February 15, 2006
Sun Trading (Sun) is a proprietary trading firm that makes markets in approximately 600 securities. Sun uses computer based algorithms to generate and send quotations directly to Exchanges, Nasdaq and ECNs. As such, Sun does not effect transactions with other than registered broker-dealers.
In its rule filing, the NASD defines Trade Shredding as a term used to describe the practice of splitting customer orders for securities into multiple smaller orders for the primary purpose of maximizing payments or rebates to the member. Further, it is noted that concerns have been raised about market participants increasingly engaging in the practice of trade shredding as a means to increase their share of market data revenues under the joint industry plans, where the Plan participant has adopted a practice of sharing its Plan revenues with market participants who send it orders.
We share the concern where members are splitting customer orders, into multiple smaller orders, solely for the purpose of maximizing payments for the benefit of the member. However, when a member is trading for its own account and posts liquidity in exchanges, Nasdaq or an ECN, trade shredding enables the member to make tighter and more efficient markets. Tape shredding in this context benefits the public because of the availability of those tighter markets.
Trade shredding in this context is a byproduct of the manner in which market data revenues are allocated and distributed under the joint industry plans. Because tape revenues are largely allocated on the basis of the number of trades, as opposed to trade volume and, more importantly, price discovery, the current allocation formulas limit the ways in which market data revenues can provide incentives for desired behavior. The Commission has addressed this issue in the newly adopted Regulation NMS. In that Regulation, the Commission requires that market data revenues be allocated based on volume and price discovery. This formula will, we believe, create incentives to quote aggressively and competitively. However, we respectfully submit that approval of this rule filing, and those similar filings by other exchanges, would be inconsistent with the goals of Regulation NMS because it will minimize the incentives available to market makers who wish to use market data revenues to benefit the public through tighter quotations. Approval of these rule filings, in advance of the changes to the allocation methodology of market data revenues contained within Regulation NMS, will result in shifting of market data revenue into the hands of the market centers that do not add to the depth and quality of the market. As paradoxical as it may seem, tape shredding serves as an incentive for proprietary market-makers to increase the quality of their quotes: increased tape revenue rebates result in tighter and more liquid markets.
Our suggestion would be for the Commission to limit the application of the rule to splitting customer orders, or more importantly, to exclude trading by market-makers and proprietary trading firms where no customer orders are involved.
Sun Trading LLC