February 13, 2002
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: File No. SR-NASD-2001-90
Ladies and Gentlemen:
Brut, LLC ("Brut")1 welcomes the opportunity to provide the Securities and Exchange Commission (the "Commission") with its comments on Exchange Act Release No. 45156 (the "Release"),2 in which the Commission solicits comment on a proposal by the National Association of Securities Dealers, Inc. (the "NASD") to: (i) amend its rules to reflect the separation of The Nasdaq Stock Market, Inc. ("Nasdaq") from the NASD upon Nasdaq's approval as a national securities exchange; and (ii) establish rules that would govern trading otherwise than on an exchange, including rules governing the Alternative Display Facility ("ADF") to be constructed by the NASD as dictated by the Commission.3
Brut believes that the Release in general, and the ADF in particular, represents important progress towards modifying market structure so that all market centers may compete on a level playing field, devoid of the competitive advantages conferred on Nasdaq by virtue of its historical legacy as a regulatory utility. Certain aspects of ADF operation, however, could operate to undermine that potential, and uncertainties still exist as to whether the NASD will work to furnish the ADF with immediate and long-term viability. Brut respectfully suggests "vigilan[ce] to prevent... the NASD [from] use [of] its regulatory authority to act in any manner in preference to, or prejudice of, Nasdaq or any other stock market, marketplace, or market participant."4
Summary of Comments
The intent of the Release is "to amend the [NASD's] rules to reflect the anticipated approval of Nasdaq as a national securities exchange and its resultant separation from NASD; and to establish the rules that would govern trading otherwise than on an exchange, including the implementation and operation of the ADF."5 As such the Release should not be reviewed in a vacuum - it must be assessed in light of Nasdaq's implementation of SuperMontage, its application to become a registered exchange, and pursuit of a strategy predicated on for-profit operation and publicly-held equity.6 Brut has previously urged the Commission to allow Nasdaq to complete this transformation only when competitive alternatives exist to Nasdaq participation.7 Whether the ADF creates such an alternative is the question that must be answered affirmatively before the Release should be approved and Nasdaq allowed to go forward with its competitive vision, including but not limited to bringing SuperMontage "live".
Brut believes that the Release does outline a framework for the operation of facilities that would allow ECNs and market-makers to reduce their reliance on Nasdaq systems, facilitating free and fair competition between among market centers, and thus is a significant step in the right direction. There are, however, certain aspects of the Release and the NASD's revised rule book that create cause for concern in that they either: (i) imply a continued deferral to Nasdaq policies that the NASD should no longer be subject to if these entities are truly independent; (ii) create tenets for the operation of the ADF and the over-the-counter market that are outdated in light of recent market developments and may undermine the competitiveness of NASD-sponsored market alternatives going forward; (iii) create regulatory inconsistencies that could jeopardize market quality. Moreover, the economics of ADF usage and other information vital to assessing the ADF's usefulness have yet to be disclosed by the NASD.
The ADF's Role in the National Market System
Brut believes the ADF's structure is appropriate in that it provides market centers with a non-Nasdaq facility for complying with certain regulatory obligations without re-creating the conditions that gave birth to the modern Nasdaq: transforming that facility into a market center in its own right. The creation of SRO-sponsored linkages and execution facilities may have made sense in the 1980s (when SelectNet and the Small Order Execution System were grafted onto Nasdaq's quotation montage) due to a lack of integrated information and connectivity between and among broker-dealers. Unfortunately, it had the unintended consequence of setting Nasdaq down the path towards competing with the broker-dealers that paid to create it and that it was ostensibly formed to serve. The ADF is a necessary step towards disentangling the national market system from that contradiction.
Given these lessons of the past, the NASD is correct to avoid creating its own proprietary network among broker-dealers, and instead set explicit standards that ADF market participants provide "direct electronic access" to all other ADF participants and also allow for "indirect electronic access" for non-ADF firms.8 Recent improvements in technological efficiency and Commission regulation9 now provide every broker-dealer with a variety of means to ensure access to information from and executions in all market centers. SEC Regulation ATS requires display of quotations from all market centers effecting significant volume in the public quotation system, and that the operators of such systems provide fair and consistent criteria for the acceptance of prospective broker-dealer customers. A number of broker-dealers and technology providers market products that allow for integrated displays of all market information, regardless of source, within a platform that allows for one-touch access to liquidity wherever it resides. These facilities are superior to previous tools available to brokers seeking to provide best execution for their customer orders, and fulfills the congressional mandate for "economically efficient execution of securities transactions."10 Accordingly, the NASD need not provide a mandatory execution facility as part of the ADF, as it would be an inexorable first step towards re-creating the competitive issues the ADF is intended to resolve.
Brut therefore believes that, in combination with private market forces, the ADF can in principle fulfill the Commission mandate to "provide NASD members with the ability to opt-out of the SuperMontage"11 consistent with national market system objectives. As described below, however, care will be required to transform that potential into meaningful long-term choice for market participants.
ADF Economics and the NASD-Nasdaq Relationship
As evidenced in its name, the ADF's reason for being is to be "a viable alternative... to Nasdaq" for purposes of quotation dissemination, trade reporting and comparison, and data collection and distribution.12 This would permit market centers to compete head-to-head with Nasdaq in the market for execution services on a level-playing field. In order to realize this potential, the ADF must: (1) be independent from Nasdaq with respect to its organization and operation; and (2) offer prospective participants a competitive economic alternative to Nasdaq participation. Without these features, the promise of the ADF will have been squandered, along with much industry and Commission time and energy. While the Release and other NASD efforts portend that the ADF will be run with a view to establishing and maintaining its competitive independence and commercial viability, much still needs to be done to see this vision realized.
With respect to the separation of NASD and Nasdaq's operations and interests, positive efforts towards this goal are obscured by continued ownership and incomplete information. The NASD's recent sale of Nasdaq common stock to Nasdaq will still leave it as a preferred stock holder.13 The NASD will also be a significant provider of services to Nasdaq going forward pursuant to a Regulatory Services Agreement, the compensation terms of which have not been publicly-disclosed, and if transaction-based would present a clear conflict of interest in building the ADF as a competitive facility. Concerns that Nasdaq may use its influence over the NASD to hinder ADF operation are only accentuated by Nasdaq statements that the ADF's creation is not required under the Exchange Act and not within the power of the Commission to mandate.14 Brut continues to urge that greater disclosure of the financial details of the Regulatory Services Agreement and any other financial dealings between the two entities to be fully disclosed to give all market participants adequate information to ensure that the NASD will operate the ADF with a view towards keeping it efficient and relevant over the long term.15
It will also be difficult to fully assess whether the ADF will serve its intended purpose until its cost structure is revealed to its potential users. Brut understands that the NASD is working to develop economic parameters for ADF usage that are on par with that of Nasdaq and exchanges currently trading Nasdaq securities, and is encouraged by its discussions with the NASD that evidence commitment to this objective. Brut submits that the NASD's recent $440 million sale of Nasdaq common stock should facilitate the operation of the ADF as a low-cost provider. Moreover, given the critical relevance of ADF economics in determining that facility's role in equities market structure, ADF-related fee filings should be subject to the notice-and-comment process of Section 19(b)(2) under the Exchange Act, as opposed to being granted immediate effectiveness pursuant to Exchange Act provisions intended for more ministerial filings.16
Regulatory Competition and Consistency
Brut believes that the rules of ADF participation should allow the ADF to compete with other quotation and trade-reporting facilities while, creating a consistent regulatory regime that protects investors without disadvantaging its users. While these aims may appear to conflict with one another at times, this can be managed by requiring consistency between Nasdaq and ADF operation where necessary to maintain fair and orderly markets, with constant attention to ensure that this does not descend into slavish devotion to the rules of one facility, creating a competitive advantage. While the easy road may be to allow Nasdaq or the ADF to become predominant in setting the standard for market regulation, to do so would ultimately undermine the competitive balance.
With these concerns in mind, certain statements by the NASD in the Release indicating deferral to Nasdaq on policy matters are troubling. A statement that "should Nasdaq amend its exchange registration with respect to matters such as trade reporting, short selling, or quotation obligations, we anticipate making similar amendments to the proposed NASD rules"17 triggers one response - why? The pending changes to the market-structure framework for trading Nasdaq securities dictates a close collaboration between the Commission, Nasdaq and the NASD to develop common regulatory standards where necessary to protect investor interests and foster competition in all other areas. To do otherwise would eviscerate the ADF's potential and pre-ordain Nasdaq as "first among equals" vis-à-vis its competitor due to regulation-derived advantages.
The following issues in particular require careful analysis:
There is no market structure issue today where the convergence of regulation and competition is more apparent than the rules governing which broker-dealer is responsible for reporting transactions in which they take part. Historically the trade-reporting process has been viewed as a compliance-oriented function with little strategic impact. As ECNs began to execute a significant portion of the overall volume, trade-reporting conventions were developed to allow for efficient and accurate reporting while adapting an inefficient regulatory regime to a new category of electronic market participants. Nasdaq has recently amended its application to become a national securities exchange with a view towards thwarting this trend and subjecting ECNs to traditional trade-reporting standards.18
In recent years, the question of which firm gets "credit" for executing a particular trade has taken on a much greater economic consequence. Nasdaq publishes historical volume and market-share statistics on its NasdaqTrader.com web site, and sells such data in real-time, which are based primarily on the basis of trade reporting.19 Nasdaq has acknowledged the inaccuracy of such data regarding ECN volumes, largely because:
"Such [trade-reporting] rules were developed for regulatory purposes and the standards under which volume is counted capture the volume of trading activity that occurs within some ATSs in a manner different from that required by the SEC's ATS Rules. Accordingly, ATSs should not rely on the individual member trade volume figures reflected on the Nasdaq Trader Web Site, because such figures are based on reported volume."20
The negative consequences of inaccurate trade-reporting attribution have recently grown as Nasdaq and national securities exchanges have introduced market-data revenue sharing programs keyed off of the amount of trades reported by the relevant participating broker.21
These developments make clear that the traditional regime for determining trade-reporting responsibility has become outdated in light of an evolution of market structure towards multiple competing market centers. A firm's status as a market maker or their position as a seller or a buyer in a particular transaction are archaic standards by which to determine trade-reporting responsibility given the growing diversification in the status of market participants and the economic, marketing and strategic consequences of such an allocation. Brut advocates careful examination trade-reporting regulation with a view to its increased importance, including exploration of the costs and benefits of moving towards a "liquidity provider" approach, whereby the market maker or ECN receiving an order for execution against an order currently residing in its order book has responsibility for reporting the resultant transaction.
It appears that Nasdaq has clouded the issues surrounding trade-reporting reform by fashioning rules blurring the question of who is responsible for reporting a trade with where that trade should be reported. Nasdaq's exchange application promoted a "destination market" trade-reporting concept designed to ensure that Nasdaq members used no trade-reporting facility other than that offered by Nasdaq, regardless of whether a transaction occurs through Nasdaq systems.22 This plan was based on Nasdaq's "theory that firms that have benefits and obligations relative to trading certain securities on Nasdaq should be viewed as having effected [all] their trades on Nasdaq."23 Such an approach runs afoul of current National Market System plans and the concept of competition among exchange markets embodied in Section 11A of the Exchange Act. Moreover, it is inconsistent with the regulatory delegation of trade-reporting responsibility to broker-dealers, with exchanges and national securities associations merely providing their members with the means to fulfill such obligations through the creation of a transaction-reporting plan.24
Provided that a transaction does not occur through the facilities of a certain exchange, a broker should have the freedom to report transactions to any exchange or national securities association of which it is a member. By applying this principle, the Commission can re-visit the idea of revising trade-reporting regulation devoid of any exchange or SRO-driven anti-competitive bent. Such efforts are overdue given the heightened importance of such rules.
Given the long-standing concern over the market impact of short sales, the regulation governing such activity should be set by the Commission as opposed to competing exchanges. As currently outlined in the Release, ADF market participants would be required to adhere to a "bid test" standard when effecting non-exempt short sales based on the national best bid/best offer,25 whereas Nasdaq's bid test would be based on only the Nasdaq best bid/best offer. Brut believes this is an aspect of the regulatory regime where consistency is important, and advocates that the Commission set a market-wide standard consistent with the feedback received in response to its concept release regarding short sales.26
The "Terminal Rule"
Proposed NASD Rule 4613(e)(2) would require ADF market makers to have quotation data from other market centers in close proximity to their ADF terminal. The purpose of this proposed rule is to "ensure that ADF participants have the data necessary to make sound order routing decisions and to satisfy with the Vendor Display Rule."27 Given the NASD's stated intention to obtain an exemption from the Vendor Display Rule,28 each vendor's own obligation under said rule,29 and the affirmative duty to search for the best economic terms available that underpin a broker-dealer's duty of best execution, Brut questions whether such an explicit rule regarding the utilization of information from certain market centers is appropriate. If such a rule is deemed necessary, it likely should apply in a fashion so market participants must have access to information from all other markets that effect a certain percentage of volume in the relevant securities. Such a rule would likely require Nasdaq market participants to have sufficient ADF quotation information at their disposal to ensure that quality execution decisions are made.
Brut believes that the development of a market-neutral facility for order display and trade reporting is essential to divorcing compliance from competition among market centers. As the first concrete step towards the creation of such a facility, Brut applauds the Release as an unparalleled step towards improving competition within the national market system. Brut respectfully submits that the intermediate and profound nature of the ADF proposal will require a dedicated effort so that the unique opportunity at hand is not wasted, so that the market structure established over the coming months can operate as a fair and effective framework for markets, intermediaries and investors for years to come.
BRUT appreciates this opportunity to offer comments to the Commission. If the Commission or its staff would find further discussions or other assistance helpful, please do not hesitate to contact me at (917) 637-2560.
Senior Vice President & General Counsel
cc: The Hon. Harvey Pitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Cynthia Glassman, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Associate Director, Division of Market Regulation
John Polise, Senior Special Counsel, Division of Market Regulation
Steve Joachim, Senior Vice President, NASD
Alden Adkins, Senior Vice President, NASD
|1||Brut operates The BRUT ECN System, one of the fastest-growing electronic communication networks ("ECNs") in the Nasdaq market. Brut's unique business model strengthens the relationships between broker-dealers and their institutional clients, while its proprietary tools ensure superior functionality and efficient access to market liquidity. BRUT is owned and supported by 26 Wall Street firms. The company is headquartered in New York City.|
|2||December 14, 2001. 67 Fed. Reg. 388 (January 3, 2002). File No. SR-NASD-2001-90.|
|3||The Commission directed the NASD to create the ADF as a condition for the approval and operation of Nasdaq's "SuperMontage" order-execution system. See Exchange Act Release No. 43863 (January 19, 2001). 66 Fed. Reg. 8020 (January 26, 2001) ("SuperMontage Approval Order").|
|4||Id., at 8051-52 (citations omitted).|
|5||Release, supra n.2, at 448-49 (citation omitted).|
|6||See Exchange Act Release No. 44396 (June 7, 2001). 66 Fed. Reg. 31952 (June 13, 2001) ("Nasdaq Exchange Release").|
|7||See, e.g., Letter from William O'Brien, Senior Vice President & General Counsel, BRUT to Jonathan G. Katz, Secretary, Commission, July 30, 2001 ("Exchange Application Comment Letter").|
|8||See Release, supra n.2, at 406 (outlining proposed NASD Rule 4300 series).|
|9||See, e.g., SEC Regulation ATS (requiring the operators of alternative trading systems with a significant share of market volume in a security to provide their price information to the public quotation system and provide fair and consistent criteria of acceptance and denials of prospective broker-dealer customers).|
|10||Exchange Act §11A(a)(1)(C)(1).|
|11||SuperMontage Approval Order, supra n. 3, at 8050.|
|12||Release, supra n. 2 at 450.|
|13||See NASD Press Release, available at http://www.nasdr.com/news/pr2002/release_02_007.html.|
|14||See Letter from Edward Knight, Executive Vice President & General Counsel, Nasdaq, to Jonathan G. Katz, Secretary, Commission, November 30, 2001, at 23-27 (stating that "the SEC... does not have the power to operate as an `economic czar' for the development of a national market system" and that "one could question the desirability of the SEC requiring the NASD to expend considerable resources to build a facility... when such a facility clearly is not required under the Exchange Act and is not clearly required by the public interest.").|
|15||See Exchange Application Comment Letter, supra n.7, at 4.|
|16||See Exchange Act § 19(b)(3)(A). Brut believes that Nasdaq is taking advantage such provisions to, without any public feedback, impose complicated fee structures intended to change the characteristics of its market, differentiate between Nasdaq participants, and enhance Nasdaq's competitive position. Such efforts contravene the purpose of these provisions. The Commission has acknowledged that "the filing of a proposed fee applicable to [SRO] members may nonetheless raise significant regulatory issues and thus be required, consistent with current Commission policy, to be submitted pursuant to Section 19(b)(2)." Exchange Act Release No. 35123 (December 20, 1994). 59 Fed. Reg. 66692 (December 28, 1994), at 13. Brut respectfully requests that the Commission curtail this trend with respect to fee filings related to Nasdaq's evolution to a for-profit entity and the creation of the ADF. See generally Letter from William O'Brien, Senior Vice President & General Counsel, BRUT to Jonathan G. Katz, Secretary, Commission, October 16, 2001, at 1 (regarding Nasdaq fee increases with respect to use of its SuperSOES system).|
|17||Release, supra n.2, at 450 n. 10.|
|18||Letter from Edward S. Knight, Executive Vice President and General Counsel, Nasdaq, to Jonathan G. Katz, Secretary, Commission, dated December 5, 2001 ("Knight Letter"), at 8 (stating amendments to Nasdaq's Form 1, which have yet to be published for public comment, are intended to "eliminate the current inconsistent trade reporting methods used by ECNs today.").|
|19||See Exchange Act Release No. 45270 (January 11, 2002). 67 Fed. Reg. 2712 (January 18, 2002). See also Nasdaq Head Trader Alert #2002-6 (January 18, 2002) (stating that "data contained in these reports... is based on information obtained from Nasdaq's Automated Confirmation Transaction Service.").|
|20||NASD Notice to Members 99-34, at 2 (May 1999).|
|21||See Exchange Act Release No. 45342 (January 28, 2002). 67 Fed. Reg. 5019, at 5021 (February 1, 2002) (outlining Nasdaq's market-date revenue-sharing program and its "focus on the reporting of non-Nasdaq system trades."). See also Exchange Act Release No. 45148 (December 11, 2001). 66 Fed. Reg. 65524 (December 19, 2001) (describing a similar program for the Cincinnati Stock Exchange).|
|22||See Nasdaq Exchange Release, supra n.6, at Proposed Rules 4630 through 4633.|
|23||Knight Letter, supra n.18, at 4.|
|24||See Rule 11Aa3-1 under the Exchange Act.|
|25||See Proposed NASD Rule 5100 and Interpretive Memo 5100-1.|
|26||See Exchange Act Release No. 42037 (October 20, 1999). 64 Fed. Reg. 57996 (October 28, 1999).|
|27||Release, supra n.2, at 453. See also Rule 11Ac1-1 under the Exchange Act.|
|28||Id., at n.19.|
|29||See Rule 11Ac1-2 under the Exchange Act.|