Mr. Jonathan G. Katz
Office of the Secretary
Mail Stop 6-9 -- Room 6507
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. SR-NASD-99-09
File No. SR-NASD-99-16
Dear Mr. Katz:
Knight Securities, Inc. ("Knight") is pleased to have this opportunity to
comment on File Nos. SR-NASD-99-09 (the "Agency Quote" proposal) and
SR-NASD-99-16 (the "Agency Fee" proposal), proposed by the National Association
of Securities Dealers, Inc. ("NASD"), through its subsidiary, the Nasdaq Stock
Market ("Nasdaq"), to establish an agency quote display structure and to allow
market makers to charge a fee when market participants access their agency
quotes.
Knight is the leading market maker in securities listed in Nasdaq and on the
NASD OTC Bulletin Board Service ("OTCBB"), trading in approximately 7,000
issues. In April, Knight's Nasdaq volume was about 3.9 billion shares for an
approximate 10.2% market share, while its OTCBB volume was about 450 million
shares for an approximate 25% market share. Thus, we believe the Commission
will find our comments useful in its consideration of the Agency Quote and
Agency Fee proposals.
For the reasons set forth below, Knight gives qualified support to both
proposals but does not regard the Agency Fee proposal as a viable long-term
solution to the inequities resulting from the fact that some electronic
communications networks ("ECNs") currently charge fees to non-subscribers when
their quotes are accessed, but market makers have not been able to do the same.
Indeed, the notion of permitting a market participant to charge a market maker
or other professional a post-transactional fee on top of his displayed bid or
offer is incompatible with the manner in which our markets have functioned and
will hamper best execution goals, cause confusion, and create significant
administrative burdens and additional expense in the tracking and payment
process. More troubling, these disadvantages will occur despite the fact that
these fee charges provide no benefits to the market or public investors.
The Agency Quote Protocol
The Agency Quote proposal will allow market makers in Nasdaq National Market
Securities ("NNM") to display in Nasdaq a second quotation, separate from their
proprietary quotation, for the purpose of displaying customer limit orders. The
second quotation - the Agency Quote - is supposed to facilitate the display and
execution of agency orders in NNM securities. The NASD states that the purpose
of the Agency Quote is to give market makers more flexibility in determining how
they wish to handle customer orders and other agency business. Instead of
having to display a customer limit order in their proprietary quote or in an
ECN, market makers also would be able to display the order in their Agency
Quote. In addition, the Agency Quote and Agency Fee proposals would allow
market makers to charge fees when their customers' quotes are accessed, similar
to what some ECNs have sought to do when market participants hit bids and lift
offers that these ECNs display on the Nasdaq montage.
The Agency Quote proposal is designed to relieve some of the burdens and
restrictions that the Order Handling Rules have placed on market makers. The
Order Handling Rules, which were adopted in 1996, incorporated into Nasdaq some
principles of auction markets. Specifically, the SEC adopted Rule 11Ac1-4 (the
"Display Rule"), which requires market makers to display their customer limit
orders that: (1) are priced better than a market maker's quote; or (2) add to
the size of a market maker's quote when the market maker is at the best bid or
best offer in Nasdaq. The SEC also adopted amendments to its Firm Quote Rule -
Rule 1lAc1-1 under the Securities Exchange Act of 1934 ("Exchange Act") - which
requires a market maker to make publicly available any superior prices that it
privately quotes through an ECN by either: (1) changing its quote to reflect the
superior price in the ECN; or (2) delivering better-priced orders to an ECN that
disseminates these priced orders to the public quotation system and provides
broker-dealers equivalent access to these orders.
Knight agrees with Nasdaq that the Order Handling Rules have affected the
structure of the dealer market in ways that have created certain difficulties
for market makers. As a result of the Order Handling Rules, market makers have
lost a certain amount of control over their quotes because they must change
their proprietary quotes to reflect certain customer limit orders held by them.
Knight also concurs with Nasdaq's view that the Order Handling Rules sometimes
make it difficult for market makers to work or negotiate institutional or
block-size orders. As an alternative, a market maker may send a customer limit
order to an ECN or another broker-dealer for handling, but, as Nasdaq
recognizes, in those situations, the market maker gives away business.
Knight supports the Agency Quote proposal because it provides market makers with
another mechanism for displaying customer limit orders which may, in turn, lead
to a reduction in customer transaction costs. In addition, Knight supports the
Agency Quote proposal because Knight believes that it is preferable to another
NASD proposal to establish a Nasdaq Central Limit Order Book. (See File No.
SR-NASD-98-17.) The SEC recently reopened the comment period on the Central
Limit Order Book proposal, and in so doing stated that the Agency Quote was an
alternative to the Central Limit Order Book. (See File No. SR-NASD-99-11.) For
the reasons set forth in Knight's comment letter on the Central Limit Order Book
proposal (dated May 21, 1999), Knight strongly opposes the Central Limit Order
Book. Among other things, the Central Limit Order Book would place the NASD in
direct competition with its own members for limit order business. While the
Agency Quote is designed to serve some of the same purposes as the Centraal
Limit Order Book, the Agency Quote does not pose the same threat to competition.
Post-Transaction Fees are Unacceptable
Knight shares the view of many market makers -- which view the NASD has
acknowledged -- that it is inequitable for an ECN to charge a fee when someone
hits one of its displayed bids or offers while market makers are prohibited from
doing likewise. This prevents an enhanced liquidity provider from competing
fairly with agency order handlers such as ECNs. The Agency Quote proposal seeks
to address this inequity by allowing market makers to charge a fee when they act
as agent, creating a more level playing field for market makers and ECNs alike.
The Agency Quote proposal, however, does not go far enough. For one class of
broker-dealers (i.e., ECNs) to be able to charge fees when their quotes on
Nasdaq are hit but not another class of broker-dealers (i.e., market makers),
contravenes Section 15A of the Exchange Act in at least two respects. First,
Section 15A(b)(6) of the Exchange Act says that the rules of the NASD shall be
designed "....to remove impediments to and perfect the mechanism of a free and
open market and a national market system.."and shall not be".... designed to
permit unfair discrimination between...brokers, or dealers...." The fee
assessments as contemplated by the NASD's proposal are impediments to a free and
open market and unfairly discriminate between brokers and dealers. Second,
Section 15A(b)(5) requires that the NASD's rules provide for "the equitable
allocation of reasonable... fees, and other charges among members.using any
facility or system which the association operates or controls." Permitting one
class of NASD membbers to charge fees for executing through Nasdaq but not
another, as this proposal would do, does not constitute an equitable allocation
of charges among members.
Knight does not, however, believe that allowing both market makers and ECNs to
charge post-transaction fees is the best way to structure the market in the wake
of the Order Handling Rules. Among other things, NASD rules currently do not
support the practice of charging fees to market participants who transact
against bids or offers displayed on Nasdaq, and the NASD has not adequately
addressed either the desirability or the legality of such fee assessments.
Historically, a market participant taking an offer on Nasdaq would pay the price
on settlement and not expect to receive a statement sometime thereafter
requesting a fee. Until 1997, the only bids or offers that could be inserted in
Nasdaq were those of Nasdaq market makers who were subject to a number of
affirmative obligations. Under NASD rules applicable to the Nasdaq market,
market makers are required by law to give broker-dealers trades at the prices
shown at their bids and offers. Nasdaq market makers currently do not issue
after-the-fact statements for transaction charges to the broker-dealers who
execute against their bids and offers.
Under the 1996 amendments to the Firm Quote Rule, a market maker must make
publicly available any superior price that such market maker privately quotes
through an ECN. A market maker is deemed to be in compliance with the Rule if
the prices it enters into an ECN are publicly disseminated and the ECN provides
equivalent access to other broker-dealers to trade at those prices.
In footnote 272 of the release adopting the Order Handling Rules, the SEC
stated that, for access to be "equivalent", the ECN must enable non-subscribing
broker-dealers to execute against the ECN's published best price to the same
extent as would be possible had that best price been reflected in the public
quote of the market maker. In the same footnote, however, the SEC added a
contradictory statement that an ECN "may impose charges for access to its
system, similar to the communications and systems charges imposed by various
markets, if not structured to discourage access by non-subscriber
broker-dealers."
Knight believes that it was improper for the SEC to have attempted to dispense
with such an important issue in a footnote to the release adopting the Order
Handling Rules. If, contrary to the current rules of the NASD, the SEC believed
that ECNs should be permitted to add fees onto their quotes in Nasdaq, the SEC
should have proposed ECN quote access fees as a new rule under the Exchange Act,
allowing for Federal Register notice and public comment. Allowing ECNs
to charge after-the-fact quote access fees is inconsistent with the established
requirement that ECNs allow non-subscriber broker-dealers access to quotes that
is equivalent to that provided by market makers. Knight does not believe that
access to an ECN quote is "equivalent" if it is more expensive. In addition,
the public should have been given an opportunity to comment on ECN quote access
fees because they contradict NASD Rules 4613(b) and 4623.
Nevertheless, if the SEC allows ECNs to charge transaction fees, it should allow
market makers to charge similar fees, whether their agency or their proprietary
quotes are accessed. For this reason, Knight gives qualified support to the
proposal to allow market makers to charge a fee in connection with the Agency
Quote.
2Permitting ECNs to charge post-transactional access fees is
also inconsistent with Section 11A(a)(1)(C)(i), which states that a National
Market System goal is "economically efficient execution of securities
transactions." These access fees impede the efficient execution of securities
transactions.
3Rule 4613(b) states that a market maker who receives an
offer to buy or sell from another broker-dealer must execute the transaction for
at least a normal unit of trading at its displayed quotation as disseminated in
Nasdaq at the time of receipt of any such offer. Rule 4623, applicable to ECNs
that determine to display their best prices in Nasdaq, requires that ECNs allow
any broker-dealer the electronic ability to effect a transaction with the ECNs'
priced orders that is equivalent to the ability to effect a transaction with a
market maker quotation in Nasdaq. (Emphasis added.) There are no exceptions to
the rules that allow a broker-dealer, such as an ECN, to place a surcharge on
the prices it displays in Nasdaq.
As a general matter, however, Knight believes it would be preferable to do away
with after-the-fact transaction fees across the board. After-the-fact
transaction fees are a cumbersome addition to the business of trading securities
in Nasdaq. These fees have resulted in administrative costs -- for tracking fee
expenses and paying bills -- that do not exist where market participants simply
trade net at displayed prices. In addition, if post-transactional fees become
standard, broker-dealers passing on these fees to their customers will need to
redesign their confirmation disclosure forms to reflect the actual price the
customer pays for the security (i.e., the execution price plus the fee).
Moreover, allowing market makers to charge fees when their agency quotes are
accessed, but not when their proprietary quotes are hit, threatens to put
customer orders at a disadvantage. The fee assessment may be a disincentive to
transact against customer displayed orders. Thus, the fee proposal seems
inconsistent withh best execution principles.
Also of note, because of Manning obligations, a market maker would be required
to execute against a displayed order of one of its customers if its own bid or
offer (at an equivalent price) were hit first. Because of this, the ability of
market makers to earn access fees on customer quotes under the Agency Quote
proposal is substantially reduced and the purpose of permitting a fee charge is
eroded.
Conclusion
Knight offers qualified support for the Agency Quote as an additional mechanism
for the display of customer limit orders. In particular, Knight believes that
the Agency Quote proposal is far preferable to the NASD's proposal to establish
a Central Limit Order Book, which threatens to have serious anti-competitive
effects. Knight also believes that the Agency Fee proposal should only be
adopted as a last resort to address, at least partially, the inequity that
results from the fact that ECNs, but not market makers, charge fees when their
agency quotes are accessed. As a general matter, however, Knight believes that
after-the-fact transaction fees are not a desirable addition to the securities
markets. In our opinion, it would be more efficient to do away with such fees
altogether and to require both ECNs and market makers to trade net, which we
believe is consistent with the objectives of Section 11A(a)(1)(C)(i) of the
Exchange Act.
4For the same reasons, customers of ECNs may not be receiving
best execution for their limit orders. If an ECN customer seeks to sell at $10
and his displayed order is transmitted by the ECN to Nasdaq at $10 plus an after
the fact charge of .01 to the buyer, then the customer's instruction to the ECN
to sell at $10 is not being carried out because the buyer is required to pay
$10.01.
Please do not hesitate to contact us if you would like to discuss these issues
in further detail.