August 20, 2002
Jonathon G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C.
Re: ADF Fails to Satisfy Conditions Precedent to Nasdaq's Super Montage Operation
Dear Mr. Katz:
NexTrade Holdings, Inc. ("NexTrade"), parent of NexTrade, Inc. hereby submits comments to the Securities and Exchange Commission (the "Commission") to the effect that the Alternative Display Facility (the "ADF") of the National Association of Securities Dealers, Inc. ("NASD") fails to satisfy the conditions precedent to the Commission's approval of the Nasdaq's SuperMontage operation.
The Commission determined that the approval of Nasdaq's SuperMontage was conditioned to the occurrence of the following events prior to or at the same time as the SuperMontage:
(1) that the NASD will offer a quote and trade reporting alternative that satisfies the Order Handling Rules, Regulation ATS, and other regulatory requirements for ATSs, ECNs, and market makers;
(2) that NASD quotes disseminated through the exclusive SIP will identify the ATS, ECN, or market maker source of the quote; and
(3) that participation in SuperMontage will be entirely voluntary, because NASD quotes will be included in the Nasdaq quotation management system while Nasdaq is the exclusive SIP, but only for display purposes, and the NASD will provide access to its quotes on a market-neutral basis.
Prior Conditions Precedent Have not Occurred. Therefore, the Commission Should Refrain from Issuing a Final Order Approving the SuperMontage.
1. The ADF fails to satisfy the Order Handling Rules (the "OHRs"), regulation ATS, and other regulatory requirements for ATSs, ECNs, and market makers for the following reasons:
First, the ADF is discriminatory and fails to satisfy the OHRs because no direct execution mechanism exists in ADF for the Quotation System of the Display Facility. Assuming arguendo that having hundreds of direct connections among market participants could satisfy the necessary execution facility, the costs for ADF "direct" connectivity will render impossible for the majority of market participants the ability to afford to execute trades against the Displayed Quotes. Conversely, the Nasdaq's SuperMontage centralizes in one facility direct access to all broker-dealers, ECNs, and any other market participant, to the benefit of the Nasdaq and to the detriment of all other markets. The NASD readily acknowledged the asymmetric and unfairly discriminatory relationship between the ADF and the SuperMontage in its amended ADF filing, in these terms:
"If indirect access were not available, the NASD believes it could be overly burdensome and prohibitively expensive on the members - particularly smaller broker-dealers - if they were obligated to link directly to every market participant."
In other words, the NASD states that obligating firms to directly connect is too much of a burden for smaller firms, yet the NASD asks the Commission to approve the ADF when it compels all its members to make such direct connections. This fatal flaw in the NASD's premise is by itself an obvious violation of the Act and grounds for denying approval of the ADF.
Further, in the adopting release for the OHRs, the Commission stated, "[S]pecifically, the display of customer limit orders advances the national market system ("NMS") goal of the public availability of quotation information, as well as fair competition, market efficiency, best execution and disintermediation."1
Nevertheless, the ADF rules obligate all ADF participants to directly link to one another without a hub or a central destination (as the Super Montage offers), using dedicated lines for each individual link, making the connection extremely difficult and expensive. This requirement unfairly discriminates against smaller broker-dealers and is in violation of Section 6 of the Act that prohibits such discrimination.2 Consequently, the Commission should not approve the ADF until such time as the NASD offers a true ADF that will enable all market participants, including smaller broker-dealers, to access an order routing mechanism that will offer at least similar executions to the SuperMontage, without discriminatory and burdensome restrictions.
Second, because the ADF has no available order routing facility, market participants, including the NexTrade ECN, will be obligated to utilize the SuperMontage order routing facility to route order flow. However, rule 4710 of SuperMontage creates an environment where orders that are displayed and due execution will be forced out of the public quote, unexecuted, to the detriment of individual investors who will fail to receive the benefit of the Best National Market Bid and Offer prices. Because this Rule violates the Order Handling Rules, as well as sections 9 and 11 of the Exchange Act, the Commission should refrain from approving the SuperMontage until such time as the NASD offers a true ADF that will safeguard the application of the Best National Market Bid and Offer quotations to the American investor, who, through broker-dealers, expects the benefit of the most efficient and transparent market in order to obtain a security price that is indeed a true reflection of market conditions and not a manipulation of a facility to benefit a few market-makers to the detriment of the American investor in general. The Commission cannot possibly equate the concept of rejecting orders due execution and removing said orders from public display as in any way improving "fair competition, market efficiency (or) best execution" or in any way advancing the NMS goal of "public availability of quotation information."
Third, the Automation Review Policy ("ARP") requirements mandate that execution systems for exchanges be developed in a standardized methodology. In the ADF the various private execution points have numerous private development methodologies. Since the Commission has not reconciled this inherent conflict, it should refrain from approving the SuperMontage until such time as the NASD offers a true ADF developed with standardized methodology, because otherwise the ADF's diverse methodology will create an inefficient, difficult, and inaccessible environment to either receive quotes or execute trades.
Fourth, the execution systems proposed in the ADF will be owned and operated by non-broker-dealers. As such, the NASD and Commission have no oversight authority regarding business operations or practices. The ARP Requirements call for exchanges to file System Change Notifications with the Commission to determine if a 19b-4 filing is necessary for certain changes. The private firms have no compulsion to file such notifications and the NASD has no authority to ensure such filings are made. As a result, the Commission should refrain from approving the SuperMontage until such time as the NASD offers an execution system that will enable the Commission to supervise and control the activities of the firms executing the systems for the ADF. Failure to supervise those firms is tantamount to allowing trading to occur in an unregulated environment, leaving market operations to the whim of whoever owns the ADF execution systems.
Fifth, the ADF as it currently stands fails to comply with regulation ATS since the NASD will have no method to ensure that the private non-broker-dealer firms, that control the execution links, follow the requisite Fair Access provisions of Regulation ATS. Under this circumstance, the Commission should refrain from approving the SuperMontage until such time as the NASD offers an ADF that will provide a method to ensure that the control of the execution links meet the required Fair Access provisions of Regulation ATS.
A. Because of the high cost structure of the ADF, smaller firms will have to obligatorily participate in the SuperMontage facility, rendering the ADF, even if the smaller firms adopted the ADF as an alternative, as it stands, impossible to perform and economically unfeasible, in addition to excluding them from participating in the ADF, which is precisely what the NASD anticipated in its amended ADF filing: "the NASD believes [the ADF] could be overly burdensome and prohibitively expensive on the members - particularly smaller broker-dealers." Clearly, under burdensome and prohibitively expensive circumstances, the Commission should not approve the SuperMontage until the NASD offers an ADF that will be "entirely voluntary" for all members, including the smaller broker-dealers.
B. The standards of system speed and reliability are far higher in ADF than the requirements to which the SuperMontage is held. Further, the consequence of system failure in the ADF could easily turn into a 20-day suspension of trading privileges. Such a suspension would destroy many small firms, rendering participation in ADF an impossible business risk to accept. Alarmingly, if the NASD had been held to the same standards it would have been forced to cease trading when it had SelectNet problems several months ago. The Commission should not approve SuperMontage until the standards of system speed and reliability are reconciled to meet technological limitations, and until the ADF necessary technology is proven to avoid system's failures that will cause adverse consequences to its users. Otherwise the NASD is fomenting the obligatory use of SuperMontage in total opposition to the "voluntary" requirement of the condition precedent to its approval.
C. The NASD's refusal to use a standard messaging protocol in the ADF vastly increases the programming cost of each direct connection, again to the detriment of smaller firms. Such costs exclude smaller firms from participating as a practical matter, turning them obligatorily into the SuperMontage to be able to participate in the market. The economic impossibility to participate in ADF fails to qualify the SuperMontage as voluntary, creating in the Commission an obligation to refrain from approving it until such time as the ADF presents a true economic possibility to all market participants.
D. The added costs of ADF participation vastly increase the cost of Best Execution for broker-dealers. The Commission has stated that a critical factor in determining whether or not a broker-dealer is satisfying its Best Execution Obligation is that orders need to be routed to the market center with the greatest likelihood of execution. Since ADF has no routing or execution functions, the compliance risk that a firm would fail to achieve Best Execution is substantially higher in ADF, thereby rendering ADF participation impossible and making the SuperMontage the obligatory trading platform. A situation that in no way can be considered voluntary, creating in the Commission a duty to find that the SuperMontage is not voluntary until the NASD offers an ADF that will offer a market center with the greatest likelihood of execution.
E. Market makers accept no order flow from other unknown market makers via indirect links. The ADF would compel them to accept such orders, which would substantially jeopardize their trading positions. Consequently, Market Makers cannot participate in ADF. To date, there are no Market Maker members of the ADF and all Market Makers must obligatorily utilize the SuperMontage platform, rendering the voluntary condition precedent to its approval as impossible to occur. Because the voluntary condition is impossible to occur, the Commission should refrain from approving SuperMontage until the NASD offers a true ADF facility that will allow access to all market participants without jeopardizing trading positions and offer the liquidity to those who have chosen it as an alternative.
F. To date, upon NexTrade's information and belief, the ADF has three participants committed: NexTrade, Bloomberg TradeBook, and the Island ECN. The math is compelling, out of approximately 5,500 firms, only three have agreed to participate in the "alternative" market and ZERO firms have agreed to use the ADF exclusively. That 99.9994% of the market is unwilling to accept the ADF as even a possible destination for trades speaks volumes about its viability as a "voluntary" alternative to the SuperMontage. Moreover, since the three committed firms are technologically savvy firms, and ECNs with millions invested in system infrastructure, it demonstrates that the ADF has cost burdens too excessive for most firms to contemplate participation. Finally, of the three committed firms, NexTrade is by far the smallest and the least able to devote huge resources to thousands of direct connections. As an ADF participant, NexTrade can be forced to develop direct lines with every other brokerage firm. NexTrade desperately wants to be in the ADF but at some point the cost of supporting direct lines will grow too great and NexTrade will be forced to withdraw from the ADF and obligatorily participate only in SuperMontage. NexTrade urges the Commission to refrain from approving the SuperMontage until the NASD offers an ADF facility that allows firms that wish to participate in the ADF an economically sustainable solution. Without a viable, supportable, and non-discriminatory economic model, the Commission is obligated to state that the conditions precedent for SuperMontage approval have not been satisfied.
NexTrade strongly believes that the ADF and the SuperMontage, as they currently stand, violate the Exchange Act and other regulations as fully described in this document. Further, there is no satisfaction or occurrence of the conditions precedent to the SuperMontage approval and consequently the ADF fails on at least two fronts, it violates the Exchange Act by promoting unfair discrimination and its untenable structure makes SuperMontage participation mandatory, not voluntary. Therefore, NexTrade urges you to vote that the ADF fails to satisfy the conditions precedent in the SuperMontage Approval Order.
Should you have any questions, or if you would like to discuss any of these issues, please feel free to contact me at (727)446-6660 Ext.122.
Respectfully submitted,
John M. Schaible
President
Cc The Hon. Harvey Pitt, Chairman
The Hon. Cynthia Glassman, Commissioner
The Hon. Harvey Goldschmid, Commissioner
The Hon. Paul Atkins, Commissioner Designee
The Hon. Roel Campos, Commissioner Designee
Annette Nazareth, Esq., Director
Division of Market Regulation
Robert Colby, Esq., Deputy Director
Division of Market Regulation
Katherine England, Esq., Associate Director
Division of Market Regulation
Elizabeth King, Esq., Associate Director
Division of Market Regulation
John S. Polise, Esq., Senior Special Counsel
Division of Market Regulation
The Hon. Paul Sarbannes, Chairman
Senate Committee on Banking, Housing and Urban Affairs
The Hon. Phil Gramm, Ranking Minority Member
Senate Committee on Banking, Housing and Urban Affairs
The Hon. Michael G. Oxley, Chairman,
U.S. House of Representatives Financial Services Committee
The Hon. John LaFalce, Ranking Minority Member
U.S. House of Representatives Financial Services Committee
Daniel Caamano, Esq., Caamano & Associates P.A.
Linda Lerner, Esq., Domestic Securities, Inc.
1 Securities and Exchange Commission Release No.34-37619A, File No.S7-30-95.
2 Sec 6 (b) 5 provides that "the rules... are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by this chapter matters not related to the purposes of this chapter or the administration of the exchange."