Report on the Practice of Preferencing

Table of Contents

Introduction

I. Background

A. History of Preferencing/Competing Specialist Programs on National Securities Exchanges

1. Competing Specialists on Exchanges: From the Late 1800s to 1991

a. Late 1800s to the 1975 Amendments to the Securities Exchange Act of 1934

b. Pacific Stock Exchange Competing Specialists (1976 - 1977)

c. New York Stock Exchange Competing Specialists (1976 - 1994)

B. The Cincinnati Stock Exchange's Dealer Preferencing Program (1991 - Present)

1. Background

2. Non-Preferenced Executions on the CSE

3. Description of the CSE's Preferencing Program

4. The Commission's Permanent Approval of the CSE's Preferencing Program in 1996

C. The Boston Stock Exchange's Competing Specialist Initiative (1994 - Present)

1. Background

2. Operation of the BSE's Competing Specialist Initiative

3. The Commission's Permanent Approval of BSE's Competing Specialist Initiative in 1996

II. Preferencing and Internalization

A. Internalization on National Securities Exchanges

B. Bypassing of Time Priority on Exchanges

1. Rules of Priority, Parity, and Precedence

2. Use of Precedence Based on Size to Bypass Time Priority

3. Crossing Orders

4. "Stopping" Stock Rules

5. Use of Marketable Limit Orders to Provide Price Improvement in Minimum Variation Markets

6. Percentage Orders

7. BSE's Competing Specialist Initiative and CSE's Preferencing Program

C. Off-Exchange Internalization: Third Market Trading

D. Summary

III. Preferencing and Agency/Fiduciary Obligations

A. Background - 1934 to 1975 Amendments to the Act

B. 1975 Amendments to the Act

C. Preferencing and Best Execution

1. CSE and BSE Permanent Approval Orders

2. Discussion

IV. Review of Order Handling Practices of Preferencing Firms

A. General Industry Order Routing Practices

B. Order Handling Practices of CSE Preferencing Dealers and BSE Competing Specialists

1. CSE Preferencing Dealers

a. Background

b. Order Handling Practices

c. Risk Management Procedures of CSE Preferencing Dealers

2. Boston Stock Exchange Competing Specialists

a. Background

b. Order Handling Practices

C. Execution Costs for Customers

V. Empirical Analysis of Preferencing Activity

A. Introduction

B. Data Description

C. The Quality of Market Quotations

D. Market Order Execution Costs and Price Improvement Statistics

E. Limit Order Execution Analysis and Dealer Routing Decisions

F. Conclusions

Tables

VI. Findings and Conclusions of the Study

Appendices

Appendix A: CSE Preferencing Pilot Program (1991 - 1996)

A. Commission Approval of the Initial CSE Preferencing Pilot Program in 1991

B. Extensions of the CSE Preferencing Pilot Program

C. CSE Request for Permanent Approval of the Preferencing Pilot Program

Appendix B: BSE Competing Specialist Initiative Pilot Program (1994 - 1996)

A. Commission Approval of the Initial BSE CSI Pilot Program in 1994

B. Extensions of BSE's CSI Pilot Program

Appendix C: Development of the CSE's National Securities

Trading System (1977 - 1990)

Appendix D: Detailed Data Description

Introduction

Section 510(c) of the National Securities Markets Improvement Act of 1996 ("NSMIA"), [Pub. L. No. 104-290, 110 Stat. 3416 (1996).] requires the Securities and Exchange Commission ("SEC" or "Commission") to conduct a study on "the impact on investors and the national market system of the practice known as `preferencing' on one or more registered securities exchanges" and specifies that the study include consideration of how preferencing impacts the execution prices received by retail securities customers whose orders are preferenced; the ability of retail securities customers in all markets to obtain executions of their limit orders in preferenced securities; and the cost of preferencing to retail securities customers. Section 510(c)(2) of the NSMIA requires the Commission to submit a report to the Congress on the results of the study by April 11, 1997. This report is submitted in accordance with that requirement.

For purposes of the study, the term "preferencing" is defined in Section 510(c)(3) of the NSMIA as "the practice of a broker acting as a dealer on a national securities exchange, directing the orders of customers to buy or sell securities to itself for execution under rules that permit the broker to take priority in execution over same-priced orders or quotations entered prior in time." The Commission notes that in its broadest sense, the term preferencing refers to the direction of order flow by a broker-dealer to a specific market maker or specialist, independent of whether or not some form of affiliation or inducement for thedirection of order flow exists between the broker-dealer and the market maker or specialist. [Internalization, a subset of preferencing broadly defined, is the direction of order flow by a broker-dealer to an affiliated specialist or order flow executed by that broker- dealer as market maker. See Securities Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 (September 12, 1996) at n.357 (File No. S7-30-95) (Order Execution Obligations Adopting Release) ("OEO Adopting Release"). ] Moreover, because specialists acting as dealers on national securities exchanges currently may execute customer orders without regard to orders or quotations entered on other exchanges prior in time, given that time priority is not maintained across markets in the national market system, any activity of a specialist who trades for his own account when there are preexisting same-priced orders or quotations on another exchange would be considered preferencing activity under the NSMIA definition of preferencing. Thus, it is important that Congress recognize that preferencing occurs on every exchange.

Nevertheless, the Commission has made the assumption that Congress intended the Commission to focus on preferencing practices that allow a dealer to take priority in execution over same-priced orders or quotations entered prior in time on the same exchange. As a result, much of the Commission's study examines both the Cincinnati Stock Exchange's ("CSE") dealer preferencing program and the Boston Stock Exchange's ("BSE") competing specialist initiative ("CSI"). [See Securities Exchange Act Release Nos. 37046 (March 29, 1996), 61 FR 15322 (April 5, 1996) (File No. SR-CSE-95-03) (order permanently approving CSE's preferencing program) ("CSE Approval Order"); 37045 (March 29, 1996), 61 FR 15318 (April 5, 1996) (File No. SR-BSE-95-02) (order permanently approving BSE's CSI) ("BSE Approval Order"). ]

Despite focusing much of the study on the CSE's and BSE's rules permitting preferencing, the Commission also examined many types of preferencing practices that have taken place on nearly all of the national securities exchanges since the adoption of the Securities Exchange Act of 1934 ("Act"), [15 U.S.C. 78a et seq.] particularly those that have had competing specialists on their trading floors at one time or another.

The report is organized as follows. Part I begins with a brief history of competing specialists on U.S. stock exchanges from the inception of the specialist function shortly after the end of the Civil War, through their longstanding presence on the floor of the New York Stock Exchange ("NYSE"), and up to and including the Commission's permanent approval of the CSE's preferencing program and the BSE's CSI. In addition, Part I contains a detailed explanation of the operation of both the CSE and BSE programs. Part II places the CSE and BSE programs in context by providing an overview of preferencing and internalization in the national market system as a whole and a description of various other practices on exchanges by which a broker may take priority in execution over pre-existing customer interest. Part III reviews a broker-dealer's obligation to achieve best execution of its customers' orders and examines how this obligation is influenced by the CSE and BSE programs. Part IV examines the order handling practices of firmsparticipating in the CSE and BSE programs, as well as the general order routing practices of both preferencing and non-preferencing firms. Part V consists of an economic analysis of CSE and BSE market quality and executions received by customers on these exchanges, and compares the results to those of other markets.

The Commission has concluded from the study that preferencing is but one method to internalize order flow, a practice that exists on all markets in various forms. Moreover, the Commission has found that, to date, preferencing has not had a deleterious effect on the national market system. To the contrary, preferencing has furthered the CSE's and BSE's ability to compete for order flow. Furthermore, the Commission has concluded that while preferencing raises significant agency-principal concerns, if the appropriate protections are in place, preferencing is not necessarily inconsistent with the best execution of customer orders. Accordingly, the Commission will continue to review the effects of the practice of preferencing on the national market system on an ongoing basis to ensure that this practice is consistent with the maintenance of fair and orderly markets, the protection of investors and the public interest, and the furthering of the national market system goals of Section 11A of the Act. [15 U.S.C. 78k-1.]

I. Background

A.History of Preferencing/Competing Specialist Programs on National Securities Exchanges

A specialist is an exchange member that "specializes" in the tradi ng of one or more stocks and has market making responsibilities for these stocks , including the maintenance of a continuous two-sided market in such stocks. [Un der the rules of the various exchanges, only a natural person is eligible to be registered as a specialist. On most exchanges, individual specialists have orga nized themselves into specialist units. Each unit is composed of one or more sp ecialist firms, which are legal entities ( e.g. , partnerships, corporations, or joint ventures) formed by specialists. Further, the rules of most exchanges provide that allocations of stock are made to specialist units, not individual specialists or specialist firms. See , e.g. , NYSE Rule 103B.] A specialist acts both as broker and dealer with regard to his or her specialty stocks. As broker, a specialist generally holds and executes market, limit, and stop orders forwarded to him or her by other exchange members. The specialist maintains a "book" of limit and stop orders that other brokers have entered with the specialist in his or her specialty stocks. As dealer, a specialist may trade for his or her own account against incoming buy and sell orders or orders on the book. Moreover, a specialist is also responsible for setting a fair opening price to clear accumulated market interest. [A specialist has the same obligation with regard to reopenings following intra-day trading halts.] A specialist's activities are circumscribed by the federal securities laws and exchange rules, which impose certainaffirmative and negative obligations on a specialist's dealings. [See , e.g. , Section 11(b) of the Act, 15 U.S.C. 78k(b), and Rule 11b-1 thereunder, 17 CFR 240.11b-1.; Amex Rule 170; and NYSE Rule 104A. For example, Rule 11b-1(a)(2)(ii), 17 CFR 240.11b-1(a)(2)(ii), requires that exchange rules provide that specialists have the affirmative obligation to engage in a course of dealings for their own account to assist in the maintenance, so far as practicable, of a fair and orderly market. Rule 11b-1(a)(2)(iii), 17 CFR 240.11b-1(a)(2)(iii) requires that exchange rules provide that specialists have the negative obligation to restrict their dealings, so far as practicable, to those reasonably necessary to permit the specialist to maintain a fair and orderly market. In addition, Section 11(b) of the Act limits a specialist's discretion by providing that a specialist may not effect as broker "any transaction except upon a market or limited price order."]

Currently, with the exception of the BSE, CSE, and the Pacific Stock Exchange ("PSE"), [Currently, the BSE trades 87 of its 2221 stocks on a competing specialist basis, while the CSE is a competing dealer market for all of its 568 stocks. Because the PSE maintains trading floors in Los Angeles and San Francisco, it utilizes a variant of the unitary specialist model in which two co-specialists coordinate a single market in a particular stock. The PSE has recently changed its name to the Pacific Exchange, and its acronym to PCX. However, to prevent any potential confusion, PSE has been used throughout.] U.S. stock exchanges are organized on the unitary specialist model. In this model, each stock traded on the exchange is allocated to a single specialist or specialist unit. Though this model may be the predominant one in use today, the specialist function developed in the context of a competing specialist model, in which there was more than one specialist making a market in a particular stock. Competing specialists have been present on one or more exchanges almost continuously from the development of the specialist system to the present. Further, in almost all instances where there have been competing specialists onexchanges, these specialists have engaged in the practice of preferencing, as that term is defined in Section 510(c)(3) of the NSMIA.

1.Competing Specialists on Exchanges: From the Late 1800s to 1991

a.Late 1800s to the 1975 Amendments to the Securities Exchange Act of 1934

In the years following the Civil War, the specialist function developed on U .S. stock exchanges in conjunction with the supplanting of the call market tradi ng format by the continuous two-sided auction trading format. [See Report of Sp ecial Study of Securities Markets, 88th Cong., 1st Sess., H.R. Doc. No. 95, pt.2 ("Special Study") at 61. In auction market trading, investors or brokers repre senting investors trade directly with each other as opposed to a dealer market i n which most trades are made through a dealer at the dealer's bid or ask price. In a call market, each stock is traded only at specific times during the day an d at one particular price, which is determined from the application of pricing r ules to the buying and selling interest accumulated up to the time of a call. Id. Conversely, in a continuous two-sided auction market, trades in a stock may take place at any time during an exchange's trading hours through competition among both buyers and sellers, which enter bids and offers for the opportunity to trade against contra- side interest as it arrives at the exchange. See also Division of Market Regulation, The October 1987 Market Break, at 4-1 n.1. An exchange's rules of priority, precedence, and parity determine which bids and offers are entitled to take part in a particular execution. See infra Part II.B.1 for a discussion on the various exchanges' rules of priority, precedence, and parity. ] The first specialists were primarily brokers, handling limit and stop orders for other exchange members, while such members moved among the various trading posts to those that were the most active at any particulartime. [See Special Study, supra note at 61. In this regard, The Twentieth Century Fund stated in its 1935 examination of the securities markets that: "[b]y 1910 most floor members, other than those representing commission firms, followed the practice of moving to any post which then seemed attractive. There were a considerable number of specialists in round lots and odd lots, who would do brokerage and dealing for their own account in other issues if time or opportunity afforded itself." The Twentieth Century Fund, The Securities Markets ("Twentieth Century Fund") (1935) at 405. ] The dealer function of specialists in their specialty stocks became more prominent after 1910, both as a result of other exchange members' need for a continuous market in stocks, particularly in those that were thinly traded, and through the increased opportunities that were available to specialists to make profits by trading for their own accounts due to the sizeable amount of order flow routed to them. [See Special Study, supra note , at 61-62 and 99-101. ]

Prior to the adoption of the Act, the NYSE had adopted a number of rules tha t circumscribed the conduct of trading by its specialists. First, the NYSE proh ibited a member, including specialists, from buying (selling) a stock for its ow n account to the disadvantage of, or before the execution of, an unexecuted orde r to buy (sell) that the member held on behalf of a customer. [See Stock Excha nge Practices, Hearings on S.Res. 84 Before the Comm. on Banking and Currency, 7 3d Cong., 1st Sess., pt. 15, at 6635, 6660 (1934) (statement of Richard Whitney, President, NYSE); similar statement at Stock Exchange Regulation, Hearings on H .R. 7852 Before the Comm. on Interstate and Foreign Commerce, 73d Cong., 2d Sess ., at 218. After the passage of the Act, the Commission formulated 16 rules gove rning the conduct of specialists and other floor members ("1935 Trading Rules"), which each of the exchanges adopted into their own rules, with some modificatio ns, by the end of 1935. See Securities Exchange Act Release No. 179 (April 17, 1935); SEC, Report on the Feasibility and Advisability of the Complete Segregat ion of the Functions of Dealer and Broker ("Segregation Study") (June 20, 1936), at Appendix O-1 (copy of the text of rules as proposed). One of these rules ex panded upon the NYSE's restrictions on a specialist's trading while the speciali st held a customer order as agent. Specifically, this rule prevented a speciali st from buying (selling) a stock for its own account (1) while holding an unexecuted customer market order to buy (sell) as agent; or (2) at a price equal to or lower than (higher than) a customer buy (sell) limit order on the specialist's book. Id. The specialist, however, was permitted to buy (sell) at a price higher (lower) than the customer's limit order . Id. See also NYSE Rule 92 (current version of rule).] Second, in 1910, the NYSE adopted a rule prohibitingspecialists from trading as dealer with a customer order on the specialist's book without obtaining the consent of the customer. [See NYSE Rules, Ch. XI, Sec. 1 (1927); Special Study, supra note , at 65.] The NYSE amended this rule in 1922 to permit a specialist to trade with a customer order on his or her book provided that the price was justified by market conditions and that the broker who entrusted the customer's order to the specialist was notified that the transaction occurred on a principal basis and accepted the trade. [See Special Study, supra note , at 65.] In 1932, the NYSE further amended this rule to require that prior to trading as dealer with a customer's order to buy (sell), the specialist must publicly bid (offer) the customer's order at a price 1/8 lower than the specialist's own offer (bid). [See NYSE Rules, Ch. XI, Sec. 1 (1932). See also NYSE Rule 91 (current version of rule). In addition, prior to pairing off, or crossing, two customer orders for execution, the specialist was required to make a bid (offer) on behalf of the customer order to buy (sell) at a price 1/8 lower (higher) than the specialist's offer (bid). See NYSE Rules, Ch. III, Sec. 13 (1927).] Finally, in 1934 the NYSE adopted a ruleprohibiting a specialist from disclosing, except to NYSE officials, any information with regard to orders entrusted to him or her as a specialist. [See NYSE Rules Ch. XI, Sec. 2 and Ch. XIV, Sec. 12 (1934). Compare Section 11(b) of the Act, 15 U.S.C. 78k(b).]

On the NYSE, the number of specialists increased significantly from 1910 to 1930. [There were 123 specialists out of a total of 858 active NYSE floor members in 1910; 169 specialists out of 871 members in 1920; and 352 specialists out of 1188 members in 1933. See Twentieth Century Fund, supra note , at 403 and 406. ] At least as early as the mid-1920s, any NYSE member seeking to become a specialist in a stock was first required to receive the approval of the NYSE's Committee of Arrangements. [See Id. at 428-29.] The Committee required the member to have made the appropriate provisions for carrying on a specialist business (e.g., arranging for clearance and settlement of trades, clerical help, and telephone connections) before he or she would be assigned a space at the post where the stocks that the specialist sought to specialize in were traded. [In practice, a member would only become a specialist in a stock if he or she had some floor experience and only in stocks in which there appeared to be a need for better service. Id. Among the Commission's 1935 Trading Rules were a prohibition against a member acting as a specialist in a stock without registering as such with the exchange and a requirement that a specialist maintain, for twelve months, records of all orders placed with the specialist in his or her specialty stocks. See Securities Exchange Act Release No. 179, supra note ; Segregation Study, supra note , at Appendix O-1.]

By 1936, the specialist system was utilized by nine of the 23 exchanges [Segregation Study, supra note , at 25-26.] registered with the Commission as national securities exchanges pursuant to Section 6(a) of the Act. [15 U.S.C. 78f(a).] The rules of the NYSE permitted more than one specialist to trade a particular stock. Stocks that were actively traded had up to six competing specialists, whereas one specialist was the norm in less actively traded stocks. [Twentieth Century Fund, supra note , at 404-405. On the NYSE as of 1933: 11 stocks had six specialists; 22 stocks had five specialists; 159 stocks had three specialists; 195 had two specialists; and 740 stocks had one specialist. Id. See also Segregation Study, supra note , at 5-6.] The Special Study suggested that over time floor brokers probably tended to give orders to those competing specialists who were willing to deal as principal when it was necessary to provide a broker with an execution at a price close to the last sale. [See Special Study, supra note , at 61-62 (adding that at one time, commission firms invited specialists to start competing books).] Furthermore, the Segregation Study noted that, in selecting a competing specialist with whom to entrust their orders, floor members generally preferred the specialist who "st[ood] ready at all times to narrow the quoted market and preventprice fluctuations." [See Segregation Study, supra note , at 41. ] Accordingly, the Segregation Study concluded that the competing specialist model provided the specialist with "an important incentive to maintain a fair and orderly market, viz, the desire to attract commission business." [Id.]

Each competing specialist in a stock maintained his or her own book of limit orders. These separate limit order books did not interact with each other. As a result, while time priority was maintained between limit orders at the same price on any given specialist's book, if there was more than one specialist making a market in a particular stock, time priority would not be maintained among all same-priced limit orders at that price on the exchange. [As was noted previously, the 1935 Trading Rules and predecessor rules of the exchanges utilizing the specialist system only prevented a specialist from trading for his or her own account while holding a same-sided customer market order at a price equal or inferior to that of a customer limit order on the specialist's book. See supra note and accompanying text.]

On the NYSE, the number of stocks that had competing specialists steadily declined after the passage of the Act in 1934, from 466 in 1933 to 37 in 1963. [See Special Study, supra note , at 62, and Table VI-3.] The Special Study associated this decline with the effect of certain Exchange regulatoryrequirements [In 1939, the Exchange began a program to compel specialists to become dealers, which the Special Study believed possibly resulted from the need of brokerage houses that were "faced with difficulty in obtaining good executions in that period of low volume." Id. This program included the institution of a specialist net capital requirement, which although considered "nominal," was vigorously enforced at its inception, leading to the demise of a number of specialist firms. Id. Contemporaneously, the Special Study noted that the NYSE withdrew the registration of some firms "for their failure to deal adequately." Id.] and allocation policies, [The Special Study cited a 1953 policy of the Exchange which did not allow the allocation of new stocks to one-member specialist firms, and did not allow any such ventures to be started. Id.] which resulted in a drastic reduction in the number of individual specialists and the concentration of specialist units over this period, [Since 1933, NYSE specialists increasingly have combined to form fewer, and larger, specialist units:

See Twentieth Century Fund, supra note 11, at 4 04; Special Study, supra note 10, at 67; Report of the Pr esidential Task Force on Market Mechanisms (January 1988), Study VI at VI-5. as well as a decrease in volume of trading per issue and the concentration of volume in the most active stocks. [The Special Study suggested the decrease in volume and concentration in active issues accentuated the importance of the dealer function, leading to thinner specialist books and less opportunity for specialists to earn brokerage income on their stocks, contributing to the decline in competing specialists on the NYSE. See Special Study, supra note , at 63-64.] By 1964, there were only twospecialists that competed with each other in two stocks on the NYSE, and there were no competing specialists at that time on the American Stock Exchange ("Amex"). [See Securities Exchange Act Release No. 7432 (September 24, 1964) (noting that the "absence of competing specialists [on the NYSE and Amex] makes an effective system of [specialist] regulation and surveillance particularly important").] In 1967 the last competing specialist disappeared from the NYSE floor. [Subcomm. on Securities, Comm. on Banking, Housing and Urban Affairs, Securities Industry Study, S. Doc. No. 13, 93d Cong., 1st Sess. (1973) ("Securities Industry Study") at 122 (citing Institutional Membership on National Securities Exchanges: Hearings on S. 1164 and S. 3347 Before the Subcomm. on Securities, Comm. on Baking, Housing and Urban Affairs, 92d Cong., 2d Sess. (1972) pt. 1, at 379 (statement of Robert Haack, President, NYSE)) ("Institutional Membership Hearings"). In 1972, the NYSE Board of Governors rejected an application by a specialist firm to be permitted to compete with another firm in the latter's 14 specialty stocks, maintaining that a recently-adopted NYSE initiative to improve specialist performance "should be given a trial period to see how effective it is before any alternative ways to achieve the same goals be adopted." See Securities Industry Study at 122 (citing Wall St. J. (January 21, 1972) at 4).]

b.Pacific Stock Exchange Competing Specialists (1976 - 1977)

In June 1976, the Commission approved a proposed rule change by the PSE to a dopt a six-month pilot program to permit competing specialists to trade on the E xchange in selected stocks. [See Securities Exchange Act Release No. 12578 (Jun e 25, 1976) (File No. SR-PSE-76-24) (order approving PSE competing specialist pi lot program on a six-month basis). As was noted above, by virtue of having two equity trading floors, the PSE already had (and continues to have) two co-specia lists in most of the stocks traded on the Exchange. Under PSE rules, a bid or o ffer that is clearly established as the first made at a particular price is enti tled to priority and has precedence up to the number of shares specified in the bid or offer, and each co-specialist is responsible for coordinating and synchro nizing orders and executions with the co-specialist on the other floor. See PS E Rule 5.8. The co-specialists coordinate the market in a stock and communicate with one another through dedicated telephone lines, and, as of October 1996, an electronic Consolidated Limit Order File, which allows each co-specialist to vi ew the orders on the other's limit order book.] ThePSE believed that consisten t with Section 11A(a)(1)(C)(ii) of the Act, [15 U.S.C. 78k-1(a)(1)(C)(ii). ] th e competing specialist pilot program would permit the PSE to test its ability to offer increased competition in selected securities. [The immediate impetus for PSE's adoption of its competing specialist program was to enable it to attempt t o establish itself as the primary market for BankAmerica stock, which began trad ing on June 28, 1976 and was initially listed on the Chicago Stock Exchange ("CH X"), NYSE, and PSE. On that date, the PSE had 17 competing specialists from 11 firms making markets in BankAmerica. See Wall St. J. (June 29, 1976) at 6. ] The PSE's program provided for the appointment of competing specialists, with r esponsibilities specified in the PSE rules, [See PSE Rule 5.35 (f) and (g) for a description of the responsibilities of PSE competing specialists.] in conjunc tion with the appointment of a book broker. [The proposal allowed for the appoin tment of a book broker on either or both of the Exchange's trading floors. See PSE Rule 5.35(c).] The book broker(s) would be responsible for operating the l imit order book and executing odd-lot orders and orders routed through the Exchange's automated order routing and execution system instocks traded on a competing specialist basis. [Under the PSE rules, a book broker was generally prohibited from engaging in principal transactions. See PSE Rule 5.35(e). Either at the request of a floor broker holding an order or whenever in the book broker's opinion the interests of a fair and orderly market were served, a book broker was obligated to call on the competing specialist(s) to make bids and/or offers or to narrow spreads in existing bids or offers or otherwise fulfill the responsibilities of a competing specialist. See PSE Rule 5.35(f).] The PSE's competing specialist program has been inactive since 1977, though the procedures pertaining to competing specialists remain in the PSE rules, and subsequently have been amended in conjunction with revisions to other PSE rules. [Securities Exchange Act Release Nos. 13458 (April 22, 1977) (File No. SR-PSE-77-6) (order approving PSE proposal to provide alternate capital requirements for competing specialists); 14549 (March 10, 1978) (File No. SR-PSE-78-3) (establishment of fee for participation in competing specialist or alternative specialist programs); 26878 (May 30, 1989), 54 FR 24616 (June 8, 1989) (File No. SR-PSE-89-05) (notice of proposal to increase capital requirements for competing and alternate specialists); and 26988 (June 28, 1989), 54 FR 28538 (July 6, 1989) (File No. SR-PSE-89-05) (order approving proposal to increase capital requirements for competing and alternate specialists).] It should be noted that the PSE continues to have competing specialists because the PSE has co-specialists in the overwhelming majority of stocks traded on its dual trading floors. However, as the PSE's rules require the maintenance of time priority between co-specialist quotes, the trading activity of PSE specialists does not strictly meet the definition of preferencing found in the NSMIA.

c.New York Stock Exchange Competing Specialists (1976 - 1994)

In adopting the 1975 Amendments to the Act, [Pub. L. No. 94-29, 89 Stat. 97 (1975) ("1975 Amendments").] Congress directed the Commission to facilitate the establishment of a national market system ("NMS") for securities. The legislative history to the 1975 Amendments asserted that the first priority in creating a NMS was to break down "unnecessary regulatory restrictions which now impede contact between brokers and market makers and which restrain competition among markets and market makers," [S. Rep. No. 75, 94th Cong., 1st Sess. 7-8 (1975) ("Senate Report") at 12-13.] and that developments in the markets had rendered a single specialist unable to serve the needs of both individual and institutional investors in a security. [Specifically, the Senate Report stated that "Committee investigations have adequately demonstrated that in our increasingly complex and institutional markets a single specialist...cannot provide adequate liquidity and continuity to the market for a security. To assure that markets are able to serve the needs of both individual and institutional investors, the Committee believes many types of market makers are necessary and that encouragement should be given to all dealers to make simultaneous competing markets within the [NMS]." Id. at 14.] As a result, the Commission undertook efforts to encourage the various exchanges to amend their rules to increase market making competition among their members.

Largely in response to the adoption of the 1975 Amendments and the Commissio n's subsequent efforts, in May 1976, the NYSE's Board of Directors endorsed a sy stem of competition between Exchangespecialists by reaffirming the ability of me mbers to register and act as specialists in stocks that were also assigned to ot her specialists. [Compare supra note .] In September 1976, the NYSE filed wi th the Commission certain procedures for the consideration of members' applicati ons to compete as specialists, which it characterized as a stated policy, practi ce, or interpretation not deemed to be a rule of the NYSE pursuant to Rule 19b-4 of the Act. [See Securities and Exchange Commission File No. SR-NYSE-76-43 (Se ptember 8, 1976).] The Commission believed that a number of the procedures wer e, in fact, changes in, or additions to, NYSE rules; accordingly, the Commission informed the NYSE that such procedures could not have any force or effect witho ut first receiving approval from the Commission under Section 19(b) of the Act. [Sections 19(b)(1)-(2) of the Act and Rule 19b-4 thereunder provide that a proposed rule change of a self-regulatory organization ("SRO") must be filed with and approved by the Commission. 15 U.S.C. 78s(b)(1)-(2) and 17 CFR 240.19b-4. However, Rule 19b-4 provides that a "stated policy, practice, or interpretation" of an SRO that is "reasonably and fairly implied" from an existing rule of the SRO is not considered a proposed rule change. Id. The specific NYSE procedures deemed to be a proposed rule change subject to the Commission's approval were: (1) an increased capital requirement for specialist units applying to compete; (2) a requirement that a unit must consist of at least five specialists in order to compete; (3) a review of the applicant unit's business history; (4) a provision that barred a competing unit that withdraws from competition from receiving new allocations for six months after such withdrawal; and (5) a training period applicable to new competing units. See Letter from George A. Fitzsimmons, Secretary, SEC, to James E. Buck, Secretary, NYSE, dated October 20, 1976 ("October 1976 Letter"). Further, the NYSE asserted that its existing rules regulating specialists were adopted contemplating the regulation of then- existing competing specialists, and therefore did not compromise the ability of specialists to compete. See Securities and Exchange Commission File No. SR-NYSE-76-43, supra note . In response, the Commission stated that while competition among specialists in the same stock was not technically prohibited under NYSE rules, the current NYSE rule structure may have imposed burdens on competition not justifiable in furtherance of the Act and "could ultimately frustrate efforts to introduce and maintain competition on the NYSE floor." See October 1976 Letter. ] However, theCommission's action did not preclude the NYSE from continuing to consider and approve applications to compete.

In October 1976, the NYSE approved an application by a specialist unit to compete in 18 stocks assigned to another unit. [A previous application to compete that was filed in June 1976 was later withdrawn following the break-up of the specialist unit facing competition and the division of its stocks among other units, including the applicant. The NYSE subsequently approved applications to compete in July 1977 and February 1978.] In February 1977, the NYSE submitted to the Commission a proposal to adopt procedures by which the Exchange would review and approve an application by a specialist unit to act as a competing specialist in stocks already assigned to another unit. [The NYSE's proposal to adopt its Procedures for Competing Specialists was noticed for public comment in Securities Exchange Act Release No. 13319 (March 1, 1977), 42 FR 13176 (March 9, 1977) (File No. SR-NYSE-77-6).]

Due to various regulatory issues raised by the proposal, the NYSE's competin g specialist proposal remained pending before theCommission until May 1986, [In the interim, the NYSE had rescinded NYSE Rule 114, which (1) required specialist units to be comprised of at least three active specialists, and (2) prohibited specialist units registered in the same specialty stock from entering customer l imit orders into a joint limit order book. The Commission believed that the res cission of this prohibition could contribute to an environment more conducive to competition among specialists as dealers, ameliorating physical constraints on the NYSE floor against such competition ( e.g. , new units might have been able to gain entry without the necessity of the Exchange providing additional facilit ies). See Securities Exchange Act Release No. 14147 (November 7, 1977) (File No . SR-NYSE-77-25). The Commission, however, requested the NYSE to furnish additi onal information as to its current rules governing the operation of multiple lim it order books in competing specialist situations, the adequacy of such rules an d whether additional rules were required and whether the NYSE believed that requ iring all competing specialists to enter limit orders into a single repository w ould further the purposes of the Act. Id. Additionally, in 1979 the NYSE adopte d a specialist evaluation program, under which a specialist unit that failed to meet minimum performance standards would be subject to a performance improvement action and, in the event of continued substandard performance, reallocation of one or more of its specialty stocks. See NYSE Rule 103A. Under Rule 103A, a s pecialist from whom a stock had been reallocated as a result of substandard perf ormance may register as a competing specialist in the reallocated stock. See S ecurities Exchange Act Release No. 15827 (May 15, 1979) (File No. SR-NYSE-77-24) .] when it was approved by the Commission on a six-month pilot basis to enable the NYSE to approve the registration of a competing specialist. [The NYSE stated that exigent circumstances caused the Exchange to approve the registration of a specialist unit to compete with another unit pursuant to the proposed procedure s, making it necessary for the Exchange to have Commission-approved procedures i n place to accommodate the unit's registration. See Securities Exchange Act Release No. 23202 (May 5, 1986), 51 FR 17424 (May 12, 1986) (File No. SR-NYSE-77-6) (order approving NYSE competing specialist procedures on a six-month pilot basis, effective May 2, 1986 through November 2, 1986).] However, the Commission required the NYSE to assess the adequacy of its rules as applied to competing specialists and develop during the pilotperiod appropriate amendments to its rules in order to accommodate competing specialist activity. [In this regard, the Commission delineated nine specific areas in which it believed such procedures should be developed: (1) the proper location on the floor of competing specialist units ( e.g. , whether they should be adjacent); (2) the routing of orders through the Designated Order Turnaround system to competing specialists; (3) opening prices and order imbalances at the opening; (4) methods for determining order imbalance trading halts; (5) trade and quote reporting and the display of quotes through the Intermarket Trading System; (6) the execution of limit orders in the same stocks held on each competing specialist's book, and application of the rules of priority, parity, and precedence under NYSE Rule 72 to the execution of such orders; (7) the participation of each competing specialist in block order executions under NYSE Rule 127; (8) the execution of various types of orders such as percentage and stop orders; and (9) the application of the specialist functions under NYSE Rule 104 to each competing specialist, including with respect to each specialist's affirmative and negative obligations. Moreover, the Commission anticipated that other NYSE rules and procedures may require amendments as the Exchange monitored competing specialist activity during the pilot. In addition, the Commission disagreed with the NYSE's statement that no further rule changes were necessary to accommodate competing specialist situations.]

The Commission subsequently extended the initial pilot program three times, through April 30, 1988. [See Securities Exchange Act Release Nos. 23869 (December 9, 1986), 51 FR 45417 (December 18, 1986) (File No. SR-NYSE-86- 31) (order extending pilot retroactively from November 1, 1986 for three months, through February 1, 1987); and 24183 (March 5, 1987), 52 FR 7721 (March 12, 1987) (File No. SR-NYSE-87-2) (order extending pilot through June 1, 1987). After an eight month lapse of the pilot, in February 1988 the Commission approved a proposal by the Exchange to reinstate the pilot until April 1, 1988. See Securities Exchange Act Release No. 25342 (February 11, 1988), 53 FR 5066 (February 19, 1988) (File No. SR-NYSE-88-01) (order reinstating pilot through April 1, 1988).] The Exchange requested the extensions to gain additional experience monitoring the activities of competing specialists before finalizing its responseto the questions posed by the Commission in the order originally approving the pilot program and submitting a request for permanent approval of its competing specialist procedures. [The Exchange's second request for extension of the pilot program indicated that specialist units had recently voluntarily withdrawn from a competitive situation. See Securities Exchange Act Release No. 24183, supra note .]

In September 1990, the NYSE submitted a proposal to permanently adopt procedures for the appointment and withdrawal of competing specialists. [The Commission noticed the NYSE's proposal for comment in Securities Exchange Act Release No. 28586 (October 29, 1990), 55 FR 46597 (November 5, 1990) (File No. SR-NYSE-90-46) (notice of NYSE proposal to adopt competing specialist procedures on a permanent basis).] The proposal included the Exchange's responses to the Commission's questions concerning the impact of competing specialist trading on certain NYSE rules. Moreover, the Exchange stated its belief that its responses were interpretations of existing rules that had been applied in previous competing specialist situations on the NYSE and that no formal modifications of its rules were necessary at that time to accommodate competing specialist trading. [In this regard, the Exchange believed that, in accordance with Section 19(b) of the Act and Rule 19(b)(4) thereunder, its responses were "stated policies, practices or interpretations" that were "reasonably and fairly implied" by existing NYSE rules and policies, and therefore were not deemed proposed rule changes under the Act. See supra note .] Consistent with its previous statements, the Commission disagreed with the Exchange's belief, given that the proposal would change significantly the existing trading procedures on the Exchange. [See supra notes and .]

In its response to the Commission's questions, the NYSE indicated that notwithstanding the existence of competing specialists, there would remain only one Exchange auction market in each stock subject to competition. Accordingly, the Exchange stated that its policies as to the execution of limit orders and the application of the rules of priority, parity, and precedence would remain unchanged. [See NYSE Rule 72. See also infra Part II.B.1.] The Exchange, however, would not require the maintenance of a unitary limit order book in a stock traded on a competing specialist basis. Therefore, limit orders at a particular price would not be executed on a strict time priority basis with regard to all such limit orders on the Exchange, but would only receive time priority with regard to other limit orders received by a particular competing specialist. [In addition, the Exchange stated that when acting as agent or principal or both, each competing specialist was to regard its competitor in the same light as it would a broker representing orders in the trading crowd, and that competing specialists may agree to "split" stock pursuant to NYSE Rule 72.20. See Id.] Further, Exchange policy provided that member organizations were to select (i.e., preference) the particular competing specialist unit that was to receive its Designated Order Turnaround ("DOT") system order business [If the member organization did not want to select a particular specialist unit, the NYSE would request the units to reach agreement on a means to handle the order flow. If such an agreement could not be reached, the NYSE would require the member organization to select a particular unit. ] and competing specialists in a stock were expected to disseminate a unitary quote through the Intermarket Trading System("ITS"), while the satisfaction of an incoming ITS commitment was the responsibility of the specialist making the bid or offer in question.

Commission staff, however, objected to the complete removal of a central limit order book on the Exchange for stocks that were to be traded on a competing specialist basis. The NYSE resisted the establishment of a unified limit order book for competing specialists, arguing that this would defeat the purpose of true competition between specialist units. In this regard, the NYSE argued that it was necessary for competing specialists to maintain separate limit order books so that each specialist could adequately represent its limit orders as agent. As the Commission and the NYSE were unable to resolve this issue, the NYSE subsequently withdrew its competing specialist proposal in September 1994 (three years after the initiation of the CSE's preferencing program). The NYSE's competing specialist program, if widely implemented, could have transformed the NYSE into a preferencing exchange as defined by Section 510(c)(3) of the NSMIA.

B.The Cincinnati Stock Exchange's Dealer Preferencing Program (1991 - Present)

1.Background

Established in 1885, the CSE is registered as a national securities exchange pursuant to Section 6(a) of the Act. [15 U.S.C. 78f(a).] Beginning in 1976, th e CSE changed its method of operation by phasing out its physical trading floor, automating its exchangeoperations, and adopting a competing market maker system . [See Securities Exchange Act Release No. 14674 (April 18, 1978), 43 FR 17894 (April 26, 1978) (File No. SR-CSE-77-1) (order approving CSE's National Securiti es Trading System on an initial nine-month pilot basis).] Trading on the CSE cu rrently is conducted through the National Securities Trading System ("NSTS& quot; or "System"), an electronic securities communication and executi on facility that interfaces with CSE member specialist workstations and order de livery systems in physically dispersed locations. [For a detailed discussion on the development of the NSTS from its inception in 1978 based upon predecessor systems to the initiation of the CSE's preferencing program in 1991, see Appendix C.] The NSTS combines a limit order file capable of being viewed by all NSTS "Users," [The CSE rules define a "User" as either a CSE member or an Approved Dealer, who may or may not be a CSE member. See CSE Rule 11.9(a)(5). An "Approved Dealer" is a Designated Dealer, a Contributing Dealer, or a specialist or market maker registered as such with another exchange with respect to a designated issue. See CSE Rule 11.9(a)(2). A Designated Dealer is a CSE member who maintains a minimum net capital amount and who has been approved by the CSE's Securities Committee to perform market maker functions by entering bids and offers into the NSTS. See CSE Rules 11.9(a)(3) and (b). During Exchange trading hours, a Designated Dealer is required to provide continuous bids and offers for round lots of his designated issues. See CSE Rule 11.9(c)(iii). A Contributing Dealer is a CSE member who maintains a minimum net capital amount and provides regular bids and offers for round lots of his designated issues. Currently, no CSE member is registered with the Exchange as a Contributing Dealer, nor are any NSTS terminals located on the floor of another exchange. See Securities Exchange Act Release No. 38117 (January 3, 1997), 62 FR 1480 at n.3 (January 10, 1997) (File No. SR-CSE-96-08) (order approving CSE Regulatory Circular re dealer quotation obligations) (citing Telephone Conversation between Jon Kroeper, Attorney, SEC, and Adam Gurwitz, Director of Legal Affairs, CSE, dated January 2, 1997).] the display of current CSE and national quotation and last saleinformation, and the electronic matching and execution of like-priced System interest according to programmed price/time and agency/principal priorities. [See CSE Rule 11.9(a)(1).]

CSE members approved to be Designated Dealers in NSTS are required to perform market making functions, including the provision of continuous two-sided markets in issues designated for trading in the System ("designated issues") in which they are registered. [See CSE Rule 11.9(a)(6).] Designated Dealers are also required to provide guaranteed executions for public agency market and marketable limit orders [A public agency order is defined as "any order for the account of a person other than a member, an Approved Dealer or a person who could become an Approved Dealer by complying with this Rule with respect to his use of the System, which order is represented as agent, by a User." See CSE Rule 11.9(a)(7). A marketable limit order is a limit order to buy (sell) that is immediately executable because the best offer (bid) available in ITS at the time the order is entered is equal to or better than the limit price on the order. See CSE Rule 11.9(c)(iv).] of up to 2099 shares at the ITS best bid or offer ("ITS/BBO"). [The ITS/BBO represents the highest bid and lowest offer available at a particular time among the market centers participating in the ITS that trade the stock.] If there is more than one Designated Dealer in a designated issue, the public agency guarantee obligation rotates among the Designated Dealers on a daily basis. [The Designated Dealer with the guarantee obligation is referred to as the "Designated Dealer of the Day." See CSE Rule 11.9(n). ]

As of April 1997, the CSE has 72 members and member organizations, including 13 Designated Dealers, seven of which participate in the CSE's preferencing program. With the exception of six stocks, the approximately 568 stocks eligible for trading on the CSE are stocks of NYSE-listed and Amex-listed companies that are traded on the CSE pursuant to unlisted trading privileges ("UTP") granted under Section 12(f) of the Act. [See 15 U.S.C. 78l(f).]

2.Non-Preferenced Executions on the CSE

Under the CSE's rules, Users may enter orders into NSTS in designated issues. NSTS executes orders that are not preferenced to a Designated Dealer based on price and time priority. [See infra Part I.B.3 for a description of trading by CSE preferencing dealers. ] All orders, and Designated Dealer bids or offers, entered into the System are queued for execution so that the highest priced bid or lowest priced offer entered earliest in time is the first to be executed. [The CSE rules, however, contain an exception to the time priority of public agency orders due to a Designated Dealer's guarantee to execute a customer limit order upon the occurrence of a transaction in another market at the price of the limit order. See CSE Rules 11.9(a)(10), (l), and (p).] In addition, all public agency orders are given precedence over professional agency orders, [The CSE rules define a professional agency order as an order entered by a User as agent for the account of a broker-dealer, a futures commission merchant, or a member of a contract market. See CSE Rule 11.9(a)(8).] and proprietary orders, bids and offers at the same price. [See CSE Rules 11.9(l) and (m). ]

Public agency market and marketable limit orders (other than preferenced ord ers) currently are executed in the following manner: [For a description of CSE d ealers' procedures for the handling of non-marketable limit orders prior to thei r execution, see infra Part IV.B.1.b.] A Designated Dealer or non-Designated Dealer User may enter a public agency market or marketable limit order into NSTS , which prices the order at the ITS/BBO at the time of its entry into the System . [A marketable limit order must be priced at the current ITS/BBO, because the e xecution of the limit order to buy (sell) at a price higher than (lower than) the ITS/BBO would constitute a trade through in violation of ITS trading rules. See CSE Rule 14.9 (ITS trade-through rule). NSTS automatically enforces the ITS trade-through rule for a marketable limit order to buy (sell) at a price higher than (lower than) the current ITS/BBO by pricing such an order at the ITS/BBO upon its entry into NSTS.] The order is first executed against any contra-side agency interest on the CSE's central limit order book at the ITS/BBO, and then against any principal interest at the ITS/BBO on the System (either in the form of a limit order on the CSE book or as represented in a dealer quote). If the order is of a size up to the lesser of 2099 shares or the quoted size at the ITS/BBO at the time of its entry into the System, any remaining portion of the order is executed against the Designated Dealer of the Day pursuant to the CSE's public agency guarantee. [See CSE Rule 11.9(n). Further, the Designated Dealer of the Day's obligation to execute such orders is reduced by the number of shares executed in the NSTS against any agency or principal interest, including that of the Designated Dealer of the Day, priced at the ITS/BBO at the time of entry of the order into the NSTS ( i.e. , the public agency order could be executed against both a Designated Dealer's quoted size at the ITS/BBO and in its capacity as Designated Dealer of the Day). See CSE Rule 11.9(n)(5).] If the order either islarger than 2099 shares [No portion of an order larger than 2099 shares is subject to the public agency guarantee. See CSE Rule 11.9(n)(4).] or the quoted size at the ITS/BBO, the remainder is exposed for 15 seconds to all Designated Dealers (whether or not they are registered in the designated issue involved) on their NSTS trading stations, priced at the ITS/BBO. Any unexecuted amount is formatted as an ITS outbound commitment and sent to the ITS participant displaying the ITS/BBO at that time.

Professional agency market or marketable limit orders are executed in the same fashion as public agency orders, with the exception that such orders are not eligible to be executed against the Designated Dealer of the Day in accordance with the public agency order execution guarantee. As with public agency orders, any amount of a professional agency order that is not executed against NSTS interest is formatted as an ITS outbound commitment and sent to the ITS participant displaying the ITS/BBO at that time.

A User who is a Designated Dealer may trade as principal in a designated issue in which it is registered [Designated Dealers may also trade on a principal basis in designated issues in which they are not registered, as long as such dealers comply with Section 11(a) of the Act, 15 U.S.C. 78k(a), and the rules and regulations thereunder. See CSE Rule 11.9(f).] by generating an order in the form of a commitment to trade for a specified numberof shares and entering it into the System. [NSTS automatically enforces the ITS trade-through rule for inter-dealer trades by rejecting any attempt by a Designated Dealer to enter a commitment to trade at a price inferior to the ITS/BBO. Compare supra note . In addition, a Designated Dealer currently may trade with another CSE dealer by changing either its bid or offer to lock the contra-side quote of another Designated Dealer.] These commitments to trade are first immediately matched with and fully or partially executed against any contra-side agency or principal limit orders on the CSE's central limit order book at the ITS/BBO. If no such interest exists, or there is any remaining unexecuted amount, the commitment then is executed against the contra-side bid or offer of any Designated Dealer(s) at the ITS/BBO, up to the size of the dealer's displayed quote. Any remaining amount would be rejected by NSTS and a notification to this effect would be sent to the dealer entering the commitment to trade.

3.Description of the CSE's Preferencing Program

The CSE preferencing program modifies the CSE's priority rules described abo ve to allow Designated Dealers participating in the program ("CSE preferenc ing dealers") to have priority over same-priced market maker or professiona l agency interest entered into the NSTS prior in time when the preferencing deal er is interacting with the public agency market and marketable limit orders it i s representing as agent. [See CSE Rules 11.9(l), (m) and (u).] Under the pref erencing program, CSEdesignated dealers send paired trades to the NSTS for execu tion. [The dealer may interact with public orders it represents as agent either by (1) taking the contra-side of the trade as principal ("paired order trade"), or (2) crossing the order with another customer order it represents as agent ("agency cross"). The majority of agency crosses are the result of a customer limit order resident in the dealer's proprietary system at the ITS/BBO, which is matched with an incoming contra-side market order. For example, if the ITS/BBO is 20 - 20 1/8, and a dealer holds a customer limit order to buy at 20, an incoming market sell order will be matched with that limit order because the dealer may not trade for its own account ahead of its own customer limit order. See CSE Rule 12.6(b).] These paired trades must be priced at or between the ITS/BBO. Before executing the paired order trade on the CSE, the NSTS replaces the dealer's side of the trade with any public agency limit order at the same price that is on the CSE's central limit order book. [NSTS will displace the dealer's side of the paired trade up to the size of the order(s) on the limit order book ( i.e. , the balance of the paired trade will remain intact and be executed). The NSTS follows the same procedure in the event of pre-existing public agency interest on the CSE central limit order book at the price of an attempted agency cross. Only one side of a paired order trade entered into NSTS is susceptible to being broken up by a public agency order, as NSTS would have automatically executed the buy and sell limit orders at the proposed trade price against one another (or contra-sided Designated Dealer interest) prior to the entry of the paired order trade. ] If there are no such public agency orders, the paired trade is executed, regardless of other prior CSE dealer quotations or orders at the same price. In this manner, the preferencing program ensures that preferenced orders still have an opportunity to interact with customer orders on the CSE's central limit order book, while permitting CSE preferencing dealers to match against their own customer orders when those orders wouldhave otherwise been executed against another professional.

For example, if Dealer A on the CSE is quoting at the ITS/BBO, preferencing Dealer B can still internalize its order flow (even if Dealer B is not quoting at the ITS/BBO) so long as Dealer B executes the order at the ITS/BBO (or better) and there is no contra-side public agency order in NSTS at that price. [In contrast, applying CSE's procedures for executing a non- preferenced trade on the CSE in this example, if there was no contra-side public agency order on the CSE's central limit order book, Dealer A would have time priority over Dealer B and customer order entered into NSTS would be executed against Dealer A. See supra Section I.B.2. ] If there is a public agency limit order in the CSE's central limit order book with priority, however, NSTS will automatically break Dealer B's paired order trade up to the size of the pre-existing public limit order on the CSE central limit order book. [But see discussion, infra Appendix A at note 26 and accompanying text (commenters' concerns regarding the lack of public customer interest on the CSE's central limit order book, and the CSE's response).] Dealer B's customer order then will be executed against the pre-existing limit order, with any remaining portion executed against Dealer B's side of the trade.

The CSE also has two order handling policies that apply specifically to preferencing dealers. The first policy is a price improvement policy applicable in greater than minimum variation markets, which requires preferencing dealers to either immediately execute a market order routed to it for execution on the CSE at an improved price or expose the order on the Exchange for a minimum of 30 seconds to allow other market participants an opportunity toprovide an improved price. [See CSE Rule 11.9(u), Interpretation and Policy .01. In exposing a market order on the Exchange for price improvement, a dealer "stops" the order ( i.e. , guarantees the execution of the order at the then-best inter-market price) in the event that the order does not receive price improvement. As part of its Order Execution Obligations proposals, the Commission had proposed a rule requiring that in markets where the difference between the best bid and offer is greater than the minimum trading variation, all market orders receive an opportunity for price improvement. See Securities Exchange Act Release No. 36310 (September 29, 1995), 60 FR 52792 (October 4, 1995) (File No. S7-30-95) ("OEO Proposing Release"). At the present time, however, the Commission has deferred taking action on the price improvement proposal. See OEO Adopting Release, supra note .] To comply with the policy, a preferencing dealer may either represent the order at an improved price in his or her CSE quote, or place the order on the CSE's central limit order book at an improved price.

The second policy is a limit order price protection policy that is designed to ensure that limit orders routed to CSE dealers for execution on the CSE receive timely executions relative to same-priced limit orders on the primary market for the security. [See CSE Rule 11.9(u), Interpretation and Policy .02. Under this policy, a public agency limit order routed to a CSE preferencing dealer for execution on the CSE would be filled if (i) the bid or offer at the limit price has been exhausted in the primary market; (ii) there has been a price penetration of the limit order in the primary market; or (iii) the stock is trading at the limit price on the primary market unless it can be demonstrated that such order would not have been executed if it had been transmitted to the primary market. The customer and the CSE dealer may agree to a specific volume related or other criteria for requiring execution of limit orders. ] This policy is substantially similar to limit order

price protection policies that have been adopted by other regionalexchanges. [The CHX and the BSE currently have limit order price protection policies nearly identical to the CSE's. See BSE Rules, Ch. II, Sec. 33; CHX Art. XX, Rule 37(a).]

4.The Commission's Permanent Approval of the CSE's Preferencing Program in 1996 [The CSE's preferencing program initially was approved on a six-month pilot basis in February 1991. See Securities Exchange Act Release No. 28866 (February 7, 1991), 56 FR 5854 (February 13, 1991) (File No. SR-CSE-90-06). Over the next five years, the Commission granted approval to a series of extensions of the CSE's pilot program. See Appendix A at note 5. For a detailed discussion on the CSE's preferencing pilot, including a summary of commentary received on the pilot and the CSE's response thereto, see Appendix A.]

On March 29, 1996, the Commission approved the CSE's preferencing program, as amended, on a permanent basis. [See CSE Approval Order, supra note .] In considering the CSE's request for permanent approval, the Commission had analyzed thoroughly the issues presented by the CSE's program, including the potential effect of preferencing on the execution of customer orders, competition among markets, and CSE market quality. This analysis involved a careful consideration of concerns raised by commenters, data submitted by the CSE and commenters, as well as the Commission's undertaking of its own data collection and examination. In approving the CSE's proposal, the Commission concluded that preferencing had improved CSE quotations and had added to the depth and liquidity of the CSE market. In addition, the Commission believed that the preferencing program, as supplemented by three order handling policies proposed by theCSE, [See Appendix A at notes 19-24 and accompanying text.] was not necessarily inconsistent with best execution of customer orders. [For a detailed discussion of the Commission's rationale for finding that the CSE's preferencing program is not necessarily inconsistent with best execution of customer orders, see infra Part III.C.1.] As a result, the Commission believed that the proposal, as amended, was consistent with the Act, particularly Sections 6(b)(5) and 11A. [15 U.S.C. 78f(b)(5) and 78k-1.]

The Commission believed that the CSE's adoption of an amended limit order display policy [See Appendix A at notes 22-24 and accompanying text.] and a primary market print protection policy [See supra note and accompanying text. See also Appendix A at notes 20-21.] addressed commenters' concerns that the ability of CSE preferencing dealers to internalize their own customer order flow provides them with an incentive to delay sending limit orders to the Exchange until they are marketable, thus depriving all orders on the CSE from the benefits of order interaction. In this regard, the Commission believed that these limit order policies should promote order interaction on the CSE through improved quotations and increased volume on the Exchange's central limit order book, as well as add to the quality of information displayed to the NMS. [The Commission noted that such orders will be included in the CSE consolidated quote and disseminated to the national market system, regardless of whether they were represented in the dealer's quote or placed on the Exchange's central limit order book. ]

Further, the Commission noted that while preferencing, and the resulting internalization of order flow by broker-dealers, may reduce order interaction on the CSE, preferencing does not inhibit dealers from providing executions of customer orders at or better than the ITS/BBO. In addition, the Commission noted that the CSE's proposed market order price improvement policy would prevent CSE preferencing dealers from internalizing market orders in greater than minimum variation markets without first executing such orders at an improved price or providing them with the opportunity for price improvement. [See supra note and accompanying text.]

The Commission also addressed the question of whether the CSE had made t he required demonstration that its preferencing program had added depth and liqu idity to the CSE market, and improved quotations. In response to the differing assertions made by the commenters and the CSE, [For a detailed discussion on the assertions and data submitted by the CSE and commenters, see Appendix A, at Sec tion C.] the Commission's Office of Economic Analysis ("OEA") evaluat ed CSE quotations and transactions before approval of the CSE filing. OEA's ana lysis found that CSE preferencing dealers often matched the NYSE BBO, and that t he percentage of time that the CSE quotes matched those on the NYSE was greatest for those stocks in which preferencing takes place. [During the time period con sidered in OEA's study, preferencing dealers accounted for more than 90% of trad es and 66% of share volume on the CSE. For the 281 stocks in which preferencing dealers accounted for 80% to 99% of total CSE trades, the CSE quote on average matched the NYSE best bid approximately 54% of the time and the NYSE best offer nearly 61% of the time. When matching at least one side of the ITS/BBO, the CSE' s quotation depth in these 281 stocks averaged over 720 shares. For all quotes in the 281 stocks, the CSE quotation depth averaged close to 900 shares.] The Commission concluded, based on the results of itsanalysis of the data submitted by commenters and the CSE, as well its own data analysis, [In response to concerns that CSE dealers' quotes do not add depth and liquidity to the NMS because they change too quickly for other market participants to react, the Commission noted that OEA analyzed the data regarding CSE quotations on a time- weighted basis, so that, unlike the figures provided by the commenters and the CSE, the results took into consideration whether the quotes at the NYSE BBO were short in duration relative to quotes outside of the NYSE BBO. In this regard, the OEA figures indicated that CSE dealers often quote at the NYSE BBO.] that the CSE's quotes compared favorably to those of the other regional exchanges and indicated that preferencing dealers had added depth and liquidity to the CSE market. [The Commission also believed that the CSE's amended limit order display policy could further add to the depth and liquidity of the CSE market. Specifically, display of limit orders could produce, among other benefits, quotes that more fully represent buying and selling interest in the market and enhance an investor's ability to monitor execution quality. The Commission concluded that this, in turn, should increase competition among CSE dealers based on their respective quotations.] The Commission, however, recognized that the quality of the CSE's market relative to other markets may change over time, and indicated that it would periodically review the practices of broker-dealers participating in the CSE's preferencing program. If the Commission found that a deterioration in their performance was evident, it would consider whether the CSE would need to discontinue the preferencing program, or take other actions toimprove the quality of market making on the CSE.

Finally, the Commission also removed the restrictions placed on the preferencing program during the pilot that limited the number of stocks that a single preferencing dealer could trade and prevented preferencing dealers from making cash payments for order flow. In this regard, the Commission concluded that these restrictions, which were put into place to allow the Commission to assess the effects of preferencing, were no longer necessary given the decision to permanently approve the preferencing program. [Contemporaneous with and after permanently approving the CSE's preferencing program, the Commission responded to numerous inquiries from Congress regarding the Commission's action. See Letter from Senator Alfonse D'Amato, Chairman, Committee on Banking, Housing, and Urban Affairs, to Arthur Levitt, Chairman, SEC, dated March 22, 1996 ( re consideration of proposal to approve CSE preferencing); Letter from Congressman Dingell, Ranking Member, Committee on Commerce, to Chairman Levitt, dated April 1, 1996 ( re permanent approval of CSE preferencing); Letter from [19 Congressmen], to Chairman Levitt, dated May 9, 1996 ( re permanent approval of CSE preferencing); Letter from Congressman Dingell, Ranking Member Committee on Commerce, to Chairman Levitt, dated April 18, 1996 ( re CSE trading in Lucent Technologies on April 4, 1996); Letter from Senator Christopher J. Dodd, Ranking Member, Senate Subcommittee on Securities, to Chairman Levitt, dated May 15, 1996 ( re CSE trading in Lucent Technologies on April 4, 1996); and Letter from Congressman Edward J. Markey, Ranking Member, to Chairman Levitt, dated June 12, 1996 ( re approval of preferencing).]

C.The Boston Stock Exchange's Competing Specialist Initiative (1994 - Present)

1.Background

The BSE is registered as a national securities exchange pursuant to Section 6(a) of the Act. Prior to the adoption of the Competing Specialist Initiative ("CSI") in May 1994, the BSE generally accounted for the smallest percentage of Consolidatedtape trades and volume of any regional exchange, with the exception of the CSE. As of April 1997, there were 30 specialists and 18 specialist units on the BSE, trading a total of 2,221 stocks. Six BSE specialist units participate in the CSI, each trading from four to 31 stocks on a competing specialist basis. Overall, 91 stocks currently are traded as part of the CSI.

The Boston Exchange Automated Communication Order-routing Network ("BEACON") is the BSE's securities communication, order routing, and execution system. [See BSE Rules, Ch. XXXIII.] The BSE rules provide for the guaranteed automatic execution of market and marketable limit orders from 100 shares up to and including 1,299 shares at the ITS/BBO. [See BSE Rules, Ch. XXXIII, Secs. 3 and 5(a). BSE specialists may alternatively provide an execution guarantee for orders of up to 2500 shares in specific stocks. See BSE Rules, Ch. XXXIII, Sec. 5(a). ] BEACON will expose a market or marketable limit order on the specialist's BEACON terminal for 15 seconds prior to automatically executing the order at the ITS/BBO to give the specialist the opportunity to improve the execution price of the order. [See BSE Rules Ch. XXXIII, Sec. 3(c). Moreover, a market or marketable limit order that would be executed outside of the primary market price range for the day in the stock will be manually handled by the specialist and receive an execution at the ITS/BBO or better as subsequent trades occur in the stock. See infra Part IV.B.2.b.]

2.Operation of the BSE's Competing Specialist Initiative

The BSE's CSI permits the appointment, in addition to theregular specialist, of competing specialists in stocks traded on the Exchange [Under the CSI, competing specialists have the same affirmative and negative market making obligations as regular specialists. However, the regular specialist remains responsible for coordinating all openings, reopenings, and trading halts to ensure that they are unitary.] and enables members to route order flow to a designated specialist for execution. A designated specialist may execute such order flow only if there are no limit orders then on the BSE central limit order book at the execution price and none of the other specialists are quoting at the ITS/BBO with time priority.

Under the CSI, BSE rules governing auction market principles of priority, parity, and precedence remain unchanged for quotes at the ITS/BBO. Specialist quotes that represent customer orders have priority over specialists' own quotes at the same price, and specialists quoting at the ITS/BBO have priority over specialists not quoting at the ITS/BBO. If two or more specialists are quoting at the ITS/BBO, the earliest bid/offer at that price has time priority and will be filled first up to its specified size. [This is in contrast to the CSE's preferencing program, which suspends time priority to allow preferencing dealers to have priority over same-priced professional interest, even at the ITS/BBO, when the dealer is interacting with public agency orders that it represents as agent. See supra Part I.B.3.] If the specialists are on both price and time parity at the ITS/BBO, all bids/offers equal to or greater than the size of the contra-side order are on parity and are entitled to precedence over smaller orders.

All limit orders transmitted to the BSE floor must be entered into BEACON, which maintains one consolidated limit order book for the Exchange and ensures that limit orders at the same price are kept in strict time priority, irrespective of routing designations. [Each specialist in a security has the ability to execute limit orders on the Exchange's consolidated limit order book through its BEACON terminal. ] Market and marketable limit orders routed through BEACON are automatically executed by the system against any contra-side orders on the consolidated limit order book. In accordance with the BSE rules governing BEACON noted above, however, before market and marketable limit orders are automatically executed by the BEACON system against contra-sided limit orders, they are exposed to the designated specialist for 15 seconds to give that specialist an opportunity to improve the price.

Under CSI rules, when there are no customer limit orders on the Exchange's consolidated limit order book at the ITS/BBO and none of the other specialists in the stock are quoting at the ITS/BBO with time priority, orders may be executed at the ITS/BBO or better by the designated specialist. Orders not directed to a particular specialist are automatically routed to the regular specialist for execution, except that the orders of a routing firm that is affiliated with a competing specialist are deemed to be designated to that member firm's affiliated specialist. This prevents member firms affiliated with a specialist from routing non-profitable orders to a non-affiliated specialist when marketconditions are unfavorable.

Until March 1997, a competing specialist had not been able to enter quotes directly into BEACON. Instead, the competing specialist had to orally communicate its quotes to the regular specialist, who would then enter the quotes into BEACON on the competing specialist's behalf. Further, BEACON presently routes orders that are not executed against BSE's consolidated limit order book to the designated specialist without systematically determining whether another specialist may be quoting at the ITS/BBO with priority. In addition, BEACON routes orders not designated to a particular specialist to the regular specialist, even though a competing specialist may be quoting at the ITS/BBO with priority.

To encourage competitive quoting by all specialists making markets in a stock, the BSE made a commitment to implement two BEACON systems enhancements. [See Letter from John I. Fitzgerald, Exec. Vice President, BSE, to Howard Kramer, Associate Director, SEC, dated February 29, 1996 (BSE agreement to complete system enhancements within one year from permanent approval of the CSI). See also Securities Exchange Act Release No. 36323 (September 29, 1995), 60 FR 52440 at n.26 (October 6, 1995) (File No. SR-BSE-95-14) (order extending BSE CSI pilot through March 29, 1996).] The first enhancement, implemented in March 1997, was to enable BSE competing specialists to enter quotes directly into BEACON. The second enhancement was to reprogram BEACON to route incoming orders to the specialist with priority on the Exchange at the ITS/BBO, or if no such priority has been established, to the designated specialist. The BSE has represented to the Commission that it will need additional time to

implement the second enhancement due to significant programming obstacles.

The Commission believes that the BSE's quote performance should improve as a result of its implementation of quote entry capability for competing specialists. In addition, the Commission will work closely with the BSE to ensure that the automatic routing of orders to the specialist at the ITS/BBO with priority is implemented as soon as practicable.

3.The Commission's Permanent Approval of BSE's Competing Specialist Initiative in 1996 [The BSE's CSI initially was approved on a one-year pilot basis in 1994. See Securities Exchange Act Release No. 34078 (May 18, 1994), 59 FR 27082 (May 25, 1994) (File No. SR-BSE-93-12). In 1995, the Commission granted approval to two extensions of the BSE's pilot program. See Securities Exchange Act Release Nos. 35716 (May 15, 1995), 60 FR 26908 (May 19, 1995) (File No. SR-BSE-95-07) (extension of BSE CSI pilot through October 2, 1995); and 36323 (September 29, 1995), 60 FR 52440 (October 6, 1995) (File No. SR-BSE-95-14) (extension of BSE CSI pilot through March 29, 1996 with clarification that BEACON limit orders are to be executed in strict time priority, allowing up to four competing specialists per stock, and increasing to 100 the maximum number of stocks in which each competing specialist could register). For a detailed discussion on the BSE's CSI pilot, see Appendix B.]

After careful review of the BSE's competing specialist program, including da ta submitted by the BSE and other sources, [See BSE, Competing Specialist Initi ative Report, submitted to the Commission on February 13, 1995 ("BSE February 19 95 Data and Report"); Letter from Karen Aluise, Assistant Vice President, BSE, t o N. Amy Bilbija, Attorney, SEC, dated April 28, 1995 ("BSE April 1995 Data"); Letter from Karen Aluise, BSE, to Glen Barrentine, Senior Counsel, SEC, dated Fe bruary 14, 1996 ("BSE February 1996 Data"). See also Letter from Robert Jenni ngs, Faculty Fellow and Professor of Finance, Indiana University School of Business, to Jonathan G. Katz, Secretary, SEC, dated June 30, 1995; and Letter from Robert Battalio, Asst. Professor, University of Notre Dame, to Jonathan G. Katz, SEC, dated March 6, 1996 (collectively, "IU Study").] the Commission determined in March 1996 thatpermanent approval of the BSE's program was consistent with the Act and the rules and regulations thereunder applicable to a national securities exchange. [See BSE Approval Order, supra note . The Commission received four comment letters on the BSE's proposal, two of which asserted that preferencing programs denied orders the benefits and protections of auction market trading, the other two included preliminary drafts of the IU Study. See IU Study, supra note . For a more detailed discussion of the IU Study, see Appendix A at note 29. ] In particular, the Commission believed that the program was consistent with Sections 6(b)(5) and 11A of the Act. The Commission also believed that while the BSE's program may increase internalization, it was not necessarily inconsistent with a broker-dealer's obligation to seek best execution of customer orders. [See infra Part III.C.1 for a detailed discussion of the Commission's rationale for concluding that the BSE's CSI was not necessarily inconsistent with best execution of customer orders.] In this regard, the Commission noted that the BSE's program provides incoming market or marketable limit orders with an opportunity to interact before a specialist can execute the orders against itself, while also providing an opportunity for price improvement for such orders before they are automatically executed. [These were the same enhancements that the BSE committed to implement pursuant to the SEC's permanent approval of the CSI. See supra note and accompanying text. Further, the Commission stated that the BSE program had enhanced order interaction on the BSE by increasing the volume of limit orders sent to the Exchange.]

The Commission noted that the data provided by the BSE during the course of the pilot indicated that trade and share volume for the Exchange overall increased during the CSI pilot. [The BSE reported that while for the month of December 1994 there were 171,075 trades and 106,753,284 shares traded on the Exchange, these numbers increased to 195,272 trades and 120,665,485 shares for December 1995. See BSE February 1995 Data and Report, supra note . The BSE also reported that the number of reports for all BSE trades to the Consolidated Tape Association also increased slightly since the beginning of the CSI. See BSE April 1995 Data, supra note .] The data indicated that competing specialists had received and executed a substantial amount of order flow in CSI stocks. [For example, the BSE's report for the last nine months of 1995 indicated that orders directed to a competing specialist accounted for 46% of total trades and 32% of total shares executed in CSI issues in April 1995, and increased steadily to 58% of total trades and 43% of total shares by December 1995. See BSE February 1996 Data, supra note . ] Moreover, the data showed that the depth of the BSE's consolidated limit order book in CSI stocks generally increased during the pilot. [Approximately 25% of the orders directed to competing specialists were limit orders. BSE April 1995 and February 1996 Data, supra note . In addition, between January - December 1995, between 12% and 21% of the orders directed to a competing specialist were executed against limit orders on the Exchange's consolidated limit order book. Id.]

In addition, the Commission stated its belief that the BSE's CSI was reasonably designed to facilitate competition among BSE specialists. In this regard, the Commission noted that a specialist could not execute directed order flow against itself if a competing specialist was quoting at the ITS/BBO, thus providing an incentive for specialists desiring to attract order flow to enter competitive quotes.

The Commission recognized, however, that the data was mixed in regard to whether the CSI had increased competition on the BSE. In this regard, BSE data had indicated that regular specialists executed less than 1% of the orders directed to a competing specialist. [See BSE April 1995 and February 1996 Data, supra note (data indicating regular specialist intercepts less than one percent of the order flow directed to competing specialists). ] The rules applicable to the CSI would have allowed regular specialists to execute a higher percentage of such orders if they had been quoting aggressively at the ITS/BBO. On the other hand, BSE data also indicated that the CSI may contribute to BSE's competitiveness within the NMS; specifically, during November 1995 BSE quotes matched at least one side of the ITS/BBO more often than in a comparable sample of BSE-traded issues in which there was a unitary specialist. [See Letter from Karen Aluise, Assistant Vice President, BSE, to Glen Barrentine, Senior Counsel, SEC, dated March 5, 1996.]

While the Commission noted that the data collected during the pilot indicated a lack of quote competition, the Commission anticipated greater quote competition once BEACON system enhancements were completed that would enable competing specialists to enter their own quotes directly into BEACON and provide for the routing of orders either to the specialist with priority at the ITS/BBO or if no specialist is at the ITS/BBO, to the designated specialist. [See supra note and accompanying text.]

For these reasons, the Commission determined to permanently approve the BSE's preferencing program. The Commission also removed the restrictions placed on the BSE CSI program during the pilot, [Specifically, these restrictions limited to four the number of competing specialists in each stock and to 100 the number of stocks in which each competing specialist could trade and prevented specialists from making cash payments for order flow in stocks in which they were registered as competing specialists.] concluding that such restrictions, which were put into place to allow the Commission to evaluate the effects of competing specialists on the BSE and the NMS, were no longer necessary.

II.Preferencing and Internalization

The NYSE's proposal for competing specialists, the CSE's preferencing program, and the BSE's CSI are three examples of programs that fit the definition of "preferencing" found in the NSMIA. The CSE and BSE programs, however, are not anomalous in the national market system. Indeed, many forms of preferencing have existed for quite some time across the various market centers. To understand the effect of the CSE and BSE programs, it is important to view them in the broader context of preferencing and internalization in the national market system and the various other practices by which a "broker [takes] priority in execution over same-priced orders or quotations entered prior in time."

As was noted in the Introduction, in its broadest sense, the term preferencing refers to the direction of order flow by a broker-dealer to a specific market maker or specialist, independent of whether or not some form of affiliation or inducement for the direction of order flow exists between the broker-dealer and the market maker or specialist. The definition of preferencing in the NSMIA appears to include only directed order flow that is internalized, [As was stated in the Introduction, internalization is the direction of order flow by a broker-dealer to an affiliated specialist or order flow executed by that broker-dealer as market maker. See supra note .] and to exclude the myriad of other arrangements to direct order flow to a particular market center.

The Act, the rules and regulations promulgated thereunder, and the rules of the various exchanges enable specialists to tradeunder certain circumstances as dealer with customer orders. [See supra note . ] Consistent with this regulatory framework, broker-dealers have established various means to internalize their customer order flow on exchanges, of which the CSE's preferencing program and the BSE's CSI are only two examples. Moreover, a number of large broker-dealer firms internalize their customer order flow in Rule 19c-3 securities, [See infra notes - and accompanying text.] third market makers internalize customer order flow in listed stocks, and internalization is commonplace in the over-the-counter market.

In addition, while the CSE's preferencing program may result in pre-existing customer interest that is represented in a preferencing dealer's quote at the ITS/BBO being bypassed by orders directed to other preferencing dealers, such a result is not unique to this program. In this regard, a number of practices under the rules of exchanges allow broker-dealers representing proprietary and customer orders to receive executions of such orders while preexisting customer interest in the trading crowd or the limit order book is bypassed.

The following discussion provides an overview of some of the means by which specialists or dealers can receive preferenced order flow, internalize customer order flow, and how broker-dealers can utilize exchange trading rules to bypass customer interest entered on the exchange prior in time.

A.Internalization on National Securities Exchanges

Specialists on all the national securities exchanges actively trade for their own account as dealer. The level of a specialist's participation as dealer in any particular stock by volume traditionally has been measured by two methods. The first method measures specialist trading in each stock by dividing the sum of a specialist's purchases and sales in the stock by twice the trading volume in the stock effected on the exchange. The resulting figure is commonly referred to as the twice total volume ("TTV") rate. [As the specialist can participate as dealer on only one side of each transaction, the maximum TTV rate is 50 percent.] The second method, referred to as the specialist participation rate ("SPR"), represents the total percentage of a stock's volume in which the specialist participates as either buyer or seller, and can be calculated by doubling the TTV rate.

In 1996, NYSE specialists participated as dealers at a TTV rate of 9.0% and a SPR of 18%, while Amex specialists participated as dealers at a TTV rate of 12% and a SPR of 24%. [In 1995, NYSE specialists had a TTV rate of 8.6% and a SPR of 17.2%. See NYSE 1995 Fact Book (May 1996) ("NYSE 1995 Fact Book") at 19-20. For the same year, Amex specialists had a TTV rate of 10.7% and an SPR of 22.14%. See 1996 Amex Fact Book ("1996 Amex Fact Book") at 20. ] The TTV rate and SPR of both the primary and the regional exchanges for 1996 were as follows:

Table II-1:Rates of Specialist Dealer Participation on Primary and Regional Exchanges - 1996

As the foregoing illustrates, specialist dealer activity is commonplace on both the primary and regional exchanges, though significantly more prevalent on the regional exchanges as measured by the percentage of trading volume effected by regional specialists. However, the amount of specialist dealer activity on the NYSE on an absolute share basis exceeds the total amount of shares transacted on all of the regional exchanges combined. In 1995, for example, NYSE specialists' purchases and sales amounted to approximately 15.05 billion shares, whereas the total combined regional exchange trading volume in NYSE-listed issues amounted to 10.61 billion shares. [Derived from data found in NYSE 1995 Fact Book, supra note , at 20 and 27. ]

Trading as dealer can be very profitable to specialists. It enables them to capture all or a portion of the spread between the bid and ask price for a stock. The more order flow a specialist attracts, especially retail orders which do not strain a specialist's liquidity, the more profitably a specialist can perform its dealing activity. Hence, all specialists, both on the primary and regional exchanges, attempt to attract as much retail order flow as possible. One of the most direct methods to accomplish this is for a broker-dealer to internalize order flow by routing customer order flow to an affiliated specialist unit. [In this context, an affiliated specialist unit is a unit in which a broker-dealer firm has a proprietary interest.] While the precise arrangements between broker-dealer firms and affiliated specialist units may vary across exchanges and firms, [See infra Part IV.A for more detailed descriptions of several existing affiliations between broker-dealers and specialist units.] such arrangements can result in significant benefits for the integrated firm as a whole and the affiliated specialist unit in particular. [It should be noted that various exchanges have rules pertaining to the adoption, maintenance and enforcement of Chinese Wall procedures to establish functional separation between upstairs firms and their affiliated specialist units. See , e.g. , NYSE Rule 98; Amex Rule 193; BSE Rules, Ch. 2, Sec. 36; and CSE Rule 5.5.] In this regard, a retail firm is likely to route most of its order flow in a particular security to the exchange on which it has an affiliated specialist unit dealing in the security. This directed order flow facilitates the marketmaking and, accordingly, the profitability of the specialist unit. [It is likely that a specialist will trade as dealer with orders represented by an affiliate at the same rate as that of its overall specialist participation on the exchange.]

So-called "upstairs" broker-dealers have affiliated specialist units on both the primary and regional exchanges. With regard to the primary exchanges, of NYSE's 38 specialist units, ten units, or 26.3%, are affiliated with upstairs broker-dealers. The ten affiliated specialist units on the NYSE trade 1061 of the 3308 securities traded on the NYSE (32.1%). As for the Amex, of its 13 specialist units, six units, or 46.2%, are affiliated with upstairs broker-dealers. These six affiliated units trade 403 of the 896 securities traded on the Amex (45%).

As the following table indicates, affiliated specialist units are even more prevalent on some of the regional exchanges than on the primary exchanges:

Table II-2:Affiliated Specialist Units on the Primary and Regional Exchanges - February 1997

Table II-3:Affiliated Specialist Units on the Primary and Regional Exchanges - 1994 [Division of Market Regulation, SEC, Market 2000: An Examination of Current Equity Market Developments ("Market 2000 Study") (January 1994), at Exhibit 29.]

Since 1994, the total number of specialist units on all of the exchanges combined has decreased, while the total number of affiliated specialist units on the exchanges has increased. The increase in the number of affiliated specialist units is especially marked on the primary exchanges. The overall number of stocks traded by affiliated units on the exchanges has increased, although the overall percentage of stocks traded that are traded byaffiliated units on the regional exchanges has decreased slightly. [This is due to the sizeable growth in the number of issues traded on the exchanges since 1994.] However, both the number and percentage of stocks traded by affiliated specialists on the primary exchanges has increased substantially.

Though the gap has closed significantly, on an overall percentage basis affiliated specialist units continue to be more prevalent and account for a higher percentage of stocks traded on the regional exchanges than on the primary markets. The nature of the trading environment on the regional stock exchanges provides significant incentives for large broker-dealer firms, particularly NYSE member firms, to purchase specialist units on these exchanges and direct their order flow to such affiliated specialists for execution. Specifically, the lower cost of obtaining a regional exchange membership and operating a regional exchange specialist unit, as well as the lower execution fees on the regional exchanges, has facilitated the purchase of regional specialist units by upstairs firms. The directed order flow from the upstairs firms to the affiliated specialist units consists mainly of small retail customer orders. [See infra Part IV.A.] Such order flow provides the affiliated specialist unit with a stream of orders that are easy to handle and which bolster the overall order flow of the specialist. Accordingly, the firm has the opportunity to make markets on a large percentage of these trades.

Moreover, off-board trading restrictions of the primary exchanges provide an additional incentive for the members of these exchanges to purchase regional specialist units. [See Market 2000 Study, supra note , Study III at III-10.] For example, NYSE Rule 390 prevents NYSE members from effecting certain transactions in NYSE-listed securities off of an exchange. [See NYSE Rule 390. See also Amex Rule 5. With the exception of the CSE, each of the regional exchanges also has off-board trading restrictions. See BSE Rules, Ch. 2, Sec. 23; CHX Rules, Art. VIII, Rule 9; PSE Rule 5.43; and Phlx Rule 132. ] The Commission has narrowed the scope of Rule 390 through the adoption of Rule 19c-3 under the Act, [17 CFR 240.19c-3.] which permits NYSE members to execute proprietary trades off of an exchange in securities listed after April 26, 1979 ("Rule 19c-3 securities"). [Prior to the adoption of Rule 19c-3, the Commission had narrowed the scope of exchange off-board trading restrictions by Rule 19c-1 under the Act, 17 CFR 240.19c-1, which enables exchange members to execute agency trades with a market maker who is not an exchange member.] On a practical basis, the purchase of a regional specialist unit allows a NYSE member firm to internalize its small retail order flow without violating the NYSE's off-board principal trading restrictions. [NYSE Rule 390. See also infra Part II.C for a discussion on NYSE member firms' internalization of their customer order flow in Rule 19c-3 securities and non-NYSE member firms' third market trading.]

In addition to broker-dealer proprietary relationships with affiliated specialist units, broker-dealers have entered into a variety of contractual joint venture arrangements with specialistfirms on most of the regional exchanges. In a typical joint venture arrangement, a broker-dealer will agree to route its small retail customer order flow to a primary or regional exchange specialist in return for a guaranteed percentage share of the specialist unit's trading profits. Additionally, in some joint venture arrangements, the broker-dealer also may agree to provide capital to the specialist unit in return for a percentage of revenues. [See infra Part IV.A. ] As a result, joint venture arrangements are functionally equivalent to affiliations through an actual proprietary relationship between the broker-dealer and the specialist unit. The following table illustrates the extent of joint venture arrangements on the primary and regional exchanges:

Table II-4: Joint Venture Specialist Units on the Primary and

Regional Exchanges - February 1997

B.Bypassing of Time Priority on Exchanges

1.Rules of Priority, Parity, and Precedence

Section 510(c)(3) of the NSMIA defines preferencing to include practices when a dealer takes priority over same-priced orders or quotations entered prior in time. As discussed below, there are different ways on the various exchanges in which priority is bypassed. Each exchange has rules of priority, parity, and precedence that determine the bids and offers that participate in a transaction and the sequence in which they do so. [See Amex Rule 126; BSE Ch. II, Sec. 6; CHX Article XX, Rules 14-18; CSE Rule 11.9; NYSE Rule 72; Phlx Rules 118-121; and PSE Rule 5.8. ] For those exchanges utilizing a physical trading floor, [With the exception of the CSE, each of the national securities exchanges uses a physical trading floor. ] once a trade in a particular stock occurs on an exchange, a new auction begins in that stock. All bids and offers must be reestablished, [There is an exception in the event that stock remains after the execution of the order. See infra note .] including any bid (offer) representing interest on the limit order book. Priority generally refers to the sequence of eligibility of bids and offers, while precedence determines the execution of bids and offers (i.e., orders with priority take precedence on the next sale at that price). Parity refers to a situation where there are simultaneous bids (offers) or an inability to determine time priority among bids (offers). Such bids (offers) are said to be atparity, or "on par" with one another. [It should be noted, however, that the NYSE and other exchanges utilize the term precedence to distinguish among bids at parity.]

Generally, priority and precedence among bids and offers are determined first by price (i.e., the bid (offer) at the highest (lowest) price has priority over bids (offers) at inferior prices, regardless of its time of entry, and is entitled to be executed first on the next sale). If there are two or more bids (offers) at the same price, priority generally is based on time of entry. The first clearly established bid (offer) at a superior price attains priority over subsequent bids (offers) at the same price, up to the size bid (offered). Because each trade closes the auction, all bids and offers that are reestablished are considered to be reentered at the same time, regardless of whether a bid or offer was previously announced but not executed. Thus, in this situation, a previously entered limit order will not take priority over a subsequently announced order in the crowd.

The exchanges take different approaches in determining which bids (offers) at parity are to be executed. Under the rules of the NYSE, BSE, and Phlx, once the bid (offer) having time priority has been executed, or when for some reason no bid (offer) has time priority, precedence is determined by the size of the bids (offers) in question ("precedence based on size" or commonly, "sizing out"). [Precedence based on size applies in two specific situations. First, any bid (offer) equalling or exceeding the amount of shares in an incoming contra-side order has precedence over all other bids (offers) at that same price and is entitled to the first execution at that price. If more than one bid (offer) equals or exceeds the size of the incoming order, all such bids (offers) are at parity. If the time sequence of their entry can be clearly determined, the bid (offer) made first in time is entitled to precedence, and will be filled. Second, if all bids (offers) are for amounts less than the size of the incoming order, precedence is accorded to the largest-sized bid (offer), and if any balance remains, the second largest-sized bid (offer) then is entitled to precedence, and so forth. If any two bids (offers) are for the same size and, if the time sequence of their entry can be clearly determined, they will be filled in that order. Otherwise, such bids (offers) will be on parity.] The Amex, CHX, and PSE do not utilize precedence basedon size, with an exception in the case of the Amex for orders to cross 25,000 shares or more. [One or both of the orders must be for the account of a member or member organization. See Amex Rule 126.01. See also infra notes - and accompanying text (Amex "clean cross" rule). ] Under the rules of these

exchanges, if no bid (offer) has price or time priority, all bids (offers) at the best price are at parity, regardless of size. [Pursuant to Amex Rule 126, a specialist who is on parity with the crowd and has an accumulation of agency orders on his or her book is entitled to a specific percentage of transactions that take place at the bid or offer price: 60% when one broker is entitled to match; 40% when two to five brokers are entitled to match; and 30% when six or more brokers are entitled to match. Until the Commission's recent approval of its codification into Amex Rule 126, this procedure was applicable specifically to openings pursuant to Amex Rule 108, but informally was applied throughout the trading day. See Securities Exchange Act Release No. 38238 (February 4, 1997), 62 FR 6591 (February 12, 1997) (File No. SR-Amex-96-39).] Whether or not an exchange utilizes precedence based on size, in the event there is no price or time priority and size precedence, bids (offers) at parity "match." In order to determine which bid (offer) is entitled to execution against an incoming order, those matching would "flip a coin (or match coins)," thewinner being entitled to the order up to the size of its bid, the loser receiving any remaining amount. Alternatively, the rules of most exchanges allow the members on parity to agree to split the lot of stock represented by the incoming order among themselves. In practice, this is what usually occurs. However, if any member of the trading crowd objects to a split, the rules of some exchanges require the members on parity to match for the lot.

2.Use of Precedence Based on Size to Bypass Time Priority

The practice of precedence based on size has a significant effect on the sequence in which orders are executed. Precedence based on size allows members with the largest-sized bid (offer) to receive an execution ahead of same-priced market interest that

otherwise would be on parity. The NYSE has justified this practice on the grounds that:

in the NYSE market it is often a practical impossibility to keep track of successive time priorities. To keep the market moving, giving bids and offers precedence based on size is often a practical necessity. [NYSE Floor Official Manual (June 1996) ("NYSE Floor Official Manual") at 38.]

At the same time, it should be recognized that "sizing out" confers a significant advantage to members representing large orders. In this regard, "sizing out" allows for such orders to receive an execution ahead of smaller market and marketable limit orders routed to the exchange. In addition, as all bids and offers must be reestablished after a trade, including the limit order book,

"sizing out" allows a broker-dealer to trade ahead of preexisting i nterest on the limit order book. [Under NYSE Rule 108.10, the specialist can com bine a bid (offer) for his or her own account with orders on the book to take precedenc