[Federal Register: October 10, 2006 (Volume 71, Number 195)]
[Notices]
[Page 59563-59573]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10oc06-96]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-54550; File No. SR-CHX-2006-05]
Self-Regulatory Organizations; Chicago Stock Exchange, Inc.;
Order Approving a Proposed Rule Change and Amendment No. 1 Thereto and
Notice of Filing and Order Granting Accelerated Approval to Amendment
No. 2 Thereto to Implement a New Trading Model
September 29, 2006.
I. Introduction
On February 2, 2006, the Chicago Stock Exchange, Inc. (``CHX'' or
``Exchange'') filed with the Securities and Exchange Commission
(``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a
proposed rule change to amend its rules to implement a new trading
model that provides the opportunity for fully automated executions to
occur within a central matching system (the ``Matching System''). On
August 10, 2006, the Exchange filed Amendment No. 1 to the proposed
rule change. The proposed rule change, as amended by Amendment No. 1,
was published for comment in the Federal Register on August 18,
2006.\3\ The Commission received one comment letter on the proposal.\4\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 54301 (August 10,
2006), 71 FR 47836 (``Trading Rules Notice'').
\4\ See Letter from Michael A. Barth, Senior Vice President,
Exchanges and Market Centers, Order Execution Services Holdings,
Inc. (``OES''), to Nancy M. Morris, Secretary, Commission, dated
August 25, 2006 (``OES Letter'').
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On September 29, 2006, the Exchange filed Amendment No. 2 to the
proposed rule change.\5\ This order approves the proposed rule change,
as amended by Amendment No. 1. Simultaneously, the Commission is
providing notice of filing of, and granting accelerated approval to,
Amendment No. 2 to the proposed rule change.
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\5\ See Form 19b-4 dated September 29, 2006 (``Amendment No.
2''). The text of Amendment No. 2 is available on CHX's Web site
(http://www.chx.com), at the principal office of CHX, and at the
Commission's Public Reference Room. See infra Section II.E for a
discussion of Amendment No. 2.
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II. Description
The Exchange proposes to amend its rules in order to implement a
new trading model that would allow Exchange participants to interact in
a
[[Page 59564]]
fully-automated Matching System. In addition, the proposed rules would
enable qualifying participant firms to register as ``institutional
brokers,'' that, among other things, would be permitted to execute
transactions outside of the Matching System under specified
conditions.\6\ Many of the features of the new trading model are
designed to comply with Regulation NMS \7\ as of the ``Trading Phase
Date'' for the implementation of that regulation--February 5, 2007.\8\
The Exchange is also proposing a number of other changes to its rules
in an effort to update them generally, as well as to reflect the
elimination of the trading floor and the new automated trading system
that will be central to the Exchange's new trading model.
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\6\ See infra Section II.C. for a more detailed discussion.
\7\ 17 CFR 242.600 et seq.
\8\ See infra note 27.
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A. The Matching System
The Matching System would be the core facility of the Exchange's
new trading model. The Exchange would no longer operate a physical
trading floor, but rather would operate an automated Matching System
where Exchange participants could submit orders from any location for
possible immediate execution.
1. Eligible Orders and Order Types
The Matching System generally would accept orders that are day
orders, limit orders, and orders for regular way settlement.\9\ Orders
could be submitted as round lots, odd lots, or mixed lots, except that
orders in securities that only trade in specific share size increments
would be required to be submitted only in those share sizes.\10\ The
Exchange believes that its quotations would qualify as ``automated
quotations'' under Rule 600(b)(3) of Regulation NMS.\11\
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\9\ See proposed CHX Article 20, Rule 4(a)(1)-(3). The proposed
rules provide for certain exceptions to these basic order
eligibility requirements. For example, the Matching System would
also accept immediate-or-cancel (``IOC'') market orders, and would
permit a ``non-regular way cross order'' to be submitted for
execution and non-regular way settlement. See proposed CHX Article
20, Rules 4(a)(7) and 4(b)(13) and (16).
\10\ See proposed CHX Article 20, Rule 4(a)(4).
\11\ See 17 CFR 242.600(b)(3). The Exchange's proposed rules
provide that each order submitted to the Matching System must be a
firm order and cannot be identified as a ``manual'' quotation. See
proposed CHX Article 20, Rule 3(a). See also infra note 54 and
accompanying text.
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Some of the order types accepted by the Matching System that the
Exchange describes as more routine would include immediate or cancel
(``IOC'') limit and market orders,\12\ fill or kill (``FOK'')
orders,\13\ sell short and short exempt orders,\14\ reserve size
orders,\15\ time in force orders \16\ and cancel on halt orders.\17\
The Matching System also would accept several different types of cross
transactions, including a cross,\18\ a cross with size,\19\ a cross
with satisfy,\20\ a cross with yield,\21\ a midpoint cross,\22\ an ISO
cross,\23\ an opening cross,\24\ and a non-regular way cross.\25\
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\12\ IOC orders would be executed against any orders at or
better than the Exchange's Best Bid or Offer (``BBO''), including
any reserve size or other undisplayed orders at or better than that
price. See proposed CHX Article 20, Rules 4(b)(12) (IOC orders) and
4(b)(13) (IOC market orders).
\13\ See proposed CHX Article 20, Rule 4(b)(11).
\14\ See proposed CHX Article 20, Rule 4(b)(21) (sell short
orders) and Rule 4(b)(22) (short exempt orders).
\15\ See proposed CHX Article 20, Rule 4(b)(20).
\16\ See proposed CHX Article 20, Rule 4(b)(23).
\17\ See proposed CHX Article 20, Rule 4(b)(3).
\18\ See proposed CHX Article 20, Rule 4(b)(4). A cross
transaction would be an order to buy and sell the same security at a
specific price that is better than the Exchange's displayed BBO and,
for securities listed on any exchange other than Nasdaq (and for
Nasdaq-listed securities, when Regulation NMS is implemented in
those issues), equal to or better than the National Best Bid and
Offer (``NBBO''). A cross may represent interest of one or more
Exchange participants, trading for a proprietary account. See infra
note 43 for a description of cross order executions.
\19\ See proposed CHX Article 20, Rule 4(b)(6). A cross with
size would be required to be for at least 5,000 shares and for a
value of $100,000 that is at a price equal to or better than the
Exchange's displayed BBO and, for securities listed on the New York
Stock Exchange (``NYSE''), the American Stock Exchange (``Amex''),
or any other exchange except the NASDAQ Stock Market (``Nasdaq'')
(and for Nasdaq-listed securities, when Regulation NMS is
implemented in those issues), equal or better to the NBBO, where the
size of the cross transaction is one round lot larger than the
aggregate size of all interest displayed on the Exchange at that
price. At such time as the Exchange disseminates a feed of all
displayable orders in the Matching System, however, a cross with
size order would be required to be larger only than the largest
order in the Matching System at the relevant price. See Amendment
No. 2. A cross with size transaction may represent interest of one
or more participants of the Exchange. See also infra note 43.
\20\ See proposed CHX Article 20, Rule 4(b)(5). A cross with
satisfy is designed to provide a participant with a mechanism for
clearing out displayed orders in the Matching System that would
otherwise have time priority (or displayed bids or offers in other
market centers that would otherwise have price priority) and then
effecting a cross transaction at that price. A cross with satisfy
could represent interest of one or more participants of the Exchange
but, to the extent that it represents interest of the participant
sending the order to the Matching System, the participant (i) would
not be eligible to satisfy existing bids or offers in the Matching
System at a price that is better than the cross price (when the
participant's customer is on the same side of the order as the
participant), and (ii) could only satisfy bids or offers in other
markets at a price that is better than the cross price if the cross
is for at least 10,000 shares or has a value of at least $200,000 (a
``block size order'') or is for the account of an institutional
customer (defined elsewhere in the proposed rules) and the
participant's customer has specifically agreed to that outcome. See
also infra note 44.
\21\ See proposed CHX Article 20, Rule 4(b)(7). A cross with
yield would automatically yield interest on the buy, sell, or either
side of the order to any order already displayed in the Matching
System at the same or better price. See also infra note 45.
\22\ See proposed CHX Article 20, Rule 4(b)(15). A midpoint
cross would execute at the midpoint between the NBBO. However, if
the NBBO is locked at the time a midpoint cross is received, the
midpoint cross would execute at the locked NBBO. If the NBBO is
crossed at the time a midpoint cross is received, the midpoint cross
would be automatically cancelled.
\23\ See proposed CHX Article 20, Rule 4(b)(14), added by
Amendment No. 2. An ISO cross would be defined as any type of cross
order marked as required by Regulation NMS to be executed without
taking any of the actions required by the Exchange's relevant rules
to prevent a trade-through.
\24\ See proposed CHX Article 20, Rule 4(b)(17). Opening cross
orders would execute immediately after the primary market opens in a
security, at the opening price. For securities listed on NYSE, Amex
and any exchange other than Nasdaq, the opening price would be the
primary market opening price. For Nasdaq-listed securities (except
in the case of an initial IPO), the opening price would be the
midpoint of the first unlocked, uncrossed market that occurs on or
after 8:30 a.m. For Nasdaq-listed securities on the date of an IPO,
the opening price would be the Nasdaq opening price. See also
proposed CHX Article 20, Rule 8(c)(2).
\25\ See proposed CHX Article 20, Rule 4(b)(16). A non-regular
way cross would be designated for non-regular way settlement. These
orders would be automatically executed without regard to either the
NBBO or any orders for regular way settlement that might be in the
Matching System.
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The Matching System also would accept several order types that are
related to Regulation NMS,\26\ and that would become effective on the
Trading Phase Date of Regulation NMS.\27\ For example, the Matching
System would accept benchmark orders that meet the requirements of Rule
611(b)(7) of Regulation NMS.\28\ The Matching System would also accept
different types of intermarket sweep orders
[[Page 59565]]
(``ISOs''), such as BBO ISOs,\29\ outbound ISOs \30\ and price-
penetrating ISOs.\31\
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\26\ 17 CFR 242.600 et seq.
\27\ See Securities Exchange Act Release No. 53829 (May 18,
2006), 71 FR 30038 (May 24, 2006) (setting new compliance dates for
Rules 610 and 611 of Regulation NMS).
\28\ See 17 CFR 242.611(b)(7); see also CHX proposed Article 20,
Rule 4(b)(2). A benchmark order, as defined in the proposed rules,
would be an order submitted by an institutional broker, and could be
executed at any price, without regard to the protected NBBO. A
benchmark order could represent interest of one or more Exchange
participants.
\29\ See proposed CHX Article 20, Rule 4(b)(1). BBO ISOs would
execute against orders at the Exchange's BBO, without regard to
whether the execution would trade through another market's protected
quotation. If a BBO ISO is marked as ``immediate or cancel,'' any
remaining balance in the order would be automatically cancelled. If
a BBO ISO is not marked as ``immediate or cancel,'' any remaining
balance in the order would be displayed in the Matching System,
without regard to whether that display would lock or cross another
market center. See proposed CHX Article 20, Rule 6(c)(3).
\30\ An outbound ISO would allow an Exchange participant to ask
the Exchange to execute an order on the Exchange while
simultaneously routing ISOs to those other markets to execute
against their protected quotations. Outbound ISOs would be executed
against any eligible orders in the Matching System (including any
reserve size or other undisplayed orders). Other than the routing of
ISOs to other market centers, no action would be taken to prevent an
improper trade-through. See proposed CHX Article 20, Rule 4(b)(18).
\31\ See proposed CHX Article 20, Rule 4(b)(19). A price-
penetrating ISO would operate much like a basic ISO, except that it
would allow a participant to execute through displayed and
undisplayed interest, at multiple price points, on the Exchange.
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In general, the Matching System would accept only orders that
comply with the sub-penny restrictions set forth in Rule 612 of
Regulation NMS.\32\ However, contingent upon the Commission granting
the necessary exemptive relief from Rule 612, the proposed rules would
permit any type of cross order to be submitted to the Matching System
in a sub-penny increment as small as $0.000001, provided that no type
of cross, except midpoint crosses, non-regular-way crosses and cross
with size orders, would be permitted to execute at a price less than
$.01 better than any currently displayed same-sided interest available
on the Matching System (or $.0001 better when the order is priced under
$1.00).\33\
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\32\ 17 CFR 242.612.
\33\ See proposed CHX Article 20, Rule 4(a)(7)(b). See also
Amendment No. 2.
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Finally, the Matching System would accept ``do-not-display'' and
``do-not-route orders.'' A do-not-display order would be an order, for
at least 1,000 shares when entered, that would not be displayed in
whole or in part, but that would remain eligible for execution within
the Matching System.\34\ A do-not-route order would be executed or
displayed within the Matching System and could not be routed to another
market center.\35\
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\34\ See proposed CHX Article 20, Rule 4(b)(9).
\35\ See proposed CHX Article 20, Rule 4(b)(10). A do-not-route
order would be immediately cancelled if its execution would
improperly trade through the ITS BBO or another market's protected
quotations. Any types of cross, IOC, or FOK orders would be deemed
to have been received with a ``do not route'' condition because
these orders either are immediately executed in the Matching System
or cancelled.
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2. Ranking and Display of Orders
All orders received by the Matching System would be ranked by
price, time of receipt, and, for round-lot orders, any display
instructions received with the order.\36\ Specifically, orders received
by the Matching System would be ranked as follows: (i) Limit orders
that are eligible to be displayed, including the displayed portion of
reserve size orders, and all odd-lot and mixed-lot orders would be
ranked together, at each price point, in time priority; (ii) at each
price point, the undisplayed portions of reserve size orders would be
ranked together in time priority and would be ranked after any
displayed orders (and any odd-lot and mixed-lot orders) at that price;
and (iii) orders that are received with a do-not-display instruction
would be ranked together, at each price point, in time priority and
would be ranked after any other orders at that price.\37\
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\36\ See proposed CHX Article 20, Rule 8(b). Orders sent to an
institutional broker for handling would not have any priority within
the Matching System unless and until they are received by the
Matching System. Id.
\37\ Id., proposed Rule 8(b)(1)-(3). The refreshed displayed
portion of a reserve-size order would receive a new ranking based on
the time it was refreshed, with any remaining undisplayed portion
retaining the ranking at which it was originally received. Id.,
proposed Rule 8(b)(4). A change to an order's size or price, or its
displayed portion, could impact its ranking within the Matching
System. A change to the display instructions associated with an
order would need to be submitted as a new order and would be ranked
based on the time the new order was received. Id., proposed Rule
8(b)(5). See also Amendment No. 2.
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All orders that are eligible for display would be immediately and
publicly displayed through the processes set out in the appropriate
transaction reporting plan for each security when they constitute the
best round-lot bid or offer in the Matching System for that security.
For display purposes, the Matching System would aggregate all shares,
including odd-lot orders and the odd-lot portions of mixed-lot orders,
at a single price point, and then round that total share amount down to
the nearest round-lot amount.\38\
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\38\ Id., proposed Rule 8(b)(6). For execution purposes,
however, all orders would retain their rankings as described above.
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3. Automatic Execution
Incoming orders generally would be matched against orders in the
Matching System, in the order of their ranking, at the price of each
resting order, for the full amount of shares available at that price or
for the size of the incoming order, if smaller.\39\ If an order could
not be immediately matched or matched in full when received, and it is
not designated as an order type that should be immediately
cancelled,\40\ it or its residual portion would be placed in the
Matching System and ranked.\41\
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\39\ See proposed CHX Article 20, Rule 8(d)(1). This general
rule would be subject to certain exceptions specifically set forth
in proposed CHX Article 20, Rule 8(e), and subject to the provisions
relating to the prevention of trade-throughs in proposed CHX Article
20, Rule 5.
\40\ See proposed CHX Article 20, Rules 4(b)(11) through (13).
Orders that would be immediately cancelled, if not executed, include
FOK orders and IOC limit and market orders.
\41\ See proposed CHX Article 20, Rule 8(d)(2); see also supra
note 37 and accompanying text.
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The proposed rules describe certain order types that would be
subject to specific executions within the Matching System.\42\ Such
order types include cross and cross with size orders,\43\ cross with
satisfy orders,\44\ cross with yield orders,\45\ sell short orders,\46\
do-not-
[[Page 59566]]
display orders,\47\ and inbound ITS commitment or linkage plan
orders.\48\ The proposed rules also describe the handling of orders in
locked and crossed markets.\49\
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\42\ See proposed CHX Article 20, Rule 8(e).
\43\ See proposed CHX Article 20, Rule 8(e)(1). Cross and cross
with size orders would be automatically executed if they meet the
requirements for such order types, and would be immediately and
automatically cancelled if they do not meet these requirements.
\44\ See proposed CHX Article 20, Rule 8(e)(4). In executing
cross with satisfy orders, the Matching System first would determine
whether the order contains a share size that is sufficient to
satisfy orders in the Matching System or bids or offers in other
markets, as applicable. If this requirement is not met, the cross
with satisfy would be automatically cancelled. If the order meets
this requirement, the Matching System then would satisfy existing
orders in the Matching System or send orders or commitments to other
market centers to satisfy bids or offers, as necessary to prevent a
trade-through and, before updating the Exchange's quotes, would
execute the cross at a price that is better than the best bid or
offer to be displayed in the Matching System and, for securities
listed on NYSE, Amex or any other exchange other than Nasdaq (and
for Nasdaq-listed securities, when Regulation NMS is implemented in
those issues), equal to or better than the NBBO. In doing so, the
Matching System would determine whether the participant that sent
the order to the Matching System is attempting to satisfy bids or
offers in the Matching System at a price that is better than the
cross price and, if so, would not allow those executions to occur,
but would instead allocate the better prices to the customer, not to
the participant sending the order to the Matching System. See also
supra note 20.
\45\ See proposed CHX Article 20, Rule 8(e)(2). A cross with
yield order would be automatically executed by matching the
participant as principal against the customer order if the customer
order that is part of a cross with yield order is at a price better
than the currently displayed best bid or offer in the Matching
System; provided, however, that if there is any order already
displayed in the Matching System at the same price as (or better
than) the participant's interest, that order or those orders would
be matched against the customer order in place of the participant's
interest as necessary to exhaust the customer order interest. If the
customer order that is part of a cross with yield order is not
eligible for an immediate execution because it is not priced better
than the currently displayed bid or offer in the Matching System,
the cross with yield order would be immediately and automatically
cancelled. See also supra note 21.
\46\ See proposed CHX Article 20, Rule 8(e)(5). Sell short
orders (including odd lot orders) would be displayed and executed
only when permissible under the provisions of Rule 10a-1 (``Short
Sale Rule'') under the Act and Regulation SHO. When a sell short
order cannot be executed or displayed at its limit price under the
provisions of the Short Sale Rule and Regulation SHO, the order
would be automatically re-priced (without violating its limit price)
to the next available price at which it can be executed or
displayed. If the Matching System cannot determine an appropriate
price at which to execute or display the order, the order would be
automatically cancelled. See Amendment No. 2.
\47\ See proposed CHX Article 20, Rule 8(e)(6). A do-not-display
order would be immediately and automatically cancelled if, at any
point, the order would prevent the execution of an inbound order
because the do-not-display order has crossed the NBBO.
\48\ See proposed CHX Article 20, Rule 8(e)(7).
\49\ See proposed CHX Article 20, Rule 6 and proposed CHX
Article 20, Rule 5, Interpretation and Policy .01(e).
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4. Preventing Trade-Throughs
An inbound order for at least one round lot would not be eligible
for execution on the Exchange if its execution would cause an improper
trade-through, both prior to and following the Trading Phase Date of
Rule 611 of Regulation NMS.\50\ The proposed rules provide that the
Exchange will follow a series of trade-through policies and procedures
in determining whether a trade on the Exchange would create an improper
trade-through.\51\ These procedures include clock synchronization
practices, as well as plans for applying the exceptions to Rule 611 of
Regulation NMS. For example, the Exchange's rules contemplate using the
self-help exception in Rule 611(b)(1) of Regulation NMS.\52\ Further,
the Exchange would automatically place an appropriate modifier on
trades executed pursuant to an exemption from, or exception to, Rule
611 of Regulation NMS in accordance with specifications approved by the
operating committee of the relevant national market system plan for an
NMS stock. If a trade is executed pursuant to both the intermarket
sweep order exception of Rule 611(b)(5) or (6) of Regulation NMS and
the self-help exception of Rule 611(b)(1) of Regulation NMS, the trade
would be identified as executed pursuant to the intermarket sweep order
exception.\53\ The proposed rules also set forth the procedures that
the Exchange would use to confirm that its own bids and offers qualify
as automated quotations and, if they do not qualify as automated
quotations, how the Exchange will identify such quotations as
manual.\54\
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\50\ See proposed CHX Article 20, Rule 5. An inbound order for
at least one round lot would not be eligible for execution on the
Exchange if its execution would cause an improper trade-through of
another ITS market or if, when Regulation NMS is implemented for a
security, the execution of all or a part of the order would be
improper under Rule 611 of Regulation NMS. Inbound odd lot orders
and odd lot crosses would be eligible for execution on the Exchange,
even if they would trade through other markets' bids and offers.
\51\ See proposed CHX Article 20, Rule 5, Interpretation and
Policy .01.
\52\ See 17 CFR 242.611(b)(1); see also proposed CHX Article 20,
Rule 5, Interpretation and Policy .01(d).
\53\ See proposed CHX Article 20, Rule 5, Interpretation and
Policy .01(h). See also Amendment No. 2.
\54\ See proposed CHX Article 20, Rule 5, Interpretation and
Policy .02. Specifically, the Exchange would send test IOC orders to
the Matching System to make this determination. See also supra, note
11 and accompanying text.
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5. Order Routing
The proposed rules also contain provisions governing the routing of
orders to other markets when execution in the Matching System would
cause an improper trade-through.\55\ If a participant has submitted a
cross with satisfy or an outbound ISO order and its execution would
cause an improper trade-through, the Matching System would execute the
order and simultaneously route orders or commitments necessary to
satisfy the bids or offers of other markets (``routing services'').
Otherwise, any inbound order for at least a round lot is not eligible
for execution on the Exchange if its execution would cause an improper
trade-through.\56\
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\55\ See proposed CHX Article 20, Rule 5, Interpretation and
Policy .03.
\56\ See proposed CHX Article 20, Rule 5(a).
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The Exchange proposes to provide these routing services pursuant to
the terms of three separate agreements, to the extent that they are
applicable to a specific routing decision: (i) An agreement between the
Exchange and each participant on whose behalf orders will be routed;
(ii) an agreement between each participant and a specified third-party
broker-dealer that will use its routing connectivity to other markets
and serve as a ``give-up'' in those markets; and (iii) an agreement
between the Exchange and the specified third-party broker-dealer
pursuant to which the third-party broker-dealer would agree to provide
routing connectivity to other markets and serve as a ``give-up'' for
the Exchange's participants in other markets. In providing the routing
services, the Exchange would use its own systems to determine when,
how, and where orders (or commitments) are routed away to other
markets.\57\ In addition, the Exchange will establish and maintain
procedures and internal controls reasonably designed to adequately
restrict the flow of confidential and proprietary information between
the Exchange (including its facilities) and the third-party broker-
dealer, and, to the extent the third-party broker-dealer reasonably
receives confidential and proprietary information, that adequately
restrict the use of such information by the third party broker-dealer
to legitimate business purposes necessary to provide routing
connectivity and to serve as a ``give-up.'' \58\
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\57\ Id.
\58\ See Amendment No. 2, supra note 5.
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6. Locking and Crossing Quotations
With certain exceptions, Exchange participants would be required to
reasonably avoid displaying, and refrain from engaging in a pattern or
practice of displaying, any quotations that lock or cross a protected
quotation.\59\ An order would not be eligible for display on the
Exchange if its display would improperly lock or cross the ITS best bid
or offer or, as of the Trading Phase Date of Regulation NMS for a
security, if its display would constitute a locking or crossing
quotation.\60\ These otherwise locking or crossing orders would either
be automatically routed to another appropriate market or, if designated
as ``do not route,'' automatically cancelled.
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\59\ See proposed CHX Article 20, Rule 6. The exceptions are
provided when: (i) The locking or crossing quotation was displayed
at a time when the other trading center was experiencing a failure,
material delay, or malfunction of its systems or equipment; (ii) the
locking or crossing quotation was displayed at a time when a
protected bid was higher than a protected offer in the NMS stock; or
(iii) the Exchange participant displaying the locking or crossing
quotation simultaneously routed an intermarket sweep order to
execute against the full displayed size of any locked or crossed
protected quotation.
\60\ See proposed CHX Article 20, Rule 6.
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B. Market Makers
The proposed rules in Article 16 set forth the responsibilities of
a participant that registers as a market maker on the Exchange.\61\ In
particular, a market maker would be required to engage in a course of
dealings for its own account to assist in the maintenance, to the
extent reasonably practicable, of fair and
[[Page 59567]]
orderly markets on the Exchange. A market maker's responsibilities
would specifically include: (1) Using automated systems to maintain a
continuous two-sided quote, for at least a round-lot, in each of the
securities in which it is registered; \62\ (2) maintaining adequate
minimum capital; and (3) meeting specific quotation or trade
requirements, with respect to its dealings on the Exchange, over the
course of each calendar month.\63\ In addition, a market maker that is
registered as a market maker solely on the Exchange and engages in
other business activities (or that is affiliated with a broker or
dealer that engages in other business activities) would be required to
establish information barriers that prevent the market maker from using
material, non-public information or information about customer order
flow handled by the firm in its trading activities.\64\
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\61\ An Exchange-registered market maker would be permitted to
trade only on a proprietary basis and would not be permitted to
handle any agency orders on the Exchange. To the extent that a
participant firm wants to act as an Exchange-registered market maker
and also handle orders from customers outside the facilities of the
Exchange, it would be required to create and strictly enforce
information barrier procedures as described infra at note 64 and
accompanying text. Since Exchange-registered market makers are not
permitted to handle agency orders, the Matching Engine will reject
any cross order instructions entered by a market maker in its market
maker trading account. See proposed CHX Article 16, Rule 1,
Interpretation and Policy .02. See also Amendment No. 2.
\62\ A market maker's continuous two-sided quotes would be
required to be at prices which are reasonably related to the
prevailing market price of the security. See CHX Article 16, Rule 8,
Interpretation and Policy .01.
\63\ See proposed CHX Article 16, Rule 8(a)-(c).
\64\ See proposed CHX Article 16, Rule 9.
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C. Institutional Brokers
Participant firms for which the Exchange is the designated
examining authority could register with the Exchange as institutional
brokers.\65\ Institutional brokers would be deemed to be participants
operating on the Exchange, although they would not effect transactions
from a physical trading floor (since the Exchange will no longer have a
physical trading floor) and could trade from any location. A customer
order would be deemed to be on the Exchange when received by an
institutional broker, but would not have priority in the Matching
System until it is entered into the system.
---------------------------------------------------------------------------
\65\ See proposed CHX Article 17, Rule 1. Each individual that
would be authorized to effect trades on behalf of the firm would be
required to separately register as an institutional broker
representative. See proposed CHX Article 17, Rule 1, Interpretation
and Policy .02.
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Institutional brokers would be required to: (1) Enter all orders
received for execution on the Exchange into an automated system to
provide an electronic record of their order handling practices; (2)
handle orders with an electronic system acceptable to the Exchange that
integrates their on-exchange activities with the Matching System and
their trading activities in other market centers; and (3) maintain
separate accounts for handling agency transactions, principal
transactions, and transactions involving errors.\66\ Institutional
brokers would also be required to maintain required records of their
trading activities.\67\ An institutional broker would be required to
use due diligence to execute a market order at the best price
available; to use due diligence to execute a limit order at or better
than the limit price, if available; and to use brokerage judgment in
the execution of a not held order.\68\
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\66\ See proposed CHX Article 17, Rule 3(a) through Rule 3(c).
The Commission recently approved, and the Exchange has implemented,
a proposed rule change regarding requirements for entering orders
into an electronic system to permit the Exchange to more readily
surveil broker order handling activities. See CHX Article 11, Rule
3; Securities Exchange Act Release No. 53772 (May 8, 2006), 71 FR
27758 (May 12, 2006).
\67\ See proposed CHX Article 17, Rule 3(f).
\68\ See proposed CHX Article 17, Rule 3(d).
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Institutional brokers would be required to use reasonable efforts
to report all transactions that are not effected through the Exchange's
Matching System to the Exchange within 10 seconds of the trade.\69\ If
an institutional broker executes an order outside of the Matching
System, it would be required to use the Exchange's Brokerplex system to
determine whether a trade would constitute a trade-through and create
an electronic record that such validation had taken place.\70\ In
general terms, the Brokerplex system would allow an institutional
broker to input the symbol for a security and pull up a window that
includes a snapshot of the Matching System BBO and the NBBO. The
institutional broker then could report a trade that is consistent with
the orders in the Matching System and the NBBO. An institutional broker
that initiates the use of this functionality to report a proprietary
trade against a customer order would be required to complete the
transaction report (without cancelling out of the functionality),
unless the institutional broker had mistakenly input the symbol for the
wrong security. The transaction also could be cancelled pursuant to CHX
rules relating to cancellations of transactions, clearly erroneous
transactions and systems disruptions and malfunctions.\71\
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\69\ See proposed CHX Article 17, Rule 3(e).
\70\ See CHX Article 17, Rule 3, Interpretation and Policy .03.
\71\ See id.
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Unless a customer specifically requests otherwise, an institutional
broker would be required to clear the Matching System before sending an
order to another market for execution.\72\ The proposed rules provide
exceptions to this requirement for: (1) Outbound ITS commitments or
ISOs that are being sent to another market to satisfy its displayed bid
or offer;\73\ and (2) customer orders that are being sent to another
market that could not be executed in the Matching System.\74\
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\72\ See proposed CHX Article 20, Rule 7. Any customer
directives for special handling of orders would have to be
documented and reported to the Exchange.
\73\ See proposed CHX Article 20, Rule 7(c).
\74\ See proposed CHX Article 20, Rule 7(d).
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D. Other Rule Changes
Proposed Article 9, Rule 17, based on an existing Exchange rule
prohibiting participants from trading ahead of customer orders, would
include a provision confirming that a participant would be deemed to be
holding an unexecuted customer order when that order has been sent to
the Matching System, but remains unexecuted.\75\
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\75\ See proposed CHX Article 9, Rule 17, Interpretation and
Policy .05. The proposed rule would also confirm that a participant
would not be in violation of the ``trading ahead'' rule if it
satisfied bids and offers in other markets in accordance with the
requirements for a ``cross with satisfy order.'' See proposed CHX
Article 9, Rule 17, Interpretation and Policy .06; see also supra
note 20 (discussing cross with satisfy orders).
---------------------------------------------------------------------------
The Exchange proposes to adopt a sponsored access rule, which would
allow Exchange participants to provide non-participant broker-dealers
with access to the Exchange.\76\ Under the proposed rule, this type of
sponsored access could be provided so long as the participant
sponsoring access, the non-participant broker-dealer, and the Exchange
entered into appropriate agreements confirming basic information about
the parties' roles and responsibilities.\77\
---------------------------------------------------------------------------
\76\ See proposed CHX Article 5, Rule 3.
\77\ See id.
---------------------------------------------------------------------------
In addition to the changes described above, the Exchange has also
proposed revisions to virtually every other chapter of its rules. These
changes are generally designed to remove references to the physical
trading floor, delete obsolete provisions and account for the new
automated trading model, as well as to better streamline and organize
the rules. For example, the CHX proposes to delete rules relating to
specialists and access to the trading floor and adopt rules that
contemplate remote access to the Exchange's automated trading systems.
In addition, changes are being proposed to rules relating to: hours of
trading, trading halts, cancelling transactions, business conduct,
disciplinary matters and trial proceedings, arbitration, Exchange
emergency suspension authority; committees; trading permits; limitation
of liability; voting designees; registration; fingerprinting; reporting
transactions; riskless principal
[[Page 59568]]
transactions; use of a customer's give-up; books and records; firm
supervision; ITS; clearance and settlement; and listing on the
Exchange.
E. Amendment No. 2
On September 29, 2006, the Exchange filed Amendment No. 2 to the
proposed rule change, which made certain revisions to the original
proposal, as amended by Amendment No. 1. In Amendment No. 2, the
Exchange described its proposed phase-in plan for the new trading
model.\78\ In Amendment No. 2, the Exchange also provided additional
discussion and clarification on certain aspects of the proposal.
---------------------------------------------------------------------------
\78\ The Exchange stated that it plans to phase in the new
trading model as follows: (i) Beginning the week of October 2, 2006,
the Exchange will begin to transition Nasdaq-listed securities to
the Matching System; (ii) during the week of October 16, 2006, the
Exchange will begin to transition all other securities that are not
currently traded by specialists to the Matching System; and (iii) by
early November 2006, the Exchange will begin to transition
securities currently traded by the Exchange's specialists to the
Matching System. The Exchange stated that, in the near future, it
will provide notice to participants of the exact dates for
transition of specific securities.
---------------------------------------------------------------------------
The Exchange also added a discussion of how the Exchange believes
that the rules of the proposed new trading model will be consistent
with Section 11(a) of the Act.\79\ The Exchange stated that it believes
that the proposed Matching System meets the requirements of Rule 11a2-
2(T) under the Act,\80\ known as the ``effect versus execute'' rule,
which provides an exemption from the prohibition of Section 11(a).
Further, the Exchange stated that it believes that the proposal does
not raise any of the policy concerns that Congress sought to address in
Section 11(a) of the Act including, specifically, the time and place
advantages that members on exchange floors might have over non-members
off the floor and the general public.
---------------------------------------------------------------------------
\79\ 15 U.S.C. 78k(a).
\80\ 17 CFR 240.11a2-2(T).
---------------------------------------------------------------------------
In Amendment No. 2, the Exchange also made certain changes to the
rule text reflecting modifications in how the Matching System will
operate. Specifically, the Exchange modified the proposed rules to: (1)
Amend the definition of a ``cross with size'' order; \81\ (2) confirm
that the Matching System will evaluate most cross orders to see if they
meet the ``cross with size'' definition and, if so, will execute them
as crosses with size; \82\ (3) provide that, when the Matching System
lacks sufficient information to determine the appropriate price at
which a sell short order could be displayed or executed, the Matching
System will automatically cancel the order; \83\ (4) confirm that cross
orders can be submitted as ISOs; \84\ (5) remove references to
functionality that is not being built; \85\ and (6) confirm that a
participant cannot change a ``display'' instruction for an order, but
must submit a new order with a new display instruction.\86\ In
addition, the Exchange revised the proposed rules to confirm the
circumstances when the Matching System would display quotes that would
lock or cross the protected quotes of other markets \87\ and to clarify
that the Matching System will trade in increments supported by the ITS
or Regulation NMS linkage plan.\88\ The Exchange also clarified how a
trade should be identified when it is executed pursuant to both the
intermarket sweep order exception of Rule 611(b)(5) or (6) of
Regulation NMS and the self-help exception of Rule 611(b)(1) of
Regulation NMS.\89\
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\81\ See proposed CHX Article 20, Rule 4(b)(6) (requiring a
cross with size to size out all of the displayed interest at a
price, but providing that, once the CHX is disseminating a book
feed, a cross with size would only be required to size out the
largest displayed order).
\82\ See proposed CHX Article 20, Rule 4(b)(6).
\83\ See proposed CHX Article 20, Rule 8(e)(5).
\84\ See proposed CHX Article 20, Rule 4(b)(14).
\85\ See proposed CHX Article 20, Rule 4(a)(7)(b) (removing a
reference to an order that executes at the midpoint of the NBBO,
because this functionality is not being built at this time).
\86\ See proposed CHX Article 20, Rule 8(b)(5).
\87\ See proposed CHX Article 20, Rule 6(d).
\88\ See proposed CHX Article 20, Rule 4(a)(7)(d); see also
proposed CHX Article 20, Rule 4(a)(7)(e).
\89\ See proposed CHX Article 20, Rule 5, Interpretation and
Policy .01(h).
---------------------------------------------------------------------------
In Amendment No. 2, the Exchange also made certain changes intended
to clarify the meaning of the proposed rules. These changes include a
change in the definition of NBBO to confirm that, as of the Trading
Phase Date of Regulation NMS, this term relates only to protected bids
and offers; \90\ the addition of language that confirms that non-
regular way crosses can execute within a penny of other orders in the
Matching System; \91\ and a change that notes that, in the last
``refresh'' of a reserve size order, the number of shares may be less
than the original number of displayed shares because that is all that
is left.\92\ Other similar changes clarify the execution of benchmark
orders; \93\ confirm the handling of BBO ISO orders; \94\ and state,
with regard to relevant provisions, that they take effect on the
Trading Phase Date of Rule 611 of Regulation NMS.\95\
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\90\ See proposed CHX Article 1, Rule 1(o).
\91\ See proposed CHX Article 20, Rule 4(a)(7)(b) (recognizing,
as already expressed in the definition of this type of order, that
non-regular way cross orders execute without regard to orders in the
Matching System, because all orders in the Matching System are for
regular-way settlement).
\92\ See proposed CHX Article 20, Rule 4(b)(20).
\93\ See proposed CHX Article 20, Rule 4(b)(2) (confirming that
benchmark orders must be executed in increments permitted by Article
20, Rule 4(a)(7)(b)). The Exchange also elaborated on its reasoning
in proposing that benchmark orders only be permitted to be submitted
to the Matching System by institutional brokers, and noted that
other participants seeking to execute benchmark orders on the
Exchange could do so through an institutional broker.
\94\ See proposed CHX Article 20, Rule 4(b)(1) (confirming that
BBO ISO orders will be displayed in the circumstances set out in the
rule because the participant routing the order to the Matching
System has already satisfied the quotations of other markets as
required by Article 20, Rule 6(c)(3)).
\95\ See, e.g., proposed CHX Article 20, Rules 4(b)(1), (2),
(14), (18) and (19); see also proposed CHX Article 1, Rule 1(y)
(defining the ``Trading Phase Date'' as February 5, 2007).
---------------------------------------------------------------------------
In Amendment No. 2, the Exchange also made changes to Article 16
governing market makers. The Exchange revised the rules to prohibit an
individual from registering both as a market maker trader and an
institutional broker representative.\96\ The Exchange also modified the
rules to provide that market makers may only trade on a proprietary
basis on the Exchange, and if a market maker handles agency orders off
of the Exchange, it must create and enforce information barrier
procedures pursuant to CHX Article 16, Rule 9.\97\
---------------------------------------------------------------------------
\96\ See proposed CHX Article 16, Rule 1, Interpretation and
Policy .01.
\97\ See proposed CHX Article 16, Rule 1, Interpretation and
Policy .02.
---------------------------------------------------------------------------
Pursuant to an exemption recently issued by the Commission,\98\ the
Exchange proposed further provisions in Amendment No. 2 to permit
``qualified contingent trades'' to be executed on the Exchange.\99\ The
Exchange asserts that these trades would meet the requirements of the
Commission's order exempting from Rule 611(a) any trade-throughs caused
by the execution of an order involving one or more NMS stocks that are
components of a ``qualified contingent trade,'' as defined in the
Commission's exemptive order.\100\
---------------------------------------------------------------------------
\98\ See Securities Exchange Act Release No. 54389 (August 31,
2006), 71 FR 52829 (September 7, 2006) (``Qualified Contingent Trade
Exemptive Order'').
\99\ See proposed CHX Article 1, Rule 2(bb) and proposed CHX
Article 20, Rule 5, Interpretation and Policy .01(i).
\100\ See Qualified Contingent Trade Exemptive Order, supra note
98.
---------------------------------------------------------------------------
The Exchange also added provisions requiring it to establish and
maintain information barriers to restrict the flow of information
between the Exchange (including its facilities) and the third-party
broker-dealer providing connectivity to other trading centers, and, to
the extent such third-party broker-dealer receives such information,
that adequately restrict the use of such
[[Page 59569]]
information by the third party broker-dealer to legitimate business
purposes necessary to provide routing connectivity and to serve as a
``give-up.'' Further, in Amendment No. 2, the Exchange revised its rule
text to reflect recent changes made to Exchange rules by other proposed
rule changes that have been recently approved by the Commission.\101\
---------------------------------------------------------------------------
\101\ In particular, the Exchange revised the proposed rule text
to reflect changes to the Exchange's disciplinary rules made in SR-
CHX-2005-06, see Securities Exchange Act Release No. 54437
(September 13, 2006), 71 FR 55037 (September 20, 2006); and to
reflect changes to the Exchange's rules made in SR-CHX-2006-23,
confirming that each participant firm only needs one trading permit
to conduct business on the Exchange, see Securities Exchange Act
Release No. 54494 (September 25, 2006).
---------------------------------------------------------------------------
III. Discussion and Commission Findings
After careful review, the Commission finds that the proposed rule
change, as amended, is consistent with the requirements of the Act and
the rules and regulations thereunder applicable to a national
securities exchange \102\ and, in particular, the requirements of
Section 6 of the Act \103\ and the rules and regulations thereunder.
The Commission finds that the proposed rule change, as amended, is
consistent with Section 6(b)(5) of the Act,\104\ which requires that
the rules of an exchange be designed, among other things, to prevent
fraudulent and manipulative acts and practices, to promote just and
equitable principles of trade, to remove impediments to and perfect the
mechanism of a free and open market and a national market system, and,
in general, to protect investors and the public interest.
---------------------------------------------------------------------------
\102\ The Commission has considered the proposed rule's impact
on efficiency, competition and capital formation. 15 U.S.C. 78c(f).
\103\ 15 U.S.C. 78f.
\104\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
A. The Matching System
The Matching System would allow participants to route orders to it
from any location for possible immediate execution through any
communications line approved by the Exchange.\105\ The adoption of the
Exchange's proposed rules, which feature the Matching System as the
core facility of the Exchange, will fundamentally change the Exchange's
current market structure from a substantially floor-based auction
market to an all-electronic one. The Commission believes that by
allowing electronic access to Exchange liquidity, the proposed new
model should help perfect the mechanism of a free and open market by
providing investors with a more efficient mechanism to have their
orders executed on the Exchange.
---------------------------------------------------------------------------
\105\ See proposed CHX Article 20, Rule 8(a)(1).
---------------------------------------------------------------------------
The Commission also believes that the Exchange's new trading model
should facilitate securities transactions by providing investors with
faster and more efficient access to the trading interest reflected in
the Exchange's published quotation, as well as interest away from the
Exchange BBO. Finally, the Commission believes that the Exchange's
proposal should enhance the opportunity for a customer's order to be
executed without dealer participation, consistent with the goals of
Section 11A of the Act.\106\
---------------------------------------------------------------------------
\106\ See Section 11A(a)(1)(C) of the Act, 15 U.S.C. 78k-
1(a)(1)(C).
---------------------------------------------------------------------------
1. Eligible Orders and Order Types
Under the proposed rule change, participants would be permitted to
submit orders to the Matching System that are day orders, limit orders,
and orders for regular way settlement (as well as certain other
excepted types of orders such as IOC market orders and non-regular way
crosses) and generally would be permitted to submit orders as round
lots, odd lots, or mixed lots.\107\ The proposed rules require that
orders submitted to the Matching System must meet the requirements of
Rule 612 of Regulation NMS, unless an exemption therefrom applies.\108\
As such, except for cross orders under certain circumstances as
discussed below,\109\ orders priced at or above $1.00 could not be
submitted to the Matching System in increments less than $0.01, and
orders priced less than $1.00 could not be submitted to the Matching
System in increments less than $.0001.\110\ The Commission believes
that these order eligibility requirements are consistent with the Act.
---------------------------------------------------------------------------
\107\ See supra notes 9-10 and accompanying text.
\108\ 17 CFR 242.612.
\109\ See infra note 124 and accompanying text.
\110\ See proposed CHX Article 20, Rule 4(a)(5).
---------------------------------------------------------------------------
The Exchange proposes to permit the Matching System to accept a
wide variety of order types. These order types include: immediate or
cancel limit and market orders, fill or kill orders, sell short and
short exempt orders, reserve size orders, time in force orders, cancel
on halt orders, do-not-display orders, do-not-route orders, various
types of cross orders, and various types of ISOs.\111\ Many of these
order types exist in the Exchange's current rules set, while others
have been proposed exclusively for use in the new trading model or for
use as of the Trading Phase Date of Regulation NMS. The Commission
believes that these order types should provide Exchange participants
greater flexibility in reaching their trading and investment
objectives. The Commission notes that a number of the proposed order
types will have different definitions prior to and following the
Trading Phase Date of Regulation NMS, which should enable users to make
use of the trading strategies of such order types immediately, as well
as after the Trading Phase Date.
---------------------------------------------------------------------------
\111\ See supra Section II.A.1.
---------------------------------------------------------------------------
As noted, the Exchange has proposed a number of cross order types
for use in the Matching System. The Commission notes that the cross
order is already permitted in the Exchange's electronic book.\112\ A
cross order would be immediately executed in the Matching System if it
is priced better than the Matching System's displayed BBO and, for
securities listed on any exchange other than Nasdaq (and for Nasdaq-
listed securities, as of the Trading Phase Date of Regulation NMS),
equal to or better than the NBBO.\113\ Similarly, a form of the cross
with size order is already permitted in the Exchange's electronic
book.\114\ Under the proposed rules, a cross with size will be required
to be larger than the aggregate size of all displayable orders
displayed on the Matching System at the cross price, consist of at
least 5,000 shares, and have a value of $100,000. The Commission notes
that it has previously approved a similar rule at another
exchange.\115\
---------------------------------------------------------------------------
\112\ See current CHX Article XXA, Rule 2.
\113\ See proposed CHX Article 20, Rule 4(b)(4) and supra note
18.
\114\ See current CHX Article XXA, Rule 2.
\115\ See Rules of the National Stock Exchange, Inc., Rule
11.12.
---------------------------------------------------------------------------
The Exchange is also proposing several completely new cross order
types that would be accepted by the Matching System, such as cross with
satisfy \116\ and cross with yield orders.\117\ The Commission believes
that these cross orders may provide an efficient means to allow
participants to effect cross transactions in the Matching System,
consistent with the Exchange's other priority and trade-through rules,
in circumstances where a cross order would otherwise be unable to be
executed and would be cancelled. A cross with satisfy order would
contain an instruction to execute orders already displayed in the
Matching System at their limit prices (up to a specified number of
shares) to the extent necessary to allow the cross transaction to occur
or to route outbound orders or commitments to other market centers to
the extent necessary to prevent an
[[Page 59570]]
improper trade-through.\118\ Once the satisfying execution has
occurred, the cross order would be executed at a price that is better
than the Matching System's displayed BBO and, for securities listed on
any exchange other than Nasdaq (and for Nasdaq-listed securities, as of
the Trading Phase Date of Regulation NMS), equal to or better than the
NBBO.
---------------------------------------------------------------------------
\116\ See supra note 20.
\117\ See supra note 21.
\118\ See proposed CHX Article 20, Rule 4(b)(5).
---------------------------------------------------------------------------
The cross with yield order is similar to the cross with satisfy,
and would contain an instruction to yield interest on the buy, sell, or
either side of the order (as specified in the order) to any order
already displayed in the Matching System at the same or better price,
to the extent necessary to allow the cross transaction to occur.\119\
The cross order would then be executed at a price that is better than
the best bid or offer to be displayed in the Matching System, and, for
securities listed on any exchange other than Nasdaq (and for Nasdaq-
listed securities, as of the Trading Phase Date of Regulation NMS),
equal to or better than the NBBO.
---------------------------------------------------------------------------
\119\ See proposed CHX Article 20, Rule 4(b)(7).
---------------------------------------------------------------------------
The Matching System would also accept mid-point cross orders, which
would be executed at the midpoint of the NBBO.\120\ The Commission
notes that this order type has been previously approved for other
exchanges.\121\ The Exchange also proposes to permit a non-regular way
cross order, which would be for non-regular way settlement and would
execute without regard to the NBBO or any other orders in the Matching
System.\122\ The Commission notes that the Exchange has represented
that participants can currently execute orders for non-regular way
settlement in the Exchange's electronic book and on the floor of the
Exchange,\123\ but this cross order type would be the only means to
effectuate this type of transaction within the Matching System.
---------------------------------------------------------------------------
\120\ See supra note 22.
\121\ See, e.g., NYSE Arca Equities Rule 7.31(y).
\122\ See supra note 25.
\123\ See current CHX Article XX, Rule 9; CHX Article XXA, Rule
2(c)(5).
---------------------------------------------------------------------------
Contingent upon the Exchange receiving exemptive relief from the
Commission, the Exchange proposes to allow all cross orders to be
submitted to the Matching System in sub-penny increments as small as
$.000001, regardless of their price.\124\ Although participants would
be permitted to submit crosses in sub-penny increments, the Exchange
proposes that cross orders (except for a midpoint cross, non-regular-
way cross or cross with size) would be required to be priced at least
$.01 better than any order on the same side of the Matching System (or,
for orders priced less than $1.00, at least $.0001 better than any
order on the same side of the Matching System).
---------------------------------------------------------------------------
\124\ See proposed CHX Article 20, Rule 4(a)(7)(b) (stating that
the provision ``shall take effect upon the granting of exemptive
relief by the Commission'').
---------------------------------------------------------------------------
The Commission believes that the proposed rules relating to cross
transactions are consistent with the Act and offer participants
flexibility in executions which meet the specified requirements of each
type of cross. In addition, the Commission notes that proposed CHX
Article 9, Rule 17, which restricts trading ahead of customer orders,
would apply to the cross order types, except as noted in Interpretation
and Policy .06 of that rule with respect to cross with satisfy
orders.\125\
---------------------------------------------------------------------------
\125\ See proposed CHX Article 9, Rule 17.
---------------------------------------------------------------------------
The Exchange also proposes to permit the Matching System to accept
several order types modeled on the exceptions in Rule 611(b) of
Regulation NMS. The Matching System would accept various ISOs, which
would allow the Exchange to immediately execute such orders without
regard to other markets' protected quotations, as contemplated by
Regulation NMS.\126\ The Commission believes that these proposed order
types are consistent with the Act, and notes that these provisions will
not become effective until the Trading Phase Date of Regulation NMS.
---------------------------------------------------------------------------
\126\ See supra notes 29-31.
---------------------------------------------------------------------------
The Matching System would also accept do-not-display \127\ and do-
not-route orders.\128\ The do-not-display order could be partially or
wholly undisplayed. Such an order would remain eligible for execution
in the Matching System, but would be ranked behind displayed orders and
behind the undisplayed portions of reserve size orders. This order type
gives a participant the ability to keep trading interest unseen, but at
the same time allows the order to remain eligible for execution while
being ranked behind any displayed interest in the Matching System. As
its name implies, a do-not-route order is an order that could not be
routed to another market. A do-not-route order would be immediately
cancelled if its execution would improperly trade through the ITS BBO
or another market's protected quotations.\129\ The Commission believes
that these proposed order types may offer participants greater
flexibility in the handling of their orders and are consistent with the
Act.
---------------------------------------------------------------------------
\127\ See supra note 34 and accompanying text.
\128\ See supra note 35 and accompanying text.
\129\ See proposed CHX Article 20, Rule 5(a).
---------------------------------------------------------------------------
2. Ranking and Display of Orders
Under the proposed rule change, all orders received by the Matching
System would be ranked by price, time of receipt, and any display
instructions.\130\ No distinction would be made with regard to agency
orders and professional or proprietary orders for priority
purposes.\131\ Orders would be displayed to the public when they
constitute the best round-lot bid or offer in the Matching System for a
security.
---------------------------------------------------------------------------
\130\ See supra notes 36-37 and accompanying text.
\131\ The Commission has approved similar priority rules for the
CHX's electronic book. See Securities Exchange Act Release No. 52094
(July 21, 2005), 70 FR 43913 (July 29, 2005).
---------------------------------------------------------------------------
Generally, incoming orders would be matched against orders in the
Matching System, in the order of their ranking, at the price of each
resting order, for the full amount of shares available at that price or
for the size of the incoming order, if smaller.\132\ However, orders
would be subject to the proposed provisions prohibiting improper trade-
throughs,\133\ and certain order types would be subject to specific
executions within the Matching System.\134\ Unless the terms of the
order direct otherwise, any order that could not be immediately
executed or executed in full would be ranked in the Matching System in
accordance with the Exchange's order priority rules.\135\ In addition,
the proposed rules provide that, unless a customer specifically
requests otherwise, institutional brokers would be required to clear
the Matching System before routing an order to another market, subject
to certain exceptions.\136\
---------------------------------------------------------------------------
\132\ See proposed CHX Article 20, Rule 8(d)(1).
\133\ See proposed CHX Article 20, Rule 5; see also supra notes
50-54 and accompanying text.
\134\ See supra notes 43-49.
\135\ See supra notes 40-41 and accompanying text.
\136\ See supra notes 72-74 and accompanying text.
---------------------------------------------------------------------------
The Commission believes that the proposed rules relating to
ranking, display and execution of orders are consistent with the
Act.\137\ In particular, the Commission believes that the priority
rules and automatic execution functionality should result in a more
efficient market and promote competition in the national market system.
Further, the Commission believes that requiring institutional brokers
to clear the Matching System
[[Page 59571]]
before routing an order to another market is consistent with previous
Exchange rules requiring members to ``clear the post'' prior to routing
orders to other markets, which also were intended to promote
interaction of orders on the Exchange.
---------------------------------------------------------------------------
\137\ The Exchange has represented that the Matching System
meets the requirements set forth in Rule 11a2-2(T) and therefore
complies with Section 11(a) of the Act. See text accompanying notes
79-80. The Commission notes that the Exchange has the obligation to
enforce the provisions of the Act, including Section 11(a)
thereunder.
---------------------------------------------------------------------------
B. Routing
The Exchange proposes to provide outbound routing services to
participants for orders submitted to the Exchange that cannot be
executed in whole or in part on the Exchange because of the trade-
through provisions of Regulation NMS. The Exchange will use its own
systems to determine when, how and where orders are routed away to
other markets. To provide the necessary connectivity to transmit such
orders to, and obtain executions on, other markets, the Exchange
proposes to use the services of a third-party broker-dealer. The
services would be provided pursuant to three separate agreements among
the Exchange, the participant on whose behalf orders would be routed,
and the third-party broker-dealer. The Exchange has represented that
its routing services would be provided in accordance with its rules,
the Act, and the rules thereunder. In particular, the Exchange routing
arrangements would: (1) Provide for the equitable allocation of
reasonable, dues, fees, and other charges among its participants and
other persons using its facilities relating to the routing services;
and (2) prohibit unfair discrimination among customers, issuers,
brokers or dealers in connection with the routing services.
The Commission received one comment letter regarding the proposed
rule change relating to routing services.\138\ In its comment letter,
OES asserted that the third-party broker-dealer described above would
operate as a system of communication of the Exchange and therefore
should be deemed a facility of the Exchange under Section 3(a)(2) of
the Act. In Amendment No. 2, CHX responded to the OES Letter and stated
its view that the third-party broker-dealer would not be a facility of
the Exchange.
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\138\ OES Letter, supra note 4.
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The Commission does not believe that the third-party broker-dealer
providing connectivity to other markets as described above should
necessarily be deemed to be a facility of the Exchange. Unlike the
broker-dealer addressed in the Commission's Order approving the Pacific
Exchange's rules establishing the Archipelago Exchange,\139\ the third-
party broker-dealer will not be owned by CHX or an affiliate of CHX. In
this case, CHX will use its own systems to determine when, how, and
where orders are routed away to other markets. Moreover, all of the
terms and conditions for CHX members to obtain outbound routing
services will be subject to CHX rules, which must be filed for approval
with the Commission. The CHX rules must, among other things, provide
for the equitable allocation of reasonable fees or other charges for
outbound routing services and must not permit unfair discrimination
among CHX members for access to the outbound routing services. CHX is
contracting with an unaffiliated third-party broker-dealer solely to
provide the necessary connectivity to obtain the execution of outbound
orders on other markets. Given this limited role, the third-party
broker-dealer should not be deemed a facility of CHX under Section
3(a)(2) of the Act. Accordingly, the Commission finds that CHX's
proposed routing arrangements are consistent with the Act.
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\139\ See Securities Exchange Act Release No. 44983 (October 25,
2001) 66 FR 55225 (November 1, 2001).
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C. Market Makers
Exchange market makers would be required to engage in a course of
dealings to assist in the maintenance, to the extent reasonably
practicable, of fair and orderly markets.\140\ Specifically, market
makers would have an obligation to maintain continuous two-sided quotes
for the securities in which it is registered, at prices reasonably
related to the prevailing market; to maintain adequate capital; and to
meet certain monthly quotation requirements.\141\ The proposed rules
also impose other obligations on market makers, including a requirement
to establish information barriers when engaging in other business
activities.\142\ These rules governing CHX market makers are similar to
other exchanges' rules previously approved by the Commission.\143\
Accordingly, the Commission believes that the proposed rules are
consistent with the Act.
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\140\ See proposed CHX Article 16, Rule 8.
\141\ See id.
\142\ See supra note 64 and accompanying text.
\143\ See, e.g., Nasdaq Rule 4613 and NYSE Arca Equities Rules
7.23-7.26.
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D. Institutional Brokers
Under the Exchange's proposed rules, institutional brokers would be
considered to be ``on the Exchange,'' and as such, customer orders
received by an institutional broker would be deemed to be on the
Exchange and immediately subject to the Exchange's rules.\144\ For
example, the proposed rules require that institutional brokers use an
electronic system, acceptable to the Exchange, integrating an
institutional broker's trading activities in the Matching System,
outside of the Matching System, and in other market centers.\145\
Additionally, because institutional brokers could execute orders
outside of the Matching System but still on the Exchange, the Exchange
has proposed rules to govern this activity.\146\ First, such
transactions would be required be reported to the Exchange within 10
seconds after the trade occurs. Further, the Exchange represents that
it has built a functionality to allow an institutional broker to pull
up a ``validation window'' to ensure that a trade being done outside of
the Matching System does not violate trade-through provisions. In
addition, to help ensure that trades outside of the Matching System are
not inconsistent with an institutional broker's fiduciary duties, once
an institutional broker pulls up a validation screen, it would be
required to complete the transaction and could not cancel out of the
functionality, subject to certain limited exceptions.\147\
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\144\ See supra note 137.
\145\ See proposed CHX Article 17, Rule 3(b).
\146\ See supra notes 68-71 and accompanying text.
\147\ See proposed CHX Article 17, Rule 3, Interpretation and
Policy .03. The institutional broker would only be permitted to
cancel out of the functionality if the broker mistakenly input the
wrong symbol for the security, or the transaction may be cancelled
pursuant to CHX Article 20, Rules 9, 10, or 11.
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The Commission believes that the proposed rules governing
institutional brokers should allow the Exchange to monitor
appropriately the activities of institutional brokers and to help
ensure that they are complying both with the rules of the Exchange and
their fiduciary duties. The Commission also believes that the proposed
rules will require the Exchange to carefully oversee the activities of
institutional brokers, and to detect any potential abuses. Accordingly,
the Commission believes that the proposed rules governing institutional
brokers are consistent with the Act.
E. Regulation NMS
The Commission believes that the proposed rule change is consistent
with the requirements of Regulation NMS.\148\ In proposed Article 20,
Rule 6, CHX proposes to adopt a rule with regard to locked and crossed
markets, as required by Rule 610(d) of Regulation NMS.\149\ The
Exchange's proposed rules include marking certain orders meeting the
requirements of Rule 600(b)(30) of
[[Page 59572]]
Regulation NMS \150\ as intermarket sweep orders and accepting orders
marked as intermarket sweep orders, which would allow orders so
designated to be automatically matched and executed without reference
to protected quotations at other trading centers. The Commission also
believes that CHX's proposed immediate-or-cancel functionality \151\ is
consistent with Rule 600(b)(3) of Regulation NMS. The Exchange has
designed its proposed rules relating to orders types and eligibility
\152\ and order execution \153\ to comply with the requirements of
Regulation NMS. As noted above, these proposed rules provide that the
Matching System will accept only orders (except for cross orders, as
discussed above) that meet the increment requirements of Rule 612 of
Regulation NMS (unless and to the extent exempted from Rule 612 by
Commission order).\154\
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\148\ See 17 CFR 242.600 et seq.
\149\ 17 CFR 242.610(d).
\150\ 17 CFR 242.600(b)(30).
\151\ See proposed CHX Article 1, Rule 2(m).
\152\ See discussion supra Section II.A.1.
\153\ See discussion supra Section II.A.3.
\154\ 17 CFR 242.612.
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In addition, as mentioned above in Section II.A, the Matching
System is designed to qualify as an automated trading center under Rule
600(b)(3) of Regulation NMS.\155\ To ensure that its systems
immediately and automatically process orders, the Exchange has included
in its rules a requirement that it use automated systems to send test
IOC orders to the Matching System to determine whether it accepts the
order automatically.\156\ Similarly, the Exchange will also use
automated monitoring systems to review, in real time, the Matching
System's handling of test IOC orders to determine whether, and within
what time frame: (1) IOC orders are executed against the displayed
quote, up to its full size; (2) any unexecuted portion of the IOC order
is cancelled; (3) a confirmation of the action taken is generated and
transmitted from the Matching System to the monitoring system (to serve
as a proxy for a transmission to the order-sending firm); and (4) the
Matching System transmits a new bid or offer (as appropriate) to the
monitoring system (to serve as a proxy for a transmission to the
appropriate securities information processor).\157\ The Exchange's
rules provide that it would automatically and immediately append a
``manual'' identifier to the bids and offers it makes publicly
available when it has reason to believe that it is not capable of
displaying automated quotations.
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\155\ 17 CFR 242.600(b)(3).
\156\ See proposed CHX Article 20, Rule 5, Interpretation and
Policy .02.
\157\ See proposed Article 20, Rule 5, Interpretation and Policy
.02.
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The Exchange has proposed a rule that renders an inbound round-lot
order ineligible for execution on the Exchange if such order would
cause an improper trade-through under Rule 611 of Regulation NMS.\158\
The Commission also notes that the proposed rules provide procedures
that the Exchange will follow to determine whether a trade would create
an improper trade-through and how the Exchange will apply various
exceptions to Rule 611 of Regulation NMS, including the self-help
exception.\159\
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\158\ See proposed Article 20, Rule 5(a).
\159\ See supra notes 51-53 and accompanying text.
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F. Other Rule Changes
In addition to the rules described in detail above, the proposed
rule change would adopt or amend a number of other Exchange rules that
address, among other things, hours of trading, trading halts,
cancelling transactions, trading permits, sponsored access, limitations
of liability, trade execution, Exchange registration, business conduct,
fingerprinting, reporting transactions, riskless principal
transactions, disciplinary matters and trial proceedings, arbitration,
books and records, clearance and settlement, and listing on the
exchange. The Commission believes that these rules are appropriate and
consistent with the Act, and many are similar to rules previously
approved by the Commission at other exchanges.\160\
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\160\ In particular, the Commission believes that the proposed
changes to the firm's supervision rules are appropriate and
consistent with the Act. See proposed CHX Article 6, Rule 5. The
Commission believes that these rules should help to ensure that
participant firms are adequately supervising their registered and
associated persons. The Commission also notes that these obligations
are similar to those required by other SROs. See, e.g., NASD Rule
3010 and Philadelphia Stock Exchange Rule 748.
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The Commission believes that the Exchange's proposed interpretation
to its trading ahead rule in CHX Article 9, Rule 17, confirming that a
participant would be deemed to be holding an unexecuted customer order
when that order has been sent to the Matching System but remains
unexecuted,\161\ is consistent with the Act. The Commission believes
that this rule appropriately confirms that a participant will remain
the agent for any customer orders that it submits to the Matching
System, and as such, will owe fiduciary duties to such customer orders
until they are executed.
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\161\ See proposed CHX Article 9, Rule 17, Interpretation and
Policy .05.
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The Commission also believes that the proposed interpretation
confirming that a participant would not be in violation of CHX Article
9, Rule 17 if it satisfied bids and offers in other markets in
accordance with the requirements for a ``cross with satisfy order'' is
consistent with the Act.\162\ The Commission notes that the conditions
of the cross with size order provide that a participant could only
satisfy bids or offers in other markets at a price that is better than
the cross price if the cross is for at least 10,000 shares or has a
value of at least $200,000 (a ``block size order'') or is for the
account of an institutional customer and the participant's customer has
specifically agreed to that outcome.\163\
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\162\ See proposed CHX Article 9, Rule 17, Interpretation and
Policy .06.
\163\ See supra note 20 (discussing cross with satisfy orders).
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IV. Accelerated Approval of Amendment No. 2
Under Section 19(b)(2) of the Act,\164\ the Commission may not
approve any proposed rule change prior to the thirtieth day after the
date of publication of notice thereof, unless the Commission finds good
cause for so doing. As set forth below, the Commission finds good cause
to approve Amendment No. 2 to the proposed rule change prior to the
thirtieth day after Amendment No. 2 is published for comment in the
Federal Register pursuant to Section 19(b)(2) of the Act.\165\
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\164\ 15 U.S.C. 78s(b)(2).
\165\ Id.
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The modification made by Amendment No. 2 to require a cross with
size to be larger than the aggregate size of all orders in the Matching
System at the same price, rather than larger only than the largest
individual order,\166\ merely retains--for the time being--a condition
for cross with size orders that exists in the Exchange's current
rules.\167\ The new provision to execute various types of cross orders
as crosses with size if they qualify as such\168\ simply builds in a
directive into cross orders generally that enables them to receive a
better execution if they meet the relevant requirements.
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\166\ See supra note 81.
\167\ See current CHX Article XXA, Rule 2(c)(4).
\168\ See supra note 82.
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The revision made by Amendment No. 2 regarding cancellation of
certain sell short orders improves the proposal by accounting for
situations in which an appropriate price cannot be determined for an
order of this type.\169\ The addition of the ``ISO Cross'' order type
makes explicit that a cross order, like other orders, may be appended
with ISO
[[Page 59573]]
instructions.\170\ The revision regarding new display instructions
\171\ changes only the method by which such an instruction would need
to be submitted, but alters no principle of priority included in the
original proposal.
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\169\ See supra note 83.
\170\ See supra note 84.
\171\ See supra note 86.
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Amendment No. 2 also improves the proposal by confirming the
circumstances in which the Matching System would display quotes that
would lock or cross the protected quotes of other markets,\172\ and
appropriately spells out that the Matching System will trade in
increments supported by the ITS or Regulation NMS linkage plan, as may
be applicable.\173\ Another provision adds clarity to how orders should
be identified, according to the proposed rules, when a trade is
executed pursuant to both the intermarket sweep order exception of Rule
611(b)(5) or (6) of Regulation NMS and the self-help exception of Rule
611(b)(1) of Regulation NMS.\174\ Other clarifying changes similarly
enhance the proposal.\175\
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\172\ See supra note 87.
\173\ See supra, note 88.
\174\ See supra note 89.
\175\ See supra notes 90-95 and accompanying text.
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Amendment No. 2 also incorporates a number of added restrictions
and requirements for market makers that set forth in more detail the
parameters by which market making may take place on the Exchange and
should aid in the prevention of abuses.\176\ In addition, Amendment No.
2 sets forth provisions requiring the Exchange to maintain internal
controls designed to restrict the flow of confidential and proprietary
information between the Exchange and the third-party broker-dealer
providing connectivity to other markets. The provision added by
Amendment No. 2 to permit ``qualified contingent trades'' to be
executed on the Exchange \177\ merely assures that market participants
would be able to benefit from the Commission's order exempting from
Rule 611(a) any trade-throughs caused by such trades. The revisions to
the text to reflect and conform to recent changes made as the result of
other, recently approved CHX proposals,\178\ as well as the technical
changes and corrections included in Amendment No. 2, raise no
substantive issues. Finally, a number of the changes mirror rules that
already have been approved for other exchanges.
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\176\ See supra notes 96-97 and accompanying text.
\177\ See supra notes 97-99 and accompanying text.
\178\ See supra note 101.
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For the above reasons, the Commission believes that the revisions
to the proposed rule change made by Amendment No. 2 pose no significant
regulatory concerns, and should not delay implementation of the
proposal. The Commission also believes that accelerated approval is
reasonable because it should help to ensure that the appropriate rules
are in place at the Exchange at the time that the CHX's final technical
specifications with respect to Regulation NMS must be published.
V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 2, including whether Amendment No. 2
is consistent with the Act. Comments may be submitted by any of the
following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or Send an e-mail to rule-comments@sec.gov. Please include
File Number SR-CHX-2006-05 on the subject line.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number SR-CHX-2006-05. This file
number should be included on the subject line if e-mail is used. To
help the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rule change that are
filed with the Commission, and all written communications relating to
the proposed rule change between the Commission and any person, other
than those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for inspection and
copying in the Commission's Public Reference Room. Copies of the filing
also will be available for inspection and copying at the principal
office of CHX. All comments received will be posted without change; the
Commission does not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly. All submissions should refer to File Number SR-CHX-
2006-05 and should be submitted on or before October 31, 2006.
VI. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\179\ that the proposed rule change (File No. SR-CHX-2006-05), as
amended by Amendment No. 1, be, and hereby is, approved, and that
Amendment No. 2 to the proposed rule change be, and hereby is, approved
on an accelerated basis.
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\179\ 15 U.S.C. 78s(b)(2).
\180\ 17 CFR 200.30-3(a)(12).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\180\
Nancy M. Morris,
Secretary.
[FR Doc. E6-16626 Filed 10-6-06; 8:45 am]
BILLING CODE 8011-01-P