February 25, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
|Re:||File No.||NASD-2001-90||Release No. 34-45156 (Dec. 14, 2001), 67 FR 387 (Jan. 3, 2002)
("NASD ADF Filing") (pending SEC review)
|File No.||10-131||Release No. 34-44396 (June 7, 2001), 66 FR 31952 (June 13, 2001)
(Soliciting comments on Nasdaq's Form 1 Filing) (pending SEC review)
|Release No. 34-44899 (Oct. 2, 2001), 66 FR 51707 (Oct. 10, 2001)
Release No. 34-44910 (Oct. 5, 2001), 66 FR 52167 (Oct. 12, 2001)
Release No. 34-, 45342 (Jan. 28, 2002), 67 FR 5019 (Feb. 1, 2002)
Release No. 34-45444 (Feb. 14, 2002), 67 FR 8051 (Feb. 21, 2002)
Not currently available through the Federal Register.
(collectively relating to Nasdaq system fee charges, rebates and incentive payments for members; all filed as immediately effective except NASD-2002-18; NASD-2002-17 currently out for comment)
|File No.||NASD-2002-28||Not currently available through the Federal Register. (NASD proposed fees for ADF)|
|Release No. 34-44898 (Oct. 2, 2002), 66 FR 51703 (Oct. 10, 2001)
Release No. 34-44914 (Oct. 9, 2001), 66 FR 52649 (Oct. 16, 2001)
(both approved in Release No. 34-45379 (Jan. 31, 2002), 67 FR 5867 (Feb. 7, 2002)
66 FR 53276 (Oct. 19, 2001)
(pending SEC review) (collectively proposing Nasdaq system fee charges for UTP Exchange)
|NASD Notice to Members 02-09||Request for Comment On Proposed Changes To NASD's Regulatory Fees (Proposing transaction fee charges for trades in Nasdaq securities wherever they occur; not yet filed with SEC)|
|Release No. 34-45310 (Jan. 18, 2002), 67 FR 3923 (Jan. 28, 2002) (pending SEC review)
Release No. 34-45047 (Nov. 8, 2001), 66 FR 57496 (Nov. 15, 2001) (accelerated SEC approval)
(collectively proposing restrictions on UTP Exchange access to Nasdaq systems)
Dear Mr. Katz:
The Philadelphia Stock Exchange, Inc. ("Phlx") respectfully requests the Securities and Exchange Commission ("SEC" or "Commission") to consider our comments on the above-referenced matters. The filings enumerated above describe the coordinated plans of the National Association of Securities Dealers, Inc. ("NASD") and its subsidiary, the Nasdaq Stock Market, Inc. ("Nasdaq"), to partition the over-the-counter securities markets into a dominant exchange market operating on Nasdaq's trading facilities and a diminished, residual over-the-counter market operating under the NASD's continuing market authority as a registered securities association.
The primary blueprints for this fundamental market restructuring are contained in Nasdaq's original Form 1 application for registration as a national securities exchange (the "Initial Exchange Filing" and, together with Nasdaq's supplemental filings,1 the "Exchange Filing") and the NASD's rule changes to redefine its role following Nasdaq's exchange registration, including the rules for the Alternative Display Facility ("ADF") that the NASD plans to offer (SR-NASD-2001-90, referred to as the "ADF Filing"). These plans are impacted by, and must be considered together with, the other rule making initiatives we have identified above (collectively, the "Interim Rule Filings") to understand the overall design that the NASD and Nasdaq are seeking to implement.2 This letter is based on our evaluation of the Exchange Filing, ADF Filing and Interim Rule Filings as a group, and sets out our comments on the issues that they raise in combination with one another. This letter is intended to supplement our September 4, 2001 comment letter on the Exchange Filing, our January 24, 2002 comment letter on the ADF Filing and our comment letters on SR-NASD-2001-64 and SR-NASD-2001-72.
The filings discussed in this letter embody a master plan designed to stifle competition from exchanges that trade or plan to trade Nasdaq securities pursuant to unlisted trading privileges ("UTP Exchanges"). The anti-competitive means proposed to be employed by the NASD and Nasdaq in achieving this objective are inconsistent with the Securities Exchange Act of 1934 (the "Exchange Act" or "Act"). Moreover, apart from the substantive statutory infirmities outlined below, the method by which the various pieces of this plan have been embedded in numerous filings, has been artfully designed to obscure, and has had the effect of obscuring, the NASD's and Nasdaq's overall intentions, precluding meaningful public comment. Finally, because the NASD and Nasdaq nearly each week continue to make successive waves of related filings and amendments, it is not clear that all of the elements of the overall scheme have even yet been completely revealed. As more fully set forth herein, the Phlx respectfully requests that the public comment process on the ADF and Exchange Filings be reopened and that certain of the filings that are currently effective be abrogated by the Commission.
As a general matter, Phlx does not object to the concept of separating Nasdaq's trading facilities from the NASD through exchange registration. We strongly object, however, to the specific plans that the NASD and Nasdaq have advanced. Through our broader analytic approach, we have identified a number of legal flaws that we believe the NASD and Nasdaq must correct before the Commission may, consistent with its obligations under the Exchange Act, approve either the ADF Filing or the Exchange Filing. These filings, in conjunction with the Interim Rule Filings, also raise serious conflict of interest concerns relating to the NASD's economic self-interest as a substantial shareholder in Nasdaq and its longstanding parent relationship to Nasdaq. The Commission has recognized the need for vigilant oversight of the NASD to assure that it does not use its regulatory authority to favor Nasdaq's market interests to the detriment of other marketplaces.3 The Commission's concern is well founded.
We find especially troubling Nasdaq's proposal to classify virtually all trades in Nasdaq securities as Nasdaq exchange executions, regardless where they occur - including internalized trades and inter-market trades between Nasdaq members and members of other exchanges or the NASD - and to direct the trade reports and associated market-data revenues for those trades to Nasdaq.4 We believe these rules constitute off-board trading restrictions, in contravention of Exchange Act Rule 19c-3. The NASD, in turn, has proposed complementary trade reporting rules in the ADF Filing that are designed to facilitate Nasdaq's expansionist ambitions.5 The NASD seeks to add weight to Nasdaq's competitive might both today and following Nasdaq's exchange registration, through Interim Rule Filings that: restrict inter-market access to Nasdaq (including pending SR-NASD-2001-69, which seeks to force UTP Exchanges to participate in the Nasdaq National Market System, or "NNMS," which is also known as SuperSOES) or establish private links to Nasdaq market makers); impose fees that penalize market participants for executing or reporting trades outside Nasdaq systems; and allow Nasdaq to use market data revenues - including the revenues that Nasdaq as an exchange hopes to divert from other markets - to purchase order flow and trade reports.
These measures are designed with one purpose in mind - to undermine the ability of UTP Exchanges to compete fairly with Nasdaq as alternative trading venues for Nasdaq securities. They impose unnecessary and inappropriate burdens on inter-market competition that cannot be justified as advancing any public interest or fundamental policies of the national market system. Accordingly, the measures are contrary to Sections 11A(a)(1)(C)(ii), 6(b)(8) and 15A(b)(9) of the Exchange Act, Exchange Act Rule 19c-3 and other regulatory requirements. They also suggest that the NASD has allowed itself to be unduly swayed by its own economic self-interest and as a result to exercise its rulemaking authority to help Nasdaq construct a foundation of protectionist measures that discriminate against UTP Exchanges, with the intention that those measures will carry forward to protect Nasdaq when it operates as an exchange.
The ADF Filing, Exchange Filing and Interim Rule Filings, in aggregate, are also overreaching in that the NASD and Nasdaq are seeking to set unilaterally, by fiat, the terms governing their inter-market relationships with the existing exchanges in the areas of access, linkages and fees. Those matters are properly the subject of discussion and negotiation among the NASD, Nasdaq (as a prospective exchange) and other exchanges under the framework of the OTC/UTP, CQS/CTA and ITS Plans.
We discuss our legal objections to the NASD-Nasdaq separation plans, as reflected in the ADF Filing, the Exchange Filing and the Interim Rule Filings, more fully in Part III.
II. Procedural Deficiencies
Apart from the legal deficiencies plaguing the NASD-Nasdaq separation plans, we believe it would be premature for the Commission to act on the NASD ADF Filing or Nasdaq Exchange Filing without providing more meaningful opportunities for reasoned public input. In our view, a number of factors have compromised the value of the Commission's public comment periods for the ADF and Exchange Filings.
First, as we have explained, it is difficult to evaluate the full implications of the ADF Filing and Exchange Filing by looking at them as stand-alone parts, without stepping back to see the overall picture that they combine to form. That type of analysis is hampered, though, by the Commission's decision to provide a separate comment period for each filing, disconnected by several months time. The NASD's approach of submitting the Interim Rule Filings without highlighting in any fashion that they are relevant to the broader NASD-Nasdaq separation plans further complicates the analysis. When notices of the filings are published in the Federal Register, it is too easy to mistake them as covering routine matters that do not warrant the degree of scrutiny they deserve. This impression is reinforced when the filings are not available through the SEC's postings of "Selected SRO Rulemakings" on its web site, as is the case for each of the Interim Rule Filings. The NASD's piecemeal filing approach only serves to obscure the reality that the Interim Rule Filings are integral parts of an aggressive strategy to enhance Nasdsaq's market dominance at the expense of the UTP Exchanges, and the cumulative anti-competitive effects of those filings.
Second, the public record available during the comment process for the Initial Exchange Filing contained materially incomplete and out-of-date information on Nasdaq's plans. Nasdaq officially submitted its Form 1 on November 9, 2000, and the Commission issued its notice soliciting public comment on the Initial Exchange Filing on June 7, 2001. Interested parties were asked to formulate their views on the basis of the original set of proposed rules included with Nasdaq's application, which were largely modeled on the NASD Rulebook in effect at that time, without regard to any revisions to the NASD rules that occurred during the intervening seven months. Nasdaq finally indicated its intention to incorporate those pre-existing NASD rule changes into its proposed exchange rules on November 13, 2001, when it submitted Amendment 1 to its Form 1, but this occurred two and one-half months after the August 29, 2001 close of the comment period for the Initial Exchange Filing. (We refer the Commission to Phlx's September 4, 2001 comment letter and other comment letters on the Initial Exchange Filing for further examples of material deficiencies in the public record.)
Third, the NASD-Nasdaq restructuring plans are in a state of flux. The Interim Rule Filings are integral to those plans, but they were all submitted after the comment period on the Initial Exchange Filing ended. Nasdaq has stated in Amendments 1 and 3 to its Form 1 that it intends to incorporate many of the Interim Rule Filings into its proposed exchange rules,6 along with other NASD rule changes that occurred during the period November 9, 2000 and January 4, 2002. Nasdaq has also submitted material revisions to its proposed trade reporting rules in Amendments 2 and 3, ostensibly to address criticisms that the original trade reporting rules were overreaching, but ironically stretching the reach of those rules even further (as we explain in Part III.G.). We only learned of Nasdaq's supplemental filings through a search of the SEC's public reference room files. The only materials available through the SEC's web site are the original outdated Form 1 materials.7 Indeed, several of the comment letters on the NASD ADF Filing touch upon the NASD's trade reporting rules but without mentioning that Nasdaq has proposed material changes to its corresponding rules, suggesting that some commenters may have evaluated the NASD's rules without the benefit of complete information on such a material matter. Interested parties cannot provide meaningful input through the comment process if they are denied the opportunity to evaluate the current, material features of the NASD-Nasdaq plans.
Finally, as we described in our January 24, 2002 letter, we believe that the comment period for the NASD ADF Filing was too short. It is a time consuming task to review and assess the entire NASD rulebook for the post-separation era included in the filing and how those proposed rules interact with the Nasdaq's proposed exchange rules - especially Nasdaq's shifting trade reporting rules.
For all of the foregoing reasons, we request that the Commission reopen public comment on the Nasdaq Exchange Filing and the ADF Filing together, once a materially complete, fixed and current record is available for public review, so that the filings may be evaluated together.8 We further request that the Commission allow 90 days for providing comments, to ensure adequate time for interested parties to review and analyze the voluminous materials. The NASD/Nasdaq separation plans have significant implications for the national market system that warrant a more thorough public dialogue through the comment process than the Commission has allowed to date. If the Commission proceeds without the benefit of informed public comment, its ultimate decisions whether to approve the ADF Filing or Exchange Filing could be vulnerable to legal challenge as procedurally deficient and "arbitrary and capricious."9
III. Legal Objections to the Substance of the NASD-Nasdaq Separation Plans
Phlx believes that the NASD ADF Filing and Nasdaq Exchange Filing, as modified by the Interim Rule Filings, suffer from major legal deficiencies that preclude the Commission from approving either of them at this juncture.
A. Standard of Legal Review
Before turning to our specific objections, we wish to address Nasdaq's contention that the Commission does not need to conduct a thorough, de novo review of Nasdaq's proposed exchange rules, on the grounds that such rules are modeled on existing NASD rules that the Commission has previously reviewed.10 Nasdaq's position is premised on the faulty assertion that the Exchange Act imposes the same legal standards on national securities exchanges and registered securities associations. Granted, Sections 6 and 15A impose substantially similar requirements, but Nasdaq ignores material differences in how exchanges and securities associations are regulated under other provisions of the Act and related SEC rules. Significantly, Nasdaq will become subject to Exchange Act Rule 19c-3, which generally prohibits an exchange from adopting rules to prohibit its members from effecting trades in exchange-listed stocks, i.e., stocks registered under Section 12(b) of the Act - which will include Nasdaq-listed stocks once it is an exchange - off of the exchange. This rule implements Congressional policy reflected in Section 11A(c)(3) of the Act that exchange off-board trading restrictions are harmful to the markets and should be allowed only in limited circumstances supported by express SEC findings, made on the basis of a hearing on the record, relating to the public interest, investor protection, and maintenance of fair and orderly markets.
We believe the Commission must conduct a rigorous review of proposed Nasdaq rules falling into areas where the legal requirements differ for exchanges and associations. Thus, for example, Nasdaq's proposed off-board trading restrictions must be evaluated in light of Section 11A(c)(3) and Rule 19c-3. As we explain in Part III.G. below, we believe that Nasdaq's proposed trade reporting rules as presented constitute off-board trading restrictions in violation of Rule 19c-3.
The failure to reevaluate Nasdaq's rules in the context of a national securities exchange mistakenly equates the trading environment of an exchange with the over-the counter market. Exchanges are characterized by centralized auctions, including trading rules that govern the sequence of trading in a particular security. Every exchange has rules of priority, parity and precedence that assure that the highest bid interacts with the lowest offer and that bids and offers at the same price have a specified priority. The over-the-counter market, including the Nasdaq market, has never functioned in this way. It is a dealer market in which each dealer acts as a "mini" exchange providing its customers with similar trade sequencing but operating independently of each other dealer. As a result, it is common in the over-the-counter market for executions to occur outside of the NBBO. To convert this type of trading environment to an exchange model without any analysis of its appropriateness is an omission that must be corrected. Currently, the existence of an auction is fundamental to the operation of a national securities exchange; deviations from that model should occur in a controlled, systematic manner that advances the goals of the national market system rather than compromises them. In fact, the Commission has scrutinized other SRO rule changes and programs that move from this model, to ensure adherence to Exchange Act principles.
We agree with the Commission that it should apply its regulatory framework under the Exchange Act in a flexible manner to allow the markets, exchange and over-the-counter alike, to innovate in response to competitive pressures. The Commission has an obligation, however, to apply that flexibility in a reasoned, fair and evenhanded manner to all marketplaces under its oversight. This is the express mandate of Section 11A (c)(1)(F).
For the same reasons, the Commission should also carefully consider the rule changes covered in the Interim Rule Filings, to the extent that Nasdaq plans to incorporate them into its rules, in terms of their collective implications for Nasdaq as an exchange. It would be inappropriate for the Commission to rely on its earlier ad hoc consideration of those filings from the perspective of Nasdaq as an over-the-counter trading facility of a registered securities association. The same holds true for any future NASD rule filings that Nasdaq decides to incorporate into its exchange rules. This means evaluating the rule changes in the context of Nasdaq's other proposed exchange rules, including the trade reporting rules, and the NASD's proposed post-separation rules. In this broader context, we believe the Interim Rule Filings collectively are inconsistent with the Exchange Act's proscriptions against unnecessary and inappropriate burdens on inter-market competition, in violation of Sections 11A(a)(1)(C)(ii), 6(b)(8) and 15A(b)(9), and should not be approved by the Commission as part of Nasdaq's Exchange Filing.
Finally, as a general comment, we urge the Commission to evaluate the various filings we address with special attention to their overall anti-competitive and anti-trust implications. We believe the Exchange Act requires no less. The legislative history of the 1975 amendments to the Exchange Act emphasizes the Commission's obligation:
to review existing and proposed rules of the self-regulatory organizations and to abrogate any present rule, or to disapprove any proposed rule, having the effect of a competitive restraint it finds to be neither necessary nor appropriate in furtherance of a legitimate regulatory objective.11
We believe that the many anti-competitive features of the NASD-Nasdaq separation plans that we identify do not withstand such scrutiny, for they cannot be justified as furthering any legitimate regulatory objective. The taint of anti-competitive intent is evident throughout the ADF Filing, Exchange Filing and Interim Rule Filings, including, the various fee, rebate and revenue sharing filings that we address in Part III.F., which have the combined effective of pressuring NASD-Nasdaq members to use Nasdaq systems to the exclusion of the UTP Exchanges for displaying quotes, routing orders, executing trades and reporting trades in Nasdaq securities. The various strategies that the NASD and Nasdaq are pursuing also raise potential concerns under the federal anti-trust laws, in that they appear to be designed to capitalize on Nasdaq's dominant market position to gain unfair competitive advantages over the UTP Exchanges.
The NASD's dual roles as industry regulator and market operator create conflicts-of-interest, in that the NASD has self-regulatory authority over broker-dealers and ECNs with which it competes today through Nasdaq. Separating the Nasdaq trading facilities from the NASD should, ideally, lessen the inherent conflicts between the NASD's regulatory and commercial interests. However, based upon the NASD-Nasdaq business strategy embodied in the various filings we address, this is not the case in practice.
The NASD formed Nasdaq 30 years ago to provide quotation and transaction reporting facilities for the over-the-counter markets. Since then, it has nurtured Nasdaq's growth and development and, like any normal parent, would like to see its offspring succeed. As part of the restructuring, the NASD has converted Nasdaq to a for-profit corporation, with the intention that Nasdaq will have an initial public offering of its common stock, to raise funding for technology improvements and business initiatives. (It is our understanding that the IPO would occur shortly after Nasdaq becomes registered as an exchange, but the timing is unclear to us.)
The NASD has a strong self-interest in bolstering Nasdaq's future chances for commercial success as an exchange before the IPO occurs, to demonstrate the stock's value to prospective investors and thereby improve the chances for a successful IPO. The NASD's economic self-interest in promoting Nasdaq's profitability may well continue after the IPO. The NASD still owns a substantial portion of Nasdaq's common stock - 25% on a fully diluted basis and 69% on an undiluted basis as of November 15, 2001.12 Although it is our understanding that the NASD plans to divest itself of common stock in an amount equal to its fully diluted holdings (approximately 33.7 million shares), it appears based on a recent press report that the NASD Board has approved the sale of those shares to Nasdaq in exchange for a combination of cash and two newly issued shares of Nasdaq preferred stock totaling $440 million in value.13 If true, the NASD will continue to hold an economic interest in Nasdaq, just in a different form and amount than its current diluted common stock holding.
Phlx is concerned that the NASD has been unduly influenced by its self-interest in assuring Nasdaq's on-going prosperity. As the Commission stated a year ago in the SuperMontage Approval Order:
It would be inconsistent with the NASD's self-regulatory responsibility for the NASD to use its regulatory power to advance Nasdaq's market interests to the detriment of its members, and the Commission intends to be vigilant to prevent this. As a result, the NASD will not be able to use its regulatory authority to act in any manner in preference to, or prejudice of, Nasdaq or any other stock market, marketplace, or market participant generally or specifically because of that entity's relationship to the SuperMontage or Nasdaq.14
We concur. We have serious reservations, though, that the NASD is adhering to these standards. We believe that the NASD's favoritism towards Nasdaq and prejudice towards the UTP Exchanges is evident in the NASD's plans to offer a rudimentary quotation and trade reporting facility (the ADF), its proposal to adopt trade reporting rules designed to complement Nasdaq's efforts to funnel virtually all trade reports to Nasdaq for its credit under the market data consolidation plans, and the anti-competitive measures embodied in the Interim Rule Filings. We believe these measures have the intention and effect of stifling competition from UTP Exchanges and may represent an abuse of the NASD's self-regulatory responsibilities and ask that the Commission review the various components of the NASD-Nasdaq separation plans with that concern in mind.
C. Risk of Degradation of Consolidated Market Data For Nasdaq Securites
1. Nasdaq Market Maker Quotes
The OTC/UTP Plan covers the collection, consolidation and dissemination of quotations and last sale reports for Nasdaq securities from over-the-counter market makers, electronic communication networks ("ECNs")15 and the UTP Exchanges. The NASD is a member of the Plan; Nasdaq currently participates indirectly, as a facility of the NASD, but has also joined the Plan in anticipation of its exchange registration.16
Under SEC Rule 11Ac1-1 (the "Quote Rule"), exchanges are generally required to collect and make available the best bid and offer quotes (including size) in their markets for inclusion in the quote data disseminated under the OTC/UTP Plan, whereas the NASD, as a national securities association, is generally required to collect and make available the bids and offers (including size) communicated by all of its registered market makers. This reporting and dissemination scheme is built around the differences between centralized exchange auction markets, which maintain central limit order books, and the decentralized competing dealer structure of the over-the-counter market, where each dealer maintains its own separate auction and the concept of a central limit order book does not apply.
Nasdaq wants to limit the quote data that it will provide as an exchange participant in the Plan. It has proposed amendments to the OTC/UTP Plan at a recent Operating Committee meeting under which it would only have to make available the best priced bid and offer from among all bids and offers communicated by its market makers,17 notwithstanding that Nasdaq will retain its current decentralized dealer market structure.
Although the Operating Committee rejected the proposal, we expect that Nasdaq will continue to press the issue with the Operating Committee and the Commission. We also anticipate that Nasdaq will attempt to rely upon its status as an exchange under the Quote Rule to justify its refusal to make available quotations from each of its market makers. This is indicated by Nasdaq's statement in its November 30, 2001 response letter in the Exchange Filing that "Once Nasdaq becomes registered as an exchange, the existing trade reporting plans will need to be amended to reflect the fact that Nasdaq trades (both current third market trades and current OTC trades) will now be exchange trades and reported as such."18
Nasdaq should have to provide at least the same market data once it becomes an exchange that it provides today. If it does not, the quote data disseminated under the OTC/UTP Plan will contain less information than today and thus be less useful to investors. The SEC should reject any efforts by Nasdaq to rely upon literal distinctions in the Quote Rule to achieve a result that is clearly contrary to the substance and intent of the rule. As Nasdaq states in its November 30 letter, it "is not a centralized, auction market, but rather is a decentralized, competing market."19 Nasdaq should not be permitted to argue, as it has, that "a central limit order book and trade through rule are inconsistent with Nasdaq's market structure"20 yet conveniently ignore the fact that its market structure differs from the single auction model characteristic of traditional exchanges as a means to evade obligations that the Quote Rule intended to apply to decentralized competing dealer markets such as Nasdaq's.
If Nasdaq is permitted to provide only top of the book quotes to the OTC/UTP Plan, it will enhance the value of its displays, which will include the full montage of market maker quotes. On the other hand, we believe based on Nasdaq's recent efforts to amend the OTC/UTP Plan that Nasdaq intends to exclude UTP Exchange quotes from its montage (other than UTP Exchanges that agree to become auto-execution participants in the NNMS and SuperMontage) and to sell its montage through vendors. If true, and the Commission permits this to occur, Nasdaq will gain an unfair competitive advantage over UTP Exchanges through monopoly control over montage displays of Nasdaq market maker quotes. The disparity will become even greater once Nasdaq fully implements SuperMontage and provides depth of book information.
We question, though, how Nasdaq can disseminate its market maker quote montage through vendors consistent with Exchange Act Rule 11Ac1-2 (the "Display Rule"). That rule generally requires information vendors and broker-dealers to provide market data from all reporting market centers if they provide market data from any one market center to their subscribers or customers. At the very least, Nasdaq would place vendors and broker-dealers in jeopardy of violating the Display Rule if it provides them with Nasdaq market maker quotes in a format that makes it difficult for them to incorporate the quotes of UTP Exchanges or otherwise requires or pressures them to exclude UTP Exchange quotes from their displays of the Nasdaq quote montage.
The Nasdaq has taken another step to further secure an unfair competitive advantage for itself. The amendments that Nasdaq recently proposed to the OTC/UTP Plan include provisions that would preclude a new SIP under the plan from collecting and making available to vendors data from UTP Exchanges containing depth of book information,21 thereby denying the exchanges the ability to offer richer displays of market data to compete with Nasdaq's displays.
2. The NASD Should Be Held To Compliance With The Quote Rule
Nasdaq's November 30 letter states that "the NASD will have to file, and have the SEC declare effective, a separate transaction reporting plan to cover any trades in either listed or OTC securities that are effected otherwise than on, or through the facilities of, the Nasdaq exchange or another national securities exchange."22 If the NASD were not a member of the existing OTC/UTP Plan, that would raise a panoply of issues regarding the consolidation of third market trade and quote data with exchange market data (including Nasdaq's data). Such issues include, among others, whether the new plan will, or should be allowed to, use a SIP other than the one for the OTC/UTP Plan; issues of coordination between the plans, which become decidedly more complex if there will be two separate SIPs; and the potential for delay in selecting a new SIP for the OTC/UTP Plan if there will be one SIP for the two plans.
Of greater concern, Nasdaq is urging the Commission to permit Nasdaq to commence operating as an exchange before the NASD has implemented its ADF and to accommodate that request has also requested the Commission to grant the NASD a temporary exemption from the Quote Rule (Rule 11Ac1-1) and the Display Rule (SEC Rule 11Ac1-2). Nasdaq seeks to justify this exemption request by arguing that:
[T]he market for Nasdaq securities will remain highly transparent if the SEC grants the NASD (but not NASD members) temporary exemptions from these rules because, for the period during the temporary exemption, broker-dealers will be displaying quotes and reporting trades to Nasdaq or another exchange.23
We disagree with Nasdaq's contention that market transparency will not suffer. Under Nasdaq's vision, the quote data displays available under the plan for Nasdaq securities would be limited to top of the book data from the UTP Exchanges, Nasdaq and, for some unspecified "temporary" timeframe, the NASD. Thus, investors would no longer be assured access to quotation displays that integrate UTP Exchange quotes into the montage of market maker best priced quotes.
Nasdaq's exemption request, if granted, would lead to another troubling - and we believe intended - result. Nasdaq has excluded NASD members from the scope of the request. But this means that existing NASD market makers would be forced to join Nasdaq24 after its separation from the NASD to meet their quotation obligations as OTC market markets under applicable SEC Rules, at least until the NASD provides an appropriate alternative quoting facility. Nothing in the Exchange Act or Commission rules, however, requires an OTC market maker to belong to an exchange. OTC market makers should not be forced into that decision to accommodate Nasdaq's business timing objectives or to help Nasdaq indirectly achieve its objective of securing a broad membership base that replicates the NASD's (which in turn will aid Nasdaq's efforts to claim all internalized trades and inter-market trades as its own).
The NASD and Nasdaq are working together on their plans to spin off Nasdaq as an exchange. The NASD and Nasdaq have also been on notice for over one year of the NASD's obligation to provide a viable alternative quotation collection and trade reporting facility on a timely basis.25 It is disingenuous for Nasdaq to now argue that they have been acting independent of one another and that it has no control over how long it will take the NASD to develop and implement the ADF it has committed to provide.
The Commission should reject Nasdaq's exemption request and hold fast to its position that the NASD must have the ADF in place before Nasdaq may begin operating as an exchange.
D. Inter-Market Order Routing Linkages For Nasdaq Securities
Last year the NASD submitted SR-NASD-2001-69, which the Commission recently published for public comment.26 Under this proposal, UTP Exchanges would be required to participate in Nasdaq's NNMS with auto-execution against their quotes. If a UTP Exchange does not agree to this, its quotes in Nasdaq securities would only be accessible via telephone, as provided today in the OTC/UTP Plan, or through private bi-lateral links to individual market makers established by the UTP Exchange. In other words, specialists at UTP Exchanges that do not participate in the NNMS would no longer be able to send orders to Nasdaq market makers through SelectNet. On the other hand, if a UTP Exchange agrees to participate in NNMS auto-execution functionality, it may use SelectNet to direct non-liability orders to other NNMS participants, receive non-directed liability orders and direct preferenced liability orders to order entry ECNs (i.e., ECNs that do not accept auto-execution against their quotes).
This proposal is the third in a series of NASD filings that are intended to alter materially the ways in which the UTP Exchanges interact with NASD-Nasdaq market makers. Last summer, the NASD implemented rules that permit UTP Exchanges to participate in the automated execution functionality of the NNMS on a voluntary basis.27 If a UTP Exchange makes that election, it is only required to receive non-liability orders through SelectNet, to avoid the risk of double executions - one through NNMS and the other through SelectNet - against a single quote displayed by the UTP Exchange.28 A non-participating UTP Exchange does not receive that benefit.
Next, the NASD received SEC approval of a somewhat moderated version of SR-NASD-2001-69, but with the same ultimate objective: to pressure UTP Exchanges to access Nasdaq market makers through the NNMS or non-Nasdaq systems. This Interim Rule Filing, SR-NASD-2001-77, which the Commission approved on an accelerated basis within one week, 29 establishes a pilot program under which UTP Exchanges that wish to use Nasdaq systems are required to choose between full participation in NNMS, including auto-execution against their quotes, or participation through SelectNet. If a UTP Exchange elects to participate through SelectNet, executions on NNMS are permitted to trade through the exchange's quotations. The pilot program is currently scheduled to end on February 28, 2002, but we expect that the NASD will seek to extend the term if it does not receive approval of the pending filing.30
The Commission should not approve SR-NASD-2001-69 or grant any extension to the pilot program under SR-NASD-2001-77. Phlx strongly objects to these attempts to force UTP Exchanges to become auto-execution participants in Nasdaq's NNMS. Superficially, it may appear that Nasdaq is simply seeking to impose reasonable controls on access to its proprietary systems. But there is much more going on than that. These measures, together with Nasdaq's proposed trade reporting rules and its new fee schedules, have adverse implications for the attractiveness of UTP Exchanges as alternative trading venues for Nasdaq securities. Nasdaq is proposing a trade reporting scheme under which it receives credit for all trade executions that occur over the NNMS systems and associated market data revenues, even inter-market trades that would otherwise be treated as occurring on a UTP Exchange under the current trade allocation provisions of the OTC/UTP Plan. (Nasdaq's proposed trade reporting rules are discussed in Part III.G.) Forcing UTP Exchanges into the NNMS imposes insupportable competitive burdens on them by making it difficult for them to attract ECNs as direct participants due to the auto-execution functionality of the NNMS; imposing per share trade execution fees on the UTP Exchanges for their orders executed through NNMS and forcing the UTP Exchanges to relinquish any claim over inter-market trades executed through the NNMS under Nasdaq's proposed trade reporting rules, either as indications of the liquidity their markets provide or to receive the market data revenues.
We also find Nasdaq's justifications to be without merit. Nasdaq claims that its restrictions are needed to protect Nasdaq market makers against the risk of dual liability on their posted quotes in NNMS and SelectNet if they have to accept incoming orders from UTP Exchanges over SelectNet. To the extent that this may be a problem, we believe much less radical solutions could be worked out with the UTP Exchanges, such as providing Nasdaq market makers a short window of time to respond to incoming SelectNet orders. The NASD and Nasdaq have made no meaningful efforts to work with the UTP Exchanges towards an amicable resolution.
We also dispute Nasdaq's claim that there is a real risk that a UTP Exchange would not respond on a timely basis to incoming SelectNet orders.31 The NASD and Nasdaq offer no empirical data to substantiate this claim. They are also too hasty to reject the use of time limits on how quickly UTP Exchanges should respond to incoming SelectNet orders as a possible solution. We agree that the NASD and Nasdaq cannot impose time limits unilaterally, but such time limits can be negotiated with the UTP Exchanges. There is no basis for the NASD and Nasdaq to assume that the UTP Exchanges will be unreasonable on this matter.
Nasdaq's reliance on SEC statements in the adopting release for Regulation ATS is also misplaced. NASD quotes the SEC's statement that "any SRO to which alternative trading systems may be linked, may determine that it is necessary for the fair and orderly operation of its market to require that publicly displayed alternative trading system orders be subject to automatic execution."32 NASD asserts that this principle should be extended to UTP Exchanges. But exchanges are not alternative trading systems and are not regulated in the same way. Alternative trading systems are given the choice of either registering - and being regulated - as national securities exchanges or complying with the terms of Regulation ATS including the requirement to belong to an SRO that may well also be a competitor. Nasdaq's position incorrectly assumes that UTP Exchanges should be treated as participants within Nasdaq's markets. The issue, however, is how to link separately licensed markets with different market structures to one another.
Phlx, like other exchanges, has announced plans to trade Nasdaq securities.33 If it is forced to participate in NNMS to link to Nasdaq market makers, it will face the consequence of having trading activity funneled away from its auction markets to Nasdaq. Quotes posted within the NNMS, even by UTP Exchange specialists, are treated as Nasdaq quotes, and the Nasdaq exchange as the liquidity provider market. Orders entered into the NNMS to trade against a quote are matched against the quote within the system and the resulting trade is treated as a Nasdaq exchange trade. There are no outbound orders to UTP Exchanges and thus no opportunity for orders entered into the NNMS to interact with other orders within the central auction of a UTP Exchange for potential price improvement when that exchange is the source of the quote being hit. Market participants will also be denied the benefits of full price discovery and potential price improvement associated with inter-market competition if Nasdaq is allowed to appropriate quotes from other UTP Exchanges into its markets. We believe these results are contrary to the objectives of the national market system reflected in the Section 11A of the Exchange Act.
Nasdaq's approach also places UTP Exchange specialists that post quotes within the NNMS to the very risk of double liability that Nasdaq seeks to avoid for its market makers by requiring the specialists to accept auto-execution against their quotes, namely, the risk of double executions against a single quote posted in the NNMS and on the exchange's trading floor or through the exchange's automated execution facility. Nasdaq and the UTP Exchanges should work together to resolve the double liability issues inherent in inter-market linkages.
We recognize that the Commission does not currently require inter-market linkages for Nasdaq securities. In our view, though, dismantling the primary means by which UTP Exchanges have (until now) interacted with Nasdaq market makers (principally SelectNet) under the terms that Nasdaq imposes represents a major step backwards from the goals of the national market system.34 It is time in the development of the national market system for the NASD, Nasdaq and UTP Exchanges to work together to develop an inter-market linkage plan for Nasdaq securities that strives for efficient order routing mechanisms on terms that are fair and reasonable for all participating markets. The discussions would also provide a framework for developing order handling rules that could be applied fairly and consistently. Until this inter-market linkage plan is developed and implemented, UTP Exchanges should be permitted to access Nasdaq market markets (both pre- and post-separation) via SelectNet, as they have in recent years.
Finally, we wish to note that the NASD and Nasdaq can make it difficult for UTP Exchanges to establish linkages to Nasdaq in other ways. In October 2000, Nasdaq advised Phlx that we would have to order special telecommunication lines and connect to a special Application Programming Interface ("API") to connect to Nasdaq systems. Despite assurances from Nasdaq at the time that all of the services we required would be available using the API connection, one year later, in October 2001, we were told this was no longer the case and that we would have to use a separate TCP/IP protocol line for providing and updating quotes and reporting trades. This occurred after we had spent months developing and testing the API line, at considerable cost, both in terms of resources and time lost.
E. Shortcomings Of The NASD's ADF
As we explained in our January 24, 2002 comment letter on the NASD ADF Filing, we do not believe that the NASD is fulfilling its promise of a year ago "to provide a market-neutral electronic linkage to the Nasdaq, as well as other marketplaces."35 The NASD plans to offer a rudimentary facility that can be used to report quotes, compare trades and report trades, but nothing more. It will not include quotes from UTP Exchanges for Nasdaq securities. It will not include modems or interrogation or display devices.36 It will not have any order routing functionality; NASD members must instead establish private electronic linkages to one another. It is hard to see how the ADF can be viewed as a viable alternative to Nasdaq systems when it will not even provide basic order messaging functionality similar to SelectNet. The rudimentary functionality of the ADF is but one more indication that the NASD has no interest in supporting a strong over-the-counter market and is seeking to advance the Nasdaq's market interests to the detriment of UTP Exchanges through various measures undertaken pursuant to its self-regulatory authority. As a further indication, the NASD has decided not to impose quotation update fees on an NASD member if the member keeps the number of its quotation updates through the ADF - i.e., changes to the sizes or prices of its quotes displayed through the ADF - below three times the number of trades that the member reports through the ADF. This will likely discourage NASD market makers from actively making markets through the ADF to avoid the fees that apply when quoting activity exceeds this threshold.37
F. Discriminatory and Anti-Competitive Fee Proposals
1. Objections To System Charges and Member Rebates
The NASD, through Nasdaq as its subsidiary, has submitted six rule filings to the SEC since the end of September pertaining to fees charged to members for using Nasdaq systems and related rebates, each as effective upon filing, with one exception (SR-NASD-2002-18, described below).38 The NASD has also submitted three parallel filings to impose the same fees on UTP Exchanges, two of which the SEC recently approved.39 It is our understanding that Nasdaq plans to continue operating under these fees as well as the pending filings once it becomes an exchange. (The NASD also recently filed its proposed fees for the ADF, in SR-NASD-28. We touch upon features of the filing, in the foregoing section, and reserve the right to submit further comments after the filing is published in the Federal Register.)
In the case of member fees, our principal objection is to the NASD's proposal in SR-NASD-2002-18 to impose higher, discriminatory fees on members if they do not report substantially all of the their trades in Nasdaq securities to Nasdaq through the ACT systems. Prior to this Interim Filing, the NASD revised its fees to (i) switch from a per order execution fee to a per share execution fee for trades that occur through the NNMS;40 (ii) provide rebates to members when their quotes are executed against through the NNMS, so long as they do not charge access fees;41 (iii) provide rebates to members when they send orders resulting in executions through the NNMS if the receiving member imposes an access fee (i.e., an ECN);42 (iv) impose the same order entry charges for orders entered into the NNMS or SelectNet;43 and (v) impose a new quotation update charge for updating quotes within the NNMS (with limited exception).44
In SR-NASD-2002-18, Nasdaq wants to raise the execution and quotation update fees for members that report less than 95% of their trades in Nasdaq securities to Nasdaq through ACT (measured on a monthly basis as an average of the percentage of trades and shares reported). Members that do not meet this threshold are classified as "Partial Contribution Members," whereas members meeting the 95% threshold are classified as "Full Contribution Members." The NASD has proposed raising the execution charge paid by Partial Contribution Members for their orders executed through NNMS by 25%, from the $0.002 per share fee that all members currently pay to $0.0025 per share executed, and the quotation update fee they pay by 100%, from the $0.01 per update fee that all members currently pay to $0.02.
The basis for imposing different, higher fees on Partial Contribution Members compared to Full Contribution Members has nothing to do with Nasdaq's costs for providing the covered services; the costs for the services should be the same regardless of a member's classification as a Full or Partial Contribution Member. Although the imposition of fee levels should not have to follow a strict correlation to the costs of providing the services, they should be supported by some reasonable, non-discriminatory justification, such as "volume discounts" that provide fee breaks for high volume usage of an SRO trading system to encourage use of the system. But Nasdaq's fee proposal cannot be justified on that basis because it draws distinctions based on the percentage of a member's total trades that the member reports to Nasdaq. Thus, a member could be one of the highest volume users of Nasdaq's systems, but if it reports less the 95% of its trades in Nasdaq securities to Nasdaq, it will have to pay higher execution and quotation update fees than a nominal user of Nasdaq's systems that reports all if its Nasdaq securities trades to Nasdaq. In short, the fee proposal is designed more to penalize members for trading Nasdaq securities on other markets than to reward them for using Nasdaq systems. Accordingly, we believe these measures constitute discriminatory and anti-competitive fees that violate Sections 15A(b)(5) and 15A(b)(9) of the Act and, if retained by Nasdaq as an exchange, will violate Sections 6(b)(4) and 6(b)(8) of the Act.
The NASD has also adopted per share trade execution and order entry charges that it now imposes on UTP Exchanges. We renew our objections to these charges.45 We continue to believe that they duplicate charges that UTP Exchanges already pay under the OTC/UTP Plan for similar services and thus promote an unlevel competitive playing field between Nasdaq and UTP Exchanges as alternative trading venues for Nasdaq securities. Further, we object to the NASD's proposal in SR-NASD-2001-72 to raise the execution fee for UTP Exchanges by 50%, from $0.002 per share to $0.003 per share. This fee is 50% higher than the fee that NASD members currently pay and that Full Contribution Members would pay if SR-NASD-2002-18 is approved and implemented. This disparity will discourage market participants from trading Nasdaq securities on UTP Exchanges, to avoid the higher fees that they would incur under the NASD's discriminatory fee proposals. To illustrate, if a Nasdaq member enters an order into the NNMS to sell 10,000 shares of XYZ, it will pay an execution charge of $20.00 ($0.002 per share x 10,000 shares), but if a UTP Exchange specialist places the same order into the NNMS, it will pay an execution charge of $30.00 ($0.003 per share x 10,000 shares).
Although not currently before the Commission, we wish to highlight another fee change that the NASD is contemplating, because it is part of the broader pattern of how the NASD is trying to make it more expensive for market participants to trade on UTP Exchanges to benefit Nasdaq's market interests. The NASD has announced that it is considering imposing transaction fee charges on trades in Nasdaq securities that take place on UTP Exchanges. 46 If adopted, this would constitute an inappropriate burden on competition contrary to Section 15A(b)(9) of the Act. It would also constitute an unprecedented and unwarranted extension of the NASD's fee making authority into matters outside its administration - trading activity that occurs on other markets - contrary to the limitations in Section 15A(b)(6) of the Act. Phlx plans to object strenuously to any such proposal that the NASD may file with the Commission and urges the Commission to reject any such proposal.
Finally, we observe that Nasdaq's proposals provide a chilling effect on liquidity providers by imposing discriminatory fees and thereby decreasing a liquidity provider's incentive to improve a market. The effect on investors is compounded by the inability to recognize a better bid or offer away (i.e., at a UTP Exchange with a favorable quote) or failure to provide an opportunity for price improvement by bettering an existing market.47 Both issues result in the reduction of competition and a true market system to the detriment of investors. This again illustrates how Nasdaq's proposals, separately and cumulatively, will result in harm to public investors.
We request that the Commission abrogate the rules imposing trade execution and order entry fees on UTP Exchanges and disapprove the pending filings that seek to impose higher, discriminatory fees on Partial Contribution Members and UTP Exchanges.
2. Objections to Revenue Sharing Program
The NASD has recently implemented a program to share certain market data revenues with members, pursuant to two Interim Rule Filings submitted as effective upon filing.48 As currently in operation, Nasdaq sets aside 80% of the net distributable revenues that it receives under the OTC/UTP Plan (through the NASD) attributed to Nasdaq Level 1 service, less associated regulatory fees charged by NASD-R. Nasdaq has agreed to pay each member a percentage of this net revenue pool for reporting trades through Nasdaq's ACT system equal to the average of (i) the percentage of all trades in Nasdaq securities and other securities covered by the OTC/UTP Plan) reported through Act represented by the member's trades and (ii) the percentage of all shares reported through ACT represented by the member's trades, in both cases counting trades that the member executes through or outside Nasdaq systems.
In SR-NASD-2002-18, the NASD is proposing to limit eligibility to participate in the program to Full Contribution Members. In other words, an NASD member must report at least 95% of its trades (in terms of number of trades and shares) through ACT to share in any of the market data revenues. Again, the NASD is seeking to pressure members to use Nasdaq systems to the virtual exclusion of UTP Exchanges for trading and reporting trades in Nasdaq securities. Phlx reserves the right to submit additional comments on this Interim Filing if it is published for comment.
We strongly object to the existing and proposed revenue sharing provisions. They are designed to unduly influence Nasdaq members to report substantially all of their trades in Nasdaq securities through ACT, for Nasdaq's credit under the revenue allocation provisions of the OTC/UTP Plan. These measures are most problematic if Nasdaq continues to apply them after it becomes an exchange, as currently planned, in light of Nasdaq's related efforts through its trade reporting rules to capture virtually all over-the-counter and inter-market trades in Nasdaq securities as Nasdaq exchange trades. (Discussed in Part III.G. below.) The revenue sharing program and trade reporting rules, taken together, create a framework under which Nasdaq as an exchange can use market data revenues diverted from other marketplaces to purchase additional trade reports away from the other marketplaces, regardless whether the trades have any real nexus to the Nasdaq exchange. In short, these measures place UTP Exchanges at a competitive disadvantage to Nasdaq in attracting trading interest to their markets. They also raise for us concerns that the NASD may be engaging in "predatory pricing" practices under the federal anti-trust laws.49
We request that the Commission abrogate the current revenue sharing rules, require the NASD to resubmit them under Section 19(b)(2) of the Exchange Act to ensure that they are subject to the scrutiny of public comment and disapprove the pending Interim Filing SR-NASD-2002-18. The Commission should also carefully reevaluate the Interim Filings relating to fees, rebates and incentive payments as part of Nasdaq's Exchange Filing.
G. Trade Reporting and Off-Board Trading Restrictions:
All Roads Lead to Nasdaq
1. Proposed Nasdaq and NASD Rules
Nasdaq's proposed trade reporting rules, in their current form as reflected in Amendments 2 and 3 in its Exchange Filing, constitute off-board trading restrictions in contravention of Rule 19c-3 under the Exchange Act in that they do not allow for the possibility that over-the-counter trades could occur somewhere other than Nasdaq, except in narrowly prescribed circumstances.50
First, under Nasdaq's proposed Rule 4623(a), a trade that is executed or facilitated on a Nasdaq system that generates automatic trade reports is a Nasdaq trade and will be reported by the system to Nasdaq. This standard will likely capture all trades executed through the NNMS (i.e., SuperSOES), SOES, SelectNet, Primex and the Nasdaq Order Collector Facility and Order Display Facility (i.e., SuperMontage). This is significant in light of the NASD-Nasdaq attempts to force UTP Exchanges to link to Nasdaq market makers through the NNMS, because Nasdaq automatically gets trade credit for all inter-market trades that occur through the NNMS. Nasdaq attempts to capture credit for inter-market trades that may occur over the phone or private linkages through other provisions, discussed below.
Second, all trades executed over-the counter in a Nasdaq security by a Nasdaq registered market maker for that security and all trades in a security executed through a member ECN that displays orders for that security through Nasdaq are required to be reported by the Nasdaq member as Nasdaq trades. These obligations apply because Nasdaq classifies such market makers and ECNs as "Registered Reporting Members," thus bringing them within the scope of proposed Nasdaq Rule 4633(b), which requires Registered Reporting Members to report to Nasdaq all trades that they execute anywhere but through a Nasdaq system or another exchange's trading floor or system. This means, for example, that internalized trades by a market maker, trades executed between two non-broker-dealer customers through an ECN that displays quotes in Nasdaq and inter-dealer trades executed through a private routing system would be deemed to be Nasdaq exchange trades.
For the remaining small universe of trades involving a Nasdaq member, it is easier to understand the reach of Nasdaq's rules by focusing on the narrow circumstances under which Nasdaq is prepared to concede (for now) that the trades could be reported to another marketplace. These circumstances are limited to the following:
If these conditions are met, a member may report the trade either to Nasdaq or to another marketplace.
In the latter case, for another exchange to have the opportunity to compete for the trade print and receive the associated market data revenues, it must adopt a rule requiring or permitting trades to be reported to it under the identical circumstances that Nasdaq has set out. No exchange should be permitted to encroach upon the autonomy and independence of another exchange's rulemaking authority as a self-regulatory organization under the Act by dictating the terms of the other exchange's rules; also, rules filed by one exchange should not be permitted to reduce or eliminate competitive opportunities currently provided to registered broker-dealers participating in various markets through multiple memberships on different exchanges. Matters relating to how exchanges interact with one another should be resolved jointly by the exchanges, not unilaterally by any one exchange. It should also be noted that Nasdaq has argued that the Commission should proceed cautiously before approving any comparable rules proposed by other exchanges.53 Further, even if an exchange has adopted such rules, Nasdaq is prepared to buy the print reports away from the exchange.
Nasdaq's trade reporting rules are a shifting target. Our description above is based on our understanding of those rules, in their current form, as reflected in Nasdaq Amendments 2 and 3 to the Initial Exchange Filing. According to Nasdaq, its original trade reporting rules followed a "destination market" concept for inter-market trades, where the marketplace providing the liquidity would receive credit for a trade. The original rules also gave members the choice whether to report internalized trades to Nasdaq, but did not mandate that any such trades be reported to Nasdaq. The original rules drew criticism through the comment process, and Nasdaq decided to amend them to "expedite the exchange registration process," ostensibly by adopting the OTC/UTP Plan protocol of assigning trade credit to the market representing the sell side of a trade. Although we are unconvinced that the Amendment 2 rule changes achieved that result, the issue is moot. Amendment 3 effectively eliminates all remnants of the sell side concept for inter-market trades,54 through rule changes that reclaim the ground covered in the original rules (but using rules) and stretch Nasdaq's reach beyond that ground by requiring Registered Reporting Members to report all internalized trades (in the case of registered market makers) and all ECN trades (in the case of ECNs displaying orders in Nasdaq) as Nasdaq exchange executions. Amazingly, Nasdaq offers only a brief description of the Amendment 3 changes, with no explanation for such a dramatic shift or how the rules in their current form are consistent with the Exchange Act, asserting instead that "the amendment does not raise any substantive issues."55 This sequence of events highlights the challenge of evaluating Nasdaq's Exchange Filing when key terms keep undergoing change.
The NASD's trade reporting rules, by the NASD's admission, are intended to complement the Nasdaq's. In other words, they are designed to aid Nasdaq's efforts to claim trade prints for over-the-counter and inter-market trades, providing another example of improper favoritism to Nasdaq over other marketplaces. The NASD attempts to disguise its rules with a cloak of neutrality, however, by pretending that the choice of reporting venues they allow their members to select from could reasonably include an exchange other than Nasdaq. That is not the case; Nasdaq's proposed trade reporting rules effectively minimize the chance that this could occur.
2. Off-Board Trading Restrictions
Nasdaq's trade reporting rules operate as off-board trading restrictions, in violation of Exchange Act Rule 19c-3, through the mechanism of deeming virtually all trades in Nasdaq securities to be Nasdaq exchange executions, except for trades that occur on an exchange floor or between two non-Nasdaq members other than through an ECN displaying orders in Nasdaq. As far as Nasdaq is concerned, the markets of a floor-based exchange auction do not extend beyond the exchange's physical trading floor and any trades that occur otherwise than completely on an exchange belong to Nasdaq, except begrudgingly in limited circumstances as described above. In short, Nasdaq does not recognize that over-the-counter trading could or should exist independent of Nasdaq. The anti-competitive nature of the rules is reinforced by the other rules we have discussed that provide a combination of penalties and rewards to encourage members to post quotes, route orders, execute trades and report trades only on Nasdaq systems; by the NASD's decision to provide a rudimentary ADF to encourage use of Nasdaq systems; and by the restrictions on UTP Exchange access to Nasdaq systems.
The Commission should disapprove Nasdaq's proposed trade reporting rules on the grounds that they violate SEC Rule 19c-3. If the Commission is receptive to Nasdaq's reporting scheme, the Commission will have to amend Rule 19c-3 first, in accordance with Section 11A(c)(3) of the Exchange Act, before it may approve Nasdaq's rules. Under this provision, the Commission must conduct a hearing on the record and make certain express findings that changing Rule 19c-3 to allow Nasdaq to adopt its proposed off-board trading restrictions is consistent with the public interest and other standards. Section 11A(c)(3) states:
(c)(3)(A) The Commission, by rule, is authorized to prohibit brokers and dealers from effecting transactions in securities registered pursuant to Section 12(b) otherwise than on a national securities exchange, if the Commission finds, on the record after notice and opportunity for hearing, that:
(i) As a result of transactions in such securities effected otherwise than on a national securities exchange the fairness or orderliness of the markets for such securities has been affected in a manner contrary to the public interest or the protection of investors;
(ii) No rule of any national securities exchange unreasonably impairs the ability of any dealer to solicit or effect transactions in such securities or between dealers acting in the capacity of market makers who are specialists in such securities and such dealers who are not specialists in such securities; and
(iii) The maintenance or restoration of fair and orderly markets in such securities may not be assured through other lawful means under this title.
In our view, the Commission cannot make these findings about Nasdaq's trade reporting rules and thus cannot amend Rule 19c-3 to accommodate Nasdaq and should disapprove Nasdaq's rules.
The Commission should not approve the ADF Filing or Exchange Filing in their current forms until the NASD and Nasdaq have cured the many legal defects that plague the plans to separate Nasdaq from the NASD. In combination with the Interim Filings (and perhaps other filings we have not yet identified), they represent a concerted effort on the part of the NASD and Nasdaq to impose a set of anti-competitive measures designed to enhance Nasdaq's already dominant market position and thwart any realistic opportunity for UTP Exchanges to compete as alternative markets for trading Nasdaq securities. It is also important for the Commission to conduct a thorough review of the overall separation plans to ensure that the NASD treats all exchange markets in a fair, non-preferential manner consistent with its self-regulatory responsibilities and consistent with Section 11A.
We have reservations that Nasdaq truly wants to be an exchange. It appears to us the Nasdaq would like to operate an over-the-counter market that is regulated as an exchange, when that suits its purposes, and as an over-the-counter facility, when it prefers that regulatory outcome. In short, Nasdaq wants to be free to engage in regulatory arbitrage, choosing the requirements it prefers in those areas where the Act and Commission rules impose different standards on national securities exchanges and registered securities associations. The Commission cannot permit this to occur, consistent with its obligation to promote fair inter-market competition under Sections 11A(1)(C), 6(b)(8) and 15A(b)9) of the Act. Any modifications to the existing regulatory framework for exchanges in light of the NASD-Nasdaq separation should be the result of careful deliberation by the Commission and open to all exchanges.
The Phlx has attempted to set out in detail the grounds for our objections to the ADF Filing, Exchange Filing and Interim Filings, taken as a whole, but our analysis is still incomplete. We did not believe we could take longer to prepare our comments, however, out of concern that the Commission would reject them as untimely. We urge the Commission to reopen comment on the Exchange Filing and ADF Filing for 90 days once a materially complete, fixed and current record is available for public review, so that Phlx and other interested parties have a reasonable opportunity to evaluate the record and offer informed comments on such an important matter as Nasdaq's separation from the NASD. We also urge the Commission to abrogate Interim Filings SR-NASD-2001-64, SR-NASD-2001-68, SR-NASD-2001-98 and SR-NASD-2002-17; to disapprove the pending Interim Filings SR-NASD-2001-72 and SR-NASD-2002-18 and to carefully reevaluate Nasdaq's proposed system charges, rebates and incentive programs as part of its Exchange Filing.
If the Commission staff would like to discuss these issues, please feel free to contact either myself or Lanny Schwartz. Executive Vice President & General Counsel at (215) 496-5406.
Very truly yours,
Meyer S. Frucher
Chairman and Chief Executive Officer
cc: Harvey L. Pitt, Chairman
Cynthia Glassman, Commissioner
Isaac C. Hunt, Jr., Commissioner
|1||The supplemental filings include Amendments 1, 2 and 3 dated, respectively, November 13, 2001, December 5, 2001 and January 8, 2002, as well as a letter dated November 30, 2001 responding to comments submitted during the comment process on the Initial Exchange Filing.|
|2||Nasdaq has recently amended its Initial Exchange Filing to incorporate many of these changes into its proposed exchange rules, but NASD and Nasdaq offer their justification for the changes in the Interim Rule Filings. Most of the Interim Rule Filings are currently in effect, as noted on the subject heading on the first page. We have conducted our analysis on the assumption that Nasdaq will likely decide to incorporate all of the rule changes reflected in the Interim Rule Filings, to the extent approved, into its proposed exchange rules.|
|3||See Release No. 34-43863 (January 19, 2001), 66 FR 8020 at 8051-8052 (Jan. 26, 2001) (order approving SuperMontage, SR-NASD-99-53) ("SuperMontage Approval Order"). We explain the basis for our conflicts of interest concerns in Part III.B.|
|4||See proposed Nasdaq Rules 4632 and 4633 and proposed IM-46332. Nasdaq's proposed trade reporting scheme is described in Part III.G.|
|5||The NASD's proposed trade reporting rules are designed to provide members that belong to more than one self-regulatory organization the choice of reporting their OTC trades to other markets pursuant to the other markets' rules. But for the situations where NASD provides such a choice, Nasdaq proposes to take it away, by requiring its dual NASD-Nasdaq members to report their trades to Nasdaq (except in limited circumstances). The only trades that Nasdaq does not attempt to claim as its own are trades between two members on another exchange's floor and trades that do not have a Nasdaq member as a party on either side. If Nasdaq successfully duplicates the NASD's broad membership base, as it intends, this situation is seldom to arise. See the discussion below in Part III.G.|
|6||Amendment 1 covered NASD rule changes approved through October 24, 2001.|
|7||Even the Public Reference Room files are incomplete. As of February 21, 2002, the attachment to Nasdaq's Amendment 1 to the Exchange Filing was missing. According to Nasdaq's transmittal letter, the attachment contains the text of Nasdaq's revisions to its proposed exchange rules, which we assume are extensive since they incorporate NASD rule changes that occurred over a close to one year period.|
|8||We originally requested a 90 day extension of the comment deadline for the ADF Filing, but since that comment period ended almost one month ago, we believe it now makes more sense to allow interested parties to comment on the Exchange Filing, the ADF Filing and other relevant filings together through a separate comment period on the separation plans.|
|9||Courts have remanded SEC approvals of SRO rulemaking when the Commission does not provide a reasoned analysis to support its findings that the SRO rule changes are consistent with the Act. See Timpinaro v. SEC, 2 F.3d 453 (D.C. Circuit 1993). We do not see how the Commission can make the necessary findings to approve the ADF Filing or Exchange Filing without meaningful public comment.|
|10||Letter dated November 30, 2001, from Edward S. Knight, Executive Vice President and General Counsel, Nasdaq, to Jonathan G. Katz, Secretary, SEC in connection with the Exchange Filing (the "November 30 letter").|
|11||Report of the Committee on Banking, Housing and Urban Affairs, United States Senate, To Accompany S. 249 at p. 13 (April 14, 1975).|
|12||See Nasdaq Form S-8, dated December 28, 2001. NASD has issued a number of warrants, options and convertible securities that the holders may exchange for Nasdaq common stock. NASD would retain 25% of the outstanding shares of Nasdaq common stock if all of those securities are exercised or converted.|
|13||Securities Week (January 28, 2002).|
|14||SuperMontage Approval Order at 8051-8052 (footnote omitted).|
|15||We use the term "ECN" generically to refer also to alternative trading systems.|
|16||Nasdaq is also currently the exclusive SIP, or securities information processor for the plan, but plans to step down from that role.|
|17||See Nasdaq's proposed Amendment No. 13 to the UTP/OTC Plan, which was considered by the Operating Committee at its meeting on January 31, 2002.|
|18||See p. 28, fn. 77 of the November 30 letter.|
|19||See p. 18 of the November 30 response letter.|
|21||See Nasdaq's proposed Amendment 13 to the UTP/OTC Plan.|
|22||See the November 30, 2001 letter in the Exchange Filing, at p. 28, fn. 77.|
|23||November 30, 2001 letter, p. 29 (emphasis added).|
|24||Nasdaq has the facilities to collect, process and make available montage displays of OTC market maker quotations. The UTP Exchanges do not.|
|25||See the SuperMontage Approval Order.|
|26||Release No. 34-45319 (Jan. 18, 2002), 67 FR 3923 (Jan. 28, 2002).|
|27||Release No. 34-44526 (July 6, 2001), 66 FR 36814 (July 13, 2001).|
|28||This does not, however, avoid double liability through the exchange's own automated execution system.|
|29||Release 34-45047 (Nov. 8, 2001), 66 FR 57496 (Nov. 15, 2001).|
|30||The Nasdaq, in fact, proposes to incorporate the requirements into its exchange rules without any indication that it considers the rules to be temporary. See Amendment 3 to the Exchange Filing.|
|31||See, e.g., SR-NASD-2001-77.|
|32||Release No. 34-45319, 67 FR 3923 at 3926 (SR-NASD-2001-69).|
|33||Release No. 34-45182 (December 20, 2001), 66 FR 67609 (December 31, 2001)(SR-Phlx-00-20).|
|34||Although our primary focus is on Nasdaq securities, we also wish to address inter-market linkages for non-Nasdaq exchange-listed securities. In the ADF Filing, the NASD is proposing to make participation in ITS by its market makers voluntary. This, too, is a step backwards and we ask the Commission to reject this approach. The Commission should require NASD and Nasdaq market makers for non-Nasdaq exchange-listed securities to participate in ITS, as they do today as ITS/CAES market makers. Thus, Nasdaq should be required to join ITS as a condition to exchange registration, and Nasdaq and the NASD should each adopt rules requiring their respective market makers for non-Nasdaq exchange-listed securities to participate in ITS.|
|35||SuperMontage Approval Order at 8053.|
|38||These include the following six filings pertaining to member fees: (i) Four Interim Filings submitted under Section 19(b)(3)(A)(ii) of the Act as effective upon filing with the SEC: SR-NASD-2001-63, SR-NASD-2001-67, SR-NASD-2001-96, SR-NASD-2002-17; (ii) a controversial proposal, SR-NASD-2001-71, to share market data revenues with members if they report substantially all of their trades in Nasdaq securities through Nasdaq's ACT system and to impose higher execution and quotation update charges on Nasdaq members that do not, which the NASD also filed as immediately effective but later rescinded; and (iii) a recent Interim Filing, SR-NASD-2002-18, that re-proposes substantially the same terms of the bi-furcated revenue sharing plan of the rescinded filing, which the NASD filed under Section 19(b)(2) of the Act to allow for public comment.|
|39||SR-NASD-2001-64 and SR-NASD-2001-68, which the Commission approved in Release No. 34-45379 (Jan. 31, 2002), 67 FR 5867 (Feb. 7, 2002), and NASD-2001-72, which is pending.|
|40||SR-NASD-2001-63 and SR-NASD-2001-67. The terms covered by clauses (ii) through (v) were adopted on a pilot basis through October 31, 200. The new per share approach for execution fees is not a pilot program, but the NASD has raised the fee otherwise specified in the rule on a pilot basis, also through October 31, 2002.|
|41||SR-NASD-2001-67. The terms apply on a temporary pilot basis through October 31, 2002.|
|43||SR-NASD-2001-63 and SR-NASD-2001-64. The terms apply on a temporary pilot basis through October 31, 2002.|
|44||SR-NASD-2001-96. The terms apply on a temporary pilot basis through October 31, 2002.|
|45||See Phlx's comment letter dated October 31, 2001 on SR-NASD-2001-64.|
|46||See Special NASD Notice to Members 02-09.|
|47||Further compounding the problem, Nasdaq currently permits its market makers to trade through a UTP Exchange's quotations if the exchange is not an auto-execution participant in the NNMS. See Part III.D.|
|48||SR-NASD-2001-96 and SR-NASD-2002-17. The latter filing expanded the percentage of the revenues described above that would be set aside to the current 80% level from 60%. The filing was submitted as effective upon filing, and is currently out for comment. Our comments in this section constitute our comments on SR-NASD-17, but we reserve the right to submit additional comments based on further review of the filing.|
|49||We do not have enough information to determine whether this is the case. We do know, however, that Nasdaq currently has the dominant market position for trading of Nasdaq listed securities, and that the NASD and Nasdaq are seeking to capitalize on Nasdaq's market strength through a variety of strategies, including its new fees and revenue sharing program. Accordingly, we ask the Commission to please address any potential predatory pricing concerns in its evaluation of SR-NASD-2002-18 and, more broadly, in its evaluation of the ADF and Exchange Filings.|
|50||Our analysis focuses on the trade reporting rules for Nasdaq securities, but we believe Nasdaq's proposed trade reporting rules for other exchange-listed securities are similar and may also constitute off-board trading restrictions.|
|51||Under proposed Rule 4631(c), a Non-Registered Reporting Member is a Nasdaq member that is not a Registered Reporting Member. Nasdaq proposes in Rule 4633(c)(3) to assign trade reporting responsibility as follows: (i) for trades where the parties have equal status as Registered Reporting Members or as Non-Registered Reporting Members, the sell side reports the trade; (ii) for trades between a Registered Reporting Member and a Non-Registered Reporting Member, the Registered Reporting Member reports the trade; (iii) for trades between a Nasdaq member and a customer, the member reports the trade; and (iv) for trades between a Nasdaq member and a broker-dealer that is not a member of another participant in the OTC/UTP Plan, the member reports the trade. See proposed Rule 4633(c)(3), included with Amendment 2.|
|52||See proposed IM-4633-2, included in Amendment 3 to the Initial Exchange Filing.|
|53||See the transmittal letter for Amendment 2 in the Exchange Filing, at p. 7.|
|54||Nasdaq claims that the rules as modified by Amendment 3 still retain the sell side reporting feature for inter-market trades. This claim is contradicted by proposed IM-4633-2 in Amendment 3, which sets out the narrow circumstances where a UTP Exchange has any chance to receive credit for an inter-market trade, which we describe above in point "3."|
|55||See the January 8, 2002 transmittal letter for Amendment 3, at p. 1.|