VIA ELECTRONIC MAIL and
January 18, 2002
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Re: File No. SR-NASD-2001-90
Dear Mr. Katz:
NexTrade, Inc. (NexTrade) hereby respectfully submits its comments to the above-referenced proposed rule changes of the National Association of Securities Dealers, Inc. (NASD). NexTrade is a Securities and Exchange Commission (Commission) registered broker-dealer and operates an electronic communications network (ECN) pursuant to a Commission staff No-Action Letter. As an ECN and NASD member firm, NexTrade appreciates the opportunity to comment on the critically-important changes proposed for operation and regulation of the over-the-counter (OTC) market.
The NASD's Proposed Rule Changes are Inconsistent with the Securities Exchange Act of 1934.
The above-referenced proposed rule change by the NASD would amend NASD Rules to reflect Nasdaq's separation from the NASD if Nasdaq is approved as a national securities exchange and to establish the rules that would govern trading otherwise than on an exchange, including quotations displayed through the NASD's proposed Alternative Display Facility (ADF). The changes proposed by the NASD would have a profoundly negative impact on the OTC market as it currently exists, and the investing public. In essence, the NASD proposes to cast off over thirty years of enhancements to the OTC markets, in favor of its former subsidiary, Nasdaq. The proposed ADF eviscerates the Congressionally-mandated goal of a "national market system" under the Securities Exchange Act of 1934, as amended (Act) because the NASD proposes to spin off its current quotation and execution system provided via the Nasdaq Workstation II and related systems, and replace it with a more primitive system, the ADF, with reduced intermarket quotation visibility and NO NASD provided method for its member firms to route or execute transactions in the OTC market.
Under Section 11A(a)(1)(C) of the Act, Congress found that it was in the public interest and appropriate to the maintenance of fair and orderly markets to assure, in relevant part, (1) economically efficient execution of securities transactions; (2) fair competition among brokers and dealers and among markets; (3) the availability to brokers, dealers and investors of quotation and transaction information; (4) and the practicability of brokers executing investors' orders in the best market. Under Section 11A(a)(1)(D) of the Act, Congress found that linkage of all markets through communication and data processing facilities will foster efficiency, enhance competition, increase information available to brokers, dealers and investors and facilitate the offsetting of investors' orders, and contribute to best execution of such orders. The NASD's proposed rule changes fall far short of the goals of Section 11A, and actually serve to undermine them. First, the NASD's proposal does away with the current "economically efficient execution" services, SOES and SelectNet. Instead, market participants are asked to provide their own order routing and execution systems. The tangle of execution systems that might arise under such circumstances could hardly be "economically efficient". Second, the NASD proposals would actually discourage competition among brokers, dealer and especially between markets. The proposals provide all the benefits of the NASD's technology to the Nasdaq market and leave the OTC market with little more than a rulebook. It would take years of development for the OTC market to be in a position where it could fairly compete with 30 years of Nasdaq technology. Further, the NASD's proposal would create an ADF that does not provide for intermarket transparency of quotations. Both market participants and investors will have to obtain additional hardware and software to receive accurate intermarket quotations for Nasdaq securities. This lack of transparency does not foster the availability of information to investors. Finally, the NASD's proposal does not further the practicability of brokers executing investors' orders in the best market. The NASD's proposal removes intermarket quotations from the OTC market. It also removes the only existing marketwide execution system in the OTC market. Without these two services, it is difficult to imagine how the NASD's proposal makes it easier for brokers to execute orders at the best intermarket price.
In order to ensure that Nasdaq and its market making firms get the order display, routing and execution technology needed to re-capture lost order flow from ECNs and other pools of liquidity, the NASD has left its member firms with less than the bare bones necessary to operate the OTC market. Any market participants that choose not to become members of Nasdaq will be left to themselves to re-create the OTC market without assistance from their self-regulatory organization. Further, firms that lack the resources and/or expertise to pursue this alternative will go out of business, leaving an oligopoly of a few players to compete or worse, to collude, to create a market that would strongly favor their position.
In addition to derailing the goal of a national market system, the proposed ADF is inconsistent with Section 15A(b)(6) of the Act, which requires, in relevant part, that the NASD "foster cooperation and coordination with persons engaged in processing information with respect to, and facilitating transactions in securities and to perfect the mechanism of a free and open market and a national market system." The NASD's proposal would lead to a "balkanized" OTC market where market participants are left to "fend for themselves" in developing efficient price discovery, routing and execution mechanisms. Further, the proposed rule change is inconsistent with Section 15A(b)(11) of the Act which requires, in relevant part, that the NASD "promote orderly procedures for collecting, distributing, and publishing quotations." The proposed ADF would not serve as a central source for intermarket quotation activity unlike the current Nasdaq Workstation II. The ADF would not include quotations from the Nasdaq market or from other markets that trade Nasdaq-listed securities. The assumption of the proposed rule is that, absent the common execution mechanism that exists today for Nasdaq stocks, each market participant would be required to seek best execution by connecting separately to each different pool of liquidity. If even one pool of liquidity is not accessible, due to lack of resources or expertise by a participant, then this would beg the question: would this lack of connectivity to that one particular equity price be deemed a violation of the duty of best execution for that participant, or worse for its retail investor?
The Commission's Order Handling Rules were designed to link pools of liquidity, not to fragment them. The Order Handling Rules were designed to foster executions against those pools of liquidity and that is why the Commission mandated the integration of private pools of liquidity for Nasdaq stocks into the Nasdaq system. The ADF proposal unwinds the Commission's adoption of the Order Handling Rules in favor of the inequities, inefficiencies, and unfairness of a fragmented environment, and proposes to practically return to the days of the pre-Nasdaq market.
The proposed rule change also is inconsistent with certain provisions of Rule 11Ac1-1 under the Act. Under Rule 11Ac1-1(c)(2), brokers and dealers are obligated to execute any order to buy or sell a subject security presented to it by another broker or dealer. While the NASD's proposed rules also would obligate its member firms to execute such presented orders, the method by which such executions would take place is unclear. Currently, NASD member firms rely on order execution mechanisms such as SOES and SelectNet to provide standardized, uniformly available order routing and execution systems. With such systems transferred (as SuperMontage) to Nasdaq, NASD member firms will be left to their own devices to provide such systems. Further, under Rule 11Ac1-1(c)(5)(ii) exchange and OTC market makers may enter orders into an ECN in order to satisfy their order display obligations only if the ECN provides, to any broker or dealer, the ability to effect a transaction that is equivalent to the ability of any broker or dealer to effect a transaction with an exchange market maker or OTC market maker pursuant to the rules of the association. Currently, all NASD member firms may access ECN orders via SelectNet. With the proposed demise of SelectNet, each ECN will be responsible for providing the ability to effect transactions with its displayed orders that is equivalent to the ability of any broker or dealer to effect a transaction with an exchange market maker or OTC market maker. How "equivalent" access will be provided among the diverse systems provided by ECNs and other market participants remains to be seen. A similar requirement for alternative trading systems (ATSs) exists under Rule 301(b)(3)(iii). Under that subsection, ATSs must provide to any broker-dealer that "has access to the national securities association" the ability to effect a transaction that is equivalent to the ability of such broker-dealer to effect a transaction with other orders displayed by the association. Indeed, both Regulation ATS and the Commission's Division of Market Regulation ECN "No-Action" letters are premised on ATS/ECNs providing access to broker-dealers directly through a national securities association. In its ECN "No Action" letter to NexTrade, the Commission's Division of Market Regulation stated, "[t]he Division notes that compliance with the ECN Amendment depends in many respects on the practical effect of the operational conditions established by [the ECN] and the manner of the operation of the linkage between the [ECN] and Nasdaq." Of concern to the Commission's Division of Market Regulation was that the ECN provide response times for orders entered into the ECN through SelectNet no slower than the response time the ECN offers to subscribers who enter orders directly into the ECN, and in any event not more than a few seconds. Under the NASD's proposal, each market participant would be responsible for ensuring access is provided to its orders on a non-discriminatory basis. However, the NASD does not clearly indicate in its proposal how it intends to enforce the requirement for comparable standards between "direct" and "indirect" access to market participants or how market participants would make indirect electronic access "readily available".
Proposed Rule 4300 is Unworkable
Proposed Rule 4300 would require NASD "Market Participants" (registered market makers and ECNs) to provide other NASD Market Participants with direct electronic access to their quotes and orders and to provide NASD member broker-dealers that are not NASD Market Participants either direct electronic access or allow for indirect electronic access. Direct electronic access is defined as the ability to deliver an order for execution directly against a bid or offer with the equivalent speed, reliability, availability, and cost, as are made available to the NASD Market Participant's own customers. Indirect electronic access is defined as the ability to route an order through customer broker-dealers of an NASD Market Participant with equivalent speed, reliability, and cost, as are made available to the Market Participant's customer broker-dealers providing indirect access. The NASD envisions that these direct and indirect linkages could be satisfied by Market Participants by providing their own bilateral linkages or by participating in multilateral linkage facilities provided by private vendors.
The NASD's proposed quote and order access requirements leave too much to chance. The NASD is abandoning its obligation to foster a national market system and leaving the development of such a system in the hands of its Market Participants. How the thousands of NASD member firms will link to one another without the use of SuperMontage is not discussed in any meaningful way. While certain third party vendors exist to link a few market participants, such third party vendors currently do not reach a majority of NASD member firms, and a mammoth programming initiative would have to be undertaken to do so. If the Commission were to approve the NASD's proposal without such linkages in place, the OTC market would grind to a halt immediately.
Proposed Rule 4300 also contains a new requirement for Market Participants to report certain order and execution data to the NASD on a real-time basis. While most Market Participants currently provide such data to the NASD via the Order Audit Trail System (OATS), this new more rigorous requirement would add significant costs to NASD Market Participants for new programming and software.
The Proposed Rules May Impose Excessive Costs on NASD Members
The NASD indicates that it will not disseminate to ADF market participants any consolidated quotation or trade data in a security from securities exchanges and market centers. Therefore, under proposed Rule 4613(e)(2) the NASD would require market makers to have in close proximity to the ADF terminal a quotation service that disseminates quotations in that security on behalf of other markets. The expense of obtaining this additional hardware and software is unknown and may impose excessive costs on NASD members, especially smaller market participants.
The NASD also proposes a new trade reporting and comparison service, TRACS. The trade reporting service would collect trade reports for NASD registered market participants, as well as any NASD member required to report transactions occurring otherwise than on an exchange. This new service also may entail new programming and hardware expenses by NASD market participants. Again, such costs are unknown at this time, but will certainly effect smaller market participants disproportionately.
Further, the NASD proposes a new trade reporting rule (Rule 6620), which would obligate any NASD member to initiate or maintain a contractual relationship with Nasdaq for the purposes of reporting Pink Sheet securities through ACT. Rather than force NASD members to support both TRACS and ACT, which would place smaller firms at a cost disadvantage, NexTrade recommends that the proposed TRACS service be expanded to include the capability of reporting Pink Sheet transactions.
Finally, the costs involved in establishing multiple execution facilities between NASD market participants is unknown, but will most likely have a disproportionate impact on small market participants. In order to continue to provide best execution of customer orders, market makers and ECNs will certainly be required to acquire additional hardware and software that may be very expensive. In today's trading environment, with decreased spreads, the cost of such new execution systems may force many small market participants out of business.
NexTrade understands the desire of Nasdaq to evolve into a for-profit exchange in order to more effectively compete in the international securities execution business. However, the NASD, as a national securities association has an obligation under Sections 11A and 15 to foster a national market system where all orders are transparent and easily accessible for execution. The proposed ADF leaves NASD member firms in a lurch while members of The Nasdaq Stock Market grab all the technological "goodies".
The proposed ADF was not the scenario envisioned by the Commission in approving the NASD's SuperMontage proposal.1 In the SuperMontage proposal, the Commission stated that before Nasdaq could be approved as a for-profit exchange, the NASD must provide its members with a "market neutral linkage to the Nasdaq and other marketplaces, but not an execution service." Unfortunately, the proposed ADF fails to provide any link at all to the Nasdaq market. Further, NexTrade believes the Commission's statement regarding an "execution service" has been misinterpreted by the NASD. While the Commission states that the NASD itself need not provide an execution service, the requirements of the Act clearly obligate the NASD to assist its members in doing so beyond a mere rule requirement.
Rather than leave its member firms to fend for themselves in developing order display, routing and execution linkages, the NASD should utilize its considerable technological expertise to either (1) modify one of its existing systems, such as ACT or SelectNet, to allow for order execution or (2) solicit bids for a third party or parties to operate such a system or systems on behalf of the NASD and its members. The latter proposal has the advantage of allowing the NASD to achieve its stated goal of moving away from operating a market and focusing on regulatory issues. Further, the latter proposal would allow for competition between execution systems and yet assure a more organized, thoughtful and "member-friendly" method of fostering a national market system. Of course, the new execution system should be fully operational prior to allowing SuperMontage to become a proprietary system of Nasdaq. To allow automated execution to exist on a uniform scale only in the Nasdaq market would quickly lead to the demise of the OTC market, while coercing NASD member firms to join the Nasdaq exchange.
NexTrade understands the competitive pressures faced by Nasdaq and its market makers. Wafer-thin spreads and increased competition among markets has left all market participants and execution venues in a position of having to find new ways to stay profitable. However, it is inappropriate and inconsistent with the Act for a self-regulatory organization to relinquish the only marketwide order execution system in favor of a for-profit exchange without providing an adequate alternative for its member firms. NexTrade respectfully requests that the Commission and the NASD focus on the needs of investors and all market participants to foster a true national market system in the OTC market. The current ADF proposal does not go nearly far enough in fostering an OTC market that allows for transparency and efficient execution.
If you have any questions regarding this matter, you may contact me at (727) 446-6660 x129.
Mark P. Barracca
|Cc:|| Katherine A. England, Esq., Division of Market Regulation, SEC
Alden Adkins, Esq., Office of General Counsel, NASD
Kathleen A. O'Mara, Esq., Office of General Counsel, NASD Regulation, Inc.
Philip Shaikun, Esq., Office of General Counsel, NASD Regulation, Inc.
|1||Release No. 34-43863, File No. SR-NASD-99-53, January 19, 2001.|
|*||Licensed in Virginia and the District of Columbia. Not licensed in Florida.|