March 20, 2000
Jonathan G. Katz, Esquire
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
RE: File No. SR-NYSE-99-48; rescission of Big Board off-board principal restrictions
Dear Mr. Katz:
The Ashton Technology Group, Inc. ("Ashton") welcomes the opportunity to comment on: (i) the above referenced proposed rule change of the New York Stock Exchange, Inc. ("NYSE"); and (ii) the NYSE's request for the Commission to adopt a market-wide requirement that all off-floor market makers not be permitted to trade as principal against customer orders unless the customer is able to buy at the consolidated best bid price or in between the consolidated best bid and offer price ("BBO"), or sell at the consolidated best offer price or in between the BBO ("NYSE Proposal"). Ashton reserves the right to address separately the Commission's request for comments on a broader range of issues relating to market fragmentation.
In summary, Ashton supports the rescission of exchange off-board trading restrictions such as NYSE Rule 390 if conditioned upon adoption of the NYSE Proposal as modified by an order exposure alternative, applying equally to upstairs market makers and exchange specialists, and calling for a new high powered order routing mechanism with auto-execution capabilities to access and trade against "exposed" orders.
The vigorous debate surrounding the efficacy of Rule 390 and its predecessor Rule 394 regarding agency and principal restrictions is older than the genesis of the 1975 Congressional mandate for a National Market System for securities trading.1 The debate has focussed on trade-offs between enhanced competition and the negative consequences of increased market fragmentation, with the Commission extolling countless times its desire to remove off-board principal restrictions if market fragmentation could be adequately addressed.
Indeed, in 1977, the Commission instituted a proceeding to adopt Rule 19c-2 under the Exchange Act that would have removed, by Commission fiat, all off-board principal restrictions. The Commission, however, ultimately moved in a measured fashion and adopted Rule 19c-3 that removed such restrictions only on securities listed on exchanges after April 1979. The Commission soon reviewed the impact of Rule 19c-3 in an early monitoring report that was inconclusive on whether the Rule had improved or harmed the market quality in the securities not subject to off-board trading restrictions or the so-called "Rule 19c-3 Securities."2
Having partially removed off-board principal restrictions, the Commission turned quickly to providing an opportunity for linking trading interests of upstairs market makers with exchange specialists in Rule 19c-3 Securities. In 1981, the Commission called for an automated interface between the intermarket trading system ("ITS") and the National Association of Securities Dealers, Inc.'s ("NASD") Computer Assisted Excution System ("CAES"). The ITS was envisioned to permit broker-dealer participants in geographically dispersed marketplaces to obtain access to each other's publicly displayed quotations. Before this limited linkage between exchanges and over-the-counter dealers was effected, ITS linked only registered exchanges.
On another front, the Commission spearheaded consideration of various order exposure rules specifically targeted to ameliorate any potential negative impacts caused by off-board trading of Rule 19c-3 Securities. The NYSE has consistently emphasized that a substantial proportion of orders executed on its floor are executed at prices superior to the BBO - in other words at prices in between the inside quotations or BBO. It was clear, therefore, that simple "quote matching" of the BBO price by internalizing firms, deprived customers of the opportunity for best order execution, and insulated or hid such internalized "captive" order flow from other competing market makers, specialists and market participants.
Accordingly, in December 1982, the Commission sought comment on a well-developed order exposure rule that would have been applicable to both upstairs market makers and exchange specialists (hereinafter either referred to as "Principal").3 The rule required the Principal to guarantee or "stop" its customer order for thirty seconds. During this thirty second period, the order had to be exposed in the public quotations at a price 1/8th point better than the Principal's proposed order execution price ("Stop Price"). If the order was not executed during the exposure period, the Principal could then execute the order at the Stop Price and cease exposing such order. If the market had moved adversely to the customer order while being exposed, the order would be guaranteed the Stop Price.
By August 1983, the Commission had tabled further consideration of the order exposure rule as a number of major upstairs market making firms ceased dealing in Rule 19c-3 Securities. Commentators at the time also had questioned the technical feasibility of exposing a substantial flow of orders, and the systemic ability of competing dealers to effectively reach out and execute against such exposed orders.
Years passed with no real progress on linkage developments or discussions regarding the removal of off-board trading restrictions. In 1990, the Division of Market Regulation called for all ITS participants to incorporate automated execution interfaces. The call went unheeded and no progress has been made on this issue to date. In the Commission's 1994 Market 2000 Study, the Commission once again focussed on Rule 390, but soon was distracted by the payment for order flow debate and upheavals in the NASDAQ marketplace that gave rise to major new order handling rules and a complete restructuring of the NASD. All the while, upstairs firms began to recognize how to escape the confines of Rule 390 by "internalizing" captive order flow and establishing specialist operations or joint account (profit sharing arrangements with other specialists) on the various regional exchanges (Rule 390 early on was interpreted to exempt trading through the facilities of any exchanges). Additionally, the relative number of new exchange listings has been growing yearly with many active issues now in this group. This has caused renewed interest in Rule 19c-3 Securities trading and the extent of off-board trading has increased.
Ashton is pleased to witness the final chapter on Rule 390 after such a long and contentious history. Ashton strongly believes in fair and open competition among marketplaces, market participants and market systems. Both exchange specialists and upstairs market makers should co-exist in a regulatory environment that encourages them to commit their capital to make the deepest and best priced markets for all public customers.
The rescission of Rule 390 is one step toward this goal. Other steps, however, must be taken expediently by the Commission and industry. Ashton believes that the Commission must exhibit the leadership in promulgating an order exposure rule with combined elements to those voiced in the NYSE Proposal and the Commission's December 1982 proposal. In short, this would be an order exposure rule for listed securities applying market-wide to exchange specialists as well as upstairs market makers (hereinafter either referred to as "Principal").
The rule would afford the Principal with the option to execute its customer order immediately if the Principal executes the order at a price one primary market tick variance above the consolidated best bid for a sell order, or one tick variance below the best offer for a buy order.4 If the BBO spread is at the narrowest tick variance, the Principal can execute the order at the BBO, i.e., sell order executed at bid, buy order executed at ask. If the Principal does not want to afford its customer with an automatic fill at a price superior to the BBO, the Principal must expose the customer order in accordance with the requirements of the Commission's 1982 order exposure rule as described above.5
To assure that the order exposure rule works effectively will require a complementary and highly efficient mechanism that enables all competitors to access and execute against exposed orders. In this regard, today's ITS is not the appropriate access and execution mechanism.
The ITS has been criticized for its many technical, operational and policy inadequacies. In short, ITS is not a model for assured and efficient trading connectivity among the linked markets: (i) it is a simple messaging system not directly tied to the Consolidated Quotation System; (ii) there is no automated execution capability offered by most linked participants (only CAES and the Cincinnati Stock Exchange, Inc. offer auto-execution interfaces to ITS); (iii) routed commitments do not have order status standing; and (iv) many upstairs market makers as well as all ECNs are not connected to the linkage. All in all, ITS is an antiquated system that needs to be scrapped and replaced with modern technology and organization.6
Ashton observes that faster, cheaper, and therefore, more readily available technology is available today to feasibly implement the new millenium order exposure rule that is so critical to addressing the fragmentation concerns that will be the inevitable by-product of Rule 390's rescission. New technology also must be examined in providing a fairer, faster and more assured linkage connecting all market participants, including ECNs, alternative trading systems, exchanges and upstairs market makers. This is absolutely essential to stimulate vigorous competition for all exposed orders. It is time to scrap ITS and replace it with a totally redesigned state-of-the-art, high powered, high capacity linkage with full automatic execution features befitting a critically important NMS facility.
"[T]he securities markets are an important asset which must be preserved and strengthened" proclaimed Congress in enacting the Securities Acts Amendments of 1975. Congress called for a National Market System that would link the various markets in which listed stocks are traded. It would be a System that would employ modern technology to facilitate the ability of brokers to execute customers' orders in the "best market" and promote "fair competition" among brokers and dealers, and among markets.
Ashton is pleased to witness another giant step being taken toward the promotion of these important goals today. We offer our continued insights, resources and technical capabilities wherever they can best serve in the work and challenges ahead to foster greater competition while reducing any adverse effects of market fragmentation upon America's premier securities markets.
|Fredric W. Rittereiser
Chief Executive Officer
|William W. Uchimoto
Executive Vice President
and General Counsel
|1||The Commission moved quickly on abrogating off-board agency restrictions by adopting Rule 19c-1 under the Exchange Act. In this regard, there were clear fiduciary problems in forcing NYSE brokers to execute agency orders on the NYSE floor when a non-member dealer was offering better prices off-board than the NYSE specialist.|
|2||See A Monitoring Report on the Operation and Effects of Rule 19c-3 under the Securities Exchange Act of 1934, dated August 1981. The Commission should consider undertaking another monitoring report on Rule 19c-3 trading to provide current empirical data for the industry to consider.|
|3|| See Proposed Rule 11A-1, Securities Exchange Act Release No. 19372 (December 23, 1982) [predecessor order exposure rules were proposed in Securities Exchange Act Release No. 18738 (May 13, 1982)]. Rule 11A-1 gave the customer an option not to expose his or her order. In this regard, institutional customers may not desire to expose large block orders as exposure could increase market impact costs for such customers. The Commission describes market impact costs as:
[a]nother type of implicit transaction cost reflected in the price of a security is short-term price volatility caused by temporary imbalances in trading interest. (footnote omitted) For example, a significant implied cost for large investors who often represent the consolidated investments of many individuals) is the price impact that their large trades can have on the market. Indeed, disclosure of these large orders can reduce the likelihood of them being filled. Consequently, large investors often seek ways to interact with order flow and participate in price competition without submitting a limit order that would display the full extent of their trading interest to the market.
See Securities Exchange Act Release No. 42450 (February 23, 2000) text accompanying n. 26.
Ashton's eVWAPTM trading system, deployed as a facility of the Philadelphia Stock Exchange, Inc., is a fully anonymous, confidential trading system that has been designed to eliminate market impact costs for institutional traders. See Securities Exchange Act Release No. 41210 (March 24, 1999) (Commission approval of eVWAPTM system, formerly known as VTSTM). See also the www.evwap.com website for a full product description of eVWAPTM.
|4||Ashton advises that when the industry converts to decimal pricing that two cents ($.02) be defined as the minimum quotation tick increment for listed issues.|
|5||Conceivably, Principals will fully automate their ability to auto-execute orders with such price improvement requirement built-in, or automatically expose their orders at the stepped up prices subject to automatic execution by a competitor or a default, internalized execution at the Stop Price if no execution occurs during the exposure period.|
|6||Even early on, ITS was criticized as primitive and likened to "two tin cans and a string" or a "tom-tom in the space age." See Wall Street Journal, Sept. 2, 1980, at 16.|