Market Structure Rules
November 15, 2000
New Rules Requiring Public Disclosure of Order Execution
and Routing Practices
The Commission is adopting two rules, Rule 11Ac1-5 and Rule 11Ac1-6, to improve public disclosure of order execution and routing practices. Taken together, the rules should greatly increase the opportunity for public investors to evaluate what happens to their orders after they submit them to a broker-dealer for execution. In addition, by making more visible the execution quality of the securities markets, the rules are intended to spur competition among market centers and broker-dealers to provide the best possible price and speed of execution for investor orders.
In today's markets, investor order flow in the same security can be divided among many different "market centers" – e.g., exchanges, over-the-counter ("OTC") market makers, and electronic communications networks ("ECNs"). The primary structural component linking these market centers in the national market system is the consolidated public quote – the best displayed bid and offer for each equity security are collected from all significant market centers and disseminated to the public on a real-time basis.
This centralized source of information, however, does not clearly show the significant extent to which the quality of order execution can vary across different market centers. At some market centers, for example, as many as 50% of certain orders, particularly market orders for small sizes (less than 500 shares) are executed at prices better than the public quotes. Similarly, for investors seeking to use limit orders to obtain better prices than the public quotes, there can be wide variations among market centers in the opportunity for such orders to be executed.
At present, few market centers provide detailed public disclosure concerning their execution quality. In addition, there is no marketwide requirement that brokers disclose to customers where their orders are routed for execution. The rules adopted today are intended to remedy this lack of public information.
- Under Rule 11Ac1-5, market centers that trade national market system securities will be required to make monthly, electronic disclosures of basic information concerning their quality of executions on a stock-by-stock basis. Such information will include, for example, how market orders of various sizes are executed relative to the public quotes. Also, for the first time, investors will be informed not just about quoted spreads, but also about effective spreads – the spreads actually paid by investors whose orders are routed to a particular market center. In addition, market centers will disclose the extent to which they provide executions at prices better than the public quotes to investors using limit orders.
- Under Rule 11Ac1-6, brokers that route orders on behalf of customers will be required to disclose, on a quarterly basis, the identity of the market centers to which they route a significant percentage of their orders. Brokers also will be required to disclose the nature of their relationships with such market centers, including any internalization or payment for order flow arrangements, that could represent a conflict of interest between the broker and its customers. Finally, brokers must respond to the requests of customers interested in learning where their individual orders were routed for execution during the previous six months.
To address concerns that misuse of the information could pose a risk of meritless litigation, a "Preliminary Note" has been added to Rule 11Ac1-5 clarifying that the Rule is designed to produce general purpose statistics that will promote competition. It does not encompass all of the factors that may be important to investors. Accordingly, the Note states that the statistical information required by the Rule alone does not create a reliable basis to address whether any particular broker failed to meet its legal duty of best execution.
The first phase-in of the rules will begin on Monday, April 2, 2001. After the market center and broker information is made available to the public, all interested persons, including the financial press, independent analysts, consultants, and others, will be able to prepare analyses of order execution quality that respond to the needs and interests of individual investors. In time, improved public disclosure concerning order execution and routing practices should promote more vigorous competition in the markets to provide better prices to investors, as well as enable investors to make more informed decisions in choosing their brokers.
Market Structure Initiatives in the Options Market:
Adoption of New Trade-Through Disclosure Rule
and Changes to Quote Rule
Please note that effective December 27, 2002, the SEC repealed Rule 11Ac1-7, also known as the "options trade-through disclosure rule."
On November 15, 2000, the Commission will consider approving initiatives designed to better ensure that customers' orders for exchange-traded options receive best execution. The absence of effective access for one market to reach a better price displayed on another market, together with the recent expansion of multiply-traded options, has significantly increased the likelihood that a customer order may be executed at a price that is inferior to a price available on another market, known as an "intermarket trade-through." In fact, intermarket trade-throughs are estimated to occur in as many as 5% of all options trades.
To address the problem of intermarket trade-throughs in the options markets, the Commission has, for several years, encouraged the options exchanges to develop a linkage voluntarily. In October 1999, the Commission ordered the options markets to develop a linkage, and last July, the Commission approved the Linkage Plan proposed by the Amex, CBOE, and ISE.
Although a linkage plan offers significant advantages, the Commission is reluctant to mandate a linkage that may fail to adapt over time to changes in the markets and may impede the entry of new participants using different business models. Moreover, the Commission recognized that there might be a number of effective ways in which technology may be relied upon to decrease the likelihood of intermarket trade-throughs in the options markets. Consequently, the Commission authorized, but did not order, the options exchanges to participate in this linkage. All five options exchanges are now participants in this Linkage Plan. At the same time, the Commission proposed a flexible, market-based approach to reduce intermarket trade-throughs without mandating the means to achieve this goal. The Commission tomorrow will consider adopting a new Trade-Through Disclosure Rule and amendments to the Quote Rule, substantially as proposed.
- Trade-Through Disclosure Rule. The new Trade-Through Disclosure Rule would require a broker-dealer to disclose to its customer when that customer's order for an exchange-traded option was executed at a price inferior to the best-published quote. Notably, this rule would not prohibit trade-throughs. Instead, it is designed to ensure that the decision not to pursue publicly displayed superior prices is rooted in the interests of customers. A broker-dealer would not have to make this disclosure to its customers if it effects the transaction on an options market that participates in a linkage plan approved by the Commission that contains provisions reasonably designed to limit trade-throughs. The Linkage Plan approved by the Commission in July would need to be slightly modified for participants' members to be exempted from the disclosure requirements of the rule.
- Amendments to the Quote Rule. The amendments to the Quote Rule would require options markets' quotes to be firm up to their published quotation size for customer orders. This rule, which includes certain accommodations designed to reflect the unique structure of the options market, would ensure that these quotes would, in fact, be honored when orders are routed to them from other markets.