaq's order display window and main trading platform. We approach this proposal as an organization that generally supports efforts to improve transparency and reduce fragmentation in the securities markets. As such, there is much we find to admire in SuperMontage. Properly implemented, its potential to provide a more complete display of trading interest for stocks and faster, easier execution of orders should offer substantial benefits to investors. There are several features of the SuperMontage proposal, however, that we believe undermine this goal. These relate primarily, though not exclusively, to the order collector facility and, specifically, to its order execution algorithm for non-directed trades. Instead of executing those orders according to strict price/time priority, the system proposes to give priority to certain types of trades. CFA is concerned that these preferences may not represent the best interests of investors. 1. SuperMontage perpetuates internalization. SuperMontage assigns its highest priority for order execution to enabling market participants to match customer orders with their internal order flow. We recognize that, in doing so, Nasdaq is simply accommodating a well established practice that is permitted under existing law. Furthermore, we recognize that Nasdaq almost certainly believes that, as long as internalization is legal and pervasive, it must accommodate the practice if it is to attract the level of use for its voluntary system that is necessary to make SuperMontage a success. On the other hand, internalization is a practice that has come under increasing scrutiny in the debate over market fragmentation. Many industry participants and observers, including CFA, have argued that internalization should be restricted on the grounds that it inappropriately isolates significant pockets of order flow from interaction with the rest of the market, thus increasing market fragmentation and denying investors the opportunity for price improvement. The Commission itself has raised these concerns and has initiated a discussion of whether additional restrictions are needed. With its proposal to create a centralized order execution facility for Nasdaq stocks that would give first execution priority to those who internalize order flow, SuperMontage adds urgency to the calls for the Commission to address this issue. We would encourage the Commission, at a minimum, to limit internalization by requiring market makers to expose orders to price improvement before internalizing them. This should then be incorporated into the automated execution algorithm for SuperMontage. 2. SuperMontage may deny investors access to better prices available through ECNs that charge access fees. If internalized executions go to the head of the line under SuperMontage, executions of orders entered on ECNs that charge an access fee go to the back of the line. The reason offered by NASD is that "such a fee represents an increase in trading costs and clearly an inferior price." While access fees may impose additional trading costs on brokers, it is not clear to us that these fees automatically translate into an inferior price for the investor. First, it is our understanding that the firm, not the investor, typically pays the access fee. In such instances, the firm absorbs the fee as part of its overhead costs and recoups it, along with other overhead costs, in the commissions it charges its clients. While it is true that investors eventually pay overhead costs indirectly, it is not true that the individual who executes a particular trade on an ECN that charges an access fee automatically receives a clearly inferior price in that instance. Because Nasdaq -- and by extension SuperMontage -- does not quote prices in increments as fine as those used by some ECNs, the investor may in fact be denied access to a better price by this system. Specifically, if rounding causes that better price to be grouped for execution with prices that are inferior, then the fact that the access fee sends that order to the end of the line for execution would result in the investor's receiving what is in fact an inferior price. NASD argues that, because SuperMontage will not be implemented until after Nasdaq implements decimal pricing, rounding will not occur to the extent that it does today. We certainly agree that, once prices are quoted in pennies, the degree of rounding should decrease considerably. However, certain ECNs already trade in increments of less than a penny. Thus, rounding will not be entirely eliminated. Although the costs involved are tiny on a per-share basis, the market-wide implications could be considerable. The NASD has offered two concessions to ECNs that charge access fees that would allow them to have their orders executed on the same priority as market makers, ECNs that don't charge a separate access fee, and agency orders of UTP exchanges. First, ECNs could incorporate their access fees into their published quotes. Or, ECNs that continue to charge a separate access fee could indicate on an order-by-order basis whether the price improvement offered by the order equals or exceeds the access fee charged, in which case it would receive the improved priority for execution. If access fees represented a direct cost to investors, these approaches might be seen as offering a reasonable approach to a thorny problem. As we have noted above, however, it is our understanding that investors do not typically pay these fees directly, instead paying them indirectly along with other overhead costs through the commissions they pay their broker. As a result, both approaches could still have the effect of denying individual investors access to better priced orders. In essence, SuperMontage would give a higher priority to brokers' ability to minimize transaction costs than it would to ensuring the best price for the investor on a particular trade. Furthermore, market makers that internalize order flow would be able to match the best bid or offer, which would incorporate the access fees, without therefore actually having to offer investors the best price they could actually receive for a particular stock. 3. SuperMontage does not fully deliver on its promise of improved transparency. One of the most significant potential benefits of SuperMontage is its promise to increase transparency in the market for Nasdaq stocks. However, both the ability for market participants to trade anonymously through SuperMontage and the system's "reserve" feature, which allows market participants to hide the extent of their trading interest, denies investors access to information that may be highly relevant to the pricing of particular stocks. We understand that Nasdaq is attempting to design a system that will attract widespread participation and that institutional investors would be unlikely to participate voluntarily in a system that denied them the ability to disguise their major market moves. We also recognize that, whether they are pension funds or mutual funds, institutional investors who seek anonymity are generally doing so to advance the interests of the pension participants and fund shareholders on whose behalf they invest. However, we believe this is an issue that deserves greater scrutiny from the Commission to ensure that certain large players are not receiving an unfair trading advantage that is not available to small investors. Conclusion SuperMontage offers significant potential benefits to investors in the form of increased transparency and greater interaction of orders for Nasdaq stocks. Investors only stand to benefit, however, if those orders interact on fair and equitable terms. As outlined above, CFA believes several significant problems still remain that should be resolved before SuperMontage is granted final approval. Respectfully submitted, Barbara L. N. Roper Director of Investor Protection