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Reg Nms S7 10 04

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  • 1. . . . . 16 Park Avenue . . New York, New York 10016 . . . From The desk of: Richard Tullo William H. Donaldson Chairman Securities and Exchange Commission 450 Fifth Street Washington, DC 20549 February 26, 2004 Dear Mr. Donaldson; The four proposals under Regulation NMS do little to modernize equity market structure while sowing the seed for a new series of future regulatory crises and expanding the regulatory subsidy that the ECN oligarchy currently enjoys. The fear is that Regulation NMS is a well meant, but ill advised , response to the NYSE intra-positioning scandal which is a symptom of poor regulatory enforcement by both the SEC and the SRO’s. Regulation NMS is like offering a bandage to a hemophiliac; it’s just a settlement that attempts to cure a disease that will require more effort and resources to heal. Mr. Donaldson, your market acumen is beyond reproach and you may be surprised by the support you receive from investors and traders if you take action to promote viable reforms. According to a review of SEC’s the press release Regulation NMS proposes: Allows orders, with customer approval, to trade-through when competing markets are posting better prices Allows orders that are traded through to be executed at prices that are as much as 5 cents worse than the best price Forces the exchanges and market centers to implement expensive technological projects for the benefit of their competition Eliminates sub penny pricing Mandates that exchange centers distribute their own proprietary information assets and customer intentions to the public ............................
  • 2. February 26, 2004 Page 2 Trade-Through The Securities and Exchange Commission (SEC) has stated that “when an agent acts on behalf of a customer in a transaction, the agent is under a duty to exercise reasonable care to obtain the most advantageous terms for the customer.”(NASDAQ Traders Manual, Chapter 12, pg 2 See Exhibit 1) Regulation NMS is redefining best execution by allowing customers to opt out of trade through protections. The SEC seems to be saying that price can be ignored by customers as an ‘advantageous term’. It is understandable that several trading constituencies are frustrated with the negative consequences of decimalization. It has been estimated that decimalization is responsible for slowing execution time for the average institution trade -on average- by about eight minutes. Decimalization has disrupted institutional trading desks and created an environment where their orders are traded against by day traders, computer programs and other market participants. It is also understandable that the ECN’s whose competitive advantage may be speed would seek to change regulations to favor their business models. Regulation NMS is an attempt to placate these two constituencies at the expense of the investing public. All ethical and professional traders fight everyday to provide their customers the best timely executions given the circumstances they face today. Regulation NMS will give traders the ability trade faster but at what cost? The SEC has not provided any guidance in regards to the time parameters that will define best execution and under what specific conditions customers can opt out of trade through protections. This new market structure can open an entirely new set of market abuses when the SEC has not demonstrated that it has control over the markets as they exist today. (SEE EXHIBIT II) It is very likely large market making firms and ECN’s will offer economic incentives or rebates to their customers institutional and retail alike to encourage opting out. It is also equally likely that fund management companies and electronic brokerages will keep the rebates while mutual fund investors pay the price in the form of inferior equity prices. The NYSE trading scandal (when not accounting for unprofitable intra positioning trades) allegedly cost investors 1.1 billion dollars. It has been estimated that the scandal cost those investors roughly .004 cents per share or 40 cents per thousand shares. Forty cents seems like a small amount of money -candy bars cost more- but it adds up when aggregated across the billion of trades handled by the securities markets. Allowing exceptions to trade through can potentially cost invests more money than the NYSE scandal and the earlier NASDAQ scandal combined.
  • 3. February 26, 2004 Page 3 For Example: Jane Doe opens a discount brokerage account and signs an agreement to receive ten free trades and in the process legally agrees to opt out of trade through protections. Jane then enters a market order to buy 1000 shares of TESTA. The inside market for TESTA is bid $10 offered at $10.03 and the order is routed to an ECN. Her order is not routed to the best price market or markets but instead depletes the ECN’s order book She receives fills of 100 shares at $10.04, 100 shares at $10.05 and eight hundred shares at $10.08 Resulting in an average price of $10.073 on her 1000 shares The inside market simultaneously changes when she receives she last fill and is now $10.00 bid offered at $10.01 This so called best execution trade has cost Jane about $60.00 But that is OK because her brokerage firm receives a 1/2 penny per share rebate for ever trade that is sent to the ECN When Jane’s trade is aggregated over a billion transactions Reg. NMS could cost investors eight billion dollars; assuming an average ticket size of 400 shares and average ‘de minimis’ price of just two cents per share. Reg. NMS also penalizes traders that enter marketable limit orders. Traders that enter bid or offer side limit orders will receive no price improvement if ‘de minimus’ trades are executed away from the market where they entered their order. A likely response from traders will be to pull their orders and enter limit orders away from the inside market and respond to bids by hitting them with market orders. This defensive pulling of limit order will result in wider spreads, less order matching, slower executions and the increased occurrence of random walks. These resulting market characteristics are good for day traders and institutions that make their profits by paying for order flow. However, wider spreads and chaos is generally not accepted by any rational investor as good for the market.
  • 4. February 26, 2004 Page 4 Mandates Reg. NMS also mandates that market centers provide access to ‘persons’ but without mandating hard linkages. This particular proposal is saying that the NYSE –primarily- and the NASDAQ –potentially- has to build infrastructure in order to allow competing markets, like ARCA, the ability to siphon off liquidity. Since nothing has been done to address ECN fees charged to market participants, ARCA most assuredly will charge the NYSE member for his own order flow. So, not only has the SEC done nothing to eliminate this subsidy enjoyed by the ECN’s but is attempting to expand the subsidy. This is equivalent to forcing Dell to build and pay for a new factory for Gateway. This is not true capitalism but crony capitalism which may be fine for a country like China or India but Americans expect more from their government. Reg. NMS also mandates that market centers distribute proprietary information; such as a market makers limit order book. The SEC does not say to whom this information must be distributed. That is troubling and the SEC should clarify why that information needs to be distributed and to whom. This mandate is also troubling because the Federal Government is forcing persons to expose their customer’s intentions to the public. The SEC’s 1996 NASDAQ market maker investigation focused on market makers communicating their customer’s intentions to other market participants. Hundreds of market makers were sanctioned for communicating orders they had in their books. It now seems that ECN’s are also lobbying to have that aspect of market integrity redefined to suit their needs. SUB-Decimalization Almost as an afterthought the SEC has finally address the problem of sub decimalization. Traders should be encouraged by this prohibition and any revision of Reg. NMS should include the ban. Sub- Decimal quoting is a tool used by some traders to step ahead of orders that should receive time priority in a fair trading market, and by some market centers that use rebate schemes to compete. Conclusions: The corporate governance failures of 2001- 02 are in part the result of a faulty long term pricing mechanism gave corrupt corporate executives asymmetrical rewards for inflating the prices of their companies. The capital loss due to the governance failures has been in excess of 500 billion dollars and continues to contribute to the national budget deficit. Second rate market structure has also resulted in
  • 5. February 26, 2004 Page 5 larger small company discounts due to declining research coverage (SEE EXHIBIT III). Financial industry layoffs totaling 80,000 has had a major impact on the economy and has resulted in loss tax revenues estimated to be 8 billion dollars. Regulation NMS does nothing to improve the equity markets’ ability to price stocks to better reflect economic value and will likely hamper the pricing mechanism. Nor does the regulation improve the ability of the equity markets to match buyer with seller. The SEC should go back to the drawing board and come back with proposals that promote liquidity while leveling the playing field for all market participants. By improving market breath instead of depth or execution time the end result will: Encourage Entrepreneurship Disable corporate crooks Result in faster executions Create Jobs Create long term wealth for investors I encourage the SEC, the SRO’s and Congress to revise Regulation NMS. Any proposed regulation must eliminate the current subsidy provided to the ECN’s and explore market structures that encourage the placing of limit orders and allow liquidity providers to make risk based economic profit. Only when the fundamental root causes of inefficient markets are addressed will its symptoms stand a chance of being cured. If you need to contact me I can be reached at (212) 679 3016. Thank you for you consideration and have a great day. Sincerely, Richard R Tullo
  • 6. February 26, 2004 Page 6 Exhibit I Best Execution Requirements The duty of “best execution” arises from the common law duty of loyalty owed by a broker to its retail customers. The Securities and Exchange Commission (SEC) has stated that “when an agent acts on behalf of a customer in a transaction, the agent is under a duty to exercise reasonable care to obtain the most advantageous terms for the customer.” This principle has been incorporated into case law and SEC decisions under the federal securities laws and must be adhered to whether acting as agent or in a principal capacity. It is important to note that the application of “best execution” involves analysis of the “facts and circumstances.” Actions that in one set of circumstances may meet your firm’s best execution obligation, may not meet that standard in another set of circumstances. It should also be noted that the best execution obligation evolves as rules and systems change. Your firm should review its execution practices, as appropriate, to ensure compliance with new rules, systems, or market conditions. The SEC has stated that, as a general matter, the duty of best execution refers to your duty to seek to execute your customer’s order in the best available market. NASD Conduct Rule 2320 states that in any transaction with or for a customer, a member and its associated persons must use reasonable diligence to ascertain the best inter-dealer market for the security and buy or sell in such market so that the price to the customer is as favorable as possible under prevailing market conditions. Among the factors that will be considered in applying the standard of reasonable diligence are as follows: Character of the market price, volatility, relative liquidity, and pressure on available communications; Size and type of transaction; Number of primary markets checked; and Location and accessibility to the customer’s broker/dealer of primary markets and quotations sources.
  • 7. February 26, 2004 Page 7 Exhibit II Fine tuning Decimalization: Creating Markets that Price Securities Fairly for All Investors. Overview Since the advent of new technologies the US equities markets have undergone more structural change in the last ten years then at any given time in history. Since 1996, regulators and the principal equity markets have introduced a series of reforms with these principal goals: Mandate limit order driven pricing Minimize human interaction with equity orders Decrease price increments The SEC and the SRO’s have for the most part succeeded in implementing these structural changes to the equity markets. These changes were driven by a report written by a committee formed after the 1987 stock market crash called “Markets 2000”. A second influence on the regulatory bodies has been the 1994 NASDAQ stock market anti-trust scandal. It appears today that the current New York Stock Exchange investigation will also usher in new reforms. The problem is that thousands of new lines of regulation and billions of new lines of computer code have been written and those regulations and computer programs may be based on faulty premises. The market structure, as it exists, today has resulted in market inefficiencies and is generating unintended externalities that are silently hurting investors, workers and the US economy. Increased mutual fund expense ratios Decreased competition in equity trading Decreased competition for financial services Less equity research Higher cost of capital for issuers Increased portfolio turnover Decreased liquidity in lower capitalized stocks 80,000 lost jobs in the financial industry Eight Billion Dollars in lost federal tax revenues Decrease in economic opportunity Decimalization as it exists today has the potential to undermine the US economy for the sake of modernity. Just because decimalization exists in Germany, France, Italy and England doesn’t mean it is better. In fact anyone who has traded ordinary shares on foreign bourses can testify to the fact that these markets do not even remotely provide the limit order protection that the major US exchanges provides for its customers. The US economy has out performed its European counter parts in part because the US equity markets are superior. This is the reason why major foreign companies from around the world seek to list on the NYSE and NASDAQ. Recently, Bill Donaldson has made public comments regarding reforming decimalization and if he is serious about change then there are two market structure alternatives that would be an improvement over the existing trading environment that is currently thin and fragmented for most issues. Multiple tiered minimum price incremented markets Multiple tiered minimum spread incremented markets Both alternative market structures have benefits over the current decimalization regime and if adopted they offer the promise of better market efficiency and better prices for all market participants.
  • 8. February 26, 2004 Page 8 Bring Back the Breath Since the introduction of tick reform breath, the amount of shares available on the best Bid or Offer size of the market, has declined for stocks not represented in the major market indexes such as; S&P 100 or the NASDAQ 100. The decline in breath was expected when tick increments were reduced from 1/4 share to 1/16 fractional increments because it was expected that overall breadth across all price quotes would be greater and it was believed that the reduction in trading costs outweighed the loss of liquidity. What wasn’t expected was the decline in tradable orders. The reduction of price increments allowed speculators to post prices ahead of larger institutional orders, in essence competing against the posted order for liquidity. The institutional response (that started when stocks traded in 1/16’s and was exacerbated by decimalization) was to pull their orders from the floor of the exchanges and from NASDAQ Market Maker desks. Today when an institution wants to buy 50,000 shares of stock they are just as likely to enter five hundred 100 share orders on an ECN as to enter a single 50,000 share order with a Specialist or Market Maker. This type of trading is enabled by reserve books and average price trading programs. The result is that liquidity for stocks is found in electronic cues and governed by algorithms and is often not available to trade freely with the other side. As a result of reduced liquidity, liquidity providers like NASDAQ Market Makers or NYSE Specialist are less likely to provide capital to trade and institutions are less likely to provide liquidity to the primary market as they buy and sell positions. These trading practices have resulting in fragmented markets as traders execute their orders based on technology and rebates and not price and liquidity. Stock markets just like any other markets have a supply and demand curve. In a stock market the demand curve is represented by market buy orders and bids. Most economists believe that as prices increase demand declines, provided that all other economic variables remain constant. Since the reductions in the minimum trading increment demand, as represented by the NASDAQ bid side market montage has changed. Clearly decimalization has changed trading behavior and these changes have created unintended consequences. Fractional Demand Curve Decimalization Dem Curve and 5000 12000 4000 3900 10000 10000 es 3000 Shar 8000 2400 Shares 2000 6000 5000 1000 4000 400 500 500 2000 2500 0 200 100 100 1000 0 67.2 67.22 67.24 67.26 67.28 67.3 67.25 67.38 67.25 67.13 Price Price In the charts above bid size increases then declines dramatically under decimalization. Typically under decimalization few orders are reflected at any point on the montage and barely any orders are reflected out side the first ten price levels (ten cents). By comparison under the old fractional system typically more size was reflected in the montage at lower price levels and overall more stock was bid for across the total price horizon. Recently, trading in Corinthian Colleges Inc. (ticker symbol COCO) has created a lot of controversy on Wall Street. On December 5, 2003 a trader inadvertently placed a large sell order on Bloomberg’s ‘Trade Book’ ECN and flooded the market in COCO with sell orders and hit all the bids posted at that time. COCO stock traded from $57.45 to as low as $38.97 in twelve minutes. While many on Wall Street are reviewing NASDAQ’s and ARCA’s actions regarding their regulatory responses to the trading activity perhaps the more interesting question is: How could just one trader pressure a stock down almost twenty points? That is a market
  • 9. February 26, 2004 Page 9 structure issue; not a regulatory issue! Cleary if there was more breath in the market for COCO, then even a two million share order should not have been able to pressure the stock down twenty points. The COCO event is more than an anomaly; the event highlights a fundamental weakness in market structure that creates smaller but serious price gaps everyday due to poor market structure. Alternative Minimum Price Increments (AMPI) The idea of trading in price increments greater than a penny has been put forward by economists, traders and even Bill Donaldson. The idea behind AMPI is that if there are less price increments than orders would be aggregated at the remaining tick sizes. Also, the AMPI by definition would create larger spreads due to the increase in tick size. It is hoped that under the AMPI, incentive will be created for Specialists and Market Makers to provide liquidity and the practice of penny-ing ahead would be curtailed. AMPI has already been adopted by the option markets; they trade in nickel increments. It seems that the nickel increment on the options market offers both low cost execution and the incentive for options traders to provide liquidity. The stock market is often not just one market but a market of markets. The stock market by nature is segmented across industries and market capitalization. That is why stocks trade higher after it is announced that they are being added to or deleted from the S&P 500 index. One big concern of those that oppose the AMPI is that it would inflate trading costs for large capitalized issues like MSFT. That concern is valid to an extent but even MSFT would be more liquid under the AMPI and the added liquidity would offset the increased tick size thus giving the investor an overall lower cost of execution under some circumstances. The real issue in regards to AMPI when applied to larger companies is what tick size maximizes liquidity and minimizes costs; the answer for MSFT may very well be a penny. The introduction of the AMPI should ideally go hand in hand with the introduction of multiple tiered markets based on market capitalization. Ideally, ticks sizes of one penny for large capitalized stocks, a nickel for mid sized companies and ten cents for small capitalized stocks should add liquidity to the market place and reduce overall trading costs. Moreover, the increased trading revenues generated by the AMPI could provide an incentive for financial industry to cover more stocks on a trading and a research basis and as a result more value would be generated by the industry for investors and issuers. Alternative Minimum Spread A less understood but interesting alternative to decimalization is the Alternative Minimum Spread (AMP). In an AMP market a stock would have a minimum spread set by the primary exchange. For example, if the minimum spread is set at ten cents then the differences between the best bid and ask price would always be ten cents or greater (Example 1). Limit orders with prices better than the inside market can be given price improvement but their existence would be aggregated at the best bid and offer (Example 2). Example 1: Bid Ask $50.50 TESTA 5000 shares ---------- 5000 shares TESTA $50.60 Example 2: Bid Ask $50.50 TESTB 1000 shares ---------- 5000 shares TESTB $50.60 (500+4500) (Assume in the market in the above example 500 shares is offered at $50.55 but is aggregated in the $50.60 offering.) Customer enters $50.60 bid for 5000 shares then 500 shares would be executed at $50.55 and 4500 at $50.60. The AMS market structure offers many benefits over both decimalization in its current form and minimum price increments. AMS markets that allow price improvement offer investors low cost execution at any decimal increment while providing traders with incentives to enhance liquidity. AMS markets also allow for low cost adoption and the cost savings is eventually passed along to all market participants. Moreover, customers concerned about penny-ing would be protected to some degree since the AMS market encourages
  • 10. February 26, 2004 Page 10 liquidity while giving the investors the opportunity for price improvement. If the AMS market is successful, the spread would be transformed from a penalty (or toll) applied to market orders to a continuously trading crossing exchange. Also under both the AMS market and the AMPI market the bid and ask represents real trading intent not the bait and switch markets that currently exist in today’s market structure. Why No Change? While it is obvious to most traders and market professionals that the current trading system is aggravating, time consuming and costly; why haven’t the powers that regulate trading sought reform. The reasons are: Politics Economists Special Interest Groups Lack of focus The trading community has done a poor job in educating the public and justifying its role in the financial markets. This lack of understanding has opened the door for regulators, economists and business interests to influence market structure to further their own ends. While the claims of these constituencies are popular the results of just some of their reforms have undermined commerce and resulted in less competition in the equity research and trading services. The principle argument used by reform advocates is that markets charge economic rent and if that rent is reduced the market as a whole benefits. This logic is the same logic used by socialist thinkers to justify housing rent controls in New York and other major US Cities. Under rent controls New York City declined from 1946 to 1980 and became virtually uninhabitable. Industry left the major cities and their economies declined even though the economists predicted that rent controls should have stimulated more economic activity under their estimates. Just as converting from rent control to rent stabilization restored housing markets in New York and San Francisco revising decimalization should allow more investors to benefit from a stronger market structure. By adjusting decimalization more jobs will be created in the financial industry and investors will benefit from improved execution and service Exhibit III Large corporations can attract more capital because an institutional investor can only invest in companies that offer liquidity. This liquidity discount has always existed but is more pronounced today because of decimalization. The liquidity discount is further aggravated by reduced institutional research available for investors. Institutional investors are also less likely buy stocks that have limited research coverage by Wall Street. Ticker Price Difference Average MCAP PE Analyst Industry High/Low Volume Coverage BSTE 45.92 71% 372,000 .7b 29 8 Biotechnology BGEN 39.59 55% 1,760,000 1.760b 34 24 Biotechnology LWSN 7.94 63% 400,000 .7b na 3 CRM Software ORCL 13.00 53% 59,000,000 68.00b 30 37 CRM Software ECLP 14.83 4.29% 731,000 .6b na 7 Healthcare Systems CERN 35.71 241% 1,200,000 1.2b 34 11 Healthcare Systems RT Asset Management