March 27, 2006

Dear SEC:

I am writing to express my views on the "accelerated effectiveness" of amendments 6, 7, and 8 to SR-NYSE-2004-05. Of necessity, any such discussion must also involve a discussion of the Commission's approval of the basic proposal and amendments 1 through 5, as significant aspects of amendment 6 in particular bear materially on the prior iterations of the proposal.

Let me state at the outset that the SEC's approval order is hardly the Commission's finest hour. Pages 1-60 simply describe the NYSE's proposal. Pages 60-89 purport to summarise the wealth of serious, substantive comments received by the Commission. It at least two instances, the Commission failed to acknowledge, let alone discuss, materially substantive comments that bear directly on the Commission's conclusions, a serious professional lapse. Ultimately, however, pages 1-89 ar e essentially a kind of legal hackwork. I do not use that term disparagingly. This is simply the sort of basic exposition that any competent lawyer ought to do well in laying the foundation for the analytical work by which lawyers earn their keep.

The "analytical" portion of the approval order (pages 89-116) is seriously inadequate, and stands in sharp contrast to the brilliance of the SEC staff's work in the Regulation NMS releases. (I say this even though I did not necessarily agree with all the conclusions). After carefully reviewing (most of) the comments received in the exposition section of the approval order, the Commission largely ignored them in the analytical discussion section. The result is that the Commission's "reasons" for approving various aspects of the NYSE's proposal read more like a series of broad, unsupported assertions than the result of a carefully reasoned process leading to logically supportable conclusions. There i s no other way to say this: on virtually every significant issue, the Commission has merely "punted."

This is not simply a matter of my disagreeing with the Commission's conclusions. The thrust of my immediate objection is simply that, regardless of what conclusions it wants to come to, the Commission must carefully work through the serious, substantive objections it receives, and reflect that "working through" in the process whereby it reaches its conclusions. There is very little such "reflection" in the Commission's purported {"analysis", and the result is an unusually arbitrary, and unsettling, display of the Commission's power. I cannot recall ever reading an SEC release as analytically deficient as this one, regardless of my views on the release's conclusions.

There are other seriously disquieting aspects of the Commission's process here. In several material aspects (as I discuss below), the Commission has taken positions entirely at odds with the philosophy it expressed in the Regulation NMS releases. Granting accelerated effectiveness to amendment 6 can only be described as an insult to public commentators. This amendment contains substantive material the NYSE developed in response to serious public comments. Clearly, the adequacy or inadequacy of the NYSE's response should have been exposed for formal, prior public comment so that it could have been appropriately assessed by those whose concerns triggered the NYSE's response in the first place. The Commission "sat on" amendment 6 for about six months (it was submitted in September 2005, but not published on the SEC's website or otherwise public exposed by the Commission). While the amendment could be found (with difficulty) on the NYSE's website, this is hardly what public commentators typically look to as to their submission of comments to the Commission. I cannot recall any prior instance of the public's receiving its first for mal notice of something so controversial (and which was the subject of significant, prior negative comment) in the context of an "after the fact" SEC approval order. This is hardly what one has come to expect of the Commission, and stands in sharp contrast to the Commission's great concern for public comments throughout the difficult and controversial process of adopting Regulation NMS.

I discuss below footnote 382, surely one of the most bizarre (and disturbing) formulations ever to appear in an SEC release. This footnote purports to reflect a telephone conversation on March 22, 2006 (the very day the Commission issued the release, not that there was any haste here!) between the NYSE and SEC staffs to the effect that the NYSE is still trying to figure out how its proposed method of specialist trading can be reconciled with the negative obligation. The NYSE has apparently agreed to provide "guidance" to specialists at some later date, a process the Commission for some unexplained reason found acceptable. Even by the generally low standards of this release, this comes as a shock. It is as though the SEC were saying, "Approval today, legality to follow." Let us hope that this was merely an epic "Homeric nod", and not some inkling of a new SEC approach to regulating markets.

Another, and very significant, objection to the Commission's process here is the fact that this matter was not handled at an open meeting. Surely, the redefinition of a critical, primary market such as the NYSE is a matter of vital public interest. The Commission has considered far less significant matters at open meetings. This was a serious lapse, particularly given the depth of negative public comment on various aspects of the NYSE's proposal.

What is one really to make of the Commission's uncharacteristic behavior with respect to all this? It is obvious that fact, law, and logic only go so far, but when the going gets tough, they are thrown out the window and "realpolitik" takes over. The NYSE clearly needed the rules to turn out as the Commission approved them in order to maintain the economic viability of its trading floor constituency. This is the unacknowledged subtext here, the tail that wagged the dog. The Commission was thus placed between the proverbial rock and a hard place: however dubious various aspects of the NYSE's proposal might seem, the NYSE market model needed to change, and the Commission could not realistically insist on changes that might put a primary market, the NYSE, out of business, even if those changes were clearly in the public interest.

And so we have the Commission's approval order, a most curious document. The Commission's lack of enthusiasm seems palpable. The Commission's repeated use of conditional terminology at critical points to describe the purported "benefits" of the proposal ("may", "might", "co uld", "potential") speaks volumes about the Commission's reservations about this matter. Indeed, for example, the Commission's phraseology such as "within the realm of judgments generally left to the discretion of an individual market" to describe the approval of various aspects of the proposal is commonly understood to be the Commission's default terminology to describe matters which the Commission feels constrained to approve, but declines to say anything particularly positive about.

It would have been far simpler, and fairer to the public, had the "hybrid" market been treated as a matter of realpolitik all along. However contentious the discussion would have been, at least it would have been far more intellectually honest

A Note on Plain English

In its summary of comments received, the Commission did not reflect my comments that the NYSE neede d to recast its proposal in plain English. This is a significant comment, as it goes directly to the degree to which investors can understand, and thus have confidence in, what the NYSE, as a primary market, is doing. The first iterations of the NYSE's proposal were virtually incomprehensible, riddled with self-invented jargon and non-intuitive terminology to describe simple, well-understood concepts. The NYSE was forced into a back-and-fill with examples (however simplistic) and the like, and even had to resort to publishing a "glossary" on its website.

The NYSE's "clarifications" have not been all that successful. It is not exactly a secret that most professional traders even today (to say nothing of the average investor) do not understand the hybrid market and find it far too complicated. And the NYSE has only itself to blame here, because the proposal (stripped of implementing technical minutiae) is not really that complicated when presented in plain English. (In fact, it is relatively simple-minded). As I have discussed in several comment letters, the proposal, in practical effect, is simply a (mostly automated) system of three competing limit order books, go along trading, clean-up pricing, volatility surge protectors, and enhanced specialist "price improvement" (flip) trading. Not complicated at all, really, until these simple concepts are described in the NYSE's strange new language. (Of course, there's an entirely different resonance between "broker agency interest files trading on parity with the display book"[almost no one understands] versus "hidden go along orders superseding the price/time priority of public limit orders" [everyone understands], but that's another matter).

A fair number of professional traders, as well as several media members, have told me they understood the NYSE's proposal far more clearly after reading my plain English translation. I'm not trying to make a "pr ide of authorship" point here, as any number of people could have provided the translation. My point is simply that the NYSE "shot itself in the foot" by not presenting this material simply and clearly to the professional trading constituencies it needs to reach out to. And that clearly is not in the public interest.

The Commission's discussion of this matter using the NYSE's convoluted terminology only adds to the general sense of obfuscation.

The Commission obviously needs to consider amending its Rule 19b-4 to give the SEC staff greater authority in demanding that SROs recast proposals in plain, simple English. In the event, it is manifestly in an SRO's self-interest to do so, as the NYSE's failure here amply demonstrates.

Amendment 6 and Specialist "Algorithmic" Trading

The NYSE proposal permits specialists (and only specialists) to electronically intercept systematised marketable orders and seize a proprietary trading opportunity in between the BBO in the guise of providing "price improvement" to the incoming order. In addition, the specialist (and only the specialist for all practical purposes) can embed an algorithm in NYSE systems to trade with incoming systematised limit orders, that improve the BBO, at the very instant that such orders are "displayed" by the NYSE.

In its amendment 5, the NYSE proposed to permit specialists to trade in this fashion if they were merely "represented" in the BBO. Commentator objections can be summarised as follows:

(i) "representation" in the BBO is largely meaningless;

(ii) it is anti-competitive, and in contravention of the negative obligation, to give the specialist the exclusive right to do this;

(iii) the specialist should, a s a market maker, be publicly quoting the "improved price" if that's the price at which the specialist believes the stock should trade;

(iv) there is no net economic benefit to the public because any "price improvement" to the incoming order is offset by the specialist's displacement of an execution for the public order at the BBO that attracted the incoming order in the first place; and

(v) the displacement of execution opportunities for public limit orders at the BBO disincents the placement of such orders, which will adversely impact the NYSE's price discovery process.

While the Commission did a roughly adequate job of noting these objections in the exposition section of its release, its failure to work through each objection specifically in the analytical section as it reached its conclusions is a singular failing of the approval order.

In amendment 6, the NYSE addressed only the first objection. (It has never addressed the other objections). The NYSE proposed that the specialist had to be "meaningfully" represented in the BBO, with "meaningful" meaning 1000 shares for very active stocks, and a lesser amount for other stocks. In amendment 8, the NYSE clarified that the 1000 share requirement applied only to the 100 most active stocks, with a 500 share requirement for all other stocks.

Although amendment 6 was never published by the SEC for formal public comment, I had noticed it on the NYSE website and commented on it in my November 8, 2005 letter. I noted that the concept was meaningless and cosmetic because adding 1000 non-priority shares to a typically large BBO in a very active stock had virtually no practical effect in terms of adding "depth" to the BBO, but simply gave the specialist an exclusive "license" to trade at prices other than the BBO. (The same holds true for other stocks, bu t specialists are most likely to engage in this type of trading in only the most active stocks, as this is where most of the profitable "flip" trading opportunities are). I know that other commentators were waiting for the Commission to publish this before submitting comments. The SEC's "accelerated effectiveness" of amendments 6, 7, and 8 has now, as a practical matter, precluded this, which is most regrettable.

The SEC's reasons for "accelerated effectiveness" on the issue discussed above simply do not withstand logical scrutiny. The Commission simply observed that "having minimums set forth in the rule for all securities should ensure that specialists can comply with the rule's requirements and ensure that all market participants are aware of the instances when a specialist would be allowed to price improve incoming marketable orders." (Page 130). The first half of this sentence is meaningless make-weight, and the second half of the sentence i s non-sensical as a practical matter. Market participants will simply be aware of what the rule's requirements are. They will rarely, if ever, be aware, in looking at a particular quotation, that the specialist has added shares and thereby will by electronically intercepting incoming orders.

The inadequacy of the Commission's treatment of this point is symptomatic of its inadequacies in treating the entire subject of specialist algorithmic trading. The Commission makes broad assertions that the proposal is consistent with various provisions of the Securities Exchange Act, but on many key issues the SEC does not provide any analysis whatsoever as to why this is so, a critical, and atypical, failing. In the analytical section, the Commission presents a classic straw man. The Commission describes, as though it were the issue, the benefits of the specialist algorithm in updating quotes, adding depth and liquidity, and placing "reserve interest" in the display book. In itself, this is a public good, to be applauded. But the real issue, specialist interference with public order execution, is never addressed head-on by the Commission. Clearly, the NYSE could easily require that specialist's algorithms perform their "public good" only in situations where they do not interfere with the public. Indeed, this has been the fundamental premise of the current regulatory framework (the public goes first) for eons. The Commission's disinclination to address this issue directly is as inexplicable as it is disturbing.

Among its conclusory assertions that the NYSE's proposal is consistent with the Securities Exchange Act is the Commission's statement (p.91) that "The Commission finds that the Hybrid Market could [note the conditional] enhance the opportunity for a customer's order to be executed without dealer participation, consistent with the goals of the Act." The shock value of this statement is e xceeded only by the shock value of footnote 382. Much of the NYSE's proposal (go along trading, exclusive electronic interception of incoming orders at the expense of the public limit order book) is clearly intended to increase dealer participation in a manner that has never been deemed to be "consistent with the goals of the Act."

The Commission's acquiescence to the NYSE's demand that specialists be permitted to compete directly with public orders is inexplicable. The Commission merely notes that specialist trading is subject to certain statutory and regulatory restrictions, and expresses an expectation that specialists will monitor the operation of the algorithm. As I demonstrate below in my discussion of footnote 382, specialist go along trading in direct competition with public orders is inherently inconsistent with Sections 11(a), 11(b), and 11A of the 1934 Act, as well as SEC Rule 11b-1 and NYSE Rule 104, and the algorithmic "price improvement" and limit order trading clearly violate Section 10(b) and Rule 10b-5. No amount of "reminders" that specialist trading is subject to these provisions can make the proposed trading schematic legal under those provisions.

The Commission also suggests, confusingly, that specialist algorithmic go along trading may simply be the result of inadvertence. The Commission notes (p. 107), "Accordingly, the specialist must make trading decisions whether to add orders to the specialist interest file without knowing the full extent of other trading interest available in the market, and consequently may trade on parity with other available floor broker interest." But this does not follow logically, as the algorithm can easily be programmed not to effect a trade for the dealer account until public orders at that price have been filled first.

The Commission notes (pp. 107-108), in a truly baffling observation riddled with conditional language on a "put the public first issue", that "the potential benefits these features may bring to the quality of the Hybrid Market justify the risks of unnecessary specialist trading." This is a hitherto unknown regulatory standard. Specialist trading is either necessary or it isn't, and if it isn't, it's illegal. That's been the law of the land since the 1930s. Now, out of the blue, the Commission is taking the position that clearly illegal trading may somehow become legal because of "potential" benefits, a bizarre canon of statutory interpretation if ever there was one. This is clearly another epic Homeric nod by the Commission.

It's quite simple: there should never be an issue of "unnecessary specialist trading because, as I noted above, the algorithm can simply be programmed not to trade when there is no market necessity, due to the existence of same price public orders, for such a trade.

The Commission's analysis o f the specialist algorithmic "price improvement" issue is similarly flawed. No one disputes that "price improvement", fairly and equitably provided, is a public benefit. Granting the specialist an exclusive privilege in this regard, however, is not only inequitable, it is clearly illegal. The Commission suggests that the NYSE is simply "replicating" privileges the specialist enjoys in the physical auction, including informational advantages. But this is nonsense, and the Commission simply has not joined issue with the serious, substantive comments that have been made. (See, e.g., the five objections I noted above).

In the physical auction, the specialist must expose an order, and can trade to provide "price improvement" only if no one else will. The specialist has an informational advantage in knowing about that order before anyone else, but cannot unilaterally take advantage of that information, which is the critical consideration here. Rather, the specialist is constrained, under the negative obligation, to act only as the trader of last resort. In the hybrid market, there is no "replication" of this, but rather a radical reversal of the entire regulatory philosophy. Not only does the specialist have the informational advantage, but he/she has the exclusive trading privilege here as well.

It is deeply disturbing that the analytical section of the SEC's approval order did not work through each of the significant public criticisms here. The Commission's conclusion on this issue, riddled again with conditional language on a critical public interest point, is seriously inadequate. The Commission stated (p. 112) its (conditional) belief that "permitting specialists to algorithmically price improve marketable orders by certain minimum amounts could increase the quality of its electronic market, and the condition that specialists be meaningfully represented in the bid or offer might enhance the depth and liquidity at the NYSE BBO."

Clearly, the quality of the NYSE's market would be enhanced if the NYSE in fact "replicated" its physical auction by allowing other market participants to provide genuine price improvement, with the specialist acting only as the "price improver" of last resort, as today. And the notion that adding a cosmetic 1000 shares to the BBO in very active stocks (the "license" to trade at prices other than the BBO) somehow enhances the depth and liquidity in such stocks in any meaningful way simply cannot be taken seriously. What the specialist is really doing is preventing executions at the BBO to the detriment of the public limit order book. And the Commission has made no effort whatsoever to address public criticisms that this is a unique form of insider trading. This is a very serious matter, and the Commission's silence is as inexplicable as it is inexcusable.

The informational level playing field issue also arises in the NYSE's proposal to permit specialists to trade electronically with incoming limit orders that improve the BBO. Essentially, the specialist's algorithm, deeply embedded in NYSE systems, would effect a trade with the order the instant it is displayed. The Commission noted that the NYSE had proposed a safeguard to prohibit the algorithm from having an informational advantage over the public. This "safeguard", according to the NYSE, is a delay in processing the algorithm, the delay time being the time it takes for the order to go from the NYSE's Common Message Switch to the display book. In its approval order, the Commission expressed its belief (p. 113) that "specialists are on a level playing field with other market participants" in this regard.

I am at an absolute loss to understand the Commission's position here, as it is absurd on its face. In my November 8, 2005 comment letter, I pointed out that this "d elay time" is in fact a matter of nanoseconds, and that the NYSE was not proposing any sort of meaningful "safeguard" here at all. Shockingly, and most unprofessionally, the SEC did not even acknowledge my comment, much less factor it into its "analysis." The specialist's algorithm has a clear informational advantage over other market participants, and a clear execution advantage as well. The algorithm alone is embedded in NYSE systems, and the algorithm alone is capable of trading with the order the instant it is "displayed."

There is no level informational playing field here. The specialist again has material market information before anyone else, and gets to trade with incoming orders before anyone else even becomes aware of them. This is insider trading, pure and simple, and in no way "replicates" what happens in today's physical auction.

Again, the Commission's failure to work through these issues in its purported "analysis" is deeply disturbing.

Amendment 6 and Floor Broker Go Along Trading

In its original iterations, the NYSE's proposal permitted floor brokers to enter hidden go along orders to trade on "parity" with, and thereby usurp the price/time priority of, public limit orders on the public limit order book. Floor brokers would have been permitted to do this at the BBO, as well as at away from the market "sweep" clean-up prices. In the face of fierce public criticism, the NYSE modified the proposal somewhat to require that floor brokers display at least 1000 shares at the BBO before they would be entitled to compete with public limit orders at that price. Prior to amendment 6, the NYSE did not address the issue of disclosure of away from the market hidden go along orders.

In amendment 6, the NYSE proposed that floor brokers indicate on their hidden , away from the market go along orders an amount that "would be disclosed" if the limit price on the order ever became the BBO. This unknown "would be disclosed" amount would be entitled to compete directly with, and usurp the price/time priority of, fully disclosed public limit orders at away from the market "sweep" prices. In my November 8, 2005 comment letter, I discussed in detail why this was a meaningless fictional construct (no information is made available to the market as to away from the market competition with public limit orders with clearly established price/time priority), and cured none of the informational and execution advantages accruing to the hidden go along orders at the expense of the public limit order book in sweep transactions.

Shockingly, and again most unprofessionally, the Commission did not even note my comment in the exposition section of its release, much less work through it in the analytical section.

The Commission's "accelerated effectiveness" (after sitting on it for six months) of amendment 6, with this highly controversial "would be disclosed" concept, is inexcusable. Given the significant public comments about hidden go along orders, this clearly should have been exposed for prior public comment.

The Commission's treatment of floor broker electronic trading is in many respects a straw man discussion. The Commission notes advantages in terms of overall efficiency, which everyone applauds, and the use of a "reserve" feature to facilitate go along trading, but these are hardly the issues. The singular failing of the Commission's "analysis" here is the absence of any reasoned discussion about the negative impact of go along trading on the price/time priority of fully disclosed public limit orders, and the unfair execution advantages accruing to the go along orders, particularly in sweep transactions, but at the BBO as well.

With respect to transactions at the BBO, the Commission's only "attempt" at joining issue is its naked and astonishing assertion that floor broker display of 1000 shares at the BBO (the license to supersede the price/time priority of public limit orders) somehow has the effect of "preserving incentives for investors to display limit orders." (Page 100). This is non-sensical on its face. Commentators have clearly noted that the effect of go along trading, even as the NYSE would permit it at the BBO, seriously disadvantages public limit order execution, and disincents the placement of limit orders to begin with. It is unacceptable for the Commission to proceed simply by way of assertion here (a classic "punt" if ever there was one). The Commission must explain specifically how and why, in the face of subsequently entered go along orders that may deny or limit their executions, investors have had their incentives for placing limit orders "preserved."

The Commission similarly "punts" on away from the market sweep executions, again making the naked and astonishing assertion that the NYSE's proposal "could" allow floor brokers to effectively represent hidden go along orders "without materially reducing the incentives [for public limit order customers] to display liquidity on the Book." (Page 109). In reality, of course, the disincentives are manifestly pronounced, as the public limit order customers are not even aware of the fictional "would be displayed" hidden limit orders that will deny or degrade the execution of their orders. The Commission's failure to explain its position here is inexcusable. Rather than fully analyse the issue, the Commission simply defaults to terminology about how exchanges "have a degree of flexibility" (p. 109) in designing their rules, an all-time cop-out on an issue of such fundamental importance to public limit order investors.

The NYSE Proposal and Regulation NMS

Regulation NMS is obviously the "elephant in the corner" with respect to the NYSE's proposing its hybrid market. But the specific forms of go along trading proposed by the NYSE have nothing to do with Regulation NMS, as the NYSE could easily design its market to give primacy to public limit orders, with floor broker go along orders receiving automated executions when they do not compete with the public limit order book, and specialist go along orders receiving automated executions when they do not compete with public go along orders. Rather, these aspects of the NYSE's proposal simply give privileged intermediaries unfair advantages over the investing public.

The NYSE's proposal in this regard is absolutely at odds with the Commission's philosophy in its Regulation NMS releases. In those releases, the Commission consistently emphasised th e importance of protecting public limit orders, and the critical role that public limit orders play in the price discovery process. The Commission's observations, while focusing on inter-market considerations in the specific context of Regulation NMS, are surely equally applicable when considering the treatment of public limit orders in a primary market/central price discovery mechanism such as the NYSE.

The Commission's unsubstantiated, and unsubstantiatable, assertions that the NYSE has somehow retained "incentives" for the placement of public limit orders are simply unworthy of this usually august agency. The go along trading contemplated by the NYSE by its very nature disincents the placement of public limit orders because it denies and degrades executions to public limit orders with clearly established price/time priority, and which attract the incoming contra side liquidity, particularly in sweep transactions. (More on this point in my Nove mber 8, 2005 comment letter).

The Commission's position that the NYSE has a "degree of flexibility" in allowing go along orders to disadvantage public limit orders is so inconsistent with Regulation NMS's emphasis on the primacy of public limit order protection that it is utterly baffling. And the Commission's disinclination to fully analyse this issue, in the face of significant negative public comments, is an appalling departure from the Commission's normally scrupulous processes.

Footnote 382 and the Overall Regulatory Framework

Earlier, I expressed my dismay with footnote 382, which is symptomatic of the Commission's failure to deal adequately with the overall regulatory framework. The so-called "guidance" that the NYSE is supposed to develop goes to the heart of whether much of the NYSE's proposal is really legal to begin with, and both the NYSE and the Commission are largely begging the question here. In its submissions, the NYSE has either ignored the underlying legal issues, or made pro forma conclusory assertions that the proposal was consistent with applicable law, or that specialists were required to comply with applicable law (as one would hope!). The Commission's approval order makes similar conclusory assertions, but presents no analysis or legal reasoning to substantiate its positions.

Both the NYSE and the Commission are engaging in a kind of circular reasoning process here. They merely "define" the practices at issue into applicable law and regulation, and then turn around and use the "defined into" concepts as the basis for the otherwise unsubstantiated assertions that the practices are legal in the first place. In reality, the practices are inherently inconsistent with the applicable law and regulations. By reading such clearly inconsistent practices into law and regulations, the NYSE and the Commission render the overall regulatory framework meaningless. This can only undermine public investor confidence in the integrity of both the NYSE's and the Commission's approach to regulating markets. Clearly, no projection of "potential benefits" can render that which is illegal, legal, absent overhaul of the regulatory framework.

(i) Section 11(a) of the 1934 Act

Section 11(a) permits specialists to engage in proprietary trading, but only when they are "acting in the capacity of a market maker." They are not permitted to engage in proprietary trading simply because they are denominated as specialists. "Acting in the capacity of a market maker" is commonly understood to mean, under the affirmative and negative obligations, that specialists may trade only when they are required to do so to maintain a fair and orderly market. Trading that is not necessary to maintain a fair and orderly market is simply proprietary trading, and not an aspect of the market making function.

Specialist parity (go along) acquisition trading is entirely outside the scope of the market making function. The "market" (the depth and liquidity to trade with contra side depth and liquidity) is already being made 100 percent by the public go along orders. The specialist adds nothing here except proprietary interference with public order execution, which has nothing whatsoever to do with "market making" under any conceivable definition.

The Commission cannot simply assert that this type of specialist trading is consistent with Section 11(a). The Commission must present specific reasons why a practice that is on its face inconsistent with Section 11(a) nevertheless comports with the statute.

(ii) Section 11(b), SEC Rule 11b-1, and NYSE Rule 104

This material reflects the negati ve obligation, which precludes specialists from trading unless reasonably necessary to maintain a fair and orderly market. Specialist parity acquisition trading, by its inherent nature, can never be reasonably necessary to maintain a fair and orderly market. The requisite depth and liquidity are already being supplied by the public go along orders with which specialists are competing, and whose executions specialists are degrading. The specialist adds nothing whatsoever here from a market maintenance standpoint.

It is simply not possible to reconcile this type of specialist trading with the negative obligation. And this is not some arcane legal technicality. The negative obligation has been the fundamental tenet of specialist regulation for more than 70 years.

Similarly, specialist algorithmic "price improvement" and limit order between the BBO trading are also inherently inconsistent with the negative obligati on. The "necessity" for the specialist's trade in such situations has always been determined by the NYSE's order exposure process. The specialist's trade is "necessary" only because, after the order is exposed to the market, no one else will trade with it. The NYSE is not only effectively rescinding the necessity test here, it is standing it on its head by giving the specialist the exclusive privilege to engage in such trading.

It defies law and logic for the Commission to simply assert, conclusorily, that these types of specialist trading are consistent with the negative obligation, and no amount of "guidance" can override clear statutory and regulatory proscriptions. If the Commission intends to persist in this view, it owes the public a detailed explanation why.

(iii) Section 11A

Among other matters, Section 11A requires execution of public orders without dealer intervention unless such d ealer trading is somehow consistent with other statutory objectives. Specialist go along trading in direct competition with public go along orders is the clearest possible example of trading that is precluded by Section 11A. The public go along orders are fully capable in the NYSE's automated market of trading promptly and efficiently with public contra side interest.

There is no conceivable "goal" of the 1934 Act that is furthered by specialist dealer intervention in this situation. The Commission's naked assertion in this regard is untenable, and if the Commission persists in its view, it owes the public a detailed explanation why.

(iv) Section 10(b) and Rule 10b-5

In providing "price improvement" and trading with between the BBO limit orders, the specialist's algorithm is clearly engaging in insider trading based on material, non-public market information. The materiality is manife st in the fact that the algorithm effects a trade based on this information. The information about the order is non-public, because only the specialist's algorithm knows about it. (The nanosecond "delay time" for between the BBO limit order trading hardly makes the information public in any level playing field sense). In today's auction, the specialist does receive material, non-public market information, but cannot act on it until it is disclosed to the market, and other market participants are afforded an opportunity to trade first.

The NYSE's proposal is absolutely inconsistent with, and cannot be reconciled with, well-settled disclose-or-abstain-from-trading insider trading law.

One can hardly take comfort in the notion that the NYSE will be providing "guidance" to specialists about the negative obligation. That's hardly the gist of the issue. There are fundamental, over-arching, hugely significant issues as to how many aspects of the NYSE's proposal are legal to begin with, and the Commission's conclusory assertions hardly suffice.

There is no way that the NYSE and the Commission can simply assert that these trading practices are consistent with the laws and regulations noted above without making the regulatory framework meaningless.

These issues MUST be addressed by the Commission. (The "treatment" in the approval order is deficient by any legal standard). And any "guidance" provided by the NYSE should be submitted to the Commission pursuant to Rule 19b-4, and exposed for prior public comment, as it bears directly on the quality of public order execution.


I cannot help but express a note of dismay that the survivability of the NYSE depends, at least in the near term, on the conferring of unique privileges on speci alists and floor brokers at the public's expense and irrespective of applicable law. The classic "specialist system" is clearly on its last legs, as the agency function largely disappears in the hybrid market, and the dealer function can be propped-up only by allowing the specialist to compete directly with public orders, and engage in exclusive "price improvement" (flip) trading. This is obviously not a sustainable business model in the longer term, and the NYSE clearly needs to move to an electronic competing dealer system that fairly gives precedence to public orders.

Be that as it may, it saddens me to say that the Commission has not performed up to its usual standard here. The Commission clearly must revisit aspects of this matter in light of applicable law and the need to fully analyse and work through public comments, and provide logical justification for its conclusions.

Sincer ely yours,

George Rutherfurd
Consultant (to two institutional trading organisations)
Chicago, IL