September 14, 2000
Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: Securities and Exchange Commission File No. SR-NASD-99-53
Dear Mr. Katz:
Instinet Corporation ("Instinet")1 appreciates the opportunity to offer its comments to the Securities and Exchange Commission (the "Commission") on Amendment Nos. 5, 6 and 7 (the "Amendments") to a proposed rule change (the "Proposed Rules") by the National Association of Securities Dealers (the "NASD") that would create a new order display and matching facility (commonly referred to as "SuperMontage") in the Nasdaq Stock Market ("Nasdaq").2
The NASD's most recent round of amendments fails to address the critical issue raised by the SuperMontage proposal: namely, that SuperMontage would transform Nasdaq into a "SuperECN" that uses the NASD's regulatory advantages to impair competition in the over-the-counter marketplace. The NASD's anticompetitive proposal would reduce pressure on Nasdaq spreads, harm investors and contravene the Commission's mandate under the Securities Exchange Act of 1934 (the "Exchange Act") - particularly its obligation to ensure that the NASD, as an exclusive securities information processor, acts "in a manner which is absolutely neutral with respect to all market centers, all market makers, and all private firms."3 We therefore continue to urge the Commission to reject the SuperMontage proposal in its amended form.
Despite our continuing opposition to the SuperMontage proposal, however, we have actively sought to work with the Commission staff and the NASD to identify ways in which the proposal could be revised to reduce its adverse impact on U.S. markets and investors. In particular, we urge the Commission to:
Part I of this letter provides a brief summary of the history of the SuperMontage proposal and the rule filing process through Amendment No. 7. Part II supplements our prior comment letters noted above and sets out our specific additional comments regarding the SuperMontage proposal in its current form.
Before turning to our comments on the amended proposal, we consider it important to note our concern regarding the tone of the NASD's most recent filing. The NASD correspondence accompanying Amendment No. 7 contains what can only be described as an unwarranted assault on Instinet and other ECNs that have offered criticisms of SuperMontage. It is wholly appropriate for Instinet and other industry participants - whether working alone, in ad hoc groups, or through trade associations - to speak out on rule changes proposed by "self-regulatory organizations" ("SROs") before the Commission, as contemplated by the Exchange Act. Ad hominem attacks, when submitted on the letterhead of the NASD, surely have a chilling effect on the constructive participation of regulated entities in such policy debates.4
I. History of the SuperMontage Proposal
The SuperMontage proposal has been designed in a manner that would enable Nasdaq to use its regulatory position to obtain a significant and unfair commercial advantage over other market participants. As described in the First Proposing Release, as well as in the Nasdaq private placement memorandum, SuperMontage is a strategic initiative to increase the volume of transactions effected through Nasdaq's systems by creating a limit order facility that competes with existing ECNs.5 The SuperMontage proposal, however, would use the NASD's regulatory authority over market makers and ECNs to give the proposed Nasdaq "ECN" a decided competitive advantage over other market participants - at the expense of hindering competition and potentially widening market spreads.
In particular, the SuperMontage proposal has consistently retained two critical anticompetitive features throughout the rule filing process. First, the proposal continues to guarantee that the Nasdaq ECN would have built-in liquidity by appropriating its competitors' most valuable asset - their "top-of book" quotes. Specifically, the NASD intends to link the new Nasdaq ECN directly to Nasdaq's existing quote montage, which was intended to be a neutral "securities information processor" through which market makers and ECNs make their best-priced orders accessible to the public under Commission rules.6 Not only would this make participation in the Nasdaq ECN involuntary for market makers and ECNs, but NASD member firms would have a compelling incentive to route their customer orders to the Nasdaq ECN rather than a competing market to satisfy their best execution obligation.
Second, the proposed priority rules for processing orders in the new Nasdaq ECN have consistently given market maker orders and orders entered directly into Nasdaq's ECN priority over most ECN customer orders (and UTP exchange participants' quotes) displayed at the same price - even as the justification for doing so has changed virtually with each amendment. For example:
Despite the NASD's numerous "technical" changes, the effect of the rules remains the same: to allow market maker orders and orders entered directly into Nasdaq's ECN to trade ahead of ECN customer orders without quoting a better price.
II. Instinet's Specific Comments Regarding the
Amended SuperMontage Proposal
The NASD must address several key issues relating to the competitive impact of the SuperMontage proposal before the Commission can approve the proposal consistent with the statutory requirements of the Exchange Act.7 Instinet and other commenters have set out their views on these and other issues in numerous comment letters to the Commission.8
A. The NASD Proposal, Even as Amended, Would Create a Regulatorily Privileged ECN that Substantially Limits Investors' Freedom to Choose How Their Orders Are Displayed and Executed
As noted above, the NASD has not resolved the significant anticompetitive issues posed by the creation of a regulatorily-sanctioned Nasdaq "SuperECN" - in particular, the potential impact of a "SuperECN" on investors' ability to choose where their orders are displayed and how their orders are executed. A Nasdaq-sponsored ECN would enjoy numerous regulatory advantages over other market participants, including among others:
Absent revision, these regulatory advantages would give the Nasdaq ECN a significant competitive advantage over other ECNs - however technologically innovative their systems may be. Unlike ECNs which have had to build liquidity over time by providing truly innovative services, the proposed Nasdaq ECN would have instant liquidity - i.e., the best-priced orders of its members - by regulatory fiat. The proposal to link Nasdaq's ECN to the Nasdaq quote montage - thereby giving the Nasdaq ECN preferred access to other markets' quotes - also violates Congress' intent that the NASD, as "exclusive securities information processor" for the over-the-counter marketplace, function "in a manner which is absolutely neutral with respect to all market centers, all market makers, and all private firms" and not be "under the control or domination of any particular market center." 9
The NASD's regulatory authority unilaterally to set the terms on which ECNs and market makers must participate in the Nasdaq ECN would further entrench Nasdaq's competitive advantage. For example, the NASD has already imposed a number of terms and conditions on its members that are not "industry practice" and that its competitors would find exceedingly difficult to negotiate in arm's-length agreements. These include, for example:
In addition, NASDR's affiliation with Nasdaq would undoubtedly lead NASD member firms to believe that NASDR would be less likely to question the quality of executions obtained through a Nasdaq ECN, rather than a competing market.10
The SuperMontage proposal, by using the NASD's regulatory authority to centralize order flow in a Nasdaq ECN, would therefore reduce incentives for market participants to develop more efficient, innovative trading systems that keep trading costs down and narrow trading spreads. As the Commission has acknowledged, ECNs have helped reduce execution costs and expand execution options by continually introducing technologically advanced trading services - e.g., anonymity, negotiation, reserve size, discretionary pricing, pegging.11 These features have enabled investors to display aggressive prices without compromising their trading strategy, thereby narrowing spreads and improving transparency. A regulatorily privileged Nasdaq ECN that monopolizes order flow in Nasdaq securities, by contrast, would have substantially less incentive to improve its systems, reduce costs, or introduce innovative new trading features that narrow spreads. When coupled with the discriminatory treatment of ECN customer orders, discussed in Part II.B below, the SuperMontage proposal would effectively stifle competition and innovation in the over-the-counter marketplace - and remove pressure on trading costs and trading spreads - in a manner that harms all investors.
In this connection, Instinet wishes to make clear that, contrary to the NASD's assertions, it does not argue that Nasdaq never may offer an automatic execution system. Instead, consistent with the statutory mandate of the Exchange Act, we maintain that Nasdaq may not operate a competing ECN or other automatic execution system so long as such a system enjoys special regulatory advantages over other competitors. In particular, we have repeatedly suggested that the NASD consider whether it can achieve its commercial objectives without establishing an unnecessary and anticompetitive link between the Nasdaq quote montage and a new order execution facility. The NASD has not, to our knowledge, articulated any policy reasons why it could not operate a voluntary automatic execution or order delivery system for market makers and ECNs without compelling all ECNs and market makers to make their best-priced orders available to it to satisfy their order handling obligations under Commission rules.12
It is critical that the Commission thoroughly review the potential anticompetitive aspects of the SuperMontage proposal and explore any feasible alternatives with the NASD before acting on the proposed rule changes.13 In particular, since the NASD has already indicated that SuperMontage will not be implemented until April 2001 (Nasdaq's current deadline for completing its transition to decimal pricing), the Commission and the NASD should use the available time to resolve these issues rather than approve the proposal in its current form.
B. The SuperMontage Algorithm, Even as Revised, Would Continue to Contain Discriminatory Priority Rules that Would Have the Effect of Reducing Pressure on Spreads
The proposed SuperMontage algorithm would reduce pressure on market spreads - to the detriment of all investors - by reducing aggressive quote competition from investors' orders. The algorithm would reduce the likelihood that investors' orders will be executed if they are submitted to an ECN - thereby driving investors either to submit their public limit orders to market makers or to avoid publishing their trading interest at all. Moreover, the algorithm would single out ECNs that charge access fees for such discriminatory treatment - and would not take any other fees into account in determining the priority of an order.14 We strongly encourage the NASD to abandon the proposed SuperMontage algorithm in favor of one that eliminates the existing discrimination against ECNs that charge access fees.
The proposed SuperMontage algorithm would reduce investors' incentives to publish competitive prices that narrow trading spreads by denying ECN customer orders time priority unless they provide significant price improvement.15 Many investors prefer to place their limit orders with an ECN since ECNs, as agency brokers, have an incentive to execute such orders as promptly as possible and do not use the information gained from such orders to benefit proprietary trading activities.16 ECNs have enabled investors substantially to narrow trading spreads in the Nasdaq market - with ECN customers displayed at the inside bid or offer approximately 75% of the time for certain high-profile, actively traded stocks.17 The pressure ECN customer orders have exerted on Nasdaq spreads, moreover, has had a marketwide impact on the quality of execution all investors receive - particularly retail investors - since market makers "internalize" a significant percentage of market orders at a price based on the NBBO.
SuperMontage, however, would permit market makers regularly to "step ahead" of ECN limit orders through Nasdaq's facilities without narrowing the spread.18 Market makers would receive automatic priority over ECN customer orders, regardless of when an ECN customer order is submitted, if the ECN charges an access fee that exceeds any opportunity for price improvement.19 In addition, SuperMontage would allow market makers to use Nasdaq's facilities automatically to "internalize" orders against their proprietary quote at the NBBO - even if other orders have time priority. If SuperMontage materially reduces the likelihood that ECN customer limit orders will be executed by according them "second class" priority, investors will have fewer options - and much less incentive - to reveal their trading interest to the marketplace.20
Adoption of the biased SuperMontage priority rules cannot be justified on the basis of ECN access fees - especially given the inconsistency of the rules with the NASD's obligation to act "in a manner which is absolutely neutral with respect to all market centers, all market makers, and all private firms."
In other words, despite a variety of arguments advanced by Nasdaq, no other fees or amounts comparable to ECN access fees (including Nasdaq's own fees)22 ever have been reflected in Nasdaq's system - much less given rise to overt discrimination in execution of orders. Moreover, where consideration of comparable amounts of price improvement would have favored ECNs (rather than disadvantaged them), Nasdaq chose not to provide market participants with an indicator letting them know that superior opportunities were available from ECNs. In other words, the NASD's determination to discriminate against ECN orders based on the fact that ECNs charge access fees - the sole source of compensation ECNs receive for their brokerage services - merely underscores the anticompetitive impact of the SuperMontage proposal.23
In light of these concerns, Instinet recommends that the NASD revise the proposed order processing algorithm to process all limit orders in SuperMontage in strict price/time priority without regard to ECN access fees. Price/time priority would preserve incentives for all investors to publish aggressive limit orders - whether in an ECN, through a market maker, or any other facility - by assuring the public that Nasdaq participants cannot trade ahead of those orders in SuperMontage. An access-fee neutral algorithm will also ensure that investors can continue to use the trading systems of their choice - and take advantage of the technologically innovative features different trading systems offer - without subjecting their orders to an unnecessary disadvantage in the marketplace.
If the Commission nonetheless permits the NASD to take access fees into account in its proposed priority rules, however, it should ensure, at a minimum, that those rules also take into account opportunities for price improvement. While the NASD stresses the need to give lesser priority to ECN orders when the associated access fees allegedly result in materially worse prices, its proposed algorithm fails to give greater priority to ECN orders that offer "net" price improvement (after taking access fees into account) over other orders displayed at the same price. Accordingly, if the Commission permits the NASD to implement the proposed priority rules, the NASD should be required further to amend its filing to provide that:
C. The Commission Should Assure that the Operational Features of SuperMontage Are Clarified to Prevent Increased Financial Exposure or Other Harm to ECNs
The NASD's proposal contains a number of features that compound its regulatory advantages and discriminate against ECNs in a manner detrimental to investors, many of which have been noted in the prior comments of Instinet and others to the Commission. Moreover, in many respects, there are elements of the system's operation that are not entirely clear, but that appear to have a significant adverse impact on competing ECNs.25
Of particular note, it appears that order delivery participants (i.e., competing ECNs) will lose their priority in the SuperMontage matching algorithm whenever they update the size of their orders. Although many of the details of the system will depend on specifications that have not yet been published in definitive form, SuperMontage apparently would provide that whenever an order displayed by an ECN is partially filled (i.e., decreased in size), the ECN will be required to submit an update that will be viewed as a new order in the system - thereby losing its priority in the order queue. Similarly, if additional size is added to an ECN order displayed in SuperMontage (to satisfy Commission requirements or otherwise), the previously displayed order would lose its priority in the queue. At the same time, the orders of automatic execution participants (i.e., market makers) can be "decremented" automatically by the SuperMontage facility without loss of standing in the queue. It is critical that any ambiguities regarding this issue be resolved - and that Nasdaq's facility not be permitted to proceed on a basis that would cause the portion of ECN orders that have already been displayed in the system to lose priority merely because they have been partially filled or otherwise updated.
In addition, at an operational level, we consider it important to underscore the adverse impact of Nasdaq's proposal automatically to cancel orders five seconds after they are routed to an ECN. This proposal could, even with the NASD's proposed system upgrades, expose ECNs to even greater financial risks than they must assume in Nasdaq today. The NASD's cancellation policy is also inconsistent with industry practice, since market centers generally do not have the right unilaterally to cancel an order sent to another market center. Accordingly, Nasdaq should either provide ECNs with additional time to respond to incoming Nasdaq orders or, alternatively, make ECNs whole for any losses they incur as a result of "DKs" caused by Nasdaq cancellations.
Under the proposal, every order sent by Nasdaq to an ECN would be cancelled five seconds later, regardless of whether the ECN has already processed the order and executed a trade with its customer.26 The NASD's proposed approach differs significantly from the way SelectNet works today, where an order entry firm has the option to cancel an order (but will not necessarily cancel the order) only after ten seconds have elapsed from time of entry.27 Notwithstanding the NASD's representations about the capacity of its new trading systems, Instinet's experience with Nasdaq technology suggests that a five-second cancellation window could leave ECNs exposed to significant financial exposure if SuperMontage fails to meet the NASD's performance goals.
The additional information the NASD proposes to provide, moreover, would not significantly help an ECN predict whether an order is likely to be prematurely cancelled. Given the lack of effective synchronization of time clocks across various systems, there is no guarantee that an ECN will be able to rely on a Nasdaq timestamp on a regular basis to determine whether there is sufficient time to execute an order. In addition, there is no way for an ECN to guess how much time it will take for Nasdaq to receive a confirmation once sent by the ECN to Nasdaq. In the event of a slowdown in Nasdaq's systems on the "return" leg, for example, an ECN could find itself in a situation where every order executed against a Nasdaq counterparty is cancelled, even if such orders appeared to arrive on a timely basis.
The NASD's proposed five-second cancellation rule is also inconsistent with industry practice. When one market sends an order to another market, the sending market generally does not have the right unilaterally to cancel the order, but must first request that the receiving market cancel the order and receive an acknowledgement of cancellation; if the receiving market executes the order before processing the request to cancel, the sending market assumes responsibility for any resulting trades.28 But for the NASD's regulatory power to set the terms of ECN participation in SuperMontage, as noted above in Part II.A, Nasdaq would have to assume responsibility for any trades resulting from an order routed to an ECN that was not cancelled in time.
Accordingly, Instinet recommends that Nasdaq give ECNs at least thirteen seconds to respond to incoming orders or, alternatively, assume responsibility for any "DKs" that result from its inability to send or receive trading messages in a timely manner. A thirteen-second window - seven seconds plus twice the maximum permitted time lag (3 seconds) between an ECN's systems and Nasdaq's systems - would provide ECNs with sufficient time to respond to incoming orders, at least until the average and worst-case turnaround time for orders on Nasdaq new order delivery system can be measured. Moreover, expanding the five-second window to thirteen seconds would not substantially delay execution of orders during normal market conditions, since ECNs must already respond to Nasdaq orders no slower than they respond to orders entered directly into their systems, "and in any event in no more than a few seconds."29
III. Conclusion
In determining whether to approve a proposed SRO rule change, the Commission must make a finding as to whether the proposed rule change is consistent with the requirements of the Exchange Act. If the rule change is to be approved, the Commission must also ensure that there is adequate factual support in the record to substantiate such a finding.30
In particular, the Commission must find that the NASD's proposed rule change:
In determining whether the proposed rule change is in the public interest and appropriate for the protection of investors, the Commission must consider whether the proposed rule change assures:
In addition, in considering whether approval or disapproval of the rule change is necessary or appropriate in the public interest, the Commission must consider whether such action will promote efficiency, competition, and capital formation.33
For the reasons set out above and in our prior comment letters, approval of the NASD's proposal cannot proceed consistent with the Commission's statutory obligations. The NASD has failed to establish a record that would permit the Commission to determine that SuperMontage would not impose "any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act."34 On the contrary, the proposal flies directly in the face of the NASD's obligation, as "in effect, a public utility," to ensure that its facilities are "not under the control or domination of any particular market center." Indeed, through multiple iterations, the constant central feature of the proposal has been to limit, rather than to enhance, the opportunity for "investor's orders to be executed without the participation of a dealer" - as well as a refusal to permit transactions to occur, as Congress required, "in a manner which is absolutely neutral with respect to all market centers, all market makers, and all private firms."
* * * *
We would be pleased to discuss any of the comments in this letter with the Commission or its staff. If we can be of further assistance to the Commission in this regard, please do not hesitate to contact the undersigned (212.310.7728), Peter Rich, our Washington representative (202.789.8550), or Giovanni Prezioso or Onnig H. Dombalagian (202.974.1500) of Cleary, Gottlieb, Steen & Hamilton, counsel to Instinet.
Sincerely yours,
Douglas M. Atkin
President and Chief Executive Officer
cc: The Honorable Arthur Levitt, Chairman
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul R. Carey, Commissioner
The Honorable Laura Simone Unger, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation,
and Senior Advisor to the Chairman
Belinda Blaine, Associate Director, Division of Market Regulation
| 1 | Instinet, a member of 20 exchanges around the world, is a registered broker headquartered in New York City and has offices in eight international financial centers. Instinet is a pure agency broker, serving its global client base by consistently reducing transaction costs and thereby increasing investment performance for investors and their proxies. |
| 2 | Exchange Act Release No. 43,133 (Aug. 10, 2000), 65 Fed. Reg. 49,842 (Aug. 15, 2000) (as amended through Amendment No. 7). The SuperMontage proposal (as amended by Amendment Nos. 1 and 2) was initially released for public comment in Exchange Act Release No. 42,166 (Nov. 22, 1999), 64 Fed. Reg. 68,125 (Dec. 6, 1999) ("First Proposing Release"). The proposal (as amended through Amendment No. 4) was re-released for public comment in Exchange Act Release No. 42,573 (Mar. 23, 2000), 65 Fed. Reg. 16,981 (Mar. 30, 2000) ("Second Proposing Release"). Instinet submitted comments on the First Proposing Release in a letter dated February 16, 2000 and on the Second Proposing Release in a letter dated April 20, 2000. |
| 3 | S. Rep. No. 94-75 at 11-12 (1975) (emphasis added). |
| 4 | In this connection, we also take issue with the NASD's suggestion that Instinet has sought to "mischaracterize" SuperMontage in an effort to protect the continuation of "special, and profitable, privileges" that it possesses. Many of the alleged "mischaracterizations" that Nasdaq cites simply reflect a lack of clarity - arising, in some cases, from the text of the Proposed Rules - in the absence of any more definitive guidance from the NASD about how SuperMontage would work in practice (see, e.g. note 8 below). Moreover, Instinet has built its business over the past thirty years without enjoying any regulatory privileges, but rather by continually providing superior trading opportunities to its customers. To the extent that the NASD seeks to characterize the ECN Display Alternative as a special "regulatory privilege," we note that Instinet opposed adoption of the Commission rules that created "ECNs" - the "special privilege" which Instinet allegedly possesses - because they compel Instinet to hand over its best-priced orders to the NASD for free. Of course, the SuperMontage proposal now seeks to exploit that "special privilege" for the benefit of a new Nasdaq ECN. |
| 5 | First Proposing Release, 64 Fed. Reg. at 68,127; Nasdaq Private Placement Memorandum at A-6. |
| 6 | S. Rep No. 94-75 at 11 (1975) (noting that the exclusive securities information processor for an SRO is "in effect, a public utility"). |
| 7 | See Part III below. |
| 8 | Instinet also submitted to the Commission staff, prior to the publication of Amendment No. 7 and as included in the public file, a list of the principal unresolved issues raised by the SuperMontage proposal apart from its broad anticompetitive impact. As discussed herein, Nasdaq has not resolved the most significant of those issues in its most recent amendments. We note that, in reference to the final point cited in that list of unresolved issues, the NASD claims that Instinet "mischaracterized" the way ECN quote updates would be processed under SuperMontage. Instinet suggested that an ECN may be subject to automatic executions in SuperMontage if the ECN inadvertently locks or crosses the market when updating its quote. Instinet's concerns were based on the text of Proposed Rule 4710(b)(3)(A), which states that Nasdaq would treat a Quote/Order entered by a Quoting Market Participant during market hours that would lock or cross the market "as a marketable limit order and enter it into the system as a Non-Directed Order for processing" in accordance with subparagraph (b) - thereby resulting in an automatic execution of that order against the Quoting Market Participant next in queue who would be locked or crossed. Although we thus reject the NASD's suggestion that we intentionally "mischaracterized" its proposal, we appreciate the clarification in Amendment No. 7 of how Nasdaq would process an ECN Quote/Order in the event of a potential lock or cross, and ask that the NASD amend the rule text to reflect the proposed procedures. |
| 9 | S. Rep. No. 94-75 at 11-12 (1975) (emphasis added). |
| 10 | The submission of Amendment No. 7 under cover of correspondence on NASD letterhead only compounds confusion on this point. Similarly, circulation only last week of a Nasdaq "Head Trader Alert" - typically used to notify members of regulatory and system developments - to solicit political support for SuperMontage further accentuates the blurring between Nasdaq's role as a regulator and a competitor. See <http://nasdaqtrader.com/ trader/news/headtraderalerts/hta200-63.stm> |
| 11 | Remarks of Arthur Levitt, Chairman, U.S. Securities & Exchange Commission at Columbia Law School, New York, N.Y. (Sept. 23, 1999). The Department of Justice has also previously expressed concerns about the possible effect of Commission rules governing the use of ECNs on "innovation and the development of new, efficient networks," especially in light of "the current rapid pace of technological change in information systems, and the significant benefits that could result from application of this new technology to securities markets." Comment Letter of the Department of Justice on the Commission's Order Handling Rules at 8 (Jan. 26, 1996) ("DOJ Comment Letter"). |
| 12 | Indeed, it would appear feasible, as a practical matter, for the NASD simply to create an ECN that interacts with the Nasdaq quote display in the same way that existing ECNs do today - with a separate quote facility that enables market makers and ECNs (including a Nasdaq ECN) to display their "quote" or "top-of-book" to the marketplace. |
| 13 | A proposal raising the serious market-wide competitive issues such as those presented by SuperMontage requires not only disclosure of the text of the proposed rule, but a full and detailed explanation, which the NASD has never provided, of exactly how the order routing algorithm and other aspects of the system will function. Many features, only recently revealed, when exposed have been shown to have important anti-competitive effects. All of the system specifications should be made available for public inspection and comment prior to any action on this proposed rule. See Part II.C below. |
| 14 | As the Commission is aware, the term "ECN access fees" refers to the amounts that market participants pay to ECNs in light of their ability, by virtue of ECNs' obligations under Commission rules, to execute orders against ECN quotes - even where they are not customers of the ECN. Because the Order Handling Rules required compulsory interaction between the brokerage orders of ECN customers and other market participants, market forces could no longer operate to establish the level of commissions that ECNs could charge for making their customer orders available to the market. As a result, the SEC provided that ECNs could receive an "access fee" comparable to and in place of commissions charged to their customers. |
| 15 | Similarly, SuperMontage would discourage ECNs from registering as national securities exchanges by giving UTP exchanges even less priority in SuperMontage than ECNs. Any ECN that elects to register as a national securities exchange would likely be required to become a member of the OTC-UTP Plan (or any successor intermarket plan, if Nasdaq itself becomes a national securities exchange) to trade Nasdaq securities. The NASD, however, would not permit UTP exchanges to submit attributable agency orders to SuperMontage at all, and would attempt to access attributable principal quotes submitted by UTP exchanges only after exhausting all other trading interest at the same price. In other words, absent Commission intervention, any ECN that sought to register as an exchange would be even worse off in SuperMontage. |
| 16 | Congress expressly recognized the advantages of executing orders through an agency broker rather than a market maker when it found that "it is in the public interest and appropriate for the protection of investors [to assure an opportunity] for investors' orders to be executed without the participation of a dealer." Section 11A(a)(1)(C)(v) of the Exchange Act. See also DOJ Comment Letter (affirming the importance of permitting investors to enter limit orders without the intervention of a market maker). |
| 17 | See Competition and Transparency in the Financial Marketplace of the Future: Hearing Before the Subcomm. on Securities of the Senate Banking Comm., 106th Cong. (Apr. 26, 2000) (testimony of Harold Bradley, Senior Vice President, American Century Investors). Indeed, one of the principal reasons the Commission adopted the Order Handling Rules and Regulation ATS was to encourage quote competition from ECN customer orders by including them in the public quote and thereby to increase pressure to narrow the national best bid and offer ("NBBO"). |
| 18 | For example, if an institution places a bid of $20.00 in Instinet that establishes the national best bid for a security, a market maker could - after having seen that bid in the SuperMontage algorithm - enter an equal $20.00 bid in SuperMontage. Under the current proposal, the market maker's order will be the first order executed if a sell order at $20.00 is then submitted to SuperMontage - even thought the later market maker order only matched the price of the institutional customer whose bid narrowed the market. |
| 19 | While we appreciate the NASD's determination to permit firms to "direct" orders to an ECN outside of the algorithm, NASD members would likely take the view, for the reasons stated in Part II.A above, that they can let a Nasdaq-sanctioned algorithm fulfill their "best execution" obligations. |
| 20 | "Implicit pricing" of ECN fees - Nasdaq's suggested alternative to its discriminatory algorithm - would exacerbate these problems by additionally causing the display of misleading prices that would further widen spreads. In an "implicit pricing" environment, an ECN would have to adjust its display price on each side of the market by the amount of its maximum access fee (regardless of the actual fee a particular counterparty would pay). For example, if an ECN is at the inside quote (e.g., 20.22 by 20.23) and charges an access fee of 1.5 cents or less, the NBBO would, with rounding, appear to be 20.20 by 20.25. Not only would implicit pricing distort the prices at which ECN customers are actually willing to trade, but the resulting widening in ECN quotes would allow market makers to internalize investor orders at a significantly more profitable spread. |
| 21 | The Commission instructed the NASD to provide a rounding indicator so that the public would know if an ECN offered price improvement over the price displayed in Nasdaq. Exchange Act Release No. 34-37619A (Sept. 6, 1996), 61 Fed. Reg. 48,290, at 48.315 n. 283 (Sept. 12, 1996). Nasdaq sought and obtained no-action relief from the obligation to implement a rounding indicator based in part on the argument that, in light of then-recent decreases in increment size, "the actual monetary difference between rounded quotes and non-rounded quotes would become significantly less for the small percentage of quotes in increments finer that 1/16th." See Letter from Richard G. Ketchum, Executive Vice President & Chief Operating Officer, NASD, to Dr. Richard R. Lindsey, Director, Division of Market Regulation, Securities and Exchange Commission (Apr. 17, 1997). As noted above, the "actual monetary difference" at issue - even if those price improvements were only 1/64 of a dollar - would have exceeded the maximum ECN access fee. |
| 22 | Nasdaq will be able to generate revenues to support its SuperMontage order matching service through fees that will not be displayed or included in the order matching priority rules. As a result, Nasdaq's rules would create a substantial disincentive for market participants to "choose" any ECN other than Nasdaq if they wish to keep their place in line. |
| 23 | Without the ability to charge access fees, ECNs would effectively be forced to give their liquidity away for free to their broker-dealer clients, since few broker-dealers would pay to access an ECN's liquidity directly if they could get free access to its limit order book through Nasdaq. Penalizing ECNs that charge access fees by giving their orders lesser priority could thus have the effect of coercing many ECNs to reduce or eliminate their fees across the board. This would be patently inconsistent with the requirements of the Exchange Act, which prohibits SROs from imposing any schedule or fixing rates of commissions charged by its members. Section 15A(b)(6) of the Exchange Act. |
| 24 | The NASD has suggested that Instinet's concerns about how the SuperMontage priority rules would account for access fees - i.e., making routing determinations based on the maximum access fee an ECN charges - could be resolved if Instinet eliminates its variable fee schedule. See Letter from Richard G. Ketchum, President, NASD, to Annette Nazareth, Director, Division of Market Regulation, Securities and Exchange Commission (July 18, 2000). Instinet should not be required to abandon a widely accepted business practice that encourages healthy competition among trading systems - a practice in place well before the adoption of the Order Handling Rules - simply to enable Nasdaq better to achieve its own commercial interests. Moreover, the NASD does not have the statutory authority under the Exchange Act to engage in a "rate-setting" exercise - either directly or indirectly - with respect to the commissions a broker may charge. Section 15A(b)(6) of the Exchange Act. |
| 25 | See note 13 above. |
| 26 | The NASD notes that orders sent to an ECN would not "in practice" be cancelled until about seven seconds have expired from the time an order is delivered to Nasdaq, since Nasdaq would delay cancellation for an additional two seconds for "internal Nasdaq system processing." The text of the rule filing before the Commission, however, would require Nasdaq to wait only five seconds before canceling an order. See Proposed Rule 4710(b)(1)(C)(ii). |
| 27 | We also understand that, in the event an order entry firm attempts to cancel an order that has been delivered to an ECN, SuperMontage would "hold the cancel request until the ECN completes interacting with the delivered order" (i.e., has executed, partially executed or declined the order). While Instinet welcomes the NASD's decision to limit an order entry firm's ability to cancel orders during the five-second window, Instinet's more pressing concern is that every order will automatically be canceled after five seconds, regardless of whether Nasdaq has received a response from the ECN. |
| 28 | As noted in Part II.A above, the NASD has proposed to change this industry practice by shifting responsibility for SuperMontage system failures to market participants who have no control over Nasdaq's systems and no choice but to participate in Nasdaq. |
| 29 | See, e.g., Instinet Real-time Trading Service (June 2, 2000). |
| 30 | Section 19(b) of the Exchange Act; Timpinaro v. SEC, 2 F.3d 453 (D.C. Cir. 1993). |
| 31 | Section 15A(b)(6) and (9) of the Exchange Act. See also S. Rep. No. 94-75 at 11-12 (1975) (cited above). |
| 32 | Section 11A(a)(1)(C)(i)-(v) of the Exchange Act. |
| 33 | Section 3(f) of the Exchange Act. |
| 34 | See Letter to Jonathan Katz, Secretary, Securities and Exchange Commission, from Kevin M. Foley, Bloomberg Tradebook L.L.C (Sept. 12, 2000). |