16 Park Avenue
New York, New York 10016

From The desk of: Richard Tullo

William H. Donaldson
Securities and Exchange Commission
450 Fifth Street Washington, DC 20549

March 10, 2004

Dear Mr. Donaldson;

The four proposals under Regulation NMS do little to modernize equity market structure while sowing the seed for a new series of future regulatory crises and expanding the regulatory subsidy that the ECN oligarchy currently enjoys. The fear is that Regulation NMS is a well meant, but ill advised, response to the NYSE intra-positioning scandal which is a symptom of poor regulatory enforcement by both the SEC and the SRO's. Regulation NMS is like offering a bandage to a hemophiliac; it's just a settlement that attempts to cure a decease that will require more effort and resources to heal. Mr. Donaldson, your market acumen is beyond reproach and you may be surprised by the support you receive from investors and traders if you take action to promote viable reforms.

According to a review of SEC's the press release Regulation NMS proposes:

  • Allows orders, with customer approval, to trade-through when competing markets are posting better prices
  • Allows orders that are traded through to be executed at prices that are as much as 5 cents worse than the best price
  • Forces the exchanges and market centers to implement expensive technological projects for the benefit of their competition
  • Eliminates sub penny pricing
  • Mandates that exchange centers distribute their own proprietary information assets and customer intentions to the public


The Securities and Exchange Commission (SEC) has stated that "when an agent acts on behalf of a customer in a transaction, the agent is under a duty to exercise reasonable care to obtain the most advantageous terms for the customer."(NASDAQ Traders Manual, Chapter 12, pg 2 See Exhibit 1)

Regulation NMS is redefining best execution by allowing customers to opt out of trade through protections. The SEC seems to be saying that price can be ignored by customers as an 'advantageous term'. It is understandable that several trading constituencies are frustrated with the negative consequences of decimalization. It has been estimated that decimalization is responsible for slowing execution time for the average institution trade -on average- by about eight minutes. Decimalization has disrupted institutional trading desks and created an environment where their orders are traded against by day traders, computer programs and other market participants. It is also understandable that the ECN's whose competitive advantage may be speed would seek to change regulations to favor their business models. Regulation NMS is an attempt to placate these two constituencies at the expense of the investing public.

All ethical and professional traders fight everyday to provide their customers the best timely executions given the circumstances they face today. Regulation NMS will give traders the ability trade faster but at what cost? The SEC has not provided any guidance in regards to the time parameters that will define best execution and under what specific conditions customers can opt out of trade through protections. This new market structure can open an entirely new set of market abuses when the SEC has not demonstrated that it has control over the markets as they exist today. (SEE EXHIBIT II)

It is very likely large market making firms and ECN's will offer economic incentives or rebates to their customers institutional and retail alike to encourage opting out. It is also equally likely that fund management companies and electronic brokerages will keep the rebates while mutual fund investors pay the price in the form of inferior equity prices.

The NYSE trading scandal (when not accounting for unprofitable intra positioning trades) allegedly cost investors 1.1 billion dollars. It has been estimated that the scandal cost those investors roughly .004 cents per share or 40 cents per thousand shares. Forty cents seems like a small amount of money -candy bars cost more- but it adds up when aggregated across the billion of trades handled by the securities markets. Allowing exceptions to trade through can potentially cost invests more money than the NYSE scandal and the earlier NASDAQ scandal combined.

For Example:

  • Jane Doe opens a discount brokerage account and signs an agreement to receive ten free trades and in the process legally agrees to opt out of trade through protections.
  • Jane then enters a market order to buy 1000 shares of TESTA.
  • The inside market for TESTA is bid $10 offered at $10.03 and the order is routed to an ECN.
  • Her order is not routed to the best price market or markets but instead depletes the ECN's order book
  • She receives fills of 100 shares at $10.04, 100 shares at $10.05 and eight hundred shares at $10.08
  • Resulting in an average price of $10.073 on her 1000 shares
  • The inside market simultaneously changes when she receives she last fill and is now $10.00 bid offered at $10.01
  • This so called best execution trade has cost Jane about $60.00
  • But that is OK because her brokerage firm receives a 1/2 penny per share rebate for ever trade that is sent to the ECN

When Jane's trade is aggregated over a billion transactions Reg. NMS could cost investors eight billion dollars; assuming an average ticket size of 400 shares and average 'de minimis' price of just two cents per share.

Reg. NMS also penalizes traders that enter marketable limit orders. Traders that enter bid or offer side limit orders will receive no price improvement if 'de minimus' trades are executed away from the market where they entered their order. A likely response from traders will be to pull their orders and enter limit orders away from the inside market and respond to bids by hitting them with market orders. This defensive pulling of limit order will result in wider spreads, less order matching, slower executions and the increased occurrence of random walks. These resulting market characteristics are good for day traders and institutions that make their profits by paying for order flow. However, wider spreads and chaos is generally not accepted by any rational investor as good for the market.


Reg. NMS also mandates that market centers provide access to 'persons' but without mandating hard linkages. This particular proposal is saying that the NYSE -primarily- and the NASDAQ -potentially- has to build infrastructure in order to allow competing markets, like ARCA, the ability to siphon off liquidity. Since nothing has been done to address ECN fees charged to market participants, ARCA most assuredly will charge the NYSE member for his own order flow. So, not only has the SEC done nothing to eliminate this subsidy enjoyed by the ECN's but is attempting to expand the subsidy. This is equivalent to forcing Dell to build and pay for a new factory for Gateway. This is not true capitalism but crony capitalism which may be fine for a country like China or India but Americans expect more from their government.

Reg. NMS also mandates that market centers distribute proprietary information; such as a market makers limit order book. The SEC does not say to whom this information must be distributed. That is troubling and the SEC should clarify why that information needs to be distributed and to whom. This mandate is also troubling because the Federal Government is forcing persons to expose their customer's intentions to the public.

The SEC's 1996 NASDAQ market maker investigation focused on market makers communicating their customer's intentions to other market participants. Hundreds of market makers were sanctioned for communicating orders they had in their books. It now seems that ECN's are also lobbying to have that aspect of market integrity redefined to suit their needs.


Almost as an afterthought the SEC has finally address the problem of sub decimalization. Traders should be encouraged by this prohibition and any revision of Reg. NMS should include the ban. Sub-Decimal quoting is a tool used by some traders to step ahead of orders that should receive time priority in a fair trading market, and by some market centers that use rebate schemes to compete.


The corporate governance failures of 2001- 02 are in part the result of a faulty long term pricing mechanism gave corrupt corporate executives asymmetrical rewards for inflating the prices of their companies. The capital loss due to the governance failures has been in excess of 500 billion dollars and continues to contribute to the national budget deficit. Second rate market structure has also resulted in larger small company discounts due to declining research coverage (SEE EXHIBIT III). Financial industry layoffs totaling 80,000 has had a major impact on the economy and has resulted in loss tax revenues estimated to be 8 billion dollars. Regulation NMS does nothing to improve the equity markets' ability to price stocks to better reflect economic value and will likely hamper the pricing mechanism. Nor does the regulation improve the ability of the equity markets to match buyer with seller.

The SEC should go back to the drawing board and come back with proposals that promote liquidity while leveling the playing field for all market participants. By improving market breath instead of depth or execution time the end result will:

  • Encourage Entrepreneurship
  • Disable corporate crooks
  • Result in faster executions
  • Create Jobs
  • Create long term wealth for investors

I encourage the SEC, the SRO's and Congress to revise Regulation NMS. Any proposed regulation must eliminate the current subsidy provided to the ECN's and explore market structures that encourage the placing of limit orders and allow liquidity providers to make risk based economic profit. Only when the fundamental root causes of inefficient markets are addressed will its symptoms stand a chance of being cured. If you need to contact me I can be reached at (212) 679 3016. Thank you for you consideration and have a great day.


Richard R Tullo

Exhibit I

Best Execution Requirements

The duty of "best execution" arises from the common law duty of loyalty owed by a broker to its retail customers. The Securities and Exchange Commission (SEC) has stated that "when an agent acts on behalf of a customer in a transaction, the agent is under a duty to exercise reasonable care to obtain the most advantageous terms for the customer." This principle has been incorporated into case law and SEC decisions under the federal securities laws and must be adhered to whether acting as agent or in a principal capacity.

It is important to note that the application of "best execution" involves analysis of the "facts and circumstances." Actions that in one set of circumstances may meet your firm's best execution obligation, may not meet that standard in another set of circumstances. It should also be noted that the best execution obligation evolves as rules and systems change. Your firm should review its execution practices, as appropriate, to ensure compliance with new rules, systems, or market conditions.

The SEC has stated that, as a general matter, the duty of best execution refers to your duty to seek to execute your customer's order in the best available market. NASD Conduct Rule 2320 states that in any transaction with or for a customer, a member and its associated persons must use reasonable diligence to ascertain the best inter-dealer market for the security and buy or sell in such market so that the price to the customer is as favorable as possible under prevailing market conditions.

Among the factors that will be considered in applying the standard of reasonable diligence are as follows:

  • Character of the market price, volatility, relative liquidity, and pressure on available communications;
  • Size and type of transaction;
  • Number of primary markets checked; and
  • Location and accessibility to the customer's broker/dealer of primary markets and quotations sources.

Exhibit II is in Acrobat format.

Exhibit III is in Acrobat format.