Mr. Jonathan G. Katz August 3, 1998 Page 1 Instinet Corporation 875 Third Avenue New York, NY 10022 212.310.9500 August 3, 1998 Mr. Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Washington, DC 20549 Re: Securities and Exchange Commission File No. S7-12-98 Dear Mr. Katz: Instinet Corporation ("Instinet") is pleased to offer its comments to the Securities and Exchange Commission (the "Commission") on the Commission's proposed new rules and rule amendments regarding exchanges and alternative trading systems.[1] As the Commission has previously recognized,[2] the technological innovations of the last two decades have fundamentally changed the way in which securities transactions are negotiated and effected. Instinet appreciates the Commission's continuing efforts to establish a regulatory framework that will foster the development of new technologies and further enhance the operation of U.S. and international securities markets. The Commission's rulemaking proposal represents, in Instinet's view, a constructive step in seeking to accommodate technological innovation within the statutory and policy objectives of the federal securities laws. Instinet is particularly pleased by the Commission's determination to allow market participants "to make a business decision about how to register with the Commission,"[3] and considers it an important development offering more latitude than the current regulatory framework. Instinet believes, however, that there are some specific issues and questions regarding the exchange registration option that need greater amplification so that firms have all the crucial information required for an educated assessment of the options. Instinet also considers it particularly important for the Commission, in pursuing this initiative, to allow investors the same flexibility and discretion for full or partial order display with all exchange member broker-dealers. The Commission should ensure that investors have the ability to utilize the services of all intermediaries as they see fit to best suit the investment needs of their clients. This issue is not only important domestically, but is also significant in the context of increasing globalization of capital markets arising, in part, from the very technologies that have given rise to the Commission's proposal. Finally, Instinet believes that the overarching goal of Commission regulation should be to create a framework that has consistency at its core, ensuring that all market participants providing similar services are permitted to compete based on comparable regulation, regardless of the technologies that they employ in their business. Instinet's comments are divided into four parts: An Overview of Instinet's Global Business, General Comments on the Proposing Release, Specific Comments on Proposed Regulation ATS, and Concluding Remarks. The following is a summary of key issues upon which our more detailed discussion is based. An Overview of Instinet's Global Business Instinet, a member of 17 exchanges around the world, is a registered broker headquartered in New York City. Instinet has 1300 employees worldwide and offices in eight international financial centers. Instinet is a pure agency broker, serving its global client base by consistently reducing transactions costs, and thereby increasing investment performance for investors and their proxies. General Comments on the Proposing Release In Part II below, Instinet has sought to identify modifications and refinements to the Commission's detailed rule proposal that, in its view, would better achieve the Commission's policy objectives, consistent with the statutory mandate governing the Commission's activities. Evaluating the "Exchange" Registration Option. The Commission's proposal outlines a new regulatory framework predicated on classifying a wide variety of market participants as "exchanges" under the Exchange Act. These entities then have the option of determining whether the Commission has provided for a regulatory "exemption" from this category. By virtue of this expanded definition of an exchange, Instinet is concerned that over time, with increasing numbers of market participants relying solely on the Commission to provide an exemption from the exchange registration requirement, this forward reaching proposal will be compromised. Moreover, Instinet suggests that for the Commission to meet its objective, market participants need an articulation of the rules and regulations pertaining to registered exchanges. Instinet urges the Commission to address a number of significant, unresolved industry issues, notably those relating to the Intermarket Trading System ("ITS") in both the listed and OTC environment. It is Instinet's view that the Commission's perspective on these significant, yet unaddressed, issues is crucial for any firm undertaking a thoughtful, educated assessment of the possibilities offered by the rule proposal's exchange registration option. Responding to Regulation ATS as a Regulatory Option. Instinet appreciates the Commission's proposal to provide a "broker" option within the contemplated regulatory framework. However, Instinet urges the Commission, consistent with its longstanding commitment to promoting innovation, to ensure and protect the ability of market participants to develop and utilize advanced trading technology unburdened by increased regulation, such as proposed in Regulation ATS. To ensure fair competition in the marketplace, it is Instinet's view that regulation should be consistent for all exchange members, regardless of the technologies they employ to serve their clients. Preserving Investors' Trading Flexibility. The Commission's proposal to mandate the full display of investor orders given to Regulation ATS brokers, but to permit discretion as to whether to display the same orders if given to non-Regulation ATS intermediaries, sharply curtails institutions' ability to effectively manage securities transactions on behalf of the individual investors for whom they act as proxies. Instinet believes that the Commission should preserve the flexibility of these investors to maximize the services of all intermediaries on an equivalent basis. Moreover, Instinet feels that effective competition - and the benefits it offers to institutions and the many individual investors they represent - can be achieved only through the application of a consistent pre-trade transparency regime to all exchange members. Enabling U.S. Broker-Dealers to Flourish in the Global Markets. Instinet, by virtue of its global presence, is concerned by the Commission's broad reinterpretation of the definition of an exchange. Given the globalization of the securities markets, Instinet cautions the Commission to ensure that any new regulatory framework preserves the ability of U.S. broker-dealers and other U.S. institutions to continue to compete in international markets. The reclassification of U.S. broker-dealers as "exchanges" is likely to interfere with this objective and could, in fact, wholly eliminate the ability of such broker- dealers to participate in numerous non-U.S. markets. Specific Comments on Proposed Regulation ATS It is Instinet's view that modifications to the fair access and order execution requirements of proposed Regulation ATS are necessary to further both the interests of investors and the objectives of the national market system. Although Instinet supports the Commission's efforts to increase efficiency in the U.S. market and reform its regulations with choice as a fundamental element, Instinet is concerned that pure agency brokerage is made less viable by the provisions of the proposed regulation requiring all Regulation ATS brokers to commit capital. I. An Overview of Instinet's Global Business Instinet believes that market efficiency can be achieved only in an environment where both proprietary trading and pure agency brokerage are allowed to co-exist as business choices within the context of the broker-dealer business. In fact, it is Instinet's provision of pure agency trading services that has made Instinet the world's largest agency brokerage. Instinet made a business decision to compete for business solely as an agent. Many of our competitors, who had historically led with their agency business, recently decided to lead strongly with proprietary trading. Starting in the late 1980's, many of the large integrated houses found their traditional agency business facing shrinking margins as commission rates were reduced and clients were demanding more control over the trading process. These entities, therefore, decided to devote more of their firms' financial and intellectual capital to the higher margin proprietary trading business while simultaneously upgrading their traditional research, market making and investment banking capabilities. This strategy has been very successful for many of these brokerage houses. However, throughout its 29 year history, Instinet has continually met its clients' needs by offering a unique value proposition. As a result of its pure agent status and its neutral position in all transactions, Instinet does not compete with client trading strategies. Also, Instinet assures clients' anonymity. One of the greatest costs of trading results from revealing one's strategy, profile or identity to the marketplace. Instinet protects its clients from this information leakage. This offers clients reduced trading costs, and a corresponding increase in investment performance, which ultimately means greater value for investors and their proxies. As a result, Instinet Corporation has grown in size and prominence, and now brokers virtually all equities in all time zones. Instinet's mission is no different from that of any other global trading firm: to secure as many investor orders as possible and execute them at the best prices possible anywhere in the world. In order to fulfill this mission, Instinet, like all other firms in the equity trading business, uses its human and technological trading skills to enable investors and their proxies to secure best execution. Instinet's goal as an agent is to find a buyer or seller at the investor's price. Large integrated dealing houses, by comparison, frequently take principal positions on client orders using their own capital to facilitate client trades. All broker-dealers - both dealer and agency firms - however, use the same basic fundamental strategy for executing the large orders that are typical of the investors they serve. That strategy is to represent pieces of the client orders simultaneously in as many different pools of global liquidity as possible. The two avenues usually taken are (1) representing pieces of client orders on the relevant exchanges to ensure that investors have access to exchange member liquidity and (2) advertising pieces of these orders to other investors and block desks off exchange, in order to tap into these important sources of "upstairs" liquidity. The ability to trade "upstairs" is key to maximizing performance for investors, regardless of the choice of intermediary - agent or dealer. Instinet is also the industry leader in applying advanced technology to agency trading. Clients can communicate, negotiate and trade electronically in many markets, and direct communications links are available to accept lists of orders from clients. Instinet's technology enables it to represent pieces of a single client order simultaneously in multiple markets for a security. Instinet's technology is complemented by its more traditional brokerage services - for example, allowing clients to place orders with one of Instinet's trading desks by telephone, often in markets where trading is not automated. Applying advanced technology to the investment process creates further efficiencies in Instinet's continuing effort to reduce investor transaction costs. Instinet faces keen competition from hundreds of integrated dealing houses around the world for institutional order flow. It is the combination of its pure agency brokerage services and advanced technology, however, that distinguishes Instinet from its competitors. II. General Comments on the Proposing Release Instinet strongly supports the Commission's goal, identified in the Proposing Release, of promoting innovation by offering regulatory flexibility to market participants under the Securities Exchange Act of 1934 (the "Exchange Act").[4] In pursuing this objective, Instinet considers it critical that the Commission establish consistent rules and regulations governing the products and services of all member firms, rather than use technology as a guide for governance. Likewise, Instinet wholeheartedly supports the Commission's determination to promote opportunity, choice and competition in the marketplace. However, Instinet would suggest that the Commission and other policy makers reconsider the potential alternative approaches available for reworking the existing U.S. regulatory framework. In particular, Instinet would encourage the Commission to continue to evaluate the possibility, described in our comments on the Concept Release, of a regulatory model enabling firms to elect between "SRO member/exchange member" and "investment exchange" status, an approach that has already begun to attract interest in European markets.[5] The Commission's idea of market participant "choice" is also embodied in the European approach. A. The Commission Needs To Supplement The Reinterpretation Of The Term "Exchange" With Associated, Relevant And Specific Rules So That Firms Can Make Educated Assessments Of The Feasibility Of Registering As An Exchange From a practical perspective, a firm undertaking a thorough assessment of whether to become regulated as an exchange would need significant additional Commission guidance on a number of crucial issues. Of particular note in the equity markets in which Instinet acts as agent, a firm would need to understand the Commission's proposed approach regarding the regulation of the Intermarket Trading System ("ITS"), including the rules governing time/price priority within a multiple exchange structure.[6] In addition, inter-exchange linkage rules need to be set forth for both the listed and over-the-counter marketplaces. Similarly, and as recognized by the Commission, firms considering exchange regulation would need to address the difficulty of reconciling the traditional exchange regulatory framework with the private ownership incentives likely to drive technological change.[7] Instinet urges the Commission to set forth its position on these crucial issues so that firms can perform the necessary assessments to determine the viability of the "exchange option" given the particular nature of their businesses. Market participants need clear guidelines. Instinet notes that the pre- existing complexities for global broker-dealers may be heightened by reclassifying them as exchanges not only domestically, but more importantly, internationally,[8] where there may be no comparable exemptions[9] from regulation as an exchange. Therefore, Instinet believes it is imperative that the Commission address these vital domestic issues so that firms may pursue a comparative analysis of their business objectives with relative certainty regarding regulatory issues attendant to exchange designation. Instinet strongly favors the Commission's new regulatory framework that offers firms the ability to structure their activities either as broker-dealers or as exchanges based on their fundamental business objectives. Instinet is, however, concerned that the expansive reinterpretation of the Exchange Act could, over time, result in the reclassification of multiple market participants as "exchanges" because of their use of technology or other "covered" characteristics. The wide scope of the Commission's proposed definition would mean that virtually every market participant providing electronic or other technologically advanced trading services will be deemed an "exchange" - and would be required to register as such absent an exclusion or exemption.[10] Thus, the proposal will shift the burden of identifying an exclusion or exemption from "exchange" regulation whenever market participants utilize or adopt innovative trading techniques. The significance of this burden is compounded by the likelihood that novel technologies will tend to emerge more rapidly than the pace at which regulatory exclusions and exemptions can be updated. At the same time, the Proposing Release does not set out any specific policy rationale for adopting an expanded definition of the term "exchange" that would counterbalance the difficulties associated with exchange status. We note that, from a legal perspective, broadening the term "exchange" does not appear necessary to achieve the Commission's objectives. The Commission has substantial statutory authority to regulate the activities of broker-dealers, regardless of whether they meet client needs through traditional means or through electronic and other advanced technologies, under the broker-dealer and other regulatory provisions of the Exchange Act.[11] Instinet notes and strongly supports the Commission's efforts to reform exchange regulation by providing increased flexibility to registered national securities exchanges in connection with their implementation of new technologies. Mounting competition and advanced technology have rendered portions of current exchange regulation obsolete when applied to dynamic electronic systems seeking to facilitate trades among various categories of market participants in a wide variety of financial products. Provisions that limit the types of securities that may be traded on and the market participants that may directly access an exchange are frequently incompatible with the operation of modern electronic systems. While newly registered exchanges, of course, should not be subject to less regulation than their more established competitors, the Commission should strive to modify the requirements currently applicable to registered national securities exchanges so that all such exchanges may compete on equal terms. Moreover, Instinet believes all of these regulations need to be thoroughly addressed and publicly disseminated. Accordingly, Instinet recommends that the Commission retain its current interpretation of "exchange"[12] and continue to regulate based on its substantial existing authority. At the same time, Instinet urges the Commission to articulate the rules and regulations described above that are critical to firms evaluating the feasibility of registering as exchanges.[13] Instinet believes that, in concert with the reform of exchange registration, the Commission will have moved the U.S. securities industry to a new and important regulatory framework. B. The Commission Should Refine The Regulation ATS Option For Technologically Innovative Brokerage Firms To Ensure And Protect Fair Competition Among All Broker- Dealers Regardless Of The Extent To Which They Employ Technology In Their Businesses Instinet urges the Commission, consistent with its longstanding commitment to promoting innovation, to protect the ability of market participants to utilize advanced trading technology unburdened by increased regulation of their businesses. As the Commission has recognized, technological innovation in the securities industry is both beneficial and inevitable and continues to have vast potential for enhancing the liquidity and efficiency of the international financial markets. Accordingly, new rules should preserve market participants' flexibility by avoiding regulation of exchange members solely due to their use of new technology to perform traditional broker- dealer functions - especially when such regulation will severely impact the competitiveness of a narrow segment of the broker- dealer community. The Commission's record of addressing policy issues within the existing regulatory regime is extensive, as indicated by, among other things, its recent promulgation of order handling rules for market makers and specialists,[14] the adoption of special recordkeeping requirements for broker-dealer trading systems under Rule 17a-23, and the issuance of numerous no-action letters and exemptions from exchange registration for novel trading systems over the past few years. Instinet notes that, while it has not always concurred with the Commission's specific regulatory decisions, a review of these initiatives suggests that many of the objectives identified in the Proposing Release (e.g., with regard to the trading of Nasdaq stocks) may have already been adequately addressed by prior rule changes, such as in the case of the order handling rules, and may not merit significant additional regulation. Adopting rules that afford exchange members the flexibility to deliver services in the most effective manner, whether through traditional means or with new technologies, can better enable the Commission to achieve one of the central objectives identified above - avoiding imposition of unnecessary regulatory burdens on member firms merely because they have succeeded in bringing new technology to bear in providing their traditional services. For example, as discussed in greater detail below, while Instinet recognizes that issues of fair access to trading opportunities or effectiveness of order execution may arise in the context of broker-dealers employing advanced technologies, those same concerns can also arise in the context of broker-dealer services delivered by more traditional means. The Commission should also be mindful of the many benefits conferred on investors through the application of new technologies. For example, technological advances have enabled agency brokers such as Instinet to continue to provide investors with an efficient, cost-effective alternative to trading with market makers and other broker-dealers acting for their own accounts, thereby freeing those investors from potential concerns regarding conflicts with dealers' proprietary positions. Moreover, regulations targeted solely at broker-dealers employing new technologies will have a particularly chilling effect on innovation - and will be particularly likely to appear unfair or discriminatory - when applied exclusively to a narrow class of broker-dealers that have utilized particular technological means in the traditional brokerage services they provide. Notably, the Commission estimates, in its cost-benefit analysis of proposed Regulation ATS, that only three firms would be affected by the proposed order display and execution access provisions, and only two firms would be affected by the proposed fair access provisions.[15] In other words, the costs and competitive burdens of the proposed new rules will be borne by only a handful of firms - precisely those that have proven most successful in building a business model based in part on advanced technology. Application of additional regulatory requirements to innovative firms will serve as a disincentive to investments in technology by all broker-dealers, since innovators risk the loss of any technological advantage that they may achieve through imposition of regulatory costs from which their competitors are excluded. The consequences of applying regulatory requirements based on the use of advanced technologies, moreover, may be especially severe if the anticompetitive impact of such requirements forces affected firms to abandon the business models they have established over time. As a firm that seeks to operate at the cutting edge of technology, Instinet encourages the Commission to assign a high priority to structuring each of its new rules to encourage innovation, as well as to ensure fair competition consistent with the policy objectives of the Exchange Act.[16] C. The Commission Must Preserve The Ability Of Institutions To Determine And Employ Trading Strategies Best Suited To The Interests Of The Investors For Whom They Are Proxies Instinet strongly favors preserving investors' flexibility to trade both "on exchange" and "upstairs" and consequently does not support the Commission's proposal to require public display of customer orders submitted to member firms subject to Regulation ATS.[17] Moreover, only a pre-trade transparency regime that uniformly applies to customer orders submitted to all exchange members - and not just the handful subject to Regulation ATS - would adequately address the Commission's concerns about market fragmentation and completeness of publicly available quotation information and avoid imposing anticompetitive burdens on a minority of member firms. Institutional investors need both floor trading and "upstairs" trading to achieve best execution for their clients in the global markets.[18] Instinet shares the Commission's belief that the fairest market for retail investors would be, at least in theory, one that provides perfect pre-trade transparency (e.g., by providing all investors, through mandatory dissemination to the public quotation stream or otherwise, with equal access to customer orders submitted to a market intermediary). Multiple investor orders, in aggregate, comprise the block orders that fund managers can best execute on behalf of their individual clients by displaying larger pieces of the order to other institutional investors and market participants "upstairs," while displaying smaller pieces of the order "on exchange." In this manner, an institutional investor may negotiate large trades with other wholesale investors while avoiding the significant negative impact the public display of the full order could have on the price and volatility of a security.[19] Institutional investors have particularly turned to agency brokers that offer upstairs trading facilities because such brokers combine optimal levels of transparency and liquidity relative to execution cost, as well as the opportunity to trade free of conflicts with proprietary positions. Experience confirms that attempts to solve this apparent regulatory dilemma by mandating perfect pre-trade transparency in one market may have the effect of driving institutional order flow into other markets that offer "upstairs" trading, thereby depriving all investors in that market of the benefits of post-trade information and increased liquidity generated by institutional trading. For example, in the late 1980s, the Paris Bourse experimented with mandatory "concentration rules," which required all orders received by any securities intermediary, either by telephone or more advanced technology, to be sent to the Bourse's central matching system (the CAC). Virtually all institutional trading in French equities immediately moved to offshore markets such as SEAQ International in London, which captured the vast majority of the Paris Bourse's block trading volume. When the Bourse subsequently reinstated a flexible pre-trade transparency regime, overall market volumes on the Bourse not only increased, but more importantly, matches on the CAC also rose dramatically. The Tokyo Stock Exchange has similarly witnessed the offshore flight of transaction volume in Japanese equity securities as a result of its prohibition of "upstairs" matching of orders. Over 25% of all transactions in Japanese equity securities are currently executed in London. Institutions trading large blocks of Japanese equity securities have refused to risk poor performance by adhering to the restrictive trading regime in Japan, and instead trade "upstairs" in other countries. As a result, retail investors in the Japanese market have lost the benefit of the liquidity and post-trade transaction information that Japanese institutions can bring to the market. Furthermore, mandating pre-trade transparency for orders submitted to a small minority of exchange members, without mandating pre-trade transparency for orders submitted to other members or to facilities that do not display client orders, imposes significant anticompetitive burdens on such member firms without resolving the Commission's concerns about market fragmentation and completeness of publicly available quotation information.[20] Many broker-dealers and facilities that would not be subject to Regulation ATS permit the anonymous and efficient execution of institutional orders without pre-trade publication to a national securities exchange or association.[21] Adopting a mandatory pre-trade transparency regime for broker- dealers subject to Regulation ATS will simply divert order flow to their competitors without any appreciable improvement in the quality of the information available to investors. Accordingly, as noted more specifically in Part III below, Instinet strongly urges the Commission not to impose a pre-trade disclosure requirement applicable to investor orders merely because those orders are submitted to a broker-dealer whose agency brokerage activities employ electronic technology to meet clients' trading needs. D. The Commission Should Ensure That U.S. Broker-Dealers Can Continue To Flourish In The International Markets In light of the growing globalization of the securities markets, fostered in significant measure by the growth of technology, Instinet wishes to underscore the need, long recognized by the Commission, to evaluate the impact of its regulations on the viability of U.S. broker-dealers using trading technologies in the international markets. Many broker-dealers employing electronic and other trading technologies have established important international linkages (including membership in foreign exchanges) or have substantial trading activity involving foreign market participants, a trend likely to continue in the future. In this context, Instinet encourages the Commission to afford these broker-dealer exchange members the flexibility demanded by the highly competitive global securities markets, as well as to consider the potential negative implications of domestic decisions on firms' non-U.S. activities. For example, a determination to classify a member firm as an "exchange" in the U.S. could significantly impair a firm's ability to participate in foreign markets. As the Commission is aware, a number of foreign regulators may regard all broker-dealers covered by the expanded "exchange" definition as "exchanges" (regardless of whether they qualify for an exemption under proposed Regulation ATS) and seek to regulate them accordingly under their national laws - or prohibit them from participating in their national markets altogether. In addition, Instinet encourages the Commission to address the significant issues posed by granting access to U.S. markets to foreign providers of electronic trading services, as described in the Concept Release. Continuing advances in trading technology render it imperative for the Commission to develop a framework governing cross-border access between U.S. and foreign markets, while eschewing radical changes that could disrupt the accommodations that U.S. broker-dealers have developed with foreign regulators over time. I. Specific Comments on Proposed Regulation ATS A. The Proposed Order Display And Execution Requirements Of Rule 301(b)(3) Would Unnecessarily Burden Market Participants' Ability To Effect Transactions Through Broker-Dealers Using Advanced Trading Technologies 1. Requiring public display of institutional orders submitted to broker-dealers subject to Regulation ATS would deprive institutional investors of efficient order execution opportunities without improving pre- trade transparency. As noted above, Instinet strongly favors elimination of the Commission's proposal to require public display of all institutional and non-market maker orders submitted to broker- dealers that would become subject to proposed Regulation ATS. Institutional investors rely upon upstairs trading to effect large transactions efficiently and anonymously, with minimal impact on publicly quoted prices. As discussed above,[22] any pre-trade transparency regime imposed upon broker-dealers that become subject to Regulation ATS because they use electronic trading technologies would simply divert institutional order flow to their competitors who are not subject to Regulation ATS or would encourage institutions to take their business to offshore facilities that are not subject to quotation and transaction information reporting in the United States. The ability of broker-dealers to offer an upstairs trading service is a crucial element of the value that they provide to investors with large trading positions. A determination to prohibit broker-dealers from continuing to provide this service merely because they have successfully implemented electronic trading technologies would thus not only limit investor choice, but would substantially damage those broker-dealers that are unable to offer this service. In addition, broker-dealers would be deterred from implementing such technologies on account of the prohibitive competitive burden not shared by other broker-dealers. The market demands a consistent pre-trade transparency regime. Moreover, as also noted above, we do not believe that the Commission should adopt a regulatory regime that imposes differential regulatory and competitive burdens on exchange members based merely on the technologies that they employ. Any mandatory pre-trade transparency regime must be applied uniformly and consistently to all exchange members if it is to have any impact on the degree and quality of information available to investors without imposing such anticompetitive burdens.[23] If the Commission determines to adopt the proposed rule, Instinet would suggest that the Commission clarify or eliminate the proposed requirement that a broker-dealer subject to Regulation ATS "ensure" that price and size data provided to a national securities exchange or association (or an exclusive processor acting on behalf thereof) is included in the quotation data made available by the exchange, association or exclusive processor to quotation vendors.[24] Any concerns in this regard would be better addressed by holding a national securities exchange, association or exclusive processor directly accountable to the Commission.[25] 2. Requiring automatic execution of client orders under proposed Rule 301(b)(3)(ii) would inappropriately subject agency brokers to principal risk. Any efficient market must provide investors with the choice of pure agency trading or capital commitment. The equity markets cannot remain liquid unless investors have the ability to choose their market intermediaries - i.e., the ability to choose between exchange members that trade purely on an agency basis and those that are also market principals. If investors, through regulation, are deprived of capital commitment, then liquidity will suffer. Conversely, if investors, through regulation, are deprived of pure agency choice, liquidity will also suffer. Rule 301(b)(3)(ii), if implemented, will deprive market participants of the ability to trade with pure agents. It is for this reason that Instinet strongly urges the Commission to eliminate the automatic execution access requirements of Rule 301(b)(3)(ii).[26] The proposed requirements, by obliging all affected brokers to assume principal risk in the event of multiple executions against their clients' orders, would compel agency brokers to abandon a fundamental element of their basic business structure. Requiring automatic execution against client orders without affording a broker the opportunity to verify whether a client order is still "live" could result in multiple executions being effected against a single client order. The risk of such multiple executions cannot, as a business matter, be passed on to the client entering the order and must be assumed by the broker- dealer. The escalation in costs resulting from the assumption of such principal risk would ultimately be borne by the broker's clients in the form of higher fees. Moreover, for brokers that have traditionally acted solely on an agency basis, the imposition of such principal risk would eliminate a key element of their business operations. Agency brokers would have to commit significant capital to the marketplace or seek alternative means to cover the principal risk resulting from the proposed automatic execution requirements. The burden of assuming significant principal risk would preclude such brokers from providing their clientele with the cost- effective execution opportunities traditionally associated with agency brokerage and could force them to restructure their operations entirely. By contrast, under the Commission's order handling rules,[27] ECNs are required to respond to non-client trade requests with response times for execution against market maker or specialist orders no slower than the response time offered to direct clients of the ECN, though, in any event, "not more than a few seconds."[28] This more balanced approach gives ECNs the time necessary to ensure that a displayed order remains available for execution, while still providing a response to the non-client that, in many instances, is faster than if the non-client's order had been routed directly to a market maker or specialist. A strong market relies on competition and investor choice. Our experience has shown that investors will move their business to markets that offer greater flexibility in order execution. The proposed automatic execution requirements, by effectively eliminating pure agency brokers from markets in covered securities, would thus impair the liquidity of those markets to the detriment of investors. Instinet also believes that the automatic execution functionality changes the nature of the marketplace. Because all brokers will be required to commit capital to the marketplace, agency brokerage will become increasingly less viable. Efficient markets require capital commitment as well as agency brokerage services. Instinet urges the Commission to reconsider this proposal. 3. The Commission Should Not Adopt The Access Fee Provisions Of Proposed Rule 301(b)(4) That Would Permit SROs To Limit Or Prohibit Access Fees Charged By Broker-Dealers Subject To Regulation ATS. Instinet opposes the proposal to limit (or eliminate entirely) access fees charged by a broker-dealer subject to Regulation ATS if the rules of the national securities exchange or association to which the broker-dealer provides price and size information limit (or prohibit) such fees.[29] SROs should not be authorized to establish fee or rate schedules for their members, regardless of whether such rules are "designed to assure consistency with standards for access to quotations" displayed on their markets. The delegation of such authority to SROs would constitute an unacceptable regulatory foray into the day-to-day operation of the market for brokerage services, as well as a shift in the Commission's previous policies on pricing. Instinet strongly believes that market forces should - as they currently do - determine the appropriate fees that broker-dealers can charge for their services. For example, agency brokers that do not trade for their own account, unlike market-makers and specialists, who are paid for their liquidity and immediacy in the form of a bid-ask spread, receive only a commission for their services. If investors find these charges unacceptable, they will take their business elsewhere. Forcing such broker-dealers to facilitate trades without reasonable compensation would effectively put them out of business, depriving investors of the benefits they provide. Moreover, granting SROs the authority to fix or eliminate access fees for their members could raise anticompetitive concerns in instances where the relevant SRO is developing products that would compete for agency order flow. SROs should not be granted a license to price broker-dealers offering potentially superior trading services out of the market. In creating the order handling rules governing the display of orders entered into certain "ECNs," the Commission provided that execution access fees "should not be structured to discourage access by non-customer broker dealers,"[30] while continuing to permit such "networks" that choose to disseminate quotes to the public display to charge appropriate fees for their services. If the Commission intends to revisit the issue of access fees in the context of the current proposal, Instinet would urge the Commission to revamp all of its public execution access fee requirements to ensure that all orders integrated into the public quote stream are treated consistently. For example, the Commission could either repeal the order handling rules altogether (while allowing brokers the option of displaying customer orders to the public quote at the fees prescribed by the SRO through whose facilities they seek access to the public quote) or leave the order handling rules intact and allow all broker-dealers to charge competitive access fees for execution against the public quote,[31] or allow all members to charge explicitly for this service even though they are already compensated for it implicitly through the spread. However the Commission chooses to restructure its rules, all broker-dealers should be able to set appropriate fees in light of the nature of the services they perform, while remaining subject to SRO rules providing that fee structures be reasonable and not unfairly discriminatory.[32] B. Violations Of Any Fair Access Requirements Should Be Handled Through SRO Disciplinary Procedures, Rather Than Through the Formal Commission Procedures That Would Be Mandated By Proposed Rule 301(b)(5)(iii)-(iv) In determining whether broker-dealers have established neutral standards for granting access to trading, Instinet believes that the Commission's rules should provide for review of denials or limitations of access to be handled through current SRO complaint and disciplinary procedures, rather than through the procedures used to appeal SRO determinations before the Commission. Instinet shares the Commission's general concern that broker-dealers should not unfairly discriminate against prospective customers, although it questions whether such a concern arises only in the context of broker-dealers that provide electronic trading opportunities. It would be inappropriate, however, to subject broker-dealers to formal Commission procedures in connection with alleged unfair denials or limitations of access, and in particular to the stay provisions of proposed Rule 401(d)(1) of the Commission's Rules of Practice, given that broker-dealers are already subject to SRO disciplinary procedures. All broker-dealers, regardless of whether they become subject to Regulation ATS, ordinarily must become members of an SRO responsible for examining them to ensure that their activities, including their relations with customers and potential customers, are subject to adequate oversight. Extending formal Commission procedures to review denials or limitations of access by broker-dealers subject to Regulation ATS unnecessarily muddies the allocation of supervisory authority over such broker-dealers and could in some cases lead to duplicative or inconsistent review proceedings. Moreover, subjecting a broker-dealer to motion procedures before the Commission, as proposed in Regulation ATS, would likely lead to the frequent filing of frivolous or vexatious complaints against the broker-dealer, thereby impeding its ability to screen out potentially unqualified customers. Such procedures would place such broker-dealers at a significant competitive disadvantage with respect to other broker-dealers that, because they are not classified as "alternative trading systems," would retain greater discretion to deny or restrict access to potentially questionable customers. C. The Commission Should Eliminate Or Clarify The Scope Of The Cooperation Requirements That Proposed Rule 301(b)(7) Would Impose On Broker-Dealers Regarding The Examination, Inspection And Investigation Of Their Clients Instinet requests that the Commission eliminate, or at a minimum, clarify the additional responsibilities a broker- dealer would have to assume in "cooperation" with a Commission or SRO investigation of its clients, as proposed in Rule 301(b)(7) under Regulation ATS. The Commission currently has the authority to inspect and examine all registered broker-dealers (including all broker-dealers that would be subject to proposed Regulation ATS),[33] and each SRO has the authority to inspect and examine its members.[34] This authority includes, in each case, the right to examine any relevant trading information maintained by the broker-dealer (for example, under the recordkeeping requirements proposed in Rule 301(b)(8) under Regulation ATS). Adopting the proposed requirement that a broker-dealer subject to Regulation ATS "cooperate with the examination, inspection or investigation of subscribers" could therefore create unnecessary confusion as to the scope of the broker- dealer's responsibilities to the Commission. For example, it is unclear whether "cooperation" would require a broker-dealer to provide to the Commission or an SRO, or to assist the Commission or an SRO in obtaining, confidential information about a client that would not be required to be maintained in the broker- dealer's records under any applicable recordkeeping requirements. Existing and prospective clients may be reluctant to utilize broker-dealers subject to this Rule without further clarification of its intended purpose. D. The Commission Should Ensure That Any Recordkeeping Requirements Imposed Under Regulation ATS Take Into Account SRO Recordkeeping Requirements And Afford Broker-Dealers Flexibility To Innovate Instinet recognizes that the requirements of Rule 301(b)(8) of Regulation ATS, together with Rule 302 and 303, generally are designed to substitute for, and in some cases augment,[35] requirements that would be eliminated by the proposed repeal of Exchange Act Rule 17a-23. Instinet considers it important, however, for the Commission to assess, in adopting any new recordkeeping requirements, the relationship of such requirements to applicable SRO recordkeeping rules, including in particular the NASD's recently-adopted rules relating to its Order Audit Trail System (OATS).[36] Instinet encourages the SEC and SROs to work toward establishing recordkeeping requirements that will minimize duplication and inconsistency to the greatest extent possible and that will also provide broker-dealers employing electronic trading technologies substantial flexibility in structuring their recordkeeping functions. E. The Commission Should Clarify That The Confidentiality Provisions Of Proposed Rule 301(b)(10) Would Not Prohibit Registered Representatives From Providing Clients With Information Regarding A Broker-Dealer's Activity Instinet requests that the Commission clarify that the required confidentiality provisions of proposed Rule 301(b)(10) under Regulation ATS would not prohibit registered representatives of a broker-dealer from providing customers with information regarding the trading activity effected by the broker-dealer (other than confidential customer information). Customers of a brokerage firm often contact firm representatives to learn or be kept aware of order and trade activity conducted through the broker-dealer, both in the electronic and more traditional contexts. While registered representatives of the firm are not authorized to reveal confidential information regarding customer transactions, representatives may facilitate customer participation in the marketplace by assisting customers in monitoring trading activity. As proposed, Rule 301(b)(10) would require broker- dealers subject to Regulation ATS to have in place adequate safeguards and procedures to protect customers' confidential trading information, including, among other things, "[l]imiting access to the confidential trading information of subscribers to those employees of the alternative trading system who are operating the system or [are] responsible for its compliance" with the Regulation and any other applicable rules.[37] Because registered representatives may be regarded as employees responsible for "operating" the firm's "systems," the proposed provision could be construed to bar such representatives from relaying information regarding trading activity to participating customers. IV. Concluding Remarks Instinet strongly supports the Commission's initiative to devise a new regulatory framework based on the principle of offering market participants the opportunity to make a business decision regarding their registration with the Commission as a broker-dealer or as an exchange. However, in order for Instinet and other market participants to make this important business decision, critical information from the Commission governing exchange rules and regulations needs to be supplied, as in the case of the Intermarket Trading System. This information is crucial for all firms to make educated assessments as to the business potential of the exchange registration option. Agents and dealers are in the same fundamental business and compete for the same client orders. The Commission should recognize that agency brokerage and proprietary trading are both necessary to market efficiency and are business choices of broker-dealers. Therefore, Instinet encourages the Commission to ensure that regulation be consistent for all broker-dealers, regardless of the business models or technologies they employ to serve their clients. Moreover, Instinet believes that the Regulation ATS rule proposal should reflect the fact that all broker-dealers are in the same business, and rules for ATS broker-dealers should not differ from rules governing all other broker-dealers. The disparity in the proposed regulation is particularly noteworthy in the order display rule. To mandate order display for those investors using ATS broker-dealers while those same investors have discretion when using non-ATS broker- dealers not only impacts investors' trading flexibility, but also restricts fair competition among firms. Finally, Instinet, as a global broker, appreciates the efforts of the Commission to ensure that U.S. broker-dealers have the ability to compete in the global markets. Instinet cautions the Commission that designating some broker-dealers as exchanges has significant international implications. It is our hope that the Commission will continue to use the good judgment demonstrated on numerous others issues on this topic as well. We would be pleased to discuss any of the comments in this letter with the Commission or its staff. If we can be of further assistance to the Commission in this regard, please do not hesitate to contact the undersigned (212-310-7728) or Peter Rich, our Washington representative (202-789-8550). Sincerely yours, Douglas M. Atkin Chief Executive Officer, Instinet International cc: Chairman Levitt Commissioner Johnson Commissioner Hunt Commissioner Carey Commissioner Unger Dr. Richard R. Lindsey, Director of Market Regulation Mr. Robert L.D. Colby, Deputy Director of Market Regulation Ms. Belinda Blaine, Associate Director of Market Regulation Ms. Elizabeth King, Senior Special Counsel, Division of Market Regulation **FOOTNOTES** [1]: Securities Exchange Act Release No. 39,844 (Apr. 21, 1998), 63 Fed. Reg. 23,504 (Apr. 29, 1998) (the "Proposing Release"). [2]: See Securities Exchange Act Release No. 38,672 (May 23, 1997), 62 Fed. Reg. 30,485 (June 4, 1997) (the "Concept Release"). [3]: Proposing Release, 63 Fed. Reg. at 23,511. [4]: Id. at 23,505-06. [5]: See Letter from Douglas M. Atkin, Chief Executive Officer, Instinet International, to Jonathan G. Katz, Secretary, Securities and Exchange Commission (Oct. 3, 1997). [6]: Instinet recognizes the Commission's efforts to date in addressing issues relating to ITS, most recently in its release regarding the Computer Assisted Execution System Linkage and the unanimous vote provision. See Securities Exchange Act Release No. 34-40260 (July 24, 1998), 63 Fed. Reg. 40,748 (July 30, 1998). [7]: See, e.g., Proposing Release, 63 Fed. Reg. at 23,525. [8]: See Part II.D infra. [9]: If the Commission determines to broaden the interpretation of the term "exchange" as proposed, Instinet requests that, as a technical matter, the Commission exclude rather than exempt from that definition firms that become subject to Regulation ATS. This technical change could reduce, to some extent, some of the problems that might arise from being deemed an "exchange" under laws other than the federal securities laws. [10]: At a technical level, we note that if the Commission adopts the proposed expanded definition of "exchange" subject to an exemption for firms that "comply" with Regulation ATS, it would be worthwhile to clarify the status of a firm falling within the "exchange" definition that, while acting in good faith, fails to comply fully with each of the technical requirements of that Regulation. Presumably, the Commission does not intend to require a broker-dealer to become subject to exchange registration based solely on technical non-compliance with the detailed provisions of Regulation ATS, especially in light of the prohibitions on other broker-dealers' effecting transactions on an unregistered exchange. See Section 5 of the Exchange Act. Accordingly, we suggest that, if the proposed definition is adopted, the exemption (or preferably exclusion) from "exchange" status extend to any registered broker-dealer that, in good faith, undertakes to comply with Regulation ATS. [11]: If the Commission determines to expand the definition of "exchange" as proposed, Instinet requests that the Commission clarify that the exemption from the definition of "exchange" provided in proposed Rule 3a1-1(a)(2) under the Exchange Act would cover not only broker-dealers "in compliance with Regulation ATS," but also those broker-dealers that are not required to comply with the substantive requirements of Regulation ATS because they are excluded from its scope provisions under Rule 301(a). In this connection, Instinet further believes that the exemption in Rule 301(a)(4) from compliance with the substantive requirements of Regulation ATS for broker-dealers that trade only government securities and Brady bonds (and related repurchase and reverse repurchase transactions) should be amended to exempt firms from compliance with the substantive requirements of Regulation ATS with respect to all trading in government securities, Brady bonds and related transactions. Broker- dealers that trade government securities as well as other securities and financial instruments should not be required to restructure their operations, at substantial expense and inconvenience to their customers, to enjoy the benefits of an exemption with respect to their government securities activities. [12]: See Exchange Act Release No. 27,611 (Jan. 12, 1990), 55 Fed. Reg. 1980 (Jan. 19, 1990) (the "Delta Release"). [13]: Instinet believes, however, that firms that do not wish to conduct their activities as broker-dealers should be permitted to opt for exchange regulation if they so desire. This could be accomplished, for example, by interpreting the statutory definition of "exchange" to include any system that does not operate through a registered broker-dealer but that holds itself out as an exchange. [14]: See footnote infra. [15]: Proposing Release, 63 Fed. Reg. at 23,541-42. Similarly, the Proposing Release reveals that only six firms have elected to display market maker and specialist quotes as "electronic communication networks" under the Commission's recently adopted order handling rules. Id. at 23,514. [16]: See Section 11A(a)(1) of the Exchange Act. [17]: See Rule 301(b)(3)(i) under proposed Regulation ATS. [18]: Institutional and other investors, unlike market makers and exchange specialists, do not perform specialized market functions and should not be subject to a mandatory pre-trade transparency regime. See Exchange Act Release No. 37,619A, 61 Fed. Reg. 48,289 (Sept. 12, 1996) (adopting (1) an amendment (the "ECN Amendment") to Exchange Act Rule 11Ac1-1 (the "Quote Rule") requiring a market maker or specialist that enters an order into an "electronic communications network" ("ECN") that widely disseminates such order either (a) to communicate the order to its national securities exchange or association for integration into the public quote or (b) to publish its best priced orders through an ECN that provides such best priced orders to a national securities exchange or association and provides any broker-dealer the ability to effect a transaction with such orders equivalent to the ability of any broker- dealer to effect a transaction with a market maker or specialist pursuant to the rules of the exchange or association to which the ECN supplies such bids and offers (the "ECN Display Alternative") and (2) a new Rule 11Ac1-4 under the Exchange Act (the "Limit Order Display Rule") generally requiring market makers and specialists either (a) to publish immediately a bid or offer that reflects the price and full size of any customer limit order that would improve or increase the size of its public quote or (b) to provide such order to an ECN for public display and execution access in accordance with the ECN Display Alternative). [19]: All institutional investors have the option, through a broker-dealer or other intermediary, to publish all or part of their orders to the market. For example, Instinet currently offers a variety of transparency regimes to its institutional customers, including allowing institutions to display their orders in the public quotation stream. [20]: See footnote supra (Commission estimates that only three firms would be subject to the proposed order display and execution access requirements of proposed Regulation ATS). [21]: The fact that a broker-dealer, in the course of seeking order execution, disseminates all or part of an order to more than one client does not, in our view, appear to raise any additional policy issues that would justify subjecting such a broker-dealer to a different regulatory regime than broker-dealers that employ less transparent technologies to achieve the same results. [22]: See Part II.C supra. [23]: Instinet believes that all customers should retain the ability to manage the transparency of their orders, whether they have placed such orders with a traditional brokerage firm or a brokerage firm that offers both traditional and electronic execution opportunities. Accordingly, in the event the proposed order display requirement in Rule 301(b)(3) is not eliminated, the Commission at a minimum should permit any customer of a broker-dealer to opt out of any mandatory pre-trade transparency requirement established under Regulation ATS. [24]: See Proposing Release, 63 Fed. Reg. at 23,558. [25]: In the Order Execution Interpretive Letter, the Commission noted that the ECN Display Alternative "does not require any particular [self- regulatory organization ("SRO")] to accept ECN priced orders for inclusion in the SRO's quote," but rather that "the Quote Rule should be interpreted as providing for ECN access to the National Market System . . . , but only through an agreement with an SRO or SROs." Id. at 77,318. The Commission further noted, however, that "[i]f ultimately no SRO were willing to accept ECN priced orders on reasonable conditions, the Commission has reserved the right to use its authority under Section 11A of the Exchange Act to require the SROs to act jointly to reach the objectives outlined in the ECN [A]mendment." Id. [26]: See Proposing Release, 63 Fed. Reg. at 23,517. [27]: See footnote supra. [28]: E.g., Bloomberg Tradebook LLC (Feb. 26, 1998). [29]: See Rule 301(b)(4)(ii) under proposed Regulation ATS. [30]: ECNs providing execution access against market maker and specialist orders under the ECN Display Alternative are not permitted to structure their fee schedules in a manner that discourages access by non- subscriber broker-dealers. See 61 Fed. Reg. at 48,314 n.272. The Commission has subsequently clarified this standard to require that an ECN not charge execution access fees exceeding the access fees charged to a substantial portion of its broker-dealer subscribers. See Order Execution Interpretive Letter at 2. [31]: While Instinet would support the notion of requiring a broker-dealer's access fee to be incorporated in its displayed quote, see Proposing Release, 63 Fed. Reg. at 23,518, SROs do not yet have the systems necessary (i.e., the ability to enter decimalized quotes) to make this a viable alternative. [32]: See, e.g., National Association of Securities Dealers Rule 2430. [33]: See Section 17(b) of the Exchange Act. [34]: See, e.g., New York Stock Exchange Const. Article VIII, Sec. 2. [35]: For example, broker-dealers subject to the proposed recordkeeping requirements would be required to maintain records with respect to all orders received as well as all orders executed through their trading facilities. Compare Exchange Act Rule 17a-23(c)(1)(ii) and (iii) with proposed Rule 302(c) under Regulation ATS. [36]: See Special NASD Notice to Members 98-33, SEC Approves New Order Trail Audit System (OATS), March 1998. [37]: Rule 301(b)(10)(i) of proposed Regulation ATS. Subparagraph (ii) of Rule 301(b)(10), which would require broker-dealers subject to the Regulation to "[implement] standards controlling employees of the alternative trading system trading for their own account," would appear to restate existing regulations regarding the misuse of confidential customer information by broker-dealers.