Michael T. Dorsey
Senior Vice President,
General Counsel and Secretary
February 9, 2001
Via Electronic Mail and
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
Attn: Jonathan Katz, Secretary
Re: File No. SR-PCX-00-25, Proposed Rule Change by the Pacific Exchange, Inc. and Amendment No. 1 thereto Relating to the Archipelago Exchange
Dear Mr. Katz:
Knight Trading Group, Inc. ("Knight") welcomes this opportunity to comment on the Pacific Exchange, Inc. ("PCX") Proposal to create a new electronic trading facility of the exchange and its subsidiary PCX Equities, Inc., called the Archipelago Exchange ("ARCA")."1 Knight opposes the Proposal because the ARCA Exchange will not accomplish the primary goal of the national market system - the promotion of fair and orderly markets. Knight objects to the Proposal for several reasons. First, because the Proposal fails to set forth the types of fees the ARCA Exchange will assess against users. Second, because the combination of the proposed exchange's market structure and its plan to expand the number of Nasdaq securities traded pursuant to the Unlisted Trading Privileges Plan ("UTP") could unfairly disadvantage market makers. Finally, Knight believes the Proposal could be anti-competitive if its order routing structure requires firms to use ARCA's affiliated broker-dealer, WAVE.
Knight, headquartered in Jersey City, New Jersey, is the parent company of Knight Securities, L.P., Knight Capital Markets, Inc. (formerly Trimark Securities, L.P.), Knight Financial Products, L.L.C. (formerly Arbitrade Holdings, L.L.C.), and Knight Securities International, Ltd. Knight's subsidiaries make markets in equity securities listed on Nasdaq, the OTC Bulletin Board, the New York Stock Exchange, American Stock Exchange, Easdaq, the London Stock Exchange and in options on individual equities, equity indices, fixed income instruments and certain commodities in the United States and Europe. The firm also maintains an asset management business for institutional investors and high net worth individuals through its Deephaven subsidiary. As a leading destination for online trade executions, Knight is the processing power behind the explosive growth in securities trading via the Internet. Knight's clients include the leading brokerage firms, and more than 1200 broker-dealers and 1000 institutional clients. The Company is included in Fortune's "e-50 Stock Index," an elite collection of companies that are shaping the new Internet-based economy. Currently, the five-year-old company employs more than 1300 people worldwide.
In 1936, Congress recognized that a primary responsibility of the Commission is to "create a fair field of competition."2 Since then, the Commission has stated that trading systems choosing to register as exchanges must satisfy all requirements that apply to national securities exchanges.3 The Securities Exchange Act requires all exchanges to have rules designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to refrain from imposing any unnecessary or inappropriate burdens on competition.4 In addition to other criteria, an applicant for registration as an exchange must demonstrate that: (1) it has the capacity to carry out the purposes of the Exchange Act; (2) it has rules designed to prevent unnecessary or inappropriate burdens on competition; (3) it has established rules providing for the allocation of fees for the use of its system; (4) it has general conflict of interest rules; and (5) it has rules that ensure that no member's order is unfairly disadvantaged.5 The Proposal fails to establish that the ARCA Exchange can satisfy these requirements.
A. The Proposal will not create a fair field of competition.
Currently, the UTP Plan enables members of UTP exchanges to trade Nasdaq securities via Nasdaq's SelectNet system. Through this system, members of UTP exchanges may indicate their interest in various UTP securities on the Nasdaq Montage. The UTP Plan and the SelectNet system enable UTP exchange members to effect transactions away from their own market and on the Nasdaq. The quotes of members of UTP exchanges that are posted on the Nasdaq Montage appear under the UTP exchange's identifier and denote the member of the UTP exchange posting the quote. Currently UTP exchanges do not assess quote access fees against NASD market makers when these firms interact with the quotes of members of UTP exchanges via SelectNet. Knight believes that pursuant to Section 12 of the Exchange Act, UTP exchanges are not permitted to charge fees to non-members for interacting with the quotes of exchange members.
Knight, however, is concerned the proposed ARCA Exchange's fee structure may not promote fair and orderly markets. Specifically, Knight believes the ARCA Exchange may attempt to assess quote access fees against non-member market makers that interact with the quotes of ARCA Exchange members on the Nasdaq Montage. The quote access fees would be similar to those currently levied against non-subscriber users of Electronic Communications Networks ("ECNs") that interact with the quotes posted by ECNs for their users on the Nasdaq Montage. It is unclear from the Proposal if the ARCA Exchange will attempt to assess quote access fees against non-members of the ARCA Exchange that interact with exchange members via SelectNet. The Proposal also fails to specify the types of fees that will be charged to Equity Trading Permit Holders ("ETP Holders"), Sponsored Participants, and other broker-dealers. The Proposal only indicates that Sponsored Participants must agree to "pay when due all amounts . . . payable to the Sponsoring ETP Holder, Archipelago Exchange, L.L.C., PCXE, or any other third parties that arise from the Sponsored Participant's access to and use of Arca [sic.]. . . include[ing] applicable exchange and regulatory fees."6 Similarly, it is unclear from the Proposal if the ARCA Exchange intends to charge ETP Holders and Participants fees similar to those charged by ECNs for accessing WAVE. Knight believes the imposition of quote access fees by the ARCA Exchange while collecting market data revenues based on the exchange's participation in the national market system would be inappropriate. The Commission should require PCX to clarify its fee structure before it takes any further action on the Proposal and to agree not to charge non-members quote access fees when they interact with the quotes of ARCA Exchange members on the Nasdaq Montage.
B. The proposed ARCA Exchange's plan to commence trading Nasdaq securities pursuant to the Unlisted Trading Privileges Plan could unreasonably restrict competition.
Pursuant to Section 12(f) of the Exchange Act, any national securities exchange may extend unlisted trading privileges to any security that is listed and registered on a national securities exchange. Before the Commission may extend unlisted trading privileges to securities, it must find that such extension is consistent with the maintenance of fair and orderly markets. The Exchange Act also requires that registered exchanges have rules that assure fair representation of members in the administration of its affairs.7 This fair representation requirement serves to ensure that an exchange is administered in a way that is equitable to all market members and participants. The Exchange Act limits the authority of the Commission to expand the number of securities traded under the UTP when the rules of the national securities exchange "unreasonably impair" the abilities of dealers to effect transactions in such securities. The Commission must ensure that proposed expansions of the UTP will not "unreasonably restrict competition among dealers in such securities or between such dealers acting in the capacity of market makers who are specialists and such dealers who are not specialists."8
Knight believes the Proposal fails to establish that the ARCA Exchange's rules will ensure fair representation of members. Knight fears that problems associated with the current operation of the UTP Plan and the interaction of members of regional exchanges with Nasdaq market makers will be compounded by the PCX's request to lift the cap on the number of Nasdaq securities traded under the UTP Plan. Knight believes the Proposal will allow ARCA, which currently trades nearly 3000 Nasdaq securities, to greatly increase the PCX's activity on the Nasdaq.9 This expansion of the number of Nasdaq securities traded on the PCX without a substantial restructuring of the PCX's regulatory structures and surveillance tools could result in an unfair and disorderly Nasdaq market.10
Knight is concerned that the Proposal coupled with the PCX proposal to lift the cap on the number of securities traded pursuant to the UTP Plan, could possibly result in the ARCA Exchange circumventing the listing requirements of the Exchange Act. If a security is not exempt from registration in accordance with Section 12(a), it must be registered before it may be traded on a national securities exchange. Through the Proposal, the ARCA Exchange seeks to avoid having to solicit potential issuers to register to trade new securities on the exchange. Instead, the ARCA Exchange appears content to allow its members to trade several thousand Nasdaq securities on the exchange pursuant to the UTP Plan, rather than attempting to attract new issues. This approach appears to violate the spirit of the national market system by transforming regional exchanges into nothing more than electronic limit order books comparable to ECNs that are permitted to compete with Nasdaq market-makers without being subject to SRO supervision.
C. The Archipelago Exchange's requirement that firms enter into a routing agreement with ARCA's affiliated broker-dealer, WAVE, in order to take advantage of certain order types could constitute an unfair denial of access to the exchange in violation of the Exchange Act.11
The Exchange Act prohibits registered exchanges from denying access to, or discriminating against, members.12 The Exchange Act also prohibits exchanges from adopting anti-competitive rules. The fair access and fair competition requirements of the Exchange Act are intended to ensure that national securities exchanges treat investors and their participants fairly, consistent with the expectations of the investing public. The fair representation requirement is juxtaposed against the potential conflict of interest that could arise when an exchange also operates a broker-dealer.
In its current form, the Proposal does not provide for fair representation of members and fails to adequately address the potential conflicts of interest that arise from WAVE, ARCA's affiliated broker-dealer serving as the order-routing mechanism for the ARCA Exchange. Knight is concerned that as a broker-dealer, WAVE could trade proprietarily while serving as the central consolidator for all orders routed from the ARCA Exchange to other market centers. Knight fears this arrangement could place WAVE at a competitive advantage over other market centers. Knight believes the exchange should be required to eliminate the requirement that WAVE serve as the exclusive mechanism for routing orders to other market centers. Knight also believes ARCA should be required to adopt safeguards to ensure that WAVE does not have a competitive advantage over other market centers that might wish to offer routing services for PCX ETP holders.13
Knight also opposes the Proposal because its anti-competitive structure prohibits some members from placing certain order types. Under the Proposal, ETP holders that do not agree to use WAVE will be unable to enter Primary Only Orders.14 The requirement that all users of the ARCA Exchange enter into a Routing Agreement requiring them to use WAVE to route orders outside of the facility is anti-competitive. Knight believes this requirement will place users of the system that choose not to enter into a Routing Agreement with WAVE at a competitive disadvantage to other ARCA users. The proposed order limitations also constitute an unfair denial of access to the ARCA Exchange. By requiring firms to use the exchange's affiliated broker-dealer in order to take advantage of certain types of orders, the Proposal violates the fair access provisions of the Exchange Act.
In conclusion, Knight opposes the Pacific Stock Exchange's Proposal to create a new electronic trading facility called the Archipelago Exchange. Knight objects to the Proposal because it fails to set forth the types of fees the PCX will assess against users of the ARCA Exchange and WAVE. Knight opposes the Proposal because the ARCA Exchange will not promote the goals of the National Market System - the creation of a fair field of competition. Knight is concerned that the proposed governance structure of the Archipelago Exchange lacks the necessary safeguards to ensure that its affiliates do not receive preferential treatment over other members and users of the exchange. Finally, Knight believes the Proposal is anti-competitive because it requires members to use the exchange's affiliated broker-dealer to make use of the various order types offered by the exchange.
I hope that the Commission and staff find these comments helpful. If Knight or I can be of further assistance to you on this matter, please do not hesitate to contact me.
Michael T. Dorsey
Senior Vice President and
cc: Hon. Arthur Levitt
Hon. Norman S. Johnson
Hon. Isaac C. Hunt, Jr.
Hon. Paul R. Carey
Hon. Laura S. Unger
Robert L.D. Colby
|1||Exchange Act Release No. 34-43,608 (Nov. 21, 2000), 65 Fed. Reg. 78,822 (Dec. 15, 2000) (the "Proposal").|
|2||See Pub. L. No. 94-29, 89 Stat. 97 (1985).|
|3||Exchange Act Release No. 34-40,760 (Dec. 8, 1998), 63 Fed. Reg. 70,844 (Dec. 22, 1998) ("Regulation ATS").|
|4||Section 6(b) of the Securities Exchange Act of 1834 (the "Exchange Act")|
|6||Proposal, 65 Fed. Reg. at 78,833.|
|7||See Section 6(b)(3) of the Exchange Act.|
|8||Section 12(f)(1)(E)(iii) of the Exchange Act.|
|9||Members of the PCX currently trade no securities pursuant to the UTP Plan.|
|10||Knight incorporates by reference its comment letter filed with the Commission regarding the PCX's request to lift the cap on the number of securities traded under the UTP Plan. See Comment Letter from Michael T. Dorsey, Senior Vice President, General Counsel and Secretary, Knight Trading Group, Inc., to Jonathan G. Katz, Secretary, United States Securities and Exchange Commission, dated December 13, 2000, regarding S7-24-89 (the "PCX /UTP Proposal").|
|11||In the Proposal ARCA describes the Routing Agreement as "an agreement between an ETP Holder and a broker-dealer affiliate of Archipelago Exchange, L.L.C., under which the broker-dealer affiliate agrees to act as agent for routing orders of the ETP Holder and the ETP Holder's sponsored Participants to other market centers or broker-dealers for execution, whenever routing is required."|
|12||See Sections 6(b) & (c) of the Exchange Act.|
|13||The Proposal also does not address whether the ARCA ECN will continue to exist if the Proposal is approved. If the ARCA ECN continues to operate as a Nasdaq market participant, what would be the nature of the relationship between PCX and ARCA? Many of the concerns raised in this letter over potential conflicts of interest would be applicable to the ARCA ECN were it to continues to exist if the Proposal is approved.|
|14||Primary Only Orders are market orders for exchange-listed securities that are routed as market-on-open orders to the primary market for participation in the primary market opening process.|