June 23, 2004
Hon. William H. Donaldson, Chairman
U.S. Securities and Exchange Commission
450 First Street, NW
Washington, DC 20549
re: Reg NMS/trade-through rule supplemental request for comment
Dear Chairman Donaldson:
In light of significant new information presented at the recent Reg NMS hearing, the Commission has wisely extended the comment period and published a supplemental request for comment regarding a number of questions arising from the views expressed by the panelists about the proposals and the ensuing dialogue with the Commissioners and staff at the hearing. Before we address the Commissions specific questions regarding the necessity of the opt-out and other exceptions to trade-through, we thought it might be valuable to step back a moment to take a big picture look at where we are with respect to trade-through today versus a year ago and also re-examine the goals that the trade-through rule was meant to further to make sure we stay focused on the right issues. We do so with the interest of the trading public and the integrity of our markets in mind. We have always taken a serious interest in our countrys market structure as it impacts greatly our ability to do our job for our public customers. As the Commission has repeatedly emphasized, we will approach this wearing our public policy hat and not merely from self-interest. Frankly, as pure agents that trade both listed and OTC stocks for the public, the publics interest is our own so that is an easy charge.
To begin with, market forces namely the demands of buy-side customers and anticipated regulatory proposals namely the prospect of modifications to the trade-through rule that would set an amount by which an electronic market could trade-through a manual market, as well as allow investors to opt-out of the trade-through rule entirely have pushed the floor-based exchanges, most notably the NYSE, to make public commitments to expand auto-ex facilities over the coming months. These significant changes from just months ago are scheduled for implementation prior to the enactment of Reg NMS. Together with the fast quote vs. slow quote distinction contemplated by the revised NMS proposal, we believe that these changes will address many of the perceived problems with the current trade-through rule regime. Investors demanding speed and certainty will no longer be able to assert that they are being disadvantaged by the manual nature of certain markets as they will able to trade-through them if they so desire.
In fact, we wonder if major rule changes on trade-through beyond the fast quote/slow quote distinction are necessary at all. Certainly there are some additional technology enhancements that should be pursued to make the rule function more effectively, e.g. injecting new life into the antiquated ITS framework by incorporating technology similar to the smart-order routers already available from private vendors, and continuing the development by the NYSE of enhancements to its handhelds that will soon allow a broker to go directly out to the ECNs or regional exchanges to get better prices if they are posted there rather than having the specialist be his/her only avenue to access other marketplaces. However, we believe that the basic trade-through regime that exists today supplemented with the fast quote/slow quote distinction would function well. In fact, a more major overhaul might even result in serious unintended negative consequences. In addition, let us recall that the Commission has always recognized the need to provide reasonable latitude within its rule and policy structure to ensure that our rapidly changing markets are not unreasonably constrained by rigid rules that require frequent modification via our more deliberate, more time-consuming process of rule change. The simple fact is rule modification cannot keep pace with changes in market structure and the pace of those changes is increasing dramatically. It is unreasonable to expect that the SEC or any regulatory body can accurately predict what our market structure will look like even a few years from now.
With this in mind, it is important that the Commission be careful in crafting the final rules that it achieves two things. First, it should not create a structure so rigid that it is not flexible enough to adapt to a rapidly evolving market structure. Second, and above all else, the proposals must focus on serving the original goals behind the adoption of trade-through protection rather than get hung up on the intricacies of the rule itself. The tail the trade-through rule, whatever its form must not be allowed to wag the dog the goal of investor protection. In fact, it may be more appropriate for the Commission to mandate that the SROs clean up the inefficiencies of ITS, eliminate unnecessary time delays in responding to orders, and insist that their members pursue best execution as a guideline, rather than re-write a complex trade-through rule.
The trade-through rule was created to protect public investors from professionals choosing to avoid their better bids and offers and trading among an elite club instead. It put the 100 share order on equal footing with the 100,000 share order. It protected and rewarded limit orders. It had the added benefit of creating a clear standard of best price that prevented broker-dealers from abusing their own customer orders. Ultimately, it protected the integrity of the markets. Importantly, it also successfully protected the individual who was traded-through by providing him/her with the right to demand an execution. The proposed rule instead seeks to rigidly define trade-throughs, prevent them and likely make such trade-throughs sanctionable rule violations, but fails to fully protect the interest of the public investor when he/she is traded-through. Any rule that does not offer guaranteed recourse to the better bid or offer being traded-through does not pass the public interest test. Preventing trade-throughs may make sense, but, if and when they occur, immediate recourse for the investor should be available. The rules should be designed to protect public investors throughout the entire process.
With that long-winded caveat and realizing that the SEC seems to be leaning towards rules that prevent trade-throughs and make non-compliance a sanctionable violation rather than simply providing a means of recourse for the investor who has been traded-through, we will now address one of the Commissions specific questions. The SEC has requested comments as to whether, if it were to adopt an exception to the trade-through rule for manual quotes, the proposed opt-out exception would still be necessary or desirable. There are four reasons why we strongly believe that an opt-out would generally no longer be necessary or desirable under such circumstances. However, we believe the Commission should consider one exception to this general rule that would permit a broker-dealer to meet its best execution responsibilities, and we will address that limited proposed exemption at the end of this letter.
First and foremost, the principal complaint that proponents of trade-through rule relief had levied against the current rulethat investors are not free to choose speed and/or certainty of execution over best advertised price even though that so-called best price might slip away due to the manual nature of certain marketswould no longer be an issue under the Commissions new proposal. The applicability of trade-through protection would be based on whether a particular quote is capable of providing an immediate automated response on a quote-by-quote basis. If a market chooses to remain entirely manual or, more likely, go from an automated quotation to a manual one in certain instances e.g. when abnormal trading volumes suggest that human intervention may find an equilibrium price with less volatility, investors will be free to ignore that quote and trade-through it, even if it is in fact the best advertised price. Of course, they will be doing this at their own peril, since these are exactly the times that a manual process seems to add the most value. But, importantly, they will have a choice. If a quote is instantly accessible via a system that can provide an immediate automated response, such as the NYSEs proposed expanded Direct + auto-execution facility, and represents the best bid or offer, what public policy reason can justify an investor, typically a fiduciary, opting out to select a worse price on another exchange or ECN? We have yet to hear an answer to this question that advances the public interest, and instead have only heard answers that advance the business models of certain industry participants.
Second, providing investors with the ability to opt-out has the potential to eviscerate completely one of the trade-through rules most basic principles--that all investors, irrespective of their connections, affiliations and locations, should be afforded equal treatment. The ability of one side of a trade to opt-out means that another order may in fact be traded-through, which might often be that of a small retail investor. That investor then misses an opportunity to trade unless he or she is given some other recourse. Allowing an opt-out is akin to a shoplifter being allowed to opt-out of the law when the proprietor whose goods are being stolen is the one being hurt
Third, allowing the ability to opt-out will likely increase internalization by broker-dealers rather than encourage more interaction of orders in a centralized market or network of markets to create better prices. Even though the decision to opt-out will rest with the investor giving the order to the broker-dealer, we would not be surprised to see variations of payment for order flow develop in this context as an unintended consequence, e.g. payment for opt-out permission or tiered commission structures based on whether opt-out permission is given. Also, there is little doubt in our minds that order management systems will be tweaked to provide an option for a default setting that in effect makes the investors opt-out box permanently checked rather than actually having the investor consider opting out on a true order-by-order basis. Opting-out could quickly become the rule rather than the exception in such circumstances..
Fourth, the actual implementation of an opt-out would be a nightmare. Required technology changes to order management systems and clearing systems, as well as front and back office procedure modifications such as calculating the cost of an opt-out and providing it to a customer on a confirm, would be costly, and fall disproportionately on smaller broker-dealers and asset managers. Several participants at the Reg NMS hearings who we might add were neither representing the ECNs or exchanges that tend to have the greatest vested interest in the outcome of this debate concurred strongly on this point.
That said, there are a few circumstances in which the strictness of a trade-through rule that would provide for sanctionable violations should be relaxed. However, these circumstances should indeed be limited. And when they occur, the party traded-through should nevertheless be able to avail herself of a process by which she can immediately be made whole. We believe that broker-dealers will on rare occasion still need to trade-through in order to fulfill their best execution duties to their clients and should be permitted to do so without triggering a violation under the rules of the market center that would be responsible for establishing, maintaining, and enforceing policies and procedures reasonably designed to prevent trade-throughs. However, when this occurs, the broker-dealer that has traded-through should be required to file a document within 24 hours with its examining authority explaining why the trade-through was necessary from the perspective of best execution. In addition, while such a trade-through deemed acceptable by the examining authority would not be deemed a violation subject to fine, censure, etc., the party who was traded-through should still have recourse as he/she does today under the current trade-through rule regime, namely the ability to demand to be filled by the party trading-through. This is important because, as mentioned above, all investor orders should be treated equally, so allowing someone to opt-out in an absolute sense i.e. without even offering the traded-through party economic recourse is never justified. Let us present a couple of examples that will hopefully give a flavor for the limited types of circumstances that would justify a trade-through so long as recourse for the person traded-through is still available.
The Commission itself has posed a potential use of the opt-out exception, namely to by-pass quotations likely to be unavailable due to prior execution. The Commission has correctly anticipated that with the fast-paced nature of the current environment in which quotes do little more than flicker in liquid stocks perhaps a specific exception to the trade-through rule is needed to provide market participants with acceptable means to execute orders under such conditions. It would not benefit the markets as a whole or the particular investor whose order was held by a broker in this situation to force the broker to attempt to access such flickering quotes. The problem of quotes becoming inaccessible because they are unreadable is only going to get worse as algorithmic trading is more broadly adopted. Soon, an actual human investor trying to buy or sell stock wont be able to see the bids and offers at allonly the computers will. Ironically, automated markets demanding trade-through relief by claiming manual markets are inaccessible may in fact end up being even less accessible by virtue of this lack of readability. This situation highlights one of the reasons the Commissions appropriate role should be limited to creating an environment in which SROs must function, recognizing that the SEC rule-changing process is necessarily a much slower and thoughtful process than the pace of change occurring in the markets they must regulate.
A second instance where more flexibility would be needed is if a broker were presented with an opportunity to buy say a 25,000 share block for a client and there were a 100 share offer on another marketplace a penny better. Requiring the broker to attempt to access that offer first would be detrimental to the client and the market as a whole as the larger trade might be missed in the interim. However, that 100 share offer should be protected as it is today under the current rules and have the opportunity on a post trade-through basis to demand that he get the same price as the larger order.
In summary, we believe that i the Commissions final proposals would best serve the public if they focused on high-level principles such as investor protection rather than on nuanced rule changes that will have a difficult time keeping up with the incredible pace of market changes, ii there is no public policy justification for the concept of a broad opt-out under the Commissions revised proposal, and iii a broad opt-out would pose real dangers most notably, unequal treatment of investors and increased internalization, and would be prohibitively expensive to implement.
Thank you for the opportunity to comment.
Richard A. Rosenblatt, CEO
Joseph C. Gawronski, COO
Rosenblatt Securities Inc.
The Honorable Paul S. Atkins
The Honorable Roel C. Campos
The Honorable Cynthia A. Glassman
The Honorable Harvey J. Goldschmid
Paul F. Roye, Director, Division of Investment Management
Annette L. Nazareth, Director, Division of Market Regulation
Bob Colby, Deputy Director, Division of Market Regulation
Robert R. Glauber, Chairman and Chief Executive Officer, NASD
Mary L. Shapiro, Vice Chairman and President Regulatory Policy and Oversight, NASD