June 19, 2003
Securities and Exchange Commission
Re: File No. S7-11-03; File No. 4-479
Ladies and Gentlemen:
Brut, LLC ("Brut")1 appreciates the opportunity to provide the Securities and Exchange Commission (the "Commission") with its comments in response to Exchange Act Release No. 47849 (the "Concept Release"),2 in which the Commission solicits industry feedback regarding a petition (the "Petition")3 of the Nasdaq Stock Market, Inc. ("Nasdaq"). The Petition requests that the Commission take action pursuant to various provisions of the Securities Exchange Act of 1934 (the "Exchange Act") to: (i) re-write the rules of all self-regulatory organizations ("SROs") related to the trading of Nasdaq-listed securities (and surveillance thereof) to make such rules identical; (ii) re-engineer the assessment and allocation of regulatory expenses among SROs for the trading of said securities; and (iii) restrict SROs that do not meet the new Commission-created standards from commencing or continuing of the trading of said securities. The Concept Release also requests comment on whether similar action need be taken regarding the regulation of exchange-listed securities and options.
Brut thinks the measures suggested by Nasdaq in the Petition are excessive and would have unnecessary anti-competitive impact, motivated more by Nasdaq's economic condition rather than altruistic desires for a better market. While structural evolution will always require adaptation of the existing regulatory framework, wholesale Commission intervention to standardize market operation and regulation is not the answer. Brut would advocate a more narrowly tailored approach that: (i) harmonizes trading rules only where the Commission has found that intermarket disparities create significant risks of abuse; (ii) continues existing Commission oversight of clearly-defined surveillance standards for SROs; and (iii) promotes effective intermarket regulation by minimizing conflicts of interest while maximizing efficiency, allowing market centers to compete with one another on a structural and economic basis. This approach would be a fair balance between the national market system objectives of market competition and investor protection.
Nasdaq, Competition & Regulation
Brut believes that the regulatory approach recommended in the Petition can only be understood when viewed through the prism of Nasdaq's efforts to embark on a strategy in competition with the market makers and ECNs it formerly served as a regulatory utility.4 In attempting this transition, Nasdaq has made choices regarding its cost structure, in particular its regulatory costs, that now places it at a competitive disadvantage. Rather than trying to improve its efficiency, Nasdaq seems bent on altering the revenue and cost structures of its competitors through lobbying efforts and requests for Commission intervention. Strategic and commercial interests, rather than investor interests, appear to be the driving force.
One of the many challenges Nasdaq faced in its transition to a for-profit operation was to segregate itself from the National Association of Securities Dealers (the "NASD"), Nasdaq's parent entity which holds primary SRO responsibility for the trading of OTC securities. As part of that process, Nasdaq entered into a Regulatory Services Agreement (the "RSA") in June 2000 with the NASD Regulation, Inc. ("NASDR"), an NASD affiliate, to pay for member regulation and market operation services that had historically been funded out of the variety of member dues, transaction fees and other revenue sources available to the NASD as a whole.5 The RSA, entered into at the virtual peak of the dot-com bubble, is a ten-year contract apparently at a high fixed rate that made no provisions for fluctuations in market volume, Nasdaq commercial success, market or regulatory developments, or renegotiation.6
It is patently evident that the RSA is a plague on Nasdaq's competitive effectiveness. Nasdaq has admitted it "cannot sustain a long-term business model" bearing its current regulatory cost structure.7 The possibility of Nasdaq in competition with other firms in the business of OTC executions, or that such a trend would give the NASD broader responsibilities to supervise OTC trading conducted in non-Nasdaq venues, appear to have been discounted. What is clear is that Nasdaq's ability to compete suffers from its decision to enter into a contract to which few risk-conscious commercial enterprises would have agreed.
Brut believes that this competitive reality is the genesis for Nasdaq efforts to ignite debate regarding OTC market center regulation. The subtle undercurrent of Nasdaq's recent lobbying efforts with the Commission, including the White Paper and the Petition, is that "unequal regulation" is purely a function of cost. The Petition alludes to "today's fierce competitive environment"8 as a problem that needs to be solved, a sinister force that "lure[s] trading away to less regulated markets, to the detriment of investors."9 Such suggestions are incredulous - a competitive, efficient, innovative market structure is the goal we have all been striving for since Congress dictated the creation of the National Market System in 1975.
The reality is that competing OTC market centers are not regulated less than Nasdaq, rather this regulation is effected through a variety of approaches, primarily due to differences in market structure. Nasdaq's regulatory regime was constructed largely in the wake of the Commission's investigation of the NASD and Nasdaq in the mid-1990's,10 and was intended to provide oversight for a then largely phone-based, market-maker oriented trading environment. Nasdaq's suggestion that more automated, agency-based markets must universally employ identical resources at equivalent cost disregards the ability of market centers to achieve equivalent ends through diverse structural means.
The Commission should guard against market participants using regulation as a weapon to protect their competitive position. Recent comments by Nasdaq executives concur that concerns regarding uniformity of market regulation often mask self-interest:
Nasdaq should not be allowed to compound its own poor decisions by perpetuating a regulatory agenda that seeks to drag its competitors "back to the pack" by imposing a Nasdaq-style cost structure on them for regulatory services. Brut respectfully submits that, if the Commission determines that Nasdaq deserves economic relief, it should come in the form of involvement in the re-negotiation of the terms of the RSA, rather than through a broad regulatory re-structuring that could have a score of unintended adverse consequences.
The Need for Intra-Market Standardization
Brut thinks that, while in some instances greater Commission clarity and standardization regarding intra-market trading rules and surveillance systems would be positive, it must be effected on an issue-by-issue basis rather than through the overly-broad methods that Nasdaq suggests in the Petition, which Brut believes would only dampen competition.
Brut has previously commented to the Commission that it should require consistency in the rule sets among markets (OTC or otherwise) where necessary to maintain fair and orderly markets and protect investor interests, while at the same time: (i) allowing for variances where there is no compelling investor-protection need; and (ii) ensuring that any standardization does not give preference to the rules of one facility, creating a competitive advantage.13 Rule disparities among market centers are not problematic per se, but only become so when creating opportunities for abuse or promoting non-natural market behavior.
With these principles in mind, the Commission should continually examine the rules of the various market centers and in close collaboration with all of them (and their users), taking action to harmonize regulation where clear instances of a disparity that threatens fair and orderly markets exist. In this regard, Commission inaction will be just as important as any action, to develop common regulatory standards where necessary to protect investor interests and foster competition in all other areas. Deference should be given to the right of each market to offer alternative structures, as this furthers the Exchange Act principle of "fair competition among... exchange markets, and between exchange markets and markets other than exchange markets."14
One area that may require standardization, as the Petition highlights, are the rules related to short sales in OTC stocks. Given the long-standing concern over the market and issuer impact of short sales, Brut has previously commented that the regulation governing such activity should be set by the Commission as opposed to competing market centers.15 There now exist three separate strands of rule-sets pertaining to the short selling of OTC stocks. ADF market participants are required to adhere to a "bid test" standard when effecting non-exempt short sales based on the national best bid/best offer,16 Nasdaq and certain regional exchanges employ a bid test based on only the Nasdaq best bid/best offer,17 and other regional exchanges have no restrictions on OTC short sales whatsoever. Brut believes this is an aspect of the regulatory regime where consistency is important, and advocates that the Commission set a market-wide standard consistent with the feedback received in response to its concept release regarding short sales.18
Addressing the need for rule conformity on an issue-by-issue basis is a far more preferable approach than any broad and brash attempt to force all markets into a single regulatory mold. Nasdaq requests that the Commission "amend the rules of all markets that trade Nasdaq securities to establish uniform trading rules, and to ensure equal surveillance and enforcement of those rules."19 Imposing such across-the-board standardization among OTC markets based on the current Nasdaq rule set would pre-ordain Nasdaq as "first among equals" vis-à-vis its competitors, and deprive other market centers of the important competitive tool of differentiation.
In complaining of "vast disparities in the rules of markets that trade Nasdaq securities,"20 Nasdaq is attempting to create a regulatory bogeyman without basis in reality. Nasdaq itself operates a market center for the trading of exchange-listed stocks with rules that vary significantly from those of the New York Stock Exchange. On other competitive fronts Nasdaq has recently stated that "[e]ach market should be permitted to determine for itself whether price and/or time priority rules should be retained or discarded."21 Why Nasdaq believes market centers trading Nasdaq-listed stocks should not have similar freedom is unclear. Nasdaq attempts to gloss over these inconsistencies only underscore the weakness of their arguments.22
Similar principles should be applied to differences between each market's surveillance methodology and technology. To a large degree, this is what the Commission is already doing by enforcing the prerequisites for SRO operation as articulated in Exchange Act Sections 6, 12 and 15A. As mentioned in the Concept Release, SROs are required "to deploy adequate examination and surveillance systems and maintain an audit trail of the transactions in its system," and that such "regulatory programs... are periodically inspected by the Commission."23 The Commission's Office of Compliance Inspections and Examinations is continually evaluating the surveillance capabilities of exchanges trading OTC stocks and, to date, has found no material deficiency.
The approach currently utilized by Nasdaq to monitor its market was implemented in response to that market's particular operational and historical characteristics - i.e., multiple market makers trading for their own accounts relying principally on individual traders. That the regulatory means that Nasdaq has chosen is the optimal or only means to monitor trading within an OTC market, or that a market must invest what Nasdaq spends to support its regulatory program, is conjecture at best. Nasdaq accuses its competitors of being "less regulated markets" that are "under funding regulation" and have created "serious flaws in the regulation of Nasdaq trading"24 without any real evidence to support its assertions. To the extent the Commission believes that further definition and detail regarding uniform audit trail standards or other minimum surveillance requirements are necessary to ensure a consistent surveillance regime market-wide, it should be effected in a manner that each OTC market can meet through a structure of its own choosing. Blanket demands for uniformity, as Nasdaq suggests in the Petition, would be counter-productive and anti-competitive.
The Role of Intermarket Regulation
As competition among markets increase, it becomes more urgent to evaluate who should take responsibility for the trading activities of a broker-dealer across multiple market centers, and how those efforts are funded. While there may be no perfect answer in the OTC context, Brut thinks that intermarket surveillance must be conducted in a manner which protects investors and preserves market integrity, minimizes the potential for conflicts of interest, and does not obfuscate each market's competitive strengths and weaknesses. To the extent current surveillance capabilities fall short of Exchange Act requirements, they should be addressed individually rather than requiring costly and comprehensive technology overhauls. The costs of such oversight should be entirely divorced from issues that drive current market competition. As such, Brut believes the approach suggested by Nasdaq in the Petition is sub-optimal.
Who Should Regulate?
The two obvious choices for performance of intermarket oversight are both fraught with real and perceived conflicts of interest. In an environment where market centers have evolved from non-profit, quasi-governmental colleagues to profit-driven competitors, there is concern that intermarket surveillance could be used to promote and pressure intra-market participation. While a "single regulator" approach would alleviate this concern, the only real candidate is the NASD, which itself has ownership, historical and other affiliations with Nasdaq that would rightfully give competing markets cause for concern, while also actively pursuing its own strategy of providing intra-market regulation on a contractual basis that could conflict with any intermarket oversight responsibilities.25 Remediation of concerns that regulation will be used to promote market interests will be no easy task.
Brut believes that ultimately a single, unaffiliated regulator would be the preferable solution for meeting purely intermarket surveillance requirements. The reasons are several:
While each market center potentially has the expertise to perform intermarket surveillance, the factors listed above ultimately dictate a single-regulator solution.
Brut takes this position while at the same time observing that it does not believe any entity is currently in the position to assume the market-neutral responsibility that comes with acting as a single intermarket regulatory authority. Until the NASD completely divests itself of its ownership of Nasdaq, its interests squarely lie with one competitor such that adequate confidence in its ability to remain above the competitive fray can not be ensured. Absent a resolution of these issues, intermarket regulation should remain localized. Even with an appropriate single regulator, the Commission must make clear that its responsibilities are well defined and with a narrow scope. Regulation of intramarket trading activity is best left to each particular market center. Only where there is a need to look at a firm's trading activity across multiple venues should responsibility shift to an entity with pan-market responsibilities.
How and How Much?
While agreeing with Nasdaq on the single-regulator concept, Brut diverges from Nasdaq opinions regarding the technology and economics necessary to implement it. In the Petition, Nasdaq touts its own surveillance technology and is critical of non-Nasdaq platforms, including the Firm Order Submission ("FOS") system and the Intermarket Surveillance Group ("ISG"). With respect to the ISG, Nasdaq complains of its voluntary nature and the inconsistency of its information with Nasdaq's Order Audit Trail System ("OATS"), ultimately concluding that "Nasdaq believes that consolidated regulation protects investors better than the coordinated regulation that ISG facilitates."26 This statement implies that intermarket regulation by definition requires that all market centers adopt similar technology for communicating with regulatory authorities, preferably those already utilized by Nasdaq. Brut believes that strict adherence to Nasdaq standards will dampen innovation and competition without any incremental investor protection. The ISG and FOS systems provide an ample framework for regulatory oversight. To the extent they require improvement, a targeted approach is highly preferable to mass migration to Nasdaq's preferred technology, and the associated costs that would be required.
With respect to the funding of intermarket regulation, Nasdaq's continued attempts to allocate such costs to market centers by linking regulatory costs with market data revenue should once and for all be rejected in favor of an approach that allocates these costs to market participants regardless of their market center preferences. In stating that "the fairest way to allocate the costs the regulation of trading Nasdaq stocks is to aggregate the... costs of regulation, and to deduct that amount from market data revenue collected pursuant to the Nasdaq UTP Plan, "27 Nasdaq errs both in who and how these expenses should be paid. In an era of for-profit exchanges, attempts to link a certain cost of operation with a certain revenue stream are farcical given the fungible nature of money. Market data revenue is unrelated to regulatory expenses and vice versa - any linkage of the two issues will reduce incentives for cost efficiency and competition in both arenas. Regardless of whether a single regulator or more decentralized approach to intermarket regulation is adopted, the funding of such efforts should be divorced entirely from efforts to analyze and reform how market data revenue is generated, collected and distributed.
When analyzing intermarket regulatory expenses independently, a cost-assessment approach focuses on market-participant trading activity, rather than market centers, appears to be the sounder approach. It is precisely because a firm has chosen to execute trades in multiple execution venues that creates the needs for a regulator to oversee all such activity. This was the approach used for years by the NASD in assessing fees under old Section 8(a) of Schedule A to the NASD By-Laws. Now that Nasdaq systems are no longer a convenient "toll booth" for the capture of all OTC trading activity, the NASD has re-engineered this mechanism in the form of the "Trading Activity Fee" ("TAF") which recently received permanent Commission approval.28 In approving the TAF, the Commission noted "the NASD's broad responsibilities with respect to its members activities, irrespective of where securities transactions take place," and that "[a]ssessing fees in relation to transactions correlates to heightened NASD responsibilities regarding firms that engage in the trading."29 Such a methodology logically allocates costs and allows the intermarket regulator to recoup expenses, permitting market centers to vigorously compete with one another for execution volume, all the while preserving fair and comprehensive oversight.
While alluding to issues that likely warrant Commission evaluation, Brut does not think the whole-scale intervention Nasdaq requests in the Petition is the correct means of adapting the current regulatory framework to post-SuperMontage market structure. Mandating uniformity would only squelch the competition that continues to lower investor and industry costs with increased efficiency and flexibility. In viewing the "hallmarks" of market quality, Nasdaq's new CEO stated that "competition is the most essential component of capitalism and sound market structure."30 Brut agrees, and respectfully requests that the Commission approach the task of evolving the self-regulatory system with this principle in mind.
A sounder approach would be to focus on specific trading rules and surveillance techniques where standardization is the only workable means of protecting investors, leaving the full benefits of robust market competition intact. While a common regulator may be needed to address the demands of intermarket surveillance evolving in the wake of this competition, a conflict-free, common-sense approach to the allocation and funding of these responsibilities is preferable to a homogenization of market center cost structure, which would dull market quality without advancing investor interests.
Please do not hesitate to contact me at (917) 637-2560 regarding this letter, or how Brut can assist the Commission and the staff in evaluating these issues in the future.
cc: The Hon. William Donaldson, Chairman