JOHN H. BLUHER
October 21, 2003
By Electronic Mail and Overnight Mail
Margaret H. McFarland
Dear Ms McFarland:
Knight Trading Group, Inc. ("Knight") appreciates the opportunity to comment on Nasdaq's recent rule filing ("Filing") which would, in part, establish maximum fees that could be charged by electronic communications networks ("ECNs") when they are accessed through the Nasdaq's SuperMontage system.1 In summary, while Knight supports the Filing for the reasons articulated below, we believe that it does not go far enough in dealing with the fundamental issues surrounding ECN access fees. As such, we urge the SEC to approve the filing and also promptly take action on the broader issues raised by ECN access fees.
Most of Knight's market making activity is executed on a principal basis and in this capacity we often provide to our broker-dealer clients an execution price equal to or better than the national best bid and offer. One of the primary sources of liquidity for OTC market makers in Nasdaq stocks is the Nasdaq SuperMontage system. In this facility, all Nasdaq market makers and many ECNs publish their bid and offer quotations and thereby make them available for execution in SuperMontage. Firms such as ours need access to this liquidity in order to continue to provide the quality of execution our customers expect. When accessing SuperMontage to take liquidity, firms like Knight pay .3¢ per share up to a maximum of $120 per order. Thus, for a 1000 share order, we would pay $3 for accessing SuperMontage. This payment, of course, is in addition to other fees paid to Nasdaq, the NASD and DTC for clearing, trade reporting and other services. Currently, ECNs charge non-subscribers who access their markets through SuperMontage an additional access fee of between .27¢ and .9¢ per share. Thus, when Knight sends a non-directed 1000 share order into SuperMontage and the order is executed against an ECN quote, Knight will be charged by the ECN anywhere from $2.70 to $9. Although, in this instance, Nasdaq will reduce its SuperMontage fee to .1¢, the ECN access fee will raise Knight's execution cost anywhere from 23% to 233%.
The ability of ECNs to charge access fees of this magnitude to non-subscribers that do not wish to pay them is the result of an SEC policy announced in 1996 at the time it required ECNs to display their quotations in Nasdaq. Based on substantial lobbying on the part of the ECN community, the SEC was convinced that it could not permit brokers to have free access to ECNs without inflicting significant economic damage on the ECN community. As a result, even though there was no Commission rule adopted nor any industry input permitted, the Commission in its 1996 adopting release expressly stated that ECNs could impose access fees on non-subscribers at a rate equivalent to the rate they charge subscribers. Unfortunately, certain ECNs have used this "contract of adhesion" to impose excessively high access fees on SuperMontage users.
The Filing would attempt to cap these excessively high fees at .3¢ per share for ECNs accessed through SuperMontage. Any ECN imposing an access fee higher than .3¢ per share could not post its quotations in SuperMontage. This rule would obviously address the most egregious cases of abuse and as such we support it as in initial step in dealing with the broader issue of access fees in general.
In addressing this broader issue, we must start by differentiating (a) access fees charged by SROs to their members and by ECNs to their subscribers from (b) access fees charged through SuperMontage. Access fees imposed on members and subscribers are charged because the member or subscriber has made an affirmative decision to route orders to that market and has agreed to pay those fees in exchange for the various services provided by that venue. Access fees charged through SuperMontage, on the other hand, are precisely the opposite. They are charged when a firm has made a decision that it did not want to route orders directly to that market and pay the fees imposed by that market and yet through the SuperMontage execution algorithm it was routed to that market anyway. We believe in competition. Competition among the various liquidity pools has in the past and, we believe, will continue to assure that access fees charged to firms that determine to route orders to them are reasonable. The same cannot be said of ECN access fees charged through SuperMontage precisely because no competition with respect to access fees is permitted. The only competition permitted within SuperMontage is with the price, time and size of quotations. Access fees do not fit into the equation. An appropriate analogy would be if a broker on an exchange floor who had the best bid in the crowd charged another broker who traded with him an access fee. The exchange auction could not operate effectively in this way.
It is for this reason that we have come to the conclusion that the only reasonable solution is for Nasdaq to either require that access fees be entirely eliminated for non-directed orders executed in SuperMontage or alternatively require that they be embedded within ECN quotations. Quotations at the same price have vastly different economic implications. When an ECN and a market maker are both at the inside market, the net price provided by the ECN is inferior to the price of the market maker by the size of the access fee. This fee distorts the SuperMontage price/time auction by permitting an ECN with an inferior price to have parity with a market maker providing a better net price. As suggested above, no auction market can exist in this fashion. As between the two alternatives of eliminating access fees in SuperMontage or embedding them within quotations, we believe the only realistic alternative would be to eliminate the fees entirely. Causing the fees to be embedded within ECN quotations, while superficially appealing, has many consequences that may be undesirable. First, the underlying premise behind the limit order display rule would be undermined. Customer orders that are routed to an ECN would not be displayed accurately; they would be displayed at a price that was inferior to the actual limit order price.
Second, embedding access fees within the quotation would necessarily require that Nasdaq and other markets permit sub-penny quotations to be displayed. This in turn would require substantial technology changes throughout the industry. Additionally, changing to sub-pennies would require the industry to rethink other related rules. For example, NASD Rule 2110-2 currently provides that a market maker cannot trade ahead of a customer's limit order for less than the minimum trading increment of a penny. If quotations were permitted in tenths of a penny, the NASD and industry would have to re-evaluate whether to permit trading ahead for a penny, a tenth of a penny or some amount in between.
Third, embedding access fees in quotations would complicate the ability of an ECN to charge varying rates to subscribers based on volume. Since the embedded fee would necessarily be the highest fee charged by the ECN, volume discounts would have to be made by rebate to particular users. While these rebates might be characterized as payment for order flow and dealt with by disclosure under existing Commission rules, given the fact that the maximum fee is being entirely absorbed by the customer, there is a substantial question whether these rebates would not have to be returned to customers. Finally, embedding ECN fees in their quotations would raise the broader issue of embedding exchange and NASD fees in quotations. These fees would be even more difficult to embed because exchanges typically have fee caps and do not charge for smaller size orders.
Eliminating access fees within SuperMontage entirely will avoid these difficult issues. It will, however, require that ECNs recoup their costs entirely from subscribers rather than from firms that have determined not to subscribe. We recognize that this may create some economic dislocation on the part of ECNs, but we know of no other way the integrity of the SuperMontage auction can be maintained.
One final issue that we would like to mention is the relationship between access fees of all kinds and the best execution obligations of market participants who regularly price their customer executions based on the national best bid and offer. The SEC has for some years articulated a standard for best execution that did not require a broker routing customer orders to assure that each and every order received the best possible price at the time, but rather that the broker make a regular and rigorous examination of the execution results provided by any particular venue and make order routing decisions on that basis. In addition to price, the SEC has stated that a firm may also consider speed of execution, ease of access and other factors. The NASD has similar rules governing the best execution obligations of its members.
Our concern stems from the fact that in examining the best execution performance of firms, regulators seem to be ignoring these other factors and focusing exclusively on price as the only relevant parameter. In the current market environment, speed of execution and ease of access can vary significantly. For example, exchanges operating physical trading floors often cannot provide the same speed of execution as electronic markets. Especially in an environment with penny spreads, the cost and time delay involved in seeking out a penny on a retail sized order may far outweigh the risk that the price will not be available when the order reaches the floor and that the market will have moved in the interim.
Similarly, although in large part competitive pressures have kept member and subscriber access fees in line, there are still markets that charge vastly more than other markets for access to their system. In fact, even if Nasdaq were to ban access fees within SuperMontage, those same ECNs who currently charge more than .27¢ for access through SuperMontage could continue to charge those same access fees in the ADF. If that were the case, it would make no sense for a firm to be unable to take those aberrationally high access fees into account when determining what price to give a customer order. As execution prices become more granular, regulators have to adjust their expectations of best execution performance to take into account these other factors that must clearly come into play.
In conclusion, we support Nasdaq's effort to cap the fees charged by ECNs when they are accessed through the SuperMontage, however we strongly believe that this initiative is only a partial remedy to the market structure deficiencies caused by these fees generally. As such, we respectfully urge the SEC to also take the necessary steps to address and resolve the broader issues relating to access fees. We would of course be happy to discuss this matter at your convenience.
Very truly yours,
John H. Bluher