May 26, 2000
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention Jonathan G. Katz, Secretary
Re: Securities Exchange Act Release No. 42450, File No. SR-NYSE-99-48
Ladies and Gentlemen:
Orrick, Herrington & Sutcliffe, LLP is pleased to respond to the concept release1 issued by the Securities and Exchange Commission ("Commission") on market fragmentation, which was released in conjunction with the New York Stock Exchange's ("NYSE") proposal to remove NYSE rule 390, its off-board trading ban. We commend the Commission for undertaking a review of the market-structure issues posed by the perceived decentralization of the U.S. equities markets.
We represent many clients in the brokerage industry with an interest in these issues and believe they deserve careful attention. A primary concern for many of our clients is the ability to provide fast, cheap and reliable trade executions at the best prices possible. Ensuring fair, efficient, deep, and liquid markets for all investors is paramount to achieving this goal.
We believe that vigorous competition naturally leads to the deepest and most liquid markets possible. We are concerned that any approach that favors regulatory reforms over competitive solutions to perceived pricing inefficiencies would impede market innovation and the concomitant high quality of order execution available in the U.S. markets.
The national market system ("NMS"), instituted by 1975 amendments to the Securities Exchange Act of 1934 ("Exchange Act"), maintains a careful balance among the many competing players in the securities markets. The NMS is premised on fair and vigorous competition enabling multiple pools of liquidity to interact and providing different venues for trading that offer investors different advantages. Vigorous competition among market centers and market participants, rather than strict regulatory controls, provides investors with the best prices and the deepest, most liquid markets possible.
II. Specific Comments
A. Replacing Rule 390 with a Price-Improvement Rule
We applaud the removal of NYSE rule 390 and support removal of all other off-board trading restrictions.2 These rules unfairly limit exchange members' ability to trade securities in the over-the-counter market or in-house, thereby isolating pools of liquidity and limiting investor choice among trading venues.
The NYSE, however, has urged the Commission to institute a new market-wide rule in place of rule 390 that would prohibit any broker-dealer from executing orders in-house or through an affiliate, a practice known as "internalization," unless it offers a better price than the prevailing national best bid or offer ("NBBO") representing trading interest displayed on the national securities exchanges and Nasdaq. The claim that such a rule is necessary to combat market fragmentation is ill conceived. Congress twenty-five years ago saw the off-board trading rules as "unnecessary regulatory constraints"3 and called on the Commission to review and amend those off-board trading rules that imposed an unnecessary burden on competition. The Commission, upon review, found the off-board trading rules anti-competitive.4
A new rule along the lines suggested by the NYSE would largely extend the trading limitations associated with rule 390 to all equities and severely weaken the Commission's own rule 19c-3, which was adopted to limit the scope of rule 390 by allowing off-board principal trading by exchange members in securities listed after April 26, 1979. Such a rule would protect order flow and trading-fee revenues for the primary markets, most notably the NYSE, by effectively compelling the routing of orders to the market center displaying the best quote (usually the primary market) unless a better price, not simply a matching price, were offered in-house. Yet, this rule would not necessarily guarantee a better net price for investors by ensuring lower overall transaction costs. Moreover, such a rule would ultimately be harmful to market competition and price improvement.
B. The Commission's Proposals on Fragmentation
The Commission has put forward several possible regulatory responses to the concerns raised by the NYSE about internalization and perceived market fragmentation, ranging from enhanced disclosures to implementing various price-time priority schemes among the securities markets. As a general matter, we are concerned that those initiatives that would impose new regulatory obligations on market participants would undermine rather than enhance market efficiency, particularly to the extent that they would strive to centralize trading interest through a single point of interaction.
C. Specific Comments on Fragmentation
The Commission's goal of improving price competition is laudable; however, we believe that a regulatory response would ultimately do more harm by restricting the free play of competitive forces within the market and by interfering with broker-dealers' service to their customers. The concept release is intended to respond to the claim that internalization and payment-for-order-flow practices harm price improvement. On the contrary, internalization offers greater depth to the market, which promotes liquidity and thus aids price improvement while stemming volatility. Consequently, internalization enables many broker-dealers to provide superior services to their customers. Similarly, payment-for-order-flow programs are instrumental to many broker-dealers' efforts to enhance their services, improve execution quality and reduce commissions. Regulatory limitations on these practices would impair their ability to effectively compete for order flow.
i. The Benefits of Internalization and Payment-For-Order-Flow
Internalization enables broker-dealers to match an order at a price that at least equals the prevailing NBBO. This practice offers fast executions that eliminate the risk of losing favorable executions should the market move away while customers' orders are exposed to the market. Internalization thus benefits individual orders; however, it also promotes better market-wide prices because it fosters competition among multiple broker-dealers.
Price-improvement opportunities are most effectively realized when competing market participants have an incentive to improve their own prices and provide superior execution quality so as to enable them to capture increased order flow. If an order was required to be routed to the individual order representing the best quote, broker-dealers would lose the incentive to match that price. If a broker must exceed that price, it may not be willing to commit additional capital to do so. Instead, the broker could simply route the order to the best quote. If orders must be routed to the best quote, market participants will know that that quote is of a finite size and will likely be exhausted quickly. Once the best quote is satisfied, inferior quotes can move up the queue. While routing to the best quote improves a limited number of orders (i.e., those necessary to satisfy the best quote), the ability for broker-dealers to match the NBBO puts price pressure on multiple broker-dealers to increase prices for a much larger volume of orders. In this regard, internalization fosters liquidity and depth. Internalization also reduces overall transaction costs, which savings can be passed on in the form of lower commissions.
Like internalization, payment-for-order-flow programs offer improved execution quality and help broker-dealers offer inexpensive, reliable and fast service. In addition, broker-dealers use these programs to fulfill their best-execution obligations, not to circumvent them. The savings afforded by these programs further contribute to lower commissions.
ii. New Market-Fragmentation Rules Would be Harmful
We believe new market-fragmentation rules along the lines suggested by the concept release would reduce price improvement opportunities by diminishing liquidity and depth, resulting in wider spreads. Moreover, such rules would limit broker-dealers' ability to exercise their professional judgment in achieving best execution for their customers, replacing that judgment with inflexible regulatory restraints.
These concerns are particularly acute with respect to any proposal that would funnel market-wide customer orders through a single queue for display and execution, such as a central limit-order book. This would slow down executions and the ability to capture favorable prices in fast-moving markets and, if restricted to public limit orders, would impede the ability of those limit orders to interact with other trading interest.5
In addition, such proposals could reduce dealer activity. In many instances, dealers and other market professionals provide a sense of the market value of a security by supplying a critical mass of trading interest and activity. In addition, active dealer participation is necessary to reduce temporal fragmentation whereby customer buying and selling demand is not represented at the same time, thus causing temporary price imbalances. Reducing dealer participation and increasing reliance on customer orders meeting directly will thus reduce the valuable pricing information and continuous liquidity available in the market and may increase the opportunity for artificial price pressures, such as short selling or manipulation, to disrupt the markets.
iii. Competition vs. Regulation
The better approach to encouraging price improvement and liquidity is a combination of competition, better access to real-time market data (i.e., transparency) and faster order-routing links, not centralized order interaction. Federal Reserve Board Chairman Alan Greenspan recently professed his own "confidence in competition as the fundamental guide to the organization of our markets:"
It has never proved wise for policymakers to try to direct the evolution of markets, and it strikes me as especially problematic at this juncture. The structure of our equity markets is extraordinarily dynamic; hardly a week goes by that a new trading venue is not announced or an enhancement to an existing system is not trumpeted. None of us can anticipate which of these venues will hit upon the combination of services that best meets the needs of investors. That can only be revealed as competition establishes winners and losers.6
While on their face, rules that dictate centralized order interaction may seem beneficial, they constrain the ability of start-up (and mature) ventures to test their ability to develop better and faster trading services. Such developments raise the bar for all market participants and foster benefits for investors that regulation cannot replicate. In addition, the development of multiple trading venues can actually benefit competition in the market as well as price improvement by allowing multiple pools of liquidity to compete rather than routing all orders through a single mechanism.
In fact, technology is available today that allows broker-dealers to search for superior prices among competing market centers. Broker-dealers will compete on the basis of their ability to execute orders not only quickly, efficiently and anonymously but also on their ability to provide superior prices. The tools used to accomplish these tasks are improving in response to market competition. The voluntary after-hours and ECN linkage models demonstrate that voluntary linkages will arise in response to competitive pressures.
By contrast, a regulatory approach that creates a single point for all order interaction poses several serious risks for the market. It would create a new NMS monopoly service provider, replacing competitive pressures with regulatory protections. This approach has proven sub-optimal. The Intermarket Trading System ("ITS"), for example, uses inefficient technology and lacks the ability to respond nimbly to market changes due to competing incentives among its members. Even the NYSE, a major participant in the ITS and other NMS programs, has recently announced its desire to withdraw from the Consolidated Tape Association, a major NMS program, and its determination that ITS should be dismantled -- both on the grounds that competitive forces can better achieve the goals the NMS programs were designed to meet. The sole-source model of the NMS plans is less efficient because it must satisfy the needs of many constituencies within the market and is prone to creating bureaucracies that delay improvements rather than reward innovations. Significantly, this type of system replaces investor and broker-dealer discretion in routing and executing decisions with automated decision making. Perhaps most alarming, a central point of order interaction poses the substantial risk of a system failure with disastrous implications for the market.
D. A Measured Approach is Warranted
The existing market structure provides the essential tools for ensuring the best price discovery. The Commission should allow competitive forces to work within this framework to respond to customers' demand for the best prices possible.
We urge the Commission to take a measured approach to the perceived market-fragmentation concerns raised in the concept release. As an initial matter, the Commission has not demonstrated a need for new market-integration rules. In fact, the release notes a low degree of fragmentation for equities. This in large part is due to the success of the Commission's 1996 amendments to the order handling rules, which included public limit orders in quotes and provided for ECN linkages to Nasdaq. These measures already ensure that limit orders contribute to vigorous price discovery. In addition, best-execution principles (and ITS trade-through rules) further ensure that customer-trading interest is executed upon the most favorable terms possible.
In addition, the Commission should not pursue additional regulatory initiatives aimed at combating fragmentation and improving prices until the effects of decimalization on market structure and pricing have been evaluated. The impact of decimalization is yet to be seen. It may lead to more vigorous quote competition, as it will be more cost-effective for broker-dealers to offer improved prices. On the other hand, it may reduce investors' opportunity for price improvement and may slow execution times by making it cheaper for dealers to step ahead of customer orders. The changes suggested by the Commission may be counterproductive in a decimal-based trading environment where an order's priority can be circumvented for a penny. Such changes could also cost more to implement and oversee than they would save in terms of price improvement. The additional costs would ultimately be borne by investors through higher execution costs, commissions and other charges.
To further achieve maximum price competition, the Commission should ensure meaningful and equal transparency for all investors, whether professional or non-professional investors. For example, many retail investors could benefit significantly from ready, affordable access to Nasdaq Level II data. Armed with the most complete market information, investors can do more to stimulate competition for price and execution quality by placing limit orders that compete with displayed quotations.
Finally, the Commission should evaluate the purported problems raised by elimination of NYSE rule 390 after the rule has been removed, rather than institute reforms in anticipation of those problems arising. This will also give the industry the opportunity to respond to any problems that do arise through marketplace solutions.
The concerns raised by the concept release merit the attention of the Commission. We strongly urge the Commission, however, to evaluate the potential burdens associated with adding new layers of regulation to resolve these concerns. We believe that time and experience will show that a better approach to improving market efficiency and pricing quality is to foster competition through marketplace solutions, rather than creating a marketplace bound by rules that dampen competition -- even with the best intentions.
Very truly yours,
\ s \
Sam Scott Miller
cc: Arthur Levitt, Chairman
Norman S. Johnson, Commissioner
Isaac C. Hunt, Jr., Commissioner
Paul R. Carey, Commissioner
Laura S. Unger, Commissioner
Annette Nazareth, Director
Division of Market Regulation
Robert L.D. Colby, Deputy Director
Division of Market Regulation
Belinda Blaine, Associate Director
Division of Market Regulation
Elizabeth King, Associate Director
Division of Market Regulation
1 Exch. Act Rel. No. 42450 (Feb. 23, 2000), 65 Fed. Reg. 10577 (Feb. 28, 2000).
2 See e.g., Exch. Act Rel. Nos. 42459 (Feb. 25, 2000)(File No. SR-CHX-99-28); 42460 (Feb. 25, 2000) (File No. SR-Amex-00-05); and 42458 (Feb. 25, 2000) (File No. SR-Phlx-00-12)(prosing removal of off-board trading restrictions for the Chicago Stock Exchange, the American Stock Exchange and the Philadelphia Stock Exchange).
3 S. Rep. No. 94-75 (1975), reprinted in 1975 U.S.C.C.A.N. 179, 198.
4 Amendment or Abrogation of Exchange Off-Board Trading Rules, 40 Fed. Reg. 41808 (1975); see Macey and Haddock, Shirking at the SEC: The Failure of the National Market System, 1985 U. Ill. L. REV. 315, section V.A.
5 See e.g., Testimony of J. Joe Ricketts, Chairman, Ameritrade Holding Corporation at the Hearing on "Trading Places: Markets for Investors," before the Senate Committee on Banking, Housing, and Urban Affairs (Mar. 22, 2000) (noting that "[e]ven the NYSE presently depends on a 40 percent ratio of proprietary volume to public volume in order to provide the continuous liquidity demanded by investors").
6 Testimony of Alan Greenspan, Chairman, Federal Reserve Board at the Hearing on "Evolution of Our Equity Markets," before the Senate Committee on Banking, Housing, and Urban Affairs (April 13, 2000) (cautioning against the implementation of a central limit-order book).