September 25, 2000
VIA FEDERAL EXPRESS
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
RE: Release No. 43084; File No. S7-16-00
Dear Mr. Katz:
Morgan Stanley Dean Witter & Co. ("MSDW") welcomes the opportunity to comment on Securities Exchange Act Release No. 43084, Disclosure of Order-Routing and Execution Practices (the "Proposing Release"). MSDW would like to emphasize at the outset that we support clear and cost effective disclosure of information that is useful to customers and broker-dealers in assessing best execution of their orders. However, the problem on which the Securities and Exchange Commission (the "Commission" or "SEC") sought comment in Release No. 42450 (the "Market Fragmentation Concept Release"),1 namely market fragmentation, has not arisen because of a lack of information - it has arisen because of an inadequate market infrastructure.
In our comment letter on the Market Fragmentation Concept Release, we indicated that requiring enhanced disclosure by market centers might be useful, but only in conjunction with the creation of strong intermarket linkages, the adoption of a price priority rule and required time priority for smaller orders.2 We agree with the Director of the Division of Market Regulation that, "[d]isclosure alone is not the solution to the market fragmentation issue."3 Consequently, we cannot support the approach the Commission appears to be taking to address fragmentation by advancing increased disclosure without addressing linkages.
Specifically, we have the following comments on the proposals:
1) The long-standing structural problems hobbling our markets cannot be solved by disclosure alone, be it disclosure of execution quality or of trade-throughs. MSDW continues to believe that fragmentation will impede the interaction of and competition among quotes and orders in dispersed market centers unless the Commission is more proactive in facilitating the development, enhancement and maintenance of effective intermarket linkages.
2) If the Commission nonetheless determines that additional disclosures by market centers and order-routing firms are appropriate to further bolster competition among market centers, we strongly urge an approach that establishes general guidelines and relies upon competition to ensure that investors receive information in a form tailored to their needs, rather than the detailed, static requirements outlined in the proposals.
3) The Commission's proposed market center and order-routing disclosure rules will deter brokerage firms from relying on the acumen of their trading professionals when attempting to achieve best execution for customer orders and will powerfully incentivize firms to route orders "by the numbers" to avoid civil and regulatory liability.
4) The theoretical benefits that the detailed disclosure rules purport to confer on investors do not justify the enormous cost burden that the rules would impose on market centers and order-routing firms (including unpredictable cost factors such as potential litigation costs).
I. Description of Proposals
A. Monthly Market Center Execution Quality Disclosure
Proposed Rule 11Ac1-5 under the Securities Exchange Act of 1934 (the "Exchange Act") would require "market centers" to provide uniform statistical measures of execution quality in monthly reports to be submitted in electronic form. The term "market center" would be defined as any exchange market maker, OTC market maker,4 alternative trading system, national securities exchange or national securities association.5 The rule would apply only to National Market System securities (i.e., exchange-listed equities and Nasdaq National Market equities), but would not apply to Nasdaq SmallCap securities or exchange-listed options. The rule would apply to "covered orders," which would include market and limit orders received by a market center during the time that a consolidated best bid and offer is being disseminated. The definition of a "covered order" would exclude any orders for which the customer requested special handling (e.g., market-on-close orders, "not held" orders, stop orders, orders to be executed at prices unrelated to the market price at the time of execution). Orders that would skew statistical measures of execution quality, such as short sale orders that must be executed on a particular "tick" or bid, are also excluded from the definition of a covered order.
Proposed Rule 11Ac1-5 would require a market center to collect, process, and disclose a significant amount of information for each security that it trades. Data would need to be categorized on a stock-by-stock basis, and by order type6 and size.7 Each market center's report would include 20 subcategories for each security, and up to 20 columns of information for a subcategory. The first 11 columns would cover information required for all types of orders,8 and the remaining nine columns would cover information required for market orders and marketable limit orders.9
The proposed rule would direct self-regulatory organizations to act together to establish and submit to the Commission a joint plan under Exchange Act Rule 11Aa3-2 governing how market centers would make their monthly reports on execution quality available to the public. The reports would need to be made available within one month after the end of the month addressed in the report.
B. Quarterly Disclosure of Order-Routing Methodology
Proposed Rule 11Ac1-6 under the Exchange Act would require broker-dealers that route "customer orders" in "covered securities" as agent for their customers to prepare and "make publicly available" quarterly reports that describe and analyze the broker-dealers' order routing practices. The rule would apply to all customer orders other than orders routed to a particular execution venue at the customer's direction ("non-directed orders"). Under the proposed rule, a "customer order" would include any order that is not for the account of a broker or dealer. The scope of "covered securities" under proposed Rule 11Ac1-6 is broader than that under proposed Rule 11Ac1-5 and would include Nasdaq SmallCap equities and listed options, as well as listed equities and Nasdaq National Market equities.10 In addition, the rule would apply to all types of orders, including not-held, pre-opening and short sale orders. However, any option order for a covered security having a market value of at least $50,000, and any other order with a market value of at least $200,000 would be excluded from the requirements of the proposed rule.11
The quarterly reports required by Proposed Rule 11Ac1-6 would include both quantitative and narrative disclosure about a broker-dealer's order routing practices.12 The quantitative analysis would include disclosure of the percentage of total non-directed customer orders, and the percentages of non-directed orders that were market orders, limit orders and other orders. It also would identify each of the venues to which non-directed orders were routed and the percentages of each category of orders routed to each particular venue. The narrative disclosure would include a discussion of the material aspects of the broker-dealer's relationship with each executing venue, including a description of any payment for order flow or "profit sharing arrangement."13 Broker-dealers also would be required to discuss, for each execution venue, the significant objectives they considered in selecting such execution venues, the extent to which such objectives were achieved, a comparison of the quality of executions actually obtained with other venues for comparable orders, and whether they have made or intend to make any material order routing changes in the succeeding quarter. These quarterly reports would need to be made "publicly available" within two months after the end of the quarter addressed in the report. A broker-dealer will be deemed to have made a quarterly report publicly available if the broker-dealer has posted such information on a free Internet website, furnished a written copy to a customer on request, and notified customers at least annually in writing that a written copy will be provided upon request.14
C. Possible Methods to Facilitate Quote Competition
The Proposing Release identified limit orders and electronic communications network ("ECN") quotes as two sources of prices that have played a critical role in improving competition within the consolidated quote. The Commission emphasized that limit orders must be protected as the markets continue to evolve. The Commission indicated that in a decimal trading environment it may be necessary to protect limit orders by requiring market makers and specialists to step ahead of resting limit orders by more than a penny to obtain priority.
To encourage a competitive, fully consolidated quote stream, the Proposing Release acknowledged that each market center's quotes must be comparable and reflect the net price at which transactions can be effected. The Commission discussed alternatives that would attempt to establish comparability for market center quotes by incorporating into ECN quotes the access fees that ECNs charge non-subscribers. Establishing comparability between the quotes of ECNs and other market centers was cited as an "important pre-condition" to including ECN quotes in the consolidated quote for listed securities.
The Proposing Release indicated that the Commission believes it is important to encourage price priority across all markets, but that market-based incentives, not government imposed systems, should determine the connections between markets. Consistent with this position, the Commission is considering whether enhanced intermarket linkages should be developed by market participants free of Commission mandate. The Commission hinted that it might take an indirect approach to improving linkages by adopting a trade-through disclosure rule that would not strictly forbid trade-throughs but instead would require that customers be informed when their order was filled at an inferior price. In considering such an approach, the Commission recognized that for some customers factors other than price (e.g., speed, size, and liquidity) might be more important.
II. Disclosure Requirements Will Not Effectively Address Equity Market Fragmentation
As we discuss below in greater detail (and as we stated in MSDW's Letter on Market Fragmentation) we believe that the Commission must be proactive in guiding the markets to a structure that not only preserves but promotes vigorous competition among market centers and provides, through an efficient, electronic, market-wide linkage and certain best practices rules, a national market system where orders from dispersed markets have the opportunity to interact and compete. We believe that mandated disclosure by market centers and order-routing firms will not adequately substitute for necessary SEC involvement or address market fragmentation concerns. We note that a number of substantial buy-side institutions, in advocating strict, market-wide price/time priority, shared our concerns regarding the problems that existing and nascent fragmentation have caused them in trying to source liquidity and efficiently execute their orders.15 Although we commend the Commission for its interest in this crucial area, we are discouraged that the Commission has chosen to focus primarily on a disclosure-based approach to fragmentation, particularly in the wake of the constructive industry dialogue that preceded and followed from the Market Fragmentation Concept Release.
A significant challenge for broker-dealers in today's trading environment is how to consistently obtain best execution for customer orders in a constantly shifting national market system. For example, the OTC markets have seen a tremendous amount of competition from ECNs, and the listed market is now likely to face similar competition. Intermarket competition is healthy and has forced our markets to innovate, but an increase in the number of market centers trading a security necessarily means that a broker-dealer must consider multiple venues when seeking to obtain best execution for a customer's order. The NYSE's recent rescission of its Rule 390 may soon illustrate this point if broker-dealers are obligated to check with a greater number of market centers trading NYSE-listed stocks.16 This new flexibility will likely lead to increasing dispersion in the trading of NYSE listed stocks.
We noted in our Letter on Market Fragmentation that the Securities Industry Association's Market Structure Committee, which is comprised of a variety of broker-dealers, agreed on the following general principles to address market fragmentation:
We continue to support all of these as minimum, baseline standards that are necessary components of a modern and functional national market system. We also remain steadfast in our support of a narrowly-designed time priority rule because it would reward, in the form of incoming order flow, a market center whose participants provide aggressive quotes. We believe that these changes would result in robust competition among market centers as well as among orders and quotes. While disclosure rules may complement these market modifications, they should not take the place of them. We fear that a disclosure-based approach to encouraging improved linkages and order interaction does not provide enough explicit direction to market participants and may allow the trading of stocks to become even more dispersed. A more direct mandate from the SEC will be necessary to steer the market to these changes.
An analogy involving air travel may help illustrate our point regarding the importance of enhancing our market infrastructure as well as the inability of government mandated disclosure alone to address existing market fragmentation. Most air travelers are primarily concerned with the following major areas of airline performance: (1) safety, (2) price, (3) on-time record, and (4) service. The press recently reported that the aging infrastructure of the airports and air traffic control system in the U.S. has resulted in increased and longer travel delays.18 The structural deterioration of our air travel infrastructure would obviously affect every airline's on-time record (increased and longer delays), price (in-flight delays burn jet fuel) and perhaps its safety record (accidents and near collisions).
Similar to broker-dealers under the proposed rules, it is feasible that airlines could be required to provide airline consumers with quarterly reports discussing and analyzing their objectives (and whether they achieved those objectives) in addressing the major areas of passenger concern, and specifically discussing the criteria an airline uses to select: (i) aircraft, (ii) pilots, (iii) brand of jet fuel, (iv) airports it services, (v) in-board meal service provider, and perhaps even (vi) speeds or altitudes it recommends to its pilots for various flying conditions (e.g., fly around or through storms - this would affect both on-time arrivals and safety). It might also be useful to know about the material aspects of the airline's relationship with a particular aircraft manufacturer, jet fuel supplier or meal service provider.
Similar to the data proposed to be required of market centers, it might be useful for passengers to have access to all sorts of data about how long an average trip between various airports takes for each type of aircraft, how long planes taxi on the runways at each airport, and other information bearing on every airline's performance in the major areas of passenger concern. Like market centers executing orders initially routed to a different market center, it might be of value for passengers to have access to all of the above information for any airline with which our hypothetical airline has arrangements to deal with cancelled or overbooked flights.
Under this type of disclosure regime, airline passengers would certainly have more information to make decisions about which airline to fly. Unfortunately the provision of this information would neither expand the capacity of our airports nor upgrade the aging technology of the air traffic control system. Airline passengers would continue to face delays although they would have plenty of reading material to keep them busy while they sat on the tarmac.
Like our air travel infrastructure, certain aspects of our national market system for equities are also in need of repair. The Commission is correct when it observes that today's investors are more demanding than ever. We believe that investors, like air travelers, want to go from point A to point B safely and quickly, at an optimal price, while receiving superior service, and being assured that they will actually arrive at their final destination (i.e., be assured of getting the stock they want quickly and at the best price available). While enhanced disclosure by market centers and order-routing firms would certainly be useful to some market participants, it will not help to route orders more efficiently or substitute for the inadequacy of the existing linkages in an increasingly fragmented market. We believe that investors would ultimately be better served by the SEC's focusing more intently on improving the performance of the intermarket linkages.
As we noted above, disclosure alone will not provide adequate incentives for market participants to construct well-working intermarket linkages, the importance of which the Commission and Chairman Levitt have frequently acknowledged.19 We believe that a comprehensive intermarket linkage is a classic "public good" and that it is appropriate for the Commission to take a proactive role in ensuring that our market infrastructure is able to facilitate fast, efficient, and cost-effective executions of customer orders.20 Moreover, investors cannot fully benefit from disclosure without a well-working linkage. Nasdaq has recognized the importance of an effective linkage by proposing its so-called "SuperMontage," which is a facility that will display the aggregate size at the top three levels of quotes in the Nasdaq montage as well as any additional quotes/orders voluntarily entered by market participants, and will provide a way for market participants to trade with other Nasdaq participants and execute customer orders in an orderly manner.21 Increased disclosure as proposed by the Commission would provide only a fraction of the benefit to investors in Nasdaq stocks that would emanate from implementation of the SuperMontage. If the main result of the Commission's dialogue with the industry on market fragmentation were increased disclosure, then we believe the Commission will have missed a unique and historic opportunity to meaningfully address critical problem areas that we fear will threaten the global primacy of the U.S. equity markets.
III. Any Disclosure Approach Should Be Voluntary, Flexible and Easily Understood by the Average Investor
If the Commission decides to shift its focus away from a price/time priority approach in favor of increased disclosure, MSDW believes that the Commission should not mandate specific disclosure but rather should adopt a voluntary disclosure approach like that recently suggested by Chairman Levitt in his Best Execution Speech. In particular, Chairman Levitt called for broker-dealers to begin "a meaningful dialogue with [their] customers about the execution of their orders. Think about distributing voluntary, plain English reports to customers . . . ." (Emphasis added.)22 Chairman Levitt went on to note that "[j]ust this month I read a magazine's survey of brokers that included execution quality in its rankings . . . most firms already track their average speed of execution and average percentage of price improvement."
The Commission should not interpose overly complicated and static disclosures when the market is already providing useful information to investors.23 Last year, Chairman Levitt himself observed:
Amidst today's current of change and tomorrow's promise of no less, now is not the time for rulemaking regarding order execution. We must not enter the millennium handcuffed by potentially cumbersome, and perhaps even soon outdated, restrictions.24
A. Competition Should Dictate Necessary Disclosure
We urge the Commission to continue to rely on the natural genius of the market, which we believe in this instance is the most efficient mechanism to ensure that investors get the information they need, when they need it, and in a format that is useful to them. Market participants that resist the demand for information or provide inferior information will quickly be punished by their customers and competitors. Reliance on market-driven, voluntary disclosures would also preserve the flexibility that investors, market centers, and broker-dealers need to respond to dynamic market conditions by continually assessing whether the information produced yesterday continues to be useful for the decisions of today and tomorrow.25
B. If Anything, the Commission Should Set Broad Disclosure Standards
Although MSDW believes that competitive forces should dictate the specific contents of disclosure by market centers, to the extent the Commission takes action in this area it should set general, "performance-based" disclosure standards and allow market centers to present data in the form they believe their customers will find relevant. A broker's duty of best execution is evaluated by a classic performance-based standard; broker-dealers need to achieve best execution for their customer orders, but how they do that is essentially left up to them subject, of course, to guidance set out by the Commission and the courts.26
Thus, we believe the Commission should provide general guidance regarding broad types of information that would be of use to order-routing firms and the public. For example, the Commission could recommend (but not require) that market centers provide data on the following: "order improvement," certainty of execution, speed of execution, and reliability of trading systems. We believe that these four general determinants of execution quality would probably be of interest to most investors, but any Commission guidance should be general enough to provide market centers the flexibility to tailor their communications to their customers' evolving information needs.
The Commission should understand that the very diversity of our nation's market participants, which the Commission itself has sought to foster,27 requires a flexible approach that allows market centers to continue to provide their customers a variety of disclosure options along with the myriad execution options they now enjoy. SEC guidance will foster an appropriate degree of uniformity while allowing market centers to respond freely to the demands of their customers. An example of this approach can be seen in our recommendation in Section IV.A2d infra that disclosure ought to be provided on the general category of "order improvements," and that market centers should be given discretion in describing how they provide this (e.g., price improvements, size improvements or other means) The NYSE has recently acknowledged the limitation of a narrow focus on price improvement by making publicly available "depth improvement" numbers.28 This initiative by the NYSE highlights the desirability of allowing market centers the flexibility to determine the best type of information to provide to customers.
Similarly, we believe it is imperative for the Commission to ensure that its guidance is simple and practical and affords order-routing firms sufficient flexibility to provide their customers only the information that they find relevant. Our support of the SEC's providing general guidance to market centers would also apply to any guidance issued to order-routing firms. If the Commission believes it necessary to propose disclosure requirements in specific areas it should focus only upon those issues where it perceives that an actual information deficiency has resulted or could result in customers being disadvantaged. To the extent the Commission believes this to be the case, we would suggest targeting any guidance to these specific concerns and avoid mandating any quantitative analyses of each and every routing venue. If the Commission believes that customers of order-routing firms are being harmed by conflicts of interest to which order-routing firms may be exposed, we would respectfully suggest that the Commission issue targeted guidance on possible narrative disclosures addressing those potential conflicts rather than regulations imposing detailed disclosure on the entire order-routing process.
IV. The Current Proposal's Deficiencies
If the Commission determines to adopt some form of disclosure regime, we point out below some of the deficiencies with the proposals and offer the following suggestions on how the rules could be improved.
A. Market Center Disclosure Requirements (Proposed Rule 11Ac1-5)
1. The Commission's Disclosure Proposal is Overly Technical and Would Be of Little Value to the Average Investor
We are concerned that the proposed disclosure rules would turn assessments of market centers' execution data into formalistic exercises based on rigidly defined standards and analyses of execution quality conducted by unregulated intermediaries. As Chairman Levitt has acknowledged, the market center data called for in the proposed rules appear to be designed primarily, if not exclusively, for an unregulated class of intermediaries, notably economists, academics, and other consultants, which would analyze and interpret the data (likely for a fee) on behalf of order-routing firms and likely even some investors.29 The Commission apparently expects order-routing firms to rely on these analyses in evaluating, or at least point to them to justify, their order-routing determinations. Thus, the market execution data disclosure is not really disclosure in the sense that it presents useful, understandable information to investors, but rather it is a mandatory source of slightly-distilled data for professional studies. Even if one accepts that this is a proper means to provide execution data to the public, which we do not, we fear that such an approach will not uniformly result in unfiltered, unbiased information. The required "analyses" of this complex data, which would be difficult and expensive for firms to perform in-house, will likely spawn a cottage industry of data analyzers for hire and may well result in paid research reports and "spinning" of results.30 We can also envision professional "ranking services" that would rank market centers based on data that does not fully reflect all the elements of best execution that an order-routing firm should consider when assessing its routing decisions. Firms could very well be prompted to look no further than these rankings and choose a firm based on this range of government-sanctioned criteria. Indeed, we believe it likely that many firms will feel compelled to rely solely on these quantitative analyses in their best execution reviews in order to avoid civil and/or regulatory liability for their order-routing decisions. MSDW does not believe that such an outcome would be beneficial to investors or the market.
MSDW believes that any required disclosures should be limited to certain easily understandable measurements. The concepts of "average realized spread" and "average effective spread" are too complex for average investors to comprehend. We doubt that these and other metrics proposed by the Commission provide useful information that an investor will use in determining whether their broker provides them best execution. The Commission should suggest certain broad areas and let market centers determine the nature and format of the information they will provide in these areas for their customers.31
2. Price Improvement Should Not Be the "Holy Grail" of Best Execution
While price improvement data would likely be considered important by most investors, the Commission should nevertheless emphasize that price improvement is but one of several execution measurements and does not hold more weight than the others. In other words, the Commission should not let price improvement continue to reign as the "Holy Grail" of best execution. MSDW believes that the SEC's (and SROs') undue focus on price improvement may dampen incentives for broker-dealers to quote aggressively and could result in widening spreads. Specifically, aggressive quoting would result in a new NBBO which a market center would then have to surpass to obtain price improvement. This could dissuade a market maker from tightening spreads in a calculated attempt to achieve higher price improvement statistics. Moreover, high price improvement statistics generally indicate that trading interest is not being exposed, and do not necessarily prove that a market is providing superior executions.
3. Price Improvement Should Be Measured By Time of Execution
MSDW believes that price improvement should be measured at the time an order is executed and not at the time of its receipt.32 The time of receipt notion appears to be based on the faulty premise that customers expect to receive the NBBO as of the time they place their order, which even in today's high-tech world is not the same as time of receipt. While the Commission has begun to educate customers regarding this issue,33 we would note that measuring the price improvement of orders at time of receipt will affect the performance data of market centers based on nothing more than price movements that occur between the time of receipt and execution, which is something entirely outside the control of market centers. Price improvement in relation to price at time of receipt would be a function of turnaround time and would be appropriately captured in the "speed" statistic, but should not be allowed to distort a firm's performance simply because a market moved in the instant between when an order was received and when it was executed. We believe this methodology is not a fair or reliable indicator of a market center's performance or a routing broker-dealer's performance.34
Time of receipt is also inappropriate given that market orders are frequently queued, especially during periods of heavy order flow. Market orders are executable at the prevailing market price but only when their turn comes in the queue. If there is an influx of orders in an auto-ex system, then an order appropriately may not receive an execution for a period of time. Furthermore, the implementation of penny increments may mean that more trades will have an unexecuted residual requiring manual handling by traders. It is inappropriate to base price improvement for a queued order on time of receipt by the market center as opposed to when the order became eligible for execution through the auto-ex system or by manual handling.
4. Size Improvement Should Be Included in Any Price Improvement Calculation
The SEC should allow a market center that provides "size improvement" to characterize it as price improvement. By "size improvement," we mean that the market center provides more liquidity to an order than existed at the NBBO, and, absent such additional liquidity, the average price per share of a customer's order would have been worse than the NBBO had the executing broker-dealer "shotgunned the montage" to fill the order. Market centers that risk their capital to provide large size executions at or near the NBBO in many cases will be providing a better execution than a market center that merely improved the NBBO, but only by a small amount. Impending penny increments underscore the importance of this observation, because liquidity will soon be dispersed over 100 price points rather than 16 or 32. Acknowledging the importance of size improvement as it relates to price improvement would give firms an incentive to provide more liquidity at the quote under circumstances (i.e., narrowing spreads due to penny increments) where disincentives might otherwise exist.35 An alternative to using the term "price improvement" might be to allow market centers to provide disclosures on the general category of "order improvements," and to give market centers discretion in describing how they provide this (e.g., price improvements, size improvements, other means, etc.).36
B. Order-Routing Firm Disclosures (Proposed Rule 11Ac1-6)
1. Any Disclosure Should be Readily Digestible by Investors
Enhanced disclosure requirements will provide market benefits only if the disclosure corrects an identified information gap, and is carefully tailored to provide targeted information that is relevant, understandable, and truly adds value in accordance with the needs of those consuming the information. The Commission has recognized the importance of information that is readily digestible by investors in its Plain English initiative, and Commissioner Unger has recommended that any disclosure provided on order execution quality use Plain English.37 The Commission's proposal is at odds with these priorities.
The proposed rules would likely result in disclosure that is prospectus-like in nature and scope. A report analyzing and describing MSDW's order-routing practices would require us to craft lengthy descriptions of the multifaceted elements that go into our brokerage judgment to justify where we route orders for all the various stocks (and options) in which we handle customer orders. The Commission should not expect a discussion of a broker-dealer's significant objectives in selecting execution venues, the extent to which such objectives were achieved, and a comparison of executions obtained, to be anything other than a dense, highly technical, prospectus-like report.
The proposed disclosure also requires information that may be impracticable to provide. For example, the proposal would require broker-dealers to compare results achieved from their order-routing practices with results available at other venues. How would a broker-dealer determine what results would have been obtained at a venue if it did not route orders to that venue?38 Does this contemplate a comparison of results with the professional analyses of execution data from market centers to which we did not route orders? Disclosure of performance comparisons may be appropriate for mutual funds, where a fund's actual performance can be compared to a benchmark index. It is wholly inappropriate, however, when used to try to quantify an inherently subjective process with no objectively determined performance benchmark.
Finally, we remain unconvinced that the quarterly disclosures by order-routing firms would provide investors with information that is especially meaningful - some of the data upon which order-routing firms' conclusions would be based would be up to six months old. Moreover, the next quarterly disclosure could lead to conclusions that are very different from the previous ones. Does the SEC anticipate that investors will pull up the web sites of, say, ten competing order-routing broker-dealers and compare their results from quarter to quarter, ultimately moving their accounts from one to another based on the disclosures provided by the order-routing firms, at least until the next round of disclosures come out? MSDW believes that the vast majority of investors will not.
2. Mandating What to Consider and Disclose Would Objectify an Inherently Subjective Process
MSDW fears that the proposed disclosure rules may result in a replacement of broker-dealers' professional judgment with comparatively inflexible decisions. As noted above, the generation of reports on execution data by academics and others seems to be a central objective of the proposed disclosure. It will be tempting for many firms to substitute such reports for broker-dealers' professional judgment, making order-routing decisions a rote, objective exercise. This would remove a key component in order-routing decisions, namely a broker's trading acumen and market judgment. A broker's knowledge of the reputational standing of a market center, the efficiency and responsiveness of its market makers, and the reliability of liquidity during calm and volatile markets are important factors that cannot be gleaned from pure trading statistics such as those currently proposed.
It is also important to recognize that best execution encompasses many factors, some of which are difficult to quantify, but no less important than those that are more easily measured.39 MSDW is concerned that the duty of best execution may be moving closer to the realm of economic analysis prompted by government mandated reports, rather than an exercise in professional judgment. Requiring disclosure of government specified factors will necessarily elevate those factors in perceived, and actual, importance due to the role they will play in regulatory enforcement actions and private lawsuits. The "hard" (government mandated) factors will undoubtedly trump alternative, non-mandated factors, even if the non-mandated factors, such as the market impact analyses favored by many institutional investors, are, to certain investors, more important.
One could expect that fear of being second-guessed by a plaintiff's lawyer, judge, arbitration panel, jury or regulator could strongly influence a broker's order-routing decisions. Brokers might be tempted, quite understandably, to begin "teaching to the test" and skewing their order routing relative to the mandated data. This likely outcome exposes a serious flaw inherent in detailed, mandated "command and control" disclosure regulations.
3. Data from Other Market Centers May Be Unreliable
Finally, we foresee issues concerning the accuracy of data produced by other market centers. What if multiple market centers claimed to be number one? In addition, how should a routing broker-dealer measure the reliability of the data produced by market centers or the third parties that the Commission expects will analyze such data? Will the Commission independently audit each market center's data or will the market centers themselves be charged with not only verifying the accuracy of their own data, but also the data of other venues.
V. Litigation Exposure (Implicit Costs)
MSDW fears that the quantitative and qualitative "analysis" proposed to be required of order-routing broker-dealers would expose these market participants to undue liability. Specifically, we are concerned that plaintiff's attorneys and opportunistic litigants would have access to voluminous, government-sanctioned data to press spurious claims and potentially impose devastating discovery costs on the securities industry. The Commission should recognize that these litigants might look to and characterize the analyses of the data performed by academics and the like as expert reports on execution performance. The threat of such litigation would naturally lead many order-routing broker-dealers to perform their order-routing "by the numbers," yet even that practice would not entirely shield them from liability due to the staleness of the data and the possibility that different consultants may draw different conclusions on the quality of a market center's performance based on the same data. Therefore, we strongly urge the Commission to provide a Regulation FD-style "safe harbor" for any statements made.40
VI. Explicit Costs
We believe the proposed disclosure rules will result in burdensome costs that are disproportionate to the nominal benefits provided to investors. We urge the Commission to recognize that mandated disclosure may ultimately raise costs for all investors, even for those who do not want or use the additional information. As both a producer and consumer of the data that is proposed to be collected, MSDW questions the overall usefulness of the specified information. The SEC's quest for enhanced disclosure would result in a rigid set of requirements that, in attempting to provide something for everyone, may not provide anything of much value to anyone but professional investors (such as day traders).
Specifically, collecting, processing, and producing the required data would also impose a large burden on market centers. Although MSDW can generate some of the data internally from OATS data, we would nevertheless be required to incur substantial costs to construct the proper databases, develop compliance and supervisory procedures to ensure accurate and timely monthly reports, and provide for review of the reports by in-house legal, operational, and technology staff. The costs to MSDW will not be insignificant; to a smaller "market center" they could be overwhelming.
VII. Other Issues
Aside from comments on specific aspects of the proposal, we offer comments on several other issues raised in the Proposing Release. The Proposing Release discussed these issues in the context of strengthening price competition in the consolidated quote. While we have not addressed all those areas in which the Commission sought comment, we have highlighted certain issues that we believe may have a significant impact on how to best address continuing market fragmentation.
A. "Penny Jumping"
The Commission requested comment on whether broker-dealers will have an increased incentive to "step ahead" of customer limit orders after the conversion to decimal pricing reduces the minimum trading increment. It is unclear to what extent "penny jumping" will be a problem, but the Commission's concern over this potential practice cannot be reconciled with its traditional focus on price improvement. The Commission's proposed disclosure requirements place great emphasis on price improvement, which can be as small as one cent better than the NBBO in a penny environment. Market centers that improve on a price should not have to improve the price by more than the minimum increment. We urge the Commission to carefully consider such effects when weighing the costs and benefits of moving to a smaller trading increment.
B. ECN Fees
The Commission expresses in the Proposing Release its desire to resolve the longstanding controversy over ECN access fees to encourage ECNs' participation in the ITS linkage via the NASD's CAES system. One way to deal with the access fee issue would be to require the best displayed bids and offers of ECNs charging "significant" access fees to reflect those fees. Thus, an ECN bid or offer at a particular price would have to be rounded to the next increment if the ECN charged, say ½ cent or more per share to non-subscribers for accessing the order through SelectNet or CAES. This alternative would facilitate the comparability of orders/quotes that would otherwise be displayed at the same price. On the other hand, the Commission seems to suggest that there might be a de minimis amount of access fee (e.g., less than ½ cent per share) that would not have to be reflected in the displayed price.
Given the millions of dollars in ECN fees that MSDW is charged per year by ECNs for having accessed their Nasdaq quote via SelectNet (including access fees less than ½ cent per share), MSDW takes issue with the characterization that any ECN access fee amount is de minimis. Moreover, as the Commission notes, with penny increments, an access fee (even one that is less than ½ cent per share) would represent a much larger percentage of the minimum tick size than it currently does. The ability of ECNs to charge access fees places market makers at a competitive disadvantage to such ECNs and also, as a fundamental matter, misleads the market as to the true price available when trading against such an ECN's quote.
Accordingly, MSDW recommends that if an ECN charges an access fee to market participants that access the ECNs' prices through linkages such as SelectNet or CAES, that access fee, no matter the amount, must be reflected in the displayed price (thereby requiring the price to be rounded to next minimum increment). Only by taking such action will the SEC level the playing field, which Chairman Levitt himself has publicly noted had been tipped in favor of the ECNs for too long.41
VIII. Conclusion
In conclusion, MSDW believes that the proposed rules will create a new disclosure- based regime that fails to address the serious problem of market fragmentation or its root causes. While the Commission is to be commended for examining the important issues surrounding market fragmentation, MSDW strongly disagrees that a disclosure-based approach is sufficient. The proposals would turn order routing into a technical, statistical analysis based on government-designed standards and would force firms to provide prospectus-like explanations of order routing decisions which will be stale at the time of publication. While we are cognizant of the value that well-designed disclosure can provide to investors and market participants, the Commission's proposals fall short of the mark. If the Commission decides to proceed with its order execution and order routing disclosure proposal, we respectfully recommend that the Commission change its approach and employ voluntary, general guidelines that rely on competition to ensure that investors receive the information that they truly desire.
We appreciate the opportunity to present our views regarding the Proposing Release and hope our comments are helpful as the Commission considers how to best deal with fragmentation of our markets. If you wish to discuss these comments further, please contact me at (212) 762-8600, or my colleagues Tom McManus (212) 762-8193 or Jill Ostergaard (212) 762-4851.
Very truly yours,
Robin Roger
Managing Director and Counsel
Cc: The Honorable Arthur Levitt, Jr., Chairman
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul A. Carey, Commissioner
The Honorable Laura S. Unger, 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
Elizabeth K. King, Associate Director, Division of Market Regulation
Daniel M. Gray, Senior Special Counsel, Division of Market Regulation
Susie Cho, Attorney, Division of Market Regulation
1 Securities Exchange Act Release No. 42450 (February 23, 2000).
2 See Letter from Robin Roger, Managing Director and Counsel, MSDW, to Jonathan G. Katz, Secretary, SEC (letter dated July 13, 2000) at 22 ("Letter on Market Fragmentation") (MSDW indicated that the non-price/time priority regulatory alternatives discussed in the Market Fragmentation Concept Release "represented an incrementalist and unsatisfactory approach to Market Fragmentation concerns" that would not "bring about the fundamental changes needed to promote greater interaction of orders and to foster quote competition among market centers.").
3 SEC OKs Plan to Link Options Markets, Proposes Rules to Ensure Best Execution, BNA Securities Regulation and Law Report, Vol. 32, No. 30 at 1017 (July 31, 2000) (quoting statement of Annette Nazareth, Director, Division of Market Regulation at Commission meeting approving publication of the Proposing Release).
4 For purposes of the proposed rule, the term "OTC market maker" would include any dealer that holds itself out as willing to buy from and sell to customers or others in the U.S. regardless of whether the dealer is located outside the U.S. or trades on a foreign exchange. Proposing Release at footnote 29.
5 Proposed Rule 11Ac1-5(a)(14).
6 Categories of order type are (1) market orders, (2) marketable limit orders, (3) inside-the-quote-limit orders, (4) at-the-quote limit orders, and (5) near-the-quote limit orders. Proposed Rule 11Ac1-5(a)(5).
7 Categories of order size are (1) from 100 to 499 shares, (2) from 500 to 1,999 shares, (3) from 2,000 to 4,999 shares, and (4) 5,000 shares or greater. Proposed Rule 11Ac1-5(a)(4).
8 These 11 columns would include the (1) number of covered orders, (2) cumulative number of shares of covered orders, (3) the cumulative number of shares of covered orders cancelled prior to execution, (4) cumulative number of shares of covered orders executed at the receiving market center, (5) cumulative number of shares of covered orders executed at any other venue, (6) cumulative number of shares of covered orders executed from zero to nine seconds after the time of order receipt, (7) cumulative number of shares of covered orders executed from ten to 29 seconds after the time of order receipt, (8) cumulative number of shares of covered orders executed from 30 to 59 seconds after the time of order receipt, (9) cumulative number of shares of covered orders executed from 60 to 299 seconds after the time of order receipt, (10) cumulative number of shares of covered orders executed from five to 30 minutes after the time of order receipt, and (11) "average realized spread" for executions of covered orders. Proposed Rule 11Ac1-5(b)(1)(i).
9 These nine columns would include (1) the "average effective spread" for executions of covered orders, (2) the cumulative number of shares of covered orders executed with price improvement, (3) for shares executed with price improvement, the share-weighted average amount per share that prices were improved, (4) for shares executed with price improvement, the share-weighted average period from the time of order receipt to the time of order execution, (5) the cumulative number of shares of covered orders executed at the quote, (6) for shares executed at the quote, the share-weighted average period from the time of order receipt to the time of order execution, (7) the cumulative number of shares of covered orders executed outside the quote, (8) for shares executed outside the quote, the share-weighted average amount per share that prices were outside the quote, and (9) for shares executed outside the quote, the share-weighted average period from the time of order receipt to the time of order execution.
10 Proposed Rule 11Ac1-6(a)(1).
11 Proposed Rule 11Ac1-6(a)(2).
12 Proposed Rule 11Ac1-6(b)(1).
13 A "profit sharing arrangement" includes any ownership or other affiliation under which the broker-dealer, directly or indirectly, shares in profits that may be derived from the execution of non-directed orders. Thus, this definition would cover internalization arrangements.
14 Proposed Rule 11Ac1-6(a)(4).
15 See, e.g., letter from Lawrence J. Lasser, President and Chief Executive Officer, and Tim Ferguson, Senior Managing Director, Putnam Investments, to Secretary, SEC, dated May 3, 2000; letter from Peter W. Jenkins, Managing Director, Scudder Kemper Investments, to Jonathan G. Katz, Secretary, SEC, dated May 5, 2000; and letter from George U. Sauter, Managing Director, The Vanguard Group, to Jonathan G. Katz, Secretary, SEC, dated May 11, 2000.
16 Securities Exchange Act Release No. 42758 (May 5, 2000).
17 Letter on Market Fragmentation at 5. MSDW also participated in and supports the SIA Market Structure Committee's comment letter on the Proposing Release, which echoes our call for a more active SEC participation in the creation of intermarket linkages and disputes the efficacy of disclosure requirements to adequately ameliorate effects of fragmentation. See letter from Mark B. Sutton, Chairman, Market Structure Committee, to Jonathan G. Katz, Secretary, SEC, dated September 25, 2000.
18 Susan Carey, Martha Brannigan, and Scott McCartney, "Air Travel Delays Increased 16.5% in June," The Wall Street Journal (July 13, 2000) at 1 ("Airport facilities are at their limits . . . technology designed to boost the FAA's air-traffic-control capacity, especially in bad weather conditions, has been delayed itself, as has a much needed effort to redesign the patchwork layout of the nation's airspace.")
19 See, e.g., Securities Exchange Act Release No. 43086 (July 28, 2000) (SEC Order Approving Options Intermarket Linkage Plan Submitted by the American Stock Exchange LLC, Chicago Board Options Exchange, Inc., and International Securities Exchange LLC.; Securities Exchange Act Release No. 42536 (March 16, 2000) (SEC Order Granting Approval to Proposed Rule Change Relating to ECN and ATS Participation in the ITS/CAES System); Chairman Arthur Levitt, Visible Prices, Accessible Markets, Order Interaction, Remarks to the Northwestern University School of Law, Kellogg Graduate School of Management, Chicago, Illinois (March 16, 2000) at 7, <http://www.sec.gov/news/speech/spch368.htm>) (". . . we must continue to insist on basic connectivity between markets in pursuit of a more effective and more efficient National Market System."); Chairman Arthur Levitt, Remarks of Chairman Arthur Levitt, at the Annual Options Industry Conference, Palm Beach, Fla. (May 5, 2000) <http://www.sec.gov/news/speech/spch368.htm>) (discussing need for an intermarket linkage in the options industry).
20 In Exchange Act Section 11A (a) (1) (D), the U.S. Congress found that, "[t]he linking of all markets for qualified securities through communication and data processing facilities will foster efficiency, enhance competition . . . and contribute to best execution of customer orders."
21 See, generally, Securities Exchange Release No. 42249 (December 17, 1999) (publishing the NASD's SuperMontage proposal for notice and comment); letter from Matthew S. DeSalvo, Managing Director, MSDW, to Jonathan G. Katz, Secretary, SEC, dated February 3, 2000 (noting that the SuperMontage will ensure continued, robust competition among market centers for the processing of orders and encourage the provision of innovative and value-added services to the investing public).
22 Id. at 6.
23 Proposing Release at 48411 ("Some market centers make order execution information privately available to independent companies, which then prepare reports on execution quality that are sold to broker-dealers. Other market centers provide reports of execution quality directly to broker-dealers or to their members.").
24 Arthur Levitt, Best Execution: Promise of Integrity, Guardian of Competition, Remarks before the Securities Industry Association, Boca Raton, Florida, (November 4, 1999) at 5; available on SEC website, http://www.sec.gov/news/speech/speecharchive/1999/spch315.htm ("Best Execution Speech").
25 Preserving such flexibility is particularly critical given the significant technological advances affecting many areas of market center and order-routing firm performance. Cutting edge broker-dealer order-routing technologies are an excellent example. See opening statement by SEC Chairman: Commission open meeting on Market Structure and Public Disclosure of Order Routing Practices and Execution Quality (July 25, 2000) at 2 ("Front-end order-routing systems that allow order-by-order customer routing may stimulate greater competition between orders.").
26 See also Securities Exchange Act Release No. 37619 (August 29, 1996) (in adopting order-handling rules, the Commission recognized that a broker's order execution obligations are not static, but rather evolving).
27 See generally Market Fragmentation Concept Release.
28 See Investment Dealer's Digest (August 21, 2000) at 5 (article discussing NYSE study on size improvement).
29 See Opening statement by SEC Chairman: Commission open meeting on Market Structure and Public Disclosure of Order Routing Practices and Execution Quality (July 25, 2000) at 3 ("Academics would publish comparative analyses of execution quality achieved by market centers, institutional investors would hire consultants to analyze market center reports, and the financial and consumer press would offer side-by-side comparisons, of, for example, speed and price improvement rates.").
30 See also letter from Junius W. Peake, Monfort Distinguished Professor of Finance, Kenneth W. Monfort College of Business, to Mr. Jonathan G. Katz, Secretary, SEC, dated September 6, 2000 ("The rules proposed by the Release (33,066 words long!) would create research publications for academics, jobs for consultants, stories for the print and electronic media, and extra work for analysts at brokerage firms.").
31 For example, a market center could choose to describe how its executions fare against the Volume Weighted Average Price ("VWAP") in the stocks where executions occur. For certain clients, a VWAP comparison might be more useful, objective and understandable than price improvement or average effective spread.
32 See Proposed Rule 11Ac1-7(b)(1) (disclosure required when a "transaction is effected at a price that trades through a better price published at the time of execution.") (Emphasis added.) Release No. 43085 (July 28, 2000) at 29.
33 The Investor Education area of the SEC's website contains the following statement under the heading Trade Execution: What Every Investor Should Know (" . . . investors may not always receive the price they saw on their screen or the price their broker quoted on the phone. By the time your order reaches the market, the price of the stock could be slightly - or very - different.") http:www.sec.gov/investor/pubs/tradexec.htm (visited August 25, 2000).
34 We would also note that filling orders with special handling requirements (i.e., larger orders) or a sudden influx of orders could depress speed and adversely affect price improvement performance. Similarly, the Commission's call for data to calculate fill rates is deficient given that cancelled limit orders could severely skew the numbers. The Commission, therefore, should carve out cancelled limit orders when calculating fill rates -- otherwise this statistic will not be very meaningful to investors.
35 It is quite possible that penny increments will result in a decrease in the size of automatic-execution guarantees provided by many market makers because they will not want to be exposed to such liability when there is less likely to be any significant liquidity at the NBBO. With reduced automatic-execution guarantees, more retail orders will leave residuals requiring manual handling.
36 The NYSE has recently acknowledged the importance of size improvement by making publicly available "depth improvement" numbers. See Investment Dealer's Digest (August 21, 2000) at 5 (article discussing NYSE study on size improvement).
37 See Report by Commissioner Laura S. Unger, On-Line Brokerage: Keeping Apace of Cyberspace (November 1999) at 45, available at www.sec.gov.
38 MSDW is disinclined to send "test trades" to other venues as a means of ascertaining the quality of executions at other market centers. We believe it would force us to unfairly discriminate among customer orders by treating certain orders as "guinea pigs" subject to what may or may not be an inferior execution in a venue that we do not ordinarily use for routing order flow for the sheer purpose of running a comparison.
39 See Market Fragmentation Concept Release at 10583 ("Price is not the sole factor that brokers consider in fulfilling their duty of best execution with respect to customer orders."); Study V: Best Execution Market 2000: An Examination of Current Equity Market Developments, Division of Market Regulation, United States Securities and Exchange Commission (January 1994)).
40 See Exchange Act Rule 243.102 ("No failure to make a public disclosure required solely by Section 243.100 shall be deemed to be a violation of Rule 10b-5 (17 C.F.R. 240. 10b-5) under the Securities Exchange Act."). Securities Exchange Act Release No. 43154 (August 15, 2000).
41 See Dynamic Markets, Timeless Principles. Remarks by Chairman Arthur Levitt, SEC, at Columbia Law School, New York, NY, September 23, 1999 (the ability of ECNs, but not market makers, to charge access fees in an "imbalance in the market place [that] must be redressed."].