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Request for Rulemaking under the Securities Exchange Act of 1934 to Adopt New Rule 11Ac1-8 To Address the Practices of Trading-Through and Locking or Crossing OTC Quotes Across Separate Market Centers4/14/2003 Mr. Jonathon Katz
Re: Petition for Rulemaking Dear Mr. Katz: NexTrade Holdings Inc., the parent company of NexTrade, Inc. ("NexTrade"), which owns and operates the NexTrade ECN, hereby petitions the Securities and Exchange Commission ("Commission")1 to adopt new Rule 11Ac1-8 pursuant to Section 11A of the Securities Exchange Act of 1934 ("Exchange Act") to address serious flaws in the integrity of market structure; the practices of trading-through and locking or crossing OTC quotes across separate market centers. Specifically, NexTrade requests that the Commission propose and adopt the attached Rule 11Ac1-8 or a substantially similar rule, to eliminate the practice of exchanges, market participants, ECNs and ATSs trading-through or locking and crossing previous OTC limit orders displayed in accordance with SEC Rule 11Ac1-4. Additionally, NexTrade hereby petitions the Commission to amend rule 11Ac1-4 to address market center access fees in order to reduce the economic incentive of market centers to trade-through and lock or cross previous OTC limit orders displayed in accordance with SEC Rule 11Ac1-4. As the Commission knows, NexTrade has submitted that the Alternative Display Facility ("ADF") is dysfunctional to the point of failure. NexTrade has argued that the core flaw of the ADF rests in Rule 4300, which has forced the ADF to attempt to operate as an allegedly viable exchange without an execution mechanism. During the approval process of the ADF, NexTrade warned the Commission that the current network of interconnectivity between brokerage firms had not propagated sufficiently to allow smaller firms the ability to satisfy their obligations under the Act if such firms choose to operate in the ADF. Since NexTrade's launch date in the ADF, December 23, 2002, NexTrade has validated all of its warnings to the Commission about the ADF's non-viability. Most of the trades NexTrade executes in the ADF are conducted at inferior prices to the NBBO. Nearly all of the quotes NexTrade posts to the ADF end up being locked or crossed prior to execution. As a consequence, customers using NexTrade through ADF are not receiving Best Execution protection on their trades. Ultimately, this inability to provide Best Execution will lead to the failure of NexTrade, other ECNs, market participants, and the ADF, ultimately to the detriment of the American investor. Unfortunately, the flaws of the ADF are being exacerbated by the continuing evolution of the OTC market structure. Prior to the threatened launch of SuperMontage, the OTC market liquidity was largely concentrated in the Nasdaq. However, since the Nasdaq made the decision to compete against its members and launch the for-profit ATS (and eventually a for-profit exchange), SuperMontage, most of the liquidity has fled to other market centers. In today's OTC marketplace, participants send their liquidity to any of six distinct market centers, none of which are bound by a common trade rule that would otherwise prevent trade-throughs and locked or crossed markets. Moreover, the problems of trade-throughs and locked or crossed markets are further fueled by the nearly universal fee structures of the existing market centers, which all pay market participants to add liquidity while charging to subtract liquidity. As a result of this common structure, it is far better, economically, for a market participant to lock or cross another quote in order to add liquidity rather than subtract liquidity. For example, if a market center rebates $.005 per share for adding liquidity while another market center charges $.009 per share for subtracting liquidity, the difference to the market participant that manages to deftly circumnavigate these different centers is $.014 per share. In light of the very tough times in the market, and the apparent total disregard from the SROs regarding Best Execution across market centers, market participants are highly motivated to put the bottom line in front of getting the best price for individual investors. Indeed, the Nasdaq recently issued a white paper that stated, "There is currently a regulatory crisis facing the markets that trade NASDAQ securities... NASDAQ believes that the current system for overseeing trading in NASDAQ securities, although adequate when NASDAQ was the sole center of liquidity, is now left with holes that grow larger by the day. Many markets have begun to trade NASDAQ securities for the first time within the past few months and have entered the market without the necessary resources or rules to maintain adequate regulatory infrastructures properly to surveil trading."2 From NexTrade's perspective, while the motives behind such admission of inadequacy may have been derived from NASD's apparent desire to "rule the regulatory world," the Commission must take such an admission seriously and recognize that it must take action because the SROs will not take the necessary action without guidance from the Commission, in particular when it is against their own interests. To assist the Commission in resolving these expanding problems, NexTrade has crafted a proposed rule to prevent trade-throughs and locked or crossed markets similar to the existing rules of NASD members for the Listed market. However, NexTrade's proposed rule has been modernized to eliminate the problems associated with the Listed version of the trade-through rules, mainly the disparity of processing speed between market centers. Additionally, NexTrade has proposed an amendment to Rule 11Ac1-4 to eliminate the economic incentive of firms to lock or cross market centers. NexTrade believes that adoption of its proposed rules would further the goals of the Commission under the Act. NexTrade believes the proposed rules are drafted in a manner to effectuate their intended purposes. NexTrade appreciates the Commission's consideration of our request and urges the Commission to take action to adopt these rules as quickly as possible. If you have any questions, or would like to discuss these matters in greater detail, please contact the undersigned at (727)446-6660 Ext 122. Sincerely, John M. Schaible
JMS/js
Cc: The Honorable William H. Donaldson, Chairman
Attachment: Draft of Rule 11Ac1-8 and amendments to 11Ac1-4
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Attachment A
Proposed Amendments to 11Ac1-4, new language underlined.
Attachment B
Proposed Rule 11Ac1-8: Intermarket Trading Rules
(a) Definitions
(1) The term "ITR Participant" shall mean any market participant, exchange, ECN, or ATS engaged in the transaction of OTC stocks.
(2) The term "ITR Security" shall mean any OTC security that may be traded by one or more ITR Participant's Systems.
(3) An "ITR Market Center Trade-Through," as that term is used in this Rule, occurs whenever an ITR Participant initiates the purchase of an ITR Security by sending a commitment to trade-through any system and such commitment results in an execution at a price which is higher than the price at which the security is being offered (or initiates the sale of such a security by sending a commitment to trade-through any system and such commitment results in an execution at a price which is lower than the price at which the security is being bid for) at the time of the purchase (or sale) by another ITR Participant as reflected by the offer (bid) then being displayed by such other ITR Participant.
(4) An ITR Member that makes a bid (offer) for an ITR Security at a price which equals the displayed offering (bid) price at that time from another ITR Member has created what is referred to in this rule as a "locked market."
(5) An ITR Member that makes a bid (offer) for an ITR Security at a price which exceeds (is less than) the displayed offering (bid) price at that time from another ITR Member has created what is referred to in this rule as a "crossed market."
(b) An ITR member shall avoid purchasing or selling such security, whether as principal or agent, at a price which is lower than the bid or higher than the offer displayed from an ITR Member ("trade-through"), unless the following conditions apply:
(i) the bid or offer that is traded-through is being displayed from a Market Center whose members are relieved of their obligations under SEC Rule 11Ac1-1(C)(2) with respect to such bid or offer;
(ii) the bid or offer that is traded-through has caused a locked or crossed market in the ITR Security;
(iii) the trade-through occurs after the displayed market center failed to respond to a request to trade in under 5 seconds.
(iv) the ITR participant disregards a displayed quote by waiving its right to assess access fees and agreeing to pay the access fee, or fees, of the displayed ITR member(s) whether said displayed quote changes or is executed.
(c) An ITR member shall not cause the market to be locked or crossed unless:
(i) the issuance of the commitment to trade or order would be prohibited by SEC Rule 10a-1 under the Act;
(ii) the ITR Member sends an order to another ITR Member whose displayed price would be locked fails to respond in 5 seconds;
(iii) the ITR member whose quote would lock or cross the markets has attempted to trade with all other ITR members with prices displayed that would be locked or crossed and all other ITR members have failed to respond in 5 seconds;
(iv) the ITR participant disregards a displayed quote by waiving its right to assess access fees and agreeing to pay the access fee, or fees, of the displayed ITR member(s) whether said displayed quote changes or is executed.
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