1 See Memorandum to Equity Markets Advisory Committee No. 9-00 and SEC Rules Committee No. 26-00, dated
February 25, 2000.
[11835]
April 25, 2000
TO: EQUITY MARKETS ADVISORY COMMITTEE No. 29-00
SEC RULES COMMITTEE No. 65-00
RE: DRAFT INSTITUTE COMMENT LETTER ON SEC MARKET FRAGMENTATION
CONCEPT RELEASE
______________________________________________________________________________
As we previously informed you,1 the Securities and Exchange Commission has issued a Concept
Release requesting comment on a broad range of issues relating to market fragmentation. The Institute
has prepared a draft comment letter (a copy of which is attached) on the Concept Release. The
comment letter first addresses our concerns with current market structures, in particular those that have
contributed to fragmentation. The letter then discusses the Institute’s recommendations to address
these concerns. Our principal recommendation is that the Commission should establish a price/time
priority rule for displayed orders across all markets.
I. Concerns Regarding Fragmentation
The letter states that fragmentation adversely affects the ability of customer orders to interact
with one another as broadly as possible and can therefore force mutual funds and other investors to look
to several different sources to find sufficient liquidity to effectively complete a trade, especially a large
trade, at the best price. The letter then discusses several factors which can cause fragmentation,
including internalization, the lack of priority rules across markets, inadequate linkages among markets,
and inadequate transparency.
In particular, the letter states that when a broker-dealer internalizes its orders, those orders are
not exposed to other orders in the marketplace, which can adversely affect liquidity and transparency.
The letter also questions whether and to what extent brokers can adequately fulfill their duty of best
execution if they internalize order flow, as orders that are routed pursuant to internalization
arrangements may not receive as favorable executions as orders not subject to such arrangements.
The letter also notes that currently there are no rules providing for intermarket time priority for
investor limit orders. Therefore, a market participant that publicly displays a limit order setting a new
best price in a market is not guaranteed that the order will ever be filled as that order has no priority
across markets. Finally, the letter discusses the
2weaknesses associated with the two primary linkages in the securities markets, the Intermarket Trading
System in the listed market and SelectNet in the over-the-counter market, and the lack of transparency
of prices in the securities markets and its effect on liquidity and the price discovery process.
II. Institute Recommendations on Market Structure
The letter states that after careful consideration, the Institute has concluded that the best way to
address the shortcomings in the securities markets is to mandate price/time priority across all markets.
This will ensure that those investors that are displaying limit orders will be afforded protection and
priority for such orders and will thus realize the benefits of displaying these orders, thereby encouraging
further use of limit orders. Therefore, the letter states that the Institute favors the sixth option proposed
by the Commission in the Concept Release, which would provide price/time priority to all displayed
orders, as the preferred option for structuring the securities market.
A. Price/Time Priority
The letter states that a price/time priority rule will rectify the problem of an investor placing a
limit order that sets the new best bid or offer in one market and not having that order executed while
other market centers trade at that price. The Concept Release requests comment on whether a market
structure employing price/time priority should incorporate a reserve size function and whether there
should be any exceptions from a price/time priority requirement for block transactions or for intra-
market agency crosses at the NBBO. The letter states that markets should be able (but not required) to
provide for a reserve size function. The letter further states that while Institute members, as institutional
investors, frequently make use of block transactions and intra-market agency crosses at the NBBO, we
believe it is important that there be consistent rules in the market and that orders of any size and dollar
amount be required to interact with one another.
1. Concerns Raised Regarding Price/Time Priority
The letter also addresses several objections that have been raised to a system mandating
price/time priority. For example, opponents of price/time priority argue that such a system would
require a single industry utility to operate the system, thereby creating a single point of failure that could
shut down all securities markets. The letter states that the Institute does not believe that a price/time
priority system needs to be structured in this manner and that the Commission should permit markets
themselves to determine how to structure linkages that would provide access to all markets and route
orders according to price/time priority.
Arguments also have been put forth that a price/time priority system removes incentives for
intermarket competition. The letter states that we believe that there will still be a variety of ways in
which markets can, and will, seek to distinguish themselves from other market centers within the broad
framework of a price/time priority system, e.g., through anonymity, reserve book features, reliability, cost
of execution.
Finally, many market participants contend that price/time priority will be illusory in a decimal
environment because even if an investor places a price setting limit order in one market, a participant in
another market can simply provide for price improvement by a de minimis amount and obtain priority
over that investor’s order while risking, in many cases, no more than an additional penny. The letter
states that the Institute disagrees with this argument and that even small price improvements can benefit
investors.
32. Alternatives to Intermarket Price/Time Priority
The letter also addresses several alternatives to intermarket price/time priority proposed by the
Commission in the Concept Release. For example, under one version, the Commission would provide
priority only to customer limit orders and would not include broker-dealer principal trades. The letter
states that we see no purpose in drawing these distinctions between customer orders and proprietary
orders and that both of these types of orders provide liquidity to the markets and facilitate price
discovery.
Under another option proposed by the Commission, the Commission would establish
intermarket trading priorities that granted time priority only to the first limit order or dealer quotation that
improved the NBBO for a security. The letter states that we believe that it is inadequate to grant time
priority only to the first trading interest to improve the NBBO and that subsequent orders or quotations
that match the improved price also are valuable to the markets as they indicate greater depth at that
price.
B. Other Recommendations
The letter also discusses several other Institute recommendations for a revised market structure
including a price improvement requirement and a requirement for increased transparency. In particular,
one of the options suggested by the Commission in the Concept Release would require that broker-
dealers only internalize customer order flow if they provide for price improvement, i.e., a price that is
better than the national best bid or offer against which the order might otherwise be executed. The
letter states that the Institute strongly supports such a requirement and believes that this requirement
would promote the interaction of orders in the securities markets and discourage internalization, or at
least help ensure that investors receive a fairer price for internalized orders. In addition, the letter states
that increased transparency and depth of book also are vital elements to an effective market structure
with price/time priority. We therefore recommend that the Commission adopt a requirement that
market centers make available for public viewing a minimum amount of their limit order book, if not the
entire book.
If you have any comments on the draft Institute letter, please provide them to the
undersigned by phone at (202) 371-5408, by fax at (202) 326-5839, or by e-mail at aburstein@ici.org
no later than Monday, May 1.
Ari Burstein
Assistant Counsel
Attachment