January 21, 2000
     
     
     
     
Mr. Jonathan Katz
Secretary
United States Securities and Exchange Commission 
450 5th Street, N.W.
Washington, D.C. 20549
     
     
Re:  File No. S7-24-99
     
Dear Mr. Katz:
     
The Island ECN, Inc. ("Island") appreciates the opportunity to comment on a 
recent concept release issued by the Securities and Exchange Commission (the 
"Commission") relating to the regulation of short sales of securities 
(hereinafter, referred to as the "Concept Release").  Island commends the 
Commission for its decision to examine ways to modernize its regulation of 
short sales of securities.  Island understands and appreciates the 
challenges faced by the Commission with respect to amending a rule that has 
gone unchanged for so many years and which tends to generate more emotional 
than scholarly commentary.
     
Island is an "electronic communications network" ("ECN") within the meaning 
of paragraph (a)(8) of Rule 11Ac1-1 (the "Quote Rule") and paragraph (a)(7) 
of Rule 11Ac1-4 (the "Limit Order Display Rule") under the Securities 
Exchange Act of 1934 (the "Exchange Act").  Island operates an automated, 
electronic limit order book.  The Island limit order book automatically and 
instantaneously executes all matching orders in accordance with strict price 
and time priority.  The best-priced orders in the Island limit order book 
are represented in the NASDAQ Level II quotation montage.  Orders placed on 
the Island limit order book have the opportunity to interact with orders of 
other Island subscribers as well as orders delivered to Island through the 
Nasdaq SelectNet Linkage.
     
INTRODUCTION
     
Island is theoretically opposed to any regulation that inhibits the 
free-market pricing mechanisms found in an efficient market.  Island believes 
there is no economic rationale for short sale regulation and that such 
regulation impedes overall market efficiency.  A short sale is simply the use 
of leverage in connection with a securities transaction.  Rule 10a-1 is an 
unnatural inhibitor of downward price movements where leverage is being 
employed.  Currently, there are no equivalent inhibitors, or pricing 
restraints, where leverage is being employed in connection with an upward 
price movement in a security.  In addition, there are no such pricing 
inhibitors found in foreign equity markets, in derivatives markets or in 
commodity markets.  Furthermore, there is no empirical evidence to suggest 
that the absence of short sale regulations for Nasdaq SmallCap and Bulletin 
Board securities has resulted in unrestricted short selling activity intended 
as a manipulative device or as a means of "demoralizing" the market.
     
Island believes that certain market constituents (e.g., issuers) have 
adopted a distorted perception of Rule 10a-1, or short sale regulation 
generally, as a result of fierce competition between the NYSE and Nasdaq for 
listings and the use of short sale regulation by those markets as a sales 
and marketing tool.  Evidence of this is the fact that in 1994 the NASD 
cited "competitive pressures" as an impetus for adopting its own short sale 
rule and failed to show empirical evidence of a need for such a rule.
     
In 1976, the Commission proposed the temporary suspension of Rule 10a-1 in 
order to evaluate the market's need for such a restrictive rule.  The 
Commission noted as a factor in its decision to propose such a suspension 
"the growing support of academicians and certain self-regulatory 
organizations for the elimination of short sale regulation except to the 
extent that short selling is used as a manipulative device."  The 1976 
Release contained the following discussion regarding the conflict between 
the "efficient market" theory and the restrictive nature of Rule 10a-1:
     
"The 'efficient markets' theory postulates that, if a market has zero 
transaction costs, if all available information is costless to all 
interested parties, and if all participants and potential participants in 
the market have identical time horizons and homogeneous expectations with 
respect to prices, that market will be efficient and prices in that market 
will fluctuate randomly.  Those conditions cannot, of course, be met by any 
market, but economists suggest that a market may be characterized as 
efficient if information is readily available to a sufficient number of 
investors, transaction costs are reasonable, and there is no evidence of 
consistency superior or inferior performance by a significant group of 
investors participating in the market.  Although theorists believe that the 
existence of even these less stringent conditions cannot be determined 
directly, there are indications that the necessary conditions for efficiency 
are reasonably descriptive of actual securities markets.
     
Measuring the existing pattern of short sale regulation against the 
'efficient markets' hypothesis, it is argued that such regulation prevents 
the securities markets from being as efficient as they otherwise would be. 
By preventing short sales on minus or zero minus ticks, it is argued that 
investors and market professionals are prevented from translating negative 
perceptions concerning the value of individual stocks or the value of stocks 
generally into market action as rapidly as they wish, thereby impeding the 
market from expressing a valuation of securities on the basis of all 
available information (including all buying and selling interest) and 
creating inefficiencies in the pricing mechanism."
     
Island fully supports this position recognized by the Commission as far back 
as 1976 and the elimination of specific short sale regulations that act as 
inhibitors of natural market pricing mechanisms.  Island does, however, fully 
support regulations that prohibit the use of short sales as a manipulative 
device.
     
Despite Island's support for the elimination of short sale regulation, 
Island understands and appreciates the difficulties faced by the Commission 
in connection with proposing an elimination of the rule.  Therefore, Island 
strongly recommends that, absent the complete elimination of short sale 
regulation, the Commission should adopt certain critical modifications to 
Rule 10a-1.  For the reasons set forth below, Island believes that Rule 
10a-1 should be amended in the following manner:  (i) adopt an 
actively-traded exclusion for certain securities; (ii) convert the Rule 
10a-1 "tick test" to a "bid test;" and (iii) modify the rule to properly 
function in the after-hours market.
     
CONCEPT RELEASE
     
The purpose of the Commission's Concept Release is to assess whether the 
restrictions of Rule 10a-1 produce benefits to the markets that are 
proportionate to the costs associated with those restrictions.  While Island 
believes those costs outweigh the benefits, Island suggests the following 
modifications be made to Rule 10a-1.
     
1.      Actively Traded Securities
     
Island believes that the Commission should adopt an exclusion from Rule 10a-1 
for certain "actively-traded" securities.  The Commission has historically 
concluded that "Rule 10a-1 is not focused solely on preventing manipulative 
activity."  It is this very characteristic of Rule 10a-1 that troubles Island, 
as well as many academicians and economists.  We believe that the Commission 
should limit the scope of its regulations to guard against manipulation and not 
to create downward price inhibitors.  An exclusion for actively-traded 
securities could provide an appropriate balance between the Commission's 
concerns regarding manipulative short selling and short selling used to 
accelerate a decline.  Consistent with the Commission's findings in connection 
with its adoption of Regulation M, certain actively traded securities are not 
susceptible to undetected manipulation.  Similarly, the use of short selling to 
accelerate a decline of an actively-trade security can be extremely costly, and 
thus, less likely to occur.
     
As a result of the development of sophisticated surveillance technologies by 
self-regulatory organizations ("SROs") to monitor market activity on a 
real-time basis, short selling with manipulative intent of actively-traded 
securities is unlikely to go undetected.  The SROs' ability to surveil in 
real-time trading and aggregation of short positions serves as a substantial 
deterrence function.  As a consequence, manipulation of actively-traded 
securities, whether through abusive short selling or through purchasing 
during a Regulation M distribution has become "more costly, and its success 
more uncertain."
     
Note, however, that a sale of a security that is a "short sale" is 
information that an efficient market should possess and digest.  Therefore, 
Island recommends that, in connection with the adoption of an exclusion for 
actively-trade securities, the Commission should encourage further 
transparency of real-time short sale information and improvements in the 
redistribution of such information to all market participants.  Such 
information is itself a critical component of the efficient market theory.
     
2.      "Bid Test"
     
The current tick test used by Rule 10a-1 is slightly flawed and presents 
serious compliance difficulties in today's highly automated trading 
environment.  The current tick test relies on the reported last sale price 
as a reference price.  As a result of the SROs' reporting rules, reported 
last sale data does not reflect real-time market movements but rather 
sporadic trades executed within a 90 second window of the real execution 
times.  Therefore, the reference price used by Rule 10a-1 has substantial 
time disconnects with the real market price of a security.  Such time 
disconnects create sporadic up-ticks and down-ticks that do not necessarily 
relate to the real-time movement of the bid/ask quotations in a security. 
These time disconnects, combined with current trading volumes, creates 
rapid-fire, up and down ticks that are extremely difficult to ensure 
automated compliance with Rule 10a-1.
     
Island believes that the bid quotation contained in the consolidated 
quotation system reflects the current market of a security.  The use of the 
bid quotation as a reference price would provide a real-time and more 
accurate depiction of the market while providing the same barrier to 
accelerations in declining markets.  In addition, as a result of 
decimalization, the last sale price will potentially experience an increase 
in rapid-fire, up and down ticks given the variety of potential trade prices 
within a given spread.  Such a result makes the tick test extremely 
difficult to comply with in a manual or highly automated market environment. 
Conversely, the bid price in a given security, while still volatile, 
statistically experiences less up and down ticks than the last sale price. 
Thus, Island believes that Rule 10a-1 should be amended to reflect the bid 
price as its reference price.  Such an amendment would also be beneficial 
because of a need for a consistent short sale rule across both listed and 
over-the-counter markets.
     
3.      Short Sales in the After-Hours Market
     
The Commission stated in it's Concept Release that "[i]f the Consolidated 
Tape does not operate after the close of regular trading hours, short sales 
can only be executed at a price above the closing price on the Consolidated 
Tape for the security (or, at the closing price if that price was an 
up-tick)."  The current application of Rule 10a-1 after the close of the 
consolidated tape is extremely disruptive to the development of an efficient 
after-hours market for listed securities.  Continuous trading was never 
contemplated when Rule 10a-1 was originally adopted and such an application 
is not consistent with the rule's intent.  Despite concerns over liquidity 
and fragmentation, the after-hours market is proving to be an extremely 
liquid trading environment.  During this month, Island's average trading 
volume for its after-hours session exceeds 7,000,000 shares.  The overall 
market has experienced daily after-hours trading volumes that exceed 
70,000,000 shares in a single evening.
     
Pursuant to the Commission's approval of the Chicago Stock Exchange's 
E-Session, the close of the consolidated tape was extended to 6:30 P.M. 
(EST).  Therefore, a reference price for compliance with Rule 10a-1 will be 
available until 6:30 P.M.  Before recommending amendments to Rule 10a-1, 
Island strongly recommends that the Commission take steps to encourage the 
consolidated tape (or the consolidated quotation system if the bid test is 
adopted) to extend its operating hours or to encourage the creation of 
alternatives to the consolidated tape and the consolidated quotation system. 
If Rule 10a-1 should continue to apply in the after-hours market, the 
Commission should modify Rule 10a-1 to allow ATSs operating in the 
after-hours to rely on their own bid price as a reference price for 
compliance with the rule.
     
CONCLUSION
     
As stated above, Island is theoretically opposed to any regulation that 
inhibits the free-market pricing mechanisms found in an efficient market. 
However, absent the elimination of Rule 10a-1, Island urges the Commission 
to (i) adopt an actively traded exclusion for certain securities; (ii) 
convert the Rule 10a-1 "tick test" to a "bid test;" and (iii) modify the 
rule to properly function in the after-hours market.
     
Thank you for your consideration.
     
     
     
Sincerely,
     
     
Chris Concannon
Associate General Counsel
The Island ECN, Inc.