November 7, 2001
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: File No. S7-14-01
Ladies and Gentlemen:
The ECN Sub-Committee of the Trading Issues Committee of the Security Traders Association (the "Sub-Committee")1 submits this letter in response to a concept release (the "Concept Release") 2 published by the Securities and Exchange Commission (the "Commission") requesting comment regarding the effects of sub-penny increments on securities market operation. The Sub-Committee believes that the forces of competition, rather than regulation, are best equipped to resolve the issues associated with the placement, display and execution of orders and quotations in sub-penny increments. Within this context the Commission should work to ensure equalized application of its rules across all market centers as related to sub-penny quoting and trading, in order to ensure fair and consistent practices for both investors and their intermediaries in the competition for order flow and best execution.
Acceptance and Execution of Sub-Penny Orders
The Commission correctly notes that electronic communication networks ("ECNs") allow their customers to place orders, and execute said orders, in increments finer than one cent.3 In this vein ECNs are no different from scores of other broker-dealers that chose not to limit their order-entry and execution systems to two decimal places. Other broker-dealers often route sub-penny limit orders to an ECN for display and execution4 as a component of their more general practices for compliance with their obligations under the Securities Exchange Act of 1934, as amended (the "Exchange Act") regarding the display of customer limit orders.5
The willingness of ECNs and other broker-dealers to accept sub-penny orders reflects the belief that customers should have the ultimate ability to choose the increments at which they trade. Customers have long taken advantage of this flexibility, providing evidence that the ability to place orders at increments finer than those allowed for in the public quotation system can be a valuable component of trade execution strategies. Investors have continued to re-affirm this value even after the decimalization of Nasdaq and registered securities exchanges.6
The Sub-Committee believes that market participants should continue to have the ability to trade in the increments of their choice, and market intermediaries should continue to be able to offer this flexibility to their customers. Given the resources necessary to provide increment flexibility, ECNs and other brokers can compete on the basis of the relative latitude they give to their customers regarding order-entry increments and the value of such practices will be determined on the basis of receipt of order flow.
Display of Sub-Penny Orders and Quotations
The concern that mandating universal display of customer orders and market-maker quotations at sub-penny increments would have an impact on market quality is not without basis. Many market participants believe that requiring the display of orders and quotes in sub-pennies within the national market system would lead to investor confusion, a decrease in transparency, and reduced opportunities for best execution through an increase and "penny jumping" and other practices designed to step ahead of public customer orders while offering insubstantial price improvement.7 Moreover, a Commission directive requiring that all market centers have the facilities to process orders at smaller and smaller increments ad nauseum could produce a strain on the systems capacity of market participants that become forced to submit to the whims of the most aggressive trading-increment competitor.
Accordingly, while the Commission order8 to reduce the minimum price variation ("MPV") to one cent has proved beneficial, in the form of greater clarity and smaller spreads, the Sub-Committee believes that an additional mandatory market-wide reduction of the MPV would produce diminishing returns while creating substantial new threats to overall market quality. Given the limited time in which markets have operated under a one-cent MPV, there is insufficient evidence to provide support that additional reductions in the MPV are clearly necessary to further the purposes of the Exchange Act. Absent such compelling evidence, the Sub-Committee believes further action by the Commission with regards to the MPV is unwarranted.
Just as Commission action to order the public quotation system to display prices at an MPV smaller than one cent is inappropriate at this time, so is any regulatory action to "roll back the clock" and prohibit ECNs and other broker-dealers from displaying their orders and quotations in finer increments should they so choose. Each market center should, beyond one-cent increments, have the flexibility to strike a balance between the incremental informational value that display of finer increments provides while preserving the clarity and the transparency that are a pre-requisite for any successful equity market. In today's competitive order-flow environment, the users of market centers, professionals and individual investors alike, will be the ultimate arbiter of where this balance lies.
Rounding and Equality of Sub-Penny Regulation
Allowing the forces of competition to determine the use of minimum trading increments beyond one cent will produce two consequences that will require the Commission's attention. First, on a general level the Commission will be need to ensure that disparate practices among market centers do not produce unfair or disparate regulation. Second, the inter-market linkages that have become a core component of the national market system produce the need for rounded display of fine-increment order prices in market centers that do not themselves accept such increments. Further Commission attention to the realities of rounding are required to ensure that market centers can compete fairly and equally with each other for order flow.
As the Concept Release details, the history of rounding is a tortuous one. ECNs seeking to integrate their order prices into the public quotation system pursuant to the ECN Display Alternative to the Commission's Order Handling Rules9 through the facilities of the Nasdaq Stock Market ("Nasdaq") had to display orders in increments finer than 1/16th on a rounded basis. While the Commission permitted the display of order prices on a rounded basis ECNs were required, upon the receipt of a non-subscriber order to execute against the displayed order at the rounded price, to effect a transaction at the actual price of the order (i.e., at the finer-increment price originally entered by the ECN's subscriber).10 This requirement persists even post-decimalization, as ECNs continue to accept subscriber orders in increments finer than those allowed for display in Nasdaq. Despite a non-subscriber's willingness to trade at the rounded price (as evidenced by their routing an order to be executed by an ECN at said price), the Commission has directed ECNs to provide such orders with price improvement by executing them at the relevant non-rounded price.
Nasdaq, in contrast, has provided contradictory interpretive guidance to market makers displaying sub-penny customer limit orders in their own Nasdaq quotation. Nasdaq has instructed market makers that incoming contra-side orders should be executed at the non-rounded price of the sub-penny order only where "there is an agreement, expectation, or understanding to treat [the incoming firm's] orders as customer orders."11 Absent such a understanding, Nasdaq has stated that market makers may execute such orders at the rounded price, and need not even pass along the related price improvement to its own customer.12 It is unclear why, given that display of customer limit orders in an ECN pursuant to the ECN Display Alternative allows market makers to avoid display of said orders in their own quotations, ECNs should be subjected to standards more stringent than those imposed on market makers with respect to execution against rounded orders.
This is but one example of the potential for unequal regulation that is a by-product of allowing market centers to accept and display orders in different increments. The Sub-Committee believes, however, that this risk is manageable, provided that the Commission and other self-regulatory organizations continually assess the rules of market center linkage and interaction to ensure that pro-competitive differences between market characteristics do not produce anti-competitive disparities in market regulation.
In summary, the Sub-Committee believes the Commission should allow the competition among market centers to build upon the improvements to market quality brought about by the whole-sale decimalization of the nation's securities markets, as opposed to taking additional action to require increased or decreased MPV flexibility of all market participants. At the same time, the Commission should work towards ensuring that market regulation is crafted, applied and enforced with the MPV differences among market centers in mind to ensure that flexibility does not produce regulatory imbalances in the current competitive environment.
The Sub-Committee is grateful for the opportunity to provide its thoughts regarding the Concept Release and would be happy to discuss these issues further with the Commission or the staff. Any questions can be directed to William O'Brien at (917) 637-2560.
Senior Vice President & General Counsel
cc: The Hon. Harvey L. Pitt, Chairman
The Hon. Laura S. Unger, Commissioner
The Hon. Isaac C. Hunt, Jr., Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Associate Director, Division of Market Regulation
|1||The ECN Sub-Committee of the Trading Issues Committee of the Security Traders Association is a forum to analyze and address legal and regulatory issues that affect ECNs and their customers. Sub-Committee member firms whose opinions are reflected in this letter include Archipelago, LLC, Brut, LLC, Instinet Corporation, NexTrade Holdings, Inc. and REDIBook ECN LLC.|
|2||Exchange Act Release No. 44568 (July 18, 2001), 66 Fed. Reg. 38390 (July 24, 2001). File No. S7-14-01 (the "Concept Release").|
|3||Id., at 38391.|
|4||See generally Nasdaq Decimalization Impact Study (June 11, 2001), available at http://www.nasdaqnews.com (citing ECNs as the handler and executing broker for a large majority of all sub-penny limit orders).|
|5||See Rule 11Ac1-4 under the Exchange Act.|
|6||See Concept Release, supra n.2, at 38391 (noting that, despite decimalization "sub-[penny] limit orders have not disappeared and continue to play an active role.").|
|7||See, e.g., Letter from Lee Korins, President and Chief Executive Officer, Michael Bird, Chairman, Trading Issues Committee, and Geoffrey Cloud, Counsel, Security Traders Association, to Laura Unger, Acting Chairman, Securities and Exchange Commission (June 27, 2001).|
|8||See Exchange Act Release No. 42914 (June 8, 2000), 65 Fed Reg. 38010 (June 19, 2000).|
|9||See Exchange Act Release No. 37619A (September 6, 1996), 61 Fed. Reg. 48290 (September 12, 1996).|
|10||See Letter from Richard R. Lindsey, Director, Division of Market Regulation, Commission, to Joseph Hardiman, President, National Association of Securities Dealers, at 13 (November 22, 1996),|
|11||Nasdaq Head Trader Alert 2001-39, at 2 (March 9, 2001), available at http://www.nasdaqtrader.com/Trader/News/2001/headtraderalerts/hta2001-39.stm.|