[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]



 
     ECNs AND MARKET STRUCTURE: ENSURING BEST PRICES FOR CONSUMERS
=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                COMMERCE, TRADE, AND CONSUMER PROTECTION

                                 of the

                    COMMITTEE ON ENERGY AND COMMERCE
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

                               __________

                            OCTOBER 17, 2002

                               __________

                           Serial No. 107-134

                               __________

      Printed for the use of the Committee on Energy and Commerce









 Available via the World Wide Web: http://www.access.gpo.gov/congress/
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                    COMMITTEE ON ENERGY AND COMMERCE

               W.J. ``BILLY'' TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida           JOHN D. DINGELL, Michigan
JOE BARTON, Texas                    HENRY A. WAXMAN, California
FRED UPTON, Michigan                 EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida               RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio                RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania     EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California          FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia                 SHERROD BROWN, Ohio
RICHARD BURR, North Carolina         BART GORDON, Tennessee
ED WHITFIELD, Kentucky               PETER DEUTSCH, Florida
GREG GANSKE, Iowa                    BOBBY L. RUSH, Illinois
CHARLIE NORWOOD, Georgia             ANNA G. ESHOO, California
BARBARA CUBIN, Wyoming               BART STUPAK, Michigan
JOHN SHIMKUS, Illinois               ELIOT L. ENGEL, New York
HEATHER WILSON, New Mexico           TOM SAWYER, Ohio
JOHN B. SHADEGG, Arizona             ALBERT R. WYNN, Maryland
CHARLES ``CHIP'' PICKERING,          GENE GREEN, Texas
Mississippi                          KAREN McCARTHY, Missouri
VITO FOSSELLA, New York              TED STRICKLAND, Ohio
ROY BLUNT, Missouri                  DIANA DeGETTE, Colorado
TOM DAVIS, Virginia                  THOMAS M. BARRETT, Wisconsin
ED BRYANT, Tennessee                 BILL LUTHER, Minnesota
ROBERT L. EHRLICH, Jr., Maryland     LOIS CAPPS, California
STEVE BUYER, Indiana                 MICHAEL F. DOYLE, Pennsylvania
GEORGE RADANOVICH, California        CHRISTOPHER JOHN, Louisiana
CHARLES F. BASS, New Hampshire       JANE HARMAN, California
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska
ERNIE FLETCHER, Kentucky

                  David V. Marventano, Staff Director
                   James D. Barnette, General Counsel
      Reid P.F. Stuntz, Minority Staff Director and Chief Counsel

                                 ______

        Subcommittee on Commerce, Trade, and Consumer Protection

                    CLIFF STEARNS, Florida, Chairman

FRED UPTON, Michigan                 EDOLPHUS TOWNS, New York
NATHAN DEAL, Georgia                 DIANA DeGETTE, Colorado
  Vice Chairman                      LOIS CAPPS, California
ED WHITFIELD, Kentucky               MICHAEL F. DOYLE, Pennsylvania
BARBARA CUBIN, Wyoming               CHRISTOPHER JOHN, Louisiana
JOHN SHIMKUS, Illinois               JANE HARMAN, California
JOHN B. SHADEGG, Arizona             HENRY A. WAXMAN, California
ED BRYANT, Tennessee                 EDWARD J. MARKEY, Massachusetts
GEORGE RADANOVICH, California        BART GORDON, Tennessee
CHARLES F. BASS, New Hampshire       PETER DEUTSCH, Florida
JOSEPH R. PITTS, Pennsylvania        BOBBY L. RUSH, Illinois
MARY BONO, California                ANNA G. ESHOO, California
GREG WALDEN, Oregon                  JOHN D. DINGELL, Michigan,
LEE TERRY, Nebraska                    (Ex Officio)
ERNIE FLETCHER, Kentucky
W.J. ``BILLY'' TAUZIN, Louisiana
  (Ex Officio)

                                  (ii)












                            C O N T E N T S

                               __________
                                                                   Page

Testimony of:
    Foley, Kevin M., Chief Executive Officer, Bloomberg 
      Tradebook, LLC.............................................     6
    Gasser, Robert C., Chief Executive Officer, Nyfix Millennium, 
      LLC........................................................    25
    O'Brien, William, Senior Vice President and General Counsel, 
      Brut, LLC..................................................    19
    O'Hara, Kevin J.P., General Counsel, Archipelago.............    14
    Ryan, Michael J., Jr., General Counsel, American Stock 
      Exchange LLC...............................................    29
Additional material submitted for the record:
    Foley, Kevin M., Chief Executive Officer, Bloomberg 
      Tradebook, LLC, response for the record....................    56
    O'Brien, William, Senior Vice President and General Counsel, 
      Brut, LLC, response for the record.........................    63
    Ryan, Michael J., Jr., General Counsel, American Stock 
      Exchange LLC, letter dated November 22, 2002, enclosing 
      response for the record....................................    66

                                 (iii)














     ECNs AND MARKET STRUCTURE: ENSURING BEST PRICES FOR CONSUMERS

                              ----------                              


                       THURSDAY, OCTOBER 17, 2002

              House of Representatives,    
              Committee on Energy and Commerce,    
                    Subcommittee on Commerce, Trade and    
                                       Consumer Protection,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 10:35 a.m., in 
room 2123, Rayburn House Office Building, Hon. Cliff Stearns 
(chairman) presiding.
    Members present: Representatives Stearns and Towns.
    Staff present: David Cavicke, majority counsel; Shannon 
Vildostegui, majority counsel; Brian McCullough, majority 
counsel; Will Carty, legislative clerk; and Consuela 
Washington, minority counsel.
    Mr. Stearns. Good morning, everybody. The subcommittee will 
come to order.
    Let me welcome our witnesses. In the securities area, there 
has been an intense focus today on corporate governance, and of 
course, with that, accounting governance over the past year. 
And, of course, rightly so. There has been a tremendous need 
for oversight and correction in these areas. And these areas, 
these issues, will continue to be of heightened concern as 
corporate America works to regain investors' confidence.
    But today we will take a look at another set of very 
important issues. These issues are less sensational than the 
scandals of the last year, so we are not likely to see 
extensive media coverage of this hearing today. Yet these 
issues are no less important to the functioning of the capital 
markets and, of course, to the protection of investors.
    Today we will focus on market structure issues. There have 
been significant market structure changes in the past year that 
have important implications for all investors. These are ECNs. 
And ECNs are basically electronic communication networks. They 
are basically technologically advanced communication systems 
for simply trading securities. As a result of advances in 
computing power and telecommunication technology as well as 
certain changes in security rules, ECNs have emerged as 
competitive alternatives to traditional stock markets.
    ECNs are basically order matching services, matching buy 
and sell orders entered into their systems by their 
subscribers, and through this simple procedure, buyers and 
sellers are able to come together. But they are relatively new 
market participants that provide trading platforms that are 
distinct from traditional floor and specialist models of the 
New York Stock Exchange and the quotation montage and market-
maker model of the Nasdaq. So basically ECNs models vary. Some 
are order matching systems, others are order routing systems. 
They have different fee structures as well as different 
customer bases.
    What the ECNs do have in common, though, is that they 
provide much of the impetus for market improvements, those we 
have seen over the past few years and certainly we will see 
into the future. ECNs were the first to trade in decimals, the 
first to show depth of book, the first to offer reserves, and 
the first to allow anonymity to trades. These are common 
features now, and the Nasdaq has incorporated these functions 
into its SuperMontage. But the competitive pressures that ECNs 
have brought to the marketplace have made trading cheaper, 
faster, and tailored to fit real market needs, and their 
presence in the marketplace will continue to push forward 
cheaper, faster, and, of course, more innovative services.
    But it is not only institutional investors that have reaped 
the benefits of ECN innovation. Small investors have also 
reaped the benefits. Competition from ECNs have reduced 
transaction costs marketwide; namely, commissions and spreads 
have dropped. For example, ECNs lead the push to 
decimalization, reducing the trade increments in which 
investors trade from one-sixteenth of $1 to a fraction of a 
cent.
    ECNs also introduced anonymity of trades, allowing my 
mutual funds to buy or sell securities without moving the 
market. This, of course, has a direct impact on the value of my 
mutual fund investment, for example.
    Over the past year, there have been some important market 
structure developments. One ECN was approved to operate as an 
exchange. Some ECNs merged and the SEC approved the Nasdaq 
SuperMontage. All have significant implications for the future 
of the marketplace, and I look forward to hearing the testimony 
of our panel today to discuss some of these issues raised by 
these market developments.
    In particular, I hope that our panel will discuss market 
data issues: Are customers still paying too much for market 
data? Are market data rebates a benefit to investors? Will 
market data rebates solve the market issues, or is a regulatory 
fix required?
    I also hope to hear some testimony on the status of 
SuperMontage: Has the Nasdaq addressed the competitive concerns 
raised by ECNs? What potential benefits or risk does the 
SuperMontage bring to the marketplace? What is the status of 
ITS. Are the access rules for listing securities responsible 
for ECNs' lower trading volumes in listed securities than in 
the Nasdaq securities?
    And finally, my colleagues, inter-ECN access fees: What are 
the different fee structures in place for access to ECN 
systems? Are these fees consistent with ECN obligations under 
the order handling rules to provide access to the best prices 
in the marketplace?
    These are some of the questions we would like to have 
discussed today and I look forward to discussing these with our 
panel. So I welcome your comments and I appreciate your 
appearing before your committee. Even though Congress is out, 
we wanted to continue the schedule of this hearing. So I thank 
you for coming.
    With that, I offer an opening statement to the 
distinguished ranking member from New York, Mr. Towns.
    [The prepared statement of Hon. Clifford Stearns follows:]
  Prepared Statement of Hon. Cliff Stearns, Chairman, Subcommittee on 
                Commerce, Trade and Consumer Protection
    In the securities area, there has been an intense focus on 
corporate governance and accounting governance over the past year. And 
rightly so, there was a tremendous need for oversight and correction in 
these areas. And these issues will continue to be of heightened concern 
as corporate America works to regain investor confidence.
    But today we will take a look at another set of important issues. 
These issues are less sexy than the scandals of the last year so we are 
not likely to see extensive media coverage of the hearing here today. 
Yet these issues are no less important to the functioning of the 
capital markets and the protection of investors. Today we will focus on 
market structure issues. There have been significant market structure 
changes in the past year that have important implications for 
investors.
    ECNs are relatively new market participants that provide trading 
platforms distinct from the traditional floor and specialist model of 
the New York Stock Exchange and the Quotation Montage and Market Maker 
model of the NASDAQ. ECN models vary--some are order-matching systems. 
Others are order routing systems. They have different fee structures as 
well as different customer bases.
    What the ECNS do have in common is that they provide much of the 
impetus for market improvements, those we have seen over the past few 
years and certainly those we will see in the future. ECNs were the 
first to trade in decimals, the first to show depth of book, the first 
to offer reserves and the first to allow anonymity to trades. These are 
common features now--and the NASDAQ has incorporated these functions 
into its SuperMontage--but the competitive pressure ECNs have brought 
to the marketplace has made trading cheaper, faster and tailored to fit 
real market needs. And their presence in the marketplace will continue 
to push forward cheaper, faster and more innovative service.
    It is not only institutional investors that have reaped the 
benefits of ECN innovation. Small investors have too. Competition from 
ECNs has reduced transaction costs market-wide--namely commissions and 
spreads have dropped. For example, ECNs lead the push to 
decimalization, reducing the trade increments in which investors trade 
from \1/16\ths of one dollar to fractions of a cent. ECNs also 
introduced anonymity of trades--allowing my mutual fund to buy or sell 
securities without moving the market. This has a direct impact on the 
value of my mutual fund investment.
    Over the past year there have been some important market structure 
developments. One ECN was approved to operate as an exchange, some ECNs 
merged and the SEC approved the NASDAQ's SuperMontage. All have 
significant implications for the future of the marketplace and I look 
forward to hearing our panel discuss some of the issues raised by these 
market developments.
    In particular, I hope that our panel will discuss market data 
issues. Are customers still paying too much for market data? Are market 
data rebates a benefit to investors? Will market data rebates solve the 
market data issues or is a regulatory fix required?
    I also hope to hear some testimony on the status of SuperMontage. 
Has the NASDAQ addressed the competitive concerns raised by the ECNs? 
What potential benefits or risks does the SuperMontage bring to the 
marketplace?
    What is the status of ITS? Are the access rules for listed 
securities responsible for ECN lower trading volume in listed 
securities than in NASDAQ securities?
    And finally, inter-ECN access fees. What are the different fee 
structures in place for access to ECNs systems? Are these fees 
consistent with ECN obligations under the order handling rules to 
provide access to the best prices in the marketplace?
    I look forward to discussing these and other issues with our panel 
today. I welcome you all and thank you for appearing before the 
Subcommittee.

    Mr. Towns. Thank you very much, Mr. Chairman. I agree with 
you that I think that this is a very important hearing, and 
even though the Congress is out, I really feel we should move 
forward with this particular hearing, and I want to thank you 
for holding it. I welcome all of my New York constituents this 
morning, of course, but I look forward to everybody's 
testimony.
    While the title of this hearing suggests that the focus is 
solely ECNs, it would be a mistake to overlook or to minimize 
the contributions and value of the exchanges and all that they 
contribute to market liquidity, capital formulation, and 
economic improvement in this country. One of the hallmarks of 
our system is that we offer users a broad array of competitive 
alternative trading venues, and I hope that we will always 
continue to do that.
    Let me note that as a result of changes in the House rules 
adopted by this Congress, most of the committee's historical 
jurisdiction over securities and exchanges are transferred to 
the newly created Committee on Financial Services. However, it 
was agreed that this committee would retain jurisdiction over 
legislation dealing broadly with electronic commerce, including 
ECNs, and that none of our jurisdiction over consumer affairs 
and consumer protection would be limited in any way.
    Accordingly, I commend the chairman of the subcommittee for 
exercising this jurisdiction and looking into these important 
matters this morning. I salute you for that, Mr. Chairman. A 
great deal has changed since the subcommittee's December 19, 
2001 hearing on ECNs. For starters, two of the witnesses at 
that hearing, Island and Instinet, have merged. Mr. Chairman, 
maybe we should not have allowed them to sit next to each other 
during that day. Also, Nasdaq commenced trading on the 
SuperMontage system this week with five stocks.
    I hope we will revisit the issue raised by these and other 
events early next year after we have had a chance to measure 
the effects on electronic commerce and the consumers. With 
Nasdaq trading below 1300 and the Dow trading only near about 
8000 and with the steady beat of corporate and accounting 
scandals and bad economic news, Wall Street is facing difficult 
times and so is the economy. Investor confidence has taken a 
serious beating.
    I hope the Congress and this administration will take the 
necessary steps to adopt responsible economic policies and to 
finish the job that the Sarbanes and Oxley Act begins. Mr. 
Chairman, on that note, I yield back and I am anxious to hear 
from my witnesses.
    [The prepared statement of Hon. Edolphus Towns follows:]
Prepared Statement of Hon. Edolphus Towns, a Representative in Congress 
                       from the State of New York
    I welcome all of our witnesses this morning, especially my New York 
constituents, but I look forward to hearing the testimony of all of our 
witnesses.
    While the title of this hearing suggests that the focus is solely 
ECNs, it would be a mistake to overlook or minimize the contributions 
and value of the exchanges and all that they contribute to market 
liquidity, capital formation, and economic improvement in this country. 
One of the hallmarks of our system is that we offer users a broad array 
of competitive alternative trading venues, and I hope that we will 
always continue to do that.
    Let me note that, as a result of changes in the House Rules adopted 
at the beginning of this Congress, most of this Committee's historical 
jurisdiction over securities and exchanges was transferred to the newly 
created Committee on Financial Services. However, it was agreed that 
this committee would retain jurisdiction over legislation dealing 
broadly with electronic commerce, including ECNs, and that none of our 
jurisdiction over consumer affairs and consumer protection would be 
limited in any way. Accordingly, I commend the chairman of the 
subcommittee for exercising this jurisdiction and looking into these 
important matters this morning.
    A great deal has changed since the subcommittee's December 19, 2001 
hearing on ECNs. For starters, two of the witnesses at that hearing, 
Island and Instinet, have merged. Maybe we shouldn't have let them sit 
next to each other that day. Also, NASDAQ commenced trading on its 
SuperMontage system this week with five stocks. I hope that we will 
revisit the issues raised by these and other events early next year 
after we have had a chance to measure their effects on electronic 
commerce and on consumers.
    With NASDAQ trading below 1300 and the Dow trading only narrowly 
above 8000, and with the steady beat of corporate and accounting 
scandals and bad economic news, Wall Street is facing difficult times 
and so is the economy. Investor confidence has taken a serious beating. 
I hope that Congress and the Administration will take the necessary 
steps to adopt responsible economic policies, and to finish the job 
that the Sarbanes-Oxley Act begins.

    Mr. Stearns. I thank my colleague.
    [Additional statement submitted for the record follows:]
 Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee 
                         on Energy and Commerce
    This hearing on ECNs and the benefits they provide to consumers is 
timely and I want to commend Chairman Cliff Stearns and Ranking Member 
Towns for convening it. ECNs are a relatively new way of trading stock; 
most are less than five years old. In that time, ECN's speed, agility 
and the favorable prices and market access they provide to consumers 
have been an important addition to our financial markets. ECNs are the 
venue for over 40% of the trading in NASDAQ Stock. Last December 
Chairman Stearns held a hearing on the role ECNs played in restoring 
trading activity after the terrorist attacks on September 11th. These 
hearings demonstrate our continuing interest in and enthusiasm for the 
development of ECNs in the market place.
    There are a number of important issues facing ECNs that have 
significant effects on consumers. These issues include the creation of 
an ECN within NASDAQ called the Supermontage. I understand that today 
is the forth day of operation of the Supermontage, and NASDAQ couldn't 
be with us today. I think we will have a hearing next spring to see the 
effects Supermontage is having on competition within the NASDAQ market. 
We learned after 9-11 that we do not want to have a single point of 
failure that would render the markets unable to function and we will 
want to be sure that Supermontage does not inadvertently become such a 
single point of failure.
    Additionally, there are important issues affecting ECNs that have 
been repeatedly studied and have been awaiting resolution at the SEC 
for too long. These issues include:

 Market access fees charged by both NASDAQ and some ECNs;
 The continued viability of the intermarket trading system, 
        which all participants say is broken but no one wants to fix; 
        And
 The costs that investors are forced to pay for market data, 
        that everyone agrees greatly exceeds the cost of collection and 
        dissemination of that market data.
    Prior to the discovery of serious accounting fraud at Enron, 
WorldCom, Tyco and Global Crossings, ECNs and market structure issues 
were front and center both in the Committee and at the SEC. I would not 
want to see resolution of market structure issues and the important 
benefits they present for consumers to be neglected or put on the back 
burner at the SEC because of the egregious conduct corporate officers 
elsewhere. Just because these issues are not on the front pages of the 
business section does not mean that there are not important consumer 
and competitive concerns that need to be addressed.
    Times have changes dramatically in the past year, and the ECNs are 
no exception. There has been consolidation among the ECNs, an ECN has 
been granted ``exchange'' status, and the SEC recently approved the 
NASDAQ's Supermontage.
    This Committee has tackled and uncovered some egregious practices 
by market participants that have rattled the markets and investors in 
the last year. As investors become increasingly disenchanted with the 
integrity of the securities markets and its participants, it is vitally 
important that we continue to examine all aspects of our economy and 
make necessary changes as appropriate. Restoring ``transparency'' has 
been the buzzword this year, but regulators have more to do than that. 
Investors need to know that the system is not stacked against them, and 
market participants must be free to compete. Regulatory barriers should 
not determine winners and losers; innovation and competition should 
determine the winners.
    I look forward to hearing from our witnesses on these issues and 
yield back the balance of my time.

    Mr. Stearns. And of course as you pointed out, these are 
constituents of yours, so we welcome all of you: Kevin Foley, 
the Chief Executive Officer, Bloomberg Tradebook; Kevin O'Hara, 
General Counsel of Archipelago; William O'Brien, Senior Vice 
President and General Counsel of Brut; Robert Gasser, Chief 
Executive Officer of NYFIX Millennium; and Michael Ryan, 
General Counsel for the American Stock Exchange. We welcome you 
and look forward to your opening statement.
    And, Mr. Foley, we will start with you.

     STATEMENTS OF KEVIN M. FOLEY, CHIEF EXECUTIVE OFFICER, 
 BLOOMBERG TRADEBOOK, LLC; KEVIN J.P. O'HARA, GENERAL COUNSEL, 
ARCHIPELAGO; WILLIAM O'BRIEN, SENIOR VICE PRESIDENT AND GENERAL 
COUNSEL, BRUT, LLC; ROBERT C. GASSER, CHIEF EXECUTIVE OFFICER, 
   NYFIX MILLENNIUM, LLC; AND MICHAEL J. RYAN, JR., GENERAL 
              COUNSEL, AMERICAN STOCK EXCHANGE LLC

    Mr. Foley. Thank you, Mr. Chairman and members of the 
committee. Thank you for your insightful comments. My name is 
Kevin Foley and I am pleased to testify on behalf of Bloomberg 
Tradebook regarding ``ECNs and Market Structure: Ensuring the 
Best Prices for Consumers.'' The topic is both important and 
timely.
    Bloomberg Tradebook is owned by Bloomberg L.P. And is 
located in New York City. Bloomberg L.P. Provides multimedia, 
analytical, and news services to more than 170,000 terminals 
used by 350,000 financial professionals in 100 countries 
worldwide. Bloomberg News is syndicated in over 350 newspapers 
and on 550 radio and television stations worldwide. Bloomberg 
publishes 7 magazines as well as books on financial subjects 
for the investment professional and nonprofessional reader.
    Bloomberg Tradebook is an electronic agency broker serving 
institutions and other broker-dealers. We count among our 
clients many of the Nation's largest institutional investors 
representing through pension funds, mutual funds and other 
vehicles, the savings of millions of ordinary Americans. 
Bloomberg Tradebook specializes in providing innovative tools 
that make large orders small and eliminate the traditional 
barrier between the upstairs market for large orders and the 
trading floor. We bring upstairs liquidity directly into 
contact with small retail trading and other small order flows 
and, in the process we consolidate what has been a fragmented 
market. Our clients have rewarded our creativity and service by 
trusting us with their business, allowing us to regularly trade 
more than 150 million shares a day in the U.S. And a quarter 
again as much in international securities.
    Electronic communications networks, ECNs, are electronic 
systems that facilitate trading and securities. Market 
structure decisions, specifically the SEC's 1996 issuance of 
the order handling rules in the wake of collusion on the Nasdaq 
market, have permitted ECNs to flourish over the past 6 years 
benefiting consumers and the markets generally. These rules 
were designed to promote market transparency in the Nasdaq 
market. In the words of then SEC Chairman Arthur Levitt: 
Electronic communication networks have been one of the most 
important developments in our markets in years, perhaps 
decades.
    But exactly what are ECNs and what are we to make of their 
impact on our markets? In simplest terms, ECNs bring buyers and 
sellers together for electronic execution of trades. They have 
provided investors with greater choices and have driven 
execution costs down to a fraction of a penny. As a result, 
these networks present serious competitive challenges to the 
established market centers. More fundamentally, they illustrate 
the breathtaking pace of change that results when technology 
and competition coalesce.
    As has often been observed, sunlight is the best 
disinfectant. Indeed, the increase promoted by the SEC's order 
handling rules and the subsequent integration of ECNs into the 
national quotation montage narrowed Nasdaq's spreads by nearly 
30 percent in the first year following adoption of the order 
handling rules. These and subsequent reductions in 
transactional costs constitute significant savings that are now 
available for investment that fuels business expansion and job 
creation. The resolution of questions regarding the Nasdaq 
exchange application and the manner in which SuperMontage is 
phased in will go a long way toward determining whether the 
securities markets of the future will be shaped by competition 
or dominated by government-sponsored monopolies. That will have 
much to do with whether our markets remain competitive, robust 
and open to innovation. For-profit exchanges will have powerful 
incentives to leverage their existing government-sponsored 
monopolies to gain an unfair advantage in currently competitive 
markets. They will have incentives to keep pace with market 
innovators not by moving forward themselves, but by slowing 
down all market participants and centralizing order flow. If 
that occurs, consumers, investors in the markets themselves, 
will be denied the benefits of competition. Everyone loses if 
exchanges comfortable as government-sponsored monopolies fail 
to innovate, leaving American markets vulnerable to offshore 
competitors.
    As the growth of ECNs illustrates, modern technology allows 
the advantages of maximum order interaction without the 
downside of centralization. State-of-the-art telecommunication 
systems like the Internet don't rely on a single monopoly 
channel; rather they rely on the networked web of multiple 
competing and redundant linkages.
    Why shouldn't the securities markets work the same way and 
reap those same benefits? Centralized systems are resistant to 
change. The innovations that ECNs have brought to the market 
would not have occurred under more centralized systems. A 
centralized system also provides a significant downside of a 
central point of failure.
    So who has benefited from the existence of ECNs? For one, 
small retail customers who for the first time have gained 
direct unfettered access to liquidity of institutional order 
flow represented directly in the market.
    Who else has benefited? Clearly, American business. The 
President of the United States Chamber of Commerce, Tom 
Donahue, summed it up succinctly in a letter to SEC Chairman 
Pitt, stating: American business has benefited mightily in 
recent years from SEC initiatives like the order handling rules 
that have enhanced market transparency, fostered competition in 
our securities markets and reduced transaction costs, 
significantly reduced spreads and increased efficiencies, and 
freed up more capital for launching new businesses and creating 
new jobs. This sunshine is important to ensure the most 
efficient capital formation process in the U.S. And to ensure 
that America's market continues to be the preeminent market in 
the world.
    Who else benefits from ECNs? All investors who have seen 
the speed and fairness of their executions improve. ECNs have 
raised the standards for all broker dealers. Even traders now 
participating in ECNs benefit from our depth liquidity and 
immediacy each time they hit an ECN bid or take an ECN offer.
    Who hasn't benefited from ECNs? Useful linkages have yet to 
be developed for the exchange listed market. As a result, 
investors in those markets have yet to reap the full benefits 
of the competition provided by ECNs. This is why it is 
imperative that the steps necessary to facilitate the promised 
display of listed stocks in the NASD's alternative display 
facility be undertaken as soon as possible.
    Clearly, the New York Stock Exchange has historically had 
no interest in encouraging linkages that would make ECNs 
players in the listed markets. It is long past time for the 
benefits ECNs have brought to the market in over-the-counter 
securities to be extended to markets in listed securities as 
well.
    The neutrality, transparency, fairness, and innovation ECNs 
collectively bring to the Nasdaq market have dramatically 
increased competition and efficiency on Wall Street, redounding 
to the benefit of consumers on Main Street and to the benefit 
of our economy. Investors in the New York Stock Exchange listed 
market should be permitted an opportunity to enjoy those same 
benefits.
    Historically, not-for-profit exchanges are contemplating a 
for-profit future. As market players that have traditionally 
functioned as public utilities become for-profit entities, 
their goals, incentives and agendas radically change as well. 
Consumers and investors will suffer if exchanges succeed in 
leveraging their existing government-sponsored monopolies into 
currently competitive arenas. These efforts will suppress 
competition, discourage innovation, and harm consumers. Thank 
you, Mr. Chairman.
    [The prepared statement of Kevin M. Foley follows:]
    Prepared Statement of Kevin M. Foley, Chief Executive Officer, 
                        Bloomberg Tradebook LLC
                             introduction.
    Mr. Chairman and Members of the Subcommittee. My name is Kevin 
foley, and I am pleased to testify on behalf of Bloomberg Tradebook 
regarding ``ECNs and market structure: ensuring the best prices for 
consumers.'' the topic is both important and timely.
    Bloomberg Tradebook is owned by Bloomberg L.P. and is located in 
New York City. Bloomberg L.P. provides multimedia, analytical and news 
services to more than 170,000 terminals used by 350,000 financial 
professionals in 100 countries worldwide. Bloomberg tracks more than 
135,000 equity securities in 85 countries, more than 50,000 companies 
trading on 82 exchanges and more than 406,000 corporate bonds. 
Bloomberg News is syndicated in over 350 newspapers, and on 550 radio 
and television stations worldwide. Bloomberg publishes seven magazines, 
as well as books on financial subjects for the investment professional 
and non-professional reader.
    Bloomberg Tradebook is an electronic agency broker serving 
institutions and other broker-dealers. We count among our clients many 
of the nation's largest institutional investors representing--through 
pension funds, mutual fund and other vehicles--the savings of millions 
of ordinary Americans. Bloomberg Tradebook specializes in providing 
innovative tools that make large orders small and eliminate the 
traditional barrier between the upstairs market and the trading floor. 
We bring upstairs liquidity directly into contact with small retail 
trading, the options market-makers and program trading flow and in the 
process we consolidate what has been a fragmented market. Our clients 
have rewarded our creativity and our service by trusting us with their 
business, allowing us to regularly trade more than 150 million shares a 
day.
                             what are ecns?
    electronic communications networks--ECNs--are electronic systems 
that facilitate trading in securities. Market structure decisions--
specifically the SEC's 1996 issuance of the order handling rules--have 
permitted ECNs to flourish over the past six years, benefiting 
consumers and the markets generally. These rules--aimed primarily at 
exchange specialists and Over-the-Counter market makers--were designed 
to promote market transparency in the Nasdaq market. In the words of 
then SEC Chairman Arthur Levitt:
        Electronic communication networks have been one of the most 
        important developments in our markets in years--perhaps 
        decades. But exactly what are ECNs, and what are we to make of 
        their impact on our markets? In simplest terms, ECNs bring 
        buyers and sellers together for electronic execution of trades. 
        They have provided investors with greater choices, and have 
        driven execution costs down to a fraction of a penny. As a 
        result, these networks present serious competitive challenges 
        to the established market centers. More fundamentally, they 
        illustrate the breath-taking pace of change that results when 
        technology and competition coalesce.1
---------------------------------------------------------------------------
    \1\ Speech by SEC Chairman Arthur Levitt, Dynamic Markets, Timeless 
Principles, Columbia Law School, September 23, 1999, available on the 
Internet at http://www.sec.gov/news/speeches/spch295.htm.
---------------------------------------------------------------------------
    As has often been observed, sunlight is the best disinfectant. 
Indeed, the increased transparency promoted by the SEC's Order Handling 
Rules and the subsequent integration of ECNs into the national 
quotation montage narrowed Nasdaq spreads by nearly 30% in the first 
year following adoption of the order handling rules. These, and 
subsequent reductions in transactional costs, constitute significant 
savings that are now available for investment that fuels business 
expansion and job creation.
    While the complete list of reforms ordered by the SEC to promote 
transparency is long and varied, all of these changes, including the 
promulgation of the Order Handling Rules, were animated by the same 
underlying principle--namely that sunlight--increased transparency--
produces the most honest and efficient markets.
              ecns--a market solution to a market problem.
    A regulatory regime that encourages transparency was a necessary, 
but not sufficient, precondition to the growth of ECNs. The reason ECNs 
have long accounted for nearly half of the reported share volume of 
Nasdaq is simple--ECNs are a market solution to a market problem.
    not all ECNs are alike. Agency ecns such as Bloomberg Tradebook, 
however, share four characteristics--neutrality, transparency, fairness 
and innovation.
    Neutrality? Bloomberg Tradebook is an agency broker. We take no 
position for our own account. Thus we are neutral in the marketplace 
and exist only to serve our customers' need to buy or sell shares. In 
addition, we are an open-architecture ECN, by which we mean that we do 
not simply internalize our participants' orders. Instead, we route most 
of the orders we receive to market makers and other ECNs for 
execution--giving our participants the option to select whatever prices 
are available in the markets. In that way, we differ from ECNs such as 
island, a closed-architecture system, which does not route orders to 
other market centers.
    Transparency? Like market makers, we maintain an electronic book of 
our customers' bids and offers. But unlike market makers we publish our 
entire book of quoted prices electronically for all our customers to 
see. Indeed, as noted above, we take advantage of this transparency to 
allow our customers to route their orders to the best available prices, 
even if they are outside of Bloomberg Tradebook.
    Fairness? ECNs are required by SEC rules to respond immediately--
and I mean immediately--to orders at any given price, in the time 
sequence they are received, whether they come from our best customers 
or from our competitors. That's probably the highest standard of 
fairness in the industry.
    Innovation? Unlike Nasdaq and the NYSE, ECNs do not enjoy the 
privileged and protected status of a government-sponsored monopoly. 
Instead, ECNs must earn their keep by innovating. At its inception in 
1996, for example, Bloomberg Tradebook introduced the concept of 
electronic order sizing to the U.S. equity markets. Electronic order 
sizing is a Bloomberg functionality that permits investors to divide 
large orders automatically into small, random-sized pieces before being 
presented to the market. With electronic order sizing, ECNs have given 
investors the tools to control the market impact of their transactions, 
reducing the extent to which the market ``moves away'' from them while 
they are buying or selling in significant quantities.
    Just as the competition from ECNs has reduced explicit 
transactional costs--commissions and spreads--innovations like reserve, 
discretion, electronic order sizing and other order handling tools have 
broken down the barrier between the upstairs market and the trading 
floor, increasing liquidity and leading to dramatic decreases in the 
implicit costs of transacting in the public markets for Nasdaq 
securities.
    Any edge we gain from introducing an innovation is a momentary one. 
To remain competitive, we must continue to innovate. We have done so 
continuously over the past six years.
    Along with neutrality, transparency, fairness and innovation, add 
lots of enthusiasm and creativity from people passionately devoted to 
serving their customers and you have a picture of who we are and why we 
exist.
    When the Senate Banking Committee held a hearing in the last 
Congress exploring the role of ECNs, Frank Zarb, then Chairman of the 
National Association of Securities Dealers, stated, ``I guess I sum up 
the answer as to why we have ECNs as the fact that the national stock 
exchanges, and I'm not only talking about ours, but the exchanges 
around the world haven't been keeping pace with the needs of the 
market.''
    Mr. Zarb is a recognized leader in business and public service. 
Investors are fortunate to have had the benefit of his leadership, but 
I respectfully submit that the reason ECNs exist is not only because of 
what national stock exchanges failed to do, but also because of what we 
innovating broker-dealers have done, in the heat of competition. Mr. 
Chairman, it's worth pondering why the stock exchanges didn't keep 
pace, as Mr. Zarb stated.
    We would submit that Nasdaq and the other exchanges, because they 
are government-sponsored monopolies, ultimately cannot provide the 
innovative ideas and customer service of the best ECNs and other 
private market participants. To spur future innovation, I'd rather 
place my faith in NASD's members--the marketplace of competing broker-
dealers.
                         the current challenge.
    At present, most SROs are nonprofit organizations. NASD, however, 
has largely completed its privatization of Nasdaq and it may well be 
that other privatizations will follow. Historically, Under the cover of 
a nontransparent bureaucracy, non-profit SROs have exploited the 
opportunity to subsidize their other costs (for example, costs of 
market operation, market regulation, market surveillance, member 
regulation) through market information fees. For all SROs, the 
incentive will be strong to continue to exploit this government-
sponsored monopoly over market data by charging excessive rates for 
market data and by using the resulting monopoly rents to subsidize 
their competitive businesses. Indeed, shareholders of the now-for-
profit exchanges will effectively demand that market data charges 
remain excessive.
    Along with its market data monopoly, Nasdaq also will have a 
powerful incentive to leverage its trade execution monopoly to the 
detriment of consumers, investors and the markets. Currently, there is 
no real alternative to Nasdaq's monopoly with respect to the execution 
of market-maker quotations/orders in securities traded via Nasdaq. 
Through a series of developments, starting with the inauguration of the 
Small Order Execution System (``SOES'') in the 1980's and progressing 
through the development of SuperSOES and SuperMontage, Nasdaq has 
evolved from a decentralized, quotation- and telephone-based system 
into a screen-based, electronic communications network embodying a 
central, electronic limit order book.
    In theory, NASD members can bypass SuperSOES through private wire 
connections between a market maker and a customer or dealer. In 
reality, however, that means of avoiding SuperSOES is not on an equal 
competitive footing with the use of SuperSOES. Orders transmitted 
through SuperSOES impose obligations on the market maker to execute 
against its published quotation.
    Only Nasdaq has the monopolistic power to deliver mandatory 
executions to market makers against their quotations. Individual market 
participants do not have the market power to replicate that obligation 
through private contractual arrangements or other private ordering.
           supermontage and the nasdaq exchange application.
    The resolution of questions regarding the Nasdaq exchange 
application and the manner in which Supermontage is phased in will go a 
long way toward determining whether the securities markets of the 
future will be shaped by competition or dominated by government-
sponsored monopolies. That will have much to do with whether our 
markets remain competitive, robust and open to innovation.
    Nasdaq has applied to the SEC to become a for-profit exchange. 
Unfortunately, Nasdaq would like not only to maintain, but also to 
expand, its government-sponsored monopoly powers while becoming a for-
profit exchange. To that end, Nasdaq petitioned the SEC in 1999, to 
expand its monopoly by centralizing quotation display and order 
execution in a ``SuperMontage'' nasdaq would control.
    Recognizing the potential anticompetitive impact of SuperMontage, 
the SEC made its January 2001 approval of SuperMontage contingent on 
Nasd's meeting certain critical preconditions which were intended to 
ensure that particpation in SuperMontage was truly voluntary.
                     alternative display facility.
    Preeminent among these preconditions was the establishment of an 
``alternative display facility'' (ADF)--a display facility that would 
be run by NASD and stand as an alternative to Nasdaq.
    The ADF was deemed so critical to the SEC that it was cited as a 
precondition to both the rollout of SuperMontage and the possible 
approval of the Nasdaq exchange application.
    NASD is not independent of Nasdaq. Unfortunately, a number of 
obstacles have been placed in the way of creating a commericially 
viable ADF, some flowing from the fact that NASd--which is charged with 
organizing and running the ADF--is not independent of Nasdaq.
    NASD and Nasdaq have interlocking boards. NASD retains a 
significant ownership interest in Nasdaq and a commercial interest in 
Nasdaq's eventual success as a for-profit exchange. The significance of 
NASD's not being independent of Nasdaq is driven home in Nasdaq's 
Amendment 2 to its form 10 registration statement. Discussing the ADF 
and its competitive potential, Nasdaq states:
        If this market becomes a viable alternative to Nasdaq, then 
        Nasdaq faces the risk of reduced market share in transactions 
        and market information services revenues, which would adversely 
        affect Nasdaq's business, financial condition, and operating 
        results.
    With Nasdaq viewing the ADF as a potential threat, we believe the 
SEC and Congress need to remain vigilant to ensure that NASD is 
wholeheartedly committed to the ADF.
                          commending the sec.
    Signficantly, as NASD and Nasdaq initially designed it, the ADF was 
to be a hidden market--in essence a ``display'' facility that few 
market participants could see. Market participants could have chosen to 
display their quotations on the ADF, but no provision had been made for 
the market at large to see those quotations. As proposed by NASD and 
Nasdaq, the transparency that has been the hallmark of regulation since 
the promulgation of the order handling rules would have been vitiated 
for the ADF, to the detriment of consumers and markets. This summer, 
the SEC rejected Nasdaq's call for a hidden market and issued 
interpretive guidance that will go a long way toward ensuring that adf 
quotations will be seen in a meaningful way.
    Likewise, while Nasdaq had argued that a viable ADF is not 
essential, the SEC made clear that a viable ADF is essential to curtail 
the potential anticompettive impact of SuperMontage. NASD hobbled the 
launch of the ADF by not releasing the final technical specifications 
necessary for participation in the ADF until August 2002, placing ECNs 
and other potential ADF participants in a difficult and disadvantaged 
position. The SEC this summer, seeking to mitigate the more damaging 
effects of an ADF that would launch too late to be an effective 
alternative to SuperMontage, took the important step of ensuring that 
the ADF and SuperMontage ``rollout'' simultaneously, a process that is 
commencing this week.
    We would also commend the SEC for recognizing that major 
superMontage/ADF issues--expressly including discriminatory and 
anticompetitive fees--will require ongoing SEC engagement.
             discriminatory and anticompetitive practices.
    Practices that are discriminatory and anticompetitive stand as good 
examples of the kinds of issues that merit both SEC and congressional 
attention. In particular, i want to call your attention to quote 
decrementation and discriminatory fees.
    Quote decrementation has to do with how orders are displayed and 
adjusted on SuperMontage to the disadvantage of ECNs and their 
customers. Under SuperMontage rules, if an ECN posts a quotation for a 
certain price and quantity in a given security, it will be penalized 
for declining an order from a counterparty with whom the ECN chooses 
not to do business. Such a counterparty may be an entity that is an 
unacceptable credit risk, but it is most likely to be one that refuses 
to pay an ECN's access fees.
    Under the SuperMontage rules, when an ECN declines an order, even 
if only for part of the quantity displayed in its quotation, the ECN's 
entire quotation will be removed from the SuperMontage quotation 
display. As a result, the ECN's customers will lose their place in the 
SuperMontage time-price queue. In addition, ECNs will be at increased 
risk for incurring costs instead of revenue. What is telling about the 
quote decrementation feature of SuperMontage is that its adverse 
effects fall exclusively upon ECNs. It is grossly discriminatory.
    SuperMontage fees differentiate between order types in a way that 
is both unfair and discriminatory. In Nasdaq's nomenclature, a 
``preferenced order'' is an order sent to a specific market participant 
that has a quotation displayed in SuperMontage at the best bid or 
offer. A preferenced order is executed through the use of the 
SuperMontage execution algorithm. A ``directed order'' is an order sent 
to a specific ECN that has elected to receive orders rather than 
executions.
    Nasdaq proposes to impose a penalty of 150% on orders directed to 
ECNs or other participants that are permitted to accept order delivery 
rather than automatic executions. By charging 150% more for directed 
orders than for orders executed using the SuperMontage algorithm, the 
fee structure penalizes ECNs and other market participants that wish to 
use their own trading algorithms to access liquidity on the 
SuperMontage screen via directed orders. These deliberately 
discriminatory fees would force orders into SuperMontage's execution 
algorithm, thereby restricting market participants from having equal 
access to all avenues of execution.
    Effectively, the proposed fees impose a penalty on NASD members 
that use alternatives to SuperMontage. By increasing the cost of using 
facilities other than SuperMontage, the SuperMontage fees compel NASD 
members to keep their trading volume on SuperMontage and discourage 
them from using the ADF or other alternatives to SuperMontage.
    Other elements of Nasdaq's proposed SuperMontage fee schedule also 
are intended to suppress competition. Nasdaq has proposed extending the 
pricing scheme it currently uses for SuperSOES--its current order 
execution system--to SuperMontage. Under the SuperSOES pricing scheme, 
NASD members that report to Nasdaq at least 95% of their trades in 
Nasdaq securities for the preceding month are deemed ``Full 
contribution members''. Those reporting fewer than 95% of their trades 
in Nasdaq securities for the preceding month to Nasdaq are deemed 
``Partial contribution members''. Full contribution members would pay 
substantially lower Nasdaq access fees than partial contribution 
members. In short, the access fee differential would punish NASD 
members for doing more than de minimis business on the ADF, or any 
trading facility other than Nasdaq's SuperMontage. It's hard to imagine 
an action more contrary to consumers' interests than extending such an 
anticompetitive pricing structure to SuperMontage.
    As it is, Nasdaq has taken unto itself the enterprise value of its 
market system, which NASD's members developed over 30 years. Nasdaq 
embodies both a quotation facility and an execution/clearance facility, 
which the ADF is not intended to provide. It may be that the ADF will 
nevertheless be a preferred venue, but that will eventuate only if it 
is allowed to compete on an equal footing with Nasdaq. Exclusionary and 
anticompetitive elements in the SuperMontage/SuperSOES combination 
should be revised to provide that equal footing.
                centralization versus de-centralization.
    For-profit exchanges will have powerful incentives to leverage 
their existing government-sponsored monopolies to gain an unfair 
advantage in currently competitive markets. They'll have incentives to 
``keep pace'' with market innovators not by moving forward themselves, 
but by slowing down all market participants and centralizing order 
flow.
    If that occurs, consumers, investors and the markets themselves 
will be denied the benefits of competition. Everyone loses if 
exchanges--comfortable as government-sponsored monopolies--fail to 
innovate, leaving American markets vulnerable to offshore competitors.
    Technology makes possible a market structure that wouldn't 
previously have been possible. That has spawned a debate over the past 
few years over whether public policy should favor a more decentralized 
market structure, or whether public policy should encourage 
centralization, as often advocated by the exchanges.
    This argument has manifested itself in a number of different ways. 
A few years ago, proponents of centralization urged support for a time 
priority Central Limit Order Book (CLOB) to deal with the alleged 
``problem'' of market fragmentation. The notion behind the CLOB was 
that, by centralizing orders in one place, a single ``black box'', 
maximum order interaction and perhaps better prices might be achieved.
    While the CLOB was ultimately rejected as unworkable and unwise, 
the previously described interaction of SuperSOES and SuperMontage 
within Nasdaq represent the same effort to centralize. The recent 
Nasdaq pricing proposal, which would clearly discourage execution of 
trades outside of Nasdaq--even if the best price for a stock were being 
offered outside of Nasdaq--is simply the latest manifestation of this 
urge towards centralization. As exchanges contemplate becoming for-
profit companies, this urge to centralize order flow and execution will 
grow more pronounced. This emphasizes the need for a functional, fully 
competitive ADF as a means to mitigate the anticompetitive effects of 
Nasdaq's market scheme. It may well be that additional remedial 
measures will be needed. The continued vigilance of the Congress and 
the SEC will be essential as these developments unfold.
    As the growth of ECNs illustrates, modern technology allows the 
advantages of maximum order interaction without the downside of 
centralization. State-of-the-art telecommunications systems like the 
Internet don't rely on a single monopoly channel--rather, they rely on 
networked webs of multiple competing and redundant linkages. Why 
shouldn't the securities markets work the same way and reap the same 
benefits?
              centralized systems are resistant to change.
    The innovations that ECNs have brought to the market would not have 
occurred under more centralized systems. A centralized system also 
provides the significant downside of a central point of failure.
    Nasdaq and the nyse argue that the absence of centralization is 
``fragmentation''. Properly understood, market fragmentation is the 
failure of supply to interact with demand and vice versa. The cure for 
fragmentation is a combination of transparency and interlinkage of 
multiple market venues and liquidity pools, a combination that takes 
place on investors' desk tops. The cure for fragmentation need not 
involve a single, monopolistic market--indeed Nasdaq proposes to trade 
NYSE stocks on its exchange and that competition is beneficial. To 
ignore these basic realities and to argue that fragmentation somehow 
justifies centralizing and monopolistic market models is fundamentally 
misleading.
                 ecns--consumers and investors benefit.
    So who has benefited from the existence of ECNs? For one, small 
retail customers who, for the first time, have gained direct unfettered 
access to the liquidity of institutional order flow represented 
directly in the market. Through electronic order sizing, Bloomberg 
Tradebook's system permits direct interaction between institutional 
orders and retail orders since the institution can cut its order into 
pieces that will interact effectively with the much smaller retail 
orders. Institutional investors--which pool the savings of many, many 
small investors--are able for the first time to find liquidity for 
their orders by interacting directly with small order flow, thereby 
consolidating what had been a fragmented market.
                      who else benefits from ecns?
    All investors who have seen the speed and fairness of their 
executions improve, as ECNs have raised the standard for all broker-
dealers. Even traders not participating in ECNs benefit from our depth, 
liquidity and immediacy each time they hit an ECN bid or take an ECN 
offer.
                    who hasn't benefited from ecns?
    Useful linkages have yet to be developed for the New York Stock 
Exchange listed market. As a result, investors in that market have yet 
to reap the full benefits of the competition provided by ECNs. While 
the SEC has allowed ECNs access to the Intermarket Trading System 
through Nasdaq, this is not sufficient. The Intermarket Trading System 
remains crippled both by its technological ineffectiveness and an 
unworkable governance structure that makes any movement nearly 
impossible. This is why it is imperative that the steps necessary to 
facilitate the promised display of NYSE listed stocks in the ADF be 
undertaken as soon as possible.
    Government-sponsored market centers like the Nasdaq Stock Market 
and the New York Stock Exchange can either make ECN transparency 
available to the entire national market system or reduce transparency 
by seeking to block ECN display linkages. Clearly the NYSE has 
historically had no interest in encouraging linkages that would make 
ECNs players in the listed market. It is long past time for the 
benefits ECNs have brought to the market in over-the-counter securities 
to be extended to markets in listed securities.
                              conclusion.
    The neutrality, transparency, fairness and innovation ECNs 
collectively bring to the Nasdaq market have dramatically increased 
competition and efficiency on Wall Street, redounding to the benefit of 
consumers on Main Street and the economy. Investors in the New York 
Stock Exchange listed market should be permitted an opportunity to 
enjoy the same benefits.
    Historically not-for-profit exchanges are contemplating a for-
profit future. As market players that have traditionally functioned as 
public utilities become for-profit entities, their goals, incentives 
and agendas radically change as well. Consumers and investors will 
suffer if exchanges succeed in leveraging their existing government-
sponsored monopolies into currently competitive arenas. These efforts 
will suppress competition, discourage innovation and harm consumers.

    Mr. Stearns. Thank the gentleman.
    Mr. O'Hara, welcome.

                 STATEMENT OF KEVIN J.P. O'HARA

    Mr. O'Hara. Good morning, Chairman Stearns, Congressman 
Towns, and other distinguished members of the subcommittee. On 
behalf of Archipelago, I am pleased and honored to be with you 
this morning and commend the subcommittee for holding this 
hearing.
    And to your earlier point, Congressman Towns, to your 
earlier point regarding Instinet and Island, let the record 
reflect that I am sitting next to representatives of Brut and 
Bloomberg Tradebook. We will come back and test your hypothesis 
several months from now.
    Let me begin by saying that were this a State of the Union 
on market structure and best execution, I would declare that 
the State of the Union is good. Though unfinished business 
still remains, significant progress has been made in recent 
years. And this subcommittee should be commended for supporting 
this progress,such as your hard work on decimalization.
    Without question, the prime benefactor of this progress is 
the consumer, or the investor in capital markets' parlance. At 
no other time has the investor enjoyed greater transparency, 
better technology, and more innovation than now in the 
execution business. Importantly, tired bogeymen, thrown up to 
retard progress by reactionaries-like market fragmentation, 
ECNs unwilling to ``catch the falling knife'' in times of 
stress--have been run out of town on a rail by a Joe Friday-
like analysis: Just the facts, ma'am, and only the facts.
    At Archipelago, we are proud of our contribution to this 
progress. And in connection with that, I am happy to report 
that the Archipelago Exchange is open for business. Not long 
ago, the Archipelago Exchange was but a dream of its cofounders 
Jerry Putnam and MarrGwen and Stuart Townsend. In March 2002, 
after much inspiration and even more perspiration, the dream 
culminated in a launch of the first fully open electronic 
national exchange.
    Armed with a ``best execution'' business model in which we 
reach out electronically to other markets to obtain the best 
price for customers, the Archipelago Exchange delivers 
transparency, speed, innovation and efficiency.
    Beginning in January 1997, the day the Archipelago ECN--our 
exchange's younger brother, if you will--executed its first 
order, our current Nasdaq business has grown to an almost daily 
average of 400 million shares or roughly 20 percent of overall 
volume. In terms of New York Stock Exchange and Amex-listed 
securities, the Archipelago Exchange executes almost 50 million 
shares per day.
    The model for an exchange is its--the business model for an 
exchange is its market structure as set out in its trading 
rules. Archipelago's market structure can be best characterized 
as fully open and transparent. Everyone, institutional 
investors, broker-dealers, and retail customers has access to 
the same information such as limited order book at the core of 
our exchange. Everyone can see the same information at the same 
time. Everyone's orders are matched consistently using strict 
price and time priority. No order can jump ahead of another 
unless it is at a superior price. The end result: Our customers 
operate on a level playing field.
    Two tenets of best execution--two central tenets of best 
execution are transparency and access. The two work cheek by 
jowl to produce a quality market. Transparency is the ability 
to see information such as a limit order book, while access is 
the ability to interact with such information. Historically, 
the market for New York Stock Exchange and Amex-listed trading 
was not driven by technological solutions to provide 
transparency and access. Instead, floor-based systems of 
frenetic brokers and ever-present and very profitable 
specialists were charged with providing transparency and 
access. Consequently, technology-based marketplaces had 
problems gaining traction in listed trading. While Archipelago 
has found a way to bridge this cultural gap by integrating our 
prices into the international market system, friction still 
exists.
    Until recently, two of the largest ECNs' merger partners, 
Island and Instinet, were permitted to hide their prices for 
exchange-listed securities from the public. Citing 
insurmountable technology, these ECNs refused to display their 
quotes in the national market system. As a result, better 
prices in their marketplaces were not available to customers 
who were not part of the club. Membership had its privileges.
    The SEC has quietly begun to tackle the sticky issue of 
public display of security prices for listed securities, 
however. Two months ago, the SEC enforced the provisions of 
Federal regulation ATS and took appropriate remedial steps 
against these hermit markets. Curiously, instead of choosing 
transparency and showing its quote to the public, Island 
defiantly went dark and ceased displaying a private market in 
five popularly traded ETFs: QQQ, DIA and SPY, SMH and MKH. 
Instinet similarly shut down its private market altogether in 
certain listed securities during regular trading hours. 
Nevertheless, the resiliency of the marketplace is such that 
these listed shares continue to trade efficiently on platforms 
despite the Island and Instinet rolling blackouts.
    As many can attest the Inner Market Trading System, or ITS, 
is the crotchety old man of electronic linkages. But while in 
need of an overhaul, to refuse ITS linkage is to make mischief 
with public investors, depriving them of both transparency and 
access.
    Happily, ITS reform is not far off. To address the issue, 
the SEC summoned the country's exchanges to Washington last 
week to discuss the trade-through provisions of the ITS plan. 
With the introduction of decimal pricing and technology changes 
that have enabled vastly reduced execution times, the trade-
through provisions of the ITS plan have limited the ability of 
automated marketplaces to provide executions when a better 
price is displayed by a market that provides manual executions. 
For example, the Archipelago Exchange can offer internal 
executions at a fraction of a second, whereas New York Stock 
Exchange or Amex often takes 15 or even 30 seconds to respond 
to a commitment to trade.
    At the SEC's urging, the ITS Operating Committee is working 
on reform. A consortium of committee members have proposed an 
approach that would accommodate the differences between floor-
based traditionalists and technology-based new entrants. This 
approach allows for the differences among marketplaces without 
a time penalty for those markets that have speed and efficiency 
as their goals. Moreover, it preserves a ``best price'' 
principle to protect investors whose orders were represented at 
a venue willing to make them accessible for instant execution.
    Finally, this committee has a record of championing the 
cause of small investors. Case in point: decimalization of our 
markets. You were a critical catalyst for this positive change 
that has narrowed effective spreads in the most liquid stocks 
on Nasdaq and the New York Stock Exchange. This fundamental 
change has led to enormous reductions in trading costs and put 
hundreds of millions of dollars back in the pockets of 
investors; i.e., your constituents. Thank you for your 
steadfast perseverance.
    Likewise, I know you care about this subject matter we are 
discussing today. ``Best execution'' is the heart of our 
markets. By your continued oversight of our markets on matters 
of transparency and access, you provide effective stewardship 
and support of best execution. Archipelago looks forward to 
continue to work with the subcommittee to enhance our 
securities markets for the benefits of investors. And I will 
gladly take your questions at the appropriate time.
    [The prepared statement of Kevin J.P. O'Hara follows:]
 Prepared Statement of Kevin J.P. O'Hara, General Counsel & Corporate 
                Secretary, Archipelago Holdings, L.L.C.
    Good morning Chairman Stearns, Vice-Chairman Deal, Congressman 
Towns and other distinguished members of the Subcommittee. On behalf of 
Archipelago, I am pleased and honored to be with you this morning and 
commend the Subcommittee for holding this hearing on ECN market 
structure and the quest to ensure best price for consumers.
                            i. introduction
    Let me begin by saying that were this a ``State of the Union 
address'' on market structure and best execution, I would declare that 
``the state of the union is good.'' Though unfinished business still 
remains, significant progress has been made in recent years. Without 
question, the prime benefactor of this significant progress is the 
``consumer,'' known as the ``investor'' in the context of capital 
markets. At no other time has the investor enjoyed greater 
transparency, better technology, and more innovation than now in the 
execution business. Importantly, tired bogeymen thrown up to retard 
progress by reactionaries--like market fragmentation, ECNs unwilling to 
``catch the falling knife'' in times of market stress, and the 
Pavlovian definition of best execution as the untimely price 
improvement by a floor-based traditionalist--have been run out of town 
on a rail by a Joe Friday-like analysis. ``Just the facts, Ma'am, and 
only the facts.''
    At Archipelago, we are proud of our contribution to this progress. 
And in connection with that, I am happy to report that the Archipelago 
Exchange is open for business!
    Not long ago, the Archipelago Exchange was but a dream of its co-
founders Jerry Putnam and MarrGwen and Stuart Townsend. In March 2002, 
after much inspiration and even more perspiration, that dream 
culminated in the launch of the first fully open electronic national 
stock exchange. This ``next-generation'' exchange competes toe-to-toe 
with the New York Stock Exchange (``NYSE'') and American Stock Exchange 
(``Amex''). Armed with a ``best execution'' business model--in which we 
reach out electronically to other markets to obtain the best price for 
customers--the Archipelago Exchange delivers transparency, speed, 
innovation, and efficiency.
    Beginning in January 1997, the day the Archipelago ECN--our 
exchange's younger brother, if you will--executed its first order, our 
current Nasdaq business has grown to an average of almost 400 million 
shares per day, or roughly 20% of overall volume. In terms of NYSE- and 
Amex-listed securities, the Archipelago Exchange executes almost 50 
million shares per day. Very soon, we will roll our Nasdaq business 
into the Archipelago Exchange as well, which will afford us the ability 
to deliver an even ``better execution'' for consumers by performing 
executions in a more efficient and cost-effective manner.
    From the day we filed our application seeking exchange status with 
the Securities and Exchange Commission (``SEC'') in August 1999, to the 
forging of our business partnership with the Pacific Exchange in July 
2000, to the day in October 2001 when the SEC formally granted 
Archipelago exchange status, it has been our singular focus to do to 
the exchange business what innovators such as Dell, Wal*Mart , and 
Southwest Airlines have done for their respective businesses: that is, 
deliver a higher quality and cost-effective product to the consumer. 
And like those agents of change, our mission has been to rework the 
traditional exchange business model using a one-two combination of 
cutting-edge technology and a laser-like focus on customer needs.
    ii. archipelago market structure: best execution business model
    The business model for an exchange is its market structure, as set 
out in its trading rules. Archipelago's market structure can be best 
characterized as ``fully open and transparent.'' Everyone--
institutional investors, broker-dealers, and retail customers--has 
access to the same information, such as the limit order book at the 
core of our exchange. Everyone can see the same information at the same 
time. Everyone's orders are matched consistently using strict price-
time priority. No order can jump ahead of another unless it is at a 
superior price. The end result: our customers operate on a level 
playing field.
    With our linkages to other markets, we offer an efficient path to 
the best price, even if it resides at a competing marketplace. Standing 
orders are anonymously displayed on our book, and marketable orders are 
either matched internally or electronically routed to a superior price 
at other marketplaces. Simply put, our exchange is the manifestation of 
best execution principles put into practice.
            iii. importance of the public quote to consumers
    Two central tenets of best execution are ``transparency'' and 
``access.'' The two-work cheek by jowl to produce a quality market: 
transparency is the ability to see information, such as a limit order 
book, while access is the ability to interact with such information. 
Historically, the market for NYSE- and Amex-listed trading was not 
driven by technological solutions to provide transparency and access. 
Instead, floor-based systems of frenetic brokers and ever-present (and 
very profitable!) specialists were charged with providing transparency 
and access. Consequently, technology-based marketplaces had trouble 
gaining traction in listed trading.
    While the Archipelago Exchange has found ways to bridge this 
cultural gap by integrating our prices into the National Market System, 
frictions still exist. Indeed, many still maintain that any such 
integration is a ``a bridge too far.'' Until recently, two of the 
largest ECNs--merger partners Island and Instinet--were permitted to 
hide their prices for exchange-listed securities from the public. 
Citing insurmountable technology hurdles, these ECNs refused to display 
their quotes in the National Market System. As a result, better prices 
in their private markets were not available to consumers who were not 
part of the club. Membership had its privileges.
    The SEC has quietly begun to tackle the sticky issue of public 
display of securities prices for listed securities, however. Two months 
ago, the SEC enforced the provisions of a federal regulation and took 
appropriate remedial steps against these ``hermit markets.'' Regulation 
ATS clearly states that ECNs with more than 5 per cent of the volume in 
any one security are required to display their quotes to the public. 
Curiously, instead of choosing transparency and showing its quote to 
the public, Island defiantly went ``dark'' and ceased displaying a 
private market in five popular exchange-traded funds, or ETFs: QQQ, 
DIA, SPY, SMH and MKH. Instinet, on the other hand, shut down its 
private market altogether in certain popular listed securities, such as 
SPY, during regular trading hours. Nevertheless, the resiliency of the 
marketplace is such that these listed-shares continue to trade 
efficiently on other platforms despite the Island and Instinet 
``rolling blackouts.''
                iv. importance of linkage: reform of its
    As many can attest, the Intermarket Trading System, or ITS, is the 
crotchety old man of electronic linkages. But while in need of an 
overhaul, to refuse ITS linkage is to make mischief with public 
investors, depriving them of both transparency and access. And SEC 
action clearly indicates that refusing ITS linkage has regulatory 
consequences: by letting the technological perfect be the enemy of the 
investor good, Island and Instinet brinksmanship beat a path to a 
Conrad-esque heart of ETF darkness.
    Happily, ITS reform is not far off. To address this very issue, the 
SEC summoned the country's exchanges to Washington last week to discuss 
the trade-through provisions of the ITS Plan. With the introduction of 
decimal pricing and technology changes that have enabled vastly reduced 
execution times, the trade-through provisions of the ITS Plan have 
limited the ability of automated marketplaces to provide executions 
when a better price is displayed by a market that provides manual 
executions. For example, the Archipelago Exchange can offer internal 
executions in a fraction of a second, whereas the NYSE or Amex often 
takes fifteen or even thirty seconds to respond to a commitment to 
trade.
    At the SEC's urging, the ITS Operating Committee is working on 
reform. A consortium of Committee members has proposed an approach that 
would accommodate the differences between floor-based traditionalists 
and technology-based new entrants. Under this proposal, automated 
exchanges like Archipelago could trade through the prices displayed by 
a manual exchange in an amount up to three cents. Prices displayed by 
an automated exchange could not be traded through, however, since these 
markets provide an automatic execution. This approach allows for the 
differences among market centers without a time penalty for those 
markets that have made speed and efficiency their goal. Moreover, it 
preserves a ``best price'' principle to protect investors whose orders 
were represented at a venue willing to make them accessible for instant 
execution.
    v. conclusion: congressional oversight champions the individual 
                                investor
    This Committee has a record of championing the cause of the small 
investor. A case in point: the decimalization of our equity markets. 
You were a critical catalyst for this positive change that, to date, 
has narrowed effective spreads in the most liquid stocks on Nasdaq and 
the NYSE by an average of 50% and 15%, respectively. This fundamental 
change has directly led to enormous reductions in trading costs and put 
hundreds of millions of dollars back in the pockets of investors. Thank 
you for your steadfast perseverance.
    Likewise, you should care about the subject matter that I have 
discussed today. Best execution is a core principle of our markets. By 
your continued oversight of our markets on matters of transparency and 
access, you provide effective stewardship in support of best execution. 
The ITS Plan reform underway by the Committee and the SEC is important 
work that will lead to better price competition and efficient order 
execution for consumers.
    Archipelago looks forward to continuing to work with the Committee 
to enhance our securities market for the benefit of investors. I will 
be glad to respond to any questions that the members of the 
Subcommittee may have at the appropriate time.

    Mr. Stearns. Thank you.
    Mr. O'Brien, welcome.

                  STATEMENT OF WILLIAM O'BRIEN

    Mr. O'Brien. Thank you. Good morning, Chairman Stearns and 
Congressman Towns, members of the subcommittee and their 
staffs. I am Bill O'Brien, Senior Vice President and General 
Counsel of Brut. On behalf of Brut, I commend the subcommittee 
for focusing on the issue of best execution of customer orders 
at this important time in the history of our Nation's markets.
    I would like to thank you for the opportunity to testify. 
Brut operates one of the largest ECNs, routinely executing over 
100 million shares of Nasdaq volume per day with a growing 
business in exchange-listed stocks as well. In August 2002, 
Brut was acquired by SunGard Data Systems, a leading financial 
services technology provider which purchased the interests of a 
consortium of broker-dealers which included Bear Stearns, 
Goldman Sachs, Morgan Stanley, Merrill Lynch and Salomon Smith 
Barney.
    The last 5 years have seen an unprecedented transformation 
regarding the manner in which security transactions are 
executed. In order to ensure that these dynamic conditions do 
not produce cataclysmic results, the legislators and regulators 
will need to work tirelessly to evolve legacy approaches to the 
oversight of market structure. Nevertheless, the core 
principles that the Congress gave the SEC in 1975 when it 
mandated the creation of a national market System can, if 
applied consistently and balanced carefully, ensure that the 
most important component of market structure, the individual 
investor, continues to receive the best possible prices when 
trading stocks.
    The launch this week of Nasdaq's SuperMontage trading 
system is but a part of the crescendo of competition in the 
securities industry that is blurring traditional distinctions. 
This environment has the potential to be a boon for the 
ultimate consumer, reducing costs, improving service, and 
furthering innovation if it takes place within a constructive 
framework.
    In drafting the Securities Act Amendments of 1975, the 
Congress emphasized that fair competition among brokers and 
dealers, among exchange markets, and among the markets other 
than exchange markets, and between exchange markets and markets 
other than exchange markets was in the best interest of the 
Nation's investors. Given the interdependence among market 
participants and the impact on market quality on certain 
competitive tactics, this competition must be carefully 
nurtured in order to produce the desired impact.
    Several of the issues currently facing ECN operators and 
the market at large are reflective of the debate regarding what 
is needed to ensure a truly fair and level playing field. 
SuperMontage has been a focal point for many of these issues. 
It is a watershed in Nasdaq's efforts to transform itself into 
the principal provider of execution services in the over-the-
counter market. Historically, Nasdaq's primary role has been to 
serve market makers and ECNs by collecting and redistributing 
their quote and trade information, leaving the business of 
actually executing trades to those parties. In a series of 
steps culminating in SuperMontage, Nasdaq now aims to draw more 
and more actual executions away from the market makers and ECNs 
and into their own internal systems, with the self-stated aim 
of becoming a central form of the execution of transactions in 
Nasdaq stocks.
    Brut thinks that Nasdaq should be free to move forward with 
this approach, enjoying the right that all enterprises should 
have to pursue their own strategic vision. At the same time, 
however, Brut has been a strong advocate for the creation of 
viable alternatives to SuperMontage so that Nasdaq's legacy of 
regulatory monopoly does not produce unintended and 
uncompetitive consequences. Market structure regulation has 
long relied upon Nasdaq infrastructure for ensuring the display 
of best price quotation information to the public. Market 
makers and ECNs effectively had no choice but to post their 
quotations in Nasdaq to comply with SEC regulations. As Nasdaq 
sought to transform those quotations into orders within 
SuperMontage, the competitive ramifications became clear: Any 
business whose use is mandated by law is virtually unstoppable.
    This is why Brut has been a strong proponent of the 
development of the alternative display facility, or ADF. Owned 
and operated by the NASD, the ADF allows market makers and ECNs 
to do business outside of SuperMontage altogether, publicly 
displaying their best prices to consumers through a truly 
market-neutral facility. After over 18 months of development, 
the ADF took on its first customer earlier this week, providing 
meaningful choice for the first time since Nasdaq's creation. 
Whether the ADF fulfills its long-term mission will be 
dependent upon a collective will to ensure that the NASD 
continues to provide an effective option to its former progeny, 
Nasdaq.
    Brut has delayed its own consideration of usage of the ADF 
while the technological and economic barriers to its usage are 
moderated by the NASD with improved connectivity solutions and 
more realistic economics. These steps are important for the 
NASD to prove to market makers and ECNs that it is serious 
about operating a truly viable SuperMontage alternative. In its 
May 2002 report, the General Accounting Office noted the need 
to manage market structure in light of such concerns, stating 
that an ongoing challenge will be to respond effectively to 
both real and perceived conflicts of interest. A continued 
insistence from the SEC and the Congress that the ADF offer 
modern technological solutions and competitive economics will 
provide meaningful discipline on Nasdaq as it competes with 
market makers and ECNs that help to build it.
    The adaptation of current regulation to promote even 
further competition in this arena should be strongly 
considered. Regional exchanges such as the Cincinnati Stock 
Exchange are implementing a variety of business models that 
would provide quotation and trade reporting services to market 
makers and ECNs in competition with SuperMontage and also 
remedy some of the inefficiencies in the pricing of market data 
that have arisen out of Nasdaq dominance. The current 
regulation of registered security exchanges can at times serve 
as a barrier to deployment of these business models. The 
reduced relevance of the distinction between heavily traded 
exchange-listed and Nasdaq stocks and the increased 
electronification of both markets dictate a reconsideration of 
how exchanges are to be regulated going forward, in order to 
realize the full competitive potential of current market 
structure.
    As ECNs seek to compete within this landscape, the need for 
ECN pricing flexibility should also be emphasized. In this 
challenging economic environment, fees are a matter of both 
extreme importance and sensitivity to Brut's customers. Our 
rate structure, which is fairly common in the industry, rewards 
users that are willing to initiate and display orders into its 
ECN with a cash rebate, while charging firms that seek to 
access that liquidity a fee. Since the implementation of the 
SEC's order handling rules in 1997, the debate over these ECN 
and access fees has ebbed and flowed with changing economic and 
regulatory conditions. Brut believes that competitive forces 
rather than regulation are appropriate to discipline the nature 
and structure of prices. These forces currently serve to 
pressure ECN rate structures in both directions. The entry of 
Nasdaq as a competitor and the rate structure for SuperMontage 
which also offers rebates to initiators of liquidity 
necessitates similar pricing in the quest to be competitive. 
What the market will bear in terms of costs also has revealed 
itself as some ECNs that have attempted to take these rate 
structures to extremes have experienced financial difficulty 
and unsustainable collection rates. ECNs themselves have worked 
to eliminate pricing inefficiencies between one another. 
Continued vibrant rate competition, rather than intervention 
and its potential for unintended adverse consequences will best 
serve the economic needs of both ECN operators and their users.
    As ECNs and others have asserted their competitive 
independence from Nasdaq, some are concerned that increased 
fragmentation will inevitably impact on another national market 
system principle, ensuring economically efficient execution of 
security transactions. Brut counts itself among the firms with 
the vision and technology to remedy such concerns, providing an 
example of how the market can respond to a changing environment 
to provide customers with the best of all possible worlds. Brut 
is representing our customer orders within SuperMontage, 
delivering customers the full functionality and liquidity of 
that market in addition to its own. We are doing so because we 
believe that to do otherwise will deny our customers best 
execution opportunities inconsistent with the congressional 
goal of executing investor orders in the best possible market. 
In addition, we offer quote information from and direct 
connectivity to nonSuperMontage ECNs and other significant 
market centers in order to provide customers with a seamless 
one stop shopping trading environment.
    Our ability to navigate this more complex market structure 
while still preserving execution quality provides evidence that 
fragmentation can work to the ultimate benefit of the consumer. 
Private connectivity between and among ECNs, broker-dealers, 
and other major markets now exist such that public utilities 
are no longer a linchpin to ensure execution quality and that 
customers receive the best prices for their transactions. This 
gives each market participant the freedom to offer its own 
unique solution to customers on its terms without any single 
point of collective reliance. This can free each firm to 
innovate, letting the market decide whether a firm's offering 
provides required service to meet trader needs.
    Legacy regulations that subvert the ability of a market 
center to offer customers its version of a quality execution to 
a need for centralization should be reevaluated in light of 
this new reality. With respect to transactions in exchange-
listed stocks, ECNs have attracted significant order flow in 
recent years as innovative products like exchange-traded funds, 
the Qs, SPDRs, the transition to decimalization, and the 
homogenization of trading operations have all eroded resistance 
to electronic trading of these securities. This success has 
triggered SEC requirements that dictate at times participation 
in the Intermarket Trading System, or ITS, an exchange-
dominated consortium with requirements that do not fit all ECN 
business models. This has put some ECNs in the uneviable 
position of choosing between options that all dilute their 
value proposition and customer execution quality. Some, like 
Island, have chosen to cease displaying their order prices to 
all customers, forcing people to trade blind. Others, like 
Instinet, have ceased trading some of these securities 
altogether. While Brut is an ITS participant through its 
involvement in the Nasdaq Intermarket, we see this development 
as counterproductive. In this era of customer mobility and 
information availability, regulations that thwart an ECN's 
ability to deliver what it perceives that it customers want 
should be reconsidered in light of the continued relevance of 
their original purpose.
    The rapid rate at which our markets are transforming 
creates the potential for a regulation gap which ECNs often 
find themselves in the middle of, due to their innovative 
nature, that puts consumer interests at risk. Chairman Pitt has 
recognized this risk, asking the staff of the SEC to hold 
public hearings on market structure issues which will be held 
over the next several weeks. ECNs have had an important role in 
helping consumers achieve the best prices by increasing 
transparency, reducing spreads, and perhaps as the greatest 
fulfillment of the congressional directive, to provide an 
opportunity for investor orders to interact without the 
participation of a dealer. In light of the changing market 
structure before us, Brut believes the principles enunciated by 
the Congress in 1975--fair competition, efficient execution, 
and flexible regulation--can continue to serve as a road map to 
promote market structure quality and investor interests.
    Mr. Chairman, Brut welcomes the subcommittee's interest in 
these important issues and I look forward to answering any 
questions that you or members have at the appropriate time.
    [The prepared statement of William O'Brien follows:]
Prepared Statement of William O'Brien, Senior Vice President & General 
                           Counsel, Brut, LLC
    Good morning Chairman Stearns, Congressman Towns, and members of 
the Subcommittee. My name is William O'Brien, and I am Senior Vice 
President and General Counsel of Brut, LLC (``Brut''). On behalf of 
Brut, I commend the Subcommittee for focusing on the issue of best 
execution of customer orders during this pivotal point in the history 
of the nation's securities markets, and would like to thank you for the 
opportunity to testify.
    Brut operates one of the largest electronic communications networks 
(or ``ECN'') for the trading of Nasdaq and exchange-Iisted securities. 
Brut routinely executes 100 million shares per day of volume in Nasdaq 
securities, and has a growing business in exchange-listed stocks and 
exchange-traded funds through. In August 2002, Brut was acquired by 
SunGard Data Systems, which purchased the interests of the other 
members of a consortium that had previously owned Brut, which included 
Bear Stearns, Goldman Sachs, Knight Trading Group, Merrill Lynch, 
Morgan Stanley, and Salomon Smith Barney.
                              introduction
    The last five years have seen an unprecedented transformation 
regarding the manner in which equity security transactions are 
executed. The pace of change, however, is poised to increase 
exponentially, as developments in the economic, technological and 
competitive environments converge to alter the landscape with rapid-
fire regularity and seismic frequency. In order to ensure that these 
dynamic conditions do not produce cataclysmic results, legislators and 
regulators will need to work tirelessly to evolve legacy approaches for 
the oversight of market structure. The core principles that the 
Congress gave the SEC as its mandate in 1975, when the SEC was 
instructed to foster the creation of a ``national market system,'' 
continue to be a relevant and insightful road map as to how to respond 
to the pressing issues of today's markets. Applied consistently and 
balanced carefully, these values can offer insight across a variety of 
scenarios and ensure that the most important component of market 
structure--the individual investor--continues to receive the best 
possible prices when trading stocks.
                        constructive competition
    The launch this week of Nasdaq's SuperMontage trading system is but 
a part of the crescendo of competition in the securities industry that 
is blurring traditional distinctions. Nasdaq, a former not-for-profit 
utility intended to serve the collective interests of the brokerage 
firms that paid to build it, is now aggressively pursuing an IPO-driven 
strategy that dictates rivalry with its creators. Regional exchanges, 
trying to remain relevant, are attempting to gain a piece of certain 
information businesses that had previously been Nasdaq's monopoly. And 
new technologies that allow for instantaneous changes in usage patterns 
have helped unleash a ferocious price war among ECNs, who can no longer 
count on customer loyalty lasting longer than a single trading day. All 
the while, firms with proprietary trading operations face their own 
competitive pressures in light of an atmosphere of declining share 
prices and sagging investor confidence.
    This competitive environment has the potential to be a boon for the 
ultimate consumer--reducing cost, improving service, and furthering 
innovation--if it takes place within a constructive framework. In 
drafting the Securities Act Amendments of 1975, the Congress emphasized 
that ``Fair competition among brokers and dealers, among exchange 
markets, and between exchange markets and markets other than exchange 
markets'' was in the best interest of the nation's investors. Given the 
inter-dependence among market participants and the impact on market 
quality of certain tactics, however, this competition must be carefully 
nurtured in order to produce the desired impact. Several of the issues 
currently facing ECN operators--and the market at large--are reflective 
of the debate regarding what is needed to ensure a truly fair and level 
playing field.
    The implementation of Nasdaq's SuperMontage trading system has been 
a focal point for many of these issues. SuperMontage is a watershed in 
Nasdaq's efforts to transform itself into the principal provider of 
execution services in the over-the-counter market. Historically, 
Nasdaq's primary role has been to serve market makers and ECNs by 
collecting and re-distributing their quote and trade information, 
leaving the business of actual execution of transactions to those 
parties. In a series of steps culminating in SuperMontage, Nasdaq now 
aims to draw more and more actual executions away from market makers 
and ECNs and into their own internal systems, with the self-stated aim 
of becoming ``a central forum'' 1 for the execution of 
transactions in Nasdaq stocks.
---------------------------------------------------------------------------
    \1\ See Exchange Act Release No. 43514 (November 3, 2000), 65 Fed. 
Reg. 69084 (November 15, 2000) at 69108.
---------------------------------------------------------------------------
    Brut thinks that Nasdaq should be free to move forward with this 
approach, enjoying the right that all enterprises should have to pursue 
their own strategic vision. At the same time, Brut has been a strong 
advocate for the creation of viable alternatives to SuperMontage so 
that Nasdaq's legacy of regulatory monopoly does not produce unintended 
anti-competitive consequences. Market structure regulation has long 
relied upon Nasdaq infrastructure for ensuring the display of best-
priced quotation information to the public. Market makers and ECNs 
effectively had no choice but to post their quotations in Nasdaq to 
comply with SEC regulations. As Nasdaq sought to transform these 
quotations into executable orders within SuperMontage, the competitive 
ramifications became clear--any business whose use is mandated by law 
is virtually unstoppable.
    This is why Brut has been a strong proponent of the development of 
the Alternative Display Facility (``ADF''). Owned and operated by the 
NASD, the ADF allows market makers and ECNs to do business outside of 
SuperMontage altogether--publicly displaying their best prices to 
consumers through a truly market-neutral facility. After over eighteen 
months of development, the ADF took on its first customer earlier this 
week, providing meaningful choice to market participants for the first 
time since Nasdaq's creation. Whether the ADF fulfills its long-term 
mission will be dependent upon a collective will to ensure that the 
NASD continues to provide an effective option to its former progeny, 
Nasdaq. Brut has delayed its own consideration of usage of the ADF 
while the technological and economic barriers to its usage are 
moderated by the NASD offering improved connectivity solutions and more 
realistic economics. These steps are important for the NASD to prove to 
market makers and ECNs that it is serious about operating a truly 
viable SuperMontage alternative. In its May 2002 report, the General 
Accounting Office noted the need to manage market structure in light of 
concerns regarding viability, stating ``an ongoing challenge . . . will 
be to respond effectively to both real and perceived conflicts of 
interest.'' 2 A continued insistence from the SEC and the 
Congress that the ADF offer modern technological solutions and 
competitive economics will provide meaningful competitive discipline on 
Nasdaq as it competes with market makers and ECNs.
---------------------------------------------------------------------------
    \2\ United States General Accounting Office, Securities Markets: 
Competition and Multiple Regulators Heighten Concern About Self-
Regulation, at 29 (May 2002).
---------------------------------------------------------------------------
    The adaptation of current regulation to promote even further 
competition in this area should be strongly considered. Regional 
exchanges such as the Cincinnati Stock Exchange are considering a 
variety of business models that would provide quotation and trade 
reporting services to market makers and ECNs in competition with 
SuperMontage. The current regulation of registered securities exchanges 
can at times serve as the barrier to deployment of these business 
models. The reduced relevance of the distinction between heavily traded 
exchange-listed and Nasdaq stocks, and the increased electronification 
of both markets, dictate a reconsideration of how exchanges are to be 
regulated going forward in order to realize the full competitive 
potential of current market structure.
    As ECNs seek to compete within this landscape, the need for ECN 
pricing flexibility should also be emphasized. In this challenging 
economic environment, pricing is a matter of both extreme importance 
and sensitivity to Brut's customers. Our rate structure, which is 
fairly common in the industry, rewards users that are willing to 
initiate and display orders into its ECN with a cash rebate, while 
charging firms that seek to access Brut's liquidity a fee. Since the 
implementation of the SEC's Order Handling Rules in 1997, the debate 
over these ``ECN access fees'' has ebbed and flowed with changing 
economic and regulatory conditions. Brut believes that competitive 
forces, rather than regulation, are appropriate to discipline the 
nature and structure of prices. These forces currently serve to 
pressure ECN rate structures in both directions. The entry of Nasdaq as 
a competitor and the rate structure of SuperMontage (which also offers 
rebates) necessitates similar pricing in the quest for liquidity. What 
the market will bear in terms of cost has also revealed itself, as ECNs 
that have attempted to take rate structures to the extreme have 
experiences unsustainable collection rates. ECNs themselves have worked 
to eliminate pricing inefficiencies between one another. Continued 
vibrant rate competition, rather than intervention and its potential 
for unintended adverse consequences, will best serve the economics 
needs of both ECN operators and their users.
                        efficient fragmentation
    As ECNs and others assert their competitive independence from 
Nasdaq, some concerned that increased fragmentation will negatively 
impact on another national market system principle, ensuring 
``economically efficient execution of securities transactions.'' 
3 Brut counts itself among the firms with the vision and 
technology to remedy such concerns, providing an example of how the 
market can respond to a changing environment to provide consumers with 
the best of all possible worlds.
---------------------------------------------------------------------------
    \3\ Exchange Act Section 11A(a)(1)(c)(i).
---------------------------------------------------------------------------
    Brut is representing customer orders within SuperMontage, 
delivering customers the full functionality and liquidity of that 
market in addition to its own. We are doing so because we believe that 
to do otherwise will deny our customers best execution opportunities 
inconsistent with the Congressional goal of ``executing investors 
orders in the best market.'' 4 In addition, we offer quote 
information from and direct connectivity to non-SuperMontage ECNs and 
other significant market centers, in order to provide customers with a 
seamless, ``one stop shopping'' trading environment that fulfills the 
need for ``availability to brokers, dealers and investors of 
information with respect to quotations for and transactions in 
securities.'' 5 All the while we are exploring ways to 
reduce our Nasdaq reliance from a cost perspective, so as to eliminate 
dependencies without jeopardizing customer interests.
---------------------------------------------------------------------------
    \4\ Exchange Act Section 11A(a)(1)(c)(iv).
    \5\ Exchange Act Section 11A(a)(1)(c)(iii).
---------------------------------------------------------------------------
    Our ability to navigate this more complex market structure while 
still preserving execution quality provides evidences that 
fragmentation can and will work to the ultimate benefit of the 
consumer. The private connectivity between and among ECNs, broker-
dealers and other major markets now exists such that public utilities 
are no longer a lynch-pin to ensure that consumers receive the best 
prices for their securities transactions. This gives each market 
participant the freedom to offer its own unique solution to its 
customers, on its terms, without any single point of collective 
reliance. This can free each firm to innovate, letting the market 
decide whether a firm's offering provide required service to meet 
trader needs. The SEC's proactive efforts to ensure market centers 
provide the investing public with objective, consistent information 
regarding execution quality, as embodied by recent Rules 11Ac1-5 and 
11Ac1-6 under the Exchange Act, allow investors to compare ``apples to 
oranges'' and make smart order-routing decisions.
    Legacy regulations that subvert the ability of a market center to 
offer customers its version of a quality execution to a need for 
centralization should be re-evaluated in light of this new reality. 
With respect to transactions in exchange-listed stocks, ECNs have 
attracted significant order flow in recent years, as innovative 
products like exchange-traded funds (such as the ``QQQ'' and ``SPDR''), 
the transition to decimalization, and the homogenization of trading 
operations have all eroded resistance to electronic trading of these 
instruments. This success has triggered SEC requirements under 
Regulation ATS, which mandate the display of ECN order prices into the 
public quotation system once certain volume thresholds have been 
surpassed. Unlike mechanisms for Nasdaq securities, however, the means 
to comply with this requirement for listed stocks also require 
participation in the Intermarket Trading System (or ``ITS''), an 
exchange-dominated consortium with requirements that do not fit all ECN 
business models. This has put some ECNs in the unenviable position of 
choosing between options that all dilute their value proposition and 
consumer execution quality. Some have chosen to cease display of their 
order prices to all customers--forcing people to ``trade blind''. 
Others have ceased trading these securities altogether. While Brut is 
an ITS participant, through its involvement in the Nasdaq Intermarket, 
we see this development as counterproductive. In this era of customer 
mobility and information availability, regulations that thwart an ECN's 
ability to deliver what its customers want should be reconsidered in 
light of the continued relevance of their original purpose.
                               conclusion
    The rapid rate at which our markets are transforming creates the 
potential for a regulation gap--which ECNs often find themselves in the 
middle of due to their innovative nature--that puts consumer interests 
at risk. Chairman Pitt has recognized this risk, asking the staff of 
the SEC to hold public hearings on market structure issues. ECNs have 
had an important role helping consumers achieve the best prices, by 
increasing transparency, reducing spreads, and perhaps as the greatest 
fulfillment of the Congressional mandate, to provide ``an opportunity . 
. . for investors' orders to be executed without the participation of a 
dealer.'' 6 In light of the changing market structure before 
us, Brut believes that the principles enunciated by the Congress in 
1975--fair competition, efficient executions and flexible regulation--
can continue to serve as a road map to promote market structure quality 
and investor interests.
---------------------------------------------------------------------------
    \6\ Exchange Act Section 11A(a)(1)(c)(v).
---------------------------------------------------------------------------
    Mr. Chairman, Brut welcomes the Subcommittee's interest in these 
important issues, and I look forward to any questions you and the other 
Members may have.

    Mr. Stearns. I thank the gentleman.
    Mr. Gasser, welcome.

                  STATEMENT OF ROBERT C. GASSER

    Mr. Gasser. Good morning, Chairman Stearns, Mr. Towns, and 
members of the subcommittee. I am Robert Gasser, Chief 
Executive Officer of NYFIX Millennium. On behalf of our parent 
company NYFIX, Inc., our partners and clients, I thank the 
committee for the opportunity to appear before you today to 
discuss the role ECNs play in current U.S. Market structure. I 
thank you for holding this hearing on the subject that is at 
the heart of the matter when talking about market structure, 
and that is the effects that changes, and sometimes lack of 
change, have had on the end investor.
    In 1999, Millennium was founded by a partnership comprised 
of NYFIX, Inc. and 10 prominent U.S. Investment banks, 
including ABN Amro, Bank of America, Deutsche Bank, JP Morgan, 
Lehman Brothers, Morgan Stanley, SC Bernstein, SG Cowen, UBS 
Warburg, and Wachovia Securities. We are a firm focused on the 
electronic interaction of listed equity order flow. As a 
result, my comments will almost exclusively focus on listed 
equity securities.
    Millennium went live in September of 2001 and has steadily 
grown its daily executed volume to our current average of 
approximately 9 million shares a day in the most recent 90 day 
period. Our customers are comprised of investment banks, on-
line trading firms, and program trading entities. In total, we 
have 65 contracted users of the system. Importantly, they 
contribute a pool of liquidity to our system by passing their 
DOT and institutional block volume through Millennium by 
default on its way to the floor of the New York Stock Exchange.
    This pass-through, as we refer to it, is allowed to 
interact with resting orders that can improve the price 
reflected on the New York Stock Exchange by at least one penny. 
If our system cannot improve price, that order is immediately, 
100 to 150 milliseconds as we clock it, sent on to its original 
destination. Trades are immediately printed in the Nasdaq 
Intermarket. We do not publish a quote in competition with the 
New York Stock Exchange and we presently have no aspirations to 
become a U.S. Stock Exchange.
    NYFIX, Inc., the parent of Millennium, is the dominant 
provider of network services and order management technology to 
the listed trading marketplace. We estimate that we touch 
approximately 40 percent of institutional block trading 
liquidity every trading day. On the reopening of the exchange 
September 17, 2001, NYFIX, Inc. touched 1.2 billion shares of 
executed listed volume. On any given day, 15 to 20 percent of 
that volume is passed through Millennium.
    U.S. Listed market structure is differentiated in one very 
critical way from the Nasdaq marketplace. In 1996, the change 
in Nasdaq order handling rules mandated by the regulatory 
overhaul of that market catalyzed growth of the ECN model. In 
effect, Nasdaq market access was democratized. The U.S. Listed 
marketplace has not experienced a transformational event of 
this magnitude. While investors who have electronic access, 
such as DOT, with the New York Stock Exchange, they must always 
interact with a gatekeeper, that being the New York Stock 
Exchange specialist, when transacting with trading 
counterparties. Firms wishing to compete with the New York 
Stock Exchange specialist have historically been relegated to 
the ITS. Many of our constituent clients aspire to compete with 
the New York Stock Exchange specialist. We provide a mechanism 
by which they can interact electronically with a subset of New 
York Stock Exchange liquidity as long as they are willing to 
improve price. We give these firms the ability to submit order 
flow instantaneously and cancel order flow instantaneously. 
Their only obligation when they submit a live order into our 
system is to transact.
    There is a quiet revolution starting in the U.S. Listed 
marketplace. Investors and traders who have become disenchanted 
with current market structure are moving beyond the 
experimentation phase. They are starting to employ ATSs like 
the ones represented here today. The value proposition is 
clear. Execution that is electronically matched without human 
intermediation takes one middleman and the resulting economic 
impact of that middleman out of the equation. What makes that 
possible today? I would submit to you that advanced technology, 
industry protocols, and high-speed networks support this type 
of healthy competition without the resultant risk of 
fragmentation.
    This quiet revolution combined with the decimalization of 
stocks, the consolidation of the New York Stock Exchange 
specialist units, the requirement to submit quality of 
execution data for the public record, and the extended bear 
market in the U.S. Equity markets is in the process of causing 
profound change to the security industry.
    Given the lack of investment returns generated in the past 
3 years, there has been increasing scrutiny placed on 
transaction costs by end investors. In an era where outsized 
investment returns have been eliminated by poor market 
performance, best execution is not a luxury item; it can make 
or break best performance.
    Market centers are compelled to publish their quality of 
execution data in accordance with SEC Reg 11ac1-5. We welcome 
this objective measurement of performance. In our most recent 
filing as of August 2002, we compared very favorably against 
the listed equity market center average in the four main 
categories used to measure performance. They are the following: 
percentage of order flow executed in 0-9 seconds; percentage of 
orders that were price improved; average order size; and 
percentage of orders exercised outside the quote. Millennium 
executed 97.9 percent of its order flow within 0-9 seconds 
versus a market center average of 52 percent. Millennium price 
improved 75.6 percent of its order flow versus a market center 
average of 32.9. Millennium's average order size was equal to 
926 shares versus a market center average of 882 shares. 
Millennium traded outside of the quote 5.9 percent of the time 
as opposed to a market center average of 21.3.
    While we can argue about the changing role of an 
intermediary, round or flat, there is one inescapable and 
unavoidable truth to the present supply chain in the trading of 
U.S. Listed equity securities. There are a lot of middlemen. 
The question becomes how does each link in that chain justify 
its own unique cost/benefit. We would argue that technology is 
changing the answer to that question and the possible outcomes. 
Special interests that argue against fragmentation are really 
arguing against competition. Our publicly available quality of 
execution data clearly makes the case for the automation of 
client interaction and the resultant benefits.
    We thank you, Chairman Stearns, Mr. Towns, and members of 
the committee for your focus on these issues.
    [The prepared statement of Robert C. Gasser follows:]
Prepared Statement of Robert C. Gasser, Chief Executive Officer, NYFIX 
                            Millennium, LLC
    Good morning Chairman Stearns, Mr. Towns and members of the 
Subcommittee. I am Robert Gasser, Chief Executive Officer of NYFIX 
Millennium, L.L.C. (Millennium). On behalf of our parent company NYFIX, 
Inc., our partners, and clients, I thank the committee for the 
opportunity to appear before you today to discuss the role ECN's play 
in current US Market Structure.
 i. comparing and contrasting millennium and other nasdaq-centric ecn's
    In 1999, Millennium was founded by a partnership comprised of 
NYFIX, Inc. and 10 prominent US Investment Banks including ABN Amro, 
Bank of America, Deutsche Bank, JP Morgan, Lehman Brothers, Morgan 
Stanley, SC Bernstein, SG Cowen, UBS Warburg, and Wachovia Securities. 
We are a firm focused on the electronic interaction of listed equity 
order flow. As a result my comments will focus exclusively on Listed 
equity securities.
    Millennium went live in September of 2001 and has steadily grown 
daily executed volume to our current average of approximately 9 million 
shares/day. Our customers are comprised of Investment Banks, Online 
Trading Firms, and Program Trading entities. In total we have 65 
contracted users of the system. Importantly, they contribute a pool of 
liquidity to our system by passing their DOT and institutional block 
volume though Millennium by default on its way to the floor of the 
NYSE.
    This pass through volume is allowed to interact with resting orders 
that can improve the price reflected on the NYSE by at least $0.01. If 
our system cannot improve price that order is immediately (100-150 
milliseconds) sent onto its original destination. Trades are 
immediately printed in the NASDAQ Intermarket. We do not publish a 
quote in competition with the NYSE and we presently have no aspirations 
to become a US Stock Exchange.
    NYFIX, Inc. the parent of Millennium is the dominant provider of 
Network Services and Order Management Technology to the Listed Trading 
Marketplace. We estimate that we touch approximately 40% of 
institutional block trading liquidity every trading day. On the re-
opening of the exchange September 17, 2001 NYFIX, Inc. touched 1.2 
billion shares of executed Listed volume. On any given day, 15%-20% of 
this volume is passed through Millennium.
                         ii. a quiet revolution
    US Listed market structure is differentiated in one very critical 
way from the Nasdaq marketplace. In 1996, the change in Nasdaq order 
handling rules mandated by the regulatory overhaul of that market 
catalyzed growth of the ECN model. In effect, Nasdaq market access was 
``democratized''. The US Listed marketplace has not experienced a 
transformational event of this magnitude. While investors have 
electronic access (such as DOT) to the NYSE, they must interact with a 
``gatekeeper'' (NYSE Specialist) when transacting with trading 
counterparties. Firms wishing to compete with the NYSE Specialist as 
market makers have historically been relegated to the ITS (Intermarket 
Trading System). This has created a market opportunity for Millennium. 
Many of our constituent clients aspire to compete with the NYSE 
Specialist. We provide a mechanism by which they can interact 
electronically with a subset of NYSE liquidity as long as they are 
willing to improve price. We give these firms the ability to submit 
order flow instantaneously and cancel order flow instantaneously. Their 
only obligation when they submit a live order into our system is to 
transact.
    There is a quiet revolution starting in the US Listed marketplace. 
Investors and traders who have become disenchanted with current market 
structure are moving beyond the experimentation phase. They are 
starting to employ ATS' like the ones represented here today. The value 
proposition is clear--execution that is electronically matched without 
human intermediation takes one middleman and the resulting economic 
impact out of the equation. What makes that possible today? I would 
submit to you that advanced technology, industry protocols, and high 
speed networks support this type healthy competition without the 
resultant risk of fragmentation.
                          iii. profound change
    This quiet revolution combined with the decimalization of stocks, 
the consolidation of NYSE Specialist units, the requirement to submit 
quality of execution data for the public record, and the extended bear 
market in the US Equity Markets is in the process of causing profound 
change to the Securities Industry.
    Given the lack of investment returns generated in the past three 
years, there has been increasing scrutiny placed on transaction costs 
by end investors. In an era where outsized investment returns have been 
eliminated by poor market performance, best execution is not a luxury 
item. It can make or break best performance.
    Market centers are compelled to publish their quality of execution 
data in accordance with SEC Regulation 11ac1-5. We welcome this 
objective measurement of performance. In our most recent filing as of 
August, 2002 we compared very favorably against a listed equity market 
center average In the four main categories used measure performance. 
They are the following: 1) Percentage of order flow executed in 0-
9seconds, 2) Percentage of orders that were price improved, 3) Average 
order size, and 4) Percentage of orders executed outside the quote. 
Millennium executed 97.9% of its order flow within 0-9 seconds versus a 
market center average of 52%. Millennium price improved 75.6% of its 
order flow versus a market center average of 32.9%. Millennium's 
average order size was equal to 926 shares versus a market center 
average of 882 shares. Millennium traded outside of the quote 5.9% of 
the time versus a market center average of 21.3%.
                              iv. summary
    While we can argue about the changing role of an intermediary all 
day long, there is one inescapable and unavoidable truth to the present 
supply chain in the trading US listed equity securities--there are a 
lot of middlemen. The question becomes--how does each link in that 
chain justify its own unique cost/benefit. We would argue that 
technology is changing the answer to that question and the possible 
outcomes. Special interests that argue against ``fragementation'' are 
really arguing against competition. Our publicly available quality of 
execution data clearly makes the case for the automation of client 
interaction and the resultant benefit.

    Mr. Stearns. I thank you.
    Mr. Ryan.

                STATEMENT OF MICHAEL J. RYAN, JR.

    Mr. Ryan. Good morning. My name is Michael Ryan and I am 
Executive Vice President and General Counsel for the American 
Stock Exchange. Chairman Stearns, Mr. Towns, and your staffs, I 
appreciate the opportunity to testify before this subcommittee 
today.
    Over the past year, as you noted, a great deal of the 
financial community's attention has been focused on the threat 
of terrorism and the need to bring law and order back to 
corporate America. As operator of a securities market that 
happens to be located less than 300 feet from Ground Zero, we 
cannot overstate the importance of both of these efforts. We 
believe the current efforts by the government will strengthen 
the existing market systems and provide new protections to 
customers, and we intend to remain an active participant in 
this process. Indeed, we look forward to participating in the 
SEC's upcoming hearings on market structure.
    Today, however, I would like to focus on a series of 
activities that relate to serious violations of the Federal 
securities laws. Before I discuss my specific points, though, I 
would like to give you a brief overview of the American Stock 
Exchange and the National Market System. The American Stock 
Exchange has a long history of innovation and is unique among 
U.S. Securities markets in that we are the only market that 
actively lists and trades securities across three diverse 
business lines: We trade equities, options, and exchange-traded 
funds, commonly referred to as ETFs.
    In equities we focus principally on providing a well-
regulated auction market for small- and mid-cap companies. Our 
options market is the second largest in the United States, and 
for the first time since getting into the business more than 25 
years ago, recently have had days where we are the most active 
equity options market. What really sets the Amex apart from all 
of the markets in the U.S. Are ETFs, which is the fastest 
growing, most innovative financial product offered by an 
exchange over the last decade. After more than 4 years of 
working with the SEC and millions of dollars in R&D expense, 
the Amex pioneered ETFs in 1993 with the introduction of an ETF 
base on the S&P 500 index, known as the SPIDER. Since then, we 
have spent millions more in developing new products, in 
educating the marketplace about the benefits of ETFs. Nine 
years later the Amex remains the clear leader in ETF listings, 
listing 121 of the 123 in the U.S. Market today, including in 
addition to SPIDERs, the QQQ which is based on the Nasdaq 100 
and DIAMONDS, which is based on the Dow 30.
    Now we are also planning the next generation of ETF 
products, variations that will provide investors even greater 
flexibility and new investment opportunities. We launched fixed 
income ETFs this summer and are getting ready to introduce 
leverage ETFs, inverse ETFs, and, most significantly, actively 
managed ETFs.
    We have been able to leverage our reputation in ETFs to 
create a global presence for the Amex. In the last year we have 
reached agreements to trade Amex-listed ETFs in Europe and 
Asia. In short, the American Stock Exchange has emerged as a 
strong, innovative, international competitor, especially in the 
development and trading of sophisticated derivative securities.
    I would like to turn to a brief description of the National 
Market System. In 1975, Congress adopted substantial amendments 
to the Federal securities laws that mandated the creation of a 
National Market System for trading securities. To achieve this 
congressional mandate, at the direction of the SEC, we now have 
in place three critical National Market System plans for Amex-
listed securities.
    Two of these plans consolidate trade and quote information 
which is sold to market participants on a real-time basis. The 
revenue generated is shared among the exchanges and Nasdaq 
ratably based on the number of trades executed in Amex-listed 
securities by each market.
    The third plan provides the mechanism for market 
participants to access trading interest across all markets, 
which is critical in achieving best execution for investors 
orders.
    Of course, with the evolution of the markets, the 
Commission has found it necessary from time to time to take 
additional steps to ensure that the National Market System is 
kept current. Most significantly, on December 8, 1998, the 
Commission adopted a new rule known as regulation ATS for 
alternative trading systems. This new rule is designed to 
integrate significant alternative trading systems into the 
National Market System. The SEC took this action to deal with 
the growing regulatory disparity between ATSs and other 
markets, disparities the SEC found negatively affected other 
securities markets and, most importantly, investors. Without 
justification however, one ATS, Island, has openly violated and 
disregarded ATS by steadfastly refusing to display its best 
price orders and the consolidation quotations and providing 
access to those orders by investors across all markets.
    Because of these violations of this new rule, we have now a 
two-tiered market rife with fraudulent and misleading trade 
reporting. To fully appreciate this problem, it is important to 
connect a few dots. First, NASDAQ has in place a payment for 
order flow program under which they pay their members, 
including Island, for trades and Amex listed securities. 
Because of an historical anomaly, NASDAQ is given credit for 
Island's trades, even though Island refuses to participate in 
the two most significant components of the National Market 
System, consolidating quotations and providing fair access to 
those quotes.
    To restore balance to the National Market System, in 
February of this year the overwhelming majority of the markets 
proposed an interpretation of the National Market System plans 
to end the practice of giving NASDAQ credit under the revenue 
sharing formula for Island's trades until Island became a full 
partner in the National Market System. Ironically, if this 
interpretation were permitted to stand, many of the problems 
today that I am raising would long have been resolved. It would 
also absolutely have prevented the next problem on the horizon, 
which is fraudulent and misleading trade reporting, which is 
the second situation I will describe to you today.
    At the beginning of this year, Island also began paying for 
order flow using the money it receives from NASDAQ. The clever 
structure of their scheme has directly led to a practice known 
as trade shredding and at least in some instances to 
manipulative wash sales. Yesterday's enforcement settlement by 
the NASD was swift securities is directly attributed to wash 
sales on Island solely for the purpose of collecting market 
data revenue.
    Third, to exacerbate matters, Island has recently announced 
that it will begin reporting--that is, selling--its trades and 
ETFs to the Cincinnati Stock Exchange in a manner that will 
neither display their best price quotes nor make them 
accessible to public investors. Regrettably, we note that the 
Cincinnati arrangement with Island, which has not been filed 
with the SEC, undermines the core purposes of Regulation ATS 
and the National Market System. Island will not be displaying 
its best orders through Cincinnati and none of Island's quotes 
will be accessible to other markets through ITS.
    Fourth, this past August the Commission provided an 
exemption for one of the most significant ITS rules for the 
three most active ETFs. This action was obviously designed 
directly to accommodate Island. Despite this and many other 
accommodations, Island has cavalierly ignored the Commission's 
efforts to have it join the National Market System, most 
recently by going dark in an effort to use a loophole in the 
provisions of Regulation ATS. As a result, Island has all the 
benefits of being exchanged without any of the burdens. It does 
not regulate the practice of its subscribers. Trading in wash 
sales are classic examples of this. Nor does it provide 
surveillance of the trading activity of its own market, does 
not need SEC approval of changes to its system or changes to 
its rules or fees, and it can pick and choose who is and who is 
not a member.
    To make matters worse, it markets itself as faster and less 
costly than exchanges, a claim so absurd that it is insulting 
to the intelligence of anyone truly familiar with their 
practices. The principal reason Island is faster is because it 
ignores investor protection rules followed by the other markets 
that ensure investors receive the best available price in the 
market. That is, it refuses to participate in the 
congressionally mandated National Market System.
    Worse still, although it defies new SEC rules explicitly 
requiring them to join the National Market System, they 
actually receive revenue generated from the National Market 
System. In other words, we, the markets that comply with the 
Federal securities laws by fully participating in the National 
Market System, are actually providing a direct financial 
support to a competitor that is ignoring these laws.
    In closing, we are simply asking that all investors be 
given the greatest assurances that they have access to the most 
fair and efficient markets, and that the Amex and the rest of 
the markets be given a fair playing field by ensuring even-
handed enforcement of the rules.
    Thank you for your time, and I look forward to your 
questions.
    [The prepared statement of Michael J. Ryan, Jr. follows:]
 Prepared Statement of Michael J. Ryan, Jr., Executive Vice President 
              and General Counsel, American Stock Exchange
    Good morning, my name is Michael Ryan and I am Executive Vice 
President and General Counsel for the American Stock Exchange. Chairman 
Stearns, Mr. Towns and distinguished members, I appreciate the 
opportunity to testify before the Subcommittee on Commerce, Trade and 
Consumer Protection concerning ``ECNs & Market Structure: Ensuring Best 
Prices for Consumers'' and wish to thank you for holding this important 
hearing. Over the past year, a great deal of the financial community's 
attention has been focused on the threat of terrorism and the need to 
bring law and order back to corporate America. As the operator of a 
securities market less than three hundred feet from Ground Zero, we 
cannot overstate the importance of both these efforts. We believe 
current efforts by the Government will strengthen the existing market 
system and provide new protections and assurances to consumers and we 
intend to remain an active participant in this process. Indeed, we look 
forward to participating in the SEC's upcoming hearings on market 
structure. In examining the current market structure today, I would 
also like to bring to your attention several issues that relate to 
serious violations of the federal securities laws that until recently 
went unchecked for more than a year and a half and are, without a 
doubt, counter to those principles that ensure a fair market for 
investors.
    Before I discuss specific points, however, it is important to 
provide you a brief overview of the American Stock Exchange and of the 
National Market System (NMS).
    The American Stock Exchange has a long history of innovation and 
diversification, and it proudly carries on this distinguishing 
trademark among exchanges today. As one of the most diversified 
financial marketplaces in the U.S., the Amex is the only primary 
exchange in the United States that actively lists and trades securities 
across three diverse business lines--equities, options and exchange 
traded funds or ETFs. We continue to provide investors--whether it be 
retail or institutional investors--with investment opportunities that 
best meet their needs.
    Since being purchased by the NASD in 1998, the Amex has undergone 
dramatic changes. For the next couple of minutes, I'd like to highlight 
some of those exciting changes and the distinguishing characteristics 
of the Amex as a self-regulatory organization (SRO), and how it differs 
and offers critical advantages to the market as compared to the other 
exchanges and ECNs.
    Essentially, the Amex marries the rules of the auction market and 
the expertise of an Exchange professional to create a high-quality, 
well regulated trading environment. The result of this advantageous 
combination is the Amex's ability to provide investors with greater 
liquidity, narrower spreads, decreased volatility and meaningful price 
discovery.
    The Amex market is a technologically advanced centralized auction 
and specialist system whose strength comes from the fact that the 
specialists have an affirmative obligation to maintain a fair and 
orderly market. This means they risk their own capital, maintaining a 
continuous two-sided quotation. With a specialist intrinsically linked 
to creating the best market for a stock, the best interest of listed 
companies and their shareholders are achieved. Other markets--whether 
they be regional exchanges, dealer markets or ECNs--provide far less of 
a commitment to the investing public.
    By buying and selling from their own account, specialists increase 
liquidity and maintain orderly markets by helping companies avoid the 
wild fluctuations and price volatility securities often seen on other 
markets. Investors also benefit from ``truer price discovery'' and 
decreased fragmentation, as customer orders in our market are matched 
up together over 70 percent of the time.
    The combination of our auction market, diversified product line, 
state-of-the-art technology and large pools of liquidity on our market 
provided by Wall Street's most experienced and well-capitalized firms, 
delivers a superior marketplace for investors in all our products.
                                equities
    The Amex equity marketplace continues to outperform the market. 
Following a strategic restructuring of the equity program which 
refocused the business on small and middle market companies, the Amex 
composite index outperformed every other domestic exchange and 
virtually every other index in both 2000 and 2001, and is on track to 
do so again this year.
    The Amex, unlike the other primary markets which focus exclusively 
on servicing large cap stocks, acts as a conduit in helping small and 
mid-sized companies develop and grow.
    We feel that now, more than ever, in this economic and political 
climate, it's critical to provide support to the capital markets--
especially the small and mid-cap companies who are more often than not 
our nation's principal source of innovation, job creation and future 
economic growth.
    Our advanced centralized auction and specialist system is 
especially beneficial to small and mid-cap companies as it maximizes 
liquidity at the point of sale. Specialists also serve as a single 
point of contact that a company can turn to for critical insight on 
their company's trading activity.
    By offering a catalogue of value-added services through our 
Investor Relations Alliance to our listed companies, we've created a 
niche marketplace for companies who can use guidance and assistance in 
seeking visibility and coverage in a difficult economy and an 
increasingly sophisticated market environment.
    Offering additional diversification and opportunities to 
investors--we also began trading NASDAQ stocks this summer. By trading 
NASDAQ stocks, the Amex is providing for the first time in these 
securities, a meaningful auction market environment with real 
opportunities for price improvement. The Amex is providing deep 
liquidity for large, institutional size orders, which creates new 
investment opportunities for investors.
                                options
    The Amex is also the second largest options exchange in the U.S., 
trading options on broad-based and sector indexes as well as domestic 
and foreign stocks.
    We trade call and put options on more than 1,800 stocks and 25 
broad, sector-specific and international indexes. And we continue to 
close in on becoming the number one domestic options marketplace for 
equity options.
    Even amid tough market conditions, we continue to see growth in our 
options business. In looking at third quarter Amex's total options 
equity volume for this year, it is up 18% as compared to this same time 
last year.
                                  etfs
    In addition to its role as a national equities market and leading 
options exchange, the Amex is the pioneer of the Exchange Traded Fund 
(``ETF''). ETFs are the fastest growing, most innovative financial 
products offered by an exchange over the last decade. After more than 
four years of working with the SEC and millions of dollars of R&D 
expense, we launched the first ETF in 1993 with the creation of the 
Standard & Poor's Depository Receipts (or commonly referred to as the 
``spider''), which is based on the Standard and Poor's 500 Composite 
Stock Price Index.
    Over the next several years, we spent millions more developing new 
products and educating the marketplace about the benefits of ETFs. Nine 
years later, the Amex remains the clear leader in ETF listings, listing 
121 of the 123 in the U.S. market today.
    For a six-year stretch through 2001, the Amex had seen ETF assets 
and average daily volume nearly double year after year. In 1999, ETFs 
at the Amex had $35.9 billion in assets. That grew to $70.3 billion in 
2000 and to $87 billion by year-end 2001. Last year, we witnessed ETF 
assets increase more than 26% at a time when most underlying indexes 
were declining.
    Remarkably, ETFs have grown globally in the face of the market 
downturn. That is due in large part to the basic features of the ETF 
and the attractive advantages they offer investors, especially in 
turbulent markets. ETFs offer investors diversification, flexibility 
against intra-day price swings and lower cost structures. Certainly, 
today these qualities are even more appealing to any investors--whether 
retail or institutional.
    Now, we're also planning the next generation of ETF products--
variations that will allow investors even greater flexibility and new 
opportunities. We launched fixed income ETFs this summer and are 
getting ready to introduce leveraged ETFs, inverse ETFs and actively 
managed ETFs.
                                 global
    We have been able to leverage our reputation in ETFs to create a 
global presence for the Amex. In the last year, we have reached 
agreements to trade Amex-listed ETFs in Europe and Asia.
    Our global expansion includes a joint venture with the Singapore 
Exchange. In May, we began trading Amex-listed ETFs in Asia, becoming 
the very first fungible trading of a product across time zones.
    We've also listed the first U.S. equivalent of an ETF trading on 
the Tokyo Stock Exchange. And we continue to work on agreements with 
the Tokyo Stock Exchange and Euronext with respect to the listing and 
trading of each other's ETFs.
    As regulations allow, we anticipate that these centers will also 
provide international trading venues for our listed companies seeking 
exposure to the global markets.
                            critical issues
    In short, the new American Stock Exchange has emerged as a strong, 
innovative international competitor, especially in the development and 
trading of sophisticated derivative securities.
    Amidst all of this, we are also preparing to separate from the 
NASD. As the NASD has publicly stated, it is ready to refocus solely on 
its role as a regulator, divesting itself of ownership of both NASDAQ 
and the Amex. That process is well underway for NASDAQ, and the Amex is 
actively discussing with interested parties the best opportunities for 
our separation from the NASD.
    Importantly, at the Amex, we pride ourselves on being a guardian of 
the capital markets as well as a proponent of innovation. The Amex has 
always been a regulator that is focused not only on strong regulation 
but also enhancing prospects for current and future economic 
prosperity. This has been at the core of the Amex for many, many years 
and will continue to be well into the future, regardless of ownership.
                         national market system
    Let me now turn to a brief description of the national market 
system--its formation and purposes.
    In 1975 Congress adopted substantial amendments to the federal 
securities laws designed to enhance the integrity and efficiency of our 
national securities markets and to ensure that all investors, wherever 
located and irrespective of their connections or affiliations, were 
provided contemporaneous, equal and fair access to market information 
and pricing.
    Thus, Congress directed the SEC to develop a national market 
system. The Commission, in turn, adopted rules under this mandate to 
enhance transparency of market information and to foster interaction of 
investor trading interest. These rules require that the markets 
disseminate to the marketplace, in real time, consolidated order and 
quotation information as well as trade executions. These rules also 
require that the markets maintain linkages among one another in order 
to minimize fragmentation.
    The SEC directed all the exchanges and NASDAQ to adopt plans to 
implement a national market system and to integrate the various 
exchanges into them. Ultimately, three critical national market system 
plans were adopted for equity securities: the Consolidated Quote 
(``CQ'') Plan, the Intermarket Trading System (``ITS'') and the 
Consolidated Tape Association (``CTA'') Plan.
    To put it in simple terms, CQ lets market participants see trading 
interest as soon at it arises, ITS provides the mechanism for market 
participants to access this trading interest across markets and CTA 
provides the mechanism to learn about trades that occur almost 
immediately after they are executed. Collectively, these three plans 
achieve the Congressional mandate of developing a national market 
system by enhancing real time consolidated transparency of market data 
(i.e., the CQ Plan for quotes and CTA Plan for trades) and fostering 
interaction of investor trading interest (i.e., ITS). Each of the Plans 
was submitted to and approved by the Commission.
    The CQ and CTA Plans provide that the market data generated from 
these Plans is to be sold to market participants on a real-time basis. 
The revenue generated is then shared among the exchanges and NASDAQ 
ratably based on the number of trades executed by that market.
    Since the adoption of these Plans, the Commission has on many 
occasions refined its national market system related rules, reinforced 
the importance of the national market system and underscored the 
central role these Plans play in meeting the mandate set forth in the 
1975 Amendments.
    Most significantly, on December 8, 1998, the Commission adopted a 
new rule--Regulation ATS (Alternative Trading System)--designed to 
integrate significant alternative trading system activity into the 
national market system. This new rule was adopted after extensive and 
careful consideration and for the express purpose of integrating ATSs 
into the national market system.
    Much like the Commission's 1996 order handling rules that were 
designed to eliminate the two-tiered market being created by Instinet 
in NASDAQ securities, Regulation ATS was adopted to address the 
Commission's well-founded concerns that these systems were leading to 
market fragmentation and harming market transparency by operating as 
private `` `hidden markets,' in which a market participant privately 
publishes quotations at prices superior to the quotation information it 
disseminates publicly.'' Further, the SEC did this to deal with the 
growing regulatory disparity between ATS's and other markets, 
disparities the SEC found negatively affected other securities markets 
and, most importantly, investors.
    The SEC noted at the time that ATS trading activity was not fully 
disclosed to or accessible by public investors, that this activity 
would likely not receive adequate surveillance for market manipulation 
and fraud, and that ATS's had ``no obligation to provide investors a 
fair opportunity to participate in their systems or to treat 
participants fairly.''
    Without justification, however, Island has openly violated and 
disregarded the clear provision of Regulation ATS that expressly 
requires orders entered in Island to be publicly displayed in the 
consolidated quotation. The violation of these important aspects of our 
federal securities laws has created a two-tiered market, complete with 
unfair advantages for certain market professionals, to the direct 
disadvantage of the other market participants and, most significantly, 
retail investors. Because of these violations of this new rule, we now 
have a two-tiered market rife with fraudulent and misleading trade 
reporting.
    The American Stock Exchange believes very strongly that this 
subcommittee should view with deep concern Island's open and continuous 
violation of Regulation ATS since May 2001. For more than a year the 
Amex has repeatedly raised objection to these violations and other 
related abuses.
    To add to this problem, NASDAQ has in place a payment for order 
flow program whereby they pay their members--including, most notably, 
Island--for trades in Amex listed securities. To be precise, NASDAQ 
``kicks back'' to Island a percentage of the market data revenue NASDAQ 
receives as a result of Island's trades, even though Island refuses to 
participate in the two most significant components of the national 
market system--consolidating quotations and providing fair access to 
those quotes.
    We believe NASDAQ's payment for order flow program raises serious 
and significant issues regarding investor protection, market 
transparency and best execution. This program directly violates the 
fundamental principles of the national market system as it was 
conceived and mandated by this Congress. Indeed, the entire system has 
now seriously deteriorated and broken down.
    Back in February, the overwhelming majority of the CTA participants 
proposed an interpretation of the CQ and CTA Plans to end the practice 
of giving NASDAQ credit under the revenue sharing formula for Island's 
trades. After all, it defies both logic and principles of fundamental 
fairness to permit NASDAQ or Island to receive direct financial benefit 
for Island's trades from the national market system when Island 
stubbornly refuses to participate in the most fundamental national 
market system functions.
    Ironically, if the American Stock Exchange and a majority of the 
other CQ/CTA participants were not forced to reverse this 
interpretation, much if not all of this problem would have long been 
resolved. It would also have absolutely prevented the next problem on 
the horizon--fraudulent and misleading trade reporting.
    Beginning sometime in February or March, Island also began paying 
for order flow. They cleverly structured their scheme along the lines 
of the NASDAQ payment for order flow program, which mirrors the CQ/CTA 
market data revenue sharing plan. That is, you get paid for every trade 
in excess of 100 shares. Needless to say, it wasn't long before 
Island's customers were breaking up trades into 100 share increments--a 
practice know as ``trade shredding'' in its most benign form and, in 
many instances, wash sales, an explicit violation of the 
antimanipulation provisions of the federal securities laws. So, for 
example, if Island is paying you $1.00 per trade regardless of the size 
and you want to trade 1000 shares, you are going to send into Island 10 
orders at 100 shares rather than 1 order at 1000 shares. Trade 
shredding and wash sales flowing from Island's scheme have proliferated 
since then.
    Unfortunately, this is not even the latest chapter. There are two 
more.
    First, to exacerbate matters, Island has recently announced that it 
will begin reporting (that is, selling) trades in ETFs to the 
Cincinnati Stock Exchange (``CSE'') in a manner that will neither 
display their quotes nor make them accessible to public investors. 
According to Island, CSE will pay Island 90% of CSE's market data 
revenue that it receives under the CTA Plan. Island therefore will be 
able to pay its users even more than under NASDAQ's Pilot Payment for 
Order Flow (``PFOF'') Program, with the aim of further increasing 
Island market share and siphoning even greater volume away from 
national market facilities. In this regard, we note that CSE's 
arrangement with Island, which has not been separately filed with the 
SEC, undermines the core purposes of Regulation ATS. Island will not be 
displaying its best orders through CSE and none of Island's quotes will 
be accessible to other markets through ITS. Indeed, Island has 
explicitly stated that orders matched at a price outside the best 
market--that is, that trade through a better price in the national 
market system, will continue to be reported to NASDAQ and be 
compensated for under NASDAQ's Pilot PFOF Program.
    Finally, against this backdrop, we were amazed and frustrated when 
we learned this past August that the Commission without discussion or 
debate amended the ITS plan for SPY (the S&P 500 ETF), QQQ (the Nasdaq 
100 ETF) and DIA (the Dow 30 ETF). The action was obviously designed 
directly to accommodate Island.
    During this entire period the Amex has honored every request by the 
Commission to refrain from taking any action based on the Commission's 
promises that the issues would be addressed expeditiously. While we 
have complied with the Commission's requests, Island has cavalierly 
ignored the Commission's efforts to have it join the national market 
system, most recently by ``going dark''--and thereby making an absolute 
mockery of the entire purpose of Regulation ATS--after the Commission 
granted a three cent exemption to the ITS trade-through rule. Our 
frustration with the situation has reached the breaking point.
    What has happened here sends a clear message to market 
participants: If you are part of the private club (in this case, 
Island), you don't need to worry about the rules and you can trade 
away. This means that outsiders cannot see or get access to a better 
price within the private club. What's more, because the private club 
refuses to connect to the national market system, investor's orders in 
the private club are disadvantaged because they cannot access a better 
price in a competing market.
    Although characterized as ATSs, these private clubs on one level 
operate for all practical and competitive purposes as an ``exchange,'' 
competing each day with the registered national securities exchanges.
    On another level, however, these private clubs have none of the 
regulatory burdens of an exchange. They do not regulate the practices 
of their subscribers (to wit, trade shredding and wash sales). They do 
not provide surveillance of the trading activity of their own market. 
They do not need SEC approval of changes to their systems. They do not 
need SEC approval to change their rules or fees. They can pick and 
choose who is and who is not a club member. And, in complete defiance 
of Regulation ATS, has operated in blatant and open violation of the 
federal securities laws for 18 months. In violating Regulation ATS, 
they do not disseminate their best available orders for consolidation 
with all other markets and they do not provide access to anyone who is 
not a part of their club.
    As a result, an ATS has all the benefits of being an exchange 
without any of the burdens. To make matters worse, they market 
themselves as faster and less costly than exchanges--a claim so absurd 
that it is insulting to the intelligence of anyone truly familiar with 
their practices.
    The only reason an ATS is faster is because they ignore the 
investor protection rules followed by the other markets that ensure 
investors receive the best available price in the market--that is, they 
refuse to participate in the Congressionally mandated national market 
system.
    Worse still, although they defy new SEC rules explicitly requiring 
them to join the national market system, they actually receive revenue 
generated from the national market system. In other words, we--the 
markets that comply with federal securities laws by fully participating 
in the national market system--are actually providing direct financial 
support to a competitor that is ignoring the federal securities laws.
                               conclusion
    During this session, Congress has had to shore up the integrity of 
our markets and the governance of our corporations in the context of 
such examples as Enron and WorldCom, which involved private ``deals'' 
to accommodate ``star performers,'' all undertaken in an opaque 
regulatory environment. We view the current regulatory scheme applied 
to ECNs as perilous because a regulatory pattern has emerged that has 
allowed certain market participants to operate outside the rules and 
outside the Congressionally mandated national market system. We are 
simply asking that all investors be given the greatest assurances that 
they have access to the most fair and efficient markets and that the 
Amex be given a fair playing field by ensuring evenhanded enforcement 
of the rules. If the house of cards falls, then Congress, together with 
regulators, securities markets and investors, will be asking why the 
warning signals had not been adequately dealt with. Thank you for your 
time.

    Mr. Stearns. I thank the gentleman. Let me just say, as 
many of you mentioned, we have had--this is a second hearing. 
And we invited NASDAQ and we invited the New York Stock 
Exchange. They came to the first hearing; they decided not to 
come to this one. Mr. Ryan, we invited Island; they didn't want 
to come. So--for whatever reason. We want to thank you folks 
for coming.
    As a person that is really not a sophisticated--has a 
sophisticated understanding of all this, it seems to me, just 
as a person standing on the outside, every time I go toCNN and 
I see the New York Stock Exchange and people running around 
down on the floor, human beings running around, making orders, 
it occurs to me, gee whiz, this could be done by computers. It 
seems something simple, but as we move forward in technology it 
seems like you could handle many more sales of stock and bonds 
by computer rather than having people run around on the floor.
    The second thing that occurs to me after 9/11 is that, why 
does it have to be in Wall Street in New York?
    And, third, why does it have to be a certain hour? Because 
if you go to an electronic communication network, you could 
actually get it at midnight. If you go on and log in and you 
find somebody selling IBM, you could buy the stock yourself. 
And so that you would have this type of fluid market where you 
wouldn't need to have a location and 9/11, which is very 
susceptible to terrorists. Second, it could have any hours. And 
then, third, it seems like it would be more efficient.
    So that is sort of the impetus that all of us think to have 
these hearings, is to understand how can ECN start to play a 
more prominent role, not just for the institutional investors, 
but also for the everyday investor who wants to buy.
    Probably a fourth reason for the ECN being advantageous is 
if you want to sell a large block of shares today. If you sell 
them in which you have a lot of interface with a lot of people, 
a lot of other people are going to tell a lot of other people 
and pretty soon that is going to affect the market. So it is 
like the old Heisenberg uncertainty principle: You never know 
exactly where something is because as soon as you go to touch 
and look at that particular subatomic particle, you changed its 
location. So if T. Rowe Price and Merrill Lynch goes in, wants 
to sell a million shares of IBM and pretty soon all the people 
who are on the floor of the Stock Exchange know it, that is 
going to impact it in some way.
    So the Heisenberg uncertainty principle, which was 
enormously famous, it almost applies to this in that you cannot 
sell large blocks unless you go out and get 10 brokers to sell 
the stock for you and let them do it under a code name or under 
a false name so that you don't disrupt the market.
    So there seems to be a lot of advantage to ECNs, and I 
think our purpose today is to understand what is preventing 
ECNs from becoming more competitive and at the same time not 
disrupt the market or not try to put any particular self-
interest at risk, but just try to let, as you pointed out, 
democracy work; that is, democratize this Stock Exchange so 
that we have innovation, speed, higher productivity and 
efficiency, and at the same time protect investors so that we 
don't have some exclusive processor having all the information, 
making all the money, and having perhaps a self-interest at the 
same time they are pushing stocks.
    So toward that end, let me just start out and move to this 
Intermarket Trading System, which all of you seem to think is 
the problem. I mean, that is what I suspect.
    So, Mr. Foley, if you can, just try to give us in a very 
short amount of time or quickly tell me what the Intermarket 
Trading System is. It looks to us it is a little bit like the 
Senate where you need a unanimous consent from everybody to get 
anything done, whereas in the House it is not quite like that. 
So everybody says, well, why do you want to be a Senator? Well, 
everybody wants to be a Senator because one person can hold up 
the train, and whereas a U.S. Congressman for the House, it is 
much more difficult.
    But this Intermarket Trading System, give us a little bit 
of a layman's term what this is and how it prevents this 
democratization of the market.
    Mr. Foley. Well, let us first describe--excuse me. Let us 
first describe the era in which the ITS came to be. I mean, I 
am still listening to the Rolling Stones, and I think we all 
are as we were in 1975. But at that time I listened on an eight 
track, and in the middle of a song there would be a 10-second 
pause with a loud click before the song would continue. And 
that is the era in which the ITS was originally conceived. We 
don't think it is designed to work. And, as you referred to the 
governance structure, that is not designed to help anybody who 
wants to make it work. It is a method whereby an exchange that 
has an order that wants to be executed and doesn't have the 
best price on the other side of that order can send a 
commitment to trade to another exchange that does have the best 
price.
    All right. The structure of ITS is at the heart of the 
debate between Island and the American Stock Exchange. Island 
under ITS rules would have to slow itself down to the pace of 
the ITS system and wait 30 seconds and so forth to find out if 
they have a trade with another exchange before they are allowed 
to effect an exchange--rather, a trade in their system. That is 
rather like telling a consumer using eBay that before you can 
buy these baseball cards we have got to go send all the 
information about the pending transaction to Sotheby's and wait 
until Sotheby's convenes an auction and make sure that 
Sotheby's doesn't have a better price, whereas the guy on eBay 
just wants to buy his baseball cards.
    So at the heart of this debate is that the current system 
really would eviscerate the benefits to consumers, which is, 
after all, why they are going to ECNs like Island to trade 
things in the first place.
    We have chosen to wait for the SEC to resolve some of the 
market structure issues that make us reluctant ourselves to 
participate in ITS. Island made a different choice. But to say 
that they are not abiding by investor protection rules, I would 
say they are probably not abiding by exchange protection rules, 
and that is a serious matter of concern. We think that the 
solution is for the SEC to move forward quickly on rules for 
how folks can be able to display their orders and listed shares 
in the alternative display facility, which will put it on 
every, you know, Reuters and Bloomberg machine and TV screen 
across the globe. That is the disinfectant, transparency.
    In the meantime, we think it is important that this 
committee take a serious look at the consumer protection issues 
that are, we think, at the heart of the issue.
    Mr. Stearns. Mr. Ryan, would you like to comment on that?
    Mr. Ryan. Sure. I agree with Kevin's assessment that the 
ITS system needs a lot of work. I think----
    Mr. Stearns. It was started in 1975.
    Mr. Ryan. Yes.
    Mr. Stearns. Okay.
    Mr. Ryan. It is an outgrowth--I mentioned that in my 
testimony--an outgrowth of the National Market System. It is 
the critical part of the National Market System for trading 
listed securities.
    Mr. Stearns. So would you agree that something that was 
established in 1975 probably needs updating or at least some 
change or not?
    Mr. Ryan. Unequivocally. I think that is true. I think that 
the--and you addressed this earlier--that the issue of market 
data and the notion of how that is distributed among the market 
participants needs a lot of work and within the next 2 or 3 
weeks the American Stock Exchange is going to be meeting with 
the other markets to talk about and put a proposal on the table 
to give credit for market data along the lines of markets who 
provide liquidity and better price discovery.
    So we look forward to the SEC's hearings and look forward 
to working on all of these issues, and I think no doubt the 
time has come to take a real hard look at this.
    I do want to make one note, though, that in terms of kind 
of the distinction--a distinction between exchanges and ECNs 
and a point that you were making about the role of an exchange, 
exchanges have specialists who have a deferment of obligation 
to the market to maintain a fair and orderly market to risk 
their capital. ECN marketplaces don't do that. They don't 
provide any liquidity if their subscribers don't show up. So, 
for--and ECNs never trade in any significant volume when--
unless the primary market is open with the specialists 
providing that liquidity. And the ECNs do come in and their 
members do come in and access that liquidity.
    That is not to say that I don't think that there may be 
room for ECNs in the marketplace, but I think that this 
committee and the SEC and the marketplace should be very 
concerned about what incentives there are to go risk capital 
and provide a continuous two-sided market and do that in a fair 
and--have the affirmative obligation of maintaining a fair and 
orderly market which exchange markets do require. I think that 
is critical and it is--unless you pull that away and let the 
markets kind of go without having the specialists there you 
will never really know the answer to that question.
    But I think when you see events like 1987, you see 
September 11th, and you see how our markets respond, and 
obviously in the days after both of those events there was a 
lot of chaos and you had specialists there who have committed 
millions and millions of capital maintaining fair and orderly 
markets, that is critical in that process.
    I also want to address the issue you raised about the 
electronic environment. The exchange markets--speaking for the 
American Stock Exchange, we are incredibly innovative in terms 
of our electronics, and we are always rolling out new trading 
systems, new mechanisms for routing orders to our floor, and we 
are in the process as well of developing a whole new trading 
environment. It will be a floor-based system, but it will also 
be capable of going off floor, if that is where the markets 
take us. We believe that the markets should drive where and how 
trading occurs, but we do think that the price discovery 
mechanism of in-person trading in today's environment provides 
a lot of value. Floor brokers going in--and they can go in and 
represent a customer order and they can have 100,000 shares and 
only show 1,000 shares or 10,000 shares and work that order for 
their customer. So that they are not by showing up and moving 
that price. And there is a variety of mechanisms for doing 
that.
    So I think there are significant value added having 
exchange markets and the specialist and the deferment of 
obligations that they provide to the marketplace.
    Mr. O'Hara. Chairman Stearns.
    Mr. Stearns. Yeah.
    Mr. O'Hara. If I may be heard on this, becauseArchipelago, 
like the Amex, is actually part of--through the PCX we actually 
operate or are a participant on these National Markets Plans. 
And I think it is worth noting that what ITS stood for as a 
principle is a good principle, and that was the concept of 
linkage. Now, we can argue about the technology and some of the 
rules surrounding that linkage, but the concept of linkage to 
getting best price or best execution for customers is a good 
idea and worth fighting for. And today, through this plan, the 
ITS committee and the SEC, we are working very quickly toward--
or apparently we are working very quickly toward amending the 
plan so that automated markets can interact in a way that don't 
hurt their business models with these traditional marketplaces.
    I hear this argument about Island not wanting to 
participate because it slows them down. Well, there is two ways 
of operating in this world: There is one that if there is a 
stop sign outside your house, you want the stop sign shouldn't 
be there? You don't just keep running through the stop sign. 
You go down to the mayor's office and you complain and you show 
statistics why it shouldn't exist. Well, Island just keeps 
running through the stop sign.
    What we did, Archipelago--we operate much like Island, we 
are an automated market. What we did within the System, we went 
down to ITS, we went down to ITS, we went down to the SEC, we 
have come up to the Hill, we have our data supporting us, and 
we have made what I believe are very solid arguments which have 
resulted in an ITS proposal for a major overhaul, the plan 
which I spoke about today. And a consortium of people on the 
committee----
    Mr. Stearns. Mr. O'Hara, would you want to make that part 
of the record?
    Mr. O'Hara. Yes, I would. It is ITS Proposal, ITS Operating 
Committee of October 10, 2002.
    Mr. Stearns. By unanimous consent, so ordered. If you don't 
mind giving a copy to our staff, then we will make it part of 
the record.
    [The information referred to follows:]




    [GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
    
    
    Mr. O'Hara. Great. And this was presented to the SEC. That 
was vetted last week. The ITS committee is talking about it 
today, and we believe in very short order this plan or a 
derivative of it will come in and will be approved and will 
make major changes with the ITS plan. It is worth noting that 
the two main obstacles to the plan are the New York Stock 
Exchange and my friend down at the end of the table, Mr. Mike 
Ryan. And if Mr. Ryan says he wants to support the ITS proposal 
today, I would be willing to hand it down and he can sign up on 
the dotted line.
    But in truth, again, we are working very quickly in the 
system to get it changed so that automated markets can interact 
with traditional markets. And I just want to underscore, the 
idea of linkage isn't a bad idea. It is good for consumers. 
Best price is good for consumers and investors and your 
constituents.
    Mr. Stearns. My time has expired. I just remember from the 
last hearing when we were talking about ECNs, we asked them 
that, during 9/11 they had trading--trading on Enron had 
stopped. The New York Stock Exchange specialist stopped trading 
blocks of it, and there were imbalances, and the ECNs picked 
that up and that was a success story. So I remember that from 
the last hearing.
    Mr. O'Hara. Right. That was the--this was last November 
when the specialists on the New York Stock Exchange shut down 
his post because that one person, the anointed person who 
controlled all the orders decided that he or she was 
overwhelmed and they couldn't get a guaranteed profit. So while 
he or she shut down their post, and in order to sort of balance 
things out so they would get their guaranteed profit, 
alternative trading systems, ECNs were in there executing 
trades for institutions, broker-dealers, and small investors.
    Mr. Stearns. Okay.
    Mr. Towns.
    Mr. Towns. Thank you very much, Mr. Chairman. Let me begin 
by first answering the question that you raised, Mr. Chairman. 
Mr. Chairman, let me begin by answering the question that you 
raised. You said why this has to be done in New York, Mr. 
Chairman. New York is the appropriate place for it to be done. 
I know that is not the nature of this hearing, but I will 
explain that to you later.
    Mr. Stearns. I think we touched a hot button.
    Mr. Towns. Let me begin by asking you, Mr. O'Brien. You 
testified that Brut has delayed its usage of the alternative 
display facility because of technological and economic barriers 
to its usage, and you urge the SEC and the Congress to insist 
on improved connectivity solutions and more realistic 
economics.
    Could you explain what these technological and economic 
barriers are and even the solutions you might propose?
    Mr. O'Brien. Sure. I would be happy to. And it was 
interesting to note that the NASD announced that the 
alternative display facility was quote, unquote, live on July 
29, when it didn't take on its first actual user until just 
this week, which highlights some of the difficulties of 
connectivity to these systems.
    When the NEC undertook the commitment to build the ADF, 
they went out and hired a Swedish technology vendor, OM Group, 
to help them build it. The technology platform that OM used was 
something basically unknown to U.S. financial market 
participants, which basically meant that to build connectivity 
to the ADF you need to build an interface, which would require 
significant investment of technology resources at a time when 
there are just not that many to spare. And when you are talking 
about wanting to have a viable competitive alternative, 
barriers to users of that alternative need to be really low.
    We have been a strong advocate for ADF interfaces to 
accommodate the financial information exchange protocol, also 
known as FIX, which is basically a standard messaging language 
by which security market participant systems talk with one 
another.
    When we were required by the SEC to certify as to whether 
or not we could use the ADF as our primary means for quoting 
NASDAQ securities on or before October 11th--which they 
required us to do at the end of the month--we talked with the 
folks at the NASD and asked when they might have fixed 
connectivity, which they had alluded to for quite some time. 
They gave us the good news that they had undertaken to hire a 
vendor to provide that connectivity, but that testing for 
quotation capability wouldn't be available until sometime in 
December. So that made how we answered that certification 
request very easy.
    But it is the example--I mean, I guess ITS provides a good 
example, that you can't create a static system at a single 
point in time and assume that that is going to be viable, and 
given that the pace of change in this industry really is week 
to week.
    On the economic front, they had originally come forth with 
a fee schedule that mimicked that of NASDAQ despite the fact 
that the systems they are offering are far less complex and 
their justification for that was, well, we needed to recoup our 
costs to build the system. I had a little hard time accepting 
that answer when you realize that they oversaw the creation of 
NASDAQ, they spun off NASDAQ, and received over $400 million in 
return, and that spin-off really necessitated the need to build 
the ADF. So the justification of cost recovery for a 
noncompetitive fee structure was a little hard to swallow.
    They have since modified that fee structure, offering 
volume discounts and the like, but only on a pilot basis, and 
it will be interesting to see when they set a permanent fee 
structure going forward that it will be a realistic alternative 
to SuperMontage usage, and I would implore the subcommittee to 
focus on that and be a strong advocate on that.
    Mr. Foley. Congressman Towns, could I address a portion of 
that question?
    Mr. Towns. Sure.
    Mr. Foley. The exchanges in NASDAQ have a monopoly on the 
gathering and dissemination of market data. All right? And 
through that monopoly we believe they seek to perfect a 
monopoly in the execution of trades as well. And we believe and 
the SEC agreed that the alternative display facility would give 
market participants a competitive alternative and would allow 
the free market competition really to be the regulator on a 
number of market structure issues. The SEC said the ADF had to 
be ready before SuperMontage was allowed to go forward. Now, 
the ADF from the NASD--the NASD and NASDAQ have interlocking 
directorates. They have members on each other's boards and so 
forth. And NASDAQ----
    Mr. O'Brien. Common spelling.
    Mr. Foley. Right. And NASDAQ is a for-profit entity. The 
people that run NASDAQ have stock options to profit from the 
performance of NASDAQ, and NASDAQ's own prospectus indicates 
that the success of the ADF would be a bad thing for NASDAQ's 
shareholders. And we think that may have something to do with 
why the ADF was approved as viable when the very market 
participants who argued for its creation indicated from--by our 
nonparticipation at this point it just isn't viable. The 
alternative display facility just doesn't display in the ways 
that we would need it to do for us to bet our business on it.
    So we are currently in the position of--for our NASDAQ 
stocks of being stuck with the SuperMontage. We believe that is 
implicitly in the market structure plan for the ADF, but it 
just isn't there right now.
    Mr. Towns. Any other comments on that before I move on? 
Okay.
    Mr. Chairman, I am going to take mine right now, because I 
want to ask them all the same question.
    Mr. Stearns. Sure. Go ahead.
    Mr. Towns. Okay.
    Several of you mentioned the phenomenon of Island going 
dark and ceasing to display private market in five popular 
exchange trading funds while Instanet shut down its private 
market altogether in certain popular listed securities during 
regular trading hours. Mr. Ryan characterized this activity as 
a serious violation of the Federal Securities laws. My question 
is, what has the SEC done about this? And let me just go right 
down the line. I would like for all of you to respond to that, 
starting with you, Mr. Foley.
    Mr. Foley. Okay. Well, first let me say that I don't view 
this as a long-term market structure problem, because Island, 
for example, their market shares collapsed since they have 
denied their own participants the ability to see their 
liquidity. So transparency is good for business. Right? So I 
think maybe there is a fait accompli over how things have 
played out and how the SEC has moved kind of slowly.
    Securities law violations, I leave that to the Securities 
law cops for them to indicate.
    Mr. Towns. Has anything been done?
    Mr. Foley. Well, using the word ``done,'' we wouldn't be 
informed about enforcement action against somebody else. But I 
don't believe--I am not expert on it, but I don't believe that 
the decision to go dark is a securities law violation. I do 
recall at the beginning of this year Chairman Pitt asked the 
NASD and Barry Shapiro not to take action against Island for 
the activity they had going on in the queues, and we thought 
presumably because they thought that was good for investors and 
they were going to work out the market structure issues. All 
right?
    I am not comfortable that the ITS Committee, in spite of 
having a great plan, needs unanimous vote to get anything done. 
After 27 years, I am not confident that they are going to 
resolve these issues. All right? I am confident that they 
wouldn't be meeting to talk about this if the envelope hadn't 
been pushed a little bit. And I think, you know, we have to 
understand the underlying conflicts and maybe be a little bit 
sympathetic to the behavior of all participants while we are 
still awaiting these issues to be fully resolved.
    Mr. Towns. Mr. O'Hara.
    Mr. O'Hara. Yes. Thank you, Congressman Towns.
    First off, on the ITS issue, note that not only is the 
committee involved, but the SEC is involved. And in fact, one 
of the Commissioners at our meeting last week said: You guys 
get it done; that is, reform it, or we will do for you.
    So literally, I mean, the tone we are getting from the SEC 
is it had better be done--and reading between the lines--and it 
better be done before the end of the year.
    Putting that aside, the reason--and again, I will venture 
some guesses. I am lawyer. I know a little bit about this, but 
again I will defer as well to the SEC and the regulators. The 
reason that Island and Instanet--well, with Island, has gone 
dark, or suffering a brownout, if you will, and Island--or 
Instanet has completely shut down its market is because they 
were forced to comply with the law.
    Let us just take a step back. When the NASDAQ collusion 
investigation settlement broke, one of the consequences or one 
of the observations was there was a world of two markets in OTC 
or NASDAQ stocks. There was the public market that you and I 
would see, retail investors would see, and then there was the 
private, clubby market that no one saw except the people in the 
room. And that was on the one hand NASDAQ and on the other hand 
was Instanet. Instanet then was a private market that most of 
the world didn't have access to. What the SEC did in 
implementing the order handling rules and other types of rules 
associated with that was to force Instanet to show its market 
to retail customers and the rest of the world, if you will, to 
get a quote out in the public. And what has gone on with these 
ETF, these exchange-traded fund products primarily, is that 
Island and Instanet decided--and apparently against, if you 
look at the text of Reg ATS--that they refused to reflect their 
quotes to the world again.
    Again, we went back--sort of went back to the future, if 
you will. That is, they went back to sort of 1990's, pre-1997, 
refused to show the world their quotes, and only let their club 
members see the quotes. And my understanding is that the SEC 
stepped forward and said, either get yourselves into the 
quote--okay?--show yourself, let ordinary retail investors have 
access and see your quote, or shut it down. It is illegal.
    And I believe--if I may be heard. I believe, instead of 
integrating technology and showing their quote, they decided to 
take these actions, and that is to go dark, if you will.
    Mr. Foley. Wasn't it true that Island--I mean, they are not 
here and we don't have a horse in this race, you know, 
Bloomberg, really. But wasn't the case that Island published 
all this information on the Internet?
    Mr. Ryan. Yes. But it was not consolidated. So you, as a 
public investor, you needed to go to two different places. And 
the National Market System requires at this stage consolidation 
of information.
    Mr. O'Hara. Plus, I mean, Kevin, how many traders do you 
know that actually trade from a sophisticated standpoint 
staring at the Internet?
    Mr. Ryan. Quite frankly----
    Mr. Foley. A lot of people.
    Mr. Ryan. Kevin, your own business model is undermining the 
market, the data that Bloomberg sells, because it is not 
selling--it doesn't have all the information that should be 
available to it.
    Mr. Towns. I didn't mean to start a fight.
    Mr. Foley. We are in favor of transparency, and you are 
right----
    Mr. Ryan. But Bloomberg as a disseminator of market data to 
customers is not getting all of the data because you are not 
taking the fee from----
    Mr. Towns. Mr. O'Brien.
    Mr. O'Brien. But I think it underscores a need in listed 
market structure reform to separate information display issues 
from execution issues. If you compare NASDAQ and the NASDAQ 
market, NASDAQ and now slowly but surely the ADF offer means 
for market makers and ECNs to show their best prices to the 
public without participating in execution system rules that 
undermine their business models. Actually, NASDAQ begrudgingly 
at times has been good about modifying the rules of its 
execution system to address ECN needs. For example, ECNs don't 
need to take automatic executions from NASDAQ because that 
subjects ECNs to financial risks as opposed to market makers, 
which are--unfortunately in the listed market, to display your 
best price quotations to the public you need to participate in 
ITS and the execution rules that come with it.
    And with all due respect to my colleague from Archipelago, 
nothing happens quickly with respect to ITS nor ever will with 
its current governance structure. And Brut says this as an ITS 
participant through our participation in the NASDAQ 
intermarket.
    But basically, each ECN is subjected to a Hobsian choice of 
getting its quotes out into the public marketplace in ways that 
may force it to undermine the execution quality of its own 
system, and that separation needs to take place.
    Mr. Towns. Thank you very much.
    Mr. Gasser.
    Mr. Gasser. Yeah. I think as a Reg ATS, that the philosophy 
behind Reg ATS is very simple, and that is publish a quote to 
one and you must publish it to many or to all. And I think 
Island in the ETF controversy, of which we are not a part, 
thankfully, but Island in the ETF controversy is interesting in 
that I think it represents some of the unintended consequences 
of the things we talked about today on the ECN front, and that 
is democratization of the, quote, democratization of access 
participation within that quote. And at the end of the day I 
suspect that the SEC delayed enforcement of the Reg ATS because 
of Island's arguments regarding investor protection for some of 
the folks that were used to operating within their system.
    But that does not, or and should not--and I think it is 
inconsistent with, I think, the views you have heard today from 
major vendors in the ECN space--it should not give them the 
ability to trade through, it should not give them the ability 
to trade through anyone. Anyone that has a legitimate quote and 
posts a better offer should have that ability to trade against 
counterparties entering the National Market System.
    But I think what it has also proven is that at the end of 
the day free market forces will prevail when the rules are 
enforced. And they certainly have in this case in that Island 
has lost significant share in the ETF as a result.
    Mr. Towns. Thank you very much, Mr. Gasser.
    Mr. Ryan.
    Mr. Ryan. Sure. A couple points just to be clear. Although 
I personally believe that Island is operating in violation of 
the Federal securities law right now in the way it is 
operating, I think it is clearly a much closer call than prior 
to when they went blank, where there was no doubt, I don't 
think anybody reasonably could say, they were operating in 
compliance with the law. They are certainly in violation of the 
spirit of Regulation ATS and in violation of the spirit of the 
National Market System by going blank.
    I also am not fully convinced that they have been damaged 
as much as others might be because of their arrangement with 
the Cincinnati Stock Exchange, and in some of the products 
involved where Instanet has not shut down, they may be shifting 
some of that overflow there. There is a lot of moving pieces, 
it is hard to tell.
    I agree with both Kevin Foley and Kevin O'Hara. It is 
difficult for me to kind of speculate as to why the SEC hasn't 
taken more action in this area. I know we have raised these 
issues with them many, many times. They have been struggling 
internally with a lot of conflicting principles that are 
involved. I think they were completely caught off guard that 
Island would take this much market share as quickly as they 
have. There was a lot of transition obviously at the SEC and a 
lot of very significant issues facing the Commission over the 
last year. And in many respects, this is probably a very 
unfortunate accident of timing, but it is, I think, a very, 
very serious accident, and something needs to be done about it 
and something should be done to look at what can avoid these 
types of situations in the past where a law can go 18 months 
like this with no enforcement.
    One thing I think is very important to note, and this goes 
back to Kevin's analogy of a stop sign, you know, maybe that 
stop sign shouldn't be there or maybe it should be a yield 
sign, you know. And there is a lot of complexities to these 
issues and a lot of varying views, but there is a process for 
fixing things. And the SEC is the arbiter of this. And if you 
don't like it, you go and try and change it. And the 
frustrating part for us is we had in fact a little over a year 
ago started having conversations with Island about coming to 
some arrangement with them and having them become part of our 
market to help bring them in compliance with the Reg ATS, and 
it was rejected because that approach would have violated other 
principles that have been kind of near and dear to the 
securities markets long before the 1975 act amendment.
    So what is frustrating from our perspective, and I think to 
a degree I am probably speaking for the rest of the panel here 
at some level, that there are rules and we should be following 
those rules. If they are broken, they need to be fixed, and 
there is a process for doing that. Until they are changed, 
everybody should be abiding by the rules that apply to them. 
There has got to be some sense that we know what is right and 
what is wrong. And it is not a perfect world and things take 
time. And God knows, you know, these are complicated times and 
complicated issues. But there has got to be some degree of 
reliability that the system is going to work and that you know 
that the rules are going to be enforced and abided by. And I 
know that at least some of the panel here have modified their 
trading models so that they are in compliance with these rules, 
and it has been to their disadvantage. We have been handcuffed, 
and things that we wanted to do we have not been able to do. A 
lot of innovative issues that we have tried to bring to the 
forefront, until we get the approval from the Commission, we 
are not doing them, you know. And we think everybody else 
should be held to that standard as best as possible.
    Mr. O'Hara. Congressman Towns, if I could just follow up on 
that. What that gets is the concept of regulatory arbitrage, 
some people who play by the rules and have to pay the expense 
of playing by the rules and others that don't. And that is what 
Michael is alluding to. And, for instance, Island, you know, 
running through the stop sign and getting to where they want to 
get quicker while the rest of us are having to stop.
    And again, our system looks a lot like Island from the 
extent that we are an electronic system and we reach out for 
best price, but we have worked in the system. And, quite 
frankly, we have had to go through what we call the sort of 
fraternity house hazing of getting into these ITS committees. 
We did. We did it successfully. Was it easy? No. Did it cost 
some money and time? Yes. But is it changing--are our 
circumstances changing? They are. And again, we have a 
marketplace here.
    Bill, my good friend Bill O'Brien, says he doesn't think 
there is going to be change at the ITS, a quick change. I think 
there is. And we will come back several months from now and we 
will compare notes, and I think it would be important for this 
committee to follow up on that issue.
    Some of our friends from the SEC are here. They have told 
this ITS Committee last Friday--they said, get it done or we 
will get it done for you. Right from the lips of one of the 
Commissioners.
    So again, I think that we are at a point in time where it 
will change, but that the underlying philosophy of ITS and what 
it was created for, linkage to give customers best prices, your 
constituents to get them best prices, is still a concept, a 
principle worth fighting for.
    Mr. Towns. Thank you very much. Thank all of you for your 
answers. On that note, I yield.
    Mr. Stearns. Thank you.
    I think after just listening to you, I think a lot of us on 
this subcommittee think it probably would be appropriate for 
the subcommittee to start looking at legislation to modernize 
ITS. So that is probably one of the things that we are getting 
out of this hearing, to try and move toward that. I am just 
going to ask two more questions, and then if Mr. Towns wants to 
ask two more then we will complete. So we appreciate your 
patience. Maybe it is a good question for Mr. Foley.
    Are customers still paying too much for market data?
    Mr. Foley. Yes.
    Mr. Stearns. And let me just go down. Mr. O'Hara?
    Mr. O'Hara. Correct.
    Mr. Stearns. Mr. O'Brien.
    Mr. O'Brien. Yes.
    Mr. Stearns. Mr. Gasser.
    Mr. Gasser. Yes.
    Mr. Stearns. Mr. Ryan.
    Mr. Ryan. I think it is a great bargain for customers.
    Mr. Stearns. Okay. You think it is a great bargain. Okay. 
And I ask who collects the money for the market data.
    Mr. Foley. It is, after all, the customers' own information 
that they contribute in the form of their orders that they then 
are required to buy back through information vendors. You know, 
if you look at the debates over payment for order flow from the 
1990's, which we don't really hear so much about, the reason we 
had payment for order flow was because spreads were 
artificially wide, and this committee addressed that issue and 
went right to the heart of the matter. Spreads are not 
artificially wide any more, and so the profit from extracting 
those spreads isn't being funneled back to investors in the 
form of cheaper commissions they get through payment for order 
flow. Now they get better execution of their orders.
    Similarly, plans to share market data fees with the brokers 
who contribute the orders that make up the market data, those 
plans can result in lower commissions and increased benefits 
for the investors that contribute that data or those data in 
the first place. But if the market data fees weren't 
artificially high, you wouldn't have that situation either.
    Mr. Stearns. Just to get on the record, has NASDAQ 
addressed the competitive concerns raised by the ECNs regarding 
the SuperMontage? Anybody can answer that.
    Mr. Foley. Kicking and screaming, right, and not in any, 
you know, willing fashion they have addressed some of the 
issues. But you have to be on your toes. New ones pop up in the 
technology. We are dealing with a pernicious problem right now 
where the SuperMontage technology can take an ECN's order out 
of the quotation system. Now, they use their monopoly as a 
place to go quote securities to try to effect a monopoly as the 
place for executing and trading securities. That monopoly would 
work to the benefit of NASDAQ shareholders, but it is not in 
the benefit of investors who, you know, would otherwise enjoy 
the fruits of competition. Real competition for NASDAQ, 
SuperMontage, just as real competition for the New York Stock 
Exchange through the ADF we think will be a solution. And then 
that is something we think the committee ought to, you know, 
continue to look at.
    Mr. Stearns. Okay. What are the different fee structures in 
place for access to ECN systems? Mr. O'Brien?
    Mr. O'Brien. I am happy to talk to that. As I said in my 
remarks, most if not all ECNs offer a rebate for initiated 
order flow. And what do I mean by that? If the market in Cisco 
Systems is $10.00 to buy and $10.02 to sell, someone wishes to 
put in an order to buy at $10.01 into the system, which means 
it is not marketable against anything else either within the 
system or with Brut, in the public market, that will be 
displayed within Brut system and in the public quote. That is 
an initiated order. When that order gets executed against, the 
person who put that order into the system would receive a cash 
rebate.
    On the flip side, where someone executes against the order 
that has been put on Brut's book, basically withdrawing 
liquidity from the system, they are charged an access fee. This 
is very similar to the pricing model that NASDAQ uses for 
SuperMontage. It is a horse by different color in the sense 
that they call the rebates they hand out to market makers 
liquidity provider rebates and their charge is execution fees. 
But it is that basic same model.
    Mr. Gasser. And that is actually where the NASDAQ and the 
lucid markets are actually radically apart from one another, in 
that that is no cross subsidy, if you will, in the lucid 
marketplace. There is no encouragement to post limit order flow 
while folks like Arch and Island will do that, there--the 
inefficiency of that market--and that inefficiency gets back 
down to this ITS issue. By inefficiency, I mean the inability 
for that quote to always interact with the marketplace and the 
listed. The marketplace has prevented that type of 
encouragement for folks to add liquidity to the market in 
competition with the New York Stock Exchange specialists. So in 
the listed centric marketplace, such as the one that we operate 
in, it is a usage fee only. It is only a charge today.
    Mr. O'Hara. Chairman Stearns, if I may add to that, the 
concept of access fees is a very American concept. That is, if 
you provide a service or a product, one should have to pay for 
it. And I think we all believe in that concept. Whether 
Archipelago reached in and took liquidity from the New York 
Stock Exchange or from Brut or from any other venue for one of 
our customers, we should have to pay for that. And that should 
apply across the board, quite frankly, that whether it is a 
market reaching into a market maker on an ECN or any other 
venue that has a service or product to provide, they should pay 
a market rate for it.
    One problem, however, that has cropped up with these access 
fees is that some venues are using their market power to charge 
competitors with sometimes three, four, five times what they 
would charge a normal ordinary customer for a hit and take. So, 
for instance, we have a best execution obligation, and we 
believe in it because Congress told us to believe in it, and we 
believe in it just as a business philosophy. So when we reach 
out to our customer--previously when we reached out to our 
customer, to Islander or Instanet, Island would charge us five 
times what they would charge a normal customer to access 
liquidity. Again, we are reaching out because Congress told us 
to get best execution, we want to get best execution for our 
customer, and they would charge us five times that rate. 
Instanet, not as bad, but a multiple of two or three times what 
they would charge their customer.
    Now, as of recently, they have changed their ways, and we 
will see if they stand on that position going forward, although 
I do note that Island has arbitrated against us. We received a 
filing saying that they want to recoup all these gouge fees 
that we have refused to pay recently, and some of my ECN 
friends as well have had to endure that. Again, we are reaching 
out for best price for our customers, and some of these other 
venues out there are saying, well, if you want to do that, 
guess what, I know it is a Federal regulation, I know it is a 
Federal concept, but we are going to charge you five times what 
we charge our customers for that.
    That is unfair and it is something that this committee--
this subcommittee should mark, because in the future we may be 
coming back and discussing this issue depending how Island and 
Instanet act going forward.
    Mr. Foley. Mr. Chairman, there is an easy way to clear up 
this issue, we think. We believe access fees should be 
abolished. As former SEC Chairman Levitt said a couple years 
ago, there is no room for these access fees in what is in the 
listed markets, for example, and otherwise fee-less world. They 
don't exist in contravention to the order handling rules 
because they were created by the order handling rules, and, you 
know, as a market compromise at the time. We charge ECN access 
fees. We are not going to unilaterally disarm when our 
competitors have that source of funding for their business 
models. But we deplore the fact that NASDAQ has now--NASDAQ, 
who has been given the power by the SEC all along to abolish 
these fees, NASDAQ has instead determined to adopt the model of 
access fees in their government-sponsored monopoly position as 
a for-profit entity, managed by people whose, you know, 
personal fortunes ride on the success of the NASDAQ securities. 
They have decided that access fees are going to be a permanent 
part of the landscape for NASDAQ securities, and we are very 
sorry to see that happen.
    Mr. O'Brien. Now, I am going to disagree quite a bit, 
because access fees, you know, it is what it is. It is just a 
business model. It is not per se wrong. ECNs is a pure agency 
broker. They do not make money on proprietary trading activity 
unless they have to charge a per transaction fee for users of 
their system. There is nothing wrong with that. I think 
sometimes the outcry over ECN access fees is a thinly veiled 
attempt to eliminate paying ECNs altogether for the valuable 
services of transparency and connectivity and order management 
that they provide to the marketplace.
    So I think the subcommittee should be focused more upon 
ways to keep the access fee market competitive. There is one 
example that I believe that NASDAQ is considering right now. 
How SuperMontage works is that within any certain price point--
meaning, by that, I mean $20 or $19.99--they allow people 
entering orders into SuperMontage to trade against firms that 
do not charge an access fee, market makers, before trading with 
firms that do, ECNs, offering price protection within any one--
within one-cent increment, but reducing, if not eliminating, 
ECN access fees.
    I think they are looking at improving the technology even 
further, because right now when looking at someone as to 
whether or not they charge an access fee, it is kind of a Y or 
N logic. But they are exploring making that logic scaler, and 
by that meaning treating ECNs that charge lower access fees 
better than those that have taken that rate structure to an 
unreasonable extreme.
    Things like that which promote competition within a 
business model as opposed to, you know, draconian measures to 
force industries to change business models altogether are what 
the subcommittee should be looking at to reduce cost and 
improve efficiency in this area.
    Mr. Stearns. Gentlemen, I thank you. What we are going to 
do is wrap up here. We appreciate all of you staying and 
participating. What we would like all of you to do, we have 
some follow-up questions we will submit in writing to you, and 
we would like you to respond. And also, we will leave the 
record open so that members can offer their opening statements 
who are not here.
    The jurisdiction of this committee today includes consumer 
protection, obviously, but also dealing with commerce, and this 
electronic ECNs are applicable. So we feel a certain amount of 
fiduciary responsibility for our constituents to bring up 
consumer protection as well as commerce. So I think we have 
done that this morning. And so I want to thank you for your 
participation, and I look forward to continuing this in the 
future. And I thank the distinguished members for being here 
today.
    With that, the subcommittee is adjourned.
    [Whereupon, at 12:26 p.m., the subcommittee was adjourned.]
    [Additional material submitted for the record follows:]
   Responses for the Record of Kevin Foley, Chief Executive Officer, 
                        Bloomberg Tradebook LLC
    Question 1. What are the potential costs and benefits to investors 
of a market in which market information is available through 
competitive forces rather than an exclusive processor?
    Response. The potential benefits to investors of a market in which 
market information is available through competitive forces are truly 
substantial. A quick look at how we have arrived at the current 
situation is instructive.
    Historically, under the cover of a non-transparent bureaucracy, 
non-profit self-regulatory organizations (SROs) have exploited their 
government-sponsored monopoly over market data fees to subsidize their 
other costs--for example, costs of market operation, market regulation, 
market surveillance, and member regulation. While at present most SROs 
are non-profit organizations, NASD has largely completed its 
privatization of Nasdaq and it may well be that other privatizations 
will follow. For all SROs, the incentive will be strong to continue to 
exploit this government-sponsored monopoly over market data by charging 
excessive rates from a captive rate base (i.e., investors) and by using 
the resulting monopoly rents to subsidize their competitive businesses. 
Indeed, shareholders of for-profit exchanges will demand that market 
data charges remain at whatever level will maximize shareholder profit, 
which likely will result in excessive charges.
    The public creates the data. While the public should bear the cost 
of consolidating the data--plus a reasonable rate of return for the 
consolidator--the public should not subsidize other exchange activities 
and thereby give them unfair advantages over their non-subsidized 
competitors.
    In enacting the Securities Acts Amendments of 1975 (the ``1975 
Amendments''), the Congress presciently warned against possible abuses 
of market power by market centers such as the New York Stock Exchange 
(NYSE) and Nasdaq that control or operate an exclusive securities 
information processor:
        The Committee believes that if economics and sound regulation 
        dictate the establishment of an exclusive processor for the 
        composite tape or any other element of the national market 
        system, provision must be made to insure that this central 
        processor is not under the control or domination of any 
        particular market center. Any exclusive processor is, in 
        effect, a public utility, and thus it must function in a manner 
        which is absolutely neutral with respect to all market centers, 
        all market makers, and all private firms . . .
Securities Acts Amendments of 1975, Report of the Senate Committee on 
Banking, Housing and Urban Affairs to Accompany S.249, S. Rep. No. 94-
75, 94th Cong., 1st Sess.11-12 (1975).
    We think the 1975 Amendments got it right. If consolidation of 
market data is truly a public utility function, it is imperative that 
it be regulated as such--with some measure of cost controls--and that 
the exclusive processor be independent of any exchange that intends to 
compete in the downstream market for financial information.
    In short, the public can have the benefits of competition even with 
an exclusive processor--as long as that monopoly public utility 
function is separated from competitive functions.
    Otherwise, the public is disadvantaged twice. First, the public is 
disadvantaged when they pay excessive rates to see the data the public 
itself creates. Second, the public is disadvantaged when those monopoly 
rents are used by SROs to unfairly subsidize entrance into currently 
competitive businesses because that anticompetitive behavior will 
undoubtedly have an adverse effect on competition in those businesses 
and will restrict output, reduce innovation and keep the prices in 
those businesses artificially high.
    Question 2. What are market data rebates and how do they work?
    Question 3. Are market data rebates good for investors? Why or why 
not?
    Response 2 and 3. Nasdaq and the NYSE have exploited their 
government-sponsored monopoly over market data to charge the public 
sums far more than the actual value of their consolidation function. 
Some of this excess market data revenue can be paid by exchanges to 
brokers that give them order flow.
    Imagine if a city government provided a hypothetical company ``call 
it Acme Transportation--with a monopoly to manage the city subway and 
permitted Acme to charge fares that far exceeded the all-in costs of 
operation plus a reasonable rate of return on Acme's invested capital. 
If Acme periodically defused public criticism by rebating some fraction 
of their overcharges, would subway riders be well served?
    In the short run, the rebates are positive--rebates are the only 
way our hypothetical subway riders receive some share of what they are 
overcharged. In the long run, however, the public would be better 
served if government ensured the public that they were not being 
overcharged for services provided by a government-sponsored monopoly. 
In a case where government in fact grants monopoly mandates' to either 
private or quasi-private entities--it should maintain close scrutiny on 
the rents the monopolist can charge, precisely to prevent overcharges. 
In the case of the SROs, our markets would be far more efficient and 
fair if charges for the fruits of the government-sponsored monopoly 
over market data bore a closer relationship to actual cost, plus a 
reasonable return on capital necessary to sustain the service.
    Rebates were recently halted in the Nasdaq market because of 
concerns over the potential for market manipulation--activity that is 
already illegal and is easy to spot and to punish. We believe rebates 
should be reinstated until such time as the revenues generated by 
government-sponsored monopolies bear a closer relationship to costs. At 
present, these rebates are the only method for redistributing excess 
market data fees to the people who both create the data and then have 
to pay too much for it--the investors.
    Question 4. Will market data rebates solve market data issues or is 
a regulatory solution required?
    Response 4. I believe market data rebates should be reinstated. 
Until real reform occurs, these rebates are important as a means of 
allowing the public to receive some percentage of the overcharges they 
are paying.
    The rebates, however, are not the real reform. Far from being a 
solution, market data rebates are, in part, symptomatic of an 
underlying problem. In effect, the exchanges can afford to provide 
market data rebates because they use governmental power to require 
their members to give them for free the raw material for generating 
market data, and the exchanges then extract monopoly rents by charging 
fees for market data that bear no reasonable relation to the actual 
costs of producing, consolidating and making it available. Regulatory 
action--coupled with the ongoing engagement of elected officials--will 
be essential to address these issues.
    Question 5. Are market data rebates creating problems with wash 
trades--are buy and sell quotes being entered simultaneously by the 
same party to generate trade revenue from market data rebates? If so, 
how do we solve this problem?
    Response 5. Not being in the enforcement business, I cannot offer 
much insight into whether wash trades are currently a problem. I'd note 
that market manipulation is already illegal and easy to spot and 
punish.
    Question 6. Is current ECN access to ITS adequate? Why or why not?
    Response 6. The ITS is an exchange-dominated consortium whose 
outmoded technology and antiquated governance structure serve as a 
significant barrier to ECNs who would seek to compete in the NYSE-
listed market. Current ECN access to ITS is thoroughly inadequate.
    Along with ITS reform, urging the SEC to take the steps necessary 
to facilitate the promised display of NYSE-listed stocks in the 
Alternative Display Facility (ADF) may be the best way to bring the 
benefits of competition to the listed market. The SEC should approve 
the ADF rules proposed by the NASD regarding NYSE-listed stocks.
    Question 7. Are the access rules for ITS responsible for ECNs' 
lower trading volume in listed securities than in NASDAQ securities? 
Why or why not?
    Response 7. Certainly the access rules for the ITS contribute to 
the lower trading volume in listed securities. ECNs' share of the 
listed market is lower because ECNs are not allowed to quote in the 
listed market independently of the exchanges, which brings ECNs under 
the umbrella of the ITS. ECNs should be able to quote in the listed 
market without having to participate in the ITS.
    There are, of course, additional impediments to ECN participation 
in the listed market. In the mid-1990s, the SEC issued the Order 
Handling Rules. The resultant transparency and the subsequent 
integration of ECNs into the national quotation montage narrowed Nasdaq 
spreads by nearly 30% in the first year. Reform of comparable scope has 
not occurred at the NYSE.
    For years, the NYSE has erected barriers to competition. Its 
infamous Rule 390, which prohibited NYSE members from dealing in listed 
securities off an exchange, is a case in point. Even if the ITS were 
reformed tomorrow, we would anticipate renewed efforts to establish 
other roadblocks to competition. That's why it is critical that there 
be significant ongoing scrutiny provided by regulators and legislators 
on market structure issues and also why it's critical that the SEC 
approve the NASD's proposed rules as soon as possible regarding the 
promised display of NYSE-listed stocks in the Alternative Display 
Facility.
    Question 8. Do access rules for ITS presume best execution at the 
NBBO? Are there any other factors that should be considered for best 
execution?
    Response 8. ITS justifies their rules by talking about best 
execution, but investors taking matters into their own hands have 
chosen ECNs for best execution when given the choice. There are indeed 
numerous other factors that should be considered for best execution, 
particularly in a decimalized environment, including speed, size, and 
quality of execution and the role of the trade-through rule.
    Question 9. Please describe the governance structure of ITS. Does 
the governance structure of ITS inhibit innovation? If so, please 
explain.
    Response 9. We are not members of the ITS, but it is our 
understanding that unanimity is required to effectuate major changes. 
That is clearly a major impediment to change, and a major impediment to 
bringing competition to the NYSE-listed market.
    Question 10. What is the difference between the old NASDAQ as an 
infrastructure for quotations and the new Nasdaq with the SuperMontage 
as an order execution facility?
    Response 10. Through a series of developments starting with the 
inauguration of the Small Order Execution System (``SOES'') in the 
1980s and progressing through the development of SuperSOES and, more 
recently, SuperMontage, Nasdaq has evolved from a decentralized, 
quotation-and-telephone system into a screen-based, electronic 
communications network embodying a central limit order book.
    In theory, NASD members can bypass SuperSOES through private wire 
connections between a market maker and a customer or dealer. In 
reality, however, that means of avoiding SuperSOES is not on an equal 
competitive footing with the use of SuperSOES. Orders transmitted 
through SuperSOES impose obligations on the market maker to execute 
against its published quotation.
    Only Nasdaq has the monopolistic power to deliver mandatory 
executions to market makers against their quotations. Individual market 
participants do not have the market power to replicate that obligation 
through private contractual arrangements or other private ordering.
    SuperMontage represents the next step in this process of 
potentially harmful centralization. It is particularly disconcerting as 
it effectively expands Nasdaq's government-sponsored monopoly powers at 
exactly the moment when the changed incentives of privatization would 
argue for curtailing Nasdaq's government-sponsored monopoly powers.
    Question 11. What potential benefits or risks does the SuperMontage 
bring to the marketplace?
    Response 11. SuperMontage centralizes display and order execution 
in one soon-to-be for-profit entity, unfairly disadvantaging all other 
competitors. Nasdaq has argued that the benefits of SuperMontage 
include upgrading Nasdaq's technology and promoting the display of 
greater depth of book. While all Nasdaq members applaud Nasdaq's 
upgrading its technology, this upgrade could have been done without 
centralizing display and order execution in a Nasdaq controlled entity. 
All of Nasdaq's competitors upgrade technology constantly without the 
carrot of an enormous government gift, the grant of Nasdaq's power to 
use regulatory compulsion to enforce its restrictions on competition 
and to advance its commercial objectives.
    Likewise Nasdaq could have opted to display greater depth of book 
without requiring the centralization of display and order execution. 
Indeed, as Nasdaq fought hard to make sure that the Alternative Display 
Facility didn't actually display quotes, it became clear that Nasdaq is 
interested in displaying its own quotations, but not in allowing the 
market-wide transparency that would foster competition. The SEC wisely 
rejected Nasdaq's position and instead issued vendor display rule 
guidance that goes a long way toward ensuring that Alternative Display 
Facility quotations can be seen.
    The potential risks of SuperMontage are clear. A for-profit Nasdaq 
will have a powerful incentive to leverage its existing government-
sponsored market data monopoly and its newly granted trade execution 
monopoly to deter competitors and discourage innovation. Nasdaq will 
have incentives to ``keep pace'' with market innovators not by moving 
forward themselves, but by slowing down all market participants and 
centralizing order flow. Everyone loses if exchanges--comfortably 
situated as government-sponsored monopolies--fail to innovate, leaving 
American markets vulnerable to offshore competition.
    The potential remedies are also clear. For good reason, the SEC 
deemed the ADF so critical to the maintenance of competition that the 
SEC set the existence of a viable ADF as a precondition to both the 
rollout of SuperMontage and the possible approval of the Nasdaq 
exchange application. A commercially viable Alternative Display 
Facility, coupled with strong and engaged government oversight, will 
create an environment in which SuperMontage can yet be a net plus for 
the market.
    Question 12. Is SuperMontage a Central Limit Order Book (CLOB)?
    Response 12. SuperMontage is certainly an order book. The 
implication of a ``central'' order book is that everyone is compelled 
to participate in it. We think compelling everyone to participate 
stifles competition and robs consumers of the benefits of innovation 
and reduced costs.
    While no single rule compels everyone to participate in 
SuperMontage, an arcane combination of rules gives many market 
participants little choice but to participate in SuperMontage. That's 
great for Nasdaq shareholders, but it would be better for investors if 
Nasdaq had to entice, rather than compel, participation in 
SuperMontage.
    A few years ago, proponents of centralization urged support for a 
time priority central limit order book (CLOB) to deal with the alleged 
``problem'' of market fragmentation. The notion behind the CLOB was 
that, by centralizing orders in one place, a single ``black box'', 
maximum order interaction and perhaps better prices might be achieved. 
While the CLOB was ultimately rejected as unworkable and unwise, the 
interaction of SuperSOES and SuperMontage represent the same effort to 
centralize. The recent Nasdaq pricing proposal, which would clearly 
discourage execution of trades outside of Nasdaq--even if the best 
price were being offered outside of Nasdaq--is simply the latest 
manifestation of this urge toward centralization. As exchanges 
contemplate becoming for-profit companies, this urge to centralize 
order flow and execution and cut off the development of competitive 
alternatives--to ``CLOB'' the market--will grow more pronounced. This 
threat emphasizes the need for a functional, fully competitive 
Alternative Display Facility as a means to mitigate the potential 
anticompetitive impacts of SuperMontage. It may well be that additional 
remedial measures are needed. The continued vigilance of the Congress 
and the SEC will be essential as these developments unfold.
    Question 13. Have structural changes that have accompanied the 
privatization of the NASDAQ been sufficient to ensure a competitive 
marketplace?
    Response 13. Structural changes necessary to ensure a competitive 
marketplace have simply not been effectuated. The most significant 
structural change to ensure a competitive marketplace would be the 
creation of a commercially viable ADF. Unfortunately, a number of 
obstacles have been placed in the way of creating a commercially viable 
ADF, some flowing from the structural problems associated with the fact 
that NASD--which is charged with organizing and running the ADF--is not 
independent of Nasdaq.
    NASD and Nasdaq have interlocking boards. NASD retains a 
significant ownership interest in Nasdaq and a commercial interest in 
Nasdaq's eventual success as a for-profit exchange. For example, NASD 
claims they no longer have any common stock in Nasdaq, except the stock 
that underlies the warrants issued in the Nasdaq private placement--but 
underlying those warrants held by NASD are more than 43 million shares 
of Nasdaq common stock, a significant ownership interest in Nasdaq 
representing a considerable stake on the part of NASD in the success of 
Nasdaq as a stock exchange. In addition, when NASD sold 33.7 million 
shares of Nasdaq common stock to Nasdaq earlier this year, it received 
approximately $440 million, payable in a combination of cash and the 
issuance to NASD of two newly issued series of Nasdaq preferred stock.
    While we could go on, the bottom line is that NASD's holdings 
represent a substantial and continuing economic interest in the success 
of Nasdaq.
    The significance of NASD's not being independent of Nasdaq is 
driven home in Nasdaq's Amendment 2 to its Form 10 Registration 
Statement. Discussing the ADF and its competitive potential, Nasdaq 
states:
        If this market becomes a viable alternative to Nasdaq, then 
        Nasdaq faces the risk of reduced market share in transactions 
        and market information services revenues, which would adversely 
        affect Nasdaq's business, financial condition, and operating 
        results.
    Nasdaq views the ADF as a potential threat. The entity charged with 
organizing and running the ADF--NASD--has a powerful interest in 
Nasdaq's success. The structural change of separating NASD's interests 
from Nasdaq's interest may be a necessary predicate to the structural 
change of ensuring a viable ADF.
    Question 14. How does the NASD's Alternative Display Facility (ADF) 
differ from the SuperMontage? Has Bloomberg signed up for the ADF? Why 
or why not?
    Response 14. Bloomberg intends to participate in the ADF at the 
earliest opportunity permitted by safe and prudent procedures for 
implementing new technology.
    There are a number of differences between the SuperMontage and the 
ADF. SuperMontage is both a display facility and an execution/clearance 
facility. ADF is just a display facility. SuperMontage is building on 
Nasdaq's enterprise value, which NASD's members developed over 30 
years. The ADF is forced to start from scratch. Those responsible for 
organizing and running SuperMontage--Nasdaq--have a clear and 
unequivocal financial interest in the success of SuperMontage. Those 
responsible for organizing and running the ADF--NASD--not only lack an 
unequivocal financial interest in the success of ADF, but also have a 
significant financial interest in seeing SuperMontage succeed.
    Bloomberg Tradebook believes a commercially viable ADF is critical 
to address the anticompetitive aspects of SuperMontage. We believe a 
viable ADF will present our clients with new opportunities to lower 
their overall transaction costs. That's why we were the first market 
participant to commit publicly to the ADF, and it is why we remain 
committed to undertake the technical steps necessary to enable 
Bloomberg Tradebook to display quotations in the ADF.
    Bloomberg has signed up for the ADF, although we have not certified 
participation to the SEC. The distinction between signing up and 
certifying requires brief discussion.
    The SEC made its January 2001 approval of SuperMontage contingent 
on the NASD's establishing an Alternative Display Facility as an 
alternative to Nasdaq. To say the least, the NASD has not moved 
expeditiously to take the basic steps necessary to allow potential ADF 
participants to move into the ADF. To take but one example, the NASD 
took from January 2001 until August 6, 2002--18 months--to provide 
market participants with final technical specifications necessary as an 
initial step to connect to the ADF. We believe many of the impediments 
to development of the ADF have been a function of the NASD's financial 
interest in Nasdaq and the interlocking Nasdaq/NASD boards.
    On August 28, 2002, the SEC asked ECNs to certify, under oath, an 
intention to use the ADF as our primary order collection and display 
facility for a significant portion of our business in Nasdaq securities 
on or before October 11, 2002. As a business matter, we certainly did 
not feel we could commit to move significant business to a facility 
that did not yet exist. As a technical matter--having only received 
technical specifications necessary for coding on August 6--we believed 
it impossible for us to ensure we could display quotes by October 11, 
especially in light of other programming demands generated by the 
simultaneous rollout of SuperMontage. Thus, we did not certify 
participation on the timetable laid out by the SEC, but we have 
communicated to the NASD a commitment to participate in the ADF.
    I would add that SEC approval of the proposed rules regarding ADF 
display of listed stocks would certainly attract additional market 
participants to the ADF.
    Question 15. Is the ADF a true alternative to the NASDAQ's 
SuperMontage?
    Response 15. The ADF is not presently a true alternative to 
Nasdaq's SuperMontage, but it is imperative for investors and the 
markets that it becomes a true alternative.
    Recognizing the potential anticompetitive impact of SuperMontage, 
the SEC made its January 2001 approval of SuperMontage contingent on 
the establishment of an ADF--a display facility that would stand as an 
alternative to Nasdaq. The ADF was deemed so critical to the SEC that 
it was cited as a precondition not only to the rollout of SuperMontage, 
but also to the possible approval of the Nasdaq exchange application. A 
commercially viable ADF is intended to make participation in 
SuperMontage ``voluntary''. Without a viable ADF--a facility where 
market participants could find potentially superior stock prices and 
liquidity in venues other than Nasdaq--the enormous reductions in 
investment spreads and transaction costs enjoyed by Americans in recent 
years will be imperiled.
    ADF is, of course, a display facility while SuperMontage combines 
in one place display and execution of orders. Despite that difference, 
the ADF can be an alternative. As long as market participants can see 
and identify liquidity, market participants can build the connectivity 
necessary to execute orders. Indeed, that is exactly what has 
transpired in the Nasdaq market over the past six years, as ECNs have 
built faster, more reliable connections to each other in the process of 
working around slower and less reliable Nasdaq systems.
    Question 16. How does the ``full contribution member'' and 
``partial contribution member'' dichotomy punish NASD members for doing 
business on a facility other than SuperMontage?
    Response 16. There are a number of elements of Nasdaq's proposed 
SuperMontage fee schedule that are intended to suppress competition. 
Nasdaq has proposed extending the pricing scheme it currently uses for 
SuperSOES--its current order execution system--to SuperMontage. Under 
the SupersSOES pricing scheme, NASD members that report to Nasdaq at 
least 95% of their trades in Nasdaq securities for the preceding month 
are deemed ``full contribution members''. Those reporting fewer than 
95% of their trades in Nasdaq securities for the preceding month to 
Nasdaq are deemed ``partial contribution members.''
    ``Full contribution members'' would pay substantially lower Nasdaq 
access fees than ``partial contribution members.'' In short, the access 
fee differential would punish NASD members for doing more than de 
minimis business on the ADF, or any trading facility other than 
Nasdaq's SuperMontage. It is hard to imagine an action more contrary to 
consumers' interests than extending such an anticompetitive pricing 
structure to SuperMontage.
    Question 17. What are the main ADF issues that need to be addressed 
on an ongoing basis?
    Response 17. There are a number of ADF issues that need to be 
addressed on an ongoing basis. The most important of these issues would 
include the following: (1) The ramifications of NASD--which is charged 
with organizing and running the ADF--not being independent of Nasdaq, 
an entity that ardently desires that the ADF fail; (2) the potential 
for Nasdaq to misuse the proceeds of its government-sponsored market 
data monopoly and/or its government-sponsored trade execution monopoly 
to preclude the realization of a competitive ADF; (3) the imposition by 
Nasdaq of discriminatory fees intended to discourage use of the ADF; 
(4) the necessity that the NASD hire the staff and invest in the 
hardware necessary to run the facility, especially as volume increases; 
and (5) the importance of the SEC approving the pending rules that 
would permit trading in NYSE-listed stocks on the ADF. This will help 
bring the benefits of competition and innovation to the NYSE listed 
market, while helping to ensure the ADF's commercial viability.
    Question 18. Why would an ECN elect to receive orders rather than 
executions? How do SuperMontage fees discriminate against ECNs that 
elect to receive orders rather than executions?
    Response 18. ECNs are required by SEC rules to respond 
immediately--and I mean immediately--to orders at any given price in 
the time sequence they are received, whether they come from our best 
customers or from our competitors. Bloomberg Tradebook, like many ECNs, 
has a system that is much faster than Nasdaq's. If Bloomberg Tradebook 
elected to receive executions, our combination of speed and immediate 
response would result in double executions.
    SuperMontage fees discriminate against ECNs that elect to receive 
orders rather than executions. In Nasdaq's nomenclature, a 
``preferenced order'' is an order sent to a specific market participant 
that has a quotation displayed in SuperMontage at the best bid or 
offer. A preferenced order is executed through the use of the 
SuperMontage execution algorithm. A ``directed order'' is an order sent 
to a specific ECN or other market participant that has elected to 
receive orders rather than executions.
    Nasdaq proposes to impose a penalty of 150% on orders directed to 
ECNs or other participants that are permitted to accept order delivery 
rather than automatic executions. By charging 150% more for directed 
orders than for orders executed using the SuperMontage algorithm, the 
fee structure penalizes ECNs and other market participants that wish to 
use their own trading algorithms to access liquidity on the 
SuperMontage screen via directed orders. These deliberately 
discriminatory fees would force orders into SuperMontage's execution 
algorithm, thereby restricting market participants from having equal 
access to all avenues of execution.
    Effectively, the proposed fees impose a penalty on NASD members 
that use alternatives to SuperMontage. By increasing the cost of using 
facilities other than SuperMontage, the SuperMontage fees compel NASD 
members to keep their trading volume on SuperMontage and discourage 
them from using the ADF or other alternatives to SuperMontage.
    Question 19. Are access fees consistent with ECN obligations under 
the order handling rules to provide access to the best prices in the 
marketplace?
    Response 19. While Bloomberg Tradebook is not prepared to 
``unilaterally disarm'' by forswearing collection of access fees while 
others charge us such fees, it is clear as a matter of public policy 
that access fees should be abolished. They distort order flow and add 
to everyone's execution costs, costs that deliver no benefit to the 
marketplace. Access fees also create an artificial distinction between 
ECN and market-maker liquidity.
    Unfortunately, the pricing structure Nasdaq is promoting threatens 
to make access fees and payment for order flow an even more dominant 
part of the National Market System. This year, in a series of pricing 
changes, Nasdaq has not only mandated an access fee for all market-
maker liquidity in SuperSOES, but also positioned itself as the 
collector of those access fees.
    Nasdaq's embrace of access fees and rebates won't decrease market-
place distortions or increase innovation. Rather, the goal is to 
establish the dominance of Nasdaq's execution facilities and enhance 
its own revenues. As bad as access fees are when charged by ECNs, the 
ability to go to an ECN with lower fees provides a market check on 
excessive charges. Unless there is a commercially viable ADF, there is 
no comparable check on the access fees charged by Nasdaq.
    Nasdaq is a stock market. The role of Nasdaq should be to act as an 
impartial clearinghouse that doesn't favor one set of market players, 
including itself, over another. Access fees should be abolished for 
both ECNs and Nasdaq.
    Question 20. Should ECNs be required to apply uniform charges to 
subscribers and non-subscribers?
    Response 20. As described above, we believe access fees should be 
abolished. Access fees distort the market and disadvantage investors by 
raising costs and undermining efficiency. That said, the worst kind of 
access fee is one in which a non-subscriber (i.e., competitor) is 
charged fees that are often many times the amount charged to 
subscribers. These charges, of course, bear no relationship to cost or 
value--they are simply intended to punish a competitor without the 
bother of actually bringing greater value to investors. There shouldn't 
be access fees, but if they exist, public policy dictates such fees be 
uniform for subscribers and non-subscribers.
    I should add that, while ECNs should be required to apply uniform 
charges for subscribers and non-subscribers, the same principle should 
apply even more strongly for Nasdaq. Nasdaq has proposed a series of 
fees that similarly bear no relationship to covering costs or providing 
value--rather these fees are intended to thwart competition by 
establishing obstacles to trading outside of SuperMontage. Again, by 
virtue of the fact that there are multiple competing ECNs, there is 
some market check on potentially abusive ECN access fees. Unless there 
is a viable ADF, there is no comparable market check on abusive Nasdaq 
fee practices.
    Question 21. Should an ECN be required to fill an order it has 
displayed when the counterparty refuses to pay the access fee?
    Response 21. Again, it would be a better world for investors and 
the markets if access fees didn't exist. However, as long as access 
fees are a legitimate and widely accepted element of the business 
models of ECNs, ECNs should certainly have the authority to refuse to 
fill an order when counterparty refuses to pay an access fee.
    The ramifications within SuperMontage of an ECN's refusing to fill 
an order when a counterparty won't pay an access fee illustrates the 
kind of discriminatory and anticompetitive practice that merits both 
SEC and Congressional attention. In this regard, I wish to call your 
attention to the controversy surrounding the issue of quotation 
decrementation.
    Quotation decrementation has to do with how orders are displayed 
and adjusted on SuperMontage to the disadvantage of ECNs and their 
customers. Under SuperMontage rules, if an ECN posts a quotation for a 
certain price and quantity in a given security, it will be penalized 
for declining an order from a counterparty with whom the ECN chooses 
not to do business. Such counterparty may be an entity that is an 
unacceptable credit risk or one that refuses to pay an ECN's access 
fees.
    Under the SuperMontage rules, when an ECN declines an order, even 
if only for part of the quantity displayed in its quotation, the ECN's 
entire quotation will be removed from the SuperMontage quotation 
display. As a result, the ECN's customers will lose their place in the 
SuperMontage time-price queue. In addition, ECNs will be at increased 
risk for incurring costs instead of revenue.
    What is telling about the quote decrementation feature of 
SuperMontage is that its adverse effects fall exclusively upon ECNs. 
That is deliberate on Nasdaq's part, and grossly discriminatory.
    Question 22. Mr. Ryan, General Counsel of the American Stock 
Exchange, testified that some of the ECNs operate as de facto clubs 
and, in effect, an exchange without the regulation or burdens 
associated with being an exchange. What should be the regulatory burden 
for ECN business as an agency order matching facility?
    Response 22. In his testimony, Mr. Ryan takes issue specifically 
with one ECN--Island--characterizing it as a ``private club'' because 
of Island's refusal to display its quotes in a handful of stocks. I 
understand the Amex's frustration at Island's decision. I also 
understand Island's frustration at being locked into a market structure 
where including Island's quotation data in the consolidated quote would 
require that Island participate in the Intermarket Trading System--a 
participation that would negate Island's advantages of speed and 
certainty of execution. This controversy underscores how critical it is 
for policy makers to comprehensively address these market structure 
issues.
    As to the general question of the proper regulatory burden for 
ECN's, I would say the SEC got it right with Regulation ATS. The level 
of regulation necessary to ensure the integrity of an agency order 
matching facility characterized by maximal transparency is going to be 
different than the regulation necessary for an exchange.
    I would add that Island's (unsuccessful) and Archipelago's 
(successful) bids to become exchanges suggest that rational market 
players do not view exchange regulation as excessively burdensome vis-
a-vis ATS regulation, especially when that regulation is viewed in the 
context of the substantial benefits of being an exchange--i.e., sharing 
directly in market data revenue that bears no relationship to cost, 
listing revenue, etc.
                                 ______
                                 
 Response for the Record of William O'Brien, Senior Vice President and 
                       General Counsel, Brut, LLC
    Question 1. What are the potential costs and benefits to investors 
of a market in which market information is available through 
competitive forces rather than an exclusive processor?
    Response. Multiple distributors of market data would likely restore 
prices to true competitive levels, rather than the artificially high 
prices that exist today. An exclusive processor has no incentive to 
lower prices to the actual consumers of market data. Competition among 
multiple distributors of such data would require pricing reflective of 
the cost of collection of such information. This competition could take 
place without any deleterious consequences for market data users, given 
a regulatory framework that already requires the provision of complete 
market information by vendors.
    Question 2. What are market data rebates and how do they work?
    Response. Market data rebates reflect the inefficiencies of the 
current pricing structure for market information. Because prices are 
artificially high, it produces substantial revenue for exchanges and 
Nasdaq far in excess of the costs of collection and dissemination of 
such data. These profits compel Nasdaq and some exchanges to lure the 
true generators of market data to use their facilities to report market 
information, which is done by ``rebating'' a portion of the revenue 
received from the exclusive processor to the participant generating the 
data.
    Question 3. Are market data rebates good for investors? Why or why 
not?
    Response. Given the current structure for dissemination of market 
information, market data rebates provide some value because they 
transfer excessive market information revenues back to the trading and 
investing public, albeit indirectly, which heretofore have previously 
been kept by Nasdaq and the exchanges, who provide relatively little 
value in the process other than commodity-like collection and 
transmission facilities. These rebates, however are highly imperfect, 
in that they:

a. Favor the generators of market data while still imposing excessive 
        costs on the users of market data. A broker-dealer with an 
        extensive retail brokerage operation, but little proprietary 
        trading activity, will continue to pay non-market costs for 
        market information without receiving any rebates. High-volume 
        proprietary or agency trading operations are the prime 
        beneficiaries of such rebates.
b. It maintains the current system whereby Nasdaq and the exchanges 
        control the cost of market information. These parties set the 
        rebate structures and continue to cloud the discussion of 
        market data pricing inefficiency by linking such revenues to 
        regulatory and other costs, with Nasdaq pursuing a for-profit 
        business models that makes such arguments suspect.
c. They create incentives for perverse market behavior, such as 
        ``wash'' transactions and ``shredding'' of large trades into 
        smaller ones, that furthers no national market system objective 
        and degrades the quality of market information.
    Question 4. Will market data rebates solve market data issues or is 
a regulatory solution required?
    Response. A regulatory solution is required to impose a system 
whereby the rates paid for market information by end users reflect the 
true cost of collection and distribution of such information. Given the 
essential nature of widely-distributed market data to comply with best 
execution obligations and advance various national market system 
objectives, the creation of a system of competing market data 
processors would produce optimal pricing for the marketplace.
    Question 5. Are market data rebates creating problems with wash 
trades--are buy and sell quotes being entered simultaneously by the 
same party to generate trade revenue from market data rebates? If so, 
how do we solve this problem?
    Response. Market data rebates do create perverse incentives to: (a) 
create ``wash transactions''; and (b) ``shred'' large transactions into 
a series of smaller ones, given revenue is received on a per trade 
basis. Both practices degrade the quality of the market information 
without any benefit. Recent SEC enforcement actions regarding these 
practices highlight that regulatory oversight is important given the 
current framework. A more long-term solution, however, would flow from 
more market-driven structures for the pricing of such data.
    Question 6. Is current ECN access to ITS inadequate? Why or why 
not?
    Response. Current ECN access to ITS is adequate. What is inadequate 
is an unequal application and enforcement of ITS rules between manual 
and electronic market center participants. Whereby an ECN must 
configure their system's operation to ensure 100% compliance with 
applicable rules, the NYSE and other manual-intensive market centers 
routinely flout ITS requirements by ``trading through'' better prices 
posted on ECNs.
    Question 7. Are the access rules for ITS responsible for ECNs lower 
trading volume in listed securities than in Nasdaq securities? Why or 
why not?
    Response. ITS rules inhibit the growth of ECN trading of listed 
securities for two reasons: (a) greater visibility of order prices that 
flow with ITS participation come at the cost of compliance with a rule 
set that can dilute the attractiveness of certain ECN business models; 
and (b) ECNs that choose to comply with ITS requirements do not get the 
advantages of increased exposure of their orders and access to other 
liquidity pools because the NYSE and other established markets do not 
comply with ITS requirements.
    Question 8. Do access rules for ITS presume best execution at the 
NBBO? Are there any other factors that should be considered for best 
execution?
    Response. The ITS access rules imply a policy of strict ``price/
time'' priority--that is, the market posting the best bid or offer 
should participate in the next transaction, subject to limited 
exceptions. This presumes: (a) that price is the paramount factor in 
all best execution analyses; and (b) the best-execution interests of 
the provider of liquidity (i.e., the party placing a limit order for 
display to the market at large) are paramount to those of the taker of 
liquidity (i.e., the party placing a market order for immediate 
execution against previously displayed interest). Both assumptions 
should be re-considered in light of diverse views on what truly is best 
execution.
    Question 9. Please describe the governance structure for ITS. Does 
the governance structure inhibit improvement? If so, please explain.
    Response. The ITS Plan is the document which governs the operation 
of ITS. The Plan calls for oversight by an Operating Committee composed 
of one representative from each SRO participant (i.e., the exchanges 
and Nasdaq, on behalf of the NASD). Votes to make material amendments 
to the ITS Plan generally require the unanimous vote of all Plan 
participants. This requirement inhibits meaningful reform. Imagine the 
amount of legislation that would be passed if Congress had a similar 
requirement.
    Question 10. What is the difference between the old Nasdaq as an 
infrastructure for quotations and the new Nasdaq with the SuperMontage 
as an order execution facility?
    Response. The primary difference between the ``old'' Nasdaq that 
merely collected and distributed broker-dealer quotations and trade 
reports, and the ``new'' Nasdaq that, culminating in SuperMontage, 
offers execution services bundled with those facilities, is that Nasdaq 
now competes directly with the market makers and ECNs it was originally 
created to serve. This is exacerbated by Nasdaq's desire to shift from 
a non-profit, market-neutral subsidiary of an self-regulatory 
organization (the NASD) to a publicly-held, for-profit entity.
    Question 11. What potential benefits and risks does SuperMontage 
bring to the marketplace?
    Response. SuperMontage has the potential to provide benefits to the 
marketplace as a new competitor in the field of trade execution 
services, offering its own unique value proposition in terms of price, 
technology and service. Given Nasdaq's regulatory legacy and historical 
monopoly privileges, however, the risk is Nasdaq will thwart 
competition through unfair use of its status within current market 
structure.
    Question 12. Is SuperMontage a Central Limit Order Book (CLOB)?
    Response. SuperMontage is a limit order book that Nasdaq hopes will 
become a CLOB. Provided that the Alternative Display Facility and other 
market centers are allowed and committed to providing non-Nasdaq 
alternatives for compliance with SEC quotation-display and trade-
reporting requirements, SuperMontage will likely remain in vibrant 
competition with other limit order book operators and never gain CLOB 
status.
    Question 13. Have structural changes that have accompanied the 
privatization of Nasdaq been sufficient to ensure a competitive 
marketplace?
    Response. There has been positive steps towards preserving market 
competition but more must be done. The Alternative Display Facility 
must continue to reduce technological and economic barriers to usage, 
both now and on a continuing basis in the future, to provide a non-
exchange, market-neutral facility to comply with SEC quotation and 
trade reporting obligations. The SEC should also take action regarding 
proposals by existing exchanges that wish to modify their rules to 
provide further competition to Nasdaq for these services.
    Question 14. How does the NASD's Alternative Display Facility (ADF) 
differ from the SuperMontage? Has Brut signed up for the ADF? Why or 
why not?
    Response. The ADF much resembles the ``old'' Nasdaq in that it 
merely provides broker-dealers a facility through which to comply with 
SEC quotation and trade-reporting obligations, without providing any 
supplemental execution services. Brut has not yet signed up to use the 
ADF for the reasons described below, along with a desire to offer 
subscribers the flexibility to expose their limit orders in 
SuperMontage.
    Question 15. Is the ADF a true alternative to the Nasdaq's 
SuperMontage?
    Response. The Alternative Display Facility can become a truly 
viable alternative to SuperMontage if the NASD: (a) completes the 
creation of compatibility with the Financial Information Exchange 
(``FIX'') protocol, which will ease the technological burdens of 
connectivity; and (b) makes permanent a fee structure that reflects the 
limited purposes of the system and operates the ADF like the low-cost 
utility it should be.
    Question 16. How does the ``full contribution member'' and 
``partial contribution member'' dichotomy punish NASD members for doing 
business on a facility other than the SuperMontage?
    Response. This pricing dichotomy, which we understand has been 
withdrawn as a rule filing, is anti-competitive in that it effectively 
ties the use product in a market where there is competition (trade 
reporting) to use of a market where there is not (removal of liquidity 
from SuperMontage). Firms seeking to pursue savings by reporting trades 
to non-Nasdaq venues would be faced with higher costs for trading 
against market makers via SuperMontage, which is effectively required 
to provide best execution of customer orders.
    Question 17. What are the main ADF issues that need to be addressed 
on an ongoing basis?
    Response. See the answer to question 15 above. The NASD must be 
committed on an ongoing basis to ensure that the ADF is technologically 
and economically viable. It should operate the ADF on a true ``non-
profit'' model, and not allow ADF-related fees to subsidize other NASD 
activities, including but not limited to the provision of regulatory 
services to Nasdaq. Potential conflicts of interest between the NASD 
and Nasdaq should be completely eliminated to ensure this commitment.
    Question 18. Why would an ECN elect to receive orders rather than 
executions? How do SuperMontage fees discriminate against ECNs that 
elect to receive orders rather than executions?
    Response. ECNs elect to receive orders rather than executions 
because to do otherwise exposes them to ``double liability'' (i.e., the 
execution of one order twice--within its own system and within Nasdaq 
simultaneously) that would crate proprietary trading risk inconsistent 
with ECN business models. SuperMontage fees currently do not 
discriminate against ECNs that elect to receive orders rather than 
executions (though early versions of the SuperMontage proposal sought 
to do so).
    Question 19. Are access fees consistent with ECN obligations under 
the order handling rules to provide access to the best prices in the 
marketplace?
    Response. SEC no-action letters provided to ECN operators under the 
``ECN Display Alternative'' component of the Order-Handling Rules 
validate the practice of ECN access fees. Such fees are consistent with 
execution service fees charged by other market centers, and facilitate 
an agency business model where an ECN operator engages in no 
proprietary trading activity.
    Question 20. Should ECNs be required to apply uniform charges to 
subscribers and non-subscribers?
    Response. ECNs are currently required, under the terms of their no-
action letters with the SEC as referenced above, to charge non-
subscriber broker-dealers a rate no higher than that paid by a 
substantial portion of its active broker-dealer subscribers. When this 
requirement is complied with, it is more than sufficient to meet fair 
access requirements. In October 2002, over 80% of Brut's broker-dealer 
subscribers paid fees at the rate that non-subscribers were charged.
    Question 21. Should an ECN be required to fill an order it has 
displayed when the counterparty refuses to pay the access fee?
    Response. ECNs should not be required to fill orders for 
counterparties that refuse to pay access fees. Much of the debate 
surrounding ECN access fees can be eliminated if: (a) viable 
alternatives to Nasdaq are created and maintained so that ECNs may 
comply with SEC quotation-display requirements through a facility that 
does not have execution capabilities (such as the ADF); and (b) greater 
clarity is given that Nasdaq and other execution system operators can 
restrict ECN participation in their systems based on access fee 
considerations. If ECNs have viable alternatives for public display of 
their quotations (which did not exist until very recently), the concern 
that firms are ``forced'' to trade with ECNs becomes an issue for 
Nasdaq and other execution venue operators to decide. They will balance 
the liquidity provided by ECNs versus the user concerns regarding 
access fees and make decisions within a competitive market framework.
    Question 22. Mr. Ryan, General Counsel of the American Stock 
Exchange, testified that some of the ECNs operate as de facto clubs 
and, in effect, an exchange without the regulation or burdens 
associated with being an exchange. What should be the regulatory burden 
for ECN business as an agency order matching facility?
    Response. The argument that ECNs have unfair advantages due to 
their classification is without merit, given that each market 
participant is free to choose its regulatory classification and the 
benefits and compliance burdens associated therewith. Exchange 
registration brings with it: (a) the ability to generate revenue from 
listing securities on your exchange; (b) direct participation in 
national market system plans such as ITS and the CTA/CQS plans (which 
govern market data); (c) can reduce clearing costs; and (d) offer 
certain brand advantages. Firms that choose to operate as exchanges and 
enjoy these advantages must comply with applicable regulatory 
requirements, while those that choose to operate as broker-dealers 
forego exchange-related privileges for a less restrictive compliance 
regimen. Current exchanges, however, should not be hamstrung by their 
current classification if they wish to seek alternative business 
models; any exchange wishing to de-register and pursue operation as a 
broker-dealer operator of an ATS should be allowed to do so by the SEC.
                                 ______
                                 
                                    American Stock Exchange
                                                  November 22, 2002
Mr. Cliff Stearns
Chairman
Subcommittee on Commerce, Trade and Consumer Protection
U.S. House of Representatives
Committee on Energy and Commerce
Washington, D.C. 20515-6115

Re: ECNs and Market Structure

    Dear Mr. Stearns: In response to your October 25, 2002 letter, The 
American Stock Exchange appreciates this opportunity to provide 
additional information to the Subcommittee on the important issues 
raised during the October 17, 2002 hearing regarding ECNs and market 
structure.
The American Stock Exchange
    The American Stock Exchange has a long history of innovation and 
diversification, and it proudly carries on this distinguishing 
trademark among exchanges today. As one of the most diversified 
financial marketplaces in the U.S., the Amex is the only primary 
exchange in the United States that actively lists and trades securities 
across three diverse business lines--equities, options and exchange 
traded funds (``ETFs''). We continue to provide investors--whether they 
be retail or institutional investors--with investment opportunities 
that best meet their needs.
    The Amex market is a technologically advanced centralized auction 
and specialist system whose strength comes from the fact that the 
specialists have an affirmative obligation to maintain a fair and 
orderly market. This means they risk their own capital, maintaining a 
continuous two-sided quotation. With a specialist intrinsically linked 
to creating the best market for a stock, the best interests of listed 
companies and their shareholders are achieved. Other markets--whether 
they be regional exchanges, dealer markets or ECNs--provide far less of 
a commitment to the investing public.
    The combination of our auction market, diversified product line, 
state-of-the-art technology and the large pools of liquidity provided 
by Wall Street's most experienced and well-capitalized firms, delivers 
a superior marketplace for investors in all our products.
    Equities
    The Amex equity marketplace continues to outperform the market. 
Following a strategic restructuring of the equity program which 
refocused the business on small and middle market companies, the Amex 
composite index outperformed every other domestic exchange and 
virtually every other index in both 2000 and 2001, and is on track to 
do so again this year.
    The Amex, unlike the other primary markets which focus exclusively 
on servicing large cap stocks, acts as a conduit in helping small and 
mid-sized companies develop and grow.
    We feel that now, more than ever, in this economic and political 
climate, it is critical to provide support to the capital markets--
especially the small and mid-cap companies who are more often than not 
our nation's principal source of innovation, job creation and future 
economic growth.
    Our advanced centralized auction and specialist system is 
especially beneficial to small and mid-cap companies as it maximizes 
liquidity at the point of sale. Specialists also serve as a single 
point of contact that a company can turn to for critical insight on 
their stock's trading activity.
    Offering additional diversification and opportunities to 
investors--we also began trading NASDAQ stocks this summer. By trading 
NASDAQ stocks, the Amex is providing for the first time in these 
securities, a meaningful auction market environment with real 
opportunities for price improvement. The Amex is providing deep 
liquidity for large, institutional size orders, which creates new 
investment opportunities for investors.
    Options
    The Amex is the second largest options exchange in the U.S., 
trading options on broad-based and sector indexes as well as domestic 
and foreign stocks.
    We trade call and put options on more than 1,800 stocks and 25 
broad, sector-specific and international indexes. And we continue to 
close in on becoming the number one domestic options marketplace for 
equity options.
    Even amid tough market conditions, we continue to see growth in our 
options business. In looking at third quarter Amex's total options 
equity volume for this year, it is up 18% as compared to this same time 
last year.
    ETFs
    In addition to its role as a national equities market and leading 
options exchange, the Amex is the pioneer of the Exchange Traded Fund 
(``ETF''). ETFs are the fastest growing, most innovative financial 
products offered by an exchange over the last decade. After more than 
four years of working with the SEC and millions of dollars of R&D 
expense, we launched the first ETF in 1993 with the creation of the 
Standard & Poor's Depository Receipts (commonly referred to as the 
``spider''), which is based on the Standard and Poor's 500 Composite 
Stock Price Index.
    Over the next several years, we spent millions more developing new 
products and educating the marketplace about the benefits of ETFs. Nine 
years later, the Amex remains the clear leader in ETF listings, listing 
121 of the 123 in the U.S. market today.
    Global
    We have been able to leverage our reputation in ETFs to create a 
global presence for the Amex. In the last year, we have reached 
agreements to trade Amex-listed ETFs in Europe and Asia. Our global 
expansion includes a joint venture with the Singapore Exchange. In May, 
we began trading Amex-listed ETFs in Asia, becoming the very first 
fungible product traded across time zones. We've also listed the first 
U.S. equivalent of an ETF trading on the Tokyo Stock Exchange. And we 
continue to work on agreements with the Tokyo Stock Exchange and 
Euronext with respect to the listing and trading of each other's ETFs. 
As regulations allow, we anticipate that these centers will also 
provide international trading venues for our listed companies seeking 
exposure to the global markets. In short, the new American Stock 
Exchange has emerged as a strong, innovative international competitor, 
especially in the development and trading of sophisticated derivative 
securities.
Background of the National Market System
    We believe an overview of relevant national market system 
developments will serve as a useful context for the issues raised in 
your October 25 letter. In 1975 Congress adopted substantial amendments 
to the Securities Exchange Act of 1934 (``Act'') designed to enhance 
the integrity and efficiency of our national securities markets (the 
``1975 Amendments''). Specifically, Congress mandated the 
implementation of a national market system. The Securities and Exchange 
Commission (``Commission''), in turn, adopted rules under this mandate 
to require the industry to develop mechanisms and procedures designed, 
among other things, to enhance transparency of market data (e.g., 
timely display of trading interest and trade executions) and foster 
interaction of investor trading interest (that is, minimize 
fragmentation and intermediation).
    Central to meeting these requirements, all the exchanges and the 
NASD/Nasdaq adopted three critical national market systems plans for 
listed equity securities: the Consolidated Quote (``CQ'') Plan, the 
Intermarket Trading System (``ITS'') and the Consolidated Tape 
Association (``CTA'') Plan (collectively referred to as ``Plans'').
    Collectively, these three plans enhance real time consolidated 
transparency of market data (i.e., the CQ Plan for quotes and CTA Plan 
for trades) and foster interaction of investor trading interest (i.e., 
ITS). Each of the Plans was submitted to and approved by the 
Commission. Their common objective is to provide the investing public 
with a consolidated national market system which provides, inter alia, 
best bid and offer information that can be viewed and accessed by any 
investor, regardless of the market to which the order is routed.
    The CQ and CTA Plans provide that the market data generated from 
these Plans be sold to market participants on a real-time basis. Under 
the current Plans, the revenue generated is then shared among the 
exchanges and NASD/Nasdaq ratably based on the number of trades 
executed by each market, but without reference to the number or quality 
of quotes displayed or whether any quotes are displayed at all.
    Since the adoption of these Plans and other similar Plans, the 
Commission has on many occasions refined the rules relating to the 
national market system (including adopting the Quote Rule and 
Regulation ATS), reinforced the importance of the national market 
system and underscored the central role these Plans play in meeting the 
mandate set forth in the 1975 Act Amendments. The Commission has done 
this by approving amendments to these Plans, approving rule changes 
submitted by all the exchanges and the NASD/Nasdaq in connection with 
the implementation of these Plans, and by adopting Commission rules 
governing the operation of the exchanges, the NASD/Nasdaq and broker-
dealers.
    In 1998, reacting in part to its well-founded concerns documented 
in the Commission's 21(A) Report against the NASD that alternative 
trading systems were leading to market fragmentation and harming market 
transparency by operating as private ``hidden markets,'' the Commission 
adopted Regulation ATS. Specifically, the operation of these 
alternative trading systems was--and, unfortunately, still is--leading 
to a two-tiered market, an unofficial one only viewable and accessible 
by the alternative trading system's members and the official market 
being created by the national market system and used by public 
investors. The Commission also took this step to address the growing 
regulatory disparity between ATS's and other markets, disparities the 
Commission found negatively affected other securities markets and, most 
importantly, public investors.
    In adopting Regulation ATS, the Commission sought to establish a 
better balance between the regulatory needs of the Congressionally 
mandated national market system and the need to encourage the 
development of innovative new markets. The Commission sought to 
accomplish its goal by allowing, on the one hand, an ATS that operated 
below a threshold of 5% of the average daily trading volume in a 
security largely to escape the regulatory constraints placed upon 
registered exchanges. On the other hand, in an effort to bring ATSs 
into the national market system, Regulation ATS attempted to subject an 
ATS that exceeded the 5% threshold to an order display and equivalent 
access requirement and an ATS that exceeded a 20% threshold to a fair 
access and certain requirements relating to its operational system.
    Since its adoption, it has become increasing clear that Regulation 
ATS has not resulted in the better balance between regulation and 
innovation sought by the Commission. While a single de minimis ATS (an 
ATS with less than 5% market share) may not have a significant impact 
on the U.S. securities markets, the Commission failed to anticipate 
that the trading of multiple ATSs operating under the de minimis 
exemption can, in the aggregate, have a very negative overall impact on 
the national market system's guiding principals of transparency, best 
execution, equal regulation and fair competition. Amex advocates the 
repeal of Regulation ATS in its current form, and we have communicated 
this view to the Commission.
    The ability of an ATS to frustrate the Regulation ATS requirements 
designed to integrate ATSs into the national market system has recently 
been vividly demonstrated by The Island ECN's choice to ``go dark'' 
(with no information at all disseminated about priced orders entered in 
Island), a tactic it adopted notwithstanding the Commission's grant of 
an unprecedented exemption to a core national market system principle--
the ITS trade-through rule--designed specifically to accommodate 
Island. Thus, a market, like Island, that matches customer orders with 
other customer orders, does not display its customers' orders and 
reports its trades through the CT Plan avoids the most substantive 
provisions of Regulation ATS, including: (1) the order display and 
equivalent access requirement, (2) the limitation on fees that are 
inconsistent with the equivalent access requirement, (3) the fair 
access requirement, and (4) the requirements with respect to the 
capacity, integrity, and security of the ATS's automated systems.
    By going dark, Island achieved precisely the result that the 
Commission sought to avoid with the adoption of Regulation ATS, namely 
the presence of a two-tired market--an unofficial one only viewable and 
accessible by the alternative trading system's members and the official 
market existing within the national market system that is available to 
all investors. Island's actions have lead to the truly perverse result 
seen today of an alternative trading system (Island) and a facility of 
a national securities association (Nasdaq) sharing in revenue generated 
by two national market system plans (the CQ and CTA Plans) while the 
ATS is invisible and inaccessible to the intended beneficiaries of the 
national market system--the investing public. Nasdaq receives the 
revenue and then pays a portion of it over to Island as payment for 
order flow. It should go without saying that allowing significant ATSs 
to opt out of the national market system because the Commission is 
reluctant to allow Regulation ATS to be enforced or because of the 
exception that allows markets, like Island, to go dark, undermines the 
core national market principles of transparency, best execution, equal 
regulation and fair competition.
    The Commission's permissive attitude toward Island provides 
incentives to these enterprises to proliferate outside the national 
market system constructs that the Amex and other market participants 
are required to abide by. Amex acknowledges the benefits of 
competition, and is eager to see the Commission facilitate market 
innovation. But by continuing to allow Island to reap artificial 
financial benefits (by the receipt of payment for order flow), to be 
unreachable and, in the actively-traded ETFs, invisible, the Commission 
is not allowing Amex to compete to attract those orders and to provide 
investors with superior executions.
    Question 1. What are the potential costs and benefits to investors 
of a market in which market information is available through 
competitive forces rather than an exclusive processor?
    Response. As Amex stated during its participation in the SEC 
Advisory Committee on Market Information (known as the Seligman 
Committee) in 2000 and 2001, there are certain types of facilities that 
should be exclusive because they call for centralized operations that 
can best be performed by a single entity. Securities clearing 
operations are a good example of this type of exclusive utility. 
Although there were five different equity clearing systems at the time 
the 1975 Securities Acts Amendments were adopted, today there is only 
one. The additional costs associated with operating multiple clearing 
organizations outweighed any benefits of competition. We believe a 
central processor operates in a similar manner.
    Under the existing market structure, there are two kinds of 
exclusive securities information processors: entities like SIAC and 
Nasdaq that actually process trade data, and entities like the CTA and 
Options Price Reporting Authority (``OPRA'') that administer, collect 
and distribute market data fees. Leaving Nasdaq aside for the moment 
because it serves several simultaneous roles as securities information 
vendor, marketplace and central processor, the other central processor, 
SIAC, performs its service at cost. We find it hard to believe that a 
for-profit entity could perform the services SIAC currently performs, 
with the same level of service, for less money.
    Amex sees no advantage in having multiple, competing consolidators 
of market data. The consolidation function should be performed by an 
exclusive consolidator under each of the plans. We are concerned that 
increasing the number of consolidators would simply introduce 
complexity and inefficiencies, such as the need for multiple disaster 
recovery sites and plans, without producing any real, offsetting 
benefits. Moreover, we believe that the competing consolidator model 
would create the possibility of differing data streams and thus is 
fundamentally at odds with the national market system. Data streams may 
vary for many reasons, including differing standards for rejecting 
apparently inaccurate data, differing transmission times among markets 
or differing timestamps for incoming market data among consolidators. 
If data streams are different, both last sale and quotation information 
could differ among vendors.
    Amex believes that SIAC has done an exemplary job as the exclusive 
information processor under the CTA and CQ Plans. The efficiency of its 
operations is demonstrated by its long record of providing reliable, 
real-time market data to the industry without significant disruptions. 
This record is all the more impressive if one takes into account the 
exponential growth in recent years in the amount of data that SIAC has 
had to collect, consolidate and make available for re-dissemination. 
That said, Amex is willing to explore opening the exclusive processing 
function to competitive bidding, if other markets believe that is 
appropriate.
Questions 2 through 5. Market Data Rebates
    As background for the issues raised in Questions 2 through 5 
relating to market data rebates and associated regulatory problems, we 
believe it is helpful to describe how market data is calculated and 
distributed for listed securities.
    The national market system in listed securities is funded by 
revenues generated from the sale of quotations and last sale 
transaction data to vendors and subscribers at prices that are fixed by 
the Participants under the direct supervision of the Commission. As 
detailed in the Commission's recent study of the economics of market 
data by the Seligman Committee, market data revenues are an essential 
mechanism for financing the operation of various markets and their 
surveillance and compliance programs.
    Pursuant to the CTA Plan, the calculation of revenue for each 
Participant is based upon the number of last sale transactions reported 
by that Participant. More specifically, the ``Gross Income'' of each CT 
Network 1, from which each Participant receives its ``Annual 
Share,'' is based on fees received from subscribers, vendors and others 
for the ``privilege of receiving and using the network's last sale 
price information.'' The ``Annual Share'' is calculated by a fraction 
using a numerator based upon the total number of last sale price 
transactions reported by the Participant and a denominator based upon 
the total number of last sale price transactions reported by all 
Participants in the network. Under the CQ Plan, the ``Annual Share'' is 
calculated the same way as in the CTA Plan, i.e., according to the 
number of last sale transaction reported in the network's securities , 
and not according to the number of quotes disseminated in those 
securities. This formula was established when the CTA was formed, at a 
time when there was no real time dissemination of quotation 
information. In 1978 when the CQ Plan was formed there seemed to be no 
point in changing this allocation formula since market data charges for 
trades and quotes were bundled and every market that reported trades in 
a security was also required to disseminate quotations. Thus, not using 
quotes to calculate quotation revenues--and using transactions 
instead--was at the time believed to be relatively inconsequential. 
However, with significant changes in the markets, including some market 
participants operating outside of the national market system, the 
allocation formula rewards market participants for violating the law 
and undermining the national market system.
---------------------------------------------------------------------------
    \1\ There are two networks in the CTA and CQ Plans: Network A 
provides quotes and last sale price information in securities traded on 
the New York Stock Exchange and Network B provides quotes and last sale 
price information in securities traded on the American Stock Exchange.
---------------------------------------------------------------------------
    This dysfunctionality is exacerbated by the practice of NASD/Nasdaq 
of rebating a portion of market data revenue to their members to use as 
``payment for order flow.'' Island is a beneficiary of this rebate 
program. Even though Island never reports its quotations to NASD/Nasdaq 
and never links with ITS, NASD/Nasdaq receives a share of both 
quotation and transaction market data revenues based on the number of 
trades Island generates. NASD/ Nasdaq, in turn, passes a substantial 
portion of its CTA and CQ Plan revenues attributable to Island's trades 
on to Island as part of its ``Payment for order flow'' program.
    Thus, despite the fact that Island does not disseminate its 
quotations to any of the Participants or allow other markets to access 
its quotations, it nevertheless gets ``paid'' a share of both CTA Plan 
and CQ Plan revenues. Island then pays over a percentage of the money 
to brokers or other of its customers as ``payment'' for executing their 
trades on Island as opposed to some other marketplace (like AMEX). The 
Island payment scheme rebates to users of its system a fixed fee for 
every trade in listed stocks regardless of size. Indeed, Island 
actively markets on its web site the fact that its customers receive 
rebates of CTA/CQ tape revenues on a ``trade-by-trade'' basis, thus 
encouraging users to break larger trades into small ones, thereby 
maximizing their rebate (and in the process moving more trades--and 
thus more CTA Plan and CQ Plan revenues--to Island).
    Revenues under the CQ and CTA Plans are allocated among market 
centers on the basis of the respective number of trades they each 
report, without regard to share volume or the quality of those markets. 
This approach disadvantages the market centers that provide greater 
liquidity by treating a single trade for 100 shares of stock the same 
as a single trade for 100,000 shares of the same stock in a different 
market. By the same token, the quality of quotation information is 
completely ignored in the allocation formula.
    Though the current methodology has the virtue of being procedurally 
simple, its simplicity comes at the great expense of substance. Indeed, 
its reliance solely on counting the number of trades (a practice dating 
back to the mid-1970s) causes it to be overly simplistic and, 
unfortunately, subject to gaming and manipulation solely for the 
purposes of collecting market data revenue, not improving the quality 
of the market. The time has come to recognize that the current 
methodology has utterly failed to achieve what should be the major 
goals of the Commission and the CQ/CTA participants--to encourage the 
provision of maximum liquidity to, and the tightest possible spreads 
in, national market system securities. To that end, Amex has proposed a 
more logical method of allocating market data revenue, rewarding 
superior pricing and displayed size.
    Question 2. What are market data rebates and how do they work?
    Response. Several markets, including the Nasdaq Stock Market, the 
Cincinnati Stock Exchange and the Chicago Stock Exchange, rebate a 
portion of their market data revenue under the CQ/CTA Plans to their 
members as a reward for executing trades on those markets. These 
payment for order flow schemes are generally filed with SEC without the 
benefit of publication in the Federal Register for notice and comment 
before they become effective. They may involve payment or credit for 
each print in an Amex or NYSE security, for example, or a more 
elaborate system of credits based on trade volume executed over a 
specified time period. Amex has had a longstanding opposition to such 
schemes, which we have communicated to the Commission on numerous 
occasions--and, indeed, the Commission recognized the abuses that can 
result from those payments when it abrogated certain payment for order 
flow programs on July 2, 2002, stating that these programs ``raise 
serious questions as to whether they are consistent with the Act and 
with the protection of investors. These questions include, among other 
things, the effect of market data rebates on the accuracy of market 
data [i.e., the potential distortion of trade reporting through wash 
sales and trade shredding] and on the regulatory functions of self-
regulatory organizations.'' 2. The Commission stated further 
that ``[i]f the self-regulatory organizations choose to re-file the 
proposed rule changes, they must do so pursuant to sections 19(b)(1) 
and 19(b)(2) of the Act.'' [Emphasis supplied].
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    \2\ Securities Exchange Act Release No.46159 (July 2, 2002) 67 FR 
45775 (July 10, 2002).
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    Ironically, despite the Commission's clear directive in its 
abrogation Order, on July 8, Nasdaq filed a proposal to reinstate its 
payment for order flow program. The Nasdaq's reinstated proposal did 
not address any of the serious questions raised by the Commission in 
the abrogation Order nor did it try to justify why the proposal is 
consistent with the Act and with the protection of investors. On July 
19, 2002, the Commission allowed Nasdaq to reinstate the program 
retroactively to July 1. To date, none of the important questions 
raised by the Commission have been answered.
    Question 3. Are market data rebates good for investors? Why or why 
not?
    Response. Market data rebates--that is, payment for order flow--are 
undermining national market system facilities by providing financial 
support and incentives to market participants that may decide to trade 
in a particular market based solely, or principally, on rebates, rather 
than whether investor orders receive best execution; by encouraging 
violations by ECNs of Regulation ATS under the 1934 Act; and by 
providing direct and significant financial support for market 
participants to engage in fraudulent and misleading trade reporting. We 
can identify no benefit--and a clear potential for harm--to public 
investors from such practices. The reason that some market centers can 
provide such inflated market data rebates is that they are not burdened 
with the regulatory or listing requirements of the primary markets. 
These market centers are able to offer low cost alternatives to the 
primary market (including negative costs such as market data rebates) 
while free-riding on the price discovery process occurring in the 
primary market. This is even more egregious if members of these markets 
do not participate in CQ/CTA or ITS, ironically reducing the integrity 
of the price discovery value of the market data for which they are 
being paid.
    Question 4. Will market data rebates solve market data issues or is 
a regulatory solution required?
    Response. Rebates have promoted investor harm as a result of market 
data revenue distributed under the CQ/CTA Plans, which was not 
contemplated when the markets agreed to the current revenue 
distribution methodology under those Plans. Amex views the current 
methodology for distributing revenue to CQ/CTA Participants as 
irremediably flawed--and a major contributing factor to incenting to 
markets to pay their members for order flow, with attendant regulatory 
problems, noted in Question 5, below. We believe a regulatory response 
is needed. (See response to Questions 5.)
    Question 5. Are market data rebates creating problems with wash 
trades--are buy and sell quotes being entered simultaneously by the 
same party to generate trade revenue from market data rebates? If so, 
how do we solve this problem?
    Response. Trading to create artificial reports based on per trade 
market data rebates has become a serious problem. Nasdaq, for example, 
pays Island on a per trade basis and Island rebates to users of its 
system a fixed fee for every trade in listed stocks regardless of size. 
Indeed, Island actively markets on its web site the fact that its 
customers receive rebates of CTA/CQ tape revenues on a ``trade-by-
trade'' basis, thus encouraging users to break larger trades into small 
ones, thereby maximizing their rebate. As a result, for example, an 
Island customer wishing to execute an order for 1,000 shares of QQQ is, 
in fact, directly paid to break that order up into 10 trades of 100 
shares. Island's users were obviously breaking their orders into 100 
share lots, encouraged by the trade-by-trade rebate. This creates the 
false and misleading impression that 10 separate orders were executed 
each at 100 shares. Regulators have taken notice. The NASD recently 
reached a settlement with Swift Trade Securities USA, Inc. and its 
president, Peter Beck, for engaging in a deceptive trading scheme 
involving fictitious wash trades in the QQQ ETF in an effort to obtain 
market data revenue generated from such transactions. (See Exhibit B) 
In addition, the SEC has taken action to abrogate several markets' 
payment for order flow programs, based at least in part on potential 
wash sales problems resulting from those programs. The Exchange views 
such activity as seriously undermining the integrity of consolidated 
tape reporting and is contrary to the intent and purpose of the CQ/CTA 
Plans to distribute revenue based on full participation in all national 
market facilities by CQ/CTA Participant members.
    In order to encourage marketplaces to improve their displayed 
pricing and order size--and to contribute to market depth and 
liquidity--Amex has proposed to CTA Participants that CQ/CTA market 
data revenues be distributed as follows: (1) 25% based on the number of 
trades; (2) 25% based on share volume traded; (3) 25% based on bids 
that are at the national best bid (NBB); and (4) 25% based on offers 
that are the national best offer (NBO). The distributions based on the 
NBB and NBO would be weighted by volume (the number of shares in the 
bid or offer), time (the number of seconds the NBB or NBO exists) and 
the percentage that each stock's traded share volume amounts to of all 
Network A or Network B securities' traded share volume.
    Question 6. Is current ECN access to ITS adequate? Why or why not?
    Response. ITS is accessible to all market participants pursuant to 
the provisions of the ITS Plan. The ITS Plan currently provides for 
delivery of ITS commitments which expire in 30 seconds, 1 minute, or 2 
minutes, at the discretion of the sending market. While a time frame of 
30 seconds 3 may not fit into the model of an ECN, the ITS 
trade through protections are designed to protect the customers of both 
the participant accessing liquidity and the participant providing 
liquidity by quoting at the NBBO. Nasdaq and the Cincinnati Stock 
Exchange, currently provide access by their members to all other 
markets through ITS. All ECNs can take advantage of the ITS link 
provided by Nasdaq, as Archipelago has before becoming an Exchange. No 
ECN that is required to provide equal access should be treated any 
differently with respect to ITS provisions than the members of Nasdaq 
and the Cincinnati Stock Exchange.
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    \3\ The time frame of 30 seconds is the maximum time that a market 
center can take to execute an ITS commitment before the commitment 
automatically expires. Nasdaq and the Cincinnati stock exchange provide 
immediate automated response to ITS commitments, and manual market 
centers often provide responses in a time frame well under 30 seconds. 
In October 2002, over 75% of all ITS commitments received a response in 
less than 15 seconds.
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    The ITS Operating Committee recognizes that in a decimal 
environment, the protection afforded by the ITS Plan to a limit order 
on an away market priced only 1 cent better than orders on the home 
market may not always be justifiable if the limit order is not easily 
accessible, and if the risk of the prices moving in the home market are 
high. The ITS Operating Committee is currently in discussions regarding 
changes to the ITS plan that may be required. The Operating Committee 
is considering issues raised by all parties, including both manual 
markets and markets that provide automated executions such as Nasdaq 
and the Cincinnati Stock Exchange.
    Question 7. Are the access rules for ITS responsible for ECN's 
lower trading volume in listed securities than in NASDAQ securities? 
Why or why not?
    Response. ECNs have access to other markets through their automated 
order delivery systems outside of ITS. Indeed, the number of orders and 
share volume sent to Amex's Amex Order File or NYSE's DOT system, for 
example, from other market participants, including dealers, far exceeds 
the number of ITS commitments, with associated volume sent through ITS. 
Even if ITS were inaccessible, this would not be a reason for ECNs' 
lower trading volume in listed securities. Indeed, in Amex-listed ETFs 
such as QQQS, SPY and DIA, Island's volume was astronomically high at 
the same time that it had determined to operate entirely outside ITS in 
these securities. However, ITS is accessible to all market participants 
as stated earlier. Island, in its single tepid initiative to inquire to 
ITS Participants about ITS access several years ago, proposed to have 
only one-way access--Island to other markets. Island has never 
seriously explored meaningful ITS access with other participant 
markets. Their purported lack of access has certainly not had any 
negative impact on their trading volume in listed ETFs. The fact that 
Island operates entirely outside ITS in all listed securities, but has 
only gained significant volume in ETFs clearly shows that their lack of 
success in non-ETF listed securities has nothing whatsoever to do with 
ITS rules. The phenomenal success ECNs have seen in Nasdaq securities 
and in ETFs is due largely to the intra-day volatility of these 
securities that attracts day traders, the largest constituency of most 
ECNs. Additionally, ETFs are derivatively priced, so primary market 
protection is not as important as an execution near the NAV, which is 
not set by supply and demand on the primary listing market.
    Question 8. Do access rules for ITS presume best execution at the 
NBBO? Are there any other factors that should be considered for best 
execution?
    Response. The NBBO is the starting point for executions through 
ITS. All ITS participants should attempt to access a superior priced 
away market (i.e., a market at the NBBO), and should avoid executing an 
order at a price inferior to the NBBO (a ``trade-through''). Proponents 
of alternative trading systems and Nasdaq recently have been advocating 
``speed of execution'' as the primary consideration in best execution. 
The Commission however, has clearly stated, ``price is the predominant 
element of the duty of best execution.'' The Commission's view of a 
national market system consisting of ``equally regulated, individual 
markets, which are linked together to make their best prices publicly 
known and accessible,'' presupposes that price is the most important 
factor in best execution and that speed of execution, like many other 
considerations, is a secondary factor.
    The SEC also has identified the other factors to be considered by a 
broker-dealer in satisfying its best execution obligations, including 
the size of the order, the trading characteristics of the security 
involved, the availability of accurate information, technological aids 
to process such data, access to the various market centers, and the 
cost and difficulty associated with achieving an execution in a 
particular market center.
    Questionn 9. Please describe the governance structure of ITS. Does 
the governance structure of ITS inhibit improvement? If so, please 
explain?
    Response. The ITS Plan is a national market system. All provisions 
of or amendments to the Plan are approved by the SEC. The ITS Operating 
Committee, which includes representatives of all U.S. exchanges and 
Nasdaq, administers Plan provisions but is not a policy making or rule 
making body. Amendments to the Plan must be effected by a written 
amendment to the Plan, executed on behalf of each Participant 
(unanimous vote required). Plan amendments are filed with the SEC for 
approval, generally with notice and the opportunity for public comment 
prior to approval. Any Participant can enforce its views regarding any 
action or inaction of the ITS Operating Committee to the SEC or any 
other forum it deems appropriate.
    The SEC attends meetings of the ITS Operating Committee and Users 
Subcommittee. The ITS Operating Committee considers all proposals of 
all participants; participants affected by an action of the Operating 
Committee, for example, as a result of failure to approve a Plan 
amendment proposed by a Participant, are able to petition the SEC to 
take appropriate action, or the Commission itself can take action it 
deems necessary to implement or amend provisions of the Plan. The 
Operating Committee is currently addressing important issues regarding 
ITS trade throughs and other issues as requested by the Commission. 
Amex believes that ITS governance promotes consensus by all markets and 
promotes progress consistent with integrity of the market structures of 
all participants.
    Question 10. What is your per trade revenue for market data? How 
does that compare to the NYSE's per trade revenue?
    Response. The per trade revenue from market data for securities 
listed on the Amex is $2.39 and for securities traded on the NYSE the 
per trade revenue is $0.27. The difference in revenue per trade is a 
reflection of the fact that there are fewer trades executed in Amex 
securities than in NYSE securities. Market data can not be sold on a 
per trade basis, the appropriate measure is the revenue per terminal 
since that is the way revenue is collected under the Plans and is 
reflective of the infrastructure costs of providing market data. As 
discussed below, the revenue collected per terminal is comparable to 
both the NYSE and Nasdaq, however the number of trades occurring on the 
NYSE and through Nasdaq is greater resulting in lower per trade 
revenue.
    Market data revenue for Amex (CTA Network B), NYSE (CTA Network B) 
and Nasdaq data are reasonably comparable, on a per terminal basis. 
Despite a tenfold increase in consolidated share and trade volume in 
Amex-listed securities since 1992 (the last time rates were raised for 
Networks A and B), market data rates have not increased. In 1992, the 
consolidated daily average Network B volume was 19.3 million shares and 
15,248 trades. In 2002 (year to date), that figure has climbed to 186.6 
million shares and 155,989 trades. Network B rates are $27.25 monthly 
per terminal (members) and $30.20 (non-members).
    Network A utilizes a sliding scale, ranging from $127.25 monthly 
for the first terminal to $18.75 per month per terminal for 10,000 or 
more terminals (members and non-members). The price for Nasdaq data, 
which was most recently changed in 1997, is $20 per terminal.
    Question 11. You testified about alleged abuses by Island regarding 
their trades of ETFs being sold to the Cincinnati Stock Exchange and 
Island's refusal to report trades. Could you elaborate why this is a 
violation of the securities laws, how it affects market competition and 
why the SEC has not taken action?
    Response. For more than 18 months the Island ECN has operated in 
open and notorious violation of the federal securities laws. Without 
any justification, Island has flagrantly violated Regulation ATS as 
well as engaging in and fostering other abusive and fraudulent trading 
practices. Throughout this period, the American Stock Exchange as well 
as many other market participants and regulators have brought these 
activities to the attention of the Commission and pleaded with the 
Commission to take the appropriate action to bring it to an end.
    Regulation ATS--On December 8, 1999, the Commission adopted 
Regulation ATS, which is designed to integrate significant alternative 
trading system activity into the national market system. Regulation ATS 
was adopted after two extensive public comment periods and much 
consideration by the Commission and the industry. The expressed purpose 
of integrating ATSs into the national market system was to address the 
Commission's well-founded concerns that these systems were leading to 
market fragmentation and harming market transparency by operating as 
private, `` `hidden markets,' in which a market participant privately 
publishes quotations at prices superior to the quotation information it 
disseminates publicly.'' Because of the lack of enforcement of 
Regulation ATS, these concerns continue to be a reality.
    Specifically, Regulation ATS requires an ATS to consolidate their 
quotes with all other markets and to provide access to these quotes 
when the ATS achieves five percent market share for four out of six 
months. Island triggered these requirements in QQQ in May 2001, in DIA 
in August 2001 and SPY in February 2002.
    Island has recently announced that it will begin reporting (that 
is, selling) trades in ETFs to the Cincinnati Stock Exchange (``CSE'') 
in a manner that will neither display their quotes nor make them 
accessible to public investors. Under the current CSE payment for order 
flow arrangement, CSE will pay a 50% market data rebate of revenue that 
it receives under the CTA Plan. Island therefore will be able to pay 
its users even more than under NASDAQ's payment for order flow program 
(under which Island is paid a 40% rebate), with the aim of further 
increasing Island market share and siphoning even greater volume away 
from national market facilities. CSE's arrangement with Island has not 
been separately filed with the SEC, and undermines the core purposes of 
Regulation ATS. Island will not be displaying its best orders through 
CSE and none of Island's quotes will be accessible to other markets 
through ITS. As we understand the situation, Island has set up a scheme 
to report trades through CSE as follows: When an order entered in 
Island ECN is priced at or between the NBBO, Island ECN transfers the 
order to Island Execution Services for matching and printing on CSE. 
Because CSE's displayed quote typically is well outside the NBBO and 
because few, if any, limit orders are resident on CSE's ``book'', there 
is virtually no chance that the Island orders to be matched will be 
broken up by other trading interest. Island orders not priced at the 
NBBO would continue to be executed in Island, outside the NBBO, but 
still rewarded by Nasdaq payment as a third market print.
    Question 12. Please explain how, in your view, Island is exploiting 
the National Market System (NMS) by collecting fees from it while not 
participating in it?
    Response. Market data revenue should only be distributed to SROs 
and their members that fully participate in the national market system. 
This involves all of the burdens necessary to comply with last sale 
reporting, quotation reporting, making oneself accessible to other 
markets through ITS and complying with the trade through rules. Markets 
and their members that choose not to undertake these obligations should 
not share in the revenues derived from them.
    Island does not disseminate quotations for inclusion in the 
consolidated quote and is not accessible by other markets through 
national market facilities. Island also receives direct payments from 
certain CQ/CTA participant markets for trades in listed securities, a 
portion of which Island has in the past paid to its customers for 
executing orders in Island. This is an abuse of the revenue sharing 
provisions of the CQ/CTA Plans, undermines market transparency and best 
execution of investors' orders, and encourages abusive and potentially 
fraudulent practices such as wash sales and tape shredding.
    Question 13. Your testimony states that some of the ECNs operate as 
de facto clubs and, in effect, an exchange without the regulation or 
burdens associated with being an exchange. What should be the 
regulatory burden for their business as an agency an order matching 
facility?
    Response. ECN order matching facilities, while, in our view, fully 
within the definition of ``exchange'' in the 1934 Act and Rule 3b-16 
thereunder, shoulder none of the regulatory burdens of other exchanges. 
Exchanges are subject to a raft of regulatory requirements. Exchanges 
are obligated to enforce compliance by their members with their rules 
and the federal securities laws. Amex and other exchanges have spent 
heavily on technology and incur significant data storage costs in 
connection with the fulfillment of their obligation to surveil trading 
in their markets. Not only are these systems very expensive to create, 
maintain and revise as is frequently needed, but given their necessary 
limitations, they also require the exchanges to employ large staffs to 
review the various reports created by them.
    In addition to the exchanges' wide-ranging regulatory 
responsibilities, they also are subject to a number of additional 
burdensome and costly requirements that are inapplicable to ATSs. Among 
these additional requirements are obligations to file and obtain 
Commission approval of rule and system changes, file to adopt, change 
and even eliminate fees (which must be fair), provide for fair 
representation of members in the management of exchange affairs, have 
outside directors on the governing board, dual siting and system 
redundancy requirements and fair membership access rules. The numerous 
requirements applicable to exchanges stifle innovation and impede their 
ability to compete with the less regulated ECN's.
    We believe ECN's should be subject to comparable regulatory 
burdens. If this does not occur, the logical alternative is for other 
exchanges to be relieved of many of the current regulatory burdens that 
impact their competitiveness.



            Sincerely,
                                       Michael J. Ryan, Jr.
                                                    General Counsel



cc: Mr. David Cavicke
   Mr. William Carty
