Bloomberg Tradebook LLC
June 20, 2003
Via e-mail: firstname.lastname@example.org
U.S. Securities and Exchange Commission
Re: SEC File No. S7-11-03
Bloomberg Tradebook LLC ("Bloomberg Tradebook")1 appreciates the opportunity to comment, in response to the request by the Securities and Exchange Commission (the "Commission") in Securities Exchange Act Release No. 47849 (May 20, 2003) on the petition submitted by The Nasdaq Stock Market, Inc. ("Nasdaq") concerning the regulation of Nasdaq-listed securities (the "Nasdaq Petition").
The Nasdaq Petition requests that the Commission take certain actions to respond to what Nasdaq characterizes as increased fragmentation of trading in Nasdaq-listed securities. Nasdaq asserts this increased fragmentation has caused the regulation of trading in Nasdaq-listed securities to become unequal, uncoordinated and, in some cases, inadequate. Nasdaq believes, for example, that when broker-dealers quote in one market while printing trades in another or when they quote and trade securities in more than one market, it becomes increasingly difficult for any single self-regulatory organization ("SRO") to oversee trading adequately in the affected securities. In further support of its petition, Nasdaq states that several exchanges do not have rules approved by the Commission for gathering the detailed trading data that are necessary for the detection of fraud, manipulation, insider trading and other violations. As a result, Nasdaq notes, there is not currently a single, coordinated, electronic audit trail for monitoring and surveillance of trading in Nasdaq-listed securities. Nasdaq also asserts that some markets are free riding on the regulation provided by other markets by lowering their execution and reporting fees to compete for trades in Nasdaq-listed securities. Nasdaq also states that, to hold down costs, these markets avoid incurring new regulatory expenses, such as the costs of adapting their existing rules and surveillance systems to the unique structure and patterns of Nasdaq trading. According to Nasdaq, these markets use the savings from less regulation as an inducement to attract trading away from the NASD's highly regulated markets to less regulated markets, to the detriment of investors.
In response to the problems it presents in its petition, Nasdaq is asking the Commission to: (i) amend the rules of all markets that trade Nasdaq-listed securities to establish uniform trading rules; (ii) order that the exchanges' costs of regulation be aggregated and deducted from market data revenue collected pursuant to the Nasdaq Unlisted Trading Privileges Plan (the "UTP Plan"); and (iii) prohibit trading by any market that fails to protect investors as required under the Exchange Act. In addition, the Commission has requested comment as to whether the same measures should be taken with respect to trading of exchange-listed securities.
The Nasdaq Petition raises two questions: (1) To what extent must the Commission establish uniform trading rules across markets to ensure that SROs are meeting their Exchange Act responsibilities? (2) Should the costs of market regulation be met out of market-data revenues?
II. TO WHAT EXTENT MUST THE COMMISSION ESTABLISH UNIFORM TRADING RULES ACROSS MARKETS TO ENSURE THAT SROS ARE MEETING THEIR EXCHANGE ACT RESPONSIBILITIES?
We note in passing that Nasdaq's assertion of regulatory subsidy perhaps should be viewed in light of the fact that Nasdaq itself might be said to be riding on the regulatory coattails of the New York Stock Exchange in that the NYSE is the Designated Examining Authority (the "DEA") and incurs the attendant examination and surveillance costs for most if not all of the NASD's largest members.2 That does not cut against the points Nasdaq makes, but it raises issues of cost allocation, discussed below.
In any event, we believe that the answer to the first question raised by the Nasdaq Petition should be a qualified yes.3 Except for the statements Nasdaq makes about the adverse effects of fragmentation and regulatory free-riding on its own revenues, the Nasdaq Petition itself provides little or no evidence in support of its request to the Commission for uniform trading rules in Nasdaq-listed securities. For example, Nasdaq does not provide any demonstration that fragmentation or regulatory free-riding has led to a serious lapse in self regulation, such as an increase in market manipulation, illegal short selling, insider trading, fraud, front running, marking the open or close, and non-compliance with the limit-order-display rule or the firm-quote rule.
Undoubtedly, some degree of regulatory uniformity is desirable, particularly to address two specific problems Nasdaq has identified that affect trading in Nasdaq-listed securities, that is, variations in the short-sale rule and gaps in audit-order-trail reporting. Differences between the Exchange Act Rule 10a-1 and NASD Rule 3350, coupled with the fact that neither applies to trading in Nasdaq-listed securities on regional exchanges, have resulted in regulatory arbitrage. Regional exchanges can offer trading in Nasdaq-listed securities free of any short-sale restrictions. While we doubt either rule is needed to address real market problems, the NYSE and the NASD have inveigled issuers over the years into believing in the efficacy of those rules to prevent bear raiding and other calamities. As a result, such a disparity in the implementation and enforcement of a short-sale rule can undermine the perceived value to issuers of a listing on Nasdaq. Nasdaq would be doubly harmed, by losing order flow to regulatory arbitrage and by being placed at an unfair disadvantage to the NYSE in competing for securities listings. We therefore believe that short-sale regulation, if it is to be imposed at all, should be uniform and non-discriminatory, which could be achieved by the Commission's establishment of a uniform short-sale rule across all market venues.
Nasdaq reports that no other market currently executing trades in Nasdaq-listed securities has rules requiring its members to report order-audit-trail information or operates a Commission-approved order audit trail. NASD uses the data Nasdaq collects through its order-audit-trail systems to create a fully integrated audit trail of quotations, trades and orders; NASD Regulation uses the audit trail to run its market surveillance programs. For transactions reported away from Nasdaq, Nasdaq states, the NASD receives the quotation and trade reports of the regional exchanges but the data are not synchronized, are not provided in a format common to all market centers and are received two days after trade date. We expect that cross-market, order-audit-trail data that are timely and are synchronized across market centers could be an important adjunct to effective market surveillance of Nasdaq-listed securities. As a result, we believe the Commission would be justified in requiring all SROs that trade Nasdaq-listed securities to have electronic audit-trail systems that are fully coordinated with the NASD's system.
A topic that is highly relevant to intermarket trading rules affecting Nasdaq stocks is the problems caused by access fees. As the Commission knows, it allowed ECNs to charge access fees when it adopted the Order Execution Rules, Rules 11Ac1-1 and 11Ac1-4 under the Exchange Act. Through rebating, access fees encourage payment for order flow, which does not benefit investors and which otherwise would have been eliminated by decimalization and the automation of the markets. In addition, access fees increase the incentives for broker-dealers and exchanges to hold onto client orders with a view to internalizing them. The incentive is to delay display or not to display at all and certainly there is little or no incentive to display orders as quotations beyond the BBO. Slowing down the process by which orders are shipped out to other market centers has a built-in incentive for a specialist or other broker-dealer, for it increases the likelihood that a contra order will come in that will allow the firm to internalize the transaction and avoid paying access fees. Resulting increases in internalization diminish order interaction, reduce transparency and diminish publicly available liquidity in the national market system.
Access fees in turn lead to locked and crossed markets. A firm that refuses to pay a market participant's access fees can reject that participant's order and lock or cross the market. Efforts to remedy that problem in SuperMontage by decrementing a firm's quotations if it fails to accept an order from a participant that refuses to pay its access fees encourage certain forms of gamesmanship. That, in turn, diminishes the efficiency of the markets. Access fees are much less important than they once were as a revenue source for exchanges and ECNs alike. In our experience, broker-dealers both pay access fees and receive rebates of access fees, in many cases with little net gain or loss. We think the solution is an across-the-board elimination of access fees, and with it the problems they engender.
Another problem that should be addressed at the same time is the lack of automation in market centers' responses to incoming order flow against their quotations, which in turn affects their response times. ECNs are held to an exacting standard of maximum permitted response time that requires automation, but UTP exchanges such as the American Stock Exchange are not. As a result, market participants are disinclined to send orders to a market center that will not respond immediately. Exchange specialists, moreover, are given up to 30 seconds to enter quotations, which is an unjustifiable economic subsidy since they can use that down time to search for an internal match, denying the liquidity to the national market system. The resulting inefficiencies lead to locks and crosses and other dislocations. The solution is to require all market centers to abide by the mandatory maximum response times imposed on the ECNs.
III. SHOULD THE COSTS OF MARKET REGULATION BE AGGREGATED AND MET OUT OF MARKET DATA REVENUES?
Nasdaq proposes that the Commission exercise its authority to require that costs of regulating trading in Nasdaq-listed securities be aggregated for all affected SROs and that the costs be deducted from market-data revenue collected pursuant to the UTP Plan. Nasdaq argues that regulatory costs should be aggregated to ensure that intermarket competition does not come at the cost of adequate regulation and to counter existing economic incentives that are leading markets to compete for order flow by reducing their regulatory costs. We suggest that this complex topic should be considered from two vantage points, cost allocation and the source of funding to defray the costs.
Cost allocation. Historically, the amounts expended by regional exchanges on regulation and surveillance have been dwarfed by the NASD and NYSE expenditures on those items. We understand that most of the regional exchanges have not had the economic wherewithal to mount surveillance and regulatory programs to rival those of the NASD or the NYSE. We do note, though, that today the Archipelago Exchange has a significant share of trading volume in Nasdaq-listed securities. If current trends continue, Archipelago may well be in a better position than Nasdaq itself in future to pay the costs of regulation.4 Also, the Cincinnati Stock Exchange (the "CSE") has been the recipient of a special benefit due to CSE's dramatic increase in Nasdaq market share.
There are, of course, several types of regulation and surveillance. That should be borne in mind in evaluating how revenues and costs should be allocated. For example, an SRO such as the NYSE or the NASD performs regulatory and surveillance functions with respect to firms for which it acts as DEA. A DEA's examination of a broker-dealer's sales practices, financial responsibility, customer protection, reporting and recordkeeping is distinct from an SRO's regulation of the SRO's market facilities. A DEA's surveillance and regulatory functions can be considerable indeed, particularly with respect to full-service firms that do a retail business. Those functions, and their attendant costs to a DEA, are substantially less onerous with respect to, for example, a broker-dealer whose sole function is the operation of an ECN and that does not act as principal, underwrite securities, make markets, issue research or make investment recommendations, or accept custody of customers' funds and securities. An SRO's market-regulation functions, in turn, differ dramatically in the case of electronic markets, where there is a reliable electronic audit trail, and floor-based markets, where the regulation may have to be considerably more labor-intensive and thus costly. Each of those factors needs to be taken into account in assessing the fairness and reasonableness of fees imposed on members and of the allocation of revenues.
Nasdaq has not put forward sufficient revenue and expense data to support its arguments on cost allocation, but there would seem intuitively to be some truth to its position that, through the regulatory fees it pays to the NASD, it effectively subsidizes other markets' regulatory responsibilities, thereby creating a classic free-riding situation. That burden may in turn be increased by the absence of a framework for uniform audit trails and uniform enforcement of marketplace rules. Nasdaq points out that it provides regulatory oversight of trading in its securities conducted by Island ECN ("Island") but that Island reports 15% of all Nasdaq trades to the CSE. That effectively causes Nasdaq, through its fees paid to the NASD, to shoulder the costs of receiving and storing Island's electronic order-audit-trail data and the costs of regulating Island as an NASD member while the CSE receives the market-data revenue attributable to Island's trades without sharing in the regulatory burden.
Nasdaq's recent loss of market share to Archipelago and to the CSE has been dramatic. It suggests, among other things, that the Commission should indeed look closely at the extent to which Archipelago and the CSE today are bearing a proportionate share of market surveillance and other regulatory costs, even though there may not be any demonstration at the moment that Archipelago's own regulation and surveillance, or those of the CSE, are insufficient to meet their own statutory responsibilities under the Exchange Act.
In any event, regulation should not be allowed to sink to the lowest common denominator and broker-dealers that wish to reduce their costs should not be able to do so by avoiding NYSE or NASD membership and gravitating to other SROs that impose less effective regulation and surveillance.5 We recommend that the Commission evaluate how best to address the current situation to reduce such incentives and to ensure that the costs of regulation are more fairly allocated than seems to be the case at present. At the same time, the allocation of revenues on the basis of trades alone, without taking into account other factors such as the dissemination of enhanced pre-trade information, may no longer be appropriate.
Defraying regulatory costs. The question of how to defray the costs of self-regulation, regardless of how they are allocated among competing market venues, is a complex one. Traditionally, the Commission has allowed SROs to apply their revenues from data sales to those regulatory expenses. The recent movement toward for-profit exchanges has changed the environment, however, as the Commission noted in Securities Exchange Act Release No. 42208 (December 9, 1999) (the "Market Data Release"):
In response, the Commission proposed establishing a cost-based limit to market-data revenues and funding certain SRO costs, principally the cost of market regulation, through those market-data revenues. The Market Data Release links funding the costs of market regulation through market data to establishing a cost-based limit to market-data revenues. That is, the Commission's proposal sought to tackle both sides of the potential threat to adequate regulation raised by for-profit SROs. It would have placed a cost-based limit on the money to be made from market data, it would have factored into the cost of market data the cost of market regulation and it would have funded the cost of market regulation through the distribution of market data revenue. Taking a more comprehensive view of the issues, the Commission further proposed to change the allocation of market data revenues from one based solely upon an SRO's proportion of transactional volume to one based more upon the value of the information they contribute to the stream of consolidated information.7
In its letter to the Commission of April 11, 2000, Bloomberg L.P. ("Bloomberg") commented on the Market Data Release. Bloomberg expressed its support for the Commission's proposed cost-based limits on market information fees but disagreed with the Commission's proposal to include the costs of regulation in the calculation of those costs. Bloomberg argued that restricting costs to the direct costs of gathering, consolidating and disseminating information would make it easier for the Commission to set appropriate rates, rates that would prevent the SROs from exploiting their government-conferred monopoly positions with respect to the data. Commenting on the anticompetitive aspects of funding market regulation through market-data fees, Bloomberg noted:
The Nasdaq Petition raises important questions that go to the heart of self regulation. Fairly evaluating Nasdaq's proposals would require a thorough examination of the costs of market data, including the costs of market regulation, and a reconsideration of the proper allocation of market-data revenues and the expenses of self regulation. Should the Commission decide to advance the discussion for further comment, we respectfully request that it publish the results of any relevant fact finding into the actual state of market regulation carried on by the SROs together with full disclosure from Nasdaq of its costs for market regulation and full disclosure of the costs of gathering, consolidating and disseminating market data. Without that information, it is not possible to conduct a fully informed discussion of the proposals in the Nasdaq Petition.
In closing, we would like to comment in response to the Commission's question as to whether the measures requested by Nasdaq also would be appropriate for the regulation and trading of exchange-listed securities. A related question is whether it is any longer necessary or beneficial to the securities markets that there be two market-regulatory systems. We note that the NYSE will shortly implement its own order-tracking system for creating a complete and systemic record of orders handled by NYSE members and NYSE member organizations.9 Once the NYSE system is implemented, the NASD and the NYSE will each separately discharge the surveillance and related market-regulatory functions for trading in the securities listed on their markets. As the U.S. securities markets become more electronic and as trading in both Nasdaq-listed and NYSE-listed securities expands to more market centers, we believe there should be uniform order-reporting standards for all securities, both Nasdaq-listed and exchange-listed, across all market centers. We do not believe it is any longer necessary to have two separate SROs deploy essentially duplicative order-tracking and order-reporting systems. We suggest that the securities markets would be better and more efficiently regulated at lower cost to all market participants if the two separate systems currently in place were replaced with a single unified system.10
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We appreciate the opportunity to make our views known to the Commission and the staff and we hope that our letter is helpful. If members of the Commission or of the staff believe we may be of further assistance in these matters, please let us know.
cc: The Hon. William H. Donaldson, Chairman