Department of Finance and Economics

180 University Avenue

Newark, NJ 07102-1897

David K. Whitcomb

Professor of Finance and Economics

O: (973) 353-5264 R: (212) 228-2388

e-mail: whitcomb@andromeda.rutgers.edu

April 13, 1998

Mr. Jonathan Katz


Securities and Exchange Commission

450 Fifth Street, NW

Washington, DC 20549

Re: File No. SR-NASD-98-21

Dear Secretary Katz:

I am Professor of Finance in the Graduate School of Management of Rutgers

University, one of the earliest academic researchers in the area of

securities market microstructure, and co-author of The Microstructure of

Securities Markets (Prentice-Hall, 1986) and numerous other journal articles

and monographs on market microstructure. I testified before the House

Commerce Committee regarding decimalization, and my comments regarding NASD

governance, various versions of the NAQCESS proposal, the order handling

rules and other NASDAQ issues have been reported by CNN, NPR, PBS, AP,

Business Week, The New York Times, Securities Week, The Washington Post, The

Wall Street Journal, and other publications and cited in previous SEC

Decisions. I am also founder & CEO of Automated Trading Desk, Inc., which

developed the first expert system for automated limit order trading. In

1997, ATD systems traded over $20 billion of Nasdaq and NYSE stocks for

clients ranging from a large investment bank to small brokerage firms.

Accordingly, I have academic, practical and personal knowledge of and

interest in the issue presently before the Commission; indeed, I wrote 4

comment letters on this issue in 19971 , which I incorporate by reference.

EXECUTIVE SUMMARY: The NASD seeks to eliminate mandatory minimum market

maker proprietary quotation size requirements ("mandatory quote sizes") on

all Nasdaq stocks, a proposal they call the Actual Size Rule ("ASR"). Their

current rationale for the ASR proposal is the economic theory argument that

the ASR, by reducing market maker quotation risk, may increase market maker

participation and reduce bid-asked spreads. To this theoretical argument are

added two NASD empirical studies2 of the so-called Pilot Test of the ASR3,

which purport to show that the ASR does not increase spreads or volatility

or reduce liquidity or access to the SOES system (a trading system essential

for immediate market access by customers whose brokers will not or cannot

sell their orders directly to dealers). There are 3 crucial flaws in the

NASD's rationale for the ASR:

1 These letters are Whitcomb to Lindsey re SR-NASD-96-43, January 7,

1997 ("Whitcomb January 7, 1997 letter"); Whitcomb to Katz re SR-NASD-97-26,

May 12, 1997 ("Whitcomb May 12, 1997 letter"); Whitcomb to Katz re

SR-NASD-97-26, July 3, 1997 ("Whitcomb July 3, 1997 letter"); and Whitcomb

to Katz re SR-NASD-97-49, August 12, 1997 ("Whitcomb August 12, 1997 letter").

2 "Effects of the removal of minimum sizes for proprietary quotes in

the Nasdaq Stock Market, Inc.," prepared by the Staff of NASD Economic

Research, June 3, 1997 ("First NASD Study") and "The effect of the Actual

Size Rule on the Nasdaq Stock Market, Inc.," prepared by the Staff of NASD

Economic Research, March 4, 1998 ("Second NASD Study").

3 This test was conducted in two phases. Phase 1 subjected 50

stocks, covering over 35% of Nasdaq dollar volume to the ASR, while in Phase

2 the pilot group was expanded to 150 stocks by adding stocks randomly

selected from NMM stocks with SOES tier sizes of 1000 and 500 shares

(excluding all stocks in the First 50 and Second 50). The analysis in both

phases is marred by the fact that the 10 largest Nasdaq stocks have all been

subject to the ASR since January 20, 1997, and the next 10 stocks have not,

making it impossible rigorously to determine the effect of the ASR on the

large stocks which account for a very significant portion of volume,

especially at the retail level. Despite my pleas to the Commission (see

Whitcomb May 12, 1997 letter and Whitcomb August 12, 1997 letter), this

fundamental flaw in the test design has never been corrected.

•NASD bases its economic theory rationale for ASR on the assumption that

Nasdaq market makers engage in perfect quote price competition. This

assumption is completely inappropriate, as is shown by the pioneering

Christie & Schultz paper4, by the Commission's Section 21 (b) Report and by

a study of quotation price behavior in September and October 1997 which I

co-authored5. Under the more realistic alternative economic model of

oligopolistic quote price behavior by market makers, there is no reason to

expect that market makers will participate in greater numbers or reduce the

equilibrium market spread in response to a risk-reducing policy change like ASR.

•NASD's own empirical studies produce data inconsistent with their economic

model's predictions. Both the First and Second NASD Studies show that market

maker participation rates and bid-asked spreads are unaffected by existence

of the ASR. These results are consistent with the results predicted under

the alternative model of oligopolistic quote price behavior by market

makers. They suggest that the only clear beneficiaries of the ASR are the

market makers, not individual or institutional investors.

•NASD asserts that the ASR does not reduce the Nasdaq market's depth or

liquidity and does not reduce access to automated execution of market orders

via the SOES system (mandated by the SEC following the October 1987 crash).

However, their own data and the results of numerous studies by others6 show

that the ASR does indeed reduce market depth, liquidity and SOES access.

Both the Second NASD Study and the Simaan-Whitcomb Study show that the

reduction in market depth and liquidity are particularly pronounced at times

of market stress, such as the "market break" of October 27-28, 19977

4 Christie, W.G. and P.H. Schultz, 1994, "Why Do NASDAQ Market

Makers Avoid Odd-eighth Quotes?" Journal of Finance, 49, 1813-1840

("Christie-Schultz Study").

5 Y. Simaan & D. Whitcomb, "The Quotation Behavior of ECNs and

Nasdaq Market Makers," NJCRFS Working Paper 98-01, December 1997

("Simaan-Whitcomb Study", attached as Appendix 1).

6 See Barclay, Christie, Harris, Kandell and Schultz, "The Costs of

Trading Nasdaq Issues: The Impact of Limit Orders and ECN Quotes," Working

Paper 97-10, February 1998 ("Barclay, et. al. Study"); ETA and

DRI/McGraw-Hill, "Analysis of Automatic Executions on the Nasdaq Stock

Market," May 1997 ("DRI/McGraw-Hill Study", attached to Comment Letter from

Richard Y. Roberts re SR-NASD-97-26, dated May 12, 1997); and Simaan -

Whitcomb Study.

7 The Second NASD Study shows that market maker average aggregate

quotation size is always smaller for First 36 (ASR) stocks than for Second

36 (non-ASR) stocks (about an 88% ratio), but it fell nearly 9% during the

two days October 27-28 vs. a negligible decline for Second 36 stocks. As I

show in the detailed analysis in Section II below, these data conceal the

real problem by inappropriate aggregation. The Simaan-Whitcomb Study (Table

3, Panel B) shows that average aggregate market maker bid size for ASR

stocks fell to only 76% of that for non-ASR stocks on October 27 (the day

the market fell 560 points), and the ratio of ASR/non-ASR average depth was

at its lowest during the half-hour periods of maximum downward stress.

Market makers still enjoy significant privileges and subsidies in the Nasdaq

marketplace. These include:

•Minimum 'tick' sizes. ECN and market maker quotes priced at intervals

smaller than 1/16th are not permitted in the Nasdaq quote montage. This is a

subsidy to dealers of huge magnitude (estimated at billions of dollars/annum

by former Commissioner Wallman in his testimony to Congress on

decimalization), as it inhibits price improvement on hundreds of thousands

of retail market orders filled each day at the NBBO.

•Free advertisement of dealer 'indications of interest' via the Nasdaq quote

montage, paid for by NASD Member dues and Nasdaq transaction fees charged

order entry firms.

•Reduced margin requirements available to Nasdaq market makers.

•Exemption from short sale limitations.8

•New privileges proposed in the NODES system including: a 17-second 'backing

away window' during which market maker quotes are visible but not hittable,

a 10-second-hold period during which limit orders (but not market maker

quotes) may not be cancelled, sole right to sponsor institutional access to


Once these special privileges and subsidies have been eliminated, it would

make sense also to eliminate any market maker responsibility to post quotes

of any minimum size. However, until this happens, eliminating that

responsibility will just reward market makers without any benefit to the

trading public.

Although the ASR would be simply a "gift" to market makers without provable

public benefit, it would create specific harm:

•ASR would reduce automated access to the market, especially at times of

market stress (as it did during October 27-28 1997).

•ASR would increase the pressure on brokerage firms to sell retail order

flow to dealers as the only practical way to guarantee their customers

access to automated executions, especially at times of market stress. The

percentage of retail order flow delivered to dealers pursuant to payment for

order flow or internalization arrangements is already very high and will be

increased in the long run by restricting access9.

•An increase in preferenced retail order flow will, in turn, reduce quote

price competition.

•ASR will make the "signals" market makers give to the market (one of their

most valuable economic functions) far "noisier" by reducing the cost of

erroneous or misleading signals.

8 Only Œprimary market makers¹ are exempt from the Œbid tick test¹

for short sales. However, all Nasdaq market makers are classified as primary

market makers.

9 Table III.11 of the Second NASD Study reports that 35 ­ 40% of all

Nasdaq trades and around 30% of share volume are generated by "proprietary

autoexecution systems". The report makes much of the fact that there was no

difference in the autoexecution statistics resulting from imposing the ASR

when the 18 days before November 10, 1997 were compared to the 20 days

following. That is completely un-surprising, since implementing purchase of

order flow or internalization arrangements requires contractual and computer

system arrangements which take months to effect.

The Commission acted decisively and effectively to force increased

competition on the Nasdaq market with the Order Handling Rules and is now

searching for ways to make the listed market more competitive (via changes

discussed in the "Concept Release"). It would be a shame if the SEC were to

approve a step that will reduce competition.

• Analysis of NASD Theoretical Arguments for ASR

The NASD has based its theoretical argument for the ASR on 3 propositions:

The First NASD Proposition is that, in an order-driven market (which they

initially assumed would occur on January 20, 1997, but now merely predict

for the future), the regulatory reason for requiring market makers to

provide a minimum of liquidity will disappear. To see how absurd this is,

assume, arguendo, that the Nasdaq market does become entirely order-driven

tomorrow. In that event, the alleged "need" for maintaining one-sixteenth

(or any) minimum price increments — subsidizing market makers in order to

retain the liquidity they provide — would immediately disappear. In other

words, if the market becomes order-driven and there is no need to maintain

market maker liquidity, then the minimum price increment should drop to one

penny the same day. I have seen no proposal from NASD to move immediately to

decimal pricing with penny increments. Indeed, in its NODES filing, the NASD

speaks of "maintaining incentives for market makers"10 and actually proposes

several new "incentives" in that filing. Talk about a diminished regulatory

reason for requiring market makers to provide minimum liquidity is just that

— talk.

The Second NASD Proposition is that "Stock Exchange specialists have 100

share minimums, so why shouldn't Nasdaq market makers?" This argument

ignores a fundamental difference between the two markets. The primary

markets for listed shares, the NYSE and the AMEX, have always given limit

orders priority over specialist quotes at the same price. This means that a

limit order placed in either market has a reasonable chance of executing. By

contrast, in the Nasdaq market, even under the Order Handling Rules and the

NODES proposal, market makers receiving preferenced market orders (or a

phone call from an institutional broker) will be able to trade ahead of all

limit orders at the inside (except those given to the particular market

maker). For example, if there are 30 dealers in a particular stock, at least

29 of them will be able to trade ahead of my limit order (and all 30 if my

order is posted on NODES or an ECN). This is part of the fact that Nasdaq

dealers have many privileges (minimum increments, free advertising, lower

margin requirements, relief from the short sale rule, and no "affirmative

obligation" to stabilize), and should, in return, have a responsibility to

make firm, meaningful quotes.

The Third NASD Proposition is the one on which they currently base their

main argument for the ASR. In the NASD's words, "economic theory indicates

that permitting dealers to quote in size commensurate with their true

trading interest could further narrow quoted spreads and enhance the pricing

efficiency of the Nasdaq marketplace."11 The NASD does not spell it out, but

the particular economic theory on which they base this proposition is the

theory of perfect competition. It is true that, in perfectly competitive

long run equilibrium, if market makers are held to firm, meaningful quotes

in the post-Order Handling Rules environment, their profits would be

diminished enough to reduce the amount of liquidity they are able to supply.

The issue here is whether market makers need to be subsidized by eliminating

their firm quote obligation (or by never having to face decimal pricing) in

order to keep them in business. The answer is "absolutely not", for several


10 See Federal Register, v. 63, no. 48, p. 12124.

11 See Federal Register v. 63, no. 55, p. 13896.

First, most market makers, especially the top ten or so "lead market makers"

who supply most of the Nasdaq market's liquidity through their institutional

brokerage business, are enormously profitable. To put it technically, market

makers as a group are earning oligopolistic profits, in part because of the

practices described in the SEC's Section 21 (b) report (which my research

with Simaan show to be continuing12) and in part because of their ability to

purchase or internalize retail order flow13. Anything that reduces their

profits, whether it be the Order Handling Rules, the Firm Quote obligation,

decimal pricing, or the activities of day traders, merely reduces the

subsidy they are enjoying as a result of the NASD's past successes as a

trade organization, operating under New Deal structures, in protecting this

oligopoly. Only when an industry is actually in perfectly competitive

equilibrium does an action which reduces profits necessarily drive some

firms out of business and reduce the quantity of "goods" produced; market

making cannot be so described.

Second, if market makers wish to reduce the risk of unwanted trades in an

environment of narrower spreads and a continued Firm Quote obligation, they

need only make more careful markets. Any market maker who fears being "hit"

by a 1000 share order need only move his quote 1/16th or 1/8th away from the

"inside" to eliminate the risk.

Third, by enabling a market maker to put customer limit orders ahead of

their quotes, the SEC has taken an action that reduces market maker risk. In

other words, we have a self-equilibrating system: As the use of limit orders

increases, narrowing spreads, dealer risk is replaced by limit order trader

risk; and the dealer's risk-reward tradeoff is left essentially unchanged.

Dealers may be required to supply less of the liquidity, but they will take

less risk.

Last, one need only look at the listed stock market to see that market

makers will not be driven out of business by narrow spreads and limit order

exposure. In both the NYSE and AMEX markets, stocks have for a long time had

substantially narrower average spreads than comparable Nasdaq stocks. In

these markets, limit orders have always been exposed (and even have priority

over specialist own-account trades) and market orders are exposed to gain

price improvement whenever the spread is more than the minimum tick size.

Despite these features, specialists, "upstairs" market makers and third

market dealers all are able to stay in business and thrive. There is clearly

no need to worry about the economic viability of market makers when some

elements of fair competition are introduced to the Nasdaq market.

12 See Y. Simaan & D. Whitcomb, "The Quotation Behavior of ECNs and

Nasdaq Market Makers," NJCRFS Working Paper 98-01, December 1997 (attached

as Appendix 1). In this paper, we show that, while the Order Handling Rules

have narrowed spreads, they have not caused market makers to abandon their

practice of avoiding "odd increments". We find that leading market makers

only quoted odd sixteenths 6.9% of the time (vs. an expectation of 50%).

Even when a market maker is alone at the inside odd sixteenths are quoted

only 11.8% of the time (vs. 49.7% of the time for ECNs). Only in an

oligopolistic industry could this practice be maintained.

13 NASD commissioned some economic studies in conjunction with their

earlier attempt to refute the Christie-Schultz Study and promote NAQCESS and

its predecessors which presented Herfindal Indexes, Concentration Ratios,

and other measures purporting to show that market making fits the definition

of a perfectly competitive industry (basically because there are many firms

in the industry). This is a gross misuse of elementary economics because it

entirely ignores the mechanism by which price maintenance is achieved in an

industry with many rival firms. The work of Christie and Schultz, the SEC¹s

21 (b) report on the "culture of collaboration", and the Simaan-Whitcomb

Study¹s evidence of continued market maker avoidance of "odd increments"

show that the industry is more accurately characterized as oligopolistic

price leadership.

• Assessment of Empirical Evidence of the Effects of the ASR

The essential point to make about the empirical evidence is that none of it

is consistent with the predictions of the NASD's "economic theory" rationale

for the ASR. The reason is that the NASD's particular economic theory

doesn't fit the Nasdaq market. On the other hand, the empirical evidence is

consistent with what one would expect under the alternative economic model

that the Nasdaq market remains an oligopoly where market makers only rarely

engage in genuine quote price competition.

I will not waste the Commission's time going over the evidence relating to

the NASD's "economic theory" prediction that the ASR will lead to increased

market maker participation and reduced spreads. Everyone, including the

authors of the First and Second NASD Studies, agrees that, 1 _ years after

the Order Handling Rules were implemented, the ASR has neither increased

market maker participation nor reduced spreads relative to stocks not

subject to the ASR. Market maker participation has increased slightly over

time and just as much for non-ASR stocks as for ASR stocks, refuting the

doomsday assertion that market makers would leave the business in droves if

they were actually forced to make markets in the "New World Order" brought

about by the Order Handling Rules. Spreads fell literally overnight when

each "cohort" of stocks was brought under the Order Handling Rules and again

when the minimum increment was reduced from 1/8th to 1/16th, but this had

everything to do with the new quote price competition resulting from the ECN

Display Rule and nothing whatsoever to do with the ASR or the willingness of

market makers to engage in quote price competition.

The most interesting and controversial empirical evidence relates to the

effect of the ASR on market depth, volatility, and on access to the SOES

system (the main means by which individual investors whose brokers do not

sell or internalize their order flow obtain immediate executions in the

Nasdaq market). Here, both the First and Second NASD Studies assert that ASR

has done no harm; whereas other researchers and the NASD's own data show

that imposition of the ASR reduces market depth, increases market

volatility, and reduces access to SOES.

How do the First and Second NASD Studies manage to turn a sow's ear into a

silk purse? By the art of regression analysis. Both studies use essentially

the same multivariate regression model14 which purportedly seeks to control

for the effects of changes in trading volume and volatility when changes in

measures such as spreads, depth (aggregate market maker quoted size at the

inside), or SOES volume are related to the presence or absence of the ASR.

However, this model was seriously flawed when it was used in the First NASD

Study, and it remains seriously flawed, as the results of as a report by

financial econometrician Professor Yusif Simaan of Fordham University

demonstrate15. The fundamental flaw in the NASD's regression model is the

fact that the contemporaneous spread, depth, or SOES volume may be both

determined by and determining of trading volume and volatility. Hence the

use of contemporaneous volume or volatility as a " control" variable may

tend spuriously to reduce the effect of the dummy variable (presence or

absence of the ASR) on the measure of change in spread, depth or SOES

volume. Professor Simaan suggested a simple feasible correction in the

flawed methodology, but NASD Economic Research never implemented it. As a

result, their regression analysis has no probative value. In the words of

former Commissioner Roberts, "the multivariate regression analysis…in the

NASD Study appears to be designed more to 'control' results than to

'control' for exogenous factors."16

14 See, for example, Second NASD Study, Appendix A, pp. 100-101.

15 See "The econometric methodology in (First NASD Study) ŒAppendix

B: Formal Statistical Analysis¹" by Yusif Simaan, July 1997. This was

appended as Attachment I of Richard Y. Roberts comment letter on

SR-NASD-97-26, dated July 2, 1997, but since the NASD ignored it in

preparing their Second NASD Study, I attach it again here (as Appendix 2).

16 See Roberts, Op. Cit., p. 3.

The direct evidence (not processed through a flawed regression model) shows

clearly that several key measures of Nasdaq market quality have been

deleteriously affected by the ASR. These measures and the main results include:

Market depth in normal times. In most studies, depth is proxied by the

(time-weighted) average aggregate market maker quotation size at the inside.

The main results are:

•The First NASD Study shows that average aggregate market maker quoted size

at the inside has declined 27.5% for First 40 stocks;17 adding ECN quoted

size at the inside leaves First 40 (ASR) stocks with a 17% decline in

liquidity available through SOES and SelectNet preferencing vs. only a 4%

decline for Second 40 (non-ASR) stocks.

•The Simaan-Whitcomb Study shows that, as of September 1997, average First

40 aggregate bid sizes were only 85% of Second 40 size; for ask quotes, the

figure was 80%18.

•The Second NASD Study shows that, just prior to the October 27, 1997 market

break, First 36 (ASR) stocks had average aggregate dealer quote sizes 88% as

large as Second 36 (non-ASR) stocks.

Market depth during market stress. A major fear of those opposing the ASR

has been that, when the chips are down, market makers will take advantage of

the ASR to avoid making markets in meaningful size on the side of the market

where the stress appears. The October 27, 1998 market break gave us an

opportunity to test this proposition. The key findings are:

•The Second NASD Study shows that, whereas "normal" average aggregate dealer

quote sizes are 88% as large for First 36 (ASR) as for Second 36 (non-ASR)

stocks, they were only 81% as large during the two days of the crisis,

October 27 and 28, 1998. In other words, the NASD's depth measure fell 8.6%

for ASR stocks vs. only 0.4% for non-ASR stocks.

•The Simaan-Whitcomb Study shows that, whereas September aggregate average

bid sizes were 85% as large for First 40 (ASR) as for Second 40 (non-ASR)

stocks, on October 27, 1997, the relative percentage fell to only 76%19.

Disaggregating by half-hour period, we found that the smallest ASR/non-ASR

depth ratios occurred during the times of greatest downward pressure,

9:30-10:00, 10:-10:30, 11:00-11:30, and especially 3:00-3:30 PM, when ASR

stocks had only 67% of the depth of non-ASR stocks.

While both the Second NASD Study and the Simaan-Whitcomb Study show a clear,

economically significant, reduction in market depth for ASR stocks, the NASD

data do not look so bad. Why? Because the NASD data aggregate over side and

day. These data do not confront the real problem, namely that at the times

of greatest market stress, market makers will refuse to make markets in

depth on the side that is subject to the most stress. By aggregating bid and

ask sizes and including October 28 (when the market's general direction was

up), the NASD data tend to conceal, rather than to illuminate the problem.

17 The actual decline is even larger since the average includes

quotes of more than 1000 shares; frequently these quotes prove ephemeral

once the first 1000 shares have been taken.

18 Simaan-Whitcomb Study, Table 2, Panel A; the percentages are

similar but the aggregate sizes are smaller for the "truncated distribution"

data of Panel B.

19 Simaan-Whitcomb Study, Table 3, Panel B

Market volatility. There is no universally-agreed measure of volatility, but

a sensible ad hoc measure that NASD Economic Research uses is "normalized

effective depth", a trade-based liquidity measure akin to the economist's

"arc elasticity". Specifically "normalized effective depth" is the dollar

volume required to move the bid-ask midpoint 1% without a reversal of

direction; a high normalized effective depth means higher liquidity and

lower volatility.

•The First NASD Study shows that the ability of First 40 stocks to resist a

1% price move decreased by 6.4%, while the ability of Second 40 stocks to

resist a similar move actually increased by 16.9%.

•The Second NASD Study reports the same statistic for "Next 103" (ASR stocks

not in the First 50) vs. the non-ASR 3207. While normalized effective depth

is much smaller at every threshold for the 103 stocks even before they

became subject to the ASR, calling into question the sample selection

procedure, it declines substantially relative to the non-ASR 3207 at every

threshold once the 103 stocks become subject to the ASR20 .

SOES access. The First NASD Study provides no meaningful data on SOES

access21 and asserts (as does the Second) that the ASR does not diminish

access to or usage of SOES, but other studies show that, as would be

expected, the ASR does indeed diminish usage of SOES:

•Data from the Barclay, et. al. Study show that average SOES trade size for

the First 50 stocks has fallen from 930 before January 20 to 776 (after

February 9), while SOES trade size for Second 50 stocks has fallen only from

909 to 854.22 Most strikingly, the Barclay, et. al. data show that SOES

trades as a proportion of all Nasdaq trades fell from 24.9% to 19.5% for the

First 50, whereas they rose from 19.8% to 21.1% for the Second 50.

•A study I commissioned and supervised at the company I founded looked at a

major client firm's SOES order completion rates (SOES volume divided by

number of shares the firm entered into SOES) for the 6 weeks before January

20, 1997 versus the two months March and April 1997 after 150 stocks had

become subject to the Order Handling Rules. We found that the SOES order

completion rates for the 50 stocks subject to the Actual Size Rule fell from

54.4% before January 20 to 47.5% in March and April, whereas SOES order

completion rates actually rose from 59.6% to 64.1% for the "Second 50"

stocks still enjoying 1000 share dealer quote minimums.22

•The Second NASD Study did look at SOES volume and the results are stunning:

(1) In a year of huge increases in Nasdaq dollar volume, for First 36 (ASR)

stocks, SOES dollar volume has risen only 16.7%, but Second 36 (non-ASR)

SOES dollar volume has increased 94%. (2) First 36 SOES volume as a

percentage of all dollar volume has fallen from 13.4% to 9.8%, a decrease of

37%. (3) SOES average trade size has fallen 6.7% for First 36 (ASR) stocks,

while it has risen 2% for non-ASR stocks24 . (4) For the 103 stocks newly

added to the ASR set, the results are not so dramatic, but the Next 103

(ASR) stocks' average dollar SOES volume/stock was only $138,800 vs.

$201,700 on average for the 3207 stocks not subject to the ASR, and SOES

volume as a percentage of total dollar volume fell from 9.0% to 6.6% in the

20 days following implementation of the ASR25.

20 See Table III.8. Through the magic of multiple regression, NASD

Economic Research makes this difference disappear, but since their

regression model confuses logical causality, we cannot rely on it to explain

away the results on normalized effective depth any more than we can for

other market quality measures.

21 The First (and Second) NASD Study presents several largely

irrelevant statistics to support their claim that "implementation of the

Actual Size Rule has not diminished the ability of small investors to

receive automated executions through SOESŠ." Their statement that "99% of

SOES trades were executed at one price" is both gramatically and

economically confusing. This means that few individual SOES orders are

filled at two or more different prices. However, it is a long way from this

to the NASD¹s conclusion that "investors received SOES executions at the

size and price they desired." If a person enters a SOES buy order when the

offer is 22 _, but gets an execution 30 seconds later at 22 1/2 (after a 25

cent "chase"), the NASD¹s statistic will misleadingly imply that she "got

the price she wanted". The DRI/McGraw-Hill Study shows that such frustrating

chases are very common. Please see former Commissioner Roberts¹ comment

letter on SR-NASD-97-26 dated May 12, 1997 for detail. (The DRI/McGraw-Hill

results actually understate the extent to which ordinary investors have to

"chase" prices, since SOES day traders are more likely than other traders

just to cancel their orders when the quote changes.)

22 See Barclay et. al. Study, Table VI. Panels A and B.

23 The higher beginning order completion rate for the Second 50

stocks may be due to their higher average quoted size; in any event, the key

statistic is the relative change between the two groups. The "Third 50"

(stocks phased in on February 24) and a sample of non-phased-in stocks both

have order completion rates and before vs. after changes similar to the

Second 50. The data consist of all 174,221 SOES orders entered by the client

firm during the periods in question and were "captured" by computer systems

maintained by Automated Trading Desk, Inc. The test described here is

similar to the test DRI/McGraw-Hill ran on ETA-supplied data (please see

former Commissioner Roberts¹ comment letter dated May 12, 1997) except that

the DRI/McGraw-Hill measure was the percentage of fully executed orders.

They found the same result: the frequency of execution fell from early

January to mid-April for the First 50 stocks, whereas it rose for all other

stock groups.

24 Results (1) to (3) above are from Second NASD Study, Table B.2.

25 See Second NASD Study, Table C.13.

Neither appropriate economic theory nor the empirical evidence supports the

NASD's proposal to expand the Actual Size Rule to cover all Nasdaq stocks.

Market makers are fat and happy despite the reduction in their unit profits

following implementation of the Order Handling Rules. This is no time to

reduce market liquidity, hurt the ability of public investors to obtain

immediate execution, and drive retail brokers into the arms of purchasers of

order flow.

Sincerely yours,

David K. Whitcomb

Professor of Finance, Rutgers University

President/CEO, Automated Trading Desk, Inc.


Appendix 1 Simaan-Whitcomb Study

Appendix 2 Simaan Analysis of NASD Econometric Methodology


James H. Lee (713)706-3300 x227 (713)977-7975 FAX jlee@soes.com


President, Momentum Securities Management Company, Houston, TX


President, Electronic Traders Association, Washington, DC