[Federal Register Volume 69, Number 33 (Thursday, February 19, 2004)]
[Notices]
[Pages 7836-7843]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-3540]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49220; File No. SR-NASD-2003-128]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment Nos. 1, 2, and 3 Thereto by the National 
Association of Securities Dealers, Inc. Relating to the Establishment 
of a Maximum ECN Access Fee in SuperMontage and the Elimination of 
SuperMontage's Price/Time With Fee Consideration and Price/Size 
Execution Algorithms

February 11, 2004.

I. Introduction

    On August 11, 2003, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its subsidiary, the Nasdaq 
Stock Market, Inc. (``Nasdaq''), filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend NASD Rules 4623 and 4710 
to: (1) Establish a maximum level of quote/order access fees for 
Electronic Communications Networks (``ECNs'') that elect to participate 
in Nasdaq's National Market Execution System (``NNMS'' or 
``SuperMontage''); (2) eliminate SuperMontage's Price/Time with access 
fee consideration execution algorithm; and (3) eliminate SuperMontage's 
Price/Size execution algorithm. On September 10, 2003 and September 15, 
2003, Nasdaq filed Amendment Nos. 1 \3\ and 2 \4\ to the proposed rule 
change, respectively. The proposed rule change, as amended, was 
published for comment in the Federal Register on September 30, 2003.\5\ 
On January 20, 2004, Nasdaq filed Amendment No. 3 to the proposed rule 
change.\6\ The Commission received seventeen comment letters on the 
proposal, as amended.\7\ On December 15, 2003, Nasdaq filed a response 
to the comment letters.\8\ This order approves the proposed rule 
change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Edward S. Knight, Executive Vice President 
and General Counsel, Nasdaq, to Katherine A. England, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated September 9, 2003, replacing Nasdaq's original Form 19b-4 
filing in its entirety (``Amendment No. 1'').
    \4\ See letter from Thomas P. Moran, Associate General Counsel, 
Nasdaq, to Katherine A. England, Assistant Director, Division, 
Commission, dated September 12, 2003 (``Amendment No. 2''). In 
Amendment No. 2, Nasdaq made technical corrections to its rule text.
    \5\ See Securities Exchange Act Release No. 48501 (September 17, 
2003), 68 FR 56358 (``Notice'').
    \6\ See letter from Thomas P. Moran, Associate General Counsel, 
Nasdaq, to Katherine A. England, Assistant Director, Division, 
Commission, dated January 16, 2004 (``Amendment No. 3''). In 
Amendment No. 3, Nasdaq made technical changes to the rule text to 
reflect the approval of or the immediate effectiveness of other 
Nasdaq proposals. The Commission notes that this is a technical, 
non-substantive amendment and not subject to notice and comment.
    \7\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Kim Bang, Bloomberg Tradebook LLC, dated October 21, 2003 
(``Bloomberg Letter''); William O'Brien, Chief Operating Officer, 
BRUT, LLC, dated October 24, 2003 (``BRUT Letter''); Linda Lerner, 
General Counsel, Domestic Securities, Inc., dated October 24, 2003 
(``Domestic Letter''); Gregg A. Dudzinski, Head of Equity Trading, 
Wm. V. Frankel & Co., dated, October 21, 2003 (``Dudzinski 
Letter''); Frederic Leslie, General Counsel, Hill, Thompson, Magid, 
L.P., dated November 7, 2003 (``Hill Thompson Letter''); Harvey 
Houtkin, Chief Executive Officer, dated October 22, 2003 (``Houtkin 
Letter''); Alex Goor, Executive Vice President, Instinet Corporation 
(on behalf of Instinet Corp. and the Island ECN, Inc.), dated 
October 22, 2003 (``Instinet/Island Letter''); Samuel F. Lek, Chief 
Executive Officer, Lek Securities Corp., dated December 16, 2003 
(``LSC Letter''); Mark E. Yegge, Chief Executive Officer, NexTrade 
Holdings, Inc., dated October 13, 2003 (``NexTrade Letter''); 
Stephen Massocca, President & Director of Trading, Pacific Growth 
Equities, LLC, dated October 20, 2003 (``PGE Letter''); Josef 
Schaible, dated August 19, 2003 (``Schaible Letter''); Ann L. Vlcek, 
Vice President & Associate General Counsel, Securities Industry 
Association, dated October 31, 2003 ( ``SIA Letter''); John P. 
Hughes et al., Chairman, Securities Traders Association, dated 
October 20, 2003 (``STA Letter''); Martin Cunningham, President, 
Security Traders Association of New York, Inc., dated October 21, 
2003 (``STANY Letter''); Roderick Covlin, Executive Vice President, 
Track ECN, dated October 17, 2003 (``Track Letter''); and Scott W. 
Anderson, Director and Counsel, Region Americas Legal, UBS 
Securities LLC, dated October 16, 2003 (``UBS Letter''); and letter 
to Margaret H. McFarland, Deputy Secretary, Commission, from John H. 
Bluher, Executive Vice President & General Counsel, Knight Trading 
Group, Inc., dated, October 21, 2003 (``Knight Letter''). The 
Commission notes that several commenters raised issues, such as the 
elimination of access fees entirely, the payment and collection of 
access fees, and decrementation within SuperMontage, that are not at 
issue in the proposed rule change. At issue in the proposed rule 
change, in part, is whether the access fee cap being proposed is 
consistent with the Act. A more detailed summary of the comment 
letters received by the Commission is available for public 
inspection in the Public Reference Room at the Commission.
    \8\ See letter from Thomas P. Moran, Associate General Counsel, 
Nasdaq, to Terri L. Evans, Assistant Director, Division, Commission, 
dated December 12, 2003 (``Nasdaq Response Letter'').

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[[Page 7837]]

II. Description of the Proposed Rule Change

    Currently, Nasdaq's SuperMontage system automates, in part, the 
matching of buy and sell trading interest using execution algorithms 
that limit the ability of users to select or anticipate who their 
counter-parties to a particular trade will be. Generally, market 
participants entering orders into SuperMontage are able to select 
between three execution algorithms by which orders that are not 
directed to a particular market participant may be executed. The three 
algorithms are based on price/time priority,\9\ price/size/time 
priority,\10\ and price/time priority that accounts for ECN quote 
access fees.\11\ Once a market participant has entered a non-directed 
order in SuperMontage, the order is executed pursuant to the selected 
algorithm and SuperMontage rules. As a result, users entering orders 
into SuperMontage may execute against a variety of market participants, 
including ECNs that charge a separate fee to other market participants 
that access their quotes/orders.
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    \9\ Generally, in the price/time algorithm, non-directed orders 
are executed (within each price level) as follows: (1) Displayed 
quotes/orders of market makers, ECNs, non-attributable quotes/orders 
of NNMS Order Entry Firms, and non-attributable agency interest of 
UTP Exchanges, in time priority; (2) reserve size of market makers, 
NNMS Order Entry Firms, and ECNs, in time priority; and (3) 
principal quotes/orders of UTP Exchanges, in time priority. See NASD 
Rule 4710(b)(1)(B)(i).
    \10\ Generally, in the price/size/time algorithm, non-directed 
orders are executed (within each price level) as follows: (1) 
Displayed quotes/orders of market makers, ECNs, non-attributable 
quotes/orders of NNMS Order Entry Firms, and non-attributable agency 
interest of UTP Exchanges, in size/time priority; (2) reserve size 
of market makers, ECNs, and NNMS Order Entry Firms, in size/time 
priority, with size priority based on the size of the related 
displayed quote/order; and (3) principal quotes/orders of UTP 
Exchanges, in size/time priority. See NASD Rule 4710(b)(1)(B)(iii).
    \11\ Generally, in the price/time that accounts for ECN quote 
access fees algorithm, non-directed orders are executed (within each 
price level) as follows: (1) Displayed quotes/orders of market 
makers, ECNs that do not charge a separate quote access fee, non-
attributable quotes/orders of NNMS Order Entry Firms, and non-
attributable agency interest of UTP Exchanges, as well as quotes/
orders of ECNs that charge a separate quote access fee where the ECN 
indicates that the price improvement offered by the quote/order is 
equal to or exceeds the quote access fee, in time priority; (2) 
displayed quotes/orders of ECNs that charge a separate quote access 
fee to non-subscribers that do not indicate that the price 
improvement offered by the specific quote/order is equal to or 
exceeds the access fee, in time priority; (3) reserve size of market 
makers, NNMS Order Entry Firms, and ECNs that do not charge a 
separate quote access fee to non-subscribers, as well as reserve 
size of quotes/orders from ECNs that charge a separate quote access 
fee to non-subscribers where the ECN entering such quote/order has 
indicated that the price improvement offered by the specific quote/
order is equal to or exceeds the quote access fee, in time priority; 
(4) reserve size of ECNs that charge a separate quote access fee to 
non-subscribers that do not indicate that the price improvement 
offered by the specific quote/order is equal to or exceeds the quote 
access fee, in time priority; and (5) the principal interest of UTP 
Exchanges, in time priority. See NASD Rule 4710(b)(1)(B)(ii).
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    In the filing, Nasdaq proposes establishing a maximum permissible 
quote/order access fee for ECNs that elect to participate and execute 
transactions in SuperMontage. Under Nasdaq's proposal, the maximum 
SuperMontage ECN access fee would be capped at $0.003 (three mils) per 
share. Participating ECNs would be free to charge quote/order access 
fees equal to or less than the $0.003 maximum.
    ECNs that desire to charge more than three mils for access to their 
quotes/orders would not be permitted to post liquidity in SuperMontage 
as NNMS ECNs. They would, however, be permitted to continue to 
participate in SuperMontage as NNMS Order Entry Firms.\12\ As NNMS 
Order Entry Firms, those ECNs would have any quotes/orders entered into 
the system displayed and processed in the same manner as other NNMS 
Order Entry Firms. This would include having their quotes/orders 
represented only via the SIZE MMID and also making them subject to 
automatic execution.\13\ As NNMS Order Entry Firms, these ECNs would 
not be allowed to impose any fee on a broker-dealer that accesses them 
through the SuperMontage system. As NNMS Order Entry Firms, such ECNs 
would be eligible for Nasdaq's liquidity provider rebate.\14\
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    \12\ An NNMS Order Entry Firm is defined in NASD Rule 4701(w) as 
a member of the NASD who is registered as an Order Entry Firm for 
purposes of participation in the NNMS. In its proposed rule change, 
Nasdaq is amending this definition to clarify that the term would 
also include ECNs or Alternative Trading Systems (``ATSs'') that 
fail to meet the NASD Rule 4623 requirements for ATSs. Nasdaq is 
also amending the definition of NNMS Order Entry Firm to clarify 
that they cannot charge any fee to a broker-dealer that accesses its 
quote/order through NNMS.
    \13\ NNMS Order Entry Firms may enter orders that are displayed 
anonymously through SIZE. These displayed orders are subject to 
automatic execution. See NASD Rules 4701(g), 4707(b)(2), and 
4710(b)(1)(A)(i).
    \14\ ECNs that participate as NNMS ECNs and charge a separate 
access fee are not entitled to receive a liquidity provider rebate. 
See NASD Rule 7010(i). Telephone conversation between Thomas P. 
Moran, Associate General Counsel, Nasdaq, and Sapna C. Patel, 
Special Counsel, Division, Commission, on January 27, 2004.
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    In concert with establishing a maximum ECN quote access fee, Nasdaq 
proposes eliminating the Price/Size and the Price/Time with fee 
consideration execution algorithms currently available in 
SuperMontage.\15\ Nasdaq proposes to implement all three changes 
simultaneously and within thirty days of any approval order issued by 
the Commission.\16\
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    \15\ Elimination of these two execution algorithms will leave 
only the Price/Time priority execution algorithm in SuperMontage. 
See supra notes 9 through 11.
    \16\ Telephone conversation between Thomas P. Moran, Associate 
General Counsel, Nasdaq, and Terri L. Evans, Assistant Director, 
Division, Commission, on February 2, 2004.
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III. Summary of the Comments and Nasdaq's Response

    The Commission received seventeen comment letters on the proposed 
rule change, as amended.\17\ Three commenters supported the proposed 
rule change, although one of these commenters recommended modifying the 
proposed rule change.\18\ Six commenters expressed general support for 
the NASD and Nasdaq's efforts to establish a maximum ECN access fee, 
but sought to have ECN access fees completely abolished.\19\ Of those 
commenters, three commenters explicitly supported approving the Nasdaq 
proposal as an interim measure.\20\ One commenter, the SIA, noted that 
its members had divergent views on the proposal, although there was 
support, albeit not unanimous support, for the proposal. According to 
the SIA, some firms viewed the cap as a fair compromise, while others 
considered it a good interim measure.\21\ Seven commenters opposed the 
proposal.\22\
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    \17\ See supra note 7.
    \18\ See BRUT Letter, Instinet/Island Letter, and Track Letter 
(strongly supporting the Nasdaq proposal, but recommending that 
Nasdaq amend the proposal to mandate that market participants pay 
the newly capped ECN access fees).
    \19\ See Dudzinski Letter, Hill Thompson Letter, Knight Letter, 
STA Letter, STANY Letter (noting that the majority of its membership 
applauded and supported the NASD's proposal), and UBS Letter.
    \20\ See Dudzinski Letter, Hill Thompson Letter, and Knight 
Letter.
    \21\ However, the SIA stated that its members believed that the 
Commission ``must act without delay to develop a market-wide 
solution that levels the playing field for all market 
participants.''
    \22\ See Bloomberg Letter, Domestic Letter, Houtkin Letter, LSC 
Letter, NexTrade Letter, PGE Letter, and Schaible Letter. Commenters 
opposed the proposal for several reasons, as more fully discussed 
herein. For example, Bloomberg believed that the Commission, not 
Nasdaq, should address the issue of access fees and PGE believed 
that the Nasdaq proposal would ``only serve to confuse the issue'' 
in light of the Commission's prior statements that it intended to 
address this issue. LSC believed that the Commission should withhold 
approval of the proposal and clarify that ECN access fees are 
anticompetitive and violate the securities laws.
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A. ECN Access Fees

    Several commenters generally supported Nasdaq's proposed maximum 
ECN access fee, because they believed that it would encourage more 
liquidity by easing fee concerns of various market

[[Page 7838]]

participants,\23\ or lower excessive burdens that are involuntarily 
imposed upon SuperMontage participants.\24\ BRUT also believed that 
Nasdaq had done an admirable job reconciling the differences among 
SuperMontage participants, while utilizing its regulatory authority in 
a non-partisan fashion.
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    \23\ See Track Letter; see also BRUT Letter.
    \24\ See UBS Letter (further stating that the Commission needs 
to act on this issue).
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1. Burden on Competition and Conflicts of Interest
    BRUT believed that the current proposal represented a fair and 
balanced effort to ``resolve an issue that has been the source of 
contention in the nation's equity markets since the Commission's 
adoption of the Order-Handling Rules in 1996.'' Further, commenters 
opined that the availability of other trading venues, such as the 
NASD's Alternative Display Facility (``ADF'') and exchanges, such as 
the Cincinnati Stock Exchange,\25\ either removed concerns that Nasdaq 
was attempting to misuse its authority at the expense of ECNs \26\ or 
provided alternatives for ECNs.\27\
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    \25\ The Commission notes the Cincinnati Stock Exchange recently 
changed its name to the National Stock Exchange. See Securities 
Exchange Act Release No. 48774 (November 12, 2003), 68 FR 65332 
(November 19, 2003).
    \26\ See BRUT Letter.
    \27\ See Instinet/Island Letter; see also Knight Letter.
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    However, several commenters believed that the proposed rule change 
was anti-competitive or an attempt by the NASD to set prices.\28\ These 
commenters believed that the proposal was designed to eliminate 
competition,\29\ require ECNs to change their business model of 
providing rebates,\30\ or force ECNs to migrate away from SuperMontage 
and its order routing capabilities.\31\ In addition, two commenters 
suggested that the proposed rule change reflected a conflict of 
interest between the NASD and Nasdaq because the NASD currently owns 
Nasdaq, and they believed that the NASD was overstepping its bounds by 
proposing a fee cap that, according to the two commenters, benefits 
Nasdaq, but hurts ECNs.\32\
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    \28\ See Domestic Letter, Houtkin Letter, NexTrade Letter, and 
Schaible Letter.
    \29\ See Domestic Letter, Houtkin Letter, NexTrade Letter, and 
Schaible Letter.
    \30\ See Domestic Letter.
    \31\ See Domestic Letter, NexTrade Letter, and Schaible Letter.
    \32\ See Houtkin Letter and Schaible Letter; see also NexTrade 
Letter (stating that Nasdaq and the NASD have a financial incentive 
to eliminate ECNs from their marketplace).
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    Nasdaq responded to commenters' concerns that Nasdaq proposed the 
access fee cap for anticompetitive reasons. Nasdaq asserted that the 
proposal was not anticompetitive because it selected a maximum ECN 
access fee cap that was closely linked to the rates charged by the most 
competitive and liquid ECNs and substantially similar to fees already 
in existence in the Nasdaq market. Nasdaq believed that this formed the 
best basis for determining an appropriate access fee cap in the absence 
of a uniform standard imposed by the Commission. Further, Nasdaq 
asserted that the Commission had repeatedly recognized that in some 
instances self-regulatory organizations (``SROs'') compete with their 
members, and that SuperMontage is a voluntary system and market 
participants that oppose the access fee cap have the option of posting 
trading interest in other market centers.
2. Best Execution
    Commenters asserted that because ECN access fees are hidden, an 
ECN's quote does not reflect the true price available at an ECN, make 
best execution difficult, and cause distortions and lack of market 
transparency.\33\ However, two commenters contended that as long as ECN 
fees remain below one cent, a customer would always receive the best 
execution, even including the ECN fee, provided that the ECN quotation 
is better than the next highest quote.\34\ NexTrade also believed that 
the forced migration of ECNs to other market centers would exacerbate 
best execution concerns, increase fragmentation, remove liquidity and 
transparency, and widen spreads since fewer participants would be 
involved in providing liquidity to Nasdaq.
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    \33\ See STA Letter and STANY Letter; see also Dudzinski Letter 
(stating that access fees can mire price discovery by masking a 
transactions true cost).
    \34\ See Houtkin Letter and NexTrade Letter.
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    In response to the comments that the proposal would exacerbate best 
execution concerns, Nasdaq stated that the proposed rule change was an 
important step in re-focusing best-execution compliance on the actual 
price of a security rather than the current pre-occupation with 
transaction costs like ECN access fees. According to Nasdaq, such 
transaction costs are highly subjective and variable across the 
universe of ECNs and counter-parties. Nasdaq believed that its proposal 
enabled users to better predict the costs of trading for their 
customers and to take appropriate actions to meet their best execution 
obligations.
3. Basis for ECN Access Fee Cap
    BRUT and Instinet/Island believed that Nasdaq had an appropriate 
basis for its access fee cap. BRUT believed that the proposal reflected 
a rate structure already in place for the vast majority of customers of 
ECNs and similar facilities on a volume-weighted basis, and preserved 
consistency with Nasdaq's own access fee. Instinet/Island also 
emphasized that if the proposal was adopted, the maximum difference in 
total transaction fees in a SuperMontage transaction involving both 
non-access fee charging participants and fee charging ECNs would be 
reduced from the current $0.007 per share to $0.001 per share.
    Further, Instinet/Island opined that ``[c]ertain ECNs are charging 
access fees in SuperMontage that bear no relation to the market's value 
of the service they are providing, as clearly evidenced by the fact 
that as a result of competition, the significant entities in the 
provision of this service (i.e., Archipelago Exchange, BRUT, Instinet, 
Island, and NASDAQ) all charge access fees at a level equal to or below 
$0.003 per share. In effect, certain ECNs on SuperMontage are taking 
advantage of SuperMontage's order processing behavior to extract 
economic rents from other SuperMontage users.'' According to Instinet/
Island, SIA, and UBS, disparities are of particular concern in an 
automated system like SuperMontage that matches buying and selling 
interest through execution algorithms that limit the ability of users 
to select or anticipate their counter-parties to a particular 
trade.\35\ Knight also stated that as a result of the disparity in ECN 
access fees, an ECN access fee could raise Knight's execution cost in 
SuperMontage anywhere from 23 percent to 233 percent.\36\
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    \35\ See also Hill Thompson Letter and Knight Letter (noting 
there is no competition with respect to access fees in 
SuperMontage).
    \36\ According to UBS, the ``seemingly random manner of this 
assessment and the current wide disparity among the fees themselves, 
deprives non-ECN market participants of the ability to effectively 
forecast execution fees.''
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    Other commenters believed that Nasdaq failed to provide a basis for 
its proposal \37\ and arbitrarily proposed a rate equal to the rate 
Nasdaq already charges.\38\ NexTrade believed that the Commission 
permitted an access fee of $0.009.\39\ Further, NexTrade and Schaible 
believed that Nasdaq set the maximum ECN fee too low and that it would 
be impossible to charge $0.003

[[Page 7839]]

per share and remain profitable.\40\ They also believed that Nasdaq's 
current fee schedule was inconsistent with the Nasdaq's proposed rule 
change to establish a maximum $0.003 access fee because Nasdaq charged 
more than three-tenths of a cent for transactions occurring on 
SuperMontage. However, Knight, for example, distinguished between fees 
charged by market centers to which members or subscribers voluntarily 
route orders to, and fees charged by ECNs through SuperMontage for 
orders that may be involuntarily routed to the ECNs as a result of the 
SuperMontage execution algorithm.\41\
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    \37\ See Domestic Letter, Houtkin Letter and NexTrade Letter.
    \38\ See Bloomberg Letter and Houtkin Letter.
    \39\ See also Schaible Letter.
    \40\ Several commenters recommended alternatives to Nasdaq's 
proposal. See Domestic Letter, Houtkin Letter, LSC Letter, and 
Schaible Letter. For example, Domestic and Houtkin suggested raising 
the maximum fee to $0.005 or $0.009, respectively.
    \41\ See also Dudzinski Letter and SIA Letter. Dudzinski 
believed that any system has a right to charge for the voluntary 
submission of orders, and that this would ensure innovation through 
competition.
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    In response to these commenters, Nasdaq stated that it decided on 
the maximum $0.003 access fee based on its understanding of the 
current, competitively-derived, fee structure and the need to allow 
further competition on fees. In Nasdaq's view, the lack of notice to 
counter-parties as to their expected costs because of the range in ECN 
access fees when utilizing SuperMontage impacts the willingness of 
market participants to use the system. Nasdaq disagreed with the 
assertion of one commenter that informing market participants of the 
highest possible fee, $0.009, would solve this problem since such an 
approach would deter market participants that consider potential 
transaction costs from routing orders to SuperMontage. Nasdaq also 
distinguished between the fees it charges and the fees charged by ECNs. 
According to Nasdaq, its fees are public, equally applicable to all 
users, and subject to specific Commission review. In addition, Nasdaq 
believed that the access fees at the heart of its proposal are those 
that ECNs seek to impose, not on subscribers interacting directly using 
the ECN's systems, but counter-parties who interact with them only 
because of SuperMontage's neutral execution algorithms.
4. Consistency With Sections 6(e) and 15A of the Act
    Instinet/Island believed that the proposed ECN access fee cap was 
consistent with section 15A of the Act. Further, BRUT believed that the 
authority of SROs to police access fees in the facilities they operate 
was well established and cited to the Commission's releases approving 
the Order Handling Rules and Regulation ATS as support.\42\
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    \42\ See Securities Exchange Act Release No. 40760 (December 8, 
1998), 63 FR 70844 (December 22, 1998) (``Regulation ATS Release''); 
and Securities Exchange Act Release No. 37619A (September 6, 1996), 
61 FR 48290 (September 12, 1996) (``Order Handling Rules Release'').
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    Bloomberg and LSC, however, believed that the Nasdaq proposal was 
inconsistent with section 6(e)(1) of the Act, which prohibits a 
national securities exchange from fixing rates of commissions, 
allowances, discounts or other fees.\43\ In addition, PGE, which 
opposed the proposal, and Hill Thompson, which supported the proposal, 
both believed that it was inconsistent with section 15A of the Act to 
allow one group of market participants to charge access fees, while 
requiring other market participants to provide access to their quotes/
orders free of charge. Additionally, Schaible believed that the 
proposal was inconsistent with the Order Handling Rules.
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    \43\ LSC agreed with Nasdaq that ECNs imposing access fees on 
other participants as they see fit might constitute a fraudulent and 
manipulative act and violate just and equitable principals of trade 
for purposes of section 15A of the Act, but asserted that fixing 
commissions was also violative of section 6(e) of the Act and not 
the solution. See LSC Letter.
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    Nasdaq disagreed with commenters who asserted that the proposal was 
inconsistent with section 6(e) of the Act. With respect to section 6(e) 
of the Act, Nasdaq stated that because it is not yet registered as a 
national securities exchange, section 6(e) is currently inapplicable to 
the proposal. Nasdaq believed, however, that Regulation ATS 
specifically permits exchanges to establish access fee standards.

B. Elimination of SuperMontage Algorithms

    Several commenters supported the elimination of the two algorithms, 
in particular the algorithm that takes into account fees.\44\ 
Specifically, Track believed that the elimination of the Price/Time 
algorithm that took into account fees would benefit ECNs participating 
in SuperMontage by providing them with the same price/time priority as 
other participants and thus, leveling the playing field.\45\ Further, 
BRUT and Instinet/Island opined that the algorithm taking into account 
ECN access fees could no longer be justified if the ECN access fee cap 
was adopted.
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    \44\ See BRUT Letter, Instinet/Island Letter, and Track Letter.
    \45\ See also BRUT Letter.
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    PGE, however, opposed the elimination of the Price/Time algorithm 
that takes into account fees until the market structure and associated 
legal issues surrounding ECN access fees were resolved to ensure a 
choice with regard to incurring such fees. The SIA stated that while 
some of its firms supported the complete elimination of both algorithms 
because they would no longer be necessary, other members supported 
retaining the algorithms.
    In response, Nasdaq stated that it linked the establishment of the 
maximum ECN access fee with the elimination of the Price/Time with fee 
consideration algorithm to foster price/time priority within 
SuperMontage. Nasdaq believed that the establishment of a maximum 
access fee cap created the appropriate framework to eliminate the 
execution algorithm that considered ECN access fees.

IV. Discussion

    The Commission has carefully reviewed the proposed rule change, the 
comment letters, and Nasdaq's response to comment letters, and finds 
that the proposed rule change, as amended, is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities association.\46\ In particular, the 
Commission finds that the proposed rule change, as amended, is 
consistent with section 15A(b)(6) of the Act because it is designed to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in regulating, clearing, 
settling, processing information with respect to, and facilitating 
transactions in securities, to remove impediments to and perfect the 
mechanism of a free and open market and a national market system, and, 
in general, to protect investors and the public interest; and is not 
designed to permit unfair discrimination between customers, issuers, 
brokers, or dealers, to fix minimum profits, to impose any schedule or 
fix rates of commissions, allowances, discounts, or other fees to be 
charged by its members.\47\ For the reasons discussed below, the 
Commission finds that Nasdaq's proposal to establish a maximum ECN 
access fee and to eliminate the two execution algorithms is consistent 
with the Act.\48\
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    \46\ In approving this proposal, as amended, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \47\ 15 U.S.C. 78o-3(b)(6).
    \48\ In approving the proposed rule change pursuant to Section 
19(b)(2) of the Act, 15 U.S.C. 78s(b)(2), the Commission is not 
required to, and has not determined that, the proposed rule change 
is the only appropriate mechanism to achieve Nasdaq's goals.

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[[Page 7840]]

A. Nasdaq's Proposed Maximum ECN Access Fee

    Rule 301(b)(4) of Regulation ATS provides, in relevant part, that 
an ATS \49\ shall not charge any fee to broker-dealers that access the 
ATS through a national securities association that is inconsistent with 
equivalent access to the ATS.\50\ In addition, if a national securities 
association establishes rules designed to assure consistency with 
standards for access to quotations displayed in the association, the 
ATS cannot charge any fee to members that is contrary to or 
inconsistent with any standard of equivalent access established by the 
rules. In the Regulation ATS Release, the Commission stated that fees 
charged by an ATS would be inconsistent with equivalent access if they 
had the effect of creating barriers to access for non-subscribers.\51\ 
Further, the Commission believed that ECN fees should be similar to the 
communications or systems charges imposed by various markets \52\ and 
that SROs should have the authority to assure that fees charged to non-
subscribers were consistent with the fees typically charged by the 
members of the SRO for access to displayed orders.\53\ For example, an 
association could establish a standard for what constitutes a fair and 
reasonable fee for non-subscriber access to an ATS, consistent with the 
effective operation of the SRO's market and the Commission's equivalent 
access requirement.\54\ The Commission contemplated at the time that 
SROs could limit (or eliminate entirely) access fees, subject to 
Commission review.\55\
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    \49\ An ECN is a subgroup of ATSs.
    \50\ 17 CFR 242.301(b)(4).
    \51\ See Regulation ATS Release, supra note 42, at 70871; See 
also Order Handling Rules Release, supra note 42, at note 272.
    \52\ See Regulation ATS Release, supra note 42, at 70871.
    \53\ See Regulation ATS Release, supra note 42, at 70871; See 
also ``Interpretive Guidance on the Order Execution Rules,'' letter 
from Richard R. Lindsey, Director, Division, Commission, to Richard 
Grasso, Chairman and Chief Executive Officer, New York Stock 
Exchange, Inc., dated November 22, 1996 (``Interpretive Guide''), at 
12. In the Interpretive Guidance, the Division stated that ``an SRO 
may set reasonable conditions on whether an ECN should be allowed 
access to the SRO's market,'' and added that ``an SRO may require 
that the prices displayed in its market by an ECN not include fees 
or other charges if the SRO believes this is necessary to make these 
prices consistent with other quotes in its market.'' See 
Interpretive Guide, at 11-12.
    \54\ See Regulation ATS Release, supra note 42, at 70871.
    \55\ See Regulation ATS Release, supra note 42, at 70872.
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    Specifically, the Commission stated that for a rule to be approved 
by the Commission, the rule must be necessary to maintain consistency 
within the SRO's market, and be designed to promote just and equitable 
principles of trade, to promote fair competition, to facilitate 
transactions in securities, and in general, to protect investors and 
the public interest. The Commission believes that Nasdaq's proposal 
satisfies these requirements and is consistent with the Act.
    The Commission recognizes that, over the years, certain ECNs have 
based their business models on charging access fees well above the 
access fees charged by other ECNs. The Commission agrees with 
commenters that such disparity in ECN access fees in a system like 
SuperMontage, which extensively automates the matching of buy and sell 
trading interest using execution algorithms, has had a detrimental 
impact on the system and its users. In particular, the Commission notes 
that the inability of system users to reasonably anticipate their 
trading costs due to hidden ECN access fees may discourage market 
participants from entering their quotes/orders into SuperMontage, 
thereby depriving all SuperMontage users of beneficial liquidity.\56\ 
Consequently, the Commission believes that Nasdaq's proposal may 
attract new order flow to SuperMontage, increasing liquidity and 
promoting greater competition among market centers.
---------------------------------------------------------------------------

    \56\ See Notice, supra note 5 and Track Letter; See also BRUT 
Letter.
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    Furthermore, the Commission believes that Nasdaq's proposal to set 
a maximum ECN cap is necessary to maintain consistency within the 
Nasdaq market and with the equivalent access requirement. Some of the 
current ECN access fees for ECNs that elect to participate in 
SuperMontage are not consistent with the fees typically charged by 
other NASD members and, thus, may discourage non-subscriber broker-
dealers from accessing ECN prices. In practice, some ECNs charge 
considerably more than other ECNs, and this may be due in part to the 
lack of competition with respect to access fees in SuperMontage.\57\ As 
a result, the Commission believes that some ECNs may rely on 
SuperMontage's order processing in order to charge higher fees to other 
SuperMontage users and still receive orders through SuperMontage. As 
indicated by Knight, differences in ECN access fees can add significant 
non-transparent costs to securities transactions. This may be 
inconsistent with the fair access standards imposed in the Order 
Handling Rules and Regulation ATS. Further, as noted by PGE and Hill 
Thompson, market makers, unlike ECNs, are prohibited from charging an 
access fee in addition to their posted quote.\58\ Approval of the 
proposed rule change should help assure that no SuperMontage 
participant will be able to impose a fee that results in substantially 
higher execution costs to other participants, consistent with the 
equivalent access requirement.\59\ As one commenter noted, the proposed 
rule change would effectively reduce the disparity in transaction costs 
between non-access fee charging participants and fee charging ECNs from 
$0.007 to $0.001 per share.\60\ The Commission, therefore, believes 
that the proposed maximum access fee cap should promote fair 
competition and just and equitable principles of trade within the 
Nasdaq market and is consistent with the protection of investors and 
the public interest.
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    \57\ See Instinet/Island Letter. The Commission notes that the 
following ECNs charge approximately three mils: BRUT's access fee 
for subscribers executing over 50,000 shares per day is currently 
$0.0027 per share, while subscribers under this threshold are 
currently charged $0.005 per share; INET charges $0.003 for trades 
that remove liquidity from the INET book; and Track charges up to 
$0.0029 for orders that remove liquidity from its book. See BRUT 
Letter (noting that BRUT anticipates modifying its rate structure 
upon approval of the proposed rule change); http://www.island.com/prodserv/bd/fee/fee.asp; and http://www.trackecn.com. NexTrade, 
however, on its website, merely stated that the ``SEC has authorized 
NexTrade to charge a rate up to $0.009 per share for each order 
matched on NexTrade's ECN.'' See http://www.nextrade.com/company/overview.asp. The Commission notes, however, that it has not 
expressed a view regarding the appropriateness of any specific 
access fee.
    \58\ Market makers are prohibited from charging access fees 
under the Quote Rule. See Rule 11Ac1-1(c)(2), 17 CFR 240.11Ac1-
1(c)(2).
    \59\ See Regulation ATS Release, supra note 42, at 70870-70871.
    \60\ See NASD Rule 7010(i). Generally, Nasdaq participants are 
charged between $0.0025 and $0.003 for non-directed orders that 
access the quotes/orders of market participants that do not charge a 
fee, while Nasdaq participants that access the quotes/orders of 
market participants that charge a fee are charged $0.001 plus the 
ECN fee. See Securities Exchange Act Release No. 48972 (December 22, 
2003), 68 FR 75301 (December 30, 2003). With the approval of the 
proposed rule change and the maximum ECN access fee of $0.003, the 
difference between accessing a fee charging participant and a non-
fee charging participant is essentially $0.001.
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    The Commission also believes that the Nasdaq proposal should 
encourage greater transparency by maintaining a closer relationship 
between displayed prices in the montage and effective execution prices 
obtained by market participants that interact with fee-charging ECNs. 
As a result, the maximum access fee cap may further facilitate 
transactions in securities by allowing market participants to rely on 
comparability of quotations across all participants within 
SuperMontage.

[[Page 7841]]

    Furthermore, the Commission believes that Nasdaq has adequately 
addressed concerns regarding the basis for its maximum access fee. The 
Commission believes that Nasdaq, in proposing this maximum ECN access 
fee, has attempted to accommodate the business models of ECNs with 
other SuperMontage users and the manner in which they participate in 
SuperMontage. As a result, the Commission believes that the maximum ECN 
access fee of $0.003 should help to ensure a more level playing field 
for market participants that elect to participate in SuperMontage.
    The Commission also believes that Nasdaq has adequately addressed 
concerns regarding Nasdaq's basis for the competitive impact of the 
proposed rule change and the conflict of interest between Nasdaq and 
the NASD. According to Nasdaq, the proposal was not anti-competitive 
because it selected a maximum ECN access fee cap that was closely 
linked to the rates charged by the most competitive and liquid ECNs and 
substantially similar to fees already in existence in the Nasdaq 
market. Further, Nasdaq asserted that the Commission had repeatedly 
recognized that in some instances SROs compete with their members, and 
that SuperMontage is a voluntary system and market participants that 
oppose the access fee cap have the option of posting trading interest 
in other market centers.
    The Commission has previously recognized that conflicting roles are 
inherent in the SRO model since SROs act not only as regulators, but 
also as operators of markets. \61\ The Commission does not believe that 
the proposed rule change is anti-competitive since Nasdaq has the 
authority (delegated by the NASD), consistent with Rule 301(b)(4), to 
establish rules designed to assure consistency with standards of access 
to quotations displayed on its facilities, subject to Commission 
approval. The Commission believes that the effect of the proposed rule 
change is not to limit competition with SuperMontage but to prevent 
ECNs from using SuperMontage to impose non-competitive fees on other 
SuperMontage participants. As discussed above, the Commission believes 
that the proposed rule change is consistent with the requirements of 
the Act and rules and regulations thereunder. While NexTrade and 
Schaible contend that Nasdaq charges more than $0.003, the Commission 
notes that Nasdaq does not charge for the entry or cancellation of non-
directed orders (other than the entry of orders preferenced to a 
particular market participant) into SuperMontage \62\ and that Nasdaq 
only charges up to $0.003 per share for orders executed within 
SuperMontage, which is consistent with the proposed rule change.\63\ To 
the extent ECNs want to charge fees in excess of $0.003, the Commission 
notes that participation on SuperMontage is voluntary and that ECNs are 
free to trade on other venues. In response to suggestions that the NASD 
has a conflict of interest relating to Nasdaq and is seeking to exclude 
ECNs that compete within SuperMontage, the Commission notes that the 
access fee cap is intended to encourage entry of orders into 
SuperMontage, and thereby encourage participation by market makers and 
ECNs.
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    \61\ See Securities Exchange Act Release No. 43863 (January 19, 
2001), 66 FR 8020 (January 26, 2001).
    \62\ See NASD Rule 7010(i).
    \63\ See NASD Rule 7010(i) and note 58; see also Securities 
Exchange Act Release No. 48972 (December 22, 2003), 68 FR 75301 
(December 30, 2003). The fees for entering or canceling directed or 
preferenced orders are higher. However, in that instance, the market 
participant entering the order has voluntarily, using SuperMontage, 
sent the order to a particular market participant, and is aware of 
the applicable fees that will be charged in SuperMontage. See NASD 
Rule 7010(i). Market participants, however, can and do access other 
market participants outside of SuperMontage.
---------------------------------------------------------------------------

    The Commission also notes that some commenters believed that Nasdaq 
should not be allowed to set a maximum ECN access fee at all because 
doing so would be inconsistent with section 6(e) of the Act.\64\ In 
particular, Bloomberg and LSC opined that the proposal was inconsistent 
with section 6(e)(1) of the Act because the proposal fixed the rates of 
fees charged by members of a national securities exchange.\65\ 
According to Bloomberg, ``[w]hile section 6(e)(1) was adopted to deal 
specifically with the rules of national securities exchanges that * * * 
had fixed minimum brokerage commission rates, the section cuts more 
broadly than that and also prohibits fixed maximum rates of 
commissions, allowances, discounts or other fees.''
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    \64\ See LSC Letter, PGE Letter, and Hill Thompson Letter. The 
Commission notes that, although Nasdaq is currently not a national 
securities exchange and that Section 6(e)(1) does not apply to it, 
Nasdaq does have an exchange application pending with the 
Commission. See Securities Exchange Act Release No. 44396 (June 7, 
2001), 66 FR 31952 (June 13, 2001) (File No. 10-131). In addition, 
the Commission notes that Section 15A(b)(6) of the Act contains 
language similar to Section 6(e)(1).
    \65\ LSC further stated that ``there can be no doubt about the 
fact that with the Securities Act Amendments of 1975 Congress banned 
a system of fixed regulated commissions in favor of competition.''
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    Section 6(e)(1) was adopted by Congress in 1975 to statutorily 
prohibit the fixed minimum commission rate system.\66\ Congress 
prohibited any national securities exchange from fixing commissions and 
fees to be charged by its members unless they were first filed with the 
Commission pursuant to section 19(b) of the Act and were found by the 
Commission to be ``reasonable in relation to the costs of providing the 
service and necessary to accomplish the purposes of the Exchange Act.'' 
\67\ Section 6(e)(1) of the Act, in relevant part, provides that ``no 
national securities exchange may impose any schedule or fix rates of 
commissions, allowances, discounts, or other fees to be charged by its 
members * * *.'' \68\ In addition, section 15A(b)(6) of the Act, in 
relevant part, provides that an association of brokers and dealers 
shall not be registered as a national securities association unless the 
Commission determines that the rules of the association ``are not 
designed to permit unfair discrimination between customers, issuers, 
brokers, or dealers, to fix minimum profits, to impose any schedule or 
fix rates of commissions, allowances, discounts, or other fees charged 
by its members * * *.'' \69\
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    \66\ H.R. Rep. No. 94-123, 94th Cong., 1st Sess. 42 (1975) 
(``House Report'').
    \67\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 61 (1975).
    \68\ 15 U.S.C 78f(e)(1).
    \69\ 15 U.S.C 78o-3(b)(6).
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    The Commission has considered the commenters' concerns regarding 
this issue and has determined that the provisions of sections 6(e)(1) 
and 15A(b)(6) of the Act regarding fixed commissions are not implicated 
by Nasdaq's proposal. As noted in the House Report, one of the purposes 
of the legislation was to ``reverse the industry practice of charging 
fixed rates of commissions for transactions on the securities 
exchanges.'' \70\ The fixed minimum commission rate system allowed 
exchanges to set minimum commission rates their members had to charge 
their customers, but allowed members to charge more. The House Report 
further noted that this practice had produced distortions in trading 
patterns, impacted unfairly on various classes of investors, and 
erected competitive impediments to the development of an efficient 
national market system, and stated that fully competitive commission 
rates are necessary to the efficient functioning of the securities 
markets.
---------------------------------------------------------------------------

    \70\ See House Report, supra note 66.
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    The Commission does not believe that Nasdaq's proposal to establish 
a maximum ECN access fee of $0.003 constitutes fixing commissions, 
allowances, discounts or other fees for purposes of sections 6(e)(1) 
and

[[Page 7842]]

15A(b)(6) because Nasdaq's proposal allows ECNs participating in 
SuperMontage the ability to charge a range of other rates--anything 
from no fee to $0.003.\71\ In addition, the maximum ECN access fee 
applies only to ECNs that choose to participate in SuperMontage. 
Therefore, Nasdaq is not fixing fees generally; it is merely imposing a 
condition, consistent with the equivalent access requirement, for 
receiving executions through SuperMontage. ECNs that want to charge 
more than $0.003 can send their quotes/orders to other venues, such as 
the ADF. Furthermore, ECNs that choose to charge more than $0.003 would 
not be completely barred from participating in SuperMontage. Such ECNs 
could elect to participate in, for example, the ADF and charge more 
than $0.003 per share, and would still be permitted to access and post 
liquidity in SuperMontage as an NNMS Order Entry Firm, but could not 
charge any access fee in SuperMontage.\72\ As NNMS Order Entry Firms, 
those ECNs would have any quotes/orders entered into SuperMontage 
displayed and processed in the same manner as other NNMS Order Entry 
Firms and would be entitled to receive a liquidity provider rebate. 
Furthermore, the Commission agrees with BRUT and Nasdaq that an SRO's 
ability to establish access fee standards is specifically permitted by 
Regulation ATS. Accordingly, the Commission believes sections 6(e) and 
15A(b)(6) of the Act are not implicated by Nasdaq's proposal and 
believes that Nasdaq has reasonably attempted to balance the divergent 
interests of SuperMontage users, including ECNs, in a manner consistent 
with the Act.
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    \71\ Currently, pursuant to a series of no-action letters issued 
by the Division, ECNs may charge fees to non-subscribers in amounts 
equal to those that they charge a ``substantial proportion'' of 
their active broker-dealers subscribers, but no more than $0.009 per 
share. The Commission has not, however, expressed a view regarding 
the appropriateness of any specific access fee. No-action letters 
are posted to the Commission's Web site at http://www.sec.gov/divisions/marketreg/mr-noaction.htm#ecns.
    \72\ Telephone conversation between Thomas P. Moran, Associate 
General Counsel, Nasdaq, and Sapna C. Patel, Special Counsel, 
Division, Commission, on January 27, 2004.
---------------------------------------------------------------------------

    Two commenters stated that as long as ECN access fees remain below 
$0.01, a customer will always receive best execution (even with the 
access fee included in the price), if the ECN's quote is better than 
the quote at the next price level.\73\ In addition, NexTrade believed 
that Nasdaq's proposal would force ECNs to other market centers, 
thereby exacerbating best execution concerns.\74\
---------------------------------------------------------------------------

    \73\ See Houtkin Letter and NexTrade Letter.
    \74\ NexTrade added that Nasdaq failed to study the impact of 
its proposal on best execution and investors.
---------------------------------------------------------------------------

    The Commission notes that the argument raised by Houtkin and 
NexTrade is applicable only if ECNs that charge the highest access fees 
are the last trading interest to be accessed at a particular price 
level. Otherwise, their higher fees result in inferior executions at 
the same displayed price. Furthermore, to the extent that some ECNs 
charge higher access fees, these fees would substantially reduce the 
value of these quotes, so that the net price offered is at times 
minimally better than the next best displayed price. If the fee cap 
reduces the fees attached to these quotes, the resulting net price 
would be improved. Moreover, the Commission believes that the fee cap 
may encourage greater use of the system, which could encourage market 
makers and ECNs to offer better prices in the system, improving the 
execution of orders and thus, enhancing competition. Furthermore, 
Nasdaq is proposing to remove the algorithms that take into account 
size or access fees from SuperMontage.\75\ As a result, the orders of 
ECNs would be accessed under the same Price/Time priority algorithm as 
other market participants, instead of potentially being accessed last 
as a result of the ``Price/Time with fee consideration'' algorithm.\76\ 
To the extent there are concerns about increased fragmentation in the 
event ECNs migrate out of SuperMontage, the Commission notes that ECNs 
are currently able to and do participate in other markets.
    The Commission believes that Nasdaq's proposal to establish a 
maximum ECN access fee should help to alleviate the concerns of market 
participants relating to their ability to obtain the best execution for 
customer orders. The Commission notes that some commenters raised best 
execution concerns related to hidden ECN access fees.\77\ Currently, 
there is limited incentive for ECNs within SuperMontage to reduce their 
access fees on their own. Therefore, the Commission believes that 
capping ECN access fees at $0.003 per share should reduce fee 
disparities among ECNs within SuperMontage and enable market 
participants to ensure that their customers' orders receive best 
execution.
---------------------------------------------------------------------------

    \75\ See supra note 15 and accompanying text.
    \76\ Id.; see also discussion in supra notes 57 through 58 and 
accompanying text.
    \77\ See STA Letter and STANY Letter; see also Dudzinski Letter.
---------------------------------------------------------------------------

B. Elimination of the Price/Time With Fee Consideration and Price/Size 
Algorithms

    The Commission believes that the elimination of the Price/Time with 
fee consideration execution algorithm in connection with Nasdaq's 
proposed maximum ECN access fee is reasonable. The Commission notes 
that, while several commenters supported eliminating the algorithm,\78\ 
PGE and some members of the SIA opposed the elimination of the Price/
Time with fees algorithm, even with the proposed fee cap. The 
Commission believes that Nasdaq's proposal balances the interests of 
its market participants and is reasonable in light of Nasdaq's proposed 
access fee cap. The Commission also believes that the elimination of 
the Price/Size algorithm, along with the Price/Time with fees 
algorithm, should allow Nasdaq to reduce system complexity within 
SuperMontage by eliminating two of three algorithms and promote greater 
price/time priority within the system.\79\
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    \78\ See BRUT Letter, Instinet/Island Letter, and Track Letter.
    \79\ According to Nasdaq, the Price/Size algorithm is rarely 
used in SuperMontage and accounts for less than seven percent of 
orders entered into the system. See Notice, supra note 5.
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\80\ that the proposed rule change (SR-NASD-2003-128), as amended, 
be, and hereby is, approved.
---------------------------------------------------------------------------

    \80\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\81\
---------------------------------------------------------------------------

    \81\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-3540 Filed 2-18-04; 8:45 am]
BILLING CODE 8010-01-P