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92-67 NASD® Responds to SEC's Market 2000 Concept Release
On November 20, 1992, the NASD® submitted to the Securities and Exchange Commission (SEC) a letter responding to the SEC's request for comments on today's market structure and regulatory environment, its "Market 2000" study. In its letter, the NASD asked the SEC to rescind off-board trading restrictions (especially those in place after U.S. markets have closed), rescind exchange-market delisting restrictions, require enhanced disclosure of payment-for-order-flow practices, and adopt regulations for proprietary trading systems.
SUMMARY OF COMMENTS
The Securities Exchange Act of 1934 (Act), as amended in 1975, reflects a heavy presumption in favor of competition. The rationale for this presumption is even more valid today than it was in 1975: all investors share a common interest in fairness and liquidity, but increasingly pursue diverse investment and trading strategies. Competition is the best means to facilitate these investor demands by promoting innovation and diversity in fair and efficient secondary market trading mechanisms.
COMPETITION FOR ORDER FLOW
The NASD believes that there is nothing unique about competition for order flow in exchange-listed stocks that would justify deviations by the SEC or Congress from the longstanding and still prevailing pro-competition approach to U.S. market structure. Competition for order flow in exchange-listed stocks has not caused a reduction in market quality. Indeed, the evidence is to the contrary — market quality has improved as competition has increased. So long as markets remain transparent, the NASD sees no reason why these trends should not only continue, but receive increasing attention and support.
The NASD also believes that competition for order flow in exchange-listed stocks has resulted in numerous innovations that would not have occurred if one market had a monopoly over order flow. The value of these competitive benefits to investors is significant and would be impossible to replicate in a monopolistic environment. Dispersal of order flow in exchange-listed stocks is a natural result of differing execution needs of diverse customers with different types and sizes of orders. Such dispersal occurs within markets as well as across competing markets. Some of these competing markets are foreign, so that it is in the interest of U.S. investors of all sizes and types for the SEC to continue to permit U.S. markets to provide the benefits that competition for order flow in exchange-listed stocks brings, rather than to force U.S. investors to seek innovation and diversity abroad.
OFF-BOARD TRADING RESTRICTIONS
While the markets have been changed and driven by competitive forces in the past 20 years, that evolution has not always been evenhanded or equitable. The exchange markets are able to trade the most active, premier Nasdaq stocks according to the Nasdaq unlisted trading privileges plan, but the majority of NASD market makers are still precluded from trading the most active, premier exchange stocks because of off-board trading restrictions. Indeed, third-market market makers are presently precluded from trading all exchange-listed securities in the only intermarket trading linkage, the Intermarket Trading System (ITS).
The SEC should respond to the success of prohibiting further expansion of off-board trading restrictions (through implementation of SEC Rule 19c-3) by now removing all off-board trading restrictions, especially during after-hours trading sessions. There is no evidence that the competition that has been allowed to occur in the marketplace has in any way harmed investors. Indeed, given the evidence of the benefits of the competition that has been allowed to occur in the form of innovation, diversity, and pricing, more competition, not less, will benefit investors.
The SEC Rule 19c-3 experiment has proven two things. First, that the auction and dealer markets can operate in synergy with each other, and second, that the existence of different types of systems and degrees of automation in market centers need not impede effective communication, competition, or regulatory oversight of markets. In that connection, recent experience demonstrates that competitive pressures are encouraging secondary markets to provide for price improvement measures including the exposure before execution of orders through ITS. Accordingly, the concerns raised by the internalization of customer order flow may be far less warranted today than in the past. For these reasons, the NASD believes that it is entirely proper for the SEC to remove all off-board trading restrictions, and to include all securities in the ITS linkage.
PROPRIETARY TRADING SYSTEMS
Competition for order flow also occurs with proprietary trading systems.1 These systems have been developed for specialized customers and in response to specialized needs. While proprietary trading systems may offer unique services to segments of the marketplace, they currently operate under an ad hoc "no action" letter approach, considerably less burdensome and time-consuming than the regulatory framework that the self-regulatory organizations (SROs) must abide by when seeking approval of or enhancements to similar systems. The SEC must fashion an equitable regulatory approach for proprietary trading systems that neither stifles the innovative developers of such systems nor unduly burdens the SROs charged with surveiling those systems or those interested in developing comparable competitive systems.
PAYMENT FOR ORDER FLOW
Given an environment where payment for order flow appears to contribute to competition and innovation and to reduce customer costs, and where best execution is occurring routinely, the only remaining regulatory issue is whether such practices are effectively disclosed. The NASD has on file with the SEC a rule proposal to require specific disclosure on customer confirmations regarding the receipt of additional remuneration for directing order flow. In addition, the 1991 study of payment-for-order-flow practices, the "Ruder" report, Inducements for Order Flow, contained recommendations that the NASD augment its rule proposal to require that firms disclose to customers a description of the firm's order-routing and execution practices as well as the inducements received by the firm. Inducements for order flow such as reciprocal trading arrangements and routing orders to affiliated or wholly owned entities for execution are commonplace in all markets, and investors should be made aware of the numerous transactional relationships that their brokers are involved in as well as the market centers in which their orders are executed so that they will be able to make informed decisions when placing their orders.
The NASD believes that competition in the markets does not damage liquidity or prevent best execution, provided there is market information available to the public. Transparency of market information significantly improves the fairness and efficiency of the markets through enhancing the ability of market makers to determine accurately the present value of a security and by permitting investors to evaluate the quality of the executions they receive. Accordingly, we believe that the Act's preference for real-time quotation and transaction reporting is entirely appropriate.
Equally critical to competition among markets for order flow is the competition for listings. There are approximately 900 Nasdaq issuers that meet the listing standards of the New York Stock Exchange (NYSE) and the competition to attract those companies to list on the exchange is intense.
The present competition for listings, however, is profoundly unbalanced. NYSE Rule 500 prevents a listed company (that is otherwise considered by the exchange to be eligible for continued listing) from withdrawing and transferring its securities from the NYSE to another exchange or the Nasdaq market without being required to comply with extremely arbitrary and burdensome rule requirements. The proposed withdrawal from listing must be approved by the company's security holders at a meeting at which a substantial percentage of the outstanding amount of the particular security is represented.
Since 1984, the NASD has been on record opposing NYSE Rule 500 as an unfair barrier to competition between the NYSE and The Nasdaq Stock Market.SM The SEC has also acknowledged that Rule 500 conceivably could have an anti-competitive effect since it would make it possible for the NYSE to prospect freely for listings from other SROs while making it difficult for them to seek listings from among NYSE-listed companies. Accordingly, the NASD believes that anti-competitive delisting restrictions should be rescinded immediately.
Today's marketplace is a highly competitive, technologically sophisticated environment that has been witness to dynamic and rapid development of new products and innovative trading mechanisms. The NASD believes that where competition has been allowed to flourish in the securities markets, overall efficiency and services for customers have improved. In order to facilitate continued growth and innovation in the markets, the NASD recommends the SEC take the following actions:
- Eliminate off-board trading restrictions.
- Permit third market makers access to all exchange-listed securities through the ITS/CAES linkage.
- Adopt disclosure requirements regarding inducements for order flow.
- Adopt procedures for review of operations and allocation of regulatory costs for proprietary trading systems.
- Eliminate exchange delisting restrictions.
1 The NASD notes that third market makers re not deemed to be operators of proprietary trading systems solely because they operate internal execution systems. Members of the NASD registered as market makers in exchange-listed stocks are required to maintain firm, continuous, two-sided quotations and are regulated as market makers.