August 28, 2001

Mr. Jonathan G. Katz
Securities and Exchange Commission
Mail Stop 5-1
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: Nasdaq Stock Market, Inc., Exchange Application: Release No. 44396; File No. 10-131

Dear Mr. Katz:

The Cincinnati Stock Exchange ("CSE" or "Exchange") respectfully submits the following comments on the Nasdaq Stock Market's ("Nasdaq") application for registration as a national securities exchange ("Form 1") under Section 6 of the Securities Exchange Act of 1934 ("Act").1 On March 15, 2001, Nasdaq submitted its Form 1 to the Securities and Exchange Commission ("Commission") and the Commission subsequently published a notice to solicit comment on June 7, 2001.2

At the outset, the CSE applauds Nasdaq for seeking registration as a national securities exchange. As an exchange, Nasdaq will presumably be subject to the same regulatory structure as other registered exchanges, which should promote a level playing field for future exchange competition.

However, several issues emerge from a review of the filing that cause the CSE great concern. The transformation of Nasdaq into a registered securities exchange and its separation from the National Association of Securities Dealers ("NASD") must be accomplished in a manner and under rules that are consistent with the Act and the National Market System for Nasdaq securities.

Initially, the CSE believes that the original 45-day comment period as well as the 30-day extension are insufficient to thoroughly analyze a filing as complex as Nasdaq's Form 1. Most recently, the registration process for the International Securities Exchange ("ISE") required nine months between the notice of filing for registration as an exchange and approval by the Commission.3 The CSE finds it hard to believe that the structural issues involved in ISE's registration were greater than those posed by Nasdaq's registration. Moreover, the simple fact that Nasdaq's Form 1 encompassed over eight volumes of rules and interpretations -- all of which needed to be reviewed because there was no indication (red-line version) whether particular rules had been changed from the previous NASD rules -- required extensive effort to digest.

Compounding the review difficulties, the NASD, which is required to develop an alternative facility for the collection of bids, offers and quotations sizes, has not had its rules and plans for operating the alternative facility published for comment. Without understanding the interplay of proposed Nasdaq and NASD rules, the CSE believes that Nasdaq's Form 1 only captures part of the picture for exchange and "over-the-counter trading" of Nasdaq securities.

The Exchange's substantive concerns primarily relate to the anti-competitive intent of specific rules as well as to other operational, regulatory, and intermarket competition issues. First, Nasdaq should be required to amend its proposed Trade Reporting Rules because they reflect a clear attempt to monopolize trade reporting and revenue generation in Nasdaq securities. Second, Nasdaq should be required to implement a central limit order book, otherwise CSE may file to eliminate its own to remain competitive with Nasdaq. Third, before registering Nasdaq as an exchange, the Commission should either amend SEC Rule 10a-1 (the Short Sale Rule) to subject all exchanges to the same short sale rule or require Nasdaq to amend its proposed short sale rule to comply with Rule 10a-1. Fourth, before registration, Nasdaq should be required to provide a linkage facility with competing exchanges that effectuate the best execution goals of the National Market System.

Trade Reporting Rules

The Exchange's paramount concern with Nasdaq's Form 1 application is Nasdaq's transparent attempt to circumscribe competition in Nasdaq securities through its proposed Trade Reporting Rules. This is in spite of the fact that Section 6 of the Act, under which Nasdaq is proposing to be registered as an exchange, requires that "[t]he rules of the exchange do not impose any burden on competition not necessary or appropriate in furtherance of the purposes of this title."4 By taking advantage of its dual role as market and securities information processor ("SIP"), Nasdaq, the market center, seems to believe that it may determine when intermarket transactions in Nasdaq securities must be reported to Nasdaq, the SIP, without regard for the Act or the National Market System plan governing multi-exchange trading of Nasdaq securities on an unlisted trading privilege basis ("Nasdaq-UTP Plan" or "Plan").5 Market data revenue is distributed under the Nasdaq-UTP Plan according to a participant's percentage of trade and share volume. Nasdaq's Trade Reporting Rules seek to limit the ability of UTP exchanges to obtain market data revenue by attempting to double report exchange executions as Nasdaq executions and to usurp a UTP exchange's ability to report trades to the Nasdaq SIP.

Nasdaq Executions

Nasdaq's proposed interpretation of Rule 4630, IM 4630-1 ("Transactions Executed on Nasdaq") defines what constitutes a non-Nasdaq transaction by establishing the conditions necessary for the execution to be considered a UTP exchange execution. If qualified by Nasdaq to be a UTP exchange execution, the trade may be reported to the SIP under UTP exchange rules. Specifically, Nasdaq proposes that if another exchange is the destination, executing market, and liquidity provider, then the execution is not on Nasdaq. Nasdaq elaborates on this definition by setting forth an example, which states, "an exchange other than Nasdaq is the destination, executing market, and liquidity provider when an order is sent to another exchange and that exchange's liquidity provider executes the order."6

First and foremost, Nasdaq has no authority to define when an execution occurs on the CSE. While sole CSE members may rightfully ignore Nasdaq's proposed definition, CSE members who are also Nasdaq or NASD members may become subject to regulatory pressure from Nasdaq's affiliate, NASDR, that forces them to comply with these anti-competitive rules. Particularly, this concern arises when common members may be quoting in one or both markets but seeking to execute trades on CSE. Clearly, Nasdaq's attempt to reach out by rule beyond its organization should be seen for what it is: an overreaching grab for trade reports.

Second, dissecting Nasdaq's proposed definition raises concerns. Nasdaq proposes that UTP executions meet three conditions to be considered non-Nasdaq executions; (1) be a "destination," (2) be the "executing market," and (3) be the "liquidity provider." The first and third conditions raise considerable issues.


The destination condition appears to be satisfied when an "order" is "sent" to an exchange. However, the use of these words implies that if a UTP exchange's quotation is executed through a Nasdaq system -- as in SuperSOES or SuperMontage -- and an execution report is delivered rather than an order, the execution would not satisfy Nasdaq's destination requirement and would thereby default to a Nasdaq execution. Nasdaq appears to be requiring that "orders" be delivered to UTP exchanges for executions to be considered exchange executions. Nasdaq's apparent insistence on order delivery is suspicious, given Nasdaq's overt effort to mandate SuperSOES as the inter-exchange linkage facility as discussed below. The CSE questions whether Nasdaq's true intent is to backdoor all inter-exchange executions as Nasdaq executions.

This concern is not relieved by reference to proposed Nasdaq Rule 4632, although it apparently contradicts IM 4630-1. Rule 4632, "Transaction Reports Automatically Generated by Nasdaq Systems," states that members need not separately report transactions facilitated or executed through Nasdaq systems, including SuperSOES, that automatically generate transaction reports. However, Rule 4632 further provides that, "[a]ll transactions facilitated or executed through a Nasdaq System will be reported to Nasdaq, except those transactions for which a Nasdaq system delivers an order/execution to another exchange. . . .7(emphasis added) Does Rule 4632 mean that if a Nasdaq system delivers an execution report to a UTP exchange, the execution is to be considered a UTP execution? The CSE cannot tell by Nasdaq's proposed rules.

Based on the inconsistency between IM 4630-1 and Rule 4632, the CSE is left guessing as to whether orders delivered to exchanges or orders and execution reports delivered to exchanges satisfy Nasdaq's destination condition. However, the more important point is that Nasdaq cannot determine when an exchange execution has satisfied a destination requirement. Only the Nasdaq-UTP Plan Operating Committee through negotiation may set terms for when any exchange receives credit for an execution.

Liquidity Provider

Nasdaq's attempt to define how a trade on another market must be consummated -- by requiring that an exchange's liquidity provider execute the trade -- further extends its anti-competitive rulemaking. Nasdaq has no authority to define the execution standards of other registered exchanges. However, Commission approval of Nasdaq's proposed rules could provide grounds for Nasdaq's affiliate, NASDR, to examine members for executing trades on other UTP exchanges. The CSE believes that the liquidity provider provision exemplifies this concern.

Although Nasdaq does not define liquidity provider, the common understanding is that a liquidity provider, often termed a specialist or, as on CSE, a Designated Dealer, assumes certain affirmative and negative obligations with respect to trading in securities in which it makes markets. What is unclear to CSE is whether a CSE Designated Dealer that is also a Nasdaq member may consider an execution between two of its customer orders effected on the CSE -- an agency/agency cross -- a CSE execution. Because the CSE Designated Dealers would not have provided liquidity to the execution, Nasdaq, and more ominously, NASDR, may consider the execution a Nasdaq execution and require under IM 4630-1 that the agency/agency execution be reported to Nasdaq. CSE can think of no reason for Nasdaq to have interjected the term liquidity provider into its rules other than to restrict the ability of common UTP exchange/Nasdaq members to execute orders away from Nasdaq.

Clearly, Nasdaq's attempt to restrict competition must be rejected. The Commission should require Nasdaq to amend its rules to eliminate those provisions that attempt to define standards for executions on exchanges other than Nasdaq because they are not necessary or appropriate in furtherance of the purposes of Section 11A of the Act.

Rule 4633 - Transactions Reported by Members

The CSE has additional reservations regarding Nasdaq's proposed trade reporting rules and, in particular, Rule 4633. The Rule provides a framework for reporting member trades both in normal market hours (subparagraph (a)) and outside normal hours (subparagraph (b)). Subparagraph (c), "Determining Which Party Reports a Transaction to Nasdaq," delineates the trade reporting obligations according to the respective parties engaged in transactions. For example, for a transaction between two Registered Reporting Market Makers, the member representing the sell side shall report the transaction.8

What is troubling about this rather detailed breakdown of trade report obligations is that in all 11 combinations of Nasdaq/Nasdaq and Nasdaq/non-Nasdaq participants, Nasdaq is requiring a trade report to Nasdaq. For example, Nasdaq has proposed in Rule 4633 that for transactions between a Registered Reporting Market Maker and any broker-dealer that is not a Nasdaq member or an OTC Market Maker, the Registered Reporting Market Maker shall report the transaction.9 In other words, for transactions between Nasdaq Market Makers and CSE members, the Nasdaq member reports the trade to Nasdaq. This appears to be the case even if the Nasdaq member contacts the CSE member and purchases securities from the CSE member on the CSE. The Nasdaq member would be required to report the execution to Nasdaq, thereby double reporting a transaction that rightfully should be reported by, and credited to, the CSE.

Clearly, Nasdaq is attempting to circumvent the fair competition obligations of Section 11 by establishing an anti-competitive framework for trade reporting. Rule 4633 is designed to ensure that trades in Nasdaq securities, wherever executed, are reported by Nasdaq, the market, to Nasdaq, the SIP, for purposes of generating market data revenue.

Market data revenue sharing, however, is determined, not by Nasdaq alone, but by the Nasdaq-UTP Plan, a plan negotiated and agreed to by Nasdaq and the UTP exchanges. With respect to trade reporting and revenue sharing, the provisions of that Plan are directly contrary to Nasdaq's proposed Rule 4633. Exhibit 1 to the Nasdaq-UTP Plan sets forth the formula for determining each Plan Participant's share of market data revenue.

Specifically, Sub-point 1 of Exhibit 1 provides:

[e]ach Participant eligible to receive revenue under the Plan will receive an annual payment for each calendar year to be determined by multiplying (i) that Participant's percentage of total volume in Nasdaq securities reported to the Processor and disseminated to Vendors for that calendar year by (ii) the total distributable net operating income (as defined below) for that calendar year; . . .10

Sub-point 2 provides:

[f]or any given year, a Participant's percentage of total trades shall be calculated by dividing the total number of trades that that Participant reports to the Processor as the selling party for that year by the total number of trades in Nasdaq securities reported the Processor and disseminated to Vendors for the year. A Participant's total share volume shall be calculated by multiplying the total number of trades in Nasdaq securities in that year that that Participant reports to the Processor as the selling party multiplied by the number of shares for each such trade.11 (emphasis added)

The Nasdaq-UTP Plan bases each Participant's market data revenue on its proportionate share of trades and shares reported to the securities information processor as the selling party. For trades between Nasdaq market makers, Nasdaq recognizes the principle that the "seller" reports. However, for trades between Nasdaq members and UTP exchange members, Nasdaq has conveniently neglected to abide by the Nasdaq-UTP Plan. Without regard to a plan it signed, Nasdaq attempts through proposed Rule 4633 to force Nasdaq members to report trades to Nasdaq even when such trades have been consummated by purchasing securities from members of other UTP exchanges.

Moreover, Nasdaq's rules contradict other specific provisions of the Plan by ignoring the requirement that the selling parties to transactions report the trades to the Processor. Section VIII, Sub-paragraph B, "Transaction Reports," of the Plan provides that,

[w]ith respect to orders sent by a Participant Market to another Participant Market for execution, each Participant shall adopt procedures governing the reporting of transactions in Eligible Securities specifying that the transaction will be reported by the Participant whose member sold the security.12

Where does Nasdaq find the authority to reject this provision of the Plan and seek to impose obligations on Nasdaq members, obligations that violate the Plan's specific terms? Nasdaq has admitted before the Operating Committee of the Nasdaq-UTP Plan that its proposed rules do not comply with the Plan. Incredulously, Nasdaq argues that the terms of the Plan must be changed to comply with Nasdaq's proposed rules.

The CSE believes that Nasdaq is putting the cart before the horse. Without any attempt to preempt criticism by negotiating Plan amendments that would accommodate Nasdaq's proposed rules, Nasdaq is asking the Commission to approve such rules so it may ram them down the collective throats of the other Plan Participants. The CSE knows of no example where exchange rules have been approved when they directly contradict the terms of the governing National Market System plan. Indeed, with respect to Island ECN's pending exchange application, the CSE understands that the Commission is requiring Island to negotiate with the Participants of the Intermarket Trading System Plan before even publishing Island's Form 1 for comment. Under the Act, the CSE fails to see a distinction between Nasdaq and Island that warrants such disparate treatment and double standard.

This issue is further complicated by the current status of Nasdaq in the Plan. In the past, Nasdaq and the NASD often jointly represented their interests, although the NASD was the Plan Participant.13 However, during the last year Nasdaq, as a separate entity, has been permitted to sit at the table with the Plan Participants and negotiate amendments to the Plan. While the Operating Committee has yet to reach a determination as to whether Nasdaq is a current member of the Plan, at no time during the last year has Nasdaq suggested Plan amendments that would accommodate its proposed rules.

The CSE believes that the Commission should offer Nasdaq the following options: (1) Nasdaq must either amend its rules to conform with the Nasdaq-UTP Plan; or (2) negotiate new provisions of the Nasdaq-UTP Plan that would be consistent with Nasdaq's proposed rules. Whichever course Nasdaq may choose, it should not be registered as an exchange based upon the rules the Commission published for comment.

Operational Issues

Besides the concerns raised above, the CSE also questions whether Nasdaq, as developed by the NASD, satisfies the heretofore established obligations imposed upon exchanges by the Commission. By not providing for the centralization of order interaction, Nasdaq would have a competitive advantage over competing dealer markets such as the CSE, dealer markets that have been required to maintain central limit order books to promote customer order interaction. If Nasdaq were registered as an exchange without similar mandatory centralizing systems, the CSE may eliminate its central limit order book to remain competitive.

As a quote driven, competing dealer market, Nasdaq permits members to "execute" transactions without interaction with any Nasdaq system, indeed, outside the purported exchange. Nasdaq merely requires members to report trades within 90 seconds of execution. While Nasdaq has developed SOES and SuperSOES which provide for automated executions for displayed quotes and orders, there is no central location or system providing priority for customer limit orders resident in such systems. Even Nasdaq's SuperMontage, because it is voluntary, allows members to execute preferenced customer orders without regard to the best bid and offer displayed in the montage.14 This permits Nasdaq members to trade as principal at prices inferior or equal to customer orders displayed on Nasdaq systems without any obligation to first execute against same or better-priced customer orders on a central limit order book.

During the process of obtaining approval for CSE's preferencing program, the Commission stressed the importance of protecting orders on CSE's central limit order book.15 The Commission held that before CSE dealers could internalize same-priced customer orders, the CSE must provide priority to customer orders on the Exchange's central limit order book.16 The CSE's introduction of a competing dealer system and internalization of customer order flow caused, in the Commission's view, the CSE to take on some of the attributes of the over-the-counter market. Indeed, the Commission stated that, "CSE combines the features of both exchange and over-the-counter markets."17 Further, the Commission held that,

[t]hus, the NSTS system provides a central location for CSE dealers to interact in a manner similar to a traditional exchange trading floor. Preferencing, however, suspends time priority between professional trading interest so that the multiple CSE dealers can execute their own customer orders without interruption by other dealers and is more akin to trading in the over-the-counter markets.18

If Nasdaq, the original over-the-counter market, is registered as an exchange without implementing a central limit order book, then it would appear that the Commission has changed its position concerning the necessary elements required to satisfy Section 6 of the Act. The CSE has maintained its central limit order book because it believed that it has been a prerequisite to being an exchange. However, competitive necessity and principles of equal regulation may demand that CSE alter its system should Nasdaq's application be approved as proposed.

Short Sale Regulation

If Nasdaq is registered as an exchange under its proposed rules, the CSE is concerned that Nasdaq alone will be exempt from the short sale rule that is imposed on registered exchanges under Section 10(a) of the Act. Although the Commission has regulated the short selling of securities since 1938, it wasn't until 1992 that the NASD proposed a short sale rule for Nasdaq National Market Securities.19

Unlike the short sale rule applicable to exchanges, SEC Rule 10a-1, which uses the preceding trade or "tick" to determine the appropriateness of a short sale execution, the NASD rule employs a "bid" test, which prohibits member firms from effecting short sales at or below the current inside bid as disseminated by Nasdaq whenever that bid is lower than the previous inside bid. Nasdaq proposes in its Form 1 to continue to apply its short sale rule after it is registered as an exchange. Because Section 10(a) and SEC Rule 10a-1 apply to short sales on registered exchanges, the Commission has indicated that, "[a]bsent an exemption, Rule 10a-1 of the Exchange Act would apply to Nasdaq upon Commission approval of their exchange registration."20 The CSE believes that if Nasdaq is granted such an exemption, other registered exchanges must equally be granted such an exemption.

In approving Nasdaq's proposed short sale bid test, the Commission stated that the tick test of Rule 10a-1 was, "the logical approach in the auction market environment where, generally, transactions in a given security are executed at one location and, consequently, are typically reported sequentially."21 NASD successfully argued for the bid test rather than the tick test by stressing the nature of Nasdaq's competing market maker structure: "[w]ith many trades occurring over the telephone and transaction reporting occurring up to ninety seconds after execution, the sequence in which trades are reported may not always reflect the sequence in which the trades occurred. Thus, the NASD believes that differences between trade reporting in the auction markets and the competing dealer market warrant consideration of a different, although analogous, approach to short sale regulation."22 The Commission agreed, stating that: "the NASD's short sale bid-test, . . ., is a reasonable approach to short sale regulation of Nasdaq National Market securities and reflects the realities of its market structure."23

The CSE agrees with the Commission's position with respect to Nasdaq's competing dealers and the short sale rule. However, from August 2000 though March of this year the CSE sought Commission approval of a limited exemption from the tick requirements of SEC Rule 10a-1 that would have permitted CSE competing dealers that are short a particular security to execute customer buy orders above the national best bid regardless of the tick. Unlike Nasdaq's rule, which exempts its market makers from the rule, the CSE proposal applied specifically to its specialists. The exemptive relief was limited to, and triggered by, the execution of customer buy orders -- in essence, a more conservative bid test.24 The Commission, although not responding formally, has been unwilling to grant the requested relief.

The CSE believes that its market structure is substantially similar to that of Nasdaq.25 The CSE uses an electronic trading environment that relies on competing specialists to generate the best CSE quotations. Moreover, when the National Market System is overlaid on the CSE competing specialist structure, the non-sequential nature of trade reporting -- stressed by Nasdaq as determinative in adopting its bid test -- becomes only more magnified. In light of CSE's competing specialist structure and the non-sequential nature of trade reporting, especially in a decimal environment, the Exchange believes that either Nasdaq's bid test or CSE's proposed relief is a reasonable approach that reflects the realities of their market structures.

Alternatively, the CSE asserts that before the Commission may approve Nasdaq's registration as an exchange, including its short sale rule, the Commission must act on the long outstanding Concept Release and request for comment on amending SEC Rule 10a-1.26 As recently as June 29, 2001, the Commission stated that, "continuation of the [Nasdaq] Short Sale Rule pilot and the continued suspension of the current PMM standards will maintain the status quo while the Commission is considering amending Rule 10a-1 under the Act."27

The CSE believes that maintaining the status quo (exempting Nasdaq from Rule 10a-1) after Nasdaq is registered as an exchange is unfair and perpetuates unequal regulation of exchanges. The Commission cannot maintain a status quo where a substantially similar market to Nasdaq, the CSE, is denied a Nasdaq-like short sale rule merely because it is a registered exchange while at the same time approving Nasdaq's registration as an exchange without subjecting it to equal exchange regulation. The CSE believes Commission approval of Nasdaq's Form 1 as filed would directly violate the Congressional finding in Section 11A of the Act that fair competition among exchange markets is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets.28 The Commission should either propose amendments to SEC Rule 10a-1 that imposes a bid test rather than the current tick test and applies to all exchanges equally, including Nasdaq, or require Nasdaq to amend its proposed rules to be consistent with the short sale regulatory regime applied to all other exchanges. Any other course will harm the competitive framework vital to exchanges trading Nasdaq securities.

Intermarket Linkage

One of the most disturbing elements of Nasdaq's migration towards exchange registration is the failure of Nasdaq, as both market center and SIP, to provide, or even discuss, linkage arrangements among competing exchanges that promote best execution. Nasdaq, however, has been demanding linkage arrangements that would effectively cause competing exchanges, like modern-day Jonahs, to be swallowed whole into Nasdaq's systems. The CSE has, and will in the future, reject this approach. The Commission should require Nasdaq to negotiate appropriate linkages with competing exchanges before it approves Nasdaq's registration.

Nasdaq has recently taken the position that linkages among Nasdaq and the UTP exchanges should be based upon an integrated automatic execution system that executes orders against the market with the best quote and delivers execution reports, rather than orders for execution, to the best quoting market. In recent Plan Operating Committee meetings, Nasdaq has expressed it position that UTP exchanges must either join Nasdaq's internal execution system, "SuperSOES," or be limited to telephonic linkages with Nasdaq quotes. Indeed, Nasdaq is attempting to dictate these terms. In a letter from Richard Ketchum, President of Nasdaq to Salvatore Sodano, President of the American Stock Exchange, Mr. Ketchum wrote,

In the short term, we believe that the only ways to remedy this problem are for AMEX to: 1) become a SuperSOES participant for incoming executions and outgoing orders; or, 2) provide an autoquoting mechanism that tracks away from the inside quote. Under the autoquoting alternative, in the rare situations where AMEX's quote would sit alone at the inside bid or ask, AMEX would authorize Nasdaq to zero out the size of the AMEX quote.29 (emphasis added)

The anti-competitive impact of this statement, which has been orally expressed to the CSE, is astounding. Nasdaq demands that its competition either become part of its internal trading system or autoquote away from the national best bid or offers ("NBBO"). If a competing exchange has the temerity to display customer limit orders in conformity with SEC Rule 11Ac1-4 that establish the best bid or offer, Nasdaq (as SIP) will remove that order from the disseminated NBBO so as not to interfere with the operation of Nasdaq's (as market center) internal trading system. Nasdaq's misuse of its dual role as market center and SIP could not be clearer.

In its order approving Nasdaq's SuperMontage proposal, the Commission referred to several commenters' concerns that as an exclusive SIP, Nasdaq would discourage competition with UTP exchanges and operate in a manner that contravenes the congressional intent that Nasdaq, as a SIP, act in a manner which is absolutely neutral with respect to all market centers, all market makers, and all private firms.30 The Commission noted that, "at the heart of the commenters' exclusive SIP argument is the concern that Nasdaq's role as an exclusive SIP compels SuperMontage. To address concerns that Nasdaq has an advantage as the mandatory collector of quotes and trade data for over-the-counter market participants, . . . the NASD has committed to provide NASD members with the ability to opt-out of the SuperMontage . . . . Thus, Nasdaq's functions as the mandatory over-the-counter data collector will be disentangled from its roles as a self-regulator and market operator."31 (emphasis added)

The Commission should revisit whether Nasdaq is disentangling its market from its SIP functions. As Richard Ketchem's comments indicate, Nasdaq is attempting to compel UTP exchanges to participate in SuperSOES and thus lose their identity. If they don't join, their quotes will be eliminated when they represent the best bid or offer for Nasdaq securities. Nasdaq, the SIP, is seeking to protect Nasdaq, the market center, from competition. Although in a different context, this is the exact concern expressed by commenters to the SuperMontage proposal.32

Nasdaq's blatant anti-competitive action is predicated on the operational characteristics of SuperSOES. SuperSOES was designed to suspend trading in a security if a non-SuperSOES participant establishes the NBBO in a particular Nasdaq security. Although Nasdaq intends to rectify this operational handicap, the fix, so to speak, will be limited to trading through UTP exchange quotes that are not a part of SuperSOES. Is this a market structure model that provides best execution? The CSE believes that linkages should promote fair access to any displayed quotation in the national market system in a manner that facilitates the best and most timely execution of customer orders. This can be accomplished without one exchange being subsumed into another's internal systems.

Nasdaq argues that if UTP exchanges participate in SuperSOES, Nasdaq will avoid operational problems and UTP exchanges will have an automatic execution link with Nasdaq market makers, thereby promoting the best execution of customer orders. However, the CSE rejects participation in SuperSOES. Participation in SuperSOES causes CSE's competing dealers to become part of the internal execution system of Nasdaq -- as if CSE members and their customer orders were Nasdaq quotes and orders. As the New York Stock Exchange ("NYSE") put it,

Thus, a regional exchange accedes to `second class' citizenship by the very way in which it reports trades and quotes under the OTC/UTP Plan: the trades and quotes emanating from its auction market are treated in the same way as the interest of a single OTC dealer. In the CTA/CQ Plan context, the analogy would be to include the internal BBO of the Nasdaq Exchange on the NYSE limit order book.33

Moreover, from a practical perspective CSE rejects SuperSOES as a linkage because it transfers multiple execution risk (double hit risk) from Nasdaq market makers to CSE specialists. In the SuperSOES approval order, Nasdaq bragged about eliminating double hit risk for its market makers. That may be so. But under SuperSOES, CSE specialists would become subject to significantly increased double hit risk because they would transfer control over their best quote to SuperSOES.

As a condition precedent to approving Nasdaq's exchange application, the CSE requests that the Commission require Nasdaq to abolish its practice of eliminating competing exchange quotes and to negotiate fair linkages among UTP exchanges and Nasdaq. Much like the listed securities world where exchange applicants are required to reach an accommodation with the Intermarket Trading System (e.g., Island), Nasdaq should be required to interface with UTP exchanges in order to provide fair access to all displayed quotations.

* * *

The CSE reiterates that it welcomes Nasdaq's registration as an exchange. However, as demonstrated above, the CSE believes that such registration must be on terms that are fair, provide equal regulation, and promote competition. Nasdaq's proposed rules fail in these regards. Consequently, the CSE requests that the Commission require Nasdaq to amend its proposed rules and republish them for review and comment before taking action to either approve or begin disapproval proceedings.


Jeffrey T. Brown
Vice President Regulation and
General Counsel

Cc: The Honorable Michael Oxley
Chairman, House Committee on Financial Services
The Honorable Harvey Pitt, Chairman, Securities and Exchange Commission
The Honorable Laura S. Unger, Commissioner, Securities and Exchange Commission
Terry L. Haines, Staff Director, House Committee on Financial Services
Annette Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Associate Director, Division of Market Regulation
Rebekah Liu, Special Counsel, Division of Market Regulation

1 15 U.S.C. 78(f).
2 Securities Exchange Act Release No. 44396 (June 7, 2001), 66 FR 31952 (June 13, 2001) (Notice of Filing of Application for Registration as a National Securities Exchange Under Section 6 of the Act).
3 See Securities Exchange Act Release No. 42455 (February 24, 2000), 65 FR 11388 (March 2, 2000).
4 15 U.S.C. 78(f)(b)(8).
5 The Nasdaq-UTP Plan is formally titled the Joint Self-Regulatory Organization Plan Governing the Collection, Consolidation, and Dissemination of Quotation and Transaction Information for Nasdaq-Listed Securities traded on Exchanges on an Unlisted Trading Privilege Basis. The participants on the Operating Committee are the NASD, the Boston Stock Exchange, the Chicago Stock Exchange, the CSE, the Pacific Exchange and the Philadelphia Stock Exchange (the American Stock Exchange will return as a participant upon Commission approval of the Plan's 12th Amendment).
6 Proposed Nasdaq Rule Interpretation IM 4630-1.
7 Proposed Nasdaq Rule 4632.
8 Proposed Nasdaq Rule 4633(c)(1).

9 Proposed Nasdaq Rule 4633(c)(8).

10 Supra Note 5 at Exhibit 1.1.
11 Supra Note 5 at Exhibit 1.2.

12 Id. at Section VIII, B.
13 The NASD negotiated and signed the Plan. Although Nasdaq, as a subsidiary of NASD, claims to be the true "party-in-interest" of the NASD signature, the Plan only contemplates participation by the party that signed the Plan. CSE believes that upon Nasdaq's registration as an exchange, Nasdaq will become eligible to become a full participant in the Plan.
14 Securities Exchange Act Release No. 43514 (November 3, 2000), 65 FR 69084 (November15, 2000)("SuperMontage Order"). In the SuperMontage Order, the Commission stated that, "[e]ven after SuperMontage is implemented, many orders probably will be executed outside of SuperMontage free from time priorities."
15 CSE's Preferencing Program modified the Exchange's priority rules to give CSE Designated Dealers priority over same-priced professional interest when interacting with ("internalizing") public agency market and marketable limit orders. See Securities Exchange Act Release No. 28866 (February 7, 1991), 56 FR 5854 (February 13, 1991).
16 Securities Exchange Act Release No. 37046 (March 29, 1996), 61 FR 15322 (April 5, 1996). (Permanent Approval Order for CSE Preferencing Program.) If there is a public agency limit order on the CSE's book with priority, CSE's National Securities Trading System ("NSTS") will automatically break a principal/agency cross and match an incoming public agency order with the public limit order on the CSE's book.
17 Id.
18 Id.
19 NASD Rule 3350. See Securities Exchange Act Release No. 34277 (June 29, 1994), 59 FR 34885 (July 7, 1994) ("Short Sale Rule Approval Order").
20 Securities Exchange Act Release No. 44497 (June 29, 2001), 66 FR 35817 (July 9, 2001) (Notice of Filing and Order Granting Accelerated Approval to Amendment No. 10 to a Proposed Rule Change by the National Association of Securities Dealers, Inc., Relating to Extension of Short Sale Rule and Continued Suspension of Primary Market Maker Standards).
21 Short Sale Rule Approval Order, supra Note 19.
22 Id.
23 Id.
24 Letter dated February 12, 2001, to James Brigagliano, Assistant Director, Division of Market Regulation, Commission from Jeffrey T. Brown, Vice President Regulation and General Counsel, CSE.
25 In obtaining approval of its bid test, NASD argued that unlike competing market maker systems, auction market specialists have a monopoly over the securities in which they trade and are able to call trading halts in response to excessive volatility or order imbalances. Like Nasdaq market makers, CSE specialists have no monopoly on the trading of issues on the Exchange and do not have authority to halt trading on the CSE in any security.
26 See Securities Exchange Act Release No. 42037 (October 20, 1999), 64 FR 57996 (October 28, 1999).
27 Supra Note 19.
28 15 U.S.C. Sec. 78k-1(a)(1)(C)(ii).
29 Letter dated May 24, 2001, to Mr. Salvatore Sodano, President, Amex from Richard Ketchum, President, The Nasdaq Stock Market, Inc.
30 Supra Note 14 at Note 444.
31 Id. at 62.
32 While the Nasdaq-UTP Operating Committee is endeavoring to develop a SIP independent of Nasdaq, it is unknown at this time if or when that will occur.
33 Letter dated October 17, 2000, to Richard G. Ketchem, President, Nasdaq from Robert G. Britz, Group Executive Vice President, NYSE.