-- Knight Securities, L.P.

1. Complaints relating to poor executions.

A recurrent theme of the investor complaints reviewed by our office relate to delayed or questioned trade executions, particularly during the period from late October 1998 through February 1999. Knight Securities was the leading provider of automated trade executions ("auto-ex") for online brokers, and the curtailment of auto-ex services by Knight was a likely source of many of these complaints. Accordingly, our inquiry evaluated Knight's performance, as well as other market makers. For illustrative purposes, the following sections address the performance of Knight during the 1998-99 Market Storm and the issues that arise for online investors involving market makers.

The tremendous stress placed upon NASDAQ market making firms in the Market Storm are best illustrated by the volatility witnessed in Internet stocks:

• On November 30, 1998, Onsale (ONSL) traded from 108 to 50 in 25 minutes.

• On November 13, 1998, the shares of theglobe.com (TGLO) commenced trading after an IPO at $9 per share, traded as high as $97, closed at $63.50.

• Also in mid-November, Avtel Communications (NASDAQ symbol "AVCO") went from $11 to $31 in the last 30 minutes of trading as a result of a mention on CNBC. At this trading peak AVCO had a market capitalization of $3 billion; today it is in violation of a loan covenant that it maintain a minimum net worth of $2 million.

• On January 14, 1999, CMGI opened at $146, traded down to $88 and back up to $130 in 15 minutes.

Volatility of this magnitude can be simply lethal for novice investors -- and is even hazardous for market makers. These and similar events prompted SEC Chairman Arthur Levitt and the NASD Regulation in late January 1999 to call upon investors to employ limit orders, as opposed to market orders, in order to gain price protection against such volatile trading conditions.109 Online firms acted quickly to disseminate this information via their websites, monthly statement stuffers and advertisements. We have sought to weigh the performance of Knight Securities under these circumstances and conclude that the NASDAQ market place must facilitate, as Knight itself has urged, better tools by which market makers may effect executions against other market makers so that auto-ex providers will have an enhanced ability to offer uninterrupted liquidity to investors.

2. Who is Knight Securities?

Knight Securities is a wholly owned subsidiary of Knight/Trimark Group, Inc. a public company since July 1998. While Knight Securities concentrates upon NASDAQ market making from its Jersey City headquarters, sister corporation Trimark Securities provides off-exchange executions for NYSE listed securities. The origin of Knight/Trimark Group began in 1995. Until just prior to its initial public offering, the business was 60% owned by a consortium of 27 broker-dealers and their affiliates with management owning the remaining 40%.110 After the 30% of Knight now owned by executive officers and directors, online broker-dealers remain the largest shareholders in Knight.111 Waterhouse owns 8.53%, Ameritrade 7.13% and E*Trade and Discover collectively about 5%.112 Waterhouse, Ameritrade and E*Trade each contributed about 12% of Knight's order flow in the quarter ending June 30, 1999, totaling 36.5%.113 The total payments-for-order-flow earned by Waterhouse and Ameritrade from Knight in the June 30 quarter was $12.4 million. Knight employs sophisticated trading systems and proprietary methods to offer "best execution" services to broker-dealers and institutional customers emphasizing automated execution. The firm also utilizes proprietary risk management systems which provide Knight with real-time, online risk management and inventory control. Knight is also beginning to deploy innovative Internet based tools that permit customer broker-dealers to access information, such as pending order status, within Knight's system.114 Knight makes markets in more than 7,000 NASDAQ and OTC Bulletin Board stocks.115 Through its Trimark subsidiary, it also makes off-exchange markets in all NYSE and AMEX-listed equity securities. As of June 1999, Knight held the largest market share, at 17.5%, of total OTC dealer trading volume.116 In the course of accomplishing its market making business, Knight may either carry inventory (be long) or borrow shares (be short). As of June 30, 1999 Knight held $200 million in long positions and $220 million in short positions.117

3. Making payments for order flow.

As a market maker in NASDAQ securities, Knight engages in the widespread industry practice of "payments for order-flow." Under this practice, broker-dealers who originate market orders receive rebates of typically between 1 cents and 2 cents per share for orders directed by them to selected market makers for execution. This payment is not reflected in the trade confirmation seen by the investor but is paid by the dealer executing the trade from its market making profits. The customer agreements of the online brokers examined typically disclosed the firm's practice of accepting such payments. Further, the fact that the broker may receive other remuneration in connection with the order is typically a disclosure on the back of the trade confirmation documents issued to an investor.118 The absence of payment for order flow revenue from investor limit orders has typically resulted in online firms charging a higher price for limit orders as compared to market orders.119 Recently, one online firm has advertised its refusal to accept payment for order flow.120

Broker-dealers that do not make markets in individual securities, including online firms, direct order flow to firms such as Knight and Mayer & Schweitzer to achieve fast and advantageous executions for their customers. Market conduct rules obligate these originating firms to closely monitor the performance of firms providing such execution services for consistency with applicable market rules and practices. Periodic reports are compiled and furnished to the firms that sell their customer order flow which analyze the market maker's execution services and the frequency of achieving price improvement for customer's orders. However, this information does not reach customers or the public.121

Payments for order flow represent the second highest expense item of Knight's business, at 24% of net trading revenues in the three months ending September 30, 1999. A closer look at Knight's most recent 10Q reveals, however, that, as a percentage of net trading revenue, payments for order flow have declined 21.6% in the first nine months of this year. For the first nine months of this year, such payments constituted 18.85% of net trading revenues compared to 24% for the same period in 1998. This change potentially reflects heightened investor understanding of the risks of market orders and greater use of limit orders which are not eligible for order flow payments. Payments for order flow have been surrounded in controversy since well before online brokerage firms arrived.122 Critics have assailed them as outright bribery and a breach of the broker's agency obligations to the customer. At a minimum, a broker's opportunity to sell customer order flow presents a potential conflict with customers receiving "best executions" since market makers paying for order flow may be less vigilant in obtaining price improvement for customers where it might reduce their own profits. The SEC has not elected to bar the practice and the New York Court of Appeals has determined that application of our common law agency disclosure duties was impliedly preempted by the conflict that would arise with the "policy-based delicate balance Congress directed the SEC to achieve."123

Amid signs that the payment for order flow practice is now gaining a foothold in the options market,124 the SEC is again sounding alarms that the practice is not clear to investors and harmfully conflicts with the broker's "best execution" duty.125 A further assault on the practice may develop when equity pricing converts to decimals on June 30, 2000. The anticipated squeeze on market makers' quote spreads is expected to reduce, if not eliminate this practice. In fact, long-term revenue estimates of analysts for online brokers omit order flow payments.126

Investors should inform themselves about the payment for order plan practices of their brokers. "With today's low commissions, investors need to start focusing on other transaction costs," says John Markese, president of the American Association of Individual Investors.127 In placing orders, they should weigh the impact of the practice in light of their price and time objectives. In selecting their brokers, they should determine what percentage of its customers get price improvement, the average savings and the time it takes to obtain these savings.128

4. Automated executions.

The average online investor clicking the order entry box on their computer probably believes that their electronic buy/sell request for a particular security is directly connected to another party who has an inventory of the stock or seeks to buy the stock. This may occur if different customer limit orders are matched. In fact, such is the model upon which electronic communication networks (ECNs) such as Instinet, Island, REDIBook and Archipelago operate. Nonetheless, NASDAQ itself is not a marketplace of firm orders but a collection of market making dealers quoting bids/asks and profiting from the spread between the bid and ask. A quote is not the equivalent of an order. An order is firm. How firm is a quote if the market maker delays responding to another dealer's attempt to trade at the quote?129 How much size is in the quote? If the quote size is only for 200 shares, how liquid is the market? How long will it take for my order to be filled?

NASDAQ requires that dealers fill orders at the price and at the size represented in their quotes "at the time of receipt of any such offer."130 However, this has never been construed by the NASD to mean instantaneous, yet that is frequently the expectation of public customers. After its quote is hit, the market maker has an additional 10 seconds to change the quote's price and size during which period it is not required to honor its quote. The minimum size for a quote on NASDAQ National Market ("NNM") securities varies, depending on volume, between 1000, 500 or 200 shares.131 In addition, NASDAQ operates the Small Order Execution System (SOES) which does operate as an automatic execution system for small orders from the public.132 In sum, the image and the legal reality of NASDAQ are quite distinct. The basis for the investor's perception of NASDAQ lies in the fact that market makers, such as Knight, go beyond NASDAQ's minimum practices and guarantee to automatically execute transactions at NASDAQ's national best bid/best offer (the NBBO) substantially beyond NASDAQ's minimum practices and in amounts well in excess of NASDAQ legal requirements.

But Knight is not a charity. It is a NASDAQ market maker like all the rest. It has no better position than any other market maker in getting executions against other dealers. During periods of abnormal volatility and volume in a particular stock or group of stocks, Knight reserves the right to suspend its auto-ex guarantee. If the flow of customer orders to Knight exceeds the parameters it has set for auto-ex in an individual security, its traders decide order-by-order whether, to trade or pass the order along.133 Knight's calculation is ultimately dependent upon whether, if it adds to a long or short position by filling the order, it will be able to reverse that position by executing trades for itself against other NASDAQ market makers. Hence, the size of market makers' quotes is the barometer of NASDAQ's liquidity. The volatility of stock prices cited above illustrate what happens when NASDAQ's market makers see risk, step on the brakes (widen their spreads and reduce the size of their quotes), liquidity disappears and prices consequently gyrate.

Under these circumstances, market makers, such as Knight, that provide auto-ex can be expected to and do in fact curtail or suspend auto-ex. As a result all orders reaching these market makers queue up and take longer to manually execute. Separate, but related, delays may occur at the broker-dealers, online or offline, that originate customer orders. These delays may arise in the event of equipment failure or insufficient bandwidth to accommodate transmitting all of the information that must be dispatched to Knight or other market makers. The correspondent's bandwidth constraint may exist at an overall ceiling level, a destination level (the size of the pipe to Knight or other market makers) or an individual security level.

During the past year's Market Storm, Knight constantly recaliberated the auto-ex parameters that it offered for securities. Changes in auto-ex parameters or suspension of auto-ex after a pre-set threshold is hit are electronically disseminated by Knight to its customer broker-dealers before the market opening and as they occur. Knight does not publicly post this information on its website and brokers who receive this data have varying practices as to what they disclose to individual investors. The prevailing practice appears to be a pop-up notice to the investor advising that a group of securities is trading in a "fast market." Since the events of January this year, online brokers have made informational efforts to educate investors of the meaning, resultant risks and behavioral adjustments arising from such conditions. Of course, there may be a general notice if such condition is endemic to the entire NASDAQ market place as has occurred this year on a number of occasions. The following is representative of the message that Ameritrade displayed during the Market Storm relating to Internet stocks:

Due to the extreme volatility in certain Internet related securities, the quotes carried by market data services may not be reflective of the actual price at which trades are occurring. In addition, most NASDAQ market makers have turned off "Auto-Execution" facilities for many of these stocks. Manual execution procedures can take much longer to complete and partial executions at various prices on market orders often occur during these types of markets. Thank you.

At the time of our July 16, 1999 on-site visit at Knight's facility, the predominant auto-ex circuit breaker on intra-day execution was a trade that created a long or short position ("inventory") aggregating thousands of shares above the minimum NASDAQ NNM quote sizes. For volatile issues, such as Internet stocks, the threshold was 60% lower, but still well above the NASDAQ quote sizes. If the trade flagged by the circuit breaker results in shares only marginally above the pre-set inventory benchmark, the Knight trader will frequently click and accept the orders. The purpose of the software is to allow Knight to tap the brakes on how much stock it will either be long or short after the trade. Knight's options, of course, always include curtailing on suspending auto-ex down to NASDAQ's minimum requirements. However, the growth in Knight's business 134 Efficient Networks, Inc., a supplier of high-speed digital subscriber lines, accounted for 65% of the parameter breaking trades. National Information Consortium, Inc. (EGOV), a builder of Internet portals to access information from and transact business with governments, was the other IPO.

For the day previous to our visit, only 31 stocks of the 4600 stocks where Knight offers an auto-ex guarantee saw trades that exceeded Knight's circuit breakers. Half of these stocks saw only five or fewer trades exceed the threshold. In contrast, 73.5% of trades exceeding the threshold were in just two securities that went public on July 15th. Both of these were Internet related issues.134 Finally, 18% of the circuit breaker trades occurred in big name NASDAQ stocks such as Amazon, Microsoft, Network Plus, Glenayre Technologies, Cisco and Viasoft.

Apart from intra-day operating parameters, Knight extends specially tailored execution services for NASDAQ's high-volume morning opening of trading. In June of this year, Knight announced a mid-point pricing plan that accommodates orders aggregating to 250,000 shares in 4800 NASDAQ issues.135 Knight guarantees that orders up to the ceiling will be executed at the mid-point of the first unlocked, uncrossed NBBO regardless of market imbalances. Knight maintains that mid-point pricing results in price improvement for all pre-opening market and marketable limit orders.

Knight is currently conducting an advertisement campaign that proclaims, "Who's the force behind the online trading revolution? We're Knight, the world's leading market maker . . . ."136 Certainly, it is true that today's market volume and speed of executions is inconceivable without auto-ex facilities by market makers at thresholds substantially greater than NASDAQ's firm quote rule.

It is our conclusion that the only way for the NASDAQ market to progress and dispense with the auto-ex curtailments witnessed during the Market Storm, not to mention preparedness for the storms of activity that may lie ahead, is for NASDAQ itself to create a tool that will permit market makers to auto-ex each other at size levels much above the current firm quote rule. Only when immediate access exists for auto-ex providers to other sources of liquidity, can we expect to stem NASDAQ execution delays.

5. Capacity and reliability.

The centrality of Knight in the online trading revolution raises significant questions.

• Is Knight a potential single point of failure that would impact the entire market if it experienced either a hiccup or a more serious event?

• How reliable are the systems that Knight has constructed?

• How much capacity does Knight have and how much capacity will it need for the market to weather the next Market Storm?

In the following sections we present the information gathered on these topics during our inquiry. We do not suggest that we can answer these questions. We did find thoughtful, competent managers that are seeking to insure satisfactory answers in an environment where there are only general directives from either NASD or the SEC.137

(a) Single point of failure.

At its present Jersey City facility Knight has built in redundant systems, including emergency power generation, to insulate itself and investors from a system outage. However, the firm lacks a "hot" back-up data center and is in the process of establishing such a facility.138 Such a facility would substantially diminish Knight's exposure to a business interruption due to fire, weather, environmental or other emergency. Knight's Trimark affiliate, located in New York, is now available as a back-up site.

No online brokers are solely reliant upon Knight as they maintain relationships with other firms, together with the communications infrastructure to reach these alternate execution points.

(b) System reliability.

Knight's uptime availability for the eighteen months covered by our inquiry was 99.95%. This performance was superior to that of any of the online brokerage firms that we examined. A single 45-minute-outage was experienced by Knight on November 30, 1998 -- a Market Storm day when Ameritrade also experienced an outage.139 On November 30th, the Monday, following the Friday (November 27th) after Thanksgiving that also witnessed unprecedented volatility in Internet stocks, Knight saw order imbalances on the morning of the 30th and suspended auto-ex for 60 stocks before the opening. Knight's systems were overwhelmed as it explained in a subsequent letter to its customers:

The additional processing required to handle approximately 40,000 orders manually significantly impacted our trading system. This deluge of order flow also strained every part of our end-to-end service from our help desk response time to our P&S department reconciliation process. As a result, we have taken action to change our auto-ex procedures and to reconfigure our system to handle the type of trading situations encountered on November 30th.140 As indicated in the letter, Knight, as a consequence, made adjustments to its systems and improved its notification procedures to its broker customers.

(c) System capacity.

Knight/Trimark recorded a 600,000 trade day on November 7, 1999, representing cumulative share volume of 328 million shares of OTC and listed securities.141 Knight claims that its installed technology provides capacity of 1.2 million trades per day. This data indicates excess capacity of 50% over a peak day, but it does not capture the relationship that the day's order flow at 9:31 AM, one of the busiest times of the day, bears to total transaction capacity at that time.

It is impossible for a regulator to say that Knight's excess capacity is sufficient -- dependent as such a prognostication would be upon both general market activity and Knight's share (recently increasing) of overall activity. As we set forth below in our recommendations, periodic public visibility of all firm's performance metrics and capacity planning will serve to ensure that firms such as Knight continue to manage responsibly the growth of the electronic marketplace.

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