[Federal Register: March 9, 2004 (Volume 69, Number 46)]
[Proposed Rules]
[Page 11125-11215]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09mr04-20]
[[Page 11125]]
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Part III
Securities and Exchange Commission
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17 CFR Part 200, et al.
Regulation NMS; Proposed Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 200, 230, 240, 242, and 249
[Release No. 34-49325; File No. S7-10-04]
RIN 3235-AJ18
Regulation NMS
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rules and amendments to joint industry plans.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
publishing Regulation NMS for public comment. In addition to
redesignating the existing national market system (``NMS'') rules
adopted under Section 11A of the Securities Exchange Act of 1934
(``Exchange Act''), Regulation NMS would incorporate four substantive
proposals that are designed to enhance and modernize the regulatory
structure of the U.S. equity markets. First, the Commission is
proposing a uniform rule for all NMS market centers that, subject to
certain exceptions, would require a market center to establish,
maintain, and enforce policies and procedures reasonably designed to
prevent ``trade-throughs''--the execution of an order in its market at
a price that is inferior to a price displayed in another market.
Second, the Commission is proposing a market access rule that would
modernize the terms of access to quotations and execution of orders in
the NMS. The third proposal would prohibit market participants from
accepting, ranking, or displaying orders, quotes, or indications of
interest in a pricing increment finer than a penny, except for
securities with a share price of below $1.00. Finally, the Commission
is proposing amendments to the rules and joint industry plans for
disseminating market information to the public that, among other
things, would modify the formulas for allocating plan net income to
reward markets for more broadly based contributions to public price
discovery.
DATES: Comments must be received on or before May 24, 2004.
ADDRESSES: To help us process and review your comments more
efficiently, comments should be sent by hard copy or e-mail, but not by
both methods. Comments sent by hard copy should be submitted in
triplicate to Jonathan G. Katz, Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments
also may be submitted electronically at the following e-mail address:
rule-comments@sec.gov. All comment letters should refer to File No. S7-
10-04. Comments submitted by e-mail should include this file number in
the subject line. Comment letters received will be available for public
inspection and copying in the Commission's Public Reference Room, 450
Fifth Street, NW., Washington, DC 20549. Electronically submitted
comment letters will be posted on the Commission's Internet web site
(http://www.sec.gov).\1\
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\1\ Personal identifying information, such as names or e-mail
addresses, will not be edited from electronic submission. Submit
only information that you wish to make publicly available.
FOR FURTHER INFORMATION CONTACT: Trade-Through Proposal: Heather
Seidel, Attorney Fellow, at (202) 942-0788 and Jennifer Colihan,
Special Counsel, at (202) 942-0735; Market Access Proposal: John S.
Polise, Assistant Director, at (202) 942-0068, Patrick M. Joyce,
Special Counsel, at (202) 942-0779, and Ann E. Leddy, Attorney, at
(202) 942-0795; Sub-Penny Quoting Proposal: Kevin Campion, Special
Counsel, or Ronesha Butler, Attorney, at (202) 942-0744; Market Data
Proposal: Sapna C. Patel, Special Counsel, (202) 942-0166; Regulation
NMS Proposal: Yvonne Fraticelli, Special Counsel, at (202) 942-0197;
all of whom are in the Division of Market Regulation, Securities and
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Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-1001.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Preliminary Statement
II. Objectives for Rule Proposals
A. Promote Equal Regulation of Market Centers
B. Update Antiquated Rules
C. Promote Greater Order Interaction and Displayed Depth
III. Trade-Through Proposal
A. Executive Summary
B. Background and Discussion
1. Foundation of Our National Market System
2. Intermarket Price Protection
a. History of Intermarket Price Protection
b. Existing Intermarket Price Protection Regime
c. Strains on Existing Intermarket Price Protection Regime
C. Proposed Trade-Through Rule
1. Markets Subject to the Proposed Rule
2. Types of Securities Subject to the Proposed Rule
3. Types of Orders Subject to the Proposed Rule
4. Bids and Offers To Be Protected
5. Required Policies and Procedures
6. Access Standards
7. Duty of Best Execution
D. Exceptions to the Proposed Rule
1. Opt-Out Orders
a. Request for Comment on Automated Execution Alternative
b. Opt-Out--Order-by-Order Consent
c. Opt-Out--Provision of National Best Bid or Offer
2. Automated Order Execution Facility Exception
a. Definition of ``automated order execution facility''
b. Operation of the Exception
c. Allowable Trade-Through Amount
3. Other Exceptions
E. Interaction with Existing Plans/Rules
F. General Request for Comment
G. Paperwork Reduction Act
H. Consideration of Costs and Benefits
I. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition, and Capital Formation
J. Consideration of Impact on the Economy
K. Initial Regulatory Flexibility Analysis
IV. Market Access Proposal
A. Access to Equity Markets in the NMS
1. Current Access Framework
2. Nonlinked Markets
3. Access Fees
B. Proposed Access Standards Under Regulation NMS
1. New Terms
2. Access to Published Bids and Offers
3. Access Fees
a. How Access Fees Cause Distortion in the Markets
b. Regulatory Alternatives With Respect to Access Fees
c. Proposed Solution: A de minimis Fee Standard
4. Locked and Crossed Markets
C. Proposed Amendments to Fair Access Standard of Regulation ATS
D. General Request for Comment
E. Paperwork Reduction Act
F. Consideration of Costs and Benefits
G. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition, and Capital Formation
H. Consideration of Impact on the Economy
I. Initial Regulatory Flexibility Analysis
V. Sub-Penny Quoting Proposal
A. Introduction
B. Decimals Conversion
1. Background
2. Impact of the Decimals Conversion
C. Sub-Penny Concept Release
1. Market Depth
2. Price Clarity and Flickering Quotes
3. Execution Priority Rules
4. Short Sale Regulation
5. Quote Rounding
6. Automated Systems
D. Nasdaq Rule Proposal and Petition for Commission Action
1. Proposed Rule Change
2. Petition for Commission Action
a. Two-Tiered Market
b. Disparate Quoting and Trading Conventions
c. Stepping Ahead of Limit Orders
d. Potential Impact on Regulatory Requirements
E. SEC Staff Research on Sub-Pennies
F. Discussion of Proposed Rule
G. General Request for Comment
H. Paperwork Reduction Act
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I. Consideration of Costs and Benefits
J. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition, and Capital Formation
K. Consideration of Impact on the Economy
L. Initial Regulatory Flexibility Analysis
VI. Market Data Proposal
A. Introduction
B. Consideration of Alternative Models
1. Deconsolidation Model
2. Competing Consolidators Model
3. Hybrid Model
C. Allocation of Network Net Income
1. Current Plan Formulas
2. Proposed New Formula
a. Security Income Allocation
b. Measures of Trading and Quoting
i. Trading Share
ii. Quoting Share
iii. NBBO Improvement Share
D. Plan Governance
E. Proposed Amendments to Rules 11Aa3-1 and 11Ac1-2
1. Independent Distribution of Information
2. Consolidation of Information
3. Display of Consolidated Information
F. General Request for Comment
G. Paperwork Reduction Act
H. Consideration of Costs and Benefits
I. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition, and Capital Formation
J. Consideration of Impact on the Economy
K. Regulatory Flexibility Act Certification and Initial
Regulatory Flexibility Analysis
VII. Regulation NMS Proposal
A. Introduction
B. Discussion of Proposed Regulation NMS
1. Rule Numbering
2. Rule 600--NMS Security Designation and Definitions
a. Transaction Reporting Requirements for Equities and Listed
Options
b. ``NMS security'' and ``NMS stock''
c. Changes to Current Definitions in the NMS Rules
i. ``Covered security''
ii. ``Reported security''
iii. ``Subject security''
iv. ``Consolidated system''
v. ``National securities exchange''
vi. ``OTC market maker''
vii. ``Vendor''
viii. ``Best bid,'' ``best offer,'' and ``national best bid and
national best offer''
ix. ``Bid'' or ``offer,'' ``customer,'' ``Nasdaq security,'' and
``responsible broker or dealer''
d. Definitions in the Proposed New Rules
3. Proposed Changes to Other Rules
4. Exemptive Authority
C. General Request for Comment
D. Paperwork Reduction Act
E. Consideration of Costs and Benefits
F. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition, and Capital Formation
G. Consideration of Impact on the Economy
H. Regulatory Flexibility Act Certification
VIII. Statutory Authority
IX. Text of Proposed Amendments to the CTA Plan, CQ Plan, and Nasdaq
UTP Plan
X. Text of Proposed Rules
I. Preliminary Statement
The Commission is publishing for public comment proposed Regulation
NMS, which incorporates a set of four, broad substantive rule proposals
on market structure, along with the procedural rule proposal to create
Regulation NMS. We recognize that, if ultimately adopted, the rule
proposals would effect fundamental innovations in the nation's equity
markets. Today's action is intended to advance the dialogue on these
vitally important market structure issues.
Giving the public an opportunity to comment on specific rule
proposals is the logical next step in the deliberate and systematic
review of market structure that the Commission has undertaken in recent
years. The central objective of this review is to determine how the
regulations governing the U.S. equity markets should be modernized. Our
markets are continually evolving because of such factors as innovative
trading technologies, new market entrants, and changing investment
patterns. We believe that one of our most important responsibilities is
to monitor these changes and to ensure that the U.S. regulatory
structure remains up to date. In this way, we can help our markets
retain their position as the deepest and most efficient in the world--
markets that offer a fair deal to all types of investors, large and
small.
By publishing the proposals, the Commission does not intend to
suggest that its market structure review is complete and that final
decisions have been reached on any of the rule proposals' provisions.
The issues undoubtedly are complex. Reaching good decisions requires a
firm grasp of the relevant facts, an understanding of the often subtle
ways in which the markets work, and the balancing of policy objectives
that sometimes may not point in precisely the same direction. To inform
its thinking, the Commission repeatedly has sought the views of market
participants and the public. Thus far, our review has included multiple
public hearings and roundtables, an Advisory Committee, four concept
releases, the issuance of temporary exemptions intended in part to
generate useful data on policy alternatives, and a constant dialogue
with industry participants and investors. The information and data
generated by these steps has formed the basis for the development of
the rule proposals.
The Commission believes that focusing comment on specific rule
proposals is the essential next step in achieving the best possible
regulatory initiatives. In this regard, in addition to seeking written
comments, we will hold one or more hearings in the coming months to
expand the opportunity for dialogue on the rule proposals themselves
and on the issues they address. The Commission will reflect the
insights gained from this open process in its final rulemaking.
II. Objectives for Rule Proposals
The Commission is publishing four substantive rule proposals that
are designed to enhance and modernize the national market system, along
with a procedural rule proposal to create a new Regulation NMS. The
rule proposals include the following regulatory initiatives:
(1) A uniform trade-through rule for all NMS market centers that
would affirm the fundamental principle of price priority, while also
addressing problems posed by the inherent difference in the nature of
prices displayed by automated markets, which are immediately
accessible, compared to prices displayed by manual markets;
(2) A uniform market access rule with a de minimis fee standard
that would help assure non-discriminatory access to the best prices
displayed by NMS market centers, but without mandating inflexible,
``hard'' linkages such as the Intermarket Trading System (``ITS'');
(3) A sub-penny quoting rule establishing a uniform quoting
increment for NMS stocks to promote greater price transparency and
consistency;
(4) Amendments to the arrangements for disseminating market
information that would reward self-regulatory organizations (``SROs'')
for their contributions to public price discovery, as well as implement
many of the recommendations of the Commission's Advisory Committee on
Market Information; and
(5) Regulation NMS, which would modernize and restructure the
Exchange Act rules governing the NMS to promote greater clarity and
understanding of the rules.
If adopted, the proposals collectively would constitute a
significant upgrade of the NMS regulatory framework and address a
variety of issues that have arisen in recent years. The NMS needs to be
enhanced and modernized, not because it has failed investors, but
because it has been so successful in promoting growth, efficiency,
innovation, and competition that many of its old rules now are
outdated. Since the NMS was created nearly thirty years ago, trading
volume has exploded, competition among market centers has
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intensified, and investor trading costs have shrunk dramatically. Each
of the major milestones in the development of the NMS--including the
creation of the consolidated system for disseminating market
information in the 1970s, the incorporation of The Nasdaq Stock Market,
Inc. (``Nasdaq'') securities into the NMS in the 1980s, and the
adoption of the Order Handling Rules in the 1990s--has successively
generated enormous benefits for investors.
In the 2000s, improvements to the NMS have continued to benefit
investors. In particular, the rescission of New York Stock Exchange,
Inc. (``NYSE'') Rule 390, trading in penny increments, and public
disclosure of order execution quality have set the stage for
exceptionally vigorous competition among market centers, particularly
to provide the best prices for orders of less than block size (10,000
shares). Since November 2001, for example (the first month for which
all markets were required to disclose their execution quality), the
effective spreads paid by investors seeking liquidity in the NMS have
declined steadily across all markets by a cumulative total of more than
40%.\2\ In November 2003 alone, these reduced spreads resulted in
cumulative investor savings of more than $340 million, or more than
$4.0 billion on an annualized basis.\3\ Importantly, small investors
seeking direct participation in the U.S. securities markets have shared
fully in these savings, and indeed likely have been the biggest
beneficiaries of NMS improvements.
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\2\ This 40% reduction in spreads since November 2001 is in
addition to the reduction in spreads that occurred immediately upon
the initiation of trading in penny increments in the first part of
2001. See infra, text accompanying notes 197-199.
\3\ Using execution quality statistics publicly disclosed
pursuant to Exchange Act Rule 11Ac1-5, investor savings are
calculated based on the share volume of market and marketable limit
orders with sizes of less than 10,000 shares that were executed at
23 NMS market centers in November 2003. The share volume for each
stock is multiplied by the difference in effective half-spreads
between Nov. 2001 and Nov. 2003 in each stock at each market center.
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The proposals published for public comment today are intended to
help assure that the NMS continues to serve investor interests in the
future. The particulars of the proposals are described in more detail
below. The balance of this overview places the proposals in the context
of the Commission's historical approach to market structure and
summarizes the goals that the proposals are designed to achieve.
The objectives for the NMS set forth in the Exchange Act are well
known--efficiency, competition, price transparency, best execution, and
direct interaction of investor orders. Each of these objectives is
essential, yet they sometimes conflict with one another in practice and
can require delicate balancing. In particular, the objective of market
center competition can be difficult to reconcile with the objective of
investor order interaction. We want to encourage innovation and
competition by the many individual market centers that collectively
make up the NMS, while at the same time assuring that each of these
parts contributes to a system that, as a whole, generates the greatest
benefits for investors--not their market intermediaries.
The Commission therefore has sought to avoid the extremes of, on
the one hand, isolated market centers and, on the other hand, a totally
centralized system that loses the benefits of vigorous competition and
innovation among market centers. To achieve the appropriate degree of
integration, the Commission primarily has relied on two tools: (1)
Transparency of the best prices through the consolidated display of
quotes and trades from all NMS market centers; and (2) intermarket
``rules of the road'' that establish a basic framework within which
competition among NMS market centers can flourish on terms that
ultimately benefit investors. Today's proposals are intended to
continue this strategy.
In particular, the proposals are designed to address a variety of
problems that generally fall within three categories:
(1) The need for uniform rules that promote equal regulation of,
and free competition among, all types of market centers;
(2) The need to update antiquated rules that no longer reflect
current market conditions; and
(3) The need to promote greater order interaction and displayed
depth, particularly for the very large orders of institutional
investors.
A. Promote Equal Regulation of Market Centers
Not that many years ago, the NMS could be divided fairly clearly
into groups of stocks, each with its own particular mix of market
centers. The traditional auction exchanges--NYSE and the American Stock
Exchange LLC (``Amex'')--dominated trading in their listed stocks, with
some dealer participation on the regional exchanges and in the third
market. Market makers dominated trading in Nasdaq stocks.
Today, these historical divisions are disappearing. For Nasdaq
stocks, automated quote-driven market centers (such as Nasdaq's
SuperMontage, the Archipelago Exchange,\4\ and Inet ATS, Inc.
(``Inet'')) have captured more than 50% of share volume. For Amex
stocks (for which approximately 39% of share volume now is represented
by two extremely active exchange-traded funds (``ETFs'')--the QQQ and
SPDR), Amex now handles approximately 27% of the volume, with the
remaining balance split among Archipelago, Inet, and others. The NYSE
has retained approximately 75% of the volume in its listed stocks, but
other market centers are attempting to raise the level of competition
and increase their share of trading. Moreover, the NYSE and Amex have
sought to add automated facilities that are integrated with and
complement their traditional exchange floors.
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\4\ The Archipelago Exchange (``Archipelago'') is the equities
trading facility of the Pacific Exhange (``PCX'').
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The intensified competition, or threat of competition, in the NMS
in recent years has benefited investors by reducing trading costs and
prompting better, more efficient services. The rules that govern the
NMS, however, need to be updated to reflect the new market conditions.
Many rules, for example, were developed separately for listed markets
and the Nasdaq market. This disparity makes little sense today when the
level of trading volume and the identity and character of participating
market centers are becoming more similar for both listed and Nasdaq
securities.
Section 11A(c)(1)(F) of the Exchange Act grants the Commission
rulemaking authority to assure equal regulation of all markets for NMS
securities. Today, in many respects, the same rules apply across all
U.S. equity markets. For instance, all broker-dealers have an
obligation to seek to obtain best execution for their customers'
orders--specifically, to seek to obtain the most favorable terms
available under the circumstances.\5\
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\5\ The Commission recognizes that execution price and speed of
execution are not the sole relevant factors in obtaining best
execution of investor orders, and 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.
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In other respects, however, there is disparity in rules across
markets, and the Commission believes the proposals set forth in
Regulation NMS will help further the statutory objective of assuring
equal regulation of all markets
[[Page 11129]]
for NMS securities. For example, the market for listed securities
currently has a trade-through rule affirming the principle of price
priority, while the market for Nasdaq securities does not. The proposed
trade-through rule would address this disparity. In addition, certain
market centers currently charge substantial fees for access to their
displayed quotes, while other market centers are not permitted to
assess such charges. The proposed access rule would address this
disparity. Finally, some market centers currently engage in sub-penny
quoting, while others do not. The proposed sub-penny rule would
establish a uniform quoting convention.
B. Update Antiquated Rules
The NMS was created in the 1970s. Although the fundamental policy
objectives that guided its creation remain as valid as ever, some of
the NMS rules and facilities no longer adequately address current
market conditions. For example, some were written long before
technological innovation opened the door for new types of services,
such as automatic execution and order routing services.
The proposals would modernize older NMS rules that have become
antiquated. The proposed market access rule, for example, could be
implemented using indirect market linkages that have been enabled by
improved communications technology, rather than a hard linkage like the
one incorporated into the ITS. The market data proposal would update
formulas for allocating income to the SROs that were adequate many
years ago when a single market dominated each group of securities, but
much less so now when volume is split among different market centers
whose contributions to the public quote and trade streams can vary
considerably.
C. Promote Greater Order Interaction and Displayed Depth
A significant strength of the current NMS is the competition among
market centers that encompass a variety of trading models, from
traditional exchanges to electronic communications networks (``ECNs'')
with automated limit order books to automated market maker systems.
This competition particularly has benefited retail investors, for whom
a primary component of execution quality is spread costs.
Conversely, perhaps the most serious weakness of the NMS is the
relative inability of all investor buying and selling interest in a
particular security to interact directly in a highly efficient manner.
Little incentive is offered for the public display of customer orders--
particularly the large orders of institutional investors. If orders are
not displayed, it is difficult for buying and selling interest to meet
efficiently. In addition, the lack of displayed depth diminishes the
quality of public price discovery.
The seriousness of this weakness has been voiced frequently in
recent years by institutional investors. For large institutional orders
(generally greater than 10,000 shares and often substantially greater),
price impact costs are a more significant component of execution
quality than spread costs. For example, assume that an institution
decides to sell 100,000 shares of a stock when the best bid is $20, but
winds up selling the stock for an average price of $19.80 because the
price declines in response to the institution's selling interest. In
this case, the 20-cent per share price impact cost is likely to greatly
exceed the spread costs in the stock that are associated with smaller
orders. Institutional investors have indicated that they need more
effective ways to interact directly with large size trading interest on
the other side of the market. The limited data on institutional trading
costs that is publicly available tends to support their complaints. For
example, one recently published analysis of worldwide institutional
trading costs found that such costs for NYSE and Nasdaq stocks rose,
respectively, by 25.1% and 29.6% for the period from 1999 through the
second quarter of 2003.\6\
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\6\ Justin Schack, ``Trading Places,'' Institutional Investor,
Nov. 2003 at 29, 32 (citing Elkins/McSherry analysis).
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A variety of factors other than market structure (such as the
decline in average stock prices) could be significant contributors to
an increase in institutional trading costs. Nevertheless, these costs
appear to have risen substantially during the same time period that
smaller order execution costs have dropped dramatically. Given the
troubling nature of this trend, we cannot afford to be satisfied with
the status quo as regards the efficiency of the NMS. A critically
important goal of the proposals is to enhance opportunities for the
direct interaction of investor buying and selling interest and to
improve the depth of public price discovery.
For example, the trade-through proposal, by modifying the existing
listed market trade-through rule to accommodate the differing nature of
quotes displayed by manual and automated markets, is intended to assist
those institutions that seek direct and efficient interaction with
contra trading interest. Similarly, the market access proposal would
help assure that all investors have non-discriminatory access to the
best prices for a security, no matter where they are displayed in the
NMS. The sub-penny quoting proposal would address the practice of
``stepping-ahead'' of displayed limit orders for trivial amounts, which
disadvantages those investors who are willing to contribute to quoted
depth by publicly displaying their trading interest. Finally, the
central objective of the market data proposal is to reward those market
centers whose quotes reflect the best prices for the largest sizes and
thereby contribute the most to public price discovery.
III. Trade-Through Proposal
A. Executive Summary
Changes in the equities markets in recent years have raised the
issue of whether a trade in one market should be executed when a quote
at a better price is displayed in another market. Rules limiting
trading at an inferior price have been in place since 1978 in the
markets for NYSE and Amex securities, but no such intermarket rules
exist in the markets for Nasdaq securities. Over the years, dramatic
changes have occurred in each of these markets, and trading in Nasdaq,
NYSE, and Amex securities has spread across an increasing variety of
market centers, including ``alternative'' highly automated markets,
many of which provide for almost instantaneous executions of matching
buy and sell orders within their systems. Various markets, including
the NYSE, Amex, and Nasdaq, have deployed new automation systems to
make their markets more efficient. Moreover, advances in technology
have led to sophisticated order routing and execution systems that can
provide extremely fast routing and execution capabilities among
competing multiple markets. Finally, the minimum pricing variation in
equity securities is now a penny instead of an eighth, resulting in
narrower spreads, at least for many actively traded stocks. At the same
time there is decreased depth at the best quote, and rapid quote
changes--often many times within a second.
The Commission believes that these changes require it to revisit
the issue of trading at inferior prices across markets.\7\ Clearly, in
a fully efficient market with frictionless access and instantaneous
executions, trading through a better-displayed bid or offer should not
occur. Yet the Commission
[[Page 11130]]
believes that even in the current markets with linkages between markets
and a range of execution speeds and fill rates, there is value in
protecting a displayed price from trades occurring at inferior prices
in other markets. This ``price protection'' encourages the display of
priced orders and fosters the execution of customer orders.
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\7\ See Section III.B.2.b. infra for a discussion of the current
ITS trade-through rule.
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The Commission therefore is proposing a rule intended to preserve
the benefits of price protection across markets, while addressing the
tensions in the operation of the current ITS trade-through rule. The
proposed rule would require an order execution facility (as defined
below), national securities exchange, and national securities
association to establish, maintain, and enforce polices and procedures
reasonably designed to prevent the execution of a trade-through in its
market. The proposed rule would apply to all incoming orders in ``NMS
Stocks''--all Nasdaq, NYSE, and Amex-listed stocks--and to any order
execution facility that executes orders internally within its market,
whether or not that market posts its best bid and offer in the
consolidated quote system.\8\
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\8\ ``NMS Stock'' is defined proposed Rule 600 of Regulation NMS
to mean any NMS Security other than an option. NMS Security is
defined in proposed Rule 600 of Regulation NMS to mean any security
or class of securities for which transaction reports are collected,
processed, and made available pursuant to an effective transaction
reporting plan, or an effective national market system plan.
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The proposed rule would have two major exceptions. One would allow
customers (and broker-dealers trading for their own accounts) to ``opt-
out'' of the protections of the rule by providing informed consent to
the execution of their orders, on an order-by-order basis, in one
market without regard to the possibility of obtaining a better price in
another market. The other exception would take into account the
differences between the speed of execution in electronic versus manual
markets by providing an automated market with the ability to trade-
through a non-automated market up to a certain amount away from the
best bid or offer displayed by the non-automated market. The Commission
believes that the proposed rule would promote competition and order
interaction between markets, provide an incentive for the use of limit
orders and aggressive quoting, facilitate the ability to achieve best
execution and help reduce the effects of fragmentation.
B. Background and Discussion
1. Foundation of Our National Market System
Amendments to the Exchange Act made almost three decades ago formed
the basis for the modern market structure in the U.S.--a national
market characterized by a system of competing markets, rather than one
centralized market. Section 11A of the Exchange Act, enacted as part of
the Securities Act Amendments of 1975 (``1975 Amendments''), sets forth
Congress'' findings regarding the nation's securities markets and
directs the Commission to facilitate the development of an NMS in
keeping with the principles set forth by Congress.\9\ Specifically,
Congress found that it is in the public interest and appropriate for
the protection of investors and the maintenance of a fair and orderly
market to assure:
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\9\ Section 11A(a)(2) of the Exchange Act, 15 U.S.C. 78k-
1(a)(2).
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The economically efficient execution of
securities transactions;
Fair competition among brokers and dealers,
among exchange markets, and between exchange markets and markets other
than exchange markets;
The availability to brokers, dealers, and
investors of information with respect to quotations for and
transactions in securities;
The practicability of brokers executing
investors' orders in the best market; and
The opportunity, consistent with the provisions
in the first and last bullets above, for investors' orders to be
executed without the participation of a dealer.\10\
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\10\ Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C).
Congress also found that the linking of all markets for securities will
``foster efficiency, enhance competition, increase the information
available to brokers, dealers, and investors, facilitate the offsetting
of investors' orders, and contribute to best execution of such
orders.'' \11\ In short, Section 11A of the Exchange Act envisions a
market structure characterized by full transparency where competing
markets are linked together to provide the ability to effectively and
efficiently execute customer orders in the best available market. It is
these core principles that have shaped the Commission's actions to
foster the development of a true NMS.
---------------------------------------------------------------------------
\11\ Section 11A(a)(1)(D) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(D).
---------------------------------------------------------------------------
Although Congress set out broad principles to govern the
development of an NMS, it did not dictate a specific form that it
should take. Instead, Congress envisioned that competitive forces, to
the extent feasible, would shape the structure of our markets, and
granted the Commission broad authority to oversee the implementation,
operation, and regulation of an NMS.\12\ In keeping with Congress'
mandate, the Commission believes that its central role is to facilitate
the development of an NMS, not to dictate the precise form that the NMS
will take.\13\
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\12\ See Securities Exchange Act Release No. 14416 (January 26,
1978), 43 FR 4354 (February 1, 1978) (``1978 Statement'') at 12-13,
17-18. See also Senate Committee on Banking, Housing and Urban
Affairs, Report to Accompany S. 249, S. Rep. No. 94-75, 94th Cong.,
1st Sess. (1975) (``Senate Report'') at 7-9 and Comm. of Conference,
Report to Accompany S. 249, H.R. Rep. No. 94-249, 94th Cong., 1st
Sess. (1975) (``Conference Report'') at 50-51, 92.
\13\ In its status report on the state of the national market
system in 1979, the Commission stated that its role in the
development of a national market system is to ``monitor and
encourage industry progress, to act as a catalyst and, when
necessary, to take regulatory action to achieve a particular goal.
However, the Congress did not intend that the Commission dictate the
ultimate configuration of the national market system or, through
regulatory fiat, force all trading into a particular mold.''
Securities Exchange Act Release No. 15671 (March 22, 1979), 44 FR
20360 (April 4, 1979) (``1979 Status Report'') at 3.
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Within the framework of this philosophy, the Commission has over
the years helped to guide the development of our NMS. For instance, the
Commission, working with the various SROs, has taken numerous steps to
implement the basic structure upon which our existing NMS is built. For
example:
In the late 1970s the Commission issued several
policy statements outlining its vision of an NMS, including a belief in
the importance of attaining nationwide protection for customer limit
orders.\14\
---------------------------------------------------------------------------
\14\ See, e.g., 1978 Statement, supra note 12, at 35-38 and 1979
Status Report, supra note 13, at 10-18.
---------------------------------------------------------------------------
In the late 1970s the Commission adopted a rule
requiring the exchanges and the National Associations of Securities
Dealers (``NASD'') to report quotations in certain securities, and
approved an NMS plan established by the SROs relating to the reporting
of quotations in exchange-listed securities (the Consolidated Quotation
or ``CQ'' Plan).\15\
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\15\ See Securities Exchange Act Release Nos. 14415 (January 26,
1978), 43 FR 4342 (February 1, 1978) (adopting Rule 11Ac1-1 under
the Exchange Act). Rule 11Ac1-1 (proposed to be designated as Rule
602) requires each SRO to collect, process and make available to
securities information vendors quotation prices and sizes for all
securities as to which last sale information is included in the
consolidated transaction reporting system contemplated by Rule
11Aa3-1 under the Exchange Act ( proposed to be designated as Rule
601). In 1978 the Commission approved a joint proposal by the SROs
to implement the requirements of Rule 11Ac1-1 under the Exchange Act
(proposed to be designated as Rule 602), the CQ Plan, which became
effective on July 28, 1978. See Securities Exchange Act Release No.
15009 (July 28, 1978), 43 FR 34851 (August 7, 1978). On February 20,
1979 quotations of third market makers were added to the
consolidated quote data stream. See Securities Exchange Act Release
No. 15511 (January 24, 1979), 44 FR 6230.
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[[Page 11131]]
Rule 11Aa3-1 (proposed to be designated as Rule
601), which requires SROs to implement a transaction reporting plan for
the collection, processing and dissemination of last sale transaction
reports in reported securities, was adopted in 1972.\16\
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\16\ See Securities Exchange Act Release No. 9850 (November 8,
1972), 37 FR 24172 (the rule was adopted as Rule 17a-15 and was
redesignated as Rule 11Aa3-1 in 1980). In the mid 1970s the
Commission approved two NMS plans proposed by various SROs to
implement the requirements of Rule 11Aa3-1. See Securities Exchange
Act Release Nos. 10787 (May 10, 1974), 39 FR 17799 (approving a
joint plan proposed by the NYSE, Amex, Midwest Stock Exchange (the
predecessor to the Chicago Stock Exchange (``CHX''), Pacific
Exchange (``PCX''), PBW Stock Exchange (the predecessor to the
Philadelphia Stock Exchange (``Phlx'')) and the NASD, which became
the Consolidated Tape Association (``CTA'') Plan) and 11255
(February 18, 1975), 40 FR 8397 (declaring effective individual
plans proposed by the Boston Stock Exchange (``BSE''), Cincinnati
Stock Exchange (the predecessor to the National Stock Exchange
(``NSX'')), Detroit Stock Exchange and Instinet for complying with
Rule 11Aa3-1 subject to each becoming an ``other reporting party''
pursuant to the CTA Plan). The Commission notes that the current CTA
Plan participants are: Amex, BSE, Chicago Board Options Exchange
(``CBOE''), CHX, NSX, NASD, NYSE, PCX and Phlx. See Securities
Exchange Act Release No. 48987 (December 23, 2003), 68 FR 75661
(December 31, 2003).
---------------------------------------------------------------------------
In 1979 the Commission approved an exchange plan
to link the various markets trading exchange-listed securities (the
``ITS Plan'').\17\
---------------------------------------------------------------------------
\17\ See Securities Exchange Act Release Nos. 14661 (April 14,
1978), 43 FR 17419 (April 24, 1978) (initial temporary approval),
15058 (August 11, 1978) (extending temporary approval), 16214
(September 21, 1979), 44 FR 56069 (extending temporary approval) and
19456 (January 27, 1983), 48 FR 4938 (February 3, 1983) (final
permanent approval). All national securities exchanges and the NASD
are now members of the ITS Plan except the International Securities
Exchange, which trades solely securities not covered by the ITS
Plan. The ITS Plan requires each Plan participant to provide
electronic access to its displayed best bid or offer to other Plan
participants and provides an automated mechanism for routing orders,
called commitments, to reach those displayed prices.
---------------------------------------------------------------------------
Rule 11Ac1-2 (proposed to be designated as Rule
603), which was adopted in 1980, imposes minimum requirements
regulating the manner in which securities information vendors display
transaction and quotation information.\18\
---------------------------------------------------------------------------
\18\ See Securities Exchange Act Release No. 16590 (February 13,
1980), 45 FR 12391 (February 19, 1980).
---------------------------------------------------------------------------
In response to the Commission's continuing
concerns regarding intermarket price protection, in 1981 the ITS
participants proposed amendments to the ITS Plan and to their own rules
requiring participants to avoid the execution of a trade at a price
worse than the best price displayed on another participant market.\19\
In 1981 the Commission approved the amendments to the ITS Plan,
including a model trade-through rule upon which the SRO trade-through
rules were based.\20\ In 1981 and 1982, respectively, the Commission
approved the exchanges' and NASD's trade-through rules.\21\
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\19\ See Securities Exchange Act Release Nos. 17703 (April 9,
1981) (adopting amendments to the ITS Plan), 17579 (February 26,
1981), 46 FR 14876 (March 2, 1981) (CHX proposal), 17612 (March 9,
1981), 46 FR 16770 (March 13, 1981) (PCX, BSE, NYSE and Phlx
proposal) and 17671 (March 30, 1981), 46 FR 20345 (April 3, 1981)
(NSX and Amex proposal).
\20\ See Securities Exchange Act Release No. 17703 (April 9,
1981), supra note 19.
\21\ See Securities Exchange Act Release Nos. 17704 (April 9,
1981), 46 FR 22520 (April 17, 1981) (order approving exchange rules)
and 19249 (November 17, 1982), 47 FR 53552 (November 26, 1982)
(order approving NASD rule).
---------------------------------------------------------------------------
In 1990 the Commission approved on a pilot basis
a proposal by several of the SROs governing the collection,
consolidation and dissemination of quotation and transaction
information for Nasdaq national market securities listed and traded on
Nasdaq and traded on exchanges pursuant to unlisted trading
privileges.\22\ The Nasdaq UTP Plan now applies to all Nasdaq
securities.\23\
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\22\ See Securities Exchange Act Release No. 28146 (June 26,
1990), 55 FR 27917 (July 6, 1990) (approval order of the Reporting
Plan for Nasdaq-Listed Securities Traded on Exchanges on an Unlisted
Trading Privileges Basis (``Nasdaq UTP Plan'')). The parties did not
begin trading until July 12, 1993; thus, the pilot period began on
July 12, 1993. The Nasdaq UTP Plan has been in operation since that
time on an extended pilot basis. See, e.g., Securities Exchange Act
Release Nos. 34371 (July 13, 1994), 59 FR 37103 (July 20, 1994) and
48318 (August 12, 2003), 68 FR 49534 (August 18, 2003).
\23\ See Securities Exchange Act Release No. 45081 (November 19,
2001), 66 FR 59273 (November 27, 2001) (extending the scope of the
Plan to include all Nasdaq/NM and SmallCap securities).
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In 1996, as part of its Order Handling Rules
initiative designed to enhance transparency and competition in the
market place, the Commission adopted Rule 11Ac1-4 under the Exchange
Act (proposed to be designated as Rule 604) (the ``Limit Order Display
Rule''), which requires certain exchange specialists and over-the-
counter (``OTC'') market makers to publicly display customer limit
orders that better the specialist's or market maker's displayed price
and/or size.\24\
---------------------------------------------------------------------------
\24\ See Securities Exchange Act Release No. 37619A (September
6, 1996), 61 FR 48290 (September 12, 1996).
---------------------------------------------------------------------------
The Commission also amended Rule 11Ac1-1 under
the Exchange Act (proposed to be designated as Rule 602) (the ``Quote
Rule'') at the same time to require a specialist or OTC market maker to
publicly display its best-priced quotations and customer limit orders
for any listed security when it is responsible for more than 1% of the
aggregate trading volume for that security, and to make publicly
available any superior prices that the specialist or market maker
privately quotes through certain ECNs.\25\
---------------------------------------------------------------------------
\25\ Id.
---------------------------------------------------------------------------
In June 2000 the Commission issued an order that
established the framework for the SROs to convert their quotation
prices from fractions to decimals.\26\ The order allowed the SROs to
select a uniform minimum pricing variation for stock quotes of no
greater than $.05 and no less than $.01.\27\ In July 2000 the SROs
submitted a Decimals Implementation Plan that set the minimum pricing
variation for equity stock quotations at one cent, and each SRO
established rules setting the minimum quoting increment for equity
securities in its market at one cent.\28\
---------------------------------------------------------------------------
\26\ See Securities Exchange Act Release No. 42914 (June 8,
2000), 65 FR 38010 (June 19, 2000).
\27\ Id. at 38013.
\28\ See Securities Exchange Act Release No. 46280 (July 29,
2002), 67 FR 50739 (August 5, 2002).
---------------------------------------------------------------------------
These and other actions resulted in a solid foundation for our NMS.
For NYSE, Amex, and Nasdaq securities, the best bids and offers of each
national securities exchange and registered OTC market maker are
collected and made available to market participants. The last sale
prices for NYSE, Amex, and Nasdaq securities are collected and
disseminated through a central reporting facility to market
participants. All national securities exchanges and registered OTC
market makers that trade ``ITS eligible'' securities (including any ECN
registered as an Intermarket Trading System/Computer Assisted Execution
System (``ITS/CAES'') market maker) are able to access each ITS
participant's top-of-book through the ITS linkage, and are subject to
existing trade-through provisions that require ITS participants'
members to seek to avoid trading at a price in one market that is
inferior to the price displayed in another market. Alternative markets
to the traditional floor-based auction markets have developed within
the existing national market system, bringing added competition to our
markets.
2. Intermarket Price Protection
The Commission believes that one of the most important goals of an
NMS is the encouragement of the display of limit orders and aggressive
quotes, which provide the basis for all price discovery in the markets.
When trades occur at prices that are inferior to displayed limit orders
or quotes, it could discourage their display because market
participants may be less willing to display limit orders or to quote
aggressively if they believe it likely that
[[Page 11132]]
such orders and quotes will be bypassed by executions in other markets
at prices that would be advantageous to them. A rule that effectively
prevents one market from executing an order at a price that is inferior
to a better price displayed on another market, especially in an NMS
characterized by multiple competing markets, may encourage market
participants to use limit orders and to quote aggressively, which in
turn can improve the price discovery process and contribute to
increased liquidity and depth. Moreover, such a rule, coupled with
adequate access among markets, also could help reduce the effects of
fragmentation and promote order interaction among competing markets by
providing that trades would not execute in each individual market
without reference to quotes and orders displayed in other markets.
In addition, when trades occur at prices worse than the displayed
quote, it gives an impression of unfairness in our market system,
especially to retail investors who see their orders executed at the
inferior prices. Trade-through rules facilitate broker-dealers' ability
to achieve best execution for their customers' orders. Pursuant to a
trade-through rule, if a broker-dealer routes an order to a market that
is not showing the best bid or offer at the time of order execution,
that market should not execute the order at a price that is inferior to
the price displayed on the other market, unless an exception applies.
a. History of Intermarket Price Protection
In the late 1970s, following the adoption of the 1975 Act
Amendments to the Exchange Act, the Commission expressed its desire to
move forward to achieve nationwide protection for customer limit
orders, calling for industry efforts to be concentrated on achieving
nationwide protection of public limit orders based on the principle of
price priority.\29\ With regard to the trading of exchange-listed
securities, the Commission believed that the ITS participants should be
given time to enhance ITS as a way of providing intermarket price
protection for customer limit orders.\30\ Although its focus was on
providing protection for public limit orders, in its 1979 Status Report
the Commission also stated its belief that nationwide price protection,
if it was to be accomplished ``in a fair manner consistent with the
Act,'' ultimately should protect all buying and selling interest
displayed by a market center as part of its current bid and offer as
well as all displayed public limit orders away from the best market
that were also superior to the price of the proposed trade.\31\
---------------------------------------------------------------------------
\29\ See 1978 Statement, supra note 12, at 34-38 and 1979 Status
Report, supra note 13, at 11-15. In its 1978 Statement, the
Commission's focus included a desire for a central limit order file
that would have provided price and time priority for public limit
orders across markets trading the same securities. In its 1979
Status Report, however, the Commission recognized that introducing a
system based upon absolute intermarket time priority for public
limit orders might have a disruptive impact on the nation's markets
at that time. The Commission thus expressed its intent to focus
attention on achieving intermarket price priority for public limit
orders.
\30\ See 1979 Status Report, supra note 13, at 15-16. In 1979
the Commission proposed, as a step towards achieving intermarket
price protection for public limit orders through ITS, its own rule
that would have prohibited a broker-dealer from executing a
transaction in a market center at a price inferior to the price of
any displayed public limit order(s) unless the broker-dealer either
simultaneously with or immediately after such execution satisfied
any better priced public limit order. See Securities Exchange Act
Release No. 15770 (April 26, 1979), 44 FR 26692. In 1992, citing the
passage of the years and the lack of progress on developing a
nationwide system for the collection and dissemination of limit
orders, the Commission withdrew its proposed rule. See Securities
Exchange Act Release No. 31344 (October 21, 1992), 57 FR 48581
(October 27, 1992) (``Withdrawal Release''). In doing so, it noted
that the trade-through rules of the SROs, while not providing the
same level of intermarket price protection that would have been
provided by the Commission's rule, did provide price protection for
public limit orders. Id. at 12.
\31\ See 1979 Status Report, supra note 13, at 25.
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In 1981 the participants in the ITS Plan proposed amendments to the
ITS Plan that stated that certain market participants should not
execute orders at a price worse than the best price displayed by
another participant market in the public quote.\32\ The proposal
included a model trade-through rule.\33\ The Plan participants also
proposed amendments to their own rules to institute trade-through rules
patterned after the model ITS rule requiring their members to avoid
trading through a better price displayed on another market.\34\ In 1981
the Commission approved these amendments to the ITS Plan and ITS
exchange participant trade-through rules.\35\ Several years later, the
NASD become an ITS Plan participant and instituted its own trade-
through rule that applies to each of its members that is a registered
market maker in exchange-listed securities (an ``ITS/CAES'' market
maker).\36\
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\32\ See Securities Exchange Act Release No. 17703 (April 9,
1981), supra note (order adopting trade-through amendments to the
ITS Plan), and Section 8(d) of the ITS Plan.
\33\ See Exhibit B of the ITS Plan.
\34\ See supra note 19. The ITS participants also proposed to
develop a ``limit order information system'' (``LOIS''), based on
the existing ITS, that would have required specialists to aggregate
and enter limit orders for display, and brokers executing a block
trade outside the best bid or offer would have been required to
satisfy the LOIS orders. This system was never implemented because
of the participants' inability to reach consensus. See Withdrawal
Release, supra note 30, at 10-11.
\35\ See Securities Exchange Act Release No. 17703 (April 9,
1981), supra note (approval of trade-through amendments to ITS) and
17704 (April 9, 1981), supra note (approval of exchange trade-
through rules).
\36\ See Securities Exchange Act Release No. 19249, supra note
(approval of NASD trade-through rule). The basic operation of the
NASD's trade-through rule is similar to that of the exchange trade-
through rules.
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b. Existing Intermarket Price Protection Regime
The NYSE and Amex markets, and the Nasdaq market, have adopted
different approaches to intermarket price protection. With regard to
NYSE- and Amex-listed securities, the ITS trade-through rule requires
members of an exchange, when purchasing or selling, either as principal
or agent, a security traded through ITS on the exchange or by issuing a
commitment to trade through ITS, to avoid initiating a trade-through
(unless an exception applies).\37\ The ITS rule defines a trade-through
to occur when a member initiates a purchase (sale) on the exchange of a
security traded through ITS at a price that is higher (lower) than the
price at which the security is offered (bid for) at the time of the
purchase (or sale) in another ITS participant market as reflected in
the offer (bid) then being displayed on the exchange from the other
participant market.\38\ Each SRO
[[Page 11133]]
requires its members, when purchasing or selling any ITS security,
either as principal or agent, on its market or when sending a
commitment through ITS, to avoid initiating a trade-through unless an
exception applies.\39\ The SRO trade-through rules also include
extensive procedures for ``satisfying'' an order that is traded-
through.\40\
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\37\ See Section (b)(1) of Exhibit B of the ITS Plan. Pursuant
to the ITS Plan and SRO trade-through rules, an ITS Participant can
send an order, termed a ``commitment to trade,'' to another ITS
Participant to trade with a better price displayed by that other
Participant market. The commitment to trade is a firm obligation to
trade for a fixed period of time, either 30 seconds or one or two
minutes, depending upon the time period chosen by the sending ITS
Participant. If the receiving ITS Participant accepts the commitment
to trade, the system reports back an execution to the sending ITS
Participant. If the commitment to trade is not accepted by the
receiving ITS Participant within the specified time frame, the
commitment is automatically canceled. A commitment to trade also may
be canceled by the receiving ITS Participant within the designated
time period if it is priced away from the receiving ITS
Participant's market at the time the commitment is received.
\38\ The ITS rule also defines a trade-through to occur when a
member of the exchange initiates the purchase (sale) of a security
traded through ITS by sending a commitment to trade through ITS that
results in an execution at a price that is higher (lower) than the
price at which the security is being offered (bid for) at the time
of the purchase (sale) in another ITS participant market as
reflected by the offer (bid) then being displayed on the exchange
from such other order execution facility. See Section (a) of Exhibit
B of the ITS Plan.
Section 8(d)(i) of the ITS Plan states that members located in
an ITS exchange participant market or an ITS/CAES market maker
should not purchase (sell) any security that is traded through ITS
at a price that is higher (lower) than the price at which the
security, at the time of the purchase, is offered (bid for) by one
or more of the other Participants' markets, as reflected in the
offer (bid) being furnished from the other market that is available
on the trading floor of, or available in the quotation service used
by, such member or ITS/CAES market maker.
\39\ See, e.g., NYSE Rule 15A and NASD Rule 5262. The exceptions
to the existing SRO trade-through rules include the following
circumstances: (1) When the size of the bid or offer traded-through
is for 100 shares; (2) the member that initiated the trade-through
is unable to avoid the trade-through because of a systems/equipment
failure or malfunction; (3) the transaction that constituted the
trade-through was not a ``regular way'' contract; (4) the bid or
offer that was traded-through was being displayed from a market that
was relieved of its obligations with respect to the bid or offer
under Rule 11Ac1-1 under the Exchange Act pursuant to the ``unusual
market'' exception of paragraph (b)(3) of that rule; (5) the trade-
through occurred on an exchange during a period when the members on
the exchange were relieved of their obligations under paragraph
(c)(2) of Rule 11Ac1-1 pursuant to the ``unusual market'' exception
of paragraph (b)(3) of Rule 11Ac1-1, provided, however, that unless
one of the other exceptions applies, during such period members
shall make every reasonable effort to avoid trading-through any bid
or offer displayed on the exchange from any other ITS Participant
whose members are not so relieved of their firm quote obligations
under paragraph (c)(2) of Rule 11Ac1-1; (6) the bid or offer traded-
through had caused a locked or crossed market in the security; (7)
the transaction involves purchases and sales effected in an opening
(or reopening) transaction; and (8) the transaction involves any
``block trade'' or ``block transaction'' as defined in the SRO's ITS
block trade policy.
Each SRO has adopted a policy regarding the execution of block
trades, based on a model block trade policy contained in Exhibit C
of the ITS Plan, that allows a member (or ITS/CAES market maker, in
the case of the NASD) to trade-through a better displayed price on
another market in the course of executing a block trade if the
member simultaneously executes the better displayed order at the
block price. See, e.g., NYSE Rule 15A and NASD Rule 5264.
\40\ In summary terms, the market whose order was traded-through
must first send a complaint to the market that initiated the trade-
through. The party that initiated the trade-through must then
respond, either by claiming an exception or by taking corrective
action. If corrective action is taken, the party that traded-through
can either satisfy the order that was traded-through at the limit
price (or, in limited circumstances, at the price that caused the
trade-through) or adjust the price of the transaction that caused
the trade-through to a price at which the trade-through would not
have occurred. In all instances where an order that was executed was
for an account other than the account of the broker-dealer involved,
the order shall receive either: (i) The price that caused the trade-
through; (ii) the price at which the order traded-through was
satisfied; or (iii) the adjusted price, whichever is most beneficial
to the order. See, e.g., NYSE Rule 15A(b)(2)(A), (B) and (C) and
NASD Rule 5262(b)(1) and (2).
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The existing trade-through rules apply to exchange members and
registered OTC market makers that trade NYSE or Amex-listed securities,
but not to block positioners that operate in the OTC market without
registration as OTC market makers.\41\ Thus, OTC block positioners
generally are not restricted by the existing trade-through rule from
trading outside the best bid and offer. Nor do the trade-through rules
apply to alternative trading systems (``ATSs'') that trade NYSE or
Amex-listed securities in the OTC market unless they are required to
(or choose to) post quotes in the consolidated quotation system through
an SRO.\42\ When an ATS displays its best bid or offer in the
consolidated quotation system through an SRO, it becomes subject to
that SRO's trade-through restrictions (and thus the ITS Plan trade-
through restrictions). For example, the NASD requires any ATS that
intends to display its quotes in NYSE or Amex securities in the OTC
market to register as an ITS/CAES market maker and thus become subject
to the NASD's (and ITS Plan's) trade-through restrictions.\43\
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\41\ Block positioners are exempt from the 1% mandatory quote
requirement of the Quote Rule, Rule 11Ac1-1 under the Exchange Act.
\42\ Specifically, pursuant to Regulation ATS, ATSs are not
required to display their best bid and offer in a particular
security through an SRO until they have 5% or more of the average
daily trading volume in that security over a six-month period. See
Section 301(b)(3)(i) and (ii) of Regulation ATS, 17 CFR 242.301 to
303.
\43\ A market maker or ATS that intends to or is required to
display quotes in NYSE or Amex securities in the consolidated
quotation system and chooses to do so through the NASD through the
Consolidated Quotations Service (``CQS'') must register with the
NASD as a CQS market maker. See NASD Rule 6320(a). Any CQS market
maker that is registered in a reported security that is eligible for
inclusion in ITS/CAES also must register as an ITS/CAES market maker
and must participate in ITS/CAES. See NASD Rules 6320(e) and
5210(e). ITS/CAES enables market makers in ITS-eligible securities
to direct orders to, and receive orders from, other ITS participant
markets.
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In contrast, the Nasdaq UTP Plan as approved by the Commission does
not contain any trade-through provisions, and no intermarket trade-
through rules currently exist with regard to the trading of Nasdaq
securities.\44\
---------------------------------------------------------------------------
\44\ In its 1985 release announcing its decision to grant
unlisted trading privileges to national securities exchanges in NMS
Securities, the Commission noted that it did not believe that a
sophisticated intermarket linkage needed to be in place during the
initial stages of trading such securities, but it encouraged the
NASD and exchanges to develop computerized intermarket trading
linkages and trade-through rules on their own. See Securities
Exchange Act Release No. 22412 (September 16, 1985), 50 FR 38640. In
subsequent releases, the Commission reiterated its belief that UTP
participants should develop an intermarket trading linkage and adopt
a trade-through rule. See Securities Exchange Act Release No. 31672
(December 30, 1992), 58 FR 3054 (January 7, 1993) and 33408
(December 30, 1993), 59 FR 1045 (January 7, 1994).
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c. Strains on Existing Intermarket Price Protection Regime
While the Commission continues to believe that a trade-through rule
can encourage the use of limit orders, facilitate best execution, and
reduce the effects of fragmentation, the Commission is concerned that
developments in the markets over the last few years have called into
question the continued viability of the existing system for achieving
intermarket price protection in NYSE and Amex stocks.
The structure of the U.S. securities market is quite different now
than when the ITS trade-through provisions were adopted. At the time
when the existing rules were put in place, order routing and execution
facilities were slower, there was less vigorous intermarket competition
in NYSE, Amex, and Nasdaq securities, and the minimum trading increment
was 1/8th of a dollar. By contrast, in today's market, rapid advances
in technology have provided a variety of means to efficiently route
orders to multiple markets. ``Alternative'' markets that provide almost
instantaneous executions by automatically matching buy and sell orders
have emerged, as has the use of ``smart'' order routing and execution
systems by broker-dealers and other market participants. Stocks are
quoted in pennies instead of 1/8ths, which has led (in many instances)
to narrower spreads, less depth at the top-of-book and rapidly changing
quotes. It also may reduce the cost of a trade-through to the investor.
Because competing market centers currently offer different speeds
and levels of certainty of execution, the challenge of providing price
protection across these diverse markets has grown. In recent years some
market participants have argued that the restrictions imposed by
existing trade-through rules for NYSE and Amex securities impede the
efficient operation of ``non-traditional'' automated markets that
operate by automatically, and nearly instantaneously, matching buying
and selling interest resident in their systems.\45\ These market
participants say that if an electronic market is subject to existing
trade-through rules, the market must slow down or forego an execution
in its system in order to send an order to another market displaying a
better price to attempt to access that better priced order, or risk
having to satisfy the better-priced order if it is traded-through.
Although the trade would occur at an inferior price, these
[[Page 11134]]
market participants say that some customers prefer the speed and/or
certainty of execution over price.
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\45\ These arguments have been made in various forums including
congressional hearings, industry publications, and discussions with
regulators.
---------------------------------------------------------------------------
Many automated markets argue that requiring them to provide this
outbound access to a non-automated market to reach the better price
displayed on that other market, no matter how marginal that better
price is and how long it takes the other market to execute the order
(if at all), not only compromises the basic structure of their markets
but also effectively grants an option to that slower market during the
time period before the order is executed. This option has value, as
there is a risk that the market for the stock may move before the order
is executed, especially if a significant amount of time passes before
the order is executed.\46\ In addition, market participants argue that
there is no guarantee that the order will even be executed at the price
that was showing at the time that the order was sent, given the rapid
quote changes that exist for some securities today.\47\
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\46\ Pursuant to the ITS Plan, an entity sending a commitment
through the ITS system may designate a time period during which the
commitment shall be irrevocable following acceptance by the system--
either thirty seconds or one or two minutes. See Section 6(b)(i) of
the ITS Plan and Securities Exchange Act Release No. 44903 (October
3, 2001), 66 FR 52159 (October 12, 2001). If the commitment is not
accepted or rejected during the applicable time period, the
commitment is automatically canceled by the system at the end of the
applicable time period. See Section 6(b)(iv) of the ITS Plan.
\47\ The Commission notes that many industry participants have
expressed frustration with so-called ``phantom quotes,'' where a
market participant is unable to interact with another market's quote
because the quote faded upon receipt of the order. The Commission
reminds markets that the firm quote rule requirements in Rule 11Ac1-
1 under the Exchange Act apply to all incoming orders, including ITS
commitments, and stresses that it is the responsibility of each
market participant that is posting a bid or offer to comply with the
rule, and each SRO's responsibility to effectively and consistently
enforce compliance by its members with the rule. See, e.g.,
Securities Exchange Act Release No. 40260 (July 24, 1998), 63 FR
40748 (July 30, 1998) (stating the firm quote rule applies to ITS
commitments and emphasizing that all ITS participants must strictly
enforce the rule to ensure that investors receive best execution and
that the market receives reliable quotation information).
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A trade-through rule like the current ITS trade-through rule
effectively prevents a market center from executing an investor's order
immediately at an inferior price, even if that is what the investor
desires. Thus, such a rule impacts an individual investor's ability to
direct the manner in which its order will be executed. In today's
environment characterized by rapidly changing quotes, narrow spreads,
and less depth at the inside, some investors may believe that best
execution is fulfilled by instructing their broker that speed and/or
certainty of execution is more important than the possibility of a
small amount of price improvement.
With respect to transactions in certain high-volume, derivatively-
priced ETFs--QQQs, SPDRs and Diamonds--that are widely traded by
electronic markets, the Commission in August 2002 issued an order to
ease the restrictions of the trade-through rules by granting, on a
temporary basis, a three-cent de minimis exemption to the trade-through
provisions of the ITS Plan.\48\ The exemption allows participants to
execute orders in these ETFs at prices no more than three cents away
from the best bid or offer displayed in the consolidated quote at the
time of execution.\49\ The Commission, in issuing the exemption, stated
its belief that the exemption would, on balance, provide investors with
increased liquidity and increased choice of execution venues while
limiting the possibility that investors would receive significantly
inferior prices.\50\
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\48\ See Securities Exchange Act Release No. 46428 (August 28,
2002), 67 FR 56607 (September 14, 2002).
\49\ Id. The Commission has extended this temporary exemption
until March 4, 2004. See Securities Exchange Act Release No. 47950
(May 30, 2003), 68 FR 33748 (June 5, 2003).
\50\ Id. The Commission's Office of Economic Analysis conducted
an analysis of trading in the QQQs in 2002, comparing trading on a
day before the de minimis exemption was implemented; a day after the
exemption was implemented before the Island ECN stopped displaying
its orders to anyone, even its subscribers (going ``dark''); and a
day after the exemption was implemented when the Island ECN was
``dark.'' The analysis showed that the percent of trades executed
outside the NBBO did not increase, and that less than 1% of total
trades were executed more than three cents away from the NBBO, after
the de minimis exemption was implemented. A copy of the analysis is
available in the File No. S7-10-04.
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In light of the Commission's three-cent de minimis exemption for
the QQQs, SPDRs, and Diamonds, the ITS participants held many
discussions regarding ways to revise the trade-through requirements in
the ITS Plan. The participants were not able to reach consensus on a
course of action (amendments to the ITS Plan must be unanimous under
the existing plan provisions). The Commission also notes that not all
market participants affected by the operation of the current trade-
through rules have a direct voice in the administration of the ITS
Plan, and are therefore unable themselves to directly influence or
affect any changes to the trade-through provisions of the ITS Plan.
With respect to the market for the trading of Nasdaq securities,
there are no intermarket trade-through rules and no mandatory
intermarket linkage other than the telephonic access required among
markets trading Nasdaq stocks under the Nasdaq UTP Plan and the access
requirements for participants in the NASD's Alternative Display
Facility (``ADF'').\51\ Over the past few years, however, a number of
new markets have begun trading Nasdaq stocks. Nasdaq stocks are traded
on Nasdaq's National Market Execution System (more commonly known as
``SuperMontage''), all of the largest ECNs, the PCX (through its equity
trading facility the Archipelago Exchange), the Amex, the BSE, and the
NSX. In addition, Nasdaq stocks are traded among participants in the
ADF. Nasdaq market makers and other registered broker-dealers also
continue to trade Nasdaq securities outside of SuperMontage or the ADF.
As a result, trading now extends beyond the Nasdaq's SuperMontage
system where displayed prices are protected. Broker-dealers trading in
the Nasdaq market rely on best execution obligations. Yet, even without
a trade-through rule, the Nasdaq market does not appear to lack
competitive quoting in the most actively traded securities.
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\51\ In general, the ADF access rules provide that any market
participant quoting in the ADF must provide (1) direct electronic
access to all other ADF quoting market participants, and (2) direct
electronic access to any other NASD member broker-dealer that is not
an ADF quoting market participant, if requested, and must allow for
indirect electronic access. See NASD Rule 3400A(a).
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C. Proposed Trade-Through Rule
The Commission believes there is value in having a rule that
provides a measure of price protection for limit orders across markets,
if the rule is designed to accommodate the current structure of our
NMS. Like the current ITS trade-through rule, a Commission trade-
through rule would encourage the use of limit orders, aggressive
quoting, and order interaction and help preserve investors' expectation
that their orders will be executed at the best displayed price. The
Commission therefore is proposing its own trade-through rule that would
apply not only to the trading of NYSE and Amex securities but also to
the trading of Nasdaq securities.
The Commission's proposed trade-through rule would require markets,
with regard to the trading of NMS Stocks--NYSE, Amex, and Nasdaq
securities--to establish, maintain, and enforce policies and procedures
reasonably designed to prevent the execution of trade-throughs in their
markets. The proposed rule includes two exceptions to the basic
requirement that are designed to address issues that have been raised
regarding the current ITS trade-through rule. One exception would allow
customers (and broker-
[[Page 11135]]
dealers acting for their own account) to provide informed consent to
having their orders executed in one market without regard to prices in
other markets. The other exception would allow an automated market to
trade through a non-automated market up to a certain amount. The
proposed rule is intended to respond to the current criticisms of the
existing rule and accommodate different marketplace models, while still
preserving important customer and market integrity protections. As
discussed in more detail in Section III.C.7. below, the Commission
emphasizes that the proposed rule is not intended to, and would not, in
any way alter or lessen a broker-dealer's best execution obligations.
1. Markets Subject to the Proposed Rule
The proposed rule would require an order execution facility,\52\
national securities exchange and national securities association to
establish, maintain, and enforce policies and procedures reasonably
designed to prevent the purchase or sale of an NMS Stock at a price
that is inferior to a better price displayed on another market.\53\ The
intent of the proposed rule is to prohibit the execution of any trade-
through by any order execution facility, national securities
association or national securities exchange, absent one of the
specified exceptions. Nevertheless, the Commission recognizes the
unavoidable ``false-positive'' and ``false-negative'' trade-throughs
that occur because quotes are updated and orders are executed more
rapidly than information can be communicated. The Commission does not
believe that an order execution facility should be held responsible for
protecting a better-priced quote that it cannot see because it has not
yet received the quote. Specifically, in an environment where quotes
can change numerous times within a fraction of a second, an order
execution facility should not be required to protect a best bid or best
offer of another order execution facility disseminated within the same
second during which the order execution facility executed the order but
which was not the best bid or best offer that the executing market saw
at the instant that it executed the order. The Commission requests
comment on whether drafting the rule to require order execution
facilities, national securities exchanges, and national securities
associations to establish, maintain, and enforce policies and
procedures reasonably designed to prevent the execution of trade-
throughs in their markets is sufficient to effectively deter and
prevent trade-throughs. Should the Commission instead, or in addition,
explicitly prohibit trade-throughs absent an exception?
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\52\ An order execution facility would be defined in proposed
Rule 600 of Regulation NMS as any exchange market maker; OTC market
maker; any other broker or dealer that executes an order internally
by trading as principal or crossing orders as agent; ATS; or
national securities exchange or national securities association that
operates a facility that executes orders.
\53\ The proposed definition of a ``trade-through'' would be the
purchase or sale of an NMS Stock during regular trading hours,
either as principal or agent, at a price that is lower than the best
bid or higher than the best offer of any order execution facility
that is disseminated pursuant to an effective national market system
plan at the time the transaction is executed. See proposed Rule 600
of Regulation NMS.
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The Commission is proposing to define ``order execution facility''
broadly to include all national securities exchanges and national
securities associations that operate a facility that executes orders,
ATSs, exchange specialists and market makers, OTC market makers, block
positioners and any other broker or dealer that executes orders
internally by trading as principal or crossing orders as agent.\54\ The
Commission believes that including broker-dealers that do not post
quotes or orders in the public quote but that nevertheless execute
orders internally is important because otherwise those markets would
have an advantage over markets that display their best quotes and
orders in the public quote. Given the availability of best bid and best
offer information, the access standards proposed by the Commission
today,\55\ and the advanced technology that currently is available for
the routing of order flow, the Commission does not believe that
including ``non-quoting'' markets within the scope of the proposed rule
would impose any undue hardships on such markets. The Commission
requests comments on the advisability of including ``non-quoting''
markets within the scope of the rule, including whether there are any
practical difficulties or other costs that would not justify the
benefits of requiring them to comply with the rule. The Commission also
requests comment on the extent of any positive or negative impact of
including these markets within the scope of the rule.
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\54\ See Rule 600 of proposed Regulation NMS. The Commission
notes that the proposed definition of order execution facility would
include any registered broker-dealer that is a member of an SRO that
executes orders internally, as an OTC market maker, exchange
specialist or market maker, block positioner, or otherwise. In
addition, however, the Commission is proposing that an order
execution facility, national securities exchange, and national
securities association may choose to accept only ``opted-out''
orders (as discussed below) and, therefore, would not be required to
comply with the requirements of the proposed rule. See section
(a)(2) of proposed Rule 611 of Regulation NMS.
\55\ See Section IV infra for a discussion of the Commission's
market access proposal.
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2. Types of Securities Subject to the Proposed Rule
The proposed trade-through rule would apply to the trading of all
NMS Stocks, which means that it would apply to the trading of all
Nasdaq, NYSE, and Amex stocks.\56\ Applying a trade-through rule to the
trading of Nasdaq securities would represent a change from the status
quo. The Commission believes that it may no longer be possible to
identify a distinction between Nasdaq stocks and other NMS Stocks for
purposes of imposing trade-through protections.
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\56\ See note 8, supra.
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The Commission requests comment on applying the protections of the
proposed rule to the trading of Nasdaq securities. The Commission also
requests comment on the practical impact of implementing a trade-
through rule for Nasdaq securities, including specifically what system,
technical, or other changes would be needed to implement the proposed
rule.
3. Types of Orders Subject to the Proposed Rule
The proposed rule would apply to any purchase or sale of an NMS
Stock during regular trading hours. Accordingly, the proposed rule
would apply to orders for the account of a broker-dealer as well as for
the account of a customer.\57\ The Commission believes that excluding
orders for the account of a broker-dealer would undermine the purpose
of the proposed rule to provide price protection to displayed better-
priced limit orders and quotes, because the broker-dealer orders would
be able to trade-through the better prices. However, a broker-dealer
(as well as a customer) may choose to opt-out of the rule's protections
with regard to orders for its own account, pursuant to the opt-out
exception proposed below. The Commission requests comment on whether
broker-dealer orders should be included within the scope of the rule.
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\57\ For purposes of the proposed rule, ``customer'' is defined
to mean any person that is not a broker or dealer. See proposed Rule
600 of Regulation NMS.
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4. Bids and Offers To Be Protected
The proposed rule would require an order execution facility,
national securities exchange, and national securities association to
establish, maintain, and enforce policies and
[[Page 11136]]
procedures reasonably designed to prevent the execution of an order at
a price that trades through the best bid or best offer of any order
execution facility that is disseminated pursuant to an effective
national market system plan. Currently, bids and offers that are
disseminated pursuant to an effective national market system plan
include, with respect to NYSE and Amex listed securities, the best bid
and best offer of each national securities exchange that trades a
particular NYSE or Amex listed security, as well as the best bid and
best offer of each individual registered market maker and ATS
(registered as an ITS/CAES market maker) that provides its best bid and
best offer to the NASD for a particular NYSE or Amex listed
security.\58\ The current ITS trade-through rule protects the best bid
and best offer of each national securities exchange and the ``ITS/CAES
BBO,'' \59\ which is one best bid price and one best offer price (with
aggregate size) for all ITS/CAES market makers, but not the best bid
and best offer of each individual ITS/CAES market maker.\60\ With
regard to the trading of Nasdaq securities, bids and offers that are
disseminated pursuant to an effective national market system plan
include the best bid and best offer of each national securities
exchange that trades a particular Nasdaq security, the best bid and
best offer of each registered Nasdaq market maker or ATS that provides
its best bid and best offer in a particular Nasdaq security to Nasdaq,
and the best bid and best offer of each ADF quoting market participant
that provides its best bid and best offer in a particular Nasdaq
security to the NASD.\61\
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\58\ See Rule 11Ac1-1 under the Exchange Act (proposed to be
designated as Rule 602), 17 CFR 240.11Ac1-1, and Sections I(w) and
VI(a) and (c) of the CQ Plan.
\59\ The ITS/CAES BBO is defined in Section 6(a)(i)(B) of the
ITS Plan as the best bid price and best offer price, together with
the sum of the sizes accompanying the bids and offers at the best
bid price and best offer price. The trade-through rule excepts bids
and offers where the size is 100 shares.
\60\ See Sections 6(a)(i)(A) and (B) and 8(d)(i) of the ITS
Plan, and e.g., NYSE Rule 15A(a)(2) and NASD Rule 5210(i).
\61\ See Securities Exchange Act Release No. 49137 (January 28,
2004), 69 FR 5217 (February 3, 2004) (notice of filing of amendments
to the Nasdaq UTP Plan).
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The Commission requests comment on the extent to which the best bid
and best offer of each individual market maker and ATS that would be
protected pursuant to the proposed rule is available to all order
execution facilities that would be subject to the proposed rule, and
the extent to which the accessibility of those bids and offers would be
impacted by the proposed access standards and market data amendments
proposed today.\62\ The Commission also requests comment as to the
scope of the bids and offers that should be protected pursuant to the
proposed rule. In particular, should the best bids and best offers of
each individual registered market maker and ATS be protected, as
proposed? Or should the proposed rule protect only the best bid and
best offer of each national securities exchange and the aggregate best
bid and best offer of each non-exchange ``market'' (i.e. one best bid
price and one best offer price with aggregate size for all ITS/CAES
market makers with respect to the trading of NYSE and Amex securities
otherwise than on an exchange, a best bid price and best offer price
with aggregate size for the Nasdaq market with respect to the trading
of Nasdaq securities, and a best bid price and best offer price with
aggregate size for the ADF with respect to the trading of Nasdaq
securities)? Further, if the proposed rule did not protect the best bid
and best offer of each individual market maker and ATS, the Commission
requests comment as to whether there should be just one best bid price
and best offer price, with aggregate size, for the trading of Nasdaq
securities other than on an exchange, or whether there should be a
separate best bid and best offer for trading on Nasdaq and a separate
best bid and best offer for trading on the ADF.
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\62\ See infra Sections IV and VI, respectively, for a
discussion of the Commission's market access proposal and the market
data proposal.
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As noted above, the proposed rule would apply only to the best bid
and best offer of any order execution facility that is disseminated
pursuant to an effective national market system plan. It would not
apply to other limit orders or quotes that are also priced better than
the order being executed but are not disseminated pursuant to an
effective national market system plan. To expand the price protection
beyond the best bid and best offer for each market would entail the
Commission requiring quoting market centers to make available, and
provide access to, their entire depth of book to other markets.
Although the Commission believes that from a policy viewpoint it would
make sense to provide protection to any better-priced quote or order
displayed in another quoting order execution facility, not just the
top-of-book of each quoting order execution facility, the Commission
questions whether protecting all displayed limit orders and quotes at
this time would be feasible. The Commission, however, requests comment
on whether it should expand the scope of the proposed rule to include
trade-through protection beyond the best-displayed bid and offer. For
example should the scope of the proposed rule include protection beyond
the best displayed bid and offer in the circumstance where a market
center voluntarily provides depth-of-book information through the
facilities of an effective national market system plan?
Current SRO rules regarding block trades in NYSE and Amex
securities, adopted pursuant to the ITS Plan (as well as the provisions
of the ITS Plan itself) allow block trades to be executed at an
inferior price as long as the party executing the block executes any
better priced order(s) displayed on another market(s) at the block
price.\63\ In the proposed rule, the Commission is not proposing to
treat large ``block-sized'' trades any differently than non-block
trades. Thus, an order execution facility could not execute a block
trade at a price inferior to the best bid or offer displayed on any
other order execution facility unless the order execution facility sent
an order to trade at the price of the better-priced order.\64\ The
Commission believes that an exception for block trades may not be
necessary because its proposed exception to the trade-through rule to
allow a customer, or broker-dealer trading for its own account, to
provide informed consent to having its order executed without the
protection of the rule would be available to a customer or broker-
dealer that wishes to execute a block trade.\65\
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\63\ For purposes of the ITS participants' block trade policies,
a ``block trade'' or ``block transaction'' is defined as a
transaction that involves 10,000 or more shares of a common stock
traded through ITS or a quantity of such stock having a market value
of $200,000 or more that (i) is effected at a price outside the bid
or offer displayed from another ITS participant market and (ii)
involves either a cross of block size or any other transaction of
block size that is not the result of an execution at the current bid
or offer on the market executing the block trade. See, e.g., NYSE
Rule 15A and NASD Rule 5264.
\64\ See Section III.D.3. below for a discussion of a proposed
exception to the trade-through requirements in those instances where
an order execution facility sends an order to execute against a
better-priced order displayed on another market at the same time or
prior to executing an order in its own market at an inferior price.
\65\ See Section III.D.1. below for a discussion of the proposed
opt-out exception.
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The Commission requests comment on whether this is the appropriate
way to handle block trades under the proposed rule. The Commission
requests comment on the extent to which treating block trades in the
same manner as other trades, combined with the proposed opt-out
exception, would impact a broker-dealer's or customer's ability to
execute a block trade, if at all. The Commission also requests comment
[[Page 11137]]
on whether a block exception would be necessary if the proposed opt-out
exception were not adopted.
5. Required Policies and Procedures
The proposed rule would require each order execution facility,
national securities exchange, and national securities association to
develop policies and procedures reasonably designed to prevent the
execution of a trade-through in its market.\66\ While the exact nature
and extent of the policies and procedures would therefore depend upon
the type, size, and nature of the order execution facility, national
securities exchange, and national securities association, these
procedures must be designed to forestall trade-throughs from occurring
other than pursuant to an exception. Among other things, the policies
and procedures of an order execution facility, national securities
exchange, and national securities association should provide for the
monitoring of quotations in other markets and prevent a trade from
being effected in its market at a price inferior to a bid or offer that
was apparent to the order execution facility in another market.
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\66\ The Commission notes that any member of an SRO that
executes orders would be deemed on order execution facility under
the proposed rule and thus subject to the proposed rule's
requirements. In addition, any member that would not be deemed an
order execution facility but receives order flow from customers or
other broker-dealers would potentially be subject to the proposed
requirement to obtain informed consent prior to allowing the
customer or broker-dealer to opt out.
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The Commission believes it is important for each order execution
facility, national securities exchange, and national securities
association to include a reasonable process in its required policies
and procedures for specifically identifying and handling ``false
positive'' and ``false negative'' trade-throughs. Given the speed with
which the quotes update in certain stocks, there may well be instances
of ``false-positive'' trade-throughs, where a market participant took
all reasonable precautions and legitimately did not think it was
trading through the best bid or best offer of any other market center
disseminated pursuant to an effective national market system plan at
the time of execution but, because of rapid-fire quote changes in the
stock (or possibly inconsistent records as to the time of execution),
it appears in hindsight that the order execution facility did in fact
trade through another market. As discussed above, the Commission does
not believe it reasonable to require a market center to protect a bid
or offer that has not yet been received by it and that the market
center, therefore, cannot see at the instant that an order is executed.
The Commission recognizes that these issues already exist under the
current trade-through rules. The Commission requests comment on
specific procedures that could be implemented to prevent and identify
instances of ``false-positive'' and ``false-negative'' trade-throughs.
The Commission also requests comment on the minimum standards to
which an order execution facility, national securities exchange, and
national securities association should adhere when establishing,
maintaining, and enforcing its required policies and procedures
6. Access Standards
The Commission recognizes that it would not be reasonable to impose
trade-through restrictions that prohibit an order execution facility
from executing an order at a price inferior to the best bid or offer
displayed in another market(s) unless the order execution facility can
see and have fair and efficient access to those prices. Therefore, the
Commission believes that an effective linkage between markets must be
in place before implementing a trade-through rule, whether it is a
``hard-wired'' linkage or required minimum access standards. This is
especially true for the market for Nasdaq stocks, where trading has
expanded to multiple markets and where there is no existing ``hard-
wired'' linkage or minimum access standards, other than the telephonic
access required by the Nasdaq UTP Plan and the minimum access standards
of the ADF.\67\
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\67\ For many years, only Nasdaq and the CHX traded Nasdaq
stocks. Recently, as discussed in Section III.B.2.c. above, other
markets have begun trading Nasdaq securities. While Nasdaq and CHX
have negotiated a bilateral linkage between their markets, it is not
clear how the other markets would be linked, if at all. The NMS plan
governing the trading of Nasdaq securities, the Nasdaq UTP Plan,
only requires telephonic access between the markets trading Nasdaq
stocks. See Section IX of the Nasdaq UTP Plan.
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The Commission believes that the access standards it has proposed
today would provide the necessary levels of access.\68\ The Commission
requests comment on whether existing access in the markets for Nasdaq,
Amex and NYSE securities is adequate to support the proposed trade-
through rule, in light of the advances in technology and the
proprietary linkages already in place today. If current access is not
adequate, the Commission requests comment on what access standards
would be needed as a prerequisite to implementing the proposed trade-
through rule.
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\68\ See Section IV infra for a discussion of the Commission's
market access proposal.
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Under the proposed access rules, an SRO would not be permitted to
post quotes or orders for another market center (such as an ATS or
market maker) through its facilities unless it has first made a
determination that the market center has provided adequate access to
its quotes and orders under the proposed access standards.\69\ The
Commission believes that this requirement is necessary to protect
against inaccessible markets becoming part of the consolidated quote.
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\69\ See Section IV.B.2. infra.
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7. Duty of Best Execution
The Commission emphasizes that the proposed trade-through rule,
including the automated market exception, in no way alters or lessens a
broker-dealer's duty to achieve best execution for its customers'
orders. A broker-dealer still must seek the most advantageous terms
reasonably available under the circumstances for all customer orders. A
broker-dealer must carry out a regular and rigorous review of the
quality of market centers to evaluate its best execution policies,
including the determination as to which markets it routes customer
order flow. A broker-dealer cannot merely assume that because the
market(s) to which it sends its customer orders is subject to the
proposed rule, the broker-dealer can abdicate its responsibilities for
evaluating the execution quality of that market. Moreover, broker-
dealers that execute customer orders internally would continue to be
evaluated against the best bid and offer (or better bid or offer, if
available) for best execution purposes, regardless of whether these
orders were executed automatically or manually. The proposed trade-
through rule does not justify a market maker executing retail orders
internally at prices inferior to the best quote, even if executed
automatically.
D. Exceptions to the Proposed Rule
To provide flexibility for market centers with different market
structures and to give investors more control over how their orders are
executed, the proposed rule would include an exception allowing
customers to ``opt-out,'' and an exception allowing an automated market
to trade through a non-automated market in limited circumstances. The
Commission also is seeking comment on an alternative to these
exceptions that would require market centers to provide automated
access to displayed quotations.
[[Page 11138]]
1. Opt-Out Orders
Some investors may, at times, value speed and/or certainty of
execution over the possibility of obtaining a slightly better price on
another market, especially prices that may be as little as one cent per
share better. These investors may want the ability to trade immediately
in the market to which they send an order without having any delay from
routing the order to another marketplace with a slightly better price,
particularly a non-automated market that does not provide the same
speed or certainty of execution as the market to which the investor
sent its order. Such order routing decisions by an investor are
facilitated by execution data now available for orders of less than
10,000 shares that can help guide investors in their investment
decisions regarding where and when to execute their orders.\70\ Large
traders may also want the ability to execute a block immediately at a
price outside the quotes, to avoid parceling the block out over time in
a series of transactions that could cause the market to move to an
inferior price.
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\70\ Rule 11Ac1-5 under the Exchange Act (proposed to be
designated as Rule 605), requires certain market centers to make
publicly available on a monthly basis standardized statistics
concerning their order executions, including such measures as the
effective and realized spreads, speed of execution and the number of
orders executed at, inside and outside of the quote. Rule 11Ac1-6
under the Exchange Act (proposed to be designated as Rule 606),
requires broker-dealers to make publicly available on a quarterly
basis a report on their order routing practices, including a
discussion of any payment for order flow arrangements.
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A further benefit of providing investors with the flexibility to
choose whether their orders should trade through a better quote is that
it might create market forces that would discipline markets that
provided slow executions or inadequate access to their markets. If
investors were not satisfied with the level of automation or service
provided by a market center, they could choose to have their orders
executed without regard to that market's quote, thus putting pressure
on the market to improve its services.
The Commission therefore is proposing an exception to the trade-
through rule to allow an order execution facility to execute an order
at a price that trades through a better-displayed bid or offer on
another market if the person for whose account the order is entered
(e.g. a broker-dealer for its own account or a customer for the
customer's account) makes an informed decision to affirmatively opt out
of the trade-through rule's protections with regard to that order.\71\
The proposed exception strives to preserve the usual customers'
expectation of having their orders executed at the best displayed
price, but allows a choice for those investors whose trading strategies
may benefit from an immediate execution priced outside the national
best bid and offer (``NBBO''). Broker-dealers, of course, would not
have to permit their customers the ability to opt out of the trade-
through rule's protections. The Commission requests comment on whether
the proposed opt-out exception is needed to enable informed traders to
design their own trading strategies appropriate to their particular
circumstances.
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\71\ See Section (b)(8) of proposed Rule 611. A broker-dealer
sending orders to another broker-dealer with whom it has a
relationship (e.g. an introducing/executing broker relationship)
would either be acting for its own account or acting on behalf of
the account of a customer. In either instance, the broker-dealer
receiving the orders would be required to obtain consent from the
sending broker-dealer with respect to each order prior to treating
an order as one that has ``opted out.'' If the sending broker-dealer
were acting on behalf of a customer, it would have to obtain
informed consent from its customer prior to sending an order to
another broker-dealer for execution.
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While the opt-out exception would provide greater execution
flexibility to informed traders, the Commission recognizes that the
opt-out exception is inconsistent with the principle of price
protection for limit orders because it would allow investors to choose
to have their orders executed without regard to better-priced orders
displayed on other market centers. If limit orders frequently remain
unexecuted after trades take place at inferior prices, investors may be
discouraged from entering limit orders, thus reducing price discovery.
In light of this concern, the Commission requests comment on the extent
to which limit orders would remain unexecuted after a trade-through,
and the impact on investors' use of limit orders, if the opt-out
exception were to be implemented.
If used frequently, the proposed opt-out exception also might
undermine investor confidence that their orders will receive the best
price available in the markets, when they see trades frequently
occurring at prices inferior to better prices displayed on other
markets. The Commission therefore requests comment on whether the opt-
out exception would undermine the principle of price priority and, if
so, the anticipated impact of this exception on the principle of price
priority.
a. Request for Comment on Automated Execution Alternative
To the extent that the need for trade-through flexibility is caused
by the inability to trade efficiently with published quotations, this
problem could be addressed more directly by requiring all market
centers to provide an automated response to electronic orders at their
quote. As discussed in Section IV below, the Commission historically
has not dictated the means of execution provided by competing market
centers. Nonetheless, if the Commission were to adopt an automatic
execution requirement, such action may allay to some extent investors'
concerns over their inability to quickly access manual markets and
control their own executions.
In addition, to the extent that trade-through flexibility is needed
to facilitate block trading, an automatic execution requirement in
conjunction with the proposed trade-through rule's provision for
simultaneously routing and trading may enable block trades to avoid
trading through without moving the market. Because the proposed trade-
through rule would allow a market participant to route orders to the
displayed quotes and then trade at a price that would otherwise be a
trade-through, a block trader could use automatic execution to
simultaneously access the existing displayed quotes and then execute
the remainder of the block at a discount, without violating the rule.
An automatic execution requirement may well deal with two of the
potential serious flaws with the proposed opt-out exception. First, to
the extent that the opt-out exception is inconsistent with the
principle of price protection for limit orders, an automatic execution
requirement at the best bid or offer for limit orders avoids this
problem. Under such an alternative, investors would not be discouraged
from entering limit orders, and price discovery would be enhanced.
Second, an automatic execution alternative also supports the
principle of price priority. It would not allow trades to occur at
inferior prices, as could happen under the proposed opt-out exception.
Such an alternative could maintain investor confidence that their
orders will receive the best bids and offers displayed in any market.
For these reasons, the Commission requests comment on whether there
is a continued need for the opt-out exception if it were to adopt an
automatic execution requirement. The Commission also requests comment
if there is a continued need for the proposed automated market
exception, if the Commission were to adopt an automatic execution
requirement, because all market centers would be required to provide
the same basic level of automatic execution functionality,
[[Page 11139]]
and thus there would be no distinction for purposes of the proposed
rule between manual markets and automated markets.
In the access discussion in Section IV, the Commission requests
comment on whether, if it were to require automatic execution, it would
need to set performance standards governing the use of the automatic
execution functionality to which all markets would be required to
adhere. The Commission specifically requests comment as to whether it
should set minimum execution performance standards that would require
that market participants' systems respond to orders from other markets
within certain time frames.\72\ Would minimum performance standards be
essential to any consideration to not adopt an opt-out exception? The
Commission also requests comment on whether, as discussed earlier, even
if the Commission were to adopt an automatic execution requirement, the
Commission should retain the proposed opt-out exception in order to
provide a market and competition-driven incentive for different markets
to provide and maintain a high level of service.
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\72\ See Section IV.A.2. infra.
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b. Opt-Out--Order-by-Order Consent
If a broker or dealer were to provide investors the ability to opt
out, the proposed rule would require the broker-dealer to obtain
informed consent from each investor who chooses to opt out of the
protections of the proposed rule on an order-by-order basis. The
Commission is not proposing to allow consent on a global basis, either
by a written agreement or otherwise, because of a concern with the
potential for abuse if consent can be obtained on a basis other than
for each particular order. Requiring an investor to provide informed
consent on an order-by-order basis, based upon its execution preference
at the time of placing the order, is intended to help protect against
less sophisticated customers, such as retail customers, consenting
without fully understanding to what they are consenting or the effect
of such consent. Specifying whether or not the order is ``opted-out''
could become another facet of the order handling instructions given to
the broker-dealer at the time of execution, and indeed consent could be
obtained electronically for those systems where orders are sent
electronically to broker-dealers.\73\ Nonetheless, in view of the time
involved in communicating the consent, the Commission requests comment
on the anticipated impact of the requirement to obtain informed consent
on an order-by-order basis on the order handling and execution
processes of each broker-dealer, and whether this requirement would be
expected to significantly slow down that process. The Commission also
requests comment on whether it is necessary to restrict consent to a
trade-by-trade basis for parties that enter into agreements authorizing
opting out, and if so, how such global consent should operate. Finally,
the Commission requests comment on whether the ability to opt out
should be available only to institutional or sophisticated investors,
who may be better qualified, or in a better position to understand, the
implications of opting out then retail investors. If so, how should the
Commission define an institutional or sophisticated investor?
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\73\ The Commission notes that if the ability to consent were
automated, just as with non-automated consent, the broker-dealer
should, consistent with any fiduciary responsibilities arising from
the particular relationship with a customer or broker-dealer,
provide each customer or broker-dealer submitting an order with
sufficient clear and concise disclosure regarding the impact of such
consent prior to the customer or broker-dealer making a
determination whether or not to opt-out for each order to allow the
customer or broker-dealer to make an informed decision. The broker-
dealer also should provide a mechanism for ensuring that the
customer fully understands the disclosure prior to making the
determination whether to opt-out.
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The requirement to obtain informed consent in order to allow an
opt-out would apply to any broker-dealer that receives order flow from
a customer or another broker-dealer even if that broker-dealer would
not be considered an order execution facility under the proposed
rule.\74\ Although the way in which a broker-dealer would obtain
informed consent consistent with any fiduciary obligations arising from
the particular relationship with an investor may differ from investor
to investor, a broker-dealer at a minimum should explain in clear and
concise terms to any customer from whom it accepts consent, for each
order, that: (1) The customer's order would be executed in the market
to which it is sent without regard to prices displayed in other
markets, even if those prices are better; (2) the customer
affirmatively would be agreeing to forego the possibility of obtaining
a better price that may be available in another market at the time its
order is executed; and (3) this could result in the customer's order
receiving an execution at a price that is inferior to the best bid or
offer displayed at the time his or her order is executed. Each time a
customer consents, the broker-dealer must be confident that the
customer fully understands this disclosure and the nature of the
consent. The Commission solicits comment on whether there are any
particular disclosures that a broker-dealer should be required to make
prior to obtaining informed consent.
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\74\ The Commission reminds broker-dealers that they would be
required to comply with the recordkeeping requirements of Rule 17a-4
under the Exchange Act, 17 CFR 240.17a-4.
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The Commission requests comment on how a broker-dealer would
fulfill this obligation to obtain informed consent with respect to
orders it receives from other broker-dealers, when it has no
interaction or relationship with that broker-dealer's customers. The
Commission also requests comment on how, if at all, broker-dealers
would fulfill this obligation with respect to retail customers who lack
complete information about comparative market quality, current market
data from all markets, and the willingness to undertake individual
market routing decisions. Further, the Commission requests comment on
whether different issues are raised when an order execution facility
receives order flow directly from customers for execution.
The Commission realizes that market participants that handle
customer or broker-dealer orders and that choose to provide these
entities the ability to opt out likely would have to make changes to
their order handling and execution practices to accommodate this
exception. Likewise, an order execution facility receiving the order
from another order execution facility, a broker-dealer, or directly
from a customer for execution would need to ensure that its systems
could distinguish between opted-out and non-opted-out orders for
purposes of execution. Broker-dealers receiving orders from their
customers and other broker-dealers likely would need to amend their
order handling procedures to accommodate those who choose to opt out,
as well as their own orders for which the broker-dealer opts out. The
Commission requests comment on order handling, systems and other
changes broker-dealers that route orders, and order execution
facilities that execute orders, would have to make before they would be
able to implement the requirements of this proposed exception.
c. Opt-Out--Provision of National Best Bid or Offer
The Commission also is proposing to require a broker-dealer to
disclose to its customers that have opted-out the national best bid or
offer, as applicable, at the time of execution for each execution for
which a customer opted
[[Page 11140]]
out.\75\ If the order were a purchase, the broker-dealer would be
required to provide the national best offer at the time of execution
and if the order were a sale, the broker-dealer would be required to
provide the national best bid at the time of execution.\76\ Such
disclosure would be required to be given as soon as possible, but in no
event later than one month from the date on which the order was
executed. The bid or offer that would be required to be disclosed to
the customer pursuant to this exception would need to be displayed in
close proximity to, and no less prominently than, the execution price
for the applicable transaction that is provided to the customer
pursuant to the requirements of Rule 10b-10 under the Exchange Act.\77\
The required disclosure could be made on the confirmation for the
transaction sent to the customer pursuant to Rule 10b-10 under the
Exchange Act, or the monthly account statement relating to that trade
sent to the customer pursuant to applicable SRO rules. Alternatively,
the broker-dealer could provide the bid or offer information on another
form of disclosure document, as long as it is clear to which
transaction the bid or offer information refers (i.e., the bid or offer
must be displayed in close proximity to, and no less prominently than,
the execution price for the relevant transaction).
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\75\ See section (c) of proposed Rule 611. The Commission is not
proposing to require a broker-dealer to provide this information to
another broker-dealer from which it receives order flow.
Specifically, a broker-dealer would be required to provide the
national best bid or offer, as applicable, to a customer with whom
it has a relationship and from whom it has received an order if the
customer opted out.
\76\ The Commission proposes to define national best bid and
national best offer to mean, with respect to quotations for an NMS
Security, the best bid and best offer for such security that are
calculated and disseminated on a current and continuing basis by a
plan processor pursuant to an effective national market system plan;
provided, that in the event two or more market centers transmit to
the plan processor pursuant to such plan identical bids or offers
for an NMS Security, the best bid or best offer (as the case may be)
shall be determined by ranking all such identical bids or offers (as
the case may be) first by size (giving the highest ranking to the
bid or offer associated with the largest size), then by time (giving
the highest ranking to the bid or offer received first in time).
\77\ 17 CFR 240.10b-10. For example, this means that the bid or
offer should not be disclosed on a separate page from the execution
price for the transaction, and should not be displayed in a smaller
font size or type than the execution price.
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The Commission intends this requirement to help ensure that
customers who opt out of the proposed rule's protections are informed
of the consequences of opting out, and are able to compare the
execution they received to the best-displayed bid or offer at the time
of execution. This disclosure would provide the customer with valuable
execution quality information upon which to base future determinations
as to whether to opt out of the proposed rule's protections.
The Commission requests comment on the extent to which this
information would be useful to investors. The Commission also seeks
comment on whether this requirement should apply when the ``customer''
is another broker-dealer. The Commission further requests comment on
whether there would be any practical difficulties in implementing this
requirement. In particular, the Commission requests comment as to how
this requirement would, or should, apply to transactions that are
reported to the customer on an average price basis. Further, the
Commission seeks specific comment as to the monetary costs of system or
other modifications necessary to provide this information to customers
who choose to opt out.
2. Automated Order Execution Facility Exception
The Commission is proposing to permit an automated market to
execute orders within its market without regard to a better price
displayed on a non-automated market, within certain price parameters.
This exception is designed to reflect the comparative difficulty of
accessing market quotes from non-automated markets, and to adjust the
trade-through requirement to these differences. The Commission believes
this would enhance the ability of individual markets with different
market structures to compete more fairly with each other. The
Commission is not attempting to favor either form of market.
a. Definition of ``Automated Order Execution Facility''
This proposed exception contemplates two categories of order
execution facilities--an ``automated order execution facility'' and a
``non-automated order execution facility.'' The Commission proposes to
define an ``automated order execution facility'' as a order execution
facility that provides for an immediate automated response to all
incoming orders for up to the full size of its best bid and offer
disseminated pursuant to an effective national market system plan,
without any restrictions on executions. A restriction would include,
for example, a limit on the number of orders for the account of the
same individual or beneficial owner that could be sent to the market
for execution within a certain time frame, or a limit on the size for
which an automated response is available, other than the full size of
the best bid or offer displayed by the market. The Commission has
proposed to narrowly define ``automated order execution facility'' to
exclude market centers that turn off their automatic execution systems
or otherwise limit the ability to access their quotes or orders on an
automated basis (other than in accordance with federal securities laws,
rules, and regulations), to ensure that market participants can readily
access these prices. A ``non-automated order execution facility'' would
include any order execution facility not qualified as an automated
order execution facility.
The Commission requests comment generally on these definitions and
categories, and specifically whether there are any restrictions that a
market center should be allowed to impose and still be considered
``automated'' under the proposed definition of automated order
execution facility. For example, should a market still be considered
``automated'' under the proposed definition if it were to provide an
exception to the operation of its automated functionality when an order
would otherwise be executed at a price that would cause a trade-
through? How should an order execution facility's response to incoming
orders with special handling instructions be treated for purposes of
whether an order execution facility would be considered automated, i.e.
are there any types of orders with special handling instructions or
conditions that an order execution facility should be allowed to
exclude from the operation of its automated functionality and still be
considered ``automated'' for purposes of the proposed trade-through
rule? For instance, should a market still be considered ``automated''
even if its automatic execution functionality does not accept orders to
sell short? The Commission also requests comment on how such an
automated market exception would work in practice for a market that
provides an automated response to its top-of-book but otherwise
operates as a manual market. Should the definition of ``automated order
execution facility'' exclude a market that has the ability to, and
does, implicitly or explicitly ``turn off'' its automated functionality
to allow for manual executions of orders on the market?
The Commission requests comment on whether the Commission, a third
party, or each individual market center should determine which market
centers qualify as automated order execution facilities, and how such
determination should be communicated to the order
[[Page 11141]]
execution facilities who must comply with the proposed rule. Further,
the Commission requests comment on whether it should specify what
``immediate'' means in terms of providing an automated response, and if
so, whether it would be appropriate to impose a minimum performance
standard with respect to response times. Specifically, the Commission
requests comment on whether it should require that an order execution
facility's system that provides automated functionality have the
capability to respond to an order from another market participant
within a certain limited time period. If commenters believe that the
Commission should specify a performance standard for ``immediate,''
what should that standard be? Should the performance standard require
that a certain percentage of all incoming orders receive an execution
within a very short time frame, and allow a longer time period for the
remaining percentage? For instance, should the performance standard
require that 98% of orders receive execution in less than one second,
and all orders receive an execution in three seconds? Or should the
performance standard require that all orders receive an execution
within the same time frame? If so, should that time frame be within one
or two seconds after order receipt? Or should another similar standard
be used? The Commission also solicits comment on the anticipated
competitive effects of the proposed exception on automated and non-
automated order execution facilities.
b. Operation of the Exception
An automated order execution facility would be able to trade
through the price of a non-automated order execution facility up to the
``trade-through limit amount'' (as defined below). An automated order
execution facility would not be allowed to trade through the prices of
other automated order execution facilities. A non-automated order
execution facility would not be allowed to trade through any other
market, whether or not it is automated. Given the structure of non-
automated markets, in particular the time it takes to manually execute
an order (which is necessarily greater because of market maker and
crowd participation), the Commission does not believe that there is a
particular need to provide a non-automated market an exception to the
proposed trade-through rule on the basis of execution speed. The
Commission requests comment on the proposed operation of this
exception. The Commission also requests comment as to the continued
need for the proposed automated market exception if it were to adopt an
automatic execution requirement.\78\
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\78\ See Section III.D.1. above for a more detailed discussion
of this issue.
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c. Allowable Trade-Through Amount
The Commission believes that the amount by which an automated order
execution facility should be allowed to trade through a non-automated
order execution facility should relate, to the greatest extent
possible, to the value of the option that must be given to the other
market when attempting to access a better price. Where price protection
is the goal, order execution facilities (and their subscribers,
customers or members) generally should not be compelled to access
another market unless the apparent price improvement from doing so
successfully is greater than the estimated cost of attempting access.
In short, the allowable trade-through amount should reflect the cost
(including time value) of attempting to access the other market.
The calculation of option value is based on several variables,
including the volatility and price of the security. Higher volatility
means more potential price movement and greater option value, while
lower volatility means less potential price movement and less option
value. Assuming volatility and other variables as constant, the value
of an at-the-money option is proportional to stock price. In granting
the three-cent de minimis exemption from the trade-through provisions
of the ITS Plan for QQQs, SPDRs and Diamonds, the Commission estimated
the option values of attempting to access a better price through ITS to
be between one and two and a half cents per share.\79\ This calculation
took into account price and volatility and the fact that ITS
commitments are irrevocable for a minimum of thirty seconds. The
Commission does not believe, however, that it would be practical to
calculate the estimated option value for each NMS Stock that would be
subject to the proposed trade-through rule based upon the individual
volatility and price of each security. The Commission therefore
proposes to calculate the allowable ``trade-through limit amount'' by
using the values of a thirty second option on stocks with a range of
volatilities, and estimates such options to have values of
approximately five to ten basis points.\80\ Specifically, the
Commission proposes the following ``trade-through limit amounts'': For
a bid or offer up to $10, the allowable amount would be one cent; for a
bid or offer between $10.01 to $30, the allowable amount would be two
cents; for a bid or offer between $30.01 and $50 the allowable amount
would be three cents; for a bid or offer between $50.01 and $100, the
allowable amount would be four cents; and for a bid or offer above
$100, the allowable amount would be five cents.
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\79\ Given that the price of the QQQs at the time was around $30
per share, three cents represented approximately ten basis points.
See Securities Exchange Act Release No. 46428 (August 28, 2002),
supra note 48.
\80\ The Commission has chosen 30 seconds because it is the
shortest amount of time for which a market sending an ITS commitment
to another market can be irrevocable.
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The Commission requests comment on the feasibility and usefulness
of this approach, and the reasonableness of the proposed trade-through
limit amounts. The Commission also requests comment on other possible
alternative approaches to determining the amount(s) by which an
automated market should be allowed to trade through a non-automated
market. The Commission further requests comment on whether the proposed
rule should provide for one trade-through limit amount, such as three
cents, that would apply to all NMS Stocks, rather than tiered amounts
as proposed.
3. Other Exceptions
Section (b)(7) of the proposed trade-through rule would provide an
exception in those instances where an order execution facility sends an
order to execute against a better-priced order displayed on another
market at the same time or prior to executing an order in its own
market at an inferior price.\81\ Specifically, the exception is
intended to apply when the market that wants to execute the inferior
priced order (Market A) sends an order, at the same time or prior to
executing the trade-through, to execute against any better-priced bid
or offer of another market (Market B) that is disseminated pursuant to
an effective national market system plan, where such order is priced
equal to or better than the price of Market B's better-priced bid or
offer and is for the number of shares displayed for that better-priced
bid or offer.\82\ If the
[[Page 11142]]
better-priced bid or offer is still available when Market A's incoming
order reaches Market B, the incoming order should execute against the
better-priced bid or offer. This exception therefore continues to
provide protection to the better-priced bid or offer. The Commission
emphasizes, however, that if the order sent by Market A to Market B is
executed against Market B's better-priced bid or offer, the broker-
dealer executing the inferior-priced order, or the broker-dealer on
whose behalf the order is being executed, still must fulfill its duty
of best execution to its customer with regard to that order, by
providing the customer order the better price. Thus, this exception
would not alter a broker-dealer's duty to provide best execution for
its customers' orders.
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\81\ The Commission notes that several SROs have submitted
proposed rule changes to the Commission to amend their trade-through
rules to include an almost identical exception. See File Nos. SR-
NYSE-2003-36, SR-CHX-2003-37, and SR-Amex-2004-07.
\82\ The Commission notes that this exception is intended to
allow for the execution of an order at a price that trades through a
better-priced bid or offer displayed on another order execution
facility if the order execution facility executing the order has
sent an order to trade with that better-priced bid or offer in
compliance with the requirements of the exception only during the
time period after the market trading through has sent the order to
the away market, but before it receives a response or the quote on
the away market is updated. It is not intended to allow an order
execution facility to execute orders as trade-throughs in reliance
on this proposed exception after it has received a response to its
order from the away market or the away market has changed its quote.
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The proposed rule also would incorporate other exceptions to the
current trade-through prohibitions. Specifically, the proposed rule
would include exceptions under the following circumstances: (1) The
order execution facility displaying the better price was experiencing a
failure, material delay or malfunction of its systems or equipment when
the trade-through occurred; \83\ (2) the order execution facility that
initiated the trade-through made every reasonable effort to avoid the
trade-through but was unable to do so because of a systems or equipment
failure, material delay or malfunction in its own market; (3) the
transaction that constituted the trade-through was not a ``regular
way'' contract; \84\ (4) the bid or offer that is traded-through was
displayed by an order execution facility that was, or whose members
were, relieved of their obligations under paragraph (c)(2) of Rule
11Ac1-1 under the Exchange Act (proposed to be designated as paragraph
(b)(2) of Rule 602) with respect to such bid or offer pursuant to
paragraph (b)(3) of Rule 11Ac1-1 under the Exchange Act (proposed to be
designated as paragraph (a)(3) of Rule 602); \85\ (5) the transaction
that constituted the trade-through was an opening or reopening
transaction by the order execution facility; and (6) the transaction
that constituted the trade-through was executed at a time when there
was a crossed market.\86\
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\83\ The Commission believes that it is appropriate to provide
an exception in those instances where a market displaying a better-
priced bid or offer was experiencing a failure, material delay or
malfunction of its systems or equipment because of the uncertainty
as to whether another market would be able to access the better-
priced bid or offer in a timely manner or receive a response, or
whether its displayed quotes were valid.
\84\ Providing an exception for a transaction that was executed
other than pursuant to standardized terms (not a ``regular way''
contract) is appropriate because the order likely was executed
taking into account factors not related to the current market price,
such as extended settlement terms or at a negotiated price away from
the market.
\85\ The Commission believes that this exception is appropriate
because an order execution facility should not be required to
attempt to match or access a better-priced bid or offer displayed on
another market when that bid or offer is not firm under the
Commission's Quote Rule, Rule 11Ac1-1 under the Exchange Act
(proposed to be designated as Rule 602).
\86\ A crossed market occurs when the best bid is higher than
the best offer. The Commission believes this exception is
appropriate because any transaction executed in a crossed market
would constitute a trade-through under the proposed rule. Therefore,
unless the proposed rule contains an exception for a crossed market,
no order execution facility could execute in a crossed market
without violating the trade-through rule. Such an exception may
provide some incentive to market participants not to intentionally
cross a market (since their bid or offer that has crossed the market
could be executed against), as well as provide an opportunity for
the order being executed to be executed at the better, crossed
price. Nevertheless, the Commission believes that intentionally
crossing the market to take advantage of this exception to the
trade-through rule would violate the access rules proposed today.
See Section IV, infra.
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The Commission believes the proposed exception for opening and re-
opening transactions is appropriate because the process for executing
orders at the open, and after a trading halt, involves the queuing and
ultimate execution of multiple orders at a single price or several
prices, making it difficult to apply the restrictions of the proposed
trade-through rule to each individual order to be executed. For
example, it would be very difficult for a market center that is
attempting to open a security to determine which of the multiple orders
it has to execute at the open would receive a better price displayed on
another market. It also could be problematic for the market center
opening the stock to be able to match the better price, or access the
other market to obtain the better price, when that away market price
may change during the time period when the market center opening the
stock is making its determination as to what price at which to open the
stock, and thus not be the current market displayed when the market
actually determines the price at which it will open? The Commission
recognizes that the opening process in the OTC market for Nasdaq stocks
is different than for the listed market, and that the application of
the restrictions of the proposed trade-through rule at the opening may
make sense in a market that does not have a single-price opening. The
Commission requests comment as to when, if at all, the execution of
orders at the opening and re-opening after a trading halt should be
subject to the proposed trade-through rule.
The Commission also requests comment on the appropriateness of the
proposed exception for where the order execution facility that
initiated the trade-through made every reasonable effort to avoid the
trade-through but was unable to do so because of a systems or equipment
failure, material delay or malfunction in its own market. What are the
types of situations in which this proposed exception would
appropriately apply? In other words, when would it be reasonable to
allow a market that is not able to execute orders in compliance with
the trade-through requirements because of systems problems to continue
to execute orders without complying with the proposed rule?
The Commission also requests comment on whether it should continue
to include an exception for when a market participant executes a trade-
through at a time when the market participant executing the order, and
other market participants in its market, were relieved of their firm
quote obligations pursuant to the ``unusual market'' exception of the
Quote Rule, provided that unless another exception applies, the market
participant executing the order made every reasonable effort to avoid
trading through the best bid or offer of any other market participant
not so relieved of its firm quote obligations under the Quote Rule.\87\
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\87\ See, e.g., NYSE Rule 15A(b)(3)(D).
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Although included in the current ITS trade-through rule, the
Commission proposes not to include an exception from the trade-through
prohibition in cases where the bid or offer that is traded through has
caused a locked market.\88\ If an exception were allowed for a better-
priced locking bid or offer on another market, the order that is being
executed would miss the opportunity to be executed at the better price.
Also, requiring a market to attempt to access a better-priced locking
bid or offer may help to unlock the market more quickly than if the
market could trade through the locking bid or offer. The Commission
also notes that the proposed access standards discussed in Section IV
below would include provisions to deter market participants
[[Page 11143]]
from locking or crossing the market, and thereby lead to fewer
instances of locked markets. Nevertheless, the Commission requests
comment on whether it should include an exception for locked markets to
the proposed trade-through rule. The Commission also requests comment
on whether it should include an exception for locked markets in the
trade-through rule if the proposed access rule were adopted without the
proposed provision that would require every SRO to establish and
enforce rules requiring its members to avoid locking or crossing the
quotations of quoting market centers and quoting market
participants?\89\
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\88\ See, e.g., NYSE Rule 15A(b)(3)(F) and NASD Rule 5262(a)(5).
A locked market occurs when the bid price equals the offer price.
\89\ See Section IV.B.4. infra for a discussion of locked and
crossed markets in the Commission's market access proposal.
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The Commission also notes that the proposed rule, unlike the
current rule, does not include an exception for trading through a 100-
share bid or offer. The Commission is concerned that a de minimis
exception, such as the 100-share exception, would provide an
opportunity for market participants to circumvent the requirements of
the proposed rule.\90\ Nevertheless, the Commission requests comment on
whether it is necessary to include an exception for a de minimis size,
such as for 100 shares. Finally, the Commission requests comment on
whether there should be any other exceptions, or whether any proposed
exception should not be included.\91\
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\90\ For example, a market (Market A) that wanted to execute an
order at a price inferior to a better price showing on another
market (Market B) could send a 100 share order at a better price to
Market B, thus establishing a new best bid or offer for Market B.
Market A could then trade through the 100 share order, subject to
the existing exception for 100 share orders, as well as any other
orders below that 100 share order on Market B because Market A only
is required to protect the best bid or best offer in each market.
\91\ Section (d) of proposed Rule 611 states that the Commission
may exempt from the provisions of Rule 611, either unconditionally
or on specified terms and conditions, any order execution facility,
national securities exchange, national securities association, or
broker or dealer, if the Commission determines that such exemption
is necessary or appropriate in the public interest, and is
consistent with the protections of investors.
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E. Interaction With Existing Plans/Rules
As noted above, no intermarket trade-through rules currently exist
with regard to the trading of Nasdaq securities. With respect to NYSE
and Amex securities, the ITS trade-through rule provides that a member
should avoid trading through a better price available in another
market, subject to certain exceptions detailed in the SROs' rules. The
ITS trade-through rule does not include an opt-out or automated market
exception. Therefore, unless the ITS Plan and SROs' rules were amended
to incorporate the flexibility of the Commission's proposed rule with
regard to the proposed opt-out and automated market exceptions, they
would remain more restrictive than the proposed rule with regard to
those two exceptions. In addition, the proposed rule would eliminate
certain of the existing exceptions to the ITS trade-through rule. If
adopted, these more restrictive provisions of the Commission rule
would, of course, control.
At this time, the Commission is not proposing to amend the ITS Plan
or the SROs' trade-through rules on its own initiative to reflect more
permissive terms of any trade-through rule that the Commission may
ultimately adopt. The Commission believes that market participants
should be able to agree, on a voluntary basis, to provide higher levels
of protection to each other's prices. And, if the Commission's trade-
through and access proposals were adopted, any participant that no
longer wanted to be subject to more restrictive trade-through
provisions in the ITS Plan could withdraw from the plan, as long as it
could comply with the proposed access standards discussed in Section IV
below. However, if the proposed trade-through rule were adopted as
proposed, the ITS participants would be required to amend the ITS Plan
and their trade-through rules where they conflict with more restrictive
provisions in the Commission's proposed rule.
The Commission requests comment on whether it should require that
the ITS Participants amend the ITS Plan and their trade-through rules
to implement the proposed trade-through rule in its entirety, if it
were adopted, even where the Commission rule would be more permissive
than the existing rules. The Commission also requests comment on
whether the Commission should amend the ITS Plan and SRO trade-through
rules on its own initiative if the proposed trade-through rule were
adopted.
F. General Request for Comments
The Commission seeks comments on the trade-through proposal
described in this section III. In addition to the specific requests for
comment above, the Commission asks commenters to address whether the
proposed rule would further the NMS goals set out in Section 11A of the
Exchange Act \92\ and, in particular, the goal of assuring ``the
practicability of brokers executing investors' orders in the best
market.''
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\92\ 15 U.S.C. 78k-1.
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The Commission also requests comment on several alternative
regulatory approaches to intermarket price protection as outlined
below. One alternative would be to adopt the proposed trade-through
rule with the automated market exception but not the opt-out exception.
Another choice would be to adopt the proposed rule without the
automated market exception and extend the existing three-cent de
minimis exemption to all securities covered by the proposed rule,
either with or without the proposed opt-out exception.
Another alternative would be to maintain the existing ITS trade-
through rule and allow the three-cent de minimis exemption for certain
ETFs (QQQs, SPDRs and Diamonds) to expire. This approach would not
address the fundamental problems identified with the operation of the
existing rule, although it likely would provide operational continuity
for the ITS Plan participants. A variation on this alternative would be
to maintain the existing rule, allow the de minimis exception to
expire, and add an opt-out exception to the existing rule. Another
option would be to maintain the existing rule and approve on a
permanent basis the three-cent de minimis exemption for the QQQs, SPDRs
and Diamonds. This alternative would not address the issues with the
current operation of the ITS trade-through rule with respect to
securities other than the QQQs, SPDRs, and Diamonds, although it would
provide operational continuity while still providing relief for those
three actively-traded ETFs. Two other choices would be to maintain the
existing rule and extend the three-cent de minimis exemption either to:
(1) All ETFs subject to the ITS Plan; or (2) all securities subject to
the ITS Plan. A variation on this latter approach would be to extend
the de minimis exemption to all securities subject to the ITS Plan but
impose a cap on the size of quotations that could be traded-through.
Each of these approaches that would include an extension of the current
de minimis exemption would provide some degree of operational
continuity.
Another approach would be to eliminate the existing ITS trade-
through rule and rely solely upon the principles of best execution. The
Commission invites comment on the need for price protection in NYSE,
Amex, and Nasdaq securities in today's market, and whether the NMS
goals and objectives could be achieved without a trade-through rule. In
light of the advent of penny spreads, more efficient executions, active
competition between markets trading like securities and a broker-
dealer's duty of best execution,
[[Page 11144]]
in the absence of a trade-through rule, would accessible better-priced
limit orders remain unexecuted if trades were occurring at inferior
prices? Would the occurrence of trade-throughs weaken customer
confidence in the fairness or efficiency of the market? What would be
the competitive effect of removing the trade-through rule from the
markets trading NYSE and Amex securities? If price protection is not
required, and better-priced limit orders can be ignored, would limit
orders be displayed less often?
The Commission requests specific comment on the costs and benefits,
and the viability, of each alternative outlined above.
The Commission also requests comment on the feasibility of the
proposed trade-through rule. In light of the active trading and
frequent quote changes in the markets, would the trade-through rule as
proposed impede the efficient execution of orders and raise opportunity
costs? Is access between markets efficient enough today to support a
trade-through rule? Would this access be adequate if the Commission's
proposed access rule--discussed in Section IV--were adopted? How should
the proposed trade-through rule reflect access fees charged by market
centers? Would the Commission's proposed access fee cap minimize access
fees sufficiently that they need not be addressed in the trade-through
rule? If the Commission does not ultimately adopt a $.001 standard for
access fees, should there be a trade-through rule exception applicable
to quotes with access fees of more than a specific amount? If so,
should this amount be $.005, $.003, or $.001, or some other amount?
The Commission requests comment as to whether, and if so, to what
extent, the proposed trade-through rule would have the desired effect
of preventing trade-throughs. Commenters are also asked to comment on
the proposed exceptions to the general rule, and whether these
exceptions would permit adequate protection of customer orders or,
alternatively, undermine the intended effect of the proposed rule.
Finally, the Commission requests comment on whether, if it were to
adopt the proposed trade-through rule, a phase-in period would be
necessary or appropriate to allow market participants time to adapt to
its provisions. If so, what aspect(s) of the proposed trade-through
rule should be phased-in, and what would be the appropriate phase-in
period?
G. Paperwork Reduction Act
Certain provisions of the proposed rule contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995,\93\ and the Commission has submitted them to the
Office of Management and Budget (``OMB'') for review in accordance with
44 U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information, unless it displays a currently valid OMB control number.
The Commission is proposing to create a new information collection
entitled ``Trade-Through Rule'' which would be Rule 611 of proposed NMS
under the Exchange Act. OMB has not yet assigned a control number to
the new collection of information imposed by proposed Rule 611 under
the Exchange Act.
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\93\ 44 U.S.C. 3501 et seq.
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1. Summary of Collection of Information
a. Establishment of Policies and Procedures
The proposed trade-through rule would require an order execution
facility, national securities exchange, and national securities
association to establish, maintain, and enforce policies and procedures
reasonably designed to prevent the execution of a trade-through in its
market. The nature and extent of the policies and procedures that an
order execution facility, national securities exchange, and national
securities association would be required to establish to comply with
this requirement would depend upon the type, size, and nature of the
order execution facility, national securities exchange, and national
securities association.
b. Disclosure Necessary To Obtain Informed Consent for Opt-Out
Exception
The proposed rule includes an exception that would permit investors
to give informed consent to the broker-dealer to whom they route their
order(s) to ``opt-out'' of the protection provided by the proposed rule
on an order-by-order basis. If a broker-dealer chooses to provide
investors the ability to opt-out, a broker-dealer would need to,
consistent with any fiduciary obligations arising from its relationship
with the investor, provide to an investor sufficient disclosure
regarding the impact of opting out prior to the investor making a
determination whether or not to opt out so that the investor can make a
fully informed decision.
c. Disclosure of National Best Bid or Offer in the Event of a Customer
Opt-Out
If a broker-dealer chooses to provide customers the ability to opt-
out, and in the event a customer chooses to opt-out for a particular
order, the broker-dealer to whom the customer routed the order would be
required within one month of the date of execution of the order to
disclose to the customer the national best bid or offer in the
security, as applicable, at the time of execution of the order. The
broker-dealer could choose how it would provide such disclosure as long
as such disclosure complies with the proposed rule's requirements. For
instance, the broker-dealer could include such disclosure on the
confirmation sent to the customer pursuant to Section 240.10b-10,\94\
on the account statement for the account sent to the customer pursuant
to applicable SRO rules, or it could provide the national best bid or
offer information in another form of disclosure that is in compliance
with the proposed requirements.
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\94\ 17 CFR 240.10b-10.
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The Commission does not believe that any other market participants
would be subject to a requirement under the proposed rule to collect
information in addition to what they are already required to collect
under existing rules.
2. Proposed Use of Information
a. Establishment of Policies and Procedures
The proposed requirement for each order execution facility,
national securities exchange, and national securities association to
establish, maintain, and enforce policies and procedures reasonably
designed to prevent the execution of a trade-through in its market
would help ensure that the order execution facility, national
securities exchange, or national securities association and its
customers, subscribers, members, and employees, as applicable,
generally avoid trade-throughs, as contemplated by the proposed rule's
requirements.
b. Disclosure Necessary To Obtain Informed Consent for Opt-Out
Exception
The need for a broker-dealer to provide an investor sufficient
disclosure regarding the impact of choosing to opt out of the proposed
rule's protections prior to the investor making an informed
determination whether or not to opt out would be necessary to help
ensure that each investor, especially a retail customer, makes a fully-
informed
[[Page 11145]]
decision whether to forego the protections afforded by the proposed
trade-through rule. The Commission notes that this requirement would
only apply to broker-dealers who choose to provide investors the
ability to opt-out.
c. Disclosure of National Best Bid or Offer in the Event of a Customer
Opt-Out
The proposed rule's requirement that a broker-dealer provide a
customer that has opted out of the proposed rule's protection with
respect to the execution of a particular order with the national best
bid or offer for that security displayed at the time of the execution
of the order, would help ensure that customers are informed of the
consequences of opting out by enabling customers to compare the
execution price they receive with the national best bid or offer for
the security displayed at the time of the execution. The Commission
believes that such information would be useful for customers in making
future decisions as to whether to opt out of the rule's protections.
The Commission notes that this requirement would only apply to broker-
dealers who choose to provide investors the ability to opt-out, and
whose customers do in fact opt-out.
3. Respondents
a. Establishment of Policies and Procedures
The proposed requirement for each order execution facility,
national securities exchange, and national securities association to
establish policies and procedures reasonably designed to prevent the
execution of a trade-through in its market potentially would apply to
the nine registered national securities exchanges and the NASD, and the
approximately 6,768 broker-dealers registered with the Commission as of
December 31, 2002, which include broker-dealers operating as equity
ATSs, broker-dealers registered as market makers in NMS stocks, and any
other broker-dealer that has the ability to execute orders within its
systems.\95\ The Commission requests comment on the accuracy of this
estimated figure.
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\95\ The Commission recognizes that this number may be over-
inclusive because it may include registered broker-dealers that do
not execute orders and broker-dealers that may not effect
transactions in equity securities.
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b. Disclosure Necessary To Obtain Informed Consent for Opt-Out
Exception
Each of the approximately 6,768 broker-dealers that were registered
with the Commission as of December 31, 2002 could potentially choose to
provide investors the ability to opt-out. If a broker-dealer were to
choose to provide this ability to investors, the broker-dealer would
need to obtain informed consent on an order-by-order basis from an
investor in order to allow the investor to opt-out. Thus, each of these
entities would need to provide adequate disclosure to an investor prior
to the investor making a determination whether to opt out of the
proposed rule's protections. The Commission assumes that not all
broker-dealers would choose to provide this choice to investors. The
Commission specifically requests comment as to how many broker-dealers
would choose to allow their customers to opt-out.
c. Disclosure of National Best Bid or Offer in the Event of a Customer
Opt-Out
The requirement for a broker-dealer to disclose the national best
bid or offer to a customer who chooses to opt out of the proposed
trade-through rule's protections potentially would apply to any of the
approximately 6,768 broker-dealers that were registered with the
Commission as of December 31, 2002 that receive order flow from
customers, if they chose to provide their customers the ability to opt-
out.\96\ This number includes clearing broker-dealers even if they do
not have the relationship with the customer, as non-clearing broker-
dealers may rely on the clearing firms that carry their customer
accounts to send confirmations, account statements, or other disclosure
documents related to transactions to their customers. The Commission
requests comment on this estimate as to how many broker-dealers would
be subject to this requirement, if they chose to offer customers the
ability to opt-out.
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\96\ This figure likely includes broker-dealers that do business
only with other broker-dealers and would not be subject to this
requirement.
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The Commission has considered each of these respondents for the
purposes of calculating the reporting burden under the proposed trade-
through rule.
4. Total Annual Reporting and Recordkeeping Burden
a. Establishment of Policies and Procedures
Although the exact nature and extent of the required policies and
procedures that an order execution facility, national securities
exchange, and national securities association would be required to
establish would vary depending upon the nature of the order execution
facility (e.g., SRO vs. non-SRO, large broker-dealer vs. small broker),
the Commission broadly estimates that it would take an SRO
approximately 250 hours of legal,\97\ compliance,\98\ information
technology \99\ and business operations personnel \100\ time,\101\ and
a non-SRO order execution facility approximately 200 hours of legal,
compliance, information technology and business operations personnel
time,\102\ to develop the required policies and procedures.
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\97\ The Commission estimates that the average hourly rate for
legal service in the securities industry is between $150 per hour
and $300 per hour. For purposes of this Release, the Commission will
use a rate of $300 per hour to determine potential legal costs
associated with the proposed rule.
\98\ The Commission estimates that the average hourly rate for a
compliance manager in the securities industry is approximately $83
per hour. See Securities Industry Association, Report on Management
& Professional Earnings in the Securities Industry 2002 (Sept.
2002). For purposes of this trade-through proposal, the Commission
applied a 35% upward adjustment for overhead, reflecting the cost of
supervision, space, and administrative support for average hourly
rate of approximately $110 per hour for compliance personnel time.
\99\ The Commission estimates that the average hourly rate for a
senior computer programmer in the securities industry is
approximately $49 per hour. See Securities Industry Association,
Report on Management & Professional Earnings in the Securities
Industry 2002 (Sept. 2002). For purposes of this trade-through
proposal, the Commission applied a 35% upward adjustment for
overhead, reflecting the cost of supervision, space, and
administrative support for average hourly rate of approximately $65
per hour for information technology personnel time.
\100\ The Commission estimates that the average hourly rate for
an operations manager in the securities industry is approximately
$51 per hour. See Securities Industry Association, Report on
Management & Professional Earnings in the Securities Industry 2002
(Sept. 2002). For purposes of this trade-through proposal, the
Commission applied a 35% upward adjustment for overhead, reflecting
the cost of supervision, space, and administrative support for
average hourly rate of approximately $70 per hour for business
operations personnel time.
\101\ The Commission anticipates that of 250 hours it estimates
would be spent to establish policies and procedures, 115 hours would
be spent by legal personnel, 100 hours would be spent by compliance
personnel, 15 hours would be spent by information technology
personnel and 20 hours would be spent by business operations
personnel of the SRO order execution facility.
\102\ The Commission anticipates that of 200 hours it estimates
would be spent to establish policies and procedures, 85 hours would
be spent by legal personnel, 75 hours would be spent by compliance
personnel, 20 hours would be spent by information technology
personnel and 20 hours would be spent by business operations
personnel of the non-SRO order execution facility.
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Included within this estimate, the Commission staff expects that
SRO and non-SRO respondents may incur one-time external costs for out-
sourced legal services. While the Commission staff recognizes that the
amount of legal outsourcing utilized to help establish policies and
procedures may vary
[[Page 11146]]
widely from entity to entity, the staff estimates that on average, each
order execution facility, national securities exchange, and national
securities association would outsource 50 hours of legal time in order
to establish policies and procedures in accordance with the proposed
rule.\103\
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\103\ The Commission staff does not anticipate that any
compliance services would be outsourced.
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The Commission staff estimates that there would be an initial one-
time burden of 200 burden hours per SRO or 1,800 hours,\104\ and 150
burden hours per non-SRO order execution facility \105\ or 1,015,200
hours, for a total of 1,017,000 burden hours to establish policies and
procedures designed to prevent the execution of a trade-through for an
estimated one-time initial cost of $145,469,475 \106\ The Commission
estimates a capital cost of approximately $101,655,000 for both SROs
and non-SROs resulting from outsourced legal work.\107\
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\104\ There are eight national securities exchanges (Amex, BSE,
CBOE, CHX, NSX, NYSE, Phlx and PCX) and one national securities
association (NASD) that trade NMS stocks and thus would be subject
to the proposed rule. The ISE does not trade NMS Stocks and thus
would not be subject to the proposed rule. The estimated 1,800
burden hours necessary for SRO order execution facilities to
establish policies and procedures are calculated by multiplying nine
times 200 hours (9 x 200 hours = 1,800 hours).
\105\ The Commission estimates that there are 6,768 potential
non-SRO order execution facilities. The estimated 1,015,200 burden
hours necessary for non-SRO order execution facilities to establish
policies and procedures are calculated by multiplying 6,768 times
150 hours (6,768 x 150 hours = 1,015,200 hours).
\106\ This figure was calculated as follows: (65 legal hours x
$300) + (100 compliance hours x $110) + (15 information technology
hours x $65) + (20 business operation hours x $70) = $ 32,875 per
SRO x 9 SROs = $295,875 total cost for SROs; (35 legal hours x $300)
+ (75 compliance hours x $110) + (20 information technology hours x
$65) + (20 business operation hours x $70) = $ 21,450 per broker-
dealer x 6,768 broker-dealers = $145,173,600 total cost for broker-
dealers; $295,875 + $145,173,600 = $145,469,475.
\107\ This figure was calculated as follows: (50 legal hours x
$300 x 9 SROs) + (50 legal hours x $300 x 6,768 broker-dealers) =
$101,655,000.
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Once an order execution facility has established policies and
procedures reasonably designed to prevent trade-throughs in its market,
the Commission estimates that it would take the average SRO and non-SRO
order execution facility approximately two hours per month of internal
legal time and three hours of internal compliance time to ensure that
its policies and procedures are up-to-date and remain in compliance
with the Commission's rule. The Commission staff estimates that these
ongoing costs would be 60 hours annually per respondent, for an
estimated annual cost of $75,631,320.\108\
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\108\ This figure was calculated as follows: (2 legal hours x 12
months x $300 x (9 + 6,768) + (3 compliance hours x 12 months x $110
x (9 + 6,768)) = $75,631,320.
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The Commission requests specific comments on these estimates,
including whether and if so, how many, order execution facilities would
choose to accept only opted-out orders, in which case they would not be
required to establish policies and procedures. The Commission also
requests comment on how costs would differ for the different types of
non-SRO respondents.
b. Disclosure Necessary To Obtain Informed Consent for Opt-Out
Exception
With regard to the proposed exception that would allow investors to
give informed consent to have their orders executed without regard to
the protections provided by the proposed rule, each broker-dealer
receiving order flow from investors that determines to provide
investors the ability to opt-out likely would incur one-time start-up
costs associated with modifying its internal order handling procedures
so as to be able to provide any necessary disclosure to investors. The
nature of the needed changes likely would vary for each broker-dealer,
depending upon how it receives order flow (e.g., manually over the
telephone or through an electronic order routing system). The
Commission staff estimates that it would take approximately 140 hours
for a broker-dealer to determine the content of the disclosures and how
they will be provided, as well as to make any necessary modifications
to its order handling systems. This includes approximately 20 hours of
legal personnel time, 20 hours of compliance personnel time, 20 hours
of business operations personnel time and 80 hours of information
technology personnel time. The Commission believes that not all broker-
dealers would provide the ability to opt-out, but for purposes of this
calculation has included all registered broker-dealers in the cost
estimate, which likely over-estimates the cost burden. The Commission
requests comment as to how many broker-dealers would offer this ability
to investors and how many would not. Further, the Commission staff has
assumed for purposes of this burden estimate that all information
technology services would be provided internally. The Commission
requests comment on the amount of information technology work that a
broker-dealer would outsource in order to make modifications to its
order handling systems necessary to provide the required disclosure to
investors, and how that would impact the costs of making those
modifications.
Included within this estimate, the Commission staff expects that
broker-dealers may incur one-time external costs for out-sourced legal
services. While the Commission staff recognizes that the amount of
legal outsourcing utilized to determine the content of the disclosures
and how they would be provided may vary widely from entity to entity,
the staff estimates that on average, each broker-dealer would outsource
8 hours of legal time in order to make this determination.\109\
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\109\ The Commission staff does not anticipate that any
compliance services would be outsourced.
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Therefore, the Commission staff estimates that there would be a
one-time burden of 893,376 hours \110\ for broker-dealers to make
changes to their systems necessary to provide disclosure to investors
regarding the impact of opting out of the protections offered by the
proposed rule for a total one-time cost of approximately
$83,923,200,\111\ plus a one-time capital cost of approximately
$16,243,200 resulting from outsourced legal work.\112\
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\110\ The estimated 893,376 burden hours was calculated by
adding 12 hours of estimated internal legal personnel time, 20 hours
of estimated compliance personnel time, 20 hours of business
operations personnel time and 80 hours of estimated internal
information technology time and multiplying that by the number of
registered broker-dealers, 6,768. ((12 + 20 + 20 + 80) x 6,768 =
893,376)).
\111\ This figure was calculated as follows: (12 legal hours x
$300) + (20 compliance hours x $110) + (20 business operations hours
x $70) + (80 information technology hour x $65) x 6,768 =
$83,923,200.
\112\ This figure was calculated as follows: (8 legal hours x
$300 x 6,768) = $16,243,200.
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The Commission staff estimates that costs to comply with this
requirement on an ongoing basis would be minimal. Specifically, the
Commission staff estimates that it would take one hours of legal time,
two hours of compliance time, two hours of business operations time and
one hour of information technology time per month to monitor that
disclosures are being made appropriately. The Commission staff
estimates that these ongoing costs would be 72 hours annually per
respondent, for an estimated annual cost of $58,881,600.\113\
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\113\ This figure was calculated as follows: (1 legal hour x 12
months x $300) + (2 compliance hours x 12 months x $110) + (2
business operations hours x 12 months x $70) + (1 information
technology hour x 12 months x $65) x 6,768 = $58,881,600.
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The Commission requests specific comments on these estimates.
c. Disclosure of National Best Bid or Offer in the Event of a Customer
Opt-Out
If a broker-dealer chooses to provide investors with the ability to
opt-out, the
[[Page 11147]]
proposed rule would require a broker-dealer to provide its customers
(but not other broker-dealers from whom it receives order flow) with
the national best bid or offer for the security, as applicable,
available at the time each customer order was executed, if the customer
chooses to opt-out of the protections provided by the proposed rule.
These broker-dealers would likely incur one-time start-up costs
associated with modifying their procedures and systems to comply with
this requirement to provide the national best bid or best offer
information to customers for each order for which a customer opts-out
of the rule's protections, either on their confirmations, account
statements or other disclosure document.
The Commission estimates that it would take approximately 350 hours
for a broker-dealer to modify its procedures and systems to be able to
provide the national best bid or offer to customers who choose to opt-
out for a particular order. This includes approximately 20 hours of
internal legal, 20 hours of compliance personnel time, 50 hours of
business operations personnel time and approximately 260 hours of
internal information technology personnel time. Therefore, the
Commission staff estimates that there would be a one-time burden of
2,368,800 hours for broker-dealers to make any changes to their systems
necessary to provide customers with the national best bid or offer in
the event a customer opts out of the proposed rule's protections,\114\
for an estimated initial one-time total cost of approximately
$193,564,800.\115\
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\114\ The estimated 2,368,800 burden hours was calculated by
adding 20 hours of estimated internal legal time, 20 hours of
estimated compliance time, 50 hours of estimated business operations
time and 260 hours of estimated internal information technology time
and multiplying that by the number of registered broker-dealers,
6,768. ((20 + 20 + 50 + 260) x 6,768 = 2,368,800)).
\115\ This figure was calculated as follows: (20 legal hours x
$300) + (20 compliance hours x $110) + (50 business operations hours
x $70) + (260 information technology hours x $65) x 6,768 = $193,
564,800.
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The Commission staff has assumed for purposes of this burden
estimate that all information technology services would be provided
internally. The Commission requests comment on the amount of
information technology work that a broker-dealer would outsource in
order to make modifications to its systems necessary to provide a
customer with the national best bid or offer in the event a customer
opts out of the proposed rule's protections, and how that would impact
the costs of making those modifications.
Once a broker-dealer's procedures are modified so as to comply with
the requirement to provide the national best bid or offer if a customer
has opted-out, the Commission believes that the burden of complying
with the requirement on an on-going basis should be minimal. The
Commission estimates that it would take the average broker-dealer two
hours of legal time, five hours of compliance personnel time, five
hours of business operations personnel time and five hours of
information technology personnel time per month to monitor whether or
not its systems are operating correctly so as to provide the required
bid and offer information, and to conduct any other necessary systems
maintenance. This ongoing cost could be included within the broker-
dealer's existing monitoring and surveillance processes. The Commission
staff estimates that these ongoing costs would be approximately 204
hours annually per respondent, for an estimated annual cost of
$148,219,200.\116\
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\116\ This figure was calculated as follows: (2 legal hours x 12
months x $300) + (5 compliance hours x 12 months x $110) + (5
business operations hours x 12 months x $70) + (5 information
technology hours x 12 months x $65) x 6,768 = $148,219,200.
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The Commission specifically requests comment on the frequency with
which commenters believe this exception to the proposed rule would be
utilized by customers presented with the ability to opt-out of the
protections of the proposed trade-through rule, and how this would
impact the information collection costs.
5. General Information About Collection of Information
a. Establishment of Policies and Procedures
This collection of information would be mandatory. The Commission
expects that the policies and procedures generated pursuant to the
proposed rule would be communicated to the members and employees of all
entities covered by the proposed rule. Any records generated in
connection with the proposed rule's requirement to establish policies
and procedures would be required to be preserved in accordance with,
and for the periods specified in, Exchange Act Rules 17a-1 \117\ and
17a-4(e)(7).\118\
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\117\ 17 CFR 240.17a-1.
\118\ 17 CFR 240.17a-4(e)(7).
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b. Disclosure Necessary To Obtain Informed Consent for Opt-Out
Exception
To the extent that a broker-dealer determines to provide investors
the ability to opt-out, this collection of information would be
considered mandatory but the nature and extent of the disclosure to be
provided by the broker-dealer necessary to obtain informed consent
would vary from investor to investor. To the extent such disclosures
are in written form, broker-dealers would be required to preserve
records of any such disclosures in accordance with, and for the period
specified in, Exchange Act Rule 17a-4.\119\
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\119\ 17 CFR 240.17a-4.
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c. Disclosure of National Best Bid or Offer in the Event of a Customer
Opt-Out
To the extent that a broker-dealer determines to provide investors
the ability to opt-out, and to the extent customers choose to opt-out,
this collection of information would be mandatory and would be provided
by broker-dealers to customers, and would also be maintained by broker-
dealers. Broker-dealers would be required to preserve a record of any
disclosure of the national best bid or offer to a customer in the event
a customer opts out of the proposed rule's protection in accordance
with, and for the period specified in, Exchange Act Rule 17a-4.\120\
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\120\ 17 CFR 240.17a-4.
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6. General Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to: (i) Evaluate whether the proposed collection of
information is necessary for the proper performance of the functions of
the agency, including whether the information shall have practical
utility; (ii) evaluate the accuracy of the Commission's estimate of the
burden of the proposed collection of information; (iii) determine
whether there are ways to enhance the quality, utility, and clarity of
the information to be collected; and (iv) evaluate whether there are
ways to minimize the burden of the collection of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549-0609, with reference to File No. S7-10-04.
Requests for materials submitted to
[[Page 11148]]
OMB by the Commission with regard to this collection of information
should be in writing, refer to File No. S7-10-04, and be submitted to
the Securities and Exchange Commission, Records Management, Office of
Filings and Information Services, 450 Fifth Street, NW., Washington, DC
20549-0609. As OMB is required to make a decision concerning the
collections of information between 30 and 60 days after publication, a
comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of publications.
H. Consideration of Costs and Benefits
As discussed above, changes in the structure of the equity markets
in recent years have called into question the continued viability of
the existing system for achieving intermarket price protection. In
light of these concerns, the Commission believes that these changes
require it to revisit the issue of trading at prices inferior to the
best available bids and offers. The Commission therefore is proposing a
new rule that would require an order execution facility, national
securities exchange, and national securities association to establish,
maintain, and enforce policies and procedures reasonably designed to
prevent the execution of an order in its market at a price that is
inferior to a better price displayed on another market.
One exception to the proposed rule would allow an order execution
facility to execute an order without regard to the protections of the
proposed rule if the person or entity for whose account the order is
entered affirmatively makes an informed decision to opt out of the
rule's protection. Another exception would provide that order execution
facilities that offer immediate automated responses to incoming orders
up to the size of their best bid and offer, without restriction, would
be permitted to trade at a price inferior to the best bid or offer of a
non-automated market up to limited amount. The proposed rule also would
provide for several other exceptions.
As a result of this undertaking, the Commission believes that there
will be identifiable cost and benefits. These are discussed below. The
Commission requests comment on all aspects of this proposed cost-
benefit analysis, including identification of any additional costs or
benefits of the proposed rule. The Commission encourages commenters to
identify or supply any relevant data concerning the costs or benefits
of the proposed rule.
1. Benefits
When an investor receives an execution in one market at a price
that is inferior to a better price displayed in another market, that
``trade-through'' has a cost to the investor receiving the inferior
execution. In addition, when trades occur at prices worse than the
displayed best bid or offer, it gives an impression of unfairness in
the market, particularly to those investors who witness their orders
being executed at inferior prices. A trade-through also imposes a cost
on the broker-dealer or customer responsible for the best displayed
order or quote that is traded through. When trades occur at prices that
are inferior to displayed limit orders or quotes, market participants
may be less willing to display limit orders or to quote aggressively if
they believe it likely that such orders and quotes will be bypassed by
executions in other markets at prices that would be advantageous to
them. If limit orders frequently remain unexecuted after trades take
place at inferior prices, investors may discouraged from entering limit
orders, thus reducing price discovery.
By requiring order execution facilities, national securities
exchanges, and national securities associations to establish policies
and procedures reasonably designed to prevent trade-throughs, the
proposed rule should help ensure that investors consistently receive
executions at the best displayed bid or offer (or better), whether
through price matching or by orders being routed to markets with better
prices, unless an investor chooses to opt out of the proposed rule's
protections or another exception applies. This would be true no matter
where the order was being executed (e.g. on an exchange, on
SuperMontage, or internally by a broker-dealer). The proposed rule also
should facilitate the ability of a broker-dealer to achieve best
execution for its customer orders because if a broker-dealer routes an
order to a market not showing the best bid or offer, that market should
not execute the order at a price that is inferior to the bid or offer
displayed on the other market unless an exception applies. These
results in turn may help bolster investor confidence in the integrity
of the market, which may encourage investors to be more willing to
invest in the market, thus adding depth and liquidity to the markets.
The Commission also believes that the proposed rule may encourage
the use of limit orders and more competitive quoting because investors
who use limit orders, and order execution facilities that quote
aggressively, would be more likely to receive an execution because
trades would not occur on another market at a price inferior to their
orders, except in circumstances where an exception applies. An increase
in the use of limit orders and aggressive quoting should likewise
enhance price discovery and liquidity in the markets.
Further, because the proposed rule would provide that trades would
not execute in one market without regard to the best bids and offers in
other markets, the proposed rule should help increase efficiency and
encourage competition and order interaction between multiple markets by
providing a greater opportunity for orders to interact with one
another, particularly on an automated basis. The proposed rule also
would permit an automated market to execute orders without regard to a
better bid or offer displayed on a non-automated market, within certain
price parameters. This exception is designed to reflect the comparative
difficulty of accessing market quotes from non-automated markets, and
to adjust the trade-through requirement to these differences. This
should enhance the ability of individual markets with different market
structures to compete fairly with each other.
In addition, the availability of the proposed opt-out exception,
which would provide investors with choice as to whether their orders
should trade through a better price, may create market forces that
would serve to discipline markets that provided slow executions or
inadequate access to their markets. If investors were not satisfied
with the level of automation or service provided by a market center,
they could choose to opt out of the proposed rule's provisions, thus
putting pressure on markets to improve their services. Similarly,
because the proposed automated market exception would allow an
automated market to trade through better prices displayed on a non-
automated market up to a certain amount, an automated market could
execute orders in its market without reference to any non-automated
market's better-priced orders. Market participants may be less likely
to send their order flow to a market center whose orders can be ignored
by other markets. To the extent that such a dynamic impacts the ability
of a non-automated market to compete and attract order flow, the
proposed exception may provide an incentive for a non-automated market
to automate, at least for its displayed best bid and offer, which would
generally increase the efficiency of the markets and improve the
accessibility of better bids and offers for all investors. Markets that
would be
[[Page 11149]]
considered automated pursuant to the proposed automated market
exception also may benefit because other markets would not be able to
trade through their best displayed bids and offers unless an investor
chose to opt out (or another exception applied). Furthermore, the
ability of automated markets to trade through non-automated markets may
encourage automated markets that do not currently quote in the public
consolidated quote system to do so, which would serve to enhance
competition and transparency in the market for NYSE or Amex securities
(where the current trade-through rules apply).
The Commission seeks comment on any additional benefits of the
proposed trade-through rule, including relevant data to help quantify
the expected benefits. The Commission specifically seeks comment on the
expected increase in efficiency and decrease in execution costs from
allowing investors to opt out and from allowing automated markets to
trade-through manual markets up to a certain amount.
2. Costs
Order execution facilities, national securities exchanges, and
national securities associations would incur costs associated with
establishing, maintaining, and enforcing policies and procedures
reasonably designed to prevent trade-throughs. It is difficult to
estimate the extent of what these costs would be because the exact
nature and extent of the policies and procedures would depend on the
type, size and nature of each entity's business.
An order execution facility, national securities exchange, and
national securities association would incur costs associated with
developing these policies and procedures. As discussed above in Section
III.G., the Commission broadly estimates that each SRO that would be
subject to this requirement would incur a one-time initial cost for
establishing such policies and procedures of approximately $47,875, and
each non-SRO order execution facility that would be subject to this
requirement would incur a one-time initial cost for establishing
policies and procedures of approximately $36,450. Once it has
established policies and procedures, each order execution facility,
national securities exchange, and national securities association also
would likely incur costs associated with maintaining and updating its
policies and procedures to ensure they continue to be reasonably
designed to prevent trade-throughs. The Commission broadly estimates
that the annual costs for updating the policies and procedures would be
approximately $11,160 per order execution facility, national securities
exchange, or national securities association. The Commission requests
comment on these estimates.
An order execution facility, national securities exchange, and
national securities association also would incur initial one-time costs
associated with taking action necessary to effectuate the policies and
procedures it has developed. For example, an order execution facility,
national securities exchange, and national securities association would
have to ensure that its members (if applicable) and its personnel
responsible for trading in its market are on notice that the order
execution facility, national securities exchange, or national
securities association is subject to the restrictions of the proposed
trade-through rule and that the members and personnel are subject to
the order execution facility's, national securities exchange's or
national securities association's policies and procedures established
pursuant to the proposed rule.\121\ Further, all order execution
facilities, national securities exchanges, and national securities
associations would have to educate and train their employees as to the
scope and impact of, and how to comply with, the proposed rule and the
policies and procedures implemented by the order execution facility,
national securities exchange or national securities association.
Moreover, an order execution facility (whether or not it is an SRO or
non-SRO), national securities exchange, and national securities
association would have to build into its trading or trade reporting
system inhibitors to prevent trading at an inferior price to a
published quote. Each order execution facility, national securities
exchange, and national securities association would incur costs
associated with modifying its systems and procedures to implement these
actions.
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\121\ The Commission notes that any member of an SRO that
executes orders would be deemed on order execution facility under
the proposed rule and thus subject to the proposed rule's
requirements. In addition, any member that is not an order execution
facility but who receives order flow from customers or other broker-
dealers would potentially be subject to the proposed opt-out
requirement to obtain informed consent.
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In addition, each order execution facility, national securities
exchange, and national securities association also must, commensurate
with its business, incur ongoing costs associated with monitoring for
and enforcing compliance with the proposed rule and its own policies
and procedures developed pursuant to the proposed rule. The order
execution facility, national securities exchange, and national
securities association could include provisions for such monitoring and
enforcement within its existing policies and procedures for monitoring
and enforcing compliance with the federal securities laws, rules, and
regulations.\122\ Each SRO order execution facility, national
securities exchange, and national securities association also would
have to include this proposed rule, and its own trade-through policies
and procedures, within the scope of its existing procedures for
bringing disciplinary actions against its members for violations of the
federal securities laws, rules, and regulations and its own rules.
Order execution facilities, national securities exchanges, and national
securities associations likely would incur costs associated with
updating existing enforcement procedures and, for SROs, with updating
disciplinary procedures. For example, order execution facilities may
incur costs associated with additional personnel time needed to monitor
for and investigate instances of trade-throughs, as well as costs
associated with modifications to existing monitoring or surveillance
systems. The costs of these monitoring and compliance tools may be
greater for markets that trade Nasdaq securities, which are not
currently subject to a trade-through rule and may not have any existing
infrastructure in place.
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\122\ For instance, an order execution facility, national
securities exchange, or national securities association should
develop real-time monitoring or surveillance procedures and reports
that would record any instance where an order is executed on its
market at a price that trades through a better price displayed on
another market.
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If a broker-dealer were to choose to provide investors the ability
to opt out of the protections of the proposed rule, it would need to,
consistent with any fiduciary obligations arising from its relationship
with the investor, provide sufficient disclosure to each investor prior
to that investor making a determination whether or not to opt out with
respect to that order so that the investor can make an informed
decision. The Commission preliminarily believes that not all broker-
dealers would offer investors the ability to opt out, but has
preliminarily included all registered broker-dealers in its cost
analysis. Therefore, the Commission estimates that each broker-dealer
would incur an initial one-time cost of approximately $14,800 to modify
its order handling procedures and systems to be able to comply with
this requirement, and approximately $8,700 annually per broker-dealer
to monitor for and
[[Page 11150]]
maintain compliance with this requirement. The Commission requests
specific comment on how many broker-dealers would choose to offer
investors the ability to opt out.
A broker-dealer that provided investors the ability to opt out also
likely would need to modify its order handling procedures to record for
each order whether or not an investor has chosen to opt out of the
proposed rule's protections for purposes of order handling. In
addition, each order execution facility that executes orders likely
would need to modify its order handling and execution procedures to
identify incoming orders that are opted-out, for purposes of
determining how to execute them, unless the order execution facility
chooses to accept only opted-out orders. Broker-dealers and order
execution facilities would incur costs associated with making these
changes. Furthermore, the proposed rule would require that a broker-
dealer that provides customers the ability to opt out and whose
customer has chosen to opt out must provide that customer with the
national best bid or offer, as applicable, at the time of the execution
of the customer's order. Again, while the Commission preliminarily
believes that not all broker-dealers would offer investors the ability
to opt out, it has preliminarily included all registered broker-dealers
in its cost analysis. Therefore, the Commission broadly estimates that
each broker-dealer would incur a one-time initial cost of approximately
$28,600 to modify its procedures and systems to provide the national
best bid and offer information to customers in compliance with the
proposed rule, as well as approximately $21,900 annually per broker-
dealer to monitor for continued compliance with this proposed
requirement. The Commission requests comment on these estimates.
Order execution facilities also may incur costs to modify their
order handling and execution procedures and systems to comply with the
proposed automated market exception, as they likely would need to
modify their systems to recognize the proposed trade-through limit
amounts, as well as which order execution facilities are deemed to be
non-automated order execution facilities. The Commission asks
commenters to quantify, to the extent possible, the dollar costs of
making each of these, and any other, order handling, execution system
and other changes necessary to comply with the proposed rule.
Another possible cost would be the potential impact of the proposed
rule on the time it would take to execute orders subject to the
proposed rule, especially in markets not currently subject to trade-
through rules. The process of observing the prices on other markets and
determining whether it is necessary to route orders to another market
or match a better price on another market could result in slower
execution times. The Commission requests comment on the extent to which
the imposition of the proposed rule may affect execution times and the
impact, if any, this would have on the quality and cost of order
executions. The Commission also requests comment on the extent to which
the necessity for a broker-dealer to provide disclosure to an investor
prior to obtaining informed consent to opt out would impact the speed
with which the order would be executed. The ability to execute orders
pursuant to the proposed opt-out and automated market exceptions also
may impact the execution price of such orders, in that orders executed
pursuant to those exceptions would forego the opportunity to be
executed at a better price displayed on another market. The Commission
requests comment as to the best way to quantify this potential cost.
The proposed rule also may adversely impact the ability of order
execution facilities that would not qualify as ``automated'' under the
proposed rule to compete with other market centers and attract order
flow because in certain circumstances automated order execution
facilities would be able to execute orders within their markets without
reference to better-priced orders displayed in a non-automated market,
and investors may be less likely to send order flow to a market center
whose order can be bypassed by executions in other markets.
The proposal would apply to broker-dealers that internalize order
flow even if they do not post quotes in the consolidated quote. The
Commission requests comment on the extent to which the trade-through
proposal would impact the profitability of such broker-dealers because
they would need to match the price of, or route to, a better priced bid
or offer displayed on another order execution facility when executing
their customer orders (unless an exception applies).
Finally, the Commission generally requests comment as to whether
the operation of the proposed rule would result in the potential costs
discussed above, and how to quantify these potential costs. The
Commission also seeks comment on any additional anticipated costs of
the proposed trade-through rule, including specifics of the dollar
amount of such cost impact.
I. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act \123\ requires the Commission,
when engaging in rulemaking that requires us 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. Section 23(a) of the Exchange Act \124\ requires
the Commission to consider the anticompetitive effects of any rules
that we adopt under the Exchange Act. Section 23(a)(2) prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
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\123\ 15 U.S.C. 78c(f).
\124\ 15 U.S.C. 78w(a).
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The proposed trade-through rule is intended to be a response to
changes that have occurred in the marketplace that have impacted the
operation of rules relating to intermarket price protection. The
proposed rule would require that an order execution facility, national
securities exchange, and national securities association establish,
maintain, and enforce policies and procedures reasonably designed to
prevent the execution of an order in its market at a price that is
inferior to the best bid or offer displayed in an order execution
facility, unless an exception applies.
The Commission preliminarily believes that the proposed trade-
through rule will bolster investor confidence in the markets by helping
to ensure that the customer orders are executed at the best price
available and providing protection against limit orders being by-passed
by inferior priced executions. The price protection provided by the
proposed rule should encourage the use of limit orders and aggressive
quoting, which should help improve the price discovery process, and in
turn, contribute to increased liquidity and depth in the markets. The
deeper and more liquid markets are, the more willing the public may be
to invest its capital, thus promoting capital formation.
The Commission also preliminarily believes that the operation of
the proposed trade-through rule should help promote efficiency in the
markets. In general, a rule that provides price protection across
markets should help increase efficiency and reduce the effects of
fragmentation because it will
[[Page 11151]]
help link together competing markets so orders should have a greater
opportunity to interact.
Further, by permitting investors to opt out of the proposed rule's
protections on an order-by-order basis, the proposed rule would allow
investors to have more control over the execution of their orders. By
allowing automated order execution facilities to trade through non-
automated order execution facilities up to a certain amount, the
proposed rule should help promote greater efficiency by enhancing the
ability of all markets, regardless of market structure, to operate
without undue constraint, consistent with investor protection. By
allowing automated order execution facilities to trade through non-
automated order execution facilities, the proposed rule also should
promote efficiency by facilitating the ability of investor orders to
interact more directly on an automated basis.
The proposed rule should promote competition and order interaction
among markets by providing that orders would not be able to execute in
one market without regard to the best quotes and orders in another
market. This should encourage the use of limit orders and aggressive
quoting. The proposed rule also should promote competition among
markets and provide choice for investors and other market participants
by enhancing the ability of different markets with different market
structures to efficiently and effectively operate within a single
national market system.
The Commission solicits comments on these matters with respect to
the proposed rule. Would the proposed rule have an adverse effect on
competition that is neither necessary nor appropriate in furtherance of
the purposes of the Exchange Act? Would the proposed rule, if adopted,
promote efficiency, competition, and capital formation? Commenters are
requested to provide empirical data and other factual support for their
views if possible.
J. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \125\ the Commission must advise OMB as to
whether the proposed regulation constitutes a ``major'' rule. Under
SBRFA, a rule is considered ``major'' where, if adopted, it results or
is likely to result in:
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\125\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified
in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C.
601).
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An annual effect on the economy of $100 million
or more (either in the form of an increase or a decrease);
A major increase in costs or prices for
consumers or individual industries; or
Significant adverse effect on competition,
investment or innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. The Commission requests
comment on the potential impact of the proposed regulation on the
economy on an annual basis. Commenters are requested to provide
empirical data and other factual support for their view to the extent
possible.
K. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA''), in accordance with the provisions of the
Regulatory Flexibility Act (``RFA''),\126\ regarding the proposed
trade-through rule.
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\126\ 5 U.S.C. 603.
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The proposed trade-through rule would require any order execution
facility,\127\ national securities exchange, and national securities
association to establish, maintain, and enforce policies and procedures
reasonably designed to prevent the execution of an order in its market
at a price that is inferior to a better bid or offer displayed on
another market, otherwise known as a trade-through. The proposed rule
would include several exceptions to the trade-through restrictions,
including an opt-out option and an exception for automated markets.
Specifically, an order execution facility would be permitted to execute
an order at a price that trades through a better-displayed price on
another market if the person for whose account the order is entered,
whether a customer or broker-dealer, affirmatively makes an informed
decision to opt out of the rule's protection. In addition, an order
execution facility that offers immediate automated responses to
incoming orders for up to the full size of its best bid and offer,
without any restriction on execution, would be permitted to trade
through the price of a non-automated order execution facility up to a
specified amount. The proposed trade-through rule also would provide
for several other exceptions.
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\127\ The proposed definition of order execution facility in
proposed Rule 600 of Regulation NMS includes any exchange market
maker; OTC market maker; other broker-dealer that executes an order
within its own market or system; alternative trading system; or any
national securities exchange or national securities association that
operates a facility that executes orders.
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1. Reasons for the Proposed Action
Over the last twenty years, there have been significant changes in
the way the markets operate and compete with each other. There have
been technological advances that have resulted in automated quoting and
handling of orders and new market participants have emerged with new
business models. Some market centers operate entirely electronically,
while others continue to conduct floor-based trading. Also, with the
advent of trading in decimals, the minimum pricing variation in equity
securities has narrowed and there is often less depth at the top-of-
book. Issues have been raised as to the continued efficient operation
of the current ITS trade-through rule due to these changes in the
structure of the markets. This trade-through proposal is intended to
address these issues and to respond to the criticisms of the existing
rule while still preserving important market integrity and investor
protections.
2. Objectives and Legal Basis
The proposed trade-through rule is designed to achieve several
objectives. The proposed trade-through rule should help promote the use
of limit orders and aggressive quoting by providing a measure of price
protection across unlinked, competing markets, while still allowing
these markets to operate under their current business models. The
proposed trade-through rule also should help facilitate the ability of
a broker-dealer to comply with its best execution obligations, and
should help to ensure that customer orders receive an execution at the
best bid or offer available across multiple markets.
The Commission is proposing the trade-through rule under the
authority set forth in Exchange Act Sections 3(b), 5, 6, 11A, 15, 15A,
17(a) and (b), 19, and 23(a).
3. Small Entities Subject to the Rules
The requirement of the proposed trade-through rule that an order
execution facility, national securities exchange, and national
securities association must establish, maintain, and enforce policies
and procedures reasonably designed to prevent the execution of a trade-
through in its market would apply to any market that executes orders in
NMS Stocks--specifically, any exchange market maker, OTC market maker,
any other broker-dealer that executes orders internally by trading as
principal or by crossing orders as agent, any alternative trading
system, and any national securities exchange or national securities
association. Each of these entities that would qualify as ``automated''
under the proposed rule also may take advantage of the
[[Page 11152]]
exception that would allow an automated market to trade through a non-
automated market up to a certain amount.
In addition, all broker-dealers who receive orders from customers
or other broker-dealers potentially would be subject to the rule's
requirements relating to the opt-out exception, regardless of whether
or not the broker-dealer executes orders, and thus may not be deemed an
order execution facility under the proposed rule. Specifically, if a
broker-dealer were to chose to provide investors the ability to opt-
out, the broker-dealer would need to provide its customers and broker-
dealers from whom it receives order flow with adequate prior disclosure
regarding the consequences of opting out of the proposed rule's
protections (e.g., potential execution at a price inferior to the best
bid or offer) to ensure that the customer or broker-dealer makes an
informed decision. If an investor decides to opt out of the trade-
through rule's protections, the broker-dealer then likely would need to
mark the order as opted-out. The broker-dealer also would be required
pursuant to the proposed rule to disclose to a customer that chose to
opt-out, within one month of the date the transaction was executed, the
best displayed bid or offer for that security available at the time the
customer order was executed. Accordingly, the proposed rule would
impact a wide variety of market participants. Each is discussed below.
a. National Securities Exchanges and National Securities Associations
None of the existing national securities exchanges is a small
entity as defined by Commission rules. Paragraph (e) of Exchange Act
Rule 0-10 \128\ states that the term ``small business,'' when referring
to an exchange, means any exchange that has been exempted from the
reporting requirements of Exchange Act Rule 11Aa3-1. None of these
exchanges is exempt from the requirements. There is one national
securities association, which the Commission has determined is not a
small entity.
---------------------------------------------------------------------------
\128\ 17 CFR 240.0-10.
---------------------------------------------------------------------------
b. Broker-Dealers, Alternative Trading Systems, and Exchange and OTC
Market Makers
The proposed rule's requirement to establish, maintain, and enforce
policies and procedures reasonably designed to prevent the execution of
a trade-through, absent an exception, would apply to any order
execution facility as outlined above.\129\ All of these entities
(except the SROs) are registered broker-dealers. The requirements
associated with the operation of the proposed opt-out exception to the
proposed rule would apply to any broker-dealer that receives order flow
from its own customers or other broker-dealers, if the broker-dealer
chooses to provide such entities the ability to opt-out. The proposed
exception to allow an order execution facility to trade through a non-
automated market could be utilized by any order execution facility that
qualified as automated under the proposed rule. The other proposed
exceptions could apply to any order execution facility subject to the
proposed rule's requirements.
---------------------------------------------------------------------------
\129\ This means that it would apply to alternative trading
systems, registered exchange specialists and market makers,
registered OTC market makers, block positioners, and any other
broker or dealer that executes orders internally.
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Commission rules generally define a broker-dealer as a small entity
for purposes of the Exchange Act and the Regulatory Flexibility Act if
the broker-dealer had a total capital (net worth plus subordinated
liabilities) of less than $500,000 on the date in the prior fiscal year
as of which its audited financial statements were prepared, and it is
not affiliated with any person (other than a natural person) that is
not a small entity.\130\
---------------------------------------------------------------------------
\130\ 17 CFR 240.0-10(c).
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The Commission estimates that as of December 31, 2002, there were
approximately 880 Commission-registered broker-dealers that would be
considered small entities for purposes of the statute. Each of these
broker-dealers potentially would be required to comply with the
requirement of the proposed rule to establish, maintain, and enforce
policies and procedures reasonably designed to prevent the execution of
a trade-through in its market. Each of these small entities also would
be able to utilize the exception for non-automated markets if it were
to qualify as automated under the terms of the proposed rule.
In addition, each of these 880 broker-dealers that are considered
small entities could potentially handle orders on behalf of customers
or other broker-dealers. If these broker-dealers wanted to offer their
customers and broker-dealers from whom they receive order flow the
opportunity to opt out, they would be required to obtain informed
consent on an order-by-order basis. This would necessitate the broker-
dealer providing prior disclosure to investors consistent with any
fiduciary obligations arising from its relationship with the investors
and recording whether the investor made a decision to opt out. The
broker-dealer also would be required to provide the national best bid
or offer to a customer who has chosen to opt out.
4. Reporting, Recordkeeping, and Other Compliance Requirements
The proposed trade-through rule would require each order execution
facility, national securities exchange, and national securities
association to establish, maintain, and enforce policies and procedures
reasonably designed to prevent trade-throughs in its market. These
policies and procedures must include the ability to monitor for and
detect instances of non-compliance with the proposed rule as well as
provide for enforcement of the proposed rule.
With regard to the proposed opt-out exception, a broker-dealer that
chose to provide investors the ability to opt-out would need to provide
adequate disclosure to each investor to ensure that the investor's
decision is an informed one, consistent with any fiduciary obligations
arising from its relationship with the investor. Broker-dealers would
be required to keep a record of any disclosure provided to the investor
prior to the investor providing the consent in compliance with
Commission or SRO books and records rules.\131\ The Commission also
anticipates that broker-dealers likely would document a customer's
decision to provide informed consent. In addition, for customers that
chose to opt out of the proposed rule's protection, broker-dealers
would be required to disclose to the customer the national best bid or
offer for that security, as applicable, available at the time the
customer order was executed.
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\131\ See, e.g., 17 CFR 240.17a-4.
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5. Duplicative, Overlapping, or Conflicting Federal Rules
The Commission has not identified any federal rules that duplicate,
overlap, or conflict with the proposed rules.
6. Significant Alternatives
Pursuant to Section 3(a) of the RFA, the Commission must consider
the following types of alternatives: (a) The establishment of differing
compliance or reporting requirements or timetables that take into
account the resources available to small entities; (b) clarification,
consolidation, or simplification of compliance and reporting
requirements under the Rule for small entities; (c) the use of
performance rather than design standards; and (d) an exemption from
[[Page 11153]]
coverage of the rule, or any part thereof, for small entities.
The Commission does not believe that it is necessary to establish
differing compliance or reporting requirements or timetables to take
into account the resources available to small entities, nor does the
Commission believe that any clarification, consolidation or
simplification of compliance and reporting requirements under the
proposed rule for small entities is necessary. The Commission notes
that the proposed rule was drafted to allow each entity subject to the
rule's requirements to develop internal policies and procedures that
are appropriate given that entity's type, size and nature. Therefore,
the Commission preliminarily believes that the proposed rule already
contains flexibility necessary for small entities. Further, the
Commission has attempted to draft the proposed rule to be as
straightforward as possible to achieve its objective. Any
simplification, consolidation or clarification of the rule should occur
for all entities, not just small entities. The Commission also does not
believe that it is necessary to consider whether small entities should
be permitted to use performance rather than design standards to comply
with the proposed rule as the rule already proposes performance
standards and does not dictate for entities of any size any particular
design standards (e.g., technology) that must be employed to achieve
the objectives of the proposed rule.
Finally, the Commission believes that an exemption from coverage of
the proposed rule for small entities would interfere with achieving the
primary goals of protecting limit orders and quotes, reducing the
effects of fragmentation and helping to ensure customers receive
executions at the best bid or offer available. If small entities were
not required to comply with the proposed rule, they would be permitted
to trade through existing limit orders and quotes on other markets,
thus reducing the price protection provided to those displayed limit
orders and quotes. In addition, investors whose orders were sent for
execution to small entity broker-dealers that were not required to
comply with the rule may not benefit fully from the price protections
provided by the proposed rule.
7. Solicitation of Comments
The Commission encourages the submission of comments with respect
to any aspect of this IRFA. In particular, the Commission requests
comments regarding: (1) The number of small entities that may be
affected by the proposed rules; (2) the existence or nature of the
potential impact of the proposed rule on small entities discussed in
the analysis; and (3) how to quantify the impact of the proposed rules.
Commenters are asked to describe the nature of any impact and provide
empirical data supporting the extent of the impact. Such comments will
be considered in the preparation of the Final Regulatory Flexibility
Analysis, if the proposed rule were adopted, and will be placed in the
same public file as comments on the proposed rule.
IV. Market Access Proposal
A. Access to Equity Markets in the NMS
In the market for equity securities today, multiple trading venues
seek to attract order flow by competing over liquidity, price, speed of
execution, and other significant terms. Currently, however, there are
few regulatory standards governing the manner of access among competing
market centers.\132\ Guided by little more than the fiduciary duty of
best execution, a broker must seek the most favorable terms for a
customer's transaction reasonably available under the
circumstances.\133\ And yet if a customer's order cannot be routed to
the market with the best price, a broker may not be able to fulfill the
duty of best execution that it owes to its customer. In practice,
therefore, the absence of a uniform standard governing the terms of
access may have created difficulties for brokers as they seek to obtain
the best available prices for their customer orders.
---------------------------------------------------------------------------
\132\ See, e.g., Rule 11Ac1-1 under the Exchange Act; Securities
Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290
(September 12, 1996) (the ``Order Handling Rules Release'').
\133\ Order Execution Obligations, Securities Exchange Act
Release No. 37619A at 50 (September 6, 1996), 61 FR 48290 (September
12, 1996); see also In the Matter of the Application of Robert Bruce
Orkin, Securities Exchange Act Release No. 32035 at fn. 22 (March
23, 1993).
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Under Section 11A of the Exchange Act, the Commission is charged
with responsibility to facilitate the development of the NMS.\134\ The
Commission has routinely sought the views of the public as it carries
out its responsibilities with respect to the NMS. In 2002, the
Commission convened a series of public hearings concerning the
structure of the U.S. equity markets. An impressive assembly of
investors, investment professionals, academics, and others participated
in a series of open hearings on market structure issues, discussing the
challenges with respect to market structure and offering widely
divergent views as to how the Commission should confront those
challenges.
---------------------------------------------------------------------------
\134\ See Section 11A of the Exchange Act, 15 U.S.C. 78k-1.
---------------------------------------------------------------------------
The participants expressed general agreement that the Commission
should further the interests of investors by promoting a market
structure that encourages the robust interaction of buying and selling
interest; that investors, both large and small, are best served by a
system that ensures prices are established through fair and vigorous
competition among competing market centers; and that investors need to
be able to execute transactions in the best market efficiently. These
views are fully consistent with general principles that Congress chose
in guiding the Commission under Section 11A of the Exchange Act.\135\
One important way in which the Commission can further those principles
is by providing for fair and effective intermarket access within the
NMS.
---------------------------------------------------------------------------
\135\ See Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C.
78k-1(a)(1)(C).
---------------------------------------------------------------------------
Ensuring access to diverse marketplaces within a unified national
market would foster efficiency, enhance competition, and contribute to
the ``best execution'' of orders for securities.\136\ Accordingly, the
Commission today is proposing new standards governing access to
quotations and the execution of orders for equity securities throughout
the NMS. The proposed new access standards, proposed to be designated
as Rule 610 of Regulation NMS, would require market centers to permit
all market participants access to their limit order books, at least
indirectly, on a non-discriminatory basis. In addition, the proposed
rule would limit any fees charged by market centers and broker-dealers
for access to their quotations to a de minimis amount. Finally, the
proposal would require SROs to establish rules to reduce the incidence
of inter-market locked and crossed quotations.
---------------------------------------------------------------------------
\136\ Id at Section 11A(a)(1)(D), 15 U.S.C 78k-1(a)(1)(D).
---------------------------------------------------------------------------
1. Current Access Framework
Broker-dealers have a duty to seek the most favorable terms
reasonably available in executing transactions on behalf of their
customers.\137\ The price at which an order can be executed is of
paramount importance for most investors, but in seeking the best price
some investors may weigh other factors, such as the speed and certainty
of execution at a specified price, even more than the possibility of
execution at a better price. In today's market for
[[Page 11154]]
equity securities, multiple marketplaces compete over price, speed, and
other terms. To fulfill the duty of best execution, therefore, a
broker-dealer must be able to identify the best available terms among
multiple competing marketplaces, and gain fair and efficient access to
those marketplaces. Any weakness or inefficiencies in the system of
reaching quotations and executing orders among market centers could
compromise a broker-dealer's ability to satisfy its duty of best
execution.
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\137\ See, e.g., Charles Hughes & Co. v. SEC, 139 F.2d 434 (2nd
Cir. 1943).
---------------------------------------------------------------------------
Today's NMS features competing pools of liquidity in stocks listed
on the NYSE, the Amex, and Nasdaq, though the nature of the competition
differs in each of those categories. For NYSE-listed stocks, the NYSE
currently dominates trading with approximately 75% of the volume. NYSE
stocks are also traded on regional exchanges, and in the OTC market by
block positioners and market makers through Nasdaq's intermarket
system. To a lesser extent, NYSE stocks are traded on ECNs. The
competition is similar for Amex-listed stocks. Although the Amex
currently has a significant part of the volume in Amex-listed stocks,
ECNs and the Archipelago Exchange, the equities trading facility of the
PCX, have the predominant share of the volume of ETFs. In stocks
registered on Nasdaq, market makers and some ECNs trade on
SuperMontage, Nasdaq's order collection, display, and execution
facility. A few ECNs post orders on the ADF, the NASD's quotation
display and trade reporting facility. Still other ECNs post their
quotes and print trades at the NSX. Finally, the Archipelago Exchange
maintains a system for electronically executing trades and routing
orders outside of SuperMontage.
With respect to exchange-listed equity securities, members of
exchanges and the NASD currently can access each other's quotes through
the ITS. Physical access is provided by ITS connectivity, and the terms
of access are governed by the ITS Plan. Participants in the ITS Plan
have agreed not to charge for access to their markets through the ITS.
The ITS Plan provides grievance procedures for violations of the ITS
trade-through rule and sets forth procedures to follow in the event of
a locked or crossed market.
The basic terms of intermarket access in Nasdaq securities are set
forth in the Nasdaq UTP Plan. Unlike the ITS Plan, the Nasdaq UTP Plan
does not establish a physical linkage for Nasdaq stocks or provide
limitations on trade-throughs or locked and crossed markets. Instead,
the Nasdaq UTP Plan requires only that each participant in the Nasdaq
UTP Plan provide direct telephone access to each market maker or
specialist in its market, and forbids participants from imposing access
or execution fees with respect to transactions in Nasdaq securities
that are communicated by telephone.\138\ Currently, the NASD, Amex,
NSX, CHX, BSE, and PCX trade Nasdaq securities under the Nasdaq UTP
Plan.
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\138\ See Nasdaq UTP Plan, Section IX (a) and (b).
---------------------------------------------------------------------------
The registered national exchanges, market makers, ECNs, and other
broker-dealers may access Nasdaq's SuperMontage through a Nasdaq member
to reach quotations displayed in SuperMontage, but they need not use
SuperMontage in order to trade Nasdaq securities. The NASD operates the
ADF as an alternative to SuperMontage. The ADF does not operate a
linkage or execution system like SuperMontage; rather, market
participants must obtain their own access to ADF participants under the
ADF's rules governing access.\139\ These rules provide that ADF
participants must make electronic access to their quotations available
in the ADF.
---------------------------------------------------------------------------
\139\ See Securities Exchange Act Release No. 46249 (July 24,
2002), 67 FR 49822 (July 31, 2002) (SR-NASD-2002-97); Securities
Exchange Act Release No. 47663 (April 10, 2003), 68 FR 19043 (April
17, 2003) (SR-NASD-2003-67) (extending pilot program).
---------------------------------------------------------------------------
Under the Commission's Quote Rule,\140\ if a market maker enters an
order into an ECN that betters its own quote, the market maker
generally must reflect that order in its quote unless the ECN has
reflected the order in the quote it provides to an exchange, the ADF,
or Nasdaq, and the ECN enables brokers-dealers to reach the market
maker's order displayed through the ECN as easily as they could reach
that order directly through an SRO. In short, the ECN must allow any
broker-dealer to effect a transaction against the order on the same
terms as if the broker-dealer had carried out the transaction directly
with the market maker whose order is represented in the ECN.
---------------------------------------------------------------------------
\140\ See Rule 11Ac1-1 under the Exchange Act, 17 CFR 240.11Ac1-
1.
---------------------------------------------------------------------------
The Commission's Regulation ATS has integrated ECNs and ATSs more
fully into the NMS.\141\ Under Regulation ATS, an ATS with at least
five percent of the trading volume in any particular security must
publicly display its best-priced orders in that security to an
exchange, the ADF, or Nasdaq, and must allow market participants to
access those publicly displayed orders.\142\ Furthermore, an ATS with
20 percent or more of the trading volume in any particular security
must provide ``fair access'' to its system; that is, it must not
unreasonably prohibit or inhibit any person from obtaining access to
the services that it offers.\143\ Such an ATS may, however, establish
fair and objective criteria, such as creditworthiness, to differentiate
among potential participants. Currently, six ATSs operate as ECNs, and
display quotes through SuperMontage, the ADF, the BSE, or the NSX.
---------------------------------------------------------------------------
\141\ See Securities Exchange Act Release No. 40760 (December 8,
1998), 63 FR 70844 (December 22, 1998) (``Regulation ATS Release'').
\142\ See Rule 301(b)(3) under the Exchange Act, 17 CFR
240.301(b)(3).
\143\ See Rule 301(b)(5) under the Exchange Act, 17 CFR
240.301(b)(5).
---------------------------------------------------------------------------
In a system with so many competing market centers and pools of
liquidity, market participants not only need to know what the best
prices are and in which market they are available, but they also must
be able to access that market routinely and efficiently. Historically,
however, markets have attempted to maintain effective control over the
terms of inbound order access by seeking to erect barriers in the form
of fees, execution priorities, membership requirements, direct bans,
and other restrictions.\144\ The proposed access standards are designed
to substantially reduce these barriers to intermarket access.
---------------------------------------------------------------------------
\144\ See, e.g., Regulation ATS Release, 63 FR 70844.
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2. Nonlinked Markets
Historically, the NYSE and the regional exchanges have primarily
functioned as agency markets, while the OTC market has primarily
functioned as a dealer market. In recent years, these distinctions have
blurred. In block trades, which occur both on and off exchanges, major
broker-dealers take one side as principal. Moreover, dealers act as OTC
market makers in a number of NYSE stocks.\145\ By contrast, the market
for Nasdaq securities, which has historically been dominated by OTC
market makers, has been marked in recent years by an explosive growth
in ECNs that function exclusively on an agency basis.
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\145\ The rescission of NYSE Rule 390 in 2000 allowed NYSE
members to serve as OTC market makers or dealers in all NYSE-listed
securities. See Securities Exchange Act Release No. 42450 (February
23, 2000), 65 FR 10570 (February 29, 2000) (notice of proposed
rescission); Securities Exchange Act Release No. 42758, 65 FR 30175
(May 10, 2000) (order approving rescission).
---------------------------------------------------------------------------
Heightened competition among market centers has led to market
fragmentation--the trading of orders in multiple locations--and this
has reduced interaction among orders dispersed across the competing
markets. The intermarket linkage systems currently in place in the NMS
provide
[[Page 11155]]
a means of access to the best displayed prices, but they are not
comprehensive and have been criticized for their inefficiencies.
In the OTC market, the development of SuperMontage, the creation of
the ADF, and the growth of ECNs have created multiple venues for the
trading of Nasdaq stocks. SuperMontage does not route orders away from
its system. Instead, market participants rely on private routing
systems to trade across markets in order to obtain the best prices for
customer and proprietary orders in Nasdaq stocks.
Before the launch of SuperMontage, nearly all of the ECNs
participated in Nasdaq. Recently, however, several ECNs have chosen to
operate independently of Nasdaq. Following SuperMontage's launch in
2002, several ECNs chose to remain outside of SuperMontage and to post
their quotes in the ADF. The ADF is a pure display and trade reporting
facility that offers neither order executions nor the automatic routing
of orders. In accordance with the ADF's rules, ADF participants are
linked to each other pursuant to privately negotiated linkage
agreements.
With respect to NYSE and Amex securities, the market centers that
trade those securities are currently linked through the ITS. The ITS
provides the ability to route commitments individually from one market
center to another for execution. In recent years critics have charged
that the ITS is inefficient, and that the ITS Plan does not easily
accommodate new business models.\146\ In particular, the provision of
the ITS Plan governing trade-throughs and locked and crossed markets
requires ITS Participants to wait up to 30 seconds for a response from
other markets to avoid trading at a price worse than their published
quote. Some ECNs have asserted that the ITS Plan is incompatible with
their trading systems, which allow trades to be executed electronically
within a fraction of a second.\147\ Moreover, because any amendment to
the ITS Plan requires the unanimous agreement of the ITS Participants,
any single Participant may effectively wield veto authority over any
proposed change to the ITS.\148\ For this reason, among others, critics
have charged that the ITS Plan has been slow to embrace new technology
and, more important, new competition.\149\
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\146\ See, e.g., Beatrice Boehmer, Trading Your Neighbor's ETFs:
Competition Or Fragmentation, J. Banking & Finance, September 2003;
Ivy Schmerken, Will The NYSE Specialist Probe Open The Listed
Markets To ECNs?, Wall Street & Technology, July 1, 2003; J. Alex
Tarquino, Electronic Communication Networks Look Toward The Big
Board, N.Y. Times, December 29, 2002.
\147\ See, e.g., Kouwe, Zachery, As The Campaign For ETF Trading
Volume Presses On, Island Goes Dark, Arca Gains Market Share, And
The Major Exchanges Fight To Hold Their Own, Alternative Investment
News, August 1, 2003; Koh, Peter, Nasdaq Faces An Identify Crisis,
EuroMoney, July 1, 2003; Sales, Robert, ADF Looks To Bypass ITS For
Listed Equities, Wall Street & Technology, December 1, 2002.
\148\ Intermarket Trading System Plan, Section 4.C; see
Securities Exchange Act Release No. 19456 (January 27, 1983), 48 FR
4938 (February 3, 1983). See also Securities Exchange Act Release
No. 40260 (July 24, 1998), 63 FR 40748 (July 30, 1998) (proposing
amendment to provision requiring unanimous approval of
participants).
\149\ See, e.g., Chapman, Peter, National Markets Under Fire,
Trader's Magazine, November 1, 2002.
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One consequence of fragmentation has been a rise in the incidence
of locked markets.\150\ A locked market occurs, for instance, when an
offer to sell at a certain price is displayed on one market at the same
price as an offer to buy on another market, but the orders cannot meet
because the two markets are not linked. For example, a market that
posts an order on SuperMontage to buy a security at $10.01 may have its
quote locked when an ECN posts an order on the ADF to sell the security
at $10.01. Because the bid and ask quotes are identical and yet they do
not execute across markets, some market centers' automatic execution
systems may perceive the quotes to be stale or incorrect, and shut
down.
---------------------------------------------------------------------------
\150\ See, e.g., Schmerken, Ivy, Nasdaq's Battle Over Locked
Crossed Markets, Wall Street & Technology, May 1, 2003.
---------------------------------------------------------------------------
There is anecdotal evidence that the incidence of locked markets
has gained pace in recent months.\151\ As discussed more fully below,
some critics have charged that the dramatic increase in the frequency
of locked markets can be traced to access fee and liquidity rebate
strategies that have created economic incentives for some market
participants to lock the market.
---------------------------------------------------------------------------
\151\ Id.
---------------------------------------------------------------------------
Another issue raised by trading across competing market centers is
the speed and/or certainty of access among these markets. Trading in
penny increments has resulting in narrower spreads, less depth at the
top-of-book, and rapid movements between price points. At the same
time, advances in technology, including the use of ``smart'' order-
routing and automatic execution systems, have provided a variety of
means of routing and executing orders in multiple markets more quickly
and efficiently. The speed at which trading occurs in some markets has
increased as market participants strive to make greater use of
technology to execute orders at the prices they see before the prices
change. Therefore, as markets have become more automated, the speed at
which markets can access each other has taken on greater importance.
Competing market centers, however, currently offer different types
of access and different speeds of execution. For instance, in the
market for trading Nasdaq securities, which is highly automated, market
participants have objected to the extension of trading pursuant to the
Nasdaq UTP Plan to exchanges that do not offer automatic
execution.\152\ With regard to exchange-listed securities, market
participants also have voiced concerns with the operation of existing
trade-through rules and the impact of those rules on the efficient
operation of automated markets. Various market participants have argued
that all competing markets should offer automatic execution.\153\
---------------------------------------------------------------------------
\152\ See, e.g., letter to Jonathan G. Katz, Secretary,
Commission, from John J. D. McFerrin-Clancy, Schlam Stone & Dolan,
dated August 15, 2002 (petition for review of Securities Exchange
Act Release No. 46205 by Knight Trading Group, Inc.).
\153\ See, e.g., letter to Jonathan G. Katz, Secretary,
Commission, from Mark B. Sutton, Chairman, SIA Market Structure
Committee, Securities Industry Association, dated May 5, 2000,
commenting on Securities Exchange Act Release No. 42450.
---------------------------------------------------------------------------
The Commission has been reluctant to mandate automatic execution,
in part because of a concern that doing so might be incompatible with
the business models of individual market centers and interfere with the
ability of individual market centers to compete.\154\ Given the changes
that have occurred in the markets in recent years, however, and
particularly the widespread use of electronic execution in some
markets, the Commission requests comment on whether its proposed access
standards should require a ``quoting market center'' or a ``quoting
market participant,'' as defined in the rule, to execute orders at its
quote automatically. The Commission also requests comment on the scope
of any such automatic execution requirement. For example, should each
quoting market center and quoting market participant be required to
offer automatic execution with respect to its entire trading book? Or
should an automatic execution requirement be limited only to the best
bids and offers of quoting market centers and quoting market
participants?
---------------------------------------------------------------------------
\154\ See, e.g., Securities Exchange Act Release Nos. 43084
(July 28, 2000), 65 FR 48406 (August 8, 2000) (proposing Rules
11Ac1-5 and 11Ac1-6 under the Exchange Act), and 46305 (August 2,
2002), 67 FR 51609 (August 8, 2002) (order approving Amex rule
proposal relating to the trading of Nasdaq securities).
---------------------------------------------------------------------------
The concept of automatic execution entails the immediate electronic
execution of orders against quotes or orders present in the market.
Yet, different automated markets can have
[[Page 11156]]
significantly different execution speeds depending on their internal
processes and the technology employed. Therefore, if the Commission
determines to require automatic execution, the Commission requests
comment as to whether it should promulgate performance standards to
ensure that the quotes of all market participants are available for
automatic execution.\155\ Such performance standards would be designed
to ensure that all automatic execution systems satisfy minimum
standards that would assure that market participant orders are executed
in substantially equivalent timeframes across markets.
---------------------------------------------------------------------------
\155\ The Commission notes that the ADF currently imposes
minimum performance standards for participants in its order
quotation and display facility. See NASD Rule 4300A(e).
---------------------------------------------------------------------------
Accordingly, the Commission requests comment as to whether it would
be appropriate to impose a minimum performance standard with respect to
response times for automatic execution. Specifically, the Commission
requests comment on whether it should impose a requirement on market
participants, mandating that their automatic execution systems provide
the capability to respond to an order from another market participant
within certain timeframes. For example, a general standard could be
imposed that would require markets to provide automatic executions of
all orders within a specified timeframe after receipt (e.g., one or two
seconds). A more refined alternative standard could require markets to
provide automatic execution of (1) all orders within a longer timeframe
after receipt (e.g., three seconds) and (2) a specified percentage of
orders (e.g., 98%) within a shorter timeframe after receipt (e.g., one
second). The Commission requests comment on the nature of any minimum
performance standard, with respect to response times for automatic
execution, that should be imposed on market participants.
The Commission also believes that, if quoting market centers and
quoting market participants were required to offer automatic execution,
it would be critical that the automatic execution functions of quoting
market centers and quoting market participants not unfairly
discriminate by offering their members faster automatic execution than
they offer to non-members. In the Commission's view, such
discrimination would be inconsistent with the standard of equivalent
access and would thwart the goals of Section 11A of the Exchange Act.
3. Access Fees
ECNs that display their quotes in the public quotation system
typically charge per share ``access fees'' to non-subscriber market
participants that trade with the orders that the ECNs display. These
fees are generally similar to the fees that subscribers pay to trade
with ECN orders.\156\ In its rules requiring ECNs and ATSs to display
their quotes, the Commission permitted ECNs to charge a fee ``similar
to the communications and systems charges imposed by various markets,
if not structured to discourage access by non-subscriber broker-
dealers.''\157\ ECNs may not charge fees that have the effect of
creating barriers to access for non-subscribers, however.\158\
Currently, pursuant to a series of no-action letters from the Division
of Market Regulation, ECNs charge fees to non-subscribers in amounts
equal to those that they charge a ``substantial proportion'' of their
active broker-dealer subscribers, but no more than $.009 per
share.\159\ The fees that ECNs charge vary in size depending on the
ECN.
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\156\ Regulation ATS Release, 63 FR 70844.
\157\ Order Handling Rules Release, 61 FR at 48314 n.272; see
Regulation ATS Release, 63 FR 70844.
\158\ Id.
\159\ The no-action letters are posted to the Commission's web
site at http://www.sec.gov/divisions/marketreg/mr-noaction.htm#ecns.
See also Regulation ATS Release, 63 FR 70844 (``The Commission
believes that fees charged by an alternative trading system would be
inconsistent with equivalent access if they have the effect of
creating barriers to access for non-subscribers'').
---------------------------------------------------------------------------
Although ECNs charge other market participants per-share fees for
access to their quotes, other market participants, most notably market
makers, must trade at their displayed quotes without imposing access
fees.\160\ Therefore, depending on the identity of the market
participant that has posted a quotation, a displayed price may be the
true price that a customer will pay, or it may be the base price to
which an access fee is subsequently appended. In addition, the
exchanges and Nasdaq typically charge a variety of transaction fees.
Accordingly, published quotes today do not reliably indicate the true
prices that are actually available to investors.
---------------------------------------------------------------------------
\160\ See Rule 11Ac1-1(c)(2) under the Exchange Act, 17 CFR
240.11Ac1-1(c)(2); see also Letter from Robert L.D. Colby, Deputy
Director, Division of Market Regulation, Commission, to Louis B.
Todd, Jr., Head of Equity Trading, J.C. Bradford & Co., dated August
6, 1998.
---------------------------------------------------------------------------
As ECNs have become more active in the equities markets, the
absence of a uniform quoting convention has made it difficult for
market participants to compare quotations readily across all
marketplaces. Indeed, because the ECNs' displayed quotes do not reflect
the per-share access fees that they impose, the NBBO can be viewed as
artificially narrow. Market makers and other broker-dealers that owe a
duty of best execution to customers nevertheless are held to the
benchmark that the NBBO reflects. Accordingly, some market participants
believe that, under the circumstances, a non-subscriber should not be
forced to pay a fee to an ECN in order to obtain the execution of a
customer order at the NBBO.
Furthermore, there is a view that the dramatic rise in locked and
crossed markets in recent years can be traced to the proliferation of
access fees, charges, and liquidity rebates offered by ECNs and
Nasdaq.\161\ These practices--paying so-called ``liquidity rebates'' to
customers that post limit orders, while imposing access fees on orders
that execute against those resting orders--arguably have encouraged
locked and crossed markets.\162\
---------------------------------------------------------------------------
\161\ See, e.g., Schmerken, Ivy, Nasdaq's Battle Over Locked
Crossed Markets, Wall Street & Technology, May 1, 2003.
\162\ Id.
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Indeed, several of the largest ECNs currently pay $.002 per share
to order providers upon the execution of their limit orders, and
simultaneously charge $.003 to the ``liquidity takers'' whose orders
execute against resting limit orders in the ECN. If, for example, a
market maker posts the best bid on SuperMontage in a particular
security at $20.00, a customer could enter a market order to sell that
executes against the bid, and sell the stock at the $20.00 bid price
(plus a $.003 per-share SuperMontage fee).\163\ By submitting a sell
limit order to an ECN that is not linked to SuperMontage and that does
not have a $20 bid at that time, the customer could lock the market at
$20.00 bid, $20.00 asked. Rather than paying an access fee to execute
against the displayed order, the customer could simply wait for some
other market participant to unlock the market by executing an order
against the customer's quote, and thus receive a liquidity rebate from
the ECN in the process. In this scenario, the $.005 per share
difference between paying an
[[Page 11157]]
access fee and receiving a liquidity rebate gives an economic incentive
to encourage the repeated locking of markets in some securities.\164\
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\163\ SuperMontage subscribers pay a fee of $.003 per share, up
to a certain per-order maximum limit, to execute against orders in
the book. ECNs currently charge non-subscribers that access their
markets through SuperMontage an additional access fee of up to $.003
per share or more. The Commission has approved an NASD rule change
that, in part, establishes the maximum fees that ECNs may charge
when their orders are accessed through SuperMontage. See Securities
Exchange Act Release Nos. 48501 (September 17, 2003), 68 FR 56358
(September 30, 2003) (proposal) and 49220 (February 11, 2004)
(approval) (SR-NASD-2003-128).
\164\ Of course, this problem would be exacerbated if the ECN
charges an even higher access fee, such as $.009 per share.
---------------------------------------------------------------------------
B. Proposed Access Standards Under Regulation NMS
The Commission today is proposing to adopt new regulations
governing intermarket access to quotes and orders in the equity markets
of the NMS. The new provisions would be designated as Rule 610 of
Regulation NMS.\165\
---------------------------------------------------------------------------
\165\ In addition, proposed Rule 610(d) would provide the
Commission with exemptive authority pursuant to Section 36 of the
Exchange Act, 15 U.S.C. 78mm.
---------------------------------------------------------------------------
1. New Terms
For purposes of the new provisions governing access, the Commission
proposes to include in a new rule that would be designated as Rule 600
of Regulation NMS two new defined terms to identify the parties to
which the access provisions apply.\166\ The Commission intends these
terms broadly to include all market participants that either are
required, or otherwise choose, to display quotations in the NMS. A
``quoting market center'' would be defined to mean an order execution
facility of any exchange or association that is required to make
available to a quotation vendor its best bid or best offer in a
security pursuant to the Quote Rule.\167\ A ``quoting market
participant'' would be defined to mean any broker-dealer that provides
its best bid or best offer in a security to an exchange or association
pursuant to the Quote Rule or Regulation ATS, and whose best bid or
best offer is not otherwise available through a quoting market center.
Accordingly, a market center such as an exchange that offers execution
functionality would be considered a quoting market center, while a
market participant that enters quotations on a quotation facility that
does not offer order execution functionality, such as the ADF, would be
considered a quoting market participant.
---------------------------------------------------------------------------
\166\ See the rule proposed to be designated as Rule 600 of
Regulation NMS.
\167\ Rule 11Ac1-1 under the Exchange Act, 17 CFR 240.11Ac1-1.
Under proposed Regulation NMS, the Quote Rule is proposed to be
redesignated as Rule 604.
---------------------------------------------------------------------------
2. Access to Published Bids and Offers
Under the proposed rule, quoting market centers and quoting market
participants would not be permitted to impose unfairly discriminatory
terms that inhibit non-members, non-subscribers, or non-customers from
obtaining access to quotations and the execution of orders through
their members, subscribers, or customers. Moreover, a quoting market
participant would be required to make its quotations accessible to all
quoting market centers and all other quoting market participants on
terms as favorable as those it grants to its most preferred member,
customer, or subscriber.\168\
---------------------------------------------------------------------------
\168\ For example, non-subscribers or non-customers of a quoting
market participant would be entitled to the very best level of
service, and at the very best rates, that it offers to any of its
subscribers or customers.
---------------------------------------------------------------------------
The proposed rule seeks to ensure access not through government-
imposed linkages, but rather through linkages established by the
marketplace. At the core of the proposed new rule is a provision that
would prohibit quoting market centers and quoting market participants
from imposing unfairly discriminatory terms that prevent or inhibit any
person from accessing their quotations indirectly through a member,
customer, or subscriber. This standard is intended to ensure that a
member, customer, or subscriber of a quoting market center or quoting
market participant can sponsor access to quotes and order execution
without receiving disparate treatment in the handling of that order
with respect to fees, speed, or other terms. Under this rule, the
quoting market center or quoting market participant would not be
permitted to treat orders from non-members, non-customers, or non-
subscribers that are communicated indirectly through a member,
customer, or subscriber any differently from the way it treats the
orders of that member, customer, or subscriber. Consequently,
securities market participants would not need to establish direct
relationships with every quoting market center or quoting market
participant in order to access the quotes of all markets; rather, these
participants need only have relationships with a member, customer, or
subscriber of a quoting market participant or a member, customer, or
subscriber of a quoting market center to obtain effective access to
those quotes.
The new rule also would require each quoting market participant to
make its quotations available, for the purpose of order execution, to
all quoting market centers and all other quoting market participants on
terms as favorable as those it grants to its most preferred member,
customer, or subscriber. Currently, although ADF participants have
established linkages among themselves pursuant to private agreements, a
non-ADF participant potentially could have no means by which to access
the quotes of an ADF participant, particularly if no ADF participant is
willing to offer ready access to non-ADF participants. Therefore, in
very limited circumstances, the proposed access rule effectively would
impose ``direct access'' obligations on an ADF participant or other
quoting market participant that has not yet established linkages
between itself and quoting market centers.
3. Access Fees
i. How Access Fees Cause Distortion in the Markets
Under Regulation ATS, ECNs that display market maker quotes or are
responsible for at least 5% of the trading volume in a stock must
furnish their quotes to the public quotation system, where the quotes
are displayed along with the quotes of traditional exchanges and market
makers. The Order Handling Rules Release stated that an ECN ``may
impose charges for access to its system, similar to the communications
and systems charges imposed by various markets, if not structured to
discourage access by non-subscriber broker-dealers.''\169\
---------------------------------------------------------------------------
\169\ Order Handling Rules Release, 61 FR at 48314, n.272.
---------------------------------------------------------------------------
Although access fees have decreased steadily in recent years, the
fees nonetheless are currently causing various distortions in the
trading of securities. Most ECNs and Nasdaq pay a per-share rebate for
limit orders that become executed against incoming orders. This rebate
rewards market participants for submitting ``resting'' limit orders
that give depth to the trading book. The ECNs and Nasdaq also impose a
per-share access fee on the incoming marketable orders that execute
against the resting limit orders and thereby ``remove liquidity'' from
the book. In this way, the ECNs and Nasdaq effectively use access fee
rebates as payment to attract liquidity to their limit order books.
Because non-subscribers cannot place limit orders on an ECN's book and
therefore cannot receive the rebates, the fees that they pay act as a
subsidy to the subscribers that place standing limit orders on the
ECN's book. Therefore, the more an ECN can charge in access fees, the
more it can rebate to its subscribers. In practice, some ECNs charge
considerably more than others. In the current decimal trading
environment, where penny spreads are commonplace, these differences can
add significant non-transparent costs to securities transactions. This
may undermine the
[[Page 11158]]
``fair access'' standards established in the Order Handling Rules and
Regulation ATS.
Furthermore, Rule 11Ac1-1(c)(2) under the Exchange Act prohibits
non-ECN broker-dealers from charging an access fee in addition to their
posted quotation.\170\ Although Nasdaq's current pricing and rebate
structure indirectly provides limited rebates of Nasdaq's access fees
to market participants, many believe that prohibiting non-ECN broker-
dealers from charging access fees, but not their ECN competitors, puts
the non-ECN broker-dealers at an unwarranted competitive disadvantage.
---------------------------------------------------------------------------
\170\ 17 CFR 240.11Ac1-1(c)(2); see letter from Robert L.D.
Colby, Deputy Director, Division of Market Regulation, Commission,
to Louis B. Todd, Jr., Head of Equity Trading, J.C. Bradford & Co.,
dated August 6, 1998.
---------------------------------------------------------------------------
Finally, many believe that ECN access fees exacerbate locked
markets. In addition to the concerns raised in Section IV.A.3. above,
some allege that certain ECNs have programmed their systems to lock the
quote of other market participants automatically. These critics believe
that some ECNs routinely lock quotations instead of routing orders to
the other quote, simply so that they can force a contra-party to be a
``liquidity taker'' and thereby collect the associated access fee
rebate for themselves.\171\ They assert that these ECNs are able to
induce others to execute against the quotation that is locking the
market, in order to clear the locked quotation and allow their
automatic execution systems to work.\172\ In the Commission's view,
impediments to access may lead to locked markets, create difficulty for
market participants seeking best execution for customer orders, and
call into question the efficiency of the marketplace.
---------------------------------------------------------------------------
\171\ See, e.g., Clary, Isabelle, Trading Under New Rules,
Securities Industry News, January 12, 2004.
\172\ Because some market makers' automatic execution systems
are programmed not to process trades while a quotation is locking or
crossing the market, market makers regularly execute against locking
or crossing quotations--and pay the ECN access fee--to clear such
quotations out of their automatic execution systems. Under NASD Rule
4613, market participants are prohibited from locking or crossing
the market in a security within Nasdaq systems, but there is no
inter-market rule prohibiting locking and crossing of the market for
Nasdaq securities. Therefore, market participants today are
permitted to lock or cross the market in the public quotation stream
when they are quoting Nasdaq securities on a non-Nasdaq system, such
as the ADF.
---------------------------------------------------------------------------
ii. Regulatory Alternatives With Respect to Access Fees
The Commission has considered various regulatory responses to the
growing problems that access fees cause. Among these, four alternatives
merit discussion here: Reflecting the access fees in the displayed
quote; rounding access fees to full-penny trading increments in the
displayed quote; banning access fees outright; and establishing a de
minimis fee standard.
First, the Commission has considered a requirement that access fees
be accurately reflected in the displayed quotes of market participants.
Because access fees are currently imposed in amounts of less than one
cent, requiring access fees to be reflected in the quote necessarily
would lead to subpenny pricing. In the Commission's view, the main
benefit of displaying quotations in subpenny increments is that
displayed quotations would accurately reflect the prices that investors
would actually pay, and quote comparability would be achieved. As more
fully discussed with respect to the rule proposed to be designated as
Rule 612 of Regulation NMS, however, the Commission believes that more
widespread use of subpenny quotations would further reduce the depth of
liquidity available to investors at any particular subpenny price.\173\
In addition, widespread subpenny pricing could very likely exacerbate
``stepping ahead'' practices, where market participants submit orders
that better the displayed quotes by economically insignificant amounts,
thereby devaluing price priority and reducing the incentive for
aggressive quoting. Furthermore, subpenny pricing could lead to an
increase in ``flickering quotes,'' where quotations change so
frequently and so rapidly as to engender confusion among investors and
complicate the efforts of broker-dealers to comply with their
regulatory obligations, including the duty of best execution.
Accordingly, the Commission does not believe that the potential
benefits of displaying subpenny access fees in quotations would justify
the costs.
---------------------------------------------------------------------------
\173\ The Commission's subpenny quoting proposal is discussed in
Section V.
---------------------------------------------------------------------------
Second, the Commission has considered a ``quote normalization''
approach that would apply a universal rounding convention to all access
fees. Under one such rounding convention, a fee at or smaller than a
prescribed amount would be rounded down to zero, and therefore not
reflected in the displayed quote, but a fee greater than the prescribed
amount would be included in the quote, which would then be rounded away
to the next full-penny trading increment. For example, if the fee
threshold were set at $.0025 per share, a fee of $.0025 would not be
incorporated into the displayed quote of an order to buy at $50.00, but
a fee of $.003 would be reflected in the displayed quote and rounded to
$49.99. This would reflect the existence of a fee in excess of the
threshold in the quoted price. The benefit of this approach is that it
could provide an economic incentive for markets to keep access fees
below the prescribed level. On the other hand, the Commission believes
that this approach could impair price transparency and distort the
accuracy of market information, because it would lead to orders being
displayed at prices better or worse than the actual price, and perhaps
materially so. As noted above, for example, an order to buy at $50.00,
posted in an ECN with an access fee at $.003 per share, would be
displayed at $49.99, or $.007 lower than the actual net price. On
balance, the Commission believes that the benefits of adopting this
quote normalization approach would not justify the costs.
Third, the Commission has considered banning access fees. The main
benefits of banning access fees are that quotes would be fully
comparable throughout the NMS, and would accurately reflect the price.
This is consistent with the guiding principles set forth in Section 11A
of the Exchange Act.\174\ Currently, however, the business models of
many ECNs depend on access fees. In addition, exchanges charge various
transaction fees for accessing the liquidity in their markets. The
Commission believes that the complete elimination of these fees could
impair the operation of these markets, thereby reducing competition
among market centers within the NMS. Accordingly, the Commission does
not believe, on balance, that the benefits of an absolute ban on access
fees would justify the potential economic costs to the markets.
---------------------------------------------------------------------------
\174\ See Section 11A(a)(1) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1).
---------------------------------------------------------------------------
Finally, the Commission considered, and is today proposing, the
establishment of a de minimis fee standard. This alternative is
discussed in full detail below.
iii. Proposed Solution: A de minimis Fee Standard
Under the rule proposed to be designated as Rule 610 of Regulation
NMS, all quoting market centers, quoting market participants, and
broker-dealers that display attributable quotes through SROs would be
permitted to impose fees for the execution of orders.\175\ Under the
proposed rule, access fees would be limited to a de minimis amount:
Access fees charged by any individual market participant
[[Page 11159]]
would be capped at $0.001 per share, and the accumulation of these fees
would be limited to no more than $.002 per share in any
transaction.\176\ This proposed access fee standard is designed to
promote a common quoting convention that would harmonize quotations and
facilitate the ready comparison of quotes across the NMS. As discussed
more fully in Section V, quoting market centers, quoting market
participants, and broker-dealers would not be permitted to reflect
these subpenny access fees in their quotations.
---------------------------------------------------------------------------
\175\ An attributable quote would disclose the identity of the
quoting market center, quoting market participant, or broker-dealer
that publishes the quote. See, e.g., NASD Rule 4701(c).
\176\ For securities priced at less than $1.00, a fee standard
of .1% of the share price would apply, with fees aggregating to no
more than .2% of the share price.
---------------------------------------------------------------------------
The proposed rule would allow an SRO's order interaction facility
to charge a maximum fee of $0.001 per share for access to its market.
Market makers, specialists, ATSs, and other broker-dealers that display
attributable quotes through SROs would also be permitted to charge a
maximum fee of $0.001 per share for access to their quotes, and would
be permitted to charge this access fee in addition to any access fee
that the SRO also imposes on the transaction.
Under the proposed rule, a customer might incur more than one
charge on a single transaction because an SRO would be permitted to
impose a fee for access to its order interaction facility and a broker-
dealer would be permitted to impose a fee for access to its quotes. The
proposed rule would limit the accumulation of these charges in any
single transaction to no more than $.002 per share. In the Commission's
view, limiting access fees to a de minimis amount--would promote
intermarket access, the standardization of quotations, and the
Commission's goals for the NMS.
The proposed rule also would prohibit a quoting market center or
quoting market participant from charging a non-member, non-subscriber,
or non-customer a fee for indirect access to the quoting market center
or quoting market participant through a member, subscriber, or
customer, although the member, subscriber, or customer could be charged
the standard access fee. The proposed rule would not address the price
or other contractual terms that a member, subscriber, or customer of a
particular quoting market center or quoting market participant may
establish with third parties seeking access. Further, the rule would
not restrict SROs or broker-dealers from rebating all or a portion of
the permissible access fees to their members, subscribers, or
customers.
4. Locked and Crossed Markets
The Commission also believes that repeated or continual locking or
crossing of a market may raise concerns about the orderliness and
efficiency of the markets. Quotes represent prices at which market
participants stand ready to trade. When the bid and offer quotes are
displayed at the same price, this indicates either that one or the
other's quote is not valid, that brokers are not diligently
representing their clients, or that inefficiencies exist that deter
trading with the quoting market. As a result, locked quotes can cause
confusion regarding reliability of the displayed quote, and create
difficulty for market participants seeking best execution for customer
orders.
As trading in Nasdaq stocks becomes more dispersed, the resulting
reduction in interaction between orders displayed in competing market
centers has increased the opportunity for locked and crossed markets.
If trading in NYSE and Amex securities becomes more fragmented without
being subject to ITS or other locked and crossed provisions, locked or
crossed markets could increase in those securities. Accordingly, the
proposed rule would require every SRO to establish and enforce rules
requiring its members to avoid locking or crossing the quotations of
quoting market centers and quoting market participants. For example,
these SRO rules may include so-called ``ship and post'' procedures that
would require a market participant to attempt to execute against a
displayed order before posting a quote that may lock or cross the
market. Under the proposal, the SRO rules also would be required to
prohibit members from engaging in a pattern or practice of locking or
crossing the quotations in any security.
The Commission recognizes that locked and crossed markets between
competing market centers can occur accidentally. For instance, quotes
may inadvertently lock or cross when two markets are changing their
quotes simultaneously. Accordingly, the proposed rule would require
each SRO to promulgate rules that would discourage market participants
from engaging in locking and crossing, but nonetheless would tolerate
some minimal incidents of locked and crossed markets.
Accidental locks often are resolved quickly. Quotes also may lock,
however, because one or both quotes have an access fee attached, which
increases the net price of trading with that quote, and creates an
undisclosed spread. Quotes also may lock due to the different speeds of
market centers. Automated markets change their quotes frequently as
quotes are executed and new orders are displayed. Other markets that
rely heavily on human traders to quote and trade may not adjust their
quotations as quickly, and these quotes may become stale. At times,
automated markets may lock the quotes of manual markets instead of
attempting to trade with those quotes.
The Commission requests comment on the extent of the concerns
arising from locked markets in particular. Some market participants say
that locked quotes convey useful price information, and the ability to
lock quotes enables markets to efficiently communicate their trading
interest. In addition, the problem of apparent locked markets resulting
from quotes with access fees attached may be reduced by the adoption of
the other access provisions of proposed Regulation NMS. For example, if
quoting market centers and quoting market participants have fair access
to each others' quotations, and access fees are limited to de minimis
levels, the economic incentives that currently encourage locked markets
may diminish. Similarly, as automated executions become more prevalent,
there may be less reason to lock a displayed quote. Therefore, the
Commission requests comment on the necessity of adopting restrictions
on locked markets in the light of the proposed provisions governing
intermarket access and access fees.
The Commission also recognizes that for fully-electronic markets
the ability to display a quote at a price is a prerequisite to trading
at that price. Accordingly, as an alternative to the locked-and-crossed
markets rule as currently proposed, the Commission requests comment as
to whether there should be an exception from the locking provisions of
proposed Regulation NMS for quotes of automated markets that lock
quotes of manual markets. More broadly, the Commission also requests
comment on whether the scope of the anti-locking and anti-crossing
provisions of proposed Regulation NMS should be limited to situations
in which trade-throughs would be prohibited. For instance, should
locked markets be permitted generally, and should market participants
be allowed to enter crossing quotations in situations where the
proposed trade-through rule would allow a quote to be traded through?
C. Proposed Amendments to Fair Access Standard Under Regulation ATS
Under Regulation ATS, an ATS with at least 5% of the trading volume
in a
[[Page 11160]]
security is required to provide its best bids and offers to a national
securities exchange or a national securities association.\177\ The
Commission believes that access to these quotations is no less
important than access to other quotations available in the NMS.
Currently, Regulation ATS requires that ATSs with at least 20% of the
trading volume in a security maintain standards ensuring that they will
not unfairly discriminate or unreasonably deny access to their
systems.\178\ In conjunction with the proposed new standards governing
intermarket access, the Commission is proposing to lower this ``fair
access'' threshold in Regulation ATS from 20% to 5% in order to ensure
that the quotes of all significant market participants are accessible
throughout the NMS. The Commission also believes that establishing a
single 5% threshold for both the transparency and access standards of
Regulation ATS will encourage fair competition between ATSs with
significant internal trading volume. The Commission requests comment on
whether the fair access standard should be expanded to apply to all
ATSs that voluntarily provide their quotes to a national securities
exchange or registered securities association for inclusion in the
public quotation stream, irrespective of an ATS's percentage of trading
volume.
---------------------------------------------------------------------------
\177\ See Rule 301(b)(3) of Regulation ATS, 17 CFR
242.301(b)(3).
\178\ See Rule 301(b)(5)(i) of Regulation ATS, 17 CFR
242.301(b)(5)(i).
---------------------------------------------------------------------------
D. General Request for Comment
The Commission seeks comments on the access proposal described
above. The Commission asks commenters to address whether the proposed
new rules relating to access to published bids and offers would further
the NMS goals set out in Section 11A of the Exchange Act.\179\
---------------------------------------------------------------------------
\179\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------
Furthermore, the Commission requests that interested persons
respond to the following specific questions:
Are the proposed rules an appropriate response
to the need for access between markets and the concerns raised by
access fees and locked and crossed quotes?
Is reliance upon private, negotiated agreements
between members and nonmembers adequate to ensure intermarket access to
competing pools of equity liquidity throughout the NMS?
Would the proposed limitation on disparate
treatment of indirect access provide sufficient access to all quoting
market centers through broker-dealers and routing systems? How would
the proposal affect ECN-subscriber relationships?
Should the Commission mandate automatic
execution--requiring that quotes be fully and immediately accessible at
their full size--as part of its proposed access standards ? If so, why?
If not, why not?
Should any such automatic execution requirement
be limited to the best bid and offer?
Do the proposed rules adequately address the
concerns that have arisen with respect to access fees? If not, what
rules would do so?
Would the establishment of a de minimis standard
on access fees be a desirable means of ensuring the comparability of
quotes for stocks trading at prices of $1.00 or more per share and, if
so, is the $.001 ($.002 in the aggregate) threshold appropriate? If
not, what means would be desirable?
Is the establishment of a de minimis standard on
access fees a desirable means of ensuring the comparability of quotes
for stocks trading at prices of less than $1.00 per share, and, if so,
is the fee standard of .1% (.2% in the aggregate) appropriate?
Would the proposed de minimis standards
interfere unnecessarily with the business models of ECNs, national
securities associations, and national securities exchanges? Are there
other, less intrusive ways of dealing with the concerns that have
arisen with respect to access fees? If so, what are they?
Would the proposed new access provisions,
quotation standardization, and new SRO responsibilities with respect to
locked and crossed markets appropriately and effectively address the
current problems with respect to locked and crossed markets? If not,
why not and what would accomplish this goal instead?
Would the establishment of a lower 5% ``fair
access'' threshold under Regulation ATS be necessary and appropriate to
accomplish the Commission's stated goals? If not, why not? Would a
threshold higher or lower than 5% be appropriate? If so, why?
Finally, the Commission requests comment on
whether, if it were to adopt the proposed new access provisions, a
phase-in period would be necessary or appropriate to allow market
participants time to adapt to them. If so, what aspect or aspects of
the proposed provisions should be phased in, and what would be the
appropriate phase-in period?
The Commission recognizes that intermarket access presents a number
of complex problems to which there may be many possible solutions.
Interested persons may wish to propose and discuss specific,
alternative approaches to intermarket access that the Commission should
consider as it seeks to accomplish its goal of strengthening the NMS.
Commenters may also wish to discuss whether there are any reasons why
the Commission should consider an alternative approach.
E. Paperwork Reduction Act
The Commission does not believe that the proposed new access rule
contains any collection of information requirements as defined by the
Paperwork Reduction Act of 1995, as amended, but the Commission
encourages comments on this point. The Commission notes that the
requirement under the rule proposed to be designated as Rule 610(c)
that each exchange and association must establish and enforce rules
that would require members reasonably to avoid locking or crossing the
quotations of quoting market centers and quoting market participants
would necessitate that each exchange and association keep records of
locked and crossed quotations for surveillance purposes. However, as
each market already has established rules and procedures for avoiding
intra-market locking and crossing, and national securities exchanges,
national securities associations, and broker-dealers participating
through Nasdaq in the ITS Plan all have rules prohibiting inter-market
locks and crosses for listed securities, the Commission believes that
these requirements are minimal. This information would be derived from
information that Section 17(a) of the Exchange Act and Rule 17a-1
thereunder already require be kept and preserved. The Commission is
cognizant, however, that the new rule proposed to be designated as Rule
610(c) would require each exchange and association to use such
information in a different manner, as by the creation of an additional
report concerning locked and crossed quotations. Accordingly, the
Commission solicits comment on this point.
The Commission also does not believe that the proposed amendment to
Regulation ATS contains any collection of information requirements as
defined by the Paperwork Reduction Act of 1995, as amended, but the
Commission encourages comments on this point. The proposed amendment to
Regulation ATS would extend the fair access requirements of Regulation
ATS to all ATSs with at least 5% of the trading volume in a particular
security. The Commission believes that this amendment will affect fewer
than ten ATSs. Accordingly, the Commission believes that the amendment
imposes
[[Page 11161]]
no new collection of information requirements. The Commission
encourages comments on this point.
F. Consideration of Costs and Benefits
As discussed above, the Commission is proposing a new rule that
would require SROs and other quoting market centers and quoting market
participants to permit all market participants access to their trading
books. In addition, in order to standardize quotations, the proposed
new rule would enable quoting market centers, quoting market
participants, and broker-dealers to charge de minimis fees for access
to their quotations, establish common quoting conventions for bids and
offers, and create a mechanism for reducing the incidence of locked and
crossed markets.
The Commission has preliminarily determined that quote
standardization would reduce the disparity that currently exists
between the publicly displayed quotation and the actual price
(including access fees) that is charged. The Commission believes that
both investors and professional traders would benefit from this
improved transparency. Also, by eliminating the disparity between the
posted quotation and the execution price, the Commission believes that
the execution cost associated with a transaction may be reduced for the
ultimate benefit of individual investors. This would also be the case
with the anti-locking and anti-crossing provisions, which would allow
for more transparent pricing and better information that would inure to
the benefit of individual investors.
The proposal may adversely affect the limited number of ATSs that
currently charge high access fees. Such ATSs would most likely be
required to re-evaluate their business plans in light of the proposed
quote standardization regime. Market makers would also be allowed to
charge access fees directly. The Commission believes that this would
further add to market transparency and allow market makers to compete
with ATSs on more equal terms. High-volume ATSs, national securities
exchanges, and Nasdaq would have to make minor to modest adjustments
but would not, in the Commission's view, be significantly affected by
the proposal.
The Commission has identified below certain additional costs and
benefits to the proposed new access rule. The Commission requests
comment on all aspects of this proposed cost-benefit analysis,
including identification of additional costs or benefits of the
proposed changes. The Commission encourages commenters to identify or
supply any relevant data concerning the costs or benefits of the
proposed rule.
1. Benefits
In carrying out its oversight of the NMS, the Commission seeks to
serve the interests of investors by proposing rules designed to ensure
that securities transactions can be executed efficiently, at prices
established by vigorous and fair competition among market centers. The
Commission believes that such access to diverse marketplaces within a
unified national market would foster efficiency, enhance competition
and contribute to the ``best execution'' of orders for qualified
securities.
The proposed new rule would establish common quoting conventions
and entitle market participants to full access to the limit order books
of quoting market centers and quoting market participants on a non-
discriminatory basis. The Commission believes that the new access
standards would increase transparency and enhance confidence in the
markets. The Commission also believes that the proposed rule would
promote interaction among markets, reduce the effects of fragmentation,
and lower the costs to investors.
The Commission believes that, by establishing a uniform standard
governing the terms of access among or between competing market
centers, the proposed rule would assist broker-dealers in complying
with their best execution obligations by enabling them to route
customers' orders to the market with the best price. The Commission
also believes that the proposed rule would alleviate the growing
problem of locked and crossed quotations in the NMS. Finally, the
Commission believes that the lowering of the fair access threshold
under Regulation ATS to 5% of trading volume in a particular security
should help to assure that all significant market participants
meaningfully participate in the NMS.
The Commission seeks comment on these benefits, as well as any
additional benefits of the proposed new access standards.
2. Costs
The Commission recognizes that the proposed rule would impose costs
on quoting market centers and quoting market participants, including
national securities exchanges and national securities associations.
SROs and other market centers would incur costs associated with any
systems changes necessary to comply with the requirement that they
permit all market participants access to their trading books. Likewise,
all broker-dealers that currently do not make their quotations
available to all other market participants on a non-discriminatory
basis would incur costs associated with systems changes to comply with
this requirement of the proposed rule. In addition, in both cases, the
quotation standardization provision of the proposed rule could result
in a reduction in the fees currently charged by quoting market centers.
In addition, every exchange and association would be required to
establish and enforce rules requiring their members to avoid locking
and crossing quotations. To the extent that an SRO may require rule
changes to comply with the proposed rule, there would be regulatory
costs. However, as each market already has established rules and
procedures for avoiding intra-market locking and crossing, and national
securities exchanges, national securities associations, and broker-
dealers participating through Nasdaq in the ITS Plan all have rules
prohibiting inter-market locks and crosses for listed securities, the
Commission believes that these requirements are minimal. Moreover,
market centers would need to develop and maintain surveillance programs
to detect when a locked or crossed quotation has occurred, as well as
disciplinary procedures addressed to those who engage in a pattern or
practice of locking or crossing quotations. Finally, the proposed
amendment to Regulation ATS would extend Regulation ATS's requirements
to all ATSs with at least 5% of the trading volume in a particular
security. The Commission expects that most ATSs will not have
sufficient volume to trigger this threshold and will therefore not have
to comply with this provision. Those ATSs that do trigger this
threshold would likely incur costs associated with systems changes and
regulatory costs to comply with Regulation ATS.
The Commission seeks comment on any additional costs of the
proposed new access standards.
F. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act \180\ requires the Commission,
whenever it engages in rulemaking and must consider or determine if an
action is necessary or appropriate in the public interest, also to
consider whether the action would promote efficiency, competition, and
capital formation. Section 23(a) of the Exchange Act
[[Page 11162]]
likewise requires the Commission to consider the impact such rules
would have on competition.\181\ Specifically, Exchange Act Section
23(a)(2) prohibits the Commission from adopting any rule that would
impose a burden on competition not necessary or appropriate in
furtherance of the purposes of the Exchange Act. The proposed access
rule is intended to address the absence of a uniform standard governing
access to quotations and the execution of orders for equity securities
throughout the NMS. The proposed rule would require SROs and other
quoting market centers and quoting market participants to permit all
market participants access to their limit order books, establish common
quoting conventions for bids and offers, enable quoting market centers
and quoting market participants, including broker-dealers, to charge de
minimis fees for access to their quotations, and create a mechanism for
reducing the incidence of locked and crossed markets.
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\180\ 15 U.S.C. 78c(f).
\181\ 15 U.S.C. 78w(a).
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The Commission believes that the proposed new access standards
would bolster investor confidence in the markets by helping to ensure
investors that their orders are executed at the best prices and are
subject to no hidden fees, regardless of the market on which the
execution takes place. The Commission further believes that the
proposed rule would establish common quoting conventions that would
increase transparency in the market, thereby enhancing investor
confidence, and thus capital formation. Moreover, the Commission
believes that the proposed rule would encourage interaction between the
markets and reduce fragmentation by removing impediments to the
execution of orders between and among marketplaces thereby increasing
efficiency and competition.
The Commission also believes that the proposed rule would assist
broker-dealers in evaluating and complying with their best execution
obligations. Finally, the proposed rule would cause markets to strive
to reduce locking and crossing of quotations on their markets. The
Commission believes that this should increase the efficiency of the
markets.
The Commission requests comment on whether the proposed rules are
expected to promote efficiency, competition, and capital formation.
G. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act,\182\ the Commission must advise OMB as to whether the proposed
regulation constitutes a ``major'' rule. A rule is considered ``major''
where, if adopted, it results or is likely to result in:
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\182\ Pub. L. 104-121, title II, 110 Stat. 857 (1996) (codified
in various sections of 5 U.S.C., 15 U.S.C., and as a note to 5
U.S.C. 601).
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An annual effect on the economy of $100 million
or more (either in the form of an increase or a decrease);
A major increase in costs or prices for
consumers or individual industries; or
Significant adverse effect on competition,
investment or innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review.
The Commission requests comment on the potential impact of the
proposed regulation on the economy on an annual basis. Commenters are
requested to provide empirical data and other factual support for their
view to the extent possible.
H. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') in accordance with the provisions of the Regulatory
Flexibility Act (``RFA'') \183\ with respect to the proposed new access
standards.
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\183\ 5 U.S.C. 603.
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The proposed new access standards would require SROs and other
market centers to permit all market participants access to their limit
order books. In addition, the proposed rule would enable market centers
and broker dealers to charge de minimis fees for access to their
quotations, establish common quoting conventions for bids and offers,
and create a mechanism for reducing the incidence of locked and crossed
markets.
1. Reasons for the Proposed Action
In recent years, there have been significant changes in the way the
markets operate and compete with each other. New technological advances
have resulted in automated quoting and handling of orders, and new
market participants have emerged with new business models. Some market
centers operate entirely electronically, while others continue to
conduct floor-based trading. With the advent of trading in decimals,
the minimum pricing variation in equity securities has narrowed and
there is often less depth at the top-of-book.
Currently, although multiple trading venues seek to attract order
flow by competing over price, speed of execution, and other significant
factors, there are few regulatory standards governing the routing and
execution of orders among or between competing market centers. The
Commission believes that it is time to establish standards governing
access to quotations and the execution of orders for equity securities
throughout the NMS. The Commission believes that ensuring access to
diverse marketplaces within a unified national market would foster
efficiency, enhance competition, and contribute to the ``best
execution'' of orders for NMS securities.
2. Objectives and Legal Basis
The proposed new access standards are designed to achieve several
objectives. The Commission believes that the proposed new access
standards would give market participants access to the prices and
liquidity found on competing market centers. The Commission also
believes that the proposed new access standards would assist broker-
dealers in evaluating and complying with their best execution
obligations. Finally, the Commission believes that the proposed rule
would alleviate the growing problem of locked and crossed markets in
the NMS.
The Commission is proposing the new access standards under the
authority set forth in Sections 3(b), 5, 6, 11A, 15, 15A, 17(a) and
(b), 19, 23(a) and 36 of the Exchange Act.
3. Small Entities Subject to the Rules
The proposed new access standards are designed to apply to any
national securities exchange or national securities association that
provides an order execution facility, or any alternative trading system
or other broker-dealer that displays its quotes other than on a
national securities exchange or national securities association order
execution facility. These entities would be required to adopt rules and
procedures that would comply with the requirement that they permit all
market participants with access to their trading books or quotations,
as appropriate, on a non-discriminatory basis. In addition, these
entities may be required to revise their fees to comply with the
quotation standardization provision of the proposed rule.
In addition, every exchange and association would be required to
establish and enforce rules requiring their members to avoid locking
and crossing quotations. The market centers would need to develop and
maintain
[[Page 11163]]
surveillance programs to detect when a locked or crossed quotation has
occurred, as well as penalties to discipline those who engage in a
pattern or practice of locking or crossing quotations. The proposed
rule would also extend Regulation ATS's requirements to all ATSs with
at least 5% of the trading volume in a particular security. Those ATSs
would likely need to adopt procedures to comply with Regulation ATS.
The proposed rule is intended to reach a wide variety of market
participants. Each is discussed below.
a. National Securities Exchanges and National Securities Association
None of the national securities exchanges is considered a small
entity as defined by Commission rules. Rule 0-10(e) under the Exchange
Act \184\ states that the term ``small business,'' when referring to an
exchange, means any exchange that has been exempted from the reporting
requirements of Rule 11Aa3-1 under the Exchange Act. There is one
national securities association, which is not a small entity as defined
by 13 CFR 121.201.
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\184\ 17 CFR 240.0-10.
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b. Alternative Trading Systems
There are 12 ATSs that are considered small entities.
c. Broker-Dealers and Exchange and OTC Market Makers
Commission rules generally define a broker-dealer as a small entity
for purposes of the Exchange Act and the RFA if the broker-dealer had a
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared, and the broker-dealer is not
affiliated with any person (other than a natural person) that is not a
small entity.\185\ The Commission estimates that as of December 31,
2002, there were approximately 880 Commission-registered broker-dealers
that would be considered small entities for purposes of the statute
that would be required to comply with the proposed rule's provisions
regarding access to quotations and quotation standardization.
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\185\ 17 CFR 240.0-10(c)
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4. Reporting, Recordkeeping, and other Compliance Requirements
The proposed new access standards would require every exchange and
association to establish and enforce rules requiring their members to
avoid locking and crossing quotations. The market centers would need to
develop and maintain surveillance programs to detect when locked or
crossed quotations have occurred, as well as disciplinary measures to
apply as necessary or appropriate. In addition, Regulation ATS would
require that all ATSs with at least 5% of the trading volume in a
particular security maintain records with respect to grants, denials
and limitations of access.
5. Duplicative, Overlapping, or Conflicting Federal Rules
The Commission has not identified any rules that duplicate,
overlap, or conflict with the proposed rules.
6. Significant Alternatives
Pursuant to Section 3(a) of the RFA, the Commission must consider
the following types of alternatives: (a) The establishment of differing
compliance or reporting requirements or timetables that take into
account the resources available to small entities; (b) clarification,
consolidation, or simplification of compliance and reporting
requirements under the proposed rule for small entities; (c) the use of
performance rather than design standards; and (d) an exemption from
coverage of the proposed rule, or any part thereof, for small entities.
The Commission believes that different compliance or reporting
requirements or timetables for small entities would interfere with
achieving the primary goal of establishing standards governing access
to quotations and the execution of orders for equity securities
throughout the NMS. If all market participants, regardless of size, are
not obligated to comply with the proposed new access standards,
investors that are customers of small broker-dealers, and market
participants seeking to access the quotations and liquidity of such
small broker-dealers, would not benefit fully from the rule,
potentially reducing the benefits of the rule. The Commission also does
not believe that it is necessary to consider whether small entities
should be permitted to use performance rather than design standards to
comply with the proposed rule as the rule already proposes performance
standards and does not dictate for entities of any size any particular
design standards (e.g., technology) that must be employed to achieve
the objectives of the proposed rule.
7. Solicitation of Comments
The Commission encourages the submission of comments with respect
to any aspect of this IRFA. In particular, the Commission requests
comments regarding: (1) The number of small entities that may be
affected by the proposed rules; (2) the existence or nature of the
potential impact of the proposed small entities discussed in the
analysis; and (3) how to quantify the impact of the proposed rules.
Commenters are asked to describe the nature of any impact and provide
empirical data supporting the extent of the impact. Such comments will
be considered in the preparation of the Final Regulatory Flexibility
Analysis, if the proposed rule is adopted, and will be placed in the
same public file as comments on the proposed rule.
V. Sub-Penny Quoting Proposal
A. Introduction
In April 2001, the U.S. equity markets completed the conversion
from pricing in fractions to pricing in decimals. This conversion has
reduced trading costs through narrower spreads, made equity pricing
easier to understand, and aligned the pricing of securities on U.S.
markets with major markets abroad, which were the Commission's primary
goals in directing the markets to make the conversion.\186\
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\186\ See, infra Part V.B.2 for a further discussion of the
impact of the decimals conversion.
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As part of the conversion to decimals, each of the major markets
established a minimum quoting increment of at least $0.01, which the
Commission approved.\187\ More recently, however, there has been a
growing trend in the industry, particularly among ECNs, to display
quotations in their proprietary systems in ``sub-pennies'' (i.e.,
increments finer than a penny). These sub-penny quotes may be superior
to the best quotes displayed on Nasdaq and the exchanges, but such
quotes are currently rounded to the nearest penny by the markets and
securities information processors, and therefore are not included in
the quotation data that is disseminated to the public.\188\
[[Page 11164]]
Therefore, this information often may not be accessible to the average
investor. Nevertheless, many broker-dealers access these sub-penny
quotes either to fulfill their best execution obligation to their
customers or simply to obtain better prices than they could through the
exchanges or Nasdaq. This access is often facilitated by order
management tools that allow market participants automatically to route
orders based on the best price available in the market, even if that
price is merely a fraction of a cent better than the best publicly
displayed price in the market. As a result, the exclusion of sub-penny
pricing from the disseminated quotation data effectively is creating
``hidden markets'' where securities trade in prices not transparent to
the general public.
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\187\ Securities Exchange Act Release No. 46280 (July 29, 2002),
67 FR 50739 (August 5, 2002) (order approving proposed rule changes
and amendments related to decimal pricing). In this Order, the
Commission approved the proposals of Amex, BSE, CBOE, CHX, the
exchange then known as Cincinnati Stock Exchange, Inc., subsequently
renamed the ``National Securities Exchange'' (``CSE''), ISE, NASD,
NYSE, PCX, and Phlx (collectively, ``Participants'') to establish a
minimum price variation (MPV) of $0.01 for equity issues, $0.05 for
option issues quoted under $3.00 a contract, and $0.10 for option
issues quoted at $3.00 a contract or greater (``July 2002 Order'').
\188\ The Commission staff had provided a no-action letter in
1997 to Nasdaq for ECNs and market makers to handle orders priced in
increments smaller than \1/16\ in Nasdaq securities without having
consolidated quotations reflect that bids or offers had been
rounded. See Letter to Robert Aber, Vice President and General
Counsel, Nasdaq, from Richard R. Lindsey, Director, Division of
Market Regulation (July 31, 1997). While the orders were rounded for
quotation purposes, the trades were reported and printed in the
actual price increments. See also Letter to Paul O'Kelley, Chief
Operations Officer, CHX, from Annette L. Nazareth, Director,
Division of Market Regulation, Commission (April 6, 2001) (providing
similar relief for CHX specialists and market makers); Letter to
Jeffrey T. Brown, Senior Vice President and General Counsel, CSE,
from Robert L.D. Colby, Deputy Director, Division of Market
Regulation, Commission (July 26, 2002) (providing similar relief to
CSE members).
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In addition, recent economic research conducted by Commission staff
and by Nasdaq suggests that market participants may use sub-penny
quoting more as a means to ``step ahead'' of competing limit orders for
an economically insignificant amount to gain execution priority, than
as an extrinsic expression of trading interest.\189\ If so, sub-penny
pricing could discourage market participants from using limit orders,
which could deprive the markets of an important source of liquidity.
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\189\ See, infra Part V.D.2.c. for a further discussion of
Nasdaq's economic study; see also, infra Part V.E. for a further
discussion of an economic study prepared by SEC staff. These studies
may both be accessed in the Commission's Public Reference Room.
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Sub-penny trading has increased since the implementation of
decimals, and Nasdaq recently filed a proposal with the Commission that
would allow securities that trade through Nasdaq systems to be quoted
in $0.001 increments. This proposal, if approved, could lead to
widespread sub-penny quoting. Simultaneous with this proposal, Nasdaq
also filed a petition for Commission action with the Commission, upon
which the Commission seeks comment below, in which Nasdaq requests that
the Commission adopt a uniform rule requiring market participants to
quote and trade Nasdaq securities in a ``consistent monetary
increment,'' with certain exceptions.\190\
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\190\ See Letter from Edward S. Knight, Executive Vice President
and General Counsel, Nasdaq, to Jonathan G. Katz, Secretary,
Commission (August 4, 2003) (``Nasdaq Petition'') File No. S7-11-03.
Although Nasdaq in its petition does not explicitly request that the
Commission impose a penny pricing increment, it asserts that
implementation of a penny increment for quoting and trading Nasdaq
securities would be ``prudent.'' Id. The Nasdaq Petition also may be
accessed in the Commission's Public Reference Room.
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The Commission is concerned that the status quo, where superior
sub-penny quotes on alternative markets are not transparent to and may
not be readily accessible to average investors, may be harmful to those
investors and to the markets as a whole. At the same time, the
Commission believes that including those sub-penny quotes in the best
publicly disseminated prices could harm investors and the markets.
Among other things, and as described in more detail below, sub-penny
quoting is likely to decrease further market depth (i.e., the number of
shares of a security that is available at any given price), increase
the incidence of market participants stepping ahead of standing limit
orders for an economically insignificant amount, and make it more
difficult for broker-dealers to meet certain of their regulatory
obligations by increasing the incidence of so-called ``flickering''
quotes. Moreover, the Commission is concerned that the potential
benefits of marginally better prices that sub-penny quotes might offer
in securities priced above $1.00 per share are not likely to justify
the costs that would result from such a change. Therefore, the
Commission is proposing to prohibit market participants from accepting,
ranking, or displaying orders, quotes, or indications of interest in a
pricing increment finer than a penny in any NMS stock, other than those
with a share price below $1.00.
B. Decimals Conversion
1. Background
In June 2000, the Commission issued an order (the ``June 2000
Order'') that established the framework for the exchanges and NASD
(collectively, the ``Participants'') to convert their quotation prices
in equity securities and options from fractions to decimals.\191\ The
June 2000 Order permitted the Participants to select a uniform minimum
price variation (``MPV'') for stock quotations of no greater than $0.05
and no less than $0.01.\192\ In July 2000, the NYSE, on behalf of the
Participants, submitted to the Commission a ``Decimals Implementation
Plan'' that set the MPV for equity securities quotations at a
penny.\193\
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\191\ See Securities Exchange Act Release No. 42914 (June 8,
2000), 65 FR 38010 (June 19, 2000) (``June 2000 Order''). On January
28, 2000, the Commission had ordered the Participants to facilitate
an orderly transition to decimal pricing in the securities markets.
Securities Exchange Act Release No. 42360 (Jan. 28, 2000), 65 FR
5004, 5005 (Feb. 2, 2000). In that order, the Commission set a
timetable for the Participants to begin trading some equity
securities, and options on those securities, in decimals by July 3,
2000, and all equities and options by January 3, 2001. Subsequently,
on April 13, 2000, the Commission issued another order staying the
original deadlines for decimalization. Securities Exchange Act
Release No. 42685 (April 13, 2000), 65 FR 21046 (April 19, 2000).
\192\ Securities Exchange Act Release No. 42914, 65 FR at 38013.
The Order noted: ``There was little agreement among the commenters
regarding a minimum quoting increment during the phase-in period;
suggestions ranged from a dime to a penny. As a result, the phase-in
plan may fix the minimum quoting increment during the phase-in
periods, provided that the minimum increment is not greater than
five cents and no less than one cent for any equity security, and
that at least some equity securities are quoted in one cent minimum
increments.''
\193\ See letter from Dennis L. Covelli, Vice President, NYSE,
to Annette Nazareth, Director, Division of Market Regulation,
Commission (July 25, 2000). Due to capacity limitations in quoting
and trading options, however, the Decimals Implementation Plan
selected uniform MPVs for quoting options of $0.05 for options
quoted under $3.00 and $0.10 for options at $3.00 or greater.
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The June 2000 Order established two other requirements. First, it
required the Participants to submit to the Commission studies analyzing
how the decimals conversion had affected systems capacity, liquidity,
and trading behavior, including an analysis of whether there should be
a uniform price increment for all securities. Results of the studies
submitted by Nasdaq and by NYSE are discussed below.\194\ Second, the
order required the Participants to submit rule filings to the
Commission that would individually establish an MPV for each market
quoting equity securities and options. In these filing, the
Participants established minimum quoting increments of $0.01 for equity
securities.\195\
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\194\ Overall, there were nine such studies prepared by the
Participants. In addition, CHX commissioned a study.
\195\ See July 2002 Order, supra n. 187. The Order also
established a $0.05 MPV for option issues quoted under $3.00 a
contract and a $0.10 MPV for option issues quoted at $3.00 a
contract or greater.
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2. Impact of the Decimals Conversion
The markets completed the decimals conversion by April 9, 2001, and
the Commission believes that the goals of decimalization--to simplify
pricing for investors, make U.S. markets more competitive
internationally, and potentially reduce trading costs (in terms of
spreads)--appear to have largely been met. In addition to making
securities pricing easier to understand and consistent with the pricing
[[Page 11165]]
increments on major markets abroad, decimals (and specifically the move
to a penny MPV for equity securities) have reduced spreads, thus
resulting in reduced trading costs for investors entering orders--
particularly smaller orders--that are executed at or within the
quotes.\196\
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\196\ Id.
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For example, Nasdaq conducted a study on the impact of the decimal
conversion on Nasdaq-listed securities and found that quoted and
effective spreads fell by an average of about 50% from the period
before the decimal conversion to the period after decimal pricing was
implemented.\197\ Nasdaq also found that small retail orders benefited
the most from reduced spreads due to the decimal conversion.\198\
Nasdaq also witnessed no increase in intraday volatility.
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\197\ The Nasdaq Stock Market, Inc., The Impact of
Decimalization on the Nasdaq Stock Market; Final Report to the SEC
Prepared By Nasdaq Economic Research (June 11, 2001) at 4 (``Nasdaq
Decimals Report''). The quoted spread is the difference between the
national best ask price and the national best bid price. The
effective spread is twice the absolute difference between the
midpoint of the bid-ask spread and the price paid (or received) by
investors, and accounts for trading that occurs at prices other than
the quoted prices.
\198\ Nasdaq found that effective spreads for small trades fell
by about 46%, whereas those for larger trades (i.e., those over 2000
shares) fell by 27%. Nasdaq Decimals Report, supra note 197 at 16.
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NYSE conducted a similar study for NYSE-listed securities and
reported similar results, noting that quoted spreads fell to less than
half their pre-decimal average size, and effective spreads were, on
average, 43% lower.\199\ NYSE found that net price improvement rose
29%.
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\199\ Decimalization of Trading on the New York Stock Exchange:
A Report to the Securities and Exchange Commission, (Sept. 7, 2001)
(``NYSE Decimals Report''). The July 2002 Order cited prior OEA
studies indicating that some of the anticipated benefits of
decimalization, such as the significant narrowing of quoted spreads,
were evident almost immediately. For example, OEA estimated that,
from December 2000 to March 2001, quoted spreads for NYSE-listed
securities narrowed an average of 37%. An even more dramatic
reduction in quoted spreads was observed in Nasdaq-listed
securities, with spreads narrowing an average of 50% following
decimalization. These results were consistent with those found in
other studies. See, e.g., Bessembinder, 2003, Trade Execution Costs
and Market Quality After Decimalization, Journal of Financial and
Quantitative Analysis, 38(4) (finding narrower average quoted,
effective, and realized bid-ask spreads, and lower volatility post-
decimalization).
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Despite these benefits, this fundamental change did not come
without costs. For example, Nasdaq found that the quoted size posted at
the inside price (the ``depth'') fell by about two-thirds (although
cumulative displayed depth fell by a smaller amount). \200\ It also
found that the number of quote updates for the securities studied
increased by 12% or more after controlling for the day-to-day
fluctuation in trading activity, which indicates a negative impact on
systems capacity.\201\
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\200\ Nasdaq Decimals Report, supra note 197 at 2, 33-37. Quoted
depth refers to displayed depth at the NBBO whereas cumulative depth
measures aggregated depth at various price levels relative to the
quote midpoint. Nasdaq noted that the fall in quoted size could be
explained, at least in part, by a decline in the use of limit orders
after decimals.
\201\ Nasdaq noted, however, that the move to decimals did not
cause unmanageable increases in message traffic. Id.
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Moreover, NYSE also found that the quoted size posted at the inside
or best price for NYSE-listed securities fell by about two-thirds.\202\
In addition, the number of orders received on NYSE systems more than
doubled, and the number of trades rose 76%. NYSE found that the typical
transaction size fell, with the average size of limit orders declining
21%. Finally, NYSE found that many more limit orders were cancelled
following decimalization, namely 42.4% compared to 34.2% pre-decimals,
which could be the result of faster-moving quotes.\203\
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\202\ NYSE Decimals Report, supra note 199 at 2, 9.
\203\ Other studies examined the effects of decimalization on
the NYSE. See Bacidore, Battalio, and Jennings, 2003, Order
Submission Strategies, Liquidity Supply and Trading in Pennies on
the New York Stock Exchange, Journal of Financial Markets, 6(3),
337-362 (finding that the average size of non-marketable limit
orders fell in the post-decimals period, limit order cancellation
rates rose significantly in the post-decimal sample period, and
quoted depth fell dramatically). See also Chakravarty, Wood, and Van
Ness, Decimals and Liquidity: A Study of the NYSE, Journal of
Financial Research, forthcoming (finding that quoted depth as well
as quoted and effective bid-ask spreads declined significantly
following decimalization and that the number of trades and trading
volume declined significantly).
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C. Sub-Penny Concept Release
On balance, the Commission believes that the benefits of decimals
to investors and to the markets have justified the costs. Nevertheless,
as the pricing increment for equity securities decreases beyond a
certain level, the potential costs to investors and the markets may
increase and could, at some point, surpass any potential benefit of
permitting securities to be quoted in finer increments.
In July 2001, to assist the Commission in determining the optimal
minimum price increment at which securities should be quoted and
traded, the Commission issued a Concept Release seeking public comment
on the potential impact of sub-penny pricing.\204\ In particular, the
Concept Release requested comment on a number of issues, including the
potential impact sub-penny pricing might have on (1) market depth
(i.e., the number of shares available at a given price), (2) price
clarity (e.g., the potential to cause ephemeral or ``flickering''
quotes), (3) marketplace execution priority rules, and (4) automated
systems.
---------------------------------------------------------------------------
\204\ Securities Exchange Act Release No. 44568 (July 18, 2001),
66 FR 38390 (July 24, 2001).
---------------------------------------------------------------------------
The Commission received 33 comment letters in response to the
Concept Release.\205\ Commenters included NYSE and three regional
exchanges, several broker-dealers and industry groups (including the
Securities Industry Association (``SIA'') and the Investment Company
Institute (``ICI''), a large ECN, and a number of individuals. The
majority opposed sub-penny pricing. Some of those opposing sub-pennies
believed that the negative impacts that accompanied trading in decimals
would be exacerbated by reducing the MPV even further, without
meaningfully reducing spreads or securing other countervailing benefits
for the markets or investors. These commenters thus recommended that
all quoting and trading of securities have a minimum increment of at
least a penny.\206\ Some commenters that opposed sub-penny quoting
thought trading in sub-pennies should be allowed.\207\
---------------------------------------------------------------------------
\205\ See Letters from Security Traders Association (STA) (1),
Wynncroft, Inc. (Wynncroft) (2), Frank Yang (Yang) (3), Dalton
Strategic Investment Services (Dalton) (4), Quaker Securities
(Quaker) (5), Investor Resources Group (Investor Resources) (6),
Sean McGowan (McGowan) (7), Momentum Securities for Electronic
Traders Association (ETA) (8), Diamant Investment (Diamant) (9), CHX
(10), Advanced Clearing, Inc. (Advanced Clearing) (11), Midwood
Securities (12), NYSE (13), Security Traders Association/ECN
Subcommittee (STA/ECN) (14), The Rock Island Company (Rock Island)
(15), Carl Giannone (Giannone) (16), T. Rowe Price (17), CooperNeff
Advisors (CooperNeff) (18), Specialist Association (19), Investment
Company Institute (ICI) (20), Securities Industry Association (SIA)
(21), Phlx (22), Investment Technology Group, Inc. (ITG) (23), BSE
(24), Richard Tsuhara (Tsuhara) (25), Josh Levine (Levine) (26),
Knight Trading Group (Knight) (27), J.R. Leming (Leming) (28),
Island ECN (Island) (29), The Security Traders Association of New
York, Inc. (STANY) (30), ABN Amro Inc. (AAI) (31), Carnes Investment
Group (32), and Ameritrade (33). Copies of these letters, as well as
a summary of all comments received, may be accessed in the
Commission's public reference room under File No. S7-14-01.
\206\ See Letters from STA (1), Yang (3), Dalton (4), Investor
Resources (6), McGowan (7), Midwood Securities (12), NYSE (13), Rock
Island (15), Specialist Association (19), and Phlx (22).
\207\ See Letters from ETA (8), T. Rowe Price (17), ICI (20),
SIA (21), ITG (23), Knight (27), and Ameritrade (33).
---------------------------------------------------------------------------
Some commenters believed that the forces of competition, rather
than regulation by the Commission or Congress, should determine the
[[Page 11166]]
minimum increment.\208\ These commenters suggested that finer
increments could improve market efficiency and provide investors with
valuable price improvement. They argued that the problems accompanying
decimals could be resolved through technology enhancements, rather than
through a market structure overhaul.
---------------------------------------------------------------------------
\208\ See Letters from CHX (10), STA/ECN (14), Giannone (16),
BSE (24), Tsuhara (25), Levine (26), and Island (29).
---------------------------------------------------------------------------
Commenters' views on the specific questions solicited in the
Concept Release are discussed below.
1. Market Depth
Many commenters noted that the narrower quoted and effective
spreads that resulted from decimals came at the expense of a material
loss of depth at the best displayed bids and offers.\209\ They
contended that the increase in the number of price points to 100, and
the spreading of buy and sell interest across these prices, made it
more difficult for market participants to ascertain the price of a
particular security and assess their chances of being able to obtain an
execution at a particular price. Market professionals complained that
they were finding it increasingly difficult to gauge market depth at or
near the NBBO and to determine how long it would take to complete an
order, thus rendering the NBBO less effective in reflecting true
trading interest.\210\ These commenters believed that the increase in
potential price points that would result from sub-penny pricing would
exacerbate the problems with diminished depth and liquidity (i.e., the
ability to find a buyer or seller at any given price), undermine the
orderliness of the markets, and cast further doubt on the accuracy of
price discovery.
---------------------------------------------------------------------------
\209\ See Letters from STA (1), Wynncroft (2), ETA (8), Advanced
Clearing (11), Midwood Securities (12), NYSE (13), Rock Island (15),
T. Rowe Price (17), CooperNeff (18), Specialist Association (19),
ICI (20), SIA (21), Phlx (22), and Knight (27).
\210\ The ICI contended that it was especially difficult to fill
entirely at the best displayed prices large orders of mutual funds,
pension funds, and other institutional firms, thus resulting in
increased transaction costs. The ICI cited, among other studies,
Nasdaq's decimal study noting that many market makers indicated that
working large institutional orders requires more trades.
---------------------------------------------------------------------------
One commenter countered these arguments, opining that sub-penny
opponents may be motivated more by concerns over broker-dealer
profitability (which would be expected to fall as spreads decline)
rather than broader policy implications of sub-penny pricing.\211\
---------------------------------------------------------------------------
\211\ See Letter from Island (29).
---------------------------------------------------------------------------
Two commenters contended that problems with respect to determining
depth and liquidity are caused by limitations in the way quotation data
is currently disseminated and that these problems have been magnified
with decimals.\212\ One of these commenters believed that one way to
address concerns over diminished depth and liquidity would be for
markets to display more depth of book information.\213\ A commenter
suggested that the marketplace would adopt new technologies to deliver
market data in a format that accurately represents buy and sell
interest, and that what this commenter viewed as the inadequacy of the
current NBBO-style quote is not a justification for limiting the size
of the MPV.\214\
---------------------------------------------------------------------------
\212\ See Letters from Levine (26) and Island (29).
\213\ See Letter from Island (29). Island noted that it showed
its 15 best orders on its system. ICI (20) noted that, if securities
were quoted in sub-penny increments, being able to view the top of
the book or even the entire book would be insufficient to provide
investors with enough information about the trading interest in a
particular security because investors could be using fewer limit
orders.
\214\ See Letter from Levine (26).
---------------------------------------------------------------------------
2. Price Clarity and Flickering Quotes
A number of the commenters believed that the conversion to decimals
clarified pricing for investors by allowing them to compare prices to
buy and sell stocks in dollars and cents, as opposed to dealing with
fractions. They contended, however, that sub-pennies would lead to
confusing prices by causing quotes to change rapidly or ``flicker.''
\215\ They argued that flickering quotes could interfere with
investors' understanding of securities prices, impair broker-dealers'
efforts to obtain best execution for customers' orders, make it harder
to compare execution quality among market centers, and increase the
incidence of locked and crossed markets and trade-throughs.\216\
---------------------------------------------------------------------------
\215\ See Letters from STA (1), Dalton (4), Investor Resources
(6), Diamant (9), STA/ECN (14), Rock Island (15), Giannone (16), SIA
(21), and BSE (24).
\216\ See Letters from NYSE (13), T. Rowe Price (17), Specialist
Association (19), ICI (20), SIA (21), Phlx (22), and BSE (24).
---------------------------------------------------------------------------
Two commenters that favored sub-penny pricing disputed the
arguments of those opposing it.\217\ They disagreed with the view that
quote flickering is necessarily a negative result, arguing that quickly
changing, accurate, timely prices are desirable features of an
efficient market. Moreover, these commenters believed that rapidly
changing price information can be presented in a comprehensible manner,
such as through graphical displays.
---------------------------------------------------------------------------
\217\ See Letters from Levine (26) and Island (29).
---------------------------------------------------------------------------
3. Execution Priority Rules
The Concept Release also sought comment on the impact, if any, sub-
penny pricing would have on the markets' execution priority rules.\218\
The majority of commenters believed that ``stepping ahead'' or
``pennying'' (i.e., attempting to gain execution priority by improving
the best bid by a penny) had increased with the advent of decimals and
that this problem would be exacerbated with sub-pennies.\219\
---------------------------------------------------------------------------
\218\ Commission and SRO rules provide customer limit orders
with priority over specialist and market maker orders at the same
price on the exchanges and on Nasdaq. See, e.g., 17 CFR 240.11a1-
1(T); NYSE Rule 92(b), and NASD's Manning Interpretation (NASD IM-
2110-2).
\219\ See Letters from STA (1), Yang (3), Quaker (5), Diamant
(9), Advanced Clearing (11), Midwood (12), NYSE (13), STA/ECN (14),
Rock Island (15), Giannone (16), Specialist Association (19), ICI
(20), SIA (21), Phlx (22), BSE (24), and Leming (28).
---------------------------------------------------------------------------
One commenter believed that sub-penny pricing would erode price
priority in the markets by encouraging institutions and professional
traders to ``jump the queue'' to achieve priority over pending orders
for a marginally better price without taking a meaningful economic
risk.\220\ Another commenter stated that such activity deters market
participants from displaying large orders.\221\ Many commenters
believed that, to obtain priority, market participants should be
required to improve on a quoted price by at least a penny.\222\ Another
commenter noted that it had performed an analysis on the manner in
which sub-penny quoting and trading was used and found that sub-penny
quoting and trading was used primarily to step ahead of resting limit
orders and undermine the NASD's Manning Interpretation.\223\ As a
result, in April 2003 that commenter discontinued all clients' ability
to enter orders in Nasdaq securities beyond two decimal places,
reasoning that virtually no benefit is derived from the quotations and
executions on a sub-penny basis.
---------------------------------------------------------------------------
\220\ See Letter from Specialist Association (19).
\221\ See Letter from ICI (20). The ICI noted that there has
already been a reduction in the use of limit orders by institutional
investors on the exchanges and Nasdaq under decimalization, citing
the SRO decimal studies in support. ICI stated that permitting the
entry of orders and the quoting of securities in sub-pennies would
allow a trader to gain priority over another trader by bidding as
little as $.001 more for the same security with almost no risk of
loss.
\222\ See Letters from NYSE (13), Phlx (22), Rock Island (15),
Specialist Association (19), ICI (20), and SIA (21).
\223\ See Letter from Ameritrade (33). See Section V.D.2.d.
infra for a discussion of the Manning Interpretation.
---------------------------------------------------------------------------
Another commenter, however, argued that finer increments would make
priority jumping more transparent and more efficient.\224\ An
additional
[[Page 11167]]
commenter disputed the theory that sub-penny increments would reduce
transparency (i.e., the ability to gauge trading interest at a
particular price) by discouraging the use of limit orders, as some
commenters contended, noting that its volume and the number of limit
orders it receives substantially increased after the introduction of
decimal pricing, despite the fact that it allows orders to be entered
up to three decimal places.\225\
---------------------------------------------------------------------------
\224\ See Letter from Levine (26). The commenter noted that when
constrained by artificially large increments, market participants
tend to enter into private priority jumping arrangements where the
incentive payments are typically not included in the price of the
executed orders and thus are hidden from the marketplace. The
commenter believed that in efficient markets, competitive forces
quickly find an equilibrium that thwarts ``parasitic pricing,''
because ``parasites'' must compete with one another and ultimately
must add information to the marketplace to survive.
\225\ See Letter from Island (29). Island further argued that it
was not even necessary to outbid another market participant to take
priority. For example, a market participant could post the highest
bid on the NYSE, yet see numerous transactions occur on regional
exchanges without receiving an execution, suggesting that trading
ahead can currently occur at the same price as a limit order. Island
argued that if trading ahead can occur at the same price, the
minimum increment becomes irrelevant in terms of discouraging limit
orders.
---------------------------------------------------------------------------
4. Short Sale Regulation
The Concept Release also solicited comment on how a reduction in
the minimum pricing increment might impact other price-dependent rules,
such as those regulating short sales--the ``tick test'' of Rule 10a-1
under the Exchange Act \226\ and the ``bid test'' of NASD Rule
3350.\227\ The majority of commenters who addressed short sale
regulation believed that the rapid trades and flickering quotes that
could result if sub-penny pricing were permitted could make compliance
with the bid and tick tests more difficult.\228\ They noted that, even
using automated compliance systems, it would be difficult for traders
to effect short sales in volatile markets, and that this would be
nearly impossible for human traders in some instances.
---------------------------------------------------------------------------
\226\ 17 CFR 240.10a-1. The current tick test of Rule 10a-1
under the Exchange Act provides that, subject to certain exceptions,
an exchange-listed security may be sold short only: (1) At a price
above the immediately preceding reported price (plus tick), or (2)
at the last sale price if it is higher than the last different
reported price (zero-plus tick).
\227\ The ``bid test'' of NASD Rule 3350 prohibits NASD members
from effecting short sales in Nasdaq NMS securities at or below the
best bid when the best bid displayed is below the preceding best bid
in a security. If there is an ``upbid'' in a security, i.e., the
best bid displayed is above the preceding best bid, there is no
restriction on the price that an NASD member can sell an NMS
security short. In November 2003, the Commission proposed a new
short sale regulation (Regulation SHO) that would, among other
things, provide a uniform short sale price test for exchange-listed
and Nasdaq securities, wherever traded. The regulation would
restrict all short sales to a price at least a penny above the
consolidated best bid. Securities Exchange Act Release No. 48709
(Oct. 28, 2003), 68 FR 62972 (Nov. 6, 2003) at Part IV. In the
release proposing Regulation SHO, the Commission noted that the
proposed bid test should offer more short selling opportunities than
the current tick test.
\228\ See Letters from Momentum/ETA (8), Advanced Clearing (11),
NYSE (13), Giannone (16), SIA (21), Phlx (22), BSE (24), and Knight
(27).
---------------------------------------------------------------------------
5. Quote Rounding
The Concept Release also sought comment on possible scenarios for
incorporating sub-penny quotes into the publicly disseminated quote
stream. In particular, the Commission sought comment on whether sub-
penny quotes should be accepted and rounded to the nearest penny prior
to display, or whether the sub-penny quotes should be reflected in
publicly disseminated quotes.\229\
---------------------------------------------------------------------------
\229\ In seeking comment on these scenarios, the Commission
stated its desire to reexamine no-action relief the staff had
granted that permitted market participants to round quotes in
increments below the minimum quoting increment without including an
indicator identifying these quotes as having been rounded. See supra
note 188.
---------------------------------------------------------------------------
Some commenters argued that quoting in sub-pennies should not be
allowed, either directly or through a rounding scenario because quoting
in sub-pennies would unnecessarily complicate administration of the
Order Handling Rules.\230\
---------------------------------------------------------------------------
\230\ See Letters from: NYSE (13), ICI (20), Phlx (22), and
Knight (27). On August 28, 1997, the Commission adopted Rule 11Ac1-4
and amendments to Rule 11Ac1-1 under the Exchange Act. See
Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR
48290 (Sept. 12, 1996) (collectively referred to as the Order
Handling Rules).
---------------------------------------------------------------------------
In addition, NYSE believed that rounding sub-penny prices to the
nearest penny would distort market information. Phlx believed that
rounding quotes would increase trade-throughs and locked markets and
create uncertainty among investors as to the quality of their
executions. It also thought that a rounding indicator attached to the
quote would not alleviate these problems.
One commenter argued that, while the Commission should not permit
the display of sub-penny increments, mandatory rounding should provide
for greater depth at the inside, thus leading to higher transparency,
which in turn would have a positive impact on overall execution
quality.\231\ This commenter believed that, without specific
guidelines, each system would round differently, thus making comparison
more difficult.\232\
---------------------------------------------------------------------------
\231\ See Letter from Advanced Clearing (11). The commenter
noted its belief that most orders submitted in sub-penny increments
are not rounded by market destinations, and thus transparency in the
market is reduced by the non-display of these orders. Furthermore,
some ECNs display out to three decimal places and will not accept
orders to four decimal places.
\232\ Id.
---------------------------------------------------------------------------
6. Automated Systems
Finally, the Concept Release requested comment on the potential
effects that quoting, trading, and reporting securities in increments
less than a penny would have on systems capacity. Although a few
commenters cautioned that introducing sub-penny trading could have
adverse technological impacts on the markets and market
participants,\233\ many acknowledged that some of the changes needed to
facilitate sub-penny trading had already been accomplished with the
switch to decimals. Notably, participants in an SIA survey indicated
that, during the decimals conversion, most market participants had made
adjustments to their automated systems and capacity that could
accommodate sub-pennies.\234\
---------------------------------------------------------------------------
\233\ See Letters from STA/ECN (14), SIA (21), BSE (24), and
Knight (27).
\234\ See Letter from SIA (21). To address the Commission's
questions relating to automated systems, the SIA conducted an
informal survey of member firms, SROs, clearing organizations, and
vendors to determine the industry's readiness to trade and quote
securities in sub-pennies.
---------------------------------------------------------------------------
The general consensus of the firms that responded to the SIA survey
was that, while redesigning systems and adding capacity to accommodate
sub-pennies is technologically feasible, it would require considerable
funds and staff time without providing any real benefit to investors or
contributing to market efficiency.
Vendors that responded to the SIA survey reported that their
display capabilities varied, with four decimal places being a common
constraint, although some were limited to two or three decimal places.
Capacity was also viewed as an important concern.
Some SROs that responded to the SIA survey indicated that they
would need to expand capacity to accommodate sub-penny trading. Others
stated that they were not yet ready to handle multiple decimal places,
and that moving beyond two decimal places would require major systems
redesign.
An ECN countered arguments that moving to sub-pennies would have a
detrimental effect on automated systems, stating it had not experienced
any capacity problems, even though 40% of its displayed orders were in
sub-pennies. That ECN believed that the continual increases in
processing power and bandwidth would alleviate any capacity concerns
and that any decision on sub-pennies should not be based on
[[Page 11168]]
the system limitations of some industry participants.\235\
---------------------------------------------------------------------------
\235\ See letter from Island (29).
---------------------------------------------------------------------------
D. Nasdaq's Rule Proposal and Petition for Commission Action
1. Proposed Rule Change
On August 5, 2003, Nasdaq filed a proposed rule change that would
permit it to adopt a minimum quotation increment of $0.001 for Nasdaq-
listed securities.\236\ The current minimum quotation increment for
those securities is $0.01.\237\ In the proposal, Nasdaq states that the
existing environment, in which market participants use quote increments
ranging from pennies to hundredths of pennies, harms investors by
creating a two-tiered market, one for ordinary investors (who may not
have access to sub-penny quotes) and another for professionals (who do
have access). Nasdaq argues that, unless and until a uniform quote
increment is established, it must implement a minimum quote increment
of $0.001 to remain competitive with ECNs that permit their subscribers
to quote in sub-pennies.
---------------------------------------------------------------------------
\236\ File No. SR-NASD-2003-121.
\237\ NASD Rule 4613(a)(1)(B).
---------------------------------------------------------------------------
2. Petition for Commission Action
Simultaneous with the proposed rule change, Nasdaq filed a petition
for Commission action requesting that the Commission adopt a uniform
rule requiring market participants to quote and trade Nasdaq-listed
securities in a ``consistent monetary increment,'' with the exception
of average-priced trades.\238\ According to Nasdaq, sub-penny trades
represented about 5% of all trades and shares executed on or reported
to Nasdaq between 1999 and 2001, but had increased to 16% in the prior
year. Nasdaq believes this increase was caused by sophisticated order
routing systems that are calibrated to sub-penny increments. Nasdaq
states that these systems gather quotes from SROs and ECNs, rank those
quotes in increments as small as 1/100th of a cent, and route orders to
the best available quotations based upon those rankings. Nasdaq
contends that these systems are a principal reason why market makers,
ECNs, and other market participants have begun accepting limit orders
and displaying quotations in sub-pennies.
---------------------------------------------------------------------------
\238\ See Letter from Edward S. Knight, Executive Vice President
and General Counsel, Nasdaq, to Jonathan G. Katz, Secretary,
Commission (August 4, 2003) (``Nasdaq Petition'').
---------------------------------------------------------------------------
a. Two-Tiered Market
In Nasdaq's view, sub-penny quotes disadvantage ordinary investors
because such quotes are not reflected in the NBBO data that is
disseminated to the public. Moreover, according to Nasdaq, most
traditional and electronic brokerage firms that serve retail investors
limit their clients to placing orders in whole penny increments.\239\
As a result, Nasdaq asserts that smaller investors generally can
neither see nor access sub-penny quotes, thereby creating a two-tiered
market, one for professional traders and one for average investors.
---------------------------------------------------------------------------
\239\ According to Nasdaq, online brokerages like Ameritrade, TD
Waterhouse, Schwab, and E*Trade accept customer orders only in penny
increments, whereas direct access firms that cater to day traders
and hedge funds typically accept orders in sub-penny increments. Id.
at p. 4. According to Ameritrade, beginning with the start of
decimalization in April 2001, Ameritrade allowed its clients to
place orders up to four decimal places on Nasdaq-listed securities
but discontinued this practice in April 2003 after determining that
its clients were ``primarily utilizing sub-penny quoting and trading
to step ahead of resting limit orders and undermine the [NASD's]
Manning provision.'' See Letter from Ameritrade (33).
---------------------------------------------------------------------------
b. Disparate Quoting and Trading Conventions
Nasdaq further contends that there is a great disparity in quoting
and trading conventions among market participants and that these
differences, which are not widely known, can disadvantage investors who
generally would not be aware of the many differences in the practices
for receiving and disseminating quote and trade information. Nasdaq
states the following:
Ordinary investors often are limited to
submitting orders in penny increments largely because many prominent
online brokerages only accept orders in pennies.
ECNs and Nasdaq market makers accept and execute
orders in sub-penny increments.
Some ECNs display and execute orders out to
three decimal places, and some do so only for stocks priced below $10
per share. Other ECNs accept and execute orders out to four decimal
places.
Market makers generally quote only in penny
increments but often offer price improvement to customer orders in sub-
penny increments.
Nasdaq, as a market center, accepts quotes in
penny increments and orders in sub-penny increments up to four decimal
places, but Nasdaq states that it truncates (or cuts off) the prices of
those orders to two decimal places and does not rank or display orders
based on sub-pennies. While SuperMontage does not execute or display
quotes and orders in sub-pennies, firms that accept orders delivered in
penny increments (as opposed to those that accept automatic executions)
can respond to those orders by offering sub-penny price improvement.
Nasdaq's Automated Confirmation Transaction (``ACT'') service accepts
trade reports from Nasdaq market participants out to six decimal
places.
Archipelago Exchange (a facility of the Pacific
Exchange) truncates orders it receives in sub-pennies and executes in
pennies. Other exchanges (which Nasdaq does not name) that trade
Nasdaq-listed securities display quotes in penny increments but allow
trade reporting in sub-penny increments.
The exclusive securities information processors
(SIPS--Nasdaq for Nasdaq securities and SIAC for exchange-listed
securities) disseminate quotes in penny increments, which means that no
sub-penny quotes are displayed to the public.
All major market data vendors, including
Reuters, Bloomberg, and ILX, provide quotation data in penny
increments.
Order matching systems such as ITG's POSIT, use
sub-penny increments to match customer orders at the midpoint of the
bid and ask quotation in stocks with a penny spread and report average-
priced trades.\240\
---------------------------------------------------------------------------
\240\ See ITG's web site for a further description of POSIT
(http://www.itginc.com/products/posit/).
---------------------------------------------------------------------------
Order management systems, such as LAVA and
Sungard's PowerNet, rank and display quotes and orders in increments up
to four decimal places.
c. Stepping Ahead of Limit Orders
Nasdaq also contends that some market participants use sub-pennies
to ``step-ahead'' of displayed quotes and limit orders for an
economically insignificant amount, thereby devaluing price priority and
reducing the incentive for aggressive quoting. Nasdaq provides an
example where the national best bid in Microsoft is 25.12. A trader
enters an order to buy 100 shares at 25.121 (Order A) and a second
trader then enters an order for 100 shares at 25.1211 (Order B). An
order routing system that ranks orders in sub-pennies would give
execution priority to Order B. Even though the total value of the trade
was $2512.11, Order B would gain execution priority over the best bid
for 11 cents and over Order A for only one cent.
Nasdaq states that its internal research on sub-penny pricing
supports the conclusion that market participants are deliberately using
sub-pennies to gain priority over orders rather than to contribute to
legitimate price discovery. Nasdaq states that in March 2003 it
analyzed sub-penny pricing behavior
[[Page 11169]]
and determined that 37% of sub-penny prices at the third decimal place
(i.e., $0.001) occur at the $0.001 or $0.009 price points and that 43%
of sub-penny prices at the fourth decimal place occur at the $0.0001 or
$0.0009 price points. Nasdaq concludes that these numbers are
statistically significant indicators that market participants use sub-
penny prices to gain priority over other orders for the smallest amount
possible.
d. Potential Impact on Regulatory Requirements
Nasdaq also contends that sub-penny pricing can complicate
compliance with various regulatory requirements, including marketplace
customer protection rules, such as the NASD's Manning Interpretation,
broker-dealer best execution obligations, and short sale restrictions.
According to Nasdaq, NASD IM-2110-2, the so-called Manning
Interpretation, is designed to ensure that broker-dealers protect their
customer limit orders by requiring NASD member firms to provide a
minimum level of price improvement to incoming orders in Nasdaq-listed
securities if the firm chooses to trade as principal with those
incoming orders at prices superior to customer limit orders they
currently hold. If the firm fails to provide the minimum level of price
improvement to the incoming order, it must execute its customer limit
orders or it is in violation of Manning. Nasdaq is currently operating
a pilot relative to its Manning Interpretation that could be impacted
in a sub-penny environment.\241\ The Manning pilot requires that before
a Nasdaq market maker may interact as principal with (i.e.,
internalize) an incoming order, it must provide price improvement to
the incoming order of at least $0.01 above any customer limit orders
that the market maker is holding if any of those limit orders are
priced at, or better than, the best market displayed in Nasdaq. If the
customer limit orders are priced outside the best market displayed in
Nasdaq, the Nasdaq market maker must price improve an incoming order by
the next superior minimum quotation increment permitted by Nasdaq.
Therefore, if Nasdaq were to change its minimum quoting increment to
$0.001 as it has proposed, market makers would be permitted to step
ahead of certain limit orders for $0.001. Nasdaq contends that a sub-
penny price improvement standard with respect to Manning would not
adequately protect investors.
---------------------------------------------------------------------------
\241\ See Securities Exchange Act Release No. 48876 (Dec. 4,
2003), 68 FR 69103 (Dec. 11, 2003) (notice of filing and immediate
effectiveness of SR-NASD-2003-180). Unless extended or approved
permanently, the Manning pilot would expire on June 30, 2004. If the
pilot were to expire, the terms of the Manning Interpretation that
were in effect prior to the pilot would apply. Under such terms,
market makers would, in certain limited circumstances (i.e., where
the spread is one cent), be permitted to price improve by one-half
cent without triggering Manning obligations. See NASD Notice to
Members 97-57. In addition to Manning, a broker-dealer has a best
execution obligation with respect to its handling of customer
orders.
---------------------------------------------------------------------------
Nasdaq also believes that sub-penny pricing makes it more difficult
for broker-dealers to comply with their best execution obligation.\242\
Nasdaq contends that in the absence of uniform quoting and trading
increments, it is difficult for broker-dealers to conduct the necessary
``regular and rigorous'' assessment to determine whether they are
meeting their best execution obligations. Moreover, Nasdaq believes
that decimalization generally and sub-penny pricing in particular
likely increases the frequency of price changes (so-called ``flickering
quotes''), thereby making it more difficult for a broker-dealer to
determine whether a particular price is ``reasonably available,'' a key
component in the best execution assessment.
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\242\ Generally, that duty requires broker-dealers to seek the
most favorable terms reasonably available under the circumstances
for a customer's transaction.
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Nasdaq further contends that flickering quotes could complicate the
administration of NASD Rule 3350, which restricts short selling.\243\
Nasdaq states that this rule relies on the most recent bid change to
assess whether a particular short sale is legal. Nasdaq contends that
sub-penny quoting will render NASD's rule ``unmanageable.''
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\243\ See supra note 227 for a further description of the
operation of NASD Rule 3350.
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Finally, Nasdaq contends that a move to sub-penny pricing will
further reduce market liquidity and depth without any economically
meaningful offsetting reduction in quoted and effective spreads and
will increase market participants' costs.
E. SEC Staff Research on Sub-Pennies
The Commission's Office of Economic Analysis (OEA) conducted
research on sub-penny trading and found clustering activity similar to
that which Nasdaq discusses in its petition for Commission action.\244\
OEA conducted a study of sub-penny trading for the week of April 21-25,
2003, and found:
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\244\ This study can be accessed in the Commission's public
reference room.
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Sub-penny trades accounted for 12.9% of trades
in Nasdaq-listed issues, 9.8% of trades in Amex-listed issues, and 1.0%
of trades in NYSE-listed issues in the sample week.\245\ Trades in ETFs
that were reported as CSE or Nasdaq executions accounted for the
majority of Amex sub-penny trades. Over 40% of all trades in Nasdaq
issues reported to CSE (where Island ECN is the dominant player) were
in sub-pennies. Most sub-penny trades in NYSE-listed issues were also
reported as Nasdaq trades.\246\
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\245\ The average size of sub-penny trades was 553 shares for
Nasdaq-listed securities (compared to 607 shares for trades in
pennies), 1,898 shares in NYSE-listed securities (compared to 1,117
shares for trades in pennies), and 1,314 shares in Amex-listed
securities (compared to 1,970 shares for trades in pennies).
\246\ Because sub-penny trading occurs on ECNs, the resulting
executions appear as trade reports on CSE (now NSX), Nasdaq, and
NASD's ADF where ECNs report trades.
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Sub-penny trades cluster at $0.001 (1/10th cent)
and $0.009 (9/10th cent) price points. In Nasdaq issues, 25.1% of sub-
penny trades executed at a $0.001 price point and 24.3% of sub-penny
trades executed at a $0.009 price point, for a combined total of 49.4%.
Trades on other tenth-cent sub-penny price points (e.g., those on a
price point of $0.004) each accounted for only 5%-7% of sub-penny
trades. In contrast, the expected price pattern is uniform increment
usage, or clustering on mid-point prices (i.e., $0.005) and larger
increments. This uniform increment usage pattern is found in penny
usage where clustering occurs on dime and nickel multiples. The sub-
penny pattern of clustering on the $0.001 and $0.009 price points is
consistent with the use of sub-penny pricing to gain priority over
existing quotes or limit orders.\247\
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\247\ For example, if the spread in a stock were $10.00 (bid)--
$10.01 (offer), a market participant would step ahead of the best
bid by bidding $10.001, and step ahead of the best offer by offering
$10.009.
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Another 12% of sub-penny trades occurred at a
price increment of $0.0001 (1/100th cent), and about one-half of these
trades occurred at the most extreme price points of $0.0001 or $0.0009.
Overall frequency of sub-penny trades and the
level of sub-penny clustering is approximately the same at all price
levels. For example, 10.5% of trades in securities priced below $1.00
were executed in sub-penny increments compared to 11.5% of trades in
securities priced greater than $60. The fraction of sub-penny trades
executed at the $0.001 and $0.009 price points was close to 50% for all
price levels. These results suggest that sub-penny prices are generated
by proprietary trading algorithms.
Sub-penny trades occur more frequently for
actively traded stocks. In the 20 most active Nasdaq stocks
[[Page 11170]]
(measured by share volume), 22.1% of trades were executed in sub-
pennies and sub-penny trades occur less frequently as trading activity
declines. Sub-penny clustering on 1s and 9s occur at each trade
activity level.
OEA observed that earlier studies suggest that traders tend to use
minor price points more often for lower priced securities.\248\ OEA
concluded that the absence of this relation in the current study
suggests that the use of sub-penny pricing for most stocks is more
likely related to traders' attempts to gain precedence over competing
orders than to legitimate price discovery.
---------------------------------------------------------------------------
\248\ See, e.g., Harris, Larry, ``Stock Price Clustering and
Discreteness,'' Review of Financial Studies (1991).
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F. Discussion of Proposed Rule
Generally, the Commission believes that competitive forces in the
marketplace should determine the prices that market participants may
bid or offer for securities. As such, the Commission acknowledges the
arguments of the commenters discussed above in response to the Concept
Release that, in the absence of a compelling public policy interest,
market forces rather than the government should determine the manner in
which securities are priced. At the same time, however, in Section 11A
of the Exchange Act Congress directed the Commission to facilitate the
development of a national market system for securities. In January
2000, the Commission determined that the markets' conversion to decimal
pricing was consistent with its obligations under Section 11A because
the Commission believed that decimal pricing could benefit investors by
``enhancing investor comprehension, facilitating globalization of our
markets, and potentially reducing transactions costs, depending on the
minimum price variant used.'' \249\ For the most part, that minimum
price variant has meant penny pricing.
---------------------------------------------------------------------------
\249\ Securities Exchange Act Release No. 42360, 65 FR at 5005.
---------------------------------------------------------------------------
As discussed above, the implementation of decimals has met the
goals the Commission had in ordering it. Decimal pricing is now an
accepted component of the U.S. securities markets. Spreads in equity
securities are far lower than they were under the outmoded, fraction-
based pricing system, thus resulting in reduced trading costs for
investors entering orders that are executed at or within the quotes.
In the Commission's view, however, the marginal benefits of a
further reduction in the minimum pricing increment are not likely to
justify the costs to be incurred by such a move. Indeed, the Commission
believes that the markets' experience with sub-penny quoting indicates
that the practice, if allowed to persist, could actually harm investors
and the markets.
The Commission believes that OEA's research discussed above
strongly suggests that much of the trading that currently takes place
in sub-pennies is the result of market participants attempting to step
ahead of penny-priced limit orders for the smallest economic increment
possible. In the Commission's view, it is unlikely that the high rate
of sub-penny clustering around $0.001 and $0.009 price points would
have occurred in the absence of stepping ahead behavior. Furthermore,
as OEA's research suggests, some sub-penny pricing as well as
clustering around the 1 and 9 price points also occurred in increments
finer than $0.001, which suggests that sub-penny pricing and the
resulting stepping ahead activity could be taken to an absurd
extreme.\250\ When market participants can gain execution priority for
an infinitesimally small amount, important customer protection rules
such as exchange priority rules and the NASD's Manning Interpretation
as currently formulated could be rendered meaningless. Without those
protections, professional traders would have more opportunities to take
advantage of non-professionals, which could result in the non-
professionals either losing executions or receiving executions at
inferior prices. If investors' limit orders lose execution priority for
a nominal amount, over time, investors may cease to use them, which
would deprive the markets of a vital source of liquidity. Therefore,
the use of sub-penny pricing could harm investors and the markets.
---------------------------------------------------------------------------
\250\ As noted above, the average sizes for sub-penny trades and
penny trades are comparable. See supra note 245.
---------------------------------------------------------------------------
Moreover, the Commission believes that the increase in flickering
quotes that could result from widespread sub-penny pricing could make
it more difficult for broker-dealers to satisfy their best execution
obligations and other regulatory responsibilities. The best execution
obligation requires broker-dealers to seek for their customers'
transactions the most favorable terms reasonably available under the
circumstances.\251\ This standard is premised on the practical ability
of a broker-dealer to determine whether a displayed price is or is not
reasonably obtainable given the technology available to that broker-
dealer. The Commission is concerned that a trend toward widespread sub-
penny quoting could make it a practical impossibility for brokers to
determine with reasonable certainty whether displayed prices are likely
to be available.
---------------------------------------------------------------------------
\251\ See Securities Exchange Act Release No. 37619A, 61 FR at
48322.
---------------------------------------------------------------------------
The same rationale would also apply with respect to compliance with
short selling restrictions. Under a bid test as the Commission has
proposed in Regulation SHO and which is the prevailing standard for
Nasdaq-listed securities, market participants must be able to determine
what was the last prevailing bid to determine whether they may effect a
short sale. The more rapidly the quote changes, the more difficult it
becomes to make that determination.
Furthermore, the Commission believes that widespread sub-penny
quoting could exacerbate a number of the disadvantageous aspects of
decimal pricing. For example, sub-penny pricing could decrease depth
(i.e., the number of shares) available at the best displayed prices.
OEA's research indicates that some market participants already are
quoting in pricing increments as narrow as $0.0001. Experience with
decimal pricing generally would seem to suggest that further decreases
in the quoting increment could lead to further declines in the number
of shares available at a given price.\252\ Finer slices of liquidity at
any given price could lead to higher transaction costs, particularly
for institutional investors (such as pension funds and mutual funds)
which are more likely to place large orders. These higher transaction
costs would likely be passed on to retail investors and others that
have assets in funds managed by the institutions. Decreasing depth at
the inside could also cause such institutions to rely more on execution
alternatives away from the exchanges and Nasdaq, which are designed to
help larger investors find matches for large blocks of securities. Such
a trend could further fragment the securities markets.
---------------------------------------------------------------------------
\252\ As discussed above, both Nasdaq and NYSE found that depth
at the inside price declined substantially with the implementation
of decimals. See supra notes200-202--and accompanying text.
---------------------------------------------------------------------------
Although sub-penny pricing currently appears, for the most part, to
be limited to trading in Nasdaq-listed securities through ECNs and
ATSs, Nasdaq's rule proposal, discussed above, effectively would extend
sub-penny trading to all securities that are traded through Nasdaq
systems, which would include all Nasdaq securities and presumably
exchange-listed securities that are traded by Nasdaq market
participants
[[Page 11171]]
pursuant to unlisted trading privileges.\253\
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\253\ OEA found that Nasdaq market participants currently report
trades in NYSE-listed securities in sub-penny increments. If sub-
penny quotes were permitted through SuperMontage, Nasdaq's primary
trading system, trading in those securities in sub-pennies could
ramp up quickly.
---------------------------------------------------------------------------
As Nasdaq states in its petition for Commission action, there
currently is no industry standard for trading and quoting increments.
Although Nasdaq and the exchanges currently permit quoting in single
penny increments, these markets allow trades to be printed in
increments below a penny. Although certain online brokers only accept
orders priced in one-cent increments,\254\ ECNs and Nasdaq market
makers accept orders and execute trades in sub-penny increments.\255\
While market makers quote through Nasdaq only in penny increments, they
may display orders in ECNs in sub-pennies. This lack of uniformity in
pricing is not only confusing but it also increases the likelihood that
more sophisticated market participants will use the discrepancy in
pricing increments as an arbitrage opportunity that is unlikely to be
available to less informed investors.\256\
---------------------------------------------------------------------------
\254\ See, e.g., Letter from Ameritrade (33).
\255\ See Nasdaq Petition, supra note 238.
\256\ For example, sophisticated market participants with access
to those trading venues that permit sub-penny pricing may buy or
sell securities at prices that are a fraction of a cent better than
would be available through Nasdaq or an exchange that only permits
penny pricing. They could then unwind those transactions through
Nasdaq or an exchange and make a risk-free profit.
---------------------------------------------------------------------------
To address the concerns discussed above, the Commission is
proposing a rule that would prohibit every national securities
exchange, national securities association, ATS (including ECNs),
vendor, broker or dealer from ranking, displaying, or accepting from
any person a bid or offer, an order, or an indication of interest in
any NMS stock in an increment less than $0.01.\257\
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\257\ An indication of interest is a non-firm expression of
interest to trade at a given price. Although the proposed rule would
not apply to options, in the solicitation of comment section below,
the Commission seeks comment on whether the proposal should be
expanded to apply to options.
---------------------------------------------------------------------------
The proposed rule would exclude NMS stocks with a share price below
$1.00. The Commission excluded low-priced securities from the proposed
rule because a sub-penny increment represents a greater percentage of
the value of a given share of such securities than it does for higher-
priced securities.\258\ Below, the Commission seeks comment on whether
such an exclusion is desirable, and if so, whether $1.00 per share is
the correct measure for low-priced securities.
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\258\ The Commission also believes that the $1.00 threshold is
an attractive cut-off point for the sub-penny pricing proposal
because it is also the level at which SROs begin delisting
procedures against issuers, which can coincide with a reduction in
trading volume, thereby reducing the economic incentives to quote in
sub-pennies. See, e.g., NASD Rule 4310(c)(4) (delisting standards
for SmallCap securities) and NASD Rule 4450(a)(5) and (b)(4)
(delisting standards for Nasdaq NMS securities). The proposed rule
provides that the Commission can grant exemptions from the sub-penny
quoting prohibition consistent with Section 36 of the Act. 15 U.S.C.
78mm.
---------------------------------------------------------------------------
The proposed rule is intended to prohibit the acceptance, display,
or ranking of trading interest in an NMS stock (other than a low-priced
security) in an increment below one cent. For example, the rule would
prohibit a market maker or specialist from accepting a customer limit
order priced in an increment below one cent. It would also prevent the
market maker or specialist from displaying its proprietary quote in an
increment below a penny whether through any exchange, Nasdaq, ADF, or
through an ECN or a vendor.
In addition, the proposed rule would prohibit market participants
from ranking orders, quotes, or indications of interest in an NMS stock
(other than a low-priced security) that are priced in an increment less
than a penny. In other words, the rule is intended to ensure that a
market participant can only receive execution priority over standing
limit orders or quotes by improving the best displayed price by more
than a nominal amount (i.e., by at least a penny per share).\259\
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\259\ The proposed rule would supplement other protections in
place to protect customer limit orders, such as NASD's Manning
Interpretation and broker-dealers' best execution obligation.
---------------------------------------------------------------------------
The proposed rule is intended to address the concern that the non-
uniform display of sub-penny quotes is creating hidden markets whereby
more sophisticated traders can view and access better prices than those
available to the general public. The proposal also could mitigate a
disincentive to using limit orders (i.e., the prospect that a market
participant can gain execution priority by bettering the limit price by
an economically insignificant amount).
The proposed rule would not prohibit an exchange or association
from reporting or ``printing'' a trade in a sub-penny increment, as
most markets currently permit. Therefore, a broker-dealer could,
consistent with the proposed rule, provide price improvement to a
customer order in an amount that resulted in an execution in an
increment below a penny so long as the broker-dealer did not accept
orders that already were priced in increments below a penny.\260\
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\260\ Such price improvement would also need to be done in a
manner that was consistent with the broker-dealer's obligations
under other Commission and SRO rules (e.g., best execution and
Manning).
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In addition, the proposed rule would not per se prohibit an
exchange or association from printing a trade that was the result of a
mid-point or volume-weighted pricing algorithm, as long as the exchange
or association or its members did not otherwise violate the proposed
rule with respect to the trading interest that resulted in the
execution. For example, a system that accepted unpriced orders that
were then matched at the midpoint of the NBBO would not violate the
proposed rule even though resulting executions could occur in share
prices of less than one cent. If such a system were operated by an
association, exchange, ATS, or broker-dealer, however, and the system
accepted orders priced in sub-penny increments and those orders matched
against one another in the system, the system operator would have
violated the proposed rule by accepting and (possibly) ranking orders
in prices below a penny.
The Commission is not proposing to prohibit trading in sub-pennies
because it does not believe at this time that trading in sub-penny
increments raises the same concerns that sub-penny quoting does. The
Commission seeks comments, however, on this and other issues below.
G. General Request for Comment
Question 1. What are the costs and benefits of a prohibition
against quoting in increments finer than a penny? Do the benefits of a
prohibition justify the costs?
Question 2. Nasdaq in its petition for Commission action and
commenters in their responses to the Commission's sub-penny Concept
Release identified a number of concerns with sub-penny pricing (e.g.,
creation of hidden markets, loss of depth and liquidity, and increases
in flickering quotes). Have Nasdaq and the commenters that opposed sub-
penny pricing accurately stated the likely impact of sub-penny pricing?
Are there other concerns with sub-penny pricing that were not mentioned
by Nasdaq or the commenters to the Concept Release? If these concerns
are warranted, do they justify the prohibition of sub-penny quoting
that the Commission has proposed?
In its petition for Commission action, Nasdaq asks the Commission
to adopt a rule requiring market participants to
[[Page 11172]]
quote and trade Nasdaq securities in a consistent monetary increment or
MPV. In one respect, the rule that the Commission is proposing would be
broader than that requested by Nasdaq in that it would apply to Nasdaq-
listed as well as exchange-listed securities. In another respect,
however, the Commission's proposal is narrower than Nasdaq's request,
in that it would prohibit sub-penny quoting but not trading.
Question 3. What are the advantages and disadvantages of the
Commission's proposal versus the rulemaking that Nasdaq proposes? For
example, which proposal would be the most likely to address the
concerns raised by sub-penny pricing in the most efficient manner? For
commenters who believe that sub-pennies raise concerns that should be
addressed with regulatory action, are those concerns limited to Nasdaq-
listed securities or do they apply to exchange-listed securities also?
Question 4. The Commission's proposal would apply to Nasdaq-listed
and exchange-listed securities alike. Are there differences in those
types of securities that might warrant different treatment with respect
to sub-penny pricing? If so, what are they?
Question 5. Would the rule that the Commission has proposed address
the primary concerns that have been raised about sub-penny pricing? If
not, are there other steps the Commission should take in addition to
(or instead of) the proposed rule to address those concerns?
Question 6. The rule that the Commission has proposed would not
prohibit, under certain circumstances, trades to be executed in sub-
penny increments (i.e., those resulting from sub-penny price
improvement or from mid-point or volume-weighted pricing systems).
Should the scope of the rule be expanded to prohibit this type of sub-
penny pricing also? If the current rule is approved as proposed, what
means would the Commission and responsible SROs need to have in place
to discern which sub-penny trades are the result of permissible trading
activity and which are not? Are these means currently in place or would
new procedures and systems need to be implemented?
Question 7. The rule that the Commission has proposed excludes
securities priced below $1.00 per share. Does sub-penny pricing in low-
priced securities raise the same concerns that have been raised about
such pricing generally? If so, are there other reasons why low-priced
securities should nevertheless be excluded from the proposed rule? If
commenters believe that low-priced securities should be excluded from
the proposed rule, is $1.00 per share an appropriate price level for
such an exclusion? Would $2.00 per share be more appropriate? If not,
what is an appropriate price level--higher or lower than $1.00? If low-
priced securities are properly excluded from the proposed rule, should
the exclusion apply as soon as a security drops below $1.00 per share
or should the proposed rule require that the securities trade below
that level for a certain period of time (e.g., for 10 trading days)?
How would investors and other market participants know whether or not a
security had met the required test?
Question 8. The proposal currently does not apply to options.
Should the Commission extend the proposal to options? Are there
differences between options and NMS stocks (to which the proposal
currently applies) that would make a prohibition such as the one the
Commission is proposing undesirable or infeasible for options? If so,
what are these differences?
Question 9. Are there other types of securities that should be
excluded from the proposed rule? For example, do ETFs, which are
derivatively priced, raise the same concerns that have been expressed
with respect to sub-penny pricing generally? If not, should ETFs be
excluded from the proposed rule?
Finally, the Commission seeks general comment on the proposal
described in this Release as well as Nasdaq's petition for Commission
action. In addition to the specific requests for comment included
above, the Commission asks commenters to address whether the proposed
rule and petition for Commission action would further the national
market system goals set out in Section 11A of the Exchange Act. The
Commission also requests comment on whether, if it were to adopt the
proposed Commission rule, a phase-in period would be necessary or
appropriate to allow market participants time to adapt to it. If so,
what would be an appropriate phase-in period? The Commission also
invites commenters to provide views and data as to the costs and
benefits associated with the proposed rule and petition for Commission
action. For purposes of the Small Business Regulatory Enforcement
Fairness Act of 1996,\261\ the Commission also is requesting
information regarding the potential impact of the proposed rule on the
economy on an annual basis. If possible, commenters should provide
empirical data to support their views.
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\261\ Pub. L. 104-121, 110 Stat. 857.
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H. Paperwork Reduction Act
The Commission does not believe that proposed Rule 612 under the
Exchange Act contains any collection of information requirements as
defined by the Paperwork Reduction Act of 1995, as amended, but the
Commission encourages comments on this point.\262\
---------------------------------------------------------------------------
\262\ 44 U.S.C. 3501 et seq.
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I. Consideration of Costs and Benefits
Under proposed Rule 612 market participants would be prohibited
from accepting, ranking, or displaying orders, quotes, or indications
of interest in a pricing increment finer than a penny in NMS stocks,
other than those with a share price below $1.00. The Commission has
identified the benefits and costs as described below and encourages
commenters to identify, discuss, analyze, and supply relevant data
regarding any additional costs or benefits. Specifically, the
Commission requests data to quantify each of the costs and the value of
each of the benefits identified. The Commission also seeks estimates
and views regarding each of the identified costs and benefits of the
proposal for particular types of market participants and any other
costs or benefits that may result from the adoption of the proposed
rule.
1. Benefits
In carrying out its oversight of the national market system, the
Commission seeks to serve the interest of investors by adopting rules
designed to ensure that securities transactions can be executed
efficiently, at prices established by vigorous and fair competition
among market centers. The Commission believes that the markets'
conversion to decimal pricing has benefited investors by, among other
things, clarifying and simplifying pricing for investors, making our
markets more competitive internationally, and reducing trading costs by
narrowing spreads. The Commission is concerned, however, that if the
MPV decreases beyond a certain point, some of the benefits of decimals
could be sacrificed. At the same time, some of the negative impacts
associated with the decimal conversion could be exacerbated. The
proposed rule restricting the use of sub-pennies could bring numerous
benefits, as discussed below. The Commission requests comments on the
benefits identified below and any benefits of the proposal we may not
have identified.
a. Preserve Price Clarity
The conversion to decimals clarified pricing for investors by
allowing them
[[Page 11173]]
to compare securities in dollars and cents rather than fractions.
Quotations in sub-pennies, however, have the potential to undercut
price clarity by forcing market participants to choose quickly between
slightly different and rapidly changing prices that could be located in
different markets. Prohibiting sub-penny quoting could reduce the
incidence of such flickering quotes which can impair broker-dealers'
efforts to fulfill their best execution obligations by making it harder
to determine whether particular prices are reasonably available.
b. Enhance Market Transparency
Market transparency, the dissemination of meaningful quote and
trade information, assists investors in making informed order entry
decisions and enhances broker-dealers' ability to meet their best
execution duties. The Commission has been particularly concerned about
the development of so-called ``hidden markets,'' in which more
sophisticated traders can view and access quotations in sub-pennies at
prices superior to the quotation information available to the general
public. The Commission's proposal could enhance transparency by
mandating that NMS stocks trade in prices displayed and readily
accessible to the general public. In doing so, the proposed rule could
help to eliminate the current two-tiered structure, one for
professional traders and one for average investors.
c. Enhance Market Depth
For investors and other market participants to make use of the
price information provided by the consolidated quotation systems, there
needs to be meaningful information available concerning depth, the
amount of buy and sell interest available at any given price. As the
MPV is reduced, the depth available for any given security may become
disseminated over more price points. In addition, smaller increments
may increase the risk for investors placing limit orders, particularly
large limit orders, by allowing one market participant to gain priority
over the limit order without making an economically significant
contribution to the price of the security. This could in turn have a
negative impact on depth, as traders become reluctant to post limit
orders. A resultant impact could be increased transaction costs
associated with executing orders, particularly large orders. The
Commission's proposal could benefit investors by helping, in
conjunction with other rules designed to protect customer limit orders,
to ensure that a market participant can only receive execution priority
over standing limit orders or quotes by improving the best displayed
price by something more than a nominal amount. The proposed rule also
could help to mitigate a disincentive to using limit orders (i.e., the
prospect that a market participant can gain execution priority by
bettering the limit price by an economically insignificant amount) and
therefore could benefit the markets by increasing liquidity, depth, and
transparency.
2. Costs
The Commission recognizes that there may be costs involved with the
proposal. A prohibition against displaying orders, quotes, or
indications of interest in sub-pennies by market participants could
lead to a removal of better pricing of securities from the market. The
restriction on the use of sub-penny quoting could decrease the
potential for narrower spreads in markets that might have chosen to
permit sub-penny pricing because there would be fewer potential price
points. Market participants, particularly subscribers of ECNs that
permit sub-penny quoting, could be adversely affected by the proposed
rule because the proposal would diminish their ability to gain
execution priority over standing limit orders based on smaller quote
changes. In other words, under the proposal, an ECN subscriber would be
required to improve the best prevailing quote by at least a penny to
gain execution priority. The Commission requests comment on each of the
potential costs of the proposed rule identified below and any costs not
described here. The Commission encourages commenters to provide data to
quantify these costs.
a. Pricing
The Commission recognizes that the proposed rule would impose some
costs, namely on investors and broker-dealers executing orders either
for customers or their proprietary accounts. In particular, restricting
the ability of market participants to display, rank, or accept orders
in sub-pennies could prevent investors, or broker-dealers executing
orders on behalf of investors, from executing their orders at better
prices. We believe that currently sub-penny use is limited primarily to
professional traders. Going forward, market participants that currently
use sub-penny price increments and those that might use them if they
were permitted could incur opportunity costs by being precluded from
quoting in sub-pennies.
b. Spreads
The bid-ask spread, the difference between what the buyer is
willing to pay for the security and the seller's asking price, might
not be as narrow as it otherwise could be in those markets that might
have decided to permit sub-penny quoting.
c. Business Models
As indicated in the OEA Study, sub-penny quoting currently is most
prevalent in Nasdaq-listed securities and in trading of ETFs where ECNs
play a more dominant role. As a result, some market participants,
specifically ECNs, who have been able to utilize business models that
achieve execution priority by improving prevailing prices by a sub-
penny increment might be adversely affected by the proposed rule.
d. Automated Systems
The restriction on the use of sub-pennies could have an adverse
technological impact on market participants. The Commission recognizes
that the proposed rule could require quoting market participants,
national securities exchanges, and national securities associations
that currently are capable of accepting and displaying orders in sub-
pennies to incur costs by reprogramming their systems to stop these
orders from entering.
J. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
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.\263\ In addition, Section 23(a)(2) of the
Exchange Act requires the Commission, when adopting rules under the
Act, to consider the impact such rules would have on competition.\264\
Exchange Act Section 23(a)(2) prohibits the Commission from adopting
any rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act.
---------------------------------------------------------------------------
\263\ 15 U.S.C. 78c(f).
\264\ 15 U.S.C. 78w(a)(2).
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The Commission has considered the proposed rule in light of these
standards and preliminarily believes that the proposed rule will not
impose a burden on competition not necessary or appropriate in
furtherance of the
[[Page 11174]]
purposes of the Exchange Act. To the contrary, by preserving the
benefits of decimalization, guarding against the less desirable effects
of further reducing the MPV, and addressing the growing number of sub-
penny quotes that are neither displayed nor readily accessible to the
general public, proposed Rule 612 may promote fair and vigorous
competition. Although we acknowledge that the proposed rule would, in
some circumstances, prevent market participants from offering
marginally better prices, the Commission is concerned that sub-penny
quoting may be used more as a means for market participants to step
ahead of competing limit orders for an economically insignificant
amount to gain execution priority than as an extrinsic expression of
trading interest.
The Commission believes that the proposed rule would assist broker-
dealers in evaluating and complying with their best execution
obligations, as well as other rules that operate off a minimum
increment. The Commission also believes that the proposed rule would
enhance depth and transparency by preventing trading interest from
being spread across an increasing number of price points. It also would
prevent market participants from gaining priority over a standing limit
order without making an economically significant contribution to the
price of a security. In these respects, the proposed rule would
encourage market participants to use limit orders, an important source
of liquidity. Accordingly, the proposed rule may promote market
efficiency, competition, and capital formation. In addition, the
proposed rule would also bolster investor confidence by ensuring that
their orders, especially large orders, can be executed without
incurring large transaction costs. This increase in investor confidence
should also promote market efficiency, competition, and capital
formation.
The Commission believes that the proposed rule would establish
common quoting conventions that would increase transparency in the
markets. Moreover, the Commission believes that the proposed rule would
encourage interaction between the markets and reduce fragmentation by
removing impediments to the execution of orders between and among
markets. The increased transparency in the markets and reduction of
fragmentation between the markets may bolster investor confidence,
thereby promoting capital formation.
The Commission requests comment on whether the proposed rule would
promote efficiency, competition, and capital formation.
K. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \265\ we must advise the Office of
Management and Budget as to whether the proposed regulation constitutes
a ``major'' rule. Under SBREFA, a rule is considered ``major'' where,
if adopted, it results or is likely to result in:
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\265\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified
in various sections of 5 USC, 15 U.S.C. and as a note to 5 U.S.C.
601).
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An annual effect on the economy of $100 million
or more (either in the form of an increase or a decrease);
A major increase in costs or prices for
consumers or individual industries; or
A significant adverse effect on competition,
investment, or innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. We request comment on the
potential impact of the proposed regulation on the economy on an annual
basis. Commenters are requested to provide empirical data and other
factual support for their view to the extent possible.
L. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (IRFA), in accordance with the provisions of the Regulatory
Flexibility Act (RFA),\266\ regarding the proposed Rule 612 under the
Exchange Act.
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\266\ 5 U.S.C. 603.
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1. Reasons for the Proposed Action
The Commission believes that while the conversion from fractions to
decimals benefited investors by clarifying and simplifying pricing for
investors, making our markets more competitive internationally, and
reducing trading costs by narrowing spreads, these benefits could be
sacrificed by decreasing the MPV from a penny to pricing increments
finer than a penny. The Commission is particularly concerned that the
growing trend in the industry, particularly among ECNs, to display
quotations in their proprietary systems in sub-pennies is creating so-
called ``hidden markets,'' in which more sophisticated traders can view
and access quotations in sub-pennies at prices superior to the
quotation information available to the general public. In addition,
Nasdaq has recently filed a proposed rule change to permit it to adopt
a minimum quotation increment of $0.001 for Nasdaq-listed securities,
while simultaneously also filing a petition for Commission action in
which it asks the Commission to establish a uniform quoting and trading
increment for securities.
The Commission thus believes that this would be an opportune time
to address these issues by proposing a uniform standard of quoting in
NMS stocks. The Commission is thus proposing to prohibit any vendor,
exchange, association, broker-dealer, or ATS (including ECNs) from
accepting, ranking, or displaying quotes, orders or indications of
interest in NMS stocks in sub-penny increments.
2. Objectives
The proposed rule is designed to fulfill several objectives.
Proposed Rule 612 seeks to promote transparency by eliminating what may
be resulting in a two-tiered system whereby broker-dealers are able to
view quotations in sub-pennies that are not displayed or readily
available to the general public. The proposed rule is also designed to
prevent widespread quoting in sub-pennies, which could harm the markets
and investors, by undermining a number of the benefits of
decimalization. In particular, sub-penny quotes could impair broker-
dealers' efforts to meet their best execution obligations, and
interfere with investors' understanding of securities prices. In
addition, the proposed rule is designed to enhance depth by preventing
quotations from being spread across an increasing number of price
points, while also encouraging the use of limit orders, an important
source of liquidity, by preventing competing market participants from
stepping ahead of limit orders for an economically insignificant
amount.
3. Legal Basis
Pursuant to the Exchange Act and, particularly, Sections 3(b), 5,
6, 11A, 15, 15A, 17(a) and (b), 19, 23(a), and 36 thereof, 15 U.S.C.
78c(b), 78e, 78f, 78k-1, 78o, 78mm, 78q(a) and (b), and 78w(a), the
Commission proposes to adopt new Rule 612.
4. Small Entities Subject to the Rule
The proposed rule would apply to any national securities exchange,
national securities association, ATS, vender, or broker or dealer. ATSs
that are not registered as exchanges are required to register as
broker-dealers. Accordingly, ATSs would be considered small entities if
they fall within the standard for small entities that would apply to
broker-dealers.
The proposed rule would prohibit these entities from accepting,
ranking or
[[Page 11175]]
displaying orders, quotes, or indications of interest in a pricing
increment finer than a penny in NMS stocks, other than those with a
share price below $1.00. The proposed rule would apply to a wide
variety of market participants. Each is discussed below.
a. National Securities Exchanges and National Securities Association
None of the national securities exchanges is a small entity as
defined by Commission rules. Paragraph (e) of Exchange Act Rule 0-10
\267\ states that the term ``small business,'' when referring to an
exchange, means any exchange that has been exempted from the reporting
requirements of Exchange Act Rule 11Aa3-1. There is one national
securities association, which is not a small entity as defined by 13
CFR 121.201.
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\267\ 17 CFR 240.0-10.
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b. Broker-Dealers
Commission rules generally define a broker-dealer as a small entity
for purposes of the Exchange Act and the RFA if the broker-dealer had a
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared, and the broker-dealer is not
affiliated with any person (other than a natural person) that is not a
small entity.\268\ The Commission estimates that as of 2002, there were
approximately 880 Commission-registered broker-dealers that would be
considered small entities for purposes of the statute that would be
required to comply with the proposed rule's provisions regarding access
to quotations and quotation standardization.
---------------------------------------------------------------------------
\268\ 17 CFR 240.0-10(c).
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c. Vendors
A vendor is defined in Exchange Act Rule 11Aa3-1(a)(11) as any
securities information processor engaged in the business of
disseminating transaction reports or last sale data with respect to
transactions in reported securities to brokers, dealers or investors on
a real-time or other current and continuing basis, whether through an
ECN, moving ticker or interrogation device. Paragraph (g) of Exchange
Act Rule 0-10 states that the term ``small business,'' when referring
to a securities information processor, means any securities information
processor that: (1) Had gross revenues of less than $10 million during
the preceding fiscal year (or in the time it has been in business, if
shorter); (2) Provided service to fewer than 100 interrogation devices
or moving tickers at all times during the preceding fiscal year (or in
the time that it has been in business, if shorter); and (3) Is not
affiliated with any person (other than a natural person) that is not a
small business or small organization under this section. The Commission
estimates that there are approximately 80 vendors but only 20% of these
or 16 are considered small entities. The Commission seeks comment on
whether these estimates are accurate.
5. Reporting, Recordkeeping, and Other Compliance Requirements
Proposed Rule 612 would not impose any new reporting, recordkeeping
or other compliance requirements on market participants that are small
entities.
6. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no federal rules that
duplicate, overlap or conflict with the proposed rule.
7. Significant Alternatives
Pursuant to Section 3(a) of the RFA,\269\ the Commission must
consider the following types of alternatives: (a) The establishment of
differing compliance or reporting requirements or timetables that take
into account the resources available to small entities; (b) the
clarification, consolidation, or simplification of compliance and
reporting requirements under the proposed rule for small entities; (c)
the use of performance rather than design standards; and (d) an
exemption from coverage of the proposed rule, or any part thereof, for
small entities.
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\269\ 5 U.S.C. 603(c).
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The primary goal of the proposed rule is to provide a uniform
pricing increment for NMS stocks. As such, we believe that imposing
different compliance or reporting requirements, and possibly a
different timetable for implementing compliance or reporting
requirements, for small entities could undermine the goal of
uniformity. In addition, we have concluded similarly that it would not
be consistent with the primary goal of the proposal to further clarify,
consolidate or simplify the proposed rule for small entities. The
Commission also does not believe that it is necessary to consider
whether small entities should be permitted to use performance rather
than design standards to comply with the proposed rule because the rule
already proposes performance standards and does not dictate for
entities of any size any particular design standards (e.g., technology)
that must be employed to achieve the objectives of the proposed rule.
The Commission also preliminarily believes that it would be
inconsistent with the purposes of the Exchange Act to specify different
requirements for small entities or to exempt broker-dealers from the
proposed rule.
8. Request for Comments
The Commission encourages written comments on matters discussed in
the IRFA. In particular, the Commission requests comments on (i) the
number of small entities that would be affected by the proposed rule;
(ii) the nature of any impact the proposed rule would have on small
entities and empirical data supporting the extent of the impact; and
(iii) how to quantify the number of small entities that would be
affected by and/or how to quantify the impact of the proposed rule.
Such comments will be considered in the preparation of the Final
Regulatory Flexibility Analysis, if the proposed rule is adopted, and
will be placed in the same public file as comments on the proposed rule
itself. Persons wishing to submit written comments should send three
copies to Jonathan G. Katz, Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments
also may be submitted electronically at the following e-mail address:
rule-comments@sec.gov. All comment letters should refer to File No. S7-
10-04. Comments submitted by e-mail should include this file number in
the subject line. Comment letters will be available for public
inspection and copying in the Commission's Public Reference Room, 450
Fifth Street, NW., Washington, DC 20549. Electronically submitted
letters also will be posted on the Commission's Internet web site
(http://www.sec.gov).
VI. Market Data Proposal
A. Introduction
The Commission is proposing to amend the rules and joint industry
plans for disseminating market information to the public. Pursuant to
these arrangements, participants in the U.S. markets have real-time
access to the best quotes for and trades in the thousands of stocks
that are listed on a national securities exchange or Nasdaq. For each
security, this information is disseminated on a consolidated basis.
Quotes and trades are continuously collected from the many different
market centers (i.e., exchanges, market makers, and ATSs) that
simultaneously trade a security and then disseminated to the public in
a single stream of
[[Page 11176]]
information. Consolidated market information has been an essential
element in the success of the U.S. securities markets. It is the
principal tool for assuring the transparency of buying and selling
interest in a security, for addressing the fragmentation of trading
among many different market centers, and for facilitating the best
execution of investor orders by their brokers.
The arrangements for disseminating market information were
developed in the 1970's when Congress enacted Section 11A of the
Exchange Act, mandating the creation of the NMS. To assure the public
availability of market information, the Commission adopted Rules 11Aa3-
1, 11Ac1-1, and 11Ac1-2 under the Exchange Act. The SROs comply with
these rules by participating in three joint industry plans
(``Plans'').\270\ Pursuant to the Plans, three separate networks
disseminate consolidated market information for NMS Stocks: (1) Network
A for securities listed on the NYSE, (2) Network B for securities
listed on the Amex and other national securities exchanges, and (3)
Network C for securities traded on Nasdaq.\271\ For each security, the
data includes (1) an NBBO with prices, sizes, and market center
identifications,\272\ (2) a montage of the best bids and offers from
each SRO that includes prices, sizes, and market center
identifications, and (3) a consolidated set of trade reports in the
security. The Networks establish fees for this data, which must be
filed for Commission approval. In 2003, the Networks collected $424
million in revenues derived from market data fees and, after deduction
of Network expenses, distributed $386 million to their individual SRO
participants.\273\
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\270\ The three joint-industry plans are (1) the CTA Plan, which
is operated by the Consolidated Tape Association and disseminates
transaction information for exchange-listed securities, (2) the CQ
Plan, which disseminates consolidated quotation information for
exchange-listed securities, and (3) the Nasdaq UTP Plan, which
disseminates consolidated transaction and quotation information for
Nasdaq-listed securities. The last restatements of the CTA Plan and
the CQ Plan were approved in 1996. See Securities Exchange Act
Release No. 37191 (May 9, 1996), 61 FR 24842 (File No. SR-CTA/CQ-96-
1). The amended versions of the CTA Plan and the CQ Plan were filed
as attachments to File No. SR-CTA/CQ-96-1, which are available in
the Commission's Public Reference Room. The Nasdaq UTP Plan was last
published in its entirety in 2001. See Securities Exchange Act
Release No. 44822 (September 20, 2001), 66 FR 50226 (File No. S7-24-
89). There have been several subsequent amendments to the Plans; the
Plans have not been republished in this connection.
\271\ Proposed Rule 600 under Regulation NMS defines the term
``NMS Stock'' to mean securities that are covered by the Plans.
\272\ Proposed Rule 600 under Regulation NMS defines the term
``national best bid and national best offer.''
\273\ See infra, section VI.C.1 (table setting forth revenues,
expenses, and allocations of net income for Networks A, B, and C).
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As the equity markets evolved in recent years, strains began to
develop in these market data arrangements, particularly with respect to
setting fees for the data and allocating revenues to SROs. In December
1999, the Commission published a concept release on market information
fees and revenues.\274\ It requested public comment on a wide range of
issues, including (1) a potential cost-based approach for evaluating
the reasonableness of fees, (2) new criteria for distributing Network
net income to SROs, (3) increased Plan and SRO disclosure, and (4)
improved Plan governance, administration, and oversight. In response,
the Commission received many comments that addressed market data
arrangements in great depth, but also reflected serious divisions in
the securities industry over how best to regulate market information.
---------------------------------------------------------------------------
\274\ Securities Exchange Act Release No. 42208 (Dec. 9, 1999),
64 FR 70613 (``Concept Release'').
---------------------------------------------------------------------------
To help resolve these divisions, the Commission established an
Advisory Committee on Market Information (``Advisory Committee'') in
the summer of 2000. The Advisory Committee, chaired by Professor Joel
Seligman, was given a broad mandate to explore both fundamental
matters, such as the benefits of price transparency and consolidated
information, and practical issues, such as the best model for
collecting and disseminating market information. The Advisory Committee
issued its report in September 2001.\275\ It made a variety of
recommendations, including (1) retaining price transparency and
consolidated market information as core elements of the U.S. securities
markets, (2) permitting market centers to distribute additional
information, such as depth of limit order book, free from mandatory
consolidation requirements, (3) adopting a ``competing consolidators''
model of data dissemination, (4) broadening governance of the Plans
through a non-voting advisory committee, and (5) rejecting a cost-based
approach for reviewing fees.
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\275\ Report of the Advisory Committee on Market Information: A
Blueprint for Responsible Change (September 14, 2001) (available at
http://www.sec.gov) (``Advisory Committee Report''). The Advisory
Committee Report includes a comprehensive description of the
arrangements for disseminating market data to the public, including
the terms, fees, and revenues of the Plans.
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Today, the Commission is proposing amendments that would implement
most of the Advisory Committee recommendations. In particular, the
amendments are intended to retain the core benefits of the current
rules--price transparency and consolidated information--while enhancing
their fairness and efficiency. To this end, the amendments would
authorize the independent distribution of additional data by individual
market centers, as well as establish uniform standards for the terms on
which such is data is distributed. Rule 11Ac1-2 (proposed to be
redesignated as Rule 603 of Regulation NMS), which requires the
consolidated display of information, would be revised to streamline its
requirements and to ease its burden of compliance. The amendments also
would broaden participation in Plan governance to help assure that
interested parties other than SROs have an opportunity to be heard. For
the reasons discussed in Section VI.B.2 below, however, the Commission
has decided not to propose the adoption of a competing consolidators
model for market data dissemination.
Finally, today's proposal is intended to address the serious
economic and regulatory distortions caused by the current Plan formulas
for allocating Network net income to the SROs. The formulas currently
are based solely on the number of trades or share volume reported by an
SRO. They therefore do not directly reward those market centers that
generate the highest quality quotes--i.e., those quotes that have the
best prices and the largest sizes that contribute the most to price
discovery. Moreover, the exclusive focus on trade reporting has
distorted SRO competition and created incentives for ``print
facilities,'' ``wash'' trades and ``shredded'' trades solely to
maximize market data revenues.\276\ The proposed new formula would
adopt a broad-based measure of an SRO's contribution to a Network's
data stream. The new allocation formula, along with the other
amendments proposed today, is intended to address those elements of the
current market data arrangements that are most in need of reform, while
retaining for investors the vitally important benefits of price
transparency and consolidated information.
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\276\ See infra section VI.C.1.
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B. Consideration of Alternative Models
Since receiving the Advisory Committee Report, the Commission has
undertaken an extended review of alternative models for disseminating
market information to the public. The current model offers many
benefits to investors and other information users, particularly with
respect to the quality
[[Page 11177]]
of information disseminated by the three Networks. These Networks have
established a solid record over the years for disseminating information
that is accurate and reliable. Moreover, the Networks assure that the
best prices offered by all significant market centers trading a
particular security are readily available from a single source. The
most significant weakness of the current model, however, is that it
affords little opportunity for market forces to determine a Network's
fees, or the allocation of those fees to a Network's SRO participants.
The Networks are the exclusive processors of consolidated information
for NMS Stocks, and the consolidated display requirement necessarily
means that all users of market information must purchase the Networks'
data at the Networks' fees.
The Commission's review has focused on three alternatives to the
current model: (1) A deconsolidation model recommended by a minority of
the Advisory Committee; (2) a competing consolidators model recommended
by the majority of the Advisory Committee; and (3) a hybrid model that
would have retained a consolidated NBBO, but deconsolidated trades and
all quotes other than the NBBO. The primary goal of each alternative is
to introduce greater competition and flexibility into the dissemination
of market data. Each, however, appears to have significant drawbacks.
The Commission is discussing its analysis of these models to inform the
public of the basis of its decision not to propose one of the
alternative models and to offer the public an opportunity to comment on
the issue.
At the outset, it is important to recognize the difficulties
involved in attempting to choose the best available model. No matter
which of the three alternatives is considered, serious trade-offs of
benefits and drawbacks must be accepted. In particular, there is an
inherent tension between the objectives of assuring price transparency
and the public availability of market information, which is are
fundamental objectives of the Exchange Act,\277\ and the objective of
expanding the operation of market forces with respect to data fees and
revenue allocation. The Commission's primary goals in resolving these
competing objectives can be divided into three broad categories: (1)
Maintaining the quality of information that is disseminated to the
public; (2) assuring the reasonableness of fees that would preserve the
wide public availability of market information; and (3) improving the
distribution of fee revenues to reward those SROs that contribute the
most to public price discovery. The following discussion reflects these
goals.
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\277\ Exchange Act Section 11A(a)(1)(C)(iii).
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1. Deconsolidation Model
A minority of the Advisory Committee recommended a deconsolidation
model,\278\ which would eliminate the requirement that vendors and
broker-dealers provide consolidated data to their customers. As a
result, the Plans and Networks would no longer be necessary. Each
market center would be required to distribute its own information
directly to multiple vendors and brokers, and would establish its own
fees for the information. Investors and other users (including other
market centers) could refrain from purchasing a market center's data if
they did not believe its value was worth the fee. The strength of this
model is the maximum flexibility it allows for competitive forces to
determine data products, fees, and SRO revenues.
---------------------------------------------------------------------------
\278\ Advisory Committee Report, supra note 275, section
VII.B.1.
---------------------------------------------------------------------------
The deconsolidation model's most significant drawback, however, is
the risk of confusion and harm to retail investors. Currently, retail
investors are able, when making a trading or order-routing decision, to
assess prices and evaluate the best execution of their orders by
reviewing data from a single source. Because of the consolidated
display requirement, they are assured that the data they receive
reflects the best quotes and most recent trade price for a security, no
matter where such quotes and trade are displayed in the NMS. If the
consolidated display requirement were eliminated, retail investors
would need to monitor the quality of the data disseminated by brokers
and vendors. These brokers and vendors simultaneously could be
displaying a variety of ``best'' quotes and ``last'' trade prices for a
single security. Although some retail investors might have the time,
inclination, and knowledge to sort through these issues, many likely
would not.
Retail investors should not be required to become experts on market
structure to participate directly in the equity markets with confidence
that they will receive a fair deal. The Commission believes that
assuring retail investors ready access to consolidated prices is a
vital benefit of the current model of data dissemination. In addition,
the consolidated stream of best quotes and trades for a security is the
single most important tool for unifying the many different market
centers that simultaneously trade NMS Stocks into something that truly
can be called a national market system. A substantial majority of the
Advisory Committee affirmed its support for the consolidated display
requirement.\279\
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\279\ Advisory Committee Report, supra note 275, section
VII.B.1.
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A second serious drawback to the deconsolidation model is the
problem of market power. The quote and trade information from a
dominant securities market may be so necessary that it can charge
monopoly-like fees for its information. High fees could curtail access
to this market information, harming some users of the information. In
turn, these fees could prompt calls for active rate regulation. In
light of the potential investor confusion and market power drawbacks,
the Commission has decided not to propose an alternative model that
would eliminate the consolidated display requirement and compromise the
benefits it provides.
2. Competing Consolidators Model
A majority of the Advisory Committee recommended the adoption of a
model with competing consolidators.\280\ This model would retain the
consolidated display requirement, but the Plans and Networks with their
central processors would no longer be required. Instead, each SRO would
be allowed to separately establish its own fees that are not
unreasonably discriminatory, to separately enter into and administer
its own market data contracts, and to provide its own data distribution
facility. Any number of data vendors or broker-dealers (``competing
consolidators'') could purchase data from the individual SROs,
consolidate the data, and distribute it to investors and other data
users.
---------------------------------------------------------------------------
\280\ Advisory Committee Report, supra note 275, section
VII.C.2.
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The Advisory Committee identified four primary benefits that might
result from implementation of this model. First, it believed that
market participants would have a greater ability to innovate.
Dissolution of the Plans' joint governance structure might allow for
modifications to occur more quickly in response to new technologies and
market opportunities. Second, it believed that dismantling the Plans
would lead to ancillary gains. Rather than acting in concert on market
data matters, SROs would no longer have the burdens associated with
joint administration, along with potential antitrust exposure. Third,
explicit information sharing arrangements imposed by the Plans on their
participants would be eliminated. The Committee believed that the
elimination
[[Page 11178]]
of this artificial cooperation among competitors could enhance the
forces of competition. Fourth, the arrangements under which market data
revenues are allocated among Plan participants would be eliminated.
Because each market separately would establish and collect its own
fees, intermarket competition could be enhanced.
The Commission has considered carefully the merits of the competing
consolidators model. It has decided not to propose the model for
adoption, however, because it does not believe that the potential
benefits of the model are sufficient to justify the model's serious
drawbacks. First, the use of multiple consolidators necessarily entails
a risk of loss of uniformity in the data that is distributed to the
public. The Advisory Committee was fully aware of this risk and
specifically discussed four types of quality problems. These related to
sequencing of information, validation tolerances, capacity, and data
protocols and formats. The Advisory Committee believed, however, that
such problems could be overcome. The Commission agrees that the
potential severity of these problems could be limited, but remains
concerned about the risk that data quality could be compromised. In
addition, switching to a competing consolidators model could lead to an
increase in processing costs caused by having many consolidators
perform tasks that currently are performed by a single processor per
Network. Such costs ultimately would be borne by investors and other
data users.
Another significant drawback of the competing consolidators model
is that it would not introduce any additional market forces into the
setting of data fees and the receipt of revenues by SROs. To comply
with the consolidated display requirement, all vendors and broker-
dealers acting as competing consolidators would have no choice but to
obtain data from each of the SROs that trade a security. The fees set
by the SROs for their data would be filed for Commission approval. Over
the years, the Commission primarily has relied on the ability of the
Networks to forge a broad industry consensus supporting their fees
before they are filed for Commission approval.\281\ If the competing
consolidators model were adopted, this consensus underlying a single
fee for a Network's stream of data would be lost. In reviewing the fees
of individual SROs, the Commission could be called upon to resolve a
host of difficult issues raised by commenters on the fees, particularly
if the new fees set by all of the SROs collectively added up to a
substantial increase over the total fees currently charged by the
Networks. The Advisory Committee did not support the primary criterion
that the Commission discussed in its Concept Release--that an SRO's
data fees should be reasonably related to the SRO's costs to generate
and disseminate the data. The Committee believed that a cost-based
standard would be unwise and ultimately prove unworkable. It did not,
however, offer an alternative objective criterion, nor is the
Commission aware of such a criterion, that could be used to resolve fee
disputes in an even-handed fashion.
---------------------------------------------------------------------------
\281\ See Concept Release, supra note 274, section III.C.
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In summary, the most significant potential benefits of the
competing consolidators model would inure most directly to the SROs,
which no longer would be required to act jointly through the Plans.
Investors and other data users, however, would bear the most
significant potential risks of switching to a new model--higher fees
for lower quality information. The Commission therefore has decided not
to propose the competing consolidators model for adoption.
3. Hybrid Model
Finally, the Commission considered a ``hybrid'' approach that would
have retained the key elements of the current model (e.g., the
consolidated display requirement, Plans, and Networks) for quotes
representing the NBBO, but deconsolidated all trade reporting and all
quotes other than the NBBO. Given that the range of data disseminated
by the Networks would be cut back significantly, the fees for Network
data also would be cut back, by as much as 75% for example. The
remaining net income of a Network could be distributed to SROs pursuant
to a revised allocation formula analogous to the one proposed in
Section VI.C.2 below. All other data currently disseminated by the
Networks--all trades and the best bids and offers from individual SROs
that do not represent the NBBO--would be deconsolidated. Each SRO would
distribute its data separately, as was discussed above with respect to
the deconsolidation model. A variant of this hybrid approach would
provide a slimmed-down NBBO, with only the best prices and little other
information, which would be distributed by the Network for the cost of
collecting, processing, and disseminating this reduced NBBO.
The most significant strength of the hybrid model is that it
potentially would preserve a baseline level of consolidated data most
needed by retail investors--the NBBO--while at the same time affording
a much greater opportunity for market forces to determine the fees for
trades and non-NBBO quotes of the individual SROs. All investors would
continue to have access to the NBBO for purposes of making trading
decisions and evaluating the best execution of their orders. For other
data, the SROs would be free to establish their own fees, subject to
Commission approval. In the absence of a consolidated display
requirement, investors and data users would be free to not purchase an
SRO's data if they believed its value did not justify the fee.
The hybrid model, however, suffers from many of the significant
drawbacks of the other alternatives. First, as discussed above, issues
relating to the quality of data would need to be addressed, such as the
problem of preserving uniformity when data is disseminated by many
different processors. Perhaps most important, however, is the issue of
whether market forces could be relied upon to assure reasonable fees
for market data that would preserve its wide availability. As discussed
previously, an SRO with a significant share of trading in NMS Stocks
potentially could exercise market power in setting fees for its data.
Few investors could afford to do without the best quotes and trades of
an SRO that is dominant in a significant number of stocks. Therefore,
instead of introducing greater competitive forces into the fee-setting
process, the hybrid model could embroil the Commission in highly
contentious disputes when a dominant SRO's fees were filed for
approval. Moreover, as noted above in the context of the competing
consolidators model, there does not appear to be any widely-accepted,
objective, and workable standard for resolving such disputes in an
evenhanded fashion.
The Commission therefore has decided not to propose the hybrid
model for adoption. At its heart, this decision is based on the
Commission's belief that investors and other data users are the most
significant beneficiaries of the current model. They receive high-
quality data at affordable fees, and must only deal with one
administrator and processor per Network to obtain a complete set of the
best quotes and trades from all SROs. In contrast, the significant
drawbacks of the current model are experienced most directly by the
SROs and other industry participants. Rather than switch to a new model
and risk compromising the benefits currently enjoyed by investors, the
Commission has chosen to propose specific solutions to the most
pressing
[[Page 11179]]
and serious problems with the current model.
The Commission requests comment from the public on its evaluation
of the relative strengths and weaknesses of the current model and of
the various alternatives. In particular, are investors and other
information users relatively satisfied with the current products and
fees offered by the Networks? If not, would investors and users fare
better under one of the alternative models considered by the
Commission, or under another type of model? How serious are the data
quality issues that might arise when multiple processors individually
and simultaneously collect and disseminate data for the same security
from many different market centers? If the Commission adopted a partly
or fully deconsolidated model, would market forces alone be sufficient
to establish fees that would assure the wide availability of data, or
would the Commission need to play an active role in reviewing fees?
What standards would be available to guide the Commission in reviewing
the fairness and reasonableness of fees? \282\ Are such standards
objective and workable, or would they require the exercise of
considerable discretion by the Commission?
---------------------------------------------------------------------------
\282\ See Exchange Act Section 11A(c)(1)(C).
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C. Allocation of Network Net Income
The Commission is proposing an amendment to the CTA Plan, the CQ
Plan, and the Nasdaq UTP Plan that would change the current formulas
for allocating the Plans' net income to their SRO participants. The new
formula is intended to establish a more broad-based measure of an SRO's
contribution to a Network's data stream than is provided by the current
formulas.\283\
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\283\ In the Concept Release, supra note 274, the Commission
requested comment on whether the Plan allocation formulas should be
revised to reflect more directly the value that each SRO's
information contributed to the stream of consolidated market data.
The commenters were almost evenly split on this issue. Five
preferred maintaining the current system. They particularly noted
the difficulty in designing a formula that would accurately accord
different values to quotations, in a manner that would provide a
meaningful incentive to improve markets. Four commenters believed
that the current formulas should be revised to reflect high-quality
market data, although each proposed different formulas to achieve
this result.
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1. Current Plan Formulas
The current allocation formulas for the Networks' distributable net
income are based on the number or share volume of an SRO's reported
trades in Network securities. Network A and Network B allocate net
income based solely on the number of trades reported by an SRO.\284\
Network C allocates net income based on an average of a participant's
number of trades and its share volume.\285\ These formulas are used to
distribute very substantial amounts of Network net income. The
following table sets forth the Networks' revenues, expenses, and net
income in 2003, along with the allocation of net income to the various
SROs:
---------------------------------------------------------------------------
\284\ Paragraph XII(a)(iii) of the CTA Plan provides that a CTA
Network's net income shall be allocated among its SRO participants
according to their respective ``Annual Shares.'' Annual Share is
defined in paragraph XII(a)(i) as a fraction of which (1) the
numerator is the number of trades in Network securities reported by
a particular SRO, and (2) the denominator of which is the total
number of trades in Network securities reported by all SROs.
Paragraph IX(a)(i) of the CQ Plan incorporates by reference the CTA
Plan's definition of Annual Share.
\285\ Exhibit 1(1) to the Nasdaq UTP Plan provides that net
income shall be allocated in accordance with an SRO's ``percentage
of total volume.'' Percentage of total volume is defined in Exhibit
1(2) as the average of an SRO's percentage of total trades in
Network securities and its percentage of total share volume in
Network securities.
\286\The Network financial information for 2003 is preliminary
and unaudited.
2003 Financial Information for Networks A, B, and C \286\
----------------------------------------------------------------------------------------------------------------
Network A Network B Network C Total
----------------------------------------------------------------------------------------------------------------
Revenues............................ $171,462,000 $99,179,000 $153,686,000 $424,327,000
Expenses............................ 9,322,000 3,508,000 25,470,000 38,300,000
Net Income.......................... 162,140,000 95,671,000 128,216,000 386,027,000
Allocations:
NYSE............................ 145,610,000 2,826,000 0 148,436,000
NASD/Nasdaq..................... 8,907,000 18,895,000 87,716,000 115,518,000
PCX............................. 1,056,000 18,662,000 19,058,000 38,776,000
Amex............................ 0 36,189,000 32,000 36,221,000
NSX............................. 795,000 10,828,000 20,661,000 32,284,000
CHX............................. 3,208,000 4,450,000 706,000 8,364,000
BSE............................. 2,234,000 2,516,000 43,000 4,793,000
Phlx............................ 330,000 1,276,000 0 1,606,000
CBOE............................ 0 29,000 0 29,000
----------------------------------------------------------------------------------------------------------------
By focusing exclusively on the number of trades, no matter how
small the trade, and the share volume of trading to compensate SROs for
their contribution to a Network's data stream, these formulas have
caused a variety of economic and regulatory distortions. First,
although quotes are disseminated by the Networks, the formulas do not
reward those market centers that generate the highest quality quotes--
i.e., those quotes that have the best prices and the largest sizes.
Such quotes are a critically important source of public price
discovery, yet currently are irrelevant to an SRO's share of Network
net income. Conversely, reports of very small trades often have less
value for purposes of price discovery, yet the report of a 100-share
trade is given equal weight with the report of a 5000-share trade under
the current Network A and B formulas.
Second, the trade-based formulas create an incentive for SROs to
operate ``print facilities'' that report a large number of trades.
These SROs attempt to attract business by awarding percentage rebates
(e.g., 50% and higher) of their data revenues to ATSs and market makers
that agree to report their trades through the SRO. The ATS or market
maker may otherwise have little connection with the SRO. To compete
with print facilities, other SROs are forced to offer rebates as well.
As a result, the purely commercial consideration of maximizing market
data revenues, rather than the quality of an SRO's regulatory expertise
or trading services, may determine which SRO is responsible for
reporting (and regulating) a trade. In addition, some ATSs and market
makers have chosen to display quotes through one SRO and report trades
to another--potentially causing confusion about where liquidity is to
be found.
[[Page 11180]]
Finally, the exclusively trade-based formulas create an incentive
for fraudulent or distortive practices, particularly by reporting a
large number of very small trades. As a result, market participants
have engaged in illegal wash trades solely to generate market data
revenues.\287\ Some market participants also ``shred'' their total
trading volume into the smallest possible trade sizes to maximize the
amount of data revenues such trading can generate. Such practices
detract from the accuracy and usefulness of the Network data streams.
---------------------------------------------------------------------------
\287\ NASD News Release, ``NASD Settles Charges Against Swift
Trade Securities for Deceptive Trading and Non-Bona Fide `Wash'
Transactions in QQQ,'' (Oct. 16, 2002) (``fictitious wash
transactions were part of an effort to obtain market data revenue
generated from such transactions'').
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2. Proposed New Formula
The Commission believes that the existing allocation formulas are
greatly in need of reform. In particular, the formulas should
incorporate a more broad based measure of the contribution of an SRO's
quotes and trades to the consolidated data stream. By expanding the
scope of the existing formulas, many of the regulatory and economic
distortions discussed above could be alleviated.\288\
---------------------------------------------------------------------------
\288\ In 2002, the Commission abrogated several of the more
extreme SRO proposals for rebating data revenues to market
participants. Securities Exchange Act Release No. 46159 (July 2,
2002), 67 FR 45775. The purpose of the abrogation was to allow more
time for the Commission to consider market data issues. Given that
the existing Plan allocation formulas would be changed to reward
more beneficial quoting and trading behavior, the Commission
anticipates that rebates would be permitted in the future, assuming
their terms meet applicable Exchange Act standards and SROs are able
to meet their regulatory responsibilities.
---------------------------------------------------------------------------
The Commission is proposing an amendment to each of the Plans
(``Formula Amendment'') that is intended to achieve this
objective.\289\ The new formula reflects a two-step process. First, a
Network's distributable net income (e.g., $150 million) would be
allocated among the many individual securities (e.g., 3000) included in
the Network's data stream. Second, the net income that is allocated to
an individual security (e.g., $200,000) then would be allocated among
the SROs based on measures of the utility of their trades and quotes in
the security. The Formula Amendment provides that, notwithstanding any
other provision of a Plan, its SRO participants are entitled to receive
an annual payment for each calendar year that is equal to the sum of
the SRO's Trading Shares, Quoting Shares, and NBBO Improvement Shares
in each Network security for the year. These three types of Shares are
dollar amounts that are calculated based on SRO trading and quoting
activity in each Network security. The Trading, Quoting, and NBBO
Improvement Shares then are added together to determine an SRO's total
allocation of net income for the year.
---------------------------------------------------------------------------
\289\ Given the close connection between fees for access to
quotes and allocating net income to SROs based on their quoting
activity, the terms of the proposed allocation formula are closely
related to adoption of the restrictions on access fees in the market
access proposal. The Commission requests comment on whether quotes
displayed by market centers that charge an access fee should be
entitled to earn an allocation of market data net income pursuant to
the measures of quoting activity discussed below.
---------------------------------------------------------------------------
Although the Formula Amendment appears complicated at first sight,
it is important to keep in mind that only SROs and other industry
participants will need to deal with the formula directly, and that the
formula will control the allocation of hundreds of millions of dollars.
No matter what formula ultimately is adopted, those parties most
affected by it will soon know its details intimately. Accordingly, the
Commission's primary objective is to adopt a formula that is as
serviceable and useful as possible, even at the cost of somewhat
increased complexity.
a. Security Income Allocation
The first step of the proposed new formula is to allocate a
Network's total distributable net income among the many different
securities that are included in a Network (the ``Security Income
Allocation''). Paragraph (b) of the Formula Amendment bases this
allocation on the square root of dollar volume of trading in each
security. Other potential alternatives would be to allocate net income
equally among Network securities, or to allocate net income based
directly on the trading volume in Network securities. The Commission
has proposed to use the square root of dollar volume, for the following
reasons.
Allocating a Network's net income equally among all of its
securities would fail to recognize the differing value of quotes and
trades for securities that are heavily traded versus those that are
rarely traded. Consequently, the initial allocation of a Network's net
income among individual securities should reflect the level of trading
in each security. On the other hand, the allocation formula also should
adjust for the highly disproportionate level of trading in the very top
tier of Network securities. A small number of securities (e.g., the top
5%) are much more heavily traded than the other thousands of Network
securities. Consequently, an allocation among individual securities
that simply was directly proportional to trading volume would fail to
reflect adequately the importance of price discovery for the vast
majority of Network securities.
Under the Formula Amendment, the distribution of net income among
all Network securities would be in proportion to the square root of the
total dollar volume in the security. The dollar volume represents the
importance of trading activity in each security. Since the marginal
value of a quote diminishes as the number of quotes increases, the net
income allocated to a security should not increase in a linear fashion
with the activity in the security. Information-theoretic arguments from
market microstructure theory suggest that the information in volumes
increases only with the square root of volume.\290\
---------------------------------------------------------------------------
\290\ Some basic probability theory underlies the motivation for
using the square root specification: The variance of a sum of
innovations to a random walk is proportional to the number of terms
in that sum. The standard deviation of the sum, which is the square
root of its variance, is proportional to the average size of the
sum. The standard deviation thus is proportional to the square root
of the number of terms in the sum.
Substantial theoretical and empirical research in finance
suggests that prices generally follow a random walk and that prices
change in response to trades with large trades having greater impact
than small trades, on average. Since it is reasonable to associate
the flow of information in price changes with the average size of
price changes, the price change standard deviation is a sensible
measure of the flow of information in prices. Combining these facts
suggests that the information in prices on average should be roughly
proportional to the square root of volume.
---------------------------------------------------------------------------
The Commission preliminarily believes that it is appropriate to
reward those SROs whose quoting and trading activity extends broadly
throughout the thousands of stocks included in a Network. Comment is
requested on this issue and whether the use of the square root function
adequately achieves this objective. Comment also is requested on
whether other criteria would be more suitable for allocating net income
among individual securities. For example, would using the square root
of trades, rather than dollar volume, better reflect the tiered nature
of trading volume, while also minimizing the potential for anomalous
results for very inactively traded securities?
b. Measures of Trading and Quoting
After a specific amount of Network net income has been allocated to
an individual security (i.e., the Security Income Allocation), this
amount must be allocated further among the various SROs that transmit
trades and quotes in the security to the Network processor. Paragraphs
(c) through (e) of the Formula Amendment provide for this
[[Page 11181]]
allocation according to three measures of an SRO's contribution to a
Network's data stream: (1) The SRO's proportion of trading in each
Network security (``Trading Share''); (2) the SRO's proportion of
quotes with prices that equal the NBBO in each Network security
(``Quoting Share''); and (3) the SRO's proportion of quotes that
improve the price of the NBBO in each Network security (``NBBO
Improvement Share'').
i. Trading Share
Under paragraph (c) of the Formula Amendment, an SRO's Trading
Share in a particular Network security would be a dollar amount that is
determined by multiplying (i) an amount equal to the lesser of (A) 50%
of the Security Income Allocation for the Eligible Security or (B) an
amount equal to $2.00 multiplied by the total number of qualified
transaction reports disseminated by the Processor in the Eligible
Security during the calendar year, by (2) the SRO's Trade Rating in the
security. A Trade Rating would be a number that represents the SRO's
proportion of dollar volume and qualified trades in the security, as
compared to the dollar volume and qualified trades of all SROs. The
Trade Ratings of all SROs would add up to a total of one. Thus, for
example, multiplying 50% of the Security Income Allocation for a
Network security (e.g., $200,000) by an SRO's Trade Rating in that
security (e.g., 0.2555) would produce a dollar amount (e.g., 50% x
$200,000 x 0.2555 = $25,550) that is the SRO's Trading Share for the
security for the year.
Applying 50% of the Security Income Allocation to the Trading Share
reflects a judgment that generally trades and quotes are of
approximately equal importance for price discovery purposes. For
securities with lower trading volume, however, this percentage can
disproportionately reward a small number of trades during the year, at
the expense of those markets that aggressively quote a security
throughout the year. For example, the Security Income Allocation for a
security with 10 qualified trades during the year might be $300. Rather
than allocate the full $300 to those SROs that reported a small number
of trades (for an average per trade allocation of $30), the proposed
formula includes a cap of $2 per qualified transaction report, so that
a total of only $20 would be allocated pursuant to the Trading Share.
The difference of $280 ($300 minus $20) is shifted to the Quoting Share
to reward those markets that consistently displayed valuable quotes in
the security throughout the more than 250 trading days during the year.
The amount of the cap of $2 per qualified transaction report exceeds
the highest amount per transaction report currently allocated for any
of the three Networks.
An SRO's Trade Rating would be calculated by taking the average of
(1) the SRO's percentage of total dollar volume reported in the Network
security during the year, and (2) the SRO's percentage of total
qualified trades reported in the Network security for the year. To be
qualified, a trade must have a dollar volume of $5000 or higher. This
dollar volume would reflect, for example, a 200-share trade at a price
of $25 per share. Analysis of Network A data indicates that this
threshold would include approximately 50% of total trades and
approximately 90% of total dollar volume. The purpose of this minimum
size requirement is, first, to eliminate those very small trades that
often have the least price discovery value and, second, to reduce the
potential for significant numbers of ``shredded'' trades.
The use of a standard that allocates 50% of Network net income
based solely on dollar volume and qualified trades in Network
securities is intended to reward an SRO for its contribution to the
consolidated stream of trade reports disseminated by a Network, without
regard to the value of the SRO's quotes. Comment is requested on
whether 50% of a Security Income Allocation generally reflects an
appropriate weighting for trading activity. In addition, is the cap on
the average per trade allocation appropriate and, if so, is $2 per
qualified trade an appropriate limit? Comment also is requested on
whether dollar volume and qualified trades are appropriate measures of
an SRO's contribution to the consolidated trade stream. Is a minimum
size requirement appropriate for the number of trades criterion and, if
so, should the amount be higher or lower than $5000? How would a
minimum size requirement affect the handling or routing of investor
orders? Alternatively, should trades with a size of less than $5000
receive some credit, but credit that is proportional to their smaller
size (e.g., a $1000 trade would receive one-fifth the credit of a trade
of $5000 or greater). Finally, should a cap be placed on the size of
individual trades (e.g., $500,000 dollar volume) to prevent the
allocation for exceptionally large trades from swamping the allocation
for smaller trades?
ii. Quoting Share
Under paragraph (d) of the Formula Amendment, an SRO's Quoting
Share in a particular Network Security would be a dollar amount that is
determined by multiplying (i) an amount equal to 35% of the Security
Income Allocation for the security, plus the difference, if greater
than zero, between 50% of the Security Income Allocation for the
Eligible Security and an amount equal to $2.00 multiplied by the total
number of qualified transaction reports disseminated by the Processor
in the Eligible Security during the calendar year, by (ii) the SRO's
Quote Rating in the security. A Quote Rating would be a number that
represents the SRO's proportion of quotes that equaled the price of the
NBBO during the year (``Quote Credits''), as compared to the Quote
Credits of all SRO's during the year. The Quote Ratings of all SROs
would add up to a total of one. Multiplying 35% of the Security Income
Allocation for a Network security (plus any shifted allocation from the
Trading Share) by an SRO's Quote Rating in that security would produce
a dollar amount that is the SRO's Quoting Share for the security for
the year.
An SRO would earn one Quote Credit for each second of time and
dollar value of size that the SRO's quote during regular trading hours
equals the price of the NBBO.\291\ Thus, for example, a bid with a
dollar value of $4000 (e.g., a bid of $20 with a size of 200 shares)
that equals the national best bid for three seconds would be entitled
to 12,000 Quote Credits. If an SRO quotes simultaneously at both the
national best bid and the national best offer, it would earn Quote
Credits for each quote.
---------------------------------------------------------------------------
\291\ Regular trading hours are defined in proposed Rule 600 of
Regulation NMS as between 9:30 a.m. and 4 p.m. Eastern Time, unless
otherwise specified pursuant to the procedures established in Rule
605(a)(2).
---------------------------------------------------------------------------
With respect to SRO quotes that are not fully accessible through
automatic execution,\292\ however, the Formula Amendment would
establish an automatic cut-off of Quote Credits when such quotes are
left alone at the NBBO as a result of quote changes by other SROs. For
example, if two SROs have transmitted bids with a price of $10 per
share that represents the national best bid in a security, and one of
those SROs subsequently lowers its bid to $9.98 per share, the second
SRO will be left alone at the national best bid. If the second SRO's
quote is fully accessible through automatic execution, its bid of $10
per share would continue to earn Quote Credits. If the second SRO's
quote is not
[[Page 11182]]
fully accessible through automatic execution, its bid of $10 per share
would cease earning Quote Credits when the first SRO lowered its bid.
The second SRO could recommence earning credits by retransmitting its
bid to the Network processor to confirm a current willingness to trade
at a bid price of $10.
---------------------------------------------------------------------------
\292\ The Commission preliminarily believes that an SRO's quotes
would not be ``fully accessible'' unless all of such quotes are
generated by market centers that qualify as an ``automated order
execution facility'' under the proposed trade-through rule. See
supra, section III.D.2. Comment is requested on whether this is an
appropriate standard.
---------------------------------------------------------------------------
The purpose of the automatic cut-off of Quote Credits for SRO
quotes that are not fully accessible through automatic execution is to
help assure that stale quotes are not highly rewarded. If an SRO's
quote is left alone at the NBBO, it would be the only SRO earning Quote
Credits throughout the time the quote remains alone at the NBBO. Given
that other SROs have moved their prices away, the quote submitted by an
SRO with manual trading may be in the process of being updated to
reflect a new price. This quote may be the last to be updated because
it is the least desirable, and it cannot be automatically executed. The
SRO should not earn Quote Credits during this time. If, on the other
hand, the SRO with manual trading remains willing to trade immediately
at the old price, it has the opportunity to retransmit the quote and
thereby recommence earning Quote Credits.
The use of time and size at the NBBO as a measure for allocating
35% of Network net income is intended to reward those SROs that
contribute valuable quotes to a Network's data stream. Comment is
requested on whether this measure achieves its purpose and is
serviceable. For example, does rewarding SROs for the length of time of
their quotes create such a powerful incentive for slowness in updating
quotes that the accuracy and integrity of the consolidated quote stream
itself would be seriously compromised? Does the automatic cut-off for
quotes that are not fully accessible through automatic execution help
ameliorate this problem? The Commission also requests comment on
whether 35% is an acceptable weighting to place on this measure of
quoting activity. As noted above with respect to the Trading Share, the
total Security Income Allocation for a security generally will be split
evenly between trading activity and quoting activity. For quoting
activity, the proposed formula allocates a higher amount to the Quoting
Share than to the NBBO Improvement Share (35% compared to 15%). This
allocation is based on a judgment that consistent quoting in size at
the NBBO adds substantial depth to the market, and that the Quoting
Share reflects a broader measure of quoting activity than the NBBO
Improvement Share. In addition, any quote that qualifies for an NBBO
Improvement Share necessarily would also qualify for a Quoting Share.
iii. NBBO Improvement Share
Under paragraph (e) of the Formula Amendment, an SRO's NBBO
Improvement Share in a particular Network security would be a dollar
amount that is determined by multiplying (i) 15% of the Security Income
Allocation for such security by (ii) the SRO's NBBO Improvement Rating
in the security. An NBBO Improvement Rating would be a number that
reflects the proportion of an SRO's quotes that improve the price of
the NBBO in a security (``NBBO Improvement Credits''), as compared to
the NBBO Improvement Credits of all SROs in the security. The NBBO
Improvement Ratings of all SROs would add up to a total of one.
Multiplying 15% of the Security Income Allocation for a Network
security by an SRO's NBBO Improvement Rating in that security would
produce a dollar amount that is the SRO's NBBO Improvement Share for
the security for the year.
An SRO would earn NBBO Improvement Credits in two ways. First, it
would earn one NBBO Improvement Credit for each five seconds of time
and dollar value of size that a quote transmitted by the SRO during
regular trading hours improves the price of the existing NBBO in a
security (``Qualified Quote'') and continues to remain equal to the
price of the NBBO on a going-forward basis. Second, an SRO would earn
NBBO Improvement Credits for a Qualified Quote equal to the total
dollar volume of the SRO's transaction reports in the security that
meet the following four conditions: (1) The transaction report must be
transmitted to the Network processor subsequent to the Qualified Quote;
(2) the transaction report must be transmitted while the price of the
Qualified Quote remains equal to the NBBO or no later than five seconds
after it no longer equals the NBBO; (3) the price of the transaction
report must be the same as the price of the Qualified Quote; and (4)
the total NBBO Improvement Credits earned for transaction reports
connected with a single Qualified Quote cannot exceed the sum of the
dollar value of size of such Qualified Quote plus the total NBBO
Improvement Credits earned for the time and size of such Qualified
Quote.
The following example is provided to illustrate the rules for
calculating NBBO Improvement Credits. Assume that SRO 1
transmits a bid at 9:45:37 a.m. with a price of $10.00 and a size of
4000 shares, thereby improving the existing national best bid of $9.98.
SRO 1's bid is a Qualified Quote and entitled to earn NBBO
Improvement Credits. At 9:45:39 a.m., SRO 2 transmits a bid
with a price of $10.00 and a size of 5000 shares. SRO 2's bid,
even though it equals the price of SRO 1's bid and has greater
size, does not affect the right of SRO 1 to earn NBBO
Improvement Credits. At 9:45:40 a.m., SRO 1 transmits a
transaction report with a price of $10.00 and a size of 1000 shares,
and also lowers the size of its bid to 3000 shares. At 9:45:44 a.m.,
SRO 1 lowers its bid to $9.99. At 9:45:47, SRO 1
transmits a transaction report with a price of $10.00 and a size of
4000 shares.
In the foregoing example, SRO 1 would have earned a total
of 80,000 NBBO Improvement Credits (30,000 credits for quoting plus
50,000 credits for trading). For the time and size of its bid, it
earned 30,000 credits for maintaining the bid price at $10.00 (equal to
the national best bid) for a full five-second increment with a size of
3000 shares. It is not entitled to credits for the full 4000-share size
of the initial bid because the size was not maintained for 5 seconds.
For its trading, SRO 1 earned 10,000 credits for its first
transaction report (which was transmitted while its bid price remained
equal to the national best bid), and 40,000 credits for its second
transaction report (which was transmitted within five seconds after SRO
1's bid no longer equaled the national best bid). Finally, the
total of 50,000 credits for transaction reports does not exceed the
maximum amount that could be earned for transaction reports (the
maximum amount was 70,000 credits--40,000 for the initial dollar value
of size of the Qualified Quote, plus 30,000 for the total NBBO
Improvement Credits earned for the time and size of the Qualified
Quote).
The purpose of the NBBO Improvement Share is to reward SROs with
quotes that frequently improve the prices of the NBBO, even if such
quotes are soon matched by the quotes of other SROs. The five-second
minimum for time and size of a price-improving quote is intended to
assure the credits are not earned for ephemeral quotes that are posted
and quickly withdrawn without trading. Credits are earned for trading
connected to a price-improving quote to assure that (1) an SRO is
rewarded for displaying a price-improving quote even if the quote is
quickly taken out by an arriving order, and (2) an SRO is rewarded for
continuing to trade when its quote is left displayed for more than five
seconds. The cap on credits for trading is intended to maintain a
[[Page 11183]]
reasonable relation between a price-improving quote and the total
number of credits that can be earned for the quote (for example, if a
price-improving quote with a size of 100 shares is followed by a
transaction report with a size of 10,000 shares).
The Commission requests comment on the formula for calculating an
NBBO Improvement Share. Does it achieve its objective of rewarding
valuable quotes? Is a five-second time period the appropriate length to
achieve its objective to preclude giving credit to ephemeral quotes?
Should an SRO also be allowed to earn credits for quotes that are left
alone at the NBBO as a result of quote changes by other SROs, rather
than just for quotes that improve the price of the NBBO? If a price-
improving quote results in a locked or crossed market, should the quote
be entitled to earn NBBO Improvement Credits? Should the weighting of
15% of a Security Income Allocation be higher or lower?
In addition, the Commission requests comment on whether the NBBO
Improvement Share creates an unacceptable risk of ``gaming'' behavior
by market participants that would harm the integrity of a Network's
data stream. For example, unscrupulous market centers, seeking to
qualify trades for NBBO Improvement Credits, potentially could engage
in the practice of ``flashing'' quotes at an improved NBBO immediately
prior to reporting a trade. These quotes would be transmitted to the
Plan processor, even though the market center had no valid, prospective
trading interest at the price (i.e., other than the trade that was
already in hand and that the market center was attempting to qualify
for NBBO Improvement Credits). The Commission notes that such quotes
would be fraudulent and would violate a variety of Exchange Act
provisions and rules. Comment is requested on whether the threat of
enforcement action and sanctions would be sufficient to deter such
behavior. Comment also is requested on whether other alternative
approaches would more usefully measure the contribution of an SRO's
quotes to a Network's data stream.
The Commission generally requests comment on the Formula Amendment
as a whole, including whether it is workable and its potential effect
on SROs, other industry participants, and investors. Are all of the
elements of the formula necessary and appropriate to achieve the goal
of rewarding markets for their contributions to the consolidated data
stream? Adoption of the new formula could result in substantial shifts
in the allocation of Network net income among the various SROs. Given
that changes in the allocation formula may lead SROs and market
participants to alter their conduct, how probative are historical
trading and quoting patterns in determining the future effect of a new
formula? Comment is requested on the likelihood of major changes in
existing levels of net income allocation and the potential effect on
SROs that receive lesser amounts of income. For example, would
potential shifts in the allocation of Network net income promote or
detract from effective self-regulation of the markets? In this regard,
comment is requested on the likely effect of the proposed formula on
the current practice of some SROs to grant substantial rebates of
Network net income to market participants.
Finally, comment is requested on the extent to which the net income
allocation formula should be modified if some market centers continue
to charge fees for access to their quotes. Under the market access
proposal discussed in Section IV, such fees would be capped at a de
minimis amount of $0.001 per share, and the accumulation of this fee
would be limited to no more than $0.002 per share. If this limitation
is not ultimately adopted, should the quotes and trades transmitted by
market centers that charge fees higher than a de minimis amount also be
entitled to receive an allocation of Network net income? Potentially,
all quotes and all trades transmitted by such market centers could be
excluded from the calculation of Trading Shares, Quoting Shares, and
NBBO Improvement Shares, thereby eliminating any allocation of Network
net income for such quotes and trades. Alternatively, only the quotes
could be excluded from the calculation, with the trades continuing to
qualify for an allocation of a Trading Share. Comment is requested on
whether either of these alternatives would be appropriate, and also on
any other alternatives that would more appropriately reflect the
charging of access fees.
D. Plan Governance
The Commission is proposing an amendment to the Plans that would
broaden participation in their governance (``Governance Amendment'').
Currently, operating committees, composed of one representative from
each SRO participant, govern the Plans.\293\ In addition, the Networks
have an administrator and a processor. For Network A, the administrator
is the NYSE, and the processor is SIAC. For Network B, the
administrator is Amex, and the processor is SIAC. For Network C, the
current administrator and processor is Nasdaq.\294\
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\293\ See generally Advisory Committee Report, supra note 275,
section III, which includes a full description of the Plans' terms
and governance, as well as the operation of the Networks.
\294\ See Securities Exchange Act Release No. 43863 (Jan. 19,
2001), 66 FR 8020 (extension of Nasdaq UTP Plan was conditioned on,
among other things, bona fide competitive bidding for Nasdaq UTP
Plan processor).
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The Advisory Committee on Market Information recommended a number
of changes to the governance of the Plans and operation of the
Networks, including the creation of non-voting advisory committees to
the Plans that would broaden participation in their governance.\295\
The Commission agrees that advisory committees potentially would
improve Plan governance. In particular, the committees would help
assure that the views of interested parties other than SROs have an
opportunity to be heard on Plan matters, and that their views are heard
prior to any decision on a matter by the Plan's operating committee.
Earlier and more broadly based participation could contribute to the
ability of the Plans to achieve a consensus on disputed issues.
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\295\ Advisory Committee Report, supra note 275, section
VII.3.B. The Advisory Committee also recommended (1) enhanced
industry efforts to streamline Plan administration, particularly the
administration of vendor and subscriber contracts, and (2) mandatory
competitive bidding for Network processors. The Commission agrees
that efforts to enhance the efficiency of Plan administration should
be encouraged, and believes that the proposal to broaden Plan
governance could help assure that the Plans continue their
cooperative efforts with the industry to streamline administration.
The Commission does not believe, however, that the potential
benefits currently would justify the costs of mandating periodic
competitive bidding for Network processors. The Plans already
provide for periodic evaluation of the processor and for replacement
if its performance is unsatisfactory. Moreover, the Commission
itself has authority, if necessary, to require a change of processor
by initiating a Plan amendment.
The Advisory Committee considered, but did not recommend,
changing the unanimous vote requirements currently included in the
Plans. Although they vary somewhat in their particulars, the Plans
generally require that significant matters, such as amendments to a
Plan and reductions in fees, be approved by all of the Plan's SRO
participants. On disputed matters, this requirement sometimes can
result in gridlock. Eliminating the unanimous vote requirement would
facilitate more flexible Plan decision-making, but also potentially
would allow SROs that collectively represent only a minority of
trading in Plan securities to dictate policy affecting all of the
SROs. The Commission has decided not to propose an amendment to the
Plans' unanimous vote requirements at this time, but requests
comment on whether they should be modified in any respect.
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Paragraph (b) of the Governance Amendment sets forth requirements
for composition of the advisory committees. Members would be selected
for two-year
[[Page 11184]]
terms to allow sufficient time for them to gain familiarity with Plan
business. The operating committee of a Plan would select, by majority
vote, at least one representative from each of the following five
categories: (1) A broker-dealer with a substantial retail investor
customer base, (2) a broker-dealer with a substantial institutional
investor customer base, (3) an ATS, (4) a data vendor, and (5) an
investor. In addition, each SRO participant would have the right to
select one committee member that is not employed by or affiliated with
any participant.
Paragraphs (c) and (d) of the Governance Amendment set forth the
function of an advisory committee and the requirements for its
participation in Plan affairs. The function of an advisory committee is
to assure that its members have an opportunity to submit their views to
the operating committee on Plan matters, prior to any decision by the
operating committee. Such Plan matters would include, but not be
limited to, new or modified products, fees, procedures for fee
administration, and pilot programs. To enable the advisory committee
members to perform their function properly, members would have the
right to attend regular meetings of the operating committee and to
receive any information relating to Plan business that was provided to
members of the operating committee. The operating committee would
retain the power, however, to meet in executive session if, by majority
vote, it determined that an item of business required confidential
treatment.
The Commission requests comment on whether the proposed advisory
committees would achieve the goal of broadening participation in Plan
matters in a useful way. Should the enumerated five categories of
parties interested in Plan matters be expanded to include others? Does
a two-year term afford members a sufficient time to gain familiarity
with Plan business, without being so long that it deters individuals
from participating? Comment also is requested on whether the types of
Plan matters on which an advisory committee is entitled to submit views
should be more specifically enumerated. Finally, is it useful and
appropriate to allow advisory committee members to attend meetings of
the operating committee and receive operating committee information
(subject to the confidential treatment exception)? If the operating
committee meets in executive session, should the Plan specify what the
advisory committee must be informed about the business conducted at
such session?
E. Proposed Amendments to Rules 11Aa3-1 and 11Ac1-2
The Advisory Committee on Market Information recommended that the
Exchange Act rules governing distribution and display of market
information be modified in two respects. First, it believed that
individual market centers (including SROs, ATSs, and market makers)
should have the freedom to distribute their own market data
independently.\296\ Such data could include ``core information''--the
trades and best quotes of a market center--which would continue to be
transmitted to the Networks, but also additional information such as
depth of order book. This additional information has become
increasingly important as decimal trading has spread displayed depth
across a greater number of price points. Second, the Advisory Committee
recommended that the Commission should consider making the consolidated
display requirement more flexible, again in order to promote wider
distribution of data by individual market centers.\297\ The Commission
agrees and is proposing amendments to Exchange Act Rule 11Aa3-1
(proposed to be redesignated as Rule 601 of Regulation NMS) and
Exchange Act Rule 11Ac1-2 (proposed to be redesignated as Rule 603 of
Regulation NMS) to implement these recommendations. In addition, the
Commission is adding a consolidation requirement to Rule 11Ac1-2
(proposed to be redesignated as Rule 603) to make explicit in an
Exchange Act rule what is currently the case in fact--all SROs must act
jointly through NMS plans to disseminate consolidated market
information in NMS Stocks to the public.
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\296\ Advisory Committee Report, supra note 275, section
VII.B.2.
\297\ Advisory Committee Report, supra note 275, section
VII.B.1.
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1. Independent Distribution of Information
Currently, paragraphs (c)(2) and (c)(3) of Rule 11Aa3-1 (proposed
to be redesignated as Rule 601) prohibit SROs and their members from
disseminating their trade reports independently.\298\ Under the
proposed amendment to the Rule, these paragraphs would be rescinded.
Members of an SRO would continue to be required to transmit their
trades to the SRO (and SROs would continue to transmit trades to the
Networks pursuant to the Plans), but such members also would be free to
distribute their own data independently, with or without fees.
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\298\ Regulation NMS would remove the definitions in current
paragraph (a) of Rule 11Aa3-1 and place them in Rule 600. Current
subparagraphs (c)(2) and (c)(3) of Rule 11Aa3-1 are proposed to be
rescinded. As a result, current subparagraph (c)(4) of current Rule
11Aa3-1 would be redesignated as subparagraph (b)(2) of Rule 601.
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Although current rules do not prohibit the independent distribution
of quotes, they do not establish standards for such distribution.
Paragraph (a) of the proposed amendment to Rule 11Ac1-2 (proposed to be
redesignated as Rule 603) establishes uniform standards for
distribution of both quotes and trades that would create an equivalent
regulatory regime for all types of market centers. First, paragraph
(a)(1) of the proposed amendment requires that any market information
\299\ distributed by an exclusive processor, or by a broker or dealer
(including ATSs and market makers) that is the exclusive source of the
information, be made available to securities information processors on
terms that are fair and reasonable. Paragraph (a)(2) of the proposed
amendment requires that any SRO, broker, or dealer that distributes
market information must do so on terms that are not unreasonably
discriminatory. These requirements would prohibit, for example, a
market center from distributing its data independently on a more timely
basis than it makes available the ``core data'' that is required to be
disseminated through a Network processor. With respect to non-core
data, however, the Commission preliminarily believes that market
centers should have considerable leeway in determining whether, or on
what terms, they provide non-core data to a Network processor. Such an
entity may be in a unique competitive position. As Network processor,
it acts on behalf of all markets in disseminating consolidated
information, yet it also may be closely associated with the competitor
of a market center. Comment is requested on this issue.\300\
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\299\ The information covered by the proposed amendment tracks
the language of Section 11A(c) of the Exchange Act, which applies to
``information with respect to quotations for or transactions in''
securities. This statutory language encompasses a broad range of
information, including information relating to limit orders held by
a market center. See, e.g., S. Report No. 94-75, 94th Cong., 1st
Sess. 9 (1975) (``In the securities markets, as in most other active
markets, it is critical for those who trade to have access to
accurate, up-to-the-second information as to the prices at which
transactions in particular securities are taking place (i.e., last
sale reports) and the prices at which other traders have expressed
their willingness to buy or sell (i.e., quotations).''); H.R. Report
No. 94-229, 94th Cong., 1st Sess. 93 (1975) (Section 11A grants
Commission ``pervasive rulemaking power to regulate securities
communications systems'').
\300\ Comment also is requested on the issue of whether and, if
so, on what terms Network processors should be required to
disseminate non-core data on behalf of market centers. The Nasdaq
UTP Plan, for example, indicates that the Network C operating
committee has determined that the entity succeeding Nasdaq as
processor should have the ability to disseminate the depth of book
information that a participant voluntarily provides, subject to the
costs of such dissemination being borne exclusively by the
participant.
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[[Page 11185]]
The ``fair and reasonable'' and ``not unreasonably discriminatory''
requirements are derived from the language of Section 11A(c) of the
Exchange Act. Under Section 11A(c)(1)(C), the more stringent ``fair and
reasonable'' requirement is applicable to an ``exclusive processor,''
which is defined in Section 3(a)(22)(B) as an SRO or other entity that
distributes the market information of an SRO on an exclusive basis. The
proposed amendment would extend this requirement to non-SRO market
centers when they act in functionally the same manner as exclusive
processors and are the exclusive source of their own data. Applying
this requirement to non-SROs is consistent with Section 11A(c)(1)(F),
which grants the Commission rulemaking authority to ``assure equal
regulation of all markets'' for NMS Securities.\301\
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\301\ See also Section 11A(a)(1)(C) of the Exchange Act (two of
the five principal objectives for the NMS are (1) the availability
to broker, dealers, and investors of market information, and (2)
fair competition among brokers and dealers, among exchange markets,
and between exchange markets and markets other than exchange
markets.
---------------------------------------------------------------------------
The Commission requests comment on the proposed authorization of
independent distribution of information by market centers, and on the
standards applicable to such distribution. In particular, would the
authorization successfully lead to the public dissemination of more
market information? If more, would the standards help to assure that
the information is made available on terms that further the objectives
of the NMS? Alternatively, would the standards potentially reduce the
information that is disseminated?
2. Consolidation of Information
All of the SROs currently participate in Plans that provide for the
dissemination of consolidated information for the NMS Stocks that they
trade.\302\ The Plans were adopted in order to enable the SROs to
comply with Exchange Act rules regarding the reporting of trades and
distribution of quotes. With respect to trades, current paragraph (b)
of Rule 11Aa3-1 (proposed to be redesignated as Rule 601) requires each
SRO to file transaction reporting plans that specify, among other
things, how its transactions are to be consolidated with the
transactions of other SROs. With respect to quotes, current paragraph
(b)(1) of Rule 11Ac1-1 (proposed to be redesignated as Rule 602)
requires an SRO to establish procedures for making its best quotes
available to vendors.
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\302\ See generally Advisory Committee Report, supra note 275,
section III.B (description of current market data arrangements).
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To confirm by Exchange Act rule that both existing and any new SROs
will be required to continue to participate in such joint-SRO plans,
paragraph (b) of the proposed amendment to Rule 11Ac1-2 (proposed to be
redesignated as Rule 603) would require SROs to act jointly pursuant to
one or more NMS plans to disseminate consolidated information for NMS
Stocks. Such consolidated information must include an NBBO that is
calculated in accordance with the definition set forth in proposed Rule
600.\303\ In addition, the NMS plans must provide for the dissemination
of all consolidated information for an individual NMS Stock through a
single processor. Thus, different processors are permitted to
disseminate information for different NMS Stocks (e.g., SIAC for
Network A stocks, and Nasdaq for Network C stocks), but all quotes and
trades in a stock must be disseminated through a single processor. As a
result, information users, particularly retail investors, can obtain
data from a single source that reflects the best quotes and most recent
trade price for a security, no matter where such quotes and trade are
displayed in the NMS. Comment is requested on these consolidation
requirements.
---------------------------------------------------------------------------
\303\ Rule 600 of proposed Regulation NMS defines ``national
best bid and national best offer.''
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3. Display of Consolidated Information
Paragraph (c) of the proposed amendment to Rule 11Ac1-2 (proposed
to be redesignated as Rule 603) would substantially revise the
consolidated display requirement. In general, the Rule currently
requires that vendors and broker-dealers, if they provide any display
of market information for an NMS Stock, also must provide a
consolidated display that encompasses information from all the market
centers that trade the stock. The proposed amendment would retain this
core requirement, but would (1) reduce the information that must be
included in a consolidated display, (2) narrow the range of contexts
that trigger the consolidated display requirement, and (3) generally
streamline the Rule's language.
Rule 11Ac1-2 (proposed to be redesignated as Rule 603) often can
require the display of a complete montage of quotes from all reporting
market centers trading a security, even though the prices of some of
these quotes may be far away from the current NBBO. The new definition
of ``consolidated display'' (set forth in Rule 600 of proposed
Regulation NMS) would eliminate this montage requirement and simply
require a consolidated display that is limited to the prices, sizes,
and market center identifications of the NBBO, along with the most
recent last sale information. Beyond disclosure of this basic
information, market forces, rather than regulatory requirements, would
be allowed to determine what, if any, additional data from other market
centers is displayed. In particular, investors and other information
users ultimately could decide whether they needed additional
information in their displays.
Also, Rule 11Ac1-2 (proposed to be redesignated as Rule 603)
currently requires a consolidated display in a broad range of contexts.
Vendors must provide a consolidated display whenever they provide any
market information to broker-dealers, and broker-dealers are prohibited
from operating or maintaining a display that a vendor would not be
permitted to provide. Under paragraph (c)(1) of the proposed amendment
to the Rule, a consolidated display would be required only when it is
most needed--a context in which a trading or order-routing decision
could be implemented. For example, the consolidated display requirement
would continue to cover broker-dealers who provide on-line data to
their customers in software programs from which trading decisions can
be implemented. Similarly, the requirement would continue to apply to
vendors who provide displays that facilitate order routing by broker-
dealers. It would not apply, however, when market data are provided on
a purely informational website that does not offer any trading or
order-routing capability.\304\
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\304\ The proposed amendment would retain the exemptions
currently set forth in current Rule 11Ac1-2(f) (proposed to be
redesignated as Rule 603(c)(2)) for exchange and market linkage
displays. The current exemption for displays used by SROs for
monitoring or surveillance purposes would no longer be necessary
because of the limitation of the proposed amendment to trading and
order-routing contexts.
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Finally, Rule 11Ac1-2 (proposed to be redesignated as Rule 603)
currently imposes specific ``keystroke retrieval'' requirements for
accessing consolidated information. The proposed amendment simply would
require that consolidated data be made available in an equivalent
[[Page 11186]]
manner as other data. In addition, the Rule contains a variety of other
provisions that appear to be no longer necessary. These include
requirements relating to moving tickers, categories of market
information, and representative bids and offers (current paragraphs
(b)(2)(iv) and (v) and paragraphs (c)(2)(iv) and (vi)). Such
requirements are deleted in the proposed amendment.
The Commission requests comment on the revision of the consolidated
display requirement set forth in the proposed amendment to Rule 11Ac1-2
(proposed to be redesignated as Rule 603). Would the proposal achieve
its goal of giving investors, particularly retail investors, the
information they need to make informed trading decisions and to
evaluate whether brokers attain best execution of their orders? Comment
also is requested on whether the proposed amendment adequately
identifies those contexts in which the consolidated display should
apply.
F. General Request for Comment
The Commission is soliciting comment on the proposed amendments to
the Plans and to Rules 11Aa3-1 and 11Ac1-2 (proposed to be redesignated
as Rules 601 and 603) relating to the dissemination of market data, as
discussed above. Interested persons are invited to submit written
presentations of views, data, and arguments concerning the proposed
amendments, including the feasibility and practicality of implementing
the proposed changes. Commenters are also invited to provide comments
on whether the Commission should adopt an alternative model for
disseminating market data to the public. Finally, the Commission
requests comment on whether, if it were to adopt the proposed
amendments, a phase-in period would be necessary or appropriate to
allow market participants time to adapt to their provisions. If so,
what aspect(s) of the proposed amendments should be phased-in, and what
would be the appropriate phase-in period?
G. Paperwork Reduction Act
The proposed amendments to the Plans and to Rules 11Aa3-1 and
11Ac1-2 (proposed to be redesignated as Rules 601 and 603) do not
impose recordkeeping or information collection requirements, or other
collections of information that require approval of the Office of
Management and Budget under 44 U.S.C. 3501, et seq. Accordingly, the
Paperwork Reduction Act does not apply.
H. Consideration of Costs and Benefits
1. Introduction
The Commission proposes to amend rules relating to the
dissemination of market data to the public. In particular, the
Commission proposes to amend three joint-industry plans--the CTA Plan,
the CQ Plan, and the Nasdaq UTP Plan--to modify current formulas for
the allocation of Plan net income to the SROs. In addition, the
Commission proposes to broaden Plan governance by amending the Plans to
require the establishment of a non-voting advisory committee comprised
of interested parties other than SROs. The Commission also proposes to
rescind the current prohibition in Rule 11Aa3-1 under the Exchange Act
(proposed to be redesignated as Rule 601 of Regulation NMS)\305\ on
SROs and their members from independently disseminating their own trade
reports. Furthermore, the Commission proposes to amend Rule 11Ac1-2
under the Exchange Act (proposed to be redesignated as Rule 603 of
Regulation NMS)\306\ to incorporate uniform standards pursuant to which
market centers, including ATSs and market makers, that contribute to
consolidated information may also independently distribute their own
trade reports and quotes. The Commission further proposes to amend Rule
11Ac1-2 (proposed to be redesignated as Rule 603) to make explicit that
all SROs must act jointly through the Plans and through a single
processor per security to disseminate consolidated market information
in NMS Stocks to the public. Finally, the Commission proposes to
streamline and simplify the requirements in Rule 11Ac1-2 (proposed to
be redesignated as Rule 603), including the data required to be
displayed under the Rule, as well as limiting the range of the Rule to
the display of market data in trading and order-routing contexts.
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\305\ 17 CFR 240.11Aa3-1.
\306\ 17 CFR 240.11Ac1-2.
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The Commission has identified below certain costs and benefits
relating to proposed amendments to the Plans and to Rules 11Aa3-1 and
11Ac1-2 (proposed to be redesignated as Rules 601 and 603). The
Commission requests comments on all aspects of this cost-benefit
analysis, including identification of any additional costs and/or
benefits of the proposed amendments. The Commission encourages
commenters to identify and supply any relevant data, analysis, and
estimates concerning the costs and/or benefits of the proposed
amendments.
2. Proposed New Net Income Allocation Formula
a. Benefits
The Commission preliminarily believes that modifying the current
formulas for allocating distributable net income under the Plans would
be beneficial to the marketplace because the new allocation formula
would reward markets for the value of their quotes and would reduce the
economic and regulatory distortions caused by the current formulas.
Under the current formulas, the allocation of Plan net income is based
on the number or share volume of an SRO's reported trades. Although
quotes are disseminated by the Networks, these current trade-based
formulas do not reward those market centers that generate quotes with
the best prices and the largest sizes that are an important source of
public price discovery. These current formulas also have encouraged
certain SROs to operate as ``print facilities'' that award percentage
rebates to ATSs and market makers that agree to report their trades
through the SRO in order to obtain a larger share of market data
revenues. The current formulas have resulted in some market
participants distorting trade reporting to obtain more market data
revenues by engaging in wash sales or by ``shredding'' their total
trade volume into the smallest trade sizes. The Commission
preliminarily believes the proposed new allocation formula would
address these problems raised by the current formulas, thereby
benefiting the NMS as a whole.
The proposed new allocation formula would be a two-step process.
The Security Income Allocation would be the initial step of the
process, when a Network's distributable net income would be allocated
among the individual securities included in the Network's data stream
based on the square root of the dollar volume of trading in each
security. The benefit of allocating the net income in this manner is
that the initial allocation would take into account the level of
trading activity in each security, while adjusting for the
disproportionate level of trading in the very top tier of NMS
Securities.
Following the initial distribution of net income, the next step in
the process would be to allocate the net income of an individual
security among the SROs that trade the security based on three criteria
that account for each SRO's trading and quoting activity. Specifically,
fifty percent of the net income allocated to a particular security
(subject to a cap of $2 per qualified transaction report) would be
allocated to SROs based on their dollar volume of
[[Page 11187]]
trading and number of qualified transactions--i.e., those transactions
that have a dollar volume of $5,000 or greater. This ``Trading Share''
criterion is intended to reward those SROs that actively trade in the
security, thereby providing liquidity and price discovery, while
setting a minimum qualifying trade size to reduce the potential for
shredding of trade volume. In addition, thirty-five percent of the net
income allocated to a particular security would be allocated to SROs
based on credits earned for the time and size of their quotes (during
regular trading hours) at the NBBO. This ``Quoting Share'' criterion is
intended to reward markets whose quotes frequently equal the best
prices and for the largest sizes. Finally, fifteen percent of the net
income allocated to a particular security would be allocated to SROs
based on credits earned for their qualifying quotes (during regular
trading hours) that improve the price of the NBBO. An SRO would earn
credit for the dollar volume of its qualifying quote if the price of
the quote were displayed for five seconds and for the dollar volume of
any trades reported at the price of the qualifying quote while it is
displayed at the NBBO or up to five seconds after it is no longer equal
to the NBBO. This ``NBBO Improvement Share'' criterion is intended to
reward aggressive quoting that improves the NBBO price. The benefit of
these broad-based measures for the allocation of net income to the SROs
is that they would reward an SRO for its overall contribution of both
quotes and trades, while potentially reducing the incentive for
distortive trade reporting practices. In addition, investors would
benefit because these broad-based measures should enhance price
discovery. The Commission therefore preliminary believes that the
proposed new allocation formula would be beneficial to those SROs that
provide the highest quality information--that contributes to price
discovery--by rewarding them with a larger portion of Plan net income.
b. Costs
The Commission recognizes that there could be potential costs
associated with modifying the current formulas for allocating Plan net
income. These formulas have been used since the creation of the
Networks in the 1970s. The SROs and the Network processors--SIAC and
Nasdaq--have become familiar with the formulas for purposes of
allocating net income and structuring their businesses. The Network
processors would need to learn the details of a new allocation formula
and to consider SRO quotes, in addition to reported trades, as a
measure for allocating net income.
The proposed new allocation formula is also more complex than the
current formulas in the Plans. Network processors, or some other entity
retained by the Networks, would be required to develop a program that
would calculate the Trading Shares, Quoting Shares, and NBBO
Improvement Shares of Network participants.
Finally, some SROs are likely to be allocated a smaller portion of
Plan net income under the proposed new allocation formula than they
would have received under the current formulas, while other SROs would
receive a larger portion of net income. This would be the result if
certain SROs are currently reporting a large number of trades or share
volume of trades, but are not necessarily providing the best quotes or
trades with larger sizes. In addition, SROs that receive a smaller
portion of the net income may need to generate additional funds with
which to operate and regulate their markets.
3. Plan Governance
a. Benefits
The Commission preliminarily believes that the proposed amendments
to the Plans requiring the Plan participants to establish an advisory
committee would enhance the NMS. Currently, a representative of each
SRO participating in a Plan is a member of the operating committee that
governs that Plan. The proposed amendments to the Plans would require
the establishment of a non-voting advisory committee comprised solely
of persons not employed by or affiliated with a Plan participant. The
proposed amendments would broaden, and accordingly should improve,
participation in the governance of the Plans.
The proposed amendments would require the Plan participants to
select the members of the advisory committee comprised, at a minimum,
of one or more representatives associated with (1) a broker-dealer with
a substantial retail investor base, (2) a broker-dealer with a
substantial institutional investor customer base, (3) an ATS, (4) a
data vendor, and (5) an investor. In addition, each Plan participant
would be entitled to select an additional committee member. The
Commission preliminarily believes that the composition of the advisory
committee should give interested parties other than the SROs a voice in
matters that affect them. These members of the advisory committee would
have the right to submit their views to the operating committee on Plan
business (other than matters determined to be confidential by a
majority of Plan participants), prior to any decision made by the
operating committee, and would have the right to attend operating
committee meetings. Broader participation in the Plans through the
establishment of an advisory committee would be beneficial to the
administration of the Plans because it could promote the formation of
industry consensus on disputed issues.
b. Costs
The proposed amendments to the Plans could potentially result in
costs to the Plan participants. Participants would be required to
engage in a selection process for purposes of establishing an advisory
committee. A Plan's operating committee as a whole would be required to
select a minimum of five committee members. Each Plan participant would
then have the right to select one committee member. This selection
process could potentially result in added costs and administrative
burden and expense to the Plan participants.
Another potential cost of the proposed Plan amendment requiring the
establishment of an advisory committee could be disruption of the
current governance of the Plans by their participants. Since the
creation of the Plans, representatives from the SROs have been the sole
participants in the Plans and have been responsible for their
administration. The additional participation of non-SRO parties could
increase the difficulty of reaching consensus on Plan business.
4. Proposed Amendments to Rules 11Aa3-1 and 11Ac1-2
a. Independent Distribution of Information
i. Benefits
The Commission proposes to amend Rule 11Aa1-3 (proposed to be
redesignated as Rule 601) to rescind the prohibition on SROs and their
members from distributing their own transaction reports and last sale
data outside of the Plans.\307\ Rescission of this prohibition would
allow market centers, including ATSs and market makers, that contribute
to consolidated information to also distribute their market data
independently of the Networks. In addition to the data that market
centers are required to provide to the Networks, the rescission would
allow market
[[Page 11188]]
centers to independently distribute other market data, such as depth of
the limit order book. Such information could be beneficial to investors
and other information users because it has become increasingly
important as decimal trading has spread displayed depth across a
greater number of price points. Market centers may also benefit from
additional revenues if they chose to charge a fee for the independent
distribution of their market data information.
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\307\ Although current rules do not also prohibit the
independent distribution of quotation information, the rules do not
provide standards for such distribution.
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The Commission also proposes to add new provisions to Rule 11Ac1-2
(proposed to be redesignated as Rule 603) to establish uniform
standards for the distribution of market data. Uniform standards would
be beneficial to the marketplace because they would create an
equivalent regulatory regime for all types of market centers. The
proposed standards would require an exclusive processor, or a broker or
dealer with respect to information for which it is the exclusive
source, that distributes quote and transaction information in an NMS
Stock to a securities information processor (``SIP'') to do so on terms
that are fair and reasonable. In addition, those SROs, brokers, or
dealers that distribute such information to a SIP, broker, dealer, or
other persons would be required to do so on terms that are not
unreasonably discriminatory. Furthermore, these proposed uniform
standards are based, in part, on similar requirements found in Sections
3 and 11A of the Exchange Act \308\ for SROs and entities that
distribute SRO information on an exclusive basis. The Commission
preliminarily believes that extending these requirements to non-SRO
market centers, including ATSs and market makers, would help assure
equal regulation of all markets that trade NMS Stocks.
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\308\ 15 U.S.C. 78c and 15 U.S.C. 78k-1.
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ii. Costs
The Commission recognizes that the proposed rescission of the
prohibition on independent distribution of trade reports under Rule
11Aa3-1 (proposed to be redesignated as Rule 601) could potentially
lead to market centers incurring costs associated with the independent
distribution of their market data if they choose to distribute such
data without charging a fee. In addition, investors may have to pay for
additional data if market centers choose to charge a fee for the
additional data. Furthermore, if market centers choose to distribute
their own quotation information, this could potentially result in one
market center's data becoming more or less valuable than another market
center's data, and thereby increase or reduce that market center's
overall income.
b. Consolidation of Information
i. Benefits
The Commission proposes to amend Rule 11Ac1-2 (proposed to be
redesignated as Rule 603) to make explicit that all SROs must act
jointly through the Plans to disseminate consolidated market
information, including an NBBO, in NMS Stocks to the public. All SROs
currently participate in Plans that provide for the dissemination of
consolidated transaction and quotation information for the NMS Stocks
that they trade. The proposed amendment to the Rule would provide the
benefit of clarifying that all SROs--whether existing or new--would be
required to participate jointly in one or more Plans to disseminate
consolidated information in NMS Stocks. The proposed amendment would
also require that all quote and trade information for an individual NMS
Stock be disseminated through a single processor (currently, SIAC or
Nasdaq). The Commission preliminarily believes that requiring a single
processor for a particular security should help to ensure that
investors continue to receive the benefits of obtaining consolidated
information from a single source.
ii. Costs
The Commission does not foresee any costs associated with this
particular proposed amendment to Rule 11Ac1-2 (proposed to be
redesignated as Rule 603), and, specifically, requests comment on
whether amending the Rule to require explicitly what is current
practice among the SROs regarding the consolidated dissemination of
information through the Plans and through a single processor would
result in any costs or burdens on the SROs or on any other entities.
c. Display of Consolidated Information
i. Benefits
The Commission proposes to amend Rule 11Ac1-2 (proposed to be
redesignated as Rule 603) in order to streamline the current
requirements and to ease the burden of compliance. Currently, the Rule
requires data vendors and broker-dealers that provide any display of
market data in a particular security to provide a consolidated display
of data from all of the market centers that trade the security. The
Commission proposes to retain this core requirement, but proposes to
streamline the data required to be displayed, reduce the range of the
contexts in which the Rule would apply, and amend the Rule's language
to clarify certain provisions and to rescind unnecessary provisions.
In particular, the Commission proposes to limit the scope of the
consolidated display requirement. The proposed amendment to Rule 11Ac1-
2 (proposed to be redesignated as Rule 603) would eliminate the burden
on vendors and broker-dealers to display a complete montage of quotes
from all market centers trading a particular security, which would
include the price of quotes that may be far away from the current NBBO.
Vendors and broker-dealers would therefore benefit from this reduced
consolidated display requirement. Furthermore, they, as well as other
persons (including investors and other information users), would have
the ability to decide what, if any, additional data from other market
centers beyond this basic disclosure to display.
The Commission also proposes to amend the Rule to limit the
consolidated display requirement to market data provided in a context
in which a trading or order-routing decision could be implemented.
Currently, the Rule applies broadly to any displays of market data
provided by a vendor to a broker-dealer and to any displays of market
data provided by a broker-dealer. This proposed amendment to the Rule
would allow vendors and broker-dealers to display market data without
having to comply with the consolidated display requirement so long as
they are not displaying it in a trading or order routing context. For
example, under the proposed amendment, if market data is provided on a
purely informational website and does not offer any trading or order-
routing capabilities, then the vendor displaying such data would not be
required to comply with the consolidated display requirement for
purposes of displaying that data. Vendors and broker-dealers would
benefit from a reduction in their consolidated display obligations
under this proposed amendment, while still providing investors with
useful information.
The Commission also proposes to amend Rule 11Ac1-2 (proposed to be
redesignated as Rule 603) to simply the rule language to require that
consolidated data be made available in an equivalent manner as other
data and to rescind unnecessary provisions in order to update the
Rule.\309\ Together,
[[Page 11189]]
these proposed amendments should benefit broker-dealers and vendors by
making compliance with the Rule easier and more efficient.
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\309\ The provisions to be rescinded would include requirements
relating to moving tickers, categories of market information, and
representative bids and offers.
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ii. Costs
A potential cost attributable to the proposed amendment to Rule
11Ac1-2 (proposed to be redesignated as Rule 603) could be that there
may be individuals who use the displayed montage of quotes from all
market centers trading a particular security. If the proposed amendment
were adopted, and vendors and broker-dealers determined not to display
this additional information, these investors would be required to
obtain the additional data at additional cost.
The proposed amendment to the Rule could also potentially result in
an administrative cost or burden for vendors and broker-dealers that
would be required to assess in what circumstances they are displaying
market data information for trading and order-routing purposes and in
what circumstances they are displaying such information for other
purposes. The Commission preliminarily believes that such a cost would
be minimal.
I. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act \310\ requires the Commission,
whenever it engages in rulemaking, and is required to consider or
determine if an action is necessary or appropriate in the public
interest, also to consider whether the action will promote efficiency,
competition, and capital formation. Section 23(a)(2) of the Exchange
Act \311\ requires the Commission, in adopting rules under the Exchange
Act, to consider the impact that any such rule would have on
competition. Section 23(a)(2) of the Exchange Act prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
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\310\ 15 U.S.C. 78c(f).
\311\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
The proposed amendments to the Plans to implement a new net income
allocation formula should help to promote efficiency in the marketplace
by eliminating incentives for market participants to distort trade
reporting under the current formulas by engaging in wash trades and by
eliminating incentives for market participants to ``shred'' their total
trade volume in order to obtain market data revenues. In addition, the
proposed amendments to the Plans to establish an advisory committee
should promote efficiency in the administration of the Plans by
allowing interested parties other than SROs to have a voice in the
governance of such Plans, which could contribute to the resolution of
potential disputes that the Plan participants would otherwise bring
before the Commission. Furthermore, the proposed amendments to Rule
11Ac1-2 (proposed to be redesignated as Rule 603) should promote
efficiency and competition among market centers by helping to assure
that independently reported trade and quote information is distributed
on terms that are fair and reasonable and not unreasonably
discriminatory. The proposed amendment to amend Rule 11Ac1-2 (proposed
to be redesignated as Rule 603) should also promote efficiency in the
dissemination of consolidated market information by requiring that all
SROs act jointly through the Plans to disseminate such information to
the public.
The proposed amendments to the Plans to modify the current net
income allocation formulas and to establish an advisory committee
should assist capital formation through a more appropriate allocation
of the Networks' net income to those who contribute most to public
price discovery, and by potentially minimizing costs that may arise
from having to resolve disputes relating to the administration of the
Plans through broader representation. The proposed amendments to Rule
11Ac1-2 (proposed to be redesignated as Rule 603) would also eliminate
the requirement to display a complete montage of quotes from all market
centers and should therefore promote capital formation by reducing the
costs to vendors and broker-dealers that are currently required to
display quotes that may be far away from the NBBO.
The Commission preliminarily believes that the proposed amendments
to the Plans and to Rules 11Aa3-1 and 11Ac1-2 (proposed to be
redesignated as Rules 601 and 603) would not impose any competitive
burden that is not necessary and appropriate in furtherance of the
purposes of the Exchange Act. In fact, the proposed new allocation
formula should provide for a more useful distribution of net income by
rewarding market centers for the quality of their quotes in addition to
their reported trades. The proposed amendments to the Plans to
establish an advisory committee should also enhance and promote
competition by broadening governance of the Plans to include other non-
SRO parties. Furthermore, the proposed amendments to Rules 11Aa3-1 and
11Ac1-2 (proposed to be redesignated as Rules 601 and 603) should
lessen the burden on vendors and broker-dealers from having to comply
with certain consolidated display requirements, and should engender
competition among market centers that contribute to consolidated
information that also choose to independently distribute their own
market data. In addition, the proposed amendment providing that all
SROs consolidate information in each NMS Stock and disseminate such
information through a single processor per security should clarify that
SROs are on an equal competitive footing with each other. Thus, the
Commission preliminarily believes that the proposed amendments should
enhance rather than burden competition by creating a more equal
competitive environment for market centers and others.
The Commission requests comment on the proposed amendments' effects
on the economy as a whole, and more specifically, how the proposed
amendments to the Plans and to Rules 11Aa3-1 and 11Ac1-2 (proposed to
be redesignated as Rules 601 and 603) are expected to affect
efficiency, competition, and capital formation. The Commission requests
that, if possible, commenters provide empirical data as well as factual
support for their views.
J. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \312\ the Commission must advise the Office
of Management and Budget as to whether the proposed regulation
constitutes a ``major'' rule. Under SBREFA, a rule is considered
``major'' where, if adopted, it results or is likely to result in:
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\312\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified
in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C.
601).
---------------------------------------------------------------------------
An annual effect on the economy of $100 million
or more (either in the form of an increase or a decrease);
A major increase in costs or prices for
consumers or individual industries; or
Significant adverse effect on competition,
investment or innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. The Commission requests
comment on the potential impact of the proposed amendments on the
economy on an annual basis. Commenters are requested
[[Page 11190]]
to provide empirical data and other factual support for their view to
the extent possible.
K. Regulatory Flexibility Act Certification and Initial Regulatory
Flexibility Analysis
1. Regulatory Flexibility Act Certification for the Proposed Amendments
to the Plans
The Commission hereby certifies, pursuant to 5 U.S.C. 603(b), that
the proposed amendments to the Plans, if adopted, would not have a
significant economic impact on a substantial number of small entities.
The proposed amendments to the Plans imposing a new net income
allocation formula would only impact the SROs,\313\ SIAC (the processor
for the CTA Plans and the CQ Plan), and Nasdaq (the processor for the
Nasdaq UTP Plan). The proposed amendments to the Plans requiring the
establishment of an advisory committee would apply only to Plan
participants. SIAC and Nasdaq would not be considered ``small
entities'' for purposes of the Regulatory Flexibility Act.\314\ The
Plan participants are either national securities exchanges or a
national securities association and, as such, are not small
entities.\315\ Accordingly, the Commission does not believe that the
proposed amendments to the Plans would have a significant economic
impact on a substantial number of small entities.
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\313\ Paragraph (e) of Exchange Act Rule 0-10 provides that the
term ``small entity,'' when referring to an exchange, means any
exchange that has been exempted from the reporting requirements of
17 CFR 240.11Aa3-1 and is not affiliated with any person that is not
a small entity. Under this standard, none of the exchanges affected
by the proposed rule is a small entity. Similarly, the national
securities association affected by the proposed rule is not small
entity as defined by 13 CFR 121.201.
\314\ See 17 CFR 240.0-10(g).
\315\ See 17 CFR 240.0-10(e).
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The Commission encourages written comments regarding this
certification. The Commission requests that commenters describe the
nature of any impact on small entities and provide empirical data to
support the extent of the impact.
2. Initial Regulatory Flexibility Analysis for Proposed Amendments to
Rules 11Aa3-1 and 11Ac1-2
This Initial Regulatory Flexibility Act Analysis has been prepared
in accordance with 5 U.S.C. 603. It relates to the proposed amendment
to Rules 11Aa3-1 and 11Ac1-2 under the Exchange Act (proposed to be
redesignated as Rules 601 and 603 of Regulation NMS).\316\
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\316\ 17 CFR 240.11Aa3-1 and 17 CFR 240.11Ac1-2.
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a. Reasons for the Proposed Action
The Commission believes that an overall modernization of the rules
for disseminating market data to the public is necessary to address
problems posed by the current market data rules. The Commission
proposes to retain the core elements of the current rules--price
discovery and mandatory consolidation--which provide important benefits
to investors and to others who use market information, while amending
other parts of the current rules that have resulted in serious economic
and regulatory distortions. More specifically, the Commission proposes
to amend the Rules 11Aa3-1 and 11Ac1-2 (proposed to be redesignated as
Rules 601 and 603) to lift certain restrictions in order to reduce the
burden on and to provide simplification and uniformity for those market
centers, broker-dealers, and data vendors that have to comply with
requirements under the Rules.
b. Objectives
The proposed amendments to Rules 11Aa3-1 and 11Ac1-2 (proposed to
be redesignated as Rules 601 and 603) are designed to fulfill several
objectives. First, the proposed amendment to Rule 11Aa3-1 (proposed to
be redesignated as Rule 601) is intended to provide market centers,
including ATSs and market makers, with flexibility to independently
distribute their own trade reports, aside from their obligation to
provide their trade reports to an SRO or to the Networks (depending on
the type of market center). Second, a prime objective of the proposed
amendments to Rule 11Ac1-2 (proposed to be redesignated as Rule 603) is
to provide uniform standards for all market centers, including non-SRO
market centers and entities that are exclusive processors of SRO market
data, for the independent distribution of market data. Third, the
objective of the proposed amendment to Rule 11Ac1-2 (proposed to be
redesignated as Rule 603) providing that all SROs act jointly through
the Plans and disseminate their consolidated information through a
single processor is to clarify the current practice among the SROs and
to require continued participation in the Plans and dissemination
through one processor per security. Fourth, an additional objective of
the proposed amendments to Rule 11Ac1-2 (proposed to be redesignated as
Rule 603) is to reduce consolidated display requirements on broker-
dealers and vendors and to limit their consolidated display obligations
to the disclosure of the NBBO and consolidated last sale information,
and to the display of market information in a trading or order-routing
context. Finally, the proposed amendments to Rule 11Ac1-2 (proposed to
be redesignated as Rule 603) are intended to ease the burden of
compliance by simplifying the current consolidated display requirements
under the Rule and by rescinding old provisions in the Rule that are
outdated and no longer necessary.
c. Legal Basis
The Commission proposes amendments to Rules 11Aa3-1 and 11Ac1-2
(proposed to be redesignated as Rules 601 and 603) pursuant to its
authority set forth in Sections 2, 3(b), 5, 6, 11A, 15, 15A, 17(a), 19,
23(a), and 36 of the Exchange Act, and Rules 11Aa3-2(b)(2) and 11Aa3-
2(c)(1) thereunder.\317\
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\317\ 15 U.S.C. 78b, 78c(b), 78e, 78f, 78k-1, 78o, 78o-3,
78q(a), 78s; 78w(a), and 78mm; 17 CFR 240.11Aa3-2(b)(2) and 17 CFR
240.11Aa3-2(c)(1).
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d. Small Entities Subject to the Rule
The proposed amendments to Rules 11Aa3-1 and 11Ac1-2 (proposed to
be redesignated as Rules 601 and 603) would affect ATSs, market makers,
broker-dealers, and SIPs that could potentially be small entities.
Paragraph (c) of Rule 0-10 under the Exchange Act \318\ defines the
term ``small business'' or ``small organization,'' when referring to a
broker-dealer, to mean a broker or dealer that 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, or if not required to file
such statements, it had total capital of less than $500,000 on the last
business day of the preceding fiscal year; and is not affiliated with
any person (other than a natural person) that is not a small business
or small organization. ATSs and market makers would be considered
broker-dealers for purposes of this definition. Paragraph (g) of Rule
0-10 \319\ defines the term ``small business'' or ``small
organization,'' when referring to a SIP, to mean a SIP that had gross
revenues of less than $10 million during the preceding fiscal year and
provided service to fewer than 100 interrogation devices or moving
tickers at all times during the preceding fiscal year; and is not
affiliated with any person (other than a natural person) that is not a
small business or small organization.
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\318\ 17 CFR 240.0-10(c).
\319\ 17 CFR 240.0-10(g).
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[[Page 11191]]
As of December 31, 2002, the Commission estimates that there are
approximately 880 registered broker-dealers, including ATSs and market
makers, and approximately 16 SIPs that would be considered small
entities. The Commission's proposed amendment to Rule 11Aa3-1 (proposed
to be redesignated as Rule 601) would enable small market centers,
including ATSs and market makers, that contribute to consolidated
information, if they so choose, to also independently distribute their
own trade reports. The Commission's proposed amendment to Rule 11Ac1-2
(proposed to be redesignated as Rule 603) would reduce the compliance
burden on small broker-dealers and SIPs by limiting the data required
to be consolidated and displayed under the Rule.\320\
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\320\ The proposed amendment to Rule 11Ac1-2 (proposed to be
redesignated as Rule 603), providing that all SROs act jointly
through the Plans and disseminate their consolidated information
through a single processor would only apply to the SROs, which are
not ``small entities'' for purposes of the Regulatory Flexibility
Act.
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The Commission requests comment on the number of small entities
that would be impacted by the proposed amendments, including any
available empirical data.
e. Reporting, Recordkeeping and Other Compliance Requirements
The proposed amendments to Rules 11Aa3-1 and 11Ac1-2 (proposed to
be redesignated as Rules 601 and 603) would not impose any new
reporting, recordkeeping or other compliance requirements on ATSs,
market makers, broker-dealers, and SIPs that are small entities. SROs
that would be subject to these proposed amendments would not be
considered small entities.
f. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no rules that duplicate,
overlap or conflict with the proposed amendments to Rules 11Aa3-1 and
11Ac1-2 (proposed to be redesignated as Rules 601 and 603).
g. Significant Alternatives
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objective,
while minimizing any significant adverse impact on small entities. In
connection with the proposed amendments, the Commission has considered
the following alternative models for disseminating market data to the
public: (1) A competing consolidators model under which each SRO would
be allowed to sell its market data separately to any number of
consolidators; (2) a rescission of the consolidated display requirement
and allowing all SROs and other market centers to distribute their
market data individually; and (3) a hybrid model that would retain the
consolidated display requirement and existing Networks solely for the
dissemination of the NBBO, but allow the SROs to distribute their own
quotes and trades independently and without a consolidated display
requirement. These alternative models were all intended to introduce
more competition in the marketplace and greater flexibility in market
data dissemination.
The primary goal of the proposed amendments to Rules 11Aa3-1 and
11Ac1-2 (proposed to be redesignated as Rules 601 and 603) is to retain
the benefits of the consolidated display requirement, which provides a
uniform, consolidated stream of data and is the single most important
tool for unifying all of the market centers trading NMS Stocks, while
providing market centers that contribute to consolidated information
with the ability to independently distribute their own market data and
reducing the consolidated display requirements on broker-dealers and
SIPs. The Commission preliminarily believes that these potential
alternative models pose an unacceptable risk of losing important
benefits that investors and other information users receive under the
current system--an affordable and highly reliable stream of quotes and
trades that is consolidated from all significant market centers trading
an NMS Stock. The Commission also does not believe that it is necessary
to consider whether small entities should be permitted to use
performance rather than design standards to comply with the proposed
amendments as the amendments already propose performance standards and
do not dictate for entities of any size any particular design standards
(e.g., technology) that must be employed to achieve the objectives of
the proposed amendments.
h. Solicitation of Comments
The Commission encourages comments with respect to any aspect of
this Initial Regulatory Flexibility Analysis. In particular, the
Commission requests comments regarding: (1) The number of small
entities that may be affected by the proposed amendments; (2) the
existence or nature of the potential impact of the proposed amendments
on small entities discussed in the analysis; and (3) how to quantify
the impact of the proposed amendments. Commenters are asked to describe
the nature of any impact and provide empirical data supporting the
extent of the impact. Such comments will be considered in the
preparation of the Final Regulatory Flexibility Analysis, if the
proposals are adopted, and will be placed in the same public file as
comments on the proposed amendments themselves.
VII. Regulation NMS Proposal
A. Introduction
The Commission proposes to simplify the structure of the rules
adopted under Section 11A of the Exchange Act (``NMS rules'') by
designating them as proposed Regulation NMS and renumbering them. In
addition, the Commission proposes to include in proposed Regulation NMS
proposed Rule 600 (``NMS Security Designation and Definitions''). This
proposed new rule would replace Exchange Act Rule 11Aa2-1, which
designates ``reported securities'' as NMS securities. Proposed Rule 600
also would include, in alphabetical order, all of the defined terms
used in proposed Regulation NMS. The proposed new rule series is Rule
600 through Rule 612 (17 CFR 242.600--612).
Proposed Rule 600 would provide a single set of definitions that
would be used throughout proposed Regulation NMS. To create a single
set of definitions, the Commission proposes to update or delete from
proposed Regulation NMS some terms that have become obsolete and to
eliminate the use of multiple, inconsistent definitions for identical
terms. In addition, the Commission is proposing to adopt two new terms,
``NMS security'' and ``NMS stock,'' which would replace some terms that
would be eliminated. These terms are necessary to maintain distinctions
between current NMS rules that apply to equity securities and ETFs only
(e.g., Exchange Act Rules 11Ac1-4 and 11Ac1-5) and those that apply to
equity securities, ETFs, and options (e.g., Exchange Act Rules 11Ac1-1
and 11Ac1-6). Proposed Rule 600 would retain, unchanged, most
definitions used in the current NMS rules and would include new
definitions used in the new rules proposed in this release. The
proposed definitional changes would not affect the substantive
requirements of the existing NMS rules.
B. Discussion of Proposed Regulation NMS
1. Rule Numbering
In proposed Regulation NMS, the Commission would renumber and, in
some cases, rename the current NMS rules, and incorporate proposed Rule
[[Page 11192]]
600 and the proposed new rules. Where applicable, current NMS rules
would be amended to remove the definitions which would be consolidated
in proposed Rule 600. The proposed titles and numbering of the rules in
proposed Regulation NMS, including the proposed new rules, appear
below:
Rule 600: NMS Security Designation and
Definitions (replaces Exchange Act Rule 11Aa2-1, which the Commission
is proposing to rescind, and incorporates definitions from the current
NMS rules and the proposed new rules);
Rule 601: Dissemination of Transaction Reports
and Last Sale Data with Respect to Transactions in NMS Stocks
(renumbers and renames Exchange Act Rule 11Aa3-1, the substance of
which would be modified); \321\
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\321\ In the market data proposal, discussed in Section VI., the
Commission is proposing to amend substantively Exchange Act Rule
11Aa3-1.
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Rule 602: Dissemination of Quotations in NMS
Securities (renumbers and renames Exchange Act Rule 11Ac1-1 (``Quote
Rule''), the substance of which would remain largely intact);
Rule 603: Distribution, Consolidation, and
Display of Information with Respect to Quotations for and Transactions
in NMS Stocks (renumbers and renames Exchange Act Rule 11Ac1-2
(``Vendor Display Rule''), the substance of which would be modified
substantially); \322\
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\322\ In the market data proposal, discussed in Section VI., the
Commission is proposing to amend substantively Exchange Act Rule
11Ac1-2.
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Rule 604: Display of Customer Limit Orders
(renumbers Exchange Act Rule 11Ac1-4 (``Limit Order Display Rule''),
the substance of which would remain largely intact);
Rule 605: Disclosure of Order Execution
Information (renumbers Exchange Act Rule 11Ac1-5, the substance of
which would remain largely intact);
Rule 606: Disclosure of Order Routing
Information (renumbers Exchange Act Rule 11Ac1-6, the substance of
which would remain largely intact);
Rule 607: Customer Account Statements (renumbers
Exchange Act Rule 11Ac1-3, the substance of which would remain largely
intact);
Rule 608: Filing and Amendment of National
Market System Plans (renumbers Exchange Act Rule 11Aa3-2, the substance
of which would remain largely intact);
Rule 609: Registration of Securities Information
Processors: Form of Application and Amendments (renumbers Exchange Act
Rule 11Ab2-1, the substance of which would remain largely intact);
Rule 610: Access to Published Bids and Offers
(proposed new rule);
Rule 611: Trade-Through Rule (proposed new
rule); and
Rule 612: Minimum Pricing Increment (proposed
new rule).
2. Rule 600--NMS Security Designation and Definitions
a. Transaction Reporting Requirements for Equities and Listed Options
Section 11A(a)(2) of the Exchange Act directs the Commission to
``designate the securities or classes of securities qualified for
trading in the national market system.'' \323\ The 1975 Amendments and
the legislative history to the 1975 Amendments were silent as to the
particular standards the Commission should employ in designating NMS
securities.\324\ Instead, Congress provided the Commission with the
flexibility and discretion to base NMS designation standards on the
Commission's experience in facilitating the development of an NMS.\325\
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\323\ 15 U.S.C. 78k-1(a)(2).
\324\ See Securities Exchange Act Release No. 23817 (November
17, 1986), 51 FR 42856 (November 26, 1986) (proposing amendments to
Exchange Act Rules 11Aa2-1 and 11Aa3-1) (``1986 Proposing
Release'').
\325\ See id.
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To satisfy the requirement that it designate the securities
qualified for trading in the NMS, the Commission adopted Exchange Act
Rule 11Aa2-1 in 1981.\326\ Exchange Act Rule 11Aa2-1 currently defines
the term ``national market system security'' to mean ``any reported
security as defined in Rule 11Aa3-1.'' Exchange Act Rule 11Aa3-1
defines a ``reported security'' as ``any security or class of
securities for which transaction reports are collected, processed and
made available pursuant to an effective transaction reporting plan.''
\327\ Exchange Act Rule 11Aa3-1(a)(3) defines the term ``effective
transaction reporting plan'' to mean ``any transaction reporting plan
approved by the Commission pursuant to this section.'' Exchange Act
Rule 11Aa3-1(a)(2) defines the term ``transaction reporting plan'' to
mean ``any plan for collecting, processing, making available or
disseminating transaction reports with respect to transactions in
reported securities filed with the Commission pursuant to, and meeting
the requirements of, this section.'' The effective transaction
reporting plans are the CTA Plan and the Nasdaq UTP Plan.
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\326\ See Securities Exchange Act Release No. 17549 (February
17, 1981), 46 FR 13992 (February 25, 1981) (adopting Exchange Act
Rule 11Aa2-1).
\327\ See Exchange Act Rule 11Aa3-1(a)(4).
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In addition to identifying those securities deemed to be NMS
securities, when adopted, the Exchange Act Rule 11Aa2-1 designation
also tacitly identified those securities that did not meet that
designation (i.e., securities other than those that are so designated
as NMS securities). Historically, securities excluded from this
designation included standardized options and small capitalization
equity securities (a subset of which has been identified as Nasdaq
SmallCap securities). Trading in options and Nasdaq SmallCap securities
has increased over the past three decades and gradually many of the
rules that govern NMS securities have been applied to these securities.
Over time, much of the terminology that has been used to distinguish
NMS securities from options and Nasdaq SmallCap securities has become
obsolete or contorted.
For example, the Nasdaq UTP Plan provides for the collection from
Plan participants, and the consolidation and dissemination to vendors,
subscribers and others, of quotation and transaction information in
``eligible securities.'' Prior to 2001, the Nasdaq UTP Plan defined an
``eligible security'' as any Nasdaq National Market security as to
which unlisted trading privileges have been granted to a national
securities exchange pursuant to Section 12(f) of the Exchange Act or
that is listed on a national securities exchange. In 2001, the Nasdaq
UTP Plan was amended to include Nasdaq SmallCap securities.\328\ As a
result, Nasdaq SmallCap securities became eligible securities because
they are now reported through an effective transaction reporting plan
(i.e., the Nasdaq UTP Plan), bringing them within the purview of the
NMS security designation. Several definitions in the current NMS rules,
however, do not reflect the inclusion of Nasdaq SmallCap securities in
the Nasdaq UTP Plan and therefore must be updated. Regulation NMS
proposes to do so.
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\328\ See Securities Exchange Act Release No. 45081 (November
19, 2001), 66 FR 59273 (November 27, 2001).
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In addition, transactions in exchange-listed options are reported
through the Plan for Reporting of Consolidated Options Last Sale
Reports and Quotation Information (``OPRA Plan'').\329\ Unlike the CTA
Plan and the Nasdaq UTP Plan--transaction reporting plans that the
Commission approved pursuant to Exchange Act Rules 11Aa3-1 and 11Aa3-
2--the OPRA Plan was
[[Page 11193]]
approved by the Commission only pursuant to Exchange Act Rule 11Aa3-
2.\330\ As such, the OPRA Plan is an ``effective national market system
plan'' but not an ``effective transaction reporting plan.'' While at
their core the CTA Plan, the Nasdaq UTP Plan, and the OPRA Plan perform
essentially the same function (i.e., they govern the consolidated
reporting of securities transactions by Plan participants), because the
OPRA Plan is not an effective transaction reporting plan, listed
options covered by the OPRA Plan are technically not ``securities for
which transaction reports are collected, processed, and made available
pursuant to an effective transaction reporting plan.'' Therefore,
options were not considered NMS securities as defined by Exchange Act
Rule 11Aa2-1. While the impact of this distinction may not be readily
apparent, the differences in the way the Plans are designated dictates
the securities laws and regulations that apply to securities reported
pursuant to those Plans.
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\329\ The exchanges that are participants to the OPRA Plan are
Amex, BSE, CBOE, ISE, PCX, and Phlx.
\330\ See Securities Exchange Act Release No. 17638 (March 18,
1981), 22 S.E.C. Docket 484 (March 31, 1981). Exchange Act Rule
11Aa3-2 codifies the procedures that SROs must follow to seek
approval for or amendment of a national market system plan.
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Further, as discussed below, some terms in the NMS rules have
become superfluous or outdated. In addition, in the current NMS rules,
certain terms are defined in different ways in different rules. Because
proposed Regulation NMS proposes a consolidated set of definitions that
would apply to all rules within the proposed Regulation, these
inconsistencies would need to be eliminated. The definitional changes
proposed in this Release, however, are not intended to change
materially the scope of the current NMS rules.
b. ``NMS Security'' and ``NMS Stock''
Some NMS rules, including the Quote Rule and Exchange Act Rule
11Ac1-6, currently apply to both (1) equities, ETFs and related
securities for which transaction reports are made available pursuant to
an effective transaction reporting plan, and (2) listed options for
which market information is made available pursuant to an effective
national market system plan. To provide a single term that would be
used in any provision of proposed Regulation NMS that applies to both
categories of securities, the Commission is proposing to adopt a new
term, ``NMS security.'' \331\
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\331\ Specifically, the Commission proposes to define an ``NMS
security'' as ``any security or class of securities for which
transaction reports are collected, processed, and made available
pursuant to an effective transaction reporting plan, or an effective
national market system plan for reporting transactions in listed
options.'' This definition currently is used to define a ``reported
security'' in the Quote Rule. See Exchange Act Rule 11Ac1-1(a)(20).
For the reasons described below, the Commission is proposing to
eliminate the term ``reported security'' from the Quote Rule and not
include it in proposed Regulation NMS.
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Because many rules in proposed Regulation NMS, including Rule 604
(currently Exchange Act Rule 11Ac1-4) and Rule 605 (currently Exchange
Act Rule 11Ac1-5), would continue to be inapplicable to listed options,
the Commission proposes to adopt a new term, ``NMS stock'' that would
be used in those provisions. The Commission proposes to define the term
``NMS stock'' as ``any NMS security other than an option.''
c. Changes to Current Definitions in the NMS Rules
Proposed Rule 600 would provide a single set of definitions that
would be used throughout proposed Regulation NMS. To create a single
set of definitions, the Commission proposes to eliminate multiple,
inconsistent definitions of identical terms. In addition, the
Commission proposes to amend some definitions in the NMS rules to
reflect changed conditions in the marketplace or to modernize
references. For example, as discussed above, several definitions in the
NMS rules have become obsolete by the extension of the Nasdaq UTP Plan
to Nasdaq SmallCap securities.\332\ Because the Nasdaq UTP Plan
includes Nasdaq SmallCap securities, those securities now are
``securities for which transaction reports are collected, processed and
made available pursuant to an effective transaction reporting plan''
(i.e., they are ``reported'' securities).\333\ For this reason, it is
no longer necessary to distinguish, as several NMS rules do currently,
between ``reported'' securities and equity securities for which market
information is made available through Nasdaq.\334\ Accordingly, the
Commission proposes to eliminate or revise the defined terms in the NMS
rules that make this distinction.
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\332\ See NASD Rule 4200 for the definition of a Nasdaq SmallCap
security. The Nasdaq UTP Plan provides for the collection from Plan
participants, and the consolidation and dissemination to vendors,
subscribers and others, of quotation and transaction information in
``eligible securities.'' ``Eligible securities'' initially included
Nasdaq NMS securities listed on an exchange or traded on an exchange
pursuant to a grant of unlisted trading privileges. See Securities
Exchange Act Release No. 28146 (June 26, 1990), 55 FR 27917 (July 6,
1990) (order approving the Nasdaq UTP Plan on a pilot basis). In
2001, the Nasdaq UTP Plan was amended to, among other things, revise
the definition of ``eligible securities'' to include Nasdaq SmallCap
securities. See Securities Exchange Act Release No. 45081 (November
19, 2001), 66 FR 49273 (November 27, 2001) (order approving
Amendment No. 12 to the Nasdaq UTP Plan).
\333\ Exchange Act Rules 11Aa3-1 and 11Ac1-2 define the term
``reported security'' to mean ``any security or class of securities
for which transaction reports are collected, processed and made
available pursuant to an effective transaction reporting plan.'' As
discussed more fully below, the Quote Rule provides a different
definition of ``reported security.''
\334\ See e.g., Exchange Act Rule 11Ac1-2(a)(4) (defining
``subject security'' to mean ``(i) any reported security; and (ii)
any other equity security as to which transaction reports, last sale
data or quotation information is disseminated through NASDAQ''); and
Exchange Act Rule 11Ac1-1(a)(6) (defining ``covered security'' to
mean ``any reported security and 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 (15 U.S.C. 78c(a)(51)(A)(ii))'').
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i. ``Covered security''
Different definitions of the term ``covered security'' appear in
the Quote Rule, the Limit Order Display Rule, and in Exchange Act Rule
11Ac1-6.\335\ In addition, as discussed below, the term has become
obsolete. Therefore, the Commission is proposing to eliminate the term
``covered security'' from proposed Regulation NMS and to replace it
with the term ``NMS security'' or ``NMS stock,'' as applicable,
depending upon the scope of the particular rule.
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\335\ Although the Quote Rule and the Limit Order Display Rule
each define the term ``covered security'' as ``any reported security
and 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
(15 U.S.C. 78c(a)(51)(A)(ii)),'' the scope of the definitions is not
identical because each rule defines the term ``reported security''
differently. The Quote Rule defines a ``reported security'' to mean
``any security or class of securities for which transaction reports
are collected, processed and made available pursuant to an effective
transaction reporting plan, or an effective national market system
plan for reporting transactions in listed options.'' See Exchange
Act Rule 11Ac1-1(a)(20). The Limit Order Display Rule defines a
``reported security'' to mean ``any security or class of securities
for which transaction reports are collected, processed, and made
available pursuant to an effective transaction reporting plan.'' See
Exchange Act Rule 11Ac1-4(a)(10).
Exchange Act Rule 11Ac1-6 defines the term ``covered security''
to 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. See Exchange Act Rule 11Ac1-6(a)(1).''
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ii. ``Reported security''
Several NMS rules use the term ``reported security.'' Although the
Limit Order Display Rule, the Vendor Display
[[Page 11194]]
Rule, and Exchange Act Rule 11Aa3-1 contain identical definitions of
``reported security,'' the Quote Rule provides a different
definition.\336\ Because the term ``reported security'' is defined
inconsistently in the NMS rules and in light of proposed changes to
related terms, the Commission proposes to eliminate the term ``reported
security'' from proposed Regulation NMS and replace it with the term
``NMS security'' or ``NMS stock,'' depending on the scope of the
particular rule.
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\336\ The Limit Order Display Rule, the Vendor Display Rule, and
Exchange Act Rule 11Aa3-1 define a ``reported security'' to mean
``any security or class of securities for which transaction reports
are collected, processed and made available pursuant to an effective
transaction reporting plan.'' See Exchange Act Rules 11Ac1-4(a)(10),
11Ac1-2(a)(20), and 11Aa3-1(a)(4). The Quote Rule defines the term
``reported security'' to mean ``any security or class of securities
for which transaction reports are collected, processed, and made
available pursuant to an effective transaction reporting plan, or an
effective national market system plan for reporting transactions in
listed options.'' See Exchange Act Rule 11Ac1-1(a)(20). As discussed
above, the Commission is proposing substantial modifications to the
current Vendor Display Rule.
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The Limit Order Display Rule uses the term ``reported security''
solely for the purpose of defining the term ``covered security.''\337\
Because the Commission proposes to eliminate the term ``covered
security,'' the term ``reported security'' also would not need to be
used in the redesignated Limit Order Display Rule (proposed Rule 604).
Therefore, as noted above, the term ``NMS stock'' would replace the
term ``covered security'' in proposed Rule 604.
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\337\ See Exchange Act Rule 11Ac1-4(a)(5). The Limit Order
Display Rule defines a ``covered security'' to include both reported
securities and other securities for which market information is
disseminated through Nasdaq.
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Similarly, the Quote Rule uses the term ``reported security''
primarily to define the term ``covered security.''\338\ Because the
Commission proposes to eliminate the term ``covered security,'' the
term ``reported security'' also would not be used in the redesignated
Quote Rule (proposed Rule 602).\339\
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\338\ See Exchange Act Rule 11Aa1-1(a)(6). The Quote Rule
defines a ``covered security'' to include both reported securities
and other securities for which market information is disseminated
through Nasdaq.
\339\ In paragraph (b)(1)(ii) of the Quote Rule, which requires
a registered national securities association to disseminate
quotations at all times when last sale information is available with
respect to ``reported securities,'' the reference to ``reported
security'' would be replaced by a reference to ``NMS security.''
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iii. ``Subject security''
The Quote Rule and the Vendor Display Rule use the term ``subject
security,'' although the rules define the term differently. To
eliminate this inconsistency, the Commission proposes not to use the
term ``subject security'' in the proposed successor to the Vendor
Display Rule (proposed Rule 603), and to retain for the Quote Rule
provision of proposed Regulation NMS (proposed Rule 602) a slightly
modified version of the definition of ``subject security'' that is
currently in the Quote Rule.
The Vendor Display Rule defines the term ``subject security'' to
mean ``(i) any reported security; and (ii) any other equity security as
to which transaction reports, last sale data or quotation information
is disseminated through NASDAQ.''\340\ As discussed above, the
extension of the Nasdaq UTP Plan to include Nasdaq SmallCap securities
renders obsolete the distinction between a ``reported security'' and a
security for which market information is disseminated through Nasdaq.
Accordingly, the Commission proposes to use the term ``NMS stock''
rather than ``subject security'' in the proposed Vendor Display Rule
successor.
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\340\ See Exchange Act Rule 11Ac1-2(a)(4).
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The Quote Rule currently defines the term ``subject security'' to
mean:
(i) With respect to an exchange: (A) Any exchange-traded
security other than a security for which the executed volume of such
exchange, during the most recent calendar quarter, comprised one
percent or less of the aggregate trading volume for such security as
reported in the consolidated system; and (B) Any other covered
security for which such exchange has in effect an election, pursuant
to paragraph (b)(5)(i) of this section, to collect, process, and
make available to quotation vendors bids, offers, quotation sizes,
and aggregate quotation sizes communicated on such exchange; and
(ii) With respect to a member of an association: (A) Any
exchange-traded security for which such member acts in the capacity
of an OTC market maker unless the executed volume of such member,
during the most recent calendar quarter, comprised one percent or
less of the aggregate trading volume for such security as reported
in the consolidated system; and (B) Any other covered security for
which such member acts in the capacity of an OTC market maker and
has in effect an election, pursuant to paragraph (b)(5)(ii) of this
section, to communicate to its association bids, offers and
quotation sizes for the purpose of making such bids, offers and
quotation sizes available to quotation vendors.\341\
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\341\ See Exchange Act Rule 11Ac1-1(a)(25) (emphasis added).
Because the Quote Rule applies to both listed options and equities
covered by an effective transaction reporting plan, the Commission
proposes to revise the Quote Rule's definition of ``subject security''
by replacing references to a ``covered security'' with references to an
``NMS security.'' In addition, for the reasons discussed below, the
Commission proposes to replace the phrase ``reported in the
consolidated system'' with the phrase ``reported pursuant to an
effective transaction reporting plan or effective national market
system plan.''
iv. ``Consolidated system''
Paragraph (a)(25) of the Quote Rule currently defines the term
``subject security'' to include, among other things: (1) With respect
to an exchange, any exchange-traded security other than a security for
which the executed volume of such exchange, during the most recent
calendar quarter, comprised one percent or less of the aggregate
trading volume for such security as reported in the consolidated
system; and (2) with respect to a member of an association, any
exchange-traded security for which such member acts in the capacity of
an OTC market maker unless the executed volume of such member, during
the most recent calendar quarter, comprised one percent or less of the
aggregate trading volume for such security as reported in the
consolidated system. Paragraph (a)(5) of the Quote Rule defines the
term ``consolidated system'' to mean ``the consolidated transaction
reporting system, including a transaction reporting system operating
pursuant to an effective national market system plan.''
The Commission proposes to clarify the definition of ``subject
security'' by eliminating the phrase ``reported in the consolidated
system'' from proposed Regulation NMS and replacing it with the phrase
``reported pursuant to an effective transaction reporting plan or an
effective national market system plan.'' Thus, proposed Regulation NMS
would define a ``subject security'' to include, among other things: (1)
With respect to a national securities exchange, any exchange-traded
security other than a security for which the executed volume of such
exchange, during the most recent calendar quarter, comprised one
percent or less of the aggregate trading volume for such security as
reported pursuant to an effective transaction reporting plan or
effective national market system plan; and (2) with respect to a member
of a national securities association, any exchange-traded security for
which such member acts in the capacity of an OTC market maker unless
the executed volume of such member, during the most recent calendar
quarter, comprised one percent or less of the aggregate trading volume
for such security as reported pursuant to an effective
[[Page 11195]]
transaction reporting plan or effective national market system plan.
This change is designed to provide a clearer, more descriptive, and
less circular definition of ``subject security'' by indicating that the
trading volume referred to in the definition is the trading volume in a
security that is reported pursuant to an effective transaction
reporting plan or an effective national market system plan. Although
replacing the phrase ``reported in the consolidated system'' with the
phrase ``reported pursuant to an effective transaction reporting plan
or an effective national market system plan'' would produce a clearer
definition of ``subject security,'' it would not alter the scope or the
substance of the definition.\342\
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\342\ This proposed amendment would also impact certain non-NMS
rules that define the term consolidated system. See, e.g., Exchange
Act Rule 10b-18(a)(7) (``consolidated system means the consolidated
transaction reporting system contemplated by Rule 11Aa3-1''). As
discussed below, the Commission is also proposing to change certain
non-NMS rules that are impacted by the definitional changes proposed
in this Release.
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v. ``National Securities Exchange''
Section 3(a)(1) of the Exchange Act defines the term ``exchange''
to mean ``any organization, association, or group of persons * * *
which constitutes, maintains, or provides a market place or facilities
for bringing together purchasers and sellers of securities or for
otherwise performing with respect to securities the functions commonly
performed by a stock exchange as that term is generally understood * *
*'' \343\ Exchange Act Rule 3b-16,\344\ adopted in 1998, interprets the
statutory definition of ``exchange'' broadly to include any
organization, association, or group of persons that: (1) Brings
together the orders for securities of multiple buyers and sellers; and
(2) uses established, non-discretionary methods (whether by providing a
trading facility or by setting rules) under which such orders interact
with each other, and the buyers and sellers entering such orders agree
to the terms of a trade. Exchange Act Rule 3b-16 was designed to
provide ``a more comprehensive and meaningful interpretation of what an
exchange is in light of today's markets.'' \345\
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\343\ 15 U.S.C. 78c(a)(1).
\344\ 17 CFR 240.3b-16.
\345\ See Securities Exchange Act Release No. 40760 (December 8,
1998), 63 FR 70844 (December 22, 1999) (adopting Regulation ATS).
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The Quote Rule's definition of an ``exchange market maker'' defines
the term ``national securities exchange'' as an ``exchange.'' \346\ To
avoid confusion between a ``national securities exchange'' and the
broader interpretation of ``exchange'' set forth in Exchange Act Rule
3b-16, the Commission proposes to use the term ``national securities
exchange'' rather than ``exchange'' throughout proposed Regulation NMS.
The national securities exchange definition is intended to capture only
those entities that operate as national securities exchanges and that
are registered as such with the Commission. It is not intended to
capture those entities that meet the ``exchange'' definition under
Regulation ATS but that operate as something other than a national
securities exchange. The use of this term is consistent with the use of
the term ``exchange'' in the current NMS rules.
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\346\ Specifically, the Quote Rule states that the term
``exchange market maker'' shall mean ``any member of a national
securities exchange (`exchange') who is registered as a specialist
or market maker pursuant to the rules of such exchange.'' See
Exchange Act Rule 11Ac1-1(a)(9). The statutory requirements
applicable to a national securities exchange are set forth in
Section 6 of the Exchange Act, 15 U.S.C. 78f.
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vi. ``OTC Market Maker''
The Quote Rule and Exchange Act Rule 11Ac1-5 define the term ``OTC
market maker'' differently.\347\ Unlike the Quote Rule, Exchange Act
Rule 11Ac1-5 defines the term ``OTC market maker'' to include an
explicit reference to a securities dealer that holds itself out as
being willing to buy from and sell to customers or others in the United
States. In proposed Regulation NMS, the Commission proposes to retain
the reference to transactions with ``customers or others in the United
States'' to indicate clearly that a foreign dealer could be an ``OTC
market maker'' if it acts as a securities dealer with respect to
customers or others in the United States.
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\347\ Compare Exchange Act Rules 11Ac1-1(a)(13) and 11Ac1-
5(a)(18).
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Accordingly, the Commission proposes to define ``OTC market maker''
for proposed Regulation NMS as ``any dealer that holds itself out as
being willing to buy from and sell to its customers, or others, in the
United States, an NMS stock for its own account on a regular or
continuous basis otherwise than on a national securities exchange.''
\348\
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\348\ The proposed definition of ``OTC market maker'' uses the
term ``NMS stock'' because there is no OTC market in standardized
options.
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vii. ``Vendor''
The term ``vendor'' or ``quotation vendor'' is defined differently
in three NMS rules: The Quote Rule and Exchange Act Rules 11Aa3-1 and
11Ac1-2.\349\ Although the definitions are similar, the definition of
``vendor'' in Exchange Act Rule 11Ac1-2 is the most comprehensive
because it encompasses any SIP that disseminates transaction reports,
last sale data, or quotation information, whereas the other definitions
are less complete in identifying the types of information that vendors
typically make available. To provide a uniform and comprehensive
definition of the term ``vendor,'' the Commission proposes to use in
Regulation NMS the definition of ``vendor'' as it is currently defined
in Exchange Act Rule 11Ac1-2(a)(2).
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\349\ The Quote Rule defines the term ``quotation vendor'' to
mean ``any securities information processor engaged in the business
of disseminating to brokers, dealers or investors on a real-time
basis, bids and offers made available pursuant to this section,
whether distributed through an electronic communications network or
displayed on a terminal or other display device.'' See Exchange Act
Rule 11Ac1-1(a)(19). Exchange Act Rule 11Aa3-1(a)(11) defines the
term ``vendor'' to mean ``any securities information processor
engaged in the business of disseminating transaction reports or last
sale data with respect to transactions in reported securities to
brokers, dealers or investors on a real-time or other current and
continuing basis, whether through an electronic communications
network, moving ticker or interrogation device.'' Exchange Act Rule
11Ac1-2(a)(2) defines the term ``vendor'' to mean ``any securities
information processor engaged in the business of disseminating
transaction reports, last sale data or quotation information with
respect to subject securities to brokers, dealers or investors on a
real-time or other current and continuing basis, whether through an
electronic communications network, moving ticker or interrogation
device.''
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viii. ``Best Bid,'' ``Best Offer,'' and ``National Best Bid and
National Best Offer''
The Quote Rule and Rule 11Ac1-2 define the terms ``best bid'' and
``best offer'' differently.\350\ In addition, the
[[Page 11196]]
term ``consolidated best bid and offer'' is defined in Exchange Act
Rule 11Ac1-5(a)(7) to 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.'' The Commission proposes to retain the definitions of ``best
bid'' and ``best offer'' as used in the Quote Rule. A new term called
``national best bid and national best offer'' would: (1) Replace the
term ``best bid and best offer'' as that term is currently used in
Exchange Act Rule 11Ac1-2 and (2) replace the term ``consolidated best
bid and offer'' as that term is currently used in Exchange Act Rule
11Ac1-5. This new term would refer to the best quotes that are
calculated and disseminated by a plan processor pursuant to an
effective NMS plan.\351\ The proposed definition of ``national best bid
and national best offer'' also would address those instances where
multiple market centers transmit identical bids and offers to the plan
processor pursuant to an NMS plan by establishing the way in which
these bids and offers are to be prioritized.
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\350\ The Quote Rule states that ``[t]he terms best bid and best
offer shall mean the highest priced bid and the lowest priced
offer.'' See Exchange Act Rule 11Ac1-1(a)(3). Exchange Act Rule
11Ac1-2(a)(15) defines the terms ``best bid'' and ``best offer'' as
follows:
(i) With respect to quotations for a reported security, the
highest bid or lowest offer for that security made available by any
reporting market center pursuant to Sec. 240.11Ac1-1 (Rule 11Ac1-1
under the Act) (excluding any bid or offer made available by an
exchange during any period such exchange is relieved of its
obligations under paragraphs (b)(1) and (2) of Sec. 240.11Ac1-1 by
virtue of paragraph (b)(3)(i) thereof)); Provided, however, That in
the event two or more reporting market centers make available
identical bids or offers for a reported security, the best bid or
best offer (as the case may be) shall be computed by ranking all
such identical bids or offers (as the case may be) first by size
(giving the highest ranking to the bid or offer associated with the
largest size), then by time (giving the highest ranking to the bid
or offer received first in time); and
(ii) With respect to quotations for a subject security other
than a reported security, the highest bid or lowest offer (as the
case may be) for such security disseminated by an over-the-counter
market maker in Level 2 or 3 of NASDAQ.
\351\ The definition of ``reporting market center'' currently in
Rule 11Ac1-2(a)(14) and incorporated into that Rule's definitions of
``best bid'' and ``best offer'' would no longer be necessary and
therefore would be deleted.
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ix. ``Bid'' or ``Offer,'' ``Customer,'' ``Nasdaq Security,'' and
``Responsible Broker or Dealer''
The Commission also proposes to update or clarify the following
terms in the NMS rules: ``bid'' or ``offer;'' ``customer;'' ``Nasdaq
security;'' and ``responsible broker or dealer.''
The Quote Rule currently defines the terms ``bid and offer'' to
mean ``the bid price and the offer price communicated by an exchange
member or OTC market maker to any broker or dealer, or to any customer,
at which it is willing to buy or sell one or more round lots of a
covered security, as either principal or agent, but shall not include
indications of interest.'' \352\ The Commission proposes to update this
definition by replacing the term ``OTC market maker'' with the phrase
``member of a national securities association'' and to call the term
``bid or offer'' rather than ``bid and offer'' to reflect the fact that
the terms are not always used in the conjunctive. Modifying the
definition to apply to any member of a national securities association
would clarify that bids and offers include quotes communicated not only
by OTC market makers but also by ATSs, ECNs, and order entry firms that
are members of the NASD but that are not market makers.
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\352\ See Exchange Act Rule 11Ac1-1(a)(4). Exchange Act Rule
11Ac1-2(a)(6) uses the Quote Rule's definition of ``bid'' and
``offer'' for reported securities, but it defines ``bid'' and
``offer'' for Nasdaq SmallCap securities as ``the most recent bid or
offer price of an over-the-counter market maker disseminated through
Level 2 or 3 of NASDAQ.'' Because Nasdaq SmallCap securities now are
reported securities, it is unnecessary to maintain the distinction
between reported securities and Nasdaq SmallCap securities.
Accordingly, to update and provide a single definition of the terms
``bid'' and ``offer,'' the Commission proposes to eliminate the
definitions of ``bid'' and ``offer'' in Exchange Act Rule 11Ac1-2
and retain modified versions of the terms as they are defined in the
Quote Rule.
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Expanding the bid and offer terms could have the unintended
consequence of also expanding the scope of the Quote Rule where those
terms are used to apply to members of a national securities association
that are not OTC market makers (e.g., ECNs, and ATSs). To avoid this
unintended expansion of the scope of the Quote Rule, the Commission is
proposing to amend the definition of ``responsible broker or dealer.''
In particular, the Commission is proposing to amend the portion of that
definition currently in Rule 11Ac1-1(a)(21)(ii) to limit its scope to
bids and offers communicated by an OTC market maker.
The Commission is also proposing to amend the definition of the
term ``customer.'' The Quote Rule currently defines that term to mean
``any person that is not a registered broker-dealer.'' \353\ To
indicate that the scope of the definition includes broker-dealers that
are exempt from registration as well as registered broker-dealers, the
Commission proposes to revise the definition by deleting the term
``registered.'' Thus, proposed Rule 600 would define the term
``customer'' to mean ``any person that is not a broker-dealer.''
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\353\ See Exchange Act Rule 11Ac1-1(a)(26).
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Exchange Act Rule 11Aa3-1 currently defines the term ``NASDAQ
security'' to mean ``any registered equity security for which quotation
information is disseminated in the National Association of Securities
Dealers Automated Quotation system (``NASDAQ'').'' \354\ This acronym
is now out-dated. Therefore, to modernize this definition and to ensure
that any type of registered security that Nasdaq lists is covered by
this definition, the Commission proposes to define the term ``Nasdaq
security'' to mean ``any registered security listed on the Nasdaq Stock
Market, Inc.''
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\354\ See Exchange Act Rule 11Aa3-1(a)(6).
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d. Definitions in the Proposed New Rules
The Commission also is proposing to include within proposed new
Rule 600 a number of new definitions that would be used in proposed new
Rules 610 through 612 of proposed Regulation NMS. These new terms are
discussed in detail in Sections III, IV, and V above. Specifically, for
the reasons discussed above, the Commission proposes to adopt the
following terms:
The term Automated order execution facility
shall mean an order execution facility that provides for an immediate
automated response to all incoming subject orders for up to the full
size of its best bid and offer disseminated pursuant to an effective
national market system plan without any restriction on execution.
The term Consolidated display shall mean (i) the
prices, sizes, and market identifications of the national best bid and
national best offer for a security, and (ii) consolidated last sale
information for a security.
The term Consolidated last sale information
shall mean the price, volume, and market identification of the most
recent transaction report for a security that is disseminated pursuant
to an effective national market system plan.
The term Non-automated order execution facility
shall mean an order execution facility that is not an automated order
execution facility.
The term Order execution facility shall mean any
exchange market maker; OTC market maker; any other broker or dealer
that executes orders internally by trading as principal or crossing
orders as agent; alternative trading system; or national securities
exchange or national securities association that operates a facility
that executes orders.
The term Quoting market center shall mean an
order execution facility of any national securities exchange or
national securities association that is required to make available to a
vendor its best bid or best offer in a security pursuant to Sec.
242.602).
The term Quoting market participant shall mean
any broker or dealer that provides its best bid or best offer in a
security to a national securities exchange or national securities
association pursuant to Sec. 242.602) or Regulation ATS (Sec. Sec.
242.300 through 242.303), and the best bid or best offer of which is
not otherwise available through a quoting market center.
The term Subject order shall mean any order to
buy or sell an NMS stock received by an order execution facility from
itself, any member, customer, subscriber, or any other order execution
facility that is executed during regular trading hours.
The term Trade-through shall mean the purchase
or sale of an NMS stock
[[Page 11197]]
during regular trading hours, either as principal or agent, at a price
that is lower than the best bid or higher than the best offer of any
order execution facility that is disseminated pursuant to an effective
national market system plan at the time the transaction was executed.
The Commission requests comment on the proposed definitions that
would be used in proposed new Rules 610 through 612.
3. Proposed Changes to Other Rules
In addition to the changes described above, the Commission is
proposing to amend a number of rules that cross-reference current NMS
rules or that use terms that proposed Regulation NMS would amend or
eliminate.\355\ These amendments are intended to be non-substantive.
Specifically, the Commission proposes to make conforming changes to the
following rules: Sec. 200.30-3; \356\ Rule 144 \357\ under the
Securities Act of 1933; \358\ Exchange Act Rule 31-1; \359\ Sec.
249.1001; \360\ Exchange Act Rule 3a51-1;\361\ Exchange Act Rule 3b-16;
\362\ Exchange Act Rule 10b-10; \363\ Exchange Act Rule 10b-18; \364\
Exchange Act Rule 15b9-1; \365\ Exchange Act Rule 12a-7; \366\ Exchange
Act Rule 12f-1; \367\ Exchange Act Rule 12f-2;\368\ Exchange Act Rule
15c2-11; \369\ Exchange Act Rule 19c-3; \370\ Exchange Act Rule 19c-4;
\371\ Rule 100 of Regulation M under the Exchange Act; \372\ Rule 300
of Regulation ATS under the Exchange Act; \373\ and Rule 301 of
Regulation ATS under the Exchange Act.\374\
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\355\ Certain other rules that would be impacted by proposed
Regulation NMS that are also the subject of other proposed
Commission rulemakings that are currently pending, such as Exchange
Act Rule 10a-1 (17 CFR 240.10a-1), are not included in this
proposal. See Securities Exchange Act Release No. 48709 (October 28,
2003), 68 FR 62972 (November 6, 2003) (proposing new Regulation SHO
regarding short sales, which would, among other things, repeal Rule
10a-1).
\356\ 17 CFR 300.30-3. In addition to the conforming changes, as
discussed below, the Commission is proposing to amend this rule to
grant the Director of the Division of Market Regulation the
authority to grant exemptions to proposed new Rules 610 through 612.
\357\ 17 CFR 230.144.
\358\ 15 U.S.C. 77a et seq.
\359\ 17 CFR 240.31-1.
\360\ 17 CFR 249.1001.
\361\ 17 CFR 3a51-1.
\362\ 17 CFR 240.3b-16.
\363\ 17 CFR 240.10b-10. Proposed amendments to Exchange Act
Rules 3a51-1 and Rule 10b-10 are currently under consideration and
have been published for comment. See Securities Exchange Act Release
Nos. 49148 (January 29, 2004) and 49037 (January 8, 2004). If the
amendments to one or both of these rules are adopted before the
amendments proposed in this release, then the new definitions would
also have to be revised.
\364\ 17 CFR 240.10b-18.
\365\ 17 CFR 240.15b9-1.
\366\ 17 CFR 240.12a-7.
\367\ 17 CFR 240.12f-1.
\368\ 17 CFR 240.12f-2.
\369\ 17 CFR 240.15c2-11.
\370\ 17 CFR 240.19c-3.
\371\ 17 CFR 240.19c-4.
\372\ 17 CFR 242.100.
\373\ 17 CFR 242.300.
\374\ 17 CFR 242.301.
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4. Exemptive Authority
Proposed Rules 610, 611, and 612 each provide that the Commission
may exempt persons from the provisions of those rules, either
conditionally or unconditionally, if it determines such exemption is
consistent with the public interest and the protection of investors. In
addition, the Commission is proposing to amend 17 CFR 200.30-3 to grant
the Director of the Division of Market Regulation delegated authority
to grant exemptions from the provisions of proposed Regulation NMS.
C. General Request for Comment
The Commission seeks comment on proposed Rule 600 and the
designation of the NMS rules as proposed Regulation NMS, as described
above. The Commission asks commenters to address whether the proposal
would further the NMS goals set out in Section 11A of the Exchange Act,
and whether the definitions contained in proposed Rule 600 are
appropriate and accurate. The Commission also seeks comment on whether
the technical changes proposed to the NMS rules successfully preserve
the scope of the current rules. In addition, the Commission seeks
specific comment on whether additional, non-substantive modifications
could be made to the NMS rules to enhance clarity or remove outdated
references. The Commission also invites commenters to provide views and
data concerning the costs and benefits associated with the proposal.
D. Paperwork Reduction Act
Neither proposed Rule 600 nor any of the conforming amendments to
the NMS rules proposed in Section VII impose recordkeeping or
information collection requirements, or other collections of
information that require the approval of the Office of Management and
Budget under 44 U.S.C. 3501, et seq. Accordingly, the Paperwork
Reduction Act does not apply.
E. Consideration of Costs and Benefits
The Commission proposes to designate the NMS rules as proposed
Regulation NMS and to adopt and include in proposed new Regulation NMS
a separate definitional rule, proposed Rule 600, that would contain all
of the defined terms used in proposed Regulation NMS and make certain
conforming amendments to the NMS rules. Currently, each NMS rule
includes its own set of definitions and some identical terms, such as
``covered security,'' ``reported security,'' and ``subject security''
are defined inconsistently. Although proposed Rule 600 would retain,
unchanged, most of the definitions used in the NMS rules, it would
delete or revise obsolete definitions and eliminate the use of
inconsistent definitions for identical terms. Proposed Rule 600 would
not alter the requirements or operation of the existing NMS rules. By
creating a single set of defined terms for Regulation NMS, proposed
Rule 600 should make the NMS rules clearer and easier to understand.
The Commission has identified below certain costs and benefits
relating to the proposal. The Commission requests comments on all
aspects of this cost-benefit analysis, including identification of any
additional costs or benefits of the proposal. The Commission encourages
commenters to identify and supply any relevant data, analysis, and
estimates concerning the costs or benefits of the proposal.
1. Benefits
The Commission preliminarily believes that proposed Rule 600 and
the related proposed amendments would benefit all entities that are
subject to the requirements of proposed Regulation NMS including
broker-dealers, national securities exchanges, the NASD, ECNs, SIPs,
and vendors. By eliminating or revising obsolete and inconsistent
definitions and adopting a single set of definitions that would be used
throughout proposed Regulation NMS, proposed Rule 600 should make
proposed Regulation NMS easier to understand, thereby facilitating
compliance with its requirements and potentially easing the compliance
burden on entities subject to proposed Regulation NMS. Increased
compliance with proposed Regulation NMS would, in turn, benefit
investors and the public interest.
2. Costs
Proposed Rule 600 would update and clarify the definitions used in
the NMS rules. Neither proposed Rule 600 nor the related proposed
amendments would alter the existing requirements of the NMS rules.
Accordingly, the Commission believes that the proposed changes would
likely impose few additional costs on entities subject to
[[Page 11198]]
proposed Regulation NMS. Although some additional personnel costs may
be incurred in reviewing the proposed changes, the Commission believes
that these costs would be minimal.
F. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act \375\ requires the Commission,
whenever it engages in rulemaking or in the review of a rule of an SRO,
and it is required to consider or determine whether an action is
necessary or appropriate in the public interest, to consider, in
addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. Section
23(a)(2) of the Exchange Act \376\ requires the Commission, in adopting
rules under the Exchange Act, to consider the impact that any such rule
would have on competition. Section 23(a)(2) of the Exchange Act
prohibits the Commission from adopting any rule that would impose a
burden on competition not necessary or appropriate in furtherance of
the purposes of the Exchange Act.
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\375\ 15 U.S.C. 78c(f).
\376\ 15 U.S.C. 78w(a)(2).
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Proposed Rule 600 and the related proposed amendments should help
to promote efficiency and capital formation by making the NMS rules
easier to understand, thereby helping to reduce compliance costs for
entities subject to the rules. Enhanced clarity in the definitions used
in proposed Regulation NMS also should benefit investors and the public
interest by facilitating compliance with the requirements of proposed
Regulation NMS. Because proposed Rule 600 would merely clarify the
definitions used in proposed Regulation NMS without imposing new
requirements, and because the related proposed amendments would create
no new requirements, this proposal should not impose a burden on
competition or alter the competitive standing of entities subject to
proposed Regulation NMS.
The Commission requests comment on whether the proposed changes are
expected to affect efficiency, competition, and capital formation.
G. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \377\ the Commission must advise the Office
of Management and Budget as to whether the proposed regulation
constitutes a ``major'' rule. Under SBREFA, a rule is considered
``major'' where, if adopted, it results or is likely to result in:
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\377\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified
in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C.
601).
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An annual effect on the economy of $100 million
or more (either in the form of an increase or a decrease);
A major increase in costs or prices for
consumers or individual industries; or
Significant adverse effect on competition,
investment, or innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. The Commission requests
comment on the potential impact of the proposal on the economy on an
annual basis. Commenters are requested to provide empirical data and
other factual support for their view to the extent possible.
H. Regulatory Flexibility Act Certification
The Commission hereby certifies, pursuant to 5 U.S.C. 605(b), that
proposed Rule 600 and the related proposed amendments, if adopted,
would not have a significant economic impact on a substantial number of
small entities. Proposed Rule 600 would revise and clarify the
definitions used in proposed Regulation NMS, thereby facilitating
compliance with proposed Regulation NMS and potentially easing the
compliance burden on entities seeking to comply with the regulation.
Neither proposed Rule 600 nor the related proposed amendments of the
NMS rules would alter the existing requirements of the NMS rules.
Accordingly, the Commission does not believe that proposed Rule 600 and
the re-designation of the NMS rules as proposed Regulation NMS would
have a significant impact on a substantial number of small entities.
The Commission encourages written comments regarding this
certification. The Commission requests that commenters describe the
nature of any impact on small entities and provide empirical data to
support the extent of the impact.
VIII. Statutory Authority
Pursuant to the Exchange Act and particularly, Sections 2, 3(b), 5,
6, 11A, 15, 15A, 17(a) and (b), 19, 23(a), and 36 thereof, 15 U.S.C.
78b, 78c(b), 78e, 78f, 78k-1, 78o, 78o-3, 78q(a) and (b), 78s; 78w(a),
and 78mm, and Rules 11Aa3-2(b)(2) and 11Aa3-2(c)(1) thereunder, 17 CFR
240.11Aa3-2(b)(2) and 17 CFR 240.11Aa3-2(c)(1), the Commission proposes
to: (1) Redesignate the NMS rules under Section 11A of the Exchange Act
as Regulation NMS rules; (2) adopt Rules 600, 610, 611, and 612 of
Regulation NMS; (3) amend current Rules 11Aa3-1 and 11Ac1-2 under the
Exchange Act and redesignate them as Rules 601 and 603 of Regulation
NMS; (4) amend the CTA Plan, the CQ Plan, and the Nasdaq UTP Plan; and
(5) amend various other rules to reflect the adoption of Regulation
NMS, as set forth below.
IX. Text of the Proposed Amendments to the CTA Plan, the CQ Plan, and
the Nasdaq UTP Plan
The Commission hereby proposes to amend the CTA Plan, the CQ Plan,
and the Nasdaq UTP Plan to incorporate the new net income allocation
formula into each Plan, which would supercede the existing allocation
formulas in those Plans, and to incorporate the new Plan governance
language into each Plan.
Set forth below is the text of (1) the proposed new allocation
formula to be incorporated into each of the Plans, and (2) the proposed
new Plan governance language to be incorporated into each of the Plans.
Proposed Formula Amendment
() Allocation of Net Income.
(a) Annual Payment. Notwithstanding any other provision of this
Plan, each Participant eligible to receive distributable net income
under the Plan shall receive an annual payment for each calendar year
that is equal to the sum of the Participant's Trading Shares, Quoting
Shares, and NBBO Improvement Shares, as defined below, in each Eligible
Security for the calendar year.
(b) Security Income Allocation. The Security Income Allocation for
an Eligible Security shall be determined by multiplying (i) the
distributable net income of the Plan for the calendar year by (ii) the
Volume Percentage for such Eligible Security. The Volume Percentage for
an Eligible Security shall be determined by dividing (i) the square
root of the dollar volume of transaction reports disseminated by the
Processor in such Eligible Security during the calendar year by (ii)
the sum of the square roots of the dollar volume of transaction reports
disseminated by the Processor in each Eligible Security during the
calendar year.
(c) Trading Share. The Trading Share of a Participant in an
Eligible Security shall be determined by multiplying (i) an amount
equal to the lesser of (A) fifty percent of the Security Income
Allocation for the Eligible Security or (B) an amount equal to $2.00
multiplied by the total number of qualified transaction reports
disseminated by the Processor in the Eligible Security during
[[Page 11199]]
the calendar year, by (ii) the Participant's Trade Rating in the
Eligible Security. A Participant's Trade Rating in an Eligible Security
shall be determined by taking the average of (i) the Participant's
percentage of the total dollar volume of transaction reports
disseminated by the Processor in the Eligible Security during the
calendar year, and (ii) the Participant's percentage of the total
number of qualified transaction reports disseminated by the Processor
in the Eligible Security during the calendar year. A qualified
transaction report shall have a dollar volume of $5,000 or greater.
(d) Quoting Share. The Quoting Share of a Participant in an
Eligible Security shall be determined by multiplying (i) an amount
equal to thirty-five percent of the Security Income Allocation for the
Eligible Security, plus the difference, if greater than zero, between
fifty percent of the Security Income Allocation for the Eligible
Security and an amount equal to $2.00 multiplied by the total number of
qualified transaction reports disseminated by the Processor in the
Eligible Security during the calendar year, by (ii) the Participant's
Quote Rating in the Eligible Security. A Participant's Quote Rating in
an Eligible Security shall be determined by dividing (i) the sum of the
Quote Credits earned by the Participant in such Eligible Security
during the calendar year by (ii) the sum of the Quote Credits earned by
all Participants in such Eligible Security during the calendar year. A
Participant shall earn one Quote Credit for each second of time
multiplied by dollar value of size that a firm bid (offer) transmitted
by the Participant to the Processor during regular trading hours is
equal to the price of the national best bid (offer) in the Eligible
Security; provided, however, with respect to quotes transmitted by a
Participant that are not fully accessible through automatic execution,
that such quotes will cease earning credits when they are left alone at
the national best bid (offer) as a result of quote changes transmitted
by other Participants. A Participant may recommence earning credits for
a quote that is left alone at the national best bid (offer) by
retransmitting the quote to confirm a current willingness to trade at
the price of such quote. The dollar value of size of a quote shall be
determined by multiplying the price of a quote by its size.
(e) NBBO Improvement Share. The NBBO Improvement Share of a
Participant in an Eligible Security shall be determined by multiplying
(i) an amount equal to fifteen percent of the Security Income
Allocation for the Eligible Security by (ii) the Participant's NBBO
Improvement Rating in the Eligible Security. A Participant's NBBO
Improvement Rating in an Eligible Security shall be determined by
dividing (i) the sum of the NBBO Improvement Credits earned by the
Participant in such Eligible Security during the calendar year by (ii)
the sum of the NBBO Improvement Credits earned by all Participants in
such Eligible Security during the calendar year. A Participant shall
earn one NBBO Improvement Credit for each five seconds of time
multiplied by the dollar value of size that a firm bid (offer)
transmitted by the Participant to the Processor during regular trading
hours increases (lowers) the price of the existing national best bid
(offer) in the Eligible Security (``Qualified Quote'') and continues to
remain equal to the price of the national best bid (offer) in such
Eligible Security. In addition, a Participant shall earn NBBO
Improvement Credits for a Qualified Quote equal to the total amount of
dollar volume of the Participant's transaction reports in the Eligible
Security (i) that are transmitted after the Qualified Quote and up to
five seconds after the price of the Qualified Quote no longer continues
to equal the price of the national best bid (offer) in such Eligible
Security, and (ii) that have prices equal to the price of the Qualified
Quote; provided, however, that the total NBBO Improvement Credits for a
Qualified Quote earned from transaction reports shall not exceed an
amount equal to the initial dollar value of size of such Qualified
Quote plus the total number of NBBO Improvement Credits earned for the
time and size of such Qualified Quote.
Proposed Governance Amendment
() Advisory Committee.
(a) Formation. Notwithstanding any other provision of this Plan, an
Advisory Committee to the Plan shall be formed and shall function in
accordance with the provisions set forth in this section.
(b) Composition. Members of the Advisory Committee shall be
selected for two-year terms as follows:
(1) Operating Committee Selections. By affirmative vote of a
majority of the Participants entitled to vote, the Operating Committee
shall select at least one representative from each of the following
categories to be members of the Advisory Committee: (i) A broker-dealer
with a substantial retail investor customer base, (ii) a broker-dealer
with a substantial institutional investor customer base, (iii) an
alternative trading system, (iv) a data vendor, and (v) an investor.
(2) Participant Selections. Each Participant shall have the right
to select one member of the Advisory Committee. A Participant shall not
select any person employed by or affiliated with any Participant.
(c) Function. Members of the Advisory Committee shall have the
right to submit their views to the Operating Committee on Plan matters,
prior to a decision by the Operating Committee on such matters. Such
matters shall include, but not be limited to, any new or modified
product, fee, contract, or pilot program that is offered or used
pursuant to the Plan.
(d) Meetings and Information. Members of the Advisory Committee
shall have the right to attend all meetings of the Operating Committee
and to receive any information concerning plan matters that is
distributed to the Operating Committee; provided, however, that the
Operating Committee may meet in executive session if, by affirmative
vote of a majority of the Participants entitled to vote, the Operating
Committee determines that an item of Plan business requires
confidential treatment.
X. Text of Proposed Rules
List of Subjects
17 CFR Part 200
Administrative practice and procedure, Authority delegations
(Government agencies), Organization and functions (Government
agencies).
17 CFR Part 230
Reporting and recordkeeping requirements, Securities.
17 CFR Parts 240, 242, and 249
Brokers, Reporting and recordkeeping requirements, Securities.
Text of Proposed Rules
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of the Federal Regulations is proposed to be amended as
follows:
PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND
REQUESTS
1. The authority citation for part 200 continues to read in part as
follows:
Authority: 15 U.S.C. 77s, 78d-1, 78d-2, 78w, 78ll(d), 78mm, 79t,
77sss, 80a-37, 80b-11, unless otherwise noted.
* * * * *
2. Section 200.30-3 is amended by:
(a) Removing paragraphs (a)(62) and (a)(71);
[[Page 11200]]
(b) Redesignating paragraphs (a)(63) through (a)(78) as paragraphs
(a)(62) through (a)(76);
(c) Revising paragraphs (a)(27), (a)(28), (a)(36), (a)(37),
(a)(42), (a)(49), (a)(61), and newly redesignated paragraphs (a)(68),
and (a)(69); and
(d) Adding new paragraphs (a)(77), (a)(78), and (a)(79).
The revisions and additions read as follows:
Sec. 200.30-3 Delegation of authority to Director of Division of
Market Regulation.
* * * * *
(a) * * *
(27) To approve amendments to the joint industry plan governing
consolidated transaction reporting declared effective by the Commission
pursuant to Rule 601 (17 CFR 242.601) or its predecessors, Rule 11Aa3-1
and Rule 17a-15, and to grant exemptions from Rule 601 pursuant to Rule
601(f) (17 CFR 242.601(f)) to exchanges trading listed securities that
are designated as national market system securities until such times as
a Joint Reporting Plan for such securities is filed and approved by the
Commission.
(28) To grant exemptions from Rule 602 (17 CFR 242.602), pursuant
to Rule 602(d) (17 CFR 242.602(d)).
* * * * *
(36) To grant exemptions from Rule 603 (17 CFR 242.603), pursuant
to Rule 603(c) (17 CFR 242.603(c)).
(37) Pursuant to Rule 600 (17 CFR 242.600), to publish notice of
the filing of a designation plan with respect to national market system
securities, or any proposed amendment thereto, and to approve such plan
or amendment.
* * * * *
(42) Under 17 CFR 242.608(e), to grant or deny exemptions from 17
CFR 242.608.
* * * * *
(49) Pursuant to section 11A(b) of the Act (15 U.S.C. 78k-1(b)) and
Rule 609 thereunder (17 CFR 242.609), to publish notice of and, by
order, grant under section 11A(b) of the Act and Rule 609 thereunder:
Applications for registration as a securities information processor;
and exemptions from that section and any rules or regulations
promulgated thereunder, either conditionally or unconditionally.
* * * * *
(61) To grant exemptions from Rule 604 (17 CFR 242.604), pursuant
to Rule 604(c) (17 CFR 242.604(c)).
* * * * *
(68) Pursuant to Rule 605(b) (17 CFR 242.605(b)), to grant or deny
exemptions, conditionally or unconditionally, from any provision or
provisions of Rule 605 (17 CFR 242.605).
(69) Pursuant to Rule 606(c) (17 CFR 242.606(c)), to grant or deny
exemptions, conditionally or unconditionally, from any provision or
provisions of Rule 606 (17 CFR 242.606).
* * * * *
(77) To grant or deny exemptions from Rule 610 (17 CFR 242.610),
pursuant to Rule 610(d) (17 CFR 242.610(d)).
(78) To grant or deny exemptions from Rule 611 (17 CFR 242.611),
pursuant to Rule 611(d) (17 CFR 242.611(d)).
(79) To grant or deny exemptions from Rule 612 (17 CFR 242.612),
pursuant to Rule 612(b) (17 CFR 242.612(b)).
* * * * *
PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933
3. The general authority citation for part 230 is revised to read
as follows:
Authority: 15 U.S.C. 77b, 77c, 77d, 77f, 77g, 77h, 77j, 77r,
77s, 77z-3, 78c, 78d, 78j, 78l, 78m, 78n, 78o, 78t, 78w, 78ll(d),
78mm, 79t, 77sss, 80a-8, 80a-24, 80a-28, 80a-29, 80a-30, and 80a-37,
unless otherwise noted.
* * * * *
4. Section 230.144 is amended by:
(a) Removing the authority citation following Sec. 230.144; and
(b) Revising paragraph (e)(1)(iii).
The revision reads as follows:
Sec. 230.144 Persons deemed not to be engaged in a distribution and
therefore not underwriters.
* * * * *
(e) * * *
(1) * * *
(iii) The average weekly volume of trading in such securities
reported pursuant to an effective transaction reporting plan or an
effective national market system plan as those terms are defined in
Sec. 242.600 of this chapter during the four-week period specified in
paragraph (e)(1)(ii) of this section.
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
5. The general authority citation for part 240 is revised to read
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 78c,
78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o,
78p, 78q, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 79q, 79t, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4,
80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise
noted.
* * * * *
6. Section 240.3a51-1 is amended by revising the introductory text
of the section and the introductory text of paragraph (a) to read as
follows:
Sec. 240.3a51-1 Definition of ``penny stock.''
For purposes of section 3(a)(51) of the Act (15 U.S.C. 78c(a)(51)),
the term penny stock shall mean any equity security other than a
security:
(a) That is an NMS stock, as defined in Sec. 242.600 of this
chapter, provided that:
* * * * *
7. Section 240.3b-16 is amended by revising paragraph (d) to read
as follows:
Sec. 240.3b-16 Definitions of terms used in Section 3(a)(1) of the
Act.
* * * * *
(d) For the purposes of this section, the terms bid and offer shall
have the same meaning as under Sec. 242.600 of this chapter.
* * * * *
8. Section 240.10b-10 is amended by:
a. Revising paragraphs (a)(2)(i)(C) and (a)(2)(ii)(B);
b. Removing paragraph (d)(8); and
c. Redesignating paragraphs (d)(9) and (d)(10) as paragraphs (d)(8)
and (d)(9).
The revisions read as follows:
Sec. 240.10b-10 Confirmation of transactions.
* * * * *
(a) * * *
(1) * * *
(i) * * *
(C) For a transaction in any NMS stock as defined in Sec. 242.600
of this chapter or any other equity security as to which transaction
reports, last sale data or quotation information is disseminated
through an automated quotation system sponsored by a registered
national securities association or a national securities exchange or a
security authorized for quotation on an automated interdealer quotation
system that has the characteristics set forth in section 17B of the Act
(15 U.S.C. 78q-2), a statement whether payment for order flow is
received by the broker or dealer for transactions in such securities
and the fact that the source and nature of the compensation received in
connection with the particular transaction will be furnished upon
written request of the customer; provided, however, that brokers or
dealers that do not receive payment for order flow in connection with
any transaction have no disclosure obligations under this paragraph;
and
* * * * *
[[Page 11201]]
(i) * * *
(B) In the case of any other transaction in an NMS security as
defined by Sec. 242.600 of this chapter, or an equity security that is
quoted on an automated quotation system sponsored by a registered
national securities association or traded on a national securities
exchange and that is subject to last sale reporting, the reported trade
price, the price to the customer in the transaction, and the
difference, if any, between the reported trade price and the price to
the customer.
* * * * *
9. Section 240.10b-18 is amended by revising paragraph (a)(6) to
read as follows:
Sec. 240.10b-18 Purchases of certain equity securities by the issuer
and others.
* * * * *
(a) * * *
(6) Consolidated system means a consolidated transaction or
quotation reporting system that collects and publicly disseminates on a
current and continuous basis transaction or quotation information in
common equity securities pursuant to an effective transaction reporting
plan or an effective national market system plan (as those terms are
defined in Sec. 242.600 of this chapter).
* * * * *
Sec. Sec. 240.11Aa2-1 through 240.11Ac1-6 [Removed]
10. The undesignated center heading preceding Sec. 240.11Aa2-1 and
Sec. Sec. 240.11Aa2-1 through 240.11Ac1-6 are removed.
11. Section 240.12a-7 is amended by revising the introductory text
of paragraph (a)(2) to read as follows:
Sec. 240.12a-7 Exemption of stock contained in standardized market
baskets from section 12(a) of the Act.
(a) * * *
(2) The stock is an NMS stock as defined in Sec. 242.600 of this
chapter and is either:
* * * * *
12. Section 240.12f-1 is amended by:
a. Removing the authority citation following the section;
b. Removing ``and'' at the end of paragraph (a)(3); and
c. Revising paragraph (a)(4).
The revision reads as follows:
Sec. 240.12f-1 Applications for permission to reinstate unlisted
trading privileges.
(a) * * *
(4) Whether transaction information concerning such security is
reported pursuant to an effective transaction reporting plan
contemplated by Sec. 242.601 of this chapter;
* * * * *
13. Section 240.12f-2 is amended by revising paragraph (a) to read
as follows:
Sec. 240.12f-2 Extending unlisted trading privileges to a security
that is the subject of an initial public offering.
(a) General provision. A national securities exchange may extend
unlisted trading privileges to a subject security when at least one
transaction in the subject security has been effected on the national
securities exchange upon which the security is listed and the
transaction has been reported pursuant to an effective transaction
reporting plan, as defined in Sec. 242.600 of this chapter.
* * * * *
14. Section 240.15b9-1 is amended by:
a. Removing the authority citation following the section; and
b. Revising paragraph (c).
The revision reads as follows:
Sec. 240.15b9-1 Exemption for certain exchange members.
* * * * *
(c) For purposes of this section, the term Intermarket Trading
System shall mean the intermarket communications linkage operated
jointly by certain self-regulatory organizations pursuant to a plan
filed with, and approved by, the Commission pursuant to Sec. 242.608
of this chapter.
15. Section 240.15c2-11 is amended by revising paragraph (f)(5) to
read as follows:
Sec. 240.15c2-11 Initiation or resumption of quotations without
specified information.
* * * * *
(f) * * *
(5) The publication or submission of a quotation respecting a
security that is authorized for quotation in the Nasdaq system (as
defined in Sec. 242.600 of this chapter), and such authorization is
not suspended, terminated, or prohibited.
* * * * *
16. Section 240.19c-3 is amended by revising paragraph (b)(6) to
read as follows:
Sec. 240.19c-3 Governing off-board trading by members of national
securities exchanges.
* * * * *
(b) * * *
(6) The term effective transaction reporting plan shall mean any
plan approved by the Commission pursuant to Sec. 242.601 of this
chapter for collecting, processing, and making available transaction
reports with respect to transactions in an equity security or class of
equity securities.
17. Section 240.19c-4 is amended by revising paragraph (e)(6) to
read as follows:
Sec. 240.19c-4 Governing certain listing or authorization
determinations by national securities exchanges and associations.
* * * * *
(e) * * *
(6) The term exchange shall mean a national securities exchange,
registered as such with the Securities and Exchange Commission pursuant
to section 6 of the Act (15 U.S.C. 78f), which makes transaction
reports available pursuant to Sec. 242.601 of this chapter; and
* * * * *
18. Section 240.31-1 is amended by revising paragraph (e) to read
as follows:
Sec. 240.31-1 Securities transactions exempt from transaction fees.
* * * * *
(e) Transactions which are executed outside the United States and
are not reported, or required to be reported, to a transaction
reporting association as defined in Sec. 242.600 of this chapter and
any approved plan filed under Sec. 242.601 of this chapter;
* * * * *
PART 242--REGULATIONS M, ATS, AC, AND NMS AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITY FUTURES
19. The authority citation for part 242 is revised to read as
follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
20. The part heading for part 242 is revised as set forth above.
21. Section 242.100 is amended by revising the definition for
``electronic communications network'' and ``Nasdaq'' found in paragraph
(b) to read as follows:
Sec. 242.100 Preliminary note; definitions.
* * * * *
(b) * * *
Electronic communications network has the meaning provided in Sec.
242.600.
* * * * *
Nasdaq means the electronic dealer quotation system owned and
operated by The Nasdaq Stock Market, Inc.
* * * * *
22. Section 242.300 is amended by:
a. Revising paragraphs (g) and (h);
b. Removing paragraphs (i) and (j); and
[[Page 11202]]
c. Redesignating paragraphs (k), (l), and (m) as paragraphs (i),
(j), and (k).
The revisions read as follows:
Sec. 242.300 Definitions.
* * * * *
(g) NMS stock shall have the meaning provided in Sec. 242.600;
provided, however, that a debt or convertible security shall not be
deemed an NMS stock for purposes of this Regulation ATS.
(h) Effective transaction reporting plan shall have the meaning
provided in Sec. 242.600.
* * * * *
23. Section 242.301 is amended by revising paragraphs (b)(3),
(b)(5), and (b)(6) to read as follows:
Sec. 242.301 Requirements for alternative trading systems.
* * * * *
(b) * * *
(3) Order display and execution access. (i) An alternative trading
system shall comply with the requirements set forth in paragraph
(b)(3)(ii) of this section, with respect to any NMS stock in which the
alternative trading system:
(A) Displays subscriber orders to any person (other than
alternative trading system employees); and
(B) During at least 4 of the preceding 6 calendar months, had an
average daily trading volume of 5 percent or more of the aggregate
average daily share volume for such NMS stock as reported by an
effective transaction reporting plan.
(ii) Such alternative trading system shall provide to a national
securities exchange or national securities association the prices and
sizes of the orders at the highest buy price and the lowest sell price
for such NMS stock, displayed to more than one person in the
alternative trading system, for inclusion in the quotation data made
available by the national securities exchange or national securities
association to vendors pursuant to Sec. 242.602.
(iii) With respect to any order displayed pursuant to paragraph
(b)(3)(ii) of this section, an alternative trading system shall provide
to any broker-dealer that has access to the national securities
exchange or national securities association to which the alternative
trading system provides the prices and sizes of displayed orders
pursuant to paragraph (b)(3)(ii)(A) of this section, the ability to
effect a transaction with such orders that is:
(A) Equivalent to the ability of such broker-dealer to effect a
transaction with other orders displayed on the exchange or by the
association; and
(B) At the price of the highest priced buy order or lowest priced
sell order displayed for the lesser of the cumulative size of such
priced orders entered therein at such price, or the size of the
execution sought by such broker-dealer.
* * * * *
(5) Fair access. (i) An alternative trading system shall comply
with the requirements in paragraph (b)(5)(ii) of this section, if
during at least 4 of the preceding 6 calendar months, such alternative
trading system had:
(A) With respect to any NMS stock, 5 percent or more of the average
daily volume in that security reported by an effective transaction
reporting plan;
(B) With respect to an equity security that is not an NMS stock and
for which transactions are reported to a self-regulatory organization,
5 percent or more of the average daily trading volume in that security
as calculated by the self-regulatory organization to which such
transactions are reported;
(C) With respect to municipal securities, 5 percent or more of the
average daily volume traded in the United States;
(D) With respect to investment grade corporate debt, 5 percent or
more of the average daily volume traded in the United States; or
(E) With respect to non-investment grade corporate debt, 5 percent
or more of the average daily volume traded in the United States.
(ii) An alternative trading system shall:
(A) Establish written standards for granting access to trading on
its system;
(B) Not unreasonably prohibit or limit any person in respect to
access to services offered by such alternative trading system by
applying the standards established under paragraph (b)(5)(ii)(A) of
this section in an unfair or discriminatory manner;
(C) Make and keep records of:
(1) All grants of access including, for all subscribers, the
reasons for granting such access; and
(2) All denials or limitations of access and reasons, for each
applicant, for denying or limiting access; and
(D) Report the information required on Form ATS-R (Sec. 249.638 of
this chapter) regarding grants, denials, and limitations of access.
(iii) Notwithstanding paragraph (b)(5)(i) of this section, an
alternative trading system shall not be required to comply with the
requirements in paragraph (b)(5)(ii) of this section, if such
alternative trading system:
(A) Matches customer orders for a security with other customer
orders;
(B) Such customers' orders are not displayed to any person, other
than employees of the alternative trading system; and
(C) Such orders are executed at a price for such security
disseminated by an effective transaction reporting plan, or derived
from such prices.
(6) Capacity, integrity, and security of automated systems.
(i) The alternative trading system shall comply with the
requirements in paragraph (b)(6)(ii) of this section, if during at
least 4 of the preceding 6 calendar months, such alternative trading
system had:
(A) With respect to any NMS stock, 20 percent or more of the
average daily volume reported by an effective transaction reporting
plan;
(B) With respect to equity securities that are not NMS stocks and
for which transactions are reported to a self-regulatory organization,
20 percent or more of the average daily volume as calculated by the
self-regulatory organization to which such transactions are reported;
(C) With respect to municipal securities, 20 percent or more of the
average daily volume traded in the United States;
(D) With respect to investment grade corporate debt, 20 percent or
more of the average daily volume traded in the United States; or
(E) With respect to non-investment grade corporate debt, 20 percent
or more of the average daily volume traded in the United States.
(ii) With respect to those systems that support order entry, order
routing, order execution, transaction reporting, and trade comparison,
the alternative trading system shall:
(A) Establish reasonable current and future capacity estimates;
(B) Conduct periodic capacity stress tests of critical systems to
determine such system's ability to process transactions in an accurate,
timely, and efficient manner;
(C) Develop and implement reasonable procedures to review and keep
current its system development and testing methodology;
(D) Review the vulnerability of its systems and data center
computer operations to internal and external threats, physical hazards,
and natural disasters;
(E) Establish adequate contingency and disaster recovery plans;
(F) On an annual basis, perform an independent review, in
accordance with established audit procedures and standards, of such
alternative trading system's controls for ensuring that paragraphs
(b)(6)(ii)(A) through (E) of
[[Page 11203]]
this section are met, and conduct a review by senior management of a
report containing the recommendations and conclusions of the
independent review; and
(G) Promptly notify the Commission staff of material systems
outages and significant systems changes.
(iii) Notwithstanding paragraph (b)(6)(i) of this section, an
alternative trading system shall not be required to comply with the
requirements in paragraph (b)(6)(ii) of this section, if such
alternative trading system:
(A) Matches customer orders for a security with other customer
orders;
(B) Such customers' orders are not displayed to any person, other
than employees of the alternative trading system; and
(C) Such orders are executed at a price for such security
disseminated by an effective transaction reporting plan, or derived
from such prices.
* * * * *
24. Part 242 is amended by adding Regulation NMS, Sec. Sec.
242.600 through 242.612 to read as follows:
Sec.
Regulation NMS--Regulation of the National Market System
242.600 NMS security designation and definitions.
242.601 Dissemination of transaction reports and last sale data with
respect to transactions in NMS stocks.
242.602 Dissemination of quotations in NMS securities.
242.603 Distribution, consolidation, and display of information with
respect to quotations for and transactions in NMS stocks.
242.604 Display of customer limit orders.
242.605 Disclosure of order execution information.
242.606 Disclosure of order routing information.
242.607 Customer account statements.
242.608 Filing and amendment of national market system plans.
242.609 Registration of securities information processors: form of
application and amendments.
242.610 Access to published bids and offers.
242.611 Trade-through rule.
242.612 Minimum pricing increment.
Regulation NMS--Regulation of the National Market System
Sec. 242.600 NMS security designation and definitions.
(a) The term national market system security as used in section
11A(a)(2) of the Act (15 U.S.C. 78k-1(a)(2)) shall mean any NMS
security as defined in paragraph (b) of this section.
(b) For purposes of Regulation NMS (Sec. Sec. 242.600 through
242.612), the following definitions shall apply:
(1) Aggregate quotation size means the sum of the quotation sizes
of all responsible brokers or dealers who have communicated on any
national securities exchange bids or offers for an NMS security at the
same price.
(2) Alternative trading system has the meaning provided in Sec.
242.300(a).
(3) Automated order execution facility means an order execution
facility that provides for an immediate automated response to all
incoming subject orders for up to the full size of its best bid and
best offer disseminated pursuant to an effective national market system
plan without any restriction on execution.
(4) Average effective spread means 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 national best bid and national best offer at the time
of order receipt and, for sell orders, as double the amount of
difference between the midpoint of the national best bid and national
best offer at the time of order receipt and the execution price.
(5) Average realized spread means 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 national best bid and national best offer five minutes
after the time of order execution and, for sell orders, as double the
amount of difference between the midpoint of the national best bid and
national best offer five minutes after the time of order execution and
the execution price; provided, however, that the midpoint of the final
national best bid and national best 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.
(6) Best bid and best offer mean the highest priced bid and the
lowest priced offer.
(7) Bid or offer means the bid price or the offer price
communicated by a member of a national securities exchange or member of
a national securities association to any broker or dealer, or to any
customer, at which it is willing to buy or sell one or more round lots
of an NMS security, as either principal or agent, but shall not include
indications of interest.
(8) Block size with respect to an order means it is:
(i) Of at least 10,000 shares; or
(ii) For a quantity of stock having a market value of at least
$200,000.
(9) Categorized by order size means 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.
(10) Categorized by order type means 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.
(11) Categorized by security means dividing orders into separate
categories for each NMS stock that is included in a report.
(12) Consolidated display means:
(i) The prices, sizes, and market identifications of the national
best bid and national best offer for a security; and
(ii) Consolidated last sale information for a security.
(13) Consolidated last sale information means the price, volume,
and market identification of the most recent transaction report for a
security that is disseminated pursuant to an effective national market
system plan.
(14) Covered order means 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 national best bid and
national best 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.
(15) Customer means any person that is not a broker or dealer.
(16) Customer limit order means an order to buy or sell an NMS
stock at a specified price that is not for the account of either a
broker or dealer; provided, however, that the term customer limit order
shall include an order transmitted by a broker or dealer on behalf of a
customer.
(17) Customer order means an order to buy or sell an NMS 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 an NMS security that is an option contract and a
market value of at least $200,000 for any other NMS security.
(18) Directed order means a customer order that the customer
specifically
[[Page 11204]]
instructed the broker or dealer to route to a particular venue for
execution.
(19) Dynamic market monitoring device means any service provided by
a vendor on an interrogation device or other display that:
(i) Permits real-time monitoring, on a dynamic basis, of
transaction reports, last sale data, or quotation information with
respect to a particular security; and
(ii) Displays the most recent transaction report, last sale data,
or quotation information with respect to that security until such
report, data, or information has been superseded or supplemented by the
display of a new transaction report, last sale data, or quotation
information reflecting the next reported transaction or quotation in
that security.
(20) Effective national market system plan means any national
market system plan approved by the Commission (either temporarily or on
a permanent basis) pursuant to Sec. 242.608.
(21) Effective transaction reporting plan means any transaction
reporting plan approved by the Commission pursuant to Sec. 242.601.
(22) Electronic communications network means any electronic system
that widely disseminates to third parties orders entered therein by an
exchange market maker or OTC market maker, and permits such orders to
be executed against in whole or in part; except that the term
electronic communications network shall not include:
(i) Any system that crosses multiple orders at one or more
specified times at a single price set by the system (by algorithm or by
any derivative pricing mechanism) and does not allow orders to be
crossed or executed against directly by participants outside of such
times; or
(ii) Any system operated by, or on behalf of, an OTC market maker
or exchange market maker that executes customer orders primarily
against the account of such market maker as principal, other than
riskless principal.
(23) Exchange market maker means any member of a national
securities exchange that is registered as a specialist or market maker
pursuant to the rules of such exchange.
(24) Exchange-traded security means any NMS security or class of
NMS securities listed and registered, or admitted to unlisted trading
privileges, on a national securities exchange; provided, however, that
securities not listed on any national securities exchange that are
traded pursuant to unlisted trading privileges are excluded.
(25) Executed at the quote means, for buy orders, execution at a
price equal to the national best offer at the time of order receipt
and, for sell orders, execution at a price equal to the national best
bid at the time of order receipt.
(26) Executed outside the quote means, for buy orders, execution at
a price higher than the national best offer at the time of order
receipt and, for sell orders, execution at a price lower than the
national best bid at the time of order receipt.
(27) Executed with price improvement means, for buy orders,
execution at a price lower than the national best offer at the time of
order receipt and, for sell orders, execution at a price higher than
the national best bid at the time of order receipt.
(28) Inside-the-quote limit order, at-the-quote limit order, and
near-the-quote limit order mean non-marketable buy orders with limit
prices that are, respectively, higher than, equal to, and lower by
$0.10 or less than the national 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 national best offer at the time of order receipt.
(29) Interrogation device means any securities information
retrieval system capable of displaying transaction reports, last sale
data, or quotation information upon inquiry, on a current basis on a
terminal or other device.
(30) Joint self-regulatory organization plan means a plan as to
which two or more self-regulatory organizations, acting jointly, are
sponsors.
(31) Last sale data means any price or volume data associated with
a transaction.
(32) Listed equity security means any equity security listed and
registered, or admitted to unlisted trading privileges, on a national
securities exchange.
(33) Listed option means any option traded on a registered national
securities exchange or automated facility of a national securities
association.
(34) Make publicly available means 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.
(35) Market center means any exchange market maker, OTC market
maker, alternative trading system, national securities exchange, or
national securities association.
(36) Marketable limit order means any buy order with a limit price
equal to or greater than the national best offer at the time of order
receipt, or any sell order with a limit price equal to or less than the
national best bid at the time of order receipt.
(37) Moving ticker means any continuous real-time moving display of
transaction reports or last sale data (other than a dynamic market
monitoring device) provided on an interrogation or other display
device.
(38) Nasdaq security means any registered security listed on The
Nasdaq Stock Market, Inc.
(39) National market system plan means any joint self-regulatory
organization plan in connection with:
(i) The planning, development, operation or regulation of a
national market system (or a subsystem thereof) or one or more
facilities thereof; or
(ii) The development and implementation of procedures and/or
facilities designed to achieve compliance by self-regulatory
organizations and their members with any section of this Regulation NMS
and part 240, subpart A of this chapter promulgated pursuant to section
11A of the Act (15 U.S.C. 78k-1).
(40) National securities association means any association of
brokers and dealers registered pursuant to section 15A of the Act (15
U.S.C. 78o-3).
(41) National securities exchange means any exchange registered
pursuant to section 6 of the Act (15 U.S.C. 78f).
(42) National best bid and national best offer means, with respect
to quotations for an NMS security, the best bid and best offer for such
security that are calculated and disseminated on a current and
continuing basis by a plan processor pursuant to an effective national
market system plan; provided, that in the event two or more market
centers transmit to the plan processor pursuant to such plan identical
bids or offers for an NMS security, the best bid or best offer (as the
case may be) shall be determined by ranking all such identical bids or
offers (as the case may be) first by size (giving the highest ranking
to the bid or offer associated with the largest size), and then by time
(giving the highest ranking to the bid or offer received first in
time).
(43) NMS security means any security or class of securities for
which transaction reports are collected, processed, and made available
pursuant to an effective transaction reporting plan, or an effective
national market system plan for reporting transactions in listed
options.
(44) NMS stock means any NMS security other than an option.
(45) Non-automated order execution facility means an order
execution facility that is not an automated order execution facility.
[[Page 11205]]
(46) Non-directed order means any customer order other than a
directed order.
(47) Odd-lot means an order for the purchase or sale of an NMS
stock in an amount less than a round lot.
(48) Options class means all of the put option or call option
series overlying a security, as defined in section 3(a)(10) of the Act
(15 U.S.C. 78c(a)(10)).
(49) Options series means the contracts in an options class that
have the same unit of trade, expiration date, and exercise price, and
other terms or conditions.
(50) Order execution facility means any exchange market maker; OTC
market maker; any other broker or dealer that executes orders
internally by trading as principal or crossing orders as agent;
alternative trading system; or national securities exchange or national
securities association that operates a facility that executes orders.
(51) OTC market maker means any dealer that holds itself out as
being willing to buy from and sell to its customers, or others, in the
United States, an NMS stock for its own account on a regular or
continuous basis otherwise than on a national securities exchange in
amounts of less than block size.
(52) Participants, when used in connection with a national market
system plan, means any self-regulatory organization which has agreed to
act in accordance with the terms of the plan but which is not a
signatory of such plan.
(53) Payment for order flow has the meaning provided in Sec.
240.10b-10 of this chapter.
(54) Plan processor means any self-regulatory organization or
securities information processor acting as an exclusive processor in
connection with the development, implementation and/or operation of any
facility contemplated by an effective national market system plan.
(55) Profit-sharing relationship means 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.
(56) Published aggregate quotation size means the aggregate
quotation size calculated by a national securities exchange and
displayed by a vendor on a terminal or other display device at the time
an order is presented for execution to a responsible broker or dealer.
(57) Published bid and published offer means the bid or offer of a
responsible broker or dealer for an NMS security communicated by it to
its national securities exchange or association pursuant to Sec.
242.602 and displayed by a vendor on a terminal or other display device
at the time an order is presented for execution to such responsible
broker or dealer.
(58) Published quotation size means the quotation size of a
responsible broker or dealer communicated by it to its national
securities exchange or association pursuant to Sec. 242.602 and
displayed by a vendor on a terminal or other display device at the time
an order is presented for execution to such responsible broker or
dealer.
(59) Quotation size, when used with respect to a responsible
broker's or dealer's bid or offer for an NMS security, means:
(i) The number of shares (or units of trading) of that security
which such responsible broker or dealer has specified, for purposes of
dissemination to vendors, that it is willing to buy at the bid price or
sell at the offer price comprising its bid or offer, as either
principal or agent; or
(ii) In the event such responsible broker or dealer has not so
specified, a normal unit of trading for that NMS security.
(60) Quotations and quotation information mean bids, offers and,
where applicable, quotation sizes and aggregate quotation sizes.
(61) Quoting market center means an order execution facility of any
national securities exchange or national securities association that is
required to make available to a vendor its best bid or best offer in a
security pursuant to Sec. 242.602.
(62) Quoting market participant means any broker or dealer that
provides its best bid or best offer in a security to a national
securities exchange or national securities association pursuant to
Sec. 242.602 or Regulation ATS (Sec. Sec. 242.300 through 242.303),
and the best bid or best offer of which is not otherwise available
through a quoting market center.
(63) Regular trading hours means 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 Sec. 242.605(a)(2).
(64) Responsible broker or dealer means:
(i) When used with respect to bids or offers communicated on a
national securities exchange, any member of such national securities
exchange who communicates to another member on such national securities
exchange, at the location (or locations) or through the facility or
facilities designated by such national securities exchange for trading
in an NMS security a bid or offer for such NMS security, as either
principal or agent; provided, however, that, in the event two or more
members of a national securities exchange have communicated on or
through such national securities exchange bids or offers for an NMS
security at the same price, each such member shall be considered a
responsible broker or dealer for that bid or offer, subject to the
rules of priority and precedence then in effect on that national
securities exchange; and further provided, that for a bid or offer
which is transmitted from one member of a national securities exchange
to another member who undertakes to represent such bid or offer on such
national securities exchange as agent, only the last member who
undertakes to represent such bid or offer as agent shall be considered
the responsible broker or dealer for that bid or offer; and
(ii) When used with respect to bids and offers communicated by an
OTC market maker to a broker or dealer or a customer, the OTC market
maker communicating the bid or offer (regardless of whether such bid or
offer is for its own account or on behalf of another person).
(65) Revised bid or offer means a market maker's bid or offer which
supersedes its published bid or published offer.
(66) Revised quotation size means a market maker's quotation size
which supersedes its published quotation size.
(67) Self-regulatory organization means any national securities
exchange or national securities association.
(68) Specified persons, when used in connection with any
notification required to be provided pursuant to Sec. 242.602(a)(3)
and any election (or withdrawal thereof) permitted under Sec.
242.602(a)(5), means:
(i) Each vendor;
(ii) Each plan processor; and
(iii) The processor for the Options Price Reporting Authority (in
the case of a notification for a subject security which is a class of
securities underlying options admitted to trading on any national
securities exchange).
(69) Sponsor, when used in connection with a national market system
plan, means any self-regulatory organization which is a signatory to
such plan and has agreed to act in accordance with the terms of the
plan.
(70) Subject order means any order to buy or sell an NMS stock
received by an order execution facility from itself, any member,
customer, subscriber or any other order execution facility that is
executed during regular trading hours.
(71) Subject security means:
(i) With respect to a national securities exchange:
[[Page 11206]]
(A) Any exchange-traded security other than a security for which
the executed volume of such exchange, during the most recent calendar
quarter, comprised one percent or less of the aggregate trading volume
for such security as reported pursuant to an effective transaction
reporting plan or effective national market system plan; and
(B) Any other NMS security for which such exchange has in effect an
election, pursuant to Sec. 242.602(a)(5)(i), to collect, process, and
make available to a vendor bids, offers, quotation sizes, and aggregate
quotation sizes communicated on such exchange; and
(ii) With respect to a member of a national securities association:
(A) Any exchange-traded security for which such member acts in the
capacity of an OTC market maker unless the executed volume of such
member, during the most recent calendar quarter, comprised one percent
or less of the aggregate trading volume for such security as reported
pursuant to an effective transaction reporting plan or effective
national market system plan; and
(B) Any other NMS security for which such member acts in the
capacity of an OTC market maker and has in effect an election, pursuant
to Sec. 242.602(a)(5)(ii), to communicate to its association bids,
offers, and quotation sizes for the purpose of making such bids,
offers, and quotation sizes available to a vendor.
(72) Time of order execution means the time (to the second) that an
order was executed at any venue.
(73) Time of order receipt means the time (to the second) that an
order was received by a market center for execution.
(74) Time of the transaction has the meaning provided in Sec.
240.10b-10 of this chapter.
(75) Trade-through means the purchase or sale of an NMS stock
during regular trading hours, either as principal or agent, at a price
that is lower than the best bid or higher than the best offer of any
order execution facility that is disseminated pursuant to an effective
national market system plan at the time the transaction was executed.
(76) Trading rotation means, with respect to an options class, the
time period on a national securities exchange during which:
(i) Opening, re-opening, or closing transactions in options series
in such options class are not yet completed; and
(ii) Continuous trading has not yet commenced or has not yet ended
for the day in options series in such options class.
(77) Transaction report means a report containing the price and
volume associated with a transaction involving the purchase or sale of
one or more round lots of a security.
(78) Transaction reporting association means any person authorized
to implement or administer any transaction reporting plan on behalf of
persons acting jointly under Sec. 242.601(a).
(79) Transaction reporting plan means any plan for collecting,
processing, making available or disseminating transaction reports with
respect to transactions in NMS stocks filed with the Commission
pursuant to, and meeting the requirements of, Sec. 242.601.
(80) Vendor means any securities information processor engaged in
the business of disseminating transaction reports, last sale data, or
quotation information with respect to NMS securities to brokers,
dealers, or investors on a real-time or other current and continuing
basis, whether through an electronic communications network, moving
ticker, or interrogation device.
Sec. 242.601 Dissemination of transaction reports and last sale data
with respect to transactions in NMS stocks.
(a)(1) Every national securities exchange shall file a transaction
reporting plan regarding transactions in listed equity and Nasdaq
securities executed through its facilities, and every national
securities association shall file a transaction reporting plan
regarding transactions in listed equity and Nasdaq securities executed
by its members otherwise than on a national securities exchange.
(2) Any transaction reporting plan, or any amendment thereto, filed
pursuant to this section shall be filed with the Commission, and
considered for approval, in accordance with the procedures set forth in
Sec. 242.608(a) and (b). Any such plan, or amendment thereto, shall
specify, at a minimum:
(i) The listed equity and Nasdaq securities or classes of such
securities for which transaction reports shall be required by the plan;
(ii) Reporting requirements with respect to transactions in listed
equity securities and Nasdaq securities, for any broker or dealer
subject to the plan;
(iii) The manner of collecting, processing, sequencing, making
available and disseminating transaction reports and last sale data
reported pursuant to such plan;
(iv) The manner in which such transaction reports reported pursuant
to such plan are to be consolidated with transaction reports from
national securities exchanges and national securities associations
reported pursuant to any other effective transaction reporting plan;
(v) The applicable standards and methods which will be utilized to
ensure promptness of reporting, and accuracy and completeness of
transaction reports;
(vi) Any rules or procedures which may be adopted to ensure that
transaction reports or last sale data will not be disseminated in a
fraudulent or manipulative manner;
(vii) Specific terms of access to transaction reports made
available or disseminated pursuant to the plan; and
(viii) That transaction reports or last sale data made available to
any vendor for display on an interrogation device identify the
marketplace where each transaction was executed.
(3) No transaction reporting plan filed pursuant to this section,
or any amendment to an effective transaction reporting plan, shall
become effective unless approved by the Commission or otherwise
permitted in accordance with the procedures set forth in Sec. 242.608.
(b) Prohibitions and reporting requirements.
(1) No broker or dealer may execute any transaction in, or induce
or attempt to induce the purchase or sale of, any NMS stock:
(i) On or through the facilities of a national securities exchange
unless there is an effective transaction reporting plan with respect to
transactions in such security executed on or through such exchange
facilities; or
(ii) Otherwise than on a national securities exchange unless there
is an effective transaction reporting plan with respect to transactions
in such security executed otherwise than on a national securities
exchange by such broker or dealer.
(2) Every broker or dealer who is a member of a national securities
exchange or national securities association shall promptly transmit to
the exchange or association of which it is a member all information
required by any effective transaction reporting plan filed by such
exchange or association (either individually or jointly with other
exchanges and/or associations).
(c) Retransmission of transaction reports or last sale data.
Notwithstanding any provision of any effective transaction reporting
plan, no national securities exchange or national securities
association may, either individually or jointly, by rule, stated policy
or practice, transaction reporting plan or otherwise, prohibit,
condition or otherwise limit, directly or indirectly, the ability of
any vendor to retransmit,
[[Page 11207]]
for display in moving tickers, transaction reports or last sale data
made available pursuant to any effective transaction reporting plan;
provided, however, that a national securities exchange or national
securities association may, by means of an effective transaction
reporting plan, condition such retransmission upon appropriate
undertakings to ensure that any charges for the distribution of
transaction reports or last sale data in moving tickers permitted by
paragraph (d) of this section are collected.
(d) Charges. Nothing in this section shall preclude any national
securities exchange or national securities association, separately or
jointly, pursuant to the terms of an effective transaction reporting
plan, from imposing reasonable, uniform charges (irrespective of
geographic location) for distribution of transaction reports or last
sale data.
(e) Appeals. The Commission may, in its discretion, entertain
appeals in connection with the implementation or operation of any
effective transaction reporting plan in accordance with the provisions
of Sec. 242.608(d).
(f) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any national securities exchange, national securities
association, broker, dealer, or specified security if the Commission
determines that such exemption is consistent with the public interest,
the protection of investors and the removal of impediments to, and
perfection of the mechanisms of, a national market system.
Sec. 242.602 Dissemination of quotations in NMS securities.
(a) Dissemination requirements for national securities exchanges
and national securities associations.
(1) Every national securities exchange and national securities
association shall establish and maintain procedures and mechanisms for
collecting bids, offers, quotation sizes, and aggregate quotation sizes
from responsible brokers or dealers who are members of such exchange or
association, processing such bids, offers, and sizes, and making such
bids, offers, and sizes available to vendors, as follows:
(i) Each national securities exchange shall at all times such
exchange is open for trading, collect, process, and make available to
vendors the best bid, the best offer, and aggregate quotation sizes for
each subject security listed or admitted to unlisted trading privileges
which is communicated on any national securities exchange by any
responsible broker or dealer, but shall not include:
(A) Any bid or offer executed immediately after communication and
any bid or offer communicated by a responsible broker or dealer other
than an exchange market maker which is cancelled or withdrawn if not
executed immediately after communication; and
(B) Any bid or offer communicated during a period when trading in
that security has been suspended or halted, or prior to the
commencement of trading in that security on any trading day, on that
exchange.
(ii) Each national securities association shall, at all times that
last sale information with respect to NMS securities is reported
pursuant to an effective transaction reporting plan, collect, process,
and make available to vendors the best bid, best offer, and quotation
sizes communicated otherwise than on an exchange by each member of such
association acting in the capacity of an OTC market maker for each
subject security and the identity of that member (excluding any bid or
offer executed immediately after communication), except during any
period when over-the-counter trading in that security has been
suspended.
(2) Each national securities exchange shall, with respect to each
published bid and published offer representing a bid or offer of a
member for a subject security, establish and maintain procedures for
ascertaining and disclosing to other members of that exchange, upon
presentation of orders sought to be executed by them in reliance upon
paragraph (b)(2) of this section, the identity of the responsible
broker or dealer who made such bid or offer and the quotation size
associated with it.
(3)(i) If, at any time a national securities exchange is open for
trading, such exchange determines, pursuant to rules approved by the
Commission pursuant to section 19(b)(2) of the Act (15 U.S.C.
78s(b)(2)), that the level of trading activities or the existence of
unusual market conditions is such that the exchange is incapable of
collecting, processing, and making available to vendors the data for a
subject security required to be made available pursuant to paragraph
(a)(1) of this section in a manner that accurately reflects the current
state of the market on such exchange, such exchange shall immediately
notify all specified persons of that determination. Upon such
notification, responsible brokers or dealers that are members of that
exchange shall be relieved of their obligation under paragraphs (b)(2)
and (c)(3) of this section and such exchange shall be relieved of its
obligations under paragraphs (a)(1) and (2) of this section for that
security; provided, however, that such exchange will continue, to the
maximum extent practicable under the circumstances, to collect,
process, and make available to vendors data for that security in
accordance with paragraph (a)(1) of this section.
(ii) During any period a national securities exchange, or any
responsible broker or dealer that is a member of that exchange, is
relieved of any obligation imposed by this section for any subject
security by virtue of a notification made pursuant to paragraph
(a)(3)(i) of this section, such exchange shall monitor the activity or
conditions which formed the basis for such notification and shall
immediately renotify all specified persons when that exchange is once
again capable of collecting, processing, and making available to
vendors the data for that security required to be made available
pursuant to paragraph (a)(1) of this section in a manner that
accurately reflects the current state of the market on such exchange.
Upon such renotification, any exchange or responsible broker or dealer
which had been relieved of any obligation imposed by this section as a
consequence of the prior notification shall again be subject to such
obligation.
(4) Nothing in this section shall preclude any national securities
exchange or national securities association from making available to
vendors indications of interest or bids and offers for a subject
security at any time such exchange or association is not required to do
so pursuant to paragraph (a)(1) of this section.
(5)(i) Any national securities exchange may make an election for
purposes of the definition of subject security in Sec.
242.600(b)(71)(i)(B) for any NMS security, by collecting, processing,
and making available bids, offers, quotation sizes, and aggregate
quotation sizes in that security; except that for any NMS security
previously listed or admitted to unlisted trading privileges on only
one exchange and not traded by any OTC market maker, such election
shall be made by notifying all specified persons, and shall be
effective at the opening of trading on the business day following
notification.
(ii) Any member of a national securities association acting in the
capacity of an OTC market maker may make an election for purposes of
the definition of subject security in Sec. 242.600(b)(71)(ii)(B) for
any NMS security, by communicating to its association bids, offers, and
quotation sizes in that security; except that for any other NMS
security listed or admitted to
[[Page 11208]]
unlisted trading privileges on only one exchange and not traded by any
other OTC market maker, such election shall be made by notifying its
association and all specified persons, and shall be effective at the
opening of trading on the business day following notification.
(iii) The election of a national securities exchange or member of a
national securities association for any NMS security pursuant to this
paragraph (a)(5) shall cease to be in effect if such exchange or member
ceases to make available or communicate bids, offers, and quotation
sizes in such security.
(b) Obligations of responsible brokers and dealers.
(1) Each responsible broker or dealer shall promptly communicate to
its national securities exchange or national securities association,
pursuant to the procedures established by that exchange or association,
its best bids, best offers, and quotation sizes for any subject
security.
(2) Subject to the provisions of paragraph (b)(3) of this section,
each responsible broker or dealer shall be obligated to execute any
order to buy or sell a subject security, other than an odd-lot order,
presented to it by another broker or dealer, or any other person
belonging to a category of persons with whom such responsible broker or
dealer customarily deals, at a price at least as favorable to such
buyer or seller as the responsible broker's or dealer's published bid
or published offer (exclusive of any commission, commission equivalent
or differential customarily charged by such responsible broker or
dealer in connection with execution of any such order) in any amount up
to its published quotation size.
(3)(i) No responsible broker or dealer shall be obligated to
execute a transaction for any subject security as provided in paragraph
(b)(2) of this section to purchase or sell that subject security in an
amount greater than such revised quotation if:
(A) Prior to the presentation of an order for the purchase or sale
of a subject security, a responsible broker or dealer has communicated
to its exchange or association, pursuant to paragraph (b)(1) of this
section, a revised quotation size; or
(B) At the time an order for the purchase or sale of a subject
security is presented, a responsible broker or dealer is in the process
of effecting a transaction in such subject security, and immediately
after the completion of such transaction, it communicates to its
exchange or association a revised quotation size, such responsible
broker or dealer shall not be obligated by paragraph (b)(2) of this
section to purchase or sell that subject security in an amount greater
than such revised quotation size.
(ii) No responsible broker or dealer shall be obligated to execute
a transaction for any subject security as provided in paragraph (b)(2)
of this section if:
(A) Before the order sought to be executed is presented, such
responsible broker or dealer has communicated to its exchange or
association pursuant to paragraph (b)(1) of this section, a revised bid
or offer; or
(B) At the time the order sought to be executed is presented, such
responsible broker or dealer is in the process of effecting a
transaction in such subject security, and, immediately after the
completion of such transaction, such responsible broker or dealer
communicates to its exchange or association pursuant to paragraph
(b)(1) of this section, a revised bid or offer; provided, however, that
such responsible broker or dealer shall nonetheless be obligated to
execute any such order in such subject security as provided in
paragraph (b)(2) of this section at its revised bid or offer in any
amount up to its published quotation size or revised quotation size.
(4) Subject to the provisions of paragraph (a)(4) of this section:
(i) No national securities exchange or OTC market maker may make
available, disseminate or otherwise communicate to any vendor, directly
or indirectly, for display on a terminal or other display device any
bid, offer, quotation size, or aggregate quotation size for any NMS
security which is not a subject security with respect to such exchange
or OTC market maker; and
(ii) No vendor may disseminate or display on a terminal or other
display device any bid, offer, quotation size, or aggregate quotation
size from any national securities exchange or OTC market maker for any
NMS security which is not a subject security with respect to such
exchange or OTC market maker.
(5)(i) Entry of any priced order for an NMS security by an exchange
market maker or OTC market maker in that security into an electronic
communications network that widely disseminates such order shall be
deemed to be:
(A) A bid or offer under this section, to be communicated to the
market maker's exchange or association pursuant to this paragraph (b)
for at least the minimum quotation size that is required by the rules
of the market maker's exchange or association if the priced order is
for the account of a market maker, or the actual size of the order up
to the minimum quotation size required if the priced order is for the
account of a customer; and
(B) A communication of a bid or offer to a vendor for display on a
display device for purposes of paragraph (b)(4) of this section.
(ii) An exchange market maker or OTC market maker that has entered
a priced order for an NMS security into an electronic communications
network that widely disseminates such order shall be deemed to be in
compliance with paragraph (b)(5)(i)(A) of this section if the
electronic communications network:
(A)(1) Provides to a national securities exchange or national
securities association (or an exclusive processor acting on behalf of
one or more exchanges or associations) the prices and sizes of the
orders at the highest buy price and the lowest sell price for such
security entered in, and widely disseminated by, the electronic
communications network by exchange market makers and OTC market makers
for the NMS security, and such prices and sizes are included in the
quotation data made available by such exchange, association, or
exclusive processor to vendors pursuant to this section; and
(2) Provides, to any broker or dealer, the ability to effect a
transaction with a priced order widely disseminated by the electronic
communications network entered therein by an exchange market maker or
OTC market maker that is:
(i) Equivalent to the ability of any broker or dealer to effect a
transaction with an exchange market maker or OTC market maker pursuant
to the rules of the national securities exchange or national securities
association to which the electronic communications network supplies
such bids and offers; and
(ii) At the price of the highest priced buy order or lowest priced
sell order, or better, for the lesser of the cumulative size of such
priced orders entered therein by exchange market makers or OTC market
makers at such price, or the size of the execution sought by the broker
or dealer, for such security; or
(B) Is an alternative trading system that:
(1) Displays orders and provides the ability to effect transactions
with such orders under Sec. 242.301(b)(3); and
(2) Otherwise is in compliance with Regulation ATS (Sec. 242.300
through Sec. 242.303).
(c) Transactions in listed options.
(1) A national securities exchange or national securities
association:
(i) Shall not be required, under paragraph (a) of this section, to
collect from responsible brokers or dealers who
[[Page 11209]]
are members of such exchange or association, or to make available to
vendors, the quotation sizes and aggregate quotation sizes for listed
options, if such exchange or association establishes by rule and
periodically publishes the quotation size for which such responsible
brokers or dealers are obligated to execute an order to buy or sell an
options series that is a subject security at its published bid or offer
under paragraph (b)(2) of this section;
(ii) May establish by rule and periodically publish a quotation
size, which shall not be for less than one contract, for which
responsible brokers or dealers who are members of such exchange or
association are obligated under paragraph (b)(2) of this section to
execute an order to buy or sell a listed option for the account of a
broker or dealer that is in an amount different from the quotation size
for which it is obligated to execute an order for the account of a
customer; and
(iii) May establish and maintain procedures and mechanisms for
collecting from responsible brokers and dealers who are members of such
exchange or association, and making available to vendors, the quotation
sizes and aggregate quotation sizes in listed options for which such
responsible broker or dealer will be obligated under paragraph (b)(2)
of this section to execute an order from a customer to buy or sell a
listed option and establish by rule and periodically publish the size,
which shall not be less than one contract, for which such responsible
brokers or dealers are obligated to execute an order for the account of
a broker or dealer.
(2) If, pursuant to paragraph (c)(1) of this section, the rules of
a national securities exchange or national securities association do
not require its members to communicate to it their quotation sizes for
listed options, a responsible broker or dealer that is a member of such
exchange or association shall:
(i) Be relieved of its obligations under paragraph (b)(1) of this
section to communicate to such exchange or association its quotation
sizes for any listed option; and
(ii) Comply with its obligations under paragraph (b)(2) of this
section by executing any order to buy or sell a listed option, in an
amount up to the size established by such exchange's or association's
rules under paragraph (c)(1) of this section.
(3) Thirty second response. Each responsible broker or dealer,
within thirty seconds of receiving an order to buy or sell a listed
option in an amount greater than the quotation size established by a
national securities exchange's or national securities association's
rules pursuant to paragraph (c)(1) of this section, or its published
quotation size must:
(i) Execute the entire order; or
(ii)(A) Execute that portion of the order equal to at least:
(1) The quotation size established by a national securities
exchange's or national securities association's rules, pursuant to
paragraph (c)(1) of this section, to the extent that such exchange or
association does not collect and make available to vendors quotation
size and aggregate quotation size under paragraph (a) of this section;
or
(2) Its published quotation size; and
(B) Revise its bid or offer.
(4) Notwithstanding paragraph (c)(3) of this section, no
responsible broker or dealer shall be obligated to execute a
transaction for any listed option as provided in paragraph (b)(2) of
this section if:
(i) Any of the circumstances in paragraph (b)(3) of this section
exist; or
(ii) The order for the purchase or sale of a listed option is
presented during a trading rotation in that listed option.
(d) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any responsible broker or dealer, electronic communications
network, national securities exchange, or national securities
association if the Commission determines that such exemption is
consistent with the public interest, the protection of investors and
the removal of impediments to and perfection of the mechanism of a
national market system.
Sec. 242.603 Distribution, consolidation, and display of information
with respect to quotations for and transactions in NMS stocks.
(a) Distribution of information.
(1) Any exclusive processor, or any broker or dealer with respect
to information for which it is the exclusive source, that distributes
information with respect to quotations for or transactions in an NMS
stock to a securities information processor shall do so on terms that
are fair and reasonable.
(2) Any national securities exchange, national securities
association, broker, or dealer that distributes information with
respect to quotations for or transactions in an NMS stock to a
securities information processor, broker, dealer, or other persons
shall do so on terms that are not unreasonably discriminatory.
(b) Consolidation of information. Every national securities
exchange on which an NMS stock is traded and national securities
association shall act jointly pursuant to one or more effective
national market system plans to disseminate consolidated information,
including a national best bid and national best offer, on quotations
for and transactions in NMS stocks. Such plan or plans shall provide
for the dissemination of all consolidated information for an individual
NMS stock through a single plan processor.
(c) Display of information.
(1) No securities information processor, broker, or dealer shall
provide, in a context in which a trading or order-routing decision can
be implemented, a display of any information with respect to quotations
for or transactions in an NMS stock without also providing, in an
equivalent manner, a consolidated display for such stock.
(2) The provisions of paragraph (c)(1) of this section shall not
apply to a display of information on the trading floor or through the
facilities of a national securities exchange or to a display in
connection with the operation of a market linkage system implemented in
accordance with an effective national market system plan.
(d) Exemptions. The Commission, by order, may exempt from the
provisions of this section, either unconditionally or on specified
terms and conditions, any person, security, or item of information, or
any class or classes of persons, securities, or items of information,
if the Commission determines that such exemption is necessary or
appropriate in the public interest, and is consistent with the
protection of investors.
Sec. 242.604 Display of customer limit orders.
(a) Specialists and OTC market makers. For all NMS stocks:
(1) Each member of a national securities exchange that is
registered by that exchange as a specialist, or is authorized by that
exchange to perform functions substantially similar to that of a
specialist, shall publish immediately a bid or offer that reflects:
(i) The price and the full size of each customer limit order held
by the specialist that is at a price that would improve the bid or
offer of such specialist in such security; and
(ii) The full size of each customer limit order held by the
specialist that:
(A) Is priced equal to the bid or offer of such specialist for such
security;
(B) Is priced equal to the national best bid or national best
offer; and
(C) Represents more than a de minimis change in relation to the
size associated with the specialist's bid or offer.
[[Page 11210]]
(2) Each registered broker or dealer that acts as an OTC market
maker shall publish immediately a bid or offer that reflects:
(i) The price and the full size of each customer limit order held
by the OTC market maker that is at a price that would improve the bid
or offer of such OTC market maker in such security; and
(ii) The full size of each customer limit order held by the OTC
market maker that:
(A) Is priced equal to the bid or offer of such OTC market maker
for such security;
(B) Is priced equal to the national best bid or national best
offer; and
(C) Represents more than a de minimis change in relation to the
size associated with the OTC market maker's bid or offer.
(b) Exceptions. The requirements in paragraph (a) of this section
shall not apply to any customer limit order:
(1) That is executed upon receipt of the order.
(2) That is placed by a customer who expressly requests, either at
the time that the order is placed or prior thereto pursuant to an
individually negotiated agreement with respect to such customer's
orders, that the order not be displayed.
(3) That is an odd-lot order.
(4) That is a block size order, unless a customer placing such
order requests that the order be displayed.
(5) That is delivered immediately upon receipt to a national
securities exchange or national securities association-sponsored
system, or an electronic communications network that complies with the
requirements of Sec. 242.602(b)(5)(ii) with respect to that order.
(6) That is delivered immediately upon receipt to another exchange
member or OTC market maker that complies with the requirements of this
section with respect to that order.
(7) That is an ``all or none'' order.
(c) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any responsible broker or dealer, electronic communications
network, national securities exchange, or national securities
association if the Commission determines that such exemption is
consistent with the public interest, the protection of investors and
the removal of impediments to and perfection of the mechanism of a
national market system.
Sec. 242.605 Disclosure of order execution information.
Preliminary Note: Section 242.605 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) 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 (a)(2) of this section, a report on the covered orders in NMS
stocks 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 NMS stocks are
traded and each 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 (a)(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 website that is free and readily accessible to the public.
(3) A market center shall make available the report required by
paragraph (a)(1) of this section within one month after the end of the
month addressed in the report.
(b) Exemptions. The Commission may, by order upon application,
conditionally or unconditionally exempt any person, security, or
[[Page 11211]]
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.
Sec. 242.606 Disclosure of order routing information.
(a) 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 NMS
securities during that quarter. For NMS stocks, 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 NMS 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
(a)(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
(a)(1) of this section publicly available within one month after the
end of the quarter addressed in the report.
(b) 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 (b)(1) of this section.
(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.
Sec. 242.607 Customer account statements.
(a) No broker or dealer acting as agent for a customer may effect
any transaction in, induce or attempt to induce the purchase or sale
of, or direct orders for purchase or sale of, any NMS stock or a
security authorized for quotation on an automated inter-dealer
quotation system that has the characteristics set forth in section 17B
of the Act (15 U.S.C. 78q-2), unless such broker or dealer informs such
customer, in writing, upon opening a new account and on an annual basis
thereafter, of the following:
(1) The broker's or dealer's policies regarding receipt of payment
for order flow from any broker or dealer, national securities exchange,
national securities association, or exchange member to which it routes
customers' orders for execution, including a statement as to whether
any payment for order flow is received for routing customer orders and
a detailed description of the nature of the compensation received; and
(2) The broker's or dealer's policies for determining where to
route customer orders that are the subject of payment for order flow
absent specific instructions from customers, including a description of
the extent to which orders can be executed at prices superior to the
national best bid and national best offer.
(b) Exemptions. The Commission, upon request or upon its own
motion, may exempt by rule or by order, any broker or dealer or any
class of brokers or dealers, security or class of securities from the
requirements of paragraph (a) of this section with respect to any
transaction or class of transactions, either unconditionally or on
specified terms and conditions, if the Commission determines that such
exemption is consistent with the pubic interest and the protection of
investors.
Sec. 242.608 Filing and amendment of national market system plans.
(a) Filing of national market system plans and amendments thereto.
(1) Any two or more self-regulatory organizations, acting jointly,
may file a national market system plan or may propose an amendment to
an effective national market system plan (``proposed amendment'') by
submitting the text of the plan or amendment to the Secretary of the
Commission, together with a statement of the purpose of such plan or
amendment and, to the extent applicable, the documents and information
required by paragraphs (a)(4) and (5) of this section.
(2) The Commission may propose amendments to any effective national
market system plan by publishing the text thereof, together with a
statement of the purpose of such amendment, in accordance with the
provisions of paragraph (b) of this section.
(3) Self-regulatory organizations are authorized to act jointly in:
(i) Planning, developing, and operating any national market
subsystem or facility contemplated by a national market system plan;
(ii) Preparing and filing a national market system plan or any
amendment thereto; or
(iii) Implementing or administering an effective national market
system plan.
(4) Every national market system plan filed pursuant to this
section, or any amendment thereto, shall be accompanied by:
(i) Copies of all governing or constituent documents relating to
any person (other than a self-regulatory organization) authorized to
implement or administer such plan on behalf of its sponsors; and
(ii) To the extent applicable:
(A) A detailed description of the manner in which the plan or
amendment, and any facility or procedure contemplated by the plan or
amendment, will be implemented;
(B) A listing of all significant phases of development and
implementation (including any pilot phase) contemplated by the plan or
amendment, together with the projected date of completion of each
phase;
(C) An analysis of the impact on competition of implementation of
the plan or amendment or of any facility contemplated by the plan or
amendment;
(D) A description of any written understandings or agreements
between or among plan sponsors or participants relating to
interpretations of the plan or conditions for becoming a sponsor or
participant in the plan; and
[[Page 11212]]
(E) In the case of a proposed amendment, a statement that such
amendment has been approved by the sponsors in accordance with the
terms of the plan.
(5) Every national market system plan, or any amendment thereto,
filed pursuant to this section shall include a description of the
manner in which any facility contemplated by the plan or amendment will
be operated. Such description shall include, to the extent applicable:
(i) The terms and conditions under which brokers, dealers, and/or
self-regulatory organizations will be granted or denied access
(including specific procedures and standards governing the granting or
denial of access);
(ii) The method by which any fees or charges collected on behalf of
all of the sponsors and/or participants in connection with access to,
or use of, any facility contemplated by the plan or amendment will be
determined and imposed (including any provision for distribution of any
net proceeds from such fees or charges to the sponsors and/or
participants) and the amount of such fees or charges;
(iii) The method by which, and the frequency with which, the
performance of any person acting as plan processor with respect to the
implementation and/or operation of the plan will be evaluated; and
(iv) The method by which disputes arising in connection with the
operation of the plan will be resolved.
(6) In connection with the selection of any person to act as plan
processor with respect to any facility contemplated by a national
market system plan (including renewal of any contract for any person to
so act), the sponsors shall file with the Commission a statement
identifying the person selected, describing the material terms under
which such person is to serve as plan processor, and indicating the
solicitation efforts, if any, for alternative plan processors, the
alternatives considered and the reasons for selection of such person.
(7) Any national market system plan (or any amendment thereto)
which is intended by the sponsors to satisfy a plan filing requirement
contained in any other section of this Regulation NMS and part 240,
subpart A of this chapter shall, in addition to compliance with this
section, also comply with the requirements of such other section.
(b) Effectiveness of national market system plans.
(1) The Commission shall publish notice of the filing of any
national market system plan, or any proposed amendment to any effective
national market system plan (including any amendment initiated by the
Commission), together with the terms of substance of the filing or a
description of the subjects and issues involved, and shall provide
interested persons an opportunity to submit written comments. No
national market system plan, or any amendment thereto, shall become
effective unless approved by the Commission or otherwise permitted in
accordance with paragraph (b)(3) of this section.
(2) Within 120 days of the date of publication of notice of filing
of a national market system plan or an amendment to an effective
national market system plan, or within such longer period as the
Commission may designate up to 180 days of such date if it finds such
longer period to be appropriate and publishes its reasons for so
finding or as to which the sponsors consent, the Commission shall
approve such plan or amendment, with such changes or subject to such
conditions as the Commission may deem necessary or appropriate, if it
finds that such plan or amendment is necessary or appropriate in the
public interest, for the protection of investors and the maintenance of
fair and orderly markets, to remove impediments to, and perfect the
mechanisms of, a national market system, or otherwise in furtherance of
the purposes of the Act. Approval of a national market system plan, or
an amendment to an effective national market system plan (other than an
amendment initiated by the Commission), shall be by order. Promulgation
of an amendment to an effective national market system plan initiated
by the Commission shall be by rule.
(3) A proposed amendment may be put into effect upon filing with
the Commission if designated by the sponsors as:
(i) Establishing or changing a fee or other charge collected on
behalf of all of the sponsors and/or participants in connection with
access to, or use of, any facility contemplated by the plan or
amendment (including changes in any provision with respect to
distribution of any net proceeds from such fees or other charges to the
sponsors and/or participants);
(ii) Concerned solely with the administration of the plan, or
involving the governing or constituent documents relating to any person
(other than a self-regulatory organization) authorized to implement or
administer such plan on behalf of its sponsors; or
(iii) Involving solely technical or ministerial matters. At any
time within 60 days of the filing of any such amendment, the Commission
may summarily abrogate the amendment and require that such amendment be
refiled in accordance with paragraph (a)(1) of this section and
reviewed in accordance with paragraph (b)(2) of this section, if it
appears to the Commission that such action is necessary or appropriate
in the public interest, for the protection of investors, or the
maintenance of fair and orderly markets, to remove impediments to, and
perfect the mechanisms of, a national market system or otherwise in
furtherance of the purposes of the Act.
(4) Notwithstanding the provisions of paragraph (b)(1) of this
section, a proposed amendment may be put into effect summarily upon
publication of notice of such amendment, on a temporary basis not to
exceed 120 days, if the Commission finds that such action is necessary
or appropriate in the public interest, for the protection of investors
or the maintenance of fair and orderly markets, to remove impediments
to, and perfect the mechanisms of, a national market system or
otherwise in furtherance of the purposes of the Act.
(5) Any plan (or amendment thereto) in connection with:
(i) The planning, development, operation, or regulation of a
national market system (or a subsystem thereof) or one or more
facilities thereof; or
(ii) The development and implementation of procedures and/or
facilities designed to achieve compliance by self-regulatory
organizations and/or their members of any section of this Regulation
NMS and part 240, subpart A of this chapter promulgated pursuant to
section 11A of the Act (15 U.S.C. 78k-1), approved by the Commission
pursuant to section 11A of the Act (or pursuant to any rule or
regulation thereunder) prior to the effective date of this section
(either temporarily or permanently) shall be deemed to have been filed
and approved pursuant to this section and no additional filing need be
made by the sponsors with respect to such plan or amendment; provided,
however, that all terms and conditions associated with any such
approval (including time limitations) shall continue to be applicable;
provided, further, that any amendment to such plan filed with or
approved by the Commission on or after the effective date of this
section shall be subject to the provisions of, and considered in
accordance with the procedures specified in, this section.
(c) Compliance with terms of national market system plans. Each
self-regulatory organization shall comply with the terms of any
effective national market system plan of which it is a sponsor or a
participant. Each self-
[[Page 11213]]
regulatory organization also shall, absent reasonable justification or
excuse, enforce compliance with any such plan by its members and
persons associated with its members.
(d) Appeals. The Commission may, in its discretion, entertain
appeals in connection with the implementation or operation of any
effective national market system plan as follows:
(1) Any action taken or failure to act by any person in connection
with an effective national market system plan (other than a prohibition
or limitation of access reviewable by the Commission pursuant to
section 11A(b)(5) or section 19(d) of the Act (15 U.S.C. 78k-1(b)(5) or
78s(d))) shall be subject to review by the Commission, on its own
motion or upon application by any person aggrieved thereby (including,
but not limited to, self-regulatory organizations, brokers, dealers,
issuers, and vendors), filed not later than 30 days after notice of
such action or failure to act or within such longer period as the
Commission may determine.
(2) Application to the Commission for review, or the institution of
review by the Commission on its own motion, shall not operate as a stay
of any such action unless the Commission determines otherwise, after
notice and opportunity for hearing on the question of a stay (which
hearing may consist only of affidavits or oral arguments).
(3) In any proceedings for review, if the Commission, after
appropriate notice and opportunity for hearing (which hearing may
consist solely of consideration of the record of any proceedings
conducted in connection with such action or failure to act and an
opportunity for the presentation of reasons supporting or opposing such
action or failure to act) and upon consideration of such other data,
views, and arguments as it deems relevant, finds that the action or
failure to act is in accordance with the applicable provisions of such
plan and that the applicable provisions are, and were, applied in a
manner consistent with the public interest, the protection of
investors, the maintenance of fair and orderly markets, and the removal
of impediments to, and the perfection of the mechanisms of a national
market system, the Commission, by order, shall dismiss the proceeding.
If the Commission does not make any such finding, or if it finds that
such action or failure to act imposes any burden on competition not
necessary or appropriate in furtherance of the purposes of the Act, the
Commission, by order, shall set aside such action and/or require such
action with respect to the matter reviewed as the Commission deems
necessary or appropriate in the public interest, for the protection of
investors, and the maintenance of fair and orderly markets, or to
remove impediments to, and perfect the mechanisms of, a national market
system.
(e) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any self-regulatory organization, member thereof, or
specified security, if the Commission determines that such exemption is
consistent with the public interest, the protection of investors, the
maintenance of fair and orderly markets and the removal of impediments
to, and perfection of the mechanisms of, a national market system.
Sec. 242.609 Registration of securities information processors: form
of application and amendments.
(a) An application for the registration of a securities information
processor shall be filed on Form SIP (Sec. 249.1001) in accordance
with the instructions contained therein.
(b) If any information reported in items 1-13 or item 21 of Form
SIP or in any amendment thereto is or becomes inaccurate for any
reason, whether before or after the registration has been granted, the
securities information processor shall promptly file an amendment on
Form SIP correcting such information.
(c) The Commission, upon its own motion or upon application by any
securities information processor, may conditionally or unconditionally
exempt any securities information processor from any provision of the
rules or regulations adopted under section 11A(b) of the Act (15 U.S.C.
78k-1(b)).
(d) Every amendment filed pursuant to this section shall constitute
a ``report'' within the meaning of sections 17(a), 18(a) and 32(a) of
the Act (15 U.S.C. 78q(a), 78r(a), and 78ff(a)).
Sec. 242.610 Access to published bids and offers.
(a) Requirements.
(1) A quoting market center shall not impose unfairly
discriminatory terms that prevent or inhibit a non-member, non-
customer, or non-subscriber of the quoting market center from obtaining
access to quotations and the execution of orders through a member,
customer, or subscriber of the quoting market center.
(2) A quoting market participant:
(i) Shall make its quotations available, for the purpose of order
execution, to all other quoting market participants and all quoting
market centers on terms as favorable as those it grants to its most
preferred member, customer, or subscriber; and
(ii) Shall not impose unfairly discriminatory terms that prevent or
inhibit a non-member, non-customer, or non-subscriber of the quoting
market participant from obtaining access to quotations and the
execution of orders through a member, customer, or subscriber of the
quoting market participant.
(b) Quotation standardization.
(1) A quoting market center may impose a fee for an order execution
against its displayed price in an amount no greater than:
(i) $.001 per share; or
(ii) .1% of price per share in the case of a security with a share
price of less than $1.00.
(2) A quoting market participant may impose a fee for an order
execution against its displayed price in an amount no greater than:
(i) $.001 per share; or
(ii) .1% of price per share in the case of a security with a share
price of less than $1.00.
(3) A broker-dealer that displays an attributable quote through a
quoting market center may impose a fee for the execution of an order
against such displayed attributable quote in an amount no greater than:
(i) $.001 per share; or
(ii) .1% of price per share in the case of a security with a share
price of less than $1.00.
(4) Accumulated access fees of quoting market centers, quoting
market participants, and broker-dealers shall not exceed $.002 per
share in any transaction; for securities priced at less than $1.00,
such fees shall not exceed .2% of the share price.
(c) Locked or crossed quotations.
Each national securities exchange and national securities
association must establish and enforce rules:
(1) That require its members reasonably to avoid locking or
crossing the quotations of quoting market centers and quoting market
participants;
(2) That are reasonably designed to enable a market participant to
reconcile locked or crossed quotations in a security before effecting a
trade in that security; and
(3) That prohibit its members from engaging in a pattern or
practice of locking or crossing quotations in any security.
(d) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any national securities exchange, national
[[Page 11214]]
securities association, quoting market center, or quoting market
participant if the Commission determines that such exemption is
necessary or appropriate in the public interest and is consistent with
the protection of investors.
Sec. 242.611 Trade-through rule.
(a) Price protection.
(1) An order execution facility, national securities exchange, and
national securities association must establish, maintain, and enforce
policies and procedures reasonably designed to prevent the execution of
a trade-through in its market, unless one or more of the provisions of
paragraph (b) of this section is applicable.
(2) An order execution facility, national securities exchange, and
national securities association that is not able to or chooses not to
comply with the requirements of paragraph (a)(1) of this section may
only accept orders that are opted-out pursuant to paragraph (b)(8) of
this section.
(b) Exceptions. The policies and procedures required by paragraph
(a) of this section do not have to be designed to prevent the execution
of a trade-through in the following circumstances:
(1) The order execution facility displaying the better price was
experiencing a failure, material delay, or malfunction of its systems
or equipment when the trade-through occurred.
(2) The order execution facility that initiated the trade-through
made every reasonable effort to avoid the trade-through but was unable
to do so because of a systems or equipment failure, material delay, or
malfunction in its own market.
(3) The transaction that constituted the trade-through was not a
``regular way'' contract.
(4) The bid or offer that is traded-through was displayed by an
order execution facility that was, or whose members were, relieved of
their obligations under Sec. 242.602(b)(2) with respect to such bid or
offer pursuant to Sec. 242.602(a)(3).
(5) The transaction that constituted the trade-through was an
opening or reopening transaction by the order execution facility.
(6) The transaction that constituted the trade-through was executed
at a time when there was a crossed market.
(7)(i) At the same time or prior to executing a transaction that
constituted a trade-through, the order execution facility sent an order
or orders to trade with each bid or offer of another order execution
facility that was disseminated pursuant to an effective national market
system plan and that was priced better than the price at which such
transaction was executed (``better-priced bid or offer'').
(ii) Each order sent by an order execution facility under paragraph
(b)(7)(i) of this section must be priced equal to or better than the
better-priced bid or offer and be for the number of shares displayed
for that better-priced bid or offer.
(8) Opt-out orders. When a broker or dealer or a customer expressly
provides, at the time an order is placed for its account, informed
consent to the execution of such order without regard to a better price
of another order execution facility that is disseminated pursuant to an
effective national market system plan.
(9) Automated order execution facilities.
(i) An automated order execution facility can trade through the
best bid or best offer of a non-automated order execution facility that
is disseminated pursuant to an effective national market system plan up
to the trade-through limit amount.
(ii) For a buy order in an NMS stock where the national best offer
is under $10 at the time of execution, or a sell order in an NMS stock
where the national best bid is under $10 at the time of execution, the
trade-through limit amount is equal to one cent.
(iii) For a buy order in an NMS stock where the national best offer
is from $10.01 to $30 at the time of execution, or a sell order in an
NMS stock where the national best bid is from $10.01 to $30 at the time
of execution, the trade-through limit amount is equal to two cents.
(iv) For a buy order in an NMS stock where the national best offer
is from $30.01 to $50 at the time of execution, or a sell order in an
NMS stock where the national best bid is from $30.01 to $50 at the time
of execution, the trade-through limit amount is equal to three cents.
(v) For a buy order in an NMS stock where the national best offer
is from $50.01 to $100 at the time of execution, or a sell order in an
NMS stock where the national best bid is from $50.01 to $100 at the
time of execution, the trade-through limit amount is equal to four
cents.
(vi) For a buy order in an NMS stock where the national best offer
is greater than $100 at the time of execution, or a sell order in an
NMS stock where the national best bid is greater than $100 at the time
of execution, the trade-through limit amount is equal to five cents.
(c) Disclosure requirement to customers that opt-out.
(1) For each buy order for the account of a customer executed
pursuant to paragraph (b)(8) of this section, the broker or dealer must
disclose to the customer the national best offer for the NMS stock at
the time of execution of the order. For each sell order for the account
of a customer executed pursuant to paragraph (b)(8) of this section,
the broker or dealer must disclose to the customer the national best
bid for the NMS stock at the time of execution of the order.
(2) The bid or offer required to be disclosed pursuant to paragraph
(c)(1) of this section must be disclosed as soon as possible, but in no
event later than one month from the date on which the order was
executed.
(3) The bid or offer required to be disclosed pursuant to paragraph
(c)(1) of this section must be displayed in close proximity to, and no
less prominently than, the execution price as reported to the customer
for the order pursuant to the requirements of Sec. 240.10b-10 of this
chapter.
(d) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any order execution facility, national securities exchange,
national securities association, or broker or dealer if the Commission
determines that such exemption is necessary or appropriate in the
public interest and is consistent with the protection of investors.
Sec. 242.612 Minimum pricing increment.
(a) No national securities exchange, national securities
association, alternative trading system, vendor, or broker or dealer
shall display, rank, or accept from any person a bid or offer, an
order, or an indication of interest in any NMS stock priced in an
increment less than $0.01, except for those NMS stocks the share price
of which is below $1.00.
(b) Exemptions. The Commission may exempt from the provisions of
this section, either unconditionally or on specified terms and
conditions, any organization, association, or group of persons if the
Commission determines that such exemption is consistent with the public
interest, the protection of investors, the maintenance of fair and
orderly markets, or the removal of impediments to and the perfection of
the mechanism of a national market system.
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
25. The authority citation for part 249 continues to read in part
as follows:
[[Page 11215]]
Authority: 15 U.S.C. 78a et seq. and 7201 et seq.; and 18 U.S.C.
1350, unless otherwise noted.
* * * * *
26. Section 249.1001 is revised to read as follows:
Sec. 249.1001 Form SIP, for application for registration as a
securities information processor or to amend such an application or
registration.
This form shall be used for application for registration as a
securities information processor, pursuant to section 11A(b) of the
Securities Exchange Act of 1934 (15 U.S.C. 78k-1(b)) and Sec. 242.609
of this chapter, or to amend such an application or registration.
27. Form SIP (referenced in Sec. 249.1001) is amended by revising
Instruction 6 of General Instructions for Preparing and Filing Form SIP
to read as follows:
Form SIP
* * * * *
General Instructions for Preparing and Filing Form SIP
* * * * *
6. Rule 609(b) of Regulation NMS requires that if any information
contained in items 1 through 13 or item 21 of this application, or any
supplement or amendment thereto, is or becomes inaccurate for any
reason, an amendment must be filed promptly on Form SIP correcting such
information.
* * * * *
Dated: February 26, 2004.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-4712 Filed 3-8-04; 8:45 am]
BILLING CODE 8010-01-U