Final Rule: S7-16-00Final Rule:
Disclosure of Order Execution and Routing Practices
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-43590; File No. S7-16-00]
RIN 3235-AH95
Disclosure of Order Execution and Routing Practices
AGENCY: Securities and Exchange Commission
ACTION: Final rule
SUMMARY: The Securities and Exchange Commission is adopting two rules to improve public disclosure of order execution and routing practices. Under Rule 11Ac1-5, market centers that trade national market system securities will be required to make available to the public monthly electronic reports that include uniform statistical measures of execution quality. Under Rule 11Ac1-6, broker-dealers that route customer orders in equity and option securities will be required to make publicly available quarterly reports that, among other things, identify the venues to which customer orders are routed for execution. In addition, broker-dealers will be required to disclose to customers, on request, the venues to which their individual orders were routed. By making visible the execution quality of the securities markets, the rules are intended to spur more vigorous competition among market participants to provide the best possible prices for investor orders.
EFFECTIVE DATE: January 30, 2001. For specific phase-in dates for compliance with the rules, see section V of this release. In addition, the national securities exchanges and the national securities association subject to §240.11Ac1-5(b)(2) shall comply with that provision by submitting a national market system plan to the Commission by no later than February 15, 2001.
FOR FURTHER INFORMATION CONTACT: Susie Cho, Attorney, at (202) 942-0748, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-1001.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Disclosure as Minimum Step Necessary to Address Market Fragmentation
III. Rule 11Ac1-5 - Disclosure of Order Execution Information
IV. Rule 11Ac1-6 - Disclosure of Order Routing Information
V. Effective Dates and Phase-In of Compliance Dates
VI. Paperwork Reduction Act
VII. Cost-Benefit Analysis
VIII. Consideration of Burden on Competition and Promotion of Efficiency, Competition, and Capital Formation
IX. Final Regulatory Flexibility Analysis
X. Statutory Authority
Text of Rules
I. Introduction
The Securities and Exchange Commission ("Commission") is adopting two rules to increase the visibility of execution quality of the U.S. securities markets for public investors.1 Market centers that execute investor orders will be required to make monthly disclosures of basic information concerning their quality of executions. Broker-dealers will be required to disclose the identity of the market centers to which they route orders on behalf of customers. Taken together, the rules should significantly improve the opportunity for public investors to evaluate what happens to their orders after they submit them to a broker-dealer for execution.
The rules arise out of the Commission's extended inquiry into market fragmentation - the trading of orders in multiple locations without interaction among those orders. In today's markets, investor order flow in the same security can be divided among many different "market centers" -- e.g., exchanges, over-the-counter ("OTC") market makers, and electronic communications networks ("ECNs"). The primary structural component linking these market centers in the national market system is the consolidated public quote. Pursuant to Commission rules, the best displayed bid and offer for each equity security are collected from all significant market centers and disseminated to the public on a real-time basis. This centralized source of information, however, may convey an inaccurate impression of the significant extent to which the quality of order execution can vary across different market centers. At some market centers, for example, as many as 50% of certain orders, particularly market orders for small sizes (less than 500 shares), are executed at prices better than the public quotes. Similarly, for investors seeking to use limit orders to obtain better prices than the public quotes, there can be wide variations among market centers in the opportunity for such orders to be executed.
At present, few market centers provide detailed public disclosure concerning their execution quality. Rule 11Ac1-5 will assure that all market centers publicly disclose, on a monthly basis, basic standardized information concerning their handling and execution of orders. Such information will include, for example, how market orders in various size categories are executed relative to the public quotes. Also, investors for the first time will be informed not just about quoted spreads, but also about effective spreads - the spreads actually paid by investors whose orders are routed to a particular market center. In addition, market centers will disclose the extent to which they provide to investors using limit orders executions at prices better than the public quotes.
To complement the improved public disclosure of execution quality by market centers, the Commission also is adopting a rule to improve disclosure of order routing by broker-dealers. Under Rule 11Ac1-6, broker-dealers that route orders as agent on behalf of their customers will be required to disclose, on a quarterly basis, the identity of the market centers to which they route a significant percentage of their orders. Broker-dealers also will be required to disclose the nature of their relationships with such market centers, including any internalization or payment for order flow arrangements, that could represent a conflict of interest between the broker-dealer and its customers. In the past, such information has been available, if at all, only by individual customer request on a transaction-by-transaction basis. As a result, there has been very little opportunity for the public to evaluate the routing practices of a broker-dealer as a whole.
In a fragmented market structure with many different market centers trading the same security, the order routing decision is critically important, both to the individual investor whose order is routed and to the efficiency of the market structure as a whole. The decision must be well-informed and fully subject to competitive forces. Currently, given the lack of comparable public information on execution quality, retail investors may conclude that the most rational strategy is simply to opt for a broker-dealer that offers the lowest commission and a fast execution. As a result, there may be limited opportunities for market participants to compete on their ability to obtain the best prices for these investor orders. By increasing the visibility of order execution and routing practices, the rules adopted today are intended to empower market forces with the means to achieve a more competitive and efficient national market system for public investors.
II. Disclosure as Minimum Step Necessary to Address Market Fragmentation
The Commission is adopting Rule 11Ac1-5 and Rule 11Ac1-6 primarily to address the serious problems that can arise from market fragmentation. For most stocks actively traded in the U.S. markets, there are a variety of market centers from which to choose in determining where to route orders for execution. Particularly for equity securities qualified for inclusion in the Nasdaq Stock Market, Inc. ("Nasdaq"), trading is widely dispersed among many different market centers. These include a large number of securities dealers that act as Nasdaq market makers. In September 2000, there were an average of 59 market makers per issue in the top 1% of Nasdaq stocks by dollar trading volume, 29 market makers per issue in the next 9% of stocks, and an overall average of 13 market makers per issue. In addition, eight ECNs operate agency markets, which together accounted for 25.8% of Nasdaq share volume in September 2000.2 For exchange-listed equities, in contrast, the primary exchanges still retain a high percentage of order flow. In September 2000, for example, the New York Stock Exchange, Inc. ("NYSE") accounted for 83.3% of share volume in NYSE equities.3
The Commission initiated its formal inquiry into market fragmentation in December 1999 when the NYSE submitted a proposed rule change to rescind Rule 390, its rule restricting off-board trading by NYSE members. In February 2000, the Commission issued a release that published the NYSE's proposal for public comment and also requested comment on a wide range of issues relating to market fragmentation ("Fragmentation Release").4 It noted that the rescission of off-board trading rules raised at least the potential for increased fragmentation of the market for exchange-listed stocks. The Commission particularly highlighted its concerns that dealer practices such as internalization and payment for order flow have contributed to the isolation of investor limit orders and to less vigorous quote competition.5
Among the commenters responding to the Fragmentation Release, the investors (both institutional and retail) were unanimous in their view that fragmentation was a problem that the Commission needed to address. Many securities industry participants, in contrast, believed that fragmentation merely was an inevitable adjunct of competition among market centers, and that such competition produces many benefits for investors. Although the comments reflected wide disagreement about a number of potential options for Commission action that would have addressed market fragmentation most directly, the majority of commenters supported some form of increased disclosure by market centers and broker-dealers concerning their execution quality and order routing practices. In July 2000, the Commission issued a release proposing Rule 11Ac1-5 and Rule 11Ac1-6 to implement this option ("Proposing Release").6
In considering the issue of fragmentation, the overriding objective of the Commission's inquiry has been quite pragmatic - to assure that investors receive the best possible prices for their orders.7 For example, do investors who seek liquidity by submitting market orders pay the lowest possible effective spread, or liquidity premium, for their orders? Similarly, do investors who supply liquidity by submitting limit orders have the best possible opportunity for their orders to be executed? The Commission believes that vigorous competition among buyers and sellers in an individual security, particularly through an opportunity for their orders to interact directly,8 is the only reliable means to achieve the best prices for investors. To the extent that substantial fragmentation of order flow stands in the way of such competition, the harm that results is not merely theoretical. Rather, investors are forced to incur higher transaction costs, and the efficiency of the U.S. markets is diminished.
The Commission's concerns about fragmentation and order interaction should not be construed as meaning that it fails to recognize the essential importance of competition among market centers, which almost by definition entails some fragmentation of order flow. The Commission repeatedly has emphasized the substantial benefits to investors of such competition, including innovative trading services, lower trading fees, and faster executions. Accordingly, the relevant issue in addressing fragmentation is not whether the objective of order interaction should be pursued to the exclusion of market center competition, but how best to secure the benefits of both market center competition and order interaction. Although these two objectives may not be entirely congruous, they both serve to further the interests of investors and therefore must be reconciled in the structure of the national market system.
Determining how best to assure an appropriate balance between market center competition and order interaction is unquestionably a difficult task. Nevertheless, the Commission's year-long inquiry has led it to conclude that increased public disclosure of execution quality and order routing practices is a minimum step necessary to address fragmentation. There currently is little or no publicly available information that would enable investors to compare and evaluate execution quality among different market centers and order routing practices among broker-dealers. Some market centers make order execution information privately available to independent companies, which then prepare reports on execution quality that are sold to broker-dealers. Other market centers provide reports on execution quality directly to broker-dealers or to their members. The information in these reports generally has not been publicly disseminated. Moreover, some broker-dealers have reported difficulty in obtaining useful information on execution quality from market centers. For example, participants in a Commission roundtable on the on-line brokerage industry indicated that not all market centers were willing to make order execution information available and, even when such information was made available, not all of it was useful or in a form that allowed for cross-market comparisons.9
Consequently, most investors have few tools with which to assess the execution quality of different market centers and the order routing practices of different broker-dealers. Execution quality can, however, vary significantly across different market centers trading the same security. If improved disclosure leads to the tightening of effective spreads across market centers, the savings to investors could be quite substantial. For example, the Commission staff has estimated that investors who submit market orders for Nasdaq securities could save $110 million in annual trading costs if market centers that currently execute such orders at effective spreads wider than the median for all Nasdaq market centers improved their effective spreads to the median.10 The variation of execution quality across market centers also has been shown by previous analyses of trading. In 1997, for example, the Commission issued a Report on the Practice of Preferencing that analyzed trading in the listed equity markets ("Preferencing Report"). The sole objective of the Preferencing Report was to evaluate the impact of two preferencing programs that had been formally implemented by the Cincinnati Stock Exchange ("CSE") and Boston Stock Exchange.11 In this limited context, the Preferencing Report found that the programs had not had an adverse effect on the national market system as a whole (particularly given that the programs were quite limited and represented only a small fraction of listed order flow).12 When NYSE trading was compared directly with trading on the regional exchanges, however, and such comparisons were made on an "apples-to-apples" basis (i.e., categorized by trading in the same stocks and by orders of the same size), the Preferencing Report found significant variations in executions across market centers.13 For example, the effective spreads on the regional exchanges for small market orders were 20% to 39% higher than those on the NYSE.14
In addition to public analyses of equity market trading, the Commission staff is aware of similar data obtained during the examination process indicating that execution quality can vary across market centers. In 1999, for example, the Commission's Office of Compliance Inspections and Examinations ("OCIE") conducted examinations of 21 broker-dealers for compliance with the firms' responsibility to examine regularly and rigorously the execution quality likely to be obtained from different market centers. In the course of these examinations, OCIE found that the firms had obtained private analyses of trading from independent companies showing marked differences in execution quality among market centers trading the same security, as well as across securities traded in different market structures.
The Commission anticipates that the two rules adopted today could provoke more vigorous competition on execution quality and order routing performance. The rules will reveal if broker-dealers are routing a significant volume of orders to market centers that execute orders at prices substantially inferior to those available at other market centers trading the same security. This improved visibility, in turn, could shift order flow to those market centers that consistently generate the best prices for investors. Finally, by facilitating comparisons among securities traded in different market structures, the disclosures required by the rules may bring competitive forces more directly to bear on broader market structure issues, such as by prompting investors and issuers to choose markets with more efficient structures.
Nevertheless, the Commission shares the concerns of many commenters responding to both the Fragmentation Release and the Proposing Release that improved disclosure alone might not prove sufficient to address all of the problems that can arise from substantial market fragmentation.15 Accordingly, the Commission intends to monitor closely the effects of the disclosure rules on trading in the coming months. The Commission also plans to monitor the pending move to decimal trading in actively-traded equities, which potentially could address fragmentation concerns by enabling more vigorous competition on quoted price. After assessing the impact of the rules and decimals, it will consider whether additional action is necessary to address market fragmentation and further the Exchange Act's objectives for a national market system.
III. Rule 11Ac1-5 - Disclosure of Order Execution Information
The Commission has decided to adopt Rule 11Ac1-5 substantially as it was proposed, subject to certain technical modifications. The Rule will require market centers to prepare and make available to the public monthly reports in electronic form that categorize their order executions and include statistical measures of execution quality. To facilitate comparisons across market centers, the Rule adopts basic measures of execution quality (such as effective spread, rate of price improvement and disimprovement, fill rates, and speed of execution) and sets forth specific instructions on how the measures are to be calculated. The statistical information will be categorized by individual security, by five types of order (e.g., market and inside-the-quote limit), and four order sizes (e.g., 100-499 shares and 500-1999 shares). As a result, users of the market center reports will have great flexibility in determining how to summarize and analyze statistical information. Users of the data will be able to analyze order executions for a particular security or for any particular group of securities, as well as for any size or type of orders across those groups of securities.
A. Comments on the Disclosure Approach of the Proposed Rule
The Commission received 51 comment letters on the disclosure of order execution practices reflected in the proposed rule.16 A majority of letters were supportive of the objective of improved disclosure, although several expressed serious reservations regarding the implementation of this objective in the proposed rule. Those who supported the rule's approach noted the current lack of useful, public information with which to compare execution quality among market centers. They believed that the information required by the rule would help address this problem.17 The Investment Company Institute, for example, noted that "[c]urrently, it can be very difficult to obtain significant and meaningful data on the execution quality of market centers. In the absence of such data, it is difficult to compare execution quality across markets." Interactive Brokers believed that the rule "will be a major step forward in improving investor awareness of the real costs they pay, both in time and money, for trade execution." Others noted that improved disclosure could benefit investors by acting as a spur to competition. Knight Trading Group believed that the proposed rules "will serve to enhance investor protection and further competition for retail orders by enabling investors and their fiduciaries to evaluate more effectively the market centers to which their orders are routed." Salomon Smith Barney noted that "an educated investor will force firms and market centers to compete vigorously with each other for customer order flow and improve the quality of executions and our capital markets." Marshall E. Blume stated that "[t]hrough disclosure, investors will learn which markets provide better execution, and competition, not the SEC, will determine which markets will thrive."18 Another commenter agreed, noting that "transparency and disclosure are the foundation of fair competition."19
Although fully supporting the objective of improved disclosure of order execution practices, five commenters expressed reservations regarding the implementation of this objective in the proposed rule. Three suggested that the Commission should require much more detailed disclosure of individual orders and transactions, rather than the rule's approach of aggregating such data into statistical categories on a stock-by-stock basis.20 Two other commenters expressed reservations about the usefulness of many statistical categories included in the proposed rule, and also noted the need for additional categories that were not included.21
The commenters that opposed the disclosure approach of the proposed rule did so for varying reasons. Five of the commenters were opposed to the approach primarily because they believed the Commission should address fragmentation by mandating a unified national linkage system with price/time priority.22 The reasons identified by other commenters opposed to the disclosure approach can be divided into three major categories: (1) the proposed rule would over-emphasize quantitative factors, particularly execution price and speed, in obtaining best execution of investor orders; (2) the information on execution quality required by the proposed rule would be too complex and not very useful to investors; and (3) the statistical disclosures required by the proposed rule would greatly increase the risk of meritless private litigation. These issues are discussed below.
1. Emphasis on Execution Price and Speed
Many of the commenters opposing the disclosure approach of the proposed rule, as well those criticizing the rule's implementation of a disclosure approach, believed that it would over-emphasize the quantitative factors of execution price and speed in obtaining the best execution of investor orders.23 The Commission agrees with these commenters that execution price and speed are not the sole relevant factors in obtaining best execution of investor orders. It repeatedly has noted that other factors may be relevant, such as (1) the size of the order, (2) the trading characteristics of the security involved, (3) the availability of accurate information affecting choices as to the most favorable market center for execution and the availability of technological aids to process such information, and (4) the cost and difficulty associated with achieving an execution in a particular market center. Rule 11Ac1-5 does not address, much less alter, the existing legal standards that apply to a broker-dealer's duty of best execution.
For example, the Commission previously has stated that a broker-dealer must regularly and rigorously evaluate the quality of execution it obtains for customers' orders.24 This responsibility is not changed by Rule 11Ac1-5. Indeed, the monthly market center reports will encompass all the orders received by a market center from any number of different broker-dealers. In contrast, a broker-dealer is responsible only for the execution quality of its own customers' orders. If a market center's overall statistics do not reflect the quality of execution of the orders of the broker-dealer's customers, the broker-dealer appropriately should consider this disparity in meeting its duty of best execution. In sum, the rules adopted today do not define, either explicitly or implicitly, a broker-dealer's duty of best execution.
The Commission strongly believes, however, that most investors care a great deal about the quality of prices at which their orders are executed, and that an opportunity for more vigorous competition among market participants to provide the best quality of execution will enhance the efficiency of the national market system. Rule 11Ac1-5 is needed, not because price is the only important factor in routing orders, but because there currently is little or no public information that would allow investors to assess a broker-dealer's handling of its customer orders. For example, the Rule will allow investors to monitor the extent to which, in choosing execution venues, there are, in fact, systematic trade-offs that must be made between price and other factors, and the amount of those trade-offs. For example, if the best prices are consistently produced by one of the leading market centers with cutting-edge, highly-reliable trading systems, there would be little, if any, trade-off between price and systems reliability. Similarly, the rules will help customer weigh the trade-off between a market center that provided immediate executions at the quote, and a market center that executed orders on average in under 30 seconds, but that consistently generated prices resulting in average effective spreads that were a significant amount per share better than those paid by investors at other market centers. Currently, however, investors have little or no information that would allow them to evaluate how their broker-dealer has responded to such trade-offs. Rule 11Ac1-5 is intended to remedy this glaring absence of public information.
The Rule's disclosure of the average spreads at which investor orders are executed should not be construed as meaning that only price "improvement" - defined as the execution of an order at a price better than the public quote at the time the market center received the order - is important. Price improvement is likely to be important to many small investors because small orders are the most likely, at least at some market centers, to receive significantly better prices than the public quotes. The Rule does not, however, focus solely on orders that receive price improvement. It requires the same types and degree of disclosure for orders that are executed at the quotes and at prices outside the quotes. Moreover, many commenters mistakenly believed that Rule 11Ac1-5 focused on price "improvement" to the exclusion of other important aspects of execution that relate to price, particularly the amount of liquidity available at different market centers. However, liquidity and price are integrally related. Liquidity reflects the extent to which larger size orders can be executed at prices that are equal to or not far away from the quotes when the order is submitted. To measure the amount of liquidity available at different market centers, Rule 11Ac1-5 requires separate disclosures concerning the extent to which orders are executed at prices better than the quotes, equal to the quotes, and outside the quotes. Each of these disclosures will be categorized by the following order sizes - 100-499, 500-1999, 2000-4999, and 5000 or more shares. Thus, these categories of information enable the comparison of the performance of market centers in executing larger orders at prices equal to the public quotes. Moreover, one particular measure included in the Rule - the average effective spread - will capture the net effect of all executions in an order size. For example, a market center's average effective spread for market orders of 2000-4999 shares in a security will reflect the share-weighted average of the executions it provided for all of those orders. Thus, if a market center gave only a few orders price improvement, but executed most orders at prices outside the quotes, its average effective spread would be higher than the average effective spread reported by a market center that executed a high percentage of orders at prices equal to the public quotes.
The Commission also wishes to emphasize that Rule 11Ac1-5 is intended to establish a baseline level of disclosure that all market centers must meet in order to facilitate cross-market comparisons of execution quality. It does not preclude market centers from disclosing whatever additional information concerning their order execution practices that they believe would more fully convey the quality of their services.
2. Usefulness to Investors of Execution Quality Information
Commenters opposed to the proposed rule also questioned the usefulness to investors of the information on execution quality that would be included in the market center reports. In particular, they believed that the information was too complex for investors to understand, that the reports would overwhelm investors with statistical data, and that, as a result, investors would be vulnerable to being misled by those willing to "spin" the data to serve their own self interest.25
As an initial matter, the Commission disagrees with the notion that investors are incapable of understanding the fundamental principles of execution quality reflected in Rule 11Ac1-5.26 Investors' current lack of familiarity with the statistical measures, rather than their inherent complexity, may contribute to an impression that the measures are complex. To date, very few market centers have made any public disclosures concerning their execution quality, such as their effective spread and rate of price improvement for different types of orders. The quoted spread, in contrast, has been widely disseminated pursuant to Commission rules and that is what investors have come to know. Given the enormous appetite of investors in recent years for better information about the markets (fueled largely by improved technology and lower communication costs), the Commission anticipates that many investors will come to appreciate the important distinction between quoted prices and the prices they actually receive. Nearly every statistical measure included in Rule 11Ac1-5, each of which is based on execution price and speed of execution, is straightforward in principle.
Commenters correctly observed, however, that a large volume of statistical data will be disclosed in the monthly execution quality reports. As discussed in the Proposing Release, the large volume of statistics reflects a deliberate decision by the Commission to avoid the dangers of overly-general statistics. Assigning a single "execution quality" score to market centers, for example, would hide major differences in execution quality, potentially creating far more problems that it solved. Instead, Rule 11Ac1-5, taking advantage of improved and more efficient information technology, requires electronic disclosure of basic order execution information that is categorized on a stock-by-stock basis. After this basic information is disclosed by all market centers in a uniform manner, market participants and other interested parties will be able to determine the most appropriate classes of stocks and orders to use in comparing execution quality across market centers.
Given the large volume of data that will be included in the reports, most individual investors likely would not obtain and digest the reports themselves.27 The Commission anticipates that independent analysts, consultants, broker-dealers, the financial press, and market centers will analyze the information and produce summaries that respond to the needs of investors. Some commenters expressed discomfort with the varied and unstructured analysis that might arise once execution quality statistics become available to the public. However, many market participants will have an interest in clearly communicating to investors the salient information in ways that investors can understand. In time, investors should be able to assess the credibility of these analyses and use them in evaluating execution performance. Indeed, one of the most serious problems investors currently face with respect to choosing a broker is assessing the quality of order routing and execution services provided by various broker-dealers. After the rules adopted today become effective, competitive forces can be brought to bear on broker-dealers both with respect to the explicit trading costs associated with brokerage commissions and the implicit trading costs associated with execution quality. The Commission believes that investors ultimately will be the beneficiaries of this expanded competition.28
3. Risk of Meritless Litigation
Several commenters expressed concern that the required disclosures of order execution and routing practices would greatly increase the risk of private securities litigation alleging that broker-dealers failed to meet their duty of best execution.29 The Commission expresses no opinion on some of the broader criticisms of private litigation made by these commenters. It is concerned, however, about comments that the required disclosures, particularly the detailed statistical information required by Rule 11Ac1-5, could be subject to misinterpretation that might pose a risk of meritless litigation. The Commission wishes to make clear its views as to the limits of these data in evaluating a broker-dealer's compliance with its legal duty of best execution. Both Rule 11Ac1-5 and Rule 11Ac1-6 are designed to require disclosure pursuant to Section 11A of the Exchange Act. They are not antifraud rules, nor do they create new duties under the antifraud provisions of the federal securities laws. The rules themselves create neither express nor implied private rights of action. Furthermore, Rule 11Ac1-5 and Rule 11Ac1-6 do not address and therefore do not change the existing legal standards that govern a broker-dealer's duty of best execution. The market center reports will provide statistical disclosures regarding certain of the factors relevant to a broker-dealer's order routing decision, but these factors alone are not determinative of whether the broker-dealer achieved best execution.
Rule 11Ac1-5 and Rule 11Ac1-6 are designed to generate uniform, general purpose statistics that will prompt more vigorous competition on execution quality. The information that will be generated as a result of these rules will not, by itself, be sufficient to support conclusions regarding a broker-dealer's compliance with its legal responsibility to obtain the best execution of customer orders. Any such conclusions would require a more in-depth analysis of the broker-dealer's order routing practices than will be available from the disclosures required by the rules.
For example, as discussed in section III.A.1 above, the execution quality statistics included in Rule 11Ac1-5 do not encompass every factor that may be relevant in determining whether a broker-dealer has obtained best execution. In addition, the statistics in a market center's reports typically will reflect orders received from a number of different routing broker-dealers. Legal conclusions about any one broker-dealer's routing practices require an assessment of additional information concerning how that broker-dealer's customer orders were executed. Moreover, under Rule 11Ac1-6, a broker-dealer's quarterly report will provide a general overview of its order routing practices. The information on where orders were routed during the quarter will be broken out only by the listing status of the security - NYSE, Nasdaq, Amex/other, and options. Within these categories, a broker-dealer may have varied its routing of different types of orders, or orders in different securities, so as to obtain results that would not be evident from the general statistics presented in the market center reports.
In sum, while the order execution and routing disclosures will represent a significant step forward in the quality of information that is currently publicly available, they alone will not provide a reliable basis to assess a broker-dealer's compliance with its duty of best execution. Therefore, the resulting statistics, by themselves, do not demonstrate whether or not broker-dealers have complied with their legal duties to their customers,30 and to conclude otherwise would be contrary to the Commission's prior statements, discussed below, about the duty of best execution. Furthermore, the Commission believes that the possibility of multiple, inconsistent standards in interpreting this information in relation to various state law claims could tend to frustrate the statutory objective of establishing and monitoring the development of a national market system31 and would undermine the Commission's effort to assure the practicability of brokers achieving best execution.32
The Commission previously has expressed three conclusions inconsistent with an overly-simplistic determination that a broker-dealer breached the duty of best execution. First, a broker-dealer is required to seek to obtain the most favorable terms reasonably available under the circumstances for a transaction (which may not in every case necessarily be the best price that might be available).33 Second, the duty of best execution does not necessarily require broker-dealers with a large volume of orders to determine individually where to route each order. Third, a broker-dealer does not violate its best execution obligation solely because it receives payment for order flow or trades as principal with customer orders.34
To emphasize these points, we have added a "Preliminary Note" to Rule 11Ac1-5. It provides as follows:
§240.11Ac1-5 requires market centers to make available standardized, monthly reports of statistical information concerning their order executions. This information is presented in accordance with uniform standards that are based on broad assumptions about order execution and routing practices. The information will provide a starting point to promote visibility and competition on the part of market centers and broker-dealers, particularly on the factors of execution price and speed. The disclosures required by this Section do not encompass all of the factors that may be important to investors in evaluating the order routing services of a broker-dealer. In addition, any particular market center's statistics will encompass varying types of orders routed by different broker-dealers on behalf of customers with a wide range of objectives. Accordingly, the statistical information required by this Section alone does not create a reliable basis to address whether any particular broker-dealer failed to obtain the most favorable terms reasonably available under the circumstances for customer orders.
The Commission believes that this clear statement will substantially address the danger of meritless litigation that might impose significant indirect costs on broker-dealers.
B. Scope of Rule
Paragraph (b)(1) of Rule 11Ac1-5 provides that every market center shall make available for each calendar month an electronic report on the covered orders in national market system securities that it received for execution from any person. Thus, the Rule is limited in scope to market centers, covered orders, and national market system securities.
1. Market Center
Paragraph (a)(14) of the Rule defines the term "market center" as any exchange market maker, OTC market maker, alternative trading system, national securities exchange,35 or national securities association. This definition is intended to cover entities that hold themselves out as willing to accept and execute orders in national market system securities. In addition, the language in paragraph (b)(1) that a market center must report on orders that it "received for execution from any person" is intended to assign the disclosure obligation to the entity that is expected to control whether and when an order will be executed.36
The Commission anticipates that the reporting entity for the vast majority of orders will be an exchange specialist, OTC market maker, or ATS. Although specialists and market makers frequently operate under the auspices of an SRO (and such an SRO likely will greatly assist its members in meeting the disclosure requirements of the Rule),37 the responsibility for executing orders generally is handled by the individual firms, and execution quality may vary significantly among them. This is particularly true where an exchange has multiple market makers in a security. It therefore is appropriate for the monthly reports to reflect these potential differences. In some cases, however, orders may be executed through a facility operated by an SRO without a member significantly controlling the order executions. Examples may include (1) the Small Order Execution System ("SOES") operated by Nasdaq, and (2) floor brokers who receive orders on the floor of an exchange and obtain an execution of the orders with little participation by a specialist. The definition of market center includes exchanges and associations to cover these situations.38
2. Covered Order
The definition of "covered order" in paragraph (a)(8) of Rule 11Ac1-5 contains several conditions and exclusions that are intended to limit its scope to those orders that provide a basis for meaningful and comparable statistical measures of execution quality. First, the Rule applies only to market orders or limit orders that are received by a market center during regular trading hours and, if executed, executed during such time. The term "regular trading hours" is defined in paragraph (a)(19) of the Rule to mean between 9:30 a.m. and 4:00 p.m. Eastern Time, or such other time as is set forth in the procedures established pursuant to paragraph (b)(2) of the Rule. There are substantial differences in the nature of the market between regular trading hours and after-hours, and orders executed at these times should not be blended together in the same statistics.39 In addition, covered orders must be received during the time that a consolidated BBO is being disseminated.40 This restriction is necessary because nearly all of the statistical measures included in the Rule depend on the availability of a consolidated BBO at the time of order receipt. The term "consolidated best bid and offer" is defined in paragraph (a)(7) as the highest firm bid and the lowest firm offer for a security that is calculated and disseminated on a current and continuous basis pursuant to an effective national market system plan. The two plans that currently provide for the calculation and dissemination of a consolidated best bid and offer for national market system securities are the Consolidated Quotation Plan for listed equities and the Nasdaq/National Market System Plan for Nasdaq equities.41
The definition of covered order excludes any orders for which the customer requested special handling for execution and that, if not excluded, could skew general statistical measures of execution quality. Types of orders specifically excluded from the Rule include, but are not limited to, orders to be executed at a market opening or closing price, stop orders, orders such as short sales that must be executed on a particular tick or bid, orders submitted on a "not held" basis, orders for other than regular settlement, and orders to be executed at prices unrelated to the market price at the time of execution. All of these exclusions are retained from the proposed rule. In addition, the Rule as adopted now specifically excludes all-or-none orders on the basis that they often may be more difficult to execute than orders without a substantial minimum quantity requirement.42
Two types of orders warrant further discussion. The first type -- immediate-or-cancel orders -- is included in the Rule. The second - orders to be executed at a market opening price - is excluded for operational reasons, notwithstanding the significant issues of quality of disclosure for investors submitting these orders, particularly in Nasdaq securities.
a. Immediate-Or-Cancel Orders
The Commission has determined that "immediate-or-cancel" orders should be included in Rule 11Ac1-5. Immediate-or-cancel orders are immediately subject to execution under normal conditions. These orders are functionally nearly the same as orders that are submitted and cancelled almost immediately thereafter, which are included in the Rule. If not executed, they simply will be included in the statistic for a market center's cancelled orders under subparagraph (b)(1)(i)(C) of the Rule. Moreover, ECNs trading Nasdaq securities receive a substantial number of immediate-or-cancel orders, particularly those that are marketable limit orders. Thus, including these orders may be important to accurately assess the quality of these ECNs, and statistics that reflect the execution quality of these orders in ECNs may be of significant interest to investors.
b. Market Opening Orders
The Proposing Release requested comment on the appropriateness of excluding orders that are to be executed at a market opening price. Several commenters believed that such orders should be included in the Rule. Edward D. Jones & Co., for example, observed that approximately 10-20% of its order flow typically was executed at the opening and that it would be useful, particularly for Nasdaq securities, to segregate opening orders into a separate statistic. The Investment Company Institute stated that "the quality of execution of market opening orders in the Nasdaq market has been an issue of significant concern to market participants" and that "information on the quality of execution at the opening would assist market participants in determining how to trade securities at the opening of the market."
The Commission fully shares the concerns of commenters over the need for improved information on the quality of execution of opening orders in Nasdaq securities. In this respect, the market for Nasdaq securities differs significantly from the market for exchange-listed securities, where the primary exchange generates and disseminates a single opening price. Moreover, it is the Commission's understanding that it is industry practice in the listed markets to provide investors with this single opening price for opening orders that are executed away from the primary exchange. In the market for Nasdaq securities, in contrast, it appears to be the common practice of many market centers to execute opening orders to buy at the quoted offer and opening orders to sell at the quoted bid, thereby charging a liquidity premium for a large volume of orders that effectively cross each other at a single point in time.
The Commission is aware that several important market centers trading Nasdaq securities have begun to offer services that give investors an opportunity to avoid paying a liquidity premium on opening orders. Such services can include, for example, "mid-point pricing," pursuant to which both buy and sell orders are executed at the midpoint of the opening quoted bid and offer.43
The Commission is concerned that many investors may not be fully aware of the significant distinction between Nasdaq and listed securities with respect to the execution of opening orders. The Commission also is concerned that many investors may not be aware of the differing services offered by market centers for execution of opening orders in Nasdaq securities, and their impact on execution quality. Without question, including a separate category for opening orders in the Rule 11Ac1-5 statistics would highlight the differences in quality of execution of opening orders across market centers. Nevertheless, the Commission is reluctant to expand the quantity of the Rule's continuing and marketwide disclosure requirements to address an issue that is limited to a specific segment of the equities markets. Including additional statistics for opening orders in market center reports alone would increase the size of the reports by 20%. All market centers, both those trading listed and Nasdaq securities, would be required to include the opening order information, even though it would be nearly the same for all market centers offering a single price execution of these orders. In addition, Nasdaq is actively considering new opening procedures that could reduce disparities in execution quality.
Instead of substantially expanding the quantity of statistics required by the Rule to address this issue, the Commission believes that the markets and broker-dealers handling customer orders should be given a further opportunity to improve execution quality at the opening in Nasdaq securities. Market centers generally inform broker-dealers in advance how they will execute opening orders. Broker-dealers are subject to a best execution duty in executing customer orders at the opening, and should take into account the alternative methods in determining how to obtain best execution for their customer orders. Broker-dealers are encouraged to communicate clearly to customers the choices available for execution of opening orders, as well as the broker-dealer's policy for obtaining best execution of such orders. If necessary in the future, the Commission will consider requiring statistical disclosure of order execution quality at the opening.
3. National Market System Securities
Rule 11Ac1-5 applies only to securities that are designated as national market system securities under Exchange Act Rule 11Aa2-1. Currently, this designation applies to exchange-listed equities and equities included in the National Market tier of Nasdaq.44 It does not apply to Nasdaq SmallCap securities, Over-the-Counter Bulletin Board securities, and exchange-listed options. SmallCap stocks tend to be inactively traded and, as a group, generate less than 5% of the dollar volume on Nasdaq while making up nearly 25% of Nasdaq companies.45 Given the relatively light dollar amount of trading in these and Bulletin Board securities, the Commission believes at this time that the value of statistical measures of trading may not justify the costs to produce the information. After gaining experience with the Rule's operation, it will consider whether the scope of the Rule should be expanded.
The Proposing Release requested comment on whether Rule 11Ac1-5 should apply to orders for listed options. Interactive Brokers LLC strongly believed that the Rule should apply to options trading.46 The Chicago Board Options Exchange ("CBOE"), in contrast, did not think that the Rule's disclosure approach was appropriate for options trading, although it did express support for the objective of improved disclosure in general.47 The Commission continues to believe that there is a need for improved disclosure of execution quality in the options markets, particularly now that there is widespread trading of options on multiple exchanges and expanding payment for options order flow. Nevertheless, potentially difficult issues would have to be addressed before options could be included within Rule 11Ac1-5. For example, a consolidated BBO is not, at this time, calculated and disseminated for options trading. A consolidated BBO is an essential element for nearly every statistical measure in the Rule, such as calculating price improvement and classifying types of limit orders (e.g., inside-the-quote and at-the-quote limit orders). Although each exchange potentially could calculate its own consolidated BBO, the calculations might vary at times and fail to provide a uniform basis for comparable statistics. In addition, categorization of orders on a security-by-security basis would be much less practical for the options markets, where there may be hundreds of series of options for one underlying security. The Commission's Office of Economic Analysis and OCIE currently are preparing a report on payment for order flow in the options markets. The report necessarily will address the quality of execution of options orders. After the report is completed, the Commission will consider whether additional action is needed to improve the quality of disclosure of execution quality in the options markets.
C. Required Information
Paragraph (b)(1) of Rule 11Ac1-5 requires market center reports to be categorized by individual security, order type, and order size. These categories are defined in paragraphs (a)(4) through (a)(6) of the Rule. The five types of orders are market, marketable limit, inside-the-quote limit, at-the-quote limit, and near-the-quote limit. The four buckets of order size are 100-499, 500-1999, 2000-4999, and 5000 or more shares. With this degree of categorization, a market center will, for example, produce statistical information for the subcategory of market orders for 100-499 shares in an individual stock.
Several commenters criticized the categories specified in the proposed rule.48 The Commission has decided to retain the categories at this time, although experience with the Rule may indicate ways in which they could be improved in the future. The categories are intended to strike a balance between (1) sufficient aggregation of orders to produce statistics that are meaningful, and (2) sufficient differentiation of orders to facilitate fair comparisons of execution quality across market centers. If a market center believes that the categories do not fully reflect its order flow and execution practices, it is encouraged to make any additional information publicly available that it believes would be helpful to investors.
1. Information Required for All Types of Orders
For each subcategory of security/order type/order size, paragraph (b)(1)(i) specifies eleven columns of information that must be provided. The first five columns provide general information on the orders received by a market center in a subcategory and the disposition of those orders. The first column is "the number of covered orders." The second, however, is "the cumulative number of shares of covered orders"; and thereafter all statistics required by the Rule are expressed either in number of shares or in share-weighted amounts. The Rule uses share-based statistics primarily to deal with those situations in which a single order receives less than a full execution or more than one partial execution.
The Rule requires disclosure of the number of shares cancelled prior to execution,49 and the number of shares executed at both the receiving market center and at any other venue (after being routed elsewhere by the receiving market center). Thereafter, all statistical measures of order execution for a market center will encompass both orders that were executed at the receiving market center and orders that were executed elsewhere. In calculating its statistics, a market center will use the time it received the order and the consolidated BBO at the time it received the order, not the time and consolidated BBO when the venue to which an order was forwarded received the order. The Commission believes that a market center should be held accountable for all orders that it receives for execution and should not be given an opportunity to exclude difficult orders from its statistical measures of execution quality by routing them to other venues. In addition, from the perspective of the customer who submitted the order, the fact that a market center chooses to route the order elsewhere does not reduce the customer's interest in a fast execution that reflects the consolidated BBO as close to the time of order submission as possible. Consequently, in evaluating the quality of order routing and execution services, it is important for customers to know how a market center handles all orders that it receives, not just those it chooses to execute.
The term "time of order receipt" is defined in paragraph (a)(21) of the Rule as the time (to the second) that an order was received by a market center for execution. The definition is intended to identify the time that an order reaches the control of the market center that is expected, at least initially, to execute the order. In many cases, a broker-dealer may receive an order from a customer in a security for which the broker-dealer also is an OTC market maker or an exchange specialist. In such cases, the market center will be considered to have received an order for execution only when the order is transmitted to the department of the firm responsible for making a market in the security.
A commenter noted the danger that a market center might attempt to manipulate the time of receipt for its order flow. It stated, for example, that "a market maker executing captive market orders pursuant to an internalization or payment for order flow arrangement who has agreed to `step up and match' the NBBO can create for itself a free option by monitoring market movements before and/or after receipt of any order and assigning as an execution price for that order whatever `NBBO' is most favorable to the market maker during the brief option period."50 The Commission agrees that it is critically important for market centers to assign a time of receipt (including seconds) to orders in a prompt, consistent, and non-manipulatory manner. The Commission's inspections of market centers will include a review for compliance with this standard, and failure to meet the standard would be a serious violation of the Rule.
The next five columns required by paragraph (b)(1)(i) of the Rule ask for the number of shares that were executed within specified periods of time after order receipt (such as "from 0 to 9 seconds" and "from 10 to 29 seconds"). Although required for all types of orders, the Commission anticipates that this information will be most useful for evaluating the execution of non-marketable limit orders. These statistics are intended to provide useful comparisons to the overall fill rates for non-marketable limit orders.51 Particularly for inside-the-quote and at-the-quote limit orders, the submitter of the order reasonably may expect that the order should be executed relatively quickly, and information on the likelihood that such an order will be executed with 10 seconds, 30 seconds, and so on, at different market centers may be helpful in guiding the order routing decision.
The final column of information required for all types of orders is the average realized spread. The term "average realized spread" is defined in paragraph (a)(3) of the Rule and is calculated by comparing the execution price of an order with the midpoint of the consolidated BBO as it stands five minutes after the time of order execution.52 The smaller the average realized spread, the more market prices have moved adversely to the market center's liquidity providers after the order was executed, which shrinks the spread "realized" by the liquidity providers. In other words, a low average realized spread indicates that the market center was providing liquidity even though prices were moving against it for reasons such as news or market volatility.
Many commenters questioned the usefulness of this statistic and recommended that it be eliminated.53 The Commission believes, however, that the average realized spread is an essential measure for evaluating a market center's order execution practices and so we have retained the measure in the Rule. Most importantly, marketwide disclosure of realized spreads will help address a potentially serious incentive problem that could arise during "stressed" markets (i.e., when prices are moving quickly). A market center of "last resort" - one that executes a greater proportion of orders when the market is stressed -- generally will post wider effective spreads during those periods, even though the realized spread may remain quite low or negative (because prices are moving rapidly against those providing liquidity during the stressed period). Thus, marketwide disclosure of realized spreads can help identify those market centers willing to supply liquidity during difficult times. If average realized spread were not included in the Rule, it might create an incentive for market centers to avoid trading in times of stress, leading to a drop in liquidity at the very time when it is most needed.
In addition, for market orders (as well as marketable limit orders), average realized spread can measure the extent to which "informed" and "uninformed" orders are routed to different market centers. Informed orders are those submitted by persons with better information than is generally available in the market. They therefore represent a substantial risk to liquidity providers that take the other side of these informed trades. In contrast, orders submitted by persons without an information advantage (often small orders) present less risk to liquidity providers and in theory should receive the most favorable effective spreads available in the market. Market centers may attempt to identify and secure a substantial flow of uninformed orders, while avoiding, and perhaps even rejecting, informed orders. The average realized spread statistic for market and marketable limit orders can highlight the extent to which market centers receive uninformed orders (as indicated by higher realized spreads than other market centers), thereby potentially helping to spur more vigorous competition to provide the best prices to these orders to the benefit of many retail investors. Other market centers, for example, may seek to obtain such profitable order flow by offering to execute the orders at narrower effective spreads (which also would result in narrower realized spreads for these orders).
Finally, average realized spread can generate useful information for non-marketable limit orders. The most significant risk of using such orders is that they will not be executed and will miss the market. The likelihood of execution can vary depending on the extent to which traders that are able to see all the orders (such as specialists, floor traders, and OTC market makers) are able to step in front of displayed limit orders by improving on the limit price as market orders arrive on the other side of the market. This can lead to another type of trading cost for limit orders that is commonly referred to as "adverse selection" - the greater likelihood that limit orders will be executed when the market is moving significantly against them. The frequency with which local traders step in front of limit orders can heighten the cost of adverse selection for limit order investors. This "last mover" advantage for local trading interest can be substantial, and the average realized spread can indicate the extent to which it affects the execution costs of limit orders.54
For market centers that comply with Rule 11Ac1-5 by comparing their order data with a record of the consolidated quote stream (the method commonly used today to prepare analyses of execution quality), calculating the statistic is not significantly more burdensome than calculating the Rule's other statistics. As with effective spread (discussed below), execution prices are compared with a record of the consolidated quote stream. Effective spread is calculated using the quotes at the time of order receipt; realized spread is calculated using the quotes five minutes after the time of order execution.
2. Information Required for Market and Marketable Limit Orders
Subparagraph (b)(1)(ii) of Rule 11Ac1-5 specifies an additional nine columns of information for subcategories of market orders and marketable limit orders. These columns are intended to help evaluate how well these orders are executed by comparing their execution prices with the consolidated BBO at the time of order receipt. The time of order receipt is used rather than the time of order execution primarily based on an understanding that customers, at least for purposes of evaluating execution quality, generally expect orders to be executed at prices that reflect, as closely as possible, the displayed quotes at the time they submit their orders. The earliest time at which a market center can be held responsible for executing an order is the time of receipt.
The first of these columns is the average "effective" spread (in contrast to the average "realized" spread that was discussed above). Average effective spread is defined in paragraph (a)(2) of the Rule and is calculated by comparing the execution price of an order with the midpoint of the consolidated BBO at the time of order receipt. The larger the effective spread, the higher the transaction costs for market and marketable limit orders in that security. The average effective spread is a comprehensive statistic that summarizes the extent to which market and marketable limit orders are given price improvement, executed at the quotes, and executed outside the quotes. As such, it is a useful single measure of the overall liquidity premium paid by those submitting market and marketable limit orders to a market center.
The final eight columns of information required for market and marketable limit orders essentially break out the major determinants of execution quality that are summarized in the average effective spread. They also are intended to provide a substantial basis to weigh any potential trade-offs between execution speed and execution price. Orders are classified based on whether they were "executed with price improvement," "executed at the quote," or "executed outside the quote," as defined in paragraphs (a)(10) through (a)(12). For shares executed with price improvement and shares executed outside the quote, market centers will disclose the number of shares, the average amount per share of price improvement or price disimprovement, and the average speed of execution. For shares executed at the quote, market centers will disclose the number of shares and the average speed of execution. Not only will these statistics help broker-dealers and investors evaluate where to find the fastest executions at the best prices, they also will indicate the extent to which market centers are able to execute larger orders at prices equal to or better than the quotes. They thereby indicate the volume of liquidity available at different market centers.
Many commenters suggested including an additional statistic for "size improvement" or "liquidity enhancement" in the Rule. These measures generally are calculated by comparing the size of order executions at the quotes with the size associated with the consolidated BBO at the time of order receipt. The Commission did not add this type of measure to the Rule, primarily because of its desire to minimize as much as possible the complexity and quantity of statistics to be disclosed. As discussed in section III.A.1 above, Rule 11Ac1-5 already includes several measures that will reflect the extent to which a market center is able to execute larger orders at prices equal to the public quotes, such as the average effective spread and number of shares executed at the quotes for larger sizes of orders. Moreover, the size associated with the consolidated BBO may not provide a useful basis on which to compare execution quality among market centers. For example, consolidated size varies substantially between Nasdaq and listed securities. For listed securities, the quoted size nearly always reflects the quotes of the primary exchanges and generally is much larger than the size associated with the public quotes for Nasdaq securities.
The Proposing Release requested comment on the usefulness of all the basic measures of execution quality included in the proposed rule, as well as on any alternative measures that commenters might suggest. For non-marketable limit orders, the Proposing Release specifically mentioned (1) the length of time that an order remained on a market center's order book while the limit price was at the consolidated BBO or better, and (2) the number of trades or share volume printed on the consolidated tape at prices equal to or less favorable than the limit order price. Several commenters expressed support for including these alternatives in the Rule.55 In addition, commenters suggested many other statistical measures of execution quality that could be included.56 At this time, however, the Commission has decided not to expand the volume of statistics required by the Rule. Many of the suggested alternatives would have substantially increased the complexity of the Rule. For simplicity reasons, the Commission therefore has retained the basic measures that were included in the proposal. Market centers are encouraged, however, to make publicly available any additional measures of execution quality that they believe will be helpful to broker-dealers and investors, particularly if they are concerned that the Rule's basic measures do not adequately capture the complexity of their order flow and executions.
D. Procedures for Making Reports Available to the Public
In light of the large volume of data the monthly order execution reports necessarily will include, they must be made available by market centers in electronic form rather than in writing. Consequently, paragraph (b)(2) of Rule 11Ac1-5 directs the SROs to act jointly in establishing procedures for market centers to follow in making their monthly reports available to the public in a readily accessible, uniform, and usable electronic format.57 Given that the reports will be made available each month by a large number of market centers, the Commission's primary concern is that interested parties have the ability to access the reports easily and efficiently. Thus, for example, it will be helpful for all the reports to be prepared in a compatible electronic format, and for users to have ready access to the locations where reports can be obtained. The volume of data included in the monthly reports, while large in written form, will not be large when compared with many electronic files commonly made available to the public over the Internet.
Rule 11Ac1-5 will be effective 60 days after publication of this release in the Federal Register. Market centers must comply with the Rule according to the phase-in schedule set forth in section V below. The SROs are directed to prepare and submit a joint national market system plan to the Commission for approval under Exchange Act Rule 11Aa3-2 by no later than February 15, 2001. At that point, public comment will be invited on the proposed plan prior to Commission approval. Many of the more detailed issues relating both to the format of the reports and to the means of access to the reports can perhaps more appropriately be addressed in the context of approval of a joint plan.
In the event that a joint-SRO plan has not been approved by the Commission prior to the compliance date of the Rule, paragraph (b)(2) also provides that market centers shall prepare their reports in a consistent, usable, and machine-readable electronic format, and make such reports available for downloading from an Internet web site that is free and readily accessible to the public. This backstop requirement will assure that valuable information on order execution quality will be made available to the public without undue delay. If necessary, the Commission will take additional action to specify in more detail a uniform format and means of dissemination for the monthly market center reports.
Paragraph (b)(3) of Rule 11Ac1-5 requires market centers to make their reports available within one month after the end of the month addressed in the report. Market centers must make their reports available without charge. If a market center believes that its particular circumstances warrant an exemption from the provisions of the Rule, it may request an unconditional or conditional exemption pursuant to paragraph (c) of the Rule, which has been added to the proposed rule. Such an exemption will be granted if the Commission finds that it necessary or appropriate in the public interest, and is consistent with the protection of investors.
IV. Rule 11Ac1-6 - Disclosure of Order Routing Information
The Commission is adopting Rule 11Ac1-6 with significant changes from the proposed rule. Primarily in response to concerns of commenters, it has substantially cut back the amount of information that broker-dealers will be required to disclose concerning their order routing practices. The majority of commenters supported disclosures that would enable investors to better understand where orders are routed for execution and the relationships between broker-dealers and trading venues.58 Several, however, expressed concern about the length and usefulness of some of the disclosure requirements included in the proposed rule.59 In addition, a number of other commenters generally questioned the value of the required disclosures.60 As discussed in section II above, the Commission believes that quarterly reports identifying the venues to which broker-dealers routed their customer orders and discussing potential conflicts of interest will be useful to investors. To maintain the brevity and reduce the compliance burdens of the reports, it has decided to delete several provisions from the proposed rule that would have required potentially long and complex explanations of order routing choices of broker-dealers.
Under Rule 11Ac1-6 as adopted, a broker-dealer that routes orders on behalf of customers will be required to prepare quarterly reports that disclose the identity of the venues to which it routed orders for execution. The reports also will disclose the nature of the broker-dealer's relationship with those venues, including the existence of any internalization or payment for order flow arrangements. Finally, broker-dealers will be required to disclose, on customer request, where they routed a customer's individual orders for execution.
In a significant change from the rule as proposed, a broker-dealer will not be required to prepare a narrative section for the reports that discusses and analyzes its order routing practices. The Commission agrees with commenters that such a requirement could result in reports that were overly long and complex. In addition, a broker-dealer will not be required to identify every venue to which it routed any orders. Instead, only the most significant venues - the top ten and any others that received 5% or more of the broker-dealer's orders - must be disclosed. The primary purpose of the Rule as adopted is simply to assure public disclosure of the significant venues to which a broker-dealer routes its customer's orders and to facilitate an evaluation of potential conflicts of interest between the broker-dealer and its customers. When combined with the information to be made available by market centers under Rule 11Ac1-5, the quarterly reports should provide a much clearer picture of a broker-dealer's order routing practices than has previously been available to the public.
A. Scope of Rule
The scope of Rule 11Ac1-6 is broader than the scope of proposed Rule 11Ac1-5. First, Rule 11Ac1-6 covers a wider range of securities. The definition of "covered security" in paragraph (a)(1) includes not only national market system securities (i.e., exchange-listed equities and Nasdaq National Market equities), but also Nasdaq SmallCap equities and listed options.61 Second, the Rule applies to all broker-dealers that route orders on behalf of their customers. The term "customer order" is defined as any order to buy or sell a covered security that is not for the account of a broker-dealer. It excludes, however, any order for a quantity of a security having a market value of at least $50,000 for a covered security that is an option contract and a market value of at least $200,000 for any other covered security. Large orders are excluded in recognition of the fact that a general overview of order routing practices is more useful for smaller orders that tend to be homogenous.62
Finally, Rule 11Ac1-6 applies to all types of orders (e.g., pre-opening orders and short sale orders), but broker-dealers must give an overview of their routing practices only for "non-directed orders." Paragraph (a)(5) defines a non-directed order as any customer order other than a directed order. Paragraph (a)(3) defines a directed order as a customer order that the customer specifically instructs the broker-dealer to route to a particular venue for execution. Consequently, all customer orders are non-directed orders in the absence of specific customer instructions on where they are to be routed.
B. Quarterly Reports
Paragraph (b)(1) of the Rule 11Ac1-6 requires broker-dealers to make publicly available for each calendar quarter a report on its routing of non-directed orders in covered securities. The term "make publicly available" is defined to require broker-dealers to do three steps -- post on a free Internet web site, furnish a written copy on request, and notify customers at least annually that a written copy will be furnished on request. The Commission expects that the broker-dealer quarterly reports on order routing will be of direct interest to investors, and so is requiring that broker-dealers make them readily available via the Internet. In addition, a primarily Internet method of dissemination will ease the burden of compliance on broker-dealers by reducing paperwork and costs. The reports must be provided on request for customers that may lack Internet access.
Paragraph (b)(2) requires that a quarterly report be made publicly available within one month after the end of the quarter addressed in the report. A longer two-month period was included in the proposed rule to allow broker-dealers an opportunity to evaluate the monthly market center reports under Rule 11Ac1-5 prior to preparing their narrative discussion and analysis of order routing practices. Because this narrative disclosure has been eliminated from the Rule as adopted, the lag-period between end-of-quarter and report dissemination has been shortened to one month to provide more timely disclosures to the public.
Rule 11Ac1-6 as adopted requires that a quarterly report be divided into four separate sections for four different types of covered securities -- one for equity securities listed on the NYSE, one for equity securities qualified for inclusion in Nasdaq, one for equity securities listed on the Amex or any other national securities exchange, and one for options. These sections reflect potentially significant differences in routing practices for the four types of securities and should enhance the usefulness of the quarterly reports to investors. For each of these four sections, paragraphs (b)(1)(i) and (ii) of the Rule require broker-dealers to give a quantitative description of the aggregate nature of their order flow. In this respect, Rule 11Ac1-6 is unlike Rule 11Ac1-5, which requires market centers to categorize their orders on a security-by-security basis. As noted above, the quarterly reports on order routing are intended to provide a general overview of a broker-dealer's practices that is accessible and useful to individual investors. Broker-dealers are free, however, to disclose any additional information concerning their order routing practices that they believe will be helpful to customers.
A broker-dealer's quantitative description of order routing must include the percentage of total customer orders for a particular section that were non-directed orders, and the percentages of total non-directed orders for a section that were market orders, limit orders, and other orders. This general description of a broker-dealer's order flow should facilitate customer understanding of its routing practices. For example, a customer may use the reports to evaluate whether the broker-dealer specializes in the type of orders that the customer typically uses. The quantitative description also will include the identity of the ten venues to which the largest number of non-directed orders for the section were routed for execution, as well as any venue to which five percent or more of non-directed orders were routed.63 In contrast, the proposed rule would have required disclosure of all venues to which non-directed orders were routed. A commenter noted that large broker-dealers may route a relatively small number of orders to many different venues.64 Disclosure therefore has been limited to the most significant venues.65
For each of the venues identified in each section of the report, the broker-dealer must disclose the percentage of total non-directed orders for the section routed to the venue, and the percentages of total non-directed market orders, non-directed limit orders, and non-directed other orders for the section that were routed to the venue. The percentages, rather than numbers, of orders are used to facilitate customer understanding of the probability that particular types of orders will be routed to different venues without the need for calculations, as well as to protect potentially sensitive order flow information.
Under paragraph (b)(1)(iii), a broker-dealer also will be required to discuss the material aspects of its relationship with each venue identified in each section of the report, including a description of any payment for order flow arrangement or profit-sharing relationship as it relates to the type of securities for that section. The term "payment for order flow" is defined very broadly in Exchange Act Rule 10b-10(d)(9) to include any payment or benefit that results in compensation to the broker-dealer for routing orders to a particular venue. This definition encompasses a wide range of practices in addition to monetary payments, such as "research, clearing, custody, products or services," "reciprocal agreements for the provision of order flow," and "discounts, rebates, or any other reductions of or credits against any fee to, or expense or other financial obligation of, the broker or dealer routing a customer order that exceeds that fee, expense or financial obligation." The term "profit-sharing relationship" is defined in paragraph (a)(7) of Rule 11Ac1-5 to mean any ownership or other type of affiliation under which the broker-dealer, directly or indirectly, shares in any profits that may be derived from the execution of non-directed orders. It therefore specifically covers internalization of customer orders by a broker-dealer that executes customer orders as principal.
The purpose of requiring disclosure concerning the relationships between a broker-dealer and the venues to which it routes orders is to alert customers to potential conflicts of interest that may influence the broker-dealer's order-routing practices. Currently, Rule 10b-10(a)(2)(i)(C) requires a broker-dealer, when acting as agent for the customer, to disclose on the confirmation of a transaction whether payment for order flow was received and that the source and nature of the compensation for the transaction will be furnished on written request. In addition, Exchange Act Rule 11Ac1-3(a) requires broker-dealers to disclose in new and annual account statements its policies on the receipt of payment for order flow and its policies for routing orders that are subject to payment for order flow. The Commission believes that disclosure of potential conflicts of interest in conjunction with a quantitative description of where all non-directed orders are routed may provide customers with a clearer understanding of a broker-dealer's order routing practices than is provided under current rules. The Commission intends to consider in the near future whether to modify or rescind, as necessary, the disclosure requirements currently in effect concerning payment for order flow, in light of the new quarterly disclosure requirements.
Rule 11Ac1-6 does not require that broker-dealers provide a quantitative estimate of the aggregate dollar amount of payment for order flow received during a quarter from each order execution venue. First, there are potentially a multitude of varying arrangements for payment for order flow. Estimating the amounts produced by such arrangements could be difficult, subjective, and costly. Second, the Commission is concerned that disclosure of the aggregate dollar amounts of payment for order flow, without requiring comparable disclosure of the dollar amount of trading profits that redound to the benefit of broker-dealers pursuant to profit-sharing relationships, potentially could paint an inaccurate picture of the relative financial incentives generated by the two types of relationships.
Although the Rule 11Ac1-6 does not require an estimate of the aggregate dollar amount of payment for order flow, a broker's description of a payment for order flow arrangement must include disclosure of the material aspects of the arrangement. These would include a description of the terms of the arrangement, such as any amounts per share or per order that the broker receives. Similarly, in describing a profit-sharing relationship, a broker would be expected to disclose the extent to which it could share in profits derived from the execution of non-directed orders. An example would be the extent of the ownership relation between the broker and execution venue.
Finally, as noted above, the Rule as adopted does not include a requirement that broker-dealers provide a narrative discussion and analysis of their order routing practices. Broker-dealers remain free, of course, to communicate such information concerning their order routing practices that they believe would be helpful to customers.
C. Customer Requests for Information
A broker-dealer's quarterly reports should provide a useful picture of its order routing practices as a whole, but will not inform individual customers where their own orders were routed. Currently, there is no market-wide requirement that brokers disclose where they route individual orders on behalf of customers. Although NYSE Rule 409(f) requires NYSE members, when confirming transactions, to disclose "the name of the securities market on which the transaction was made," transactions executed at venues other than exchanges typically are classified as "OTC." Thus, the identity of the particular OTC market maker or ATS that executed an order is not required to be disclosed. Moreover, the NYSE's rule does not cover non-members or securities that are not listed on the NYSE.
To assure that customers have ready access to routing information concerning their own orders, paragraph (c) of Rule 11Ac1-6 requires broker-dealers, on request of a customer, to disclose to the customer the identity of the venue to which the customer's orders were routed for execution in the six months prior to the request, whether the orders were directed orders or non-directed orders, and the time of the transactions, if any, that resulted from such orders.66 To alert customers to the availability of individual order routing information, paragraph (c)(2) of the Rule requires broker-dealers to notify their customers at least annually of their option to request such information.
With Rule 11Ac1-6, those customers interested in monitoring the broker-dealer's routing their orders will be entitled to learn important information about how their orders were handled. When combined with information that such customers may already maintain, such as the time they submitted an order to their broker-dealer, the consolidated BBO at the time they submitted the order, and the price at which an order was executed, the information to be provided on request potentially could give customers a considerable capacity to monitor and evaluate their broker-dealer's order routing decisions and the quality of executions obtained at different venues. Broker-dealers would not, however, be required to bear the expense of providing individualized order routing information to those who had not asked to receive it.
V. Effective Dates and Phase-In of Compliance Dates
Rule 11Ac1-5 is effective on [insert date 60 days after publication in the Federal Register]. The first phase-in of securities subject to the Rule will begin on Monday, April 2, 2001. As of this date, the Rule will apply to the 1000 NYSE securities, 1000 Nasdaq securities, and 200 Amex securities with the highest average daily share volume for the quarter ending December 31, 2000. On this first phase-in date, market centers must begin collecting the necessary data to prepare their monthly reports. In addition, they must make their first report, for April 2001, available by the end of May 2001. The second phase-in date will be July 2, 2001. From this date forward, the Rule will apply to the next 1000 NYSE securities, the next 1000 Nasdaq securities, and the next 200 Amex securities with the highest average daily share volume for the quarter ending March 31, 2001. The third and final phase-in of Rule 11Ac1-5 will begin on October 1, 2001. From this date forward, the Rule will apply to all national market system securities. As discussed in section VI.B below, the Commission believes that all market centers currently collect the basic order data that is necessary to generate the Rule's statistical measures. In addition, many market centers already prepare, or retain independent companies to prepare, similar statistical reports for private use. It is likely, therefore, that market centers will be able to make arrangements for production of reports under Rule 11Ac1-5 in advance of the compliance dates. If a market center believes that it will be unable to meet the compliance dates for good cause, it may request a temporary exemption from the Commission pursuant to paragraph (c) of the Rule. Finally, the Commission directs the national securities exchanges and the national securities association subject to Rule 11Ac1-5(b)(2) to comply with that provision by submitting a national market system plan to the Commission by no later than February 15, 2001.
Rule 11Ac1-6 also is effective on [insert date 60 days after publication in the Federal Register]. Broker-dealers must comply with the Rule for all covered securities on July 2, 2001. Accordingly, a broker-dealer's first report, for the quarter beginning in July and ending in September, must be made publicly available by the end of October 2001. In addition, broker-dealers would be required to respond to customer requests for information on orders that were routed on July 2, 2001, and after.
VI. Paperwork Reduction Act
As explained in the Proposing Release, certain provisions of Rule 11Ac1-5 and Rule 11Ac1-6 contain "collection of information" requirements within the meaning of the Paperwork Reduction Act of 1995 ("PRA").67 Accordingly, the Commission submitted the collection of information requirements contained in the rules to the Office of Management and Budget ("OMB") for review. They were approved by OMB, which assigned the following control numbers: Rule 11Ac1-5, control number 3235-0542, and Rule 11Ac1-6, control number 3235-0541, with an expiration date for each of November 30, 2003. The collections of information are in accordance with Section 3507 of the PRA.68 With regard to Rule 11Ac1-5, the Commission staff has adjusted its PRA burden estimate in response to comments to include the potential for upfront preparations to comply with the data collection requirements of the Rule. With regard to Rule 11Ac1-6, the Commission staff has adjusted its PRA burden estimate to reflect a change from the rule as proposed that reduces the amount of information that broker-dealers will be required to disclose concerning their order routing practices. Accordingly, the Commission has submitted PRA change worksheets to OMB to reflect the adjusted estimates of the burden of compliance.
The collections of information relate to rules that will help further the national market system objectives set forth in Exchange Act Section 11A(a)(1)(C). These objectives include the economically efficient execution of orders, fair competition among broker-dealers and among markets, the availability to broker-dealers and investors of information with respect to transactions in securities, and the practicability of brokers executing investors' orders in the best market. The collection of information obligations imposed by Rule 11Ac1-5 and Rule 11Ac1-6 are mandatory. The monthly order execution reports prepared and disseminated in electronic form by market centers pursuant to proposed Rule 11Ac1-5 will be available to the public and will not be kept confidential. Likewise, the quarterly order routing reports prepared and disseminated by broker-dealers pursuant to Rule 11Ac1-6 will be available to the public and will not be kept confidential. The individual responses by broker-dealers to customer requests for order routing information required by Rule 11Ac1-6 will be made available the customer and not to the general public. The Commission, SROs, and other securities regulatory authorities would gain possession of the responses only upon request. Any responses received by the Commission, SROs, and other securities regulatory authorities will be kept confidential to the extent permitted by the Freedom of Information Act.69 An agency may not conduct or sponsor, and a person is not required to comply with, a collection of information unless it displays a currently valid OMB control number.
A. Comments on Collection of Information Requirements
The Commission requested public comment on the collection of information requirements contained in the Proposing Release. Commenters that addressed recordkeeping and reporting burdens generally focused their attention on the statistical disclosures required by Rule 11Ac1-5. Knight Trading Group, Inc. believed that Rule 11Ac1-5 would be "feasible and implementable without undue burden on market centers because they already must produce much of the required information" pursuant to existing regulatory requirements. Knight also noted that third party vendors could generate the required reports for market centers and that "such an approach would offer an alternative for market centers that do not wish to incur the costs associated with developing and administering any systems needed to collect and disseminate the required information."70 The Investment Company Institute stated that "given technological advances in the dissemination of information and the wide use of the Internet by retail investors, we believe that the reports can be made available to the public in a reasonably efficient manner at a low cost."71 In addition, the Transaction Auditing Group, Inc., a third party service provider for the analysis and reporting of execution quality, noted that "as long as dissemination is permitted via the Internet, the collection, analysis and publication of large volumes of information would be feasible.72
Several other commenters, in contrast, suggested generally that complying with the recordkeeping and reporting requirements of Rule 11Ac1-5 would be burdensome for many market centers.73 A comment letter submitted on behalf of five broker-dealer firms, for example, stated that, although the firms had "not done a rigorous cost analysis with respect to the proposals, the Firms expect that the cost of compliance would be considerable, in terms of programming and monitoring tasks."74 The CHX stated that the "data capture, preparation and reporting burden involved in complying with proposed Rule 11Ac1-5 would be significant, even for the CHX, and, in all likelihood, excessive for many other market centers."75 The Phlx estimated that "the cost of creating the reporting system, as well as creating the interfaces with our members to meet their requirements under the Rule, would be at least $500,000 and require between six months and one year to fully implement."76
The Commission does not agree with these high estimates concerning the recordkeeping and reporting burden of Rule 11Ac1-5. As a basis for compliance, market centers themselves need maintain only the most basic order information, such as the type and size of order, the time of order receipt, the time of order execution, and execution price.77 The Commission believes that all market centers retain this basic order data.78 This data must then be compared with a record of the consolidated quote stream to generate the statistics required by Rule 11Ac1-5. Although some market centers may choose to program their own systems to perform this task, third party vendors already provide this service for many market centers. Based on Commission staff discussions with industry sources, it appears that individual market centers could obtain this service for approximately $2500 per month, and smaller market centers may be able to obtain this same service at an even lower cost. Accordingly, the Commission believes that the total costs to prepare the monthly order execution reports do not appear to be large for any market center.79
While the Commission received no comments that specifically addressed the PRA discussion of Rule 11Ac1-6, it did receive several comments that touched on PRA related issues. Most commenters supported improved disclosure of order routing practices by broker-dealers. Some, however, were concerned about the potentially long length and limited usefulness of some of the disclosure requirements included in the rule as proposed.80 To maintain the brevity and reduce the compliance burdens of the quarterly reports, the Commission has deleted several provisions from the proposed rule that would have required potentially long and complex disclosures. In particular, it has eliminated paragraph (b)(iv) of the proposed rule, which would have required a discussion of the significant objectives that the broker or dealer considered in determining where to route non-directed orders, the extent to which order executions achieved those objectives, a comparison of the quality of executions actually obtained with those produced by other venues for comparable orders during the relevant time period, and whether the broker or dealer has made or intends to make any material change in its order routing practices in the succeeding quarter. In addition, paragraph (b)(ii) has been altered so that a broker-dealer will not be required to identify every venue to which it routed any orders. Instead, only the top ten venues and any others that received 5% of more of the broker-dealer's orders must be disclosed.
One commenter addressed the burden of complying with paragraph (c) of Rule 11Ac1-6, which requires broker-dealers to provide, upon customer request, information regarding the customer's orders routed for execution in the six months prior to the request. The commenter asserted that "it is apparent that this would be a time-consuming, burdensome and expensive requirement to fulfill."81 The Commission strongly believes that those brokerage customers who express an interest in obtaining information about the routing of their own orders should have ready access to such information. Indeed, another commenter doubted that, as a matter of agency law, "any firm would presently fail to honor such a customer request." 82 Particularly considering that the level of disclosure contained in the quarterly broker-dealer reports has been reduced, a requirement that broker-dealers respond to customer requests for order information will help assure that customers can obtain the data they need to evaluate the quality of their broker-dealer's services. Broker-dealers must retain customer order information to comply with existing regulatory requirements. The Commission does not believe that responding to customer requests for such information will constitute an unduly burdensome requirement for broker-dealers.
B. Total Annual Reporting and Recordkeeping Burdens
The collection of information obligations of Rule 11Ac1-5 will apply to all market centers that receive covered orders in national market system securities. Market centers are defined as exchange market makers, OTC market makers, alternative trading systems, national securities exchanges, and national securities associations. The Commission estimates that approximately 140 exchange market makers, 450 OTC market makers, 29 alternative trading systems, seven national securities exchanges, and one national securities association will be subject to the collection of information obligations of Rule 11Ac1-5. Each of these respondents will be required to respond to the collection of information on a monthly basis.
Rule 11Ac1-5 will require market centers to make available to the public monthly order execution reports in electronic form. To prepare the reports, market centers first will need to collect basic data on orders and executions (e.g., type and size of order, time of order receipt and execution). Second, this data will need to be processed to calculate the statistics required by the Rule and present those statistics in an electronic report.
The Commission believes that market centers covered by the Rule retain all of the underlying raw data necessary to generate these reports in electronic format. Consequently, it does not appear that the Rule will require substantial additional data collection burdens. Commenters noted, however, that market centers may incur startup costs to prepare their systems to generate the specific data required by the Rule.83 The Commission staff estimates that, on average, market centers could spend 90 hours to complete these preparations. Assuming internal staff costs of $53 per hour, the estimated 627 market centers could expend a total of approximately $3 million in startup costs, or a total of approximately $600,000 per year annualized over an expected useful life of five years. In addition, the Commission staff estimates that, on an ongoing basis, the Rule will cause respondents to spend an average of 6 hours per month in additional time to collect the data necessary to generate the reports, or 72 hours per year.84 With an estimated 627 market centers subject to the Rule, the total data collection burden to comply with the monthly reporting requirement is estimated to be $600,000 per year for startup costs and 45,144 hours per year on an ongoing basis.
Once the necessary data is collected, market centers can either program their systems to generate the statistics and reports, or transfer the data to a service provider (such as an independent company in the business of preparing such reports or an SRO) that will generate the statistics and reports. Although the largest market centers and SROs may choose to generate the reports themselves, the Commission anticipates that the great majority of market centers will rely on service providers to prepare the reports for them. It is significantly more efficient to consolidate the processing and reporting function in a limited number of entities than for each market center to prepare its own reports. Once an entity has incurred the upfront costs of programming its systems to process data and generate a report for a single market center, there is very little additional cost to performing the same function for many additional market centers. Based on discussions with industry sources, the Commission staff estimates that an individual market center could retain a service provider to prepare a monthly report for approximately $2500 per month. This per-respondent estimate is based on the rate that a market center could expect to obtain if it negotiated on an individual basis. Based on discussions with industry sources, we believe it is likely that a group of market centers, particularly the smaller members of a particular SRO, could obtain a much lower per-respondent rate on a collective basis. Thus, particularly for the smaller members of an SRO, the monthly cost to retain a service provider could be substantially less than $2500. Based on the $2500 estimate, however, the monthly cost to the 627 market centers to retain service providers to prepare reports would be $1,567,500, or an annual cost of approximately $18.8 million.
Rule 11Ac1-6 will require broker-dealers to prepare and disseminate quarterly order routing reports. Much of the information needed to generate these reports already should be collected by broker-dealers in connection with their periodic evaluations of their order routing practices. To comply with the Rule, however, broker-dealers will incur additional burdens in preparing the reports and disseminating them on a free Internet web site (and responding to requests for written copies of the reports).
The collection of information obligations of Rule 11Ac1-6 will apply to all broker-dealers that route non-directed customer orders in covered securities. The Commission estimates that there are currently approximately 3800 broker-dealers that could be subject to the collection of information obligations of the Rule.85 Each of these respondents (if engaged in the business of routing non-directed orders on behalf of customers) will be required to respond to the collection of information on a quarterly basis with respect to the Rule's reporting obligations, and on an ongoing basis with respect to the Rule's requirement to respond to customer requests for order routing information.
There are extreme differences in the nature of the securities business conducted by the approximately 3800 broker-dealers that could be subject to the Rule. They range from the very largest firms with nationwide operations, which are relatively few in number, to thousands of much smaller introducing firms. To handle their customer accounts, these small firms rely primarily on clearing brokers. There currently are approximately 330 clearing brokers. The Commission previously has noted that "from a functional perspective, introducing and clearing brokers act as a unit in handling a customer's account. In most respects, introducing brokers are dependent on clearing firms to clear and to execute customer trades, to handle customer funds and securities, and to handle many back-office functions, including issuing confirmations of customer trades and customer account statements."86 The Commission anticipates that clearing brokers primarily will bear the burden of complying with the reporting and recordkeeping requirements of the Rule on behalf of many small introducing firms. In addition, however, there are approximately 610 introducing brokers that receive funds or securities from their customers.87 Because at least some of these firms also may have greater involvement in determining where customer orders are routed for execution, they have been included, along with clearing brokers, in estimating the total burden of the Rule.
As discussed above, the reporting requirements of Rule 11Ac1-6 have been cut back from the proposed rule. The Commission staff estimates that each firm significantly involved in order routing practices will incur an average burden of 20 hours to prepare and disseminate a quarterly report required by Rule 11Ac1-6, or a burden of 80 hours per year. With an estimated 940 broker-dealers significantly involved in order routing practices, the total burden per year to comply with the quarterly reporting requirement in Rule 11Ac1-6 is estimated to be 75,200 hours.
Rule 11Ac1-6 also would require broker-dealers to respond to individual customer requests for information on orders handled by the broker-dealer for that customer. Clearing brokers generally would bear the burden of responding to these requests. The Commission staff estimates that each clearing broker will incur an average burden of 0.2 hours to prepare, deliver, and retain a response to a customer required by Rule 11Ac1-6. The annual burden could vary significantly among clearing brokers based on the number of customers and number of inquiries by each customer. The Commission staff estimates that an average clearing broker will incur an annual burden of 400 hours (2000 responses x 0.2 hours/response) to prepare, disseminate and retain responses to customers required by the Rule. With an estimated 330 clearing brokers subject to the Rule, the total burden per year to comply with the customer response requirement in Rule 11Ac1-6 is estimated to be 132,000 hours.
VII. Cost-Benefit Analysis
The Commission is adopting two rules to improve public disclosure of broker-dealer and market center practices in the routing and execution of customer orders. The rules are intended to increase access to information about how investors' securities transactions are executed, thereby enhancing an investor's ability to make choices on the basis of execution criteria important to the particular investor. The required disclosures also should aid broker-dealers in satisfying their duty of best execution. The disclosures and enhanced investor knowledge should promote vigorous and beneficial competition among broker-dealers to seek out, and among market centers to provide, superior execution of customer orders.
A. Costs and Benefits of Rule 11Ac1-5
Under Rule 11Ac1-5, each market center (defined as any national securities exchange, national securities association, exchange market maker, OTC market maker, or alternative trading system) will be required to make monthly disclosure of certain statistical measures of execution quality on a security-by-security basis.88 The Commission anticipates that the Rule will generate the benefits and costs described below.
1. Benefits
There currently is little or no publicly available information that would allow investors and broker-dealers to compare and evaluate execution quality among different market centers. Some market centers make order execution information privately available to independent companies, which then prepare reports on execution quality that are sold to broker-dealers. Other market centers provide reports on execution quality directly to broker-dealers or to their members. The information in these reports generally has not been publicly disseminated. Moreover, some broker-dealers have reported difficulty in obtaining useful information on execution quality from market centers. For example, participants in a Commission roundtable on the on-line brokerage industry indicated that not all market centers were willing to make order execution information available and, even when such information was made available, not all of it was useful or in a form that allowed for cross-market comparisons.
By improving public disclosure of execution quality, the Commission anticipates that the Rule will help broker-dealers fulfill their duty of best execution. That duty requires a broker-dealer to seek the most favorable terms reasonably available under the circumstances for a customer's order. Routing orders to a market center that merely guarantees an execution at the best published quote does not necessarily satisfy that duty; best execution is a facts and circumstances determination. A broker-dealer must consider several factors affecting the quality of execution, including, for example, the opportunity for price improvement, the likelihood of execution (which is particularly important for customer limit orders), the speed of execution, and the trading characteristics of the security, together with other non-price factors such as reliability and service. While broker-dealers currently may be able to obtain order execution information from some market centers, that information may be of limited use and may not allow broker-dealers to compare execution quality among the different market centers. Although these statistics are by no means determinative of best execution, the Commission expects that the monthly reporting of the uniform statistical measures required by the Rule will provide broker-dealers with a clearer sense of execution quality among market centers, and will be helpful to broker-dealers in seeking to fulfill their duty of best execution.
The Commission also believes that the reporting required by Rule 11Ac1-5 will facilitate investors' ability to evaluate the quality of order executions provided by different market centers and to have meaningful input into how their broker-dealer executes their orders. Differences in execution quality across market centers can be very important to investors. For example, a difference in execution price of 1/16th for a 1000 share order can equal a savings of $62.50 for an investor. Currently, investors possess few tools to compare order executions on different markets, and they typically leave routing decisions to their broker-dealer. Different investors, however, may have different concerns and priorities related to execution of their orders, such as an opportunity for price improvement and the speed of execution. The Rule will require disclosure of information that will enhance investors' evaluation of these matters.
The Commission believes that Rule 11Ac1-5 will have the additional benefit of stimulating competition between market centers to improve the quality of their executions. Market centers compete to attract order flow. An important way in which market centers seek to attract order flow is by providing - and developing a reputation for providing - superior executions. The Rule will give broker-dealers and investors meaningful information, which they have not previously had, bearing on execution quality. Access to that information will allow broker-dealers and investors to direct orders to market centers on the basis of their order execution performance. Improved disclosure should result in some increase in the number of shares executed with price improvement and a reduction in the number of shares executed with price "disimprovement." Price disimprovement can occur, for example, because of quote exhaustion - the cumulative volume of orders is greater than quoted size and the market center does not provide liquidity enhancement. The Commission anticipates that public disclosure will benefit investors by putting competitive pressure on market centers to reduce inefficiencies, to increase opportunities for price improvement, to decrease instances of price disimprovement, and to improve the quality of execution in all other respects. Market centers that are able to provide better service should be rewarded with more order flow. Ultimately, the Commission anticipates that these improvements in execution also will benefit investors by leading to reduced trading costs, increased trading quality, and possibly increased trading volume.
For example, if investors that now pay more than the median effective spread were able to obtain executions at the median effective spread, the required disclosures could save investors in Nasdaq stocks $110 million in annual trading costs,.89 Moreover, the savings to investors would be even greater if effective spreads improved to the level of the 25th percentile of Nasdaq market centers.90 There also could be a similar type of benefit for investors in the listed markets, although possibly to a lesser extent given the smaller number of market centers. Finally, over time the disclosures rules may provide the impetus for new market structures that provide further reductions in trading costs.
In commenting on the costs and benefits of Rule 11Ac1-5, the Mercatus Center asserted that the potential savings in transaction costs for investors must also be counted as a cost to market intermediaries, noting that "this sum is simply a transfer of wealth from brokers and market centers to investors" and that "when calculating the net benefits or costs of a rule, such wealth transfers cancel each other out."91 In contrast, we believe that the savings to investors described above may be associated with an additional net benefit that would be realized at the market centers. The ultimate result depends on what causes the differences in execution quality that we currently observe across market centers. If these differences are all due to differences in efficiency, then the potential savings to investors discussed above would necessarily be the result of transfers of order flow to the more efficient market centers. This consolidation would likely result in further efficiencies due to economies of scale.
On the other hand, the differences in transaction costs across market centers may reflect differing abilities by market centers to thwart competitive pressures and earn quasi-monopoly rents in the absence of adequate disclosure. If this were the case, then any investor savings might simply be the result of squeezing out some of these excess profits, with no attendant change in order routing practices. As the Mercatus Center points out, under this scenario the savings to investors represent a wealth transfer from the owners of the market centers. Of course, there are several other benefits to investors, discussed below, that flow from reduced transactions costs, even if one assumes that there are no net efficiency improvements available.
The savings calculation presented above implicitly assumes no change in the amount or type of transactions made by investors. Apart from direct savings to investors, a reduction in transaction costs will allow investors to manage their portfolios to better match their needs and desires, through a combination of rebalancing more frequently and incorporating a different mix of securities.92 For example, some investors currently may avoid holding certain less-liquid securities because of transaction costs. After the Rule is implemented, they may want to include these securities in their portfolio if the Rule leads to a significant reduction in transaction costs.
Another potential benefit of reduced transactions costs is a reduction in the cost of capital applied to new investments. Amihud and Mendelson (1986)93 provide both theoretical and empirical evidence that lower relative spreads are associated with lower required returns. Further, their empirical conclusions are supported by Brennan and Subrahmanyam (1996).94 The intuition behind these studies is simple: in considering how much they are willing to pay for securities up front, investors consider how much of the future value will be lost to transaction costs.95
2. Costs
For purposes of the Paperwork Reduction Act, the Commission staff has estimated that compliance with Rule 11Ac1-5 by the estimated 627 market centers could require 56, 430 hours for initial preparations and, on an ongoing basis, impose 45,144 in burden hours for data collection and $18.8 million in other costs ($2500 per month for preparation of reports by service vendors). The staff estimates that 100% of the burden hours could be expended by market centers' internal staff. Assuming internal staff costs of $53 per hour, the estimated 627 market centers could expend a total of approximately $600,000 per year in startup costs (a total of $3 million annualized over an expected useful life of five years) and a total of approximately $2.4 million per year in ongoing data collection costs. The estimated aggregate annual cost for compliance with the Rule could be approximately $21.8 million ($18.8 million + $2.4 million + $0.6 million).
Several commenters asserted that the costs of disclosing the execution quality information required by Rule 11Ac1-5 would be substantial. Many of these same commenters asserted that the benefits of the rules would be minimal and that the costs associated with the rules would outweigh the benefits.96
As discussed above in connection with the PRA, the Commission disagrees with these commenters' estimates regarding the direct costs of compliance with Rule 11Ac1-5. As a basis for compliance, market centers themselves need maintain only the most basic order information, such as the type and size of order, the time of order receipt, the time of order execution, and execution price. The Commission believes that all market centers retain this basic order data.97 Such data then must be compared with a record of the consolidated quote stream to generate the statistics required by the Rule. Although some market centers may choose to program their own systems to perform this task, independent companies already provide this service for many market centers. These independent companies have expended the up-front costs of automating the processes and maintaining a record of the consolidated quote stream. Market centers need only transmit their basic order information to the service provider, which then is able to generate the necessary reports from the information. Based on discussions with industry sources, it appears that individual market centers could obtain this service for approximately $2500 per month, and it is possible that smaller market centers could obtain this same service at an even lower cost. Accordingly, the total costs to prepare the monthly order execution reports do not appear to be large for any market center. The Commission believes the significant potential benefits from disclosure justify these costs.
B. Costs and Benefits of Rule 11Ac1-6
Under Rule 11Ac1-6, broker-dealers that route orders in equity and options securities on behalf of customers will be required to prepare quarterly reports that give an overview of their order routing practices. The Rule also will require broker-dealers to disclose to customers, on request, where that customer's individual orders were routed for execution.
1. Benefits
The Commission anticipates that improved disclosure of order routing practices will result in better-informed investors, will provide broker-dealers with more incentives to obtain superior executions for their customer orders, and will thereby increase competition between market centers to provide superior executions. Currently, the decision about where to route a customer order is frequently made by the broker-dealer, and broker-dealers may make that decision, at least in part, on the basis of factors that are unknown to their customers. The Rule's disclosure requirements will provide investors with a clearer picture of the overall routing practices of different broker-dealers. The Commission contemplates that this will lead to greater investor involvement in order routing decisions and, ultimately, will result in improved execution practices. Because of the disclosure requirements, broker-dealers may be more inclined (or investors may direct their broker-dealers) to route orders to market centers providing superior executions. Broker-dealers who fail to do so may lose customers to other broker-dealers who will do so. In addition, the improved visibility could shift order flow to those market centers that consistently generate the best prices for investors. This increased investor knowledge and involvement could ultimately have the effect of increasing competition between market centers to provide superior execution.
The order routing disclosures of Rule 11Ac1-6, when combined with the execution quality disclosure made by market centers, will allow investors to monitor the extent to which, in choosing execution venues, there are, in fact, systematic trade-offs that must be made between price and other factors, and the amount of those trade-offs. For example, if the best prices are consistently produced by one of the leading market centers with cutting-edge, highly-reliable trading systems, there would be little, if any, trade-off between price and systems reliability. Similarly, the rules will help customers weigh the trade-off between a market center that provided immediate executions at the quote, and a market center that executed orders on average in under 30 seconds, but that consistently generated prices resulting in average effective spreads that were a significant amount per share better than those paid by investors at other market centers. Currently, however, investors have little or no information that would allow them to evaluate how their broker-dealer has responded to such trade-offs. Rule 11Ac1-6, along with Rule 11Ac1-5, is intended to remedy this glaring absence of public information. After the rules become effective, competitive forces can be brought to bear on broker-dealers both with respect to the explicit trading costs associated with brokerage commissions and the implicit trading costs associated with execution quality. The Commission believes that investors ultimately will be the beneficiaries of this expanded competition.
2. Costs
For purposes of the Paperwork Reduction Act, the Commission staff has estimated that the Rule 11Ac1-6 could, on an annual basis, impose 75,200 burden hours on broker-dealers to comply with the quarterly reporting requirement of the Rule. The staff estimates that 100% of those burden hours will be expended by broker-dealers' internal staff. Assuming internal staff costs that average $85 per hour,98 the aggregate annual cost of compliance with the quarterly reporting requirement could be approximately $6.4 million. In addition, compliance with the Rule will require staff time to respond to requests by customers for disclosure of the market centers to which their orders have been routed. For purposes of the Paperwork Reduction Act, the Commission staff has estimated that compliance with such requests could, on an annual basis, impose 132,000 burden hours. Assuming average internal staff costs of $53 per hour, the annual cost of compliance with the customer response requirement could be approximately $7 million.
As noted in section III.A.3 above, several commenters have raised concerns over the potential risk of meritless class-action suits faced by brokers as a result of increased disclosure. From society's perspective, the time and effort spent both asserting and defending any meritless action is a net cost. The Commission believes, however, that the potential for meritless litigation has been minimized by its inclusion of a Preliminary Note to Rule 11Ac1-5. The Note, with the attendant discussion in this release, states, among other things, that the statistical disclosures do not encompass all of the factors that may be important to investors in evaluating the order routing services of a broker-dealer and that the disclosures alone do not create a reliable basis to address whether any particular broker-dealer failed to meet its legal duty of best execution. This clear statement should substantially address the risk that the required disclosures will be misinterpreted and misused in private litigation. In light of the addition of the Preliminary Note and the best execution considerations addressed above, the Commission believes that the benefits of better visibility of execution quality justify any residual risk of meritless litigation arising after the additional information is publicly available.
VIII. Consideration of Burden on Competition and Promotion of Efficiency, Competition, and Capital Formation
Section 23(a)(2) of the Exchange Act requires the Commission, when making rules under the Exchange Act, to consider the impact of such rules on competition.99 In addition, Section 3(f) of the Exchange Act requires the Commission, when engaging in rulemaking that requires it to consider or determine whether an action is necessary or appropriate in the public interest, to consider whether the action will promote efficiency, competition, and capital formation.100
The Commission has considered Rule 11Ac1-5 and Rule 11Ac1-6 in light of these standards and believes that the rules will not impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. To the contrary, by enhancing the disclosure of order execution and order routing practices, the Rules should promote fair and vigorous competition. Investors currently have little information to evaluate the order routing practices of their broker-dealers. As a result, there currently may be limited opportunities for fair competition among broker-dealers based on the quality of their order routing services. By requiring broker-dealers to disclose information on their order routing practices, the Rules may stimulate competition among broker-dealers based on the quality of their order routing services. Similarly, by requiring market centers to disclose order execution information in a manner that permits comparative analysis, the rules may stimulate competition among market centers based on the quality of their order execution services. In addition, because the rules would apply equally to market centers, with respect to order execution disclosure, and broker-dealers, with respect to order routing disclosure, the rules would not result in disparate treatment of these entities that could hinder competition.
The Commission also believes that the rules will allow investors and broker-dealers to make better-informed choices in finding the best market for orders to be executed. Accordingly, the rules may promote market efficiency. In addition, the availability of information on order execution and order routing quality may bolster investor confidence, thereby promoting capital formation.
IX. Final Regulatory Flexibility Analysis
This Final Regulatory Flexibility Analysis ("FRFA") has been prepared in accordance with the Regulatory Flexibility Act.101 It relates to Rule 11Ac1-5 and Rule 11Ac1-6 under the Exchange Act. The rules will require market centers to make disclosures of order execution information and broker-dealers to make disclosures of order routing information.
A. Need for the Rules
The Commission believes that there is a need for improved disclosure of order execution information by market centers. Investors today can obtain consolidated quote information that represents the best bid and offer from among different market centers. This information, however, may not accurately reflect the quality of order executions that may be obtained from the different market centers. Many market centers offer significant opportunities for execution of orders at prices better that the consolidated quote. Conversely, some market centers execute orders at prices less favorable than the consolidated quote at the time of order receipt. The amount of price improvement or disimprovement may result in significant savings or costs to investors. Although some market centers make order execution information available to private companies or to their members, this information generally has not been publicly disseminated. Moreover, the lack of uniformity in the way this information is prepared has made it difficult for users of the information to compare execution quality across market centers.
The Commission also believes that there is a corresponding need for disclosure of order routing information by broker-dealers. If investors do not know where their broker-dealers route orders for execution, the order execution information provided by market centers will be of little benefit to investors. The lack of availability of order routing information also may make it difficult for investors to monitor their broker-dealer's order-routing decisions.
Rule 11Ac1-5 is designed to address the need for improved disclosure of order execution information by market centers. In particular, the Rule is intended to provide investors and broker-dealers with uniform information on execution quality that can be used to compare execution quality across market centers. This information should assist investors and broker-dealers in finding the best market for orders to be executed, thereby promoting competition among market centers and broker-dealers on the basis execution quality and leading to more efficient transactions in securities.
Rule 11Ac1-6 is designed to address the complementary need for broker-dealers to disclose to customers where their orders are routed for execution. The primary objective of the rule is to afford customers a greater opportunity to monitor their broker-dealer's order routing practices. Supplied with information on where their orders are routed, as well as information about the quality of execution from the market centers to which their orders are routed, investors will be able to make better informed decisions with respect to their orders. The information also may assist investors in selecting a broker-dealer.
B. Significant Issues Raised by Public Comment
No commenter specifically addressed the Initial Regulatory Flexibility Analysis that was included in the Proposing Release. Some commenters stated, however, that they believed compliance with the proposed rules, particularly Rule 11Ac1-5, could be significantly more burdensome for smaller firms than for large ones.102 As discussed below, the Commission does not agree that compliance with the rules will be unduly burdensome for those entities that are considered small entities for purposes of the Regulatory Flexibility Act.
C. Small Entities Subject to the Rules
Both Rule 11Ac1-5 and Rule 11Ac1-6 will affect entities that are considered small entities for purposes of the Regulatory Flexibility Act.
1. Small Entities Affected by Rule 11Ac1-5
Rule 11Ac1-5 will impose disclosure requirements on every market center that receives covered orders in national market system securities. Market centers are defined as exchange market makers, OTC market makers, alternative trading systems, national securities exchanges, and national securities associations.
Exchange market makers, OTC market makers, and alternative trading systems that are not registered as exchanges are required to register as broker-dealers. Accordingly, these entities would be considered small entities if they fall within the standard for small entities that applies to broker-dealers. Under Exchange Act Rule 0-10(b), a broker-dealer is considered a small entity for purposes of Regulatory Flexibility Act if (1) it had total capital of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared, of, if not required to prepare such statements, it had total capital of less than $500,000 on the last business day of the preceding fiscal year, and (2) it is not affiliated with any person (other than a natural person) that is not a small entity.103 Based on this standard, the Commission estimates that two exchange market makers, one OTC market maker, and no alternative trading systems that will be subject to Rule 11Ac1-5 are small entities.104
None of the national securities exchanges or the national securities association subject to the Rule is a small entity. Paragraph (e) of the Exchange Act Rule 0-10105 provides that the term "small business," when referring to an exchange, means any exchange that has been exempted from the reporting requirements of 17 CFR 240.11Aa3-1. Under this standard, none of the national securities exchanges affected by the Rule is a small entity. Similarly, the national securities association subject to the Rule is not a small entity as defined by 13 CFR 121.201.
2. Small Entities Affected by Rule 11Ac1-6
Rule 11Ac1-6 will impose disclosure requirements on every broker-dealer that routes non-directed customer orders in covered securities. Under the standard for determining whether a broker-dealer is a small entity in Exchange Act Rule 0-10(b), the Commission estimates that approximately 41 broker-dealers subject to Rule 11Ac1-6 are small entities.106
D. Projected Reporting, Recordkeeping and other Compliance Requirements
1. Reporting Requirements under Rule 11Ac1-5
Rule 11Ac1-5 will impose new reporting requirements on market centers, including those considered small entities. Under the Rule, market centers will be required to prepare and make available to the public monthly reports that categorize and summarize their order executions. For purposes of the Paperwork Reduction Act, the Commission staff estimates that individual market centers will spend 90 hours in initial preparations and, on an annual basis, spend 72 burden hours and incur $30,000 ($2500 per month) in monetary costs to comply with the monthly reporting requirement. Assuming internal compliance staff costs of $53 per hour, the total cost per small entity for burden hours will be $4770 for initial preparations and $3816 on an annual basis. The Commission estimates the total cost, on an ongoing basis, required to prepare and disseminate the monthly reports by the estimated three small entities subject to the Rule will be $108,360 per year (3 x ($30,000+$3816)). As discussed further above, small entities likely could obtain a much reduced rate through the auspices of an SRO or other organization.
2. Reporting Requirements under Rule 11Ac1-6
Rule 11Ac1-6 will impose new reporting requirements on broker-dealers, including those considered small entities. Under the Rule, broker-dealers will be required to prepare and make available to the public quarterly reports that give an overview of their routing of non-directed orders in covered securities. In addition, broker-dealers, on request of a customer, will be required to disclose the identity of the venues to which the customer's orders were routed in the six months prior to the request, whether the orders were directed or non-directed orders, and the time of the transactions resulting from such orders.
As discussed in section VI.B above, it is unlikely that many small entities will have significant involvement in order routing practices, primarily because they are affiliated with a clearing broker. With respect to the 41 small entities that are subject to the Rule and are not affiliated with a clearing broker, the Commission does not anticipate that they engage in significant order routing on behalf of customers. If any of the 41 small entities were required to comply with the Rule, the Commission staff estimates that they would expend, on average, 32 hours to prepare quarterly reports and 2 hours to respond to eight customer requests.107 Assuming internal compliance costs that average $85 per hour, the aggregate cost for each small entity to comply with the Rule is estimated to be $2890.
E. Agency Action to Minimize Effect on Small Entities
The Regulatory Flexibility Act directs the Commission to consider significant alternatives that would accomplish the stated objectives, while minimizing any significant adverse impact on small entities. In connection with Rule 11Ac1-5 and Rule 11Ac1-6, the Commission considered the following alternatives: (1) the establishment of differing compliance or reporting requirements or timetables that take into account the resources available to small entities; (2) the clarification, consolidation, or simplification of compliance and reporting requirements under the rules for small entities; (3) the use of performance rather than design standards; and (4) an exemption from coverage of the rules, or any part thereof, for small entities.
1. Rule 11Ac1-5
Rule 11Ac1-5 is designed to provide uniform order execution information from the different market centers to allow investors and broker-dealers to compare execution quality across markets. Accordingly, the Commission believes that establishing differing reporting requirements for small entities would be inconsistent with the objectives of the Rule. Similarly, the Commission believes that the clarification, consolidation, or simplification of reporting requirements for small entities would be inconsistent with the objective of providing uniform order execution information from the different market centers.
Regarding the use of performance standards rather than design standards, Rule 11Ac1-5 specifies the statistical measures that must appear in the monthly order execution reports. The Commission considered whether the Rule should require market centers only to make available electronic files with raw data on an order-by-order basis. Under this alternative, market centers would provide the necessary fields of information, and analysts could calculate the statistical measures of execution quality that they consider appropriate. The Commission has not adopted this alternative because it would be inconsistent with the objective of assuring a uniform basis for comparing execution quality across market centers. The Rule does not establish a particular technology for disseminating the required reports to the public, other than requiring that market centers make their data available for downloading from a free website in a consistent, usable, and machine-readable electronic format.
As to whether Rule 11Ac1-5 should exempt small entities from its coverage, the Commission considered several alternatives that could minimize the impact of the Rule on small entities. Specifically, the Commission considered an exemption for market centers that execute relatively few orders in total. Also, the Commission considered an exemption to eliminate the disclosure requirement for individual securities in which a market center executes relatively few orders. Finally, as discussed above, the Commission considered whether it would be feasible to allow small market centers to provide raw data rather than the statistical measures required by the proposed rule. No commenters expressed support for these types of exemptions or exceptions for small entities. Given the need for a uniform basis to compare execution quality across market centers, the Commission has determined not to adopt exemptions or exclusions specifically for small entities.
2. Rule 11Ac1-6
Rule 11Ac1-6 is designed to provide investors with information on the order routing practices of their broker-dealers. The Rule requires broker-dealers to prepare quarterly order routing reports and respond to requests from individual investors for information on how their orders were routed. As to the establishment of different reporting requirements or timetables and the clarification, consolidation, or simplification of reporting requirements for small entities, the Commission does not believe that the proposal could be formulated differently for small entities and still achieve its stated objectives.
The Commission requested comment on whether to exclude from the Rule broker-dealers that route a relatively small number of customer orders. No commenter expressed support for such an exclusion. Moreover, an exemption from the Rule for small entities would be inconsistent with the objectives of the Rule. Its primary objective is to afford customers a greater opportunity to monitor their broker-dealer's order routing practices. All broker-dealers currently have an obligation to periodically review their order routing practices to meet their duty of best execution to their customers. The Commission does not believe that the disclosures required by Rule 11Ac1-6 will be unduly burdensome for small entities, particularly now that the requirement of a narrative discussion and analysis of order routing objectives and results has been eliminated from the rule as it was proposed.
X. Statutory Authority
Pursuant to the Exchange Act and particularly Sections 3(b), 5, 6, 11A, 15, 17, 19, 23(a), and 36 thereof, 15 U.S.C. 78c, 78e, 78f, 78k-1, 78o, 78q, 78s, 78w(a), and 78mm, the Commission proposes to adopt Sections 240.11Ac1-5 and 240.11Ac1-6 of Chapter II of Title 17 of the Code of Federal Regulations in the manner set forth below.
List of Subjects in 17 CFR Part 240
Broker-dealers, Reporting and recordkeeping requirements, Securities.
Text of Rules
For the reasons set forth in the preamble, the Commission is amending Chapter II of Title 17 of the Code of Federal Regulations as follows:
PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE
ACT OF 1934
1. The authority citation for Part 240 continues to read in part as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
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2. Sections 240.11Ac1-5 and 240.11Ac1-6 are added before the undesignated center heading "Securities Exempted from Registration" to read as follows:
§ 240.11Ac1-5 Disclosure of order execution information.
Preliminary Note
§240.11Ac1-5 requires market centers to make available standardized, monthly reports of statistical information concerning their order executions. This information is presented in accordance with uniform standards that are based on broad assumptions about order execution and routing practices. The information will provide a starting point to promote visibility and competition on the part of market centers and broker-dealers, particularly on the factors of execution price and speed. The disclosures required by this Section do not encompass all of the factors that may be important to investors in evaluating the order routing services of a broker-dealer. In addition, any particular market center's statistics will encompass varying types of orders routed by different broker-dealers on behalf of customers with a wide range of objectives. Accordingly, the statistical information required by this Section alone does not create a reliable basis to address whether any particular broker-dealer failed to obtain the most favorable terms reasonably available under the circumstances for customer orders.
(a) Definitions. For the purposes of this section:
(1) The term alternative trading system shall have the meaning provided in §242.300(c) of this chapter.
(2) The term average effective spread shall mean the share-weighted average of effective spreads for order executions calculated, for buy orders, as double the amount of difference between the execution price and the midpoint of the consolidated best bid and offer at the time of order receipt and, for sell orders, as double the amount of difference between the midpoint of the consolidated best bid and offer at the time of order receipt and the execution price.
(3) The term average realized spread shall mean the share-weighted average of realized spreads for order executions calculated, for buy orders, as double the amount of difference between the execution price and the midpoint of the consolidated best bid and offer five minutes after the time of order execution and, for sell orders, as double the amount of difference between the midpoint of the consolidated best bid and offer five minutes after the time of order execution and the execution price; provided, however, that the midpoint of the final consolidated best bid and offer disseminated for regular trading hours shall be used to calculate a realized spread if it is disseminated less than five minutes after the time of order execution.
(4) The term categorized by order size shall mean dividing orders into separate categories for sizes from 100 to 499 shares, from 500 to 1999 shares, from 2000 to 4999 shares, and 5000 or greater shares.
(5) The term categorized by order type shall mean dividing orders into separate categories for market orders, marketable limit orders, inside-the-quote limit orders, at-the-quote limit orders, and near-the-quote limit orders.
(6) The term categorized by security shall mean dividing orders into separate categories for each national market system security that is included in a report.
(7) The term consolidated best bid and offer shall mean the highest firm bid and the lowest firm offer for a security that is calculated and disseminated on a current and continuous basis pursuant to an effective national market system plan.
(8) The term covered order shall mean any market order or any limit order (including immediate-or-cancel orders) received by a market center during regular trading hours at a time when a consolidated best bid and offer is being disseminated, and, if executed, is executed during regular trading hours, but shall exclude any order for which the customer requests special handling for execution, including, but not limited to, orders to be executed at a market opening price or a market closing price, orders submitted with stop prices, orders to be executed only at their full size, orders to be executed on a particular type of tick or bid, orders submitted on a "not held" basis, orders for other than regular settlement, and orders to be executed at prices unrelated to the market price of the security at the time of execution.
(9) The term exchange market maker shall mean any member of a national securities exchange that is registered as a specialist or market maker pursuant to the rules of such exchange.
(10) The term executed at the quote shall mean, for buy orders, execution at a price equal to the consolidated best offer at the time of order receipt and, for sell orders, execution at a price equal to the consolidated best bid at the time of order receipt.
(11) The term executed outside the quote shall mean, for buy orders, execution at a price higher than the consolidated best offer at the time of order receipt and, for sell orders, execution at a price lower than the consolidated best bid at the time of order receipt.
(12) The term executed with price improvement shall mean, for buy orders, execution at a price lower than the consolidated best offer at the time of order receipt and, for sell orders, execution at a price higher than the consolidated best bid at the time of order receipt.
(13) The terms inside-the-quote limit order, at-the-quote limit order, and near-the-quote limit order shall mean non-marketable buy orders with limit prices that are, respectively, higher than, equal to, and lower by $0.10 or less than the consolidated best bid at the time of order receipt, and non-marketable sell orders with limit prices that are, respectively, lower than, equal to, and higher by $0.10 or less than the consolidated best offer at the time of order receipt.
(14) The term market center shall mean any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association.
(15) The term marketable limit order shall mean any buy order with a limit price equal to or greater than the consolidated best offer at the time of order receipt, and any sell order with a limit price equal to or less than the consolidated best bid at the time of order receipt.
(16) The term effective national market system plan shall have the meaning provided in §240.11Aa3-2(a)(2).
(17) The term national market system security shall have the meaning provided in §240.11Aa2-1.
(18) The term OTC market maker shall mean any dealer that holds itself out as being willing to buy from and sell to its customers, or others, in the United States, a national market system security for its own account on a regular or continuous basis otherwise than on a national securities exchange in amounts of less than block size.
(19) The term regular trading hours shall mean the time between 9:30 a.m. and 4:00 p.m. Eastern Time, or such other time as is set forth in the procedures established pursuant to paragraph (c)(2) of this section.
(20) The term time of order execution shall mean the time (to the second) that an order was executed at any venue.
(21) The term time of order receipt shall mean the time (to the second) that an order was received by a market center for execution.
(b) Monthly electronic reports by market centers.
(1) Every market center shall make available for each calendar month, in accordance with the procedures established pursuant to paragraph (b)(2) of this section, a report on the covered orders in national market system securities that it received for execution from any person. Such report shall be in electronic form; shall be categorized by security, order type, and order size; and shall include the following columns of information:
(i) For market orders, marketable limit orders, inside-the-quote limit orders, at-the-quote limit orders, and near-the-quote limit orders:
(A) The number of covered orders;
(B) The cumulative number of shares of covered orders;
(C) The cumulative number of shares of covered orders cancelled prior to execution;
(D) The cumulative number of shares of covered orders executed at the receiving market center;
(E) The cumulative number of shares of covered orders executed at any other venue;
(F) The cumulative number of shares of covered orders executed from 0 to 9 seconds after the time of order receipt;
(G) The cumulative number of shares of covered orders executed from 10 to 29 seconds after the time of order receipt;
(H) The cumulative number of shares of covered orders executed from 30 seconds to 59 seconds after the time of order receipt;
(I) The cumulative number of shares of covered orders executed from 60 seconds to 299 seconds after the time of order receipt;
(J) The cumulative number of shares of covered orders executed from 5 minutes to 30 minutes after the time of order receipt; and
(K) The average realized spread for executions of covered orders; and
(ii) For market orders and marketable limit orders:
(A) The average effective spread for executions of covered orders;
(B) The cumulative number of shares of covered orders executed with price improvement;
(C) For shares executed with price improvement, the share-weighted average amount per share that prices were improved;
(D) For shares executed with price improvement, the share-weighted average period from the time of order receipt to the time of order execution;
(E) The cumulative number of shares of covered orders executed at the quote;
(F) For shares executed at the quote, the share-weighted average period from the time of order receipt to the time of order execution;
(G) The cumulative number of shares of covered orders executed outside the quote;
(H) For shares executed outside the quote, the share-weighted average amount per share that prices were outside the quote; and
(I) For shares executed outside the quote, the share-weighted average period from the time of order receipt to the time of order execution.
(2) Every national securities exchange on which national market system securities are traded and national securities association shall act jointly in establishing procedures for market centers to follow in making available to the public the reports required by paragraph (b)(1) of this section in a uniform, readily accessible, and usable electronic form. In the event there is no effective national market system plan establishing such procedures, market centers shall prepare their reports in a consistent, usable, and machine-readable electronic format, and make such reports available for downloading from an Internet web site that is free and readily accessible to the public.
(3) A market center shall make available the report required by paragraph (b)(1) of this section within one month after the end of the month addressed in the report.
(c) Exemptions. The Commission may, by order upon application, conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this section, if the Commission determines that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.
§240.11Ac1-6 Disclosure of order routing information.
(a) Definitions. For the purposes of this section:
(1) The term covered security shall mean:
(i) Any national market system security and any other security for which a transaction report, last sale data or quotation information is disseminated through an automated quotation system as defined in Section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)); and
(ii) Any option contract traded on a national securities exchange for which last sale reports and quotation information are made available pursuant to an effective national market system plan.
(2) The term customer order shall mean an order to buy or sell a covered security that is not for the account of a broker or dealer, but shall not include any order for a quantity of a security having a market value of at least $50,000 for a covered security that is an option contract and a market value of at least $200,000 for any other covered security.
(3) The term directed order shall mean a customer order that the customer specifically instructed the broker or dealer to route to a particular venue for execution.
(4) The term make publicly available shall mean posting on an Internet web site that is free and readily accessible to the public, furnishing a written copy to customers on request without charge, and notifying customers at least annually in writing that a written copy will be furnished on request.
(5) The term non-directed order shall mean any customer order other than a directed order.
(6) The term effective national market system plan shall have the meaning provided in §240.11Aa3-2(a)(2).
(7) The term national market system security shall have the meaning provided in §240.11Aa2-1.
(8) The term payment for order flow shall have the meaning provided in §240.10b-10(d)(9).
(9) The term profit-sharing relationship shall mean any ownership or other type of affiliation under which the broker or dealer, directly or indirectly, may share in any profits that may be derived from the execution of non-directed orders.
(10) The term time of the transaction shall have the meaning provided in §240.10b-10(d)(3).
(b) Quarterly report on order routing.
(1) Every broker or dealer shall make publicly available for each calendar quarter a report on its routing of non-directed orders in covered securities during that quarter. For covered securities other than option contracts, such report shall be divided into three separate sections for securities that are listed on the New York Stock Exchange, Inc., securities that are qualified for inclusion in the Nasdaq Stock Market, Inc., and securities that are listed on the American Stock Exchange LLC or any other national securities exchange. Such report also shall include a separate section for covered securities that are option contracts. Each of the four sections in a report shall include the following information:
(i) The percentage of total customer orders for the section that were non-directed orders, and the percentages of total non-directed orders for the section that were market orders, limit orders, and other orders;
(ii) The identity of the ten venues to which the largest number of total non-directed orders for the section were routed for execution and of any venue to which five percent or more of non-directed orders were routed for execution, the percentage of total non-directed orders for the section routed to the venue, and the percentages of total non-directed market orders, total non-directed limit orders, and total non-directed other orders for the section that were routed to the venue; and
(iii) A discussion of the material aspects of the broker's or dealer's relationship with each venue identified pursuant to paragraph (b)(1)(ii) of this section, including a description of any arrangement for payment for order flow and any profit-sharing relationship.
(2) A broker or dealer shall make the report required by paragraph (b)(1) of this section publicly available within one month after the end of the quarter addressed in the report.
(c) Customer requests for information on order routing.
(1) Every broker or dealer shall, on request of a customer, disclose to its customer the identity of the venue to which the customer's orders were routed for execution in the six months prior to the request, whether the orders were directed orders or non-directed orders, and the time of the transactions, if any, that resulted from such orders.
(2) A broker or dealer shall notify customers in writing at least annually of the availability on request of the information specified in paragraph (c)(1) of this section.
(d) Exemptions. The Commission may, by order upon application, conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this section, if the Commission determines that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.
By the Commission.
Jonathan G. Katz
Secretary
Dated: November 17, 2000
Footnotes
1 The two rules, 17 CFR 240.11Ac1-5 and 17 CFR 240.1Ac1-6, were proposed for public comment in Securities Exchange Act Release No. 43084 (July 28, 2000), 65 FR 48406 ("Proposing Release"). Section 11A of the Securities Exchange Act of 1934, 15 U.S.C. 78k-1, grants the Commission authority to promulgate rules necessary or appropriate to assure the fairness and usefulness of information on securities transactions and to assure that broker-dealers transmit orders in a manner consistent with the establishment and operation of a national market system. The principal national market system objectives set forth in Section 11A(a)(1) include the efficient execution of securities transactions, fair competition among market participants, the public availability of information on securities transactions, and the best execution of investor orders. The rules adopted today should significantly further these objectives.
2 Source: NASD Economic Research Dept., www.nasdaq.marketdata.com (visited Oct. 31, 2000). It is doubtful that the emergence of agency market centers operated by ECNs has significantly worsened fragmentation in the market for Nasdaq securities. Since the creation of the Nasdaq market in the 1970's, order flow in such securities always has been fragmented among a significant number of market makers.
3 Source: NYSE. In addition, the American Stock Exchange LLC ("Amex") accounted for 69.9% of share volume in Amex equities during September 2000. Source: Amex.
4 Securities Exchange Act Release No. 42450 (Feb. 28, 2000), 65 FR 10577. The Commission subsequently approved the rescission of Rule 390, in part because the rule had tended to restrict the competitive opportunities in listed securities of ECNs that operate agency markets. Securities Exchange Act Release No. 42758 (May 5, 2000), 65 FR 30175. It emphasized, however, that its desire to clear away any regulatory barriers to competition should not be interpreted as an indication of whether the ECNs would or should attractive a significant amount of listed market share. That will be determined by competition. The Commission also emphasized that its criticism of Rule 390 should not be interpreted as criticism of the quality of the NYSE's market, noting that studies repeatedly had demonstrated its high quality of execution and important public price discovery function. Id. at note 28 and accompanying text.
5 These dealer practices are discussed in section IV.A.2 of the Fragmentation Release.
6 Securities Exchange Act Release No. 43084 (July 28, 2000), 65 FR 48406.
7 Section IV.A.1 of the Fragmentation Release discusses the various ways in which investors seek to obtain the best prices, including the use of market orders by investors seeking liquidity and the use of limit orders by investors supplying liquidity. In addition, it discusses the alternatives used by large investors to interact with smaller orders (often by offering better prices for such orders) without being forced to display their full trading interest, which might move the market significantly against them.
8 An opportunity for investor orders to be executed without the participation of a dealer is, subject to efficiency and best execution objectives, one of the five principal objectives for a national market system. Exchange Act Section 11A(a)(1)(C)(v), 15 U.S.C. 78k-1(a)(1)(C)(v).
9 See Report by Commissioner Laura S. Unger, On-Line Brokerage: Keeping Apace of Cyberspace 40-41 (Nov. 1999) (available at http://www.sec.gov). One of the recommendations in Commissioner Unger's Report was that the Commission should consider requiring market centers to make publicly available certain uniform information on execution quality and requiring broker-dealers to provide their customers with plain English information about the execution quality available at different market centers, order handling practices, and the broker-dealer's receipt of inducements for order flow. Id. at 45. In addition, one of the largest broker-dealers noted in its comment letter on the Fragmentation Release that even it had been frustrated in its own attempts to obtain useful order execution data from certain markets. Letter from Lon Gorman, Vice Chairman and President, Capital Markets & Trading Group, Charles Schwab & Co., to Jonathan G. Katz, Secretary, SEC, dated July 5, 2000, at 7.
10 This estimate is described in the cost-benefit discussion in section VII.A.1 below.
11 The practice of preferencing, under which orders are directed to a particular exchange specialist that is entitled to take priority in execution over same-priced orders entered prior in time, is quite similar to internalization by OTC market makers.
12 The Preferencing Report specifically noted (p. 172) that preferencing programs would require reconsideration if "a significant increase in the amount of preferencing activity as a percentage of overall national market system activity" resulted in the decline of execution quality on the national market system.
13 Commenters on the Proposing Release correctly noted that the Preferencing Report found higher fill rates for non-marketable limit orders on the regional exchanges than on the NYSE. Letter from Jeffrey T. Brown, Vice President Regulation and General Counsel, Cincinnati Stock Exchange, to Jonathan G. Katz, Secretary, SEC, dated Sept. 25, 2000, at 9 ("CSE Letter"); Letter from Richard Brueckner, Chief Operating Officer, Pershing Division of Donaldson, Lufkin & Jenrette Securities Corporation, to Jonathan Katz, Secretary, SEC, dated Sept. 29, 2000, at 3 ("Pershing Letter"). The fill rates are reported in Tables V-17 and V-18 of the Preferencing Study. Only a small number of non-marketable limit orders, however, were routed to the regional exchanges, even when evaluated as a percentage of total order flow (and therefore adjusting for the much smaller share volume of the regional exchanges). See Preferencing Report, Table V-2 (regional exchanges' non-marketable limit orders represented 11.5% to 17.3% of their total order executions compared to 45.7% of NYSE executions). Indeed, the Preferencing Study found that four of the five largest broker-dealer participants in the CSE preferencing program (all that were examined) generally did not use the CSE's limit order book, but preferred either to place limit orders on their proprietary limit order books or to route the limit orders to the primary market. Preferencing Report at 114.
14 Preferencing Report, Table V-7. In addition, Table V-11 indicates that, when compared for same stocks and order sizes, the NYSE average price improvement rate for small market orders was 45% to 180% higher than that of the regional exchanges. Analogous results were reflected in other tables (V-12, V-14, V-15, V-16) that were adjusted for trading in the same stocks and order sizes. Most of the tables in the Preferencing Report, however, compared NYSE trading for one week in all of its stocks with regional exchange trading for four weeks in a smaller number of NYSE stocks. They therefore did not attempt to capture distinctions between trading in comparable stocks during the same time period, as will be facilitated by the monthly market center reports to be made available under Rule 11Ac1-5.
15 See, e.g., Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 1 ("ICI Letter"); Letter from Robin Roger, Managing Director and Counsel, Morgan Stanley Dean Witter & Co., to Jonathan G. Katz, Secretary, SEC, dated Sept. 25, 2000, at 1 ("Morgan Stanley Letter"); Letter from Mary A. Burnes, Principal, OTC Trading, Edward D. Jones & Co., to Jonathan G. Katz, Secretary, SEC, dated Sept. 19, 2000, at 1 ("Edward Jones Letter"); Letter from Robert C. Gasser, Managing Director, J.P. Morgan Securities Inc., to Jonathan Katz, Secretary, SEC, dated Oct. 5, 2000, at 2 ("J.P. Morgan Letter").
16 The comment letters and a comprehensive summary of comments have been placed in Public File No. S7-16-00, which is available for inspection in the Commission's Public Reference Room.
17 See, e.g., ICI Letter, note 15 above, at 2; Letter from James E. Buck, Senior Vice President & Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC, dated Oct. 17, 2000, at 1 ("NYSE Letter"); Letter from Thomas Peterffy, Chairman, and David M. Battan, Vice President and General Counsel, Interactive Brokers LLC, to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 2 ("Interactive Brokers Letter"); Letter from Michael T. Dorsey, Senior Vice President and General Counsel, Knight Trading Group, Inc., to Jonathan G. Katz, Secretary, SEC, dated Oct. 25, 2000, at 2 ("Knight Trading Letter"); Letter from William R. Harts, Managing Director, Salomon Smith Barney Inc., to Jonathan G. Katz, Secretary, SEC, dated Nov. 3, 2000, at 1 ("Salomon Smith Barney Letter"); Letter from Andrew A. Davis, Chairman and CEO, The Rock Island Company, and William R. Surman, Senior Vice President - Equity, Rock Island Securities, Inc., to Jonathan G. Katz, Secretary, SEC, dated Sept. 8, 2000, at 2 ("Rock Island Letter"); Letter from Alan R. Shapiro, President, and Howard Kohos, Executive Vice President, Transaction Auditing Group, Inc., to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 8 ("TAG Letter").
18 Letter from Marshall E. Blume, Howard Butcher III Professor of Financial Management, The Wharton School, University of Pennsylvania, to Jonathan G. Katz, Secretary, SEC, dated Sept. 7, 2000, at 1 ("Blume Letter").
19 Letter from Meng-yuan Wang, Executive Director of EMM, UBS Warburg, to Jonathan G. Katz, Secretary, SEC, dated Sept. 25, 2000, at 1.
20 CSE Letter, note 13 above, at 9; Blume Letter, note 18 above, at 1; Letter from Cameron Smith, General Counsel, Island ECN, to Jonathan Katz, Secretary, SEC, dated Sept. 27, 2000, at 9 ("Island Letter"). The Proposing Release requested comment on disclosure of "raw data" as an alternative. The Commission is not adopting the alternative. If a market center believes, however, that the basic statistical measures included in the Rule do not adequately reflect the complexity of its order flow and execution quality, it also could make its raw data publicly available as a means to promote greater understanding of its performance.
21 Letter from Mark B. Sutton, Chairman, Market Structure Committee, Securities Industry Association, to Jonathan G. Katz, Secretary, SEC, dated Sept. 26, 2000, at 1 ("SIA Market Structure Committee Letter"; Letter from Lon Gorman, Vice Chairman, Charles Schwab & Co., to Jonathan G. Katz, Secretary, SEC, dated Sept. 28, 2000, at 1-2 ("Schwab Letter").
22 See, e.g., Morgan Stanley Letter, note 15 above, at 1; Letter from Junius W. Peake, Monfort Distinguished Professor of Finance, Kenneth W. Monfort College of Business, to Jonathan G. Katz, Secretary, SEC, dated Sept. 6, 2000, at 3 ("Peake Letter").
23 See, e.g., Pershing Letter, note 13 above, at 1 ("The Commission seems to be trying to create a quantitative definition of best execution."); SIA Market Structure Committee Letter, note 21 above, at 3 (the proposed rules "elevate price and speed over other, less easily quantifiable, measures that may be important to certain investors in assessing execution quality"); Schwab Letter, note 21 above, at 9 ("by focusing on price and speed, the Commission is explicitly endorsing these elements and implicitly indicating that all others are not relevant in the determination of best execution").
24 See, e.g., Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290 ("Order Handling Rules Release"), at section III.C.2.
25 See, e.g., Morgan Stanley Letter, note 15 above, at 12-13; Pershing Letter, note 13 above, at 2; Letter from Robert H. Forney, President and Chief Executive Officer, Chicago Stock Exchange, to Jonathan G. Katz, Secretary, SEC, dated Oct. 5, 2000, at 9 ("CHX Letter"); Letter from Lanny A. Schwartz, Executive Vice President and General Counsel, Philadelphia Stock Exchange, Inc., to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 1 ("Phlx Letter").
26 For example, the quoted spread and the effective spread are analogous to the manufacturer's suggested retail price ("MSRP") for a product and the varying prices actually charged at different stores. The first reflects the price that might be charged; the second reflects the price actually charged, which could be better or worse than the first, and often is. The Commission similarly believes that investors, with proper explanation, can grasp the concept underlying average realized spread. This statistic is calculated by comparing the execution price of an order with the public quotes as they stand five minutes after the time of execution. As discussed further in section III.C.1 below, it measures the extent to which a market center receives order flow that is difficult to handle - either because it arrives during times when the markets are stressed or it comes from informed traders. It highlights those market centers that are willing to accept such difficult order flow, a praiseworthy quality that the Commission does not want the Rule's disclosure requirements to discourage.
27 If interested, however, investors with access to the Internet and capable of using widely-available office application software could readily download and analyze a market center's monthly execution quality report. Private vendors also may offer services that enable individual investors to access and review market center reports.
28 A commenter suggested that, without an independent verification requirement, some market centers might produce reports that were materially misleading. Morgan Stanley Letter, note 15 above, at 17. The Commission does not believe that an independent verification requirement is necessary at this time. Market centers subject to Rule 11Ac1-5 will be regulated entities that have met the integrity and competence standards of the Exchange Act. In addition, all market centers will be subject to inspection by the Commission. If registered as a broker-dealer, they also will be subject to inspection by their respective self-regulatory organizations ("SROs"). The Exchange Act grants the Commission and SROs ample enforcement powers to deal with any market center that makes materially misleading disclosures concerning its execution quality.
29 SIA Market Structure Committee Letter, note 21 above, at 5; Letter from Bruce E. Coolidge of Wilmer, Cutler & Pickering, to Jonathan G. Katz, Secretary, SEC, dated Oct. 10, 2000; Letter from Roger D. Blanc of Wilkie Farr & Gallagher, to Jonathan G. Katz, Secretary, SEC, dated Oct. 5, 2000, at 10 ("Wilkie Farr & Gallagher Letter"); Schwab Letter, note 21 above, at 13-17; Morgan Stanley Letter, note 15 above, at 17; Letter from the Regulatory Studies Program of the Mercatus Center at George Mason University, to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 14 ("Mercatus Center Letter"). But see Knight Trading Letter, note 17 above, at 12-14.
30 For this reason, broker-dealers will be able to explain in their disclosures to customers the full range of factors that influenced their order routing decisions.
31 Exchange Act Section 11A(a)(2). See also Guice v. Charles Schwab & Co., 674 N.E.2d 282 (N.Y. 1996), cert. denied, 520 U.S. 1118 (1997).
32 Exchange Act Section 11A(a)(1)(C)(iv).
33 Similarly, the Commission has noted that "in evaluating its procedures for handling limit orders, the broker-dealer must take into account any material differences in execution quality." Order Handling Rules Release, note 24 above, at section III.C.2 (emphasis added).
34 See id. at section III.C.2.
35 A national securities exchange is an exchange registered under Section 6 of the Exchange Act. An exchange exempted from registration pursuant to Section 5 of the Exchange Act therefore is not included within the Rule's definition of market center.
36 When a market center receives an order for execution, the order must be included in its statistical disclosures of execution quality even if the order is routed to another venue for execution. See section III.C.1 below.
37 Indeed, the Commission anticipates that many SROs may, on behalf of their members, assume substantially all responsibility for complying with the Rule. Such an assumption of responsibility would be an acceptable way for an SRO and its members to meet the Rule's requirements.
38 The Commission's staff will be available to provide interpretive guidance to market centers on how orders should be reported under the Rule.
39 See Division of Market Regulation, SEC, Report on Electronic Communications Networks and After-Hours Trading (June 2000), at 29 (for the 15 largest capitalization stocks in the Nasdaq 100 index, average quoted spread, average effective spread, and trade price volatility increased significantly after the close of regular trading hours).
40 The Proposing Release requested comment on orders received when the consolidated BBO is locked or crossed. One commenter suggested that such orders be excluded, as well as orders received during "fast" markets. TAG Letter, note 17 above, at 4. The adopted Rule continues to encompass such orders. Its statistical measures can all be calculated during periods when markets are locked, crossed, and fast. Moreover, one of the important characteristics of a market center is its ability to handle orders well during difficult market conditions.
41 The full title of the Nasdaq Plan is "Joint Self-Regulatory Plan Governing the Collection, Consolidation, and Dissemination of Quotation and Transaction Information for Exchange-Listed Nasdaq/National Market System Securities and for Nasdaq/National Market System Securities Traded on an Unlisted Trading Privilege Basis."
42 One commenter requested clarification concerning orders that are not sent to a market center for prompt execution, as are traditional market orders, or that are not priced orders. Letter from P. Mats Goebels, Senior Vice President & General Counsel, ITG, Inc., to Jonathan G. Katz, Secretary, SEC, dated Sept. 29, 2000, at 5. Such orders would not fall within the definition of "covered order" in subparagraph (a)(8), which applies only to market orders and limit orders.
43 The market centers that offer these improved prices for opening orders may, however, exclude them from their payment for order flow schedules, thereby potentially reducing the payments to broker-dealers that obtain these better prices for their customers.
44 Rule 11Aa2-1 incorporates the definition of "reported security" that is used in Exchange Act Rule 11Aa3-1 -- any security for which transaction reports are made available pursuant to a reporting plan approved under Rule 11Aa3-1. Only exchange-listed equities and Nasdaq National Market equities currently fall within this definition.
45 See NASD Economic Research Dept., http://www.marketdata.nasdaq.com (visited June 27, 2000).
46 Interactive Brokers Letter, note 17 above, at 4.
47 Letter from Thomas A. Bond, Chicago Board Options Exchange, to Jonathan G. Katz, Secretary, SEC, dated Oct. 9, 2000, at 3 ("CBOE Letter").
48 Phlx Letter, note 25 above, at 4; CSE Letter, note 13 above, at 6-7; Schwab Letter, note 21 above, at 10-11.
49 A commenter suggested that the Rule should exclude cancelled orders in calculations of execution quality measures. Letter from Richard G. Ketchum, National Association of Securities Dealers, Inc., to Jonathan G. Katz, Secretary, SEC, dated Oct. 17, 2000, at 3. In fact, the Rule does not specify whether cancelled orders should or should not be included in calculating measures such as price improvement rates for market orders and fill rates for limit orders. Instead, market centers will disclose the number of cancelled shares, and analysts are free to use or exclude cancelled orders in performing their calculations as they think most appropriate.
50 Interactive Brokers Letter, note 17 above, at 3-4.
51 The overall fill rates for such orders can be calculated by comparing the number of shares executed with the total number of shares received. Such overall fill rates for non-marketable limit orders can be difficult to interpret because of the problem of cancelled orders. An aggressive user of non-marketable limit orders frequently will submit orders with limit prices at or inside the current consolidated BBO. If market prices move away from the order, the order submitter may cancel and resubmit the order at a new limit price that reflects the changing consolidated BBO. Consequently, the same person potentially may cancel and resubmit an order several times to maintain the aggressiveness of the limit price. These cancellations can make it difficult to evaluate overall fill rates and cancellation rates.
52 The proposed rule incorporated a 30-minute time period for calculating average realized spread. Several commenters suggested that, given the volatility of stock prices, five minutes would be a more appropriate time period and would generate more useful information. ICI Letter, note 15 above, at 4; Rock Island Letter, note 17 above, at 2. The Commission agrees and has incorporated a five-minute time period in the Rule as adopted.
53 See, e.g., NYSE Letter, note 17 above, at 9-10; NASD Letter, note 49 above, at 4-5; SIA Market Structure Committee Letter, note 21 above, at 4.
54 For example, if local traders at a particular market center display a great deal of expertise in deciding when to step ahead of displayed limit orders, the average realized spread for those limit orders would be comparatively high (they would almost always be executed only when the market was moving significantly against them).
55 See, e.g., TAG Letter, note 17 above, at 5; Edward Jones Letter, note 15 above, at 3.
56 See, e.g., NASD Letter, note 49 above, at 5; Schwab Letter, note 21 above, at 9-10.
57 Section 11A(a)(3)(B) of the Exchange Act authorizes the Commission, by rule or order, to require SROs to act jointly with respect to matters as to which they share authority in planning, developing, operating, or regulating the national market system.
58 See, e.g., Letter from Edward J. Nicoll, Chairman and CEO, Datek Online Holdings Corp., to Jonathan G. Katz, Secretary, SEC, dated Sept. 25, 2000, at 1 ("Datek Letter"); Letter from James H. Lee, President Momentum Securities, LLC, to Jonathan G. Katz, Secretary, SEC, dated Oct. 11, 2000, at 5; ICI Letter, note 15 above, at 5.
59 NASD Letter, note 49 above, at 4; CHX Letter, note 25 above, at 11; Edward Jones Letter, note 15 above, at 4.
60 Morgan Stanley Letter, note 15 above, at 15; Schwab Letter, note 21 above, at 3-4; Wilkie Farr & Gallagher Letter, note 29 above, at 3.
61 To include Nasdaq SmallCap equities, paragraph (a)(1)(i) of Rule 11Ac1-6 incorporates the language of current Rule 11Ac1-1(a)(1) - "any other security for which a transaction report, last sale data or quotation information is disseminated through an automated quotation system as described in Section 3(a)(51)(A)(ii) of the Act." This language covers SmallCap equities, but excludes equities quoted on the OTC Bulletin Board operated by the NASD. To include option securities, paragraph (a)(1)(ii) of the Rule includes "any option contract traded on a national securities exchange for which last sale reports and quotation information are made available pursuant to a national market system plan." This language includes any option securities for which market information is disseminated on a real-time basis pursuant to the national market system plan administered by the Options Price Reporting Authority ("OPRA").
62 In addition, a new paragraph (d) has been included in the Rule explicitly providing that the Commission may exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of Rule 11Ac1-6. Such an exemption will be granted if the Commission determines that it is necessary or appropriate in the public interest, and is consistent with the protection of investors.
63 The term "venue" is intended to be interpreted broadly to cover "market centers" within the meaning of Rule 11Ac1-5(a)(14), as well as any other person or entity to which a broker routes non-directed orders for execution. Consequently, the term excludes an entity that is used merely as a vehicle to route an order to a venue selected by the broker-dealer. Interpretive issues may arise in determining the applicability of the Rule when a person or entity trades under the auspices of an exchange. To assure meaningful disclosure of significant execution venues, all orders routed to a particular exchange for execution should be aggregated when calculating a broker-dealer's top ten market centers and those with 5% of orders. If a particular market maker or dealer at the exchange receives orders pursuant to any arrangement that gives it a preference to trade with the order as principal, such arrangement must be specifically included in the discussion of the relationship between broker-dealer and venue that is required by Rule 11Ac1-6(b)(1)(iii).
64 Schwab Letter, note 21 above, at 5.
65 Interpretive issues could arise in the case of an order that is routed to multiple venues by the broker-dealer (if an execution venue alone makes the decision to forward an order to a second venue, the second venue generally would not be included in a broker-dealer's report). If an order is executed after being routed by the broker-dealer to multiple venues, the venue that executed the order should be considered the venue to which the order was routed for purposes of the Rule. If an order is not executed after being routed to multiple venues (e.g., it was cancelled or expired), the first venue should be considered the venue to which the order was routed for purposes of the Rule. The Commission's staff will be available to provide further interpretive guidance on compliance with the Rule.
66 Currently, Rule 10b-10(a)(1) requires a broker-dealer to include the time of transaction on the confirmation of a transaction or a statement that the time of transaction will be furnished on written request. To assure consistency, paragraph (a)(9) of Rule 11Ac1-6 adopts the definition of the term "time of the transaction" set forth in Rule 10b-10(d)(3) - "the time of execution, to the extent feasible, of the customer's order." Broker-dealers must maintain customer order information to comply with Rule 10b-10 and other existing regulatory requirements. The Commission therefore disagrees with a commenter's assertion that the "on request" disclosures of Rule 11Ac1-6 would be costly and redundant. Schwab Letter, note 21 above, at 6. Another commenter doubted, as a matter of agency law, that "any firm would presently fail to honor such a customer request." Datek Letter, note 58 above, at 5.
67 44 U.S.C. 3501 et seq.
68 44 U.S.C. 3507.
69 5 U.S.C. 552 et seq.
70 Knight Trading Letter, note 17 above, at 6, 9.
71 ICI Letter, note 15 above, at 5.
72 TAG Letter, note 17 above, at 2.
73 See, e.g., Charles Schwab Letter, note 21 above, at 12; CHX Letter, note 25 above, at 6; Morgan Stanley Letter, note 15 above, at 18; Letter from Deborah A. Lamb, Chair, Advocacy Advisory Committee, and Maria J.A. Clark, Associate, Association for Investment Management and Research, to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 3-4.
74 Wilkie Farr & Gallagher Letter, note 29 above, at 4.
75 CHX Letter, note 25 above, at 6.
76 Phlx Letter, note 25 above, at 3.
77 In its comment letter, BRUT ECN disputed the Proposing Release's estimate of six hours per month to collect the data necessary to generate the monthly reports. It stated that its compliance would require "upwards of 100 hours initially to ensure for the efficient generation of required data, although said process would streamline future compliance efforts." Letter from William O'Brien, Senior Vice President & General Counsel, The BRUT ECN, L.L.C., to Jonathan G. Katz, Secretary, SEC, dated Oct. 5, 2000, at 1 n. 3 ("BRUT Letter"). To reflect the potential for upfront preparations to comply with data collection requirements, the estimated burden of compliance in section VI.B below has been updated.
78 For example, NASD rules require members trading Nasdaq securities to submit electronic data on individual order executions to the NASD pursuant to its Order Audit Trail System ("OATS") requirements. NASD Rules 6950-6957. This data includes the basic order information that would be necessary to calculate the statistical measures of execution quality required by Rule 11Ac1-5. One commenter stated that it believed "the NASD's OATS project, which entailed the development of data collection and warehousing on a similar scale, is a useful comparison of the development costs" of Rule 11Ac1-5. Schwab Letter, note 21 above, at 12. Market centers that already comply with the OATS data requirements, however, will have the Nasdaq order information necessary to comply with the data collection requirements of Rule 11Ac1-5.
79 The CHX stated that the Proposing Release's "estimate of six hours per month for each market center to generate the required reports seems to us unrealistically low." CHX Letter, note 25 above, at 6. The Proposing Release, however, separately addressed the issues of (1) data collection and (2) generation of the monthly reports from such data. The estimate of six hours per month applied solely to the burden of data collection. After the data is collected by market centers, it can be transferred to third party vendors with programs in place to generate the necessary reports. The Proposing Release estimated that vendors could provide this service for approximately $2500 per month.
80 See, e.g., Morgan Stanley Letter, note 15 above, at 15; NASD Letter, note 49 above, at 4; CBOE Letter, note 47 above, at 4-5.
81 Schwab Letter, note 21 above, at 6. In addition, another commenter believed that the proposed retention period of six months was "onerous and unnecessary" and that a 90-day time period would be sufficient. Edward Jones Letter, note 15 above, at 5. The Commission has retained the six-month period to assure that individual customers, after having an opportunity to review the quarterly reports giving a general overview of their broker-dealers' order routing practices, can obtain information concerning their own orders for the full period covered by the quarterly report.
82 Datek Letter, note 58 above, at 5.
83 See BRUT Letter, note 77 above, at 1.
84 These figures could vary substantially among market centers. In addition, some SROs may provide this data collection service for their members because such centralized data collection is more efficient than data collection by individual members.
85 This estimate is based on FYE 1999 FOCUS Reports received by the Commission. While there are currently approximately 7500 broker-dealers registered with the Commission, only approximately 3800 broker-dealers potentially route non-directed orders in covered securities.
86 Securities Exchange Act Release No. 40122 (June 30, 1998), 63 FR 35508, n. 65.
87 This estimate is based on FYE 1999 FOCUS Reports received by the Commission.
88 As set out more specifically in section III.C above, the required disclosures will reflect statistical measures of such things as number of orders, number of shares, number of cancelled orders, size of spreads, frequency and size of price improvement, frequency of executions at the quote, frequency of executions outside the quote, and speed of execution (both with and without price improvement).
89 These savings are based on a sample of market orders for 10 high-volume Nasdaq securities from June 2000, and represent the projected benefits summed over all Nasdaq stocks for one year. The annual savings exclude changes in effective spread for marketable limit orders and for any trade greater than 4999 shares.
90 Under this assumption, annual savings to Nasdaq investors would be approximately $175 million. These savings are calculated in the manner described in the preceding note.
91 Mercatus Center Letter, note 29 above, at 16.
92 The Mercatus Center's comment letter addresses the potential benefits associated with more frequent rebalancing, but ignores the potential changes in securities that investors choose.
93 Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. Financial Economics 223 (1986).
94 Michael J. Brennan & Avanidhar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns, 41 J. Financial Economics 441 (1996).
95 Both studies examine cross-sectional differences in required returns associated with cross-sectional differences in transaction costs so their empirical estimates may not be indicative of the size of the reduction in market-wide required returns that would accompany a market-wide reduction in transaction costs.
96 Mercatus Center Letter, note 29 above, at 18; Phlx Letter, note 25 above, at 3; Morgan Stanley Letter, note 15 above, at 18; Wilkie Farr & Gallagher Letter, note 29 above, at 4.
97 For example, NASD rules require members trading Nasdaq securities to submit electronic data on individual order executions to the NASD pursuant to its Order Audit Trail System requirements. NASD Rules 6950-6957. This data includes the basic order information that would be necessary to calculate the statistical measures of execution quality required by Rule 11Ac1-5.
98 A higher average rate of internal staff costs is used for the preparation of quarterly reports based on the assumption that they would be prepared, at least in part, by higher level staff than that involved with responding to customer requests.
99 15 U.S.C. 78w(a).
100 15 U.S.C. 78c(f).
101 5 U.S.C. 601 et seq.
102 Morgan Stanley Letter, note 15 above, at 18; Wilkie Farr & Gallagher Letter, note 29 above, at 4.
103 Exchange Act Rule 0-10(b), 17 CFR 240.0-10(c).
104 These estimates are based on the FYE 1999 FOCUS Reports received by the Commission from exchange market makers, OTC market makers, and ATSs that would be subject to Rule 11Ac1-5.
105 17 CFR 240.0-10(e).
106 This estimate is based on the FYE 1999 FOCUS Reports received by the Commission from broker-dealers subject to Rule 11Ac1-6.
107 These estimates are smaller than those used generally to estimate the burden costs for purposes of the Paperwork Reduction Act. Assuming any of the 41 small entities actually route non-directed orders on behalf of customers, it is likely that the number of orders would be very small. The burden of preparing quarterly reports and responding to customer requests would therefore be substantially less than the overall industry average.
http://www.sec.gov/rules/final/34-43590.htm
