May 18, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: SEC File No. SR-NYSE-99-48
Dear Mr. Katz:
The Philadelphia Stock Exchange, Inc. ("Phlx") appreciates the opportunity to comment on the questions regarding market fragmentation raised in Release No. 34-42450 (February 23, 2000) ("Release") of the Securities and Exchange Commission ("Commission"), concerning New York Stock Exchange ("NYSE") Rule 390. As the Commission knows, the Phlx has long favored the abolition of Rule 390 because of its fundamentally anticompetitive effects, and we applaud the Commission's decision to approve its abolition.
Before addressing specific questions raised in the Release, we note that those questions arise in the context of unparalleled technological advances affecting our markets and consequent uncertainty regarding basic issues of market structure. As Chairman Levitt noted on March 16 in a speech at the Northwestern University School of Law, "the very ground beneath our feet is undergoing seismic shifts." In the midst of this uncertainty, the Commission has received requests from various quarters to take basic steps that would preempt market forces and affect the structure of our markets, by governmental fiat, for years to come. Not surprisingly, many of these requests are inconsistent, even dramatically opposed to one another. At one extreme, for example, the NYSE seeks to withdraw from, and thereby destroy, the Intermarket Trading System1 which, however imperfect, remains the basic linkage between the equity markets. Such a step would be a radical departure from the Commission's history of encouraging the interaction of U.S. securities markets and would be a risky wager. At the other extreme, a group of large market participants has endorsed a plan by which the Commission would mandate a "Super National Market System," or "Super-NMS," that would involve, among other things, technologically advanced linkages among self-regulatory organizations ("SROs") and electronic communications networks ("ECNs") and strict price-time priority for orders, so that orders would flow automatically to the market that first posted the best price.2 Such a step may be consistent with the Commission's emphasis on market integration, but it would be a departure from the Commission's record of regulating rather than dictating the manner in which our markets function. As Chairman Levitt noted in that same speech at Northwestern Law School, a single monolithic market might make the world simpler. "But I believe Congress was visionary in choosing not to mandate such a market. Over the last 25 years, our system of competing market centers has been the driving force behind faster and cheaper executions, spawning new trading systems that provide anonymity and greater liquidity."
The Phlx agrees with the position long held by the Commission3 that the public would benefit from firm linkages among equity market centers, possibly together with some form of rule on price-time priority that would reward a participant who takes the risk of improving prices. As Chairman Levitt noted last February, the technology exists to put such a system in place, with appropriate rules relating to order size, among other things. The Commission's views on market integration were a major impetus for the formation in 1978, pursuant to section 11A(a)(3)(B) of the Securities Exchange Act of 1934, of the Intermarket Trading System ("ITS").4 ITS is a commitment system and not a composite book. Nevertheless, it permitted the various market centers to interact to a degree not previously possible and provided enhanced protection for limit orders. In approving the ITS plan, however, the Commission declined to impose a consolidated book on the industry. Doing so, it said, "would have an impact on existing market institutions which could properly be viewed as a fundamental change in the manner in which securities trading is now conducted, and it is difficult to foresee, and to provide against, the problems and difficulties which might arise."5 This view remains sound today. It is apparent from the conflicting positions taken by market participants that there is no consensus in the equities market for a consolidated order book or for strict price-time priority. It is also apparent that without a significant degree of market consensus, the Commission cannot impose a system by fiat without the risk of creating an inefficient, government-mandated trading system that would be relatively inflexible and slow to adapt to on-going market developments.
The Phlx is convinced that competitive results can be achieved by a variety of market structures, including both a highly integrated structure and a structure characterized by competing, independent, but linked market centers. We therefore believe that the Commission should presently eschew measures that would preempt the market's evolution or alter its fundamental structure or operation. Rather, the Commission should ensure that a freely evolved market structure continues to operate in an increasingly fair and transparent manner, and should hold the present course of moderate regulation and incremental improvement designed to curb abuses and promote quality executions.
The Commission is right to be concerned that the emergence of ECNs, the demise of Rule 390, the growth of the so-called third market, the possible entry of new exchanges, and other factors, while creating a healthy competitive environment for inter-market competition, have the potential for creating pools of liquidity where orders and other market interest do not interact sufficiently, thereby resulting in harm to investors. The Phlx believes, however, that the market has not yet had a chance to fully adapt its systems and business practices to the very large number of major new initiatives affecting the equities markets. Some of these initiatives, such as the promulgation of Regulation ATS and the Order Handling Rules, the partial opening of ITS, and decimalization, have been introduced or fostered by the SEC. Others have been the result of spontaneous market forces and have been, if possible, even more far-reaching. Neither the Commission nor members of the industry can now predict with confidence how these changes will affect our marketplace even in the fairly short term. Moreover, no one has defined or measured fragmentation at this stage (if it exists), or shown that it is inconsistent with investor protection and the other goals of the National Market System. We therefore believe that it would be prudent for the Commission to observe and study the impact of these developments and initiatives for a reasonable period of time before introducing structural or other basic changes in the market.
With this general approach in mind, we now turn to certain specific questions posed in the Release.
1. Effect of Fragmentation on the Markets
a. Fragmentation in General
- To what extent is fragmentation of the buying and selling interest in individual securities among multiple market centers a problem in today's markets? Every regulatory strategy involves a decision that some problems are more important than others, and that the less important problems can be managed if not solved. Fragmentation is not an important problem so long as liquidity and execution speed and quality can be assured. Execution speed and quality have consistently shown significant and steady improvement, and liquidity now moves with greater ease and speed than ever before. We believe further that market interaction can be enhanced through simple but meaningful improvements in ITS, namely, by shortening response time and by promulgating and enforcing a tighter rule prohibiting trade-throughs.
- In the existing over-the-counter market, what are the incentives for investors and dealers to quote aggressively? Two factors combine to produce this result: severe competition, which has recently been enhanced by a dramatic rise in investor knowledge and direct market access, and stricter enforcement of the Order Handling Rules. The same factors will induce brokers to develop and rely on order-by-order routing systems and will reduce any perceived need for Commission action. The introduction of decimalization, which is proving to be harder to digest than the Commission may have first anticipated, is likely to encourage even more aggressive quoting and should be completed before any further major changes are contemplated.
b. Internalization and Payment for Order Flow
- Is it possible for a non-dominant market center to compete successfully for order flow by price competition, without using internalization and payment for order flow arrangements? Under current market conditions and rules, probably not.
- Do investor market orders that are routed pursuant to internalization and payment for order flow arrangements receive as favorable executions as orders not subject to such arrangements? We believe that such orders receive comparable execution in our market. The Phlx monitors execution quality, and our sources of order flow are extremely conscious of such quality and would not tolerate poor executions of market orders. If anything, their attention to the quality of market-order executions has been increasing. Along with certain other market centers, we also provide automatic price improvement of smaller retail orders regardless of whether the order was paid for.
c. Best Execution of Investor Limit Orders
- Are brokers able to make effective judgments concerning where to route limit orders so as to obtain the highest probability of an execution? Yes. However, in light of payment for order flow arrangements, the Commission must continue to enhance the enforcement of the best-execution obligation, as we perceive it has been doing.
- Is it consistent with national market system objectives (such as efficiency, best execution of investor orders, and an opportunity for investor orders to meet without the participation of a dealer) for market makers to trade ahead of previously displayed investor limit orders held by another market center (that is, trade as principal at the same price as the limit order price)? In effect, this question asks whether a CLOB should be imposed on the NMS. As noted earlier, the Commission previously took the position, with which we still agree, that ITS is a commitment-to-trade system and that a CLOB should not imposed on the market. We nevertheless believe that ITS can be substantially improved by shortening the permissible response time and imposing and enforcing a stricter prohibition against trade-throughs. In that regard, many markets address the issues raised in this question by providing limit-order print protection. As part of the overall interaction between markets that insures limit order protection, the same standards that are imposed on listed markets should also be imposed on ECNs.
2. Possible Options for Addressing Fragmentation
a. Require Greater Disclosure by Market Centers and Brokers Concerning Trade Executions and Order Routing.
- The Commission seeks comment on a large number of possible measures it might take relating to executions and order routing. The promulgation of any detailed rules governing order routing and executions would be unwise at this juncture, because the shape of the market is changing so quickly. We would not preclude consideration of such measures after market structure issues become less frothy, but such requirements could preempt market developments if taken now.
- With regard to mandating enhanced disclosure regarding payment for order flow, internalization and order handling practices, we doubt that there is an effective and practical way to provide clear and useful disclosure to retail customers about execution quality, and we believe that requiring further disclosures would not be meaningful. Brokers now request and obtain all the information they need from market centers to satisfy their best execution obligations.
b. Restrict Internalization and Payment for Order Flow
- Internalization and payment for order flow in the equities market, if managed properly, can be consistent with vigorous competition. Unless the Commission were willing to change its fundamental course and impose strict intermarket linkage with price-time priority - which appears not to be the case for the equities market - it should be willing to tolerate a variety of competing arrangements. Competition among market centers has emerged as a key feature of U.S. equities market centers, and such competition takes many forms. One of those forms is rapid, certain execution combined with internalization. Because many markets find it difficult to attract order flow on the basis of quote competition, the ability to offer these arrangements is essential. As the Commission noted throughout its Preferencing Report,6 payment for order flow and internalization have been with us for many years, during which time investors have become better off. A blanket regulatory hostility to internalization is therefore not warranted. It is also important to remember that many market centers actually combine different forms of execution for different types of order, and that hybrid systems respond to market demands. For example, it may be useful for a market center to follow price-time priority on small orders while permitting internalization of other orders.
c. Require Exposure of Market Orders to Price Competition
- The Release inquires about the possibility of requiring market centers to expose their order books to price competition. Two ways of doing so are suggested: one would involve automatic price improvement in specified circumstances; another would require exposure at a better price for a specified period before executing an order as principal in a security whose quoted spread is greater than one minimum variation. As the Commission is aware, automatic price improvement is already available in some markets, as is order exposure in some circumstances. These are competitive tools that market centers should be free to employ - or not. Some of our members favor a somewhat different approach recently mentioned by the Chairman at Northwestern, namely, "price transparency below the top of the book," but more information about the details of that proposal should be provided before forming a definitive view. The Phlx would welcome an opportunity to contribute to the formulation of any new regulation in this area. We note, however, that such a step may create a new issue of message-traffic capacity.
d. Adopt an Intermarket Prohibition Against Market Makers Trading Ahead of Previously Displayed and Accessible Investor Limit Orders
- A fundamental threshold issue that should be addressed before any new trading or display rules are promulgated is whether they will apply to both SROs and ECNs. ECNs increasingly look and act like SROs and should have the same obligations as SROs when it comes to the handling of orders. This is a basic issue. At present, SROs compete with ECNs on an uneven playing field. Much has been written about fragmentation of the market in terms of place and time; this is an additional type of institutional fragmentation by which institutions that play virtually the same economic functions are regulated differently. We are not in favor of fundamental new rules for equities at this point, but if new rules are adopted, they should be applied to both SROs and ECNs.
- In any case, we are concerned that such a trading-ahead proposal would have far-reaching consequences. The proposal obviously requires that markets have timely access to one another. "Timely" access meant one thing in 1978 when ITS was adopted, it means something else now, and it will probably soon mean immediate access. Accordingly, while the trading-ahead proposal may appear modest, we do not believe it could be put into effect unless the Commission was to engineer and impose a new market structure, and we oppose that. A proposal of this kind is impossible without virtually immediate access among markets and a CLOB or something much like it - namely, a single, intermarket order file. In passing, we also note that the proposal would require the Commission to define an "investor." The difficulty of performing that apparently simple task has bedeviled the Nasdaq's Small Order Execution System, and would raise similar problems here, but on a wider scale.
- We favor improving the ITS system in two simple ways that would increase intermarket accessibility. First, we would like to see a requirement that the market that receives an ITS message must respond within 30 seconds, and eventually within an even shorter period. The current one-minute rule, while an improvement over the recent past, has already become quaintly old-fashioned under current market conditions. Second, we would like to abolish the rule requiring unanimous approval of any change to ITS rules. We recognize that ITS must not be allowed to become a vehicle by which ECNs or others obtain the benefits of membership in primary markets without the related burdens or expense, but given the imperfections of ITS, even with the improvements we propose, there is no realistic danger of that happening.
f. Establish Price/Time Priority for All Displayed Trading Interest
- Please see our comments under item 2.c and 2.d, above.
Rapid technological advances have improved the operation of capital markets around the world and have significantly enhanced competition and the consequent benefits to investors. The Order Handling Rules, the recent removal of a major anti-competitive obstacle in the form of NYSE Rule 390, and other regulatory reforms have also made the market more transparent, have increased competition, and have benefited investors. The market's competitive engine is dynamic and powerful, and while it advances in fits and starts, it works. At this juncture, we strongly counsel against all of the more radical steps now under discussion - creating a CLOB, destroying ITS, imposing rules that would preempt different modes of competition - and urge instead that the Commission pursue a course of steady, incremental reforms, including the improvement of ITS, combined with increased vigor in the enforcement of already existing rules. The Phlx appreciates the opportunity to make these comments.
Meyer S. Frucher
Chairman and Chief Executive Officer
cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Norman S. Johnson, Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Annette L. Nazareth, Esq., Director, Division of Market Regulation
Robert L. D. Colby, Esq., Deputy Director, Division of Market Regulation
1 Letter from James E. Buck to Jonathan G. Katz regarding Release No. 34-42208, SEC File No. 57-28-99, p. 23.
2 "Responding to Chairman Levitt's Call: A Plan for Achieving a True National Market System," Wall Street Journal Interactive, February 29, 2000
3 See, e.g., Statement on the Future Structure of the Securities Markets (1972); Policy Statement of the Securities and Exchange Commission on the Structure of a Central Market System (1973); Release No. 34011942 (Dec. 19, 1975).
4 Release No. 34-14416 (Jan. 26, 1978).
5 Release 34-14116.
6 Report on the Practice of Preferencing Pursuant to Section 510(c) of the National Securities Markets Improvement Act of 1996 (April 11, 1997).