Hill, Thompson, Magid & Co., Inc.
15 Exchange Place, Suite 800
Jersey City, NJ 07302-3912
June 7, 1999
Johnathan G. Katz
Office of the Secretary
Securities & Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: File No. SR-NASD-98-17; File No. SR-99-11
Dear Mr. Katz:
Hill, Thompson, Magid & Co., Inc. ("Hill") submits this letter in response to a recent National Association of Securities Dealers, Inc. ("NASD") proposal wherein the Securities and Exchange Commission ("Commission" or "SEC") re-opened the comment period on an earlier NASD proposal to develop a Nasdaq-operated limit order execution and delivery facility ("Central Limit Order Book" or "CLOB"). The Commission, in re-opening the comment period, solicited views on whether the proposed Central Limit Order Book should be adopted on a pilot basis.
Hill is a registered market maker in over 6,000 securities traded on the Nasdaq Stock market and the NASD’s OTC Bulletin Board Service. We have a strong interest in both the continued growth of these markets and in the quality of executions available to our customers. While we believe that long-overdue changes to Nasdaq-sponsored systems can benefit investors by enhancing market liquidity, we do not believe that a limit order facility operated by Nasdaq is such a change.
The Proposed Central Limit Order Book is Unnecessary and Will Not Benefit Investors
It may be tempting to view the proposed Central Limit Order Book as a feature that will somehow integrate the market in Nasdaq securities and reverse the growing problem of cascading liquidity pools. This is not an accurate perception. In the short-term, the CLOB will simply result in further fragmentation. Each Nasdaq market maker already acts as a de facto limit order file. To the extent that a Nasdaq-operated and member-funded CLOB attracted customer orders, it would simply drain liquidity from one source to create another. No recognizable benefit is achieved by establishing an additional market maker in every CLOB-eligible security whose sole contribution to liquidity is to display customer orders that would otherwise be displayed by existing market makers or ECNs.
In the long-term, however, the CLOB’s impact is not likely to be so benign. Nasdaq’s liquidity is a result of market makers committing substantial capital. Nasdaq cannot be an order-driven market and simultaneously attract a dozen or more competing market makers in stocks characterized more by their volatility and small size than by their stability and liquidity. Market makers have invested heavily in systems designed to handle, display and process customer orders. Any system that competes directly with market makers, allocates significant dollar and network usage resources to itself at the expense of market makers and that funds itself by levying dues on those same market makers will ultimately impact the ability and willingness of market makers to continue to commit liquidity. A small number of Nasdaq issues may trade smoothly in an order-driven market, but the vast majority will suffer serious declines in liquidity and price continuity as market makers concentrate activity in fewer stocks and as some market makers withdraw entirely from the business. The CLOB will not compensate for this loss of capital merely by displaying the customer orders that, in less ebullient markets, will be the source of demand for liquidity, not the source of supply.
A Nasdaq-Operated Limit Order Book Raises Conflicts of Interest
The proposed Central Limit Order Book would present market makers and ECNs with the prospect of having to compete directly with their regulator. The proposed CLOB is described as a voluntary display mechanism, but as long as an affiliate of Nasdaq conducts examinations of firms’ order-routing decisions and retains the authority to define best execution, CLOB will never be objectively voluntary. Arguably, Nasdaq’s own ability to design market-wide systems presents an even greater conflict. One of the proposed CLOB’s features is the display of all limit orders resident in the system rather than just the best-priced orders. The ability to display multiple prices and sizes has not been extended to market makers through the Nasdaq Workstation. Nasdaq’s ability to determine the design of market systems would, from the beginning, provide greater systems capacity to the CLOB than to its market maker competitors. Future innovations could present Nasdaq with similar opportunities to add desirable features to the CLOB that are not available to the market makers.
The NASD Filing Remains Unacceptably Vague
The adoption of a central limit order book, whatever the ultimate design, would have a dramatic effect on the Nasdaq market. It would certainly disrupt existing relationships between market makers, order flow firms and customers. Yet the NASD has not adequately explained to its members the cost of creating and operating the facility, the precise sources of the funds needed or whether it intends to charge fees for accessing the orders or rebates for routing the orders to the facility. NASD has undertaken no publicly disclosed analysis of the effects of adopting the proposed CLOB and has stated merely that it "does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate . . ." More information about the impact of the Central Limit Order Book, the systems costs to both market makers and the NASD and about the proposed fee structure should be required before even a pilot is approved.
We believe that, as currently proposed, the CLOB further fragments the market rather than addresses existing issues of fragmentation; that an NASD-sponsored and Nasdaq-operated limit order facility would constitute an unhealthy conflict of interest between Nasdaq’s market makers, their chief regulator and Nasdaq itself; that insufficient analysis is currently available to proceed with a pilot program with the potential to disrupt the market’s fundamental structure; and that some discussion of the cost and fee structure must take place before any action can responsibly be taken on this proposal. Hill does not support the proposed Central Limit Order Book on either a pilot or permanent basis.