July 5, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
RE: Request for Comment on Issues Related to Fragmentation (Release No. 34-42450; File No. SR-NYSE-99-48)
Dear Mr. Katz:
Charles Schwab & Co., Inc. ("Schwab") appreciates the opportunity to comment on the SEC's concept release on market fragmentation. We commend the Commission for taking an interest in important market structure issues such as competition and efficient linkages between markets. We are nonetheless concerned that with its narrow focus on fragmentation, the Commission is underestimating the tremendous benefits that investors have realized from heightened competition between and among our markets.
Far from undermining market quality, the proliferation of new order handling technologies and new competitors made possible in part by the Commission's order handling rules in 1996 has resulted in unprecedented innovation and efficiencies. The weight of evidence indicates that our markets have never been more efficient and that transaction costs have never been lower. While there are those who argue (despite all apparent evidence to the contrary) that pricing efficiency suffers with trading activity divided among a larger number of participants, it should come as no surprise to those familiar with the inexorable power of markets that heightened competition would lead to lower prices and better service.
As a practical matter, no matter how many specialists or market makers trade a security, our market is less fragmented than ever. Congress successfully addressed the risk of potential fragmentation in 1975 with its framework for a national market system to consolidate trading interest among markets trading the same security. The Commission's inclusion of prices available on ECNs and ATSs in 1996 and 1998 into the NMS further consolidated trading interest and prevented fragmentation, and private vendors have responded with their own innovative solutions for linking markets. Today, with prices on the various competing markets consolidated and disseminated and accessible through various inter- and intra-market linkages, investors can trade at the best available prices regardless of the number of competitors trading a security. While certain aspects of the NMS are not without shortcomings, these shortcomings are unrelated to fragmentation of trading among a plethora of competitors striving to offer the best prices and services to attract customer orders.
Instead, these shortcomings largely relate to issues concerning the availability of accurate information about trading interest and the efficiency of linkages for accessing this trading interest. In our view, the Commission's release does not devote sufficient attention to these issues, which have a disproportionate impact on individual investors. We recognize that regulators are in the difficult position of having to balance the often competing interests of different market participants. However, in our experience, a transparent market that treats retail investors fairly and offers maximum opportunities for these investors to participate is a market that will be more efficient for all investors. As a starting point for any reassessment of market structure, we would therefore urge more study of the actual experience of retail investors and their needs and expectations when executing orders.
For example, investors repeatedly tell us they need current information about the prices at which securities are quoted and the prices at which securities are trading. Unfortunately, this information in any useful form is prohibitively expensive and often stale. Stale because the "real-time" snap-shot of the current market that most customers rely on is no longer current by the time a customer enters the details of its order or clicks the execute button; prohibitively expensive because the real-time streaming quote updates that customers actually need to stay current are not cost effective for the average customer.
Investors tell us they want more information about market prices. Information about depth of the market and the total price they'll pay or receive for their order. Information about imbalances on the bid or offer side of the market. Information that is readily available on a cost effective basis to all other market participants. Information that will be even more critical when securities are traded in penny increments.
Investors tell us they have serious concerns about the accuracy of the quotation and transaction information that's disseminated by the exchanges and Nasdaq. Even with the tremendous advances we've seen in automation of our markets, trade reports, quote updates and ITS commitments are still subject to the one to two minute timeframes established in a world before micro-processors. These delays seriously undermine the quality of the data on which investors rely, especially in fast moving markets when price information is most critical yet furthest behind.
Investors tell us they want certainty. Certainty they will receive the price quoted to them at the time they place their orders. The Commission focuses almost singularly on price improvement, a factor that can be an important element of execution quality. But far more important to investors is that they avoid price disimprovement - that is, an execution price that is worse than the price quoted to them at the time of order entry. This point bears emphasizing for it relates to every one of the market structure proposals in the Commission's release. Certainty implies fast, accurate, automated execution, in contrast to order queues, manual handling and execution delays. Certainty implies dealer liquidity commitment and size guarantees. Certainty implies efficient linkages between markets. And certainty implies reliable technology for routing orders and processing trades.
Our specific comments on the Commission's release follow. These observations reflect our direct experience in serving investors and in executing hundreds of thousands of their orders daily. They also reflect our assessment of the substantial quantifiable economic benefits of increased competition in our markets. Vibrant competition has produced a diversity of firms and services catering to the retail investor. Our own firm was quite literally born of the changes wrought in 1975 that lifted barriers to competition, and the individual investors we represent have benefited tremendously from the emergence of innovative new markets and execution systems since then. Regulators need to ensure maximum opportunity and incentives for innovation of new methods and systems for handling orders. Rather than erecting expansive new trading restrictions and expensive new infrastructures and bureaucracies, regulators should be eliminating regulation that impedes competition and efficient access between markets, prevents transparency of critical market information and puts the individual investor at a disadvantage.
Arguments against fragmentation are typically based on academic theories that division of order flow among competing markets undermines market quality. Far from undermining market quality, the weight of empirical evidence indicates that a proliferation of competitors lowers transaction costs and otherwise increases market efficiency. For example, studies have consistently concluded that the introduction of ECNs on Nasdaq since the Commission's 1996 order handling rules has contributed to significantly narrower spreads and increased price discovery. Since the rules were first implemented in January 1997, quoted spreads have been reduced by 41%, with ECNs establishing the inside market price approximately 11% of the time.1 A survey of execution costs by consulting firm Elkins/McSherry Co. found the average cost of executing trades in Nasdaq and NYSE-listed stocks has continued to come down.2
In the options markets, the arrival of new entrants has resulted in similar improvements in market quality. Prior to full multiple listing last year, many actively traded options were listed on only one exchange. According to the Commission's own data, effective spreads fell between 22% and 44% in four of five actively-traded options it examined following multiple listing.3 Evidence of narrower spreads, lower transaction fees, more liquid and efficient markets, and recent technological upgrades since exchanges began competing aggressively for order flow in these options demonstrates the clear economic benefit to investors of unrestricted inter-market competition.
Earlier Commission studies also confirm the benefits of competition. In its examination of the equity markets issued in 1994, the Commission's Division of Market Regulation expressly endorsed the current system of competing markets and rejected the concept of a single market structure, noting that a single market risked stifling innovation and competition:
"Since at least the Special Study of the Securities Markets in 1963, the Commission consistently has stated that the benefits of competition should not be lost in an attempt to capture the advantages of uniformity. Forcing all order flow into a single market would reduce the incentive of system operators to respond to system users. Many market innovations of the past 20 years originated either outside of the primary markets or in response to competitive pressure from alternative markets, such as third market makers or [proprietary trading systems]."4
The Commission staff further noted that data it had examined showed no indication that market quality was being compromised by the current competitive market structure, and that the "U.S. equity markets are not fragmented to the point that price discovery and liquidity have been adversely affected.5
To some degree, the Commission's current release is founded on concerns that the elimination of the NYSE's Rule 390 off-board trading restrictions will result in increased internalization and fragmentation of trading in listed stocks at the expense of market quality. It is unclear why the Commission would expect internalization and fragmentation to increase with the elimination of Rule 390 since NYSE member firms already have been widely internalizing order flow in 390 securities by trading through affiliated specialists on the regional exchanges. Nonetheless, concerns about the impact of increased competition and fragmentation are not borne out by the economic evidence. In fact, research by the Commission's own Office of Economic Analysis comparing stocks of similar price and volume characteristics found no difference in percentage or effective spreads between issues subject to and exempt from off-board trading restrictions.6 In adopting Rule 19c-3 in 1979, the Commission concluded that the presence of alternative markets would provide additional incentives for markets to compete aggressively in the types and costs of services offered to brokers and investors.7 New services, dramatic advances in order handling technologies, and significant cost reductions over the intervening twenty years are clear evidence of the benefits of intermarket competition. Presumably, if fragmentation and market quality were a concern for listed stocks eligible for off-board trading, the Commission would have addressed this issue long since Rule 19c-3 was adopted in 1980.
The current concept release does not attempt to reconcile any of the prior analyses, findings and conclusions of the Commission and its staff. In view of the tremendous benefits investors have realized from the proliferation of new order handling technologies and new competitors, we urge the Commission to review these studies and carefully assess the potential impact of its current proposals on market efficiency and competition.
Transparency and Access
Congress's approach in establishing a national market system was that ready accessibility of quote information and prices would be the best prophylactic against fragmented markets. Fragmentation remains an issue only to the extent that NMS goals are not being fully realized, such as where the best market prices are not readily available to individual investors or where linkages are inefficient. Information about prices is critical to an investor's trading decision. While the exchanges mete out real time quotes for a fee, the level of price information is far less extensive (insufficient information about depth) and useful (unreliable without streaming updates) than what is readily available on a more cost effective basis to the professionals with whom they must compete for a fill. Regulatory sanctioned monopolies prevent the retail customer from accessing similar information on similar terms.
The high cost and inaccessibility of this critical market data also frustrate the Commission's limit order display rule by preventing the retail customer from confirming display of its order, tracking the order and assessing market conditions to determine whether to update the order. This disadvantage will only be exacerbated with the move to decimal pricing. Professionals with access to real-time streaming quote data offering to pay a penny more than the displayed quotes will be able to step ahead of orders from retail customers who have no ability to monitor their orders and jockey for position.
The other contributing factor to any vestigial fragmentation we still see in our market is the absence of efficient linkages. While competition and innovative new linkages have played a significant role in addressing inefficiencies on Nasdaq, an outdated regulatory sanctioned monopoly continues to impede new entrants, technological innovation and efficient linkage in the market for exchange-listed securities. In particular, the ITS linkage connecting the listed markets is slow and cumbersome and plagued by antiquated technology and an unworkable governance structure that is used to deny access to new participants and prevent meaningful reform. Absence of linkage is also a crucial issue in the market for exchange-listed options, although we note that private vendors are already developing their own linkage solutions and the Commission is currently evaluating several proposals for an industry linkage connecting the five options exchanges.8
Experience has repeatedly shown that in an unfettered competitive market, participants and private vendors will respond to perceived inefficiencies with a market-based solution. Fragmentation is no exception. A variety of ECNs and other trading systems have responded to complaints about fragmented markets and inefficient linkages with systems that consolidate and provide efficient access to the best prices among competing participants in the Nasdaq market. When the current Nasdaq linkage (SelectNet) proved too expensive and inefficient to handle today's record volumes, market participants forged links with one another to create trading networks that bypass SelectNet for faster and more reliable access to the best market prices. The Nasdaq Stock Market, with its SuperMontage proposal, is now responding with its own virtual system to consolidate and route trading interest among competing markets.
Our markets are constantly evolving, and a competitive marketplace ensures that inefficiencies are only temporary. Multiple markets and better technology are the best solution for getting a customer the lowest price. Regulatory intervention in market structure should be limited to removing regulation that impedes competition among markets, as in the case of the outdated infrastructure and governance of the ITS linkage for listed stocks.
B. Order Routing Disclosures
Schwab has long believed that greater transparency - including transparency about how the market operates and how orders are handled - empowers customers. We are therefore ardent proponents of maximum disclosure about the quality of order handling and execution available in competing market centers. In fact, we have been frustrated in our own attempts to obtain useful execution data from certain markets and thus appreciate the Commission's interest in enhanced disclosure.
Although the Commission could require markets and/or broker-dealers to calculate and publish execution quality data in a standardized format, to ensure the usefulness and reliability of any standardized disclosure, the Commission would have to be sensitive to a number of important considerations. First, any required disclosures must address a broad range of empirical factors that affect execution quality, such as the likelihood of receiving the quoted price and the potential for receiving worse prices; the availability of price improvement; the speed of execution and confirmation; and the level of fees and other costs of obtaining an execution. Second, as the Commission has repeatedly recognized, additional factors such as the capacity and reliability of order handling and processing systems, the difficulty of obtaining an execution in a particular market, and the level of service provided by a market, will also necessarily have a bearing on a firm's order routing decisions.9 It is difficult to conceive how these less quantifiable but no less important factors might be incorporated into any standardized disclosures.
The Commission also needs to be sensitive to the very real concern about potential selection bias with respect to data on execution quality. Different markets handle orders from different types of customers with very different trading characteristics and consequently, different execution prices. Different securities also imply different trading characteristics and pricing. These factors make it very difficult to draw meaningful conclusions from one-dimensional execution data and highlight the limitations of standardized disclosures. A far better alternative would be to require each market to make raw data on execution quality regularly available to broker-dealers and the public at large. This would afford brokerage firms and private vendors the best opportunity to analyze the data in accordance with the specific needs and expectations of their customers and to control for differences in trading characteristics among different types of customers and securities. Ultimately, the quality of broker-dealer disclosure will be dependent on how the Commission resolves these issues for market center disclosure.
C. Internalization and Payment for Order Flow
Segmentation of Retail Orders
The Commission's release reflects concerns that internalization and payment for order flow are fragmenting trading and undermining market efficiency by preventing retail orders from interacting in the broader market. The reality is that by segmenting retail orders, market makers and specialists on the exchanges and Nasdaq can offer these customers a far better deal than is available to any other market participant. Because it is less risky to trade with a retail customer than with an institution or other professional, market makers and specialists are willing to provide retail orders a better price in the form of price improvement than the one-size-fits-all price (their displayed bid or offer) they charge the rest of the world. In addition, retail customers receive automatic execution and other special order handling services not available to other traders. This practice of routing retail orders to specialists and market makers for special handling is no different from the customer segmentation practices we see in other industries, such as insurance and banking, which result in lower prices for the least risky and least expensive customers. In the securities markets, however, some academics theorize that these practices reduce efficiency for the overall market in that all orders are not interacting in a central place. Theory aside, from the perspective of the retail customer, the fact is that segmentation nets the customer a better price.
For a firm entrusted with hundreds of thousands of orders each day, internalization is one of the most effective ways to ensure our customers get reliable, high quality executions. Our proprietary technology is one of the major advantages. Schwab has consistently been at the forefront of developing new trading platforms to serve its customers. Executing orders through our own specialists and market makers allows us to use state-of-the-art technology we develop, ensures that our customers get attentive service, and allows us to offer customers value-added benefits such as stop order protection, price improvement and automatic execution guarantees that are not always available in other markets. Our proprietary trading technology is producing similar benefits for customers in the options markets, where we have begun facilitating larger customer orders as principal. To date, customers have received over $6 million in price improvement as a result of this program.
Order Flow Rebates
Potential conflicts of interest arise in virtually every facet of the securities business: research and underwriting; advice and sales commissions; brokerage and dealing. These tensions predate the Exchange Act and the Commission itself, but in recognition of the cost to capital formation and market efficiency of strict separation, Congress (and the Commission) have instead consistently relied on the disinfectant of sunlight and full disclosure to protect customers. In this same vein, after an exhaustive analysis of payment for order flow in 1994, the Commission concluded that as long as brokers were providing their customers with best execution and as long as the practice was adequately disclosed, the practice could actually lead to more competition in the market and a reduction in transactions costs for customers. The Commission's current release does not explain what has changed in the intervening six years - a period marked by increased competition, significant reductions in transactions costs, major innovations in order handling services, and significant reductions in order flow rebates - that would now lead the Commission to a different conclusion.
At the time, the Commission determined that enhanced disclosure coupled with the broker's traditional duty of best execution would be sufficient to protect investors from the potential conflict of interest inherent in order flow rebates. And indeed since then, firms have expanded their disclosures, standards for handling customer orders have become more stringent as a result of new rules and interpretations, and monitoring of execution quality (both by firms and by regulators) has become more rigorous. It would appear that the approach adopted by the Commission in 1994 is being realized. Also consistent with the Commission's expectations at the time, competition for order flow has produced enormous benefits for retail customers as markets, specialists and dealers have raced to offer innovative new services such as automatic execution, liquidity enhancement, print protection, automated price improvement opportunities, automatic crossing of orders, mid-point pricing for opening orders on Nasdaq, and automatic stop order protection, to name a few. In this light, it is unclear why the Commission would now consider measures to restrict competition for retail order flow.
As with internalization, the practice of payment for order flow arises because orders from retail investors are less risky and specialists and market makers are therefore willing to pay rebates of perhaps a penny or so per share to brokerage firms to attract these types of orders. Payment for order flow is also a necessary, competitive response to regulated minimum increments. In a world where orders cannot be executed at any price, order flow rebates allow market makers and specialists to move along the continuum of prices to the optimal price. The practice is so widespread that just about every retail brokerage firm receives some form of payment or reciprocal order flow for its customer orders, and even various exchanges, ECNs and the NASD pay for order flow in one form or another.
The rebates we receive from payment for order flow help lower our costs, and we pass these savings back to customers. Firms like ours use cost savings and rebates and even trading profits from executing customer orders to expand the menu of services we offer customers and to lower the prices we charge them. For example, new rebates and cost savings on various exchanges recently enabled us to lower commissions for active traders and we continue to explore additional ways to pass on savings and rebates to our customers. Order flow rebates also help defray the costs of providing customers with access to real time quotes and certain types of research. Basic economics dictates that in a competitive market, reductions in marginal cost will get passed back to customers in the form of lower prices (is there any doubt, with brokers offering trades for zero commissions, that retail brokerage is not intensely competitive?) and at least one study has found a positive correlation between payment for order flow and lower commissions.10 The Commission's concept release does not indicate whether the Commission itself has conducted any analysis of the extent to which payment for order flow redounds to the benefit of customers.
Sensitive that order flow rebates may nonetheless create the appearance of a conflict of interest, Schwab took a strong stand against payment for order flow in 1996 and tried to lead the way to eliminate the practice. Competition forced us to back off from this position. Nevertheless, to ensure that the potential conflict of order flow rebates does not undermine our goal of getting best execution for customers, firms like ours go to extraordinary lengths to measure and compare execution quality among the various markets. Execution quality is what drives order routing decisions, and our customers, who are some of the most educated and sophisticated around, would not have it any other way. These customers use their access (albeit limited) to real-time quotes, "time and sales" information and other market tools to keenly scrutinize the executions they receive. The best strategy for protecting customers is to give them better information and tools: real-time information about market prices and depth so they can better assess the quality of their executions, and consistent with the Commission's proposals for enhanced disclosure, accurate information about the quality of executions available in each market.
The NYSE's Price Improvement Proposal
The Commission's release seeks comment on a proposal by the New York Stock Exchange that would prohibit specialists or market makers on any other market from executing orders as principal unless they provided a certain form of price improvement. Although we are supportive of ways to obtain better prices for customers, the proposed requirement would prescribe one form of improving prices at the expense of all other forms of price improvement. There are a variety of ways to give customers a better price than the quoted market - for example, getting a sixteenth more for the customer's sell order, or perhaps executing a 2000 share order at the market quote when the quote was only good for 500 shares (often referred to as "liquidity enhancement" or "size guarantees"). The NYSE proposal focuses on one form of price improvement (shaving a sixteenth from the best bid or offer) but would exclude other forms of price improving orders offered by competitors but less prevalent at the NYSE itself. Our own specialists and market makers employ a variety of methods to obtain price improvement for customers. These customers would be deprived of tens of millions of dollars each year in improved prices obtained through other forms of price improvement that would be precluded under the NYSE's proposal. Markets should be free to compete on how they provide price improvement, and firms seeking best execution for their customer orders should be free to choose among them. Regulation should not be used to favor the interests of one competitor over another.
In actuality, the NYSE's proposal is a thinly veiled attempt by the Exchange to erect new barriers to competition in the wake of Rule 390. Forced to repeal its anticompetitive off-board trading restrictions, the NYSE now proposes an alternative means to restrict competition by proposing a rule to limit firms from sending orders to its competitors in the OTC market and on the regional exchanges. Indeed under the proposed rule, NYSE specialists could continue to match the prices of other markets without providing price improvement. Although the Commission's release characterizes the NYSE as an "agency market,"11 a 1997 Commission study found that NYSE specialists trade as principal on 18% of shares traded.12 In fact, NYSE specialists traded more shares as principal than the total number of shares traded as principal and agent on all of the regional exchanges combined.13 The Commission's release does not explain why NYSE specialists should be treated differently, or how such discrimination could be justified by the purposes of the Exchange Act.
Although the NYSE has long argued that market quality depends on centralizing orders on the NYSE, the Commission's 1997 report on the practice of preferencing found that execution quality on competing markets was as good and in some cases exceeded that available on the NYSE. For example, limit orders sent to certain regional exchanges had a higher likelihood of execution and price improvement rates on market orders and marketable limit orders were comparable and sometimes better on certain regionals.14 It would hardly seem consistent with market quality to divert orders from competing markets willing to provide a faster execution at the same price and at lower cost. As the Commission has consistently recognized, competition from the regional exchanges and OTC dealers trading listed stocks has produced such innovations as automated order handling and print protection, and has driven the primary markets to respond with their own order handling enhancements.15 Indeed, the NYSE has recently proposed offering automatic execution against the specialist's book, another example of how competition from other markets has spurred change at the NYSE.16 Forcing centralization of order flow on the NYSE would deprive investors of the benefits that have been realized through competitive alternatives to a market that has been consistently slow to innovate. Instead of erecting new barriers to markets seeking to compete with the NYSE, the Commission should be eliminating existing impediments to competition, such as certain anticompetitive and anachronistic aspects of industry linkage and price reporting plans.
The Commission's release also seeks comment on whether the Commission should require firms to offer customers an opportunity for price improvement by exposing customer orders to price competition. As a general matter, we are supportive of order handling systems designed to get better prices for customer orders, and in fact, order exposure is one of the methods used by our own specialists and market makers to regularly obtain price improvement for customers. Nonetheless, we would have significant concerns if the Commission were to prescribe one form of price improvement over all other possible methods of obtaining improved prices, especially to the extent a single price improvement formula would preclude competition and the development of innovative alternatives.
Depending on market conditions and other factors, mandatory order exposure could also have a negative impact on execution quality. For example, publishing a marketable order at an improved price in the NBBO presents a trade-off between a delayed execution and an opportunity to receive a better price. The Commission asks whether investors would not be willing to wait a few seconds for the possibility of a better price, but the question is really whether customers would be willingly to wait for a better price at the risk of receiving a worse price, or in the case of a limit order, of not receiving an execution at all. Certain forms of mandatory order exposure would also impose significant operational difficulties on the market, increasing message traffic and slowing quote information that would seriously affect the quality of the information disseminated to investors. Accordingly, we would encourage the Commission to allow competition among market participants to determine the most appropriate mechanism for obtaining price improvement for customer orders and promoting an efficient market.
D. Time Priority
Common Message Switch
The Commission's release includes three proposals intended to address the possibility that limit orders displayed in one market may be isolated from interacting with trading interest occurring on other markets. Each of these proposals would require market participants to adhere to varying degrees of time priority in executing customer orders. With our markets frequently expected to handle hundreds of quote updates and transactions per second, time priority in any form would necessitate a computerized message switch to monitor the timing of quote updates and route orders accordingly. Time priority would therefore require the development of expensive, inefficient and unreliable infrastructure and would impose severe technological constraints on our national market system.
As an initial matter, a common message switch would introduce a single point of failure that would undermine the capacity, reliability and resilience of our marketplace. Today's system of multiple competing markets affords maximum redundancy if one market or market center encounters systems problems. No one systems failure would bring the entire market to a halt - indeed, when individual markets and market centers have experienced systems problems forcing a closing of their own markets, the other participants have been able to continue trading and service the additional business. In contrast, with a common message switch, any failure in the technology imbedded in the switch would render all markets inaccessible. Furthermore, without market incentives to continually update and innovate, the technology of a time-priority message switch will inevitably be the most cumbersome and inefficient among routing alternatives. Indeed, this has consistently proven the case with industry linkages in the equities markets, such as SelectNet and ITS.
Forcing all order flow through a common message switch also forecloses opportunities for private vendors to offer alternative competing networks. The open market structure of the national market system for equities has made it possible for private network vendors and even the markets themselves to offer more efficient and cost effective alternatives to cumbersome, expensive and technologically obsolete utilities such as SelectNet and ITS. This model of industry utilities coupled with competing private linkages among markets is a far preferable architecture in terms of capacity, redundancy, efficiency and innovation than a single monopoly messaging structure.
Market-Wide Limit Order Protection Rule
The first of the Commission's time priority proposals is for a limit order protection rule that would obligate participants to protect limit orders displayed on a competing market. As noted above, the message switch required to enforce priority among displayed orders and ensuring protection of appropriate orders on other markets would introduce a single point of failure, slow the execution of customer orders and otherwise impair execution quality. These costs are hardly justified by the potential theoretical benefits of the proposed limit order protection obligation. Indeed, we have seen no data to suggest that customer limit orders have been disadvantaged in the absence of such an obligation. The market itself and an alignment of interests between broker and customer ensure best execution of limit orders. With brokers only receiving a commission if a limit order is executed, brokers have every incentive to route orders to markets that ensure the highest likelihood of execution.
Concerns about protecting retail limit orders can be addressed with far less expense and dislocation by allowing competitive forces to operate and by ensuring stringent enforcement of a broker's best execution obligation to ensure that customer limit orders are handled in a manner ensuring high likelihood of execution. By way of example, to ensure that customer limit orders receive sufficient opportunities for execution, certain regional stock exchanges require their specialists to protect customer limit orders against transactions at the limit order price in the primary market. Because likelihood of execution is an important component of a broker's best execution analysis, even those specialists and market makers that are not subject to these "print protection" obligations protect their customers against prints in the primary markets.
Finally, we note that any proposal to protect "investor" limit orders would require the Commission to draw bright-lines in the mostly gray area distinguishing investors from traders. As a general matter, there is little practical difference between dealers, institutional traders and even certain active retail traders, all of whom may have comparable access to market information, tools and trading interest. Beyond the definitional difficulties, discrimination against the quotes of certain market participants would undermine the Commission's stated goal of promoting quote competition since certain "investor" bids and offers would always take precedence.
Time Priority for Displayed Trading Interest
On the theory that time priority would incent more aggressive quotes, the Commission has proposed several versions of a mandatory time-priority linkage that would route orders to the market that was first to quote the inside price. As an initial matter, we are concerned that time-priority routing would prevent competition on any basis other than who can update their quotes the fastest. For example, time priority would prevent competition among markets with respect to price improvement. Today, a market may match the prices available in another market, plus offer its customers additional value-added benefits such as price improvement opportunities and liquidity guarantees. With time priority, markets would have no competitive incentive to offer price improvement or otherwise facilitate retail orders, which would be executed automatically at the prevailing quote. Time priority would thus effectively eliminate the possibility of price improvement and accord more value to speed of quotation updates than to getting the best price for a customer's order.
Time priority would also prevent competition on numerous other factors on which markets compete. We note that there are significant differences among the various markets with respect to quoted market depth and liquidity guarantees, the speed and reliability of order routing and execution systems, the ability to handle more complex orders, the frequency of errors and commitment to error resolution, and the level of exchange fees and other trading charges. Indeed, experience prior to full multiple listing of options demonstrates the enormous problems firms had in trading certain of the most actively traded options when there was no alternative but to execute such orders on exchanges with inadequate technology and operational infrastructure and resources. Customers are reaping enormous benefits from competitive initiatives by the various markets to offer price improvement and other services, reduce fees, and roll out the newest and best technology. It would be unfortunate to now force customers into a game of Russian Roulette in the form of a time-priority routing switch that risks problem executions in one or more markets not adequately prepared under the circumstances to provide best execution and eliminates any competitive incentives to innovate.
The arguments for time priority are based on unsubstantiated academic theories. Advocates of time priority argue that replacing today's system of competing markets with a centralized time-priority switch would incent traders to quote more aggressively since the first trader at the quote would get the first order. Of course, in the real world competition is a difficult thing to legislate, and there is no evidence that government-mandated time-priority routing would in fact lead traders to quote better prices (and even more importantly, to provide better executions) than in an unfettered marketplace where participants are free to compete with one another on price improvement, liquidity and any number of other factors.
Advocates for time priority also fail to anticipate the tremendous change that decimals will have on quote behavior and our markets generally. Although today's minimum tick sizes make it relatively expensive for traders to outbid one another, the entire academic debate about the theoretical incremental benefit of time priority becomes moot when our markets convert to full decimal pricing, at which point it will be relatively inexpensive for traders to establish price priority by offering to pay a penny more than the next trader. In any event, it is likely that the anticipated narrowing of spreads as a result of decimalization will eliminate any potential incremental benefit from time priority.
A Level Playing Field for the Retail Customer
A particularly disturbing element of the Commission's proposal for a time-priority linkage is that institutional orders would be exempt from the display and time priority requirement. Retail customers are already at a major informational disadvantage to institutional customers in terms of access to market information. Rules that carve out institutional investors put individuals at a further disadvantage to institutions and other professionals who hold back the bulk of their trading interest on upstairs trading desks or ECN reserve books. It would be grossly unfair and discriminatory to require full display of all retail orders when retail customers would not have the same opportunity to gauge institutional trading interest.
The professional's proximity and ability to closely monitor trading activity allows them to pick off retail orders just as the market starts moving against them, to step ahead of retail orders when the market starts moving in their favor (an advantage that will only get worse with decimals and the ability to step ahead of retail orders by bidding only a penny more), and to pick and choose when they want their own orders displayed. There are frequently situations where a customer seeking to avoid telegraphing trading interest to the market would not want their order displayed; and while this may seem more obvious for the institution with a 20,000 share order, it is just as true for the 20 retail customers when their individual 1,000 share orders get aggregated and displayed. Rather than increasing transparency, disparate display requirements for retail and institutional orders would only discourage retail customers from using limit orders to avoid getting picked off. The Commission should encourage maximum transparency by giving ordinary investors ready access to the same market information available to professionals. The Commission should be skeptical of proposals that force retail customers to tip their hands while allowing the professionals to play their cards upstairs and close to the vest.
* * *
While we share the Commission's interest in a transparent and efficient market, we believe that market regulation should be designed to provide maximum opportunities and incentives for competition and innovation. Individual investors have benefited enormously from a competitive market structure that has fostered competition and innovation and resulted in better prices, faster turnaround times, and lower fees. Costly new bureaucracies, rules and infrastructure will only stifle competition, discourage the development of alternative order handling mechanisms, and increase transaction costs for investor orders. Fragmentation remains an issue for investors only to the extent that NMS goals of accurate price information and efficient linkage have not been fully realized. Any meaningful assessment of fragmentation must therefore begin with the various regulatory impediments that inhibit competition and efficient access between markets and prevent transparency of critical market information.
Please do not hesitate to contact us if you would like to discuss these issues in further detail.
cc: Hon. Arthur Levitt, Chairman
Hon. Norman Johnson, Commissioner
Hon. Isaac C. Hunt, Jr. Commissioner
Hon. Laura Simone Unger
Hon. Paul R. Carey, Commissioner
Joseph Lombard, Counsel to the Chairman
Annette Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Senior Associate Director, Division of Market Regulation
Elizabeth King, Associate Director, Division of Market Regulation
|1||See, e.g., NASD Economic Research, Market Quality Monitoring: Overview of 1997 Market Changes, at 2, as cited in Securities Exchange Act Release No. 39884 at n.312 (April 17, 1998).|
|2||Schack, Cost Containment, Institutional Investor, November 1999, at 43.|
|3||Remarks by Chairman Arthur Levitt, U.S. Securities and Exchange Commission, at Columbia Law School, New York, NY (September 23, 1999).|
|4||Division of Market Regulation, U.S. Securities and Exchange Commission, Market 2000: An Examination of Current Equity Market Developments at 13-14.|
|5||Id. at 14 (January 1994).|
|6||Office of Economic Analysis, U.S. Securities and Exchange Commission, Fragmentation vs. Consolidation of Securities Trading: Evidence from the Operation of Rule 19c-3, at 10-11 (March 1995).|
|7||Securities Exchange Act Release No. 16888 at 12 (June 11, 1980).|
|8||See Securities Exchange Act Release No. 42456 (February 24, 2000).|
|9||See, e.g., Market 2000 Report, supra note 4, at V-2 to V-3, citing Second Report on Bank Securities Activities: Comparative Regulatory Framework Regarding Brokerage-Type Services 97-98, n.233 (February 3, 1977).|
|10||See Battalio, Jennings and Selway, Dealer Revenue, Payment for Order Flow, and Trading Costs for Market Orders at Knight Securities, L.P., NASD Working Paper 98-03 (August 1998).|
|11||Securities Exchange Act Release No. 42450 at Section IV.A.2. (February 23, 2000).|
|12||U.S. Securities and Exchange Commission, Report on the Practice of Preferencing 51 (April 11, 1997).|
|14||See, e.g., id. at 160-61.|
|15||See, e.g., Market 2000 Report, supra note 4, at 13-14.|
|16||File No. SR-NYSE-00-18, Securities Exchange Act Release No. 42913 (June 8, 2000).|