May 30, 2006

 

Nancy M. Morris

Secretary

Securities and Exchange Commission

100 F Street NE

Washington, D.C. 20549-1090

 

Re:          File No. SR-NSCC-2006-04

National Securities Clearing Corporation; Notice of filing of Proposed Rule Change Relating to Trade Submission Requirements and Fees and Pre-Netting

Release No. 34-53742 (April 28, 2006)

 

 

Dear Ms. Morris:

 

Knight Capital Group, Inc. (Knight)^[1] welcomes the opportunity to offer our comments to the Securities and Exchange Commission (Commission) on the above referenced rule filing of the National Securities Clearing Corporation (NSCC).

 

Knight opposes this proposal in its current form and respectfully requests that the Commission reject this rule filing – particularly, the provision to eliminate all forms of “pre-netting” on trades submitted to NSCC.  Knight does not take issue with the concerns advanced by the NSCC, rather we oppose strongly the “means” they propose to achieve their “ends.”  In fact, we believe that there are far less disruptive and costly solutions which can achieve the stated goals of the NSCC. 

 

Trade compression occurs when trades for the same security, on the same side are grouped together for clearing purposes.  More specifically, it is a process by which an executing firm (the one locking-in a trade) compresses trades with a willing counter-party and reports the compressed (single) trade to the NSCC for locking-in purposes.  Trade compression simplifies transaction processing and offers many advantages, including minimizing the number of transactions submitted for clearing and internal processing.  Trade compression has been a growing part of the backbone of the U.S. capital markets for the last several years.  In fact, as executing firms take on more and more of the correspondent clearing tasks for routing firms – through qualified special representative agreements (QSRs), and with ever increasing trading volumes, trade compression has been (and continues to be) a critical part of the clearing process and has helped to reduce dramatically transaction costs overall.

 

Hundreds of thousands (potentially millions) of trades are compressed each day.  The results are huge clearing cost savings, which ultimately result in less transaction costs to the investor.  In its filing, the NSCC has offered no valid basis for overturning this longstanding industry practice.  In fact, such action effectively interferes with the legitimate rights of correspondents and clearing firms to process and settle trades in the most efficient and cost effective manner.  Thus, the NSCC’s effort to eliminate a well-established industry practice through regulatory fiat without fully vetting the impact on the industry is simply excessive and unfair.

 

Fee Structure

 

As stated, the proposed resolution has significant implications to the cost of clearance for those firms which have negotiated clearing arrangements based on the economics of compression.  NSCC states that the “proposed fee revisions are designed to offset the transaction costs that would otherwise result from requiring real-time trade input.” However, the proposal fails to consider the economic inequity of its impact to all market participants.  Those firms who currently compress their trades will be disadvantaged under the new fee structure based on the percent of total trades compressed today, while firms who do not currently compress trades will see a considerable decrease in their costs.

 

Although the NSCC has indicated that the proposed fee changes will be “revenue-neutral to NSCC,” the fees under the proposal will not be expense-neutral for all existing market participants.  The increase in expenditures will be significant and may ultimately result in higher costs to the individual investor.  By way of illustration, the increased costs and burdens will be borne heavily by those firms that engage in high volume trading (those who add vast amounts of liquidity to the marketplace), as well as by electronic communication networks (ECNs).  As it stands today, ECN profitability (or lack thereof) is measured in fractions of a penny per share.  Thus, it is essential for them to keep their costs at a low level – to do otherwise, would eliminate completely their viability.  Prohibiting ECNs from legitimately compressing trades would thrust upon them significantly higher clearing costs and erode whatever little profitability they now garner – unless, of course, they affiliate in some manner with an Exchange (like ArcaEx or Instinet).  ECNs that are affiliated with an Exchange can utilize that relationship to report matched trades to NSCC – effectively eliminating the clearing costs associated with those trades. 

 

Consequently, the majority of the costs associated with this NSCC proposal will likely be borne by those firms that contribute a significant amount of liquidity to the marketplace and those ECNs who remain independent.

 

No where else to go

 

Virtually all broker-to-broker equity trades are reported to the NSCC for post-trade processing and settlement.  In effect, the NSCC has a monopoly in this arena.  U.S. broker/dealers cannot simply move their post-trade reporting to another competitor.  None exist.  If market participants are forced to deal with the NSCC in this regard, we submit that the NSCC should be required, at a minimum, to fully explore less invasive, equally effective measures prior to causing the imposition of millions of dollars of increased costs upon the industry and investors.

Less invasive ways to achieve the same goal

 

As stated previously, we do not object to the principle concerns proffered by the NSCC.  However, the reasons provided by the NSCC for reducing “systemic risk” can be addressed in a more cost effective and far less disruptive manner.

 

Business Continuity

 

In its filing, the NSCC stated that, “[w]ithout real-time submission, should an event occur after trade execution that disrupts trade input (the so-called ‘9/11 risk’), submission of trade data could be significantly delayed or even lost.”  Prior to 9/11, this may have been true.  However, the Commission and other self-regulatory organizations (SROs) addressed this problem.  For example, on April 7, 2004, the Commission approved rules proposed by the NASD and NYSE (File Nos. SR-NASD 2002-108 and SR NYSE-2002-35) which require NASD and NYSE members to develop business continuity plans that establish procedures relating to an emergency or significant business disruption.  These rules, which require all broker-dealers to comply, address data back-up and recovery, mission critical systems and alternate communications.  As a result, while some minimal risk may remain that there could be a loss of trade data, that risk has been reduced considerably (if not completely eliminated) by the responsible actions of the SEC and SROs.

 

Straight-through processing

 

While this may be a worthwhile goal at some point in the future, it is our understanding that this initiative remains under consideration by the NSCC and that the methodology and operation of a shortened settlement cycle is still under review.

 

Risk Mitigation

 

In addition to the points noted above, we believe that market participants could provide the NSCC with real-time trade data while continuing to compress trades.  These are not mutually exclusive processes.  As a result, the best of both worlds can indeed be achieved.  Market participants can submit real-time trade files to the NSCC so they may monitor for risk, and the marketplace can continue to compress and clear trades in the most cost effective and efficient manner.

 

Trade Reconciliation

 

As noted above, shortened settlement cycles are still on the drawing board.  These initiatives should be fully vetted and discussed (which could take years) before eliminating trade compression. 

 

 

Conclusion

 

We commend the efforts of the NSCC to make improvements to the marketplace, but emphasize urgently that the inequities described above will result in a far more disruptive clearing process, and impose millions of dollars in additional clearing costs which may be passed ultimately on to the investor.  With so many viable, less invasive alternatives available, we believe the NSCC can achieve its stated goals without all of the negative consequences discussed above.  We would be happy to work with the NSCC and other industry participants to address these issues.

 

Thank you again for providing us with the opportunity to comment on these rule proposals.  Knight would welcome the opportunity to discuss our comments with the Commission.

 

 

Sincerely yours,

 

 

 

Leonard J. Amoruso

 

 

 

cc            Chairman Christopher Cox

                Commissioner Paul S. Atkins

                Commissioner Roel C. Campos

                Commissioner Cynthia A. Glassman

                Commissioner Annette L. Nazareth

                Robert L. D. Colby, Deputy Director, Division of Market Regulation

                Karen Saperstein, General Counsel, NSCC