September 13, 2000
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: File No. SR-NASD-99-53
Ladies and Gentlemen:
The BRUT ECN, L.L.C. ("BRUT") welcomes the opportunity to provide the Securities and Exchange Commission (the "Commission") with its comments on the most recently-published amendments (the "Amending Release")1 to proposed rule changes filed by the National Association of Securities Dealers, Inc. (the "NASD") designed to allow its wholly-owned subsidiary, the Nasdaq Stock Market, Inc. ("Nasdaq") to modify its systems to expand order-display capabilities and integrate order-management and collection facilities, commonly known as "SuperMontage."2 If approved, SuperMontage would operate to centralize the display, routing and execution of trading interest in over-the-counter ("OTC") securities, profoundly impacting the character and development of U.S. financial markets. Both the tone and the substance of the Amending Release raise concerns as to the desirability of that outcome, in particular under the protectorate of the NASD and Nasdaq.
I. The Role of Nasdaq in OTC Market Structure
A fundamental distinction between the structures of the markets for trading listed and OTC securities is the core function those markets' utility institutions have traditionally served. Exchanges have historically attempted to provide a single point of execution for transactions in exchange-listed securities, both in a physical sense (the floor) and an actual sense (the specialist). Exchange members were in many instances required to route orders to the exchange for execution, even where the member and its customer had agreed to the terms of a transaction prior to routing to the floor for execution.3 The over-the-counter market, conversely, eschewed the exchange model and focused on centralizing the display of market participants' trading interest in OTC stocks in an easily-disseminable electronic format (i.e., through Nasdaq), while allowing for executions to occur across multiple market centers.4 Participation in Nasdaq, by means of posting "top of the file" proprietary or customer trading interest for public display via Nasdaq, is effectively required of all major market participants pursuant to a host of NASD and Commission rules.5 While the NASD and Nasdaq have responded to Commission mandates and member concerns to amend Nasdaq systems to incorporate limited order-routing (SelectNet) and execution capabilities (SOES), at its core Nasdaq remains a vehicle for market participants to post proprietary and customer trading interest for market-wide display, with actual executions occurring outside the system.
This market structure model has served the OTC market well in several respects, fostering the national market system objectives of competition, innovation and investor choice. With no monopoly for the routing and execution of order flow, broker-dealers developed along distinct business models to create alternative execution environments to meet the needs of diverse market participants, lowering costs and offering features such as anonymity, electronic dis-intermediation and enhanced order management. This process was facilitated by an OTC market structure that allowed for the development of de-centralized pools of liquidity, where order flow could interact within separate trading systems according to the needs of investors with respect to each individual order. The Commission has fostered this environment by working to bring more transparency to order prices and activity in each market center without mandating the manner in which any one order must be executed.6 The NASD has been in a unique position to regulate this diverse market in that it did not tout Nasdaq or any other NASD-sponsored system as a comprehensive execution alternative, which would place it in direct competition with its member firms. Listed-market structure is only now beginning to incorporate the flexibility inherent in the OTC market, eliminating barriers to non-exchange liquidity centers and providing for enhanced linkages and access among execution alternatives.7 These are positive market events, given that where there is transparency of information and ease of cross-market access, a market model offering a choice of sufficiently-liquid execution alternatives works best to satisfy the needs of investors today and create future improvements.
Yet just as the market for exchange-listed securities is evolving towards distinct, yet linked, liquidity and execution centers, the NASD is proposes a de-evolution of OTC market structure towards a Nasdaq-sponsored monopoly. The creation of an "Order Collector Facility... which would serve as a single point of order entry and single point of delivery of Liability Orders and executions"8 is a paradigm shift with respect to how Nasdaq serves the OTC market, and would inevitably operate to centralize order flow through SuperMontage, having a profound effect on all market participants. Rather than allowing market makers to better manage their limit order book, SuperMontage would effectively take book-management responsibilities away from market makers, imposing its own order-execution algorithm. ECNs would be required to compete for order flow based not on the characteristics of its trading environment, but rather according to the execution preferences of SuperMontage as dictated by Nasdaq. The NASD's status as an SRO responsible for monitoring best-execution compliance would assist in this endeavor, creating compelling, if not coercive, reasons for member firms to route order flow to SuperMontage. The implementation of SuperMontage, which would work to drive all trading interest through a single entity that was the sole source of order information, routing and execution, would thus be contrary to recent market developments.
Such a metamorphosis of Nasdaq would not improve OTC market structure and would ultimately undermine overall market quality. Nasdaq properly serves market participants in its current form, centralizing order information for market-wide display in order to allow for multiple execution mechanisms to provide best execution of customer orders within their own unique frameworks. The NASD recognizes that "Nasdaq's strength [is] as a collector and aggregator of trading interests - the traditional role of a market."9 To allow for the modification of Nasdaq through the adoption of SuperMontage, into the "central means for accessing liquidity in Nasdaq"10 while Nasdaq retains its informational monopoly, and the NASD maintains its regulatory responsibilities, would be a dangerous consolidation of market functions that would prove inconsistent with the goals of a national market system.
II. The Amending Release and ECN Access Fees
As discussed above, we believe that SuperMontage is flawed at its core, and would produce market centralization and stagnation. Despite NASD protestations to the contrary, the Amending Release does not address such concerns in that it proposes only slight modifications to SuperMontage, while leaving its core purpose and functions intact. Nothing about SuperMontage is "completely voluntary,"11 as characterized in the Amending Release. Current order-display regulations require participation in Nasdaq, and as SuperMontage draws more and more orders into Nasdaq systems, market participants will have little choice but to do the same in order to compete for executions according to Nasdaq-mandated priorities.
The Amending Release's discussion of SuperMontage's order-execution algorithm underscores the inherent friction that would be created by turning Nasdaq into an execution center while it retains its data-processing functions under the NASD's regulatory oversight. The NASD and Nasdaq seek to preference or penalize ECNs within SuperMontage based on the order-access fees charged by each ECN. The Amending Release describes this regime as "consistent with previously articulated Commission policy,"12 despite a recent Commission statement that the treatment of such fees is "[o]ne of the most important issues [yet] to be resolved."13 The application of such standards would be rigid, failing to distinguish between myriad ECN fee structures. The NASD's offer to allow ECNs "to indicate on an order-by-order basis whether the price improvement offered by [an] order exceeds the access fee charged"14 and adjust execution priority accordingly is unrealistic, given that such reporting would be difficult in a dynamic order environment and the Amending Release offers no concrete plan for doing so.15 ECN customers would continue to be disadvantaged within SuperMontage based on the fee structure of ECN operation, as dictated by Nasdaq.
Such power should not be placed in the hands of the NASD and Nasdaq if they desire to operate SuperMontage as a competitive market facility. If Nasdaq, as envisioned by the NASD, is to become a for-profit central execution center, it is inappropriate for Nasdaq to impose any methodology of prioritization within the system on factors other than displayed price. The Commission, in consultation with market participants, should be the arbiter of how ECN access fees and other factors that potentially affect best execution should be considered in the furtherance of the goals of the national market system. As a self-regulatory entity the NASD can and should have a role in dealing with the issues, but only if it divests itself of Nasdaq, or ceases to advance Nasdaq as a unifying order-management system for the OTC market.
III. The Preservation of Competition
We are concerned about the NASD and Nasdaq's approach to comments submitted by market participants with respect to SuperMontage. Rather than responding to the bona fide comments of market participants, the NASD and Nasdaq dismiss them as "preposterous,"16 "mischaracterizations"17 and "unpersuasive."18 The Amending Release goes so far as to single out ECNs in general, and certain ECNs in particular, of "seemingly intentional"19 attempts to thwart approval of SuperMontage through subterfuge of some sort.20 Such pronouncements coming from the self-regulatory organization ("SRO") responsible for regulating these ECNs is disconcerting and un-productive, and inconsistent with the Commission's attempt to solicit maximum information from market participants during the public comment period.
The NASD and Nasdaq's response to valid ECN concerns regarding the operation of SuperMontage highlight the potential anti-competitive effect of allowing Nasdaq to operate a full-scale, profit-oriented execution system while remaining affiliated with an SRO and continuing its role as a central market utility. As Nasdaq begins to compete with ECNs and market makers for executions, its interests diverge from those market participants that it was originally created to serve. A desire to improve overall market efficiency and execution quality is replaced by the profit motive, and the amount of order flow collected in Nasdaq is the only measure of success. Doing a meaningful competitive analysis is rejected in favor of re-stating that "the NASD and Nasdaq do not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate"21 because it is not in Nasdaq's commercial interests to do so. In seeking approval for SuperMontage, the concerns of ECNs are minimized because ECNs are no longer constituents of the NASD and Nasdaq, but are the competition.
Competition advances investor interests only when it operates in a robust atmosphere where each execution alternative succeeds or fails based solely on the benefits it can offer to market participants. The emergence of ECNs since the introduction of the Order-Handling Rules is evidence of how such competition can improve price discovery, investor flexibility and market efficiency. The approval of SuperMontage would introduce a quasi-regulatory competitor would threaten the competitive balance, creating un-natural incentives for use of the system and restricting the flexibility of its competitors. Rather than benefit from augmented competition, investors would be disadvantaged as meaningful execution alternatives dwindle. The Commission should consider these potential unintended consequences in evaluating the merits of SuperMontage, evaluating whether a compelling need exists for approving the system in its current form.
As discussed above, while BRUT believes in regulatory adaptation in the face of rapid market evolution, SuperMontage as amended is a step in the wrong direction towards market consolidation where diversity and fair competition are clearly superior. The Commission should continue to work with market participants towards improving market quality while maintaining the characteristics that have served it well to date.
BRUT appreciates this opportunity to offer comments to the Commission. If the Commission or its staff would find further discussions or other assistance helpful do not hesitate to contact me at (917) 637-2560.
Senior Vice President & General Counsel
The BRUT ECN, L.L.C.
cc: The Hon. Arthur Levitt, Chairman
The Hon. Norman S. Johnson, Commissioner
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Associate Director, Division of Market Regulation
1 Exchange Act Release No. 43138 (August 10, 2000), 65 Fed. Reg. 49842 (August 15, 2000). File No. SR-NASD-99-53.
2 See Exchange Act Release No. 42166 (November 22, 1999), 64 Fed. Reg. 68125 (December 6, 1999) (the "Proposing Release") (publishing the NASD's original SuperMontage proposal); Exchange Act Release No. 42573 (March 23, 2000), 65 Fed. Reg. 16981 (March 30, 2000) (publishing NASD amendments to the proposal).
3 See, e.g., former NYSE Rule 390; former American Stock Exchange Rules 5 and 6.
4 Nasdaq is the sole "securities information processor" for OTC securities registered with the Commission pursuant Section 11A(b) of the Exchange Act, a function that in the market for exchange-listed securities is performed by pan-exchange organizations such as the Consolidated Tape Association. See Exchange Act Release No. 42208 (December 9, 1999), 64 Fed. Reg. 70613 (Dec. 17, 1999).
5 See, e.g., NASD Rule 4613 (requiring registered market makers to maintain two-sided quotations in Nasdaq); Regulation ATS under the Exchange Act (requiring the inclusion of certain ECN order information in Nasdaq).
6 See, e.g., Rule 11Ac1-4 under the Exchange Act (requiring the public display of customer limit orders that improve upon the size or depth of the Nasdaq best bid and offer (the "NBBO"); Regulation ATS under the Exchange Act, supra note 5.
7 See Exchange Act Release No. 42758 (May 5, 2000), 65 Fed. Reg. 30175 (May 10, 2000) (rescinding NYSE Rule 390); Exchange Act Release No. 42536 (March 16, 2000), 65 Fed. Reg. 15401 (March 22, 2000) (approving the linkage of ECNs to the Intermarket Trading System).
8 Proposing Release, supra note 2, at 68126-68127.
9 SuperMontage Fact Sheet, attachment to Nasdaq Head Trader Alert #2000-63, available at http://www.nasdaqtrader.com/Trader/News/headtraderalerts/hta2000-63.stm (September 8, 2000), at 1.
10 Amending Release, supra note 1, at 49854.
12 Id., at 49855.
13 Exchange Act Release No. 43084 (July 28, 2000), 65 Fed. Reg. 48406 (August 8, 2000) at 48420.
14 Amending Release, supra note 1, at 49856.
15 If approved, such a provision should allow for ECN orders to be given equal priority where the price improvement offered equals or exceeds the relevant access fee. To give equal priority only where price improvement exceeds the fee would penalize users of ECNs that charge access fees. See Proposed NASD Rule 4710(b)(1)(B)(i), Id., at 49846.
16 Id., at 49856
17 Id., at 49857.
18 Id., at 49856.
19 Id., at 49857.
20 See also SuperMontage Q & A, attachment to Nasdaq Head Trader Alert #2000-63, available at http://www.nasdaqtrader.com/Trader/News/headtraderalerts/hta2000-63.stm (September 8, 2000), at 1 (stating in an apparent reference to ECNs that "[o]ne group's financial interest should not be allowed to stifle innovation and market enhancements that will benefit the vast majority of investors").
21 Amending Release, supra note 1, at 49859 (emphasis added). See also the Proposing Release, supra note 2, at 68135; Exchange Act Release No. 42573, supra note 2, at 16993.